The latest weekend note by Eric Peters, CIO of One River Asset Management, is his latest masterpiece in lyrical, stream of consciousness, financial analysis, and can be broadly divided into to broad parts: his latest take on financial markets analyzing the build up of disequilibrium which eventually culminates with discrete "flushes" that reset the system; how bold investors inevitably give up on financial sense and logic long (or just) before said flush takes place, and what this upcoming Minsky Moment could mean for the future. We have excerpted from this section in the current note, as for the remainder of his weekend observations - which deal with tectonic macro and geopolitical shifts - we will follow up in a subsequent post.
Anecdote: “The most common example is a ball sitting atop a hill,” she said, polished accent, hint of condescension. “Locally stable, but one nudge and it’s all over.”
She drove terribly fast, discussing Minsky Moments; the idea that persistent stability breeds instability. “Naturally each cycle is different in key respects, and that’s because you’re far better at preventing past problems from recurring than new ones from arising.”
I smiled, amused, insulted. “Despite knowing this all too well, you humans remain inexplicably fixated on the rearview mirror. And this blinds you to all manner of hazards ahead.”
She initiated a few perfect turns of the Tesla, dodging a squirrel or two, tumbling, unhurt. “The source of instability in this cycle is your dissatisfaction with ultra-low bond yields.” $8trln of sovereign debt carries a negative yield, still our central bankers buy. “You should logically respond to this historic rise in valuations across asset classes with a reduction in your expectations for future returns.” I nodded. “But instead you respond with indignation.”
So I explained to her that without robust growth and a compounding stream of uninterrupted 7.5% returns, our entitlement systems will implode. They probably will anyway. And lacking the stomach for an honest accounting of this predicament, we prefer to pretend it doesn’t exist.
“Is this humor or sarcasm?” she asked. “Both,” I answered. “Fascinating, anyhow, you then demand that we algorithms produce mathematically impossible returns. So we apply leverage, which makes nearly anything possible, even at valuations that are 99th percentile in all of human history. The more leverage we apply, the more stable your system appears. The flatter your hilltop.
Naturally, we ensure that today’s leverage looks different from yesterday’s disaster, recognizing your powerful aversion to repeating recent mistakes.” And I stared out the window, lost in thought, fall’s kaleidoscope whizzing by.
“The giant miss in this cycle has been the duration of financial repression,” he said. The Bank of England had just hiked rates for the first time in a decade. Doubling them to 0.50%. Faced with an inflation rate of 3% and 5yr/5yr inflation swaps priced at 3.4%, the BOE estimated just two more 25bp interest rate hikes in the coming 3yrs. 10yr government bonds yield 1.26%. For years, every incremental increase in inflation expectations has led to lower real yields. “Financial repression has been so beaten into investors that they appear to have given up.”
“Long lasting adjustments occur when large imbalances need to be cured,” said my favorite strategist. “They require decisive policies, without which you can become trapped.” He turned to Tokyo. “70% of Japanese corporates pay no taxes because of the loss-carry-forward from 30yrs ago.” Policy makers never allowed the 1989 collapse to properly cleanse. “This is incredibly inefficient and the government knows exactly what to do.” But no one has the will. “So you end up with this perpetual ho hum outcome, lifted and lowered by the global cycle.”
“This is where Japan finds itself today,” continued the same strategist. “A cyclical upswing and a renewed excitement about Abenomics, but not much changes until they really address the structural issues.” Only Japanese banks are really cheap; trading at 50% of book.
“But banks have no loan demand for as far as the eye can see. And the firms that could borrow, invest, and create disruption by wiping out inefficient supply chains are prevented from doing so by government policy to forestall the cleanse of something that happened 30yrs ago.”
“We have few big structural imbalances in the US,” he said. “Admittedly there are large generational imbalances but these won’t be cured today.” Entitlements, pensions, states, and municipalities are tomorrow’s problem. “US imbalances are really just financial.” The bank and residential real estate flush from our last crisis has left both in better balance. Student loans are a problem, but not systemic. Same for auto loans.
“But we’ve had this financial engineering cycle of buybacks, ETFs, passive strategies, leveraged quant investing, crowding.”
“The thing about flushing the excesses of financial engineering is that it can happen quickly,” he continued. “You saw that happen in 1987 for instance. And like then, it need not have a massive impact on the economy.”
For financial engineering to take down an economy, its unwind needs to devastate large balance sheets. And it’s not clear where that would happen today.
“The next cleanse will be sharp, deep, fast, and will feel like the end of the world, but it won’t be. It’ll slow economic growth for sure, but 18mths later we’ll be back near the highs.”