"Macro" Musings

[yadayada]

I think the trillions of dollars that are pumped into the system by central banks are  making sure of that. Most of these professionals have no alternatives, so equity markets it is. Worst case you get only a few % long term. You can't leave it all in cash.

 

Honestly there has not really been a delevering, what you saw is that debt simply moved from private balance sheets to public balance sheets. Or what will really turn out to be private balance sheets again when those pensions cannot be paid.

 

Also interesting to note that for example in Italy, the younger generation so far paid 50% more taxes then the older generation (before 1970), and likely won't get a full pension. Must be similar elsewhere too. Then you hear about money laundering schemes, and see that the same old boys club that were sitting on the boards and running the banks are still running the show... You have to wonder how long that is sustainable before you see major unrest. Especially if the system melts down when governments cannot jump in anymore, and central banks lose credibility.

 

There comes a point where governments have to seriously tighten the belt, and then you will see major GDP contractions. As a large % of spending is government spending. Already the discussion about Japan is that the government can simply tax the people or not pay all those pensions. The discussion is no longer about various ways they can repay the debt. Japanese people might be submissive and just take it, but Im not so sure about the US or various EU countries. Interesting times :) .

[wisdom]

Looks like the mainstream media is starting to talk about deflation.

 

https://finance.yahoo.com/news/banks-in-europe-are-charging-to-hold-deposits--could-it-happen-here-195532627.html

 

[obtuse_investor]

Watching this page every single day is my new favourite, albeit scary, passtime.

 

http://bpp.mit.edu/usa/

[ni-co]

Watching this page every single day is my new favourite, albeit scary, passtime.

 

http://bpp.mit.edu/usa/

 

Yeah, thanks! Gundlach pointed at this index, too.

 

I think the trillions of dollars that are pumped into the system by central banks are  making sure of that. Most of these professionals have no alternatives, so equity markets it is. Worst case you get only a few % long term. You can't leave it all in cash.

 

When you have zero inflation cash is inexpensive. I certainly don't agree with your worst case scenario. Take a look at this long term "S&P 500" chart in real prices: http://www.multpl.com/s-p-500-price/ from 1912 until 1954 your real return was zero. That's 42 years. No wonder people were giving up on equities. Same thing from 1929 until 1959 (30 years) or even 1983 (54 years; also interesting to think about the point in time when Buffett started his partnership). When you look at real prices there are very, very long stretches in history where you would have made zero return if you were fully invested at all times.

 

Honestly there has not really been a delevering, what you saw is that debt simply moved from private balance sheets to public balance sheets. Or what will really turn out to be private balance sheets again when those pensions cannot be paid.

 

Here, I completely agree. Take a look at this: http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging

[yadayada]

I think you are underestimating dividends reinvested:

 

http://dqydj.net/sp-500-return-calculator/

 

After inflation that was still a 6% annual return between 1912 and 1954.

 

I think that is why a lot of these large funds go for an index.

 

Probably still a good return because PE levels were low, so dividend pay out was higher. Must have been a lot of low hanging fruit :) .

 

I think the worst timing must have been right in the dot com bubble. Would take you over a decade to get back to break even :) . But still tells you how low risk it is. Your likely to make a 4-5% return after inflation over 15 years, even the market doesn't do much from todays levels. Miles ahead of those crappy bonds I would say.

[ni-co]

I think you are underestimating dividends reinvested:

 

http://dqydj.net/sp-500-return-calculator/

 

After inflation that was still a 6% annual return between 1912 and 1954.

 

I think that is why a lot of these large funds go for an index.

 

Probably still a good return because PE levels were low, so dividend pay out was higher. Must have been a lot of low hanging fruit :) .

 

I think the worst timing must have been right in the dot com bubble. Would take you over a decade to get back to break even :) . But still tells you how low risk it is. Your likely to make a 4-5% return after inflation over 15 years, even the market doesn't do much from todays levels. Miles ahead of those crappy bonds I would say.

 

Yes, you are right. I overlooked that. You'd have to subtract tax, though. This doesn't take away from my main point, though: People don't have large enough time horizons. We've had credit expansion since the 1930s and it's completely underestimated how much this has been adding to stock market returns. We will now have credit contraction for "a few" decades and this will subtract significantly from equity price returns – or asset price returns in general. Cash will become much more valuable when inflation isn't normal anymore.

[wisdom]

http://www.bloomberg.com/news/articles/2015-02-13/-9-trillion-question-is-how-tighter-fed-will-impact-world

 

potential fallout of fed raising rates. How it will impact countries like China, etc.

 

[ni-co]

“Slow growth underlies our economic woes, Shilling explained, and it is due to continuing deleveraging following the financial crisis. It normally takes a decade for deleveraging to complete following a crisis, he said. We are eight years into it, and “it may take more than two more years.” Meanwhile, the U.S. economy is operating at a “half-speed expansion”

 

Meager wage growth is dampening growth, according to Shilling. Profit margins have shot up, but only through corporate cost cutting. That’s fine for businesses, he concedes, but the flip side is depressed wages and income. The bottom 90% of wage earners have paid the highest price, he said. Median real wages have been basically flat since the financial crisis, according to Shilling. Without increased consumer spending, slow growth and deflation are certain.

 

[…]

 

Slow to negative growth on a global basis leaves three results: declining commodity prices, deflation and competitive devaluations.

 

[…]

 

Consumers will be the winners of low energy prices, Shilling said, but so far they are not spending that money. Retail sales for January were down 1.1%. Outside the U.S., a strong dollar has offset the increase in consumer income. The losers are oil producers.

 

[…]

 

“A commodity price decline was already underway,” Shilling said, “due to excess supply versus decline. The energy-price collapse simply accentuated that.”

 

[…]

 

I think the 10-year is going to 1%,” he said, “not 2.9% as economists forecast.” That would result in a 12% return over a one-year horizon.

 

It’s not just because U.S. Treasury bonds are safe haven, he said, but also because their spread is high relative to all other sovereign bonds. The yields on European sovereigns are too low, according to Shilling, and will get arbitraged away by declining U.S. rates.

 

http://www.advisorperspectives.com/newsletters15/Why_You_Should_Own_Bonds.php

 

This is almost exactly what I'm thinking right now. I'm a bit sceptical with regard to the USD/EUR. If the euro breaks apart we will see a massive revaluation move in Germany – a tail risk I'm trying to hedge as good as I can because it matters to me personally. Otherwise I think Shilling has it exactly right.

 

All value investors jumping into oil right now should carefully think about the implications and risks of the above scenario vs the rewards of a scenario in which oil goes back to +$100. This is an awful risk/reward bet in my opinion. You have 10-20% upside in big oil and a really huge downside – thanks to the yield chasers. Buying XOM for its 3% yield is a really dangerous game to play (honestly, I think it's much safer to buy the 10 year treasury at 2.1% if you need the yield). Buffett, as always, smells a rat. There's really no margin of safety in big oil right now.

[ni-co]

Is this insane or not? That's the 5 year chart of the 10Y US treasury (orange) vs. the 10Y Italian government bond (green). I have to tell myself over and over again "Markets can remain irrational a lot longer than you can remain solvent" but that's a spread position I'm willing to take.

[giofranchi]

Is this insane or not?

 

Insane?!… Maybe!… Until you realize that governments, so much into debt as they are, will do anything to keep rates as low as possible for as much time as possible.

 

Imo it all revolves around inflation: if it keeps going down, rates will follow suit. And if we finally experience deflation, rates might get near zero like Japan (and Germany already!).

 

Gio

 

[ni-co]

Is this insane or not?

 

Insane?!… Maybe!… Until you realize that governments, so much into debt as they are, will do anything to keep rates as low as possible for as much time as possible.

 

Imo it all revolves around inflation: if it keeps going down, rates will follow suit. And if we finally experience deflation, rates might get near zero like Japan (and Germany already!).

 

Gio

 

Yes, Gio, I realize this. Yet it only works as long as the market consensus is that a country is able to serve its debt. Greece doesn't have an inflationary problem, yet. And look what rates did. It's even worse: as soon as the market consensus shifts rates will rise and the country, therefore (!), won't be able to serve them. If or better when this happens it will be a self-fulfilling prophecy. If Germany signals markets that it's not willing to stem the southern countries' debt (which it very much helped to accumulate), the euro zone will break apart just by those countries' rates going up.

 

In other words: deflationary pressures are a structural problem for the creditor countries. The only reason debtor countries suffer from it is that creditors "export" their structural problems via the euro and its rules. If the euro zone broke apart there would be huge inflationary pressures in countries like Italy and even more deflationary pressures in Germany.

[giofranchi]

Yes, Gio, I realize this. Yet it only works as long as the market consensus is that a country is able to serve its debt. Greece doesn't have an inflationary problem, yet. And look what rates did.

 

I don’t think I agree 100% here… What I wanted to say is that imo it is no longer a matter of creditworthiness… Imo interests rates are clearly being manipulated, in order to relieve highly indebted governments from the burden of interests that otherwise would be unsustainable.

Do you think anyone truly believe Japan would ever be able to repay its debt?! I don’t…

Do you think anyone truly believe Italy would ever be able to repay its debt?! I don’t…

Most observers by now think that France is in big trouble too...

Things in Europe just get messed up by the fact we pretend we are a nation, but we are not, and probably will never be… So interest rates get manipulated also as a mean to reproach those countries which don’t conform diligently to what Germany dictates… Sorry to say this, I know you are from Germany, but I simply don’t see how else to read the EU situation right now…

I repeat: it is no more a matter a creditworthiness: as long as inflation or deflation permit government and central banks to keep interests rates suppressed, they will stay very low and even get lower.

 

Gio

 

 

[giofranchi]

I mean: in Japan not even pension funds are buying government bonds anymore… The Japanese Central Bank right now is the market for government bonds! How could their price not be manipulated?! ???

 

Gio

 

[ni-co]

Yes, Gio, I realize this. Yet it only works as long as the market consensus is that a country is able to serve its debt. Greece doesn't have an inflationary problem, yet. And look what rates did.

 

I don’t think I agree 100% here… What I wanted to say is that imo it is no longer a matter of creditworthiness… Imo interests rates are clearly being manipulated, in order to relieve highly indebted governments from the burden of interests that otherwise would be unsustainable.

Do you think anyone truly believe Japan would ever be able to repay its debt?! I don’t…

Do you think anyone truly believe Italy would ever be able to repay its debt?! I don’t…

Most observers by now think that France is in big trouble too...

Things in Europe just get messed up by the fact we pretend we are a nation, but we are not, and probably will never be… So interest rates get manipulated also as a mean to reproach those countries which don’t conform diligently to what Germany dictates… Sorry to say this, I know you are from Germany, but I simply don’t see how else to read the EU situation right now…

I repeat: it is no more a matter a creditworthiness: as long as inflation or deflation permit government and central banks to keep interests rates suppressed, they will stay very low and even get lower.

 

Gio

 

I think I mostly agree with you. Yet, I think in Europe the two aspects intermingle. Yes, I am from Germany, but I regard the German economic/euro policy as stupid and dangerous. German politicians and the political consensus don't realize that they caused this debt problem for debtor countries. It was very beneficial for our economy to force our savings onto Italy, Spain etc. However, it has created huge imbalances for which we now try to blame other countries. And our solution is to force those countries to save more? This is just ridiculous.

 

The point where I might differ, I guess, is that you seem to imply that central banks can play this game forever. This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment. I don't think the US are prepared to do it any longer. This is only a question of how much they are willing to let the dollar rise. As soon as the US pull the brakes the whole world economy is going to collapse under the global lack of demand.

[giofranchi]

The point where I might differ, I guess, is that you seem to imply that central banks can play this game forever. This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment. I don't think the US are prepared to do it any longer. This is only a question of how much they are willing to let the dollar rise. As soon as the US pull the brakes the whole world economy is going to collapse under the global lack of demand.

 

This makes a lot of sense... though its consequences are a little scary...

 

Gio

[ni-co]

The point where I might differ, I guess, is that you seem to imply that central banks can play this game forever. This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment. I don't think the US are prepared to do it any longer. This is only a question of how much they are willing to let the dollar rise. As soon as the US pull the brakes the whole world economy is going to collapse under the global lack of demand.

 

This makes a lot of sense... though its consequences are a little scary...

 

Gio

 

We're going to get through it, I guess. It might actually be good for Italy :)

I'm a bit scared of asset price levels and how they're going to react under such a scenario. That's why I turned so bearish last year.

[giofranchi]

It might actually be good for Italy :)

 

Well, I just don’t see how… If the US say to the EU: stop printing, because the Euro has been devalued too much! And as a consequence Draghi stops buying Italian government bonds, and the creditworthiness of Italy then starts to matter once again… well, Italian government bonds yields will spike up like they did in 2011… but this time what’s going to bring them down? And, given the shape it finds itself in, Italy simply cannot afford paying high interests on its debt…

 

Gio

 

[ni-co]

It might actually be good for Italy :)

 

Well, I just don’t see how… If the US say to the EU: stop printing, because the Euro has been devalued too much! And as a consequence Draghi stops buying Italian government bonds, and the creditworthiness of Italy then starts to matter once again… well, Italian government bonds yields will spike up like they did in 2011… but this time what’s going to bring them down? And, given the shape it finds itself in, Italy simply cannot afford paying high interests on its debt…

 

Gio

 

Yes, you're right, I thought more about the long term. I think leaving the euro and inflating the debt away could actually be a net positive for Italy. The status quo is simply awful for countries like Italy. The only other option would be debt restructurings every few years within the euro zone – I can't see this working out politically (in creditor countries) and I can't see why this should be any better for Italy than simply leaving the euro.

[giofranchi]

Yes, you're right, I thought more about the long term. I think leaving the euro and inflating the debt away could actually be a net positive for Italy. The status quo is simply awful for countries like Italy. The only other option would be debt restructurings every few years within the euro zone – I can't see this working out politically (in creditor countries) and I can't see why this should be any better for Italy than simply leaving the euro.

 

That’s why I said the situation is scary… Think about it: the best solution you see is for the 3rd largest bond market in the world to leave the Euro… Wow! We better expect a lot of turbulence…!! ::)

 

Gio

 

[ni-co]

Yes, you're right, I thought more about the long term. I think leaving the euro and inflating the debt away could actually be a net positive for Italy. The status quo is simply awful for countries like Italy. The only other option would be debt restructurings every few years within the euro zone – I can't see this working out politically (in creditor countries) and I can't see why this should be any better for Italy than simply leaving the euro.

 

That’s why I said the situation is scary… Think about it: the best solution you see is for the 3rd largest bond market in the world to leave the Euro… Wow! We better expect a lot of turbulence…!! ::)

 

Gio

 

Do you see any other long term solution? I think the problem is that politicians don't speak out the only two logical solutions to the euro zone problem:

1. United States of Europe (my personal favorite but not (yet) politically feasible I'm afraid),

2. Euro zone break up.

 

Every other "solution" is no solution but kicking the can down the road – the can thereby getting bigger and bigger. You might say "well, there's been a lot of can kicking down the road for quite a few years" and you'd be right but I think the state of the world economy is a catalyst this time.

[petec]

This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment.

 

 

Trying to work this through in my head - can you elaborate?

[frommi]

Do you see any other long term solution? I think the problem is that politicians don't speak out the only two logical solutions to the euro zone problem:

1. United States of Europe (my personal favorite but not (yet) politically feasible I'm afraid),

2. Euro zone break up.

 

Every other "solution" is no solution but kicking the can down the road – the can thereby getting bigger and bigger. You might say "well, there's been a lot of can kicking down the road for quite a few years" and you'd be right but I think the state of the world economy is a catalyst this time.

 

I share your opinion about germany, but in the case of italy i think a default in a number of steps with a central bank program to support the banks is the most probable outcome.

No country really wants to leave the EU, you can see this in the case of greece. The politicians will try to kick the can down the road for the next decades, because all they are interested in is that the next bomb doesn`t explode in their legislative period. There is no incentive for a politician to think long term.

[ni-co]

This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment.

 

 

Trying to work this through in my head - can you elaborate?

 

The main effect of and reasoning behind QE is keeping interest rates down and, thereby, devaluing the euro. The effect is twofold: you're making exports cheaper/imports more expensive and you pay people less money on their savings. Both depresses household consumption in the eurozone (traveling, foreign products become more expensive), forces up the savings rate (you have to save more to buy a house or for your retirement because you receive lousy returns) and, at the same time, makes the industrial sector much more competitive internationally, not only by making their products cheaper but also by providing them with cheap financing. That's what China's been doing for years now and what Germany's been doing within the euro zone.

 

The euro zone, Japan, China, GB and even countries like Australia do the same thing now, albeit with different tools. On the other side of this trade there is more or less the US only (and smaller countries like Switzerland). Their consumers can buy products on the cheap, this increases their consumption and decreases their savings rate. Alternatively, the US could keep their savings rate constant by forcing people into higher unemployment – this forces consumption upwards in relation to savings as unemployed people still consume but don't save – or they would have to intervene in trade. They can intervene with tariffs (making imports more expensive), with higher consumption taxes or with monetary policy, essentially doing what the rest of the world is doing and, thereby, forcing the USD downwards.

 

Momentarily, they do none of the above and this is going to either hurt their economy or let the US (private and/or public) debt grow. It has been this way until 2008 but you can only raise your level of debt so much and it became unsustainable. Since 2008 we are therefore in a worldwide deleveraging (the US had to delever and the rest of the world has to follow sooner or later). That's pretty much what we are witnessing in my opinion.

 

By the way, I'm stealing all this from Michael Pettis' book "The Great Rebalancing" but his explanation just made complete sense to me. I think a good part of it is "classic" Keynes, though I haven't read the original. Some of it is a bit counterintuitive at first but it will become completely logical if you think it through. It also fits perfectly into Ray Dalio's explanation of what's happening right now.

 

Yesterday, Martin Wolf wrote a very good article for the FT basically explaining the same mechanics (http://www.ft.com/intl/cms/s/0/4c7dfcb8-b5d5-11e4-b58d-00144feab7de.html – paywall – maybe googling "Unbalanced hopes for the world economy" works?). And there is a good interview with Pettis from 2013:

[giofranchi]

ni-co,

thank you for the nice discussion!

 

My view is the US have gone through QE1, QE2, and QE3 in the last 4 years… They have printed lots of money, and have also prompted the EU to do the same.

 

Now what?! Finally the EU has decided to follow suit, and the US already starts complaining because the USD is getting too strong?!… ???

 

The USD is getting stronger, and imo will continue to do so, because it is a safe haven among currencies… And in a deleveraging there might be a lot of volatility, but ultimately safe havens will be sought out and coveted. I simply don’t see a way to stop this process.

 

Everyone, the US, the EU, Japan, China, etc. must print money. If they refuse to do so, their economies stagnate, like it has happened in the EU and Japan before they both started printing money.

 

Now, if everyone is printing money, which currency is going to get stronger? The USD (imo).

 

Gio

 

[ni-co]

Thank you, too, Gio.

 

Yes, you are right. The problem is that QE and ZIRP worldwide brought us into a currency war – in hindsight this seems to have been unavoidable. No country wants to be the one with the high currency – including the US! A high USD is the one thing that keeps the FED from raising rates. Consensus view in the US is that lower prices will make consumers consume more. I'm very skeptical about that, to say the least. Not only is there no indicator showing that to be true (be aware that oil prices have been falling drastically since September 2014 – no positive effect on Christmas retail sales!), but baby boomers are in the process of going into retirement and they haven't been saving enough for that! They are happy over every dollar they don't have to spend right now. So, if products become cheaper because of the rising USD and consumers don't want to consume more there almost has to be a deflationary spiral.

 

This is what the FED is afraid about and what keeps them from raising rates in spite of the good unemployment figures. I think for the time being there might remain some upward pressure on the USD but the US don't want to let this escalate because it could kill their recovery. The problem is that any counter measure the US is going to take would likely kill any hope for a recovery in the rest of the world.

 

As long as we're in this deflationary environment and the deleveraging process is going on there has to be downward pressure on asset prices – this is just a question of time. Because my most important goal is avoiding the risk of permanent loss of capital I'm only hedged and not outright short – I bought a few put options, though.

 

I think sometimes it's almost easier to take the birds-eye view. Think about it this way: Deflation means that the value of money rises in relation to the things you can buy with it. You can see this in commodity prices but what is true for commodities should be true for (most) productive assets, too. The products those assets produce are going to fall in price and this should bring asset prices down sooner or later.

 

There seems to be broad consensus that inflation lifts asset prices I wonder why there is so much resistance to the thought that the reverse should also hold true: Real deflation has to bring asset prices down. The only assets that won't get hurt are those that are assured to keep their cash generation levels at least where they are – especially US Treasuries.