China’s ‘helicopter money’ is blowing up a bubble

Investment implications go far beyond the mainland’s markets

Arthur Budaghyan

An air show in Tianjin, China. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth © VCG via Getty Images

The escalation of the trade conflict between the US and China has raised the likelihood of greater stimulus by Beijing to prop up the economy. While China’s excessive debt isn’t news, investors must wake up to the reality of “helicopter money” — enormous money creation by Chinese banks “out of thin air”.

While this sugar rush may provide short and medium-term cover for investors, the long-term effects will exacerbate China’s credit bubble. China, like any nation, faces constraints on frequent and large stimulus, and its vast and still rapidly expanding money supply will produce growing devaluation pressures on the renminbi.

When a bubble emerges we are often told that this bubble is different. Many economists justify China’s credit and money bubble and continuing stimulus by pointing to the nation’s high savings rate. But this narrative is false. At its root is the idea that banks are channelling or intermediating deposits into loans. This is not how banks operate.

When a bank expands its balance sheet, it simultaneously creates an asset (say, a loan) and a liability (a deposit, or money supply). No one needs to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends.

In all economies, neither the amount of deposits nor the money supply hinge on national or household savings. When households and companies save, they do not alter the money supply.

Banks also create deposits/money out of thin air when they buy securities from non-banks. As banks in China buy more than 80 per cent of government bonds, fiscal stimulus also leads to substantial money creation. In short, when banks engage in too much credit origination — as they have done in China — they generate a money bubble.

Over the past 10 years, Chinese banks have been on a credit and money creation binge. They have created Rmb144tn ($21tn) of new money since 2009, more than twice the amount of money supply created in the US, the eurozone and Japan combined over the same period. In total, China’s money supply stands at Rmb192tn, equivalent to $28tn. It equals the size of broad money supply in the US and the eurozone put together, yet China’s nominal GDP is only two-thirds that of the US.

In a market-based economy constraints are in place, such as the scrutiny of bank shareholders and regulators, which prevent this sort of excess. In a socialist system, such constraints do not exist. Apparently, the Chinese banking system still operates in the latter.

There are clear downsides. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth. Slowing productivity and strong money growth ultimately lead to rising inflation — the dynamics inherent to socialist systems.

In the long run, more stimulus in China will entail more money creation and will heighten devaluation pressures on the renminbi. As we all know, when the supply of something surges, its price typically drops. In this case, the drop will take the form of currency devaluation.

As it stands, China’s money bubble is like a sword of Damocles over the nation’s exchange rate. Chinese households and businesses have become reluctant to hold this ballooning amount of local currency. Continuous helicopter money will increase their desire to diversify their renminbi deposits into foreign currencies and assets. Yet, there is no sufficient supply of foreign currency to accommodate this conversion. China’s current account surplus has almost vanished.

As to the central bank’s foreign exchange reserves, at $3tn they are less than a ninth of the amount of renminbi deposits and cash in circulation. It is inconceivable that China can open its capital account in the foreseeable future.

If China chooses the path of unrelenting stimulus, investors should recognise the long-term negative outlook for the renminbi. Continuous stimulus will beef up investment returns in local currency terms, but currency depreciation will substantially erode returns in US dollars or euros in the long run.

The investment implications go beyond Chinese markets. Market volatility over the past few months as the talk of stimulus picked up has given us a peek into the future. As the renminbi has depreciated by 12 per cent since early 2018, the pain has reverberated across Asian and other emerging markets. The MSCI Asia and MSCI EM equities indices have each fallen 24 per cent in dollar terms since their peak in January 2018. Long-term pressures could play out even more dramatically.

Fortunately, Chinese authorities recognise these issues. Yet they face an immense task of stabilising growth while containing credit and money expansion. This will be hard to achieve in an economy that has become addicted to credit creation.

Arthur Budaghyan is chief emerging market strategist at BCA Research.

Areas of concern

Parts of America may already be facing recession

Slowdowns in housing construction and manufacturing are ominous

IT CAN BE hard to know when isolated announcements become something more. Since last November General Motors has cut several thousand factory jobs at plants across the Midwest.

In early August US Steel said it would lay off 200 workers in Michigan. Sales of camper vans dropped by 23% in the 12 months ending in July, threatening the livelihoods of thousands of workers in Indiana, where many are made. Factory workers are not the only ones on edge.

Lowes, a retailer, recently said it would slash thousands of jobs. Halliburton, an oil-services firm, is cutting too.

In any given month, even at the height of a boom, more than 5m Americans leave a job; nearly 2m are laid off. Most of the time, however, overall employment grows. But not all the time.

America may or may not be lurching towards a recession now. For the time being employment and output continue to grow. But in the corners of the economy where trouble often rears its head earliest, there are disconcerting portents.

Recessions are synchronised declines in economic activity; weak demand typically shows up in nearly every sector in an economy. But some parts of the economic landscape are more cyclical than others—that is, they have bigger booms and deeper slumps. Certain bits tend to crash in the earliest stages of a downturn whereas others weaken later. Every downturn is different.

Those caused by a spike in oil prices, for example, progress through an economy in a different way from those precipitated by financial crises or tax increases.

But most recessions follow a cycle of tightening monetary policy, during which the Federal Reserve raises interest rates in order to prevent inflation from running too high. The first rumblings of downturns usually appear in areas in which growth depends heavily on the availability of affordable credit. Housing is often among the first sectors to wobble; as rates on mortgages go up, this chokes off new housing demand. In a paper published in 2007 Edward Leamer, an economist at the University of California, Los Angeles, declared simply that “housing is the business cycle”. Recent history agrees.

Residential investment in America began to drop two years before the start of the Great Recession, and employment in the industry peaked in April 2006. Conditions in housing markets were rather exceptional at the time. But in the downturn before that, typically associated with the implosion of the dotcom boom, housing also sounded an early alarm.

Employment in residential construction peaked precisely a year before the start of the downturn. And now? Residential investment has been shrinking since the beginning of 2018.

Employment in the housing sector has fallen since March.

Things may yet turn around. The Fed reduced its main interest rate in July and could cut again in September. If buyers respond quickly it could give builders and the economy a lift. But housing is not the only warning sign. Manufacturing activity also tends to falter before other parts of an economy. When interest-rate increases push up the value of the dollar, exporters’ competitiveness in foreign markets suffers. Durable goods like cars or appliances pile up when credit is costlier.

In the previous cycle, employment in durable-goods manufacturing peaked in June 2006, about a year and a half before the onset of recession. This year has been another brutal one for industry. An index of purchasing managers’ activity registered a decline in August. Since last December manufacturing output has fallen by 1.5%. Rather ominously, hours worked—considered to be a leading economic indicator—are declining. Some of this is linked to President Donald Trump’s trade wars, which have hurt manufacturers worldwide. But not all. Domestic vehicle sales have fallen in recent months, suggesting that Americans are getting more nervous about making big purchases.

In some sectors, technological change makes it difficult to interpret the data. Soaring employment in oil industries used to be a bad sign for the American economy, since hiring in the sector tended to accompany consumer-crushing spikes in oil prices. But America now produces almost as much oil as it consumes, thanks to the shale-oil revolution. A recent fall in employment and hours in oil extraction may be a bad omen rather than a good one. By contrast, a fall in retail employment was once unambiguously bad news. But retail work in America has been in decline for two and a half years; ongoing shrinkage may not signal recession, but the structural economic shift towards e-commerce.

Other signals are less ambiguous. In recent decades employment in “temporary help services”—mostly staffing agencies—has reliably peaked about a year before the onset of recession. The turnaround in temporary employment in 2009 was among the “green shoots” taken to augur a long-awaited labour-market recovery. Since December it has fallen by 30,000 jobs.

Even if America avoids a recession, the present slowdown may prove politically consequential. Weakness in some sectors, like retail, is spread fairly evenly across the country. But in others, like construction or, especially, manufacturing, the nagging pain of the moment is more concentrated (see map). Indiana lost over 100,000 manufacturing jobs in the last downturn, equal to nearly 4% of statewide employment. It is now among a modest but growing number of states experiencing falling employment: a list which also includes Ohio, Pennsylvania and Michigan.

Those four states, part of America’s manufacturing heartland, suffered both early and deeply during the Great Recession. In 2016 all delivered their electoral-college votes to Mr Trump, handing him the presidency. The president’s trade war might have been expected to play well in such places. But if the economic woe continues, voters’ faith in Mr Trump is anything but assured. Choked states might well turn Democrat-blue.

It’s Official: The World’s Third Oil Shock Is Underway…

By Nick Giambruno, chief analyst, The Casey Report

The world’s next oil shock is playing out exactly as I predicted…

On Saturday morning, tensions in the Middle East escalated after drones attacked two major oil facilities in Saudi Arabia.

The strikes knocked out more than half of Saudi Arabia’s crude oil output… and 5% of the world’s oil supply. The Houthi movement in Yemen, which is at war with Saudi Arabia, claimed responsibility. The U.S. government, however, has blamed Iran.

In any case, this attack is unprecedented and makes escalating actions almost inevitable. I think it’s only the beginning.

If you thought this attack was disruptive, understand that it’s only a tiny example of what could really happen in the case of a full-fledged war with Iran, which grows more likely by the hour.

If you’ve been reading the Dispatch, this shouldn’t come as a surprise at all. I’ve been saying that the chances of war with Iran are higher than ever…

And when it happens, it will have tremendous consequences for the price of oil.

We’re seeing this play out just as I predicted. The attacks sent the global oil markets into chaos… and crude oil prices are up 14% today as I write.

And I saw it coming a mile away. Today, I’ll show you everything you need to know about the rising tensions with Iran – including what Iran could do next…

Tensions Flaring

You see, about a year ago, I warned readers of my newsletter, The Casey Report, that the next big war in the Middle East was coming. And I showed them why it would focus on Iran.

But let me give you a quick refresher of what’s going on…

Tensions in the Persian Gulf region were already near a boiling point as U.S. sanctions choked Iran’s economy. But Iran hasn’t taken this economic strangulation lying down. It has a few cards to play, too.

Let me explain…

Things have been heating up around a key waterway in the Middle East – the Strait of Hormuz.

Six oil tankers were attacked near the Strait and the Persian Gulf, and the U.S. government blamed Iran.

Iran then shot down a $120 million U.S. drone. It claims the drone was flying in its airspace.

In response, Trump approved airstrikes against Iranian targets. It would have started a full-scale war… but Trump pulled back at the last minute.

And those are just a few of the skirmishes that are now making headlines. In short, tensions between the U.S. and Iran are flaring.

But Iran holds a powerful card… because it controls the Strait.

Oil’s Most Important Chokepoint

The Strait is a narrow strip of water that links the Persian Gulf to the rest of the world. It’s the most important oil chokepoint in the world.

Five of the world’s top 10 oil-producing countries – Saudi Arabia, Iran, Iraq, the United Arab Emirates, and Kuwait – border the Persian Gulf. The Strait of Hormuz is their only sea route to the open ocean… and world markets.

Every day, nearly 19 million barrels of oil pass through the Strait of Hormuz. That translates into roughly 33% of the world’s oil traded by sea. It’s over $1.2 billion in value every single day.

That’s part of the reason why big Middle East wars are often catastrophic for global oil supplies.

After all, almost 40% of global oil exports comes from the Middle East. Take a look:


As you can see, shutting down the Strait is Iran’s next powerful option in this conflict. And the investment implications are huge…

The Next Oil Shock

If Iran shuts down the Strait of Hormuz, it would cause the largest oil supply shock the world has ever seen.

And that will cause a huge price shock.

A “price shock” is when the price of something rises so quickly that businesses cannot react.

Two classic examples are the First and Second Oil Shocks.

The First Oil Shock happened in 1973.

A regional war in the Middle East caused the price of oil to nearly triple. It triggered a massive gas shortage in the U.S.… and a lot of panic.

Drivers sat in lines stretching for blocks, waiting to fill up their gas tanks. Some gas stations closed.

Others operated by appointment only. Rationing was introduced.

The Second Oil Shock came in 1979. Crude prices nearly tripled again… also caused by conflict in the Middle East.

You can see what happened to the oil price during both oil shocks in the next chart.


I would expect the Third Oil Shock’s effect on the oil price to be at least as severe as the first two shocks. Recall that oil prices nearly tripled both times.

In today’s prices, that would likely mean oil shooting to around $200 a barrel…

A Golden Opportunity

However, the market doesn’t appreciate how close we are to a war yet.

Yes, the price of oil is rising, but this is just the beginning.

In this environment, you want to own the highest-quality oil stocks. That means two things:

1) Companies that have done well during turbulent times in the past.

2) Companies that aren’t heavily exposed to trouble in the Middle East.

As Middle East supply disruptions cause oil prices to skyrocket around the world, companies that fulfill these criteria will be your ticket to profits.

So if you haven’t yet, now’s the time to get in.

Three JPMorgan metals traders charged with market manipulation

US prosecutors allege ‘massive, multiyear scheme’ to defraud customers

Henry Sanderson and Neil Hume in London

US prosecutors have charged three JPMorgan metal traders with a “massive, multiyear scheme” to manipulate markets and warned they were continuing to probe higher echelons at the largest US bank.

Michael Nowak, head of precious metals trading, was charged on Monday along with two colleagues, Gregg Smith and Christopher Jordan, on federal racketeering charges normally used to take down organised crime syndicates.

The indictment alleged that the three traders engaged in “widespread spoofing, market manipulation and fraud” while working at JPMorgan, which along with HSBC dominates global flows of gold and silver trading.

They placed orders they intended to cancel before execution in an effort to “create liquidity and drive prices toward orders they wanted to execute on the opposite side of the market”, it said.

The case will increase scrutiny over global precious metals markets and the dominance of large banks such as JPMorgan, with prosecutors indicating more senior executives and other banks are under investigation.

“We’re going to follow the facts wherever they lead,” said Brian Benczkowski, assistant attorney-general. “Whether it’s across desks or upwards into the financial system.”

The Dodd-Frank financial reform law of 2010 imposed criminal penalties for spoofing, the practice of duping other market participants by entering and rapidly cancelling large orders.

This was the first time that federal racketeering charges have been applied in a spoofing case, a derivatives lawyer said.

Mr Nowak, who joined JPMorgan in 1996, is on leave from the bank, according to a person familiar with the matter, as is Mr Smith, a precious metals trader. JPMorgan declined to comment. Mr Nowak’s lawyers at Skadden, Arps, Slate, Meagher & Flom said Mr Nowak had “done nothing wrong” and they expected “him to be fully exonerated”. Mr Smith and Mr Jordan could not immediately be reached for comment.

Between 2008 and 2016, the traders sought to take advantage of algorithmic traders by placing genuine orders to buy or sell futures, some of them so-called “iceberg orders”, that concealed the true order size, the indictment alleged.

At the same time they placed one or more orders that they intended to cancel before executing, so-called “deceptive orders”, on the opposite side, which were fully visible to the market, the indictment alleged.

“By placing deceptive orders, the defendants and their co-conspirators intended to inject false and misleading information about the genuine supply and demand for precious metals futures contracts into the markets,” the DoJ said.

The DoJ alleged the three men named in the indictment placed deceptive orders for gold, silver, platinum and palladium futures contracts on exchanges run by the CME Group, including the Nymex and Comex exchanges.

In addition, the men also allegedly defrauded JPMorgan’s own clients who had bought so-called “barrier options” by trading precious metals futures contracts “in a way that sought to push the price towards a level at which the bank would make money”, Mr Benczkowski said.

Barrier options are contracts that pay out if the underlying asset breaches a pre-determined price level.

A former JPMorgan trader, Jonathan Edmonds, pleaded guilty to charges of spoofing last November. Another former JPMorgan precious metals trader, Christian Trunz, pleaded guilty in August.

A third trader, Corey Flaum, who worked with Gregg Smith at Bear Stearns before it was acquired by JPMorgan, also pleaded guilty in July, Mr Benczkowski said.

Gold bugs and retail investors have fixated for years on JPMorgan’s precious metals business and its influence over gold and silver markets. “It’s no surprise to me,” said Ted Butler, an independent analyst and persistent critic of the bank’s role in metal markets.

Additional reporting by Gregory Meyer in New York

The Real Loser From the Oil Price Jump Is China

Nation is already dealing with an inflation spike and weak manufacturing margins

By Nathaniel Taplin

Higher oil prices are no longer an unalloyed negative for the U.S., but they are for the world’s largest crude importer: China.

The country is already dealing with a vicious outbreak of African Swine Fever that has pushed the price of pork, its staple meat, up over 40% on the year. Inflation is running at its hottest since 2013, excluding the volatile Chinese New Year holiday period. And amid the ongoing trade war with the U.S., August data released Monday showed investment, retail sales and industrial growth all slowing further—the latter to its weakest in 17 years.

For much of the past year, cheap oil has eased the pain for beleaguered Chinese consumers and businesses. Following Saturday’s attacks on Saudi Arabia, though, the Brent benchmark on Monday has risen about 10% to $65 a barrel. And it could stay elevated for a while, even as Saudi Arabia brings some production back online—in part because investors are now reevaluating the risk of more disturbances in the Middle East. Brent futures show investors betting that oil prices won’t fully move back down to where they were on Friday until next summer, even with the global economy widely expected to weaken further.
All of this will make shoring up sagging Chinese growth even more difficult. China has managed to dull the impact of U.S. tariffs with a cheaper currency. Pricier oil, on top of out-of-control food prices, makes devaluing the yuan even riskier than it already was. Beijing’s recent move to exempt new purchases of U.S. pork and other agricultural products from tariffs should be viewed primarily in the context of China’s increasingly alarming domestic food prices rather than softening trade tensions.

Expensive oil makes looser monetary policy riskier too. Analysts widely expect an imminent cut to rates on a key central bank lending facility that underpins China’s new benchmark lending rate. But policymakers remain trapped between a weakening economy and too-pricey food and housing. House prices are still up over 10% on the year, and growth in housing investment actually accelerated to a four-month high in August.

The outlook for Chinese growth is weaker than ever. Given the constraints, though, modest rather than overwhelming 2015-style policy stimulus is probably the best investors can hope for.

A gas station in north China's Hebei

Gold And Backwardation, A Dangerous Mix

by: Austrolib
- Backwardation is a phenomenon in the futures market where spot prices are higher than for future delivery. Usually futures are in contango, where futures sell at a premium to spot.

- Backwardation happens when there is a shortage of a commodity, usually from seasonal factors like prior to a harvest. It is quickly resolved through arbitrage or an increase in supply.

- But what if backwardation happens not because of higher demand to hold a commodity now, but because of lower demand to hold dollars into the future?

- This could theoretically happen if and when dollar interest rates go negative, cheapening futures relative to spot because dollars are taxed.

- Only much higher rates across the yield curve can pull commodities futures out of backwardation in that case.

The mechanics of an eventual crack-up boom continue to be put into place. Last week, Alasdair MacLeod at Goldmoney made the case from a futures market perspective. What does a crack-up boom look like numerically in the futures market? His answer: It looks like permanent backwardation across all commodities. How does this theoretically happen? His answer: Negative dollar interest rates. Here I’d like to go into how this actually works, conceptually.
First of all, let's define terms. Backwardation is when the spot price for a commodity is more expensive than for delivery of that commodity in the future. The closer to the present, the more expensive the contract. Contango is the opposite, when spot is cheaper than a futures contract and the farther out in time you go, the more expensive the contract. Contango is normal.
Backwardation is abnormal, and is corrected by an increase of supply, or price increases by people playing futures arbitrage.
Why is contango normal? Because a supplier delivering a commodity in the future allows that supplier to keep his dollars in the present and earn interest on those dollars. That interest is reflected in the higher price for a futures contract the farther into the future you go.
Backwardation is abnormal because it means that the demand for a commodity at a certain time is high enough to counteract interest earned on dollars held. Those with a supply would gladly sell in the present to buy that cheaper futures contract and earn the difference. If supplies are short though, backwardation persists until supplies are replenished.
Backwardation from the Commodity Side
Seasonal backwardation is normal in consumable commodities. It is always a temporary phenomenon where a premium for spot is caused by a physical shortage of a given commodity at a certain time as explained above, for example, immediately before the seasonal grain harvest. This is resolved by the harvest, because then there are present supplies for futures traders to sell while buying the futures contract and profiting on the spread, lowering present prices and raising future prices.
This returns the market to contango, where it usually stays until another temporary shortage may arise for whatever reason. There is nothing troubling about this and it happens in cycles.

Backwardation from the Dollar Side
Here's where Macleod adds his critical twist. He asks, what if backwardation is coming not from the commodity side of the equation like a wheat shortage before harvest, but rather from the dollar side of the equation? In other words, not from a positive desire to hold wheat now, but from a negative desire to hold dollars into the future? These are mirror images of the same phenomenon numerically at least, but the latter is in an "evil twin financial universe" if we can call it that. Here's why.
Contango, the normal situation in commodities markets, is generally caused by the logical desire to hold dollars for as long as possible. For, say, gold delivered in 2025, the seller gets to hold on to the dollars paid for that contract for 5 years. The interest he can earn on those dollars is reflected in the premium usually demanded for later deliveries.
But when we suddenly introduce negative interest rates, there is an unnatural disincentive to hold dollars for longer created by central banks trying to pump asset prices. The longer you hold dollars when rates are negative, the more money you lose. The premium turns into a discount against shorter deliveries, with the highest-priced contract being the most immediate delivery available. And voila, backwardation.
Here is the crux of it. Macleod says the following in his latest piece, and this is the paragraph I want to focus on:
If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. Yet here are backwardation conditions being imposed from the money side.
Let’s work this out step by step. We will use gold here, but it applies for any commodity, because they are all traded in dollars. Let us assume that in order to counter the next recession, the Federal Reserve pushes the fed funds rate to -4%. Let’s now make two assumptions and see what happens logically. First, let’s assume a negative yield curve between the 5Y and the fed funds rate, which is what we have now. The 5Y yield is at 1.39%, and the fed funds rate is at 2.12% currently. That’s a negative spread of 73 basis points.
So assuming the same spread, fed funds rate of -4% puts the 5Y at -4.73%. The COMEX offers gold delivery currently out to 2025, about 5 years, so if 5Y yields are –4.73% and overnight is -4%, if you are a seller of gold futures for 2025 you lose 4.73% a year multiplied by 5 for that contract. That’s a total loss of 23.65% over the 5-year period due to the negative interest rates imposed on dollars.
However, if you sell a contract for delivery in one month (let's use 1M rates as a proxy for the fed funds rate) you lose only 4/12, or 0.33%. Obviously, in that case, gold for delivery in 2025 would be about 24% cheaper than gold deliverable in one month.
Can arbitrage be made over this spread to return the market to contango? Let's consider. Can a speculator make a profit buying gold deliverable in 5 years and selling gold deliverable in 1 month?
No, because he's going to lose 24% on gold deliverable in 5 years with negative interest rates.
He can only speculate about making money on this move if he is betting on higher interest rates down the road. There is no risk-free arbitrage here as there is with wheat once the harvest comes in and backwardation becomes contango. Plus, there is no such thing as a gold shortage because gold does not get consumed like, say, wheat does. More gold supply does not alleviate the backwardation. Only higher dollar interest rates can possibly do that.
Therefore, in a negative yield curve situation with overnight rates at -4%, everyone tries to buy gold now, raising the dollar price across deliveries and locking the market in backwardation from the dollar side - NOT the gold side. Other commodities fall in terms of gold and rise in terms of dollars.
The result when enough traders realize what's going on, is the crack-up boom across the entire commodity complex as the entire commodities futures market warps into backwardation due to negative dollar interest rates.
But what if the yield curve is positive? Let’s say the fed funds rate is -4% again. The highest the spread between the 5Y and overnight rates has gone is about 300bps, so let’s assume rates on the 5Y of -1%. What happens then? That means for gold delivered in 5 years, the seller of that contract loses 5% (1% a year multiplied by 5). The seller of 1-month gold loses -4%/12, or .33%. Gold is locked in backwardation whether the yield spread is positive or negative.
What could even theoretically stop this process to put gold back in contango? The only possible answer is higher dollar interest rates across the board. How much higher? Let’s say yields on overnight rates are still -4%, and yields on the 5Y move up to 1%. What would be the highest spread between them in history, but let's stick with this. Then sellers can earn 5% on 5Y gold (1% a year), lose 0.33% selling one-month gold. That's a spread of 5.33% down the delivery line, theoretically putting 5Y gold at a 5.33% premium. Unless, of course, the price inflation rate is higher than 5.33%. In that case, a seller of 5Y gold would still lose money in real terms and the premium for 1-month gold remains. Still backwardation persists.
The only thing that can take the gold market out of backwardation from negative rates is much higher interest rates across the board with a yield spread substantially higher than the price inflation rate. If, say, rates on the 5Y were 20% like they used to be in 1980, and one-month rates at 0%, then we have a 100% gain waiting 5 years for gold, and no loss for buying it in a month. That could do it, depending on the rate of price inflation and if the loop hasn’t spun out of control by that point. Price inflation would have to be below 20% a year for the market to return to contango in that case.
The big problem is, once the futures market gets locked into backwardation from negative rates, the fear Macleod expresses is that at that point, everyone starts plowing into commodities fast and price inflation explodes, making it much harder to reverse the backwardations. The Fed will not have much time to reverse the situation once it starts, if doing so is even possible without destroying the incredibly leveraged global economy.
Negative dollar interest rates are an absolute disaster waiting to happen. If it ever does happen, once we start to see nominally negative rates in the United States, the danger of a crack-up boom becomes very real. The only cure would be to jack up dollar interest rates very quickly to rates higher than the inflation rate. This was possible in the late 1970s and early 1980s when rates actually did go to 20%.
Debt was so much smaller back then. But this time, the wave of bankruptcies across corporate and sovereigns would break records.
The entire German and Swiss yield curves are already below zero. It’s not causing backwardations in commodity markets though because commodities are priced internationally and settled in dollars, the reserve currency, not euros or Swiss francs. But a systemic shock to Europe could lead the Fed to introduce negative rates in the world’s reserve currency if the European Central Bank and Swiss National Bank go there first. If that happens, duck and cover.
You can either hope this doesn’t happen and assume the Fed understands the threat of backwardation from the dollar side, and therefore won’t introduce negative rates under any circumstances. Or you can prepare for it, assuming they will.

martes, septiembre 17, 2019


Brexit, the Novel

If UK Prime Minister Boris Johnson had to worry about the value of the pound or the fragility of the British economy, he would need to be much more careful. But the British are resilient, the Bank of England will take the necessary actions, and the value of the pound does not matter much – all of which means that Johnson could win.

Simon Johnson

johnson119_David M. BenettGetty Images_boris johnson book

WASHINGTON, DC – The best way to think about the United Kingdom’s political predicament and presumed imminent exit from the European Union is to read the Slough House spy novel series by Mick Herron (the sixth installment, Joe Country, just appeared). Herron writes about the modern MI5 intelligence agency and the machinery of government in general – not directly about economic policy. But he perfectly captures how bureaucracies function, as well as what political “leadership” really means in a complex world where illusion and misdirection prevail in democratic systems.

The contrast with classic spy novels, such as the early work of John le Carré, is readily apparent and part of the fun for readers. During the Cold War, the so-called Moscow Rules guided how spies could survive in hostile environments: “watch your back” was the guiding idea. Today, according to Herron, a set of London Rules prevails, the most important of which is “cover your ass” and protect your career.

Britain has had many economic difficulties and some serious crises over the past century, and it is tempting sometimes to draw parallels – for example, to difficulties associated with the gold standard between the world wars or the Suez Crisis in 1956. But the international system is now quite different, Britain’s role in the global economy is much diminished, and the pound floats freely against major currencies.

In 1956, as well as in other prominent historical episodes, preserving the value of the pound was viewed by policymakers as important, if not essential. Through at least the early 1990s, there was an ever-present fear that devaluation (relative to the dollar and other currencies, including the Deutsche Mark) would fuel inflation, which would necessitate higher interest rates and overall economic contraction.

Today, the world is quite different. Fixed exchange rates in the developed economies disappeared in the 1970s, first with a bang (the devaluation of the dollar under US President Richard Nixon) and then with a whimper (as leading central banks focused on bringing down inflation). An even bigger shift came with disinflation almost everywhere, along with what appears to be an extremely resilient anchor for long-term inflation expectations around 2% per year in places like the UK, the eurozone, and the United States.

The good news from this shift is that a country like the UK is now more resilient to shocks. The Bank of England is well run and communicates its policy clearly. Rather than destabilizing the economy, a depreciation of the pound most likely could help boost the economy, including by making exports more competitive.

Britain also has a strong (though not perfect) education system, producing well-qualified scientists, engineers, and executives. If, for example, the London-based financial sector suffers a downturn because of reduced access to European opportunities after Brexit, other sectors such as pharmaceuticals or autos or software will find it easier over time to attract talent.

Unfortunately, not all the news is good – which brings us back to Herron’s Slough House novels. Herron’s older heroes worked during the Cold War, when the stakes seemed existential and the tactics were brutal. Modern Britain, seen through Herron’s lens, faces no such severe threats, yet the tactics of intelligence operatives (and their handlers) are no less ruthless (though often also more humorous). Herron’s acerbic but undeniable contention that many modern politicians believe in little except their own survival and potential career advancement or glory is also relevant to Brexit.

The Suez Crisis was precipitated by then-Prime Minister Anthony Eden’s belief that he was standing up to an authoritarian ruler (Egyptian President Gamal Abdel Nasser), in contrast to Neville Chamberlain’s policy of appeasement of Adolf Hitler in the 1930s. British military action, supported by France and Israel, was based on a presumption of Britain’s continuing imperial power, and it failed when there was a run on the pound – ultimately due to lack of support from the United States.

Today the constraints on developed-country politicians are greatly reduced. The irony of a strong independent central bank is that it is much more able to offset the effects of other irresponsible policies. If UK Prime Minister Boris Johnson had to worry about the value of the pound or the fragility of the British economy, he would now need to be much more careful. But the British are resilient, the Bank of England will take the necessary actions, and the value of the pound does not matter much.

What would Herron’s characters and plot lines produce in this scenario? It’s hard to say, because politics and bureaucratic skulduggery are doubtless just as prevalent in the EU as they are in the UK.

My suggestion: a “hard” Brexit that, when it plays out, is really no such thing. There will be a pragmatic relationship with Europe, disguised as confrontation, and slower medium-term growth will be blamed on the outside world. By generating enough populist anger, partly owing to his own irresponsible actions, Johnson could even win a general election.

As a novel, it might seem ridiculous. As a potential real-life scenario, it seems quite plausible.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with Jonathan Gruber, of Jump-Starting America: How Breakthrough Science Can Revive Economic Growth and the American Dream.

Black Hole Investing

By John Mauldin

Scientists say the rules change in a cosmic “black hole” at what astrophysicists call the event horizon. How do they know that? Not by observation, since what happens in there is, by definition, un-seeable. They infer it from the surroundings, which say that the mathematics of the universe as we understand them change at the event horizon.

Or maybe not. One theory says we are all inside a black hole right now. That could possibly explain a few things about central bank policy.

Last week I showed you Ray Dalio’s latest Three Big Issues article. To recap, Ray says we are now in a world where…

  • Central banks have limited ability to stimulate growth as we approach the end of a long-term debt cycle.

  • Wealth and political polarity are producing internal conflict between the rich and poor as well as between capitalists and socialist.

  • There is also external conflict between a rising power (China) and the existing world leader (the USA).

The world last saw this combination in the 1930s, which is not comforting, to say the least. But as I said, we can get through this together if we approach it wisely. That’s a big “if,” given the ways some investors behave at cyclical peaks, but people will do what they do. We can only control our own actions, and today I want to talk about some we can take.

We are approaching the black hole, which means we can’t rely on previously reliable strategies. Let’s start with a jolt of reality.

Realistic Forecasts

As investors we have to make assumptions about the future. We know they will likely prove wrong, but something has to guide our asset allocation decisions.

Many long-term investors assume stocks will give them 6–8% real annual returns if they simply buy and hold long enough. Pension fund trustees hire consultants to reassure them of this “fact,” along with similar interest rate and bond forecasts, and then make investment and benefit decisions.

Those reassurances are increasingly hollow, thanks to both low rates and inflated stock valuations, yet people running massive piles of money behave as if they are unquestionably correct.

You can, however, find more realistic forecasts from reliable, conflict-free sources. One of my favorites is Grantham Mayo Van Otterloo, or GMO. Here are their latest 7-year asset class forecasts, as of July 31, 2019.

Source: GMO

These are bleak numbers if you hope to earn any positive return at all, much less 6% or more. If GMO is right, the only answer is a large allocation to emerging markets which, because they are emerging, are also riskier. The more typical 60/40 domestic stock/bond portfolio is a certain loss, according to GMO. (Note these are all “real” returns, which means the amount by which they exceed the inflation rate).

Others like my friends at Research Affiliates (Rob Arnott), Crestmont Research (Ed Easterling), or John Hussman (Hussman Funds) have similar forecasts. They differ in their methodologies but the basic direction is the same. The point is that returns in the next 7 or 10 years will not look anything like the past.

If you think these are reasonable forecasts (I do), then one reaction is to keep most of your assets in cash for at least a fractionally positive, low-risk return. That’s simple to do. But it probably won’t get you to your financial goals.

Remember, though, this forecast is what GMO expects if you buy and hold those asset classes for the next seven years. Nothing requires most of us to do that. We are free to move between them and use other asset classes, too… which is exactly what I think we should do.

Profound Technological Change

I mentioned last week that technology will bring profound changes. I’m expounding on that in my book. It has major investment implications. Companies small and large, all over the world, are right now inventing new technologies that are going to change our lives.

I’ve used this example before, but think of the now-ubiquitous smartphone. Apple launched that category with the iPhone in 2007. Many who saw them as expensive toys at first now can’t live without them. That shows you how fast, and how deeply, a technology we didn’t even know we needed can change everyday life. Not always for the better, but the change is real.

The iPhone ecosystem around it spawned other successful companies. The productivity gains it gave users led to growth in seemingly unrelated fields.

We have a radically different (and, on balance, better) economy now than we would have without it.

Note also, the iPhone launched just months before the Great Recession began, and proved indispensable anyway. So our macro challenges, serious though they may be, won’t necessarily stop progress. They may even accelerate it.

I expect to see fortunes made in biotechnology, and particularly life extension and age reversal drugs, but that will only be the beginning.

Autonomous vehicle technology is going to restructure our cities and enhance our productivity as we put those traffic jam hours to better use. AI and Big Data will enable quantum leaps in many fields.

I could go on with more examples, but here’s the point: Innovation will continue in almost any economic scenario you can imagine. Recession will, at most, delay it a bit. Not every innovative company will succeed but some will, and the rewards will be huge. If you want capital gains, the opportunities will be there… but not in a passive index strategy. You will need active management and expert managers.

Owning index funds won’t help much because by definition most of these companies will start out small and not have meaningful presence in the indexes. By the time they are big enough to be meaningful, the really massive gains will have already been made. That means you will want to find active managers who focus on particular fields and allocate them some of your risk (not core!) capital. These will not be sure things.

Income Challenges

Now, capital gains aren’t (and shouldn’t be) everyone’s goal. Many of my Baby Boomer peers have assets but need current income, which is scarce and getting scarcer in this low-yield world. The way central banks are going, conventional debt instruments probably won’t do it.

This week the ECB lowered its base rate to -0.50% and announced it will stay there for a long time. I think it is increasingly obvious we are headed back to the zero bound on short-term US government debt. That will drag down interest rates on most fixed income instruments.

Here again, I think the market will provide solutions but they won’t be what once was thought of as “normal.” Our parents and grandparents could count on 5% or better yields in safe, predictable CDs and Treasury bills. That’s fantasy now. So, what do you do?

The first thing, if you’re not already fully retired, is to maximize your job income and increase your savings. Watch your spending, too. Now is not the time for frivolity. Be the ant, not the grasshopper.

That still won’t be enough for most income-seeking investors. We will need higher yields from our portfolios. Right now, this is more than a minor challenge unless you want to take significant principal risk. Government bonds yield nothing (or less) and corporate bonds are headed that way. High-yield bonds indeed have higher yields but also higher risk. What to do?

I think interest rates are going lower and will stay lower for a very long time, just as I and my fellow Boomers are hitting retirement age. (I’ll start getting Social Security when I turn 70 next month. I remember reading somewhere that I’ll earn something like 1 to 2% compound returns on my Social Security “investment.” Ouch.)

The good news is that markets eventually respond to demand. More and more companies will concentrate on returning investor capital. As businesses stabilize into steady cash flow, they will be able to pay increasingly higher dividends, and may find it is a good way to maintain their share prices. In addition, I think many old-fashioned value companies are getting ready to come back into favor as their steady dividends become attractive to a retiring generation.

Remember, there are different ways to slice this pie. It doesn’t have to be standard dividends. I expect innovative structures will emerge to offer yield with controlled risk—new kinds of preferred shares, convertible securities, etc. Some exist right now, but legal barriers restrict them only to the wealthiest investors. Here again, if the demand exists, elected officials will respond by relaxing those barriers.

Higher yields come with higher risk, of course. That’s why you should spread your capital across more than one and not risk too much on any one strategy. A strategy I have seen used with great success is simple high-yield bond timing. While those trading algorithms can be complex, even simple ones can sometimes yield above-market returns over a full cycle.

As my dad would tell me when I was growing up, “Son, betteth not thy whole wad on one horse.” That was as close to biblical language as he could get.

Central banks and politicians are the problem, not the solution. Last week President Trump openly told the Federal Reserve to reduce interest rates to zero or lower.

Seriously? What business activity will that encourage? The latest National Federation of Independent Business survey (by my good friend Bill “Dunk” Dunkelberg) clearly shows that small businesses aren’t worried about interest rates. What they need is more customers and predictable government policies. In a world of trade wars and potential currency wars brought on by central bank manipulation, predictable is not a word that comes to mind.

Further, do the president and his economic advisors understand the realities facing the average retiree? In this zero-interest-rate world, exactly how are retirees supposed to survive without taking much more risk than they should?

The financial repression emanating from central banks all over the world borders on criminal, and that they think they are “helping” us is risible.

They are on the verge of destroying a generation come the next recession.

They have encouraged retirees to seek yield and riskier investments precisely when they should not be.

They are robbing savers and asking us to say thank you because they are so wise.

Crazy Numbers

Many financial advisors, apparently unaware the event horizon is near, continue to recommend old solutions like the “60/40” portfolio. That strategy does have a compelling history. Those who adopted and actually stuck with it (which is very hard) had several good decades. That doesn’t guarantee them several more, though. I believe times have changed.

But those decades basically started in the late 40s and went up until 2000. After 2000, the stock market (the S&P 500) has basically doubled, mostly in the last few years, which is less than a 4% return. When (not if) we have a recession and the stock market drops 40% or more, index investors will have spent 20 years with a less than 1% compound annual return. A 50% drop, which could certainly happen in a recession, would wipe out all their gains, even without inflation.

And yes, there have been historical periods where stock market returns have been negative for 20 years. 1930s anyone? Yes, it is an uncomfortable parallel.

The “logic” of 60/40 is that it gives you diversification. The bonds should perform well when the stocks run into difficulty, and vice versa. You might even get lucky and have both components rise together. But you can also be unlucky and see them both fall, an outcome I think increasingly likely. Louis Gave wrote about this last week.

Historically, the optimized portfolio of choice, and the one beloved of quant analysts everywhere, has been a balanced portfolio comprising 60% growth stocks and 40% long-dated bonds. Yet recently, this has come to look less and less like an optimized portfolio, and more and more like a “dumbbell portfolio,” in which investors hedge overvalued growth stocks with overvalued bonds.

At current valuations, such a portfolio no longer offers diversification. Instead, it is a portfolio betting outright on continued central bank intervention and ever-lower interest rates. Given some of the rhetoric coming from central bankers recently, this is a bet which could now be getting increasingly dangerous.

(Over My Shoulder members can read Louis Gave’s full “Dumbbell Portfolio” article with a summary and key points. Not a member? Click here to join us.)

We are rapidly approaching the event horizon where central bank intervention and ever-lower interest rates will not help your bond portfolio. That is already the case in Europe and Japan. Stocks are at historically high valuations and subject to a severe bear market brought on by a recession.

“Diversification” is not simply owning different asset classes. They have to be uncorrelated to each other and, more important, stay uncorrelated. That was a problem in 2008 when lots of previously disconnected categories suddenly started moving in lockstep.

For the moment, I still think long-term yields will keep falling, helping the bond side of a 60/40 portfolio. Meanwhile, negative or nearly negative yields will push more money into stocks, driving up that side of the ledger. So 60/40 could keep firing on all cylinders for a while. But it won’t do so forever, and the ending will probably be sudden and spectacular.

Which brings us to my final point. The primary investment goal as we approach the black hole should be “Hold on to what you have.” Or, in other words, capital preservation. But you may not realize that capital preservation can be better than growth, if the growth comes with too much risk. Here’s the math.

  • Recovering from a 20% loss requires a 25% gain

  • Recovering from a 30% loss requires a 43% gain

  • Recovering from a 40% loss requires a 67% gain

  • Recovering from a 50% loss requires a 100% gain

  • Recovering from a 60% loss requires a 150% gain

If you fall in one of these deep holes you will spend valuable time just getting out of it before you can even start booking any gains. Once you start to fall, the black hole won’t let go. Far better not to get too close.

Friends don’t let friends buy and hold. I can’t say that strongly enough. You must have a well thought out hedging strategy if you’re going to be long the stock market. If your investment advisor simply has you in a 60/40 portfolio and tells you that “we are invested for the long term and the market will come back,” pick up your capital and walk away. I can’t be any more blunt than that.

Every investment advisor, including me, uses these words in their disclosure documents: Past Performance Is Not Indicative of Future Results. I think that has never been more true than for the coming decade. The 2020s will be more volatile and difficult for the typical buy-and-hold index fund investor than anything we have seen in my lifetime.

Active investment management is not particularly popular right now since passive strategies have outperformed. But I think that is getting ready to change. You should start, if you’re not already, investigating active management and more proactive investment styles. You will be much happier if you do.

Personally, I am still happily invested in a number of hedge funds but the strategies I select are limited, as many hedge fund styles have seen great challenges in producing acceptable risk/reward returns.

That is getting ready to change. I believe some hedge fund styles like the distressed debt, fixed income and event driven spaces are going to be very attractive. Who knows? Maybe even long/short funds will eventually find their former mojo.

At the economic event horizon, we all need to become black hole investors. Relying on past performance as the tectonic plates shift underneath us, as the central bank black holes begin to suck historical performance into their maws, we must look forward rather than backwards to design our portfolios.

At the event horizon, as the Jefferson Airplane song of my youth says, logic and proportion are fallen sloppy dead. You better feed your head with much more forward-looking strategies.

Sunday I will fly to New York, meeting with old friends and new, and researching some management styles and managers, along with a few new biotech investments. Yes, my own personal focus is on biotech, and I do have a larger position of my personal portfolio in biotech stocks than I do in other areas. I should probably take a more holistic approach, but I actually give money to other managers who focus on different parts of the market, and spend more of my personal portfolio time on biotech. Ask me in 10 years if that was a good decision.

Tuesday night I get to be with Danielle DiMartino Booth on her birthday in New York, celebrating it with a number of our mutual friends. Danielle was Richard Fisher’s personal researcher at the Dallas Fed and now writes the must-read Daily Feather newsletter.

In one of the early Batman movies, the Joker says, “Where does he get all those wonderful toys?” I read The Daily Feather and I ask myself, “Where does she get all those wonderful stories and analogies?” And the data is truly a marvel.

I’ll be back in Puerto Rico on Wednesday afternoon, with meetings in San Juan before returning home to Dorado. Then the next Monday I will fly to Houston in the early evening. I will spend the next day with my partners at SMH (Sanders, Morris, Harris) going over strategies for clients and meeting with companies (yes, one might be biotech) and hopefully Texas barbecue for dinner. Then up early the next morning to go back to Puerto Rico.

Theoretically, I have no travel scheduled for the next month after that. But past performance suggests that something will happen to keep me from staying home for 30 days straight. We’ll see…

And with that, I will hit the send button. You have a great week and I hope you get to spend it with good friends and great conversation. It’s hard to get any better than that combination.

Your trying to figure out how I got old enough to get Social Security analyst,

John Mauldin
Co-Founder, Mauldin Economics


How rock-bottom bond yields spread from Japan to the rest of the world

Japan’s impact is felt keenly in American and European corporate-credit markets

IT WOULD BE hard to think of a business that is on the face of it quite as dull as Norinchukin Bank. A co-operative, it was founded almost a century ago to take deposits from and lend to Japanese farmers. Yet Norinchukin came blinking into the spotlight earlier this year when it emerged that it had been a voracious buyer of collateralised loan obligations (CLOs)—pools of risky business loans used to finance buy-outs by private-equity firms. At the last count, in June, Norinchukin owned $75bn-worth.

The escapades of Norinchukin offer a parable. One part of its lesson is that when interest rates are stuck near zero for a long time, as they have been in Japan, banks’ normal source of profits comes under pressure. The other part is the lengths to which they must go to boost those profits, in this case by buying exotic foreign securities with attractive yields.

Norinchukin is not alone. Japanese banks and insurance companies have been big buyers of the triple-A-rated tranches of CLOs, as well as other sorts of investment-grade corporate debt.

For this, blame negative bond yields. When the Bank of Japan’s board meets on September 19th, it is not expected to reduce its main interest rate, currently -0.1%. But any increase in interest rates seems a long way off. And as long as rates are at rock-bottom in Japan, it is hard for them to rise in other places. Bond-buying by desperate Japanese banks and insurance companies is a big part of what keeps a lid on yields elsewhere.

Japan’s sway on global asset markets has been felt ever since it liberalised its capital account in 1980. Later that decade Japanese investors snapped up trophy properties in America, such as the Rockefeller Centre in New York and Pebble Beach golf course in California. In the 1990s they piled into American tech firms. Both forays ended badly, but Japan’s stock of foreign securities has kept growing as its surplus savings have piled up.

Japan is already the world’s biggest creditor. Its net foreign assets—what its residents (government, householders and firms) own minus what they owe to foreigners—are worth around $3trn, or 60% of its annual GDP. And that understates Japan’s influence on global asset markets. Since 2012 both sides of its national balance-sheet have grown rapidly (see chart), as Japanese investors borrowed abroad to buy yet more assets.

Japan’s impact is felt most keenly in corporate-credit markets in America and Europe. Its pension and insurance firms, which need to make regular payments to retirees, are at least as hungry for bonds with a decent yield as are their peers elsewhere. But the grasping for yield is made all the more desperate by the struggles of Japan’s banks.

It is hard to make money from lending to the government when bond yields are negative. In ageing, high-saving Japan, private-sector borrowers are scarce. So bank profits have suffered.

A report last year by a financial regulator found that half of Japan’s regional banks lost money on their lending businesses.

Though yields in Europe are lower than in America, they are nevertheless attractive to Japanese buyers who hedge their currency risk. Most currency hedges are for less than a year and many are for three months. The cost of such hedges is linked to the cost of short-term borrowing in the foreign currency.

A rising yield curve thus gives the best currency-hedged returns: the yield is high at the long end but short rates are low. For that reason, currency-hedged Japanese investors have preferred to buy corporate bonds or other credit securities in Europe rather than in America, where short-term interest rates are relatively high.

Locals lament that high-quality European and American corporate bonds are treated as safe assets, akin to sovereign bonds. Analysts’ efforts to work out which companies are more or less likely to default, and so which bonds are more or less valuable, seem almost quaint. “The Japan bid is not driven by credit risk,” complains one analyst. “It is all about headline yield.”

Some see Japan as a template: its path of ever-lower interest rates one that other rich, debt-ridden economies have been destined to follow and will now struggle to escape. But Japan’s troubles also have a direct influence on other countries. This makes itself felt through the country’s considerable sway over global capital markets.

The outworkings are strange and unpredictable. Who would have thought that the rainy-day deposits of Japan’s farmers and fishermen would be used to fuel leveraged buy-outs in America and Europe?