Has the Bluff Been Called?

From October 2014; the second in a two part series investigation the QE fueled multi-asset bubble

A year ago, I posted Can the Bluff be Called?, which spoke about the beginning of a rising equity market. The focus was the markets on steroids, a steroid called easy money administered by a doctor called Mario Draghi and other central bankers around the world. In his Bumblebee address, he vowed to do “whatever it takes” to salvage the European economy and keep the Euro together. As I pointed out then, there were a select group of men and women at the top central banks in the world, who were willing to use nuclear power to avert an impending armageddon. A couple of years on from the Bumblebee address, we have seen record rises in equity markets around the world, as hot money chased the highest returns. Emerging markets (EM) were both embattled and supported in equal measure. That is the nature of hot money. However, two years on, economic activity has shown little signs of sustained improvements and Germany — the bellwether, the flagbearer of Europe, the EU and the Euro is one quarter away from a recession. Mr. Abe’s third of the three arrows in Japan hasn’t yet left his bow. But at least the EMs and the US seem to be doing better. But how has it come to this? With the central banks having pumped more money into the system than ever before, why hasn’t it translated into an improving economy? Why have more and more people stopped looking for a job? And why do the Western baby boomers now have to hope that the EM young savers bail them out?

The fight to save the Euro

Back in 2012, Mario Draghi tried saving the Euro the only way he could — by bringing down the spreads between the German Bunds and the bonds of the Southern profligates. He had to enable the profligates to continue to borrow. He had to make a big bang announcement and he knew that he had to keep the money managers around the world onside. He came out and announced, what amounted to, infinite liquidity and eventually, what amounted to, a bond buying spree. A risk on year, morphed into a risk off second half. However, there wasn’t a commensurate increase in business sentiment. France continued to struggle with structural reforms — they couldn’t sort out housing or taxation. Italy didn’t come up with structural reforms either. These countries threw away a lifeline that Draghi threw their way. Without labour reforms or manufacturing returning to these shores, there is no way France or Italy can work their way out of this. And yet, in fractured parliaments reforms are the hardest things to pass.

No one can call the end of a debt super-cycle with any degree of precision. Can the Bluff be Called spoke about the hedge fund manager Deepak Narula, who was 3 years too early with his bet on the sub-prime — the bet that came to be called as the big short. With the markets flushed with liquidity as the European Central Bank borrows more and more, it is near impossible to pinpoint when this bubble will burst, but changes in the perceptions of various market participants are a good lead indicator. You now hear a lot more money managers and senior economists starting to worry about the EU, as now it is France and Italy on the line, not Greece and Spain.

Germany could never commit the political suicide of throwing the profligates a lifeline, yet the EU is its’ largest trading partner. Such dichotomies are rife on this continent and we are no closer to solving it that before the Bumblebee.

Japan — Teetering

The Norwegian sovereign fund, the wealthiest in the world, makes every Norwegian a millionaire. Japan’s debt, on the other hand at the beginning of 2012, stood at JPY977trn — more than 200% of GDP and a per capita debt of USD80,000. A simple reason why the Japanese debt problem is so huge, much bigger than the European debt problem is that Japan’s is more than 20 years old. As a country starts putting bonds out to fund its expenditure, the interest can be covered by tax revenues while very little needs to be “topped up” by the investors in terms of further bond purchases, but as the buckets of interest and expenses keep rising, more and more investors need to plug the funding shortfall. Even all this works just fine under a low interest rate scenario. This is, after all, how the European economies survived — with Greek bonds trading within a few basis points (1 basis point = 0.01%) of German debt. However, the problem with large buckets of interest and expenses comes up when interest rates rise. Suddenly, there aren’t enough investors willing to risk money, and the existing ones look to sell. Then the yields start painting the true picture of the economy — they rise and soon they skyrocket.

What was peculiar about the European debt crisis was that everything look fine, till it didn’t. There weren’t too many warning signs and the opportunities to place asymmetrical bets existed long beyond it should have. Japan continues to present that opportunity, simply because one cannot call the end of a multi decade debt super-cycle. But as the population ages, Japan will draw on its savings not add to them. And with most of the existing debt being held by Japanese funds (which procure the money from Japanese corporations and households), the new debt has largely come to be owned by foreign funds. This foreign dependency makes it vulnerable to a spike in yields. Even corporations have lower savings now that Japan is turning into a net importer. The minute the foreign money managers start selling, Japan will have to start offering higher interest rates to attract new investors. Currently Japan’s revenues are only sufficient to cover a fifth of their debt. Japan spends 23% of their tax revenues on servicing their debt. You can paint the, spiralling, picture if yields were to spike by even 1% this year or the next. And what is Japan needs to offer interest rates close to 4% to attract investors? They won’t be able to — they’ll be bankrupt before that.

Complacent won’t work anymore

The Western working population is shrinking as countries age. Germany, Italy and Japan lead the way with the others in the developed world not too far behind. Why these economies thrived post the 1960’s was that the baby boomers focused on generating economic returns with the money they earned — they didn’t spend too much of it on making babies., like their parents did post the war. Their money found the most economic use — building for future growth. The money went into building factories and highways and dams and ships. And sure enough, decade after decade there was growth.

Many of these baby boomers retired early, and a lot of their wealth towards the end of their working life was invested in assets — assets like land and debt — because these provided the best returns. However, property prices crashed in the most spectacular way we have seen. Post the crash, a lot of these baby boomers are now left hoping that the EM savers (who are projected to number 330 million by 2025) will pump money into Western assets. This will help their assets retain some value. But what if, these EM savers choose to invest in Mumbai, in Lagos or in Manila? What happens to West End prices and what happens to prices on Park Street? They crash. And that will wipe out even the wealthy baby boomers who were standing after the Great Recession. The West needs to find ways to foster manufacturing — as their infrastructure is largely already built. They need to sell to the East and to the South.

This is the third arrow which no politician has shot yet — structural reform. So far, the markets have been easy to excite — but monetary and fiscal largesse imply that structural reforms are to follow. If not, the countries are walking towards the end of their economic might. The bluff is close to being called.

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The previous part in the series, Can the bluff be called? (October 2013)

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