The third financial bubble in 15 years is now underway. No one can really knows how far it may yet expand. The extremities of human emotions and possible policy responses really cannot be forecast in 2014. What we do know for certain is that overall investment risks have again risen, as seen in the rather cathartic start to the year. Here’s how we see the script playing out.
Scripting a bubble
The soothing story that’s warming the cockles of investors’ hearts at the moment presupposes stable global economic growth, central banks confidently driving up asset prices while remaining on standby to inject even more stimulus should growth falter, growing government debt and deficits, emerging market growth as the engine of global recovery, a resurgent Japan based on nothing more than smoke-and-mirrors quantitative easing, and the return of gold to its status of an anachronism.
This has been a great script so far – not because it holds much causal or theoretical credibility, but because it has been joyously believed. And somewhat dangerously, there’s now no one left to convert to this perspective.
Never before have financial markets been as complicit with the bidding of the central banks. Its players are in collusion with the narrative that the central banks want to create, each signaling to the other that they must play together to create a rising wealth effect – the biggest unhinged financial bubble for some time.
It’s a colossal experiment that at some point will end unfortunately, in one way or another. We identify current conditions as a renewed financial bubble that carries uncompensated risks. That’s why we have been maintaining a cautious stance in our portfolios. Timing and judging the possible extent of overexuberance is always problematic. Nevertheless, we think there will be rewards for the prudent and patient. It has always worked out that way before.
New story shifts the plot line
Just what is the new story? It holds some very significant shifts. In part, we think these will recognize both the unsustainability of the current beliefs that are held so confidently as well as patent theoretical falsehoods. Here is the new story that we perceive is developing:
The most serious misreading is of the true nature of the inflationary regime. Overindebtedness, secular shifts, and the impact of technology betray an underlying disinflationary (even deflationary) influence despite what central banks may wish to do. There is no way that profit growth can continue indefinitely in such an environment. The cash economy, in nominal terms, is being gradually squeezed.
U.S. drags on global growth
Crucially, emerging markets have for many years now been the world’s economic locomotive. Once, the world relied up the U.S. as its economic engine. But now, the U.S. is a drag on global GDP growth. After the global financial crisis, China and other less-advanced nations contributed two thirds of world GDP growth. That period is over (for now). This is a critical difference.
Economic growth still does not show any sign of acceleration. This has been the major hope for 2014. It is not happening. It is becoming ever more difficult to believe in the tooth fairy.
It is now more than five years after the crisis, and central banks are still seeking to stimulate economic growth. The record has been catastrophic. In the meantime, economies have become inured to near-zero interest rates and continual quantitative easing. That means that the next economic recession (and surely one will arrive eventually) will occur with policy interest rates still near zero. That will be a first. That such an outlook would be celebrated with inflated asset values (including the stock market) strains credulity to the breaking point.
Financial excess redux
Financial systems are again vulnerable to instability. And speculative financial positions are once again high and unsustainable, while financial excesses are evident virtually everywhere. What this means (usually) is that policy reversals or accidents are likely to meet ill-prepared markets.
The price of gold is the reciprocal of the collective faith placed in central banks. Yes, right now central bankers are received as the Masters of the Universe. But money has a metaphysical power born of collective humanity’s will to pursue and preserve wealth. All manipulated fiat money systems have failed throughout history. For now, at the very least, gold-related holdings are still merited for insurance purposes and also as an insulation to malingering deflationary forces. And, if 2014 finally does cast aspersions on the immortality and foresight of central bankers, gold will prove to be a resilient investment this year.
The denouement of the central banking confidence game may likely already be in sight. That we see in Japan. The Abe “confidence” boost is playing out. Massive quantitative easing has still not boosted GDP growth, and that is the case even without the slowing impacts of Abe’s “third arrow” of reforms.
In Europe this year the European Central Bank (ECB) will be stress testing 130 major banks as it prepares to assume the role of a common European regulator. We expect that this will show that the quality of assets on the banks’ books is much poorer than commonly believed. (The same is also true in the U.S.).
Here be monsters
All in all, we remain in a new, uncharted monetary environment. Just as economic and monetary policies have been unprecedented to this point, so will the next monetary tightening phase. In fact, it is already here. It will likely not take the form of rising interest rates (as everyone expects) but in reduced quantitative easing (that’s what the “taper” is all about), or simply, even lower monetary velocity and/or further waning impact of quantitative easing. The message? The next tightening phase is underway. Caution is in order.
Yes, we too want to believe that the old story will continue indefinitely. But, more than that, we want to make sure that our clients aren’t vulnerable to yet another reckless, feckless financial bubble… remarkably, the third one in 15 years.
We may risk missing the last “high risk” returns that are being extracted from libidinous investor enthusiasm (misplaced as we believe that it is). However, as our track record well proves, it’s how much one keeps during the inclement financial times that is a major determinant of long-term returns.
Our current investment policies have been adjusted accordingly. We remain broadly and globally diversified, holding some insurance as well as relying on higher yields.
Wilfred Hahn is Chairman and Co-CIO of HAHN Investment Stewards, engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article is excerpted from the February 2014 HAHN Global ETF Flash. You can reach Wilfred by phone at HAHN Investment Stewards, toll-free 1-888-419-6715, or by email at firstname.lastname@example.org.
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