When you give someone US$1 billion as an interest-free loan, with an uncertain payback period and no interest costs, do you think they will:
a. Settle all their outstanding debts and start earning money to repay this new facility?
b. Invest in some safe securities to eke out a secure return?
c. Bet the whole thing on red?
If you answered “c”, then congratulations – you are now eligible to become a banker in the United States. The unsaid part of the current global rally in risk assets is that the process is being driven almost exclusively by financial institutions that are currently in the intensive care unit of the US Treasury.
Be it the tightening of credit spreads for high-yield bonds or the rising prices of commercial mortgage-backed securities, the sole buyers inevitably tend to be the very financial institutions whose holdings of these securities in 2007 jeopardized the entire financial system.
It is not the hedge fund villains who have ridden back from their dirty past to ramp up their purchases of distressed securities, bonds and equities; rather these hedge funds are still going bust at regular intervals. There are many examples of silly behavior in global markets as I write this:
1. US and European stocks are pretty much where they started the year, give or take a few points, despite macroeconomic data getting steadily worse;
2. Significant jumps in the stock prices of various emerging market countries, including those in Asia, in the last few weeks;
3. Credit spreads of the world’s most leveraged companies have tightened dramatically since the beginning of the year, despite rising corporate defaults;
4. Some of the most beaten-up parts of the securitization market including residential and commercial mortgage-backed securities (RMBS / CMBS) have shown some improvement in recent weeks even as property sales / price data gets progressively worse;
5. Banks have raised new capital (including for example Bank of America’s $13.2 billion common equity issued this week) from the sale of common equity to the public.
My basic premise is that it is in understanding the dynamics of point No. 5 above that the rest of the market moves make any sense. In other words, I contend here that financial institutions globally are misrepresenting economic data for their own short-term selfish ends.
Making such contentions is no easy task. What is the evidence: firstly, we have to “prove” that a crime is taking place to then allege that the perpetrator also happens to be the main beneficiary of such an event. To do that, let us examine some of the most recent data that underpins the markets over the long term:
a. The European Union recorded the sharpest economic decline in its history for the first quarter of this year, led down by Germany’s awful figures for the quarter;
b. Figures for the month of April appear no better, highlighting likely declines in the quarters to come for Europe;
c. US indicators on gross domestic product growth, unemployment and new investment all continue to flash red as I write this; only the color-blind could possibly see any green shoots in this data ;
d. Japan stunned with an annualized 15% decline in its economy, shrinking an amazing 4% in just the first quarter of this year;
e. Granted, some of this was due to inventory declines, but the overall trend is abysmal even after taking into account all the government stimulus spending being stored up.
Why then are investors persisting with this course of action that adds risks? Many theories have been propounded, but a clear framing of the future outlook would help to understand the sheer “courage” that is involved in buying such assets now. To make things easier, I have used a modified decision tree wherein the basic trend has been used as the title, with financial market consequences being highlighted below each such possible trend. Such an approach is provided below:
1. Green Shoots of economic recovery are for real (hahahahahaha, but let’s take these bubble-spewers at face value for now; or else read “Truth is too hard to handle”).
a. This could only be due to the US and European consumer spending money on borrowed time; yet again
b. Over the short-term that would argue for buying risky assets such as stocks and high-yield bonds and going short US Treasuries;
c. Inflation will rise inevitably, so buy physical commodities including gold;
d. Go short anything near the government bond curve including US Treasuries and German Bunds, among others.
2. We are into a Great Depression
a. The monetization of the debt cycle would have failed for this outcome to percolate to the masses in Europe and the US;
b. Financial institutions in Group of Eight leading industrialized countries cannot raise any capital from the public;
c. Forget about stocks, high-yield bonds that will fall in price dramatically just as soon you buy them for your retirement account;
d. Buy some government bonds, but only of countries that can service their future debt obligations (that is, avoid the likes of the US and pretty much all of Europe);
e. You will need to have some stuff that has real economic value rather than the worthless IOUs issued by G-8 governments, so buy some gold;
f. This might also be a good cue to buy some weapons and ammunition.
3. We will have a Y-shaped recovery (see How about a Y-shaped recovery, Asia Times Online, February 23, 2008.)
a. The US and Europe are toast, but emerging markets will do well;
b. Financial institutions in G-8 countries cannot raise any capital from the public;
c. Buy emerging market equities and bonds, sell everything else;
d. As most emerging market currencies are quite funky and don’t really fit into your wallets, you will need some gold for your travels.
What the average reader thinks for himself is one thing; what he is being told by the financial media at large (and G-8 financial media in particular) is altogether a different matter. Whilst I would normally lean towards the school of an incipient economic recovery after a couple of years of any economic bust, a number of factors conspire to deny any such notion in my mind at the moment:
1. This is very much a crisis caused by excess leverage in the US (and, less so, in Europe). Until the leverage is washed out, there is no chance of any economic recovery;
2. Governments have engaged in widespread monetization of such leverage, rather than addressing the core event itself. This has the effect of actually making the future even more uncertain. For example, General Motors or Chrysler as private companies would have entered bankruptcy many months ago; but thanks to government intervention now re-emerge as worker-owned companies that couldn’t possibly get bank financing down the road (due to the destruction of creditors’ rights by the Obama administration). Ergo, this is money wasted by the government at great cost to the average US taxpayer: not exactly the recipe for an economic recovery;
3. Then there is the question of bank funding. Most analysts point to a funding gap of around US$20 trillion for the G-8 banking system by 2011, made worse by the reduced velocity of money (that is, a lower money multiplier). This problem has not been addressed, and most likely will not be; unless banks can pledge more useless collateral with their central banks and in effect get “free” funding;
4. Export-driven markets are toast, be it China or Germany or Japan. All these countries will have to reinvest in their domestic markets: some to fruitful results (China) but others to no avail (Japan). Whatever they do, it is clear what they will NOT do – that is, they will not buy more US sovereign and state-guaranteed debt;
5. Many of the weaker emerging market countries are facing funding pressures; particularly those in Eastern Europe. The resulting increase in defaults promises to fell the rest of the European banking system that hasn’t already fallen victim to the US financial collapse. This will also divert more resources from the International Monetary Fund and so on, to the expense of the G-8;
6. Increased strategic risks: think Pakistan’s ongoing fights with the Taliban, Iran’s nuclear weapons program, Russia’s anger with the North Atlantic Treaty Organization over Georgia as just a few examples of what could go wrong in the very, very near future.
Based on all this, it is clear to me that the only people who could possibly believe that risky assets such as high-yield bonds and common stocks are a good buy are either the people who currently own them (and therefore will post profits when they rise in price) or those that need to get out of their positions (that is, sell their bond positions or raise new equity).
In most cases, the answer is “both of the above”, namely US and European banks who are loading up on some securities to cause artificial shortages that in turn help to raise prices of the rest of their books. These institutions have the benefit of knowing that a good trade gets them out of jail, but bad trades only result in more government assistance being lavished on them.
They aren’t playing with their own money, but rather with yours. When you are only ever going to lose other people’s money, the rules change and an entirely different “game” takes hold. That is what you are seeing now; until the final blows of economic data help to chase these fake rallies out of the market. When that happens, the biggest losers will be the people who own these risky assets like high-yield corporate bonds in the US (or Europe) and stocks of banks across G-8.
What should the average investor do amidst all this game theory around them? Neither a lender or borrower be; neither a buyer or seller be. Close your positions on these financial assets, buy some physical commodities, sit back and watch the fun.
Health warning: As with the last time I wrote such an article on financial markets, the same warning holds for this article. Unlike my colleagues at Asia Times Online such as David Goldman and Julian Delasantellis, I remain a pseudonymous contributor to these pages; therefore following my advice should be considered significantly risky.