Don’t worry, here comes the three horsemen of the apocalypse!

Ambrose Evans-Pritchard has neatly summed up some industry think in his latest piece, “Global banks see market rally on Greek exit”. 

But this type of industry thinking is also likely to scare away the retail investor, through rational cognitive dissonance or otherwise. 

Apparently, we are set for a big rally, once Greece leaves the Euro, as Central Banks the world over pump yet more liquidity into the financial system.  This will either be via LTRO Repo type (temporarily exchange your securities for cash) transactions or the better for the banks and sovereigns, QE (buy your duff securities for a price you would not be able to dream of otherwise). 

Here is my very quick, write it as you think it, opinion on this “play”.

Either way, securities markets will be saved yet again (?).  But for how long say the now wary and scarred investor?  Because this is now so many times bitten, irreversibly cynically shy!

The fact we are now in a position where further central bank liquidity fests are needed to restore confidence in asset markets, banks, sovereign debt, yet again, should create inexorable and ineffable discomfort.  This is surely, the last redoubt before the final collapse of capitalism’s contrived byzantine complexity. 

Liquidity does not equal lending, or demand, and it does not offset declines in balance sheet asset values per se.   In order to generate demand from QE/liquidity operations, these operations need to restore confidence in markets, the financial system and the economy.  We need people to spend more and we need banks to lend more.  But we know that this has not necessarily happened to the degree required to generate a lasting long term recovery in the last few attempts. 

At this stage of the cycle we need to get rid of non performing, or at risk of non performing liabilities, thereby creating the necessary imbalance between money supply and economic consumption capacity.  This means central banks facilitating the buying/writing off of all or part of non performing loans and leases in the banking system, and/or buying up and writing off beleaguered sovereign debt at the margin.   

Further liquidity at this stage of the cycle does imply an acceptance of the need to debase the money supply.  As discussed, it is not the increase in money supply that is the problem, but the implied write off of assets and asset values required to create the necessary imbalance between money supply and consumption capacity.  Money will be backed by fewer assets, and there will be more of it.

Now obviously this needs to be done with “care”, because you do not want to create too large an imbalance – although how you can do this type of anarchic exercise with care is doubtful. 

Now, this also means that asset prices will need to readjust to the change in dynamics: bond prices will have to rise in low yield economies (they will fall in debt ridden economies) to account for higher inflation, and equity prices will need to adjust for a jump in nominal demand – this may just as easily result in a drop in prices in response to the uncertainty over the inflation and demand impact or a rise in prices as investors realise the dynamics favour equity based investments.

The risk is that low risk, safe harbour assets will be annihilated so that equity based risk assets are favoured.  That is if the outcome is positive.  One problem with all this is that banks will still be loathe to lend and consumers unable or unwilling to borrow, meaning that governments will need to lead the way, meaning that government debt will likely re-expand, creating yet further declines in low risk asset prices and higher bond yields, thereby creating secondary negative shocks to the equity markets.        

Additionally, you have the problem of coordinating all of this globally and making sure that the economic activity does not accentuate existing structural imbalances.  In other words, the risk is that we move further away from efficient market structures and relationships.   A mistake at this stage has very, very, very large risks.

The only other route is deflation and depression, and this implies a rise in bond values for some, a collapse in others, a collapse in most equity markets and a wholesale restructuring and cleansing of the economic order. 

There is too much debt in the world: to right the imbalance we need to wipe off the debt and inequitably favour equity, or write off the equity and inequitably favour the debt.  We have been muddling in the middle ground, for too long, effecting neither outcome.

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