Grubby greenbacks, dear credit, full shops and empty factories … Inflation reached an absurd 231,000,000% in the summer of 2008. Output measured in dollars had halved in barely a decade. A hundred-trillion-dollar note was made ready for circulation, but no sane tradesman would accept local banknotes. A ban on foreign-currency trading was lifted in January 2009. By then the American dollar had become Zimbabwe’s main currency, a position it still holds today. … Zimbabwe’s dollar had been too liberally printed: a swollen stock of local banknotes was chasing a diminished supply of goods. Now the American banknotes the economy relies on have to be begged, borrowed or earned. Even so, the monetary system works surprisingly well. A scarcity of greenbacks keeps inflation in the low single digits. The economy has made up much lost ground.
In 1948, the behaviorist B.F. Skinner reported an experiment in which pigeons were presented with food at fixed intervals, with no relationship to any given pigeon’s behavior. Despite that lack of relationship, most of the pigeons developed distinct superstitious rituals and maneuvers, apparently believing that these actions resulted in food. As Skinner reported, “Their appearance as the result of accidental correlations with the presentation of the stimulus is unmistakable.” ... Superstition is a by-product of the search for patterns between events – usually occurring in close proximity. This kind of search for patterns is essential for the continuation of a species, but it also lends itself to false beliefs. As Foster and Kokko (2009) put it, “The inability of individuals – human or otherwise – to assign causal probabilities to all sets of events that occur around them… will often force them to make many incorrect causal associations, in order to establish those that are essential for survival.” ... The ability to infer cause and effect, based on the frequency with which one event co-occurs with some other event, is called “adaptive” or “Bayesian” learning. Humans, pigeons, and many animals have this ability to learn relationships in their world. Still, one thing that separates humans from animals is the ability to evaluate whether there is really any actual mechanistic link between cause and effect. When we stop looking for those links, and believe that one thing causes another because “it just does” – we give up the benefits of human intelligence and exchange them for the reflexive impulses of lemmings, sheep, and pigeons.
My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about. ... central bank action has had the effect of de-linking equities from the global growth cycle, as equity investors have chosen to blatantly ignore the fall in global trade in favour of more risk-taking at the back of accommodating central banks. Risk-on, risk-off has miraculously turned into risk-on, risk-on. “Don’t fight the Fed”, as they say, and equity investors have obviously chosen not to. ... First and foremost, returns are going to remain subdued because GDP growth will stay low for a long time to come. Demographic factors, productivity factors and mountains of debt in the majority of countries all point in the same direction, and that is towards below average economic growth. ... The most structural of those factors – demographics – will remain a negative for the U.S. economy for another 10-15 years, whilst economic growth in the euro zone and Japan will be negatively affected by demographics until at least 2050. This does not imply that there cannot be extraordinarily good years every now and then, but the average growth rate will almost certainly be low, causing interest rates to stay relatively low for a lot longer than most expect and corporate earnings to disappoint as well.
Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over. ... Timing the end of an asset bull market is nearly always an impossible task, and that is one reason why most market observers don’t do it. The other reason is that most investors are optimists by historical experience or simply human nature, and it never serves their business interests to forecast a decline in the price of the product that they sell. Nevertheless, there comes a time when common sense must recognize that the king has no clothes, or at least that he is down to his Fruit of the Loom briefs, when it comes to future expectations for asset returns. Now is that time and hopefully the next 12 monthly “Ides” will provide some air cover for me in terms of an inflection point. ... Even with the recognition of the Minsky Moment in 2008 and his commonsensical reflection that “stability ultimately leads to instability,” investors have continued to assume that monetary (and at times fiscal) policy could contain the long-term business cycle and produce continuing prosperity for investors in a multitude of asset classes both domestically and externally in emerging markets. ... If real growth in most developed and highly levered economies cannot be normalized with monetary policy at the zero bound, then investors will ultimately seek alternative havens. Not immediately, but at the margin, credit and assets are exchanged for figurative and sometimes literal money in a mattress. As it does, the system delevers, as cash at the core or real assets at the exterior become the more desirable holding. The secular fertilization of credit creation and the wonders of the debt supercycle may cease to work as intended at the zero bound.
It has always baffled me how the financial industry in general, and financial newspapers in particular, appear to be hell-bent on forecasting this or that in early January. I actually find it outright laughable when someone projects the FTSE100 to be at 7,000 by Christmas time, or for the U.S. 10-year T-bond to hit 2.5% by midsummer. How on earth do they know? The generally poor predictive record proves they don’t, I suppose. On the other hand, that is perhaps what the majority of investors want. If you belong to that majority, there is no need to read any further. You will be wasting your time. ... If you see any forecasts from me (and you do), you will note that (i) they are very long term in nature, and (ii) they are based on structural trends, not tactical (cyclical) trends. Why is that? Partly because I think short-term forecasting is a sucker’s game, and partly because I know for certain that the structural trends that we have identified will happen. It is only a question of when, but more about that later. ... You can hardly open a newspaper these days without some commentator looking to buy fame by attempting to predict the next crisis but, as I just pointed out, the last one isn’t over yet. Therefore a far more relevant question is: What is likely to be the next leg of the GFC? ... I think three topics are particularly likely to steal the limelight in 2016:
- All sanctions against Russia to be lifted and trade relationships to be normalised.
- The EM crisis widens as commodity prices continue to fall.
- The credit market is spoiling the party again.
At current spreads, high yield seems to be no worse than fair value and probably better than that, even if we assume (as we do) that we are entering a fourth default cycle. In today’s environment, that makes it one of the best available risk assets for investors. But the nature of the high yield market suggests it is a good candidate for overshooting fair value to the downside whenever defaults begin to rise in earnest. Our response for BFAS at current levels is to continue to search for credit securities offering a superior combination of expected returns and downside protection while augmenting this at the margin with more index-like credit exposure. ... It would be lovely to claim we will be able to time the bottom for credit precisely. We will not, and unlike with equities, even if we did know the timing perfectly, getting material exposure to the asset class quickly would be extremely difficult. This leaves us with the hunch we are probably getting in a little early, the fear that we might not get all the exposure we would like before spreads move to less attractive levels, and the sure knowledge we won’t get the bragging rights of having called the turn. In other words, it seems to be an utterly classic value investing opportunity.
Given the importance of spillovers from monetary policies, especially in the face of globally low inflation, it is important we start building a global consensus on how to get better outcomes for the world. Nevertheless, with economic analysis of these issues at an early stage, it is unlikely we will get strong policy prescriptions soon, let alone international agreement on them, especially given that a number of country authorities like central banks have explicit domestic mandates. ... This paper therefore suggests a period of focused discussion, first outside international meetings, then within international meetings. Such a discussion need not take place in an environment of finger pointing and defensiveness, but as an attempt to understand what can be reasonable, and not overly intrusive, rules of conduct. ... As consensus builds on the rules of conduct, we can contemplate the next step of whether to codify them through international agreement, see how the Articles of multilateral watchdogs like the IMF will have to be altered, and how country authorities will interpret or alter domestic mandates to incorporate international responsibilities. ... The international community has a choice. We can pretend all is well with the global financial non-system and hope that nothing goes spectacularly wrong. Or we can start building a system for the integrated world of the twenty first century.
Financial crises pose challenges for macroeconomists. Schularick and Taylor (2012) show that credit booms precede crises. Mendoza and Terrones (2008) claim that not all credit booms end in crises. Herrera et al. (2014) argue that crises are not necessarily the result of large negative shocks, but also of political considerations. There is a need for models displaying financial crises that are preceded by credit booms and that are not necessarily the result of large negative shocks. ... In a recent paper (Gorton and Ordonez 2016), we show that credit booms are indeed not rare, that some end in crises (bad booms) but others do not (good booms). Are these two types of booms intrinsically different in their evolution, or do they just differ in how they end? We show that all credit booms start with a positive shock to productivity on average ten years before the end of the boom, but that in bad booms this increase dies off rather quickly while this is not the case for good booms. This suggests that a crisis is the result of an exhausted credit boom. We then develop a simple framework that rationalises these empirical findings and highlight several shortcomings of standard macroeconomic models that tend to neglect the interplay between macroeconomic and financial variables.
Since launching in 2006, it has raised billions of dollars and installed hundreds of thousands of home solar systems, more than anyone in America. But lately SolarCity is in deep trouble. Customers aren't signing up in the numbers they did two years ago, back when oil was trading at more than $100 a barrel. U.S. lawmakers are investigating the company's financial practices. Earlier this year, in the span of two months, the company's stock lost 70 percent of its value. ... The company, in fact, could be one of the most risk-laden in operation today. To install solar systems across 27 states and Mexico, SolarCity takes on gobs and gobs of debt — billions of dollars a year. The eventual goal is to create a massive network of home solar systems. The problem is, if customers stop paying their SolarCity energy bills or investors stop lending, the company will blow up like the subprime housing bubble. ... As they built solar systems on one rooftop after another, they also burned through more and more cash. To attract more lenders, the company packaged and resold the debt to banks as complex bonds and other financial products that handed the financiers shares of SolarCity's tax credits.
It’s gunning for the $93 billion U.S. market for credit card issuing, an industry that’s dominated by giants such as American Express and Capital One, with PayPal and ambitious startups in close pursuit. Like PayPal, Klarna is an online-payments platform with an emphasis on “buy-now-pay-later” financing. … His dream is that enough merchants embrace Klarna as a free-floating credit issuer so that millions of shoppers will no longer see credit cards as a first choice for financed payments. ... Siemiatkowski has spent the past 11 years quietly turning Klarna into his home country’s biggest digital-payments platform. Klarna processes 40% of all Swedish online payments. Klarna’s big selling point is ease and simplicity. It lets you skip paying for an item up front–no more squinting at a credit card, typing in numbers and remembering a password. You simply enter your e-mail and delivery addresses. That information, plus your activity on an e-commerce site time of day, the product you’re buying and any Web cookies that can be picked up from your visit? is enough for Klarna to decide whether you’re a creditworthy human. Siemiatkowski calls this a “one click” experience. ... Remarkably, Klarna’s bold bet on people’s honesty and solvency has worked. Its default rates are under 1%. Credit card default rates in the U.S. have averaged 2.2% for 2016. ... Siemiatkowski would rather trust his customers than see them walk away at a checkout: 69% of online shoppers in the U.S. abandon their shopping carts, often because they’re asked to create an account or the process takes too long. That’s around $260 billion in lost orders.