Tale of Two Euros

The past two weeks of the Cyprus banking crisis have been chaotic at the least, and challenging known economic theory at the worst.  The most recent developments, in my opinion, may be creating the biggest risk the unified currency has faced at any point in this crisis.

The first steps involving “resolving” the banks are exactly as they should be:  Burn up the stockholders, then the bondholders, then the uninsured depositors.  Moral hazard is removed from the equation and risk is compensated in the accepted hierarchy.

The next step, however, is the source of my concern.  That step involves implementing capital controls.

Implementing capital controls is neither a new nor unilaterally negative phenomenon.  Their use has ebbed and flowed throughout history.  They were prevalent during World War I, eased in the years leading up to the rise of the Nazi party, and returned in forms such as the tax imposed by the Nazis on the Jews attempting to leave Germany to avoid oppression.

During John Maynard Keyne’s heyday (the Bretton Woods era), capital controls were widely implemented and were considered a lynchpin in controlling the breakouts of banking crises.  The history of that era would certainly validate that correlation (although not necessarily proving causation).

August 15, 1971 marked the end of Bretton Woods when Nixon abolished the gold standard.  From that point until the most recent financial crisis, capital controls were largely eliminated – first in the developed countries and later in the emerging markets.  Lack of capital controls accelerated globalization while, at the same time, increasing the likelihood of banking crises.

Then came the 2008 financial crisis and the Great Recession.  Suddenly countries pined for the good old days of Bretton Woods – or at least the financial stability capital controls brought to that era.  Keynesian economic policies began being implemented across the West with bond-buying programs and the manufacturing of money being the perceived saviors from the crisis.  Perhaps it was a natural progression, then, that Keyne’s other belief – the usefulness of capital controls – would surface at this time.

Which leads me to my confusion about the controls about to be implemented in Cyprus.

Capital controls don’t exist in a vacuum.  In fact, one model of capital controls involves the idea of the “Impossible Trinity.”  Basically, the Impossible Trinity says that countries desire three fortuitous things:

  • Free capital flows (no capital controls)
  • A fixed exchange rate
  • Sovereignty over monetary policy

The rub, however, is obtaining all three is an impossible trinity.  A country can only have two at the expense of the third.  Graphically, it works like this:

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A = Free capital flow and fixed exchange rates; therefore, there will be no sovereignty in monetary policy

B = Free capital flow and sovereignty in monetary policy; therefore, there can be no fixed exchange rate

C = Fixed exchange rate and sovereignty in monetary policy; therefore there will be no free capital flows

Flipping the formula for “C” over, implementing capital controls leaves you with two desirable levers:  Fixing your exchange rate and implementing monetary policy as a sovereign.  Unfortunately for Cyprus, neither of those two desirable levers is at their disposal as part of a unified currency.

I think that puts Cyprus in uncharted territory.  In a way, having no levers puts Cyprus at the full mercy of the decisions made by the monetary union as a whole.  The union has free capital flow (for now) providing it with flexibility in exchange rates and monetary policy.  Cyprus, on the other hand, is now singly focused on stemming the exodus of cash when its banks reopen.  But that cash is denominated in Euros.

By restricting the mobility of Cyprus Euros, do you not create a second class of Euros – those that are mobile and those that are restricted?  And shouldn’t the restricted class of Euro’s be worth less than those maintaining their mobility?  And since Cyprus has no fortuitous levers at its disposal to find equilibrium, won’t this imbalance persist?  And, by the way, doesn’t whole idea violate the European treaty forbidding the use of capital controls by any country within the monetary union?

To me, this is a troubling crack in the facade; both from monetary and a legal perspectives.  History may look back at these “Hail Mary” attempts to save the common currency as the very seeds of its demise.

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I Can’t Get No Satisfaction

I client asked me an interesting question last week.  After reviewing his monthly report, he simply asked, “Are you satisfied with your recent performance?”

It’s a short question, but one with a lot of built-in complexity.

Any period we lag a highly publicized index like the S&P 500 (whether or not it is a relevant benchmark) we ask this question of ourselves, so I found the question to be very relevant.  In hindsight, having more equity exposure would have produced better results in the intermediate term, so measured by that metric, I’d be foolish to be satisfied.  We would always like to capture gains when they are available to be captured.

The question, though, leads into a larger issue – which I suppose underlies the original question.

Should we have, in retrospect, changed our method of managing money to take advantage of a persistently rising stock market?

John Maynard Keynes had an interesting perspective on that question, as well as on those who manage money.  Their primary objective or “their first and last rule” as he put it, is to keep their jobs.  As Jeremy Grantham added, “To do this you must never, ever be wrong on your own.”  So, the great majority of advisers go with the flow, creating momentum that drives prices far above or far below fair value.  Grantham sites an interesting observation regarding the volatility of the stock market, GDP growth and the fair value for the stock market.  Two thirds of the time, annual GDP growth and the annual change in the fair value of the market is within +/- 1%.  The market’s actual price, courtesy of the herding mentality, is within a whopping +/- 19% two thirds of the time.  The rough conclusion:  The market moves 19 times more than is justified by the underlying engines.

Circling back to Keynes, he notes that a money manager who follows his long-term strategy “will be perceived as eccentric, unconventional and rash in the eyes of average opinion.  And if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

So this is the trouble with money managers acting as agents.  They are consistently forced to weigh their career risk against their assessment of investment risk.  In today’s environment, avoiding career risk means accepting only two premises:  First, there is no need to add alpha; you simply have to leverage beta.  In English, that means you don’t need to bring skill to the game, you only need to apply leverage to the market in order to beat the market.  Second, the only thing in the world that matters is liquidity. As long as liquidity is being provided, stocks will go up.  Evidence of these premises in practice is easy enough to find.  Presently, mutual funds are levering beta at the historical level of 1.1.  As for liquidity, it’s easy to find charts showing stocks rising during periods of quantitative easing and immediately retreating when the spigot has been turned off.

Our mindset differs from that of many advisers in that we are (and invest as) principals, not agents.  Without being flippant, I don’t spend much time worrying about career risk.  I accept that there will be periods of time we under-perform the herd or a stock index, and at those times we may be perceived as “unconventional.” When this happens we may not receive much of Keynes’ mercy.  Incidentally, we don’t spend much time expecting mercy either.  That’s why we keep our investments as liquid as is practical – capital is free to move in or out at the discretion and personal judgment of the investor.

Given the increasing risks we see in the global financial markets, we will not be increasing our risk profile at this time.  We are convinced that risk is being underpriced.  We believe that behavioral issues, rather than rational issues, are driving stock prices.  I’ll spend some time addressing those risks in my next blog post, but it is our intention to maintain low betas, seek ways of adding alpha, and keeping a fair amount of powder dry so we may apply systemic hedges to the portfolio when or if our macro outlook comes to pass.

Back to the original question… in terms of our investment returns aligning with our objectives, I’d have to say we’ve done what we set out to do.  We are asked by our investors to deliver consistent returns in a risk averse way and our portfolios continue to be invested to reflect that objective.  And over various stretches of time, doing that isn’t particularly satisfying.