Dylan Grice kicked off Thursday’s Altegris investment conference with a very big-picture view of markets, highlighting a slow-motion unraveling of trust inflamed by the world’s central bankers through quantitative easing.
Connoisseurs of deep thinking in financial markets relished Grice’s research reports when the Scottish analyst wrote them for Societe Generale.
Now a portfolio manager for Aeris Capital, a Zurich-based family office, Grice characteristically took a long step back to make explicit what investors take for granted: namely, the relationship between money and trust.
“Money and trust are bound together,” he told the conference’s 600-plus attendees in San Diego. “When you play games with money, you’re playing games with trust,” he said, noting that the word “credit” comes from the Latin credere, meaning to believe.
Grice argued that that that faith, upon which markets and the very organization of society depends, is at risk.
“Our central bankers don’t understand what they’re doing — the consequences of what they’re doing by artificially creating money,” he said.
Grice explained how this breakdown is occurring by portraying the typical Western politician who wants more revenue, but fears that raising taxes will bar him from re-election.
By printing money instead, he can use the money to accomplish his objectives, be they construction of bridges or schools or development of agriculture or defense.
The relatively small segment of the population receiving contracts paid for with this printed money substantially benefit. They can send their children to good schools and eat in swanky restaurants. And the politician gets re-elected.
But “there are no free lunches,” Grice says. So who pays for this largesse? The relatively large portion of the population distant from the printed money who can’t afford those same good schools or expensive restaurants or nice houses. That second group ends up blaming the first smaller group.
“Quantitative easing is a redistribution; it breeds distrust,” said Grice, who then quoted Keynes, approvingly, at length:
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.
“Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers’…Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Grice cited historical instances of hyperinflation, showing that they coincided with society turning on itself: “In Europe in the 1920s, they blamed the Jewish communities,” he said, adding that Diocletians persecuted the Christians during a bout of hyperinflation in ancient Rome, while medieval English inflation coincided with witch hunts.
The investment analyst took his audience on an extended foray into game theory to understand how trust is developed and undermined. In brief, he explained the famed “prisoners’s dilemma,” whereby the police have only enough evidence to convict on a lesser charge, so they separate the prisoners hoping to extract a confession.
The dilemma for the prisoners is that if one testifies against the other, he’ll do OK, but his partner in crime will face a 10-year prison sentence, and vice versa. Alternatively, if both testify against one another, they’ll both receive 5-year sentences (reduced because of their cooperation with the police); if both remain silent, they’ll each receive 1-year sentences on the police’s lesser evidence.
Since neither knows what the other is doing, they eventually rat on each other, avoiding the risk of bearing the full sentence, and thereby produce a result that is bad for each. But if the process is repeated rather than a one-off, they eventually discover the benefits of cooperation.
This solution to the prisoner’s dilemma, called Tit-for-Tat, came from Anatole Rappoport, who demonstrated the simple act of repeating his fellow’s last move was mathematically always the optimal move.
But bringing in problems in evolutionary biology (i.e., Darwin’s natural selection), Grice added:
“The problem with Tit-for-Tat is that errors destroy the cooperative equilibrium. One mistake triggers an endless cycle of retaliation,” a problem solved by Harvard biologist Martin Nowak’s “generous Tit-for-Tat,” which allows for errors.
“If you cooperate, then I will probably cooperate. If you defect, then I will probably retaliate, but I might just forgive and keep on cooperating,” Grice describes.
Thus, while society and nature start out with suboptimal outcomes as individuals pursue their self-interest (survival of the fittest), “Eventually two cooperators are going to come along,” and that winning strategy will spawn offspring.
Eventually it evolves from “Tit-for-Tat to “generous” Tit-for-Tat, until eventually it evolves to a stage of always cooperating.
That is world economy’s current stage, which worries Grice because of the process’s cyclical nature.
“The problem is that if everyone cooperates, incentives for non-cooperating become very high.” In other words, there becomes a high payoff for cheating, which leads back to the state of nature’s “always defect” default position. “That’s how you get war,” Grice warns.
Grice cites Nowak’s reflection that in all his work on the evolution of cooperation, he has never found there to be an equilibrium.
And Grice warns that’s true of markets. A lender might take a chance on a borrower, who then repays, thus strengthening the confidence of the creditor, who makes more loans. Further repayments inspire an abundance of loans until the borrower overborrows and defaults, thus making lenders reluctant to lend.
The lender’s solution to low trust is high yields. Grice notes that yields today are at all-time lows, indicating high trust that is vulnerable to the world’s trust busters.
As a demonstration of the rise of non-cooperators, Grice cites Japan’s Prime Minister Shinzo Abe, who posed, gloating, in a jet with the numbers 731, understood by Chinese viewers as code for a World War II unit that conducted chemical and biological experiments on Chinese prisoners.
“Imagine Angela Merkel flying around the Mediterranean on a fighter plane with a swastika on it,” is how Grice described the provocation.
In financial markets today, we see a rising breakdown in trust in the credit deflation in the U.S. that gave rise to Occupy Wall Street; in a rise in capital controls in various countries; and citing China’s credit bubble, Grice asks: “What’s going to happen when credit deflation hits China,” a country he notes is prone to revolutionary instability.
So what’s a worried investor to do?
Cash and gold for starters. Cash gives an investor “optionality,” and Grice calls gold the “ultimate hard currency,” as it is “the oldest way to save in the history of our civilization.”
While the portfolio Grice manages for his family office contains both, he also advocates owning “necessities and natural monopolies” (as opposed to government monopolies) and capital-efficient businesses.
He cites eBay (a stock he does not own) as an example of a natural monopoly in that “it has the characteristics of an exchange; it serves as a hub,” he says.
“They’ll still go down in a bear market, but they’re on high ground.”
Capital-efficient businesses, meanwhile, will fare well if there is a capital shortage, which Grice sees on the horizon.
Performing an “Ngram analysis” with the help of Google using the words “saving” and “spending,” Grice finds that former word has been trending massively down and the latter trending massively up in recent decades.
“We’ve become a nation of spenders and we have a shortage of saving. If interest rates are too low, you have too much demand and not enough of supply of capital; there’s a shortage of capital.”
And that, Grice fears, is another dangerous consequence of central bankers’ easy money policies.