Don Coxe is chairman of Coxe Adivsors LLP and is an advisor to several commodity funds. He has been consistently ranked as a top portfolio strategist and received a lifetime achievement award from Brendan Wood in 2011. He will be sharing more insight with Inside the Market readers next month.
It was so easy for so long… For almost five years, the Fed and the Treasury, and the Bank of China and the Politburo, have been printing and lending money at a rate that might have drawn approbation from the Bank of Weimar.
Once the shadow banks – hedge funds here, and state and local enterprises there – understood that they had no interest rate or volumetric risks to constrain their borrowing, they became the premier users – and abusers – of “financial heroin.” (In 2009, in our discussion of The Power of Zero , we coined the term “financial heroin” for the seemingly limitless liquidity being injected into the veins of the economy; the biggest and baddest banks were mainlining, and we deemed this a habit that would be hard to break.)
Money supplies exploded in both of the world’s biggest and most influential economies. Interest rates dove and stayed stuck at levels that central bankers believed would lead to sustained growth.
Across the industrial economies, five years of unprecedented monetary expansion were accompanied by deficits at levels that Keynes would have deemed guarantors of strong growth.
So why haven’t these drastic policies worked? Why, for example, are companies sitting on cash with near-zero returns or using it to buy back stock rather than investing for future earnings growth?
First, we must understand why the hectic monetary policies and zero interest rates have lasted for so long.
Dr. Bernanke gave a series of lectures last year at Princeton explaining the Fed’s interest rate policies. A student asked why he wasn’t concerned about the impact of his policies on seniors accustomed to saving through insured bank deposits, and on pension funds that cannot meet their goals because of the minimal interest rates.
He responded that the Fed was aware of these collateral effects, but explained that the Fed had just two mandates: controlling inflation and maintaining economic growth at acceptable levels. Nothing in those mandates referred to the externalities that so concerned the questioner. But he made it clear that the unconventional policies would not be continued once the economy showed signs that the Fed’s therapies were finally curing the patient’s recession disease.
With that assurance Bernanke had placed “Chekhov’s Gun” on the Fed’s Wall. A century ago, that renowned Russian playwright noted that if a theatre set included a gun on the wall or the mantel piece in the First Act, it would be surely be fired in a later act. And, once the gun was used by one character against another, the situation of all the players was irretrievably transformed.
The Gun has not yet been fired...yet.
But in June Dr. Bernanke made it clear he believed that he – or his successors – would reach for it soon. That pledge immediately roiled financial markets long addicted to the Fed’s heroin. In particular, hedge funds responded in horror, unwinding positions across much of the financial spectrum. In the ensuing turmoil, many observers recalled Warren Buffett’s dictum: “When the tide goes out, you find who’s been swimming naked.”
Simultaneously, the Bank of China began imposing a tourniquet on the reckless speculation in the shadow banking systems in all too many of its provinces. That dangerous process had forced spectacular money supply growth, and spawned corruption and insta-billionaires who aroused widespread resentment about the privileges of a new class of new rich. Its sudden termination unleashed a wave of bankruptcies.
The simultaneous challenges to financial liquidity in the two biggest economies stunned stock and bond markets worldwide. From Paul Krugman on the American Far Left to the economics departments on Wall Street, this turmoil triggered rage against the Fed and the Bank of China.
The supply of financial heroin was suddenly being constrained by the markets themselves, and the addicts continued to react in pain and fury.
Heroin was the battlefield anesthetic of choice for severely wounded soldiers in World War II. The key for doctors was to monitor the recoveries of the grievously wounded soldiers: once they showed signs of survival, and as soon as possible, the heroin had to be reduced and then withdrawn, because the patients would otherwise become addicts. They would then be unfit not only for the risks of the battlefield, but for the demands they would face when they returned home.
Moving to morphine and other less potent pain-killers had to be done while a soldier was still in great pain, and was insisting that the doctor maintain the heroin “just a little longer.”
Zero interest rates are mortal enemies for what Albert Einstein called “The greatest force in the universe” –compound interest rates.
Lowering compound interest rates to record-low levels, attacked two core concepts of capitalism: the pricing of risk across the spectrum and the compounding of returns.
Capitalism is the first economic system to be based on the pricing of risk and the compounding effects on economic growth through saved investment returns–and therefore has the most to lose from the prevention of its operation.
That process of compounding is the basic formula for funding pension plans–and it provides the fuel for a growing economy.
The biggest winners from nearly-free money have not been the free market production and capital investment that together drive economic growth. Once borrowing costs became negligible, speculators took over from long-term investors. As a renowned Wall Street veteran told me. “The hedgies’ time horizon is lunch.”
This etiolation of the life force of capitalism works in other unproductive ways: Once highly-taxed investors came to believe that zero rates were going to be around for many years, they began switching from bonds into stocks with high, reliable – and lower-taxed – dividends. The balance between dividends and growth in equity valuations which had shaped capital markets and economies for many decades shifted from growth to income.
Consider the impact on the financial strategies of some of the major technology companies that have shaped our economy: IBM, Microsoft, Apple and their brethren have been borrowing big at surreally-low rates to pay dividends and, in some cases, to buy back their stocks. Not a dime went into capex. The biggest IPO sensation of the year, Apple’s first bond issue, was oversubscribed many times in an orgy of demand – recalling the dot.com IPOs at the peak of what would soon become tech’s Triple Waterfall collapse. In retrospect, Apple’s first was the heroin addicts’ last, maniacal gasp for gains in bonds.
As the sardonic song of the Nazification of Germany (in Caberet, the musical of 30’s Berlin) advised, “Money makes the world go round.”
Money going into stocks for their 3 per cent dividends is hardly stimulating economic growth. It responds to investors’ desire for secure money NOW, not potential growth later. That is a potentially lethal lust for the continuance of capitalism.
In that environment, the best-performing bonds have been junk bonds, a group heavily dominated by LBO securities whose issuance enriched so many private equity magnates. Once again, the huge growth in junk bonds has not been a sign of burgeoning economic growth, but of shrewd cashouts by wealthy elitists in the shadow market.
Grand scale short-term gain with no risk of short-term pain is no recipe for long-term capitalist growth. The longer the financial heroin flows, the more the capitalist forces of risk and reward will be skewed away from economically productive growth through long-term investing.
Caught in the fallout from the sudden switch in speculators’ liquidity situations have been shares and bonds in emerging markets, including so many economies that were moving up the learning curve of capitalist economic and fiscal strategies. Those nations as a group have collectively managed positive growth since the industrial world plunged into Depression conditions. Again, it was levered speculators who have panicked, as the margin clerks sharpened their pencils, and emerging markets became submerging markets for the first time in 15 years.
Result: growth forecasts for the emerging economies are already being marked down. The explanation for shell-shocked finance ministers in those countries as they ask, “Why us?” is that no good deed goes unpunished when virtue’s values are being systematically downgraded.
So what is a true investor with a time horizon longer than days, weeks or even months to think about the turmoil attending the promise of staged heroin withdrawal?
We believe that the phase-out of the heroin is an occasion for rejoicing. Let the tapering begin!
1. The Fed – and the Bank of China – are displaying some confidence that the worst of the recession is over and growth, albeit modest growth, is about to resume.
2. Capitalism is the system that has produced most of the economic growth in the world for the past two centuries. According to Niall Ferguson, in 1978 when Deng Xiaoping became impressed with how the working class benefited from capitalism, the average American was 22 times as rich as the average Chinese; today the ratio is five to one. That is the most astonishing large-scale growth in wealth in the history of the world, and it was achieved because Deng and his followers embraced capitalism and abandoned Marxist-Leninist economic formulas. India, Indonesia, Vietnam, Chile and Colombia have had similar transformations. Even Russia under Putin has embraced a form of state capitalism under KGB auspices. (Tragically, the new governments that replaced the old dictatorships in the Arab Spring have not embraced capitalism and pluralism, but have accepted the doctrine that “Islam is the answer.” That principle of piety was framed to show a believer how to lead a virtuous life leading to an eternity in Heaven, and not to explain how to create opportunities and economic progress in the competitive global economy of here and now.)
3. As long as the monetary heroin was enriching the very rich and not stimulating risk-taking and long-term investment, the booming stock market–particularly the S&P 500–was not engaged in a virtuous interaction with the economy to permit sustained rising earnings forecasts based on sustained, visible economic growth.
4. Contrast that rally with the Reagan Rally and the subsequent stock market booms which came when interest rates on Treasuries fell from 15.7 per cent in a three-decade-long bull market that not only enticed investors to invest for growth, but supplied the equity capital for growth. A bond rally that lasts so long and drives rates down to all-time lows is ultimately gripped by greed in a new form: income – not growth. Immediate pleasure from one’s treasure rather than deferred growth of wealth through compounding. That attitudinal shift is a challenge to capitalism.
We welcome the return to risk in the stock market and we welcome China’s determined – and drastic – assault on the dark corners of its unbridled experiment in capitalism. The spectacle of the creation of vast numbers of nouveaux-riches from speculation and bribes in a supposedly egalitarian and communitarian society was a serious challenge to the continuation of the China Miracle.
The Roman Empire dominated most of the known world in its time as long as its system of a citizen army and the virtuous leadership of Augustus and his successors bore resemblance to how Rome thereafter actually functioned. It could not long survive Nero and Caligula.
We are long-term investors with a special interest in companies that produce what a growing global economy absolutely needs–food, fuels, and metals. Our companies came through the crash without resort to bailouts or handouts or cashouts. They are among the purest exemplars of capitalism as it was conceived, as it evolved, and as it triumphed. Naturally, they are being recommended by almost no Wall Street houses, whose swollen balance sheets with non-market-priced assets are financed with near-zero-cost liabilities.
We look forward to a return to the systematic pricing of risks and rewards. Getting from here to there will be painful after such sustained ingestion of heroin, but the sooner that process begins, the better it will be for economic growth, workers, savers, pension funds–and equity investors. (Already, according to Mercer, the funding levels of major U.S. corporate pension funds have benefited dramatically from the panicky leap in long-term yields.)
If, as we believe, capitalism will survive the heroin era, then its most conspicuous exemplars should find the later years of this decade to be an era of true growth and rewarding returns.
 The Great Degeneration: How Institutions Decay and Economies Die: Niall Ferguson, Penguin Press HC, June 13, 2013  Mr. Coxe leads the Global Commodity Strategy investment management team – a collaboration of Coxe Advisors and BMO Global Asset Management – to create and market commodity-oriented solutions for investors. He is advisor to the Coxe Commodity Strategy Fund and the Coxe Global Agribusiness Income Fund in Canada, and the Virtus Global Commodity Stock fund in the US, and the UCIT Global Commodities Fund, as well as accounts for clients of BMO Global Asset Management.