Algebris Investments’ The Silver Bullet

The Silver Bullet Interplanetary Bubbles

ALGEBRIS INVESTMENTS

A Martian economist lands on Earth. The most famous economists from Earth gather to greet
their new visitor. They speak about Earth’s flourishing economy and global growth rates: the
US is above 2%. Europe is catching up towards that, and Emerging Markets are in good shape
with China still resilient despite approaching 6%. Earth seems to have recovered well from the
global financial crisis.

The Martian, however, appears skeptical. "Last time I visited in 1946, Earth was just
recovering from a great civil war, where over 36m people died. Now you are telling me you
have solved all your problems and created this system called fiat money. But how come debt
levels have grown even bigger than in war time, and so has inequality? And why do you think
Alberto Gallo, CFA
Portfolio Manager, the solution is to buy even more assets?"
Algebris Macro Credit Fund
Head of Macro Strategies Our alien friend continues. "You see – back in Mars we have very limited resources. Water
agallo@algebris.com
and food are really hard to produce, so we have to make the most of it. Investing in productivity
and maintaining equality of resources and opportunities are a priority to survive. On Earth, he
Tom Cotroneo, CFA
continues, humans may be chasing a dream of limitless growth, which they try to achieve not
Chief Risk Officer
by improving productivity but with shortcuts – like boosting debt and asset prices – and
tom@algebris.com
assuming limitless resources."
Tao Pan, CFA
"And so, Earth's growth engine appears very unbalanced. You just had a financial crisis in
Macro Analyst
tpan@algebris.com 2007, and debt levels are higher now than before. By allowing even more borrowing and
boosting financial asset prices, inequality has grown even higher. There is more employment,
Aditya Aney, CFA but wages are not picking up. Is this a sustainable situation?"
Macro Analyst
aaney@algebris.com "We are still suffering from hysteresis", say the earthling economists. "Structural scars from
the recession. These include a mismatch between skills acquired by our workforce during the
Pablo Morenes past decades, for example in real estate and finance, against today's new sectors, like
Macro Analyst technology. It's a cyclical problem, with low interest rates and some time we will solve it. But
pmorenes@algebris.com we still haven’t figured out why inflation is still low. In fact, it is a mystery…"

The Martian shakes his head. "This doesn't seem the best course of action, in my view. On
Algebris (UK) Limited
1 St. James's Market the first hand, you have structural underinvestment in productivity, like education and
London SW1Y 4AH infrastructure. On the second hand, you still have low interest rates generating collateral
effects like asset bubbles, or misallocating resources to firms that survive only because of
Tel: +44 (0)20 3196 2450
www.algebris.com zero borrowing costs. On the third hand, politics are becoming more polarised, reflecting rising
inequality and trending dangerously towards populism. On the fourth hand, you also risk
hurting your planet; climate change means weather events are becoming more extreme and
natural disasters more frequent".

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 Algebris Investments’ The Silver Bullet

Earthling economists are baffled, used to thinking in two-hand juxtapositions. The Martian's
four-dimensional trade-off spans from productivity, monetary policy, politics and
Weather events are more extreme
% of US regions with summer environmental issues. What should they do?
temperature much below or above
normal The perfect policy combination would be a combination of fiscal stimulus, potentially also
60%
Much Above Normal aimed at reducing inequality and improving productivity, together with normalisation in
40% Much Below Normal monetary policy. The difficulty, however, is that these efforts need to be harmonised across
various countries. Is it possible to normalise monetary policy without coordination? The short
20%
answer is no. One example is price action following central bank’s hawkish message at Sintra.
0% Long-term interest rates have moved lower, while the Dollar weakened with falling consensus
on fiscal stimulus. In turn, currency appreciation can redistribute inflation from hawkish
-20%
countries to others, defying the central banks’ intent. As we wrote in our latest Silver Bullet in
-40% August, the result can be a currency war.
-60%
1910 1934 1958 1982 2006

Source: Algebris (UK) Limited, US National Global QE Has Dampened Volatility

Centers for Environmental Information
Central bank balance sheet size, $ tn vs VIX Index
Fed ECB
20 BoE BoJ 70
PBoC SNS
18
VIX Index (RHS) 60
16
14 50

12
40
10
30
8
6 20
4
10
2
0 0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Algebris (UK) Limited, Bloomberg

This makes our Martian friend pessimistic. With rising political risk globally, achieving
coordination on fiscal and monetary policy appears very difficult. There is some hope on
monetary policy coordination. The ECB started with hawkish words in June, followed by the
Bank of England and most recently, the Federal Reserve. It will be more difficult, however, for
fiscal policy to come to the rescue in an orderly manner, as monetary stimulus is withdrawn.
In the US, the Trump administration is tentatively passing corporate tax cuts over the coming
months. The UK is still evaluating its Brexit strategy, let alone focusing on a long-term
industrial plan for the country. The situation is slightly better in Europe, Canada and China.

As an investor, a potential failure in normalising monetary policy would be bad news. First, it
would reduce returns in "risk-free" assets. Second, it would encourage asset bubbles to grow
even further, diminishing expected returns. Third, it would leave the economy and our society
in worse shape and with less policy dry powder to use in case of a future slowdown.

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 Algebris Investments’ The Silver Bullet

Bubblenomics

Investors need to be prepared for three scenarios:

1. Perfect coordination: a normalisation in monetary policy accompanied by fiscal stimulus,

with coordination across regions
2. Tentative coordination: a tentative normalisation in some regions, with imperfect
coordination across regions and currency appreciation resulting from that
3. Currency war and return to QE infinity: a failed normalisation, with imperfect coordination
and lack of fiscal policy stimulus

The last scenario means policy rates could remain low for longer. It also means bubbles would
grow larger in financial markets, as interest rates stay low for too long. We discussed the link
between QE and asset bubbles in The Silver Bullet | The Low Volatility Trap.

From QE to Markets: How Loose Monetary Policy Reduces Risk Premia and Volatility

Source: Algebris (UK) Limited

There's a few typical characteristics behind a bubble, which is typically a trade where an asset
vastly exceeds its intrinsic value, associated with a number of irrational behaviors. These include:
How bubbles look like
Price index vs no. of months from the
1. This time is different: asset bubbles can be linked to a new type of good or technology.
start of the bubble
Tulip mania (1934-1937)
Investors conclude that “this time is different”, and therefore normal rules don’t apply.
South Sea Stock (1719-1720) 2. Fear of missing out: the bubble attracts more types of investors, from fast money, to asset
Nikkei (1984-1991)
Nasdaq (1995-2002) managers to retail and increasingly less experts in the field.
BitCoin (2015-Now) 3. Sky is the limit: upside for gains is considered limitless.
4,000
4. Flipping: the hope of a quick profit and the loss of a long-term investment view shows up in high
3,000
transaction volumes, like for flipping condos – buying and selling houses you have not even seen.
5. No credit, no problem: bubbles tend to appear more frequently when credit is cheap and freely
2,000 available, and the opportunity cost of taking risk is low.
6. Buy the dip: policymakers suppress volatility by providing guidance that they will be there for
1,000 investors, should a crisis happen. This can prompt additional risk-taking or buy-the-dip behaviour,
e.g. with the famous Greenspan put.
0 7. Borrow while you can: as asset valuations increase, companies are tempted to stretch their
T+0 T+20 T+40 T+60 T+80 capital structures for even larger mergers or to pay dividends to shareholders, ignoring their long-
Source: Algebris (UK) Limited, Bloomberg, term cost of capital.
Yale South Seas Bubble 1729 Project, Altas 8. Bidding wars: buyers fight to buy an asset, as happened with London properties.
9. The trend is your friend: investors assume that tomorrow will be like today, and do not see any
catalysts that could derail the current trend.
10. Financial engineering: derivative products are created to extract more returns from the
existing asset, often taking a multiple of the risk.
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There have been examples of asset bubbles in history, including the Dutch’s craze for tulips in the
17th century, the Baburu Keiki years in Japan and the chase after technology during the dot-com
boom.

Bubbles in History Asset Duration % Peak appreciation

Tulip mania (Holland) Tulip 1636 – 1637 3800%

South Sea Company (UK) Stocks Jan - Aug 1720 820%
Mississippi Company (France) Stocks 1719-1720 2000%
Railway Mania (UK) Stocks 1830-1850 275%
Roaring Twenties stock-market bubble (US) Stocks 1925-1929 322%
Poseidon bubble (Australia) Stocks 1969-1970 450%
Silver Thursday (US) Silver 1979-1980 713%
Nikkei +196%, house price
Japanese asset price bubble Stocks, real estate 1986-1991
+156%
The dot-com bubble (US) Stocks 1995-2000 Nasdaq +890%
China stock bubble Stocks 2006-2008 520%
Uranium bubble of 2007 Uranium 2005-2010 600%
Central bank bubble? Everything? 2009 - present
Source: Algebris (UK) Limited, Wikipedia

Where are the bubbles today? The potential suspects are:

Equities: Equity prices have risen in tandem with the size of central bank balance sheets
since the crisis. Taking SPX as an example, valuations appear rich: purely historical, forward
or cycle-adjusted valuation multiples are all well above historical averages.

However, we cannot say the broader equity markets are today in a bubble, given economic
data both in the US and Europe remains stable or strong, unemployment is low or heading
lower and central bank policy remains accommodative – which has made other assets
relatively expensive as well – relative to historical levels.

We are more concerned however, that relative changes in monetary or fiscal

policy may lead to an overall correction. Equity markets may see a repricing in our view, if
there is a meaningful broad shock to growth and confidence, such as protectionist headwinds
in the form of aggressive trade barriers or geopolitical/political paradigm shifts such as a
Korean War or a U.S. President Impeachment. A broader risk would be the repricing of long-
Long bonds: a crowded trade
term interest rates, which so far have remained stable, thanks to central banks’ stable
Average yield vs duration
8 guidance on inflation and terminal rates, as from the latest Federal Reserve press conference.
2000 mid-2016
6
FAANGs: Facebook, Apple, Amazon, Netflix and Google appear a possible candidate.
4 Current consensus and sentiment seems to price almost unlimited earnings potential, but we
think there are three possible scenarios that could cap this potential in the medium term,
2
highlighting today’s valuations might be irrational.
0
Avg 30yr gov Global bond
bond yields of portfolio 1. Regulatory & political risk could erode their monopolistic position, whether through forced
Japan, UK and duration, yrs business model or fiscal changes
US, %
2. Competition from other FAANGs, Asian FAANGs or unforeseen competitors
Source: Algebris (UK) Limited, IMF 3. Central Bank normalisation triggering more attractive risk/reward opportunities in other
GFSR October 2016 assets

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 Algebris Investments’ The Silver Bullet

Rates: at the start of normalisation
No. of years of interest payments to
cover capital losses due to 1%
increase in yield
Rates: G-10 bond markets have had a multi-decade bull run. The reasons are many:
populations are ageing, inflation is structurally lower due to new technologies, central banks
were already lowering rates before the crisis to keep debt sustainable, and the room to use
more credit to boost growth and asset prices has become limited.

100 ~600 years There are signs of a bubble: investors have piled into long duration carry trades on
expectations of QE infinity, valuations appear stretched with interest payments barely
30-year JGB
protecting bondholders from yield moves or inflation (long-end Gilts in particular), and
30-year Bund
governments are issuing more long-dated debt – recent examples include Austria’s 100-year
50 30-year UST
bond and Italy’s 50-year bond, issued at 2.1% and 2.8% yield. A normalisation in monetary
policy should lead to a repricing in interest rates, as the long duration trade unwinds and term
premia normalise. However, a lack of real deleveraging and structurally lower inflation may
0 mean a slower hiking cycle and lower terminal rates in developed markets. In other words,
10 11 12 13 14 15 16 17 rates should be wider, but may not return to historical-wides.
Source: Algebris (UK) Limited, Bloomberg

Bubble
Potential %
Type Size Duration Valuations Irrational Behaviour risk
bubbles Appreciation
Indicator
Australian Property Real Loan to income ratios were 1.8x - Uninterrupted GDP
A$4.9tn 29 years 510% High
Market economy their long term average growth for 26 years
- lower for longer rates
London Property Real Loan to income ratios were 2.3x
£6tn 25 years 333% - “property ladder” High
Market economy their long term average
mentality
Average home prices were 18.1x - Mainland money inflow
Hong Kong Real
HK$20tn 12 years 67% gross annual median household - Belief in “inelastic High
Property Market economy
income in 2016 demand” for housing
Market-implied volatility at
historical lows: VIX average in
Short VIX ETFs Financial $3bn 7 years 705% - Buy the dip mentality High
2017 at 11.4 vs long-term average
of 19.4.
- Speculation
Price highly sensitive to regulatory
BitCoin Financial $56bn 2 years 1526% - Pursuit of new High
changes.
technology
- Buy the dip mentality
FAANGS Financial $2.5tn 12 years 1363% Pricing unlimited earnings potential High
- Fear of missing out
Current yield at half of long-term
average Medium/
EM HY Financial $935bn 9 years 240% - Hunt for yield
0.04% percentile rank in long-term High
range
P/E ratio 30% above long-term - Buy the dip mentality
SPX Financial $22tn 8 years 213% Medium
average - Fear of missing out
10y Bund yield 370bp tighter vs
10y Bund yield long-term average
Bunds Financial €2tn 27 years - Belief in QE Infinity Medium
860bp tighter 6.4% percentile rank in long-term
range
10y UST yield 400bp tighter vs
10y UST yield long-term average - Belief in QE Infinity
USTs Financial $20tn 30 years Medium
700bp tighter 6.1% percentile rank in long-term - Trump stimulus fading
range
Current spread 6bp tighter vs long-
Spread 252bp term average
US IG Financial $6.4tn 9 years - Belief in QE Infinity Medium
tighter 49% percentile rank in long-term
range
- Belief in QE Infinity
Current spread 118bp tighter vs
- Hunt for yield
Spread 970bp long-term average
US HY Financial $1.3tn 9 years - Corporate releveraging: Medium
tighter 27% percentile rank in long-term
share buybacks, cov-lite
range
loans
Current spread 28bp tighter vs
Spread 383bp long-term average
European IG Financial €2.1tn 9 years - Belief in QE Infinity Low
tighter 39% percentile rank in long-term
range
Current spread 273bp tighter vs
Spread 1116bp long-term average - Belief in QE Infinity
European HY Financial €330bn 9 years Low
tighter 4% percentile rank in long-term - Hunt for yield
range
Source: Algebris (UK) Limited, Bloomberg, Global Property Guide

Credit: QE also provides a strong anchor to credit, as central banks purchase investment
grade debt and pushed investors to go down into high yield bonds. In our view, the risk of a
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 Algebris Investments’ The Silver Bullet

bubble is higher in US than in European credit, even though spreads appear tighter in Europe
Short-vol strategies have boomed
vs long-term averages. This is because European corporates have not re-levered as much as
Contracts held (gross) in inverse VIX
ETPs their US peers or engaged in shareholder-friendly activities. In addition, default rates are likely
0 to remain lower for European high yield, given better average ratings, less issuance of
-20 covenant-lite debt and lower exposure to the energy sector. In the US market, instead, we
-40 have seen more evidence of shareholder-friendly behavior from borrowers.
000s of Contracts

-60
-80
Short volatility strategies: Prolonged QE and the resulting search-for-yield activity have
-100
compressed market-priced volatility and led to a surge in short volatility strategies, as we
discussed in The Silver Bullet | The Low Volatility Trap. Open contracts held in inverse VIX
-120
ETFs have grown by over 700% since 2012, but more importantly investors have also been
-140 XIV
selling volatility in FX, rates and credit, driving risk premia lower across assets. So far such
-160 SVXY
Total
strategies have produced attractive risk-adjusted returns, as global central banks take turns
-180
12 13 14 15 16 17 to add to the QE punch bowl. Meanwhile, political and geopolitical risks are rising, creating a
divergence between real world uncertainty and market-priced volatility. This appears to be a
Source: Algebris (UK) Limited, Bloomberg
potential bubble, as the risk of a sharp repricing in volatility following central banks’ QE exits
remains high: investors who have grown so used to the central bank put may need to adjust
from their buy-the-dip, low volatility environment.

Cryptocurrencies: Advocates of cryptocurrencies may argue that they represent a form of

disruptive technology, similar to how fiat money replaced the gold standard. However, the
Short-vol strategies have boomed
Inverse VIX ETPs*, AUM $bn fundamental difference between cryptocurrencies and fiat money is that they may not yet
qualify as “money”. As per the IMF, money can be anything that can serve as 1) a store of
3.0
value, 2) a unit of account to provide a common base for prices or 3) a medium of exchange.
2.5 Taking BitCoin, the most well-known cyptocurrency, as an example, currently its acceptance
2.0
at merchants is low and getting lower, putting its potential as a medium of exchange or a unit
of account in doubt. Its high price volatility and susceptibility to regulatory risks also make it a
1.5 poor store of value: a warning by the Chinese central bank in 2013 against treating BitCoin as
1.0
legal tender triggered a 60% decline in its value. Since the crash, BitCoin has resumed its
upward trend and appreciated by more than 15 times since 2015, largely due to investor
0.5 speculation rather than more visibility on its intrinsic value or wider acceptance at merchants.
0.0
The fast price appreciation and lack of rational analysis by investors chasing the trend mean
2014 2015 2016 2017 that BitCoin and other cryptocurrencies are likely a growing bubble.
Source: Algebris (UK) Limited, Bloomberg,
*ETPs used are XIV and SVXY
The Bubble Galaxy
Bubble size = potential loss from a crash*

2500% Cryptocurrencies
combined FAANGS Financial
$76bn $790bn Real assets
2000%
BitCoin
1500% $33bn London property Australian
% Appreciation

market property market

Short VIX ETFs £1.2tn A$0.9tn
1000% $2.2bn
EM HY
$140bn
500%

0%
Short-dated Bunds
Long-end Gilts Duration of appreciation, years
€14bn
-500% £260bn
0 5 10 15 20 25 30 35 40

Source: Algebris (UK) Limited, Bloomberg, BAML Indices, OECD, Savills, UK Gov. *Assumptions for potential loss from a crash:
-60% decline for BitCoin/cryptocurrencies, as happened in 2013; -20% decline for London and Australian property market, as
happened during the US housing market crash; for FAANGS, assuming their PE ratios converge to the market average; for short-
dated Bunds, assuming a return to positive yield from around -60bp now; for long-end Gilts, assuming a catch-up with inflation
and a 200bp widening in yield; for EM HY, assuming a 15% decline; for short VIX ETFs, assuming a -70% decline.
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Real Estate: Déjà Vu-bble?
Real house price index
(Quarterly to March 2017)
Source: Algebris (UK) Limited, Dallas Federal
Reserve
Algebris Investments’ The Silver Bullet
Real estate: Cheap credit, relatively scarce supply and strong domestic and foreign investor
interest have driven rapid price increases in several real estate markets, most obviously
Australia and Canada. With real disposable incomes having been fast outpaced by prices,
and a rapid build-up of leverage we are ready to call a bubble, though we are not the first nor
we suspect the last. Other niches of overvaluation include large international cities like London
or Hong Kong, where limited supply, low interest rates and loose regulation have favoured
cash inflows which use property assets as a cash-park.
The Martian economist beams back a memo to the Interplanetary Economic Council: “Earth
has improved, but the humans are still prone to the same fallacies. Short-sighted use of
resources, search for utopian never-ending wealth, irrational behaviour and euphoria and lack
of long-term balance. There is no need to invade yet. Without a change in policy and
incentives, they will probably self-destruct over the coming century.”
Conclusions: Navigating the Bubble Galaxy
A multi-decade credit expansion in developed markets, followed by prolonged central bank
easing to fight the crisis has created asset bubbles in financial and real assets. Today,
investors need to navigate this environment and position for a potential normalisation in
monetary policy.
The Bank for International Settlements has long called for monetary policy normalisation, on
the basis that inflation may be structurally lower – as we argued in previous Silver Bullets.
Central banks seem to be finally following this advice, as recently shown by the Bank of
Canada, Bank of England, the European Central Bank and the Federal Reserve.
That said, normalising policy will not be easy and may take longer than expected. This means
that asset overvaluation may persist, and that countries in a better position to normalise will
see their currencies appreciate.
The bubble galaxy may end up deflating slowly, rather than in a big bust. We remain cautious
and position for the few remaining areas of value. In fixed income markets these are areas to
which markets still apply unreasonable tail risk, in our view, like the Eurozone periphery
including Greece as well as bank debt. We continue to think that Sweden and Norway, as well
as the Eurozone, will have an easier time normalising policy than the UK, despite the recent
hawkish rhetoric by the Bank of England, as we discussed recently in the Financial Times.
“If everything is a bubble, then the definition of bubble needs to change”
J.G., Macro Portfolio Manager
The Silver Bullet is Algebris Investments' macro letter.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager
for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan, Aditya Aney
and Pablo Morenes.
For more information about Algebris and its products, or to be added to our
Silver Bullet distribution list, please contact Investor Relations at algebrisIR@algebris.com or
Sarah Finley at +44 (0) 203 196 2520. Visit Algebris Insights for past Silver Bullets.
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 Algebris Investments’ The Silver Bullet

Previous articles:

The Silver Bullet | Currency Wars: The Inflation Menace, 20 July 2017

The Silver Bullet | Rebalancing and Revolutions, 20 July 2017

The Silver Bullet | The Low Volatility Trap, 15 June 2017

The Silver Bullet | Is the Reflation Trade Over?, May 22, 2017

The Silver Bullet | Europe’s Opportunity, May 4, 2017

The Algebris View | Investing in the Time of Populism, Fiscal Excesses and the End of QE
Infinity, April 20, 2017

The Silver Bullet | Introducing the Brexit Walrus, March 31, 2017

The Silver Bullet | Europe’s Long Way out of QE Infinity, March 23, 2017

The Silver Bullet | Don’t Fret about Frexit, March 8, 2017

The Silver Bullet | Greece: More Melodrachma, No Default, February 20, 2017

The Silver Bullet | Don’t Give up on Europe, February 6, 2017

The Silver Bullet | 2017: When Inflation Dreams Become Nightmares, January 19, 2017

The Silver Bullet | 2017: The Movie, December 14, 2016

The Silver Bullet | Investing in the Time of Populism, November 15, 2016

The Silver Bullet | Trick or Tantrum?, October 31, 2016

The Silver Bullet | The High Price of a Hard Brexit, October 12, 2016

The Silver Bullet | Investing when the monetary tide is turning, September 20, 2016

The Silver Bullet | Central bankers: the tide is turning, September 7, 2016

The Silver Bullet | Perpetual Motion, August 12, 2016

The Silver Bullet | We are still dancing, July 14, 2016

The Silver Bullet | The Divided Kingdom, June 28, 2016

The Silver Bullet | Brexit: it’s not EU, it’s me, June 13, 2016

The Silver Bullet | Trumponomics, June 1, 2016

The Silver Bullet | Brazil: The Caipirinha Crisis is Just Starting, May 17, 2016

The Silver Bullet | China: Feeling the Stones of Japanification, May 4, 2016

The Silver Bullet | Alice and the Mad Interest Rate Party, April 19, 2016

The Silver Bullet | Helicopter Money (that’s what I want), April 12, 2016

Additional reading:

The International dimension of the ECB’s asset purchase programme, Speech by Benoît
Cœuré, Member of the Executive Board of the ECB, at the Foreign Exchange Contact
Group meeting, 11 July 2017
Scars or scratches? Hysteresis in the euro area, Speech by Benoît Cœuré, Member of the
Executive Board of the ECB at the International Center for Monetary and Banking Studies,
Geneva, 19 May 2017
Exchange rate pass-through into euro area inflation, ECB Economic Bulletin Issue 7, 2
November 2016
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 Algebris Investments’ The Silver Bullet

Jarociński, M., Lenza, M., An inflation-predicting measure of the output gap in the euro area,
ECB Working Paper Series No 1966, September 2016
Williamson, S., Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-
Inflation Problem?, Federal Reserve Bank of St. Louis, July 2016
Contessi, S., Kerdnunvong, U., Asset bubbles: detecting and measuring them are not easy
tasks, Federal Reserve Bank of St. Louis, July 2015
Borio C., Persistent unusually low interest rates. Why? What Consequences?, BIS, 28 June
2015

Sources:

The source for all images is Wikimedia Commons unless indicated otherwise.

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