Economy Rolling Over: Focus On Housing And Tariffs

by: Mad Genius Economics

Summary

Trade Wars: All stake holders lose in the long run.

Housing and autos are already in recession mode.

Banks only do well with long rates rising faster than short rates.

Don't fear holding cash... lots of cash.

“We regard inflation as a public enemy of the worst type. But we have not hesitated, either, to ease or restrict the basis of credit when need was indicated. The full force of monetary policy has been made effective more promptly than ever before to respond to natural demands. This has been done by the timely use of monetary policy and credit; by the return to the public of purchasing power through the biggest tax cut in the history of the nation; by cutting unjustified Government spending; by timely encouragement to construction, home building, and needed improvements.”

I urge you to reread this quote, and try to guess when it was said. You might think this was written or spoken within the last 8-10 months by a Fed governor, the Fed chairman, Secretary of Treasury, or some other bureaucrat. It wasn’t. It was actually published 63 years ago on November 28, 1955, in Time Magazine.

The salient difference is the part about cutting spending. Regardless of your political affiliation, the Trump administration has held true to many campaign promises and has done many positive things for the country, however, we have seen no such spending cuts during the current administration as we see mentioned in the above quote.

In fact, the Trump tax cuts have added over $779 billion in deficit spending to what is already estimated, even if you account for the economic growth created by the tax cuts. As noted here, this deficit was brought about by the new tax law. Treasury issued over $488 billion in additional debt in the first quarter alone. According to Treasury itself, the current federal budget deficit (current fiscal year) under GAAP standards for all obligations is $6.02 trillion! The full report can be seen at the Bureau of Fiscal Service website.

The point I’m making here is that Trump and the Republican House and Senate passed a massive tax reform, but they did not make a commensurate cut in spending. Just the opposite in fact, because spending is increasing, as seen in the BFS report. If you think current national debt service payments are a lot now, with the ten-year treasury just over 3%, just wait until that hits, 4%, 5%, 6%, or more!

As of September (latest available info from Treasury), the average interest rate on bonded national debt is 2.494%, which is up from the same time last year when it was 2.284. On $21.7 Trillion of debt, that would be over $541.2 Billion a year in debt service payments. This all will weigh very heavy on the dollar, and as such it will have a tremendously negative impact on the economy.

I’ve written extensively about rate hikes and spending in the past, so I am not going to belabor the issue. If you want to see what I’ve written, please review my prior postings. When you do, you’ll note that much of what I’ve said is now coming to fruition or is visible on the horizon. And please keep in mind a couple of over-arching issues, including rate hikes, Fed asset sales, and new Treasury issues to fill budget gaps. It’s a triple whammy. Some of my other predictions are coming to fruition as well, such as emerging market pain, housing, stocks peaking, and others.

Trade Wars

Before speaking about what is happening now, at least according to the mainstream media, it’s important to see the full picture of what is really happening with this trade war. Even with a brief perusal of history, one can easily conclude the context of trade wars is that they usually lead to military wars. But it’s not a jump from “we’re imposing a tariff of 25% on Chinese goods” to “you pissed us off with your tariff and we’re sending warships.” CNN already reported this happening here and here.

There are more steps in between, and there will be an ebb and flow. Included in those steps of trade wars are tariffs, sanctions, corporate tax increases or cuts, currency manipulation, capital controls, engaging other trade partners, abandoning the status quo of financial systems, intellectual property theft, and much more. Ray Dalio recently posted an excellent summary on LinkedIn right here.

Let’s be clear also that we’re not just speaking about trade talks breaking down with China at the end of September, and it isn’t just because of 10% tariffs on Chinese goods, set to move up to 25% in January 2019. It’s also everything the Trump administration is doing with all of our other trade partners, including NAFTA, steel tariffs on Mexico and Canada, tariffs on cars made in the EU, and more.

On the surface, Mr. Trump has tariffs wrong. The pros and cons have been written about extensively by Adam Smith (The Wealth of Nations), Henry Hazlitt (Economics in One Lesson), and others. Let’s have a look at what we can expect.

To be sure, there may be short-term benefits to imposing tariffs. Let’s imagine for a moment that there is a widget we can build here in the USA, and it can also be built in China. The only difference being that the Chinese widget may be sold at retail for $25, and the American widget for $30.

Who benefits and who loses from a $5 tariff on the Chinese widget? The Chinese manufacturer will view the $5 tariff per widget as a cost of doing business, and if he was selling his widget to the American importer for $10.00 (and the importer then retailed it for $25), he will instead sell it to the American importer for $15.00. The importer, seeing that his cost has risen, will turn around and sell it for $30 retail to ensure that his profit margin is still high enough that he will stay in business. Neither gain nor loss for the Chinese manufacturer.

What about American manufacturers? Previously they could not compete with Chinese manufacturers at the current retail price of $25. Since all purchasers of this widget will now be forced to pay at least $30 for a widget, the American manufacturers can now compete at the new market price of $30.

Rather than find a way to reduce the cost to manufacture widgets in America, or perhaps exit the widget business all together in favor of something more profitable, American widget makers can now make a profit, albeit inefficiently. We have a gain for the widget makers here in the good old USA as well as their investors, and we have a gain for the few thousand workers employed in the American widget industry as well.

And finally, how about the American consumer? The consumer, including widget making employees, actually all lose. Anyone who purchases a new widget will have to pay $5 more for every widget they buy, instead of using that money for something else, like socks, bread, gas, baseball gloves, and the like. They won’t be able to save it either, and they certainly won’t be able to invest in various business opportunities.

So the consumer, who is supposed to account for 70% of American GDP, has nothing to gain and everything to lose. And the American economy will print higher retail numbers, but those higher retail sales won’t deflate for inflation, taxes, and tariffs. It will look like GDP is growing even if it isn’t.

If we take tariffs to the next level of discussion, we’ll see that American manufacturing really loses out, as do Chinese manufacturing and Chinese consumers. In addition to manufacturing, the laborers who work in those factories, and all factories also will lose, because capital will be invested in inefficient economic models of manufacturing.

The American investment into widget making will suddenly appear to be more profitable than it really is, and the Chinese will appear to have a higher barrier to entry. We will have an inefficient industry seeing more capital investments than it should. Money should flow to where it’s treated best, not treated preferentially.

There is a good example of this, found here, in the Chicago Tribune from August 16, 2018. Exactly what we expect from a tariff. Imported steel becomes more expensive, domestic steel can now compete, so the domestic company (US Steel, in this case) makes $2 billion in upgrades to its flagship plant, and hires 800 more workers for other plants. If I am investing in business, though, this is not where I want my money. It’s not the most efficient use and I won’t profit how I want or expect.

The additional outgrowth of this type of situation is that housing and cars are becoming more expensive. In fact, anything with Chinese raw materials will be more expensive, and all final products will be more expensive as well. Homebuilders such as Hovnanian are getting pinched (more below). Hovnanian in particular reported a loss on top line revenue falling by over 22% YOY.

Hovnanian isn’t the only homebuilder experiencing problems because of tariffs. Here you can see how lumber has become more expensive. Here we can see how the original 10% tariff increased already frothy pricing, due to higher prices on construction materials like granite, ceramic tiles, and the gypsum found in drywall. And here we see steel and aluminum affecting home construction costs.

There is much more that can be said about the negative consequences of tariffs, but I think that’s beyond the scope of this article. To summarize though, in the short term, selected domestic industries may benefit from a tariff. In the long term, the entire economy becomes less efficient and everyone loses.

Outlook On Tariffs

Beyond short-term winners, there may be other benefits to a tariff. For example, if President Trump is using tariffs as a negotiating tactic to force trading partners to bring their tariffs down. It is my belief that this is what Trump wants to do.

The real idea of what he wants to do on policy can be seen in both his own and administration officials’ comments, especially if they speak in concert with each other. The best example of this, regarding tariffs, was at the G7 summit this past summer. The official transcript was released here on June 9, 2018. If you scroll down to the Q&A section, both Trump and Kudlow emphasized the need to dramatically reduce or eliminate tariffs, barriers, and subsidized trade. In other words, they endorse completely free trade on a worldwide basis, without any type of government-imposed intervention.

If Trump really endorses free trade, that means that his current actions of tariffs against any partner, particularly China at this juncture, are meant to be short term in nature, and they are meant to be retaliatory, with the goal of getting tariffs reduced or removed. These current tariffs are just political posturing.

If the action fails, though, my fear is that it could spiral out of control and become this century’s version of the Smoot-Hawley Tariff Act of 1930, which is recognized as worsening and lengthening the Great Depression.

Other Options On Tariffs

I asked Professor Gary Wolfram of Hillsdale College about these tariffs. Professor Wolfram is a recognized expert in taxation and policy analysis (i.e., the unintended economic consequences of public policy), and author of A Capitalist Manifesto: Understanding The Market Economy And Defending Liberty (Dunlap Goddard, 2012).

Professor Wolfram said that China has other means to get around the Trump tariffs, and he used steel as an example. Chinese steel plants can ship their product directly to the United States and incur the tariff, or they may ship it indirectly through any other country, such as Indonesia, and avoid the tariff.

I personally witnessed this happening when I worked in imports, over a decade ago. If we brought 10” dinner candle pairs in, directly from China, we may have paid $2.00 per pair, including all manufacturing, shipping, and tariffs. However, we didn’t actually do that. We first bulk shipped the candles to Malaysia, then transferred them into display packages, then shipped them to America with a “Made in Malaysia” sticker. Including the additional labor, this actually brought down the cost by over 60% to about $0.70 per pair because it reduced the tariffs. A similar situation today renders Trump's tariffs impotent and useless.

Professor Wolfram added another tactic the Chinese may employ. If they don’t like Mr. Trump, they may want to influence either the upcoming midterm House and Senate elections, or they may try to influence Trump’s bid for reelection in 2020. To accomplish this they may selectively impose tariffs on goods coming out of battleground states. Coal state like Pennsylvania, Ohio, West Virginia, or Tennessee come to mind. They could do the same for Midwestern states that are known for farming corn or soybeans.

By pushing enough states to vote out Republican incumbents, the house, senate, or both may turn Democrat, thereby stalling Trump's policy initiatives. Or the Chinese could push enough states to vote for the Democratic challenger, giving him/her enough electoral votes to turn Trump into a lame duck in 2020.

One more weapon the Chinese have in this trade war is a currency war. To their credit the Chinese government is generally very slow to change the exchange rate between the Renminbi and Dollar. However, if they want to remain competitive in America as well as the rest of the world, they can easily change the currency peg at will. If they move the RMB lower against the dollar, thereby nullifying the effect of the tariff, they will be able to stay competitive against products that are made in America.

And then the Chinese have their ace of spades. That would be their currency reserves in the form of over $1.2 trillion of treasuries. I don’t think China is likely to use any options here, but it’s more and more possible as trade wars continue. More likely is the mere threat to use this option. This option is to begin reducing purchases of treasuries or selling off their treasury holdings, and use the proceeds to purchase other fiat currencies and gold instead.

Russia did this back in the spring, as is well documented by Zero Hedge here. Russia dumped nearly $100 billion in treasuries, and the 10-year spiked to 3.11%. Again, I don’t foresee the Chinese resorting to this option. They’ll save it for another, more poignant opportunity. Zero Hedge laid out the case for China reducing its holdings here.

Treasuries

Speaking of treasuries, I still think market participants are making a HUGE mistake regarding what the rate hikes will do to treasuries, what quantitative tightening will do to treasuries, what additional government borrowing because of tax policy will do to treasuries, and what the implications are for the economy. Remember, the Fed is in a rate hike cycle in addition to tightening by reducing the size of its balance sheet.

For every 25 bps rate hike, the service on the national debt goes up by $54.25 billion per year at the current level of $21.7 trillion of national debt. With four more planned hikes of 25 bps by December 2019, the debt service is an additional $217B, not including service on additional borrowing. As both the amount of debt and interest rates rise, so too does the debt service.

As noted the Fed is also reducing its balance sheet, now in full swing at a level of $50 billion per month. The Fed will be selling treasuries and there is not enough demand from foreign central banks, institutions, and individuals to soak it all up. Bloomberg and CNBC recently wrote that China is actually reducing holdings.

Wolfstreet is also paying attention, and they show that it’s mostly bond funds, pensions, and institutions buying Treasuries, while much of it is also just traded. The reason? Why accept a yield of 1.8%-1.9% on the S&P 500 with all the risk associated with it, when you can derisk your holdings into three-month treasuries paying 2.3% or six- month treasuries paying 2.5%?

What we really have is a double whammy of rate hikes and too much supply coming into the market. It’s a one-two punch that will send rates much higher than anyone is expecting. This is further compounded by Treasury selling bonds, bills, and notes, to allow the government to meet its budget, currently at a deficit of about $1.0 trillion per year.

If you think the Fed will step in to protect the treasury market, think again. What will happen is the Fed will continue hiking rates through the end of this year, and as everyone recognizes the economy has rolled over, the Fed will be left with no choice but to dial back on its current policy of hiking and selling.

Pausing that policy move won’t be enough because the rest of the world will recognize that this emperor has no clothes, and they’ll begin selling treasuries as well just like Russia did earlier in the year. Do you remember when the ten-year last hit 3% earlier in the year? Russia sold nearly 100% of its nearly $100B of treasury reserves. I know, I mentioned it above, but it’s worth repeating that $100B in treasury sales markedly moved markets.

That will be in addition to an expanding US government needing more borrowed money to operate. As the economy sinks further, tax receipts will fall precipitously, causing yet more government borrowing. As this unfolds the Fed will not be able to hold rates down, no matter how low they set the target rate and even if the Fed goes to a negative interest rate policy.

The Fed will try that too. According to St. Louis Fed data, the average drop in target rates at the Fed is about 6.1% going into a recession. Even if we get another hike this year and 3 more next year as the Fed has telegraphed to us (for a total of 100 bps, bringing the target to 3.25%), we will probably see a negative rate near -3.0%, once the Fed is forced to recognize we are in a recession.

Fed Bond Buying And Selling Is Misinterpreted

In Capitalist Manifesto (p 120), Wolfram discusses Fed policy of buying bonds, which we saw happening in the aftermath of the financial crisis. He sets an interesting expectation of the consequences and misinterpretations of actions.

Wolfram posits that when the Fed buys bonds, the market will be flooded with cash and interest rates will fall on the upward price pressure. Business executives and owners receive a signal that people are saving money. That’s because if we see the price of bonds rising, we assume it means there are more buyers demanding bonds with their saved cash.

However, it’s only the Fed buying, not people, and what really happens is that people are levering up as interest rates fall, using that leverage to buy more stuff. As people buy more stuff, businesses receive the signal that demand is increasing for all the stuff they offer. This pushes the businesses to invest mistakenly in valuable resources in producing capital goods for which the demand doesn’t really exist. In other words, it’s all an illusion because of lower interest rates.

I would venture to guess that in a scenario where consumers are having difficulty getting by, living paycheck to paycheck, if they are able to loosen their budgets by reducing interest payments, some demand which is produced will be real demand. Let’s say in a situation that someone needs to buy new shoes for all his family members, he may put that off a little longer until his interest payments fall and loosen his budget. One new pair of shoes will certainly add value to his life.

A businessman may need dress shoes. A second pair may add a little more value, for example, a pair of sneakers if he likes to go for a walk every day. More than that, extra purchases, as Wolfram says, and the demand is not quite real. It’s an illusion created by low interest rates.

Additionally, if buying bonds creates the illusion of demand that otherwise would not exist, leading to malinvestments by businesses, it stands to reason that the opposite is true as well. Selling of bonds by the Fed will look like a decrease in demand for goods and services.

The Results Of Rate Hikes

With bond rates rising. the question remains how will this affect the average household with debt, how will it affect any business with debt, how will it affect emerging market companies with debt denominated in USD, how will it affect the banking system here in America (and any bank that has lent to EM denominated in USD), and how will it affect the economy at large? The next question is how will markets react to this, then how will the Fed react to markets, and how will markets then react to Fed actions.

Once you know what to anticipate, you can take proactive steps to not only protect your wealth, but also profit quite handsomely from what is about to happen. Remember that on the opposite side of every crisis there lies opportunity.

Back in January this year I made several predictions (it was actually written in the last two weeks of December 2017 and published January 2) regarding the aforementioned questions. You can certainly go back and see how prescient some of my calls were at the time, especially with regard to emerging markets. Just because you don’t hear anything day to day in the mainstream financial media, doesn’t mean EM is improving or that the problems have gone away. EM is actually getting worse. Turkey, Italy, Venezuela, Brazil, Argentina, Poland…this is just the tip of the iceberg.

So it is not just the fact that the federal government has over $21.7 trillion in liabilities currently on the books, but it’s also that the whole economy has seen growth only because of more debt being taken on by households and businesses in the last 10 years…about $70T more debt. It’s only able to be sustained when rates are rock bottom. But the more rates rise, and rise they will, the less sustainable it becomes.

And that is the main issue with all this debt (consumer credit, revolving credit, mortgages, business loans, government borrowing, personal loans, student loans, etc). The amount of debt you owe could be many thousands of times your actual income, as long as it is sustainable. But once it becomes unsustainable, it’s all gonna hit the fan while you are standing right there in front of it.

So we’re seeing the catalyst for the breakdown in the bond market, which will spill over into the stock market as well as the economy at large. In the short run market participants have the story all wrong. They think rising interest rates and weak bonds are good for the dollar. It’s actually bad for the dollar because it implies the dollar is weakening and inflation is just around the corner.

In fact, the latest inflation read on the CP-Lie is 2.9%. In the long run, we’ll see a lot of volatility and a recognition of a weakening dollar, which will be followed by much more massive doses of inflation. By definition, a weakening dollar means inflation. It’s a loss of purchasing power. The Fed won’t be able to paper over the structural economic problems we’re having just by printing more dollars, because that is like throwing gasoline on a fire.

Housing And Autos Signaling Recession

The entire body of economic advisors, financial industry professionals, bankers, and anyone involved in money, all agree that “as housing goes, so goes the economy.” If you want to know about the health of the economy, you need to examine housing. And it wouldn’t hurt to examine the auto market as well. And banks for that matter.

There are a few points to make about housing right now. First and foremost is that housing is grossly overpriced. It’s so overpriced that it’s even higher than the prior peak in April 2006, which was 206.66 on the Case Shiller 20 City Composite, and 226.90 on the Case Shiller 10 City Composite. The same indices are now 213.76 and 227.05, respectively.

Put another way, the average price of a single-family home in America has always been between 180-200 ounces of gold. According to the St. Louis Fed, the average price of a new home right now, in dollars, is $390,200 as of 3Q18 (down from $399,700 in 4Q17). Priced in gold, using $1234/oz (COMEX 10/25/18), that is over 316 ounces of gold (over 323 ounces for 4Q17).

Put yet another way, when you go to the mortgage broker/banker, the maximum home price you can afford is about 2.6 times your income. If you earn $61,372 (the median household income for 2017, according to FRED), you shouldn’t take a mortgage of more than $160K. Using the traditional LTV of 80/20, that puts the home value at $200K. Even if you do a 95/5 LTV that puts the ratio of home value to income at 3.1 and a mortgage of $190K. Transferring that $190,000 back to the 2.6 ratio would leave the home at $237,500. Current average single-family homes are now priced $152,700 higher, or nearly 60% more than people should be able to afford.

Regardless of how you measure home prices, they are at or near all-time highs. That is not the only way to measure housing, though. On January 22 this year the S&P Homebuilders Select Industry Index peaked at 4715.24. As of the market close on October 12, the index is down to 3371.95. It’s off by almost 1400 points, or -28.49%... firmly into bear market territory.

How about the top 5 homebuilder ETFs? They’re off. Waaay off. Bear market territory off. As of October 25, XHB has fared best since peaking in January, and it is off by 27.91%. PKB is off 28.75%, ITB is off 33.89%, and HOML is off 64.23%. The worst of the top 5 is NAIL, and it’s off a whopping 75.24%.

Adding pressure to the housing rout is climbing mortgage rates, falling building permits, falling pending sales, falling mortgage applications, mortgage refinancing isn’t even on the map, falling construction spending, a falling NAHB housing market index, ever-increasing incentives given by homebuilders and sellers, the National Association of Realtors is reporting similar stats, and the Mortgage Bankers Association is reporting that available mortgage credit is also decreasing. All while prices are still rising! Even though prices haven’t rolled over yet, that’s a deep and worsening bear market in housing.

In fact, September existing home sales was expected to come in at a decline of -0.2%. Year over year the drop was -4.1%, for the sixth consecutive monthly decline and seventh monthly YOY decline! Even if the economy is not yet in recession, the housing market is flashing as such.

Don’t make the mistake to think that it’s a lack of supply, either. Inventory is building up. It’s demand that is falling. And that will become worse as tariffs and inflationary pressures build up on construction materials, compounded by rising interest rates. If you think the current rout in housing is bad, just wait. We’re just getting started, and I predicted this here on Seeking Alpha for over a year.

To that prediction I will add that commercial real estate will also have a hell of a time. Commercial is valued differently, because it’s not a home you want to live in. Regardless of what you want to do with the property, you buy it for the future cash flow. And regardless of what complicated math you use, to calculate the value of the property, you need to calculate the present value of all future cash flow. that’s predicated on the interest rate on the loan, and the higher the rate, the lower the present value of future cash flow. Therefore, as rates will continue to rise, commercial real estate will plummet.

Turning to cars, the major manufacturers Ford, Nissan, Toyota, and Honda, are reporting declining sales year over year. 11.2% decline for Ford, 10.4% for Nissan,12.2% for Toyota, and 7.0% for Honda. If sales are declining, it should show up in earnings, which means it will also show up in the prices of their shares. Putting further pressure on autos is subprime auto loan applications falling, prime auto loans are falling, and used car prices and sales are both falling…all indicative of a worsening auto market.

We can see it in the data as well. If the economy is growing at 4.2% as the BEA would have us believe, shouldn’t auto loans and sales grow at nearly the same pace? In fact, auto loans have continued slowing, as the data from FRED suggest. The YOY change in auto loans is down to a growth rate of only 1%. The difference is striking.

In the last 12 months, Ford shares peaked at $13.23. The company now holds the prestigious title of single digit midget, with shares trading at $8.18 (October 24, 2018), and it is off by -38.22%. I’m not a stock analyst, but my guess is that this has happened because EPS is off by over 47%. Honda shares peaked at $36.73 in February, and now trade at $26.04, meaning shares are off by -29.10%. Toyota peaked at $140.72 in January, and now trades at $114.57, so it is off by -18.58%. Finally, ADR’s of Nissan peaked at $21.90 in January, and shares now trade at $17.40, making it off by -20.55%.

Banks

As housing and cars are pretty important sectors of the economy, it would be prudent to examine banks as well. As noted in previous installments, motor oil is to your car what banking/lending is to the economy. Like it or not, banks help us facilitate transactions. Virtually all transactions. I mentioned above what is going on in banking, both in my discussion of housing as well as cars. Let’s have a closer look at the sector as a whole.

As noted above, the pace of lending in both mortgages and auto loans is slowing. So much so that the pace is slower than GDP growth. Additionally, total bank assets are also growing, and FRED is reporting that total bank assets are at an all-time high of $16.847 trillion. That makes sense, given that the national debt is at record levels and always climbing.

However, here again the percent change from a year ago is on a clear downward path. Even though it fluctuates from week to week, the trend is a downward pace of growth. 1.5% year over year as of October 3, and the recent trough was 1.09% on September 12. Further, if you look at the chart you will see the growth rate is making lower highs as well as lower lows. Lending should be growing at or near the pace of the economy if conditions are supportive and healthy.

Now at a record high of $2.56T (FRED), at present it also looks like treasuries and agency securities are the only asset class growing at banks. And this class of assets is growing at about the stated pace of GDP growth while the Fed is unwinding $50B per month from its own balance sheet. Only banks and other financial institutions are buying these, no one else in significant numbers.

As you can see at this Fed link, all other assets are moving in the wrong direction, save for reverse repos. What? Reverse repos are when a bank lends assets to another bank (usually treasuries because they’re “the least risky” asset class) with an agreement to repurchase them at a specified time. This is where banks gain leverage, because they can’t borrow to invest in the markets without collateral. If they don’t have collateral, they borrow it.

Herein lies a HUGE problem. If a bank borrows $99 and puts in an additional $1 of its own to play the market, and it’s leveraged against borrowed treasuries that were sold to someone else with the contract stating they’ll be bought back, what happens to the bank if its speculations fall by as little as 1%? Those bets are worth absolutely nothing.

Besides shareholders, who cares for bank assets? Bank assets are comprised of mostly treasuries, highly leveraged derivatives, and loans of all types and quality. If one bank is showing less and slowing assets, perhaps we could say that bank may be in trouble or at the very least changing its business model. But if all banks are showing a slowing pace of loans as well as a slowing pace of asset growth, I think that means trouble is on the horizon.

This is compounded by excess reserves at the lowest point since April 2013 (FRED). Banks have less money to lend out. Charge-offs are also increasing their pace. The bottom was 1.75% of loan balances in the first half of 2015. That has increased to 2.25% of loans being charged off. And the percent change from a year ago is now solidly in positive territory since the beginning of 2016 (FRED).

The ratio of loan loss reserves to total outstanding loans is now at 1.22%, the lowest it’s been since 3Q07. Prior to 3Q07, the last time it was that low was in the early 1980’s. This would seem to indicate that banks are a little too giddy about the quality of their loans. At the same time, a good portion of loan portfolios at banks and other institutions is corporate bonds. The quality of those bonds is abysmal, as nearly 70% of all corporates are now either total junk rating or BBB (the lowest investment grade). You better check the composition of your bond funds.

In January this year, PIMCO was already warning about the quality of BBB bonds. The report is quite damning of the entire BBB component as well as the agencies who rate those bonds. This report from MATASII in April this year also warns about BBB rated bonds, noting at the time that BBB rated bonds were already crossing over 50% of the entire investment grade bond market. Now famed author of Fed Up and former Dallas Fed advisor, Danielle DiMartino Booth, expressed similar concerns in this article on Bloomberg.

Adding even more fuel to the fire of bank problems are loans made in US dollars to emerging market companies. According to the latest BIS report of July 31, 2018, EM non-bank loans (loans to EM businesses) are now up to $3.7T (excluding USD borrowing through foreign exchange swaps). That’s a hell of a lot of money to pay back when the local currencies are starkly depreciating against the dollar, especially in countries experiencing political turmoil such as Turkey, Italy, Brazil, and Argentina. Over 10% of EM companies have obtained that prestigious title of zombie companies, meaning they are totally insolvent if not for the fact that they rolled over old debt into a new issue.

On top of that, countries like Argentina and Turkey, currently at the front of investors’ minds, have far less foreign currency reserves than they’ve borrowed. If they declare a default (it’s happened many times in the past) they’ll be forcing investors to take a haircut that is likely to be a #1 on the clippers. If you don’t know what that is, it’s a 1/16 of an inch buzz cut…almost bald. Argentina’s currency reserves are about 20% of all USD denominated loans, and Turkeys’ reserves are about 25%.

As a side note, this means that those borrowers are neutral to net short the dollar against their local currency, because as I’ve said in the past, if the dollar appreciates against their currency, they’ll be paying back more local currency into rate hikes in order to pay back USD denominated loans. If they were long the dollar, they wouldn’t be borrowing in dollars.

According to the BIS, banks are selling their leveraged EM loans in the form of collateralized loan obligations (CLO). Leveraged loans, collateralized, packaged, and sold as investments. And these loans are not prime borrowers. Sound familiar? Warren Buffet is often quoted as saying that the subprime CMO’s that are blamed for the financial crisis of 2008 are weapons of mass financial destruction. These particular CLO’s contain a falling number of covenants (protective clauses that benefit the lenders: US domiciled banks) making them look like the junkiest of junk in the trash heap of financial hell! To see more about this specifically, you can read this article from Forbes, which also details that in addition to banks, insurance companies and pension funds are at risk.

Perhaps the greatest risk to banks, currently, is the flattening of the yield curve. This actually multiplies the effects of other risk factors. Here’s why. The Fed is raising interest rates on the short end of the curve. The Fed can’t do much to manipulate the long end unless it is active in long-term treasury bonds. If it buys long-term bonds, that will create demand, prices will rise, and the rates will fall. If it sells, the opposite is expected to happen.

However, the actual policy is to raise rates on the short end of the curve in conjunction with selling treasuries, both of which are putting pressure on short-term rates. Remember that the banks want to borrow at the cheapest rate possible, then lend back out at higher rates. As the curve flattens there is not enough margin between the rate they pay to borrow versus the rate of return on loans. Eventually, the banks will turn off the lending spigot. TV talking head have it wrong when they tell you that rising rates are good for bank profits. That is only true if the long end of the yield curve rises faster than the short end. Currently, the short end is rising faster, hence, a flattening curve.

Additionally, any current loans that are variable rate, and any current loans that are being rolled over, will all be seeing higher rates to the borrower. This makes it more and more difficult to pay back the loans. As I’ve written extensively about this in the past I don’t find it necessary to rehash the full extent of the implications of a flattening or inverted yield curve.

We can already see what is happening to banks and financial institutions by looking at their shares by examining bank and insurance indices. That will also hint to what is about to happen to all the pensions they administer on behalf of millions of people. Info is gleaned from Bloomberg as of market close on 10/25.

NASDAQ BANK INDEX

CBNK

-9.56%

-6.8%

NASDAQ OTHER FINANCIAL

CFIN

-2.57

5.69

NASDAQ INSURANCE

CINS

-8.01

-10.23

KBW BANK INDEX

BKX

-10.02

-2.96

NASDAQ 100 FINANCIAL

NDF

-4.74

0.67

I spoke to one mutual fund manager who has 15% of his large cap value fund in banks. He claims that he is protected from everything that is going on because “When it comes to banks, we’ve only invested in smaller regional banks who are ready for takeover bids.”

He blew off my questions and deeper probing about his portfolio, yet we now have the canary in his coal mine in the form of Bank OZK. On Friday, October 19, 2018, shares took a seriously deep dive by over -26%. It’s now at $24.86 after it peaked at $56.25 in January 2017, for a total loss of -55.8%. Why? According to Motley Fool they recently charged off two commercial loans totaling $46M. It seems that this is just the tip of the iceberg for OZK, as analysts have been questioning their loans for several years. And for good reason. Their non-performing asset ratio was up by 53.33%, earnings were off by 23% and also missed estimates, and top line revenue fell short by $13M as well.

I know what you’re thinking…“Is this some kind of joke? Two loans? Whoopdie freakin’doo!” I get that.

The big deal is time will show that this is not isolated and it is not contained, as indicated in this video clip on Yahoo Finance. Remember the last time professional government bankers told us an issue was contained? That was Ben Bernanke in his testimony to Congress in regard to subprime home loans. We’re already hearing calls of isolation and containment on CNBC and other financial outlets.

Implications For Your Portfolio

The implications here are pretty straightforward. Because the stock market is completely overvalued by all measures, you won’t lose any money by taking profits off the table. I would not hang onto a slippery slope of hope. Don’t be afraid to hold 40-50% of your assets in cash and let it sit. If you are desperate to do something with your cash, you can put it into one-month and three-month treasuries at 2.1% and 2.3%, respectively.

The ultra short durations will minimize the risk of price losses against a landscape of rate hikes and FOMC asset sales. Neither bill will beat inflation, but 1) it is only a short-term move, because 2) there will be plenty of opportunities to deploy your cash into steeply discounted and good cash flow positive assets very soon. You’ll be able to buy companies like Apple and Amazon again, but instead of paying the current pie-in-the-sky valuations, your cost to get in will be much more normalized.

For G-d sake, if you have any margin debt in your brokerage account, eliminate it. You want to have cash available to deploy into the right investments at the right time. Don’t confuse your margin capacity with a cash position, because your margin capacity will be wiped out in a few brief moments if there is a daily plunge of 1000+ points on the DJIA. The more levered up your portfolio, the more likely you’ll see a margin call.

In general, margin debt is now the highest it has ever been, both in the sheer amount as well as the percentage of margin to total market cap. It’s a complete financial nuclear disaster waiting to blow. Don’t be the victim, and you will only have yourself to blame if you don’t address this. Whatever you need to do in your situation to eliminate that margin, you must consider doing it.

The only reason I recommend to anyone to have a margin account is that you won’t have to wait T+2 for trades to settle before you transfer cash to your checking account. That can be useful if you need cash in a jiffy. It could also be useful if you are transferring cash into your brokerage account, and before it comes in you find a compelling opportunity that is quickly evaporating. Especially if you receive an enormous life insurance payout or similar, as your bank will have a lame excuse to hang onto the funds for 10 business days or more. Otherwise your margin debt is like heroin; you get addicted and need more and more, until it kills your portfolio.

It would also be prescient to hold gold (and silver), and you can now earn interest on your gold paid in additional ounces. You’ll receive somewhere in the neighborhood of about 2-3%, so if you invest 100 ounces you’ll get back 102-103 ounces after a year. So much for gold not paying dividends, and the hedge against market and economic volatility is now stronger than ever.

If you do buy PM, make sure you buy from reputable dealers, stay away from companies with celebrity and radio advertisements, and stick with bullion coins and bars. Stay away from gold ETFs as well, and instead you will be better off owning a gold mutual fund. Not all funds are created equal, so make sure to choose a fund based on the skills of the manager. And no, 35 years in the mutual fund industry doesn’t count. It’s successful years managing a portfolio of precious metals mining stocks. Once you’ve found several managers you are comfortable with, avoid any funds employing leverage, and then check the ratings and returns.

Additionally, because the risks of EM are so high right now, I wouldn’t touch it with a 10-foot pole. If you own EM funds, you should give consideration to selling out. Also, any ETFs or mutual funds that hold financials, home builders, or autos, you might consider cutting your positions here too. This is a fantastic place to find your tax-loss sales, and if you wait around any longer I fear that your losses will multiply exponentially.

It would behoove you to check the holdings of any funds you are in to make sure you are properly shielded; pot stocks and pipe dreams don’t protect you from bad asset allocations. Fund allocations in the financial sector of 10% or more are doomed, whereas funds with less than 5% will fare much better.

It is wise to look into energy as well. Regardless of your political leanings, the Trump administration has made some favorable decisions for energy. For several reasons the biggest opportunity right now is in midstream MLPs (transportation and storage of energy). As oil was falling into 2016, all subsectors in the energy industry fell. Including midstream companies. But midstream companies rely on long-term contracts with drillers and refineries, not the price of oil, which means the price of the contract doesn’t change with fluctuations in the oil spot price of WTI crude.

Further making the case for midstream MLPs is that the Federal Energy Regulatory Commission recently decided that midstream companies may now renegotiate their new and existing contracts for higher prices. That’s enhanced by the fact that current capacity for transportation and storage can’t meet current demand. It’s a winning situation for midstream MLPs, and it’s only a matter of time before the market recognizes their true value and reprices accordingly.

Not a day goes by that you won’t see another article in the financial media talking about midstream MLPs. Analysts from all the major firms, such as Goldman Sachs, are bewildered that these companies have not rebounded. Returns of 8% or more, with tax advantages, are easy to find in the midstream sector and in their mutual funds/ETFs. Because the companies are vastly underpriced, still having not recovered from the rout in 2016, there is a large margin of safety as well. On top of fat monthly distributions with great tax advantages, the sector is ripe to pop.

If I am correct that things will play out as I’ve predicted, it’s about time you leave your position in cryptocurrencies where they belong: the fiat currency crypt. At this time, as the stock market is as volatile as it is, if cryptos were to perform the stated function of storing wealth (among other functions), the coins would not be continuing to fall in price. The top 100 coins have a total market cap of $203B, and coin #100 and below all have a market cap below $1,000,000. Less than a year ago that total market cap was $800B.

Advocates of cryptos claim it will replace the currency in your bank account. There’s only one problem. In order for a currency to work, one of the properties it must have is confidence, and confidence means there is a widespread belief that the next guy will take it in exchange for his goods or services. The cryptos don’t have that. The only reason to hold a position is if you can profitably day trade it. If you can’t, someone else has already gotten wildly rich off your foolish stubbornness.

The largest threat to your wealth is government intervention, and with the next crisis the government won’t be able to resist the temptation to intervene. When it does, all cryptos will be rendered illegal and replaced with some version of what I’ve been calling FedCoin. Yes, I am aware of all the arguments of why cryptos are decentralized and anonymous and governments can’t touch them and all that, as well as how and why the blockchain technology works. It’s all irrelevant when it comes to government intervention. I’ve covered this in the past and if you want to see what I’ve written, please browse my prior articles.

“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises, Human Action

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