“When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”

-Chuck Prince, CEO Citigroup July 2007

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” 

-Frederic Bastiat, 19^th century French economist and author

“A reliable way to make people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth. Authoritarian institutions and markets have always known this fact.”

-Daniel Kahneman

“Asset values aren’t out of line with historical norms”

-Janet Yellen 21^st September 2016

“The ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense and large.”

-Paul Singer during a recent Bloomberg interview

There’s a lot to cover this week, and unfortunately this will be a longer than usual commentary. We don’t usually start with quotes as some other commentators do, but this week seems a bit different, so please bear with us as we dive into the maelstrom.

Last week was, in our opinion, a very important week for global central banking. If we are right, then investors really do need to think long and hard about how they allocate their money. In the short term, the markets have displayed a “risk on” tone, which nowadays means US Dollar down and everything else up. This knee jerk reaction does not chime with our longer term thinking one iota, but that’s bubble investing for you – as Chuck Prince said in July 2007, as long as the music is playing, you’ve got to get up and dance. (For what it’s worth, the S&P 500 made the first of what was effectively a double top within days of Mr Prince’s now infamous comment before plunging more than 50%. Mr Prince retired on 4^th November 2007.)

In his 2013 book “The Road to Recovery” Andrew Smithers explains in detail what he thinks is holding back the post Global Financial Crisis economy and offers up some thoughts as to what policymakers should do. We highly recommend everyone read it, especially our venerated central bankers. As Mr Smithers says, it is essential to analyse the causes of previous crises so that we do not repeat the errors that led to them.

Quoting from the book, “there have been three, and happily only three, examples of financial crises in the past 100 years that have caused severe and sustained losses of output;

• The slump of the 1930s, which followed the Wall Street crash of 1929
• The stagnation of the Japanese economy, which followed their stock market crash of 1990
• The Global Financial Crisis and economic weakness that followed sharp falls in share and house prices

Each occasion had its own individual characteristics, but they were all marked by the existence of high levels of private sector debt and were triggered by sharp falls in asset prices”

So, to paraphrase, the last thing centrals bankers should want is to allow both debt and asset prices to get too high, as there comes a point when neither are sustainable. Nobody knows what the exact trigger will be, but when asset prices start falling, the risk of a financial and economic crisis becomes very real indeed. As we all know, policymakers have been actively encouraging more borrowing as they have lowered rates to zero, and in quite a few cases, even negative territory.

As can be seen in chart 1 below, debt is higher today than it has ever been. There has been limited deleveraging in various household sectors (due to demographic factors in our opinion and not through choice), and in the financial sector (because of regulatory changes and household deleveraging), and this is a positive development. However, corporate debt has jumped sharply and Government debt only ever moves higher. Collectively, there has been no deleveraging which should be part of the post crisis healing process. Arguably, the global debt profile is consistent with the pre-crisis scenario outlined by Andrew Smithers.

Chart 1 – Global Debt to GDP

As regards the current valuation of financial assets, high grade bonds everywhere (Europe and Japan especially) are in the final stage of a 35 year bull market and most are in what can only be described as bubble like territory. In equities, the US market is by far the most stretched, and on non-earnings valuation measures, are trading at levels consistent with the bubble peaks of 1929, 2000 and 2007. For example, the chart below shows the enterprise value to Gross Value added (similar to revenue). As can be seen, the current market valuation exceeds that seen in 2007 and is on a par with the 2000 peak (a time that everyone acknowledges as the all-time bubble valuation extreme).

Chart 2 – Enterprise value to Gross Value added – comparable to 2000 peak bubble valuations

During her post meeting press conference, Janet Yellen said that asset values are in line with historical norms. Either she is repeating a falsehood, hoping that investors buy into that narrative, or she is simply ignorant of historical valuation measures that actually matter (n.b. the so called Fed model simply does not stack up as a reliable valuation measure over the long term).

Furthermore, all of our central bankers should be fully aware that stimulus can only bring forward future consumption to the present. If they are lucky, all bankers can do is smooth the cyclicality of the economic cycle, but what they cannot overcome are the structural headwinds that are now impacting the global economy. Therefore, we have to suspect that they know they are running policy far too loose, and this is extreme short termism. The resulting increases in debt and financial excess will cost us all dearly in the end.

So, we have record levels of debt and all major assets trading at or near bubble valuations. This is the set up for a financial and economic crisis unless policymakers change course and put in place policies that will 1) generate real GDP growth that benefits everyone, 2) lower debt levels and 3) smooth the financial transition from overvalued assets to fairly valued assets. However, policymakers are not likely to change course, because they are petrified that markets will react badly. They will continue with the policies that have brought us to the present over indebted and overvalued condition until they are forced to change or the financial bubble bursts.

Which takes us to the Bank of Japan. The initial fanfare with which their new policies were greeted is typical of bull market behaviour, however, the market reaction became more muted within just a few hours of the announcement. The two main changes were a move from QQE + NIRP to QQE with yield curve control. This will be achieved by controlling the overnight rate (currently set at -0.10%) and targeting the 10 year bond yield around the current level of zero per cent. Furthermore, it is widely expected that the yield curve control implies a steeper curve to help the banks. The second change is a commitment to let inflation run above 2% for a while in an effort to convince everyone about how serious they are on achieving their 2% inflation goal. At the same time, all previous policies will remain, including the Yen80 trillion a year balance sheet expansion.

In our opinion, these changes now increase the likelihood of some sort of policy failure, and so puts their credibility, diminished as it already is, at risk. Let’s tackle the inflation commitment first. For over three years, the Bank of Japan has been aiming to get inflation up to 2%, and have failed, blaming exogenous factors like the large decline in oil. We doubt very much whether a strengthened commitment alone will suddenly ignite a little bit of inflation. Perhaps more fiscal stimulus, other than that already announced, will make a difference, but having had 26 supplemental budgets in the 26 years since their own financial crisis, any new fiscal spending plans will somehow have to be different in nature.

As for the new “yield curve control”, this is where it gets interesting because, simply put, a central bank cannot target both bond yields and balance sheet expansion at the same time. Let’s play with several scenarios to illustrate this.

First, let’s assume that the 10 year bond trades with a near zero yield and virtually no volatility. In this scenario, it seem highly unlikely that the Bank would need to buy Yen80 trillion a year of bonds. In fact, we suspect that the Bank would soak up new issuance (about Yen 40 trillion including year 1 supplemental budget spending), but buying another Yen40 trillion may prove a challenge. Even if they do achieve both the zero bond yield and balance sheet target, who’s to say that the sellers of the Yen 40 trillion of 10 year bonds don’t simply buy longer dated bonds, thereby flattening the yield curve.

Second, current holders actually believe that inflation will reach 2% or higher, and rather than sit holding an asset with a negative real yield, decide to sell en masse to the BoJ. In order to maintain the zero yield for the 10 year bond, the Bank has to buy more than Yen 80 trillion, which may prove problematic. With their balance sheet already equal to approximately 90% of GDP, and 40% of outstanding debt, the BoJ is nearing capacity limits.

A third scenario is that a zero yield for 10 years is better than a negative yield in shorter maturity assets, and anyway, banks, pension funds have to hold Government debt to meet regulatory requirements. As such, the main holders of JGBs may decide to hoard what they have left which would mean the BoJ would fail to expand their balance sheet by Yen 80 trillion. Furthermore, what if the JGB hoarding leads to a falling 10 year bond yield? Will the bank of japan actually sell bonds to push up yields and actually shrink their balance sheet?

What strikes us is that in scenarios 1 and 3, the BoJ will be reducing the size of the QE, or a so called tapering which is a tightening of policy and not something they want. At the other end of the spectrum, they will have to go all out to maintain yield curve control, whilst they are already operating near capacity limits. In addition, under all three scenarios, they continue to play a dominant role in a market where liquidity is drying up fast. It’s all very well trying to control the market, but at what long term cost, both to the BoJ’s credibility and the efficacy of a free market?

Perhaps the outcome will be more benign, whereby the BoJ has control of the yield curve, is expanding its balance sheet as planned, remaining JGB holders are happy despite rising inflation and market liquidity remains ample. However, this is something that won’t last forever. At best, the BoJ continues to buy a bit of time for politicians to implement deep structural reform in order to generate robust growth. At worst, investors lose faith in Japanese policies.

To take one last look at this policy tweaking by the BoJ. There have been quite a few commentators heralding the move to a steeper yield curve as being a great support to the banks, thereby removing one of the nasty effects of negative interest rates. Let’s think about what they have done. They have set the overnight rate at -0.1% and have a current target of zero for the 10 year yield. I think we need to assume that the 10 year target yield will not rise any time soon, and so the only way to steepen the curve further is to cut the overnight rate. However, the negative rate experiment is not working and critics are getting more vocal. In the meantime, will this new yield curve control make a difference with current rates? Well, if we are right that the curve remains pretty flat because the BoJ can’t cut the overnight rate by much and they are unlikely to raise the 10 year target, then this part of the new policy mix is actually a bit of a dud.

Chart 3 – The Japanese Yield Curve (10s less 2s)

We do have to entertain one more scenario with the BoJ. All of this is simply a cover for massive monetary financing, or helicopter money. They are keeping the yield curve at or below zero so that the Government can issue debt free of charge. They are committing to buying all new bond issuance so that it doesn’t crowd out the private sector. They will keep doing this until inflation is stable above 2%.

Well, this may sound great in theory, but once you go down this route, there is no turning back. Why would anyone other than the central bank finance the Government? All private sector savings would focus on either equities and property domestically or overseas assets. The BoJ would absolutely break anything that is left of the Government bond market, and perhaps put the Yen into a terminal tailspin. Yet, in today’s age of policy experimentation, nothing can be ruled out. However, it appears to us that the BoJ has actually continued to simply dig within the big hole it finds itself in. The chances of this grand experiment going wrong just gets bigger the more they tweak their experiment. There comes a point in time when the credibility of the BoJ receives a fatal blow, and that moment may not be that far away.

Which brings us back to the global landscape, and the following list of current news;

• The BIS and Moodys are highlighting the fragility of the debt fuelled growth policy in China
• The OECD lowered global growth forecasts
• Both the OECD and UN are urging growth policies that benefit the masses rather than the few
• The US election is beginning to loom large
• The recent EU summit ended on a sour note
• The latest rumours from ECB sources say that policy changes may only be tweaks
• Messy geopolitics from the middle east, through Russia to China

So we have a policy shift in Japan that may well end up with QE being tapered, politicians calling for fairer growth, and all of the major macro risks (which were never solved) simmering near boiling point. For investors, the main prop to ever rising market prices were the hugely experimental policies delivered by the major central banks. As should have been expected, these policies failed to overcome the very real structural headwinds (eg demographics and poor productivity) and may be themselves deflationary as zombie companies are able to stay alive and savers simply save more to offset zero yields and therefore forego some current consumption.

Not that Janet Yellen can admit this, but the Fed along with her counterparts in the developed economies, has allowed debt to increase to even more unsustainable levels, and created bubbles in all mainstream assets. This combination is the precursor to financial and economic crises as outlined by Andrew Smithers, which will be triggered by a decline in asset prices. If central banks decide to or are forced to abandon their support of financial markets, and lose credibility, then it seems inevitable that financial prices will decline, most likely in a disorderly manner. And this is why the potential tapering that the new BoJ policies will lead to is such a big deal. If investors realise that policies are shifting away from supporting markets, and/or the BoJ loses credibility, then the risks escalate rapidly.

Our fear here is that there is very little that policymakers can do to avoid the crises that their policies have all but guaranteed. For years now, central bankers have been trying to buy a little bit of time and growth through extraordinary policies without any consideration for the long term effects. Frederic Bastiat would surely classify the current central banking cohort as bad economists. They fail publicly to admit that their policies have created a massive financial bubble, with Yellen following in the footsteps of her predecessor in claiming that bubbles cannot be predicted in real time. This is simply rubbish.

There are reliable valuation measures like market cap/GDP, market cap/GVA, tobins Q, Shiller CAPE which all indicate that the equity market is in or close to bubble territory. At best, investors can expect close to zero nominal returns from either a balanced (equity and bond) or equity only portfolio over the next 10 to 12 years with low volatility. At worst, we could see a significant bear market in financial assets, leading to economic hardship, ballooning fiscal deficits and massive pension problems. In this worst case scenario, will the geopolitical risks stabilise, improve or deteriorate?

In the big picture, the risks in our opinion have simply grown in the last few years, especially because central banks have allowed (even encouraged) debt to continually increase and have supported financial bubbles in all mainstream assets. The window of opportunity to change policies and generate an elegant deleveraging with stable markets and economic growth that benefits the many and not just the few is closing rapidly. We doubt very much that current policymakers can execute such a policy shift.

Despite “risk on” kneejerk reactions to any policy shifts or dovish words from central bankers, the market structure is very fragile and fully/wholly dependent on investors faith that central bankers will continue to foster even greater bubble finance conditions. As Paul Singer, a very successful hedge fund manager recently said, the breakdown in markets will be surprising, sudden, intense and large. If he is correct, there will be no time for investors to react and protect their portfolios. The time for doing this is now whilst conditions remain relatively calm.
Stewart Richardson
Chief Investment Officer