The signs of deflation are now flashing all over the globe. In our
estimation, the possibility of an associated financial crisis is now
dangerously high over the next few months.
As we’ve been saying for a while, our preferred model for how things are
going to unfold follows the Ka-Poom! Theory as put out by Erik
Janszen of iTulip.com.
That theory states that this epic debt bubble will ultimately burst first
by deflation (the "Ka!") before then exploding (the
"Poom!") in hyperinflation due to additional massive money printing
efforts by frightened global central bankers acting in unison.
First an inwards collapse, then an outwards explosion. Ka-Poom!
We’ve been tracking the deflationary impulse for a while, and declared deflation the winner back in July of this year.
A Failed Strategy
What exactly do we mean by deflation? Back in 2008 the central banks
of the developed world, as well as China, had a choice:
- admit that prior policies geared towards encouraging
borrowing at a faster rate than income growth were a horrible idea, or
- double down and push those failed policies even harder
As we all know, they chose option #2. And so here we are, just 8 years
later, with nearly $60 trillion in new debt piled on top of the prior
mountain -- while GDP grew by only $12 trillion over the same time period:
(Source)
[Note: Global nominal GDP is
projected to be $68.6 trillion in 2015, virtually unchanged from 2013]
In other words, instead of saying to ourselves: Hmmm.... it was
probably a terrible idea to pile up debt at 2x the rate of income growth,
what the world did instead was to double down on that terrible idea and pile
on more debt at 5x the rate(!) of nominal GDP growth.
Talk about not learning from your past mistakes....
At any rate, what all of that money printing, lower interest rates and new
debt creation did was force capital over the globe to look for some place to
go. Absent any really good and creative ideas, that money primarily chased
yield. It piled into risk assets like stocks and junk bonds, often in
bubble-like fashion (meaning, in haste), and without proper due diligence.
The only way the central bank “strategy” (and we use that word very
loosely) could have worked was if very rapid economic growth emerged to
justify the accumulated levels of debt, comprised of both old and new
borrowing. Central banks were indeed hoping such growth would materialize and
lesson the burden of servicing the interest on all that debt.
But that growth, quite predictably (as forecasted by us among many
others), did not emerge.
Perhaps Japan’s experience should have tipped the central bankers off as
to why not. For several decades now, Japan has served as a warning: too
much debt is the malady, not the cure.
So here we are. What are we to make of it all? It's our view
that the financial markets are important to monitor because they will signal
to us when sentiments has shifted, and events start unfolding at a faster
pace.
Judging from the market action over the past month, we think that shift
has happened. And we're increasingly concerned that this next ‘correction’
could be pretty rough for a lot of folks.
Bright Red Warning Lights
The global economy is downshifting fast, and there are lots of flashing
red warning lights indicating as much.
Doug Noland has captured the emerging market pain caused by the hot
money that is now flooding out of those territories, as well as provided a
great explanation of the bubble dynamics in play:
The Federal Reserve is flailing and global currency markets are in
disarray. Notably, the Brazilian real dropped more than 10%
in five sessions, before Thursday’s sharp recovery reversed much of
the week’s loss. This week the Colombian peso dropped 3.0%, and the
Chilean peso fell 3.1%. The Mexican peso dropped 1.9%.
The Malaysian ringgit sank 4.5% for the week, with the South
Korean won down 2.7% and the Indonesia rupiah losing 2.2%. The
Singapore dollar fell 1.8%. The South African rand sank 4.4% and the Turkish
lira fell 1.4%.
Notably, market dislocation was not limited to EM. The
Norwegian krone was hit for 4.4%, and the Swedish krona lost 2.0%. The
British pound declined 2.3%. The Australian dollar also lost 2.3%.
The global Bubble is bursting – hence financial conditions are tightening.
Bubbles never provide a convenient time to tighten monetary policy.
Best practices would require central bankers to tighten early before Bubble
Dynamics take firm hold. Central bankers instead nurture and accommodate
Bubble excess. It ensures a policy dead end.
As the unfolding EM crisis gathered further momentum this week, the
transmission mechanism to the U.S. has begun to clearly show itself. While
“full retreat” may be a little too strong at this point, the global leveraged
speculating community is backpedaling. Biotech stocks suffered
double-digit losses this week, as a significant Bubble deflates in earnest.
It’s also worth noting that the broader market underperformed.
(Source)
What does it mean when we see currencies in retreat across the
globe? It means that the hot, speculator money is rushing out of weaker
economies and back towards the stronger center. This is consistent with
a liquidity crisis, one where all the borrowed money used to spark all those
heady asset gains and falling yields on the way out do the exact opposite on
the way back.
And Doug is exactly right – there’s never a good time to pop a
bubble. So the central bankers just sits, paralyzed, afraid to even
raise rates by a token amount for fear that the daisy-chain of global bubbles
will burst as a result. They needn’t fear: the bubbles will burst no matter
what the Fed does.
A credit default swap (CDS) is a bit of insurance you can buy if you own a
bond and are worried that the issuer may default on it. In a stable
climate, the cost of that insurance (measured in percentage points above the
stated yield on that debt) is pretty flat. It's usually close to the yield of
the bond in question.
So you might have to pay 1% to 2% (i.e. 100 to 200 basis points) above the
yield on, say a Brazilian ten year bond, to insure it against a default.
As things begin to break down and become less certain, that cost will rise.
Now take a look at this chart of recent emerging market CDS 'spreads':
(Source)
See those CDS ‘spreads’ blowing out to the upside? That’s the sort of
thing I was tracking in 2008 that gave me a clear early warning that things
were about to fall apart. While these levels are not (yet) flashing the
same level of danger that we are seeing in the CDS paper for Glencore (which
is almost certain to go bankrupt now) and for US shale drillers (tons of
bankruptcies coming there, too), these are pretty serious warning signs.
Why would the sovereign debt of Russia, Turkey, Brazil, and Malaysia be
spiking right now? Because the hot money is flooding out of those
countries. There's now an elevated risk that they may default on their bonds
in the future.
These emerging market countries are being squeezed from every direction.
But the worst pain is being experience by those that borrowed heavily in
dollars (or other stable currencies). From the WSJ (Sept 29), we see
the magnitude of the predicament for companies located in EM nations:
Developing-country firms quadrupled their borrowing from around $4
trillion in 2004 to well over $18 trillion last year, with China
accounting for a major share.
Now, prospects in industrializing economies are weakening
fast even as the U.S. Federal Reserve is getting
set to raise interest rates for the first time in nearly a decade, a move
that will raise borrowing costs around the world.
The burden of 26% larger average corporate debt ratios and
higher interest rates come as commodity prices plummet, a staple
export for many emerging-market economies.
Compounding problems, many firms borrowed heavily in dollars.
As the greenback surges against the value of local currency revenues, it
makes repaying those loans increasingly difficult.
(Source)
So the afflicted countries are going to see vastly weaker exports,
plunging currencies, and their local corporations unable to pay off
dollar-denominated loans -- on borrowing that ballooned from $4 trillion in
2004 to over $18 trillion just 11 years later. It’s an amazing
statistic, one of many fostered by a cluster of central banks that know
everything about blowing bubbles but nothing about ending them.
The punchline from the above article is this: “That massive debt
build-up means it is “vital” for authorities to be increasingly vigilant,
especially to threats to systemically important companies and the firms they
have links to, including banks and other financial firms, the IMF said.”
Decoded, that means that $18 trillion is a big number. If even a small
portion of that goes into default, it could easily drag down whole swaths of
the developed world’s financial corporate structure.
Well, based on this ETF which holds bonds priced in local currencies, we
can get a sense of the pain those EM companies holding dollar denominated
loans, but being paid in local currency, are feeling:
Ouch! Based on the above chart, the past year has been painful
indeed for those emerging market corporations and governments.
Not So Fast There….
One so-called ‘bright spot’ in the world economy is the US, which
supposedly is doing better than everyone else. As you know, I consider
US GDP statistics to be nearly useless because of all the statistical tricks and
gimmicks that are now deployed (such
as now counting ‘intangibles’ to go along with Owner Occupied Rent which
records the price value of people not paying themselves rent, etc.,) to make
things look better than they are.
So I’m having trouble believing that the US economy is doing well when our
major trading partner to the south is struggling so much due to a drop in
exports:
Mexico factory exports slump by most in over 6-1/2 years in Aug
Sept 25, 2015
(Reuters) - Mexico's factory-made exports slumped in August by the
most in more than 6-1/2 years after uneven growth in the first half
of 2015, data showed on Friday, while consumer imports rose.
Manufactured exports sank 7.2 percent in August compared with July,
falling back after two months of gains, the national statistics agency said
in a statement. It was the biggest month-on-month drop since December
2008, data showed.
Mexico exports mostly manufactured goods like cars and televisions and about
three-quarters are sent to the United States.
(Source)
It’s hard to imagine that the US economy is doing fine when a major
trading partner who exports 75% of its finished product to the US is
experiencing a deep export slump.
But it’s not just Mexico that's seeing a big decline in export activity:
For the first seven months of 2015, U.S. exports dropped 5.6% to $895.7
billion. The value of South Korean exports shrank a revised 14.9% in August
from a year earlier, the sharpest fall in six years, as shipments to China
dropped. Chinese imports in August fell 13.8% in dollar terms from a year
earlier, after an 8.1% decrease in July.
(Source – WSJ)
If this keeps up, 2015 will see the worst global trade performance since…wait
for it…2008. For the US, 2015 will be the first year that exports have
declined since the financial crisis. Ditto for a number of other
countries.
Beyond exports, the surveys of US manufacturing and service sector
activity are also flashing recession warning signs. In fact, the
manufacturing survey has only been this low in the past during prior
recessions. Maybe this time is different?
(Source)
On the plus side for the US: reasonably robust housing activity, low
initial claims for unemployment, and growing income and expenditures. But the
data for some of these is suspect (nearly 100 million working-age adults are
not counted in the workforce), and in other areas, not robust enough to hang
too many hopes on.
Add it all up, and there are a number of signs that not only is the US
economy is far from robust, it may even be teetering on the verge of a
recession. But the global economic landscape is decidedly tilted towards
contraction, not expansion.
Why is all this important" We track all of this because seeing these
signs early gives us a better chance to mentally and physically prepare for
the next shock. The press does a very good job of constantly painting
everything in a rosy light, and that’s fine, but it’s not very helpful if it
also misleads.
Lots of people are woefully unprepared for what’s coming next. For many it
will be a shock. Not because they couldn’t see it
coming years in advance and made their own mental and financial adjustments
on their own terms, but because they wouldn’t. Preferring
to avoid an unpleasant truth they put it out of sight and out of mind, hoping
that somehow things would work out in their favor.
In Part 2: From Deflation To Hyperinflation, we detail out
the likeliest progression of the unfolding deflationary rout and the
inevitable tsunami of money printing that the central banks will respond
with, unleashing the final hyperinflationary chapter.
Click here to read Part 2 of this report (free
executive summary, enrollment required for full access)
