Oh
Welcome to trade ideas. I'm Alex Rosenberg here with David Levine founder of Odin River and also someone know you as the paranoid bull
Thank you all for joining us here at real vision great to be back
So helped us make sense of these markets here because with so many, you know
As we are talking on Monday morning the S&P is up 1% a lot of up 1% down 1% That seems to be the norm
these days and people are really trying to figure out what's driving the market now and what will drive us in the weeks months and
Perhaps year or two years ahead
So if you were to tell us what the stakes are what the market is trying to figure out right now
What would that be? Well, it's good to put this in context
So what's really interesting if you look at the S&P 500 today?
It's around 2900 last January the end of January 2018
The S&P 500 was higher than it is today last August it was higher than it is today
and
what's really interesting is that there's been a variety of different narratives that have taken over in the first half of this year because we
Bottomed in 2018 at the end of December has been quote-unquote bullish. There's been a lot of confidence volatility settled down
What's really funny though?
Is that confidence was based on tweets was based on a back-and-forth trade policy was based on the idea that Donald J
Trump will control the markets up and down ahead of the election and get reelected
The narrative didn't really make sense if you think about it
So if I look at the last two weeks where the markets are up and down where equity market volatility is up where Treasury market?
Volatility is up where the bond yield curve has been inverting?
That's a little bit more normal in my opinion given how volatile the real world actually has been since last
January remember last January was the beginning of the end of the top of a bull market
We had 90 percent of asset classes globally down in 2018
And so what happened the first half of this year in my opinion is sort of a bear market bounce
We had volatility settle we had
Correlations go back up. And so a lot of confidence in a narrative that maybe in my opinion wasn't really justified
So what we're seeing now is more uncertainty
We're seeing that across various different markets and in my opinion that's more reflective of the fundamentals
So I think what's happening is markets are becoming more normal
What we were seeing the first half of the year wasn't very normal
And so what I expect is more the same more volatility more uncertainty
And markets beginning to reflect the fundamentals that we know are very volatile in the real world now, which the fundamentals will matter most
We'll see trade war is very important
Global slowing in China, very important yield curve inverting important 16 trillion dollars of negatively yielding sovereign credit
Important US economy are we in recession import so there's many different questions
Primarily macro related that need to be answered in the coming weeks
Those will probably determine the fate of things
But I would expect more volatility like this and more uncertainty and maybe even narratives taking hold again
Like everything's going to be fine, or maybe not we'll see what happens at Hong Kong
there's a lot of uncertainty but in my opinion a little bit more of a normal market in the last couple weeks and what we
Saw before so let you play a little dealer's choice here and of those questions
Which one do you think that most investors are getting the most wrong?
Where where is the most where's the biggest problem and investors thinking when it comes to this market?
You know, there's one thesis that have been talking about for the last period of years and I call it the myth of the infallible
central banks meaning in order for systemic risk to exist
there has to be an assumption that everyone's making that later is
Turns out to be wrong and it's got to be very very big and most people have to believe it to be true
Right. Now that assumption in my opinion is called the myth of the infallible central banks
So embedded in a variety of these different assumptions that people are making about the markets is the idea
Don't fight the Fed
Don't fight the BOJ. Don't fight the ECB in my opinion. That's just not a good assumption to make meaning
Central banks have limits those limits are political. Those limits are legal and in the United States right now
We had all the former Fed chairs write an article in The Wall Street Journal just in the last few weeks
Questioning the feds very independence right now in the United States. So confidence is also very important for central bank's
so what I would say is what level of confidence is the right level of confidence in central banks is a very important question and
How this myth of the infallible central banks kind of becomes unwound in the coming weeks and months
Is very important and that could happen in a variety of different ways
Two most obvious ways where we see that happening today in the banking system
the European financial system European banks
we know they're under pressure near all-time lows Japanese banks under pressure near decade lows and
The fundamentals of those have been challenged very much by central bank policy in Europe and Japan the second most obvious places is showing up
sixteen trillion dollars in negatively yielding debt
Primarily the majority of which is sovereign credit 16 trillion and negative
The yielding debt should never exist that was created by central bank's so we have these very big market signals that are already occurring
Which are kind of showing us they're reaching the limits of central bank power and central bank credibility and central bank effectiveness
So as those unfold in the coming weeks, I think those will be very important in two weeks and months actually
Those would be very important themes to watch unfold. Let's just drill down a bit on the negative
yielding bonds that something that has sort of crept into the conversation as the Overton Window is being opened about
Something that could happen in the US as well
I guess I'm trying to understand because to me it seems like a success of central banks that they were able to make
people buy negative yielding bonds, you know by setting rates negative but and and you know,
Seeing that translate throughout the curve of the risk spectrum as well. I mean people talking about negative yielding mortgages
Now what sort of your thesis about why that's so problematic and what it means for the future of central banking. Oh sure
It's just really really basic. So if I lend you money I need to be compensated for that risk
We know for a fact
not hypothesis fact systemic risk exists in
2008 it was proven beyond a doubt that if you have a credit bubble
You can have systemic risk and that can show up immediately across the entire world
We almost had a global financial system collapse beyond repair in 2008. Thankfully we were able to repair it
Therefore the risk of lending the risk of participating in the financial market is positive
That is why the risk-free rate is always positive whenever you study finance
There is a compensation for systemic risk that is embedded in every discount rate
And whenever we teach finance, it's one of the basic fundamental building blocks
Now what central bank's decided was?
let's ignore that what we care most about is stimulating the economy by inflating asset prices and we will ignore
systemic risk because we believe don't worry central banks will be
Infallible don't worry government's will be able to pay their debts
Overlook this very basic fact, which is that systemic risk is positive
Therefore interest rates actually have to be positive in my opinion because of the very nature of risk itself systemic risk
And so by making the mistake of lowering rates to zero and below
The central bank's forced the system to underprice systemic risk
throughout
Every single asset class that exists now the concept of negative yields ignores systemic risk
It also suggests that you and I are entering a contract where I'm guaranteed to lose money by lending you money
That is just not something that people should do in finance. So this goes very deep. It goes very deep
and so I don't believe it is a success to have 16 trillion of
Negatively yielding debt actually thinks to sign the systems
I should really know a lot of trouble you had the Austrian bond up 50 percent in a month you had
You know German government debt up 20 percent in a couple months for what reason in my opinion
No other reason than a blow off top
quite similar to calm only way bigger way more important because this is government debt government debt is
way more central to the financial system than subprime CDOs or any other kind of
Credit instrument that's ever been an issue in the past. So I actually don't think it's a success to see the negative yields
I think it's actually really troubling and it's a sign of how far the system has gone. So going along with that thesis
How do you see it playing out from here or you know, this is a blog top if this is a moment of capitulation
What does that mean for the months ahead? Well, the two the most important places to look are the
the banking system and then the credit markets and
Those two things are are both in trouble meaning if you're bank
You have to be able to make money by lending and what negative rates do is it forces?
Interest rates negative and it also forces the yield curve to be flat
Those two factors make it very very hard for banks to make money
So when we look at the equity market prices of European and Japanese banks, not surprisingly
They're near all-time lows in Europe and near decade lows in Japan
So my opinion the banking systems of both Europe and Japan are really important because central banks now
Especially in Japan are at the limits of what they can actually do to help the situation
If the BOJ were to increase their interference or their kind of influence of on the interest rate markets in Japan actually make things worse
So there's really difficult. They're in a really difficult situation in Japan
If the fundamentals continue to remain as bad as they are in Europe similarly, we saw Deutsche Bank already announcing a restructuring
So we're in the middle of the European financial system unwinding now
there is a German Court case outstanding that is you know, this is a little obscure, but it's important thing the German
Federal Constitutional Court, which is kind of the equivalent of the Supreme Court right now is reviewing the legality of QE
They have never ruled that the QE that was done in 2015 and Beyond is illegal
Everyone assumes that the German Constitutional Court is gonna come back in a few months and say don't worry Q
He's okay the 33 percent rule that the drug. He's been following if they want to increase it to 50 percent. That's gonna be okay
But it might not be the case. We actually don't know today nobody in the world
Maybe the judges know but I don't even know if they've decided know whether q is legal in Germany
Which is just wild to think about if they were to come back and say it's illegal
The point is that there's a lot of uncertainty in these markets, especially in the financial system
So I'd start with you know coming back to your question of what what's most important the financial system itself
Especially in Europe and Japan and the the second point which is credit market volatility
I mentioned a little bit about this court case
That would be something that would be quite volatile across credit markets and we're to come back in a negative way
But credit market volatility more generally is also very important to watch if you look at the last couple weeks
Credit market volatility has picked up
Treasury market volatility has picked up even more than equity market volatility now if we start to see that volatility
Increase that could be quite dangerous because it would also be a sign that we're likely starting to see defaults
Spreads could begin to widen and we could begin a credit cycle now everything I've said so far has ignored the fundamentals remain weak
Fundamentals remain very weak China just had one of the worst quarters in 20 plus years
industries like automotive
And semiconductors and others are weakening and so and not to mention oil and gas like there's a bunch of industries where fundamentals are weak
So if we get credit market volatility picking up while fundamentals remain weak
Ignoring whether or not the u.s. Is in a recession
We could start to have a default wave we can start to have credit volatility and those two things banking
System vulnerability in Europe credit market volatility throughout the system those would be things which they could be quite dangerous in this environment
so when it comes to all these
Particular issues and I'm glad we talked about central bank's already because the answer really comes back to central bank's
I mean central banks could save, you know, Georgia make another European banks and central banks could couldn't
You know continue to do things too. So, can I just in a row? Yeah, please
Getting this is the key
Point right which is the myth of the infallible central bank. And the reason it's a myth remember in 2008
This is really important to remember in
2008 the actions that the Fed took were not in their authority
They were granted to them by Congress
They were granted to them by unified front of Democrats Republicans and the White House coming together
Locking arms and saying we need to bail out AIG. We need to bail out goldman sachs
We need to bail out the financial system because it's important because we don't want the economy to go into a tailspin
even in the united states
Could you imagine today Nancy Pelosi walking into the White House with President Donald Trump and saying hey
Let's bail out AIG and gomen Sachs. I
don't know how all that would go over perhaps in an election year the Democrats might say oh
why don't we make this a tougher negotiation than
President would like they may be incentive to make things even more difficult
Than they otherwise might given the context of the politics here to Europe where you were going before
They actually tried to create a merger between to which bank and another bank in Germany and they failed
The reason is that it's not that straightforward
You have union workers on the board of deutsche bank and union work has said no merger. We don't want to get fired
And when you start to think about bailing out banks in Europe, that's where the laws become really important
so one of the key issues in this German case that I mentioned is
that the german constitution and the German laws want to make sure
That Germany is not financing the deficits of other countries specifically countries like Italy
so if you got into a situation where you needed a bank bailout
You'd actually need to have the different countries cooperated at the end of the day might that happen
I think probably but most likely that would take time
And therefore you'd have significant volatility in the near term
in other words one of the best things that could happen for a bailout of the financial system in Europe might be
significant volatility
You know if markets are down 30 or 40 percent and you have a lot of volatility and there's quote/unquote flood on the streets
That's when maybe there's a political will to come together and give the central bank
The authority it needs to act in a time of crisis which is what happened in a way
But the point is that there are limits to what the central banks can do at any point in time
And I think we're nearing those limits and at the very least
To paraphrase if there is a central bank put the strike price is much lower than people might currently think of us
It's a great way of putting it. I think that's right. So given this view of the world that you articulated
What does it mean for you when it comes to asset allocation?
And so I think what it means coming back to the very beginning of the conversation what our equity markets doing today?
They're much more volatile. Right? We saw we saw VIX as one measure of volatility but realized volatility
It's really picked up in the last couple weeks
Valuations on any kind of cyclical adjusted basis are very high
The same is true for credit markets bond yields, very low meaning bond price is very high the asymmetry
associated with any of the things that I'm talking about
Meaning the risk to the downside if any of the things I'm talking about materialize are quite significant both in equity markets and credit markets
For me, that means being that short now. I don't advise that for non-professional investors
It's really shorting is quite dangerous and it can be, you know, very asymmetric to the downside
It takes a lot of you know, both patience and things, you know
Having a good sense of position sizing risk management and stuff like that in my opinion
De-risking is is probably the most prudent thing to do
FDIC insured savings accounts where you have, you know, 2% interest and you have a guarantee at least from the government
I don't believe they will let FDIC insurance go even in its systemic type
Crisis, it's pretty attractive
You have 2% you know guaranteed in this market where you have negatively 16 trillion and negatively yielding credit including you know
the US 10-year below that
2% you know, it's pretty attractive in my opinion. So maybe not the sexiest trade idea we've ever
Yeah, I think this is not a time to try to be sexy now
I mean, you know you for me
You know being short is something that does make a lot of sense and when you say net short stocks bonds
Yeah, and so the way that I construct, you know, my portfolio is to be long progress
I'm long this conversation like I'm long transparency and there's a reason why at paranoid bull
My Twitter account is is somewhere where I share my ideas
I believe very much in the mission of real vision and very much in the modernization of Finance. And so
being invested in themes like increased transparency and Finance themes like
Increased transparency and media and companies that are benefiting from that post public and private
Holding that forever to me is a great thing to do now
Being short broader equity markets being short companies that are being disrupted
Yes being short credit, which is again something that you know when advise to your average investor
but doing these things in the context of portfolio to me makes a lot of sense, especially if one
You know constructs it with not a lot of leveraging and some prudence with position sizing. I think it's the right way to go
Well David, I'm along this conversation - thank you so much for joining us here in real vision. Thank you for having me
It's great to be back