Chancellor: Beware the hyperreal financial market
LONDON, May 18 (Reuters Breakingviews) - On paper, Americans have never been richer. Their household assets topped $130 trillion at the end of December, up 10% in a year, according to the Federal Reserve. Record levels of wealth during a global pandemic and rolling lockdowns, and after years of low savings and investment, might seem paradoxical – that is until recognising that much of the reported wealth is virtual or hyperreal. Sooner or later, the day will arrive when much of these apparent riches vanish in a puff of smoke.
In a hyperreal world, as depicted in the 1999 sci-fi blockbuster “The Matrix”, an unbridgeable gulf separates appearance from reality. From this perspective, virtual wealth consists of claims not represented by anything of value in the actual world. Like the steak consumed by the Matrix’s villain Cypher, it looks juicy enough and tastes delicious but it’s all an illusion. During the subprime credit boom, examples of illusory capital included synthetic collateralised debt obligations (CDOs), and CDOs which invested in other structured securities (known as CDOs-squared). Clients of Bernie Madoff discovered that his investment returns were faked.
Since the Lehman Brothers crisis, the financial Matrix has grown larger and more complex. At the apex of the vast pyramid of hyperreal claims are overvalued and unproven enterprises, often located among the unicorn herds of Silicon Valley and recently listed special purpose acquisition companies. Cryptocurrencies and non-fungible tokens are another type of hyperreal asset, as they lack any counterpart in the real world. Also worthy of inclusion are expensive contemporary artworks, such as Jeff Koons’s “Balloon Dog” (one of five copies which sold for $52 million in 2013) or the self-shredding drawing by the British artist Banksy (given away by Sotheby’s for just $860,000 in 2018).
At a lower level of the hyperreal pyramid are hundreds of billions of dollars of unfunded private and public pension commitments. The U.S. stock market, which trades at more than twice its historic average replacement cost (as measured by Tobin’s Q), is a major source of ephemeral fortunes. The balance sheets of many S&P 500 Index companies are filled with assets listed as “intangibles”. Many large firms, including PepsiCo (PEP.O) and Lockheed Martin (LMT.N), report negative shareholders’ equity. Earnings per share are often goosed by debt-funded share buybacks. All profits generated by financial engineering, whether by listed firms or private equity, are by their nature unreal.
Next to be considered are the trillions of dollars of outstanding corporate and public securities, whose growing liabilities have outpaced economic growth for years. In theory, government bonds derive their value from discounted future fiscal surpluses. In reality, highly indebted countries, such as Japan with debt at 235% of GDP, according to the Bank for International Settlements, and Italy at 172%, will never produce the surpluses necessary to validate their debts. Thus, it might be said that holders of Japanese government bonds and Italian BTPs are sitting on virtual assets. More virtual still is the vast amount of wealth held in the form of derivatives, whether equity investment via the futures market or bond exposure through swaps.
How did this Everest of hyperreal wealth come about? In part, the answer is technology. Derivatives arrived with electronic trading. Cryptocurrencies obviously couldn’t exist without computers. But the explanation is more complicated. Since the collapse of the Bretton Woods monetary framework in 1971, money has become untethered from gold or any other commodity. Central bankers are free to print, or rather digitally conjure up, as much fiat money as they wish. Once money has become virtual, interest rates no longer reflect the supply of, or demand for, actual savings.
By pushing interest rates down to zero and sometimes lower, central bankers are ultimately responsible for the great wealth bubble. In recent years, central banks have created money to acquire trillions of dollars of securities. As Seth Daniels of JKD Capital wrote in an eye-opening letter for the firm’s private clients: “when a central bank buys an asset, the ‘price’ it pays is not a true market price, but a hyperreal price.”
Occasionally, glitches appear in the Matrix – flash crashes, taper tantrums, surges in volatility, and last year’s Covid-19-related collapse. Like the sunglass-wearing sentinels in the film, central bankers are primed to defend the world of hyperreal wealth. Since the Covid crash, they’ve been working overtime. The markets have experienced a “crack-up boom”, which Daniels suggests may be the final stage of the cycle. Retail investors on the Robinhood trading platform, touting “meme stocks” on WallStreetBets and avidly following the stock promoter known as “Davey Day Trader”, are under no illusion. For them, speculation is an act of rebellion against a corrupt system. “The good news,” tweets Davey, whose real name is David Portnoy, and is the founder of Barstool Sports, “is that I know it’s rigged… the stock market is disconnected from reality. The whole thing is a pyramid scheme. We’re living in the Matrix.”
Printing hyperreal money to excess carries the threat of inflation. Investors need to get real, says Daniels. To preserve wealth, they must embrace investments that are scarce, permanent and useful. This implies focusing on businesses that are inflation beneficiaries, as well as natural resources: “It’s time to stop obsessing about electrons and to start concentrating on neutrons and protons, too,” he advises. During Weimar Germany’s hyperinflation, investors dumped cash and bonds and stampeded into real assets (in the so-called “Flucht in die Sachwerte”). Investors have recently been piling into commodities and real estate.
As the world of financial hyperreality dissolves, passive investment strategies and algorithmic traders will struggle to keep up, Daniels predicts. Flesh-and-blood professionals who, like the Matrix’s hero Neo, can read the market’s code, have a better chance of preserving wealth. But since the stock of financial claims far exceeds the capacity of the real economy to service them, wealth destruction on a large scale appears inevitable, either through debasement or default or some combination. Losers must console themselves with the wise words engraved on the gravestone of the Victorian art critic John Ruskin: “there is no wealth but life.”
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