Money of the Future
By John Mauldin
Trust Issues
John Mauldin
Chairman, Mauldin Economics |
Money of the Future
By John Mauldin
John Mauldin
Chairman, Mauldin Economics |
Whistling Past The $70 Trillion Debt Graveyard
"There is also just the simple issue that markets are very extended above their long-term trends, as shown in the chart below. A geopolitical event, a shift in expectations, or an acceleration in economic weakness in the U.S. could spark a mean-reverting event which would be quite the norm of what we have seen in recent years."
"This morning, we are adding a small 2x S&P 500 short position to the trading portfolio to hedge our core long positions against a retracement over the next few weeks. We will remove the short if the market can regain its footing and move higher, or the market sells off and reaches oversold conditions."
"The mean reversion trade: For the past few weeks I've been musing that the 'irresistible force' that has moved all markets has been the aggressive repricing of future interest rate expectations since last November. We've had a HUGE rally in the bond market, MASSIVE flows into bond funds, record levels (>$13.7T) of negative yielding bonds, inverted yield curves, even Greek bonds trading through Treasuries…as markets anticipate a recession and much more Central Bank largess…which might just take us into MMT and/or never-never land where the Central Banks just buy all the bonds and that's that. I've thought that this irresistible force may have gone too far too fast and was due for a 'set-back' which would precipitate mean reversion trades across markets.
The core concepts of the mean reversion trades I'm considering are as simple as, 1) the public buys the most at the top (thank you, Bob Farrell,) and 2) when they're yelling you should be selling, and 3) positioning risk leaves some markets especially vulnerable."
"A divided House on Thursday passed a two-year budget deal that would raise spending by hundreds of billions of dollars over existing caps and allow the Government to keep borrowing to cover its debts, amid grumbling from fiscal conservatives over the measure's effect on the federal déficit.
65 Republicans joined the Democratic majority in the 284-149 vote, with 132 Republicans voting against the bill, despite President Trump's endorsement and pressure from key outside groups, including the Chamber of Commerce, to avoid a potentially catastrophic default on the Government's debt."
"In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation's entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.
In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in."
Do some math here.
The U.S. spent $986 billion more than it received in revenue in 2018, which is the overall 'deficit.' If you just add the $320 billion to that number you are now running a $1.3 Trillion deficit.
"According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…
"America's debt load is about to hit a record. The combination of cheap money and soaring debt helped fuel the decade-long economic expansion and bull market, but America's gluttony of loans could work against it if its fragile economic balance shifts.
In the first quarter of 2019, the United States' total public- and private-sector debt amounted to nearly $70 trillion, according to research by the Institute of International Finance. Federal government debt and liabilities of private corporations excluding banks both hit new highs."
"The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies."
"If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the subprime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the subprime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses."
"According to the latest IIF Global Debt Monitor released today, debt around the globe hit $246 trillion in Q1 2019, rising by $3 trillion in the quarter, and outpacing the rate of growth of the global economy as total debt/GDP rose to 320%.
This was the second-highest dollar number on record after the first three months of 2018, though debt was higher in 2016 and 2017 as a share of world GDP. Total debt was broken down as follows:
And while the developed world has some more to go before regaining the prior all time leverage high, with borrowing led by the U.S. federal government and by global non-financial business, total debt in emerging markets hit a new all time high, thanks almost entirely to China."
- Households: 60% of GDP
- Non-financial corporates: 91% of GDP
- Government 87% of GDP
- Financial Corporations: 81% of GDP
"The deleveraging cycle WILL occur, all that Central Banks can do is hope to extend the current cycle long enough that "maybe" economic growth will catch up with the problem and lower the risk.
The irony is that it is the Central Banks on actions (lowering interest rates to zero and flooding the system with liquidity) which has inflated the debt bubble."
"There is no way you ever emerge from eight years of free money without a debt bubble. If it's not a LatAm cycle, then it's energy the next, commercial real estate after that, a tech mania years after, and then the mother of all of them, housing over a decade ago. This time there is a huge bubble on corporate balance sheets and a price will be paid. It's just a matter of when, not if."
The Next Phase of Trump’s Trade War with China
China remains committed to its 40-year-old process of reform and opening up. But following through on this commitment will require China's leaders to find ways to manage escalating tensions with the US and avoid a costly – and potentially devastating – reconfiguration of the global economy.
Yu Yongding
BEIJING – US President Donald Trump and Chinese President Xi Jinping may have agreed at the G20 summit in Osaka to resume trade negotiations, but the path to ending the trade war remains far from clear. After all, the two leaders reached a similar agreement at the previous G20 summit – in Buenos Aires last December – and those talks ultimately failed, not least because Trump mistook China’s conciliatory attitude for weakness.
Whether Trump makes the same mistake this time remains to be seen. In any case, it is worth considering how the trade war might unfold over the coming months and years – and what China can do to protect itself.
Import tariffs may, for the foreseeable future, remain steady – neither escalating further nor being rolled back. The agreement in Osaka kept Trump from following through on his threat to impose additional tariffs on $300 billion worth of Chinese exports. But it did nothing to reverse past measures, such as the 15-percentage-point tariff hike, to 25%, on $200 billion worth of exports that the Trump administration implemented after the last round of talks broke down in May.
While these tariffs have not yet had serious consequences for China’s economy, their effects are likely to deepen over time. But China will be more likely to persuade the United States to remove them – or, at least, not to raise them further – if it refrains from retaliating with tariffs of its own. Instead, China should focus on reducing its bilateral trade surplus with the US on its own terms. It is increasingly clear that Trump’s tariffs have done more damage to America’s businesses and consumers than to China.
Already, opposition to Trump’s trade war is intensifying within the US. For example, the US Chamber of Commerce – one of America’s most powerful business lobbies – has called for the reversal of all tariffs imposed over the last two years. With the 2020 presidential campaign already underway, the last thing Trump needs is to stoke opposition within his own political base, let alone risk tipping the global economy into recession.
The effects of the trade war have already spread to cross-border investment. In recent years, rising Chinese production costs have driven many foreign firms – and, increasingly, even Chinese companies – to relocate their operations to lower-cost countries like Vietnam and Thailand. The trade war is accelerating this process. According to Vietnam’s government, inward foreign direct investment increased by nearly 70% year-on-year in the first five months of 2019, the largest such increase since 2015. Meanwhile, growth in US investment in China is slowing.
The Trump administration wants US companies to leave China. It is up to China to persuade them to stay. That means improving the local investment environment, including by responding to foreign companies’ legitimate complaints – say, by enhancing intellectual-property protections – and, more broadly, strengthening adherence to World Trade Organization rules.
But the pressure on China does not end there. The US is also eager to exclude the country’s high-tech companies from global value chains. Trump recently announced that he would allow US companies to continue to sell to the Chinese tech giant Huawei, after a months-long campaign against the company. But it remains highly unlikely that his administration – which reversed a similarly aggressive policy toward the smartphone company ZTE last year – will abandon its efforts to strangle China’s high-tech industries.
China has three options. First, it could accede to US pressure to disengage from global value chains. Second, it could remain committed to integration, hoping that, thanks to existing interconnections, sanctions on Chinese high-tech companies will also hurt their US counterparts (such as Qualcomm) enough that the Trump administration backs down. The third option is to focus on supporting domestic high-tech companies’ efforts to strengthen their own positions within global value chains and develop contingency plans.
China must also prepare for the possibility that the trade war will escalate into a currency war. If the renminbi comes under devaluation pressure and the People’s Bank of China does not intervene to stabilize its value against the US dollar – as it should not – the US may label China as a currency manipulator. And, unfortunately for China, there is little it could do about it.
China’s prospects for coping with financial sanctions – which the Trump administration is likely to use more often – are similarly bleak. Last month, a US judge found three large Chinese banks in contempt of court for refusing to produce evidence for an investigation into North Korean sanctions violations. The ruling ignores the fact that, according to Chinese law, any request for banking records should be handled in accordance with the US-China mutual legal assistance agreement.
The chances of resolving such disputes appear slim. Chinese financial institutions thus need to prepare for more troubles, including the risk of being blacklisted – that is, deprived of the right to use the US dollar and important services, such as the Society for Worldwide Interbank Financial Telecommunication (SWIFT) financial messaging service and the Clearing House Interbank Payments System (CHIPS). It is a punishment few firms can survive.
Already, one Chinese bank is included on the Correspondent Account or Payable-Through Account Sanctions (CAPTA) list, meaning that it cannot open correspondent or payable-through accounts in the US. China must be prepared for worse to come.
China’s government has few options here, but it can step up legislative efforts to protect Chinese banks’ interests, while encouraging Chinese financial institutions to treat compliance with US financial regulations with the utmost care. It should also continue working to internationalize the renminbi, though there is still a long way to go on this front.
China remains committed to its 40-year-old process of reform and opening up. Today, that process must focus on redoubling efforts to strengthen property rights, adhering to competitive neutrality, and defending multilateralism. But following through on this commitment will require China to find ways to manage escalating tensions with the US and avoid a costly – and potentially devastating – reconfiguration of the global economy.
Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006.
Why parts of Wall Street are fretting over ‘toxic’ loans
Leveraged-loan investor says private equity firms are abusing their market power
Robin Wigglesworth in New York
Steve Ketchum is not happy. The hedge fund manager is a big investor in so-called leveraged loans, a corner of the debt market that involves lending to riskier, lower-rated companies.
Mr Ketchum believes in the asset class. It makes up the bulk of the $21bn his firm manages. But he worries that heavy-hitting private equity firms are sabotaging the market by relaxing terms on the loans they are foisting on to investors.
“At some point they could kill the golden goose,” he warned from his Park Avenue offices in New York. “If they push for more toxic loan structures and this affects default or recovery rates in a recession, the demand for leveraged loans won’t keep up with future needs.”
The US leveraged loan market has roughly doubled over the past decade to $1.1tn, according to the Federal Reserve’s latest Financial Stability Report, as acquirers of companies — often private equity firms such as KKR, Apollo and Blackstone — have loaded their targets with as much debt as they think they can handle.
Globally, some $2.2tn of similar loans are outstanding, says the Bank of England, reflecting investors’ thirst for income-generating assets in a world of ultra-low interest rates.
But deteriorating lending standards have raised eyebrows among regulators including the Fed and the International Monetary Fund.
The Financial Stability Board, a global body set up in the wake of the financial crisis, this year launched an investigation into risks emanating from the loans, which are arranged by big banks and bought by institutional investors like Mr Ketchum’s firm, Sound Point Capital. Some top bankers, too, have sounded cautious notes.
“It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on,’’ Brian Moynihan, chief executive of Bank of America, said last month.
Mr Ketchum said that some of the commentary on leveraged loans was too gloomy. He argued that the market, on the whole, is in better shape than it was before the financial crisis, thanks to private equity firms having to stump up more of their own money when they do deals. Moreover, most leveraged loans are now in steadier hands, like his, rather than sitting within banks.
Nonetheless, he is growing increasingly frustrated at private equity firms systematically stripping out legal protections known as covenants, to make the loans “covenant-lite”. Before the financial crisis, about a quarter of the (much smaller) leveraged loan market was considered cov-lite, but it now stands at almost 80 per cent, according to Moody’s.
“Covenant-lite is the scourge of corporate lending,” he said. “If you lend someone money then you want all the rights you can get. We are more aggressive about saying ‘No’ these days.”
The hedge fund manager says the two most “odious” abuses are adjustments to ebitda and the gutting of so-called restricted payments clauses.
Ebitda stands for earnings before interest, taxes, depreciation and amortisation, and is a commonly used measure of a company’s operating profitability, before accounting for the way it is funded.
But some companies massage their ebitda higher with adjustments known as “add-backs”, to make debt burdens seem lighter. If ebitda, used in the loan documentation to set debt limits, is inflated, the financial test ratios will be looser, reducing their effectiveness as a sign of trouble ahead.
When Blackstone bought Refinitiv, the data part of Thomson Reuters, for example, the ratio of debt to ebitda looked reasonable at 5.7 times. But stripping out add-backs — loosely-defined future activities to cut costs — the ratio rose to over seven times.
Many other deals have similar features. The average acquisition had a headline debt/ebitda ratio of 5.6 times last year, according to UBS, but if one excludes add-backs the average leverage was closer to 7.4 times. The average in 2007 was 4.5 times.
Restricted payments clauses, meanwhile, are limits on how much money company owners can extract from the business, which might threaten its creditworthiness. Ravenous demand among investors for leveraged loans means that some private equity firms are gutting these clauses to pay themselves big dividends.
Some say that means there will be plenty of pain for investors in the next downturn. The leveraged loan default rates in the previous two major reversals — in the wake of the dotcom bust and the financial crisis — were about 25 per cent and 20 per cent respectively, with average recoveries of about 65-68 cents on the dollar, according to Pimco. However, in the next default cycle the investment group forecasts a default rate of 30 per cent and average recoveries of just 50 cents on the dollar.
The market could double or even triple in size over the next decade, reckons Mr Ketchum, a former media and telecoms banker at BofA. But not without more restraint from dealmakers.
“My friends who run private equity firms need to take a longer-term view on covenant negotiations,” he said.