Good morning. A quick rundown of what’s on the MoneyWeek website this morning – if you fancy debating the effect of Brexit on farmers, have a read of Simon Wilson’s briefing piece here and give us your views in the comments; get Matthew Lynn’s take on bitcoin if you missed it earlier this month; and while today’s Money Morning is mainly about bonds, it’s worth remembering that stocks are pretty expensive too.
We live in an era that’s unusually prone to financial crises.
We’re almost certain to see another one in the not-very-distant future.
That’s not me talking (although I agree). That’s Deutsche Bank.
And you can blame it all on Richard Nixon…
How the world changed in 1971
Deutsche Bank (which I shall now refer to as DB, for ease) has just released its latest big report on long-term returns from various asset classes. These reports are always interesting and a useful way of gaining perspective on markets.
But the most interesting part of this year’s report is DB’s in-depth discussion of financial crises at the start. I’m going to romp through it very quickly although I might return to some of the finer details later this week if we get time.
DB’s conclusion – looking back over several centuries – is that our era is unusually prone to financial crises. Why? Primarily because it has become easier to take on debt.
In 1971, US president Richard Nixon severed the global monetary system’s last connection to the gold standard. The resulting collapse of the post-World War II Bretton Woods currency regime made it easier for countries to ramp up debt levels, while financial deregulation also enabled rampant money creation by banks (this is a tale that regular MoneyWeek readers will have heard Bill Bonner tell on many occasions. It’s just nice to see it get an “official” endorsement).
The trouble is, the more debt piled up in a system, the less stable it is. That’s how leverage works. To wrap your head around this idea, just think about house prices.
If you own your house outright and house prices fall by 10%, it’s pretty much irrelevant. If you’re sitting on a 90% mortgage and a precarious employment situation, it’s potentially life-ruining.
As a result of all this debt, you get more financial crashes. However, at the same time, it’s also easier to bail the system out afterwards, because there are no restrictions on credit creation. “In a fiat currency world, intervention and monetary creation is the path of least resistance.” Hence the tendency for central banks to step in at a moment’s notice to bail out the troublemakers (usually the banks).
The danger with this, of course, is that “by continually using stimulus to deal with crises and not letting creative destruction take over, you make a subsequent crisis more likely by passing the problem along to some other part of the global financial system, and usually in bigger size.”
Put bluntly, the modern era is one of colossal financial moral hazard. I realise it sounds old-fashioned and slightly puritanical to talk about moral hazard. And it clouds the argument somewhat, because it makes it sound like we all need to be “punished” in some way. So let’s try to frame it in a more neutral manner.
Being on the gold standard made it very hard to expand the money supply. That was overly restrictive sometimes and not always very helpful. But being off it, makes it all too easy to rely on monetary expansion to deal with any sort of discomfort at all. And the risk is that in doing so, you store up more trouble for tomorrow.
Which brings us to where we are today. Sitting on levels of “record peacetime government debt and multi-century low bond yields”, and facing the problem of “unwinding unparalleled central bank balance sheet sizes”.
To spot the next financial crisis, stick with the obvious candidates
So where’s the next crisis coming from?
DB runs through a long list of potential flashpoints, all of them potentially valid, but with financial crashes, I find it’s not a bad idea to focus on the obvious. That might sound odd, as there’s still this view that the 2008 crisis came out of the blue. But that’s nonsense (I’d phrase it more aggressively than that, but this is a family newsletter).
Remember that US house prices started falling in 2006. Even if you dismissed the potential for that to cause problems (bearing in mind that there were property bubbles in most other developed nations too), then the clues mounted thick and fast after that.
Hedge funds were imploding regularly by mid-2007. Northern Rock blew up in September 2007. Bear Stearns went in April 2008. By that point you’d have had to be wilfully blinkered – or in a position of power and desperate to pin the blame on someone else – not to realise there was a big problem somewhere.
The same goes for most financial crises. You might not know when they’re going to crack, but you can see where it’s going to go wrong – the dotcom bust is an obvious example.
Right now, there is no asset in the world more glaringly overvalued – and more important – than the bond market. All of the other overvaluations – the US stockmarket, house prices in various large pockets of the world – are symptoms of this particular bubble.
What makes this view more compelling (I think), is that it’s also the only outcome that is both blindingly obvious yet also so unthinkable that most people can’t imagine that it would ever come to this. There are still plenty of people who deny that a bond bubble is even a possibility.
As a result, I can’t escape this idea that the most feasible path for a future financial crisis is via the bond market. And the one thing that bonds hate more than anything else is inflation.
As I noted in yesterday’s Money Morning, Hugh Hendry has signed off from running his hedge fund with one potential parallel for the modern day – 1965. And as the DB team point out, politics is getting inflationary too: “the recent rise in populism… is as much a rebellion against an era of depressed real wages as much as anything else and it’s starting to get to a point where important national votes are now being won.”
Inflation is of course, also the best way out of our current predicament. It will “eventually see the debt burden adjust to systemically lower levels in real terms”, note the team at DB. But as the experience of the 1970s shows, it’ll be a heck of a bumpy ride to get there.