We sympathize with traditional stock and bond investors, who are faced with extremely poor choices today. QE has distorted the prices of all traditional asset classes to such an extent that none currently promises a fair return with modest risk.... Because the dominant force in securities-price movements today is government policy, particularly the governmental buying of bonds and stocks, there is a vulnerability to all trading and investing prospects that cannot be assessed or measured with confidence... Since there is no history of Americans losing confidence in the basic soundness of their currency and their government, and since monetary policy today is so manipulative and large, it will be hard to parse the reasons for any particular market moves in 2014.
- Paul Singer, Elliott Management
As always, perhaps the best periodic commentary on the state of the "markets" (even if such a thing has not existed for the past 5 years) and global economy comes from the person whose opinion has not been swayed by fly-by-night screechers and book-peddling pundits who fit in CNBC's octobox and who come fast and are forgotten even faster, and whose 37 year track record at Elliott Management, whose assets he has grown from $1.3 million to $23 billion, speaks for itself: Paul Singer.
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Below are the key excerpts from his January letter.
VISION
Imagine how mainstream experts would have reacted to the following set of predictions in 2006: “In two years Lehman will be bankrupt; Merrill and Bear will be acquired in distressed takeunders; Citicorp, AIG, Chrysler, GM, Delphi, Fannie and Freddie will be taken over by the government facing possibly hundreds of billions of dollars of losses; and only 13 global megabanks will survive.”
The 2008 crisis had a lasting and profound impact on virtually the entire developed world. The financial system was brought to the brink of collapse; conditions were created for the radical monetary policy of the past five years and a severely distorted recovery; the plans and dreams of hundreds of millions of people were disrupted, in some cases catastrophically; and societal values were significantly twisted away from individual responsibility toward dependency. In fact, the consequences of the bubble, the bust and the policy aftermath are not yet in full historical view. Despite all the pain, policymakers
refuse to take responsibility for the bubble, the distortions of the bubble years, the ensuing failure to lay the groundwork for strong post-bust growth, the continued riskiness and fragility of the major financial institutions, the lack of appropriate policies to deal with the bust, or their total inability to deal with competitive and technological challenges in the labor market.
It is not that the path toward destruction was impossible to see. On the contrary, a number of people saw the disaster coming, even if they did not all see the timing or the shape of it. The strangest part of the whole series of events is that only a few large professional investors noticed the smoke and shouted “fire.” Policymakers, particularly at the Fed and including (importantly) Janet Yellen, paid some small lip service to the building risks, but they were wedded to their primitive “models” and had a completely inadequate grasp of modern financial instruments, leverage and the interconnectivity of financial institutions. Not only did policymakers fail to understand what was happening and how to deal with the crisis and its aftermath, but also many of those same policymakers, and ALL of the structures and assumptions that prevailed pre-crash, are still in place today. No apologies have been issued. There has been a great deal of partisan back-and-forth and successful lobbying, but sadly the financial system is still not sound. This may be impossible to prove until the next crisis, but you could have said the same about conditions leading up to the last one.
Policymakers were and remain asleep at the wheel. The lack of introspection at the Treasury, the Fed, Congress, the White House and other regulatory bodies is astounding. Instead of taking reasonable and conservative steps to strengthen the financial system and to reach consensus on what is necessary to generate growth, there has been a series of cronyist, ideological, punitive steps that have neither catalyzed the growth that this country needs nor made financial institutions safe. At the same time, the Administration has allowed (and encouraged) the Fed to carry the ball all by itself, heaping praise on it for saving the world at the very time that the White House is shirking its own responsibilities. The Fed’s “dual mandate” (to promote “maximum employment” as well as “price stability”) is bunk in today’s context. It seems as if the entire world is acting as if the Fed actually has a “total mandate” and the rest of the federal government gets to stand around and applaud its heroic efforts. In fact, what we have now is a lopsided recovery, gigantic price risk in financial markets because of QE, and unknown but potentially massive risks of inflation and the ultimate loss of confidence in the major paper currencies, all because the federal government is more interested in ideology than in getting the country back on track, and the Europeans are more interested in preserving the euro than promoting the prosperity of the sovereign nations of Europe.
* * *
For private investment firms like hedge funds, leverage in the modern world is a matter of semi-volition. True, it is much more readily available than in the past, but there are credit departments and initial margins limiting the size of positions. The big financial institutions, on the other hand, found themselves in an environment starting a couple of dozen years ago in which leverage was entirely voluntary, subject to no real constraint because they were not required to post initial margins with each other. Since many of their positions were “hedges” in similar securities, they risk-underwrote those trades using models that projected very little possibility of generating losses. As a result, the entire system has become super-leveraged, super-interconnected and very brittle. Given the benefits of hindsight, we do not have to prove the proposition that the limits of leverage were exceeded in the recent past and that the system was improperly risk-managed by governments and by the managements of financial institutions. It is frustrating, therefore, that no meaningful de-risking of the financial system has occurred since the crisis. You will see a system primed for a rerun of 2008, perhaps even faster and more intense this time.
***
MONETARY POLICY GOING FORWARD
QE has created asset price booms, but historically high excess bank reserves are still generally not being lent, and monetary velocity remains relatively low. But last spring, we witnessed the first tangible sign that the Fed may be trapped in its current posture. The Fed cannot retreat due to excessive debt in the system, the fragility of major financial institutions (still opaque and overleveraged) and the prospect that a collapse of bond prices could lead to a quick, deep recession. This situation may be the early stages of a phase in which the Fed is afraid to act because it has the “tiger by the tail,” and perhaps is beginning to realize that the current situation carries significant risks. QE has not generated a sharp upsurge of sustaining and self-reinforcing growth thus far. What it has done is lift stock and asset prices and exacerbate inequality. If investors lose confidence in paper money, as evidenced by either a hard sell-off in one of the major currencies or a sharp fall in bond prices, the Fed and other major central bankers will be in a pickle. If they stop QE and/or raise short-term rates to deal with the loss of confidence, it could throw global markets into a tailspin and the worldwide economy into a severe new recession. However, if they try to deal with the loss of confidence by stepping up QE or keeping interest rates at zero, there could be an explosion in commodity and other asset prices and a sharp acceleration in inflation. What would be the “exit” from extraordinary Fed policy at that point? The current, benign-looking environment (low inflation and
stable economies) is by no means ordained to be the permanent state of things. At the moment, “tapering” is expected to get underway, but that prospect represents a tentative, slight diminution of bond-buying. It contains no real promise of normalizing monetary conditions. If the economy does not light up, the impact of another year of full-bore QE is impossible to predict. Five years and $4 trillion have created economic and moral distortions but very little sustainable value. Maybe the sixth year will produce the “riot point.” Nobody knows, including the Fed.
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As we and others have said, the Fed is overly reliant upon models that do not account for real-world elements of instruments, markets and traders in the derivatives age. Models cannot possibly take into account unpredictable interactions among huge positions and traders in new and very complicated instruments. Thus, the Fed should be careful, humble and conservative. Instead, it is just blithely plowing ahead as if it knows exactly what is going on. Intelligent captains sail uncharted waters with extra caution and high alert; only fools think that each mile they sail without sinking the vessel further demonstrates that they are wise and the naysayers were fools. This is a formula for destruction. The crash of 2008 should have been smoking-gun evidence of the folly of this approach, but every mistake leading up to the crash, especially excessive and “invisible” leverage and interest rates that were too low, has been doubled down upon in the years since.