Lying rides upon debt's back. --Benjamin Franklin
The US and Europe are both in the game of reducing their Debt/GDP ratios. However, they have gone about it in dramatically different ways, and both have convincingly failed. The US has had no funding issues, and has issued debt in an attempt to kick start growth. Rates are at all time lows but growth has stalled and Debt to GDP ratios have risen from 40% of GDP in 2007, to over 70% now, as growth has lagged debt creation.
In Europe, which doesn't benefit from having the world's reserve currency, we see the exact opposite policy. The Eurozone's route is one of cutting both debt and spending in pursuit of fiscal austerity. The assumption is that Debt/GDP will fall as debt is reduced. This has also failed. Growth in the Eurozone has collapsed, and ratios have risen accordingly.
Both regions face considerable headwinds. The US faces the so called "Fiscal Cliff." The markets have largely ignored this but the implications for the US Economy are extremely significant. Left unresolved, it could lead to a negative 4-4.5% drag on GDP, while the opposite scenario, a permanent extension of the Bush-era tax cuts, and the suspension of the Budget Control Act of 2011 would lead to an explosion in the US Debt to GDP ratio, which would rapidly rise through 100%. While in Europe, we have the serious social, political and economic consequences of fiscal austerity. Unemployment is skyrocketing, especially amongst the young, while politicians lack the electoral mandates, and determination, to do what is required. Aggressive pursuit of austerity is political suicide; just ask Nicolas Sarkozy.
Into the breach have stepped Ben Bernanke's Fed, and Mario Draghi's ECB. Bond buying is the answer along with the concomitant ultra low rates. They have jointly enacted the biggest transfer of debt from the private to the public sector in history. Both the Fed and the ECB have used the word "unlimited". No matter what, both central banks will continue buying bonds until rates are at levels that they consider appropriate. The Fed is targeting the anaemic housing market, while the ECB is attempting to lower sovereign bond yields, to allow already extremely indebted Eurozone countries to issue even more debt, but at levels they can afford.
Irrational exuberance --Alan Greenspan
And how have the markets reacted? Quite conventionally actually. Asset prices have risen. The S&P 500 is now 200 points below its all time high having risen 250% since 2009, and the Euro Stoxx has risen 20% since Draghi's "whatever it takes" speech in London in late July.
So should we have confidence in this market rally? Categorically the answer is "no". Firstly the numbers don't stack up. In October 2007 when the S&P500 hit its all time high, gold was half the price it is today and the dollar index is actually higher today than it was in October 2007. This means that the S&P 500 in real (gold terms) is lower now than in 2011, let alone 2009 and miles lower than in 2007. A big red flag.
The markets are scattered with other divergent indicators. The P/E for the Russell 2000 has doubled relative to the Dow since Draghi's speech in London. Forward P/E's for the Russell 2000 were 9x the Dow last week. That's a record. That tells us that investors are chasing high beta performance. These current market tops have not been matched by the Relative Strength Index (RSI), and the broad NYSE Composite is not mirroring the strength in the S&P500, while the Bloomberg USA IPO Index has been declining since late 2010.
We are currently in a world where hope trumps reality. It seems that there are very few people these days who remember working through those mid 1990's markets, and who heard Alan Greenspan utter his fateful phrase "irrational exuberance". Never has a term been more fitting than for these late summer 2012 markets.
It's fashionable to make 'bet the company' decisions, but don't do it. --Joel Spolsky
First we had the "Greenspan Put", referring to Alan Greenspan's accommodative monetary policy from 1987 through to 2000. Then we had the "Bernanke Put", and now we have the "Draghi Put." Moral hazard anyone? I would argue that while recent events are being received positively by a market desperate for good news, the Draghi Put is a myth, and that we are engaging in the most dangerous example of "kicking the can down the road" in history. Let us hope we are not all sitting here in a year or two watching the financial system crash around us.
Consider this scenario. It's November 2012. The People's party in Spain have agreed structural reforms with the European Union. These include substantial austerity measures, and in return the ECB embarks on "unlimited" bond buying in the 2-3 year sector. Spain's funding worries evaporate as bond prices rally. Markets rally and the risk premium in European markets starts to decline. Italy quickly follows suit.
Roll forward 12 months. The ECB has bought over € 2 Trillion of Spanish and Italian Bonds. They have sterilised this via short term deposit actions and issuing 1 week CDs, so there has been no significant impact on the monetary supply. However, the austerity measures are biting in both Spain and Italy. Unemployment is rising fast; workers are on strike. In Italy snap elections are held. The Five Star Movement, Lega Nord and La Destra combine together under an anti Europe banner, and win enough votes to form a government. In Spain the Catalans and the Basques turn Euro-sceptic, followed by the Socialist parties and further snap elections are held, which are won by Euro-sceptic parties. Then both governments follow through, deciding to take the pain, leave the Eurozone, revert to the Lira and the Peso and default on all their debt. Can't happen? Spain and Italy will be denied access to the capital markets indefinitely? Tell that to Argentina. Indeed Greece has spent 50% of its time since independence in the 19th century in default.
What therefore would be the implications of this turn of events? Well, we have a bankrupt European Central Bank for a start. In addition, do you think banks will continue lending money to the ECB as snap elections approach? The ECB's Sterilisation policies would be in tatters. Rampant inflation in the eurozone anyone? If you think it would be bad for the Eurozone to fall apart now, wait until the ECB has been buying trillions of euros of debt for a couple of years. I won't even begin to speculate on the repercussions but I think we can all assume they would be catastrophic.
You think that is farfetched? In Spain 62% of people distrust the EU. Wait until austerity bites even harder. Unemployment amongst the young is at 50%. Spain in July saw € 94 billion withdrawn from Spanish banks, and in Italy the anti-Eurozone Five Star party is now the second most popular party and is now ahead of Berlusconi's People of Freedom. 34% of people in Italy are now actively dissatisfied with the European Union, the highest in Europe. It will not take much to go from dissatisfaction to distrust, and thence to a vote to exit.
What we are faced with is an economic crisis that can only be solved by politicians who do not enjoy the mandates necessary to do what is required. It is a dangerous and explosive mix, and by entering into it, the ECB is playing with fire. Herein lies the weakness of capitalism. It is administered by politicians. Capitalism would have seen the death of AIG, Morgan Stanley, Goldman Sachs. It would have seen Greece leave the Eurozone. Ireland would not have subjugated its entire population to save one bank. The equity and debt holders would have been left holding the can. It would have been very painful. We would probably be in a depression, but we would probably be seeing the light at the end of the tunnel by now rather than staring into the abyss. Look at the Icelandic example. A short painful deleveraging and devaluation, combined with fiscal austerity, is allowing Iceland to begin to emerge from its own crisis. If we are not careful, the mother of all "Black Swans" will soon be trundling over the horizon.
We seek to find peace of mind in the word, the formula, the ritual. The hope is the illusion. --Benjamin Cardozo
We don't have this scenario as our base case. Anemic growth, and a lost decade in Europe is probably more likely, as the European debt maturity ladder slowly rolls off. The Eurozone is in the throes of a managed recession. But a break-up scenario is more plausible than many would have you believe, while financial journalism, bar some notable exceptions, is currently neglecting its responsibility to report on the current situation objectively, which further contributes to the tail risk.
What therefore should you do? Well we are short equities, short the euro, short currencies that are running current account deficits, long gold and silver and receiving interest rates as rates are going nowhere soon. However here is the rub. The Draghi and Bernanke Puts are creating more not less tail risk, as the inflationary genii will soon be out of the bottle, and the reflationary implications when the economic situation does stabilise are going to wipe out the purchasing power of future generations. Inflation is not to be taken lightly, and it is hopelessly optimistic to assume that the Fed and the ECB will be able to curb inflationary expectations by a few interest rate rises. They are probably already behind the curve. So at some stage you need to be short US and European fixed income. And double up on that gold holding.
Think seriously about buying downside protection. Take profits. Very importantly, re-examine your asset correlations, your hedges, and look at the real tail risks residing in your portfolios. Fasten your seat belts. Stop staring in the rear view mirror and watch the road. The juggernaut might be coming. Don't be on the wrong side, and above all, do not rely on the Draghi Put.