Brexit Vote Is Only The Beginning: Evolution Is Essential

by: Danielle Park, CFA

In 1982, North America was grinding its way through a second "double-dip" recession in two years. Financial markets were in year 16 of a secular bear market that had been pummeling prices and grinding stock valuations from historic highs (P/Es above 20) in 1966 to historic lows (P/Es under 10) by 1982.

In the process of recurring economic strife, tax rates and regulation had increased to near historic highs, household savings rates had doubled back above 12%, and household debt levels had been worked down near historic lows. As these economic foundations fell back into place, few people could see that a secular expansion cycle for corporate and government revenues was about to begin. From 1982 to 2000, the financial growth that followed was the strongest and longest ever recorded.

As the good times rolled on, key government regulation was pushed back from excessive to minimal, tax rates were steadily lowered, wages stagnated but women entered the workforce en masse to increase household income, interest and saving rates fell, and consumer debt levels rose along with the stock market. In the process, corporate pay incentives fixated on ways to continually escalate reported earnings and share prices at all costs. A new market-focused media sector blossomed, and pensions and individuals increasingly shifted their savings out of interest-bearing bank deposits and into publicly traded funds and markets. Like the Great Oz presiding over it all, the financial sector came to unprecedented power and influence over thinking and policies, which became increasingly levered and risk-seeking.

By the late 1990s, the secular boom cycle had run its course. A short-sighted obsession with accounting tricks and financial gimmicks spawned publicly traded multi-national behemoths valued at obscene multiples of often fictional profits. Dividend yields slumped, and fundamental measurements were denounced as irrelevant in the brave new world of expanding equity valuations (P/Es went to an unheard-of 40+). Then, the much deserved corporate implosions began: from Asian markets to Long-Term Capital Management in 1998 to WorldCom, Enron, Tyco, Nortel, to most public markets between 2000 and 2003.

The US Central Bank that had repeatedly slashed rates through every episode of weakness from 1980 to 2003 cut overnight rates to just 1% and left them there for a year. Reeling from deserved losses yet still unrepentant, the financial sector delved into new and even more reckless ways to package and sell debt to "investors". From 2003 to 2006, credit billowed and asset prices soared, before markets burst once more and the great financial crisis spread.

Already at the zero bound in rates, and with the credit genie still frozen, central banks moved through an increasingly desperate series of experimental "stimulants" since 2008. For a while, low savings rates weakened further and consumer and corporate debt levels rose. But economic growth did not recover, even as central banks swapped trillions in debt off banks in exchange for cash. The cash did not move into the real economy and has been re-circling aimlessly through garishly overvalued and inefficient capital markets.

(For some perspective on just how far above reasonable value current equity prices remain today, see Cory's annotated big-picture chart of the S&P 500 here.)

Today, as German 10-year treasury bonds move into negative yields, there is now some $10 trillion in government bonds in the world where lenders are paying the debtors to borrow.

The trouble is this. Once people have run out of savings and wage growth, and you have piled trillions in low- to zero-rate loans onto every person and corporation in the world willing to borrow, you run out of takers. We have seen this in realty sales, and we are seeing this in automotive sales today.

As highlighted (on the left) in this recent promotion from Dodge, once you have used zero down and zero rate financing for 3, then 5, then 7 years (84 months), and added thousands of free upgrades to push cars out the door on to every driver with a pulse, you run out of customers who can pay anything at all.

Then, as with negative bond rates, you start having to pay your customers to take your products. Witness the new "no payments" for 30-, 60- and now 90-day offerings. With vehicle inventories at record highs, what comes next? Will this become the "Don't pay for 12, 24 and then 36 months" promotions that have become the mainstay of furniture and appliance offerings?

The point is, if customers can't pay for your product and you can't keep operations afloat by expanding your debt more and more, you can't continue. Economic reality hits at the end of the credit line. And the world is there today.

The bankers and product sellers cannot defy math forever. After 30 years of "add debt and stir", we have come to the end of the credit road. All the systems that have enabled capital extraction to a few, while emaciating the many, are now out of fodder.

We should expect to see a break-up and retreat of what has become the ruling status quo over the past three decades. We should expect bankruptcies, reorganization and political upheaval. The world has earned this next catharsis phase. The process will be messy, but will reinvigorate through creative destruction, while re-distributing resources from empty financial antics into productive pursuits - the kind that help to rebuild household savings and cut oppressive political and corporate conglomerates back down, in support of strengthening the masses and democracy.

Whatever the outcome of the political referendum in Britain next week, we should not be surprised to see more break-ups and reorganizations ahead. The era of "financialization", and the "globalization" that it promoted, has come to a secular close once more. Wise people should understand why and adapt. Evolution is essential.

"Stripped of distractions, it comes down to an elemental choice: whether to restore the full self-government of this nation, or to continue living under a higher supranational regime, ruled by a European Council that we do not elect in any meaningful sense, and that the British people can never remove, even when it persists in error."

- Ambrose Evans-Pritchard, UK Telegraph, June 13, 2016

Disclosure: No positions.

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