Financial Tumors
Pfäffikon SZ, Switzerland – A while ago I got into a discussion on the problems surrounding the Dutch housing corporation Vestia. Vestia would be the tip of the (derivatives) iceberg. The parliamentary inquiry – one of the heaviest parliamentary power plays in The Netherlands – was the result. To begin with, I hold the opinion that only a handful of specialists truly understand derivatives. In particular the consequences which derivatives cause when a position turns itself against you are often not well understood. The leadership at Vestia believed they knew where interest rates would bottom out. Too bad they sunk to levels so low we hadn’t seen them before. In extreme markets one must be very solvent, so goes a wise saying perpetuated on the trading floor. Advice which Vestia wittingly disregarded. No one can predict the market and that includes the leadership at Vestia.
Obstinate
Vestia is indeed the tip of the iceberg. The derivatives market today has become a game. On a daily basis through social platforms I see the most “amazing” suggestions pass by in attempts to persuade one to get involved with derivatives. For banks, brokers and asset managers derivatives amount to an attractive source of commissions. I believe you’re better off staying away, unless you know what you’re doing.
Derivatives, however, have an additional function. For example, assigning simple accountants the task of masking gigantic losses through complex constructions. These construction will see the light of day sooner or later. I find it remarkable that banks have once again started to promote securitizations and derivative constructions. And to think these are the constructions that caused the all too familiar snowball mid 2008. Perhaps a point of attention for the regulators. The banker is obstinate, that much is clear.
Derivatives 10 Times GDP
To give you an idea, the current derivatives market world wide spans some USD 700 trillion. With it, the exposure in derivatives has been pumped up to levels exceeding those from before the Lehman Brothers debacle. Scarier perhaps is the fact that the world wide exposure to derivatives is roughly 10 times the worldwide GDP.
Two Faces
The S&P 500 has more than doubled since 2009. Moreover, various European stock exchanges have done well. The market still does not seem extremely expensive, but it must be noted that the underlying economies are far from having reached their pre-Lehman levels. It is this fact in particular that worries me. There is a risk premium from the Fed interwoven with the stock market. Moreover, the Fed has to deal with a conflict of interest. On one hand interest rates will most likely have to rise at some point, however, on the other hand, doing so will have a negative impact on the Fed’s gigantic balance sheet. The longer the Fed prolongs the current loose monetary policy, the more financial tumors will arise. There will be attempts to mask these with complex derivative constructions.
In addition, the current geopolitical problems give the market two faces. When the problems decrease, the S&P 500 will probably rise above the 2000 mark. But extra friction can easily drop the market. No one at this point can tell you how it will end.
Restrained
Last week I mentioned I was practicing restraint at the moment. I am not hoping for a crash in the markets, but considering the aforementioned developments, it’s not something we can exclude completely. When the Fed leaves the market too aggressively, things could happen quickly. Moreover, France worries me. More specifically the French banks that are getting an additional hit due to the European sanctions against Russia. Perhaps it’s a good idea for you to take another look at your derivative positions this weekend.
It remains for me to wish you a good weekend.
Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the above shares and has no intention of doing so in the next 72 hours.
