In 2019 Letter, Crispin Odey warns of growing contagion risks as debt continues to grow

Odey Asset Management released its full-year numbers for 2019. In its December report to investors, which was reviewed by ValueWalk, the fund said it was down 11.1% for the full year. For December, Odey International Fund was up 10.97%, while for the fourth quarter, it was up 8.64%. For the second half of the year, the fund was down 6.5%.

The only two of Odey’s top 10 holdings that were long were positions in Banco Macro and SLC Agricola. The others were all shorts: Long Gilt Future for March 20, JPN 10-year bond for March 20, Aust 10-year bond future for March 20, IRS: fix/ float ICE LIBOR GBP 6-month, Melexis, Netflix, Tesla and Hertz Global Holdings.

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A warning about contagion

In his commentary, Crispin Odey said we are “now tasting the last intoxicating draughts of this longest ever bull market.” He included commentary from emails between himself and Andrea Badelt of Eriswell Capital Management. Much of the commentary came from a message Badelt sent to him.

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“The world economy which weakens into monetary easing whilst stock markets catch up with bond markets in their rating,” the letter states. “To be fair, no one should be in any doubt that this will ultimately end badly.”

The commentary notes that the year has begun with a number of “classical” threats to the financial markets, including the prospect of war in the Middle East, a spike in oil prices, the danger of nuclear conflict, trade tension, political instability, energy inequality and Brexit. However, despite all these risks, investors have been not been concerned.

Asset prices make everything look safe during this period of low volatility, but Badelt (and Odey) warned that the low volatility comes with an increased risk that problems which strike one asset class will quickly spill over to other assets. In considering what might cause such contagion, he said it probably won’t take a very big shock event.

They note in regards to human behavior.

And especially – as is the case today – if that second risk is a slow-burn non-newsworthy factor which can also evade detection by many conventional risk systems by actively supressing volatility. Even more dangerous is when this second risk can also evade extreme value analysis through lack of historical precedent.
Most potent of all are those factors with the potential to first magnify asset prices to the point of actively fomenting asset bubbles, then decimating them as growth and corporate earnings stutter.

“Prophets of doom”

Badelt notes that most sudden things that happen are bad, like wars, terrorist attacks or new tariffs. Sudden events such as these attract a lot of media coverage, but they don’t impact asset prices as much as might be expected. On the other hand, most of the things that happen gradually are good, like a prolonged period without a recession, longtime peace, or medical advances. Odey said the situation lends itself to what he calls “prophets of doom.”

“Human’s irrational dread of catastrophe fuels an irrational fear of sudden losses… which in turn creates a ready market for the prophets of doom,” she wrote. “At times of heightened tensions — like today — these voices appear across the media with warnings of impending disaster, ostensibly based on their savvy reading of geopolitical events and market trends.”

However, she said such situations are more about these people’s “skill in weaving narratives which arouse our sense of horror.” Daily fears become much larger because people become unable to tell the difference between 1-in-a-million chances and 1-in-100 chances.

As a result, these prophets of doom are generally wrong, although all the worries do have a dangerous side effect.

Systems need to watch out for the second risk

The commentary went on to warn that while value investors are worried about one big risk, they overlook an even more serious risk, thinking that it’s very unlikely that two negative events will occur at the same time. However, he noted that when probabilities become correlated like in cases of collective risk diversification, the odds of one negative event leading to another one are much greater.

Badelt said this is especially true when the second risk is a “slow-burn non-newsworthy factor which can also evade detection by many conventional risk systems by actively suppressing volatility.” She said it’s even more dangerous when the second risk evades extreme value analysis due to lack of historical precedent.

The second risk she was warning about was a stall in productivity. Since 1880, the annual growth rate of productivity in the G7 has been 2% to 2.5%, which he said “suggests the existence of an underlying constant, the ‘productivity metronome.'”

Beware the productivity stall

She noted that recessions do interrupt the trend of normal circumstances, but usually the productivity growth of 2% to 2.5% continues in the background. She notes that economic productivity is different than technology progress. The two are brought together when technological or scientific progress create new, more productive jobs to pick up the workers that were displaced by efficiency savings in other parts of the economy.

However, about every 60 to 100 years, this connection breaks, and the displaced workers are forced into lower-paid, less-skilled work. The result is a productivity stall, which often lasts 20 years or more.

At this point, she said it’s unclear where all these well-[aid and more productive jobs will come from, which he said is a “BIG PROBLEM because the credit-based intertemporal forward-shift in consumption is finite.”

She also said Western central banks seem to think they can safely hold much higher government debt if needed. They also believe China holds the required fiscal space “to smooth any blowouts in its ballooning private sector debt.”

“Do you believe that central banks can safely walk the debt monetisation tightrope?” she asked.

Debt continues to grow

“Western central banks’ ‘worst case’ scenario is spiraling inflation, unexpected and severe rate hikes, and deep recession,” Badelt wrote. “They don’t see that outcome as particularly likely and neither do we. The trouble is that the difference between their ‘base case’ and “worst case’ scenarios is largely irrelevant today.”

She said the base case is just managing government debt up to where there is not “credible way out” any longer. On the other hand, the best case scenario depends on having plenty of new, well-paid jobs in new industries, which he said “seems farfetched at best.”

Odey responded to Badelt to say that she is right in that there won’t be a sudden crash.

“What happens is that we wake up to the fact that none of this debt can be paid back,” he wrote. “Too few life boats [sic] on the titanic.”

He noted that it has nothing to do with the interest rate. Rather, it’s the “redemption yield that was never accrued and paid back and has now become dependent on a single repayment which is only payable if the asset is sold. To whom?”

He also said that since the debt deflation cycle is halted, mistakes aren’t being cleared. He said everything becomes like third-world countries, and it has nothing to do with capitalism.

“You staffer on for years and then like soviet Russia, people get bored of no growth, no improvements in living standards and rebel,” he said. “But they don’t realise that growth is only achievable if you have the war between the new and the old.”

He questioned how long people will “wait patiently,” adding that governments also “start to misbehave.”

This article first appeared on ValueWalkPremium