ETIENNE DE MARSAC: We're living in a big bubble that is made of small bubbles. And these bubbles will deflate either naturally when, suddenly, people come back to reason, or either because the regulator or the central banks will start to focus on them. An excess cannot be corrected without another excess. This is based on emotions. This is based on perceptions. A misguided perception of reality conducts to another misperception.
ROGER HIRST: I'm going to sit down with Etienne de Marsac, who's got around 20 years experience in hedge funds, investment management companies, and also within some of the European institutions such as the EIB, where he helped manage their $600 billion balance sheet. Now, he's going to look at the state of the markets, what are the key elements that are driving them at the moment, and particularly from the angle of central banks, and central bank liquidity, and whether we are now at a tipping point.
So I think what's really interesting from his perspective is that he thinks that central banks, starting with the ECB, are going to change the way that they look at their major targets and maybe even change their policies. And this could have a very, very significant impact on global asset prices. Etienne, a very warm welcome to Real Vision.
ETIENNE DE MARSAC: Hi, Roger. Thank you for inviting me.
ROGER HIRST: Not at all. I think this is your first time. So maybe if you could just give us a little bit of background, because you've been in this business for over 20 years in hedge funds, investments, even in some of the European institutions. So maybe give us a little bit of color about this career that you had.
ETIENNE DE MARSAC: Well, indeed, I started already 20 years ago. The financial environment was totally different. I spent so 20 years in the fixed income market as a global fixed income and currency trader, or investment manager. And indeed, I had the opportunity to move or to come across many various institutions, some of them quite small, some of them quite big.
And as you said, my last two principal or serious experiences were in Luxembourg in a hedge firm before joining the EIB, the European Investment Bank, which is basically one of the biggest European banks in the European universe. People basically don't know in general, but the balance sheet of the bank is roughly 600 billion euros, and the role of this Development Bank is to provide credit to the whole Europe, but also the rest of the world.
So it was these last two experiences were extremely interesting, extremely unusual. The hedge fund, because it was very technical-- a cross-asset hedge fund. So where we were trading equity, derivatives, commodities, fixed income, credits, globally all assets, with an overlay on the top of it. And then, the EIB, when I was in charge of investing the long-term liquidity buffers of the banks. So roughly 10 billion euros that needs to be invested for regulatory reasons. And before coming into this universe, this European universe, I had no idea about how regulation can distort prices. And I think this is pretty much the biggest thing that I've been taught and that I will remember.
ROGER HIRST: And so bringing in all of that, I guess in some ways, the key thing here now as you're running money again is the state of the market. Because we have this incredible-- so to some people, it's an incredible world where the S&P has been marching higher, and although we're not at the lows in yields, it feels distorted. Valuation feels distorted. And yet, central banks are behind it. How do you perceive the state of the market right now?
ETIENNE DE MARSAC: That's a key question. I'm a little bit suspicious right now. Either I've been participating to this very risk-on environment for many years, except to 2018, which was a little bit different, a different context, where or when the United States and, namely, the Fed tried to escape from the quantitative limiting but did not manage to do it.
I've been participating to the risk-on environment for a long time. But right now, I have the feeling, indeed, that the valuations have been too far, are too much stretched. And even if you cannot short right away the market, which would be completely foolish, I am tempted to have a lower participation to this risk-on environment.
So I qualify the environment as being greedy. I can feel some greed in the market. I can see some hubris within market participants. I can see a quite non-irrational exuberance, if I may say so. That is to say, a logical one that is explained by, mainly, three factors, three features-- first one being the American president very frequently referring to the levels of the stock markets as a key feature or as a key measure to qualify the efficiency of his policies.
So this is very unusual. We had an example very recently last week when, during the conference following the signature of the phase one deal, Mr. Trump referred two times to the level of the S&P 500 and the Dow Jones as a key measure of the efficiency of his policies. And I think this is slowly and surely introducing a misperception of reality that price on the equity markets can go on upper and upper unless-- until Mr. Trump-- or, while Mr. Trump is still in power.
So this is the first one. The second point, of course, has been induced by the omnipotence of central banks, or at least the perception that they will be here forever. I must admit that they have been extremely efficient, really good, at addressing liquidity issues as well as solvency issues, the latest example being the way the Fed addressed the repo issue in the repo market last year, beginning of last year, by injecting very precisely between $60 billion to $120 billion per day of liquidity exactly where the liquidity was required. I've been extremely surprised by this efficiency in the securities. So I must admit central banks, and particularly the Fed, has been quite efficient.
The ECB is also part of the story. That the money supply impulse-- so that the year-over-year difference between the net asset purchases of the previous year relative to the new year-- the net impulse has increased by $3 trillion, not to mention the money supplied by China.
So the central banks have been extremely successful in injecting liquidity. And so it would be absurd to not to participate to this party. But I have the feeling that we may be slowly but surely going into the end of these bubbles, on the end of this everything bubbles, that it is right now jeopardizing the equilibrium of financial assets. And yes, I think we need to pay attention to various signals of excess leverage, excess liquidity, absence of notion of risk, greed, and, yeah, pretty much, that's all.
ROGER HIRST: And do you think-- I think what a key area is here is that it feels like we deserve a pullback, but the pullback that you expect, is going to be a correction-- 5% to 10%-- which takes out the exuberance. Because in many ways, this is not a euphoric top that we are seeing, if it is a top at all. it's not a euphoria of mass participation by the man on the street, which is one of the reasons, in some ways, where this valuation story, which has been there for a few years now, has been ignored because it's a liquidity story.
So do you think that the next chip phase, or the next downleg that we have, is a correction, or it's the beginning of a financial crisis? Or do you think that at financial crisis, potentially, is still quite a long way down the road because the liquidity, it might come out a little bit, but every time we've seen initial return, the liquidity comes back even faster.
ETIENNE DE MARSAC: An easy question. If I'm honest I must admit that I don't really know the answer the party can goes on again and again and quite longer so that there has been a tremendous effort done by the regulations and the regulators around the world to avoid the same type of financial crisis.
So basically, these acronyms like BRRD-- so bank resolution-- BRR, so bank resolution regime, LCR ratios, these type of acronyms, they all provide support to the idea that the next financial crisis won't happen within the banking sector that had been extremely recapitalized these last years.
If we step back a little bit and we focus on the European sector, the recapitalization effort is of about 6 trillion euros in 20 years. That's huge. That's even bigger than the impact of the balance sheets of the ECB. So the solvency issue has been addressed within the banking sector, either in the US or in Europe, but it is also having an amplificating effect on these euphoria that we were discussing. The liquidity buffers, they need to be invested.
As an example within the EIB, one of my last missions were to invest between 5 and 10 billion euros or dollars on sovereign bonds. Care less the level of the prices, of the level of risk, of the level of rates, because the cost of being non-compliant to regulation is even bigger than the cost of being of having a negative carry on your holdings.
So the banking sector is in a better shape, but you can still see some fragilities in some areas. And the so-called doom loop, which is a way the banking sector is being forced to buy sovereign debt at ridiculous levels because they are AAA and because they consume very low level of risk-weighted assets could be a factor or a trigger of a bigger meltdown. We had the example quite recently in Italy with-- when the blowup of the Italian sovereign bonds is having a direct effect on the sovereign spreads.
To answer a little bit more specifically to your question, I think we are not-- we are living in a big bubble that is made of small bubbles, and these bubbles will deflate-- either naturally, when suddenly people come back to reason, or either because the regulator or the central banks will start to be-- or will start to focus on them. And last week, Robert Kaplan, for instance, made a speech about the financial instability that needs to be tackled.
And I have the feeling that probably, if a crisis emerges, it will be internal. It will come from the central bank themselves. They were the ones who inflated the bubbles, and they could be the ones who will try to deflate it.
Not a very long time ago, one year, one year ago, Mr. Powell, through the quantitative tightening, was exactly trying to get out of this mess and trying to exit the balance sheet of the Fed, assuming it would create some bout of volatility. He went a little bit too far-- much too far-- with a very clumsy communication that the financial market could not really understand.
But this is how I see the world. Either it will correct because of a doom loop within the banking sector-- either it will be directly due to a change of focus of central bankers trying to address the global imbalances that they have created for all the reasons that we know-- inflation targeting, et cetera.
ROGER HIRST: Well, how do you think we move from this? Because we currently have is almost a virtuous circle. How does the virtuous circle turn into the doom loop? Because if anything, the central bankers themselves, I think, have learned a few things. One is in the 2000s, they cut rates, and the equity market fell in 2000 to 2003 and 2008. So now, gone, it's not the price of capital. It's the availability of capital. Hence QE, and hence, during last quarter's repo issues, the capital went in. It was-- that was more important than the cost of capital.
So the central banks, haven't they-- in some ways, they're now saying, OK we will put-- rather than a put under the equity market or the bond market, we're going to put a cap on volatility until we stabilize everything. We continue to provide that liquidity. In some ways it's not that we've got asset bubbles everywhere. We've got extremes but no euphoria.
But we might have a bubble in central banks. But why don't we just keep on doing this? Because at the moment, there's no inflation. At the moment, there's no-- at the moment, as we saw with Powell's misstep with the rate hike in 2018 at the end and the final move down, they know what will cause things to blow up, so they know what they can do. So why don't they just keep it going?
ETIENNE DE MARSAC: Just because at some stage, the targeting financial stability and targeting price stability is becoming two different goals, two orthogonal goals, that will hurt, themselves, each other. The world of the central bank, they have chosen to privilege the inflation targeting, despite the bubbles that they may have created all around. They perfectly know this. They are perfectly aware of the bubble created within the fixed income market, within the corporate market, or within the equity market. But it will only require a change of focus.
And I think this is where we are slowly coming right now. The ongoing valuation of the tools that the Federal Reserve is using and also the ECB is using is an ongoing valuation that will last some months. But maybe-- and I will discuss this after at the end of your interview-- but there are probably some surprises to expect from the review of the tools, the review of the CPI figures, the review of the methodologies, and globally, the review of this inflation targeting and the level of inflation.
Is the level of inflation of 2% still relevant in an environment of pressurized prices, in an environment where the quality effort is pushing the prices to the downside? Have a look at your iPhone, for instance. Your iPhone, the price of your iPhone is the same than what it was five years ago, basically, but there is much more technology inside it.
So how is this technological aspect being taken into this inflation reflection or this inflation target that the central bank are having? Is the CPI computed 50 years ago still relevant in this new environment? Our grandmothers, they were not buying phones, or they could not use so many services that are free from the moment.
On your telephone, you have a WhatsApp application that is totally free. It used to be-- it used to eat used to consume a lot of wealth before, so you used to pay for it before. So how do you account for this new environment? And this ongoing debate within the central bank, I'm sure, is going to lead to some surprises that we will face next year.
Still, the amount of risk in the financial market is much too high. Coming back to the 1999 years, the global level of debt was of $80 billion. Right now, it is of roughly $270 billion. So it multiplied by three. Meanwhile, I don't need to say that the growth of the earnings did not follow the same train. So we have a big issue of loss of efficiency in the allocation of capital. More and more debt is explaining or is leading to less and less growth.
So the capital efficiency is a big issue. So globally, what I'm discussing here is the liquidity trap, so the Keynesian, the very basic Keynesian liquidity trap, when providing liquidity, even providing debt and more and more debt, you favor zombie bonds or zombie corporates that are less and less efficient and that, at some stage, are going to blow up. So either you let them blow up themselves-- and WeWork is a perfect example, for instance-- or either you raise interest rates in order to increase the debt servicing so that these zombie corporate dodge themselves.
What is a zombie corporate, if I may open a parentheses? It's a company that is not able to pay its debt or more than one year of debt servicing, or more than two years of debt servicing. So its revenues are less than two year of debt servicing. If you have a look at the environment, you will see-- you see that in Canada, the number of zombie corporates is increasing to 30%.
So 30% of the corporate world is made of zombie corporates. In the United States, it's 20%. In China, it's 25%, and so on. And these figures have doubled in 10 years. And I think it's not healthy. They shouldn't be kept