The Bermuda triangle of economics
The mystique of the Bermuda triangle has caught the imagination and interest of generations. In the same way I feel there is now a Bermuda triangle of economics - a space where everything tends to disappear without radar contact. A black hole where rationality and science is replaced by hope, superstition and nonsense pundits like myself pretending to understand the real drivers of the economy.
The Bermuda Triangle in real life runs from Bermuda to Pueto Rico to Miami. The economic one runs from high stock market valuations to high unemployment to low growth/productivity. Just like with the real Bermuda triangle, in the Bermuda triangle of economics there is plenty of scientific evidence which can explain most, if not everything, of what is going on but that does not suit Hollywood, sorry the Federal Reserve.
Neither does it suit main stream banking analysis or the media in dealing with reality and facts: The mystique simply sells better! After all, there is a reason why people leave science education for PhD's in apps and virtual reality.
There are even fairy tale beliefs that the sunken Atlantis could be placed in the middle of this triangle. It has been renamed Modern Monetary Theory (MMT) to make it suit the black whole's main premise: Make sure to have fancy names for what is essentially the same economic recipe: Print and spend money, then wait and pray for better weather.
The economic Bermuda Triangle, EBT, is getting harder and harder to justify - if for nothing else because the constant reminders of crisis keep us all defensive and non-committed to investing beyond the next quarter. We all naively think we can exit the 'risk-on' trade before anyone else. A less cynical person than me could think that some things in life need to be experienced - not talked about.
Where to from here?
A long time ago policymakers entered a one-way street where reversing is, if not illegal, then impossible. Enough though about the polices though. What is more important is what is next?
If a political scientist should create a simple model for how this Bermuda Triangle works the first action point would be to test the premise of the policy. No theory is better than its premise - clearly.
In the Federal Reserve version of the premise: It is to create a positive wealth effect which ultimately leads to better sentiment and investment. The barometer of success is the stock market, but does the stock market really correlate to "wealth"? Clearly the stock market been on a tear, but is everyone, the average Joe benefitting? Clearly not. Ownership of stocks is almost exclusively for the top 10 percent of the population. Social divide is much higher today than before the crisis. Furthermore 85% of jobs and growth comes fromSME's – meaning the 15% of the stocks, the listed, which is flying is benefitting but the SME's is not. We have market for the 15% biggest in the corporate world and the top 10% of the private sphere, so I guess when Fed and BOJ talks about wealth effect the really talk about ELITE effect?
In Japan - they are more open - they simply want to create a bubble - I repeat, a bubble. That is kind of interesting when policy makers for years have said it is impossible to figure out when there is a bubble! I guess - proactively wanting a bubble makes it more transparent? Confused? Certainly I am but then again Abenomics is 'Double Dutch' to me anyway.
So the premise does not hold but how will the policy makers deal with failure? Change course? Never! It would be worse than blasphemy! A one-way street means the cars can only go one-way - not reverse - optionality is for democracies and capitalistic systems - not for a time of crisis - in times of crisis we need the foresight of our great supreme leaders, sorry, politicians and central bankers to guide us. Their divine insight will lead us safely ashore to the beaches of Lalaland where the sun always shines.
No the response is to do more - take the Bank of Japan's quantitative easing (QE) infinite released on April 4 - now one month into the experiment JGB's yields are higher, not lower.
The yield curve is steeper, inflation expectations are flat but Nikkei and USDJPY are higher. A success? Yes, except in the one area you wanted to impact: The yield and the yield curve!
The other part is that for this to work the stock market needs to keep outpacing the fall in JGB's -The Government Pension Fund manages in excess of 1,000 billion US Dollar - Their allocation? 65 percent in JGBS - and less than 11 percent in stocks hence the present score board would read:
650 billion US Dollar x (146.50 - 143.50) = 2% = - 13 bln. USD. 110 billion US Dollar x 40% = 48 bln. USD. A net gain of 35 bln. US but...
What if - Nikkei comes off a 10 percent - then 48 bln. US Dollar becomes 37 bln. and the new eqilibrium price: 138.50 only 5 figures away.
A price point which will make Japan less well of, not better, plus it would have increased the funding price of the 240% debt to GDP. Some strong macro fund managers think that a collapse in Japan is less than 12-18 month away, among them Mr. Kyle Bass stands out. Maybe Japan should be careful for what it wants. My conclusion on Japan is:
1. Japan scenario is neither black or white but a continues gradual process. Japan is notoriously slow in changing, in its political process and ultimately nothing will have changed materially one year from now. Yes, the Nikkei could be the start of a secular bull market as Stanley Druckenmiller recently said in New York, but it is already up 60 percent from the low and with China and Europe slowing down its likely to see major correction and probably soon.
2. The unintended consequences of the QE Infinite in Japan is so far (as shown above) a higher yield. Even higher than the recent rise in US rates - USDJPY becomes vulnerable for a major correction down to 95/96
3. Japan will not go bankrupt inside 12-months or even 12 years, but the hope of a recovery will be wane and soon. Watch how the Upper House election in the Diet in July becomes the final destination for Abenomics. Abe needs to secure 63 and 100 new seats. 63 seats to maintain momentum behind his economic policy and 100 to secure majority to change the Constitution.
Delivering "cheap money" is the easy part of his three pillar strategywhich got him elected. Using stimulus correctly and working on the supply side of the economy will be impossible - due to structure, lack of immigration, health care and ageing costs. I wish Japan well, but nothing will be saved by using the economic Bermuda Triangle, of all countries Japan should know - it invented the economic version of it!
Another key event will be the German election:
In Germany Merkel will win the battle (the election), but probably lose the war: She needs to step up. Europe expects it. The market wants it. The problem is: She can't afford it.
Bailing-in will mean a loss of rating for Germany - keeping austere will cost exports and long-term growth. Which scenario to choose? I personally think she will fail - fail to reconcile - she is already short of a Chancellors majority - after the election the Greens and SPD will hold her hostage - staying in power will mean giving in. Simply.
That how ever will be the end of the honeymoon for Europe. Germany can not save Europe. Each country in Europe needs to realise their recovery comes from inside their own political willingness to reform and eating reality pills. Europe is destined to repeat the history of Japan. Unless an even more severe crisis makes us wake-up.
This means we see July-October as a very important time frame for this experiment. We firmly believe the German election will be the game changer - but we could get a surprise already in July unless Japan's Prime Minister Abe gets JGB yields under control.
Policy conclusion
The Fed is testing the waters with their 'tapering' - but Bernanke is financing the budget deficits via his QE - hence he will continue, maybe less aggressive but QE is not ending.
Bank of England gets new boss in July - This will kick-start American style policies which sit right in the middle of the economic Bermuda Triangle - with GBP being the main casualty.
Bank of Japan - will soon - correct its maturity in buying - buying longer and deeper - the July election is getting closer.
ECB - is close, very close to doing something which will smell and feel like QE - Selling the sick man of Europe France make a lot of sense here
Strategy
We are entering the realisation part of this global slow-down. Unlike three months ago, policy makers now realise that growth is not coming back in six month's time as they all love to estimate in their press conferences. So over the summer the Federal Reserve, Bank of England, Bank of Japan, International Monetary Fund, European Central Bank will all go back to the drawing board and.... do more of the same.
The policy is not wrong, clearly, it is only the amplitude of it. I agree withJeff Gundlach who believes QE is here to stay for a long, long time, but also that the only thing which will get us out of this funk is innovation and reality. How do I reconcile this?
By allowing the 70 percent likelihood for Extend-and-pretend Season 4 through to July-October (German and Japanese elections) which will lead us to Japanisation (dis-inflation, no growth and productivity plus an ageing population).
There is a 30 percent chance of failing before July - failing as in the market collapsing or social tensions rising, governments falling and the financial system under pressure.
We are due for a new crisis. We have governments and central banks pro-actively pursuing bubbles hence the probability of bursting one will need to have risen by the same magnitude as the desperate moves of policy makers.
Allocation
We have a very balanced approach to investment despite our strong views:
70 percent of our assets are placed in the Saxo Fortified Portfolio which is based on the approach introduced by Harry Browne in his: Fail-Safe Investing: Lifelong Financial Security in 30 Minutes - a personal finance book written by American investment analyst and politician Harry Browne.
· 25 percent in U.S. stocks, to provide a strong return during times of prosperity. For this portion of the portfolio, Browne recommends a basic S&P 500 index fund such as VFINX or FSKMX.
· 25 percent in long-term U.S. Treasury bonds, which do well during prosperity and during deflation (but which do poorly during other economic cycles).
· 25 percent in cash in order to hedge against periods of "tight money" or recession. In this case, "cash" means a money-market fund. (Note that our current recession is abnormal because money actually is not tight - interest rates are very low.)
· 25 percent in precious metals (gold) in order to provide protection during periods of inflation. Browne recommends gold bullion coins.
We have done our own approximation and an introduction is available tomorrow here on TradingFloor.com with historic returns.
Then we have 15 percent in a Turtle Model, which is essentially an option model of bets in high volatility trades with high leverage but also strict discipline.
Finally we allow 15 percent allocation to Alpha trading or directional bets. Here are some ideas we think have traction beyond the next week:
In the alpha model we are presently focusing on these trades:
- Short AUD. We firmly believe that the end or pause of the Super Cycle in commodities will not only hurt Australia but also come as a negative surprise despite plenty of warnings and a fuse which was lit many months ago with the peak of Gold more than 12 month ago. We are short AUD.
- Short OAT - French government bond. This is brand new position initiated after Japanese investors replaced domestic funds as the biggest buyers of French government bond in April - a well known seasonal play, where after year-end (March 31) Japanese lifers and funds go overseas in the first months to fill out their new "mandates". Short OAT is a play on European QE. The Club Med pressure for easier and easier rules on collateral and richer funding is happening. We short the "Sick Man of Europe".
- US dollar bull cycle has started. We do not see any alternative to long US dollar in this cycle of currency manipulation. The US started early and now we go full circle with the euro being the final pawn - of course preceded in July by the new governor Carney at the Bank of England. Short GBPUSD and EURUSD now in place.
- Long EMG bonds - The weakness in BRIC and EMG overall is overlooked. Sure, yes they have performed poorly, but even success stories like Poland, Chile and South Africa call for further monetary easing. It will be too little to late as inflation is underlying most macro data, but the fx and rates will take the correction. Be long mainly strong EMG bonds: Poland, Chile, Russia vs. OAT/BTP
- Overweight bonds. We have been overweight for a while and continue to like bonds. It is no longer only a valuation play but also due to the implicit "equity put option" - the fact bonds if - not that we predict it will- stock corrects.
In Alpha terms we are neutral on stocks - the Beta (Saxo Balance Portfolio makes us long). In a world where money printing and monetary illusion is present stocks can be plus minus 25 percent.
We simply want to await negative chart patterns and policy mistakes to enable a short position.
The Fed's minute changes to their language will dictate the short-term, but I must say the JGB rise in yield could indicate what my friend Mr. E calls : "The end of Bernankes put". If this is so then we will see the usual pattern of sell in May emerging, with July Upper House and German September election as the political risk. The tail-risk remains Cyprus, growth in general, social tensions and a major financial institution failing.
Cyprus just announced its temporary capital controls will remain in place at least for another two months. Iceland is in its fifth year of temporary capital controls. Want to bet how long Cyprus' restriction will remain in place?
Conclusion
Japan is not a binary event but QE Tokyo style saved investors' bacon in Q1/Q2 of 2013. Japan's progress from here will be slow and gradual. Ultimately deflation and a stronger JPY will be back.
MMT is sunken but not Atlantis - The wealth effect is a Piper's dream.
The individual: The inventor, the toolmaker, the consumer, and the investor will be needed because what the world is short on is innovation, appetite for life and risk and a belief in ourselves.
The Bermuda Triangle of economics has made us all entitlement receivers - creating a version of life where we choose to believe that no change is good.
Med venlig hilsen | Best regards
Steen Jakobsen | Chief Economist
Saxo Bank A/S | Philip Heymans Allé 15 | DK-2900 Hellerup
Phone: +45 39 77 40 00 | Direct: +45 39 77 62 23 | Mobile: +45 51 54 50 00
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