Titan Inv Partners – The Minsky Moment is almost upon us

While credit crises have centuries of history, it is during the last 40 years in particular that we seem to have witnessed a sequence of continual boom and bust. No sooner is there the bursting of one credit bubble than a new one is inflated elsewhere…

For a great many years, monetary policy has relied on external stability through exchange rates being pegged to gold or some other similar system. The “supply” of money was essentially restricted and a function of demand kept a degree of international balance. It was in the early 1970s however that governments started looking at monetary policy as a tool to achieve domestic goals. A floating exchange rate system was subsequently adopted by developed countries which, when combined with progressive financial deregulation and the liberalisation of capital flows, led to massive hot money flows seeking out the best interest rates. Mexico, Japan, the United States, Europe and Southeast Asia have all experienced extreme volatility in levels of economic activity due to the variability of these money flows. Crisis after crisis has since ensued with ever more irregularity.

The cycle is by now a familiar one: optimism picks up, credit facilitation is expanded, risk is (again) not correctly assessed and so asset prices are once more pushed to unsustainable levels… that is until the day everybody realises that prices are no aligned with fundamentals. That point is also known as “the Minsky Moment” and we believe that is now upon us.

Stock market “forecaster” Mr Parker in his plush offices… I’m in the wrong job!

Talk this weekend of “S&P 3000” by one Mr Adam Parker of Morgan Stanley had me hit my forehead so hard with utter disdain at these so called soothsayers (I mean forecasters) that although I am in the deep South East of Spain, no doubt the slapping could be heard back in ol Blighty. That these guys get paid a single cent to expound their brand of “wisdom” defies belief. It was only very recently that the very same chap was one of the most bearish on the Street! “Make, you, cannot, up, sh*t, this” is a phrase that one can rearrange and, in my opinion, is very applicable here!

Years of trade surpluses in emerging countries like China have contributed to a massive expansion of credit in the US and Europe with the Chinese using every trick in the book (and some not even in there!) to maintain their currency at favourable competitive terms relative to their major export destinations including purchasing government securities from the developed world en masse.

With so much money entering these countries, not just financial assets but housing markets were lifted to levels way beyond true fundamental value. Christ, even the heavily indebted (still) European periphery has been able to issue new debt at premium prices without anyone smelling a rat. Yet. The hot money flow has been so large that banks in fact had to invent new ways of achieving leverage to get a growing share of the anticipated huge profits.

But the “smell of smoke” reversed the hot money flows in 2007 and the developed world entered a credit crunch, coined as the GFC (Great Financial Crisis) and which precipitated a massive recession. Southern Europe needed to be bailed out and countries like Portugal, Ireland and Greece had to adopt very harsh austerity policies. With debt-to-GDP surpassing 100% and almost all this debt being financed mostly through external sources, the big idea was to cut government expenses and increase revenues such that government debt could be made manageable again relative to GDP.

“Fooled ya again” Super Mario!

Fortunately for them, with so much emphasis on deleveraging, and with a little help from “Super” Mario Draghi, these embattled countries were able to reverse the rise in sovereign debt yields. In Portugal for example, from a peak near 15%, the 10y debt yield is now at an all time low of just 3.2%. That is quite an improvement..! Investing in European government debt is now, to some it seems, seen as a no risk proposition.

Unfortunately however, the above story is not justified by the economic data. GDP is growing at a very low rate in Europe yes and so low bond yields would be expected sure. In Portugal, her economy is barely growing but, on the other side, the government budget deficit is still at a 5% annual rate and growing. Despite all the efforts of various politicians, the debt-to-GDP ratio in Portugal is not falling, even though the yield on the sovereign itself is decreasing. The same applies to almost any other European country. Growth is sluggish everywhere and deleveraging has been a very lengthy process that has thus far failed to yield any significant debt:GDP results. Economic theory tells us the opposing drag of these should cancel any yield pull either way out.

Put simply, investors are pricing in the likelihood of an outright ECB QE intervention, entailing the purchasing of sovereign debt from any troubled country. Notwithstanding last week’s measures, that included banks now actually paying to hold money with the ECB through the negative deposit rates, and a reduction in 2 year yields on German and other European debt that means investors are also PAYING the Governments of these highly indebted countries to actually give them money – work that one out – I believe we are now at the point of “maximum optimism”. Not only that, but I doubt the ECB will actually press the button on real, vanilla QE.

This excess optimism has lead aberrations such as the current lows for 10Y debt yields. Just look at the 130% debt-to-GDP level in Portugal. Do you really believe 3.2% adequately compensates for the real risk here? And what about Germany, where the lucky investor can earn less than 1% per year in a 10Y investment? The case for Greece is no less aberrant too as its 174% debt-to-GDP confers a 5.74% interest rate on the lucky holder…

Current European sovereign yields are the result of heavy speculation and are far lower than the European fundamentals justify. Indeed, we would have to be looking at a long and deep 10 year depression to remotely justify these yields. Even the mere hint of inflation with the Euro falling towards 120 as the year progresses will likely reverse these yields.

Just wait for October which is now almost upon us and when the Fed will end the current QE programme, we rather suspect we will see those yields start to increase as hot money begins to be repatriated to the US. Personally, I think that the German Bund is a generational short opportunity here now. One to sell and re-visit in 3 years.

This piece should not be taken as an advocation to buy (or sell) these instruments and you should always take independent financial advice in relation to your own circumstances.