Fiscal hopium rally brings another opportunity to reduce risk

Global risk markets have experienced the steppest 30 percent decline in history over the last month.  We should expect to see some big reversal rallies punctuating the downtrend–even while the trend continues down.

Today, as algos key on the promise of a big US federal aid package and a G7 pledge to do “whatever is necessary”, the bounce is big.  This affords yet another opportunity to review risk exposure amid a global recession, liquidity crunch, and forced selling yet to come.  The unravelling here is only just begun.  See WSJ: The Hedge Fund trades going haywire:

The fact that many such trades are financed by leverage to juice returns has made the fallout worse. The use of debt to enhance yields is probably the reason why some theoretically more stable sectors like utilities have actually performed worse than the broader market in the current bear market, for example.

Some trades that make sense normally are turned upside down in a crisis, when traders don’t sell what they should but what they can.

As well as Bloomberg’s We’re looking at a system-wide margin call:

“The Federal Reserve ushered out a second wave of quantitative easing Monday. But the worst scramble for cash is happening in an opaque corner of the market, where Chairman Jerome Powell has little control. What we’re witnessing is a system-wide margin call.

With the coronavirus outbreak intensifying, asset managers are getting squeezed by a record outflow from bond funds and billions more from stock funds. Even bigger withdrawals are probably happening in the over-the-counter world, where trades are conducted out of public eye, through broker-dealers. When traders get margin calls, they resort to selling their most liquid assets, usually stocks and U.S. Treasuries. This only deepens the slide.

Consider OTC derivatives, which are mostly betting slips on the future movements of interest rates and currencies…As of June 2019, the notional amount of such derivatives rose to $640 trillion, the highest since 2014, data provided by Bank of International Settlements show.”

For some perspective on this, the credit derivatives market was essentially non­existent in the early 1990s, and in 2008 had a notional value of about $50 Trillion.  Over the last 12 years, these financial weapons of mass destruction have ballooned nearly 13x larger.

It took 12 years to make the mess that’s now imploding.  We should not expect the clean up to be completed in a month.  Open doors should be used as exits.

Posted in Main Page | Comments Off on Fiscal hopium rally brings another opportunity to reduce risk

The health toll of reckless financial policies

A study published in the Journal of the American Medical Association in 2018 found that a sudden loss of wealth—negative wealth shock—can trigger health problems and reduce longevity.

With limited years remaining to regain losses in older age, researchers noted that the health consequences of such shocks can be long-lasting.  The effect was most marked if a person lost a home, and more pronounced for people with fewer assets, but wealth shocks crossed socio-economic lines, affecting people regardless of how much money they had to start with. This was a US-based study but lead researcher Lindsay Pool of Northwestern University medical school added: “This is really a story about everybody…North or south of the border, we’re all in equal danger.”

According to Dr. Alan Garber of Harvard University in an accompanying editorial, the findings suggest a wealth shock is as dangerous as a new diagnosis of heart disease. He also noted that doctors need to recognize how money hardships may affect their patients.

Other researchers who study the relationship between economics and health noted the strength of the association between a big financial setback and mortality. “The magnitude of it is quite remarkable,” says Ellen Meara, a professor of health policy at the Dartmouth Institute. “If it’s losing the wealth that’s causing it, I think we want to ask ourselves: Is there any way to protect people against that kind of a shock?” (See: Losing your nest egg is hazardous to your health).

Central bankers and financial firms encouraging nest eggs into risky assets at high valuations should note the real-life consequences here. Unfortunately, most continue to put short-term theories and profit hopes ahead of the longer-term best interests of customers, workers, retirees and the economy. Individual savers are prone to follow along without appreciating the prospects for lasting harm. As Raghuram Rajan, said in February 2019:

“Capitalism works when many people have a chance at doing reasonably in the market. We wasted ten years since the financial crisis not really focusing on these things and hoping that one stimulus after another will somehow elevate growth.”

Speaking last March, ex-FOMC head Janet Yellen admitted that central banks don’t have enough bullets left in their policy guns to combat increasing financial stress. Some have suggested the US Fed may resort to directly buying corporate bonds and equities in this downturn to try and reflate prices. Increasingly desperate ploys seem to be the dominant ideas today.

None of this was of necessity but rather the product of specific policy choices—choices to unduly enrich few at the expense of the many.  Such episodes have been recurring in history and have always been followed by periods of wealth redistribution via higher taxation, asset repricing, social transfers, conflict and sometimes force. All are underway now.

Where debt was created over the past two decades to invest in innovation and things that help to strengthen households and the economy, there will be lasting benefits. But the majority of debt created has been to enable households to buy over-priced assets and depreciating consumer goods, and for companies to meet short-sighted financial ends like share buy-backs, mega-mergers and increased executive compensation. Now we are ten years older and the masses are less financially secure than they were a decade ago.

Debt payments (at historically low interest rates) are consuming 15% of Canadian household income—the highest ever—with just 6% of respondents saying that saving for retirement was a priority (CIBC study).  According to Statistics Canada’s latest data, the median net worth of Canadian families was $295,100 in 2016. Most were hoping that building equity in homes would somehow offset other savings voids.

Asset owners over the age of 50 hold the bulk of the paper wealth in the world. But the corollary of high prices is low yields, and so most are income-poor heading into retirement. To raise cash, they need to sell their assets to financially-capable, willing buyers –this will require lower prices.

The classic definition of savings is present consumption denied, but there’s more to it. Savings are a reflection of personal discipline in both the degree to which spending is less than income and the care afforded capital once amassed.

Our savings self-insure against interruptions or reductions in income and provide funds for critical investments like infrastructure, education, life-enrichment, care of ourselves and our community, innovation and invention. Savings are stored energy from which all good things can be powered. But over the last 30 years, central banks and governments have increasingly directed policies and incentives that favour debt over savers and savings. This went to such extremes that the masses are now drowning in debt (negative-savings) and in some countries, savers are paying borrowers to take their funds. In the process, financial discipline and social stability have been greatly undermined and we must change course.

Only higher interest rates, tighter lending, insolvencies, break-ups, restructuring, write-offs and financial pain where it’s deserved can put the global economy on more stable footings. Durable economic strength cannot be achieved by further emaciating the masses—and especially not the young who are needed to carry the social costs of their elders. Resilience can only increase when a healthy share of current consumption and short-term profits are denied in favour of savings and investment for the future.

Net worth is preserved in secure assets with reliable income streams and by eschewing debt for personal consumption. We understood this during war times where workers, savers and governments worked together for mutual benefit. From here, a brighter future requires a focus on prudence, rather than speculation and gambling. The payoff will be wider compound benefits and resource sharing with less waste.

We see much upside to be gained in this necessary—albeit painful—process. The asset price declines needed to reboot the system, seem to be finally underway now. Our aim remains to steer clear by holding the lower-risk, most liquid assets to which others move as risky markets deflate.  In doing so we seek to preserve savings, financial strength and peace of mind and be some of the few ready to take advantage of attractively priced investment opportunities coming on the other side.

Posted in Main Page | Comments Off on The health toll of reckless financial policies

Understanding the negative wealth effect now compounding

It’s important to appreciate that owners in the world’s most expensive real estate markets are the same top 10% of households holding the bulk of global securities individually and through pensions, mutual and Exchange Traded Funds, as well as private equity.  They also owe the most debt.

Equity exposure as a share of disposable income leapt above 55% by 2018 compared with less than 20% in 1989. This higher concentration makes net worth more vulnerable to falling asset prices now than in past cycles. (If you have not yet read The High Beta Rich, by Robert Frank, this is another great time to do so).

With 78% of North American workers reportedly living paycheque to paycheque, and 60% having less than $1,000 in savings, people holding the bulk of equities also drive big-ticket consumer spending in the world.  It makes sense then, that it is typical for luxury spending–things like jewelry, boats, personal aircraft and all manner of services– to fall with equity prices.

Eighty-five percent of vehicles in North America are financed (loan or lease). While some might think that higher-income households pay cash rather than finance their autos, the data does not bear this out.

Those with top percentile incomes tend to finance more expensive vehicles and change them every 2-4 years. Thus, autos sales too are sensitive to downturns in equity markets. Similarly, rising equity markets encourage asset owners to borrow against their holdings to fund consumption and further asset buying, while market drops have the opposite effect—they are forced to pull in spending, sell assets and raise cash to pay down loan balances.

By 2018 security holders owed the most debt margined against their portfolios ever in history. Prior margin debt peaks occurred in February 2000 and August 2008, respectively six and four months before the market peaked each cycle. The mountain of margin debt still outstanding today portends unprecedented forced selling yet to come.

Cash liquidity in the financial system topped in 2017 and fell to cycle lows in 2018. Asset market booms typically end 1 to 2 years after global liquidity peaks, followed by a banking crisis 1 to 2 years after cycle troughs.

This bear market and global recession have considerably more forced deleveraging to run.  Best to move ahead of the herd than panic with it.

Posted in Main Page | Comments Off on Understanding the negative wealth effect now compounding