Terra Incognita

Fall is around the corner and I hope everyone had a great summer. I’m taking this opportunity to re-connect and share with you a short missive.

If you are trying to make sense of this economic environment and you can’t, welcome to the club. I don’t have forty year plus of experience behind the belt and when I talk to people who do, they are clueless. The environment we are in is terra incognita. Sure we can go back in history to study the cause and effect of certain specific policy, but any attempts feel useless when applied to today’s climate. I don’t remember being tested on negative interest rate in university. We never lived in a time with so much global central bank intervention. Their collective action is distorting the “normal” course of action, if we assume there’s any meaning left to the word normal. We have over $16 trillion in negative interest rate bonds. I’m not a macroeconomics expert, but common sense dictates that when things are so out of whack, it’s not going to end well.

The dreaded over-used expression “this time is different” comes to mind. Basically we claim that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. There’s the sentiment that the important lessons from history to show us how much–or how little–we have learned don’t apply anymore. Throughout history, rich and poor countries alike have been lending, borrowing, crashing–and recovering–their way through an extraordinary range of financial crises. We just had a major generational financial crash just ten years ago. Yet, that harsh lesson seems like distant history. Total global debt levels have reached a whopping $246 trillion as of Q1-2019 – up from $164 trillion in January 2009, the time of the last financial crisis. This level of debt represents almost 320% of global GDP. The “time” might be different, but the outcome might be similar.

Here are some economic and financial topics that are just mind numbing. Feel free to reach out to discuss any.

  • We are apparently living in a period of “strong” economic growth, though it has been slowing down a little bit lately. Still we are at full employment and wages are rising. Normally during good economic times the government might call for a budgetary surplus. This is, basically, standard Keynesianism. But instead governments are running major deficits like they are trying to get out of a major recession. This situation raised three important questions that I don’t see anybody talk about:
    1. What will governments do to stimulate the economy when a real recession hits? The classic economic 101 textbook response is more stimulus/deficit/debt.
    2. This led to question #2: How are we going to pay for these deficits? Of course we can’t raise taxes of 1) it won’t help the economy and 2) Good luck getting re-elected. So it has to be more money printing and monetary stimulus.
    3. I don’t see any politicians, or financial media being alarmed with the ever growing deficit. There are long term consequences to this type of action. The deficit problem is not urgent right now but if we don’t address the problem, the problem will eventually address us and that’s not good. We are perpetually “kicking the can down road” until the can becomes a massive iron wrecking ball that is stuck in the middle of the road. Any attempt to kick it will break your foot. Worse, it might roll back and crush us.
    4. I asked a leading economist in Canada these questions and his answer was: “Good questions”.
  • If the economy is so “strong”, why can’t it handle interest rates north of 2.5%. Really, 2.5%, it’s not much. To be relative, the rates were at 19.5% in 1981. Imagine buying your house on a credit card. To be fair, homes were a fraction of today’s cost (a prolong period of low rates led to very expensive housing). Now the Fed has lowered its rate in July and has indicated that it might go lower. Actually they have clearly indicated that they don’t know what they are doing to do. Read: Fed’s George: It’s ‘too soon’ to judge next move on rates.
  • Then there’s M.M.T. that is gaining a lot of traction. Politicians on the left and economists are talking about M.M.T., which sounds like the street name of a new drug. M.M.T. actually stands for Modern Monetary Theory, which is pushed by Bernie Sanders adviser Stephanie Kelton. Mrs. Kelton, the face of M.M.T., believes the government should just print more money. When asked “How will we pay for it?” she says that it shouldn’t be a central question in American politics. Simply printing more money is always the answer. When I first heard of M.M.T. it sounded like a joke an economist would tell. But economists are not known for their sense of humour and the joke got picked up by politicians and the media and M.M.T. is now a real “serious” discussion topic. How does it pass the common sense test? But the problem is by asking that question we are assuming there’s common sense left out there. M.M.T. is a polarizing idea. Kelton has been described as an economist with an idea “that will either solve the world’s problems or send it into ruin!” Didn’t Zimbabwe and Germany, among many others, went down that road in the past? Historically speaking, printing too much money led to hyperinflation. But I guess this time is different. Kelton is working on a book, “The Deficit Myth” which will come out next year. It will be in the accounting & finance section, not fiction.
  • The puzzle of negative interest rates. Imagine lending money to someone and having to pay for the privilege of doing so. Or being asked to invest and informed of how much money you’ll lose. What if I said I wanted to borrow $100 from you and pay you back $98 five years later? Would you do it? Sounds absurd, but increasingly that’s the global bond market these days. There are currently more than $16 trillion (30%, and counting, of the global tradable bond universe, according to JPMorgan) in negative yielding debt around the world as central banks try to ease monetary conditions to sustain the global economy. This is possible because Denmark, as well as Sweden and Switzerland, has seen rates in money markets drop to levels that turn banking upside-down. Swiss banks in particular, where interest rates are negative at -0.75 per cent, have been passing on these rates to clients with high cash balances. Credit Suisse and UBS had held fire, but recently said they would have to start passing them on, too. Jyske Bank will effectively pay borrowers 0.5% a year to take out a loan. How? Jyske Bank is able to go into money markets and borrow from institutional investors at a negative rate, and is simply passing this on to its customers. Negative rates are counterintuitive, unprecedented — and to my mind — mind-bendingly insane and downright scary. They are like a parallel universe where everything you’ve ever learned about finance and human behavior is turned upside down. Worse, negative rates are being normalized by economists, bankers, and commentators. Worse, I have a funny feeling this will end badly. Negative interest rates have all the hallmarks of serious trouble for the financial markets; an anomaly growing in scale which seemingly came out of nowhere that is under-recognized, poorly understood and dismissed as not consequential. I’m not sure what form the ugliness will take or, more vexing, what we should do about it.
  • A lot of people think cash is the safest bet in a world of negative interest rates….there’s a cost: inflation and referring to investors who have stayed on the sidelines and missed out on the great bull run in equities. Yet perception of risk is an emotional thing. If people feel comfortable paying extra money in the form of negative rates for the known loss they will suffer on cash versus the unknown and potentially larger loss on riskier assets, it can be hard for wealth managers to talk them out of it.
  • Brexit is a full-on terra incognita. That’s a storm nobody has figured out how to navigate. The Americans and English have a thing for turning politics into awesome theatrics performance. How is this the real world?
  • The WeWork IPO is being sold as the holy grail of investments…The mission of WeWork is to elevate the world’s consciousness. That’s very nobel for an office space rental business. The company disclosed last month of net losses of more than $900 million for the first six months of 2019 on revenues of $1.54 billion. It will achieve 5-star status when the losses are higher than the revenues. WeWork has long-term lease obligations at $17.9 billion that is financed by short-term assets, a recipe of disaster when the next downturn comes. Basically the short-term assets melts and you are stuck with the debt. This stock screams “buy” when the CEO and co-founder cashed out of more than $700 million from his company ahead of its IPO. But at least he returned around $5.9 million worth of stock to the company, which he had originally received in exchange for the “We” trademarks. I’m not making this stuff up. Maybe the trademark “I” is my ticket into the sun. Yet, despite the tons of red flags in their S1, WeWork is expected to be valued around $47 billion because WeWork consider themselves as a “platform tech” in the “space as a service” segment instead of where it should be: real estate. Who is buying this stuff? What I noticed is that stocks listed on the stock market are either trading at 10x P/E or 100x P/E.

To conclude, governments and central banks are acting like they are in a recession with big budget deficit and excessive monetary stimulus policy. Any attempt to normalize the situation has encountered hiccups, like the tamper tantrum (a bout of panic selling after Federal Reserve hinted at a reduction in stimulus) and the December 2018 mini-correction.

For investors, attempting to figure out how to play these developments is a crazy game. Just don’t. Add in a dose of trade war, political circus, political uncertainty, Twitter and you have an instant aging formula.

Happy fall,

Brian

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