'Fog Of War' Describes Economic Outlook

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Includes: DIA, IWM, QQQ, SPY
by: Bruce Wilds

Summary

We are currently in a state equivalent to an economic "fog of war" where it is difficult to see what is happening before us.

As the decline in asset prices becomes more apparent we face the risk of contagion is soaring in the massive derivatives market.

Nothing can be more disruptive and destabilizing to an economy than cross border money flows and the carry trade.

2016 Scary We are currently in a state equivalent to an economic "fog of war" where it is difficult to see clearly what is happening before us. The world is experiencing a record amount of wealth shifting around within the global financial system. Money is crossing borders in growing amounts in an effort to escape risk. This is adding to the general confusion as commodity prices continue to fall. As the decline in asset prices becomes more apparent the fear that contagion risks are soaring will move forward and take center stage.

Each day it is becoming more obvious the main goal of QE was to bolster and prop up the underlying value of assets that feed into and support the massive derivative market. They have allowed this to take precedence over the economy. Since 2008 the central banks knew an implosion of derivatives and the resulting contagion spreading from it would indeed bring the whole financial system crashing down. So far the actions of the central banks and government stimulus has delayed a massive economic Armageddon, but by not addressing the real issues and causes at the root of our problems they have only put off and set back the event. A complacent public will eventually be shocked to find they must shoulder the cost of these policies that will come in the form of an economic reset and financial trauma.

Interest Rates Verses Government Spending
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Over the last few year countries and central banks have transferred private debt and bank debt on to the backs of the people as public sector debt has soared. This means governments need markets to go ever higher or it will become evident they cannot pay interest on their debt. When the markets drop we will see a big fall in government revenue and deficits will soar far beyond current predictions. As economies across the world continue to slow we should ponder what sectors will provide the growth we seek to propel us forward. It is becoming clear that artificially low interest rates and massive amounts of money poured into the system have not given us the kick we need and if anything they have only compounded the hazards ahead. Stated as simply as possible, we have cars, we have houses, we have smart phones, and we have more money being spent on healthcare than ever before. What we do not have is solid sustainable private sector job growth. We continue to see massive government spending across the world as the key support behind the global economy.

In March of 2014 I wrote about how everyone paying attention knows that the size of the derivatives market dwarfs the global economy. Paul Wilmott who holds a doctorate in applied mathematics from Oxford University has written several books on derivatives. At the time Wilmott estimated the derivatives market at $1.2 quadrillion, to put that in perspective it is about 20 times the size of the world economy. The world’s annual gross domestic product is around 55 trillion dollars. This large poorly regulated market and the contagion associated with it remains the Achilles Heel of the world economy. The fact is today many of these financial arrangements are related to cross border investment and currencies.

Many of the bets placed in the financial casino known as the global market are shrouded intentionally or merely by the nature of the transaction. This can easily move them into the area of "carry trades" or some other highly leveraged trade that slip into the area of derivatives. Derivatives fall into many categories from futures, options, credit default swaps, and any complex combinations of these. They can also be used to wager, bet, and speculate on a market move or direction. Regulation is difficult and spotty at best in that a derivative transaction in one country might be considered a simple spot trade in another. Many of these transactions that appear on the surface as simple are in reality a bet on a bet on a bet. Remember this is only part of a much larger market that includes hundreds of trillions of dollars in non-reported agreements and private contracts.

Through the fog we must recognize that nothing can be more disruptive and destabilizing to an economy than cross border money flows and the carry trade. Both these practices have dramatically increased as the central banks of the world have engaged in the mass printing of money and keeping interest rates artificially low. Such an economic environment screams for gamblers to come forth and enter these games in search of quick gains and easy money. In reality much of this is totally out of the control of central banks, or that of any regulatory agency, but because of their actions it goes on every day. Also, troubling is the people making money in the process of structuring and selling these agreements often play fast and loose with the value of the collateral backing them or flat out lie about it.

In the financial markets of today things have grown far less transparent due to speed at which transactions occur and the complexity of our modern world. Often when we look behind the curtain we find the products of sophisticated traders are highly leveraged and stack layers of risk upon the huge amount of risk that already exist. When we mix in the impact of derivatives and its sister the "shadow-banking" sector we find the water gets really murky. The policies of recent years have set the stage for a scenario of where the dominoes begin to fall. Recent moves of central banks entering equity markets and government pension funds becoming big buyers of stocks speaks volumes as to how the red flags of caution have been totally ignored. Bottom-line is the fog before us could be hiding a big black hole ready to suck us in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.