Saturday, 5 February 2011

Mean reversion

There are currently two highly dangerous, but broadly aligned, policy agendas in operation which are responsible for distorting the price of risk assets and for fueling unrest in the developing world. The first one is motivated by a recession in the world's richest and most powerful economy, the other by the world's highest paid investment bankers. The US, as a result of its own poorly regulated and unfettered capitalism delivered primarily by their investment banks, allowed the creation of the biggest asset price bubble in recent history, which was led by housing. When markets mean reverted and this bubble burst, as inevitably it had to, it pushed the whole of the developed world into recession.

The US, in its drive for purely quantitative growth does not like to take stock and review the broader agenda of qualititave items that affect their citizens (although some attempts were made in this regard in the latest state of union speech). As a result of this fixation with growth for growth's sake, it is deeply uncomfortable for the US to imagine a period of sub-optimal growth or even recession. The "r" word, for those who have watched west-wing, is commensurate with political suicide. Despite having the wealth and resources to cope with recession and re-invent itself, the US has chosen a different path and that is to wage economic warfare on the less well off starting with their own poor segment of society and extending out to the entire poor world, and thereby preserving and extending the wealth of the rich and super-rich. The speeches and credibility of the Fed Chairman, Ben Bernanke, are now in the quantum sized world. You cannot observe them and predict their momentum at the same time. One day it is inflation targeting, the next it is core inflation targeting, then it is unemployment rate and when none of the above allow him to persist with QE, it is rate of job growth. As a Princeton professor he must have the basic intellect to be acutely aware of the enormous misery he might be causing in the world, including his own backyard. And this is far greater than the consequences of sub-optimal growth for a period in the US. But his approach is clearly sod the poor billions, the rich must grow richer.

Investment banks are playing a big part too. They shy away from being overly critical of Bernanke's policies because they support their own to generate easy profits. One element of this profit growth comes from their commodities divisions which sell complex instruments to investors linked to commodity prices. Oil is often the largest component of this, and the unregulated self interest of these groups of indiviudals requires them to talk up the oil price despite the recent attempts by oil producers and the counterfactual evidence. When the Saudi's agree to increase production as a policy response to bring down the oil price, Mr J Currie, a commodity economist in the largest oil trading house on the street, Goldman Sachs, points to a non-existent shortage in spare capacity of the Saudis. Official data put this spare capacity to about 4 million barrels which is respectable by any historic measure. When inventory data points to increasing stocks, GS ignores this and points to economic growth figures in the US, avoiding the obvious conclusion that economic growth data is backward looking and therefore should have caused a commensurate decline in stocks during the same quarter, which failed to materialise (Gasoline stocks at 18 year highs). There are further contortions to hide the evidence, such as recommending that the highly liquid US crude benchmarks should be subjugated in preference of a more opaque European oil benchmark, Brent (for which there is substantially less published data) mainly because temporarily it has a higher price. GS is in the midst of inflating the next big bubble conveniently supported by arguments provided by Bernanke but by ignoring the supply and inventory data. They are not the only culprits though as there is now big fixed investment in the financial commodity business in almost every investment bank due to attractive margins. The bubble is promoted through greater asset allocation towards financial commodities (stuff you cannot eat or use in any way), and thereby creating a misallocation of productive capital towards speculative demand for items such as oil futures.

Both can talk up their book for now, but the world has always found a route, often hazardous, towards mean reversion. The danger signs are there for all to see and for a growing majority to feel.

1 comment:

  1. It's ironic that the inflation hedging meme the investent banks are selling to risk averse retail investors is actually causing the very inflation they aim to avoid.

    It won't be long before there's a speculative spike - quite possibly engineered - and then the banks will surf, if not drive, the collapse all the way down as financial holders liquidate as they did in 2008.

    The price will crash through the mean to the lower bound 'buyer's market' price level at which point financial buyers will kick in again provided the dollar interest rate remains at zero.

    So it's not so much mean reversion as cycling through the mean.