Today’s Financial Review contains an interview with one of Australia’s better market strategists, Gerard Minack. He’s leaving the industry after 25 years to do his own thing. Some of his parting comments are worth discussing, given the crazy times we are in.
From the AFR:
‘“Unbelievably we’re repeating the same cycle all over and expecting a different outcome. That’s not to say you can’t own equities but own them knowing it’s all going to end in tears,” he says.
‘He thinks current conditions are playing out like the aftermath of the tech-wreck, but says investors need to consider if this period is more like 2003, when there are potentially three or four good years ahead, or 2006, when the bubble is about to burst.
‘He’s leaning toward the 2006 view.’
We agree with Minack, but with a few qualifications. The one major similarity is investor complacency. We remember 2006 well. In a past role we had a weekly meeting with the sales team. Each week we’d tell them this was all going to go pear shaped. The US housing market was out of control and the bubble would eventually burst, we just didn’t know when.
The sales guys thought we were a pain in the backside. They wanted good news stories. They wanted to give clients a reason to buy, and they wanted to earn commissions. Which, sadly, is how the financial industry works.
Now there is a similar feeling of complacency slipping back into the market. We wouldn’t say it’s as innocent as 2006, but it’s certainly there.
But in Australia at least, there is a major difference. Back in 2006, EVERYTHING was going up in price. A global credit bubble had fuelled a burst of spending and investment by the PRIVATE sector. Anything with leverage soared in price (remember Babcock and Brown?). There were rolling bubbles in the resources sector (nickel, copper, uranium, zinc etc) and investor cash flooded into junior miners. China would make them all millionaires.
But post the 2008 crash, things are a little different. The complacency is back, driven by the perception of infallibility of central banks, but it’s not widespread. This time, the flow of money is the product of PUBLIC spending. This flood of government money (generated by massive deficit spending in most of the world’s developed economies) has a couple of effects.
Firstly, it props up private sector consumption and prevents economies from falling back into a full-blown recession/depression. Secondly, it emits a massive torrent of collateral into financial markets.
This is a very important point. Let us explain why.
Most developed country sovereign debt, once it passes into the hands of the financial sector, becomes a source of more ‘cash’. That is, the holder of the debt can generally hand it to a financial institution as security to borrow funds. Or, if the holder IS a financial institution, they lend it out and then take it back as collateral for another loan they make. Now back in their hands, the institution can lend it out again! It’s a bit like pass the parcel, with each pass creating more and more financial asset purchasing power.
This is very roughly how the ‘shadow banking’ system works. It takes financial assets like government bonds and turns them into ‘money’ through the process of collateralisation.
But it doesn’t just utilise sovereign debt as collateral for further lending. Back in 2006, mortgage debt was THE collateral of choice. It was the widespread use of mortgage debt as collateral that caused the credit crunch and crash of 2008.
When it became apparent that mortgages were quite useless as security on borrowed funds, lenders called their loans in pronto. It was a run on the shadow banking system, and it was what brought Bear Stearns and Lehman Bros down. In the shadow banking system, loans are generally overnight and are ‘rolled over’ on a daily basis. So when the music stops, deafening silence follows.
This evaporation of mortgage debt as a trusted source of collateral saw a massive increase in the demand for ‘risk-free’ collateral, i.e. sovereign government debt. That’s why you saw a huge plunge in government bond yields during the panic, and why yields have stayed low throughout the ‘recovery’.
The point we’re making here is that the huge issuance of government bonds, and the monetisation of those bonds through the shadow banking system, has provided the FINANCIAL system with a huge amount of speculative liquidity. Meanwhile, the REAL economy continues to struggle because it’s primarily driven by inefficient government spending.
That’s why there is such a disconnect between financial markets and the real economy right now. The real economy is weak. You’re seeing evidence of this in the poor share price performance of the resource sector and the complete lack of capital in the junior mining sector. Many other economic indicators in Australia and around the world point to a moribund recovery.
Yet the financial markets point to booming conditions. The explosion of ‘good’ collateral (in the form of government bonds) and the explicit approval of global central banks for speculators to embrace risk have created the conditions for massive financial asset inflation.
Think about it. A hedge fund takes a treasury bond, which it has borrowed from somewhere else, hands it over to an investment bank or prime broker as collateral for a cheap loan and buys some high yielding junk bonds, or derivatives of an index that tracks junk bonds.
It’s a low risk trade when you have central banks promising to buy bonds (keeping demand strong and yields low) which keeps the value of the collateral intact. And as long as the collateral value stays intact, the risk appears low.
As we wrote to subscribers of Sound Money. Sound Investments earlier this year when we explored this topic in depth, the Achilles’ heel of the system is goods and services inflation. Once it gets into the system, there will be a good old fashioned bank run on the ‘shadow banks’ as the value of collateral falls and speculators unwind their leveraged bets.
Where will capital flow then? What happens when the financial systems’ only risk free asset, sovereign debt, stops being risk free? Perhaps it will then flow to the only true risk free financial asset, gold.
The people of Japan will probably be the first to experience the loss of risk-free status of their government’s bonds. It is ironic and sad then that some are rushing to sell their useless gold for yen.
We shouldn’t be surprised really. History repeats in financial markets more than anywhere else.
But getting back to Minack, he’s probably right. While it’s a different climate, as far as wild risk-taking and damn the consequences go, we’re back to 2006. Only this time it’s the central bankers leading the party. Which means the hangover will be so much worse the next time around.
But the next crash is in the indeterminate future, and in the meantime there is self-delusion and hope. So buy equities, but only in the knowledge that it will all go pear shaped. Join the fund manager game of rotating from banks to resources (as per today’s action) and then back again at some point down the track.
But look around and you’ll notice fewer chairs in the room as the music gets louder. If you don’t fancy your chances of claiming a chair when the music stops, you may want to start edging towards the exits.
for Markets and Money
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