Socgenpopular Delusions

World Global Strategy

12 November 2009

Popular Delusions Knowing what you don’t know: random thoughts on value, volatility and inflation

Dylan Grice (44) 20 7762 5872 [email protected]

Although few predicted it, we “know” the Berlin Wall was destined to fall with hindsight. Yet when it did, it was triggered by events which were unpredictable even with the same hindsight. Our governments look insolvent. Historically this has caused inflation and funding crises. But as with predicting the demise of communism in the East, who knows when? With government bonds overvalued and inflation expectations “generous” it feels wrong that risk assets and volatility trade around their historical averages.

“The corrupt and brutal regime of President Ceausescu of Romania was infamous across the world. His ferocious government had run the country emphatically for many years, crushing any signs of dissent ruthlessly. In November 1989 he was re-elected President for another five years as his supporters at Party Conference gave him forty standing ovations. Q

On December 21st the President, disturbed by a small uprising in the western city of Timisoara in support of a Protestant Clergyman, was persuaded to address the public rally in Bucharest.

Q

One solitary man in the crowd, Nica Leon, sick to death with Ceausescu and the dreadful circumstances he created for everyone started shouting in favour of the revolutionaries in Timisoara. The crowd around him, obedient to the last, thought that when he shouted out “long live Timisoara!” it was some new political slogan. Q

They started chanting it too. It was only when he called, “Down with Ceausescu!” that they realized something wasn’t quite right. Terrified, they tried to force themselves away from him, dropping the banners they had been carrying. In the crush the wooden batons on which the banners were held began to snap underfoot and women started screaming. The ensuing panic sounded like booing. Q

The unthinkable was happening. Ceausescu stood there on his balcony, ludicrously frozen in uncertainty, his mouth opening and shutting. Even the official camera shook with fright. Then the head of security walked swiftly across the balcony towards him and whispered, “They’re getting in”. It was clearly audible on the open microphone and was broadcast over the whole country on live national radio. Q

IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 9

Q

This was the start of the revolution. Within a week Ceausescu was dead”.

www.sgresearch.socgen.com

Jon Snow of the BBC, quoted in “Wall and Piece” by Banksy

Popular Delusions

Inevitable randomness Watching some of the documentaries over the weekend marking the 20th anniversary of the fall of the Berlin Wall, I found myself marvelling over and over at the extent to which arguably predictable events can have unequivocally random triggers. I say arguably predictable because, although most commentators were completely caught out by the sudden demise of hitherto steadfast communist regimes, a minority understood exactly why they would one day fall. But no one could possibly have known when. Proving that economists don’t have a monopoly on cringeworthy predictions, Ceausescu famously said weeks before he was toppled that democratic reforms would occur in Romania only when pears grew on apple trees. Presumably he attached a probability of zero to the existence of a Nica Leon. The Berlin Wall itself might even have come down by accident. An announcement on easing restrictions on East Germans’ travelling to West Germany was botched by politburo spokesman Gunter Schabowski, who seems not to have properly read his brief. Not knowing when the new policy was to come into effect, and pressed by the foreign media during a live broadcast to give a date, he blurted out “immediately, without delay”. Minutes later a newsreader at ARD in West Germany broadcast that “This 9th of November is an historic day. East Germany has announced that, starting immediately, its borders are open to everyone!” Of course that wasn’t the new policy, and it wasn’t supposed to be effective immediately. But by then it was too late. The broadcast had been picked up all over East Germany and, within hours, check points across the border were crowded with hundreds of thousands of deliriously ecstatic East Germans celebrating their new-found freedom. Why is this relevant? Consider the following chart summarising market valuations. The red marks show where we are currently in terms of standard deviations from the historic mean and the lines show the historical ranges. Nothing to see here: current valuations in historical context – (std deviations from average) 8 6 4 2 0 -2 -4 -6 S&P500 (1881-now ) Source: SG Global Strategy

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Bonds (1881-now )

Credit (1921-now )

Volatility (1900-now )

Popular Delusions

At first glance it seems there’s nothing to get excited about. Risk assets – equities and credit – are on the expensive side of their historical ranges, though hardly egregiously so. But two things stand out: volatility is right on its average and government bonds are expensive.

Neurological tricks and equity volatility This subdued volatility makes me nervous. Bloomberg’s Betty Liu interviewing Warren Buffet in early March remarked that analysts were complaining they couldn’t value their companies in this “new environment” because no one had any idea what the future held. Even CEOs wouldn’t give forecasts because they had no visibility for the rest 2009 or even beyond. Buffet replied with typical candour: “Betty, we didn’t have any visibility in 2006 either, we just thought we did … people say “Oh, the future’s too uncertain now” … Well the future was uncertain then, or in 2007 too, they just didn’t know it was uncertain.” 1 This is a fundamental truth. The future is always uncertain. Only the extent of our selfdeception changes over time. Nicolas Taleb has famously explained why and how we live with this delusion and how our cognitive system overrides the role of the random. The Nica Leons and Gunter Shabowskis of the world are airbrushed out because their existence poses intractable questions. Indeed, the natural state of the mind is to see order even where there is none, a happy delusional equilibrium tricking us into seeing what can’t be seen. 109 years of variant delusion – DJIA daily volatility 80% 70% 60% 50% 40% 30% 20% 10% 0% 1900 1909 1918 1927 1936 1945 1954 1963 1972 1981 1990 1999 2008

Source: SG Global Strategy

And if equity volatility is a proxy for market visibility, then current equity volatility at its historical average suggests we are in such a delusional equilibrium right now. And thanks to Taleb’s insights, which teach us that this delusional equilibrium is merely a neurological sleight of hand and not based on anything fundamentally true, the current confidence exhibited by the “average” level of equity volatility today isn’t based on anything fundamentally true either. It’s based on the tricks of our collective minds.

1

Interview with Bloomberg’s Betty Liu recorded on 5 & 6 March 2009

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Popular Delusions

Events which are unexpected enough to disturb the delusional equilibrium must happen, because truth outs eventually. Sometimes the unexpected is worth savouring: the Berlin Wall fell; Nelson Mandela was released. Sometimes they’re not: the Asian economies weren’t tigers, and the sub-prime crisis wasn’t contained. Yet these surprises are the events which create opportunity. CEOs refusing to forecast, analysts complaining they have no visibility, risk appetites declining across asset classes and equity vol “spiking,” like some sort of collective mental breakdown, is the least risky time to invest. The illusion of predictability is shattered, and the reality of uncertainty temporarily fairly priced. Temporarily because we know that our brains are hardwired to reassert the delusional equilibrium. The next chart shows valuations in November of last year and March of this. On each occasion volatility was historically high. With the collapse of Lehman (November) and concern that governments were about to go bust (March) the market then knew that it didn’t know. Volatility more closely reflected the reality that we never know what’s around the corner and risk prices reflected the emotional discomfort such realisation causes. It was a good time to be active. In November credit was cheap while in March equities were a bit cheap. Today volatility is low/average. We’ve forgotten that we don’t know. We’ve once again found our happy, delusional equilibrium which allows us to pretend our world is ordered. It’s fun and it’s comfortable, but it’s not the time to be making aggressive bets. November 2008 valuations

March 2009 valuations

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4

-6

-6 US St ocks

Bonds

Cr edit

Volat ilit y

US St ocks

Bonds

Cr edit

Volat ilit y

Source: SG Global Strategy

The mispricing of long-term inflation risk One event which might some day cause such a vol spike is a repricing of inflation risk in the bond market. I’ve written in detail about the historical relationship between fiscal strain and inflation. Although inflation is widely considered a monetary phenomenon, past episodes of runaway inflation – from ancient Rome to modern day Zimbabwe - have generally had as their root cause a government unable to pay its bills. They have been fiscally generated. 2 Some have argued that fiscal scare stories shouldn’t be taken seriously because government debt to GDP remains at manageable levels even after the gargantuan fiscal stimuli. And, if the true measure of government liabilities were represented by the red bars below (on balance sheet government debt), then I’d agree. But they’re not. Our governments account for pensions and health promises in a way which no company would ever get past its auditor, on

2

4

See “Inflation is Always and Everywhere a Fiscal Phenomenon”, Popular Delusions 09/10/09

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Popular Delusions

a current period flows basis. A more accurate actuarial estimate of capitalised net liabilities has been done by Gokhale, with his results shown as the grey bars. Are our governments solvent? Official Net Debt, % GDP *

To tal net liabilities (o n and o ff balance sheet), % GDP **

750%

500%

250%

0% Germany Spain France * 2010 OECD pro jectio ns ** 2005 estimates o f to tal Fiscal Imbalance

Italy

UK

EU

US

Source: SG Global Strategy, OECD, Gokhale (2009)

I don’t see how our governments can pay these liabilities. EU and US net liabilities add up to around $135tr alone. 3 That’s four times the capitalization of Datastream’s World equity index of about $36tr, and forty times the cost of the 2008 financial crisis. Our governments appear to be insolvent. They’re liquid, so they can stay afloat the way the Detroit auto companies did for years despite being insolvent. But unlike the Detroit auto companies, our governments’ debt doesn’t trade at distressed prices and as an effective option on finding an escape from impending bankruptcy. I think they should. Such liabilities have historically crippled governments (and economies, and companies, and anyone else for that matter). And although governments usually default via inflation, our governments are short real goods and services (e.g. earnings-linked pensions, health care), which they won’t be able to inflate away. This means there will ultimately be even more pressure to inflate away whatever they can. That’s not to say there’s anything inevitable about inflation as an outcome. Retirement ages and taxes will certainly rise, entitlements will be cut and this will lower the burden. Gokhale suggests that in the absence of any policy changes an increase in government saving of 8% of GDP into perpetuity would restore balance. But this implies some very tough decisions, and our governments haven’t demonstrated such toughness in a long time. With a 30y implied rate of just 2.4% the bond market seems to be backing them. It’s surely worth looking at ways to take the other side of that bet?

3

As far as I’m aware, Gokhale hasn’t done any calculations for Japan but they’re in the same boat

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Popular Delusions

Trust your government! 30y inflation breakevens show no concern over government insolvency 3.5

3

2.5

2

1.5

1

0.5

0 05/2002

05/2003

05/2004

05/2005

05/2006

05/2007

05/2008

05/2009

Source: Bloomberg

If you’re still not convinced, consider the following chart showing the distribution of US inflation rates in recent decades. Inflation has averaged 3.7% since 1951 when the Fed discontinued its bond yield fixings. True, this includes the inflationary 1970s. But if we exclude that period and calculate the average inflation rate from 1982 to the present (the “Great Moderation”), we find that it has averaged just over 3% in this time. So 30y inflation expectations are currently pricing in an even more benign inflationary environment than during the central banking’s golden age. 30y inflation breakevens show no concern over government insolvency: distribution of post WW2 US headline inflation rates 100 90 Implied 30y average inflatio n

"Great M o deratio n" average inflatio n rate

80 70

P o st WW2 average inflatio n rate

60 50 40 30 20 10 0 -2

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

Source: SG Macro Strategy

If inflation is mispriced, so is everything else Risk assets exist in the orbit of “risk free” assets, so this isn’t just a bond market problem. It’s true that equities look cheap if we anchor around the last twenty five years or so. The

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Popular Delusions

following chart shows the Shiller PE for the S&P500, alongside the US market’s median priceto-book, is at the low end of its range. Equity valuations might be considered “unchallenging.” Stocks historically cheap?

45 40 35 30 25 20 15 10 5

Shiller PE

Median PB 2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

0

Source: SG Macro Strategy, Shiller, Factset

But the next chart shows how misleading narrow historical framing can be. During the 20th century, the ultra-low valuations have occurred when inflation wasn’t under control. Low/stable inflation regimes, which I’ve loosely defined as occurring during the 1920s, the 1950s to the early/mid 1960s and the 1980s to the present, have seen considerably higher Shiller multiples than inflationary regimes. The average multiple during inflationary regimes has been 12.2x. During price stability it has been 19x. Shiller PE shifts during inflation regimes Price St abilit y

50

4

45 3.5 Price St abilit y

40

Price St abilit y 3

35 30

2.5

25 2

20 15

1.5

10 1 5 WW1 inf lat ion 0 1881

WW2 Inf lat ion

60s inf lat ionary pressure eplodes in t he 70s

???? 0.5

1891

1901

1911

1921

1931

1941 Shiller PE

1951 1961 M edian PB

1971

1981

1991

2001

Source: Shiller, Factset, SG Macro Strategy

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Popular Delusions

When will inflation become a problem?! For all my emphasis on long-term inflation there is no sign at all of cyclical inflation pressure. So when will this inflationary maelstrom visit us? When will our governments wake up to find the capital markets closed to them? When will they be forced to fund their working capital requirements with the printing presses? What will trigger this crisis? The truth is I don’t know. Maybe it won’t happen for another ten years, by which time the Hospital Insurance trust fund assets will probably have been run down, leaving it reliant on current government revenues for funding. 4 Or maybe the trigger will be Japan. The domestic savers who have been the biggest buyers of JGB are now retiring and running down their assets (the Japanese saving ratio is now almost zero). Doesn’t this mean there are now no buyers of JGBs? Such a funding crisis could easily force the government to pay its bills with printed money. It might even cause contagion across developed bond markets as everyone realises we’re all in the same boat. The oil markets could be a source of volatility too. While the biggest single source of improvement in the US current account deficit has been lower oil prices, the Guardian reported on Tuesday that an IEA whistleblower said the US applied pressure on them to inflate their potential reserve estimates because revealing the true state of the energy markets’ supply potential would cause panic buying. So maybe Matt Simmons is right. Maybe Saudi oil production has peaked and we face a looming energy shortage worse than that of the 1970s. Maybe this will morph into a funding crisis for the US government. Maybe it will be none of the above. Maybe a spiritual descendent of Gunter Shabowski, the politburo spokesman who accidentally brought down the Berlin Wall and exposed the unsustainability of the communist model, will do the same thing for our governments’ fiscal positions. A stray comment at a press briefing might be erroneously interpreted as meaning China wants to sell all its Treasury holdings, and this might set in train an irreversible cascade of financial panic. I wish I knew. But I don’t. What I do know is that, like Eastern Europe before the fall of the Berlin Wall, our governments’ current actions are inconsistent with long-run stability. I know that not being able to predict the crisis trigger doesn’t mean there isn’t a crisis trigger. I know that with human nature being what it is, people assume that because outcomes such as government funding crises and runaway inflation haven’t troubled developed markets for many decades, they can’t ever happen again. And I know that with volatility at these levels the market is much more confident in its ability to predict what lies in the future than I am. So while there are some interesting micro exceptions, (I’ve written about agriculture in recent weeks and will write about others shortly) from a purely top-down perspective I just can’t get excited about the reward being offered for the risks we face.

4

See the “2009 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal

Supplementary Medical Insurance Trust Fund” page 16

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Popular Delusions

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