When the Mainstream Narrative is Wrong
Today’s Daily Reckoning Australia can’t help but begin with something we normally avoid: front page news!
There’s a report in the Australian Financial Review that Australia, the US, Japan and India *might* be forming some sort of regional infrastructure partnership.
There’s no guarantees here…but the suggestion is that it’s in response to China’s One Belt, One Road plan.
Let’s keep tabs on this one. It would be bullish for the markets if it gets the go ahead…especially the resource sector.
It might even fuel the inflationary winds currently blowing.
This topic – and how it plays out in the stock and bond markets – is on the mind of my colleague Jim Rickards.
There was an anomaly that occurred here in the recent market swoon.
Jims says people have missed the significance of this…but it points to one key sector in particular.
Read on to find out why…
When the Mainstream
Narrative is Wrong
By Jim Rickards
There’s something very important about the recent market activity that hasn’t gotten any attention:
This was the first major stock decline in almost 20 years in which both stocks and bonds declined at the same time.
When I say ‘bonds declined’, I mean bond prices, not the yields on bonds.
You may have heard a lot about rising bond yields lately, but it’s important to keep in mind that as bond prices decrease, their yields increase. It works like a seesaw.
Bond prices have gone down periodically. Stocks have also gone down periodically. But they have been typically inversely correlated for a very long time, meaning when stocks are going up, bonds are going down and vice versa.
This is the famous risk-on, risk-off trade. In other words, when risk is off, people sell stocks and buy bonds as a haven. Stocks go down and bond prices go up. Interest rates go down. That lasts for a period of time.
Then, interest rates become low enough and investors assume that’s a good sign for the economy. So they rush back into stocks. Then it’s risk on again.
Investors start selling bonds and interest rates creep up a bit. Eventually, interest rates reach a point where bonds are attractive again, and investors flee back to bonds. It goes in cycles.
Again, you have this seesaw effect where stocks are going down, bonds are going up or vice versa. But that’s not what happened recently. Both bond prices and stock prices actually fell together during the correction.
We’ve had large equity drawdowns before. In August 2015, stocks fell 11%. That was technically a correction.
In January 2016, stocks also fell around 11%. Another correction.
We also saw stock drawdowns in 2010, 2011 and of course 2008.
But in every one of those drawdowns — every time — bond prices went up and interest rates came down.
For the most part, that’s not happening now. The bond offset hasn’t been there to compensate for the stock losses.
Incidentally, gold, cryptocurrencies and oil also took hits this time. Gold was down off its recent high around US$1,335 to around US$1,315. It wasn’t a big draw down, but down is down.
It’s back up above US$1,350 right now (and another bull market is beginning). Cryptos also took it on the chin. Oil had a huge rally in January. Now it’s back down to the US$60 mark.
In every one of these previous stock drawdowns, investors had a cushion. If they were losing money in stocks, but they were making money with another asset. Not this time
Markets are wildly complicated. If you look at any particular day, you’ll see a lot of variation. But with everything getting hammered at once, this was the first time we’ve seen that kind of correlation in 20 years.
Why is this such a big deal?
It tells me something different is going on that’s different from what we’ve seen over the past eight or nine years. What’s going on now is much more serious. It tells me this could be the beginning of a liquidity crisis.
The credit is drying up.
This tightening has been going on in different ways. First, the Fed embarked upon a rate hike cycle in Dec. 2015.
It’s no surprise that the economy would be slowing because monetary policy works with a lag, especially when the Fed is tightening in a disinflation environment.
Now, in addition to the rate hikes, the Fed is normalising its balance sheet. That means they’re not rolling over their securities when they mature. They’re retiring them.
The Fed is not taking that money and buying new bonds. The money disappears. That means the balance sheet is shrinking.
Picture someone standing in front of a furnace shovelling a big pile of hundred dollar bills into it, reducing the money supply.
That’s what the Fed is doing. It’s called ‘Quantitative tightening’ or ‘QT’. It’s the opposite of quantitative easing. The Fed is destroying money.
This has never been done before. It is completely unprecedented. The Fed has never printed that much money before, so it never had that much money to unwind from its balance sheet.
We’re therefore getting a double dose of Fed tightening.
There’s the actual rate hikes, plus reductions in base money.
Balance sheet reductions have the equivalent effect of a rate hike. We may see as many as four 25 basis point rate hikes this year.
But when you add in the projected balance sheet reductions this year and into 2019, it’s the equivalent of four rate hikes by itself — in addition to three or four actual rate hikes.
This is more like the Fed raising rates 2% in a year, which is huge.
In other words, we’re getting two forms of tightening. It’s not surprising to me that the stock market has come down as a result of these reductions.
It’s not surprising that the economy is slowing down. I expect we’ll see more to come.
But there’s one more factor that’s being talked about very much. I call it…
‘The debt bomb’
The debt bomb has been getting bigger since 1981. Debt-to-GDP was close to the all-time low when Ronald Reagan was sworn in. Reagan took it from 35% to 55%. Bush 41 and Bill Clinton took it up a bit, to around 60%.
Bush 41 lost the presidency when he said, ‘Read my lips, no new taxes.’ He raised taxes, in part to keep a lid on the debt-to-GDP ratio. Bill Clinton did the same thing.
Bill Clinton cut spending. Unfortunately, he cut it in the wrong places. He cut defence intelligence and we got 9/11, but he did cut spending. Both administrations pursued the same policy to keep a lid on that debt-to-GDP ratio.
Bush 43 added several trillion dollars to the debt, which took the debt-to-GDP ratio up to over 70%. Then, Obama doubled the debt in eight years, from about US$10 trillion to about US$20 trillion, and the debt-to-GDP ratio went up over 100%, the highest since World War II.
The ratio will increase under Trump, perhaps dramatically.
But there’s something else that nobody is talking about, which is student loan debt.
There are about US$1.5 trillion worth of student loans outstanding, all government guaranteed. There are some private loans not guaranteed by the government, but predominantly, this is a government guaranteed market.
Those default rates are skyrocketing, up over 20%. Bear in mind that a 5% or 6% default rate in mortgages is huge. The same applies to credit cards. Anything north of 5% is a very high default rate, but in student loans, it’s over 20%.
That means that you’ve got US$$300 billion or more of student loans going bad.
Now, this has not hit the budget yet because they’ve been masking it. They offer grace periods. They offer deferrals. They do consolidation loans.
They offer public service as a way to get out of paying the debt. They’ve been doing that for years and they’re running out of tricks.
Now, the defaults are piling up.
That’s going to start hitting the budget this year in a big way and even more so next year. These student loan defaults are going to hit the budget like a tsunami.
We’re looking at conservatively, a trillion dollars of additional debt. By the way, everything I just mentioned is additional debt on top of the budget deficit we already have.
So we’re looking at one to two trillion, one conservatively. I think two trillion is a better estimate of the budget deficit increases because of the tax cut.
This all comes at at time when the debt to GDP ratio is already over 105%.
This is what has the market spooked.
There is no way out of this except inflation. The US is not going to outright default because we can always print the money.
But we will default in the sense of having to ramp up the inflation, so the debt will have to be paid with rapidly depreciating dollars.
It’s like paying someone back a quarter when they lent you a dollar.
Now, to date the Fed hasn’t been able to generate inflation.
But if they try hard enough and long enough, they will. But in the short run, to the extent that we’ve had disinflation, that makes the debt burden even higher.
We’ve been running up the credit card for decades.
We’ll be paying for it all in the years ahead. Get your gold now, while it’s still cheap.
For The Daily Reckoning Australia