Churchouse Letter
February 2015         by Peter Churchouse

A Lesson From The Mountains

How to Avoid a Financial Avalanche

There is an almighty bubble brewing in one of the largest global asset markets...
Europe is in the doldrums. I think QE won't work. And there is a lack of will to make the structural changes required.
But never fear! We still have ways to implement defensive & profitable ideas!
“In economics, things take longer to happen than you think they will, and then happen faster than you thought they could.”
– Rudi Dornbusch, Economist

Right now I’m on my annual ski trip in the French Alps. My wife and I do this every year. It’s always a breath of fresh air, especially for us Hong Kong folks. The skiing is wonderful, the food and wine even better. And it’s a great time for me to get a lot of reading, research and writing done away from the daily noise of the markets.

As I sit here high in the mountains after our first day of skiing, I remember something that happened last year. Our guide Guillaume was shepherding us along a flat, boring piste that we were using to get across to another valley. He paused for a moment to let us catch our breath after a lengthy traverse. Then he told us a worrying story. About 10 days earlier, an avalanche had swept down the hill to our left, across the piste exactly where we were standing. Three skiers were carried down the mountainside.

The avalanche was small. But the lesson was not. Even a small avalanche is hugely powerful and can sweep you away in seconds. You have no ability to resist.

Luckily the French rescue services swung into action very quickly and the three skiers were rescued alive.

That day at lunch I asked Guillaume more about avalanches, their causes and any early warning signs. He is an extremely experienced mountain man, and expert skier.

He told us another story from the previous season. He and two instructor friends had been skiing off-piste high in the Alps.

There was the crack of ice breaking, and a growing rumble start-ed behind them. They set off down the mountain at full pelt veering all over the mountainside to get out of the path of the descending wall of snow.

He paused in the story for a second.

One of his two friends didn't make it.

Turning the conversation back to the avalanche site that we had just passed, I asked what conditions had led to this life-threatening event. What triggered it?

Guillaume mentioned that there had been a significant buildup of snow over the previous two weeks or so. Day after day it had snowed, sometimes quite heavily. The snow just kept piling high-er and higher on the slopes and in the valleys.

“How can you predict when and where an avalanche might happen?” I asked. He replied that it is very difficult. He simply said that when you have seen a large buildup of snow, you can just feel that the risk of an avalanche is rising. There are some physical signs that highlight risky areas, but it is as much about experience as anything tangible.

Excess in the System

Reflecting on those conversations, I draw strong parallels between those avalanches in the Alps and the rising risks in financial markets. It is hard to put a finger on it, but experience tells you that something does not feel quite right.

The avalanche follows an excess buildup of snow.

Financial disasters follow excess in the financial systems, be it an excess of debt or of prices.

It is hard to know where and when the ice is going to crack and that snow is going to come cascading down, wiping out anyone in its path, just as it is difficult to predict where and when that buildup of financial excess is going to come crashing down.

Guillaume could not identify precisely which of many catalysts would send the snow tumbling.

I cannot identify which of many possibilities might trigger the financial equivalent of an avalanche.

Trying to predict that specific “trigger” is, if you ask me, not that important. It’s like trying to identify the final snowflake that triggers an avalanche.

What is far more important is acknowledging the avalanche risk itself …

And in my opinion, Europe’s sovereign bond market is a gigantic accident waiting to happen.

So just after European Central Bank (ECB) Chairman Mario Draghi has unleashed his plans to drop another 1.1 trillion of central bank money into global markets, it’s a good time to take a step back and survey the mountain, the weather – and take stock of financial-avalanche risks.

In this month’s edition of The Churchouse Letter I’ll be covering a lot of ground.

I’m going to talk about Quantitative Easing (QE), particularly in Europe along with why I think the bond market is in a potentially dangerous bubble.

I’ll cover in depth the reasons why I think QE won’t be very effective Europe.

Now whilst a lot of what you read below might appear quite negative, I certainly don’t seek to scaremonger you. I’m sure you can get all the doom and gloom you want elsewhere!

But at the same time I would be doing you a disservice if I didn’t share with you some of my deep concerns about Europe in particular right now.

We have three straightforward investment recommendations for you. I believe they will be sensible, defensive and profitable for your portfolio.

So let’s start with quantitative easing.

We find ourselves seven years on from the global financial crisis (GFC). But major central banks, most notably the ECB and the Bank of Japan (BOJ), are printing even more money and ballooning their balance sheets.

Central Bank Balance Sheets from March 1999 to January 2015 for the Fed in USD, the European Central Bank in EUR, and the Bank of Japan in JPY.

Why? Despite the most accommodative monetary policy that most observers have seen in our lifetimes, we remain entrenched in a world economy where inflation and growth are low or non-existent.

Printing money is the ONLY tool that these central banks have left

It’s important to understand this point. Basic monetary policy traditionally works by lowering interest rates, which reduces the cost of servicing debt. Asset prices then rise, causing a wealth effect and in turn generates spending.

But interest rates are already at zero, and have been for a while. Any positive growth effect has long since disappeared.

On top of this, debt is already too high. Contrary to popular opinion, global debt to GDP has steadily increased since the GFC*.

The world has not even begun to deleverage yet!

* Geneva Reports on the World Economy 16 "Deleveraging? What Deleveraging?"

Major Central Bank Policy Rates from March 2006 to February 2015, includes the U.S., Europe, the U.K. and Japan.

More debt will not save us.

So if rates can’t go lower, then central banks are left with one option for stimulus – to increase the supply of money by buying assets.

The problem is that this bond buying is distorting the price of sovereign bonds to an absolutely spectacular degree.

If you thought the U.S. Treasury market was in a bubble, then just cast an eye across the Atlantic.

In Europe, bond prices are at extremes right now. There’s simply no other way to describe it.

Look at the Figure 3. This shows you the yields on two-year government bonds for a range of European countries.

Two Year Sovereign Bond Yields for Switzerland, Denmark, Germany, Austria, Finland, Netherlands, France, Belgium, Sweden, Slovakia, Portugal, Spain, U.K. Italy, Slovenia and the U.S.

In TEN of them (seven in the Eurozone), yields are negative. That means you are PAYING the government to take your money for two years.

During the GFC of 2007-08, two-year U.S. Treasury yields certainly never went negative, and that was during one of the biggest credit and liquidity crunches imaginable.

And here we are, nearly seven years later, looking at negative yields across Europe.

It’s one thing to see temporary slight dips into negative yield territory in very short term government paper during a financial crisis.

For example, investors scrambling for places to park cash drove one month T-Bills into negative territory in late 2008.

But to have this kind of persistent negative yield in so many countries at lengths of two years or more is totally unprecedented.


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