If corporations were people, a good many of them would be psychopaths. That was the conclusion of a study done some ways back, in which the routine behaviors of publicly traded companies were put under the lens of psychiatric analysis.
Similarly, if Mr. Market were to check himself into a psych ward, his file would no doubt contain the phrase “obsessive compulsive” – perhaps bolded in caps.
This is so because markets, and particularly currency markets, have the habit of deeply fixating on one point of data or one particular relationship at a time. What’s more, the “obsession du jour” can swing with schizophrenic verve. Last month it was the current account deficit. This month it is interest rate differentials. Next month it will be geopolitical factors... and so it goes.
Though the number crunchers don’t realize it (or fail to acknowledge it), markets are also very much driven by narratives and stories. There is nothing quite as powerful as a strong story, convincingly and artfully told. Investors gravitate to these narratives and stories as a natural consequence of being human. As Eric Beinhocker recounted in his wonderful book The Origin of Wealth, humans are born storytellers. An affinity for stories is woven into our DNA.
A Shaky Plot Line
Lately the story has been one of rose-tinted recovery. Optimism has won the day, routing pessimism through and through. This is not just the conclusion of grumpy bears, but also the verdict of the Credit Suisse Global Risk Appetite Index (try saying that five times fast).
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The Credit Suisse Global Risk Appetite Index (whew, that’s tiring just to type) hit “euphoria” levels last week, in the fastest bounce off pure panic levels since the crash of 1987. The going narrative is one of buoyant profits, fast-healing consumers, and a world in which better days – much, much better days – are just around the bend.
There is just one problem with this warm-hearted tale. It doesn’t make a lick of sense...
Underneath the shiny, thin veneer of surface-level data, economic conditions have remained rotten. Almost wherever a sufficiently motivated investor chooses to look, “good news” turns out to be bad news in drag – lipstick on a pig, as some wags like to say.
Case in point – the recent U.S. jobs report. As the WSJ dryly noted, “the decline in the jobless rate was primarily caused by people dropping out of the labor force, and the rate is likely to rise again.” Whoopty-do! Time to celebrate anyway... there are at least a dozen examples like this, in which sentiment has willfully detached from reality.
Pulling the Jenga Block
The trouble with building a house on hope alone, it turns out, is that the structure grows more and more rickety as time goes on. There is no rest for the wicked, especially when the wicked are in the business of falsehoods. Maintaining a ruse, if only for the sake of continuing to fool one’s self, is hard and constant work.
In this, the rosy recovery story is not unlike a highly stacked jenga tower.
Jenga, if you’ll recall, is a parlor game played with 54 wooden blocks. The blocks are assembled into a crisscrossed 18-story tower. The objective is to skillfully withdraw blocks, one at a time, and use them to add height without crashing the tower.
Pull the wrong block, of course, and the whole thing comes avalanching down...
A good old-fashioned market hope jag behaves the same way. As factual struts and supports are removed, the jag can stay intact (and even grow taller for a time). But, eventually, the jag goes the way of all unsupportable schemes.
Last week the BOE (Bank of England) pulled a key jenga block of sorts in announcing a much larger round of QE (quantitative easing) measures than expected. The BOE’s decision to monetize a larger quantity of debt than anticipated caught investors flat-footed; the pound fell sharply and well-nigh instantaneously on the news. In a display of sympathy and commiseration, the euro and the Swiss franc fell sharply too.
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As John Authers of the Financial Times put it, “the sums involved are not vast. But it is the symbolism that counts. The Bank [of England] did not have to do this. Whatever their reason, the implications are not appealing.”
Erik Nielsen, the chief Europe economist at Goldman Sachs, responded to the BOE’s shock move by doing his best impression of the wide-eyed rube who just fell off the turnip truck.
“They’re too nervous to say that things are getting better... in some ways, the central bankers seem less confident than the markets are these days,” Nielsen said.
No really Erik, you think? Would that be why the BOE is still talking and acting as if Britain is in deep crisis, even as pie-eyed investors pretend all is well?
In Disastrous Shape
And now we come back around to that perception-reality gap again. Investors are prone to embrace the pollyanna case because markets are structurally naïve – how could they be anything other, when the vast majority of Wall Street players have a long-only orientation – and the idea that Britain was in recovery was just such an example of rose-colored naivete?
The truth, as laid out by less biased observers like British financial historian Niall Ferguson, is a bit more grim.
“The probability of a real sterling crisis is around one in three, and the probability of major tax hikes and cuts in public spending is roughly one in one,” Ferguson says. “We’re not Iceland or Ireland, but we’re closer to them than we are to the U.S... this kind of red ink implies both spending cuts and tax hikes that could make the 1980s look like a teddy bear’s picnic.”
The 77-year-old Nigel Lawson, Britain’s Chancellor of the Exchequer under Maggie Thatcher from 1983 to 1989, does not disagree. “[Britain’s] public finances are easily the worst we’ve ever had in peacetime,” Lawson remarks. “It’s essential they take tough action straightaway.”
Andrew Bosomworth, a fund manager with the Munich outpost of PIMCO, also believes the pound could get pounded. “In a worst-case scenario, there could be a run on the currency,” Bosomworth said.
So much for “sound as a Pound” (an old British expression denoting safety and security). They may have to file that one away with the retired yankee aphorism “safe as houses.”
This is the rottenness that lies beneath the floorboards. Stomp that polished wood hard enough and a foot could go right through.
Et Tu, Euro?
The point here is not just to pick on Britain. As bad as the bulldog looks, there is a case that continental Europe (and the experimental currency that is the euro) is in even worse shape.
So why have investors been ignoring this reality thus far? Remember Mr. Market’s obsessive-compulsive tendencies... his penchant for delusion... his taste for enchanting bedtime stories.
The swaying tower of jenga blocks that is investor optimism has led Mr. Market to believe that risk-related assets are only for buying... that the dollar is only for selling... and thus that currencies like the British pound and the euro were wonderful for bidding up, at least in the short term.
When that bubble of delusion is well and truly punctured – and the Bank of England may well have done it last week by tacitly acknowledging Britain’s dire economic state – a slow-motion avalanche in euro-area currencies could ensue.
So be wary of dust and gravel spray... those light pebbles could be followed by boulders. In my globe-roaming trading service, Macro Trader, we intend to take full advantage of this developing situation.
Warm Regards,
JL
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