Excesses in the system, can they keep building up?

Dear Reader,

I continue with a little armchair thinking that was fuelled by a discussion this morning with an apt portfolio manager.

"Get me out of the USD and convert it to GBP and AUD", he said. I went through the argument presented in a recent blog discussing the potential of the AUD weakening due to its historic strength, and the tendency for currencies to move in a sinusoidal manner in the long term.

"Sure", he says. "But this currency has high interest rates, its economy is fighting inflation, and rates are likely to rise more. Furthermore, the Chinese are not going to de value their currency soon (he believed), and the exports will not fall. Meanwhile, their domestic market is growing. I want AUD. In 6 to 9 months, we can talk again". He was a little less convinced about GBP, but wanted out of USD. The client, for curiosity, also has a good position in Canadian dollars (CAD).

It seems that the low interest rates and quantitative easing in developed economies have incentivised investors to move to currencies such as the AUD and CAD. These capital movements can therefore be concluded to be supported by government distortions. Or are they not distortions, but the often quoted "new normal?". Gold is another asset that is profiting handsomely from such dynamics.

Perhaps governments will continue to behave in such a way, such that these trends are likely to continue, the excesses will build up until...bang. What will be that bang? If we feel it is being fuelled by governments, then we have to appreciate what can stop their tap flowing. For any person that has been overleveraged will know, debt has the properties of cancer. When it grows to a certain size, there is very little you can do to stop it from killing you. Prevention, and early treatment, is the best cure, if not the only one. Lets use an example of two countries with economy A and B:-

Country A has debt to GDP of 100%, which is expected to grow GDP at 5% nominal in the next few years. Country B has debt to GDP of 65%, but is expected to grow at only 3% nominal.

If initially both governments can borrow at 3% for 10 years, then interest payments will make up 3% of country A, and only 1.95% of country B. Both are less than annual GDP growth, so the GDP of each economy is growing over time (in nominal terms) in this scenario.

If however both countries start large quantitative easing programs because national banks have poorly allocated capital in their lending programs, foreign investors may be more reluctant to lend money to these governments due to these added pressures. Such problems could be amplified. For example, in country B the banking sector is twice the size of the countries economy. As a result, 10 year government bond yields increase to 4.5% and 5.5% respectively for countries A and B. If this scenario was to remain for a number of years, we will see that interest payments will become 4.5% and 3.6% of GDP for countries A and B. As a consequence of these results, economy B is now in negative GDP growth, as interest payments are larger than the annual increase in economic activity. This has the consequence of making foreign investors more fearful, making interest payments higher, and hence making GDP decline larger. This is a terrible positive feedback loop which becomes more probable as an economy takes on more debt, because the cost of the debt has to be lower to activate this feedback loop.

You may say in that scenario, the country that was issuing the debt, you should get out of their currency. As they accumulate more debt, the day of the big bang, or the positive feedback loop, becomes closer. This gives more reason to move to currencies such as the AUD, as the leveraged country is likely to see risk asset pricing fall as money is moved out of their currency, as well as the currency depreciate and the cost of borrowing rise. This is a non linear and unpredictable event as it is triggered by a lack of confidence, i.e. human emotion. However, once it happens, it is very difficult to stop because of this powerful positive feedback loop that appears. This event, for a trader, is as close to a sure bet as you can get. The feedback loop will push this process with such might that only a unique major event can stop it.

The question is, how big an event requires the current trade to stop? I believe it just needs bad news from China. The lack of transparency and free floating currencies in many emerging markets is a bonus for developed countries: it allows more investment capital to be denominated in their currencies. As a result, we see large fluctations amongst the major currencies as a means to let out the tensions in global economies.

In conclusion, the bet on AUD is implicitly assuming that China news flow will be good, or at least less worse, than news from developed countries. If you are confident on that bet, then its makes sense to join the late bandwagon.

Though we feel the positive feedback loop can happen, it cannot happen, by definition, everywhere. In terms of debt accumulation it is most likely to happen in Europe, in terms of increasing the money supply, it comes from the USA.

As non macro economists, we use such reasoning in a very limited manner. We have considered going short the JPY, AUD and EUR. However, have not acted on such thoughts due to a lack of conviction. What we try and do is buy companies from all over the world that are cheap and generate earnings all over the world. Hence a weakening currency in one country, will benefit that company by making its pricing more competitive, hence offering a limited "hedge" on the currency the company is denominated. As a result, at best, we want to be neutral currencies in our portfolios and want returns to come from our security selection and asset allocation.


Yours sincerely,

Alessandro Sajwani