CheckRisk has made the assertion that the period 2017-2020 is likely to see a repeat nancial crisis, which could quite easily dwarf the 2008 credit crunch. There are, naturally, some ways the coming crisis can be avoided, however, the expected outcomes are narrowing and that is clearly supporting our confidence levels about the prediction. This week we look at the assumptions behind our forecast, the playbook the Federal Reserve has at its disposal, why they are the only game in town, and a little bit of human nature. In other words the stepping stones to the crisis, and more importantly where risk is currently paying you to place your funds. Ultimately, the most important issue is that if CheckRisk is wrong will the areas that we think will benefit from risk still work? The reason this is critical is that we rmly believe the current outlook does not require CheckRisk to be 100% right. Infact, being partially right will be more than enough.
Risk is not unlike a game of chess. There is both opportunity and cost in each decision that is made when moving a piece. The game begins with an almost in nite number of choices, however, these have been refined into a well known catalogue of classic openings or gambits. These gambits lead the players to a point where the game becomes more free form. Like two armies lined up with each other before the actual battle commences the opening advantages will be set because of the ground chosen, the relative strengths of the armies and the tactics employed.
In the melee of the middle game of chess it is the small advantages and bold moves that lead to a decisive end game. A captured pawn, may lead to an ultimate advantage, the middle game is delicate because there are still a myriad number of outcomes available dependent on each players decisions. Somewhere in that middle game things often change. A player either makes a better move than his or her opponent, or the other player makes a mistake that leads to the opponent’s advantage. At this point the game has subtly changed and is headed for the end game. Here risk and chess become very similar indeed. Once the power has been lost it is very hard to regain it, particularly against a skilled player. There is a gradual, painful unwinding. Death by a thousand cuts. In chess one can resign when things are hopeless, in life one cannot.
The so-called “End Game” is characterized by a narrowing number of moves that are possible to gain a win, or to avoid a loss and to seek a draw. Experts can solve for multiple moves in the End Game. The game, however, is not over until there is a check mate, a draw or a resignation. Wins may be thrown away, losses can happen because of overconfidence and poor execution. The point being in the End Game there is always a right and a wrong way to end things.
The current state of play in the global economy and nance is analogous to the end game in chess. Central Banks and Governments have set out their boards based on easy monetary policy and QE. What was previously unconventional has become conventional. The problem is that the goals of QE have not been achieved. In a on remains below target and the Fed has been unable to normalise interest rates. The number of possible outcomes are narrowing.
We are now just over eight months away from the period in question that CheckRisk believes is one of significant risk. As a result it is possible that markets, if they feel the same way, will begin to discount that period ahead of the event by selling ahead of me. Let us look at the assumptions CheckRisk has made and what the possible playbook is for the Fed given the assumptions.
CheckRisk End Game Assumptions are:
1) That the Federal Reserve will con nue to act as a rational agent.
2) That the increase in global debt continues to have a marginal impact on global GDP.
3) That inflation will remain below or at target until 2017
4) That the natural economic cycle will lead to a mild recession during the period 2017-2020
and most likely in 2018.
5) That the Federal Reserve is unable to raise rates above 2.5% by 2017. Any increase in interest rates to 2.5% or greater before 2017 will bring a global recession forward all things being equal.
6) That Central Banks will not be proactive in changing their approach before 2017.
7) That Central Banks will continue to be reactive to crisis as it emerges.
8) That QE remains the central tool of monetary policy until it becomes necessary to bypass the
banking system with either Helicopter Money or Infrastructure Spending Programs.
9) That no crisis such as Brexit, Grexit, the Middle East, China debt, or unknown risk accelerates the crisis time horizon to pre 2017. Clearly this would accelerate the time horizon.
Not all of the assumptions need to be 100% correct, however, numbers four and five are key regarding the period 2017 to 2020. If the assumptions are broken CheckRisk will adjust its view.
Assuming the above CheckRisk believes that the Federal Reserve has only two realistic options in their playbook; to create a draw or lose. To be clear the Fed can still do a lot of things but they still boil down to the following, “extending and pretending”, versus “ losing control” of the interest rate term structure. In effect we believe that the stepping stones to the crisis period 2017-2020 have already been laid out and that central bank policy error is such an important driver of the eventual outcomes that little else matters regarding financial market risk. The Fed is a “rational” agent in our model and so they will naturally try to avoid losing control of the interest rate mechanism. Negative interest rates are an example, in our view, of a central bank stepping out on thin ice. Negative interest rates, de facto, are an acceptance that interest rates no longer function as a risk tool.
The Fed is the only real game in town because the world is quite simply awash with US Dollars. It therefore matters to the rest of the world what the Fed does. In 2008 and 2009 economists were confidently predicting the end of USD hegemony, how wrong a prediction that has turned out to be. The US decided the best way to regain control was to flood the world with USD credit. As a result all that matters for the moment, at least, is how that excess money supply is handled.
The US Federal Reserve knows that it is extremely late in the cycle to be tightening interest rates. The very function of rates is to slow an expanding economy. If an economy is barely growing interest rate increases can only serve to threaten that flame. Consequently the Fed is caught between the devil and the deep blue sea. Not only are they late but they know that trying to get where they ought to be ahead of the next cyclical downturn risks precipitating the very recession they are seeking to avoid. There is a bent to try to raise interest rates, which is going to mean that equity and bond markets will trade around a volatility of expectations linked to the interest rate cycle.
The next recession should be a mild cyclical downturn, however, it is important to recognize that there is a real risk that it is coinciding with a credit cycle top as well. Global debt has been growing faster than world gdp for almost 50 years. That is, quite simply, unsustainable. Either inflation must grow, GDP must grow or another debt crisis will occur under the sheer weight of obligations facing governments, banks, business and consumers. If the Fed were able to get rates to 2.5%, without causing a premature recession, they would still be far short of the requisite 350bps to 500bps they would need to stop a mild recession developing into a more serious one.
Given the picture painted above it is clear that the Federal Reserve and other banks must move very gently. As a result we believe that they cannot over react before a crisis occurring. For investors that is not good news, it means that a crisis becomes more rather than less likely. The Fed’s best bet is to try to play for time.
The up side, of course, is the market outlook. Each new round of QE or easy monetary policy in Europe and elsewhere, has had less effect. The impact of QE is being gradually attenuated. The unconventional has become the conventional and so to maintain the status quo more extreme measures must be undertaken. This is why the Fed, and other central banks are beginning to float the idea of so called Helicopter Money and by passing the banks entirely. What investors can expect is that the central banks will wait and see how the markets are receiving their policy actions, and only react in a crisis.
Assuming this leads to side ways trading markets, which is our expectation, then investors should be using any market strength to reduce risk exposures to equity, and bond investments. This means raising cash amounts, buying some gold on weakness as it is clear a new bull market in precious metals has begun and more importantly thinking about where the next flow of government money is going to go. This is where the majority of available funds should be placed as it is the lowest risk option. There is a case to be made too for favouring high quality corporate debt over government debt, and avoiding everything else.
CheckRisk believes that the logical outcome of all of the above is that as the next crisis approaches central banks are incentivised, alongside governments to go for infrastructure spending. There are several reasons for this. Firstly, central banks know that they have created a swathe of zombie banks, this is what we mean by the Japanification of the West, those banks will not be resuscitated but they will not be killed off either. Secondly, political instability in Europe and elsewhere means that vested interests have every incentive to get people back to work, infrastructure is an excellent way to do that, and to recoup the investment in taxes on pay. Third, infrastructure spending increases the long term competitivity of an economy, the US has been very slow in improving its core infrastructure, the next President can make a significant impact in their first 100 days by going for infrastructure projects. Fourth, infrastructure deals do not cost a government the entire cost of a project. It is possible to use leverage by involving private investors aswell as bond based dancing.
As always when planning ones strategy for the end game it is important to recognize what could possibly go wrong. In our view the biggest issue for CheckRisk about the outline above is that a crisis occurs sooner than expected and central banks react quickly thus extending the 2017-2020 period out to 2023 for example. It is important to recognize that this is entirely possible and in the interest of central bankers. However, they must wait until a crisis occurs, for fear of creating one through their inadvertent actions. It is a Hobson’s Choice for the Fed and others.
Investors, however, are not trapped by the same decision making inertia. The right choice given the approaching environment, is to start managing aggressively for risk. If you are wrong you will lose some performance, but that is far outweighed by the benefits of being right.
Global Debt a zero sum game?
There is an idea circulating among economists that global debt is some how going to be eradicated by a grand gesture of largesse between debtors and creditors. The idea sounds brilliant. The US government, for example, is the biggest purchaser of US government debt and acts in this sense as both a creditor and debtor. This is also the case for many other central banks.
There is a case to be made that since “global debt” is a closed system, as one client said this week, “We do not borrow from Mars,” that there could be a netting of process. CheckRisk may not be thinking as inventively as others in this regard but we beg to differ. Debt is by definition on someone else’s asset, even if the US government owes money to itself. The chart below shows the breakdown of the public debt owed as a % of total government debt around the world.
The point is, that even if the US owns 70% of its own debt there is a signi cant rump of debt held by other na ons, the same is true all around the world. Even entering discussions about debt forgiveness would lead to mayhem in government bonds. Imagine what price discovery would do if it became clear that the biggest owner of public debt were planning to write it of . Our view is that most investors would want to be first in the queue of sellers. Effectively, it would be a default event. So the concept of debt write o s via a hypothetical netting system is just that, a concept. It appears to us to be both impractical and more importantly unenforceable. The crucial issue is that since 2008 there has been a market distor on generated by QE, the resolution to that is that eventually market forces will reassert themselves. The sheer weight of global debt and the lack of acceleration in GDP growth is what troubles CheckRisk.
Learn more about CheckRisk here.