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Month: August 2017

Safe assets, revisited

Safe assets, revisited

The idea of a shortage of ‘safe’ assets is a favorite of mine, dating back from 2011 when I first wrote about a crunch in triple-A rated assets for FT Alphaville to more recent things such as this piece for Bloomberg, and sometimes even on this blog. So it was a pleasure to discover, courtesy of Simon Hinrichsen (a former Odd Lots guest whom you should definitely follow on Twitter), a new paper on exactly this topic from Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas. Read it for rather glorious sentences such as this one: “What is relatively new, relative to post–World War II history, is that the global economy is going through a complex structural period where the standard valuation adjustment for safe assets— via interest rate changes—have run out their course.”

Here’s a summary I wrote as part of our morning ‘Five Things’ newsletter, which you can sign-up for here.

“Want a stylized prism through which to understand almost everything that’s happened in the global financial system over the past two decades? Then take a look at this paper on “The Safe Assets Shortage Conundrum.” In it, the authors argue that savers’ desire to put their money in a reliable instrument has created a need for ‘safe’ assets that the financial system has had various degrees of success in fulfilling. In the early 2000s, the private sector tried to fill that need by creating triple A-rated bonds out of subprime mortgages. We know what happened next. After that, safe financial assets became largely the purview of governments via the bonds they sell – first the eurozone (which then experienced its own ratings problems) and then the U.S. Supply has ultimately failed to keep up with demand, however, mostly because slower growth has meant ‘safe’ governments in the developed world have been unable to generate assets at a fast enough pace to satisfy savings from emerging markets. It’s a state of affairs that will probably stick around for a long time, and one that helps explain why bond yields continue to plumb new lows, seemingly without rhyme or reason. But seriously, go read the whole thing.”

A side note: I do wonder what might constitute safe in the current environment. Yes, government debt is the clear winner here but corporate debt issued by cash-heavy, investment grade, national champion corporates – think Apple – can’t be far behind…

Fair wages for robots

Fair wages for robots

No, seriously.* Hear me out.

Citi’s Willem Buiter offers one possible explanation to stubbornly low-inflation, and by extension, sluggish economic growth. Here’s the excerpt:

“We draw attention to one additional hypothesis: that we underestimate the amount of slack in the economy not primarily because we underestimate the amount of slack in the labor market or overestimate the degree of utilization of tangible capital but rather because potential output can be boosted greatly at effectively zero social marginal cost and without increased use of labor and tangible capital, through the use of new production methods based on recent advances in information technology, machine learning, artificial intelligence, big data, the internet of things, robotics, automation, autonomous machines and nanotechnology.

Because the value added in many of these new activities is mostly pure rents (returns to genius, luck and monopoly power) the distribution of income and wealth created by these activities is increasingly unequal. That weakens the aggregate marginal and average propensity to consume. Unless this shortfall of demand is made up for by increased consumer demand through fiscal redistribution towards households with higher marginal propensities to spend, or by capital expenditure, public consumption or net exports, some of the potential output gains may not materialize but turn into excess capacity and a growing (or at least larger than expected) output gap. Lower-than-expected inflation is the result.”

As Paul Caple pointed out on Twitter, there’s a simple mismatch at play here. Advances in technology mean you can boost potential output without the need for (mere) humans, yet consumption remains a human-driven activity. With more profits accruing to owners of capital — the Piketty-esque element in Buiter’s argument above — consumption drags. After all, there’s only so much a billionaire can spend, much as they might try. Meanwhile, the proximate cause of greater potential output is paid nothing, and presumably contributes nothing to consumer demand beyond potentially making goods more affordably or efficiently, which may or may not encourage people to by them (As the cycle of improvement continues there’s only so many times you’re going to upgrade your TV. iPhones appear to be the exception here).

The solution is simple: pocket money for robots.

A politically-unpalatable solution for sure, but think of the “fiscal redistribution” that could be achieved. The nuts and bolts spending, if you will. Unlike human beings, robots can also be programmed to spend consistently, thereby avoiding the over-savings problem that has plagued the 2000s. So long as the robot-owners don’t extract the wages as rent. And so long as the robots themselves don’t go off the rails: I can save I I everything else to me to me to me to me to me to me to me to me to me.

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*Readers assume all responsibility for taking this seriously.

Flows before pros?

Flows before pros?

A recent Barron’s interview with James Montier got me thinking. In it, the GMO man answers a question about lofty valuations across both bonds and stocks that have caused consternation for asset allocators seeking good value in the market. In response, he says: “The US market is at its second or third most expensive point in history. So people are saying, ‘I either don’t understand the world anymore, or I don’t think that valuation matters anymore.'”

I think he has a point but maybe not the one he means. Valuations do matter because in a world of inflated asset prices but suppressed actual price inflation or economic growth, they’ve become the easiest and most surefire way for investors to generate outperformance, and so, that is what they are chasing. I still think Citigroup’s Matt King put it best, when he argued two years ago that something fundamental had changed in the market’s behaviour.

The crux of this argument is that markets used to be self-limiting. Prices of securities would move up to a point where their yields would become unattractive, at which time investors would trim some of their positions, causing prices to go down and yields to recover. Now the intense search for returns has altered that dynamic, with investors chasing inflows as a means of getting higher prices and higher profits.

While the notion that  value investing is disappearing in a market that has moved ever upward for the past five years is not exactly new, King’s presentation here is stark. Investors have been moving in tandem, he says, making markets far more homogenous. The chart below shows investor positioning in credit markets, where the number of longs has vastly outnumbered the shorts, along with the International Monetary Fund’s herding metric. In short, investors across a number of asset classes are going mooo as one-way positioning dominates…

We often say the market can stay irrational longer than you can stay solvent. Maybe the updated version should be that the market can self-perpetuate for longer than expected.