Incongruence

Strange title, huh? Bear with me.

Though I've been an amateur observer and perpetual head scratcher in watching the economy and the markets' (yes, possessive plural) reactions to this or that news item, I have only received clarity this a.m. for what has been troubling me. It's not that I haven't been writing and talking about it, it is that I hadn't really built a mental model for it. Reading a couple of things in the space of a couple of days has both reinforced and clarified my discomfort. First, if you read nothing else for the balance of the year, read this article, Liquidity boom and looming crisis, in the "Asia Times" by Henry C K Liu.

We all have to build models to make sense of things. Every sales pitch that you have ever heard is a mental model that someone has carefully crafted to convince you that the pedaled product has all of the benefits you want and none of the detriments (that cannot be facilely explained away) you fear.

So what is my great break-through thinking? Understand first, that this is just a personal epiphany, and each of you are probably way ahead of me. My epiphany is reduced to a single word: incongruence. Incongruence? Sure. All of life's mysteries are solved by looking at the incongruent space between things that are supposed to line up to make something true: Incongruences are used by

• Scientists to realign their theories
• Spouses of cheating wives/husbands to sniff out deceit (Okay, I needed a little drama!)
  
• Parents to keep their kids on the straight and narrow path.

You get the idea. So if you wish to avoid incongruency, what do you do? You avoid that space. You always go back to your main points--in music the analogy would be you would just hit the major chords and forget about the harmony. After a while that tactic becomes, well, discordant.

Isn't it precisely this type of "thing" that is going on now when we hear about how robust the economy is, how strong the consumer is, and how housing will rebound? Therefore, if you struggle to put this mosaic of pieces together into something that is recognizable without resorting to Rorschach impressionism, then you have to look for incongruence.

So, I want to list some of the things that don't quite line up with the rosy picture that we are given. The backdrop, of course, is that the world is awash in liquidity.

• Ceding of risk to parties unknown. While I've written about this with respect to mortgage backed securities, the issue is larger. I give the Economist (April 21/27) credit for cementing this concept for me. Because investors were hungry for yield and sanguine about risk, they provided an eager funding source for lenders. However, due to the sophistication of financial instruments, meaning derivatives, you can presumably hedge any risk you wish. If mortgage lenders were off-loading risks to bond holders, they really had no incentive to keep underwriting standards high. Expand the venue to any corporate debt instrument that can be hedged, and you have the same environment for underwriting laxity.The Economist notes:
  

"If lenders know they can sell risk on quickly, they have less incentive to worry about repayment than when loans stayed on their books. When watching credit risk becomes no one's responsibility, the consequeneces can be painful, as the subprime-mortgage mess shows. A few weeks ago, it seemed that this lesson had been learned. Perhaps it is about to be dished out again." (The Economist, April 21/27, p. 14)

So long as the music is blaring and everyone is partying and exchanging scraps of paper all is well. But when the music stops--that's what an economic slowdown or a turn of the liquidity tap will do--people, whomever the hell they are, are going to be holding slips of paper that are going to cause their hands to tremble and their wishing they were a little more sober at the party.

• Housing/Job numbers. Barry Ritholtz has been writing about the nuttiness in job numbers for a long time, and you can read about it here. But with residential construction slowing remarkably, you'd expect some different numbers coming out of these employment reports. The glib answer is that commercial construction has taken over. Well residential and commercial contractors are not so interchangeable: framers, roofers, electricians to name a few are doing very different work.
  

In addition to the jobs portion, new residential construction has been a significant contributor to our economic recovery. That investment is falling off the cliff. Again, I point to the glib answer of commercial construction, but I also understand that commercial construction peaks after residential construction in economic slowdowns. I've not seen any quoted facts about the amount of concurrent res/comm construction and the amount of NEW commercial construction. So I have to ask, HOW CAN THIS NOT COME TO PASS? (Again, I'll restate my bias having had to navigate the awful 1990-1992 recession--NO ONE will tell you that you are in a recession until the fat elephant ass of the economy sits on our collective heads. [Potential shock is that the reality of this impact--both employment and investment--finally steeps into the psyche of the market.]

• Consumer spending: Salary growth is still small in percentage terms. Interest rates have gone up (think about home equity lines which are little talked about which carry variable rates in many instances) and mortgage equity withdrawals are shrinking. BUT, consumers are now tapping into short term credit. How long before the consumer just drops in his/her tracks? [Potential shock is that consumer spending will decline. April is already known to be bad--watch the price component in spending though for it has inflated other spending numbers. So if the price component is stripped out and consumer spending continues to dwindle, then this will affect Asian markets considerably].
  

• Short term borrowing to finance long term assets (Financial arbitrage): When you run a business you line up appropriate maturities with your financing with your asset. You buy long lived assets with longer term money. You want your working capital to be just that, working capital to finance your inventory, receivables as well as any losses you may incur due to seasonality factors of your business. Now explode the venue to the worldwide sphere of activity.
  

Due to the large differences in currency values/interest rates, people are arbitraging currency.s-t money rates to buy longer term assets such as bonds/stocks of other countries/companies (that's the s-t/l-t maturity mish-mash I'm speaking to). In many cases, the small amount of arbitrage opportunity is augmented by goosing up the leverage. What happens when the underlying arbitrage dynamics change? Well that is the "Great Unwinding". [As an aside, i have to wonder with some amusement as to what "name" They will give this portended event". ] I don't think that it is a question of if, but when--and perhaps the current stasis is sustainable for some time. How long is really THE question.

So what will happen with the Great Unwinding? I surmise that assets (stocks/bonds) will be sold and that prices will tumble. I'm not sure that I see that bonds would be any safer than stocks. It is important to understand that this is just my amateur noodling on this stuff--but I don't think I'm terribly far off the mark--and you are welcome to, indeed I encourage you, to tell me that I'm wrong. [Potential shock is the yen strengthening through currency/rates.]

• Inflation: I went to the store yesterday--a warehouse club, for I rarely go to the grocery store except to get "accoutrements". Everything is markedly more expensive. I'm not talking about 10-15%, more like 20-30%. I particularly noticed it with milk and meats. Gas , food, healthcare are the mainstay expenditures for most families--and these expenses have gone up considerably. I think that price of gold is telling us that too. With housing where it is I certainly understand the Fed's precarious position with respect to interest rates. [Potential shock: inflation fails to curb and the Fed raises rates. I think that the housing issue will temper this risk considerably, but that will lead to USD devaluation.]
  

• USD/Trade: With all of the chatter about trade practices and rates, I wouldn't be a bit surprised if the shock to the world financial stasis comes from an over-zealous Congress looking to curb currency "inequities". [Potential shock: I hate to think about it--Bond prices go up--taxes go up, since you have to finance your deficit with either taxes or debt--USD goes down].
  

That is my meager attempt to describe what I consider significant incongruencies that do not add up to the rosy picture that some would have us believe. Feel free to fill in the blanks or clarify/correct my view.

So long as we are at stasis, then I fully acknowledge, that liquidity is functioning as the great lubricant for the economic euphoria. But if there is a shock, then the lubricant will dry up and the "ride" will be far less comfortable.