Are markets headed for a nasty surprise?

While even some enlightened professional investors prefer to live in the world of passive delusion – actively trying to see no evil, hear no evil – the risk managers in the crowd, including CLSA, focus on logic and explore all primary probability paths. Good research – and journalism – is at its best when it follows the story where it leads and doesn’t filter out the negative; it treats the audience like the intelligent people they are and assumes they can handle the truth.

Where this leads CLSA might not always a pretty spot, but for fiduciary-bound professional asset managers ignoring logical risk potential might be akin to falling short on a key duty.  In a Bits & Pieces report out July 29, the research firm known for taking on unpleasant topics often muted in the mainstream is at it again.

CSLA, Jeffrey Gundlach, Negative Rates

With the stock market levitating amid negative interest rates, how long will the magic last?

In a world of negative interest rates and EU bank stress tests that didn’t consider risk modeling during key negative market environments, there are those who prefer to live and embrace the bubble. And there are those, such as Jeffery Gundlach, who have a thesis a market environment change is approaching that might not benefit investors.

CSLA takes this approach.

Looking at stunning trends in both the bond and stock markets, the report wondered at what point does it all end?

The “unconventional” monetary policy levitation that is currently being executed has a shelf life. The masses might ignore this concept and think a technical asset bubble will continue forever. CSLA, wondering if “anyone is listening?” says the “inevitable” is a risk that investors might want to consider.

The limits of gravity will eventually be felt. Some might have thought interest rates at zero percent might be the floor for gravity, but central bankers in Europe think differently. They can use magic to make even gravity suspend disbelief.

US public pension fund managers are “toast” for more than trouble finding yield, there is principal risk

Due to negative interest rates, US public pension fund managers “are toast,” the CSLA report said.

The “toast” observation that is most frequently associated with pension fund managers is the notion that a significant portion of their “risk-free” rate of return now has risk. Pension fund managers, in a search for yield in a negatively yielding environment, have taken on significant principal risk.

The CSLA piece indicates today’s risks may be more complex and extensive than just a stretch for yield.

These risks can primarily be seen in comments made by the Bank of International Settlements and, yes, Janus Capital’s Bill Gross.


CSLA points to the BIS and Bill Gross to highlight the negative interest rate conundrum

Ever since the 2008 financial crisis, quantitative monetary policy was asked to do all the economic heavy lifting without any meaningful assistance from the fiscal side of the equation. There were risks to this simulative approach to the market – particularly when exiting such addictive programs. During 2012 to 2015, questioning those risks was considered impolite and thus in central bank circles such speech was typically muted.

But now, a questioning is taking place. As the economy is in the midst of a tranquil bubble that has hypnotized its economically sophisticated audience, the exit risks are seen by conducting supply and demand market structure analysis. These are risks that were generally not considered openly in the past, but they are now more loudly being questioned.

One powerful establishment banking force, the Bank of International Settlements, questions negative rate logic

“Exit difficulties (from unconventional monetary policies) and political economy problems loom large,” the BIS was profanely quoted as saying. How dare anyone question the magic people. “Short term gain may well give way to longer-term pain.” In other words, artificially inflated markets find gravity at some point. There is no long term magic, is the message from the inside of the practical banking industry as delivered by the BIS.

“As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come,” the BIS went on to say. Market cycles are a historical phenomenon that economic planners should recognize and work with, but certain economists would rather ignore and pretend they are above those pedestrian market structure laws. Caveat emptor, a free market principle, might apply in this circumstance.

But the big question is: Why? What is the point of untested and unconventional monetary policy when the economy is doing reasonably well?

“The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong,” the BIS said. To some the economy is not doing as well as it could. While central bank quantitative magic has done a wonderful job of lifting high end asset prices, the real economy – most specifically measured in average wage growth – has decidedly been muted if not ignored.

Even still, the economy, at present even by the most negative indicators, is not at emergency levels. To coin a phrase, America is great and the economy is doing reasonably well. So why the emergency policies and where will it lead?

“Ultimately, central banks’ credibility and legitimacy could come into question,” the Bank of International Settlements said.

The powerful commentary that CSLA didn’t end with the influential BIS statements blasting central bank negative interest rates from the inside. There is always comments from Bill Gross, the man who rode one of the greatest bull market runs in history to its negative rate end point:

Here’s my thesis in more compact form: For over 40 years, asset returns and alpha generation from penthouse investment managers have been materially aided by declines in interest rates, trade globalization, and an enormous expansion of credit – that is debt. Those trends are coming to an end if only because in some cases they can go no further. Those historic returns have been a function of leverage and the capture of “carry”, producing attractive income and capital gains. A repeat performance is not only unlikely, it is impossible unless you are a friend of Elon Musk and you’ve got the gumption to blast off for Mars. Planet Earth does not offer such opportunities.

Planet earth does not offer such opportunities. Eventually gravity is a principle of nature that even the magic people will one day discover cannot be violated forever. CSLA, for its part, notes the VIX at absurdly low levels and surveys the growing list of likely risk factors and sarcastically says “What, me worry? Nope.”