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“During the 10 years I traded for George Soros, I never heard him speak about a winning trade. To hear him talk, you’d think he had nothing but losers. Conversely, listening to the biggest losers, you’d think they had nothing but winners.” ― The Education of a Speculator by Victor Niederhoffer

 

Starting a new year, more so a new decade, it has become almost customary to look back and reflect on what transpired and what insights can be gleaned to have a better tomorrow. For us, in the context of public market investing, learning that the S&P 500 Index outperformed almost four fifths of all US stocks in 2019 and approximately two-thirds of them over the last three-years was astonishing.

 

Not active managers, stocks! Simply staggering.

 

This begs the questions, is the committee that selects stocks for inclusion in the US equity index comprised of geniuses? (Hint: it is not.)

 

Financial Innovation in the 1920’s

 

The ‘Roaring Twenties’ was a decade of economic growth and widespread prosperity. A significant, not comprehensive, list of socioeconomic achievements of the US economy in the 1920’s is as follows:

 

1. A 20 per cent increase in the national income per capita from 1922 to 1928
2. A 30 per cent increase in physical production
3. An almost doubling of profits of the larger corporations
4. A housing program that expanded faster than population
5. An increase in average health and longevity
6. An increase in educational facilities greatly surpassing the growth of population
7. A per capita increase in savings and insurance
8. A booming stock market, at least until October 1929
9. A 5-hour decline the average working week
10. Slowly rising wages with little to no inflation
11. Ever increasing productivity per worker

 

(Source: Prosperity Fact or Myth by Stuart Chase)

 

A recovery from wartime devastation and deferred spending, a boom in construction, and the rapid growth of consumer goods such as automobiles and electricity are often credited for the economic boom during the decade. A less well-known contributor to the boom and the subsequent bust, however, is the financial innovation that took place.

 

The twenties were a decade of rapid financial innovation – from the development of the modern investment trust to consumer credit tied to purchases of durable goods like automobiles. And of the democratisation of financial markets – between 1922 and 1929 US national banks and their affiliates operating in securities business increased from 72 to 235, a more than threefold increase.

 

Credit fuelled a real estate boom in 1925 – real estate bond issuance accounted for nearly a quarter of all corporate debt issued in the US in 1925. Issuance of commercial mortgage-backed securities financed the construction of most of the US skyscrapers in the 1920’s and led to overbuilding and then widespread vacancies. New York and Chicago were the primary focus of the real estate run-up. More office buildings taller than 70 metres were constructed in New York between 1922 and 1931 than in any other ten-year period before or since, according to the National Bureau of Economic Research.

 

 

Credit also powered the Wall Street boom of 1928-29 and a consumer-durables spending spree spanning the second half of the decade. That these booms developed under the fixed exchange rates of the gold standard meant that they generated little inflationary pressure in the US, and that their effects were transmitted to the rest of the world. Without inflation, the Federal Reserve had no reason to increase short-term interest rates.

 

Eventually, however, the Fed and other central banks grew concerned over the speculative excesses in financial markets and started tightening monetary to rein in asset-price inflation. Banks passed higher rates and costs of increased reserve requirements to borrowers and reduced the amount of margin they will offer to stock market speculators. By this time, however, investors, particularly stock market speculators, were highly leveraged. Consequently, borrowers felt the pinch of tighter monetary policy leading them to reduce their spending, and consumption and investment turned down.  Ultimately, as we know, the deflationary bust that ensued almost took down the financial system and the economy more generally.

 

Financial Innovation in the 2000’s

 

More well-known are the transgressions of Wall Street in the 2000’s that led up to the Global Financial Crisis.

 

Yield starved institutional investors following the interest rate cuts enacted by Alan Greenspan in response to the bursting of the tech bubble began investing heavily in another Wall Street concoction. Real estate-backed collateralised debt obligations that came with the stamp of approval from the credit rating agencies offering a higher yield than bonds with comparable rating became the flavour du jour in 2000’s.

 

We all know how that story ended.

 

 

 

Financial Innovation Today

 

“Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.” ― George Soros

 

The S&P 500 is outperforming individual stocks not due to some superior skill in index composition, but because institutional investors are opting to pass over active managers in favour of investing passively in free-float market-capitalisation weighted indices. Compounding the challenge for active managers, the largest institutional investors in the world are actively running systematic volatility selling programs that make the market even harder to beat.

 

An example of a systematic volatility selling program includes selling a fixed dollar value of S&P 500 Index call options and put options with the same strike price and expiration on daily / weekly / monthly basis. There is no bet on the direction of the stock index; as long as the S&P 500 Index does not go up or down too much, the straddle will be profitable.

 

Following the short volatility blow up of February 2018 and the sharp market sell-off in the fourth quarter of 2018, Wall Street became even more innovative. For example, Bank of America Merrill Lynch created something a called a VCorrel swap, while we do not know exactly it works, we understand it scales volatility exposures for its clients dynamically over the course of a trading session rather than at market opens and closes. When volatility is expensive e.g. during an intra-day market sell-off, the swap involves selling more volatility and reducing exposure when volatility is cheap. Such dynamic volatility selling programs reduce intra-day volatility much like selling put and call options at market open and close reduced day-to-day volatility.

 

Lower volatility emboldens speculators to take more risk and increase leverage.

 

The innovations of the 1920’s led to the construction boom of the likes never witnessed before or since. The innovations of the 2000’s blew the greatest and probably the first truly global real estate bubble. Extending that, we do not think it unreasonable for the current rendition of the bull market, in stocks and bonds collectively, to evolve into a bubble bigger than anyone, ourselves included, expects.

 

“When I see a bubble forming, I rush in to buy, adding fuel to the fire.” ― George Soros

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed

 

“Housing wealth – the net equity held by households, consisting of the value of their homes minus their mortgage debt – is the most important source of wealth for all but those at the very top.” ― Janet Yellen

 

“Housing traditionally is not viewed as a great investment. It takes maintenance; it depreciates. It goes out of style. All of those are problems. And there’s technical progress in housing. So, new ones are better. So, why was it considered an investment? That was a fad.” ― Robert Shiller

 

A short one this week.

 

A technology focused private equity fund manager is buying a stake in an English football club at a huge mark up over its last valuation. LVMH is acquiring Tiffany’s by paying a premium of 37 per cent over its undisturbed share price and in the process more than doubling its market share in branded jewellery. Saudi Aramco is slated to go public imminently with the largest market capitalisation for any company listed across any market.

These are exactly the kinds of events that would be expected in and around market tops. It is getting precarious and we would not be surprised to see a pull back with bullish sentiment so high and VIX so low. With global central banks in easing mode and given the abundance of liquidity, we still expect markets to push on to higher levels before the party ultimately ends. For markets to continue marching to higher level, however, we think there is a need for another catalyst ― what that may be remains to be seen.

On to the update.

 

US Housing and Consumer Charts and More

 

US Housing and Durables Goods Spending

 

Falling long-term interest rates equate to more affordable housing and on a relative basis make the economics of owning a home better than of renting one. With, US long rates having dropped sharply during the summer, US home purchases have picked up.

On an annual basis, sales in October increased 4.6 per month from the same month the previous year, marking the fourth straight month of year-over-year gains.

With homeowners in the US remaining in their homes thirteen years on average, five years longer than they did in 2010, and housing inventory estimated to be at an 11-year low, the surge in demand for housing is rippling through to increased applications for and issuance of building permits.

The thing about buying a home is that, once you have bought one, it comes a with a long list of mandatory and not-so-mandatory purchases.  For this reason, US consumer durable goods spending tends to closely track home sales and housing permit issuance with a lag.

The below are charts of the year-over-year change in new houses sold and new residential building permits issued versus the year-over-year growth in consumer spending on consumer durables, respectively.

 

 

While demand for housing fluctuates with long-term interest rates, once a house has been bought the spending that follows it, will follow irrespective of the fluctuation in interest rates. This makes consumer durable plays, broadly the consumer discretionary sector, a less interest-rate sensitive means of gaining exposure to the robust demand for US housing.

The following is a chart of the Consumer Discretionary Select Sector SPDR ETF $XLY versus monthly consumer durable expenditures.

 

 

If spending on consumer durables picks up as is suggested by the pickup in demand for housing, the consumer discretionary sector is likely to be one of the better performing sectors in the US market in the coming months.

 

US Real GDP and Real Long-Term Yields

 

The below is a chart of US real GDP growth versus the yield on 10-year Treasury bonds deflated by CPI. Barring a sharp drop in the GDP print for the second half of the year, long-term bonds still look expensive.

 

The Search for Anti-Fragility

 

Nassim Taleb describes antifragility as a property of systems that increase in capability to thrive as a result of stressors, shocks, volatility, noise, mistakes, faults, attacks, or failures.

As markets scale to new heights, it becomes increasingly important to scale into assets that provide some degree of antifragility, that is benefit from rising volatility.

Over the coming weeks and months, we hope to identify as many antifragile assets as we can to provide different options investors can incorporate into their portfolios. One such asset is the Japanese yen.

Since the beginning of 2009, the VIX has increased by 10% or more from one trading day to the next on 225 occasions, on average the Japanese yen, versus the US dollar, has gone up by 30 basis points on those days. The VIX has increased by 20% or more from one trading day to the next on 61 occasions, on average the Japanese yen has gone up by 50 basis points on those days. The VIX has increased by 30% or more from one trading day to the next on 22 occasions, on average the Japanese yen has gone up by 80 basis points on those days. The very definition of antifragile.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

“And the little screaming fact that sounds through all history: repression works only to strengthen and knit the repressed.” ― The Grapes of Wrath by John Steinbeck

 

China’s Priorities

 

From the Wall Street Journal (emphasis added):

 

In the trenches of China’s debt-addled economy, the government has made a startling decision: Let companies fail.

That has left creditors angry, debtors fighting to save their businesses and judges on a mission to promote the benefits of bankruptcy.

After years of pumping out financial support to keep the economy humming and workers happy, China has embarked on a debt reckoning. Beijing is building a bankruptcy system to take on a significant pickup in corporate defaults.

The country now has more than 90 U.S.-style specialized bankruptcy courts to help sort through a morass of corporate debt that, until recently, would have been swallowed by state banks and other creditors.

It is a sign that Beijing is worried about the number of failing companies and trying to find a fix. The system is helping, many lawyers, foreign investors and lenders say, as it takes some pressure off local governments that lack the resources for so many bailouts.

[…]

China introduced formal bankruptcy laws in 2007. But courts routinely rejected applications from struggling businesses and their creditors because of concerns over potential social unrest and large-scale layoffs.

Many insolvent companies chugged along with state subsidies and loans from state-owned banks. Some simply walked away from their debts, leaving creditors hanging.

[…]

It is part of a shift from what Judge Ye described as policy-mandated bankruptcy—the government largely decides which companies fail or survive—to a “market-oriented bankruptcy” process that lets market forces decide who are the winners and losers.

 

While some cultural blowback is to be expected, this is a positive development. If China is going to transition from an investment-led to a more balanced economy, malinvestment needs to be discouraged. Market-oriented bankruptcy proceedings replacing government-led bailouts is a welcome step in the right direction.

 

Household, or private, consumption accounted for less than 40 per cent of China’s GDP in 2018, the thirteenth consecutive year in which private consumption has accounted for less than 40 per cent of GDP. Such persistently low-levels of private consumption, as a share of GDP, are unprecedented in recorded economic history. Given the magnitude of and the prolonged period over which the Chinese consumer has been repressed, China’s leadership is unlikely to be able to encourage households into increasing spending merely by tweaking policy. Difficult policy decisions will need to be made and stuck with. Discouraging and allowing markets to punish corporate malinvestment is once such decision.

 

Malinvestment is a direct consequence of over-investment. Over-investment requires an abundance of domestic savings or the ability to attract high-levels of foreign direct investment.

 

Foreign private investors require some form of protection when investing in jurisdictions where the political risk-premium is high. The protection for investing in China was provided by its burgeoning pile of net foreign assets.

 

In the chart below, in the top panel the magenta line is the level of foreign exchange reserves held by China and the bars in bottom panel represent the cumulative foreign direct investment into the Mainland since 1995. The two series have been in almost perfect lockstep.

 

 

The rest-of-the-world is becoming increasingly unable and unwilling to absorb China’s trade surpluses. Thereby inhibiting further increases in Chinese foreign exchange reserves and by extension the flow of foreign capital into the Mainland.

 

Lower appetite for Chinese trade surpluses implies lower demand for Chinese exports. Lower Chinese exports in turn means the investment needs of Chinese corporates are reduced.

 

From the Financial Times:

 

China’s listed manufacturers are increasingly putting their money into financial assets such as stocks and bonds rather than investing in their own businesses, as the potential returns from capital expenditure wane.

 

To curb speculation and malinvestment, there needs to be an increase consumption in China. Consumption will only increase once the powers that be put to an end to their policies of financial repression. That is, an end to artificially low interest rates that penalise depositors for the benefit of large corporates, excessive levels of direct and indirect subsidies to state-owned enterprises and an undervalued currency. Additionaly, the burden of creating social safety nets needs to be removed from households and placed it on the state.

 

China does not need 6 per cent plus of GDP growth, it needs private consumption growth of 3 to 4 per cent above the rate of GDP growth for the next decade, or possibly even longer. The People’s Bank of China this week rolling over its one-year medium-term lending facility at 3.25 per cent, 5 basis point below the previous rate of 3.3 per cent, and setting the direction of monetary policy toward easing, suggests GDP growth not household consumption growth remains the priority for Chinese policymakers.

 

Industrial Strength

 

This has been a difficult year for American manufacturers, marked by trade war related changes and an almost synchronised global economic slowdown. Output, investment and employment are all down at US manufacturing companies and surveys revealed manufacturers to be less than optimistic on near-term prospects.

 

With that in mind, consider the below chart of the Industrial Select SPDR ETF $ XLI.

 

 

Industrial stocks are breaking out to all-time highs and that too on improving relative strength (second panel above).

 

The following constituents of the ETF appear to the most interesting from the long-side.

 

Fastenal  $FAST

Fastenal resells industrial, safety, and construction supplies such as such as screws, threaded rods, and nuts and offers services including inventory management, manufacturing, and tool repair.

 

 

Rollins Inc.  $ROL

Rollins Inc. provides essential pest control services and protection against termite damage, rodents and insects.

 

 

Pentair $PNR

Pentair sells comprehensive range of smart, sustainable water treatment solutions to homes, business and industry globally.

 

 

Alaska Air $ALK

Owner and operator of two US based airlines: Alaska Airlines and Horizon Air.

 

 

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

“There is no nonsense so errant that it cannot be made the creed of the vast majority by adequate governmental action.” ―  Bertrand Russell (1872 – 1970), British Nobel laureate in literature

From The Toxic Bubble of Technical Debt Threatening America by The Atlantic:

“A kind of toxic debt is embedded in much of the infrastructure that America built during the 20th century. For decades, corporate executives, as well as city, county, state, and federal officials, not to mention voters, have decided against doing the routine maintenance and deeper upgrades to ensure that electrical systems, roads, bridges, dams, and other infrastructure can function properly under a range of conditions. Kicking the can down the road like this is often seen as the profit-maximizing or politically expedient option. But it’s really borrowing against the future, without putting that debt on the books.

In software development, engineers have long noted that taking the easy way out of coding problems builds up what they call “technical debt,” as the tech journalist Quinn Norton has written.

 […]

Almost everywhere you look in the built environment, toxic technical-debt bubbles are growing and growing and growing. This is true of privately maintained systems such as PG&E’s and publicly maintained systems such as that of Chicago’s Department of Water Management. It’s extremely true of roads: Soon, perhaps 50 percent of Bay Area roads will be in some state of disrepair, not to mention the deeper work that must occur to secure the roadbeds, not just the asphalt on top.”

The Federal Reserve cut interest rates for the third time this year while also signalling that it does not expect to reduce rates further barring a sharp slowdown in the economy.

Suppression of G-7 interest rates, particularly following the bursting of the dotcom bubble and then the Global Financial Crisis, enabled gross over indebtedness, severe misallocation of capital and moral hazards to build up globally. This leaves governments and central banks with little choice but to respond to any signs of instability with further stimulus, either fiscal or monetary, to avoid the inevitable asset impairment cycle that would lead to a deflationary bust.

Suppressing interest rates slowly erodes trust in the financial system by facilitating the survival of zombie companies and unstable financial structures. The complete obliteration of trust in the financial system ultimately begets high rates of inflation and rewards owners of real assets.

Ideologically, we understand and appreciate the case for a complete loss of confidence in the dollar-based financial system and the eventual breakout of high inflation. And barring a discovery that materially reduces energy costs and increases supply at the same time, or a step-up in global productivity of the like witnessed during the industrial revolution, we expect the end game for the current global order to be no different than to that of other regimes in history.

In the theory of complex systems there is a concept of the ‘adjacent possible’ ― the set of all possible states of the world that could potentially exist in the next time step, given the present state of the world. Understanding the current state of the world then drastically reduces the next possible state of the world from all possible states to a subset of possibilities that are conditional on the present.

Ideologies aside, our analytical framework does not yet consider a complete loss of trust in the global financial system in the adjacent possible. Rather, the next crisis, whenever it may be, and the response to it by governments and central banks is likely to sow-the-seeds for the obliteration of trust in global financial systems.

On to this week’s update.

Signs of Rotation: Geography, Sector and Style

Global equities are on track for a third-successive week of positive returns driven by easing financial conditions, diminishing Brexit uncertainty, prospects of a thawing of tensions in the US-China trade dispute, and US earnings season going better than anticipated. (US companies are beating earnings expectations by ~5 per cent; notably, the bar had been lowered heavily with consensus expectations slating earnings per share to decline 3 per cent year-over-year.)

In the recent upturn there have been some noticeable rotations across sectors, geographies and styles. With the short-term outperformance of value over growth getting the most airtime.

While notable on a shorter-term horizon, most rotations appear trivial relative to performance trends during this record-long business cycle. For example, over the past decade non-US equities have delivered returns only one-third of US ones, measured in USD terms, while the iShares Russell 1000 Growth ETF has delivered a total return more than 1.5 times the total return delivered by the iShares Russell 1000 Value ETF.

With that being said, we run through a series of charts of identify regions, sectors and styles benefiting from rotation, albeit in the short-term, and could provide tactical alpha generating opportunities.

The Rest of the World

Value is often discussed in terms of the value and growth indices in the US. Given, the relatively paltry returns from non-US markets over the last decade, one could argue that anything non-US is essentially a value play.

With a dovish Fed, the easing trade dispute and a cyclically weaker US dollar, we can envision a scenario where money managers look to shift allocations into non-US markets lured by any one or a combination of value, reflationary pressures or improving growth prospects. The one difference we anticipate in any geographical reallocations in this cycle versus previous cycles is investors no longer analysing emerging markets simply through the prism of China. Rather, we expect a more discerning, less-homogeneous approach to emerging markets as investors attempt to identify winners and losers of the fallout from the US-China trade dispute.

We expect the next two to three months to be favourable for the rest-of-the-world relative to the US and for non-US equity markets to match or better US equity markets.

Russia

Russia looks one of the most attractive markets relative to both the US (first chart) and the world ex-US (second chart).

Brazil: Long-Only and Relative to Mexico

Brazil is shaping up well against the broader emerging markets space (first chart) and long Brazil $EWZ with short Mexico $EWW is a pair trade (second chart) that we would look to put on.

Why? Because Brazil has pro-business government and the potential to increase agriculture sales to China should the trade-dispute once again escalate while Mexico has a socialist leader and is running a record trade surplus with the US.

Europe Relative to Japan / The UK Against Germany

Another pair trade that we like is long European equities $VGK and short Japanese equities $EWJ. Japanese equities need not go down but the Japanese could weaken relative to the euro as Brexit uncertainties are mitigated and the general risk-on environment gathers steam.

The above trade could combine well with long the UK $EWU and short Germany $EWG and hedge out some of the risks emanating from the continued industrial slowdown in Germany. However, an outright long in the UK (second chart) looks a better trade should sentiment continue to remain ebullient.

Sectors

Autos

The automotive sector has been one of the worst hit in recent years with the stringent emissions standards going into force Europe, removal of tax subsidies in China on auto purchases and the chaotic implementation of new emission standards in China this past summer. With comps likely to be easier on a year-over-year basis at the end of this year and early next year, autos could surprise to the upside in performance.

We are not quite ready to go long here but should the sector gather further momentum $CARZ could be a high beta long to play risk on sentiment.

 

Energy

Given the low long-to-short ratio in futures markets, CTAs limit short oil any positive trade developments, supportive crude demand from refineries returning from maintenance, and prospects of deeper OPEC+ cuts could prompt a sharp rally in oil and energy names.

In the chart below we can see the horrendous performance of $XLE relative to $SPY. Energy has been a long-running pain trade. The risk-to-reward is tempting especially with the number of active oil rigs in the US below 700 for the first time since 2017.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

“There are decades where nothing happens; and there are weeks where decades happen.” ― Vladimir Lenin

 

“There is nothing so permanent as a temporary government program.” ― Milton Friedman

 

What an eventful few weeks!

 

• Prime Minister of the United Kingdom, Boris Johnson, suspended Parliament for five weeks in the run up to the Brexit decision in an attempt to hijack proceedings and has now been found by the Supreme Court to have acted “unlawfully”.

 

• An aerial attack took place on Saudi Aramco’s facilities at Abqaiq and temporarily took out more than 5 million barrels a day of crude oil production ― representing roughly the equivalent of 5 per cent of global oil supply. The price of oil spiked by almost 20 per cent on the news but has fall back to levels prior to the attack following assurances from the Saudi Arabian government to quickly ramp up production.

 

• The We Company, purveyors of the WeWork brand of office space, has seen its prospective IPO unceremoniously unravel, culminating with the board room coup by Masayoshi Son-led Softbank and the ousting of co-founder and CEO Adam Neumann.

 

• Overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap Treasuries for cash, suddenly rose to 10 per cent, up from their normal levels of 2-2.5 per cent. (Something we touched upon in January.)

 

• And most recently, Speaker of the House of Representatives, Nancy Pelosi, announced that the House will proceed with an “official” impeachment against President Trump.

 

All of this is unfortunate; none of it feels unusual anymore and maybe explains why the S&P 500 is barely 2 per cent from all-time highs.

 

On to this week’s update.

 

Modern Monetary Theory

 

The course of markets is unpredictable, crooked as the corrupt, companies rising and falling by whim and chance, bated by politicians, manipulated by greed, taken hold of by the unscrupulous, rattled by rogues, addled by analysts.

 

This has all been true since there have been markets. It still holds true today. The reality, however, has not discouraged attempts to chart the motions of prices and model the behaviour of markets as if these were matters of physics, like gravity and the coming and goings of the tides. New business models, novel algorithms, ‘structured’ products and twists on age-old policies have been unveiled at different points in history to mark the start of a new era, in which the course of markets might be made predictable, investment returns consistent and the behaviour of market participants that would be ruled not by fear and greed but by reason and rationality. The goals are always lofty, and their fate always the same.

 

The current incarnation of these less-than-illustrious elixirs being promoted is Modern Monetary Theory (or MMT in more common parlance). In this week’s piece, we take a much overdue look at MMT.

 

Before going on to the specifics of MMT, however, a few fundamental concepts are summarised so that the conclusions drawn are coherent.

 

Private vs Public Asset Creation

 

Private asset creation, including money is less susceptible, on a system-wide basis, to miscalculation and misallocation than government led asset creation, which is subject to the vagaries of politicians and public sector bureaucracy, which lead to miscalculation and gross misallocation.

 

If government created assets occupy an increasing share of system-wide assets at the expense of the more sound, private sector created assets, there is greater misallocation and confidence in the monetary system is gradually eroded.

 

The Role of Central Banks in Asset Creation

 

Central banks, particularly in developed economies, are responsible for less than 10 per cent of money and liquidity creation in the financial system.

 

Nine-tenths or greater of the money in the financial system today is actually deposits held within commercial banks and their equivalents. Deposits, are of course, created by commercial banks engaging in the acts of lending or investing. The prevailing global currency regime, that of US dollar denominated deposits, allows (authorised) commercial banks to create and destroy deposits, within the bounds of regulations, at their discretion.

 

When a loan is repaid deposits, that is money, are destroyed. Deposits are also destroyed when commercial banks sell securities held on their balance sheets.

 

For central banks to increase their share of asset creation, it is will require undertaking transactions directly with sectors other than the financial sector. This is where MMT would hand central banks greater control of the process of creating and destroying money. More on that anon.

 

What About QE?

 

Quantitative easing (QE) and other refinancing programmes initiated by the major central banks following the Global Financial Crisis created the illusion of liquidity.  Illusion because these programmes did not inject liquidity into the real economy, rather they forestalled a cascading debt default and asset impairment cycle in a bid to restore confidence in the financial system.

 

That is central banks, a few exceptions aside, continued to transact with the financial sector and not directly with sectors from the non-financial economy. Moreover, regulations, commercial and competitive considerations and structures created by central banks, such as the reverse repo facility, meant that QE did not result in money flowing to main street. And as such did not result in central banks having a bigger role in the creation and destruction of money.

 

Money Creation ≠ Inflation

 

“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.” ― A History of Interest Rates, Sidney Homer and Richard Sylla

 

If liquidity and money creation occurs in tandem with a growing productive capital base in the economy, money creation does not lead to inflation rather it contributes to rising living standards.

 

If money is created to sustain zombie companies or to avoid the mothballing of excess capacities, it drives down returns on invested capital. Declining returns eventually unleash deflationary forces as an increasing portion of debt in the system becomes unsustainable without ever increasing policy intervention. Simply put, deflation is the market’s signal for discouraging investment into additional capacities and an attempt to stoke consumption.

 

Inflation, the bad kind, occurs when continued policy intervention and money creation precipitates a loss of confidence in the central bank and eventually the currency. Credibility cannot be measured explicitly but we know the US has a lot more of it than, say, Argentina. It is this credibility that even allows a policy such as MMT to warrant a serious discussion in the US.

 

MMT: The Nuts & Bolts

 

Put simply, MMT is the recognition that government spending is not constrained by either taxation or its ability to borrow — at least not if the government has monetary seigniorage without the obligation to maintain a fixed exchange rate, whether against gold or another fiat currency. In these terms, the US federal government is not constrained, but the governments of European Monetary Union member states, say, or the Republic of Panama, are.

 

For governments meeting the above conditions,  proponents of MMT advocate that policymakers can, nay should, create and spend as much money as necessary to achieve full employment and a targeted rate of inflation. Be it through the manipulation of aggregate demand or funding public healthcare  or a universal basic income. If this entails running ever increasing fiscal deficits or devaluing the country’s currency, so be it.

 

Advocates of MMT only recognise resource constraints as limitations on a government’s ability to run larger and larger fiscal deficits. Take labour, for example. The government can pay public employees as much as it wants but it cannot employ more people than exist. The MMT framework also proposes that government spending should only focus on areas where it can utilise resources more efficiently than the private sector, otherwise there will be opportunity costs. Sticking with the case of labour, the MMT framework would encourage  government to limit public sector employment to the extent that it does not draw employees from the private sector into the public sector.

 

Focus Should be on the Path, Not the Endgame

 

Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.

 

And as far as the path is concerned, it is not unreasonable, in our opinion, that initially MMT reinforces deflationary not inflationary forces. That is, by opening up the monetary spigots policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts.  Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.