True Partner article: Icarus versus Goldilocks

Page 1: The myth versus the fairytale

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10-2019 – By Mr. Tobias Hekster and Mr. Govert Heijboer, Chicago / Hong Kong

Ever since the Great Financial Crisis a decade ago, the main recourse Western nations took to restart their economies has been Quantitative Easing (”QE”). While the term has quite a scientific ring to it, it was an untested theory to avoid the mistakes which exacerbated the Great Depression of last century: keep the financial system awash in liquidity and prevent a collapse of the banking system. Desperate situations require desperate measures and few would dispute that an untold calamity had been avoided.

After the excesses of the prior decade, restraint was the new game in town. In the United States, the fiscal restraint was politically driven as the Tea Party intended to stifle the Obama recovery. In Europe, especially in the northern economies, there was simply no political capital available for bailing out Southern Europe after bailing out the highly unpopular financial sector just before. Quantitative Easing was a more palatable way to prop up the faltering recovery. Contrary to the public works programs which helped solve the Great Depression, fiscal policy was lacking, leaving all the heavy lifting to monetary stimuli.

The direct impact of central bank liquidity was to lift asset prices. If the equity markets would represent the overall economy, recovery was bearing fruit. However, the proverbial disparity between ‘Wall Street’ and ‘Main Street’ became visible as buoyant equity markets did not seem to translate into rising wages and prosperity outside of the major metropolitan areas. The rising markets were not a tide that lifted all boats, but instead more accelerated the growth of inequality. The surge in populism across the globe can at least partly be attributed to this uneven recovery and resulting inequality.

To QE infinity and beyond…

In 2013, while the banking system across the globe was out of the woods, the economic recovery finally appeared to pick up outside of merely the capital markets. Realizing limits in efficacy of monetary stimuli and underscoring these were temporary measures, the Federal Reserve started to telegraph an end to the operations in order to limit any unintended consequences of the unprecedented operation and preserve a Goldilocks economy. But the markets wanted none of that and thus the Taper Tantrum erupted. The Federal Reserve blinked first and QE Infinity was born. The Taper Tantrum will likely be seen as a watershed moment, the birth of an explicit Central Bank “put option” supporting the equity markets with ondemand interventions. The term tantrum was well chosen, as most parents know that giving in to tantrums might not be the best way to raise a child.

Let’s fast forward six years to now and take stock of where we stand. The Central banks through QE have provided the market with Icarus like wings: equity markets in the United States are at the all-time highs. Valuations across the globe are at levels seen at prior market peaks, not for the exuberant expectations associated with prior peaks, but as a direct consequence of the monetary reflation as the true action has occurred in the debt markets. Yields have cratered and over 17 trillion dollars’ worth of bonds even trade at negative yields. Old investment wisdoms have been turned upside-down with shares being held for dividend yield and bonds for appreciation in a high stakes game of pass the hot (negative yielding) potato. A world where a 100-year bond issued at a 2% coupon can yield a 100% return in one year as its yield to maturity declines to 1%. A world where yield starved investors pile into Argentinian century bonds. That gambit did not end well - Argentina appears on path to do what it has done seven times before in the past 100 years: default.

It is this scarcity of yield that defines many aspects of today’s economy. Pensioners and savers are deprived of income unless they engage in ever larger risks. Lack of follow-through to the real economy results in a scarcity of investment opportunities for companies who thus resort to near continuous share repurchases (there is a bit of a conflict of interest here) and acquisitions which tend to concentrate market power, further exacerbating inequality. (the ‘Moat’ that Warren Buffet speaks of so highly). Most macro-economic knowledge from our university years has been rendered useless in a zero-interest rate world. Oddly enough, one chart from that past springs to mind: there is a concept of a liquidity trap where lower interest rates no longer have a positive effect on economic output. In study books, the level was set at 2%. Coincidentally the level to which the Federal Reserve has just lowered its key benchmark rate. Capital Asset Pricing Mode (CAPM) has been replaced by There Is No Alternative (TINA). Markov’s efficient frontier is now a straight-line market sensitivity, known as beta. And after umpteenth successful instances of buy-the-dip, the concept of Downside Risk has devolved into Fear of Missing Out (the Bottom).

Goldilocks or Icarus economy?

Pundits tend to describe the economy as ‘Goldilocks’; not too hot, not too cold and keeping the ‘bears’ at bay (as originally coined by David Shulman from Salomon Brothers in 1992). One has to keep in mind though, that in the end Goldilocks is a fairytale. One can just as easily make the analogy with the Greek myth of Icarus, who escaped his imprisonment by King Minos by flying away over sea on wings of feathers and wax. His escape started off in a Goldilocks kind of way, flying not too high and not too low. Not too low as the seawater would dampen his feathers. Too exhilarated and empowered by his ability to fly, however, he ignored his father’s other warning of not flying too close to the sun as that would melt his wings, resulting in the catastrophic consequence of his drowning.

Imperial skin…

For us volatility traders, current market dynamics are not the most conducive to say the least. But of course volatility traders are known as glass half empty types and maybe as party poopers. All the vested interests are married to the current status quo of ever decreasing yields and rising markets. All is thus well and the emperor has beautiful clothes. We would like to share our observations not only as to why we doubt the current trajectory will not end in tears, but also more importantly how to protect one’s portfolio should you start to see some glimpses of uncovered imperial skin in the markets.

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October 2019 Volatility Update - Icarus versus Goldilocks>>