How not to stimulate the spread of Covid 19

Compared to previous recent pandemics, Covid-19 appears at first glance to have a relatively low death rate of around 3%. This 30-fold higher rate of death than seasonal flu is the statistic being passed to us by national leaders and the WHO as a means to give us some comfort.

Hiding behind this number is that an additional 7%, of those who have contracted the coronavirus, remain in a critical condition. Furthermore, the rate of infection far surpasses that of SARS or MERS. This suggests it has the potential to become the most deadly virus encountered by humanity in over a century.

In order to deal with the threat of widespread infection, governments and political commentators are discussing and hopefully preparing the healthcare systems to cope with an expected rise in demand for hospital beds. However, perhaps an equally large proportion of time is being spent discussing the economic consequences of the coronavirus and trying to come up with steps to mitigate those consequences. As usual there is much talk of getting the central banks to intervene by lowering the price of money to assist the economy.

Although the economy will need some sort of stimulus if it falls into a recession, I am not sure this is the time for it. There are many reasons for taking this point of view.

1. Providing incentives to boost economic activity from the natural rate dictated by the existential threat we face is bad health policy. One could easily see a strong correlation between economic activity and the spread of the coronavirus. Think of the marginal worker receiving extra pay to get on public transport to come to work, whereas he or she might otherwise stay at home. We should instead focus everyone's minds, including those obsessed by fortunes available on Wall Street, if they are able to distract themselves, to stopping the virus and let that dictate our economic activity, however dire the economic outcome. Reducing economic activity temporarily might help to reduce the spread of the virus.

2. If we are then successful at facing off this threat and containing it, only then should the relatively bare cupboard which contains the central banker's remaining toolkit be opened to deal with a recession. Using the tools now means, if worse is to come, the central banks will have even less firepower when they need it most.

3. We should be prepared to suffer a recession and declining living standards for a short period than have 1/2 the world infected. For an economic policy standpoint, the latter would in any case result in a far worse economic outcome.

Homo Brexitus

Politics

As we head for the polls, it is worth reflecting that a desire to drop our European identities, likely comes with the shedding of our proud British heritage. Leaving Europe will almost certainly isolate us from Scotland and Wales who will probably prefer to be with Europe, not us. And the"little" England, which would emerge, would not be a fair and gentle land. England remains mired in its class system, more than any other democratic nation in the world. And although the working class remain key supporters of the leave vote, they are being led to make a decision, which would in the long run worsen their lot, by a combination of wealthy media oligarchs and wealthy public school educated politicians for their political agendas. I doubt that Boris, Iain and Nigel want to exit because they genuinely believe it is best for the country. Lets call a spade, a spade. Boris wants to be PM, Nigel wants a return to relevance of a fascist party and Mr Duncan-Smith might simply take umbrage at the lack of structure the class system, which the broader diversity and greater meritocracy inherent in the UK population, is causing. No doubt some of them and their friends would like a diminution of the aspiring classes.

Furthermore, despite the claims of some of the leave campaigners, the apparently stricter control of our borders from Europe will not reduce the terrorist threat. If anything the likely Orwellian society that will emerge from the reduction of our borders, will make us bigger targets. Lets not forget white supremacists still care deeply about their annual holidays in Turkey and Egypt. Terrorists will target anyone, but they will target those people who collectively spite them the most. And terrorism ("violence to achieve political ends") as we have seen recently with the sad loss of Jo Cox is not monopolised by Muslims. Wasn't it a Muslim who tried to stop the violence against Ms Cox? Europe is a large, progressive, rich and tolerant continent where violence continues to be rare. If we are to continue protecting ourselves from the threats and ideologies of extremist groups that emerge from time to time, as they will, our best hope is to do it with the collective assistance of larger groups of like minded people, such as our rich neighbours on the continent, with whom we share a common history.

Economics 

The reduction of our once proud nation to its constituent little lands will not be economically progressive either. Many free trade agreements will have to be rewritten. Anyone familiar with basic trade theory will understand that this will make us poorer.

Houses will not magically become more affordable. Without European caps, large bank bonuses will re-emerge and they will refuel the rise in house prices.

Workers rights will be decimated, and this is particularly relevant to the working class, without the oversight of EU regulations.

If we turn our back on the Europe, it is very probable the people of Europe will turn their backs on us. But the extremists will redouble their efforts.

Philosophy

Humanity will always need a central power to organise itself along society's desired common goals. Most animal kingdoms are feudal systems.  An all conquering King or Queen protects his or her territory and subjects in return for their loyalty, labour, military support and, in some kingdoms, sexual favours. Feudalism is inherent in nature and this was how we were, until relatively recently, organised.  Democracy and laws of course represent some evolutionary progress but these laws are usually applied within strict boundaries which have mostly emerged from feudal systems, and accident.

A bigger progression for humanity would come from goals which look to extend such boundaries. A grander project to unite societies and states, such as that of the United States, are therefore laudable in that they demonstrate greater human aspiration. 

In that sense UKIP and the far Conservative right are equivalent to feudal apes that never evolved. They deserve to be sent to some sort of natural history museum and preserved, for the rest of us to gaze with continual wonderment and to remind us how man has come a long way. The House of Lords might be a good location for such a museum.

Wave function

All things in nature, upon closer inspection, describe a wave function. Arguably the science of economics, or indeed human sentiment and endeavour, is not immune from this natural law. Downward economic swings are an integral feature of the wave nature inherent in the path economies can take. Indeed they are as natural as economic booms. When a central banker arrogantly intervenes against this law by using "unprecedented" steps to dampen the amplitude of the wave in its down cycle, he will inevitably dampen the amplitude on the up cycle. And extend the wavelength. Because to use layman's language there is no free lunch. For those not persuaded, think of the empirical evidence from Japan and now the West.

Furthermore central bankers of the free market world today, trained to believe in the hegemony of capitalism over communism, are guilty of the same accusation they have levelled at the failed economies of the communist states. Massive injections of liquidity into the otherwise freely operating markets to control economic output are as doomed to failure as the central planning of the old soviet states.

Happiness

Daniel Kahnemann, a nobel prize winning behavioral psychologist, has determined that perception of lifelong happiness has an "end-bias". Essentially his thesis, which he seems to have proven through extensive empirical research, is the self-assessment of an individual's happiness is heavily weighted towards a person's recent and current state of happiness. This is not a surprising conclusion, partly because of the inherent negative discount factor built into memories. The corollary of this thesis must be that, in those final moments, as the key events of our lives flash before us, whether we die happy or sad depends on our conscience. How many of those events are made murky with regret? Even if the distance of our death keeps our conscience at bay through our lives, surely it makes a gasping appearance in those final clarifying moments. Hence, even if there is no god to judge our deeds, we finally do it ourselves. And if this is correct, then a clear conscience is the closest thing an atheist will ever have to a heaven. This final self-assessment explains the existence of morality without religion, albeit through an inductive logic. This is marrying Dawkins philosophy with Kahnemann's research. But it is a philosophy which should work for agnostics, and the very religious equally well. We do have some empirical evidence that the desire for a clear conscience becomes the overwhelming force later in our lives: Think of all the tyrants busy giving away their money as they approach their final days.

There is no financial wisdom here, but during the hiatus nothing happening in the markets has seemed as engaging as some of the bigger questions. Perhaps there is another message here, and that is, it is never too late to press the button for a reset to factory settings.

Dumb and Dumber

As either a pension fund or a wealthy private individual seeking to chase the hottest financial fad in the last three years, the opaque and illiquid commodities market, which your private and investment banking advisors have pushed hard, due to the large fees they can earn, you may have considered and invested an increasing portion of your cash in commodities long only plays and supposedly more savvy long-short commodity hedge funds. As a consequence, the wallet size and market influence of commodity funds has continued to increase dramatically at the detriment of western consumers. And within commodities, oil focussed hedge funds have seen the most dramatic growth. It is worth asking then, amidst the hoopla, what has been their performance as a group to date? When compared with every other type of hedge fund (L-S equity, RV, global macro, etc), over the last three years volatility of returns of oil hfs have been the highest (~30%), the beta with the underlying asset class has been close to 1 and Sharpe ratios one of the lowest (~1). These metrics tell us, oil hedge fund returns have broadly tracked the direction of oil prices over this period, but provided no real decrease in volatility of returns when compared with the long only play. At the same time returns have been poor (-ve or low single digits for most funds). Originally, long only commodity investments were sold as a means to hedge out the performance of traditional assets in a financial portfolio composed primarily of equities and bonds (as an inflation hedge). That mythical diversification has been debunked by three years of returns which have been highly correlated with every other market. So a strategy which diversifies further through specialised oil hedge fund managers makes a modicum of sense but the results do not appear to hold up to even modest scrutiny. It is often said passive, long only money is the dumb end of investment. And that certainly may be truer today for those still tempted to enter into oil markets at the very elevated levels they have reached. However when you look closely at the performance of commodity and oil funds, it may a case of one investment being dumb and the other even dumber.

Hormuz Straightjacket

There appears to be much speculation about whether Iran will (and can) block the straight of Hormuz. For this to be a credible counter-measure against nuclear sanctions, Iran's leadership has to be prepared to lose all external as well as domestic support. To understand this point you have to appreciate;

1. 25% of Iran's GDP, and virtually all of its hard currency, is derived from oil exports. Losing those exports entirely would mean a collapse in the domestic economy, which would result in greater domestic unrest.
2. Combine this with a war with the whole world, which will likely be ready to bear arms against the loss of oil supply.
3. And the fight would not merely be waged by the distant west, who will be trigger-ready with their long range missiles. Iran's close neighbours and cartel partners who rely on the Straight of Hormuz to sustain their own economies and keep their own people well-fed in these times of sudden "arab springs" would fight tooth-and-nail against Iran.


Can it still happen? Iran is full of very clever people, and I imagine their leaders would be very aware of the yawning precipice should they contemplate what in effect would be a combination of domestic unrest and war with the rest of the world. Tenable?

The end of an empire

As you would expect an intense debate is ensuing this weekend about the impact of the S&P downgrade on the markets. Will the markets fall sharply on Monday? As you would expect the articles being written and comments being left on financial blogs are largely from those either caught unaware going into the weekend or those simply talking their book.

A downgrade is a downgrade and at the margin, it should result in a net selling of treasuries and a rise in yields, whether this occurs on Monday morning or takes longer. The search for alternatives to the dollar will also accelerate.

If the asset markets fall precipitously, no doubt acrimonious accusations will be levelled at the S&P for their "irresponsible" action. No-one should be distracted by this. Their actions address squarely the dysfunctional political and economic thinking which have infected the rich west. The financiers that rule the world capped by their biggest benefactor, Mr Bernanke have long believed the solution to conjuring wealth is cheap money and continued borrowing and, as the tea-partiers seem to believe, without their own citizens ever needing to pay it back. It is not. Ultimately it is, as we still teach our kids, hard work. But for the west it may be too late. We have gotten lazy. In the meanwhile, all the nasty, dirty work over the last two decades has been progressively pushed to industrious foreigners, whether it is cleaners from eastern europe, nurses from the phillipines, manufacturers in china or telephone helpdesks in India. Continued specialisation to develop comparative advantage is fine but what is that we in the west specialise in? Whatever it was, it has become smaller and less significant on the global stage. For example our touted western financial innovation, retains a centre stage, but for all the wrong reasons, such as the danger it poses to the world economy.

The downgrade is a historic, watershed moment which may well be remembered as a marker of the decline of the west coupled by the rise of the east. This process has been a long time coming but we have been lacking in meaningful symbols. S&P may well have provided it on Friday 5 August 2011.

Low rates are the problem

In the post-crisis world, with the developed world facing anaemic growth prospects, we need to rethink the old 20th century economic models. The current group of central bankers are simply wrong to ignore the permanent destruction of household spending power which is accompanying uncomfortable levels of inflation. High retail inflation in the UK which has persisted for almost two years has eroded and continues to erode meaningfully the average household's purchasing power. Raw material and goods inflation is not "transient" in its impact on the economy. Permanent rises in the price of food, energy and other necessities for everyday life do not disappear even if the rate of their increase drops. Earnings by the majority in the UK which comprise of middle-income families, the young aspirational worforce, and the retirees have remained stagnant for this period whilst purchase prices have shot up. Unlike the rich, the young and the middle income earners have limited financial assets, the inflation of which by the persistently easy monetary policy, might offset this decline in real earnings. Unlike the rich, the retirees assets sit largely in liquid bank deposits, providing paltry income, and which they have accumulated through decades of thrift.

Persistently low rates also change the behaviour of the thrifty. Very often they become more thrifty. This is what happened in Japan over twenty years, a nation with notoriously high savings rates. And this is likely to happen in the UK and the US. This is because when rates' expectations fall, the saver feels the need to save more to earn the same return from their financial assets. This is how actuaries model pension liabilities, so this insight into households behaviour should not come as a shock. If banks had a symmetrical incentive to provide leverage at low rates then some of this impact might be more muted, although arguably households may be wary themselves of taking on more debt when their finances are being squeezed. In any case, after a credit bust, with capital ratios on the increase, credit will be remain far more limited and expensive for most.

Very few economic textbooks have analysed this perverse phenomenon of self-imposed rising thrift in a post credit-bust world. Low rates also exacerbate the public sector projected funding shortfall by lowering discount factors for future commitments. This provokes governments to cut spending by more than they would if rates were higher thus exacerbating the nations economic woes.

It is therefore highly arguable that persistently low rates are the right prescription in a high inflation, post-crisis world. It is too simplistic to assume the impact of low rates will push forward consumption, and assist deleveraging. Low rates as we have seen can also significantly and permanently erode the economic incentives of a nation's workforce as it is doing today (and has in the past). The sooner we have a central banker who recognises the negative feedback loop of low rates, the quicker we can arrive at a more enlightened economic model. Central banks last remaining great idea is to increase the wealth of the minority and hope for the trickle down effect to emerge. This is not working. Time to rethink economics.

OPEC's symbolic quotas

OPEC meetings and the decision on quotas has little more than symbolic value these days when you consider oil production from OPEC has been substantially above quota levels for over two years. The Saudis remain the swing producer and have continued to demonstrate their commitment to meeting incremental increases in global demand. They also have the biggest spare capacity within the cartel. The Saudi's aside, Iraq has been busy ramping up its capacity (2.7 million barrels per day up 15% yoy) and remains unconstrained by quotas. Arguably OPEC discord, as history has shown, is bad for oil prices as it reduces production co-ordination between cartel members and increases the risk of even greater cheating. The real reason oil prices are where they are, as the UN has rightly pointed out this week, is due to herding behaviour of investors and the "go long oil" meme being sold by Wall Street covering every conceivable scenario. Inflation, EUR correlation, risk on, diversification, easy money, and now OPEC discord - the list is long. In the meantime the strain on US (and ROW) consumers, slowing global growth, tightening monetary policy by emerging nations and high stock levels (US crude stocks have never been higher and in terms of days of supply exceed even those in 1998 when oil prices were $10 per barrel) are soundly ignored by the same investors, perhaps due to some selective information disclosure by Wall Street to its investing clients. This trend has little to do with fundamentals and everything to with fanciful marketing. When all the tortured arguments for oil's rally finally run thin, the final justification for the runaway oil price might be to call it a momentum trade. Others might call it a bubble.

SS Inc. structurally bullish on horse-manure

Rogan Josh, senior analyst at Stoleman Scraps Inc. (SSI) said in telephone interview earlier today that the latest correction on horse-manure, and general BS, was likely over and current levels provided an excellent opportunity to go long. Josh explained demand for BS was insatiable and despite the current glut, strong demand would tighten the balance to critical levels by year-end. Mr Josh deflected familiar accusations that traders at SSI had pre-positioned their books to be long BS prior to the research release by explaining, "Look as a firm we have always been structurally long BS, and always will be, but that is what clients have come to expect of us and we need to be positioned to serve them best. In any case, with interest rates continuing at record lows, where else would you put your money? BS provides truly unparalleled opportunities for asset diversification in a traditional portfolio of financial excrement". Many other other Wall Street houses also involved in the distribution of BS, released new research supporting its medium term bullish fundamentals.

The Next Big Short

A key argument used to sell commodities to investors ranging from large money managers to high net worth individuals is that commodities provide a good inflation hedge. Two main theses cited to support this view are:

1. The introduction of a long position in commodities provides inflation protection in a traditional portfolio of bonds and stocks due to the negative correlation between interest rates and commodity prices. This negative correlation results from the "usual" transmission mechanism of interest rates which central banks raise in response to the rising threat of inflation from higher commodity prices. In an environment where the world's dominant central bank and protector of the world's reserve currency, otherwise known as the Fed, pursues interest rate policy which relies on an inflation index which specifically EXCLUDES commodity prices, then this very same transmission mechanism is of course broken. Given that a significant proportion of the worlds tradable financial assets are either in dollars or move sympathetically to dollar assets, the traditional argument for including commodities in an investment portfolio is, to put it mildly, utterly flawed.

2. Euphoric commodity bulls in extremis also suggest that when (not if) Armageddon finally arrives and paper money is worthless as a means to purchase goods, commodity indices will rule the day. We should therefore all be invested heavily in commodity indices and bull notes and warrants. These commodity bulls are confused. In particular they are confusing the ownership of physical food and energy with ownership of financial assets linked to commodities prices. If Armageddon ever arrives, take it from me, you will not be able to fill your car up with an oil-linked bull note. And furthermore, it would almost certainly be useless to go back to the bank who sold you these commodity bull notes and indices, to get them to pay for your hyperinflated food at the supermarket, as in a Armageddon type scenario that bank might have ceased to exist or at the very least defaulted on its financial obligations.

Who is to blame for putting forward the faulty logic and driving flows into commodities markets? You have guessed it. Wall Steet.

Michael Lewis has written a very good new book, the Big Short. I recommend anyone who is following the advice of a Wall Street salesperson, or is considering investment in sexy new investment products linked to commodities, should read it as a stark warning of what can happen when you blindly follow the advice and allure of fast talking bankers. CDOs used to be the sexy new products and they were considered a one way bet. Today the one way bet is of course commodities. When you can retire with a large bonus after a single and successful year of dumping toxic waste onto unsuspecting investors by relying on misleading and faulty logic, new bubbles no doubt will keep emerging and then blowing up on a regular basis.