Polls show that about half the American people favor it as well. The argument in favor is that GBI gives everyone a firm financial foundation on which they can seek other employment, turn down “lousy” jobs, get education and training, provide household services to family, friends and community, or maybe just be artists.
The argument against GBI is that it encourages laziness, discourages productive work, is unaffordable by heavily indebted governments, and will produce inflation, which destroys savings and impedes capital formation.
But, what about hard evidence? Some countries around the world have already started GBI programs and the initial results are not favorable.
Finland has decided not to expand a pilot program of GBI. The program’s results in terms of job gains were disappointing. This tends to support the views of those who claim that GBI discourages work rather that encourages it through training. This is a small sample; there will be a lot more discovered about the effects of GBI in the years ahead.
Meanwhile, the political debate is going full-speed ahead. And it is not going away soon. The advocates for GBI see no problem with the budget deficit aspects of this. In their view, the Fed can monetize the debt forever; so there’s no problem finding the money.
The guaranteed jobs plan sounds better to politicians than GBI, but it still causes massive budget deficits without much in return.
In the end, the GBI and guaranteed jobs plans will fail as they always do. But that does not mean they won’t be tried. You should expect this to be a big political issue in the 2018 mid-term elections later this year and the 2020 presidential election. The deficits that go along with GBI will guarantee that America continues to go broke.
The combination of tax cuts and massively expanded government already guarantee ballooning deficits ahead. And this is when the economy is supposedly strong.
But the economy is long overdue for a recession. The typical post-WWII economic expansion lasted only 58 months or so. The current “expansion” — and I use the scare quotes because it’s been so week by historical standards — is 108 months.
What happens when the inevitable recession does strike?
Tax receipts will dry up and the government will almost certainly unleash a flood of deficit spending to stimulate the economy. And the Fed’s current policy of quantitative tightening (QT) will swing into reverse.
Debt, already at frightening levels, will spike. But the economy is in the condition it’s in today because of too much debt and not enough growth. More debt will only make things worse.
Central banks have little room to cut rates or print money in a future crisis, even with the Fed’s recent hikes. That’s why the Fed is so determined to raise rates, so it can cut them again when it needs to.
Meanwhile, taxpayers have no tolerance for more bailouts. And governments around the world are experiencing political polarization. It’s not just here in the U.S. There is simply no will and no ability to deal with the next panic or recession when it hits.
The systemic dangers are clear.
The next panic will be unstoppable without extreme measures — including IMF money printing, and lockdowns of banks and money market funds.
The calls for a guaranteed job or guaranteed basic income will soar. Unfortunately, the money won’t be there to support it.
I’m Jim Rickards, a colleague of Nilus here at Agora, filling in for him this weekend.
One of the first things I learned as a registered Washington lobbyist, (yes, I admit it, I was a lobbyist in the 1990s), is “you can’t beat something with nothing.”
That’s a Washington insider’s way of saying that if you don’t like an opponent’s policies, it’s not enough to moan and complain about them and throw insults. You have to come up with a policy of your own that appeals to voters and can be offered to the public as an alternative.
This has been a problem for Democrats lately.
They can’t stand Donald Trump and insult him all day long, but they won’t prevail in major elections scheduled in 2018 and 2020 unless they offer the voters something other than constant ridicule of Trump.
A few smart Democrats, including Bernie Sanders and Cory Booker, have figured this out. Their alternative to Trump’s policies is a government guaranteed job for every American who wants one. The jobs will be low or negative productivity government jobs requiring few or no skills and offering no advancement.
This proposal may sound odd coming at a time when the official unemployment rate is 3.9%, the lowest in almost twenty years. Unemployment is 3.7% for adult white men and 3.5% for adult white women, while African-American unemployment is approaching historic lows.
Why roll out a jobs program now?
The answer is that the official unemployment statistics are highly misleading. They do not count approximately 10 million able-bodied working age adults who have simply given up on work.
Adjusted for those “missing workers,” the real unemployment rate is about 10%, a depression level figure.
Interest in the guaranteed jobs program is high. Critics say the program will destroy incentives and undermine the traditional work ethic. Supporters say it will help to raise wages because private employees will have to match the wages being offered by the program itself in order to compete with the government jobs.
In that sense, this is really a backdoor way to raise the Federal minimum wage and increase benefits. Whichever side you’re on, get used to hearing about this debate in the years ahead.
Who knows, maybe Trump will end up supporting it. Trump is not a traditional conservative, but he is a shrewd politician who may just steal his opponent’s best idea. You can’t beat something with nothing.
There is also a parallel idea beginning to gain traction in important circles…
I’ve been writing lately about something called “GBI,” which stands for guaranteed basic income. GBI is the new buzz phrase that’s the talk of academia, Silicon Valley and the elites on both coasts.
GBI goes by other names including universal basic income, UBI, or just basic income, but the policy is the same regardless of the name. The idea is that governments will guarantee every citizen a certain basic income as a matter of right. Everyone making below a certain amount of money gets a check.
It’s really just welfare by another name, but it would apply to a much broader group than just the poor and you would not have to pass any income tests or work requirements to qualify.
There is no means testing and no work requirement. The government just hands every man and woman a check every month whether rich or poor, young or old, employed or unemployed.
The idea behind GBI is that technology is making many jobs obsolete and those jobs are not coming back. Some Americans can compete in the new high-tech high-reward world, but most cannot.
If people cannot get jobs and incomes stagnate, then there will be no consumption and no one to buy the gadgets that the tech companies are making. Instead, everyone will get a check so they can spend freely.
My reason for highlighting GBI is that you’re going to be hearing a lot more about it in the next two years. Instead of a guaranteed job, leading Democratic Party politicians in the U.S. support GBI as part of their platform...
Emerging-market debt crises are as predictable as spring rain. They happen every 15–20 years, with a few variations and exceptions.
In recent decades, the first crisis in this series was the Latin American debt crisis of 1982–85. The combination of inflation and a commodity price boom in the late 1970s had given a huge boost to economies such as Brazil, Argentina, Chile, Mexico and many others, including countries in Africa.
This commodity boom enabled these emerging-market (EM) economies to earn dollar reserves for their exports. (By the way, we didn’t call them “emerging markets” in the 1980s; they were the “Third World” after the Western world and the communist world.)
These dollar reserves were soon supplemented with dollar loans from U.S. banks looking to “recycle” petrodollars that the OPEC countries were putting on deposit after the oil price explosion of the 1970s.
I worked at Citibank from 1976–1985 during the height of petrodollar recycling and even discussed the process personally with Walter Wriston, Citibank’s legendary CEO. In the 1960s, Wriston invented the negotiable eurodollar CD, which was later critical to funding those EM loans.
Wriston is considered the father of petrodollar recycling once the petrodollar was created by Henry Kissinger and William Simon under President Nixon in 1974. I remember those days extremely well. The bank made billions and our stock price soared. It was a euphoric phase and a great time to be an international banker.
Then it all crashed and burned. One by one, the lenders defaulted. They had squandered their reserves on vanity projects such as skyscrapers in the jungle, which I saw firsthand when I visited Kinshasa on the Congo River in central Africa. Most of what wasn’t wasted was stolen and stashed away in Swiss bank accounts by kleptocrats.
Citibank was technically insolvent after that but was bailed out by the absence of mark-to-market accounting. We were able to pretend the loans were still good as long as we could refinance them or roll them over in some way. Citibank has a long and glorious history of being bailed out, stretching from the 1930s to the 2010s.
After the defaults, the reaction set in. Emerging markets had to flip to austerity, devalue their currencies, cut spending, cut imports and gradually rebuild their credit. There was a major EM debt crisis in Mexico in 1994, the “Tequila Crisis,” but that was contained by a U.S. bailout led by Treasury Secretary Bob Rubin. On the whole, the EMs used the 1990s to rebuild reserves and restore their creditworthiness.
Gradually, the banks looked favorably on this progress and new loans started to pour in. Now the target of bank lending was not Latin America but the “Asian Tigers” (Singapore, Taiwan, South Korea and Hong Kong) and the “mini-tigers” of South Asia.
The next big EM debt crisis arrived right on time in 1997, 15 years after the 1982 Latin American debt crisis. This one began in Thailand in June 1997.
Money had been flooding into Thailand for several years, mostly to build real estate projects, resorts, golf courses and commercial office buildings. Thailand’s currency, the baht, was pegged to the dollar, so dollar-based investors could get high yields without currency risk.
Suddenly a run on the baht emerged. Investors flocked to cash out their investments and get their dollars back. The Thai central bank was forced to close the capital account and devalue their currency, forcing large losses on foreign investors.
This sparked fear that other Asian countries would do the same. Panic spread to Malaysia, Indonesia, South Korea and finally Russia before coming to rest at Long Term Capital Management, LTCM, a hedge fund in Greenwich, Connecticut.
I was chief counsel to LTCM and negotiated the rescue of the fund by 14 Wall Street banks. Wall Street put up $4 billion in cash to prop up the LTCM balance sheet so it could be unwound gradually. At the time of the rescue on Sept. 28, 1998, global capital markets were just hours away from complete collapse.
Emerging markets learned valuable lessons in the 1997–98 crisis. In the decade that followed, they built up their reserve positions to enormous size so they would not be disadvantaged in another global liquidity crisis.
These excess national savings were called “precautionary reserves” because they were over and above what central banks normally need to conduct foreign exchange operations. The EMs also avoided unrealistic fixed exchange rates, which were an open invitation to foreign speculators like George Soros to short their currencies and drain their reserves.
These improved practices meant that EMs were not in the eye of the storm in the 2007–08 global financial crisis and the subsequent 2009–2015 European sovereign debt crisis. Those crises were mainly confined to developed economies and sectors such as U.S. real estate, European banks and weaker members of the eurozone including Greece, Cyprus and Ireland.
Yet memories are short. It has been 20 years since the last EM debt crisis and 10 years since the last global financial crisis. EM lending has been proceeding at a record pace. Once again, hot money from the U.S. and Europe is chasing high yields in EMs, especially the BRICS (Brazil, Russia, India, China and South Africa) and the next tier of nations including Turkey, Indonesia and Argentina.
As Chart 1 and Chart 2 below illustrate, we are now at the beginning of the third major EM debt crisis in the past 35 years.
Chart 1 measures the size of hard-currency reserves relative to the number of months of imports those reserves can buy. This is a critical metric because emerging markets need imports in order to generate exports. They need to buy machinery in order to engage in manufacturing. They need to buy oil in order to keep factories and tourist facilities operating.
Chart 1 shows how many months each economy could pay for imports out of reserves if export revenue suddenly dried up.
Chart 2 shows the gross external financing requirement, GXFR, of selected countries calculated as a percentage of total reserves. GXFR covers both maturing debt denominated in foreign currencies (including dollars and euros) and the current account deficit over the coming year.
Both charts reflect a crisis in the making.
The hard-currency import coverage for Turkey, Ukraine, Mexico, Argentina and South Africa, among others, is less than one year. This means that in the event of a developed-economy recession or another liquidity crisis where demand for EM exports dried up, the ability of those EMs to keep importing needed inputs would be used up quickly.
Chart 2 has even more disturbing news. Turkey’s maturing debt and current account deficit in the year ahead is almost 160% of its available reserves. In other words, Turkey can’t pay its bills.
Argentina’s ratio of debts and deficits to reserves is over 120%. The ratio for Venezuela is about 100%, and Venezuela is a major oil exporter.
These metrics don’t merely forecast an EM debt crisis in the future. The debt crisis has already begun.
Venezuela has defaulted on some of its external debt, and litigation with creditors and seizure of certain assets is underway. Argentina’s reserves have been severely depleted defending its currency, and it has turned to the IMF for emergency funding.
Ukraine, South Africa and Chile are also highly vulnerable to a run on their reserves and a default on their external dollar-denominated debt. Russia is in a relatively strong position because it has relatively little external debt. China has huge external debts but also has huge reserves, over $3 trillion, to deal with those debts.
The problem is not individual sovereign defaults; those are bound to occur. The problem is contagion.
History shows that once a single nation defaults, creditors lose confidence in other emerging markets. Those creditors begin to cash out investments in EMs across the board and a panic begins.
Once that happens, even the stronger countries such as China lose reserves rapidly and end up in default. In a worst case, a full-scale global liquidity crisis commences, this time worse than 2008.
A full-blown EM debt crisis is coming soon. It is likely to start in Turkey, Argentina or Venezuela, but it won’t end there.
The panic will quickly affect Ukraine, Chile, Poland, South Africa and the other weak links in the chain.
The IMF will soon run out of lending resources and will have to pass the hat among the richer members. But the Europeans will have their own problems, and the U.S. under President Trump is likely to reply, “America First,” and decline to participate in bailing out the EMs with U.S. taxpayer funds.
At that point, the IMF may have to resort to printing trillions of dollars in special drawing rights (SDRs) to reliquify a panicked world. SDRs are essentially world money. Elites are working behind the scenes to ultimately replace the dollar with SDRs as the leading reserve currency.
A new crisis will bring that goal one step closer to reality.
Is the Fed ready for the next recession?
The answer is no.
Extensive research shows that it takes between 300 and 500 basis points of interest rate cuts by the Fed to pull the U.S. economy out of a recession. (One basis point is 1/100th of 1 percentage point, so 500 basis points of rate reduction means the Fed would have to cut rates 5 percentage points.)
Right now the Fed’s target rate for fed funds, the so-called “policy rate,” is 1.75%. How do you cut rates 3–5% when you’re starting at 1.75%? You can’t.
Negative interest rates won’t save the day. Negative rates have been tried in Japan, the eurozone, Sweden and Switzerland, and the evidence is that they don’t work to stimulate the economy.
The idea of negative rates is that they’re an inducement to spend money; if you don’t spend it, the bank takes it from your account — the opposite of paying interest. Yet the evidence is that people save more with negative rates in order to meet their lifetime goals for retirement, health care, education, etc.
If the bank is taking money from your account, you have to save more to meet your goals. That slows down spending or what neo-Keynesians call aggregate demand. This is just one more example of how actual human behavior deviates from egghead theories.
The bottom line is that zero means zero. If a recession started tomorrow, the Fed could cut rates 1.75% before they hit zero. Then they would be out of bullets.
What about more quantitative easing, or “QE”? The Fed ended QE in late 2014 after three rounds known as QE1, QE2 and QE3 from 2008–2014. What about QE4 in a new recession?
The problem is that the Fed never cleaned up the mess from QE1, 2 and 3, so their capacity to run QE4 is in doubt.
From 2008–2014, over the course of QE1, 2 and 3, the Fed grew its balance sheet from $800 billion to $4.4 trillion. That added $3.6 trillion of newly printed money, which the Fed used to purchase long-term assets in an effort to suppress interest rates across the yield curve.
The plan was that lower long-term interest rates would force investors into riskier assets such as stocks and real estate. Ben Bernanke called this manipulation the “portfolio channel” effect.
These higher valuations for stocks and real estate would then create a “wealth effect” that would encourage more spending. The higher valuations would also provide collateral for more borrowing. This combination of more spending and lending was supposed to get the economy on a sustainable path of higher growth.
This theory was another failure by the eggheads.
The wealth effect never emerged, and the return of high leverage never returned in the U.S. either. (There is a lot more leverage overseas in emerging-market dollar-denominated debt, but that’s not what the Fed was hoping for. The EM dollar-debt bomb is another accident waiting to happen that I’ll explore in a future commentary.)
The only part of the Bernanke plan that worked was achieving higher asset values, but those values now look dangerously like bubbles waiting to burst. Thanks, Ben.
The problem now is that all of that leverage is still on the Fed’s balance sheet. The $3.6 trillion of new money was never mopped up by the Fed; it’s still there in the form of bank reserves. The Fed has begun a program of balance sheet normalization, but that program is not far along. The Fed’s balance sheet is still over $4 trillion.
That makes it highly problematic for the Fed to start QE4. When they started QE1 in 2008, the balance sheet was $800 billion. If they started a new QE program today, the they would be starting from a much higher base.
The question is whether the Fed could take their balance sheet to $5 trillion or $6 trillion in the course of QE4 or QE5?
In answering that question, it helps to bear in mind the Fed only has $40 billion in capital. With current assets of $4.4 billion, the Fed is leveraged 110-to-1. That’s enough leverage to make Bernie Madoff blush.
To be fair to the Fed, their leverage would be much lower if their gold certificates issued by the Treasury were marked to market. That’s a story for another day, but it does say something significant about the future role of gold in the monetary system.
Modern Monetary Theory (MMT) led by left-wing academics like Stephanie Kelton see no problem with the Fed printing as much money as it wants to monetize Treasury debt. MMT is almost certainly incorrect about this.
There’s an invisible confidence boundary where everyday Americans will suddenly lose confidence in Fed liabilities (aka “dollars”) in a hypersynchronous phase transition. No one knows exactly where the boundary is, but no one wants to find out the hard way.
It’s out there, possibly at the $5 trillion level. The Fed seems to agree (although they won’t say so). Otherwise they would not be trying to reduce their balance sheet today.
So if a recession hit tomorrow, the Fed would not be able to save the day with rate cuts, because they’d hit the zero bound before they could cut enough to make a difference. They would not be able to save the day with QE4, because they’re already overleveraged.
What can the Fed do?
All they can do is raise rates (slowly), reduce the balance sheet (slowly) and pray that a recession does not hit before they get things back to “normal,” probably around 2021. What are the odds of the Fed being able to pull this off before the next recession hits?
Not very good.
Have a look at the chart below. It shows the length of all economic expansions since the end of World War II.
The current expansion is shown with the orange bar. It started in June 2009 and has continued until today. It is the second-longest expansion since 1945, currently at 107 months. It is longer than the Reagan-Bush expansion of 1982–90.
It is longer than the Kennedy-Johnson expansion of 1961–69. It’s longer than any expansion except the Clinton-Gingrich expansion of 1991–2001. Just on a statistical basis, the odds of this expansion turning to recession before the end of 2020 are extremely high.
In short, there’s a very high probability that the U.S. economy will go into recession before the Fed is prepared to get us out of it.
That means once the recession starts, the U.S. may stay in the situation for decades, which is exactly what happened to Japan beginning in 1990. By the way, Japan’s most recent GDP report for the first quarter of 2018 showed negative growth. Japan has had three “lost decades.” The U.S. is just finishing its first lost decade and may have two more to go.
The situation is even worse than this dire forecast suggests. The reason is that by preparing to fight the next recession, the Fed may actually cause the recession they’re preparing to cure. It’s like trying to run a marathon while being chased by a hungry bear.
The Fed needs to raise rates and reduce their balance sheet in order to have enough policy leeway to fight a recession. If they move too quickly, they’ll cause a recession. If they move too slowly, they’ll run out of time and get eaten by the bear.
This is the ultimate monetary finesse. This mess was caused by Bernanke’s failure to raise rates in 2010 and 2011 when the economy was in the early stages of an expansion and in a better position to absorb rate hikes. It was also caused by Bernanke’s insistence on QE2 and QE3 despite zero evidence then or now that it does any good. (QE1 was actually needed to deal with a liquidity crisis, but that was over in 2009. There’s no excuse for what came later.)
A recession is coming, the Fed is unprepared and it’s extremely unlikely the Fed will be prepared in time.
The Fed may not be ready, but you can be. This is a time to reduce your exposure to risky assets such as stocks, increase your allocation to safe assets such as cash and allocate 10% of your portfolio to gold and silver as insurance against a collapse scenario much worse than a recession.
The only other recommendation is to do what the Fed is doing… pray.
A major blind spot in U.S. strategic economic doctrine is the increasing use of physical gold by China, Russia, Iran, Turkey and others both to avoid the impact of U.S. sanctions and create an offensive counterweight to U.S. dominance of dollar payment systems.
This is the Axis of Gold.
This gold-based payments system will dilute and ultimately eliminate the impact of U.S. dollar-based sanctions.
Gold offers adversaries significant defenses against these dollar-based sanctions. Gold is physical, not digital, so it cannot be hacked or frozen. Gold is easy to transport by air to settle balance of payments or other transactions between nations.
Gold flows cannot be interdicted at SWIFT, the international payment system. Gold is fungible and non-traceable (it is an element, atomic number 79), so its origin cannot be ascertained.
We have a lot of data to support the claim that the Axis of Gold exists and is gaining strength.
We know that for example, Russia has tripled its gold reserves in the last ten years. It’s gone from about 600 tons to over 1800 tons of physical gold, and is moving very quickly towards 2,000 tons. That’s an enormous amount of gold.
China is also amassing physical gold at an astounding rate. Like Russia, it has tripled its gold reserves, officially from 1,600 tons to 1,800 tons.
But we have very good reason to believe China actually has a lot more gold than that.
China might actually own up to 4,000 tons of physical gold. We don’t know the exact number because China is highly secretive about its gold acquisitions. But that’s a reasonable estimate. China is also the world’s largest gold producer with mining output of about 450 tons per year.
Iran also has an enormous amount of gold. Iran received billions of dollars in gold from the Obama administration as bribes to join in the now discredited nuclear deal (the “JCPOA” or Joint Comprehensive Plan of Action) to limit Iran’s nuclear weapons program.
Iran has also received gold imported from Europe via Turkey, but the exact amount is unknown.
We don’t have any insight into how much it has because it’s also highly nontransparent. But in the first quarter of 2018, Iranian gold bar and coin purchases more than tripled.
Turkey is also acquiring enormous amounts of gold, which should not be surprising given Turkish president Recep Erdogan’s recent comments questioning the role of the dollar in global trade.
The Turkish central bank has almost doubled its gold holdings since last May, according to the World Gold Council. And it was the second largest buyer of gold among central banks for the first quarter of 2018.
So that’s the Axis of Gold. Again, evidence for this Axis of Gold is overwhelming.
I have contacts in the national security industry community who have, in their own roundabout way, been able to confirm that to me, so it’s very clear that’s what’s happening.
This is the type of information you don’t see in the headlines. This is very granular, but it’s all going on behind the scenes.
I’ve explored the implications in many financial war games and other meetings as I’ve described in my books.
I’m also on the Board of Advisors of the Center for Sanctions and Illicit Finance, which is the leading think tank on this subject. I meet with others who are expert in this area, including current and former government officials.
I’ve warned the Pentagon and the Treasury Department about this threat for years. But the message has yet to sink in. The U.S. is still unprepared for this coming strategic alternative to dollar dominance.
Meanwhile, U.S. trade sanctions on China, Russia and Europe are just beginning to bite. Trump’s new sanctions on Iran may be the last straw in the world’s willingness to tolerate what is perceived as U.S. bullying through the use of dollar-based sanctions.
These headwinds are illustrated in the chart below. This shows the customers for oil exported by Iran. China is Iran’s largest oil customer by a wide margin. China’s need for imported oil is huge and Iran’s need for hard currency from its oil exports is existential.
If the U.S. makes it impossible for Iran to pay or receive dollars or other hard currencies for its oil exports and machinery imports, Iran will have to resort to other payment channels. China would be willing to pay Iran in yuan, but Iran’s appetite for yuan is limited.
As mentioned above, an obvious solution is for Iran and China to settle their balance of payments accounts in gold.
Trump’s sanctions on Iran are a double-whammy.
On the one hand, they impede global trade and growth; especially in Europe where growth was already slowing down before the sanctions. On the other hand, the Axis of Gold will create enormous demand for physical gold as an alternative to dollar payments vulnerable to U.S. sanctions.
At the same time, the Axis of Gold creates huge embedded demand for gold as the Axis nations build out an alternative to the dollar payments system.
But right now gold mining output is flat, western central bank sales of gold have ceased, and acquisition of gold by the Axis is increasing.
With limited output, limited western sales, and huge eastern purchases, it’s only a matter of time before a link in the physical gold delivery chain snaps and a full-scale buying panic erupts. Then the price of gold will soar regardless of paper gold manipulations.
Meanwhile, Fed tightening combined with weak growth will push the U.S. economy to the brink of recession later this year.
That will cause the Fed to reverse course and pause in their path of rate hikes. The pause will come possibly in September, and almost certainly by December. The perception of the Fed flipping from tightening to ease will remove a major headwind to higher gold prices and create a tailwind.
Future Fed ease combined with strong demand for physical gold will result in much higher gold prices by year end. The next few months could still be a bumpy ride for gold, but late summer and fall look promising for much a push to $1,400 per ounce or higher.
Last week’s drawdown in gold prices should be seen for what it is, a temporary reversal in a new bull market. The current gold price of about $1,300 per ounce is a classic “buy-the-dips” opportunity that won’t come again soon.
But before long it may be too late for investors to benefit because the ready supply of physical gold will be gone. The time to take a position is now.
The days of dollar dominance are numbered. The process won’t happen overnight, but the signs all point in one direction.
Emerging markets, EMs, have had an amazing run over the past two years. Moving in lock step with U.S. stock markets, the leading EM stock ETF has produced gains of over 50% since early 2016.
But just as U.S. stocks have run into higher volatility and major drawdowns in recent months, EM stocks have also encountered head winds. A major reversal of EM stock gains is emerging.
The reason U.S. stocks and EM stocks have moved together is not difficult to discern. Both asset classes are what economists call “risky” assets, in contrast to “safe” assets such as developed-market government bonds or even “risk-free” assets such as short-term U.S. Treasury bills.
(Of course, no asset is truly risk free. The U.S. credit rating suffered a downgrade in 2011 and may be downgraded again later this year).
These distinctions between risky and risk-free assets are used by portfolio managers to construct diversified portfolios that attempt to optimize total returns on a risk-adjusted basis — that is, taking into account volatility, return and liquidity.
The difficulty is that major institutional investors such as banks, insurance companies and pension funds have return targets they must meet in order to have a profitable and competitive business. These return targets come from promises to insurance policy holders, retirees or stockholders. Naturally, portfolio managers are expected to take more risk in order to earn higher returns.
Developed-market government bonds have been unattractive to many portfolio managers for the past decade. These bonds offered negative returns in the cases of Japan, Germany and Sweden. Returns were not much higher in the U.S. and Canada.
Pension managers and insurance companies in particular expect their portfolios to meet return targets of 6–8% in order to pay promised benefits. With government bond rates stuck near zero, these portfolio managers went elsewhere in search of higher returns.
Many low-yielding developed-economy government bonds were purchased by the central banks of the issuing countries as part of money printing programs intended to drive down yields and force investors into risky assets such as stocks and real estate.
This effort on the part of central banks to reduce yields on safe assets and force investors into risky assets, known as the “portfolio channel” method, was supposed to produce a “wealth effect.”
In theory, investors would drive up stock prices, which would encourage consumer confidence and consumer spending and ultimately result in a return to trend economic growth of 3% or higher.
The wealth effect never materialized. Consumer confidence was boosted by higher stock prices but consumers never increased their spending to any significant extent. Instead, they paid down debt as a way to repair their personal balance sheets after the historic losses of 2007–08.
Instead of producing more consumption, the portfolio channel effect only produced asset bubbles in U.S. and emerging-markets stocks. Investors chased the stock market higher as a way to meet their investment return targets.
The same was true in emerging markets. EMs also borrowed heavily in dollars at low rates to finance the expansion of their manufacturing and export capacities. U.S. and EM stocks enjoyed a “Goldilocks” moment the past two years. Institutional investors purchased these assets for higher yields.
The purchases drove up prices, which attracted more buying. The feedback loop continued as higher prices encouraged more buying, which led to higher prices, and so on.
The persistence of this feedback loop practically eliminated volatility, as stocks seemed only to rise and never fall. Computers interpreted this absence of volatility as a sign that these markets were less risky, since volatility is a standard measure of risk in prevailing risk-management models.
Using “risk parity” approaches, the computers then bought even more equities because they seemed to offer an optimal combination of high return and low risk, the Holy Grail of investment management.
Now lately this entire process has been thrown into reverse. The three bears have returned home and Goldilocks has jumped out the window and fled into the forest.
The primary cause of this reversal is central bank tightening. This already exists in the U.S. and is coming soon to the U.K. and the eurozone. Japan may be a few years behind the rest of the developed world but it is also working toward policy normalization.
The result is that yields on low-risk developed-economy government bonds suddenly look relatively attractive to institutional investors compared with the drawdowns and increased volatility of U.S. and EM stocks.
The Great Unwind has begun.
Hot money has been heading out of stocks and moving in the direction of government bonds, where higher risk-adjusted returns await.
With this market backdrop in mind, what are the prospects for emerging markets in the months ahead?
Outflows from EM stocks have just begun and are set to accelerate dramatically in the months ahead.
This could lead to a full-blown emerging-market debt crisis with some potential to morph into a global liquidity crisis of the kind last seen in 2008, possibly worse.
