We Are Entering A Period Of Consequences

by: Kevin Wilson


Winston Churchill's warnings about the impending threat from Nazi Germany were mostly ignored, but as he said, eventually Europe's era of half-measures was followed by a period of consequences.

Churchill persisted because of history; this serves as a metaphor of sorts for the aggregate risk the world economic system now faces, based on history; markets have ignored this risk.

Extreme monetary policies are an attempt to appease the markets as much as solve economic problems; these efforts will ultimately fail when some event trigger causes a re-rating of risk.

We can't predict when the markets will finally turn, but we can say that the risk is very high, and that there's likely to be no warning when it comes.

We will soon face another crisis; it is recommended that defensive positions be held or bought in TLT, IEF, BIV, BOND, AGG, SPLV, USMV, OTCRX, QLENX, QMNIX, and/or BXMX.

Source: davidstockmanscontracorner.com

When Winston Churchill spoke about the impending threat from Nazi Germany in the 1930s, it would have paid the average European to listen up and take action accordingly. However, as is the case with all Cassandras, he was ridiculed and treated as an outcast for years before the wisdom of his observations was finally acknowledged. He persisted because he knew history. Although it may be a bit of a stretch as a metaphor, I think that the current financial situation in Europe, Japan, and China represents, in aggregate, a similar threat to the global economic system. Thus, a very long period of "procrastination, of half-measures, of soothing and baffling expedients, of delays, is coming to a close. In its place we are entering a period of consequences." In my opinion, the extreme monetary policies of recent years are symptoms of an underlying disease, which is runaway government spending that propels both mal-investment and unsustainable levels of debt throughout the world.

These extreme monetary policies are the de facto equivalent of the West's attempts to appease Hitler in 1938 and 1939. That is, they have only delayed the inevitable, and made the consequences far worse. Under current market conditions in the US for example, it appears that fundamentals don't count for much of anything. Every political disaster (e.g., Brexit, the Turkish coup, China's loss of face on the law of the sea decision) is shrugged off (Chart 1); every negative piece of market news (e.g., poor earnings, falling revenues, falling profit margins, rising defaults) is also shrugged off (Charts 2 and 3); and of course every negative piece of economic news (e.g., structurally declining productivity, structurally declining GDP, abysmal labor participation rates, underfunded pensions) is shrugged off as well (Chart 4). In fact, recently it seems that economic crises paradoxically tend to drive the market violently upwards after a brief moment or two of panic, as the highly predictable, knee-jerk central bank intervention that always happens nowadays, is observed once again. This bare-faced manipulation of the markets continues to be seen as a positive no matter what the cost to the economy (or society in general) of such frequent interventions.

Chart 1: S & P 500 Response to Brexit Crisis of June 23, 2016

Source: Investopedia.com

Chart 2: Highest Median Price/Revenue Ratio Ever

Source: Nasdaq.com

Chart 3: Divergence Between Fake (Operating) and Real (GAAP) Earnings

Source: zerohedge.com

Chart 4: Divergence Between Global Markets and Global GDP

Source: zerohedge.com

The markets are apparently not even mildly interested in the actual state of the economy, no matter what the risk may be of declining activity in the US, or another great financial crisis in Europe or Asia. Given the current extremely high valuations in markets, this behavior (to follow our metaphor) is like Neville Chamberlain coming home from Munich in 1938 and declaring that "peace with honor" was at hand. As Churchill tersely commented, "An appeaser is one who feeds a crocodile, hoping it will eat him last." Likewise, the central bankers keep appeasing the markets, but in the end the markets are still going to "eat" the central bankers when the truth about the economy can no longer be denied. That day may be sooner than many think. The only way to avoid what is coming is coordinated, prudent, and courageous fiscal action, which is as unlikely now as peace in Europe was in 1938.

Neville Chamberlain, 1938

Source: vox.com

This is because monetary stimulus (to mix my metaphors) is like heroin addiction to the markets: they may say they would like to quit, but they never miss an injection opportunity. The central banks have nurtured the markets at every turn, but have completely ignored the actual economy, and the laws of capitalism while we're at it. Thus we have had Federal Reserve support of non-banks and foreign banks during the crisis in 2008, and then ZIRP, and QE, and then in some cases NIRP, and now finally the prospect of helicopter money. Many observers are concerned about the damage being done to capitalism by all of this wild experimentation by the central banks. But since markets insist on judging all things through the prism of market liquidity alone, there is no end in sight yet to this risk-taking mentality. Clearly, we have not yet seen the last of the dangerous ideas these so-called monetary experts have up their sleeves. Helicopter money (monetary finance) is going to happen, first in Japan and then in Europe, and that may finally change the market's attitude when it realizes what the true implications of this are likely to be.

Event risk for the markets therefore is now as high as I have ever seen it in my lifetime, except for a few weeks in the fall of 1987 (Black Monday Crash), a few weeks following September 10, 2001 (9/11 Terror Attacks), and a few weeks in September and October, 2008 (Great Financial Crisis). The fools in both parties in our recent and current governments that have been endowed with fiscal authority have sat on their hands or ignored major problems for many years. The fools that have monetary policy authority are willing to destroy capitalism in order to preserve the political system's current status quo, however pathetic it may be. There will of course continue to be delaying tactics and can-kicking exercises, but there will never be a genuine attempt to permanently resolve the structural economic problems plaguing the major economies. This is in spite of the fact that history shows a number of examples where smaller countries were able to permanently resolve the problems stemming from major crises. For examples, we need only look at Japan in the 1930s, Sweden and Finland in the 1990s, or Iceland and Ireland in the aftermath of 2008 (Chart 5).

Chart 5: Iceland's Rapid Recovery from Total Meltdown in 2008 Crisis

Source: wsj.com; theautomaticearth.com

Given the long term survival of Japan in spite of the stupendous failure of its political system to deal with its economic problems over three decades, the question arises as to whether we should assume the same kind of kick-the-can survival rates for Japan, Europe, China, or even the US, going forward. This is a very tough question on the face of it. How much tolerance will the respective markets have for the continued failure of their respective economies? The answers will vary a bit, but since everything is interconnected in the financial system now, once a big player falls, all the rest will likely be in some kind of trouble as well. Thus we will perhaps have some minor crises along the way, but in the end there will be a tipping point for a major crisis, where what happens is just too much to be absorbed by the system.

How far are we from that day? I have no idea, and will make no explicit claims. However, it is important to note that there was no warning worth mentioning in 1987, and very little warning of the market shut-down caused by the 9/11 attacks. Although there was plenty of warning in advance of the Lehman Brothers failure in 2008, the behavior of the Fed and the Treasury over the preceding six months had convinced markets that nothing big was going to happen, in spite of the biggest fraud in human history. Then after letting Lehman fail, one week later the authorities bailed out huge insurer AIG (NYSE:AIG), and then the House of Representatives failed to pass the TARP legislation that the Bush Administration said was critical to survival (Chart 6).

Chart 6: The Market Crash of 2008

Source: blogs.afraidtotrade.com

In other words, there's always the unexpected. In the end, something unexpected will happen, and instead of being ignored as usual, it will finally tip the scales and all hell will break loose. I will add that we have already come so far down the road that it seems very unlikely that we can go much further without the proverbial unexpected event happening. The reason I say this is not because I know what will happen, but because I know what has already happened. By that I mean, just look at the situation we find ourselves in. First, Japan has run the game out to the bitter end, and now that they are functionally bankrupt, they face the endgame. This means that ONLY the traditional endgame options are left: currency devaluation and austerity, with eventual recovery; or alternatively, money printing, potential complete currency destruction, and hyperinflation. Which path will they choose? I can't say for sure, but the Japanese government's failure to deal with the crisis over three decades suggests they will not choose wisely. That decision is likely within a few months, as I have written elsewhere; however, note that money in circulation is already rising logarithmically (Chart 7).

Chart 7: Japanese Circulating Currency Is Expanding Rapidly

Source: Deutsche Bank

Second, the European banking crisis is far worse than the authorities admit. Deutsche Bank (NYSE:DB) has a leverage ratio of 40:1, compared to 31:1 for Lehman Brothers. Can it be bailed out successfully? Yes, but only if the EU rules are not followed by the main proponent of those rules, Germany. How about those abysmal Italian banks, or the Swiss, French, British, Spanish, or Greek banks? They're not all quite as leveraged as Deutsche Bank, but many are in dire straits anyway. The only way to save them (bail them out) is to violate EU rules. This is more likely to be done than not, but no one is going to close the bad banks, fire the management, and clear the decks. As a result, systemic risk will not be permanently resolved by new recapitalizations alone. The problem, according to bank analyst Christopher Whalen, is that the regulatory system is focusing on the wrong thing. That is, the increases in bank capital do not deal at all with the impact on liquidity of a general lack of trust. Whalen has made a good case for this lack of trust being the real cause of the 2008 financial sector meltdown. If he is right, the EU banking crisis is still likely to blow up, and fairly soon (Chart 8).

Chart 8: Capital Outflows from Southern European Banks

Source: mishtalk.com

Third, China is faring well so far, but the signs of impending trouble are widespread. I wrote a few months ago about this: "Corporate debt in China…after years of easy money, a real estate bubble, a stock bubble, and an explosion of shadow banking… has risen to 180% of GDP, and total debt excluding the financial sector has reached 255% of 2014's GDP. If you do the math, that's about $26+ trillion in debt. The sustainability of an economy carrying that much debt, similar in percentage terms to what Greece has been carrying, depends on several things: 1) the banking system must remain trusted and reliable in investors' eyes; 2) debt service must be feasible under projected conditions; 3) government must be seen to back the stability of the system; and 4) no major shocks to the system can occur. But some of these at least, and possibly all, are now in doubt."

There are estimates that bad loans in the Chinese shadow banking system probably exceed $1 trillion, and there may be another $1 trillion in leveraged loans in the formal banking system. Hedge fund manager Kyle Bass also thinks that about 20% of regular loans in the banking system are non-performing, which may mean there's another $3 trillion that is doubtful. SocGen suggests that bad loans will increase by at least $150 billion as China rids itself of overcapacity in iron mills and coal mines. According to Bank of America, all this suggests that a massive debt write-off, a major re-capitalization of the banking system, and a major currency de-valuation are required. A gradual devaluation, as we know, is already almost a year old, but it will have to go a lot farther than it has so far (Chart 9).

Chart 9: China Has Much Farther to Go on Devaluation

Source: kkr.com

Finally, the US markets are hitting new highs almost daily while virtually every metric indicates that they are quite overbought, massively over-valued, and facing both declining profit margins and declining revenues. Median price/sales ratios are the highest ever recorded (Chart 2 above). This of course doesn't mean it can't continue to go up. But the risk/reward trade-off, which was already poor, is now egregiously so. There is at most about 6% upside left, according to chart analysts like Lance Roberts, while there is as much as 50% downside risk (Chart 10). Yet professionals face career risk if they don't buy into this strange and dangerous rally.

Chart 10: Corporate Market Value/GDP Ratio for US Markets

Source: dshort.com; advisorperspectives.com

In conclusion, what does it mean when central bankers are so adamant that nothing must ever hurt the markets, that virtually all economic or political events are considered suitable excuses for intervention? In my opinion, it means that when the big surprise that tips us over finally arrives, it will be hitting a market that expects to get bailed out, and can plan accordingly. But what no one plans on is what happens when the markets are so afraid that the interventions don't work anymore. As fund manager John Hussman has pointed out, once the market is seriously risk averse, no amount of intervention will make any difference (Chart 11). That day is approaching, because we now have many ways to make a disaster, and almost no willingness or ability to prevent one.

Chart 11 : Failure of Fed Interventions in 2008-2009

Source: hussmanfunds.com

As for trades, I am still not convinced that the recent equity rally means anything at all. The currency and bond markets are telling the real story here, as well as the banking indexes in equity markets. Investors should stay defensive unless a real, confirmed breakout of 3% or more above the old 2015 highs occurs. In the meantime, it makes sense to hold some intermediate to long Treasuries: the I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the I-Shares 7-10 Yr. Treasury Bond ETF (NYSEARCA:IEF), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the I-Shares Core Aggregate Bond ETF (NYSEARCA:AGG); also defensive sector funds like the Powershares S & P 500 Low Volatility ETF (NYSEARCA:SPLV),and the I-Shares Edge MSCI Minimum Volatility ETF (NYSEARCA:USMV); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), or the AQR Equity Market Neutral Fund (MUTF:QMNIX); and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S & P 500 Buy-Write Fund (NYSE:BXMX).

Disclosure: I am/we are long BIV, BOND, OTCRX, QLENX, QMNIX, BXMX.

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.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.