Broken Arrow: What The Fed Will Soon Face

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Includes: GLD, IAU, OTCRX, TLT, WHOSX
by: Kevin Wilson
Summary

Some 53 years ago this week (in 1965), the first major battle between the US Army and the North Vietnamese Army (“NVA”) was fought in Vietnam.

The attacks on the US position became so intense that the forward air controller issued a “Broken Arrow” call, indicating that a US unit was about to be overrun.

This may serve as a metaphor for what the Fed is going to face if the current economic slowdown and market sell-off turns into another financial collapse.

The pieces needed to produce such a situation are already in place; the Fed will be forced to restart ZIRP and QE, plus begin equity purchases and/or drop helicopter money.

The prudent should consider holding GLD or IAU, plus OTCRX, WHOSX, and TLT.

Landing Zone X-Ray, Battle of Ia Drang, Vietnam (November, 1965)

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INTRODUCTION

Some 53 years ago this week (in mid-November of 1965), the first major battle between the US Army and the North Vietnamese Army (“NVA”) was fought at two landing zones near Ia Drang, Vietnam. In charge of LZ X-Ray was Lt. Col. Hal Moore, who commanded the 1 st Battalion of the 7 th (Air) Cavalry Regiment. Ironically, this was also Lt. Col. George Custer’s regiment in 1876 when his famous last stand took place at Little Big Horn. Moore was a legendary leader who eventually rose to the rank of Lt. General. The situation he and his men faced as they landed in their LZ was very dangerous. The US Army had ordered them in to provoke a big fight so they could both take the initiative and test their new airmobile tactics. They would be relying on the presumed American firepower advantage to win in a situation where it was assumed they could potentially be surrounded for a period of time (Wikipedia, 2018). The “NVA” troops nearby outnumbered Moore’s unit by 2.5/1.0 and could indeed easily surround them, which they promptly did. The fighting was extremely intense by late afternoon, and that evening the tactical picture was terrible for the US Army (see map below), as their defensive perimeter was penetrated repeatedly by “NVA” troops from several directions, and landing operations were curtailed.

LZ X-Ray Tactical Situation (Surrounded), Night of Nov. 14-15, 1965

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The next morning, November 15, 1965, the attacks became so intense that Lt. Col. Moore had his forward air controller issue a “Broken Arrow” call on the radio net, indicating that a US unit was about to be overrun by the enemy (Moore, Harold G. & Galloway, Joseph L., 1992; We Were Soldiers Once… And Young, Random House Publishing Group, New York, 432p). This brought all available ground support aircraft in all of South Vietnam to their aid in short order. This in turn led to a devastating series of attacks on “NVA” positions but also to a tragic friendly fire incident (which unfortunately is not all that unusual in such extreme circumstances). There were also a number of heavy bomber sorties by B-52s, and tremendous artillery fire support from a base only five miles away. Eventually Moore’s command was supplied well-enough and reinforced enough by the 2/7 Air Cav. to “win” the fight, and the badly damaged “NVA” units withdrew.

Historically the US Army came away from the battle having proven its huge firepower advantage, the viability of airmobile operations, and the tremendous courage of its troops, although at high cost. The “NVA” came away having proven the effectiveness of their close-in infantry tactics and the tremendous courage of their troops, although they too paid a very great price. Both sides claimed tactical victory. However, North Vietnamese leader Ho Chi Minh concluded that the main lesson of the battle was that the North Vietnamese could eventually win the war through the attrition of US forces, which might cause political turmoil and homeland morale problems. This is indeed what ultimately happened.

I’ve briefly retold the story of the Battle of Ia Drang and its famous Broken Arrow call because I think it may serve as a metaphor for what the Fed is going to face if the current economic slowdown and market sell-off turns into another financial collapse. Of course this may not ever come to pass, but many of the pieces needed to produce such a situation are already in place. My purpose here is to describe those pieces of the picture and then suggest what the Fed might do when a Broken Arrow situation is faced by the markets.

To begin with, we are of course very late in the economic cycle, and there are threats to that cycle continuing, as economic analysts like David Rosenberg (quoted by Stephanie Landsman, 2018) have pointed out. Furthermore, the economic slowdown in Europe, the effects of the US-China trade war, and the huge global corporate debt overhang are all potential triggers for a global recession that could begin within just a few months (John Mauldin, 2018a).

THE PATH TO A BROKEN ARROW MARKET

Taking Mauldin’s first-mentioned threat first, it was recently reported that Germany’s 3Q/2018 GDP growth has dropped to a negative 0.2% QOQ (Carsten Brzeski, 2018). The troubles with the Italian budget deficit, and between the Italian government and its adversaries in the EU, has caused Italian bond yields to soar (Chart 1) and could set up a replay of the 2011 eurozone crisis. Italy owes Germany a total of at least $558 billion as of August under the Target2 System, which reflects the capital flight from Italy to Germany since 2008 (Mish Shedlock, 2018). The UK is in total disarray as the Brexit deadline approaches, and their leadership appears to have no vision or over-arching goals driving their negotiations (John M. Mason, 2018). The result has so far been chaotic and may continue to be so. Overall QOQ GDP growth in the EU-28 and eurozone have fallen below 0.5% and are still falling (Chart 2).

Chart 1: Italian Sovereign Yields Soaring

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Chart 2: EU-28 and Euro-19 QOQ GDP Growth Below 0.5% and Falling

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Global shipping traffic is slowing down in response to the trade war, according to officials at AP Moller-Maersk (as quoted by Will Martin, 2018). Indeed, shipping is now projected to drop by up to 2% in 2019. Other evidence of damage from the tariffs comes in the form of a 30% drop in those US imports that are affected by the first $34 billion tranche of new US tariffs on Chinese goods (Chart 3). The later, much larger tranche ($200 billion) has not yet been in effect long enough to see a result, but anything like the 30% drop already observed will be taken very seriously by the markets, one would have to think. Overall US imports (and the US trade deficit) have not yet dropped; in fact they’ve actually increased as importers have stocked up in anticipation of the increasing amount of tariffs now scheduled to begin or already in place (The Straits Times, 2018).

Chart 3: Impact of US Tariffs on Chinese Goods Beginning to Hit

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Corporate debt has exploded worldwide under the easy money regime set up by the world’s central banks in recent years (cf. Chart 4). A huge number of these companies (some 12% of all developed country corporations; Chart 5) are now corporate debt zombies (John Mauldin, 2018b) that will likely fail immediately once the real trouble starts, and this could lead to great financial instability. The “BIS” report on this phenomenon (Ryan Banerjee and Boris Hofmann, 2018) is very sobering. Given that corporate debt is so huge and so much of it is of poor quality (cf. Chart 6) some authors have expressed concern about the health of the high yield bond market (Danielle DiMartino Booth, 2018). High yield spreads have already been rising for a bit, and if they follow the usual pattern, they will soon rise much more (Jeffrey Gundlach, quoted by the ValueWalk blog, 2018).

It is not hard to imagine a collapse of the now-enormous high yield bond market if rates climb further, the economy continues to slow down, and bond issues receive reduced ratings. It is also not hard to imagine an end to cheap corporate debt financing, which will no doubt cause the share buybacks that are now propping up the markets (Chart 7) to implode, just as they did in 2008-2009 (Chart 8).

Chart 4: US Corporate Debt/GDP at Record High

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Chart 5: Zombie Corporations Have Proliferated

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Chart 6: The Amount of BBB and Lower Bonds Is Huge

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Chart 7: Corporate Buybacks Have Driven the Market

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Chart 8: Peaks in Buybacks Are Eventually Followed by Troughs

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HOW WILL THE FED RESPOND TO A BROKEN ARROW CALL?

I have long lamented the excesses which the Fed felt it was justified in going to since 2007 (e.g., Kevin Wilson, 2017a; Kevin Wilson, 2018a). Unfortunately, it appears that former Fed chairs Ben Bernanke and Janet Yellen delayed the re-normalization of rates for far too long, and now Fed Chair Powell faces a terrible quandary. It is starting to look like the next recession is going to arrive well before rates are fully re-normalized (cf. banking sector analyst Dick Bove, quoted by Michelle Fox, 2018; Charles Hugh Smith, 2018). A bear market of epic proportions will be associated with it and will likely get started a bit in advance of it (cf. Goldman Sachs data quoted by Thomas Franck, 2018; Dennis Gartman, quoted by Shawn Langlois, 2018). Long-time bear John Hussman has been far too early for far too long in his prognostications of doom for the markets, but his methodology for determining the potential maximum draw-down has been proven highly accurate multiple times; he now calls for a drop of 65% from the high when this is all over (John Hussman, 2018).

Let’s assume for the purposes of argument that something like this actually happens in the coming quarters. How will the markets respond? In my opinion, this is one of the most accident-prone markets ever (Kevin Wilson, 2018b). Which means the drop will resemble a waterfall pattern that will take no prisoners. Some place along the path of that precipitous descent the phones will be ringing loudly and persistently at the Fed, and a panicky Wall Street banker will be on every outside line. They will collectively call a Broken Arrow event, and they will be very public about it. The Fed will have no choice but to first reverse course and start cutting rates, and then resort once again to extreme measures (Kevin Wilson, 2017b). This implies a return to ZIRP and a restart of the Fed’s Quantitative Easing remedy. Of course, since the potential global issues in a crisis emanating from Europe or China are even worse in some ways than they were in 2008, these Fed remedies will most likely fail.

The Fed will then move to whatever “new” extreme measures it has cooked up in preparation for such a situation. These might include either: 1) the wholesale purchase of equities (cf. Japan and Switzerland in recent years) and perhaps even high yield bonds; and/or 2) the initiation of a helicopter money drop (cf. Kevin Wilson, 2016). Almost certainly the federal deficit will balloon by trillions of dollars in short order, and Congress and the President will do their best to “help;” that huge increase will be monetized by the Fed, just as it has been in Japan. The destruction of price signals in the markets will continue almost ad infinitum. This could all lead eventually to the global reset or debt default that author John Mauldin has been talking about recently (John Mauldin, 2018c). Since global economies have been generating debt at 10x the economic growth rate recently, this global default scenario is probably not as far off as anyone would hope. It will happen because debt doesn’t buy much growth anymore, and because central bankers alone cannot save us from the abyss that yawns before us as a result of our profligate fiscal ways.

In the end, I believe that those who own long-term Treasuries and gold will make a lot of money in the next 12-36 months, and those holding stocks will writhe in pain at their enormous paper losses. Allowing for human nature, most people will sell closer to the bottom than the top. A bull market for the US Treasury bond is historically the norm under these circumstances (Eric Hickman, 2018), and a strong one is likely again (Van Hoisington & Lacy Hunt, 2018). Given the current long-term sell-off from the January market high, the renewed sell-off from the October market high, and the state of certain national economies (e.g., China, Europe, Japan), it makes sense to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) is an alternative ETF that may be safer for those who want to hold it for a somewhat longer period of time. But the safest form of gold in the event of a true financial apocalypse is physical gold.

Also, for those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could be held to protect assets in the event of a much sharper market draw-down associated with deteriorating economic data. Those in a more defensive frame of mind because of the expected eventual market slide should also hold some long Treasuries, in spite of bearish arguments to the contrary, as a stock market crash would be hugely supportive of bond prices: examples include the Wasatch-Hoisington Treasury Fund (WHOSX), and the I-Shares 20+ Yr. Treasury Bond ETF (TLT).

Disclosure: I am/we are long GLD, OTCRX, WHOSX, TLT. 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: Disclaimer: 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.