Muddling for Solutions

By John Mauldin

Chart: JQI White Paper

Source: Pew Research Center

Toward a Theory of Journalistic Objectivity

By: George Friedman



Last Sunday, I received an email from a close friend telling me and others that after 60 years he was canceling his subscription to The New York Times because he was tired of its bias against U.S. President Donald Trump and, even more, its failure to cover the world except through the prism of Trump. A few weeks ago, another friend of mine said that he was no longer able to write about the world without making clear the harm that Trump was doing and the disgraceful sort of man he was.

The interesting point is that one believed that The New York Times was falsifying reality with its hostility to Trump, while the other said that describing Trump in any way other than vile was falsifying reality. Few of us hold opinions we know to be false, and therefore few of us see ourselves as falsifying reality. We think of ourselves as clarifying reality and as being the victims of others.

That makes each of us a spokesperson for truth and those who disagree with us as in error. The political question is how should we treat those we think are in error? One way is to think of them as reasonable people, to be respected even in disagreement. The other is to regard them as either too stupid to realize they are in error or deliberately corrupt. If you follow the latter approach, they are unreasonable people and unworthy of respect.

Both are very intelligent, reasonable men, and in other circumstances they would like each other. The issue here is not the intellectual, moral or emotional differences between the two, but how the media should present a president about whom they disagree. This debate transcends the current national frenzy over the president. We have had many such times in American history. Rather it is a question of what is the intellectually appropriate manner for a newspaper or other media to deal with the frenzy.

Opinion vs. Fact

The New York Times is clearly hostile to Trump. The Times would argue that it is not hostile but faithfully reporting the news, which in the case of Trump happens to paint him in a bad light. Its critics say that the paper deliberately interprets Trump’s actions in the worst possible way and, even worse, spends so much time disparaging him that it either has no space for other vital global news or views all world events as affected by Trump’s actions, no matter how marginal they might be.

This raises the question of what a newspaper ought to be. Benjamin Franklin published the Pennsylvania Gazette in the 19th century. It mixed news and opinion without shame. Early newspapers were not committed to neutrality. Franklin believed he was committing himself to truth, and achieving it by stating his opinion. The difference between The New York Times and Franklin rests in the fact that Franklin did not believe providing thoughtful opinion was unethical whereas modern journalism thinks that it should be presented on editorial pages, separate from the news pages.

More precisely, modern journalism draws an ethical line between opinion and fact. But in practice it is hard to distinguish what is, from what ought to be. More important, the vision of what ought to be seems to define what is important. The hidden sphere of opinion rests not in how the story is being told, but in the choice of the story that should be told. In making decisions over what is and what isn’t important, the newspaper is already painted over by opinion.

The problem is not with approaching your life’s work as a journalist with a vision of the world.

It is impossible not to. The problem is pretending, particularly to yourself and then to your readers, that your selections are devoid of prior choice, that the editor and reporter are blank slates, reflecting reality without prejudice. The presentation of facts without framework is impossible.

Ben Bradlee was the editor-in-chief of The Washington Post. He was a close friend of the Kennedys and he hated Richard Nixon. It was the Post that transmitted the information provided by Deep Throat, a senior FBI official, to the public. The fact that the Post didn’t reveal for decades that its secret source was an FBI official left out a critical dimension of the story. It was not that Nixon was not guilty, but it was also true that the source and Bradlee wanted Nixon to fall.

The Post wanted to get Nixon, and Nixon committed a crime. Both statements can be true. But the Post pretended to be neutral and hid the fact that its source was in the FBI. The framework of motives was hidden from the public and dismissed when Nixon supporters charged the Post with burying important details.

An Evolution

According to contemporary journalism, approaching a newsworthy subject with a personal agenda is unethical. The difference between Franklin and Bradlee is that Franklin made no claims about journalistic ethics. Bradlee did. For Franklin, having a view on fishing or justice is not incompatible with being a good journalist.

The only caveat must be that the view is openly stated and held to be true by the author. Indeed, Franklin reveled in using his paper as a platform. His ethical principle, if there was one, was that he stood responsible for what he wrote.

After World War II, there was an evolution in newspaper publishing toward the idea of journalistic objectivity. Most newspapers had political leanings before the war, and while these persisted after the war, the major newspapers sought increasingly to draw a sharp distinction between the editorial and news pages. Part of this had to do with the increased power of journalism schools and the rise of technocracy.

Before the war, the local news beat was frequently covered by high school graduates with street smarts and little formal journalistic education. Over time, these reporters could be promoted to covering national and even international news. H.L. Mencken, one of the great reporters in the first half of the 20th century, symbolized this. He was a high school graduate who mixed reporting with his own pungent views liberally.

With the rise of journalism schools, journalism was seen through a technocratic lens paralleling the other professions. It possessed a method taught in journalism schools that required expertise. But more importantly, and less consciously, the journalism schools taught not only how to cover the news, but what constituted the news. It is hard to encapsulate what their vision of the news was, but we can get a sense by recalling what was covered by what used to be called the “mainstream press.”

The mainstream press reflected the dominant ideology following World War II. It focused on the Cold War, on the American economy and on the politics of the two political parties and the framework in which they thought. The John Birch Society and the Communist Party were observed as oddities, not as valid movements.

Writing and editing without a framework is impossible. As I have said, the mere selection and rejection of what is to be published shapes the newspaper. One of the tasks of an editor is to decide what stories make it to print. There is only so much space in a newspaper or time on television, and there are many things happening in the world.

The decision on how much space to devote to a subject derives from some concept of what is important and what is not. This is the foundation of journalism and almost any field. And that decision has its roots in some model of reality, whether it’s conscious or not.

The Problem With Modern Journalism

The problem is that modern journalistic ethics insist that simplistic objectivity is possible, and it compels journalists and newspapers to pretend that their political beliefs, or support for the Redskins, does not shape the way in which the news is presented. Franklin would never hide his personal views, nor would he ever see them as prejudices.

Rather, in his mind they were well-honed reflections that he provided the world as a gift, without prejudice. In this sense, reporters at Fox and CNN are better journalists and more honest than those at The New York Times or The Washington Post. They make no bones about who they are, nor do they hide how they shape the news. They don’t have what used to be called the mainstream press’s objectivity and don’t pretend to have it.

Objectivity is not impossible. But the first step of objectivity is to know yourself and to be aware of what you are doing and why. Knowing your own motive and not being ashamed of it allows your readers to choose whether to read your publication and allows you to impose the discipline of your own intentions.

At any case, it can’t be hidden and, over time, becomes readily apparent to your readers, who may approve or disapprove but will read your publication nonetheless to hear another view. But without that objective evaluation of your purpose, all other objectivity is lost.

True objectivity is enormously difficult, as all great things must be. I face this dilemma every day. I solve it not by pretending not to have a view, but by practicing an idiosyncratic method, geopolitics as I understand it, that allows me – I believe – to understand the world more deeply.

To use geopolitics well, you must force yourself to separate your superficial political views from your work. That is not easy; I and my staff are human. But we believe that only by abandoning the politics of our time can we actually understand the deeper structure of things. We are less interested in whether Trump is right or wrong than in the underlying forces that created his presidency, and all other presidencies.

There is the objectivity of knowing your politics and the objectivity in caring for something other than the daily political discourse. But objectivity is more than simple neutrality. It is being conscious of your ends and the methods that help you to reach those ends, and freely admitting what those ends are. Objectivity is enormously difficult, as is rigidly separating belief in method from beliefs on current affairs. The objectivity I am speaking of has more in common with Benjamin Franklin than with contemporary journalism.

True Objectivity

It is impossible to be perfectly objective, even in my terms. But then it is difficult to love, to be courageous and to be just. The difficulty of each of these things does not excuse anyone from trying. The shallow claim to objectivity of contemporary journalism is transparent. That does not mean that objectivity is impossible, as imperfect as all things human might be.

But clinging to an objectivity that is both simplistic and transparent undermines the Republic. Objectivity is not pretending not to have an agenda, but showing clearly what that agenda is. You cannot live without an agenda and you cannot free yourself from the responsibility of having it. And then the world can see the degree to which your agenda is profound or trivial.

The agenda does not have to be a political goal, although if it is, then that is legitimate. For me, it is a consistent method of understanding how the world works and what things are more important than others. I try to make it clear that I am working from this model, geopolitics, and that the breadth and emphasis of what my organization, Geopolitical Futures, addresses comes from there.

Franklin made no bones about the reasons he chose to write as much as he did on what he did. This I think is true objectivity. Newspapers in the United States used to be unabashedly political, and that meant they covered some topics obsessively and ignored others. But we knew who they were.

Defining objectivity as possessing no preconceptions works if you really have no preconceptions, but what human is a blank slate, and what human has the discipline not to care? Journalism, like all crafts, requires a structure that defines the proportions of their craft and then the content, and that structure must be visible to those who care to understand it. The mere assertion of objectivity is not such a structure. It is merely a principle that neither constrains nor compels.

Donald Trump will pass into history, and so too will the passions of the moment. But the problem of objectivity will live on. Anyone can claim to be objective. It is not a structure that guides or constrains. It is just an intent that does not impose order. The irony and intentions of Franklin can be understood and seen in his writing. The problem is not the writing of The New York Times or the selection of stories; it is the assertion of objectivity without definition or rigor.

State of the union

Revisiting the euro’s north-south rift

Income gaps remain, but cross-border flows are more balanced




SINCE THE euro zone was first engulfed by a sovereign-debt crisis a decade ago, northern member states have dished out plenty of strictures. “Greece, but also Spain and Portugal, have to understand that hard work...comes before the siesta,” advised Bild, a German tabloid, in 2015.

Two years later, even as the crisis receded, Jeroen Dijsselbloem, then the Dutch finance minister, told southerners: “You cannot spend all the money on drinks and women and then ask for help.”

Northerners’ constant fear of underwriting southern irresponsibility has led politicians from Amsterdam to Helsinki to put the brake on banking reforms and fiscal integration across the zone. It has caused numerous fights over monetary policy, the latest of which is in full swing. On November 1st the European Central Bank (ECB) resumed quantitative easing (QE), the purchase of bonds using newly created money.

The decision to do so, made in September, was roundly attacked by newspapers—and even former and current central bankers—in northern countries including Germany and the Netherlands. The complaints reflect savers’ dread of negative interest rates and a suspicion that easing lets indebted southern countries off the hook.

Together this can make monetary policy seem like a source of transfers.

In reality, the matter of whether north subsidises south is complicated. Gaps in living standards remain wide, but cross-border flows have become more balanced. And the north is partly responsible for the monetary policy about which it complains.

When the euro first came into being it shackled together a disparate set of countries. GDP per person in Greece, Portugal and Spain was 30-40% lower than in Germany. But Germany, still feeling the aftereffects of reunification, was battling sluggish growth and high unemployment. It was rich, but others were richer.

In Austria average income per head was a tenth, and in the Netherlands a fifth, higher than that in Germany.

In the first decade of the currency union cross-border bank loans fuelled public and private overspending in the south, which pumped up wages and eroded competitiveness. Current-account deficits widened, to 12% of GDP in Portugal and 15% in Greece. When crisis hit, private financial flows dried up.

In Greece, Ireland, Portugal and Spain they were replaced by bail-out funds. TARGET2, a payments system used to settle accounts between national central banks and the ECB, also acted as a buffer, enabling central banks in the crisis countries in effect to borrow from others.

If you divide eight of the countries that joined the euro before 2001 (ie, excluding the mostly eastern late-joiners) into north and south, it is clear that economic dispersion has widened (see chart).

The north—Austria, Finland, Germany and the Netherlands—has raced ahead, with Germany aided by labour-market reforms.

The south—Greece, Italy, Portugal and Spain—has fallen behind. France sits between the two.

In 1999 its income per head was nearly level with Germany’s. It ran a current-account surplus.

Today, with still-high unemployment, debt and a current-account deficit, it seems more southern.




However, southerners rely less on financial flows from the north. In many places balance has replaced imbalance (though stocks of debt are still large).

Consider, for instance, the flow of funds between Germany and Spain. Spain’s current-account deficit with Germany has nearly closed. Mirroring that, net capital flows have shrunk.

In 2006 German investors ploughed a net €50bn ($63bn) into Spain. Last year that fell to €3bn.

The reversals partly reflect relative improvements in the south’s competitiveness. Between 2015 and 2018 German labour costs grew more than twice as fast as those in the south.

Labour flows from south to north. Federico Fubini, an Italian journalist, computes that Germany received 2.7m migrants from other EU countries in 2008-17, up to a third of whom hail from the south. Countries such as Greece and Portugal have lost young and relatively highly educated workers. That means a large transfer of skills and investment in education.

Northerners have other grievances. TARGET2 balances, for instance, are frequently deemed newsworthy in Germany. In 2018, as its credits in the system approached €1trn (30% of GDP), some economists claimed these represented “stealth bail-outs” of countries such as Italy and Spain, which had large debits. Central bankers responded that much of the increase reflected arcane accounting made necessary by QE.

If a southern central bank buys a bond from an investor based outside the euro area, but with correspondent-banking links to Frankfurt, it adds to Germany’s TARGET2 credits. Daniel Gros of the Centre for European Policy Studies, a think-tank in Brussels, points out that these would need to be settled only if the currency union were to disband wholly.

But the resumption of asset purchases means that Germany’s credits will probably rise further, causing more complaints.

An abiding grumble concerns the effects of monetary stimulus. Spanish and Italian banks are by far the biggest users of the ECB’s cheap funding scheme for banks. QE depresses bond yields, meaning lower interest bills for more indebted governments.

But monetary policy is not a zero-sum game between north and south, says Marcel Fratzscher of the German Institute for Economic Research. The German government also benefits from lower interest costs.

Northern countries, which are more export-oriented, have gained the most from a weak euro.

And less stimulus would have been needed in the first place had Germany and the Netherlands spent more at home, pushing up euro-zone demand and inflation, rather than building up huge current-account surpluses.

All these divisions make reforming the currency union a tortuous process at best. On November 5th Olaf Scholz, Germany’s finance minister, said that he would back a common deposit-insurance scheme for the euro zone.

But the catch—and a very big one—is that banks in the south would need to back their large holdings of national sovereign debt with more reserves.

Northerners’ fears of transfers to the south are not going away.

The High Stakes of the Coming Digital Currency War

Just as technology has disrupted media, politics, and business, it is on the verge of disrupting America’s ability to leverage faith in its currency to pursue its broader national interests. The real challenge for the United States isn't Facebook's proposed Libra; it's government-backed digital currencies like the one planned by China.

Kenneth Rogoff




SOUTH BEND – Facebook CEO Mark Zuckerberg was at least half right when he recently told the United States Congress that there is no US monopoly on regulation of next-generation payments technology. You may not like Facebook’s proposed Libra (pseudo) cryptocurrency, Zuckerberg implied, but a state-run Chinese digital currency with global ambitions is perhaps just a few months away, and you will probably like that even less.

Perhaps Zuckerberg went too far when he suggested that the imminent rise of a Chinese digital currency could undermine overall dollar dominance of global trade and finance – at least the large part that is legal, taxed, and regulated. In fact, US regulators have vast power not only over domestic entities but also over any financial firms that need access to dollar markets, as Europe recently learned to its dismay when the US forced European banks to comply with severe restrictions on doing business with Iran.

America’s deep and liquid markets, its strong institutions, and the rule of law will trump Chinese efforts to achieve currency dominance for a long time to come. China’s burdensome capital controls, its limits on foreign holdings of bonds and equities, and the general opaqueness of its financial system leave the renminbi many decades away from supplanting the dollar in the legal global economy.

Control over the underground economy, however, is another matter entirely. The global underground economy, consisting mainly of tax evasion and criminal activities, but also terrorism, is much smaller than the legal economy (perhaps one-fifth the size), but it is still highly consequential.

The issue here is not so much whose currency is dominant, but how to minimize adverse effects.

And a widely used, state-backed Chinese digital currency could certainly have an impact, especially in areas where China’s interests do not coincide with those of the West.

A US-regulated digital currency could in principle be required to be traceable by US authorities, so that if North Korea were to use it to hire Russian nuclear scientists, or Iran were to use it to finance terrorist activity, they would run a high risk of being caught, and potentially even blocked.

If, however, the digital currency were run out of China, the US would have far fewer levers to pull. Western regulators could ultimately ban the use of China’s digital currency, but that wouldn’t stop it from being used in large parts of Africa, Latin America, and Asia, which in turn could engender some underground demand even in the US and Europe.

One might well ask why existing cryptocurrencies such as Bitcoin cannot already perform this function. To an extremely limited extent, they do. But regulators worldwide have huge incentives to rein in cryptocurrencies by sharply proscribing their use in banks and retail establishments.

Such restrictions make existing cryptocurrencies highly illiquid and ultimately greatly limit their fundamental underlying value. Not so for a Chinese-backed digital renminbi that could readily be spent in one of the world’s two largest economies. True, when China announces its new digital currency, it will almost surely be “permissioned”: a central clearing house will in principle allow the Chinese government to see anything and everything. But the US will not.

Facebook’s Libra is also designed as a “permissioned” currency, in its case under the auspices of Swiss regulators. Cooperation with Switzerland, where the currency is officially registered, will surely be much better than with China, despite Switzerland’s long tradition of extending privacy to financial transactions, especially with regard to tax evasion.

The fact that Libra will be pegged to the US dollar will give US authorities additional insight, because (at present) all dollar clearing must go through US-regulated entities. Still, given that Libra’s functionality can largely be duplicated with existing financial instruments, it is hard to see much fundamental demand for Libra except among those aiming to evade detection. Unless tech-sponsored currencies offer genuinely superior technology – and this is not at all obvious – they should be regulated in the same way as everyone else.

If nothing else, Libra has inspired many advanced-economy central banks to accelerate their programs to provide broader-based retail digital currencies, and, one hopes, to strengthen their efforts to boost financial inclusion. But this battle is not simply over the profits from printing currency; ultimately, it is over the state’s ability to regulate and tax the economy in general, and over the US government’s ability to use the dollar’s global role to advance its international policy aims.

The US currently has financial sanctions in place against 12 countries. Turkey was briefly sanctioned last month after its invasion of Kurdish territory in Syria, though the measures were quickly lifted. For Russia, sanctions have been in place for five years.

Just as technology has disrupted media, politics, and business, it is on the verge of disrupting America’s ability to leverage faith in its currency to pursue its broader national interests. Libra is probably not the answer to the coming disruption posed by government-sanctioned digital currencies from China and elsewhere. But if not, Western governments need to start thinking about their response now, before it is too late.


Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. He is co-author of This Time is Different: Eight Centuries of Financial Folly and author of The Curse of Cash.

How The Machine Works

 

 

Summary

 

- Why does the cycle keep "rolling on?"

- It's a simple question, with a simple answer, but investors who came to the party post-crisis aren't well-apprised.

- With but a brief interruption in 2018, the dynamics that have dominated for a decade are still in place.

- Remember: Acknowledging reality doesn't make you less rich, although it might make you less enamored with your own assumed genius.

 

 

Earlier this month, I was perusing a short 2020 look-ahead piece by BofA's US high yield strategist Oleg Melentyev and he struck a tone similar to something I would write.

 

"This credit cycle is turning eleven years old next year and it appears intent to keep on rolling," Melentyev wrote, in a note dated November 2.

 

"The pillars that defined the last 10 years – insatiable investor appetite for yield and corporations willing to take on more debt to improve their EPS – are still largely here," he added.

 

I occasionally have to remind myself that there's a whole universe of investors and would-be "asset managers" who were minted after the crisis, or who, even if they were investing prior to 2008, don't necessarily appreciate the extent to which circumstances have conspired to make it awfully easy to log double-digit gains in passive strategies.

 

Let me make a couple of quick points.

 

First, it's always been easy to log solid returns. I used to make a point of including this caveat in everything I wrote for this platform, but I grew weary of it - it felt perfunctory because it was.

 

I was constantly trying to preempt boilerplate comments from the handful of readers who are inclined to present the accumulated wisdom of Jack Bogle in congealed form as though they had discovered something the rest of us hadn't.

 

Let me just reiterate this for the thousands of new readers who have jumped aboard since I last included it: There is no question that the cornerstone of any portfolio should be a balanced fund with ~60% in the S&P, ~20% in long-end, developed market bonds and the rest split between bills, gold and some selected emerging market exposure.

 

You don't need to spend any time on investment forums to know that.

 

Just read Bogle.

 

I was replicating that exposure for myself using the tips I collected from serving grasshoppers to stuffy millionaires as a bartender before a lot of you knew what stocks were.

Second (and this might seem to run a bit contrary to the first point there because nobody drinks grasshoppers anymore), I'm actually not that old.

 

Of course, it's all relative, so to some readers I suppose I would count as "old," but folks who have read me for the last three years have probably gathered that I'm not ancient.

 

Okay, with all of that in mind, have a look at the following pair of simple charts from BofA's Melentyev:

 

(BofA)

 

 

In the current cycle, non-financial corporate debt has grown by $4.3 trillion.

 

That's in the left pane.

 

BofA describes the right pane, noting that "the value of equity repurchases in [the] form of both share buybacks and M&A [tracks] at $3.7 trillion."

 

To be absolutely clear, there is nothing at all wrong with milking that dynamic for all it's worth if you're a market participant.

 

And there are any number of ways to do that.

 

The simplest way has been to just sit in an index fund.

 

And here's why, from Melentyev:

Our earlier research on this topic has shown that about a 30% of total EPS growth in the last five years was derived from share buybacks alone. M&A transactions have undoubtedly made a meaningful contribution to artificially engineered earnings growth in recent years, although those are more difficult to isolate and measure. In essence, this was the music of this credit cycle – to borrow cheaply and to turn around to improve the bottom line through either share repurchases or M&A.

At the risk of rankling some folks, I'm using broad strokes here to make the point as succinctly and effectively as possible.

 

Have a look at the following two visuals from Goldman:

 

(Goldman)

 

I want to emphasize that there are all manner of ways to slice and dice the numbers on corporate cash usage in order to argue that management teams are actually very good stewards of capital and don't simply plow it all into repurchases willy-nilly.

 

Goldman has done extensive work on this, and my use of those charts is not to suggest that the bank believes buybacks to be out of control or that management teams are reckless.

 

Again, I'm using broad strokes to make a simple point.

 

Generally speaking, this cycle has been characterized by low rates incentivizing debt issuance and financial engineering, where that latter term simply means using the proceeds from debt to fund corporate activities (buybacks or otherwise) that ultimately serve to inflate the bottom line and share prices.

 

The tax cuts at the end of 2017 catalyzed another wave of buybacks.

 

Some of the largest, most heavily-weighted names in the market have accounted for a ton of buyback activity, which in turn helps buoy those stocks.

 

Obviously, that props up cap-weighted indexes and thereby the products indexed to them.

 

Without naming names, too much of what you see on business television glosses over this rather simple reality in the interest of keeping viewers sated.

 

Allow me a brief aside on that.

 

I generally keep it tuned to Bloomberg or C-SPAN at home, but some of the local haunts I frequent on the island don't have Bloomberg TV and wouldn't turn on C-SPAN if I paid them, so I have to settle for CNBC.

 

Quite a bit of the programming the network runs centers around a familiar collection of personalities who, you might have noticed, present as experts on every stock and every sector under the sun.

 

Supposedly, they're "traders" and "portfolio managers," but over the course of an hour, they'll collectively claim to have an informed opinion on everything from Boeing to Apple to Ford to Kimberly-Clark and back again.

 

And it's not just "Well, I owned some of that 10 years ago, and I have no reason to think it's not still a great company."

 

No, these folks will speak authoritatively about any earnings report you care to ask them about, sometimes within minutes of its having been released, despite the fact that even an analyst who spent his or her entire career covering the name on Wall Street couldn't give you a comprehensive assessment that quickly.

Any real PM will tell you that's ridiculous. Think about your own portfolio outside of any index funds you might own. In all likelihood, you spent quite a bit of time researching your individual holdings because, you know, that's what one does when one decides to invest in an individual name.

 

Would you feel comfortable going on national television every day and weighing in on anything that happens to be moving during a given session no matter if you know something about it or not? Of course you wouldn't. Nor should you.

 

Now let me tie that brief tangent into our discussion.

 

One of the main reasons it's possible for a dozen or so people to speak comfortably in public every day about a range of wholly disparate stocks is that in the post-crisis world, it's really all just one trade.

 

Sure, there will be idiosyncratic company risk here and there, but in a world where investment grade corporates can borrow for free (basically in the US and literally in Europe) and TINA ("there is no alternative") is the law of the land, there's essentially no risk in going on television and pin-balling back and forth between "analysis" of whatever names are moving on high volume that day.

 

None of that is to say "it's all fake" or to suggest we're "building castles in the sky."

 

I generally don't like those derisive characterizations of financial engineering as long as "financial engineering" still means something that's on the right side of legal.

 

Although folks like SocGen's Andrew Lapthorne will be happy to explain to you why "borrowing money to buy back your elevated shares is clearly nonsense" (to quote one of his best notes), gains are still gains as long as you have the good sense to lock a portion of them in every once in a while.

 

And yet, there likely is a limit to this.

 

It's just that we haven't hit it yet.

 

What we learned in 2018 is that when policy is normalized it can be highly disruptive.

 

Things went along okay in the US for most of last year, but by the time Q4 rolled around, the combination of tighter monetary policy and political tumult was too much.

Given the juxtaposition between the second half of 2018 and 2019 in terms of how monetary policy has pivoted to reestablish the conditions outlined above and thereby engineer a recovery in asset prices, you'd think it would be abundantly clear to all but the most obtuse observers what's in the driver's seat here.

 

Have a look at this:

 

(Heisenberg)

 

 

And that's just the Fed, ECB, RBA and RBNZ, and only what I can think of off the top of my head.

 

In other words, that doesn't include the myriad emerging market rate cuts and the dozens upon dozens of dovish pronouncements and other soundbites that have emanated from officials over the past nine months.

 

Here's BofA's Melentyev one more time:

The sharp volatility spike in Q4 2018 appeared meaningful enough to give birth to a theory that corporate behavior could change and more companies would engage in deleveraging. While there are some examples of this, the most noticeable change in behavior has happened at the monetary policy committees of major central banks. Both the Fed and the ECB have abandoned their plans to normalize policy and instead turned to more easing in the aftermath of this vol episode. Since then, global yields have collapsed and the appetite to reach for yield and borrow at low coupons has returned, again with some exceptions in cap structures levered to the limit. And if this behavior has defined most of the last ten years of this credit cycle, its ongoing presence suggests that it is likely to keep rolling for a foreseeable future. We think the cycle will turn when this behavior stops.

Does this mean that corporations aren't really healthy - that it's all an "illusion," so to speak?

Well, no. Or at least not in the US.

Clearly, the tax cuts helped (even if they contributed to more financial engineering) and it's worth noting that although the third quarter did, in fact, see the first YoY contraction in S&P 500 earnings since 2016, with nearly 90% of companies having reported, the decline in earnings is only 1%. That's much better than the 3% drop consensus was looking for and if you exclude energy, earnings actually grew.

 

(Goldman)

 

 

But the crucial thing to remember (and I certainly hope this came through in the above) is that it simply isn't possible to disentangle these discussions.

 

Everything has become so tethered to the ebb and flow of monetary policy and its effects across assets that trying to describe the environment without reference to that is not only misguided, it's nonsensical.

 

Perhaps the most poignant illustration of this is the extent to which falling yields (i.e., the bond surge and "duration infatuation") has been reflected in equities.

 

As JPMorgan's Marko Kolanovic put it late last month, "low volatility crowding turned the conventional economics upside down: instead of high-risk stocks leading to higher returns, low-risk stocks consistently produced higher returns."

 

SocGen spelled it out in a recent risk premia outlook piece.

 

"With rates being pushed lower, investors have been forced into chasing the trend in bonds markets [while] in equities, funds have loaded up on Quality and Low Volatility," the bank wrote this month, adding that "CTA Trend funds have been allocating massively to bonds."

 

It goes without saying that the proliferation of "smart" beta products and the factor investing craze have facilitated this. Have a look at this visual:

 

(SocGen)

 

Of course, the more money that gets funneled into popular stocks (e.g., tech heavyweights) the higher the likelihood that the line gets blurred between what's really a "low volatility" stock.

 

The potential exists for things like momentum, low volatility and and growth to become synonymous, especially to the extent growth (as a style) is en vogue in a world where growth (in the traditional sense of the word) is subdued by the standards of historical economic expansions.

 

What we've seen in this regard in 2019 is actually an extension of a long-running dynamic.

 

As bond yields declined over the post-crisis period and central banks persisted in accommodation, investors crowded into bond proxies.

 

CTAs chased the momentum in rates and now the whole thing (duration, low volatility, momentum factors, etc.) is almost literally one trade.

 

In a note dated Friday, Kolanovic illustrated the point, observing that a momentum factor is now almost 100% correlated with a cross-asset CTA strategy which Marko notes "doesn’t even hold any individual stocks, but rather mostly fixed income instruments."

 

(JPMorgan)

 

 

From a tactical perspective, Marko expects the recent bond selloff to continue.

 

That, he said Friday, will probably mean the rotation away from "bubbly" areas (like defensives and low volatility) and into value and cyclicals will continue at least through the end of the year.

 

For what it's worth, Kolanovic does not agree with me that yields will rise fast enough to derail stocks.

 

But for our purposes here, what I want readers to consider is that there's no glory to be had in pretending as though this cycle isn't defined by the dynamics outlined above.

 

It doesn't make you any less rich (your returns aren't any less real) if you come to terms with the reality of this situation.

 

On the flip side, I would argue that not coming to terms with this ultimately will make you less rich (and reduce your returns) because at some point, the machine as described above will bump up against some manner of limit.

That limit could come in the form of central banks hitting a lower bound beyond which rates simply cannot be pushed without something literally breaking (we often toss around the word "break" in a haphazard way, but eventually, banks in Europe and Japan won't be able to function no matter how expertly crafted any tiering regime might be).

 

It may also come in the form of a pushback against what this machine has created.

 

The following chart shows that the 1% in America now controls nearly as much wealth as the 50 to 90 percentile groups combined.

 

(Heisenberg)

 

 

That is due in no small part to the explosion in value of the stocks owned by the wealthiest Americans. The one-percenters now control around $13.3 trillion in wealth tied to corporate equities and mutual fund shares, more than every other percentile group combined (i.e., more than the bottom 50%, the 50 to 90 percentile group and the 90 to 99 percentile group together).

 

Because financial assets are overwhelmingly concentrated in the hands of the affluent, the benefits of all the dynamics outlined above accrue exponentially, not linearly. That, in turn, means that the longer rates stay low, facilitating all of behavior detailed above, the faster this inequality machine is going to spin.

 

As BofA's Ajay Kapur put it this week, "the wealth effect on global plutonomists will be massive, boosting economies and consumption – dominated in size and volatility by rich people."

 

Eventually, that will become wholly untenable, leading to political shifts.

 

At the very least, margins are likely to be crimped going forward as pressure mounts on management teams to share the wealth. Indeed, growth in buybacks has turned sharply negative, even as repurchases are still elevated on an absolute level.

(Goldman)

 

 

Don't look for what's been working over the last 10 years to keep working over the next decade.

 

The political tide is shifting, and central banks have hit the limit.

 

If I had to guess, what's coming next is some manner of public-private partnership between central banks and fiscal policy, that will see deficits directly monetized to fund public works and redistributive initiatives.

 

If that happens, expect a steeper curve and a prolonged rotation to cyclicals.

 

It doesn't require a Democrat to bring about that outcome, by the way. In the US, a second term for President Trump would likely lean in that direction too. Remember, the President is a populist first and a Republican second.

 

Plan accordingly.