I’m Not Predicting, I’m Observing

George Soros has a great line, one that I’ve stolen many times: “I’m not predicting. I’m observing.” We really don’t have a crystal ball, and it really is a dumb idea to pretend that we do. But what’s not dumb is to keep your eyes and ears open, observing both what the world is telling you (playing the cards) and what other market participants are telling you (playing the players), and reacting accordingly. That’s the heart of tactical investing.

What I’m observing today is that the European *story* is broken. I’m not saying that real world European companies are broken or that real world European economies are broken. In both cases, a few are but most aren’t. What I’m saying is that the buy-Europe!™ story that has been pitched by the sell-side ad nauseam for the past six months is broken and that these stocks are defenseless against the steady stream of anti-Europe political news we are going to endure for the next eight weeks.

Here’s the S&P 500 Index (“SPX”) in white, German DAX Index (“DAX”) in green, and Stoxx 600 Index in red over the past six months:

Source: Bloomberg, as of 02/26/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

Yes, the DAX has outperformed the SPX over the past six months. Why? Because every sell-side strategist and his cousin has been pounding the table that Europe is recovering and Europe is cheap and why worry about all those elections, anyway, because even if Le Pen wins it’ll just be like Brexit and everything will be fine.

The truth is I don’t know whether or not Le Pen will win in France this May. I don’t have a crystal ball. But what I do know is that nothing is happening between now and those elections that makes it less than a 50/50 coin toss whether Le Pen wins. There’s going to be a steady stream of negative press about all of the candidates from now until then, the difference being that core Le Pen supporters, like core Trump supporters, don’t care about the negative press. There is no story that could make these stocks go UP, but there will be plenty of stories that can make these stocks go DOWN.

And yes, I know that for “patient, long-term investors” and all the Warren Buffett wannabes out there, what happens over the next eight weeks doesn’t matter a bit, and if European stocks go down it just means that they’re even more “on sale”. But what I also know is that whenever I read a sell-side note talking about why something is a buy *today* for “patient, long-term investors”, that’s typically a signal to start shorting whatever they’re pitching. What I also know is that it’s a lot easier to be Warren Buffett when you’ve got $100 BILLION in more-or-less permanent capital from your insurance float. Good for him. Ain’t my situation. I’m guessing it isn’t yours, either.

But the risk here isn’t just a temporary blip on the European horizon. Here’s a picture of 2-yr French bond yields to 2-yr German bond yields (yellow), 2-yr Italian bond yields to Germany (red), and 2-yr Spanish bond yields to Germany (green) over the past six months. If you lived through the summer of 2011, this chart should give you a shiver.

Source: Bloomberg, as of 02/26/17. For illustrative purposes only. Past performance does not guarantee future results.

This is telling you that bond markets are starting to get really nervous about Europe and the stability of the Euro system, and the time frame of their nervousness is over the next two years. Could all this blow over if we get a market-friendly political result in May? Absolutely. And if that happens, maybe I’ll buy Europe THEN. But until then, I’ll listen to what the bond market is telling me over whatever Goldman Sachs and Morgan Stanley and the rest of our sell-side friends is pitching me. I’m not predicting. I’m observing.

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1914 is (still) the New Black

There are decades where nothing happens; and there are weeks where decades happen.

Vladimir Lenin (1870 – 1924) 

In 1914, Europe had arrived at a point in which every country except Germany was afraid of the present, and Germany was afraid of the future. 

Sir Edward Grey (1862 – 1933) 

Last week’s email, “1914 is the New Black”, was the most widely read Epsilon Theory note to date, and given yesterday’s events it bears repeating, as the echoes of 1914 are growing louder and louder. We are, I think, likely embarked on the death spiral phase of a game of Chicken, just as in the summer of 1914. The stakes are, for now at least, not nearly as cataclysmic today as they were a century ago, but the social and political dynamics are eerily alike.

I’m often asked how to get a better take on a historical event like the lead-up to World War I, and the answer is that there’s no substitute for immersing yourself in what people were actually saying and writing at the time the events transpired. If you’re lucky, perhaps you’ll pick a period that also attracted the attention of a gifted historian like a Robert Caro or a David McCullough. Second best, I’ve found, is to find a gifted editor or anthologist to smooth the path a bit. One such anthologist is Peter Vansittart, who collected a wide range of original texts in his classic books, “Voices: 1870 – 1914” and “Voices from the Great War”. I’ve taken some of those texts and appended them below. They speak for themselves, I hope, to illustrate the defining characteristic of a spiraling game of Chicken – all sides begin to speak in terms of “having no choice” but to take aggressive actions to defend their own interests.

Before the quotes, though, three other historical observations:

  1. The Austrian ultimatum to Serbia – long seen as the proximate cause of World War I – was accepted by the Serbian government almost in its entirety. Unfortunately, that “almost” part made all the difference. An important anecdote to remember the next time someone calls your attention to Tsipras’s acceptance of 90% of the Eurogroup reform ultimatum.
  2. Anti-establishment voters are always underrepresented in establishment polls. Noted segregationist and Alabama governor George Wallace won the 1972 Democratic Party primary in Michigan despite showing third in polls. Daniel Ortega and his Sandinista regime lost the 1990 Nicaraguan election by 10 percentage points to Violeta Chamorro despite leading by more than 10 points in every pre-election poll. The Syriza NO landslide was no surprise here, and this is an important phenomenon to keep in mind when you start to see opinion polls from Italy and France published over the next few days.
  3. Politics always trumps economics. My favorite 1914 quote in this regard is from Lord Cunliffe, governor of the Bank of England from 1913 – 1918, who famously declared that war was impossible because “The Germans haven’t the credits.” So what if Greek banks run out of euros? The Greek government will make their own, or maybe issue California-style IOUs and dare the Eurogroup to boot them out of the currency. If you think that an ECB squeeze can put this political genie back in the bottle, you’re making the same classic error as Walter Cunliffe did.

And now the quotes.

I held a council at 10:45 to declare war with Germany. It is a terrible catastrophe but it is not our fault. An enormous crowd collected outside the palace; we went on the balcony both before and after dinner. When they learned that war had been declared, the excitement increased and May and I with David went on to the balcony; the cheering was terrific

King George V (1865 – 1936) 

England alone carries the responsibility for peace or war, no longer us.

Kaiser Wilhelm II (1859 – 1941) 

In this most serious moment I appeal to you to help me. An ignoble war has been declared to a weak country. The indignation in Russia shared fully by me is enormous. I foresee that very soon I shall be overwhelmed by the pressure brought upon me and be forced to take extreme measures which will lead to war. To try and avoid such a calamity as a European war, I beg you in the name of our old friendship to do what you can to stop your allies from going too far. — Nicky

Tsar “Nicky” Nicholas II (1868 – 1918) in a letter to his cousin, Kaiser “Willy” Wilhelm II 

Now Tsarism has attacked Germany, now we have no choice, now there is no looking back. 

Kurt Eisner (1867 – 1919) 

Necessity knows no law; we must hack our way through. 

Theobald von Bethmann-Hollweg (1856 – 1921) in a speech to German Reichstag 

The few neutral states are not sympathetic toward us. Germany has not a friend in the world, she stands utterly alone and has only herself to depend on. … How different it all was a few weeks ago, when we launched so brilliant a campaign – now a bitter disillusionment is setting in. And how much we shall have to pay for all that is being destroyed! 

Helmuth von Moltke the Younger (1848 – 1916) in a letter to his wife 

In this war it is a question … of German civilization against barbarous Slavdom. 

Helmuth von Moltke the Younger (1848 – 1916)

The year 1914 in America seemed the crest of a wave of passionate idealism among young people, and of passionate selfishness among middle-aged people. 

John Cowper Powys (1872 – 1963)

July 25: Unbelievably large crowds are waiting outside the newspaper offices. News arrives in the evening that Serbia is rejecting the ultimatum. General excitement and enthusiasm, and all eyes turn towards Russia – is she going to support Serbia? The days pass from 25 to 31 July. Incredibly exciting; the whole world is agog to see whether Germany is now going to mobilize.

July 31: Try as I may I simply can’t convey the splendid spirit and wild enthusiasm that has come over us all. We feel we’ve been attacked, and the idea that we have to defend ourselves gives us unbelievable strength … You still can’t imagine what it’s going to be like. Is it all real, or just a dream?
diary of Herbert Sulzbach, “With the German Guns” (1935) 

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1914 is the New Black

Man in Black: All right. Where is the poison? The battle of wits has begun. It ends when you decide and we both drink, and find out who is right … and who is dead.

“The Princess Bride” (1987) 

Time is a game played beautifully by children.

Heraclitus of Ephesus (535 – 475 BC) 

How can you hide from what never goes away?

Heraclitus of Ephesus (535 – 475 BC)

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Whoever cannot seek the unforeseen sees nothing, for the known way is an impasse.

– Heraclitus of Ephesus (535 – 475 BC)

Let me just say that I am very negatively surprised by today’s decisions by the Greek government. That is a sad decision for Greece because it has closed the door on further talks, where the door was still open in my mind.

Jeroen Dijsselbloem, head of Eurogroup finance ministers

The judge smiled. Men are born for games. Nothing else. Every child knows that play is nobler than work. He knows too that the worth or merit of a game is not inherent in the game itself but rather in the value of that which is put at hazard. Games of chance require a wager to have meaning at all. Games of sport involve the skill and strength of the opponents and the humiliation of defeat and the pride of victory are in themselves sufficient stake because they inhere in the worth of the principals and define them. But trial of chance or trial of worth all games aspire to the condition of war for here that which is wagered swallows up game, player, all.

Cormac McCarthy, “Blood Meridian, or The Evening Redness in the West” (1985) 

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success.

Alexis de Tocqueville (1805 – 1859) 

Children and lunatics cut the Gordian knot which the poet spends his life patiently trying to untie.

Jean Cocteau (1889 – 1963) 

epsilon-theory-1914-is-the-new-black-june-29-2015-power

If you don’t like how the table is set, turn over the table.

– Frank Underwood, “House of Cards” (2013)

Nothing like a good Friday-after-the-close blockbuster to set the stage for an interesting week.

At 1am Saturday morning Athens time, the Greek government called for a nationwide referendum to vote the Eurogroup’s reform + bailout proposal up or down. The vote will happen on Sunday, July 5th, but Greece will default on its IMF debt this Wednesday, and as a result the slow motion run on Greek banks is about to get a lot more fast motion unless capital controls are imposed. If you want to get into the weeds, Deutsche Bank put out a note, available here, that I think is both a well-written and comprehensive take on the facts at hand. As for the big picture, I’ve attached last week’s Epsilon Theory note (“Inherent Vice“), as this referendum is EXACTLY the sort of self-binding, “rip your brakes and steering wheel out of the car” strategy I wrote about as a highly effective way to play the game of Chicken.

Look, I have no idea whether or not Tsipras will be successful with this gambit. But I admire it. It’s a really smart move. It’s a wonderful display of what de Tocqueville praised as the “condition of semi-madness” that was so politically effective in 1848, and I suspect will be today. Plus, you can’t deny the sheer entertainment value of hearing Dijsselbloem splutter about how he was open to a revised, revised, Plan X from Greece all along, if only Tsipras would continue with this interminable charade. “The door was still open, in my mind.” Priceless.

So long as Tsipras can avoid market anarchy and TV coverage of violent ATM mobs this week, I think the NO vote is likely to win. The referendum is worded and timed in a way that allows very little room for Antonio Samaras and other Syriza opponents to turn the vote into a referendum on the Euro itself, which has proven to be a successful approach in the past. Particularly as the Eurogroup rather ham-handedly denied the request for a one-week extension in the default deadline, the referendum is being framed by Syriza as what Cormac McCarthy called a “condition of war”, an over-arching game where “that which is wagered swallows up game, player, all.” It may well be a close vote, but it’s hard to vote YES for a public humiliation of your own country under any circumstances, much less when that YES vote is being portrayed as giving aid and comfort to the enemy.

Here’s how I see the game playing out after the vote.

If Greece votes to accept the Eurogroup reform proposal after all, then the game of Chicken resolves itself within the stable Nash equilibrium of a shamed Greece and a triumphant Euro status quo. I would expect an enormous risk-on rally in equities and credit, particularly in Euro-area financials. Hard to say about rates … peripheral Euro debt (Italy, Spain) should rally, and German Bunds might, too, as the Narrative will be that Germany “won”. But reduction of systemic risk is a negative for any flight-to-safety trade, so this outcome is probably not good for Bunds in the long term, or US Treasuries over any term.

If Greece votes to reject the proposal, then either the game resolves itself within the stable Nash equilibrium of a shamed Euro status quo and a triumphant Greece (if the ECB and EU decide to cave to some form of the original Greek proposal), or we enter the death spiral phase of a game of Chicken, as all parties start to talk about how they “have no choice” but to crash their cars. That latter course is the far more likely path, I think, given how the various Euro Powers That Be are already positioning themselves. It’s all so very 1914-ish. Draghi’s cap on bank-supporting Emergency Liquidity Assistance (ELA) is the modern day equivalent of Czar Nicholas II’s troop mobilization. Good luck walking that back.

If we go down the death spiral path and some form of Greek exit from the Euro-system, I expect the dominant market Narrative to be that Greece committed economic suicide and that the rest of Europe will be just fine, thank you very much. That should prevent a big risk-off market move down, or at least keep it short-lived (although you should expect Bunds and USTs to do their risk-off thing here). Unless you’re a hedge fund trying to make a killing on those really cheap Greek bonds you bought two years ago, there’s no reason to panic even if we’re on the death spiral.

Over time, however, I expect that dominant Narrative to be flipped on its head. Greece will quickly do some sort of deal with Russia (hard currency for port access?), and then the IMF will strike a deal because that’s what the IMF does. More and more people will start to say, “Hey, this isn’t so bad”, which is actually the worst possible outcome for Draghi and Merkel. At that point, you’ll start to see the Narrative focus on the ECB balance sheet and credibility, and as Italian and Spanish rates start to creep up and as the spread to Bunds starts to widen, people will recall that ECB QE only has national banks buying their own debt … the Bundesbank ain’t propping up Italian sovereign debt. I suspect it will be a slow motion contagion, all taking place in the Narrative and expressed in Italian, Spanish, and French politics over the next 12 months or so. The Red King will start to wake.

One last point on how the market Narrative will shift if we go down the death spiral path, and that’s the dog that will stop barking. The incessant and often silly focus on Fed “lift-off” is about to go on summer hiatus, which can’t happen soon enough for me. 

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7 Quick Points on Europe

#1) Here are the most relevant recent notes for an Epsilon Theory perspective on the underlying political and market risks in Europe: “The Red King” (July 14, 2014) and “Now There’s Something You Don’t See Every Day, Chauncey” (Dec. 16, 2014).

#2) Markets reacted positively to last Thursday’s announcement because Draghi doubled the amount of QE that he leaked to the press on Wednesday. Financial media pegged QE at 600 billion euros on Wednesday and 1.2 trillion euros on Thursday. Once again, Draghi played the Narrative game like a maestro.

#3) This is NOT open-ended QE. Sorry, but the Narrative game doesn’t work like this. If you mention a target date (September 2016), then that becomes the Schelling focal point, no matter how much you try to walk that back by saying it’s open-ended.

#4) Risk-sharing, or the lack thereof, matters. Draghi won approval of a doubled QE target by minimizing the mutualization of QE risk among EU countries. 80% of the bond-buying will be done by national central banks, and Germany will only buy German government bonds, France will only buy French bonds, etc. That’s important for two reasons. First, if Italy or Spain goes off the rails, then the Bundesbank’s balance sheet isn’t immediately crippled. Second, this is why German bonds are rallying just as hard (harder, really) than periphery bonds. It’s also why US bonds are rallying so hard, because you can’t maintain a huge spread between the only risk-free rates left in the world.

#5) Market complacency on Greece is a mistake. Not because Greece itself is a huge systemic threat, but because the same political dynamics in Greece are coming soon to Italy. Greece is Bear Stearns. Italy is Lehman.

#6) In tail-risk trades as in comedy, timing is everything. Even if you think that it’s an attractively asymmetric risk/reward profile to bet on a Euro crisis (and I do), this is a heavily negative carry trade. If you don’t know what the phrase “negative carry trade” means, then please don’t make this bet. If you do know what it means, then you know that you either have to play a lot of hands to make the odds work out for you (and the nature of systemic crises makes that impossible) or you have to be spot-on with your timing.

#7) In a fundamentals-driven market you need to look at fund flows; in a Narrative-driven market you need to look at Narrative flows. With Draghi’s announcement last Thursday, there is no longer a marginal provider of market-supportive monetary policy Narrative. Or to put this in game theoretic terms, the 2nd derivative of the Narrative of Central Bank Omnipotence just flipped negative. We’ve shifted from an accelerating Narrative flow to a decelerating Narrative flow, and that inflection point in profoundly important in game-playing. The long grey slide of the Entropic Ending begins.

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Now There’s Something You Don’t See Every Day, Chauncey

epsilon-theory-now-theres-something-you-dont-see-every-day-chauncey-december-16-2014-rocky

Narrator: Well, today we find our heroes flying along smoothly…
Rocket J. Squirrel: Flying along smoothly?
Bullwinkle J. Moose: You’re just looking at the picture sideways!
Rocket J. Squirrel: Actually it’s like this!
Narrator: Oh… OH GOOD HEAVENS! Today we find our heroes plunging straight down toward disaster at supersonic speed!
Bullwinkle J. Moose: That’s better.

The Rocky and Bullwinkle Show (1959 – 1964)

There are decades where nothing happens; and there are weeks where decades happen.

― Vladimir Lenin (1870 – 1924)

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success. 

― Alexis de Tocqueville (1805 – 1859)

A match as a pen
Blood on the floor as ink
The forgotten gauze cover as paper
But what should I write?
I might just manage my address
This ink is strange; it clots
I write you from a prison
in Greece.
― Alexanderos Panagoulis (1939 – 1976) 

The revolution is now just a sentiment.
― Pier Paolo Pasolini (1922 – 1975)

epsilon-theory-now-theres-something-you-dont-see-every-day-chauncey-december-16-2014-napoleon-dynamite

Pedro: Vote for me, and all your wildest dreams will come true. 

― “Napoleon Dynamite” (2004)

epsilon-theory-now-theres-something-you-dont-see-every-day-chauncey-december-16-2014-election

Tammy Metzler: [her campaign speech] Who cares about this stupid election? We all know it doesn’t matter who gets elected president of Carver. Do you really think it’s going to change anything around here? Make one single person smarter or happier or nicer? The only person it does matter to is the one who gets elected.
― “Election” (1999)

So inscrutable is the arrangement of causes and consequences in this world, that a two-penny duty on tea, unjustly imposed in a sequestered part of it, changes the condition of all its inhabitants.
― Thomas Jefferson, “Autobiography” (1821)

Like every other male homo sapiens I know, I watch a lot of sports. There’s only one team that I watch as a fan – the University of Alabama football team (my grandfather and uncle played there, and I was raised in the Church of Bear Bryant) – by which I mean that these are the only games I watch where I could not care less about the quality of the gameplay, but only care about winning in as lopsided a fashion as possible. For example, while the rest of the world thought the 2011 Championship game where Alabama beat LSU 21-0 was a miserably boring affair, a Bama fan like myself thought it was a performance of absolute beauty. Roll Tide.

Fans and gamblers care about outcomes. For everyone else watching a game, we’re there for something else. One of those things – and for me the centerpiece of any non-Bama, non-Hunt-participant sporting event – is the chance that we might see something we’ve never seen before. For example, a few weeks back I was watching the Sunday night Giants-Cowboys game on television even though I don’t really care about the New York Giants and the last time I rooted for the Dallas Cowboys was when I was 6 years old and wearing footie pajamas with a big blue star on them. A year from now I will no longer remember (and don’t care today) who won that game. But I will never forget the greatest catch I have ever seen – Odell Beckham, Jr. throwing himself backwards, reaching out behind his head, and cleanly catching the long pass with 3 fingers of one hand for a touchdown. That’s why I watch the games – for moments like this where something happens that I’ve never seen before and almost certainly never will again.

epsilon-theory-now-theres-something-you-dont-see-every-day-chauncey-december-16-2014-football

I spend a lot of my time watching politics, too, which is just another type of game. And as with my sports-watching, I care deeply about the outcome in only a small fraction of the political events that I follow, mostly local elections, but occasionally broader elections that impact my personal notions of political identity or justice. For the vast majority of political events, though, I’m really just watching in hopes that something exciting will happen.

Last weekend’s election in Japan was the opposite of exciting. It was a foregone conclusion – roughly the equivalent of Alabama playing a Division III team – because Abe scheduled the vote in precisely the same way that powerhouse college football teams schedule creampuffs. Abe announced the election on November 18, giving the opposition parties less than a month to field candidates in the various prefectures (they don’t call them “snap elections” for nothing), which allowed many of his LDP candidates to run either unopposed or with token opposition. This sort of political ploy is impossible in the American electoral system and too risky in a system that requires the head of government to submit to a national vote or referendum, but it’s a smart play in Parliamentary systems where the Prime Minister is selected by virtue of his bureaucratic leadership of the political party with the most locally elected representatives. Abe has to win a seat in the Japanese Diet, just like John Boehner must be elected to Congress from his local Ohio district every two years, but Abe’s position as head of government stems from the same source as John Boehner’s House Speakership – the support of fellow party members and allied coalition party members – not some national vote on Abe himself. It allows a Prime Minister to reset the clock on his tenure as national leader by simply resetting the clock on the locally elected representatives who support him, and that’s a very powerful tool.

What it doesn’t mean, of course, is that Abe is a nationally elected leader or that his policies enjoy some sort of “mandate” from the Japanese electorate, even though this is naturally what Abe will claim. As Speaker of the House Tip O’Neill famously said, “all politics is local”, and that holds true for Japan (in fact, is probably more true) than for the US. The backbone of Abe’s majority in the Japanese Diet comes from single-member districts (as opposed to the larger multi-member and “block” districts), where it’s American-style plurality that elects one person to the House of Representatives (yes, same name for the lower House in both Japan and the US). So in a multi-party system like Japan with many competing parties and candidates, you can often win these single-member districts without a majority of votes even in the local district, much less on a national scale. And in fact Abe’s party – the LDP – won 78% of these single-member district seats with an aggregate vote of less than 50% of the single-member district voters. Combine this structurally-biased vote outcome with a record low voter turnout (about 52%), and it’s really hard to read this election as a full-throated popular vindication for Abenomics. But it was certainly the smart play for Abe to call for the election – because the outcome was never in doubt – and you can already read non-Japanese financial media like the Wall Street Journal talking about his “mandate”. It’s ridiculous and misleading, of course, but no more ridiculous or misleading than the Narrative creation that takes place constantly in The Hollow Market, most recently on oil prices.

The upcoming elections in Greece, however, are another matter entirely.

These snap elections are not a carefully planned tool of Narrative creation and status quo regime support as we just saw in Japan, but are … potentially … a keg of dynamite that could spark revolutionary change within the status quo European system. I use that word “revolution” cautiously, because it just doesn’t mean what it used to in the West, not even in Greece where as recently as 40 years ago revolution meant coups and armed insurrections and political prisoners. Revolution today is sentiment, a narrowly constrained concept where we talk about a return to a sovereign monetary policy as if it were the equivalent of storming the Bastille. Such is life in the Golden Age of the Central Banker. 

I know, I know … we’ve heard this song before, most recently in the late spring and early summer of 2012 when the threat of a Syriza-led coalition government and a Greek exit from the Euro threw global markets for a loop. New Democracy and its allies won enough seats to form a stable coalition, and just like that the Greek problem was “solved”. What’s different today? Not much. Time has passed. The real economy of Greece is just as broken as it was 3 years ago, but there’s been progress on the structural deficit (which makes an exit from the Euro more feasible) and there certainly doesn’t seem to be the same fear of the abyss (in Greece or the rest of the EU) as in 2012.

What’s really different about the Greek elections now and the Greek elections in 2012 is the lack of a Oh-My-God-Look-At-Greece media Narrative today, particularly in the US. You’ve got the occasional headline in the European press about what a Syriza-led government might mean for the Euro system, and certainly Greek equity markets (and in a reverberating sense Italian and Spanish markets) and Greek sovereign debt have taken it on the chin since the snap elections were announced. But US financial media has been almost totally AWOL on this story. Here it’s all oil, all the time, which means that any power transition in Greece will come as a big negative “surprise” to US investors and US markets. Certainly it will come as a negative surprise to all those US investors who have been loading up on European equities over the past two months in anticipation of Draghi launching a “dramatic” acceleration of ECB-flavored QE.

Now maybe we’ll see a repeat of June 2012 tomorrow and over the next few weeks. Maybe this will end up being a boring game where the two teams basically agree to a draw, to postpone the knock-down drag-out fight for another day. But there’s a decent chance that we’re going to see something in Greece that we’ve never seen before. There’s a bit of madness to the Greek electoral saga of the past 3 years that, as de Tocqueville pointed out, is the hallmark of democratic revolutions. And just as the somewhat mad IDEA of small-l liberalism spread like wildfire through Europe in 1848, deposing old-school aristocracies across the Continent, so, too, do I think that the somewhat mad idea of growth-oriented nationalism can depose the new-school aristocracies of the Troika. As Thomas Jefferson wrote in his autobiography, it’s amazing how a seemingly small event combined with a powerful idea – say a two-penny tax on tea in some far-off colony, combined with a determination by said colonists to demand representation – can change the entire world. The mandarins in Brussels and the apparatchiks in Frankfurt will speak of the events in Greece as “contagion”, a modern version of the same “scientific” language that royalists and their flunkies used in 1848 to condemn “the mob”. Good luck with that.

What’s the market impact of all this? Look, first of all this may be a false alarm and the Red King will simply return to his tranquil slumber. Second, even if Syriza takes control of the government they may ultimately prove to be just as status quo-oriented as New Democracy. That latter bit happens more often than you’d think. Second Republics can turn into Second Empires in the blink of an eye. But what I can tell you with confidence is that the Common Knowledge of the market today is that Greece is “fixed”, which means that any un-fixing will hit markets like a ton of bricks. It’s an asymmetric risk/reward profile – in a bad way – for global markets in general and European markets in particular from an Epsilon Theory perspective.

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Hey Spike

epsilon-theory-hey-spike-october-9-2014-dogs

The strong do what they can, while the weak suffer what they must.

— Thucydides, “The History of the Peloponnesian War” (395 BC)

Global growth is really bad! Hooray!

That was the verdict of US markets yesterday, as the Fed minutes “revealed” (to use the breathless phrasing of mainstream financial media) a “growing concern” with the damaging impact of European torpor and a stronger dollar on US growth, and it’s a perfect example of why I’ve called a top in the Narrative of Central Bank Omnipotence. Not a top in market price levels (although I’m increasingly thinking that, too), but a top in market faith that price levels are completely determined by central bank policy. This is an observation that I’ve discussed at length (and perhaps ad nauseam) in recent Epsilon Theory notes like “The Ministry of Markets” and “Fear and Loathing on the Marketing Trail”, so I won’t belabor that again here.

What’s interesting to me is not this latest success of the Narrative of Fed Omnipotence. No, what’s interesting to me is this week’s failure of the Narrative of ECB Omnipotence. The Fed minutes totally bailed the market out today and (truly) revealed the Fed as the only central bank with the Common Knowledge firepower to withstand a serious growth scare. The ECB, on the other hand, has lost an enormous amount of Narrative mojo over the past week. The perception of Mario Draghi has clearly shifted from Super-Mario, willing and able to do “whatever it takes”, to what we would call in Texas “all hat and no cattle”.

Is this fair? Is this reflective of fundamental reality? No, of course not, but since when did that matter? Draghi didn’t change. Germany’s position didn’t change. Miserable European growth rates didn’t change. What changed is the direction of US monetary policy. Draghi’s beautiful words work wonders when he’s standing behind the 600-lb gorilla of the US Fed. But when that gorilla begins to stumble off along a different jungle path, as we’ve seen over the past few months … well, that’s an enormous challenge even for as skilled a Missionary as Mario Draghi. Toss in a few well-timed slashes from a master bureaucratic knife-fighter like Jens Weidmann, some disappointing macroeconomic news, and all of a sudden you’ve got a crisis in confidence with European markets.

I’m reminded of the distinction in political regime theory between “sensitivity” and “vulnerability”. Sensitivity reflects the forcefulness with which external events impact a country or institution within a given regime. Vulnerability reflects the cost of changing that regime. So, for example, while both the US and Japan would be quite sensitive to a supply shock in the price of oil from a Middle Eastern blow-up, Japan would be far more vulnerable than the US if that temporary shock became a permanent change in the oil supply picture. Because the US has more domestic energy alternatives, the long-term cost of adapting to a new and different energy world would be much greater for Japan than the US. Similarly, while both the Fed and the ECB are sensitive to growth shocks, the ECB is far more vulnerableto a world of secular growth stagnation. And the market smells that vulnerability like stink on a wet dog.

I’ll have more to say about sensitivity and vulnerability in future notes, because I think it’s a valuable concept for asset allocation and risk management. Beta and volatility are measures of sensitivity, not vulnerability, but they dominate our econometric risk measurement techniques. We need a measure of portfolio vulnerability (and this is not at all the same thing as tail risk), and I think it lives in the epsilonterm.

Today, though, the Epsilon Theory point is that we’re seeing the first unexpected ramification of a divergence in global monetary policy – the ECB is revealed as the yappy little Chester to the Fed’s bulldog Spike. Now in the cartoons there’s always a large enough scare to turn big bad Spike into a quivering mess, and that may well turn out to be the case as the global growth boogieman continues to grow in scale and scope, particularly if it spreads into the political sphere. But for now markets are still fervent believers in Fed Omnipotence, even as faith in the ECB is starting to crumble. I’m a seller of both Narratives.

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Finest Worksong


Take your instinct by the reins
You'd better best to rearrange
What we want and what we need
Has been confused, been confused
– REM, “Finest Worksong” (1987)

The politics of dancing
The politics of oooh feeling good
– Re-flex, “The Politics of Dancing” (1983)

The fault, dear Brutus, is not in our stars, but in ourselves.
– William Shakespeare, “Julius Caesar” (1599)

In theory there is no difference between theory and practice. In practice there is.
– Yogi Berra, (b. 1925)

Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. …

Indeed, the IMF’s expectation for long-run global growth is now a full percentage point below what it was immediately before the Global Financial Crisis. …

But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors. 

– Fed Vice Chairman Stanley Fischer, “The Great Recession: Moving Ahead”, August 11, 2014

There is one great mystery in the high falutin’ circles of the Fed, ECB, and IMF today. Why is global growth so disappointing? There are different variations on this theme – why aren’t businesses investing more? why aren’t banks lending more? – but it’s all one basic question. First the Fed, then the BOJ, and now the ECB have taken superheroic efforts to inflate financial asset prices in order to bridge the gap between the output shock of 2008 and a resumption of normal economic growth. They’ve done their part. Why hasn’t the rest of the world joined the party?

The thinking was that leaving capital markets to their own devices in the aftermath of the Great Recession could result in a deflationary equilibrium, which is macroeconomic-speak for falling into a well, breaking your leg, at night, alone. It’s the worst possible outcome. So the decision was made to buy trillions of dollars in assets, forcing all of us to take on more risk with our money than we would otherwise prefer, and to jawbone the markets (excuse me … “employ communication policy”) to leverage those trillions still further. All this in order to buy time for the global economic engine to rev back up and allow private investment activity to take over for temporary government investment activity.

It was a brilliant plan, and as emergency intervention it worked like a charm. QE1 (and even more importantly TLGP) saved the world. The intended behavioral effect on markets and market participants succeeded beyond Bernanke et al’s wildest dreams, such that now the Fed finds itself in the odd position of trying to talk down the dominant Narrative of Central Bank Omnipotence. But for some reason the global economic engine never kicked back in. The answer? We must do more. We must try harder. And so we got QE2. And QE3. And Abenomics. And now Draghinomics. We got what we always get in the aftermath of a global economic crisis – a temporary government policy intervention transformed into a permanent government social insurance program.

But the engine still hasn’t kicked in.

So now villains must be found. Now we must root out the counter-revolutionaries and Trotskyites and Lin Biao-ists and assorted enemies of progress. Because if the plan is brilliant but it’s not working, then obviously someone is blocking the plan. The structural villains per Stanley Fischer (who is rapidly becoming a more powerful Narrative voice and Missionary than Janet Yellen): housing, fiscal policy, and the European economic slow-down. Or if you’ll allow me to translate the Fed-speak: consumers, Republicans, and Germany. These are the counter-revolutionaries per the central bank apparatchiks. If only everyone would just spend more, why then our theories would succeed grandly. 

Hmm. Maybe. Or maybe what we want and what we need has been confused. Maybe the thin veneer of ebullient hollow markets has been confused for the real activity of real companies. Maybe the theatre of a Wise Man with an Answer has been confused for intellectually honest leadership. Maybe theoretical certainty has been confused for practical humility. Maybe the fault, dear Brutus, is not in external forces like Republicans or Germans (or Democrats or Central Bankers), but in ourselves. 

Let me suggest a different answer to the mystery of missing global growth, a political answer, an answer that puts hyper-accommodative monetary policy in its proper place: a nice-to-have for vibrant global growth rather than a must-have. The problem with sparking renewed economic growth in the West is that domestic politics in the West do not depend on economic growth. What we have in the US today, and even more so in Europe (ex-Germany), are not the politics of growth but rather the politics of identity. At the turn of the 20th century the meaning of being a Democrat or a Republican was all about specific economic policies … monetary policies, believe it or not. You could vote for Republican McKinley and ride on a golden coin to Prosperity for all, or you could vote for Democrat Bryan and support silver coinage to avoid being “crucified on a cross of gold.”

Today’s elections almost never hinge on any specific policy, much less anything to do with something as arcane as monetary policy. No, today’s elections are all about social identification with like-minded citizens around amorphous concepts like “justice” or “freedom” … words that communicate aspirational values and speak in code about a wide range of social issues. Don’t get me wrong. There’s nothing inherently bad or underhanded about all this. I think Shepard Fairey’s “HOPE” poster is absolute genius, rivaled only by the Obama campaign’s genius in recognizing its power. Nor am I saying that economic issues are unimportant in elections. On the contrary, James Carville is mostly right when he says, “It’s the economy, stupid.” What I am saying is that modern political communications use neither the language nor the substance of economic policy in any meaningful way. Words like “taxes” and “jobs” are bandied about, but only as totems, as signifiers useful in assuming or accusing an identity. Candidates seek to be identified as a “job creator” or a “tax cutter” (or accuse their opponent of being a “job destroyer” or a “tax raiser”) because these are powerful linguistic themes that connect on an emotional level with well-defined subsets of voters on a range of dimensions, not because they want to actually campaign on issues of economic growth. Candidates have learned that while voters certainly care about the economy and their economic situation, the only time they make a voting decision based primarily on specific economic policy rather than shared identity is when the decision is explicitly framed as a binary policy outcome – a referendum. Even there, if you look at the ballot referendums over the past several decades (Howard Jarvis and Proposition 13 happened almost 40 years ago! how’s that for making you feel old?), the shift from economic to social issues is obvious.

Both the Republican and the Democratic Party have entirely embraced identity politics, because it works. It works to maintain two status quo political parties that have gerrymandered their respective identity bases into a wonderfully stable equilibrium. The last thing either party wants is a defining economic policy question that would cut across identity lines. But until the terms of debate change such that an electoral mandate emerges around macroeconomic policy … until voters care enough about Growth Policy A vs. Growth Policy B to vote the pertinent rascals in or out, despite the inertia of value affinity … we’re going to be stuck in a low-growth economy despite all the Fed’s yeoman work. I know, I know … what blasphemy to suggest that monetary policy is not the end-all and be-all for creating economic growth! But there you go. At the very moment that elections hinge on the question of economic growth, we will get it. But until that moment, we won’t, no matter what the Fed does or doesn’t do.

What reshapes the electoral landscape such that an over-riding policy issue takes over? Historically speaking, it’s a huge external shock, like a war or a natural disaster, accompanied by a huge political shock, like the emergence of a new political party or charismatic leader that triggers an electoral realignment. In the US I think that the emerging appeal of national Libertarian candidates (all of whom, so far anyway, have the last name Paul) is pretty interesting. The 2016 election has the potential to be a watershed event and set up a realignment, if not in 2016 then in 2020, which hasn’t happened in the US since Ronald Reagan transformed the US electoral map in 1980. And yes, I know that the conventional wisdom is that a viable Libertarian candidate is wonderful news for the Democratic party, and maybe that will be the case, but both status quo parties today are so dynastic, so ossified, that I think everyone could be in for a rude awakening. It’s a long shot, to be sure, mainly because the US economy isn’t doing so poorly as to plant the seeds for a reshuffling of the electoral deck, but definitely interesting to watch.

What’s not a long shot – and why I think Draghi’s recently announced ABS purchase is a bridge too far – is a realigning election in Italy. 

I like to look at aggregate GDP when I’m thinking about the strategic interactions of international politics, but for questions of domestic politics I think per capita GDP gives more insight into what’s going on. Per capita GDP gives a sense of what the economy “feels like” to the average citizen. It addresses Reagan’s famous question in the 1980 campaign with Jimmy Carter: are you better off today than you were four years ago? It’s a very blunt indicator to be sure, as it completely ignores the distribution of economic goodies (something I’m going to write a lot about in future notes), but it’s a good first cut at the data all the same. Here’s a chart of per capita GDP levels for the three big Western economies: the US, Europe, and Japan.

epsilon-theory-finest-worksong-september-15-2014-gdp-eu-us-japan
Source: World Bank. For illustrative purposes only.

The Great Recession hit everyone like a ton of bricks, creating an output shock roughly equal to the impact of losing a medium-sized war, but the US and Japan have rebounded to set new highs. Europe … not so much.

Let’s look at Europe more closely. Here’s a chart of the big three continental European economies: Germany, France, and Italy.

epsilon-theory-finest-worksong-september-15-2014-germany-france-italy
Source: World Bank. For illustrative purposes only.

Germany off to the races, France moribund, and Italy looking like it just lost World War III. I mean … wow. More than any other chart, this one shows why I think the Euro is structurally challenged.

First, why in the world would Germany change anything about the current Euro system? The system works for Germany, and how. Alone among major Western powers, the politics of growth are alive and well in Germany. “But Germany, unless you lighten up and embrace your common European identity, maybe this sweet deal for you evaporates.” Ummm … yeah, right. The history books are just chock-full of self-interested creditors with sweet deals that unilaterally made large concessions before the very last second (and often not even then).

Second, why in the world would Italy accept anything about the current Euro system? The system fails Italy, and how. The system fails other countries, too, like Spain, Portugal, and Greece, but these countries are in the Euro by necessity. Their economies are far too small to go it alone. Italy, on the other hand, is in the Euro by choice. Its economy is plenty big enough to stand on its own, and with a vibrant export potential, an independent and devalued lira is just what the doctor ordered to get the economic growth engine revved up. Short term pain, long term gain.

Why doesn’t Italy bolt? Lots of reasons, most of them identity related. Also, let’s not underestimate the power of cheap money to keep the puppet-masters of the Italian State in a Germany-centric system. The system may fail Italy as a whole, but if you’re pulling the strings of the State and can borrow 10-year money at 2.5% to keep your vita nice and dolce … well, let’s keep dancing.

Still, nothing focuses the electoral mind like the economic equivalent of losing a major war. At some point in the not so distant future there will be an anti-Euro realigning election in Italy. 

And that will wake the Red King.

In the meantime, Draghi will go forward with his ABS purchase scheme, a brilliant theory that will deliver frustratingly slim results quarter after quarter after quarter. Until the politics of growth are embraced outside of Germany, European banks will remain reticent to lend growth capital to small and medium enterprises. Until the politics of growth are embraced outside of Germany, large enterprises with plenty of cash and access to cheap loans will remain reticent to invest growth capital. Maybe a little M&A, sure, but no new factories, no organic expansion, no grand hiring plans. The thing is, Draghi knows that he’s pushing on a string with the ABS program and that growth won’t return until the fundamental political dynamic changes in France in Italy, which is why he is calling both countries out by name to institute “structural reforms”. But in typical European fashion this entire debate is Mandarin vs. Mandarin, with almost all of the proposals focused on regulatory reform rather than something that must be hashed out through popular legislation. So long as economic policy reform is imposed from above … so long as we are engaged in modern-day analogs of Soviet Five-Year Plans … I believe we will remain stuck in what I call the Entropic Ending – a long gray slog of disappointing but not catastrophic aggregate economic growth. That’s not a terrible environment for stocks, certainly not for bonds, and the alternative – economic reform based on the hurly-burly of popular politics, is almost certain to be a wild ride that markets hate. But to get back to what we need (real growth) rather than what we want (higher stock prices) this is what it’s going to take. Elections always matter, but in the Golden Age of the Central Banker they matter even more.

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