So, after a month on my little island in the sun I return to the fray. I admit to having from time to time dipped in and out of the FT and to having religiously stuck to my daily reading of Reaction and weekly listen to Inside Baseball with Old Chestnut but apart from that I have let markets be markets. I’m not sure who did better without whom. Alas, I must now recommit myself and where to start?
I recall my physics teacher once asking the class whether we had ever noticed that a train driver backs up before he goes forward. Why, he asked, did he do that? We all sat there looking sheepish. Thus, he explained, by compressing the coupling on the wagons on the train, he could start up with one beginning to move after the other and thus reduce the amount of friction which he at any one time had to overcome. It’s one of those funny little truisms, one of those “Aha!” moments which has stayed with me, and I will try to learn from it. I shall briefly go backwards before I begin to go forwards.
One thing that has not changed in that time is the Fed’s position on its monetary policy trajectory. What has changed, however, is the markets’ formerly critically misguided belief that there were half a dozen rate cuts on the docket and that they were to begin in March. Any old bond dog with more than a few grey hairs could have told them that they were smoking dope but for a long time they refused to listen. It was like watching a traditional English Christmas pantomime. “Oh yes you will!” “Oh no we won’t”. “Oh yes you will!” Oh no we won’t!”
If there is one thing that has changed in the month, it’s that the Fed’s assurances about an early rate cut not being on the cards are starting to be most reluctantly taken seriously. Thus, with Fed Funds unchanged and US Treasury Bill rates back where they were when I left, the two-year note is trading 35 bps higher at 4.48 per cent, the 10-year note is 24 bps higher at 4.18 per cent and the 30-year bond is trading at 4.37 per cent or 20 bps higher on the month. That, by the way, also translates into a more inverted two-year/10-year yield curve, a phenomenon which somehow continues to defy received logic. I shall not go down that rabbit hole.
Over the same period, stock markets have been on fire. Or at least all other than the miserable old London FTSE which, while the S&P has put on 6.8 per cent and broken through the 5,000 pt barrier, has in the month lost 0.7 per cent which leaves it along with the Chinese indices amongst the few losers. As rate cut expectations are reined in, the dollar has picked up a bit of strength, rising from give or take ¥144 to ¥149, from £1.2650 to £1.2525 and with the broader dollar index rising from 102.25 to 104.00.
I am less surprised by the behaviour of bonds and currencies than I am by stocks but as a bond guy, superannuated or not, the behaviour of stock jockeys will always perplex me. I have with great interest followed the discussion as to how many rate cuts the Fed will undertake. I have in my mind’s eye looked through the memo and articles of association of the Federal Reserve System and have nowhere found a reference to how much or how little “a rate cut” is supposed to be. 0.25 per cent? 0.5 per cent? 1.0 per cent? The educated discussion ought to be about by how much the Fed will cut, not about how often.
Monetary policy, and not only that of the Fed, is made up by a lot more than just headline rates but people with little or no experience of the subject have taken to holding forth with the same authority as they do on who was going to win the African Cup of Nations. Other than a few patriotic and biased Ivorians, nobody would have put money on the host nation Côte d’Ivoire – Ivory Coast to you and me – to whom I would like to offer my heartiest congratulations. When at BNP, I used to cover the African Development Bank which in those days was based in Abidjan and I have many fond memories of my visits there. I wrote for the AFDB the programme which calculated the rolldown on their portfolio. Rolldown you ask? Yes, there is more to understanding bonds than propping up the bar and holding forth about central bank’s interest rates policy. I digress.
The other thing that struck me over the month of tanning my tummy and sticking to my principle of only reading hardbacked books was the developing debate with respect to private debt. My love (not) for private equity is no secret and I was struck by an article in the FT which tried to distinguish the current shape of PE from its roots in corporate raiding in the 1980s when KKR, Kohlberg Kravis Roberts, brought the world to a standstill by completing the US$ 24.88 bn leveraged buyout of RJR Nabisco, a transaction which was immortalised in Bryan Burrough’s book Barbarians at the Gate.
In the age of conglomerates, RJ Reynolds had merged with the National Biscuit Company in order to immunise earnings against the slings and arrows of a single product business. The effect was a pricing of the company’s stock to the lowest common denominator at which point the value of the components exceeded that of the whole. Theoretically at least. The vastly overpriced RJR Nabisco deal ultimately cost KKR around US$750 million, but the scene had been set for 50 years of private equity deconsolidation madness in which the principals have by the score become billionaires while shareholders and private equity fund investors have been left with at best marginally above average returns.
Now all the rage is private debt. To me, private debt is any debt that is not listed and publicly traded. That, to my mind, is nothing other than what bank debt is although, in the regulators’ post-GFC panic to make sure that nothing bad ever again happens “on my watch”, capital reserve rules have rendered large parts of the lending process unprofitable. What could be issued in public markets was, which explains the explosive mushrooming of the high yield (or junk bond) market while those who could no longer be sensibly banked by the sector and who did not make the cut to issue publicly have turned to the unregulated shadow banks. And private debt is nothing other than shadow banking in the same way that private equity is in the main still nothing other than good old KKR-style corporate raiding. And who in the main provides the leverage for the private equity and private debt players? Of course it’s the banks, stupid!
I refer back to Peters’ First Law which holds that credit risk is like energy; it can be converted but it can’t be destroyed. It doesn’t matter how you slice and dice credit risk, how you hedge it or in what vehicles you pack it, if the borrower defaults someone will lose their money and the further away the ultimate lender is from the original borrower, the more parties will have taken out their pound of flesh in passing it through. The bon mot “Where are all the customers’ yachts?” does not come from nowhere and having once again from a distance inspected some of the eye-wateringly huge and expensive hardware moored at Falmouth harbour in Antigua, I know exactly what they mean.
The answer lies not in regulating private debt and private equity markets but in deregulating the public ones. In his “must read” list, my friend Morris Sachs has Edwin Lefèvre’s 1923 masterpiece “Reminiscences of a Stock Operator” which related valuable lessons in risk management. It is there that all of us can learn the basic principles of weighing up risk and return along with the author’s warning of what happens when the level of risk is underestimated. The GFC demonstrated what happens to liquid markets in the case of a crisis. One of my early mentors used to bang on that in markets there is always a bid. You might not like it, but it will always be there. The catastrophic collapse of Neil Woodford’s empire was an abject lesson in what can happen to the realisable price as opposed to the perceived valuation of illiquid assets in a supposedly liquid investment vehicle when under stress. Unwittingly, regulators have regulated an epic quantum of risk away from themselves and are now worrying. Goethe’s Sorcerer’s Apprentice in the 21st century?
It must be at least four or five years since I first declared China to be uninvestable. It was when President Xi first showed signs of wanting to govern beyond the conventional 10 years and began moves to swing himself into what was looking to become a presidency for life. That was the point in time when it became clear that any developing issues, negative ones that is, within the growing economy would be suppressed for political purposes and that markets would become the administration’s plaything. The seeds for today’s crisis in both China’s economy and markets were laid then and for all who were willing to see. Beijing’s decision that court rulings in China and in Hong Kong should become mutually binding followed Hong Kong’s winding up order on the crumbling Evergrande.
Evergrande’s last hiding place had just been closed off. Sure, the company has US$ 300 bn of debt against US$ 240 bn of assets, so the shortfall is “only” US$ 60 bn against the nation’s annual GDP of around US$ 18 trn. But that is not the point. The property bubble is set to deflate and, with it, large swathes of private wealth will go up in smoke. China is already reporting deflation and the comparisons to Japan, which has been struggling for 35 years, are not without merit. Be reminded that Japan’s Nikkei index peaked in 1989 at just under 40,000 pts. From there it dropped and by 2009 was back down at 8,000 pts. It has rallied back but even today has yet to get above 37,000 pts. The Beijing administration is struggling to create a bottom to the ailing Chinese stock markets, but I recall Tokyo having tried to do the same.
Nasim Taleb popularised the concept of the black swan event, being one which ambushes markets when least expected. He has now added the white swan event which is one which also lays an ambush but is one which had all the time been there to see. China’s real estate crisis with all the implications is surely a case in point. And whereas the US markets are being driven higher by the Magnificent Seven along with their friends and relations, London’s FTSE 100 index is weighed down by a preponderance of international miners and commodity players who are being held back by the uncertain prospects for future growth in the Middle Kingdom.
“Apart from that, Mrs Lincoln, how did you like the play?” Although there is more than enough going on in all markets, be that stocks, bonds or commodities, the overall picture is little changed. All that has changed is how traders and investors alike are interpreting what they see.
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