Most successful pundits are selected for being opinionated, because it’s interesting, and the penalties for incorrect predictions are negligible. You can make predictions, and a year later people won’t remember them.
(Nobel Prize winner in Economics for Behavioral Finance theory)
It’s time for a reality check.
The scary market narrative right now goes something like this: slower global growth – led by China – unleashed deflationary forces that exposed malinvestment and excessive leverage in commodity and industrial companies that will lead to widespread corporate bankruptcies, sovereign debt defaults and another banking crisis. Central banks are out of monetary bullets and resorting to zero sum currency wars. Some are calling it a death spiral.
Part of the hysteria is due to the scale and opacity of the problems (see Market Psychology and the Investor Narrative). One hedge fund manager is making the rounds talking about how China’s debt has ballooned to over $34 trillion – a mere 10% write-down more than wipes out the $3 trillion plus of foreign currency reserves China accumulated over decades. Or take US dollar denominated debt issued by offshore entities, which the BIS estimates at $9.8 trillion – a five-fold increase since 2000. The collapse in commodities and emerging currencies means a wave of defaults. When you start throwing around the word “trillions,” you get people’s attention. That said, good luck finding anyone who can accurately break down those trillions to individual companies and lenders to map out who indeed is truly exposed. As Warren Buffett said, “only when the tide goes out do you discover who’s been swimming naked.”
So, here’s where the reality check comes in. To frame it, let’s recall some of the market-moving predictions made by pundits over the past several years:
- The Fed is recklessly printing money which will lead to (hyper)inflation. Many trillions of dollars later, inflation is lower (actually, too low).
- We’re at peak oil so expect prices to remain above $100 indefinitely and the US will be at the mercy of oil-exporting nations. One word: shale.
- When the Fed finally raises short term interest rates, long term rates will spike. Nope.
- When China starts selling Treasuries, rates will go through the roof. China sold $500 billion of reserves last year, and rates … dropped.
- The US Government is on the verge of bankruptcy with a nearly 10% budget deficit [in 2009]. Last year the deficit was 2.5% and borrowing costs are at historical lows.
The first lesson is the media gives extreme predictions the most airtime. Assume I stand on the roof tomorrow and shout,
“The Fed Funds rate will be minus 2% in one year!!!”
I’d be headline fodder on Marketwatch, Yahoo Finance and other sites. Pretty sure I’d be on Fast Money by mid-week to duke it out with the regulars. At least until someone topped me and predicted minus 3%. When it comes to predictions, “big” doesn’t mean accurate.
Second, all information is not created equal. In one of the posts on oil (see The Trouble with Oil), we argued that people read too much into short term volatility. A change in OPEC policy – that matters. The lifting of sanctions on Iran – yes. But a 3% up or down move in oil at the open has zero information value about, say, global growth this year. (As an aside, when something drops 75%, it’s bound to be more volatile. The 10% plus move on Friday was around $3 per barrel – a 3% move two years ago. It’s just math.) When prices move, we assume that someone else knows something and scan the headlines waiting for the next shoe to drop. But usually it’s just noise.
Third, to the chagrin of economists, economics isn’t a hard science. Economic “truisms” provide a simple framework for understanding a complex world. Take the relationship between printing money and inflation. For many, this “economic certainty” guaranteed that expansion of the Fed’s balance sheet would lead to inflation – tough to control once out of the bottle. But if the Fed can (seemingly) print money without inflation, should our thinking change? Why not have the Fed simply write off the $4 trillion of government debt it owns and start again? If so, why not jumpstart the economy with a $2 trillion fiscal program to upgrade infrastructure, education spending, job retraining, etc.?
For the record, the house view here is that global deleveraging is a serious problem, and will expose malinvestment on a breath-taking scale (for a local example, see The Trouble with Oil (Part Three)). What’s harder to predict is how policy makers, companies and other participants in the global economy in turn will react, and the subsequent repercussions through a complex global economy. We call these second order effects. Do US consumers spend or save the $1000 per household benefit from lower oil prices? Does Germany – paranoid about hyperinflation due to its experience after World War I – back off its insistence on austerity in a deflationary world? Does consumption of, say, oil increase at lower prices (demand elasticity) and drive prices up sooner than expected?
With time, we will get insight into these and many other questions. In the meantime, unfortunately, uncertainty and volatility will persist. What we can say with certainty, however, is that we should do our best to tune out the many pundits who clamor for airtime and feed off the anxieties of investors.