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A central banker and the end of banking alchemy

global-investingnew|By Matein Khalid|Dr. Mervyn King broke with tradition by publishing his book “The End of Alchemy: money, banking and the future of the global economy”. After all, retired governors of the Bank of England do not, as a rule, do not write/publish books, let alone write books that lambast the City of London’s culture of greed and hubris. It is no coincidence that Dr. King quotes T.S. Elliot at the outset “Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?” The worst financial crisis since the Great Depression gutted Britain’s banking system occurred on Dr. King’s watch, even though light touch regulation and political pressure make the FSA and Downing Street complicit in Britain’s banking crisis.

The very title of Dr. King’s book castigates the bankers who he criticized even during his tenure as the governor of one of the Western world’s oldest, most revered central banks. Alchemy was a medieval pseudo-science that is not dissimilar to the illusions of international banking whose epicenter was often the City of London. He castigates greed crazed bankers for their high risk lending and trading, their faith in impotent financial models and fiendishly complex instruments, their instinctive herd instinct. Dr. King fulminates “Even understanding the risks, it was safe to follow the crowd”.
Dr. King believes central bankers should be not just a lender of the last resort but “pawnbrokers of all seasons”, a mechanism to link collateral with risk metrics in lending. I was alarmed by his last chapter “The Audacity of Pessimism”, when he compares the financial world of 2016 to the economic uncertainties of the 1930’s. It is apt that Dr. King quotes from the great Victorian chronicler of the City, Walter Bagehot, whose Lombard Street (1873) is a banking classic. He demolishes the illusion that bankers can model risk and uncertainty, let alone forecast rational decision making or macroeconomic disequilibrium.
The contrast between Mervyn King’s memoirs and former Federal Reserve chairman Alan Greenspan’s Age of Turbulence could not be greater. Greenspan, once hailed as Maestro by Wall Street, had faith in the power of free market capitalism to work its magic and economics to model a complex world. Greenspan’s worldview, shaped by his mentor Ayn Rand, was shared by successive Nobel laureates in economics – Robert Merton, William Sharpe, Harry Markowitz, Franco Modigliani, Merton Miller, Lawrence Klein and Myron Scholes.
Greenspan’s global reputation was tarnished after his policies on financial deregulation and minimal regulatory constraints on investment banks culminated in the subprime mortgage crisis, the seizure of the world’s debt markets and the failure of Lehman Brothers in 2008. Dr. Mervyn King’s views the quantitative measure of risk embraced by the iconic names in world finance as largely useless. He leans towards the “radical uncertainty” intellectual tradition in economics whose progenitors included both Lord Keynes and his nemesis Friedrich von Hayek of the Austrian School.
The world of 2016 reflects Dr. King’s skepticism. The Japanese yen rallied from 124 to 106 against the US dollar despite negative interest rates and the Bank of Japan’s quantitative easing program, the most aggressive on the planet relative to QE. The Euro rose against the dollar after the ECB cut its deposit rate to minus 40 basis points and purchased corporate bonds in its asset purchase program. A December hike in the Fed Funds rate by the Yellen Fed triggered global financial disaster, as did the People’s Bank of China’s shift in its yuan managed float in August 2015. Financial markets, bank CEO’s and central banks face systemic uncertainties that make a mockery of the intellectual pillars of the efficient markets hypothesis and theories of portfolio diversification. A naive faith in risk and statistics based financial models failed international banking in 2016. The real world is complex, messy, prone to serial six sigma catastrophes, as Black Monday in 1997, the collapse of the Mexican peso in 1994, LTCM and the Russian default in 1998, the Internet crash in 2000 and the global banking crisis in 2008 made obvious. Global “casino capitalism” is prone to epic bouts of raw, visceral, interconnected, leveraged panic at the speed of light.
Stock Pick – Why buy global real estate investment trusts (REITs)?
It is now obvious that the bull market in commercial real estate is now over. I expect the bear market in GCC property, two years old this June, to accelerate in the next twelve months as excess supply, fall in oil prices and government spending, a contractor debt time bomb (Saudi Bin Laden corporate debt alone is $30 billion), systemic banking stresses (LIBOR is 0.53 EIBOR is 1.10%, Saudi SIBOR is 2.14 in a pegged currency) and a higher dollar take their toll. I can easily envisage another 30% price falls as this bear market continues in the next two years as the hawkish Fed will mean a higher US dollar, lower oil prices, wider credit risk spreads and lower asset prices.
It is a pity that so few UAE investors know how to create income and profits via a real estate investment trust (REIT). A global REIT portfolio allow me to invest in economics, property themes and bull market credit cycles across the world, diversify economic risk, hedge inflation risk and generate high cash dividend yields. As investors in Dubai property have learnt the hard way since 2014, “liquidity is like a cab on a rainy night. It disappears when you need it the most”. J.P. Morgan said these words more than a hundred years ago but liquidity is the single most crucial lodestar of my investment strategy – the ability to go into cash in a microsecond. This is only possible by owning a diversified spectrum of global REITs.
What do I want when investing in a REIT? One, a secular bull market property theme. For instance, after 2010, it was obvious that the new “millennial” generation was not interested in owning illiquid, high risk leveraged property, like the suburban McMansions whose prices dropped so traumatically from Utah to Umm Suqeim in 2008-9. The big money was betting on multi-family apartments as an attractive property segment and that meant the Avalon Bay Community REIT. In 2006, I desperately wanted to take advantage of the global trade cycle, China’s growth and Singapore’s phenomenal role as a container shipping, finance and import-export hub. So I went investment hunting in Changi-or more accurately, Suntec Tower and the Fullerton hotel. The result? Cambridge Industrial Trust, one of Singapore’s best performing REIT’s in the past decade I chronicled so many times in this column.
Global REIT’s have made 25 – 40% in the past two years even though ownership of “brick and mortar” apartment and villas in Dubai have meant losses of 15 – 25%. This is the best performer in the global asset classes I track most years. I have no interest in Emirates REIT listed in the UAE as the office tower vacancy rate is 40%. I have no interest in hotels in the UAE but find extraordinary 10 – 12% dividends in emerging/frontier markets like Pakistan, Singapore and Australia. Warehouses (big boxes) in Britain are a winner due to the exponential growth of E-commerce. From Manhattan office towers to Japanese condos, from Singapore industrial parks to German shopping malls, global REIT’s allow even small investors to benefit from the world’s top performing property market via a single dirt cheap trade via an Interactive Brokers account.
While Private Bankerji routinely fleeces NRI clients with $200 minimum trade or 10 cents a share (some Stone Age Bankerji’s demand 0.5% of the trade order to buy equities. Shame, shame, puppy shame, Bankerji Boyo!).
A REIT that is a money spinner? Pakistan. Terrorism is at ten year lows. The IMF has given Islamabad a $6.7 billion loan. Karachi is a city of 20 million in one of the world’s great consumption stories. The rupee is anchored by the most credible inflation, current account and monetary management metrics in South Asia – and yes, this influences Raghuram Rajan’s RBI in India. Bank loan growth, a mere 17% of GDP in Pakistan (news 30% of GDP in Sri Lanka and Bangladesh) has just begun to revive. The Karachi stock market trades at 8 times earnings while Mumbai is at 17.8 times and Manila 18 times earnings. Hawkes Bay, Elphinstone Street, Empress Market, Gizri, Sunset Boulevard. The city on the Arabian Sea, the city of my birth I last saw in 1996, is also the city of the world’s juiciest frontier market REIT.
Wall Street – Wall Street will crash again this autumn
The American equities bull market is now seven years old and vulnerable to a rise in Federal Reserve interest rates that even Janet Yellen confirmed is probable this summer when she spoke at Harvard College. I cannot forget the S&P 500 index was 2100 and the Volatility Index was 14 (almost near current levels) when the Yellen Fed hiked the rate for the first time since 2006. The result? A global financial firestorm. The S&P 500 index lost 10% of its value in the next eight weeks. Crude oil tanked below $30. The US high yield debt markets went into free fall. Wall Street money center banks lost 15 – 20% of their value, even though their net margins fatten when interest rates rise. The Chinese yuan sagged as Beijing battled epic capital flight and another crash in the Shanghai Shenzhen stock market.
Will another Fed rate hike spook the financial markets? Yes. The 25% surge in the US dollar and the big chill in world trade (China) have exported deflation across the world, as King Dollar hits the pegged stock/property markets of the GCC and Hong Kong. The political omens have also darkened. Both Trump and Clinton have embraced protectionist rhetoric. From Ukraine to Spain, Berlin to Belarus, Warsaw to Vienna, Europe faces the threat of anti-EU, xenophobia, nationalist political parties, some a throwback to the fascisti of the 1930’s. Brexit is a wild card that has divided both the UK and the Conservative Party, whatever the outcome. China faces the history’s biggest credit Frankenstein. Boko Haram has wrecked havoc in West Africa. Venezuela is Latin America’s latest failed state. Civil wars rage in Libya, Iraq, Syria, Yemen, Afghanistan and the Sinai. East Ukraine and the Crimea are under Russian military occupation. North Korea has tested international ballistic missiles. The Chinese Politburo routinely threatens both Taiwan and opponents of its maritime claim on the South China Sea. Does the US stock market reflect these risks? Absolutely not.
It is surely ominous that the Yellen Fed will be forced to tighten policy even though the macroeconomic data points to an unmistakable “profit recession” in both the US and Europe. Even the IMF concedes that the global business cycle is not immune to a fall in trade, cross-border capital flows and corporate profits. To paraphrase the Bard of Aron, a recession by any other name smells just as bad! There is no doubt that the world is on the precipice of the ugliest recession since the 2009 post Lehman credit market Armageddon. Does the Volatility Index at 13-14 remotely price in another 2008 scale macro shock? Absolutely not.
I believe 2016 will witness a market crash on the scale of August – October 2011, when the S&P 500 index lost 20% of its value. In fact, I would not be surprised to see American equities tank by 25 – 30% since the outlook for earnings growth, margins, capex worldwide and geopolitics is so much uglier now than it was in 2011 and China, Trump, Russia, Venezuela, Nigeria, Daesh, Syria and the Sinai have raised the geopolitical risk barometer to crisis point. The foreign policy chickens of an impotent Obama White House will come home to roost on Wall Street this autumn and the world will fell the shock waves of multiple Lehman scale financial neutron bombs as Japan’s Prime Minister Shinzo Abe so rightly predicted. So I go back in time to Black Monday (October 19, 1987) and Black Tuesday (October 29, 1929). Savage stock market falls preceded recessions in 2008, 2011, 1990 and 1982. This time will be no different.
The Bernanke Fed’s epic monetary experiment that bailed out the US and world banking system after 2008 also spawned speculative asset and credit bubbles that his successor’s “QE exit” rate hikes will trigger. In July 2007, the peak of the credit bubble, US equities traded at 16.4 times earnings, far below the current 20.5X. In July 2007, the thirty year US Treasury note yielded 5.1%. In June 2016, the thirty year US Treasury note yields 2.2%. This is overvaluation on a degree I cannot fathom or condone, no matter the LTV gobbledygook whispered to me by Private Bankerji! Lord Keynes said in the long run we are all dead. In the short run, we bleed with margin calls!

 

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Mr. Matein Khalid serves as Head of Capital Markets and Advisor to the Chairman at Bin Zayed Group LLC. Mr. Khalid serves as the Chief Investment Officer of Salama. He manages Bin Zayed's global equities portfolios in the US, Russia, Latin America, Europe and the Far East. He is responsible for the Bin Zayed's hedge funds / private equities portfolios and external fund manager selection. He also advises the Chairman and board on investment banking relationships, financing and new issues in the international debt markets and merger/acquisition deal flow. Mr. Khalid has 20 years experience in the international capital markets and has worked with investment banks, private banks and securities firms in New York, London, Chicago, Geneva, Abu Dhabi and Dubai. He is an adjunct professor of banking and finance at the American College of Dubai, where he is also a member of the Board of Directors. Mr. Khalid writes on global financial markets and Middle East studies for newspapers and magazines in the UAE, Bahrain, Oman, Qatar and the United States. He has also taught courses on capital markets at J.P. Morgan Chase, (New York), SP Jain and Emirates Institute of Banking (Dubai). He has also taught at capital market seminars at Morgan Stanley (London), Chase Manhattan Bank (Geneva) and Barclays Capital (Hong Kong). Mr. Khalid has briefed ASEAN finance ministers and ultra high net worth investors in Hong Kong at the invitation of the chairman of Barclays Capital. He holds an MBA in finance and BS in Economics from the Wharton Business School and a BA/MA in international relations from the University of Pennsylvania in the US.