The Three Ds That Spell Risk & Opportunity

By Capitalist Exploits

Yesterday we discussed the lurking dangers of a standard portfolio theory, when markets are mispricing assets.

Today, we’ll take an incisive look at the rapidly converging three “Ds” of risk, and the once in a lifetime opportunity they create:

Debts, Demographics, and Deflation.

Balloons:

Ever held a balloon underwater?

The further we push it down the greater the pressure.

As soon as you let it go we know what happens. The change in the size of the balloon is nonlinear and the balloon increases in size at an exponential rate.

The same thing happens when asset prices are artificially held either too low or too high. The asymmetry builds just as pressure inside the balloon builds.

The greater the mispricing of assets, the greater the asymmetry and the greater the risk to a standard portfolio theory approach. To say that assets are mispriced today would be like saying Godzilla is just a little monkey.

Global assets have never been more mispriced in history. This has to do with the fact they are priced off of benchmarks, the most notable being the US 10 year treasury. What’s important to understand is that the pricing of the US 10 year bond and in fact every sovereign bond cannot be the true market price.

Why?

Because the market has been pricing not only government bonds but every other global asset based on assumptions of what the central banks will be doing.

Like pushing a balloon the extreme depths so too global central banks have bludgeoned rates lower by buying ever-increasing amounts of bonds. And since assets are priced off the bonds they have been severely distorted. It’s not a situation where just one asset or sector is distorted but where the entire spectrum of assets are distorted.

When rates start to rise the consequences will involve a wide array of re-pricing of assets across the world in a nonlinear (asymmetric) fashion.

The graph below shows the extreme situation we find ourselves in. Sovereign bonds are now trading at the highest level in 5,000 years as interest rates have fallen to 5,000-year lows.

This would all make perfect sense if the three components we’re going to look at today were the exact opposite of what they actually are.

There are three main reasons so much risk exists today and they are the 3 D’s.

Debt, Demographics and Deflation

Let’s begin with debt. It’s easily the most significant of the three though they all tie together as you’ll see shortly.

Global debt, standing at an eye-watering 225% of global GDP, has never been higher…. ever!

Remember the housing crisis of 2008 that led to the global financial crisis?

Misallocations of capital manifested themselves in the American housing boom which when it burst brought the world’s financial markets to its knees.

But at the heart of this fiasco stood the Federal Reserve who in an attempt to contain the bursting of the dot.com bubble in 2000, slashed interest rates and held them down for a protracted period of time, thereby fueling the housing bubble.

When the housing bubble burst it was much greater than it’s predecessor the dot.com bubble. No matter. Central banks myopic to damage already caused once again stepped in and this time they’ve gone full retard.

How so?

Central banks assets have climbed to $21 trillion. In this crazy world of incomprehensible numbers it can be difficult to grasp the severity of numbers, so let me put $21 Trillion into context for you.

$21 trillion amounts to 29% of the world economy as of the end of 2015. Or put another way it amounts to one third of the market cap of every single listed stock in the world. So when you next look at your stock portfolio realise that by default you’re partnering with the central banks.

What’s more is that nearly 75% of this $21 trillion is controlled by just 4 policy makers. The Federal Reserve, the European Central Bank, the Bank of Japan and the People’s Bank of China. In fact the ECB’s balance sheet now equates to an incredible 33.4% of Eurozone GDP and the Fed’s balance sheet equates to 24.2% of US GDP.

The concentration of wealth and risk is quite simply on a scale never before experienced, much less imagined.

The idea behind this explosion in central bank intervention is to stimulate the economy in the vain hope that once stimulated it will, like a well-watered tomato plant begin to bear fruit.

Central bank stimulation comes by way of credit expansion and this has reached the end of its productive life, which is to say it simply isn’t bearing any fruit any longer.

Economists call this “pushing on a string”. The fact that each additional dollar of credit provides an ever diminishing, and eventual negative return in GDP growth. A fact that central bankers are now realizing.

And so we’ve now moved into the next and likely final stage of this insane financial experiment, the ramifications of which we all have to live with. Buying assets directly in the marketplace. A strategy the largest central banks are now employing.

Make no mistake: we are in a central banker bubble.

Debt in the system has reached saturation point which is why we’re seeing both productivity, as well as the velocity of money progressively falling.

This means the income which central bankers were so desperately hoping would result from all of the debt issued, has not only failed to materialize but is actually now one of the main causes of productivity falling. You see when you take quality collateral out of the system as the central banks have now done you decrease productivity and this brings me to the other side of this $21 trillion dollar coin. Those $21 trillion worth of assets have been bought with debt. Debt that cannot and will not be paid back.

Why?

Part of the answer is to be found in the next D.

Demographics

The writer and economist Arthur Kemp famously said that “demographics is destiny” and he was correct.

Debts can be repaid by way of default, income, or in the case of sovereign debt by taxes, or by way of inflation which is really simply another means of default.

The demographic shock which I’ve previously discussed at length ensures tax receipts will fall at the same time that obligations rise. This is already happening and in fact accelerating us towards a day of reckoning.

The promises made by the welfare state can’t and won’t be kept and the impact will be felt directly in social benefits, health care, and in particular pension obligations. All substantial problems.

The situation is as untenable as a lion and an impala cohabiting peacefully.

This deadly combination of debt and demographics provides us with an explanation as to why deflation has been such a powerful force.

Deflation

Thanks in no small part to central bank interventions, what we’ve enjoyed has been asset price inflation. Houses, stocks, bonds, and art have all gone up, while things like consumer goods have all gone down. It would look like a perfect world except that it’s not. Growth has been falling, incomes are stagnant, and wealth inequality has exploded.

Despite the credit expansion by central banks, each dollar of credit has ceased to have the multiplier effect that Central bankers are looking for. All of this has been causing deflation.

Except that now we have visible signs that we have reached the end of the credit cycle. There is quite simply no more juice to squeeze out of the credit orange.

Given that this tipping point has already been reached it’s no surprise therefore that we see bond yields creeping back up. This time around though inflation is unlikely to slowly creep back into the marketplace but arrive with a force not unlike a meteor strike. Risk happens incredibly fast when markets are as untenable and fragile as they are right now.

Now what?

It’s sobering to think about, but our job is quite simple. We seek to take advantage of the gross distortions in the marketplace because quite frankly they are distortions that are providing us the type of opportunities which come around only once in a generation.

Tomorrow we’ll cover a well-known example to see how such opportunities can play out.

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