Economic Brake Lights

By John Mauldin


But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

Warren Buffett (b. 1930), 1987 Berkshire Hathaway Annual Report

Those who do not learn from history are doomed to repeat its mistakes.

—George Santayana (1863–1952), Spanish-American philosopher

Those who don’t study history are doomed to repeat it. Yet those who do study history are doomed to stand by helplessly while everyone else repeats it.

—Tom Toro (b. 1982), American cartoonist for The New Yorker

All good things come to an end, even economic growth cycles. The present one is getting long in the tooth. While it doesn’t have to end now, it will end eventually. Signs increasingly suggest we are approaching that point.

Whenever it happens, the next downturn will hit millions who still haven’t recovered from the last recession, millions more who did recover but forgot how bad it was, and millions more who reached adulthood during the boom. They saw it as children or teens but didn’t feel the full impact. Now, with their own jobs and families, they will.

Again, there’s no doubt—none, zero, zip—this will happen. The main question is when. Just a few weeks ago, I had hopes we could postpone it possibly even beyond the 2020 elections. It could still happen, but a barrage of data in the last few weeks suggest this may be more hope than reality. And as I constantly remind you, hope is not a strategy.

Last week (and indeed for the last year), I talked about our growing debt problem and how it could trigger a crisis. Excessive leverage may light the fuse, but the real problems are deeper. A new report, just out this week, highlighted an important one.

Zombies and Unicorns

Debt can be useful when used wisely and wisdom begins with being able to repay it. So, if you have a debt-financed business, for example, you should have enough steady revenue to cover your other expenses and the interest on your debt—with a plan to reduce that debt. If you can’t, something is wrong.

It turns out this is far more common than most of us think. A new Bank for International Settlements study examined a database of 32,000 listed companies in 14 advanced economies to identify “zombie” businesses. By their broad definition, a company is a zombie if it is…

  • at least 10 years old, and

  • its interest coverage ratio has been below 1.0 for three consecutive years.

That’s a low bar… yet 12% of the public companies they examined couldn’t pass it.

BIS doesn’t identify the companies by name. I suspect they are probably separate from the “unicorns” we hear about, which are mostly equity-financed by hopeful venture capitalists. In theory, bankers and bond buyers should be more risk-averse than VC investors, but that does not appear to be the case. Thousands of companies are going years with little prospect of repaying their debts, yet for whatever reason, the lenders see no need to stop lending to them, much less foreclose.

Nor are these sketchy foreign companies. Looking only at US listed companies, about 16% qualify as zombies. So, we are actually more zombie-friendly than our average global peers.

Why lend covenant-light money to speculative firms like WeWork with the expectation they will repay? This is a relatively new phenomenon. The red lines in the two charts below are the percentage of zombie companies, broadly and narrowly defined. In either case, it was close to zero in the late 1980s and has climbed steadily since then. Worse, once you become a zombie company, the probability of remaining one is high and rising. Not exactly something that should comfort lenders.

Not coincidentally, it was about the beginning of this data when Michael Milken pioneered the junk bond (politely “high yield”) market, whose purpose was (and is) to make credit available to marginal companies not otherwise attractive to most lenders. Milken made them attractive by dangling high yields at potential bond buyers. This was supposed to compensate them for the higher default risk. It worked, too. Now it may be working too well.

Faced with a probable loss, lenders always face a temptation to “extend and pretend.” They convince themselves that another year or another quarter will let it turn into a sterling borrower who pays in full and on time. And more often than not, the zombie company has a charismatic CEO or founder who can charm lenders.

Now, there are perfectly understandable, human reasons for this. No one wants to force people out of their homes or put a company out of business and leave its workers jobless. But capitalism requires both creation and destruction. Keeping zombies alive hurts healthy companies. BIS found it actually reduces productivity for the entire economy.

The other side is that lenders must lose their money, too. Those who make irresponsible lending decisions have to face market discipline or they will keep doing it, causing further problems. Unfortunately, we do the opposite. Bailouts and monetary stimulus over the last decade generated a lot of unwise lending that is not going to end well.

Many (possibly most) of these zombie companies should fail. Or, more accurately, they will fail either suddenly in a crisis, or in slow motion if their lenders won’t bite the bullet. There really are no other options. And when they do, it will hurt not only their lenders but their suppliers, workers, and shareholders.

That, my friends, is how recessions begin. If we’re lucky, it will occur gradually and give us time to adapt. But more likely, given high leverage and interconnected markets, it will spark another crisis.

Not long before the last crisis, Ben Bernanke assured us the subprime “problem” was contained. It reminds me of the old Hemingway line, “How does one go bankrupt?” The answer: “Slowly, and then all at once.”

Missing Investment

Having said all that, let’s assume for a minute the US avoids recession, or at least postpones it a few more years. That doesn’t mean the present boom will continue. Expansion/recession isn’t a binary choice. There’s lots of room in between, which means a lot of room for conditions to worsen without actually reversing.

I titled this letter “Economic Brake Lights” because it’s a fitting metaphor. If you’re driving down the highway and the cars in front of you put on their brakes, they aren’t necessarily stopping. They are probably just decelerating, i.e. reducing their forward speed in reaction to conditions ahead. The other cars could be coming to a complete stop, however, so you slow down until you have better information.

Likewise, we are starting to see businesses tap their brakes. The initial US GDP report showed continued growth in the third quarter, a 3.5% annual rate. That was good, but the report had some warning lights, too. Non-residential business investment grew only 0.8% annualized, a sharp deceleration from the first quarter’s 11.5% rate.

And as we get a little bit deeper into the data, we see that 2.1% of that GDP growth was actually inventory building. That counts as growth as far as GDP is concerned. When it is sold, it does not add to GDP. This is why automotive companies “stuff the channel” by sending inventory down to their dealers. Once off their books, it counts as “sold.”

Higher inventory functions like debt. Just as debt is future consumption brought forward, inventories are future sales brought forward—at least in terms of GDP accounting.

(Sidebar: The Trump tariffs may have unintentionally boosted the inventory cycle by encouraging businesses to stockpile goods ahead of higher tariffs. If that is so, we could see either a swift reduction if Trump and Xi reach an agreement or the slower reduction as those inventories dwindle in 2019. I have literally no idea, nor do any of my usual sources, what will happen. Stay tuned.)

The first quarter’s sharp investment growth was partly a response to the corporate tax cut passed last December, which included several provisions intended to produce exactly that effect. I said at the time it would work for a while but probably fade, and it is doing so faster than many of us would like.

Now, I don’t necessarily expect tax policy to drive business decisions. You invest in expanded capacity when you think it will produce revenue, and the costs will let you still make a profit. Taxes are only part of that decision and probably not the most important part. Ultimately, businesses expand and hire when they think consumers are ready to buy their products.

The problem is that strong GDP growth forecasts assume businesses will make the kind of investments it now appears they are not. If so, then we may look back and see this year’s second quarter growth of 4.2% was the peak, and it’s downhill from here. The Atlanta GDP estimate now shows 2.4% for the fourth quarter. My personal opinion is we will be lucky to average 2% in 2019.

That doesn’t mean growth will drop all the way to zero or below. I can imagine a few more years of sideways-to-flat conditions. It wouldn’t be the worst thing in the world. But if that’s what we get, some stock investors will be mighty disappointed because share prices are assuming much more.

The Deficit and Debt Drag on the Economy

As I’ve written, and as my friend Dr. Lacy Hunt has demonstrated from the economic literature, increasing debt becomes a drag on an economy, especially after it rises over the 80 to 90% of GDP level. US government debt is now 106% of GDP, and if you add state and local debt, which causes similar drag, total government debt at all levels is over 120% of GDP. Shades of Italy and Greece.

Congress wants you to believe last year’s deficit was $779 billion. They don’t mention the off-budget deficit, which adds just as inexorably to total debt. It is not easy to find that number, but fortunately, my friend Michael Lewitt writing in The Credit Strategist brings us this pithy note:

Our current prosperity is built on an explosion of debt; it is therefore unsustainable. The US added roughly $1.3 trillion of GDP in the fiscal year that ended in September but also added $1.271 trillion of debt. Interest rates, while still running well below real-world inflation, are rising in a heavily leveraged economy. The $1.271 trillion increase in federal debt was nearly $500 billion or 39% higher than the official annual deficit of only $779 billion, which means that politicians are keeping significant amounts of debt off-balance sheet. I don’t know who they think they’re fooling, but they aren’t going to be able to keep this con game running much longer. Over the past five years, the official deficit was reported as $2.977 trillion whereas the federal deficit grew by $4.777 trillion, meaning that 38% of the actual shortfall was hidden by our feckless leaders. And all of these figures do not include trillions of more dollars of off-balance sheet entitlement obligations promised by the government to future retirees and other voters.

That deficit was for fiscal 2018, which ended on September 30. The CBO’s latest projection is we will add close to $1 trillion of debt in 2019 and over $1 trillion in 2020. If the Democrats take the House next week, even narrowly, is there any real hope of cutting that deficit without tax increases? Which both the Senate and Trump will not accept?

The off-budget deficits have averaged around $360 billion for the last five years, generally increasing over time. But if we take just that average and add them to the projected deficits, the US government deficit will be (drumroll, please) approximately $1.4 trillion per year for the next five years, which will mean $29 trillion total debt by 2024.

And that’s without a recession. Throw in a recession, and we’ll get to $30 trillion long before then. Care to speculate what interest rates will be? What quantitative easing will look like? What all the other market disruptors will look like?

As Mr. Rogers might like to say, can you spell volatility, boys and girls? In fact, let’s close this letter talking about volatility and liquidity.

Swimming in Liquidity

There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys, how’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?”

David Foster Wallace, This is Water (2005)

My friend Chris Cole at Artemis Capital in Austin occasionally writes a rather brilliant client letter. He graciously sends it to me. I’m going to share the full letter in Over My Shoulder soon, but here’s a quick bite.

Chris notes the above story about the two young fish not being aware they are swimming in water, and suggests most investors are doing the same.

We have been swimming in a sea of liquidity for so long that we notice it only when it disappears. Then central banks provide more liquidity, and things go back to what we think is normal.

But liquidity is simply investor willingness to buy and sell. It is as much about market and investor sentiment as any true “fundamental.” Here’s Chris Cole:

In markets and in life, we swim in mediums of thought abstractions… the same way a fish swims in water. When the medium collapses, so does the reality… causing us to question the nature of both. As Foster Wallace eloquently explains, “The immediate point of the fish story is that the most obvious, ubiquitous, important realities are often the ones that are the hardest to see and talk about.” Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth. It is the moment where we learn that we are a fish living in a false reality called water… and that reality can change... or there are other realities. True volatility isn’t the change of the thing, it’s the changing of the medium around it and the realization that the thing never really existed in the first place.

This is all you need to know to understand when the volatility storm will truly come. It is not about valuations, money printing, or where the VIX is at any point. When the collective consciousness stops believing growth can be created by money and debt expansion, the entire medium will fall apart violently, otherwise it will continue to be real.

The belief that the medium is the reality is what holds the edifice together temporally.

You might dismiss this as way too bearish. Maybe it is, right now and for the next few years. But when global debt starts suffocating economic growth and impinging on liquidity, or central banks react with too much liquidity, then the relative Sea of Tranquility in which we have been swimming could become quite tempestuous indeed.

That is why I keep harping on The Great Reset. Going back to the first quotes, we are going to relive or at least rhyme with history. I think we will set a new standard for what the word volatility (absent a shooting war) really means.

Work Your IRA Like a Mule

IRAs are almost as common as cell phones. Nearly every investor either has one or has some other kind of plan that can pour into an IRA.

It’s the tax benefits that make them so popular. But few investors work their IRA as hard as they could. A lot of opportunity for tax savings slips by. And that means a lot of opportunity for building wealth slips by.

Starting next week, I’m going to try to fix that. That’s when we start a series of short articles showing what’s really possible with an Individual Retirement Account. They’re written by my friend and colleague Terry Coxon who is not only knowledgeable but is passionate about the topic.

Terry has also prepared a comprehensive guidebook on getting the most out of your IRA. He calls it Supersize Your IRA. I call it Work Your IRA Like a Mule. It’s available for a limited time—just one week only. You can learn more about his guidebook here.

Germany, Georgia, and Thanksgiving

In theory, I will be doing my final edits to this letter on a plane to Frankfurt, Germany. We are supposed to have Wi-Fi, so I will do a little work before going to sleep. I now try to get to Europe at least one day earlier than I used to, as adjusting to jet lag seems to be getting more difficult for me. I am really looking forward to this conference, as I expect to learn a great deal more than I impart. I have as many questions as they do.

The next weekend, I will be in Georgia for a few days before returning home to prepare for Thanksgiving with all my children, friends, significant others, and grandkids. Also in theory, I should soon have my new golf clubs to break in. Or maybe to break me. We’ll see who surrenders first.

And now, it is time to hit the send button. Have a great week! Mine looks to be busy and informative.

Your thinking a lot about The Great Reset analyst,

John Mauldin
Chairman, Mauldin Economics

Clarity on Britain’s future relationship with the EU is a long way off
Philip Stephens

Business craves certainty. Britain’s politicians and voters would like to change the subject. They are all about to be sorely disappointed. The outcome of the present set of Brexit negotiations between Britain and the EU27 remains uncertain. There is one immutable certainty. This is just the beginning. The sequel to these talks promises another protracted spell of, well, acute uncertainty. Oh, and the threat of another cliff-edge.

It was not supposed to be like this. Remember the glib assurances of cabinet Brexiters that waving goodbye to Europe would be a walk in the park? A trade deal with the EU27 would be the easiest in history. As Michael Gove pronounced with his customary self-confidence: “The day after we vote to leave we hold all the cards and we can choose the path we want.” More than two years have passed since the referendum. Mr Gove now holds high office in a government that has given way to Brussels at each and every turn. All the while, the real Brexit finishing line has receded.

After this week’s bump in the road about arrangements for Northern Ireland, British officials point to several possible outcomes of the talks with Michel Barnier’s EU team. There is still some optimism that a deal can be struck by the end of the year. This would see Britain formally leave the EU on March 29 2019, clutching an exit treaty and a political declaration about the future relationship. Transition arrangements would run at least until December 2020.

Strangely enough, prospects for a successful conclusion may have been improved by the impasse over a so-called backstop arrangement to guarantee an open border between Northern Ireland and the Irish Republic. Had a formula been agreed now, anti-European irreconcilables in the Conservative party would have had time to shoot it down. The best chance Theresa May, the prime minister, has of getting an accord through parliament is to present it at the last moment as a single, take-it-or leave-it package including both exit treaty and political declaration.

A second possibility, though one viewed as the least likely, would see the country crash out of the union without any agreement — perhaps because the Brussels talks had failed to resolve the seemingly intractable Northern Ireland question, or perhaps because a settlement signed up to by Mrs May had been repudiated by enough Tory MPs to deny its passage through parliament. Hardline Brexiters say the economic disruption would be shortlived. I wonder if Mr Gove is now quite so sure.

A third option circulating in hushed tones around the corridors of Whitehall is an extension of the two-year Article 50 negotiating window. The prime minister has ruled this out. And the idea is anathema to hardline Tories. But one can see the circumstances in which Britain would be forced to swallow its pride. The threat of a no-agreement, cliff-edge Brexit might well see parliament force the prime minister’s hand. An extension would also be needed were paralysis to result in Mrs May’s departure and/or a general election. That, in turn, would open the possibility of a second referendum. Such a standstill would require the consent of the 27. It is difficult to see why they would withhold it.

Peer through all this fog and the future beyond March 29 holds as many uncertainties as now. The present negotiations will be extended or Britain will step out of the EU into an economic no-man’s-land. An exit treaty would settle only immediate issues about money, citizenship and Ireland. The big economic questions would be unresolved.
The joint political declaration promises fine words devoid of hard substance. It does not free the government from the question it has ducked and dodged since the referendum vote: where precisely does Britain want to strike a balance between a desire to repatriate notional “sovereignty” and the economic imperative to retain ready access to its most valuable markets?

Should it break entirely with the EU customs union or seek an arrangement as close as possible to the status quo? How much access does business need to the single market? How important to Britain’s economic wellbeing are the present, friction-free supply chains that criss-cross the channel? Does anyone really imagine that Britain has anything to gain from diverging from most EU standard-setting? And why would it want to? Does parliament want a Norway model of close alignment with the EU27 or a Canada-style free trade agreement? Whatever happens during the next few months, business, politicians and voters will be no more certain by March 29 as to the scope and depth of future ties.

The referendum asked none of the questions; and ministers, who do not agree among themselves, have failed since to provide answers. A 20-month transition period, Mrs May has now acknowledged, will not be enough to hammer out an accord on permanent economic arrangements — holding out the threat of another cliff-edge in December 2020. Officials in Brussels say it will take three, probably four, years to strike a bargain. The transition phase will have to be extended — and with it the uncertainties.

There is, of course, one other certainty about Brexit. It will leave Britain a poorer, inward-looking place — a nation prone to bouts of populism on the streets and blood-letting at Westminster. On one narrow point Mr Gove is right. This is not what Britain voted for.

Bond funds hit by biggest monthly withdrawals in almost 3 years

Investors take out $36bn during October with fixed-income ETFs succumbing to turbulence

Nicole Bullock, Robin Wigglesworth and Joe Rennison in New York

The deepening markets reversal has led to the first monthly outflow from bond ETFs in two years, for a net redemption of $1.57bn in October © Dreamstime

Investors withdrew $36bn from bond funds in October, the biggest monthly net redemption in almost three years, as even exchange traded fixed-income funds succumbed to the global market turbulence.

Bond ETFs have become increasingly popular with investors on the lookout for cheap, simple ways to get exposure to fixed-income markets. But the deepening bond reversal led to the first monthly outflow in two years, for a net redemption of $1.57bn, according to preliminary numbers from EPFR Global.

All told, bond funds around the world saw $36bn pulled out in the month to Wednesday, the biggest withdrawal since December 2015, the preliminary figures show. Of note is that the outflows follow a stampede of investors into bond investments. Last year these funds took in more than $600bn.

“Investors were de-risking any sort of credit position,” said Matthew Bartolini, head of Americas research for State Street SPDR exchange traded funds. “You had concerns over peak earnings growth and you had ongoing geopolitical flash points whether it was the Italian budget reforms or trade war rhetoric that continues to percolate.”

Bond ETFs were hard hit by the $2.5bn withdrawal from junk bond ETFs.

Interest rate increases from the Federal Reserve also mean higher borrowing costs for US companies and represent a potential threat for corporate margins.

Within the broad bond fund category, US bond funds suffered net outflows of more than $13bn, while political and economic uncertainty helped to drive $9bn from Europe-focused funds. Investors also withdrew $3.8bn from emerging market debt funds.

Corporate debt was initially fairly resilient when market turbulence began in early October, but the sell-off has gradually gathered pace, sending bond prices sliding and yields climbing higher.

“It’s a reasonable action to take in this market. It has been completely the other direction for a very long time,” said Kathleen Gaffney at Eaton Vance. “Is it over because you are not getting compensated? Or are investors maybe thinking getting into cash right now is safer than reaching for yield? That seems a rational logic.”

The Bloomberg-Barclays Global Aggregate index of international bonds is now down 3.4 per cent for the year — on track for its third-worst year since its inception in 1990 — while US junk bonds lost 1.6 per cent in October, its worst month since January 2016.

LQD, a $31bn bond ETF that tracks the US corporate debt market, fell for a fourth day running on Thursday to trade at its lowest level since the 2013 “taper tantrum” that followed the Fed’s announcement of plans to trim its quantitative easing programme.

The fixed-income ETF has now lost almost 8 per cent of its value this year, and is on track for its worst year since its inception in 2002.

The rolling global market rout of October sent ETF trading volumes spiralling higher, with just US ETF volumes averaging more than $11bn a day last month, according to BlackRock.

Passive bond funds also had record volumes, with junk bond ETFs averaging $3.2bn of trades a day, and investment-grade bond ETFs averaging $1.7bn a day.

South Korea Prepares for a Future Without the US

Seoul’s long-term goals for North Korea are incompatible with Washington’s, and sooner or later it will have to strike out on its own.

By Phillip Orchard        

The United States and South Korea are finding it harder and harder to stick to the same playbook on North Korea. Consider what’s happened just in the month since North Korean leader Kim Jong Un and South Korean President Moon Jae-in met in Pyongyang for a landmark summit.

In early September, the South opened a liaison office with the North, reportedly without first informing the U.S., which opposed the move. South Korean Foreign Minister Kang Kyung-wha later publicly admonished Washington for its purported inflexibility on the good faith measures Pyongyang demanded. The next week, Kang said that Seoul was considering lifting sanctions on North Korea related to its sinking of a South Korean ferry in 2010. Another senior South Korean official walked back the claim, but not before U.S. President Donald Trump said Seoul “does nothing without our approval,” a comment that riled the Korean public. On Oct. 12, South Korea’s new military chief pledged to push for the transfer of wartime operational control, or OPCON, over his country’s forces from Washington – which has held it since the Korean War – back to Seoul. The U.S. State Department expressed concern a few days later over plans to connect road and rail links between North and South Korea as early as next month. And on Oct. 18, Reuters reported that Washington was pressuring Seoul to abandon plans with Pyongyang for a no-fly zone over the Demilitarized Zone.

These disagreements have brought thorny issues over the shape and size of the U.S.-South Korea alliance back to the surface. They don’t spell the imminent end of the partnership; allies squabble, short-term interests diverge, and political forces make mountains out of molehills – especially when one side of a partnership has troops on the other side’s soil and each could start a war the other may not want. So long as an alliance is rooted in firm strategic logic, these things generally don’t matter. But in the case of the U.S. and South Korea, the strategic logic is starting to crack, and Seoul has little choice but to defy Washington where it must to prepare for the day when it may have to strike out on its own.
Different Means to Different Ends
U.S. and South Korean interests in exactly how nuclear negotiations with North Korea would play out were never going to align neatly. Though both would like Pyongyang to fully disarm, they disagree on the odds for achieving that outcome and, more important, on what’s at stake if the North doesn’t capitulate. Seoul thinks denuclearization is a long shot, at best, and has resigned itself to living with a nuclear neighbor. North Korea already has the missiles and artillery necessary to lay waste to South Korea, a threat it relies on as its primary deterrent to invasion. Seoul’s most pressing interest, then, is to keep the U.S. – a target Pyongyang cannot yet reliably strike – from starting a war in which it would bear most of the risk. That’s why South Korea was so quick to claim the role of mediator between the U.S. and North Korea once Pyongyang signaled a willingness to talk at the start of the year. To keep Washington on board with the process, Seoul is touting the sincerity of Pyongyang’s denuclearization promises and facilitating dialogue. To keep Pyongyang on board, meanwhile, Seoul has been dangling incentives, modestly pulling back its defenses and emphasizing that the diplomatic process it is leading is the main force keeping U.S. military action at bay.


South Korea has bought itself some time with this strategy, but it hasn’t brought North Korea any closer to disarming. And so long as the U.S. is still pushing for North Korea’s complete, verifiable and irreversible denuclearization, Seoul’s outreach to the North will weaken Washington’s hand. Even if the U.S. can’t persuade North Korea to give up its nukes without going to war, it still has other ways to discourage Pyongyang from moving forward with its long-range missile program – the one North Korea needs to truly put the American homeland at risk – and to shape the country’s behavior as a nuclear power. Nevertheless, now that its threat of war is off the table, at least temporarily, and now that China and Russia are finding less and less reason to keep up sanctions pressure, the U.S. is losing its leverage.

Pyongyang has demonstrated an extraordinary pain tolerance over the decades, and the U.S. needs all the pressure it can muster to get North Korea to make a deal. That’s why Washington balked at Seoul’s mention of lifting even sanctions entirely unrelated to North Korea’s nuclear program. It’s also why it seems to be balking at the plans to establish a no-fly zone over the DMZ. For years up until this spring, the U.S. routinely flew bombers from Guam over the region to try to probe for weaknesses in North Korea’s air defenses and to remind Pyongyang of its willingness and ability to deal with the nuclear issue by force. Washington doesn’t want the North to think it’s in the clear just yet.
Preparing for the Eventualities
Ultimately, if the U.S. were to deem it necessary to go to war with North Korea, South Korea could do little to stop it. Seoul’s situation today underscores a historical reality for the Korean Peninsula: It has always been in danger of becoming a pawn in the games of foreign powers. Since the peninsula’s partition, when both North and South became wholly dependent on outside powers for their defense needs, that danger has become only more acute. It’s a position that has required constant, nervy maneuvering from both governments to prevent their security from being sacrificed for that of their patrons.
(click to enlarge)


In light of their vulnerability, South Korea has a long-term imperative to pursue reunification with the North. Made whole again, Korea would become one of East Asia’s strongest military powers, finally capable of looking outward rather than primarily across the 38th parallel, and it would obtain a freedom of action that it hasn’t enjoyed in centuries. The odds of reunification happening quickly, if at all, are slim. But the process has to start somewhere, and it won’t start at all if the North is in full isolationist mode. Pyongyang won’t take the small but risky reciprocal steps necessary to normalize relations with Seoul if it feels doing so would expose it to attack from the U.S. or the South. And Kim won’t pursue any sort of confederation until he can pick up some momentum toward narrowing the gap in economic development between the two Koreas. Considering its immediate and more distant goals, Seoul is keen to move first and quickly to try to draw Pyongyang out of its defensive shell with tangible incentives and to give it a taste of the economic fruits international integration has to offer.

Reunification would almost certainly require a radical redefinition of the U.S.-South Korea alliance, if not its end. Of course, Seoul is in no position to break away from Washington at present. The detente with Pyongyang is still far too fragile for South Korea to feel comfortable without U.S. military might on its side, especially now that North Korea’s nuclear arsenal can offset some of its own conventional advantages. Hawkish factions at home will also keep the current South Korean government and its successors from drifting too far from the U.S. Furthermore, the U.S. pressure on the North is working in South Korea’s interests in some ways, serving as the stick to Seoul’s carrots.

The debate over OPCON reflects South Korea’s ambivalence. Seoul has pushed for the transfer repeatedly in the past, and Washington has generally been open to it. After all, the U.S. doesn’t need forces in South Korea to enforce its core interests in the Western Pacific, and it is eager for its allies across the globe to take on heavier shares of the joint security burden. Yet the target dates for the OPCON transfer have come and gone time and again – in 2009, 2012 and 2015. The postponements are due in part to the many sticky issues the U.S. and South Korea would have to sort out ahead of the transfer; the last thing either side wants is a command structure in flux when war is still a real possibility. But the primary reason is that Seoul has never felt quite comfortable with the idea that U.S. troops might leave the peninsula altogether after the OPCON transfer – perhaps before South Korean forces were ready to stand on their own. (The U.S. defense secretary and his South Korean counterpart agreed on Oct. 19 to take another shot at the OPCON transfer at “an early date.”)

South Korea’s misgivings aside, the past two years have put the perils of overreliance on the U.S. in stark relief. Unlike in previous discussions of the OPCON issue, moreover, Seoul now sees an opportunity to start mending ties with Pyongyang for good. And so, South Korea is doubling down on preparations to go its own way. Preparing for the end of an alliance isn’t the same thing as pushing for it, though. It’s just a recognition that seismic shifts in the region are always a possibility.

Is Latin America Facing a Wave of Right-Wing Populism?

Many observers now argue that the wave of right-wing populism that has engulfed the US and much of Europe is headed for Latin America. But, while their concern does have some merit, there are key differences between the Latin American – and even Brazilian – context and that of Europe and the US.

Cristóbal Rovira Kaltwasser  

jair bolsonaro

SANTIAGO – On October 7, roughly 46% of the Brazilian electorate voted for Jair Bolsonaro for president. This means that almost 50 million Brazilians endorsed a politician espousing radical right-wing populist rhetoric, marked by authoritarianism, xenophobia, and misogyny. Does Bolsonaro’s success portend a new era of radical right-wing politics in Latin America?

The Brazilian election result is certainly cause for concern. Though Bolsonaro, who has a military background, was the frontrunner, few thought he would win more than 40% of the vote in the first round. Instead of a tight runoff between Bolsonaro and Fernando Haddad of the Workers’ Party (PT) that ends with Haddad winning, it seems likely that Bolsonaro will be Brazil’s next president.

Many observers now argue that the wave of right-wing populism that has engulfed the United States and much of Europe is headed for Latin America, where conditions are ripe for populist politicians to thrive. But, while their concern does have some merit, there are key differences between the Latin American – and even Brazilian – context and that of Europe and the US.

In Europe, the main issue fueling support for the radical right is immigration, which was propelled to the forefront of public life by the massive influx of refugees that peaked in 2015. Yet, in Latin America, citizens are far more concerned about economic prosperity and public safety than immigration.

As for the US, President Donald Trump’s agenda, like his electoral victory, depends on partisan loyalty. Republican leaders may have their problems with Trump’s style, but their support has been vital to his administration’s achievements. The confirmation to the Supreme Court of Brett Kavanaugh – whose response to sexual assault allegations during the confirmation process would have disqualified him under less partisan circumstances – is a case in point.

Bolsonaro, by contrast, does not have a powerful party machine to back him, even as he upends rules and norms. He is a member of the Social Liberal Party, which has changed much of its platform – embracing far more conservative social policies – since he joined this year.
The Bolsonaro phenomenon is not even representative of wider Latin American politics, which have shifted rightward lately, but remain moderate. Both Argentina’s Mauricio Macri and Chile’s Sebastián Piñera – elected in 2015 and 2017, respectively – have been governing as center-right leaders.

Given this, it seems clear that Bolsonaro’s rise is the direct result of Brazil’s particular circumstances, which include a devastating economic recession and revelations of massive corruption scandals that have tainted the PT and the country’s entire political class. But the fact that a Bolsonaro presidency would not be part of a broader right-wing populist wave in Latin America does not make the prospect any less dangerous for Brazil.

These conditions are very similar to those that facilitated, in the late 1990s, the rise of Venezuela’s Hugo Chávez, who proceeded to implement radical institutional reforms that gave him virtually unfettered power to subvert democratic processes. Those reforms are a key reason why Chávez’s successor, Nicolás Maduro, has been able to turn Venezuela’s government into an authoritarian regime.

Could a Bolsonaro presidency pose a similar threat to Brazil’s democracy? The short answer is yes, precisely because, as with Maduro, it would be hard for Bolsonaro to govern otherwise.

To govern legitimately, Bolsonaro would need to secure widespread public support and among political and business elites. Yet, while Brazil’s new Congress is more conservative than the previous one, it is very fragmented, with established parties on the left and the right having lost support. This will make it difficult for the next president to pursue his legislative program, unless he manages to secure the support of a broad coalition.

The business community, for its part, is divided on Bolsonaro’s economic agenda. Many express serious doubts about the sustainability of the neoliberal reforms that his economic team has proposed.

Moreover, if Bolsonaro is elected, he may have a hard time maintaining popular support, given the challenges he will face in delivering on his campaign promises. If he is unable to produce results quickly, large segments of the population could turn against him, particularly given that the PT retains a large base of support that can be expected to mount concerted resistance to a Bolsonaro administration.

Under these circumstances, Bolsonaro and his military allies may well resort to undermining Brazil’s democracy, much as Chávez did in Venezuela. This could include not only governing by decree and purging state institutions, but also silencing the media and repressing civil society. This would be ironic: during the campaign, Bolsonaro has often warned that a PT government would transform Brazil into Venezuela with its leftist policies, even though previous PT administrations have done no such thing.

As former Brazilian President Fernando Henrique Cardoso has indicated, it may not be a realistic threat, but it has helped Bolsonaro mobilize voters who were already angry with the PT – and the political establishment as a whole – for its involvement in massive corruption scandals. If this (understandable) anger clouds Brazilians’ judgment to the point that they elect Bolsonaro, their worst fears may become reality. Their country will be thrown into tumult, just like Venezuela has been, owing to the rapid erosion of democratic institutions.

So Latin America as a whole probably is not facing a wave of right-wing populists. But that does not make the threat Brazil faces any less potent. To confront it, mainstream parties on the right and the left will have to take a powerful and effective stand in defense of liberal democracy.

Cristóbal Rovira Kaltwasser is Professor of Political Science at Universidad Diego Portales in Santiago, Chile. He is the co-author, with Cas Mudde, of Populism: A Very Short Introduction, and one of the editors of The Oxford Handbook of Populism.

Time Is Running Out for Deutsche Bank to Stand Alone

Germany wants a strong bank that its major companies can rely on in a world increasingly dominated by American banks

By Paul J. Davies

As Deutsche Bank DB -1.83%▲ has been quietly busy with its latest restructuring, chatter about a potential merger between Germany’s largest lender and its smaller rival Commerzbank CRZBY -1.79%▲ has grown louder.

What makes this chatter stand out is that its source has increasingly been political. This matters for Deutsche: If it fails to demonstrate decisively that it can improve its very poor profitability, pressure from Berlin and elsewhere to do something more radical may become irresistible.

Germany wants a strong bank that its major companies can rely on in a world increasingly dominated by American banks. Deutsche needs to show it can fulfill that role. Its results for the rest of this year, starting with third-quarter numbers on Wednesday, could seal its fate.

Deutsche has made clear that its only focus for now is finding its feet and showing it can make stable—if low—returns. If Christian Sewing, chief executive, can do this by the end of 2019, he may be more interested in pursuing a cross-border deal to build a more powerful pan-European bank.

His task, however, is a hard one. He should hit cost-cutting targets this year and next—targets were missed by his predecessor—but arresting the fall in revenue will be a much bigger struggle.

Commerzbank is in the middle of its own cost cuts, though its task is simpler. But neither bank is expected by analysts to make a return on equity much above 5% in the foreseeable future.

Germany is a tough market where the five biggest lenders have only a 30% share, according to Citigroup ,compared with a 60% average in Europe as a whole. Many German banks also aren’t shareholder owned and so don’t have the same profit imperative. Even a merger of Deutsche and Commerzbank may not make much of a difference to anyone’s market power. Analysts at Berenberg call it the last option for Deutsche.

However, investors seem to view their fates as intertwined: The two banks’ stock prices have traded with a correlation of nearly 90% this year. And a deal could make sense for other reasons.

A tie-up could strengthen Deutsche’s balance sheet and, critically, lower its funding costs.

Funding used to be Deutsche’s key competitive advantage, but that vanished when Europe’s new bank bailout rules made its bonds much more risky, according to Goldman Sachs .  

The twin tower skyscraper headquarters of Deutsche Bank are reflected in the windows of a neighboring office block in Frankfurt, Germany. Photo: Alex Kraus/Bloomberg News 

Commerzbank would lift the share of cheap deposits in its funding base and make the German government, which currently owns 16% of Commerzbank, a major shareholder.

Prospects for a deal have been helped by Commerzbank’s share price collapse this year, which means Deutsche would need to issue far less of its own heavily discounted equity to buy its rival. The different asset types of the two lenders would also produce a better leverage ratio than Deutsche has alone —solving another key problem for the larger bank.

This isn’t a deal to inspire, but it has merits. As a last resort, it may be closer than Deutsche likes to think.