Crossing the Rubicon XI

Since the beginning of the year both the Portuguese and the Greek equity markets have been outstanding performers. In fact, the movement could be traced back to last summer spiking in the last month or so. Another indication of what is going on can be seen in the drastic reduction of the interest rate spreads between both these countries and German governmental bonds. Not only that, Spain, Italy or Ireland, albeit in less pronounced fashion, are all part of the same market movement. The local stock exchanges are boosting while spreads are narrowing and this is all part of the same package, an expectation that the economy of the periphery of Europe will support these asset prices.

There is a common misperception out there that stock exchange prices discount future events. This view is held mainly by people who do not act directly in the markets (namely politicians, but these only hold this view when markets are going up). The logic behind it is quite simple: if investors know something will happen tomorrow, they will act upon it today. With thousands of people closely monitoring what is happening it is only natural that the price at which a given share trades swiftly changes to incorporate (and provide) new information. The problem is that neither investors, nor nobody else for that matter, know what will happen tomorrow. So all the market actually coordinates is the present value of future expectations. The quality of those expectations influences the level to which those expectations will accurately match future events. Institutions are keen in shaping these expectations. Institutions play a fundamental part in reducing future uncertainty. They are benchmarks to how people are expected to behave. Increased market volatility could and often is a manifestation of decreased quality from the institutions backing market participants’ decisions.

What the recent price movements in the above countries tell us is that there is a preference for assets from these countries when compared to others. The conclusion is obvious, there is less perceived risk looming over these countries or, better still, the generalised expectation is that things will eventually work out well for them.  But what does “work out well” really means? It means investors expect those governments to service their debt and for the companies listed there to sell their products at profitable margins. From the investors who are buying those assets point of view it doesn’t really matter how this is achieved. It could either be that those economies will grow stronger or that someone is going to provide those countries with the necessary resources for those goals to be met. The general hope is a little bit of both. By helping those governments, the EU, the IMF and the ECB are hoping, in time, those countries can fend for themselves. But this is where I do not see how.

Greece is a mess. People are going back to the villages and to barter. There is a monetized economy subsidized by Europe that is government run or, at least, government dependent. High unemployment means people have to look elsewhere for means to attain their goals and that is what they are doing. The task of bringing these people back to the market economy could be facilitated by the fact that people would rather be in a monetized economy than to operate in its border. But the state-run economy of Greece has low productivity and capital goods are being withheld from more productive uses to service the system’s incumbent beneficiaries. There is no way the Troika can supervise the process of bringing unemployed people back to productive activities. Generally speaking because it cannot acquire the ability to do so, and particularly because it cannot circumvent the very same people that brought Greece to where it is now.

Portugal is not doing much better. Austerity there meant decreased deficits, and yet a deficit by definition means a nation is still spending more than it gathers in taxes.  The debt to GDP ratio is now somewhere north of 120% and, despite the fact no one expects that debt to be paid, servicing it alone is already a very heavy toll for the Portuguese highly taxed citizens. There is widespread dissatisfaction with the government, yet change means putting the previous ruling party back in charge. The private sector is also leveraged raising the total debt to GDP ratio to some staggering 350%. The country was never famous for its social services network yet, to make things worse, social benefits (that people believe they paid for) and pensions (that they most likely did pay for but were used to pay previous generations) are being cut (except for those lucky enough to work in the public sector, to whom most of those cuts were obviously deemed unconstitutional by civil-serving judges). Clever people are emigrating en masse, the number of those leaving the country being larger than the number of births (Did I say clever? I meant qualified, clever people, like rats off a ship, left a long time ago).

Spain seems a lot better than Portugal, except for the fact that the country is disintegrating. Catalonians, if not in their majority, at least the most politically-active members of society want to split from Madrid. This came to the point where the Catalonian local politicians will have to concede in order to disguise their own incompetence. For 30 years they’ve played the number of looking like they favoured independence while acting as a buffer to those same independent claims behind closed doors in exchange for a larger share of the Spanish state pie. If the Spanish treasury acts recklessly enough to guarantee the share of the national debt theoretically allocated to Catalonia like London seems to be doing, it will be a too good opportunity for Barcelona to miss. If Catalonia goes, the Basque Country would follow suit, the only excuse they lack is international recognition. They are too small to get it for themselves but if Catalonia gets it, their case would be a mere expedient. Even if the country remains united taxes have risen to Swedish levels, something that is very likely to reduce the possibility of increased tax exactions although the government is not deterred in is want to do so.

Where I’m trying to get at is that no one should put high hopes on economic miracles. This does not necessarily mean the promises made by asset prices from these countries will not come true. In Northern Italy (mainly Lombardy), their southern countrymen are commonly regarded as bloodsuckers thriving on their wealth. To some they are not even worthy of the rank of countryman, Italy’s southern border would only stretch as far as Tuscany, maybe Rome, everything lying beyond that point being part of Africa (presumably Libya).  On the other hand, the South of Italy complains the North is not providing them with enough resources to develop or, in a milder version the corrupt political class in Rome keeps all the money. And yet this state of affairs survived for the last 150 years. Similarly there is no end to the amount of money that can be spent by the government of Andalusia, Spain in infrastructures or social services to develop the local economy. The region remains at the bottom of most economic indicators. One is tempted to suspect they are not really trying. Maybe, just maybe, local rulers from both the origin and the destination of these transfers are better served by the current situation. This is why despite the fact I don’t understand what Germans have to gain with supporting their southern European neighbours I do not eschew the possibility that it will (continue) to happen.

Some supposed benefits from increased transfers within the UE might be successfully sold to the German public. The mighty German companies will export more into these countries, providing more jobs, or the country will attract talent from those depressed areas to perform the most productive jobs inside the union increasing the sustainability of the German social security schemes permanently threatened by one of the longest standing inverted population pyramids in the World, are recurrent arguments. The problem with these arguments is that it is impossible to perform economic calculations on the real value of these transfers for the society as a whole. Assumptions have to be made and that is where it starts to go wrong. Collectivists, even of the mildest sort, thrive on the impossibility of these calculations, but ironically, it is the very impossibility of performing economical calculations that prevents any collectivist organization of society. In Margaret Thatcher’s famous words: socialism ends when it runs out of other people’s money. Social engineering progresses by bending institutions to their notion of what goals they should aim (maximizing social output if we are to believe their benevolence) blind to the fact they are feeding uncertainty outside their narrow calculations. It will show where and when it is least expected. Riding the periphery convergence trade in its multiple guises is all very well if people know what they are getting into. If it is based in an expectation that the economic outlook is improving, then it is time to get out.


The Card Players

 If we take a random look at the economic stats of lately we can quite reasonably assume the global economy is on the rise again. Not only that, also the financial industry is hiring people and assets under management are growing, not only due to rising asset prices but also because money is coming back from deposits and other supposedly “safer” investments.

A month ago or so I read a long-term forecast that said the World GDP could rise to as much as 100 trillion in five to seven years time. I cannot disagree even because GDP is just a number and one to which governments around the world pledge significant resources. I sometimes find it hard to believe the amount of wealth that can be destroyed just to make that number rise by a couple of tenths. But then again, it is not their wealth to start with.

Well my question is not if we will reach that number but rather how much is deemed necessary, on average, in global growth of asset prices, for the combined GDP of world countries to reach 100 trillion y 5-7 years?

For the time being things look good, with QE’s excess liquidity being channeled to Paul Cézanne, Francis Bacon or Andy Warhol works of art. I must admit it is mighty clever of those art purchasers. They are acquiring unique pieces of human ingenuity by delivering a very large quantity of reproducible-at-will pieces of…well…digital bits and bytes. Those pieces, in turn, are backed by assets (namely debt) of dubious quality kept in central banks mainly to achieve the transfer of wealth from productive individuals to capital structures inadequately built to satisfy human needs (the worst of all, as we very well know, is called “the government”).

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.


Not only those few fortunate investors can gaze at the excellence of those few works of magnificent art, but fine paintings come with the additional advantage of transportability.  They can be carried around and put to rest faraway from the greed of bureaucrats and politicians. Something digitalized property claims, also known as financial assets, cannot. Could it be a coincidence that the first country to replace the use of a piece of paper to signify ownership of financial assets for a central clearing entity that just transfers registrations of ownership was Nazi Germany?

But the best thing is Francis Bacon’s paintings and Andy Warhol’s photos, like common shares, have a zero percent weight in the CPI so we can all pretend nothing is going on.

The Funk Soul Brother

The other day I got to see this graph. I’m sorry I cannot say where it comes from but I got it in a e-mail that somebody sent to somebody who, in turn sent to somebody else. Over and over, so I’m afraid I cannot give due credit to the author.

S&P vs Balance sheet

Anyway, I believe the reality it describes is pretty much clear to everybody: ultimately the increase in Fed’s balance sheet is not only sustaining but also driving up equity prices. This is the helicopter theory at its best, the fundamentals behind the rally ever since March 2009.

In reality it is not such a clear cut deal. The Fed began its balance sheet expansion before equity markets did pick up. At first, most investors run for cover and prefered hard currency to uncertain ventures. It is only when they began to trust business as usual would find support that they gradually came back. But, what about now? (The funk soul brotha, right about now…)  Back they are, so how come the FED is not reversing their policy?

The answer is, of course, it can’t. I know there are talks of taper but talking is cheap. What the balance sheet expansion aims at is to make interest rates low enough to make any financial asset an attractive investment, irrespective of how low its productivity is in satisfying human needs. If leveraged the better. There is no turning back. Massive savings are now supporting expensive and hardly profitable capital structures. The largest and less productive of these is called “the government”.

I do not know if this is an intended or non-intended consequence of central bank policy (I suspect the later), but I do know that the only way for governments to keep their promises to creditors, voters and supporters alike is by exacting more resources, a.k.a. wealth, from their subjects in the future. Those wealth producers, in turn, will have less to go around with. Believing the possibility of creating virtually infinite amounts of money (more accurately money substitutes) equates to being able to almost infinitely increase capital is an illusion. It ignores the decreased quality of that specific capital good that is being “produced” in exponential amounts. The rally will continue for as much as the illusion that wealth is being produced is maintained. New ventures backed by promises of future wealth will be issued, while in reality capital is being destroyed/malinvested  throughout the whole process.

On the “fake and paid for Nobel” laureates…

…my friend David Howden had this to say:

This year’s Nobel Prize is shared between three eminent economists, Eugene Fama, Lars Peter Hansen and Robert Shiller. For the purposes of this article commemorating their achievement, I wish to compare Fama and Shiller’s accomplishments, contributions and what the Prize really represents. As we shall see, though both academics won the award for their work on asset prices, their results and conclusions couldn’t be more at odds with each other.”

You can read it here.