Since the end of QE and the “taper” in October 2014, the Fed has been trying to “normalize” their balance sheet and interest rates. The balance sheet needed to be reduced from $4.5 trillion to about $2.5 trillion through “quantitative tightening” or QT, which is tantamount to burning money.
Interest rates needed to be raised to around 4% in stages of 0.25%. The purpose of QT and rate hikes was so that the Fed would have the capacity to lower rates and increase the balance sheet (“QE4”) again to fight a new recession.
The rate hikes started in December 2015 (the “liftoff”) and the balance sheet reductions started in October 2017. Both started slowly but have gained momentum. Rates are now up to 2.5% and the balance sheet is just below $4 trillion.
The Fed’s problem was that actual rate hikes were about 1% per year and the balance sheet reduction at $600 billion per year had the effect of another 1% of rate hikes. Would the Fed be able to achieve its goals of 4% rates and a $2.5 trillion balance sheet without causing the recession they were preparing to fight?
It turns out the answer is no. In late December, Fed chair Powell announced the Fed would be “patient” on rate hikes. That means no more rate hikes until further notice. Now, the Fed has also apparently thrown in the towel on balance sheet normalization.
When QT began, Janet Yellen said it would “run on background” and would not be an instrument of policy. Ooops. Now the Fed is ending it so it clearly is an instrument of policy.
Right now, my models are saying that Powell’s verbal ease is too little too late. Damage to U.S. growth prospects has already been done by the Fed’s tightening since December 2015 and the Fed’s QT policy that started in October 2017.
The 2009–2018 recovery has already been the weakest recovery in U.S. history despite a few good quarters here and there. And there’s little reason to expect it to pick up from here. In fact, growth is slowing.
GDP expanded 3.4% in the third quarter of 2018, which looks good on paper. But the trend is pointing down. Q2 growth was 4.2%. This trend tends to confirm the view that 2018 growth was a “Trump bump” from the tax cuts that will not be repeated. And Q4 GDP, which has been delayed due to the government shutdown, will probably be lower than Q3.
Some of the major banks have downgraded their Q4 GDP forecasts after yesterday’s poor retail sales report.
Goldman Sachs, for example, previously projected fourth-quarter GDP to expand at 2.5%. Now it’s down to 2.0%. Its projections for the rest of the year are no better. JPMorgan also revised down its previous Q4 forecast from a previous 2.6% to 2.0%. And Barclays lowered its Q4 forecast from 2.8% to 2.1%.
Even the Atlanta branch of the Federal Reserve, which is known for perpetually overestimating GDP, has cut its Q4 forecast by almost half. A little over a week ago its reading was 2.7%. But after yesterday’s retail sales report, its latest forecast comes it at just 1.5%.
We also have other signs the economy is slowing down. A report this week revealed a record seven million Americans are now at least 90 days behind in their car loan payments. There is also a student loan crisis unfolding.
Total student loans today at $1.6 trillion are larger than the amount of junk mortgages in late 2007 of about $1.0 trillion. Default rates on student loans are already higher than mortgage default rates in 2007. This time the loan losses are falling not on the banks and hedge funds but on the Treasury itself because of government guarantees.
Not only are student loan defaults soaring, but household debt has hit another all-time high. Student loans and household debt are just the tip of the debt iceberg that also includes junk bonds corporate debt and even sovereign debt, all at or near record highs around the world.
But it’s not just the U.S.
China and Europe are both slowing at the same time. China’s problems are well-known. And while the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative. Markets see the global slowdown (despite Fed ease) and are preparing for a recession at best and a possible market crash at worst.
Still, why has growth slowed down at all?
The answer has to do with debt, Fed policy, political developments, as well as currency wars and trade wars. Specifically, the U.S. and China, the world’s two largest economies, are discovering the limits of debt-fueled growth.
According to the Institute of International Finance (IIF), it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. Meanwhile, many of the debts taken on since 2009 are still on the books.
The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.
When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.
Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation.
The world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.
What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.
Warnings of economic collapse are no longer confined to the fringes of economic analysis but are now coming from major financial institutions and prominent economists, academics and wealth managers. Leading financial elites have been warning of coming collapses and dangers.
These warnings range from the IMF’s Christine Lagarde, Bridgewater’s Ray Dalio, the Bank for International Settlements (known as the “central banker’s central bank”), Paul Tudor Jones and many other highly regarded sources.
Coming back to the U.S., the Fed may have avoided a recession for now, but they have left themselves far short of what they’ll need to fight the next recession when it comes. That could lead to another lost decade. The U.S. looks more like Japan with each passing day.
Investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.
A Chinese financial and economic crisis has been in the forecasts of many analysts for years, including my own. So far, it has not happened. Does this mean China has solved the problem of how to avoid a crisis? Or is the crisis just a matter of time, set to happen sooner than later?
My view is that a crisis in China is inevitable based on China’s growth model, the international financial climate and excessive debt. Some of the world’s most prominent economists agree. A countdown to crisis has begun.
As I explained above, China has hit a wall that development economists refer to as the “middle income trap.” Again, this happens to developing economies when they have exhausted the easy growth potential moving from low income to middle income and then face the far more difficult task of moving from middle income to high income.
The move to high-income status requires far more than simple assembly-style jobs staffed by rural dwellers moving to the cities. It requires the creation and adoption of high-value-added products enabled by high technology.
China has not shown much capacity for developing high technology on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and “national champions” such as Huawei in the telecommunications sector.
Unfortunately for China, this growth by theft has run its course. The U.S. and its allies, such as Canada and the EU, are taking strict steps to limit further theft and are holding China to account for its theft so far by imposing punitive tariffs and banning Chinese companies from participation in critical technology rollouts such as 5G mobile phones.
At the same time, China is facing the consequences of excessive debt. Economies can grow through consumption, investment, government spending and net exports. The “Chinese miracle” has been mostly a matter of investment and net exports, with minimal spending by consumers.
The investment component was thinly disguised government spending — many of the companies conducting investment in large infrastructure projects were backed directly or indirectly by the government through the banks.
This investment was debt-financed. China is so heavily indebted that it is now at the point where more debt does not produce growth. Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.
China’s other lifelines were net exports and large current account surpluses. These were driven by cheap labor, government subsidies and a manipulated currency. These drivers of growth are also disappearing due to demographics that reduce China’s labor force.
China is facing competition by even cheaper labor from Vietnam and Indonesia. Trade surpluses are also being hurt by the trade wars and tariffs imposed by the U.S.
Meanwhile, the debt overhang is growing worse. China’s creditworthiness is now being called into question by international banks and direct foreign investors.
The single most important factor right now is the continuation and expansion of the U.S.-China trade war. When the trade war began in January 2018, the market expectation was that both sides were posturing and that a resolution would be reached quickly.
I took the opposite view. Trump waited a full year from his inauguration before starting the trade war. Trump has given China every opportunity to come to the table and work out a deal acceptable to both sides.
China assumed it was “business as usual” as it had been during the Clinton, Bush 43 and Obama administrations. China assumed it could pay lip service to trading relations and continue down its path of unfair trade practices and theft of intellectual property.
By January 2018, Trump decided he had been patient enough and it was time to show China we were serious about the trade deficit and China’s digital piracy. Since the trade war began, the U.S. has suffered only minor impacts, while the impact on China has been overwhelming.
The deteriorating situation in China is summarized nicely in this excerpt from an article dated Feb. 5, 2019, and titled “The Coming China Shock,” by economists Arvind Subramanian and Josh Felman:
"Back in September, we saw some discontinuity in China’s economic performance as inevitable. Even if the country was not heading for a full-blown crisis, we believed it would almost certainly experience some combination of rapidly decelerating growth and a sharply depreciating exchange rate. That prognosis has since become even more likely. With global economic growth and exports declining, China’s economy is on track to slow further relative to the 6.4% growth recorded in the fourth quarter of 2018. The double-digit average achieved from the 1980s until recently has never seemed more distant."
The impact described by Subramanian and Felman is illustrated in the chart below. This chart shows the price and volume of trading in the iShares China Large-Cap ETF (NYSE:FXI).
FXI peaked at $54.00 per share on Jan. 26, 2018, almost exactly on the day the trade wars began. The index has trended steadily downward from there to the current level of about $42.50 per share, a 21% decline with volatility along the way.
This decline is only a partial reflection of the trade war impact. Wall Street has consistently underestimated the hard economic toll the trade war has taken on China. Wall Street formed the view that the trade war would be short and of minimal impact. Instead it has stretched for 14 months with no end in sight.
The tariffs imposed by the U.S. on China so far have dramatically slowed the Chinese economy. Yet those tariffs are minor compared with what’s in store.
March 1, 2019, is the deadline for the current “truce” in the trade war intended to facilitate negotiations. U.S. demands — especially in the area of verifiable limitations on the theft of U.S. intellectual property — are impossible for China to meet because it depends on such theft to advance its own economic ambitions.
It is highly unlikely that the outstanding issues will be resolved by March 1. Some minor issues may be resolved and some “deal” announced. A deal may include a reduction in the U.S.-China trade deficit through larger purchases of U.S. soybeans by China.
But the big issues including limits on U.S. investment in China, forced technology transfers to China and theft of intellectual property will not be resolved.
The best case is that the deadline will be extended and the trade talks will continue. The worst case is that the truce will fall apart and the U.S. will impose massive tariff increases on Chinese exports to the U.S. as planned. Either way, China’s export-driven economy will continue to suffer.
Given these economic, trade war and political head winds, weakness in China is only getting worse.
And China’s leadership can only hope the damage can be limited before the people begin to question its legitimacy.
Today we bear dramatic news:
Markets have entered a “phase transition zone”… the “magic space between order and chaos.”
This we have on the authority of the brains at Fasanara Capital.
But what will emerge on the other side — order or chaos?
Today our mood is heavy, our brow creased with thought… as we hunt the answer.
We begin with a hypothesis:
Since the financial crisis, central banks have acted as an overprotective parent… or an overzealous referee of a prize fight.
They have kept the bears separated from the bulls, chained in a neutral corner where they could do no harm.
That is, they have throttled off the violent combats, the savage brawls of the market.
“This stock is worth x,” shout the bulls in a normal market. “No — it is only worth y,” roar the protesting bears.
They are soon upon each other’s throats.
Into a cloud of dust they vanish, arms, legs, elbows, flying — and may the better man win.
Ultimately a winner emerges with the proper price.
The professional men call it price discovery.
Price discovery represents, to mix the figure a bit, the democracy of the marketplace.
Each investor has a vote. His vote may contrast bitterly with the other fellow’s.
But the better ideas will generally win the election… and the worse will lose.
The world is left with better mousetraps, superior companies, happier customers.
An Amazon cleans out a Sears. An Apple pummels a Compaq into nonexistence. A Google shows an AOL its dust.
And so on. And so on.
But after the financial crisis, the central banks rolled in with their tanks… and declared martial law.
The democracy of the marketplace went under the treads.
Is this company superior to that one? Does it deserve its stock price?
No one could say.
QE and zero interest rates put blindfolds over everyone’s eyes… and tape over their mouths.
“Passive” investing waged additional war on price discovery.
“Passively” managed funds make no effort to pinpoint winners. They track an overall index or asset category — not the individual components.
Passive investing has rendered actively picking stocks a fool’s errand.
Some 86% of all actively managed stock funds have underperformed their index during the last 10 years.
Explains Larry Swedroe, director of research at Buckingham Strategic Wealth:
“While it is possible to win that game, the odds of doing so are so poor that it’s simply not a prudent choice to play.”
Despite the gaudy averages, only a handful of stocks accounted for most of the market’s gains these past few years.
Through last August, for example, the FAANG stocks — Facebook, Amazon, Apple, Netflix, Alphabet (Google’s parent company) — accounted for half of the S&P’s gains.
But it was the false stability of Saddam Hussein’s Iraq. Hang the leader and the place goes to pieces.
In October the FAANGs began going to pieces. A period of vast instability resulted.
And the stock market came within an inch of a bear market by year’s end.
Since investors were all going blind, who could take up the load?
Markets began approaching Fasanara’s “phase transition zone.”
In a word… central banks have destroyed the market’s “resilience.”
Fasanara:
The market has lost its key function of price discovery, its ability to learn and evolve and its inherent buffers and redundancy mechanisms. In a word, the market has lost its “resilience”…
Our inability as market participants to properly frame market fragility and the inherent vulnerability of the financial system makes a market crash more likely, as it helps systemic risk go unattended and build further up.
It is this systemic risk and loss of resilience that heightens the likelihood of a crash:
Conventional market and economic indicators (e.g., breaks of multiyear equity and home price trendlines, freezing credit markets, softening global [manufacturing]) have all but confirmed what nontraditional measures of system-level fragility signaled all along: that a market crash is incubating, and the cliff is near.
But how close is the cliff?
Complex systems like markets, argues Fasanara (and Jim Rickards), are especially vulnerable in this “phase transition zone.”
The butterfly flaps its wings in Brazil and normally that is that.
But in highly unstable conditions, the butterfly flaps its wings and whips up a hurricane off Florida.
Small inputs, that is, have outsized effects under instability… shifting “order” into “chaos.”
What are some of the flapping butterflies that could conjure the hurricane?
Among the eight Fasanara identifies:
Trade war. China. Oil. Trump and the Mueller investigation.
Any one of these — in theory — could tip markets over the chaotic border.
“Given our overall view for market system instability,” warns Fasanara, “it becomes crucial to monitor upcoming catalyst events, as any of them may be able to accelerate the large adjustment we anticipate.”
Meantime, we remain, suspended in the “magic space between order and chaos.”
The first time I appeared on live financial television was August 15, 2007. It was a guest appearance on CNBC’s Squawk Box program at the early stages of the 2007-2008 financial crisis.
Of course, none of us knew at that time exactly how and when things would play out, but it was clear to me that a meltdown was coming; the same meltdown I had been warning the government and academics about since 2003.
I’ve done 1,000 live TV interviews since then, but that first one remains memorable. Carl Quintanilla conducted the interview with some participation from Becky Quick, both of whom could not have been more welcoming.
They and the studio crew made me feel right at home even though it was my first time in studio and my first time meeting them. Joe Kernan remained off-camera during my interview with his back turned reading the New York Post sports page, but that’s Joe. We had plenty of interaction in my many interviews over the years that followed.
When I was done, I was curious about how many guests CNBC interviewed over the course of a day. Being on live TV made me feel a bit special, but I wanted to know how special it was to be a guest. The answer was deflating and brought me right down to earth.
CNBC has about 120 guests on in a single day, day after day, year after year. Many of those guests are repeat performers, just as I became a repeat guest on CNBC during the course of the crisis. But, I was just one face in the midst of a thundering herd.
What were all of those guests doing with all of that airtime? Well, for the most part they were forecasting. They predicted stock prices, interest rates, economic growth, unemployment, commodity prices, exchange rates, you name it.
Financial TV is one big prediction engine and the audience seems to have an insatiable appetite for it. That’s natural. Humans and markets dislike uncertainty, and anyone who can shed some light on the future is bound to find an audience.
Which begs a question: How accurate are those predictions?
No one expects perfection or anything close to it. A forecaster who turns out to be accurate 70% of the time is way ahead of the crowd. In fact, if you can be accurate just 55% of the time, you’re in a position to make money since you’ll be right more than you’re wrong. If you size your bets properly and cut losses, a 55% batting average will produce above average returns.
Even monkeys can join in the game. If you’re forecasting random binary outcomes (stocks up or down, rates high or low, etc.), a trained monkey will have a 50% batting average. The reason is that the monkey knows nothing and just points to a random result.
Random pointing with random outcomes over a sustained period will be “right” half the time and “wrong” half the time, for a 50% forecasting record. You won’t make any money with that, but you won’t lose any either. It’s a push.
So, if 70% accuracy is uncanny, 55% accuracy is OK, and 50% accuracy is achieved by trained monkeys, how do actual professional forecasters do? The answer is less than 50%.
In short, professional forecasters are worse than trained monkeys at predicting markets.
Need proof? Every year, the Federal Reserve forecasts economic growth on a one-year forward basis. And it’s been wrong every year for the better part of a decade. When I say “wrong” I mean by orders of magnitude.
If the Fed forecast 3.5% growth and actual growth was 3.3%, I would consider that to be awesome.
But, the Fed would forecast 3.5% growth and it would come in at 2.2%. That’s not even close considering that growth is confined to plus or minus 4% in the vast majority of years.
If you have defective and obsolete models, you will produce incorrect analysis and bad policy every time. There’s no better example of this than the Federal Reserve.
The Fed uses equilibrium models to understand an economy that is not an equilibrium system; it’s a complex dynamic system. The Fed uses the Phillips curve to understand the relationship between unemployment and inflation when 50 years of data say there is no fixed relationship.
The Fed uses what’s called value-at-risk modeling based on normally distributed events when the evidence is clear that the degree distribution of risk events is a power curve, not a normal or bell curve.
As a result of these defective models, the Fed printed $3.5 trillion of new money beginning in 2008 to “stimulate” the economy only to produce the weakest recovery in history. Now, the cycle of monetary tightening has been ongoing in various forms for nearly six years.
Let’s not be too hard on the Fed. The IMF forecasts were just as bad. And the “the wisdom of crowds” can also be dramatically wrong.
It does not have very high predictive value. It’s just as faulty as the professional forecasts from the Fed and IMF.
There are reasons for this. The wisdom of crowds is a highly misunderstood concept. It works well when the problem is simple and the answer is static, but unknown.
The classic case is guessing how many jellybeans are in a large jar. In that situation, the average of 1,000 guesses actually will be better than a single “expert” opinion. That works because the number of jellybeans never changes. There’s nothing dynamic about the problem.
But, when the answer is truly unknown and the problem is complex and dynamic such as capital markets forecasting, then the wisdom of crowds is subject to all of the same biases, herding, risk aversion, and other human quirks known through behavioral psychology.
This is important because when academics say “you can’t beat the market,” my answer is the market indicators are usually wrong. When talking heads say, “you can’t beat the wisdom of crowds,” I just smile and explain what the wisdom of crowds actually does and does not mean.
By the way, this is one reason why markets missed Brexit and Trump. The professional forecasters simply misinterpreted what polls and betting odds were actually saying.
None of this means that polls, betting odds, and futures contracts have no value. They do. But, the value lies in understanding what they’re actually indicating and not resting on a naive and superficial understanding of the wisdom of crowds.
Does this mean that forecasting is impossible or that the experts are uninformed? Not at all. Highly accurate forecasting is possible.
The problem with the “experts” is not that they’re dopes (they’re not), or they’re not trying hard (they are). The problem is that they use the wrong models. The smartest person in the world working as hard as possible will always be wrong if you use the wrong model.
That why the IMF, Fed, and the wisdom of crowds bat below .500. They’re using the wrong models.
But here at Project Prophesy, I can confidently say I’ve got the right models, which I developed for the CIA working in collaboration with top applied mathematicians and physicists at places like the Los Alamos National Laboratory and the Applied Physics Laboratory.
It’s these models that let me accurately forecast events like Brexit and the election of Donald Trump, while all the mainstream analysts laughed in my face. It’s not that I’m any smarter than many of these people. It’s just that I use superior models that work in the real world, not in never-never land..
These models do not assume equilibrium systems and normally distributed risk like mainstream models. My models are based on complexity theory, Bayesian statistics, behavioral psychology and history. They produce much more accurate results than all of the alternatives.
This is the methodology behind my forecasts, which allows my readers access to actionable market recommendations they won’t find elsewhere.
Fed Chair Jay Powell did not deliver any early Christmas presents to the markets last month, but he did pop the cork on a bottle of Champagne as a belated New Year’s gift on Friday, Jan. 4.With just a few words, Powell sent the most powerful signal from the Fed since March 2015. Investors who understand and properly interpret that signal stand to avoid losses and reap huge gains in the weeks ahead.First, let’s focus on Powell’s comments. Then we’ll explain what they actually meant.The Fed has taken a March rate hike off the table until further notice. At a forum in Atlanta two Fridays ago, Powell joined former Fed chairs Yellen and Bernanke to discuss monetary policy.In the course of his remarks, Powell used the word “patient” to describe the Fed’s approach to the next interest rate hike. When Powell did this, he was reading from a script of prepared remarks in what was otherwise billed as a “roundtable discussion.” This is a sign that Powell was being extremely careful to get his words exactly right.
Fed Chairman Jay Powell (left) joined former Fed chairs Janet Yellen and Ben Bernanke at a roundtable in Atlanta recently. Powell revived the word “patient,” which was last used by the Fed in December 2014. It’s a powerful signal of no rate hikes until further notice.When Powell said the Fed would be “patient” in reference to the next rate hike, this was not just happy talk. The word “patient” is Fed code for “No rate hikes until we give you a clear signal.” This interpretation is backed up by the Fed’s past use of verbal cues to signal ease or tightening in lieu of actual rate hikes or cuts.The word “patient” has a long history in the Fed’s vocabulary. Prior to March 2015, the Fed consistently used the word “patient” in their FOMC statements. This was a signal that there would not be a rate hike at the next FOMC meeting. Investors could do carry trades safely.As long as the word “patient” was in the Fed’s statements, investors knew that there would be no rate hike without warning. It was like an “all clear” signal for leveraged carry trades and risk-on investments. Only when the word “patient” was removed was the Fed signaling that rate hikes were back on the table. In that event, investors were being given fair warning to unwind carry trades and move to risk-off positions.In March 2015, Yellen removed the word “patient” from the statement. That was a signal that a rate hike could happen at any time and the market was on notice. If you had a carry trade on and were relying on no rate hike, then shame on you.In fact, the first rate hike (the “liftoff”) did not happen until December 2015, but the market was on notice through the June and September 2015 FOMC meetings that it could happen. (The liftoff was originally planned for September 2015, but was postponed because of the U.S. market crash in August 2015. This crash was due to the shock 3% China currency devaluation on Aug. 10; U.S. stocks fell 11% in four weeks.)Now, for the first time since 2015, the word “patient” is back in the Fed’s statements. This means no future Fed rate hikes without fair warning. This could change again based on new data and new statements, but a change is unlikely before March at the earliest. For now, the Fed is rescuing markets with a risk-on signal. That’s why the market rallied that Friday and has reversed December’s downward trend.But we’re not out of the woods. Just because the Fed signaled they will not raise rates in March does not mean that all is well with markets. The U.S. stock market had already anticipated the Fed would not raise rates in March. The statement by Powell confirms that, but this verbal ease is already priced in. As usual, the markets will want some ice cream to go with the big piece of cake they just got from Powell.On the one hand, if we’re at or near the start of a bear market it will take more than a Fed pause to offset that. On the other hand, there’s no reason for markets to crash based on the U.S. economy alone since the Fed may make more candy available by continuing to use the word “patient” in March. So we’re in wait-and-see mode.Meanwhile, there’s an even bigger threat on the horizon — China. Unobserved by many analysts, the Chinese are reducing their money supply even faster than the Fed.
The Fed’s signal on rates says nothing about Fed reductions in the money supply under the quantitative tightening (QT) program. The U.S. money supply reductions are going ahead at $600 billion per year.
China is burning money even faster to prop up the yuan in the midst of a trade war with Trump. What does it mean when the world’s two largest economies, comprising 40% of global GDP, both hit the brakes on money supply?
Nothing good. Milton Friedman demonstrated that monetary policy operates with a lag of 12–18 months. These U.S. and Chinese monetary tightening policies started just over a year ago. The initial impact of what has already been done by the central banks is just being felt now.
This means that the U.S.-China tightening will continue to be felt over the next year regardless of what the Fed does in March. Stopping rate hikes now is like hitting the car brakes when you’re driving on a frozen lake. You’re going to slide a long time before the car comes to a halt. Let’s hope you don’t hit a soft spot before then or you’ll end up underwater.
Of course, the China and U.S. domestic growth and monetary policy narratives converge in the trade war discussions going on now. The continuing trade war is another head wind to growth. No doubt Powell had this scenario in mind when he opted to use the word “patient.”
The risk to investors is that markets are on a sugar high because of Powell’s recent comments. But the sugar will soon wear off and the Fed won’t provide more until March at the earliest. By then, the reality of slower growth in China and the U.S. and a lack of substantive progress in the trade wars will give the market a dose of reality like getting hit with a cold bucket of water in the face.
Evidence for this slowing comes from the latest Atlanta Fed update to their fourth-quarter GDP forecast, which now projects 2.6% growth after being as high as 3% earlier in the quarter.
What are the implications for investors of belated Fed ease combined with signs of weaker growth in China and the U.S.?
Right now, my models are saying that Powell’s verbal ease is too little too late. Damage to U.S. growth prospects has already been done by the Fed’s tightening since December 2016 and the Fed’s QT policy that started in October 2017.
The U.S., China and Europe are all slowing at the same time. Markets see this (despite Fed ease) and are preparing for a recession at best and a possible market crash at worst.
One potential catalyst is the start of the Chinese New Year celebration of the Year of the Pig. Kicking off with the Little New Year on Jan. 28, this celebration actually stretches over two weeks and is accompanied by reduced productivity and liquidity in Chinese markets. That’s a recipe for volatility.
We also have a Fed FOMC meeting on Jan. 30. No rate hike is expected, obviously, but there will be a written statement issued. Markets will be looking for the word “patient” in print, and if they don’t find it, there could be a violent reversal in the sugar high that started two Fridays ago.
Investors should prepare now before markets reprice.
The case for a pending financial collapse is well grounded. Financial crises occur on a regular basis including 1987, 1994, 1998, 2000, 2007-08. That averages out to about once every five years for the past thirty years. There has not been a financial crisis for ten years so the world is overdue. It’s also the case that each crisis is bigger than the one before and requires more intervention by the central banks.
The reason has to do with the system scale. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.
This means a market panic far larger than the Panic of 2008.
Today, systemic risk is more dangerous than ever because the entire system is larger than before. Due to central bank intervention, total global debt has increased by about $150 trillion over the past 15 years. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.
Each credit and liquidity crisis starts out differently and ends up the same. Each crisis begins with distress in a particular overborrowed sector and then spreads from sector to sector until the whole world is screaming, “I want my money back!”
First, one asset class has a surprise drop. The leveraged investors sell the sinking asset, but soon the asset is unwanted by anyone. Margin calls roll in. Investors then sell good assets to raise cash to meet the margin calls. This spreads the panic to banks and dealers who were not originally involved with the weak asset.
Soon the contagion spreads to all banks and assets, as everyone wants their money back all at once. Banks begin to fail, panic spreads and finally central banks step in to separate winners and losers and re-liquefy the system for the benefit of the winners.
Typically, small investors (and some bankrupt banks) get hurt the worst while the big banks get bailed out and live to fight another day.
That much panics have in common. What varies in financial panics is not how they end but how they begin. The 1987 crash started with computerized trading. The 1994 panic began in Mexico. The 1997–98 panic started in Asian emerging markets but soon spread to Russia and the big banks. The 2000 crash began with dot-coms. The 2008 panic was triggered by defaults in subprime mortgages.
The problem is that regulators are like generals fighting the last war. In 2008, the global financial crisis started in the U.S. mortgage market and spread quickly to the overleveraged banking sector.
Since then, mortgage lending standards have been tightened considerably and bank capital requirements have been raised steeply. Banks and mortgage lenders may be safer today, but the system is not. Risk has simply shifted.
What will trigger the next panic?
Prominent economist Carmen Reinhart says the place to watch is U.S. high-yield debt, aka “junk bonds.”
I’ve also raised the same argument. We’re facing a devastating wave of junk bond defaults. The next financial collapse will quite possibly come from junk bonds.
Let’s unpack this…
Since the great financial crisis, extremely low interest rates allowed the total number of highly speculative corporate bonds, or “junk bonds,” to rise about 60% — a record high. Many businesses became extremely leveraged as a result. Estimates put the total amount of junk bonds outstanding at about $3.7 trillion.
The danger is that when the next downturn comes, many corporations will be unable to service their debt. Defaults will spread throughout the system like a deadly contagion, and the damage will be enormous...
