Is globalization over? - look at financial flows

The great trade decline during the Depression marked the end of an era of global trade. We have not seen the same decline in trade flows since 2008. By the end of 2009, trade flows popped higher after declining sharply in 2008, yet a closer look will show that there has been a significant decline in cross border capital flows which is the river of trade in the current global economy. The great era of globalization in the last 25 years has been driven as much by capital flows as trade.

Global financial assets have grown by only 1.9% since 2008. Financing has become more localized. If capital is the oil of commerce, we are seeing a sticky sludge that will reduce the movement of goods and services across borders. If capital flows decline the modern link between countries will also decline. 

Dumping gold - it may be early

ETF's have been called the People's Central Bank. They are the world's third largest gold holder against the US and Germany. Still, money is starting to flow out of gold as investors seem to be giving up on this store of value.

Some are calling this the end of the gold bull market. There seems to be a good reason for leaving gold if you focus on inflation. There is no strong inflation from the QE programs; consequently, there is less reason to hold gold as an inflation hedge. Even the threat of a bank run in Cyprus has not caused gold prices to move higher. The floor seems to be around $1660, but it is unclear what will move it higher. The market has soured on gold given the nice run on stocks, but it is not clear these equity gains will continue. Even without a equity forecast there are reasons to hold gold. 

It is early to exit gold based on recent price declines and outflows. Further weakness provides a buying opportunity. With financial repression, banking problems, more QE, and the potential for higher inflation expectations, gold may still be a good investment. The sensitivity to these events has declined because we have not seen as much follow-through after the strong gold gains. The current rest may set-up the market for new gains if there is a flight to quality catalyst.

Is the wealth effect working?

The Fed has caused asset prices to increase in an effort to improve wealth. This increase should lead to the rebirth of consumer spending. This is what was the policy in place after the Tech decline. The Fed drove down interest rates to create a wealth effect; however, the result was a bubble in housing that may have pushed spending higher but then lead to the reverse effect post 2007. Are we making the same mistakes again?

 Researchers have found a weak effect between stock wealth and consumption and stronger effect with respect to housing wealth increases. The elasticity with respect to housing in down markets has been measured to be about .1 so a housing decline of 30+% should lead to a decline in consumer spending of about 3%. The sensitivity to up markets has been measured to be less and there has been less of a wealth effect since 2008. The may be associated with the greater uncertainty about wealth gains. Note that the VIXX volatility index has actually declined over this period. Nevertheless, given the lower sensitivity, there needs to be more of a wealth increase to get consumption higher. If the Fed tries to engineer this increase in wealth, we may be left with another bubble.

Red-blooded Risk - not your ordinary risk book

Aaron Brown, the author of Red-Blooded Risk: The Secret History of Wall Street, is not your ordinary risk manager. He is  an expert poker player, trader, and academic who knows a thing or two about how to manage the real risk in a portfolio. This is not your ordinary risk book but a history of risk management, the musings of the author, an academic march through some of the important history and concepts behind risk management interspersed with cartoons. If you want a simple book with a well defined outline, this is not the place. However, Brown has some of the most interesting things to say about risk management that I have seen in print.

Brown thinks of risk through play within a game. Knowing the game helps tell you baout the risks thatc an be taken and how they can be measured. He also makes a strong distinction between frequentism and bayesian analysis. A problem that can be counted can use fundamental probabilities to measure risk, but most of the problems we face are hard to count and have limited data so we have to develop some priors on how to answer the question. Thus, you need a bayesian point of view. More importantly, you have understand how to bet and what to wager in order to be a good at managing risk. Measurement is one thing, but interesting what it means to wager and how to size these correctly is critical. Knowing the pay-off is critical if you want to bet.

Brown discuses his key seven principles of risk management:
1. Risk duality - the idea that you have to understand and exploit the unexpected;
2. Valuable Boundary - it is necessary to set risk boundaries;
3. Risk Ignition - if you set the right level of risk taking you will be able to grow returns exponentially, the Kelly criteria;
4. Money - money is not the only way to measure or should be thought of when measuring risk;
5. Evolution- there is natural selection when taking risk because we have different utility or sensitivity to risk;
6. superposition - some things and activities cannot be measured with money;
7. Game theory - we are playing games against others.

This is not an easy book. brown discusses a lot of important philosophical topics on risk with a flair of story-telling. It is a good read but requires some very careful thought.