Third Time Lucky?

Bill Gross, who runs Pimco, the world’s largest fixed income fund, is also a great salesman. So he caught the attention of his audience of financial advisers in Chicago recently when he told them he would reveal the secrets of Pimco’s spectacular success.
“I’ll be handing you the keys to the Pimco Mercedes,” he said.
Pimco does not just trade bonds; it insures them. “Insurance”. . . that’s the secret.
It’s highly active in derivative markets and is now one of the biggest sellers of insurance against market volatility.
The latest hot market is a reminder of previous episodes of this nature.
In 1987, the asset du jour was portfolio insurance. Investors, keen to lock in profits from a bull market, created a boom in sales of software that triggered computerised sell orders at pre-set stop points.
It turned out to be a classic exercise in the fallacy of composition where a particular strategy operated quite well at the individual level but which created a cascading flood of sell orders when orders were originated from a multitude of sites.
Stock markets around the world experienced a stampede of sellers with most falling more than 20 per cent in a single day.
A significant element in the episode was that the markets in most securities were widely regarded as overpriced.
A second more damaging market collapse occurred in 2008 when Lehman Brothers’ collapse exposed the full extent of debt and counter-party risk in the financial system.American International Group (AIG) was still boasting in 2007 that it was the fifth largest business in the world. 
It had been amongst the heaviest players in the derivatives business. One popular product, credit default swaps (CDS), dominated by AIG, was considered so bullet-proof the company believed it would never have to pay out on any claims that were insured by CDS’s but simply collect premiums.

Costly bailout of AIG

The bailout of AIG cost US taxpayers an estimated $180 billion.
Bull markets, notably in equities, preceded the crashes of 1987 and 2008. These markets, fuelled by easy money, created a powerful demand for insurance to lock in those bull market profits.
As it turned out, the “insurance” that was supposed to protect those profits actually exacerbated the crisis.
Last weekend the Bank of International Settlements, one of the few institutions to identifythe risk and destructive power of the global financial crisis, warned that “euphoric” financial markets had become detached from the reality of a lingering post-crisis malaise.
In its annual report, the BIS pointed out that while the global economy was still struggling to escape the shadow of the GFC capital markets were “extraordinarily buoyant.”
The BIS report states: “Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”
It notes that extraordinarily (a word which crops up often in the report) easy monetary conditions have spread to the rest of the world, encouraging financial booms there.
They have done so directly because currencies are used well beyond the borders of the country of issue. In particular, there is some $7 trillion in dollar-denominated credit outside the United States and it has been growing strongly post-crisis.
They have done so indirectly through arbitrage across currencies and assets.
Although the BIS does not specifically cite the current M and A boom, it is a manifestation of the very accommodative and lengthy programs of monetary stimulus in such economies as the US and, arguably, also China

BIS: worrying signs 

It does say: “Based on leading indicators that have proved useful in the past, such as the behaviour of credit and property prices, the signs are worrying.”

And the report warns that compared with the past specific vulnerabilities may have changed in unsuspected ways particularly in the emerging market economies (EME).

Should a severe financial crisis occur in the EME sector, it’s now unlikely that the advanced economies (AE) would escape unscathed.

At the time of the Asian crisis, 1997, the EMEs accounted for around one third of global  GDP. Now they account for half of the global economy. This increased heft is mirrored in the international financial system.
Australia’s exposure to Asian EMEs is the largest, as a proportion of its GDP, of any of the  advanced economies. 
In a rare allusion to Australia, the BIS report states: “The ramifications of financial stress would  be particularly serious if China, home to an outsize financial boom, were to falter. Especially at  risk would be the commodity-exporting countries that have seen strong credit and asset price increases and where post-crisis terms-of-trade gains have shored up high debt and property prices.

The potential for a debt-related crisis that let loose a contagion through the EMEs may have been reduced by the buildup in foreign reserves. But that has probably been more than balanced by private sector borrowing of EMEs that have raised capital through their foreignaffiliates. These do not show up in the official statistics.

Another area of EME concern has been the burgeoning presence in the EME space of them global asset management industry. This has grown strongly over the past decade especially in the fixed income markets.

The BIS report puts it this way: “Like an elephant in a paddling pool, the huge size disparity between global investor portfolios and recipient markets can amplify dislocations. It is far from reassuring that these flows have swelled on the back of an aggressive search for yield: strongly procyclical, they surge and reverse as conditions and sentiment change.”

That’s not the only section of the BIS report that is “far from reassuring”.

It sums up: “The bottom line is simple. The global economy has shown many encouraging signs over the past year. But it would be imprudent to think it has shaken off its post-crisis malaise. The return to sustainable and balanced growth mmay remain elusive
That’s not what the financial markets are saying. But they were just as bullish back in 2007 and 1987.

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Max Walsh


Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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