Some Thoughts about Quantitative Easing

The crisis of 2008 was precipitated by the realization that debt levels in the economy had become acutely excessive. In a short space of time, investors lost faith in banks and one another, suspecting that their respective counterparties had excessive exposure to the debt that had been created. The sudden desire to avoid this debt and to avoid those alleged to be holding this debt led to flight to safety and in particular, a malfunctioning LIBOR market.

Under normal circumstances, government should never have stepped in. The scale of the debt problem, however, held governments to ransom over bailout funding. What ensued was a wholesale transfer of debt from private balance sheets to government balance sheets.

The financing of these assets, or debt, by governments through the issue of government bonds is the equivalent of a transformation of one form of debt (secured in most cases, by the way) to another (quite clearly unsecured.) The private sector has been understandably wary, even leery, of government debt, as evidenced by the CDS spreads on Greek, Irish, Portuguese, Spanish, Italian, Belgian debt. Countries with a sovereign currency have the luxury (quite frankly cold comfort) of being able to monetize their debt by using their left hand (central bank) to purchase what their right hand (treasury) is issuing.

Part of the emergency bailout procedures taken in the dying days of 2008 included extension of credit beyond mere transfers of debt. In the midst of violent volatility, it never occurred to investors that trying to expand credit is hardly a solution for a problem defined by excessive levels of credit. The appropriate analogy is ‘trying to put out a fire with gasoline.’

Our experiences with the Greenspan Put are instructive. It was Greenspan’s untested thesis that bubbles were best left to inflate to failure rather than be deflated prior to bursting. When such bubble had burst, the Fed would supply liquidity and cut interest rates in a policy that hardly promoted symmetry of returns to excessive versus responsible behavior. The phenomenon of interest, however, was the efficacy of interest rate policy. Experience has found that the initial rate cut has significant impact at least on risky asset markets, the second less so, and the third and subsequent rate cuts tend to be less and less effective. Interest rate policy it would seem is subject to rapidly diminishing marginal returns.

Since 2009 the Fed has bought ABS and it has bought US treasuries. The impact of the first round of debt purchase had a strong positive effect on risky asset markets and helped to pull the economy out of recession, at least on traditional measures of output growth. If one subtracts debt from GDP, it is questionable if the Fed’s action was very effective. Upon cessation of the first debt monetization risky assets fell back into volatile sideways trading only to be buoyed by a second effort of debt monetization this time targeted at US treasuries. It is no coincidence that the recent volatility in markets has coincided with a cessation of so-called QE2.

That the market envisages or anticipates a QE3 should be a sign that the economy and its capital markets are vulnerable and incapable of resuming pre crisis trend growth in the absence of bailouts. This alone should blunt the impact of a QE3. Rational or rationalized expectations would imply almost no impact coming from a QE3. Whatever asset price inflation another round of quantitative easing might inspire, a concomitant debasement of the underlying accounting currency would take away in real terms. The operation of QE creates a hierarchy which puts real assets such as gold first and low to zero yielding assets such as cash last. The exception to this hierarchy is the instrument by which the QE is being implemented.

Expectations for the Future:

– A continued (not a double dip) recession in US and Europe

– Emerging markets such as China slowing down as infrastructure build slows

– A more correlated global cycle biased towards weakness

– More debt transfer and transformation

– Debt deleveraging and pay down

– Trade protectionism

Caveat:

In times of great economic stress, observers can only base their analyses on a stable geopolitical environment. Social and political stability can be at risk when economic stress reaches beyond certain levels. The efforts to resuscitate economies with unconventional policies such as debt monetization carry side effects which are not always predictable or desirable. One of the side effects of debt monetization is fiat currency debasement. It expresses most evidently in hard assets, in real assets, in agricultural products and food. Food price inflation amid shrinking real output and persistent unemployment can precipitate social and political change, sometimes violently. The complexity of capital and derivative markets and the global financial system also provide ammunition for politically motivated debate. The scale of the debt problems and the grubby deals that incumbent governments have had to enter into to deal with them introduce considerable political risk. A shrinking economic pie just makes all parties less patient and more intolerant.

In the current volatility, and don’t expect this to be a linear race to the bottom, there will be significant countertrend rallies, its easy to lose sight of the big picture.

– the boom experienced from 2002-2007 was fed by low interest rates, rising housing markets, and unprecedented credit creation on the back of rising collateral value.

– a tangible measure of economic well being should be the real value of GDP less debt. GDP is calculated off expenditure which can be expanded simply by the assumption of more debt. On these measures, 2002-2007 might not be regarded as such an unmitigated success after all.

– the problem was not 2008 but the period 2002-2007 during which there was excessive credit creation.

– real GDP growth less credit is a not only a less volatile quantity, it turns out to be a less exuberant one. The problem that the world faces is that real and nominal GDP must now revert to mean through a process of debt deleveraging. This is problematic and painful.

– credit creation could not be reversed without acute withdrawal symptoms. As a result there have been a series of debt transfers and transformations: TARP, TALF, HAMP, QE, various ad hoc bailouts et al, to rotationally transfer debt from corporates, households and the private sector to government. I preemptively describe this as rotational because there is the possibility of the converse transfer, already beginning with the commercial banks.

– debt transfers notwithstanding, the total stock of debt is constant but for repayment of coupon and principal. Or reorganization. The paying down of this debt has to come out of output. Plainly, you cannot pay down debt without economic growth and you cannot pay it down faster than allowed by the level of economic growth.

– the debt created before 2007 has to be paid down through economic growth. 2008 was merely a reaction to the realization that lending standards and quality of collateral were deficient and that the ability of the economy to repay its debt obligations was not a foregone conclusion. All the transfers and transforms following 2007 was merely a reaction to the reaction following the realization. Noise. Loud and ominous.

– collateral damage from the 2008 event takes two main forms. The first is that credit creation and distribution channels have been and remain to a certain extent, impaired. The second is that much of the growth pre 2008 would be negative or infeasible without the scale and cost (arguably mispriced by the distorting impact of unilateral interest rate determination by the Fed) of credit prevailing at the time.

– the above provides a framework for estimating trend growth and thus the level of feasible output at each date in the future ex credit.

– in addition it implies that any retrenchment in credit will impact the traditional measures of real GDP growth (mostly negatively). The credit retrenchment can occur quickly (with painful consequences) or slowly (with other consequences).

The above is an incomplete but hopefully useful summary of the landscape before us. The investment implications are many and provide ample opportunities not only to avoid loss but to make money. The converse, unfortunately is also true.

– generally, debt will attempt to be transferred from constituency to constituency. It went first from banks and private hands to government. There it is being transformed into government debt which was under QE2 transferred to the Fed. It is now being transferred back to commercial banks (in a form of QE3 and thus back into private hands. Rotational trading and asset allocation can capture the price volatility that follows in the cash, futures, swap and repo markets, not to mention the Muni and ABS markets. .

– different countries are net creditors / net debtors (on a stock basis) and different countries are net borrowers / lenders (on a flow basis.) Sovereign local and hard currency debt will price demand and supply, credit worthiness, FX and inflation differentially affording relative value opportunities.

– private businesses with localized or global operations will have differential fortunes arising from the differential fortunes of the respective economies. These themes will drive equity and credit long short relative value strategies.

– credit retrenchment means only one thing: further distressed companies (not to mention a number of sovereigns). The easy credit years bore and sustained businesses which under tighter credit conditions would struggle to exist or could not exist. Expect delinquencies and default rates to increase in the coming years. This will result in fertile ground for the distressed debt investor.

While there will be ample opportunities for profit in the current and future reality the opportunity for loss is equally great. Naïve strategies will suffer. Traditional notions of value, of momentum, and of fundamentals, will not suffice. While there is nothing new under the sun, the current environment is not one we have encountered for nearly a century. And crises of similar magnitude and nature occurred before the advent of derivatives of the current complexity. It is therefore important for the investor to be at the forefront of financial engineering while not being wedded to established wisdoms and methods.

Following the sharp declines in equity markets globally I thought I would reflect on how one should react. The fact is, you should have sold on July 15 and gone on holiday.

A beach far from the financial centres would have been the ideal spot. To be safe, you ought also to have covered all short positions. So uncertain is the outlook that bailouts and unilateral restructurings can be very damaging to short positions as well.

What to do in the short term depends so much on the long term view. There are some who believe that any part of a long term strategy must or should be optimal in the short term as well. I tend to agree, although not entirely.

Investing, apart from intelligence and fundamentals, is also to a large extent about psychology, emotion and sentiment. In many ways, “no memory” investing can be quite effective. It requires the investor to re-buy their portfolio regularly looking only at current valuations and the future expected environment taken at the current time. Unfortunately this does not lead to any magic advice for dealing with the current acute weakness in risk assets. It all depends on the investor or trader themselves.

This one, having cleared all out July 15 is not going to take big bets long or short. Discretion is the better part of valor. For those with substantial risk on coming into the rout, the question is, is this reflective of longer term problems, or a technical correction. If the latter, then you may procrastinate. It’s a bad idea to procrastinate, but you can almost justify to the wife why the vacation money is toast. If the former, then you would like to unload in the most unceremonious fashion. Do not. The market always gives the trader a second chance, to unload in more elegant fashion. Its called a snap-back rally. But unload one must, if one’s view is that recession and distress lie ahead. Just wait a few days and do it mid or end next week.

The longer term outlook, as followers of this blog will know, is poor. Only time can heal the wounds where unfortunately the only band-aid is another country’s skin.

You may recall my view in 1Q that the US economy was already in recession at the time.

The rationale for this was that with housing prices and mortgage rates falling and residential rents stagnant, the price deflator for calculating GDP was underestimating inflation and thus overestimating real GDP growth. The risk to the reported GDP number was that if the shelter element in the deflator rose, GDP growth would be hit. Rents are rising as households switch from home ownership and mortgages to renting. I expect this trend to continue and that for a constant level of nominal GDP, this will lead to negative or at best diminished real growth numbers.

Putting aside the technicalities of calculating real GDP, ancillary evidence points to a further slowdown.

The economy is a massive feedback mechanism hence the intractability of predicting its pace and direction.

For the weakness in the economy, the housing market is as good a starting point as any. Housing has for a long time provided the collateral for consumer loans that fueled consumption. Absent a recovery in housing, there will be no recovery in consumption. That part of the economy servicing domestic demand will continue to be in recession. A recovery in housing requires a recovery in employment and the availability of mortgage credit. Absent a recovery in employment, house prices will stagnate at best. The feedback loop is of course that absent a recovery in corporate profits, in no small part reliant on domestic consumption, there is no recovery in employment. The trend in mergers is a negative factor for employment even as it improves corporate profitability.

Government is severely constrained and will likely not be able to provide fiscal stimulus without nasty side effects.

This leaves exports where a weakening USD is a positive factor. Be that as it may, headwinds remain in the form of Europe which is in similar shape and has to export, Japan, historically a major export economy, and China, the current export champion of the world. Not everyone can be a net exporter. Neither do they need to be. The lines we draw to separate companies by country of listing is arbitrary and in times like these, not useful.

To be clear, there has been a raging bull market throughout all the turbulence coming from the Japan Quake, Middle East unrest, European sovereign debt crisis, emerging market inflation, et al, but this bull market has been limited to developed world exporters. Conversely there has been a raging bear market in emerging market exporters. Therefore, in the past year, it has been profitable to invest in companies whose source of revenues or marginal source of revenues came from the emerging markets while shorting companies whose source of revenues came from the wounded economies of the developed world. This strategy worked because there was a clear decoupling between emerging and developed economies. It was possible, with appropriate stock picking, to run a profitable net long book in the face of falling equity markets. This may change.

The efforts to debase currency, and concomitantly debt, by the Western central banks have had collateral effects on emerging market inflation. Efforts by emerging market governments to deal with these inflationary pressures have inflated cost of capital and diminished credit availability. The impact on their exporters is doubly hard when coupled with the difficult operating environment. The impact on domestic businesses is also negative. The credit controls also drive credit underground (read off-balance sheet) to where surveillance and governance can be poor. The net effect is to render the emerging markets an even more treacherous place to invest. Further, these efforts at keeping hot capital at bay are likely to choke off domestic consumption in emerging markets. This would reverse or hinder the positive trend in developed market exporters.

Where once there were clearly defined long opportunities and short opportunities, one struggles to find good long ideas. The luxury stocks trend is likely to continue, but the dispersion of returns within the sector are likely to rise as valuations become stretched and some companies experience brand fatigue. The market is very clearly a trading market where investors are playing chicken, seeking to flinch just before the market turns.

A word about US treasuries and a potential QE3. With sentiment turning as negative as it is, it is impractical for the US Fed to announce a QE3. If established, it is more likely to be operated in stealth or under the guise of something else. Financial oppression in the form of Basel 3 and other capital requirements already coerce commercial banks to fund the government (by buying treasuries) instead of private enterprise. This has a nasty side effect in that employment grows most in SMEs while the government is retrenching. For the treasury market, however, it provides a large bloc buyer with little else to do except to invest in the securities of an issuer whose securities carry a zero risk capital weighting, yet isn’t particularly credit worthy.

A country never has to default in debt it issues in its own currency. The exception to this is the Euro zone where the ability to print Euros lies with the ECB and not the national banks. Tough.

A country can choose to default in debt it issues in its own currency. That’s a different matter.

If the US never has to default in debt it issues in USD, why then the drama and debate surrounding the debt ceiling, surely a purely academic and legal point rather than a practical one? There are several possible explanations. Here is one.

The US is trying to engineer a much weaker USD against the RMB and the major currencies. The rounds of QE did a good job but not good enough and it is now in the purview of the politicians to debase the currency further under the guise of a phoney war.

Without the cover of debt default the US might be branded a currency manipulator by the Chinese, or the Europeans risking a damaging trade war. By feigning injury, the US hopes it can beggar its neighbours and get away with it. They won’t. So damaged is the world economy that no quarter will be given.

Anyway, nice try.