By Steve Blumenthal
November 1, 2013
When you were a kid and you and your friends would line up for a race, someone would shout, “on your mark, get set, go!” Oh, how we all positioned to win.
Flashback to April 2011. My cell phone rang – it was John Mauldin. “Are you sitting down?” he asked. I had just gotten off of the ski lift and stood there on top of my skis. “How’d it go?” I replied. I had been looking forward to the call…the skiing could wait.
The night before, John was invited to a private dinner with House Speaker John Boehner and a few of his friends. Deep into the discussions on debt and entitlements Mauldin asks, “Ok boys, what’s your plan?” “I’ll tell you exactly what we are going to do; we are going to print and print and keep on printing,” Boehner replied.
Irresponsible, unimaginable, doable? My mind was racing. Understanding economic systems, global trade, currency regimes and the fragile balance that exists I couldn’t help to conclude that someone yelled “go”. The global race was on: It is a race to debase.
What is evident today is dysfunctional government leadership, global central bankers in full throttle, debt accumulating beyond comprehension, and pension and entitlement promises that can’t possibly be met. We are living in a highly manipulated period of time. This is not normal and it is not healthy. How you diversify risks and manage equity and fixed income holdings is crucial to your clients and your long-term success. Fasten your seat belts as it is going to get choppy.
I share the below courtesy of my friend, John Mauldin. It is the intro to his new book entitled Code Red. It just hit the bookshelves a week ago.
“When Lehman Brothers went bankrupt and AIG was taken over by the US government in the fall of 2008, the world almost came to an end. Over the next few weeks, stock markets went into free fall as trillions of dollars of wealth were wiped out. However, even more disturbing were the real-world effects on trade and businesses. A strange silence descended on the hubs of global commerce. As international trade froze, ships stood empty near ports around the world because banks would no longer issue letters of credit. Factories shut down and millions of workers were laid off as commercial paper and money market funds used to pay wages froze. Major banks in the US and the UK were literally hours away from shutting down, and ATMs were on the verge of running out of cash. The world was threatened with a big deflationary collapse. A crisis that big comes around only twice a century. Families and governments were swamped with too much debt and not enough money to pay them off. But central banks and governments saved the day by printing money, providing almost unlimited amounts of liquidity to the financial system. Like a doctor putting a large jolt of electricity on a dying man’s chest, the extreme measures brought the patient back to life.
The money printing that central bankers did after the failure of Lehman Brothers was entirely appropriate in order to avoid a Great Depression II. The Fed and central banks were merely creating some money and credit that only partially offset the contraction in bank lending.
The initial crisis is long gone, but the unconventional measures have stayed with us. Once the crisis was over, it was clear that the world was saddled with high debt and low growth. In order to fight the monsters of deflation and depression, central bankers have gone wild. Central bankers kept on creating money. Quantitative easing was a shocking development when it was first trotted out, but these days the markets just shrug. Now, the markets are worried about losing their regular injections of monetary drugs. What will withdrawal be like?
The amount of money central banks have created is simply staggering. Under quantitative easing, central banks have been buying every government bond in sight and have expanded their balance sheets by over nine trillion dollars. Yes, that’s $9,000,000,000,000 – twelve zeros to be exact. (By the time you read this book, the number will probably be a few trillion higher, but who is counting?) Numbers so large are difficult for ordinary humans to understand.
In the four years since the Lehman Brothers’ bankruptcy, central bankers have torn up the rule book and are trying things they have never tried before. Usually interest rates move up or down depending on growth and inflation. Higher growth and inflation normally mean higher rates and lower growth means lower rates. Those were the good old days when things were normal. Now central bankers in the US, Japan, and Europe have pinned interest rates close to zero and promised to leave them there for years. Rates can’t go lower, so some central bankers have decided to get creative. Normally central banks pay interest on the cash that banks deposit with them overnight. Not anymore. Some banks like the Swiss National Bank and the Danish National Bank have even created negative deposit rates. We now live in an upside down world. Money is effectively taxed (by central bankers, not representative governments!) to get people to spend instead of save.
These unconventional policies are generally good for big banks, governments, and borrowers (who doesn’t like to borrow money for free?); but they are very bad for savers. Near zero interest rates and heavily subsidized government lending programs help the banks to make money the old-fashioned way: borrow cheaply and lend at higher rates. They also help insolvent governments by allowing them to borrow at very low costs. The flip side is that near-zero rates punish savers, providing almost no income to pensioners and the elderly. Everyone who thought their life’s savings might carry them through their retirement has to come up with a Plan B when rates are near zero.
In the bizarre world we now inhabit, central banks and governments try to induce consumers to spend to help the economy while they take money away from savers who would like to be able to profitably invest. Rather than inducing them to consume more, they are forcing them to spend less in order to make their savings last through their final years!
Savers and investors in the developed world are the guinea pigs in an unprecedented monetary experiment. There are clear winners and losers as prudent savers are called upon to bail out reckless borrowers. In the US, UK, Japan, and most of Europe, savers receive close to zero percent interest on their savings while they watch the price of gasoline, groceries, and rent go up. Standards of living are falling for many and economic growth is elusive. Today is a time of financial repression, where central banks keep interest rates below inflation. This means that the interest savers receive on their deposits cannot keep up with the rising cost of living. Big banks are bailed out and continue paying large bonuses while older savers are punished.
Central bankers must hide the truth in order to do their job. We may dislike what they are doing, but if politicians want to avoid large-scale defaults, the world needs loose money and money printing.
Ben Bernanke and his colleagues worldwide have effectively issued and enforced a Code Red monetary policy. Their economic theories and experience told them it was the correct and necessary thing to do – in fact, they were convinced it was the only thing to do!
Bernanke understands that the world has far too much debt that it can’t pay back. Sadly, debt can only go away via: 1) defaults (and there are so many ways to default without having to actually use the word!), 2) paying down debt through economic growth or 3) eroding the burden of debt through inflation or devaluations. In our grandparents’ age, we would have seen defaults. But defaults are painful, and no one wants them. We’ve grown fat and comfortable. We don’t like pain.
Growing our way out of our problems would be ideal, but it isn’t an option. Economic growth is elusive everywhere we look. Central bankers are left with no other option but to create inflation and devalue their currencies.
No one wants to hear that we’ll suffer from higher inflation. It is grotesque and not what central bankers are meant to do. But people can’t handle the truth, and inflation is exactly what the central bankers are preparing for us. They’re sparing some the pain of defaults while others bear the pain of low returns. But a world in which big banks and governments default is almost by definition a world of not just low but (sometimes steeply) negative returns. As I said in
Endgame, we are left with no good choices, only choices that range from the merely very difficult to the downright disastrous.
Today’s battle with deflation requires a constant vigilance and use of Code Red procedures.
Unfortunately, just as in A Few Good Men, Code Reds are not standard operating procedures or conventional policies. Ben Bernanke, Mario Draghi, Haruhiko Kuroda, and other central bankers are manning their battle station using ugly means to get the job done. They are punishing savers, encouraging people to borrow more, providing lots of liquidity, and weakening their currencies.
This unprecedented global monetary experiment has only just begun, and every central bank is trying to get in on the act. It is a monetary arms race, and no one wants to be left behind. The Bank of England has devalued the pound to improve exports by allowing creeping inflation and keeping interest rates at zero. The Federal Reserve has tried to weaken the dollar in order to boost manufacturing and exports. The Bank of Japan, not to be outdone, is now trying to depreciate the yen. By weakening their currencies, they hope to boost their exports and get a leg up on their competitors. In the race to debase currencies, no one wins.
Emerging market countries like Brazil, Russia, Malaysia, and Indonesia will not sit idly by while developed central banks weaken their currencies. They are fighting to keep their currencies from appreciating. They are imposing taxes on investments and savings in their currencies. Countries are turning protectionist. The battles have only begun in what promises to be an enormous, ugly currency war.
If the currency wars of the 1930 and 1970s are any guide, we will see knife fights ahead. Governments will fight dirty, they will impose tariffs and restrictions and capital controls. It is already happening and we will see a lot more of it.
Some central banks are better armed than others. Indeed, you might say that the four biggest central banks – the Fed, BOE, ECB, and BOJ – have nuclear arsenals. In a fight for national survival – which is what a crisis this major will feel like – will central bankers resort to the nuclear option; will they double down on Code Red policies? The conflict could get very messy for those in the neighborhood.
The arsonists are now running the fire brigade. Central bankers contributed to the economic crisis the world now faces. They kept interest rates too low for too long. They fixated on controlling inflation, even as they stood by and watched investment banks party in an orgy of credit. Central bankers were completely incompetent and failed to see the Great Financial Crisis coming. They couldn’t spot housing bubbles, and even when the crisis had started and banks were failing, they insisted that the banks they supervised were well regulated and healthy. They failed at their job and should have been fired. Yet governments now need central banks to erode the mountain of debt by printing money and creating inflation.
Investors should ask themselves: if central bankers couldn’t manage conventional monetary policy well in the good times, what makes us think that they will be able to manage unconventional monetary policies in the bad times?
And if they don’t do a perfect job of winding down condition Code Red, what will be the consequences? Economists know that there are no free lunches. Creating tons of new money and credit out of thin air is not without cost. Massively increasing the size of a central bank’s balance sheet is risky and stores up extremely difficult problems for the future. Central bank policies may succeed in creating growth, or they may fail. It is too soon to call the outcome, but what is clear (at least to us) is that the experiment is unlikely to end well.”
John captures and tells the story well. I believe he has another best seller to add to his list. It is another must read.
Some concluding thoughts:
As depressing as the situation may seem, there are opportunities and there is certainly a path through to the other side of this global debt crisis. I believe many will remain incorrectly positioned, overweighting yesterday’s top performers, having no formal investment game plan and little regard to risk.
I believe a much better plan is to weave together a broad set of different sources of risks, add non-correlating asset classes, shorten one’s fixed income exposure and actively risk protect long-term equity exposure. Yes, it is more work than a simple 60/40, but I believe it has a better chance of navigating the period ahead. To be blind to the uniqueness of the period we are living in is simply irresponsible.
If you find it helpful, every Wednesday I post a piece called Trade Signals. I share a few ideas around managing equity risk exposure. For now, the cyclical bull trend remains intact (I post two charts that I like to use to monitor the cyclical trend). This is just one idea around active risk protection. There are most certainly others – find an approach that works best for you.
Equities can be easily hedged with inexpensive put options or some other form of risk protection. Bonds can be managed more tactically and inflation hedges are available in liquid form with movement in securities’ prices comes great opportunity. Add unconstrained strategies into your portfolio mix.
The traditional 60/40 allocation is in trouble while a broader mix will likely perform better. Stocks for the long haul? I say yes, but allocate in an intelligent way. Cap weighted funds over-concentrate your risk. Seek broader solutions and actively risk manage that exposure.
Be forward looking. Everyone writes about what happened yesterday. You want to sell when everyone is buying and buy when everyone is selling. This is a game of opposite. Certainly opposite of what you might be feeling emotionally, which is hard to do.
Looking forward I believe the global central banks will achieve their goal to create inflation. From country to country tensions will rise. We are seeing just that today. Investing is about capturing movement and the big movement I see ahead is the impact rising interest rates will have on both bonds and stocks. The move might just be quicker and higher than we think. Fed Funds are at 0.25% today. They should be at 2% according to the Fisher rule. That puts 10-year Treasuries at 4.5% and 30-year Treasuries at 5.5%. I think we’ll see 7.5% or more on both within three years. Be prepared to benefit when that day comes.
When I need to find my happy place, I think about skiing and after what I quoted above I think I’m now in need! Skiing has always been a big part of my family. It might just be the best activity we do together. Everyone is crazy happy at the end of each ski day.
As time moves forward and the unknowns unfold, I’m sure you and I will be celebrating just as we are today. There will be far more good days than bad days and we will continue to create no matter how the financial landscape unfolds.
The world broke in 2008 and we all made it through. We have another crisis coming. This time the bubble is in the bond market and it just might be the bubble of all bubbles. Some will profit and some will struggle, but make it through we will.
Let’s do our very best to be in a position to take advantage of the opportunities that will present itself at the lows of the next major correction. Until then, take advantage of the numerous tools that exist and, of course, stay crazy happy. It is so great to be alive!
I mentioned in last week’s On My Radar that I’d share some thoughts about banks. Certainly, what I’ve discussed above will affect every bank; yet I’m most concerned about the banks with large derivative exposure. Hopefully, I’ll be prepared to share some thoughts on banks next week.
I’m hoping to golf tomorrow with the boys. They are not as crazy happy after four hours of golf but I do enjoy the walk together. The trees are red, yellow and deep orange and it is supposed to be a great day.
Wishing you an outstanding weekend.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Suburban Philadelphia
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.net
610-989-9090 Phone
610-989-9092 Fax
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