Recession Rumbles

By John Mauldin

 

I’m often asked if recession is coming, and for quite different reasons. Some people worry about their investments. Others are worried about their employment or their kids. Political types wonder if and how recession could affect the next election.

To all those people, for quite some time now, my answer has been: “Yes, but not just yet.” That’s still what I think today, but more of the early warning signals I have used in the past are beginning to flash again.

Looking at the data, I see some good news but also some leading indicators weakening. I see smart people like Dave Rosenberg argue we may already be in recession today. And I see Wall Street not really caring either way, so long as it gets enough rate cuts to prop up asset prices. None of that is comforting.

Today we’ll look around and see what is happening. Because I try to be aware of my own biases, we’ll consider some more optimistic views, too. They may not be convincing, but it’s important to confront them.

As you’ll see, the storm clouds are gathering. Someone is likely to get hit. It might be you.

Longer and Weaker

Let’s begin by reviewing where we are. I think we all agree this recovery cycle has been both longer and weaker than in the past. Any growth is good, of course, and certainly better than the alternative. But the last decade wasn’t a “boom” except in stock and real estate prices.

(Quickly, let’s put to rest the myth that the longer a recovery goes, the greater the likelihood of a recession. That’s a tautology. Recoveries don’t stop because of length. Back to the main point…)

I like this Lance Roberts chart because it shows long-term (5-year) rates of change, over a long period (since 1973) in three key indicators: Productivity, wage growth, and GDP growth. You can see all three are now tepid at best compared to their historical averages.
 


Source: Lance Roberts

 
These measures have been generally declining since the early 2000s, suggesting that whatever caused our current problems preceded the financial crisis. But we don’t need to know the cause in order to see the effects which, while not catastrophic (at least yet), are worrisome. And, as Lance points out, a decade of bailouts and dovish monetary policy didn’t revive previous trends.

The growth deceleration is also visible if we zoom into the recent past, via the Goldman Sachs Current Activity Indicator. It peaked in early 2018 (not coincidentally, at least in my opinion, about the time Trump started imposing tariffs on China) and slid further this year. Much of it is due to a manufacturing slowdown, but the consumer and housing segments contributed as well.
 


Source: Goldman Sachs via The Daily Shot

 
Again, this doesn’t say recession is imminent. The US economy is still growing by most measures. But the growth is slowing and, unless something restores it, will eventually become a contraction.

My friend Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) makes the extraordinarily valid point: Recessions don’t happen from solid growth cycles. Economies generally move into what he calls a “vulnerable stage” before something pushes them into recession. We all pretty much agree that the US economy, not to mention the global economy, is in a vulnerable stage. It won’t take much of a shock to push it into recession.

That’s bad news for many reasons, but one is that we have a lot of catching-up to do. My friend Philippa Dunne recently highlighted some IMF research on lingering damage from the financial crisis. Per capita real GDP since 1970 is now running about $10,000 per person below where the pre-crisis trend would now have it. Philippa calculated that at current rates, the economy won’t be where it “should” be until the year 2048.
 


Source: TLR Analytics

 
A recession will push us even further below that 1970–2007 trend line. And all the zero interest rate policies (ZIRP) and quantitative easing in the world will not get us back on trend, just as it did not after 2008. No matter how fast we try to run, it will get even harder to catch up with that trendline.

Inversions-R-Us

The inverted yield curve is one of the more reliable recession indicators, as I discussed at length last December in The Misunderstood Flattening Yield Curve. At that point, we had not yet seen a full inversion. Now we have, and it appears in hindsight perhaps the curve was “inverted” back then, and we just didn’t know it.

You may recall that the Powell Fed spent 2018 gradually raising rates and reducing the balance sheet assets it had accumulated in the QE years. This amounted to an additional tightening. I said it was a mistake but alas, the Fed didn’t listen to me. In fact, I repeatedly argued that the Fed was running an unwise two-variable experiment by doing both at the same time. Many serious observers wonder which is more problematic for the economy. I think the balance sheet reduction has had more impact than lower rates.

If you assume, as Morgan Stanley does below (and I have seen variations of this from numerous other analysts) every $200B balance sheet reduction is equivalent to another 0.25% rate increase, which I think is reasonable, then the curve effectively inverted months earlier than most now think. Worse, the tightening from peak QE back in 2015 was far more aggressive and faster than we realized.

Let’s go to the chart below. The light blue line is an adjusted yield curve based on the assumptions just described.


Source: Morgan Stanley

 
But even the nominal yield curve shows a disturbingly high recession probability. Earlier this month, the New York Fed’s model showed a 33% chance of recession in the next year.
 


Source: New York Fed

 
Their next update should show those odds somewhat lower as the Fed seems intent on cutting short-term rates while other concerns raise long-term rates. But it’s still too high for comfort, in my view.

But note that whenever the probability reached the 33% range (the only exception was 1968), we were either already in a recession or about to enter one. For what it’s worth, I think Fed officials look at their own chart above and worry. That’s why more rate cuts won’t be surprising. And frankly, and I know this is out of consensus, I would not rule out “preemptive quantitative easing” if the economy looks soft ahead of the election next year. Just saying…

But that’s not everyone’s view. Gavekal gives us this handy chart showing inversions don’t always lead to recession right away. (I noted 1968 above and I think 1998 is a separate issue. But then again, that’s me.)


 
Fair enough; brief inversions don’t always signal recession. But as noted, when you consider the balance sheet tightening, this one hasn’t been brief. Note also that an end to the inversion isn’t an all-clear signal. The yield curve is often steepening even as recession unfolds.

One thing seems certain: While the yield curve may not signal recession, it isn’t signaling higher growth, either. The best you can say is that the mild expansion will continue as it has. That’s maybe better than the alternative, but doesn’t make me want to pop any champagne corks.

Rob Arnott of Research Affiliates is simply one of the finest market analysts anywhere. He has won more awards and accolades than almost anyone I know. I am honored to call him friend and frequently get the benefit of his commentary about my letters or in this case, a note I used in my Over My Shoulder service from a former Fed economist. I’ll let Rob speak for himself:

I’m fascinated that there are so many economists and pundits who think that cutting rates is a bad idea, when many (sometimes the same people!) thought ZIRP was fine for a half-dozen years.

I was struck by Yellen’s recent comments that it’s “very difficult” to bring long rates down. This would seem to lend credence to Bianco’s assertion that yield curve inversion doesn’t “predict” a recession; it “causes” a recession. The “causality” is a controversial idea. My argument: The long end is set by the markets, not regulators. It is high when inflation and/or growth expectations are strong, and low when inflation/growth expectations are low. When the long end falls below the short end (or the short end rises above the long end), the long end is telling us that people are happy to lend long-term at rates lower than the short-term cost of capital and are disinclined to borrow at rates at or above the short-term cost of capital. This probably means some blend of risk aversion and pessimism. The Fed waits until it sees signs of weakness, so it’s always behind the curve. By the time there is objective evidence of weakness, it’s too late for the Fed to do a thing.

This is also why critics are wrong to criticize Steve Moore or Judy Shelton for wanting higher rates before Trump’s election, and lower rates today. The graph below suggests that the long bond was begging the Fed to normalize, within months after the Global Financial Crisis had passed. And is now saying “we’re running out of time to ease.”


Source: Research Affiliates

 
For what it’s worth, I think an inverted yield curve is similar to a fever. It simply tells us something is wrong in our economic body. And sadly, at least historically, Rob is right. The Fed has always been behind the curve.
 
To Powell’s credit, he may be trying to get in front of it, at least this time. I am less hopeful about the results, for different reasons I will describe in another letter someday.

Freight Freeze

The yield curve and other financial indicators are, while interesting, somewhat disconnected from the “real” economy. What’s happening on Main Street, where real people buy and sell real products used in everyday life? The news isn’t reassuring there, either.

The physical goods we buy—food, clothing, furniture, houses, and most everything else—have one thing in common. They (or their components) travel long distances to reach us. Sometimes it’s from overseas, sometimes domestic, but none of us live in close proximity to all the things we need. The market economy brings them to us.

People have aptly compared the economy’s transportation sector to the body’s circulatory system. It’s a good metaphor. Blood delivers nutrients to your organ just as trucks deliver products to your home. Problems begin when those deliveries slow… and they are.

The Cass Freight Index (which I have followed for more than a decade) measures shipment volume (by quantity, not cost) across the economy: truck, rail, air, ship, everything. The chart below shows its year-over-year percentage change.
 


 
You can see shipment growth picked up in 2016 following an extended weak stretch. This continued into early 2018 then a steep slide ensued. (Note that this is about the same time as the manufacturing contraction shown in the Goldman Sachs chart above and coincides with the first Trump tariffs.) Annual growth went below zero in December 2018 and has been there ever since—now seven consecutive months.

“What’s the big deal?” you may ask. Look how long that 2014–2016 contraction lasted. It didn’t signal a recession. Two points on that…

First, that retreat sprang from an oil price collapse that began in November 2014 and quickly affected US shale production. This greatly reduced freight volumes.

Second, while it didn’t spark a generalized recession, that particular part of the economy had its very own recession, and it was a nasty one. Ask anybody in the energy business and energy-producing regions how fondly they remember those years.

The current shipment contraction is potentially far worse. We can’t blame it on a sudden event like OPEC opening the spigots, nor is it focused on a particular sector. The Cass data shows declines everywhere, in everything.

Do I blame this on Trump’s trade war? Partially, yes, but I think more is happening. Years of flat wages forced many households to take on more debt. This has a cumulative effect; you can handle the payments for a while, but eventually things happen. Rising interest rates didn’t help. (In casual conversation, a friend told me his American Airlines Citibank card is now charging him 22% even though his credit score is over 800.)

This would once have been a normal pattern, not good but also not alarming. The economy had cycles and we dealt with them. But the long duration and weak magnitude of this growth phase is making the inevitable downturn potentially “feel” worse to many. The pain adds up and eventually becomes a recession.

Action Plan

So if you have investments, what does all this mean for your investments? It probably won’t be good. Stock valuations are historically high relative to our actual income. You might recognize that as Warren Buffett’s supposed favorite indicator: the ratio of stocks to gross national income.

Steve Blumenthal recently shared a good chart on this. He explains it so well, I’ll just quote him.

The chart below looks at what Warren Buffett said is his favorite valuation measurement. It compares the total value of the stock market to Nominal Gross Domestic Income. Stock Market Capitalization is the number of shares a company has outstanding multiplied by its current share price. All US companies are calculated and added together to get the total value of US stocks. Think of Gross Domestic Income as what we collectively earn. When stock prices go up, the collective value of the market goes up and when you compare it to our collective income, you get a ratio to determine if prices got ahead of themselves (overvalued) or are cheap relative to our incomes (undervalued).

Ned David Research (NDR) tested the data back to 1925 and organized the ratio of stock market value to income into five quintiles (most overvalued to undervalued).

Here is how to read the chart:

·         First focus on the bottom section of the chart. The red line tracks the ratio since 1925.

·         Above the green dotted line is the top quintile or most overvalued in terms of stock market price to income. Below is the bottom quintile or where bargains are best. The red arrows mark prior peaks in valuation (1929, 1966, 2000, 2008, and today).

·         Next, look at the red rectangle in the upper left-hand section of the chart. Focus in on the yellow circle. It shows the subsequent five-year return achieved when the ratio was in the top quintile (most overvalued) and was just 1.41%. That is the total return after five years, meaning your $100,000 grew to just $101,410. Annualized, that is a compounded return of approximately 0.22% per year. Not good. The 10-year return was just 50.66%, which is an annualized compounded return of approximately 4.25%. Not so good.

·         Now look at the subsequent 5- and 10-year returns when the ratio was in the bottom quintile (most undervalued). +123.87% average five years later and +367.36% 10 years later. Pretty great.

·         NDR said that no indicator they have tested has done a better job historically at showing subsequent 5- to 10-year returns. We should take note.


 
John here again. In other words, when you start matters, and now is not a good time. You want to buy on weakness, not strength. The weakness will come, but this isn’t it.

There is a counterargument, though. Maybe all this history doesn’t matter when we have central banks doing absurd things like negative interest rates. I see real risk that the Fed will go to NIRP before all this ends. Imagine what that will do to the trillions presently stashed in bonds. Will people (not to mention pension funds) happily pay for the privilege of being owed money? If not, where will they put their cash?

The answer, for many, may be in stocks. The resulting money flow could keep equity prices high despite negative fundamentals. I’m not predicting that outcome, but it’s possible.

We are in such bizarre times, all bets are off. It is certainly not the time for “buy and hold” unless your goal is to lose everything. If not, then you need an active, flexible, defensive investment strategy now more than ever.

One caveat: The last two times (2000 and 2006) the Fed cycle was where it is today, stocks actually rose for about six months. In 2006, I painfully remember being on the Larry Kudlow show with Nouriel Roubini where we were both talking about bear markets. Larry and John Rutherford were beating us up, telling us the markets would rally. They were right. Equity indexes went up 20% more after that December 2006 television show, before falling 50% and then some. Which is one reason my own personal strategies are now more nuanced than simply “sell everything and go to cash.” There are ways to properly hedge and still participate in the markets.
 
But that’s another letter…

New York, New York, Maine, and Montana

I thought I was staying home, but Monday finds me flying to New York for two days for last minute meetings while Shane is in Mexico. Then early August sees me in New York for a few days before the annual economic fishing event, Camp Kotok. Then maybe another day in New York before I meet Shane in Montana. Palo Alto is calling, too. So much for the light travel schedule.

Puerto Rico is now home for Shane and I. You may have seen news of large protests in Old San Juan. Everyone pretty much knew the government was corrupt, but recently revealed text messages exposed some disturbing details. The fact that the protests are nearly entirely peaceful (from what I can see) is amazing. The people are right to be outraged.

I have grown to love this island and the people. These are some of the happiest and most welcoming people of the 65 countries that I have visited in my life. A little transparency in their government would go a long way to solving the ills that plague them.

And with that, I will hit the send button. You have a great week and find some friends and family to be with. I’m looking forward to meeting a few friends in New York myself…

Your on recession watch analyst,
 

John Mauldin
Chairman, Mauldin Economics

The Bard and the Bank Regulators

“Be wary then; best safety lies in fear,” said Laertes to Ophelia as she embarked on her doomed dalliance with Hamlet. That is sound advice for banks and their regulators, too, as they face the prospect of technological disruption.

Howard Davies

davies64_bgwalkerGettyImages_shakespearestatuebuilding


LONDON – Banking supervision teams at the Bank of England “now receive the equivalent of twice the entire works of Shakespeare of reading each week.” So says Huw van Steenis, the author of a new report, “Future of Finance,” commissioned by the Bank’s outgoing governor, Mark Carney.

One might argue with the word “equivalent.” Few regulatory submissions rival the Bard’s output in their timelessness or vivid use of language: the Bank of England would probably send them winging straight back to their originators if they did. But van Steenis’s point about the volume of reporting is a valid one. The system of banking supervision has become highly complex, with a risk that the forest is entirely lost from view in the midst of thousands of trees.

The team that produced the report commissioned McKinsey and Company to assess the cost of all this reporting to banks in the United Kingdom. Their estimate is £2-4.5 billion ($2.5-5.7 billion) per year – rather a broad range, but even the lower bound is a big number, with a material impact on profitability.

Van Steenis argues that better use of technology – regtech – could make a difference. Regulators should be using artificial intelligence and machine learning to interrogate regulatory returns and identify risks and anomalies. He also points out that much of the complexity has its origin in the overlapping and sometimes conflicting priorities of different regulators. In comparison with the United States, the UK system is relatively streamlined, but banks must still satisfy the requirements of the Bank of England, the Financial Conduct Authority, the Competition and Markets Authority, the Payment Systems Regulator, and the Open Banking Implementation Entity. They are not always easy to reconcile.

The problem is particularly acute in relation to the payments system, which, owing to new entrants – perhaps soon to include Facebook with its Libra currency – has become far more complex to oversee. As a result, a number of regulators impose their own requirements.

Van Steenis argues for “a joined-up strategy to improve our payments infrastructure and regulation,” and an approach which he describes as analogous to air traffic control, to ensure that the demands of different regulators do not land on banks and others in an unmanageable and uncoordinated way. The UK government has responded positively to that idea, but it will not be easy to bring greater coherence to a range of regulators that each has its own legal obligations and political masters. Air traffic controllers can order a plane to enter a holding pattern, as anyone who has flown into Heathrow in recent years knows only too well. Who can tell a statutory regulator to get back in its box and wait for others to finish their work? We must hope that the government can answer that question.

The most interesting parts of “Future of Finance” concern how means of payment are changing. Cash is in decline in many countries, though the rate differs markedly from place to place. Cash usage has fallen by over 80% in Sweden in the last decade and is now dropping by 10% per year in the UK, while it is barely changing in Germany. Van Steenis warns that the “Swedish experience shows that without a coordinated plan, the pace of change risks excluding some groups in society.”

He is also a skeptic when it comes to cryptocurrencies: “crypto assets that are not backed by currency are an unreliable store of value, inefficient medium of exchange and simply won’t cut the mustard.” And he does not see a compelling case for a central bank digital currency, which puts him at odds with some others in the central banking world, who see attractions in the idea, not least greater leeway to impose negative interest rates.

But, despite skepticism about the viability of cryptocurrencies, bankers will not find “Future of Finance” reassuring reading. It points out that Ant Financial, which I visited in Shanghai last week, is now the world’s largest financial services firm, with over a billion customers, and not a single brick-and-mortar branch. There are more mobile and contactless payments in China each year – worth $15.4 trillion – than are managed by Visa and MasterCard combined. And in response to the report, the Bank of England announced that in the future, non-bank payment providers will be allowed to hold interest-bearing accounts at the central bank, a privilege previously available only to commercial banks.

Anyone working in finance knows that a revolution is under way, driven by disruptive technology. The full implications, for providers of finance and those who regulate them, are only dimly understood so far. The Bank of England’s report sheds valuable light on aspects of that revolution. It examines the threat to traditional banks’ core income streams in an analog world.

It is right to face up to that threat, and to be anxious. As Laertes said to Ophelia as she embarked on her doomed dalliance with Hamlet, “Be wary then; best safety lies in fear.” That warning probably does not appear in the Shakespeare-sized weekly reading of the Bank of England supervisors. Perhaps it should.


Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of the Royal Bank of Scotland. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.

Why War With Iran Isn’t in the United States’ Interests

The strategic calculus behind such a confrontation just doesn’t benefit the U.S.

By Xander Snyder

 

 
The U.S.-Iran standoff continues to evolve quickly, yet the blow-by-blow commentary covering tanker attacks, a downed drone, and reversed orders for airstrikes from the White House fails to consider the strategic logic behind an intervention, if in fact the Trump administration decides to intervene. With that in mind, it’s worth taking a moment to imagine what a war between the two would actually look like.
By now, the U.S. should have learned a thing or two from the Vietnam and Iraq wars. Distant foreign conflicts are difficult to win without a well-defined case for what success looks like and an overwhelming military commitment, the kind the American public is usually unwilling to provide unless faced with a massive and immediate threat. Small-scale engagements accomplish little and are instead more likely to evolve into larger conflicts. Installing foreign governments in the American image is more difficult, costly, time-consuming and even deadly than leaders are likely to claim. Backing a local proxy is often unpalatable for the country’s sense of ethics, but U.S. adversaries often have no such qualms.

Those proxies are often an ineffective substitute for a U.S. military presence when it comes to pursuing U.S. objectives. And without a substantial, long-term commitment of U.S. forces, such wars are more likely to open a power vacuum when the U.S. withdraws. The result: a collapsed government, an invasion by a neighbor, a revolution that creates new and uncertain structures – or some combination of these. In fact, the U.S. has had few true victories in the wars it has fought since World War II.
 
 
Limited Airstrikes
Consider the U.S. government's options, then, for a war with Iran. If the U.S. chooses a kinetic response, the first and most likely option would be a limited strike, similar in scale to or perhaps somewhat greater than the strikes on Syria that the Trump administration ordered on Syria in April 2017 and 2018. But Iran is not Syria. Iran has a sophisticated air defense infrastructure and plenty of air denial capability, increasing the chance of U.S. casualties. Further, a limited air strike probably wouldn’t accomplish anything meaningful. It might take out a handful of radar and air defense installations, sending a political signal but affecting in no real way the strategic reality on the ground. The only time U.S. air power alone has significantly shifted the reality on the ground was in Kosovo, but Iran today is far more powerful than Serbia in 1999.
Instead, a limited strike has a good chance of working against US interests. Iran’s economy is hurting, and its society appears more divided as citizens continue to grow frustrated with the government. The U.S. has deployed sanctions as a strategy to hobble the economy enough to create social pressure on Tehran, forcing the government to spend less on its defenses and its funding of militias in Syria and Iraq. And so far, they’ve been effective. If the U.S. sustained this tactic, over time Iran’s domestic situation would worsen, and its citizenry would be more likely to blame its leadership for their problems. And that would likely intensify the divisions within the government that are already emerging, resulting in either a more Western-friendly government or one dominated by the Islamic Revolutionary Guard Corps.
Even limited U.S. airstrikes, however, would increase the probability of the IRGC consolidating power. Where sanctions may help create division, an attack would unite Iran’s hard-liners and reformers against the U.S. That unity would likely occur under the aegis of the hard-liners who have been warning all along that this day would come if Iran were foolish enough to trust the U.S. As the most powerful entity in the county, the IRGC would probably take over, and do so with popular support.
 
Use of Ground Force
Ground force is a less likely choice for the U.S., even with limited objectives (like eliminating specific military equipment or securing passage through the Strait of Hormuz). But it would be more likely to achieve what the U.S. really wants: for Iran to recall its foreign militias so that they will defend the home front. But when a military force is rapidly removed without a replacement ready to take its place, it creates a power vacuum and, therefore, an opportunity for others to fill the void. In this case – the Islamic State and other jihadist groups. Timing matters too. The pace at which Iran withdraws its militias from Syria and Iraq, states that are already precariously fragile, will create an outsized risk to violently alter the regional balance of power.
 
 
If the Islamic State moves back into the space vacated by Iran, it would be the U.S. that would have to again deal with this problem, which would require reoccupying parts of Iraq while fighting Iran. That, in turn, would likely entail support from Syrian and Iraqi Kurdish forces, which would again put pressure on U.S.-Turkey relations. But the Syrian Kurds may not see a long-term alliance with the U.S. as in its best interest after the U.S. threatened to leave them high and dry in December 2018. They could instead seek out a political resolution with Damascus, backed by Russia, that would protect them from Turkey. It’s possible that if the Islamic State re-emerged, Russia could step in to back Kurdish groups such as the Syrian Democratic Forces to fight back. But that would mean the U.S. would be depending on Russian assistance to cover its western flank, and in exchange for such cooperation Russia would likely demand U.S. concessions in places like Ukraine. In short, going all-in with Iran would require either a large-scale U.S. occupation or dependence on Russia in Syria and Iraq to prevent the Islamic State from coming back. Neither of those are appealing options for Washington.
If it’s regime change that the U.S. is after in Iran, the risks are even greater. The fallout would look much like that of the second Iraq war, but on a far greater scale. Installing a pro-American regime isn’t easy, but it can easily fail. The U.S. would have to commit to an indefinite occupation of Iran or again risk the emergence of a power vacuum. And it would still have to deal with the rest of the Middle East. In the best-case scenario, the U.S. would install a new head of government while facing a lengthy insurgency, which would likely include the vestiges of the IRGC and its heavy weaponry. After a long, costly occupation, the U.S. would withdraw, leaving Iran’s leaders to face opposition on their own. The half-life of U.S.-installed leaders in the Middle East is not long – just ask the shah of Iran.
Whether limited airstrikes or a full-scale invasion, a U.S. military confrontation with Iran would create more problems for the U.S. than it solves. As barbs are traded on the international stage, it’s these kinds of strategic considerations that Washington will need to consider before going to war.

Investors should expect central banks to do the unexpected

Modern monetary theory may seem unlikely now, but things can change quickly

Katie Martin


Some investors fear we will look back on these messages from Mario Draghi and the Fed with a sense that we were at the peak of global monetary madness © AP


We now know what weary, miserable investors want to hear. The answer came just minutes after last week’s fund manager survey from Bank of America Merrill Lynch showed that investors were the most gloomy since the financial crisis of 2008. As they sat sobbing into their lattes, wracked by fears of trade wars and a global slowdown, a hero came along to turn that frown upside down: Mario Draghi.

The outgoing European Central Bank president managed finally to make investors listen to the message he has been trumpeting for the past couple of weeks: he is prepared to cut rates and buy more bonds in an effort to support the eurozone economy in the sunset weeks of his tenure.

Suddenly those forlorn fund managers were wiping away their tears, cracking smiles, and punching the big green button marked “buy stocks”.

“In two to three hours, we had a complete change,” says a bemused-sounding Kasper Elmgreen of Amundi Asset Management. The refreshed exuberance was bolstered further when the US Federal Reserve added its loud voice to the dovish choir later in the week.

Not to spoil the party, but some investors fear that, in the coming years, we will look back on these messages from Mr Draghi (or “Mario D”, as US president Donald Trump labelled him on Twitter) and the Fed with a sense that we were at the peak of global monetary madness.

The concern here is that central banks have tried all this before with, by some metrics, limited success. Since the global financial crisis central banks have slashed rates and pumped trillions into the bond markets, and they still cannot hit their inflation targets.

In fairness, central banks are using the only tools at their disposal, but it is striking that they are revving up to take broadly the same steps yet again. “For me, we are into the realms of the insane,” says James Athey of Aberdeen Standard Investments. “We are doing the same thing over and over again and expecting different results.”

Amid this sense of exasperation, investors are starting to wonder what is next. If yet more rate cuts and yet more bond buying fail to do the trick, then what? That is why some previously fringe concepts of how monetary policy could work might are starting to hit the mainstream.

Jim Cielinski of Janus Henderson suggested at an event last week that central bankers could be close, very close, to effectively ripping up their mandates and trying something new. This possibly includes so-called modern monetary theory: crudely, a project centring on printing cash to fund fiscal expansion.

“Think how brazen that idea was just a year ago. It was ludicrous. What a silly concept,” he said, describing some elements of the framework as “bunk”.

Over dinner in a plush corner of Mayfair — an unlikely forum for a serious discussion about what many see as a lefty pet project — Mr Cielinski noted that while MMT may seem unlikely now, “things move fairly quickly”.

“I can promise you that in ‘09, I wouldn’t have talked to anybody who said rates were going negative, anybody who said wait a year or two and there will be $13tn of negative yielding bonds. You will pay somebody to take your money, central banks will be buying trillions of dollars of assets . . . including corporate bonds. You would laugh them out of the room.”

Now, of course, all that is the bedrock of global markets. We consider it to be normal. Why not push the boundaries just that bit further? “Even central bankers, when their backs are against the wall, they do look for things in the toolkit that weren’t there before,” Mr Cielinski said.

If conventional policy, which was thought to be unconventional such a short period of time ago, does not work this time, then it may be time for investors to brace for a brave new world. Some are already starting to.

The Real Reason the Deep State Hates Russia... And What it Means for Gold

by International Man


For years, the Deep State in the US—the permanently entrenched bureaucracy that runs the show no matter which party is in power—has labelled Russia "public enemy number one."

To help us better understand the situation we’re turning to Doug Casey’s friend, Mark Gould.

Mark is an executive for a company in the oil industry, also working on several media projects. He also has 30 years of experience in Russian telecommunications as co-founder of CTC Media (previously NASDAQ:CTCM); and afterwards pioneering digital compression for TV (the core technology for video streaming) on the Soviet Satellite system, Moscow Global. Mark currently lives in Moscow.

International Man: Naturally, Americans have a lot of misconceptions about Russia. And that’s what we want to help clear up today. The importance of Russia to world affairs is simply too important to ignore or to not understand properly.

Also, this perception gap about Russia could be key to finding interesting investment opportunities—particularly in the natural resources space—that are off the radar of the mainstream financial media.

John McCain used to call Russia a gas station masquerading as a country. This is a childish and overly simplistic characterization. Others in the US media and government have made similar comments. What does the mainstream image of Russia get wrong?

Mark Gould: The US perspective is stuck in the 1960s and even earlier, going back to the 19th century.

Russia is a unique society. It’s a normal place, operating under its own rules and customs.

Viewing it through the prism of the Soviet past is not concurrent with present realities. Russia is an independent state that has its own concerns, people, leaders, and problems just like America does. And the people are patriotic and so is the president.

Russia is charting its own path. It doesn’t want to be under the thumb of the IMF or the World Bank.

Americans think that Russians are warlike or devious, because they’re mixed Eurasian. But what they really are is descended from the Viking Rus that swept down from northern Europe all the way to Kiev and then founded Moscow in the 9th century.

So, it’s a group-oriented society, as the Vikings were. Despite the image of Vikings as warlike and terrible, they really weren’t. They were traders. Everybody pillaged, raped, and stole, but there’s also a lot of trading going on—despite what TV shows want to say it was all about.

It’s a real modern, upwardly mobile society. This whole image of oligarchs and kleptocrats, that really is a thing of the past. The overall ambiance would be shocking to most Americans.

There are fancier and better restaurants, better fashions, beautiful women, less out-of-shape people, and so forth.

International Man: What makes the Deep State in the US so hostile to Russia?

Mark Gould: Conceptually and politically, sanctions don’t work as a political solution or a diplomatic solution.

It’s an international insult to suspend a fellow member of the G8 for an internal matter in what Russia considers its near-abroad the same way the US considers Cuba or Nicaragua its near-abroad. I’m referring to the situation with Crimea.

Whenever you screw around with another country’s access to the sea, it means war. Always. Not 99% of the time, not 98% of the time, but 100% of the time.

In 1965, Khrushchev gave back Crimea to Ukraine when he was drunk and likely because he had governed Ukraine under Stalin. In 2010 Ukraine extended Russia’s lease until 2042 for its Black Sea Fleet centered in the port city of Sevastopol in Crimea, which gives Russia access from the Black Sea to the Mediterranean and thus to the Atlantic.

Leaving Crimea in the hands of a hostile power is like a knife to Russia’s throat. And Russia responded accordingly.

NATO was looking for a reason to justify its continued existence after the end of World War II and after the end of the Cold War. And if you think there weren’t CIA operatives and State Department operatives fomenting for Ukraine to join NATO, you’re naïve.

International Man: Is there any hope for better relations, or are relations likely to get worse? And what are the consequences of that?

Mark Gould: I don’t think it’s going to get better fast. I think neoliberals and neoconservatives are the bane of existence of mankind, especially with the two-party system in America. So, I’m not sanguine about it at all.

I do not see it getting better unless some enlightened individual gets into office in the US and actually does the bold things that need to be done, and that is: End the sanctions, get back in communication, recognize that Russia has a human face, and let it rejoin the G8.

And don’t be afraid of the rise of Russia. It’s a normal thing.

I’m saying all that in the face of the fact that the entrenched military-industrial complex wants war, and I think a series of wars. In my entire life as an American, I think there’s maybe been eight years that there haven’t been wars. And that’s absurd.

Frankly, if you want to talk about the only adult in the room… Vladimir Putin is the only adult in the room.

A lot has been made about his being part of the KGB.

But the same people who complain about that don’t make a peep about George H.W. Bush, who was head of the CIA.

International Man: The Central Bank of Russia has been the world’s largest buyer of gold in recent years. What do they see coming, and what are they preparing for?

Mark Gould: Russia is hedging its bets. That’s my simple answer.

If you go back in history a little bit, you can get the Russian perspective on gold.

The Russian ruble has always been backed by gold. It’s not a new idea. And Russia has more reserves in gold that backs the currency than almost any other country.

Russia is also the world’s largest producer of oil; it’s the second largest producer of natural gas; it’s number two in sunflower oil.

Kicking Russia out of SWIFT or doing anything like that would be basically cutting off your nose to spite your own face. The US government would be complete idiots to do that.

Money is an idea backed by confidence, and gold has held that for many years for many people and for many countries.

Russia is hedging its bets. It’s building its own trade alliances. For example, recently Russia signed a deal with Huawei, the Chinese company that’s been banned from American markets.

International Man: Russia has been building alternatives to Western-dominated systems. This includes measures to protect itself from sanctions involving the US financial system, an alternative to the SWIFT system, alternative trade deals with other BRICS countries, the Eurasian Economic Union, and integration with China’s New Silk Road program. Where do you see this trend going?

Mark Gould: Well I think it’s going to continue.

Russia is building alliances; who doesn’t? To expect Russia not to look after its own economic self-interest is absurd. It’s the same thing the US or the UK or France or Indonesia do.

Russia’s building alliances with those countries—especially BRICS countries—that have a similar perspective.

I think the trend is going to continue. I don’t think it’s a hostile thing toward the US. Russia is just doing what it considers necessary to survive.

And US perspective is, "You don’t have any right to do that, because we are the arbiters of what is fair and correct in national self-interest for the world." And that’s a pretty arrogant perspective.

So, I don’t see Russia disappearing or growing smaller. The US sanctions are actually encouraging the development of the agricultural, high-tech, and other aspects of the Russian economy.

International Man: By many valuation metrics, Russia is one of the cheapest markets in the world. What investment opportunities do you see in Russia?

Mark Gould: Mark Feldman is a friend and one of the partners in the Standard Capital Group in Moscow.

I asked him the other day, "What is your number-one recommendation to invest in?"

He said, "That’s an easy one. Russian government bonds."

And then afterward he said, "Commodity-producing assets."

Russian gold companies can be bought for four to five times EBITDA.

Or real estate, or retailers. You can still buy those at four to five times EBITDA also.

There’s only one public real estate company in Russia, called PIK; they build apartment buildings.

And there is Petropavlovsk, a publicly traded Russian gold company. All of these companies are good buys in this market.

International Man: Is there anything else you would like to add in regard to investing in Russia.

Mark Gould: The time to invest is when it’s still a mystery, and Russia has been a mystery way before Churchill came up with his, "Russia’s a riddle wrapped in a mystery inside an enigma."

Going back to Voltaire, it was still a mystery. And Communism just made it even more confusing.

But the bottom line is that the right time to invest is while it’s still a mystery. If you come here, it’s like riding on a bus. You get on the bus, you get off the bus, and your eyes are opened. You go, "Oh my god, who knew you would find superstores bigger than any IKEA or Costco you’ve ever seen in America? Or that they run for blocks and blocks and blocks?"

The time is now. It’s not tomorrow, it’s now.


Living Life Near the ZLB

Doug Nolan


There must be members of the FOMC that feel they are about to be railroaded into a 50 bps cut a week from Wednesday. Chairman Powell essentially pre-committed to a reduction last week in testimony before Congress. For a Federal Reserve preaching “data dependent” for a while now, the less dovish contingent at the Fed must be asking, “But what about the data?”

It was interesting to see headlines Thursday afternoon from a speech by the President of the New York Fed, John Williams: “Williams: Lesson With Zero Rates is to Take Swift Action,” “Williams: Currently Estimates Neutral Rate in U.S. Around 0.5%.” Soon afterward, headlines from Fed vice chair Richard Clarida reinforced the point: “Fed’s Clarida: Central Bank Needs to Act Preemptively,” and “Clarida: You Don’t Necessarily Want to Wait Until Data Turns.” Things turned rather boisterous ahead of the Fed’s “quiet period.”

Markets were all ears. The implied yield on August Fed Funds futures dropped a quick nine basis points to 1.98%, a full 43 bps below the current rate. The Market’s Thursday afternoon pricing of a high probability of a 50 bps cut elicited an unusual backtrack: “Fed Says William’s Speech ‘Not About’ Potential Policy Actions.” (The President tweeted he liked Williams’ “first statement much better than his second.”) The implied rate on August Fed Funds futures closed the week at 2.10%, with market odds (60%) back to favoring a 25 bps cut. Ten-year Treasury yields dropped seven bps this week to 2.06%, with bund yields down 11 bps to negative 0.32%.

William’s speech, “Living Life Near the ZLB,” deserves of some attention: “My wife is a professor of nursing, and she says one of the best things you can do for your children is to get them vaccinated. It’s better to deal with the short-term pain of a shot than to take the risk that they’ll contract a disease later on. I think about monetary policy near the zero lower bound—or ZLB for short—in much the same way. It’s better to take preventative measures than to wait for disaster to unfold… Over the past quarter century, a great deal of research has gone into understanding the causes and consequences of the zero lower bound.”

[Note to PhD economics students: the clearest path to the upper echelon of the Federal Reserve System is to formulate some crackpot theory justifying aggressive monetary stimulus] How much “ZLB” Fed research has been conducted for environments characterized by record stock prices, strong Credit growth, booming corporate Credit markets, and a world with $13 TN of negative-yielding debt? Williams references a 2002 paper (co-authored with Dave Reifschneider) that evaluated “effects of the ZLB on the macro economy and examined alternative monetary policy strategies to mitigate the effects of the ZLB.”

“This work highlighted a number of conclusions based on model simulations. In particular, monetary policy can mitigate the effects of the ZLB in several ways: The first: don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might… When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress. …My second conclusion, which is to keep interest rates lower for longer. The expectation of lower interest rates in the future lowers yields on bonds and thereby fosters more favorable financial conditions overall… Finally, policies that promise temporarily higher inflation following ZLB episodes can help generate a faster recovery and better sustain price stability over the longer run. In model simulations, these ‘make-up’ strategies can mitigate nearly all of the adverse effects of the ZLB.”

There would be outrage if the Fed was using similar “model simulations” to justify a policy course at odds with the markets. In a world of unprecedented complexity, model simulations are basically worthless. If the Fed cannot even effectively model consumer price inflation from actual policy measures, how are models simulating impacts on future economic and inflation outcomes (from untested experimental policy) supposed to be credible? Besides, how have the ZLB experiments been progressing in Europe and Japan?

Williams: “An added impetus to this research has been the growing evidence that the neutral rate of interest rate has fallen significantly. I... have devoted a significant chunk of my academic career to studying r-star, or the long-run neutral rate of interest, and its implications for monetary policy. Our current estimates of r-star in the United States are around half a percent.”

What happened to the traditional central bank focus on money and Credit? This “natural rate” framework is problematic – and particularly so in Bubble environments. What was the estimate of r-star last November with 10-year Treasury yields at 3.24% and December ’19 futures implying a 2.93% Fed Funds rate? R-star is defined as the “interest rate that supports the economy at full employment/maximum output while keeping inflation constant.” In a world where loose financial conditions and booming securities markets are required to sustain the global Bubble, one can indeed make the argument that r-star is quite low. R-star is today only relevant in the context of a policy objective of sustaining the Bubble.

I thought it was outrageous in 2013 when chairman Bernanke stated the Fed was ready to “push back against a tightening of financial conditions”. It was as if I was the only analyst that had an issue with Bernanke essentially signaling that the Fed would not tolerate risk aversion or market pullbacks. Now the Fed and global central banks are taking another giant leap – the latest iteration of New Age experimental central banking: The “insurance rate cut” – “an ounce of prevention is worth a pound of cure.”

This is not about prevention, and William’s vaccine analogy is misguided. The world is suffering from chronic (debt) illness. An individual with diabetes, heart disease or cancer will find a cure in a vaccine. Over the years, activist monetary policies have been likened to giving an alcoholic another shot of whiskey or a drug addict another hit of heroin. While these have obvious merits, to counter Williams analogy I’ll instead use antibiotics. Global central bankers have been fighting the world’s chronic debt and economic maladjustment disease with steady doses of antibiotics. Not surprisingly, these pathogens have built up strong resistance to medication.

More stimulus at this point in the cycle is not for prevention – but instead a narcotic for sustaining unsound financial and economic booms (i.e. “extend the expansion”). The Fed and central bankers are again crossing a dangerous red line – compelled to aggressively administer antibiotics hoping to prevent a plague that has evolved to the point of thriving on antibiotics.

It wasn’t that long ago that Fed policy stimulus operated through a mechanism of adding reserves directly into the banking system, with additional reserves working to reduce rates while encouraging borrowing and lending. Policy would act to provide a subtle change in lending conditions that over time would reverberate throughout the economy. The Federal Reserve under Alan Greenspan increasingly shifted to using the markets as the mechanism to loosen financial conditions and stimulate the economy. The 2008 crisis unleashed the policy of direct market intervention, with Bernanke later doubling-down with his “push back” comment.

The U.S.’s coupling of market-based finance with market-directed monetary stimulus created a powerful – seemingly miraculous - combination. Others wanted in on the action. It was pro-Bubble for the U.S., but nonetheless took the world by storm. It became Pro-Global Bubble, and the world today is engulfed in historic market and financial Bubbles.

What is the “r-star” for economic equilibrium today in China? Chinese Bubble finance evolved to become the marginal source of finance globally and the Chinese economy the marginal source of global demand. With Aggregate Finance expanding almost $2.0 TN during the first half, Chinese Credit is again leading a global Credit upsurge.

July 16 – Bloomberg: “China’s efforts to shore up sagging economic growth are leading to a resurgence in indebtedness, underlining the challenge President Xi Jinping’s government faces in curbing financial risk. The nation’s total stock of corporate, household and government debt now exceeds 303% of gross domestic product and makes up about 15% of all global debt, according to a report published by the Institute of International Finance. That’s up from just under 297% in the first quarter of 2018.”

July 15 – Bloomberg (Alexandre Tanzi): “Global debt levels jumped in the first quarter of 2019, outpacing the world economy and closing in on last year’s record, the Institute of International Finance said. Debt rose by $3 trillion in the period to $246.5 trillion, almost 320% of global economic output, the Washington-based IIF said… That’s the second-highest dollar number on record after the first three months of 2018, though debt was higher in 2016 and 2017 as a share of world GDP. New borrowing by the U.S. federal government and by global non-financial business led the increase.”

July 15 – Financial Times (Jonathan Wheatley): “Debt in the developing world has risen to an all-time high, adding to strains on a global economy flagging under the weight of rising trade protectionism and shifting supply chains. Emerging economies had the highest-ever level of debt at the end of the first quarter, both in dollar terms and as a share of their gross domestic product, according to… the Institute of International Finance. The figures include the debts of companies and households. The IIF said that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. In recent months the US Federal Reserve has changed its policy outlook and a string of emerging market central banks have cut interest rates… ‘It’s almost Pavlovian,’ said Sonja Gibbs, the IIF’s managing director for global policy initiatives. ‘Rates go down and borrowing goes up. Once they are built up, debts are hard to pay down without diverting funds from other goals, whether that’s productive investment by companies or government spending.’”

Only “almost Pavlovian”? I’ve been closely monitoring Bubbles going back to Japan’s late-eighties experience. It’s always the same: Everyone is happy to ignore bubbles when they’re inflating. Bubble analysis, by its nature, will appear foolish for a while. But bubbles inevitably burst. There is no doubt that China’s historic bubble will burst, and I expect this will prove the catalyst for faltering bubbles across the globe – including here in the U.S.

The obvious transmission mechanism will be through the securities markets. Global markets have become highly synchronized – across asset classes and across countries and regions. Market-focused monetary stimulus has become highly synchronized, essentially creating a singular comprehensive global bubble.

July 18 – Bloomberg: “A cash crunch at one of China’s best known conglomerates is getting worse as the company said it will not be able to pay its upcoming dollar notes. China Minsheng Investment Group Corp.’s offshore unit said in a filing that it won’t be able to repay the principal, as well as the interest on the 3.8% $500 million bond due August, after considering its liquidity and performance. On Thursday, the property-to-financial conglomerate announced it only managed to repay part of the principal on a 6.5% 1.46 billion yuan note. The development underscores the liquidity crisis that has been pressuring the… company that aspired to become China’s answer to JPMorgan... It will be the first time that the firm’s dollar bond creditors will miss out on repayment.”

“Repo Rate on China’s Govt Bonds Briefly Hits 1,000% in Shanghai,” read an eye-catching early-Friday Bloomberg headline (picked up by ZeroHedge). Repo rates were back to normal by the end of the session, yet it sure makes one wonder… Aggressive PBOC liquidity injections have for the past several weeks calmed the Chinese money market after post Baoshang Bank government takeover (with “haircuts”) instability. The implicit Beijing guarantee of virtually the entire Chinese Credit system is now being questioned. This greatly increases the risk of Chinese money market instability – with ominous ramifications for China and the world.

With this in mind, there’s a particular circumstance that could catch global markets and policymakers by surprise: A dislocation in China’s “repo” securities lending market that reverberates throughout repo and derivatives markets in Asia, Europe and the U.S. This latent risk, in itself, could help explain this year’s global yield collapse and market expectations for aggressive concerted monetary stimulus. When Chairman Powell repeats “global risks” in his talks these days, I think first to global “repo” markets, global securities finance and global derivatives.

Markets are these days are luxuriating in impending Fed rate cuts and global rate reductions that have commenced in earnest. Liquidity abundance as far as eyes can see… What could go wrong? It’s already started going wrong. The flow of Chinese finance to the world is slowing.

July 18 – CNBC (Diana Olick): “Challenging conditions in the U.S. housing market, along with tighter currency controls by the Chinese government, caused a stunning drop in foreign demand for American homes. The dollar volume of homes purchased by foreign buyers from April 2018 through March 2019 dropped 36% from the previous year, according to the National Association of Realtors. The decline was due to a drop in the number and average price of purchases. Foreigners bought 183,100 properties with a total value of about $77.9 billion, down from 266,800 valued at $121 billion in the previous period. They paid a median price of $280,600, which is higher than the median for all existing homebuyers ($259,600), but it was down from $290,400 the previous year. ‘A confluence of many factors — slower economic growth abroad, tighter capital controls in China, a stronger U.S. dollar and a low inventory of homes for sale — contributed to the pullback of foreign buyers,’ said Lawrence Yun, NAR’s chief economist. ‘However, the magnitude of the decline is quite striking, implying less confidence in owning a property in the U.S.’”