Is it Safe . . . . ?

Anyone who has seen the 1976 film Marathon Man will no doubt recall the cringe-inducing scene where a sadistic Nazi dentist (played by Laurence Olivier) tortures the protagonist (Dustin Hoffman) by drilling into his teeth without anaesthetic. Throughout the ordeal, Olivier repeatedly asks, “Is it safe?” Not knowing what “it” refers to, Hoffman is unable to come up with an answer to avert the torture.
 
I couldn’t help thinking of this scene in the movie and the constant question, “Is it safe?”, without relating it to the current investment climate. It is over 5 years since the eye of the last financial crisis, with stock markets almost back to their 2007 highs, while gold struggled. It must be safe, right?

 
Humans seem to have a propensity to forget cataclysmic events quite quickly. The longer the passage of time from a major event, the lower the probability people tend to think of it happening again. Think of people stocking up on food after a hurricane, then as time passes on people’s propensity to stock food diminishes. Or the fall in air travel immediately after a plane disaster. This is known as recency bias, where events that have happened most recently are deemed to be most likely; and, the corollary, events that happened a long time ago are judged much less likely.
 
This makes no sense, whether it be earthquakes or a financial crisis. The likelihood of an earthquake happening in a known unstable zone is far less one month after a major earthquake than it is ten years later. If the root cause is the level of instability, then any passage of time only increases the probability of the coming crisis, rather than diminishing it.
 
In the case of the global financial markets – which should reflect the concerns of worldwide investors – it would seem that we are following the same time-conditioned path. As we are now five years on from the last crisis, there is a growing belief there is a diminishing chance of a new one happening anytime soon. This is dangerous thinking.
 
In the case of the individual’s ‘financial crisis index’, it appears fairly straightforward to predict using the following standard variables:
 
• total income expected currently, and in the future;
• total debt currently, and in the future;
• (emergency) savings as insurance firepower.
 
Depending on the change in the variables coupled with the ability and rate at which to service the debt, this will give us a very good idea of our own financial crisis possibility. Let’s call it the “F-point”.
 
Is it really any different in the real world? Let’s have a quick look at the world’s biggest economies.
 
Nominal growth (which includes inflation) took a hit after the financial crisis. Apart from the US, which will see modest growth in GDP based on recent trends, and China, which continues to grow, nominal growth – that is a country’s income – looks set to be poor. Real growth will struggle to be positive.
 

 
Meanwhile the total public and private sector debt of most of the world’s major economies is colossal, and in many cases continues to rise at an astonishing rate.
 

Source: McKinsey

 
While private debt growth has stalled in many economies, the slack has been taken up by the public sector. To support this process of public re-leveraging, central banks continue to accumulate government debt at an amazing pace.
 
Although year-on-year growth in G4 central bank balance sheet expansion has gone down lately, it is still about 8%, and has not been negative for over 3 years. On current projections, the weighted average central bank balance sheet will be nearing 25% of GDP in 5 years or so. This has to be paid back somehow? But how, and with what?
 

 
 
 
 
 
 
 
 
 
 
 
 

So, the $64 trillion question is: is the financial stability of the world economy increasing or decreasing?
 
The basic observation from where I’m sitting is that we are getting more and more into debt with less and less growth to service it and pay it off. There is a clear F-point becoming more likely with the passage of time. In 2007, the world had emergency firepower of 5% central bank rates that could be cut, and trillions of dollars of bonds yet to be purchased to back stop the system. What do we have today? Far, far less options.
 

 
Currently many investors are questioning their exposure to gold, whether they bought it 10 years ago, 5 years ago or 6 months ago. At the same time they are congratulating themselves on their equity returns, or their property gains after the resurgence in many housing markets. (In the UK, the ability to get multi-million pound mortgages has only recently returned to pre-Lehman availability.)
 
Over the years gold has demonstrated a zero and often inverse correlation to equities especially during crises. So it is often the case that in the short-term if you are making stellar returns in equities, your gold investments might suffer.
 
Nevertheless, it would appear that the world’s central banks do not hold the same concerns as regular investors on their exposure to gold, as their net buying clearly implies:
 

 
What do they know about the future of the currency system and the next financial crisis?
 
Is it safe?
 

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