On the heels of my most recent piece, "The Commoditization of Everything," I wanted to provide an update based on recent developments. In particular, two topics have my gears turning: the Volker Rule and Government Discretionary Spending Freeze. Both resonate to my aforementioned article, which argues:
To pile on evidence of that central theme, consider a recent musing of Morgan Stanley's Cheif Economist, David Darst: 'Emerging Markets house 60% of the world's population. We've been overweight EMs for awhile now, but also consider byproducts of their potential demand, like the need for clean water: water is the next homerun.' His is truthfully a sound investment thesis, but I still shudder at the thought of a "water bubble." I can't help but picture it in an apolcalyptic light. Commoditizing water and putting it in the hands of Wall Street sounds like an [accidental?] means of population control. I digress....financial innovation has monetized so many vehicles to provide mass, exchanged-based access as outlets for ever-burgeoning liquidity. These vehicles were non-correlated assets once-upon-a-time... probably because there wasn't mass access to them via liquid exchanges. Nothing is sacred anymore, and that makes it real hard for anyone (institutional or retail) to hide from volatility.
Much of this rally is attributable to there being a rush of liquidity chasing a dearth of quality. That's not crucial to the thesis herein, but it's something to keep in mind. In context of the proposed Volker Rule: by simple supply/demand or simple market dynamics, what will happen when we eliminate the demand provided by prop trading desks? Who will replace their bid in open markets? Let's not forget that the Fed's swollen balance sheet already holds a huge supply of MBSs that will return to open markets soon. A glimpse of said balance sheet from ZeroHedge:
MBS are that red stack. Unless the Fed plans on holding until maturity (a lose-lose when you think about it), they're going to need buyers to absorb this stuff and prevent a systemic shock.
Some back of the envelope math:
Yes, the Volker Rule will reduce some supply by shuttering some hedge funds after preventing banks' investment in them... but then again, all that's doing is reshuffling their underlying assets at discounted prices. Hugely deflationary!Goldman Sachs alone reached a record $245mm Value-at-Risk in July 09. (VaR--the measure of how much money the firm could lose in a single day of trading--is a very loose estimate of the firm's proprietary activity if you assume that risk exposure from client transactions is offsets non-risk based prop activity.) That's almost $89.5 billion in demand that Goldman alone brings to the market annually. If you take those peanuts away from markets, then add $1.25t of additional supply from the MBS waiting on the Fed's balance sheet, you'll experience a supply shock on US Dollar denominated open markets.
To put those numbers into perspective, the worldwide stock markets were estimated at $35.6t in value as of 2008. (Derivatives markets are harder to nail down, but they're around $700t in notional value). Add up all the prop desks out there, all the bank investments in PE and hedge funds, and you're arriving at a multiple of that $89.5b Goldman example. Reguardless, when you start dripping trillions of dollars of supply into markets while sucking out demand at the same time, there will be a ripple.
Is this part of the Fed's strategy to syphon liquidity out of the system? Banks will redeem/liquidate investments prohibited by the Volker Rule. What will they do with the cash proceeds? Lend; deposit them with the Fed; or leverage up at the discount window to buy Treasuries. In the words of SNL's Sean Connery, "I see your game, you rogues." Well done Team Obama. But one caveat: why would you be syphoning liquidity when you're simultaneously teasing deflation? On top of it all, I think the prepayment risk inherent in Fed-owned MBS (refinancing of the underlying mortgages given historically low rates) is doing enough already to curb inflation.
Discretionary Spending Freeze
My political views aside, this is a well-intended proposal by the Obama administration--even if it's populist. It's nonetheless cosmetic. From Business Insider:
That chart shows that Government Discretionary Spending as a percent of GDP ("Other Government" in beige) has been in a three decade long redux, and it's projected to stagnate henceforth--even before Obama's intiative was leaked earlier this week.
I hate cliches, but just like the Volker Rule, the Discretionary Spending Freeze is closing the barn door when the horse is already in the next county. These are steps in the right direction though. Earnest talk of real solutions like this are long overdue. As I've said all along, the US economy needs to take its licks now, because perpetuating this scharade for another decade will only make retribution far more painful. Any good Ponzi-schemer knows that. (For my unborn childrens' sakes, please hear me!)
I see the dilemma; what President would want to be the one who starts the unwind? Maybe Obama has the guts. For what it's worth I think McCain had the guts too--out of a genuine love for his country. A real freeze in government spending would cut off a line of deficit spending that's the lifeblood of a mature economy in a secular fight to simulate growth.
Do I see an escape or a solution other than a hard-landing? Of course. Most global developed markets are facing the same demographic woes as the US. There's been a natural, real reduction in demand as a result of aging populations. Generally, these demographics won't turn over until 2020, at which time the US is projected to be the first country out of the population stagnation doghouse. That being said, I look around the international Fixed Income landscape, and I see very few strategic opportunities for soverign allocations beyond the Americas. Since risk has been transferred from consumers, to banks, to the Treasury/Fed, soverign solvency is the danger here. But, as long as the US remains one of the least sick patients in the infirmary, it can support ungodly debt-levels to finance its way through these doldrums.
In conclusion, the recent White House proposals look like the first Jenga logs removed from the American [Ponzi] tower. The disinflationary policy maintained since the '80s built that tower. Hopefully the Great Recession's Quantitative Easing added the last logs, because the higher the tower, the bigger and messier the crash.
Disclosure: FXP, SKF