The Greenspan Put and the Elephant in the Room

The “Greenspan put” in perspective

All hell broke loose when Federal Reserve Chairman Alan Greenspan started hiking rates in early 1994, rather unexpectedly. By the end of the year, the Fed Funds target rate had risen from 3% to 6%. Bond markets around the world tanked. Credit spreads widened. Emerging markets securities swooned with Mexico at the epicentre of a financial year convulsed with fear. The markets were so bad that for the first time in the firm’s history, Goldman Sachs laid off bankers.

In spite of the earnings hit to banks, Mexico’s devaluation, his irrational exuberance speech of 1996, the 1997 Asian crisis, the multiple black swan events of 1998, the risks around the introduction of the euro in 1999, and a civilization-ending computer programming glitch codenamed “Y2K”, Chairman Greenspan did not bring rates back down to 3% until after the September 11 terrorist attacks. Rather than cut rates at the slightest sign of trouble, what happened for most of that period was that Greenspan refrained from further tightening. Those who are hopeful of a “fast and furious” Fed pivot should take note.

Tech stocks and cryptos are this season’s naked swimmers – but not the whole story

Unprofitable tech companies and cryptocurrencies seem to have replaced emerging markets and high yield as the most vulnerable asset classes in financial markets, but perhaps this is only the case in investors’ imagination. The $2 trillion lost in cryptocurrencies’ market value adds to the carnage of 2022, but it is not where the real pain lies. The bulk of the losses, amounting to tens of trillions, are in Government bonds, high-grade credit, and broad equity indices. There should be also widespread losses in private equity investments, but the highly complex process of marking to market illiquid investments is very far removed from common sense. This is the reason why some very sophisticated institutional investors pay such high fees to make S&P500 like returns, but with none of the volatility and in spite of higher leverage.

There is a second source of losses for cryptocurrency holders that is less well publicised. In the second quarter of 2022, Immunify reported $671 million in losses to fraud, a heady amount but a significant improvement over the $1.2 billion lost in the first quarter. Cryptocurrencies not only have failed as a safe haven in an inflationary world; as it turns out, for many people, they have proven to be not even safe from theft.

Arguably, social media is one of the biggest changes in our societies since the 1990s, especially when it comes to retail investors’ sources of information. Thirty years ago, most punters got their news from the financial press or newswires. Although, there were some financial news channels on cable TV, such as Financial News Network or CNBC, these shows had not fully adopted their current sports broadcast tone. In any case, most people were too busy making money then to watch TV during office hours.

Check a fact, save a civilization

Fact checkers were still important members of the professional media elite at the time. Even if gathering data was already inexpensive and easy, many people still did not use primary sources. As Jim Rogers observed, reading a company’s annual report makes you more knowledgeable on the firm than 98% of investors. If, in addition, you read the footnotes to the financial statements, you become more knowledgeable than nearly 100% of your peers.

Professional and amateur investors alike were beginning to adopt the Internet but it would not be widely used for a few more years. When one of us joined Bankers Trust in January 1997, work email was a most welcome novelty. There were some opinion forums online for sure, but none had the reach of Twitter or Facebook.

More recently, social media has taken to the airwaves with the rise of Podcasts. Pundits do not even need to write down their thoughts anymore. It is a pity because writing often leads to some introspection and even to checking facts and figures. Thanks to the Internet, and armed with a $50 recording kit, many of us are taking to the airwaves. Live punditry is so much fun yet it can also be harmful, for nothing travels faster than fake news.

Deservedly so, some financial Podcasts have gained huge followings. Few, if any, are as popular as the “All in” podcast. Unfortunately, as bright as the besties might be, as eloquent as their exposition is, as successful as their successful investments have been, their fact checking is lackadaisical when not altogether disingenuous.

Last weekend some members of the panel debated the sustainability of US Government debt. This is an important and heady subject, for the implications of a “no” answer are beyond the paygrade of most investors, the “All in” podcast hosts included.

The blind man, the elephant, and the outlook for U.S. debt

One of the participants, who usually does not come across as particularly interested in purely financial issues, suggested that at the current rate of deficit spending and in an environment of rising rates, the path of US Treasury debt will soon reach escape velocity. A second, and generally more financially inclined panellist, reasonably suggested looking at the ratio of US government debt to GDP, the weighted average maturity and the weighted average coupon to get a sense of how refinancing at higher rates might affect the US government’s ability to service debt. All these data points are good starting points, yet they are of little use without an analysis of the US Federal Government’s ability to generate a primary surplus, or failing that, long-term forecasts of nominal GDP growth and entitlement programs’ outlays.

It is important therefore not to confuse nominal and real GDP growth rates as they did. What matters for debt sustainability is the nominal growth rate of GDP, not the real rate of growth as they suggested. This is the case because, while inflation is an unfair tax especially on lower income people, it is also of great benefit to many debtors, especially for those who pay a fixed rate of interest, as the US Treasury does in large part.

While they observe that the US Federal Government has been unwilling or unable to collect more than 19% of GDP in taxes since WWII, the solution to fiscal deficits does not need to be higher tax revenues. Reducing the size of entitlement programs is the crux of the issue of fiscal sustainability everywhere. The social security tab will become more manageable if pensions are means-tested and de-indexed to inflation. Both Medicare and Medicaid may see large cost savings by using some or all of the best practices of Government healthcare plans in other countries. The Inflation Reduction Act offers a hint of times to come as it projects significant savings in those programs.

All euro zone debt is “foreign”

While many people seem to be fixated with the US fiscal woes, there are worse offenders among G20 countries. Argentina is the exception for they have made defaulting on government debt a national badge of honour. The United States has a lower ratio of credit to the non-financial system / GDP, at 275%, than many developed economies. In addition, the US dollar remains the world’s reserve currency. The US’s exuberant privilege may not last forever but it will last long enough to allow the US Treasury to refinance at a reasonable cost.

The Eurozone countries share a currency, but none of the countries individually controls the supply of euros. As such, all euro area debts are denominated in a “foreign currency.” With this in mind, France’s ratio at 353% of GDP is remarkable, especially because France has become a net debtor country, as its International Investment Position has turned negative and only second in size to that of the US. Japan, Germany, Hong Kong (somebody please tell Bill Ackman), and China are the largest international creditors.

Spain will spend as much as it can until the tide ebbs

Spain comes in third place among the countries to keep an eye on. Neither the overall debt to GDP at 284% nor the Government debt ratio at 123% are noteworthy in a world awash in debt. However, the debtor international investment position at 70% of GDP is of some concern, especially because most of Spain’s claims on the rest of the world are in countries with very weak economies and currencies historically.

Yesterday, the coalition government of Spain managed to pass the 2023 budget through parliament. The Government’s press release highlights their great achievement as spending in social programs reaches an all-time high. Government projections show spending growing 7% vs. 6% nominal GDP growth. This would lead to a deficit of 3.9% of GDP, which would show some improvement over 2022’s deficit of 5% of GDP. There is a small snag in the story line, which is that neither the Bank of Spain nor most independent economists are buying these growth projections. Yet, none of these considerations were a focus of the debate, which the government deflected by using a clumsy personal attack on one of its own cabinet members as an excuse to explode in indignant protest.

This budget may well mark the end of an era of fast growing spending, as history ebbs and flows, next year we may see a significant swing towards the conservative parties. They may come to power just in time to deal with a new era of austerity as the Covid induced relaxation of the EU’s budget rules ends.

In some countries, the media go through the budget with a fine toothcomb. Not here. The Government has derailed the normal discussion of line items by including a number of articles in the budget law with which they have bought the support of the enemies of the state in exchange for largely undebated and scandalous changes to the laws of the country.

Because of concessions on changes to the criminal code granted to the Catalan and Basque pro-independence parties as well as to the communists in the coalition, most of the debate centred on political rather than fiscal issues.

Extend and pretend, delay and pray.

This is so fitting to the national character for two reasons. The first reason is that, according to the rules of homegrown coping mechanism that pass for intelligence, problems that are obvious to anybody looking in are deemed not to be problems at all. (This can often leave foreigners wondering if their Spanish interlocutors are self-deluded or taking them for idiots. Either way, it does not reflect well on the locals.) The second reason is a strong belief in Deus ex machina solutions to existential problems such as the “whatever it takes” moment. Most people believe that the EU will save the day, because the EU would not tolerate certain outcomes. They should look to Hungary or Poland for clues.

Because problems in parliament are infrequently addressed directly, nobody there pointed to the elephant in the room: the social security system of public pensions is bust. Why spoil a debate on a possibly unconstitutional legal provision embedded in the budget with boring projections on future revenues and outlays. Admittedly, actuarial accounting is not a barrel of monkeys but the consequences of the current social security funding gap are the single most important issue for the country’s future socially, economically, and politically.

It is somewhat annoying that, in spite of everybody in the public and private sectors doing everything they can to hurt themselves financially for decades, to many observers the country seems to be doing just fine. At least at first look.

Demography defines destiny

However, were you to dig a little deeper, you would find out that Spain is falling behind the leading economies of the euro area. Former PM Zapatero suggested in 2007 that Spain was doing so well under his watch that its GDP per capita would soon grow larger than Italy’s, a G7 country. His hubris proved to the kiss of death on this issue as in any other economic or financial issue on which he expressed an opinion.

Income per capita started to decline after reaching a nadir in 2013. It recovered to a new nominal all-time high of $28,000 in 2019, which may not be reached again for some time, partly because of the policy response to the pandemic and partly because of a stronger USD. (For the record, Italy’s GDP per capita peaked in 2007 at $34,000 and slid to $31,500 in 2021).

Neither the euro nor membership in the EU are going to sort out the serious challenges of education, rapidly ageing population or the fiscal deficits facing Spain, just as they have not solved Spain’s centuries old backsliding in scientific research.

The rapidly ageing population is arguably a symptom not so much of the success of birth control or family planning, but rather of the demise of the Spanish middle class. The total fertility rate in much wealthier France is much higher, as it is in Scandinavia, the Benelux, and Ireland. Children have become luxury items that only more affluent families can afford.

If you think education is expensive…

The public education system is in shambles. The curriculum is an arena for political battles. Some private colleges turn out competent professionals in the law, business management and engineering. However, these private colleges are not research universities. Some basic research is conducted in the large state universities, yet there have been just two Spanish Nobel Prize winners in a science category, both in medicine. The most recent was sixty-three years ago, in 1959.

The Public Pension and Health systems are the pillars on which rests the success of Spain’s political system since the 1960s. Unfortunately, the pension system is not sustainable for the following reasons: the calculation method for the pension is too generous, most people receive multiple times the money they contributed to the system; the beneficiaries are living longer than expected as life expectancy grows over time; and finally the age dependency ratio is getting larger. It is currently at 47.6% against a global average of 40.1%.

It will probably befall on the next administration to fix this problem. A Conservative coalition will face mass protests and strikes if they were to try to pass changes to pensions while trying to balance the budget. The current members of the opposition should be careful what they wish for.

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Bull Markets Climb Walls of Worry, Bear Markets Slide Down a Slope of Hope

Animal Spirits in Retreat

With all eyes on inflation, the slightly better US CPI on Thursday propelled both equities and bonds upwards with all the force of a bear market rally, which is often undistinguishable from a short squeeze. Those looking for an inflection point parsed the runes and concluded that we are on the path to lower inflation in the US.

The Chief economist at one of the bulge bracket banks now expects the Personal Consumption Expenditures (PCE) index to drop to 2.9% by December 2023 from 5.1%. While they are slightly less sanguine than consensus at 2.7%, their argument is very similar to those of bullish investors: supply constraints will ease, shelter inflation will peak in the spring, and slower wage growth will reduce pressure on services inflation.

This set of forecasts include targets for a declining Fed Funds target range towards 3.25-3.5 by 2025 and 10-year Treasury note yield towards 3.65% (you have to tip your hat at this level of precision). It also includes forecast for both a stronger EUR and JPY, which of course would depend on the path of policy rates in those two currency areas as well. It is remarkable that in his view real rates will be even lower in the age of Quantitative Tightening (QT) than they were most of the time in the age of QE.

While all of these forecasts are sensible, if only perhaps somewhat circular and path dependent, there is an inherent conflict of interest as there are very powerful reasons to be bullish if you work for an investment bank. We do not recall too many of these large banks’ economists or strategists warning their customers about the spike in inflation, the upcoming rout in bond markets, or the froth in the valuation of the unprofitable companies they were taking public.

In addition, while new regulations on capital and risk taking that ensued from the Financial Crisis left banks in a less precarious balance sheet position when facing a new downturn, they have led to a weaker income statement position. It is not likely that banks may make as much P&L from dislocations as in previous cycles to compensate for lower fee income during a downturn. More than ever, banks are dependent on capital markets and advisory activity levels but they remain as short volatility going into a crisis as always. This short volatility exposure manifests itself in various ways including being stuck with underwriting commitments such as the Twitter loans, which are allegedly trading at 60 cents on the dollar.

The equally well-respected economist from another bank points out today that policy makers such as Fed Governor Wallace have been forced to come out to tamper pivot expectations if nothing else because market rallies tamper with the Fed’s tightening policy. Wallace remarked yesterday that markets got “way up in front”, the CPI “was just another data (sic.) print”, and that models such as the Taylor rule suggest that policy rates should be around 6-7%. Nonetheless, that economist’s team is also convinced that US rates are near a turning point, but they are less convinced this is the case in the euro zone.

Several large hedge funds have larger daily risk exposures today than most of the bulge- bracket investment banks. Many people worry that the current crisis will hit the ballooning non-bank financial intermediaries industry. This may well be the case, yet we are not sure that most banks, or even some of the largest non-bank financial intermediaries, are not hoping for such an outcome, as they will benefit from consolidation.

Only very large organizations are in a position to afford regulation that is more stringent. In fact, in our personal experience we have recently seen both sudden and large tightening of margin requirements in general and very bad faith in both the mark to market and liquidity facilitation for less liquid positions with one counterparty. We are surely not alone in remarking these developments. Few things bend the tightening will of the Fed as effectively and quickly as a large financial blow-up.

FTX hubris may lead to wearing ties at the office

The FTX story is a good example of what can go wrong with an unregulated non-bank financial intermediary as a bubble bursts. The company description on their website is very straightforward, “FTX is a cryptocurrency exchange built by traders, for traders. FTX offers innovative products including industry-first derivatives, options, volatility products and leveraged tokens. We strive to develop a platform robust enough for professional trading firms and intuitive enough for first-time users.”

Corporate Governance at FTX is perhaps the most interesting aspect of the story. Apparently, FTX, a company incorporated in Antigua and Barbuda and domiciled in the Bahamas, might not have a board of directors. Because of this lack of outside supervision and the apparent financial illiteracy of many of their customers, the company’s messianic founder had free rein to comingle the equivalent of billions of dollars of customer funds.

Indeed, financial knowledge seems to be cyclical. How institutional investors such as Sequoia or Tiger Global signed-off on a depositary arrangement similar to that of Madoff Securities or Lehman Brothers Prime Brokerage is beyond comprehension. The subsequent lending of customer funds to a related party may or may not be a case of fraudulent conveyance, but it would not have been possible had best in class client protection practices been in place.

Some people probably believe that FTX’s downfall could become an opportunity for Coinbase Global, Inc., a US domiciled and regulated larger platform. This might be the case if Coinbase survives this rocky patch of declining prices and trading volumes. It would appear that both Cryptocurrencies’ prices and trading volumes might also have been boosted by the same Government transfer payments and easy credit conditions that inflated many other assets’ prices.

Inconveniently, Coinbase’s revenues are falling off a cliff perhaps because of tighter financial conditions and the end of helicopter money. Revenues for the first nine months of 2022 are down 52% while operating expenses are up 52%. Not surprisingly, the company now has an operating loss, but stock based compensation was still up 48% in the third quarter. You cannot make this up!

In spite of this precarious situations, especially for a company that is regulated as a trust, Brian Armstrong, Coinbase’s Chairman, CEO, and co-founder agreed to an interview on the All in podcast this weekend. Uncharacteristically for a hip crypto guru, Mr Armstrong was wearing a suit and a tie. More characteristically for his industry, he never once made mention of his firm’s current losses. To listen to him you might think he was running the New York Stock Exchange. On the contrary, he did mention that in retrospect he had been concerned about how much liquidity FTX seemed to have on only $1 billion in revenues when they themselves at Coinbase did not have that kind of money available in spite of their $7.8billion in revenues and 4.6billion in EBITDA.

Of course, Mr Armstrong chose his words carefully and referred to 2021 numbers, which at the speed of developments in his industry is like talking about the Pleistocene in geological terms. His raptured interviewers did not even bring up the burning issue that these data points were irrelevant today for Coinbase customers. Nobody discussed the broader and more pertinent topic of what exactly is the nature of the value of the assets that these platforms are helping the public trade.

The Minsky moment we are going through is no different from others we have endured in the past. Misplaced incentives promote the same irresponsible behaviour. Similar charismatic and messianic leaders enthral willing believers to part with their hard-earned dollars or, more often than not, those of their investors. Legislators and regulators are well behind the curve as usual. Also as usual, there will be some sacrificial lambs who will be handed down exemplary sentences by the courts.

All those who ignored the writing on the wall, will cynically repeat once again the mantra of their brethren, “Who could have though this possible!” Finally, legislators and regulators will come up with new rules as onerous and yet as useless as previous regulations have proven to be for the protection of both the uninformed and the conflicted agents who time and again suffer losses in such schemes. Sic Transit Gloria Mundi!

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