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Archive for October 2014

Archive for October, 2014

Outside the Box: The Colder War

 

The story of energy is the story of human expansion. From the days when we roamed the African savanna, we tamed first fire and then other forms of energy, using them as tools to control our environment and improve our lives. The control of energy has always been at the heart of the human story.

This week our Outside the Box essay is from my friend Marin Katusa, who has written a fascinating book about a part of that story, a subplot of intrigue and conspiracy. Under Putin, Russia has aspired to dominate the energy markets. Called The Colder War, Marin’s book is a well-written tale of the rise of Putin and his desire to change the way the world’s energy markets are controlled.

I sat down a few months ago with an advance copy, not sure what to expect. Marin is personally very colorful and entertaining, but would that charisma translate to words on a page? I started on a Sunday afternoon and finished before I laid my head on the pillow that night. The Colder War was an entertaining and gripping story of the rise of Putin and the shifting sands of the world of oil. It was also an insightful overview of the last century. I highly recommend it.

At the end of the day, I disagree with Marin as to Putin’s ability to achieve his vision. While Putin wants to displace the petro-dollar as the global medium of energy exchange, he will fail. But maybe that’s the hometown boy in me thinking my team will win.

But that is the last 10% of the book. The first 90% is an easy must-read. Warning: it is not written from a US perspective. Marin’s view of the events of the last century sound more like those I hear when I travel outside the US.

I took the liberty of checking his story with a good friend of mine, Jerry Fullenwider, a very successful Texas oil entrepreneur, who lived in Russia during Putin’s rise. He confirmed Marin’s tales and more. He has his history right. And what a history it is. Today’s OTB is the introduction to the book, and if you’re intrigued, you can listen to Marin talk about the book and obtain a copy here.

I write this note from the airport in Geneva, where I am waiting on a plane to return to Atlanta for a day and then home. It is hard to imagine a more perfect few days than I have spent here on the lake.

It has been an exhilarating week, full of thought-provoking lectures and conversations. I am ready to go home and meditate on what I have learned. As usual, I intend to work and write on my way back to the States, so that I am ready to go to bed when I arrive. You have a great week.

Your watching the dollar analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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The Colder War

By Marin Katusa

I am going to tell you a story you’ll wish weren’t true.

Sometime soon, likely in the next five years or so, there is going to be an emergency meeting in the White House Situation Room. It probably will start in the wee hours of the morning, when the early risers among Europe’s oil traders and currency speculators have already begun to scramble out of the way of what’s coming. None of the worried participants in that meeting will have a good solution to propose, because there will be no way for the United States to turn without embracing calamity of one kind or another.

The president will listen as his closest advisers lay out the dilemma. After a long silence, he will say, “You’re telling me that everything – everything – is coming unglued.”

He’ll be right. At that point, there will be no good options, only less awful ones.

Don’t count on the wise and worldly who occupy the highest echelons of government power to know what they are doing when they sit in that meeting. Solving the puzzle of what to do will fall to the same kind of people who today are standing by and letting the disaster build.

Some of them just don’t know any better. They see all of mankind’s turmoil as cartoonlike conflicts between white hats and black hats. Others know that reality is more complex, but choose to feign ignorance – it’s so easy, and often politically convenient, to let everything boil down to good guys battling bad guys.

For years, political power players in the United States have joined their media allies in portraying Vladimir Putin as a coarse bully, a leftover from the KGB, a ruthless homophobic thug, a preening would-be Napoleon who worships men of action – especially himself. Even Hillary Clinton, who should know better, likened him to Hitler.

The ruthless part is quite real, but there is so much more to the truth. I’ve been studying Putin’s moves for as long as I’ve immersed myself in analyzing world energy markets – over a decade now. He’s a complicated man whom Americans have been viewing through the simplifying lens their leaders like to hold up. He is less of an ogre but far more dangerous than politicians and the media would lead you to believe.

It has been a terrible mistake for Washington’s political circles to dismiss him for so many years as just a hustler temporarily running a country, to cast him as a shooting star destined to flame out in the unforgiving world of Russian politics. It has been to his advantage that short people tend not to be taken seriously, even if, like Putin, they are martial arts champions and have a chiseled physique to display at age 62. And his less-than-dignified moments posing as He-Man have played into our readiness to treat him more as a clown than as a dangerous competitor.

But Washington should never have thought of him as a Cold War relic, any more than it should have thought of Russia as a once-lionlike country that had devolved into a goat. It should have seen that Putin has a long-range plan for Mother Russia – a map covering decades, not the four-year election cycles that dominate the attention of U.S. politicians – and both the vision and the resources to make the plan work. For 15 years, Putin has been formulating, bankrolling, and directing Cold War: The Sequel. Or, as I like to term it, The Colder War. He’s in it to win it.

And the way he plans to win it isn’t through the sword, but through control of the world’s energy supplies.

There’s no undoing the U.S. government’s failures to date. What I can do now is tell you the true story of the Colder War. I can trace the connections of world events you’ve read about and that only seemed unrelated. I can explain why Putin does what he does, so that you can anticipate what he’s likely to do next. I can show you the worldchanging power shift that is little recognized even though it is unfolding in plain sight, right before our eyes.

It’s all about energy – oil, gas, coal, uranium, hydroelectric power. Today, when you’re talking about energy, you’re talking about Putin. And vice versa.

Energy is what makes the world go round. For most of the past 60 years, the United States has prospered, largely because it has dominated the energy market but also because it issues the currency in which energy and other resources are traded – a nice monopoly to have. The United States has been top dog for so long, it’s a shock to imagine that things might soon be different.

Slowly but surely, however, U.S. strength has been ebbing as Putin positions himself for the final push. While the United States dithers over green energy, Russia has a Slavic tiger in its tank.

To understand where Vladimir Vladimirovich Putin is taking Russia, you need to go back to the country’s lost decade, the years after the collapse of the Soviet Union in 1989. If you were a Westerner, it was a time of prosperity and of self-congratulation for having won the Cold War. But if you were an average Josef Vodka caught up in the chaos that followed the demise of communism, it was a time of hardship, dislocation, and frightening uncertainty. And if you were Vladimir Putin, it was a time of anger and hardening – and preparing.

Given the country’s stunning rise since the 1990s, it’s easy to forget how bad things were.

It was 10 dismal years of lawlessness presided over by politicians who had been left bewildered by the task of bringing their country into the modern world. The sad decade was marked by the ascent of wildly profitable criminal syndicates and a coterie of oligarchs who fed on the government’s naïve plans for turning state enterprises into private ones. Operating as barely legal businessmen, they became billionaires almost overnight.

While the few celebrated, morale among ordinary Russians sank. They had just suffered through a long war in Afghanistan and its humiliating end. Then came the implosion of the Soviet Union, the grand empire they’d been told had been built for the ages. National pride had become a painful memory.

When the communist economy ground to a halt, no one in the government of the newborn Russian Federation knew what to do. Free markets were just beginning to emerge. Sizable and mature private businesses didn’t exist. There were no banks competent to judge credit risks. Almost no one understood stocks, bonds, commodities, or any kind of market other than the black one that had long flourished – and continued to do so. Property rights were a slogan with uncertain application. The ruble was worthless outside the country while internally inflation ran wild. Jobs disappeared, leaving millions unemployed. Infrastructure was crumbling. Millions of Russians fell into destitution.

It was the very definition of hard times. People’s prospects were so bleak that many clamored for a return to communism, the despised regime under which they at least knew where they stood (“We pretend to work; they pretend to pay us,” as the Soviet-era joke went). And the problems weren’t just with the economy.

There was, in particular, Chechnya. A secessionist movement of Islamic Chechens was reading the disorganization in Moscow as an invitation to press their bid for independence. They accepted the invitation, and in late 1994 the First Chechen War began.

Putin’s predecessor, Boris Yeltsin, was still in office at the time. Despite Moscow’s superior manpower, weaponry, and air support, the ragtag Chechen guerrillas fought Yeltsin’s mighty Russian army to a bloody, embarrassing stalemate.

By late 1995, Russian forces were utterly demoralized. That, along with a Russian public still smarting from the Afghanistan disaster and deeply opposed to the present conflict, led Yeltsin’s government to declare a ceasefire at the end of the following year.

Putin had been watching the debacle from afar, and it ground away at him. During most of the conflict, he was just another minor political figure in St. Petersburg, far removed from Kremlin politics. But he was filled with ambition and had already set his sights on higher office. To that end, he gathered together a circle of close confidants and in 1996 moved to Moscow, where a former colleague had invited him to join the Yeltsin administration.

Surrounding himself with loyal supporters was a shrewd strategy, or it might have been simply a matter of caution, given the hazards of Russian politics. Either way, it insulated him from potential enemies and would give him an unassailable base when he later moved to consolidate power.

Later came soon.

By 1998, Vladimir Putin – a formerly-obscure, low-level KGB agent – had become an ascendant political star to whom Yeltsin had taken a liking. First, in July 1998, Yeltsin had installed him as head of the Federal Security Service (FSB, successor to the KGB). Then, barely a year later, he appointed Putin to the office of prime minister.

In retrospect, it seems a meteoric rise. At the time, though, no one thought much of Putin. After all, he was Yeltsin’s sixth prime minister in eight years; it was a dead-end job. The new guy wasn’t expected to last longer than any of his predecessors.

Not for the last time, Putin was badly underestimated.

Becoming prime minister immediately drew Putin into the Chechen fray, which had heated up again. But rather than see it as a hopeless mess, he saw an opportunity to prove how different he was from the indecisive Yeltsin, whom he already felt confident he could replace. And the first milestone on that path was to engineer an ending very different from the first Chechen conflict.

Which he did.

In late September of 1999, newly-installed Prime Minister Putin ordered Russian warplanes to strike the Chechen capital of Grozny. A week later, Russian armored battalions that had been amassed on the border for months rolled across it. The Second Chechen War was on.

This time around, following a scorched-earth strategy, the Russian military turned its weapons on civilian targets. To avoid a repeat of the heavy Russian casualties sustained in the First Chechen War, they advanced slowly and in overwhelming force, using artillery and air power to soften Chechen defenses. Nearly 300,000 of Chechnya’s 800,000 civilians fled from the Russian advance and sought refuge in neighboring Russian republics.

The early success of the campaign in Chechnya positioned Putin perfectly for the stunner that came next: On December 31, 1999, Boris Yeltsin – whose approval rating had fallen to single digits – abruptly resigned. As provided in the Russian constitution, Prime Minister Putin succeeded Yeltsin and became acting president. Putin had jumped from an appointment as head of the FSB in July 1998 to an appointment as prime minister barely a year later, and then to acting president three months after that. It was an astonishing rise, unprecedented in Russian political history.

Had Putin expected to move so far so fast? Was it all planned? Of course we can’t know. But whether it happened mostly by design or mostly by chance, we can see that he played carpe diem masterfully.

He knew the kind of leader Russians had been pining for, so he gave priority to advancing his persona as the fearless tough guy. The one who pushed the take-no-prisoners approach in Chechnya. The one who would leave the president’s office to fly into the war zone to express his support of, and solidarity with, the troops. That was something Yeltsin never would have done.

The Russian people notice shows of strength, and they like them.

In an August 1999 poll, Putin had garnered less than 2 percent support as a presidential candidate despite (or perhaps because of) Yeltsin’s backing. By the time Election Day arrived in March 2000, his situation had changed entirely. Putin faced a lot of opposition. But none of the other candidates had a prayer. Russian troops had captured Grozny in February and the lightning victory in Chechnya was fresh in people’s minds. Putin was riding a wave of popularity. He took 53 percent of the vote and became president.

The reign of Vladimir Putin had begun. Like Peter the Great, the historical figure he most admired, he vowed to restore his country as a power of consequence. He knew that it wasn’t going to happen easily. But he believed he had been endowed with all the right qualities to bring it off: physical stamina, a keen intellect, a deep understanding of the ways of politics in the real world (and the role that energy plays), and an unwavering boldness of vision. It was time to tighten his hold on power by dealing with his enemies.

Next in Putin’s sights: the oligarchs.

Marin Katusa’s The Colder War is available here.

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Important Disclosures

The article Outside the Box: The Colder War was originally published at mauldineconomics.com.

Things That Make You Go Hmmm: This Little Piggy Bent The Market

 

About 18 months ago, I had a very pleasant chat with a gentleman by the name of Luzi Stamm.

You may detect some measure of surprise in my words, and the reason for that is quite simple: Luzi Stamm is a politician; and, as regular readers will know, I am no fan of that particular class.

But Herr Stamm was different.

An MP representing the Swiss People’s Party, Stamm was spearheading a federal popular initiative which needed 100,000 signatures in order to comply with the Swiss parliamentary system’s rigid framework regarding referendums. (OK all you “referenda” people out there, I know, OK? But I’m going with “referendums,” so pipe down).

That initiative was one of three being pursued: firstly, a motion to limit immigration into Switzerland to 0.2% per year; secondly, a drive to abolish the flat tax system and for resident, nonworking foreigners to be taxed based instead on their income and their assets; and thirdly, Stamm’s initiative… Well, we’ll get to that shortly; but before we do, we need to understand a little about how Swiss democracy works.

(Wikipedia): Switzerland’s voting system is unique among modern democratic nations in that Switzerland practices direct democracy (also called semi-direct democracy), in which any citizen may challenge any law approved by the parliament or, at any time, propose a modification of the federal Constitution. In addition, in most cantons all votes are cast using paper ballots that are manually counted. At the federal level, voting can be organised for:

Elections (election of the Federal Assembly)

Mandatory referendums (votation on a modification of the constitution made by the Federal Assembly)

Optional referendums (referendum on a law accepted by the Federal Assembly and that collected 50,000 signatures of opponents)

Federal popular initiatives (votation on a modification of the constitution made by citizens and that collected 100,000 signatures of supporters)

Approximately four times a year, voting occurs over various issues; these include both referendums, where policies are directly voted on by people, and elections, where the populace votes for officials. Federal, cantonal and municipal issues are polled simultaneously, and the majority of people cast their votes by mail. Between January 1995 and June 2005, Swiss citizens voted 31 times, to answer 103 questions (during the same period, French citizens participated in only two referendums)

In Swiss law, any popular initiative which achieves the milestone of 100,000 signatures MUST be put to the citizens of the country as a referendum, and in a country of just 8,061,516 people (according to the July 2014 count — never let it be said that the Swiss aren’t precise), that’s a pretty big ask; but the Swiss do love their votes — so much so that, since 1798, there has been a seemingly never-ending procession of issues which the Swiss people have been entrusted by their leaders to decide: 

In 2014 alone there have already been three referendums concerning such diverse issues as the minimum wage, abortion, and the financing and development of railway infrastructure. (For those of you just dying to know the outcomes, the abortion referendum, which would have dropped abortion coverage from public health insurance, failed by a large margin, with about 70% of participating voters rejecting the proposal. The railway financing was approved by 62% of the voters, and the motion that would have given Switzerland the highest minimum wage in the world — 22 francs ($23.29) an hour — was soundly defeated, with 76% of the voters saying “nein.”)

One wonders what the outcome would be of a similar motion to hike the minimum wage to such lofty heights in the US. Or in Great Britain.

The bottom line? The Swiss just think (and, importantly, vote) differently.

But back to Luzi Stamm and the SPP initiative.

Immigration and taxes aren’t uppermost in Stamm’s mind. What he IS concerned about is gold.

When we spoke on the telephone last year, Stamm explained to me that he hadn’t really properly understood the part gold played in the Swiss monetary equation until he’d had it explained to him by a friend more versed in finance (Stamm is a lawyer by background but with an economics degree from the University of Zurich); but once he understood how it all worked, Stamm realized that the changes to Swiss monetary prudence which had occurred in just a few short years were (a) potentially disastrous for the country and (b) not remotely understood by his countrymen (and women).

So Stamm decided he ought to do something about it.

The Swiss had accumulated a significant gold reserve the old-fashioned way — through seemingly constant current account surpluses — over many decades, but in May 1992 they finally joined the IMF.

Once THAT little genie was unleashed, things began to change.

In November of 1996, the Swiss Federal Council issued a draft for a new Federal Constitution, and contained within that draft was an amended position on monetary policy (article 89, in case you’re wondering) which severed the Swiss franc’s link to gold and reaffirmed the SNB’s constitutional independence:

Money and currency are a federal matter. The Confederation shall have the exclusive right to coin money and issue banknotes.

As an independent central bank, the Swiss National Bank shall follow a monetary policy which serves the general interest of the country; it shall be administered with the cooperation and under the supervision of the Confederation.

The Swiss National Bank shall create sufficient monetary reserves from its profits.

At least two-thirds of the net profits of the Swiss National Bank shall be credited to the Cantons.

Spiffy.

In April 1999, the revision of the Federal Constitution was approved (how else than through a referendum?), and it came into effect on January 1, 2000.

Oh… sorry… I almost forgot to mention that in September 1999 — after the revision had been adopted but before it had been officially enacted — the SNB became one of the signatories to the Washington Agreement on Gold Sales, meaning that all that lovely Swiss gold which had been sitting there, steadily accumulating and making the Swiss franc one of the last remaining “hard” currencies on the planet, was eligible to be sold.

A single line in the Swiss National Bank’s own history of monetary policy identifies the beginning of the demise of one of the world’s great currencies:

On 2 May, the SNB begins selling gold holdings no longer required for monetary policy purposes.

And there you have it. “No longer required for monetary policy purposes.”

That’s what happens when you finally embrace the beauty of fiat. Not only do you get to sell gold, you get to call the proceeds of those sales “profits.”

The absurdity borders on breathtaking.

At the beginning of 2000, the Swiss National Bank (SNB) held roughly 2,600 tonnes of gold in its reserves. That equated to approximately 8% of total global central bank gold reserves. After the revised constitution became law, the Washington Agreement took over and… Bingo!:

Swiss gold reserves were plundered gently sold in line with the Washington Agreement, and the “profits” (the language used by the SNB themselves) were distributed amongst the Swiss cantons; so everybody in a position to raise questions ended up getting a nice, fat slug of “profit” to keep them quiet help their Canton pay the bills.

Now, does anyone notice anything particular about the period when the Swiss gold sales were at their highest? Yessss… that’s right (as with the UK’s sales), the bulk of Swiss sales were made at the lows in the gold price (between $300 and $500 per ounce — blue shaded area).

To look at it another way, the Swiss National Bank went from being one of the soundest central banking institutions on Earth to just another in the morass of apologist financial institutions that lost sight of their mandates while grasping for a Keynesian free lunch, egged on by a new breed of politicians who knew nothing of the principles of sound money or, if they did, were happy to put them to the back of their minds as they extended their hands.

Sadly, as went the soundness of the SNB, so went the soundness of the Swiss franc itself.

As you can see from the chart above, the SNB has, over the last two decades, oustripped its nearest rival in gold sales by a factor of three.

Adding to the fun and games was the decision in September 2011, at the height of the euro crisis, to peg the Swiss franc to the euro (something that obviously couldn’t have been done prior to breaking the gold peg) in order to stop it appreciating.

How? Why through literally unlimited printing of Swiss francs to stop the exchange rate breaking 1.20.

At the time, the SNB was unequivocal:

The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. The Swiss National Bank is therefore aiming for a substantial and sustained weakening of the Swiss franc.

All this talk of “massive overvaluation of the Swiss franc” is utter bollocks a little disingenuous. (“Surely not!” I hear you cry.)

Between 1970 and 2008, the strength of the Swiss franc was legendary. During that time, it appreciated by 330% against the US dollar and by 57% versus the Deutsche mark/euro. Consequently, a strong currency went hand-in-hand with a strong economy. How awful.

The problem was NOT in the OVERvaluation of the Swiss franc, as the SNB would have you believe, but rather in the UNDERvaluation of the competition; and the only thing the SNB could do was to join in the great devaluation race.

That move weakened the currency by about 9% in 15 minutes, and the immediate effect on the SNB’s balance sheet was obvious:

 

(Mitsui Global Precious Metals): As late as the end of 2009, the SNB held 38.1 billion CHF in gold out of total reserves of 207.3 billion CHF, with gold representing a touch over 18 per cent of all its reserves. At the end of July 2014, it owned 39.1 billion Swiss Francs in gold (or 1,040 tonnes) from total reserves of 517.3 billion CHF, meaning that roughly 7.6 per cent of its assets were in the form of the yellow metal.

 

Note that the rise in value of Swiss gold by CHF 1 billion wasn’t enough to counter the destructive nature of overt and unchecked money printing.

Like the Fed, the BoJ, and the BoE before them, the SNB became, at a stroke, another previously sound institution that unhesitatingly ripped its balance sheet to shreds:

Since 2009, the SNB has quintupled its balance sheet, making it (on a relative basis) the most prolific of the central bank printing machines. Not bad for the world’s 96th-largest nation.

Since the EUR peg was instituted just three years ago, the SNB’s balance sheet has more than doubled.

So, with the Swiss franc’s soundness under attack from within its own borders, Luzi Stamm decided to try to use the Swiss love for referendums and the rigidity of the Swiss political process to try to reinstate the Swiss franc as a sound currency.

To that end, Stamm proposed the Swiss Gold Initiative (“Save Our Swiss Gold”).

Funnily enough, the proposal was rejected by lawmakers, but Stamm gathered three like-minded MPs and, more importantly, enough signatures on his petition (100,000) to ensure that a referendum on the proposal would take place; and that vote will happen on November 30th — six weeks from now.

Stamm pulled off a masterstroke in securing the involvement in the Swiss Gold Initiative of Egon von Greyerz who, along with being one of the most highly respected figures in the gold industry, happens to be one of the world’s nicest human beings.

We’ll get to Egon’s involvement shortly, but first let’s take a look at the motions that make up the Swiss Gold Initiative, which are threefold:

1. The gold of the Swiss National Bank must be stored physically in Switzerland.
2. The Swiss National Bank does not have the right to sell its gold reserves.
3. The Swiss National Bank must hold at least 20% of its total assets in gold.

(NB. Before we get to the part of this story where the SNB tell us how big a nightmare it would be to force them to hold 20% of their reserves in gold (come on, you KNEW that was coming), I’d point you back to the chart on page 8. Remember? The one that showed the Swiss held 18% of their reserves in gold just five short years ago?)

Click here to continue reading this article from Things That Make You Go Hmmm… – a free newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore.

Thoughts from the Frontline: A Scary Story for Emerging Markets

 

The consequences of the coming bull market in the US dollar, which I’ve been predicting for a number of years, go far beyond suppression of commodity prices (which in general is a good thing for consumers – but could at some point threaten the US shale-oil boom). The all-too-predictable effects of a rising dollar on emerging markets that have been propped up by hot inflows and the dollar carry trade will spread far beyond the emerging markets themselves. This is another key aspect of the not-so-coincidental consequences that we will be exploring in our series on what I feel is a sea change in the global economic environment.

I’ve been wrapped up constantly in conferences and symposia the last four days and knew I would want to concentrate on the people and topics I would be exposed to, so I asked my able associate Worth Wray to write this week’s letter on a topic he is very passionate about: the potential train wreck in emerging markets. I’ll have a few comments at the end, but let’s jump right into Worth’s essay.

A Scary Story for Emerging Markets

By Worth Wray

“The experience of the [1990s] attests that international investors have considerable resources at their command in the search for high returns. While they are willing to commit capital to any national market in large volume, they are also capable of withdrawing that capital quickly.”
– Carmen & Vincent Reinhart

“Capital flows can turn on a dime, and when they do, they can bring the entire financial infrastructure [of a recipient country] crashing down.”
– Barry Eichengreen

“The spreading financial crisis and devaluation in July 1997 confirmed that even economies with high rates of growth and consistent and open economic policies could be jolted by the sudden withdrawal of foreign investment. Capital inflows could … be too much of a good thing.”
– Miles Kahler

In the autumn of 2009, Kyle Bass told me a scary story that I did not understand until the first “taper tantrum” in May 2013.

He said that – in additon to a likely string of sovereign defaults in Europe and an outright currency collapse in Japan – the global debt drama would end with an epic US dollar rally, a dramatic reversal in capital flows, and an absolute bloodbath for emerging markets.

Extending that outlook, my friends Mark Hart and Raoul Pal warned that China – seen then by many as the world’s rising power and the most resilient economy in the wake of the global crisis – would face an outright economic collapse, an epic currency crisis, or both.

All that seemed almost counterintuitive five years ago when the United States appeared to be the biggest basket case among the major economies and emerging markets seemed far more resilient than their “submerging” advanced-economy peers. But Kyle Bass, Mark Hart, and Raoul Pal are not your typical “macro tourists” who pile into common-knowledge trades and react with the herd. They are exceptionally talented macroeconomic thinkers with an eye for developing trends and the second- and third-order consequences of major policy shifts. On top of their wildly successful bets against the US subprime debacle and the European sovereign debt crisis, it’s now clear that they saw an even bigger macro trend that the whole world (and most of the macro community) missed until very recently: policy divergence.

Their shared macro vision looks not only likely, not only probable, but IMMINENT today as the widening gap in economic activity among the United States, Europe, and Japan is beginning to force a dangerous divergence in monetary policy.

In a CNBC interview earlier this week from his Barefoot Economic Summit (“Fed Tapers to Zero Next Week”), Kyle Bass explained that this divergence is set to accelerate in the next couple of weeks, as the Fed will likely taper its QE3 purchases to zero. Two days later, Kyle notes, the odds are high that the Bank of Japan will make a Halloween Day announcement that it is expanding its own asset purchases. Such moves only increase the pressure on Mario Draghi and the ECB to pursue “overt QE” of their own.

Such a tectonic shift, if it continues, is capable of fueling a 1990s-style US dollar rally with very scary results for emerging markets and dangerous implications for our highly levered, highly integrated global financial system.

As Raoul Pal points out in his latest issue of The Global Macro Investor,The [US] dollar has now broken out of the massive inverse head-and-shoulders low created over the last ten years, and is about to test the trendline of the world’s biggest wedge pattern.”

One “Flight to Safety” Away from an Earth-Shaking Rally?
(US Dollar Index, 1967 – 2014)

For readers who are unfamiliar with techical analysis, breaking out from a wedge pattern often signals a complete reversal in the trend encompassed within the wedge. As you can see in the chart above, the US Dollar Index has been stuck in a falling wedge pattern for nearly 30 years, with all of its fluctuations contained between a sharply falling upward resistance line and a much flatter lower resistance line.

Any break-out beyond the upward resistance shown above is an incredibly bullish sign for the US dollar and an incredibly bearish sign for carry trades around the world that have been funded in US dollars. It’s a clear sign that we may be on the verge of the next wave of the global financial crisis, where financial repression finally backfires and forces all the QE-induced easy money sloshing around the world to come rushing back into safe havens.

Let me explain…

The EM Borrowing Bonanza

As John Mauldin described in his recent letter “Sea Change,” the state of the global economy has radically evolved in the wake of the Great Recession.

Against the backdrop of extremely accommodative central bank policy in the United States, the United Kingdom, and Japan and the ECB’s “whatever it takes” commitment to keep short-term interest rates low across the Eurozone, global debt-to-GDP has continued its upward explosion in the years since 2008… even as slowing growth and persistent disinflation (both logical side-effects of rising debt) detract from the ability of major economies to service those debts in the future.

Global Debt-to-GDP Is Exploding Once Again
(% of global GDP, excluding financials)

*Data based on OECD, IMF, and national accounts data.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

As John Mauldin and Jonathan Tepper explained in their last book, Code Red, monetary policies have fueled overinvestment and capital misallocation in developed-world financial assets…

Developed World Financial Assets Still Growing
(Composition of financial assets, developed markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

… but the real explosion in debt and financial assets has played out across the emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on top of a massive USD-funded carry trade.

Emerging-Market Financial Assets Have Nearly DOUBLED Since 2008
(Composition of financial assets, emerging markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

These QE-induced capital flows have kept EM sovereign borrowing costs low…

… and enabled years of elevated emerging-market sovereign debt issuance…

… even as many those markets displayed profound signs of structural weakness.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

Outside the Box: Hoisington Investment Management Quarterly Review and Outlook: Third Quarter 2014

 

I featured the thinking of Dr. Lacy Hunt on the velocity of money and its relationship to developed-world overindebtedness and the potential for deflation in this week’s Thoughts from the Frontline, and I thought you’d like to peruse Lacy’s entire recent piece on the subject.

Lacy takes the US, Europe, and Japan one by one, examining the velocity of money (V) in each economy and bolstering the principle, first proposed by Irving Fisher in 1933, that V is critically influenced by the productivity of debt. Then, turning to the equation of exchange (M*V=Nominal GDP, where M is money supply), he demonstrates that we shouldn’t be the least bit surprised by sluggish global growth and had better be on the lookout for global deflation.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I am writing this note in a car going to Athens, Texas, where I’ll join Kyle Bass and friends at his Barefoot Ranch for a huge macro fest. October is one of my favorite times of the year to be in Texas, and the ranch is a beautiful venue. I am sure I will have some challenging conversations.

Last night in Chicago I was picked up by Austyn Crites, who drove me downtown in rush-hour traffic, which gave us a lot of time to talk about his current passion, high balloons. I have been fascinated with them for some time, but there hasn’t been a lot of reliable information.

Basically, Google and Facebook are both planning to launch very large helium balloons full of radios and cameras and float them up to 60,000+ feet. The concept is working in several remote locations now. It’s a way to get full wireless internet coverage. With about 40,000 balloons you can blanket the earth. Literally. Full connectivity. Everywhere. Austyn wants to design a new type of balloon and be the manufacturer. It’s tricky as you need a VERY thin balloon envelope (that does not leak) the size of small house in order to get enough payload that high.

But he thinks the final cost of the balloons will fall dramatically and that you might be able eventually to pull off the operation for a billion or so a year (since balloons eventually come down and need to be replaced).

But if you are Google and you get the search revenue from connecting an additional five billion people? Chump change. Same for Facebook. But what if Apple or Samsung want to make it so that their phones are afforded free or very cheap access? A consortium of consumer companies could easily see free wifi as a tool for branding. Current telecoms will have to get in the business to compete.

I kept coming back to the costs and tech issues. There are new things that will have to be invented, but nothing as complex as some of the problems that have already been overcome. They will be rolling out in parts of the world in a few years. Coming to a region near you in 5-10 years. Total game changers. While a hundred other game changers are coming down the tunnel.

Austyn’s company’s challenge is to be the little guys who don’t know they can’t invent a new process that the big guys are working on as well. Can he pull it off? He has the passion and drive. I love meeting young people like him doing their part to change the world. They are everywhere, too. It’s why I’m optimistic about the future of the human experiment, if just a tad bearish on governments. You can follow Austyn at his website.

Time to hit the send button, as we are getting close and I don’t want to miss a minute. I will report back what I can. Have a great week.

Your dreaming of really, really cheap, ubiquitous connectivity everywhere analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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Hoisington Investment Management – Quarterly Review and Outlook, Third Quarter 2014

Faltering Momentum

The U.S. economy continues to lose momentum despite the Federal Reserve’s use of conventional techniques and numerous experimental measures to spur growth. In the first half of the year, real GDP grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such increases are insufficient to raise the standard of living, which, as measured by real median household income, stands at the same level as it did seventeen years ago (Chart 1).

Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250%-275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, well above the critical level noted in various economic studies.

In terms of growth, it looks as if the second half of 2014 will continue to follow this slow growth pattern. Although all of the data has not yet been reported, it appears that the year-over-year growth in real GDP for the just ended third quarter period is unlikely to exceed the 2.2% pace of the past five years. Economic vigor is absent, and the final quarter of the year looks to be weaker than the third quarter.

Poor domestic business conditions in the U.S. are echoed in Europe and Japan. The issue for Europe is whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question is the degree of the erosion in economic activity. This is for an economy where nominal GDP has been unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the U.S. stands at 334%, compared with 460% in the 17 economies in the euro-currency zone and 655% in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by the real world data.

Falling World Wide Inflation

In this debt-constrained environment, it is not surprising that inflation is receding sharply in almost every major economy, including China. The drop in price pressures in the U.S. and Europe is significant, and the fall in Chinese inflation to 2%, from a peak of nearly 9% in 2008, is notable.

In the latest twelve months, the CPI in the euro currency zone rose a scant 0.3% (Chart 2), the lowest since 2009, while the core CPI increased by 0.7%, near the all time lows for the series. The yearly gain in the U.S. for both core and overall CPI was 1.7%. Since 1958 when the core CPI came into existence, it and the overall CPI have increased at an average annual rate of 3.8% and 3.9%, respectively, over 200 basis points greater than the current rates. Both the overall and core personal consumption expenditures U.S. price indices rose by 1.5% in the twelve months ending August of 2014. Both of these are near the all time lows for their respective series.

The risk of outright deflation in Europe with inflation at such low levels, and the danger of similar developments in the U.S., should not be minimized as inflation has fallen in almost every previous U.S. and European economic contraction. Lower inflation is, in fact, almost as much of a hallmark of recessions as is decreasing real GDP. From peak-to-trough the rate of CPI inflation fell by an average of slightly more than 300 basis points in and around the mild U.S. recessions of 1990-91 and 2000-01. Starting from a much lower point, the CPI in Europe at those same times dropped by an average of 150 basis points. Given that inflation is already so minimal in both the U.S. and Europe, even the mildest recession could put both economies in deflation.

Japan’s recent quantitative easing has helped devalue its currency by 44% versus the dollar, since the 2011 lows. This import- dependent country has therefore seen its costs rise dramatically. This, along with higher consumption taxes, has created a current year- over-year inflation rate of 3.3%. These higher prices are an enormous drag on economic growth as incomes fail to rise commensurately. Thus negative GDP growth will result in a continuing pattern of deflation. Japan’s CPI has been zero or negative on a year-over-year basis in 16 of the last 23 quarters.

Declining Money Velocity A Global Event

One factor that connects poor growth with the low inflation and low bond yields evident in the U.S., Europe and Japan is that the velocity of money (V) is falling in all three areas.

Functionally, many things influence V. The factors that could theoretically influence V in at least some minimal fashion are too numerous to count. A key variable, however, appears to be the productivity of debt. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then V will rise since GDP will rise by more than the initial borrowing. If the debt is unproductive or counterproductive, meaning that a sustaining income stream is absent, or worse the debt subtracts from future income, then V will fall. Debt utilized for the purpose of consumption or paying of interest, or debt that is defaulted on will be either unproductive or counterproductive, leading to a decline in V.

The Nobel laureate Milton Friedman, as well as economist Irving Fisher, commented on the causal determinants of V. Friedman thought V was stable while Fisher believed it was variable. Presently, the evidence suggests that Fisher’s view has prevailed. Fisher would not be at all surprised by the current impact of excessive debt since he argued in his famous 1933 paper “The Debt-Deflation Theory of Great Depressions”, that falling money velocity is a symptom of extreme over-indebtedness.

Tracking that theory, it is interesting to note that velocity is below historical norms in all three major economic areas with existing over indebtedness. The U.S. V is higher than European V, which in turn is higher than Japanese V. This pattern is entirely consistent since Japan is more highly indebted than Europe, which is more highly indebted than the U.S. Unfortunately, broad monetary conditions (M2 money growth and velocity) are deteriorating, with 2014 displaying conditions worse than at the end of last year. The poor trend in the velocity for all three areas indicates that monetary policy for these countries is not a factor in influencing economic activity in any meaningful way.

United States. The U.S. year-over-year M2 growth has remained at about 6%, an annual growth level that has been consistent since 2008 (Chart 3), and the velocity of money has trended downward by about 3%. In the first half of 2014, V declined at a rate of 3.6%, but it is still too early to tell if this represents a new V deceleration to the downside (Chart 4).

According to the equation of exchange (M*V=Nominal GDP), the expected growth of nominal GDP is constrained to no more than a 3% increase with velocity declining by 3% and money supply expanding by 6%. However, when assessing the type of debt currently being employed (unproductive, at best) the risks are for lower growth levels. 2014 has witnessed a resurgence of consumer auto and mortgage lending that was achieved by a lowering of credit standards. The percentage of subprime consumer auto loans (31%) returned to the peak levels reached prior to 2008. Such lending has historically turned counterproductive. If this were to occur again, velocity would accelerate to the downside, resulting in a sub 3% path for nominal GDP.

Europe. V has only been available in Europe since 1995 as that is the starting date for GDP in the euro-currency zone. During the span from 1995 through 2013, V averaged 1.4, dropping from a peak of about 1.7 in 1995 to 1.03 in 2013 (Chart 5). Over that span, therefore, euro V has been trending lower at about a 2.6% per annum rate. On the money side, euro M2 increased by 2.4% in 2013, which is weaker than the average growth in the last four years (Chart 6). If the trend rate of decline in V remains intact, then nominal GDP in the euro zone could be flat. Inflation of any magnitude would result in a negative real GDP outcome.

Japan. From the start of the comparable M2 and nominal GDP statistics in 1969 in Japan, V in Japan has averaged 1.0, dropping from 1.54 in 1968 to a record low of 0.57 in the latest year (Chart 7). Thus, over this period V was falling at an average rate of 2.2% per annum. M2 in Japan increased 3.6% in 2013, which is slightly higher than the growth rate of recent years (Chart 8). If V’s downward trend remains intact, nominal GDP would be estimated to grow by 1.2%. However, inflation is currently running at 3.3%, suggesting real GDP could decline by over 2% in the next twelve months. This circumstance illustrates the double-edged sword caused by a sharply depreciating currency. The weaker yen boosts exports but raises domestic inflation. Japanese inflation is already exceeding the rise in wages and household spending. These events are consistent with a contraction in economic activity and are the expectation derived from the analysis of money growth and its velocity.

Debt Research

Important new research by four distinguished economists (three in Europe and one in the U.S.) is contained in a report titled “Deleveraging? What Deleveraging?” (Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, Geneva Reports on the World Economy 16, September 2014). It provides additional evidence on the role of “debt dynamics” and the state of the global debt overhang. They write, “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.” Further, it is a “poisonous combination” when world growth and inflation are lower than expected and debt is rising. “Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown.”

This research also identifies two other highly significant trends. First, global debt accumulation was led by developed economies until 2008. Second, the debt build-up since 2008 has been paced by the emerging economies. The authors write that the rise in Chinese debt is especially “stunning”. They describe China as “between a rock (rising and high debt) and a hard place (lower growth).” In addition to China they identify India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa as belonging to the “fragile eight” group of countries that could find themselves in the unwanted role of host to “the next leg of the global leverage crisis.”

We interpret this research to mean that the monetary policy may begin to become ineffective at emerging market central banks, just as has happened in the U.S., Europe and Japan. Weaker growth conditions in the emerging markets are thus likely to accentuate, rather than ameliorate, poor business conditions in the major economies. Indeed, this year’s downturn in global commodity prices is consistent with the beginning of such a phase. The huge jump in emerging market debt is also significant because research has found the severity of economic contractions is directly related to the leverage in the prior expansion.

Asset Bubbles

Historically, in our judgment, the most important authority on the subject of asset bubbles was the late MIT professor Charles Kindleberger, author of 20 books including the one of the greatest books on capital markets Manias, Panics and Crashes (1978). He found that asset price bubbles depend on the growth of credit. Atif Mian (Princeton) and Amir Sufi (University of Chicago) provided confirmation for Kindleberger’s pioneering work and expanded on it in their 2014 book House of Debt. Chapter 8, entitled “Debt and Bubbles,” contains the heart of their insights. Mian and Sufi demonstrate that increasing the flow of credit is extremely counterproductive when the fundamental problem is too much debt, and excessive debt can fuel asset bubbles.

Based on our reading of these two books we would define an asset bubble as a rise in prices that is caused by excess central bank liquidity rather than economic fundamentals. As Kindleberger clearly stated, the process of excess liquidity fueling higher prices in the face of faltering fundamentals can run for a long time, a phase Kindleberger called “overtrading”. But eventually, this gives way to “discredit”, when the discerning few see the discrepancy between prices and fundamentals. Eventually, discredit yields to “revulsion”, when the crowd understands the imbalance, and markets correct.

Economists have commented on the high correlation between the S&P 500 and the Fed’s balance sheet since 2009. From 2009 to the latest available month, the monetary base (MB) surged from $1.7 trillion to $4.1 trillion. We ran the MB increase against the S&P 500 and found a very high correlation of 0.69. While correlation does not prove causality, the high correlation is certainly not inconsistent with the idea that the Fed liquidity played a major role in boosting stock prices. However, even as the MB has exploded since 2009 and stock prices have soared, the U.S. economy has experienced the worst economic expansion on record. In spite of a further large rise in the base this year, the GDP growth has subsided noticeably and corporate profits after taxes and adjusted for inventory gains/losses (IVA) and over/under depreciation (CCA) has declined 10% in the latest four quarters. Such discrepancy between the liquidity implied by the base and measures of economic performance could indicate the process of bubble formation. Kindleberger’s axiom that asset price bubbles depend on excess liquidity may yet face another test.

Still Bullish on Treasury Bonds

With the nominal growth trajectory extremely soft, U.S. Treasury bond yields are likely to continue working lower as similar circumstances have created declines in government bond yields in Europe and Japan. Viewing the yields overseas, it is evident that ample downside still exists for long U.S. Treasury bond yields, as the higher U.S. yields offer global investors an incentive to continue to move funds into the United States.

Another factor suggesting lower long- term U.S. Treasury yields is the strength of the U.S. dollar. In many industries, the price leader for certain goods in the U.S. is a foreign producer. A rising dollar leads to what economists sometimes call the “collapsing umbrella”. As the dollar lifts, the foreign producer cuts U.S. selling prices, forcing domestic producers to match the lower prices. This reinforces the prospect for lower inflation as nominal GDP wanes. This creates a favorable environment for falling U.S. Treasury bond yields.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

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Important Disclosures

Thoughts from the Frontline: The Flat Debt Society

 

International Monetary Fund chief Christine Lagarde says the global economy is facing “the risk of a new mediocre, where growth is low and uneven.”…  Lagarde said Europe’s 18-nation bloc that uses the euro currency – collectively the world’s biggest economy – is facing the “not insignificant” risk of falling back into a recession. (VOA News)

Since at least the beginning of 2006, the most asked question I get after a speech is “Do you think we will have inflation or deflation?” In an attempt at humor, my answer has been “Yes.” I go on to try to explain that we are in a deflationary environment, but eventually we will see inflation. When QE1 was announced, there were many pundits (none of the Keynesian variety) who immediately said the risk was for significant inflation, and there were even those (like Peter Schiff) who talked of hyperinflation and the demise of the dollar. Interest rates would rise, and US government bonds would collapse.

My response at the time was that the Federal Reserve would print more money than any of us could possibly imagine (and who imagined $3+ trillion?), and we would not see any inflation. My reasoning was that we were in a deleveraging world where the velocity of money was clearly falling. I explained – once again – the relationship between inflation and the velocity of money.

Beginning with last week’s letter, “Sea Change,” my answer to that question for the foreseeable future will be simply, “Deflation.” In Endgame Jonathan Tepper and I described the economic environment of a deleveraging world, especially that of Europe. In Code Red we described the coming world of currency wars, with Japan having fired the first shot. Sadly, we continue to see the themes of those books play out in the real world.

Over the coming months we are going to explore the implications of a rising dollar for equity markets, global trade, commodity prices (especially oil), interest rates, and Federal Reserve policy, just to mention a few of the areas that will be impacted as global currency flows shift and protectionism is on the rise. Not all markets and governments will be affected in the same way, and there will be any number of opportunities for investors who are willing to think outside of the status quo.

In this week’s letter we’re going to explore some of the implications of deflation. We will start with an internal client letter from my friend Charles Gave that deserves to be shared. Then we’ll explore a few thoughts on the velocity of money. I should note that I am deeply indebted to Dr. Lacy Hunt for my understanding of the velocity of money. To the extent I get things right it is because of his frequent and long-suffering help, and if I get something wrong it’s because I didn’t understand the things he said correctly or couldn’t communicate them properly. These two men, both of whom I think of as mentors and statesmen, have had a huge impact on my thinking. The fact that they both talk with deeply resonating basso profundo voices that remind me of the voice of God in a movie soundtrack may have something to do with that impact! In any case, it lends an air of authority to their musings. Charles even has the long flowing white hair. (Thanks to David Hay for sending me the following note from Charles.)

The Return of the XIX Century Panic?

The readers may have noticed that for the last few months, I have almost never written on economic activity, monetary policy or inflation. Most of my writings and presentations have been on one topic and only one, how to construct an “antifragile” portfolio to use the terminology coined by Nassim Taleb. For me, the monetary policy followed by the central banks had to lead to a collapse in the velocity of money, and from there to deflation.  

My recommendation was thus to hedge any equity positions with a long-dated US zero. So far so good.

Let me hazard for the first time in quite a while a prognosis on the future of ‘economic activity’ in the US. In the 19th century, which was deflationary most of the time, we did not move from a recession to a bear market, but from a bear market, called a “panic” at the time, to a recession. Let me explain.

When there is no inflation [see my notes below – John], the choices are between a deflationary boom and a deflationary bust. And the sober reality is that we move from one to the other only when the stock market crashes. What create the recession are not excess inventories or capital spending as in an inflationary period but the collapse in asset prices which had been pumped up by the general mood of optimism. 

[Reread that paragraph at least a few times. We’re going to explore this concept further.]

Since we had plenty of debts attached to the prices of those assets, margin calls came in, and from there we moved to a true collapse in the velocity of money, accompanied more often than not by banks going belly up (see Barings with Argentina for a good example).

I have absolutely no doubt that trillions of dollars must have been borrowed one way or the other to play the rise in asset prices engineered by the central banks. Similarly, I have no doubt that huge amounts must have been borrowed to develop new sources of energy and that the break-even price for these new sources is probably being reached as I write. [Emphasis mine.]

To use my usual Wicksellian analysis, it is probable that the market rate is moving very quickly ABOVE the natural rate. If it were not, bonds would have no reason to outperform equities as they have for the last 12 months….

If I am right, it implies that a recession may be arriving and this recession should be preceded by a genuine collapse in bank shares, where most of the bad debt is probably parked and the bank shares are underperforming big time. The good news [is] of course that we are arriving at the end of one of the stupidest periods in economic history; the bad news is that asset prices will have to adjust to the new reality.

I maintain what I have said for a long time: No negative cash flows. No big debts. Hedge with government bonds.

The Velocity Trap

Hold those thoughts for a moment, as we need to explore the velocity of money a little further before looking at the implications of what Charles is telling us.

The St. Louis Fed defines the velocity of money as “the frequency at which one unit of currency is used to purchase domestically produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time.”

Irving Fisher gave us the famous Fisher Equation of Exchange. Reduced to its most simple form, it comes out as P=MV, where P is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing P by M. By the way, this is known as an identity equation. It is true at all times and all places, whether in Greece or the US.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

Important Disclosures

Thoughts from the Frontline: The Flat Debt Society

 

International Monetary Fund chief Christine Lagarde says the global economy is facing “the risk of a new mediocre, where growth is low and uneven.”…  Lagarde said Europe’s 18-nation bloc that uses the euro currency – collectively the world’s biggest economy – is facing the “not insignificant” risk of falling back into a recession. (VOA News)

Since at least the beginning of 2006, the most asked question I get after a speech is “Do you think we will have inflation or deflation?” In an attempt at humor, my answer has been “Yes.” I go on to try to explain that we are in a deflationary environment, but eventually we will see inflation. When QE1 was announced, there were many pundits (none of the Keynesian variety) who immediately said the risk was for significant inflation, and there were even those (like Peter Schiff) who talked of hyperinflation and the demise of the dollar. Interest rates would rise, and US government bonds would collapse.

My response at the time was that the Federal Reserve would print more money than any of us could possibly imagine (and who imagined $3+ trillion?), and we would not see any inflation. My reasoning was that we were in a deleveraging world where the velocity of money was clearly falling. I explained – once again – the relationship between inflation and the velocity of money.

Beginning with last week’s letter, “Sea Change,” my answer to that question for the foreseeable future will be simply, “Deflation.” In Endgame Jonathan Tepper and I described the economic environment of a deleveraging world, especially that of Europe. In Code Red we described the coming world of currency wars, with Japan having fired the first shot. Sadly, we continue to see the themes of those books play out in the real world.

Over the coming months we are going to explore the implications of a rising dollar for equity markets, global trade, commodity prices (especially oil), interest rates, and Federal Reserve policy, just to mention a few of the areas that will be impacted as global currency flows shift and protectionism is on the rise. Not all markets and governments will be affected in the same way, and there will be any number of opportunities for investors who are willing to think outside of the status quo.

In this week’s letter we’re going to explore some of the implications of deflation. We will start with an internal client letter from my friend Charles Gave that deserves to be shared. Then we’ll explore a few thoughts on the velocity of money. I should note that I am deeply indebted to Dr. Lacy Hunt for my understanding of the velocity of money. To the extent I get things right it is because of his frequent and long-suffering help, and if I get something wrong it’s because I didn’t understand the things he said correctly or couldn’t communicate them properly. These two men, both of whom I think of as mentors and statesmen, have had a huge impact on my thinking. The fact that they both talk with deeply resonating basso profundo voices that remind me of the voice of God in a movie soundtrack may have something to do with that impact! In any case, it lends an air of authority to their musings. Charles even has the long flowing white hair. (Thanks to David Hay for sending me the following note from Charles.)

The Return of the XIX Century Panic?

The readers may have noticed that for the last few months, I have almost never written on economic activity, monetary policy or inflation. Most of my writings and presentations have been on one topic and only one, how to construct an “antifragile” portfolio to use the terminology coined by Nassim Taleb. For me, the monetary policy followed by the central banks had to lead to a collapse in the velocity of money, and from there to deflation.  

My recommendation was thus to hedge any equity positions with a long-dated US zero. So far so good.

Let me hazard for the first time in quite a while a prognosis on the future of ‘economic activity’ in the US. In the 19th century, which was deflationary most of the time, we did not move from a recession to a bear market, but from a bear market, called a “panic” at the time, to a recession. Let me explain.

When there is no inflation [see my notes below – John], the choices are between a deflationary boom and a deflationary bust. And the sober reality is that we move from one to the other only when the stock market crashes. What create the recession are not excess inventories or capital spending as in an inflationary period but the collapse in asset prices which had been pumped up by the general mood of optimism. 

[Reread that paragraph at least a few times. We’re going to explore this concept further.]

Since we had plenty of debts attached to the prices of those assets, margin calls came in, and from there we moved to a true collapse in the velocity of money, accompanied more often than not by banks going belly up (see Barings with Argentina for a good example).

I have absolutely no doubt that trillions of dollars must have been borrowed one way or the other to play the rise in asset prices engineered by the central banks. Similarly, I have no doubt that huge amounts must have been borrowed to develop new sources of energy and that the break-even price for these new sources is probably being reached as I write. [Emphasis mine.]

To use my usual Wicksellian analysis, it is probable that the market rate is moving very quickly ABOVE the natural rate. If it were not, bonds would have no reason to outperform equities as they have for the last 12 months….

If I am right, it implies that a recession may be arriving and this recession should be preceded by a genuine collapse in bank shares, where most of the bad debt is probably parked and the bank shares are underperforming big time. The good news [is] of course that we are arriving at the end of one of the stupidest periods in economic history; the bad news is that asset prices will have to adjust to the new reality.

I maintain what I have said for a long time: No negative cash flows. No big debts. Hedge with government bonds.

The Velocity Trap

Hold those thoughts for a moment, as we need to explore the velocity of money a little further before looking at the implications of what Charles is telling us.

The St. Louis Fed defines the velocity of money as “the frequency at which one unit of currency is used to purchase domestically produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time.”

Irving Fisher gave us the famous Fisher Equation of Exchange. Reduced to its most simple form, it comes out as P=MV, where P is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing P by M. By the way, this is known as an identity equation. It is true at all times and all places, whether in Greece or the US.

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal.

What that means is that to understand rate of change in pricing (known as either inflation or deflation) you must know not only the amount of money in circulation – the money supply – but the rate at which the money is circulating through the economy. If the velocity of money is slowing, the supply of money can rise without an increase in inflation.

And that is precisely what has been happening. In fact, the velocity of money has been slowing since 1997 (back in the Clinton years – remember him?). But it slowed rapidly prior to both recent recessions and for the past few years has been falling off the cliff. The following chart is from the St. Louis Federal Reserve FRED database.

Note that when Milton Friedman did his famous study on the relationship between money supply and inflation he based his research on the period from the early ’50s until the late ’70s. The only way that inflation can only be solely a monetary supply phenomenon is if Fisher’s equation of exchange is not true. But Prof. Friedman so firmly believed in that equation that he had it put on his license plate:

For the period of time that Friedman was studying velocity it was largely stable; but after he had completed his monumental research, velocity in fact did change, as we can see from the graph. (It is actually even more complicated than I will go into in this letter, as one has to look at demographics and population as well as productivity. But let’s not digress.)

If you were looking only at the St. Louis Fed chart, and you saw the little hook upward for the recent quarter, you might reasonably wonder whether velocity might not now be turning, since it appears to be at an all-time low. If velocity began to rise, would inflation come back?

Thanks to a great deal of research done by others and encapsulated by Dr. Lacy Hunt at Hoisington Management, we can actually reconstruct the velocity of money back to 1900. And as the graph below shows, in deflationary periods velocity can slow even more than it has recently. I should point out that Lacy emphasizes that the velocity of money is mean-reverting over very long periods of time. So there will come a day when velocity begins to rise and we will need to start paying attention to inflationary forces.

My friends at GaveKal produce their own velocity indicator, which is a combination of multiple market spreads and fundamental data from around the world. I thought I would include it, as it is often useful to look beyond the borders of the United States. Notice that velocity has become quite volatile in the last year but has once again turned to the downside.

There are many factors that affect the velocity of money, but one of the key elements is debt. What matters is not so much the amount of debt but the productivity of debt. Fisher told us you become over-indebted when you get too much unproductive debt.

Debt (leverage) can be a very good thing when used properly. For instance, if debt is used to purchase an income-producing asset, whether a new machine tool for a factory or a bridge to increase commerce, then debt can be net-productive. Hyman Minsky, one of the greatest economists of the last century, saw debt in three forms: hedge, speculative, and Ponzi.

Roughly speaking, to Minsky, hedge financing occurred when the profits from purchased assets were used to pay back the loan; speculative finance occurred when profits from the asset simply maintained the debt service and the loan had to be rolled over; and Ponzi finance required the selling of the asset at an ever higher price in order to make a profit. Minsky maintained that if hedge financing dominated, then the economy might well be an equilibrium-seeking, well-contained system. On the other hand, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy would be what he called a deviation-amplifying system.

Minsky’s Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by (stable) hedge finance to a structure that increasingly emphasizes (unstable) speculative and Ponzi finance.

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles that are seemingly an inevitable feature of financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops; and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As the climax of such a speculative borrowing bubble nears, banks and other lenders tighten credit availability, even to companies that can afford loans, and the economy then contracts.

“A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”

The Economic Singularity

Singularity was originally a mathematical term for a point at which an equation has no solution. In physics, it was proven that a large-enough collapsing star would eventually become a black hole, so dense that its own gravity would cause a singularity in the fabric of space-time, a point where many standard physics equations suddenly have no solution.

Beyond the “event horizon” of the black hole, the models no longer work. In general relativity, an event horizon is the boundary in space-time beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational pull becomes so great that nothing can escape.

This theme is an old friend to readers of science fiction. Everyone knows that you can’t get too close to a black hole or you will get sucked in; but if you can get just close enough, you can use the powerful and deadly gravity to slingshot you across the vast reaches of space-time.

One way that a black hole can (theoretically) be created is for a star to collapse in upon itself. The larger the mass of the star, the greater the gravity of the black hole and the more surrounding space-stuff will get sucked down its gravity well. The center of our galaxy is thought to be a black hole with a mass of 4.3 million suns.

We can draw a rough parallel between a black hole and our current global economic situation. (For physicists this will be a very rough parallel indeed.) An economic bubble of any type, but especially a debt bubble, can be thought of as an incipient black hole. When the bubble collapses in upon itself, it creates its own black hole with an event horizon beyond which all traditional economic modeling breaks down. Any economic theory that does not attempt to transcend the event horizon associated with excessive debt will be incapable of offering a viable solution to an economic crisis. Even worse, it is likely that any proposed solution will make the crisis more severe.

In Endgame, we explored the idea of a Debt Supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust that unfortunately is almost by definition deflationary. Unfortunately, much of the developed world is at the end of a 65-year-long Debt Supercycle – and thus we approach our economic singularity.

A business-cycle recession is a fundamentally different thing from the end of a Debt Supercycle. A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past or in a manner that the models would predict.

There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth. But there is a limit to how much money a government can borrow. Clearly that limit can vary significantly from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.

When unproductive debt (Minsky’s Ponzi finance) takes over, velocity will continue to fall until you clear up the debt. Debt overhang must be dealt with. One of the amazing things about Irving Fisher is that he did not have access to the data we have today, but he inferred the entire process from having lived through it during the Great Depression. It is Friedman who compiled the data. (Friedman also said that Fisher was the greatest economist.) One of the critical things Fisher understood was that extreme over-indebtedness was the prime problem, and falling velocity was merely one of the symptoms. Velocity’s falling as precipitously it has in the last decade is a warning sign that we are on the wrong track.

A great deal of the blame for slower growth can be laid at the foot of debt. As Lacy Hunt writes this week:

Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250–275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, well above the critical level noted in various economic studies.

The modern economic equivalent of the Flat Earth Society is the Flat Debt Society, whose members contend that there is no negative impact no matter how large the debt gets. They point to Japan and note that their debt has risen to 250% of GDP – and the country still exists. The fact that nominal GDP is where it was 20 years ago is only evidence to them that Japan has not spent enough. But Japan is not a special case. They’re going to have to deal with a great deal of pain in absorbing their debt back into the central bank. It is going to dramatically impact the value of the yen, hurting retirees, pensioners, and consumers. There is no free lunch.

The boom of the last 60 years roughly correlates with ever-increasing debt. History teaches us (with over 200 incidents to learn from) that there is an endpoint beyond which debt becomes destabilizing and has to be dealt with, generally through a period of great destabilization.

An Exogenous Cause of the Next US Recession

I (and others) have argued that while the US is in a slow-growth period, there is nothing internal that could push us into recession. Rather, the catalyst for recession would have to be something from outside the country – what economists call an exogenous event. The two primary risk factors I see on the horizon are China and Europe having crises of their own that seriously affect the world.

I argued last week that we are moving into a far more deflationary environment, brought on by a rising dollar. Above, Charles Gave pointed out that in a deflationary environment the typical causes of business-cycle recession are no longer the primary culprits. Let’s review this paragraph from Charles:

When there is no inflation, the choices are between a deflationary boom and a deflationary bust. And the sober reality is that we move from one to the other only when the stock market crashes. What creates the recession are not excess inventories or capital spending as in an inflationary period but the collapse in asset prices which had been pumped up by the general mood of optimism.

In one of the great ironies, if he is right, it is precisely the inflation of assets brought on by QEs 2 and 3 that has put us in the greatest danger of another recession. The parallels with the 1920s and ’30s is an obvious but not very pleasant one. Growth in leverage and asset inflation during the ’20s led to the crisis of the ’30s.

Rather than using the time that monetary policy has bought us to restructure our fiscal policy, we have doubled down on increasing government debt and student loans. Can anyone seriously argue that transfer payments and other government debt are productive debt? We are already seeing current consumption seriously impacted by student loans.

If Charles is right, then we (I include myself in this group) are looking for the cause of the next recession in exactly the wrong place. The argument many economists and analysts have been making it that since there is nothing fundamentally wrong with the economy, any correction in the stock market is simply a pause on the way to further bull-market highs. What Charles is saying is that the correction itself leads to the recession in a deflationary environment.

This is something that no developed-market participant has any personal experience with. The last time we saw a true deflationary environment was in the 1930s. Charles argues that at the zero point, at the zero bound between inflation and deflation, there is a change in the forces that drive economic growth.

This is as profound a change as the one that occurs when liquid water turns to ice. Except that we know precisely the temperature at which water starts to freeze. Unfortunately, our measures of inflation are nowhere near as precise as our measures of temperature. Our measures of inflation are subjective (as I have shown in numerous letters) and are only generally useful in getting the direction right. Different measurement and analytical techniques might show strong inflation or outright deflation, based on the same underlying data.

While I can find no rhyme in Charles’s assertions, I can certainly see the rhythm, a simple synchronicity. It is exactly what you would expect to happen at the end of an Debt Supercycle. And it is precisely that relationship among debt, asset prices, and deflation that the Flat Debt Society will tell you does not exist. They will tell you the chance of too much debt creating a problem has precisely the probability of hell freezing over. It is just that in their theory hell never gets to 32°. Classical economists, on the other hand, do see the potential for too much of the wrong kind of debt to freeze up the markets. Minsky Moment indeed!

It is not just in the US that there are problems. The problems of Europe, Japan, and China have all been chronicled in this letter. Michael Pettis has been arguing for some time that the world must be seen in the context of global imbalances. For instance, if China is consuming 60% of the world’s iron ore production, that is not a sustainable trend. Ore production has risen to meet demand, but as China inevitably begins to rebalance, it is causing iron ore demand to collapse (and Pettis thinks it has further to go); and that deep dip in demand is putting pressure on the economies of countries like Australia and Brazil that produce iron ore. There are scores of such imbalances that have built up in the world. In his latest blog, Pettis writes:

“[But I do think that the framework [the imperative of global rebalancing] I have used over the past decade has been useful, at least to me, in understanding both the rebalancing process in China and the events that led up to the global crisis of 2007-08. And I think it continues to be useful in judging the adjustment process – or, more likely, the lack of adjustment – that explains why we still have a rough ride ahead of us. This framework has made it relatively easy to make predictions, sometimes “surprising” ones, because by working through the imbalances and assuming – safely, I think – that deep imbalances always eventually reverse one way or the other, we can work out logically the various ways in which this rebalancing must take place.

I have argued that since the 2007-08 crisis we have seen some adjustment in the US, very limited adjustment in China or Japan (except to the extent that Beijing under Xi Jinping has stopped imbalances from getting worse), and worsening imbalances in Europe, and it is for this reason that I have never been impressed by the strong market recoveries we saw around the world. If I had to summarize the key points about the framework I use, I would make four main points:

  1. The adjustment process. All growth creates imbalances, and in every case these imbalances will eventually reverse. What really determines a developing country’s long-term success, I believe, is not how well it does during the growth years, but rather how well it manages the subsequent adjustment. Growth miracles are very common, but real success stories are rare. The reason, I would argue, is that developing countries too easily reversed the great gains they made during the good years because the adjustment turned out to be far more costly than anyone had anticipated. It is far more important, consequently, for economists and policymakers to understand how to manage adjustment and minimize adjustment costs than to figure out how to generate rapid growth.
  2. Debt and balance sheets. Probably the single biggest sources of adjustment costs are the amount and structure of debt, or, more generally, the structure of balance sheets. Economists must understand (but almost never do) national balance sheets and sovereign financial distress as well as corporate finance specialists understand business balance sheets and corporate financial distress.
  3. Savings imbalances. The purpose of savings is to fund productive investment, and while the amount of productive investment opportunities is probably infinite, institutional constraints in every country significantly can reduce the ability of productive investment fully to absorb the total amount of savings created within an economy. These constraints vary from country to country, and until we understand how to remove these constraints, rising income inequality and mechanisms that repress the growth of median household income (relative to GDP growth) often result in what I would call excess savings. The consequences of excess savings include speculative asset booms, trade imbalances, unemployment, and unsustainable increases in debt.
  4. Globalization. In a “globalized” world, no country, not even the US, can protect itself from the consequences of imbalances elsewhere. The global economy is a system in which certain types of imbalances are impossible. I especially focus on the requirement that global savings and global investment always balance, but there are others. Because an imbalance at the global level is impossible, if there are imbalances in one country or region, there necessarily must be the opposite imbalances in another, and the more open an economy, the more likely it is to respond to imbalances elsewhere. It is impossible, in other words, to understand any non-autarchic economy in the world except in the context of global imbalances.

This rebalancing process that Pettis describes (we will review his new book when it comes out in a few weeks) will almost certainly mean an adjustment in asset prices around the world. That adjustment is going to lead to the increased volatility that I was talking about last week, and that volatility is going to lead to a flight to a safe-haven currency, which the world sees as the US dollar. The potential is growing for a real correction leading to outright recession in a period when inflation is receding.

The stock market is down only 5% from its high, and the last two times the Fed has exited QE the market dropped roughly 20% over three months. Even Jim Bullard, who only a few weeks ago was writing about dealing with the risk of inflation and normalizing interest rates sooner than the expected June 2015 FOMC meeting, said in a speech last week that “We could go on pause on the taper at this juncture and wait and see how the data shakes out into December.” When a “hawk” like Bullard (who represents the normally monetarist St. Louis Federal Reserve) started talking about postponing the end of QE, the markets responded with a massive upward move. Talk about your whipsaw communication.

I am pretty sure that Yellen and team are not all that pleased with the corner into which they are now painted. While $15 billion a month is not all that significant in the grand scheme of things – and I think the market, on reflection, will understand that – it has been enough to get the rockets roaring.

The Federal Reserve is in danger of losing the narrative. And the pressure on them to do something will grow if we continue to see the dollar rise and inflation fall. If the markets respond as they have to the end of past QEs, will the Fed once again feel that it needs to respond with yet another round of QE to forestall a drop in asset prices?

Ambrose Evans-Pritchard argued this week that the world economy is so damaged that it may need permanent QE:

Combined tightening by the United States and China has done its worst. Global liquidity is evaporating.

What looked liked a gentle tap on the brakes by the two monetary superpowers has proved too much for a fragile world economy, still locked in “secular stagnation”. The latest investor survey by Bank of America shows that fund managers no longer believe the European Central Bank will step into the breach with quantitative easing of its own, at least on a worthwhile scale.

Markets are suddenly prey to the disturbing thought that the five-and-a-half year expansion since the Lehman crisis may already be over, before Europe has regained its prior level of output. That is the chief reason why the price of Brent crude has crashed by 25pc since June. It is why yields on 10-year US Treasuries have fallen to 1.96pc, and why German Bunds are pricing in perma-slump at historic lows of 0.81pc this week.

We will find out soon whether or not this a replay of 1937 when the authorities drained stimulus too early, and set off the second leg of the Great Depression.

While I believe that central banks should not focus on asset prices but instead on ensuring overall stable monetary prices, the reality is that markets have responded quite positively to quantitative easing. I along with many others argued that the withdrawal process from QE was never going to be easy. As Minsky taught us, the longer the central banks try to maintain a period of stability, the greater the problems of instability will be at the end of the process.

I’m not certain where I read it, but someone suggested that the world economy should be checked into the Betty Ford clinic to learn to withdraw from the massive overdose of quantitative easing that various central banks have foisted upon it.

Recessions are by definition deflationary. Two things we learned from This Time is Different by Rogoff and Reinhart are that economies are more fragile and volatile than we knew and recessions are more frequent after a credit crisis.

When we enter the next recession (and there is always another recession), the Flat Debt Society will be screaming for more stimulus, more quantitative easing, and more debt. Count on it. Their prescription for dealing with the problems arising from debt is similar to telling an alcoholic to drink more whiskey. They deny that debt can be a problem. Their theories prove it. They even have books and papers by noted academics to show that there is no such thing as too much debt, at least as long as you can print money. Currency wars be damned.

We’re entering a period of renewed global volatility. Adjust your portfolios and hedges accordingly.

Chicago, Athens (Texas), Boston, Geneva, Atlanta, and New York

I’m back on the road. Tomorrow is jam-packed with meetings and ends with a late-night discussion with Woody Brock here in Dallas. Tuesday I go to Chicago for a speech, fly back very early to a meeting with Kyle Bass and friends at his Barefoot Ranch in Athens, Texas, and then fly out to Boston to spend the weekend with Niall Ferguson and some of his friends at his annual briefing. I am sure I will be happily surfing mental stimulus overload that week. I fly from Boston to Geneva for a few days and then more or less directly to Atlanta for a day (board meeting), before heading back to Dallas. I will also be going to New York in the middle of November.

This weekend I flew to Houston to be with Worth Wray and his new bride, Adrienne. It was a lovely wedding, and the bride was beautiful. One of the interesting episodes had nothing to do with the wedding but rather with my taxi driver. He’s an engaging fellow from Ethiopia who is been in the States for years, and the first time he drove for me I took his card and have called on him for four trips. We have gotten to know each other, and this time around he began to express his frustrations over the response to Ebola.

The world ignores Africa. Just a little help would save so many lives, but we don’t even get the basics. And they ignore what we have learned about Ebola. The doctors and other healthcare workers in Africa know how to take care of these patients and keep from getting the disease themselves. But nobody wants to pay attention to what we have learned.

Sadly, last night I learned that the situation is even worse than he thought. Presbyterian Hospital in Dallas is one of the finest institutions in Texas, but their initial procedures for dealing with their first Ebola patient were simply incompetent. The details will eventually come out, and Presbyterian is doing the right things now, but our entire healthcare system is simply unprepared to deal with what should have been a very foreseeable crisis. While I don’t think that Ebola in its current form will be a serious risk to developed-world countries, it does expose some major flaws in our system.

Replace the FDA

But the worst flaw is in our drug regulatory process. Only a few months ago the FDA (Food and Drug Administration) was doing everything it could to slow down the development of new drugs for Ebola. Now that there are a few cases of Ebola in the US and we have a general news panic, it seems they can’t encourage drug development fast enough. Nothing changed except the politics.

A few people in the US contract Ebola and suddenly the FDA allows companies to pull out all the stops. My side bet is that we will have a cure for Ebola in the not-too-distant future.

The serious tragedy here is that millions of people die every year from all sorts of diseases that are on the verge of being cured. There are very hopeful new technologies in the labs, but the FDA is preventing them from getting to you. When I say millions of people that is NOT an exaggeration. But those diseases haven’t caused a political firestorm. We need to change that. We need to create a firestorm to force change on the most deadly bureaucracy in America.

There are hundreds of life-saving drugs and other therapies that are being kept from you and me because bureaucrats are using 19th-century science to try to deal with technologies developed in the 21st century. They are more interested in protecting their personal fiefdoms and reputations than in saving lives. Gods forbid we have a drug that might cause a problem, so they sacrifice progress and our collective health – indeed our very lives – on the altar of self-interested bureaucratic expediency. Oh, they couch it in all sorts of high-sounding words, but the results are the same. You and I are prevented from making good choices about our own healthcare and saving the lives of our loved ones.

The FDA does not need to be reformed; it needs to be replaced. We need as a country to create a commission to design a 21st-century Drug Regulatory Authority and then turn over the regulatory process to this new authority. If any of the current structure fits in the new system, then fine. Otherwise, close it down.

As an economist, I would point out that we are leading the world in biotechnology research, but we’re going to see that research create jobs elsewhere if we don’t figure out how to develop the cures and procedures in this country. We need to slash the cost of drug development by 90%. If we do that, we will see the number of new drugs and procedures increase by orders of magnitude.

Pat Cox and I are watching companies that have the ability to cure scores of some of the most debilitating diseases known to mankind, but they are frustrated at every level by the FDA. And the technologies that are on the drawing board are even more mind-blowing. We simply have to get our heads around this situation and make the needed changes.

I’ve talked with a number of other people around the country and am quite serious about trying to form a group to launch an initiative to replace the FDA with sensible 21st-century regulation. It will take some money and time to build an organization. If you have either, drop me a note and let me know, and I will get in touch with you.

It is time to hit the send button. I am excited about all the meetings and people I will get to see in the next 12 days, but the travel schedule is going to be a little rough. Nothing I haven’t done before, and it will totally be worth it. You have a great week!

Your seeing deflation everywhere analyst,

John Mauldin
subscribers@mauldineconomics.com

Outside the Box: Calling Into Question

 

A note has been circulating among economists, calling into question the wisdom of another group of economists who wrote an open letter to the Federal Reserve a few years ago suggesting that one of the risks of their quantitative easing program was increased inflation. Since we have not seen CPI inflation, this latter group is calling upon the former to admit they were wrong, that quantitative easing does not in fact cause inflation. To no one’s surprise, Paul Krugman has written rather nastily and arrogantly about the lack of CPI inflation.

Cliff Asness has responded with a thoughtful letter, with his usual tinge of humor, pointing out that there has been inflation, it just hasn’t been in the CPI. We’ve seen it in assets instead. That money did go someplace, and it has disrupted markets. So why is Cliff’s letter a candidate for Outside the Box, when the markets seem to be bouncing all over heck and gone?

Because, come the next crisis, there is going to be another move for yet another round of massive quantitative easing. And the justification will be that increases in the money supply clearly don’t have much to do with inflation.

I should note that while I did not agree with the original letter (I thought we were in an overall deflationary environment, and I wrote that the central banks of the world would be able to print more money than any of us could possibly imagine and still not trigger inflation – views came in for considerable pushback), my reasons for believing QE2 and QE3 were problematic dealt with other unintended consequences. And ultimately, as global debt gets restructured (which will take many years) inflation will become a problem. Did you notice how Greek debt spreads blew out yesterday? It’s not just about oil. And trust me, France is going to be the new Greece before we know it. The people who think they can control markets and direct investors like sheep are going to be in for a huge surprise, but the nightmare is going to be visited upon the participants in the market.

We then move to a few thoughts from Peter Boockvar, in a letter he writes to savers, noting that the same people who brought you quantitative easing are also responsible for the demise of any income that might possibly have come from saving.

I wish I had good advice for your savings, but I can’t advise buying stocks that have only been more expensive in 2000 on some key metrics right before you know what, and I can’t recommend buying any long term bond as the yields also stink relative to inflation. With the Fed now saying that the dollars in your pocket are now worth too much relative to money in people’s pockets overseas and thus joining the global FX war, maybe you should buy some gold, but I know that yields nothing either. You are the sacrificial lamb in this grand experiment conducted by the unelected officials working at some building named Eccles who seem to have little faith in the ability of the US economy to thrive on its own as it did for most of its 238 years of existence. Borrowers and debt are their only friends. To you responsible saver that worked hard your whole life, may you again rest in peace.

And then we finish with some thoughts from our friend Ben Hunt, who takes exception to being told how to think and believe and act by “those smart people with degrees” who only want to do what’s best for us. Not just in economics but with regard to ISIS and Ebola and everything else. After reading Ben’s essay I called him and said, “Me too!”

I am tired of being manipulated, placated, spin-lied to (if it’s not a word it should be), mutilated, spindled, and folded.

We have to keep our eyes open and entertain the possibility that central banks will “lose the narrative,” that is, their ability to control markets with simple statements. The BIS recently had this to say:

Guy Debelle, head of the BIS’s market committee, said investors have become far too complacent, wrongly believing that central banks can protect them, many staking bets that are bound to “blow up” [at] the first sign of stress.

Mr. Debelle said the markets may at any time start to question whether the global authorities have matters under control, or whether their pledge to hold down rates through forward guidance can be believed. “I find it somewhat surprising that the market is willing to accept the central banks at their word, and not think so much for themselves,” he said. [Source: Ambrose Evans-Pritchard, “BIS warns on ‘violent’ reversal of global markets”]

The 10-year US Treasury slipped below 2% earlier today, but has rebounded somewhat to 2.06% as I write. Oddly, the yen seems to be strengthening slightly as the stock markets once again fall out of bed. Oil continues to weaken. As noted above, Greeks spreads are blowing out. Super Mario needs to get on his bike and start peddling before that concern spreads to other nations almost as insolvent. France will soon be downgraded again. Don’t you just love October?

What an interesting time to hold a midterm election. Have a great week!

Your really thinking through the implications of a stronger dollar analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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The Inflation Imputation

By Cliff Asness, AQR Capital Management LLC

In 2010, I co-signed an open letter warning that the Fed’s experiment with an unprecedented level of loose monetary policy – in amount, and in unorthodox method – created a risk of serious inflation. Sporadically journalists and others have noted that this risk has not come to pass, particularly in consumer prices. Recently there has been an article surveying each of us as to why; seeming to relish in, when provided, our various rationales, presumably as they sounded like excuses. It seems none of the responses provided what the authors clearly wanted, a blanket admission of error. I did not comment for that article, continuing my life long attempt not to help reporters who’ve already made up their mind to make fun of me – I help them enough through my everyday actions, they don’t need more!

More articles of similar bent keep showing up. The authors seem to find it amusing that four years of CPI data wouldn’t get people to change their economic views, while ignoring that 80 years of overwhelming evidence has not dissuaded Keynesians from the belief that this time, if they could only run everything, not just most things, they’d really get it right.

Focusing my attention, as was predestined, Paul Krugman lived up to his lifelong motto of “stay classy” with a piece on the subject entitled Knaves, Fools, and Quantitative Easing. Some lesser lights of the Keynesian firmament have also jumped in (collectivists, of course, excel at sharing a meme). Responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary. I will, at least partially, make that error here, while mostly trying to deal with the original issue separate from Paul’s screeds (though one wonders if CPI inflation had risen in the last four years if Paul would be admitting his entire economic framework was wrong – ok, one doesn’t really wonder – and those things never happen to Paul anyway, just ask him).

Let me say up front that this essay will satisfy nobody. Those looking for a blanket admission of error will get part of what they want; a small part. Those hoping I hold the line denying any misstep will also be disappointed. I believe truth, as is often the case in similar situations, lies in the middle of these and I prefer truth, as I see it, to any reader walking away sated.

We indeed warned about the risks of inflation in 2010 and the CPI has been, to put it mildly, benign since then. First, to give the baying crowd just a bit of what it wants (I will take some of it back soon), our bad (I say “our” but obviously I speak only for myself). When you warn of a risk and it doesn’t come to pass I do think you owe the world this admission, even if you later explain what it means to warn of a risk not a certainty, and offer good reasons why despite reasonable worry this particular risk didn’t come to pass. I, and many other signatories, live in the world of economic or political prognostication, in my case money management, where if you get a bit more than half your calls right you are doing quite well, more than a bit more than half, you’re doing fabulously. I’ll put our collective record up against Krugman’s (and the Krug-Tone back-up dancers) any day of the week and twice on days he publishes.

Let’s start with the big one. We did not make a prediction, something we certainly know how to do and have collectively done many times. We warned of a risk. That’s a very specific choice people like the open letter writers, and Paul, have to make all the time, and he knows this, but that doesn’t deter him. Rather, Paul engages in the old debating trick of mentioning this argument himself and dismissing it. This technique worked for Eminem at the end of Eight Mile. But let’s not be fooled by chicanery (silly Paul, you are no Rabbit). If I had wanted to make a prediction, I would have made one. I didn’t, nor did my fellow signatories. Frankly, if there are any economists, aside from those never-uncertain-but-usually-wrong like Paul, who did not think such unprecedented Fed action represented at least a heightened risk, I think it was malpractice on their part. An honest Paul Krugman (we will use this term again below but this is something called a “counter-factual”) would have agreed with our letter but qualified that while heightened, he still didn’t think this risk would come to fruition and that he thought it was a risk worth running. Still, I will give the critics half credit here, accept half blame, and issue a demi mea culpa. By writing the letter we clearly thought this risk was higher than others did, and wished to stress it, and it has not (as most commonly measured) as of now come to bear. Our, and my, (half) bad. I hope that makes the critics (half) happy and they can stop copying each other’s articles over and over again.

Of course being able to call out risks, not just make firm predictions, is quite important. If you believe the risk of an earthquake is 10 times normal, but 10 times normal is still not a high probability, it’s rational to warn of this risk, even if the chance such devastation occurs is still low and you’ll look foolish to some when it, in all likelihood, doesn’t happen. If you can’t point out risks you are left with either silence as an option, or overly and falsely self-confident forecasts. Perhaps the latter may work for former economists turned partisan pundits but the rest of us will have to live with the ex ante and ex post ambiguity of discussing risks. It’s a real subtlety but I think there is truth somewhere in between the current attack meme of “you predicted inflation risk and were wrong and are now hiding behind the word ‘risk’“ and “we only said it was a risk so we cannot be wrong.” I think when you boldly forecast a risk you are saying more than “this might happen but either way I can’t be blamed” and something less than “this will happen and I stake my reputation on it.” We should all be mature enough to know the difference, but apparently that ship has sailed…

Not surprisingly, the above stress on risk jibes with my personal view of monetary policy, one that might not be shared by all my co-signatories. I tend to think it matters less than most think, and matters less often than most think. I tend to view it, for finance fans, in a “Modigliani Miller” (MM) framework, where most corporate financing transactions are paper-for-paper, mattering little. But, in the MM framework bankruptcy costs do matter. Therefore most corporate capital structure decisions are irrelevant, except to the extent they increase the chance of serious financial distress, in which everyone but the lawyers lose (in many models this risk must be balanced against the tax advantages of debt).

From this perspective, slight adjustments to the target Fed funds rate based on exquisitely sensitive perceptions of the probability of economic overheating or slowdown probably make little difference (and don’t even start me on the dots), but deflation or excessive inflation are important to avoid as their damage can be great. They are the bankruptcy costs of monetary policy. Thus, I think sounding the alarm, not making a prediction, that experimental and aggressive monetary policy raised one of these risks was appropriate. But, still, I think most people engaged on the topic spend a lot of time talking about monetary policy in the same way dogs spend a lot of time talking, yes in their secret dog language, about the cars they chase. The cars aren’t affected and generally don’t care.

Now, if you thought the above was an excuse on par with, continuing my canine fixation, “the dog ate my inflation,” and not the demi mea culpa I intended, you’re really going to hate the full blown non-conciliatory excuses about to come.

Economically, I think what everyone of any political or economic stripe missed, certainly including myself, was how little money would circulate, how little would be lent and then spent. In econo-geek, how low the money multiplier would be. Money kept by banks at low but positive interest rates at the Fed clearly isn’t doing much of anything, creating inflation as we feared, or helping the economy as they hoped. To the extent inflation worriers like us were wrong, so were those predicting great economic benefits. The Fed clearly wanted this money lent by banks and spent by companies on investment and by people on consumption. They didn’t get that, and we didn’t get the inflation we feared. This is not to say that low interest rates, real and nominal, and high prices for risky assets (and the supposed “wealth effect” that comes with them) were not Fed goals. They clearly were. But it seems these intermediate goals have not had their desired effect on the real economy.

Quantitative easing (QE) and other inventive forms of loose monetary policy have simply been less than hoped or feared. Some may declare Fed policy a great success as we’re not in a depression, but they can’t show any counter-factual, and given that this money has largely sat dormant, albeit presumably lowering risk premia (raising asset prices), it’s likely we’d have a similar record-weak recovery with or without it. How this is a victory for one side of the debate or another is beyond me, but obviously clear to Paul and his back-up singers. Of course, it’s also clear to Paul that the 2009 stimulus package saved us from this same second Great Depression (but more stimulus would of course have been much better). Yep, and if we traded good cash for just one more “clunker” we’d be growing at 5% per annum by now with a normal labor participation rate.

By-the-way, ignored in the critics’ review of the original letter was the line, “In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program…” On this I’m unapologetic. We were right, we’re still right, and thanks to people like Paul we’ve moved in the wrong direction. But that’s a fight for another day.

In a field without a broad set of counter-factuals we all stick too much to our priors and ideologies, and perhaps I’m doing that now. But at least I see it, and that’s always step one. Paul is stuck on step zero (if he ever gets up to “making amends” I will be around but given his history he might never get to me). But, if you’d like to advance past step zero, Paul, we’re still waiting on why Keynesianism failed to fix the Great Depression (no doubt not quite enough stimulus; just one more Hoover Dam would have done it, or, as they called it back then, “Dams for Clunkers”), strongly predicted a deep post-WWII depression, didn’t predict stagflation, and generally was on a the downward spiral to the intellectual dustbin until the great recession resuscitated it, not as a workable intellectual doctrine, but as an excuse for politicians to spend on their constituents and causes.

Also remember, much like when the Germans bombed Pearl Harbor, nothing is over yet. The Fed has not undone its extraordinary loose monetary policy and is just now stopping its direct QE purchases. When monetary policy is back to historic norms, and economic growth is once again strong, a normal number of people are seeking and getting jobs, and inflation has not reared its head, I think we can close the books on this one, still recognizing that forecasting a risk and having it fail to come to bear is not a cardinal sin. But which one of those things has happened yet? Paul, and others, should by now know the folly of declaring victory too early.

At the risk of enraging a whole different group (I promise I’m not denying anything I’m just making an analogy, and one I know is very far from dead on) I’m amazed that a Paul Krugman can look at 15+ years of the earth not warming and feel his beliefs need no modification or explanation, but 4 years of the CPI not inflating is reason not simply to declare victory, but to decry those who disagree with him as “Knaves and Fools.” In fact, rather than also anger Mr. Gore and Steyer, I hope they find this paragraph supportive as I’m saying these debates are rarely settled in either direction in short time frames. Now, if I were cheekier (cheek is not denial!) I’d ask if perhaps our letter was right and the inflation we predicted is in fact occurring in the depths of the ocean? Or, maybe we should ex post relabel our letter a warning of the risk of “extreme price action” including of course the extreme stability we have experienced in CPI these last few years.

Now, while not pointing to the actual ocean it is fascinating where inflation has shown up. Don’t limit your view of inflation to the CPI. No, this isn’t a screed where I claim to have invented my own consumption basket showing inflation is rising at 25% per annum – though some of those screeds are interesting. It’s the far simpler observation that we have indeed observed tremendous inflation in asset prices since this experiment began (of course this was part of the Fed’s intent – but it was meant to stoke real activity not an end unto itself!). Stocks, the spreads on high yield bonds, real estate, you name it. Inflation is hard enough to forecast, but where it lands is even harder. If one counts asset inflation it seems we’ve indeed had tremendous inflation. While admittedly difficult to prove, as is any of this if we’re being honest as economics rarely offers proofs, you’d be hard pressed to find many economists or Wall Street professionals who don’t see current extremely high asset prices, and low forward looking returns to investors, as at least a partial consequence of the cocktail of QE, loose monetary policy, and financial repression. I understand Paul and others wanting to avoid this as not only does it show that they have no right to crow on inflation, but that the policies they advocate, and we decried, have had little effect on the economy but instead have, at least partially intentionally, exacerbated the inequality Paul spends the other half of his columns excoriating (while of course living himself off the global median income in protest and solidarity).

By-the-way, again the critics somehow manage to skip another prescient forecast in this same short open letter. We explicitly worried that the Fed’s policies “will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.” That’s econo-geek for “will drive financial market prices up and prospective returns down, and create financial instability when the Fed tries to stop.” Again, while this would perhaps not surprise the Fed, which actively desired low interest rates and a “wealth effect,” it seems that a fair reading shows that this much maligned letter wasn’t as wrong as the critics say, and was very right in ways the critics ignore.

Moving on, please recall that many, not all, supporters of QE and very loose monetary policy in general, did so exactly because they thought it would create some inflation, and they thought (and many still think) that’s what the economy needs. We, we the letter signers, are responsible for our own forecasts, but you might forgive us a bit for taking the other side at their word!

Bottom line, the half mea culpa above was not a throw away. When you go out of your way to warn of a risk and after a suitable period that risk has not come to bear, at least where everyone, including you, expected it, you should admit some error, and I do. But there is a still a big difference between pointing out a risk and making a forecast (hence the half admission!). A big reason this risk hasn’t come to fruition is, while not as dangerous so far as we thought, it appears QE was only mostly useless. To the extent even that is only mostly true, where effects did show up, it actually caused rather a lot of inflation, but inflation that went straight into the pockets of those who needed it least and whom Paul wouldn’t swerve his car to avoid. That is, it inflated financial assets, benefited the rich, and enhanced inequality.

So, to those who’ve been waiting for one of us to say it, you can have half the mea culpa you clearly want, but mostly Paul is wrong, and twisting the facts, and doing so as rudely and crassly as possible, yet again. The rest of the JV team of Keynesians who have also jumped on board are doing the same thing, just with more class and less entertainment value than the master.

Now for a real prediction: Paul will continue to be mostly wrong, mostly dishonest about it, incredibly rude, and in a crass class by himself (admittedly I attempt these heights sometimes but sadly fall far short). That is a prediction I’m willing to make over any horizon, offering considerable odds, and with no sneaky forecasts of merely “heightened risks.” Any takers?

Cliff Asness is Founding and Managing Principal of AQR Capital Management, LLC

 

Dear Saver, May You RIP

By Peter Boockvar, The Lindsey Group LLC

Dear Saver,

To the forgotten and misunderstood soul, may you rest in peace. There just seems that nothing can save you now. You were bloody and battered after the stock market bubble crashed in 2001 and 2002. Afterward, you stuck with stocks but also decided to play it safe in real estate. That was ok for a few years but your stock portfolio fell again by 50% and while you have a great new kitchen and wood paneled library, the value of your house is now worth much less than your mortgage. I know, renting can be so much easier! But some guy named Greenspan said something about a wealth effect.

Finally you said enough is enough. You wanted a safe, conservative place for your savings where living off fixed income of mostly CD’s and bonds was possible. Maybe you’d buy an occasional stock again but maybe not. You called your local branch banker and were told that for the privilege of being a Platinum Honors client that you would be able to secure a better rate on a money market savings account. Nice! You were told that you’d be able to get .10%, more than triple the standard rate of .03% that the average person gets! Disgusted, you went online and saw this great add on the Bank of America website, it said “With a Featured CD I can earn a fixed rate on my nest egg.” Sounds enticing until you scrolled down the page and saw it paid .08% for a fixed 12 month term. It had to be a typo but unfortunately it was not.

Questioning now how you can ever retire on your savings after working hard for the past 40 years, you decided to find out who can possibly be responsible for these pathetic yields when you know your cost of living is rising well above the 1.5-2% that these statisticians at the government keep telling you. You ask what an hedonic adjustment is? Don’t worry about it because the purchasing power of your money relative to inflation has been declining day after day for at least 6 years now. This is madness you say. I agree.

You started to read the papers and watched the news and learned that the men and women that work at the Federal Reserve, mostly economists who call themselves central bankers, sit around a large table and decide what the right interest rate should be. Ok you say, they are smart, they have models created by people that likely did really well on their SAT’s, they know what they’re doing and this can’t last. Well, I’m sorry to say to you, we’re 6 years into zero interest rates and these people have no intention of ever saving your savings. You’re screwed and even though they say it’s in your best interest because zero rates and money printing will help the economy, don’t believe them anymore because the strategy has failed. After all, If these policies actually worked, I wouldn’t be writing this letter to you.

I wish I had good advice for your savings but I can’t advise buying stocks that have only been more expensive in 2000 on some key metrics right before you know what and I can’t recommend buying any long term bond as the yields also stink relative to inflation. With the Fed now saying that the dollars in your pocket are now worth too much relative to money in people’s pockets overseas and thus joining the global FX war maybe you should buy some gold but I know that yields nothing either. You are the sacrificial lamb in this grand experiment conducted by the unelected officials working at some building named Eccles who seem to have little faith in the ability of the US economy to thrive on its own as it did for most of its 238 years of existence. Borrowers and debt are their only friends. To you responsible saver that worked hard your whole life, may you again rest in peace.

Sincerely yours,

Peter Boockvar
Managing Director
Chief Market Analyst
The Lindsey Group LLC

 

Calvin the Super Genius

By Ben Hunt, Ph.D., Salient

People think it must be fun to be a super genius, but they don’t realize how hard it is to put up with all the idiots in the world.  – Bill Watterson, “Calvin and Hobbes”

Here is the most fundamental idea behind game theory, the one concept you MUST understand to be an effective game player. Ready?

You are not a super genius, and we are not idiots.  The people you are playing with and against are just as smart as you are. Not smarter. But just as smart.  If you think that you are seeing more deeply into a repeated-play strategic interaction (a game!) than we are, you are wrong. And ultimately it will cost you dearly.  But if there is a mutually acceptable decision point – one that both you and we can agree upon, full in the knowledge that you know that we know that you know what’s going on – that’s an equilibrium. And that’s a decision or outcome or policy that’s built to last.

Fair warning, this is an “Angry Ben” email, brought on by the US government’s “communication policy” on Ebola, which is a mirror image of the US government’s “communication policy” on markets and monetary policy, which is a mirror image of the US government’s “communication policy” on ISIS and foreign policy. We are being told what to think about Ebola and QE and ISIS. Not by some heavy-handed pronouncement as you might find in North Korea or some Soviet-era Ministry, but in the kinder gentler modern way, by a Wise Man or Woman of Science who delivers words carefully chosen for their effect in constructing social expectations and behaviors.

The words are not lies. But they’re only not-lies because if they were found to be lies that would be counterproductive to the social policy goals, not because there’s any fundamental objection to lying. The words are chosen for their  truthiness, to use Stephen Colbert’s wonderful term, not their truthfulness. The words are chosen in order to influence us as manipulable objects, not to inform us as autonomous subjects.

It’s always for the best of intentions. It’s always to prevent a panic or to maintain confidence or to maintain social stability. All good and noble ends. But it’s never a stable equilibrium. It’s never a lasting legislative or regulatory peace. The policy always crumbles in Emperor’s New Clothes fashion because we-the-people or we-the-market have not been brought along to make a self-interested, committed decision.Instead the Powers That Be – whether that’s the Fed or the CDC or the White House – take the quick and easy path of selling us a strategy as if they were selling us a bar of soap.

This is what very smart people do when they are, as the Brits would say, too clever by half. This is why very smart people are, as often as not, poor game players. It’s why there aren’t many academics on the pro poker tour. It’s why there haven’t been many law professors in the Oval Office. This isn’t a Democrat vs. Republican thing. This isn’t a US vs. Europe thing. It’s a mass society + technology thing. It’s a class thing. And it’s very much the defining characteristic of the Golden Age of the Central Banker.

Am I personally worried about an Ebola outbreak in the US? On balance … no, not at all. But don’t tell me that I’m an idiot if I have questions about the sufficiency of the social policies being implemented to prevent that outbreak. And make no mistake, that’s EXACTLY what I have been told by CDC Directors and Dr. Gupta and the White House and all the rest of the super genius, supercilious, remain-calm crew.

I am calm. I understand that a victim must be symptomatic to be contagious. But I also understand that one man’s symptomatic is another man’s “I’m fine”, and questioning a self-reporting immigration and quarantine regime does not make me a know-nothing isolationist.

I am calm. I understand that the virus is not airborne but is transmitted by “bodily fluids”. But I also understand why Rule #1 for journalists in West Africa is pretty simple: Touch No One, and questioning the wisdom of sitting next to a sick stranger on a flight originating from, say, Brussels does not make me a Howard Hughes-esque nutjob.

I am calm. I understand that the US public health and acute care infrastructure is light years ahead of what’s available in Liberia or Nigeria. I understand that Presbyterian Hospital in Dallas is not just one of the best health care facilities in Texas, but one of the best hospitals in the world. But I also understand that we are all creatures of our standard operating procedures, and what’s second nature in a hot zone will be slow to catch on in the Birmingham, Alabama ER where my father worked for 30 years.

The mistake made by our modern leaders – in every public sphere! – is to believe that they are operating on a deeper, smarter, more far-seeing level of game-playing than we are. I’ve got a long example of the levels of decision-making in the Epsilon Theory note “A Game of Sentiment“, so I won’t repeat all that here. The basic idea, though, is that by announcing a consensus based on the Narrative authority of Science our leaders believe they are stacking the deck for each of us to buy into that consensus as our individual first-level decision. This can be quite effective when you’re promoting a brand of toothpaste, where it is impossible to be proven wrong in your consensus claims, much less so when you’re promoting a social policy, where all it takes is one sick nurse to make the entire linguistic effort seem staged and for effect … which of course it was. The fact that we go along with a game – that we act AS IF we believe in the Common Knowledge of an announced consensus – does NOT mean that we have accepted the party line in our heart of hearts. It does NOT mean that we are myopic game-players, unerringly led this way or that by the oh-so-clever words of the Missionaries. But that’s how it’s been taken, to terrible effect.  

I am calm. But I am angry, too. It doesn’t have to be this way … this consensus-by-fiat style of policy leadership where we are always only one counter-factual reveal – the sick nurse or the sick economy – away from a breakdown in market or governmental confidence. I am angry that we have been consistently misjudged and underestimated, treated as children to be “educated” rather than as citizens to be trusted. I am angry that our most important political institutions have sacrificed their most important asset – not their credibility, but their authenticity – on the altar of political expediency, all in a misconceived notion of what it means to lead.

And yet here we are. On the precipice of that breakdown in confidence. A cold wind of change is starting to blow. Can you feel it?

W. Ben Hunt, Ph.D.
Chief Risk Officer, Salient

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Important Disclosures

The article Outside the Box: Calling Into Question was originally published at mauldineconomics.com.

Thoughts from the Frontline: Sea Change

 

You don’t need a weatherman
To know which way the wind blows.

– Bob Dylan, “Subterranean Homesick Blues,” 1965

Full fathom five thy father lies.
Of his bones are coral made.
Those are pearls that were his eyes.
Nothing of him that doth fade,
But doth suffer a sea-change
Into something rich and strange.

– William Shakespeare, The Tempest

Did you feel the economic weather change this week? The shift was subtle, like fall tippy-toeing in after a pleasant summer to surprise us, but I think we’ll look back and say this was the moment when that last grain of sand fell onto the sandpile, triggering many profound fingers of instability in a pile that has long been close to collapse. This is the grain of sand that sets off those long chains of volatility that have been gathering for the last five years, waiting to surprise us with the suddenness and violence of the avalanche they unleash.

I suppose the analogy sprang to mind as I stepped out onto my balcony this morning. Texas has been experiencing one of the most pleasant summers and incredibly wonderful falls in my memory. One of the conversations that seem to occur regularly among locals who have a few decades under their belts here, is just how truly remarkable the weather has been. So it was a bit of a surprise to step out and realize the air had turned brisk. In retrospect it shouldn’t have fazed me. The air has been turning brisk in Texas at some point in October for the six decades that my memory covers, and for quite a few additional millennia, I suspect.

But this week, as I worked through my ever-growing mountain of reading, I felt a similar awareness of a change in the economic climate. Like fall, I knew it was coming. In fact, I’ve been writing about it for years! But just as fall tells us that it’s time to get ready for winter, at least in more northerly climes, the portents of the moment suggest to me that it’s time to make sure our portfolios are ready for the change in season.

Sea Change

Shakespeare coined the marvelous term sea change in his play The Tempest. Modern-day pundits are liable to apply the word to the relatively minor ebb and flow of events, but Shakespeare meant sea change as a truly transformative event, a metamorphosis of the very nature and substance of a man, by the sea.

In this week’s letter we’ll talk about the imminent arrival of a true financial sea change, the harbinger of which was some minor commentary this week about the economic climate. This letter is arriving to you a little later this week, as I had quite some difficulty writing it, because, while the signal event is rather easy to discuss, the follow-on consequences are myriad and require more in-depth analysis than I’ve been able to bring to them on short notice. As I wrestled with what to write, I finally came to realize that this sea change is going to take multiple letters to properly describe. In fact, it might eventually take a book.

So, in a departure from my normal writing style, I am going to offer you a chapter-by-chapter outline for a book. As with all book outlines, it will be simply full of bones but without much meat on them, let alone dressed up with skin and clothing. I will probably even connect the bones in the wrong order and have to go back later and replace a leg bone with a rib, but that is what outlines are for. There is clearly enough content suggested by this outline to carry us through the next several months; and given the importance of the subject, I expect to explore it fully with you. Whether it actually becomes a book, I cannot yet say.

I should note that much of what follows has grown out of in-depth conversations with my associate Worth Wray and our mutual friends. We’ve become convinced that the imbalances in the global economic system are such that the risks are high that another period of economic volatility like the Great Recession is not only likely but is now in the process of developing. While this time will be different in terms of its causes and symptoms (as all such stressful periods differ from each other in many ways), there will be a rhyme and a rhythm that feels all too familiar. That should actually be good news to most readers, as the last 14 years have taught us a little bit about living through periods of economic volatility. You will get to use those skills you learned the hard way.

This will not be the end of the world if you prepare properly. In fact, there will be plenty of opportunities to take advantage of the coming volatility. If the weatherman tells you winter is coming, is he a prophet of doom? Or is it reasonable counsel that maybe we should get our winter clothes out?

Three caveats before we get started. One, I am often wrong but seldom in doubt. And while I will marshal facts and graphs aplenty to reinforce my arguments, I would encourage you to think through the counterfactuals presented by those who will aggressively disagree.

Two, while it goes without saying, you are responsible for your own decisions. It is easy for me to say that I think the bond market is going to go in a particular direction. I can even bet my personal portfolio on my beliefs. I can’t know your circumstances, but if you are similar to most investors, this is the time to make sure you have a truly balanced portfolio with serious risk management in the event of a sudden crisis.

Three, give me (and Worth, whom I am going to draft to write some letters) some time to develop the full range of our ideas. To follow on with my weather analogy, the air is just starting to get crisp, and winter is still a couple months away. Absent something extraordinary, we are not going to get snow and a blizzard in Dallas, Texas, tomorrow. We may still have some time to prepare, but at a minimum it is time to start your preparations. So with those caveats, let’s look at an outline for a potential book called Sea Change.

Prologue

I turned publicly bearish on gold in 1986. At the time (a former life in a galaxy far, far away), I was actually writing a newsletter on gold stocks and came to the conclusion that gold was going nowhere – and sold the letter. I was still bearish some 16 years later. Then, on March 1, 2002, I wrote in Thoughts from the Frontline that it was time to turn bullish on gold. Gold at that time was languishing around $300 an ounce, near its all-time bottom.

What drove that call? I thought that the future directions of gold and the dollar were joined at the hip. A bit over a year later I laid out the case for a much weaker dollar in a letter entitled “King Dollar Meets the Guillotine,” which later became the basis for a chapter in Bull’s Eye Investing. As the chart below shows, the dollar had risen relentlessly through the early Reagan years, doubling in value against the currencies of America’s global neighbors, causing exporters to grumble about US dollar policy. Then the bottom fell out, as the dollar made new lows in 1992. From 1992 through 2002 the dollar recovered about half of its value, getting back to roughly where it was in 1967. Elsewhere about that time, I predicted that the euro, which was then at $0.88, would rise to $1.50 before falling back to parity over a very long period of time. I believe we are still on that journey.

One of the biggest drivers of economic fortunes in the global economy is the currency markets. The value of your trading currency affects every aspect of your business and investments. It is fundamental in nature. While most Americans never even see a piece of foreign currency, every time we walk into Walmart, we are subject to the ebb and flow of global currency valuations, as are Europeans and indeed every person who participates in the movement of goods and services around the globe. In fact, globalization means that currency values are more important than ever. The world is more tightly interconnected now than it has ever been, which means that events which previously had no effect upon global affairs can trigger cascades of events that affect everyone.

I believe we are in the early stages of a profound currency-valuation sea change. I have lived through five major changes in the value of the dollar in the 45 years since Nixon closed the gold window. And while we are used to 40% to 50% moves in the stock market and other commodity prices happening in just a few years (or less), large movements in major trading currencies typically take many years, if not decades, to develop. I believe we are in the opening act of a multi-year US dollar bull market.

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Important Disclosures

The article Thoughts from the Frontline: Sea Change was originally published at mauldineconomics.com.

Thoughts from the Frontline: Sea Change

 

You don’t need a weatherman
To know which way the wind blows.

– Bob Dylan, “Subterranean Homesick Blues,” 1965

Full fathom five thy father lies.
Of his bones are coral made.
Those are pearls that were his eyes.
Nothing of him that doth fade,
But doth suffer a sea-change
Into something rich and strange.

– William Shakespeare, The Tempest

Did you feel the economic weather change this week? The shift was subtle, like fall tippy-toeing in after a pleasant summer to surprise us, but I think we’ll look back and say this was the moment when that last grain of sand fell onto the sandpile, triggering many profound fingers of instability in a pile that has long been close to collapse. This is the grain of sand that sets off those long chains of volatility that have been gathering for the last five years, waiting to surprise us with the suddenness and violence of the avalanche they unleash.

I suppose the analogy sprang to mind as I stepped out onto my balcony this morning. Texas has been experiencing one of the most pleasant summers and incredibly wonderful falls in my memory. One of the conversations that seem to occur regularly among locals who have a few decades under their belts here, is just how truly remarkable the weather has been. So it was a bit of a surprise to step out and realize the air had turned brisk. In retrospect it shouldn’t have fazed me. The air has been turning brisk in Texas at some point in October for the six decades that my memory covers, and for quite a few additional millennia, I suspect.

But this week, as I worked through my ever-growing mountain of reading, I felt a similar awareness of a change in the economic climate. Like fall, I knew it was coming. In fact, I’ve been writing about it for years! But just as fall tells us that it’s time to get ready for winter, at least in more northerly climes, the portents of the moment suggest to me that it’s time to make sure our portfolios are ready for the change in season.

Sea Change

Shakespeare coined the marvelous term sea change in his play The Tempest. Modern-day pundits are liable to apply the word to the relatively minor ebb and flow of events, but Shakespeare meant sea change as a truly transformative event, a metamorphosis of the very nature and substance of a man, by the sea.

In this week’s letter we’ll talk about the imminent arrival of a true financial sea change, the harbinger of which was some minor commentary this week about the economic climate. This letter is arriving to you a little later this week, as I had quite some difficulty writing it, because, while the signal event is rather easy to discuss, the follow-on consequences are myriad and require more in-depth analysis than I’ve been able to bring to them on short notice. As I wrestled with what to write, I finally came to realize that this sea change is going to take multiple letters to properly describe. In fact, it might eventually take a book.

So, in a departure from my normal writing style, I am going to offer you a chapter-by-chapter outline for a book. As with all book outlines, it will be simply full of bones but without much meat on them, let alone dressed up with skin and clothing. I will probably even connect the bones in the wrong order and have to go back later and replace a leg bone with a rib, but that is what outlines are for. There is clearly enough content suggested by this outline to carry us through the next several months; and given the importance of the subject, I expect to explore it fully with you. Whether it actually becomes a book, I cannot yet say.

I should note that much of what follows has grown out of in-depth conversations with my associate Worth Wray and our mutual friends. We’ve become convinced that the imbalances in the global economic system are such that the risks are high that another period of economic volatility like the Great Recession is not only likely but is now in the process of developing. While this time will be different in terms of its causes and symptoms (as all such stressful periods differ from each other in many ways), there will be a rhyme and a rhythm that feels all too familiar. That should actually be good news to most readers, as the last 14 years have taught us a little bit about living through periods of economic volatility. You will get to use those skills you learned the hard way.

This will not be the end of the world if you prepare properly. In fact, there will be plenty of opportunities to take advantage of the coming volatility. If the weatherman tells you winter is coming, is he a prophet of doom? Or is it reasonable counsel that maybe we should get our winter clothes out?

Three caveats before we get started. One, I am often wrong but seldom in doubt. And while I will marshal facts and graphs aplenty to reinforce my arguments, I would encourage you to think through the counterfactuals presented by those who will aggressively disagree.

Two, while it goes without saying, you are responsible for your own decisions. It is easy for me to say that I think the bond market is going to go in a particular direction. I can even bet my personal portfolio on my beliefs. I can’t know your circumstances, but if you are similar to most investors, this is the time to make sure you have a truly balanced portfolio with serious risk management in the event of a sudden crisis.

Three, give me (and Worth, whom I am going to draft to write some letters) some time to develop the full range of our ideas. To follow on with my weather analogy, the air is just starting to get crisp, and winter is still a couple months away. Absent something extraordinary, we are not going to get snow and a blizzard in Dallas, Texas, tomorrow. We may still have some time to prepare, but at a minimum it is time to start your preparations. So with those caveats, let’s look at an outline for a potential book called Sea Change.

Prologue

I turned publicly bearish on gold in 1986. At the time (a former life in a galaxy far, far away), I was actually writing a newsletter on gold stocks and came to the conclusion that gold was going nowhere – and sold the letter. I was still bearish some 16 years later. Then, on March 1, 2002, I wrote in Thoughts from the Frontline that it was time to turn bullish on gold. Gold at that time was languishing around $300 an ounce, near its all-time bottom.

What drove that call? I thought that the future directions of gold and the dollar were joined at the hip. A bit over a year later I laid out the case for a much weaker dollar in a letter entitled “King Dollar Meets the Guillotine,” which later became the basis for a chapter in Bull’s Eye Investing. As the chart below shows, the dollar had risen relentlessly through the early Reagan years, doubling in value against the currencies of America’s global neighbors, causing exporters to grumble about US dollar policy. Then the bottom fell out, as the dollar made new lows in 1992. From 1992 through 2002 the dollar recovered about half of its value, getting back to roughly where it was in 1967. Elsewhere about that time, I predicted that the euro, which was then at $0.88, would rise to $1.50 before falling back to parity over a very long period of time. I believe we are still on that journey.

One of the biggest drivers of economic fortunes in the global economy is the currency markets. The value of your trading currency affects every aspect of your business and investments. It is fundamental in nature. While most Americans never even see a piece of foreign currency, every time we walk into Walmart, we are subject to the ebb and flow of global currency valuations, as are Europeans and indeed every person who participates in the movement of goods and services around the globe. In fact, globalization means that currency values are more important than ever. The world is more tightly interconnected now than it has ever been, which means that events which previously had no effect upon global affairs can trigger cascades of events that affect everyone.

I believe we are in the early stages of a profound currency-valuation sea change. I have lived through five major changes in the value of the dollar in the 45 years since Nixon closed the gold window. And while we are used to 40% to 50% moves in the stock market and other commodity prices happening in just a few years (or less), large movements in major trading currencies typically take many years, if not decades, to develop. I believe we are in the opening act of a multi-year US dollar bull market.

Chapter 1 – The Boys Who Cry Wolf

We all know the story of the boy who cried “Wolf!” once too often. I have been pounding the table about a dollar bull market for about three years now. I see eyes roll when I speak at conferences around the world and boldly forecast that the dollar is going to get stronger than anyone in the room can possibly fathom. All the signs have been pointing to it, and indeed we’ve seen the dollar move upward in a rather herky-jerky fashion off the lows of 2010, but not in a way that has been all that dramatic (except, arguably, against the Japanese yen). Indeed, the relative trading range of the dollar has been relatively constrained over the past six to seven years, pivoting around 80 on the DXY (symbol for the US dollar spot index).

This is in contrast to the true doom-and-gloomers, who are forecasting “the Demise of the Dollar.” At the same time, they are calling for an unseemly rise in interest rates, and many of them believe the Federal Reserve will push us over the brink into hyperinflation. Needless to say, then, you should buy massive amounts of gold and get your money out of the country.

I have had long conversations with many who believe in such a scenario. I call some of them close friends, even if we disagree on something as fundamental as the future of the dollar. I’ve come to the conclusion that their conviction is a lot like a religious belief.  I’m not going to change them, and so I make very little effort to try. So, fair and friendly warning: if you think the US dollar is headed to oblivion, you are not going to like this book outline or the next few months of my letter.

(Sidebar to those of you who, like me, own gold. You do not have to be a dollar bear to be constructive on gold and believe that it belongs in a diversified portfolio. But more on that front if we do a chapter on gold.)

Getting back to portents of winter, this week saw two side comments by Federal Reserve members that put a distinct chill in the air.

The first is from William Dudley, the president of the Federal Reserve Bank of New York and a permanent voting member on the FOMC. In a speech at Rensselaer Polytechnic Institute, he pushed back on the idea that it is time to raise rates. While acknowledging the relatively positive stance of the Federal Reserve in its forecast, he said:

While I believe that the risks around this consensus forecast are reasonably well balanced, I also believe that the likelihood that growth will be substantially stronger than the point forecast is probably relatively low. [my emphasis]

He went on to cite weaker than expected consumer spending and the expectation that consumer durable purchases will be weaker in the future (by which I assume he means automobiles, which have been on a blistering, back-to-the-all-time-high pace due to supereasy credit, much of it subprime and with durations beyond five years.) He faults mortgage lenders for the substandard housing recovery, as if the last massacre of lenders was not enough to scar their collective psyche for decades.

(Sadly, he might have a point. Somewhat humorously, Ben Bernanke tells us he was turned down for a mortgage because his income is somewhat unsteady. He did not fit the “check-the-box” protocol of his local mortgage lender. I sympathize. I was turned down multiple times earlier this year before finding willing lenders who actually competed for my business. My business life does not accord with a standard check-the-box mortgage. I read about another business owner who noted that any of his 300 employees could get a mortgage, but he could not because his income was not stable enough. Go figure.)

Each of Dudley’s points was covered in long paragraphs. And then he delivered a short, throwaway line that caught my attention. He cited the growth in the exchange value of the dollar over the last few months as a reason for downside risk. Really? Go back and look at the chart above and see the relatively minor dollar moves of the past few months. Why should dollar strength show up in a list of reasons for upcoming weakness in the US economy?

The next day saw the release of the minutes of the previous month’s FOMC meeting. In the part labeled “Staff Review of the Financial Situation,” the staff mentioned “… responding in part to disappointing economic data abroad, the US dollar appreciated against most currencies over the inter-meeting period, including large appreciations against the euro, the yen, and the pound sterling.”

While there are precedents for the staff review to mention the dollar, it doesn’t happen often. (In January 2002 the staff notes included concern about the strength of the dollar. That concern went away rather quickly. Coincidence? Hat tip, Joan McCullough.) The strengthening dollar is clearly on the minds of the members and staff of the Federal Reserve. Hmmm…

The key here is to note that the strength of the dollar (or lack of it) is not traditionally a Federal Reserve concern. The relative value of the dollar is the purview of the US Treasury, while the Federal Reserve is responsible for maintaining stable purchasing power (interest rates and money supply, etc.). Both organizations are careful not to tread on the other’s territory.

What if we are at the beginning of another 10-year bull market in the dollar? Is it unthinkable that the value of the dollar could rise back to 120 on the index over that time? Let’s look at that chart again:

From a very long-term perspective, 100 on that index is certainly a possibility, and 120 is not without precedent. But if the dollar rises to those levels, even in the very short-term, volatile patterns of the past, it changes everything it touches. And the value of the dollar touches everything. So let’s think about some of the consequences over the long term of a rising dollar.

Chapter 2 – A Monkey Wrench for the Fed

A rising dollar is almighty inconvenient for a Federal Reserve that would like to eventually raise interest rates. Multiple regional Fed presidents and Fed governors would really like to see inflation in the 2% range prior to raising rates.

A dollar that is rising against the currencies of our major trading partners is inherently disinflationary, if not outright deflationary. (Pay attention to how often that word deflation occurs in this outline.) The current inflation rate is 1.7%. The Dallas trimmed-mean PCE inflation rate was actually negative in August and has been falling for the last five months, more or less coinciding with the rising dollar.

The makeup of the Federal Reserve FOMC voting membership next year is going to be decidedly “dovish.” Dallas Fed President Richard Fisher will retire, and his voice will no longer be present. Yellen and the entire team (with two notable exceptions) have been out and about using the words data-dependent, with Minneapolis Fed President Kocherlakota arguing that raising rates anytime in 2015 would be a mistake.

Look at what Federal Reserve unemployment and inflation-rate predictions are as of September 17:

Fourteen of the 17 members of the Fed (including the 12 regional presidents) anticipate that rates will be raised in 2015.  Most observers think the first rate increase will happen at the June meeting.

What happens if unemployment continues to fall toward 5.5% and inflation drops below 1.5%? Can this Fed – not you or I, but the aggressively Keynesian members sitting on that board – justify raising rates if inflation is only 1.5% and falling? Which is the more important data number, unemployment or inflation? Or do they both need to click into place?

If the dollar were to continue to rise and thus allow Europe and Japan to export their deflation to the US, it is not clear that the Fed would raise rates in June.

A rise in the dollar from its current 85 on the DXY to 120 over the next six or seven years will throw a monkey wrench into the plans of the Federal Reserve.

Chapter 3 – Every Central Bank for Itself

A rising dollar presents all sorts of problems and opportunities for the central banks of the world. Japan has chosen the most aggressive monetary policy in the history of the world and will, I believe, work to see the value of the yen cut in half over time. Notice in the chart below that it was only 20 years ago that the yen was at 250. It touched 150 less than eight years ago. Forty years ago it was at 357. Is it so unthinkable that the yen could retrace half that move? Not to the Japanese. That would take it into the range of 200 to the dollar. I made the case for such a move in Endgame and doubled down on the prospects for Japan in Code Red. Japan is a bug in search of a windshield. The yen is embarked on a multi-year decline.

Europe would clearly like to see a weaker euro against the dollar and other major trading currencies. Ditto for almost every central bank in the world. But a rising dollar creates special problems for China and some emerging markets, problems we will look at in later chapters.

In an important speech on Saturday, October 11, Fed Vice-Chairman Stan Fischer outlined the mechanisms for the international transmission of monetary policy. Fischer says the international effects of monetary policy “spill back” onto the US, and the central bank cannot make “sensible” choices without taking them into account.

[T]he U.S. economy and the economies of the rest of the world have important feedback effects on each other. To make coherent policy choices, we have to take these feedback effects into account.

He ended with an assurance to all that the Federal Reserve would provide liquidity to the world in the event of another crisis. Because it is in our interest, he says. This will be the ultimate test of game theory, where it might take years to find the Nash equilibrium.

The bottom line? It’s every central bank for itself. No matter how much pleading there is from peripheral central banks, there will be no true coordination among the major central banks. (Hat tip to David Kotok for alerting me to Fischer’s speech as I was writing. He also pointed out that the unintended consequences of the feedback effect means that policymaking can be dangerous.)

Chapter 4 – The Man Behind the Euro Curtain

Was it only a few years ago that Mario Draghi uttered his famous line, “We will do whatever it takes”? Interest rates in Europe have collapsed since then, as the European bond markets believed that Mario had their back. He has not had to do anything of true significance to back up those words, and what he has done has been lackluster.

This week Mario was up on the stage in Washington DC, where he essentially said that the problems in Europe cannot be fixed by monetary policy but are fiscal and regulatory and require actions from governments, not from central banks. The Bundesbank has clearly held sway, at least so far as the prospects for European quantitative easing go. While Draghi hinted that he would like to do €1 trillion worth of QE, it is not clear exactly how he would go about that.

Mario is like the Wizard of Oz. He talks a good game and puts on a good show, but it is soon going to become apparent that he really doesn’t have any magic, at least not until the Germans allow him to open up his trunk of tricks. Right now they’re keeping it safely stowed away in Berlin.

German intransigence is going to precipitate a crisis in Europe. Italy has been in a recession. France is crossing into one. Spain is barely holding on. Even German exports are slowing. France and Italy are balking at meeting the 3% deficit targets mandated by the EU treaty. Germany has drawn a line in the sand; France and Italy fully intend to cross it. This should be interesting; but however it turns out, I don’t think it will be good for the euro.

How long can interest rates in Europe stay at the irrationally low levels where they are today? We touched on that question in past letters, so I won’t cover that ground again, other than to say negative interest rates in Ireland and France are as indicative of dysfunctional markets as anything one might postulate.

When Draghi loses the narrative, or his ability to simply jawbone the market to where he would like it to be, all hell is going to break loose in the European bond market. Exactly what will the safe-haven currency be? The Swiss can’t print enough francs. Even Norway doesn’t have that many kroner. It will be the US dollar. Implications in a later chapter.

Chapter 5 – The Wrong Side of the Trade

Close to 50% of sales and profits for the S&P 500 come from outside the US. A strong dollar will put a strain on those dollar-denominated profits. Not an insurmountable problem, as Japanese businesses have figured out how to thrive in a rising-yen environment for decades. But old US business dogs are going to have to learn new tricks in a rising-dollar world.

But a strong dollar is not just a problem for US exporters. It is particularly a problem for countries that are financed by the dollar carry trade. Multiple trillions of dollars have left the US courtesy of quantitative easing and have ended up financing all manner of trades and investments around the world. As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.

If you are a Chinese businessman and you can borrow dollars (which you certainly can) and you believe that your government is going to make the yuan stronger over time, you will be able to pay back cheaper dollars and make the difference on the carry (the difference between what US bonds pay and returns that can be earned in China). But what happens if the yuan begins to fall? That trade unwinds swiftly and negatively. And it unwinds at a time that is particularly inconvenient for China. Flood the market with too much money, and inflation becomes a problem. (The Chinese are in a different phase of the monetary cycle than the US is, so the problems are not the same.)

It is not just China. Those dollars have filtered into every nook and cranny of the world; and now, if those trades are unwound, investors and most specifically hedge funds are going to have to buy dollars to unwind their trades. That will force the dollar ever higher against various currencies; and while any one currency is not significant enough to create a structural difference that can impact global trade, together they will have a significant effect.

There is a crisis brewing in emerging markets. Most of the world’s hedge funds and investors are on the wrong side of the dollar trade. Unwinding that trade is going to be a bitch (that is a technical economics term). Worth Wray will be writing about that very topic in a few weeks. You do not want to miss that letter.

Chapter 6 – The Texas Carry Trade

A rising dollar is going to put pressure on oil prices in particular and on energy prices in general. And falling oil prices have a strong secondary effect on Federal Reserve interest-rate policy. Pay attention, there will be a quiz.

Over at The National Interest, Sam Rines of Chilton Capital writes that Texas has been the engine of growth for the US for the past five years:

Job creation might be a good place to start. Texas has created jobs – there is little arguing that point. For instance, we know the U.S. economy only recently gained back the jobs lost in the Great Recession. This is not true of Texas. While the United States dropped about 6 percent of employment, Texas lost 4 percent and recovered them all by August 2011 – nearly three years before the United States as a whole.

Here is where the numbers get interesting. From its peak in January 2008 through today, the United States has created only 750,000 jobs. Texas created over a million jobs during that same period – meaning that the rest of the country (RotC) is still short 300,000 jobs. During the recovery, job creation has been all Texas or – at the very least – disproportionately Texas.

Choosing a different starting point – for example, in the trough of job losses – changes the extremity of the story. And there are all sorts of reasons for this disparity between Texas and the rest of the country, most of which miss the main point. In a conversation with Worth, Rines called the disparity the Texas Carry Trade. I like that.

The Texas story is by and large an oil story. We are far more diversified that we were in the ’80s, but oil is clearly the driver. Texas has been at the forefront of job creation because our borders happen to contain the mostly inhospitable scrubland known as the Permian Basin in West Texas, not to mention the coastal plays and those in East Texas. Much (not all) of the growth in oil has come from horizontal drilling and fracking. And while there are enormous amounts of energy in Texas, it is not necessarily cheap energy – not like it was in the “good old days.”

Seventy-dollar oil considerably restrains the enthusiasm of Texas oil companies, let alone the banks and individuals that finance them.

And it is not just Texas companies. The Marcellus play in the Northeast is responsible for hundreds of thousands of jobs. And it’s much the same story all over the US. Oil has been a significant portion of the growth of US GDP for the past five years. If you take the massive oil boom away, the US looks a lot like Europe in terms of growth and job creation. Which is to say, anemic.

Seventy-dollar oil starts to show up in the unemployment rate, which makes it more difficult for the Federal Reserve to raise rates.

I was talking with Joe Goyne, president of Pegasus Bank in Dallas. He is one of those entrepreneurial bankers who actually analyzes a loan personally rather than letting some computer determine whether it fits the criteria. (The country would be better off with a lot more Joes running the banking industry, but that’s another story.) Joe’s customers are a who’s who of Dallas. We were discussing my convictions about a strong dollar and what that would do to the price of oil. Joe offered, “You won’t believe the pain in Dallas if oil falls to $60.” We went on to discuss some details. Does $60 oil sound far-fetched? Joe and I both remember $15 oil. Texas has been through numerous oil busts. The running joke in the late ’80s was “Would the last person leaving Houston please turn out the lights?”

The late ’80s was an ugly time for Texas. Will the Saudis ever allow oil to dip below $60 again? Can they afford to cut their production that much? What will happen to Russia if Brent drops to $80, let alone $60? It’s not just Texas. And while the world might benefit from lower energy prices, they would create havoc in a few key regions. And throw another monkey wrench in Federal Reserve policy. And in terms of the oil price, gods forbid that peace breaks out in the Middle East. But, sadly, given current circumstances, it doesn’t look like we have to worry about that.

Chapter 7 – The Bond Bull Comes Stampeding Back

Many of us in the US look at Europe and wonder how interest rates can fall to such insane levels. And the answer is that bond markets have rationales all their own. The unwinding of carry trades means the demand for dollars will rise just as the Federal Reserve cuts off the spigot. Some people look at Japan’s flooding the market with yen as an antidote and hope that the ECB, too, will soon start printing; but that is not going to reduce the demand for dollars to unwind the carry trade.

Whatever Japan and Europe do, the growth of global liquidity is still likely to fall over the next few years; and that is an inherently deflationary event, especially in dollar terms.

In addition, when – not if – there is a renewed crisis in Europe, the flight to safety is going to put pressure on the dollar and further downward pressure on US interest rates. While it is not altogether certain that China will have a major crisis – although reasonable economic historians would suggest that is the probable case – if it happens it will put further upward pressure on the dollar as a safe-haven currency. God forbid those two events – crises in Europe and China – happen at the same time. Our necks would snap at the severity of the acceleration in the value of the dollar. The convergent crises would also trigger a global recession.

We’re going to see a return of the bond bull market with a vengeance. Almost the entire world has hedged its bets for a rising interest-rate environment and assumes a benign dollar market. Almost no one expects a falling interest-rate environment, yet that is precisely what we will get if the dollar continues to rise and we have a crisis or two.

Chapter 8 – The Third Leg of the Secular Bear Market

I was writing about secular bear markets in 1999. I was early to the party, as usual (although my friends will note that I’m often late to real-time, real-life parties). I noted in Bull’s Eye Investing that it typically takes three events to completely wash out a trend. We have had two significant corrections since April 2000, accompanied by two recessions. I think the next recession will give us that final third leg of the secular bear market, hard on the heels of another correction that tests (but maybe doesn’t quite touch) the lows of 2009.

At that point I will trade my secular bear beret for a snappy new secular bull Panama. And while we may see a significant correction out of the current volatility, I don’t think the final dénouement of the secular bear will come without a global recession.

Since most of you have been through this before, you can probably figure out what strategy you should choose; but I would suggest at least thinking about having some type of hedge/moving average/risk-dispersion strategy in your toolkit.

The point is to get through this next crucial phase with as much of your capital intact as possible, in order to be able to take advantage of the coming secular bull market, when it will be anchors aweigh. Remember, we always get through these things. It is almost never the end of the world, and betting on the end of the world is a losing proposition anyway. Specifics to come later (maddening, I know, but there are space limits).

Chapter 9 – Commodities in a Dollar Bull Market

This book outline is running a little long, but a quick word on commodities. In general, commodity prices are going to face downward pressure, at least in dollar terms. That includes copper, most of the base metals, oil, etc. Silver has clearly been in a very ugly bear market. I would continue to accumulate insurance gold, but I would invest in gold only in terms of yen or another depreciating currency. Bear in mind that precious metals – along with other commodities – can and will fall precipitously in the event of a deflationary shock… although the inflationary effects of an aggressive central bank response may ultimately drive the yellow metal far above its current price.

Chapter 10 – The Return of Volatility

The final chapter and conclusion pretty much end as you would expect: the demise of monetary policy’s ability to soothe the soul of the markets and the return of volatility. We hopefully get a full-fledged restructuring of the sovereign debt markets. The Fed and sister central banks will try the same tired tools they have been using. Except they have already been to the zero rate boundary and have wasted the opportunity they had to increase rates so that they could lower them later. Another round of quantitative easing? Quite possible if we get a true deflation scare or a global recession. But I don’t think it will have the same results. The unintended consequences and the unknown spillovers will only increase eventual volatility.

For new readers, I invite you to read my books (co-authored with Jonathan Tepper) Endgame and Code Red. They pretty much lay out the background you need in order to understand what will be happening in the future. We are seeing the end of the debt supercycle and the beginning of currency wars. We’ll experience the throes of hyper-indebted nation-states trying to survive what they will see as irrational attacks by a bond market. “How can you not have faith in the government? We are doing our best to try to make everything work out just fine. As long as you cooperate.” Which bond markets have a nasty habit of not doing. Oh, you can placate them in the short term, but ultimately they want to be paid back in risk-adjusted buying power. And that is the one currency that many nation-states will no longer have. Now without major reforms and a significant restructuring of the social order.

A final thought. Businesses will keep on doing what they do, in spite of the machinations of governments and monetary authorities. Entrepreneurs will adjust. New inventions will be made. Over the medium term, life on earth will get better. I honestly do see a return of the secular bull market and a pretty cool third decade, an updated version of the Roaring Twenties. Only this time there will be no need for speakeasies. I fully intend to be around to enjoy it and am looking forward to being relatively optimistic about the future. I really don’t get much personal pleasure from writing these Debbie Downer letters. But my role is to not think about the world as it should be or as I want it to be, but to be as right as I can about the direction we are going. The ride could just be a little bumpier in the short term of the next few years. Fasten your seatbelts.

And for those of you looking for specific advice, let me point you to Jared Dillian, the new editor of my own Bull’s Eye Investor service. He has been finding ways to trade and invest in this market. Last Friday he wrote:

Guys, the price action has been bad for a while. And it is getting worse. The market is demonstrating repeatedly that it can’t hold its gains. In my 15 years of doing this, I’ve only seen worse price action twice: 2000, and 2007.

You can read about Jared and appreciate his baleful glare of a photo right here. Want to sit on a trading desk across from him? I want him on MY side of the table. See if you might want him in your corner as well.

Chicago, Athens (Texas), Boston, Geneva, and Atlanta

I have one more week to enjoy Dallas, and then I’m back on the road. I will go to Chicago for a speech, fly back to a meeting with Kyle Bass and his friends at the Barefoot Ranch in Athens, Texas, and then fly out to Boston to spend the weekend with Niall Ferguson and some of his friends at his annual briefing. I am sure I will be happily surfing mental stimulus overload that week. I fly from Boston to Geneva for a few days and then more or less directly to Atlanta for a day (board meeting), before heading back to Dallas.

Next Saturday is wedding day. It has been years since I’ve been to a wedding, and next Saturday I will go to two. I fly to Houston to watch my young associate, Mr. Worth Wray, tie the knot with his lovely fiancée, Adrienne. You have to admire a young man for playing above his weight class. He gets married in the morning, and that afternoon we fly back to Dallas to attend the wedding of David Tice’s daughter Abigail.

Next Monday evening I get to spend some time with Woody Brock here in Dallas before I launch my travels. I’ll be back in time for Halloween.

It’s time to hit the send button. I smell stir-fry chicken and vegetables simmering on the stove and need to find a piece of mindless entertainment with which to relax with family and friends. Have a great week,

Your ready to find his sweaters analyst,

John Mauldin
subscribers@mauldineconomics.com

 

The article Thoughts from the Frontline: Sea Change was originally published at mauldineconomics.com.

Outside the Box: The world’s greatest stock picker? Bet you sold Apple and Google a long time ago.

 

My good friend Barry Ritholtz, famous for launching The Big Picture blog (and since graduating to being a regular Bloomberg columnist as well as writing a weekly column for the Washington Post), is well-known for being a contrarian. Barry is a regular dinner partner when I get to New York, and he also participates in the annual Maine fishing trip. We frequently trade information … and barbs. The word colorful affectionately comes to mind when I think of Barry (and maybe opinionated would work).

I can usually count on him to find at least a few things to disagree with me on at our dinners. No matter what devastating arguments I produce to demonstrate the errors in his thinking, he conjures up new facts to support his flawed positions. We have had a few of these episodes as members of a panel in front of a large public audience, much to the amusement of the spectators (and watching Barry can be an entertaining spectacle). My only real frustration with Barry is that he is mentally faster than I am and he seemingly remembers every obscure data point from the last thousand years. I consider it a triumph if I merely hold my ground.

But one thing we do agree on and are both passionate about is that we human beings were not designed for these modern times. As I so often say, we evolved on the African savanna dodging lions and chasing antelopes. We have converted those survival instincts into an unwieldy approach to dealing with financial markets, which is not the optimal way to approach investing. Both of us write a great deal about behavioral investing and the foibles of human nature.

I was struck by the insights of Barry’s latest Washington Post column. How difficult it is for us humans to hold on in the middle of dramatic volatility. Don’t you wish you had held Apple for the last 10 years? A 1000-bagger is not to be sneezed at. But dear gods, the volatility! And what about the stocks that once looked like a better bet than Apple that went to zero? How do you decide when to hold and when to fold? (Cue Kenny Rogers.)

This is a short Outside the Box, but it’s one that should make you think, which is the purpose of this letter.

And in a departure from my usual close, I want to offer two links. The first is to a fascinating web post at something called distractify.com of 52 colorized historical photos. You  have seen most of these photos in black and white (or at least you have if you have reached my advanced age). Seeing them in color is quite another story.

Second, and not for the faint of heart, is a link to a rather heated exchange between Ben Affleck and Bill Maher over radical Islam and Islamaphobia. I generally find Maher annoying, sometimes in the extreme. But this “conversation” is instructive. It illustrates the tensions in the Western world around dealing with Islamic beliefs and the religion in general. The other guests chime in with fascinating anecdotes. You can decide for yourself who wins this argument, but it is one that is increasingly important in our world. And I am not sure anyone will be comfortable with the answers. This is courtesy of my friends over at Real Clear Politics.

I am still luxuriating in the aftermath of my birthday party on Saturday night. Friends flew in from all over the country (and from around the world) and surprised me. Too many to mention, but I was deeply honored and humbled. My staff and friends and family put the whole thing together (huge thanks to Shannon and Mary and Shane and my kids). My daughter Melissa put together a playlist on Spotify of all the songs she has heard me listening to over the years. Three and a half hours of one hit after another. We are working on making it available to those of you who are already on Spotify.

And just for the record, that morning I did 66 consecutive push-ups on my 65th birthday. I then went on to do a total of 360 push-ups (50×5+44) in less than two hours, with the help of an Avacor machine to cool me down between sets, in a workout that included a similar number of abs, lat pulldowns, arm exercises, etc. Knock on wood, I do not plan to go gently into that good night. As a geek, I am coming late in life to loving the gym. But better late…

It is time to hit the send button. I am off to the Great Investors’ Best Ideas Symposium here in Dallas. It is a who’s who of famous investors, all of whom agreed to speak and to give one investment tip to aid a great charity. Bill Ackman, David Einhorn, Paul Isaac, Bill Miller, Ray Nixon, Richard Perry, T. Boone Pickens, Michael Price, Tom Russo, and moderated by Gretchen Morgenson. Have a great week while thinking about how to get your human nature under control.

Your more human that I want to admit analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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The world’s greatest stock picker? Bet you sold Apple and Google a long time ago.

By Barry Ritholtz
The Washington Post, Oct. 4, 2014

Let’s imagine for the moment that you are the World’s Greatest Stock Picker. You have an uncanny talent for ferreting out “the next Microsoft” – companies that are on the sharpest edge of what’s next, that are about to undergo tremendous growth. These firms will rule the world: They will be the most powerful, profitable and influential corporate entities known to man.

Even better, your superpower is that you can find these companies when they are tiny, before they have had their explosive growth, when hardly anyone has heard of them. You find and buy these stocks while their prices are still in the single digits. Companies like Apple, Google, Tesla, Netflix and Chipotle that will one day measure their growth in increments of thousands of a percent.

Can you imagine how much wealth you could create?

I have some bad news for you, kiddos: Even if you had that superpower, it would be worth surprisingly little to you. The odds are that it would not create much wealth, and it might even cost you money.

How could that be possible?

The short answer is your brain. The three-pound ball of gray matter sitting atop your spinal cord was never designed to make risk/reward decisions in capital markets. It took about 100,000 years to optimize for its intended purpose: Keeping you alive.

The occasional Darwin Award aside, it does an outstanding job of keeping you safe from all manner of predators on the savanna. That you now live in a condo and enjoy lattes is irrelevant to its functionality. Its job remains keeping you alive long enough for you to procreate, pass your genes along and perpetuate the species.

This dynamic, opportunistic, self-organizing system of systems occasionally runs into trouble when we try to force it to perform other, “off-label” uses. That includes buying and selling pieces of paper that represent tiny slices of companies. As we shall see, that big, under-utilized brain of yours is no help anytime it gets over-stimulated by your emotions.

Which is precisely why being the World’s Greatest Stock Picker is unlikely to be how any of you is going to get rich. Let’s use the shares of five companies as examples: Google, Tesla, Chipotle, Netflix and Apple.

The performance of each since its initial public stock offering has been nothing short of astounding. Since going public, each stock has generated returns of more than 1,000 percent. A $10,000 IPO allocation in any one is now worth at least $100,000.

To give you an idea of just how phenomenal these companies have done, Google is the laggard of the lot. Since its IPO in August 2004, it has gained a mere 1,282 percent. Tesla edged out the boys from Mountain View, Calif., with a gain of 1,352 percent. And they did it in less than four years – Tesla’s IPO was June 2010 – vs. the decade it took Google to gain 1,000 percent.

Those spectacular returns look downright paltry compared with the 2,865 percent gain Chipotle has had since going public in 2006. And Netflix beats that, rising 5,816 percent since 2002.

Then there is Apple. It is a beast unto itself, racking up a mind-boggling 22,288 percent in appreciation since its 1980 debut. It has become world’s biggest company by market capitalization.

Even if you bought large chunks of each of these firms at their IPOs, the odds are that nearly all of these giant gains would have eluded you. Why? As I shall show you, each of these companies would have sent you running for the exits – repeatedly – over the years, screaming as if your hair were on fire.

Don’t believe me? Consider the facts:

• Netflix has lost 25 percent of its value on four separate days. Not over four days; on separate occasions, it lost 25 percent in a single day. In one four-month stretch in 2011, it lost 80 percent of its value. On Netflix’s worst day, it fell 41 percent.

• Chipotle has lost 15 percent in a single day on four occasions. During the 2007-2009 crash, it lost 76 percent of its value – about 50 percent worse than the market overall.

• Tesla went up 400 percent in 6 months, then lost 40 percent over the next 10 weeks. In one month, it lost about 25 percent of its value.

• Google lost nearly 70 percent in the Great Recession. During its worst quarter, its stock price fell more than 36 percent.

• Apple has lost 25 percent or more six times in the past 10 years alone. That was after its meteoric rise. During its worst week, it was cut in half, falling 51 percent. It saw similar damage during its worst month and quarter as well – getting cut in half in each time   period.

How often have you invested in a stock, only to get scared out of it when things grew shaky? That’s fairly typical behavior for investors.

Now imagine how you would have behaved if you happened to have a significant part of your net worth tied up in that one holding.

Let’s say a decade ago, you put $15,000 into Apple. You bought 1,000 shares at $15 (with $13 cash) because you thought that newfangled iPod had some potential. Since then, it split two for one and then earlier this year, it split seven for one. You now are holding 14,000 shares of Apple. At the current price of about $100, it is worth $1.4 million dollars. For most people, this is a very high percentage of their net worth. How well do you sleep when 90 percent of your total net worth goes through giant swings?

Apple was worth about the same amount in September 2012 – just before it gave back almost half its value, falling 44 percent. Would you have held on? What about all of those prior 50 percent corrections?

This is not an academic theory. Consider how you have reacted to much more modest drops in your holdings. How often were you shaken out of a stock, only to see it rocket higher after you sold? And somebody was dumping stocks in March 2009; after all, selling climaxes (also known as capitulation) are how bottoms are made.

Some years ago, I recommended to the brokers I worked with to do just that regarding Apple. They bought millions of shares at an average price of $15. At $20 dollars, they were selling it, whooping it up and high-fiving one another. When I asked why they were selling it when my price target was higher ($30!), I was told: “It’s a 33 percent winner – time to ring the bell, Ritholtz!” That was even before any trouble had hit.

How many of you, dear readers, could hold onto a giant winner like these five for the duration? How do you know that any of these are not about to turn into a classic disaster stock? Think about once-giant winners that collapsed: Lehman Brothers, WorldCom, Lucent, JDS Uniphase.

All of these were one-time market heroes; all went bust in spectacular fashion. Your superpower gives you the ability to find the giant winners, but it does not give you the ability to hold onto them, nor does it give you the ability to distinguish between the superstars and the washouts.

As we have discussed previously, this is a feature, not a bug. The good news is your brain has kept you alive long enough to read this column. The bad news, it also made you sell Apple 10,000 percent ago.

The reality is, when it comes to risk/reward decisions, you are just not built for it.

 

Barry Ritholtz is Chairman and Chief Investment Officer at Ritholtz Wealth Management. His columns on personal finance can be found at the Washington Post. His daily musings on all things finance- & Wall Street-related can be found on Bloomberg View. Be sure to check out Masters in Business, his weekly interview series on Bloomberg Radio. Follow him on Twitter @Ritholtz.

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