Excerpted from Paul Singer’s Elliott Management letter to investors,
The world believes it is in a sweet spot. There is global consensus that central banks know what they are doing and are in control, and that if economies falter, a bigger dose of QE or ZIRP or NIRP (negative interest rate policy – we just made that one up) will keep it from getting out of hand. Additionally, there seems to be a universally held belief that the U.S. is unquestionably the safe haven for the foreseeable future, that its financial crisis and long recession are behind it and that China has complete control over its own destiny. It may not surprise you to learn that we either disagree with or remain unconvinced about every one of the foregoing propositions.
Conditions in the global economy are clearly abnormal. The policymaker response to those conditions is extraordinary, with minimal focus on an all-out push for higher growth. Instead, the primary focus is on boosting “inflation” with repeated doses of bondbuying, stock-buying and super-low interest rates. We cannot appreciate why policymakers are not jumping up and down clamoring for structural pro-growth reforms and policies, and why there is a compliant consensus that the only policy that is possible is more monetary easing. Apparently, most politicians are happy to leave the hard economic and policy decisions to their central banks instead of introducing legislation to properly address the world’s economic problems. It is impossible to assess what will change or destroy the consensus that current policies will hold the global economy and financial system afloat forever, but when assessing the scope and shape of risks to our assets, it is most useful to match them to the size of the aberrations which could cause reversal or surprise. Today, those potential changes are strikingly large.
We have frequently said that real deflation (price and credit collapse, not a tiny downturn in aggregate prices or “insufficient” inflation) is impossible. Governments are too alert to that possibility, have no compunction about debasing their currencies and will simply not stand for seriously-falling prices. The issue of real inflation, at the other end of the spectrum, is deemed by just about everyone but us, plus a few beleaguered stragglers and fellow travelers who “didn’t get the memo,” to be a non-issue into the future as far as one can peer.
We are a little bit more simpleminded than the consensus-buyers who are looking just ahead. They think there is slack in the global economy, workers do not have pricing power and inflation is something that governments always will need to boost and push just to reach their (arbitrary) targets. We, on the other hand, are most focused on the combination of the trustworthiness of governments to protect the value of paper money (which has never been lower than at present), plus the structural impediments and barriers to smoothly functioning growth, innovation, entrepreneurship and private-sector job creation. Confidence in policymakers and central bankers today should be low or nonexistent, but confidence has not (yet) been lost. Leadership in the developed world is weak and confused, except for President Putin (although his is not the kind of strong leadership that we have in mind as a model for bringing the developed world out of its torpor).
It is for this reason that we are not complacent, because we can easily imagine a transition from the current post-2008 context to a different and scarier environment. Recent abrupt and intense trading shakeouts give some hint of the potential power and violence that resides in modern, over-leveraged, technologically wired markets, and confidence in paper money and central bankers can be lost at any moment. When it is, and what that development will look like, are mysteries. The difference between “us” and “them” is that we are trying hard to figure out what is essentially unknowable and impossible to ascertain, while most people are just shrugging and accepting the current calm as a given.
Government action is obviously a more powerful contributor to the trading context in many areas than ever before, and it is also true that a good amount of government action is increasingly arbitrary, ideologically driven and arguably lawless, even in the most developed countries. This factor is hard to quantify and mitigate in risk management, but traders who wish to preserve their capital “no matter what” need to take it into account in their trading and risk controls.
These are the considerations that are front and center in our strategic assessment of the trading landscape: trying to make sure that a sudden loss of confidence in paper money, or in any of the major markets in which we trade, does not unacceptably jostle our portfolio; keeping dry powder for the inevitable moment when the next flood of distressed securities becomes available at reasonable prices; and being cautious and visionary about the regulatory landscape in order to be cognizant of regulatory directions as well as where regulators are focusing today. Our mix of strategies is a good one, and we need to keep making the research and analysis process more and more robust. This effort is key to making sure that the next trading crisis does not surprise us in major ways.
In the last few years, thanks to QE and ZIRP, the common investor has made very good returns despite the lack of solid growth in the global economy. Such an imbalance between economic growth and good investment returns for both stocks and bonds is abnormal and unsustainable for extended periods of time. We at Elliott aim to make at least some money in every environment, with a combination of activities emphasizing complexity and manual effort, including activism. Thus, a period such as the most recent few years masks the benefits of exerting the effort (and accepting the costs) to hedge rather than not, and to try to make things happen rather than passively ride the wave. We are certainly not complaining, but merely observing these factors, and further speculating that the time may be near when complacency in the stock and bond investing community may be seriously jostled. We design our positions so that they will, in most cases, be governed more or less by their own idiosyncratic paths, even in periods of disruption. We of course recognize that events and resolutions will be affected in various measures by macro developments, and that liquidity considerations in adverse market conditions will impact even completely uncorrelated positions.
One very clear implication of the diminished liquidity in markets due to the withdrawal of a great deal of position-taking capital is that the punishment for being wrong has become more severe. We suppose the other side of the coin is that aberrations which can create attractive trades can also be larger and more compelling, given the reduced participation from Wall Street prop desks.
Markets are not getting more efficient; indeed, the press of money and zero-percent interest rates doth not efficiency make. People should have learned that lesson in 2006-08, but they did not (much to their ultimate peril, we think). And here we are again.