What Will the Next Crisis Look Like?


One of the main topics of discussion everywhere I go is, what will the next crisis look like; along with: Where will it come from; what will the market response be; and what will be the source of the volatility? There is always volatility during a crisis.

I have been saying in writing for some time that I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space. Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century. Given the massive amount of high-yield bonds that have been stuffed into mutual funds and ETFs, when the prices of those funds begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.

My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen – and he has 25 years of experience as a high-yield trader. There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again.

But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.

But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box. He sees additional sources of weakness coming from other areas, too.

Frankly, the lack of volatility is beginning to worry me a bit. Minsky constantly reminded us that stability begets instability. Stability is a pretty good word to describe the current markets – but such stability always ends in a “Minsky moment.” We don’t know when; we don’t know where it starts; but we know it’s coming.

There was a great deal of response, mostly positive, to last week’s Thoughts from the Frontline, “The Fragmentation of Society.” If you haven’t read it, you might want to. I hadn’t recognized the similarities between today and 1968 until I was reminded of them by Dr. Kolanovic and his essay.

But having lived through that era, I do get it. I think the next financial crisis will also be a trigger for a social crisis, not unlike 1968 and its aftermath. Remember, part of the follow-on was the collapse of Bretton Woods when Nixon took the US off the gold standard in 1971. Economic crises have big consequences. I will be writing about some of the current pressures again this weekend.

Until then, have a great week. Housing expert John Burns is coming by tonight, and I’m going to take him to my favorite local hole-in-the-wall BBQ hangout, called Smoke, in West Dallas. That neighborhood is starting to get gentrified, but it hasn’t changed the exquisite level of their barbecue. They serve a monster barbecued beef rib that raises your cholesterol even as you stare at it. It’s to die for. Hopefully, not literally.

Your who moved my volatility analyst,

John Mauldin, Editor
Outside the Box


What Will the Next Crisis Look Like?

By Marko Kolanovic, PhD, and Bram Kaplan

Next year marks the 10th anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50th anniversary of the 1968 global protests against political elites. Currently, there are financial and social parallels to both of these events. Leading into the 2008 GFC, some financial institutions underwrote products with excessive leverage in real estate investments. The collapse of liquidity in these products impaired balance sheets, and governments backstopped the crisis. Soon enough governments themselves were propped by extraordinary monetary stimulus from central banks. Central banks purchased ~$15T of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2018. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis. We will call this hypothetical crisis the “Great Liquidity Crisis” (GLC). The timing will largely be determined by the pace of central bank normalization, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006. We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis:

·         Decreased AUM of strategies that buy Value Assets: The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The ~$2T rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.

·         Tail Risk of Private Assets: Outflows from active value investors may be related to an increase in Private Assets (Private Equity, Real Estate and Illiquid Credit holdings). Over the past two decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private Assets increased by ~20%. Similar to public value assets, private assets draw performance from valuation discounts and liquidity risk premia. Private assets reduce day-to-day volatility of a portfolio, but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis.

·         Increased AUM of strategies that sell on ‘Autopilot’: Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~$1T over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.

·         Trends in liquidity provision: The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion), to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.

·         Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multi-asset portfolios. An analogy is with the 2008 failure of endowment models that assumed Emerging Markets, Commodities, Real Estate, and other asset classes are not highly correlated to DM Equities. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk. Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models.

·         Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks. Sign of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial crypto- coin offerings’ that in many cases have very questionable value.

 
We believe that the next financial crisis (GLC) will involve many of the features above, and addressing them on a portfolio level may mitigate the impact of next financial crises.
 
What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor (e.g., see here). Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others.
 
To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.


UAE: the Middle East’s power broker flexes its muscles

From the rise of Iran’s influence, to frustration over US engagement, events have shaken up the once risk-averse, oil-rich Gulf state

by Andrew England and Simeon Kerr in Abu Dhabi




Behind roadblocks and newly laid roads, workers are putting the finishing touches to a gleaming “floating dome” that emerges from the sand like a large spaceship. The 7,000-tonne latticed structure is the centrepiece of a new Louvre that will finally open in Abu Dhabi next month.

The museum is the flagship project of the emirate’s multibillion-dollar development plans — the latest instalment of its efforts to present itself to the world as a tolerant global city that links east and west. It forms part of a plan conjured up a decade ago by an ambitious younger generation of leaders.

Back then, the talk in the United Arab Emirates’ capital was about weaning the economy off its dependence on oil and equip a youthful population, raised in a conservative society, with the skills to prosper in the modern world.

But a militaristic element has been added to Abu Dhabi’s grandiose vision. The UAE, steered by Abu Dhabi’s rulers, has deployed combat troops to the battlefields of Yemen since 2015, introduced national service and emerged as one of the region’s most interventionist foreign policy players.


Emirati military troops during UAE National Day in December 2015 © EPA


“It’s no longer the cuddly little Switzerland,” says an executive and long-term resident of the UAE.

Popular uprisings that rocked the Arab world in 2011, the rise of Isis, frustration with former US president Barack Obama and concerns about Iran have converged to shake up the Middle East and shape the thinking of the once risk-averse, oil-rich Gulf state. The UAE is now pursuing a strategy it criticises its rivals Qatar and Iran for: intervening in its neighbours’ affairs in pursuit of its own national security goals.

It joined Saudi Arabia, Bahrain and Egypt in cutting diplomatic and transport links with Qatar in June and, in the words of regional officials and analysts, is “driving from behind” on the embargo. The UAE backs Khalifa Haftar, the military strongman in Libya, violating a UN arms embargo on the country to boost his air power, according a UN report. It has also built a military base at the Eritrean Red Sea port of Assab and is deploying its petrodollars to help counter Qatar’s influence over Hamas, the Palestinian militant group.

The transformation of Abu Dhabi, and the UAE’s foreign policy, is traced to the 2004 death of Sheikh Zayed bin Sultan al-Nahyan, who helped found the federation in 1971 and built its reputation as a low-key, neutral mediator.

Today, the UAE boasts what analysts describe as the region’s best equipped and trained military — a force developed with the aid of foreign advisers. These included Erik Prince, the co-founder of Blackwater, the private security company. Jim Mattis acted as an unpaid adviser to the UAE on how best to modernise its military before he became US defence secretary, and is credited with coining the phrase “little Sparta” to describe the nation’s military prowess.

“The assertive role Abu Dhabi is playing both in the Gulf and across the region is a world away from the consensual diplomacy of Sheikh Zayed’s era,” says Kristian Coates Ulrichsen, a research fellow at Rice University in the US. “As Abu Dhabi picks sides and tethers itself to the Saudi mast it risks becoming enmeshed in regional faultlines as never before.”


The 'chief executive': Crown Prince of Abu Dhabi and Deputy Supreme Commander of the UAE Armed Forces Sheikh Mohammed bin Zayed al-Nahyan © AFP


The man driving change is Sheikh Mohammed bin Zayed al-Nahyan, Abu Dhabi’s Sandhurst-trained crown prince, a son of the late leader. When his father died in 2004, Sheikh Mohammed’s elder half-brother, Sheikh Khalifa, became UAE president. But Sheikh Mohammed was long considered the “chief executive” and, with his half-brother ill, he has consolidated power.

Sheikh Mohammed is aided by a small group of trusted lieutenants including Yousef al-Otaiba, the UAE’s ambassador to the US. Mr Otaiba is said to be close to Jared Kushner, President Donald Trump’s son-in-law, and a White House adviser on the Middle East. Mr Otaiba is seen as one of the most influential diplomats in Washington. The UAE has paid millions to think-tanks and consultants to ensure its worldview is heard in the US capital, according to emails from Mr Otaiba that were leaked earlier this year by hackers keen to embarrass the Gulf state.

Sheikh Mohammed, 56, has also forged a close alliance with Crown Prince Mohammed bin Salman, Saudi Arabia’s powerful 32-year-old heir apparent. Both share visions of modernising their nations and brook little political dissent. They are hawks on Shia Iran, which Sunni-led Gulf states accuse of destabilising the Arab world, and deem political Islamist groups such as the Muslim Brotherhood — which took power in Egypt after the 2011 revolution before being ousted two years later — an existential threat to the absolute monarchies and the broader región.

UAE and US arms deals in Middle East


When Mr Trump called for new US sanctions on Iran this month and threatened to tear up the 2015 nuclear accord, the UAE and Saudi Arabia were among the few states to publicly applaud.

Abdulkhaleq Abdulla, an Emirati analyst, says the UAE’s assertiveness reflects a new-found confidence in Abu Dhabi over its “soft” and “hard” resources, ranging from its financial clout to strong relations with the west and growing military power. “It has dawned on them that they have lots of [levers] and they can cash in,” he says.

The emirate is home to the world’s second-largest sovereign wealth fund, the Abu Dhabi Investment Authority, which is estimated to have assets of more than $800bn. At the same time, its concerns about the neighbourhood are greater than “at any other time — more than after the Iranian revolution, the Iran-Iraq war and Saddam’s invasion of Kuwait,” Mr Abdulla says.

Prolonged low oil prices have forced even super-rich Abu Dhabi to delay projects and slash jobs at state entities. But the UAE continues to splurge on the latest weaponry.

UAE and Big defence spenders in Middle East


It has an indigenous population of more than 1m, about 10 per cent of the total. Yet in 2014, the most up-to-date estimate of military expenditure, the UAE spent $22.8bn on defence — ranking it 14th globally, according to the Stockholm International Peace Research Institute. Arms imports, mostly from the US but also Russia and others, increased 63 per cent between the periods of 2007-2011 and 2012-2016, Sipri estimates.

Emirati officials insist that the billions poured into culture, tourism and high-tech manufacturing can only bear fruit if the region is stable.

“We are putting all our focus on the generations to come and . . . we need a stable region to see the fruition of what we are doing today,” says Mohammed al-Mubarak, one of Abu Dhabi’s 18-member executive council, its top decision-making body.

But it is a high-risk strategy for a nation that prospered by staying clear of the turmoil that has blighted the region. “When a power is overstretched, it risks getting bruised,” says Mr Abdulla.

The UAE’s reputation has already been tarnished by concerns about the high number of civilian deaths and allegations of abuses in Yemen, where it is estimated that about 1,500 Emirati special forces are deployed as part of a Saudi-led coalition backing an exiled government fighting Iranian-allied Houthi rebels. Human Rights Watch has accused the UAE of supporting Yemeni forces that have abused dozens of people during security operations. The UAE and Saudi Arabia deny the claims.

“If they are going to get credit for things like their role in fighting terrorism,” says William Hartung, an analyst at the Center for International Policy, “it should be balanced with some of the consequences of their actions.”


Abu Dhabi's Louvre is set to open next month


Since the Saudi-UAE led coalition intervened in the Yemen conflict, the country has endured what aid agencies describe as the world’s worst man-made humanitarian crisis. Riyadh and Abu Dhabi say they are backing the legitimate government. Emirati troops have also been fighting al-Qaeda alongside US special forces.

Emirati officials acknowledge the cost of getting bogged down in a foreign land is both reputational and financial. Yet Sheikh Mohammed appears convinced of the UAE’s approach.

In a statement last year he spoke of the “heroic role” of the military in defending “Arab security against attempts to interfere in its domestic affairs and combating the forces of extremism”. He also hinted at a growing sense in the Gulf that it can no longer depend on Washington as its protector, adding that these factors “make self-reliance on our own defence capabilities a first priority”.

The sentiment is a legacy of Mr Obama’s presidency, much reviled in the palaces of the autocratic Gulf. The region’s leaders accused him of abandoning former Egyptian president Hosni Mubarak, in the tumult of the Arab spring. They also derided his decision to sign the nuclear deal with Tehran, believing it would embolden the Islamic republic. Relations have improved with the Trump administration, but Gulf officials acknowledge that the US president is unpredictable.

And the UAE, in alliance with Saudi Arabia, has taken matters into its own hands. Abu Dhabi and Riyadh led the embargo on Qatar, accusing it of sponsoring terrorism, meddling in regional affairs and backing political Islamist groups, despite it being a key US ally and host to America’s largest military base in the Middle East. So far, they have rebuffed US state department pressure to resolve the diplomatic crisis.

Emile Hokayem, a senior fellow for Middle East security at the International Institute for Strategic Studies, says that while the UAE is concerned about “US retrenchment . . . if you want to influence the US or other key actors you have to look credible, and a military build-up is essential in this respect”.

“The first strategy is to establish dominance, jointly with Saudi Arabia, on security and foreign policy in the Arabian peninsula. The second is to ally, co-opt or restrain actors in the first circle around the peninsula, Egypt and so on, and then identify and support allies in the third circle [globally],” he says.

“The crisis with Qatar is about telling the world ‘we are the ones who matter’.”

But there is a human cost. Two years ago, 45 Emirati troops were killed in a single day of fighting in Yemen, the deadliest incident in the UAE’s military history. Abu Dhabi has built an imposing monument to security forces killed in the line of duty — the vast majority in Yemen in the past two years.

The commemoration opened last year on Martyrs’ Day, a new public holiday that is part of efforts to foster a greater sense of nationalism and ensure domestic support for the UAE’s aggressive stance, observers say. So far, the leaders appear to have secured the buy-in of Emiratis. One businessman recalls how he told his son that he did not have to do national service, introduced in 2014 for 18-30 year-olds, because he was an only son. But the 18-year-old “begged me to do it”.

“If you speak to most UAE nationals they feel the Yemen [intervention] was a good thing because the Iranians are coming to the peninsula,” the businessman says. But he adds that the older generation worries that younger Emiratis are getting carried away with the “little Sparta” tag.“They think we are shaping the region,” the businessman says. “My problem is we are giving ourselves more weight than we deserve. When you start taking military action abroad you have a greater risk of something happening at home, especially when your people are less than 10 per cent of the population.”


Diplomatic battle: The UAE’s man in the US caught up in controversy

Yousef al-Otaiba’s almost 10-year tenure in Washington has coincided with the Gulf federation’s transformation from a low-profile US ally into a regional superpower keen to assert its national interest militarily. Confident and suave, the 43-year-old father of two is one of the most experienced and deft diplomats, quick to cultivate new relationships.

The son of the former oil minister, Mana al-Otaiba, he became a close adviser to Sheikh Mohammed bin Zayed al-Nahyan in the early 2000s. His appointment as US ambassador in 2008 showed the crown prince’s determination for a newly empowered UAE to seek a global reputation, a US official wrote in a diplomatic memo leaked this year.

Both informal and direct, officials say he does not hesitate to assert the UAE’s position, which is assumed to be a direct line from Sheikh Mohammed, and of late in lock step with Saudi Arabia. Abu Dhabi, a longstanding opponent of what it sees as Iran’s destabilising influence, has led efforts to undermine Islamist movements. Mr Otaiba has also co-ordinated the UAE’s diplomatic assault on Qatar, which the emirate and its Arab allies accuse of sponsoring terrorism.

In June, hackers began releasing messages from the ambassador’s personal email account. The trove of emails lifted the lid on Mr Otaiba’s outsized influence in the US, showing him spreading anti-Qatar messaging and detailing the UAE’s role in the conflict in Libya. They also dragged the ambassador into the multibillion-dollar scandal at the Malaysian sovereign wealth fund 1MDB, revealing meetings between Mr Otaiba’s business partner and Jho Low, a financier at the heart of the scandal.UAE officials say they will not comment on the emails, regarding the leak as a politically motivated attack. Simeon Kerr


Millions of Leaked Files Shine Light on Where the Elite Hide Their Money

By MICHAEL FORSYTHE

The offices of Appleby, an offshore law firm, in Hamilton, Bermuda. The company is at the center of leaked documents being called the Paradise Papers. Credit Meredith Andrews for The New York Times


The offices of Appleby, an offshore law firm, in Hamilton, Bermuda. The company is at the center of leaked documents being called the Paradise Papers. Credit Meredith Andrews for The New York Times

It’s called the Paradise Papers: the latest in a series of leaks made public by the International Consortium of Investigative Journalists shedding light on the trillions of dollars that move through offshore tax havens.

The core of the leak, totaling more than 13.4 million documents, focuses on the Bermudan law firm Appleby, a 119-year old company that caters to blue chip corporations and very wealthy people. Appleby helps clients reduce their tax burden; obscure their ownership of assets like companies, private aircraft, real estate and yachts; and set up huge offshore trusts that in some cases hold billions of dollars.

The New York Times is part of the group of more than 380 journalists from over 90 media organizations in 67 countries that have spent months examining the latest set of documents.

The Paradise Papers

A series of stories that reveal the offshore financial dealings of some of the world's biggest corporations and wealthiest people. Nearly 100 news organizations in an international collaboration examined more than 13 million leaked documents from a law firm, an offshore services company and corporate registries from tax havens.

As with the Panama Papers, the Paradise Papers leak came through a duo of reporters at the German newspaper Süddeutsche Zeitung and was then shared with I.C.I.J., a Washington-based group that won the Pulitzer Prize for reporting on the millions of records of a Panamanian law firm. The release of that trove of documents led to the resignation of one prime minister last year and to the unmasking of the wealth of people close to President Vladimir V. Putin of Russia.

The predominantly elite clients of Appleby contrast with those of Mossack Fonseca — the company whose leaked records became the Panama Papers — which appeared to be less discriminating in the business it took on. Much of the material makes for dull reading: Spreadsheets, prospectuses and billing statements abound. But amid these are documents that help reveal how multinational companies avoid taxes and how the superrich hide their wealth.

The records date back to 1950 and up to 2016.

Appleby has offices in tax havens around the world. In addition to is Bermudan headquarters, it works out of places the British Virgin Islands and the Cayman Islands in the Caribbean; the Isle of Man, Jersey and Guernsey off Britain; Mauritius and the Seychelles in the Indian Ocean; and Hong Kong and Shanghai.

Americans — companies and people — dominate the list of clients. Past disclosures, such as the 2013 “Offshore Leaks” from two offshore incorporators in Singapore and the British Virgin Islands, the 2015 “Swiss Leaks” from a private Swiss bank owned by the British bank HSBC and another leak in 2016 from the Bahamas were dominated by clients not from the United States.

The documents come not only from Appleby, but also from the Singaporean company Asiaciti Trust and official business registries in places such as Bermuda, the Cayman Islands, Lebanon and Malta.

Setting up companies offshore is generally legal, and corporations routinely do so to facilitate cross-border transactions such as mergers and acquisitions. Appleby, in a public statement on Oct. 24, after inquiries from I.C.I.J., said that it was “subject to frequent regulatory checks” in “highly regulated jurisdictions.”

“Appleby has thoroughly and vigorously investigated the allegations and we are satisfied that there is no evidence of any wrongdoing, either on the part of ourselves or our clients,” the company said.

But with this latest leak, some wealthy individuals and multinational corporations may think twice about using offshore ownership structures, said Jack Blum, a lawyer who worked for decades on congressional committees investigating money transfers overseas.

“The danger of being found out has increased exponentially,” Mr. Blum said in an interview.

“If I were a rich guy looking to hide money offshore so that the tax man won’t get me, my nightmare would be to put it in the hands of somebody whose documents leak.”

 Gold Speculators Refuse To Give Up; Another Drop Likely 

 
Normally winter is a good time for gold, with men buying their significant others jewelry for Christmas and lots of New Years Day marriage proposals. Here’s an overview of the dynamic from Adam Hamilton of Zeal Intelligence:
Seasonality is the tendency for prices to exhibit recurring patterns at certain times during the calendar year. While seasonality doesn’t drive price action, it quantifies annually-repeating behavior driven by sentiment, technicals, and fundamentals. We humans are creatures of habit and herd, which naturally colors our trading decisions. The calendar year’s passage affects the timing and intensity of buying and selling. 
Gold stocks exhibit strong seasonality because their price action mirrors that of their dominant primary driver, gold. Gold’s seasonality generally isn’t driven by supply fluctuations like grown commodities experience, as its mined supply remains fairly steady all year long. Instead gold’s major seasonality is demand-driven, with global investment demand varying dramatically depending on the time within the calendar year. 
This gold seasonality is fueled by well-known income-cycle and cultural drivers of outsized gold demand from around the world. And the biggest seasonal surge of all is just now getting underway heading into winter. As the Indian-wedding-season gold-jewelry buying that drives this metal’s big autumn rally winds down, the Western holiday season is ramping up. The holiday spirit puts everyone in the mood to spend money. 
Men splurge on vast amounts of gold jewelry for Christmas gifts for their wives, girlfriends, daughters, and mothers. The holidays are also a big engagement season, with Christmas Eve and New Year’s Eve being two of the biggest proposal nights of the year. Between a quarter to a third of the entire annual sales of jewelry stores come in November and December! And jewelry historically dominates overall gold demand. 
According to the World Gold Council, between 2010 to 2016 jewelry accounted for 49%, 44%, 45%, 60%, 58%, 57%, and 47% of total annual global gold demand. That averages out to just over half, which is much larger than investment demand. During those same past 7 years, that ran 39%, 37%, 34%, 18%, 20%, 22%, and 36% for a 29% average. Jewelry demand remains the single-largest global gold demand category. 
That frenzied Western jewelry buying heading into winter shifts to pure investment demand after year-end. That’s when Western investors figure out how much surplus income they earned during the prior year after bonuses and taxes. Some of this is plowed into gold in January, driving it higher. Finally the big winter gold rally climaxes in late February on major Chinese New Year gold buying flaring up in Asia. 
So during its bull-market years, gold has always tended to enjoy major winter rallies driven by these sequential episodes of outsized demand. Naturally the gold stocks follow gold higher, amplifying its gains due to their great profits leverage to the gold price. Today gold stocks are once again now heading into their strongest seasonal rally of the year driven by this robust winter gold demand. That’s super-bullish! 
Since it’s gold’s own demand-driven seasonality that fuels the gold stocks’ seasonality, that’s logically the best place to start to understand what’s likely coming. Price action is very different between bull and bear years, and gold is absolutely in a young bull market. 
After being crushed to a 6.1-year secular low in mid-December 2015 on the Fed’s first rate hike of this cycle, gold powered 29.9% higher over the next 6.7 months.

This is pleasant reading for anyone long gold or gold mining shares. But the futures markets continue to tell a different and less encouraging story. See Strange Things Happening In The Paper Gold Market, which noted that last month speculators were overly long and were as a result losing their shirts in the ongoing price correction — but were for some reason refusing to throw in the towel. The conclusion was that they’d need more convincing via another big price decline.

That decline happened — yet nothing has changed in the futures market. The speculators remain dangerously long and the commercials remain aggressively short, a structure which over the past decade has always preceded a price drop.



Here’s the same data presented visually. Note the trend flattening lately at bearish levels.




Now we’ll see whether favorable seasonal factors trump an unfavorable futures structure.

As always, this kind of analysis is fun and useful only for people looking for entry points. For stackers and other dollar cost averagers, monthly squiggles are meaningless on the long ride to $5,000.


Resurrecting Creditor Adjustment

ROBERT SKIDELSKY



LONDON – With all the protectionist talk coming from US President Donald Trump’s administration, it is surprising that no one has mentioned, much less sought to invoke, an obvious tool for addressing persistent external imbalances: the 1944 Bretton Woods Agreement’s “scarce-currency clause.”

That clause, contained in Article 7 of the agreement, authorizes countries, “after consultation with the [International Monetary] Fund, temporarily to impose limitations on freedom of exchange operations in the scarce currency”; and it grants those countries “complete jurisdiction in determining the nature of such limitations.” A country’s currency is considered scarce in the foreign-exchange market if it imports more than it exports – which is to say, if it runs a current-account deficit.
 
The scarce-currency clause has an interesting history. In his original plan for an International Clearing Bank, the British economist John Maynard Keynes proposed an escalating range of sanctions against member states that maintained continuous credit balances (and less onerous sanctions on countries with persistent debt balances). The idea was to pressure countries to reduce their current-account surpluses. Surplus countries would not be prevented from spending their money freely, but they would not be permitted to hoard it.
 
The United States, which was by far the world’s largest creditor, understandably refused to go along with Keynes’s proposal. As a result, the IMF was left to provide short-term financial help for deficit countries, and otherwise to uphold the orthodox doctrine of debtor adjustment. But, to placate the British, Harry Dexter White, the US Treasury official now remembered as the architect of the Bretton Woods Agreement, inserted Article 7 to allow dollar-deprived member states to restrict their purchases of US godos.
 
The scarce-currency clause has remained a dead letter ever since. In the early postwar years, the US plugged up European countries’ current-account gaps with Marshall Plan funds. By the early 1970s, the US itself was running trade deficits, and the dollar was in oversupply. The US Congress urged the IMF to invoke the scarce-currency clause against “recalcitrant” surplus countries, but its efforts were in vain. As the Princeton University historian Harold James has pointed out, the tables had turned: the US had taken up Keynes’s arguments, but creditor European countries, along with Japan, successfully resisted them.
 
Fast-forward to today. Of the world’s four largest economies, only the US suffers persistently weak competitiveness. China, Japan, and Germany, by contrast, are super-competitive. And because China has been willing, for its own reasons, to finance the US deficit, the dollar and the renminbi now seem to be locked into misaligned positions.
 
To redress this state of affairs, the economist Vladimir Masch suggests that the US should pursue a plan of “compensated free trade” (CFT), which essentially amounts to a unilateral activation of the scarce-currency clause. The Trump administration would set a ceiling on the US trade deficit each year, and then impose limits on major US trading partners’ surpluses.
 
This would largely affect China, Japan, Germany, and Mexico, which contributed $347 billion, $69 billion, $65 billion, and $64 billion, respectively, to the US’s $737 billion trade deficit in 2016.
 
Under Masch’s CFT arrangement, it would be up to each surplus country to limit its exports to the US. Countries could exceed their export quotas only if they paid a fine equal to the difference between the value of their actual and allowed exports. And if they tried to export more than allowed without paying the fine, their surplus exports would be blocked.
 
The problem with this plan is that it puts no pressure on Germany to reduce its surpluses with other eurozone countries. To be sure, after the 2008 global financial crisis, the European Union did establish a Macroeconomic Imbalance Procedure to fine eurozone countries with surpluses exceeding 6% of GDP or deficits exceeding 4% of GDP. But the MIP, even if it is in the spirit of Keynes’s proposal for an International Clearing Union, lacks two essential mechanisms.
 
First, Keynes’s plan would have automatically levied sanctions against persistent creditors, whereas the EU’s framework has proved incapable of doing so. Germany has exceeding 6% of GDP for over a decade with impunity. Although its surplus vis-à-vis the eurozone recently shrank to under 3% of GDP, that is largely a reflection of impoverished Mediterranean countries importing fewer German goods. If those countries’ economies recover and return to anything near full employment, the German surplus will likely rebound.
 
The MIP’s second flaw is that it lacks the omit protections for debtors that are afforded by the scarce-currency clause. Without the ability to devalue their currencies, the only recourse the eurozone’s persistent debtors have is to threaten to leave the single currency. But, as the Greek crisis demonstrated, this is not a credible threat. The result is that imbalances between creditors and debtors have been locked into place.
 
One way to unlock current imbalances would be to adapt the Bretton Woods mechanism. Each eurozone member state would pay into a European Monetary Fund in proportion to its national income and level of trade. And the Fund would have its own scarce-currency clause, allowing for member states to discriminate against imports from creditor countries.
 
In his wide-ranging speech at the Sorbonne last month, French President Emmanuel Macron for the creation of a European Monetary Fund, though he did not spell out the details of what he envisions. A mechanism that provides for trade discrimination could potentially violate the EU’s free-trade principles. And yet economic integration has always depended on some degree of creditor adjustment. Without it, a free-trade system will eventually break down. Advocates of open borders can pay now, or they will certainly pay later.
 
 
Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in history and economics, is a member of the British House of Lords. The author of a three-volume biography of John Maynard Keynes, he began his political career in the Labour party, became the Conservative Party’s spokesman for Treasury affairs in the House of Lords, and was eventually forced out of the Conservative Party for his opposition to NATO’s intervention in Kosovo in 1999.


Lemmings in Full Gallup Towards Cliff

By: Michael Pento


It's official…the stock market has broken above 23,000, and its valuations should now scare even the most mind-numbed carnival barker on Wall Street.  The forward 12-month PE ratio is 18, compared to the 10-year average of just 14. The 12-month trailing PE for Pro-forma earnings, which takes into account non-recurring items that seem to recur ever quarter, is trading at 20 times earnings. But on a reported earnings basis—the number you report to the SEC under penalty of the law and according to GAAP standards--the 12-month trailing PE is 25.5 times earnings.

The S&P 500 was 666 in March of 2009 and it is trading at 2,560 today. It has risen to such an absurd valuation that it is now destined to absolutely crash.

The market’s incredible ascent is a direct result of central banks that have printed $15 trillion of fake credit since 2009; and are still printing at the pace of $120 billion each month. This has compelled investors to pile into passively managed ETFs that indiscriminately send the stocks contained within it higher regardless of the fundamentals.  But once central banks become sellers of those assets the exact opposite dynamic will become true. Those asset sales will cause massive ETF redemptions on the part of the investing public, which will send individual stock prices plummeting and push ETF prices into a death spiral.

Therefore, we should all be fully aware where all the inflation created by central banks ended up. This isn’t your typical 1970’s style inflation that drove up CPI to 15%. Instead, the inflation has settled into asset prices, and the scenario is such that makes the conditions leading up to the Great Recession seem tame.

The S&P Core Logic Case Shiller National Home Price Index hit an all-time high in July; and this index is up 6.11% annualized over the last five years. Perhaps it is the unabated rise in home prices that has led Quicken Loans to recently offer a 1% down payment on home mortgages—as if offering mortgages to people with no skin in the game is a new and exciting idea!

The market cap of equities is 139% of GDP. For comparison, it was 66% of GDP in 1987 before the Dow dropped 23% in just one day. And Charles Schwab Inc. reports that new accounts openings are at levels they have not seen since the internet boom of the late 1990s, up 34% over the first half of last year. Add to this the record-high level of margin debt, minimal cash reserves, $3 trillion piled into passive ETFs (up 200% since 2009) and you will get a glimpse of how drastic the bubble has become.

But the greatest bubble in the history of bubbles resides in the sovereign bond market. The incredible $8 trillion in negative yielding sovereign debt and the unfathomable $1.6 trillion in corporate debt with a yield less than 0% has pushed stocks and real estate investors into a yield-chasing frenzy.

With markets this frothy there are good reasons to be cautious and to have a plan to protect your profits.  Here are some of the landmines that are set to explode shortly.

First, we have the Quantitative tightening, or reverse QE, on the part of the Fed. In September of this year, Janet Yellen unleashed plans to reduce the Fed’s 4.5 trillion-dollar balance sheet.

Starting this month, $10 billion of those bonds--$6 billion of Treasuries and $4 billion of mortgage bonds--will be peeled off the Fed’s massive balance sheet. The amount of bond sales will slowly increase until they get to $50 billion a month by October of 2018. After that, the monthly reductions will remain steady until the balance sheet is paired down by about $2 trillion.

Then we have Mario Draghi, Head of the European Central Bank (ECB). His program of buying 60 billion euros ($71 billion) of bonds a month is set to expire this December; and the ECB is expected to announce the tapering schedule for its QE scheme on October 26th.

In addition, we have escalating geo-political and military risk in North Korea and in Iran. By refusing to certify the Iranian Nuclear deal, President Trump has gotten under the skin of the terrorist-sponsoring nation, which has recently felt compelled to do some saber-rattling of its own. And then we have Trump’s favorite Twitter nemesis known as the North Korean rocket boy, Kim Jong un. A few days ago the North Korean deputy U.N. ambassador cautioned that the situation on the Korean Peninsula, "Has reached the touch-and-go point and a nuclear war may break out any moment."  He further warned that, "The entire U.S. mainland is within our firing range and if the U.S. dares to invade our sacred territory, even an inch it, will not escape our severe punishment in any part of the globe."

On top of this poop sandwich is the huge decline of earnings growth of the S&P 500. For 2017, the Q1 year-over-year earnings was 14.5%, Q2 came in at 11%, but FACT Set is projecting Q3 will come in at a paltry 1.7% yoy earnings growth.

Therefore, the only factor keeping the market still afloat is the misguided hope that Trump and Congress can deliver on sweeping tax cuts. Trump has assured that even though he, Mitch McConnell and Paul Ryan have gotten nothing done on other major legislative initiatives to date, they are poised to deliver the biggest tax relief in the history of our country…or even the world. However, with the Border Adjustment Tax gone and state and local tax deductions on life support, broad-based tax reform is becoming impossible to pay for. This means only a small tax cut is in play for next year because in order for the cut to comply with the Byrd rule under Reconciliation it cannot add to the deficit outside of the 10-year horizon. A short-term tax cut isn’t something most in D.C. espouse and its economic effect would be minimal.

Very soon it will become evident that there will be no significant tax reform, or cut, coming to support market prices—if one is to arrive at all. When combined with the credible threat of WWIII, central bank asset sales and the collapse in earnings growth; equities are very likely to fall “big league.” The key is to have a hedged strategy in place now that is designed to profit while we await the inevitable chaos to begin and to capitalize on the downfall once it starts. You still have time to extricate yourself from the Lemming herd that is about to take its third 50%+ investment cliff dive since 2000.


Strange Things Happening In The Paper Gold Market


Back in September the hedge funds that speculate with gold futures contracts got extremely bullish, which – since speculators are usually wrong when they’re overexcited – was a signal that gold would be going down for a while. It did:




Then things departed from the usual script. A falling gold price tends to make trend-following speculators bearish, which leads them to close out their long positions and expand their short bets. It also leads commercial players – the banks and fabricators that tend to be right at turning points – to start shifting from short to long.

But not this time. As the most recent commitment of traders (COT) report shows, speculators are staying long and commercials are staying short.





Here’s another way to visualize the process. The gray bars on the next chart represent the speculators and the red bars the commercials. Note how their positions tend to move in waves either away from or towards the middle line that represents zero. But lately their positions have flattened out.




The implication? It might take a bigger drop in gold’s price to make speculators and commercials switch sides.

This of course means nothing for gold’s long-term, highly-positive trend. But it does matter for traders who want to play the monthly or quarterly squiggles, and investors looking for entry points to buy bullion or mining stocks. That entry point might be a few weeks and another hundred or so dollars off.