A View from the Trenches, January 18th, 2010: "Profiting from the cycle"
Given last week’s events, it may be important to step back and look at the current environment with a bit of perspective.
Historians date Polibius’ life between 201-118 B.C. Polibius, who
made insightful observations on the transition that took place from
Greek to Roman culture, also wrote “The Histories”. In its Book VI, he
suggested that there is a cycle in the forms of government. Based on
his own experience, civilizations started under a monarchy, which
provided the necessary cohesive force. But as power corrupts, the
monarchy morphed into tyranny. Under tyranny, people suffered and
reacted by choosing the best among them (i.e. the “aristos”) to bring
down the tyrant. Tyranny therefore gave way to an aristocracy. Polibius
then noted that the aristocracy would later rule only for their own
benefit, becoming an oligarchy. The people had to revolt once more and
forced the oligarchy into a democracy. But democracy would later lead
to demagogy. The only way to get rid of the demagogue was to find a
leader to bring it down. This leader would be the monarch, and the
cycle would start all over again.
We can also find a cycle in economic thought. In particular and
relevant to our situation (the Keynesian paradigm we live in since the
1930s) , we could suggest the following: Central banks issue money
that, through the credit expansion process, generate asset bubbles.
Banks lend to the participants in the inflated markets at higher
leverage ratios to remain profitable until these markets go bust. When
they go bust, the financial system goes bankrupt and governments bail
them out. The bailouts are financed with public debt which will have to
be repaid. Consistent with Keynesianism, these governments refuse to
restructure their budgets and to address their growing fiscal deficits,
they increase taxes and promote social hate against “proprietors of
stock” (i.e. bankers, investors, etc.), who are to blame for their
greed and the generation of asset bubbles. The situation becomes
increasingly untenable and soon governments find themselves debasing
their currencies, generating inflation. As the asset bubbles
(inevitably in raw materials) end up also lifting consumer prices, the
lower income (with fixed wages) strata of economies begin now
questioning the wisdom of their politicians. If these economies are
educated, as is expected in the developed world, they replace their
leftist politicians with radical conservatives. The conservatives begin
by privatizing government-owned assets, reducing taxes and reopening
their economies to free trade. But they don’t reduce government
expenses, because they also believe in Keynesianism and because they
need the vote of the public. Therefore, deficits may still linger at
the beginning, but the tax rate reductions, privatizations and free
trade lift productivity. As governments tax activity, when activity
picks up, revenue increases and deficits wane. But the higher activity
at higher prices requires a new and higher level of money supply, to
support the rate of interest. For that, there are central banks issuing
money, which takes us back to the start of the cycle…
If we understand the cycle, we can always make money in each stage.
Banks in particular will also always make money: Financing the asset
bubbles, with the refinancing of public and private debt, with advisory
and capital markets fees during the privatization of government assets
(you will see this soon in Greece), with FX fees when free trade
reopens and with derivatives as activity picks up. Such is the cynical
nature of Keynesianism…In my view, we are currently at the beginning of
the cycle, with governments increasing taxes (i.e. reserve requirements
in China, bank taxes in the US, higher regulation worldwide) and
promoting social hate against proprietors of stock. However, in this
global world, there is some heterogeneity. As I wrote on January 7th (www.sibileau.com/martin/2010/01/07 ), we will see a dichotomy in capital flows:
“…Since my last letter of 2009, the US Treasury announced it would
lift the cap on the Preferred Stock Purchase Program (…) This explicit
show of support for agency debt (which I assumed it was going to
smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010.
I say relative because the strength should show vs. those countries
that explicitly decide to import USD inflation (i.e. Brazil) or face
serious fiscal problems (i.e. Euro zone), while the weakness should
show vs. those countries that will profit from the credit-inflated
recovery (Emerging markets or commodity currencies, like the CAD)…”
If we give serious consideration to this dichotomy and play a beta
strategy in any space (credit, stocks, fixed income), we’ll be ahead of
the curve in 2010.
Martin Sibileau
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