February 5, 2021
By Steve Blumenthal
“Stay away from high quality fixed income securities.
It’s a bubble. People are very bullish on equities because of where
interest rates are. If they go even lower, you ought not to be that bullish.”
– Leon Cooperman,
Chairman & CEO, Omega Advisors
No, not now, not yet, but it’s coming. The linchpin? The Achilles heel? The trigger? Inflation!
It’s about confidence in the narrative. Confidence in the Fed. Confidence in the government. When it’s lost, the party ends, and the hangover begins.
We are fortunate to have access to some great thinkers—people who challenge our views and provide us with valuable insights. The system is complex, and no investor navigates it perfectly. That’s why I turn to a host of experts with years of experience and skin in the game: Ray Dalio, Felix Zulauf, Paul Singer, Warren Buffett, Mark Finn, Leon Cooperman, Seth Klarman, Jeremy Grantham, Howard Marks, and Lacy Hunt. There are more, of course, but you get the point. Listen to what they have to say, take it in, think.
Last week, I listened to an outstanding podcast during which Grant Williams and Bill Fleckenstein interviewed Elliott Investment Management’s Paul Singer. Here’s a taste:
- In the response to 2008, this ZIRP, zero interest rate policy, this quantitative easing, this emergency policy, which was certainly needed in the immediate aftermath of the crisis. The central banks allowed the crisis to develop by not really understanding the risks. But once the crisis did develop, of course, you needed to radically reduce interest rates and do some asset buying during the crisis period. That was crash playbook and appropriate. But what happened after that, nine years of crisis techniques, long after the crisis was finished, was extremely dangerous.
- I think the central banks came to enjoy their role of being Samson holding up the global financial system and economy. And they weren’t punished by consumer price inflation, they didn’t understand that this asset price inflation, which had a secondary or tertiary positive effect on growth and employment. But they didn’t understand that was a form of inflation, that that’s where the free money and the money printing went. And so they didn’t at all take into account that they were exacerbating the inequality that became a populist political theme.
- It’s very difficult, given that economists don’t have a good history of predicting inflation, turning points in inflation, the reasons why inflation exists or doesn’t exist, the reasons why these emerging market countries with policies very similar to those that are undertaken now in the developed world, that some of these emerging market countries are generating through excessive spending and money printing, really staggering amounts of inflation.
- So, I think when we’re talking about the end game, in terms of central bank policy, I think we’re at the beginning of a path dependent and complicated set of processes in which the first thing that may happen may be some growth in inflation.
In the ongoing push/pull between deflation and inflation, we are near—but not yet at—an inflection point. Today’s message is about putting this front and center on our radar screens so we are better prepared to adapt and adjust accordingly.
For now, I think the following from Dr. Lacy Hunt (via Bloomberg’s Elizabeth Stanton) is hard to disagree with:
Being bullish on Treasuries is still warranted because the economic harm from the pandemic ‘will take years’ to repair, Hoisington Investment Management Co. said in its latest quarterly report. Reasons to trust the bond rally include “massive” global debt loads that blunt the impact of monetary policy and the diminished ability of government spending to help the economy.
“Presently, the overwhelming judgment of market forecasters is that interest rates will rise throughout 2021 owing to the expectation that additional fiscal stimulus coupled with an easy monetary policy will create an inflationary cocktail as pandemic related shutdowns lessen,” Hoisington said.
The contrarian decision “to maintain a bullish stance on long U.S. Treasury yields is not whether rates can rise, since it happens transitorily every year, but whether they can stay elevated,” according to the report. Unless Congress changes the Federal Reserve’s powers, “long dated U.S. Treasury rates will eventually gravitate to lower levels as inflation continues to recede.”
Hard to argue with Lacy, yet with a zero interest rate policy and a 10-year Treasury yielding 1.15%, we are so near the end game. Lacy remains bullish on bonds, though the risk/reward is more challenging today. I remain ready for one last shot at a mortgage refi. Looking for the 10-year to drop back towards 50 bps. Such a move may or may not present.
Lee Cooperman says, “I can’t see investing for 1% when I can invest in alternative investments that will pay me much more. I have virtually no interest in bonds at the present time.” Frankly, I think they are both right.
From Jeremy Grantham: “I’m also worried about inflation. If you think you live in a world where output doesn’t matter and you can just create paper, sooner or later you are going to do the impossible and that is bring back inflation. Something we haven’t seen for years. And you keep it up on a global basis, you will have inflation.” (Via Bloomberg: “Why Grantham Says the Next Crash Will Rival 1929, 2000”)
I could be wrong but I believe inflation will kill confidence. Inflation is the linchpin, the trigger. Inflation will kill the narrative that says the Fed has got our back.
No, not now, not yet, but it’s coming. Deflation now, inflation later.
Grab a coffee and find your favorite chair. In this past Wednesday’s Trade Signals, I shared a few charts on inflation. I added a chart on the U.S. dollar to the list. An important indicator of inflation and confidence, which I explain in the TS section. You’ll also find the text from Grant Williams and his partner Bill Fleckenstein’s podcast with Paul Singer (with my emphasis via bolding). It’s long, but excellent. Thanks for reading.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- The End Game Podcast – Paul Singer
- Trade Signals – Inflation vs. Deflation
- Personal Note – Honoring Girls and Women in Sports
“I gave up a long time ago trying to base my investment management activities,
on the concept that markets, and investors and traders are rational.”
“But if you print your own currency, you don’t have to worry about taxes,
you don’t have to worry about deficits. You don’t have to worry about default,
you can spend whatever you want. Now, I think that’s the road to perdition.
I just think that’s the road to destruction. And that destruction would come if inflation really lit up.”
– Paul Singer
If you’re game, put your sneakers on, plug in, and head out for an hour-long walk. This podcast is excellent. Click on the picture and get moving:
Alternatively, following is the text from the Paul Singer interview (bold emphasis, highlights, and small edits are mine, many typos). It’s about 6,000 words, making for a pretty long read… It’s shared (mostly) in its entirety because I think you’ll gain much from the conversation! I certainly did. Hope it’s helpful. Here it is:
In the response to 2008, this ZIRP, zero interest rate policy, this quantitative easing, this emergency policy, which was certainly needed in the immediate aftermath of the crisis, the central banks allowed the crisis to develop by not really understanding the risks. But once the crisis did develop, of course, you need to radically reduce interest rates and some asset buying during the crisis period was certainly sort of playbook, crash playbook and appropriate. But what happened after that, nine years of crisis techniques, long after the crisis was finished, was extremely dangerous.
And I think the central banks came to enjoy their role of being Samson holding up the global financial system and economy. And they weren’t punished by consumer price inflation, they didn’t understand that this asset price inflation, which had a secondary or tertiary positive effect on growth and employment. But they didn’t understand that was a form of inflation, that that’s where the free money and the money printing went. And so they didn’t at all take into account that they were exacerbating the inequality that became a populist political theme.
This whole period of 2010 to 2019 just built a confidence in the central bankers. In the case of Japan, and the Swiss National Bank hundreds of billions of dollars of stocks. The Japanese central bank, even a couple of years ago, was a 10% or more shareholder in several 100 of the top Japanese stocks.
[When the Fed tried to exit they couldn’t]. So you have this gradual build up and these small attempts by the United States, by the Fed to start to normalize financial conditions [balance sheet reduction] from 4.5 trillion to like 3.7 or 3.8. And [raising interest rates] allow the 0% interest rates to go up to 2.25, 2.50%.
[Then], as we know, toward the end of 2018, the last 25 basis point rise from 2.25% to 2.50% seemed to be the catalyst for a 20% downturn in global stocks. So they [Fed] panicked. I mean, it was an abrupt downturn, on the Fed. The President told the Fed the interest rate should be zero. Why should Europe be quote “Ahead of the United States,” close quotes, reducing interest rates. And so what that showed me and other practitioners was, the Fed was trapped, the central bankers were trapped, they couldn’t normalize. A lousy 2.5 percent short term rate, caused this, or seemed to be the catalyst for this 20% downturn.
If you fast forward to early 2020, pre-COVID, what you find is everyone [every central bank globally] was back to zero interest rates or below. And, again, this, let’s call it $17 trillion, still on the central bank balance sheets. I made the point that this was not a good condition to be in, pending, or in advance of, the next adverse market conditions from whatever direction they could come in. So here you have, starting in February, this 36% drawdown in the US stock market, in a straight line as a result of the developing COVID situation, and the policy response.
And so all of a sudden, in a very short period of time, the $17 trillion has gone to something like $24, $25 trillion spending deficits have gone through the roof, and the interest rates basically everywhere, except for China, policy rates, are zero or below.
And what bonds are relying on is some combination of the following. I think there’s a very widespread belief on the part of investors that inflation is, as the central banks say, it is really hard to generate. They think, “Wow, if only we could get to 2%. And it’s so dangerous being under 2%.” They think it’s dangerous.
And they think it’s so dangerous, that they switched from, “Let’s get to 2%.” To “Let’s average 2% over a period of time.” Now we’re getting into the nitty gritty of the danger here and the problem and what happens next, and then next after next. Because let’s average 2%, when you’re coming from under 2%, it has the following characteristics. Inflation, what period are you averaging? Are you averaging two years, five years, 10 years of consumer price inflation?
And so when inflation gets to be 2.25, or 2.5 on a few monthly readings, or 2.75, do they really mean that they are going to stand by and start congratulating or high fiving each other because they finally generated the inflation? The reason I’m asking it that way is because how do you distinguish inflation readings of 2.5 percent annualized or 2.75 or 3, how do you distinguish that as merely creating this arithmetical average, which is completely arbitrary. How do you distinguish that from a situation in which, after 13 years, and counting, of the most radical policy of the developed world in history, from inflation breaking out?
If you look at the inflation of the 1960s, and 70s, inflation came in the mid to late 1960s, from basically very low levels, they didn’t see it coming. They, meaning the policymakers, the central bankers, and when it came, they thought it was temporary, and one off, and one thing leads to another. So we know about the oil embargo of 1973, which took oil prices up three or four times. So wages, prices, guns and butter, the Great Society, the Vietnam War, and increases in the money supply, all combined. But once inflation lifted off, it just kept on going.
And so from 1, 1.5, 2, in 1968, I believe it went to something like three or four. Labor unions had more power back then. A lot more power than they do today. We’ll talk about tomorrow in a while. But once they generate some inflation, bondholders today and investors and policymakers I believe, universally believe, that it’s not the case that inflation if it pokes above 2, or 2ish, they don’t think that that’s an accelerating point or a point of escape velocity. They will think, “Oh, it’s fine. It’s great. We’ve gotten some inflation, we’re no longer in danger of inadequate inflation.”
But because of the radical monetary policy, which has been going on for such a long time, without consumer price liftoff, let’s just call it. Because of that I think policymakers and investors don’t really have that in their minds as possibilities. And so it’s not necessarily the case, in my view, that the financial world in the economic world will respond to the latest burst of radical monetary and fiscal policy the same way as it did from 2010 to 2019.
Another way of saying what I just said is, I think there’s a really good chance, given the determination to spend trillions and trillions more on COVID relief, and stimulus, whatever you want to call it, to guarantee, quote, unquote, which is ridiculous, these super low interest rates for the next three years, and to keep verbally boxing themselves in. I think there’s a really good chance of a tremendous surprise and a surprise in the relatively near future. What would that surprise be? Some combination of actual consumer price inflation bursting out and keeping on going. That would be a stunning development to central bankers.
And the reason it would be stunning is because they will be sitting back and watching the first burst of 2.5 and 3% inflation. But if it keeps going, what I regard as their smug assumptions regarding what’s actually radical monetary policy will start to be challenged. And once they realize that their theories, which had no theoretical or empirical basis, by the way, that their theories were wrong, or could possibly be wrong, and inflation is not coming down. But wage pressures are coming in for a variety of reasons, supply chain issues are on the horizon from just in time. Hasn’t COVID made a tremendous change in the mentality of governments, and corporations from just in time? Is going to start being just in case? Isn’t the last 20-years’ worth of corporate decision making that says, “Where’s the cheapest, most reliable stuff? Oh, okay, China, and five other places?” That’s no longer going to be the sole discussion around the table.
It’s going to be, okay, what about national security? What about national economic security? What about political policies aimed at bringing supply chains of all kinds of stuff closer to home, not just America and America first or whatever, but a generalized global understanding that just in time, let’s buy the cheapest, and reliable, by the standards of the new history, will be changing. So, I said, some combination of that, or currency movements generating inflation, I think is highly likely.
It’s very difficult, given that economists don’t have a good history of predicting inflation, turning points in inflation, the reasons why inflation exists or doesn’t exist, the reasons why these emerging market countries with policies very similar to those that are undertaken now in the developed world, that some of these emerging market countries are generating through excessive spending and money printing, really staggering amounts of inflation. So I think when we’re talking about the end game, in terms of central bank policy, I think we’re at the beginning of a path dependent and complicated set of processes in which the first thing that may happen may be some growth in inflation in these different areas that we’ve been talking about, combined with more of what we’ve been seeing in the bond markets in recent days, really, of some kind of response to the anticipation of the spending and the increased deficits that seem to be on the horizon.
And once that lights up into somewhat higher inflationary numbers there could be a wage pressures, there could be from the expected increase in labor power under the new American government. So I think there can be something analogous to the wage-price spiral and all I can say about any attempt to quantify it or date it, I think it’s kind of doomed because it depends what happens after those pressures and those price rises start to happen. For example, I think it’s been senseless for people to be continuing to own long term bonds at these crazy yields. In Europe, the 30-year swap got to minus 40 basis points. And I believe today, it’s basically, zero, it’s plus two basis points or something.
And in America, the 30-year government bond is 1.6% or 1.7%. It doesn’t make sense, even with current inflation, to hold those instruments. No institution can meet their goals by owning those bonds, they’re no longer a hedge against equity portfolios. They are speculative instruments. When you buy something with no yield, where you can only make money if the yield goes from zero to the minus five or minus 10. You’re engaged in speculation; you’re not engaged in investing.
And when you’re doing that, at the same time that because of the same forces, stocks are priced toward the very top end of the historical range. And the signs of speculation are every bit as, let’s just call them vivid, as the most speculative episodes in modern financial market history. What do you have and part of the question was, will the bond market be the catalyst? Or something like that. We can see already that the bond market seems to be anticipating some increase in inflation. But markets can and frequently do try to get ahead of what they anticipate.
And so it’s not necessarily the case that the bond market will just gradually readjust to gradual increases in inflation. If I’m correct, that there’s a deep-seated belief, a kind of a rigid belief, that real inflation in the 1970s style is impossible, or really not something that you should really put in your risk matrix. Then the realization, if I’m right, that that’s incorrect, that actually, all of this, this lavish monetary and fiscal policy is going to likely lead to significant inflation, then bonds could have a very significant and abrupt and intense price readjustment. I’m not talking about the 15%. But a price readjustment to yields of three or four for the 30-year or the 10-year in America, would cause quite a ruckus, including in the stock market, as the stock market realizes perhaps, that things have changed and the Fed is not necessarily going to be protecting every investor stocks and bonds against loss.
Paul, when you lay that case out, and it seems so logical, and the facts are on your side behind all the argument and bullet points. I’m sort of amazed that with other smart people in the world why so little credence is given to that to the consequences of that outcome? I would have thought, given the investment environment I’ve lived through since the early 80s that if you would have told people that the central bank is trapped, and the policy consequences were quite severe, I wouldn’t have guessed that the response would be to buy as much beta as possible. Do you think it’s because nothing, quote unquote, bad has happened against the central banks as you said at the beginning of your answer? Did you think that’s what’s made people sort of blind to this outcome? Is it just the financial equivalent of muscle memory? Or does it doesn’t even matter to speculate as to why?
I mean, this is an interesting discussion in a lot of respects. But I think if there’s one thing that I would say is the most useful thing I can respond to these elements, it’s best to think about financial markets as examples of mass human behavior, rather than anything scientific or model able. Because financial markets contain numbers, lots of numbers and prices, and marks to market everything. It’s easy to misunderstand them as actual physical phenomena. And people who are engaged in quantitative trading and investing do seem to make money by some process related to computers spitting out numbers and orders.
But if you think of investing and trading as examples of mass human behavior, then what you said a couple of moments ago is exactly right. It’s, how are people conditioned, it’s not logical to think that 0% interest rates can persist and not result in a crack. It’s not logical that people can walk into the office or their computer today, and pay an $800 billion enterprise value at more than 1,000 times earnings and the earnings are fake anyway.
But they do it because either others around them are doing it or because they think, and basically, they’re wrong about this, that they will be able to get out before the others get out. Or some combination of those things. So I gave up. I mean, I’ve been investing for a long time, like yourself. And I gave up a long time ago trying to base my investment management activities, on the concept that markets, and investors and traders are rational.
So people have been lulled into a variety of beliefs. And one of the main beliefs and I think it’s very, very dangerous is to trust the central banks, and to trust that this radical monetary policy will not end in tears. Now, I admit I just used the word end. And previously, I said, there’s no end. It’s just path dependent. And this leads to that. And that leads to the other. I have a hard time thinking about what happens when inflation gets rolling, I would recommend to anyone listening to this podcast, to do some reading about the great inflations of the last 100 years.
I think the thing that’s most interesting about the great inflation’s is once they get underway, and well before it’s thousands of percent a day or a week, once they get underway, central banks get trapped in the sense that they know that if they diminish or end the money printing, or whatever the technological equivalent of money printing is at that time, the next thing that will happen instantly is a crash, a financial crash, a deep recession or depression.
And so that’s what I mean by trapped. I think central bank policy around the world has been something that has stored up this false confidence, has stored up, let’s call it the ammunition for a future crash. And if the overall performance of the global economy and stocks and bonds in the next two or three or four years does not match or look like the performance in 2010 through 2019, it’s probably because real inflation, real crack in global bond markets, and probably a crack in global stock markets is to blame.
Paul, can I ask, there’s a couple of things in there, I’d love to ask you about. Because you talked about how market participants have become conditioned to certain outcomes. And we’ve talked about how the Federal Reserve haven’t been punished so in their own way they’ve also become accustomed to the outcome, the outcome being their success at every turn whenever they try and fight any kind of small downturn. But I think the scenario you laid out so eloquently suggests, particularly within the context of your supposition that rates go to 3% or 4% is a major problem, that none of this can now be allowed to happen. Which suggests that yield curve control will be at some point essential. And with everybody kind of conditioned to getting the same outcome, does that actually give the central bank’s more latitude because everybody is going to suffer if regular market forces, particularly inflation reassert themselves? And so does everybody buy into this and sits passively while yield curve control, for example, is instituted?
You know, it’s very interesting, the way you framed the question, because there’s no such thing as sitting passively. You’re describing a set of actions and pressures, let’s use that physical metaphor for a second. That have to go somewhere. So let’s say inflation sort of breaks out a little breakout, little breakout, it’s not 5, 6, 7. It’s 2.5, it’s 3 it’s 3.25, whatever it is for a few months. So, you’ve posited, and it’s reasonable to pause it because that’s the working assumption, you’ve posited that somewhere between the current 1.5% yield on the US 30 year or something like that, the Fed’s going to step in, yield curve control. Okay.
But by stepping in, with inflation at the 3 level and pointing to the sky… By the way, the five-year inflation swap this morning was 220. Now, I admit that there’s little liquidity in those kinds of instruments, but that’s up from like 120, just a few months ago. So they step in with yield curve control, and where does the pressure go, it may go in the exchange value of the dollar, the dollar may fall. Or if it’s a simultaneous set of actions by the major central banks of the world the major currencies may fall against gold, silver commodities, real estate, and so the notion that they can control everything seems fanciful to me.
And I think they’ll run out of flexibility when they realize this, that’s why I framed the 2010s, 2009-10 to 2019, as this period that they got away with something, they engaged in something experimental and radical, and it only had good effects. It held things up. You didn’t need the legislature’s creating excellent, intelligent pro-growth policies, because the central banks did it all. Well, now, you have these extra elements. There’s no shyness, there’s no austerity that’s going to happen anywhere in the developed world. So you’ve got the spending, you’ve got this insane, modern monetary theory, which basically says, “Well there’s this inflation thing. And that’s sort of a control… Or not a control, a guardrail. You don’t want to cause inflation.”
But if you print your own currency, you don’t have to worry about taxes, you don’t have to worry about deficits. You don’t have to worry about default, you can spend whatever you want. Now, I think that’s the road to perdition. I just think that’s the road to destruction. And that destruction would come if inflation really lit up.
It’s very interesting that the markets seem to think that inflation and a bad economy are sort of incompatible. It’s really not true. And that many of the great inflation’s are at a time when there’s economic dysfunction, malfunction, under-performance, which is attempted to be overcome by the spending and the money printing. So on the face of it, that’s where the developed world is headed now.
Paul, when you talk about your framework for looking at financial markets as being more sort of psychology and emotion as opposed to math problems, if I can restate it that way. And you talk about how, if inflation, once inflation gets started, how difficult it is to stop. And I can remember that from the 70s as well. Does the psychology, psychological component matter in the getting started have it? Or do you think it has to kind of get started before psychology starts to really change? I mean, people are so ingrained to think that all of this works, and they’ve got all the rationalizations worked out as to why inflation can’t possibly get started, even given the policies that are being pursued. I was just kind of curious if, after you noted the unpredictability of how it kind of gets going. How crucial is psychology in terms of psychology changing at the start of the process? If that’s a fair way to think about it.
It’s the ballgame. It’s the whole ball of wax. Let me answer it by reference to one of the key tenets of central bank policy and practitioners thinking about central bank policy. Because the arithmetic is compelling, the combination of actual debt plus entitlements in the developed world, which to me, are the functional equivalent of debt, are unpayable. They’re absolutely unpayable. The arithmetic is clear. And when I say unpayable, I’m not talking about the nominal currency, I’m talking about purchasing power. You will not get, in your Social Security, Medicare, Medicaid and the government bonds, the value that you put in plus a rate of return on that value. Okay. That’s easy.
So what practitioners and economists say is, “Well, there’s a variety of ways to deal with this. One is default. Great. The other is inflating your way out of it.” And one of these central bankers, I think, was Evans a couple of days ago literally said something like, “Well, if inflation went 3%,” which I giggled when I read this for a couple of reasons. One of them is the way he said that it was like, “Wow, I’m going to name a crazy number, 3%.” Read the quote. So he says, “If inflation went to 3%, it wouldn’t be a bad thing.” Okay.
So, this is pathetic, okay, it wouldn’t be a bad thing. Here’s the problem. The reason the statement, “We can inflate our way out of it is preposterous,” is exactly what your question was. It’s investor psychology. [When] Investors lose confidence in central bankers, the dollar and or bonds and or the ability to control inflation, you can paint pictures, you can imagine scenarios, and they’re not trivial scenarios. If that happens, they will front run or attempt to front run the inflation.
How do you do that? You do that by selling down the bonds. What is the Fed going to own all bonds? The way the central bankers have gotten away with this for 13 years is Mario Draghi will do whatever it takes. Well, you stand up there, and you’re fierce enough and you beat your chest, and you look strong enough and you start growling. People say, “Wow, they’ll do whatever it takes.” So you don’t have to do anything. Okay, so that’s part of policy. If people actually lose confidence in money, I think it’s going to be an interesting fight. Let’s call it a fair fight between investors trying to get out, and governments, at least at the beginning, helping them to get out by holding up the prices.
But to answer your question very precisely the reason I said it’s a ballgame is that confidence, and investor and citizen psychology is the key. And that’s what policymakers have been relying on. And they don’t really… They seem to think that it’s infinite, that the confidence is infinite. And that the damage they can do to the reality of the currency, the forward rate of return, that investors just will either be fooled or placid in the face of it. It’s really stunning to me. As simple as, how could investors today, and we have a lot of institutional investors. How can they sit around their tables, and maintain their positions in stocks and bonds at today’s prices? And say, “Oh, we are aiming at a 7% annual return on our investment pool?” Where is that 7% investment return from today’s prices going to be coming from? The bond side, the arithmetic is just really, really simple. On the stock side, I don’t understand why more people don’t say, “Wow, the bull market is at a place where the forward rate of return historically, is kind of low. It’s not 7% or 8% a year, it’s maybe 4% or 5% for the next 10 years. So how are we going to repair the buildings? How are we going to do what we need to do?”
Paul it’s funny, a good friend of mine who’s an RIA wrote a piece to his clients recently, and the piece was entitled Take Profits. This was at the beginning of the year. And he had a bunch of emails both internally and externally from people saying that was an alarmist headline for a piece. And it kind of got me thinking, take profits used to be called investment advice. And now take profits has become too alarmist. And I think that speaks of everything you’ve just talked about here that people are fully invested, we’re in that stage of the mania, where confidence is so high, and that nothing can go wrong.
And earlier, you mentioned how the central bankers didn’t seem to understand that this asset price inflation that we’re talking about now, was a form of inflation. So they clapped themselves in the back and said that there was no inflation from their policies. Is it that simple that they don’t understand that or do they understand it? And they’re hoping nobody else understands it? Because I go back and forth between the two. And I really don’t know the answer to that.
I’m pretty sure they don’t understand it. And I’ll give you some supportive evidence in a moment. Let’s go back to 2005-6, roughly 2005-6. They don’t understand it because the financial system and the financial innovations, derivatives and all kinds of complicated securities have gone way ahead of economic and financial theory. There are no models and real experience to understand what happens when from zero in 1970 or 1975, that 1,000 trillion dollars notional of a variety of different kinds of derivatives have erupted in like 40 or 45 or 50 years.
And so, I said I’d offer some evidence, as you may know, you can obtain the minutes of fed meetings, all fed meetings, going back years. And so, people have published some of what went on in fed meetings in 2005, ‘6, ‘7. And what you can see clearly, because now we can see it in hindsight, but what you can see clearly is they had no idea of what the CDOs, CDO squared subprime CTOs, that tying together of people in these tight webs of derivatives, where the BBB tranches of mortgage securitizations were used, particular trenches were use dozens and dozens of times, to construct securitizations and securitizations of securitizations, where the BBB was magically, because it was married to 50 BBBs from different pools magically turned into 85%, AAA rated.
The central bankers had no idea what was going on the ground, in the financial system on the structuring desks. And by the way, neither did, as we now know, the risk departments of the major financial institutions of the world didn’t have a clue either. And so the answer is that the complexity of the financial system went way beyond and is way beyond the understanding of central bankers, and they’re just playing at thinking of this area as a science.
It has elements of science, but they don’t understand why markets can go down 20% and up to 25% in like two months, that’s December 2018. Down 36% in a straight line, up 67% in a straight line, that’s February, March 2020, and the rest of 2020. And so you need some kind of explanation of why correlation and herding is clearly in recent years, more powerful, more abrupt, and more intense, than in the past. And, to me, the answer is derivatives. Samethink, groupthink, and when people change their minds in one direction or another, there’s just so much tightness both in the structures in their portfolios, in the leverage in the system, both overt leverage and through the derivatives markets. And I think central bankers, they don’t even know how to catch up.
Paul, something obviously, you have great amount of experience in is distressed sovereign debt. And yet here we find ourselves in a world where three-year Greek bonds have a negative yield. And I kind of go backwards and forwards with whether this is the end of an entire business model, or it’s one of the greatest opportunities of a lifetime for someone like you. How do you kind of look at that and weigh it up?
Well, I’m not going to answer the question just with reference to sovereign debt. The yield on Greek sovereign debt or Italian sovereign debt or any other sovereign debt is subject to a lot of forces. Including the consolidation, let’s call it or attempted consolidation of Europe. But I think the more interesting part of the question to me is, what do you do with deep valuation aberrations? And I think in this environment, it’s very, very hard.
We’ve had in house spirited discussions, let’s just call it about European yields. And I’m not talking about Greece, I’m talking about the Euro swap or can we declare zero yield for a 30 years euro swap a currency that some consider potentially a junk currency? Can we declare that an extreme? And can we trade it? Well a while ago, here it is at zero or plus two basis points for the 30-year swap, it’s quite a thing to do with your money. And at one point at the bottom I don’t know a year ago, something, it was minus 40. Minus 40 basis points for 30-years. I mean, wow. Wow.
I lived through the worst trade in my history in 2008, where I was long, Japanese inflation linked bonds against Japanese non-inflation linked bonds. And I put that position on at an implied deflation rate of 2.5 percent per year. At the bottom, after I’d lost more money that I thought I could possibly lose in any trade they were trading at minus 4.5 percent per year.
Now, at a time like that, at a price like that the answer to the question, what did you do is based on two things. Did I have emotional staying power? That was a tough time, the last few months of 2008. I stuck with that trade and it came obviously all the way back. But I think that modern markets, I mean, if there’s anything useful, I can say, I think investors in the more humble, even more humble than in the past, and you always have to be humble, really humble to survive for a long time in the trading and investing in markets. But I think it’s getting more difficult to dig your heels in from an overvaluation or an undervaluation standpoint.
Paul, what’s more important to ride that trade out? Do you think what’s more important, is it experience or tenure, because there’ll be a lot of people who put that trade on in. And obviously, face values, as you said, it just made so much sense. But so many people would be stopped out by their customers, once it got to the extremes it reached, is it tenure? Or is it your experience? How do you mentally manage something like that?
Well, let me just say that, and I think it is a very interesting point. The way it got to 4.5%, is that most people that were in the trade, it was a popular trade. Most people were stopped out. They were stopped out by the predatory investment banks. I’m not going to name them. Okay.
You don’t have to; we know who they are.
Or by their customers, or by their psychology. So your question was about the psychology of it. It’s a much longer topic, but I don’t like rigid trading rules for myself. Flexibility versus rigidity, let’s call it, have to be individually assessed. There are times when you make a mistake, you think it’s a mistake, or it might be a mistake, you’ve got to get out. And there’s no magic to the difference between that. And it may be a mistake, but I don’t think it’s a mistake. And I’m going to stick with it. And sometimes you’re right, and sometimes you’re wrong, but I can’t think of magic tools. Guys, I’m unfortunately going to have to bail. Do you have enough here.
Yeah, I think we should do Paul. I mean, all your points were so spectacular. I’m sure you could have lots more, but I think that was really great.
Yeah, we’re grateful for the time you’ve given us, Paul. Thank you so much. It’s hugely appreciated.
Thanks so much, guys. This was fun. I hope it was useful. Take care.
# # #
A lot to digest. I hope you found Grant and Bill’s podcast helpful. You can subscribe here.
February 4, 2021
S&P 500 Index — 3,750 (close)
Notable this week:
“Until we redress the debt morass, an unstable situation that if you know your history
ultimately ended Great Britain’s world dominance (sterling, too),
then inflation has no staying power — full stop.”
– David Rosenberg,
Founder, Rosenberg Research (“Breakfast with Dave, ” Feb. 2, 2021)
- The dollar was down nearly 7% in January. A falling dollar means the cost of goods we import costs more; thus, a falling dollar is inflationary on goods we import and we import a great deal. Unit labor costs up 3.40% year-over-year ending September 30, 2020. Wage costs have been low for years. Expect wage costs to rise.
- Geopolitical challenges: a rising power (China) facing a declining power (U.S.). Re-shoring of manufacturing, regionalizing of supply chains, shift away from China, tariffs/trade wars, etc. Keep an eye on what’s going on near the Strait of Taiwan. (Breaking news: U.S. sends war ships through the Strait of Taiwan as the tensions are high.) Taiwan is the global leader in semi-conductors.
- Commodity prices are higher. Core commodities prices rose 1.7% year-over-year ending December 31, 2020. Not an immediate worry but to be watched.
- Continued and expanding fiscal policy is short-term expansionary.
- Debt is the most critical situation we face. Debt suppresses growth.
- Continued and expanding fiscal policy long-term deflationary: CBO projects the government running annual trillion dollar plus budget deficits for the next ten years. (See next chart.)
- The output gap is a powerful deflationary force. There is way too much excess capacity to produce goods. Think of this as excess capacity available in the global economy to produce things. Globalization is a big reason. COVID added to the excess. Excess capacity will suppress inflationary pressures until the gap closes.
- Money velocity correlates strongly with inflation. Velocity is the movement of money within the economy. You buy bread from the baker, the baker takes that dollar and buys dough, and spends excess money on a new truck, car salesperson makes a commission, the auto workers earn a salary, the manufacturer makes money, the dealers make money and all spend a portion of what they make, etc. There is a measurement of the movement of money in the system called “money velocity” and it sits at a record low. Simply, people are not spending. They are saving more. Spending less. Also a symptom of too much debt. Supports deflation.
- Lastly, demographics are a powerful economic force. When you are older, you generally spend less, produce less (working fewer hours, less productivity). Aging demographics are a challenge to the developed countries. Deflationary.
Bottom line: Deflation now, inflation later but there is reason for concern and that is the massive amount of money being created by the global central bankers. You’ll see below that the price trends put us in the “high inflationary pressures” zone. The Fed will let it run well beyond 2% and if confidence is lost in the current narrative, it could become a real issue. Inflation could quickly get out of control. Today, no. Later, possible… So we keep watch…
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“Somewhere behind the athlete you’ve become
and the hours of practice and the coaches who have pushed
you is a little girl who fell in love with the game and never looked back… play for her.”
– Mia Hamm,
Two-Time Olympic Gold Medalist, and Two-Time FIFA Women’s World Cup Champion
National Girls and Women in Sports Day was this past Wednesday. It’s fun watching Susan coach her kids (both boys and girls). I love how sports forces the kinds of situations we grapple with throughout our lives to play out in tight periods of time. A loss. A win. A confrontation with a teammate. Unfair behavior by a competitor. A bad call by an official, or one that transforms your fortune for the better. Sports forces us to challenge the boundaries of our comfort zones and teaches us our failures may be just our greatest teachers.
Of course, it’s not just in sport. It’s in music, chess, art, business, family.
I went searching for some coaching quotes that might inspire. Here are a few:
“There’s no substitute for hard work. If you work hard and prepare yourself, you might get beat, but you’ll never lose.” – Nancy Lieberman, Former Professional Basketball Player and WNBA Coach, Broadcaster for the Oklahoma City Thunder, and Power Coach
“You can’t stop negative thoughts from coming in, but you can make sure they leave as quickly as they enter.” – Nkem Mpamah, Author of The Art of Achievement and Fulfillment: Fundamental Principles to Overcome Obstacles and Turn Dreams Into Reality
“It’s not whether you get knocked down, it’s whether you get up.” – Vince Lombardi, Former American Football Coach and NFL Executive
“I’d rather regret the risks that didn’t work out than the chances I didn’t take at all.” – Simone Biles, Olympic Gymnast
“When you encourage others, you in the process are being encouraged because you’re making a commitment to that person’s life. Encouragement really does make a difference.” – Zig Ziglar, Author, Salesman, and Motivational Speaker
“If you want to achieve something in life, you have to take risks.” – Dipa Karmakar, Olympic Gymnast
“There is always going to be a reason why you can’t do something; your job is to constantly look for the reasons why you can achieve your dreams.” – Shannon Miller, Former Olympic Gymnast
“Courage, sacrifice, determination, commitment, toughness, heart, talent, guts. That’s what little girls are made of; the heck with sugar and spice.” – Bethany Hamilton, Professional Surfer and Shark-Attack Survivor
A hat tip to girls and women in sports. I told Susan last night, “Look how far their/our world has come in the last ten years.” As the father of a strong, driven, and fiercely independent daughter, I’m smiling.
Speaking of sports, I’m looking forward to watching the Super Bowl Sunday night. A cold IPA and pizza with Susan and the boys. I really don’t have a preference. Old GOAT vs. future GOAT. Looks like it is going to be a great game and hopefully fun commercials. They are usually creative and fun. Enjoy the game!
Wishing you a great week.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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