Just when you thought the world could not spin much faster, global monetary events in 2015 have picked up speed.
Begun, The Currency Wars Have
A key macro theme of mine for some time now has been the increasing importance of relative global currency movements in financial market outcomes. And what have we experienced in this very short year-to-date period so far? After years of jawboning, the European Central Bank has finally announced a $60 billion monthly quantitative easing exercise to begin in March. Switzerland “de-linked” its currency from the Euro, China has lowered the official renminbi/US Dollar trading band (devalued their currency), China lowered its banking system required reserve ratio, the Turkish and Ukrainian currencies saw double digit declines, and interest rate cuts have been announced in Canada, Singapore, Denmark (4 times in three weeks), India, Australia and Russia (just to name a few). All of the above occurred within five (!) weeks.
What do all of these actions have in common? They are meant to influence relative global currency values. The common denominator under all of these actions was a desire to lower the relative value of each country or area’s currency against global competitors. As a result, foreign currency volatility has risen more than noticeably in 2015, necessarily begetting heightened volatility in global equity and fixed income markets.
If we step back and think about how individual Central Banks and country specific economies responded to changes in the real global economy historically, it was through the interest rate mechanism. Individual Central Banks could raise and lower short term interest rates in order to stimulate or cool down specific economies as they experienced the positive or negative influence of global economic change upon them. Country-specific interest rate differentials acted as pressure relief valves. Global short term interest rate differentials acted as an intentional relative equalization mechanism.
But in today’s world of largely 0% interest rates, the interest rate “pressure relief valve” is gone. The new pressure relief valve has become relative currency movements.
This is just one reality of the historically unprecedented global grand Central Banking monetary experiment of the last six years. Whether for good or bad, it is simply the environment in which we find ourselves today. And so we must deal with this reality in ongoing investment decision-making.
Pressure Is Mounting
There has been one other event of note in early 2015 that directly relates to the potential for further heightened currency volatility to come. That event is the recent Greek elections.
We all know that Greece has been in trouble for some time. Quite simply, they have borrowed more money than they are able to pay back under current debt repayment schedules. The New York consulting/banking firm Lazard recently put out a report suggesting Greek debt requires a 50% “hair cut” (default) in order for Greece to remain fiscally viable. The European Central Bank (ECB), largely prompted by Germany, is demanding 100% payback. Herein lies the key tension.
Of course the problem with a needed “haircut” in Greek debt is that major Euro banks holding Greek debt have not yet marked this debt to “market value” on their balance sheets. In one sense, saving Greece is as much about saving the Euro banks as anything. If there is a “haircut” agreement, a number of Euro banks will feel the immediate pain of asset write-offs. Moreover, if Greece receives favorable debt restructuring/haircut treatment, then what about Italy? What about Spain, etc? This is the dilemma of the European Central Bank, and ultimately the Euro itself as a currency. This forced choice is exactly what the ECB has been trying to avoid for years. Politicians in the new Greek government have so far been committing a key sin in the eyes of the ECB – they have been telling the truth about fiscal/financial realities.
What does the last minute late February stick save in again kicking the can down the road another four months for Greece really accomplish? Absolutely nothing. The exact thing that has been accomplished over the last 2.5 years since Mr. Draghi uttered his infamous “whatever it takes” commentary. At least the Euro area has been 100% consistent in accomplishing zero in terms of real reforms and reconciliation, right? But we all know time is running out. We need to watch the capital markets carefully.
Time To Toss The Playbook
What does this set of uncharted waters circumstances mean for investment decision making?
It means we need to be very open and flexible. We need to be prepared for possible financial market outcomes that in no way fit within the confines of a historical or academic playbook experience.
This may sound a bit melodramatic, but it's something I have been anticipating for some time now, ever since a very unique occurrence took place in Euro debt markets in early February. Nestle´s shorter term corporate debt actually traded with a negative yield. Think about this. Investors were willing to lose a little bit of money (-20 basis points, or -.2%) for the “safety” of essentially being able to park their capital in Nestle’s balance sheet. This is a very loud statement and may be a very important “signal” for what lays ahead.
Academically, we all know that corporate debt is “riskier” than government debt (which is considered “risk free”). But the markets are “telling us” that may not be the case at the current time when looking at Nestle´ bonds as a proxy for top quality corporate balance sheets. Could it be that the balance sheets of global sovereigns (governments) are actually riskier than top quality corporate balance sheets? And if so, is global capital finally starting to recognize and price in this fact? After all, negative Nestle´ corporate yields were seen right alongside Greece raising its hand suggesting Euro area bank and government balance sheets may not be the pristine repositories for capital many have come to blindly accept. This Nestle´ bond trade may be one of the most important market “signals” in years.
As I’ve stated many times, one of the most important disciplines in the investment management process is to remain flexible and open in thinking. Dogmatic adherence to preconceived notions can be very dangerous, especially in the current cycle.
As such, we cannot look at currency movements and investment asset class price reactions in isolation. This may indeed be one of the greatest investment challenges of the moment, but one whose understanding is crucial to successful navigation ahead. In isolation, who would be crazy enough to buy short term Nestle´ debt where the result is a guaranteed loss of capital in a bond held to maturity? No one.
But within the context of deteriorating global government balance sheets, all of a sudden it is not so crazy an occurrence. It makes complete sense within the context of global capital seeking out investment venues of safety beyond what may have been considered “risk free” government balance sheets, all within the context of a negative yield environment. Certainly for the buyer of Nestle´ debt with a negative yield, motivation is not the return on capital, but the return of capital.
If we think about what this cycle has been up until now, things we’ve never seen in our lifetimes (let alone in history), now seem familiar. ZIRP, QE, etc. Ho Hum.
It’s this very premise that keeps me up at night when translating this philosophical question to equities and other private sector assets (corporate bonds, etc.). Again, I’m simply forcing myself to abandon preconceived ideas and contemplate what may appear the impossible. Will things we’ve never seen before in private sector assets (equities, corporate credit, etc.) seem familiar before this cycle is over?
In Part 2: Investing In The Age Of Anomalies, we examine the heightening importance of global capital flows in today's market environment. As the system becomes more unstable, capital seeks safety — and that can lead to non-intuitive outcomes, at least in the short term.
For example, despite their obviously stretched valuations, US equity prices may power higher from here for longer than many expect, as capital suffering from negative interest rates elsewhere in the world is attracted to the relative safety and higher return of 'blue chip' stocks.
The analysis and understanding of these capital flows may well be more important than any other factor in determining investment performance during this next phase of the markets. As they say: Follow the money.