Deflation is back on the front burner and it's going to destroy all of the
careful central planning and related market manipulation of the past 6 years.
Clear signs from the periphery indicate that a destructive deflationary
pulse has been unleashed. Tanking commodity prices are confirming that idea.
Whole groups of enterprises involved in mining and energy are about to be
destroyed. And the commodity-heavy nations of Canada, Australia and Brazil
are in for a very rough ride.
Whether the central banks can keep all of their carefully-propped equity
and bond markets elevated throughout the next part of the cycle remains to be
seen. We know they will try very hard. They certainly are increasingly
willing to use any all tools at their disposal to keep the status quo going
for as long as possible.
Whether it’s the People’s Bank of China stepping in to the market to buy
10% stakes in major Chinese corporations in a matter of weeks, the Bank Of
Japan becoming the majority owner of key ETFs in the Japanese markets, or the
Swiss National Bank purchasing $100 billion of various global equities, we
see the same desperation. Equity prices are being propped, jammed and
extended higher and higher without regard to risk or repurcussions.
It makes us wonder: Why haven’t humans ever thought to print their way
to prosperity before?
Well, that’s the problem. They have.
And it has always ended up disastrously. History shows that the
closest thing that economics has to an inviolable law is: There’s no such
thing as a free lunch.
Sadly, all of our decision-makers are trying their hardest to ignore that
truth.
First, The Fall….
So how will all of this progress from here?
We’ve always liked the Ka-Poom! theory by Erik Janzen which we
explained previously like this:
One of the models of the future that I favor is the Ka-Poom
theory put out by Erik Janszen of iTulip.com back in 1999.
Basically it states that the end of a bubble era begins with a sharp
deflationary event (the ‘Ka’ part of the title), but ends in a highly
inflationary blow-off, (the ‘Poom’).
It’s a one-two punch. Down then up.
The reason you get the deflationary portion is simply because bubbles
always burst. They are seeking a pin from the moment they are born.
The logic for the inflationary secondary reaction is that the central
banks always respond to deflation with more money printing. Ironically, this
is a doomed attempt to stem the damage caused by their prior money printing
efforts.
They never learn.
So that’s what we’re looking for here at Peak Prosperity: a deflationary
crunch savage enough to scare the central banks into opening the monetary
spigots even wider. But this next time, we think they’ll seek to goose
economic growth by giving money directly to the people as well as non-bank
corporations.
And we think that deflationary bust has already begun. Our record-high
stock markets simply somehow haven’t gotten the memo yet.
So that’s it: prices first go down (Ka!) and then they rocket back up
(Poom!). When it's all over some years down the line, many of the world's
fiat currencies (Yen, Euro, Bolivar, Real, and maybe a few Pesos and the
Rupee, too) will be damaged or dead.
Dreams are dashed. And those who are mentally unprepared and emotionally
unequipped will have a very hard time adjusting.
This predicted implosion has to happen. It's a mathematical result of the
grave errors made by central banks and government busybodies, who mistook the
low volatility and easy gains of the virtuous portion of the money printing
cycle for actual success.
Goaded on by their great fortune, they simply doubled down over and over
again; seeking the same bang for those freshly-printed dollars (or yen,
euros, and yuan). Of course, their efforts progressively resulted in
diminishing returns. Yet they completely ignored charts like the one below,
which explains much if you just stop and think about it for a couple of
seconds:
(Source)
This chart says that between 1947 and 1952, when the middle class was
expanding like crazy, each new dollar of debt increased the GDP by
$4.61. Today, that number is $0.08(!). We can flip this, to say that it
takes $12.50 of new debt to boost GDP by $1.
Clearly this is an unsustainable trend. What's been the response from the
central banks? Why to encourage more debt, of course! We need more
GDP, they say, and new credit formation is critical to that process!
Well, what else would you expect a banker to say? Note that the central
banks are deadly mute on topics like the role of cheap debt in fostering
mal-investment, to say nothing of the importance of net energy and
functional ecology to the human experience.
Central planners may have a lot of power because of their access to and
use of the magic printing press. But their knowledge of the real world is
horribly immature, if not entirely wrong.
From The Outside In
The way things tend to work is that trouble begins on the outside and
works its way towards the center. The weaker periphery elements get clobbered
first, the strongest last. So it’s Greece before Spain, and Spain before
France. It’s the poor before the middle class, and the middle class
before the rich.
We can already see the signs of this process in play, but it's now
accelerating.
Mexico
In January 2015 the Mexican peso, stung by falling oil export revenues,
breached the 15-to 1-level against the US dollar for the first time since the
2009 crisis. Today, it's 16.12-to-1:
(Source)
Brazil
Meanwhile, the Brazilian real has declined by a stomach-churning 45% in
the past 12 months versus the dollar:
(Source)
Where one Brazilian real used to be worth 45 cents a year ago, it's now
worth just 30 cents. All of the hedge funds that tried to get rich off of the
fat 12.5% yield that Brazilian 10-year debt offers just got their heads
handed to them as a result of the plummeting currency exchange ratio.
Why is Brazil tanking so hard? It’s due to a combination of challenges:
corruption scandals, poor trade prospects (as commodities collapse) and
growing political risk. But the big one is that it's 'miracle' economic
growth has crashed into a brick wall.
Puerto Rico
Similarly, Puerto Rico is in dire financial straits. There are huge
haircuts coming for investors in Puerto Rican bonds and -- like Greece --
many years of economic hardship for the island's populace:
More than half of all muni bond funds have investments in Puerto Rican
tax-exempt bonds, even though the sunny Caribbean island is an economic
basket case. Its outstanding municipal debt of $72 billion amounts to
$30,000 for each of the commonwealth’s residents, almost three times average
annual per capita income. Puerto Rico’s ratio of debt to gross
domestic product is more than triple that of any other U.S. state or
territory, and the island’s economy has been mired in recession for nine
years.
(Source)
How does a small island nation even borrow 3x average annual income per
capita? It turns out it’s remarkably easy in the free-money liquidity
fest offered up by the Fed. It was only a year ago that yield starved
“investors” (more properly called speculators) placed $16 billion in bids for $3.5 billion of newly
issued Puerto Rican junk muni bonds.
Venezuela
In even worse shape is Venezuela. It's so far down the road to financial
ruin that it's almost certainly gong to be the next victim of hyperinflation.
Inflation in Venezuela signals default impending
Jul 16, 2015
Venezuela is about to earn another ignominious distinction.
Long home to the world’s highest inflation rate, the country now is set to
become the site of the 57th hyperinflation event in modern
recorded history, says Steve Hanke, professor of applied economics at Johns
Hopkins University. While the feat may be little more than a formality in a
country where Hanke calculates annual cost-of-living increases already run at
772 percent, it’s the latest sign a debt default may be closer than
previously thought.
With Venezuela’s currency losing 32 percent of its value in the past month
in the black market, according to dolartoday.com, and falling oil prices
throttling the cash-starved nation’s biggest revenue source, the government
may run out of money to pay its debts by year-end, according to Societe
Generale. Derivatives traders have ratcheted up the probability of a default
within one year to 63 percent, compared with 33 percent just two months ago.
(Source)
Things are about to get even more dire for the people of Venezuela.
Already suffering acute shortages of consumer staples, they're about to
experience the same type of horrific monetary devaluation that Zimbabwe did.
China
China is anything but a peripheral country, but the import/export numbers
suggest that China is slowing down hard and ripe for a crash. Instead of
trying to gracefully manage its transition from an industrial economy to a
consumer economy, China is simply plowing ahead following the same script
that fostered its growth in the first place.
Loans are being hurriedly pushed out the door to support everything from
the stock market to real estate. Despite these efforts, lots is going wrong,
as evidenced by the vicious bursting of China's stock bubble and the
heavy-handed government rescue efforts that have followed:
Half the shares traded in Shanghai and Shenzhen were suspended. New floats
were halted. Some 300 corporate bosses were strong-armed into buying back
their own shares. Police state tactics were used hunt down short sellers.
We know from a vivid account in Caixin magazine that China’s top
brokers were shut in a room and ordered to hand over money for an
orchestrated buying blitz. A target of 4,500 was set for the Shanghai
Composite by Communist Party officials.
Caixin says the China Securities Finance Corporation - a branch of the regulator
- now owns an estimated $200bn of Chinese stocks and has authority to buy a
further $500bn if necessary to prop up the market.
This use of “brute force” - in the words of Peking University
professor Michael Pettis - has done the trick. Equities have recovered. How
could they not do so, since selling was illegal, and not to buy was also
illegal?
(Source – AEP Telegraph)
We get the following interesting chart, from this same article which
supports the idea that China’s rate of economic growth has slowed sharply and
is well below the officially-stated rate of 7%:
Throwing lots and lots of new money at the problem of slowing growth and
collapsing equity prices is exactly backwards from what should be done.
The problem is not that equity prices are falling, it's that they are too
high compared to earnings (70x trailing earnings!).The problem is not that
real estate building and sales are slowing down, it’s that too much was built
and prices are already far too high (20x median income or higher!).
Assume The Crash Position
In Part 2: Assume The Crash Position, analyzes how if
deflation does indeed take over and swamp the official efforts at damage
control, quite a lot of fantasy wealth in today's stock, bond and real estate
markets will be destroyed. This means you want to be positioned away from
risk-based financial assets right now -- with stocks and low & junk grade
bonds are right at the top of that list. Cash and short maturity
sovereign debt of good countries will be much better places to hang out while
the storm rages.
Like it or not, things are getting interesting again. The prudent move
here is to watch developments very closely, position yourself defensively,
and be ready to react nimbly, if necessary. After years of suppression, the
forces of reality are threatening to overwhelm our managed global ""markets"'.
And it's about damn time.
Click here to read Part 2 of this report (free
executive summary, enrollment required for full access)
