"Sleepwalking Toward a Precipice":
Our Observations and Outlook, Part 2
Foreword from dshort: The article below is the text portion of Jason Leach's fabulously illustrated presentation, which is available here. The illustrations are a must see!
What We Will Cover...
It's Structural: The credit crisis and Great Recession revealed structural problems in the United States, Europe and China which may hinder their future growth prospects.
Political Dysfunction: Political leadership has been unwilling or unable to address these structural issues effectively, resulting in temporary, expedient solutions that often make problems worse.
Fourth Branch Solutions: With the failure of political leadership, "central planning" has been ceded to central banks to "reflate" markets and reliquify insolvent banking systems and insolvent sovereign nations.
The Unknowns: Given the fragile nature of global economies coming out of crisis, a variety of uncertainties could also negatively impact growth.
Market Matters: Over the next decade, we see "double-wide" possibilities for economic growth translating into "double-wide" possibilities for U.S. and global markets.
Euro Zone.the failed experiment
Euro Zone Insolvency Mix: The European Monetary Union (EMU) is a 17-member subset of the larger 27-member European Union. In 1999, this "Euro Zone" adopted both a single currency and single monetary policy administered by the European Central Bank (ECB). In the first decade of its existence, use of the Euro across countries with differences in competitiveness, tax collection, wages and entitlements, inevitably led to wide trade imbalances, high deficits and rising debt in weaker periphery Euro Zone countries. The 2008-2009 financial and economic shocks catalyzed this mix of structural problems, raised borrowing costs significantly for periphery countries, and in 2010, set off periphery Euro Zone nation solvency crises.
"Enhanced Crisis-inium": Euro Zone, EU, and IMF leaders (the "troika") fumbled over numerous liquidity and austerity measures to fight sovereign debt crisis but their actions served only to "enrich" it. In 2010-2011, troika leaders secured over 1/2 trillion dollars to bail out Portugal, Ireland, and Greece (twice), and forced adoption of strict budget cuts, tax increases, and labor reforms. In 2012, leaders forced a $132B private sector "haircut" on Greek bonds, approved enhanced bailout funds to cover Spain and Italy, and forced all countries to adopt a "fiscal compact" to cap deficits. The "fixes" left Greece with more debt, eliminated future private buyers of distressed sovereign debt, provided insufficient capacity for bail outs (~$650 billion), and reduced growth through austerity.
Euro Zone."the change bank, that's what we do"
"Single Word Scores": As European leaders administered multiple acronym fixes, world markets shuddered with every new half-baked solution. The European Central Bank vigorously resisted becoming "lender of last resort" for distressed countries and banks, but relented in late 2011 and early 2012, lending trillions to Euro Zone banks via Long Term Refinancing Operations (LTRO) as Spanish and Italian yields (the rate at which they borrow) spiked, and normal channels of bank funding dried up. The ECB became the "single word score" that could calm fears of another financial crisis. As in the U.S., failure of political leadership ceded power to the central bankers to reliquify insolvent banking systems, and in the Euro Zone's case, insolvent sovereign nations.
"Fonzi Finance": In a scheme too cool to be called "Ponzi", the ECB provided insolvent banks $1.3 trillion in 3-year, cheap loans (LTRO), the banks in turn bought hundreds of billions in distressed Euro Zone sovereign bonds, and then deposited the risky sovereign bonds back at the ECB as "collateral" for the original loans. This game of "pass the parcel" may have prevented a second financial crisis in late 2011/early 2012, but it also made the sovereign debt crisis bigger (allowing for hundreds of billions in immediately impaired sovereign debt to be issued), will weigh on long-term growth by misallocating capital to insolvent banks and insolvent nations, and left taxpayers of the Euro Zone on the hook for the bailing out banks and countries indefinitely.
Euro Zone."moles follow the gold"
"The New Barbarous Relic": The root cause of the seemingly never ending Euro Zone debt crisis is the core structural problem of the Euro, and related adjustment processes. The use of a single currency across multiple economies is much like the mis-priced gold standard of the 1920s and early 1930s (Keynes' "barbarous relic"). The Euro forces uncompetitive, highly indebted countries to adjust internally (pushing down wages and prices) as opposed to externally (devaluing currency to improve competitiveness, increase growth, and pay down debt). Tied to the "new barbarous relic" with no means of external adjustment, weak periphery countries face years of deflationary depression and debt default/restructuring are unavoidable.
Euro Zone Whack-A-Mole 2012: Debt crisis contagion in the Euro Zone is the inevitable post-economic crisis outcome of highly indebted countries beholden to a single currency union and thus hard debt math limits. Changes in sovereign debt levels depend on: (i) growth, (ii) borrowing rates, and (iii) budget surpluses/deficits before interest payments. When there is doubt that growth will challenge borrowing rates, and/or that budgets will worsen, perception that debt levels will perpetually rise causes new borrowing rates to spike. At borrowing rates above 7% (where Greece and Portugal reside and where Spain and Italy are going), highly indebted countries without control over their currency can't ever pay off their debt - moles go up.
Europe."straightjackets, walks, and transmissions"
Fiscal Straightjackets & Walking Stocks: The survival scenario for the Euro Zone features: (i) years of transition to a "United States of Europe" with centralized budget and Eurobonds, (ii) the ECB bridging the gap via LTRO and direct sovereign bond purchases, (iii) core countries losing their AAA ratings, (v) sovereign debt default or restructuring of multiple Euro Zone members, (vi) multiple large bank failures/nationalizations, (v) flexibility on austerity limits ("fiscal straightjackets"), (vi) slow growth to recession in the core, (vii) depression in the periphery, (ix) ever increasing social unrest and political swings to "fringe" parties, and (v) possibly one or more members leaving (e.g., Greece, Portugal).
European Transmission: The degree to which the Euro Zone resolution transmits to the rest of the world relies on how orderly it is and whether there are Euro Zone exits. The orderly default of Greece in 2012 had a minor effect on the global economy. Alternatively, disorderly defaults and/or orderly and disorderly exits could cause a collapse of the European economy and banking system, financial and economic contagion around the world, and global depression. It is not a question of "if" or "when", but rather, "how bad." The major structural problems of the Euro Zone cannot easily be fixed by politicians or, in turn, central bankers, and thus Europe is sleepwalking toward a precipice, and unfortunately, dragging the rest of the world with it.
China."what in the whirl?"
The Structural Junk: The dramatic slowdown in global growth and trade in the financial crisis and Great Recession shone a light on major structural issues in China's "state-capitalist" economy.
China's economy has an extreme over-reliance on public investment and exports (70% of GDP growth over 10 years), with domestic consumption (30% of growth) hindered by violent inflation swings, misaligned tax policies (middle/lower classes 50% of taxes vs. 3% in the U.S.), artificially high savings rates (inadequate social safety nets, limited investment opportunities), a rapidly growing wealth divide, aging population, and distortions from the "one child policy".
Small and medium-sized enterprises (SMEs) are handicapped by China's preference for monopolistic, inefficient state-owned enterprises (SOEs), a wasteful state-directed banking system that lends predominately to SOEs, widespread corruption, random enforcement of rule of law, and overarching tension between which form of capitalism should drive growth, state capitalism or free market capitalism.
Local governments are over-reliant on continuous local real estate speculation (land sales 20%-40% of gross revenues) and overburdened by state emphasis on continuous investment in public works (no long-term public bond markets).
China."middling kingdom of growth"
Steroid Economy: China targets GDP growth at the state level to onboard millions in new workers every year. Consensus is that 8% annual GDP growth is the minimum to achieve China's aims, below 8% is, in effect, a "China-cession", and well below 8% may have considerable negative effects (large scale social unrest). Since China's economy is precariously dependent on its distorted investment-led growth model, if investment were to flatten (build the same amount of projects as the year before), GDP growth could fall by more than 50%. The second major contributor to GDP growth, exports, is subject to flat to falling European and American demand due to post-crisis deleveraging.
Trade Winds a Slowin': In response to a fall in exports and GDP growth during the financial crisis, the central government authorized a $580 billion stimulus package and the People's Bank of China (PBOC) allowed banks to issue $2.7 trillion in new loans (~45% of GDP) for investment projects. The massive stimulus allowed China to weather slowing trade winds and maintain above 8% GDP growth, but it exacerbated China's structural issues as investment increased from 40% to 50% of GDP at the expense of consumption, SOEs became a larger part of the economy, real estate bubbled and is busting, inflation skyrocketed, and banks lent and local governments borrowed to virtual insolvency. As in the U.S. and Euro Zone, actions taken after crisis only served to enhance existing structural problems – the "same difference".
China."the orient of debt"
The Orient of Debt: China's state-led growth model is heading towards a debt crisis. The state-owned banking system is the largest in world history with over $17 trillion in assets, but it misallocates capital due to fixed profit margins, flexible accounting standards, and politicized, state-directed lending to local governments, SOEs, high profile political projects, and over 100 countries. Publicly, China's debt/GDP ratio is around 20%-30%, but it is around 100%-200% when inevitable bailouts of banks and other SOEs are included (on par with the U.S and Euro Zone). The right path to remediation would be state asset sales, but it is more likely China will socialize bad debts. Again - the "same difference".
The Great Rebalance: China's investment-led growth model is unsustainable. In order to rebalance toward more consumption, China needs to: (i) privatize SOEs (sell them), (ii) remove its currency peg that benefits exporters at the expense of consumption (high inflation), (ii) remove capital controls (allow consumers to earn investment income), (iii) "marketize" the financial system so banks compete for consumer deposits (consumers earn more interest) and lend to profitable SMEs (SMEs increase wages more than SOEs), (iv) allow local governments to issue bonds and not be as dependent on land sales for revenues (deter real estate speculation by consumers), (v) reform the tax system (free up middle class spending power), and (vi) institute a viable social security program (lowering savings rates and increasing consumption).
China.An 800 lb Panda named "Status Quo"
Status Quo: Ultimately, if China doesn't rebalance effectively, it will lead to unsustainable debt levels, prolong China's growth downturn, and be a drag on growth not only in China, but in the U.S., Europe, and emerging economies due to delayed Chinese consumption of foreign goods. The grip on power and money by the communist party, associated elites and favored state-owned "champion" enterprises is the major obstacle to rebalancing. The 800 pound panda in the room is that no one believes the status quo is sustainable long term, but then again, no one in power is incented to change it. For all the admiration of China's meteoric rise to a global economic powerhouse, its structural flaws are just as awe inspiring, they have been exacerbated by political failure and central bank excess as in the West, and if they are not rectified, China is sleepwalking toward a precipice along with the West.
The Unknowns:."white pigeons & black swans"
MENA in Flux: Egypt, the largest Arab country, is poised for rule by the radical Muslim Brotherhood and Saudi Arabia's royal rule may be replaced by extremists within a decade. There is growing enmity between Iran and Israel with heightened risk that the U.S. and/or Israel will use military force to stop Iran's nuclear development. An oil price shock due to conflict in Middle East North Africa (MENA) could roil global markets and cause global growth to slow dramatically (90% of post-WWII U.S. recessions have been preceeded by oil price shocks).
Pandora's Box: In 2010, the U.S. or Israel unleashed Stuxnet, a virus that successfully took control of nuclear facilities in Iran - the first ever use of a computer virus to cause physical damage. Posting of the source code on the Internet made advanced cyber terrorism available to anyone, and in 2011 American hackers demonstrated how to blow up a plant or open doors at a correctional facility. Cybercrime is growing rapidly, with over 90% of U.S. companies hacked at least once per year, and over $1 trillion worth of intellectual property stolen annually.
Bull Market in Bad: In 2011, total global economic cost from natural disasters was $380 billion, 70% above the 2005 record of $220 billion. In the next 10 years, the number of natural disasters could double with population growth in dangerous coastal areas (21 of 25 megacities are close to coasts). 2011 was the costliest disaster year ever in the U.S. with a record 14 separate billion dollar disasters, including 400-year droughts and wildfires, 1000-year deluges and flooding, the 2nd highest tornado count in U.S. history, and soaring heat (26,500 records and 4th warmest winter).
The New Markets - Return Free Risk: U.S. stock exchanges have become server farms for high frequency trading with 80% of trades by just 2% of participants, 90% of orders cancelled, and "flash crashes" and market manipulation becoming the norm. Commodity financialization, all time high asset correlations, rising volatility, and a shrinking AAA country world (7 of 19 AAA countries have lost ratings) all increase risk in markets and economies. The $700+ trillion over the counter derivatives market (10X the size of global GDP) daisy chains enormous risk across institutions, and billions of new "structured notes" tying bonds and CDs to derivatives on stocks and commodities may be brewing a "Subprime II..
American Revolutions: Energy demand met by domestic sources rose to 81% in 2011 (the highest in 20 years), and the U.S. is on course to be the world's top energy producer by 2020. Advances in software, robotics, materials and processes could lead to a manufacturing revolution in the U.S. with "flexible" factories relocating near cheap energy and U.S. consumers (up to 30% of goods imported from China could be made in the U.S. by 2020). These positive disruptions could boost jobs, incomes, government revenues, cut the U.S. trade deficit, and provide greater flexibility in dealing with the Middle East and China.
Central Bank Rule."one big monetary experiment"
One Big Monetary Experiment: After crisis, central banks "printed" money to buy bad bank assets and inflate markets, doubling the size of their balance sheets in the process. When balance sheet expansion stops, it may quickly deflate asset prices and reverse the 10%+ boost to GDPs from the stimulus. Unwinding the unprecedented monetary experiment without damaging global growth will require uncanny judgment and timing on the part of central bankers.
The Distorter: The market effects of expansionary monetary policy are evident in the strong moves up after the beginning of QE programs, and the anticipatory falls toward the end of stimulus. Market dependency on Fed stimulus is distortionary. Future rollercoaster rides depend on the Fed's view of inflation expectations, employment and economic data, and movements in the Euro and Chinese Yuan versus the U.S. dollar.
Paper, Boxes & Steel: In times of economic stress, nations devalue their currencies for growth and debt reduction. But, all countries can't devalue at once, and competitive currency devaluations ("currency wars") have arisen between both developed and developing nations. On the main front, tensions have escalated from attempts to label China a "currency manipulator" to trade duties on American SUVs and enormous tariffs on Chinese solar panels. Currency and trade wars weigh on growth and sometimes worse.
The Euro Zone experiment was destined to encounter major difficulties after a crisis and economic slowdown. How the experiment is resolved has large implications for global growth. The decisions Chinese leaders make to address myriad structural flaws and change or maintain the status quo will determine that country's economic future and affect global growth as well. A variety of unknowns face global economies and markets in coming years with wide ranging potential effects. Central bankers acting as central planners for economies face an unwinding of a massive monetary experiment, which may harm growth. And, existing currency wars and potential trade wars loom large over global economies.
In Part III of this work, we discuss our ideas for navigating these uncertain times, protecting and growing wealth. We'll see you there.
(c) Cravens Brothers Wealth Advisors