Debt Clock Ticking

By John Mauldin

 TFTF Image

Rather go to bed without dinner than to rise in debt.

—Benjamin Franklin
 

What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?

—Adam Smith
 

There are no shortcuts when it comes to getting out of debt.

—Dave Ramsey
 

Modern slaves are not in chains, they are in debt.

—Anonymous

 
Debt isn’t always a form of slavery, but those old sayings didn’t come from nowhere. You can find hundreds of quotes on the Internet discussing the problems of debt. Debt traps borrowers, lenders, and innocent bystanders, too. If debt were a drug, we would demand it be outlawed.

The advantage of debt is it lets you bring the future into the present, buying things you couldn’t afford if you had to pay full price now. This can be good or bad, depending on what you buy. Going into debt for education that will raise your income, or for factory equipment that will increase your output, can be positive. Debt for a tropical vacation, probably not.

And that’s our core economic problem. The entire world went into debt for the equivalent of tropical vacations and, having now enjoyed them, realizes it must pay the bill. The resources to do so do not yet exist. So, in the time-honored tradition of lenders everywhere, we extend and pretend. But with our ability to pretend almost gone, we’re heading to the Great Reset.

I’ve been analogizing our fate to a train wreck you know is coming but are powerless to stop. You look away because watching the disaster hurts, but it happens anyway. That’s where we are, like it or not.

And we don’t even really like to talk about it in polite circles. In a private email conversation this week, which must remain anonymous, this pithy line jumped out at me:

The total of Federal (remember they do not use GAAP) debt, state debt, and city debt [unfunded liabilities included] exceeds $200 trillion dollars. There is no set of math that works to pay this off. Let me be sure it’s heard by repeating it: There is no set of math that works to pay this off. Therefore, there has to be some form of remediation. This conversation is uncomfortable, so it is avoided.

Today’s letter is chapter 5 in my Train Crash series. If you’re just joining us, here are links to help you catch up.


Last week, we discussed the Italian political crisis and potential eurozone breakdown. That is a dangerous possibility, but far from the only one. As we’ll see today, the world has so much debt that the cracks could happen anywhere.

I said above that if debt were a drug, we would outlaw it. But we also know that people get hooked on illegal drugs all the time. The law doesn’t stop them. Likewise, common sense and regulations don’t stop us from overusing debt. And as we will see, the withdrawal can be painful indeed.

First, a quick announcement. If you have any interest in the mining and energy resource sectors, be on the lookout for an email from my partner, Ed D’Agostino. He is going to interview one of the top speakers from my Strategic Investment Conference—Marin Katusa. Marin is an expert in the resource sector and he impressed the crowd at the SIC with his sector knowledge. You’ll want to hear what Marin has to say.

I’ve followed Marin’s career for the last fifteen years, and I greatly respect his opinion of the mining and energy resource sector. I encourage you to listen in on Ed’s interview.
 

Three years ago, the McKinsey Global Institute released a massive research report called Debt and (not much) Deleveraging. It reviewed the global debt situation and where it might be taking us. The answers were not pleasant. I wrote about it at the time in Living in a Free-Lunch World.

The McKinsey team created this fascinating graphic summing up the world debt situation as of mid-2014.


Source: McKinsey Global Institute

 
From the Great Recession’s beginning through Q2 2014, global debt grew $57 trillion to $199T. (From here on, I will use capital T to denote trillions, since we must use the word distressingly often). That includes household, corporate, government, and financial debt. It does not include unfunded liabilities.

Dr. Woody Brock wrote this week:

CBO projections show that within 18 years, entitlements spending will absorb all US federal tax revenues—leaving no revenues even for interest expense on the debt and for the military. In Germany, which proudly pays annually for its expenditures without incurring debt, Deutsche Bank has estimated that by 2045, income tax rates of 80% (total, not marginal rates) would be needed for its PAYGO system. The entire workforce of the nation would be in bondage to the elderly. Other nations face even worse prospects.

I should note that the CBO projections assume no recessions and an optimistic compound 3% growth rate. I think most of my readers would assume that neither will end up being the case.

But even $199T back in 2014 was a lot of money. We should also note that, through the magic of double-entry accounting, each dollar of debt liability appears on someone else’s balance sheet as a $1 asset. Debt is wealth, if you are the lender. Most of you reading this probably are, in some fashion.

(If we could somehow make this debt magically disappear, we would also make wealth disappear, but we may have to do exactly that. This is a serious problem we will address later in this series. For now, just note that I am aware of it.)

McKinsey calculated that from 2007–2014, world debt levels grew at a 5.3% compound annual growth rate. That was slower than the previous seven years but still considerably faster than the world economy grew. Hence, debt as a share of world GDP rose to 286%.

Not all the debt categories grew equally. Government debt grew far faster than household, corporate, or financial debt. Household debt growth fell to a relative crawl, from 8.5% annual growth in 2000–2007 to only 2.8% in 2007–2014. Which makes sense because families had little choice but to deleverage, often via bankruptcy.

Government and corporate borrowers faced no such pressure. Their debt kept growing at a slightly higher pace after the recession. Yes, some corporations hunkered down and rebuilt their balance sheets. Most did not. They kept borrowing and lenders kept lending, encouraged by central bank-generated liquidity.

This is an important point I’ll return to in future letters. We talk a lot about profligate governments running up debt, and rightly so, but they are not alone. Businesses are equally and sometimes more addicted to debt. That would be fine and even positive if it were funding innovation and new production. But much of this new corporate debt paid instead for share buybacks that reduce equity, leaving the corporation more leveraged. That seems to be what shareholders want. They should beware what they wish for.
 

As far as I know, McKinsey has not updated that 2015 report, but we can get similar data from the Institute for International Finance’s Global Debt Monitor.
 


 
The totals aren’t the same as McKinsey showed for those years, so I suspect they have different data sources. They’re close enough for our purposes, though.

Adding together the same-colored bars, we get these global debt totals:

  • 1997:   $74T

  • 2007:   $167T

  • 2016:   $216T

  • 2017:   $238T

If those are accurate and my math is right, global debt grew at an 8.5% compound rate from 1997 to 2007. Then it slowed to 3.6% from 2007 through 2017. That’s good. We went on a worldwide debt diet.

But last year, we appear to have binged because debt grew 10.2% from 2016 to 2017. Breaking it down by sector, non-financial corporate debt grew 11.1%, government debt grew 6.7%, household debt grew 12.5%, and financial sector debt grew 11.3%, all in calendar 2017.

Looking only at 2017, government debt seems to be the least of our problems. The biggest debt growth was everywhere else. But why did it suddenly accelerate last year? In part, because the world economy grew enough to let global debt-to-GDP ratios fall slightly.

Here’s another IIF chart showing global debt as a percentage of GDP for both “mature” (what they call developed countries) and emerging markets:


 
The developed world is far more leveraged than the EM world, but EM countries are no pikers at 210%. They often lack the stabilizing resources developed countries possess, too. IIF points to Argentina, Nigeria, Turkey, and China for the largest debt ratio increases last year. But many emerging market businesses and financial companies borrowed money in dollars, as the dollar was relatively weak and US interest rates ridiculously low.
 
Further, our yield-hungry investors, both as individuals and its institutions, were more than willing to lend to them to get something more than 1–2% that they could from sovereign bonds.

This level of emerging market debt is unsustainable because, among other reasons, debt matures and must be either repaid or refinanced. Here’s emerging market debt by maturity:


 
Some $4.8T in emerging market debt matures from this year through 2020, much of which will need to be rolled over at generally higher rates and, if USD strength continues, in a disadvantageous currency environment. Will that be possible? I don’t know, but we’re going to find out—possibly the hard way.

But that’s a relatively minor concern. We have a much bigger one back home.
 

The IIF report includes this note about US corporate debt:

US non-financial corporate debt hit a post-crisis high of 72% of GDP: At around $14.5 trillion in 2017, non-financial corporate sector debt was $810 billion higher than it was a year ago, with 60% of the rise stemming from new bank loan creation. At present, bond financing accounts for 43% of outstanding debt with an average maturity of 15 years vs. the average maturity of 2.1 years for US business loans. This implies roughly around $3.8 trillion of loan repayment per year. Against this backdrop, rising interest rates will add pressure on corporates with large refinancing needs.
 

I see at least three alarming points in this paragraph.

First, corporate debt is now 72% of GDP. That’s in addition to the government debt that is approaching (or has passed depending on how you count debt) 100% of GDP and household debt at 77% of GDP. Add in 81% financial sector debt, and the US combined debt-to-GDP ratio is near 330%.

Second, 60% of new corporate debt is coming not from bond sales but new bank loans—and those bank loans have much shorter maturity, averaging 2.1 years. That means refinancing time is coming for much of it, and rates are not going lower.

Third, IIF infers about $3.8T in corporate loan repayments each year­—just in the US. That’s a lot of cash companies need to find and I’m not sure all can do it. Aside from higher interest rates, the companies that need credit (as opposed to high-rated ones that borrow only because they can do it cheaply) tend to be riskier.

From a recent Moody’s report, we see that 37% of US nonfinancial corporate debt is below investment grade. That’s about $2.4T.


Source: Moody's Investors Services

 
The proportion is similar globally. Furthermore, all corporations, both investment grade and speculative, added significantly more leverage since the Great Recession.


 
Again, not all leverage is the same. Some companies borrowed to fund share buybacks but have vast cash flow and reserves. They can easily deleverage if necessary. Smaller, riskier companies have no such choice. I think they present the greatest systemic risk.

That said, it’s still a bit mind-boggling that, even after the Great Recession, just a decade later the average non-financial business went from 3.4x leverage to 4.1x. They are now roughly 20% more leveraged than they were the last time all hell broke loose. CEOs and boards seem to have learned little from the experience—or maybe learned too much. If you believe the Fed has your back, then leveraging to the moon makes sense.

Now, I know some readers will take comfort in the fact that 63% of the corporate debt is rated investment grade. But as they say in Texas, hold on, cowboy, don’t ride away so fast. A lot of that debt is rated BBB, the lowest investment grade rating. For the glass half-empty crowd, that means they are just one step above junk. The chart below from my friend Rosie (David Rosenberg) shows that the number of BBB-rated companies is up 50% since 2009.


Source: David Rosenberg

 
The problem, as I described in High Yield Train Wreck, is that bondholders and lenders won’t wait for the rescuers. When funds and ETFs, which hold BBB debt, start getting redemptions, investors won’t hang around to see which domino falls next. Institutions have rules that will make them start selling troubled bonds early. Liquidity probably won’t be there. Clearing the market will require sharply lower prices, which will create more selling pressure and eventually recession.

To further exacerbate the problem, the rating agencies that didn’t react quick enough in 2008 may be a little bit more trigger-happy this time. This will cause heartburn for CEOs with BBB paper outstanding.

To be sure, regulators and Congress took measures to avoid a similar crisis repeating. The banks aren’t the problem. The “shadow banking system” is the source for much of the shaky debt. The same investors stretching for yield in emerging markets have loaded up on private debt, too.

Steve Wasserman’s last weekly commentary is a good capstone here:

Moody’s has issued a statement that CMBS loans are now almost as risky as in 2007 because 75% of them are interest only, and the interest only period is now 6 years, up from 2.2 years just a few years ago. In addition, they are becoming much more covenant light, and are at higher leverage. All of this is a red flag since these things create much more risk of serious problems when the recession hits. There is also a bigger concentration of single tenant properties, which, as we have seen in retail, can be deadly in a recession. Asset and sponsor quality is also deteriorating. There is now so much competition to put out loans by so many non-bank sources, that borrowers can get lenders to compete, which always means lower quality underwriting. Far too much capital chasing too few good deals.

Underwriting is not nearly as bad as in 2006–2007 yet, but it appears the trend is what it always has been, when the economy is strong and there is too much capital, underwriting standards fall down, and then the stage is set for a bad outcome when the economy goes bad. It is typically 10–12 years between collapse of the last crash and then credit quality deterioration and the next credit collapse. We are at 10 years. Dodd Frank had rules to try to avoid a replay of 2008 in CMBS, but a lot of loans now are made by private equity funds that are not subject to these regulations.

One thing that is immutable is that as each generation comes into Wall Street, they think they know better how to do it, and they eventually do the same dumb loans in pursuit of profits and bonuses. It has never been different. We are not about to have a major crash again, but CMBS loan quality is deteriorating now, and one day in the next 2–3 years, it will be a bad problem. When they start doing a lot of CDOs and virtual CMBS pools with derivatives, then that is a sure sign the end is near.

I think Steve pretty much has it right. We’re ok for now, but we will have a problem when recession strikes. The next crisis, which I think will be yet another debt crisis, won’t look like the last one, but it will rhyme.
 

As in nature, carnage for some is opportunity for others. Investment bankers who specialize in corporate liquidations and restructuring see good times coming. Here’s a haunting quote from last month:

"I do think we're all feeling like we were back in 2007," Bill Derrough, the co-head of recapitalization and restructuring at Moelis & Co., told Business Insider. "There was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time."

A matter of time, indeed. Moelis and others are confident enough to start staffing up before the business appears, despite the tight labor market. Think about how unusual this is. Most companies are in a just-in-time, fully-optimized production mode. You succeed by precisely matching production capacity with current sales… unless you are a restructuring specialist. In that case, you hire the best people you can find and let them twiddle their thumbs until opportunities appear. And you think they will, soon.

Others will have opportunity as well—even you, if you are holding cash and in position to buy some of the valuable assets that will get “restructured” in the next few years. Doing it successfully will take extensive research and iron discipline. Many will try, few will do it well. Start preparing now and you may be one of the few.

Remember, in 2009, it was easy to find great companies paying 4% to 6% dividends with single digit P/E ratios. You didn’t have to be an accredited investor to pick up juicy returns. You will get another chance not too many years from now. Patience, grasshopper.
 

I know, I know. I said I wasn’t traveling in June and July. Except for when things came up, and they have.

After I finished my last letter, I found out I had to be in Boston on Tuesday morning very early, flying in the night before and then back home the next night. Now I have to be in New York Monday evening and back in Dallas Tuesday afternoon. Then I must go to St. Louis for a day, too.

In August, I go to Grand Lake Stream, Maine for the Camp Kotok economists gathering/fishing trip. Then I have an Ashford, Inc. board meeting in Beaver Creek where Shane and I will spend an extra couple of days at the Ashford-owned Grand Park Hyatt. At some point, Shane and I go to Cleveland for an executive checkup with Dr. Mike Roizen. Mike West of BioTime and Patrick Cox will be there, too. Besides getting rather aggressive all-day physicals, you can imagine we will have some fascinating health and aging conversations.

Speaking of Mike R., we are pulling for a miracle comeback by the Cavaliers. A game six in Cleveland will make everything in my world stop so I can be there to be on the floor with Mike. Sometimes a man just has priorities.

Then after Maine, we will spend a couple days in Gloucester with Woody Brock followed by a leisurely trip down to Newport, Rhode Island to see my great friend Steve Cucchiaro, now of 3Edge and Windhaven fame, and his fiancé.

Recently, my daughter Tiffani had a different type of celebration with her daughter (my granddaughter), Lively. They celebrate Lively’s “half birthday” exactly halfway through the year from her last birthday. It turns out the Ritz has a young girl package that makes for a very special day. Tiffani sent me a video as Lively opened her “half birthday” present: the new Taylor Swift album, which made her very happy. But tucked inside it were tickets to the upcoming Taylor Swift concert and Lively practically exploded with excitement. Who knew? Thankfully, there weren’t tickets for Papa John (as she calls me). I’m not sure I could handle 20,000 screaming young girls while listening to Taylor Swift’s music at the same time.

But you know what? Seeing the excitement in her eyes, I would’ve steeled myself and gone into that breach just to see that look again! Tomorrow, I will accompany that excited young girl to the Nasher Sculpture Museum with her mother. It would be a dream if she can be just as excited with Rodin.

And with a smile on my face, I will hit the send button. You have a great week! Hopefully there is a young one that can light up your life as well, or an old friend.

Your much rather deal with a Taylor Swift concert than The Great Reset analyst,


John Mauldin
Chairman, Mauldin Economics


Lack of European reform, not Italy, will break the eurozone

Stop treating the euro as an article of faith and fight for its sustainability

Wolfgang Münchau


Giuseppe Conte, Italy's prime minister, should stake a strong position at this month’s European Council in the debate on eurozone governance © Reuters

It is unfortunate that so many Europeans treat European integration as an act of faith. The Brexit debate pits Europhile true believers against sceptical atheists, which is why we are talking about the two equally absurd propositions: a second referendum and a hard Brexit.

Italians treat the question of their euro membership in a similar way. You either belong to this camp, or that. If you are, like me, somewhere in the middle, people feel confused. I believe it is reasonable for a struggling country such as Italy to remain in the eurozone for as long as there is the faintest hope that the relationship is sustainable.

It was the unconditional pro-Europeanism of Italy’s past leaders that gave rise to the current nationalist backlash. Previous governments accepted European legislation that was profoundly against Italian interests.

There was the rule to count Italy’s contributions to the European Stability Mechanism, the bloc’s rescue umbrella, as relevant in the calculation of the maximum-allowed deficit. Then the acceptance of a bank resolution law that would leave thousands of Italian savers unprotected. And worst of all, the agreement in 2012 to accept the fiscal compact, which effectively requires Italy to run balanced budgets. If former prime ministers had been more ruthless, the anti-European backlash would be milder.

I find it equally silly for the Five Star Movement and the League to have raised the issue of an all-out confrontation with the EU in the way they did. The idea of asking the European Central Bank to write off Italian debt purchased as part of the quantitative easing programme was mad. The notion appeared in a first draft of the coalition agreement and was later dropped. It is absurd on many levels. For starters, most of the Italian debt is held by the Bank of Italy, not the ECB. If they want to take on the eurozone, they have to smarten up.

My first piece of advice to them is to drop the unilateralism and take a transactional view — setting out conditions that would allow Italy to remain and prosper in the eurozone.

As a first priority, Giuseppe Conte, Italy’s prime minister, should stake a strong position at this month’s European Council in the debate on eurozone governance. Angela Merkel has rejected virtually every substantive part of the reforms proposed by Emmanuel Macron. Mr Conte should consider supporting the French president to impress on the German chancellor the exorbitant costs of a German “no”. Pedro Sánchez, the Socialist party leader who was sworn in on Saturday as Spain’s prime minister, might help strengthen such an alliance.

Mr Conte should make the point that an unreformed eurozone has little chance of survival. Until now, the best argument for Italy to remain in the euro is to hope that the eurozone will eventually be reformed. If we know for certain that is not going to happen, the argument shifts. It is not Italian politics that kills the euro, but a lack of reforms in the eurozone and Germany’s massive current account surplus.

The best way to confront the eurozone policy is from within. Italy could use its weight in the upcoming appointments of the EU’s most important jobs: the presidents of the European Commission, the European Council and the ECB. There are deals and trade-offs to be made. Do not talk about a unilateral exit until all else has failed.

Secondly, the Keynesian fiscal boost outlined by Italy’s coalition government is well intended but too large. They should tone it down and accompany a mildly expansionary fiscal policy with some targeted structural reforms, to the banking sector, the judicial system and public administration.

Thirdly, there is nothing wrong with a genuine plan B, a list of measures to roll out if a crisis makes continued eurozone membership unsustainable. I would be surprised if the previous government did not have such a plan deep in a drawer. But plan A should be resisted: creating a situation that would inexorably lead to eurozone exit. It was suspicions of such a plan that persuaded Sergio Mattarella, the Italian president, to veto Paolo Savona as finance minister.

And finally, do not even think about asking the electorate to cast a vote on Italy’s euro membership. This would be self-defeating for any politician who dares ask the questions. Eurozone exit is an accident to be prepared for, not an outcome to seek. I doubt an Italian government would survive it.

As for the rest of us, we should stop treating this new government as some unexpected shock. The populist government is the logical consequence of 20 years of economic mismanagement by Italy’s centre-left and centre-right parties. That is what caused the mess.

If you are really pro-euro, my advice is to stop treating the euro as an article of faith but fight for its sustainability. That fight cannot be won in Italy alone. It requires big policy shifts in Brussels too.


Q1 2018 Z.1 Flow of Funds

Doug Nolan


The first-quarter 2018 Z.1 "flow of funds" report can be viewed in two ways. From one perspective, key conventional data are un-extraordinary. Household debt expanded at a 3.3% rate during the quarter, down from Q4's 4.6%. Home Mortgage borrowings slowed from 3.4% to 2.9%. Total Business debt grew at a 4.4% pace, unchanged from Q4 and down from Q1 '17's 6.1%. Financial sector borrowings were little changed, after expanding 1.6% during Q4. Bank lending was, as well, unremarkable.

From another perspective, extraordinary Credit growth runs unabated. Total System (non-financial, financial and foreign) Credit expanded at a (record) seasonally-adjusted and annualized rate (SAAR) of $3.513 TN during 2018's first quarter, compared to Q4's SAAR $1.411 TN and Q1 '17's SAAR $860 billion. This booming Credit expansion was fueled by an SAAR $2.519 TN increase of federal borrowings. Granted, this was partially a makeup from Q4's slight contraction in federal debt growth.

In nominal dollars, Total U.S. System Credit expanded a blazing $962 billion during Q1 to a record $69.717 TN (349% of GDP). Non-financial Debt (NFD) expanded a record (nominal) $874 billion, with one-year growth of $2.413 TN. One must return to booming 2007 for a larger ($2.508 TN) four quarter-period of Credit expansion. NFD ended Q1 at a record $49.831 TN, matching a record 250% of GDP. NFD expanded $4.086 TN over the past two years, the strongest expansion since '07/'08.

Outstanding Treasury Securities ended Q1 at a record $17.046 TN, increasing a nominal $615 billion during the quarter. Treasury Securities jumped $1.172 TN during the past four quarters and $1.669 TN over two years. Outstanding Treasury Securities has increased $10.995 TN, or 182%, since the end of 2007. Treasury debt-to-GDP ended Q1 at 85%, more than double 2007's 41%. It's worth adding that total Treasury and Agency Securities ended Q1 at a record $25.920 TN, or 130% of GDP.

Not coincidently, the historic securities boom also runs unabated. Total Debt Securities (TDS) expanded $789 billion during the quarter to a record $43.868 TN. TDS began 2000 at $15.606 TN and closed 2007 at $28.828 TN. TDS ended Q1 at a near record 220% of GDP, up from 2007's 200%. Equities ended Q1 at $45.156 TN, or a near-record 226% of GDP. Equities-to-GDP posted cycle peaks of 181% in Q3 2007 and 202% in Q1 2000. Total (Debt and Equity) Securities ended Q1 at a record $89.024 TN, or 446% of GDP. For comparison, Total Securities were at 379% to end Q3 2007 and 359% at Q1 2000. When it comes to the perceived wealth of U.S. securities markets, "Off the Charts," as they say.

The ballooning Household Balance Sheet continues to be a key Bubble metric. Total Household (and Non-Profits) Assets ended Q1 at a record $116.343 TN, gaining $1.072 TN for the quarter. Household Assets were up $7.169 TN in four quarters and $14.955 TN over two years. Q1 saw Real Estate assets increase $490 billion (y-o-y up $1.868 TN) and Financial Assets gain $511 billion (y-o-y up $5.054 TN). With perceived wealth inflating so rapidly, why would spending not be strong?

Household Liabilities increased $44 billion for the quarter ($538bn y-o-y) to $15.574 TN. Household Net Worth (Assets less Liabilities) surged $1.028 TN during Q1 - surpassing $100 TN ($100.77 TN) for the first time. Household Net Worth inflated $6.630 TN (7.0%) in four quarters and a stunning $13.959 TN (16.1%) the past two years. Household Net Worth-to-GDP, a key stat in Bubble Analysis, ended Q1 at a record 505% of GDP. For comparison, this ratio ended the seventies at 342%, the eighties at 378%, the nineties at 445% and 2007 at 459%. A bonus stat: Household Net Worth ended Q1 about 50% higher than the peak from Q2 2007 ($67.744 TN).

Such an historic inflation requires extraordinary monetary fuel. Today's monetary inflation is unconventional and, candidly, rather convoluted. Commercial Banks ("Private Depository Institutions") expanded (financial assets) SAAR $1.139 TN during the quarter. But of this, SAAR $632 billion was an increase in Reserves at the Fed. Loans expanded SAAR $429 billion, down from Q4's $537 billion and the slowest growth in four quarters. To be sure, there's nothing conventional about this Bubble.

International flows have played a major role in the prolonged U.S. boom. Rest of World (ROW) holdings of U.S. financial assets increased SAAR $753 billion to a record $26.901 TN. This was up from Q3's $535 billion but below typical levels from recent years. After reducing holdings by SAAR $228 billion during Q4, ROW added to Treasuries by SAAR $302 billion in Q1. ROW increased Agency and GSE MBS by a notably large SAAR $130 billion. Also funneling liquidity into U.S. securities markets, ROW increased U.S. Corporate Equities SAAR $192 billion. ROW assets have expanded $13.152 TN since the end of 2008, or 96%. ROW holdings ended the nineties at $5.621 TN.

The Security Broker/Dealers expanded assets SAAR $225 billion to $3.273 TN (high since Q2 '09), although this growth was basically in "Miscellaneous Assets" (to a 14-quarter high $881bn). There was a big (SAAR $283bn) drop in Security Repo assets, with an even larger (SAAR $350bn) gain in Security Repo liabilities. Broker/Dealers expanded Treasury holdings SAAR $84 billion during the quarter.

Wall Street off-balance sheet "Funding Corps" increased financial asset holdings by a notable SAAR $458 billion (second-largest increase since 2008) to $1.804 TN, the highest level since 2009. Funding Corp assets have surged nominal $418 billion in two years, or 27% (four-year growth of 47%). Reminiscent of 2006/07.

We know that corporations have been returning about $1.0 annually to shareholders (buybacks and dividends). What's more, corporations are now benefitting from a dramatic reduction in taxes. This was apparent in Q1 data. Non-financial Corporate Businesses paid taxes at SAAR $165 billion, down from Q1 '17's $278 billion. Corporate Checkable Deposits and Currency jumped another $50 billion during the quarter to $1.193 TN. It is not obvious in the data what impact repatriation of overseas assets is having, but it could be influencing U.S. market liquidity (at the expense of foreign U.S. dollar securities liquidity).

Federal Tax Receipts were reported at SAAR $3.478 TN during Q1, down $110 billion, or 3.1%, from Q1 '17. Meanwhile, federal Expenditures increased $146bn, or 3.4%, to a record SAAR $4.388 TN. Federal Government Total (excluding contingent) Liabilities jumped nominal $492 billion during Q1 to a record $19.696 TN (99% of GDP). State and Local Government Liabilities expanded a notable $130 billion during Q1, explained by rapid growth in "Claims of Pension Fund or Sponsor."

A few miscellaneous categories are deserving of brief mention. Credit Unions expanded assets by nominal $61.5 billion, or 18% annualized, during the quarter to a record $1.404 TN. Open Market Paper surged nominal $82.6 billion, or 34% annualized, to $1.049 TN (almost seven-year high). Checkable Deposits & Currency jumped $137 billion, or 13% annualized - and surged $402 billion, or 10.2%, over the past year - to a record $4.352 TN. Time & Savings Deposits expanded $206 billion, or 7% annualized - and $363 billion, or 3.2%, in four quarters - to a record $11.899 TN. Awash in cash, the growth in outstanding Corporate Bonds slowed to $104 billion, or 3.2%, to $13.055 TN (up $627bn, or 5.0%, y-o-y). Led by an SAAR $159 billion increase in "World Equity Funds," ETF holdings expanded SAAR $250 billion during Q1 to a record $3.411 TN.

Bank Loans expanded SAAR $429 billion during Q1, about in line with the average over the past eight quarters. Keep in mind that this amounts to only 12% of the SAAR $3.513 TN Q1 expansion of Total System Credit. Back in the four-year boom period 2004 through 2007, Bank Loans increased quarterly on average SAAR $670 billion. More than ever before, market-based finance dominates. And while everyone marvels at the wondrous U.S economy these days, I would warn of serious and mounting vulnerability to a market liquidity event.

Again this week, no end in sight for EM liquidity challenges. The South African rand dropped another 2.9%, the Mexican peso 1.7% and the Argentine peso 1.4%. Central banks were forced to aggressively hike rates in defense of dislocating currencies in Turkey and Brazil. The Turkish lira rallied 3.9%. Friday's wild 5.3% rise in Brazil's currency, erased earlier losses (two-year lows against the dollar) and saw the real muster a 1.5% gain for the week. Brazilian stocks sank 5.6% this week, with one-month losses of 14.4%.

Global market instability was not limited to EM. Italian 10-year yields surged 44 bps this week to 3.13%. Italian two-year yields jumped 66 bps to 1.67%. Italy's bank stocks were slammed 6.5% this week. Portuguese 10-year yields rose 18 bps to 2.06%, and Greece yields gained 18 bps to 4.65%. Up three bps to 1.47%, Spanish yields were relatively well-behaved.

The ECB signaled it will discuss a QE exit strategy at next week's meeting. For Italy, and to a lesser extend the Eurozone periphery, this is untimely news. Perhaps there is some recognition in the global central banking community that dollar strength now poses acute risk to the faltering EM Bubble. A more hawkish ECB and stronger euro takes some of the gas out of the appreciating dollar. It also risks taking more air out of the European bond Bubble. Even at the eurozone's "core", German 10-year yields rose six bps (to 45bps) this week and French yields jumped 11 bps (to 82bps). The ECB faces quite a dilemma.

Here at home, there's a speculative Bubble problem in U.S. equities. Reminiscent of Q1 2000, there is a heck of a short squeeze and derivative-related melt-up in the face of a deteriorating global backdrop. The S&P500 rose 1.6% and the Mid Caps jumped 2.2% this week, but these gains don't do justice to some of the pain being meted out on the short side. The retail sector (XRT) jumped 6.3% this week. The S&P Department Store index spiked 11.5%. With almost 39 million shares short, Tesla surged 26 points (8.9%) in five sessions. Other notable short squeezes included Five Below (41.7%), Endo Intl (21.8%), Under Armour (15.9%), Williams-Sonoma (13.5%), Twitter (12.4%), Macy's (12.2%), Wendy's (10.1%) and JD.Com (10.6%) - to name only a few. When the marketplace is transfixed by a short squeeze, little else matters.

An overheated economy and highly speculative equities market should weigh on the FOMC during Tuesday and Wednesday's meeting. And a potentially critical ECB meeting comes Thursday. Currency instability, fragile EM and European periphery and a Bubbling U.S. create quite a challenge for our global monetary commanders. Cracks in the global Bubble have markets betting central bankers don't have the guts to normalize.

And there's this weekend's Trump Tariff focused G7 ("G6 plus the U.S.") meeting in Quebec, followed by Tuesday's Trump/Kim summit in Singapore. Prospects for a breakthrough with North Korea seem brighter than on the trade front. After Singapore, attention will turn to U.S. and Chinese trade negotiations. It's bound to get interesting.

June 8 - Reuters (Ben Blanchard and Denis Pinchuk): "Chinese President Xi Jinping gave visiting Russian President Vladimir Putin China's first friendship medal on Friday, calling him his best friend, underscoring the close ties between the two despite deep reservations many Western nations have of Putin. Meeting in Beijing's Great Hall of the People, Xi lauded their relationship. 'No matter what fluctuations there are in the international situation, China and Russia have always firmly taken the development of relations as a priority,' Xi told Putin at the start of their formal talks."


The Californization of America

By Steve Kettmann


            CreditRichie Pope



SOQUEL, Calif. — Across the country, Democrats are winning primaries by promoting policies like universal health insurance and guaranteed income — ideas once laughed off as things that work only on the “Left Coast.”

At the same time, national politicians from both sides are finally putting front and center issues that California has been grappling with for years: immigration, clean energy, police reform, suburban sprawl. And the state is home to a crop of politicians to watch, from Kevin McCarthy on the right to Gavin Newsom and Kamala Harris on the left, part of a wave that is likely to dominate American politics for the next generation.

California, which holds its primaries on Tuesday, has long set the national agenda on the economy, culture and technology. So maybe it was just a matter of time before it got back to driving the political agenda, as it did when Ronald Reagan launched his political career in the 1960s. But other things are happening as well. The state is a hub for immigrants, a testing site for solutions to environmental crises and a front line in America’s competition with China. On all sorts of big issues that matter now and will in the future, California is already in the game.

In a way, California even gave us Donald Trump. So much of his “training” to be president came while he was an entertainment celebrity, on a show that, for a stretch of its existence, was produced in Los Angeles. And of course the means of his ascent — the smartphone, social media — came out of Silicon Valley. That’s a lot to have on a state’s conscience. 
California is a deep-blue state — only 26 percent of its residents approve of Mr. Trump, and Democrats dominate the Legislature, statewide offices and most large city governments. But the state’s leaders are also aware that setting the political agenda for the country means making a stark break with naked partisanship. Getting that right will determine whether California, in its newly dominant role, perpetuates the political divide or moves America past it.




For decades, California, even as it grew in size and wealth, was seen as an outlier, unintimidating, superficial and flaky. We were no threat. We were surfer dudes and California girls who got high and turned on, tuned in and dropped out. We spawned Apple and Google, but we also spawned hippies and Hollywood. For a time, our governor was nicknamed Moonbeam.

As recently as the 2000s, with California at the center of the subprime-mortgage crisis, it was fair to wonder whether we had a future; a popular parlor game was to imagine how the state might be divided up into more manageable statelets.

That was the old California.

The new California, back from years of financial trouble, has the fifth-largest economy in the world, ahead of Britain and France. Since 2010, California has accounted for an incredible one-fifth of America’s economic growth. Silicon Valley is the default center of the world, home to three of the 10 largest companies in the world by market capitalization. 
California’s raw economic power is old news. What’s different, just in the past few years, is the combination of its money, population and politics. In the Trump era, the state is reinventing itself as the moral and cultural center of a new America.


Jerry Brown — Governor Moonbeam — is back, and during his second stint in office has been a pragmatic, results-focused technocrat who will leave behind a multibillion-dollar budget surplus when his term ends in January. But he has also been a smart and dogged opponent of the Trump agenda, from his high-profile visits to climate-change negotiations in Europe to substantive talks in Beijing with President Xi Jinping.




California is hardly monolithic. The region around Bakersfield provides the power base for Mr. McCarthy, the House majority leader and an indefatigable defender of President Trump, who calls him “my Kevin.” Other sizable pockets of Trump supporters live along the inland spine of the state, especially in the north near the Oregon border.

Still, there’s no doubt California runs blue — so blue, people say, that its anti-Trump stance is inevitable. But that’s not right; in fact, California defies Mr. Trump — and is turning even more Democratic — not for partisan reasons but because his rhetoric and actions are at odds with contemporary American values on issue after issue, as people here see it, and because he seems intent on ignoring the nation’s present and future in favor of pushing back the clock.

California doesn’t just oppose Mr. Trump; it offers a better alternative to the America he promises. While Mr. Trump makes hollow promises to states ravaged by the decline of the coal industry, California has been a leader in creating new jobs through renewable energy.

While Mr. Trump plays the racism card, California pulls in immigrants from all over the world. For California, immigration is not an issue to be exploited to inflame hate and assuage the economic insecurities of those who feel displaced by the 21st-century economy, it’s what keeps the state economy churning.

For us, immigration is not a “Latino” issue. The state’s white population arrived so recently that all of us retain a sense of our immigrant status. My great-great-grandfather Gerhard Kettmann left Germany in 1849 and made his way to California during the Gold Rush. That’s why everyone is able to unite, even in our diversity.

And the draw of California is more powerful than ever. People come not only from countries around the globe to work in Silicon Valley — more than seven in 10 of those employed in tech jobs in San Jose were born outside the United States, according to census data analyzed by The Seattle Times — they come from all over the country. 
It seems as if every other idealistic young person who worked in the Obama White House or on the Hillary Clinton presidential campaign later moved to California. All these new arrivals create major problems, from housing shortages to insane Los Angeles-style traffic in Silicon Valley. They also create a critical mass of innovation.



Many Californians see the next decade as a pivot point, when decisions about the environment and the economy will shape America’s future for generations to come. “It’s ‘Mad Max’ or ‘Star Trek,’” said Gavin Newsom, the lieutenant governor and leading candidate to succeed Governor Brown. It’s no mystery which movie he thinks Mr. Trump is directing.

Nationally, Mr. Newsom is known mostly as a cultural pioneer, having allowed same-sex marriage as the mayor of San Francisco in 2004 — among the first big-city mayors to do so. But he sees himself in more pragmatic terms, more like a latter-day Robert Kennedy, a believer in the idea that government can do more for the people if it’s smarter about trying new ideas and updating old assumptions.

Mr. Newsom doesn’t mind making bold claims, and he and his main Democratic challenger, the former Los Angeles mayor Antonio Villaraigosa, are both vowing to build 500,000 homes in California every year for seven years. He also wants to provide single-payer health care to everyone in the state and commit the state to 100 percent renewable energy for its electricity needs. Sure, these are campaign promises — but in California, they suddenly seem like practical, feasible ideas.

California for years was divided between its main population centers. Northern California, birthplace of Berkeley’s Free Speech Movement in 1964 and the Summer of Love in San Francisco later that decade, was often at odds with large sections of Southern California, particularly Orange County, a bastion of suburban Republicans.

That divide is eroding. Orange County even went for Hillary Clinton in 2016. California remains diverse culturally, but politically, it is increasingly unified. That can be a potent engine for social and economic progress; it can also be an excuse for insularity and political grandstanding. 
The key, many of the state’s politicians say, is to promote the former without falling into the trap of the latter — no easy task at a time when many Californians see their state as the base of the anti-Trump resistance.


Take Vivek Viswanathan. Raised on Long Island by parents who immigrated from India, he did policy work for the Hillary Clinton presidential campaign and Governor Brown and is now running for state treasurer.

It would be easy for him to run far to the left, mixing anti-Trump rhetoric with unrealistic policy promises. Instead, he wants America to see a different California — a state that mixes pragmatism and progressivism.

“I’m one of those people that think the threats that we face from Washington are very real, and not just to the resources we need, but the values that make us who we are,” he said. “California is really a model for what the country can be if we make the right choices.”

The first test of a unified California’s newfound political heft could come this fall. Democrats need to pick up 24 seats in the House of Representatives to win control of it, and they have their eye on seven California districts carried by Mrs. Clinton in 2016 that have Republican incumbents, including four that are wholly or in part in Orange County.

Further north, in the Central Valley, a deputy district attorney for Fresno County named Andrew Janz is running a surprisingly competitive race against Devin Nunes, the chairman of the House Intelligence Committee. Mr. Nunes has used his position to defend the president, while providing little congressional oversight — something that doesn’t sit well with even moderate California Republicans.

“The momentum is definitely on our side,” Mr. Janz told me. “My opponent is more concerned about blaming Democrats than getting the job done. The people here honestly want Nunes to focus less on creating these fake controversies and more on doing the work that’s required to move us along into the 21st century here in the Central Valley.” 
Again and again, this is the message coming from the state’s rising politicians — anger with the president and his allies not out of an ideological commitment, but because the president seems more interested in personal gain than national progress.





The more visionary among California’s leaders, including Mr. Newsom, recognize that their state has the highest poverty rate in the country, by some measures, and that addressing the problem — through affordable housing, job programs and early education — has to be a priority. To the extent these are national problems, too, other states may soon be looking to Sacramento, not Washington, for leadership.

It’s also a given that one or more Californians could figure prominently in the 2020 presidential race, including Ms. Harris, a first-term senator who has gained a reputation for her withering examinations of the president’s cabinet nominees. Mr. Newsom, particularly if he wins the governor’s race this year by a convincing margin, could also make the jump to the national stage, following Ronald Reagan and Jerry Brown.

To see how different the stereotype of California is from the reality, consider another of the state’s rising political figures, the billionaire Tom Steyer.

To most people in Washington or New York, Mr. Steyer is the “Impeachment Guy” who has spent millions of dollars on television ads in which he speaks to the camera directly and makes a case for the urgent need to impeach President Trump. Impeachment is a widely popular idea among Democrats, but political realists say it’s unlikely to happen absent a Democratic surge in the midterm elections — in other words, that’s California for you.

But at home, Mr. Steyer is anything but a dreamer. His organization NextGen America focuses on developing solutions to climate change and economic inequality, issues that resonate here, especially among the young. The goal is to show the way not through talk, not through TV ads, but through action.

“I think California has this great advantage, which is we have a functioning democracy,” Mr. Steyer said in a recent interview. “With all our problems — and we have a lot of them, the biggest one being economic inequality — we have a spirit in business and in politics that says, sure, there are big problems, but we can address them. That spirit is a great advantage and it’s not true in Washington, D.C., right now.”

His bet — and that of millions of others in my state — is that soon, California will pick up the slack. 


Steve Kettmann, a columnist for The Santa Cruz Sentinel, is a co-director of the Wellstone Center in the Redwoods.


Getting to Yes With Kim Jong-un

Yoon Young-kwan

Korean leaders Moon Jae-in and Kim Jong-Un hold surprise second summit


SEOUL – Has North Korea’s ruler, Kim Jong-un, made a strategic decision to trade away his nuclear program, or is he just engaged in another round of deceptive diplomacy, pretending that he will denuclearize in exchange for material benefits for his impoverished country?

This is, perhaps, the key question in the run-up to the summit between Kim and US President Donald Trump in Singapore on June 12. Until then, no one will know the answer, perhaps not even Kim himself.

Optimists tend to believe that Kim’s declared intention to denuclearize is sincere. They highlight the fact that North Korea’s economy has changed fundamentally since he succeeded his father, Kim Jong-il, in 2011. It is now more open, with foreign trade accounting for almost half of GDP, the result of a gradual marketization process that began in the mid-1990s. But with this openness comes vulnerability, which explains Kim’s active diplomatic efforts to prevent serious economic disruption from the existing international sanctions regime.

Unlike his father, the 34-year-old Kim has been active in pursuing pro-market economic growth and may be aiming to emulate Deng Xiaoping, the architect of China’s reforms in the late 1970s. Kim’s recent sacking of three senior old-guard military officials may hint that he is ready to offer some important concessions to prepare a favorable diplomatic environment for concentrating on economic development. The key question remains whether Trump is now ready to embrace Kim’s North Korea as President Richard Nixon did with Deng’s China.

Pessimists, however, caution against believing that Kim is serious about denuclearization. There is so far no evidence, they argue, that Kim is different from his father (and grandfather, Kim Il-sung), when it comes to adhering to international agreements. They are skeptical, for example, that North Korea will cooperate fully on three major issues.

First, despite Kim’s declaration, it remains unclear whether he is agreeing to “complete, verifiable, and irreversible dismantlement” (CVID) of North Korea’s nuclear weapons program. His commitment remains aspirational and lacks substance or operational content. Second, given North Korea’s bad track record, the pessimists think it unlikely that Kim will permit intrusive nuclear inspections, which is a critical component of CVID. Finally, North Korea has not yet clarified the terms of its denuclearization. Its past official position –withdrawal of US troops from South Korea and an end to the bilateral alliance, would be a non-starter.

But there may be a way to achieve denuclearization that satisfies both optimists and pessimists. To find it requires taking a step back and considering the most fundamental reason for the diplomatic failures of the last three decades: the high level of mutual distrust, which has made a small and weak country like North Korea, surrounded by big powers, paranoid about its own security. In order to address this problem at the root, the US should have taken a political approach, rather than focusing repeatedly on concluding a narrowly defined military-security deal.

For example, President George H.W. Bush’s administration declined North Korea’s offer to establish diplomatic relations in 1991-92, when the fall of the Soviet Union heightened Kim Il-sung’s sense of insecurity. Likewise, North Korea’s major complaint regarding the October 1994 Geneva Agreed Framework was that the US did not keep its promise to improve political relations with North Korea. The Clinton administration tried a political approach in 2000, but it was too little too late.

The first Trump-Kim summit may not be able to resolve all three major issues dividing the US and North Korea all at once. But that does not mean the summit will be a failure. For the first time, the US is tackling the fundamental cause of the North Korea problem, rather than focusing on its symptoms. And this is why Trump’s seemingly impromptu decision to meet Kim face to face is meaningful and productive, especially if he can bolster Kim’s confidence that he and his regime will be safe without nuclear weapons and that the international community will help him to focus on economic growth.

That said, Trump would be well advised to leave the details of the denuclearization process in the hands of diplomats who have much experience in dealing with North Korea. In the meantime, he will need to rebuild an international coalition to maintain effective economic sanctions, which is the most powerful leverage for persuading Kim to accept CVID. Here, close cooperation with China will be essential. Moreover, the US should reward critical concessions by North Korea – for example, permission to conduct intrusive inspections of its entire nuclear program by international inspectors – even before the completion of CVID.

There are of course no guarantees that it will work. What is clear is that successful denuclearization of North Korea will require a combination of bold political decisions – say, formally ending the Korean War, opening liaison offices, or relaxing some economic sanctions – and realistic prudence.


Yoon Young-kwan, former Minister of Foreign Affairs of the Republic of Korea, is Professor Emeritus of International Relations at Seoul National University.


Brazilian Markets Plummet As Elections Approach

by: Ian Bezek

- Brazilian markets dropped as much as 9% Thursday, capping a 33% decline since January.

- The trucking strike is over, but the consequences have just begun.

I- t's too early to buy Brazil on the whole, but there may be a couple of stocks worth taking a look at as prices tumble.

- This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner
 
    
2018 is shaping up to be an exciting year for emerging markets. Lately, we're getting a fresh panic every couple of weeks, with Brazil taking the mantle now that Argentina and Turkey have calmed down for the moment. Brazilian stocks, which were sprinting to multi-year highs as recently as January, have skidded since then. In fact, the country, as measured by the iShares MSCI Brazil Capped ETF (EWZ) is down by almost a third in just a few months - highlighted with an impressive 5% dump (as of this writing) on Thursday:
 
 
 
Long-time readers probably remember that I'm fundamentally bearish on Brazil as an economy on a longer time horizon. The country has massive entrenched problems, including but not limited to an unaffordable pension scheme, unbelievable levels of corruption, off-the-charts income inequality, and a populace that tends to vote for politicians that don't uphold investor-friendly values.
 
I've long used the Heritage Foundation's Index of Economic Freedom as a quick shortcut for getting a look at whether a country is investable for the long-term or should merely be used for shorter-term trades. Countries that don't embrace free market principles are unlikely to deliver promising environments for capital formation and the protection of outside shareholders in the long run.
 
As such, in the part of the world I follow most closely, Latin America, we can see a pretty clear differentiation between the countries that treat foreign investors well and the ones that tend to give investors more trouble. The 2018 Heritage rankings for LatAm shake out as follows (countries with US-listed ADRs only):

  • Chile - #20
  • Colombia - #42
  • Peru - #43
  • Mexico - #63
  • Argentina - #144
  • Brazil - #153
Incredibly, Brazil, even with a "pro-markets" government in the form of Michel Temer, is ranked at #153 in the world, sandwiched between Afghanistan and Uzbekistan in the rankings.
 
Heritage's breakdown of Brazil's situation fails to inspire:
 
 
 
Its fiscal health score is particularly alarming, since even traditionally profligate spending countries like Greece (70), Italy (68), and Japan (49) score reasonably well on this metric. Brazil's combination of massive debt and near 10% of GDP budget deficits lately has the country in a league of its own.
 
Not surprisingly, the gigantic fiscal shortfall has led to a fresh plunge for the Brazilian Real:
 
 
 
 
That's a 20% devaluation for the year, as Brazil tries to keep pace with its neighbor Argentina in the race for 2018's worst-performing currency. Things came to a head on Thursday with Brazil's central bank intervening aggressively in the swaps market to try to prop up the value of its currency. Despite that, the Real proceeded downward, hitting fresh 2-year lows. It's also approaching new all-time lows.
 
Why Is Brazil Tanking?
 
The most obvious cause is the ongoing unrest regarding rising fuel prices. The country was paralyzed recently by a 10-day long fuel strike. Brazil is uniquely reliant on road transportation, and thus the trucking strike brought the country's logistics to a standstill, with food shortages and other major problems arising.

Finally, given the societal chaos, the government felt compelled to cave in. It rolled back fuel price hikes and the head of Brazilian state-run oil company Petrobras (PBR) was forced to resign. Petrobras has lost almost half its value since May 15th - pretty amazing for a company that had a greater than $100 billion market cap at that point:
Chart PBR data by YCharts

Even with the fuel strike over, things have hardly gone back to normal. As The Guardian noted, the event raised questions about the stability of Brazilian democracy. Strikers were calling for a military coup to resolve the situation. Now that the incident has passed (at least for the time being), the public is questioning whether nationally important companies should be allowed to try to make profits - as the Guardian article put it:
Brazilians argue over when and how state-controlled oil company Petrobras should set fuel prices - the cause of the strike - and whether it should make money for its shareholders or swallow losses for the benefit of the nation.
As a foreign investor, this should scare you. If a country's electorate views the so-called national good as more important than the property rights of private businesses, expect your capital to get plundered sooner or later. A political system that allows property rights to be violated in that manner will almost certainly see it happen sooner or later as long as voters have a populist streak.
 
That brings us to the other matter - the upcoming presidential election this fall. Foreign investors have long been hyping up the Brazilian story since the current Temer government is pro-markets, and there had been hope that the next government would continue in that vein.
 
This, however, is not going to happen. Current president Temer is profoundly unpopular, often polling at single-digit approval ratings. Arguably the country's most popular politician would be former socialist president Lula da Silva. It appears he will be unable to run this time, however, due to corruption charges.
That leaves the frontrunner as populist right-wing firebrand Jair Bolsonaro. Originally seen by outsiders as a Trump-like figure with little chance of winning, Bolsonaro has benefited greatly from the collapsing support for the current government, and the corruption scandals on the left-wing side of the spectrum. And while his views on policing and the military may seem extreme, foreigners hoped that Bolsonaro's right-wing tendencies would extend to business matters as well.
 
With the fuel strikes, however, Bolsonaro stuck to his populist leanings, supporting the strikers, rather than embattled Petrobras. This has sent foreign investors into a panic, since his stance suggests that Bolsonaro will not be a reliable defender of investor interests. With the second place candidate in the upcoming election also holding anti-market views, that puts Brazilian stocks and its currency into a high-risk political position. There's a reason I avoid countries like Brazil and Argentina for much more than short-term catalyst-driven trades.
 
What Happens Next?
 
Like in Argentina last month, we'll have to see what sort of maneuvers Brazil's Central Bank can come up with to try to prop up the currency. In Argentina, two massive interest rate hikes didn't do the trick, but a third one, plus a hard floor for the Peso and a request for IMF assistance, has staunched the bleeding for now. Brazil's Central Bank loves currency swaps, and is pushing that lever hard again now, despite it seeing limited effectiveness during the 2015 currency meltdown there.
 
Brazil has a more difficult position than Argentina in the short-term. Temer is a lame duck president and his successor is unlikely to care about catering to foreign investors. That's a stark contrast to Argentina, where President Macri's coalition did well in the mid-term elections last year, and thus he retains a reasonable amount of political capital. And unlike Temer, Macri isn't embroiled in corruption schemes or stuck with a rock-bottom approval rating.

Also, Brazil's voters simply don't seem willing to support the sort of austerity that Argentina has reluctantly accepted. A recent poll found that more than 85% of Brazilians supported the fuel strikes, but far fewer would support the higher taxes necessary to fund lower fuel prices that the truckers demanded. Given Brazil's dismal fiscal position already, higher budget deficits are the last thing the country needs.
 
All this adds up to me being uninterested in investing in Brazil at this time on a country-wide basis. EWZ, the country ETF, is still way up from the 2015-16 lows despite the economy barely making it out of recession and quite possibly heading back into another one next year.
 
Data: Tradingeconomics.com. Yes, Brazilian stocks did move up almost 150% off the lows, thanks to GDP growth briefly topping 1% before decelerating again.
 
 
The political situation is hardly fixed - sure, it was a positive that Rousseff was kicked out of the presidency, but there's little indication that the next elected president will be all that much better. And the country's fiscal situation is dreadful.
 
With both Colombia and Mexico at reasonable valuations, there's no reason to walk into the political minefield that is Brazil with its equity market still up so much from recent levels. Colombia's next president will be a devoted right-winger, and Mexico's, while a leftist, will have little control of the legislature and thus won't be able to create the same sort of havoc that is likely to occur in Brazil:
Chart GXG data by YCharts

I do think there are some reasonable values in a couple of Brazilian companies, and a few more that are meaningfully exposed to the country though headquartered elsewhere. I've recently recommended Despegar.com (DESP) and Corporacion America Airport (CAAP), both Latin American businesses headquartered elsewhere that derive a significant amount of revenues from Brazil - and both have gotten beat up in 2018. And I bought one Brazilian company that should be relatively less affected by the current mess - see Ian's Insider Corner for more on that.
 
In general though, there's no reason to get too aggressive trying to buy the Brazilian drop just yet.
 
The stock market ran up way too far there despite a lack of much tangible economic or political progress. Just as we saw in Argentina earlier this year, misplaced optimism is now giving way to a more grim and realistic appraisal of the situation. Combined with a one-way upward trade in the US Dollar as of late, emerging markets are coming under fire more generally, and there's no rush to buy the falling knives just yet.