A World Without Consequences

by: Eric Parnell, CFA


We are increasingly living in a world without consequences.

What was once true in financial markets has increasingly spread to the geopolitical stage.

The potential cost down the road for this apparent lack of accountability today could be extreme.

A contagion of global and potentially epic proportions is becoming more deeply embedded with each passing day. And the impact from this epidemic is both far and wide with a meaningful influence on global politics, acts of war and even financial markets. What is this global dilemma? It is the increasing realization that we are seemingly living in a world without consequences. Global actors with considerable weight, some of which have dubious objectives to say the least, are able to move freely without accountability. Moreover, these actors are likely feeling increasingly emboldened by the fact that each unthinkably controversial line crossed is apparently met with little to no response other than equivocation from those that are charged with the responsibility of maintaining order and formulating a response. While trying to ignore and delay dealing with the major geopolitical and financial problems besetting the world today may continue to provide the easy way out in the short-term, such disregard can ultimately lead to gravely disastrous costs at some inevitable point in the intermediate-term future.

So what do those of power, influence and ambition have to fear in the world today? A review of recent events suggests very little may stand in their way. And this sense of unchecked freedom in many respects has its genesis in the response to the financial crisis.

Financial Markets Without Consequences

It was nearly a decade ago that major global banking institutions were busy at work using the housing bubble to recklessly contrive complex financial instruments and insurance against these instruments for sale to global investors eager to purchase these supposedly high quality investments at attractive yields. Of course, the housing bubble eventually collapsed, and the global banking sector quickly found itself plunging into the abyss. In the process, well-known names such as Bear Sterns, Lehman Brothers and Washington Mutual ceased to exist, while others such as American International Group (NYSE:AIG), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) found themselves on emergency life support. At the darkest hours of the crisis in late 2008, central banks including the U.S. Federal Reserve understandably rode to the rescue with what were then extraordinary actions to save the global economy.

But all of this happened more than six years ago now. And where are we today so many years later? The global financial system was stabilized by early 2010, but what was once extraordinary and is now expected stimulus continues to freely flow to this day nearly six years later. But what about the consequences suffered by the major financial institutions that acted so recklessly in causing the financial crisis in the first place? Who has been held accountable as promised to the American people by then Fed Chair Ben Bernanke during his 60 Minutes interview in March 2009? And who of note has gone to jail like Enron's Kenneth Lay and WorldCom's Bernie Ebbers in the controversies that followed the bursting of the tech bubble that came before the financial crisis? The answer? Not only have there been no substantive consequences, these same financial institutions have been encouraged by persistently generous monetary policy to reengage in many of the same bad behaviors witnessed prior to the last crisis in 2007 and 2008. It has been the equivalent of instead of punishing the teenager that recklessly crashed their parent's SUV as a result of irresponsible behavior, giving this same teenager the keys to the faster sports car in the other garage bay. Sure the kid may have a lot of fun with the new faster ride along the way, but it is a story that unfortunately does not end well. And worse yet, it is a likely ending that is preventable if responsibility had been taught instead of a free pass being issued.

Such is the predicament facing global financial markets today. Yes, they are setting fresh new all time highs seemingly every month. But they are doing so not on the solid foundation of economic expansion and sustained earnings growth. Nor are they doing so supported by attractive valuations, as stock prices are expensive by many measures today. Instead, they are rising largely on the fuel of easy money from the Fed including the goosing of earnings per share through issuing debt for share buybacks. Speaking of debt, lending markets once again are rife with potential rot as borrowers of the most questionable credit quality are freely issuing debt again with covenants that are heavily tilted in their favor. In addition, margin debt to purchase stocks, while still below February's record highs, is still 15% above the peak levels prior to the last crisis in 2007. It will be interesting to see if margin debt has indeed peaked, and if so whether the experience that follows for stocks will be similar to what was seen following the past two margin debt peaks in September 2000 and July 2007.

Geopolitics Without Consequences

The sense that actions in financial markets are without consequences have increasingly spread to the global political stage in recent years as well. For when the sense of actions without consequence spills over into the geopolitical sphere, the eventual impact can stretch far beyond just money, as it can imperil national security and in the worst case scenarios can lead to anarchy in certain parts of the world. And such a geopolitical backdrop and its associated uncertainty are hardly the sound foundations for bullish financial markets in the long run.

The events in the Ukraine and the Middle East provide only the latest example of this deeply troubling global political trend. In late February 2014 following the Ukrainian Revolution, Russia invaded and subsequently annexed the Crimean peninsula. The world paused at the time to ponder the global response to Russia's actions. But other than some isolated sanctions and referendums, the Crimean situation has seemingly been left as an afterthought only a few months later. Instead, the crisis quickly spilled over to eastern Ukraine, where an armed pro-Russian separatist insurgency erupted in Ukrainian oblasts such as Donetsk and Luhansk. In the months since, the general policy approach has been that much like the conflict in Georgia from 2008; as long as the conflict remained confined between Ukraine and Russian supported separatists in Ukraine and did not spread to impact others that were not directly involved in the conflict, the global response would be limited to additional targeted sanctions and little more.

The notion that the crisis in Ukraine is an isolated problem quickly changed on July 17, however, with the shooting down of Malaysia Airlines Flight 17 allegedly by pro-Russian separatists in Ukraine supposedly using a Russian supplied Buk surface-to-air missile. Suddenly, the crisis in Ukraine had become a global issue as demonstrated by the list of innocent civilian casualties that were lost in the tragedy.

Malaysia Airlines Flight 17 Passengers by Nationality:

Netherlands - 193

Malaysia - 43

Australia - 27

Indonesia - 12

United Kingdom - 10

Belgium - 4

Germany - 4

Philippines - 3

Canada - 1

New Zealand - 1

(Note: The flight contained 12 passengers with dual nationality including three from Vietnam and one each from the United States, Australia, Belgium, New Zealand, Ireland, Israel, Italy, Romania and South Africa.)

The world understandably paused once again last week. The crisis in Ukraine had suddenly crossed the line to directly and terminally impact the lives of those not directly involved in the conflict. What would be the response by global leadership to this tragedy, and how swift would this action be? Investment markets also paused last Thursday to consider how this anticipated response might impact the global economy and financial markets.

Well since that time, stocks have rallied in three of the last four trading days and are already trading higher than where they were before the crash. Why? Markets have been assuaged at least so far in part because the global response to the downing of MH17 has been generally minimal. The United States has spoken mostly of how they would prefer Russian President Putin to respond without making any explicitly direct demands. As for European leaders, they have been reluctant to pursue more crippling economic sanctions against Russia for its alleged role in the tragedy recognizing that such actions would likely have a boomerang effect on their own economies given their dependence on Russia as an energy supplier and trade partner. And beyond the economic implications, not only have no new sanctions been issued, but investigators also met with resistance for several days afterwards in trying to secure what became a badly compromised crash site. In short, instead of reticence on the part of the actors, we saw further insubordination in the wake of catastrophe.

Before the downing of MH17, the consequences that might befall a country or a global leader for such an action was uncertain. But assuming the outcome would likely be negative, they would almost certainly seek to avoid such an event actually taking place. But what is the implied message for the global community in the aftermath of the tragedy? In short, a country can take actions that lead to the mass death of innocent civilians from around the world, and the response from global leadership will likely be little more than equivocation, delay and eventual sanctions that will do little to deter opposing global leaders from considering bolder steps in the future. After all, if there is no meaningful punishment for playing a crucial part in shooting down a commercial airliner, the natural question that follows is "what else can I get away with?"

The sense of no consequences is not limited to Russia. For in Iraq, a country in which U.S. military troops were stationed as recently as December 2011 following the U.S. led toppling of Saddam Hussein in 2003, the jihadist military group ISIS has swept its way through Syria and Iraq in recent months, claiming territory and declaring the establishment of a new caliphate in the process. This recent movement has included the acquisition nearly $2 billion of military and financial assets including roughly $1.5 billion in cash and gold bullion looted from the Mosul central bank and other banks in the city. The organization has also sought to reignite sectarian violence by targeting Shias in Iraq and has also moved to drive Christians out of occupied regions including some that have resided there for more than two millennia. But what have been the consequences from the global community for ISIS carrying out all of these bold actions in recent months? Essentially none to date.

What Is The World To Do?

All of this leads to the obvious next question. What exactly should the global community do to impose a sense of consequences in these and other crises unfolding around the globe? This, of course, is a complicated question with no easy answers. Why? Because these problems have been left to fester for so long that they have evolved to the point of erupting today.

This leads to the following very important point. In short, being proactive and moving in advance to prevent problems from taking place in the first place is far more preferable than being reactive and waiting to fix a problem in a scramble once it has finally erupted.

There is a dire cost to repeatedly "kicking the can down the road" when it comes to the problems facing the world today. Yes, it can be tough to let the global economy endure a recession every few years and even allow major financial institutions to fail in an organized way as a result of making bad operating decisions. And it can be even tougher to strategically station our military defenses to secure certain locations around the world that would otherwise be unstable without our presence, such as maintaining a status of forces agreement in Iraq after our 2011 withdrawal. But it is far worse to pretend these problems simply don't exist by either ignoring them or trying to paper them over with money printed out of thin air, for they eventually will present themselves in ugly fashion one way or another.

Unfortunately, actions taken by policy makers to try to make things better may have played a role in making things worse today. In regards to Ukraine, would we even be talking about the annexation of Crimea and a pro-Russian separatist movement today if endlessly easy global monetary policy from central banks did not induce hot money flows into emerging markets like Ukraine and contribute to the country being so burdened with bad debt that they had to spurn a trade agreement with the European Union and turn to Russia for emergency financial support, which ultimately helped incite the Ukrainian Revolution that followed. Yes, we have picked up roughly 650 S&P points thanks to the persistent flow of liquidity from the Fed since the summer of 2010, but has it really been worth it when economic growth remains sluggish and the negative spillover effects are continuing to build with each new dollar that is pumped into the system. Policy makers have had the chance to take action more prudent policy actions over the last several years to prevent future unintended consequences whether direct or indirect, and hopefully they will at minimum stay to their current course of tapering QE and not return to such actions in the future. As for the damage already done, we will only learn more about it in time. Such is the nature of unintended and indirect costs for unusually accommodative policy actions for far too long.

Investing In A World Without Consequences

Where does all of this leave the average investor? In the short-term, the answer continues to favor remaining long risk assets including the U.S. stock market (NYSPY). The uptrend remains firmly intact, at least for large cap U.S. equities. And until we see definitive evidence that the trend has changed and what is now the third longest bull market in history appears finally ready to draw to a close, it remains a more than reasonable approach to participate. This does not imply from a risk control perspective that one should fully allocate to stocks, as a partial allocation instead based on one's own risk tolerances is prudent in recognition of the current and growing challenges present in the current environment. The same risk aware principles hold true in the short-term for asset classes that are closely related to the stock market such as high yield bonds (NYHYG), senior loans (NYBKLN), preferred stocks (NYPFF) and emerging market debt (NYEMB). In short, continue to participate in a measured way, but remain cautious and on close watch for the earliest signals of any future change in the tides.

In the intermediate-term, the answer to the above question is likely to definitively change. At some still unknown point in the future, the current bull market in stocks will finally draw to a close and a new bear market will begin. And given the general lack of sustained economic growth and the currently high leverage levels in the market system coupled with historically high valuations and not only in stocks but other related asset classes suggests that the bear market that follows has the potential to be far more severe and prolonged than the historical average.

As a result, investors should increase their readiness to take evasive action at some point in the future with each additional point that the S&P 500 adds to the upside today. For at some point, the substantial costs of living in a world without consequences will finally come home to roost, and those investors that stand at the ready to act in advance of such a turn will not only benefit from having protected themselves but can also be positioned to capitalize when the time finally arrives.

Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author is long PFF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. I am long stocks via the SPLV and XLU as well as selected individual names. I also hold a meaningful allocation to cash at the present time.

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