THE NEXT SHOE TO DROP

February 2016

 

Summary of contents:-

• The next stage in the process of unwinding could be a retreat for the surplus nations of Germany and China from their previously prudent fiscal stance which has also been deflationary.

• It should not be long before the Germans are faced with allowing their banks to fail or having to save those banks and participate in quantitative easing and/or some form of fiscal imprudence.

• This should put the deflationary pressures behind us and potentially lead to a significant rise in inflation. China has already started taking action to ease its banking problems.

• The Chinese economy is picking up again, a fact that would now be obvious if the

authorities had not manipulated their GDP data and put so much lipstick on the pig a year ago.

• Things are so bad that there is no right answer. If they raise rates it'll be nasty. If they don't raise rates, it just makes matters worse. It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit.

• The total amount of debt in the U.S. is about $50 trillion and the total amount of money (i.e., currency and reserves) in existence is about $3 trillion. So, if we were to use these numbers as a guide, the amount of promises to deliver money (i.e., debt) is roughly 15 times the amount of money there is to deliver. The main point is that most people buy things with credit and don’t pay much attention to what they are promising to deliver and where they are going to get it from, so there is much less money than obligations to deliver it.

• Inflation in financial assets is more dangerous than inflation in goods and services because this financial asset inflation appears like a good thing and isn’t prevented even though it is as dangerous as any other form of over-indebtedness.

• Debt reduction (i.e., defaults and restructurings) and austerity are both deflationary and

depressing while debt monetization is inflationary and stimulative.

• Steve Russell (Ruffer Total Return Fund) suggested that Index Linked Gilts and gold would be the only good investments over the longer term everything else would be bad.

• Whilst we believe that Index Linked Gilts should be a good long term investment, they have risen in value over the last few years as have most other financial assets through artificial monetary stimulus and investors desperation to get out of cash and the short term downside risk could be as much as 25%.

• Both the UK and US stock market have been overvalued by approximately 100% and need to fall by around 50% in order to reflect the true state of company profits.

• An entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions (normally diversified portfolios) that have flown blind, free of price discovery.

• The International Swaps and Derivatives Association say that there is a gross notional

outstanding value of about $86tn. Oh dear!

• The price of oil will probably rise to $50 a barrel this year and $70 a barrel in 2017.

• Continued financial warnings.

In our last quarterly investment report we discussed the implications of the Chinese de-pegging,

albeit in a managed fashion, from the US dollar. We have already started to see the early stages of

those implications – the sale of foreign exchange reserves, a fall in the US Dollar Index (when most market participants had been anticipating a strengthening), a fall in stock markets, a rise in lower quality bond yields (due to increased corporate risk), a rise in the price of gold and this week even saw a rise in US inflation despite widespread fears of deflation. The ultimate outcome should be a

reduction in the global savings glut, a reduction in the oversupply of goods and services and

consequently a long term increase in inflation and interest rates and a reduction in the value stock, property and bond markets.

 

The next stage in this process could be a retreat for the surplus nations of Germany and China from

their previously prudent fiscal stance which has also been disinflationary and in the case of Germany a change in their attitude towards quantitative easing which they have previously decried, because of their fears of a repeat of the 1920's hyper-inflationary Weimar regime. Both countries (they are not alone) have banking problems. In a recent email alert, I warned clients to keep no more than £75000 in any one bank (or bank group) as around 50 European banks now have leverage ratios greater than the 31 level which saw the collapse of Lehman Brothers in 2008. The two largest German banks have amongst the worst of the leverage ratios and it should not be long before the Germans are faced with allowing their banks to fail or having to save those banks and participate in quantitative easing and/or some form of fiscal imprudence. Having been the chief enforcers of fiscal prudence and austerity, this should put the disinflationary pressures behind us and potentially lead to a significant rise in inflation. China has already started taking action to ease its banking problems.

 

Ambrose Evans-Pritchard (Telegraph) – 'Students of the 1930s and the Keynesian liquidity trap

might argue that the equity bloodbath is positively good for the world economy to the extent that it

reflects an erosion of the global savings glut – the ultimate cause of our Long Slump – and entails a

shift in spending power back to ordinary people. A clutch of distressed sellers are having to

liquidate stocks, bonds and property for month after month on a grand scale. This is the exact

reversal of what happened during the commodity boom when they siphoned off their surpluses –

thereby depriving the world economy of aggregate demand – and pumped up global asset prices.

The money is rotating out of the markets and into our pockets. Americans have hardly begun to

spend their bonanza. They have let it pile up in bank accounts, pushing up the US household

savings rate from 4.5% to 5.5% in fifteen months, much to the surprise of the Fed. Sooner or later

they will spend it, unless you think America has undergone a Puritan conversion. The oil price

slump does not itself send any useful signal about the health of the global economy. The price slide

is almost entirely the result of over-supply, greatly compounding OPEC's political decision to flood

the market to flush out rivals, and to slow the onrush of renewables. It is a textbook 'positive supply

shock', worth 2% of world GDP. The wild card remains the volume of capital flight from China, and

what that money is being used for. The People's Bank has run through $300bn of foreign reserves

over the last three months. At this pace it is just four months away from the safe floor of $2.8tn

under the IMF's adequacy metric for a country with a pegged (although managed) exchange rate.

The picture is much more dangerous if we are instead dealing with capital flight in tooth and claw, a

collapse of confidence in the ruling party itself. The Chinese spent $5tn on fixed capital investment

last year, as much as North America and Europe combined. There is so much spare capacity in

Chinese industry that a 15% fall in the yuan – as some suggest, would send a deflationary tidal

wave across a world already on the cusp of a depression. The overwhelming odds are that no such

calamity is about to happen. China is a police state with extreme coercive powers and all kinds of

ways to tighten capital controls, openly acknowledged or otherwise. The Chinese economy is

picking up again, a fact that would now be obvious if the authorities had not manipulated their GDP

data and put so much lipstick on the pig a year ago.’

 

William White, Chairman of the OECD's review committee and former chief economist of the

Bank for International Settlements (BIS) – 'The situation is worse than it was in 2007. Our

macroeconomic ammunition for downturns is essentially all used up. Debts have continued to build

over the last eight years and they have reached such levels in every part of the world that they have

become a potent cause for mischief. It will become obvious in the next recession that many of these

debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think

that they own assets that are worth something. The only question is whether we are able to look

reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly.

Debt jubilees have been going on for 5000 years, as far back as the Sumerians. The Fed is now in a

horrible quandary as it tries to extract itself from QE and right the ship again. It is a debt trap. Things are so bad that there is no right answer. If they raise rates it'll be nasty. If they don't raise

rates, it just makes matters worse. It was always dangerous to rely on central banks to sort out a

solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and

now we are hitting the limit.'

 

Ray Dalio, Bridgewater Capital - Depressions are typically ended by central banks printing

money to monetize debt in amounts that offset the deflationary depression effects of debt reductions and austerity. The total amount of debt in the U.S. is about $50 trillion and the total amount of money (i.e., currency and reserves) in existence is about $3 trillion. So, if we were to use these numbers as a guide, the amount of promises to deliver money (i.e., debt) is roughly 15 times the amount of money there is to deliver. The main point is that most people buy things with credit and don’t pay much attention to what they are promising to deliver and where they are going to get it from, so there is much less money than obligations to deliver it. Over the long term, typically

decades, debt burdens rise. This obviously cannot continue forever. When it can’t continue a

deleveraging occurs. Since the ratio of financial assets to money is so high, obviously if a large

number of people tried to convert their financial assets into money and buy goods and services at

the same time, the central bank would have to either produce a lot more money (risking a monetary

inflation) and/or allow a lot of defaults (causing a deflationary deleveraging). When debts can no

longer be raised relative to incomes and the time of paying back comes, the process works in

reverse. It is that dynamic that creates long-term debt cycles. These long-term debt cycles have

existed for as long as there has been credit. Even the Old Testament described the need to wipe out

debt once every 50 years, which was called the year of Jubilee. Inflation in financial assets is more

dangerous than inflation in goods and services because this financial asset inflation appears like a

good thing and isn’t prevented even though it is as dangerous as any other form of over indebtedness. In fact, while debt financed financial booms that are accompanied by low inflation are

typically precursors of busts, at the time they typically appear to be investment-generated

productivity booms (e.g., much of the world in the late 1920s, Japan in the late 1980s and much of

the world in the mid-2000s). In deleveraging’s, rather than indebtedness increasing (i.e., debt and

debt service rising relative to income and money), it decreases. This can happen in one of four

ways: 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4)

debt monetization. Each one of these four paths reduces debt/income ratios, but they have different

effects on inflation and growth. Debt reduction (i.e., defaults and restructurings) and austerity are

both deflationary and depressing while debt monetization is inflationary and stimulative.

 

Neil Hume – The Fourth Turning - The world has fundamentally shifted over the last decade, especially since we’ve emerged from the Great Recession. We are seeing slower demographic

growth, over-leveraging, a productivity slowdown, institutional distrust, policy gridlock, and

geopolitical drift. But the professional class has been very slow to understand what is going on, not

just quantitatively but qualitatively in a new generational configuration that I call the Fourth

Turning. They don’t accept the new normal. They keep insisting, just two or three years out there on

the horizon, that the old normal will return—in GDP growth, in housing starts, in global trade.

But it doesn’t return. So even while they grudgingly downgrade their near-term forecasts, they keep

reassuring us that a better future is still out there if we just wait another year. Like a receding

mirage, the good news always keeps glimmering on the horizon.

 

The Ruffer Total Return Fund

This is the best performing asset allocation fund in the UK mutual fund industry in the last sixteen

years. I attended their inaugural investment conference two weeks ago and in the middle of their

one hour presentation joint manager Steve Russell suggested that Index Linked Gilts and gold

would be the only good investments over the longer term, everything else would be bad.

 

Whilst we believe that Index Linked Gilts should be a good long term investment, they have risen in value over the last few years as have most other financial assets through artificial monetary stimulus and investor’s desperation to get out of cash. Consequently we consider that the short term downside risk could be as much as 25%. However, we will keep this under review and if inflationary risk outweigh current valuations then we may re-enter the market.

 

Stock Markets

Investors buy shares in the anticipation that the companies that they own will increase their profits

over time and out of their profits they will provide a return to shareholders. In the last four years

US company profits have remained largely flat and yet over the same period the US S&P 500 Total

Return Index has almost doubled in value. Over the same period the UK stock market total return

was 71% and yet the profits of UK public companies declined by 33%.Consequently, both the UK

and US stock market have been overvalued by approximately 100% and need to fall by around 50%

in order to reflect the true state of company profits. If it is not clear to those that know this, that the

stock market gains of the last four years were artificial and unsustainable then it will be obvious only when they have un-recoverably lost most of their investment (inflation adjusted) . The problem for companies now is that if the world economy is to grow (as it needs to in order to pay down the debt) then companies will have to pay higher wages (due to current low levels of unemployment) or they will have to invest capital both of which should lead to a reduction in profits thereby exacerbating the enormous gap between stock market returns and company profits.

 

Danielle DiMartino Booth – 'Market behaviour suggests that an entire generation of passive

investors is about to discover the downside risk of holding highly concentrated positions (normally diversified portfolios) that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.

 

Banks

The International Swaps and Derivatives Association say that there is a gross notional outstanding

value of about $86tn. That is 114% of global GDP and should it remain uncleared, default or be

bailed out it could make the global QE to date of $11tn seem like a drop in the ocean.

 

Oil

Pierre Andurand, the founder of the $615m Andurand Capital Management who correctly predicted

the slump in oil prices, said the commodity has probably hit bottom and will end the year higher.

The price of oil will probably rise to $50 a barrel this year and $70 a barrel in 2017, though

investors should expect heightened volatility along the way, he said in an interview on Bloomberg

TV.

 

 

Paul Horsnell, head of commodities research, Standard Chartered - 'There is a very low buffer of

spare capacity at around 1%. This is a bigger than usual bust, and will involve a bigger than usual

boom when the legacy of $300bn of investment cuts is fully felt in 2017 and beyond. The speed of

the US production drop could surprise everyone, as will the time it will take for US shale to regain

the previous output peak. We also think that the relative lack of extra OPEC output will surprise.’

 

Based upon cyclically adjusted price/earnings ratios, energy companies in the United States are

41% cheaper than any other main sector.

 

Howard Simons, the president of Rosewood Trading in Glenview Illinois, and an old Chicago

commodities hand, says:' Historically, when contangos (current price less than the forward price) in

oil unwind, they move very fast, because you get a huge reward for being the first mover. I would

say this will happen within a six-month period.” The steeper the contango in the recent past, the

faster the prospective unwind of the speculative positions.

 

Other Market Warnings

John Dizard, FT – 'Unfortunately, market illiquidity seems to be metastasising into more dangerous

forms. The most serious I believe is the spread of formal and informal capital controls. Those are

what led to the rather sudden end of the last great period of globalised finance (and international

trade growth) in July 1914. We now seem intent on making the same mistakes the major powers

made back then without even the excuse of wartime necessity.'

 

Mohammed El-Erian, chief economic adviser at Allianz and an FT contributing editor, believes it to

be a mistake to see the current state of the global economy as a modestly, disappointing equilibrium

– 'sluggish, but relatively stable', in the version he quotes from the Economist. In reality we have

been incubating an ugly brood of existential challenges: high unemployment and rising inequality;

the decay of the system of global economic governance bequeathed by Breton Woods; the

disintegration of trust in national institutions and the growth of political insurgency; and a financial

system that is more prone to liquidity illusion and less well anchored to economic reality than ever.

 

 

The views reflected herein are those of Vertis Private Wealth Management Limited and should not be regarded as a recommendation to invest in any one product or service; before investing you should always consider personal investment advice.

 

Where you seek the advice of Vertis Private Wealth Management Limited we continually monitor markets and will advise you where there is a change in the findings of our research and provide advice and guidance on any alterations that may be required to the investment strategy that we have previously recommended.

 

Vertis Private Wealth Management Limited does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.

 

Vertis Private Wealth Management Limited – February 2016