Category: Currencies

“Welcome to our Country Club!”

Posted on by David Merkel

Image Credit: born1945 || When I was a boy, I spent many days caddying at the local country club.

(This is one of my occasional experiments. Bear with me if you will…)

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Wagner: I don’t get the thrill.

Hawker: What’s not to like?

W: This is nothing like the investment memorandum said it would be.

H: It’s a work in progress. Don’t look at what it is now, think of what it will be like when everyone clamors to join us.

W: This is just a field.

H: So?

W: When I bought a small share in the ownership of this club, the memorandum had pictures of the golf course, lodge, tennis courts, bar, swimming pool, pro shop, and more. All that is here is this field.

H: You needed to read the memorandum more closely. One day we will have all that and more. As for now, we promote the potential of this place to the masses who will want to join us at a much higher price than we got in at.

W: So when will it be built?

H: That is a matter of secondary importance.

W: Huh? What’s of primary importance?

H: Encouraging others to buy shares in this, and never selling our interests.

W: Wait. You did not buy this so you could golf?

H: No merely to own, and never to sell.

W: So this is a speculation on this land?

H: Don’t say speculation! Bad word! This is an investment in the concept of getting something valuable in the future. Besides, the country club doesn’t technically own this field yet… there is a memorandum of understanding to acquire it once the price of ownership interests get high enough… at that point we will swap newly issued shares for the land. We transact everything in shares; it is our currency.

W: It doesn’t own this field? What does it own?

H: The future. Everyone is going to want to buy a share in this wondrous venture, and at progressively higher prices. Congratulate yourself, you got in on the ground floor.

W: There is no floor here! Where has the money gone that I have paid?

H: An earlier investor sold you some of his interests. Don’t worry, he still owns over 25% of the shares. Purely a portfolio management decision for him. The Founder strongly believes in the vision for this concept.

W: The concept of building a country club?

H: The concept of selling interests in the club at ever higher prices to the masses who will want an appreciating asset. And we have the track record. Prices of ownership interests have continually gone up. On a mark-to-market basis, the returns exceed 20%/year. How is that for a successful investment?!

W: I can understand the concept of buying rare and beautiful art to hang on the wall of my house as an investment. It might appreciate over time or not. I enjoy looking at it, and my friends as well, while I pay insurance premiums to protect it for my heirs. Is the only value of this investment possible monetary gain? At least will there be dividends paid?

H: You are missing the point. With this, your heirs will have something far more valuable than a stream of dividends. They will own a share in something that everyone wants to buy. Everyone wants to own an investment that only goes up.

W: So the only driver of value here is others envying what we have, and wanting to buy it from us at prices higher than what we paid?

H: Envy is an ugly word, but yes, and that is why we continually promote how wonderful this investment will be.

W: I am disappointed. I really wanted to golf. Hmm… what if I sold my interests and used the money to go golfing, whether I buy another country club membership, or just hit the links at the local public course?

H: And I am astounded. Why would you give up the glorious future of this enterprise?

W: I want to golf. Say, if you are so convinced, would you buy my interests from me at 5% more than I paid for them?

H: Well, I would be a “better buyer” at that price, but I don’t have enough cash to do that.

W: Would the Founder be interested?

H: The Founder continues to acquire ownership interests as a result of his labors as management. That is how he gets paid. As far as I have heard, he graciously sells them to those who want a piece of the action.

W: Uh-huh. At this point I would rather golf. I will sell my interests to the best bidder.

H: I thought better of you than that. Giving up on an astounding future just to play a game?

W: No, giving up on a game to enjoy life.

Notes and Comments

Notes and Comments

Posted on by David Merkel

1) I still can’t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

2) I’ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.

Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.

I’m sensitive to when models keep having errors in the same direction… 2-3 weeks ago, errors were close to even — as many up as down. But since then more new cases have persistently come in than the first model would have predicted.

Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.

As such, don’t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that — social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:

  • Unemployment
  • Division of labor
  • Pensions, both public and private
  • health care for those that don’t have COVID-19
  • Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn’t close many things at all — their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don’t have to go to restaurants! We don’t need low-end malls! And more… we just don’t know what all will change. That said, never underestimate the ability of Americans to forget.

5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.

Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren’t doing much. The market took their bluff and ran with it. How is this?

  • All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
  • They are mostly financing assets, not buying them.
  • When they are buying assets, they aren’t taking much risk, either in duration or credit.
  • The QE that they are doing is just a closed loop with the banks — it doesn’t get into the general economy.

The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.

Personally, I like the fact that the Fed is taking little risk. That’s the way a central bank should be. But that’s not the way the markets are interpreting the matter — they think the Fed will always rescue them.

7) But at least at present, I don’t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won’t subsidize exporters anymore, and will stop investing in US Dollar claims?

Of the major governments, the US is the “cleanest dirty shirt,” but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time… pity that the competition is so poor.

8 ) When will we learn that savings doesn’t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don’t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.

That’s all for now.

Why I Like Foreign Small Cap ETFs

Why I Like Foreign Small Cap ETFs

Posted on by David Merkel

Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap

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This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?

  • They diversify a US-centric portfolio better.? There are several reasons for that:
  • a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
  • b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
  • They are often cheaper than the large caps.
  • Institutional interest in the small caps is smaller.
  • They have more room to grow.
  • Less government meddling risk.? Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)

Surprise! Return to RT Boom/Bust

Surprise! Return to RT Boom/Bust

Posted on by David Merkel

After almost three years, I returned to RT Boom/Bust on Tuesday.? There are many changes at RT.? Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.? They are bursting at the seams, and their funding has doubled, so I was told.

I get surprised by who watches RT and sees me.? My? congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”? And then there is my friend from Central Africa who says, “The CIA has you on their list.? Watch out!”? He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.? Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.? Here were my notes for the show, with a little more to fill in:

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  1. Mr. Merkel, what exactly is a sovereign money system?

The banks can?t lend against deposits.? Deposits are segregated, and wait for the depositor to use them.? The deposits no longer can be used by the bank but only the depositor.? There would be no need for deposit insurance, because deposits are off of the bank?s balance sheet.

  1. What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can?t make money off of lending against the deposits. Banks would no longer do ?maturity transformation? by lending long against short-term deposits.? Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

  1. Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.? First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.? Not one canton voted for it.? Only 22% of the electorate voted for it.? Second, things aren?t that bad now, and the financial system isn?t that levered.? ?If it ain?t broke, don?t fix it.?? Third, this is a total experiment with no real world precedents.? Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.? This is another example of that.? We don?t know what the unintended consequences might be.

Some unintended consequences might be:

  • Transition would be difficult
  • Recession during the transition, because middle and small market lending would likely suffer
  • Pay for transactional accounts ? no interest even if inflation is high.
  • Increase in savings accounts, which might be short-dated enough to be transactional
  • Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
  • Could be subverted if Government becomes dependent on free money, leading to inflation
  • Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?
  1. Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.? Most credit bubbles result from short-term lending funding long-term assets.? This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?? If some new class of lender became dominant, the threat could reappear.

We aren?t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.? Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren?t any categories of private debt big enough and misfinanced enough to create a crisis.? That said, watch margin loans, student loans, and auto loans in the US.

  1. Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.? There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.? These ideas get a lot of press after crises, but fade away afterward.? Most of them would work, but all of them lower bank profits.? Concentrated interests tend to win against general interests, except in crises.

  1. You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.? I believe they should be regulated like insurance contracts, and require that those seeking insurance have an ?insurable interest? that they are trying to hedge.? Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can?t absorb the losses.

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I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.

Where Money Goes to Die

Where Money Goes to Die

Posted on by David Merkel

Photo Credit: eFile989

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It is often a wise thing to look around and see where people are doing that is nuts. ?Often it is obvious in advance. ?In the past, the two most obvious were the dot-com bubble and the housing bubble. ?Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

I have often said that that lure of free money brings out the worst economic behavior in people. ?That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

I’ve written about Bitcoin before. ?It has three main weaknesses:

  • No intrinsic value –?can?t be used of themselves to produce something else.
  • Cannot be used to settle all debts, public and private
  • Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them. ?That’s fine, sort of. ?But how many people, and are there alternative uses that transcend exchange? ?Even in exchange, how legally broad is the economic net for required exchangability? ?Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies. ?At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility. ?(We actually had a moderately rare one, but didn’t know it and our kids happily played with it. ?Isn’t that wonderful? ?How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies. ?The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about. ?Remember that absurd is like infinity. ?If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal. ?(Give China a little credit for starting to limit them.) ?It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators. ?Remember, Madoff never raked off that much… but it was a negative-sum game. ?Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero. ?Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage. ?Many people don’t get volatility, both applied and actual. ?It spikes during panics, and reverts to a low level when things are calm. ?It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways. ?There are two ways to get killed playing credit. ?One is to speculate that defaults are going to happen and overdo going short credit during the bull phase. ?The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts. ?Then there are those that are short volatility because it pays off when volatility is low. ?When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit. ?Doesn’t matter much if you are a professional or amateur. ?That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

 

Brexit Boogeyman Bellows “Boo!”

Brexit Boogeyman Bellows “Boo!”

Posted on by David Merkel

Picture Credit: Peanuts Reloaded || Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles
Picture Credit: Peanuts Reloaded || Roughly: “Perhaps today Brexit;?Monday an exit from Italy or Spain; [then]?Europe dismantles”
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At a time like this, when the Brexit Boogeyman goes “Boo!” it’s time to take stock of the situation amid panic.

Though the UK will face some political unrest as the Prime Minister resigns, and article 50 is likely but not certainly invoked, the nature of political discourse hasn’t shifted in full. ?Though an important question, it is only one question, and more things will remain stable than change.

At least that is most likely. ?If you think of “real options” theory, you could say, “Okay, a door opened today that was previously locked. ?What new doors beyond that one could be opened?” ?Other countries could leave the EU and/or?Eurozone [EZ]. ?The EU/EZ could dissolve. ?The odds of other countries leaving isn’t that high. ?For the EU or EZ to dissolve would take a lot of doing, and the odds of that happening is very low, though higher than the odds yesterday.

As I said a week ago:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom. ?If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today. ?Even with a subpar agreement,?perfidious Albion is very effective at getting what they need completed. ?This is especially true of their very effective and creative financial sector in the City of London without which most effective international secrecy, taxation avoidance and regulatory avoidance business could not be done.

Whatever happens, it will happen slowly. ?Leaving a complex multinational group like the EU takes two years at least. ?How it all works out in detail is not predictable.

I can say that human systems tend toward stability. ?People act to preserve the things that they like. ?Only under severe conditions does that cease to be true, and even then typically only for short periods of time.

I can also say something a little more controversial. ?Wealth, assets, and money [WAM] act like they are alive and have more votes than people do under most conditions. ?Why am I saying this?

Governments come in, and go out, but for the most part, the same things get done. ?Those thinking that radical change will come are usually deeply disappointed. ?WAM tend to maintain the status quo, not because their owners bribe politicians and suborn regulators pay political action contributions, ?but because people want the streams of goods and services that help make WAM valuable. ?Only a genuine crisis at least as large as?the Great Depression or the Civil War can create truly radical change that reshapes the basic desires of most of the people in a nation.

Capitalist democracies that respect the rule of law (e.g., the government is also governed by?a higher law) are usually pretty stable; systems that don’t have significant capitalism or democracy may last a couple generations, but tend to fall apart.

All that said, there is significant economic pressure to do two things after the Brexit:

  • Rethink the single currency and common laws
  • Maintain a free-ish trade zone in goods and services

The Eurozone does not allow for the necessary economic adjustments across nations in a fiat?monetary system. ?Nations need their own currencies, central banks, etc. ?They also need to govern themselves via their local culture, not someplace far away with misguided idealists who think they know what’s best for all.

Free-ish trade maintains most of what is needed?for human needs. ?The European Union is a political construct meant to prevent war from ever recurring in Europe. ?The best way to do that is through trade. ?Severe wars rare start between nations that rely on each other and interact through commerce.

My view is that ten years from now, the goods and services that people want will get delivered, regardless of the governmental structures in Europe. ?I will invest accordingly.

Practical Implications

Things will be rocky in the short run, and there will be more bumps along the road as the Brexit negotiations go on. ?I will be resisting panic and euphoria in modest ways. ?This isn’t the sum total of my strategies, but I expect that profitable business will continue, and that people and nations will pursue generally intelligent long-term self-interest as events unfold.

When I say modest, I tweak my portfolios at the edges. ?Brexit does not comprise more than 5% of what I would do with assets. ?As with any investment idea, spread your bets, diversify, don’t bet the farm.

And, I would say the same even to governments — if you don’t have contingency plans for the possibility of the EU shrinking or even disappearing, you are not truly prepared for all contingencies. ?As Warren Buffett once said (something like) “We’re paid to think about the things that ‘can’t happen.'”

In closing, many thought that Brexit could not happen. ?Now, what else “can’t happen?” 😉

A World Deep in Debt…

A World Deep in Debt…

Posted on by David Merkel

Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most coircumstances
Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most circumstances. ?I do support debt-for-equity swaps to delever the system.

Debt, debt, debt…?debt is kind of like a snowflakes. ?A single snowflake is a pretty star, but one quintillion of them is a horrendous mess. ?In the same way, most individual debts are reasonable and justifiable, but when debt becomes a pervasive part of the economic system, the second order effects kick in:

  • As fixed claims grow relative to equity claims, the economy becomes less flexible, because many are counting on the debts for which they are creditors to be paid back at par.
  • Economies that are heavily indebted grow slower.
  • Central banks following untested and dubious theories like QE and negative interests rates try help matters, but end up making things worse. ?(Gold would be an improvement. ?Just regulate the solvency of banks tightly, which was not?done in cases where?the gold standard failed.)
  • Political unrest leads to dubious populism, and demands for debt cancellation, and a variety of other quack economic cures.
  • The most solvent governments find high demand for their long debt. ?Long-dated claims raise in value as inflation falls along with monetary velocity.

Thus the mess. ?Bloomberg had an article on the topic recently, where it tried to ask whether and where there might be a crisis. ?I’ve argued in the last year that we shouldn’t have a major crisis in the US over domestic debts. ?There are a few areas that look bad:

  • Student loans
  • Agriculture loans
  • Corporate debts to speculative grade companies that are negatively affected by falling crude oil and commodity prices.
  • Maybe some auto loans?

But those don’t add up to a debt market in trouble as when residential mortgages were on the rocks.

But what of other nations and their debts, public and private?

Tough question.

That said, the answer is akin to that for a corporation with a tweak or two. ?It’s not the total amount of indebtedness versus assets or income that is the main issue, it is whether the debts can continue to be rolled over or not. ?A smaller amount of debt can be a much larger problem than a bigger amount that is longer. (point 2 below)

Take a step back. ?With countries there are a variety of factors that would make skeptical about their financial health:

  • Large increases in indebtedness
  • Large amounts of short-term debt
  • Large amounts of foreign currency-denominated liabilities (also true of the entire Eurozone — you don’t control the value of what you will pay back)
  • A fixed, or pseudo-fixed exchange rate (versus floating)
  • A weak economy, and
  • Debt and/or debt service to GDP ratios are high

The first point is important because whatever class of debt increases the most rapidly is usually the best candidate for credit troubles. ?Debt that is issued rapidly rarely gets put to good uses, and those that buy it usually aren’t doing their homework.

Under ordinary circumstances, this would implicate China, but the Chinese government probably has enough resources to cover their next credit crisis. ?That won’t be true forever, though, and China needs to take steps to make their banking system sound, such that it never generates losses that an individual bank can’t handle. ?Personally, I doubt that it will get there, because members of the Party use the banking system for their own benefit.

Points 3, 4, and 6 deal with borrowers compromising on terms in order to borrow. ?They are stretching, and accepting?terms not adjustable in favor of the debtor, or can be adjusted against the debtor. ? If you control your own currency, these problems are modified, because of the option to print currency to pay off debt, and inflate problems away. (Which creates other problems…)

By pseudo-fixed interest rates, I take into account countries that as neo-mercantilists make policy to benefit their exporters at the cost of their importers and consumers. ?These countries fight changes in the exchange rate, even though the exchange rate may technically float.

Point 5 simply says that there is insufficient growth to absorb the increases in debt. ?Economies growing strongly rarely default.

Conclusion?

My view is this: the next major credit crisis will be an international one, and will involve governments that can’t pay on their debts. ?It won’t include the US, the UK, and certainly not Canada. ?It probably won’t involve China. ?Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.

And, as an aside, if?this happens, people will lose faith in central banks as being able to control everything. ?I think the central banks and national treasuries will find themselves hard pressed to find agreement at that time. ?QE and negative interest rates might be controllable in a domestic setting, but in an international framework, other nations might finally say, “Why would I want to get paid back in that weak currency?” ?(And what holds that back now is that virtually all of the world’s currencies except gold are involved in competitive devaluation to some extent.)

My advice is this: be careful with your international holdings. ?The world may be peaceful right now, and everyone may be getting along, but that might not last. ?Diversification is a good idea, but don’t forget that there is no place like home, unless the crisis is in your home.

On Currencies That Are A Store Of Value, But Maybe Not For Long

On Currencies That Are A Store Of Value, But Maybe Not For Long

Posted on by David Merkel

Picture Credit: Dennis S. Hurd
Picture Credit: Dennis S. Hurd

I get letters from all over the world. ?Here is a recent one:

Respected Sir,

Greetings of the day!

I read your blog religiously and have gained quite a lot of practical insights in financial field. Your book reviews are very helpful and impartial.

I request you to write blog post on dollar pegs in Middle East and under what conditions those dollar pegs would fall.

If in case you cannot write about it, kindly point me to some material which can be helpful to me.

Thanks for your valuable time.

Now occasionally, some people write me and tell me that I am outside my circle of competence. ?In this case I will admit I am at the edge of that circle. ?But maybe I can say a few useful things.

Many countries like pegging their currency to the US dollar because it provides stability for business relationships as businesses in their country trade with the US, or, with other countries that peg their US dollar, or, run a dirty peg of a controlled devaluation. ?Let me call that informal group of countries the US dollar bloc. [USDB]

The problem comes when the country trading in?the USDB begins to import a lot more than they export, and in the process, they either liquidate US dollar-denominated assets or create?US dollar-denominated liabilities in order to fund the difference.

Now, that’s not a problem for the US — we get a pseudo-free pass in exporting claims on the US dollar. ?The only potential cost is possible future inflation. But, it is a problem for other countries that try to do so, because they can’t manufacture those claims out of thin air as the US Treasury does.

Now in the Middle East it used to be easy for many countries there because of all the crude oil they produced. ?Crude oil goes out, goods and US dollar claims come in. ?Now it is reversed, as the price of crude is so low. ?Might this have an effect on the currencies of the Middle East. ?Well, first let’s look at some currencies that float that are heavily influenced by crude oil and other commodities: Australia, Canada, and Norway:

Commodity Currencies

As oil and commodities have?traded off so have these currencies. ?That means for pegged currencies the same stress exists. ?But with a pegged currency, if adjustments happen, they are rather large violent surprises. ?Remember the old saying, “He lied like a finance minister on the eve of the devaluation,” or Monty Python, “No one expects the Spanish Inquisition!”

That’s not saying that any currency peg will break imminently. ?It will happen later for those countries with large reserves of hard currency assets, especially the dollar. ?It will happen later for those countries that don’t have to draw on those reserves so rapidly.

Thus my advice is threefold:

  1. Watch hard currency reserve levels and project future levels.
  2. Listen to the rating agencies as they downgrade the foreign currency sovereign credit ratings of countries. ?When the ratings get lowered and there is no sign that there will be any change in government policy, watch out.
  3. Watch the behavior of wealthy and connected individuals. ?Are they moving their assets out of the country and into hard currency assets? ?They always do some of this, but are they doing more of it — is it accelerating?

Point 3 is an important one, and is one seemingly driving currency weakness in China at present. ?US Dollar assets may come in due to an excess of exports over imports, but they are going out as wealthy people look to preserve their wealth.

On point 2, the rating agencies are competent, but read their writeups more than the ratings. ?They do their truth-telling in the verbiage even when they delay downgrades longer than they ought to.

Point 1 is the most objective, but governments will put off adjustments as long as they can — which makes the eventual adjustment larger and more painful for those who are not connected. ?Sadly, it is the middle class and poor that get hit the worst on these things as the price of imported staple goods rise while the assets of the wealthy are protected.

And thus my basic advice is this: gradually diversify your assets into ones that will not be harmed by a devaluation. ?This is one where your government will not look out for your well-being, so you have to do it yourself.

As a final note, when I wrote this piece on a similar topic, the country in question did a huge devaluation shortly after it was written. ?Be careful.

On Currencies that are Not a Store of Value

On Currencies that are Not a Store of Value

Posted on by David Merkel

Photo Credit: Jason Wesley Upton || Of course this isn't China...
Photo Credit: Jason Wesley Upton || Of course this isn’t China…

I know this is redacted, but it is advice to?a reader?in a really remote area of the world. ?You might find it interesting.

I am currently with the XXX?team in XXX.? We are taking about trying to budget the [project]?with the inflation of the past months being 50%. And September being 91%. I think XXX?would appreciate your thoughts on the likely economic and inflation situation. They are trying to decide whether to move to working on dollars. And how to budget if they stay in the [local currency].

Dear [Friend],

One question that may not matter so much? is the inflation rate 50-91%/year, or 50-91%/month?? The reason I ask this is if that is the rate per month, then you should try to do as much business as you can in dollars, and/or treat the local currency like a hot potato? don?t hold onto it long ? it is not a store of value.? It is normal in such a situation for another currency to become the practical currency when inflation gets that high? even if it is illegal.

If the rate is 50-91%/year, that?s not great to work with, but prices are still moving slow enough for you to have some degree of a planning horizon in the local currency.? Still, any big transactions should be done in dollars, unless you are certain that you are getting a favorable rate in the local currency.

As for budgeting, it could be useful to do the budget in both currencies.? This will help to raise the natural question of what happens if you don?t have the right currency.? Here?s what I mean: ask what currencies you would naturally use to transact to accomplish your goals ? look at both revenues and expenses.? If you find your expenses are mainly in dollars or euros, but revenues are in the local currency, you will need to do one of two things.? Either a) try to charge in hard currency terms, or raise revenue rates regularly, or b) build in a significant pad in local currency terms for the things you would typically buy in a hard currency.

Feel free to send me a spreadsheet on this. ?As an aside, you can tell XXX that I have little trust that the situation will improve rapidly. ?The government is too corrupt, its budget way out of balance, and any revenue from oil is down. ?It would take a hero willing to end the corruption, and then survive ending it, in order for the inflation to stop.

In closing, the following paragraph is illustrative, and not strictly relevant:

I realize that you all aren?t investing in the country, but if you were, I would give the following advice: invest in land.? In a nation where there are no securities market, and the government is the cause of the inflation, land is the only thing that retains value.? AIG used to do this all the time in countries, particularly when they couldn?t remit their earnings there back to the US.? As they say in Argentina, ?The wealthy preserve their wealth by owning land.?? So long as land is not expropriated, it protects wealth against governments who steal via inflation.? Gold is similar, but where you are, something that light and valuable could easily be stolen.

Anyway, I missed you at XXX, and hope and pray that you are doing well.? If you or anyone else on the team has questions on this, just let me know.? I?ll make time for you.

In Christ,

David

There’s a Reason for Risk Premiums

There’s a Reason for Risk Premiums

Posted on by David Merkel

Think
Photo Credit: Jason Devaun

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. ?In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? ?I don’t have the article in front of me but I’ll toss out a few.

  • Many were Credit-oriented. ?Lend and make money.
  • Some were volatility-oriented. ?Sell options on high volatility assets and make money.
  • Some were currency-oriented. ?Buy government bonds where they yield more, and short those that yield less.
  • Some had you act like a bank. ?Borrow short, lend long.
  • Some were like value investors. ?Buy cheap assets and hold.
  • Some were akin to arbitrage. ?Take illiquidity risk or deal/credit risk.
  • Others were akin to momentum investing. ?Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

  • Someone will start a hedge fund off this.
  • Many of these are correlated; with enough leverage behind it, the hedge fund?could leave a very large hole when it blows up.
  • Yes, who wouldn’t want to be a bank without regulations?
  • What an exercise in data-mining and overfitting. ?The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
  • Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. ?(Even those are not truly free; animals have to be fed and cared for.) ?They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that?pays all of its interest and principal. ?Usage: “Is it ‘money good?'” ?”Yes, it is ‘money good.'”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. ?There are a few problems though:

  • Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
  • Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. ?What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? ?What insurance company wouldn’t want to sell off its junk bonds at that time as well? ?And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. ?Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. ?Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

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