A Compounding and Confounding Deflationary Problem

Businessman analyzing investment charts at his workplace
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Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.

—Albert Einstein

The Daily Reckoning usually starts with a summary of overnight market activity…something like ‘Dow up, dollar down, gold steady’, or a version of that brief outline.

In times of turmoil, as in the case of Brexit for example, we dedicate a little more ink to the market summary…the whys and wherefores.

However, ascribing a reason for market movement these days — higher or lower corporate earnings, good or bad employment numbers, strong or weak consumer data, positive or negative Purchasing Managers Index (PMI) readings — is somewhat a wasted exercise.

It is ALL about central bank intervention. Any dip in the share market that is greater than 5% triggers a programmed central bank response…stimulus. Pure and simple.

Markets no longer work on good old fashioned price discovery — what an asset is worth relative to a reasonable rate of return on money.

In a world of negative yielding fixed interest securities — the majority of which is being offered from the public sector, but with the private sector, like Nestle, also now getting in on the ‘being paid to borrow money’ act — there is no ‘north’ bearing on the price discovery compass. The central bankers have built a reinforced lead dome to repel the magnetic fields of prudent and responsible investing.

The contradiction created by negative rates is evident in the following Bloomberg headline:


Source: Bloomberg
[Click to enlarge]

On 12 July, 2016, Bloomberg ran a story based on warnings issued by ratings agencies Moody’s and Fitch on rising defaults in US high yield debt:

Missed payments on high-yield or speculative bonds are already near levels that prevailed in 2009 and 2010, according to analysts at Moody’s and Fitch Ratings, who are forecasting defaults will get worse before they get better next year. At $50.2 billion, U.S. high-yield defaults have already surpassed the $48.3 billion total for all of 2015, and they’re on course to reach as much as $90 billion by year-end, according to a separate July 12 report from Fitch.

Typically, the report is couched in the language of optimism: ‘While it is raining today, the sun will come out tomorrow’. Unfortunately, what we have seen since 2009 is rain, rain and more rain. The IMF, RBA, Fed, BoE, PBoC, BoJ, ECB and the rest of the ‘officialdom alphabet’ have consistently forecast better times ahead, only to be forced to issue multiple revisions to the downside.

In spite of the rise — and forecast rise in defaults — three days later Bloomberg reported this story:


Source: Bloomberg
[Click to enlarge]

According to the article:

For investors with $12 trillion of negative-rate bonds worldwide, U.S. junk securities and their 6.9 percent average yield look like a gold mine. But with so many investors streaming into the market, the debt is now yielding almost 3 percentage points less than the average of the past two decades, Bank of America Merrill Lynch index data show…“They’re out there scrounging through the dumpster looking for yield,” said Karyn Cavanaugh, a strategist at Voya Investment Management, which oversees $203 billion. “When you have artificially low rates, you force people to go out and look for things that they normally wouldn’t.”

Such is the scarcity of decent nourishing returns, investors are sifting through the investment market’s rubbish bins in search of anything resembling a morsel of return…no matter how unpalatable and hazardous to one’s financial health it may be.

Central bank policies have turned investors into yield scavengers…begging for any income scraps that can be thrown their way.

People may say ‘it’s the energy sector that’s defaulting due to a slump in the oil price, therefore other sectors are fine.’ There are none so blind as those who do not want to see. If the energy sector is suffering from a decline in revenues, then other sectors that feel the revenue pinch from a deflationary world are also going to say ‘too bad, so sad’ to those stupid/gullible/desperate/greedy enough to have lent them their hard-earned in the first place.

We are living in a ‘low growth, high debt, negative interest rate’ world.

A world created by monetary policies that continually encourage more and more debt. Four decades of this blind pursuit of growth has reduced us to ‘scrounging through the dumpster looking for yield.

These sad and sorry conditions have left us — or, more importantly, central bankers and politicians — with only poor choices.

Recognise the situation for what it is — a spiral into even more bizarre ‘solutions’ that only make the problems worse — and take our medicine.

Or, continue on the never-before-trodden path of greater and more freakish stimulus programs that takes us further into economic abyss. An unexplored world where we have no experience with, or comprehension of, the capital-destroying monsters lurking all around us.

Or the market gods decide to take matters into their own hands, teaching the central banker pretenders that they’re in charge.

The outcome from this extreme situation is not going to be some smooth, non-volatile path back to a 1950s ‘Happy Days’ type world.

No, we are not going to be that lucky. The lurch from this present extremity means we’re facing a violent capital-destruction correction that will veer off into one extremity or another — either deflation or hyperinflation.

Which one awaits us? My theory has been that we are heading for a deflationary world, from which we may (most probably will) experience a high-to-hyperinflationary style response.

Why do I think a deflationary world awaits us? The answer (I think) lies in Einstein’s compound interest quote at the beginning of this article. We all know the wisdom of the snowballing principle of ‘interest upon interest’ growing our capital at an exponential rate over a long period of time.

But in a negative yielding world, we are compounding the deflationary problem. The capital ‘snowball’ is melting. Year after year, money is being taken from investors’ principals.

They have less to spend. They feel less wealthy. They change consumption habits. This is the reverse of the dynamics we witnessed in the 20th century…the time when Einstein pronounced the eighth wonder of the world.

If he was alive today, would he say negative rates are the ‘ninth wonder of the world’; or would he wonder how in the hell we got ourselves into such a mess? My money is on the latter.

In the 15 July, 2016 Bloomberg article, analyst Karyn Cavanaugh said: ‘This isn’t really a normal environment.

How true. This is a confounding world with serious problems, which are being compounded by the actions of economic academics. They have either lost sight of reality, or they’re failing to recognise the sheer scale of destruction their policies will unleash on the system.

Either way, the road back to a normal environment will be littered with the corpses of those who failed to recognise the lunacy of the drivers at the helm of this economic vehicle.

Regards,

Vern Gowdie,
For The Daily Reckoning

Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.
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