The Pen is mightier than the Sword! Read on:

From: Guy Haselmann (Scotiabank GBM) Global Macro Commentary – A Clockwork Orange

• As an 18-year old college freshman taking ‘Pysch 101’, I watched the highly-disturbing Stanley Kubrick film-version of A Clockwork Orange.  The story takes place in a dystopian futuristic London and exposes the extreme battle of good versus evil.  After the sociopathic and violent gang leader Alex was captured, the government decided to deploy a modern behavioral modification method to reform him.  This experimental treatment was  highly-controversial. The government’s idea was to use the cruelest members of society to control everyone else.  While well intentioned, the unintended consequences were poorly understood.

• Extracting out the violence, I can’t help but notice the symbolic similarities of the motif-ridden story with the 2008 financial market fallout and subsequent attempts at economic rehabilitation.  Leading up to 2008, unsavory behavior of both borrowers and lenders conspired with lax rules to provide the conditions for the crisis to manifest.  Today, there are daily articles about how restrictive regulations are stifling banks and market-makers and causing a deleterious impact on market liquidity.  The intention of regulators is to deter risk taking in the banking system with the goal of preventing a similar banking-style crisis from ever re-occurring.

• The film forces the viewer to weight the values and danger of both individual liberty and state control.  It forces us to consider how much liberty we are willing to give up for order, and how much order we are willing to give up for liberty.  The central idea of the film has to do with the freedom of the individual to make free choices, but free choice becomes problematic when it undermines the safety and stability of society. It reminds me of the markets price discovery mechanisms (or lack thereof).

• Bond rates and stocks are in the midst of the greatest detachment of prices from economic reality in history.  Even during the Great Depression of the 1930’s, when unemployment was 25% and there was confirmed deflation, the US 10-year rate never traded below 2.00% yield.  How then is it possible that the US 10-year note traded below 2.0% last month with the US economy near full-employment and inflation relatively stable near 1.5%?

o The answer to the question is that price levels have become influenced by regulatory rules and central bank hoarding.  They are also a function of shifts in investor behavior to the ‘respondent conditioning’ of central bank policies that foster moral hazard and risk seeking activity.

• By promising to ‘do whatever it takes’, central banks have conditioned investors to buy the dip and over-weigh the riskiest assets.   Despite the Fed being possibly out of fire power, the ‘classical conditioning’ response remains strong.  However, it can wear off.   In the movie, Alex was actually ‘cured of the cure’; he had so much of the ‘medicine’ that it eventually became ineffective.  In the end, the experiment failed:  the state replaced Alex’s violence with its own; he was freed; and eventually the original problem resurfaced in a different form.

o This seems analogous to the Fed trying to eradicate systemic risk in the banking system.  Yet, in the process, the Fed has fomented large asset price inflation; compromised market liquidity; and as Richard Fisher says, “the Fed is now the largest hedge fund in the world”.

• Prior to being ‘cured of the cure’, side-effects materialized or became counter-productive to the process (as they were in experiments by B.F. Skinner or Ivan Pavlov).  For global central banks, the long term problems of financial repression are clear. Any policy that punishes savers and frugality, and rewards borrowers and profligacy is not prudent in the long-run.  Moral hazard and reduced investor discipline results from debt monetization.  It also reduces incentives for politicians to control public finances.

• Any process that is unsustainable will eventually end.  Ever-growing reliability on debt-driven consumption and increases in levels of entitlements in order to drive economic growth, boost living standards, or manage inequality concerns, is untenable and a ruinous direction.  Even Keynes said that a government should borrow money to close the GDP gap and get the economy back on track, but once it is back on track, the borrowed money should be paid back.  Seven years into this crisis, the level of debt in major economies has increased.

• There is no “free lunch”.  At some point the underlying issues will have to be addressed with the correct policy tools.  The end to political polarization in Washington may require a financial crisis.  QE4 will never happen as it would compromise the Fed’s independence, so the next financial burden will require a congressional response.

• Regardless, at this point, Fed policies and its $4.5 trillion balance sheet have reached their practical limit and may have even become a source of systemic risk and market uncertainty.  In this light, it is time to pull back.  I suspect the Fed will hike rates no later than the July FOMC meeting. (Re:  ‘Data Dependency’, see May 13 note “Lone Voice”.)

• “What is it going to be then, eh? – Anthony Burgess, A Clockwork Orange.  By: Guy Haselmann  |   Director, Capital Markets Strategy

The Economy: Economic data continues to look like a disheveled Spirit of 76 with a bent fife and dented drum. The exception was Housing starts, resembling Chris Evans’ Captain America as they surged to a 7-year high. Interestingly, builders confidence was down for the same time frame. Bipolar numbers or bipolar builders? Overall, we’re hearing that things seem to be slowly improving. The Fed minutes were released this week. As expected, given the confused data points, the Fed remains dovish and pushed the interest rate lift-off into the fall. Some are saying the sluggish economy will see lift-off deferral pushed out into 2016.

Food for Thought: We are quickly moving into the summer. We have the official start on Memorial Day this Monday. Find a cold one or a tall one. Mix liberally with a good book and enjoy yourself. Join us next Friday, May 29th from 2-5PM at the San Diego Yacht Club for a social. Great food, drinks and the best ambiance in San Diego. Have a safe and relaxing holiday!

The Economy: This week has been all about corporate earnings reports and the Fed. Economic reports have been mixed with consumer confidence up to a 7-year high and home prices and durable goods slightly lower. Earnings have been a bright spot with U.S. businesses continuing to show positive results. The Fed met for two days and released results of the confab. As scheduled for a year, the Fed ended QE. Financial markets had a muted response with stocks and bonds down slightly. But the Doomsday Crowd was out in force. The mainstream media’ s 24/7 news mandate means that viewers must be fed a never ending stream of negative titillation. Instead, let’s focus on improving corporate profits, rising employment, low oil prices, benign inflation and the Fed’ s intention to keep interest rates at historic lows.

Food for Thought: The past 2-weeks have seen more volatility in the stock market than we’ve had in years. Many are feeling sucker-punched by the 3-5% pullback that was gone in a blink. Stocks remain the only game in town through January 2015 … at least. One of these days this raging bull will stop. But nobody can see when that will be. It’s long in the tooth but not the longest bull market by any means. Bear markets need a recession and that simply isn’t in the cards.

The Economy: Economic data remains weak. The June interest rate liftoff that was a near certainty in January has been pushed out to at least September. After a near vertical rise, the dollar is falling. After a near vertical plunge, oil is rising. We see both moves as overdue but temporary. Interest rates are rising and the Fed will probably lead by following. Fed Chair Yellen put a shot across the bow with comments about the speed at which market rates could increase as well as comments that stock prices were “generally quite high” and that they represent “potential dangers.” She’s right on both counts and is stating the obvious. Interest rates will go up and stocks will eventually go down. We applaud her candor and her attempts to let some of the air out of the bubbles.

Food for Thought: April is typically the strongest month of the year for stocks. Now we’re in that “Sell in May and Go Away” period. Truth or Dare. We continue to see markets as being in a topping process. We are using a two pronged approach of core strategic and tactical allocation. We have been taking profits, averaging down on existing positions when appropriate, and raising cash. There are abundant shorts out there for the stout of heart. The recent market weakness should serve as warning that in stocks can actually go down. … and remember that there is always opportunity in chaos. But you have to keep your powder dry. Joe Kennedy cashed out of the market when he heard his shoe shine boy talking about stocks. Bernard Baruch exited in 1928 saying he wasn’t greedy. Perhaps the sign of the apocalypse is that Costco is now selling $3000 bottles of scotch and $3000 bottles of brandy.

The Economy: 6-years into it we’re still waiting for the recovery to catch fire. This week economic data again disappointed. The question is increasingly becoming, “When will this litany of under-performance end?” Even with the inherent errors in data reporting, the lack of statistical integrity, the political manipulation and corruption of the reporting entities, the numbers still disappoint. Just the fact that we’re still calling this a recovery is indicative of the uneven performance of this “expansion.” So the question becomes, “How do you play this situation in which the mainstream media spouts self-interest-conflicted optimism while the numbers disappoint.” We would say, “Be optimistic but play it conservatively and cautiously.”

Food for Thought: Gordon Gekko famously said, “Greed … is good.” Let’s tone it down and say that, “Self-interest is good.” Nowhere is this more evident than in the media. … and by media I mean all media: academic, governmental, journalistic and social. So the safe play is to treat it all as entertainment. … and if you treat it as entertainment then rest assured that the old adage, “95% of everything is crap” applies. Review your investment portfolio in light of the jingoistic noise of the media and see if you’re set-up to benefit in the future.