One Finger in the Dyke: Cautiously Considering 2015, Part II

January 30, 2015

Dutch legend tells of a small boy who passed a leaking dyke on his way to school. Knowing he'd be in trouble for being late, he remained there. Finger plugging the hole. Until a passersby saw him and went for help. Which eventually arrived in the form of men who sealed the leak.
To this day, the story is used to teach children that if they act decisively, even with limited strength and resources, they can help avert disaster. Affect positive outcomes.
Two allegories are utilized in this effort.
First, the boy commits to plugging the dyke and being tardy for school. While most students might prefer a finger in the dyke over the classroom, the idea represents self sacrifice. Another allegory is that of the small trickle escaping the hole in the dyke. The boy's awareness that even a trickle can become a stream. The stream a torrent. And the torrent a raging flood capable of leveling an unsuspecting village.
Studying 2015's macro picture, we find Christian Andersen's story helpful. Even allegorical.
Fed Chairperson Janet Yellen has her finger in the dyke. Removing it prematurely could turn a trickle into a torrent. Wipe out six years of fiscal engineering. And an entire economy.

The difference between Andersen's story and our reality? Policy makers could have sealed the dyke long ago. By permitting an organic economic recovery. Avoiding policies that stunt economic growth when the economy was the only thing on which they should have been focused.
Alas, that was not to be. Policy makers placed a finger in the dyke. Painted the dyke. Landscaped the dyke. Provided uniforms and a meal plan for the dyke's employees. So that six years later, everything around the dyke looked different. Was called progress. But for the fact that someone still stood, very uncertainly, with a finger in the dyke.
What happens when that finger is removed? When rates finally rise? We too wonder as much. Gazing out over the possibilities of 2015. Postulating those hidden, unexpected but semi-likely events for which we're paid to help clients navigate. The finger-in-the-dyke allegory that is long-term and historically low interest rates and a tepid economic recovery? We worry over and consider such possibilities and outcomes so that clients need not.
First, let's gander the big picture. Procure an unemotional, as-objective-as-it-gets market vantage point. Today. Six years into one of the oddest-ever economic recoveries. Following a doozey of a crises. Amid kaleidoscopic uncertainty. Our crystal ball takes us to New Year's Day. Precisely one year ago.
2014 began with markets skyrocketing on the wings of monetary policy, low-inflation trends and a mild economic recovery. All of which provided a brisk tailwind throughout Q1. April brought a cycle turn and two months of choppy, go-nowhere trading. Bulls and bears battled it out through mid-May. Then bulls gained the upper hand and led markets higher until July's third week. Bears mounted a spirited stand through early August. But bulls regained momentum through mid-September. Then, bears wrested back control and sent markets lower through mid-October while investors were discounting the chances of a global economic decline. But, bulls mounted a sneak attack and regained control in December, only to lose their grip in early January. Recently, bulls have dug in. Mounted a counter attack. Which brings us to today.
The role of an investment advisor? Multifold. Preserve capital through market cycles while integrating a modicum of risk befitting the client's profile and tolerance. Determine which asset classes and underlying instruments might enable clients to achieve personal goals while balancing the need for, and exposure to, risk.
Yet, too often, advisors forget this. Simply buying, holding and forgetting the facets of a portfolio until positions have risen and fallen endlessly. Or have been decimated as a down cycle degrades years of progress.
It is the height of difficulty to outperform steroidal markets. Yet, that is not the goal. Outperforming personalized, blended benchmarks and preserving capital. That is the purview of a good advisor.
An advisor uses the maps at his disposal to look ahead. Analyze the route a client is taking to reach his ultimate objectives. This involves looking deeply at the rough terrain to be trekked. And determining the safest means of traversing it.
By rough terrain, we're not speaking of traditional pullbacks. But of changes in the landscape. Shifting tectonic plates. Large scale events that one plans for and then prays for their lack of fruition.
In the spirit of Hans Christian Andersen's allegory, let's consider one such possibility. In so doing, let's move our story from Holland to Switzerland.
Two weeks ago, the Swiss National Bank (SNC) stunned the financial world. Ditched the Swiss franc's long-standing peg to the euro, designed to prevent Eurodollars from trading below 1.20 francs. The policy was designed to stabilize the franc and protect Switzerland's impeccable financial integrity. But, by late 2014, it was damaging the economy and hampering imports.
The decision to scuttle the peg? A huge surprise. Arrived at amid mounting speculation that the European Central Bank (ECB) would soon announce an American-style stimulus program that would put more euros in circulation and further dilute their value. Such expectations had pushed the euro down to near-decade lows against the dollar.
The Swiss confronted a Gordian Knot. Shedding the peg would be chaos. But keeping it would be a disaster. So they acted decisively. And chose to untie it.
When the peg was lifted, the franc shot higher. Jumping 30 percent immediately. Swiss stocks tanked. And traders, specifically those involved in currency trades involving the Swiss franc, were devastated.
Of course, the SNB was correct. A week later, the European Central Bank did announce a bond buying program along the lines of the U.S. Fed's quantitative easing.
Let's pause, briefly for some perspective.
The peg to the euro was created after the 2008 crisis to hold down the value of the franc. The goal?  To protect Swiss exports. Chocolate. Drugs. Watches. Cuckoo clocks. To maintain the peg, the SNB had to buy euros each time the franc appreciated. Typically achieved by issuing more francs. Which they'd been doing for years at a very high cost. The SNB's balance sheet had risen to 80 percent of Swiss GDP. Quintupling the Swiss money supply.
This was a problem. As is central-bank driven currency inflation worldwide. Except, unlike most central banks, the SNB is not entirely government-owned. 45 percent of the bank is held by private shareholders which include both individuals as well as the country's cantons. These denizens of responsibility were increasingly uncomfortable with the prospect of being short francs and long euros. Especially when the ECB was preparing to launch its quantitative easing program. Which would crush the value of the SNB's euro holdings.
Having seen the writing on the wall, the SNB acted decisively. Otherwise, they'd concluded, their losses might see no end.
The bankers had to unwind their position quickly. Even at the cost of short-term pain. And the pain was not small. Although the bank had recently posted a profit of 38 billion francs, the mark-to-market loss on the currency position was estimated at 75 billion francs. 13 percent of Swiss GDP.
The ramifications of the SNB's decision have crashed over Switzerland's gunwales. The SNB will likely need a recapitalization due to the massive loss. Requiring other banks and individuals to lend large amounts of capital. Further, the SNB has now imported massive amounts of deflation as it dropped its interest rate to negative 0.75 percent. Meaning, people will lose three quarters of a percent by saving money with Swiss banks.
Sounds bad. But it's better than losing 20 percent or more on euros. Because the SNB knew that the short-term mayhem would be dwarfed by the alternative should it have continued its unsustainable peg.
Allegorically, the situation provides broad insight into the world's broader problems.
Central banks have used fiscal and monetary policies to rig every major market worldwide. By manipulating asset prices, they managed to inflate the value of paper assets. While having no idea as to how to redirect that paper wealth into the real global economy. Resultantly, growth is miniscule in Japan, China and the eurozone. Only slightly better in the U.S.
The SNB looked into the abyss. Realized its position was untenable. So, they unwound it. Leaving us to wonder what that means for other central banks.
Moreover, the SNB's decision has undermined the blind faith investors and government policy makers have wrongly placed in these "all-powerful" central banks. Shown the limits of the banker's abilities. Revealed that they too can make large, costly mistakes. That the attempts to manage everything, from inflation, to employment and all data points in between, can fail.
Consequently, the SNB decision will be view as a harbinger of times to come. While underscoring the lack of central bank omnipotence. Now, investors and analysts will wonder, "What mistakes and policy errors come next?"
This event served to ratify the idea that, perhaps, we've been trapped. No growth. Little on the horizon. No real innovation in terms of the computer, locomotive, steam engine or cotton gin with the potential to open up new frontiers of real growth.
Looking further out, one can sense that conditions are ripening for another crisis. As pressures build in a fashion indicative of 2008 - strong dollar, falling oil, weakening yen, depreciating high yield debt and collateral aligned with weakening energy producers. Could there be a crisis of subprime oil, as opposed to subprime mortgages?
Concurrently, does the smart money really accept the idea that low oil prices will be good for growth? You might save $500 a year on gas. But if you lack a well-paying career, does it matter? Waiters and bartenders don't begin families on the wings of cheaper gas.
Unlike 2008, we still have some buttons to push. Ammunition to fire. But, we've spent a ton of capital thus far with little to show for it.  And as major emerging markets begin to falter, commodity dependent countries like Brazil, Russia and South Africa, quaking under the weight of too much debt and inflation - isn't that indicative of 1998's multiple financial crises? The Russian Financial Crisis? The Asian Contagion? All of which culminated with the collapse of huge hedge fund Long-Term Capital Management?
What do these developments, and the tea leaves they reveal, mean for the Fed? At a time when the Federal Open Market Committee's post-meeting language is so opaque? Lacking clarity in a way that can, in turn, only reveal a lack of real vision. Smart people with a plan communicate simply and clearly. Smart people without a plan? They speak another language.
At one time, the Fed set precedent by proffering clear communiqués on its policies and path ahead. Today, facing the existential problem as to how it might unwind its massive financial spider web, the Fed has become less clear. As if changing the words "a considerable period of time" to the idea that it can "be patient" is manna for an anxious investor class.
Further, while the Fed states that its decisions are "data dependent," it has failed to indicate which data points will set policy. All of which finds investors in a brave, new central bank-driven world. With no forward guidance. No clear policy levers. And more uncertainty than we've faced since December 2008. If that is the Fed's goal, the creation of uncertainty, mission accomplished.
Of course, we know how the markets feel about uncertainty. And as revealed by the recent experiences of other central banks, decisive action can lead to turmoil. But, at least it's calibrated, carefully gauged turmoil. What type of turmoil is wrought by indecision, uncertainty, and a central bank set on importing massive amounts of each?
Today, our quiet little hamlet sits just below the dyke. Bernanke, noticing a leak, put his finger in it. Permitted the water level to rise. Tiring, he stepped aside and replaced his finger with Yellen's. While the water continued to rise. And the unsuspecting villagers go about their business. Confident that a finger in the dyke will hold. And lead to better times ahead.

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