by David Robertson, CFA
December 2016
A timeless example of opposing possibilities was illustrated by the philosopher Soren Kierkegaard in his book, Either/Or. According to Wikipedia, Kierkegaard's work "outlines a theory of human development in which consciousness progresses from an essentially hedonistic, aesthetic mode to one characterized by ethical imperatives arising from the maturing of human conscience." The point of the exercise was to help answer the question, "How should we live?"
Stark alternatives now also present themselves to investors. Having enjoyed a period of declining interest rates for nearly 35 years now, it has been easy for investors to realize excellent returns from capital markets without much effort. That world, however, is quickly evolving into a very different one characterized more by binary outcomes than by stable equilibria. Not only is this new landscape likely to be far less profitable for investors in general, it carries with it the ongoing risk of extremely negative outcomes. In such a fundamentally different environment, "How should we invest?"
With few clouds currently darkening the financial skies, investors might be forgiven for doubting this thesis. The US economy is moving along reasonably well, unemployment is extremely low, and rates are low but starting to normalize. In addition, it is certainly possible to read some positive economic implications from the president-elect's early statements.
As we have apprised readers for some time now, however, underlying investment risks have steadily been rising. High levels of debt across the globe not only serve as a brake on economic growth but also significantly increase the risk of "accidents". Aging demographics and slowing population growth further compound these risks by constraining the opportunities to "grow" out of the debt. Increased financialization combined with increased interconnectedness not only broadens the reach of breakdowns but also amplify the consequences when they do occur. In short, the investment landscape is best characterized by what Nassim Taleb describes as "fragile".
While none of this is especially new, what is new is that some of those underlying risks are beginning to bubble to the surface. As they do, problems that had been considered abstract and remote are becoming tangible and real.
One of those risks is with underfunded pension plans. The Economist reports on one particular case [here]: "Bank runs, with depositors queuing round the block to get the cash, are a familiar occurrence in history. A run on a pension fund is virtually unprecedented. But that is what is happening in Dallas, where policemen and firefighters are pulling money out of their city's chronically underfunded plan, and Mike Rawlings, the mayor, is suing to stop them."
According to the story, "At the start of the year the fire and police pension fund had $2.8bn in assets. Since then nearly $600m has been withdrawn from the plan." Not surprisingly, losing 21% of the fund's assets in such a short time seriously affected its health. "Even at the start of 2016, the plan was just 45% funded, and was expected to become insolvent within 15 years." Accounting for recent withdrawals, the funded ratio is estimated to have fallen to 36%.
The Dallas case exposes important lessons about nonlinearity. One is that there is little noticeable change up to a certain threshold, but once that threshold is crossed, there are big changes. A natural consequence is that what had been perceived as underlying or abstract problems become very real ones almost instantaneously.
Specifically, in Dallas now, "There are only two possible solutions to the shortfall: put more money into the fund or cut the benefits." In response, "The pension scheme has asked that the city make a one-off payment of $1.1bn in 2018, which the city says would require it to more than double property taxes." The imminent risk of property tax increases, combined with higher borrowing costs due to the subsequent downgrade by both Fitch and Moody's of Dallas bonds, are now real impositions on every Dallas taxpayer. Dallas is the first big example of this, not the last.
Another simmering risk that is on the threshold of boiling over is Europe. After forestalling the Greek drama in 2010 and the nuisance of Cyprus in 2013, Europe is at a tipping point now that one of its largest members, Italy, is on the ropes. The story started off in a very similar way to the Dallas pension crisis. According to the Financial Times, [here], "This tendency [of wishful thinking] is especially evident in the discussion about Italy's future in the Eurozone."
On one hand, Italy's travails are highlighted by the magnitude of its Target2 (Eurozone) imbalances: "Germany's surplus is at €754bn while Italy's deficit is at €359bn." More importantly, however, the nature of the imbalances reveals the real problem: "But the bulk is due to what might be described as a silent bank run." In other words, just as Dallas police and firefighters have been scrambling to withdraw pension benefits while the fund still had money to pay them, so too are depositors moving money out of Italy's banks before those deposits can be used to recapitalize the banks.
Of course this puts pressure not just on Italy's banks, but on Italy's government - and by extension, the European Union itself. As the Financial Times reports, "One day Italy will be led by a party in favour of withdrawal from the euro. When that happens, euro exit would turn into a self-fulfilling prophecy. There would be a run on Italy’s banks and its government’s bonds." As a result, "[the next German chancellor’s] choice will not be between a political union or no political union, but between a political union or Italy's withdrawal from the euro. The latter would imply the biggest default in history. The German banking system would be in danger of collapsing." In short, Italy may well be the critical pressure point in determining the future of the European Union.
Perhaps the most important of simmering risks is that of emerging markets. Indeed one of the most vulnerable spots is with emerging market debt because of the vicious cycle a rising dollar presents. As the Economist describes [here], a strong dollar affects emerging markets in three important ways: "First, sharp falls in currencies put pressure on central banks to raise interest rates ... Second, a stronger dollar also has an indirect impact on credit conditions in emerging markets [by tightening credit] ... A third effect comes from the legacy of past dollar borrowing. As firms rush to pay off their dollar debts, which loom ever larger in home-currency terms, they are likely to cut back on investment and jobs."
Nowhere are these travails as important as in China. That there might be a problem should not be a surprise. As reported in the Financial Times [here], "The country [China] is home to the world's most leveraged corporate sector, a notoriously volatile property sector and a swath of banks that depend on borrowing on the money markets to fund loans." Debt and leverage are never healthy foundations and can be calamitous when credit tightens and liquidity dries up. Indeed, these conditions make "the Chinese economy particularly sensitive to expectations of increasing interest rates."
Given the tight controls on China's economy and monetary policy, however, the pressure has largely been hidden from view: "Some 15 to 21 per cent of loans in the Chinese banking systems are already non-performing, says Fitch, compared with official numbers of less than 2 per cent." While these forces have been held at bay for some time, cracks are beginning to show in the form of currency depreciation. The Financial Times reported [here], "But the tide has turned. The renminbi hit an eight year low versus the dollar late last month and is on track for its worst one year fall on record."
Historically, China has used a strategy known as a "dirty float" to manage its currency. Practically, this has meant that China has stepped in with its massive reserves to support the currency when periods of weakness strike. "The fear is that an uncontrolled depreciation of the renminbi would spark turmoil in the broader economy and, in an extreme scenario, even lead to political instability." The consequence of the "dirty float" approach has been that, "This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November."
The significant decline in reserves in just a two and half year period has raised concerns about sustainability. As Henny Sender notes in the Financial Times [here]: "However, as the level of foreign-exchange reserves shrinks and authorities in Beijing step up efforts to prevent people moving capital out of the country, more analysts are wondering if the Chinese government is in danger of losing control of its capital account."
This puts China in an unenviable position. On one hand, "For China, that [interest rate rise by the US Federal Reserve] adds to the capital outflow pressure stemming from concerns over its slowing economy and spiralling debt." On the other, "The risk for China is that it finds itself increasingly hostage to sentiment as the renminbi threatens to sink below the 7 mark against the dollar, while reserves look likely to fall below the critical $3tn mark next month."
Either way, "Beijing faces a stark choice. Either row back on freeing up capital flows - as it has already begun to do this year - or relinquish control of the exchange rate and accept a hefty devaluation." Indeed, the conundrum harkens back to dollar strength in the early 1970s when Nixon's Secretary of Treasury John Connally claimed, "The dollar is our currency, but it's your problem."
In sum, the examples of public pension funds in the US, Italy's banks, and China's debt represent fomenting problems that are subject to binary outcomes and that threaten to have global consequences. The evidence suggests that we are rapidly approaching a tipping point, one which Jeff Gundlach identified in a recent presentation [here]: “We’re getting to the point where further rises in Treasuries, certainly above 3 percent, would start to have a real impact on market liquidity in corporate bonds and junk bonds." Hugh Hendry was more dramatic with his description [here] earlier in the year of the consequences of a devaluation in China: "The world is over with a 20% devaluation [of the yuan]."
One of the most important implications is that investors who take their cues exclusively or primarily from the condition of the US economy, are likely to be woefully unprepared for what is to come. Another lesson for investors is that binary landscapes require fundamentally different approaches than incremental ones.
In a world of modest day to day changes, rational expectations can model behavior reasonably well. In such situations metaphors such as "smooth sailing" and "well-oiled machine" are apt in describing the fairly regular and reliable outcomes.
However, when outcomes become characterized as binary, fragile, and either/or, different mechanisms are at work. A common factor in all of the above examples is the role of human behavior. Runs, whether on pension funds, banks, or foreign currencies, the key determinant of outcomes is psychology. Can I get my money out before everyone else? Once that concern becomes pervasive, panic and forced behavior dominate market actions. Under such conditions, conventional models of rational expectations catastrophically fail to predict outcomes and become worse than useless as guides.
In order to contend with such drastically different conditions, investors need a fundamentally different mindset. For one, constant engagement is required to assess conditions and opportunity. As Ben Hunt describes [here], "In a game of ubiquitous self-absorption, even a little bit of other-awareness goes a really long way." One must also be constantly probing for information and insight while also remaining judicious in demanding adequate compensation for investment risks that are taken. Finally, Hunt gives a clue as to what doesn't work in this landscape: "Passive strategies give you ZERO information about the strategic gameplay of markets."
According to Kierkegaard, a person's ethical choices boil down to: "In simple terms, one can choose either to remain oblivious to all that goes on in the world, or to become involved." The choices for investors are somewhat similar: Investors can remain oblivious or become involved. While an "either/or" investment landscape is not nearly as easy to navigate or as profitable, it is not to say that there will not be opportunities. It is just more likely that they will be periodic rather than systemic, and available mainly to those with their eyes wide open and ready to pounce when they arise.
December 2016
A timeless example of opposing possibilities was illustrated by the philosopher Soren Kierkegaard in his book, Either/Or. According to Wikipedia, Kierkegaard's work "outlines a theory of human development in which consciousness progresses from an essentially hedonistic, aesthetic mode to one characterized by ethical imperatives arising from the maturing of human conscience." The point of the exercise was to help answer the question, "How should we live?"
Stark alternatives now also present themselves to investors. Having enjoyed a period of declining interest rates for nearly 35 years now, it has been easy for investors to realize excellent returns from capital markets without much effort. That world, however, is quickly evolving into a very different one characterized more by binary outcomes than by stable equilibria. Not only is this new landscape likely to be far less profitable for investors in general, it carries with it the ongoing risk of extremely negative outcomes. In such a fundamentally different environment, "How should we invest?"
With few clouds currently darkening the financial skies, investors might be forgiven for doubting this thesis. The US economy is moving along reasonably well, unemployment is extremely low, and rates are low but starting to normalize. In addition, it is certainly possible to read some positive economic implications from the president-elect's early statements.
As we have apprised readers for some time now, however, underlying investment risks have steadily been rising. High levels of debt across the globe not only serve as a brake on economic growth but also significantly increase the risk of "accidents". Aging demographics and slowing population growth further compound these risks by constraining the opportunities to "grow" out of the debt. Increased financialization combined with increased interconnectedness not only broadens the reach of breakdowns but also amplify the consequences when they do occur. In short, the investment landscape is best characterized by what Nassim Taleb describes as "fragile".
While none of this is especially new, what is new is that some of those underlying risks are beginning to bubble to the surface. As they do, problems that had been considered abstract and remote are becoming tangible and real.
One of those risks is with underfunded pension plans. The Economist reports on one particular case [here]: "Bank runs, with depositors queuing round the block to get the cash, are a familiar occurrence in history. A run on a pension fund is virtually unprecedented. But that is what is happening in Dallas, where policemen and firefighters are pulling money out of their city's chronically underfunded plan, and Mike Rawlings, the mayor, is suing to stop them."
According to the story, "At the start of the year the fire and police pension fund had $2.8bn in assets. Since then nearly $600m has been withdrawn from the plan." Not surprisingly, losing 21% of the fund's assets in such a short time seriously affected its health. "Even at the start of 2016, the plan was just 45% funded, and was expected to become insolvent within 15 years." Accounting for recent withdrawals, the funded ratio is estimated to have fallen to 36%.
The Dallas case exposes important lessons about nonlinearity. One is that there is little noticeable change up to a certain threshold, but once that threshold is crossed, there are big changes. A natural consequence is that what had been perceived as underlying or abstract problems become very real ones almost instantaneously.
Specifically, in Dallas now, "There are only two possible solutions to the shortfall: put more money into the fund or cut the benefits." In response, "The pension scheme has asked that the city make a one-off payment of $1.1bn in 2018, which the city says would require it to more than double property taxes." The imminent risk of property tax increases, combined with higher borrowing costs due to the subsequent downgrade by both Fitch and Moody's of Dallas bonds, are now real impositions on every Dallas taxpayer. Dallas is the first big example of this, not the last.
Another simmering risk that is on the threshold of boiling over is Europe. After forestalling the Greek drama in 2010 and the nuisance of Cyprus in 2013, Europe is at a tipping point now that one of its largest members, Italy, is on the ropes. The story started off in a very similar way to the Dallas pension crisis. According to the Financial Times, [here], "This tendency [of wishful thinking] is especially evident in the discussion about Italy's future in the Eurozone."
On one hand, Italy's travails are highlighted by the magnitude of its Target2 (Eurozone) imbalances: "Germany's surplus is at €754bn while Italy's deficit is at €359bn." More importantly, however, the nature of the imbalances reveals the real problem: "But the bulk is due to what might be described as a silent bank run." In other words, just as Dallas police and firefighters have been scrambling to withdraw pension benefits while the fund still had money to pay them, so too are depositors moving money out of Italy's banks before those deposits can be used to recapitalize the banks.
Of course this puts pressure not just on Italy's banks, but on Italy's government - and by extension, the European Union itself. As the Financial Times reports, "One day Italy will be led by a party in favour of withdrawal from the euro. When that happens, euro exit would turn into a self-fulfilling prophecy. There would be a run on Italy’s banks and its government’s bonds." As a result, "[the next German chancellor’s] choice will not be between a political union or no political union, but between a political union or Italy's withdrawal from the euro. The latter would imply the biggest default in history. The German banking system would be in danger of collapsing." In short, Italy may well be the critical pressure point in determining the future of the European Union.
Perhaps the most important of simmering risks is that of emerging markets. Indeed one of the most vulnerable spots is with emerging market debt because of the vicious cycle a rising dollar presents. As the Economist describes [here], a strong dollar affects emerging markets in three important ways: "First, sharp falls in currencies put pressure on central banks to raise interest rates ... Second, a stronger dollar also has an indirect impact on credit conditions in emerging markets [by tightening credit] ... A third effect comes from the legacy of past dollar borrowing. As firms rush to pay off their dollar debts, which loom ever larger in home-currency terms, they are likely to cut back on investment and jobs."
Nowhere are these travails as important as in China. That there might be a problem should not be a surprise. As reported in the Financial Times [here], "The country [China] is home to the world's most leveraged corporate sector, a notoriously volatile property sector and a swath of banks that depend on borrowing on the money markets to fund loans." Debt and leverage are never healthy foundations and can be calamitous when credit tightens and liquidity dries up. Indeed, these conditions make "the Chinese economy particularly sensitive to expectations of increasing interest rates."
Given the tight controls on China's economy and monetary policy, however, the pressure has largely been hidden from view: "Some 15 to 21 per cent of loans in the Chinese banking systems are already non-performing, says Fitch, compared with official numbers of less than 2 per cent." While these forces have been held at bay for some time, cracks are beginning to show in the form of currency depreciation. The Financial Times reported [here], "But the tide has turned. The renminbi hit an eight year low versus the dollar late last month and is on track for its worst one year fall on record."
Historically, China has used a strategy known as a "dirty float" to manage its currency. Practically, this has meant that China has stepped in with its massive reserves to support the currency when periods of weakness strike. "The fear is that an uncontrolled depreciation of the renminbi would spark turmoil in the broader economy and, in an extreme scenario, even lead to political instability." The consequence of the "dirty float" approach has been that, "This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November."
The significant decline in reserves in just a two and half year period has raised concerns about sustainability. As Henny Sender notes in the Financial Times [here]: "However, as the level of foreign-exchange reserves shrinks and authorities in Beijing step up efforts to prevent people moving capital out of the country, more analysts are wondering if the Chinese government is in danger of losing control of its capital account."
This puts China in an unenviable position. On one hand, "For China, that [interest rate rise by the US Federal Reserve] adds to the capital outflow pressure stemming from concerns over its slowing economy and spiralling debt." On the other, "The risk for China is that it finds itself increasingly hostage to sentiment as the renminbi threatens to sink below the 7 mark against the dollar, while reserves look likely to fall below the critical $3tn mark next month."
Either way, "Beijing faces a stark choice. Either row back on freeing up capital flows - as it has already begun to do this year - or relinquish control of the exchange rate and accept a hefty devaluation." Indeed, the conundrum harkens back to dollar strength in the early 1970s when Nixon's Secretary of Treasury John Connally claimed, "The dollar is our currency, but it's your problem."
In sum, the examples of public pension funds in the US, Italy's banks, and China's debt represent fomenting problems that are subject to binary outcomes and that threaten to have global consequences. The evidence suggests that we are rapidly approaching a tipping point, one which Jeff Gundlach identified in a recent presentation [here]: “We’re getting to the point where further rises in Treasuries, certainly above 3 percent, would start to have a real impact on market liquidity in corporate bonds and junk bonds." Hugh Hendry was more dramatic with his description [here] earlier in the year of the consequences of a devaluation in China: "The world is over with a 20% devaluation [of the yuan]."
One of the most important implications is that investors who take their cues exclusively or primarily from the condition of the US economy, are likely to be woefully unprepared for what is to come. Another lesson for investors is that binary landscapes require fundamentally different approaches than incremental ones.
In a world of modest day to day changes, rational expectations can model behavior reasonably well. In such situations metaphors such as "smooth sailing" and "well-oiled machine" are apt in describing the fairly regular and reliable outcomes.
However, when outcomes become characterized as binary, fragile, and either/or, different mechanisms are at work. A common factor in all of the above examples is the role of human behavior. Runs, whether on pension funds, banks, or foreign currencies, the key determinant of outcomes is psychology. Can I get my money out before everyone else? Once that concern becomes pervasive, panic and forced behavior dominate market actions. Under such conditions, conventional models of rational expectations catastrophically fail to predict outcomes and become worse than useless as guides.
In order to contend with such drastically different conditions, investors need a fundamentally different mindset. For one, constant engagement is required to assess conditions and opportunity. As Ben Hunt describes [here], "In a game of ubiquitous self-absorption, even a little bit of other-awareness goes a really long way." One must also be constantly probing for information and insight while also remaining judicious in demanding adequate compensation for investment risks that are taken. Finally, Hunt gives a clue as to what doesn't work in this landscape: "Passive strategies give you ZERO information about the strategic gameplay of markets."
According to Kierkegaard, a person's ethical choices boil down to: "In simple terms, one can choose either to remain oblivious to all that goes on in the world, or to become involved." The choices for investors are somewhat similar: Investors can remain oblivious or become involved. While an "either/or" investment landscape is not nearly as easy to navigate or as profitable, it is not to say that there will not be opportunities. It is just more likely that they will be periodic rather than systemic, and available mainly to those with their eyes wide open and ready to pounce when they arise.
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