Jurassic Banks

Life finds a way. So does the inevitable economic cycle...

CHAOS THEORY studies the behaviour of dynamic systems that are highly sensitive to initial conditions, writes Tim Price on his blog, ThePriceofEverything.

In a chaotic system, tiny changes in initial conditions lead to wildly divergent outcomes further down the line. Under chaos, short term prediction may yield certain benefits, but long term prediction is impossible.

Chaos theory has relevance to a variety of discipline, among them weather and climate. When snow settles on a snow mass, at a certain point, under certain conditions, that mass will shift from a stable equilibrium – safety – to an unstable equilibrium – the risk of an avalanche.

But the precise snowflake that triggers the avalanche cannot be predicted. The same holds for dropping grains of sand onto a table. For some time, the sand pile will remain stable. At a certain point, it will shift to being unstable. One single grain of sand then has the capacity to shift the sand pile over. But we cannot predict in advance which grain that will be.

The film 'Jurassic Park', adapted from Michael Crighton's novel, brought chaos theory into the popular realm. A wealthy scientist, John Hammond (Richard Attenborough), using DNA derived from fossilised mosquitoes, decides to recreate dinosaurs on a remote island.

Once brought back to life, won't they breed? No, says Hammond. Because all the dinosaurs on the island are engineered to be female, by way of chromosome control. Dr Ian Malcolm, played by Jeff Goldblum, has been brought along to assess the project. His assessment is sceptical to the point of hostility:

"The kind of control you're attempting is not possible. If there's one thing the history of evolution has taught us, it's that life will not be contained. Life breaks free. It expands to new territories. It crashes through barriers. Painfully, maybe even...dangerously.

"I'm simply saying that life...finds a way."

Life – nature – does indeed find a way. Malcolm survives into the inevitable sequel, and gets to be (justifiably) sceptical and hostile all over again. One of his companions is overwhelmed at the spectacle of the CGI dinosaurs. His response:

"Oh yeah. [Facetiously] Oooh! Aaah! That's how it always starts. Then later there's running and, um, screaming..."

'Jurassic Park' is, of course, fiction.

That central banks exist today, on the other hand, is fact. And it is fact that for several years they have been attempting to impose artificial constraints on market prices. For an object lesson in the efficacy of State interference in the market process, we give you the Shanghai and Shenzhen stock exchanges.

Western market observers have no claim to moral or cultural superiority here. Western central banks have, for years, been pulling the same stunt in relation to interest rates and the price of money itself. In the ailing Eurozone, the Richard Attenborough role has been played by Mario Draghi, who made the following timeless pronouncement in July 2012:

"Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough."

We think the not-so-secret objective of QE all along was to trigger inflation (or avoid deflation).

How's that project coming along?

Eurozone annual inflation has been below 0.5% since July 2014. Almost 11% of the Eurozone workforce is jobless. There's a plausible argument that QE, ZIRP and NIRP are not inflationary, but deflationary: by allowing otherwise insolvent businesses to operate, they are creating a surplus of goods and services that, in an otherwise weak economic environment with inadequate demand, is causing prices to fall. Perhaps they should stop with these policies. But that is not the way of the bureaucrat. The beatings must continue until morale improves.

Since the global financial crisis, the financial markets have been a battleground between the forces of deflation and inflation. Deflation represents the free market. A free market wants to reset the game, and clear all the redundant pieces from the table. Inflation represents the State, and its economic agents, the central banks, whose notional independence from the State may be unlikely to survive this ongoing crisis. The State 'merely' wants to perpetuate itself, and is somewhat indifferent to the costs incurred to its citizenry in the process.

Financial analyst and market historian Russell Napier uses the analogy of the falcon and the falconer. The falcon is the markets; the falconer is the State.

"The attempt to train the wild forces of supply and demand by the authorities has really ramped up since 2009. Just four trading days into 2016 [it is obvious] that they have failed to create a pet to do their bidding. The wild forces of supply and demand have sought to deliver deflation, at least since 2008, but the falconer has demanded the lift-off of inflation.

"'Whatever it takes' may ultimately be constitutionally impossible and the ECB may not be prepared to print sufficient Euros to ensure that every government of the Eurozone makes all payment of principal and interest. If that reality dawns then yield spreads widen in the Eurozone and ultimately your interest and principal may not be paid in Euros.

"For those investors who have to be in equities, North Asia is the only game in town. They, in the form of China, Japan, and probably also South Korea, will win the currency wars. Their success in winning this game triggers the scale of deflation that generates the global credit crunch that is virtually inevitable as deflation takes hold.

"If you had not noticed, 2016 has begun with gold and the USD rising simultaneously. This is different and important. This is very positive for gold and very bad for the world.

"Real rates have further to rise but a few more days of a strong USD and a strong gold price means gold has probably entered a bull market that should last for decades rather than years; its value boosted initially by its ability to avoid conscription, but underpinned by the authorities' mass mobilization of resources to ultimately generate inflation.

"From 2009-2015 investors were well paid, at least in the developed world, to believe the most impossible of the six things before breakfast: that central bankers can subvert the desires, wishes, greed and fear of millions of people who set prices every day through their actions.

"You now have two choices: keep believing the most impossible thing, or accept that the wild force that establishes market prices has not been tamed. It's not a pet, it's a falcon and 'The falcon cannot hear the falconer'."

Judging just from the first week of market activity of 2016, life is finding a way. Nevsky Capital have decided to close their fund, citing the risks of investing in a world where opaque central bank activity, questionable data and the rise of algorithmic trading make the rational analysis of relative prices impossible.

We elect to fight on, making pragmatic use of the least risky (i.e. powerfully inexpensive) high quality equities, predominantly in Asian markets (though we have no exposure to China); well risk-managed systematic trend-following funds that offer the potential to benefit in falling as well as rising markets; and gold.

The skies are darkening with financial market chickens coming home to roost. What's in your investment armoury?