Stocks Take Off Because Earnings Have Been a Pleasant Surprise

By Jack Hough 

Photograph by Miti 

Talk of an earnings recession is so last-week. With numbers in for just over 20% of S&P 500 members, the latest growth prediction stands at negative 3.3%. That’s as good as a gain, and it pushed market indexes to new highs on Tuesday.

Two things we knew going into reporting season were that the earnings growth consensus stood at negative 4.3%, and that companies would surely surprise to the upside. They almost always do. The only question was whether it would be a big surprise or a small one.

It’s a big one so far. According to FactSet, earnings have come in 6.3% ahead of expectations.

The five-year average is 4.8%. At this rate, better-than-expected results might be enough to pull earnings just above break even versus a year ago, averting an earnings recession.

Coca-Cola(KO), United Technologies(UTX), and Twitter(TWTR) were among the companies driving the market higher on Tuesday following well-received financial reports. They helped the S&P 500 close up 0.9% at a new record high of 2933.68. The Dow Jones Industrial Average also gained 0.5%. The Nasdaq Composite also reached a new high, adding 1.3%.

The prospect of a slight earnings gain for the first quarter might not sound especially positive compared with last year’s 22% earnings growth, but it’s bullish enough to send the stock market still higher from here.

That’s because interest rates are still the most powerful force in the financial universe. In recent years, the Federal Reserve has hiked its core federal-funds rate from near zero to a target range of 2.25% to 2.50%. That had a muted effect on long-term bond rates, but it had threatened to raise short rates high enough to compete with stocks for investor affection.

This year, however, the Fed has signaled that it will stay put on rates for now. The 10-year Treasury recently yielded 2.6%, while the S&P 500 index traded at 18 times last year’s earnings. That’s equivalent to an earnings “yield”—earnings divided by price—of about 5.5%.

That’s quite a spread. The 10-year Treasury normally has a lower yield than the stock market, because of its higher relative safety. But the historical average yield for the 10-year Treasury is between 5% and 6%, and for the stock market, the long-term average earnings yield is between 6% and 7%.

The alternatives to stocks are so stingily priced at the moment that the market doesn’t need much of an excuse to rise. As it hits new highs in coming days, give 25% of the credit to the realization that we’re dodging an earnings recession, and the remaining 75% to a foreseeable future of still-low rates.

Gold: Seasonality Bearish, Futures Turning Bullish

Early 2019 looked like a great set-up for gold, but failed to live up to its billing. A nice December-through-March run took the price back to the $1,350 resistance that had repelled it four times in the past five years. And that was that. No penetration and fast spike into the $1,500s. Just another failed attempt.


Now comes the “sell in May and go away” part of the annual cycle, as Asia’s wedding season ends and demand for gold jewelry dries up.
But the news is not all boring. Futures are saying something a bit more positive. The story, in a nutshell, is that speculators bought into the early 2019 “great set-up” thesis and piled into long contracts. Here’s a late-March commitment of traders (COT) report showing speculators more than 2:1 long and commercials (who take the other side of speculators’ trades and tend to be right at big turning points) more than 2:1 short. This kind of structure usually ends badly, and the latest episode was no exception.

Gold COT gold futures bullish

But as gold has fallen this month, speculators have fled and the futures structure has turned more positive. The most recent COT report shows speculators cutting their net long position by a huge 49,000 contracts and the commercials cutting their net shorts just as dramatically.

Gold COT gold futures bullish

Here’s the same process in graphical form. See how the speculators – the gray bars pointing upward – were actually a bit short (meaning the gray bars drop below the middle dividing line) in late 2018.

That’s both unusual and extremely bullish (because remember, speculators are usually wrong when they’re most certain). Then, with gold rising in early 2019, the speculators shifted gears aggressively, going extremely long, which is bearish.

Gold COT gold futures bullish

Now, with gold falling again, the speculator longs are shrinking back towards zero. One more week like the last one (very possible since gold is still dropping, which should further spook the speculators), and the structure of the futures market will be bullish once again.

Will it be enough to offset weak seasonality? Maybe. In any event it’s a bit of good news in a stretch that frequently needs it.

The CIA’s Next Coup Could Be on American Soil

By Nick Giambruno, chief analyst, Crisis Investing

The Establishment is setting up Donald Trump…

The mainstream media hates him. Hollywood hates him. The “Intellectual Yet Idiot” academics hate him.

Most critically, the CIA hates him. So does the rest of the Deep State, or the permanently entrenched “national security” bureaucracy.

I think there’s a very simple reason for this: He’s threatening to take away its livelihood.

Trump wants to make nice with Putin and the Russians. But countering the so-called “Russian threat” is how many thousands of Deep State bureaucrats make a living.

These people feed off a $1 trillion-plus military/security budget. Playing nice with the Russians would kill their jobs.

Trump has said:

We will pursue a new foreign policy that finally learns from the mistakes of the past. We will stop looking to topple regimes and overthrow governments.

Toppling regimes is the CIA’s bread and butter. No wonder it hates him.

Though, the feeling is mutual.

Trump has used plenty of sharp words to describe the “intelligence community.” He’s also the first president since John F. Kennedy to openly take on the CIA.

Going forward, the Deep State has three main cards to play against Trump…

1. The delegitimization card

2. The Herbert Hoover card

3. The John F. Kennedy card

If one doesn’t work, it’ll escalate to the next.

Let’s start with the delegitimization card.

As you may know, the U.S. – specifically the CIA – has helped orchestrate multiple color-coded revolutions around the world over the past 20 years:

• The Bulldozer Revolution in Serbia (2000)

• The Rose Revolution in Georgia (2003)

• The Orange and Euromaidan revolutions in Ukraine (2004 and 2014)

• The Tulip Revolution in Kyrgyzstan (2005)

• The Cedar Revolution in Lebanon (2005)

• The Green Revolution in Iran (2009)… though that one didn't work.

• The Saffron Revolution in Myanmar (2007)

All of these AstroTurf revolutions have one thing in common. In each case, George Soros’ non-governmental organizations (NGOs) helped delegitimize the targeted government.

Here’s how it worked: Soros’ NGOs would help fund and organize “professional protesters.” Then they’d use specific color branding to help rally others to their cause.

The pattern was predictable. Now it’s playing out in the U.S.

It smells to me like the CIA and George Soros’ NGOs are trying to foment a “color revolution” in the U.S., just like they’ve done in numerous foreign countries.

The U.S. color revolution already has a color. It’s purple (the mix of red and blue, i.e., red and blue states).

Hillary Clinton has worn purple in almost every public appearance since Trump’s election.

There’s a flood of social media postings about the color purple. So the branding is already done. And, of course, the professional protesters financed and organized by George Soros are already there.

Of course, there are legitimate complaints against Trump. But the usual suspects are using their normal tricks to remove a government they don’t like. It just so happens that, this time, the target government is in Washington D.C., instead of Eastern Europe or the Middle East.

Still, I don’t think the Deep State is going to win with the delegitimization card. In fact, it’s already moving on to the next option: the Herbert Hoover card.

History books remember Herbert Hoover as one of the worst American presidents…

Hoover, a Republican, was a rich and successful businessman with investments all over the world. He was also somewhat of an outsider, having never held elected office until he was inaugurated in March 1929.

Today, people associate him with massive infrastructure projects like the Hoover Dam, as well as the Mexican repatriation program, which deported over 500,000 illegal Mexican immigrants.

Hoover also placed tariffs on foreign products entering the U.S. and established other protectionist trade policies.

Of course, when people think of Hoover, they mostly think of the Great Depression.

Throughout the 1920s, the Federal Reserve’s easy money policies helped create an enormous stock market bubble.

In August 1929, the Fed raised interest rates and effectively ended the easy credit period.

Only a few months later, the bubble burst on Black Tuesday, in October 1929, barely seven months after Hoover took office. The Dow lost over 12% that day. It was the most devastating stock market crash in the U.S. up to that point. It also signaled the beginning of the Great Depression.

This happened on Hoover’s watch. And because of that, people pinned the blame squarely on him, regardless of where the fault lay.

Hoover was an easy target. The Democratic National Committee’s publicity chief coined the term “Hooverville” for the countless shantytowns that sprung up across the country.

The term was such a hit, they tried coming up with others.

Newspapers were “Hoover blankets.” The cardboard used in a worn-out shoe was “Hoover leather.” A “Hoover wagon” was a car with horses hitched to it because the owner couldn’t afford gas.

Blaming the Great Depression on Hoover was easy for Democrats. In the minds of many people, Great Depression = Herbert Hoover.

It was obvious a Democrat would win the next election, which is exactly what happened. It took Republicans another 20 years to take back the White House.

Now there’s a good chance Trump will go down as Herbert Hoover II…

Like Hoover, Trump is a rich businessman with investments around the world. He’s also an outsider who hasn’t held elected office before.

Like Hoover, Trump has a troubled relationship with Mexico. Hoover started the Mexican repatriation program. Trump has inflamed Mexicans with his rhetoric and plans to build a border wall.

Hoover implemented enormous infrastructure projects like the Hoover Dam. Trump wants to spend $1 trillion on infrastructure.

Hoover signed the Smoot-Hawley Tariff Act into law under pressure from struggling American workers. The law raised tariffs on thousands of imported goods to record levels. It also kicked off a trade war, reducing American exports by half. It was a crushing blow to the American economy.

Trump is the most protectionist president since Hoover. Just look at the massive tariffs he’s slapped on China. He’s even called himself “a Tariff Man.”

Then there’s the stock market bubble…

Hoover inherited a stock market bubble near its peak – fueled by the Fed’s easy money policies.

I think Trump has, too. And he knows it. He’s called the stock market a “big, fat, ugly bubble.”

There’s an excellent chance this bubble will burst on Trump’s watch. And Democrats will pin the blame on him, just as they did with Hoover.

Trump is the perfect scapegoat. If new shantytowns sprout up, they won’t be Hoovervilles – they’ll be “Trump Towers.”

Trump could go down as the worst president in U.S. history…

But it will not be his fault.

The Deep State’s next move is to pin the coming stock market collapse on Trump. When people think “Greater Depression,” they’ll think “Donald Trump.”

The economy has been on life support since the 2008 financial crisis. The Fed has pumped it up with unprecedented amounts of “stimulus.” This has created enormous distortions and misallocations of capital that need to be flushed.

Think of the trillions of dollars in money-printing programs – euphemistically called quantitative easing 1, 2, and 3.

Meanwhile, with zero and even negative interest rates in many countries, rates are the lowest they’ve been in 5,000 years of recorded human history.

The too-big-to-fail banks are even bigger than they were in 2008. They have more derivatives, and they’re much more dangerous.

If the Deep State wants to trigger a stock market collapse on par with 1929, it just has to pull the plug on the extraordinary life support measures it’s used since the last crisis – something it’s already started to do by hiking interest rates.

If that doesn’t work, its only option is the JFK card…

Chuck Schumer, a powerful Democratic senator and quintessential Deep State swamp creature, discussed the war between Trump and the intelligence community on TV.

Schumer said, “Let me tell you, you take on the intelligence community, they have six ways from Sunday at getting back at you.”

It doesn’t take much imagination to understand what he’s alluding to.

Of course, the Deep State could try to assassinate Trump. It’s obvious the possibility has crossed his mind. He’s taken the unusual step of supplementing his Secret Service protection with loyal private security.

This all points to a crisis ahead…

At minimum, I expect an epic stock market crash as the Deep State plays the Hoover card against Trump.

Remember, the Fed has warped the economy far more drastically than it did in the 1920s, during the dot-com or housing bubble, or during any other period in history. I expect the resulting stock market crash to be that much bigger.

Now, at this point, we’d understand if you were ready to panic.


There’s lots of doom and gloom ahead. But remember, a crisis brings both danger and opportunity.

The upside is, this will create enormous speculative opportunities that will bring life-changing wealth for the well-prepared.

As Doug Casey has said:

Opportunities like that don't occur every week, or every month, not even every year. So you've got to be like a crocodile waiting perhaps for months, perhaps for a year, before the correct prey comes by.

Michael Pento: China Can’t Stop What’s Coming

by John Rubino

As this longest-ever expansion finally runs out of steam, the question on everyone’s mind is, “who will save us this time?”

The last big crisis was “fixed” by a combination of lower interest rates globally and massive buying of commodities by China. But with interest rates still at cyclical lows in a big part of the world (and nearly $10 trillion of bonds sporting negative yields), central banks have limited ammo.

And according to Pento Portfolio Strategies’ Michael Pento, China is in no shape to carry the load alone:

China Can’t Save the Global Economy Again 
China has acted as part of the life support system for the global economy during the past two decades. The other part being comprised of central banks. When the Tech Bubble burst back in 2000, China began printing and borrowing an incredible amount of money to create demand for fixed assets. After the Great Recession struck in 2008, Beijing again reacted with a massive government stimulus package that helped further inflate its real estate bubble and placed a pervasive bid under global markets. It was much the same in the wake of the global slowdown and earnings recession in the U.S. in 2016. In fact, China has been a humongous tailwind for growth since 2000; taking on about $38 trillion in new debt, which amounted to an incredible 150-percentage point increase in its debt to GDP ratio. 
Because of this untenable debt load, China recently began a much-needed policy of deleveraging, leaving many to speculate how long the global economy can sustain itself without its main growth engine. After all, the Red Nation had been responsible for roughly a third of global growth since 2008. However, and regrettably, China’s flirtation with austerity did not last very long. Authorities have now begun to reset priorities away from reigning in the nation’s $40 trillion worth of debt and are instead seeking to prop up the economy with yet more debt. 
Some of the debt ratios in China not only exceed that of the U.S. but are also estimated to be twice as high as that of the average emerging market economy.  
Total debt has more than quadrupled since 2007. Total debt including household, corporate and government increased from 160% of GDP in 2008 to over 304% of GDP in 2018, according to the Institute of International Finance. 
China debt to GDP
And all this begs the question: With its massive debt load, does China have the gas left to fuel the global economy, or has Wall Street misplaced its faith in an ersatz economic savior and a resolution to the trade war? 
For the past three decades, China has been the global growth darling of the world and Wall Street. The communist nation has averaged GDP growth of 9.9% from 1979 to 2010, according to the World Bank. 
Under its unique combination of communism and capitalism, China’s growth seemingly defied the laws of economics and the business cycle. But a cursory look beneath the surface exposes China’s economic miracle was continuously levitated by a dangerous mountain of debt. 
While the central government in China holds little debt and enjoys healthy foreign currency reserves, regional government debt, household debt, and corporate debt have exploded. Regional governments in China provide schools, hospitals, and transportation services. However, they have almost no power to raise taxes and receive very little of the taxes levied in their territory. These localities balance their budget by issuing Local Government Financial Vehicles (LGFV). This type of debt is extremely opaque, making it difficult to accurately calculate the actual level of indebtedness, but it ranges between $5 trillion to $7 trillion, according to CHEN, Z. China’s Dangerous Debt: Foreign Affairs. 
State Owned Enterprises or SOEs accounted for more than half of total corporate debt, or 72% of GDP in 2017 according to the International Monetary Fund (IMF). 
Most of these enterprises are Zombie corporations meaning they have an unsustainable business model. They exist mainly to employ people and must constantly take on new debt to pay off interest on existing debt. This type of state-directed debt is nonproductive in nature and is a primary contributor to the plunge in labor productivity. 
The Private Sector Corporate debt consists of bank loans, bond offerings, and shadow banking activities. These debt-laden companies are even more vulnerable to a drop in asset-values and/or a rise in borrowing costs . Slowing growth and tighter regulations have recently triggered many bankruptcies in this space. 

Finally, we have Chinese household debt, which has been dramatically outpacing household income for the past decade. 
But debt is not the only overhang on the Chinese economy. China has a shrinking labor force and a population that is rapidly aging. In 2010, 13% of the population was 60 years old or older; but by 2030 that figure skyrockets to 25%. According to Statista, the labor force in China is shrinking by 0.2% between 2016-2026 and then it drops further from there. 
All these factors prove that China’s recent economic problems have little to do with a trade war. The Shanghai Composite Index peaked two years before the first direct tariffs on China’s exports were put into effect. 
Wall Street believes that resolving the trade war will become a panacea growth. But the Chinese economy has been fueled by a powerful credit bubble over the past few decades. And its credit-driven economy has become a significant growth engine for the global economy whose “recovery” is predicated on debt. Indeed, Global debt has increased by $150 trillion since 2003 and $70 trillion since 2008: 
In the vanguard for this global re-leveraging process was, and is, China. According to S&P Global Ratings, China’s household debt increased by 716%, Non-financial corporate debt jumped by 400%, and total government debt climbed by 416%; all since 2008. And now that immense pile of debt dung is exploding, and it just can’t be easily remedied by yet another stimulus package from Beijing. 
Proof of China’s debt-disabled condition can be found in the current data. Mobile phone shipments in China totaled 14.51 million in February, a nearly 20% plunge year-on-year, according to data recently released by the China Academy of Information and Communications Technology. In addition, China Auto sales plummeted 14% year over year in February. But last month was no aberration. Car sales were down for the 8th month in a row and have crashed by 16% in January and 13% in December. In addition, China’s Industrial Production in the first two months of this year fell to a 17-year low. 
Similar to Japan in late-1980s, China’s economic growth once appeared to be unstoppable. This mistakenly led most on Wall Street to believe that the communist nation would eventually leave the U.S. economy far behind in the dust. However, students of history know that Japan’s growth phenomenon came to a sudden halt in 1989; at the same time of its epoch market crash. Likewise, China’s economy and equity market peaked in 2015 and the Shanghai Index has fallen by 43% from that point. 
By accumulating debt at such an aggressive rate, China is following in the same footsteps as its historical enemy to the east. All indications are that it will soon experience a similar fate, as the government’s debt scam implodes. 
The joke here is that equity markets are banking on yet another global growth slingshot to occur very soon. But as to why the supposedly bastion of capitalism that exists on Wall Street has misplaced its faith in a communist nation’s ability to magically produce a targeted rate of growth on demand should be a mystery. Sadly, the truth can be found in that carnival barkers are always is search of a good story to tell; no matter how much fiction is involved. 
Investors would be wise to use extreme caution given the fact that this global earnings and growth recession is occurring while equities are at all-time high valuations and at the same time debt levels are off the charts. Especially when central banks have either very little, or in most cases, zero room left to lower the cost of debt and boost economic growth.

Running out of Reasons to Be Cheerful for Emerging Markets

The emergence of an inverted U.S. Treasury yield curve is a bad sign for emerging markets

By Jacky Wong

On Friday, investors woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected.
On Friday, investors woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected. Photo: ritchie b tongo/Shutterstock 

A dovish Federal Reserve has given emerging markets a lift this year. Now investors are starting to realize the Fed’s change of heart may not be all good news.

Until recently, stocks, bonds and currencies in emerging markets had all risen this year. The MSCI Emerging Markets Index is still up 10%, partially reversing last year’s 17% loss. The Fed helped kick investors into risk-taking mode when it signaled in January that it was done raising interest rates.

That helped spur a resurgence of so-called carry trades—borrowing in dollars to earn higher returns in emerging-market assets—leading to stronger EM currencies, especially high-yielding ones such as the Indian rupee and the Mexican peso. The Fed’s announcement last Wednesday that there would likely be no more rate increases this year fueled further gains in EM assets.

That is, until Friday, when investors finally woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected. The 10-year Treasury yield dropped below that of the three-month on Friday for the first time since 2007. Such a yield-curve inversion preceded each of the past seven U.S. recessions. EM assets have since taken a hit: The Mexican peso fell 1.6% on Friday, while Asian stocks plunged on Monday.

To be sure, a yield-curve inversion for one day isn’t a guaranteed predictor of bad things to come. It does, though, add to a worrying pileup of bad news for the global economy that investors have been all too ready to ignore this year. Many have also seemed to assume that another Beijing stimulus would stoke the Chinese economy back to health. But significant monetary policy easing there has failed to translate into higher lending to the private sector: Beijing may now have to enact a U-turn on its shadow-banking crackdown. Meanwhile, the uncertain outcome of U.S.-China trade talks still looms.

Expectations of lower U.S. rates juiced up emerging markets. As investors recalibrate what those lower rates really mean, reasons are mounting to believe the best may be over for EM this year.

Banks come up against tough market for bail-in debt

After the crash, banks were ordered to raise a new form of debt. It has not been easy

David Crow

Firm stance: the ECB in Frankfurt supervises eurozone banks © Getty

“Never again will the American taxpayer be held hostage by a bank that is too big to fail,” said Barack Obama in 2010, as he unveiled a series of post-financial crisis reforms designed to make the banking system safer. A decade later, the largest US banks have only become bigger.

In a speech in the City of London last month, Christine Lagarde, managing director of the International Monetary Fund, noted that in the US, “the top five banks now hold about 45 per cent of total banking assets, compared with about 40 per cent in 2007”.

Given the persistence of the “too big to fail” problem, global policymakers have introduced measures designed to ensure that banks facing failure can be saved without resorting to taxpayer bailouts. Chief among these efforts is the introduction of a new type of “bail-in” debt designed to prop up banks in a future financial crisis, known as total loss-absorbing capacity (TLAC) debt.

The idea is that a bank teetering on the edge would first be able to use its equity to absorb the losses and then recapitalise itself by “bailing in” some of its bondholders.

The world’s largest banks, which pose the greatest systemic risk, must raise bail-in debt equivalent to 18 per cent of their risk-weighted assets by 2022, under rules from the Financial Stability Board, the international body that monitors the global banking system.

In the EU, policymakers have gone further by stipulating that most banks — including small and medium-sized lenders — must raise a similar type of bail-in debt known as the “minimum requirement for own funds and eligible liabilities”, or MREL.

Banks in this situation face a daunting task, especially in Europe. Analysts at UBS estimate that EU banks will need to issue €450bn of TLAC and MREL instruments this year to comply with the new rules.

But it is a tough funding market, with investors concerned about low profitability and, in Europe, political volatility. Banks have had to pay more than usual to issue debt. In November, UniCredit, Italy’s largest bank, offered a hefty 7.83 per cent coupon on a so-called senior non-preferred bond, which counted towards its bail-in debt requirements.

Mark Geller, a debt capital markets banker at Barclays, says there has been “robust demand” so far from investors for the new class of bail-in debt.

“There have been periods of market volatility as we saw at end of last year,” adds Mr Geller.

“But I think the fact that banks have been careful around issuing to keep on track to meet their deadlines has given them the opportunity to steer clear of some of the more difficult environments.”

However, there are concerns that bail-in debt, which has proven to be more expensive to issue than many bank executives had hoped, could weigh on profitability at lenders already struggling to generate good returns.

Ironically, although bail-in debt was designed by regulators to insure banks against failures, the process of raising MREL in fact threatens to weaken the viability of some lenders.

Analysts at Barclays reckon that the issuance of bail-in debt could wipe up to 2 per cent off the pre-tax profits of European banks over the next few years, rising to 8 per cent if funding markets were to become more challenging.

There is little need for alarm, argues Thibault Godbillon, a policy expert at the European Banking Authority, the regulator. “You need to be careful when you say ‘banks need to issue new debt’,” he says. “In the majority, banks are replacing existing debt as opposed to issuing new debt. It’s an incremental cost but it’s not an absolute cost.”

Mr Godbillon points out there are “other ways to meet the requirements”, which mainly involve making a lender less risky or combining it with a larger, healthier bank.

“You can merge with another institution, you can reduce your risk-weighted assets, lower your risk profile, maybe make a bit less money,” Mr Godbillon says. “There are other options that are there for sure.”

But Jérôme Legras, head of research at Axiom Alternative Investments, warns that some of Europe’s more fragile banks will find it hard to issue bail-in debt, such as “Italian mid-caps or Greek banks”. He agrees that the MREL requirements will lead to deals in the European banking sector.

“I think it’s going to increase consolidation, and in a few cases where no other options [exist] banks will have to issue new equity, but it will be extremely expensive,” says Mr Legras.

Nor is there any guarantee that bail-in debt will work as planned in the event of the next global financial crisis, when governments may decide that bailing out banks — especially ones of national or global systemic importance — is a better option than relying on an untested system.

Ukraine Elected a New President. So What?

Petro Poroshenko was hardly a threat to the country’s oligarchs, and there’s little reason to think his replacement will be much different.

By Ekaterina Zolotova

Ukraine held its second round of presidential elections on Sunday, and the results are in: The country will be led by a comedian. Volodymyr Zelenskiy earned 73 percent of the vote; incumbent Petro Poroshenko just 24 percent.
Poroshenko has already conceded, but it’s difficult to say how much he will be missed. For all the promise of the Orange Revolution and the Maidan protests that eventually led to Poroshenko’s ascension, Ukraine never really began to live, as Poroshenko put it, “in a new way.” Poroshenko himself is a member of the oligarchic class that has long dominated Ukraine, and though his administration was a material threat to many of his contemporaries, it was hardly a threat to the system itself.
The House Poroshenko Built
Although estimates of the exact magnitude of their wealth vary, Cyril Muller, the World Bank’s Europe and Central Asia chief, has said that the net worth of the three richest Ukrainian individuals exceeds 6 percent of gross domestic product. In 2018, Ukrainian magazine Novoye Vremya put the wealth of oligarchs Rinat Akhmetov, owner of one of the largest holding companies in Ukraine, around $12.2 billion, and Privat Group co-owners Ihor Kolomoyskyi and Gennadiy Bogolyubov at about $1.6 billion each. Poroshenko himself controls some 100 state-owned enterprises and comes in at the 6th richest in the country, according to the magazine, with an estimated actual wealth of $1.1 billion. The oligarchy controls sectors from the media and metallurgy to telecommunications and natural gas, and Ukraine’s richest individuals invest in the political sphere to reap personal benefit.

Poroshenko came to office with promises to curb their power. In a country with rising poverty and debt, that was a winning message. Among his initiatives was a push to nationalize key enterprises and reduce the capital held by the country’s oligarchs. His reforms were also driven by pressure from the United States and European Union, which were concerned that the oligarchic system discouraged foreign investment.
However, in practice any power Poroshenko took from the oligarchs was transferred into his own hands. Seeing the centralization of power as his only hope for holding on to that power, Poroshenko reneged on another key campaign promise: to empower Ukraine’s region governments. Poroshenko claimed his reversal was due to increasing separatism. But in truth, power transferred to the regions would likely end up in the hands of other oligarchs – and that would allow them to nominate someone other than Petro Poroshenko for president.
In centralizing power, Poroshenko bred bad blood between himself and the country’s richest, most powerful men – men like Dmytro Firtash, who controls much of Ukraine’s natural gas distribution; Vadim Novinsky, who has a major stake in Ukrainian metallurgy; and Sergei Taruta, former governor of Donetsk and founder of the Industrial Union of Donbass, one of Ukraine’s largest corporations. Most powerful among Poroshenko’s foes, however, is Ihor Kolomoyskyi, who, during the collapse of the Soviet Union, established PrivatBank, now the largest commercial bank in Ukraine. Kolomoyskyi, the former governor of Dnipropetrovsk, had a major falling out with Poroshenko when the president dismissed him from his office in 2015 and, the following year, nationalized PrivatBank – with serious implications for Kolomoyskiy’s fortune.
Many of the country’s oligarchs have a vested interest in a stronger parliament and a weaker presidency – a system on which their wealth depends. Fortunately for them, they are able to exercise enormous influence over elections by funding their preferred candidates’ campaigns and heavily influencing the media. (Ukraine’s key media outlets are largely controlled by oligarchs.), Kolomoyskyi, along with many of his peers, feared another Poroshenko term could mean the complete destruction of his business empire, and they lined up to support his various opponents in the race.
President-elect Zelenskiy is often portrayed as a man of the people. And while he, unlike Poroshenko, is not an oligarch, he has the oligarchs' backing and so is unlikely to go up against them. And judging by the election results, it seems that despite Poroshenko’s best efforts, the oligarchs remain extremely powerful, and their power is unlikely diminish under the Zelenskiy administration. Still, it’s difficult to say what exactly Zelenskiy’s election will mean for the oligarchy’s future. Zelenskiy said in an interview that he would dissolve the Rada, Ukraine’s parliament, as soon as possible; it’s packed with his opponents, and he knows he’ll have trouble getting his agenda through the current assembly. But there are Rada elections comping up later this year, during which each oligarch – Poroshenko included – will do their best to promote candidates who will advance their interests. And Zelenskiy, for his part, cannot just dismiss the oligarchs. He’ll have to negotiate with them if he wants to hold onto power. Don’t expect him to take any tough political action in his first term.
Meanwhile, in Moscow
Perhaps nobody is paying more attention to Ukraine's political uncertainty than Russia. Turmoil there worries Moscow far more than a Ukrainian ship in the Sea of Azov. Perhaps the worst-possible scenario – the outbreak of a political struggle between oligarchs and collapse of an already fragile Ukraine – would cost Russia dearly; Russian firms and businesspeople have invested heavily in Ukrainian sectors like telecommunications and energy.
Ukraine also remains an important buffer zone for Russia. It’s a key transit zone for Russian oil and gas exports to Europe, and despite ongoing talks, there’s no quick or easy alternative route for those exports to Europe. Neither Russia nor Europe is interested in letting the simmering Ukraine conflict become a serious confrontation between Russia and the West.
Zelenskiy has shown somewhat less hostility toward Russia than his predecessor, and a slight warming in bilateral relations can be expected – but no more. Ukraine’s foreign policy remains unchanged, and for the moment Zelenskiy will have to focus on managing internal changes. And this fall, he’ll have to watch the new elections, when Ukraine’s businessmen continue trying to recoup their losses.

The Rules Will Change but That’s (Probably) OK

By John Mauldin

“But the emperor has nothing at all on!” said a little child.

“Listen to the voice of innocence!” exclaimed his father; and what the child had said was whispered from one to another.

“But he has nothing at all on!” at last cried out all the people. The emperor was suddenly embarrassed, for he knew that the people were right; but he thought the procession must go on now! And the lords of the bedchamber took greater pains than ever, to appear holding up the robes although, in reality, there were no robes at all.

—“The Emperor’s New Clothes” by Hans Christian Andersen

When you write about controversial topics for hundreds of thousands of readers for 20 years, you develop a thick skin. Virtually anything I say will upset someone.

So, when people say something like, “John Mauldin wakes up sucking lemons and then moves onto something sour,” as happened after last week’s letter, it doesn’t bother me. (It actually made me smile.) I write what I believe is correct. Those opinions change over time as I get new information.

I’m not the only one who changes. Laws and policies that may seem etched in stone are often more flexible than generally thought. In last week’s Japanification letter, I described how no one anticipated the various extreme measures taken in the last crisis, from TARP to QE to NIRP. Yet once those ideas were in play, they happened quickly.

I think the next crisis will bring similarly radical, sudden changes. We will think the unthinkable because we will see no other choices. That means the range of possible scenarios may be wider than you think.

To think this may be so is not necessarily bearish.

Fiscal Insanity

As of now, my best guess is the US will enter recession sometime in 2020. I may be off (early) by a year or two, but it’s coming. We know two things will happen.

  • Tax revenues will fall as people’s income drops.

  • Federal spending will rise as safety-net entitlement claims go up.

The result will be higher deficits. Keynesian economics advocated running deficits during recessionary and economically difficult times and surpluses the rest of the time. That’s not what we did.

Last year (fiscal 2018) the “official” budget deficit was $779 billion. The national debt went up $1.2 trillion. The “small” $421-billion difference was more than half the official budget deficit. That is the off-budget spending that Congress doesn’t count. It includes the revenue and spending of certain federal entities that Congress wants to isolate from the normal budget process. Lately it has run in the multiple hundreds of billions of dollars, every year.

Below is a graph showing the projected budget deficits for 2019 and 2020 from a website called The Balance. You can find similar numbers all over the internet. I’m using the US but the situation is similar in most developed countries (though hopefully not yours).

Now, add another $400 million to each of those numbers. What is called the “unified budget” is now $1.5 trillion.

Next, let’s go to a very handy website called The US Debt Clock. (Scrolling around you can find the debt for your own country and state and other useful data.) We see that halfway through fiscal year 2019, the debt is already well over $22 trillion. It will be $23 trillion before the end of this year. By the end of 2020, Trump’s first term, it will be approaching $25 trillion. And that doesn’t include state and local debt of $3 trillion plus their $6 trillion unfunded pension liabilities.

And as I pointed out before, all that is without a recession. The unified deficit will easily hit $2 trillion and approach $2.5 trillion in the next recession. Within 2 to 3 years later, the total US debt will be at least $30 trillion. Not including state and local debt or unfunded pension obligations (more on those later).

Recognizing that simple arithmetic is not being bearish. It’s recognizing reality.

There are calls for a 70% tax rate on incomes over $10 million. Experts quoted in The Washington Post estimated it would produce about $72 billion a year. And you can guarantee that people will work their income statements to get below that. And in the face of a $2.5-trillion deficit? It doesn’t do very much, let alone pay for any new programs.

The simple fact is that raising income taxes on whatever we think of as the wealthy doesn’t get us close to a balanced budget. But what about actually doing a wealth tax? Like 1% of total net worth on the 1% wealthiest in America? Helpfully, The Washington Post article calculates that for us (my emphasis):

Slemrod, of the University of Michigan, said in an email that the wealthiest 1 percent of Americans own roughly one-third of the $107 trillion in wealth in America. This group collectively holds about $20 trillion in wealth above $10 million per household.

From there the calculation of wealth tax is simple: a 1 percent wealth tax on the wealthiest 1 percent of households above $10 million could raise about $200 billion a year, or $2 trillion over 10 years. Tedeschi, the former Obama official, found a 0.5 percent wealth tax on the top 1 percent could raise at most $3 trillion over 10 years.

But this, too, would probably change Americans' behavior and perhaps lead them to try shifting their wealth overseas, and the economists say the actual amount of revenue is likely lower than their estimates suggest. And this is assuming there are no exemptions to what is considered wealth, such as housing assets.

Again, a few hundred billion a year is nothing to sneeze at, but at the rate we’re going would make only a small dent in the deficit.

The real problem? Unfunded entitlement spending. The CBO is projecting literally trillion-dollar deficits in the latter part of this next decade simply because of unfunded entitlement spending. And then there’s the pesky little fact that we spent $500+ billion last year on interest payments.

In a recession and bear market, the $6 trillion of unfunded pension liability on state and local balance sheets could easily rise to $9 trillion, a number most cannot meet. Either firefighters, police officers, teachers, former government workers, etc., would not get their agreed-upon pensions or state and local taxes would have to rise precipitously, or the federal government will have to step in.

All of this will happen in an environment in which the Federal Reserve will be fighting a recession and a slow-growth economy, trying to move those asset prices back up to help the pension funds. So for me to suggest that the balance sheet of the Federal Reserve could grow to $10 trillion by the middle of the next decade and $20 trillion by the end of the decade is not entirely outrageous. And we haven’t really approached Japanese territory yet.

This analysis is not “bearish.” It is simply looking at the numbers, doing the arithmetic, and observing that we’ll have to borrow a great deal of money to meet our obligations.

I might be wrong if politicians from either party run and win with a platform of “I’m going to cut your Social Security and Medicare, slash the defense budget, and zero out a lot of little other pesky expenditures that you probably like.” I feel sure that won’t happen.

Avoiding the Windshield

The Emperor isn’t wearing any clothes. Maybe I’m that naïve little boy who isn’t smart enough to see the beautiful cloth in which our national budgets are arrayed, and how easily we can raise more taxes from invisible sources.

And like the Emperor in the above story, we just keep walking and telling ourselves that nobody will notice.

The bulk of that debt will end up on the Federal Reserve’s balance sheet, just like the bulk of European debt will end up on the balance sheet of the European Central Bank, the Bank of England, and so on.

Exactly the path the Bank of Japan has already gone.

Let’s examine how that worked for them. From one perspective, it has done quite well. From another, they have paid a cost. Is it worth it? I think many Japanese, likely a big majority, would say yes.

The Bank of Japan has more than 140% of Japanese GDP on its balance sheet. Its laws let it buy equities not just in Japan but all over the world and it has. Yet the currency is roughly the same value as it was when the Bank of Japan got busy with that project.

I am personally well aware of that because I was the one who called Japan “a bug in search of the windshield.” Just like I am predicting that much of the US deficit will end up on the balance sheet of the Federal Reserve, I said the same thing would happen to the Japanese. I also said it would devalue their currency. I actually put real personal money, not just token money, on the prediction. I bought a 10-year yen put option. That trade has not worked out so well. I don’t even want to open the envelopes from J.P. Morgan containing that information.

But I learned a lesson and I had a great deal of company. Many hedge fund managers and other investors made the same bet. In essence, we said that Japan is going to print money and the same thing will happen to it that happened to every other country in the same situation: The currency will lose value.

Instead, it brought one of the most surprising macroeconomic outcomes that I could imagine. Talk about thinking the unthinkable back in 2008. What happened is unthinkable to me, and to a lot of other people.

First, let’s realize that Japanese debt-to-GDP has risen to 253%. Notice in the graph below that the increases are much smaller each year. That is a (surprising!!!) point I’m going to make next.

For the last two decades, the Japanese have been promising they would balance their budget in 7 to 10 years—and they’re actually beginning to make progress. Their fiscal deficit is in fact smaller every year in terms of GDP and actual numbers of dollars. Good for them.

The deficit should fall even further as they have a small sales tax increase kicking in the fall of this year. It is, of course, controversial whether they will actually implement the tax, but I expect them to eventually do so. And sometime in the next decade, it is entirely possible that Japan will actually have a balanced budget, and then a surplus that lets the government begin paying down that debt.

Of course, they have to navigate global recessions, and all the sturm und drang and vicissitudes of life, but they are clearly trying to move in the correct direction. Kudos to Abe and Kuroda-san.

The Cost of High Debt

All this has not been without cost. It brought severe financial repression on savers. If you could somehow buy a new Japanese government bond, which is almost impossible because the BOJ buys everything that isn’t nailed down, you would get negative yield. That’s one reason Japanese savers are not selling their bonds. Even 1–2% on bonds bought “back in the day” is a lot more than they can get now.

The Japanese government bond market was once one of the world’s most liquid. Now it trades by appointment. Here is the JGB yield curve right now. Notice it is negative out to 10 years. So if somehow you had bought a 20-year bond 10 years ago, which makes your Japanese bond now a 10-year bond (effectively), you would have a nice capital gain. But then where would you put the proceeds if you sold? That’s why there are very few actual sales in the Japanese bond market.

As Lacy Hunt will demonstrate to us at the SIC (get your virtual Pass here), massively increasing debt actually reduces interest rates, productivity, and GDP growth, exactly as we see in Japan. They ran massive government debt, bringing future consumption into the then-present, and now must live in a world where that future consumption doesn’t happen, GDP growth is negligible if not negative, and investors have to live by new rules.

To some degree, we already see the first evidence of that in the US. My good friend Ben Hunt notes that the S&P 500 companies have the highest earnings relative to sales in history.

Source: Ben Hunt

Quoting Ben:

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales… earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

Ben goes on to say many people think that is because of technology. He argues it is the financialization of our economy and the Fed’s loose policies. I agree 100%. If you think they haven’t changed the rules since the 1980s and 1990s, you aren’t paying attention, boys and girls!

It goes without saying that those profits are not going to labor, and the same monetary policies that were supposed to enhance the economy have contributed mightily to wealth and income disparity. When you muck around with the markets, don’t be surprised if you get unintended consequences. We have them in spades, and everybody wants to blame “the rich” rather than the incentives the government and Federal Reserve created.

New Rules, or Moving the Goalpost

I don’t think it is bearish to notice the political and arithmetic implications of our budget process. I want to help my readers understand that the rules are going to change. That is not necessarily a bad thing. It is just what it is.

The massive increase in debt, huge quantitative easing programs, and increased financialization of the investment process are going to change the rules of investing we have lived under for the last 50 years.

It is going to be difficult, more difficult than now, to get a positive return on your bonds without taking significant risk. And your returns are going to be lower. Think Japan. Think Europe. For that matter, think the US.

If somehow the gods of American football changed the rules so you needed 12 yards for a first down, the field was now 120 yards long, and gave a few advantages to receivers, the nature of the game would change. It would still be recognizable as football but it wouldn’t be the game we know.

That’s not unprecedented. Football in my father’s day was significantly different from now. I’m sure there are people nostalgic for the way it was. I just want to watch the game as it is today. And when it comes to investing, if I have to change my style and look for different opportunities, it is just acknowledging a rule change.

I am not being bearish when I say there is the potential for future rule changes. I am simply pointing out what I see.

I think I am truly the most optimistic man in the room. Everywhere I turn I see opportunities. But then, I’m looking beyond my Bloomberg or business TV.

The world is changing around us and we have to adapt. Many won’t notice the changes and end up like the dinosaurs. That is very sad. What will happen to people who are counting on pension funds is also going to be very sad. Or we taxpayers are going to have to step in and bail them out. As a taxpayer, that is also sad.

Is there a way out of all of this? Absolutely. We can overhaul the tax system like I wrote two years ago, actually balance the budget, fund all the entitlement spending, and watch GDP growth once again become part of our national conversation.

But it will take a crisis before we consider that. In the meantime, let’s pay attention to how the rules are changing and adapt.

Now, how is that bearish?

The rules really are changing and past performance is not, and will not be, indicative of future results.

Dallas, Cleveland, Chicago, Puerto Rico, and Washington DC

Travel just seems to happen to me. I have to go back to Dallas to have my root canal checked and get a new cap, then run to the airport to get to Cleveland to have my eyes checked because of the cataract surgery (which seems to have gone well), then run to another airport to get to Chicago for a speech, some meetings, and a dinner the next night, then back to Puerto Rico and finish next week’s letter before flying off to Washington DC to do a video with my friend Neil Howe.

Almost every day I have one if not two conference calls with speakers who will appear at the Strategic Investment Conference, going over what they will say and how the panels will interact. It is hard for me to curb my enthusiasm. There will be so much important information conveyed that will help you understand the changes that are coming. We will discuss China, Europe, geopolitics, debt, central bank policy, all sorts of market and market opportunities, real investment ideas, and much more. And hopefully have a lot of fun while we are doing it. If you can’t make it (get on the waiting list if you think you might be able to change your schedule), then you really should get the Virtual Pass. It’s the best deal out there.

One of the best things about going to Dallas is that I will get to see some of my kids. Maybe even catch an action movie with the boys. And a few friends have time slotted as well. Sunday will be a full day. You have a great week!

Your calling it as I see it analyst,

John Mauldin
Chairman, Mauldin Economics