Not Bearish Enough

The morning after Lehman Brothers went bankrupt I spoke to Jim Grant, the brilliant economic historian and a well-known bear, who simply said: “We haven’t been bearish enough…”

In the years leading to 2008, our small group of likeminded contrarians spent countless hours discussing the timing of the upcoming crisis and its consequences. We parsed the data on the grossly mis-rated subprime bonds, the leverage hidden inside the CDOs, the overly tight credit spreads and the excessive leverage. But to be perfectly honest, not even the most bearish of us considered systemic risk as a real threat. We had been bearish on credit and equities but, given the ensuing systemic blow up, we hadn’t been bearish enough.

One of the lessons from the last crisis was that modern economics and finance heavily focus on the data and the models whereas identifying systemic risks is about the broader context and “preexisting conditions” - economic, structural, political, geopolitical, social, etc. The subprime debacle was considered “contained” because it was a relatively small market by size.  Structurally, though, its impact was amplified via derivatives and securitization, which made it large enough to topple the financial system whose vulnerability was not being captured by the conventional ratios. Collective failure to look beyond the data was the reason why so few recognized the crisis when it began in the summer of 2007 with a failure of two Bear Stearns structured credit funds. Neither did they recognize it when Bear Stearns itself failed, requiring a Fed bailout. By mid-2008 the risks were in the open and yet, almost no one was willing to consider the obvious implications.

The same is true today. Even those who profess being bearish are not worried, at least in public, about systemic risks. Over the past three months, a number of prominent investment managers have expressed grave concerns about the state of the markets and the economy and some have gone as far as to say that we were in a  “global debt bubble” and that the current period was similar to the late 1930s. And yet, no one has articulated the potentially catastrophic risks to capital their views imply. For if we are truly in a global debt bubble and the current period is really similar to the late 1930s, is it reasonable to have confidence that outcomes would be no more serious than a garden variety bear market and/or a run of the mill economic recession?

The elephant in the room that neither the sell side analysts nor the money managers are willing to confront head on is that since the 1982 peak in rates, Western demand has been heavily subsidized through the ever-expanding credit, while the asset values have been lifted by the ever-declining rates. This worked while the declining rates were offsetting the impact of the rising debts and keeping the debt service manageable. However, this system broke down in 2008 requiring massive bailouts, near-zero rate levels, US$ trillions in subsidies and QE to stabilize the system. Since then, global debts rose to the staggering US$247 trillion, 318% of GDP and 40% higher than in 2007, the TBTF banks grew bigger than ever and the rates, until recently pinned near or, in some cases, below zero, have decimated the savers leaving both public and private pension plans severely underfunded.

Since excessive leverage, the reason behind the 2008 crisis, has not been addressed, the Fed’s attempt to normalize rates is roiling both the equity and credit markets, i.e. the “patient” has been left on life support for ten years and the Fed’s attempt to have him walk on his own is not going well. This is a symptom of too much debt vs the cash flows available to service it at normalized rates. Because every US$1 of debt is someone’s asset, there is no painless fix. The only question is when, how and to whom will the losses be allocated.

Capital stewardship is first and foremost about avoiding catastrophic losses, which is why the key, as Pericles advised 2,700 years ago, is not to predict the future but to be prepared for it. Clearly, preparing for something requires an idea of what it could be. And so, instead of recounting the market action and making predictions, I would like to simply point out some issues and recent developments that I believe directly bear on systemic risks we are likely to confront in the coming year and beyond.

A couple of notes first:

• While material systemic risks can result in catastrophic losses, risks are not certainties. However, as with any insurable risk, if the probability of catastrophic losses is material, failure to address such risks in advance is imprudent, if not reckless. Investors and politicians got a pass for not being ready in 2008 but using the same “black swan” defense next time would ring hollow.

• Systemic risks tend to turn into systemic disruptions during acute market and economic crises. This is known as second- and third-order effects whereby a seemingly “contained” initial debacle sets off a chain reaction of consequences that few would have thought even remotely possible immediately before they occurred. E.g. The pre-2008 thinking was that a failure of a major investment bank would be Armageddon and not worth insuring. It turned out to have been no Armageddon and those few who had the foresight to worry about it, got paid very well for buying insurance well in advance.

With this in mind, here is a quick run through some of the systemic risks, in no particular order. These represent, in my opinion, the most obvious candidates for becoming the second and third-order effects of a steep market decline, a recession, or a credit bust.

Demographics

The upcoming pension crisis is a big topic but, in brief, there is no plausible path for avoiding it. Promises to the current and future retirees are not backed up by sufficient reserves and, therefore, can only be met on a pay-as-you go basis, which is not feasible, given the already stretched government finances.

For years, pension underfunding was a future problem but now the future is here - 75 million U.S. baby boomers started turning 65 in 2011 and by 2029, every baby boomer will be over 65 and eligible for the benefits. In the meantime, the Social Security system has turned cash flow negative, which means that instead of buying treasuries with excess cash, it will be steadily selling treasuries to fund the deficits. A conversion of a long-term structural buyer of the treasuries into a structural seller at a time when the government is running large deficits is a problem that would become a major problem in the next recession and/or financial crisis.

The same is true for the state, municipal and many private pensions that are underfunded as well. The only way to fix the pension system is to either increase taxes and mandatory contributions or to reduce the promised payouts. Both options are politically disruptive but tough choices will have to be confronted and soon.

This is one risk that will not dissipate; pensions and entitlements are set to become a serious financial mess with the equally serious political consequences.

Geopolitics

Over the past 25 years, globalization and offshoring have transferred swaths of the Western manufacturing base and intellectual property to the Communist China. The thinking had been that integrating China into the global economy would cause it to transition from a totalitarian Communist state into a Western-style democracy, while, at the same time, super-charging corporate profits via much lower labor costs. It sounded like a win-win at the time but that time is over. Corporate profits did boom but instead of joining the Western economic and geopolitical alliance, the Chinese Communist party has implemented “Made in China 2025,” a state-led industrial policy that set course to challenge the U.S., triggering a U.S. response that includes tariffs and is already having significant consequences.

If the start of the U.S.-Soviet Cold War (“CWI”) has been pinned to the 1946 Winston Churchill’s “Iron Curtain” speech, future historians will likely pin the start of the U.S.-China Cold War (“CWII”) to the Vice President Pence’s October 2018 remarks at the Hudson Institute. Mr. Pence’s message was as clear as Mr. Churchill’s:

“...I come before you today because the American people deserve to know… as we speak, Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States. China is also applying this power in more proactive ways than ever before, to exert influence and interfere in the domestic policy and politics of our country. <...> Today, America is reaching out our hand to China; we hope that Beijing will soon reach back – with deeds, not words, and with renewed respect for America. But we will not relent until our relationship with China is grounded in fairness, reciprocity, and respect for sovereignty.”

Translation: We will not rest until China stops challenging the U.S. and shows “renewed respect for America,” i.e. recognizes the U.S. dominant position in deeds, not words. I expect China to make whatever promises serve her immediate goals but as to the deeds... good luck with that.

In early December, reinforcing the hardening U.S. position, The General Accountability Office (GAO) released a report on the long range threats facing the United States that placed China at the top of the long term strategic threats facing the U.S.:

“China is marshalling its diplomatic, economic, and military resources to facilitate its rise as a regional and global power. This may challenge U.S. access to air, space, cyberspace, and maritime domains. China’s use of cyberspace and electronic warfare could impact various U.S. systems and operations.”

And then there is Russia, which is right below China on the GAO list of threats. Late in 2018 Russia has announced implementation of hypersonic weapons against which the U.S. and NATO have no current defenses. From the same GOA report:

“China and Russia are pursuing hypersonic weapons because their speed, altitude, and maneuverability may defeat most missile defense systems, and they may be used to improve long-range conventional and nuclear strike capabilities. There are no existing countermeasures.”

In the post-WWII world, investors have done well by ignoring the geopolitics but it certainly looks like the “times they are a changin.” Here is my take on the potential near to medium term substantive financial and economic implications:

Trade war with China is the current “tip of the spear” in the budding U.S.-China conflict and it is already being felt across many industries and companies. We may see tactical pull-backs but the strategic direction will not change unless China accepts the U.S. hegemony, which is not likely. Trade wars are bad for confidence and, by extension, for the markets and asset values.

The Western defense complex can no longer rely on the Chinese-made components, i.e. the high-tech intellectual property and supply chains are facing radical de-globalization. This process is in the early stages but will have major implications, both positive and negative, for many companies and markets. Multiple recent developments related to the Chinese telecommunications giant Huawei Technologies are a sign of things to come. Please click here for the details.

The advent of the hypersonic weapons poses material military and financial risks:

Since the 1940s, the U.S.-USSR nuclear parity maintained peace between the superpowers by ensuring a “mutually-assured destruction” in case of a nuclear war. A period of Russia (and soon China) having an edge in WMDs until the U.S. develops countermeasures is both destabilizing and extremely dangerous, especially in light of the current state of the US-Russia relations and the intensifying US-China trade war.

Less stability is an intangible but the financial implications are concrete - the U.S. must now catch up by developing its own hypersonic weapons at a cost that is likely to be high. Getting into an arms race, while running US$1+ trillion structural deficits is problematic, even without a recession or a financial crisis.

These long term military and geopolitical risks would not be of immediate relevance if we did not live in a world where a lot, if not most, of the consumer and high tech goods bear a sign “Made in China” and where China holds $1.14 trillion in US Treasuries - almost 8% of the publicly held U.S. debt. For these reasons alone, a cold war with China will be very different from the one with the Soviet Union. The USSR was never intertwined with the Western economies through numerous supply chains and financial obligations.

Any conflict with China, even if only a Cold War, will have direct financial and economic consequences across all supply chains and markets.

Weaponized Finance

The use by the U.S. of economic and financial sanctions against China, Russia, Iran, Venezuela and others has “weaponized” the USD and the global financial system over which the U.S. has been exercising de-facto control. This is causing China, Russia and others to seek alternatives to the USD (by accumulating physical gold) and poses real threats to the USD reserve currency status and to the U.S.’ ability to grow its debts without a loss of confidence.

Commingling finance with geopolitics has placed the global monetary and financial systems squarely into the epicenter of the geopolitical conflicts already underway. For example, in November, the Bank Of England, a storied and previously impartial custodian of gold reserves for many countries, has refused Venezuela’s request to repatriate US$500 million of its gold on the grounds that it was not sure how Venezuela would use this gold. Since neither the U.S. nor the UK are in a declared state of war with Venezuela, this de facto sequestration of sovereign assets speaks to the elevated sovereign risks for all financial assets and custodial arrangements within the financial system and its institutions.

Property rights did not use to be privileges conferred only on those whom the governments like but if this is what they are becoming, every investor ought to consider their sovereign risk exposure.

On November 1, 2018, confirming the strengthening financial-national security nexus, John Bolton, the U.S. National Security Advisor made the following statement:

“It is a fact that when your national debt gets to the level that ours is, that it constitutes an existential threat to the society and that kind of threat ultimately has a national security consequence for it.”

Bolton merely voiced the obvious - the U.S.’ ability to maintain hegemony relies on its ability to fund defense spending that relies on the continuous borrowing at low rates. This has only been possible due to the USD’s global reserve currency status. If the last financial crisis was handled as a financial emergency, investors should consider the implications of the next financial crisis being handled as a national security emergency. Those unfamiliar with IEEPA, the U.S. law that gives the President virtually unlimited powers to deal with the international financial national security threats, can look it up here. It is quite an eye opener.

Politics

This topic is well covered elsewhere and so I would just make a brief comment. Regardless of one’s political views, it is a fact that the Western world has not seen this level of political divisiveness and rancor since the 1930s and the same is true for the resurgence of populism and nationalism on both sides of the Atlantic.  We all know how the 1930s ended and, while we should all hope for a different outcome, it is hard to ignore political risks as insignificant. Populism and nationalism have always been bad for peace, business and, especially, for private capital and property rights. Since all politics are local, acute political risks translate into sovereign risks that are specific to each jurisdiction. The only way to manage sovereign risks is through jurisdictional asset diversification. This may not be feasible for most institutional investors but it is eminently feasible for private investors and is one area where individuals have an edge over the institutions.

Market Structure

While the current market structure embeds a number of new risks - reliance on the high frequency trading for liquidity, the rise of passive investing, prevalence of the ETFs, untold trillions in derivatives, etc., all of these risks ultimately boil down to one catastrophic systemic risk - failure of the counterparties, including the banks, exchanges and dealers, to meet their obligations.

Looking back to 2008, we may never know which counterparties could have met their obligations in full without the bailouts. We do know that Lehman Brothers couldn't and didn’t. And neither did Refco or MF Global, the only other US broker dealers that did not get bailed out.

In light of the blatant imbalances and risks, complacency about the counterparty risk can only be based on the assumption that the governments will always stand behind the financial system and its institutions. This, however, is not the current plan - both the US and the EU regulations prescribe bail ins, not bailouts, as the way to deal with the future crises. It is ironic that investors who have been willing to take the regulators at their word on most issues, doggedly refuse to believe the bail in policies, which have been developed to prevent future bailouts. These regulations are now on the books; no one can say they have not been warned.

Conclusion

Barring an extended period of above-trend global growth, which is hard to envision, a whole lot of financial claims must be written down before the global financial and economic systems can be put back on a solid footing. The 35-year-long debt super cycle that propelled rates to their 5,000-year lows and asset values to their 5,000-year highs is coming to an end. Someone will have to lose a lot of purchasing power while the books are getting balanced; there just isn’t any way around it.

It is not an accident that the word credit comes from the Latin word “credere,” which means trust or belief, i.e. confidence. Systemic risks and instability undermine confidence and, without confidence, the global house of credit cannot stand. Whether any of systemic risks come to bear in 2019 or later, ignoring them is imprudent as the risks are real and growing. Allocating a portion of one’s portfolio to assets that do not rely on the financial system and institutions has never made more sense. Such assets confer independence from the financial system and some, like physical gold, also provide the liquid buying power during times when others do not have it, which is when it is most valuable. There is no better way to insure one’s capital than being in a position to buy when everyone else is selling. As it is, the only time insurance is available is when few see the need for it. Since most investors remain “not bearish enough,” insurance remains available but, given the recent market action, this may not last.