Playing The Financial Markets – The Greatest Game of All

All tides turn. Last night a major sporting tide may have done just that...

Please indulge your editor, a New South Welshman, for one moment. State-of-Origin II, played in front of 83,000 fans in Sydney last night, was a cracker. Turning points and symbolism go hand in hand, usually with a dose of irony.

Like when commodity trading giant Glencore listed in May 2011, just before financial markets - and commodity prices - crashed. The commodity complex is yet to recover. Thank you Glencore for the advance warning...

Or what about Facebook's shocker? Marketing for the company's public listing got underway in a buoyant environment. Everyone thought Europe had solved its problems and it was all good. Facebook was going to be the next Apple or Google. The market peaked probably around the time Facebook's shares had been allocated to gullible investors. By mid-May, when Facebook listed on the NASDAQ, the market had already started its decline. Thank you Facebook.

Getting back to the footy, the turning point in Queensland's dominance (they've won this series for six long years in a row) came with a Jonathon Thurston strip of the ball just after half-time. Thurston rakes the ball out of the opposition's hands about once every series. Usually it results in QLD getting the ball in an advantageous position...and they end up scoring a try and winning...again.

But last night the ball 'strip' backfired. NSW scored a try from it. It was enough to win them the game. Thank you Jonathon Thurston.

Of course there is still one game to go. We're not getting ahead of ourselves. But we sense a turning of the tide...

Speaking of games, what about this great game that is the market? With rugby league, or AFL, or soccer, you can switch off if you aren't interested. In cricket, if you're fed up with taunting from the field, you can take your bat and ball and go home.

But where do you go if you're fed up with the people who run the financial markets? This great game we're playing has no start and end point. It has no rules. The referees are corrupt. Yet you can't leave. Not entirely anyway.

Gold, as in physical bullion, is the only way out of the game. It's the only way to 'tap-out'. But you can't put all of your assets in gold. As gold bears are so fond of saying, gold pays no income...and you can't eat it either. If you're retired, or heading in that direction, you need income to live on.

So what to do? The desire for income keeps you in the game. But 'safe' yields are low all around the world. And where yields are high, the income is far from safe. Aussie banks offer a generous yield of over 7%, plus a franking credit. It is safe?

We don't know. We'd guess not. But today we only have questions. Answers are elusive in the big game. More to the point, answers are just a guess. No one knows how this is going to play out.

That's because being 'in the game' comes with counterparty risk. You put your money in the bank. The bank lends it out to someone else. You receive interest. Interest is your reward for accepting counterparty risk...or relying on someone else to get your money back

You buy a government bond. The government, God forbid, becomes your counterparty. The government's good for it, you think. But if enough investors start to think that maybe the government isn't good for it, like in Greece, Italy, Portugal or Ireland, just to name a few recent examples, then the interest rate starts to rise.

As the interest rate rises, prices fall. You may still get your income, but your capital takes a hit. That's counterparty risk.

And because money = debt in this great modern monetary game, counterparty risk is on the rise. Put another way, for every liability there is an asset. Just as one person's junk is another one's treasure, one person's debt is another one's asset. Now, there is too much debt in the word. Economic growth is too slow to service the debt.

As a result, the debt turns 'bad'. For all intents and purposes, it ceases to exist. That means someone's asset also ceases to exist. Any asset write down first hits an individual's (or company's) equity. Bad debt is silently eating into the world's equity. In other words, debt is like a black hole...it eats into the world's store of 'wealth'.

We say 'silently' because the adjudicators of the great game refuse to acknowledge the bad debt. Instead they create more, hoping to paper over the cracks. The bad debt piles up. It rots...and we ignore the stench.

Why the ignorance? It comes back to counterparty risk. Writing off the bad debts, and the assets that accompany it, would attack the heart of the financial system - the banks. The banks are all linked together in a death chain of derivatives. The death of a counterparty would shoot through the financial system like an electric shock.

What happens then is anyone's guess. But at that point you'd be hoping you have a decent little insurance policy outside the system.

Felix Zulauf, famed Swiss money manager, likes the thought of safety and insurance as well. In a recent interview in the 'Barron's Roundtable' investor forum, Zulauf nominated cash, gold and Aussie Government 3-year bond futures as his top investment picks. He likes Aussie bonds because he doesn't like China's economic prospects...

From the Roundtable discussion:

'There is too much debt in the industrialized world and the financial system is virtually bust. Real disposable personal income is stagnating or declining. Employment participation keeps heading south. This produces a chain reaction: Weaker consumer demand in the West weakens manufacturing in places like Asia, which weakens natural-resource producers such as Australia or Brazil.

'As for the euro, it is a misconstruction. As I said in January, I expect the disintegration to begin in the second half of this year. That should lead the world into financial and economic chaos. My two major themes into 2013 are euro disintegration and China weakness, due to the bursting of a real-estate boom.

'The global economy is weakening cyclically on top of a highly fragile credit system. It is an explosive cocktail. The tower of debt is compounded by the gigantic over-the-counter derivatives market. In the past 10 years the notional value of derivatives worldwide has grown from $100 trillion to almost $800 trillion. The numbers are mind-boggling. If something goes wrong in the real economy, it could shake the whole credit system dramatically. It is a dangerous situation.'

On China and just how bad things are likely to get in general:

'China won't be able to save us, as it did in 2009. The Chinese will lower interest rates but their actions will be reactive and lag. If my thesis is right, we must assume things will go awfully wrong in the next 12 months and the system will be at risk of collapsing. Most U.S.-focused investors might not understand it as they see corporations doing well.

'The potential exists for a broad-based nationalization of the credit system, capital controls and dramatic restrictions on financial markets. Some might even be closed for some time.

'We are witnessing the biggest financial-market manipulation of all time. The authorities have intervened more and more, and thereby created this monster. They might change the rules when the game goes against their own interests.

'We are in a severe credit crunch. It starts when the weakest links in the system can't finance their activities. Then you have a flight to safety into Treasuries and German bonds, compounded by a quasi-shortage of good collateral. That's why bond yields have fallen so low. This isn't an inflationary environment but a deflationary one.'

The game is getting interesting, dear reader...

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives...

The Avalanche and the Phase Transition of the Financial System
2012-06-08 - Greg Canavan

A Financial Crisis that Repels Private Capital
2012-06-07 - Eric Fry

Floating Towards Japan's Economy on a Sea of Bad Debt
2012-06-06 - Bill Bonner

Pirate Politics to Save the European Union
2012-06-05 - Nick Hubble

China's Economy... Where All is Not As It Seems
2012-06-04 - Greg Canavan

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