The Hierarchy of Safe Assets - Vivek Kaul's Diary
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The Hierarchy of Safe Assets

Jul 19, 2016

33

We begin the week with a failed (and perhaps staged) coup attempt in Turkey. A top Air Force general is in jail, 6,000 other judges and military personnel have been arrested and over 300 people are dead after the events which began Friday night. Recep Tayyip Erdogan remains in power.

Based on futures markets in the US and early trading, investors are not worried. The S&P 500 closed down on Friday. But it's broken through its upper resistance amid mostly positive earnings announcements from corporate America.

Are the markets telling you that despite the avalanche of awful and depressing news, everything is fine? Is that the signal you should be taking?

Let me just remind you of the idea I brought up a few weeks ago (Safety at any price). The idea, based on the work of former New York Federal Reserve vice president John Exter, is that there is a hierarchy of liquid and "safe" assets into which capital flows in a crisis. Gold is the bed rock, followed by cash, government bonds, high-quality corporate bonds (if you can find them), and stocks.

I'd suggest, at least in the US, soaring blue chip indices and plummeting 10-year bond yields fit perfectly with Exter's explanation. This is a slow-motion crisis. Capital is fleeing to a few concentrated sectors and asset classes. That's not a bullish sign. It's a sign that there are few "safe" places left. How ironic, given how much our financial overlords have done to "de-risk" the world with easy money.

Brexit fears averted?

In the UK, the picture is more complicated. Prime minister Theresa May went to Scotland on Friday to meet with first minister Nicola Sturgeon. The PM said she'd take a UK-wide view of Brexit, which seemed to suggest going it slow and not triggering Article 50 of the Lisbon Treaty (which notifies the European Union of the UK's decision to leave).

But then international trade secretary Liam Fox told the Sunday Times he was aiming for a Brexit date of 1 January 2019. That would suggest the PM will give the EU notice at the end of this year. But we still don't know.

In the meantime, Japanese software giant SoftBank will buy ARM Holdings for $32 billion. The falling pound and, perhaps, the prospect of Britain out of the EU, is the backdrop for huge foreign investment in the UK. Remember, correlation doesn't equal causation. And there will be people who complain about increased foreign ownership of British assets.

But the falling pound is likely to attract more cashed up buyers from abroad. Britain's on sale. And capital is shopping for a good deal. It's finding it in the UK and not in the EU. The government may even abandon austerity and take advantage of low rates to borrow a lot and build... something. Anything. Meanwhile, Germany approaches a key decision that, according to one analyst, could affect us all for a long time.

Merkel's moment

Russel Napier is one of the keynote speakers at this year's MoneyWeek Conference on 3 October (When banking dies: how to survive the monetary endgame). The conference sold out quickly (although you can pre-order a recording of the proceedings now). He made some insightful comments over the weekend about what's at stake in Europe.

If Germany's Angela Merkel gives the European Central Bank permission to help EU-member countries flog more debt, we'll see rising stock prices and helicopter money. But if the Germans insist that the Italian banking system can't be bailed out by the state, and if they, along with the EU Commission, insist on advancing the political centralisation of Europe (rather than reverting to a common market), well then it could be curtains for the EU and recession for the economy.

Which will it be? Helicopters and higher stock prices or political union at any cost? Napier writes (emphasis added is mine):

Investors need to remain very cautious indeed as it is in no way clear that Mrs Merkel will hand over the keys to der Hubschrauber [the helicopter]. Should she do so, however, major changes in investment allocation are necessary as helicopter money will be raining from the skies in Japan, the Eurozone, the UK and even in the USA if President Clinton also wins the House and the Senate. This form of reflation will likely work and in due course work too much. Few things are binary in investment, but this huge decision to be taken in Berlin is the biggest binary event for investors this analyst has yet come across. The repercussions will reverberate throughout this century.

Time is ticking away and a decision will have to be made within weeks if a European recession, which will raise severe questions about the survivability of the European political union, is to be averted...

[A] failure to endorse helicopter money within a few weeks most likely means Germany is ultimately backing away from the European political union project. This is amongst the most important political decisions of the 21st century and one full of pain for global equity investors if Germany decides not to act. Early clues as to which way The Chancellor might swing are to be found in Italy.

The central issue is whether a recession in Europe will doom the political project. It really does hinge, for now, on what happens in Italy. If the EU and the ECB are seen to rigidly impose losses on Italian pensioners (unsecured bank creditors) for the sake of observing EU rules , the current of unrest within the EU will turn into a swiftly flowing river... leading directly to French and German elections next year.

But if the EU relaxes the rules and fires up the helicopters to prevent a recession, it will show that the political union is powerless to enforce its own rules. It will show that the whole idea of different countries having monetary and fiscal union - while having vastly different economies - is a failure of an idea.

Now that would be something, wouldn't it? If Britain leaving the EU triggered the break-up of the EU. Russia and China - both of which are making the most of the last days of Barack Obama's presidency - would be celebrating their geopolitical good fortune. The EU in tatters, America at war with itself, and nobody to stop the strong from taking from the weak. A golden age of trade behind us. A new age of capital and conflict in front.

Please note: This article was first published in Capital & Conflict on July 18, 2016.

Dan Denning studied literature and history, moving to Agora Financial in Baltimore fresh out of college. Working alongside Bill Bonner and Addison Wiggin, he became managing editor of Strategic Investments. He then moved via Paris and London to Australia, publishing a book - The Bull Hunter - along the way, and opened Agora's successful office Down Under. He returned to London in 2015 and became the publisher of Fleet Street Publications' financial newsletters.

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