Why the World Needs the US Economy to Struggle

By John Mauldin

Jan 04, 2015


The headlines this morning talk about the US dollar hitting an 11-year high. I have been saying for years that the dollar is going to go higher than anyone can imagine.

This trade is just in the early innings. And the repercussions will be dramatic, not only for emerging markets that have financed projects in dollars, but also for commodities and energy, gold, and a variety of other investments. The world is at the doorstep of a new era of volatility and currency wars. 
 

In this week’s letter, my associate Worth Wray explores what a rising dollar means for emerging markets and what central banks are likely to do in response. Can they smooth the ride, or will it be the world’s scariest roller coaster? This letter will print long because of the number of fabulous charts Worth provides. I might make a brief comment or two at the end. Here’s Worth.


On the Verge of a Disaster… or a Miracle

By Worth Wray

Twenty years after the first divergence-induced currency crisis of the 1990s, commodity prices are tumbling, the US dollar is rallying, and externally fragile emerging markets are reliving the horrors of their not-so-distant past. Except, this time, major economies like the United States, the United Kingdom, the Eurozone, Japan, and the People’s Republic of China may not be able to side-step the ensuing contagion.

With 2014 now behind us, I want to focus this week's letter on what may prove to be the most important global macro pressure points in the coming year(s):

  • The growing divergence among the world’s most important central banks
  • The ongoing collapse in oil and other commodity prices as a function of excess supply and/or weakening global demand
  • The rise of the US dollar, driven by divergence and risk aversion… and the squeeze it’s putting on the multi-trillion-dollar carry trade into emerging markets
  • The vicious slide in emerging-market currencies
  • The rising risk of 1990s-style contagion and financial shocks
  • And what, if anything, can avert the next global financial crisis

But first, let me tell you a story.

As some of you already know, I was born and raised in Baton Rouge, Louisiana – an old Southern city built on a bluff above the Mississippi River. It’s about an hour northwest of New Orleans – you can see it circled on the map below.


Given its inland position, Baton Rouge is fairly insulated from the fiercest impact of coastal storms; but hurricane season still tends to be the most stressful time of year. Our oak-covered neighborhoods and low-lying swamplands are vulnerable to the high winds and flood rains that can accompany a direct hit – not to mention the violent tornadoes that occasionally occur in the unpredictable northeastern quadrant of the tropical cyclone zone.

These storms don’t hit us often, but locals recall a handful of hurricanes that dealt heavy blows to the area over the years. And it goes without saying that the damage from any storm gets dramatically worse the closer you get to the Gulf of Mexico. Entire towns along the Gulf Coast have been swallowed up and swept away over the years by catastrophic storms like Camille (1969), Andrew (1994), and more recently Katrina (2005).

Twelve years ago, my father and I found ourselves in the path of such a storm.

According to the National Hurricane Center, Hurricane Lili was “supposed” to make landfall as a relatively weak storm. Just another named hurricane for the record books that would soon fade from our collective memory… or so we thought.

At 10:00 PM on Tuesday, October 1, 2002, Lili was a Category 2 hurricane with maximum sustained winds of 105 mph. Routine hurricane season stuff.


I went to sleep that night expecting a little rain and few uneventful days home from school; but when I woke up on Wednesday, October 2, I was shocked to see Lili develop an incredibly well-articulated eye wall and grow more powerful by the hour – from 110 mph at 7:00 AM that morning to 135 mph at 1:00 PM and finally to 145 mph at 10 PM that night.

I remember the nervous look on my dad’s face that night as the two of us boarded up our doors and windows. A little earlier that evening, one of his local government contacts shared that, behind closed doors, state and local officials were expecting “mass casualties” from Morgan City (on the coast) to Baton Rouge… but it was already too late to order an evacuation so far inland. Given the mild forecasts, few were prepared for a major hurricane; and at that point in the day, making a public announcement would do little more than spark a panic. The best we could do was hunker down and pray.

This was the last advisory I saw before my head hit the pillow that night: Lili had strengthened to a strong Category 4 hurricane with maximum sustained winds around 145 mph, reported gusts above 210 mph, and the very real possibility of making landfall as a merciless Category 5. If you look at the Saffir Simpson hurricane scale, there’s a reason the first word you see next to Category 4 and 5 storms is catastrophic. These storms are real killers.


Expecting to wake up early the next morning to sounds of thunder, pounding rain, and the eerie whistle of gale-force winds – or worse, I went to sleep Wednesday night with this image swirling through my mind:


But when I woke, I was shocked once more to learn that Lili – for reasons no one had anticipated – had all but died in the night and made landfall that morning as a small Category 1 hurricane with maximum sustained winds of only 90 miles per hour. In less than twelve hours, it had sharply decelerated from what could easily have been one of the most catastrophic storms on record to an inconvenience for most inland communities. Sure, it inflicted some damage along the coast – tearing up marshlands, knocking down power lines, blowing over trees, and flooding homes – but a Category 4 or 5 storm would have swallowed those areas whole.

As far as I know, there was no precedent in the Gulf of Mexico – or anywhere in the world – for Lili’s sudden death. It baffled even the most experienced meteorologists and left us all scratching our heads. Some people talked of miracles; others insisted there had to be a logical explanation. I imagine there’s some truth to both ideas.

While the press coverage surrounding Lili’s remarkable weakening has largely faded into obscurity, I was able to find one surviving article from USA Today that captures the confusion in the storm’s aftermath: “Scientists Don’t Know Yet Why Lili Suddenly Collapsed.”

Hurricane Lili showed forecasters there is still a lot they don't know about hurricane intensity. Lili weakened in the hours before landfall Thursday as rapidly as it had strengthened into a ferocious storm the day before. Forecasters with the National Hurricane Center in Miami had hinted as early as Monday that Lili could rev up into a dangerous hurricane over the extraordinarily warm Gulf of Mexico, though they were surprised to see it grow so strong so quickly. But Lili's quick demise … had them admitting they didn't know what had happened…. National Hurricane Center Director Max Mayfield agrees. At a loss to explain Lili's fluctuations, he says, “A lot of Ph.D.s will be written about this.”

We still don’t have a definitive answer, but three theories emerged in the immediate aftermath:

1) Dry air was pulled into the storm and ate away at its moisture-sucking core;

2) Winds aloft increased across the storm, creating wind shear and tipping the delicate balance that keeps intense storms going;

3) Water cooler than the 80° necessary to sustain a hurricane sapped Lili's strength when it moved over the same part of the north-central Gulf of Mexico that had been churned up by a smaller hurricane, Isadore, a week earlier.

Regardless of why it happened, I learned something that day that will stay with me for the rest of my life: Even when a disastrous course of events is set in motion, disaster does not always strike. Surprises happen. Even miracles. Forecasts are often wrong – but it always pays to prepare.

Let me explain…

Boom & Gloom

Just before Halloween, I wrote a letter (“A Scary Story for Emerging Markets”) explaining that the widening gap in economic activity among the United States, Japan, and the Eurozone was starting to demand a dangerous divergence in monetary policy.

Within a matter of days, the FOMC announced the end of its QE3 program... and then the Bank of Japan shocked the world, announcing a massive expansion in its own asset purchases timed to coincide with the government pension fund’s announcement that it was getting out of JGBs and into global equities.



Just as I had feared, the US dollar and Japanese yen were breaking out in opposite directions on real policy action, as Mario Draghi meanwhile continued to talk the euro down with the threat of future action. This may seem like a trivial shift in global FX markets, but it may have been the most important development we have seen since the global crisis peaked in 2008.
 


Since then, global economics has been a story of boom, gloom, and doom, as Marc Faber likes to say. We’re seeing a boom in US economic activity (or as much of a boom as you can expect with a massive debt overhang); a gloomy slowdown and slide toward deflation across Europe and China, along with the still-likely failure of Abenomics in Japan and renewed signs of FX contagion in emerging markets; and doom in commodities markets, particularly oil.

I’ve shared this next chart before, but it’s worth an update. Those of us who watch the US dollar were not surprised by the collapse in oil prices, because the dollar’s surge was already telling us something about global demand.
 



What did surprise a lot of economists (myself included) was the breakdown within OPEC, particularly Saudi Arabia’s willingness to accept whatever price the market offered in order to protect its market share. Conspiracy theories aside as to whether OPEC’s move constitutes an anti-American trade war against US shale producers or a pro-American squeeze on Russia, Iran, and Venezuela, it’s already putting a serious squeeze on Texas oil men, Russian “oiligarchs,” and oil-exporting emerging markets.

We’ll revisit the oil shock in a bit, but for now let’s get back to the US dollar.

As my friend Raoul Pal has argued in the public media and explained in depth in a recent Real Vision TV presentation, “The Law of Unintended Consequences,” the dollar has just broken through the trendline of the biggest wedge pattern in the history of fiat money.
 



For readers who are unfamiliar with technical analysis, breaking out from a wedge pattern often signals a complete reversal in the trend encompassed within the wedge. As you can see in the chart above, the US Dollar Index has been stuck in a falling wedge pattern for nearly 30 years, with all of its fluctuations contained between a sharply falling upward resistance line and a much flatter lower resistance line.

Any breakout beyond the upward resistance is an incredibly bullish sign for the US dollar and an incredibly bearish sign for carry trades around the world that have been funded in dollars. As you can clearly see, the US Dollar Index, sitting at 91 today, has clearly broken above that trendline. This is a VERY big deal and a clear sign that we may be on the verge of the next phase of the global financial crisis, where financial repression finally backfires and forces all the QE-induced easy money sloshing around the world to come rushing back into safe havens.

The US dollar gained against all 31 of its major counterparts in 2014 (for the first time in 25 years), but whether its upward surge continues depends on three factors: (1) continued policy divergence, which largely depends on continued economic divergence among key developed economies, (2) short covering by investors making levered bets in foreign markets with US dollar funding, and (3) global risk aversion and/or outright capital flight from emerging markets.

Any one of these forces, if it becomes strong enough, is capable of driving the other two. For example, an early Fed rate hike, a serious easing announcement from the ECB, or perhaps even a surprise devaluation by the People’s Bank of China would be enough to send the US Dollar Index soaring into the mid-90s, which in turn would cause a rush of short covering, which would likely trigger a series of violent currency crashes across the emerging world. Or, it could be the other way around: a major balance of payments crisis in the emerging world – as we’ve started to see in Russia – could easily spread to other emerging markets; and if enough of those dominoes start to fall, the resulting backwash into US dollars would likely trigger short covering, which would only intensify the broad outflow pressures on emerging markets.

As Lacy Hunt of Hoisington Investment Management explains, even leaving aside contagion effects and dollar short covering, the divergence in debt loads among the United States, Japan, and the Eurozone is enough to explain a lot of the economic divergence we are seeing; and he suggests that the trend should continue for the forseeable future:

US growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the US stands at 334%, compared with 460% in the 17 economies in the euro-currency zone, and 655% in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by real-world data [not to mention recent experience].

From that perspective, there’s no reason we should expect a major departure from easy monetary policy in Japan or from the expectation (if not the realization) of easy-money policy to come in Europe. Inflation expectations are far too low in both regions, and the erosion of economic activity is far too worrying.

That leaves the United States as the economy to watch if the nasty combination of short covering and emerging-market contagion does not trigger a massive rip in the dollar in the next several months. (All bets are off under that scenario, which is certainly possible.) That said, if US economic activity continues to accelerate or just muddle through at present levels, the odds are very high that the Federal Reserve will hike its target interest rate in the next three to six months. I know it sounds extreme, and a lot of people will point to the myriad delays in hiking the rate under Ben Bernanke’s leadership, but the Yellen Fed now finds itself in a bit of a box.

Despite the fact that US trend economic growth is running far below its long-term average, we’ve just seen Q3 2014 real GDP growth revised to 5%, the fastest quarterly rate in 10 years, which puts the trailing 12-month average at roughly 2.5%. The current account deficit has collapsed to a 16-year low of 2.2%. And, as of November, the US headline unemployment rate is sitting right on its 60+ year average of 5.8%.

What looks weak here relative to history? What warrants accommodation?

Of course, the Fed’s decision also depends largely on inflation and inflation expectations, which may not take as hard a beating as some people expect, even in a scenario of $40 to $60 oil. Of course, the headline inflation rate could flirt with negative territory, but core inflation is likely to remain largely intact and near its 2% target. It’s creating a difficult call for those in Washington.



I don't know if the Fed WILL hike interest rates this summer, but I do believe Chairwoman Yellen and Vice-Chairman Fischer INTEND to do so. And I think they are communicating their intention clearly for central banks around the world to hear. In his speech on the Fed and the global economy this past October, the vice-chairman (who, bear in mind, ran the IMF during the Asian Financial Crisis in 1997, the Russian default in 1998, and the related collapse of Long Term Capital Management) essentially said that clear communication is the FOMC’s only responsibility to the rest of the world:

My teacher Charles Kindleberger argued that stability of the international financial system could be best supported by the leadership of a financial hegemon or a global central bank. But I should be clear that the US Federal Reserve System is not that bank. Our mandate, like that of virtually all central banks, focuses on domestic objectives. As I have described, to meet those domestic objectives, we must recognize the effect of our actions abroad, and, by meeting those objectives, we best minimize the negative spillovers we have to the global economy. And because the dollar features so prominently in international transactions, we must be mindful that our markets extend beyond our borders and take precautions, as we have done before, to provide liquidity when necessary…. In the United States, we are working to ensure that our financial institutions and other market participants are prepared for the normalization of monetary policy and the return to a world of higher interest rates. It is equally important that individuals, businesses, and institutions around the world do the same. For our part, the Federal Reserve will promote a smooth transition by communicating our assessment of the economy and our policy intentions as clearly as possible.

 
Keep in mind that the slide in oil prices did not deter the FOMC from replacing its “considerable time” phrase in December with a slightly more hawkish tone of “patience,” which seems to be a clear cue to the central banking community, even if Wall Street interpreted it as being more dovish than it really was. Some people hear what they want to hear, but I imagine that Raghuram Rajan and his peers at the other emerging-market central banks heard something very different than did the Wall Street strategists and retail investors who bought equities that day.

While my friends remind me that “patience” can mean a very long time, I’m unsettled by the fact that the FOMC’s language transition is very similar to the one it employed ahead of its 2004 rate hike.
 

 

Of course, intents and purposes can change. But after a year and a half of the Fed’s telegraphing its steady march toward the exits, US economic data remains remarkably robust, even if the strong dollar and the US shale slump eventually weigh on growth and employment.

In addition to the contagion we are already seeing in the wake of oil’s global nosedive, US dollar strength leaves me seriously cautious about the reversal it could trigger in emerging markets.

Emerging Markets & the Next Global Financial Crisis


Hyman Minsky taught that instability often emerges from the excess leverage and misallocation that naturally grow during long periods of perceived stability; yet central banks have now manufactured one of the longest-running periods of global market complacency in the modern era.

Against the backdrop of extremely accommodative central bank policy in the United States, the United Kingdom, and Japan, and the ECB’s “whatever it takes” commitment to keep short-term interest rates low across the Eurozone, global debt-to-GDP has continued its upward explosion in the years since 2008… even as slowing growth and persistent disinflation (both logical side-effects of rising debt) detract from the future ability of major economies to service those debts. It should come as no surprise that the consequences stretch far beyond our borders.



Despite the urgent need to get debt growth under control, the short-sighted combination of financial repression and excess liquidity has fueled overinvestment and capital misallocation in developed-world financial assets…
 



… but the real explosion in debt and financial assets has played out across the emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on top of a massive USD-funded carry trade.
 



In a recent presentation at the Brookings Institution, BIS Head of Research and Princeton University Professor Hyun Song Shin shared his research revealing that dollar-denominated credit to non-bank offshore borrowers is now more than $9 TRILLION.
 



While some of that new funding has come through equity issuance, the vast majority has come from bank loans and corporate bond issuance…
 


Source: Business Insider
 

… with the growth in offshore credit to emerging markets showing a striking correlation to Fed policy since 2009:
 



If you step back and take a look at how dependent many of the emerging markets have become on offshore bond issuance and/or cross-border loans, you’ll see that a number of countries are seriously addicted to foreign capital in one form or another.
 


If and when investor risk appetites change, this shaky funding structure will leave a number of emerging market borrowers in the firing line. Buttiglione, Lane, Reichlin, and Reinhart expand on that idea in their latest Geneva Report on the World Economy:

The super-low interest rate environment in advanced economies has encouraged a new wave of debt issuance by firms in emerging economies. In contrast to the mid-2000s phase, this new wave of global liquidity has been primarily intermediated through the bond market rather than the international banking system.

The result was the strong increase in the ratio of total debt (ex-financials) to GDP for emerging economies, by a staggering 36% since 2008. Higher leverage, although helping to shield these economies from the chilling wind blowing from advanced economies, is an increasing concern in terms of the future risk profile given the ongoing steep slowdown of nominal growth, which reduces the ‘debt capacity’ of emerging economies exactly when they would need to expand it.

Moreover, a substantial proportion takes the form of offshore issuance through the foreign affiliates of domestic corporations. These offshore liabilities pose an indirect risk to domestic financial stability in emerging markets, since a disruption in offshore funding would compromise the consolidated financial health of the issuing corporates, damaging economic performance and generating a reduction in corporate deposits in the domestic banking system. In terms of funding risks, the surge in issuance leaves these firms vulnerable to shifts in appetite among global bond investors.

That leaves us with a BIG question: how great a portion of the recent inflows can depart quickly? The short answer is, no one knows. The longer answer is, it depends on the shorter-term carry trade into those markets, which might come unwound at any moment. While it’s very difficult to know for certain, reasonable estimates of the size of that trade range from $2 trillion to $5 trillion – which makes it the largest carry trade in modern history.

Keep in mind that we have now seen three major carry trades in the last twenty years. The first fueled an obviously overextended credit boom in Southeast Asia that culminated in the Asian Financial Crisis of 1997 and served as a major catalyst for Russia’s default and the collapse of Long Term Capital Management. That carry trade has been estimated at several hundred million dollars – nowhere near the current flow. The second was largely funded in yen in the days leading up to 2008 and has been estimated at roughly $1 trillion. Its forceful reversal was one of the major causes for the collapse in emerging-market credit conditions and the sharp rally in the Japanese yen during the 2008 crisis. We simply have no historical precedent to suggest what will happen if and when a $2 trillion to $5 trillion carry trade unwinds, but I can assure you it will be ugly.

As I wrote in October, we need to seriously prepare for a bigger wave of EM crises that could be induced by (1) a reversal in capital flows triggered by central bank policy divergence, a strengthening US dollar, and the resulting unwind in the USD carry trade, (2) a dramatic fall in commodity prices as global growth decelerates, or (3) both.

Trouble is, the story has gotten a LOT more complicated than it seemed when I first started thinking about this idea in the wake of Fed Chairman Bernanke’s initial taper comments… or even when I outlined my thesis in October.

The first signs of EM crisis – now affectionately and erroneously known as the “taper tantrum” – saw local markets and currencies slip in proportion to their reliance on foreign funding. Countries with both current account and fiscal deficits, relatively high inflation rates, and slipping growth prospects immediately found themselves in the firing line.

Global markets were quick to lump countries such as India, Turkey, South Africa, Indonesia, Argentina, Brazil, and Russia into a common category and threatened the quick withdrawal of funding in the event that the Fed moved forward with its plans to tighten – first to taper its ongoing QE3 asset purchases and then presumably to move on to rate increases.

The immediate response was painful. Each of these countries’ currencies suffered sharp depreciations, with the Indian rupee, Brazilian real, and Indonesian rupiah taking the hardest hits.

While the Indian rupee initially fell the hardest, incoming RBI governor Raghuram Rajan was quick to take note of the Fed’s signal and, as a first order of business, immediately began hiking interest rates in September 2013. But rather than admit that he was acting to shore up the rupee – and risk eroding the FX market’s confidence – Rajan argued that, like Fed Chairman Paul Volcker in the 1980s, he was putting India on a credible path in the fight against inflation. And he stuck to his guns in the following months, as fears about capital flight quieted and the USD carry trade continued to grow.

At that moment, Rajan was an outlier among EM central bankers – most of whom did nothing as the imminent risk of flow reversal seemed to recede. When Bernanke’s successor, Janet Yellen, established a credible trend of tapering the Fed’s asset purchases by $10 billion at every meeting, fear and panic returned, but only for a few months. In stark contrast to India, the Reserve Bank of Turkey was forced to hike rates – acknowledging their desperate need to shore up the lira – and then to hike again as market confidence eroded.

But those events were like the faint hints of an earthquake far offshore. And global markets were a little TOO calm. From February to May 2014, the fear receded again, and capital flows returned even to the most fundamentally weak emerging markets… including Turkey.

The latest “tantrum” has been more about falling commodity prices, largely due to the slowdown in China’s massive investment boom, along with weakness in Japan, Europe, and much of the emerging world. As a result, the demand for commodities – particularly oil (where a glut in supply from US shale production is playing a role) – has started collapsing… and the once steadfast alliance among OPEC nations has been shattered.

As prices fall, the immediate balance of payment risks in emerging markets are falling on those countries that rely on commodity export revenues. As foreign demand falls and prices with it, countries that were large net exporters six months ago are becoming net importers… revealing increasingly dangerous and fragile twin deficits in countries like Russia and Brazil… while countries like India and Turkey are actually seeing their current account deficits improve, given the lower costs of commodity imports. Of course, modest improvements in economic fundamentals only count for so much when contagion strikes.

For now, it’s worth noting here that even the Turkish lira and the Indian rupee are getting pulled into the contagion from Russia’s financial crisis, despite what lower oil and other commodity import prices mean for their current accounts and inflation rates. It’s an important lesson.

It remains to be seen whether the ruble’s collapse will continue as Russia’s financial crisis deepens or if it will be halted as China steps in and prevents the sudden breakout of the USD for the time being. But we need to look at Russia's ongoing experience in handling the first divergence-induced crisis. It’s the first major domino to fall, of the many that may topple in the coming months, quarters, years… and the first of the fragile currencies to depreciate in a meaningful way. I doubt it will be the last.

If the Federal Reserve does not back off from its tightening path, or if it simply pauses where it is for several quarters, allowing contagion and risk aversion to take over, that could be enough to set off a major rally in the USD and the subsequent unwind of the USD-funded carry trade. Regardless of the actual number (which is almost impossible to pinpoint accurately), the amount of capital that could be quickly withdrawn from EM markets could be massive. And more importantly, funding would stop, forcing local firms to borrow within their own potentially crippled financial systems rather than through international bond markets.

While a carry trade reversal would almost certainly exacerbate the slowdowns already in progress in several major emerging countries, it doesn’t necessarily mean total currency collapse. Then again, a number of these economies are inviting just that. And when one or two currencies start to go, they could easily push the USD even higher, putting pressure on a whole additional set of countries. Think 1994 to 1998 on steroids… with all the risks such pressures could pose to our highly levered, highly interconnected global financial system.

Why the World Needs the US Economy to Struggle

Looking back on the 1990s, most economic historians, central bankers, and investment strategists continue to think of Mexico's Tequila Crisis, the Asian Financial Crisis, and the Russian default crisis as if they were separate incidents. I think that’s an enormous error that derives from a misunderstanding of the true causes of contagion.

The Tequila Crisis in 1994 was the first divergence-induced accident of the period, and it could easily have bubbled over into full-blown contagion had it not been for $40 billion in emergency loans and guarantees from the US government. Instead of merely seeing their currencies slide in the oft-forgotten “Tequila effect,” Brazil, Argentina, Chile, et al. could easily have been thrown into another decade of full-blown disaster... and who knows how far the sickness could have spread.

While it might be somewhat misleading to speculate about what might have happened, we do know two things: (1) the capital that fled Mexico in 1994 and 1995 did not return quickly, and (2) those Latin American events marked a turning point for the US dollar.

Although US government intervention in Mexico restored a sense of calm to FX markets, it also sent US dollar investments running to Asia, where the USD's rise was a major contributing factor to the eventual collapse of the Southeast Asian growth miracle. And investment managers' collective memories of the 1982 and 1994 Mexican peso crises likely contributed to the panicked mood as they dumped the Thai bhat, Malaysian ringgit, Indonesian rupiah, Philippine peso, and South Korean won in 1997. Furthermore, the Asian crisis (which drove the USD higher and destroyed commodity demand across SE Asia), along with a global glut in oil supply, was a major catalyst for Russia's disastrous default in 1998.

All of these events were connected by initial surges in private-sector credit – largely funded in US dollars – and all of the countries involved fell as a consequence of capital flight, either as a function of policy divergence (which eventually pushed the USD higher), risk aversion (which immediately pushed the USD higher), or both.

While the US can probably decouple from global growth conditions long enough to justify a Fed rate hike in the coming months, our global financial system is far too levered, far too interconnected, and far too gravely mismanaged for the US to continue booming as commodity prices collapse and the emerging-market borrowing bonanza comes to an abrupt and violent end. The deflationary storm can blow back at us far more quickly than the FOMC believes.

If the last thirty years have taught us anything about cross-border capital flows and financial contagion, it’s that herding behavior – especially among fund managers, who have piled in to emerging-market corporate bonds in recent years – can amplify distress, even in small economies with limited trade and financial linkages, into legitimate threats to the world’s strongest markets.

I don’t know if the divergence we are seeing among central banks will continue. I don’t know if the US dollar will keep breaking out of its 30-year downtrend. I don’t know if commodity prices will continue to collapse or if a rapid unwind in the US dollar-funded carry trade will spark emerging-market contagion capable of further destabilizing the global financial system. But these forces are playing out just as I’ve feared over the last eighteen months, and they are creating an economic storm capable of shaking the world in far more profound ways than a Category 5 hurricane crashing into the Louisiana coastline.

Just as Hurricane Lili may have died when it hit a patch of cold water just before making landfall, the only thing that can stop a major breakout in the US dollar and an ensuing global financial crisis may be a cold patch of economic data such as collapsing US inflation expectations and, most likely, another round of job losses in the very near term. I just don’t see either happening quickly enough to stop the dollar in its tracks. Everything – from the Fed’s policy stance to the ECB’s resolve – will change once the big unwind begins, but that’s a story for another letter.

It may be time to pray for a miracle but prepare for a disaster.

Head-Banging Central Banks

John here. Worth actually wrote a much longer piece that we had to edit for the letter, but the rest will show up in the new book that we are beavering away on. It will be about the major changes that are in store for the global economy over the next five years. Plus some discussion about what central banks will try to do to smooth out the disruptions. We are in for some very volatile markets. Anything and everything will be on the table.

The following quote is from Stan Fischer, vice-chairman of the Fed and one of the true global thought leaders on the role of central banks in crises. When he speaks, everyone listens. He made this comment during a panel discussion about the actions central banks might take in the next crisis:

Finally, what to do about the lender of last resort. Rajan emphasized liquidity, and so did the discussants. That is what central banks can provide in a crisis, but you have to bear in mind the rule that the lender of last resort should lend to the market and not to specific institutions. This whole development is paradoxically reemphasizing the role of the central bank in the management of the system. If he is right, Raghu said the key problem is going to be liquidity. That is what central banks are about.

I have reflected a long time on the Long Term Capital Management crisis. The thing that struck me most was [that] the story of LTCM could have appeared in Clappin’s book on 19th-century crises. It is a very modern crisis, but the way it was resolved was almost identical to the way that crises always used to be resolved. The central bank was brought in and banged a few heads together. There was an argument about whether they should have done it, but in the end, that was how it was resolved.

Central banks as head bangers. Who knew? Actually, Volcker did the same thing during the crisis caused by the Hunts cornering the silver market. Nearly every major investment bank and a few major commercial banks were technically insolvent. Volcker sat in the room and listened to the back and forth and then told everyone exactly how it would be solved. No one in the room was happy, but the country dodged a major crisis.

The powers that central bankers have this time around are even headiers than they were in the ’80s or ’90s. But will they lose their ability to assuage the markets through injections of liquidity when the fundamental problem is not liquidity but too much debt?

We are also going to do something in this book that I have not done in a very long time. We are going to lay out very specifically how we think you can keep your investment portfolio working for you while avoiding much (though not all) of the escalating risk. The next five years are going to require lthat you rethink your strategy. Worth and I have been working on this for a couple of years and are now just about ready to write about it. Stay tuned.

Cincinnati, the Cayman Islands, Zurich, and Florida

I see Cincinnati, Grand Cayman, Zurich, and Florida on my schedule. I will be in Cincinnati on the 13th for the CFA forecasting dinner. Then in February it’s on to the Caymans. It has been awhile since I was in the Cayman Islands, and this time I’ll take a short hop over to Little Cayman to visit my friend Raoul Pal for a few days. A brilliant macroeconomist and trader, Raoul has now based himself in Little Cayman, although he frequently flies to visit clients. He is also a partner with Grant Williams in Real Vision Television, a fascinating new take on internet investment TV.

And speaking of Raoul, if you want to learn more about the US dollar carry trade and what its rapid unwind could mean for the global economy, my good friend and legendary global macro investor Mr. Pal explains it all in a recent video presentation on Real Vision TV called “The Law of Unintended Consequences.” I asked him to make that video public so that Mauldin Economics readers can get an exclusive behind-the-curtain preview of Real Vision and hear from a man who comes up with macro trades and ideas that are implemented by some of the world’s largest hedge funds. We have been exchanging notes for years, and I can tell you without a doubt that this guy is the real deal. I don’t say this very often, but you REALLY don’t want to miss this video.


I will resume my regular weekly writing schedule next week with my own forecasting issue; but this time, instead of predicting (and being wrong) about where the S&P will end up this year, I am going to do a five-year forecast about events I feel confident about. Of course, that confidence is relative, since I have zero confidence in my ability to predict where the S&P will be in 12 months.

It is time to hit the send button, but first a few of my resolutions. Besides losing the 15-20 pounds I still carry from last year’s failed resolution, I intend to read more books this year and less news. And I’ll try to travel less. I have really enjoyed the reduced travel of the last few months and feel much better physically because of it. This morning I actually did 80 pushups, which was a little surprising to me, but I guess the training is paying off.

Let me wish you the very best and most prosperous of New Years from the whole team here at Mauldin Economics. We will do our best to help you prosper, this year and every year.

Your starting to see how the pieces of the future puzzle fit analyst,
John Mauldin
John Mauldin

15 Surprises for 2015

John Mauldin

Dec 31, 2014


It’s that time of year when people start thinking about New Year’s resolutions and investment planning for the future. It’s also the time of year when analysts feel more or less compelled to offer up forecasts. My friend Doug Kass turns the forecasting process on its head by offering 15 potential surprises for 2015 (plus 10 also-rans). But he does so with a healthy measure of humility, starting out with a quote from our mutual friend James Montier (now at GMO):

(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

Lessons Learned Over the Years

 
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen
 
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
 

1.       How wrong conventional wisdom can consistently be.
 

2.      That uncertainty will persist.
 

3.      To expect the unexpected.
 

4.      That the occurrence of black swan events are growing in frequency.
 

5.      With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns. 

Quoting from a very eclectic group of names, Doug does indeed give us a few surprises to think about, and I pass his thoughts on to you as this week’s Outside the Box. (Doug publishes his regular writings in RealMoneyPro on theStreet.com.) 

As a bonus, and as a thoughtful way to begin the new year, we have a letter that my good friend and co-author of my last two books Jonathan Tepper wrote to his nephews. He began penning it on a very turbulent plane ride that he was uncertain of surviving. It made him think hard about what was really important that he would want to pass on to his nephews. As the song goes, I found a few aces that I can keep in this hand. I think you will too. 

His letter made me think about what I want to be passing on to my grandchildren, including the newest one, Henry Junior, who showed up less than 24 hours ago. They are going to grow up in a very different world than the one I grew up in, and I mostly think that’s a good thing. But the values that I hope can be passed on don’t change. Good character never goes out of fashion. 

My associate Worth Wray came down with a very nasty bug this past weekend, so he missed his deadline for delivering his 2015 forecast to you. We’re giving him a few more days and will run it this weekend – which also of course gives me a little more time to mull over my own forecast.
 
Taking to heart James Montier’s quote above, I’m going to forgo the usual 12-month forecast and look farther out, thinking about what major events are likely to come our way over the next five years. I actually think that approach will be for more useful for our longer-term planning.
 
Thanks for being with me and the rest of the team at Mauldin Economics this past year; and from all of us, but especially from me, we wish you the best and most prosperous of new years. 

You’re staring hard at crystal balls analyst,
 

John Mauldin, Editor
Outside the Box



15 Surprises for 2015


Doug Kass, Seabreeze Partners

Dec. 29, 2014 | 8:12 AM EST

Stock quotes in this article:

CSBUXTSLATWTRGMGLDJNKSPYQQQAAPLBAC, GOOGLFBCSCO

It’s that time of year again.

"Never make predictions, especially about the future." – Casey Stengel

By means of background and for those new to Real Money Pro, 12 years ago I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook. Wien originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Byron Wien's list will be out in early January and it will be fun to compare our surprises.)

It takes me about two to three weeks of thinking and writing to compile and construct my annual surprise list column. I typically start with about 30-40 surprises, which are accumulated during the months leading up to my column. In the days leading up to this publication I cull the list to come up with my final 15 surprises. (Last year I included five also-ran surprises.)

I often speak to and get input from some of the wise men and women that I know in the investment and media businesses. I have always associated the moment of writing the final draft (in the weekend before publication) of my annual surprise list with a moment of lift, of joy and hopefully with the thought of unexpected investment rewards in the New Year.

This year is no different.

I set out as a primary objective for my surprise list to deliver a critical and variant view relative to consensus that can provide alpha or excess returns. 

The publication of my annual surprise list is in recognition that economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.

History demonstrates that inflection points are relatively rare and that the crowds often outsmart the remnants. In recognition, investors, strategists, economists and money managers tend to operate and think in crowds. They are far more comfortable being a part of the herd rather than expressing – in their views and portfolio structure – a variant or extreme vision.

Confidence is the most abundant quality on Wall Street as, over time, stocks climb higher. Good markets mean happy investors and even happier investment professionals.

The factors stated above help to explain the crowded and benign consensus that every year begins with, whether measured either by economic, market or interest-rate forecasts.

But an outlier's studied view can be profitable and add alpha. Consider the course of interest rates and commodities in 2014, which differed dramatically from the consensus expectations.

To a large degree the business media perpetuates group-think. Consider the preponderance of bullish talk in the financial press. All too often the opinions of guests who failed to see the crippling 2007-09 drama are forgotten and some of the same (and previously wrong-footed) talking heads are paraded as seers in the media after continued market gains in recent years.

Memories are short (especially of a media kind). Nevertheless, if the criteria for appearances was accuracy there would have been few available guests in 2009-2010 qualified to appear on CNBC, Bloomberg and Fox News Business.

Indeed, the few bears remaining are now ridiculed openly by the business media in their limited appearances, reminding me of Mickey Mantle's quote, "You don't know how easy this game is until you enter the broadcasting booth." 

Abba Eban, the Israeli foreign minister in the late 1960s and early 1970s once said that the consensus is what many people say in chorus, but do not believe as individuals.

GMO's James Moniter, in an excellent essay published several years ago, made note of the consistent weakness embodied in consensus forecasts.

As he put it:

"(E)conomists can't forecast for toffee ... They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else ... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!"

Lessons Learned Over the Years


"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." – Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

1.       How wrong conventional wisdom can consistently be.
 

2.      That uncertainty will persist.
 

3.      To expect the unexpected.
 

4.      That the occurrence of black swan events are growing in frequency.
 

5.      With rapidly-changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well-known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." – UBS (top 10 surprises for 2012)

Let's get back to what I mean to accomplish in creating my annual surprise list.

It is important to note that my surprises are not intended to be predictions, but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these possible-improbable events. In sports, betting my surprises would be called an overlay, a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.

The real purpose of this endeavor is a practical one – that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.

Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and group-think (or group-stink, as I prefer to call it). Mainstream and consensus expectations are just that and, in most cases, they are deeply embedded into today's stock prices.

It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.

Nothing is more obstinate than a fashionable consensus and my annual exercise recognizes that, over the course of time, conventional wisdom is often wrong.

As a society (and as investors), we are consistently bamboozled by appearance and consensus.

Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank, Citigroup (C), the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing's new paradigm (in the mid-2000s) of non-cyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

My Surprises for 2014


These generally proved in line with my historic percentages.

"How'm I doin'?" –  Ed Koch, former New York City mayor

While over recent years many of my surprise lists have been eerily prescient (e.g. my 2011 surprise that the S&P 500 would end exactly flat was exactly correct), my 15 Surprises for 2014 had a success rate of about 40%, about in line with what I have achieved over the last 11 years.

As we entered 2014, most strategists expressed a constructive economic view of a self-sustaining domestic recovery, held to an upbeat (though not wide-eyed) corporate profits picture and generally shared the view that the S&P 500 would rise by between 8-10%.

Those strategists proved to be correct on profit growth (but only because of several non-operating factors and financial engineering), were too optimistic regarding domestic and global economic growth and recognized (unlike myself) that excessive liquidity provided by the world's central bankers would continue to lift valuations and promote attractive market gains in 2015. Not one major strategist foresaw the emerging deflationary conditions, the precipitous drop in the price of oil and the broad decline in domestic and non-U.S. interest rates.

Many readers of this annual column assume that my surprise list will have a bearish bent (to be sure that is the case for 2015). But I have not always expressed a negative outlook in my surprise list. Two years ago my 2012 surprise list had an out-of-consensus positive tone to it, but 2013's list was noticeably downbeat relative to the general expectations. I specifically called for a stock market top in early 2013, which couldn't have been further from last year's reality, as January proved to be the market's nadir. The S&P closed at its high on the last day of the year and exhibited its largest yearly advance since 1997. (I steadily increased my fair market value calculation throughout the year and, at last count, I concluded that the S&P 500's fair market value was about 1645.)

As I said, in 2014 my success rate was at about 40% (which included five also-ran predictions).

This contrasted with my 15 surprises for 2013, which had the poorest success rate since 2005's list (20%).

By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to my experience in 2011. About 40% of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, 33% in 2006, 20% in 2005, 45% in 2004 and 33% came to pass in the first year of my surprises in 2003.

Below is a report card of my 15 surprises for 2014 (and the five also-ran  surprises).

Surprise No. 1: Slowing global economic growth. RIGHT

Surprise No. 2: Corporate profits disappoint. HALF RIGHT (as financial engineering buoyed EPS).

Surprise No. 3: Stock prices and P/E multiples decline. WRONG

Surprise No. 4: Bonds outperform stocks. Closed-end municipal bond funds are among the best asset classes, achieving a total return of +15%. VERY RIGHT

Surprise No. 5: A number of major surprises affect individual stocks and sectors. (Starbucks (SBUX) falls, 3D printing stocks halve in price, General Motors (GM) drops by 20% in 2014). MORE WRONG THAN RIGHT

Surprise No. 6: Volkswagen AG acquires Tesla Motors (TSLA). WRONG

Surprise No. 7: Twitter's (TWTR) shares fall by 70% as a disruptive competitor appears. MORE RIGHT THAN WRONG

Surprise No. 8:  Buffett names successor. WRONG

Surprise No. 9: Bitcoin becomes a roller coaster. RIGHT

Surprise No. 10: The Republican Party gains control of the Senate and maintains control of the House. Obama becomes a lame duck President incapable of launching policy initiatives. RIGHT

Surprise No. 11: Secretary Hillary Clinton bows out as a presidential candidate. WRONG

Surprise No. 12: Social unrest and riots appear in the U.S. RIGHT

Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis. HALF RIGHT

Surprise No. 14: The next big thing? A marijuana IPO rises by more than 400% on its first day of trading. WRONG

Surprise No. 15: An escalation of friction between China and Japan hints at war-like behavior between the two countries. WRONG

Also-Ran Surprises: Crude oil trades under $75 a barrel (short crude and energy stocks) RIGHT, VIX trades under 10 (short VIX) RIGHT, gold trades under $1,000 (Short GLD) DIRECTIONALLY RIGHT.

What Was the Consensus for 2014 and What Is the Consensus for 2015?


"The only thing people are worried about is that no one is worried about anything ... That isn't a real worry." – Adam Parker, chief U.S. strategist at Morgan Stanley

"In ambiguous situations, it's a good bet that the crowd will generally stick together – and be wrong." – Doug Sherman and William Hendricks

As mentioned earlier, we entered 2014 there was a generally upbeat outlook for global economic and profit growth, as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year and the same could be said for the general expectation of rising oil prices.  As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.

·   Both U.S. and global economic growth disappointed the consensus (despite a strong third-quarter 2014 U.S. GDP number).
 

·   S&P earnings were a slight beat, but only because of more-aggressive-than-anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
 

·   Bond yields declined unexpectedly. The 10-year yield dropped to about 2.2% from 3.05%.
 

·   Deflationary forces were also a surprise, most notably no one projected that oil prices would fall to under $60 s barrel and that the Bloomberg Commodity Index would hit a five-year low in December, 2014.
 

·   Stock prices ended the year about 5% above beginning-of-the-year consensus forecasts.

Virtually all strategists are now self-confident bulls, as gloom-and-doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as bumps in the road and as opportunities to buy because (after the correction(s)) we will be up, up and away."

After missing the 25% rise in valuations in 2013 (and a further expansion in P/E ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average P/E ratio has increased by about 2% per year over the last 25 years.)

The domestic economy has forward momentum (as witnessed by +5% Real GDP growth in 3Q 2014), so the extrapolation of heady growth is now in full force by the consensus.

In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.

"We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation." – Goldman Sachs, Global Opportunity Asset Locator (December 2014)

As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.

The consensus is for U.S. economic growth of +2.5% to +3.25% real GDP, bond yields to be 50-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8-10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.

Here were Goldman Sach's views for 2014 made 12 months ago (with actual in parentheses). As can be seen, the brokerage's growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P were not ambitious enough:

·   U.S. real GDP was estimated at +3.1% for 2014. ( +2.4%A)
 

·   Global real GDP was estimated at+3.6% for 2014. (+3.0%A)
 

·   S&P 500 EPS $116 top-down estimate and $119 bottom-up estimate for 2014 ($119/shareA)
 

·   Year-end S&P 2014 S&P 500 price target was estimated for 2014 at 1900 (2080A)
 

·   Inflation/headline CPI +1.5% for 2014. (+1.1%A)
 

·   U.S 10-year Treasury yield 3.25% for year-end 2014. (2.20%A)

Again, let's use Goldman Sachs' principal 2015s views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to its uninspiring expectations last year.

·   2015/2016 U.S. real GDP +3.1%, +3.0%
 

·   2015/2016 global real GDP +3.6%, +3.9%
 

·   2015 S&P 500 operating per share profits $122/share
 

·   Year-end 2015 S&P 500 price target 2100
 

·   2015/2016 Consumer Prices +1.0%, +2.4%
 

·   2015 closing yield on the U.S. 10-year Treasury note 3%

The Rationale Behind My Downbeat Surprises for 2015


There are numerous reasons for my downbeat theme this year. In no order of importance: corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (P/E ratios) rose again after a 25% expansion in 2013 (compared to only +2% annual growth since the late-1980s. As well, so many gauges of valuations are stretched (market cap/GDP, the Shiller P/E ratio and many others). 

Above all, I expect the theme of the U.S. as an oasis of prosperity will be tested in 2015-16 as contagion might be a bi**h.

Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes, the markets have grown complacent after a trebling in prices over the last five years.

Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.

My 15 Surprises for 2015


At last, here are my 15 surprises for 2015 (with a strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).

Surprise No.1 – Faith in central bankers is tested (stocks sink and gold soars).

"Investment bubbles and high animal spirits do not materialize out of thin air.  They need extremely favorable economic fundamentals together with free and easy, cheap credit and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth." – Jeremy Grantham

"The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows – unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth – in inflation-adjusted terms – is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine." – Claudio Borio

European QE Backfires: The ECB initiates a sovereign QE in January 2015, but it is modest in scale (relative to expectations) as Germany won't permit a more aggressive strategy. Markets are disappointed with the small size of the ECB's initiative and European banks choose to hold their bonds instead of selling. ECB balance sheet still can't get to 3 trillion euros and the euro actually rallies sharply. Bottom line, QE fails to work (economic growth doesn't accelerate and inflationary expectations don't lift). 

Draghi Is Exposed: Mario Draghi is exposed for what he really is: the big kid of which everyone is scared. For some time, no one wanted to fight him (or fade sovereign debt bonds, which would be contra to his policy). But, after the meek January QE, the response changes. He is now seen as the bully who never throws a punch and who always has gotten his way. But at the time of the January QE a medium-sized kid (and a market participant) teases him and Draghi warns him again to stop it. The kid keeps teasing. Draghi the bully takes a swing, it turns out he can't fight and the medium-sized kid whips his butt. From then on, the big kid is feared no more. For some time Draghi has said he will do "whatever it takes," but he never really had to do anything. When he finally gets going and has to act rather than talk, he will expose himself as only a bully and as a weak big kid. Mario Draghi gets fed up with the Germans and returns to Italy (where he was governor of the Bank of Italy between 2006-2011) and becomes the country's president. 

Shinzo Abe and Haruhiko Kuroda Resign: Kuroda, an advocate of looser monetary policy, stays on at the Bank of Japan (for most of the year), but the yen enters freefall to 140 vs. the dollar and wage growth lags badly. Japanese people have had enough and, by year end, Prime Minister Shinzo Abe and Haruhiko Kuroda are forced to resign. 

The Fed Is Trapped: The Federal Reserve surprises the markets and hikes the federal funds rate in April 2015. A modest 25-basis-point rise in rates causes such global market turmoil that it is the only hike made all year. The Federal Reserve is now viewed by market participants as completely trapped, as an ah-ha-moment arrives in which there is limited policy flexibility to cope with a steepening downturn in the business cycle in late 2015/early 2016. Stated simply, the bull market in confidence in the Federal Reserve comes to an abrupt halt.

Malinvestment Becomes the It-Word in 2015: Steeped in denial of past mistakes and bathing in the buoyancy of liquidity and the elevation of stock prices in 2014, market participants come to the realization that the world's central bankers in general, and the Fed in particular, once again has taken us down an all-too-familiar and dangerous path that previously set the stage for The Great Decession of 2007-09. It becomes clear that the consequences of unprecedented monetary easing and the repression of interest rates has only invited unproductive investment and speculative carry trades. The impact of a lengthy period of depressed interest rates uncork malinvestment that has percolated and detonates among differing asset classes as the year progresses. Already seen in the deterioration and heightened volatility in commodities (the price of crude, copper, etc.), in widening spreads in the energy high yield (with yields up to 10% today, compared with only 5% a few months ago) and with the average yield on the SPDR Barclays High Yield Bond ETF (JNK) up to 7% (from a low of 5% earlier in 2014), the consequences of financial engineering (zero-interest-rate policy and quantitative easing) and lack of attention to burgeoning country debt loads and central bankers' balance sheets, in addition to inertia on the fiscal front result in rising volatility in the currency markets.
 
Malinvestment in countries like Brazil (where consumer debt has risen by 8x and export accounts have quintupled over the last eight years on the strength of a peaking export boom, in oil and iron ore, so dependent on the China infrastructure story that has now ended) translate in to a deepening economic crisis in Latin America and in other emerging markets.

Then, EU sovereign debt yields, suppressed so long by Draghi's jawboning, begin to rise. Slowly at first and then more rapidly, EU bond prices fall, putting intense pressure on the entire European banking system. (In his greatest score, George Soros makes $2.5 billion shorting German Bunds). The contagion spreads to other region's financial institutions. Shortly after, social media and high valuation stocks get routed and, ultimately, so does the world's stock markets.

As a result of the influences above, the VIX rises above 30. The price of gold soars to $1,800-$2000 and the precious metal is the best-performing asset class for all of 2015.

Strategy: Buy GLD and VIX, Short SPY/QQQ and German Bunds

Surprise No. 2 – The U.S. stock market falters in 2015.

"In a theater, it happened that a fire started offstage. The clown came out to tell the audience. They thought it was a joke and applauded. He told them again and they became more hilarious. This is the way, I suppose, that the world will be destroyed – amid the universal hilarity of wits and wags who think it is all a joke." – Soren Kierkegaard.

Market High Seen in January, Low Seen in December (at Year End): The U.S. stock market experiences a 10%+ loss for the full year. (Note: Not one single strategist in Barron's Survey is calling for a lower stock market in 2015. Projected gains by the sell side are between +6-16%, with a median market gain forecast at +11%). The S&P Index makes its yearly high in the first quarter and closes 2015 at its yearly low as signs of a deepening global economic slowdown intensify in the June-December period. 

While earnings expectations disappoint, the real source of the market decline in 2015 is a contraction in valuations (price-earnings multiples) after several years of robust gains. Investors begin to recognize that low interest rates, massive corporate buybacks, the suppression of wages, phony stock option accounting and other factors artificially goosed reported earnings and that earnings power and organic earnings are less than previously thought. So, 2015 is a year in which the relevant ways of measuring overvaluation (market cap/GDP currently at 1.25 vs. 0.70 mean) and the Shiller CAPE ratio (currently at 27x vs. 17x mean) become, well, relevant.

With few having the intestinal fortitude to maintain skepticism and short positions into the unrelenting bull market of 2013-14, there is none of the customary support of short sellers to cover positions and soften the market decline, when it occurs.

Stocks begin to drop in the first half, well before the real economy tapers, underscoring the notion (often forgotten) that the stock market is not the economy.

But by mid-year it becomes clear that U.S. economic growth is unable to thrive without the Fed's support.

Year-over-year profits for the S&P decline modestly in the second half of 2015. Domestic Real GDP growth falls to under +1.5% in the third and fourth quarters.

By year end the market begins to focus on The Recession of 2016-17, which looms ahead in the not so distant future.

Strategy: Short SPY

Surprise No. 3 – The drop in oil prices fails to help the economy.

"In its November 14, 2014 Daily Observations ("The Implications of $75 Oil for the US Economy"), the highly respected hedge fund Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%." – Mike Lewitt, The Credit Strategist

Despite the near-universal view that lower oil prices will benefit the economy, the reverse turns out to be the case in 2015 as the economy as a whole may not have more money – it might have less money.

Continued higher costs for food, rent, insurance, education, etc. eat up the benefit of lower oil prices. Some of the savings from lower oil is saved by the consumer who is frightened by slowing domestic growth, a slowdown in job creation and a deceleration in the rate of growth in wages and salaries. 

And the unfavorable drain on oil-related capital spending and lower-employment levels serve to further drain the benefits of lower gasoline and heating oil prices.

In The Financial Times, recently, Martin Wolf wrote: "(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand."

But Wolf, and the many other observers, as Mike Lewitt again reminds us, "fail to explain how the $1.3 trillion that has been deducted from the global economy is able to shift from one group to another. "

Surprise No. 4: The mother of all flash crashes.

"America is the 'arch criminal' and 'unchangeable principal enemy' of North Korea." (Dec. 22, 2014)

"America is a 'toothless wolf' and 'the empire of devils."" (March 27, 2010)

"North Korean missiles will reduce Washington, D.C. to 'ashes.'" (August 19, 2014)

"America is a 'group of Satan' bent on destroying Korean religion." (April 22, 2013)

"American 'ideological and cultural poisoning' is undermining socialism around the world." (July 16, 2014)

– Selected quotes from North Korea's state-controlled media

Hackers attack the NYSE and Nasdaq computer apparatus and systems by introducing a flood of fictitious sell orders that result in a flash crash that dwarfs anything ever seen in history.

In the space of one hour the S&P Index falls by more than 5%.

The identity of the attacker goes unknown for several days and it turns out to be North Korea. 

Strategy: Buy VIX, Short SPY/QQQ

Surprise No. 5: The great three-decade bull market in bonds is over in 2015.

"Take then thy bond thou thy pound of flesh..." – Portia, The Merchant of Venice

Last year not one strategist saw lower interest rates (though that was my No. 1 Surprise last year). This year, not one strategist expects a spike in interest rates.

In the first half of 2015, European yields and U.S. yields start to converge, in that European yields begin to jump to where the U.S. 10-year yield resides. The failure of Draghi's policy (see Surprise No. 1) will result in an acceleration in the European debt yields rising and in a decay in debt prices. That will mark the end of the great three-decade bond bull market in the U.S. and it will occur as global growth eases.

Strategy: None

Surprise No.6 – China devalues its currency by more than 3% vs. the U.S. dollar.

"It's not like I'm anti-China. I just think it's ridiculous that we allow them to do what they're doing to this country, with the manipulation of the currency, that you write about and understand, and all of the other things that they do." – Donald Trump

For years, China has essentially pegged it's currency to the U.S. dollar. (liberalization meant that a narrow trading range is permitted). With the huge run in the U.S. Dollar, China's currency has appreciated compared with other Asian currencies. As a result, China has lost its manufacturing edge and its trade surplus has all but disappeared. Whether it's a permitted day-to-day weakening, changing the peg from the dollar to a basket of currencies or whether there is an overnight surprise devaluation, China's currency will weaken materially in 2015.

Strategy: None

Surprise No. 7 – Apple (AAPL) becomes the first $1 trillion company.

"There's an old Wayne Gretzky quote that I love. 'I skate to where the puck is going to be, not where it has been.' And we've always tried to do that at Apple. Since the very, very beginning. And we always will." – Steve Jobs

Apple's next generation iPhone is seen to likely outsell its latest phone iteration as Re/Code uncovers (and reveals) some amazing and unique new features/applications that are planned for the next generation phone.

I don't know what features it will have or how it will improve design or performance. But I think there is now a near-consensus that it won't and that the next product upgrade cycle is a while away.

So, I predict Apple 2016 estimates rise significantly (to $10/share) and, despite a weak market backdrop, Apple becomes the first $1 trillion dollar market-cap company and the best-performing large-cap in 2015.

Apple becomes the only one-decision stock during the stock market swoon during the last half of 2015. It is a must own.

Strategy: Buy APPL

Surprise No. 8 – Legislation is introduced that allows for repatriation for foreign cash.

"The only difference between death and taxes is that death doesn't get worse every time Congress meets." – Will Rogers

As signs of domestic economic growth fade in the second half of 2015, Congress and the Administration agree on a broad program to repatriate foreign cash at a low tax rate.

The deal briefly rallies the U.S. stock market, but equities soon succumb to a slowing domestic economy and diminishing corporate profit growth.  

Strategy: None

Surprise No. 9 – Energy goes from the worst-performing group in 2014 to the best-performing group in the first half of 2015 and then falls back later in the year.

"Oil vey!" – Kass Daily Diary term

Energy stocks are on a roller coaster in 2015.

As the price of crude oil rises steadily (towards $65 a barrel) in early 2015, the energy sector (which was among the worst in 2014) becomes the best market group in the first half of the year. Slowing global economic growth during the last half of the year leads to profit-taking in the energy sector as the price of crude oil closes the year at under $50 and at its lowest price in 2015.

In a surprise move, the president signs approval for the Keystone Pipeline in the second half of the year.

Strategy: Buy oil stocks in first six months of the year, sell/short mid-year.

Surprise No. 10 – More chaos in the Democratic Party.

"Mothers all want their sons to grow up to be president, but they don't want them to become politicians in the process." – John F. Kennedy

Sen. Elizabeth Warren pushes Secretary Hillary Clinton so far to the left that she loses independent voters, though she easily gains the Democratic nomination for president. 

Former President George H.W. Bush passes away during the first half of the year and Governor Jeb Bush immediately declares his candidacy.

By the end of 2015, Jeb Bush is well ahead in the polls and is a big favorite to win the presidency in 2016.

Strategy: None

Surprise No. 11 – Food inflation accelerates after Russia halts wheat exports.

"As life's pleasures go, food is second only to sex. Except for salami and eggs. Now that's better than sex, but only if the salami is thickly sliced." – Alan King

Russian turmoil continues and Putin decides to halt exports of wheat again to keep as much homeland as possible, resulting in a price spike in wheat, but also corn and soybeans. This price rise, on top of U.S. food inflation that is already running higher, offsets the consumer benefit of still-relatively-low gasoline and heating oil prices.

Strategy: None

Surprise No. 12 – Home prices fall in the second half of 2015.

"I told my mother-in-law that my house was her house and she said, 'Get the hell off my property.'" – Joan Rivers

Under the weight of reduced home affordability, still-low household formation gains and continued pressure on real incomes, home prices fall in 2015.

Builders lose pricing power.

Strategy: Short homebuilders.

Surprise No. 13 – Individual and sector market surprises.

"Those who are easily shocked should be shocked more often." – Mae West

·   Bank Stocks Fall – Though bank stocks have been recent market leaders, the weight of a flattening yield curve, still-tepid loan demand and an implosion in the European banking system make the sector among the worst market performers. Moreover, a major cyber attack against Bank of America (BAC) that actually destroys a percentage of customer records further diminishes enthusiasm for the group.
 

·   Twitter Feeding – Carl Icahn, calling it his "new Netflix," discloses a 9.9% position in Twitter. This stimulates a bidding war between Google (GOOGL) and Facebook (FB) to acquire the company. Google wins the battle and pays $60 a share for Twitter.
 

·   Volatility Rising – The VIX rises to over 30 in the second half of the year.
 

·   Google Institutes a Share Buyback and Shaves Capital Spending – After a lackluster performance in 2014, Google's management reverses course on its previously outsized capital spending program on non-core businesses and becomes more shareholder friendly. The company dials back spending and institutes a stock buyback program.
 

·   Corporate Inefficiency in Large-Cap Technology Targets Activist Investors –- Two hedge funds establish a filing position in Cisco (CSCO) and force Chairman John Chambers out. The new CEO announces a large special dividend and a massive stock buyback and a cutback to the employees' too-generous stock option plan. More than 10% of the workforce is laid off and Cisco's shares soar. Several other tech companies are targeted.

Strategy: Long AAPL TWTR, CSCO, VIX, GOOGL and short banks

Surprise No. 14 – Berkshire Hathaway (BRK.A) makes its largest acquisition in history.

"When I was 15 years old, I read an articls about Ivan Boesky, the well-known takeover trader – turned out years later it was all on inside information! But before that came to light, he was very successful, very flamboyant. And I thought, 'This is what I want to do.' So I'm 15 years old, I decide I'm going to Wall Street." –  Karen Finerman

During the depths of the market's swoon in the later part of the year, Warren Buffett scoops up his largest acquisition ever. The $55+ billion acquisition is not in his customary comfort zone (a consumer goods company), but rather the deal is for a company in the energy, retail or construction/equipment areas.   

Strategy: None

Surprise No. 15 – A derivative blowup precipitates an abrupt market drop.

"I view derivatives as time bombs, both for the parties that deal in them and the economic system." – Warren Buffett

The $300 trillion holdings of derivatives by the U.S. banking industry has been all but forgotten.

The four-largest U.S. banks account for $240 trillion of that total, dwarfing their combined $750 billion in statutory capital! This sort of exposure in which notional derivatives are more than 300x the banks' net worth, is, as my friend The Credit Strategist's Mike Lewitt has written, "would be laughable if the consequences of a financial accident were not so potentially catastrophic."

To make matters worse, the passage of the $1.1 trillion spending bill passed this month (written by lobbyists and voted on by bought-and-paid-for legislators who probably neither read nor understood the complex spending bill) has kept taxpayers on the hook –through the FDIC – for those derivatives (what Warren Buffett previously called "financial weapons of mass destruction.") 

On any measure, the sheer size of these derivative portfolios pose potential risk to the world's financial stability. What we have learned from the past cycle is how opaque the exposure really is and how stupid and avaricious our bankers really are when allowed to venture into territories of leverage.

Whether it is energy derivatives or some other asset class, a derivative blowup in 2015 will serve to preserve the wise words of Benjamin Disraeli (who served twice as Great Britain's Prime Minister) that "what we have learned from history is that we haven't learned from history."

It will also harm our markets, once again.

Strategy: Short SPY

10 Also-Ran Suprises for 2015



Dec. 26, 2014 | 7:32 AM EST

Stock quotes in this article: BABASHLDIBMBRK.AMONIF

·       On Monday I will deliver my 15 Surprises for 2015.  I think it is my most interesting list in years.

Here are my 10 also-ran Surprises for 2015 that I had considered but didn't make the top 15.

1.       China's Real GDP growth falls below 5% in 2015 as economic growth decelerates markedly in the second half of the year.
 

2.      An accounting "discrepancy" is found at Alibaba (BABA). The shares plummet and the hedge fund community feels the pain.
 

3.      Under pressure from suppliers and a falling stock price, Ron Johnson is installed as CEO ofSears Holdings (SHLD).
 

4.      George Soros makes $2.5 billion by shorting German Bunds.
 

5.      The price of crude oil drops below $40 a barrel in the second half of 2015.
 

6.      The consumer price index turns negative (year over year).
 

7.      IBM (IBM) whiffs and the share price drops below $125 a share. Berkshire Hathaway(BRK.A) suffers a near-$4 billion loss (on paper). At Buffett's suggestion, senior management is replaced.
 

8.      Warren Buffett announces his successor.
 

9.      Uber goes public at a $50 billion capitalization. The share price never exceeds the IPO price in 2015.
 

10.  Monitise's (MONIF) subscription adds far outpace expectations this year. (The shares double in price).

Letter to My Nephews


By Jonathan Tepper

December 29, 2014 

You can learn a lot from books, but many things can only be learned the hard way by living, suffering and enjoying life.

A year and a half ago, I was in a plane with very bad turbulence, and I worried that if the plane went down, many of the lessons I’ve learned in life would end up at the bottom of the ocean.  I wrote a letter to my nephews for them to read when they were older.  I hope they’ll find it useful.

—————–

Dear nephews,

I’m writing this on a plane. The reason I started writing this was that I feared the plane might go down, and if it went down, all the lessons I’ve learned in life would disappear with me. By writing this, I hope to pass on the few lessons I’ve learned.

The most important lesson is that the vast majority of things you worry about will not bother you the next day. A year later you will not even be able to remember them if you try. When you grow older, you will not worry about what grades you got. You won’t worry about games you lost.   You won’t worry about what other people thought about you. Most of the things you worry about will never happen.
 
Even if the worst things that you worry about happen, life will still go on. Learn to enjoy every day, and try to enjoy it as if it is your last. It has taken me a long time to understand this, and I wish I had understood it sooner.

Happiness is not a destination but a journey. You will never be smart enough, rich enough, have a pretty enough girlfriend, boyfriend, husband or wife, or win enough prizes and awards. Whatever it is you want, there is always something better. Enjoy the journey of learning, working, and living. If you enjoy the journey, you’ll probably achieve a lot more than if you focused on goals.

Money can provide security, but once you have security, more money cannot buy you more happiness. If you show me someone who thinks money can buy happiness, I’ll show you someone who has never had a lot of money.

Things don’t make you happy, but memories will always stay with you. Whatever it is that you buy, you will soon get used to it. It will make you happy for a short while, but it will not make you happy forever. Experiences and memories can make you happy forever. I can’t even remember most of the toys I’ve had in my life, but I still think of my times with Timothy and your Grandmom with great happiness and fondness. I remember walking Timothy to school and how happy we were. I remember hugging your Gradmom when I came home for a weekend. Those memories will never go away. The happiest memories of my friends are my travels and dinners with them, not the things I’ve bought for myself. You’ll remember dinners and travels with friends and family more than any shiny things you’ll ever have.

Your family is the most important thing you have in life. Friends, boyfriends, girlfriends and co-workers come and go, but the only thing that you can always count on is your family. (If you find a friend who is always there for you, you’re extremely lucky. They exist, but they’re very rare.) One day, you will have your own family. You must love them and look after them. You will understand one day that just as your grandparents die, your parents will as well. Strive to be a good son and daughter. One day, you will be like your parents. Your parents are not perfect, and you will not be either. But you can be loving and be a good son and daughter. One day you can be a good parent.

Never stop learning, and always be ready to teach yourself things you don’t know. The only things you will remember are things you care about. You will forget about all the rest. You must teach yourself and care about what you learn. No one can teach you everything you need to know at school or university. You will also forget most of what you study, and that is fine. As Jacques Barzun said, “Civilization is all that remains after you have forgot all that you specifically set out to remember.”

Never live someone else’s life. Find your gifts and the things that give you pleasure, develop those gifts, and pursue them.   Do what makes you happy and be great at it. You have skills and gifts that no one will ever have or see again. If you’re a businessman, build businesses. If you’re a writer, write. If you’re a scientist, discover. If you do what you love and love what you do, you will work very hard, but you will enjoy every day.

One of the things that most influenced me was something Steve Jobs once said:

When you grow up, you tend to get told that the world is the way it is and your life is just to live your life inside the world, try not to bash into the walls too much, try to have a nice family life, have fun, save a little money.

That’s a very limited life. Life can be much broader once you discover one simple fact, and that is that everything around you that you call life was made up by people that were no smarter than you. And you can change it, you can influence it, you can build your own things that other people can use. Once you learn that, you’ll never be the same again.

And the minute that you understand that you can poke life and actually something will, you know if you push in, something will pop out the other side, that you can change it, you can mold it. That’s maybe the most important thing. It’s to shake off this erroneous notion that life is there and you’re just going live in it, versus embrace it, change it, improve it, make your mark upon it.

I think that’s very important and however you learn that, once you learn it, you’ll want to change life and make it better, cause it’s kind of messed up, in a lot of ways. Once you learn that, you’ll never be the same again.

I hope that you will find what you love and you will change the world.

Life is full of struggle, and many bad things will happen to you. This is one thing that I can guarantee you. Most of my friends died of AIDS, and your uncle Timothy died in a car accident and your Grandmother committed suicide after suffering from a very bad brain tumor. These things happened and cannot be changed. Many people suffer great tragedies and live full and happy lives. Remember the people you love and mourn them. Accept that terrible things happen, and try to live as if each day is your last with those you love. There is nothing else you can do.

The best way to avoid anxiety, stress and unhappiness is to avoid internal contradiction. Don’t think that one thing is right and do the opposite. Listen to your conscience and obey it. Be a good person and live according to your convictions. You cannot answer for other people, but you can always answer for yourself. As long as you live according to your most basic beliefs, you will not have regrets or guilt. You will be able to die happily knowing that you looked after the poor and needy, that you were loving to those around you, and that you failed often but did your best. You will not lose a night of sleep if you always try to do your best.

I love you very much.

Much love,

Uncle Jonathan