The End Of The BeginningSteve Blumenthal
“The training wheels are coming off. Next week, the European Central Bank will conduct its final meeting of 2018 and is widely expected to announce the cessation of its QE asset purchase program. The ECB began buying sovereign bonds in 2015 and added corporate debt to the mix a year later. ECB president Mario Draghi, who piloted the program, will soon be riding off into the sunset, as his term ends on October 31, 2019.” – Philip Grant, Grant’s Interest Rate Observer
I concluded a three-part series reviewing Ray Dalio’s “Template for Understanding Big Debt Crises” in early October. You can find them here, here and here. I believe it is the most important global macro issue for us to get our heads around. I bring this up again this week because the European Central Bank is attempting to exit the Quantitative Easing game. My concern is liquidity.
Borrowing and spending expands an economy and helps businesses make money and incomes grow. Your and my spending is someone else’s income. It’s when the borrowing reaches a point that it is harder to find a willing lender and the income needed to finance the previously accumulated debt becomes stressed, that economies slow. There are short-term debt accumulation cycles and long-term debt accumulation cycles. Both are challenging; however, long-term debt accumulation cycles are the most challenging.
John Mauldin wrote about Dalio’s book. As usual, he did a masterful job simplifying the issue:
Science tells us energy can neither be created nor destroyed within a closed system. Whatever amount is there will stay the same, though it might change form. If only the same were true for debt.
Within the closed system called Earth, we are much better at creating debt than eliminating it. But when we have too much, we eventually eliminate it in painful and unpleasant ways via some kind of debt crisis. This has happened over and over again throughout history.
Today we’ll look at a new book by Ray Dalio calledPrinciples for Navigating Big Debt Crisesin which he examines those debt cycles and what we can do about them. I read it on my recent trip to Frankfurt and I highly recommend youdo the same. That link is for Amazon but you can also get a free PDF copyhere. I read it on my Kindle so I could highlight and save notes in the cloud for later reference. Worth every penny of the $14.99 I spent.
At a minimum, you should read the first 60 pages, which explain his principles and thoughts. The rest of the book dives deep in the weeds of 48 modern debt crises, sorting them into different types and then analyzing each type. Data wonks will love that part. Ray gives us a brillianttour de forceexamination of how debt crises arise and what you can do when one strikes.
At first blush, you will think that Ray is more optimistic than I am about the next debt crisis and an eventual event which I called The Great Reset, which I’ve written about extensively this year. I see The Great Reset as a generation-scarring economic cataclysm. Debt crises, while painful, have a fundamentally different character.
Ray’s book has helped me refine what I mean by The Great Reset. We’ll explore this more in future letters but here is one very important, critical, point:
It is possible we will have another debt crisis separate from The Great Reset I envision. Indeed, it may be quite likely.
In one sense, what we called the “Great Recession” was just another garden-variety credit cycle. Unlike the Great Depression, so far it doesn’t seem to be changing the behavior of those who went through it. The Great Depression was a soul-searing, generational-impacting event. The events around 2008, bad as they were, had nowhere near that effect.
In fact, we are now doing many of the things we did in 2006 and 2007—reaching for yield, etc. It is as if we did not learn that the stove was hot. We are loading up on all sorts of unrated and low-rated credit and even leveraged (!!!) loans to juice returns in a low-rate world, telling ourselves “This Time is Different.”
Really, we tell ourselves that. And it never is. Sometimes I sit in awe and amazement at the human capacity for believingSix Impossible Things Before Breakfast. And we do it time and time again, over and over, insanely expecting a different result.
But that is getting ahead of ourselves, so let’s start exploring Ray’s book.
Before we get into the book, you should know a little about Ray Dalio and the company he founded, Bridgewater Associates. At $150 billion or so under management, it is one of the world’s largest and most successful hedge fund operators. It is also an extremely unusual company.
Dalio decided early in his career, after enduring some painful losses and nearly going bankrupt, to rigorously examine his mistakes. When he was wrong—as all traders sometimes are—he would review his process, identify mistakes and keep a record of them. This helped him avoid making them again.
Eventually he extended this process to his entire company. At Bridgewater, the staff use a computer system to constantly rate each other’s decisions, both small and large. The result is a giant database of who tends to be right and on which subjects they are strong and weak. This affects personnel decisions, work assignments and all sorts of other things. It’s all transparent, too. Everyone at Bridgewater knows everyone else’s business.
Obviously, not everyone thrives in that environment. But over time, it’s made Bridgewater into what Ray calls an “idea meritocracy.” People who make good decisions get identified and rise to the top.
I tell you all that so you understand Dalio is highlyempirical. He doesn’t make guesses without evidence, and you see it in this rigorous historical examination of previous debt crises. It was originally an internal Bridgewater study that informed the firm’s (very successful) trading of the 2008 crisis. The team examined 48 debt crises over the last century to develop an “archetype” or template showing how they unfold.
Lending Allows Spending
Like me (and many others throughout history), Ray recognizes that debt can be good or bad, depending on how it is used. He goes further with an important insight on the way debt is cyclical. He explains it so well I will quote him at length here (emphasis mine).
To put these complicated matters into very simple terms, you create a cycle virtually anytime you borrow money. Buying something you can’t afford [out of your capital or cash—JM] means spending more than you make. You’re not just borrowing from your lender; you are borrowing from your future self. Essentially, you are creating a time in the future in which you will need to spend less than you make so you can pay it back. The pattern of borrowing, spending more than you make, and then having to spend less than you make very quickly resembles a cycle. This is as true for a national economy as it is for an individual. Borrowing money sets a mechanical, predictable series of events into motion.
In other words, debt actuallycreates its own cycles. Lending (especially from institutions that can create money under afractional reserve bankingsystem) allows spending that spawns more spending, which eventually must reverse into contraction that spawns more contraction. That may seem obvious but we often forget it. As we apparently have done even as I write.
After examining dozens of debt cycles, Ray’s team built this template to describe the six stages of the deflationary variety. Source:Ray Dalio
Stage 1 is the “good” part. People borrow money, but not too much and they use it for productive purposes. This helps the economy grow and lifts asset prices… which is where things start going wrong.
In Stage 2, which Dalio terms the “Bubble,” people look at the recent past and decide asset prices, total demand, and consumption will keep going up. They overconfidently borrow more money and start having too much leverage, although it is never possible to actually define the moment when the right amount becomes “too much.”
Stage 3, the “Top,” occurs when central banks and regulators and sometimes even the lending institutions themselves see problems and take steps to moderate growth—always thinking they can slow down without braking too hard. They raise interest rates, tighten lending standards, and so on.
Stage 4, ominously called the “Depression,” happens when growth slows or reverses beyond the ability of monetary and political authorities to help. Yet they keep trying. This is when we see interest rates go to zero or negative. The central bankers are out of bullets at this point. Everyone just has to suffer.
Stage 5 is the deleveraging phase, when businesses and families reduce spending to pay down debt and reduce their leverage. It can last a long time, but as leverage falls people get a handle on their debt service costs and slowly start to recover. Eventually the economy reaches Stage 6, normalization, and the cycle repeats.
So where are we in the cycle? From Mauldin,
Already-huge federal deficits will therefore keep growing just as the Federal Reserve both raises rates and reduces its balance sheet assets. So far, this combination hasn’t stopped GDP growth or even perceptibly slowed it, but at some point it will. That is the goal, after all, and Ray’s template shows it usually succeeds.
In this case, I think the trigger will be a crowding-out effect as Treasury borrowing combined with Fed tightening raises household and corporate debt service costs. Everyone has a breaking point and it is getting closer.
The “seventh-inning stretch,” if you don’t know the term, is a point near the end of a baseball game. There’s enough time left for the trailing team to catch up so no one wants to leave yet. You stand up, stretch, singing “Take Me Out to the Ballgame,” then settle back in to see what happens.
That’s kind of where we are in the debt cycle: near the end, but not yet sure of the outcome. The difference is that none of us are just spectators. We are all in the game, and we will all either win or lose.
A Beautiful Deleveraging
Ray has been writing over the past few years about what he calls “A Beautiful Deleveraging,” when the central bank manages to defuse the debt-burdened economy without a major crisis. Here is what he says:
The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.
There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them:
- Austerity (i.e., spending less)
- Debt defaults/restructurings
- The central bank “printing money” and making purchases (or providing guarantees)
- Transfers of money and credit from those who have more than they need to those who have less.
1, 2, and 4 above require varying levels of pain for lenders and borrowers. Number 3 still has pain for all concerned, something like 2008-2014 when the Fed and other central banks around the world bought trillions in assets, but it was likely better than what would have happened absent those policies.
The Federal Reserve is late in the process of raising rates, but under Powell seems committed to reaching what many economists call “the natural rate of interest.” My personal belief is that we are close to that point now. If we go past it, then I think the Fed will tip the economy over into a recession. This will be preceded by an inverted yield curve, or the place where short-term government interest rates are higher than long-term US bond rates. Since World War II, this “inverted yield curve” has always preceded a recession by somewhere between 9 and 15 months.
Grab a coffee and find your favorite chair. We’ll look at the Hot Spots, the ECB and I share a few thoughts around the change in how markets function. Also, I’ve been getting a number of questions about the inverted yield curve. It is not yet inverted (Trade Signals section – you’ll need to click the link to see the charts). When it does invert, recession has usually followed nine month to twelve months or so later.
As an aside, John Mauldin and I will be hosting a free 2019 Investment Outlook webinar on December 11 at 2 p.m. ET. If you’d like to listen in, please click on the image below to register.
OK, forget the coffee and drink something that will soothe your soul. We’ll all be OK. Let’s get to the next opportunity with wealth in good shape. Click on the orange link that follows to access the balance of this week’s On My Radar. Take a look at the European Central Bank section. It ties in nicely to where we are in the current cycle. And do skip through to the personal section. You’ll find some great advice from President George H.W. Bush in a personal letter he wrote to a friend. It is his advice to young people and, frankly, us older people as well. What a wonderful human being.
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Included in this week’sOn My Radar:
- Where are the Hot Spots?
- “It’s the Worst Time to Make Money in Markets Since 1972,” by Elena Popina, Bloomberg
- The European Central Bank – A Non-economic Buyer of First, Middle and Last Resort
- “JPMorgan Asset Says Cash Better Than Stocks for First Time in Decade,” by Cecile Gutscher, Bloomberg
- What Marko Kolanovic is Looking at Now
- Trade Signals – More Evidence of a Bear Market
- Personal Note – President George H.W. Bush’s Advice to Young People
Where are the Hot Spots?
They are pretty much everywhere. I’m most concerned about U.S. corporate debt, leveraged loans and high yield bond ETFs and mutual funds. I’m also concerned about EU banks and the sovereign debt of Italy, France, Portugal and Spain.
But closer to home it is the accumulation of corporate debt from approximately $2 trillion in 2008 to more than $5 trillion today, and that’s just in the investment-grade space. The debt in the high yield bond sector has doubled. Simply look at where investment-grade corporate debt stood in 2008 vs. where it is today. Much of that has been used to finance share buybacks, which helped make earnings per share look better… that was good for a while yet the debt remains.
Much of the corporate debt was lent by individuals via their investments in bond ETFs and mutual funds, leveraged loan ETFs and mutual funds, high yield bond funds and investment grade bond funds. The zero interest rate policy drove investor savings from banks to bond funds. The risk today largely sits in the hands of individual investors and the quality of the bonds they own have never been worse.
Here is a look at U.S. Total Credit Market Debt compared to GDP (what we as a country produce). Bottom line: We hit a wall in 2008. Debt remains higher than at the peak of the last long-term debt cycle (mid-1930s). When debt is growing and expanding, it fuels the economy. Until it gets too large relative to income. Then, as it must get paid back (or individuals, companies and even governments default), the reverse happens.
Further, this is not just a U.S. issue. The problem is the same and even worse in other developed countries. We’ve got to figure out what “beautiful” will be. We don’t yet know. On the road to solving the debt will be a number of bumps. Buckle up.
Here is a quick look at U.S. Government Debt Outstanding (note 2008 vs. today):
Here is a look at World Private Debt:
- World Private Non-Financial Debt as of March 2018: $119.4 trillion
- World Public Non-Financial Debt as of March 2018: $64 trillion
- Note comparison vs. 2008
Rising interest rates will present a problem. Global recession will present a problem.
Finally, some salient commentary from my friends at Peak Capital:
The bond market got crushed in October with only modest recovery in November causing some to speculate that a $9 trillion corporate debt bomb is close to detonating. The question of whether what we are witnessing is a short-term re-pricing of debt or a looming crisis will become more evident when corporate debt refinancing spikes in 2019. As spreads widen and insurance against defaults is the most costly since the 2011 deflation scare, the higher cost of borrowing will immediately squeeze profit margins and slow corporate spending and hiring (just ask GM employees). While most of the population uses stock market performance as the gauge of economic prosperity, the truth is the credit markets most often provide the advance warning of impending economic trouble. After a decade, the era of ultra-easy money has ended as the Fed completes two years of rate hikes. The yields on Asian corporate bonds issued in USD are at 7 year highs while the yields on US corporate debt are at an 8.5 year high according to Barclay’s data.
Hedge fund luminary Paul Tudor Jones, who famously predicted and profited from the 1987 crash, made headlines recently with his comments about a crisis in corporate bonds. Among the alarming data points I have identified, the cash-to-debt ratio has fallen to 12%, the lowest in history according to Fitch Ratings. Equally alarming is Moody’s Covenant Quality Indicator that shows how protected investors are in the case of a default. This gauge has remained at the lowest classification for 18 consecutive months, even as the leverage loan market now exceeds $1.3 trillion. Loans with no requirements to meet financial tests like maximum leverage or coverage ratios have risen to 80% of debt compared to just 25% in 2007 according to BAML. [Emphasis mine.] The foundational cracks, however, seem to be at the border of investment-grade and high yield debt. I am extremely concerned that bonds rated BBB issued in the last 5 years when the economy was strong will get downgraded to junk status when the economy slows. This will lead to forced selling of the bonds and disrupt global markets. General Electric (GE) is the bellwether for this issue. The yields on GE bonds maturing in 2025 have seen yields rise from 2.9% to over 6.4% just this year, resulting in bond holders losing over 20% of their value. When your investment grade bonds, with ultra-low risk of default, lose over double-digits, people may panic.
For now, the U.S. economy remains in good shape. That’s not the case globally. The biggest challenge to equities and corporate bonds will come during recession. That’s when liquidity dries up. I predict an economic decline globally into January 2020 and a 50% chance of recession later in 2019. Data dependent of course. Keep your eye on the TS charts.
It’s the Worst Time to Make Money in Markets Since 1972,” by Elena Popina, Bloomberg
- Ned Davis Research puts markets into eight big asset classes — everything from bonds to U.S. and international stocks to commodities. And not a single one of them is on track to post a return this year of more than 5 percent, a phenomenon last observed in 1972, according to Ed Clissold, a strategist at the firm.
- In terms of losses, investors have seen far worse. But going by the breadth of assets failing to deliver upside, 2018 is starting to look historic.
- Nothing’s working, not large or small-cap stocks in the U.S., not international or emerging equities, not Treasuries, investment-grade bonds, commodities or real estate. Most of them are down, and the ones that are up are doing so by percentages in the low single digits.
- That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied. In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.
- Clissold has a villain: evaporating central bank stimulus.
- “Overhanging the markets have been concerns over how asset prices would handle the removal of ultra-easing monetary policies,” Clissold, chief U.S. strategist at Ned Davis Research, said in a note published last week. “During previous instances of market turbulence, ‘there was a bull market somewhere.’”
The European Central Bank – A Non-economic Buyer of First, Middle and Last Resort
“The End of the Beginning,” by Philip Grant
“The training wheels are coming off. Next week, the European Central Bank will conduct its final meeting of 2018 and is widely expected to announce the cessation of its QE asset purchase program. The ECB began buying sovereign bonds in 2015 and added corporate debt to the mix a year later. ECB president Mario Draghi, who piloted the program, will soon be riding off into the sunset, as his term ends on October 31, 2019.
As the ECB’s balance sheet has grown to €4.65 trillion, up 117% since early 2015 to equal 30% of full-year 2017 European GDP (the Fed’s balance sheet represents 21% of 2017 U.S. output by comparison), both sovereign and corporate credit spreads collapsed as investors basked in the warm glow of a non-economic buyer of first, middle and last resort.”
When the biggest buyer of bonds cares little of what he buys and then exits stage left, you have to imagine there may be an impact on trading, on price and on liquidity. Are we at “The End of the Beginning?” Meaning, how long will it take the ECB to be drawn back into the game? Markets will be tested to see if they can stand on their own two feet. I have my doubts. Debt is the problem (most everywhere). The Great Reset? The ECB will be back. How we figure this out remains unknown.
I believe we are at an important turning point: Grant calls it, The End of the Beginning. Love that title. Ten years of global central bank intervention, a pause, a test… My two cents: The global Central Bankers will be back. I’ve contended for some time that despite the Fed’s Quantitative Tightening, much of the global liquidity has been coming from the ECB. A net plus in the global liquidity equation. That liquidity looks to be ending for now. Liquidity will be tested. The big question is: Who will now step in to fund the debt?
The global economy is slowing, I expect it to slow into January 2020. I expect recession by then. “The End of the Beginning,” indeed. Keep your stop-loss risk management game plan in place.
“JPMorgan Asset Says Cash Better Than Stocks for First Time in Decade,” by Cecile Gutscher, Bloomberg
- Cash isn’t only a safe place to invest, it now offers a better risk-adjusted return than equities, according to JPMorgan Asset Management.
- The Team said it’s preparing “for an environment of slowing earnings growth and rising macroeconomic risks” that will weigh on equities and has led the group to de-risk its portfolios.
- If they are right, being boring may turn out to be the key to success next year, just like in 2018. U.S. Treasury bills were poised to end the year with the highest risk-adjusted returns of the world’s biggest assets, according to data compiled by Bloomberg.
What Marko Kolanovic is Looking at Now
I’ve had my eye on Marko Kolanovic for some time. He is the Global Head of Macro Quantitative and Derivatives Strategy atJPMorgan Chase & Co. and has gained a following for his forecasts about whether systematic investing approaches such as risk-parity strategies, volatility-targeting funds and commodity-trading advisers will be buying or selling.
In a recent Bloomberg interview, Kolanovic was asked, “What bigger picture market trends are you watching these days?”
He said, “There’s this fragility in the marketplace that came with the new structure of liquidity, with electronic market-making, computers, and growth in passive. Passive assets and quant assets will grow, and computers and AI will have a bigger role in market-making. At some point that’s going to end up badly—most likely when the next recession hits. Some of the problems around computerized liquidity are going to be fully exposed, and it may really deal a blow to investors and markets overall. Not that we are forecasting it with a certain timeline, but more that investors should have it in the back of their minds.
Is there a way to hedge yourself for some type of catastrophic event where liquidity collapses and this whole microstructure potentially fails? Can you design strategies that are going to be resilient to this type of fragility? Can you run some effective hedges that won’t cost you a lot of money? We are thinking about a number of things like timing: market-timing and timing of risk premia. It’s almost a holy grail—can you time these risk premia? So recently we’ve been testing machine-learning algorithms in the context of timing.
There’s more algorithmic trading, where algos are going through headlines or sorting through earnings statements or going through social media in real time and trading. What are the consequences for investors?
We’re seeing reaction time get shorter and shorter for releases, which can also incur costs or take advantage of slower human investors. There are signs of potential abuses with social media posts and headlines. That’s going to get worse and worse and be more of an impediment for human investors to make money. It’s going to cause more confusion in the marketplace.”
SB here: The reason I shared the above is to simply bring to the surface the change in dynamics in how the markets function today. Bank trading desks are gone. The stock exchanges are a fraction of their former selves. Risk parity, AI, the passive investing craze, high frequency computerized trading… The big events happen when liquidity dries up. The market making function (buyer of last resort) no longer exists. Thus, my risk obsession. So let’s keep a close watch… (see recession dashboard and supporting trend charts in Trade Signals below).
Trade Signals – More Evidence of a Bear Market
December 5, 2018
S&P 500 Index — 2,744
More evidence of a bear market: the Long-term Trend (13/34-Week EMA) on the S&P 500 Index signal turned negative this week, signaling a confirmed downtrend for U.S. large-cap equities. The Ned Davis Research CMG Large Cap Long/Flat indicator also signaled caution by reducing equity exposure from 100% to 80%. We’ve been talking about equity market risks for some time and we are now seeing it show up in the market trend. Risks suggest using rallies to lighten up on equity exposure. Should the indicators continue to deteriorate, we will reduce our exposures accordingly.
I’ve added a new chart to the equity trend line-up this week: A simple rule to manage tech exposure risk. It is the NASDAQ Index 200-day Moving Average Trend model. The process uses the same rule the S&P 500 Index 200-day MA model uses, except it plots the NASDAQ Index. When the 200-day MA line drops by 0.50% from a high point, a sell is signaled. When the line rises by 0.50% from a low point, a buy is signaled. The current signal is a buy but, after many years, the trend line is changing direction. Approximately 75% of the time since 1973, the trend line was rising and, when rising, the NASDAQ returned 13% per annum. 25.5% of the time, the NASDAQ trend line was falling. During falling periods, the NASDAQ lost 0.7% per annum. The idea is to stay in-line with the trend in price. You’ll find the chart below with explanation of how it works along with hypothetical historical data in the body of the chart. I believe it is mandatory to put a rules-based stop-loss risk management process on everything you own, and I favor diversifying to a few different processes to further enhance your total portfolio diversification. None are prefect. It is important to avoid the big mistakes. Trend following can help.
Notable too is that Don’t Fight the Tape of the Fed indicator moved to a +1 reading. Interesting… It may be due to the rally in bonds… I’ll take a deeper dive and update you next week… Surprising to me given the weakness in Long/Flat and the other trend indicators. Worth keeping an eye on. Put it in the “better news for now” category.
High yield bonds remain in a sell. That’s good news if you are inside stepping the decline. I continue to believe the high yield market should be high on our dashboard of indicators. Historically, a good leading economic indicator. The Zweig Bond Model remains in a sell, favoring short-term bond exposure over long-term high quality bond exposure.
As the great Art Cashin says, “Stay wary, alert and very, very nimble.”
Click here for this week’s Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – President George H.W. Bush’s Advice to Young People
Below is his advice to young people. Just wonderful! I’m going to share it with my kids.
The letter says:
“I cannot single out the one greatest challenge in my life. I have had a lot of challenges and my advice to young people might be as follows:
- Don’t get down when your life takes a bad turn. Out of adversity comes challenge and often success.
- Don’t blame others for your setbacks.
- When things go well, always give credit to others.
- Don’t talk all the time. Listen to your friends and mentors and learn from them.
- Don’t brag about yourself. Let others point out your virtues, your strong points.
- Give someone else a hand. When a friend is hurting, show that friend you care.
- Nobody likes an overbearing big shot.
- As you succeed, be kind to people. Thank those who help you along the way.
- Don’t be afraid to shed a tear when your heart is broken because a friend is hurting.
- Say your prayers!!!”
There is nothing more important to say… Welcome home 41, welcome home.
Have a great weekend…
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO