central banks, moral hazard and the prospect for global markets

Central Banks, Moral Hazard and the Prospect for Global Markets

A N AUSTRIAN PERSPEC TIVE

P R E S E N T E D B Y: - P R A S H A N T K T R I V E D I , C FA

7/17/2014 © MULTI-ACT EQUITY RESEARCH SERVICES PVT. LTD 1

Consensus View-2015

• US - GDP was up by 3% per annum in the last quarter , the US should be on a normal growth path soon. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. With energy independence the US$ will be strong, keep bonds yield down; equities, with the Fed’s help appear to be the only game in town”.

• In short:Central Banks have helped us dodge a bullet and 2008-9 is for the history books

• China – China will slow down but GDP growth will remain at 7% p.a. and, in any case, if it goes lower, the authorities will bring on a “stimulus”.

• Europe – Mario Draghi’s “do what it will take” means the ECB will unleash their QE soon. Europe will turn the corner despite German “foot-dragging”. As proof, Spanish yields are down from 7.5% in 2012 to 1.65 % now.


Consensus

• Japan – Abe’s resounding election victory gives him the mandate to get Japan back on track, Abe will release his “third arrow” soon. Yen is sure to start going back down again, boost exporter profits and boost the Nikkei .

• India- With a slew of reforms in the Budget, the RBI poised to lower rates (they already did by 25 basis points in a shocker on January 15th 2015 ), “Ache Din to Zaroor Ayenge” and not just for Equity investors!

• In short, the “do whatever it will take” Central Banks have our back covered and equity prices can only go onward and upward !


It ain’t what you know…..

“It ain't what you don't know that gets you into trouble. it's what you know for sure that just ain't so”.

- Mark Twain


EUR-CHF


QE- A bullet dodged ? Or disaster in the making !

• QE 1- November 2008

• QE 2- November 2010

• QE 3 – September/December 2012 – US$ 85B per month.

• June 2013 /September 2013 “ The Taper/Untaper”- reduction in buying as a

prelude to elimination by Fall 2014

• OMT Summer 2012 “whatever it takes” Mario Draghi

• August 2010, August 2011 & in April 4th 2013, QE as part of “Abenomics”

• China – Total Social Financing has increased by USD 15 Trillion from 2008 to 2014

( US$ 9 T to US$ 24 T).



Review of QE


Credit to Private NF Sector

Source : Pie Economics

4/6/2015 © MULTI-ACT EQUITY RESEARCH SERVICES PVT. LTD. 9

Growth in Liabilities

What was QE intended to achieve ?

• Portfolio balance channel will induce investors to seek higher risk assets to compensate for the reduction in yield.

• Lower interest rates, will help boost consumption of “interest-sensitive” goods and foster capital spending by Corporates.

• Low interest rates will “induce” the Private Sector including Banks to start extending credit again.

• This will “jump-start” the economy, thereby reaching “escape velocity”, and bring on a virtuous cycle of economic growth


What has it achieved instead ?

• Encouraged “moral hazard”: a tendency to be more willing to take risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.

• Worked mainly in the financial sector and raised asset prices so that the “prospective return” on all assets is lower than the historical “required return”.

• Encouraged companies to issue debt and buy-back equity thus diluting “financial flexibility”, weakening balance sheets and hindering capital expansion.

• Diluted the credit structure of the economy through giving Ponzi financing units in the economy a new lease of life and creating new “Ponzi” units.



Hussman.. Prospective Returns

Source : John P. Hussman, March 24th 2014


GMO Prospective Return

Why is QE self-defeating ?

• "The problem with QE is that it works in practice but it doesn’t work in theory." Ben Bernanke, January 16th 2014

− It confuses a “stock” effect for what is in reality a “flow” effect ?

− Lowers “prospective” return below historical “required” returns, irrespective of growth in the

economy, the natural tendency once QE is halted is for asset prices to sink lower. Only timing

remains uncertain !

− Increases inequality between the top 1% and the bottom 99% and hence risks a severe

“backlash” from the electorate (and maybe even politicians at some stage).

− Increases “systemic” financial risk and increases prospects for Financial Instability, since the

impact on asset prices is at the margin but the entire “stock” is inflated !


Backlash of the “Ruling Class”

"Gentlemen! I too have been a close observer of the doings of the Bank of the United

States. I have had men watching you for a long time, and am convinced that you have

used the funds of the bank to speculate in the breadstuffs of the country. When you

won, you divided the profits amongst you, and when you lost, you charged it to the

bank. You tell me that if I take the deposits from the bank and annul its charter I

shall ruin ten thousand families. That may be true, gentlemen, but that is your sin.

Should I let you go on, you will ruin fifty thousand families, and that would be my

sin! You are a den of vipers and thieves. I have determined to rout you out, and by

the Eternal, (bringing his fist down on the table) I will rout you out.” Andrew

Jackson, 1832



“Revolt of the 99%”

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Source : Bob Hoye, Pivotal Events.

© MULTI-ACT EQUITY RESEARCH SERVICES PVT. LTD

Why is 2009 different from 1998?

• This time its Austrian !

• Private Sector in the developed world unwilling to voluntarily extend credit because credit quality

is very poor ! Low interest rates do not allow you to price risk properly in a portfolio.

• In order to prevent massive defaults , ZIRP needs to be maintained for the foreseeable future but

with diminishing effect in keeping asset prices high. They CANNOT do away with ZIRP without

causing massive defaults.At the first sign of a downturn there is a “rush for the exits” !

• For economists with an Austrian perspective, 2008 was not a sub-prime crisis gone “wild”, but

only the culmination of several flaws in the global monetary structure & various financial

processes in their terminal phases.


Flaw # 1 :an abscense of “Sound Money”

• Lack of a proper global “money” at the base of the financial structure -the absence of what Austrians term a “commodity” money is responsible for the build-up of “fiduciary media” beyond historical precedent.

• Central Banks hit the “zero-bound” of a process of targeting/administering lower interest rates as a panacea for economic slow down since 1987 and had to resort to QE, in order to have some semblance of a monetary policy to provide economic “stimulus”.

• Having resorted to QE, Central Banks are maintaining QE despite clear financial “bubbles” and economic dysfunction, because they realize that they are in a monetary “roach motel”, you can “check in-but you cannot check out” !


This time its Austrian

• August 14th 1971,Nixon abandoned the Gold Exchange Standard and the world ushered in an “all-fiat” money system.

• The absence of a “commodity” money at the base of a monetary system means “real” savings ≠ “real” investment.

• In a world of a “dirty-peg” floating rate and free of the “Gold Standard”, imbalances between countries can build up without any self-adjustment mechanism

• US “over” consumption/ Chinese “over”/mal-investment.


……………just a proliferation of “fiduciary media”

• Savings = investment in nominal terms, but the “financialization” of developed economies means it is not “real” savings; just the emission of “fiduciary media”: in Austrian terminology -liabilities masquerading as “money”.

• The ultimate back-stop of these “fiduciary media” and fiat money hence the Global credit structure, in extremis, is the US tax-payer and German tax-payer (for Europe) !

• The real value of these “fiduciary media” will need to be re-priced versus “real” money, once confidence in Central Banks is lost.



There is no such thing as “Savings Glut”

Real Investments=

RealSavings

“Savings Glut”=

“Fiduciary media”=

Liabilities=

Mal-Investment

Possible catalyst for QE to ended?

• Central Banks declare victory and gradually end QE . If it is a “flow” effect the end of QE and the end of “front

running” by market participants is enough to reverse the process.

• Central Banks admit defeat and end QE !

• Demographics exposes the absence of any tax payer back-stop and most of the entitlements as a “Ponzi” scheme

• Policy in China reverses from unbridled credit expansion, mal-investment and stimulus to one with the long term in

mind .

• Political “earthquake” of the 99% at election time. 2016 is the US elections

• Geopolitical landmines

• Russia/Ukraine

• Middle East and its impact on Energy prices


the “taper”…will they or won’t they ?

• So what are the prospects for financial markets?

• Where are the opportunities when we “normalize” ?

• Central Bank’s have made “credit” appear safer than it really is.

• Central Banks have suppressed volatility, bank on enormous volatility.

• If one is Long-Only, very hard-almost impossible- to visualize earning an absolute return

over the next 5 years.

• Investors will need to embrace long-short strategies to have even a chance of earning an

Absolute return

• Making positive returns will be about investing in Business Models and Balance Sheets !

• Asset Classes will behave idiosyncratically and NOT as they have done historically since

Post WWII


Implications for Asset Classes - Global

• Cash – Highest Quality Cash Asset is Gold.

• Why? Gold is the only monetary asset that is no one else’s liability

• Bonds – Net Creditors-both Sovereigns or Corporates

• Equity – High Quality Equity : Sound Business Models and Balance Sheets.

• Real Estate- Location. Location. Location.

• Need to be at the highest Quality end of each asset class to ensure that a portfolio declines relatively the least.


India- the Bad news and the Good news !

India – there is both bad and good news…..

but the bad news is that the bad news is likely to be experienced before the good news !



Low Household Financial Savings

• Low Real interest rates have deterred savings in financial products which have declined since 2008. Financial products primarily consists of fixed income securities in India.

• Negative real interest rates may have lead to preference towards “Physical Savings”, primarily real estate, which have also shown significant appreciation over the last few years.

• Gold is not considered as part of savings in National accounting calculations, but treated as consumption. Higher imports of gold would also have contributed to lower financial savings to some extent over last 2 years.


New Capex

New capex as a % of GDP is currently at one of the lowest point in the available history of the data.Source: CMIE

Credit Structure-PSU Banks


Source : Multi-Act

The Good News

India is the largest private holder of gold stock in the world. If Gold gets re-priced the

“real” wealth effect and relative boost in purchasing power/consumption to the rest of

the world will be material and significant.


…..some other money manager quotes…

……Fed-induced speculation does not create wealth. It only changes the profile of returns over time. It redistributes wealth away from investors who are enticed to buy at rich valuations and hold the bag, and redistributes wealth toward the handful of investors both fortunate and wise enough to sell at rich valuations and wait for better opportunities.

- John P Hussman, March 24th , 2014

“With so much dry kindling, it will not take much to spark the next conflagration…Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets…Central banks should normalize crisis-induced policies as soon as possible. Financial markets will, of course, object loudly.” Stephen Roach..December 29th 2014


………..a few more quotes

''….Next bust will be unlike any other…..Over the next seven years we think the market will have negative returns. The next bust will be unlike any other because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before.”

- Jeremy Grantham, GMO, March 2014

"that first tapering discussion we got a very strong market response... remember tapering is still slowing the rate of increase, we are still increasing the balance sheets." Just the discussion of lowering the rate of increase of the balance sheet crashes the market. On Gold: “It is still by all evidences the premiere currency where no fiat currency, including the dollar, can match it…But it's also got a monetary characteristic which is intrinsic. It's not inbred into human beings. I cannot conceive of any mechanism by which you could say that, but it behaves as though it is”

Alan Greenspan,October 2014 interview.


Mark Twain

October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February."

- Mark Twain


DISCLAIMER

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central banks, moral hazard and the prospect for global markets

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