The Road to Default

By John Mauldin


Nothing is forever, not even debt. Every borrower eventually either repays what they owe, or defaults. Lenders may or may not have remedies. But one way or another, the debt goes away.

One of Western civilization’s largest problems is we’ve convinced ourselves debt can be permanent. We don’t use that specific word, of course, but it’s what we do and is why government debt keeps rising. We borrow faster than we repay previous borrowing—and I mean governments everywhere, China as well as the US.

Our leaders have no real plan to reduce the debt, much less eliminate it. They just want to spend, spend, spend forevermore. And most citizens are okay with that. As I will note below, the Republican Party I grew up with, which back then seemed to constantly talk about deficits and debt, is now comfortable with 5% (and growing) of GDP deficits.

As a result, I think we will spend the latter part of the 2020s going through a kind of worldwide bankruptcy. We won’t call it that, and it will take a lot of argument because we won’t have a court to take charge. But we will collectively realize the situation can’t go on and find a way to end it. I’ve taken to calling this “the Great Reset.”

Once the Great Reset is over, we’ll find a much better world waiting for us. Getting there will be the hard part.
Debt Monster

In last week’s “Slowing but Not Stopping (Yet)” letter, we talked about the mounting signs of economic slowdown and possible recession. Falling freight volumes are particularly troubling.

My friend and economist Peter Boockvar wrote about the latest shipping data, which came out this week:

The October Cass Freight index fell 5.9% y/o/y which is the 11th straight month of y/o/y declines. Cass Freight repeated what they’ve said for the past 5 months that “the shipments index has gone from ‘warning of a potential slowdown’ to ‘signaling an economic contraction.’” Moreover, “Several key modes, and key segments of modes, are suffering material increases in the rates of decline, signaling the contraction is getting worse.” The underline is theirs, not mine. To continue, “The weakness in spot market pricing for many transportation services, especially trucking, along with recent airfreight and railroad volume trends, heightens our concerns about the economy.”

Here are the 3 main areas of concerns:

1) “We are concerned about the increasingly severe declines in international airfreight volumes (especially in Asia) and the ongoing swoon in railroad volumes, especially in auto and building materials;

2)We see the weakness in spot market pricing for transportation services, especially in trucking, as consistent with and a confirmation of the negative trend in the Cass Shipments Index;

3)As volumes of chemical shipments have lost momentum, our concerns of the global slowdown spreading to the US increase…The trade war looks as if it has reached a ‘point of no return’ from an economic perspective, as the rates of decline are accelerating.” Again, the underline is theirs.

But not all the news is bad, and we could muddle along in this slow-growth mode for a few more quarters or even years. The problem is that even this mild growth is happening only due to monster amounts of debt. A decade of bailouts, QE, ZIRP, and so on encouraged everyone to lever up, and they have. Ray Dalio described this in his latest LinkedIn post.

Because investors have so much money to invest and because of past success stories of stocks of revolutionary technology companies doing so well, more companies than at any time since the dot-com bubble don’t have to make profits or even have clear paths to making profits to sell their stock because they can instead sell their dreams to those investors who are flush with money and borrowing power.

There is now so much money wanting to buy these dreams that in some cases venture capital investors are pushing money onto startups that don’t want more money because they already have more than enough; but the investors are threatening to harm these companies by providing enormous support to their startup competitors if they don’t take the money.

This pushing of money onto investors is understandable because these investment managers, especially venture capital and private equity investment managers, now have large piles of committed and uninvested cash that they need to invest in order to meet their promises to their clients and collect their fees.

In other words, much of what we see right now isn’t real economic activity. It is artificial, incentivized by the monetary policies that ended the last crisis, but should have stopped much sooner.

Now people are beginning to see this emperor has no clothes. The first evidence is in the failure-to-launch of “unicorn” companies like WeWork, whose early investors assumed they could palm off their shares to unwitting IPO buyers. Nope, didn’t happen, not going to. But that’s minor compared to the other threat they face: rising interest rates.

In case you haven’t noticed, our negative-rate-loving overseas friends are having a change of heart. The Bank of Japan and European Central Bank are plainly looking for an exit from NIRP as their commercial banking sectors find it increasingly impossible to turn a profit. And whatever many on the progressive left think about banks, they are a critical part of the economy.

Over here, the Federal Reserve’s rate-cutting at the short end is raising rates at the long end and, not coincidentally, un-inverting the yield curve. (By the way, the yield curve almost always normalizes as recession begins. So that is not an “all clear” signal.)

This is happening, in part, because the Fed is having to “help” the Treasury sell enough T-bills to cover the government’s growing deficit. This is helping reduce interest costs a bit because shortening the average maturity lets the Treasury pay lower rates. But it also leaves less capital at the long end, pushing those rates higher. And loan demand isn’t shrinking because so many people figured they would keep refinancing forever.

This will change in due course. And as we see debt-laden businesses run into difficulty—often because they were bad ideas in the first place—bankers will tighten lending standards, and the dominoes will start to fall.
Recipe for Conflict

I realize some readers are of the progressive persuasion that debt doesn’t matter, we owe it to ourselves, etc. This is not correct. Debt does matter, and there are limits to how much an economy can bear. I’ll admit, the limit is proving higher than I thought, but there is one and every day brings us closer to it.

You really need to watch this video of a recent conversation between Ray Dalio and Paul Tudor Jones. Their part is about the first 40 minutes. Jones begins by positing that Donald Trump is the best salesman in American history because he (a) got the Republican Party to accept annual deficits at 5% of GDP and (b) convinced the Fed to cut interest rates even with unemployment at 50-year lows.

Of those two, the budget deficit is the least surprising. I (sadly) realized long ago that even Republicans are fiscal conservatives only rhetorically, and like all politicians will respond to constituent demands. Everybody wants lower taxes (for themselves) and higher spending (on their own priorities). That’s what our system delivers. Not good, but it’s reality. And so the debt grows ever larger.

No candidate can run on anything close to fiscal balance, because to do so would mean either advocating higher taxes or cutting entitlement programs. Both are guaranteed vote killers.

We learned this week that the federal deficit for the last 12 months rose above $1 trillion for the first time since 2013. The official on-budget debt is only part of it, too. Off budget will be at least another $200 billion.

With GDP weakening (today the New York and Atlanta Fed models both cut their fourth-quarter GDP growth projections to 0.4% or below) and without a significant trade deal (something more than just around the margins for optical reasons), we can expect lower government revenues and higher government spending to further increase the deficit.

Add in unfunded pension debt, both at the federal level and lower. Does anyone really think that in a serious crisis, Washington won’t bail out bankrupt state and local pension plans? And of course it will step in to save the laughably unfunded Pension Benefit Guaranty Corporation, which insures private defined benefit pensions. All these unaccounted-for liabilities will amplify future deficits at some point.

We are not going to get out of this debt trap by cutting benefits or raising taxes. I agree with Ray Dalio that we are almost certainly going to monetize it. I highly suggest that you read his latest piece titled “The World Has Gone Mad and the System Is Broken.” It is the shortest and best summary of his views that he has put out in a long time.

Since there isn’t enough money to fund these pension and healthcare obligations, there will likely be an ugly battle to determine how much of the gap will be bridged by 1) cutting benefits, 2) raising taxes, and 3) printing money (which would have to be done at the federal level and pass to those at the state level who need it). This will exacerbate the wealth gap battle.

While none of these three paths are good, printing money is the easiest path because it is the most hidden way of creating a wealth transfer and it tends to make asset prices rise. After all, debt and other financial obligations that are denominated in the amount of money owed only require the debtors to deliver money; because there are no limitations made on the amounts of money that can be printed or the value of that money, it is the easiest path.

Note, Ray isn’t saying he prefers this path, or that it is a good choice. He thinks it is what we will do. I agree. This is what will happen, and it’s going to have consequences.

The big risk of this path is that it threatens the viability of the three major world reserve currencies as viable store holds of wealth. At the same time, if policy makers can’t monetize these obligations, then the rich/poor battle over how much expenses should be cut and how much taxes should be raised will be much worse. As a result, rich capitalists will increasingly move to places in which the wealth gaps and conflicts are less severe and government officials in those losing these big tax payers will increasingly try to find ways to trap them.

If that sounds like a recipe for conflict, you’re right. It will probably get ugly. We can’t yet say exactly how, because there are lots of ways this could unfold. The Fed has plenty of power already, and Congress can give it more. The only real limit is what the markets will bear in terms of currency depreciation.

One way or another, this will get to a Great Reset in which debt simply… disappears. That will inevitably create winners and losers. Some people who did everything right will get punished. Some irresponsible fools will get rewarded. Neither is good, but that’s not the point. We are talking about what will happen, not what we want.
Currency Wars?

In the video conversation mentioned above between Paul Tudor Jones and Ray Dalio, Ray again highlights some problematic similarities between our times and the 1930s. Both feature:

1.   a large wealth gap

2.   the absence of effective monetary policy

3.   a change in the world order, in this case the rise of China and the potential for trade wars/technology wars/capital wars.

He threw in a few quick comments as their time was running out, alluding to the potential for the end of the world reserve system and the collapse of fiat monetary regimes. Maybe it was in his rush to finish as their time is drawing to a close, but it certainly sounded a more challenging tone than I have seen in his writings.

It brought to mind an essay I read last week from my favorite central banker, former BIS Chief Economist William White. He was warning about potential currency wars, aiming particularly at the US Treasury’s seeming desire for a weaker dollar. Ditto for other governments around the world. He believes this a prescription for disaster.

One possibility is that it might lead to a disorderly end to the current dollar based regime, which is already under strain for a variety of both economic and geopolitical reasons. To destroy an old, admittedly suboptimal, regime without having prepared a replacement could prove very costly to trade and economic growth.

Perhaps even worse, conducting a currency war implies directing monetary policy to something other than domestic price stability. There ceases to be a domestic anchor to constrain the expansion of central bank balance sheets.

Should this lead to growing suspicion of all fiat currencies, especially those issued by governments with large sovereign debts, a sharp increase in inflationary expectations and interest rates might follow. How this might interact with the record high debt ratios, both public and private, that we see in the world today, is not hard to imagine.

I called Bill to ask if he thought this was going to happen. Basically, he said no, but it shouldn’t even be considered. It was his gentlemanly way of issuing a warning. Currency devaluations against gold were part of the root cause of the Great Depression. Coupled with protectionism and tariffs, they devastated global economic growth and trade.

Do I think it will happen in any significant way in the next few years? It is not my highest probability scenario. But imagine a recession that brings the US deficit to $2 trillion, possibly followed by a governmental change that raises taxes and spending. This could bring about a second “echo” recession with even higher deficits. This would force the Federal Reserve to monetize debt in order to keep interest rates from skyrocketing, thereby weakening the dollar.

Couple this with a concurrent crisis in Europe, potentially even a eurozone breakup, resulting in countries all over the world trying to weaken their currencies with the potential for higher inflation in many places.

In such a scenario, is it hard to imagine a desperate president and Congress, toward the latter part of the next decade, regardless of which party in control, instructing the US Treasury to use its tools to weaken the dollar? Can you say beggar thy neighbor? Can you see other countries following that path? All as debt is increasing with no realistic exit strategy except to monetize it?
Timing Is Everything

As Bill and I talked scenarios, he reminded me of Herbert Stein’s dictum: “If something can’t go on forever, it won’t.” But then he quoted another famous economist (whose name escapes me) who replied, “But it can go on a lot longer than you think.” Kind of like Keynes reminding us that the markets can remain irrational longer than you can remain solvent.

The world has grown accustomed to having the dollar as reserve currency. It is comfortable letting central banks monetize debt and governments run ever-larger deficits. Somehow, we’ve even become used to negative rates. Things can indeed go on longer than one might think.

I can seriously imagine the market rising significantly over the next few quarters as easily as I can imagine a bear market. But it will be a few years before the gut-wrenching Great Reset happens. We have time, if we properly use it, to position our lives and help those around us prepare for the coming storm.

We will have the chance to invest in new companies that will absolutely, astoundingly change the world for the better. They’re going to be extraordinarily valuable franchises. There will be fixed income opportunities even as interest rates drop.

I almost find it ironic that on the one hand I talk about the Great Reset while I am writing a book called the Age of Transformation, marveling at all of the wonderful new opportunities we will have.

Learn to deal with change and take advantage of it. Oh yeah, and consider slowly increasing your allocation to physical gold. I don’t think of gold as an investment. I think of it as central bank insurance. And after meditating on today’s letter, I think I may need a little more insurance. Just a thought…
Philadelphia and Dallas

I will be flying into Philadelphia for a “hit-and-run” set of meetings Thursday before flying back on Friday morning to Puerto Rico. Then the next week, Shane and I will be in Dallas for Thanksgiving with the family (I will have a big hand in the food preparation) and a wedding.

I have been trying to arrange a meeting with Ray Dalio, as I seriously want to talk with him about some of the scenarios he would pursue. Schedules are tricky things. I really appreciate his willingness to expose his ideas to the world, when at this stage of the game, he really doesn’t need to. But he clearly cares about the future of the Republic. And Leon Cooperman. If you haven’t read his latest letter to Elizabeth Warren, you should. I have always been a big fan of Paul Tudor Jones and after seeing him in that interview, it just reminded me how funny and thoughtful he is.

Thousands of others, less well-known but all up and down the income and political spectrum, are just as committed to the future of the country and humanity. Am I naïve to hope we can overcome the partisan divide? It wouldn’t be the first time that a divided country has come together to work for the common good. In fact (spoiler alert), that is precisely the scenario I see happening around the time of the Great Reset.

Do we have to get there? No, there are paths we can take to avoid all that. Just not one that I see as politically possible today. But by 2024, who knows? One can always hope.

And with that, I will hit the send button. You have a great week.

Your already thinking about Thanksgiving dinner analyst, 


John Mauldin
Co-Founder, Mauldin Economics

State of denial

America’s public-sector pension schemes are trillions of dollars short

Police officers, teachers and other public workers face a brutal reckoning

Perhaps it takes teachers to give politicians a lesson. Any official who wants to understand the terrible state of American public-sector pensions should read the financial report of the Illinois Teachers Pension Fund.

Its funding ratio of 40.7% is one of the worst in America, according to the Centre for Retirement Research (crr) in Boston (see table).

Since it was established in 1939, Illinois officials have not once set aside enough money to fund the pension promises made.

As a result, three-quarters of the money the state (or rather the taxpayer) now pays in each year merely covers shortfalls from previous years.

The situation is getting worse.

In 2009 the schemes’ actuaries requested $2.1bn, but only $1.6bn was paid.

By 2018 the state paid in $4.2bn, still well short of the $7.1bn the actuaries asked for.

The trustees have warned that the plan would be “unable to absorb any financial shocks created by a sustained downturn in the markets”.

Other schemes have attracted similarly stark warnings.

Illinois is the class dunce, with six languishing schemes.

Chicago Municipal is just 25% funded and the actuaries warn that “the risk of insolvency for the fund has increased”.

The actuaries of the Chicago police scheme warn that “this is a severely underfunded plan” with a shortfall of $10bn; the funded ratio is not projected to reach 50% until 2043.

Offering workers a defined-benefit pension, where an income based on final salary is paid for the rest of their lives, is an expensive proposition, especially as life expectancies lengthen.

Pension shortfalls are common across America, with the average public scheme monitored by the crr just 72.4% funded.

That adds up to a collective shortfall of more than $1.6trn.

When a scheme is underfunded, one of three things can happen.

More contributions can be made, by employers or workers or both.

Benefits can be cut.

Or the scheme can earn a higher return on its investments to make up for the shortfall.

Cities and states are paying more, but still not enough.

In 2001 public-sector employers contributed a further 5.3% of their payroll to meet pension promises; now that figure is around 16.5% on average (see chart).

Even so, in no year since 2001 has the average employer contributed as much as demanded by actuaries.

Last year’s shortfall was just under 1% of payroll.

This reluctance is understandable.

Politicians dislike raising taxes—or cutting services to pay for higher contributions.

Workers do not want to see their current pay reduced by higher deductions, or their future benefits cut.

And in any case, in some states courts have ruled that pension benefits, once promised, cannot be taken away.

Arizona attempted a reform in 2012 that would have increased contributions for anyone with less than 20 years’ service.

Workers sued and the courts ruled in their favour in 2016, requiring the scheme to repay $220m.

Since the failed reform plan was instituted, employers’ contributions as a share of payroll have almost doubled.

So states and cities have crossed their fingers and hoped that their investments will bail them out. America’s buoyant stockmarket has done its best to help.

Returns on government bonds have also been good for much of the past three decades.

Even so, the average public-sector scheme is less well funded now than it was in 2001.

And the markets are unlikely to keep being so helpful.

In 1982 the government sold long-term Treasury bonds with a yield of 14.6%; now such bonds yield just 2.4%.

Equity valuations are high by historic standards.

That suggests future returns will be lower than normal.

Kentucky offers a sobering example of how states can spiral towards disaster.

In 2001 its retirement system was 120% funded and employers were putting in just 1.9% of payroll.

After the dotcom slump, the funding position deteriorated.

By 2005 the scheme was less than 75% funded and the required contribution had gone up to 5.3%.

But the state fell short of the target every year until 2015, by which point the contribution had leapt to nearly 33% of payroll.

In 2018 the actuaries asked for 41%.

Kentucky’s scheme covering “non-hazardous” workers (those who are not employed by the emergency services) is just 12.8% funded.

One of its beneficiaries is Larry Totten, who worked for Kentucky’s park service and retired in 2010 after a 36-year career.

When he found out about the scheme’s parlous state, he joined Kentucky Public Retirees, a group that lobbies for pensioners.

“There’s enough blame to go around,” he says.

Though it was state governors (of various parties) who failed to pay the required amounts into the scheme, it was the state legislature that let them get away with it.

Such severely underfunded schemes risk entering two vicious circles.

The first involves costs. Kentucky’s public pension scheme covers a wide range of state employers and some have to pay 85% of payroll to cover their pension obligations.

Employing someone on $50,000 a year requires an extra $42,500 of contributions.

They naturally seek to lay off workers to reduce this cost.

But that leaves fewer people paying in without changing the number currently receiving retirement benefits.

That increases the short-term squeeze.

The second concerns the accounting treatment of public-sector funds.

Many assume nominal returns on their portfolios of 7% or more after fees.

This optimism has a big impact.

Calculating the cost of a pension promise requires many assumptions—how long people will live, how much wages will rise and so on.

Future payouts must be discounted to calculate a cost in current terms, and thus contributions.

The higher the discount rate, the lower the current cost and the less employers have to pay in.

Public-sector schemes use the assumed rate of investment return as their discount rate—so a high rate lowers the apparent cost.

But if a scheme becomes severely underfunded, a plunge in the stockmarket could leave it unable to cover current payouts.

So it must invest in safer, lower-yielding securities, such as government bonds.

That reduces the discount rate and makes the pension hole even bigger.

Kentucky’s non-hazardous scheme uses an expected return of 5.25%, much lower than most public-sector schemes.

These calculations look surreal by comparison with private-sector pension funds.

Their accounting rules regard a pension promise as a debt like any other.

After all, courts insist pensions have to be paid, whatever the investment returns.

The discount rate must therefore be based on the cost of debt—for companies, the yield on aa-rated corporate bonds.

Since that yield, now around 3%, is far lower than the return assumed by public-sector funds, private-sector pension liabilities are very expensive.

Faced with a $22.4bn shortfall, General Electric recently froze pension benefits for 20,000 employees.

These different accounting approaches seem to imply that it is cheaper to fund a public-sector pension than a private-sector one. In reality, that cannot be the case.

The public-sector pension deficit is therefore much larger than the $1.6trn estimated by the crr.

It is hard to be precise about how much larger, but the accounts of troubled schemes give some indication.

The Chicago Teachers scheme has a shortfall of $13.4bn, and a funding ratio of 47.9% on the basis of an assumed return of 6.8%.

Its financial report reveals that a one-percentage-point fall in the discount rate would increase the deficit by $3bn.

The private-sector accounting approach would lower the discount rate by around four percentage points.

This is a crisis no one wants to solve, at least not quickly.

The Chicago Teachers scheme is aiming for 90% funding, but not until 2059—long after many retired members will have died.

New Jersey’s teachers’ scheme is not scheduled to be fully funded until 2048.

Such promises might as well be dated “the 12th of never”.

The bill for taxpayers seems certain to rise substantially.

For the states with the biggest pension holes, political conflict is in store.

China Update

Doug Nolan

We shouldn’t read too much into one month.

With a holiday week, October is typically a sluggish period for lending in China.

But at $88 billion, the growth in Aggregate Financing was about a third below estimates.

It was also the weakest month in years – running about a third of September’s level and 16% below a slow October 2018.

Even with a weak October, six-month growth in Aggregate Financing was 16% ahead of 2018 - with year-to-date growth up 20%.

Principally, overheated Credit system turn increasingly susceptible to trouble.

October Bank Loans increased $94 billion, 17% below forecasts and the weakest lending month since December 2017. Growth was down sharply from September’s $241 billion and ran 5% below October 2018.

A slow October reduced one-year growth to 12.4%, matching the slowest growth rate since March 2017 (a decade low).

Year-to-date, Bank Loan growth of $2.038 TN ran 3.3% ahead of comparable 2018.

It’s worth noting Bank loans were up 27.2% in two years.

Consumer (chiefly mortgage) Loan growth dropped to $60 billion (from September’s $108bn), the weakest expansion since February and 25% below October 2018.

At 15.4%, one-year growth slowed to the weakest pace since May 2015.

At $870 billion, year-to-date Consumer lending was running 2.6% below comparable 2018.

Notably, three-month growth was down 9.0% versus comparable 2018.

Consumer Loans were, however, up 36% over two years, 68% in three and 138% over five years.

Over recent years, Beijing repeatedly responded to heightened economic and financial fragility with serial stimulus.

I have argued policymakers dangerously extended the “Terminal Phase” of a historic Credit Bubble.

Importantly, policy stimulus pushed China’s mortgage finance Bubble into precarious late-cycle extremes.

In my view, Chinese apartment markets demonstrated classic “blow-off” speculative dynamics – creating acute fragility in the process.

From about 5% annual inflation back in early 2018, the 70 Cities Newly Built Residential Buildings price index hit a high of 11.4% this past April.

Year-over-year price increases have now slowed for six consecutive months (to 8.0%).

Of the 70 cities tabulated, 69 showed year-on-year increases in New Home (apartment) prices, with 50 cities posting price gains during October. Still, momentum has clearly waned.

Average New Home Prices increased 0.50% in October, the slowest price inflation since March 2018. Price gains peaked at 1.49% in August 2018 and have been trending downward ever since.

I tend to see Existing Home Sales data as more illuminating.

Examining Existing Home Sales, half (35) of the cities reported price declines in October, up from September’s 28, August’s 20 and May’s 11.

On a year-on-year basis, 13 cities have now posted price declines versus only two in June.

And while average Existing Home prices were up 4.24% y-o-y, this gain has been almost cut in half over the past six months.

Key (i.e. highly inflated) markets are much weaker than the average.

October prices were down 0.60% in Beijing, that market’s fourth consequence decline.

Beijing prices have declined 1.5% over the past year.

Prices in Guangzhou are down 2.4% y-o-y, with Shanghai prices up only 1.1%.

November 5 – Wall Street Journal (Bingyan Wang, Liyan Qi and Stephanie Yang): “Thirty floors above the showroom of a Chinese developer, a 29-year-old woman stood on a small rooftop ledge about 8 feet off the rooftop itself, threatening to jump and declaring that her recent home purchase had ruined her life. Ms. Hou… was one in a group of angry home buyers who had gathered at a real estate sales office in Tianjin… on Saturday, demanding their money back for half-constructed apartments that had now dropped in price. In recent years, Chinese officials have tightened financing to developers and rules on lending for home buyers in an effort to cool a buying frenzy and runaway prices. The government has delivered a consistent message: Apartments are for living, not for speculation.”

I’ve again highlighted the above WSJ extract to emphasize the point that the Chinese (borrowers, lenders, regulators and government officials) have no experience with collapsing mortgage finance and apartment Bubbles.

It is president Xi who has championed housing “is for living in and not speculation.”

Beijing for years has employed timid – and inevitably unsuccessful – measures to rein in housing-related excess.

The upshot has been upwards of 60 million unoccupied apartment units, while mortgage-related Credit growth has become an increasingly prominent source of system liquidity and purchasing power.

It’s worth noting Consumer (largely mortgage) borrowings that averaged $46 billion monthly during 2015 had more than doubled to $97 billion a month this year (March through September).

With a “phase 1” U.S./China trade deal supposedly imminent, global markets have turned more forgiving of disappointing Chinese data.

Yet it’s worth noting October year-on-year Fixed Investment was weaker (5.2%) than expected (5.4%), and the lowest reading since at least 1998.

Industrial Output (y-o-y) dropped to 4.7% from 5.8%, significantly trailing estimates (5.4%).

Also missing estimates (7.8%), Retail Sales (y-o-y) declined from 7.8% to 7.2%, matching the lowest level since 2003.

When I see a sharp slowdown in Credit expansion coupled with broad-based indications of economic deceleration – my analytical curiosity is piqued.

As I have written in the past, trade war escalation is a potential catalyst for near-term Chinese financial and economic instability.

Yet, from the perspective of historic Credit and economic Bubbles, a trade truce would have only marginal impact on underlying fundamentals.

I hold the view Chinese Credit is heading toward an inevitable crisis of confidence – with or without a trade pact.

China’s Bubbles have inflated dangerously since 2016’s brush with Crisis Dynamics.

The S&P500, Dow and Nasdaq all traded to record highs this week.

Perhaps Chinese market moves were more noteworthy.

The Shanghai Composite dropped 2.5% this week to a 10-week low.

The Hang Seng China Financials index sank 4.4%, while Hong Kong’s Hang Seng index fell 4.8%.

November 13 – Bloomberg (Tian Chen and Claire Che): “Cracks are starting to emerge in Hong Kong’s currency and money markets, as traders speculate the local dollar’s resilience to increasingly violent protests won’t last. Hong Kong stocks were already showing signs of stress, losing more than 5% over the past week. Now, liquidity conditions in the foreign-exchange market are the tightest since the late 1990s, or the aftermath of the Asian financial crisis. Interbank rates are climbing -- making funding costs more expensive for banks -- while a gauge of expected swings in the Hong Kong dollar is near its highest in a month.”

In the near-term, China is facing a crisis of confidence in its small bank sector, rapidly rising corporate defaults and an increasingly fragile mortgage finance Bubble.

Meanwhile, odds are rising of a run on the Hong Kong dollar with an attendant crisis of confidence in Hong Kong as an international financial hub.

Recalling the nineties, the breaking of currency pegs can be exceedingly disruptive.

China remains the marginal source of both global finance and economic growth.

Despite all the hoopla of record high U.S. stock prices, the risk of global instability is rising.

Again, I don’t want to read too much into October’s abrupt lending slowdown.

Yet is does have the potential to be the beginning of something important.

China – along with the world more generally – has never been as vulnerable to a sudden Credit slowdown.

Bubbles don’t function well in reverse.

November 15 – Reuters (Marc Jones): “Global debt is on course to end 2019 at a record high of more than $255 trillion, the Institute of International Finance estimated on Friday — nearly $32,500 for each of the 7.7 billion people on planet. The amount, which is also more than three times the world’s annual economic output, has been driven by a $7.5 trillion surge in the first half of the year that shows no signs of slowing. Around 60% of that jump came from the United States and China. Government debt alone is set to top $70 trillion this year, as will overall debt (government, corporate and financial sector) of emerging-market countries. ‘With few signs of slowdown in the pace of debt accumulation, we estimate that global debt will surpass $255 trillion this year,’ the IIF said…”

November 14 – Bloomberg: “China’s central bank unexpectedly added liquidity to the banking system Friday to help lenders through the tax season, a move that analysts saw as a sign that larger-scale stimulus is unlikely in the near term. The People’s Bank of China offered 200 billion yuan ($29bn) of one-year loans to banks Friday. It kept the interest rate unchanged at 3.25%, showing restraint in monetary policy after this week’s worse-than-expected economic data. Liquidity in the banking system is at a ‘reasonable, sufficient’ level as the operation offsets companies’ need for funding to pay tax…”

Curious, isn’t it, that the world’s two great Credit engines are currently both requiring extraordinary central bank liquidity injections…

Fingers point at hedge funds after Japan bond sell-off

Trend-following investors switched bets after price crossed key threshold

Laurence Fletcher and Tommy Stubbington in London and Leo Lewis in Tokyo

M&A bankers and lawyers say a 'profound' change of attitude is slowly embedding itself in Japanese boardrooms, making hostile bids a more plausible reality
Massive holdings of Japanese government bonds at the country’s central bank mean that the market rarely budges © Bloomberg

Hedge funds are taking the blame for a drop in Japanese government bond prices that has reverberated around global debt markets.

Benchmark bonds in the US, Germany and the UK have all taken a tumble in recent weeks, driven by an unusual outbreak of optimism about the global economic outlook that has boosted equities.

But sharp price falls in the typically tranquil Japanese government bond market have stood out — and some analysts say they bear the fingerprints of trend-seeking computerised hedge funds scrambling to cover losses.

The suspicions are rekindling a debate about the influence of these hedge funds, which have frequently been blamed when markets swing to extremes without clear fundamental triggers.

“Futures-driven selling has been the main cause of the [Japanese market] move,” said Peter Chatwell, head of rates strategy at Japan’s Mizuho International. “It looks like an unwind of leveraged long positions.”

Massive holdings of JGBs at the country’s central bank mean the market rarely budges, but the 10-year benchmark yield leapt this week to a high of minus 0.02 per cent, from minus 0.19 per cent at the start of November — a large move by Japanese standards that reflects falling prices.

The yield slipped back to minus 0.09 per cent on Thursday.

Line chart of 10-year government bond yield (%) showing Hedge funds dump Japanese debt

Certain types of hedge funds that try to latch on to trends in global markets — known in the industry as commodities trading advisers, or CTAs — had been betting successfully on rising JGB prices since around this time last year, according to Société Générale’s Trend Indicator.

But their investments turned sour as the market went into reverse in early September, leaving them nursing losses. The Trend Indicator has, as of late last week, shifted to betting on falling prices.

The global pullback in fixed income since mid-September has been sparked by easing trade tensions and a sense that the gloom about the prospects for the world economy was overdone.

Selling in JGBs — which also reflects receding expectations that the Bank of Japan is on the brink of cutting interest rates — has been a catalyst for broader moves at crucial points during the sell-off, including over the past week, according to Jim McCormick, global head of desk strategy at NatWest Markets.

“CTAs have built in some cases record long positions in core fixed income markets,” Mr McCormick said. “With momentum signals now turning less bullish, positions could be set to follow.”

Bond traders and analysts in Tokyo point out that trend-following hedge funds had built huge net long exposure to Japanese bonds by the end of August. Those positions, said analysts at Nomura, were highly leveraged and prone to sharper moves in the weeks and months that followed.

Some analysts calculate that the key point for many of those funds in 10-year yields was minus 0.11 per cent. Once the yields popped above that level in November, many funds that had bought the bonds in the August rush were left holding losses, turning them into automatic sellers.

Critics say these funds, which run about $300bn in assets, push markets further than they otherwise would have moved, damaging other market participants. But many managers of trend-following funds say the amount they trade is only a fraction of total market volume and their footprint is small.

And while these managers have sold Japanese government bonds, the extent to which they are now betting on falling prices varies. The bonds are “not a big short”, said an executive at one hedge fund.

Rotterdam-based hedge fund Transtrend, which manages $5.4bn in assets, owned Japanese government bonds for most of this year, making money in the process, but started cutting this position late last month. Rather than betting on falling prices, the fund now has no exposure. 
“We do not believe that Transtrend has played a significant role in exacerbating the safe haven or JGB trend,” said executive director André Honig. “For the CTA sector as a whole, it shouldn’t be the case either.”
CTAs employ teams of PhD scientists to design algorithms to spot and profit from market trends, and they have been enthusiastic buyers of bonds on very low or negative yields in recent years.
While many human hedge fund traders and other investors have recoiled at the prospect of effectively paying for the privilege of lending money to a government, quants, which feel no fear, kept holding on as the trend took yields into the deep freeze.
That has been a big driver of gains at trend-following funds this year. Such funds are on average up 6.2 per cent this year to the end of October, according to data group HFR, despite suffering some losses in recent months as bonds weakened.
London-based Aspect Capital has gained 18.5 per cent this year in its main fund. It has been betting on rising bond prices, according to an investor letter seen by the Financial Times, and suffered a loss on its bond position in early November. The letter did not detail which countries’ bonds Aspect owned. Aspect declined to comment.
Mr Chatwell said the swings in the market had undermined bond-buying strategies in recent weeks. He said: “While there’s all this volatility it’s harder to generate income from the JGB market. A lot of investors are sitting on the sidelines and waiting for a better entry point.”

Old, not yet rich

China’s median age will soon overtake America’s

Demography may be the Chinese economy’s biggest challenge

SHORTLY AFTER 9am the neighbourhood care centre for the elderly shuffles to life. One man belts out a folk song. A centenarian sits by his Chinese chessboard, awaiting an opponent.

A virtual-reality machine, which lets users experience such exotic adventures as grocery shopping and taking the subway, sits unused in the corner.

A bigger attraction is the morning exercise routine—a couple of dozen people limbering up their creaky joints.

They are the leading edge of China’s rapid ageing, a trend that is already starting to constrain its economic potential.

Since the care centre opened half a year ago in Changning, in central Shanghai, more than 12,000 elderly people from the area have passed through its doors.

The city launched these centres in 2014, combining health clinics, drop-in facilities and old-people’s homes. It plans to have 400 by 2022.

“We can’t wait. We’ve got to do everything in our ability to build these now,” says Peng Yanli, a community organiser.

The pressure on China is mounting.

The coming year will see an inauspicious milestone. The median age of Chinese citizens will overtake that of Americans in 2020, according to UN projections (see chart).

Yet China is still far poorer, its median income barely a quarter of America’s.

A much-discussed fear—that China will get old before it gets rich—is no longer a theoretical possibility but fast becoming reality.

According to UN projections, during the next 25 years the percentage of China’s population over the age of 65 will more than double, from 12% to 25%.

By contrast America is on track to take nearly a century, and Europe to take more than 60 years, to make the same shift.

China’s pace is similar to Japan’s and a touch slower than South Korea’s, but both those countries began ageing rapidly when they were roughly three times as wealthy per person.

Seen in one light, the greying of China is successful development. A Chinese person born in 1960 could expect to live 44 years, a shorter span than a Ghanaian born the same year.

Life expectancy for Chinese babies born today is 76 years, just short of that in America.

But it is also a consequence of China’s notorious population-control strategy.

In 1973, when the government started limiting births, Chinese women averaged 4.6 children each.

Today they have only 1.6, and some scholars say even that estimate is too high.

Fertility was bound to decline as China got wealthier, but the one-child policy made the fall steeper.

Even though the country shifted to a two-child policy in 2016 and may soon scrap limits altogether, the relaxation came too late.

The working-age population, which began to shrink in 2012, will decline for decades to come.

By the middle of the century it will be nearly a fifth smaller than it is now.

China will have gone from nine working-age adults per retired person in 2000 to just two by 2050.

The economic impact is being felt in two main ways.

The most obvious is the need to look after all the old people. Pension payouts to retired people overtook contributions by workers in 2014.

According to the Chinese Academy of Social Sciences, the national pension fund could run out of money by 2035.

The finance ministry is taking small steps to shore the system up: in September it transferred 10% of its stakes in four giant state-owned financial firms to the fund.

But far more is needed. Government spending on pensions and health care is about a tenth of GDP, just over half the level usual in older, wealthier countries, which themselves will have to spend more as they get even older.

The second impact is on growth. Some Chinese economists—notably Justin Lin of Peking University—maintain that ageing need not slow the country down, in part thanks to technological advances.

But another camp, led by Cai Fang of the Chinese Academy of Social Sciences, has been winning the argument so far.

A shrinking labour pool is pushing up wages and, as firms spend more on technology to replace workers, pushing down returns on capital investment.

The upshot, Mr Cai calculates, is that China’s potential growth rate has fallen to about 6.2%—almost exactly where it is today.

The labour shortage is hitting not just companies but entire cities.

From Xi’an in the north to Shenzhen in the south, municipalities have made it easier for university graduates to move in, hoping thereby to attract skilled young workers.

China could, in theory, mitigate the downside from its ageing by boosting both labour-force participation and productivity—that is, getting more people into work and more out of them. Neither is easy.

Retirement ages are very low in China (in many jobs, 60 for men and 50 for women), but the government has resisted raising them for fear of a backlash.

And a return to state-led growth under Xi Jinping appears to be hurting productivity.

As George Magnus, an economist, writes in “Red Flags: Why Xi’s China is in Jeopardy”, demography is not destiny, and China has time to change course.

“The bad news, though, is that the time that is available is passing by rapidly,” he says.

One piece of good news is that China is thinking creatively about how to look after the swelling ranks of pensioners. Traditionally, children have been expected to care for their elderly parents, which helps explain why public investment in old-age homes has been minimal.

But most families now have just one child, and that child is working. Suzhou, a wealthy city near Shanghai, shows how China can take advantage of its scale.

In 2007 Lu Zhong, an entrepreneur, founded Jujiale as a “virtual retirement home”, dispatching helpers to private homes on demand.

It now has 1,800 employees serving 130,000 retired people.

Mr Lu says that it needs to grow by about 15% a year to keep up with demand.

Yet that is a silver lining in a grey-haired cloud. On October 1st China celebrated the 70th anniversary of the People’s Republic.

By the centenary in 2049, Mr Xi has vowed, China will have developed to the point that its strength is plain for the world to see.

But as Ren Zeping, a prominent economist, tartly noted in a recent report, the median age in China in 2050 will be nearly 50, compared with 42 in America and just 38 in India.

That, he wrote, raised a question: “Can we rely on this kind of demographic structure to achieve national rejuvenation?”

A U.S.-China Trade Deal Won’t Rescue Emerging Market Stocks

What is happening in the slowing Chinese domestic economy matters far more for the MSCI EM index than the latest mood on tariffs

By Mike Bird

The prospect of a limited truce on trade between China and the U.S. was enough to lift global stocks in October, but even an actual deal—however likely that is—would offer little more than temporary relief for beleaguered emerging markets.

Rather, emerging-market stocks will have an opportunity to outperform only if the Chinese economy enters an unexpected upswing.

Given Beijing’s reluctance to undertake a 2016-style stimulus this year, that seems unlikely.

Emerging markets are a diverse bunch, but if there is a dominant driver of their problems in 2019 it is probably the slowing Chinese domestic economy, which is only partly related to U.S. tariffs.

The MSCI EM Index is trailing the MSCI World Index by 10 percentage points this year on a total-return basis.

Even once the U.S. is removed from the calculation, EM stock markets are lagging well behind those of the world’s other advanced economies for 2019.

The flagship EM index has seen its direct weighting to China increased in recent years, from 17.9% a decade ago to almost 32% now.

But it isn’t just Chinese stocks themselves dragging the benchmark down.

Shoppers at a Costco in Shanghai. Photo: wu hong/Shutterstock

South Korea, the second-largest component of the index, has had an even more miserable year.

In large part, that is because of its exposure to the manufacturing sector of its big neighbor. China buys around 25% of its exports, up from 10% 20 years ago.

There is a similar story for commodity exporters outside Asia, such as Brazil.

China accounts for more than a quarter of the South American country’s outward trade, up from more like 2% in 1999.

Excluding Asia makes little difference to the underperformance of EM stocks versus their developed-market counterparts this year.

When EM stocks fared badly last year, the difference was often attributed to the unwinding of Federal Reserve largess, which had helped them in previous years.

A mountain of dollar debt would become more difficult to service in a world of higher interest rates.

This year, that monetary trend has reversed, sending 10-year Treasury yields a full percentage point higher.

This may have saved them from a worse fate, but it hasn’t been enough to fuel an EM rally.

Their recent underperformance hasn’t left EM stocks on particularly cheap valuations.

The index is priced around 12 times its expected earnings for the next 12 months, not far from its highs over the past decade. In fact, their performance could have been a lot worse.

The EM index is up 9% for 2019, while more modest Chinese growth has left the CRB Raw Industrials Spot Price Index down 9%. The two usually move in tandem.

Halting additional U.S. tariffs on Chinese goods might provide a meager lift for EM equities.

But given China’s struggle to deal with its mounting debt pile while providing further stimulus to the economy, growth will very likely continue to slow.

Unless something on that front changes, EM stocks—whose wagons have become firmly hitched to China—will struggle to make major gains.

Hong Kong Protesters Call for U.S. Help. China Sees a Conspiracy.

The United States, viewed as a champion of democracy, occupies a symbolic role in the protests. Activists now want President Trump to take a tougher stand against Beijing.

By Edward Wong

Protesters rallying last month in Hong Kong.Credit...Lam Yik Fei for The New York Times

HONG KONG — The Hong Kong protests at times seem like love fests with the United States. Depending on the day, demonstrators wave American flags or Uncle Sam recruitment posters, and even dress as Captain America, complete with shield.

The United States represents democracy, and the activists hope that maybe, just maybe, it will save Hong Kong. Five months in, they are trying harder than ever to draw the United States into their movement.

The protesters are pressing Hong Kong officials and their overseers, the authoritarian Communist Party leaders of China, for greater democratic rights and rule-of-law in the autonomous territory. As they see it, the Trump administration might be able to make demands of Chinese leaders or Hong Kong officials, especially because members of elite political circles want to maintain access to the United States.

Also, they note, the trade war with China, started by President Trump, is adding pressure over all on President Xi Jinping.

For the American government, the protests are more complicated — a potential policy dilemma but also a potential point of leverage with Beijing and a way to channel American values to the rest of the world.

“The United States should continue to deter Beijing from use of force, maintain an unblinking eye on Hong Kong, and make Beijing pay a heavy reputational cost for curtailing the rights and freedoms of Hong Kong citizens,” said Ryan Hass, a former State Department and National Security Council official now at the Brookings Institution.

Yet, he added, “I worry that the protesters in Hong Kong risk misinterpreting American sympathy and support of their cause for expectation that the United States will shield them from Beijing’s heavy hand.”

If the protesters are sending out a siren song, some American officials and lawmakers are answering it, eager to show their commitment to the cause.

Members of Congress have appeared in Hong Kong in public displays of solidarity. Last month, Senator Ted Cruz, Republican of Texas, donned an all-black outfit, while Senator Josh Hawley, Republican of Missouri, posted photographs from a protest.

In Washington, Nancy Pelosi, the speaker of the House, has met with activists, pro-democracy politicians and Jimmy Lai, a publisher considered radioactive by Beijing. Vice President Mike Pence singled out Hong Kong as a beacon of liberty in a speech, saying, “We stand with you; we are inspired by you.”

And versions of a bill that would give support to the protesters are moving though Congress with bipartisan backing. The legislation, among other things, would allow the United States to impose economic sanctions and a travel ban on Hong Kong officials deemed responsible for human rights abuses.

“We hope this bill will pass,” said Selina Po, a 27-year-old protester wearing a mouth mask in the Admiralty neighborhood as she held up a sign with the bill’s name, the Hong Kong Human Rights and Democracy Act. “It’s our hope for winning this war. We’re trying all we can.”

But American officials say the United States needs to weigh its moves carefully.

Greater involvement by Americans could give Beijing more ammunition in its propaganda effort to portray the pro-democracy movement as one stoked by foreign forces.

The Chinese government and state-run news organizations talk about “black hands” behind the unrest and spread conspiracy theories, including one centered on an American diplomat in Hong Kong who was photographed with activists in the lobby of the JW Marriott Hotel.

As the protests persist, American officials are watching for surges in violence and tracking the movement of People’s Liberation Army soldiers into Hong Kong. Some are beseeching demonstrators to stick to nonviolent tactics, even in the face of police crackdowns and attacks by people sympathetic to Beijing.

On Sunday, at least six people were injured when a man with a knife who is believed to be against the democracy movement attacked a family at a shopping mall. In the melee, the attacker bit off part of the ear of a pro-democracy district council member, Andrew Chiu.

“We’re telling everyone that we interact with, we don’t want violence,” Secretary of State Mike Pompeo said on Wednesday. “We think there should be a political solution to the conflict that’s taking place there.”

Two Democratic Congressmen, Tom Suozzi of New York and John Lewis of Georgia, the icon of the American civil rights movement, posted a video last month praising the activists for their “great work” and urging them to stick to nonviolence.

Whether the United States takes greater action on Hong Kong hinges on the unpredictable Mr. Trump. Administration officials and American lawmakers talk openly about checking the authoritarian impulses of the Chinese Communist Party. But the president rarely, if ever, mentions human rights and democracy, and he has not made strong statements on Hong Kong.

He is a transactional president. In June, he told Mr. Xi on a call that he would stay quiet on Hong Kong as long as Washington and Beijing were making progress on trade talks, according to an American official who spoke on the condition of anonymity.

In October, the Trump administration imposed some restrictions on Chinese companies and organizations for their roles in the mass repression of Muslims in mainland China, but Mr. Trump has held back from harsher actions for fear of upsetting the trade negotiations.

If a Hong Kong bill reaches Mr. Trump’s desk, analysts say, the president might see it as merely a tool to wring concessions from China and could forego support if a trade agreement were close.

“Strong American bipartisan support for the peaceful protesters is not enough to override President Trump’s transactional instincts,” Mr. Hass said. “He does not look at Hong Kong through a values-based lens. And as long as he remains president, this outlook will limit America’s responses to developments in Hong Kong.”

Administration officials argue that Mr. Trump’s approach gives the United States a stronger hand in constraining Beijing on Hong Kong — even if it appears that Mr. Trump just wants to use the Chinese territory to his advantage.

“America expects Beijing to honor its commitments,” Mr. Pence said, “and President Trump has repeatedly made it clear it would be much harder for us to make a trade deal if the authorities resort to the use of violence against protesters in Hong Kong.”

In the eyes of Beijing, there has been no shortage of provocations by American politicians. On Oct. 22, Ms. Pelosi posted on Twitter a photograph of herself on Capitol Hill with three pro-democracy figures — Mr. Lai, Martin Lee and Janet Pang.

“My full support and admiration goes to those who have taken to the streets week after week in nonviolent protest to fight for democracy and the rule of law in #HongKong,” she wrote.

On Wednesday, Ms Pelosi slammed the decision by Hong Kong officials to bar the activist Joshua Wong from running in local elections. She said it was “another blow against rule of law in Hong Kong and the principle of ‘one country, two systems,’” referring to the foundation for the policy of autonomy that Britain and China agreed would be used to govern the territory.

Ms. Pelosi met Mr. Wong in Washington in September.

A Chinese Foreign Ministry spokeswoman, Hua Chunying, lashed out, saying, “It is precisely because of the naked cover-up and connivance of external forces such as Pelosi that the violent anti-law forces are even more fearless.”

“No matter how your eyes are blinded by prejudice, no matter how your heart is filled with evil, Hong Kong is China’s Hong Kong,” the spokeswoman added. “Any attempt to interfere in Hong Kong affairs will not succeed.”

Many demonstrators want American intervention and are focusing their attention on the legislation. The mere threat of American sanctions, they say, would give the movement greater voice with Beijing.

On Oct. 14, the night before a vote on the bill in the House of Representatives, protesters held a rally in the Central district to call for its passage. Tens of thousands attended, many of them carrying American flags.

“The power of Hong Kong people alone is limited, and we need other countries, such as the U.S., to help us counter China and keep ‘one country, two systems,’” said Eric Kwan, 32. “I doubt the act can be an ultimate game-changer, but I think it is enough to give pressure to China.”

Along with allowing for sanctions, the legislation requires the State Department to review each year whether Hong Kong is still autonomous enough to qualify for the benefits of the 1992 Hong Kong Policy Act, which grants the city a trade and economic status different from that of mainland China.

Some American officials say the bill could harm Hong Kong residents if the United States determines that the territory no longer qualifies as an autonomous entity. But the bill’s proponents defend its practical and symbolic value.

“Standing in support of Hong Kongers and preserving Hong Kong’s autonomy should be a priority of the United States and democracies worldwide,” said one of the bill’s sponsors, Senator Marco Rubio, Republican of Florida.

The bill passed the House by unanimous vote last month. Though the Senate majority leader, Mitch McConnell, has not scheduled a vote yet, the measure is expected to pass that chamber easily, with a veto-proof majority. Then Mr. Trump would have to decide whether to sign it into law.

Ezra Cheung contributed reporting from Hong Kong, and Amber Wang contributed research from Beijing.