Reminiscing about 2012

Doug Nolan

Credit booms are powerfully reinforcing. New Credit provides additional purchasing power that spurs spending, economic output, corporate earnings/cash-flow and income growth. 
Monetary expansions, as well, fuel inflating asset prices, most notably in securities and real estate. In both the Financial Sphere and the Real Economy Sphere, Credit expansion and its myriad inflationary effects beget more self-reinforcing Credit.

Importantly, the upside of a Credit Cycle feeds off the commanding forces of cooperation and integration. The economic pie is expanding, and it becomes easily-recognized that working together offers more than zero-sum outcomes. In prolonged booms, a “virtuous cycle” appears almost a certain, natural outcome.

Yet the inevitable Credit cycle downturn ensures a vicious sequel. The bursting of the Bubble sees so many rewarding boom-time endeavors turn infeasible, unprofitable or unworkable. 
Hopes are dashed and dreams are crushed. Confidence, flowing over-abundantly throughout the boom, is suddenly in such short supply; faith wanes in policymaking, the markets, finance and in institutions more generally. Meanwhile, the unfolding bust illuminates the inequities and nonsense from the Bubble-period. Powerful forces then shift to tearing at the fabric of cooperation, integration and good faith that were so crucial throughout the boom period. 
Yesterday’s partner is today’s competitor.

Nowhere did this historic global Credit Bubble have greater integrative influence than in Europe. The euphoria of the victory of democracy and free-market Capitalism, along with technological advancement, financial innovation and developments in contemporary monetary management, emboldened Europe’s leaders to take the fateful plunge toward unprecedented integration, including a common currency.

To appreciate the complexities of the current market, economic and geopolitical backdrop, it’s helpful to return back to that fateful summer of 2012. European integration was under existential threat, though the seriousness of the situation was appreciated by few. A potentially momentous crisis of confidence had gathered powerful momentum. Fear of a European periphery debt crisis was being transmitted to a more general questioning of the solvency of the European banking system. And with Europe’s banks major operators in derivatives and throughout EM, European travails had begun reverberating throughout global markets.

Markets were increasingly questioning the viability of the euro currency – and such concerns invariably raised doubts as to the stability of global finance and, accordingly, economic prospects around the globe. As I chronicled the seriousness of developments back in 2012 (in the face of the media and pundits generally downplaying associated risks), my analysis appeared extremist and misguided. It was only later that inside accounts (notably from the Financial Times) confirmed the extent to which European policymakers had worked to avert acute financial and economic crisis.

Bond manager Jeffrey Gundlach made headlines this week with the comments “central banks are losing control.” I would suggest that central bankers actually lost control back in 2012. 
Mario Draghi’s “whatever it takes” pledge was part of desperate measures to save the euro. Yet “whatever it takes” actually amounted to concerted central bank intervention to shield global markets and economies from the intensifying forces of the downside of a historic Credit Cycle. 
The global Credit boom persevered for a few more years, right along with historic market distortions and economic maladjustment. Downside risks have grown significantly.

European bank stocks (European Stoxx 600) this week traded to the lowest level going back to those dark days of 2012. It’s worth noting that European Banks rallied 90% from summer 2012 lows to July 2015 highs. During this period, Italy’s FTSE Italia All-Share Banks Sector Index surged from 6,000 to a high of 15,557. “Whatever it takes” fueled an almost doubling of Italian and Spanish equities indices. Germany’s DAX index traded at 6,000 in the summer of 2012, then more than doubled to 12,374 by April 2015.

“Whatever it takes” stock gains may have been spectacular, yet they have been overshadowed by the phenomenal collapse in European bond yields. Excerpted from my July 26, 2012 CBB: “Spain's 10-year yields jumped 62 bps to 6.91% (up 187bps y-t-d). Italian 10-yr yields rose 20 bps to 6.01% (down 102bps). Ten-year Portuguese yields rose 8 bps to 10.01% (down 277bps).
The new Greek 10-year note yield declined 19 bps to 25.19%.”

“Whatever it takes” became a global phenomenon, both from the standpoint of central banker policy and securities markets inflation. Replicating Draghi, BOJ head Haruhiko Kuroda unleashed shock and awe monetization and currency devaluation. The dollar/yen was trading at 78 in the summer of 2012 before extraordinary BOJ stimulus worked to devalue the yen to 124 to the dollar by mid-2015. After trading below 8,500 in the summer of 2012, Japan’s Nikkei surged to above 20,700 by August 2015. Japan’s TOPIX Bank Stock Index rallied from 100 in the summer of 2012 to 246 by June 2015. And while the S&P500 rose 66% from summer 2012 lows to record highs, it’s worth noting that the U.S. broker/dealers (XBD) surged from 80 to 203.

It’s no coincidence that European and Japanese equities have led the developed world on the downside the past year. There’s no mystery surrounding the poor performance of global financial stocks. Bullion’s almost 2% rise this week boosted 2016 gains to 22%. The yen has gained almost 14% against the dollar so far this year. Ten-year bund yields traded with negative yields for the first time this week. U.S. 10-year Treasury yields traded to the lowest level since 2012.

Despite shoring up reflationary efforts earlier in the year, extraordinary ECB and BOJ monetary stimulus has not been successful. Underlying economic and inflation trends remain problematic in the face of major securities markets inflations. Indeed, the wide divergence between securities market prices and economic prospects ensures acute vulnerability to market risk aversion and risk-off speculative dynamics.

Despite Friday’s 4.1% surge, European banks stocks declined another 1.4% this week (down 25% y-t-d). Friday’s 6.7% rally (reminiscent of U.S. financial stocks in 2008) still left Italian bank stocks down 1.9% for the week - increasing 2016 losses to 44%. In Asian trading, Japan’s TOPIX Banks Stock Price Index sank 5.1% (down 34.3% y-t-d), trading almost back to April lows. Hong Kong’s Hang Seng Financial Index dropped 2.9% (down 15.1%).

Italian sovereign spreads (to bunds) ended the week 13 bps wider to a one-year high 149 bps. Italian spreads have now widened 28 bps in three weeks. Spain’s 10-year bond spread also widened 13 bps this week to a more than one-year high 153 bps. Portugal’s 10-year bond spreads surged 22 bps this week to an 18-week high 327 bps. Greek yields surged 60 bps.  Credit spreads widened significantly throughout Europe this week, sometimes spectacularly.

The murder of a pro-“remain” UK politician further clouds analysis of next Thursday’s referendum. Recent polling had Brexit in a narrow but widening lead. Yet London’s bookies place odds slightly in favor of Remain. Recall that polls had the Scots favoring independence a week prior to their referendum, although the actual vote broke strongly against independence. 
The Scottish experience has likely influenced Brexit betting.

Markets have grown comfortable that electorates will bitch and moan but, at the end of the day, will side with the best interest of the financial markets. At some point, I would expect increasingly disillusioned voters to disregard much of the fear mongering. The interests of voters and markets might very well part ways.

The Brexit vote is a serious potential “risk off” catalyst. Significant amounts of currency and risk market hedging have transpired. This portends a period of unstable markets. If Brexits wins, derivative-related exposures could foment illiquidity and market dislocation, as traders are forced to dynamically hedge their derivative books into unsettled markets. Victory for remain would entail the abrupt unwind of hedges across various markets. At least in the very short-run, this would equate to yet another destabilizing short-squeeze.

Still, a vote to remain would do little more than remove a near-term catalyst. European leaders are understandably nervous that a successful Brexit campaign would embolden independent and anti-Europe movements throughout the continent. Yet few believe a remain vote will diminish animosities and hostility toward integration and European leadership.

Back in 2012, Mario Draghi recognized how even the notion that a country might exit the euro could unleash market dynamics that would rather quickly place Europe’s markets and banking system in peril. “Whatever it takes” was orchestrated specifically to expel any market doubt with regard to the viability and sustainability of European monetary integration. On the back of a wall of liquidity and inflating securities markets, Draghi’s gambit held things together for a few years. That said, the ECB bet the ranch – and was compelled to ante up in response to market instability early this year. The outcome of the game is very much in doubt.

While Britain is not even a member of the euro, Brexit provides a test of ECB policymaking. Is Europe robust or fragile? Has relative financial stability been nothing more than a brittle ECB-fabricated façade? Are the forces mounted against integration and cooperation too powerful to disregard? Is European integration – along with the euro currency - viable long-term? It’s an untimely test, with confidence in Europe’s banks already waning. It’s furthermore an untimely test because of faltering confidence in the ECB and contemporary global central banking more generally. Global market instability has again resurfaced and there will be no resolution next week.

June 17 – Financial Times (Sam Fleming): “Close watchers of the Federal Reserve were bemused this week after an unidentified policymaker forecast just a single increase in official interest rates over the coming years. On Friday James Bullard, the president of the St Louis Federal Reserve, revealed that he was the rate-setter behind that unexpectedly low dot on the Fed’s ‘dot plot’ of rate forecasts, as he executes a big shift in his views of the economy that puts him at odds with other rate-setters who see a gradual series of increases. The former hawk said in a statement that he expects rates will remain unchanged in 2017 and 2018 following a single rate rise, in a leap towards an ultra-dovish outlook.”

The FOMC has confounded Fed watchers with its abrupt pivot back to ultra-dovishness. There shouldn’t be much confusion. Global market fragility has reemerged, and the Fed’s rapid retreat has confirmed the seriousness of what’s unfolding. Central banks have thrown everything at the problem, yet markets remain as vulnerable as ever. At least the world was not facing the downside of China’s historic Credit Bubble back in 2012.

The Fed has never admitted that global concerns have been dictating U.S. monetary policy since 2012. It has now become clear, throwing the analysis of policymaking into disarray. The harsh reality is also increasingly apparent: global monetary management is dysfunctional and central bankers have become perplexed - without a backup plan. Such an uncertain backdrop is pro-currency market instability and pro-de-risking/deleveraging.

In a replay of 2012, U.S. markets have remained resilient in the face of rapidly escalating European and global risks. Back then our markets ended up being positioned well for “whatever it takes.” They’re again well positioned, it just that whatever it takes it's proving not to be enough.

Why is America so alarmed by a Brexit vote?

There are strong parallels between those backing Leave and Donald Trump’s supporters
Why is America so alarmed by Brexit? Lest the reader be in doubt, remind yourself of this.
Never before has a sitting US president visited a fellow democracy in a bid to sway an election.
Nor, until now, have 13 former US secretaries of state and defence risked addressing a letter to a foreign electorate with the same motive. Ditto eight former Treasury secretaries and five former supreme commanders of Nato. Not only has the US establishment broken its non-interference rule over Brexit, it is stamping on its smithereens. If we did not know better, it might seem the UK was uniquely important to the future of the world.
Seductive though that thought may be — particularly for a Brit living in Washington — there is a domestic subtext that can be summarised in two words: Donald Trump. If the British are foolish enough to leave Europe, perhaps Americans are crazy enough to elect Mr Trump. Of course, no one would claim a causal link between what happens in Britain on June 23 and the US presidential election in November. Most American voters have never heard of Brexit. Nor would most feel strongly either way if they had.

Yet there are sufficient echoes to trouble America’s besieged elites. In much the same way US music companies test products in the British market, or TV production companies simply borrow what works, the Brexit referendum has become a trial balloon for the health of western democracy. Think of The Office, that dystopian Slough-set comedy that captivated British viewers. Not long after, the US Scranton-based version pulled off a similar hit. For decades, US and UK political trends have tracked each other. Margaret Thatcher swept to power in 1979, the year before Ronald Reagan was elected president. Bill Clinton’s New Democrats paved the way in 1992 for Tony Blair’s New Labour five years later.

The demographic parallels between those backing Brexit and Mr Trump’s supporters are too close to ignore — almost eerily so. Their motives are equally simplistic. Leaving Europe is to Brexiters what building a wall with Mexico is to Trumpians — a guillotine on the cacophonous multiculturalism of 21st-century life. From an empirical point of view, Mr Trump’s beautiful wall is no different to the splendid isolation of Boris Johnson, the leading Brexit campaigner: both are reckless illusions. From a poetic standpoint, however, they offer a clean solution to the alienations of the postmodern society.

Winston Churchill joked that Britain and America were divided by a common language. Today blue-collar whites on both sides of the Atlantic are speaking in the same idiom. They both yearn for the certainties of a lost age.
Both also rely on the specious legalese of their plutocratic champions. Mr Johnson wants to liberate the UK from an often fictitious web of European regulations. Mr Trump insists he is opposed only to illegal Hispanics. Legal ones are apparently welcome. Their true appeal, however, is based on nationalist populism. Both can legitimately point to the hypocrisy of the elites they campaign against.

Mr Cameron vowed to cap net UK immigration at 100,000 a year — a promise he failed to keep.

Successive US administrations have promised to enforce America’s borders before offering amnesty.

As a test of market conditions, Britain’s contest between elite hypocrisy and populist sincerity could not be bettered.
Then there is the future of the west. On his UK visit in April, Barack Obama made an eloquent pitch for Britain’s role in Europe. He reminded Britons that the vision of a united Europe was conceived by Churchill as a means to prevent a recurrence of humanity’s two bloodiest wars.

There was a grander context, even romance, to the President’s words that Mr Cameron could never emulate. Britain’s prime minister has spent too long denigrating Europe — and validating the concerns of those against immigration — to make a positive case, which is why he asked Mr Obama to do it for him. It is worth noting that Mr Cameron hired Jim Messina, the manager of Mr Obama’s 2012 re-election campaign, to help make his fear-based economic case against Brexit; even the product managers are interchangeable.
Beyond doing a favour for a friend, Mr Obama had larger motives. Washington’s elites rightly fear that Brexit could spark a chain reaction that could lead to the disintegration of the EU.

That, in turn, could trigger the collapse of the transatlantic alliance. US global power has always been magnified by the strength of its alliances. The self-inflicted isolation of America’s closest European ally could be the start of a great unravelling.
Here, too, Mr Trump plays the ghost at the banquet. For the first time since Nato was formed, the US is fielding a presidential candidate who would be indifferent to the demise of the military alliance.
Moreover, Mr Trump stands alone among US public figures in supporting Britain’s exit from the EU.
“Oh yeah, I think they should leave,” he said recently. He added that it would be Britain’s decision to make alone. The latter was true enough. But Mr Trump’s insouciance crystallised what troubles Washington. There are points in history when all that is solid melts into air. Will 2016 be one of those moments?

What Clinton and Trump Are Really Saying on Foreign Policy

George Friedman
Editor, This Week in Geopolitics

Candidates Clear on Their Foreign Policy “Wants”

Forget for a moment that Hillary Clinton is a criminal, Donald Trump is crazy, and both are liars. This is an election year, and demons stalk the world. It is now clear that one of them will be president of the United States.

Behind the heated rhetoric lie two very diverse visions for American foreign policy. But what presidents want and what they get are usually very different things. Nevertheless, the chief task is to decode the “wants” from the campaign noise.

What they disagree on is vital and easily expressed. Clinton wants to keep the international system as it has been since 1945. Trump rejects the basic ideas that have guided foreign policy since that time.
A Series of Aftermaths: War Ends, Soviets Fold, Towers Fall

The US emerged from World War II having learned two lessons. The first was Pearl Harbor. It taught that an enemy can strike at any time without warning.

The second was the price of delay. Had the US entered the war earlier and opposed Hitler before the Munich Agreement, much suffering could have been avoided.

Global involvement would be the first line of defense. Cheyenne Mountain, home of the North American Defense Command, would be the ever watchful second line. It made sense yet was exhausting.

During the Cold War, this approach seemed right because the Soviet Union had to be blocked on the ground. It had to be deterred from nuclear war as well. The Soviet Union fell, but the military and economic structures the US had created remained.

The United States intervened in Somalia, Haiti, Kuwait, and Bosnia in the 1990s. The Soviets were gone, but the US still saw itself as the global guarantor of security.

Then 9/11 happened, and the classic American fear was made real. It was an attack out of nowhere. As the US awaited more attacks, it went on the offensive in the Islamic world. It built a coalition that has fought wars for 15 years.
US Still Deeply Embedded in the World

Vigilance and constant involvement were the principles. The US operated through a complex system of alliances, trade agreements, monetary arrangements, and troop deployments.

Alliances like NATO and the IMF are multilateral. Some are bilateral, like with Japan or Australia. Others, like the agreement with Israel, are informal but every bit as real. Still others, like NAFTA, are purely economic.

Through this web of cooperation, the United States remains deeply embedded in the world. It must not only stand guard against global missile threats, but also act as the world’s sentry for political, military, and economic instability.

The post-1945 concepts that emerged are woven into the complex global system that has brought the US into a series of wars and constant negotiations.
Smart Crisis Avoidance or Obsolete Assumptions

The US also sees maintaining the stability of the international economic system as its duty. The Vietnam War, the Third World debt crisis, and concerns about Brexit became the United States’ responsibility.

Clinton argues that this system avoided catastrophe. From her point of view, the most important thing is what didn’t happen.

Because of NATO, the Soviets didn’t invade Western Europe. Nuclear war didn’t happen.

Because of NAFTA, the instability that is sweeping the rest of the world didn’t reach the US.

Because of the IMF and World Bank, there has been intense and significant global economic development. The world didn’t stand still.

Trump counters that the assumptions behind our fundamental stance have become obsolete. Vigilance remains a basic issue, but from Trump’s point of view, it has not evolved to handle the threat that struck on 9/11.

The nature of the threat has changed. During the Cold War, the US watched the skies.

Now, Trump argues, the US must exclude Muslims and watch its borders.

For Clinton, international involvement means relatively easy entry into the United States.

This benefits the country in many ways. For Trump, this is thinking shaped by the Cold War period. For him, 9/11 made immigration a national security issue.

Trump also argues that NATO is outdated. Today, the EU has 200 million more people and a larger GDP than the US. There is no reason Europe’s military capability can’t match or exceed that of the US.
Stump Speeches Will Not Define a National Strategy

The Europeans have created a situation where the United States must, by treaty, defend Europe, while shifting the costs to the United States.

NATO may have been a reasonable pact while Europe was recovering from war, but WWII ended over 70 years ago. The world is very different today.

In the same way, free trade was essential for restarting the global economy in the post-war world. Now, the US must evaluate whether all free trade is in its best interest.

There are pressing issues that can’t be settled until a national strategy is defined. What should our relations with Russia and Central Europe look like? To what extent does Chinese power in the South China Sea matter to the United States? Is free trade always good? To what extent should the US be involved in the Middle East?

Mexico is now the 11th-largest economy in the world. How do we deal with its rising power?

The issues are endless, and many are potentially deadly. The dispute between Clinton and Trump is fundamental, regardless of how the debate is framed.

Trump’s argument is that constant involvement may have prevented Munich, but it is now exhausting America. Constant vigilance is unsustainable and might benefit the world, but not the US. Clinton argues that continued involvement costs less than the instability that even a partial withdrawal would mean.

The campaign “wants” are clear. What we will actually get is far less so.

The Morality of Prosperity

Grinding poverty was the norm for humanity until 1800. It changed with the rise of values like tolerance and respect for individual liberty.

By Darrin M. McMahon


What accounts for the wealth and prosperity of the developed nations of the world? How did we get so rich, and how might others join the fold? Deirdre McCloskey, a distinguished economist and historian, has a clarion answer: ideas. It was ideas, she insists—about commerce, innovation and the virtues that support them—that account for the “Great Enrichment” that has transformed much of the world since 1800.

Whatever Bernie Sanders might say, the Great Enrichment is a fact, an astonishing departure from the grinding poverty that was once the norm for our ancestors in every society of the world. Conditions of widespread impoverishment began to change around 1800, when a dramatic takeoff began—first in Western Europe and North America, more recently in India and China.

There are different ways to quantify the takeoff. But the upshot is that income in the 34 countries that constitute the Organization for Economic Cooperation and Development has risen since 1800 on the order of 2,900%. All told, Ms. McCloskey concludes, the Great Enrichment is “the most important secular event” since the Agricultural Revolution that began in the 10th century B.C., and it has pulled millions and millions of people out of poverty and destitution.

How to explain this startling transformation? Economists and social theorists have put forward a number of explanations, from capital accumulation to property rights and the rule of law.

Left-wing critics of capitalism, for their part, have either denied the Great Enrichment altogether or argued that the West’s wealth was extracted, zero-sum, from the colonized and oppressed.

Ms. McCloskey convincingly dismisses each one of these explanations. The Chinese, after all, long had a thriving mercantile culture and good “institutions.” But the Great Enrichment didn’t begin there. Italian bankers accumulated vast sums of capital in the Middle Ages and the Renaissance. But by the 18th century, their leading cities languished in faded grandeur. And the “economic effect of imperialism on ordinary Europeans” was, for all its horrors, “nil or negative.” One can’t explain the Great Enrichment by theft.

No, this monumental achievement was caused by a change in values, Ms. McCloskey says—the rise of what she calls, in a mocking nod to Marx, a “bourgeois ideology.” It was far from an apology for greed, however. Anglo-Dutch in origin, the new ideology presented a deeply moral vision of the world that vaunted the value of work and innovation, earthly happiness and prosperity, and the liberty, dignity and equality of ordinary people. Preaching tolerance of difference and respect for the individual, it applauded those who sought to improve their lives (and the lives of others) through material betterment, scientific and technological inquiry, self-improvement, and honest work. Suspicious of hierarchy and stasis, proponents of bourgeois values attacked monopoly and privilege and extolled free trade and free lives while setting great store by prudence, enterprise, decency and hope.

Such values were best expressed, Ms. McCloskey maintains, in the writings of Adam Smith and Benjamin Franklin. But they found their way into a whole range of 17th-, 18th- and 19th-century productions, from novels and sermons to newspaper columns and works of art.

Collectively, they constituted a striking shift in rhetoric that justified new values for a world in which improvement and innovation were not just tolerated but esteemed.

Ms. McCloskey clearly relishes a good argument, and there is plenty of material in the book to argue about. One might take issue, for example, with the coherence of categories like “bourgeois” or “bourgeoisie,” which seem to be ever-rising in influence but are difficult to situate on the ground. She is also somewhat vague about why bourgeois ideology emerged when and where it did. Was it an effect of the Protestant Reformation? (Somewhat, she suggests.) A product of the Scientific Revolution and the Enlightenment? (Not entirely, it seems.) Finally, it is not clear why an event as complex as the Great Enrichment needs to be reduced to a single cause—ideas—in the first place.

Most historical events of this magnitude are multi-causal and over-determined.

And yet, even when it is not entirely convincing, “Bourgeois Equality” is always learned, provocative and smart. It is, in fact, a rarity: a work of economic history that is engaging (and often funny) on nearly every page. There can be little doubt, moreover, that it succeeds in its overall aim, serving as a bracing reminder that ideas do matter and that they have played an essential part in forging the world’s prosperity.

That is a vital lesson for the present and the future as well. For Ms. McCloskey’s book is ultimately a call to extend the wonders of the Great Enrichment to those parts of the world that it has yet to touch. We can end dire poverty once and for all, she believes, while continuing the trend of reducing inequality between nations, even if inequality rises within them.

To leave markets free to do their work, and ordinary people empowered to innovate and improve, is an achievable goal. But as Ms. McCloskey warns, a “clerisy” of naysayers has assailed bourgeois values from the start, dismissing capitalism as unjust and decrying its freedoms as illusory. Those voices are still strong, and growing stronger, on both the left and the right, urging retrenchment and retreat. As “Bourgeois Equality” reminds us: If we hope to leave a better world to our children, this is not a time to be building walls.

Mr. McMahon, a professor of history at Dartmouth College, is currently writing a history of equality.

A Tale of Two Debt Write-Downs

Adair Turner

Newsart for A Tale of Two Debt Write-Downs

SINGAPORE – At the end of 2015, Greece’s public debt was 176% of GDP, while Japan’s debt ratio was 248%. Neither government will ever repay all they owe. Write-offs and monetization are inevitable, putting both countries in a sort of global vanguard. With total public and private debt worldwide at 215% of world GDP and rising, the tools on which Greece and Japan depend will almost certainly be applied elsewhere as well.
Since 2010, official discussion of Greek debt has moved fitfully from fantasy to gradually dawning reality. The rescue program for Greece launched that year assumed that a falling debt ratio could be achieved without any private debt write-offs. After a huge restructuring of privately held debt in 2011, the ratio was forecast to reach 124% by 2020, a target the International Monetary Fund believed could be achieved, “but not with high probability.”
Today, the IMF believes that a debt ratio of 173% is possible by 2020, but only if Greece’s official European creditors grant significant further debt relief.
Greece’s prospects for debt sustainability have worsened because the eurozone’s authorities have refused to accept significant debt write-downs. The 2010 program committed Greece to turn a primary fiscal deficit (excluding debt service) of 5% of GDP into a 6% surplus; but the austerity needed to deliver that consolidation produced a deep recession and a rising debt ratio.
Now the eurozone is demanding that Greece turn its 2015 primary deficit of 1% of GDP into a 3.5%-of-GDP surplus, and to maintain that fiscal stance for decades to come.
But, as the IMF rightly argues, that goal is wildly unrealistic, and pursuing it would prove self-defeating. If talented young Greeks must fund perpetual surpluses to repay past debts, they can literally walk away from Greece’s debts by moving elsewhere in the European Union (taking tax revenues with them).
The IMF now proposes a more realistic 1.5%-of-GDP surplus, but that could put the debt ratio on a sustainable path only if combined with a significant write-down. Eurozone leaders’ official stance, however, continues to rule that out; they will consider only an extension of maturities and reduced interest rates at some future date.
If pursued to the limit, such adjustments can make any debt affordable – after all, a perpetual non-interest-bearing debt imposes no burden at all – while still enabling politicians to maintain the fiction that no debt had been written off. But the maturity extensions and rate reductions granted so far have been far less than needed to ensure debt sustainability. The time has come for honesty: A significant write-down is inevitable, and the longer it is put off, the larger it eventually will be.
Greece’s unresolved debt crisis still poses financial stability risks, but its $340 billion public debt is dwarfed by Japan’s $10 trillion. And while most Greek debt is now owed to official institutions, Japanese government bonds are held in private investment portfolios around the world. In Japan’s case, however, debt monetization, not an explicit write-off, will pave the path back to sustainability.
As with Greece, official fiscal forecasts for Japan have been fantasies. In 2010, the IMF described how Japan could reduce net debt (excluding government bonds held by quasi-government organizations) to a “sustainable” 80% of GDP by 2030, if it turned that year’s primary fiscal deficit of 6.5% of GDP into a 6.4%-of-GDP surplus by 2020, and maintained that surplus throughout the subsequent decade.
But virtually no progress toward this goal had been achieved by 2014. Instead, the new scenario foresaw that year’s 6%-of-GDP deficit swinging to a 5.6% surplus by 2020. In fact, fiscal tightening on anything like this scale would produce a deep recession, increasing the debt ratio.
The Japanese government has therefore abandoned its plan for an increase in sales tax in 2017, and the IMF has ceased publishing any scenario in which the debt ratio falls to some defined “sustainable” level. Its latest forecasts suggest a 2020 primary deficit still above 3% of GDP.
But the debt owed by the Japanese government to private investors is in free fall. Of Japan’s net debt of 130% of GDP, about half (66% of GDP) is owed to the Bank of Japan, which the government in turn owns. And with the BOJ buying government debt at a rate of ¥80 trillion ($746 billion) per year, while the government issues less than ¥40 trillion per year, the net debt of the Japanese consolidated public sector will fall to 28% of GDP by the end of 2018, and could reach zero sometime in the early 2020s.
The current official fiction, however, is that all the debt will eventually be resold to the private sector, becoming again a real public liability which must be repaid out of future fiscal surpluses. And if Japanese companies and households believe this fiction, they should rationally respond by saving to pay future taxes, thereby offsetting the stimulative effect of today’s fiscal deficits.
Realism would be a better basis for policy, converting some of the BOJ’s holdings of government bonds into a perpetual non-interest-bearing loan to the government. Tight constraints on the quantity of such monetization would be essential, but the alternative is not no monetization; it is undisciplined de facto monetization, accompanied by denials that any monetization is taking place.
In both Greece and Japan, excessive debts will be reduced by means previously regarded as unthinkable. It would have been far better if debts had never been allowed to grow to excess, if Greece had not joined the eurozone on fraudulent terms, and if Japan had deployed sufficiently aggressive policy to stimulate growth and inflation 20 years ago. Throughout the world, radically different policies are needed to enable economies to grow without the excessive private debt creation that occurred before 2008. But having allowed excessive debt to mount, sensible policy design must start from the recognition that many debts, both public and private, simply cannot be repaid.

Asset management

Index we trust

Vanguard has radically changed money management by being boring and cheap

WHEN John Bogle set up Vanguard Group 40 years ago, there was no shortage of scepticism.

The firm was launching the first retail investment fund that aimed simply to mimic the performance of a stock index (the S&P 500, in this case), rather than to identify individual companies that seemed likely to outperform. Posters on Wall Street warned that index-tracking was “un-American”; the chairman of Fidelity, a rival, said investors would never be satisfied with “just average returns”; and the Securities and Exchange Commission (SEC), Wall Street’s main regulator, opposed the firm’s unusual ownership structure. The fund attracted just $11m of the $150m Vanguard had been hoping for, and suffered net outflows for its first 83 months.

“We were conceived in hell and born in strife,” Mr Bogle recalls.

Vanguard now manages over $3.5 trillion on behalf of some 20m investors. Every working day its coffers swell by another billion dollars or so. One dollar in every five invested in mutual or exchange-traded funds (ETFs) in America now goes to Vanguard, as does one in every two invested in passive, index-tracking funds, according to Morningstar, a data provider.

Vanguard’s investors own around 5% of every public company in America and about 1% in nearly every public company abroad. Although BlackRock, a rival, manages even more money, Vanguard had net retail inflows of $252 billion in 2015, more than any other asset manager.

Impressive as they are, however, these statistics still understate Vanguard’s influence. By inventing index-tracking, and providing it at very low cost, the firm has forced change on an industry known for its high margins and overcomplicated products. Delighted investors and disgruntled money managers speak of “the Vanguard effect”, the pressure that the giant’s meagre fees put on others to cut costs. Some rivals now sell passive products priced specifically to match or undercut it.

Ask any employee for the secret of Vanguard’s success, and they will point to its ownership structure. The firm is entirely owned by the investors in its funds. It has no shareholders to please (and remunerate), unlike the listed BlackRock or Fidelity, a privately owned rival.

Instead of paying dividends, it cuts fees. Mr Bogle’s rationale for this set-up is simple: “No man can serve two masters.” The incentives of the firm and its customers are completely aligned, he says. Competitors implicitly agree. “How are we supposed to compete when there’s a non-profit disrupting the game?” complains one.

Bill McNabb, Vanguard’s current CEO, says the ownership structure permits a virtuous cycle, whereby its low fees improve the net performance of its funds, which in turn attracts more investors to them, which increases economies of scale, allowing further cuts in fees. Even as the assets Vanguard manages grew from $2 trillion to $3 trillion, its staff of 14,000 or so barely increased.

Meanwhile, fees as a percentage of assets under management have dropped from 0.68% in 1983 to 0.12% today (see chart). This compares with an industry average of 0.61% (or 0.77%, when excluding Vanguard itself). Fees on its passive products, at 0.08% a year, are less than half the average for the industry of 0.18%. Its actively managed products are even more keenly priced, at 0.17% compared with an average of 0.78%.

The index-trackers account for over 70% of Vanguard’s assets and over 90% of last year’s growth.

Investors are gradually absorbing the idea that, in the long run, beating the market consistently is impossible, Mr McNabb says. That makes being cheap more important than being astute.

Last year investors in America withdrew $145 billion from active funds of different kinds and put $398 billion into passive ones.

“In an industry with serious trust issues, Vanguard has proven an exception to the rule,” says Ben Johnson of Morningstar. Its investors stay with it roughly twice as long as the industry average. The firm actively shuns short-term “hot money” because it brings extra trading costs.

Mr McNabb tells the tale of the CEO of a foundation who wanted to park $40m with a Vanguard fund for a few months. When the fund turned him away, he “went ballistic”, complaining to the SEC, but Vanguard did not budge.

Vanguard also insists on keeping things simple. It offers only 70 different ETFs, compared with 383 at BlackRock. It steers clear of voguish products, such as funds of distressed energy firms.

It refused, presciently, to set up an internet fund in the late 1990s.

But Vanguard’s conservatism can also be a weakness. It has been slow to expand abroad: its customer base is 95% American. It was slow to get into ETFs as well, allowing BlackRock to become the biggest provider, although Vanguard is catching up. BlackRock is also a one-stop shop for all manner of investments, including alternatives such as private equity and hedge funds, whereas Vanguard caters only to the mainstream. This may be one of the reasons why it does less well with the biggest institutional investors, which want lots of investment options and the kind of bespoke service that Vanguard does not offer.

There is always a chance that a clever fintech startup, or a tech giant like Apple, might create a cheaper or simpler way for individuals to invest, luring away some of Vanguard’s customers.

As it is, it is getting harder for Vanguard to keep cutting fees: to shave its average fee by a hundredth of a percentage point, it needs to attract an extra $560 billion in assets under management. And heavier regulation is always a risk. Last year the industry’s giants won an important battle when they convinced regulators that, unlike banks, fund managers should not be subject to more onerous rules simply because they are big. But talk of rules intended to stem panic in collapsing markets has not gone away.

Nonetheless, there is plenty of room for Vanguard to keep growing. Only a third of American equities are held by index-tracking funds, and a smaller share elsewhere. Regulators in America and beyond are discouraging or barring financial advisers from receiving commissions from firms whose products they recommend—a move that should push even more money to Vanguard as advisers lose the incentive to offer expensive products (Vanguard refuses to pay commissions).

As the move from defined-benefit to defined-contribution pensions continues, and as Asia sets up its retirement systems, there will be growing demand for the sort of “DIY” investing that has underpinned Vanguard’s success. With interest rates and investment returns expected to be low for years to come, keeping fees down will be more important than ever. As Tim Buckley, the firm’s chief investment officer, puts it: “The biggest advantage Vanguard has, aside from its structure, is the greed of our competitors.”

Follow the Yellow Brick Road

by Jeff Thomas

For over a hundred years, it’s been theorised that author L. Frank Baum wrote his 1900 book, “The Wonderful Wizard of Oz”, as a fanciful way to explain the economic situation at the time and that the Yellow Brick Road was a reference to the path created by gold ownership.

Whether or not the theory is correct, for many people today, “Follow the Yellow Brick Road” might serve as a mantra for alleviating economic woes.

What will happen is that one day, gold will suddenly be up $100 per ounce, then the next day, $200 per ounce. At first the pundits will be claiming that it’s an anomaly, but as it continues rising, a point will be reached when the average person says to himself, “This seems to be a trend. I’d better buy some gold.” Unfortunately, once the trend is underway, the price that day will have no bearing on whether gold is available. Your local coin shop may be sold out. If you go online, the mints may say that demand is exceeding supply. Large entities will be buying all they can get and the smaller buyers will be way down on the order list, unlikely to take delivery of even a single ounce.

These Are the Good Old Days

Gold has experienced a four year bear market and only recently has begun to rise again. But is it in reality a barbarous relic? Not by a long shot. For over 5,000 years, whenever people have experienced erratic economic periods, they’ve bought gold in order to stabilise their economic position. This has particularly been true whenever fiat currencies have been on the rise and were in danger of hyper-inflating, as in recent years. Most currencies are in decline against the U.S. dollar—a currency which, itself, is very much in danger of collapse in the not-too-distant future.

In the ’70s, I was buying gold in London, as it rose from $35. It reached a high of $850 in January, 1980, then crashed. When gold dropped below $400, I began buying Krugerrands.

Sounds like a bargain, and yet, word on the street was that gold was headed further south.

But I was buying long. I was not playing the market; I was building my economic insurance policy. I wasn’t too fussed over price fluctuations, as my gold holdings were meant to cover me if my other investments proved to be a mistake.

At present, gold is well above the high of 1989, but, if we adjust for inflation, we see that gold is actually a bargain at present. This excellent Casey Research chart from 2014 explains it better than mere words:

This tells us that $8,800 would not be an unreasonable level for gold today, if conditions were as dire as they were in 1980. However, conditions are far more dire—debt levels are far beyond any historical levels and markets are in a bubble, just waiting for the arrival of a pin.

A decade ago, when gold topped $700, I predicted $1,500 at some point and even my closest colleagues wondered what I’d been smoking. But it turned out that my prediction was, if anything, conservative. Over the last four years, some of the world’s most informed prognosticators—Eric Sprott, Peter Schiff, Jim Rickards, and Jim Sinclair—have all predicted gold to rise to between $5,000 and $7,000, and some have suggested numbers as high as $50,000.

But this hasn’t happened.

Are they wrong? No, it just hasn’t happened as of yet.

Conversely, Harry Dent has predicted a drop to $750. So, who’s right? Well, actually, they may all be right. After a crash in the markets, deflation is a certainty, as brokers and investors dump investments of every type in order to cover margin losses. This panic sell-off will most assuredly include gold, even though the holders will not wish to sell their gold. This panic promises to create an immediate and possibly very dramatic downward spike in gold.

However, large numbers of long-term investors already have their orders in for any price below $1,000. If the spike drops below that number, it will therefore be brief, as every ounce that hits the market at $999 is scooped up.

In addition, the Federal Reserve will make good on its decades-long promise to roll the printing presses to counter any sudden deflation. That very act will light the fuse on the gold rocket and send it skyward.

Will the Sun Rise in the Morning or Set in the Evening?

The argument over whether gold will drop to $750 or rise to $5,000 is a pointless one. Any understanding of basic economics assures us that we shall see both sudden deflation and dramatic inflation. It’s as natural and inevitable as sunrise and sunset. (By the way, several of the above individuals have standing bets with each other as to the $750 number. The prize? An ounce of gold.)

But it matters little who will win the bets. What matters is the overview. Rickety economic times are now upon us and they will soon morph into crisis times. In such times, precious metals always return to centre stage, as paper currencies and electronic currencies return to their intrinsic worth of zero.

Gold does not so much rise against fiat currencies, as fiat currencies collapse against gold.

Most assuredly, we shall see a dramatic rise in gold, but, just as in the ‘70s, the average person will fail to understand why and will simply chase the upward trend. When gold hits $2,000, but no one is willing to sell for under, say, $2,500, those who are chasing the trend will pay the $2,500 and that will become the new price across the board. Then it will leap higher—again and again, as monetary panic grips the investment world. The inflation-adjusted 1980 price of $8,800 should not be a surprise at all—in fact it would be low, as, in the coming years, conditions will be far more dire than in 1980.

Gold may well blow through $10,000. Even the $50,000 figure is not impossible, as we shall be seeing a runaway bull market where those chasing the trend carry gold beyond any rational value.

But gold has an intrinsic value. 2,000 years ago, an ounce of gold could buy you a good suit of clothes. That’s still true today. A gold mania will fuel the gold price beyond anything logical, but a correction will be equally inevitable, dropping it to its intrinsic value.

We shall see a gold rise for the record books. The wise investor should already have stocked up his supply of physical gold and gotten rid of gold ETFs. He should already have his seat belt fastened and ready for take-off. We’re off to see the wizard.

Current Yield

Treasury Bond Rally Could Point to Trouble Ahead

Rates in the U.S., Europe, and Japan are all at or near record lows. But that suggests weak economic growth and fragile markets.

By Amey Stone

Treasuries rallied last week, but celebrations aren’t in order. Sure, bonds get more valuable when interest rates fall, but it is disconcerting when yields get this low.

Treasury rates have now fallen below the lows of mid-February—when oil was crashing and global markets feared recession. The yield on the 10-year note closed Friday at 1.64%, nearly a four-year low, according to Tradeweb. The yield curve flattened, with the spread between two-year and 10-year notes at a nine-year low.
For Treasury rates to be so low suggests economic weakening and fragile markets. Pixabay
Already low European and Japanese rates plumbed new depths. The 10-year German Bund threatened to turn negative, ending the week with a yield of just 0.02%. Fitch Ratings estimated that at the end of May, $10.4 trillion in sovereign debt was trading with negative yields, up 5% from April. That number is even higher now.
For rates to be so low—and the yield curve so flat—suggests economic weakening and fragile markets.
“The world, including the U.S., is coming around to the view that potential growth is lower,” sums up Raman Srivastava, portfolio manager of the Dreyfus/Standish Global Fixed Income fund. “That keeps a lid on yields.”
But there are reasons for the lower Treasury yields that have little to do with the U.S. economy, which is actually growing faster in the second quarter than it did in the first. Huge global demand for U.S. bonds, which yield much more than bonds of other developed countries, is a big part of the story. Recent Treasury auctions indicate demand from foreign buyers is at record levels. The European Central Bank started buying member-country corporate bonds last week, helping to drive down corporate rates in the U.S. as well.
The British vote over exiting the European Union, known as Brexit, is June 23. Polls suggest a close vote.
That’s creating demand for safe U.S. bonds since global markets are likely to freak out if the U.K. votes to leave. Political risk in general is running high, including in the U.S., says Srivastava. Meanwhile, economic data has disappointed despite epic amounts of stimulus, calling into question central banks’ effectiveness.
And let’s not forget the Federal Reserve, which meets Tuesday and Wednesday this week. The Fed won’t hike rates given the jarringly weak May payrolls report, but it may still raise them later this year. Investors who believe that would be a policy mistake may be buying Treasuries as a defensive move against more market mayhem. 

“The message is a bit clouded,” says Anthony Valeri, a strategist at LPL Financial. He thinks events in Europe are the main driver of the recent Treasury rally and that it could reverse. Still, he says, “if the yield holds below the 1.66% level for a number of days, that’s a very strong statement that lower yields may be here to stay for longer.”
FOR INCOME INVESTORS , the best advice is to diversify across different types of assets, says Jim Sarni, managing principal of investment firm Payden & Rygel. “You need a wider opportunity set,” he says.
Jenny Van Leeuwen Harrington, portfolio manager at Gilman Hill Asset Management, argues this environment favors dividend stocks. Not only do many yield more than bonds, but some, such as utilities, benefit from low interest rates. Art DeGaetano of Bramshill Investments believes corporate credit is the best place to find yield with less risk. He notes his fund is positioned conservatively ahead of Brexit.
Srivastava holds sovereign bonds from countries like Australia and New Zealand, where central banks may be pressured to cut rates now that the U.S. is less likely to hike rates soon.

Sticking with high quality, despite low yields, makes sense, he says. Riskier assets are generally supported by lower rates, but with yields low and stock prices high, markets are vulnerable to a shock, and the stimulative power of monetary policy is limited, Srivastava says, adding: “That’s a troubling prospect.”