Excerpted from Artemis Capital Management letter to investors,
Dorothy Thompson once said “peace is not the absence of conflict”. Never forget there is a form of peace and stability reinforced by a foundation of underlying volatility. Game theorists call this the paradox of the Prisoner’s Dilemma, and it describes a dangerously fragile equilibrium achieved only through brutal competition. The Prisoner’s Dilemma is the most important paradigm for understanding shadow risk in modern financial markets at the pinnacle of a multi-generational debt cycle unparalleled in the history of finance.
In their masterwork tapestry entitled “Allegory of the Prisoner’s Dilemma” the artists Diaz Hope and Roth visually depict a great tower of civilization that rests upon a bedrock of human cooperation and competition across history. The artists force us to confront the fact that after 10,000 years of human civilization we are now at a cross-roads. Today we have the highest living standards in human history that co-exist with an ability to destroy our planet ecologically and ourselves through nuclear war. We are in the greatest period of stability with the largest probabilistic tail risk ever.
The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe from the risk of devastating conflict on our own soil?
In 1961, at the height of the Cold War, a B-52 bomber carrying two Mark 39 thermonuclear bombs accidentally crashed in rural North Carolina. A low technology voltage switch was the only thing that prevented a 4-megaton nuclear bomb with 250 times the yield of the bomb dropped on Hiroshima from detonating on American soil. In addition to killing everyone within the vicinity of the blast, the winds would have carried radioactive fallout over Washington D.C., Baltimore, Philadelphia, and New York City. It is not inconceivable to imagine that, at the height of cold war, a weapon of that magnitude exploding randomly on the eastern seaboard would have triggered immediate accidental retaliation against the Soviets resulting in full scale Armageddon and the end of humankind as we know it. This is just one of many nuclear accidents during the cold war.
Peace has a dark side. Peace can exist due to hidden conflict in the Prisoner’s Dilemma.
Global Capitalism is trapped in its own Prisoner’s Dilemma; fourty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior. The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, are creating a dangerous ‘shadow convexity’ that will fuel the next hyper-crash.
Central banks in the US, Europe, Japan, and China now own substantial portions of their own bond or equity markets. We are nearing the end of a thirty year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razors edge of risk. Do not fool yourself – peace is not the absence of conflict – peace can exist on the very edge of volatility.
The middle class is unknowingly trapped in the Prisoner’s Dilemma and this is perhaps our greatest non-linear risk as a nation. America is built on the promise of upward mobility but that promise is increasingly becoming a lie. Wealth inequality is at the highest level in 100 years and close to levels last achieved before the 1928 crash that led to the Great Depression.
Today the top 0.1% of households now control an equivalent amount of the wealth as the bottom 90%. Since 1973, real family income for the top 1 percent has grown over 150% while incomes for the lowest 20% of earners has remained stagnant. The median household income adjusted for inflation in 2011 was just below its level from 1989 and $4,000 lower than in the year 2000.
The illusion of a middle class prosperity has been sustained via low interest rates, consumer debt, and globalization. Instead of helping the problem, accommodative monetary policy has accelerated this pace of income inequality in the US.
“Economic inequality has long been of interest within the Federal Reserve System” said Janet Yellen during a April 2015 speech. Yellen has repeatedly argued that accommodative monetary policy reduces income inequality by lowering unemployment. While it is true that unemployment has declined, her conclusion assumes that lower wealth inequality and lower unemployment are correlated in some kind of linear fashion. In reality, the wealth gap peaked the year before the Great Depression started when the country was close to full employment and the joblessness rate was only 2.08%. The point is that full employment with extreme income disparity can and often does co-exist. If we measure the average income in a hypothetical village of 100 people, 99 of which have minimum wage jobs, the last of which is Warren Buffett, who employs the rest, you have income disparity and full employment. To this extent, Yellen’s argument that lowering unemployment somehow decreases the wealth gap is illogical. During Yellen’s September 17th, 2015 press conference she alludes to a mysterious academic paper that somehow proves otherwise, but I looked everywhere and couldn’t find that paper. I do have a non-academic paper entitled “Common Sense” that takes a very different view.
Yellen’s treatment of the wealth gap problem is an example of mistakenly linearizing a non-linear problem. The Bernanke-Yellen Fed has achieved a linear decline in unemployment via exponential growth in the monetary base. When asset prices increase in a non-linear fashion the top 1% of wealthy families that own real estate, stocks, bonds, and have access to low rates will benefit disproportionately. When the middle class earns a dollar, they spend that dollar on goods and services that reach the real economy. When the top 1% earns a dollar that money is likely to be reinvested in assets.
As a result, we have seen non-linear inflation in asset prices but no significant inflation in real wages or core CPI. With no wage inflation, global central banks are inclined to continue their rotation of devaluation further exacerbating this mad cycle and encouraging an even greater income gap and vast political risk. The policies of the Fed have simply exchanged nonlinear expansion of the wealth gap in exchange for a linear decline in the unemployment rate.
What is clear is that Janet Yellen would make a terrible derivatives trader because she just does not seem to understand that you cannot hedge a nonlinear risk with the linear benefit. The current monetary experiment, left unchecked, will inevitably threaten the very fabric of our democracy.
The global economy is suffering from a cancer of debt-deflation, income inequality, and low growth. Instead of treating the root cause, policy makers have treated the symptom of asset price declines. Whenever the patient feels weak an increasing amount of policy drugs are required to maintain the illusion of stability to the point where the patient is addicted to the painkillers.
In all instances, policy intervention has generated a short-term market fix at the expense of addressing the longer-term fundamental problems.
The Federal Reserve has expanded its balance sheet $4.5 trillion to create middle class jobs but instead has incentivized asset bubbles and the highest wealth concentration since before the Great Depression. The European Central Bank and Bank of Japan are pursuing quantitative easing to drive up asset prices rather than addressing the core issues of structural reform and weak demographics that are causing their deflation. European institutions rely on last minute ‘bail-outs’ and quantitative easing to avoid debt default while ignoring the necessary fiscal and philosophical integration required to make a unified Europe a success. China is struggling to shift from an export driven economy to a consumption driven economy despite decelerating growth, total debt growing four times faster than GDP, and the valuation of the Shanghai Composite at levels comparable to 2007.
How does spending an estimated 10% of GDP, including $263 billion in direct stock market intervention, coupled with cheap real estate loans to build ghost cities, fundamentally address any of China’s real problems?
The root cause of the cancer is never confronted and as a result, the fundamental health of the patient does not improve. Neither the doctors nor the patient wish to face the reality that difficult and painful therapy is needed to destroy the cancerous leverage in the system. The inevitable result of this denial will be the death of the patient.
