What are the ingredients which Suggest a Financial Crisis?

@RaoulGMI identified the following factors contributing to a crisis, before Coronavirus:

  1. Stocks: Largest Equity Bubble of All Time: (Pension Crisis & Buyback Bubble)
  2. Demographics:
    • Largest Retiree Wave, all wanting to sell stocks and bonds at the same time
    • Millennials are too poor and indebted (make 20% less than parents)
  3. Corporate Credit: Largest Credit Bubble of All Time
    • ($10 Trillion + Off balance Sheet = 75% of GDP)
  4. Student Loan Bubble:
    • $1.6 Trillion
  5. Auto Loan Bubble
    • ($1.2 Trillion)
  6. Indexation Bubble
  7. ETF/Market Structure Bubble
  8. Foreign Borrowings (Dollar Standard Bubble)
  9. Monetary Policy Bubble (The Central Bank Bubble)
  10. EU Banking Crisis
  11. A Trade War:
    • The Trade Wars “shattered” supply chains
  12. Coronavirus
    • Largest Supply & Demand Shocks of all Time


Big Picture:

Central Banks have been fighting for the last 20 years:

  • Full Scale Debt Deflation and a Solvency Crisis

Turns into:

  • A loss of confidence in the Dollar Standard and the Entire Financial Architecture

(page 29-30)

Covid-19 has exposed our financial fragility

An orgy of borrowing, speculation and euphoria has left the markets on the verge of catastrophe

Financial markets have experienced the fastest ever crash over the past few weeks. Even during the dotcom bust and the Lehman crisis, stocks did not fall this quickly. In less than a month, we have seen major indices fall almost 30%, and stocks in sectors such as oil and travel down by 80%. We are experiencing terrifying daily declines not seen since the 1929 stock market crash that preceded the Great Depression.

We are at a watershed moment: the coronavirus Covid-19 is a catalyst fast bringing many long simmering problems to the boil. It is exposing the creaking financial systems around us and it will change the way economies function. Economic and financial pundits, however, have been focusing almost exclusively on the short-term effects of coronavirus and so are missing the much bigger themes at play.

Epidemiologists tell us that when it comes to the virus, we are looking at a once in a century event. It is highly contagious and highly lethal. Experts are not comparing Covid-19 to SARS or Swine Flu, but to the Spanish influenza of 1918 that killed between 50 and 100 million people worldwide.

We do not have good data on what the stock market did during the 1918 flu, but we do know that it led to a severe recession. The connection between influenza and recessions is well documented. Going as far back as the Russian flu in 1889-90, the Spanish flu in 1918, the Asian flu in 1957-58 and the Hong Kong flu of 1968-69 — they all led to recessions. This one will be no different.

But this recession will not only be driven by the economic loss of able-bodied workers, it will be helped along too by the steps political leaders take to avoid the spread of the coronavirus. In medicine, the immune system’s response can often be worse than the disease. When the body goes into septic shock, the immune system overreacts, releasing what doctors refer to as a cytokine flood, which can reduce blood to vital organs and lead to death. Sepsis is common and kills more than 10 million people a year. Today, the political reaction to Covid-19 is causing something akin to a septic shock to the global economy.

The recession is likely to be very sharp and but brief. Recessions are self-regulating. De-stocking of shelves and warehouses leads to re-stocking. Collapsing low interest rates and oil prices eventually spur spending and borrowing. Government spending and central bank easing eventually feed through to the real economy. While there will be massive panic and bankruptcies today, there is little doubt that markets will be better in a year, and certainly will be in two to three years,

But the structural changes to how our economy operates, however, will be felt for decades to come. And this is in large part because we didn’t learn the lessons of the last crash.

Over the years since the 2008 crisis, central banks have been trying to stamp out every single small fire that flares up (the European crisis in 2011-12, the Chinese slowdown in 2015-16, the slowdown last year); but suppressing volatility and risk only creates bigger fires. Risk is like energy and cannot be destroyed. It can only be transformed.

Forest fires are a useful analogy. California has infrequent, devastating forest fires; the Mexican state of Baja California has many small frequent fires and almost no major catastrophic fires. Both states have a similar climate and vegetation, yet they have vastly different outcomes. That’s because when there are very few small fires, underbrush grows, vegetation increases and creates greater kindling for the next fire. Suppressing small risks only makes them emerge eventually as very big ones.

In politics and economics, massive change events tend to happen not in orderly sequences, but in sudden spasms, like the Arab Spring, or the collapse of the Eastern Bloc. Watching events unfold is often like watching sand grains pile slowly on top of one another until a final, random grain causes the entire pile to collapse. People knew the Arab countries were fragile and that the Eastern Bloc might eventually fall, but predicting which grain of sand would do it precipitate either was impossible.

Physicists call these transitions critical thresholds. Critical thresholds are everywhere in nature. Water at moderate temperatures is disorganised and free-flowing, yet at a given critical value, it has an abrupt transition to a solid. It’s the same with the sandpile: one grain too many can trigger collapse — but which one?

In 1987 Per Bak, Chao Tang, and Kurt Wiesenfeld found that while sandpiles may be individually unpredictable, they all behave the same way. The critical finding of their experiments was that the distribution of sand avalanches obeys a mathematical power law: The frequency of avalanches is inversely proportional to their size. Much like forest fires, the less frequent they are, the more catastrophic they are.

It’s the same with financial markets and the economy. We will experience years of quiet, interrupted by sudden avalanche. Years of slowly adding grains of sand can end abruptly — to our great surprise. Today in financial markets, many unsustainable trends have been building, and the coronavirus is merely the grain of sand that has tipped the sandpile.

It would be controversial to say that the stock market reaction to the coronavirus would not have been very big had we not been in the middle of an orgy of borrowing, speculation and euphoria. Of course, stocks would have fallen with coronavirus headlines, but it is unlikely they would have crashed the way they did without those exacerbating factors. Furthermore, without enormous underlying imbalances of high corporate debt, the prospect of poor sales would not have driven so many stocks to the verge of collapse.

This aspect of the current crisis has so far gone unreported. But not unmentioned. A few weeks before the crash, Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner, issued a dire warning, “I think there are lots of troubles coming,” he said at the Los Angeles-based Daily Journal annual shareholders meeting. “There’s too much wretched excess.”

Speculative euphoria was at record highs. As Sir John Templeton once said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” Investors were all on the same side of the boat, and it capsized, as happens in market crashes.

  • Investors were buying a record amount of call options, or bets on stock prices rising further. According to SentimenTrader, by early February, “We’ve never seen this level of speculation before. Not even close.”
  • Asset managers were betting in record quantities on stock futures, which are instruments to bet on underlying indices. Positioning in S&P futures hit a new high as of February 11.
  • Hedge fund borrowing to buy stocks was at a 24-month high. They were highly confident markets would keep rising.


QF Research@ResearchQf

Asset Manager positioning in S&P futures hit a new high as of February 11 in both net contracts and value. S&P futures comprises the bulk of equity futures positioning by these funds.

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It was not a coincidence that there was such euphoria. Retail brokerages had announced over the past few months that they were eliminating all commissions on trading activity. Buying and selling stocks was suddenly “free”. It was like pouring truckloads of kerosene on a blaze. At Charles Schwab, daily average trading revenue exploded 74% after the change.

In scenes reminiscent of the dotcom boom, stocks were doubling overnight. Virgin Galactic Holdings, with no revenue, was worth over $6 billion dollars. Tesla, which has never made money selling cars, had a market capitalisation greater than any other car manufacturer. Its stock price quadrupled in less than three months. The market was so stretched that it would have crashed due to its own absurdity — with or without coronavirus.

The source of this “free” trading came from high frequency trading firms that are supposed to act as market makers, executing buys and sells for clients. Except that they are not really disinterested middlemen; they are running their own trading strategies to make money off retail investors. They execute the order flow of so called mom and pop investors and profit from these “dumb money” retail traders, in the words of Reuters.

The brokerages which sell retail orders receive hundreds of millions of dollars in return from the market makers. This means that, essentially the market makers are bribing the brokerages to profit from retail traders. For example, E*Trade received $188 million for selling its customer order flow last year, while TD Ameritrade made $135 million in the fourth quarter alone. The market makers are willing to pay so much because they almost never lose money — they trade fast and know where the market is going.

As Warren Buffet once said, “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” Retail is the patsy.

Ken Griffin is the owner of Citadel Securities the biggest market-making firm, and his business is so profitable that he has gone on one of the greatest property buying sprees of all time. In 2015 Griffin paid $60 million for multiple condo units in Miami. He paid a U.S.-record $239.96 million penthouse in New York City, a $122 million mansion in London, and over $250 million in Palm Beach properties. Market making against “dumb money” is a fabulous business.

As the mania deflated in late February, though, mom and pop were abandoned. As the crash started, market makers pulled back and provided less liquidity. Retail investors were left high and dry. It is no wonder prices fell so quickly.

The high frequency market makers have since been pleading for more capital, and rumors swirl that many are experiencing financial difficulties. The illusion of benign market makers looking after retail investors has vanished.

There are echoes here of the old problems from the Lehman crisis; but they have mutated into different forms. During the Lehman crisis, mortgage bonds were pooled together, and insurance companies and pension funds bought them. Today, retail investors have been buying popular funds known as Exchange Traded Funds (ETFs). These are easy to trade and cheap, but they have a fundamental problem. While ETFs have simple tickers like HYG, JNK, LQD that the average retail broker can trade on their screen, they are really holding hundreds of individual bonds inside of them that the investor is unaware of. These bonds are not easy to trade at a moment’s notice and are highly illiquid. But while the ETFs rose slowly and steadily, and investors poured more money in, lulled by a false sense of security.

While the ETF shares trade daily by the second, the underlying bonds are not easy to trade on their own. In the old days, insurers and pension funds bought these bonds, put them away in a drawer and never traded them. Today, though, investors expect instant liquidity from an illiquid investment. Liquidity mismatches are as old as banking itself (deposits and cash are highly liquid, while mortgages and loans are often completely illiquid); the problems of ETFs have been known all along, and the outcome has been inevitable.

As the coronavirus panic spread, the ETFs started trading at big discounts to the underlying value of the baskets of bonds. Markets are broken, and the gap is a sign of how illiquid the underlying holdings really are.

But these ETFs should never have been allowed in the first place. In the words of Christopher Wood, an investment strategist at Jefferies, “they commoditise equity and bond investing in an insidious way which ultimately creates a dangerous illusion of liquidity. True, ETFs are cheap. But so is fast food.”

While ETFs may appear technical and unrelated to the broader problems in markets, they share the same underlying problem. We have had the illusion of safety and liquidity for some time, and it is the coronavirus that has exposed the gaping holes in financial markets.

The coronavirus won’t kill companies. But it will expose their bloated, overleveraged balance sheets. Corporate debt in companies has never been higher and has now reached a record 47% of GDP.

Rather than encouraging moderation, central bankers and policy makers have been reloading the all you can eat buffet and persuading everyone to come back for third and fourth plates. The European Central Bank and the Bank of Japan have been buying corporate bonds, and central banks have kept funding at zero rates, which has encouraged a massive increase in indebtedness over the past decade.

Central bankers have long promoted high corporate leverage because they see it as a way to stimulate demand. Even now, many economists see no problems on the horizon. In the New York Times, Nicolas Veron, a senior fellow at the Peterson Institute for International Economics in Washington, was openly mocking anyone advocating prudence, “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years.” Like most central bankers for the past decade, he argued, “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”

But while debt has encouraged growth, it has also introduced much greater financial fragility, and so the growth is fundamentally unsound. We are now finding out that less debt, rather than lower rates is better for financial stability.


The global economy has gone mad


According to FactSet, 17% of the world’s 45,000 public companies haven’t generated enough cash to cover interest costs for at least the past three years. Debt has been used to finance more debt in a Ponzi fashion. The Bank for International Settlements looked at similar economic measures globally and found that the proportion of zombie companies — companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt — is now higher than 12%, up from 4% in the mid 1990s.

Entire industries are zombies. The most indebted and bankruptcy prone industry has been the shale oil industry. In the last five years, over 200 oil producers filed for bankruptcy. We will see dozens if not hundreds more bankruptcies in the coming year. They were all moribund with oil at $50 dollars; they’re now guaranteed to go bust with oil at $30.

Only now, belatedly, are groups like the IMF waking up to the scale of the problem. In a recent report they warned that central banks have encouraged companies to pursue “financial risk-taking” and gorging on debt. “Corporate leverage can also amplify shocks, as corporate deleveraging could lead to depressed investment and higher unemployment, and corporate defaults could trigger losses and curb lending by banks,” the IMF wrote.

According to the IMF, a downturn only half as bad as 2008 would put $19 trillion of debt—nearly 40% of the corporate borrowing in major countries—at risk of default. The economic consequences would be horrific.

Corporate debt has doubled in the decade since the financial crisis, non-financial companies now owe a record $9.6 trillion in the United States. Globally, companies have issued $13 trillion in bonds. Much of the debt is Chinese, and their companies will struggle to repay any of it given the lockdown and the breakdown in supply chains.

We have not even begun to see the full extent of the corporate bond market meltdown. One little discussed problem is that a large proportion of the debt is “junk”, i.e. lowly rated. An astonishing $3.6 trillion in bonds are rated “BBB”, which is only one rating above junk. These borderline bonds account for 54% of investment-grade corporate bonds, up from 30% in 2008. When recessions happen, these will be downgraded and fall into junk category. Many funds that cannot own junk bonds will become forced sellers. We will see an absolute carnage of forced selling when the downgrades happen. Again, the illusion of safety and liquidity will be exposed by the coronavirus.

The average family is encouraged to save money for a rainy day, in case they are fired, or they face hardship. Saving some money is considered prudent. It’s quite different for business. Companies pocket the profits in the good years and ask Uncle Sam to bail them out in the bad years. Heads shareholders win, tails the taxpayer loses.

Industry can’t be blamed for not expecting an act of God or force majeure, but in the past 30 years we have seen two Gulf Wars, 9/11, SARS, MERS, Swine Flu, the Great Financial Crisis, etc. Saving for a rainy day should only be expected in cyclically sensitive industries.

But rather than do that, companies have been engaging in a rather more reckless strategy: borrowing to buyback shares. This may boost their Return on Equity (ROE), but it is not remotely prudent and makes their companies highly vulnerable. Borrowing to prop up their own shares means they have less on hand when hard times come.

According to Barons, “Stock buybacks within the S&P 500 index totaled an estimated $729 billion in 2019, down from a record $806 billion in 2018.”

And then along came coronavirus.

Of those industries that are now seeking a bailout, none has saved for a rainy day. Boeing, the poster boy of financial engineering and little real engineering, bought back over $100 billion worth of stock over the past few years. Today it is asking the government for a backstop to its borrowing.

According to Bloomberg, since 2010, the big US airlines have spent 96% of their free cash flow on stock buybacks. Today, they’re asking US taxpayers for $25 billion.

Airline CEOs have been handsomely paid while not saving for a rainy day. Delta Airline’s CEO Ed Bastian made the most, earning nearly $15 million in total compensation. American CEO Doug Parker $12 million, while United CEO Oscar Munoz earned total compensation last year of $10.5 million.


Corporate buyback culture is financial engineering not value creation


The cruise liners were little different. Over the past decade, Carnival Cruises paid $9.2 billion dollars in dividends to its billionaire owners and bought back $6.7 billion of shares. Royal Caribbean, which is a smaller company, paid out $2.7 billion in dividends and $1.6 billion in buybacks. And the smallest cruise liner Norwegian Cruise Line spent $1.3 billion on share buybacks.

For years, the cruise lines have triumphally proclaimed massive dividends and buybacks. For example, Carnival proudly announced in 2018. “In just three years, we have doubled our quarterly dividend and invested $3.5 billion in Carnival stock.”

Cruise lines have no real claim to any bailout. They pay no taxes due to a legal loophole, and all their vessels fly the flags of Liberia, Panama and the Marshall Islands. Furthermore, their owners tend to be billionaires with more than enough financial wherewithal to recapitalise their own businesses. Their shareholders are not among the 1%. They’re among the 0.01% of richest people in the world. In the worst-case scenario, the US has a highly efficient bankruptcy process. Bondholders of today become shareholders of tomorrow, and the companies can have a fresh start. Bondholders would only be more than happy to own the equity of these companies.

Banks, too, will inevitably be asking for bailouts before this is over. Banks have among the most aggressive stock buyback programs of any industry, with some repurchasing a staggering 10% of their outstanding shares annually. The eight biggest banks have announced they will suspend their share buybacks for the next two quarters due to the COVID-19 pandemic on the global economy. In 2019, the top eight banks bought back $108 billion of their own stock.

If any good can come of the current crisis, perhaps it is exposing the irresponsibility of share buybacks and lack of prudence of most companies.

Monetary policy was one of the mechanisms employed in response to the last crisis, in the hope its effects would trickle down to the unwashed masses. Central banks bought vast amounts of treasuries and mortgage bonds to tighten financial spreads for banks and borrowers, but none of it went directly to households. It was all intermediated by the financial system and those who had access to capital.

The absurdity of the policy was perfectly illustrated recently in Europe. The European Central Bank has been busy buying bonds, and recently it bought bonds from LVMH, the luxury conglomerate owned by the world’s richest man Bernard Jean Étienne Arnault. The bonds had a negative yield, meaning that the ECB was paying LVMH to borrow. LVMH used the ECBs money to buy Tiffany.

If rates are now so low that billionaires are being paid to borrow, monetary policy has reached the limits of its usefulness.

Investors own stocks because their bond portfolios have acted like a hedge. Whenever stocks have fallen, bonds have gone up. In every downturn since the 1980s, central banks have cut rates, but most government bonds now have close to zero yields.

Extremely low interest rates and high valuations mean that any small change in interest rates will make portfolios much more volatile. If interest rates were to rise even slightly, they would vaporise many bond and stock portfolios. The margin of safety in bonds and stocks has diminished rapidly as rates have approached zero.

The world is now upside down. Many investors now buy stocks for current income and buy bonds to trade given how volatile they have become. Things cannot hold.

What do high frequency market making, share buybacks and high corporate debt have in common? They are supposedly tools to make trading, growth and returns on capital more efficient and cheaper, yet they have made the system more fragile and less resilient. Perhaps returns on capital and cheapness of market orders and ETFs are less important than stability and anti-fragility, i.e. designing systems that are robust in the face of stress.

We have seen the fragility in supply chains in the recent crisis.When the coronavirus struck in China, suddenly companies everywhere found out that outsourcing all their manufacturing and even medicines and face masks to China might be a problem.

Manufacturing has become less robust, more fragile, even if the returns on capital are better for those companies that outsource everything to China in pursuit of share buybacks.

The lessons of history are instructive. Although planting a single, genetically uniform crop might be more efficient and increase yields in the short run, low genetic diversity increases the risk of losing it all if a new pest is introduced or rainfall levels drop.


Have we been played by China?


The Irish Potato Famine is one such cautionary tale of the danger of monocultures, or only growing one crop. The potato first arrived in Ireland in 1588, and by the 1800s, the Irish had used it to solve the problem of feeding a growing population. They planted the “lumper” potato variety. All of these potatoes were genetically identical to one another, and it was vulnerable to the pathogen Phytophthora infestans. Because Ireland was so dependent on the potato, one in eight Irish people died of starvation in three years during the Irish potato famine of the 1840s.

The lessons from nature are dire. In the 1920s, the Gros Michel banana was almost wiped out by a fungus known as Fusarium cubense, and banana shortages became a growing problem. The widespread planting of a single corn variety contributed to the loss of over a billion dollars worth of corn in 1970, when a fungus hit the US crop. In the 1980s, dependence upon a single type of grapevine root forced California grape growers to replant approximately two million acres of vines when the pest phylloxera attacked.

Today, China is manufacturing’s monoculture.

Against this dangerous backdrop of volatility and uncertainty, the coronavirus will now achieve the impossible. For the past few years, two ideas have floated around on the political fringes of the Left, but they have been dead on arrival. No one has seriously thought they might become government policy. Today, the Left and Right in the United States and Europe are embracing them.

Andrew Yang, a former tech executive from New York, ran a quixotic, obscure presidential campaign in the United States based on the idea that every citizen should receive a Universal Basic Income (UBI). He advocated a “Freedom Dividend”. This would be a form of universal basic income that would provide a monthly stipend of $1,000 for all Americans between the ages of 18 and 64.

Today, Trump, Pelosi, Romney and others are fully backing Yang’s idea. Respected think tanks such Brookings and Chatham House have advocated UBI. But once it is implemented, there will be no going back. Handouts will start small and grow.

The other big idea has come from Stephanie Kelton, who advised Bernie Sanders and advocates for Modern Monetary Theory (MMT). Kelton argues that in any country with its own currency, budget deficits don’t matter unless they cause inflation. The government can pay for what it needs by simply printing more money — no reason to borrow by issuing bonds. Helicopter money.


Could free cash fix the economy?


Her ideas were widely criticised across the Left and Right, ranging from Paul Krugman to Warren Buffett to Federal Reserve Chairman Jay Powell.

Yet today, the two ideas have come together. There are no atheists in foxholes. Even libertarians on Twitter are now calling for government intervention. Investors and politicians of all stripes are calling for UBI financed by MMT money issuing.

This is an epochal turning point, a great reset. The coronavirus is the grain of sand that will cause the avalanche.

For once the taboo of printing money to pay citizens is broken, we can never go back. Governments will spend money with few constraints, aided by central banks. It’s a strategy that has not worked well in emerging markets, and it did not work well in the 1970s — which has conveniently been forgotten.

Undoubtedly, the government must compensate citizens from mandatory curfews and quarantines. The short-term impacts of the lockdowns must be mitigated, but temporary policies must not become permanent political expedients.

That’s why the danger is not today or even a year from now, it’s five to ten years away, when the crisis has past, along with the reason for UBI and monetary easing. What politican will be disciplined enough to stop spending? What central banker will raise rates when it is unpopular to do so?

Today we are reaping the whirlwind of the last financial crisis. Rather than pursue lower leverage, less debt and more robust institutions and more responsible corporate behaviour, investors and companies instead learned that they would be bailed out in a crisis.

Central banks became enamored of their own success as fire fighters, and they have busily been trying to put out fires by

  • encouraging reckless behaviour,
  • prizing low volatility above a robust financial system,
  • viewing “risk management” as preferring no financial corrections ever.

They should accept that sometimes putting out every single fire creates greater conflagrations. They should be humbler about the extent and limits of their power.

It looks like they’re about to learn the hard way.

Fears of corporate debt bomb grow as coronavirus outbreak worsens

Is A U.S. Recession Coming? with Raoul Pal | Recession Watch


Due to the precarious construction of the recent economic expansion, the resulting damage of a recession could be unusually devastating. In this deep-diving presentation, Raoul Pal presents many specific indicators of weakness, speaks to the potential market impact, and explains how a “doom loop” could quickly take matters from bad to catastrophic. He also suggests steps that savvy investors could take to prepare themselves. Finally, he previews some of the conversations he plans to have over the next two weeks on Real Vision, as he seeks to better understand both the current risks and the potential opportunities. Filmed on July 8, 2019 in New York.

Clip Summary:

Q: Why was Christine Legarde brought in to the European Central Bank?

A: Europe is in a “Doom Loop”. Legarde is a politician and lawyer, not an economist.  She is the head of the IMF, which makes sense because she is going to negotiate the nationalization of the banks.

The Corporate Debt “Doom Loop”

So today I’m gonna talk to you as
Ralph’s pal from global macro investor not real vision because real vision doesn’t have a view of our markets and a view about economies
But I do have a view I’ve got a strong view that’s been developing for a while
Now as most of you know, I’m a student of the business cycle
I look at the ups and downs the undulations of GDP and you realize that
Things aren’t linear and most economists. Don’t put some sort of cycle into their forecasts once I realized how cyclical things were
I realized there is an element of predictability
Now obviously sometimes with the cycle things don’t work out exactly as you imagine. The timing doesn’t work
For example, I did think we were going to get a full recession in 2015 didn’t quite happen
That way we came very close to at a manufacturing recession around the world
We had a few emerging market crises, but it didn’t quite get to full recession, but it came incredibly close
but now we’ve got to a point where I’ve been monitoring how the cycle is developing and
I’ve come on to real vision a couple of times to talk about the bond trade because I said look the cycles turning the best
Thing to do is be long bonds and that’s been a spectacular trade
So particularly the short end in the euro dollar market and even in the long end whether it’s TLT or bond futures
There’s been a huge amount of money to be made in that
But now we’re getting to the point where the Fed looked like they’re about to start to ease and we need to decide
Okay, how far are they going to go and are we going to go into a recession?
this is probably the only
Call that matters, and I’ve talked before there’s the only asset class that matters right now is the dollar which is range-bound
So it’s currently not the predominant factor
Outside of that it’s chand aside is the world gonna go into recession and is the u.s. Going to go in recession?
My hypothesis is it looks like that is the case
Now one of the things anybody who knows me knows that I don’t talk in certainties
So I’m not saying look it’s definitely a recession. We’re all screwed whatever it is
I don’t even know how severe it can be but what I’m interested in is the probabilities and the
Probability that we’re going into recession or even in recession now are very high
so having realized this I thought you know, I’m
Not the only person who thinks this but there is a whole group of people who think the opposite
And it’s one of those turning points where I fell insecure to know am I right or not? I
Think I’m right and I think that people I advise
They think I’m right
but there’s a whole group that doesn’t and I thought it would be really
Interesting to explore this thing fully on real vision for me to essentially take over the platform for two weeks
To really dig in and interview all of the best people I can find in the world
People have really respect people who doesn’t don’t have the same view as me whom may happen to have the same view or just different
Perspectives to find out really what’s going on and it’s going to help me and all of you go on a voyage of discovery
To really figure out are we going to recession or not?
And then we’ll try and figure over the course of these two weeks as well
The opportunities and the trades that we can make to protect ourselves or to make money whichever way this goes
So let’s start at the beginning
the Fed started raising rates a while ago back in 2016 and
it was really incremental and that incremental rate rise really didn’t
Mean a lot to most people we kind of brushed it off because rates were going from a very low level to another low level
But they kept going up. There were rate rise off the rate rises off the rate rises, but all very incremental and small
Then the Fed started cutie quantitative tightening
They started shrinking some of their balance sheet as well
And again, it didn’t look a lot compared to how much the balance sheet had grown over the previous decade
But that our continued for a while and nobody was that concerned about it. I started getting a different perspective
From about August of last year and it really came to the fore in September October, November and December
where I suddenly thought the Fed of over-tightened and
That nuanced shift happens incredibly quickly because everybody at the time was saying the Fed aren’t tightening enough and oh my god
The economy’s heating up and if you remember everyone was arguing about labor inflation wage inflation
The Fed are behind the curve and from everything
I looked at the Fed had gone too far already and they pretty much baked a recession into the cake
So what was I looking at?
The first thing I looked at is it’s the rate of change
of interest rates that count and I think I I showed this on my last presentation on real aversion back in I think it was
October last year the rate of change of
LIBOR so that’s just interest rates
They had gone up enough over 2-year rates of change basis that it was the largest
percentage increase in rates in all history and
Again, many of us a year, but the rates are so low. Why does it matter but the point being is in fact almost everybody
Refinanced at the lows. So everybody with the house everybody with the business
every corporate balance sheet every Bank
Everybody took out
more debt at low rates
and debt exploded
So even my mortgage had gone up 40%
And I was a little bit sure. I hadn’t realized and it was only what I suddenly got this statement through her Wow
Forty percent and then I got I wrote about a global macro investor and there was a large family office
And the principal the family office
called me up and said
We financed all of our debts
For the family office all the leverage that they used and all the other bits and pieces in their businesses and all of that stuff
He said I refinance in 2015. He said it’s gone up 80%
I’m like wow and how much leverage if you got I said well reasonable because money’s been free
So we took reasonable answer leverage, but it’s gone up and it’s meaningful. So I started think they really have over tightened
So if you look at this chart of the two yawns here year LIBOR and I put it against the business cycle
So I use a Curie you can see it suggests that the business cycle
should fall
Significantly from here now. That’s one thing. The other thing is
The Fed are still tightening by the balance sheet that’s not stopped yet
We don’t know whether it’s in the July meeting the September meeting
When are they going to stop doing that but really there’s a mass tightening going on and if you can see that keeps going on
month after month
there is another nuance about to hit us and that is the
debt ceiling at some point
They’re gonna have to agree a new debt ceiling. It’s most likely to be this summer and
That will also mean that the Treasury who have been funding the government in the meantime
Are going to start withdrawing the funding by issuing bonds
So there could be a huge tightening to come in the August September October time period of this year
So there’s some further tightening to come even if the Fed end up cutting interest rates
The other thing that most people don’t realize is even with these ultra low rates
People have been really penalized and if you talk about what upsets people about the kind of 1% and the 99%
one of the simple things where this shows up is credit cards if you look at interest rates on credit cards there in fact at
all-time highs
High and they were we interest rates were much higher in the 90s the early 90s
2000s. It’s extraordinary how much people are being penalized to borrow money while and that’s at a household level while at
The corporate level there’s many corporates around the world not yet in the u.s
Who are borrowing at negative rates and I’ll come on to a whole lot about the corporates in a bit later in this whole thesis
So you can see we’ve got the set up where it feels like
Rates may have gone too far
And I’ve come a lot more on to the rates market later in the yield curve and some of the signals there
but you see what turns a
Slowdown and we started to see the slowdown happening in December
We saw the volatility rising again in the equity markets and we started to see the bond market rallying like crazy
the yield curve inverting super fast all across the curve is
What then happened is what you normally need to turn what looks like something about
Into a much harder bility of being a recession is the extraneous event and that was trade wars
So you trade wars are not what everybody thinks there was a lot of noise about them and at first
People weren’t sure what Trump was going to do, but he first went after the Chinese
anyone after the
Europeans and then he’s been going around off the Canadians and the Mexicans and then he’s done the deal with the Mexicans and he’s done
a deal with the Canadians
But trade wars are happening and China. The Chinese situation is very very complicated
And with Europe – we haven’t got anywhere in the Europe negotiations yet. You see the problem is is his aggressive
Negotiating tactics have created a knock-on effect that most people don’t understand
If you are a corporate and you have this game of cat-and-mouse with China in the u.s
about not only normal trade, but also
about technology and the banning of
Technology to stop technology spreading there is a definite move within the US administration
To really isolate China in numerous ways, but particularly economically
But don’t forget we’ve come from the most globalized world. We’ve probably ever had
so if we back up maybe six years with the epicenter of globalization and
Everybody has decided that China is the future
All the big corporations around the world whether it’s BMW of General Electric have all moved to China. They’re building factories
They’re outsourcing and they have supply chains
Suddenly, they’re being told. Well, you don’t know whether those supply chains are going to stay you
Don’t know whether you can actually stay in China, or maybe even the Chinese end up booting you out
You don’t know whether you can produce cars in Mexico or not
It’s really confusing because it’s Trump gonna go back against what he’s just done with the Mexicans what happens with the Canadians?
How does that work?
Is there any labor arbitrage anymore in a world where he’s even going after Vietnam a country so small to be irrelevant to?
Stop the Chinese
Circumventing trade tariffs. He’s also manipulating OPEC and you don’t really know where this world is and you know
No doubt, there’ll be a timer and start picking on India as well
So he’s picking on all of the countries in the world
And that’s all well and good and I’ve talked about this on television before is a shift away from globalization
It’s not the end of the world
It is the shift itself that rates have changed that matters that rate of change is incredibly unsettling for corporate America
particularly and the global corporations the multinationals almost in cross every boardroom around the world right now as a conversation is
can we outlast Trump and
that’s a bet if we don’t we’ve got hell to pay with our shareholders if
Something happens and we don’t have an answer. We’re in trouble
Well, okay, we’ll build some inventory
So everybody’s built inventory just to give them some sort of buffer and now they need to make the decision
Do we pull the plug now or do we wait wait and see whether Trump goes wait and see whether there’s any option
So those two outcomes are really interesting to me
Because if you pull the plug now you break the global supply chains that’s happening everywhere
We’ve seen the announcement from Apple this week alone that they’re doing it the others decide
Well, we’ll wait and see so what does that really mean? That means corporate expenditures stops?
They tend to then spend a fortune on something like McKinsey or KPMG or somebody else
Who’s going to give them the advice on building new global supply chains bringing their business back to the US?
it’s a two three or four year projects before they make the choice of where they’re going to spend and
Rebuild their their supply their factories and all of this stuff. So
That generally means it’s a big crimp on borrow on spending that comes from corporations
Particularly in FDI. So that’s going to hurt several countries around the world particularly China
but there’s a lot of countries and a lot of companies who are going to see this spending freeze and
Have to wait and sit it out
So that is going to have the effect of lowering growth and I think that is what tipped this
Situation from a merely a slowdown that was looking nasty
Into it for me an almost certain recession. So the question is is where are we now?
Many of you will remember I used to use the is M. It’s my main way of looking at the business cycle
I don’t use it much morning more because
It kind of got a bit broken and the reason got a bit broken was not because of fed manipulation or anything else
It’s because the oil sector became so large that the oil price became the largest
influence of the I am itself particularly the refinery cycle every year
So I shifted away to the egg cream and that’s the economic
economic cycles Research
Measure and it’s a weekly
Indicator and I use the urine year return of the weekly indicator to give me the business cycle
It works very much like the is M and it correlates with everything like GDP. So you see the chart here of
At Crete with quarterly GDP and you can see how well correlated it is. It’s indicating that we’ve got some weakness to come
So that’s the first interesting point
Then I’d like to put the ikura against a number of other indicators that may be forward-looking and this is where it gets interesting
I’m going to show you a whole series of charts now for you to look at
So this chart is the cash freight shipments index
You can see how dramatically freight shipments have fallen and how much they’re
suggesting that the could fall from here and therefore
GDP as well
Car loadings a similar way of looking at transportation. It’s collapsing capsule goods orders
These are the big-ticket items the things that a lot of times you use financing for or are involved in the global supply chains
You can see how they are rolling over as well and following eccrine lower
If you believe in this supply chain story and it seems to be bearing itself out in the press almost daily
Then you’ve got to imagine the capital goods orders are going to come lower but households are also struggling with the with the rates
So you’ve seen that and how much car sales are fallen, so calf sales have languished and they’re expected to go further
Clothing sales have collapsed in recent months as well, which has been an extraordinary move and restaurant sales as well have been extremely weak
So your sons are seen not only as shipping and moving Goods around week, but you’re also seeing a weakness in
The consumer and a weakness in business expenditure another great global indicator. I’ve looked at is semiconductor sales
semiconductor sales are
Extraordinarily weak right now and eight who are suggesting the global business cycle has a lot further to fall back in the US
We’ve also got the housing cycle
It looks like that the the Case Shiller house index is starting to weaken significantly
And is now at the weakest level since before the previous recession
And we also have weakness in house prices overall and construction so I’m concerned that all
Parts of the economy are showing evidence of weakness
And I know many people say well unemployment’s not unemployment strong
Unemployment interestingly enough is the most lacking of all indicators and just remember that every time the Fed cut rates and unemployment
Was below 4% We went to a recession almost immediately afterwards
They’re all lagging
So don’t get trapped in the in the unemployment look at the forward-looking indicators and they’re looking problematic
So those are just some of the u.s. Indicators that I’m finding concerning
There is a general theme of weakness that lies ahead and if you go back to that first chart
I showed you of the two-year on 2-year rate of change of LIBOR of interest rates
Then you’re going to expect to see a creek come down further and all of these things that are correlated come down further
Also, don’t forget the equity correlates perfectly to asset prices if you look at the year on your SMP
It basically is the business cycle now
I understand that equity prices as part of the equity calculation
But I can use hard data and a bunch of other variations of the business cycle and they all show the same thing the equity
Market is cyclical right now just because of the construction of what he was doing last year. It’s at all-time highs
It should actually significantly weaken in october/november if the equity stays where it is
the other thing to bear in mind is that looks like there is in marginal pause in the data and you’ll see that in the
global data in a second
so that’s one of the things I’m waiting for over the
Summer is let’s wait and see how this plays out and whether we get some weakness further on again, which is my expectation
but it’s really want to pick people’s minds about I
Look at the world PMI, you can see the world PMI is just heading into recession territory. So it’s weak
It’s telling us that there is a definite susceptibility to anything else going wrong, and I’ll come to some of the banana skins later
But anything going wrong is going to turn this from a slowdown into something much uglier
I think the tum the Trump trade situation. Is that very thing?
We’re starting to see many central banks around the world expressing concern and thinking about cutting rates
In response to this kind of very weak economy that’s starting to develop
The other thing is is that trade tariffs are showing up in the data when we look at world trade volumes
Well trade volumes have started to come off sharply and I think that’s really important
We also have a GMI indicator for world trade and it is also coming off very dramatically
So it’s something we need to be very careful of to see how this develops and again the one thing and I’ll talk about it
Later that we really need to be worried about is if the dollar goes higher than here another concern for me is the European economy
the European economy
was really led by Germany, which is
different this time around it’s not the the
peripheral European economies
It was Germany that started first firstly a relatively strong euro and secondly trade disputes. So trade issues those two things
suddenly started to mark a turn in Germany and
Germany has gone pretty much to recession GDP is not negative yet
but all of the forward-looking indicate are showing that Germany is going towards recession if you look at for example
industrial production or if we look at
Exports, we can see that there’s some concerning signs in Germany
And if we look at the zoo survey, which is their forward-looking PMI, it suggested that GDP is going to go negative 2 percent
That’s quite a big move for one of the largest economies in the world and the largest economy in Europe
But you see it’s not just at Germany level
We’ve got Italy that is actually in recession again a mild recession right now and we have France that is starting to weaken
And is only just growing so we’ve got the three largest economies in Europe. Not in great shape
Spain is the only one that looks ok right now when we get to pour chill again, it’s getting weak and
Holland doesn’t look great
so Europe is looking a bit of a mixed bag and we’ll come back to Europe later because it’s one of the weak points and
I think it’s one of the places that we all need to understand in this globalized slowdown
We can also get a bit granular with China
China struggled from load of monetary tightening if a couple of years ago and
the government trying to rein in the speculative excess of
A cheap money boom that came out of the back end of the global recession
So China’s been tight and it kind of broke the financial system doesn’t function
Properly in China any longer and the government is involved frequently trying to keep some sort of liquidity
They’re not interested in bailing out the rest of the world by another liquidity event. It’s just not in China’s interest
They just don’t have the ability to do so and why should they why should they when the rest of the world’s being so antagonistic?
So the point being is China’s very domestically focus
They’re trying to unwind their bubble
They’re trying to stimulate enough just to flatten it out trying the Japan way of doing things
But that means that China which was the marginal rate of change of growth of the global economy. They’re just not players right now
They are negative in terms of imports
for most of most of the raw
Materials so then they’re not going to be driving other countries GDP growth and I think that’s a really important matter
We’ve talked about the u.s. There’s no real growth there. We’ve talked about China
There’s no real growth there and we’ve talked about Europe and there’s no real growth there. So where is the growth engine?
There isn’t one and then when he broaden out to the rest of Southeast Asia
You can see that South Korea is also starting to slow down
Exports there a week and the same in Taiwan and we can assume the same as across Asia
Overall, Australia far too small the economy to matter in the globalized context
but as we know
Australia and has we feature on real vision has a problem with its own domestic economy with its massive house price broom and the
Overhang from the mining boom as well. So the Australia’s are cutting rates. They’ve got a slowdown going on
they’re trying to manage it the best they can without it turning to ugly and without it turning and
Rotting the banks at the core. We have to wait how that plays out
but again
It just tells you the number of countries who are in a similar situation
And the same can be true and said of Canada – which is one of the larger countries in the world
But again, they’ve had some problems. They’ve got the back end of a commodity boom
plus they’ve got an excessive leverage in the
Housing industry and that all needs to unwind and they too are going to be cutting rates so I don’t see a situation where anybody
Can save this and we’ve got I think the tipping point with tariffs that over overrides all of this
So this is why I’m really start to get concerned
But you see I
may be picking this up, but the bond markets always smarter than everybody and
I always incredibly amazed how right the bond market gets these things
Everybody argued when the yield curve was flattening the bond markets wrong. It’s just the Fed
Everyone says it doesn’t mean anything the yield curve. It’s just a different world right now
The yield curve started flattening then they started inverting and they started inverting all the way across the curve
We got the twos tens
Swaps curve which is the main one every time it gets to zero we go to recession
Shortly after we’ve hit that we had the ones twos curve going to the second most inverted in history
So that means two-year rates were trading below one-year rates suggesting that the easing that was necessary was large
They were screaming the Fed had gone too far
And then we had two year rates versus Fed Funds the magnitude
I think 70 odd bate 75 basis points
so the magnitude of that was also
extraordinary and was telling you the Fed had gone too far and things had to change quickly the Fed suddenly started realizing this by
December January February, they started changing their tune
Now we are here with the market saying well
We had a good employment data the Fed know that they’ve cut 25 or not to talk. They don’t need to do this. It’s ridiculous
Bond market indicators have never been at these levels without the Fed cutting 50 basis points immediately and 50 again soon after
so my core view is if this continues in any way unless
We see some sort of trough in the very near future in the forward-looking data
Then the Fed are going to cut 50 and 50 again. I don’t see the point of the Fed trying to cut 25 and
disappointing the bond market
Think if they have to play a very very careful game here and what they need to do is at least try to be in
front of the curve
That to your auntie row year rate of change tells you they can’t be ahead of the curve the curves well ahead of them
But the market needs some sort of perception, but I do think there’s a backup coming in the bond market
we’ll talk about this in a bit in a bit as people are trying to readjust the probabilities to do zero did the
25 to 350 I think in a completely reverse is this a bump up?
Meltdown coming, you know, I see all this noise on Twitter all day and we’ll address some of that in a bit
See the other thing
The Fed have got is the Fed of got a problem because they still tightening the balance sheet as I talked before
But when they look at what they’re trying to do they have that dual mandate that you’re – employment
Well employment looks fine right now and it always does at the peak of the cycle and they always cut one employee when unemployment is
Almost at the all-time lows
But the key is inflation expectations. They’re collapsing. They’re collapsing all across the world
But if you look at the ten-year break-even rate
It’s breaking this big Head and Shoulders pattern and it looks like we’re going down to 1% or so
That’s enough to be a 50% miss on the 2% implicit target that feds got on inflation. And this is 10 years out
So it’s telling you that the rates are so tight because there’s so much leverage within the akan me that they can’t raise rates without
Collapsing future inflation expectations and future demand. So I think that’s a really
Important indicator we could also you see the five year on five year inflation expectations
That again is breaking towards all-time lows
There is a complete collapse in inflation expectations regardless of the narrative that we heard
Only up until November December of wage inflation. It’s all going to come back
that was my if you remember my premise for the bond market rally was that narrative was wrong that appears to be playing out but
Not only does it appear to be playing out. It appears to be going from benign to
Nasty, so I think it’s something we need to watch but inflation is not just collapsing in the u.s. It’s collapsing around the world
So the rest of the world is also seeing an inflationary
Deflationary or disinflationary issue. I think the most extreme is Europe if we look at the five-year five-year breakevens in Europe
We see this enormous collapse in in inflation expectations and that’s with an economy with negative interest rates
I mean what the hell do you do about that? Europe is going to become a big issue again
Something will come on through in a second
But that is a real warning of how to generate inflation in a world straddled by debt. It becomes really complex
And how do you stop the downside?
Becoming a much larger event that it ordinarily would be when I look at these kind of theses
I like to cross-check against asset classes
I like to look across the world and see okay, how asset class is trading and the first one I look at copper
I look at the chart of copper and it’s a clear head and shoulders top and to me that’s telling me
That the economy is slowing down
What’s also interesting if I put the copper chart against the ten-year break-even?
You can see it’s the same chart
So copper basically is a real-time example of future inflation expectations
And they look like they’re going to break down together. If I look at the CRB industrial metals index
You can see that this big uptrend and this major
Topping pan a huge topping pattern is forming and I think that it’s likely to break that
And why I think it’s likely to break is one of the I think it’s probably the second ugliest chart pattern in the world
Which is the CRB commodities index if you look at this chart?
It looks like we’re going to go into a secular bust income
Due any day now and to last into the next few years as we reach for that final bottom
And I think that bottom could be uglier than many of us are
expecting a because of the size of the boom that we had the amount of capital that flowed into it and
particularly in the oil space and other some of the mining space as well and
also because what I think is going to happen to the dollar
So these charts are really ugly charts to mean it makes me very concerned that there is a broader
Disinflation or deflationary world out there that’s developing and it’s something I talked about in the last video. I did for real vision
That’s subsequently now develop further
So, let’s talk a bit about the risks
So I think I’ve established a case why it looks like there’s a possible recession coming. My probabilities are higher
They may be higher than yours. You may think I’m wrong
That’s okay. But you have to works you have to understand that the likelihood of something happening here is
reasonable so you’re gonna have to factor this into your investments or your working lives or all the things that a recession can affect and
I think that’s really important. Your business is – so let’s think about the risk now. One of the risks is China I
Don’t think an implosion of the Chinese economy is much of a risk because the US are basically forcing everybody out of China anyway
So it’s happening in slow motion
We’re also finding there’s a trade ban going on with many other issues with a try at China
So that’s not great. The Chinese themselves going to be propping up their economy. They’re trying to stop their banking system falling over
Okay, so that’s relatively stable because it’s a closed system. They’re gonna have some inflows from MSCI
And that was the inclusion of China both debt and equity is in the indices
Although I think the US are going to try and overturn that by putting political pressure on MSCI themselves
We’ll wait and see about that
But I know it’s just it’s a way for China to get capital and that’s what China needs its dollar starved and the u.s
Knows it
so if China’s dollar starved
the best weapon you’ve got is the dollar and if you look at the chart of the Chinese RMB
It has been pressing its nose against that seven ceiling for a while forming
What is one of the largest cup and handle?
Mason’s I’ve ever seen if that does go and seven breaks
Then we’re going to see an almighty move in the dollar against the RMB now, it doesn’t necessarily mean there’s a catastrophic
Devaluation coming out of China but a shift in the terms of trade which has massive global ramifications
And we’ll obviously knock on all the way through and I think you can see also if I look at the ADX Y
Which is the Asian currency index if I look at the big monthly chart?
There’s an enormous head and shoulders top that’s looking to break
this is the largest chart pattern I’ve ever seen in any currency market, but that is a
incredible chart pattern that tells me there’s a potential currency crisis in the making and
it’s to do with a strong dollar the other one that’s affected by the strong dollar and the weakness in global trade and
Particularly interest rates is Europe
So the European banks something I’ve talked about
Extensively for many years on real vision as the European banks have gone lower and lower and lower and I said there’s a big problem
Here and I know many bank analysts will say well, you know, there’s not solvency problem here. There’s you know, it’s different
They’ve got the right capital resources. Well, I look at the share price
I just look at the share price and it looks like the share prices want to go to zero
So the worst chart in the world
I’ve got a label at the GMI worst chart in the world is the European banks Index charts. It is a truly
terrifying chart because this is all of the banks in Europe and it looks like if
They break that key support then we’re going into a full banking crisis in Europe. And I think that’s a reasonable probability and
Here’s why you see the European banks are
international in nature Deutsche Bank
even the Swiss banks credit Swiss UBS Societe Generale in France Santander BBVA
All of these banks are international funded banks
Yes, they get their funding and the collateral with the ECB
but the reality is the day to day funding is the dollar euro dollar market and
They don’t get access to all the capital they need there’s a shortage of dollars out there, which is a problem
I think the dollar goes higher which creates a problem for these banks
If you look at that European banks index and look at it compared to the 10-year bond yield you can see the highly core
So as bund yields go down the banks go down, but you see the problem here is the ECB has one mandate alone
They’ve got the mandate of inflation and we showed you before the inflation expectations in Europe are collapsing
So it’s a one-trick pony the ECB can only do one thing cut rates
I talked to the ECB recently at a Goldman Sachs event that I was hosting in London, and I asked them
Okay. What are you gonna do?
what are you gonna do with the next recession comes and they’re like
Well, we can cut rates a bit more and we can do a bit more QE
but you can see there’s a general understanding that they can’t go that much further and
that’s a
problem for the banks because how do you stimulate so the banks are falling because these yields are really bad negative yields are bad for
Banks, the flattening yield curves not good for banks. The whole situation is a bad setup for the banking system and
The Europeans can only deal with it by cutting rates, which is bad for the banks
So you’ve created a bit of a Doom loop there. So there’s a bit of a cycle. That’s not good. So the question is is how do you stop it and my
idea is Christine Lagarde was brought in specifically for this
Why would you want her as a central banker? Why would you want her as the head of the ECB?
The ECB was a very technical Bank
It’s always very good with technical monetary policy because it was it was very policy driven He was less kind of broad-based macro driven than the Fed. He was really in the weeds
But Lagarde is not that
She is the head of the IMF. She’s a politician and she’s a lawyer and
what does she do she negotiates and
If you put something like that in control of the ECB
It tells you that there is going to be a shift or from in the ECB which is moving towards
Probably Negotiation for this banking settlement somewhere. Everybody has to get together and do something. It’s not just Germany here. It’s not just Deutsche Bank
That’s the you know, the poisonous one. There’s not one poisonous Apple here. It’s a whole system that’s in a mess
There’s still too much debt in that European banking system. That’s not been written off properly
so if these banks are probably going to have to go in the hands of the
Governments, they’re going to probably have to wipe out the equity holders somehow and the bondholders will become the government
So that’s the way you stop a systemic crisis
But somebody’s gonna have to pay for all of that and that’s gonna be a ton of issuance of debt
So if somebody has to negotiate new treaties
to allow all these companies to exceed their deficits and to increase their funding and the ECB to buy more of this funding and there’s
A whole load of stuff that needs to get done. There’s much more political and legal than it is
Than it is monetary policy. So I think that’s why Lagarde is there if you want somebody for the next recession
Clearly the person who ran the IMF that deals in
Bailouts is the right person so I get that and I think it makes sense. But Europe, that’s a tricky mess
This is not a quick fix overnight and it makes me concerned that this can go from not very good to very ugly very quickly
And I have a feeling if I look at the share price of the banks that by the end of the summer
We could be there already where we’re starting to see some of the real strains and where the Deutsche Bank ever gets to its full
Restructuring before they have to do something about it
My guess is hearing the story of Renaissance capital pulling its prime broking lines
from Deutsche Bank means that we’re potentially in the death spiral where it goes from not being a
Solvency problem to potentially being a solvency problem. Who knows wait and see
You know getting in the weeds of the banks is not my thing
But looking at the macro setup, I can see that this is a problem waiting to happen or is happening right now
The other thing I think is further to develop is the tech market I think there is a complete
Euphoria that has taken place in the private sector
Particularly within the private investment sphere. So it’s private equity and VC. I think too much money has been allocated
without the thought of getting the money back and I think no
better example than the poster child of soft bank and
how they put a hundred billion to work plus added leverage in and just basically
completely rewrote the rules of valuation of any firm out there with no clear sight of how to get out of I
Think there’s some huge problems with what he is signaling
Mercy Sun is signaling by trying to IPO the whole of the vision fund to start another fund if you’ll try IPO
Kind of a VC fund on this scale
Without actually the companies themselves going public
It’s telling you he doesn’t think the future IPO value is the same as the current
Private value and we’ve seen that with some of the recent tech issues
They traded higher as private companies than as it as public companies that there is a different
dichotomy between this and that’s telling me that things got to
effervescence in the private sector and it’s starting to come off and it will knock on through as
People realize that that the future of tech is not yet
not quite as bright as people thought it was and there are some really system merit
Systemic problems because the owner over ownership of this sector and the expected returns that’s embedded within it
I’m really worried about
Softbank I’m really worried about what it says for the world
So we’ll wait and see how that develops but I think there’s a tech problem
I also think as I’ve mentioned many times before I think there’s a tech problem coming as I mentioned before there’s a problem coming with
Google and Facebook and their battle with the DOJ and various other parts of the US government
I think they’re going to be treated as monopolies. I think they’re going to have shown to to have abused their monopolistic power
I think they are also
Using data in ways that people
Don’t want and I think their power is going to be curtailed and I’ll be broken up in various ways
So I think that’s coming and I think it will come over all through this next recession
So there is another Delta on the bad news something that can drive a little bit further
That worries me and I’m monitoring all of these themes as they all kind of come together
And it makes me worried but there’s two really big ones left
That I haven’t yet talked about on real vision
Some of you will have read it in global macro investor for those year of subscribers
And then recently I published much less than a publishing global macro investor. I published it in macro insiders and in think-tank
Wide Doom loop article and if any of you are interested in this piece
I think you should go back and have a look at that article
If you’re not subscribers sign up for a free trial and go and have a look through
This article and this goes through all of what I’m talking about in great length
I think there is something really interesting in macro insiders Julian Britton and myself
debated at length about
what this really means and whether or accession is coming and I think will probably show that later on this week as well because somebody
from macro insiders I think will really add value to you much like this Doom loop article, but the issue is
corporate debt
And this is when it gets really big
So bear with me and maybe get stiff drink while I sit down and talk to you about the Doom loop
You see every recession needs a poster child there’s always one there’s always the thing you pin it on
Back in 1990 is the savings and loan crisis
Back in 2000. It was the tech wreck
And then back in 2008. It was the housing market and
This time I think there’s an even bigger and more concerning one. I think it’s the corporate debt sector
I think this is the poster child of the next recession and let me explain why firstly you’ve got to realize that
Debt is basically a function of the business cycle and you have is most cycles
You have a super cycle and you have the normal cycle
So the normal credit cycle is very clear
If I look at the Aerie against the let’s say the hyg ETF. You can see how highly correlated they are
And also if you look at the area’s Moody’s be double-a to triple-a credit spreads
You can see it’s basically a function of the business cycle
so the business cycle drives credit spreads and it drives the
availability of credit and it drives the excess use of credit and all of the issues that come along with it and obviously the
Fed Drive, the credit cycle by raising interest rates or lowering interest rates also the behavior of credit
Availability which is the credit managers and how they give out credit again is really cyclical so we can look at the index
against the area and we can figure out that if at Kri the business cycle turns
Then we’re going to see some problems emerging in all of the debt market now. Here’s an interesting chart for you. Talk about recession
I find hilarious that the New York Fed publishes a recession probability index
The recession probability index is in the 30s now 30% chance of recession
It’s ridiculous because if you look back at every single time has ever been at this level
It’s been a recession. So when it gets to about 20 something it’s a hundred percent chance of recession
So the Fed New York Fed is basically telling you were going into recession
So if we’re going to recession, which is my core hypothesis, then we’re going to see credit spreads widening ordinarily. That’s not a big problem
Because that’s what happens and we had it in 2008 and you know corporate spreads widened out and they narrowed
Yes the banks that was a whole different issue the bank debt and household debt. We’ve had that as well
But this time around it’s somewhat different see this time
since that previous recession the size of the global corporate debt market has
Exploded and in particular in the u.s
US corporate debt as a percentage of GDP is the highest in all recorded history by using the fed data we get about
47 percent of GDP in debt, but if I use other data, particularly the IMF we’re getting numbers of about
75% the Fed data’s on taking account off balance sheet
So if it’s off balance sheet derivatives and all the other debts that’s on corporate balance sheets
Which we know are all over the place then we get to about 76 percent of GDP in debt
That’s a really really high number. So in nominal terms
Debt is now 10
Trillion dollars and it’s just gone up in a straight line as I said doubling in size since the last recession and this is extraordinary
Amount of debt don’t forget. This is the same time. The households have been gently easing out of debt
The financial system has been easing out of debt and the government has not but the government’s been kind of relatively flat
But the corporate sector went on a massive debt orgy
it was one of the largest increases of debt we’ve ever seen in history in 10 years a
Truly monumental debt buildup. What do they do with this debt? Well, this debt has been
Basically used for one thing. That’s equity buybacks
They bought back more equity than any other time in history. In fact
They’ve been pretty much the only buyer of the equity market if we look at all forms of other equity market ownership
They’ve been all in decline for the last five years while buybacks have been stepping up stepping up taking into account
All of the net sellers and pushing the market higher and there’s less liquidity
Around because you’re taking more shares out of the market by buying them back
so the less liquidity the more your shares go up and then when you add in passive indexation
It’s been pushing the markets higher from this enormous debt issuance. That’s all well and good but
once you start flooding the market with debt you create dynamic which is little understood and
That’s the lowering of overall credit quality of the entire market and this is not a u.s. Penomet
It’s a global phenomena, but in the u.s. Now
over 50% of the entire bond market this triple be
Trouble B is essentially one large notch above junk bonds
It used to be a world where there’s a lot of triple-a credit double-a credit
They’re all falling by the wayside
What you’re getting is?
everybody taking so much debt that they’re becoming triple B and all of the main bulk of American large cap firms are now triple B debt and then beneath that
you’ve got a trillion dollar so you got four trillion dollars of of
triple B and you’ve got a trillion dollars of
junk that
junk alone is the largest the junk bond markets ever been but the real growth in this whole thing has been
The triple B sector, you can see from this chart that if we put all the different types of bonds in a nice
stack next to each other the size of the triple B market is absolutely
Enormous and when you break down the u.s. Triple B debt market you can also say it’s pretty lumpy
there are five large beer moths that account for
seven hundred and seventy billion dollars of debt
And if you add in the US shale industry you’re talking about a trillion dollars of debt. Those companies are
General Electric General Motors
AT&T forward and Dell they account for everything here. It’s huge
You’re obviously there’s a massive tier of corporations behind it that triple-b
But really the risk comes down to five big firms just to understand how leveraged these companies are. Here’s the chart of debt-to-equity
General Electric is over 200% debt-to-equity
General Motors 250
AT&T about a hundred percent
Ford about four hundred and fifty percent and Dell about one hundred and twenty five percent of AT&T is
the largest the most indebted
Company the world has ever seen
it is a hundred and seventy billion dollars in debt and
Is over a hundred percent of market cap in debt that dynamic can change?
Dramatically if the share price Falls it’s digested an enormous acquisition in Time Warner
And if you remember a o L Time Warner was ringing the bell of the top of the last cycle
It kind of feels like AT&T Time Warner may be ringing the bell for this cycle – and it was a debt owed you’d allowed
To do it because AT&T thought fine, you know, we’re a phone company we get plenty of cash
The problem is is corporate cash flow is correlated to the business cycle
If you look at the Eckrich and look at S&P cash flow, you see they’re highly correlated
So what looks affordable acquisition now suddenly becomes unaffordable later if that starts to happen
Then you’ve got a problem and you’ve got a problem because look AT&T is not going bust
Well, at least I don’t think so, but it’s gonna get downgraded to junk
There is no way on earth the junk bond market can take a downgrade like AT&T
Realistically if you start to get in a recession
You should see I don’t know 10 20 % of these triple B’s get downgraded. So we’re talking
huge numbers that have to get absorbed into that junk space
But there’s only a trillion dollars there and the buyers are different and this is a crucial thing here
the buyers of
Junk bonds are not the same buyers as the buyers of investment a great credit
Those bars invest in great credit will have to sell if it gets downgraded
So that means that there is a huge amount of selling
But the people in the junk bond market don’t have 30% more 40% more cash suddenly to buy this stuff
so the only way of doing it is by obliterating the junk bond mark
So these get downgraded in any way shape or form you want to find that out the junk bond market?
becomes completely insolvent, but what’s worse here is
if you look at the
Debt that’s coming up
It’s a complete wall of the stuff that needs to be renewed over what looks like it’s going to be the next recession
That’s going to be a huge problem to try and roll all this financing that all comes to you at the same time
When the banks aren’t gonna be particularly keen on
Letting this financing out and the companies are going to be desperate to get it but their cash flows are gonna be going down
So the affordability becomes a little more problematic even with rates being cut
This is why the Fed need to cut rates and need to cut rates fast because this corporate thing is an avalanche
Waiting to happen and the butterflies flapped its wings and the avalanche is starting to crumble
But you see this issues not just the US as I mentioned a couple of times it’s global
When we look at the global corporate debt-to-gdp
we’re at 95%
This is the same color of la-la-land levels that we had on household debt back in 2008
There is an extraordinary amount of corporate debt. And the worst thing about it. Almost all of it is in US dollars globally
It’s in u.s Dollars except in Europe and that’s all trading at negative yields now because it’s European debt that could be used as collateral
That has a huge value for the system. That’s slightly
so we’ve got a huge problem because if you think about that, it’s globalized and it’s in dollar funding and
There’s not enough dollars around certainly not to roll all of this debt
Particularly if the banking system in Europe is going to desperately be sucking for these dollars
We’ve got a big funding issue to come
And again if the dollar starts going higher
It becomes a much bigger problem
For all of these corporates to deal with and a big big problem for the junk bond market to deal with overall and the investment-grade
Market, see I’m not the only one talking about this Stan Druckenmiller has been talking about it
there’s a number of people who talked about it and
The BIS and the IMF have both warned about it much like they did ahead of the 2008 recession
They’re saying there is a huge problem with corporate indebtedness. There’s a huge problem with the buybacks
There’s a huge problem with the dynamics that it’s creating
And this is the thing. It’s the knock-on effects that I’m really worried about in this whole equation a credit event
Okay, a secondly credit event really nasty but with a couple of other things thrown in like a retirement crisis
Then we’ve got something really really concerning that we have to avoid the Fed have to be
Really aggressive in this or we’ve got a much bigger problem than we realized. You see the bond market is supporting equity markets
I talked about before it’s all the book buyback. So here’s the graph of the buybacks that I talked about before
They’re basically supporting the whole market
So if the corporate bond market gets a little bit tighter and cash flows go all of the corporates gonna stop by equity the largest
Bar will have left the room very quickly. So let’s go through the causation here ari widens. It starts falling south for the reasons
I’ve talked about it starts widening out the spreads as soon as the spread starts widening out corporate cash flow start going with Acree and
Corporate start going. Okay. I need to be careful here. So what they do is they stop buying back shares
So that’s the largest equity market buyer who’s left the room. So that’s a really big deal
So let’s go back to the area chart with the year on your S&P
The equity falls and this credit cycle Falls then the SMP is gonna fall with it in the year-on-year terms and also an outright terms
So we’re setting ourselves up for something that could be quite interesting. Now. We know that
Consumer confidence is pretty much tied to the equity market right now
and so if the equity market starts
falling because the buybacks have gone then it’s gonna build on itself and then it’s gonna build itself in a way that’s going to bring
Out the baby boomers and I’ll come on to that in a sec. So there’s another issue here
We had a guest on real vision who talked about the corporate bond market and the pension system
You see I’ve talked about the pension system a lot and I’ll come on to that in a sec again
the pension system has been a bar of equity but increasing bar of corporate bonds because there’s been some yield there and
Also as you get an aging population and people are getting closer to retirement you need more bonds
But they need you to take as much risk as possible
So they’ve bought a ton of junk and a ton of this triple B stuff. So they’ve been the big buyers
Now what’s been really interesting is they’ve been in a loop like the buyback loop which has been drift by tax receipts
you see place like, Illinois who have
bankrupt pension systems
Have been raising taxes and with that tax receipts they have been
Then putting it into the pension system to fill the gap the pension funds have been buying bonds
So you’ve got this cycle with tax receipts coming in and you’re buying bonds
You just create this loop the problem is is tax receipts are also cyclical
So once that happens and the tax receipts start falling because level of business activity is falling well
Then guess what the corporate debt bar goes away, too
So you’re creating a market where there’s no equity buyer a no corporate debt buyer because of how the pension funds operate
That’s a real problem. And then if anything gets downgraded to junk who’s the bar of that junk that doesn’t really exist
Either you can see the chart here of US state and local current tax receipts
Year on year and it’s basically the same as the business cycle
No surprise and it’s gone negative as tax receipts have been lower than expected
Recently and again, that should stop pushing the credit spreads wider and that brings us back to the baby boomers
These are the guys who all these assets are the equity investments and the bond investments
They’re the they’re the owner of all of this stuff and they need to sell them to
And they need to sell them because they’re going to retirement and if there is a risk in the system
They cannot take the risk of losing their money
Because that is their pile that they retire with and I talked about this at length in the retirement crisis video
so the chances are there’s a behavioral adjustment of which they become net sellers in two rallies and
Sellers in two dips as opposed to buyers in two dips
And that’s because they don’t have work or the amount of work needed or income needed to sustain an investment portfolio
It’s more about living expenditure. And those that retire they don’t have more money to put back into the market. That is their pool
They’re done. So they need to reduce risk fast. So when you’ve got a situation where
Everybody is a net seller. You’ve got a problem that happened in Europe and it happened in Japan
We’ve seen what it does it basically lowers
for decades the price of equities and
Changes the structure of markets for a long period of time and I think that is one of the potential outcomes again
I’m not saying it’s necessarily going to happen, but there’s a potential outcome here. So you start to see the various knock-on effects
I’ll put them on the screen here and then I’m going to go through a bit again. Later
Because there was a lot of points to get across so as the triple B credits get downgraded to junk and the debt markets freeze
Pensions will be forced sellers and take enormous losses and were switched to Treasuries at 1% yields or less
This will essentially bankrupt the defined benefit pension system
It has to default on its promises when you throw in the net divesting of assets
The baby boomers will do in the next recession. You have the perfect storm. There’ll be no buyers of equity
There’ll be no bars of debt corporations will not be able to service the debts or roll them
The pension system will break then throw in the EU banking system, which is fragile and needs dollars and the entire
Bloody system will freeze all over again. This is why I called the Doom loop and it’s small incremental steps that create something quite quick
Can the Fed get in the way of it?
Can they stop this Doom loop because there is a cycle here because the moment you start widening credit spreads
You start creating selling you start creating less buybacks the equity market Falls if the equity market Falls then AT&T share price Falls
Then they stop and pricing default wrist or downgrade return to AT&T
And then what you know is the junk bond spreads widen the whole thing works in this endless cycle
So let me go through the points of the cycle again as well just to clarify
Phase 1 the business cycle weakens credit begins to widen
corporate cash flow worsens our tad and shares fall and volatility increases
I think that’s where we’ve got to now I think phase 1 we accomplished and it started really in about October
Phase 2 the business cycle weakens again credit widens more cash flow gets worse as do profits tax receipts fall and state pension funds
Stop buying debt big triple B stocks fall and bonds fall even more sharply equities fall hard
So I think this is the next phase and I think it’s coming after the summer. We’ll wait and see my forward-looking indicators suggest that
The Europe has a sesee up cycle right now. There’s a bit of stabilization of data
I have a feeling that if I’m right about the debt ceiling or the dollar breaks higher
Then I think we’re going to start to see
phase 2 come in when we start seeing phase 2 we know where this is going because then the story becomes very
Their face one was the alarm bells face – they strap yourselves in. Okay, let’s go into Phase three
This is when things get ugly the baby-boomers starts a panic to get out of equities permanently. There’s down grades of triple beads
Junk the EU banks can’t take the funding stress and the ECB and the government step in credit spreads explode credit seizes up entire list
Pension funds are forced sellers on downgrades equities going to tailspin
There are no natural buyers credit widens dramatically offered only no bids junk bond market
Overwhelmed pension funds get to trouble defaulting on obligations big famous companies are being forced towards bankruptcy
Unnecessarily, that’s the really ugly face and that’s the one
Where I think many of us have got a sense that there was an end game
That’s at the end of all of this if there is one it lies in the heart of that whether we get there or not
It’s going to be a function of what the Fed does and what the central banks do and how they deal with this
And there’s many outcomes for that and it is not going to be a straight battle
But all I do know is these things tend to accelerate much faster. I’m very cognizant of what happened in the UK
with Woodford’s fund and Neil Woodford’s fund and also with HC o new Texas, these are
these are
liquidity problems and we’ve talked a lot on real vision about liquidity in the lack of liquidity and markets and if you put in a
Bad event with low liquidity you’ve got a problem and I think we’re starting to see alarm bells coming
so as I said
We phase one let’s see what happens with phase two. The end of it is the Fed are gonna have to buy credit
They’re gonna have to stop this they have to stop the Doom loop
And the other thing they will do is underwrite the pension system
and this is part of the MMT and also part of the way that you get rid of the
quantitative easing giving money
to the rich or the people who need it the least the people who can borrow and
This way you give it to people who have a pension and there also happened to be voters huge numbers of baby
Boom voters you’ll be bringing back into the system
So it’s actually a very attractive thing for both the Federal Reserve and the government to push to do
So I think that’s what comes of it
You’re gonna have to do something about this pension plan black hole and this is probably the way to do it
You see Europe in the UK dealt with a lot of this in the past because they started to
put restrictions on what pension funds could do and the kind of risks that they could take but they’ve still got a
Problem with with credit for sure and I think the Europeans will be involved in having to support their own pension system as well. So
Where does this all leave us? Well, that’s what this week’s gonna be about
you can see how important this all is and this is not just
Doom mongering. This is the reality of the probabilities. You cannot deny that the business cycle is weakening
You can deny that it’s going to a recession, but we need to find out more. We need to find out from other people
I really want to find out I want to have that debate with people
because I
Really want to know and assess the probabilities and figure out whether my probabilities are right. So I’m gonna leave you with a few things
the things that really matter to me
I’ve given you a bunch of chance to look at that
You can follow I would use that your stocks banking index has one very important chart
You can use maybe FedEx for world trade tariffs and stuff like that. FedEx looks pretty bad
But I think the primary chart is the chart of truth that I’ve always called it
which is the bond market the
Thirty-year Channel and how it perfectly kind of POTUS head at the top of the channel and then reversed. It’s telling us that
bond yields are gonna go probably down to zero that’s ten-year bond yields if I show you the chart here of the
Long-term pattern of two-year bond yields. It’s very clear that they’re going to go negative and this chart suggests
They’re going to go to negative two percent now
For somebody in America that might sound outrageous
To anybody else in the world. It’s normal, right Europe’s had negative rates now for a long time as of Japan
You know all across the place we’ve seen negative rates. So get used to it. It’s the mindset of what’s coming
I don’t think you’re gonna be able to avoid it because of the confluence of events that we’ve got coming with the excessive debt that
Massively built up over the short period of time and then with the wave of retirees coming and the Fed having over tightened
I think the dollar chart is extremely important. I think use the broad trade-weighted dollar index
it is a
Huge cup and handle formation as well. And if it breaks this 130 level then we’re going to see the final
Catastrophic large rise in the dollar that could break the rest of the system. I’ve been warning of this for some time
The dollar has been range-bound. It keeps looking like it’s going to break down then suddenly break up and then break down
I don’t know, but I do know it’s gonna break and it’ll be the last of the asset classes
To make its move if it breaks down
Okay, we’ve got to give ourselves some breathing space. We’re going to save emerging markets
We’re gonna save some of this debt situation for another day and we’ll extend. What is the longest business cycle in all history?
but if not
Then we’re going to start to accelerate all of these events and a global recession with some really nasty outcomes
It’s becoming more and more likely and also
Abxy, the Asian dollar currency index. I think that’s an important chart to keep on your screens and maybe keep your focus on the
EEM the equity market the emerging market ETF
These things are all within this basket what we need to be looking at and in the end
What do I think the trade is my personal view? And again, I’m gonna talk to other people about this I think
It is bonds if I’m right and we’re gonna get worse. We may see about a bounce in bonds now
I’ve just taken profits and a whole bunch of my bond positions, but I’m looking to aggressively add now. This is one of the biggest
Highest conviction trades I’ve ever had and I think that the bond market particularly the short end the Eurodollar futures in the two year futures
You need to leverage up and buy as much as you can of these into any bands
I think we’re hopefully getting a short bounce now
But I think once we get through and we start to see the economic data weakening once more
You won’t be able to buy bonds. I think I’m really interested in buying dollars. I’d like him to break
Once they break higher then I want to add all sorts of dollars. I
Don’t want to short the equity market. It’s too dangerous. It’s too difficult
And I think it’s a balance ii trade versus the bond market trade
Obviously I will be get drawn into it again
But every time I try get my ass handed to me, so I’m gonna try and avoid doing that one the last two
I’m pretty obvious one is gold because gold is an option on the end
So if we are going to go to extreme monetary policy, which looks like I’ve walked you through a set of pretty easy
Probabilities that that could happen in the next 18 months. Well, then gold has to go higher now
It’s sure if the dollar goes higher Gold’s gonna come back a bit but over time
I think the dollar on gold go higher and gold goes a lot higher over the longer run and it’s now
acting as that probability on this endgame and the final one is Bitcoin bitcoin is
Again, a probability on the ability to build a different financial future. We’re seeing noise coming out of China about building a cryptocurrency
We’ve seen the very interesting thing that Facebook’s done
It’s another thing that I will do for real vision at some point is talk about that more debt
Not that I think the Facebook cryptocurrency is the answer but the globalized currency and what they were doing with the globalized currency
I think really is very interesting some that talks about on real vision from the very beginning maybe in the first ever interview
They were all talking towards coming towards this moment now
This is why we started real vision and also this is why I do global macro investor. We’re in a very macro environment
It’s super interesting, but it’s also super dangerous. So me publishing global macro investor. I thought had to get this across to you
So everybody understands the risk ahead and can do their own work on it
So I’m really looking forward to taking you with me on this journey
There’s going to be a lot of learning. There’s gonna be a lot of debate and I’m going to bring different angles
I’m gonna bring people from the oil market the retail market the car market the VC market
I’m doing macro experts Bitcoin experts gold experts
I’m gonna bring everybody to the table and we’re gonna talk it all out and figure out ok
What the hell is going on and what the real probabilities are. Guess what we’re doing a sweepstake
You can get a chance to win a premium subscription to real vision, but we’re not just giving away one
But 10 subscriptions. All you have to do is subscribe to our real vision youtube channel like this video and comment down below on
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Retirement crisis and many of the aspects of economic and investing life that will affect you and your savings

Raoul Pal’s Thesis: The “Doom Loop”

Raoul Pal is a former hedge fund manager who retired at age 36 but remains actively involved in the world of macroeconomics and finance. In recent years, he started a finance news and content service called Real Vision.

In a video posted on YouTube on August 14th, Pal discusses his case for a recession in the next year or so as well as a very alarming scenario he calls the “doom loop.” It’s a fascinating and frightening thesis, and I find it persuasive. Here’s the line of reasoning:

(1) The Fed lowers interest rates to stimulate the economy through increased lending. How else are lower interest rates supposed to stimulate anything besides through more lending, i.e. more debt?

(2) As a result, all sorts of market and government actors increase their debt loads. Corporations, especially, took advantage of falling rates to refinance and take on more debt.

Source: Deloitte

(3) Some of this debt buildup has been for acquisitions or mega-mergers, but much of it was taken on simply for share buybacks. See, for instance, this chart showing the way in which debt issuance and share buybacks became tightly correlated right around the time that the Fed Funds rate bottomed near zero. (See my article addressing this subject here.)

Source: Hussman Funds

Debt-funded buybacks have served as a convenient way for corporate executives to lift earnings per share, thus meeting guidance more regularly and reaching the targets for their performance bonuses more often. (I wrote about this subject here.) What’s more, an SEC study found that insider selling tended to coincide with the announcements or implementation of buybacks.

(4) Indeed, if you look at the performance of U.S. stocks versus any other country or world region’s stocks, you’ll notice a stark difference. U.S. stocks have soared ahead of the competition. It turns out that this is largely because of buybacks, as corporations themselves have been the biggest net buyers of corporate stock since the Great Recession:

Source: Avondale Partners

Notice that institutions (including pension funds) have been net sellers of U.S. equities since the recession. This likely means that pensions have been forced to sell many of their assets to fund benefit payouts but have sold other assets such as Treasuries at a faster rate than equities.

(5) Who is buying all this debt being issued to fund buybacks? The answer, in large part, is pensions. Mainly corporate pensions:

Source: Milliman

Writes Mark Johnson: “This uptick in bond buying has caused corporate pension funds to play a more influential role in the bond market, since pension managers tend to hold bonds for the long term. As more and more companies adopt the strategy of buying more bonds, pension demand could total $150 billion a year. It is estimated that corporate pension funds buy more than 50 percent of new long-term bonds, up from an estimated 25 percent a few years ago.”

So corporate pensions are buying more and more bonds. Which bonds? Specifically, corporate bonds: “Pension plans… like to use corporate bonds to hedge liabilities.” Corporate bonds offer the highest yields. Of course, pensions are only allowed to own investment grade corporate debt, but if they opt for longer duration or lower rated bonds they can get a higher yield. In the previous twelve months, BBB-rated corporate bonds have yielded as high as 4.83%, certainly better than the highest yield offered by the 20-year Treasury bill in the last twelve months — 3.27%.

BBB-rated corporate debt has grown to be roughly half of all corporate debt outstanding. That’s one (small, for some companies) step above junk status.

(6) During a recession, much of this investment grade debt (Pal guesstimates 10-20%) will be downgraded. But remember: pensions cannot own junk bonds. If BBB-rated debt on their books gets downgraded, they will be forced to sell it, even at a loss. If multiple downgrades happen quickly in succession, the supply of newly labeled junk bonds will overwhelm demand from other market buyers of those debt instruments. This could lead to a fire sale scenario, in which the prices of junk bonds plunge as pensions dump huge supplies into an unsuspecting market.

(7) Not only would pensions have to accept a fraction of their cost basis for these former investment grade bonds, they would also see their primary revenue stream — tax revenue — slacken during a recession. Tax receipts, after all, are as cyclical as the business cycle. When individuals and businesses aren’t making as much money, there is less available to be taxed. This would diminish demand for corporate bonds, which would cause corporate bond yields to spike.

(8) All of this chaos in the credit markets will make it very difficult for corporations to issue debt at anything other than high rates. This will cause the costs of new debt to soar high enough for buybacks to become prohibitively expensive. Moreover, cash flows will dry up, as they do in every recession, and thus every potential source of funds to use for buybacks will disappear.


(9) If the previous points play out, the biggest net buyer of U.S. equities over the last ten years will no longer be a buyer. “The largest buyer will have left the room,” as Pal says. In fact, publicly traded corporations may actually be net issuers of shares during the next recession as they were in 2008-2009.

In the words of Jesse Colombo“If the stock market performed as poorly as it did in 2018 with record amounts of buybacks to prop it up, just imagine how much worse it would be if buybacks were to slow down significantly or grind to a halt?”

I don’t see how the preceding chain of events playing out as described would not ultimately result in a very nasty stock market crash. Whether it’s a relatively quick crash like in 2008-2009 or a bit more drawn out like from 2001-2003 is unknown. Either way, I see the above scenario as plausible. Disturbingly so.

Since I’m an income-oriented investor, my preferred method of hedging against this possible crash scenario is to hold ample cash and ultra-short term bond funds. That way, if this scenario does play out, I will be prepared to buy assets at fire sale prices with yields higher than I might ever see again in my lifetime.

Raoul Pal’s thesis is fascinating, but it could be wrong. What I’m much more certain of is that the Fed bears the majority of the blame for the underfunding of pensions and thus for putting us into a situation in which Pal’s thesis would even be possible.