Let’s take a step back from the abyss. Whether the financial world ends in fire or ice, it still ends. Let’s admire the view from the edge of the abyss. Better yet, let’s ponder the latest note from Goldman Sachs managing director Christian Mueller-Glissmann to clients in which the “drawdown risk” to the S&P 500 appears “elevated”.
A note of caution. You have to take what traders say about their own trades with a grain of salt. See George Soros below, for example. A trader wouldn’t tell you anything useful about his position until after the fact. Most of the time they’re just talking their own book.
But the comments I want to bring to your attention today are about macro. They’re trades based on big picture trends, macroeconomics, and politics. It’s not technical. It’s about big sweeping changes in capital flows and asset prices. That’s the “capital” part in Capital & Conflict.
The Goldman MD’s main point is that 20% sell-offs in the market are often provoked by “concerns of a global nature”. Of course it could be that the sell-offs would happen anyway and events are falsely blamed for them. But between Brexit, Trump, the Federal Reserve, and the South China Sea you can take your pick of “concerns” which could cause the S&P 500 (and global markets) to correct by more than 20%. According to Mueller-Glissmann (emphasis added is mine):
With the S&P 500 close to all-time highs, stretched valuations and a lack of growth, drawdown risk appears elevated… During the S&P 500 drawdowns in August 2015 and at the beginning of 2016, bonds provided a less effective hedge with monthly returns of a standard 60/40 portfolio dipping to -5 percent, much larger drawdowns than during the Euro-area crisis and the global ‘growth scare’ in October 2014… With equities at the upper end of their recent range, we believe equities offer poor asymmetry with little return potential and potential for more frequent and larger drawdowns… investors are increasingly concerned about the recovery catalyst in the next drawdown as central bank capacity is increasingly questioned and global growth and inflation remain stubbornly low.
Translation: stocks and bonds are both overvalued, and inflation and growth are both low. There are no “safe assets” to hide in, and central banks are left with increasingly bad ideas.
Okay, maybe I took some liberties with his analysis. But coming at this from an alternative point of view, the key idea is that traditional asset allocations don’t work well when returns between stocks and bonds are correlated. You can’t diversify or hedge risk effectively when both stocks and bonds are “stretched.”
I won’t bang on about bonds. But this is a question I hope to ask my old mate Vern Gowdie when he drops by for coffee later. Vern is a retired financial planner from the Gold Coast in Australia. His radical idea, when I began working with him a few years ago, was to go to an all-cash position.
Why is that “radical”? Because despite what you may have been told, cash is an investment position. It’s a bet on a deflationary debt collapse and a contraction in the money supply. When you’re all in cash and have no position in stocks or bonds, you’re preparing for a “drawdown” far in excess of 20%. Vern, citing previous deflating asset bubbles, planned for a 90% drawdown.
You might consider that over-conservative financial planning or excessive risk aversion. But when you’re responsible for other people’s money, and their retirement, preparing for the worst – not losing money – is not a bad place to start. From there, it’s deciding how much you want to risk playing a game of musical chairs with central banks calling the tune.
From an academic point of view, it’s also worth noting that our own Tim Price and Charlie Morris have rejected the view that bonds deserve 40% of your assets, in the current environment when British interest rates are at all-time lows. They’re not just being contrarian. Both of them don’t see much upside for bonds with interest rates already so low. There is far more risk than reward.
But what about Brexit?
If Goldman is worried that Brexit is one of the “concerns” that could lead to a 20% drawdown in stocks, should you be worried too? Chancellor George Osborne says yes. Showing the fortitude and perseverance that have characterised the British attitude toward adversity, Osborne told the BBC last night, “there’s a lot to be scared about.”
He was responding to allegations that he and the prime minister have engaged in a scare-mongering campaign to persuade the British public to vote Remain in the referendum on European Union membership on 23 June. Appearing on the BBC, Osborne said, “If we vote to leave, then we lose control… if we lose control of the economy, we lose control of everything. People should be under no illusions.”
Control of their own economic and political future is precisely what the British people can get if they vote to leave. Also, note to chancellor: the government doesn’t control the economy. We don’t want the government to have “control of everything.”
He’s right about one thing. People should be under no illusions that when push comes to shove, a certain species of political conservative reveals its preference for arguments from authority. If we’ve learned anything this week, it’s that Cameron and Osborne don’t believe the British people can be trusted.
To be fair, the elites on the left and the right are united in this belief these days: you don’t know what’s best for you so you need to be told. This is not your Britain.
Ever the voice of calm reason, The Fleet Street Letter’s Charlie Morris had something to say about Brexit in his latest update. Charlie commented that both the pound and the euro had rallied against the US dollar on the back of a weak jobs report last Friday in America. Then he wrote:
This is important because despite a shift in the polls towards Brexit, the pound hasn’t collapsed at all. The scare mongering campaign, otherwise known as “Project Fear”, is hugely exaggerating events. If Britain votes to leave, life will continue as normal. There will be a period of renegotiation, and a new agreement will be reached. The fall out – if there is any – will not come from Britain leaving. It will come from a diminished EU as other European nations follow Britain’s lead.
I won’t publish the rest of Charlie’s analysis (which is available to FSL readers). But the last point gets to the heart of the matter. For Charlie, this is your Britain.
Elites in British public life and elites at organisations like the IMF, OECD, the World Bank, Goldman Sachs and JP Morgan all want to remain because it’s good for them. They make the rules for the rest of us and live a largely separate life, benefitting immensely from the financialisation of the economy (and from huge and perpetual public debts).
No wonder they don’t want any change. The status quo is good for those at the top. And it keeps everyone in their proper place. If Britain bolts from the EU, the stampede will be on (see Soros below). It will be the high-water mark for the whole European project in its current, anti-democratic, bureaucratic, highly-regulated form. And that’s not a bad thing. Why?
The project will be forced to evolve into something the people of Britain and Europe find more useful (and more accountable). In nature, apex predators don’t have to adapt. They’re at the top of the food chain. They kill what they want. When you’re the king of the jungle, it’s good to be the king.
Brexit is an external event (like the meteor that killed the dinosaurs) which threatens the current unnatural political order in Europe. British and EU political elites are acting like annoyed and cornered predators. Annoyed because they have to lower themselves to seek the public’s approval. Cornered because now that they’ve left the result to democratic forces, it’s beyond their control.
And as Osborne said last night, it’s about control, isn’t it?
Soros back behind the wheel
George Soros is back making investment decisions for his fund, according to The Wall Street Journal. The last time he took such a hands-on approach to the macro trading strategy was in 2007, according to the Journal. Back then it was concerns about US housing and credit that led to bearish bets.
And today? He’s worried about China… and Brexit. Soros writes in an email that:
China continues to suffer from capital flight and has been depleting its foreign currency reserves while other Asian countries have been accumulating foreign currency… China is facing internal conflict within its political leadership, and over the coming year this will complicate its ability to deal with financial issues.
He makes a point Charlie made earlier this year: Chinese growth has hit a structural limit. China won’t grow more until it gets more productive. And that comes down to political and institutional reforms in favour of personal and economic liberty, which, as you might know, are at odds with Marxism/Maoism.
Economically, China’s big debt problem puts Soros in the “deflationist” camp. You know the camp: too much debt, too much global productive capacity, too much fake economic growth “brought forward” by fiscal and central banks stimulus and a long period of low growth as the debt drags.
Not exactly encouraging. But it does explain why his fund took a position in Barrick Gold in the first quarter. And on Brexit? Strap yourself in! Soros writes:
If Britain leaves, it could unleash a general exodus, and the disintegration of the European Union will become practically unavoidable… I’m confident that as we get closer to the Brexit vote, the ‘remain’ camp is getting stronger… Markets are not always right, but in this case I agree with them.
I’m not sure when he wrote that. But I bet it was before George Osborne went on the BBC last night. I’d love to see what Soros is betting on now.