Imaginary Prosperity

World sentiment and confidence seemed to sag towards the end of 2015 and the trend has accelerated into early 2016 in spite of continuing comforting media headlines and words from world leaders. So what is going on?

Since the great recession (2008-2009), world leaders, the IMF and central banks have taken the road of “whatever it takes” to get the world economy moving again: 

• ·         Stimulus and bailout programs
• ·         Zero Interest Rate Policy (ZIRP)
• ·         Central Bank exchange of toxic debt for Sovereign Debt (such as US Treasuries)
• ·         Encouraging (manipulated) statistics and rosy projections
• ·         Positive propaganda

The message to markets, firms and ordinary citizens was basically “We’ve got your back”, “Fear not – spend and borrow”. And by and large, that is what most did. Money was almost free. Real estate started to move, autos were purchased, and stock markets ramped up and up. Riskier and riskier debt instruments such as “high-yield” bonds became popular. Indebtedness soared at almost all levels of society: consumers, business and government.

An examination of some of the cheer leading is most amusing: “growth”, “green shoots” and recovery are always just around the corner. Today may be a problem but tomorrow it’s going to be great. The IMF’s successive revisions are a good example.

Virtually everyone has been in the game. The worst information manipulator is likely China. Yet, by late 2015, even these statistics started to show some negative trends.

Also, there were many visible signs early on that something was very wrong, at least for those who paid attention to indicators that were difficult to manipulate. By early 2011, for example, world commodity prices were sinking. Why?

The plummeting price of oil was easy to explain away as a Saudi thing, say,  but what about rice, wheat, copper, nickel, iron, soybeans, sugar, etc? By 2013 even lumber prices had started to decline. This didn’t look like a recovering world economy at all. Yet China, while not growing at the previously torrid rates, was still supposedly exhibiting growth. Really? I was in China in the Spring of 2015 and while their achievements are amazing and construction activity was evident, the number of vacant buildings everywhere also amazed me. China is definitely slowing.

Another small matter: World trade! How come world trade volume is contracting?

 

World trade volumes started to slip in early 2015. Prices paid are even worse (lower)!

Another indicator related to World Trade is the Baltic Dry Index, a measure of world shipping demand/supply. It has reached levels below that of the “Great Recession” of 2008-2009.

 

 

 

Meanwhile consumers are getting tapped out, even at current low interest rates. Indebtedness is rising almost everywhere. 

In Canada, for example, household debt to disposable income has reached 171%.

 

In the U.S., many indicators are contradicting the Cheerleader in Chief (Obama) and the Federal Reserve chiefs. Manufacturing has been slumping and inventories have been rising, for example. 

 

 

And the much vaunted automobile sector has been spun shamelessly. But look at the U.S. Census Bureau’s own reports.

 Peaked in 2013!

  

But the actual situation is likely worse still because automobile inventories have been piling up.

  

Similar problems for U.S. Steel Production.

And then there are new home sales that are sputtering along but even at today’s low mortgage rates, aren’t anywhere near the rate 10 years ago:
 

 And what about the U.S. consumer? Well, there has been considerable deterioration since mid 2012, with debt to income ratios widening steadily.

Much the same has been repeated around the globe. Trillions in central bank stimulus (printing) by the likes of the Federal Reserve, The People’s Bank of China, the Bank of Japan, The Swiss National Bank, The European Central Bank and the Bank of England have kept economies sputtering along with the bulk of the money going into securities such as stock markets and bonds. It has been wonderful for the banks and financial centres such as Wall Street but not that good for the middle classes around the world.

 

Since the end of the “Quantitative Easing” stimulus period dubbed QE3, things have started to get wobbly in the stock markets again and also in lower quality (high yield) bonds. In some parts of the world, real estate prices have begun to deteriorate sharply.

 

The continuing decay in commodity prices as well as rising commercial, consumer and government debt loads have also taken their toll.What will the Debt to GDP charts look like if a world recession takes hold? Will any of this be manageable?

Let’s face it; interest rates cannot be lowered much from where they are now, though they may go a bit negative. Governments and Central Banks have almost run out of tools. Another round of distortion creating stimulus may soon be upon us in spite of clear evidence that these measures have at most kicked the problems down the road at the expense of increasing the structural problems that led to the various rounds of stimulus in the first place. We now have much bigger problems than we already had. The scary thing to me is that unlike other periods in history, the world has embarked almost in unison on a coordinated and massive mission to keep economies afloat.

When this crisis finally breaks, it won’t be an Asian crisis or a South American crisis or an emerging economies crisis, it will likely be a world-wide crisis with virtually no major pockets of strength to moderate its effects. In such a scenario, valuations in almost all asset classes including currencies, real estate, stocks, bonds and commodities will change drastically. Financial dislocations and misery will abound. Be on guard!

Central Banks and World Stock Markets

With few exceptions, the world’s stock and bond markets continue making new highs, all the while listening for the tiniest of clues that Central Banks (CB's) might be reversing gears or curtailing their apparently endless backstopping of securities.

But so far at least, any time things seem to get a little wobbly, especially after some slightly concerning remark from one or other mouthpieces of the world’s main CB's, one of their members steps up to the plate with news of new “liquidity injections” and soothing words.

But of course, propaganda notwithstanding, the underpinning economies and fiscal situations of most nations continue to deteriorate. So the pricing of securities and their actual free market values continue to diverge ever wider.

What is worse, the whole concept of risk seems to be disappearing. Take a look at sovereign bonds. It used to be that the bigger the risk that a nation could not repay its debt obligations, the higher the interest rate demanded to lend to that nation. Logical, huh? Well take a look at Spain's debt situation since 2008:

Now take a look at the yields on Spain's bonds!

Spain Government Bond 10Y Yields (courtesy of http://www.tradingeconomics.com)

So the divergence is pretty clear! Sometime in 2012, the markets began to let go of all pretense that there is any risk whatsoever in holding toxic debt, provided that CB's could be counted on to buy it up whenever things start to look dicey and real buyers had disappeared. This is the essence of "ZIRP", the so-called Zero Interest Policy espoused in one form or another by most of the world's CB's, which, in some cases has become "NIRP" or negative interest rate policy.
Of course, this engenders precisely the opposite behaviour by indebted nations to that required to reduce their reliance on borrowing. After all, if you can borrow for next to nothing, what the heck, right?

Of course, this moral hazard has spread throughout the world's economies, as subordinate interest rates for almost everything have been driven lower. Consumers continue to buy on credit, especially for big ticket items such as vehicles where interest rates are often next to zero. In the meantime, savers and pensioners are being ravaged. A yield of 2.5% on $1million in savings will only bring $25,000 annually. It's hard to live on that. And how many have saved a million, anyway?

Interestingly, when CB support becomes questionable, the markets begin to work again. Look at these charts of a selection of Government 10 Year Yields. What is the only one that makes any real market sense? Well, Greece, of course. And why? Because it is not certain whether Greece will remain a part of the EU. So in that case it could not depend on being backstopped by the European Central Bank (ECB). So Greece's bonds get priced accordingly.

The bottom line is that in an attempt to rescue the banking system (remember that most CB's are run to a large degree by bankers) and the economy, central banks have created enormous investment bubbles in securities that are artificially priced on a variant of the greater fool theory, where the greater fools to whom you can pitch your investments are the CB's.

But CB's may be slowly coming to be in fear of what they have created and increasingly, concerns are being expressed that the divergences between markets and reality can not continue indefinitely.

I urge all to observe the markets carefully as the day will come when CB's can't or won't continue to madly print and buy everything in sight in an attempt to keep it all glued together. When things get unglued this time, the carnage will be much worse than anything we have seen in recent history.

Why do Nations Borrow ?

As the world gets increasingly mired in debt, Every day I listen to economists, talking heads as well as regular folks using terms such as "excessive debt", "manageable debt", "excellent (or poor) debt to GDP ratio", "low deficit", manageable deficit", etc. Debt and deficits may or may not be manageable but it is a slippery slope at best. Shakespeare had it right in Hamlet: "Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry." When individuals enter into significant debt, it is usually to borrow money for a major purchase, such as a home with the idea of repaying this debt over one's working life. Many people, maybe most, especially in the past, have done exactly that. In addition, they have usually saved some money along the way and managed to leave something for their children. Individuals normally don't have chronic deficits because this would mean that such an individual was adding to his outstanding debt every year, rather than paying off the debt. This wouldn't make sense and would lead to bankruptcy. So, do individuals need to borrow in the first place? Well, maybe not, but if the idea is to acquire something like a home early on in one's career, or to start a business, this can make sense, provided that the repayment terms are not too onerous relative to one's earnings and spending habits and of course, that the loan is repaid.

But why would nations ever need to borrow, especially chronically (i.e. run deficits)? Since a nation is a very large collection of individuals, it would seem that whatever expenditures governments contemplate should be paid for by passing the hat around, usually in the form of taxes and duties. If you need to spend more, tax more. Why would any nation ever want to borrow money so future taxpayers would be on the hook? And why would you borrow chronically? Will it be easier to pay those taxes tomorrow than today? Do nations around the world expect some big infusion of money down the road from the equivalent of rich old aunt Millie passing away? Let's face it. Short of possibly having to repel an invading force where the very existence of a nation is at stake, sovereign borrowing just does not make any sense. What's worse, future interest payments will only serve to reduce the outlays available to provide citizens with government services. No, in fact, nations should purposefully run small surpluses for that rainy day to defray the unusually high costs of repelling aggressors or to deal with natural or man-made disasters.

Well, in fact, I think most of us know why nations borrow. It is human nature combined with politics. Politicians love to bribe the citizenry with their own or future taxpayers' money. And citizens? For the most part, they love to bribed. They vote for a better today, for their pet projects, etc. Tomorrow's pain is something that can be set aside for . . . tomorrow.  Unfortunately, history demonstrates that with time, borrowing costs mount and lenders become scarce, leading to debt crises. Then central banks are urged to print some of the shortfalls. This process is often disguised to reduce the rate at which confidence is eroding. We engage in stimulus, quantitative easing, blah, blah, blah. Eventually, as confidence erodes even more, increasingly massive printing becomes the only short-term measure available to avoid banking and institutional failures and finally city, state and sovereign failures. Unfortunately, history also shows that such a remedy eventually destroys that nation's currency in addition to that nation ultimately succumbing economically. If a minor currency is destroyed in this way, that country's transactions and trade can be substituted in some other currency, such as the $US. However, should that currency be the world's principal reserve currency . . .

Housing, Mass Psychology and Contrarian Investing

Some more observations on the Canadian housing situation, mass psychology and illustration of the statistical value of being a contrarian investor - a great article by Ben Rabidoux on his Financial Insights Blog.

The Fed's "Exit Plan"

As if the banks have not had a good enough series of meals at the public trough, here we go again. See this article from businessinsider.