The following is an excerpt from the “Around the World in 8 Pages” series and the most recent report published by Librarium Associates Ltd, and their Managing Partner, Mr. Sune H. Sorensen.
Sune, who acts as a strategic advisor to BFI (www.bficapital.com), believes that the world can often make a lot more sense by viewing it from different angles. In that spirit, and in keeping with Tolkien’s statement “Not all who wander are lost”, staying away from the masses and keeping your own very independent thinking cap on, can sometimes reveal the safest and most suitable path of all.
“The key is not to predict the future but to prepare for it.” Pericles, 500 BC
“We have not been bearish enough”
In this particular excerpt, Mr. Simon Mikhailovich, a contrarian investor, entrepreneur and an expert on systemic risks, provides his insights on the world facing the US and international investors as the sun set on 2018.
The morning after Lehman Brothers went bankrupt, I spoke to Jim Grant, the brilliant economic historian and well-known bear, who simply said: “We haven’t been bearish enough…”
In the years leading to 2008, our small group of likeminded contrarians spent countless hours discussing the timing of the upcoming crisis and its consequences. We parsed the data on the grossly mis-rated subprime bonds, the leverage hidden inside the CDOs, the overly tight credit spreads and the excessive leverage. To be perfectly honest, however, not even the most bearish of us considered systemic risk as a real threat. We had been bearish on credit and equities but, given the ensuing systemic blow up, we hadn’t been bearish enough.
One of the lessons from the last crisis was that modern economics and finance heavily focus on the data and the models, whereas identifying systemic risks is about the broader context and “preexisting conditions” - economic, structural, political, geopolitical, social, etc. The subprime debacle was considered “contained” because it was a relatively small market by size. Structurally, though, its impact was amplified via derivatives and securitization, which made it large enough to topple the financial system whose vulnerability was not captured by the conventional ratios. Collective failure to look beyond the data was the reason why so few recognized the crisis when it began in the summer of 2007 with a failure of two Bear Stearns structured credit funds. Neither did they recognize it when Bear Stearns itself failed, requiring a Fed bailout. By mid-2008, the risks were in the open and yet, almost no one was willing to consider the obvious implications.
The same is true today. Even those who profess themselves bearish are not worried, at least in public, about systemic risks. Over the past three months, market legends such as Ray Dalio, Paul Tudor Jones, Stanley Druckenmiller, and Jeffrey Gundlach, have all voiced grave concerns about the markets and the economy. Some have gone as far as to say that we are in a “global debt bubble” and that the current period is similar to the late 1930s. And yet, none of the experts have mentioned the potentially catastrophic risks to capital their views imply.
For if we truly are in a global debt bubble and the current period really is similar to the late 1930s, is it reasonable to expect that outcomes would be no more serious than a garden variety bear market and/or a run of the mill economic recession?
The global systemic risk called DEBT
The elephant in the room that neither the sell-side analysts nor the money managers are willing to confront head on is that since the 1982 peak in rates, Western demand has been heavily subsidized through ever-expanding credit, while the asset values have been lifted by the ever-declining rates.
This worked while the declining rates were offsetting the impact of the rising debts and keeping the debt service manageable. However, this system broke down in 2008 requiring massive bailouts, near-zero rate levels and US$ trillions in subsidies and QE to stabilize it. Since then, global debts are up by over 40%, the TBTF banks are bigger than ever and the rates, until recently pinned near or in some cases, below, zero, have left public and private pension plans severely underfunded.
Record levels of debt globally
Since excessive leverage, the reason behind the 2008 crisis, has not been addressed, the Fed’s attempt to normalize rates is roiling both the equity and credit markets, i.e. the “patient” has been left on life support for ten years and the Fed’s attempt to have him walk on his own is not going well.
This is a symptom of too much debt vs. the cash flows available to service it at normalized rates. As every US$1 of debt is someone’s asset, there is no painless fix. The only question is when, how and to whom will the losses be allocated.
Since capital stewardship is first and foremost about avoiding catastrophic losses, the key, as Pericles advised 2,700 years ago, is not to predict the future but to be prepared for it. Clearly, preparing for something requires an idea of what it could be. And so, instead of recounting the market action and making predictions, I would like to simply point out some issues and recent developments that I believe have a direct bearing on the systemic risks we are likely to confront in the coming year and beyond.
The perilous path of the US
Source: J. Gabriel – US Treasury – CBO
While material systemic risks can result in catastrophic losses, risks are not certainties. However, as with any insurable risk, if the probability of catastrophic losses is material, failure to address such risks in advance is imprudent, if not reckless. Investors and politicians got a pass for not being ready in 2008 but using the same “black swan” defense next time would ring hollow.
Systemic risks tend to turn into systemic disruptions during acute market and economic crises. This is known as second- and third-order effects, whereby a seemingly “contained” initial debacle sets off a chain reaction of consequences that few would have thought even remotely possible immediately before they occurred.
The pre-2008 thinking was that a failure of a major investment bank would be Armageddon and not worth insuring. It turned out to have been no Armageddon and those few who had worried about it got paid very well for buying insurance well in advance.
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