Our Nuts Are in Danger

John Mauldin

 


Life would be so much easier if we didn’t have to worry about our financial futures. Though I suppose we don’t have to worry. Animals don’t. Squirrels instinctively store away nuts and thus live through winter without much thought.

We humans have retirement winters, and we’re more sophisticated than squirrels. We generally outsource the job of managing our nuts/money to professionals. All well and good if we save enough and if the professionals do their jobs right. As we saw last week, the elected squirrels who run Social Security haven’t evolved to face changing conditions. Our Social Security nuts are in danger.

But the problem is even bigger. Today I want to continue this theme using some recent corporate news as our springboard. Economic changes have made future planning increasingly difficult for government retirement systems, private pension plans, and individual investors. How do you generate a reliable income stream for an uncertain but potentially lengthy lifespan in a world where interest rates are barely above zero and possibly below it?

The easy answer is “save more,” but that strategy has limits. We all have current expenses. Yes, we can live simpler lives, but we can’t save 100% of our income. Yet that’s what it will take in some scenarios.  

If you’re starting to envy the squirrels, you aren’t the only one.

Big Gaps

Remember “defined benefit” pensions? That is the kind of plan in which the employer guarantees the worker a set monthly benefit for life. They are increasingly scarce except for small closely held corporations.

My US accountant has set up well over 1,000 defined benefit plans, including two for me. His primary customers are dentists. The same rules apply for small closely held businesses as for large corporations. These plans can be great tools for independent professionals and small business owners.

But if you have thousands of employees, DB plans are expensive and risky.

The company is legally obligated to pay the benefits at whatever the cost turns out to be, which is hard to predict. The advantage is you can use some hopeful accounting to set aside less cash now and deal with the benefit problems later. The problem is “later” comes faster than you would like, and procrastination can be a bitch.

At some point, the risks outweigh the benefits, which is why few large companies have open DB plans these days. But the plans are often still in effect for older workers, and the amounts are large and frequently underfunded. Companies are slowly dealing with the problem.

And that brings us to the lesson for today. On October 7, General Electric (GE) announced several changes to its defined benefit pension plans. Among them:

  • Some 20,000 current employees who still have a legacy defined benefit plan will see their benefits frozen as of January 2021. After then, they will accrue no further benefits and make no more contributions. The company will instead offer them matching payments in its 401(k) plan.

  • About 100,000 former GE employees who earned benefits but haven’t yet started receiving them will be offered a one-time, lump sum payment instead. This presents employees with a very interesting proposition. Almost exactly like a Nash equilibrium. More below…

The first part of the announcement is growing standard. Employers prefer 401(k) plans because they transfer investment risk to the employees. Other than the matching payments—which end when the worker quits or retires—the company has no future obligations.

The second part is more interesting, and that’s where I want to focus.

Suppose you are one of the ex-GE workers (and I’ll bet I have some readers in that group) who earned benefits. As of now, GE has promised to give you some monthly payment when you retire. Say it’s $1,000 a month. What is the present value of that promised income stream? It depends on your life expectancy, inflation, interest rates and other factors. You can calculate it, though. Say it is $200,000.

Is GE offering to write you a generous check for $200,000? No. We know this because GE’s press release says:

Company funds will not be used to make the lump sum distributions. All distributions will be made from existing pension plan assets in the GE Pension Trust. The company does not expect the plan's funded status to decrease as a result of this offer. At year-end 2018, the plan's funded ratio was 80 percent (GAAP).
 

So GE is not offering to give away its own money, or to take it from other workers. It is simply offering ex-employees their own benefits earlier than planned. But under what assumptions? And how much? The press release didn’t say.

If that’s you, should you take the offer? It’s not an easy call. First, you are making a bet on the viability of General Electric. In September 2000, GE stock traded at $58+ per share. As I write this it is $8.45. The board has slashed dividends and the dividend yield is now only 0.47%.

As of April, GE had $92 billion in liabilities in its pension plan, on assets a little below $70 billion. Commendably, the company is “pre-funding” $4–5 billion into the DB plan. As we will see, however, this is chump change to the actual obligations.

In various ways, the choice GE pensioners face is one many of us will have to make in the coming years. GE isn’t the only company in this position.

You’re still affected even if you don’t have a DB plan. Lots of people are reaching retirement age to find they only have 80% (and often less) of their “fully funded” amount. They have to fill the gap somehow. Most often, that means reducing expenses or working longer, if you’re able.

Rising Pressure

When GE says its plan is 80% funded under GAAP, it necessarily makes an assumption about the plan’s future investment returns. Here’s what they say in the 2018 annual report.
 


Source: GE

 
I dug around and found the “expected rate of return” was 8.50% as recently as 2009, when they dropped it to 8.00%, then 7.50% in 2014, to now 6.75%.

So over a decade they went from staggeringly unrealistic down to seriously unrealistic. They still assume that every dollar in their pension fund will grow to almost $4 in 20 years.

That means GE’s offered amounts will probably be too low, because they’ll base their offers on that expected return. GE hires lots of engineers and other number-oriented people who will see this. Nevertheless, I doubt GE will offer more because doing so would compromise their entire corporate viability, as we’ll see in a minute.

In any case, more companies will do such things and affected workers won’t be happy. We’ll see the same in state and local government pensions, which are often even more underfunded and have even more absurd investment projections. These are becoming untenable and lump sum offers like GE’s help highlight that fact.

This, in turn, will raise pressure on plan sponsors to reduce those projections, which will increase the amounts they must contribute to their plans, which (for the corporate ones) will reduce earnings.

See where this is going?

We are right now entering an earnings season that may not be disastrous but doesn’t look too impressive, either. It is getting harder to justify the valuations investors place on many stocks.

If you take out the buyback activity from companies themselves, and the index funds and ETFs that buy indiscriminately as yield-starved investors give them more cash, who is really buying stocks in any major way?

And what happens when they stop buying?

If you’re holding stocks, you better have an answer.

Victoriously Breaking Even

In last week’s Social Security discussion, I noted a fatal flaw in ideas to convert the system into private accounts. Two flaws, actually: 1) Most people don’t know how to invest successfully and 2) now is a terrible time to learn.

(Note, that probably doesn’t include you. You’re reading this letter so you have at least some basic economic and financial literacy. But you represent maybe 5% of the population.)

I dislike saying “it’s different this time” but it really is. Today’s conventional investment wisdom came from an era when there was this thing called “risk-free rate of return.” Everyone could count on earning something, though perhaps not much, without risking it all. Inflation might erode your principal over time but you could at least see it coming.

Now there is no such option. Banks and Treasury securities pay zero, almost zero, or slightly below zero in some places. Don’t like it? Start adding risk. That is your only choice now.

We are in a world where simply breaking even counts as a victory… and that is a serious problem if you need to fund a long retirement.

My friend John Hussman’s September letter, Going Nowhere in an Interesting Way, is a fascinating and important read on this topic. (Over My Shoulder members can read my annotated version here.)

Hussman’s main point: It’s folly to assume stocks will continue performing the way they have in recent years. First, the last two decades haven’t been so great. The S&P 500 total return since 2000 was just 5.4% annually and getting there took the most extreme valuations in US history.

He calculates that assuming 4% nominal growth in economic fundamentals and a historically normal valuation 20 years from now, average annual gain for the next two decades will be -1.0%. Yes, that’s a negative sign.

Ok, that’s just stocks, you may say. I’m a bond guy. Fair enough. So maybe instead of -1.0% you’ll earn a positive 2%. That still makes real growth difficult.

Investment math is actually pretty simple if your return assumption is 0%. Calculate how much you need to retire, and save that much. Hussman does it more elegantly. 

Suppose an investor has accumulated a lump-sum of savings, and wants to finance a long-term stream of real, inflation-adjusted spending. How large must the initial “endowment” be, as a multiple of annual spending, to finance those future outlays, assuming that it’s passively invested in a conventional portfolio mix (60% S&P 500, 30% Treasury bonds, 10% Treasury bills)?

As a convention, we assume a 36-year horizon, representing a 64-year-old investor hoping to fund spending over a potential 100-year lifespan. There’s nothing special about that horizon, and we obtain similar results using any horizon beyond about two decades, because long-dated distributions have very little impact on the total present value.

The chart below presents our estimate of the Endowment to Spending Multiple going back to 1928. The equity market return estimates are based on the Margin-Adjusted P/E before 1950, and the ratio of nonfinancial market capitalization to corporate gross value-added after 1950. The bond market return estimates use the yield to maturity on long-term Treasury bonds at varying horizons.


 
You’ll notice that the current E/S Multiple is over 31, which basically says that if you insist on passively investing a lump-sum in a conventional portfolio mix in order to fund your retirement, you’d better already have nearly all the dollars you hope to spend, because the prospects for significant long-term capital growth from present valuations are dismal. Contrast this with 2009, when the estimated E/S multiple was 18, or with 1982, when the E/S multiple fell to a record low of 9.

 
A pretty dismal outlook: If you want to fund an income stream, your lump sum should be 31X the annual income you seek.

But Wait, There’s More

At the risk of sounding like Ron Popeil of Ronco fame (But Wait, There’s More!), whom readers of a certain age will remember nostalgically, there is more. Sadly, you can’t buy it on late-night television.

The reality is simple. Valuations are high and returns based on historical numbers do not suggest anything close to the 6.75% GE expects, let alone the ridiculous numbers public pension plans expect.

I asked mi buen amigo (I’m trying to learn Spanish) Ed Easterling of Crestmont Research to send me his latest numbers. Based on historical numbers using the Shiller model (other models would be slightly worse) it looks like this. We are currently in the top decile.


 
Get that? Historical returns based on 110-year models suggest future returns will be anywhere from -1.8% to +3.6%, from where we are today.

Note that 3.6% compound is the top end past historical performance. Also note that I have continually cited academic arguments that the debt situation that we are in today, both as a government and privately, preclude the potential for above-historical-average growth, suggesting lower growth is more likely.

Then quickly, let’s look at the seven-year projected returns from GMO:
 


Source: GMO

 
Note that these are real returns and not nominal returns. So GMO is actually projecting seven-year returns somewhere around -1.5%. Still quite ugly.

What happens when we have a recession? Remember those ugly things? Pension plan assets suffer a major hit and unfunded liabilities soar! Do you really think central banks can forestall recessions forever? When they are already at the zero bound? Look at the historical frequency, again from Crestmont Research.


Source: Crestmont Research

 
We are in the first decade to have no recession in, well, forever. Think we can dodge that bullet in the 2020s? Gods forbid, what happens if we have two? The stock market goes sideways for a really long time. Kind of like the 2000s. Then what does GE’s 6.75% return assumption look like? Especially in the zero-bound world of bonds? The answer is “burnt toast.”

Let’s generously assume a 2%+ dividend yield from where we are today. But the chance of a multiple expansion is damn near zero. The Shiller multiple is already 28.6%. (Yes, I get that you can spin P/E multiples numerous ways, but Nobel Laureate Bob Shiller does as well as anybody to reduce the spin.)

GE has $92 billion in pension liabilities offset by roughly $70 billion in assets, plus the roughly $5 billion they’re going to “pre-fund.” But that is based on 6.75% annual return. Which roughly assumes that in 20 years one dollar will almost quadruple. What if you assume a 3.5% return? Then you are roughly looking at $2, which would mean the pension plan is underfunded by over $100 billion—and that’s being generous. GE’s current market cap is less than $75 billion, meaning that technically the pension plan owns General Electric.

This is why GE and other corporations, not to mention state and local pension plans, can’t adopt realistic return assumptions. They would have to start considering bankruptcy.

If GE were to assume 3.5% to 4% future returns, which might still be aggressive in a zero-interest-rate world, they would have to immediately book pension debt that might be larger than their market cap.

GE chair and CEO Larry Culp only took over in October 2018. We have mutual friends who have nothing but extraordinarily good things to say about him. He is clearly trying to both do the right thing for employees and clean up the balance sheet. He was dealt a very ugly hand before he even got in the game.

GE needs an additional $5 billion per year minimum just to stave off the pension demon. That won’t make shareholders happy, but Culp is now in the business of survival, not happiness.

That is why GE wants to buy out its defined benefit plan beneficiaries. Right now, the company is on the wrong side of math. It doesn’t have anything like Hussman’s 31X the benefits it is obligated to pay. Nor do many other plans, both public and private. Nor does Social Security.

To be clear, I think GE will survive. Its businesses generate good revenue and it owns valuable assets. The company can muddle through by gradually bringing down the expected returns and buying out as many DB beneficiaries as possible. But it won’t be fun.

Pension promises are really debt by another name. The numbers are staggering even when you understate them. We never see honest accounting on this because it would make too many heads melt.

And again, a recession is probably coming in the next year or two. The Treasury yield curve has been inverted for three months now and Campbell Harvey, who pioneered that indicator, says it is “flashing code red.” This will further aggravate the pension problem.

If I am a GE employee who is offered a buyout? I might seriously consider taking it because I could then define my own risk and, with my smaller amount, take advantage of investments unavailable to a $75 billion plan.

We are like a football team facing a very tough schedule. Winning will take a solid team working together. Going it alone will be difficult in the 2020s.


Announcing “7 Deadly Economic Sins” Week

Regular readers know my “Things to Worry About” list is pretty long: unsustainable national debt, the fact that nearly 50% of all corporate bonds are teetering on the edge of the BBB cliff, power struggles between competing nations, the insanity of Modern Monetary Theory, a growing partisan split in the US and Europe, an exceedingly hostile US-China relationship, and the threat of negative interest rates.

I think all of these warrant taking a closer look, so October 14–20 will be “7 Deadly Economic Sins” Week at Mauldin Economics.

Seven of my closest friends and I will sit down for thoughtful conversations with our own Jonathan Roth. You probably already know them: Louis Gave, Grant Williams, Peter Boockvar, Lacy Hunt, George Friedman, William White, and Samuel Rines.

They’ll all give you their take on the root causes of the coming global economic crisis.

On Monday, we will start the week with me talking about the deadly economic sin of Lust. Please watch for my emails throughout the week so you won’t miss this special treat.

New York and Butterflies

Other than being in New York October 21 and thereabouts, I’m trying to stay close to home. And when I say home, I can now say that I have finally closed on my home here in Dorado Beach East, Puerto Rico. Getting a loan here is kind of like a Spanish soap opera unless you are willing to pay the going rates. I am paying close to 6%, a far cry from the 2.375% mortgage I had in Dallas. Seriously, there is an opportunity for a jumbo mortgage lender in Puerto Rico. Under 5%, you can sweep the market. Refi’s will line up. On solid loans.

The eye doctor says I am okay and so back to the gym tomorrow. Patrick Cox and Terry Coxon are coming this weekend to discuss funds focused on biotechnology investments. It will be a fascinating weekend of speculation.

And finally, one picture from the butterfly sanctuary my wife Shane has literally created in our home. Seriously, she is raising butterflies, mostly Monarch but also a few other species. It is fascinating to watch them go from eggs to caterpillars to cocoons to butterflies. Here is one of her babies…


 
And with that glorious image I will hit the send button. You have a great week while we all contemplate a lower-return future. And figure out how we beat the average.

Your creating a team to control our future analyst,



John Mauldin
Co-Founder, Mauldin Economics

Here’s one way to fix Brexit’s Irish border problem

The government has already conceded that some rules for Northern Ireland will be set by the EU

Martin Sandbu




Amid the fallout from the UK Supreme Court’s landmark decision on the suspension of parliament, it is easy to forget that Boris Johnson’s first significant engagement with Brexit as prime minister was in a letter to Donald Tusk, president of the European Council.

In it, he reneged on the UK’s December 2017 commitment to keep Northern Ireland aligned with the EU regulations and customs rules until other ways to avoid border infrastructure and controls could be agreed. This was formalised as the “backstop” for Northern Ireland only, later extended to an all-UK version at Britain’s behest.

The commitment, undertaken in the so-called EU-UK Joint Report, had been the EU’s precondition for entering talks on long-term trade relations. By reneging, the UK went back on something the EU took in good faith. From Mr Johnson, such behaviour is hardly shocking, even if it should be. More importantly, it is counterproductive. When the UK has asked to sort out border issues after Brexit, Irish leaders are at pains to emphasise that they cannot replace a legal guarantee with a promise. Given what happened to the earlier promise, who can blame them?

While not couched in these terms, the EU now insists on recommitting the UK government to the Joint Report. That is how we should read the overture by Jean-Claude Juncker, the president of the European Commission, to alternatives to the backstop if “all” its objectives can be met by other means than aligning with EU rules.

No such means have been identified. This reality is the same as that faced by Theresa May. So Mr Johnson’s premiership started by reverting to his predecessor’s late-2016 position only to turn into a fast-forward replay of her evolution towards a softer Brexit. The question is whether he will move far and fast enough towards EU demands in the limited time left and be able to sell the concessions this entails better than she did.

By accepting the notion of a single regulatory area for agrifood, Mr Johnson and his Democratic Unionist partners have already conceded that some rules for Northern Ireland will be set by the EU. That makes extending regulatory alignment to industrial goods a simple question of scope. There is no deep reason why Britain should refuse to accept for industrial goods what it accepts for agrifood — regulatory checks on boats crossing the Irish Sea — and the prime minister now hints he may do just that.

There is a problem of democracy, in that Northern Ireland will be governed by rules decided elsewhere. But this is a problem the EU is willing to ameliorate. The Joint Report explicitly provided for an economic border in the Irish Sea if Northern Ireland’s elected institutions agree. Mrs May’s withdrawal agreement includes a Joint Committee to oversee the backstop, on which those institutions could have representatives. And models exist: non-EU countries in the single market, such as Norway, have a system for adopting EU rules that preserves formal sovereignty while protecting the single market’s integrity.

Mr Johnson was therefore right to spot a “landing zone”. In substance, it looks much like where Mrs May ended up landing. (Northern Ireland will also have to stay in the EU’s value-added tax rules, but this is so technical as to escape politics.) The thorniest problem remains: customs.

Mr Johnson, like Mrs May, will accept regulatory differentiation but insists on one trade regime for the whole UK. For her, this meant an all-UK tie-in with the EU customs union. For him, it means Northern Ireland out of it. The customs border this entails is why customs is shaping up to be the one outstanding obstacle to a deal. Even accepting alignment on all other things would create two borders rather than just one.

The UK will not convince anyone that technology can substitute for border controls. But another rejected alternative may be worth revisiting. The “customs partnership” where the UK would have its own trade deals but enforce EU tariffs on imports destined for the single market was only ridiculed because it was unrealistic to identify which goods were headed for the EU when entering the UK customs area. But it is not quite as unrealistic to identify which goods cross into Northern Ireland and end up there or return to Great Britain.

The UK could offer to enforce EU customs rules on all goods crossing the Irish Sea, but where its own future tariffs were lower, it would rebate the difference for Northern Irish consumers — on the model of VAT refunds for travellers — or for re-exports back to Great Britain. Such tariff rebates could be managed via the tax system for individuals, so only Northern Irish residents would benefit, and via VAT tracking for re-exports. Since named individuals and firms would have to claim the rebate, fraud attempts could be detected.

While convoluted, such a system is not unworkable, and it would tick a number of important boxes. It would secure the correct tariff revenue for the EU and enforce its commercial policy. It would allow the government to promise — honestly — that Northern Ireland would share the benefits of trade deals. It would keep the Irish land border open.

The question for the UK government is not whether to concede but how to defend its concessions. A politically sellable customs solution is at the crux of whether it delivers a broken Brexit or an orderly one.

Explosive Silver Prices Will Be Mind Boggling

by: Bob Kirtley


Summary
 
- Gold has been ignored for 6 years and silver has been totally forgotten about by the majority of the investment community.

- This chart depicts the sudden rise in silver prices from around $14.50/oz to a high of $19.50/oz in just 4 months.

- Silver has been moving faster than gold as the gold/silver ratio shows that it now stands at a reduced level of 83.

All in all, the scene is set for an exodus from some of the large investment classes and into the precious metals sector, particularly silver.


Introduction

Gold has been ignored for 6 years and silver has been totally forgotten about by the majority of the investment community. This was evident when the gold/silver ratio rose to almost record levels at 95 which was reached in July 2019. The situation has started to change over the last few months as we have seen both gold and silver prices spring to life and increase in value. In particular, silver has been moving faster than gold as the gold/silver ratio shows that it now stands at a reduced level of 83.
 
This chart depicts the sudden rise in silver prices from around $14.50/oz to a high of $19.50/Oz in just 4 months. We can also glean that during that period of rapid movement, silver formed a number of higher lows which is usually a positive indication of a strong advance.
 
 
 
 
Gold/Silver Ratio chart
 
This chart shows that the gold/silver ratio rose to 95 when silver was out of favor and has subsequently reversed as silver prices gained some traction. Over the last 20 years, the average has been around 60 for this ratio so there is still room for silver to move to higher ground before it hits that average. There are some who are calling for the ratio to drop to around the 15 level.

These predictions generate vastly different prices for silver as per the following:
 
Gold at $1,500/Oz, the ratio at 83, Silver priced at $18.00/Oz. Gold at $1,500/Oz, the ratio at 60, Silver priced at $25.00/Oz. Gold at $1,500/Oz, the ratio at 15, Silver priced at $100.00/Oz.
 
The above calculations assume that gold will not increase in price, but we are firmly of the opinion that the new bull market in precious metals has started and will surpass previous all-time highs for both metals. If the price of gold continues to gain momentum, then the estimates shown for silver will be superseded by a considerable amount.
 
 
 
 
Reasons Behind This Move
 
There are a myriad of reasons that will drive this bull market, the two main reasons in our very humble opinion are the demise of fiat currencies and an economic recession which is long overdue.
 
A quick look at the currencies shows us that the central banks around the world are driving interest rates down to zero and in some cases negative territory, so there is no longer a return for savers who keep cash in a bank. They will need to do something else or sit and watch as their hard-earned wealth shrinks before their eyes.
 
We know that the European Central Bank has just re-introduced Quantitative Easing and we suspect it won’t be very long before other central banks follow suit. The constant printing of money only serves to weaken a currency and reduce its purchasing power.
 
The current economic recovery has been one of the longest in history and now looks to be exhausted as the S&P 500 struggles to retake the 3,000 level. The pullback could be severe as investors will move their funds out of the general markets in order to preserve their gains and avoid losses. Again, they too will be looking for a new home for their investment funds.

Other assets such as property have been in a bubble for some time in many parts of the world, and should that bubble burst, investors will look to liquidate their positions.
 
Conclusion
 
All in all, the scene is set for an exodus from some of the large investment classes as mentioned above and the precious metals sector has bottomed and is now heading for higher ground. The higher gold and silver go, the more airtime they will receive, and more and more investors will take an interest followed by taking an active part in this sector of the market.
 
Furthermore, it must be remembered that gold and silver and their associated stocks are tiny compared to the stock or bond markets, so even a small reallocation of funds will make a big impact on the demand side for these assets.
 
Silver prices will accelerate faster than gold prices so please give it some serious consideration along with the good quality silver producers that are due to experience a ballistic price rise before this bull market reaches its conclusión.

Free Exchange

Repo-market ructions were a reminder of the financial crisis

Soon enough post-crisis reforms will face serious tests

 

FOR ANYONE who lived through the global financial crisis, trouble in the market for repurchase agreements, or repos, induces a cold sweat. During the week of September 16th the repo market—the epicentre of the crisis 12 years ago—ran short of liquidity, forcing the Federal Reserve to intervene suddenly by injecting funds.

By the following week fears of a reprise of the global crisis were easing, though banks remained eager recipients of Fed liquidity. But the episode was a reminder that financial dangers lurk. At some point one will give post-crisis reforms a real-world stress test. It is unclear whether they are up to the challenge.

The financial crisis combined several storms into a single maelstrom. It was part debt-fuelled asset boom. A long run of rising home prices in America led to complacency about the risks of mortgage lending. Ever more recklessness fuelled the upward march of prices, until the mania could no longer be sustained. Borrowers began to default, saddling lenders with losses and creating a widening gyre of insolvency. Painful enough on its own, America’s housing bust became truly explosive thanks to an old-fashioned bank run.

Banks fund themselves on a short-term basis via demand deposits, but also on money markets, such as that for repos. Many bank assets, by contrast, are illiquid and long-term, such as loans to firms and homebuyers. This mismatch leaves banks vulnerable. During the Great Depression, many failed when nervous depositors demanded their cash all at once.

Though government-provided deposit insurance now protects against this hazard, it did not extend to money markets. In 2008, then, questions about the health of banks and their collateral triggered a flight from those markets, leaving healthy and unhealthy banks alike unable to roll over short-term loans and at risk of imminent collapse.

These twin woes were amplified by the global financial system’s interconnectedness. Cross-border capital flows soared in the years before the crisis, from 5% of global GDP in 1990 to 20% in 2007, spreading financial excess and outstripping regulators’ capacity for oversight.

Money from around the world poured into America’s mortgage market, and the resulting pain was correspondingly global. The Fed’s first crisis intervention, in August 2007, was in response to money-market turmoil prompted by financial difficulties at funds run by a French bank, BNP Paribas.

Chastened by the near-death experience, governments introduced regular stress-testing and made banks adopt “living wills”: plans to wind themselves down in the event of failure without endangering the system as a whole. Central banks added credit-risk indicators to their policy dashboards.

Regulators increased banks’ capital and liquidity requirements: bigger buffers against losses and liquidity droughts, respectively. In advanced economies bank balance-sheets look stronger than in 2007, and no obvious debt-fuelled bubbles have inflated.

Yet all that is less reassuring than might be hoped. Post-crisis, both governments and markets have proved surprisingly tolerant of risky borrowing. Despite household deleveraging, companies have taken on enough debt to keep private borrowing high; at 150% of GDP in America, for instance, roughly the level of 2004.

In America the market for syndicated business loans has boomed, to over $1trn in 2018, and loan standards have fallen. Many loans are packaged into debt securities, much as dodgy mortgages were before the crisis. Regulators have declined to intervene—remarkably, considering how recent was the crisis.

Just as the threat of bank runs migrated from depositors to money markets, so systemic risk may now be building up in non-bank institutions. Investment funds, pension managers and insurance companies have been eager buyers of securitised bank loans. As recently noted by Brad Setser of the Council on Foreign Relations, an American think-tank, some have begun to take on an ominously bank-like maturity mismatch.

Insurers in some countries, including Japan and Korea, have been hoovering up hundreds of billions of dollars of foreign bonds, hedging the exchange-rate risk on a rolling, short-term basis. If, in a crisis, these funds cannot renew their hedges, they could be exposed to significant losses. The vulnerabilities of supposedly staid firms may be an underappreciated source of risk for big banks.

These obscure dangers arise because finance remains extraordinarily globalised. Outstanding cross-border financial claims, though lower than just before the crisis, remain well above the historical norm. Money continues to slosh around the global economy, seeping into cracks beyond the reach or outside the view of national regulators. It is impossible to be sure that unanticipated turmoil in one corner of the financial system cannot spiral into something catastrophic.

The gyre next time

Troubles in repo markets illustrate the threat posed by this opacity. Market-watchers blamed the cash crunch on firms’ need to pay corporate-tax bills at the same time as sucking up more new government debt than usual. But banks were aware of these factors well ahead of time. Other, as yet poorly understood, forces seemed to have provided the nudge that tipped repo markets into disarray.

No obvious disaster looms. But the world did not appreciate the peril it faced in 2007 until too late. There are ways to keep financial risk in check. The Great Depression convinced many people that financial capitalism was inherently dangerous, but in the 40 years that followed, crises were infrequent—a testament to draconian financial regulation and capital controls.

Since the deregulation of the 1970s and 1980s, crises have been depressingly common. Just how far back the pendulum has swung will be clear only decades from now, when it becomes possible to look back and count the consequent misfortunes. Rattled once more by repo gyrations, it is tempting to say not far enough.

Over the line

America signs a limited trade agreement with Japan

The deal shows how hard it is for the Trump administration to rewrite the rules of world trade




PRESIDENT DONALD TRUMP teased trade-watchers on September 25th when he reannounced a deal with Japan (just weeks after announcing an agreement in principle). He promised it would mean “really big dollars for our farmers and for our ranchers”.

A White House press release boasted about the extra access American exporters of beef, pork and cheese would get to the Japanese market.

Robert Lighthizer, the United States Trade Representative, told journalists that American tariff reductions would arrive by January 1st. But despite all the fanfare, the text of the deal remained unpublished.

There had been hopes that Mr Trump might sign a mini-deal with India, too, during his meeting with the country’s prime minister, Narendra Modi, on September 24th. American companies complain that India’s price controls on heart stents and knee implants force them to sell at below cost price.

The hope was that, in return for a package that solved that problem, India might be reinstated as a member of America’s Generalised System of Preferences, which offers lower tariffs on some products. But negotiators failed to resolve their differences in time.

The mismatch between the demand for photo opportunities and the supply of worked-out trade deals explains both anticlimaxes. Such agreements are complex legal documents, and the language needs to be clear enough that neither side can squeeze out more concessions on the sly.

This is trickier when neither trusts the other. The deal with Japan was as difficult as any other, even though the negotiators had relatively recently sealed the Trans-Pacific Partnership (TPP), an agreement including America and Japan negotiated by the Obama administration, only to be rejected by Mr Trump.

Despite the lack of detail, one thing is clear: the deal will be narrow. Apart from some rules on digital trade, it seems to be focused on tariff barriers. It omits cars and car parts, even though these account for around two-fifths of Japanese goods exports to America. This has drawn criticism. Myron Brilliant of the US Chamber of Commerce, a lobby group, described the agreement as “not enough”.

The narrow scope is partly because the Trump administration wants to avoid having to seek full congressional approval. (American trade law allows small tariff concessions to be made without it.)

But it raises questions about whether the agreement complies with the rules of the World Trade Organisation, which say deals must include “substantially all the trade” if they are to withstand legal challenge.

The WTO does permit smaller interim agreements—and, mirabile dictu, that is how the Trump administration describes this one. The leaders’ joint statement said that within four months of the mini-deal coming into force, the two countries hope to finish consultations and “thereafter” start negotiating a deal that would address issues including barriers to trade in services and investment.

Some are sceptical. Wendy Cutler, a former negotiator on the TPP, fears “negotiating fatigue”.

Even with domestic pressure from American producers to whom the interim deal offered nothing, “it’s difficult to see how the second stage would be concluded on an expedited basis,” she says.

Further doubts stem from the leverage that has been granted to Japanese negotiators. They were brought to the table after America walked away from the TPP by the threat of tariffs on cars and car parts.

Now they have concessions they can roll back if the Trump administration enacts those.

Threats have worked once. But they could be less use in securing the big concessions needed if this supposed staging post is not to become the final destination.

Global economy is at risk from a monetary policy black hole

Governments should borrow more to stave off secular stagnation

Lawrence Summers

Kristalina Georgieva, managing director of the International Monetary Fund (IMF), pauses while speaking ahead of the IMF and World Bank Group Annual Meetings in Washington, D.C., U.S., on Tuesday, Oct. 8, 2019. Georgieva, in her first major address as head of the IMF, painted a downbeat picture of the world economy and said a more severe slowdown could require governments to coordinate fiscal-stimulus measures. Photographer: Andrew Harrer/Bloomberg
The new managing director of the IMF, Kristalina Georgieva, has warned that economic growth globally is decelerating © Bloomberg


New IMF managing director Kristalina Georgieva’s first speech makes bracing reading for the global financial community as it gathers this coming week in Washington for the annual IMF and World Bank meetings. Ms Georgieva noted that while two years ago growth was accelerating in 75 per cent of the world, the IMF now expects it to decelerate in nearly 90 per cent of the global economy in 2019 to the lowest level in a decade.

This shift into reverse comes as central banks in Europe and Japan have embraced negative interest rates and investors expect further rate cuts from the US Federal Reserve. Bonds worth more than $15tn are trading with negative yields.

If the primary problem were on the supply side, one would expect to see upward price pressure. Instead, despite loose fiscal and monetary policy, central banks in the industrialised world have as a group fallen well short of their inflation targets for a decade and markets project that this will continue.

Europe and Japan are engaged in black hole monetary policy. Without a major discontinuity, there is no prospect of policy rates returning to positive territory. The US appears to be one recession away from entering the same black hole. If so, the whole industrialised world would be providing at best negligible and often negative returns to risk-free savings and falling short of growth and inflation targets. It would also have to maintain financial stability amid increased incentives for leverage and risk-taking.

All this requires new thinking and new policies, much as the rapid inflation of the 1970s forced a reset back then. Once economies are in the monetary black hole, central banks that focus on inflation targeting will be ineffectual in hitting their immediate goal and unable to stabilise output and employment. The policy action has to shift elsewhere.

Today’s core macroeconomic problem is profoundly different from the problem any living policymaker has seen before. As I have been arguing for some years now, it is a version of the secular stagnation — chronic lack of demand — that terrified Alvin Hansen during the Depression. In today’s global economy, private investment demand is manifestly unable to absorb private savings even with negative real interest rates and limited restraints on financial markets. That is why even with burgeoning government debt and unsustainable lending, growth remains sluggish and below target.

Since 2013, when I first argued that we were seeing more than simple “economic headwinds”, interest rates have been much lower, fiscal deficits have been much larger, and leverage and asset prices have been much higher than expected.

Yet growth and inflation have fallen short of forecasts. That is exactly what one would expect from secular stagnation: a chronic shortage of private sector demand.

What is to be done? To start it would be helpful if policymakers acknowledged this week that the policy problem is not smoothing cyclical fluctuations or preventing profligacy. Rather the fundamental issue is assuring that global demand is sufficient and reasonably distributed across countries.

The place to start is by dampening down trade wars — deeds, threats and rhetoric. Trade warriors think they are participating in zero-sum games globally with one country gaining demand at the expense of another by opening markets or imposing protection.

In fact trade conflicts are negative-sum games because there is no winner to offset the demand that is lost when uncertainty inhibits and delays spending decisions.

Given the risk of a catastrophic deflationary spiral, central banks are probably right to attempt to ease monetary conditions. But diminishing returns have surely set in with respect to monetary policy and there is risk of doing real damage to the health of the banks and other financial intermediaries.

Most important governments need to rethink fiscal policy. Government debt or government support for private debt is needed to absorb savings flows. With real rates near zero or even negative, the cost of debt service is very low and low rates can be locked in for decades.

That means that the debt levels that were prudent when rates were at 5 per cent no longer apply in today’s zero interest rate world. Governments that run chronic surpluses are failing to do their part to support the global economy and should be the object of international scrutiny.

There are other possible interventions. Increasing pay-as-you-go public pensions would reduce private saving without pushing up deficits. Public guarantees could spur private green investments.

New regulations that prompt businesses to accelerate their replacement cycles will increase private investment. Measures to create more hospitable environments for investment in developing countries can also promote the absorption of global saving.

Spurring sound spending is the antidote to secular stagnation and monetary black holes. It should be an easier technical problem to solve and much easier to sell politically than the austerity challenges of earlier eras. But problems cannot be solved until they are properly diagnosed and the global financial community is not there yet. Hopefully that will change this week.


The writer, a former US Treasury secretary, is a Harvard economics professor. The article draws on collaborative work with Anna Stansbury, PhD candidate at Harvard


What the Heck is Happening in the Cayman Islands?

Doug Nolan


Another quiet week… When the Fed on Friday announced its “Not QE” balance sheet reflation strategy, the Dow was already 400 points higher on anticipation of a positive trade negotiation outcome.

The Federal Reserve will Tuesday begin buying $60 billion of Treasury bills monthly through 2020’s second quarter. This follows a five-week period where Federal Reserve Credit surged $187 billion.

In addition, the Fed said it will continue with its overnight and term “repo” market interventions, along with reinvesting proceeds from maturing longer-dated maturities.

I have speculated the Fed’s balance sheet might inflate to $10 TN over the course of the next crisis and down-cycle. It’s possible that we could see expansion approaching $500 billion over the next six to nine months.

Announcing its “Not QE” plan as markets were in the throes of an intense short squeeze creates poor optics. Most analysts had expected the rollout to come at the Fed’s end-of-month meeting - or even during November. This is one more example of the Fed acting as if it is facing a serious risk to financial stability.

October 11 – Bloomberg (Rich Miller and Christopher Condon): “…The central bank… stressed that ‘these actions are purely technical measures to support the effective implementation’ of interest-rate policy and ‘do not represent a change’ in its monetary stance. ‘In particular, purchases of Treasury bills likely will have little if any impact on the level of longer-term interest rates and broader financial conditions.’”

There may come a day when bond markets push back against central bank interventions – “purely technical” or otherwise. Ten-year Treasury yields jumped six bps Friday to 1.73% - though this move higher was in response to the markets’ “risk on” mood ahead of the completion of trade talks. Two-year Treasury yields rose 5 bps Friday to 1.60%, up 19 bps for the week (and reversing most of last week’s drop).

The implied yield on January Fed funds futures rose 9.5 bps this week to 1.555% (current Fed funds rate 1.82%). Even with a successful “Phase 1” trade deal with China – not to mention the Fed’s plan to expand its holdings - the probability of a rate cut at the Fed’s October 30th meeting was little changed this week at 71%.

University of Michigan Consumer Confidence was reported at a much stronger-than-expected – and three-month high - 96. The Current Conditions component jumped 4.9 points to 113.4, the high going back to December 2018 (116.1). The St. Louis Fed’s Real GDP Nowcast Model has Q3 GDP at 3.12%. And if the world is indeed at the cusp of a U.S./China trade truce, there is even less justification for an additional rate cut. Yet I am not convinced trade risks – or economic vulnerabilities more generally – are the crux of underlying market fragilities or central bank unease.

It was an unfittingly low-key headline: “Better Data on Modern Finance Reveals Uncomfortable Truths.” The subheading to Gillian Tett’s Thursday FT article was more direct: “It is Unnerving That the Shadow Banking Sector is Swelling, Given its Role in the Financial Crisis.”

The FT’s list of “most read” articles included “Why Investors See Inflation as a Very British Problem” and “TP ICAP Pays £15m to Settle FCA Charges Over ‘Wash Trades.’” Ms. Tett’s insightful piece failed to make the cut. I was however reminded of an FT article from early 1998 highlighting the explosion of trading in Russia currency and bond derivatives, along with Gillian Tett’s exceptional reporting on the proliferation of subprime CDOs and mortgage derivatives late in the mortgage finance Bubble period.

October 10 – Financial Times (Gillian Tett): “What the heck is happening in the Cayman Islands? That is a question often asked in relation to corporate tax. This week, for example, the OECD called for an end to the loopholes that let global companies cut their tax bills in places like the British overseas territory. As the debate bubbles on, there is another facet of globalisation that merits more discussion: the financial flows associated with offshore centres, particularly between banks and non-bank entities.”

“Cross-border lending by banks to non-bank financial institutions, such as hedge funds, has also jumped, from $4.8tn in 2016 to $6.6tn in 2019. More striking, those non-bank institutions have quietly ‘become important sources of cross-border funding for banks, particularly in international currencies,’ the BIS notes.

Yet again, those offshore financial centres feature: almost 20% of banks’ cross-border dollar funding is now supplied by entities based in the Cayman Islands, a ratio only topped by those in the US, while entities based in Luxembourg and the Caymans are crucial in the euro markets. Or as the BIS concludes, ‘Banks’ positions with [non-banks] are concentrated in few countries, particularly financial centres.’”

“Non-bank intermediaries’ share of total financial system assets increased from 31% to 36%” between 2007 and 2017, observes a report from the IESE Business School… Meanwhile, the BIS data shows that banks’ cross-border dealings with non-bank entities has been swelling too. One reason is that banks are increasingly funding governments (by buying their debt).

But their exposure to non-financial companies is also rising noticeably, both to onshore and offshore subsidiaries. ‘Banks lend significant amounts to non-financial corporations located in financial centres . . . [providing] credit to the financing arms of multinational corporations located there,’ the BIS notes, adding that banks’ claims on NFCs [non-financial corporations] in the Cayman Islands are larger than on those in Italy. (Yes, really.)”

Convoluted, murky stuff: The amalgamation of “offshore financial centres,” “cross-border dollar funding,” “non-bank intermediaries” and “offshore subsidiaries,” make CDOs, special purpose vehicles, and other mortgage financial Bubble era “shadow” financial processes appear rather clear and luminous by comparison.

Ms. Tett’s article pinpoints the “belly of the beast.”

The GSEs, securitizations, sophisticated mortgage derivatives, and “repo” finance created the nucleus of the risk intermediation and leverage fueling precarious mortgage finance Bubble excess. I am convinced the mushrooming of government bonds, the proliferation of global “repo” markets and off-shore securities lending operations, along with unmatched global derivatives excess and leveraged speculation, are at the epicenter of the runaway “global government finance Bubble.”

Tett’s article notes the global push to accumulate reliable official data. The BIS (Bank for International Settlements) has expanded data for non-bank counterparties and offshore financial centers. While interesting – and certainly illustrating the enormous scope of offshore finance – I’m not confident that the BIS and global central bank community have a handle on what evolved into colossal global flows intermediated through securities finance and “offshore” finance. The recurring extensive revisions to the Fed’s Rest of World (ROW) Z.1 data informs me that there are major shortcomings and outright holes in the data.

Indeed, What the Heck is Happening in the Cayman Islands?

A few snippets from the BIS’s September 2019 Quarterly Review - International Banking and Financial Market Developments (referenced in Tett’s article).


“Derivatives trading in over-the-counter (OTC) markets rose even more rapidly than that on exchanges, according to the latest BIS Central Bank Triennial Survey… The daily average turnover of interest rate and FX derivatives on markets worldwide – on exchanges and OTC – rose from $11.3 trillion in April 2016 to $18.9 trillion in April 2019.”

“The turnover of interest rate derivatives increased markedly between April 2016 and April 2019, especially in OTC markets, where trading more than doubled from $2.7 trillion per day to $6.5 trillion.”

“The OTC trading of FX derivatives also rose substantially… In OTC markets, the daily average turnover of FX derivatives increased from $3.4 trillion to $4.6 trillion between April 2016 and April 2019.”

Tett’s article also mentioned data from the Financial Stability Board (FSB), whose Global Monitoring Report on Non-Bank Financial Intermediation 2018 (issued in February) includes detail on global non-bank entities through the end of 2017.

The FSB’s tabulation of MUNFI (monitoring universe of non-bank financial intermediaries) has a 2017 ending value of $185 TN, up substantially from the $100.6 TN to close out 2008. FSB analysis focuses on a “Narrow Measure of NBFI” (non-bank financial intermediaries), and then breaks down this category by Economic Function (subgroups EF1 through EF5). EF1 – ended 2017 at $36.7, more than double the $14.2 TN from 2008.

“EF1 includes collective investment vehicles (CIVs) with features that make them susceptible to runs.” This group includes fixed-income funds, hedge funds, money market funds, trust companies, ETS and real estate funds (along with smaller components). “EF1 growth is mainly attributable to the four jurisdictions where most EF1 entities reside – US (with 26.3% of total EF1 assets), China (16.5%), the Cayman Islands (14.3%), and Luxembourg (8.9%).”

Breaking down “Narrow Measure of NBFI:” Investment Funds ($45.4 TN, 13.6% ’17 growth); Captive Financial Institutions and Money Lenders ($25.9 TN, 0.5% ’17 contraction); Broker-Dealers ($9.6 TN, 1.1% ’17 contraction); Money Market Funds ($5.8 TN, 10.2% ’17 growth); Hedge Funds ($4.4 TN, 15.8% ’17 growth); Structured Finance Vehicles ($4.9 TN, 2.2% ’17 growth); Trust Companies ($4.6 TN, 27.1% ’17 growth).

“The resulting narrow measure was $51.6 trillion at end-2017” (from ‘08’s $36.2TN). “The total financial assets of entities in the narrow measure grew in 2017 (8.5%), both in absolute terms and relative to GDP... This growth rate is consistent with the average annual growth rate (8.8%) of the narrow measure over 2011-16. This average growth rate was mainly driven by the Cayman Islands, China, Ireland and Luxembourg, which together accounted for 67% of the dollar value increase since 2011.”

Such heady growth in finance comes with consequences. That growth in non-bank (“shadow”) finance over this boom cycle has been driven by entities in the Cayman Islands, China, Ireland and Luxembourg bodes well for the accumulation of leverage and latent risk intermediation issues – not so much for sustainability and stability.

Other highlights: “The total repo assets of banks and OFIs grew by 9.6% in 2017 to reach $9.4 trillion, while their total repo liabilities grew by 9.8% to reach $9.2 trillion, largely driven by banks’ increasing use of repos.”

“Hedge funds’ assets grew in 2017, based on data reported from 15 jurisdictions. The Cayman Islands continues to be the largest hub for such funds among reporting jurisdictions (87% of submitted total hedge fund assets) where they grew by 17.5%, driving the overall growth of the reported sector.” This passage come with a curious footnote: “There is no separate licensing category for hedge funds incorporated in the Cayman Islands, thus the Cayman Islands Monetary Authority (CIMA) estimated their size based on certain characteristics (eg leverage).”

“China accounted for most trust company assets (88% of global trust company assets) and overall growth. The growth rate of China’s trust company assets has increased over the past three years (16.6% in 2015, 24.0% in 2016 and 29.8% in 2017).”

In a recent CBB, I posited it was no coincidence that instability in Chinese money markets was followed not many weeks later by instability in U.S. “repo” finance. I believe a decade of zero and near-zero rates and unrelenting global QE has fostered unprecedented leveraged speculation on a global basis. I suspect the size of “carry trades” and myriad forms of speculative leverage dwarf that from the mortgage finance Bubble era – having seeped into all corners, nooks and crannies of global fixed-income markets. Moreover, “repo,” securities shorting, derivatives and securities finance more generally are the unappreciated sources of global liquidity abundance – in tightly interconnected funding markets with the nucleus in “offshore financial centers.”

I hold the view that massive leverage has accumulated in U.S. fixed income, in Chinese Credit, European debt, dollar-denominated bonds globally and EM debt more generally. I’ll assume heady grown in “repo” and offshore financial intermediation only accelerated since 2017.

It was no coincidence that U.S. “repo” market tumult followed on the heels of an abrupt reversal in global bond yields. I appreciate how the enormous global buildup in leveraged speculation works miraculously so long as bond yields are declining (bond prices rising).

Furthermore, uncertainty associated with escalating U.S./China trade frictions spurred a historic global speculative “blow-off” and market dislocation. If only bond yields could fall forever – even as debt and deficits expand uncontrollably.

It’s not clear to me how the global system doesn’t turn increasingly unstable, which I believe explains why the ECB and now the Fed have resorted again to QE.

Question: “When you first became chair, you were spotted numerous times carrying Paul Volcker’s book under your arm – and I’m curious what lessons did you learned from Paul Volcker and what lessons are you taking through your chairmanship?”

Jerome Powell, October 8th, 2019, during Q&A at a National Association of Business Economics event in Denver: “I’ve known Paul Volcker since I was an Assistant Secretary in the Treasury in 1992 or 1991. Of course, at that time, he had just relatively recently left the Fed - and I was frightened of even meeting him. I was just so intimidated by this global figure. And he couldn’t have been nicer and more interested in helping me and supporting me and we kind of kept up. He was really a great person to know. I read numerous accounts of his life. This book, if you haven’t read it, really sums it up really well. I don’t think there has been a greater public servant in our broad area in our lifetimes. He really just did exactly what he thought was the right thing – all the time. And he lets the chips fall where they may. He was famously booed at a Washington Bullets basketball game when he had rates very high… He’s a great man. I’m still in touch with him. I actually thought that I should buy 500 copies of this book and just hand them out at the Fed. I didn’t do that. It’s a book I strongly recommend, and we can all hope to live up to some part of who he is.”