Japanese Policy Failure Means Disaster For Us All

John Mauldin


This week’s Outside the Box is a little bit different. I’m going to start with a selection from Mohamed El-Erian’s latest note. Mohamed himself is soft-spoken and calm, and I tell you that because the piece that follows is as close to capitals, underlining, and bolding with lots of exclamation points as Mohamed can get. He continues to get more concerned about the direction of central bank policy around the world and its unknown and unintended potential consequences. I will just cut and paste part of Mohamed’s essay into this introduction.

I want to follow up with a presentation by Kevin Wilson at Blue Water Capital on Japan. Basically, this piece illustrates the potential problems created by the current philosophical direction that the Bank of Japan is taking in their country.
 
Essentially, Kevin is talking about the policy failure of Abenomics and the unintended consequences of negative interest rate policies (NIRP). A major economic disruption in Japan would have significant effects on the global economy. His summary sentence?

Given Japan's massive debt and demographic headwinds, the oncoming recession may trigger an endgame that would involve a possible depression and eventual default and devaluation.

That speculation sounds a lot like what I was writing in Endgame and Code Red.
 
While I see a little bit different outcome than Kevin does (in terms of what a default might look like), I think he has properly highlighted the concerns we should all have.

Now let’s look at Mohammed’s note:

Forced out of their mysterious anonymity and highly technical orientation, central banks have been dramatically thrust into the limelight as they have become single-handedly responsible for the fate of the global economy. Responding to one emergency after the other, they have set aside their conventional approaches and instead evolved into serial policy experimenters.

Often, and very counter-intuitively for such tradition-obsessed institutions, they have been forced to make things up on the spot. Repeatedly, they have been compelled to resort to untested policy instruments. And, with their expectations for better outcomes often disappointed, many have felt (and still feel) the need to venture ever deeper into unknown and unfamiliar policy terrains and roles.

For those accustomed to the conventional operation of economies and financial systems, all this constitutes nothing less than an unthinkable transfiguration for central banks. Yet the structural breaks have not stopped there.

What central banks have been experiencing is part of a significantly broader change whose effects will be felt by all of us, our children, and, most likely, their children, too. It is a change that speaks to much bigger and consequential evolutions in the global economy, in the functioning of markets, and in the financial landscape. And the implications go well beyond economics and finance, extending also to national politics, regional and global negotiations, and geopolitics.

Understanding the unplanned and, for them and many others, uncomfortable conversion of central banks from largely invisible institutions to the only policy game in town, provides us with a unique perspective on the much larger changes impacting our world. It speaks to the how, why, and so what by:

·         explaining how the global system has fallen further and further behind in meeting the legitimate aspirations of hundreds of millions of people on multiple continents, including those related to economic betterment, remunerative employment, and financial security; 

·         detailing why the world is having such difficulties growing, why countries are becoming increasingly unequal, and why so many people live with this recurrent sense of financial instability and even distress; and 

·         shedding light on why so many political systems struggle mightily just to understand fast-moving realities on the ground and catch up with them, let alone direct them to better destinations. By living in this world, most of us have already observed either directly or indirectly a set of unusual, if not previously improbable, changes.

It is a phenomenon that is being felt at multiple levels. And, so far, all this is just the beginning. In the years to come, this extremely fluid world we live in is likely to pull us further out of our comfort zones; and it will challenge us to respond accordingly. And we shouldn’t just wait for governments to make things better. Unless we understand the nature of the disruptive forces, including tipping points and T-junctions, we will likely fall short in our reaction functions. And the more that happens, the greater the likelihood we could lose control of an orderly economic, financial, and political destiny — both for our generation and for future ones.

To keep this introduction from getting overly long, I’m going to go ahead and hit the send button rather than adding my usual personal comments. Have a great week, and I think you will enjoy this weekend’s letter. It is guaranteed to make you think and is probably a little controversial as well. Let’s just say that it’s an open letter about economic policy to a potential future president.

Your continuing to be concerned about central bank policy analyst,

John Mauldin, Editor
Outside the Box




Japanese Policy Failure Means Disaster For Us All


By Kevin Wilson, Blue Water Capital
 
Summary

·         An underappreciated threat to the global economy involves the potential failure of Japan's NIRP measures, which, in conjunction with the apparent failure of Abenomics, may send Japan into its endgame.

·         Japanese interest rate, money velocity, inflation, GDP, trade, consumer, currency exchange, and banking data all provide evidence of the failure of Abenomics and the potential failure of NIRP.

·         The Japanese stock and bond markets also reflect extreme stress, but the macro outlook is such that apparently cheap stocks may actually be the biggest short ever (EWJ, DXJ, JOF).

·         Hoarding of cash and a surge in sales of personal safes are potential harbingers of a deflationary death spiral in which consumers simply do not respond to government actions.

Given Japan's massive debt and demographic headwinds, the oncoming recession may trigger an endgame that would involve a possible depression, and eventual default and devaluation.
 


 
For some time, now many analysts have been focused on at least three major threats to the global economy: 1) the risk of a hard landing and currency devaluation in China; 2) the chance that Italy's failing banks and weakening economy will trigger the next round of the European financial crisis; and 3) the potential for a major credit crisis and trade collapse in emerging markets, as commodities continue their collapse and the dollar holds strong. There are, of course, other threats to the global economy as well, including one that should be getting more media coverage than it has: the chance that "Abenomics" fails and Japan finally gets to its endgame. Since the BOJ shifted unexpectedly to NIRP in late January, signs have started to appear that not only is NIRP failing to deliver on its promised improvements so far, but the opposite has transpired instead.
 




 
It was already evident that there were problems with Abenomics even before the NIRP decision. For example, the velocity of money has continued to fall, inflation has stayed stubbornly low or negative, household incomes were declining rather than rising, household spending declined sharply as the tax increases from Abenomics kicked in, and as a result, consumer confidence in Japan has been negative for years on end.
 




 
The yen initially fell dramatically under Abenomics, but has made little or no progress towards a lower valuation in the last 18 months or so. The yen was supposed to weaken even more under NIRP, but has instead paradoxically strengthened, at least in the short run.
 


 
Japanese banks sold off massively in response to the decision on NIRP. Even the newly minted Japan Post Bank, which just had its IPO six months ago, plummeted over 20% below its IPO price, according to Gillian Tett of the Financial Times. The JGB yield is now negative out to 10-year maturities.
 


 
Once again, Japanese bonds have defied the short-sellers and produced a capital gain for holders. Indeed, as renowned perma bear Albert Edwards of SocGen pointed out recently, for Japanese investors, the total return on the JGB 30-year bond has beaten that from the MSCI Global Equity Index over the last 15 years.
 


 
Demand for cash in Japan, always relatively high, has increased since the NIRP decision, according to Naohiko Baba, Tomohiro Ota, and Yuriko Tanaka at Goldman Sachs. They note that demand for cash is now very sensitive to interest rates, even to the point that cash and deposits are nearly perfect substitutes. Since deposit rates are so low now, there is little penalty or downside in holding cash. Not coincidentally, sales of household safes for storing (hoarding) cash have soared in Japan since the NIRP decision.
 


 
Hoarding is about the worst consumer outcome one can imagine, relative to the ultimate success or failure of Abenomics. Of course, years of market underperformance, deflation, and ZIRP have convinced Japanese consumers (the famous mythical investor "Mrs. Watanabe") to preserve cash assets and avoid stocks. Clearly, the BOJ's recent NIRP decision has backfired with the already fearful average Japanese consumer. The number of banknotes in circulation in Japan is extremely high relative to GDP and to other national economies, such as those of the USA, Switzerland, the eurozone, Denmark, and Sweden. This is in part due to a Japanese cultural preference for cash, and in part due to the long-term decline in deposit rates. Note that all of these, except the USA, already have NIRP in place, in some cases for years now.
 




 
As I have said elsewhere, the debt-deflation cycle in Japan has resisted Keynesian and monetary stimulus, including extreme measures like QQE and ZIRP, for years. Japan is again entering recession, deflation has again reared its head, and trade has given up its early gains under Abenomics and is now in serious decline again. Virtually every aspect of Abenomics is now in failure mode, and since the reform part of the package has never been enacted, it is unlikely that the government can regroup in a meaningful way under present conditions.
 


Years of stubborn adherence to theory has scared the populace into a semi-permanent skepticism and deep fear about what is coming. The government, despite its good intentions, has failed to sell the deal. Now, the Japanese government faces a thoroughly discouraged and mistrusting consumer, who is hoarding cash in the same way that many people did during the Great Depression. A deflationary death spiral may be on the way. The Japanese corporate sector has not responded to calls from the government to increase wages, but it has been willing to exploit cheap money for some malinvestment games, like share buyback programs.
 


 
Given the absolutely enormous debt load on the Japanese economy, and the structural headwinds they face as a result of deteriorating demographics, it seems to me that the Japanese economy, as noted years ago by author John Mauldin, is "a fly in search of a windshield."
 


 
I believe the failure of NIRP is going to provide that metaphorical windshield in the next two years or less, as Japan at last faces its endgame. I make this somewhat bold prediction based on the fact that the country is already monetizing the majority of their deficit, has more income from debt than they do from tax receipts, has already conducted the biggest QQE stimulus on the planet by far, and will face far worse trouble as the recession takes root.
 
Something like this was predicted years ago by Mauldin and his co-author Jonathan Tepper (see their book Endgame, 2011, John Wiley & Sons, New York, 318p). Those who think Japanese stocks (EWJ, DXJ, JOF) look cheap right now should bear in mind that the macro picture is about to turn as ugly as it ever gets. In fact, in my opinion, Japan Inc. is the biggest short ever, just as hedge fund manager Kyle Bass said it would be. And if you are looking for something that could finally trigger a US recession, as suming we are not already in one by then, I think an event like this would easily qualify.
 




Emerging-market debt

The well runs dry

Why borrowing in dollars is central to the business cycle in developing countries
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OIL PRICES have perked up a bit, but producers are still reeling from the slump in crude prices last year. The boss of Pemex, Mexico’s state-owned oil firm, said this week that the company faced a “liquidity crunch”. Malaysia’s state oil firm is laying off workers. Petrobras, Brazil’s troubled oil giant, recently secured a $10 billion loan from the China Development Bank to help it to pay off maturing bonds. The trouble at these firms underlines broader concerns about the burden of corporate debt in emerging markets. A particular worry for resources firms is the rising cost of servicing dollar debts taken out when the greenback was much weaker than it is now. Short-term dollar loans to be repaid with earnings in falling currencies featured prominently in past emerging-market crises. But the concern about the role of dollar lending in the current cycle is different.

The numbers are startling. Corporate debt in 12 biggish emerging markets rose from around 60% of GDP in 2008 to more than 100% in 2015, according to the Bank for International Settlements (BIS).

Places that experience a rapid run-up in debt often subsequently endure a sharp slowdown in GDP.

An extra twist is that big emerging-market firms were for a while able to borrow freely in dollars. By the middle of last year, the stock of dollar loans to non-bank borrowers in emerging markets, including companies and government, had reached $3.3 trillion. Indeed until recently, dollar credit to borrowers outside America was growing much more quickly than to borrowers within it. The fastest increase of all was in corporate bonds issued by emerging-market firms.

Jaime Caruana, the head of the BIS, argues that a global liquidity cycle—the waxing and waning of dollar borrowing outside America—helps to explain the slowdown in emerging-market economies, the rise in the dollar’s value, and the sudden oil glut. When the dollar was weak and global liquidity was ample thanks to the purchase of Treasuries by the Federal Reserve (so-called “quantitative easing”, or QE), companies outside America were happy to borrow in dollars, because that was cheaper than borrowing in local currency. Capital inflows pushed up local asset prices, including currencies, making dollar debt seem even more affordable.

As long as the dollar remained weak, the feedback loop of cheap credit, rising asset prices and strong GDP growth could continue. But when the dollar started to strengthen, the loop reversed. The dollar’s ascent is tied to a change in America’s monetary policy which began in May 2013, when the Fed first hinted that it would phase out QE. When the Fed’s bond-buying ended in October 2014, it paved the way for an interest-rate increase 14 months later. The tightening of monetary policy in America has reduced the appetite for financial risk-taking beyond its shores.

The impact of this minor shift on the value of the dollar has been remarkable, particularly against emerging-market currencies (see chart 1). Wherever there has been lots of borrowing in foreign currency, the exchange rate becomes a financial amplifier, notes Mr Caruana. As companies scramble to pay down their dollar debts, asset prices in emerging markets fall.

Firms cut back on investment and shed employees. GDP falters. This drives emerging-market currencies down even further in a vicious cycle that mirrors the virtuous cycle during the boom. Since much of the credit went to oil firms, the result has been a supply glut, as producers pump crude at full tilt to earn dollars to pay down their debts.
.


Mr Caruana’s reading of events has dollar borrowing at its centre. Yet the sell-off in emerging-market currencies has more to it. Rich countries that export raw materials, including Australia, Canada and Norway, have also seen their currencies plummet against the dollar. Falling export income as a consequence of much lower oil and commodity prices is likely to have played a similar role in the slump in other currencies.

Some analysts think the problem of dollar debt is blown out of proportion. There are countries, such as Chile and Turkey, where dollar debts loom large (see chart 2). But the average dollar share of corporate debt in emerging markets is just 10%. Chinese firms account for more than a quarter of the $3.3 trillion of dollar loans to emerging markets—and since August, when fears surged that the yuan would be devalued, they have been swapping dollar loans into yuan, notes Jan Dehn of Ashmore Group, a fund manager.


Much of the foreign-currency debt taken out by companies elsewhere was long-term: the average maturity of bonds issued last year was more than ten years, for instance. That pushes refinancing, and the associated risk of default, far into the future. In many cases, dollar debt is matched by dollar income—even if, as in the case of oil exporters, it is much diminished by low prices. And there are pots of dollars in emerging-market banks to which indebted companies may have recourse.

In any event, the dollar’s ascent has stalled because of concerns about America’s faltering economy and doubts that the Fed can raise interest rates again. Yet the cycle of dollar lending nevertheless has implications that may not be fully appreciated. A recent study of firm-level finances by Valentino Bruno and Hyun Song Shin of the BIS found that emerging-market firms with strong cash balances are more likely to issue dollar bonds. That goes against a tenet of corporate finance, that firms only borrow to invest once they have exhausted internal sources of funds. It suggests that financial risk-taking was the motivation for borrowing. On average, 17-22 cents of every dollar borrowed by an emerging-market company ends up as cash on the firm’s balance-sheet. Such liquid funds could go into bank deposits, or be used to buy other firms’ commercial paper or even to lend to them directly.

In other words, the authors say, companies seem to be acting as surrogate financial firms. As a result, dollar borrowing spills over into easier credit conditions in domestic markets.

This is one of the ways the dollar-credit cycle exerts a strong influence over overall lending in emerging markets. The credit cycle took an apparently decisive turn last year. The stock of dollar credit to emerging markets stopped rising in the third quarter, says the BIS, the first stalling since 2009. Dollar credit is much harder to come by than it was. So are local-currency loans. Bank-lending conditions in emerging markets tightened further in the fourth quarter, according to the Institute for International Finance. The dollar may have peaked but, for emerging markets, tight financial conditions are likely to endure.


Donald Trump embodies how great republics meet their end


The Americans will have to decide what sort of person they want to put in the White House
 
James Ferguson illustration©James Ferguson
 
 
What is one to make of the rise of Donald Trump? It is natural to think of comparisons with populist demagogues past and present. It is natural, too, to ask why the Republican party might choose a narcissistic bully as its candidate for president. But this is not just about a party, but about a great country. The US is the greatest republic since Rome, the bastion of democracy, the guarantor of the liberal global order. It would be a global disaster if Mr Trump were to become president. Even if he fails, he has rendered the unthinkable sayable.
 
Mr Trump is a promoter of paranoid fantasies, a xenophobe and an ignoramus. His business consists of the erection of ugly monuments to his own vanity. He has no experience of political office. Some compare him to Latin American populists. He might also be considered an American Silvio Berlusconi, albeit without the charm or business acumen. But Mr Berlusconi, unlike Mr Trump, never threatened to round up and expel millions of people. Mr Trump is grossly unqualified for the world’s most important political office.
 
Yet, as Robert Kagan, a neoconservative intellectual, argues in a powerful column in The Washington Post, Mr Trump is also “the GOP’s Frankenstein monster”. He is, says Mr Kagan, the monstrous result of the party’s “wild obstructionism”, its demonisation of political institutions, its flirtation with bigotry and its “racially tinged derangement syndrome” over President Barack Obama. He continues: “We are supposed to believe that Trump’s legion of ‘angry’ people are angry about wage stagnation. No, they are angry about all the things Republicans have told them to be angry about these past seven-and-a-half years”.
 
Mr Kagan is right, but does not go far enough. This is not about the last seven-and-a-half years.

These attitudes were to be seen in the 1990s, with the impeachment of President Bill Clinton.

Indeed, they go back all the way to the party’s opportunistic response to the civil rights movement in the 1960s. Alas, they have become worse, not better, with time.

Why has this happened? The answer is that this is how a wealthy donor class, dedicated to the aims of slashing taxes and shrinking the state, obtained the footsoldiers and voters it required. This, then, is “pluto-populism”: the marriage of plutocracy with rightwing populism. Mr Trump embodies this union. But he has done so by partially dumping the free-market, low tax, shrunken government aims of the party establishment, to which his financially dependent rivals remain wedded. That gives him an apparently insuperable advantage. Mr Trump is no conservative, elite conservatives complain.

Precisely. That is also true of the party’s base.
Mr Trump is egregious. Yet in some respects the policies of his two leading rivals, Senators Ted Cruz and Marco Rubio, are as bad. Both propose highly regressive tax cuts, just like Mr Trump. Mr Cruz even wishes to return to a gold standard. Mr Trump says that the sick should not die on the streets. Mr Cruz and Mr Rubio seem to be not quite so sure.
 
Yet the Trump phenomenon is not the story of just one party. It is about the country and so, inevitably, the world. In creating the American republic, the founding fathers were aware of the example of Rome. Alexander Hamilton argued in the Federalist Papers that the new republic would need an “energetic executive”. He noted that Rome itself, with its careful duplication of magistracies, depended in its hours of need on the grant of absolute, albeit temporary, power to one man, called a “dictator”.
 
It is unwise to assume constitutional norms in the US would survive the presidency of someone who neither understands nor believes in them
The US would have no such office. Instead, it would have a unitary executive: the president as elected monarch. The president has limited, but great, authority. For Hamilton, the danger of overweening power would be contained by “first, a due dependence on the people, secondly, a due responsibility”.

During the first century BC, the wealth of empire destabilised the Roman republic. In the end, Augustus, heir of the popular party, terminated the republic and installed himself as emperor.

He did so by preserving all the forms of the republic, while he dispensed with their meaning.

It is rash to assume constitutional constraints would survive the presidency of someone elected because he neither understands nor believes in them. Rounding up and deporting 11m people is an immense coercive enterprise. Would a president elected to achieve this be prevented and, if so, by whom? What are we to make of Mr Trump’s enthusiasm for the barbarities of torture?

Would he find people willing to carry out his desires or not?

It is not difficult for a determined leader to do the previously unthinkable by appealing to conditions of emergency. Both Abraham Lincoln and Franklin Delano Roosevelt did some extraordinary things in wartime. But these men knew limits. Would Mr Trump also know limits? Hamilton’s “energetic” executive is dangerous.

It was the ultra-conservative president Paul von Hindenburg who made Hitler chancellor of Germany in 1933. What made the new ruler so destructive was not only that he was a paranoid lunatic, but that he ruled a great power. Trump may be no Hitler. But the US is also no Weimar Germany. It is a vastly more important country even than that.

Mr Trump may still fail to win the Republican nomination. But, should he do so the Republican elite will have to ask themselves hard questions — not only how this happened, but how they should properly respond. Beyond that, the American people will have to decide what sort of human being they want to put in the White House.
 
The implications for them and for the world of this choice will be profound. Above all, Mr Trump may not prove unique. An American “Caesarism” has now become flesh. It seems a worryingly real danger today. It could return again in future.


What Did The ECB Do?

The Nattering Naybob


Discussion of the potential effects on equity, bond, commodity, capital and asset markets regarding:

ECB Announcement; The 3 things the ECB Did.

The 4 things the ECB Announced; Market Reactions.


The ECB did three things:
  1. dropped the main refinancing rate to zero from 0.05%
  2. cut the deposit rate to -0.4 from -0.3%
  3. cut the marginal lending facility rate to 0.25 from 0.30%


The ECB announced four things:
  1. expanded its quantitative easing asset buying to 80 billion euros ($88.7 billion) a month from 60 billion euros
  2. for the first time, investment grade non bank debt (read euro corporate bonds) are now eligible for purchase
  3. announced from June 2016 to March 2017 at a quarterly frequency, a new series of four targeted longer term refinancing operations (TLTRO II), each with a maturity of four years with the possibility of repayment after two years.
  4. Draghi said that further rate cuts would "probably" NOT be necessary.

Market Reactions

Core ECB government bond yields barely reacted. Upon further review, the deposit rate cut to -0.4% makes 80% of German bunds now eligible for ECB purchase.

Above note, percentage of core ECB bonds in negative territory. Around 50% of government bonds in Europe trade with negative interest rates, which amounts to about $3.5T.
 
 
Above note, a chart from year-end 2015 showing Switzerland and other ECB countries with negative bonds.
 
The initial FX reaction saw the Euro plunge vs USD. Upon further review, on reduced prospects of further deposit rate cuts, the Euro reversed and advanced vs USD, as in, price the Euro for recovery?

Initially European markets surged on the news. Upon further review, with future cuts "probably" not in the cards, European markets hit the panic button and sold off into the close.
 
Draghi: "The amount that banks can borrow is linked to the amount of loans they have on their balance sheet, So a bank that is very active in granting loans to the real economy can borrow more than a bank that concentrates on other activities."
 
Upon further review, with the new round of TLTRO, four year loans being offered at the main refinancing rate of 0% (with an additional discount for more active lenders as mentioned above), which could take that rate negative, effectively banks could get paid to borrow by the ECB.
 
This alleviated fears of further NIM (net interest margin) compression or squeeze on bank profits. Under the radar, bank shares rallied 6%.

Above note, a workout on bank NIM's in NIRP.
 
On the surface, paying the banks to borrow with the stipulation that they make "real economy" loans, and put them on their balance sheet, sounds good. Upon further review, this ECB press release included the following advisory/disclaimer: "Further technical details of the TLTRO II operations will be announced in due course."
 
The definition of insanity is doing the same thing over and over again and expecting different results. QE has not worked in the US, Japan or Europe, yet central banks keep insisting on more of what has put the global economy in its current sorry state. Results of the ECB announcement TBD, in due course.
 
This is the 18th in a series of thematically related missives which will attempt to identify the macroeconomic forces with potential to adversely effect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive, to one of my mentor's Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence in not masticating and spoon feeding the baby ducks, as in learning the hard way, by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard
 
Since the market potential is broad in both scope and scale, our conclusion: more grief in the dollar "short" or squeeze and its associated liquidity issues, with the potential to adversely effect capital, commodity, equity, bond and asset markets. Will it happen? TBD, and forewarned is forearmed.
 
As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this would tie into any list of investments or assets. Those listed below happen to influence the indices more than most.
 
Would like to thank you folks fer kindly droppin in. You're all invited back again to this locality. To have a heapin helpin of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!
 
Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment's value. Past performance is, of course, no guarantee of future results.


Brazil’s political and economic crisis

Standing by their man

The accusations against a former president make a tense situation even more fraught
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THE Speaker of Congress’s lower house indicted for corruption; the country’s most revered politician detained by the police and then charged; a billionaire sentenced to two decades behind bars.

All this happened in Brazil this month. In 2014, when investigators made the first arrests linked to a bribery scandal at Petrobras, the state-controlled energy giant, few imagined that courts and the police would reach so deeply into the country’s elites. The fearlessness of law-enforcers cheers Brazilians, who are fed up with high-level impunity. But their recent successes deepen the country’s political paralysis and do nothing to alleviate its economic crisis.

The giant-killing began on March 3rd, when the supreme court voted to charge Eduardo Cunha, Speaker of the federal Chamber of Deputies, with accepting bribes linked to the award by Petrobras of contracts for building two oil-drilling ships. The chief prosecutor accuses him of managing the Petrobras “bribe pipeline”, which channelled billions of reais from construction firms to executives and politicians in the ruling coalition in exchange for padded contracts. Mr Cunha denies wrongdoing. On March 8th a federal court sentenced Marcelo Odebrecht, the former boss of Brazil’s largest construction conglomerate, which bears his family name, to more than 19 years in prison for corruption and money-laundering.

The biggest shock was the brief detention for questioning by police on March 4th of Luiz Inácio Lula da Silva, Brazil’s former president and the mentor of its current one, Dilma Rousseff (pictured with him above). The bribery scheme appears to have started while Lula, as he is universally known, was in office from 2003 to 2010. Prosecutors say they have evidence that Lula, members of his family and the Lula Institute, an NGO he heads, received “undue advantages” worth 30m reais ($8m) after he left office from building firms embroiled in the affair. Lula was “one of the principal beneficiaries of the crimes” committed at the oil company, prosecutors allege. He denies any wrongdoing. After being released without charge, he fulminated against “persecution” and intimated that he would run for president again in 2018. On March 9th, in a separate investigation, São Paulo state prosecutors charged him with failing to declare ownership of a sea-side property. He says he is not the owner.

Where this leaves the country is uncertain. The real interrupted its recent slide, and São Paulo’s stockmarket surged by 18%, following Lula’s detention. The markets are hoping that, as the Petrobras investigations progress, Ms Rousseff will eventually be forced out of office and a new government will take charge of the economy, which is in the midst of the worst recession in decades. But uglier scenarios seem at least as likely.

Survival mode
 
After Lula’s detention, Gilberto Carvalho, a leading light of his (and Ms Rousseff’s) left-wing Workers’ Party (PT), warned investigators in a newspaper interview against “playing with fire”. José Guimarães, the PT’s leader in the lower house of Congress, urged supporters to wage “political war” against “coup-mongers”. A journalist covering the events at the former president’s flat in São Bernardo do Campo, on the outskirts of São Paulo, was roughed up for representing “fascist media”.

Feelings are likely to rise still higher on March 13th, when anti-government groups plan to hold demonstrations across the country to renew their demands for Ms Rousseff’s impeachment.

The organisers, a hotchpotch of social movements ranging in ideology from centrist to loonily right-wing, hope to bring out more than the record 1m people, disproportionately from the middle class, who protested a year ago. The government’s supporters plan counter-demonstrations on the same day.

The threats to Ms Rousseff are growing. One motion to impeach her, on the grounds that she used accounting trickery to hide the true size of the budget deficit in 2015, is being debated in the lower house of Congress. To that charge her foes want to add fresh allegations that she tried to interfere with the Petrobras probes, which she denies. Brazil’s electoral tribunal is investigating whether Petrobras money helped finance her re-election campaign in 2014; its mastermind, João Santana, was arrested last month. If the tribunal concludes that the campaign was tainted, it could annul the election and call a new one.

The president’s survival strategy relies on mobilising her left-wing base. That is one reason she has failed to tackle the budget deficit, which widened to 10.8% of GDP in January. This has sapped confidence in the economy, which contracted by 3.8% in 2015 and is expected to shrink by as much this year. The PT’s opposition to austerity is likely to harden after the detention of Lula, who is still lionised by the left for his pro-poor policies.

But Ms Rousseff’s embrace of the PT risks alienating her centrist allies, whom she also needs. It is hard to impeach a president: both houses of Congress must vote in favour by two-thirds majorities. But that hurdle is not insurmountable. Just 100 left-wing deputies in the 513-seat lower house would never vote for impeachment, reckons João Castro Neves of Eurasia Group, a consultancy. In addition, Ms Rousseff needs 70-odd centrists to avoid the threat.

As the economy worsens and the president’s approval ratings remain barely above 10%, some are likely to waver. Members of the Party of the Brazilian Democratic Movement (PMDB), the centrist party of the vice-president, Michel Temer, are likely to call for a break with the government at a convention on March 12th. The indictment of Mr Cunha, also a member of the PMDB, may weaken the president still further. He was a leading champion of impeachment and a big obstacle to Ms Rousseff’s (half-hearted) efforts to rein in the budget deficit. But the threat of a Petrobras-related indictment limited his effectiveness. Anti-government forces may now find a less encumbered leader.

Ms Rousseff may yet survive until the end of her term in 2018. The demonstrations against her take place on Sundays, which limits their impact. The electoral authority will not annul her election without clear proof of wrongdoing, which has yet to surface. The PMDB may stick to its tactic of supporting Ms Rousseff in exchange for patronage. The party may not want to burden Mr Temer, who would succeed her if she is impeached, with responsibility for dealing with political paralysis and a stricken economy. But this month’s turbulence leaves the president weaker, Brazil less governable and policy adrift.


Gold and the US Monetary Base Signals the Greatest Depression

By: Hubert Moolman



Gold is currently trading in excess of $1200 an ounce. This is well above the 1980 all-time high.
 
However, this is an incomplete representation of what gold is trading at relative to US dollars.
 
When you look at the gold price relative to US currency in existence, then it is at its lowest value it has ever been. This is an example of how paper assets are completely out of tune with tangible (real assets).
 
The US monetary base basically reflects the amount of US currency issued. Originally, the monetary base is supposed to be backed by gold available at the Treasury or Federal reserve to redeem the said currency issued by the Federal Reserve. The Federal Reserve does not promise to pay the bearer of US currency gold anymore; however, it does not mean that gold (it's price and quantity held), relative to the monetary base has become irrelevant.
 
When the US monetary base gets too big relative to the gold price (& US gold reserves), then market forces seek to correct the situation. This has happened a number of times over the last 100 years, but on two occasions, it was so critical, that the situation actually overcorrected. This was during the 30s and the 70s.
 
Below is a chart from inflation.us, which illustrates this:
 
Historical Percentage of US Monetary Base Back by Official US Gold Reserve
 
 
It shows the extent to which the US monetary base was backed by the official US gold reserves over the last century. Note that even under the gold standard, US currency was not fully backed by gold.
 
One can see the two occasions (1933 & 1970) when the lack of gold backing became so critical that the gold price corrected to a situation where US gold backing actually became more than 100%.
 
What differentiate these two occasions from other times when the ratio of US gold backing was also low (like 1921, for example), is the timing relative to economic conditions. The low level of gold backing in 1933 came after a period of massive credit extension (the roaring 20s), and a few years after the Dow's 1929 peak. At that time (post 1933) the economic conditions were such that the ability to extend credit was severely limited, due to the excesses caused by the credit extension during the 20s. This led to reduced economic activity over the following years.
 
In a similar manner, the 1970 low level of gold backing came after a period of massive credit extension (post-war period), and a few years after the 1966 Dow peak. At that time (post 1970) the economic conditions were such that the ability to extend credit was severely limited, due to the excesses caused by the credit extension during the post-war period (to early 60s).
 
This led to reduced economic activity over the following years. Note that the 70s were a bit different because debt levels relative to GDP were low as compared to the 30s.
 
Currently, the gold backing of the US monetary base is at all-time lows, and it appears that we have reached a point similar to that of 1933 and 1970. In a similar manner to the 20s and the post-war period, we had massive credit extension from the late 80s. Furthermore, the Dow appears to have peaked like it did in 1929 and 1966.
 
This period seems to be more like the 30s than the 70s because debt levels relative to GDP are excessively high. Deteriorating economic conditions, with high relative debt levels and an inability to extend credit further are the worse conditions for banks to operate under. These were the main reasons for the banking crisis of 1933.
 
This will be the main reasons for the coming (already happening) banking crisis. The lack of confidence in banks will be a critical part of the coming gold rally. Remember that if we were to get a 100% gold backing of the US monetary base, based on current US official gold reserves, gold would have to be trading in excess of $15 000.

Greatest Depression
 
Previously, I have written about the Gold to Monetary Base ratio chart. There is a strong fractal analysis signal that the worst economic (and political) years are straight ahead, and this agrees with the expectation above. I believe the coming period will be far worse than the Great Depression.
 
Below is that Gold to Monetary Base ratio chart (from macrotrends.net), I have previously featured, as well as some commentary (italics) that went with it:
Gold to Monetary Base Ratio
 
On the chart, I have indicated the three yellow points (a) where the Dow/Gold ratio peaked. These all came after a period of credit extension, which effectively put downward pressure on the gold price. Points 2 were placed just to show the similarities of the three patterns.
 
After the peak in the Dow/Gold ratio and point 2, the Gold/Monetary Base chart made a bottom at point 3 on each pattern. It is at these points that the monetary base could not expand relatively faster than the gold price increased. Today, this could mean that the point at which the game is up for those who are short gold.
 
I do not know if point 3 is in on the current pattern; however, given the fact that the bullion banks are under pressure as indicated in the spike in the gold coverage ratio at the COMEX, it might well be.
 
Since then, the ratio has started spiking upwards, due to the spike in the gold price, and the drop in the adjusted monetary base. It actually seems that point 3 could very well be in.
 
After point 3 in November 1932 and December 1970, very bad economic years followed. During the Great Depression 1932 and 1933 was in fact the worst years of the entire Depression. Again, current pattern (or period) is more like the Great Depression period than that of the 70s.
I believe we will will have similar events in the immediate future:
  • gold and silver revaluation (probably mainly in the open market) - this will mainly be in the form of currency devaluation.
  • major government (especially the USA) and corporate bankruptcies/defaults
  • increase in wars (all kinds of wars)
  • banking collapse
  • and much more...


When you compare the current pattern (1980 to 2016) to that of the Great Depression one (1920 to 1932), it gives you a visual of how much worse the current depression (The Greatest Depression) will be.

Volkswagen

Emission impossible

The German carmaker will escape its emissions scandal largely unscathed. That is bad news for a firm in need of an overhaul           



VOLKSWAGEN’S new boss, Matthias Müller, was no doubt hoping that his firm’s launches of new models at the Geneva motor show this week would help it move on from the scandal over its cheating in emissions tests. A British prankster had other ideas. As VW’s sales chief, Jürgen Stackmann, unveiled a new version of the Up city car, Simon Brodkin, a comic whose past targets include FIFA’s former boss, Sepp Blatter, gatecrashed the presentation in overalls, with a spanner and a “cheat box” which he tried to fit to the car (see picture), before being led off by security men.

Mr Müller can afford to see the funny side of the stunt: he owes his job to the scandal. He was brought in to replace Martin Winterkorn, who was forced out when it emerged last September that 11m of the company’s diesel cars had been fitted with software to cheat tests for nitrogen-oxide emissions. This week VW admitted that Mr Winterkorn had been sent a memo in May 2014 about irregularities in the cars’ emissions, but said he may not have read it. Speaking to The Economist in Geneva, Mr Müller promised “monumental change”. But whatever VW does to make amends, the more far-reaching overhaul that it needs seems unlikely to happen.

The emissions scandal was a symptom of a corporate culture focused on ramping up output to 10m vehicles a year and toppling Toyota as the world’s biggest carmaker. In the quest for scale, profitability suffered. Operating profits have hovered around €12 billion ($13 billion) for years despite a big expansion in output, with the group’s huge returns from China disguising poor performance in Europe and losses in America and emerging markets.

Mr Müller says he is determined that VW not be “paralysed” by the emissions affair. Its sales fell in Europe and America in January even as their overall demand for new cars rose. But Mr Müller says 2016 has started well and that he expects little lingering impact from the scandal. He may be right. General Motors’ faulty ignition switches and Toyota’s “unintended accelerations” forced both firms to make huge recalls and generated plenty of bad press. Yet sales recovered within a few months.

Uncertainty about financial penalties will hang over VW for some time. It has delayed its annual report for 2015 until April, when the picture should be clearer. America’s Department of Justice could in theory levy a fine of €60 billion but it is unlikely to go that far. Some analysts reckon that the cost of settling with the authorities and private litigants, worldwide, and fixing the affected cars or compensating their owners, might come to a grand total of as much as €30 billion—roughly the amount by which VW’s stockmarket value has fallen since the scandal broke. Others think it could be far less: both GM and Toyota escaped with fines of around €1 billion.

If paying for its perfidy proves painful but not life-threatening, the impetus to overhaul VW will lose some of its force. Change is needed. VW is a sprawl of brands of varying fortunes. Almost two-thirds of its profits come from its premium-car brand, Audi, and performance-car division, Porsche (see chart 1). The main VW brand is a drag on the group: Sanford C. Bernstein, a research firm, reckons that in 2014 the brand’s profits essentially came from parts sales and royalties (paid by its joint ventures) in China, and that it made no money in its core European market.

Mr Müller is making a start by attempting to revamp the culture of a company in which hitherto a strict hierarchy sent decisions, big and small, to the German engineers that ran VW from its headquarters in Wolfsburg. Mr Müller has replaced seven out of ten senior executives.

Some are outsiders, though many of the “new” faces are, like Mr Müller, VW insiders ingrained in the firm’s ways. He is, however, trying to speed up sclerotic decision-making by giving the heads of the group’s profusion of brands more responsibility.

A comprehensive restructuring plan is promised for later in the year, but the firm has said it will concentrate harder on profits. As a start, it will make €1 billion of cost cuts at the VW brand next year. But analysts reckon the company, which alone among big carmakers failed to reduce costs during the financial crisis, has plenty more fat to cut. For no good reason, its administrative expenses have trebled since 2007.

The firm will also cut the extravagant number of model variations it offers—more than 300 at last count—and its absurdly long lists of options. The choice of steering wheels on the VW Golf is set to fall from 117 to a mere 43. VW will “reconsider all costs”, says Mr Müller, including even its hallowed research-and-development budget. In 2014 it was €13 billion, €5 billion more than Toyota’s. But it is unclear what VW’s huge outlays have yielded. It missed the craze for SUVs, it is lagging its main rivals in electric-car technology and it lacks a cheap platform for budget cars in emerging markets. A project to standardise the underpinnings of many VW group models with a platform called the MQB seems not to be producing the expected cost savings.

Mr Müller is resistant, however, to disposing of any part of the firm, even a unit that makes marine diesel engines. A gruff “No” is his response when asked if he would consider selling it, though it is unclear that this division, or another that builds lorries, or Ducati, a maker of exotic motorbikes, is a core part of VW.

The most intractable problem is low productivity, especially at the mass-market VW brand. The group’s labour costs have risen from around 13% of sales in 2007 to almost 17%. Outside China (where it makes cars in joint ventures with local firms), the group’s 520,000 workers made 6.7m vehicles in 2014, or about 13 each. That is about the same productivity as at Daimler’s Mercedes division, which makes only high-margin premium models (see chart 2).

As other carmakers have shifted production to low-wage countries, VW has remained largely stuck in Germany. Some 45% of its employees are based there, many enjoying a four-day work week. The VW brand’s German factories are “among the highest-cost plants in the industry”, says Patrick Hummel of UBS, a bank.

But VW’s commitment to Germany is absolute. “We are a German company”, says Mr Müller, and will “preserve German jobs”. Powerful unions would be sure to resist job cuts. Mr Müller says that they agree on the need for reform but admits to disagreement over how it might happen. Unions could also prevent a wider rethink that might shift investment from the VW brand to others that are more profitable. The supervisory board, made up largely of union representatives and nominees of the state of Lower Saxony, which holds a 20% stake in VW, has the power to resist most changes of strategy.

Maybe an outsider with a mandate for change, if backed by the Porsche-Piëch family, which controls the voting shares, could have achieved more. But Mr Müller’s hands seem tied. The good bits of the VW group will continue to prop up the underperforming bits. That burden may get heavier: premium and low-cost carmakers are thriving while the mass market, the core of VW’s business, becomes more competitive. Odd as it sounds, VW could have done with a bigger crisis.


Barron's Cover

Trump or Clinton: Who’s Better for Investors?

Why Republicans will likely hold their noses and vote for Hillary in the 2016 presidential election.

By John Kimelman                

 
On the presidential campaign trail, Hillary Clinton has called out Wall Street for wrecking Main Street during the financial crisis. And her desire to jack up taxes on short-term capital gains isn’t exactly good news for the investor class.

Yet Clinton, the strong favorite to win the Democratic nomination, seems better suited to help the markets than the Republican front-runner, Donald Trump. With a Trump-Clinton race looking more likely after last week’s Super Tuesday voting, Barron’s has sized up each candidate’s positions on taxes, spending, trade, and other issues that directly affect markets.

Our conclusion: Clinton is the more investor-friendly of the two.
 
Photo: Daniel Acker/Bloomberg
 
 
Her recent rhetoric aside, Clinton’s moderate political instincts and left-center policy goals suggest a president who wouldn’t stand in the way of the financial markets. A fan of compromise and a knowledgeable Washington player, she might even be able to strike a bargain with House Speaker Paul Ryan and Senate leaders on tax reform.

Just look at the company she keeps. Many Wall Streeters, including Roger Altman, executive chairman of Evercore; Marc Lasry, chairman of Avenue Capital Group; and George Soros, chairman of Soros Fund Management, are supporting her candidacy and contributing to her campaign and political action committees.

“Hillary would be fairly predictable, and markets like predictability,” says Greg Valliere, the chief strategist of Horizon Investments and a well-known handicapper of the political scene.

“She is a bit more moderate than Obama, and despite all the concerns that she would repeat the Obama agenda, she would be more willing to compromise,” particularly on efforts to lower tax barriers that prevent U.S. corporations from repatriating profits made abroad.

Make no mistake. We are not endorsing Hillary Clinton for president of the United States. Nor are we saying that she would be the best president for investors from among the current crop of candidates. We are simply weighing the impact of a President Clinton on the financial markets, based on her stated positions and past actions, against those of her most likely rival, Donald Trump.
 
Photo: Drew Angerer/Bloomberg
 
 
Though some of Trump’s tax-cutting initiatives could potentially help both the economy and markets, those tax cuts coupled with his adamant refusal to address ballooning entitlement costs, such as Medicare and Social Security, would expand the national debt to the breaking point. On top of that, his call for heavy tariffs against China could cause a trade war that would devastate the world economy. In a cover story last fall (“Trump Is Wrong on China,” Nov. 14), we noted that Trump’s tariff plans were reminiscent of the protectionist policies of the 1920s and early 1930s that plunged us into the Great Depression.

Clinton, by contrast, hasn’t offered any ideas that are overly risky for the economy or markets, though her aggressive stance of driving down prescription-drug costs has Big Pharma investors concerned. Like Trump, Clinton has yet to offer a realistic plan to cut spending on entitlements, which make up about two-thirds of federal spending.

Valliere, who advises his firm’s institutional-investor clients, adds that he knows a number of professional investors who are considering “holding their nose and voting for Hillary, because the devil you know is better than the one you don’t know.”

Even David Kotok, a top money manager who doesn’t plan to vote for Clinton, thinks she can please the markets. “As far as being market-friendly, Hillary is a formidable contender,” says the chairman of $2.4 billion Cumberland Advisors. “There is a substantial constituency in the markets that could find her a very acceptable president.” Kotok is a Republican and plans to vote for John Kasich in the coming Florida primary.

Many Americans have trouble voting for Clinton because they are troubled by her reputation for accepting campaign contributions and personal favors from special-interest groups, including the financial-services industry. Six-figure speaking fees, not to mention large contributions to the Clinton Foundation, certainly call her objectivity into question. Then there’s her poor judgement when, as secretary of state and the nation’s top diplomat, she used a private computer server to conduct government e-mail communication.

That has led to a FBI investigation into whether national security was compromised. If Clinton is indicted on charges arising from her e-mail practices, it could destroy her candidacy. It’s difficult to gauge the odds of this happening.

ANY APPRAISAL OF TRUMP must factor in his brash personal style, which is a turnoff to many. Though he gave a restrained speech after his Super Tuesday victories, Trump’s penchant for put-downs, which was much on display at the Republican debate on Thursday night, reveals a personality type that many view as unsuited to the presidency.

His initial failure to strongly repudiate the support of former Ku Klux Klan Grand Wizard David Duke has raised questions about his political character. Then there’s a nagging concern that Trump, a career real estate developer and reality-television star, hasn’t properly schooled himself in the myriad issues a president will face.
 
                
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Trump’s refusal to release his recent tax returns to the general public raises the question of what he has to hide. Normally, the failure of a candidate to release his tax returns would be a big deal, says Valliere, “but I think he’ll get away with it because he gets away with everything.” Clinton has posted the past eight years of her returns on her Website.

In recent days, a number of leading Republicans have voiced fears of a Trump presidency, including 2012 Republican nominee Mitt Romney, who in a scathing speech called Trump “a phony” and “a fraud” who “has neither the temperament nor the judgment to be president.” Indeed, the Republican Party appears to be ginning up a Stop Trump movement, which could throw the nomination open to a vote in a brokered convention come July.

“Trump is not presidential,” says a leading hedge fund manager who requested that his name not be used. “He is appealing to people’s worst instincts. And I can’t stand Hillary Clinton. She is pandering to the 99%. She is not a person of integrity.”

All of that may be true, but the likelihood of a Clinton-Trump matchup in November is growing. A CNN poll of Democrats nationwide conducted on Feb. 24-27 has Clinton leading Sanders 55% to 38%, and a CNN poll of Republicans has Trump with 49%, Marco Rubio at 16%, and Ted Cruz at 15%. If the polling data over the past month is any indicator, Clinton and Trump have both gained steam in recent weeks as they piled up primary victories.

SHOULD CLINTON WIN the presidency, investors can expect a president whose tax, spending, and trade proposals will be easily processed by markets, assuming they make it through Congress.

Clinton plans to encourage long-term investment by raising the short-term capital-gains rate on couples making more than $465,000 per year. She also wants to effectively raise the marginal income-tax rate to 43.6%, from 39.6%, on taxable income of more than $5 million, according to the Tax Foundation.

Her tax-raising agenda focuses on the wealthy and leaves most other Americans untouched. Republicans in Congress will probably oppose such a hike, but some Wall Streeters have spoken favorably of her plans.

By contrast, Trump’s more ambitious and business-friendly agenda cuts the corporate tax rate to 15% from the current 35% and consolidates the seven current tax brackets into four, with a top marginal rate of 25%, according to the Tax Foundation.

He would also create a special repatriation tax of 10% on the foreign profits of U.S. companies to encourage them to invest those funds in the U.S., as part of the effort to spur capital investing and hiring in the U.S.

Cumberland Advisors’ Kotok believes that Trump’s ideas for lowering taxes and bringing U.S. corporate earnings abroad back to the U.S. are appealing and could help spur some economic growth. “I would characterize it as a modernist version of the supply-side argument,” he adds.

But there are questions about whether this plan would create added problems for the economy while creating new jobs. A study of Trump’s polices by the Tax Foundation concluded that while they would cut taxes by close to $12 trillion over the next decade, the costs would also expand the federal debt by more than $10 trillion, a dangerous development.

And there are no guarantees that most of these repatriated profits will be put to good use.

Indeed, past efforts to offer tax breaks or holidays to encourage repatriation haven’t always resulted in companies hiring millions of new workers in the U.S. or building new plants. A study by the nonpartisan National Bureau of Economic Research of the last U.S. tax holiday, in 2004, found that “repatriations did not lead to an increase in domestic investment, employment, or R&D, even for the firms that lobbied for the tax holiday stating these intentions.”

Then there’s the political feasibility of it all. “Our concern with Trump’s 15% corporate tax rate…is not in the policy merits, but in the politics,” wrote David Bahnsen, the chief investment officer of the Bahnsen Group, a wealth management firm, on Forbes.com. “Because Trump has offered no specifics about how to pay for it, and because we think he would face a very challenging relationship with Congress, we cannot be excited for this tax reform because we do not believe it will happen in its present form.”

For all of Trump’s bold talk, much of his plan to “make America great again” could prove to be fiscally impractical. And his aggressive tariff threats could cause turmoil with our trading partners, whether or not those plans see the light of day. The more temperate Clinton is promising less when it comes to revitalizing the U.S. economy and bringing competitors like China to heel. But sometimes less is more.