This Is Not 2008: It's Actually Worse

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Published : January 18th, 2016
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The S&P 500 has begun 2016 with its worst performance ever. This has prompted Wall Street apologists to come out in full force and try to explain why the chaos in global currencies and equities will not be a repeat of 2008. Nor do they want investors to believe this environment is commensurate with the Dot.Com Bubble that caused the NASDAQ to plummet 78% and the S&P 500 to shed 35% of its value. In fact, they claim the current turmoil in China is not even comparable to the 1997 Asian Debt Crisis: when dollar-denominated debt loads couldn't be repaid and the Thai baht lost half its value, and the stock market dropped 75%.

Indeed, the unscrupulous individuals that dominate financial institutions and governments seldom predict a down-tick on Wall Street, so don't expect them to warn of the impending global recession and market mayhem. But a recession has occurred in the U.S. about every five years on average since the end of WWII; and it has been seven years since the last one -- we are overdue. Most importantly, the average market drop during the peak to trough of the last 6 recessions has been 37%. That would take the S&P 500 down to about 1,300; if this next recession were to be just of the average variety.

But this one will be worse.

A major contributor for this imminent recession is the fallout from a faltering Chinese economy. The megalomaniac communist government has increased debt 28 times since the year 2000. Taking that total north of 300% of GDP in a very short period of time for the primary purpose of building a massive unproductive fixed asset bubble. Now that this debt bubble is unwinding, growth in China is going offline. The renminbi's falling value, cascading Shanghai equity prices (down 40% since June 2014) and plummeting rail freight volumes (down 10.5% y/y), all clearly illustrate that China is not growing at the promulgated 7%, but rather isn't growing at all. The problem is China accounted for 34% of global growth, and the nation's multiplier effect on emerging markets takes that number to over 50%. Therefore, expect more stress on multinational corporate earnings as global growth continues to slow.

But the debt debacle in China is not the primary catalyst for the next recession in the United States. It is the fact that equity prices and real estate values can no longer be supported by incomes and GDP. And now that QE and ZIRP have ended, these asset prices are succumbing to the gravitational forces of deflation. The median home price to income ratio is currently 4.1; whereas the average ratio is just 2.6. Therefore, despite record low mortgage rates, first-time home buyers can no longer afford to make the down payment. And without first-time home buyers, existing home owners can't move up.

Likewise, the total value of stocks has now become dangerously detached from the anemic state of the underlying economy. The long-term average of the market cap to GDP ratio is around 75, but it is currently 110. The rebound in GDP coming out of the Great Recession was artificially engendered by the Fed's wealth effect. Now, the re-engineered bubble in stocks and real estate is reversing and should cause a severe contraction in consumer spending.

Nevertheless, the solace offered by Wall Street is that another 2008 style deflation and depression is impossible because banks are now better capitalized. However, banks may find they are less capitalized than regulators now believe because much of their assets lie in Treasury debt and consumer loans that should be significantly underwater after the next recession brings unprecedented fiscal strain to both the public and private sectors. But most importantly, even if one were to concede financial institutions are less leveraged; the startling truth is that Businesses, the Federal Government and the Federal Reserve have taken on a humongous amount of additional debt since 2007. Even Household debt has increased back to a its 2007 record of $14.1 trillion. Specifically, Business debt during that timeframe has grown from $10.1 trillion, to $12.6 trillion; the Total National Debt boomed from $9.2 trillion, to $18.9 trillion; and the Fed's balance sheet has exploded from $880 billion, to $4.5 trillion.

Banks may be better off today than they were leading up to the great recession but the government and Fed's balance sheets have become insolvent in the wake of their inane effort to borrow and print the economy back to health. As a result, the Federal Government's debt has now soared to nearly 600% of total revenue. And the Fed has spent the last eight years leveraging up its balance sheet 77:1, in its goal to peg short-term interest rates at zero percent. Therefore, this inevitable, and by all accounts brutal upcoming recession, will coincide with two unprecedented and extremely dangerous conditions that should make the next downturn worse than 2008.

First off, the Fed will not be able to lower interest rates and provide any debt service relief for the economy. In the wake of the Great Recession Former Fed Chair, Ben Bernanke, took the overnight interbank lending rate down to zero percent, from 5.25%, and printed $3.7 trillion and bought longer-term debt in order to push mortgages and nearly every other form of debt to record lows. The best the Fed can do now is to take away its 0.25% rate hike made in December. Secondly, the Federal Government increased the amount of publicly traded debt by $8.5 trillion (an increase of 170%), and ran $1.5 trillion deficits to try to boost consumption through transfer payments. Another such ramp up in deficits and debt -- which are a normal function of recessions after revenue collapses--would cause an interest rate spike that would turn this next recession into a devastating depression.

It is my belief that in order to avoid the surging cost of debt service payments on both the public and private sector level, the Fed will feel compelled to launch a massive and unlimited round of bond purchases. However, not only are interest rates already at historic lows, but faith in the ability of central banks to provide sustainable GDP growth will have already been destroyed given their failed eight-year experiment in ZIRP and QE. And adding $1.5 trillion dollars per year to the $19 trillion U.S. debt won't be taken well by the bond market either. Therefore, the ability of government to save the markets and the economy this time around will be extremely difficult, if not impossible. Look for chaos in currency, bond and equity markets on an international scale throughout 2016. Indeed, it already has begun.


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Mr. Michael Pento is the President of Pento Portfolio Strategies and serves as Senior Market Analyst for Baltimore-based research firm Agora Financial. Pento Portfolio Strategies provides strategic advice and research for institutional clients. Agora Financial publishes award-winning newsletters, critically acclaimed feature documentaries and international best-selling books. Mr. Pento is a well-established specialist in the Austrian School of economics and a regular guest on CNBC, Bloomberg, FOX Business News and other national media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes, Contributor to and is a blogger at the Huffington Post. Prior to starting Pento Portfolio Strategies and joining Agora Financial, Mr. Pento served as a senior economist and vice president of the managed products division of another financial firm. There, he also led an external sales division that marketed their managed products to outside broker-dealers and registered investment advisors. Additionally, Mr. Pento has worked for an investment advisory firm where he helped create ETFs and UITs that were sold throughout Wall Street. Earlier in his career Mr. Pento spent two years on the floor of the New York Stock Exchange. He has carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Mr. Pento graduated from Rowan University in 1991.
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China first.
When you are sitting on a few trillion dollars in your foreign reserves that will NEVER be paid back with anything of value, what do you do?
Use them as collateral for internal financing of infrastructure.
Just a simple case of use it or lose it.
China might have already figured that out.

When corporations borrow to buy back stock, what is actually happening is asset stripping.
Increasing debt without increasing productivity is the path to bankruptcy.
But the buy backs allow smart gamblers to book a profit and leave the Rubes holding the bag.
After all, the stock price is buoyed up with these buy backs. This makes the company look strong when it is actually on the ropes and going down.
Debt is immaterial when the outcome is already baked in the cake.

The consideration that banks are flush with reserves is a silly notion at best.
Debt held by the banks is considered an asset.
Yet the true value of that asset is an unknown until the money changes hands.
And non-performing assets have zero value.

Rather than the government attempting to sell a massive number of bonds to fill their bottomless coffers, the next shoe to drop will be nationalization of pensions.
Top of the list is state and municipal pension programs.
Most are grossly under-funded and the Rubes will worship Washington for having the foresight to protect their pensions.

The current memes on eliminating cash is just smoke and mirrors.
For the most part, few people hold cash.
Those that do know that cash is still king and they know how to convert cash into tangibles.
Still, the meme keeps the Rubes from looking behind the curtain.

If the notion of negative interest really worked, we would see some results already.
With interest rates already near zero, it is evident that the idea of time-preference is lost on the Rubes.
Businesses have no option but to keep cash assets in the bank.
What the Rubes fail to grasp is that these bank carrying costs are just passed on to the end consumer.
Just as corporate taxes are. Yes Dorthy, all your demands for increasing corporate taxation to make them pay their fair share is coming out of your pocket.

The feudal system was, is and will continue to be.
If you can't pick it up and walk away with it, you don't own it.
Property tax ring a bell? You are just a discount renter. No more, no less.
During the middle ages the term was "freeholder".
The rest were villeins who needed authorization from the manor to do anything. Think debtors.
Even the money you deposited in the bank is not yours.
You really thought it was a demand deposit? Try drawing it out as a lump sum and see what you get.

Oh and increasing the taxes on the 1%'ers?
They already pay more than you.
Besides the only difference between the Rubes and the 1%'ers is the level of debt.
And when there is little discretionary money, the sale price of the assets will fall far short of covering the debts that will shortly be due and payable on demand.
Don't tell me you failed to read that clause in the contract?

Welcome to the new reality that is just the old reality with a fresh paint job.
Otherwise a good article. Thanks.
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China first. When you are sitting on a few trillion dollars in your foreign reserves that will NEVER be paid back with anything of value, what do you do? Use them as collateral for internal financing of infrastructure. Just a simple case of use it or lo  Read more
overtheedge - 1/18/2016 at 7:40 PM GMT
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