The Bubble in Complacency

The warning signs have been growing in number and frequency. Yet for all the fretting about the trade wars, Cold War II, Brexit, Euro-fragility, populism, sky-rocketing debts, underfunded pensions, and the slowing economy, the vast majority of investors remain confident that all of these problems can and will be solved painlessly.

«That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.»

Aldous Huxley

To paraphrase the 1930s poem by Pastor Martin Niemöller about the perils of complacency, first they came for the interest rates, but investors did nothing because they liked how the ever-declining rates kept lifting asset prices. Next, they came for the free markets, but investors did nothing because they loved how «Quantitative Easing» kept lifting asset prices further still. Then came the war on cash, but investors did nothing because digital claims were so convenient.

As the next downturn gets closer, it pays to remember this lesson of history - whenever it gets bad enough, they always come after capital but, by that time, it is too late to do anything.

The warning signs have been growing in number and frequency. Yet for all the fretting about the trade wars, Cold War II, Brexit, Euro-fragility, populism, sky-rocketing debts, grossly underfunded pensions, social instability, and the slowing economy, the vast majority of investors remain confident that all these problems can and will be solved painlessly. If they thought otherwise, the S&P 500 would not be trading within 2.5% of its all-time high and the yield on the corporate junk bond index would not be hovering within 1% of its all-time low.

And why would investors worry? Don’t they «know» that authorities will always do «whatever it takes» to keep rates low and asset prices high? After all, Western governments have been at it for decades. Indeed, rates have been in a secular downtrend and assets in a secular uptrend for 37 years, since the early 1980s.

In other words, no Western investor under the age of 75 has ever managed capital through a 1930s or a 1970s-style systemic crisis: the kind that can (and periodically does) ravage all financial assets simultaneously - stocks, bonds, levered real estate and even cash. And since the biggest lesson of history is that people do not learn its lessons, complacency continues to rule the day regardless of the facts.

What are the facts? For one, both corporate debt to GDP and total global debt to GDP ratios now stand near or above record highs. Since excessive debt and leverage caused the crisis of 2008, why would a subsequent 50% increase in global debt and record leverage not be a problem?

Out of necessity, the investment business has developed a nuanced view that was recently summed up by David Lafferty, chief market strategist at Natixis: «I’m very worried [about debt] if you have a long time horizon. I’m not at all worried if you have a short time horizon.»

Translation: Epic debt will bring a disaster someday but now is not that day. And how many fiduciaries realized that epic debt and leverage were short-term problems in late 2007? Not many.

Or how about this: Over $12 trillion of bonds trade with a «negative yield» (a euphemism for a capital haircut) and the trend is gaining momentum. Firstly, who really thinks that lending $100 in order to get back less than $100 years later is a viable proposition?

If it is, we are the first humans in 4,000 years to think so. «A history of interest rates» by Sidney Homer and Richard Sylla covers four millennia of financial history but contains no mention of negative interest rates. Lack of precedent has not deterred the IMF from advocating «deeply negative» rates as a way to fight the next recession (see here, here, here).

Since rates peaked in 1982, the standard way of curtailing downturns has been to cut rates by 4% to 6% but, given today’s miniscule or negative rates, who would want to lose 5% or 6% annually? Wouldn’t most people empty their accounts and hoard cash? Not to worry, the IMF proposes to enforce deeply negative rates by making physical cash either unavailable or impractical and then imposing negative rates (capital haircuts) on the digitized assets trapped within the financial system. The thinking is that without access to physical monetary instruments, investors would have no way of escaping negative rates and would spend capital rather than have it expropriated. Spending would provide the stimulus for the recovery. Or so the IMF wizards hope.

Finally, how about the fact that by 2029 all of the baby boomers, the largest and the longest-living generation in history, will be over 65 and eligible to collect promised, but largely unfunded, pensions and health benefits?

This problem is not a risk but a certainty and there are only two ways to deal with it - either entitlement promises must be significantly reduced or the younger generations must pay much higher taxes to support the long-living boomers. Whatever happens, either option requires legislation and is fraught with materially adverse financial, social and political consequences.

Maybe none of these realities matter but what if they do? The key, as Pericles pointed out 2,700 years ago, is not to predict the future but to be prepared for it. But how can investors be prepared for a financial crisis if they limit themselves to the instruments that depend on financial counterparties and markets?

This is why the current bubble in complacency is so pernicious. It has left investors defenseless by instilling blind faith in the ability to hedge systemic risks with instruments that are vulnerable to the very risks they are supposed to hedge. This is akin to plugging one’s backup generator into the electric grid - it will work perfectly until the power cuts out, which is when one really needs a backup generator!

This brings us to physical gold - the only universally liquid financial asset that is cyber-immune and can be effectively custodied and negotiated without relying on financial institutions or markets. It is no accident that many central banks have been aggressively accumulating gold reserves. Who if not an arsonist would smell the smoke first?

Russia and China have been the largest gold buyers for the same reasons all investors should hold physical gold reserves outside the financial system - independence from financial institutions and fiat currencies, cyber immunity, genuine scarcity, ready liquidity under any market conditions, invaluable buying power when others do not have it, and lack of the ultimate risk - permanent impairment.

And yet, despite its proven insurance value, Western proponents of gold continue to be ridiculed as paranoid «gold bugs». Maybe they are but, as Andrew Grove, the famous CEO of Intel, aptly put it: «Success breeds complacency. Complacency breeds failure. Only the paranoid survive.»

Is it better to risk ending up a confident pauper or to suffer the ridicule but ensure financial survival and independence? Now is not a moment too soon for everyone to make their own decision.