The global economy

How China is battling ever more intensely in world markets

But does it play fair?

IF DONALD TRUMP had slapped punitive tariffs on all Chinese exports to America, as he promised, he would have started a trade war. Fortunately, the president hesitated, partly because he wants China’s help in thwarting North Korea’s nuclear ambitions. But that is not the end of the story. Tensions over China’s industrial might now threaten the architecture of the global economy. America’s trade representative this week called China an “unprecedented” threat that cannot be tamed by existing trade rules. The European Union, worried by a spate of Chinese acquisitions, is drafting stricter rules on foreign investment. And, all the while, China’s strategy for modernising its economy is adding further strain.

At the heart of these tensions is one simple, overwhelming fact: firms around the world face ever more intense competition from their Chinese rivals. China is not the first country to industrialise, but none has ever made the leap so rapidly and on such a monumental scale.

Little more than a decade ago Chinese boom towns churned out zips, socks and cigarette lighters. Today the country is at the global frontier of new technology in everything from mobile payments to driverless cars.

Even as China’s achievements inspire awe, there is growing concern that the world will be dominated by an economy that does not play fair. Businesses feel threatened. Governments that have seen Brexit and the election of Mr Trump, worry about the effects of job losses and shrinking technological leadership. Yet if the outcome is to be good, they must all think clearly about the real nature of China’s challenge.

Go, in three dimensions

Undoubtedly, China has form. It kept its currency cheap for years, boosting exporters; it finances its state-owned giants with cheap credit; and its cyber-spies steal secrets. Yet depictions of corporate China as just an undemocratic, state-run monster, thieving and cheating to get ahead, are crude and out of date. Home-grown innovation is flourishing. The innovators are mainly private, not the many heads of a single creature called China Inc. To separate hype from reality, think of Chinese competition as having three dimensions: illegal, intense and unfair. Each needs a different response.

First, consider illegality. The best example is the blatant theft of intellectual property that makes for the most sensational headlines, such as the charges laid in 2014 against five Chinese military officers for hacking into American nuclear, solar and metals firms. The good news is such crimes are declining. An agreement with America in 2015 seemingly led to a marked drop in Chinese hacks of foreign companies and, as Chinese firms produce more of value, they are themselves demanding better intellectual-property protection at home.

The second dimension—intense but legal competition—is far more important. Chinese firms have proven that they can make good products for less. Consumer prices for televisions, adjusted for quality, fell by more than 90% in the 15 years after China joined the World Trade Organisation (WTO). China’s share of global exports has risen to 14%, the highest any country has reached since America in 1968. That may fall as China loses its grip on low-value industries such as textiles. But it is gaining a new reputation in high tech. If data are the new oil, China’s tech industry has vast reserves in the information generated by the hundreds of millions of its people online—unprotected by privacy rules. Whether you make cars in Germany, semiconductors in America or robots in Japan, the chances are that in future some of your fiercest rivals will be Chinese.

Last, and hardest to deal with, is unfair competition: sharp practice that breaks no global rules. The government demands that firms give away technology as the cost of admission to China’s vast market (see article). Foreign firms have been targeted in the biggest of China’s anti-monopoly cases. The government restricts access to lucrative sectors, while financing assaults on those same industries abroad. Such behaviour is dangerous precisely because today’s rules offer no redress.

Don’t get angry. Get even

Sorting Chinese competition into these categories helps calibrate the response. Blatant illegality is the most straightforward. Governments must prosecute and seek redress, whether through the courts or the WTO. Firms can better protect themselves against cyber-thieves—from China and elsewhere.

Though it is politically hard, the best response to intense competition is to welcome it.

Consumers will gain from lower costs and faster innovation. Misguided attempts to hold back the tide would not only lose those potential gains but might also blow up the world trading system, with catastrophic results. Rather than try to stop the loss of jobs, governments should provide retraining and a decent safety net. Both companies and governments need to spend more on education and research. Six years ago Barack Obama said America faced a new “Sputnik moment” in China’s rise. Since then not much extra has been devoted to research, training and infrastructure.

The hardest category is competition that is unfair, but not illegal. One approach is to coax China into behaving better by acting collectively. America, Europe and big Asian countries could jointly publish information about economic harm from China’s policies—as they did by sharing details about overcapacity in the steel industry, nudging China into cutting its excesses.

They should demand reciprocity, requiring China to give foreign companies the same access that its own firms enjoy in their markets. Governments need to review their policies for screening investments from China so that they can block genuine threats to national security (though only those). And they should also require that investors with state backing report this in full, and punish those hiding their true identity.

Much of the responsibility for putting this right falls on China. It may ask why it should hold itself back. After all, 19th-century Germany and America grew rich behind subsidies and tariff walls; Britain and Japan were bullies. Yet, having done so well out of the global commercial ecosystem, China should recognise that it has become one of its custodians. Abuse it—illegally or by overburdening it—and it will break.

Global Retirement Reality

John Mauldin

Today we’ll continue to size up the bull market in governmental promises. As we do so, keep an old trader’s slogan in mind: “That which cannot go on forever, won’t.” Or we could say it differently: An unsustainable trend must eventually stop.
Lately I have focused on the trend in US public pension funds, many of which are woefully underfunded and will never be able to pay workers the promised benefits, at least without dumping a huge and unwelcome bill on taxpayers. And since taxpayers are generally voters, it’s not at all clear they will pay that bill.

Readers outside the US might have felt smug and safe reading those stories. There go those Americans again, spending wildly beyond their means. You are correct that, generally speaking, we are not exactly the thriftiest people on Earth. However, if you live outside the US, your country may be more like ours than you think. Today we’ll look at some data that will show you what I mean. This week the spotlight will be on Europe.

First, let me suggest that you read my last letter, “Build Your Economic Storm Shelter Now,” if you missed it. It has some important background for today’s discussiion, as well as a special invitation to attend my Strategic Investment Conference next March 6–9 in San Diego. With so much change occurring so quickly now, next year’s conference is an event you shouldn’t miss.
Global Shortfall
I wrote a letter last June titled “Can You Afford to Reach 100?” Your answer may well be “Yes;” but, if so, you are one of the few. The World Economic Forum study I cited in that letter looked at six developed countries (the US, UK, Netherlands, Japan, Australia, and Canada) and two emerging markets (China and India) and found that by 2050 these countries will face a total savings shortfall of $400 trillion. That’s how much more is needed to ensure that future retirees will receive 70% of their working income. This staggering figure doesn’t even include most of Europe.
This problem exists in large part because of the projected enormous increase in median life expectancies. Reaching age 100 is already less remarkable than it used to be. That trend will continue. Better yet, I think we will also be healthier at advanced ages than people are now. Could 80 be the new 50? We’d better hope so, because the math is pretty bleak if we assume people will stop working at age 65–70 and then live another quarter-century or more.

That said, I think we’ll see a great deal of national variation in these trends. The $400 trillion gap is the shortfall in government, employer, and individual savings. The proportions among the three vary a great deal. Some countries have robust government-provided retirement plans; others depend more on employer and individual contributions. In the aggregate, though, the money just isn’t there. Nor will it magically appear just when it’s needed.

WEF reaches the same conclusion I did long ago: The idea that we’ll enjoy decades of leisure before our final decline simply can’t work. Our attempt to live out long and leisurely retirements is quickly reaching its limits. Most of us will work well past 65 whether we want to or not, and many of us will not have our promised retirement benefits to help us through our final decades.

What about the millions who are already retired or close to retirement? That’s a big problem, particularly for the US public-sector workers I wrote about in my last two letters. We should also note that we’re all public-sector workers in a way, since we must pay into Social Security and can only hope Washington gives us something back someday.

Let’s look at a few other countries that are not much better off. 
UK Time Bomb
The WEF study shows that the United Kingdom presently has a $4 trillion retirement savings shortfall, which is projected to rise 4% a year and reach $33 trillion by 2050.
This in a country whose total GDP is $3 trillion. That means the shortfall is already bigger than the entire economy, and even if inflation is modest, the situation is going to get worse. Further, these figures are based mostly on calculations made before the UK decided to leave the European Union. Brexit is a major economic realignment that could certainly change the retirement outlook. Whether it would change it for better or worse, we don’t yet know.

A 2015 OECD study (mentioned here) found that across the developed world, workers could, on average, expect governmental programs to replace 63% of their working-age incomes. Not so bad. But in the UK that figure is only 38%, the lowest in all OECD countries. This means UK workers must either build larger personal savings or severely tighten their belts when they retire. Working past retirement age is another choice, but it has broader economic effects – freezing younger workers out of the job market, for instance.

UK employer-based savings plans aren’t on particularly sound footing, either.
According to the government’s Pension Protection Fund, some 72.2% of the country’s private-sector defined-benefit plans are in deficit, and the shortfalls total £257.9 billion. Government liabilities for pensions went from being well-funded in 2007 to having a shortfall 10 years later of £384 billion (~$500 billion). Of course, that figure is now out of date because, just a few months later, it’s now £408 billion – that’s how fast these unfunded liabilities are growing. Again, that’s a rather tidy sum for a $3 trillion economy to handle.
UK retirees have had a kind of safety valve: the ability to retire in EU countries with lower living costs. Depending how Brexit negotiations go, that option could disappear.

Turning next to the Green Isle, 80% of the Irish who have pensions don’t think they will have sufficient income in retirement, and 47% don’t even have pensions. I think you would find similar statistics throughout much of Europe.

A report this summer from the International Longevity Centre suggested that younger workers in the UK need to save 18% of their annual earnings in order to have an “adequate” retirement income – which it defines as less than today’s retirees enjoy. But no such thing will happen, so the UK is heading toward a retirement implosion that could be at least as damaging as the US’s.
Swiss Cheese Retirement
Americans often have romanticized views of Switzerland. They think it’s the land of fiscal discipline, among other things. To some extent that’s true, but Switzerland has its share of problems, too. The national pension plan there has been running deficits as the population grows older.

Earlier this month, Swiss voters rejected a pension reform plan that would have strengthened the system by raising women’s retirement age from 64 to 65 and raising taxes and required worker contributions. From what I can see, these were fairly minor changes, but the plan still went down in flames as 52.7% of voters said no.

Voters around the globe generally want to have their cake and eat it, too. We demand generous benefits but don’t like the price tags that come with them. The Swiss, despite their fiscally prudent reputation, appear to be not so different from the rest of us. Consider this from the Financial Times:
Alain Berset, interior minister, said the No vote was “not easy to interpret” but was “not so far from a majority” and work would begin soon on revised reform proposals.

Bern had sought to spread the burden of changes to the pension system, said Daniel Kalt, chief economist for UBS in Switzerland. “But it’s difficult to find a compromise to which everyone can say Yes.” The pressure for reform was “not yet high enough,” he argued. “Awareness that something has to be done will now increase.”
That description captures the attitude of the entire developed world. Compromise is always difficult. Both politicians and voters ignore the long-term problems they know are coming and think no further ahead than the next election. The remark that “Awareness that something has to be done will now increase” may be true, but there’s a big gap between awareness and motivation – in Switzerland and everywhere else.

Switzerland and the UK have mandatory retirement pre-funding with private management and modest public safety nets, as do Denmark, the Netherlands, Sweden, Poland, and Hungary. Not that all of these countries don’t have problems, but even with their problems, these European nations are far better off than some others.

(Sidebar: low or negative rates in those countries make it almost impossible for their private pension funds to come anywhere close to meeting their mandates. And many of the funds are by law are required to invest in government bonds, which pay either negligible or negative returns.)
Pay-As-You-Go Woes
The European nations noted above have nowhere near the crisis potential that the next group does: France, Belgium, Germany, Austria, and Spain are all pay-as-you-go countries (PAYG). That means they have nothing saved in the public coffers for future pension obligations, and the money has to come out of the general budget each year. The crisis for these countries is quite predictable, because the number of retirees is growing even as the number of workers paying into the national coffers is falling. There is a sad shortfall of babies being born in these countries, making the demographic reality even more difficult.
Let’s look at some details.

Spain was hit hard in the financial crisis but has bounced back more vigorously than some of its Mediterranean peers did, such as Greece. That’s also true of its national pension plan, which actually had a surplus until recently. Unfortunately, the government chose to “borrow” some of that surplus for other purposes, and it will soon turn into a sizable deficit.

Just as in the US, Spain’s program is called Social Security, but in fact it is neither social nor secure. Both the US and Spanish governments have raided supposedly sacrosanct retirement schemes, and both allow their governments to use those savings for whatever the political winds favor.

The Spanish reserve fund at one time had €66 billion and is now estimated to be completely depleted by the end of this year or early in 2018. The cause? There are 1.1 million more pensioners than there were just 10 years ago. And as the Baby Boom generation retires, there will be even more pensioners and fewer workers to support them. A 25% unemployment rate among younger workers doesn’t help contributions to the system, either.

A similar dynamic may actually work for the US, because we control our own currency and can debase it as necessary to keep the government afloat. Social Security checks will always clear, but they may not buy as much. Spain’s version of Social Security doesn’t have that advantage as long as the country stays tied to the euro. That’s one reason we must recognize the potential for the Eurozone to eventually spin apart. (More on that below.)

On the whole, public pension plans in the pay-as-you-go countries would now replace about 60% of retirees’ salaries. Further, several of these countries let people retire at less than 60 years old. In most countries, fewer than 25% of workers contribute to pension plans. That rate would have to double in the next 30 years to make programs sustainable. Sell that to younger workers.
The Wall Street Journal recently did a rather bleak report on public pension funds in Europe.
Europe’s population of pensioners, already the largest in the world, continues to grow. Looking at Europeans 65 or older who aren’t working, there are 42 for every 100 workers, and this will rise to 65 per 100 by 2060, the European Union’s data agency says. By comparison, the U.S. has 24 nonworking people 65 or over per 100 workers, says the Bureau of Labor Statistics, which doesn’t have a projection for 2060. (WSJ)
While the WSJ story focuses on Poland and the difficulties facing retirees there, the graphs and data in the story make clear the increasingly tenuous situation across much of Europe. And unlike most European financial problems, this isn’t a north-south issue. Austria and Slovenia face the most difficult demographic challenges, right along with Greece. Greece, like Poland, has seen a lot of its young people leave for other parts of the world. This next chart compares the share of Europe’s population that 65 years and older to the rest of the regions of the world and then to the share of population of workers between 20 and 64.
These are ugly numbers.

Source: WSJ
The WSJ continues:
Across Europe, the birthrate has fallen 40% since the 1960s to around 1.5 children per woman, according to the United Nations. In that time, life expectancies have risen to roughly 80 from 69.

In Poland birthrates are even lower, and here the demographic disconnect is compounded by emigration. Taking advantage of the EU’s freedom of movement, many Polish youth of working age flock to the West, especially London, in search of higher pay. A paper published by the country’s central bank forecasts that by 2030, a quarter of Polish women and a fifth of Polish men will be 70 or older.

Source: WSJ
Next week we will look at the unfunded liabilities of the US government. It will not surprise anyone to learn that the situation is ugly, and there is no way – zero chance, zippo – that the US government will be able to fund those liabilities without massive debt and monetization.

Now, what I am telling you is that every bit of analysis about the pay-as-you-go countries in Europe suggests that they are in a far worse position than the United States is. Plus, the economies of those countries are more or less stagnant, and they are already taxing their citizens at close to 50% of GDP.

The chart below shows the percentage of GDP needed to cover government pension payments in 2015 and 2050. But consider that the percentage of tax revenues required will be much higher. For instance, in Belgium the percentage of GDP going to pensions will be 18% in about 30 years, but that’s 40–50% of total tax revenues.
That hunk doesn’t leave much for other budgetary items. Greece, Italy, Spain? Not far behind.
And there is other research that makes the above numbers seem optimistic by comparison.
The problem that the European economies have is that for the most part they are already massively in debt and have high tax rates. And they can’t print their own currencies.

Many of Europe’s private pension companies and corporations are also in seriously deep kimchee. Low and negative interest rates have devastated the ability of pension funds to grow their assets. Combined with public pension liabilities, the total cost of meeting the income and healthcare needs of retirees is going to increase dramatically all across Europe.

Macron, the new French president, really is trying to shake up the old order, to his credit; and this week he came out and began to lay the foundation for the mutualization of all European debt, which I assume would end up on the balance sheet of the ECB. However, that plan still doesn’t deal with the unfunded liabilities.
Do countries just run up more debt? It seems like the plan is to kick the can down the road just a little further, something Europe is becoming really good at.

In this next chart, note the line running through each of the countries, showing their debt as a percentage of GDP. Italy’s is already over 150%. And this is a chart based mostly on 2006 and earlier data. A newer chart would be much uglier.
I could go on reviewing the retirement problems in other countries, but I hope you begin to see the big picture. This crisis isn’t purely a result of faulty politics – though that’s a big contributor – it’s a problem that is far bigger than even the most disciplined, future-focused governments and businesses can easily handle.

Look what we’re trying to do. We think people can spend 35–40 years working and saving, then stop working and go on for another 20–30–40 years at the same comfort level – but with a growing percentage of retirees and a shrinking number of workers paying into the system. I’m sorry, but that’s magical thinking. And it’s not what the original retirement schemes envisioned at all. Their goal was to provide for a relatively small number of elderly people who were unable to work. Life expectancies were such that most workers would not reach that point, or would at least live just a few years beyond retirement.

As I have pointed out in past letters, when Franklin Roosevelt created Social Security for people over 65 years old, US life expectancy was about 56 years. If the retirement age had kept up with the increase in life expectancy, the retirement age in the US would now be 82. Try and sell that to voters.

Worse, generations of politicians have convinced the public that not only is a magical outcome possible, it is guaranteed. Many politicians actually believe it themselves. They aren’t lying so much as just ignoring reality. They’ve made promises they aren’t able to keep and are letting others arrange their lives based on the assumption that the impossible will happen. It won’t.

How do we get out of this jam? We’re all going to make big adjustments. If the longevity breakthroughs I expect happen soon (as in the next 10–15 years), we may be able to adjust with minimal pain. We’ll work longer years, and retirement will be shorter, but it will be better because we’ll be healthier.

That’s the best-case outcome, and I think we have a fair chance of seeing it, but not without a lot of social and political travail. How we get through that process may be the most important question we face.

I haven’t even thrown in the complications that are going to arise because of changes in the nature of employment and the future of work that will be caused by technological change in the next 10–20 years. That will mean even fewer workers for each retiree. Facebook’s Zuckerberg talks about a basic minimum income. I think that is the wrong thing to do. It is the nature of human beings to need to do things that contribute meaningfully to the lives of their family and society. But the reality is that increasing numbers of people are already having trouble finding that sort of work.

Maybe we should think about basic minimum employment. FDR put a generation of people to work building public projects that helped get us through the Great Depression. Our world is going to change in ways that we don’t yet understand and that we are not prepared for, psychologically, socially, politically, or economically.

In the US and much of Europe we have developed social echo chambers in which we talk just to ourselves and those who are like-minded, ignoring or demonizing the other side. We have lost the ability to disagree rationally and productively. When the children’s books written by Dr. Seuss are considered by some to have been written by a white racist and are therefore deemed unacceptable to be in a public library, you know the quality of civil discourse has spiraled downward.

I do not like that, Sam I am.
Lisbon, Denver, Lugano, and Hong Kong
In a few hours, Shane and I will leave for the airport to catch a late-night flight to London and then on to Lisbon. My hosts, the event coordinators of the large food retailing group of Jerónimo Martins, have been particularly gracious with their arrangements and in giving us plenty of time to explore Lisbon. And the rest of the speaking lineup is quite impressive, so I imagine that I will be attending a lot of the conference. They are focused on how the world is changing, which is right up my alley.

Then we are back to Dallas on October 4 – my 68th (!) birthday – and I speak the next day at the Dallas Money Show. I am told that my 20-minute talk at 9:15 AM Central Time will be available on live stream. Go here and then click on the “LIVE STREAM” tab. I will be in Denver on November 6 and 7, speaking for the CFA Society and holding meetings. After a lot of small back-and-forth flights in November, I’ll end up in Lugano, Switzerland, right before Thanksgiving. Then there will be a (currently) lightly scheduled December, followed by an early trip to Hong Kong in January. It looks like Lacy Hunt and his wife, JK, will join Shane and me there. Lacy and I will come back home exhausted from trying to keep up with our indefatigable better halves.

I am really looking forward to both Lisbon and Hong Kong, and I have never been to Lugano. Some of the back-and-forth trips do wear me out, but I enjoy it when I get to play tourist with Shane. I am sure I will have to go on an even more serious diet when I get back from Lisbon, because everybody tells me the food is fabulous.

It’s time to hit the send button and get ready to run to the airport. You have a great week. I see a little port sampling in my near future. Just for appearances… 

Your ready to explore Lisbon and Portugal analyst,

Low Inflation Is No “Mystery”

By Brian S. Wesbury, chief economist, and Robert Stein, deputy chief economist, First Trust

Last week, at her press conference, Federal Reserve Chair Janet Yellen said continued low inflation was a “mystery.”

She’s referring to Quantitative Easing (QE) and the lack of the economic evidence that it worked. The Fed bought $3.5 trillion of bonds with money it created out of thin air in an extraordinary “experiment” to avoid repeating the mistakes of the deflationary Great Depression. Milton Friedman was the leading scholar in this arena, proving the damage done by a shrinking money supply during the 1930s.

The money supply is a “demand-side” economic tool. A lack of money inhibits demand, while a surplus of money (more than the economy needs to grow) can cause inflation.
The idea of QE (which has been tried unfruitfully for more than a decade in Japan) was to boost “demand-side” growth. And, yet, inflation and economic growth have both been weak. In other words, demand did not accelerate.

So forgive us for asking, but after unprecedented expansion of banking reserves and the Fed balance sheet, with little inflation, is it really a “mystery?” Or, is it proof of what we believed all along: QE didn’t work?

We get it. Just the fact that the US economic recovery started in 2009 and stock prices went higher is all some need to convince themselves that QE worked. But no one knows what would have happened without QE.

Back in 2008, even Janet Yellen knew there were problems with QE. During a December 2008 Fed meeting, she said there were “no discernible economic effects” from Japanese QE. Back then she was a Fed Governor and this was said during internal debates about whether to do QE. Today she leads the Fed and bureaucracies can never admit failure.
So, the lack of inflation becomes a “mystery.” 

Conventional Wisdom is so convinced that QE worked, it can’t see anything as a failure.
QE supposedly pushed up stock prices and drove down interest rates, while at the same time boosting jobs.

As for the lack of demand-side growth, the explanations are confusing. Yellen says low inflation is a mystery, others say it’s because of new technologies, global trade, and rising productivity. Slow real GDP growth is blamed on global trade, a Great Stagnation in productivity and the lack of investment by private companies. QE gets credit for the things that went up, but things that didn’t are explained away, denied, or determined to be mysteries.

We have promoted an alternative narrative that agrees with the 2008 Janet Yellen – QE didn’t work. It flooded the banking system with cash. But instead of boosting Milton Friedman’s key money number (M2), the excess monetary base growth went into “excess reserves” – money the banks hold as deposits, but don’t lend out. Money in the warehouse (or in this case, credits on a computer) doesn’t boost demand! This is why real GDP and inflation (nominal GDP) never accelerated in line with monetary base growth.

The Fed boosted bank reserves, but the banks never lent out and multiplied it like they had in previous decades. In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008, which is the same rate it grew in the second half of the 1990s. 

So, why did stock prices rise and unemployment fall? Our answer: Once changes to mark-to-market accounting brought the Panic of 2008 to an end, which was five months after QE started, entrepreneurial activity accelerated. New technology (fracking, the cloud, Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and productivity in the private sector. In fact, if we look back we are astounded by the new technologies that have come of age in just the past decade. These new technologies boosted corporate profits and stock prices and, yes, the economy grew too.

The one thing that did change from the 1990s was the size of the government. Tax rates, regulation and redistribution all went up significantly. This weighed on the economy and real GDP growth never got back to 3.5% to 4%.

Occam’s Razor – a theory about problem solving – says, when there are competing hypothesis, the one with the “fewest assumptions” is most likely the correct one.

The Fed narrative assumes QE worked and then uses questionable economics to explain away anything that does not fit that theory. It blames “mysterious” forces, both strong and weak productivity and claims business under-invested. We’ve never understood the weak investment argument; why would business leave opportunities on the table by not investing?

Our narrative is far simpler. It looks at M2 growth, gives credit to entrepreneurs, and blames big government. After all, the US economy grew rapidly before 1913 when there was no Fed, and during the 1980s and 90s, when Volcker and Greenspan were not doing QE. And history shows that inventions boost growth, while big government and redistribution harm it. Because it has the fewest assumptions, Occam’s Razor suggests this is the more likely hypothesis.

The Fed has never fracked a well or written an app. We understand that government bureaucracies want to take credit for everything. But, in spite of record-setting money printing, inflation did not rise. Prices are measured in dollars, so if those dollars had actually entered the economy, prices in dollar terms would have gone up. They didn’t, which clearly says that money didn’t enter the economy and QE didn’t work as advertised.

Some say that’s because the money went into financial assets, but if that was the case the P-E ratio for the S&P 500 would be through the roof. But because earnings have risen so sharply, the P-E ratio is well within historical averages based on trailing 12-month earnings and relative to bond yields.

We also understand that entrepreneurship is a “mystery” to some people because they can’t do it. Most people can’t change the world the way entrepreneurs can, but that doesn’t mean that by rearranging the assets of an economy in a different way, entrepreneurs don’t create new wealth.

By claiming that low inflation is a “mystery” the Fed is admitting it doesn’t understand the mechanics of QE. Yet, it is perfectly willing to allow people to think QE is what saved the economy. This is teaching an entire generation of young people, who in many cases don’t study economic history, that growth requires government intervention. The only “mystery” is why they would allow this to happen.

‘Nonprime has a nice ring to it’: the return of the high-risk mortgage

Subprime loans were one of the main causes of the financial crisis. So why is lending to high-risk borrowers making a comeback?

by: Ben McLannahan

© Sandy Suffield

It was about a decade ago that Dan Perl chucked it all in to go surfing in Mexico. As a veteran underwriter of subprime mortgages, he’d seen enough by April 2007 to know that there was serious trouble ahead. So he pulled down the shutters, took an extended break in Baja, California, and then lay low for a few years, trading loans for a New York firm, Carl Marks & Co.

But now he is back in the game, leading a small band of lenders making subprime loans once more. Or “nonprime”, as they prefer to call it these days. The sector is on course to produce about $10bn this year — a tiny slice of America’s $1.6tn overall home-loan market but one that’s growing rapidly.

Plenty of people told Perl, 68, that he couldn’t bring this stuff back so soon after the global financial crisis, and after regulators all over the US radically tightened rules on mortgages. People said he was risking his net worth, that he’d “be sued into oblivion”.

“How many times we hear that, Kyle?” he asks, turning to his protégé, 39-year-old Kyle Gunderlock, who was a VP of sales at Perl’s old firm and is now president of the new one, known as Citadel Servicing Corp, based in Irvine, California.“

‘You guys are going to get f***ing arrested,’ is the one I always remember,” says Gunderlock.

The way Perl and his peers see it, there’s nothing shady or menacing about the business of subprime.

On the contrary, they say, specialist lenders in this area are performing a vital service for the world’s largest economy. For every comfortably off professional who could walk into a branch of Chase or Wells Fargo and get a home loan without any fuss, they argue, there are many more who would struggle. People who are self-employed or on variable incomes, for example, may not check all the boxes a big bank needs. Ditto new immigrants with thin credit histories, or people with a few scratches and dents in their files.

“Making credit available to borrowers who are subprime is national policy and it is an important part of economic growth,” says Julian Hebron, head of sales at RPM Mortgage in Alamo, California. “It’s untrue to call it a scourge.”

But what’s worrying some economists is a feeling that we’re on a slippery slope; that the same forces which fed the crisis last time round — rampant demand for yield among investors, skewed incentives on Wall Street and a government determined to relax regulatory restraints — could feed another.

Under President Donald Trump, for example, agencies are under orders to review just about every financial rule that emerged under Barack Obama. In June, the Treasury department put out a report saying that tight underwriting standards were partly to blame for “anaemic” growth in housing, which accounts for almost one-fifth of GDP.

The market for securitising subprime loans is picking up, too, spreading the risk of default in much the same way as before. Fitch, the credit rating agency, expects $3bn of issuance of nonprime mortgage-backed securities (MBS) this year, up from about $1bn over the previous 18 months. (Back in January, it was predicting $2bn for the year.)

Meanwhile, some old characters are re-emerging, including a few who gained a certain notoriety a decade ago. Kyle Walker, the former head of Fremont, a big mortgage firm that was rapped by federal regulators for “unsafe” practices in March 2007, is back running a nonprime shop called HomeXpress in Newport Beach, California. Dan Sparks, a former Goldman Sachs trader mentioned more than 500 times in a Senate report on the mortgage meltdown, is now buying nonprime loans from a hedge fund up in Stamford, Connecticut. (Walker did not respond to requests for comment and Sparks declined to comment.)

All of this is happening without a proper reckoning from the last time around, says Richard Bowen, a former chief underwriter at Citigroup, which ranked as America’s top subprime lender in 2007. Bowen says he tried to raise the alarm internally about rampant fraud in mortgage applications, before being stripped of underwriting responsibilities. He left the group in 2008. He draws a contrast with the savings and loan crisis in the US in the 1980s, after which about 800 senior bankers went to jail. The running total from the crisis that began in 2007? Zero. Even though it was “many, many, many” times worse, says Bowen, “no one has been held accountable. And I can assure you it’s not because of a lack of evidence.”

On the morning I meet Perl, on a blazingly hot day in June, he’d been up the hills behind his house in San Juan Capistrano with his white Labrador Ella. Now he’s showered and holding court in his office, dressed in jeans, loafers and a checked shirt.

He was born in Brooklyn to a conservative Jewish family but grew up in Sherman Oaks, a relatively spacious suburb of Los Angeles, and Santa Monica. After a degree from UCLA and an English teaching job at Santa Monica High, he formed a loan brokerage in the mid-1970s with his college pal Bill Ashmore, who now runs Impac, another mortgage firm based a few miles up the San Diego Freeway from Citadel.

After the crash of 1987, Perl-Ashmore parted ways; Perl into subprime (or “Bs and Cs”, as lower-grade loans were called then) and Ashmore into “Alt-A”, slightly classier yet not quite prime. In the 1990s Perl’s business grew strongly, partly on the back of a loan he invented called the NINA — aimed at customers with “no income, no assets”. He was known as the Big Kahuna.

Kyle Gunderlock and Dan Perl of Citadel Servicing Corp

But by 2005, says Perl, it was clear that things were slipping out of control. His outfit, then known as First Street, was a top 20 underwriter nationwide, in a sector which produced about $1tn of subprime mortgages — about one-third of the total US mortgage market — that year. Also clustered in Orange County were some of the best-known subprime shops in the country, such as New Century, Ameriquest and Fremont.

But margins were shrinking and loans were being written that should never have been written. At one point New Century had a 2 per cent error rate, meaning that one in every 50 of its borrowers never made a single payment. The company’s collapse in early April 2007, owing $8.4bn to banks including Morgan Stanley, Barclays and UBS, was one of the defining moments of the crisis.

Mike Fierman, managing partner and co-CEO of Angel Oak of Atlanta, Georgia, was also in the thick of it back then, running a firm called SouthStar Funding. He says he had no choice: if he wanted to compete, he had to drop standards. Like Perl, he bailed in April 2007, after Goldman and Lehman Brothers said they’d had their fill of subprime. But until that point they and other investment banks had hoovered up everything he’d offered them. They’d then wrap it up into MBS, on which credit rating agencies — competing between themselves to win the most business — would typically slap an attractive rating.

“Everyone was complicit,” says Fierman. “You felt trapped; investors were demanding more loans than could be produced in a responsible way. The only way to produce that kind of volume was to be irresponsible.

”Brokers were going after “gardeners and serving maids and house cleaners and gas-station attendants and strippers on poles,” says Perl. “That’s not lending. That ain’t the way you do it.”

He got out about 18 months before the collapse of Lehman brought the world economy to the brink of ruin. “Honest to God, Ben, do you ever just get a bad vibe?” he asks me. “Do you ever walk down a dark hall and say, ‘This is not a place I should be?’”

This time it’s different, say the lenders. Thanks to the Dodd-Frank Act of 2010, the nonprime loans being written now bear little relation to the sludge that stunk up the system a decade ago.

Perl and Gunderlock say they spent weeks going through the 800 pages of Dodd-Frank that was relevant to mortgages, as they looked to crank up the machine again. There were all kinds of proscriptions on funding and closing and servicing a loan, says Perl, but in the end it came down to this: “People have to be relatively reasonable about how they treat borrowers. You can’t lie, you can’t cheat, you can’t steal.”

Gone, as a result, are some dubious features that caused trouble last time round, such as zero deposits or low teaser rates that adjusted sharply higher in two or three years. Gone, too, are the negative amortisation loans that allowed borrowers to pay less than the interest due, so that the loan balance actually grew.

There’s no more “stated income” either: whatever the borrower declares, the lender has to check by looking at pay stubs and tax returns, rather than assuming it’s the truth.

Granted, standards in nonprime are generally looser than those that apply to mortgages eligible to be bought by government agencies such as Fannie Mae. Such loans are known as “qualified mortgages”, or QM, and they account for the vast majority of America’s home-loan market.

But today every mortgage has to conform to an overarching standard known as ATR, or “ability to repay”. Unless a lender can be convinced in eight separate ways that the borrower has the means to pay the thing back, it can be sued down the track if the loan goes bad.

The new regulatory framework is “actually pretty rational”, says Matt Nichols, founder and CEO of Deephaven Mortgage, who set up the Charlotte, North Carolina-based firm in 2013 after more than a decade running Goldman’s residential mortgage business. So far he’s bought about $1bn of nonprime loans from a network of 100 or so brokers, and has resold about half of that into the MBS market.

In a $250m MBS deal in June, more than 40 per cent of borrowers who got mortgages bought by Deephaven had had a prior “credit event” such as a bankruptcy, foreclosure or short sale, according to Kroll, a credit rating agency. The deal was roughly six times oversubscribed, nonetheless.

“Ability to repay, as a rule, is common sense,” says Nichols. “You’ve got to rely on something other than their word for it, right?”

Perl and others note that investors in these new classes of nonprime MBS have extra degrees of comfort. Under Dodd-Frank reforms that took effect in 2015, sponsors of a deal need to retain an interest of at least 5 per cent of the aggregate credit risk of the assets they’re turning into securities. It’s known as “skin in the game”: if originators are on the hook for losses, the theory goes, they’ll take a lot more care over what they’re producing.

Before the crisis, there was no minimum ownership, resulting in mortgage firms simply flipping all kinds of dross at Goldman or Merrill or Bear Stearns. “This is not an originate-to-sell model; it’s an originate-to-own model,” says Fierman of Angel Oak. His firm, which buys nonprime loans from other brokers as well as originating its own, has been the most active of MBS issuers, completing four deals since 2015 worth a total of $630m. He says that Angel Oak has gone well beyond the basic 5 per cent threshold, owning as much as 10 per cent of its MBS deals at various points. “Trust has to be built with investors,” he says. “They’re watching us closely.”

Some of the big names on Wall Street have already tiptoed back in. Pimco, the world’s biggest bond house, has 25 per cent of the equity in Perl’s Citadel, according to a person familiar with the ownership structure. Blackstone, the private equity giant, has a cluster of nonprime investments, including a stake in Bayview Asset Management, a firm which buys mortgages from Coral Gables, in Florida.

Will the big US banks get back into subprime? Inevitably, says Guy Cecala, CEO and publisher of Inside Mortgage Finance, the industry bible. He notes that overall mortgage originations in the US have slipped about one-fifth this year, mostly because a rise in interest rates has caused refinancing business to drop.

“At the end of the day, every lender out there, unless they want to see their business decline, has to look at alternative products,” he says.

In the meantime, other banks are taking supporting roles. Credit Suisse and Nomura, for example, are supplying lines of credit to originators and underwriting securitisations of subprime mortgages. Fitch, DBRS and Kroll, the credit rating agencies, have given their stamps of approval to a succession of securitisation deals.

Even Standard & Poor’s, which paid $1.4bn in 2015 to the US Department of Justice to resolve a probe into ratings inflation, is back on the scene, rating five deals this year. (Moody’s, which settled with the government in January this year, has yet to re-appear.)

Some investors, for their part, are reluctant to dive in. Tracy Chen, a fund manager at Brandywine Global in Philadelphia, says she’s tempted, but wants the MBS market to increase to about $20bn in total before she would feel comfortable trading in and out of positions. “The market is still not very transparent, and there’s not much trading volume. I need to wait for it to scale up before I enter.” The caution is understandable: she was at UBS in the run-up to the crisis, when the Swiss bank took tens of billions of dollars of losses on its subprime portfolio.

But even the more cautious investors may change their minds, in time. As long as interest rates stay near historic lows, “anyone will scramble for what yield they can find”, says Bowen, the ex-Citigroup whistleblower, who now lectures on ethics.

He cites the sale of junk bonds in August by Tesla, the trendy carmaker that is still consuming much more cash than it is earning. The $1.8bn deal, which lacks restrictions to stop Tesla issuing more debt whenever it wants to, is “insane”, he says.

For now, loan books are in good shape. At Impac, just a handful of non-QM loans written over the past three years are more than 60 days delinquent, says Ashmore, the CEO. Only one loan is in foreclosure, among about 2,200 in total.

He expects the total nonprime market to increase to $100bn before long. “I believe if I can deliver superior risk-adjusted returns, there’ll be more than enough capital.”

At Citadel, which normally aims a notch or two below the typical Impac customer, in terms of credit score and debt-to-income ratios, there are seven foreclosures among 3,500 or so loans. That has prompted Perl to push out the boat a bit. In August he launched a new loan called “The One”, allowing a self-employed borrower to qualify based on one month’s bank statement rather than the usual 12.

The move has “got everyone a little nervous”, he admits, despite a long list of safety features. But he reckons he has another four to five years of “clear sailing” before the market starts to turn once more.

One regret? Not trademarking “nonprime”, which he thinks he coined five years ago.

As for “subprime”, he never liked it.

“It sounds kind of Neanderthal, doesn’t it? It sounds almost like you’re a monkey and humans are better. But nonprime has a nice ring to it.”

Ben McLannahan is the FT’s US banking editor

The Euro´s Narrow Path

Barry Eichengreen

BERKELEY – With Emmanuel Macron’s victory in the French presidential election, and Angela Merkel’s Christian Democratic Union enjoying a comfortable lead in opinion polls ahead of Germany’s general election on September 24, a window has opened for eurozone reform. The euro has always been a Franco-German project. With a dynamic new leader in one country and a fresh popular mandate in the other, there is now an opportunity for France and Germany to correct their creation’s worst flaws.

But the two sides remain deeply divided. Macron, in long-standing French tradition, insists that the monetary union suffers from too little centralization. The eurozone, he argues, needs its own finance minister and its own parliament. It needs a budget in the hundreds of billions of euros to underwrite investment projects and augment spending in countries with high unemployment.

Merkel, on the other hand, views the monetary union’s problem as one of too much centralization and too little national responsibility. She worries that a large eurozone budget wouldn’t be spent responsibly. While not opposed to a eurozone finance minister, she does not envision that official possessing expansive powers.

But there is a narrow path forward that should be acceptable to both sides. It starts with completing the banking union. Europe now has a single supervisor in the European Central Bank, but it lacks a common deposit insurance scheme, which German officials oppose on the grounds that there has been inadequate risk reduction in the European banking system. In other words, they worry that the fees levied on German banks will be used to pay off depositors in other countries.

The solution lies in bulletproofing the banks by strictly applying the demanding capital standards of Basel III and limiting concentrated holdings of government bonds. The paradox here is that European regulators, including German regulators, have in fact been arguing for looser application of those regulations in negotiations with the United States. In doing so, they have been arguing against their own best interests.

Next, Europe needs to transform the European Stability Mechanism, its proto-rescue fund, into a true European Monetary Fund (EMF). Its resources could be augmented by increasing governments’ capital subscriptions and expanding its ability to borrow. Decision-making could be streamlined by moving from the current unanimity rule to qualified majority voting.

The EMF could then take the place of the ECB and the European Commission in negotiating the terms of financing programs with governments. The final decision of whether to extend an emergency loan would no longer fall to heads of state in all-night talks. Rather, it would be taken by a board made up of eurozone representatives, including from civil society, nominated by the European Council and confirmed by the European Parliament, giving the process a legitimacy it currently lacks.

But Germany will agree only if it sees steps limiting the likelihood of expensive intervention.

This brings us to the vexed question of fiscal policy. It is past time to abandon the fiction that the ultimate source of fiscal discipline is a set of strictly enforced EU rules. Taxation and public spending remain sensitive national prerogatives, rendering outside oversight ineffectual.

Assigning oversight to the European Commission in Brussels promises, inevitably, not discipline but a dangerous populist backlash.

The alternative is to return control of fiscal policy to national governments, abandoning the pretense that policy can be regimented by EU rules. Governments could then make their own decisions; if they make bad decisions, they will have to restructure their debts. Adopting a European debt-restructuring mechanism would help to avoid the worst fallout. Any adverse consequences would no longer spread to other countries, because their banks would no longer hold concentrations of government bonds. They would not bankrupt the EMF, which would be able to lend only in cases of illiquidity, not insolvency.

These ideas will horrify dedicated euro-federalists. One bone they can be thrown is a pilot unemployment insurance fund amounting to, say, 1% of eurozone GDP. This would be analogous to US arrangements under which the federal government provides partial funding for state-administered unemployment insurance. And it would give the eurozone finance minister something to do. If the initial modest program was shown to work, it could be scaled up.

But German politicians are aware that unemployment is 2.5 times higher in France than at home, raising the danger that transfers would all go one way. That’s why such proposals are contingent on structural reforms that reduce unemployment where it is high and increase the flexibility of labor and product markets.

This is essentially the bargain Macron has offered Merkel. To paraphrase, “I’ll undertake deep structural reforms if you agree to modest steps in the direction of fiscal federalism, completing the banking union, and creating a European Monetary Fund.”

No one on either side of the Rhine will regard this bargain as perfect. But with the euro in the balance, the perfect should not be allowed to become the enemy of the good.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.

Hidden Gems Shows A Foreboding Future

By: Chris Vermeulen

A quick look at any of the US majors will show most investors that the markets have recently been pushing upward towards new all-time highs.  These traditional market instruments can be misleading at times when relating the actual underlying technical and fundamental price activities.  Today, we are going to explore some research using our custom index instruments that we use to gauge and relate more of the underlying market price action.

What if we told you to prepare for a potentially massive price swing over the next few months? 

What if we told you that the US and Global markets are setting up for what could be the “October Surprise of 2017” and very few analysts have identified this trigger yet?  Michael Bloomberg recently stated “I cannot for the life of me understand why the market keeps going up”.  Want to know why this perception continues and what the underlying factors of market price activity are really telling technicians?

At ATP provide full-time dedicated research and trading signal solution for professional and active traders.  Our research team has dedicated thousands or hours into developing a series of specialized modeling systems and analysis tools to assist us in finding successful trading opportunities as well as key market fundamentals.  In the recent past, we have accurately predicted multiple VIX Spikes, in some cases to the exact day, and market signals that have proven to be great successes for our clients.  Today, we’re going to share with you something that you may choose to believe or not – but within 60 days, we believe you’ll be searching the internet to find this article again knowing ATP ( accurately predicted one of the biggest moves of the 21st century.  Are you ready?

Let’s start with the SPY.  From the visual analysis of the chart, below, it would be difficult for anyone to clearly see the fragility of the US or Global markets.  This chart is showing a clearly bullish trend with the perception that continued higher highs should prevail.


Additionally, when we review the QQQ we see a similar picture.  Although the volatility is typically greater in the NASDAQ vs. the S&P, the QQQ chart presents a similar picture. 

Strong upward price activity in addition to historically consistent price advances.  What could go wrong with these pictures – right?  The markets are stronger than ever and as we’ve all heard “it’s different this time”.


Most readers are probably saying “yea, we’ve heard it before and we know – buy the dips”.

Recently, we shared some research with you regarding longer term time/price cycles (3/7/10 year cycles) and prior to that, we’ve been warning of a Sept 28~29, 2017 VIX Spike that could be massive and a “game changer” in terms of trend.  We’ve been warning our members that this setup in price is leading us to be very cautious regarding new trading signals as volatility should continue to wane prior to this VIX Spike and market trends may be muted and short lived.  We’ve still made a few calls for our clients, but we’ve tried to be very cautious in terms of timing and objectives.

Right now, the timing could not be any better to share this message with you and to “make it public” that we are making this prediction. A number of factors are lining up that may create a massive price correction in the near future and we want to help you protect your investments and learn to profit from this move and other future moves.  So, as you read this article, it really does not matter if you believe our analysis or not – the proof will become evident (or not) within less than 60 days based on our research.  One way or another, we will be proven correct or incorrect by the markets.

Over the past 6+ years, capital has circled the globe over and over attempting to find suitable ROI.  It is our belief that this capital has rooted into investment vehicles that are capable of producing relatively secure and consistent returns based on the global economy continuing without any type of adverse event.  In other words, global capital is rather stable right now in terms of sourcing ROI and capital deployment throughout the globe.  It would take a relatively massive event to disrupt this capital process at the moment.

Asia/China are pushing the upper bounds of a rather wide trading channel and price action is setting up like the SPY and QQQ charts, above.  A clear upper boundary is evident as well as our custom vibrational/frequency analysis arcs that are warning us of a potential change in price trend.  You can see from the Red Arrow we’ve drawn, any attempt to retest the channel lows would equate to an 8% decrease in current prices.


Still, there is more evidence that we are setting up for a potentially massive global price move. 

The metals markets are the “fear/greed” gauge of the planet (or at least they have been for hundreds of years).  When the metals spike higher, fear is entering the markets and investors avoid share price risks.  When the metals trail lower, greed is entering the markets and investors chase share price value.

Without going into too much detail, this custom metals chart should tell you all you need to know.  Our analysis is that we are nearing the completion of Wave C within an initial Wave 1 (bottom formation) from the lows in Dec 2016.  Our prediction is that the completion of Wave #5 will end somewhere above the $56 level on this chart (> 20%+ from current levels).  The completion of this Wave #5 will lead to the creation of a quick corrective wave, followed by a larger and more aggressive upward expansion wave that could quickly take out the $75~95 levels.  Quite possibly before the end of Q1 2018.


We’ve termed this move the “Rip your face off Metals Rally”.  You can see from this metals chart that we have identified multiple cycle and vibrational/frequency cycles that are lining up between now and the end of 2017.  It is critical to understand the in order for this move to happen, a great deal of fear needs to reenter the global markets.  What would cause that to happen??

Now for the “Hidden Gem”…

We’ve presented some interesting and, we believe, accurate market technical analysis. We’ve also been presenting previous research regarding our VIX Spikes and other analysis that has been accurate and timely.  Currently, our next VIX Spike projection is Sept 28~29, 2017.  We believe this VIX Spike could be much larger than the last spike highs and could lead to, or correlate with, a disruptive market event.  We have ideas of what that event might be like, but we don’t know exactly what will happen at this time or if the event will even become evident in early October 2017.  All we do know is the following…

The Head-n-Shoulders pattern we first predicted back in June/July of this year has nearly completed and we have only about 10~14 trading days before the Neck Line will be retested. 

This is the Hidden Gem.  This is our custom US Index that we use to filter out the noise of price activity and to more clearly identify underlying technical and price pattern formations.  You saw from the earlier charts that the Head-n-Shoulders pattern was not clearly visible on the SPY or QQQ charts – but on THIS chart, you can’t miss it.

It is a little tough to see on this small chart but, one can see the correlation of our cycle analysis, the key dates of September 28~29 aligning perfectly with vibration/frequency cycles originating from the start of the “head” formation.  We have only about 10~14 trading days before the Neck Line will likely be retested and, should it fail, we could see a massive price move to the downside.

US Head-n-Shoulders_F

What you should expect over the next 10~14 trading days is simple to understand.

_ Expect continued price volatility and expanded rotation in the US majors.

_ Expect the VIX to stay below 10.00 for only a day or two longer before hinting at a bigger spike move (meaning moving above 10 or 11 as a primer)

_ Expect the metals markets to form a potential bottom pattern and begin to inch higher as fear reenters the markets

_ Expect certain sectors to show signs of weakness prior to this move (possibly technology, healthcare, bio-tech, financials, lending)

_ Expect the US majors to appear to “dip” within a 2~4% range and expect the news cycles to continue the “buy the dip” mantra.

The real key to all of this is what happens AFTER October 1st and for the next 30~60 days after. 

This event will play out as a massive event or a non-event.  What we do know is that this event has been setting up for over 5 months and has played out almost exactly as we have predicted. 

Now, we are 10+ days away from a critical event horizon and we are alerting you well in advance that it is, possibly, going to be a bigger event.