Preparing, badly, for a crash
19 May 2014
There are many who believe that the financial markets are in a giant bubble. Armageddon is just around the corner, so the argument goes. It is a common ploy. Predict the worse and, if it happens, claim that you are a prophet.
In a sense, it is just a statement of the obvious. Global financial markets have been massively distorted since the GFC in 2007. Very bad things can still happen; the wonder is that it has not been much worse. In an era when money is being printed on an unprecedented scale, it is hardly surprising that it is hard to value assets -- the cost of capital (the interest rate), which is the engine of capitalism, has largely evaporated.
One of the doom sayers, is Ashok Jacob, director of Ellerston Capital. Interviewed in the AFR he exhibits the contradiction of professional investment. He says he is a deeply worried pessimist, yet he is fully invested in the market. How does that work?
"Describing himself as a “fully invested bear”, he believes global financial markets are caught in a huge asset bubble. But he acknowledges professional investors such as he can’t afford to sit on the sidelines while prices soar.
“It is one of the oddest periods in financial history,” he told The Australian Financial Review in an interview. “You have to be invested but you have to be bearish with a longer-term approach.”
The director of Ellerston Capital is concerned the global economy is heading for “back-breaking hardship” if inflation rises sharply. It could also trigger a sharp upturn in interest rates, which would likely hit the price of shares, bonds and property. He thinks the price falls could be 20 to 30 per cent.
But he added there was no sign of that happening in the near term and is confident about the broader market.
Australia is also relatively insulated from global instability and would be seen as a haven as long as China’s economy remains stable, he said.
Ellerston, which focuses on shares, was established as a subsidiary of the Packer family’s holding company in 2004. Today it invests $3 billion on behalf of clients around the world.
“You may get a little bit of a recession and I can’t see how you can get much earnings growth, but Australia doesn’t have the big bogeyman or the big bear around the next corner that Western countries do. It is not as exposed to this run-up in equities around the world,” he said."
Jacob argues, rather implausibly, that the current conditions have their roots in the abandonment of the gold standard in the 1960s, which allowed countries to print their own money. He points out that the world’s top five Western central banks have multiplied their monetary base by nine times since the financial crisis in 2007-08. There is little incentive for politicians to take liquidity out and trigger a recession as their goal is to survive the next election.
What he does not mention is the massive increase in "liquidity" caused by the growth of the derivatives market, now running at over $US4 trillion a day. That is what distorted everything, not leaving the gold standard (to put it in context, the entire US debt is about $17 trillion -- less than five days trade in the $US).
There is probably an asset bubble occurring, but there also probably needs to be in order to stabilise the worst financial excesses in modern history. Jacob is stronger on sound investment policy, which is after all what he is supposed to be good at:
"He said a dramatic market correction could happen suddenly and without warning, but hard assets like high-quality property and blue chips offered some insulation.
“Hopefully these are going to hold their value through a massive inflation bust,” he said. Mr Jacob cites the ABCD rule coined by former United States politician and businessman David Stockman: “invest in Anything Bernanke Cannot Destroy”.
The big exception was the technology industry which many, including Mr Jacob, believe is overvalued.
“A bubble has emerged in the net space. For a revenue multiple to work you need revenue growth of 30 to 50 per cent-plus to continue for a very long time. What actually happens is that it never continues that long and you have a crash landing.”
He was confident in China’s ability to drive jobs growth although there could be wobbles as it seeks to bring lending under control. He also played down the potential for Australia to become the food bowl of Asia, saying there were opportunities but volumes would be limited.
Ellerston last week raised its stake in former takeover target GrainCorp to 7.6 per cent after selling 18 months ago to pave the way for Archer Daniels Midland’s $3.4 billion offer for the grains-handling group. Treasurer Joe Hockey rejected that bid late last year following concerns from growers and the National Party."
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