November 2013 - Richard 'Jerry' Haworth: Loss and Gain

Loss and Gain

     When I compare
What I have lost with what I have gained,
What I have missed with what attained,
 Little room do I find for pride.

     I am aware
How many days have been idly spent;
How like an arrow the good intent
  Has fallen short or been turned aside. 

     But who shall dare
To measure loss and gain in this wise?
Defeat may be victory in disguise;
  The lowest ebb is the turn of the tide. 

Henry Longfellow

Massive credit extension has created a 30-year bull market in nominal asset prices and along with commensurate gains in productivity due to peace, deregulation and the internet; we have long enjoyed the tail winds of prosperity. Add the government’s ongoing sponsorship of the property bubble. No brainer really… Property is the one asset which the average punter can leverage up to 20 times his wealth. Once the nominal price of his house goes up, he feels flush due to the “wealth effector in the case of the US can refinance and he is flush due to real money. He then consumes more, is happier and is a more compliant citizen. A win all round!

2008’s liquidity crisis put the collateral underlying credit into question, especially property credit and loan extension. Central banks stepped into the breech to avert a financial meltdown.

Post 2008, central banks had to make a choice, deflate the credit bubble and risk systemic collapse at all levels of society or collateralise the credit with the full backing of their respective sovereign balance sheets and printing presses. They chose the latter. Again a no brainer, everybody who counts wants inflation. Yes savers, old people and old school realists don’t count.

Where is this new stock of money going?

Well firstly it must go into the rapidly deflating credit balloon to give the appearance of stability hence no collateral or liquidity crisis. Secondly it must go to the real economy, getting consumers to spend and businesses to hire. Fast forward to today and nearly all of the new stock of money is going into financial “assets” creating bull markets in structured credit, equity and bond markets. And by the way, when financial “assets” go up it is not inflation (wink wink) …only when REAL assets go up is it inflation!

And real assets are staying low for now. Investors are not realising that real wealth cannot be wished into existence as money wealth can.

What does this do for volatility?

Up to now is it suppressing volatility, creating this “slack tide” with the apparent lack of movement as central banks stand in as collateral providers. Bull markets in financial assets further suppress volatility as uncertainty wanes.

  “But who shall dare
To measure loss and gain in this wise?
Defeat may be victory in disguise;
  The lowest ebb is the turn of the tide.“

What seems like a defeat for long volatility funds may well be their victory as they accumulate exposure to extremely cheap volatility.  And whilst becalmed for now, volatility funds are loading up with convexity, ready to monetise the next volatility upswing which, if the last few volatility cycles are any guide, is not too far down the road.