America rejects the world it made

Trump demands change but turning against rules-based order is potentially dangerous

Gideon Rachman

The “global rules-based order” is a yawn-inducing phrase but it means something important.

All countries in the world, bar a few rogue states, deal with each other according to an agreed set of legal, economic and military rules.

Ignore or overturn them and confusion and conflict break out. Some non-western countries have long believed that the phrase is little more than a cloak for US global domination. Since America effectively wrote the rules, it was assumed that the whole system must be biased in favour of the US.

But Donald Trump does not see it that way. The US president thinks that clever foreigners have manipulated the international system, so that America now trades at a massive disadvantage and is forced to accept hostile rulings by international tribunals. When it comes to security, Mr Trump complains that America spends billions giving cheap protection to ungrateful allies. He is demanding change.

“You break it, you own it,” runs the pottery shop slogan. But when it comes to the global rules-based order, the Trump administration’s view seems to be, “We no longer own it, so we are going to break it.” America is turning against the world it made — and the consequences are unpredictable and potentially dangerous.

The coming year will be a big test of how far the Trump administration is willing to go with the US potentially launching a multi-pronged assault on the international trading system: demanding radical changes to the North American Free Trade Agreement, hobbling the World Trade Organization and slapping tariffs on Chinese goods. Tension between the US and South Korea, or within the Nato alliance, could easily surface this year — raising questions about America’s commitment to the rules that govern world security.

The underlying question is what the world will look like, after a few years of a US administration committed to radical change in the international system.

Broadly speaking, there are four possibilities. The first is that America succeeds in getting the changes it wants and the system survives, in a modified form, with the US still the clear global leader.

Option two is that a new system emerges, with the rest of the world operating under multilateral rules and ignoring unilateralist America, as far as possible.

The third possibility is that the withdrawal of US leads to a collapse in the rules-based order — and general chaos.

Option four is that the US is satisfied with essentially cosmetic changes, and the system continues much as it is now.

It is too early to say which of these scenarios will prevail. The Trump administration would argue that option one: a changed system — still led by America — is already in the making. Canada and Mexico have entered into negotiations about a revised Nafta. The European members of Nato are increasing their military spending. China will probably make trade concessions, if enough pressure is applied.

Set against that, there are also elements of option two — a world without America — emerging. When the US withdrew from the Trans-Pacific Partnership trade deal, the other 11 members decided to go ahead without America. Last week, Mr Trump signalled that the US might rejoin a revised TPP — but it is probably too late for that. Meanwhile, the EU has been energised by Mr Trump’s anti-trade rhetoric and is now close to concluding trade deals with Japan and with the Mercosur group of South American nations. And China is forging ahead with its Belt and Road initiative, co-operating with other nations to create infrastructure across the Eurasian landmass and the Pacific.

However, the US is too important for an effective new world order to be constructed without American participation. That is why there are also strong arguments for option three — chaos.

If the Trump administration continues to block the appointment of judges to the WTO’s appellate court, then the entire world trading system will pay a price. There are also certain functions that America performs — in particular, providing military muscle and the world’s reserve currency — that are impossible to replicate under current circumstances.

If the US withdrew its security guarantees in the Pacific, for example, the combined efforts of Japan, India and Australia would not fill the gap. And neither the euro nor the renminbi is ready to serve as the world’s reserve currency, even if America’s management of the dollar becomes irresponsible.

But the fact that nothing very serious has yet happened also supplies some evidence for option four — in which the US contents itself with cosmetic changes that allows Mr Trump to claim some “wins”. Big business in America might revolt if the Trump administration does try to break up Nafta. And, whatever Mr Trump says, the US gains security and political advantages from playing the role of “world policeman” and will not abandon those lightly.

Those factors make me think that cosmetic change is the likeliest outcome of the Trump administration’s assault on the global rules-based order. But the US is playing a high-risk game. Nationalistic gestures are always likely to provoke nationalistic responses, particularly from a rising power, such as China. Mr Trump may not really intend to break the current global order. But he could still do it by accident.

The new battlegrounds

The future of war

War is still a contest of wills, but technology and geopolitical competition are changing its character, argues Matthew Symonds

IN THE PAST, predictions about future warfare have often put too much emphasis on new technologies and doctrines. In the 19th century the speedy victory of the Prussian army over France in 1870 convinced European general staffs that rapid mobilisation by rail, quick-firing artillery and a focus on attack would make wars short and decisive. Those ideas were put to the test at the beginning of the first world war. The four years of trench warfare on the western front proved them wrong.

In the 1930s it was widely believed that aerial bombardment of cities would prove devastating enough to prompt almost immediate capitulation. That forecast came true only with the invention of nuclear weapons a decade later. When America demonstrated in the first Gulf war in 1990-91 what a combination of its precision-guided munitions, new intelligence, surveillance and reconnaissance methods, space-based communications and stealth technology could achieve, many people assumed that in future the West would always be able to rely on swift, painless victories. But after the terrorist attacks on America on September 11th 2001, wars took a different course.

This special report will therefore offer its predictions with humility. It will also limit them to the next 20 years or so, because beyond that the uncertainties become overwhelming. And it will not speculate about the clear and present danger of war breaking out over North Korea’s nuclear weapons, which with luck can be contained. Instead, it will outline the long-term trends in warfare that can be identified with some confidence.

In the past half-century wars between states have become exceedingly rare, and those between great powers and their allies almost non-existent, mainly because of the mutually destructive power of nuclear weapons, international legal constraints and the declining appetite for violence of relatively prosperous societies. On the other hand, intrastate or civil wars have been relatively numerous, especially in fragile or failing states, and have usually proved long-lasting. Climate change, population growth and sectarian or ethnic extremism are likely to ensure that such wars will continue.

Increasingly, they will be fought in urban environments, if only because by 2040 two-thirds of the world’s population will be living in cities. The number of megacities with populations of more than 10m has doubled to 29 in the past 20 years, and each year nearly 80m people are moving from rural to urban areas. Intense urban warfare, as demonstrated by the recent battles for Aleppo and Mosul, remains grinding and indiscriminate, and will continue to present difficult problems for well-meaning Western intervention forces. Technology will change war in cities as much as other types of warfare, but it will still have to be fought at close quarters, block by block.

Even though full-scale interstate warfare between great powers remains improbable, there is still scope for less severe forms of military competition. In particular, both Russia and China now seem unwilling to accept the international dominance of America that has been a fact of life in the 20 years since the end of the cold war. Both have an interest in challenging the American-sponsored international order, and both have recently shown that they are prepared to apply military force to defend what they see as their legitimate interests: Russia by annexing Crimea and destabilising Ukraine, and China by building militarised artificial islands and exerting force in disputes with regional neighbours in the South and East China Seas.

In the past decade, both China and Russia have spent heavily on a wide range of military capabilities to counter America’s capacity to project power on behalf of threatened or bullied allies. In military jargon, these capabilities are known as anti-access/area denial or A2/AD. Their aim is not to go to war with America but to make an American intervention more risky and more costly. That has increasingly enabled Russia and China to exploit a “grey zone” between war and peace. Grey-zone operations aim to reap either political or territorial gains normally associated with overt military aggression without tipping over the threshold into open warfare with a powerful adversary. They are all about calibration, leverage and ambiguity. The grey zone particularly lends itself to hybrid warfare, a term first coined about ten years ago. Definitions vary, but in essence it is a blurring of military, economic, diplomatic, intelligence and criminal means to achieve a political goal.

The main reason why big powers will try to achieve their political objectives short of outright war is still the nuclear threat, but it does not follow that the “balance of terror” which characterised the cold war will remain as stable as in the past. Russia and America are modernising their nuclear forces at huge expense and China is enlarging its nuclear arsenal, so nuclear weapons may be around until at least the end of the century. Both Vladimir Putin and Donald Trump, in their very different ways, enjoy a bit of nuclear sabre-rattling. Existing nuclear-arms-control agreements are fraying. The protocols and understandings that helped avert Armageddon during the cold war have not been renewed.

Russia and China now fear that technological advances could allow America to threaten their nuclear arsenals without resorting to a nuclear first strike. America has been working at a concept known as Conventional Prompt Global Strike (CPGS) for over a decade, though weapons have yet to be deployed. The idea is to deliver a conventional warhead with a very high degree of accuracy, at hypersonic speeds (at least five times faster than the speed of sound), through even the most densely defended air space. Possible missions include countering anti-satellite weapons; targeting the command-and-control nodes of enemy A2/AD networks; attacking the nuclear facilities of a rogue proliferator such as North Korea; and killing important terrorists. Russia and China claim that CPGS could be highly destabilising if used in conjunction with advanced missile defences. Meanwhile they are developing similar weapons of their own.

Other potential threats to nuclear stability are attacks on nuclear command-and-control systems with the cyber- and anti-satellite weapons that all sides are investing in, which could be used to disable nuclear forces temporarily. Crucially, the identity of the attacker may be ambiguous, leaving those under attack uncertain how to respond.

Rise of the killer robots

At least the world knows what it is like to live in the shadow of nuclear weapons. There are much bigger question-marks over how the rapid advances in artificial intelligence (AI) and deep learning will affect the way wars are fought, and perhaps even the way people think of war. The big concern is that these technologies may create autonomous weapons systems that can make choices about killing humans independently of those who created or deployed them. An international “Campaign to Stop Killer Robots” is seeking to ban lethal autonomous weapons before they even come into existence. A letter to that effect, warning against a coming arms race in autonomous weapons, was signed in 2015 by over 1,000 AI experts including Stephen Hawking, Elon Musk and Demis Hassabis.

Such a ban seems unlikely to be introduced, but there is room for debate about how humans should interact with machines capable of varying degrees of autonomy, whether in the loop (with a human constantly monitoring the operation and remaining in charge of critical decisions), on the loop (with a human supervising machines that can intervene at any stage of the mission) or out of the loop (with the machine carrying out the mission without any human intervention once launched). Western military establishments insist that to comply with the laws of armed conflict, a human must always be at least on the loop. But some countries may not be so scrupulous if fully autonomous systems are seen to confer military advantages.

Such technologies are being developed around the globe, most of them in the civil sector, so they are bound to proliferate. In 2014 the Pentagon announced its “Third Offset Strategy” to regain its military edge by harnessing a range of technologies including robotics, autonomous systems and big data, and to do so faster and more effectively than potential adversaries. But even its most ardent advocates know that the West may never again be able to rely on its superior military technology. Robert Work, the deputy defence secretary who championed the third offset, argues that the West’s most enduring military advantage will be the quality of the people produced by open societies. It would be comforting to think that the human factor, which has always been a vital component in past wars, will still count for something in the future. But there is uncertainty even about that.

Stock Selling Unleashed!

By: Adam Hamilton

The unnaturally-tranquil stock markets suddenly plunged over this past week.  Volatility skyrocketed out of the blue and shattered years of artificial calm conjured by extreme central-bank distortions. 

This was a huge shock to the legions of hyper-complacent traders, who are realizing stocks don’t rally forever.  With stock selling unleashed again, herd psychology will start shifting back to bearish which will fuel lots more selling.

As a contrarian student of the markets, I watched stocks’ recent mania-blowoff surge in stunned disbelief.  On fundamental, technical, and sentimental fronts, the stock markets were as or more extreme than their last major bull-market toppings in March 2000 and October 2007!  I outlined all this in an essay on these hyper-risky stock markets on 2017’s final trading day.  The ominous writing was on the wall for all willing to see.

January’s extreme surge in the US stock markets made this selloff case even more likely.  Mid-month in another essay I warned, “The stock markets are now dangerously overbought, implying a major selloff is probable and imminent. … Such extremes are very unusual and never sustainable for long, signaling major selloffs looming.”  So the fact these crazy stock markets finally rolled over wasn’t a surprise at all.

But I was awestruck at the sheer violence of what happened last Friday and the subsequent Monday, it was very odd.  Even though the countless market extremes argued strongly for a major selloff, they tend to be much more gradual initially off bull-market peaks.  So it was fascinating to watch all this unfold in real-time with my data feeds and CNBC.  Students of the markets live for anomalous exceedingly-rare events!

The igniting catalysts were multilayered.  The US flagship S&P 500 broad-market stock index (SPX) had blasted to a dazzling new all-time record high on Friday January 26th.  It was stretched a mind-boggling 14.0% over its key 200-day moving average, which itself was high and steeply rising!  The 8.9-year-old stock bull that had powered 324.6% higher felt unstoppable.  Traders were universally convinced it would continue.

But just a couple trading days later on Tuesday January 30th, significant selling emerged. 

That morning Amazon, Berkshire Hathaway, and JP Morgan declared they were going to form a healthcare company.  That unanticipated news way out of left field crushed the major healthcare stocks, hammering the SPX 1.1% lower.  That was actually a significant down day by recent standards, the worst seen since mid-August.

With euphoric bullish psychology dented, Jobs Friday arrived a few trading days later on February 2nd.  That official monthly US jobs report saw a modest headline beat, but the big news came on the wages front.  Average hourly earnings beat expectations by climbing 2.9% year-over-year, the hottest read on wage inflation since June 2009.  That triggered inflation fears with the 10-year Treasury yield already at 2.78%.

Higher prevailing interest rates are a huge problem for bubble-valued stock markets.  The SPX had just left January with its 500 elite component stocks sporting a simple-average trailing-twelve-month price-to-earnings ratio way up at 31.8x!  Historical fair value is 14x, twice that at 28x is formal bubble territory.  In a higher-rate environment, extreme valuations are far harder to tolerate.  So the stock markets sold off.

A week ago Friday the SPX slid all day long to close at a major 2.1% loss.  That proved its biggest down day since way back in September 2016, before Trump won the election and the resulting extreme stock rally first on Trumphoria and later on taxphoria.  Something was changing, the unnaturally-low volatility regime was crumbling.  That left speculators and investors alike very nervous heading into last weekend.

It had been an all-time-record 405 trading days since the SPX’s last 5% pullback, unbelievably extreme.  So that selloff really struck a nerve, I started to hear from casual acquaintances I hadn’t spoken to for years.  At a friend’s Super Bowl party Sunday night, once the guests I didn’t know found out what I do for a living I felt like a celebrity.  We spent the first quarter talking about the markets, people were really concerned.

Monday the 5th was extraordinary, a record day in some respects.  SPX futures were down less than 1% in pre-market trading, nothing wild.  But once the US stock markets opened, the selling started gradually snowballing.  It greatly intensified around 3pm, with the SPX plunging from -2.3% to -4.5% on the day in literally 11 minutes!  There was no news at all, it simply looked and felt like cascading stop-loss selling.

All prudent traders put trailing stop-loss orders on their stock positions.  They are an essential measure to manage risk.  Once a stock falls a preset percentage from its best level achieved during a trade, that position is automatically sold.  In big stock-market selloffs, as stop losses are sequentially hit they feed into the ongoing selling.  The more stocks fall, the more stops triggered, the more sell orders fuel the maelstrom.

The SPX bounced a bit, but still plunged a whopping 4.1% on close Monday!  That was a serious down day by any standard, actually the worst since way back in mid-August 2011 which followed Standard & Poor’s downgrading US sovereign debt.  Everyone takes notice when stock markets suffer their biggest daily drop in 6.5 years.  That really changes collective psychology, shattering the euphoria rampant in January.

But amazingly that SPX plunge wasn’t the most-interesting thing Monday.  The implied volatility on SPX options is tracked in the famous VIX fear gauge.  It skyrocketed a stupendous 125.8% higher that day, its largest daily spike ever witnessed!  That wreaked colossal havoc in the short-volatility market.  Since Trump’s election win, more traders and capital have flocked to bet on the idea that volatility will keep falling.

Students of market history knew that was an absurd bet before Monday’s spike.  Stock-market volatility has always been cyclical, just like stock prices.  Exceptionally-low or -high volatility levels always mean revert back to normal.  So betting that the record-low stock volatility in recent months would keep going even lower was a foolish, suicidal bet even before Monday. 

That epic VIX spike totally gutted these guys.

There are, or were, extraordinarily-risky inverse-VIX exchange-traded notes.  These were designed to rally when volatility fell, some even with leverage which traders liked to further amplify with their own margin.  One of the leading inverse-VIX ETNs was XIV, which is VIX spelled backwards.  It had closed at $129.35 per share on Thursday February 1st, but by this Tuesday it had imploded 94.3% in a termination event!

All these inverse-VIX ETNs were shorting VIX futures, so they had to become massive buyers on that sharp SPX selloff to close out those devastated positions.  On Monday the banks sponsoring these crazy ETNs had to buy an extreme record 282k VIX futures contracts!  That catapulted the VIX itself to 50.3 on Tuesday morning, about as high as it ever gets outside of actual crashes and panics. 

What a wild ride!

That begs the question what happens next?  This stock-market-selling and volatility shock happened at a time when stock markets were already very precarious.  Such an extreme event has to start altering herd psychology.  This first chart looks at the SPX superimposed over the VIX during the last few years, both on a closing basis.  Once serious selling starts out of toppy stock markets, it usually portends much more coming.

This week’s stock selling unleashed emerged in some of the most-toppy stock markets ever witnessed.  Again the average SPX-component TTM P/E leading into it was a bubble-valued 31.8x! 

Again the SPX had stretched 14.0% above its 200-day moving average, some of the most-overbought conditions seen in all of SPX history.  The SPX had rocketed vertically for most of January in popular-mania-grade euphoria.

The future impact of stock selling being unleashed really depends on the market conditions that birthed that selling spike.  If stock prices were near multi-year lows leading into selling spikes, with valuations lower than their historical average of 14x earnings, these events can mark selling climaxes before major reversals higher.  But unfortunately the exact opposite was true leading into our current sharp SPX plunge.

Coming out of what looked and felt like a mania blowoff top, this past week’s serious selling is surely an ominous omen.  Stock markets can’t rally forever, yet that’s exactly what they seemed to be doing since Trump’s surprise election victory.  Between Election Day and late January’s latest record high, the SPX had soared 34.3% higher in just 1.2 years!  And that span was incredibly extreme with record-low volatility.

Again as of last Friday it had been an all-time-record 405 trading days without a single 5% peak-to-trough SPX pullback.  That’s 1.6 years!  Nothing like that had ever happened before.  Technically a pullback is a 4%-to-10% selloff in the stock markets on a closing basis.  The last pullbacks were minor, a 4.8% one in late 2016 following a 5.6% one in mid-2016.  Those were the last material selloffs in the SPX before this week.

Periodic selloffs to rebalance sentiment are essential to keeping stock bulls healthy.  The longer markets go without significant selloffs, the more greed and complacency multiply.  Traders forget that stocks fall too, and their hubris leads them to take all kinds of excessive risks.  Like betting that record-low volatility will persist indefinitely.  The leveraged speculation eventually gets so extreme that it threatens the entire bull.

My favorite analogy on this is forest fires.  Officials love to suppress natural wildfires to protect structures.  But the longer firefighters put out every little wildfire, the denser forest underbrush gets.  This fuel source grows out of control, eventually leading to a conflagration far too extreme to put out.  Rather than having a bunch of smaller wildfires to keep fuel in check, suppression eventually guarantees a super-destructive hell fire.

Periodic pullbacks and corrections in stock markets allow the underbrush of greed to be burned away before it gets thick enough to become a systemic risk.  Traders naively believe levitating stock markets are less risky, but the opposite is true.  The longer a span without a serious selloff, the higher the odds one is coming soon.  Normal healthy bull markets actually suffer 10%+ corrections once a year or so to keep balance.

It’s been 2.0 years since the last actual SPX correction, which bottomed in early 2016.  The lack of both smaller pullbacks and larger corrections let complacency grow unchecked into greed, euphoria, and even hubris recently.  And these emotional extremes have to be mostly burned away for this bull to have any hope of eventually heading higher.  The only thing that can eradicate widespread greed is major stock selloffs.

After Monday’s serious 4.1% plunge, the SPX was still only down 7.8% since its peak just 6 trading days earlier.  While that is unusual speed to see such a decline, it still only ranks towards the high end of mere pullback territory.  We hadn’t even hit a correction yet at 10%, and they can stretch as high as 20%.  The SPX’s last corrections ran 12.4% over 3.2 months in mid-2015 and 13.3% over 3.3 months into early 2016.

Given the extreme overvalued and overbought conditions leading into this past week’s plunge, there’s no way even that was enough to rebalance away the euphoric sentiment.  So it’s all but certain the SPX will grind lower in the coming months, heading down well over 10% into deep correction territory.  At 10% the SPX would merely be back to early-November levels, merely erasing the recent mania-blowoff surge.

If this correction approaches 20% as it really ought to, that would drag the SPX all the way back down to 2298.  Those levels were first seen just over a year ago in late January 2017.  That would reverse the lion’s share of the entire past year’s taxphoria rally, wreaking tremendous sentiment damage.  But don’t forget corrections tend to take a few months, not a few days.  So the selling is way more gradual than Monday’s.

That extreme 50 VIX spike Tuesday morning must be considered.  Again that’s about as high as the VIX ever gets in normal corrections, implying the immediate selling pressure should have abated.  The only times higher VIX levels are briefly seen is after crashes and panics.  A crash is a 20%+ drop in just two trading days from very-high stock-market levels.  This past week’s Friday-Monday selloff wasn’t even close.

Crashes are exceedingly rare in history, and next to impossible today given the widespread use of stock-market circuit breakers.  They effectively close markets for a time after intraday selling milestones are hit.  Today the SPX has levels triggered at 7%, 13%, and 20% intraday declines.  The trading halts depend on when these declines occur within a trading day, before or after 3:25pm.  They would slow crash-grade plummets.

Panics are steep 20%+ selloffs within two weeks, extreme but much slower than crashes.  They tend to cascade from lows out of late-stage bear markets to climax them.  They are very rare too, with 2008’s being the first formal one since 1907.  The VIX can temporarily soar above 50 in crashes and panics, but those extremes never last for long.  In normal market conditions, a 50 VIX spike should mark an absolute bottom.

But the problem this week is Tuesday’s extreme VIX spike was the result of panic buying of VIX futures to liquidate those inverse-VIX ETNs.  That has never happened before.  Without that dynamic, the VIX likely wouldn’t have gone much above 30.  That too implies this stock-market selloff still has plenty of room to run.  So the stock selling unleashed is likely to persist over a few months at least, despite the VIX spike.

Given the extremes in these stock markets in late January, I still suspect the odds heavily favor a new bear market over 20% instead of a bull-market correction.  I presented this compelling SPX-bear case in late December, and don’t have room to rehash it here.  Normal bear markets tend to cut stocks in half over a couple years or so, 50% SPX losses.  That works out to a gradual average selling pace of 0.1% per day.

The last couple SPX bears give an idea of what to expect in the inevitable next bear after such an epic stock bull.  The SPX fell 49.1% over 2.6 years ending in October 2002, and 56.8% over 1.4 years that climaxed in March 2009.  A 50% SPX loss, which is conservative since bears tend to be proportional to their preceding bulls’ sizes, would drag this index back to 1436.  That’s September-2012 levels, a long way down!

No one knows whether this stock selling unleashed will culminate in a bull-market correction under 20% or a new bear market over 20%.  But either way, speculators and investors ought to swiftly boost their anemic portfolio allocations to gold.  The record-high stock markets in recent years have led to radical gold underinvestment.  Gold tends to rally on balance when stocks fall, it’s the ultimate portfolio diversifier.

As this final chart shows, after the last SPX correction ending in early 2016 gold surged into a major new bull market.  Hyper-complacent stock traders suddenly realized that they needed to own gold to diversify their stock-heavy portfolios.  That gold bull has persisted, powering higher in a strong uptrend ever since despite this past year’s extreme taxphoria stock-market rally.  A new SPX correction will work wonders for gold.

That last SPX correction into early 2016 wasn’t large at just 13.3%.  Yet that was still enough to motivate complacent investors to flock back to gold.  Their heavy buying catapulted gold 29.9% higher in just 6.7 months!  Gold turned on a dime from deep 6.1-year secular lows because a major stock-market selloff finally convinced investors to up their meager gold allocations.  Every investor should have 5% to 10%+ in gold.

Just a week ago that ratio was likely only running around 0.14% based on the values of that leading GLD gold ETF and the collective market capitalizations of the 500 SPX companies!  So with gold allocations essentially zero late in an extreme stock bull, there’s vast room for massive capital inflows into gold in the coming years as investors rebalance their portfolios.  Gold thrives for a long time after major stock selloffs.

The gold buying isn’t instant when the SPX falls though, as traders need time to process the drop and its likely implications.  Back in early 2016 stock investors really didn’t start aggressively buying GLD shares until the SPX suffered multiple big down days.  The SPX fell 1.5%, 1.3%, 2.4%, and 1.1% on separate trading days in a single week before gold buying resumed.  More big SPX losses soon accelerated these inflows.

If you don’t have a significant gold allocation in your portfolio, you ought to get buying.  It can be done with physical gold bullion or GLD shares.  If you want to leverage gold’s bull market that will accelerate following a major stock selloff, consider the stocks of great gold miners

They tend to amplify gold upside by 2x to 3x due to their fantastic profits leverage to gold.  The precious-metals sector thrives after stock selloffs!

Finally the stock selling unleashed is likely just beginning due to what the major central banks are doing this year.  The Fed’s unprecedented quantitative-tightening campaign to start reversing its trillions of dollars of QE liquidity injected that levitated stocks for years is accelerating throughout 2018.  At the same time the European Central Bank slashed its own QE campaign in half until September, when it may cease entirely.

Between the Fed’s QT and ECB’s QE tapering, global stock markets face central-bank tightening running $950b in 2018 and another $1450b in 2019 compared to 2017 levels!  This will certainly strangle this QE-inflated monster stock bull.  So on top of everything else this week’s sharp selloff portends, the euphoric stock markets were already in serious trouble from record extreme central-bank tightening.  Got gold yet?

Absolutely essential in falling markets is cultivating excellent contrarian intelligence sources. 

That’s our specialty at Zeal.  After decades studying the markets and trading, we really walk the contrarian walk.  We buy low when few others will, so we can later sell high when few others can.  While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.

The bottom line is the stock selling unleashed this week isn’t over.  Given the fundamental, technical, and sentimental extremes around January’s record highs, a sub-10% pullback isn’t enough to eradicate the euphoria.  At best a major correction approaching 20% is necessary, and those tend to run a few months or so.  This week’s extreme VIX spike to levels that usually mark major bottoms was artificial, not normal.

And after such an extreme bull market largely driven by record central-bank easing, the odds really favor this selloff eventually growing into a 20%+ new bear.  Especially with the major central banks starting to aggressively pull their liquidity in 2018.  Whether a major bull correction or major new bear market, gold tends to thrive after major stock-market weakness. 

That leads investors to buy gold to re-diversify their portfolios.

You Can’t Unring the Bell

Let’s talk about the crash, or the mini-crash, or the dislocation, or whatever you want to call it.
Six percent intraday is getting close to crash territory, especially when you’ve seen no volatility over the last two years.

We discussed the probability of this happening in a previous issue of The 10th Man, which was all about the short volatility trade. The title is Black Monday, if you want to look it up.

We even discussed it years ago in a piece about covert gamma, which is the idea that the market is very asymmetric to the downside. All of these things came to pass.

And I’ve been warning my Daily Dirtnap readers about the short volatility trade blowing up pretty often over the last six months or so.


  • June 16: “I expect an unwind. Short volatility... People piling into short vol strategies at the highs. It will end in tears (probably).”

  • July 18: “…It wouldn’t take much to redeem XIV these days. Just one bad day in the stock market. What happens if that happens? All kinds of bad stuff…”

  • October 2: “Yes, we are living in the lowest vol period in history. Probably because we have given people easy tools with which to short vol. Will it blow up? Narrator: Yes, it will.”

You get the picture. Of course, I was also sharing what trades I thought would work in the event of the short vol trade getting hammered.
What Just Happened

Anyway, let me explain the significance of what just happened. Short volatility, as a strategy, has been discredited. In the past, people had come to expect less and less volatility. They will now expect more and more.

And I’m not just talking about explicit short vol trades like inverse VIX ETNs, VIX futures or options, variance swaps, or other exotic vol products. I’m talking about implicit vol strategies as well—any strategy in the financial markets which is dependent on low volatility will blow up.

All of them—all of them—will cease to exist.

It is the path that is uncertain. Will they all blow up this week? Probably not.

This is what we have been waiting for, folks. We have been waiting for volatility to return to the markets. Believe it or not, this is a lot healthier, even though it doesn’t feel like it.
The volatility bell has been rung, and you can’t unring it.
Play By Play

For the benefit of everyone who might not fully understand what just happened (including Carl Icahn), let me walk you through it.

Lots of people were short volatility. As you know, they were short volatility through inverse VIX exchange traded products (ETPs) like XIV and SVXY, but the “short vol trade” was much bigger than that. But let’s focus on the VIX ETPs for a moment.

XIV was essentially just short VIX futures; this isn’t hard to figure out. If you’re short something and it doubles, you lose 100%. XIV was short VIX futures and they nearly doubled, and it lost nearly 100%.

The prospectus says if that if the fund loses a certain amount (80%, I believe) it would shut down and return capital to investors. XIV will be gone in about a week or so.

A lot of people lost money on XIV. A lot of people who didn’t have money to lose, lost money on XIV. A lot of people also made money shorting XIV. That’s some good old-fashioned trading, right there. Once it became clear in the afterhours that the fund was nearly kaput, the piranhas jumped in.

My concern months ago was that the vol market could break under the strain of the leveraged VIX products. When the VIX moves, the VIX ETPs rebalance, and the more it moves, the more they had to rebalance.

I heard that there were 280,000 VIX futures to buy on the close on Monday, but you know what? The market was able to absorb it. It’s amazing how hard it is to break a market.

Now, a lot of people are going around blaming the VIX ETPs for being some kind of high-stakes casino, and saying we should ban these products.

Slow down there, Turbo. VXX was created because people wanted to be long volatility, and there are good reasons for wanting to be long volatility—like hedging credit. XIV was created because people figured out how expensive it was to be long volatility, and they wanted to do the opposite.

XIV did exactly what it was supposed to do—make money for six years and give it all back in one day. That’s short vol.
What If

If the entire market is dependent on low volatility, what is the likelihood that stocks have made money for six years and will give it all back in one day?

Not zero.

Over the last few days, there has been a lot of vol selling going on. People are trying hard to unring the bell.

But you can’t. Volatility is back, and there’s nothing you can do about it.
So Here’s the Thing

If you are still with me, it means you want to know everything about what happened this week. And you probably would like to know what will happen next. And… you might want to know how to invest in this new environment.

This is what I do for a living. I write, every day, about the markets, how to invest, and where I’m putting my own money.

If you can keep up with three pages of writing every day (you know you can) then you should join me and about 3,000 other readers. I encourage you to take the next step and read me every day in The Daily Dirtnap, the investment letter I started in 2008. I just started the 10th year of publishing, and there is no end in sight.

Look, I try to give you guys serious things to think about in The 10th Man. But the Dirtnap is where I talk to investors and market watchers almost every business day. Now that some action is returning to the markets, it’s where you need to be.

Germany and the U.S., Springing to Inaction

By Jacob L. Shapiro


Germany – the beating heart of Europe, one of the four largest economies in the world, a country helmed by an entrenched, established and respected politician – can’t seem to muster a government. It’s been 129 days since it had one. Now, to be fair, this isn’t uncommon among Europe’s parliamentary systems. The Netherlands went 225 days without a government last year, and Belgium holds the record at a whopping 589 days from 2010 to 2011. But Germany is not the Netherlands or Belgium. What happens there can shake the world.

The same could be said of the world’s only superpower, the United States, which has political problems of its own. The government in Washington recently reopened after a three-day shutdown, though it is funded only until Feb. 8. Unless Republicans and Democrats can come to some kind of agreement on immigration reform – something that has eluded both parties for decades – the government may well shut down again. Even if it doesn’t, political gridlock will so preoccupy Washington that it will actually impair U.S. foreign policy.
Inequality Is the Real Issue
Domestic problems are affecting German and U.S. behavior in eerily similar ways. In both countries, a widening gap in wealth inequality is creating the conditions for potentially radical political change. Of the 28 countries that report wealth distribution data to the Organization for Economic Co-operation and Development, Germany and the United States stand out. In Germany, the bottom 60 percent of the population possess just 6.5 percent of wealth in the country, the lowest figure in Europe. In the U.S., the bottom 60 percent possess just 2.4 percent – the lowest figure of any reporting country. The top 10 percent of both countries, on the other hand, account for a disproportionate amount of wealth – nearly 60 percent in Germany and nearly 80 percent in the U.S., the two highest figures of reporting OECD countries.
In the case of Germany, this seems particularly mystifying. The country is, after all, enjoying record-low unemployment rates, and by all accounts, its economic growth has exceeded even the more optimistic projections (full disclosure: ours was not so optimistic). But these figures tell only part of the story. The real issue is inequality, in terms of household wealth and real income. Germany may be a rich country – the average net wealth per household is about 214,000 euros, or $265,000 – but the median net wealth per household in Germany is about 61,000 euros. For reference, that’s about 4,000 euros less than it is in Greece, which Germany almost kicked out of the EU for its profligacy. On a per household basis, the bottom half of households in Germany possess less wealth than the bottom half of households in Greece.

And things are getting worse. Sure, unemployment has steadily decreased since 2009, but jobs are not translating into increased wealth for the lower and middle classes. From 2009 to 2016, unemployment declined in Germany by roughly 2 percent. At the same time, the relative poverty rate – defined by Germany’s Federal Statistical Office as the “percentage living in households with an income below 60 percent of national average” – rose about 2 percent. That is not so much a measure of increased poverty as it is increasing wealth for Germany’s top wage earners, as more and more Germans find that the same salary they made a few years ago now puts them below the poverty level.

Income inequality has been increasing too. Kreditanstalt fur Wiederaufbau, a government-owned development bank, published a report in March 2016 that showed that household income grew by 6 percent and 21 percent for the bottom two quintiles, as opposed to roughly 39 percent for the top quintile. Consumer prices over the same time horizon rose by about 24 percent, which means in real terms, 40 percent of German households have seen their purchasing power decline. In 2000, Germany had one of the lowest rates of income inequality in the EU. Now it is simply average – and trending in the wrong direction.

This trend is creating serious political problems. The most notable is the difficulty with which Chancellor Angela Merkel is cobbling together a coalition after German voters turned outside the mainstream to voice their frustration with the status quo. There are other troubling indicators, though. The Social Democrats, or SPD, fared no better than Merkel’s Christian Democratic Union in elections and may face insurrection from their members even if CDU and SPD negotiators come to an agreement. IG Metall – the largest industrial labor union in Germany and in Europe – walked out of talks with industry representatives on Jan. 27 and is now threatening 24-hour “warning strikes” if its demands on salaries and a 28-hour work week are not met.

Germany’s domestic political issues, punctuated by the absence of a German government, are beginning to reverberate throughout Europe. Political uncertainty in Germany has cast a shadow over EU negotiations with the United Kingdom on the conditions of Brexit, since Brussels cannot move forward with a deal without the German government’s approval. France’s president, Emmanuel Macron, continues to wait for a German government to be installed so Berlin can respond to French proposals for EU reform. Internal debates over the status of refugees cannot be resolved if Germany cannot even decide for itself what its immigration policy should be – one of the major current sticking points in the coalition negotiations. In effect, Europe is in a holding pattern, waiting for a German government that will be in a very weak domestic position even if the CDU and SPD conclude an agreement in the next week.
The Advantage in Washington’s Absence
Germany’s inequality problems began roughly when the country reunified in 1990. West Germany absorbed East Germany more easily than many predicted, and that created some of the socio-economic conditions today. But inequality is a much older issue in the United States. Modern income and wealth inequality in the U.S. has been creeping upward since the 1970s.

Donald Trump’s surprising electoral victory in 2016 was at least partly a political expression of that underlying dynamic. It is no coincidence that in the years before Trump’s election, the share in total income of the top 10 percent of all U.S. earners rose to just under 49 percent – a share surpassing that of any time during the Great Depression. This type of wealth inequality is a refrain in U.S. economic history that produces massive political change, of which Trump is likely just a precursor.
The 2008 financial crisis aggravated the problem. The median income in the United States is at a record high – but when you look at median wealth figures divided by lower, middle and upper income, you see that only the upper income levels have recouped the wealth lost during the financial crisis. Lower- and middle-income U.S. households are still doing worse today than they were in 2007. Like Germany, the United States is also enjoying low unemployment rates – 4.1 percent in December 2017, according to the U.S. Bureau of Labor Statistics. Again, though, employment doesn’t tell the whole story. The Federal Reserve Bank of St. Louis noted in a report this past month that the net increase in jobs created since 2000 – roughly 17 million jobs – has been among workers 55 and older. Jobs don’t help if they don’t pay enough and don’t create opportunities for young workers.

These problems demand Washington’s full attention, and the government is too preoccupied by its own political affairs to do much abroad. Unlike Europe, where countries are waiting on Germany, the world is not waiting on the U.S. – it’s taking advantage of its absence. It’ll be tough for Trump to sell a major war on the Korean Peninsula to a divided electorate. North Korea and China understand as much and are now attempting to split South Korea off from the U.S.-led alliance structure in the Pacific. Turkey’s foray into Afrin is in part a test to see how much it can shape Syria unilaterally – and the test results show an indifference. Russia, meanwhile, is doing its best to parlay a weak hand in the Middle East and Eastern Europe into Russian influence and concomitant U.S. concessions, whether by masterminding a fanciful diplomatic solution to the Syrian civil war or continuing to seek a settlement with the U.S. over Ukraine. Russia has not found much success so far, but the current U.S. posture does nothing to deter Russia from continuing to try.

Domestic politics are less predictable than international politics. Generally, they are less important too. But when two of the world’s four largest economies and the world’s pre-eminent military power are so hamstrung by problems that their behavior on the world stage is affected, the issues cease to be domestic. The U.S. and Germany have officially crossed that line. Germany has no government, and whatever government it eventually forms will be weak and hypersensitive to domestic concerns about inequality and immigration. The U.S. government is squabbling with itself rather than efficiently solving problems, whether at home or abroad. In that sense, it is working the way the Constitution designed it in 1789: without the rest of the world in mind. In 2018, that has global ramifications.

domingo, febrero 11, 2018



How to Lose a Trade War

Stephen S. Roach  

Workers assemble new vacuum cleaners

NEW HAVEN – Protectionist from the start, US President Donald Trump’s administration has now moved from rhetoric to action in its avowed campaign to defend US workers from what Trump calls the “carnage” of “terrible trade deals.” Unfortunately, this approach is backward-looking at best. At worst, it could very well spark retaliatory measures that will only exacerbate the plight of beleaguered middle-class American consumers. This is exactly how trade wars begin.

China is clearly the target. The January 23 imposition of so-called safeguard tariffs on imports of solar panels and washing machines under Section 201 of the US Trade Act of 1974 is directed mainly at China and South Korea. Significantly, the move could be the opening salvo in a series of measures.

Last August, the US Trade Representative launched Section 301 investigations against China in three broad areas: intellectual property rights, innovation, and technology development. This is likely to lead to follow-up sanctions. Moreover, a so-called Section 232 investigation into the national security threat posed by unfair steel imports also takes dead aim at China as the world’s largest steel producer.

These actions hardly come as a surprise for a president who promised in his inaugural address a year ago to “…protect [America’s] borders from the ravages of other countries making our products, stealing our companies, and destroying our jobs.” But that’s precisely the problem. Notwithstanding the Trump administration’s cri de coeur of America First, the US could well find itself on the losing side of a trade war.

For starters, tariffs on solar panels and washing machines are hopelessly out of step with transformative shifts in the global supply chains of both industries. Solar panel production has long been moving from China to places like Malaysia, South Korea, and Vietnam, which now collectively account for about two-thirds of America’s total solar imports. And Samsung, a leading foreign supplier of washing machines, has recently opened a new appliance factory in South Carolina.

Moreover, the Trump administration’s narrow fixation on an outsize bilateral trade imbalance with China continues to miss the far broader macroeconomic forces that have spawned a US multilateral trade deficit with 101 countries. Lacking in domestic saving and wanting to consume and grow, America must import surplus saving from abroad and run massive current-account and trade deficits to attract the foreign capital.

Consequently, going after China, or any other country, without addressing the root cause of low saving is like squeezing one end of a water balloon: the water simply sloshes to the other end. With US budget deficits likely to widen by at least $1 trillion over the next ten years, owing to the recent tax cuts, pressures on domestic saving will only intensify. In this context, protectionist policies pose a serious threat to America’s already-daunting external funding requirements – putting pressure on US interest rates, the dollar’s exchange rate, or both.

In addition, America’s trading partners can be expected to respond in kind, putting export-led US economic growth at serious risk. For example, retaliatory tariffs by China – the third-largest and fastest-growing US export market – could put a real crimp in America’s leading exports to the country: soybeans, aircraft, a broad array of machinery, and motor vehicles parts. And, of course, China could always curtail its purchases of US Treasuries, with serious consequences for financial asset prices.

Finally, one must consider the price adjustments that are likely to arise from the inertia of existing trade flows. Competitive pressures from low-cost foreign production have driven down the average cost of solar installation in the US by 70% since 2010. The new tariffs will boost the price of foreign-made solar panels – the functional equivalent of a tax hike on energy consumers and a setback for efforts to boost reliance on non-carbon fuels. A similar response can be expected from producers of imported washing machines; LG Electronics, a leading foreign supplier, has just announced a price increase of $50 per unit in response to the imposition of US tariffs. American consumers are already on the losing end in the Trump administration’s first skirmishes.

Contrary to Trump’s tough talk, there is no winning strategy in a trade war. That doesn’t mean US policymakers should shy away from addressing unfair trading practices. The dispute-resolution mechanism of the World Trade Organization was designed with precisely that aim in mind, and it has worked quite effectively to America’s advantage over the years. Since the WTO’s inception in 1995, the US has filed 123 of the 537 disputes that have been brought before the body – including 21 lodged against China. While WTO adjudication takes time and effort, more often than not the rulings have favored the US.

As a nation of laws, the US can hardly afford to operate outside the scope of a rules-based global trading system. If anything, that underscores the tragedy of the Trump administration’s withdrawal from the Trans-Pacific Partnership, which would have provided a new and powerful framework to address concerns over Chinese trading practices.

At the same time, the US has every right to insist on fair access for its multinational corporations to operate in foreign markets; over the years, more than 3,000 bilateral investment treaties have been signed around the world to guarantee such equitable treatment. The lack of such a treaty between the US and China is a glaring exception, with the unfortunate effect of limiting of US companies’ opportunities to participate in the rapid expansion of China’s domestic consumer market. With trade tensions now mounting, hopes of a breakthrough on a US-China investment treaty have been all but dashed.

Trade wars are for losers. Perhaps that is the ultimate irony for a president who promised America it would start “winning” again. Senator Reed Smoot and Representative Willis Hawley made the same empty promise in 1930, leading to protectionist tariffs that exacerbated the Great Depression and destabilized the international order. Sadly, one of the most painful lessons of modern history has been all but forgotten.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.