January 19, 2015
QE and the ECB: "Authorize" is a Slippery Word
Last week, the Swiss National Bank abandoned its attempt to tie the Swiss franc to the euro. For the past three years, the SNB has been trying to keep the franc from appreciating relative to the rest of Europe by accumulating euros and issuing francs. As the size of Switzerland’s foreign exchange holdings began to spiral out of control, Switzerland finally pulled the plug. The Swiss franc immediately soared by 49% (from 0.83 euros/franc to 1.24 euros/franc), but later stabilized to about 1 euro/franc. While numerous motives have been attributed to the Swiss National Bank, the SNB made its reasons clear: "The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified." In effect, the SNB simply did what the German Bundesbank wishes it could do: abandon the policies of European Central Bank president Mario Draghi, and the euro printing inclinations he embraces.
A quick update on what we call our "joint parity" estimates of currency valuation (see our recent discussion of the Japanese Yen in Iceberg at the Starboard Bow). Considering long-term purchasing power parity (which certainly does not hold in the short-run) jointly with interest rate parity (see Valuing Foreign Currencies), we presently estimate reasonable valuations of about $1.35 for the euro, and about $1.13 for the Swiss Franc - so after the wild currency moves of last week, we suddenly view the Swissie to be almost precisely where we think it should be relative to the dollar. At least one hedge fund and a number of FX brokerages were wiped out last week as their customers were caught with leveraged short positions against the franc. Data from the CME shows asset managers and leveraged money heavily short the euro (with commercial dealers on the other side), and by our estimates, the decline in the euro is overextended. That's a high-risk combination for euro shorts.
The chart below may offer some insight into what the SNB was thinking last week, from the perspective of our own joint-parity estimates of currency valuation. The chart reflects data just before the SNB abandoned its peg to the euro (data for the euro reflects the German DM prior to 1999, appropriately scaled). Back in August 2011, the Swiss franc surged to significant overvaluation relative to the euro. That’s when the SNB instituted the peg, attempting to hold the exchange rate at 1.20 francs per euro (just under 0.84 euros per franc). Prior to last week’s move, the overvaluation of the franc – relative to the euro – was no longer evident, and the franc had become substantially undervalued relative to the dollar. Having abandoned that peg, the franc has surged to what we view as fair value relative to the U.S. dollar.
Notably, the FX markets are providing some information here. From the standpoint of the EUR/CHF, the current exchange rate (now about 1.0 euros per franc) suddenly opens up a fresh gap versus the euro, which would be eliminated at a USD/EUR exchange rate of about $1.35/euro. That is, a fair value of 1.13 USD/CHF divided by a fair value of 0.84 EUR/CHF implies a fair value of 1.35 USD/EUR. Put simply, we view the Swiss franc as fairly valued against the U.S. dollar, but the U.S. dollar as overvalued relative to the euro (and most currencies). Conversely, from the standpoint of the dollar, the euro appears to have overshot to the downside. We expect that the Swiss franc will move back toward about 0.84 euros/franc (about 1.20 francs/euro), but not by depreciating sharply relative to the dollar. Rather we expect that both the dollar and the Swiss franc are likely to depreciate relative to the euro - conversely, that the euro is likely to appreciate relative to the dollar and the franc.
This week, the European Central Bank will authorize a fresh program of quantitative easing in Europe. My impression is that the structure of this venture will be far different from what seems to be commonly envisioned (and priced into an exchange rate that is has already overshot to the downside). The political realities for Germany have led it to shift its focus from opposing QE outright to changing the structure under which QE will proceed. It’s that potential impact on the structure of QE that seems underappreciated. Germany has two primary interests here. One is to ensure that any losses are borne by the individual member states, and the second is that as few euros as possible are created with the backing of questionable sovereign debt. Put simply, Germany’s agreement to allow QE to proceed is likely attached to particular strings that limit its exposure to the sovereign debt of its less credit-worthy neighbors.
Under Article 16 of the Protocol that established the European System of Central Banks (ESCB), the ECB Governing Council has the exclusive right to authorize the creation of euros, but either the ECB or the individual national central banks can issue those euros. The ECB will authorize a large QE program this week, but my impression is that the details will leave the ECB itself responsible for executing only a fraction of the announced program, with the remaining majority of the program (perhaps 60-75%) being nothing more than the option for each national central bank to purchase its own country’s government bonds, at its own discretion, and its own risk. Moreover, that option is likely to be limited to something on the order of 25% of the outstanding government debt of each respective country.
With German government debt trading at negative yields out to maturities of 5 years, German buying of German debt would essentially guarantee a loss to the Bundesbank. As a result, the likelihood that Germany will act on the option to buy that debt seems rather slim. The same argument holds, if to a lesser extent, for other credit-worthy countries in the Eurozone, which means that the bulk of that option will be taken up by smaller and less credit-worthy members. With a cap of perhaps 25% of total government debt, the actual size of QE when implemented is likely to be dramatically smaller than whatever number is announced this week. That certainly doesn’t rule out an ebullient knee-jerk response to whatever massive number is announced, but pay attention to the details, because they are likely to have a significant effect on what happens next. We’ll see.
Bottom line – “authorize” is a slippery word.
A flexible view toward a market collapse or a further bubble
For our part, I’ll reiterate what I’ve emphasized since June, when we completed our long and awkward transition from our pre-2009 methods to our present methods of classifying market return/risk profiles (see A Better Lesson than “This Time is Different” to review that narrative): The near-term outcome of speculative, overvalued markets is conditional on investor preferences toward risk-seeking or risk-aversion, and those preferences can be largely inferred from observable market internals and credit spreads. The difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes, has little to do with the level of valuation and everything to do with investor risk preferences. Yet long-term investment outcomes remain chiefly defined by those valuations.
So if market internals, credit spreads, lopsided sentiment and other factors improve measurably – even with valuations as extreme as they are at present – we would expect to shift to an outlook more along the lines of “constructive with a safety net.” For now, we have a hard-negative view of equity market risk, but that will change as observable conditions shift.
I’ll emphasize again that while market internals, sentiment, credit spreads and other factors were included in the ensemble methods that came out of our stress-testing against Depression-era data, the ensembles didn’t sufficiently capture their effect in bubble periods. Part of the reason is that overvaluation has reliably poor outcomes over the complete market cycle. That effect is so strong that in any study that draws data from multiple cycles, the negative average effect of overvaluation tends to dominate when you estimate the prospective return/risk profile. In order to capture bubble-tolerant factors, we had to impose them as overlays. The reason I call the period from 2009 to mid-2014 an “awkward transition” is exactly because it required us to address a series of interrelated problems, with the full-cycle ones addressed fairly early on, but QE creating the need to address features that have appeared only during the most speculative periods in the historical record.
Probably the best way to show the effect of completing those adaptations is to reprint a chart from the June 16, 2014 comment Formula for Market Extremes. In the chart below, each line tracks the cumulative total return of the S&P 500 Index, restricted to various return/risk classifications that we identify from observable valuations, market action, and so forth. In prior market cycles, severely overvalued, overbought, overbullish syndromes were followed fairly quickly by significant market losses. The ensemble methods that came out of our stress-testing efforts picked up that regularity. Unfortunately, the main effect of speculative yield-seeking resulting from QE and zero interest rate policies was to reduce the overlap and increase the delay between the emergence of those syndromes on one hand, and the shift toward risk aversion among investors (which we infer from observable market internals, credit spreads, and related factors). As a result, we saw sustained periods where conditions were severely overvalued, overbought, and overbullish, yet the market continued to advance.
So while the ensemble methods certainly navigated full-cycles well, we’ve seen much more persistent risk-seeking in the period since 2009, resulting in the excruciating tendency for the market to advance despite overvalued, overbought, overbullish syndromes that had a more immediate effect in other cycles. If you go back to the September 9, 2013 comment The Lesson of the Coming Decade, you’ll see we were still facing a residual of that problem at that time. Again, the lessons to be drawn from the recent cycle aren’t that historically reliable measures of valuation are irrelevant, but are instead about the conditions that distinguish overvalued markets that tend to continue higher from overvalued markets that drop like a rock. In my view, we completed the necessary adaptations in June. The purple line shows the effect of the overlays that we’ve implemented. As I’ve noted in other comments (see Iceberg at the Starboard Bow), the typical outcome for the S&P 500 in conditions that match the present are even more severe.
We remain hard-negative toward the equity market, but that view will remain flexible to new evidence – which may allow some variant of “constructive with a safety net” if internals and credit spreads improve, even in the absence of improved valuation.
As always, we can’t offer assurances about the future, or that any of the lessons from market history will be of use in market cycles still ahead of us. But I can offer assurance that we’ve completed this adaptation in a way that’s robust to every market cycle we’ve observed across history, including Depression-era data, post-war data, and the period since 2009.
In Honor and Remembrance of Dr. Martin Luther King, Jr.
Dr. King noted that he tried to speak on the subject below at least once a year. That still seems an appropriate way to honor him. If you've never read Dr. King's writings, this talk is a good place to start. The road to peace always begins with the recognition by each side that the person they would call their enemy also suffers. In our common humanity, each of us might be like the other if we had suffered the same way – whether that suffering takes the form of injustice, poverty, violence, abuse, or even ignorance. In a world where people – on both sides of the word “enemy” – seem so inclined to carelessly pour their reservoir of suffering onto others without recognizing their shared humanity, our best cause for hope still resides in the wisdom of peacemakers like Dr. King. One can’t read his words without coming away better for it.
Loving Your Enemies
“I want to use as a subject from which to preach this morning a very familiar subject, and it is familiar to you because I have preached from this subject twice before to my knowing in this pulpit. I try to make it a, something of a custom or tradition to preach from this passage of Scripture at least once a year, adding new insights that I develop along the way out of new experiences as I give these messages. Although the content is, the basic content is the same, new insights and new experiences naturally make for new illustrations.
“So I want to turn your attention to this subject: "Loving Your Enemies." It's so basic to me because it is a part of my basic philosophical and theological orientation—the whole idea of love, the whole philosophy of love. In the fifth chapter of the gospel as recorded by Saint Matthew, we read these very arresting words flowing from the lips of our Lord and Master: "Ye have heard that it has been said, ‘Thou shall love thy neighbor, and hate thine enemy.' But I say unto you, Love your enemies, bless them that curse you, do good to them that hate you, and pray for them that despitefully use you; that ye may be the children of your Father which is in heaven."
“Over the centuries, many persons have argued that this is an extremely difficult command. Many would go so far as to say that it just isn't possible to move out into the actual practice of this glorious command. But far from being an impractical idealist, Jesus has become the practical realist. The words of this text glitter in our eyes with a new urgency. Far from being the pious injunction of a utopian dreamer, this command is an absolute necessity for the survival of our civilization. Yes, it is love that will save our world and our civilization, love even for enemies.
“Now let me hasten to say that Jesus was very serious when he gave this command; he wasn't playing. He realized that it's hard to love your enemies. He realized that it's difficult to love those persons who seek to defeat you, those persons who say evil things about you. He realized that it was painfully hard, pressingly hard. But he wasn't playing. We have the Christian and moral responsibility to seek to discover the meaning of these words, and to discover how we can live out this command, and why we should live by this command.
“Now first let us deal with this question, which is the practical question: How do you go about loving your enemies? I think the first thing is this: In order to love your enemies, you must begin by analyzing self. And I'm sure that seems strange to you, that I start out telling you this morning that you love your enemies by beginning with a look at self. It seems to me that that is the first and foremost way to come to an adequate discovery to the how of this situation.
“Now, I'm aware of the fact that some people will not like you, not because of something you have done to them, but they just won't like you. But after looking at these things and admitting these things, we must face the fact that an individual might dislike us because of something that we've done deep down in the past, some personality attribute that we possess, something that we've done deep down in the past and we've forgotten about it; but it was that something that aroused the hate response within the individual. That is why I say, begin with yourself. There might be something within you that arouses the tragic hate response in the other individual.
“This is true in our international struggle. Democracy is the greatest form of government to my mind that man has ever conceived, but the weakness is that we have never touched it. We must face the fact that the rhythmic beat of the deep rumblings of discontent from Asia and Africa is at bottom a revolt against the imperialism and colonialism perpetuated by Western civilization all these many years.
“And this is what Jesus means when he said: "How is it that you can see the mote in your brother's eye and not see the beam in your own eye?" And this is one of the tragedies of human nature. So we begin to love our enemies and love those persons that hate us whether in collective life or individual life by looking at ourselves.
“A second thing that an individual must do in seeking to love his enemy is to discover the element of good in his enemy, and every time you begin to hate that person and think of hating that person, realize that there is some good there and look at those good points which will over-balance the bad points.
“Somehow the "isness" of our present nature is out of harmony with the eternal "oughtness" that forever confronts us. And this simply means this: That within the best of us, there is some evil, and within the worst of us, there is some good. When we come to see this, we take a different attitude toward individuals. The person who hates you most has some good in him; even the nation that hates you most has some good in it; even the race that hates you most has some good in it. And when you come to the point that you look in the face of every man and see deep down within him what religion calls "the image of God," you begin to love him in spite of. No matter what he does, you see God's image there. There is an element of goodness that he can never slough off. Discover the element of good in your enemy. And as you seek to hate him, find the center of goodness and place your attention there and you will take a new attitude.
“Another way that you love your enemy is this: When the opportunity presents itself for you to defeat your enemy, that is the time which you must not do it. There will come a time, in many instances, when the person who hates you most, the person who has misused you most, the person who has gossiped about you most, the person who has spread false rumors about you most, there will come a time when you will have an opportunity to defeat that person. It might be in terms of a recommendation for a job; it might be in terms of helping that person to make some move in life. That's the time you must do it. That is the meaning of love. In the final analysis, love is not this sentimental something that we talk about. It's not merely an emotional something. Love is creative, understanding goodwill for all men. It is the refusal to defeat any individual. When you rise to the level of love, of its great beauty and power, you seek only to defeat evil systems. Individuals who happen to be caught up in that system, you love, but you seek to defeat the system.
“The Greek language, as I've said so often before, is very powerful at this point. It comes to our aid beautifully in giving us the real meaning and depth of the whole philosophy of love. And I think it is quite apropos at this point, for you see the Greek language has three words for love, interestingly enough. It talks about love as eros. That's one word for love. Eros is a sort of, aesthetic love. Plato talks about it a great deal in his dialogues, a sort of yearning of the soul for the realm of the gods. And it's come to us to be a sort of romantic love, though it's a beautiful love. Everybody has experienced eros in all of its beauty when you find some individual that is attractive to you and that you pour out all of your like and your love on that individual. That is eros, you see, and it's a powerful, beautiful love that is given to us through all of the beauty of literature; we read about it.
“Then the Greek language talks about philia, and that's another type of love that's also beautiful. It is a sort of intimate affection between personal friends. And this is the type of love that you have for those persons that you're friendly with, your intimate friends, or people that you call on the telephone and you go by to have dinner with, and your roommate in college and that type of thing. It's a sort of reciprocal love. On this level, you like a person because that person likes you. You love on this level, because you are loved. You love on this level, because there's something about the person you love that is likeable to you. This too is a beautiful love. You can communicate with a person; you have certain things in common; you like to do things together. This is philia.
“The Greek language comes out with another word for love. It is the word agape. And agape is more than eros; agape is more than philia; agape is something of the understanding, creative, redemptive goodwill for all men. It is a love that seeks nothing in return. It is an overflowing love; it's what theologians would call the love of God working in the lives of men. And when you rise to love on this level, you begin to love men, not because they are likeable, but because God loves them. You look at every man, and you love him because you know God loves him. And he might be the worst person you've ever seen.
“And this is what Jesus means, I think, in this very passage when he says, "Love your enemy." And it's significant that he does not say, "Like your enemy." Like is a sentimental something, an affectionate something. There are a lot of people that I find it difficult to like. I don't like what they do to me. I don't like what they say about me and other people. I don't like their attitudes. I don't like some of the things they're doing. I don't like them. But Jesus says love them. And love is greater than like. Love is understanding, redemptive goodwill for all men, so that you love everybody, because God loves them. You refuse to do anything that will defeat an individual, because you have agape in your soul. And here you come to the point that you love the individual who does the evil deed, while hating the deed that the person does. This is what Jesus means when he says, "Love your enemy." This is the way to do it. When the opportunity presents itself when you can defeat your enemy, you must not do it.
“Now for the few moments left, let us move from the practical how to the theoretical why. It's not only necessary to know how to go about loving your enemies, but also to go down into the question of why we should love our enemies. I think the first reason that we should love our enemies, and I think this was at the very center of Jesus' thinking, is this: that hate for hate only intensifies the existence of hate and evil in the universe. If I hit you and you hit me and I hit you back and you hit me back and go on, you see, that goes on ad infinitum. It just never ends. Somewhere somebody must have a little sense, and that's the strong person. The strong person is the person who can cut off the chain of hate, the chain of evil. And that is the tragedy of hate – that it doesn't cut it off. It only intensifies the existence of hate and evil in the universe. Somebody must have religion enough and morality enough to cut it off and inject within the very structure of the universe that strong and powerful element of love.
“I think I mentioned before that sometime ago my brother and I were driving one evening to Chattanooga, Tennessee, from Atlanta. He was driving the car. And for some reason the drivers were very discourteous that night. They didn't dim their lights; hardly any driver that passed by dimmed his lights. And I remember very vividly, my brother A. D. looked over and in a tone of anger said: "I know what I'm going to do. The next car that comes along here and refuses to dim the lights, I'm going to fail to dim mine and pour them on in all of their power." And I looked at him right quick and said: "Oh no, don't do that. There'd be too much light on this highway, and it will end up in mutual destruction for all. Somebody got to have some sense on this highway."
“Somebody must have sense enough to dim the lights, and that is the trouble, isn't it? That as all of the civilizations of the world move up the highway of history, so many civilizations, having looked at other civilizations that refused to dim the lights, and they decided to refuse to dim theirs. And Toynbee tells that out of the twenty-two civilizations that have risen up, all but about seven have found themselves in the junk heap of destruction. It is because civilizations fail to have sense enough to dim the lights. And if somebody doesn't have sense enough to turn on the dim and beautiful and powerful lights of love in this world, the whole of our civilization will be plunged into the abyss of destruction. And we will all end up destroyed because nobody had any sense on the highway of history.
"Somewhere somebody must have some sense. Men must see that force begets force, hate begets hate, toughness begets toughness. And it is all a descending spiral, ultimately ending in destruction for all and everybody. Somebody must have sense enough and morality enough to cut off the chain of hate and the chain of evil in the universe. And you do that by love.
“There's another reason why you should love your enemies, and that is because hate distorts the personality of the hater. We usually think of what hate does for the individual hated or the individuals hated or the groups hated. But it is even more tragic, it is even more ruinous and injurious to the individual who hates. You just begin hating somebody, and you will begin to do irrational things. You can't see straight when you hate. You can't walk straight when you hate. You can't stand upright. Your vision is distorted. There is nothing more tragic than to see an individual whose heart is filled with hate. He comes to the point that he becomes a pathological case. For the person who hates, you can stand up and see a person and that person can be beautiful, and you will call them ugly. For the person who hates, the beautiful becomes ugly and the ugly becomes beautiful. For the person who hates, the good becomes bad and the bad becomes good. For the person who hates, the true becomes false and the false becomes true. That's what hate does. You can't see right. The symbol of objectivity is lost. Hate destroys the very structure of the personality of the hater.
“The way to be integrated with yourself is be sure that you meet every situation of life with an abounding love. Never hate, because it ends up in tragic, neurotic responses. Psychologists and psychiatrists are telling us today that the more we hate, the more we develop guilt feelings and we begin to subconsciously repress or consciously suppress certain emotions, and they all stack up in our subconscious selves and make for tragic, neurotic responses. And may this not be the neuroses of many individuals as they confront life that that is an element of hate there. And modern psychology is calling on us now to love. But long before modern psychology came into being, the world's greatest psychologist who walked around the hills of Galilee told us to love. He looked at men and said: "Love your enemies; don't hate anybody." It's not enough for us to hate your friends because—to to love your friends—because when you start hating anybody, it destroys the very center of your creative response to life and the universe; so love everybody. Hate at any point is a cancer that gnaws away at the very vital center of your life and your existence. It is like eroding acid that eats away the best and the objective center of your life. So Jesus says love, because hate destroys the hater as well as the hated.
“Now there is a final reason I think that Jesus says, "Love your enemies." It is this: that love has within it a redemptive power. And there is a power there that eventually transforms individuals. That's why Jesus says, "Love your enemies." Because if you hate your enemies, you have no way to redeem and to transform your enemies. But if you love your enemies, you will discover that at the very root of love is the power of redemption. You just keep loving people and keep loving them, even though they're mistreating you. Here's the person who is a neighbor, and this person is doing something wrong to you and all of that. Just keep being friendly to that person. Keep loving them. Don't do anything to embarrass them. Just keep loving them, and they can't stand it too long. Oh, they react in many ways in the beginning. They react with bitterness because they're mad because you love them like that. They react with guilt feelings, and sometimes they'll hate you a little more at that transition period, but just keep loving them. And by the power of your love they will break down under the load. That's love, you see. It is redemptive, and this is why Jesus says love. There's something about love that builds up and is creative. There is something about hate that tears down and is destructive. So love your enemies.
“There is a power in love that our world has not discovered yet. Jesus discovered it centuries ago. Mahatma Gandhi of India discovered it a few years ago, but most men and most women never discover it. For they believe in hitting for hitting; they believe in an eye for an eye and a tooth for a tooth; they believe in hating for hating; but Jesus comes to us and says, "This isn't the way."
“As we look out across the years and across the generations, let us develop and move right here. We must discover the power of love, the power, the redemptive power of love. And when we discover that we will be able to make of this old world a new world. We will be able to make men better. Love is the only way. Jesus discovered that.
“And our civilization must discover that. Individuals must discover that as they deal with other individuals. There is a little tree planted on a little hill and on that tree hangs the most influential character that ever came in this world. But never feel that that tree is a meaningless drama that took place on the stages of history. Oh no, it is a telescope through which we look out into the long vista of eternity, and see the love of God breaking forth into time. It is an eternal reminder to a power-drunk generation that love is the only way. It is an eternal reminder to a generation depending on nuclear and atomic energy, a generation depending on physical violence, that love is the only creative, redemptive, transforming power in the universe.
“So this morning, as I look into your eyes, and into the eyes of all of my brothers in Alabama and all over America and over the world, I say to you, "I love you. I would rather die than hate you." And I'm foolish enough to believe that through the power of this love somewhere, men of the most recalcitrant bent will be transformed. And then we will be in God's kingdom.”
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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