QBAMCO On Unreserved Credit Growth And Imperial Constraint
Authored by Lee Quaintance and Paul Brodsy of QBAMCO,
“Crucifixion can be discussed philosophically until they start driving the nails.”
- Wallace Stegner
This piece seeks to make the economic case for savers to allocate wealth to physical gold (in proper form) and for investors to allocate capital to precious metal miners. Our argument orients readers with our economic and market predispositions, seeks to explain current macroeconomic events within that context, outlines gold’s fundamental valuation framework, and then applies that framework to gold and various financial asset investment choices. The piece is long and may be best consumed at home.
Hypothesis: Due to decades of unreserved credit growth that temporarily boosted the appearance of sustainable economic growth and prosperity, rational economic behavior cannot produce real (inflation-adjusted) economic growth from current levels. The nominal sizes of advanced economies have grown far larger than the rational scope of production that would be needed to sustain them. This fundamental problem explains best the current state of affairs: malaise (i.e., bank system de-leveraging and economic stagnation) spreading through the means of production and the need for increasing policy intervention to stabilize goods, service and asset prices (by depressing the first three and inflating the last?).
1. Most of the last forty years represented a golden age of financial asset investing that is unlikely to be repeated for a very long time. Consider that the last generation benefitted greatly from a unique combination of factors, including:
- a global monetary system that for the first time (1971) allowed currency to be created entirely in the banking system through lending activities, without material constraint
- a generation of declining global interest rates coincident with perpetually easy credit conditions (beginning in 1981)
- very little initial debt on household and government balance sheets as a percentage of assets and income (i.e., leverage-able balance sheets)
- the building need for post-war baby boomers to invest for retirement
- the advent and maturing of asset securitization, asset-backed securities, and the high yield bond market, which broadly expanded systemic credit and debt distribution
- new market technologies that reduced trading and monitoring costs and provided greater access to equity and fixed income markets
- great technological and scientific innovations with commercial applications, which captured equity investor imaginations
- the opening of previously closed large economies to Western commerce and financial assets
- economic policies seeking near-term nominal GDP growth as a first priority, including central bank backstopping of market losses
2. The combination of factors above set the stage for a financial asset investment culture in which the markets could emphasize nominal growth over real growth and risk-adjusted profitability. (Indeed, record credit creation and debt assumption demanded that economies sustain asset price inflation so the value of bank loan books and bond portfolios could be sustained.)
3. Established equity indexes, weighted by market capitalization, further motivated equity market investors to seek nominal growth and de-emphasize real profits. Dedicated equity investors, such as pension and mutual funds, endowments, foundations, insurers, etc., judge their performance against these indexes. Thus, the great majority of sponsoring capital in the stock market has had incentive to reward increasing market caps over increasing profitability. (Although more independent investors have been in the position to try to time and re-allocate their investments more freely than indexed or closet indexed investors, they too have been unable to escape the pull of general market behavior towards increasing market caps.)
4. The emphasis on ever-increasing market caps further directed the incentive structure among listed businesses to continually increase their market caps. Top-line revenue is most easily increased by leveraging corporate balance sheets. Thus, competition for market share and investor sponsorship accelerated corporate debt assumption as a secular business model.
Equity markets, theoretically meant to 1) aid in forming capital and 2) perpetually price the value of the means of producing that capital, instead gradually came to ignore return-on-capital metrics in favor of quarterly share performance. Real return investing suffered. Given their implicit tether to market-cap weighted equity indexes, the values of publicly traded businesses were generally punished when they shrunk their revenues to become profitable. (Private businesses, on the other hand, were under no such pressures and could behave rationally.)
5. Despite being major shareholders of publicly traded companies, professional asset managers are compensated through a percentage of the nominally priced assets they manage. As a result, they too have had commercial disincentive to encourage public businesses they have stakes in to emphasize profits over market cap growth (unless they are already distressed), and have no incentive to lobby equity index publishers to change the way they calculate their indexes.
6. There is no longer an economic “message of the market.” As a result of the financial market incentives and their influence over business behavior noted above, it has become reasonable to separate nominal stock market performance from real economic growth and the expectations for it. More recently, derivative and technology-driven equity trading strategies have boosted trade volume many times its organic level, and central bank financial repression (i.e., bond monetization) has supported bond and stock prices (i.e., bigness). These trends have further obscured economic signals the markets historically provided.
Presently, there are no public financial markets that value businesses or future income streams within the context of capital formation of their broader economies. Financial markets have become discrete exchanges of abstract relative value in which “investors” are forced to chase short-term relative nominal returns.
7. There is no commonly perceived place to save risk-free. Saving at a bank has not been a rational alternative to investing in financial markets given that modern economies have inflationary models supported by perpetually easy credit conditions. This, in turn, has ensured diminishing purchasing power for savers of modern currencies. Only recently (2008) has this become obvious. Central banks’ zero interest rate policies (“ZIRPs”) have pinned benchmark interest rates near zero, producing obvious negative real interest rates. Thus, conventionally storing one’s wealth in cash or in fixed-income instruments offers little or no sanctuary for unlevered investors looking to maintain or increase future purchasing power.
8. The almost complete blending of financial markets with financial media has lent the markets a patina of transparency, constancy and stability. Financial media provides market (not commercial) news to a small niche audience (CNBC’s “Squawk Box” reaches only 150,000 viewers on a good day), and serves as a platform for monetary and fiscal policy communications. Major corporate earnings and economic data releases have come to resemble made-for-TV sporting events and provide a thin financial narrative. Thus, a small investor class controlling significant perceived wealth is forced to abide by consensus macroeconomic perceptions, which do not necessarily reflect true structural commercial and economic forces.
9. Organizations that produce economic data are closely tied to organizations executing fiscal and monetary policies. Whether or not the data are managed or manipulated, as is increasingly suspected by observers, they are produced and released in a manner that evokes predictable responses from financial markets, which in turn send popularly understood (yet potentially erroneous or incomplete) economic signals. The net result for economic policy makers is that their policies are relatively easy to sell to the public. A declining headline unemployment rate or increasing home sales figures are positive political and media events, regardless of declining employment participation rates or stagnant mortgage applications, and regardless of the millions of people experiencing lifestyle distress in diametric opposition to what the data imply.
10. The common perception of economic and commercial health established by policy makers through financial management and media, and supported by financial market participants, defines ongoing economic and commercial reality, regardless of whether it is sustainable.
Analysis: These observations lead us to the unscientific conclusion that we live and work in a contrived meta-economy that can be managed through narrow channels in financial and state capitals. We do not dispute that perception is reality; however, we argue there is growing social dissension from the significant gap separating the popular perception of self-determinism through free markets (and the sustainability of economic cyclicality and wealth that implies), from the burgeoning awareness that the sustainable values of our production and assets are being managed, and that the current trajectory of our economies might not support the future needs and expectations of the masses.
Over time our meta-economies have produced great debt and economic malinvestment (too many homes and home contractors, not enough competitive manufacturing; too much insurance, not enough affordable health care; too many bond traders, not enough engineers), and a boom/bust global economic model that may be more accurately defined as an oscillating leveraging cycle (discussed in more detail un “Burning Matches,” below).
Future “prosperity” now relies on a battery of central bankers directing monetary policies consistent with the expectations of their sponsoring banking systems and governments. This, in turn, implies that the best interests of the means of production, along with savers and unlevered investors, must be in line with those of their banking systems and governments. The weight of overwhelming evidence does not bear this presumption out: the balance sheets of governments and of banks and other levered investors have clearly taken priority over the masses they ostensibly serve.
Now that economies are being forced to de-lever, nominal entities (those perpetually leveraged, such as banks) are the recipient of central bank policy support (e.g., bank reserve creation via targeted asset purchases), while unlevered savers and investors are left to manage their own affairs. Meanwhile, governments that failed to properly regulate banking systems’ credit policies, and that failed to enforce fiscal policies consistent with the long-term sustainability of their economies, have begun aggressively seeking relief from central bank money creation capabilities and from their non-bank private sectors (e.g., the Cyprus bail-in, which confiscates bank deposits and fiscal provisions like the 2014 White House budget, which proposes capping retirement savings).
Credit for a significant portion of past prosperity, as well as blame for the widespread, unsustainable economic leverage it has led to today, rests with the entire political spectra across modern liberal democracies that perpetuated finance-based economies incapable of serving their societies’ long-term interests. Such is the social cognitive dissonance of over-levered societies living under over-levered governments.
Simply, prosperity was pulled forward through economic leveraging and the only ways to reconcile that now are to either let the nominal value of the general price level (GPL) deflate, or inflate the quantity of the total money stock (which deflates the value of our labor, goods, services and assets in real terms to varying relative degrees). Conventional fiscal or monetary policy solutions cannot fix what ails over-levered global economies today. This implies any notion of economic or market cyclicality is misguided.
It is obvious that global economic and market environments are in great transition, no longer defined by financial cycles, and it is further obvious (to some) that fiscal and monetary policy makers are almost out of unconventional ideas. Debtor governments are funding themselves through the almost infinite balance sheets of central banks. Financial asset markets are being funded by newly created bank reserves and the noblesse oblige of captive dedicated investors mandated to seek relative nominal returns, rather than investing with an eye toward capital formation and purchasing power enhancement. It is against this backdrop that we ask the question: are there really unpredictable market shocks or are investors not paid to care?
Given the overwhelming past misallocation of capital cited above, we think the most important realization for investors in the current environment is that price levels of goods, services and assets may be biased to rise but they are not sustainable in real (inflation-adjusted) terms. Due to the unknowable sustainable value of the currencies in which they are denominated, projected growth rates can only be valued relative to each other. As such, financial assets do not necessarily provide a path to secular capital or wealth creation, only to coincident relative financial returns amid ever increasing currency dilution. We think the real value of interest rates and all investables should be calculated by discounting nominal rates and asset prices by past and necessary future money stock growth (reserves plus unreserved deposits). (Please see “Gold as a Rational Investment in Advance of Manifest Inflation,” below.)
We believe most investors today intuit the following: the global financial asset markets have captured virtually all of the perceived wealth in the West => as a result, the markets’ health and continued funding has become the first priority of policy makers => this perceived economic imperative allows monetary policy makers to ensure their economies do not contract in nominal terms (without regard for real growth or real return-on-assets) => the smart play (i.e., “the wisdom of crowds”) suggests it is wisest to keep one’s wealth in levered financial markets.
The crowd is ignoring the obvious and will miss great opportunity, in our view. Today’s negative real interest rates amid one of the most inflationary global monetary regimes on record presents a rare chance to capture significant Alpha if/when the monetary system resets again (which we argue it must).
Full in-depth article (PDF) below: