Credit Writedowns

Now, you may well deduct from all of this that I am as bearish as I have ever been, but nothing could be further from the truth. The issues I have discussed in this month’s letter are clouds on the horizon which are likely to take years to play out and, in the meantime, investors will continue to be preoccupied with far more mundane issues. All I know is that financial markets cannot stay disconnected from economic fundamentals forever so, ultimately, the Tony Dyes of the world will be proven right. Unless they lost their jobs beforehand, that is.

In the short term, though, a continuation of the currently lax monetary policy is likely to lead to higher assets prices. The investor mindset is very much in risk-on mode at the moment, as documented by the surprisingly calm reaction to the crisis in Cyprus. Mind you, none of this incorporates the risk of an outright war between the two Koreas or an escalation of hostilities between Israel and Iran, just to mention two wild cards. Barring a Black Swan event, though, we are on relatively firm ground for now, but the seeds of the next crisis have already been sown.

The seemingly never-ending debate on passive vs. active investment management is beginning to annoy me. The discussion is one-dimensional and, at times, completely derailed. I shall be the first to admit that the long-only industry has not covered itself in glory in recent years. Nor has large parts of the alternative investment management industry for that matter. It is nevertheless the wrong discussion to have.

“Who is afraid of currency wars?” asks Gavyn Davies in the FT. I have known Gavyn for 25 years and have to confess that he is way out of my league intellectually. He is one of the smartest people I have ever met and, thankfully, also one of the humblest. He rarely gets things wrong so, when I occasionally disagree with him, it always makes me slightly uneasy. In his latest post in the FT, he makes the valid point that the currency war debate has flared up yet again following newly elected Japanese Prime Minister Abe’s decision to change tact and openly bully his own central bank into action.

Yet Gavyn – and he is certainly not alone in that regard – ignores one important aspect in his argumentation and that has to do with what actually drives exchange rates. Just because a currency is depreciating doesn’t mean it is subject to manipulation. A quick look at chart 1 makes it pretty clear that the recent weakening of the yen is just a tiny blip on the curve. It all begins with the outlook for bond yields which, if you believe various commentators, is extremely bleak.

By Niels Jensen The Absolute Return Letter, December 2012 “It’s one thing to have an opinion on the macro, but something very different to act as if it’s correct.” -Howard Marks, Oaktree Capital Management It can be a frustrating, and rather futile, experience to be an economist. Financial markets do not always behave as if there is a connection between [...]

Three years on, I remain absolutely convinced that deflation, driven primarily by consumers eager to repair their balance sheets, will be a powerful force for many years to come but, at the same time, I must admit that I see worrying signs of inflation expectations beginning to creep in.

I have been an observer of financial markets, and of those who operate within the markets, for almost 30 years. I have never before experienced investors paying more attention to career risk than they do at present. A preoccupation with career risk changes behavioural patterns. Decisions become more defensive, and sometimes less rational.

I note that several of the policy mistakes listed above date back to the same period, namely the late 1990s. Not only does it demonstrate the gung-ho approach of the time, but it also goes to show that policy mistakes do not necessarily rear their ugly heads immediately and, by the time they do, the damage has been done.

We are staring into a cyclical downturn in the second half of this year. Behind that is a whole other set of challenges, more structural in nature, which will take years to sort out. Our American friends – except for a small but rather vocal minority – won’t accept that they have their own set of problems which are quite serious. Our Asian friends will continue to ‘cheat’ their way to prosperity until we put our foot down. And the Europeans will argue ‘til the cows come home about what is the right remedy for our disease whilst society as we know it unravels around us. But, it is not all doom and gloom. As Churchill used to say (and I paraphrase), they will eventually make the right decisions once they have pursued every other avenue. It is precisely for that reason that equities are cheap. We just don’t know how long it will take.

From a game theory perspective, the moment one of the 17 eurozone member countries realises it would be better off outside the eurozone, it has everything to gain from being the first mover. We have all been led to believe that a break-up will be devastating for everyone. That is not entirely the case. It could certainly prove disastrous for those left inside a dysfunctional currency union but for the first mover the advantages are numerous and it is only a question of time before someone in Greece, Spain, Portugal or Italy reaches that conclusion.

Our brains are not calibrated to deal with the unexpected. Most of us believe we are good risk managers but in reality we are not. Most of us trust that risk can always be quantified and expressed through some fancy modelling whereas, often, it cannot. The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. The return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect.

Remember the scene in A few Good Men where Colonel Jessup (Jack Nicholson) and Lieutenant Kaffee (Tom Cruise) trade insults? Following some pretty intense questioning, Kaffee yells at Jessup: “I want the truth”. With the deadly glare that only Jack Nicholson can muster, Jessop retorts: “You can’t handle the truth”. I was reminded of this rather famous moment in film history when a long time reader of the Absolute Return Letter asked me recently: Why don’t you tell the truth about the UK economy? Why don’t you tell it as it is – that the situation in the UK is worse than it is in the eurozone? I decided to take up the challenge from the reader. I am not sure that I actually agree that the UK is in a worse position than most eurozone countries; it is worse in some respects but better in others. More about this in a moment.