Headaches and some future trends

At a conference we attended last weekend, numerous figureheads from the financial world spoke (a.o. John Mauldin, Marc Faber, Louis-Vincent Gave, Martin Barnes, and John Paulson). This gave us a perfect opportunity to get inspiration and to hear what these ‘financial gurus’ consider the most important trends in the coming months to years.

Troubled Europe

First of all, they were virtually unanimous in their expression of major concerns regarding the fiscal situation in Europe. This is what kept some of them up at night. Europe seems not to be dealing with the troubled banks, and is ‘kicking the can further and further down the road’ regarding the PIGS (Portugal, Ireland, Greece, and Spain, although Spain’s prime minister Zapatero argues the correct aberration is ‘PIG’). Spanish banks are giving the biggest headache: as the Spanish real estate market is in dire state, Spanish banks are hiding enormous losses, and not writing off non-performing loans (those should be numerous, given that over 20% of the Spanish population is currently unemployed). Hence, Europe is postponing dealing with two enormous problems: bad assets at banks, and the unsustainable fiscal track on which some peripheral countries are.

Mayor currency weakness

The other general opinion was that the dollar, yen and euro are actually all weak currencies and that the currencies of the emerging countries are, therefore, to be preferred. However, since most of these countries are pegging their currencies (directly or indirectly) to the American dollar, the American dollar has to devalue against other currencies that are not pegged: the sterling, yen, euro, Australian and Canadian dollar, etc. Some of these currencies must then be overshooting vs. the American dollar (i.e. rising above their ‘fair’ value, given fundamentals). What we are currently seeing in the financial markets is very likely the start of a return of these currencies’ values towards their ‘fair’ value. Hence, beware of some pullbacks in a.o. the euro and Australian dollar. 

Flawed pricing, capital misallocation

Another poignant remark made at that conference was that we have to realize that price-forming in the financial markets is entirely based on the dollar and yields on US Treasuries. As the US has the biggest economy in the world and large amounts of money can only be traded on the American markets without influencing the rate too much, the dollar is the reserve currency and the currency against which all other currencies are compared. Furthermore, yields on US Treasuries are seen as riskless. Therefore, they form the core of the entire bond market: all bond risks are calculated in comparison with riskless US Treasuries. Two things have changed recently, however:            

• US public finances have deteriorated to such an extent that US Treasuries can no longer be seen as riskless. Standard & Poor’s confirmed this not long ago with its threat to downgrade the credit rating of US Treasuries, should US deficits not be corrected soon and given that the US debt ceiling comes within close sight.
• The Fed is buying US Treasuries on a large scale and paying for them with dollars it is creating ‘out of thin air’. This is artificially boosting the price of US Treasuries (pushing down Treasury yields) and undermining the dollar.

In other words, we can no longer rely on the stability of the two pillars on which the financial system is based. This situation is asking for the wrong pricing in the financial markets, and misallocation of capital (with huge implications for the return on assets in the future).

Favorite asset classes?

Furthermore, another point that we feel is at least as important, is the fact that financial institutions regard putting money in a deposit account at central banks not as an option, as it offers almost no interest (the real interest rate is negative in many countries). Also there is a strong mistrust of bonds and investing in property is not seen as an attractive option at the moment by many of the speakers at the conference. A major alternative is, therefore, to invest in stocks (Faber’s favorite option).

Persistent trends

Apart from the fact that people almost never invest 100% of the money in stocks, there is a great deal of concern regarding the current economic situation (largely due to the enormous debts in both the private and public sector). Hedge funds are therefore becoming increasingly popular. Their aim is to earn money in both rising and falling markets, through using trend-following models. In other words, as long as the trend is upward – whether that is the case is determined on the basis of the behavior of various moving averages – the hedge fund buys these investments. As soon as a particular trend becomes visible, it is increasingly reinforced by the action of the hedge funds and the trend also lasts longer. Once the trend has reversed again, there is a long movement in the opposite direction. On average, over the entire cycle this remains neutral, but with exaggerated spikes that persist longer than one would expect on the basis of the underlying fundamentals. Hence, capital flows in mostly the same direction (given that these trend-following hedge funds do not speculate against the trend), exaggerating existing trends.

The above should then be combined with the fact that the enormous amounts of liquidity that are being created by central banks end up at the banks’ balance sheets, but they are not being used to extend new loans. Alternatively, these amounts have to be invested, in order to at least gain some revenue with these additional reserves. Lately, banks have been investing increasingly in hedge funds.

Combining the trend-following hedge funds with the giant amounts of extra cash currently in the financial system, historically big swings can be expected in the financial markets. In other words, financial markets will show increasingly big swings and trends can be persisting longer than before.