FYI | Nov 05 2013
By Tim Price, PFP Wealth Management
“No matter how cynical you get, it is impossible to keep up.”
– Lily Tomlin.
Cognitive dissonance: “the discomfort experienced when simultaneously holding two or more conflicting cognitions: ideas, beliefs, values or emotional reactions. In a state of dissonance, people may sometimes feel “disequilibrium””.. An increasing number of investors are doubtless experiencing some form of cognitive dissonance now as they watch equity markets sail up into the wide blue yonder. And yet, something doesn’t feel quite right. If you want an easy visualisation of cognitive dissonance, imagine a photograph of cheering partygoers on The Titanic even as the ship starts to sink beneath the waves.
H.L. Mencken once said that a cynic is a man who, when he smells flowers, looks around for a coffin. The financial environment is certainly flowery, courtesy of central banks who seem to want to drown markets in liquidity. They may end up succeeding. If they gave awards to commentators indefatigably pointing out the sartorial failings of the Emperor’s new clothes, the tireless Doug Noland would already be a Laureate, many times over. This from his latest Credit Bubble Bulletin:
From Q&A: “In the spirit of simple questions, you’re spending a Trillion dollars a year on this asset purchase program…”
Federal Reserve Bank of St. Louis Fed President James Bullard: “It’s worse than that. We’re manufacturing it out of the blue.”
Continuation of question: “That’s my question. Where does that money come from? And given that it’s presumably our money – taxpayer money – should we be troubled then that half of it is going to prop up government spending, which is also our money?”
Bullard: “We’re creating the money. So you’ve got a Treasury bond and I (the Fed) want to buy it. So you have an account with me at the Fed, so I credit your account and buy your piece of paper. So what that does is that increases base money – which is reserves held at the Fed. That’s your account with me – plus all the cash that’s out there circulating. So that’s the monetary base and the monetary base is off the charts – absolutely off the charts. The monetary base by itself doesn’t create inflation. It’s only when that starts becoming money and circulates out in the economy. And the St. Louis Fed is famous for looking at different measures of the money supply – M1, M2, all that stuff. Those measures of the money supply have not gone off the charts. So, where’s the missing link? What has happened is that the banks have a lot of reserves but they are perfectly content to just leave them at the Fed – and they’re not turning around and making a lot of loans. If they do turn around and start making a lot of loans, money supplies will go up dramatically. And, presumably, if that goes on for too long, that will lead to a lot of inflation. So that’s the conventional story about why this is so dangerous in creating inflation. However, the truth – the empirical matter is – over the last five years these central bank balance sheets have been very large and that lending process has not gotten going. The money supplies have not been ramping up and you have not seen inflation. In fact, inflation has stayed at low levels. Inflation is close to 1.2% on our headline inflation measure per PCE [personal consumption expenditure] right now. So it’s very low and it’s below our 2% inflation target… So the inflation hasn’t materialized. And, believe me, I’m the biggest inflation hawk.” – Federal Reserve Bank of St. Louis President James Bullard, November 1, 2013, speaking in St. Louis .
“The conventional view holds that massive QE has not caused inflation because the Fed’s monetary fuel has remained unused as “reserves” on bank balance sheets. From this viewpoint, inflation risks lurk somewhere out in the future: when the banks eventually lend these “reserves” and the monetary fuel finally makes its way into the real economy. Moreover, the optimistic view holds that the Fed has the tools to adeptly manage any future inflation issue. “I take a much different view. QE is anything but benign. The Fed’s monetary fuel certainly doesn’t just sit inertly on bank balance sheets. Indeed, this monetary inflation is immediately unleashed upon the financial markets, with the newly created “money” setting off a chain-reaction of transactions, flows and market impacts. Over time, this dynamic foments huge distortions in marketplace liquidity, risk perceptions, speculative financial flows, asset prices and market stability. And, somehow, when Fed officials discuss QE they avoid any mention of what have become conspicuous inflationary effects on securities prices.
“Fundamentally, the repeated injection of Fed liquidity over time – and especially at key junctures – into the financial markets has created Bubbles increasingly vulnerable to even subtle changes in market perceptions and/or changes to the risk-taking and speculative leveraging backdrop. This is the essence of the so-called “addiction” induced by the Fed’s historic monetary inflation…
“The global leveraged speculating community would appear particularly susceptible to year-end performance dynamics. Funds that have posted big years might move aggressively to lock in 2013 gains and ensure huge paychecks. At the same time, there are an unusually large number of funds struggling with lackluster performance despite the big year in equities. When the Fed backtracked on tapering, even the most cautious had little alternative but to jump aboard the equities melt-up. This creates a backdrop of unstable markets and a bevy of potentially “weak-handed” traders and portfolio managers. Scores of funds would likely have low tolerance for losses, creating the possibility for a mercurial market backdrop. I suspect many view the current market environment as an accident in the making…
“The Fed’s failure to begin tapering in September will come back to bite. Already highly speculative markets became only more vulnerable and Bubble Dynamics only more conspicuous. This week from BlackRock’s Larry Fink: “It’s imperative that the Fed begins to taper. We’ve seen real bubble-like markets again. We’ve had a huge increase in the equity market. We’ve seen corporate-debt spreads narrow dramatically.”
“Federal Reserve Bank of Philadelphia President Charles Plosser made notably cautious comments Friday on CNBC. “I think many people – myself included – I’m not alone in this – are beginning to worry about the consequences of how we unwind ourselves from all this stuff… It’s not because that we know what’s going to happen. It’s because unintended consequences or the build-up of risks can be very important. I think we have to balance, not just the risks in the economy, but our own risks that we’re creating down the road..”
As Doug Noland concludes, “There is growing acceptance that the Fed has gone too far with its experimental policymaking – and the costs associated with overheated markets are mounting. In the “old” days, there was appreciation for the risks associated with a diffident central bank finding itself “behind the curve.” The essence of the analysis was that if the Fed were slow to tighten, our central bank would eventually face cumulative excesses and the need for more aggressive tightening measures. And while the Fed has removed “tightening” from its vocabulary, the analytical premise remains valid: With monetary policy having remained ultra-loose for way too long, the risks associated with cumulative excesses have begun to expand rapidly. The Fed doesn’t have until March or June to start winding down increasingly destabilizing QE.”
How you feel about QE probably reflects your exposure to Anglo-Saxon stock markets. If someone seems to be helping to boost your net worth, perhaps quite dramatically, chances are you’re unlikely to want them to stop. But as asset managers and perhaps more relevantly capital allocators, we feel obliged to diversify across more realms than just those of listed common stocks. The stock market, after all, is not – in our view – an engine to create wealth so much as a historical record of where it’s already been created. Listed stocks are second-hand assets; the primary purpose of the stock market is to raise expansion capital for young companies and simultaneously to allow founding entrepreneurs and their backers to cash in some of their chips. If you view the stock market as the default and almost exclusive choice for your savings, you are acting not as an investor but as a speculator. Nobody in their right minds would devote their life savings to hoarding second-hand cars, but then a colossal industry of vested interests and economic agents has not arisen around the second-hand car trading market, spurred on by facile second-hand car cheerleaders in the popular media.
To return to the topic of cognitive dissonance. Elliott Management’s Paul Singer and his latest letter to investment partners were recently quoted quite extensively on Zero Hedge:
“The recent trading environment has felt something like walking into a place and having a sense that something is wrong and dangerous but not knowing exactly what will happen or when. “QE Infinity” has so distorted the prices of stocks and bonds that nobody can possibly determine what the investing landscape would look like, or what the condition of the economy and financial system would be, in the absence of Fed bond-buying.
“What has been happening with the U.S. federal government in its recent highly-theatrical phase, as contentious and difficult as it has been, is merely a precursor to much bigger events.. we are talking about the underlying structural issues of the federal budget deficit, economic growth, the deeply contentious Affordable Care Act, and the long-term insolvency of the country due to the government having made (and continuing to make) massively unpayable promises for the future. As we have pointed out, the current annual federal deficit, so ballyhooed to be “coming down nicely,” is actually catastrophically out of control. It is not a trillion dollars. The true figure is more like $7 trillion (and growing!) after accounting for unfunded liabilities, which are mounting at a fantastic pace. It is not an exaggeration to say that America is deeply insolvent, and for that matter, so are most of continental Europe, the U.K. and Japan. No combination of achievable growth rates and taxes can pay for the promises that have been made. The numbers are clear and inexorable.”
On the one hand, western equity markets continue to surge higher. We have a new (crude) acronym: BTFATH has replaced BTFD in online investment chatter. (Since this is a family show, if you don’t know, you’ll just have to look them up.) On the other hand, in Paul Singer’s sobering but hardly inaccurate words, “America is deeply insolvent, and for that matter, so are most of continental Europe, the U.K. and Japan.”
Still bullish ?
It’s not like we’re not participating in the equity market; we merely choose to favour explicit classic value with a strong secular tailwind behind it – Greg Fisher’s Halley Asian Prosperity Fund being a case in point. But we also choose to diversify much further by asset class, into things like creditor country bonds, uncorrelated assets and gold, because most of the West is bankrupt, and at some point the piper will want to be paid.
Tim Price
Director of Investment
PFP Wealth Management
4th November 2013.
Follow me on twitter: timfprice
Email: tim.price@pfpg.co.uk Homepage: http://www.pfpg.co.uk
Weblog: http://thepriceofeverything.typepad.com Bloomberg homepage: PFPG
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