Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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Are debt and wealth really two separate forces in a monetary system? Part 1

I write with reference to a discussion in a recent Bloomberg View article, We’re Still Not Sure What Causes Big Recessions.

Debt/broad money supply is a key foundation of asset and human capital values and their supporting GDP flows.  Because of this, wealth and debt effects (new loans create deposits) on GDP/income flows should not be considered as separate forces. 

Debt in its money supply origination (bank deposits) is a foundation of both GDP flows and asset values and it is when debt, and specifically in the form defined, increases relative to GDP/national income flows that we should pay attention.  And we need to pay attention to all flows, not just income flows on risky assets, for example corporate profits which can squeeze out returns on both fixed interest and human capital during periods of enforced low interest rate policy.

Money leverages many activities, and asset values are always to a certain extent in a form of a bubble, but excess leverage, especially during periods where we have structural imbalances and frame transitions creates instability and risks to the financial system. 

Frame transitions that we need to watch out for with respect to excess asset focused money supply growth are where drivers of GDP growth are in decline (labour and population demographics, productivity and global transitions impacting the same) requiring lower levels of capital or growth rates of capital accumulation resulting in increasing levels of capital depreciation.  In this context monetary frame dynamics should also be contracting or slowing.  Frame transitions can be accentuated by increasing income and wealth inequality, something that may also be an emergent property of economic systems during frame transitions.   This can also leverage asset prices to prospective GDP flows.

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Helicopter drops: feeding the animals in order to keep the zoo in business..

I was reading “Helicopter drops might not be far away” by Martin Wolf in the FT.  By now those interested in macro economics/monetary policy/asset markets should be well aware of the long gradual easing in interest rates, especially since the 1990s.  Lower interest rates did not just encourage people to borrow for consumption, but they also boosted the amount of borrowing for asset purchases with rising asset values also looping back into consumption for a while.   During this period, global money supply growth also became ever more asset focussed. 

For a while this helped stimulate consumption in key economies, also aiding in developing economy growth.   Developed economy consumers became ever more indebted at a time when income growth was also slowing, but given that asset markets kept rising and interest costs kept falling, everything was able “to keep on going for a while”…many felt that this period of low interest rates and rising asset markets was a “great moderation” and few seemed to notice the enveloping divergence. 

While the financial crisis was the bursting of this particular reality, it also marked the onset of a period of unprecedented financial engineering in response, itself a denial of that reality. 

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Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

Can QE be reversed?

I just read a post on the subject of reversing quantitative easing.  Just a quick few points:

For a given velocity of asset focussed money supply and a given preferred allocation of money within the “asset portfolio”, the withdrawal of liquidity will impact the demand for assets via a) increased supply of certain assets, b) the reduced amount of money and hence readjustment of preferred percentage money allocation and c) via changes in asset preferences, in particular preferences for assets that may have increased in supply as QE was taking place. 

With QE, we have the introduction of higher levels of portfolio focussed cash with a reduction in relative supply of higher quality assets and this would cause problems if this also skews the universe of demand and supply for higher risk/less liquid assets: that is the universe pushes outwards.

As QE is reversed and money is withdrawn and lower risk/more liquid assets are injected into the asset portfolio, demand for higher risk/less liquid assets may drop as these assets are displaced within the asset portfolio: that is the asset universe contracts. 

The issue here is that we risk a secondary asset impact over and above the expected price adjustment of all assets as portfolio liquidity is withdrawn.  Unconventional monetary policy is likely to have altered the asset profile of the asset portfolio and this adjusted profile is likely to be hit most at its weaker newly developed extremities . 

The risk is that certain asset classes get crushed in the rush for the exits.  The question is how much does the market for these asset classes at the outer edge of the universe get impacted and to what extent will this likewise impact consumption and future consumption expectations?  If you cannot sell an asset you bought at a certain price with an expectation over a future value with any degree of certainty, then we have a discounted present value demand shock.  If QE is substantial and the potential reverse substantial too, this shock can be quite large.

QE may not just have impacted pricing but also market structure, liquidity, and introduced larger amounts of higher risk/less liquid assets into core portfolio destinations than would have occurred without it.

This is not a complete analysis by any means but we have changed the nature and structure of asset markets and therefore the relationship with asset markets and consumption functions. 

I discussed some of these issues in another related post:

A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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QE and metaphysical dialogue

Once upon a time economic analysis was “relatively” straightforward…growing, slowing, boom, recession…all part of an upward cycle…even if you got it wrong, it never really mattered…most problems appeared consequences of excess growth…

Something changed some time way back and we have been edging in spurts, lunges and various headlong gallops to yet higher precipitous vantage points…the valleys along the way have also yielded some many interesting experiences….whether this change was a structural process that started some way back in the 1980s (secular stagnation and there are indications this could be the case), or the consequence of a misplaced emphasis on maintaining the stability of the business cycle in the late 1990s (LTCM, Asian Crisis..again consequences of this are clear), that saw central banks lowering interests rates to maintain the growth cycle, or the increasing levels of consumption and debt and widening wealth and income inequality that came hand in hand with lower interest rates and more “stable” and longer growth cycles and or financial deregulation, is a part of the overall complexity of the matter. 

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Some other asset focussed and hence QE relevant charts…

Scratching my head?  How far does this asset thing need to be pushed before mission accomplished?

assetsgdp

The blue line shows household and NPO asset per capita relative to annual growth in income per capita (over rolling 10 year periods).   The red line shows the annualised increase in disposable personal income per capita over 10 year rolling periods.

Now clearly assets are growing relative to income at a time when income growth is declining.   QE is filling the income growth gap.

parabolicasstinc

Thoughts re a simple QE model of asset price bubbles…assorted recent tweets

I was thinking along similar lines..but if debt amplifies interest rate increases, what on earth is a neutral IR policy?

Why is raising interest rates currently a greater risk than usual?  Not just highly priced asset markets but significant levels of debt and an increasing amount of new debt issuance in lower credit quality assets.   In proportion to GDP growth, debt and asset levels are at historically high levels.  A given amount of economic return is spread much more thinly over a much wider range and supply of assets and hence the impact of interest rate increases are much more highly leveraged.  Understandably we needed to support asset prices during the abyss that opened up late 2008 to early 2009, but I am much less sanguine about monetary support 2011 onwards.

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Thoughts re a simple QE model of asset price bubbles…Will this bubble burst or will it collapse under its own weight..?

In a recent tweet I made the following comment:

“Bursting implies force>than constraint, collapse implies constraint>than its force”

In a recent blog post I discussed the large build up of money supply in the US (this is pretty much replicated across the globe) and the fact that money supply in excess of nominal GDP growth is likely asset focussed.  My point in this tweet was that a bubble either bursts, or deflates, or collapses under its own weight. 

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Thoughts re a simple QE model of asset price bubbles–money holdings

I am just parsing through a simple model of QE attempting to bring together the disparate strands and thoughts…

One point that is worth pointing out is the extremely large increases in money holdings in the US economy, especially over the last 12 years with regard to their differential with nominal GDP growth.  I dealt in detail with the physics of changes in money supply and its distribution between expenditure and asset portfolios in a document I wrote in 2008.

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Is the balance sheet recession over? Financial sector debt…

Financial sector debt (and as noted consumer debt) has fallen significantly since the crisis:

image

Yet, if we look at the financial sector assets with respect to non financial sector credit market debt, we start to see an interesting picture:

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Central Banks and bubbles..

I do find it funny to see how many rely on the words of central banks to determine whether markets are or are not in bubble territory.   Central banks these days are in the business of mind manipulation for the furtherance of asset price stability and economic survival and to expect them to malign the object of their obvious intent would be insanity.  Central banks are supporting asset prices for balance sheet purposes and to suggest these prices were in bubble territory would be counterintuitive.  

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Brief comments on Mckinsey “QE and ultra-low interest rates: Distributional effects and risks”

QE and ultra-low interest rates: Distributional effects and risks (McKinsey)

McKinsey state that QE does not appear to have affected equity prices.  In a sense, you could say that because most of the cash used to buy the bonds has remained on the Fed’s balance sheet, and because the supply of money itself has little impact on future real returns, and if investors and agents assume that QE itself will not directly impact economic activity then in a rationale world it is unlikely that QE would impact equity prices – equity prices being determined by the future real supply of returns.

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Fama on tapering–it all depends on your view of the Fed and the market.

Just watched a short clip on Zero Hedge with Ric Santelli and Eugene Fama discussing tapering.  Fama said that tapering would be a neutral event.

Fama’s point was that tapering is a simple balance sheet exercise whereby the Fed transfers the securities it has bought for the short term debt (deposits) it has issued.  I guess in a sense, if it is a neutral exercise, the impact would be determined by the interest rate differential on the two.  But it could be a lot more than this.

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An exercise in going where your thoughts lead! “Perhaps, perhaps” says the Fed about QE!

On its own, I would not place too much weight on today’s movements in US securities: people have been building up the pricing risk of a change in Fed Strategy for some time and today’s movements reflect only a very miniscule readjustment. 

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Volatility, China and QE instability

QE may have reached its limits, that is the stability it brought to the financial system may now have passed its inflexion point, overwhelmed by the relationship between portfolio focussed money and the supply of real returns: volatility may now dominate as asset prices become increasingly sensitive to real fundamentals. In other words the inherent leverage of QE risks negatively impacting asset prices, whereas before it provided support.

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Could too much money in the system lead to deflation? There is a risk.

Low interest rates and quantitative easing could deter new capital investment projects. QE is no doubt helping asset prices rise, but it is also forcing down the cost of capital at a time when the return on capital should, arguably, be higher, given the risks. Returns on the different components of the cost of capital equation should justify the risk, and cash and bonds are both important components.

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When beta is wrong…and by implication expected return, risk and covariance..

One of my many issues with modern portfolio theory is that it assumes not only that markets clear but that supply and demand are also optimal.

In a low growth environment where asset prices are being pushed upwards through quantitative easing, modern portfolio theory tenets becoming increasingly irrelevant for efficient asset allocation in risk return space and a serious risk to effective withdrawal management.  In such an environment we have to be very careful in our assessment of beta and the risks both allocating to and away from it present.  

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As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

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