We hosted a conference call with Jim Rickards back on 8/29/2012 where he outlined his bull case for the Euro. On 5/21/2013 we had a follow up call with Jim to get his updated perspective on global markets, policy implications, and the current manifestations of the currency war.
A replay of the call and the presentation materials can be accessed via the following links:
Replay: CLICK HERE
Materials: CLICK HERE
Below we review the key themes of the call, highlight some of the notable callouts and provide some discussion around points where Hedgeye and Jim are in disagreement.
THE SETUP: Below we highlight the key themes of the call (paraphrased and extended where appropriate to provide context).
Inflation vs. Deflation and Dynamic vs. Static
A snapshot view of the economy and the, thus far, “well-tamed” inflation readings belie entropy building under the hood as the inflationary (policy) and deflationary tug of war plays out under the surface. “Nothing happens on the fault line of two tectonic plates most of the time until it does” – the inflation-deflationary dynamics represent the interplay of a complex system with the potential for a decidedly unexpected and non-linear outcome.
The goal of monetary policy in a deleveraging period is to stimulate inflation and drive positive nominal growth in an attempt to offset the deflationary forces inherent to a debt deflation scenario. Achieving positive, nominal growth is critical because debt is nominal, so nominal growth is required to ease the real debt burden and because of negative real interest rates, the goal of financial repression and the policy supported yield chase, requires that nominal interest rates (inflation) be positive.
The FED’s Sisyphean Fight
Monetary policy remains a blunt instrument. The Fed, through policy initiatives and open market operations, can effectively control the base money supply. What it can’t control is private sector demand for credit or banks willingness to lend. While the Fed can print as much money as it wants in hopes of moderating both an acute shock and a protracted deleveraging, if that money simply sits at the Fed as excess bank reserves, it can’t work to drive credit creation, money turnover (M1 Velocity) or end demand growth
So, what we’ve observed over the last 5 years is a continual rise in base money and a continued collapse in velocity as Fed printing has proved ineffectual in the face of declining consumer and investment demand and a lack of risk appetite from lenders.
Velocity: A Socio-psychological phenomenon
In a deleveraging, and when interest rates are already at their lower bound, increasing the money supply is not an effective enticement for consumers to spend, re-lever or accelerate economic activity broadly. The Fed has two primary approaches to attempt to bend the velocity curve:
- Negative Real Interest rates: Negative real interest rates make borrowing a negative cost (i.e. the bank is effectively paying the borrower to borrow). Note that while interest rates are at nominal lows, real rates are still slightly positive and well above historic lows in real rates.
- Inflation Shock: The theory of Inflation inertia (which remains the prevailing economic theory) suggests that inflation expectations drive actual inflation in a type of self-fulfilling prophecy. Thus, if the Fed provides a 2% inflation target, actual inflation will likely come in at ~2%. However, what the Fed needs is an inflation shock to catalyze accelerating consumption – this only occurs if actual inflation is significantly different than expected inflation. Thus, the Fed needs inflation of ~4% (vs. the 2% target) to drive a real behavior change.
Nominal vs Real Growth: The Fed needs 4% inflation
As stated above, the Fed needs nominal growth to help ease the real debt burden and avoid a painful, debt deflation.
If deflationary forces overcome inflationary policy efforts you could have a situation in which Real growth accelerates. This would occur simply if deflation is greater than the drop on nominal growth (i.e. -1 Nominal growth less -4 Inflation = +3 Real Growth).
In this situation, positive real growth is realized but with broader negative economic consequences;
- Negative nominal growth means debt burdens get more expensive in real terms which leads to liquidity traps, defaults & bankruptcies, Declining Tax revenues, rising Debt/GDP levels, etc.
- Federal Tax revenues decline as the gov’t can’t tax real income growth that occurs via negative nominal GDP and inflation growth.
We Are In A Depression
“We are in a depression that won’t end until a host of policy changes occur.”
- We have 50M people on foodstamps, 20M unemployed or underemployed, 11M on disability (most for life) alongside a secular decline in hours worked, stagnant personal incomes, flat/negative real wage growth, and a dearth of business investment
- 2 Reasons for Business Non-Investment:
- Precautionary savings – rainy day savings allowing for corporate self-financing in case of a re-current credit/liquidity event and a shut-down in the commercial paper mkt.
- Regime Uncertainty: So many policy shifts that businesses just go to the sidelines – healthcare, taxes, regulatory/environment policy…all uncertain/unstable from a multi-year perspective and stymieing multi-year, high ROI Investment.
Complexity Theory: If the Fed gets the inflation they are looking for, can they actually handle it?
The fed continues to use equilibrium models when they should be using non-equilibrium and complexity based models. In effect, they believe they can use a thermostat to control the temperature of the economy. In actuality, the economy/inflation functions more like a nuclear reactor in that once a threshold is breached, the system goes critical and is no longer amenable to conventional “dial it up, dial it down” policy initiatives.
In effect, inflation becomes non-linear and is more likely to go from 2% to 4% then straight to 8-10%. In large part, this occurs because of a behavioral/psychological shift occurs in the collective consumer/business psyche and once the velocity curve is bent, its hard to bend it back the other way in short order.
To review the critical components and characteristics of complex systems:
Commonalities of Complex Systems: All 4 factors apply to capital markets
- Diversity - you need a lot of agents or participants and they need to be diverse from each other.
- Connectedness - how are the agents arranged, so that they can observe and perceive one another to figure out what the others are doing, or not?
- Interaction - if I do something does that affect what other people do, or vise versa?
- Adaptability - based on the experience do I adapt, do I learn?
Characteristics of Complex Systems:
- Emergent Properties - the whole is greater than the sum of its parts. That is to say, things come out of the system that one would not infer based on knowing all the pieces in the system.
- Phase Transitions
- Critical State Dynamics - when the players in the system are arranged in such a way that they’re vulnerable to some kind of a collapse, what physicists call a phase transition.
- Power Law Distribution – it’s an exponential function that is scale dependent. In other words, if the size of system is doubled, risk goes up by 10X, not 2X.
Q: If deflation gets some traction, do big moves have to occur in JGB’s or Treasury yields?
A: The prevalence of deflation would cause a big rally in treasuries. “I could see the 10Y going to 80bps” similar to yields we’ve seen in Japan. “We are Japan, we’re just 7 years in while Japan is 20Y in”. Monetary Policy may be able to get us out from here, but they need to bend the velocity curve.
Q: How do you view the Behavioral component as it relates to the market/policy currently?
A: If velocity does turn, it will go to 1,2,3..then go straight to 7,8,9 which is exactly what happened in the 70’s. Velocity increasing is a psychological phenomenon and you can’t bend it back once it gets some mojo - thats what makes it an exponential phenomenon
Q: How does the Fed navigate from here?
A: There will be trades as we move along. The dollar will rally but then they will come back in with messaging and a reminder that they will dial it up to get inflation and dollar devaluation. They clearly want the wealth effect - 50% of the wealth of the American people is in housing and stocks.
The problem is if they are too successful, you get an asset bubble and the bubble could pop. This would destroy confidence and kill velocity – exactly the factors policy was attempting to cultivate. So, how do you inflation the bubble without popping it?...you deflate it every once in a while, and you do this via communication – hint that a ‘taper’ is being considered and let equities correct a bit. It is all communications management. “This is just lying, propaganda, money illusion”…”they are just trying to lie to us & head-fake us”
Q: How would you have handled the crisis if you had been chairman of the Fed?
A: I would have acted similarly in 2008/2009 in the early stage in providing liquidity. But I would have let the banks fail & nationalized them by executive order.
- All liabilities are guaranteed, strip out bad assets, clean up the balance sheet, break it up & then re-IPO the banks
- Clean banks with clean balance sheets could actually do some lending
- Would have raised rates (25-50bps) signaling that USA is open for business & trying to attract capital – grow via saving and investment and not debt & consumption
- Negative impacts would have been steeper & worse early on, but we would be back to growing 4-6% at present
Gold: Keep 10% of investible assets in gold. Gold wins either way - Fed gets the inflation they want & gold goes up or deflation wins out & you want gold in a deflationary environment (for example, gold went up 75% during Depression) as the treasury bids up gold as a way of causing generalized inflation (ie if gold goes up, silver goes up, oil goes up, etc).
Yen: Keep shorting the Yen. “Yen is not done declining, its going to go to the 110 to 120 level”.
Sterling: When Yen hits 110, rotate out of short yen/long gold to short sterling/long gold.
Euro: Long Euro/Short USD
Europe: Only Economy I’m really bullish on is Europe. Very Virtuous cycle present there:
- Falling Labor costs
- Inflow of foreign capital & technology
- Currently Inefficient with increasing labor & capital mobility offering efficiency upside
- Demographics are not a problem if you look at it from a labor force perspective – immigration for eastern Europe and Turkey and secular unemployment presents a positive setup for protracted big labor force increases.
“We are in a Depression that won’t end until policy changes”
“China is completely unsustainable. Probably headed for a collapse in 2014, maybe 2015 at the latest”
“Yen is not done declining, its going to go to the 110 to 120 level”.
“Private Equity is completely out of ideas”
Rickards vs. HEDGEYE: We very much like Jim’s process and his contextualization of current macro dynamics. We disagree with some of the conclusions.
Process: Jim has an attractive analytic framework for processing information and contextualizing market and policy events (he’s also uniquely adept at articulating the complex in a straightforward & tractable manner). A dynamic, complexity based model with a behavioral overlay is the right approach and parallels our own.
Deflation: We understand the need for nominal growth in a debt deflation scenario. However, we think there is a fair probability price deflations play out in a more nuanced fashion – essentially, more of what has been occurring over the last year. Targeted and rotating asset class deflations – commodities (currently), treasuries (likely next), etc – are economically manageable and present trade-able opportunities. Inflation/Deflation need not be a completely binary, On/Off or all-or-nothing type dynamic here.
Inflation/Growth: Jim used 5% nominal growth as his bogey, with a base assumption that we only get ~1% real growth. If we do, in fact, get a continuation in domestic #GrowthAccelerating then the inflation component necessary for hitting that 5% nominal target comes down. Here, the magnitude and need for negative real rates is reduced as is the level of ongoing easing initiatives. With employment, housing and confidence accelerating and $USD dollar strength and credit trends supportive, we think key pieces are in place for driving a positive reflexive economic cycle in the immediate/intermediate term.
$USD: Citing falling labor costs, inflow of foreign capital, upside to efficiency, and positive labor force demographics, Jim indicated he likes both the Euro currency and the setup for the European economy relative to that of the USA. While we wouldn’t necessarily take issue with that reasoning we think it holds the potential for significant duration mismatch.
Being inefficient (efficiency upside) and having significant, secular unemployment (labor force upside) may indeed be opportunities, but ‘if’, the magnitude of, and the timeline over which that upside may be realized is highly uncertain. Here, our disagreement may be principally a function of duration. At present, we continue to like U.S. consumption related exposure and select European exposure on the long side (ie. Germany,at a price) while holding a negative view of EU country exposure broadly.
Gold: Jim continues to like gold and thinks it wins under both inflationary or deflationary scenario’s. Here again the difference of investment opinion may be duration based. We have been bearish on gold since November and continue to see further upside for the $USD and further downside for gold over the intermediate term as the domestic macro data improves and monetary policy leans incrementally hawkish on both an absolute and relative basis.
We always enjoy the opportunity to host Mr. Rickards. We are fans of his process and the conversations are open and constructive. We occasionally differ in our interpretation of the data and investment conclusions, but that's what makes a market. We looking forward to catching up with Jim again.
Christian B. Drake