Brian Pretti: The World's Capital Is Now Dangerously Boxed In

If you would have told me that we would be in this set of circumstances today ten years ago, I would have told you you were out of your mind.

~ Brian Pretti

This week Chris speaks with Brian Pretti, managing editor of, a financial commentary site published by institutional buy-side portfolio managers. In their discussion, they focus on the global movement of capital since quantitative easing (QE) became the policy of the world's major central banks.

The ensuing excellent discussion is wide ranging, but the key takeaway is that capital is being herded into fewer and fewer asset classes. With such huge volumes of money at play, very crowded trades in assets like stocks and housing have resulted -- bringing us back to familiar bubble territory in record time.

The key for the individual, Pretti emphasizes, is risk management. The safety many investors believe they are buying in today's markets is not real.

The Housing Market Is a One-Sided Investment Cycle

I think what we have got going on here in housing is we have got an investment cycle, not an economically-driven housing cycle, from the standpoint that really, never before have 40 to 50% of all residential real estate transactions been for cash. We have never seen that in prior cycles, absolutely not. You know, what is driving that? Well, in one sense – and it is not a point of blame, but more a look at the unintended consequences of what the actions of QE are – when you lower these interest rates and you take away safe rate of return in alternative assets. Five years ago you could have got 5% in a CD, a Treasury bond, even a money market fund. Well, for a lot of those people who had been savers and investors in safe assets, they do not have rate of return any more. What do they do? They take their $300-$400 thousand nest egg out of the bank, and they turn around and buy a rental property where they can theoretical get the 6%, 7% cash on cash rate of return. And all of a sudden that becomes their rate of return.

So, I think we are clearly seeing this, where assets are being lifted out of other investments – whether it is Treasurys or CDs or bank accounts – and being used to buy residential real estate. Of course, the issue becomes one of risk, meaning a Treasury bond never really needs a replacement roof, and the water heater does not break, and there are no vacancies. So, we are increasing risk in these asset class choices and investment choices, but it is a forced choice, because there is no other rate of return. And for people who need that to live, that is why I think we are seeing the big cash transaction levels that we have never really seen before.

Second part of the equation, foreign money is absolutely on the move. I mean, we are talking on the first business day of the new year, and one of the things that is in the news this morning and being talked about is, Is there going to be some type of an IMF-driven 10% deposit tax in the Euro banking system? Well, this has been being talked about now for probably two, three, four months. The trial balloons go up in the air. The Euro banking crowd has also talked about potentially negative interest rates. So may be a very simple question, Chris. If you are a Euro citizen and your net worth is caught up in euros and/or you have assets in the Euro banking system, what do you do? You get them out before something like this happens.

And really, maybe we can draw the parallels, too, with Japan, where we have seen monetary debasement and true currency debasement in very violent form over the last year since Abe’s been elected. If you are a Japanese citizen and your net worth is caught up in yen, you have lost 20% of your global purchasing power. What do you do? Capital begins to move globally.

And I think part of what we are seeing – well, maybe one last piece here, too, is, the current leadership in China is cracking down on corruption. So, I know you know full well, moving capital out of China is illegal. There is only one way to get it out. You have got to have serious capital. So, what is it doing? It is hiding in alternative assets globally. It is coming to what it perceives, for now, the perception of safety that maybe includes the U. S. dollar, and if you are coming to the U. S. dollar, what do you do? Well, you can buy bonds, you can buy stocks, you can buy a business, you can buy real estate, and because safe rate of return has been basically taken away, real estate and perhaps stocks, too, are a repository for that foreign capital.

And then, maybe lastly more than not, that global capital being on the move is concentrating in some of these geographic areas that we are seeing. I mean, prices in the New Yorks, prices in the Londons, prices in the San Francisco Bay Areas are just really off the charts here. So this is very much unlike prior cycles where we saw – and I know this sounds a little simplistic and Pollyannaish – but we see younger families getting jobs, making a little bit more money. All of a sudden, they can afford a home; they take on a mortgage purchase application. Maybe they buy your or my house and the food chain moves up. That is not happening this time. So, this is really an investment cycle, as opposed to a true economically-driven housing cycle.

And I just ask myself, is the lynch pin in all of this the dividing line of alternative rates of return, meaning interest rates? And as we saw rates pick up really since May of last year, we saw things like mortgage purchase apps and refi apps just drop like a rock. So as we move forward, these big metrics that are the interest rates that are Treasury rates are very, very meaningful. And will they be the catalyst of change, ultimately, in the housing cycle, as opposed to the economy being that catalyst? We are just seeing something very different this time.

The Box Global Capital Is Now In

The minute the Fed started talking about tapering – I mean, if we roll the clock back to 2009 when the Fed started their QE extravaganza, that money absolutely got into U.S. equities and got into U. S. bonds. But as the money kept being printed, it rolled across Planet Earth. It got into the emerging markets, it got into their bonds, their currencies, their equities. It got into global real estate, it got into gold, it got into commodities. The minute the 'taper' keyword was starting to be used by the Fed, all of a sudden, global investors were anticipating the recission of that tidal wave of liquidity. And all of a sudden, these asset classes started to contract to the point where it is really U.S. equities, the very large blue-chip global equities here that continue to perform well. They offer yields higher than safe bonds, for now, and are also the only place we are seeing rate of return.

But within this, we are herding capital into a very, very small sector of asset classes. And then lastly, fortunately or unfortunately, when we have the global central bankers and the global politicians doing what they are doing – Europe, we may take 10% of your assets in the European banking system. Europe, we may invoke negative interest rates; you bring a dollar into a bank, we will give you back 99 ½ cents. You cause capital to move, potentially, and to me this is a big issue. I think 2013 was driven as much by momentum, and there is no place else to go, and all those other wonderful things, as it was driven by the weight and movement of global capital. Global capital coming out of China, because it was scared of – if we are going to crack down on corruption and you have got corrupt capital, you get it out right away. Japan, the drop in the yen, you have got to move some of your capital to an alternative venue in an alternative currency. Europe, the threat of confiscation, and maybe just the basic question of, What the heck is the euro going to look like in three years? I know if my net worth was caught up in euros, I sure as heck would not be 100% vested in the euro.

So, a lot of this, I think, too, is global capital is hiding in an asset class that it considers to be relatively safe, because all these other asset classes have proven to be unsafe. And for right or for wrong, in U.S. and really large blue-chip globals, they have been very, very good stewards of capital over time. Their balance sheets are relatively clean, and if you are looking for safety, then this is just a very simple question. Would you rather lever your family’s balance sheet to one of the global governments, or would you rather lever it to Johnson & Johnson? Which one do you trust more? Which one is going to take better care of your capital over time?

So I think there are so many different factors that have been forcing capital into these narrow asset classes that basically are equities and real estate. The key issue to me, going forward, is risk management. For people who sat this one out, for people who have said, Hey, wait a minute; I am looking at the Bob Shiller CAPE ratio here, and we are at levels that we have only seen four times in the last 100 years.You have got to be kidding me. I am not getting into this thing. The only way to participate in these markets, in my mind, is to make sure that you have a plan for managing risk, period. This is not throw your money into the equity market and hope for a great 2014, because every year that the market was up like it was last year was followed by a year that blah, blah, blah. It does not matter. It is about making sure that we manage risk. And we need to draw hard lines underneath certain levels of capital.

Very easy to say, but for your listeners, too, I think this comes down to individual families and making an assessment of how much risk they can afford to take. Below that line, they do not allow it to happen. I know it may sound trite:You have every day of your life to get back into the market, but sometimes you do not have a second chance to get out. 

Click the play button below to listen to Chris' interview with Brian Pretti (101m:31s):

This is a companion discussion topic for the original entry at

That was hard to follow for a nuts and bolts sort of brain such as mine. I do not have an intuitive grasp of the concept of "Capital" or even Money.
To misquote Adam Smith (I have lost the reference)

A house is no more an investment than is a pair of trousers.
And another quote from one J.Christ
Birds have their nests, foxes have their dens but there is no pillow for the Son of Man. Make yourselves a warm bed.
So what's a poor boy to do? Orlov and I have independently come to the conclusion that a sailboat side-steps the entire train-wreck of the real- estate bubble. I am on the hard right now. I have to get out the sander and sand the hull. I would have a complete failure of resolve if the boat were an inch longer- so a boat is not without it's down-side.

The white South African government knew that it was in serious trouble and pinned all their hopes for stability on a middle class of home owners. Perhaps this is what the FED also wants, but by printing money the toothpaste came out the back end of the tube. What happened was that the big end of town priced the middle class out of their homes.

No stable middle class has some serious consequences. hence the hollow-point rounds.

Got to get out the grinder-catch you all later.

 $350 billion is half of the deficit of the budget, rates go up to about 1.5 percent it should eat  up all of the deficit.
This is about $ 700 billion, sending the treasury department and the fed of to own orbit. The budget will now stand on it"s own, can you spell failure!

Thoroughly enjoyed this podcast I hope you will have Brian as a regular guest. Listened to the podcast twice just to pick up bits and pieces I missed the first time. What a great way to start off the new year!
AK Granny


[quote=AkGrannyWGrit]Thoroughly enjoyed this podcast I hope you will have Brian as a regular guest. Listened to the podcast twice just to pick up bits and pieces I missed the first time. What a great way to start off the new year!
AK Granny
Well, I share your views on Mr. Pretti; he was a real pleasure to talk to.  I only wish our before and after conversations had been recorded, too.
Much more was shared when the mic was off.  
So if he's willing, we'll have him back.

I thoroughly enjoyed this podcast. His perspective and insights from a capital markets and finance analyst currently in the trenches was excellent especially regarding the question, What is next? Just great stuff.
His critique of the sound-bite nature of financial news was such a breath of fresh air. It seems so much of financial news these days is meant to deceive rather than inform. I will be listing to this podcast a few more times for sure!

I did notice one beginning of the new year glitch in that the presenting date on the youtube part of the podcast was January 4, 2013 rather than January 4, 2014. It is always tough to make that year change transition when it comes around!

Thanks to Chris and Brian for taking the time to share your knowledge, experience, and insights!

Well, nothing new here, and of course the 'gold' word was uttered once , but the subject wasn't discussed (as in the last OTC with Mish), probably because the 'pre talk'  made it clear that Brian doesnt see gold going anywhere price wise, except sideways or down, as he believes along with Jim Puplava, whose interviewed him many times, deflation and a strong US$ will continue to be negative for gold , and the US is the only game in town till the flock of black swans appear. So gold it appears remains a very expensive insurance policy especially when wrapped around the 4th finger of the left hand (sic). For those with a weird sense of humour, watch the latest interviews with Sprott predicting $2000 by the end of 2014, $5000 thereafter  - LOL.
Happy NY , GB.

Same here Arthur, I've got my wooden sailboat hauled out in the driveway, awaiting some new varnish and paint this spring.
Enjoyed listening to Brian Pretti.

Chris, Brian,
Highly articulate and thoughtful podcast.

I have just one question, and it comes up over and over.

Brian Pretti said:

"the Fed has not been printing $85 billion dollars buying stocks. They are buying bonds, and yet the 10-year Treasury yield has doubled. Ultimately, the free markets are bigger than the central banks. And I know, this may sound crazy and lot of people have said this already, we are just not there yet. The capital markets are bigger."

The Fed has an unlimited printing press.  They already are buying 30% to 90% of new UST issuance.  With thin-air money.  That is unprecedented and historically massive.

If they are going to go that far, why not 100% of all new UST?  Why not 100% of all UST, new and rolled?

Why not 100% of stock market?

They are already, IMHO, setting prices of all major markets at the margin, by unprecedented purchases, and indirect purchases via futures and derivatives.  I repeat.  Their checkbook is unlimited.  The counter-parties is limited.

Our checkbook, our savings and that of pension funds, investment houses is limited.

Why can't the Fed set the price exactly where they want it, forever?

I think that is the scenario that plays out in 2014.  Immoral people keep doing something immoral, if it benefits them personally, until something or somebody stops them.  Lord knows, our government and business leaders will not stop them.  The asset holders, and the people themselves must stop them.  Bank runs, strikes, protests, societal shutdown is what it must come down to.  But clearly there needs to more pain to motvate the folks.

But Brian, do you think a few pension fund managers with limited capital throwing a temper tantrum will stop an entity with unlimited money-printing power, who thinks it is in charge of the world?

(I realize the nominal price setting game comes to an end eventually, when oil stops pumping and food is not grown, but those are physical and human limits, not monetary ones).

Thanks again,


for you to make a post and not bash Austrian economics or those influenced by its school who are partial to gold or alternate currencies?  I've come to the conclusion that PP has a rather intelligent crowd that can critically think on its own and form opinions.  For me, there is no need to constantly be lobbing grenades at those who have differing opinions.  I'll even lend my ear to the Paul Krugmans of the world to hear what he has to say even though I agree with almost none of it.As for the interview, it was excellent.  Very well put together.

That's what I say. If they can buy bonds then why not stocks? Especially since it's a smaller market and as they said, the stock market's for show, the bond market's for dough. I'm not holding my breath waiting for a crash. But who knows, maybe we'll get one.
But just because the Fed can buy all these things doesn't mean it can go on doing this till the cows come home until there is mass social unrest which forces it to stop, because the Fed has to deal with the international community as well. There will come a point where the rest of the world won't tolerate it anymore. I think we're already there, and the other factor is coming into play: when will the world's gold run out, which I consider to be the more likely scenario triggering the end. China and India are in competition to buy the gold while it remains; their citizens know exactly what is happening.
What this means is that if the rejection is brought on internationally rather than domestically, the US will enter hyperinflation directly without having to go through a deflationary crash first.
This is also why I don't really buy into these bail-in concerns. The entire financial system is a ponzi scheme based on CONfidence. As soon as the average person loses confidence then it's game over. The best way to get the average person to lose confidence is to lock up the banks in a holiday and take a portion of depositors' money. Then it's basically game over and the elites lose control, at least financially. And I would guess the amount of depositors' money they'd have to steal would be many times what depositors actually have, since if confidence is lost and the banks have to fess up, then they are going to face their derivative obligations and there's no way they could bail-in 100X global GDP, or whatever it is! I can't see these bail-ins doing anything but hastening the ultimate demise of the banking system, not helping it lurch even further along. Sure they might work in tiny Cyprus, but that's just a little country "over there in the Middle East". Try it Europe- or USA-wide and it's a totally different ball game.

I second the request to have Brian back again. This was a great podcast for me because it was informative without being overly technical for the layman (woman). More like this please.
To underscore the importance of some points made, here is a link to another article that also reiterates the importance of interest rates, and how low rates have been so enabling to the wrong crowd.

I also remain a fan of Dimitri Orlov, and his hypothesis that it will be another liquidity crunch that leads us into the collapse. The two combined - increasing 10 year treasury rates and decreasing liquidity will be a strong tell in this big poker game.


I'm beginning to warm to your and Orlov's boat idea a lot Arthur. Despite the saying that you only get two good days with one - the day you buy it and the day you sell it!  And there's also the trend amongst smugglers to go as far as submarines. Of course the wind does't blow underwater.