Another week, and another round of reckoning begins. But what is there to reckon about when our all-conquering central banks have apparently succeeded in removing risk from the investment equation? No matter what the data, it’s all just an excuse to buy some asset class, usually equities. ‘Nothing to see here people…buy a stock, and move along.’
The reckoning business has become a tough job these days. I see risks wherever I look, but no one seems to agree. In Australia, the population is high on property…really high. The Financial Review reports today that a bunch of retail shops on the popular Chapel Street strip in Melbourne sold on a yield of just 2.7%.
Where’s the risk premium in that transaction? Granted, there are all sorts of justifications you could make for paying such a high price for quality property. But the only justification that stands the test of time when it comes to investing, as opposed to speculating on capital gains, is whether you are getting adequate reward for the risk.
2.7% for some shops on Chapel Street? Call me sceptical, but that sounds like a lot of risk for not much reward. It’s also a transaction that perfectly illustrates Australia’s screwed up policy towards property. That is, it encourages speculation and the targeting of capital gains over income. It does this via favourable tax treatment (negative gearing, capital gains concessions) and supply side restrictions.
But I’m not going to get into that today. Everyone knows that there will be no day of reckoning for Aussie property. It would be un-Australian.
Today I’m going to focus on risk…a much neglected concept recently. If you’re more interested in the reward side of things, check out Phil Anderson’s latest project. Phil’s bullish on the future, and sees plenty of rewards…especially in Aussie property.
Thankfully, there are still a few people out there who share our concerns. The Bank for International Settlements (BIS) released its 84th Annual report over the weekend and sounded a cautious note on the state of the markets and the global economy. Here are a few quotes from the introduction to the 200 plus page report, with my emphasis added.
’The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved. To overcome that legacy, policy needs to go beyond its traditional focus on the business cycle. It also needs to address the longer-term build-up and run-off of macroeconomic risks that characterise the financial cycle and to shift away from debt as the main engine of growth.
‘By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilised, global equity markets reached new highs and credit spreads continued to narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.
‘In this second phase of global liquidity, corporations in emerging market economies are raising much of their funding from international markets and thus are facing the risk that their funding may evaporate at the first sign of trouble. More generally, countries could at some point find themselves in a debt trap: seeking to stimulate the economy through low interest rates encourages even more debt, ultimately adding to the problem it is meant to solve.’
In my view, the global economy is already in a debt trap. We haven’t recognised it yet because the leverage that the new debt provides is still working to the upside. The trap has yet to jam shut. But it’s coming.
Doug Nolan, of Credit Bubble Bulletin fame, provides ample evidence of the building debt trap. In his regular weekend article, Doug calculated the total amount of marketable debt securities (TMDS) issued through US financial markets and compared the size of the debt outstanding to the size of the economy.
In his calculation, total debt includes outstanding treasury securities (as in those traded in financial markets) mortgage backed securities issued by federal agencies like Fanny Mae, corporate debt and municipal debt.
TMDS kicked off the 1990s at US$6.28 trillion, or 114% of GDP. During that decade, TMDS grew by 120% and finished it at 147% of GDP. That brought us the tech bubble and bust, which policymakers sought to mitigate by encouraging the use of debt. Geniuses…
From 2000 to 2007, TMDS went on to expand by another 102%. Since the 2008 bust, debt has continued its expansionary thrust, growing by another 30% and hitting a record 220% of GDP. No wonder the BIS wants to ‘shift away from debt as the main engine of growth’.
But what other engine is there? Structural reform? The promotion of real investment over speculation? Good luck with all that BIS. The punters have had bread and circuses for a while now. The politicians won’t be taking it away from them. Which is why the next crisis is all but assured. The only catalyst for change is a crisis.
But I digress. Doug’s not finished. He also calculates ‘total securities’ outstanding by adding the value of equities to debt. He then compares the total to the size of the economy. The results are frightening:
‘Even more importantly from a Bubble analysis perspective, in 21 quarters Total Securities (debt & equities) inflated $27.2 TN, or 61%, to end March 2014 at a record $72.039 TN. To put this in context, Total Securities began 1990 at $10.0 TN, ended 1999 at $33.0 TN and closed 2007 at a then record $53.01 TN. Amazingly, Total Securities as a percent of GDP ended Q1 at 421%. For comparison, Total Securities to GDP began the nineties at 183%, ended Bubbly 1999 at 356% before peaking at 378% in a more Bubbly 2007. No Bubble today? “Valuations in historical range”?’
No wonder we all worship at the altar of central banking. Total securities now completely overshadow the income produced by the real economy. No wonder central banks the world over constantly need to pump money into the system…without it, prices would begin to deflate.
Don’t think the US economy is an isolated case, either. It’s the best of a bad bunch, remember? No, what’s happening in the world’s largest economy is emblematic of what’s happening elsewhere.
As debt continues to expand and risks are ignored…and as punters continue to seek yield, thrills and capital gains, an awful reckoning awaits the blind and ignorant.
When this will happen nobody knows. But the first cracks will begin to appear when the Fed tries to normalise interest rates. Another step on that path starts tomorrow, when they reduce their debt monetisation program by another US$10 billion per month. By October, the policy of QE will be all but over.
Perhaps the punters might start to panic before then? Who knows…but it sets things up nicely for another wild September/October period. Actually, it’s about time, we haven’t had one for a while.