WEIRD THINGS HAPPEN
2016-04-20 4pm EDT | #stocks #bonds #inflation #Volcker #Hugh Hendry #debt
It is easy to get caught up trying to trade the squiggles of the market. I am as guilty as anyone. Too often I mix time frames, desperately attempting to catch the next 25 handle move in the S&P instead of just focusing on the next 250.
So in the interest of reminding myself about my long term view, I will take a moment to sketch out my market beliefs.
Let’s start with debt. The amount of debt in the global financial system has long past the point where nations will be able to grow out of it.
When you hear someone argue the economy just needs time to organically grow out of the debt problem, you might as well stop listening to their overly optimistic pipe dreams. It ain’t going to happen. Period. Full stop. We have long past the point where we could grow out of our problem.
That leaves two solutions. We could have a massive 1929 style depression where debt is destroyed through a painful restructuring. Some really smart investors believe this outcome is inevitable. These deflationistas argue eventually the debt cannot be piled on any higher. At that point, the system implodes on itself in a deflationary collapse.
I am not completely dismissing this possibility, but I do not believe this is a high probability outcome. During the 2008 credit crisis, the global economy tried to contract through a debt de-levering. Although the world’s Central Bankers were slow to realize the seriousness of the contraction, after some frightful scares, they responded with a mammoth increase in monetary stimulus. They managed to stop the vicious circle of debt destruction. Yet in doing so, the previous trend of debt creation was returned in its full glory. Here is a chart I borrowed from the always entertaining Grant Williams:
Since the 2008 credit crisis, global debt has increased by $57 trillion! The answer to the question of whether the world’s Central Bankers will allow a deflationary debt cycle to take root is obvious. Well, at least, they will attempt to not allow it.
Recently it has become fashionable to believe Central Bankers are powerless to create inflation. I don’t buy that argument. Not for one second. In fact, the market’s doubt regarding the Central Bankers’ ability to create inflation is only causing these Central Bankers to force feed even more monetary stimulus down the economy’s throat. This will result in the eventual inflation being even greater than it had to be.
This line of reasoning might seem completely asinine to you. After all, deflation is the real problem and everyone knows it. All you need to do is look around the world at Central Banks’ inflation forecasts to realize the “true” danger lurking out there.
So let’s go over this. Everyone, including the Central Bankers, is convinced inflation will be stubbornly low for the indefinite future. Yet the economics professors in charge of the printing presses have told us they will not allow deflation in any form (and have already shown their willingness to do whatever it takes). But owning long duration fixed income at minuscule yields is the most popular investment out there? It makes no sense.
Actually it makes perfect sense. Investors are notoriously terrible at dealing with recency bias. What passes for investment analysis is often just extrapolation of current trends. This trend of lower inflation has been in place for a long time (30+ years), so it is tough for investors to imagine any different.
Over a trader’s lifetime there are only a few times when there are really big macro changes. Too often they are overlooked because everyone is staring at the screen worried about the next blip. Yet I believe we are on the cusp of one such change.
I have spoken about this before, but recently Hugh Hendry from Eclectica Asset Management did such a brilliant job articulating this phenomenon I took the time to transcribe his speech:
“In 1979 Volcker raised rates by 100 basis points on a Saturday morning. It was a different era of Central Banking. And again, thank goodness the world is dominated by strange things. Strange things keep happening. I call it irony and paradox, it sounds more intellectual. But it’s just weird.
You get a new Chairman of the Federal Reserve, and in a recession, he raises interest rates. He says I am a new sheriff. We’ve been lying to you. There is inflation. That’s the bad news. The good news is I’m going to kick it out of the system.
If we were to put ourselves in the shoes of speculators when you hear that announcement, what would you do? You would buy 10 year treasuries. What happened? 10 year treasuries collapsed. What else happened? The gold price went parabolic to the upside. Just weird. We live in a weird world.”
“We got another Central Banker that famously, or infamously, said in 2003, we cannot have deflation. I will print paper. I will use helicopters. I will spread it. We called him Weimar Ben. What happened? He was the Federal Reserve Chairman that resided over the lowest 10 year Treasury yield ever! Try my job. It’s hard because weird things happen.”
Hugh calls it weird, but I just call it myopic thinking. These long term trends do not change on a dime. But they do change, and it is often obvious to anyone willing to step outside the group think.
For all the investors out there hiding in fixed income and shorting all the asset classes that have been ripping for the past two months, I would be extremely careful.
Shorting US treasuries after Volcker cranked rates worked for a while too. But one of the greatest bond bull markets was born out of Volcker’s moves.
I am confident the same will be said in reverse from the actions of all of these desperate Central Banks. Shorting anything except fixed income is an extremely dangerous proposition in this environment. Maybe you catch a squiggle here or there, but all the surprises will be to the upside, not the other way round. Bet on inflation returning, not deflation.
Thanks for reading,