10 minutes into the future…

Growth remains positive but slow, equities are expensive, credit spreads are tight, and interest rates are low. High quality assets are even more expensive leaving only lower quality, less liquid, more esoteric or clearly troubled assets with any value.

A significant contributor to the current state of affairs is central bank policy which has included suppressed interest rates and competitive demand for assets. The only hope for traditional assets such as equities and bonds to appreciate is further central bank purchases or a sudden spurt in economic growth and productivity.

On the risk side of the argument we have, in addition to expensive valuations and slow growth, monetary policy being close to or at its limits, a dip into negative growth even if cyclically and short lived, social tensions from inequality and most pressing of all, political tensions from Europe to America to the South China Sea.

Governments may mitigate some of these pressures with fiscal policy but sovereign balance sheets are already heavily indebted. China’s growth has been supported only by a significant expansion of credit. The US has had contentious debates about their debt ceiling and Europe is constrained by fiscal rules which most of its member countries have been in protracted breach of.

If fiscal stimulus becomes widely adopted it will provide a lifeline to economies and markets for another 3 to 5 years, depending on how determined the effort. However, the world has experienced 8 years of recovery since the financial crisis of 2008, and a cyclical downturn can be expected soon.

That the monetary policy lever has not had a chance to be reset or restored is a serious concern. In the next downturn, monetary policy will have no room to act. The parachute has been deployed, there is no spare, and we haven’t packed it back in the bag.

The fate of fiscal policy will likely be the same as that of monetary policy. A slippery slope from which there is no return. Slowly, the wisdom of austerity has been pushed back, first in the fringes and then in the centre of academic orthodoxy. The biggest challenge for fiscal stimulus is not how it will be deployed but how it will eventually be rolled back.

Eventually, debt will have to be repaid or repudiated. The first step to debt forgiveness is to place the debt in friendly hands. This stage has already been done. The Bank of Japan, for example, owns over a third of Japan’s national debt. Were it to convert this debt into perpetual, zero coupon debt, the debt burden of the government would fall dramatically. If this debt was written off, it would reduce the leverage of the sovereign balance sheet to facilitate new issuance.

The mockery that such a debt restructuring would make of the concept of money and debt will have unpredictable consequences. Either interest rates go down with the leverage, or up as the internal (inflation) and external (exchange rate) purchasing power of the currency is questioned.

For the investor, this scenario is depressing. The only strategy is chicken. In the game of chicken, two cars drive towards each other at speed. The first to flinch, loses. If no one flinches, both die. The winner is the one who flinches as late as possible. For the traditional long only investor trafficking in equities and bonds, the runway is short. For less constrained investors, the runway is longer, slightly, but still finite.

Markets in asset backed securities, structured credit and leveraged finance may not be as accessible to fast money retail investors and their proxies such as mutual funds and exchange traded funds and may retain value for longer. However, it is a matter of time before the relentless pursuit of yield finds these niches and squeezes the value out of them. Regulation, complexity and tax structure may present barriers but not for long as the collective intellect of the financial industry is turned towards circumvention.

Shorting. If assets are expensive, then perhaps it makes sense to hold a short exposure to these assets. However, shorting is not a mirror image of ownership. The risks to shorting extend beyond the economics of the trade to the mechanics, regulation and legality of establishing and maintaining a short position. Shorting is an unpopular strategy particularly when it works.

What is an investor to do in this environment? If Lord Keynes’ observation that in the long run we are all dead, then chicken is a viable alternative. But do choose the longer runway, which means eschewing conventional, accessible assets and strategies.

In the long run, however, average returns have to be low, since growth is moderate and assets are expensive. The problem is most tangible in the pensions and savings industry where liabilities are chronically underfunded. The individual or individual institution may attempt to navigate the temporal distribution of returns, i.e. market timing, but for the industry as a whole, the problem is chronic.

As the memory of war fades and technology allows us to fight wars from long distances we become distanced by time and space. The more time passes and when wars are fought in faraway places and fought with detachment the more likely we are to engage in it.

Capitalism leads to inequality of wealth.

• Capitalism is based on competition. Capitalism incentivises competition and the maximization of inequality at the micro and macro levels.
• To maximize profits companies have to maximize revenues and minimize costs. Minimizing costs implies indirectly minimizing payments to resources, labour included.
•  Labour’s share of GDP has shrunk consistently for at least the last 60 years. The relentless accumulation of intellectual capital and innovation results in greater efficiency and productivity of resources and capital. To the detriment of labour.
• Individuals supply labour. Individuals can only store a small and finite amount of knowledge in their lifetimes.
• Business entities like corporates are able to accumulate intellectual capital. As the share of returns to innovation increase, enterprises’ share of GDP will increase.
• Capital is scalable whereas labour is not. Intellectual property is an inexhaustible resource whereas labour is not. Individuals do not generally licence their intellectual property, they sell it as an integral part of their labour, rendering the intellectual property of the individual an exhaustible resource.
• Ownership of businesses allows the individual to accumulate more wealth than supplying labour.

· Inequality of wealth leads to slowing economic growth and carries political risks.

• The potential for inequality promotes greater effort, enterprise and innovation.
• Past a certain point, inequality impairs growth. The rich save a greater proportion of their income than the poor and thus greater inequality translates to more saving and a slower rate of circulation of money leading to slower growth.
• When the perceived probability of advancement from the lower strata to the higher strata becomes sufficiently small under the current economic and social system the lower strata will find it unacceptable.

· Slow economic growth has wide ranging risks.

• Humans have evolved social behaviour as an economic expedient. Sufficiently weak economic growth can threaten faith in the social compact.
• Slow growth can therefore encourage less cooperation, more competition, trade protectionism and other anti-trade practices, disintegration of economic and political unions, civil and martial conflict.

· Slow economic growth coupled with high levels of inequality imply that the majority of households experience negative growth.

· Central bank policy has limits and limitations.

• Central banks make policy while having imperfect information about and imperfect understanding of the economy. This leads to oscillations in later time periods. The probability that policy is suitable and adequate is extremely low.
• The more activity, the more potential imbalances are accumulated. The cost of policy is cumulative.
• The engagement of fiscal policy introduces the same theoretical instabilities as monetary policy but adds complexity and the political dimension.

· Low interest rates have multiple effects.

• Low interest rates make it cheaper to borrow and therefore boost consumption and investment.
• When lower interest rates stimulate growth they are inflationary.
• Low interest rates can encourage over-investment and over-capacity which in an economy suffering from weak demand can be deflationary.

· Firms versus Individuals:

• A highly knowledge based economy encourages labour specialization which can lead to loss of flexibility and diversification in the labour force.
• Firms are able to accumulate a diversified portfolio of intellectual capital and even trade in intellectual property. Individuals find it more difficult to do so.

· Globalization and open factor and goods markets increase competition in specific segments of the labour market.

• Segments facing the most immigration face unemployment and wage pressures.
• Segments which face outsourcing also face unemployment and wage pressures.
• For the other sectors, the increased efficiency and productivity is a positive development.

· Technology and Human Ingenuity

• Technology can either augment or substitute human ability. So far the ability for technology to substitute human ability has been limited.
• When labour is abundant the need for and the return on investment in human replacement is low. Efforts turn to augmentation instead of replacement. When labour is limited or inadequate, the reverse is true.
• Low unemployment, rising wages, tight labour markets and low participation rates indicate a mismatch between supply and demand for labour, namely, a labour shortage, an environment which might drive investment in human substitution.
• If human substitution increases in incidence social questions about the ownership of automatons may arise. Apart from technological and practical questions, the advent of human substitution technologies will generate many questions in the legal and ethical domain.

· Time and technology blunt the memory of the cost of war.

On September 21st there were two central bank meetings, the Fed and the Bank of Japan, both closely watched but both garnering very little expectations.

The Fed was expected to do nothing and to signal a December rate hike, which it did. The market reaction was positive, not because this was unexpectedly good news but because investors had taken risk off the table, despite having no big expectations for this FOMC. Some of these investors put capital back to work in the anti-climax. The buying, although relatively muted was indiscriminate as investors bought equities, credit, duration, oil and gold.

The BoJ was perhaps even more closely watched and with similarly low expectations. Investors had expected the review to justify current efforts and recommend more negative interest rates. They also expected a targeted effort to steepen the long end of the JPY yield curve. What the BoJ delivered was a promise to raise inflation expectations, perhaps beyond 2%, to be flexible about its bond buying, to maintain a cap on the 10 year JGB yield and an effort to steepen the yield curve. It was a lacklustre package, maybe even a disappointing one. The initial reaction was a rise in equities and a fall in JPY. It is too early to tell where they go from here but if the market was unimpressed by the BoJ’s negative rate debut in January it is hardly going to be impressed this time.

One view is that the BoJ’s lack of determination is a sign that the government should shoulder some of the burden. The Prime Minister has publicly welcomed the “new policy” and will “coordinate closely with the BoJ to accelerate Abenomics.” Quite how new the policy is and how Abenomics is to be accelerated remains to be seen. As long as rates and JPY do not rise too quickly or far, the economy appears to have a chance to muddle on, and there are some signs of material progress in Abenomics’ Third Arrow. Economic immigration, for example, has been growing as regulations have been relaxed and businesses begun to hire foreigners.

On current demographics and reasonable growth forecasts, Japan will not be able to repay its national debt in the foreseeable future. It has already amended its 2016 debt issuance by  3.7% or +60 billion USD, paltry, but a start.

It needs to keep issuing debt. The debt must be bought by private investors, such as the private commercial banks. The BoJ will then buy the seasoned bonds from these private investors. It could buy the bonds directly from the government but this would merely finance the fiscal deficits, which would be direct debt monetization or helicopter money, which is apparently frightening and illegal. Passing through private hands has an advantage. It is Chinook helicopter money, two rotors. First, it still monetizes the national debt, indirectly but effectively. But second, it generates a profit for the initial buyers, and thus puts money in their pockets. Now, if bond yields decline continuously, this generates a capital gain for the investor, but is not sustainable since eventually you get to negative rates at long maturities and undermine the entire savings, banking and insurance industry. A more sustainable strategy is to steepen the yield curve, particularly at long maturities. In February 2016, investors who held on to 20 year JGBs for 5 years say, would have made 1.5% p.a., on top of a 0.5% – 1% coupon just from the rolldown. This ROA is quite substantial given current interest rates. For a bank which can leverage the position, and since JGBs consumer zero capital, the impact on ROE is significant. This works best at long maturities as duration multiplies the roll down which is otherwise too small at shorter maturities. By September the yield curve has flattened so that the same trade would earn 0.95% p.a. This strategy only works with a steep yield curve.

There are a couple of loose ends to this strategy. At some point the national debt will simply get too big. One way of addressing this issue is for a selective debt forgiveness whereby the BoJ converts its holdings of JGBs to zero coupon perpetuals. Or cancels them altogether.

This just leaves the persistent strength of JPY. This is troublesome for an export economy like Japan. When the BoJ cut rates into negative space in January, JPY weakened for less than 24 hours before appreciating some 16% to September. One way would be for the government or the BoJ to buy USD and USD assets such as US treasuries.

This strategy supports the following measures: 

BoJ keeps buying JGBs in secondary market. Check

BoJ keeps the yield curve steep. Check.

BoJ keeps short rates low, perhaps further into negative space. Maybe.

BoJ converts debt to perpetual zeros or cancels its JGBs. Maybe.

Japan government increases issue of JGBs. Check.