SOME TREES GROW TO THE SKY

SOME TREES GROW TO THE SKY

Miracles do happen or so the herd seems to think at various times in history. That’s why groupthink takes over, ‘liquidity’ momentum trades, regardless of value, call the shots and asset bubbles can be blown out of all proportion. Once you’re in such a phase, it feels like it could last forever. Nobody knows how long a ‘buying stampede’ can last, even if it is a rare one, which has already lasted twice as long as the typical one in history. As long as the primary trend is considered to be up, it may have years left to run! Riding the crest of a long wave is the fastest way to lose any perspective of what usually happens next. Every cycle turns eventually, for whatever reason, and it’s suddenly a whole new ball game.

This whole new ball game is devastating for most. Very few dare to stop playing, before disaster strikes. Most prefer to wait around and become sitting ducks. Whenever historic bubbles burst, with ensuing declines of 90% in a relatively short period of time, unthinkable hard times are bound to follow. Those responsible for letting things getting out of hand, because they lacked the guts to put a stop to it, will have left the scene long before the ‘miracle’ turns into a nightmare. The dream of a ‘free lunch’ will again have dissipated.

The intended consequence of overly lax monetary policies, like Zero or even Negative Interest Rates plus Quantitative Easing (QE), is the destruction of savings. A sustainable economic growth model has to be based upon a pool of savings, which has been painstakingly accumulated over time. If it’s increasingly dependent on credit growth, then this growth model cannot survive, without an everexpanding level of credit to pay the interest on previously issued liabilities. Eventually, this model will hit the wall, because sufficient additional credit cannot be created, which is bound to lead to a capital shortage. Hard to believe, when liquidity today seems to be ‘abundant’!

We now live in very dangerous, unstable times, because unsound money and credit are dominating the global capital markets. Policymakers have designed an artificial world to keep the show on the road, as the global economic growth cycle, for a variety of reasons, has experienced a secular slowdown since its peak 14 years ago, in 2000. But the next phase could well consist of global capital markets going into deep freeze, bank holidays, capital controls, some kind of Debt Jubilee and a collapse of world trade. Markets will therefore tend to discount further real deleveraging, extended economic stagnation and a continued declining trend in both inflation and interest rates. This will be the death knell for credit-driven risk assets, like equities, commodities and real estate. Only quality fixed income holdings, particularly of core well-established government bonds, will weather this storm.

Most of the private sector, which lacks the taxing powers of governments, will suffer greatly. That’s why an investment portfolio should emphasize a 60% Bonds/ 40% Stocks split for the next few decades, as the 60 year inflation and interest rate cycle reverses permanently and risk aversion becomes the name of the game. The notion, that yields of long-term Treasuries could rise 4%, leading to a negative total return of 40% ( but zero loss if held till maturity!), will have to be abandoned. If that ever happened, it would be extremely short-lived anyway, because this heavily indebted world, as a percentage of GDP, cannot afford higher interest rates. Anybody, who believes in the ‘normalization’ of interest and growth rates, obviously refuses to accept, that the world has changed and that ‘the cult of the equity’ since the 1950’s and the 1960’s is over. Needless to say, that expensive, illiquid alternative investments should be eliminated altogether, before it is too late.

RICK SCHMULL

25th September, 2014

WESTCLIFF-On-SEA, Essex, U.K.

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THE BEST OF TIMES, THE WORST OF TIMES

THE BEST OF TIMES, THE WORST OF TIMES

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair…

Charles Dickens, A Tale of Two Cities

What could go wrong? A U.S. economic recovery with lower bond yields. A dovish Federal Reserve and an ECB, which will be forced to implement ‘large-scale’ Quantitative Easing. An abundance of liquidity as far as the eye can see, which the markets somehow will have to absorb. Ultralow interest payments on debt and strengthened balance sheets. A possible comeback of U.S. capital and consumer spending, extending the economic expansion. Today’s Central Banking schemes bring ever greater riches to those, who courageously overcome their fear and forget everything in history. Aren’t markets hitting ‘new highs’ all the time?

What could possibly go wrong? Won’t all the pieces for a sustained recovery of many more years eventually fall into place? Isn’t this ‘a new era’, after U.S. earnings per share have quadrupled, in real terms, since 1992, after being stuck at zero for 30 years? Will the powerful, secular uptrend in U.S. profit margins simply keep growing? Shouldn’t markets be at current valuations and aren’t they headed for even higher valuations?

Questions, questions! This is a ‘false’ economic recovery. Nothing is what it seems. Never in history, has there been such a concerted effort to distort and cover up the truth about the ‘real’ economy. Any meltup, as the world supposedly has found the key to permanent prosperity, will be followed by a meltdown. But during these exciting times, when nothing can go wrong and everything has a backstop and therefore remains under control, the sheep could be seduced to finally behave like animals and take more risk. Once the sheep switch from bonds to stocks, run up their credit card debt and embark on another spending spree, then the world is on track to ‘normalization’. Traumatic busts have become things of the past. Uhh…?

Alas, what’s too good to be true, usually is. In reality, global economic growth is anemic, or not impressive at all. In the next decade, even the possible annual GDP growth in the U.S. could be half the rate of the last 50 years. The economy hitting ‘escape velocity’ any time soon is wishful thinking. Financial engineering (buybacks of shares via debt financing) and Mergers & Acquisitions (take-overs with or without debt financing) , the main reasons for these buoyant markets, are slowing down. The downtrend in chronic low inflation, bond yields and interest rates is secular and will persist for many years. Most deleveraging from overindebtedness is still ahead of us. The ageing of the global population is accelerating, especially in Europe and the BRIC’s, which will affect consumer spending and investment style (shift to bonds is secular). The financial sector will continue to shrink dramatically (much higher liquididity ratios) and financialization is bound to grow less than the real economy, which is the opposite of the last few decades. Therefore, the world faces the ominous prospect of a ‘lost decade’, a global Japan scenario, especially Europe. Deflation will not be prevented by onorthodox monetary policies, because real wages of the middle class will continue to decline (internet, globalization) and the velocity of money will continue to fall (secular weak demand for credit).

There is NO reason to rejoice about Europe! Government bond yields of the weakest members of the Eurozone have been collapsing, as their stagnant economies are likely to remain so. Political uncertainties are bound to rise dramatically again. Why would markets assume, that the ECB could purchase government bonds, which would result in a politically unacceptable redistribution of risk? The Eurozone is NOT a country. How much risk to the taxpayer would the ECB be willing or able to accept, by buying very risky Asset Backed Securities? Or will this be just another bailout for the European banks? Large-scale quantitative easing (QE) could perpetuate Zombie Banking, because the necessary adjustments for a healthy banking system would be postponed. Markets seem to be overly optimistic about the possible impact of any loose monetary policy.

Liquidity-driven markets are unstable. It’s great, while it lasts, but when the tide goes out, the insane Carry-Trades, based on faulty models, of the overleveraged speculators, will prove to be their undoing. And then the world will be back to square one. Another financial crisis, much bigger than the previous one.

RICK SCHMULL

September 4th, 2014

WESTCLIFF-On-SEA, Essex, U.K.

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