Decade of Living Dangerously, Part 2

By John Mauldin


If living dangerously is your goal, just keep adding reasonable, manageable, prudent risks.

Eventually they’ll add up to serious danger.

Hyman Minsky showed how stability leads to instability. Humans have a way of reinterpreting stable periods that seemingly redefines words like reasonable, manageable, and prudent. That’s why we continue chasing yield and risk until we go too far.

To think that we have somehow eliminated recessions and risk, or that central banks and the government have somehow become adept at managing the business cycle, is simply foolish. Yet we keep doing it, every single time.

Debt seems harmless enough at first. You have reliable cash flow, repayment is no problem, and you’re going to spend the borrowed money wisely. But human nature tends to make us overdo otherwise good things. And, with debt, you may also have lenders actively urging you to borrow even more. Everything is fine… until it’s not.

Personal debt, while sometimes excessive, isn’t the main problem. Government and corporate debt are the bigger challenge and the reason we will spend the 2020s living dangerously. All that debt is ultimately personal debt, too, since most of us are either taxpayers, shareholders, or both.

In Part 1 of this forecast I described my relatively benign outlook for the next 12 months. The calm may last into 2021 and even beyond. But beneath the surface, pressure will still be increasing. It will grow slowly, almost imperceptibly, but eventually explode.

Or, to use another metaphor: We are frogs in the kettle and someone just turned on the heat. By the time we notice, our good options will be gone.
 

My friend Ben Hunt at Epsilon Theory has been writing a series called The Long Now. I won’t try to summarize because you should read it yourself.
 
Suffice it to say, it is both thought-provoking and disturbing. A quick snippet from his introduction:

The Long Now is everything we pull into the present from our future selves and our children.

The Long Now is the constant stimulus that Management applies to our economy and the constant fear that Management applies to our politics. (Ben has a rather broad view of what he calls capital “M” Management which includes government, central banks, and others.)

The Long Now is the Fiat World of reality by declaration, where we are TOLD that inflation does not exist, where we are TOLD that wealth inequality and meager productivity and negative savings rates just “happen”, where we are TOLD we must vote for ridiculous candidates to be a good Republican or a good Democrat, where we are TOLD that we must buy ridiculous securities to be a good investor, where we are TOLD we must borrow ridiculous sums to be a good parent or a good spouse or a good child.

 
Ben’s point goes way beyond debt, but that’s where he starts. By definition, debt is spending that we “pull into the present from our future selves and our children.” Or as I’ve said often, debt is future consumption brought forward in time.

Debt lets you consume more now, but to repay it you (or someone) must consume less in the future. Used properly, debt can enhance growth enough to cover the eventual repayment. That’s not what is happening—and it’s a big problem in a consumer-driven economy.

However, Ben Hunt observes that the problems can simmer much longer than we usually think. Humans have an amazing ability to postpone the inevitable and—when the subject is debt—a financial incentive to do so. That’s true for both borrowers and lenders.

“The Long Now” is a good way to describe the extended simmering period. At any given moment, you’ll be able to say, accurately, the situation is stable (like right now). Since last December we have seen markets go gangbusters. If you were in US stocks, in a buy-and-hold index fund, you made money and lots of it. Even value and dividend players are scooping up big returns. Remember last week and last year I was worrying about corporate bonds? Silly me…


Not Worth the Risk

A huge amount of money is clearly turning to corporate bonds as it reaches for yield. But then again, why not? The world seems stable. We seem to finally have some progress in the US/China trade wars. The market is telling us everything is okay… much like it did in 2007. Then came 2008.

We are using this stability to justify turning up the heat by adding more debt. There’s no reason to think we will stop. The Institute of International Finance, whose Global Debt Monitor tracks the numbers, says worldwide debt climbed $7.5 trillion in the first half of 2019 to hit $250.9 trillion.


Source: CNBC

 
In November, IIF estimated global debt would surpass $255 trillion by year end. If so, it was a 4.8% increase for the calendar year.
 
That’s faster than GDP growth for either the entire world or most developed countries. It’s also faster than population growth in most places.

Let’s think about that number for a second. That growth rate, which there’s every reason to think will accelerate further, means we can expect $400 trillion in global debt by 2030. That’s not counting the $120 trillion in US government unfunded liabilities. My friend Larry Kotlikoff thinks it’s closer to $200 trillion and I think it is reasonable to assume Europe is in that ballpark. They too have made pension and healthcare promises that their budgets can’t deliver without significant deficits (thus more debt) and in general, their tax systems are already stretched to the max.

While longtime readers know I’m against higher taxes, I can do the math here in the US. We are going to have to raise taxes if we want to stay anywhere within shouting distance of fiscal sanity.

That which can’t continue, won’t. It is simply not possible for per capita debt to keep growing faster than the economy in which the debtors live. There are limits. Recent experience suggests they are more distant than many of us thought, but they’re out there.

One last thought. When we do have a recession, which again I point out is likely to be after the election (the only meaningful data point between now and the end of next year), the deficit will explode to over $2 trillion per year and, without meaningful reform, never look back. That puts US debt at $35 trillion+ by the end of 2029.

Here’s a chart Patrick Watson and I made a few months back, projecting deficits at the end of the next recession. We assume CBO spending projections (which are likely low) and that tax revenue falls by the same percentage it did in the last recession.



Unproductive and Non-Linear

We worry about US government debt, and rightly so, but it’s only the beginning. Corporations have leveraged themselves to the teeth, and much of that debt could easily turn into government debt.

The last financial crisis revolved around mortgages and related derivatives. Millions learned a hard lesson and spent the next decade deleveraging. Yes, people still get in over their heads but it’s far less common now.

However, that missing mortgage debt has been replaced with additional government debt. The overall debt picture continues to worsen. For the moment, it is sustainable because the economy is growing (albeit slowly, but at least it isn’t contracting).

Lacy Hunt of Hoisington Investment Management tracks a number that ought to give us all cold chills. “Debt Productivity” is the amount of new debt associated with a given amount of GDP growth. Last quarter he found that each dollar of global debt generated only $0.42 of global GDP growth. That was down 11.1% from ten years earlier.
 


 
Worse, this isn’t a linear trend. We can expect it to accelerate as debt grows faster than GDP. At some point, debt becomes completely about consumption and, as noted, bringing consumption forward means less consumption later.

Debt growth isn’t linear, either. It has risen almost everywhere even without the negative events (recession, war, etc.) that historically drive it higher. We might be in better shape if corporations had, like homeowners, used the last decade to deleverage. They didn’t, in part because central banks made borrowing all but irresistible. Companies borrowed vast sums not because they needed to, but because they could. Often they used it to repurchase their own equity and further leverage their balance sheets.

My friend Peter Boockvar says we no longer have a business cycle, but a credit cycle. Central bank rate cuts encourage us to borrow, which is fun, but they can’t cut forever. Then they stop cutting, liquidity dries up, and we panic. Then we get things like the present repo crisis.

This isn’t lost on the powers that be. There is actually something of a debate going on in monetary policy circles. Some at the Federal Reserve think we are in a Goldilocks era, with everything being just about right, and thus more rate cuts and QE are fine. Others have serious concerns and more than likely really wish to pound on the podium. But decorum says they can’t.

Whatever happens, the visible result is that each recovery phase is smaller than the last. Eventually they will stop being recoveries at all until we “rationalize” the aggregate debt. That’s economist-speak for default/monetization/restructuring or whatever term you want to use. Until that happens, the word “recovery” will be meaningless. We can’t repay debt without growth. We’ll have to liquidate it in some fashion.

How do we do that? Inflation is the historically tried-and-true method. Right now central banks are struggling to generate the kind of inflation that would do this. Maybe they’ll figure it out, but I think default is the more likely outcome.

However, it won’t be the kind of default any of us have ever seen before, or even imagined.

The Great Reset

I said all the above to set up my 2020s outlook. In short, I expect we will rock along sideways in this “Long Now” period. At any given time, we’ll look at the data and think we avoided the worst. We will get some recessions and financial crises, but they’ll look “manageable” after we get through them. Indeed, we will manage them.

What we won’t see is sustained expansion of the strength necessary to finance our debt, which will continue growing as The Long Now progresses. So the debt burden will get heavier, and eventually be unbearable. Then the proverbial stuff will hit the fan.

A couple of years ago in my Train Wreck series, I described a multi-step process.

  • The Beginning of Woes: Something, possibly high-yield bonds, will set off a liquidity scramble. It will spread through the already-unstable financial system and trigger a broader credit crisis.

  • Lending Drought: Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter recession.

  • Political Backlash: Concurrent with the above, employers will be automating jobs as they grow desperate to cut costs. Suffering workers—who are also voters—will force higher “safety net” spending and government debt will skyrocket. A populist backlash could lead to tax increases that prolong the recession.

I still expect something like that sequence, though it may be more of a drawn-out, rinse-and-repeat process. I think we could see multiple sequences before a final, market-clearing Great Reset, which I expect in the latter half of the 2020s.

After each recession/crisis, and especially as technology begins to eat into middle-class jobs, expect complete political upheaval every four years at a minimum. The politicians will make promises and they will simply not be able to deliver, and a new group will make different promises that don’t work, either.

The deepening political divide isn’t just left and right. It’s also both sides being frustrated with what they consider to be “elites.” If you’re reading this letter, most of the population would probably put you in that category. Yet you probably don’t feel elite. I sure don’t. I am one of the luckiest and most blessed men in the world, but I certainly don’t think, at least from my very humble beginnings, of myself as anything approaching elite. This disconnect is a big part of the problem.

Philippa Dunne recently said in The Liscio Report that we no longer have a shared sense of reality in this country. We observe the same circumstances with our own interpretation of reality, then wonder why other people don’t see it the way we do.

I look at these problems every day and I have trouble understanding the complexities. The average person? A man hears what he wants to hear and disregards the rest. We have retreated into our social media and personal echo chambers and made them our reality, completely different than that of other groups/tribes.

In online gaming worlds, players “grind” through dungeons and zombies to gain points to move on. In my version of The Long Now, we are now entering the “grinding” phase. We just simply push forward, taking on whatever challenge comes next (whether zombies or central bank policy, which may be the same thing). Meanwhile the debt will keep accumulating, slowing growth but buying yet more “grinding” time.

Eventually we will reach The Great Reset, and it won’t just be another recession or even a depression. It will be a true, world-shaking, generational crisis. My friend Neil Howe talks about the Fourth Turning, a societal calamity that happens every 80 years or so. The last one was World War II. My good friend George Friedman has a forthcoming book titled, “The Storm before the Calm.” He sees two cycles in the geopolitical world, one 80 years and one 50 years, that converge in the late 2020s. Coincidence? Maybe, but it’s just about when I think we will have The Great Reset.

We will see political and social upheaval. The capstone: All that debt will be brought to the market, rebalanced, and the market will “clear” at some new valuation. All asset prices (and every debt is someone’s asset) will reset.

There will be winners and losers. Because we don’t know who will be in political control of any particular place when this happens, it is simply impossible to predict the winners and losers today. Plus technology could change the very nature of international currency markets.

But first we will endure The Long Now. It will look like it can go on forever, and maybe it will. I don’t know the future. But my understanding of history, my perceived reality, says it can’t continue. There will be a reckoning, after which we will see real growth and prosperity. Good times are coming. At least I think and hope so.

The Great Reset won’t hurt everyone equally, or in the same ways. The pain will be unequally distributed. As I said, a lot depends on who controls the process. Politically, populists are gaining power in both left and right wings. Their concerns and priorities differ, but both are anti-elite and both want their favored groups to have “more” and push the costs on someone else.

That sounds like a formula for violence, and it is, but eventually people tire of fighting and become willing to compromise. Or the market forces them to compromise. That will be The Great Reset—a kind of global do-over. No one will get everything they want, but everyone will get a fresh start. Then the cards will fall where they may.

The unknowable part is how much pain we will have to suffer first. It could be a lot…

The good news is that the grind of The Long Now will let you prepare for whatever comes. And we have many examples of countries going through their own individual “Great Resets.” In the case of Argentina and/or Italy, many times. I have visited both countries and they are wonderful places when they are out of crisis.

That’s exactly what I think will happen all over the world after The Great Reset. It will be a wonderful place to be.

You don’t have to be all alone in The Great Reset. Personally, I can’t think of anything better in any crisis than being part of a tight-knit group of like-minded individuals, whether that is close family or my social and business circles.

Next week, we will—for a very short time—reopen the Mauldin Economics Alpha Society to accept 100 new members. There have been some big changes since last year, so make sure to read your invitation when you receive it. As we only have a limited number of seats available this year, we are asking readers who are interested to fill out a membership application. I assure you, though, that it will be more than worth your time.

New York and the Most Optimistic

Man in the Room

I’m looking for an introduction to two people – Andrew Yang and Ambrose Evans-Pritchard. If anyone can help me with this, please send me a note here. Thank you.

At some point in the next few weeks I anticipate going to New York, and several more times this year. I have no other plans to leave Puerto Rico until I finish this 1,200-pound gorilla on my back of a book.

Speaking of Puerto Rico, many friends heard about the recent earthquakes and asked if Shane and I are alright. Short answer, we are. The earthquake was on the other side of the island from us. But the southwest portion got hammered with the 6.4 magnitude earthquake early this week and many aftershocks. Quakes here have (knock on wood) been minor compared to California, but the entire Caribbean is along a slower-moving fault line, which means more small quakes and fewer large ones. Small comfort to those whose homes collapsed this week. And I vividly remember the Haiti quake which took one of my best friends.

Power is slowly coming back up. We have a large diesel generator in our garage that is keeping us going, although we have to be frugal with our electric usage. Internet service is down on much of the island, so I am using mobile phone hotspots. Restaurants and stores are generally open. Maintenance services are available.

All in all, it’s a minor price for living in paradise. Earthquakes, tornadoes, hurricanes, fires, and all sorts of disasters can strike anywhere. It just reminds you how we are not in control of everything in our lives.

I know that talking about The Long Now and The Great Reset sounds gloom and doom. But in my personal life, I am launching new businesses, making plans, investing in new ventures, and seriously contemplating an aging-focused venture capital fund. I see opportunity everywhere I look. Humanity has faced problems before. Our time will be different, but progress will continue.

I am the most optimistic man in the room, if a tad realistic about our economic landscape. I just want to make sure that I am on the other side of the island when that big future economic earthquake hits, and have backup power. Just saying…

Next week we are going to look at why we should be more optimistic than at any time in human history. Seriously. But now it’s time to hit the send button, so let me wish you a great week and the best for 2020.

Your planning to optimistically grind analyst,



 
John Mauldin
Co-Founder, Mauldin Economics

The superpower Split

Don’t be fooled by the trade deal between America and China

The planet’s biggest break-up is under way




On january 15th, after three years of a bitter trade war, America and China are due to sign a “phase one” deal that trims tariffs and obliges China to buy more from American farmers.

Don’t be fooled. This modest accord cannot disguise how the world’s most important relationship is at its most perilous juncture since before Richard Nixon and Mao Zedong re-established links five decades ago.

The threat to the West from China’s high-tech authoritarianism has become all too clear.

Everything from its pioneering artificial-intelligence firms to its gulags in Xinjiang spread alarm across the world.

Just as visible is America’s incoherent response, which veers between demanding that the Chinese government buy Iowan soyabeans and insisting it must abandon its state-led economic model.

The two sides used to think they could both thrive; today each has vision of success in which the other lot falls behind. A partial dismantling of their bonds is under way.

In the 2020s the world will discover just how far this decoupling will go, how much it will cost and whether, as it confronts China, America will be tempted to compromise its own values.

The roots of the superpower split go back 20 years. When China joined the World Trade Organisation in 2001 reformers at home and friends abroad dreamed that it would liberalise its economy and, perhaps, its politics too, smoothing its integration into an American-led world order.

That vision has died.

The West has faced a financial crisis and turned inward.

China’s behaviour has improved in some ways: its giant trade surplus has fallen back to 3% of GDP.

But it has an even bleaker form of dictatorship under President Xi Jinping and has taken to viewing America with distrust and scorn.

As with every emerging great power, China’s hankering to exert its influence is growing along with its stature.

It wants to be a rule-setter in global commerce, with sway over information flows, commercial standards and finance.

It has built bases in the South China Sea, is meddling with the 45m-strong Chinese diaspora and bullying its critics abroad.

President Donald Trump has responded with a policy of confrontation that has won bipartisan support in America. Yet the China hawks thronging Washington agencies and corporate boardrooms share no consensus over whether America’s goal should be the mercantilist pursuit of a lower bilateral trade deficit, the shareholder-driven search for profits in American-owned subsidiaries in China or a geopolitical campaign to thwart China’s expansion.

Meanwhile, Mr Xi oscillates between grim calls for national self-reliance one day and paeans to globalisation the next, while the European Union is unsure if it is an estranged American ally, a Chinese partner or an awakening liberal superpower in its own right.

Muddled thinking brings muddled results. Huawei, a Chinese tech giant, faces such a disjointed campaign of American pressure that its sales rose by 18% in 2019 to a record $122bn. The EU has restricted Chinese investment even as Italy has joined China’s belt-and-road trade scheme.

China spent 2019 promising to open its big, primitive capital markets to Wall Street even as it undermined the rule of law in Hong Kong, its global financial hub. The phase-one trade deal fits this pattern.

It mixes mercantilist and capitalist goals, leaves most tariffs intact and puts aside deeper disagreements for later.

Mr Trump’s tactical aim is to help the economy in an election year; China is happy to buy time.

Geopolitical incoherence is neither safe nor stable.

True, it has not yet inflicted a big economic cost—since 2017 bilateral trade and direct investment flows between the superpowers have dropped by 9% and 60% respectively, but the world economy still grew by about 3% in 2019. Some businesses, such as Starbucks’s 4,125 cafés in China, need never be affected.

But confrontation is constantly spreading into new arenas.

America’s campuses are convulsed by a red scare about Chinese spying and intimidation.

Rows blaze over athletes kowtowing to China, naval docking rights and alleged censorship on TikTok, a Chinese app used by teenagers worldwide.

In the background is the risk of a confrontation between the superpowers over Taiwan, which holds elections in January.

Each side is planning for a disengagement that limits the other superpower’s day-to-day influence, reduces its long-term threat and mitigates the risk of economic sabotage. This involves an exceptionally complex set of calculations, because the two superpowers are so intertwined.

In technology, most electronic devices in America are assembled in China, and, reciprocally, Chinese tech firms rely on foreign suppliers for over 55% of their high-end inputs into robotics, 65% of those into cloud computing and 90% of those into semiconductors.

It would take 10-15 years for China to become self-sufficient in computer chips and for America to shift suppliers. Likewise in high finance, which could serve as a vehicle for sanctions.

The yuan accounts for just 2% of international payments and Chinese banks hold over $1trn in dollar assets.

Again, shifting trade partners to the yuan and winding down the banks’ dollar exposure will take at least a decade, probably longer.

And when it comes to research, China still trains its best talent and finds its best ideas in America’s world-beating universities—at the moment there are 370,000 mainland students on campuses in the United States.

Were the superpower rivalry to spiral out of control, the costs would be vast. To build a duplicate tech hardware supply-chain would take $2trn or so, 6% of the superpowers’ combined gdp.

Climate change, a great challenge which could provide a common purpose, would be even harder to cope with. Also at stake is the system of alliances that is a pillar of America’s strength.

Some 65 countries and territories rely on China as their largest supplier of imports and, asked to choose between the superpowers, not all of them would opt for Uncle Sam—especially if it continues to pursue today’s policy of America First.

Most precious of all are the principles that really made America great: global rules, open markets, free speech, respect for allies and due process.

In the 2000s people used to ask how much China might become like America.

In the 2020s the bigger question is whether a full superpower split might make America more like China.

End of the American era in the Middle East

The US pullback from Syria has emboldened Russia and Iran

Gideon Rachman
Comment illo WEB 31/12/2019 issue
© Daniel Pudles


For centuries, the Middle East has been dominated by outside powers.

The collapse of Ottoman rule at the end of the first world war was followed by a century in which western nations — first Britain and France, then the US — were the most powerful external actors. But that era of American dominance is now coming to a close.

The decline of US influence in the Middle East was captured by an impotent tweet from President Donald Trump on Boxing Day: “Russia, Syria, and Iran are killing, or on their way to killing, thousands of innocent civilians in Idlib Province. Don’t do it!” Underlying the president’s hand-wringing about Syria is a rapid decline in the ability and willingness of the US to shape events in the Middle East — leaving a gap that is being filled by other powers, such as Russia, Iran and Turkey.

Of course, if the Americans are directly challenged they can and will respond forcefully — witness the bombing raids that the US staged on an Iranian-backed militia on the Iraq-Syria border this weekend. But the appetite for broader strategic plays in the Middle East seems to have largely disappeared from the White House.

As recently as 2011, the US, Britain and France staged a military intervention in Libya which toppled the Gaddafi regime, while Russia fumed impotently on the sidelines. However, the west’s unwillingness to manage the aftermath in Libya — or to get seriously involved in Syria — left an opening for Moscow. Russia’s unexpected military intervention in Syria in 2015 was treated with scepticism in the west. But Russian forces have waged a brutal campaign that has helped the Assad regime regain control of most of the country — with the assault on Idlib potentially opening the way to a conclusive victory.

Two events in recent months have rapidly accelerated the decline in US power in the Middle East. In September, Iranian missiles struck the oil facilities of Saudi Aramco. Since Saudi Arabia is one of America’s closest allies, it was widely assumed that the US would inevitably stage a military response. In the event, the Trump administration did nothing.

The following month, Mr Trump announced a pullout of American troops from Syria. In a symbolic move, Russian forces moved in swiftly to occupy evacuated US bases, with television reporters sending home incredulous dispatches, surrounded by discarded American kit. The US had abandoned not just its bases, but its Kurdish allies, leaving them to the mercy of a Turkish military offensive.

The American pullback has further emboldened Russia and Iran, while causing US allies to rethink their dependence on Washington. Russia, Iran and China have just staged their first ever joint naval exercises in the Gulf of Oman, a stretch of ocean traditionally dominated by the US fifth fleet and crucial to the global flow of oil.

Russian “mercenaries”, connected to the Kremlin, have also now intervened in Libya to back the rebel forces led by General Khalifa Haftar, potentially increasing Moscow’s influence over both the country’s oil and the flow of refugees to Europe. In Libya, as in Syria, it now appears that Turkish forces will intervene on the opposite side to the Russians. However, this proxy conflict has not prevented a certain closeness emerging between Russia and Turkey.

The Turks are not the only regional power that is looking with increasing interest towards Moscow. In the wake of the Trump administration’s inaction over Aramco and Syria, Mr Putin paid a successful visit to Saudi Arabia and the United Arab Emirates, prompting Prince Mohammed bin Zayed, de facto ruler of the UAE, to announce improbably: “I think of Russia as my second home.”

Mr Trump and his supporters shrug their shoulders at this declining influence. After the costly debacles of the Iraq and Afghanistan wars, Americans are understandably wary of further military involvement in the region. In another recent tweet, the US president said that all outsiders, including “Napoleon Bonaparte”, were welcome to help the Kurds, adding, “we are 7,000 miles away”.

European powers, which are much closer to the Middle East, cannot afford to be so casual. But their policy towards the region is even more impotent and inward-looking than that of the US.

When Mr Trump announced his pullout from Syria, Annegret Kramp-Karrenbauer, Germany’s defence minister, tentatively suggested that Europeans should think about deploying a peacekeeping force.

The idea gained no traction whatsoever.

Instead, EU nations are watching the Russian-Syrian offensive with a mixture of horror at the humanitarian consequences and dread that a new flow of refugees will soon be heading towards Europe.

Already some 235,000 people have fled from the Idlib area, adding to the millions internally displaced within Syria, and the roughly 4m refugees across the border in Turkey.

The Europeans are also alarmed that Islamist fighters may soon be streaming back into western Europe.

In the long run, even the US may pay a price for frittering away its regional influence in such a casual manner.

As the past century has demonstrated, turmoil in the Middle East and Europe has a way of eventually crossing the Atlantic Ocean.

For Banking Investors, Credit Is Due

A change in loan-accounting rules may shift the focus from rates to credit for bank stocks, especially consumer lenders

By Telis Demos




Credit risk was mostly a nonfactor for banking investors in 2019. It was all about interest rates.

The new year might be a different story.

This isn’t to say that the long-awaited “normalization” of default rates on loans to consumers and businesses will suddenly arrive, at least not without an accompanying recession.

But a technical tweak to the way lenders account for loan losses will nevertheless force investors to reckon with banks’ long binge on consumer credit, and what that might mean over a complete economic cycle.

Starting in 2020, most big lenders will have to follow a new standard for how they reserve for potential losses on loans, called current expected credit loss, or CECL. Previously, when lenders booked new loans, they typically reserved capital for anticipated losses over the next 12 months. Under CECL, they will have to reserve for expected losses over the lifetime of the loan.

In practical terms, that will mean noisy first-quarter 2020 earnings reports, as lenders make one-time adjustments to reserves. Analysts at Keefe, Bruyette & Woods forecast a median 36% reserve increase for the companies they cover, translating into a 7% increase in 2020 provision expenses, and around a 1% drag on earnings per share. But in economic terms, CECL only shuffles the timing of reserves, not the ultimate amount, to say nothing of realized losses. From a long-term investors’ perspective, it is in theory a wash.

So investors wouldn’t be totally misguided to mostly ignore all of this—as long as the lender can absorb the hit to capital without needing to raise more equity to meet regulatory requirements.


Share prices of a group of the largest consumer-lending banks—such as Capital One Financial, Discover Financial Services and Synchrony Financial—rose about 30% in 2019. Photo: Rachel Wisniewski for the Wall Street Journal


There is a bit more to the story, though. From now on, new loans will require more reserves upfront. Banks that are counting on operating at a level close to their regulatory capital minimums might have more trouble managing to these levels, either affecting their ability to return capital or to make new loans.

In addition, estimates of required reserves will continue to fluctuate, despite banks’ best estimates of their potential lifetime losses. As Morgan Stanley banking analysts put it in a recent note, “banks do not have perfect foresight.” Morgan Stanley and other analysts believe CECL could actually increase the volatility of reserve levels during economic downturns as banks are forced to make quicker adjustments to their estimates.

It also is worth considering where the credit cycle stands. Normally, the impact of CECL might be somewhat muted, since riskier loans are mostly short-term anyway—asking banks to reserve for the whole length of the loan doesn’t change that picture dramatically. But with lenders having enjoyed a long, placid cycle, they are now doing things like extending the duration of auto loans by years, and making more unsecured personal loans that usually go to lower-rated borrowers. So this might be an especially touchy time to start turning over rocks in loan and card books.

Amid a party atmosphere in financial stocks, it has been easy to miss the growing concern about consumer loans. Share prices of a group of the largest consumer-lending banks—such as Capital One Financial, Discover Financial Servicesand Synchrony Financial —rose about 30% in 2019, roughly matching the rise in the KBW Nasdaq Bank index.

But as a group they are actually trading at a relatively sharp discount—about 8.6 times forward earnings, versus their five-year average of 9.9 times. Meanwhile, S&P 500 banks average 12.1 times, versus their five-year average of 11.5 times.

Simply scrutinizing loans won’t make them any more likely to default. Still, investors should be ready for what things at the party look like when the lights are turned on.

China’s Damaging Policy Disruptions

Like an overprotective parent, China’s central government needs to learn to let go. While a more relaxed approach to economic management carries some short-term risks, it is essential to future growth and prosperity.

Zhang Jun

zhang41_FRED DUFOURAFP via Getty Images_chinayuanmoney


SHANGHAI – China’s economic growth is expected to have slowed to just over 6% this year, and it is unlikely to accelerate anytime soon. In fact, economic commentators generally agree that China’s economic performance in 2019 – the worst in nearly 30 years – could be the best for at least a decade. What observers can’t seem to agree on is how worried China should be, or what policymakers can do to improve growth prospects.

Optimists point out that, given the size of China’s economy today, even 6% annual GDP growth translates into larger gains than double-digit growth 25 years ago. That may be true, pessimists note, but slowing GDP growth is hampering per capita income growth – bad news for a country at risk of becoming mired in the middle-income trap – and compounding the fiscal risks stemming from high corporate and local-government debt.

Whichever side of the fence one falls on, one thing is indisputable: policy inconsistencies and governance errors have contributed significantly to China’s economic slowdown. The problem lies in the slow pace of progress on structural reforms. Long-term growth depends on decentralization of government authority, increased marketization, and greater economic liberalization, with the private sector gaining far more access to finance and other factors of production.

The Chinese government’s shift toward economic overreach can have immediate adverse effects – and often does. Consider the rise in China’s consumer price index, driven partly by sharply higher pork prices, owing to lower-level governments’ decision to shut down small pig farms over violations of environmental rules over the last few years, as reported by the former spokesman of China’s National Bureau of Statistics.

In recent years, environmental and air-quality regulations have taken a heavy toll on many Chinese businesses, especially the small and medium-size manufacturing firms that are so vital to China’s future economic dynamism. Of course, protecting the environment is important, not least for the sake of public health, and government-induced institutional changes have improved air quality.

But the central government’s top-down approach, which imposes a rigid set of indicators on subnational governments, is a blunt instrument that might be undermining local authorities’ incentive to support real growth.

China owes much of its past success to local-level experimentation and competition, fueled by the promise of promotions for officials presiding over the most successful regions. Nowadays, local officials reap greater rewards for meeting environmental targets, rather than growth targets – and it shows.

The short-term consequences of Chinese government overreach can also be seen in the financial sector. After the 2008 global financial crisis, the government urged banks to ramp up lending, and companies to accumulate large amounts of debt, in order to offset the external shock. While this kept the growth engines running, it caused a sharp increase in financial risk.

By 2016, however, the government had reversed its position. Even as the People’s Bank of China kept its policies neutral, banks were ordered to pursue drastic deleveraging and credit contraction, and China’s sizeable shadow banking sector shrank considerably. This aggressive approach damaged many businesses’ balance sheets, raising the risk of debt crisis. It also prompted substantial capital flight and weakened private investment, including in real estate, thereby undermining nominal GDP growth. As a result, China’s broad money supply has not declined as a share of GDP.

Beyond the growth impediments stemming from how the government pursues its goals, moreover, is the problem of how rapidly, unexpectedly, and frequently those goals change. This disrupts investor expectations and erodes market confidence. Not only are companies hesitating to invest; many are scaling back their workforces. In recent years, layoffs have increasingly become unavoidable even among China’s Internet giants.

Far from opening the way for progress on structural reform, the Chinese government’s excessive top-down interventions are reinforcing structural imbalances. Indiscriminate and unpredictable top-down dictates hurt all businesses, but private companies suffer the most. After all, state-owned enterprises enjoy powerful official protections, making them more likely to survive, despite their inefficiencies.

Like an overprotective parent, China’s government needs to learn to let go. Yes, a more conventional approach to macroeconomic management carries some risks. Companies might decide to accumulate excessive debt, and banks might issue too much or too little credit. But the resulting fluctuations are likely to be largely temporary.

In the longer term, such an approach will strengthen investor and market confidence, enable the most dynamic companies to thrive, and support the stable economic growth needed for China to become a high-income developed country by mid-century. In order to achieve this goal, the central authorities may eventually have to get out of their own way.


Zhang Jun is Dean of the School of Economics at Fudan University and Director of the China Center for Economic Studies, a Shanghai-based think tank.

Everything You Wanted to Know about Gold but Were Afraid to Ask

Jared Dillian




I remember where I was the first time I heard about gold. I was in my 1995 Toyota Tercel in downtown San Francisco, listening to the radio.

Usually I listened to the Razor and Mr. T on KNBR 680, but for some reason I had the news on.

The announcer mentioned that gold was up that day, to $265 an ounce.

It wasn’t a white light moment.

And gold didn’t seem exceptionally cheap to me. $265 an ounce seemed like a lot.

But if I’d known anything at all about the price history, I might have had a different opinion.

I didn’t think about gold much when I got to Lehman Brothers in 2001, either. I was getting a job in equities. All the jobs were in equities or fixed income. I didn’t even know that Lehman Brothers had a commodities desk, and even if I did, nobody would have thought about getting a job there.

Around this time I was reading a lot of Ayn Rand stuff, and I kept coming back to Alan Greenspan’s 1966 essay titled “Gold and Economic Freedom.” I probably read it a hundred times and even memorized parts of it. The takeaway was that if the government had too much debt, it would be compelled to print money to buy the debt to keep interest rates down.

The year was 2005—we were still three years away from quantitative easing, although it was already a twinkle in Bernanke’s eye.

That was about the first time that I thought of gold as an investment. And coincidentally, that was the time that some folks from State Street and the World Gold Council came by the office to sign us up as Authorized Participants for the new gold ETF, GLD.

To this day, GLD remains a very important financial innovation—subsequent attempts to securitize commodities have led issuers to create products in ETN form that tracked or held futures contracts, introducing basis and roll risk into the equation.

GLD is simple—it holds physical gold. A few years later, there would be some arguments about “paper gold” and unallocated versus allocated gold. But GLD is still trucking to this day, and it’s the most liquid and practical way to buy large quantities of gold.

Of course, when Bernanke actually did launch quantitative easing, gold got really popular, along with something called CMS caps, which was basically a structured call option on interest rates. People thought there would be lots of inflation, and if you read Greenspan’s “Gold and Economic Freedom” essay, you might be led to believe that.

Gold worked, but the CMS caps didn’t, as bond yields actually went lower. Of course, the feared inflation never materialized. But as far as trades go, the gold trade was a pretty good one, and it worked based on the fear of inflation, not actual inflation.

After the last eight years in purgatory, gold is starting to work again. The technicians are saying that it broke out. This is where things get complicated. Why does one buy gold?

Is it as an inflation hedge?

Is it because of political risk or geopolitical risk?

Is it because of deficits?

Is it because of stupid monetary policy?

It is kind of a confluence of all these things:

• Inflation trades have started to work in the last month or so

• The election is going to be bananas, and now there is tension in the Middle East

• The deficit problem seems to be intractable, and people are talking about MMT

• Powell is widely seen as caving to Trump’s demands

Which means it should be a pretty good environment for gold.

You don’t need gold if you believe that the Federal Reserve will be a good steward of purchasing power. That looks less likely under this administration or any subsequent administration. The takeaway:

You don’t need inflation to skyrocket for gold to work-although we should have learned that from the 2009–2011 period.

Am I a gold bug? Maybe, but without the conspiracy theories. I’ve always been pessimistic about the Fed’s ability to control the currency. That pessimism has at times been unwarranted.

Bernie Sanders is essentially tied in Iowa and New Hampshire. The probability of him being president is not zero (in fact, it’s about eleven percent). Try to imagine what a Bernie Sanders Fed would look like, given what we know about his love for MMT. Something tells me that the Sanders Fed would be even less free from political influence than the Trump Fed.

I’m not here to tell scary stories. Some people say that gold outperforms stocks. Some people say that stocks outperform gold. It depends on where you pick your starting point, and people are very dishonest about that.

I will say this: It only takes a small amount of gold to dramatically change the risk characteristics of your portfolio—for the better.

And I don’t think that millennials own a single ounce.

Finally, I recorded a new DJ mix over the holidays—please go here to check out Sin.