It is normal to panic after a day like the one we had yesterday (and for the last two weeks). It can lead investors to do foolish things. But to remain calm and do nothing is just as foolish. The market senses that things might be wrong and turn for the worst. And even if the market is itself wrong, a debacle could trigger a recession which itself could trigger some ill-conceived government intervention that could really put all of us in real trouble.
While I am still hoping that there is enough fire power in the economy for the recovery to take hold and to avoid another disastrous government intervention, I am not completely certain that fear and gridlock as well as market uncertainty can’t bring back another recession. In fact, I think that it is a real possibility that cannot be ignored. The recession is not what scares me the most however; it’s what could happen after that does.
Read The Economic Manifesto of Elliott’s Paul Singer published in the New York Times on Wednesday and reproduced below. Evelyn Rusli and Azam Ahmed review the hedge fund manager’s latest investors letter. According to Paul Singer, a recession could turn bad into worse. Given the incompetence of our leaders, government measures to temper the downturn would probably do a lot more harm than good. Rahter than bring us out of troubles, it could sent the economy into a tail spin. The piece sent shivers down my spine.
I never feared the August 2nd debt limit deadline. Politicians have no balls. They were not going to let anything bad happen. With the number of Wall Street lobbyists in Washington, how could they not obey their masters? The smell of campaign contributions is too strong for them to resist. And voluntarily putting in jeopardy the financial system of the United States by making the U.S. government default on its obligations is something that is not on the wish list of bankers who are behind these contributions.
Politicians today do whatever lobbyists tell them to do while at the same time trying to avoid being stigmatised by unpopular legislations or politically difficult decisions. Both strategies together maximise the probability of being reelected even if these are conflicting, illogical and inefficient. This is why politicians have a hard timing making decisions that make any sense.
Yet, you have to ask yourself: Why get elected in the first place if you are not going to lead by making hard sensible decisions? I guess the ancillary advantages of being a politician are worth it. I don’t get it but this is the way it is. For now. Hopefully, things are going to change one day. But I am not counting on it happening too soon. If it happened, it probably would mean that we are in a deep crisis.
Yes, a real deep crisis may change things for the better. And the market is telling us that we may be closer to one such crisis than we would like to think. After the media turned a banal debt limit deadline into a circus and tried to make us believe that there was a chance that the U.S. could default, we now realise that this was just a side show to sell newspapers and fill air time. The real problems still lay ahead and the “compromise”, which we expected would deliver the goods, did not achieve anything. Absolutely nothing. No hard decisions were made. No imagination was used in coming up with durable and credible solutions. And nothing was gained but the obvious. Everyone now seems to agree on this. And this is why the market is tanking.
But the real threat here is, as we continue our likely descent into oblivion, that government intervention continues to be as inefficient as it has been; and that it eventually leads us into an inflationary environment that will destroy our wealth. That is why gold is reaching new highs these days. Gold is the worst investment vehicule but it performs well when other assets, especially cash and bonds, see their value eroded by inflation. Stocks and real estate are also a hedge against inflation but only in the long run. For those who own such assets, the interim period of the crisis might be very cruel if they run out of cash and are forced to sell at depressed values. The winners will then be investors able to snap such devalued assets at the right time and hold them until they recover.
Even for those who do not have much wealth, an inflationary spiral would likely mean vastly reduced pensions and social services as well as the prospect of unemployment; that is, if they are not already unemployed.
The way things would unfold if a crisis struck in the coming years is probably highly unpredictable but one has to be prepared for the worst. The crisis may be a few years away but when it will be at our door step, it will hit with lightning speed. You better get prepared for the tsunami because it will be too late to do anything when it strikes. Without knowing exactly what the worst scenario would look like, it is important above all to retain a source of liquidity. The ideas is not to be forced to sell depressed assets at the peak of the crisis; that is, if you are lucky to have some assets to begin with. Cash is such a source. A job is another one. But both can dry up pretty quickly in a crisis, especially during an inflationary period when government securities pay less than the rate of inflation.
It seems counter-intuitive that liquidity would disappear as the Fed is making sure that we are now all swimming in cash. This is because pumping cash can only work for a while. As long as inflation expectations are anchored, money can keep the system afloat without negative consequences. However, once these levees break, if you are not prepared and cannot escape, the inflation tsunami will destroy your assets and leave you completely naked, regardless of your initial wealth. Inflation is the great humbling equaliser.
Investing in long term fixed-income assets in such an environment becomes too risky. Real estate is not liquid and thus may be depressed if the need to access cash becomes extreme. Own it only if you can sustain the storm and you don’t expect to need cash. And if you decide to leverage these assets, make sure that you don’t over do it and that your mortgage has a long term horizon to ensure that you will not be caught refinancing on unfavorable terms when inflation strikes. Renting rather than owning for sure provides more flexibilty. This helps to explain why residential real estate is depressed and is likely to remain depressed for a while. If it is commercial real estate that you own, remember that during a crisis, your revenues from renting properties may decrease. Some real estate is thus better than other.
The value of stocks will still depend on the ability of companies to make money. However, the whole market might be under pressure. Moreover, in a crisis situation, many companies may be under financial duress. Finally, again, the need for investors to access liquidity during the crisis may force them to sell their assets which may expose you to sell yours at low valuations if you are in the same situation. Choose your stocks carefully and evaluate your staying power remebering that borrowing against your stock market protfolio here is usually not an option to liquify your assets in case you need cash.
What remains is gold. Other commodities, like silver, might work but others that are cumbersome and costly to store can’t be counted on as stores of value. Their prices are likely to tumble unless you have reasons to believe that they will be in short supply during the crisis.
But I still hate gold. Hence, instead of buying gold, I am parking cash in short term government securities and insured bank deposits which I think are safer and more conservative alternatives; even if it means that I could be slowly bleeding to death. What I am thinking is that the crisis may bring along a Volcker before it is too late. If this happened, there would be short term pain for sure. But it would also mean that cash would be king once again and gold would be squashed.
Here is the NYT piece which summarizes the Paul Singer letter :
“Stability is not the way of the world.”
That is how Paul Singer, founder of the $17 billion hedge fund Elliott Management, describes the current environment in his latest letter to investors, a 14,000-word screed that attacks government officials in the United States and Europe for their fiscal recklessness and portends an end to American hegemony should the ship not soon be righted.
In the colorful and often angry letter, Mr. Singer takes particular aim at the Federal Reserve (a “group of inbred academics,” in his view) for its use of artificially low interest rates and quantitative easing to stimulate the economy. The approach, he said, has distorted the price of just about everything.
“The distortions in public policy in the U.S. and Europe have introduced extraordinary undercurrents which are hidden from sight, but they are entirely capable of changing the landscape very quickly, and probably not for the better,” he said in the letter, which was obtained by DealBook.
Mr. Singer, whose fund gained 1.1 percent in the second quarter, released the letter several weeks before Capitol Hill reached a compromise on the contentious debt ceiling issue. That battle does not fully account for the country’s long term insolvency issues, he wrote, nor what he calls the “unpayable Big Three” — Social Security, Medicare and Medicaid.
“In both the U.S. and Europe, the budget and balance sheet numbers do not work,” the letter said. “When ‘off-balance sheet’ promises are taken into account, the U.S. and most countries of the Euro zone are insolvent.” And by extending reams of credit, the developed nations, he explained, are undermining their credibility, an erosion that — once complete — will exact untold consequences.
“As this is written, the prices of financial assets do not seem to take into account the risk of a history-altering reversal of confidence in paper money, the U.S. dollar, the American economy and its political leadership, or the Euro currency block.”
“Yet poor policy and incompetent leaders are creating massive systemic risks, and modern markets can concentrate and change their focus instantly — for all the right reasons, for no apparent reason, or for some combination of the two.”
Given the Fed’s “increasingly cavalier attitude” toward monetary policy, Mr. Singer said, it is up to the markets to “take away its freedom of action.” In that event, Elliott expects a “collapse” in the dollar’s exchange rate, a busted bond market and surging commodity prices — all accompanied by extreme volatility in the equity markets.
And as for how to extract the economy from the depths of whatever reckoning is to come, history does not inspire confidence in the eyes of Mr. Singer. Calling the government’s management of the financial crisis “horrendous,” Mr. Singer said the stimulus plan was a failure that led to a uniquely feeble recovery and an employment situation that “is simply putrid.”
“Instead of addressing the unsound financial system by deleveraging the banks, making them understandable and transparent, and modernizing the regulatory scheme, the bulk of the actions taken by the new government, starting in early 2009, consisted of an ideological wish-list and cronyism. Very little was oriented toward supporting the private sector, except for the surviving banks, which were nursed back to ‘health’ (that is, mostly as highly-leveraged trading shops) with lavish dollops of close-to-free money and blanket guarantees.”
So what would it take to fix the current dilemmas outlined by Mr. Singer, a hardcore conservative?
“Some are consumed with guilt and cry plaintively, ‘Tax me more, it feels so good!’ But many others will take their jobs, projects and ideas elsewhere, to places where they are not just thought of as sheep to be fleeced. The world, in terms of choices available to educated, ambitious workers and entrepreneurs, is way bigger than just the United States, Japan and Europe.”
Instead of raising taxes in a futile attempt to pay for burdensome entitlement programs, Mr. Singer said legislators should be focused on slashing obligations. He admitted that restructuring the health care system would require complex solutions, but Mr. Singer said there were also some easy fixes to trim costs, like lifting the retirement age or changing the way benefits are calculated.
And what to do about the Federal Reserve and its chairman, Ben S. Bernanke, whose confidence in the Fed’s ability to control inflation seems “more like careless talk radio rants than expressions containing the prudence and conservatism needed from the guardian of the value” of the dollar? Mr. Singer wants the Fed to ease off the gas pedal and change directions.
“The Fed should state that it has done more than enough, and that fiscal and regulatory policy needs to pick up the responsibility for growth and job creation.”
“We should demand that the Fed start commenting — in their beautiful prose — on the value of the dollar. They also need to start normalizing interest rates carefully, while developing intelligent policies to deal with the possible resultant decline in many asset prices (possibly balanced by optimism in the increased probability of sound money policies in the future). Until interest rates are normalized, capital will continue to be misallocated throughout the economy, real investment ‘risk’ will be almost impossible to determine and a firm foundation for solid growth in the American economy cannot be created.”
His most bitter medicine is perhaps reserved for Europe, which he chides for propping up Greece — “a hopelessly insolvent country.” Mr. Singer’s solution is simple: let Greece fail. He argues that Germany and France can only write so many checks before “elected officials are dragged out of the Reichstag by voters, or until German credit is on the verge of collapse.” Although the countries have become the informal lenders of last resort for the continent, Mr. Singer warns that they too are on shaky ground.
“The appropriate course is for Greece (and perhaps others) to have as controlled a default as possible and to exit from the Euro. The ’strong’ European countries will then have to ameliorate the severe economic shock which the defaulting countries will suffer, and they will also have to control and limit the damage to their own banking systems which presently hold a significant amount of the ‘bad’ debt.”
So what to make of all the volatility? Mr. Singer shies away from hanging up the Doomsday clock. With a healthy dose of uncertainty, he says he’s not sure if the “current market volatility is the start of something big or just a spooky episode.” However, if the next financial crisis is indeed brewing, Mr. Singer says, it will not enter as a lamb:
“You should expect surprising transmission mechanisms, the tearing apart of vulnerable market connections and assumptions, and a whole new set of insolvencies and problems. There is no way to predict the shape and timing of it, except our guess is that when the next real crisis (not just a head fake) starts, it will play fast, very fast.”
Yet for all the bearish musings in the letter, there is one thing Elliott is bullish on: itself.
The fund said it is still finding significant opportunity in “structured products, readily available at cheap prices from banks that are still under pressure; securities related to distressed real estate in the U.S., Europe and Japan; and discounted claims in the Madoff bankruptcy.”
In defense of its size, Mr. Singer says its returns have not suffered as it has grown. Based on an in-house statistical analysis, the fund achieved its best performance in 2007 and 2009, when it was at its biggest.
It is also getting bigger. The firm, the letter said, is “currently in the process of raising additional capital.”
About The Author – Luc Vallée
Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.
Shared Under Licence From
The Sceptical Market Observer: Why The Crisis May Escalate.
Images: Flickr (licence/attribution
) and her (licence/attribution