“There’s nothing more important than trying to stay home, wash your hands, and get your supplies,” CNBC’s Jim Cramer said.
Jim Rickards explains why there’s a financial crisis coming, and in so doing, reviews the unusual origins of his predictive analytics tool. He also explores complexity theory and Bayesian statistics. Jim Rickards is a renowned author and the chief global strategist at Meraglim. Filmed on July 12, 2018 in New York.
This has roots that go back to 9/11.12:24Tragic day, September 11, 2001, when the 9/11 attack took place.12:31And what happened then– there was insider trading in advance of 9/11.12:37In the two trading days prior to the attack, average daily volume and puts, which is short12:43position, put option buying on American Airlines and United Airlines, was 286 times the average12:50daily volume.12:51Now you don’t have to be an option trader, and I order a cheeseburger for lunch every12:55day, and one day, I order 286 cheeseburgers, something’s up.12:59There’s a crowd here.13:00I was tapped by the CIA, along with others, to take that fact and take it forward.13:06The CIA is not a criminal investigative agency.13:10Leave that to the FBI and the SEC.13:11But what the CIA said was, OK, if there was insider trading ahead of 9/11, if there were13:17going to be another spectacular terrorist attack, something of that magnitude, would13:22there be insider trading again?13:24Could you detect it?13:26Could you trace it to the source, get a FISA warrant, break down the door, stop the attack,13:30and save lives?13:31That was the mission.13:32We call this Project Prophecy.13:34I was the co-project director, along with a couple of other people at the CIA.13:39Worked on this for five years from 2002 to 2007.13:43When I got to the CIA, you ran into some old timers.13:47They would say something like, well, Al-Qaeda or any terrorist group, they would never compromise13:53operational security by doing insider trading in a way that you might be able to find.13:59And I had a two word answer for that, which is, Martha Stewart.14:03Martha Stewart was a legitimate billionaire.14:05She made a billion dollars through creativity and her own company.14:08She ended up behind bars because of a $100,000 trade.14:11My point is, there’s something in human nature that cannot resist betting on a sure thing.14:15And I said, nobody thinks that Mohamed Atta, on his way to Logan Airport, to hijack a plane,14:21stopped at Charles Schwab and bought some options.14:23Nobody thinks that.14:24But even terrorists exist in the social network.14:26There’s a mother, father, sister, brother safe house operator, car driver, cook.14:32Somebody in that social network who knows enough about the attack and they’re like,14:36if I had $5,000, I could make 50, just buy a put option.14:40The crooks and terrorists, they always go to options because they have the most leverage,14:44and the SEC knows where to look.14:47So that’s how it happens.14:49And then the question was, could you detect it.14:52So we started out.14:53There are about 6,000 tickers on the New York Stock Exchange and the NASDAQ.14:57And we’re talking about second by second data for years on 6,000 tickers.15:03That’s an enormous, almost unmanageable amount of data.15:06So what we did is we reduced the targets.15:08We said, well, look, there’s not going to be any impact on Ben and Jerry’s ice cream15:12if there’s a terrorist attack.15:14You’re looking at cruise ships, amusement parks, hotels, landmark buildings.15:18there’s a set of stocks that would be most effective.15:22So we’re able to narrow it down to about 400 tickers, which is much more manageable.15:26Second thing you do, you establish a baseline.15:28Say, what’s the normal volatility, the normal average daily volume, normal correlation in15:35the stock market.15:36So-called beta and so forth.15:37And then you look for abnormalities.15:39So the stock market’s up.15:42The transportation sector is up.15:43Airlines are up, but one airline is down.15:46What’s up with that?15:47So that’s the anomaly you look for.15:48And then the third thing you do.15:49You look for news.15:50Well, OK, the CEO just resigned because of some scandal.15:54OK, got it, that would explain why the stock is down.15:57But when you see the anomalous behavior, and there’s no news, your reference is, somebody16:03knows something I don’t.16:04People aren’t stupid, they’re not crazy.16:06There’s a reason for that, just not public.16:08That’s the red flag.16:09And then you start to, OK, we’re in the target zone.16:12We’re in these 400 stocks most affected.16:15We see this anomalous behavior.16:17Somebody is taking a short position while the market is up and there’s no news.16:21That gets you a red light.16:23And then you drill down.16:24You use what in intelligence work we call all source fusion, and say, well, gee, is16:28there some pocket litter from a prisoner picked up in Pakistan that says cruise ships or something16:34along– you sort of get intelligence from all sources at that point drilled down So16:38that was the project.16:40We built a working model.16:41It worked fine.16:42It actually worked better than we expected.16:44I told the agency, I said, well, we’ll build you a go-kart, but if you want a Rolls Royce,16:48that’s going to be a little more expensive.16:50The go-kart actually worked like a Rolls Royce.16:52Got a direct hit in August 2006.16:55We were getting a flashing red signal on American Airlines three days before MI5 and New Scotland17:04Yard took down that liquid bomb attack that were going to blow up 10 planes in midair17:09with mostly Americans aboard.17:11So it probably would have killed 3,000 Americans on American Airlines and Delta and other flights17:16flying from Heathrow to New York.17:18That plot was taken down.17:20But again, we had that signal based on– and they made hundreds of arrests in this neighborhood17:26in London.17:27So this worked perfectly.17:30Unfortunately, the agency had their own reasons for not taking it forward.17:37They were worried about headline risk, they were worried about political risk.17:41You say, well, we were using all open source information.17:45You can pay the Chicago Mercantile Exchange for data feed to the New York Stock Exchange.17:48This is stuff that anybody can get.17:49You might to pay for it, but you can get it.17:52But the agency was afraid of the New York Times headline, CIA trolls through 401(k)17:58accounts, which we were not doing.18:00It was during the time of waterboarding and all that, and they decided not to pursue the18:06project.18:07So I let it go, there were plenty of other things to do.18:09And then as time went on, a few years later, I ended up in Bahrain at a wargame– financial18:14war game– with a lot of thinkers and subject matter experts from around the world.18:20Ran into a great guy named Kevin Massengill, a former Army Ranger retired Major in the18:27US army, who was working for Raytheon in the area at the time was part of this war game.18:32We were sort of the two American, little more out of the box thinkers, if you want to put18:36it that way.18:38We hit it off and I took talked him through this project I just described.18:42And we said, well look, if the government doesn’t want to do it, why don’t we do it18:45privately?18:46Why don’t we start a company to do this?18:47And that’s exactly what we did.18:49Our company is, as I mentioned, Meraglim.18:51Our website, Meraglim.com, and our product is Raven.18:55So the question is, OK, you had a successful pilot project with the CIA.19:01It worked.19:02By the way, this is a new branch of intelligence in the intelligence.19:06I-N-T, INT, is short for intelligence.19:08And depending on the source, you have SIGINT, which is signal intelligence, you have HUMINT19:14which is human intelligence, and a number of others.19:17We created a new field called MARKINT, which is market intelligence.19:20How can you use market data to predict things that are happening.19:24So this was the origin of it.19:26We privatized it, got some great scientists on board.19:30We’re building this out ourselves.19:31Who partnered with IBM, and IBM’s Watson, which is the greatest, most powerful plain19:38language processor.19:40Watson can read literally millions of pages of documents– 10-Ks, 10-Qs, AKs, speeches,19:47press releases, news reports.19:51More than a million analysts could read on their own, let alone any individual, and process19:57that in plain language.19:58And that’s one of our important technology partners in this.20:02And we have others.20:04What do we actually do?20:07What’s the science behind this.20:09First of all, just spend a minute on what Wall Street does and what most analysts do,20:13because it’s badly flawed.20:15It’s no surprise that– every year, the Fed does a one year forward forecast.20:22So in 2009, they predict 2010.20:24In 2010, they predict 2011.20:27So on.20:28Same thing for the IMF, same thing for Wall Street.20:30They are off by orders of magnitude year after year.20:34I mean, how can you be wrong by a lot eight years in a row, and then have any credibility?20:38And again, the same thing with Wall Street.20:41You see these charts.20:43And the charts show the actual path of interest rates or the actual path of growth.20:48And then along the timeline, which is the x-axis, they’ll show what people were predicting20:52at various times.20:54The predictions are always way off the actual path.20:57There’s actually good social science research that shows that economists do worse than trained21:02monkeys on terms of forecasting.21:04And I don’t say that in a disparaging way– here’s the science.21:07A monkey knows nothing.21:08So if you have a binary outcome– up, down, high, low, growth, recession– and you ask21:17a monkey, they’re going to be right half the time and wrong half the time, because they21:20don’t know what they’re doing.21:21So you’re to get a random outcome.21:24Economists are actually wrong more than half the time for two reasons.21:28One, their models are flawed.21:29Number two, what’s called herding or group behavior.21:32An economist would rather be wrong in the pack than go out on a limb and maybe be right,21:37but if it turns out you’re not right, you’re exposed.21:40But there are institutional constraints.21:42People want to protect their jobs.21:44They’re worried about other things than getting it right.21:47So the forecasting market is pretty bad.21:48The reasons for that– they use equilibrium models.21:52The capital markets are not in equilibrium system, so forget your equal equilibrium model.21:57They use the efficient market hypothesis, which is all the information is out there,22:01you can’t beat the market.22:02Markets are not efficient, we know that.22:05They use stress tests, which are flawed, because they’re based on the past, but we’re outside22:12the past.22:13The future could be extremely different.22:16They look at 9/11, they look at long term capital management, they look at the tequila22:20crisis.22:21Fine, but if the next crisis is worse, there’s nothing in that history that’s going to tell22:25you how bad it can get.22:27And so they assume prices move continuously and smoothly.22:30So price can go from here to here or from here to here.22:34But as a trader, you can get out anywhere in between, and that’s for all these portfolio22:38insurance models and stop losses come from.22:41That’s not how markets behave.22:42That go like this– they just gap up.22:44They don’t hit those in between points.22:45Or they gap down.22:46You’re way underwater, or you missed a profit opportunity before you even knew it.22:51So in other words, the actual behavior of markets is completely at odds with all the22:56models that they use.22:57So it’s no surprise the forecasting is wrong.23:00So what are the good models?23:01What are the models that do work?23:03What is the good science?23:04The first thing is complexity theory.23:07Complexity theory has a long pedigree in physics, meteorology, seismology, forest fire management,23:13traffic, lots of fields where it’s been applied with a lot of success.23:18Capital markets are complex systems.23:20The four hallmarks of a complex system.23:24One is their diversity of actors, sure.23:26Two is their interaction– are the actors talking to each other or are they all sort23:30of in their separate cages.23:31Well, there’s plenty of interaction.23:33Is there communication and is there adaptive behavior?23:37So yeah, there are diverse actors, there’s communication.23:40They’re interacting.23:42And if you’re losing money, you better change your behavior quickly.23:45That’s an example of adaptive behavior.23:47So capital markets are four for four in terms of what makes a complex system.23:51So why not just take complexity science and bring it over to capital markets?23:55That’s what we’ve done, and we’re getting fantastic results.23:57So that’s the first thing.23:58The second thing we use is something called Bayesian statistics.24:03It’s basically a mathematical model that you use when you don’t have enough data.24:08So for example, if I’ve got a million bits of data, yeah, do your correlations and regressions,24:14that’s fine.24:15And I learned this at the CIA, this is the problem we confronted after 9/11.24:19We had one data point– 9/11.24:20Janet Yellen would say, wait for 10 more attacks, and 30,000 dead, and then we’ll have a time24:26series and we can figure this out.24:28No.24:29To paraphrase Don Rumsfeld, you go to war with the data you have.24:33And so what you use is this kind of inferential method.24:37And the reason statisticians dislike it is because you start with a guess.24:41But it could be a smart guess, it could be an informed guess.24:44The data may be scarce.24:45You make the best guess you can.24:47And if you have no information at all, just make it 50/50.24:50Maybe Fed is going to raise rates, maybe they’re not.24:53I think we do better than that on the Fed.24:55But if you didn’t have any information, you just do 50/50.24:58But then what you do is you observe phenomena after the initial hypothesis, and then you25:05update the original hypothesis based on the subsequent data.25:07You ask yourself, OK this thing happened later.25:10What is the conditional correlation that the second thing would happen if the first thing25:14were true or not?25:16And then based on that, you’d go back, and you either increase the probability of the25:19hypothesis being correct, or you decrease it.25:21It gets low enough, you abandon it, try something else.25:24If it gets high enough, now you can be a lot more confident in your prediction.25:27So that’s Bayesian statistic.25:29You use it to find missing aircraft, hunt submarines.25:32It’s used for a lot of things, but you can use it in capital markets.25:36Third thing, behavioral psychology.25:38This has been pretty well vetted.25:40I think most economists are familiar with it, even though they don’t use it very much.25:43But humans turn out to be a bundle of biases.25:48We have anchoring bias, we get an idea in our heads, and we can’t change it.25:52We have recency bias.25:54We tend to be influenced by the last thing we heard.25:57And anchoring bias is the opposite, we tend to be influenced by something we heard a long26:01time ago.26:03Recency bias and anchoring bias are completely different, but they’re both true.26:07This is how you have to get your mind around all these contradictions.26:11But when you work through that, people make mistakes or exhibit bias, it turns out, in26:16very predictable ways.26:18So factor that in.26:19And then the fourth thing we use, and economists really hate this, is history.26:23But history is a very valuable teacher.26:26So those four areas, complexity theory, Bayesian statistics, behavioral psychology, and history26:33are the branches of science that we use.26:35Now what do we do with it?26:37Well, we take it and we put it into something that would look like a pretty normal neural26:41network.26:42You have nodes and edges and some influence in this direction, some have a feedback loop,26:47some influence in another direction, some are influenced by others, et cetera.26:51So for Fed policy for example, you’d set these nodes, and it would include the things I mentioned26:55earlier– inflation, deflation, job creation, economic growth, capacity, what’s going on27:02in Europe, et cetera.27:03Those will be nodes and there will be influences.27:05But then inside the node, that’s the secret sauce.27:08That’s where we have the mathematics, including some of the things I mentioned.27:12But then you say, OK, well, how do you populate these nodes?27:15You’ve got math in there, you’ve got equations, but where’s the news come from?27:19That’s where Watson comes in.27:20Watson’s reading all these records, feeding the nodes, they’re pulsing, they’re putting27:24input.27:25And then we have these actionable cells.27:26So the euro-dollar cross rate, the Yuandollar cross rate, yen, major benchmark, bonds, yields27:36on 10 year treasury notes, bunds, JGBs, et cetera.27:41These are sort of macro indicators, but the major benchmark bond indices, the major currency27:46across rates, the major policy rates, which are the short term central bank rates.27:50And a basket of commodities– oil, gold, and a few others– they are the things we watch.27:55We use these neural networks I described, but they’re not just kind of linear or conventional28:06equilibrium models.28:07They’re based on the science I describe.28:09So all that good science, bringing it to a new field, which is capital markets, using28:13what’s called fuzzy cognition, neural networks, populating with Watson, this is what we do.28:19We’re very excited about it, getting great results.28:21And this is what I use.28:23When I give a speech or write a book or write an article, and I’m making forecast.28:28This is what’s behind it.28:32So we talked earlier about business cycles, recessions, depressions.28:37And that’s conventional economic analysis.28:40My definition of depression is not exactly conventional, but that’s really thinking in28:44terms of growth, trend growth, below trend growth, business cycles, et cetera.28:50Collapse or financial panic is something different.28:52A financial panic is not the same as a recession or a turn in the business cycle.28:57They can go together, but they don’t have to.28:59So let’s talk about financial panics as a separate category away from the business cycle29:04and growth, which we talked about earlier.29:06Our science, the science I use, the science that we use with Raven, at our company, Meraglim,29:12involves complexity theory.29:14Well, complexity theory shows that the worst thing that can happen in a system is an exponential29:21function of scale.29:23Scale is just how big is it.29:24Now you have to talk about your scaling metrics.29:27We’re talking about the gross notional value derivatives.29:28We’re talking about average daily volume on the stock market.29:31We’re talking about debt.29:33We could be talking about all of those things.29:35This is new science, so I think it will be years of empirics to make this more precise.29:39But the theory is good, and you can apply it in a sort of rough and ready way.29:43So you go to Jamie Dimon, and you say, OK, Jamie, you’ve tripled your gross notional29:50value derivatives.29:51You’ve tripled your derivatives book.29:53How much did the risk go up?29:54Well, he would say, not at all, because yeah, gross national value is triple, but who cares?29:59It’s long, short, long, short, long, short, long, short.30:01You net it all down.30:02It’s just a little bit of risk.30:04Risk didn’t go up at all.30:06If you ask my 87-year-old mother, who is not an economist, but she’s a very smart lady,30:10say, hey mom, I tripled the system, how much did the risk go up?30:14She would probably use intuition and say, well, probably triple.30:17Jamie Dimon is wrong, my mother is wrong.30:21It’s not the net, it’s the gross.30:22And it’s not linear, it’s exponential.30:24In other words, if you triple the system, the growth went up by a factor of 10, 50,30:28et cetera.30:29There’s some exponential function associated with that.30:32So people think, well gee, in 2008, we learned our lesson.30:36We’ve got debt under control, we’ve got derivatives under control.30:39No.30:40Debt is much higher.30:41Debt to GDP ratios are much worse.30:44Total notional value, gross notional values of derivatives is much higher.30:47Now people look at the BIS statistics and say, well, the banks, actually, gross national30:52value derivatives has been going down, which it has, but that’s misleading because they’re30:57taking a lot of that, moving it over to clearing houses.30:59So it’s never been on the balance sheet, it’s always been off balance sheet.31:02But even if you use the footnotes, that number has gone down for banks, but that’s only because31:07they’re putting it over clearing houses.31:09Who’s guaranteeing the clearing house?31:10The risk hasn’t gone away, it’s just been moved around.31:12So given those metrics– debt, derivatives, and other indices, concentration, the fact31:21that the five largest banks in America have a higher percentage of total banking assets31:26than they did in 2008, there’s more concentration– that’s another risk factor.31:31Taking that all into account, you can say that the next crisis will be exponentially31:37worse than the last one.31:38That’s an objective statement based on complexity theory.31:41So you either have to believe that we’re never going to have a crisis.31:44Well, you had one in 1987, you had one in 1994, you had one in 1998.31:49You had the dotcom crash in 2000, mortgage crash in 2007, Lehman in 2008.31:55Don’t tell me these things don’t happen.31:56They happen every five, six, seven years.31:59It’s been 10 years since the last one.32:02Doesn’t mean it happens tomorrow, but nobody should be surprised if it does.32:05So the point is this crisis is coming because they always come, and it will be exponentially32:11worse because of the scaling metrics I mentioned.32:14Who’s ready for that?32:15Well, the central banks aren’t ready.32:17In 1998, Wall Street bailed out a hedge fund long term capital.32:23In 2008, the central banks bailed out Wall Street.32:25Lehman– but Morgan Stanley was ready to fail, Goldman was ready to fail, et cetera.32:31In 2018, 2019, sooner than later, who’s going to bail out the central banks?32:35And notice, the problem has never gone away.32:37We just get bigger bailouts at a higher level.32:40What’s bigger than the central banks?32:42Who can bail out the central banks?32:43There’s only one institution, one balance sheet in the world they can do that, which32:46is the IMF.32:48The IMF actually prints their own money.32:51The SDR, special drawing right, SDR is not the out strawberry daiquiri on the rocks,32:55it’s a special drawing right.32:56It’s world money, that’s the easiest way to think about it.32:58They do have a printing press.33:00And so that will be the only source of liquidity in the next crisis, because the central banks,33:07if they don’t normalize before the crisis– and it looks like they won’t be able to, they’re33:11going to run out of runway, and they can expand the balance sheet beyond the small amount33:17because they’ll destroy confidence, where does the liquidity come from?33:20The answer, it comes from the IMF.33:23So that’s the kind of global monetary reset, the GMR, global monetary resety.33:28You hear that expression.33:31There’s something very new that’s just been called to my attention recently, and I’ve33:36done some independent research on it, and it holds up.33:39So let’s see how it goes.33:42But it looks as if the Chinese have pegged gold to the SDR at a rate of 900 SDRs per33:51ounce of gold.33:52This is not the IMF.33:53The IMF is not doing this.33:55The Federal Reserve, the Treasury is not doing it.33:58The ECB is not doing it.33:59If they were, you’d see it.34:00It would show up in the gold holdings.34:02You have to conduct open market operations in gold to do this.34:05But the Chinese appear to be doing it, and it starts October 1, 2016.34:11That was the day the Chinese Yuan joined the SDR.34:15The IMF admitted the Yuan to the group was four, now five currencies that make up the34:21SDR.34:22So almost to the day, when the Yuan got in the SDR, you see this a horizontal trend where34:29first, gold per ounce is trading between 850 and 950 SDRs.34:37And then it gets tighter.34:38Right now, the range is 875 to 925.34:41Again, a lot of good data behind this.34:44So it’s a very good, it’s another predictive indicator.34:47If you see gold around 870 SDRs per ounce, that’s a strong SDR, weak gold.34:54Great time to buy gold, because the Chinese are going to move back up to 900.34:58So that’s an example of science, observation, base and statistics, inference, all the things35:04we talked about that can be used today in a predictive analytic way.35:08A crisis is coming, because they always do.35:10I don’t have a crystal ball, this is plenty of history to back it up.35:13It’ll be exponentially worse.35:15That’s what the science tells us.35:16The central banks will not be prepared, because they haven’t normalized from the last one.35:20You’re going to have to turn to the IMF, and who’s waiting there but China with a big pile35:24of gold.
Victor Sperandeo, President & CEO of EAM Partners, sits down with Adam Rodman, founder and portfolio manager at Segra Capital Management, to break down the relationship between shifting political tides and macroeconomic trends. Sperandeo provides his view on the history of recessions in the United States and on the current inflationary environment. Filmed on January 3, 2019 in Dallas.
Investment-grade corporate bonds have been a major tailwind to the economic cycle as yields continue to drop.
Treasury bond yields are falling faster than IG spreads are widening, resulting in lower borrowing costs, but a major increase in late 2018 may have triggered a change in employment.
A rise in corporate bond yields impacts cash flows, margins and, eventually, employment decisions.
Corporate bond prices (yields) are a long leading indicator that impacts the economic cycle through changes in corporate capital spending and employment.
The corporate sector is more leveraged than previous economic cycles. A recession can be triggered if the Coronavirus outbreak causes corporate rates to rise, accelerating the decline in employment growth.
Along with money supply, building permits and corporate margins, corporate bond prices or corporate bond yields fall into the “long leading” indicator bucket, according to “the father of leading indicators,” Geoffrey Moore. Geoffrey Moore’s work found value in using the Dow Jones Corporate Bond Price Index (graphed below), but any measure of corporate bond yields will likely yield similar results. If using bond yields rather than bond prices, the indicator should be inverted as higher corporate bond yields usually translate to lower profit margins and slowing employment growth.
Dow Jones Corporate Bond Price Index:
Source: Bloomberg, EPB Macro Research
As the chart clearly shows, lead times before a recession can be quite long while lead times for recovery are more abrupt. The recovery (or suddenly lower corporate bond yields) has historically been quite helpful in restarting the hiring process and capital spending process.
From an economic cycle sequence perspective, lower bond prices or higher corporate bond yields reduce margins/profitability and have a resulting impact on the rate of capital spending and employment plans. The drop in capex and reduction in employment growth is what ultimately leads to lower income growth, consumption growth, and, eventually, a recession.
In Lacy Hunt’s most recent Quarterly Review and Outlook, he outlined Milton Friedman’s work, which explains that monetary changes (interest rates) and economic cycle impacts typically cluster around two years.
As the research of Nobel Laureate Milton Friedman documented, the typical lags between monetary change and economic fluctuations cluster around two years, confirming the importance of the two-year time frame.
A change in interest rates today may impact future projects. Still, existing investments will likely continue, resulting in a lag between the change in interest rates and the impact on more coincident economic data such as employment.
As a result of this finding, when studying interest rates, it can be valuable to use a 24-month change formula rather than a year-over-year method to more closely capture the two-year cluster.
The last point to stress before highlighting some of the more recent trends is that the level of corporate debt is at a record high relative to GDP.
Corporate Debt to GDP Ratio:
Source: Bloomberg, EPB Macro Research
Thus, similar to federal debt, there are diminishing marginal returns or reduced efficacy of each new dollar of debt. More importantly, however, smaller changes in interest rates (corporate bond prices) can have a similar or larger impact on corporate health and the resulting repercussions on overall employment.
Throughout the rest of this note, we will look at the impact of changes in corporate bond prices (yields) and the lagged relationship to employment, as well as some considerations when making a recession forecast.
Currently, corporate bond yields are still falling because Treasury rates are declining faster than spreads are widening. Lower corporate bond yields are helpful on the margin, but the late 2018 spike (two-year cluster) may have been enough to start the process of reduced employment, something very evident in recent data. If the Coronavirus outbreak causes corporate bond yields to rise and accelerates the existing decline in employment growth, a recession is very much in the cards.
Today’s rate of employment growth is insufficient to trigger a recession based on past samples. Still, when an existing downward trend is coupled with a negative shock, recession risk must remain firmly on the table.
US Corporate Sector Health Heading Into 2018
Corporate America has been plagued by anemic economic growth in this economic cycle. Masked by the rising share price of roughly 500 companies, thousands of corporations that aren’t publicly traded have been forced to operate in a low-profit growth regime.
Financial engineering has allowed publicly-traded companies to report strong earnings growth. Total corporate profits reported in the GDP report is a far more accurate, albeit delayed, data source on the real (non-adjusted) profits generated by the corporate sector.
From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.
On a five-year annualized basis, corporate profits have increased by just 2.2% with the latest year-over-year reading falling 0.3%.
Amazingly, corporate debt has increased, and share prices have soared with very little profit growth, a phenomenon exposed by persistently lower Treasury rates.
Corporate Profits Growth:
Stacking together real estate debt, corporate debt, and consumer debt shows that the largest increase across economic cycles is coming from the corporate sector.
In the last economic cycle, corporate debt was only 25% of the credit market. In 2018, corporate credit increased to 38% of the total.
Corporate Sector Debt As A % of Total:
As a result of lower profits and more debt, the leverage ratio in corporate America has surged to recessionary levels.
Importantly, the leverage ratio usually increases during a recession as profits (the denominator) fall. Morgan Stanley’s research from 2018 calls out that leverage is at an all-time high in a “healthy economy,” which highlights just how leveraged and sensitive to changes in interest rates the corporate sector has become.
Corporate Sector Leverage:
When corporate borrowing costs rise, employment typically suffers as the increase in interest expense compresses margins.
Again, due to weak economic growth and lackluster profit growth across the entire corporate sector, margins (proxied below) have been compressing since the early stages of this economic cycle.
Lower margins foreshadow weaker employment growth and capital spending growth.
With corporate leverage at extreme levels and corporate margins already in decline, the corporate sector was particularly vulnerable to any spike in corporate borrowing costs as a result of an economic slowdown.
When the Federal Reserve embarked on a monetary tightening cycle, economic conditions globally started to deteriorate with a lag, hitting most economies in 2018 and 2019.
US corporate borrowing costs surged in late 2018 and early 2019, which triggered a more aggressive decline in employment growth and persistent weakness in capital spending growth.
Late 2018 Credit Event – Enough To Trigger A Recession?
Typically, before recessions, corporate bond prices decline (yields increase) as the Federal Reserve is raising interest rates, and the tighter monetary conditions eventually slow the economy, leading to wider corporate bond spreads.
Corporate bond prices declined three other times this economic cycle, coinciding with the three economic slowdowns before the current downturn.
The 2018 decline in corporate bond prices was larger than the previous three, a sign that economic conditions would weaken. When comparing to the past two recessionary samples, the decline in 2018 was marginally weaker than in 1999. Still, given the leverage ratio and decline in margins, a smaller decline could have a similar impact.
Corporate Bond Prices Tumble:
Graphed another way, the chart below shows the 24-month change in Baa corporate bond yields.
The chart is graphed by the number of months before/after a recession with 0 on the x-axis indicating the start of a recession.
The 2018 rise in corporate bond yields was undoubtedly less than the previous three samples, only spending 14 months above 0% on a 24-month change.
Corporate Bond Yield 24-Month Change:
The corporate sector is far more levered today, with weaker margins and lower trend growth as compared to the prior three recessions.
Thus it remains possible that the decline in corporate bond prices was enough to trigger a downshift in employment growth, an effort to preserve margins.
Impact On The Real Economy
Cycles in employment can be monitored separately from cycles in growth. Geoffrey Moore tracked cycles in growth, inflation, and jobs independently.
Leading indicators of economic growth turned lower very early in 2018, some in late 2017. Inflation indicators did not plunge until September 2018, and jobs growth did not inflect lower until corporate bond yields spiked in late 2018.
Cyclical employment, defined in the chart below as durable goods manufacturing, construction, and trade/transportation services, started to show rapidly-declining rates of growth.
Employment Growth Changed:
Source: Bloomberg, EPB Macro Research
If we track the change in cyclical employment growth before the three previous recessions, we can see recessionary periods begin with similar declines in cyclical employment.
Today’s current track of cyclical employment growth is currently insufficient to be recessionary based on past samples. However, if the trajectory does not flatten or inflect higher, history suggests that income and consumption growth will follow, leading to recessionary conditions.
Employment Growth Trend Relative To Past Samples:
Employment growth over the next six months remains critical. If corporations continue to post weaker rates of employment growth or accelerate layoffs as a result of the Coronavirus outbreak, a recession is still firmly in play.
An existing trend of weaker growth and employment, originated by the Federal Reserve tightening cycle and deleveraging in China, exposed the economy to a negative shock.
It’s clear using the chart above how a negative shock (COVID-2019) coupled with an existing downturn in growth/employment can create a recession.
The Current Shock
The current economic shock has resulted in a widening of corporate bond spreads. Using popular credit ETFs (LQD) and (HYG), we can track the implied spread above Treasury bonds. Both investment-grade and high-yield credit spreads, particularly high yield, have been widening materially in the past several weeks.
Investment-Grade / High-Yield Corporate Spreads:
Source: Bloomberg, EPB Macro Research
Luckily, however, corporate yields are a function of Treasury rates plus a spread.
For investment-grade bonds, Treasury rates are still declining faster than spreads are increasing, resulting in lower investment-grade bond yields.
High-yield bonds, however, are starting to see higher yields, a firm negative for corporate margins and future employment.
Investment-Grade / High-Yield Corporate Bond Yields:
Source: Bloomberg, EPB Macro Research
The current slowdown in employment growth, specifically cyclical employment growth, is severe and can be seen in many economic data points. If leading indicators of economic growth were turning higher, however, and cyclical employment growth started to increase, the economy may very well avoid a recession.
The negative shock of the Coronavirus has likely caused employment plans to freeze, irrespective of any increase in borrowing costs.
If the Coronavirus continues to cause a sell-off in risk assets and spreads start to widen faster than Treasury rates decline, corporations will be faced with higher borrowing costs at a time when economic growth was on shaky ground to being with.
Employment Growth Trend Relative To Past Samples:
Should an increase in borrowing costs accelerate the decline in employment growth, and the black line in the chart above drifts into the yellow circle, a recession will be tough to avoid.
Clearly, a call for a recession is premature, and my economic outlook has zero forecasts concerning the virus or any predictions regarding a conclusion.
Rather, when constructing an allocation to weather a shock, we must be mindful of the current state of the economy and the susceptibility to a recession from a negative event.
Currently, a recession is not imminent based on the data above. Still, the situation can evolve quickly, and the economy is far from immune to a shock in its current state.
Keys To Watch and Outlook
The increase in corporate bond yields late in 2018 was small in relation to other recessionary periods. Still, given
- the level of corporate leverage,
- anemic profit growth, and
- weak economic conditions,
a smaller increase can have a more significant impact.
Employment growth has been in a downtrend since that late 2018 period, contributing to weaker rates of consumption growth seen in recent reports.
The economy is not imminently vulnerable to a recession, but that can change in a matter of weeks. The impact on employment is the key to watch when judging lasting recession risk.
Moving forward, if the current shock causes employment growth to suffer, already in a fragile state, recessionary conditions will be tough to avoid.
An acceleration in corporate layoffs will be exacerbated by higher borrowing costs, making credit spreads and bond prices a vital signal.
Given the susceptibility to a recession pending a worsening of conditions, investors should consider an added layer of protection should this negative shock take a turn for the worse.
If conditions worsen or simply do not improve for several weeks, a recession may be difficult to avoid, mainly due to the initial conditions before the shock began.
If the economy does tumble into a recession, risk assets are highly exposed, and a continued overweight allocation to Treasury bonds and gold will likely offer the best protection.
The model portfolio at EPB Macro Research continues to have an overweight exposure to Treasury bonds and gold.
- The stock market has been set up for a brutal fall for months now.
- Valuations are stretched, revenue already was flat and economic indicators are past peak, heading the wrong way.
- The central banks already are firing bazookas and seeing diminishing marginal impact.
- If the stock market doesn’t hold support around 3000 on the S&P 500, we could see a retest of the December 2018 lows.
- If the stock market does hold support, then you will want to look to sell into any rallies before it turns more decidedly down.
In my annual outlook for 2020, I tried to warn people that the stock market was on thin ice. Risk management also has been my refrain for months on my weekly “Investing 2020s” webinars.
In my outlook, I suggested an early year “volatility event” would cause a small correction. It didn’t matter what the volatility was. The market has been looking for a reason to lower valuations.
On Jan. 23, I stated on my Twitter feed that Coronavirus “is actually the most important story in the world…” The Coronavirus COVID-19 outbreak has become the volatility event that’s driving a necessary stock market correction.
For many investors, the urge is to buy the dip here. That’s a bad idea. The stock market has a long way to fall sometime this year.
A better strategy is to reassess you risk tolerance and accept that valuations matter. Ultimately, you should be selling the rips on the very disrupted S&P 500 ETFs (SPY) (VOO), or rallies, in an attempt to bring your cash levels up temporarily. You will get opportunities to buy back into equities at lower valuations in coming quarters.
I have covered for members of Margin of Safety Investing for months now that stock market valuations are very high. A single-digit percentage stock market correction has not changed that.
An argument is made that because interest rates are low, the stock market can sustain higher valuations. I would agree that is true, however, to what degree should be asked. Should the stock market be the third most highly valued in history?
The chart above shows that despite low interest rates heading towards zero, corporate profits haven’t been growing much the past several years. What we have with low interest rates is a period of diminishing marginal returns.
Given that the stock market is a forward looking projector, what happens when lower interest rates or monetary stimulus cannot push corporate profits higher? What happens when businesses simply cannot borrow more for almost free to improve profitability via production or share buybacks? Clearly that challenge already is manifesting.
Q Ratio and Creative Destruction
If you believe that a stock represents the value of an underlying business, I point you to the Q Ratio. That’s total market cap divided by its replacement cost. Essentially, if you are a business person, here’s when you ask: Should I make an investment in the stock of a business or should I simply start a competing business?
The obvious answer for a business person seeing these valuations is to start a business and compete, rather than buy highly-priced stock. What do we know happens when more competition is introduced to a market? Prices fall.
I understand this is a simplistic way of looking at this. We are not going to see thousands of new businesses sprout up to compete, but we are seeing some. And these new businesses are in fact disruptive of many of the older businesses.
Consider the concepts of creative destruction. Think about the unicorns and all the disruption industries are seeing from tech innovation. At some level, perhaps how entrepreneurs get financing, high valuations are in fact encouraging competition to established players already in the market. That can’t be good for many companies or their stock prices.
As Stanley Druckenmiller said a while back: “Buy the disruptors, sell the disrupted.” We’ll come back to this thought below.
The Buffett Indicator
Now that everybody has gotten a chance to read Warren Buffett’s annual letter, let’s take a look at his favorite valuation metric for the broader stock market: The ratio of total market cap and U.S. GDP.
In that chart I stake out the “old normal” for valuations and a hypothetical “new normal” based on lower interest rates and looser monetary policy. In either reality, the stock market has a long way to fall. I would suggest that we should consider it might fall to the place where the old and new normals overlap. That would imply a 30%-40% stock market correction is on the horizon.
What The Shiller PE Ratio Really Tells You
Many people criticize the Shiller PE ratio as unimportant or wrong. That’s a juvenile misunderstanding of what the ratio is. It’s not a short-term oscillator or predictor of imminent stock market movements. Rather, it’s an indicator of expected stock market returns on a normalized basis over the next 10 years based on the last 10 years earnings.
Because earnings move in cycles spanning rather long time frames, the Shiller PE ratio, though imperfect, is a good predictor of whether to expect big, small or middling stock market returns in the next decade.
It’s not hard to see that investing during periods of low Shiller PE yielded better long-term returns than investing during periods of higher valuations.
Shiller also overlays interest rates and earnings. The patterns should give us pause. Return to the question I asked above: What if interest rates rise?
There’s at least two very plausible scenarios over the next 10 years that make rising or higher interest rates a strong possibility: Modern monetary theory or helicopter money – more on these soon.
What the Shiller PE really is telling people today is that the 2020s will be more like the 2000s than the 2010s.
SPY Quick Technicals
Currently, the S&P 500 is a bit oversold and running into minor support levels. This could cause a slight relief rally.
You will notice I’m using a weekly chart. Why not daily? Simply put, I’m not a day trader, I’m more concerned with bigger market moves over longer time horizons. The weekly charts help me get the intermediate term time frame (six months to two years) better in hand.
On the daily chart (not shown here) that most default to, the RSI is showing an oversold signal. On the weekly however, we can see that the S&P 500 has quite a bit of selling left to it before it’s truly oversold.
We also see that money flows, as measured by Chaikin Money Flow, can fall quite a bit further as well. Look to the fourth quarter of 2018 for a hint as to what might be on the horizon.
Finally, MACD, a measure of momentum, is indicating a longer-term downturn as it crosses over on the weekly time frame.
In February 2018, I covered How Low Can The Stock Market Go and about nailed it. The same story is playing out now, in my opinion. I believe the December 2018 lows are in play for later this year, possibly lower.
Stop Buying The Dips, Sell The Rips
Buying the relatively small dips is no longer a viable strategy through the next significant stock market correction. Instead, investors with a forward outlook and some sense of valuation reality will sell the rips in the short term, then wait to buy the big dips.
I believe that two or three times this coming decade we will see corrections of larger scale. In the short term, Coronavirus may have triggered a slight acceleration and potential deepening of what already was coming to a market near you soon. The economic impact is real and it could expand greatly. We simply do not know yet.
Also, don’t discount the impact of the coming election. At a minimum, it presents a case for uncertainty. Markets do not like uncertainty. Corporations already have slowed down capital investment which is not a good sign.
What if President Trump loses? The richest investors will want to lock in lower capital gains tax rates on highly-appreciated assets by year-end. That could perpetuate a late 2018 style sell-off.
The bottom line is to sell the S&P 500 indexes, which are full of disrupted companies to begin with, on any rips. Then, wait to make new investments later, at lower valuations, in the companies and industries that are disrupting the economy and showing real growth.
We believe the 2020s are going to be more volatile than the easy money inspired 2010s. We also believe that many companies and industries will be significantly impacted by disruptive technology.
With that in mind, we offer to help you build a margin of safety, while taking part in the opportunities that are emerging. Join me, Kirk Spano, and our other top ranked MoSI analysts for deep research and a 4-step approach to finding great growth and dividend investments.
Investment visionary Kiril Sokoloff, chairman and founder of 13D Global Strategy & Research, draws on his deep knowledge of history and on the interplay between different market forces in order to forecast what’s ahead — and to suggest how savvy investors ought to position themselves today. In this deep-diving conversation with Real Vision co-founder Raoul Pal, Sokoloff helps answer the most pressing questions around markets and the economy. He also provides a read on how other significant minds are making sense of the increasingly powerful forces that are shaking our financial world. Filmed on July 10, 2019 in upstate New York. To learn more about 13D Publications, visit www.13D.com/trial Note: When this interview was filmed, gold was trading at about $1,400 per troy ounce.
There is a trust and debt problem.
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.
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”
Transcript00:00So today I’m gonna talk to you as00:02Ralph’s pal from global macro investor not real vision because real vision doesn’t have a view of our markets and a view about economies00:09But I do have a view I’ve got a strong view that’s been developing for a while00:12Now as most of you know, I’m a student of the business cycle00:16I look at the ups and downs the undulations of GDP and you realize that00:21Things aren’t linear and most economists. Don’t put some sort of cycle into their forecasts once I realized how cyclical things were00:29I realized there is an element of predictability00:32Now obviously sometimes with the cycle things don’t work out exactly as you imagine. The timing doesn’t work00:36For example, I did think we were going to get a full recession in 2015 didn’t quite happen00:42That way we came very close to at a manufacturing recession around the world00:45We had a few emerging market crises, but it didn’t quite get to full recession, but it came incredibly close00:52but now we’ve got to a point where I’ve been monitoring how the cycle is developing and00:57I’ve come on to real vision a couple of times to talk about the bond trade because I said look the cycles turning the best01:03Thing to do is be long bonds and that’s been a spectacular trade01:07So particularly the short end in the euro dollar market and even in the long end whether it’s TLT or bond futures01:13There’s been a huge amount of money to be made in that01:16But now we’re getting to the point where the Fed looked like they’re about to start to ease and we need to decide01:23Okay, how far are they going to go and are we going to go into a recession?01:26this is probably the only01:28Call that matters, and I’ve talked before there’s the only asset class that matters right now is the dollar which is range-bound01:35So it’s currently not the predominant factor01:38Outside of that it’s chand aside is the world gonna go into recession and is the u.s. Going to go in recession?01:44My hypothesis is it looks like that is the case01:48Now one of the things anybody who knows me knows that I don’t talk in certainties01:52So I’m not saying look it’s definitely a recession. We’re all screwed whatever it is01:56I don’t even know how severe it can be but what I’m interested in is the probabilities and the02:02Probability that we’re going into recession or even in recession now are very high02:07so having realized this I thought you know, I’m02:13Not the only person who thinks this but there is a whole group of people who think the opposite02:18And it’s one of those turning points where I fell insecure to know am I right or not? I02:24Think I’m right and I think that people I advise02:28They think I’m right02:30but there’s a whole group that doesn’t and I thought it would be really02:34Interesting to explore this thing fully on real vision for me to essentially take over the platform for two weeks02:40To really dig in and interview all of the best people I can find in the world02:44People 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 different02:51Perspectives to find out really what’s going on and it’s going to help me and all of you go on a voyage of discovery02:58To really figure out are we going to recession or not?03:01And then we’ll try and figure over the course of these two weeks as well03:05The opportunities and the trades that we can make to protect ourselves or to make money whichever way this goes03:30So let’s start at the beginning03:33the Fed started raising rates a while ago back in 2016 and03:37it was really incremental and that incremental rate rise really didn’t03:43Mean a lot to most people we kind of brushed it off because rates were going from a very low level to another low level03:48But they kept going up. There were rate rise off the rate rises off the rate rises, but all very incremental and small03:55Then the Fed started cutie quantitative tightening03:58They started shrinking some of their balance sheet as well04:01And again, it didn’t look a lot compared to how much the balance sheet had grown over the previous decade04:08But that our continued for a while and nobody was that concerned about it. I started getting a different perspective04:15From about August of last year and it really came to the fore in September October, November and December04:22where I suddenly thought the Fed of over-tightened and04:26That nuanced shift happens incredibly quickly because everybody at the time was saying the Fed aren’t tightening enough and oh my god04:34The economy’s heating up and if you remember everyone was arguing about labor inflation wage inflation04:39The Fed are behind the curve and from everything04:42I looked at the Fed had gone too far already and they pretty much baked a recession into the cake04:47So what was I looking at?04:49The first thing I looked at is it’s the rate of change04:51of interest rates that count and I think I I showed this on my last presentation on real aversion back in I think it was04:57October last year the rate of change of05:00LIBOR so that’s just interest rates05:04They had gone up enough over 2-year rates of change basis that it was the largest05:09percentage increase in rates in all history and05:13Again, many of us a year, but the rates are so low. Why does it matter but the point being is in fact almost everybody05:21Refinanced at the lows. So everybody with the house everybody with the business05:27every corporate balance sheet every Bank05:30Everybody took out05:32more debt at low rates05:35and debt exploded05:37So even my mortgage had gone up 40%05:41And I was a little bit sure. I hadn’t realized and it was only what I suddenly got this statement through her Wow05:47Forty percent and then I got I wrote about a global macro investor and there was a large family office05:53And the principal the family office05:55called me up and said05:57We financed all of our debts05:59For the family office all the leverage that they used and all the other bits and pieces in their businesses and all of that stuff06:04He said I refinance in 2015. He said it’s gone up 80%06:09I’m like wow and how much leverage if you got I said well reasonable because money’s been free06:14So we took reasonable answer leverage, but it’s gone up and it’s meaningful. So I started think they really have over tightened06:19So if you look at this chart of the two yawns here year LIBOR and I put it against the business cycle06:25So I use a Curie you can see it suggests that the business cycle06:30should fall06:32Significantly from here now. That’s one thing. The other thing is06:36The Fed are still tightening by the balance sheet that’s not stopped yet06:41We don’t know whether it’s in the July meeting the September meeting06:45When are they going to stop doing that but really there’s a mass tightening going on and if you can see that keeps going on06:53month after month06:55there is another nuance about to hit us and that is the06:59debt ceiling at some point07:02They’re gonna have to agree a new debt ceiling. It’s most likely to be this summer and07:08That will also mean that the Treasury who have been funding the government in the meantime07:14Are going to start withdrawing the funding by issuing bonds07:17So there could be a huge tightening to come in the August September October time period of this year07:22So there’s some further tightening to come even if the Fed end up cutting interest rates07:27The other thing that most people don’t realize is even with these ultra low rates07:32People have been really penalized and if you talk about what upsets people about the kind of 1% and the 99%07:39one of the simple things where this shows up is credit cards if you look at interest rates on credit cards there in fact at07:46all-time highs07:47High and they were we interest rates were much higher in the 90s the early 90s07:532000s. It’s extraordinary how much people are being penalized to borrow money while and that’s at a household level while at08:01The corporate level there’s many corporates around the world not yet in the u.s08:04Who are borrowing at negative rates and I’ll come on to a whole lot about the corporates in a bit later in this whole thesis08:11So you can see we’ve got the set up where it feels like08:15Rates may have gone too far08:17And I’ve come a lot more on to the rates market later in the yield curve and some of the signals there08:22but you see what turns a08:24Slowdown and we started to see the slowdown happening in December08:27We saw the volatility rising again in the equity markets and we started to see the bond market rallying like crazy08:32the yield curve inverting super fast all across the curve is08:37What then happened is what you normally need to turn what looks like something about08:43201508:44Into a much harder bility of being a recession is the extraneous event and that was trade wars08:55So you trade wars are not what everybody thinks there was a lot of noise about them and at first09:01People weren’t sure what Trump was going to do, but he first went after the Chinese09:07anyone after the09:08Europeans 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 done09:14a deal with the Canadians09:15But trade wars are happening and China. The Chinese situation is very very complicated09:21And with Europe – we haven’t got anywhere in the Europe negotiations yet. You see the problem is is his aggressive09:28Negotiating tactics have created a knock-on effect that most people don’t understand09:33If you are a corporate and you have this game of cat-and-mouse with China in the u.s09:38about not only normal trade, but also09:42about technology and the banning of09:45Technology to stop technology spreading there is a definite move within the US administration09:51To really isolate China in numerous ways, but particularly economically09:56But don’t forget we’ve come from the most globalized world. We’ve probably ever had10:02so if we back up maybe six years with the epicenter of globalization and10:07Everybody has decided that China is the future10:10All the big corporations around the world whether it’s BMW of General Electric have all moved to China. They’re building factories10:18They’re outsourcing and they have supply chains10:21Suddenly, they’re being told. Well, you don’t know whether those supply chains are going to stay you10:27Don’t know whether you can actually stay in China, or maybe even the Chinese end up booting you out10:31You don’t know whether you can produce cars in Mexico or not10:34It’s really confusing because it’s Trump gonna go back against what he’s just done with the Mexicans what happens with the Canadians?10:40How does that work?10:41Is there any labor arbitrage anymore in a world where he’s even going after Vietnam a country so small to be irrelevant to?10:47Stop the Chinese10:49Circumventing trade tariffs. He’s also manipulating OPEC and you don’t really know where this world is and you know10:57No doubt, there’ll be a timer and start picking on India as well11:00So he’s picking on all of the countries in the world11:02And that’s all well and good and I’ve talked about this on television before is a shift away from globalization11:07It’s not the end of the world11:08It is the shift itself that rates have changed that matters that rate of change is incredibly unsettling for corporate America11:17particularly and the global corporations the multinationals almost in cross every boardroom around the world right now as a conversation is11:24can we outlast Trump and11:27that’s a bet if we don’t we’ve got hell to pay with our shareholders if11:32Something happens and we don’t have an answer. We’re in trouble11:36Well, okay, we’ll build some inventory11:38So everybody’s built inventory just to give them some sort of buffer and now they need to make the decision11:43Do we pull the plug now or do we wait wait and see whether Trump goes wait and see whether there’s any option11:50So those two outcomes are really interesting to me11:53Because if you pull the plug now you break the global supply chains that’s happening everywhere11:57We’ve seen the announcement from Apple this week alone that they’re doing it the others decide12:03Well, we’ll wait and see so what does that really mean? That means corporate expenditures stops?12:08They tend to then spend a fortune on something like McKinsey or KPMG or somebody else12:13Who’s going to give them the advice on building new global supply chains bringing their business back to the US?12:18it’s a two three or four year projects before they make the choice of where they’re going to spend and12:24Rebuild their their supply their factories and all of this stuff. So12:28That generally means it’s a big crimp on borrow on spending that comes from corporations12:33Particularly in FDI. So that’s going to hurt several countries around the world particularly China12:38but there’s a lot of countries and a lot of companies who are going to see this spending freeze and12:42Have to wait and sit it out12:44So that is going to have the effect of lowering growth and I think that is what tipped this12:49Situation from a merely a slowdown that was looking nasty12:52Into it for me an almost certain recession. So the question is is where are we now?12:58Many of you will remember I used to use the is M. It’s my main way of looking at the business cycle13:02I don’t use it much morning more because13:04It kind of got a bit broken and the reason got a bit broken was not because of fed manipulation or anything else13:09It’s because the oil sector became so large that the oil price became the largest13:14influence of the I am itself particularly the refinery cycle every year13:19So I shifted away to the egg cream and that’s the economic13:22economic cycles Research13:24Institute13:24Measure and it’s a weekly13:26Indicator and I use the urine year return of the weekly indicator to give me the business cycle13:30It works very much like the is M and it correlates with everything like GDP. So you see the chart here of13:36At Crete with quarterly GDP and you can see how well correlated it is. It’s indicating that we’ve got some weakness to come13:44Okay13:44So that’s the first interesting point13:46Then I’d like to put the ikura against a number of other indicators that may be forward-looking and this is where it gets interesting13:52I’m going to show you a whole series of charts now for you to look at13:55So this chart is the cash freight shipments index13:59You can see how dramatically freight shipments have fallen and how much they’re14:05suggesting that the could fall from here and therefore14:08the14:09GDP as well14:11Car loadings a similar way of looking at transportation. It’s collapsing capsule goods orders14:17These are the big-ticket items the things that a lot of times you use financing for or are involved in the global supply chains14:25You can see how they are rolling over as well and following eccrine lower14:29If you believe in this supply chain story and it seems to be bearing itself out in the press almost daily14:35Then you’ve got to imagine the capital goods orders are going to come lower but households are also struggling with the with the rates14:42So you’ve seen that and how much car sales are fallen, so calf sales have languished and they’re expected to go further14:49Clothing sales have collapsed in recent months as well, which has been an extraordinary move and restaurant sales as well have been extremely weak14:56So your sons are seen not only as shipping and moving Goods around week, but you’re also seeing a weakness in15:05The consumer and a weakness in business expenditure another great global indicator. I’ve looked at is semiconductor sales15:13semiconductor sales are15:15Extraordinarily weak right now and eight who are suggesting the global business cycle has a lot further to fall back in the US15:21We’ve also got the housing cycle15:23It looks like that the the Case Shiller house index is starting to weaken significantlyAnd is now at the weakest level since before the previous recessionAnd we also have weakness in house prices overall and construction so I’m concerned that allParts of the economy are showing evidence of weaknessAnd I know many people say well unemployment’s not unemployment strongUnemployment interestingly enough is the most lacking of all indicators and just remember that every time the Fed cut rates and unemploymentWas below 4% We went to a recession almost immediately afterwardsThey’re all lagging16:01So don’t get trapped in the in the unemployment look at the forward-looking indicators and they’re looking problematic16:08So those are just some of the u.s. Indicators that I’m finding concerning16:12There is a general theme of weakness that lies ahead and if you go back to that first chart16:17I showed you of the two-year on 2-year rate of change of LIBOR of interest rates16:22Then you’re going to expect to see a creek come down further and all of these things that are correlated come down further16:29Also, don’t forget the equity correlates perfectly to asset prices if you look at the year on your SMP16:34It basically is the business cycle now16:37I understand that equity prices as part of the equity calculation16:41But I can use hard data and a bunch of other variations of the business cycle and they all show the same thing the equity16:46Market is cyclical right now just because of the construction of what he was doing last year. It’s at all-time highs16:52It should actually significantly weaken in october/november if the equity stays where it is16:57the other thing to bear in mind is that looks like there is in marginal pause in the data and you’ll see that in the17:03global data in a second17:04so that’s one of the things I’m waiting for over the17:07Summer is let’s wait and see how this plays out and whether we get some weakness further on again, which is my expectation17:14but it’s really want to pick people’s minds about I17:20Look at the world PMI, you can see the world PMI is just heading into recession territory. So it’s weak17:27It’s telling us that there is a definite susceptibility to anything else going wrong, and I’ll come to some of the banana skins later17:35But anything going wrong is going to turn this from a slowdown into something much uglier17:39I think the tum the Trump trade situation. Is that very thing?17:43We’re starting to see many central banks around the world expressing concern and thinking about cutting rates17:50In response to this kind of very weak economy that’s starting to develop17:55The other thing is is that trade tariffs are showing up in the data when we look at world trade volumes18:02Well trade volumes have started to come off sharply and I think that’s really important18:06We also have a GMI indicator for world trade and it is also coming off very dramatically18:12So 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 it18:18Later that we really need to be worried about is if the dollar goes higher than here another concern for me is the European economy18:25the European economy18:27was really led by Germany, which is18:30different this time around it’s not the the18:33peripheral European economies18:34It was Germany that started first firstly a relatively strong euro and secondly trade disputes. So trade issues those two things18:43suddenly started to mark a turn in Germany and18:46Germany has gone pretty much to recession GDP is not negative yet18:50but all of the forward-looking indicate are showing that Germany is going towards recession if you look at for example18:55industrial production or if we look at18:58Exports, we can see that there’s some concerning signs in Germany19:01And if we look at the zoo survey, which is their forward-looking PMI, it suggested that GDP is going to go negative 2 percent19:07That’s quite a big move for one of the largest economies in the world and the largest economy in Europe19:12But you see it’s not just at Germany level19:15We’ve got Italy that is actually in recession again a mild recession right now and we have France that is starting to weaken19:22And is only just growing so we’ve got the three largest economies in Europe. Not in great shape19:27Spain is the only one that looks ok right now when we get to pour chill again, it’s getting weak and19:34Holland doesn’t look great19:35so 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 and19:40I think it’s one of the places that we all need to understand in this globalized slowdown19:44We can also get a bit granular with China19:47China struggled from load of monetary tightening if a couple of years ago and19:53the government trying to rein in the speculative excess of19:57A cheap money boom that came out of the back end of the global recession20:03So China’s been tight and it kind of broke the financial system doesn’t function20:08Properly in China any longer and the government is involved frequently trying to keep some sort of liquidity20:14They’re not interested in bailing out the rest of the world by another liquidity event. It’s just not in China’s interest20:20They 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?20:26So the point being is China’s very domestically focus20:30They’re trying to unwind their bubble20:32They’re trying to stimulate enough just to flatten it out trying the Japan way of doing things20:38But that means that China which was the marginal rate of change of growth of the global economy. They’re just not players right now20:44They are negative in terms of imports20:47for most of most of the raw20:49Materials so then they’re not going to be driving other countries GDP growth and I think that’s a really important matter20:55We’ve talked about the u.s. There’s no real growth there. We’ve talked about China20:59There’s no real growth there and we’ve talked about Europe and there’s no real growth there. So where is the growth engine?21:04There isn’t one and then when he broaden out to the rest of Southeast Asia21:08You can see that South Korea is also starting to slow down21:12Exports there a week and the same in Taiwan and we can assume the same as across Asia21:17Overall, Australia far too small the economy to matter in the globalized context21:21but as we know21:22Australia and has we feature on real vision has a problem with its own domestic economy with its massive house price broom and the21:29Overhang from the mining boom as well. So the Australia’s are cutting rates. They’ve got a slowdown going on21:34they’re trying to manage it the best they can without it turning to ugly and without it turning and21:39Rotting the banks at the core. We have to wait how that plays out21:41but again21:42It just tells you the number of countries who are in a similar situation21:45And the same can be true and said of Canada – which is one of the larger countries in the world21:50But again, they’ve had some problems. They’ve got the back end of a commodity boom21:54plus they’ve got an excessive leverage in the21:57Housing industry and that all needs to unwind and they too are going to be cutting rates so I don’t see a situation where anybody22:05Can save this and we’ve got I think the tipping point with tariffs that over overrides all of this22:12So this is why I’m really start to get concerned22:18But you see I22:20may be picking this up, but the bond markets always smarter than everybody and22:24I always incredibly amazed how right the bond market gets these things22:31Everybody argued when the yield curve was flattening the bond markets wrong. It’s just the Fed22:35Everyone says it doesn’t mean anything the yield curve. It’s just a different world right now22:40The yield curve started flattening then they started inverting and they started inverting all the way across the curve22:47We got the twos tens22:50US22:51Swaps curve which is the main one every time it gets to zero we go to recession22:55Shortly after we’ve hit that we had the ones twos curve going to the second most inverted in history23:03So that means two-year rates were trading below one-year rates suggesting that the easing that was necessary was large23:08They were screaming the Fed had gone too far23:10And then we had two year rates versus Fed Funds the magnitudeI think 70 odd bate 75 basis pointsso the magnitude of that was alsoextraordinary and was telling you the Fed had gone too far and things had to change quickly the Fed suddenly started realizing this byDecember January February, they started changing their tuneNow we are here with the market saying wellWe 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 ridiculoustheseBond market indicators have never been at these levels without the Fed cutting 50 basis points immediately and 50 again soon afterso my core view is if this continues in any way unless23:55We see some sort of trough in the very near future in the forward-looking data23:59Then the Fed are going to cut 50 and 50 again. I don’t see the point of the Fed trying to cut 25 and24:06disappointing the bond market24:07I24:08Think if they have to play a very very careful game here and what they need to do is at least try to be in24:13front of the curve24:14That to your auntie row year rate of change tells you they can’t be ahead of the curve the curves well ahead of them24:20But the market needs some sort of perception, but I do think there’s a backup coming in the bond market24:26we’ll talk about this in a bit in a bit as people are trying to readjust the probabilities to do zero did the24:3125 to 350 I think in a completely reverse is this a bump up?24:35Meltdown coming, you know, I see all this noise on Twitter all day and we’ll address some of that in a bit24:44See the other thing24:45The Fed have got is the Fed of got a problem because they still tightening the balance sheet as I talked before24:50But when they look at what they’re trying to do they have that dual mandate that you’re – employmentWell employment looks fine right now and it always does at the peak of the cycle and they always cut one employee when unemployment isAlmost at the all-time lowsBut the key is inflation expectations. They’re collapsing. They’re collapsing all across the world25:11But if you look at the ten-year break-even rate25:13It’s breaking this big Head and Shoulders pattern and it looks like we’re going down to 1% or so25:18That’s enough to be a 50% miss on the 2% implicit target that feds got on inflation. And this is 10 years out25:25So 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 without25:32Collapsing future inflation expectations and future demand. So I think that’s a really25:37Important indicator we could also you see the five year on five year inflation expectations25:42That again is breaking towards all-time lows25:45There is a complete collapse in inflation expectations regardless of the narrative that we heard25:49Only up until November December of wage inflation. It’s all going to come back25:54that was my if you remember my premise for the bond market rally was that narrative was wrong that appears to be playing out but26:00Not only does it appear to be playing out. It appears to be going from benign to26:03Nasty, 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 world26:11So the rest of the world is also seeing an inflationary26:14Deflationary or disinflationary issue. I think the most extreme is Europe if we look at the five-year five-year breakevens in Europe26:22We see this enormous collapse in in inflation expectations and that’s with an economy with negative interest rates26:28I mean what the hell do you do about that? Europe is going to become a big issue again26:33Something will come on through in a second26:34But that is a real warning of how to generate inflation in a world straddled by debt. It becomes really complex26:40And how do you stop the downside?26:42Becoming a much larger event that it ordinarily would be when I look at these kind of theses26:47I like to cross-check against asset classes26:50I like to look across the world and see okay, how asset class is trading and the first one I look at copper26:57I look at the chart of copper and it’s a clear head and shoulders top and to me that’s telling me27:02That the economy is slowing down27:03What’s also interesting if I put the copper chart against the ten-year break-even?27:07You can see it’s the same chart27:09So copper basically is a real-time example of future inflation expectations27:14And they look like they’re going to break down together. If I look at the CRB industrial metals index27:19You can see that this big uptrend and this major27:22Topping pan a huge topping pattern is forming and I think that it’s likely to break that27:27And why I think it’s likely to break is one of the I think it’s probably the second ugliest chart pattern in the world27:33Which is the CRB commodities index if you look at this chart?27:37It looks like we’re going to go into a secular bust income27:41Due any day now and to last into the next few years as we reach for that final bottom27:47And I think that bottom could be uglier than many of us are27:50expecting a because of the size of the boom that we had the amount of capital that flowed into it and27:56particularly in the oil space and other some of the mining space as well and28:00also because what I think is going to happen to the dollar28:03So these charts are really ugly charts to mean it makes me very concerned that there is a broader28:09Disinflation or deflationary world out there that’s developing and it’s something I talked about in the last video. I did for real vision28:15That’s subsequently now develop further28:19So, let’s talk a bit about the risks28:21So I think I’ve established a case why it looks like there’s a possible recession coming. My probabilities are higher28:28They may be higher than yours. You may think I’m wrong28:30That’s okay. But you have to works you have to understand that the likelihood of something happening here is28:38reasonable so you’re gonna have to factor this into your investments or your working lives or all the things that a recession can affect and28:46I think that’s really important. Your business is – so let’s think about the risk now. One of the risks is China I28:53Don’t think an implosion of the Chinese economy is much of a risk because the US are basically forcing everybody out of China anyway29:01So it’s happening in slow motion29:03We’re also finding there’s a trade ban going on with many other issues with a try at China29:07So that’s not great. The Chinese themselves going to be propping up their economy. They’re trying to stop their banking system falling over29:15Okay, so that’s relatively stable because it’s a closed system. They’re gonna have some inflows from MSCI29:20And that was the inclusion of China both debt and equity is in the indices29:24Although I think the US are going to try and overturn that by putting political pressure on MSCI themselves29:30We’ll wait and see about that29:31But 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.s29:38Knows it29:39so if China’s dollar starved29:41well29:41the best weapon you’ve got is the dollar and if you look at the chart of the Chinese RMB29:48It has been pressing its nose against that seven ceiling for a while forming29:52What is one of the largest cup and handle?29:54Mason’s I’ve ever seen if that does go and seven breaks29:58Then we’re going to see an almighty move in the dollar against the RMB now, it doesn’t necessarily mean there’s a catastrophic30:06Devaluation coming out of China but a shift in the terms of trade which has massive global ramifications30:12And we’ll obviously knock on all the way through and I think you can see also if I look at the ADX Y30:19Which is the Asian currency index if I look at the big monthly chart?30:23There’s an enormous head and shoulders top that’s looking to break30:26this is the largest chart pattern I’ve ever seen in any currency market, but that is a30:31incredible chart pattern that tells me there’s a potential currency crisis in the making and30:36it’s to do with a strong dollar the other one that’s affected by the strong dollar and the weakness in global trade and30:42Particularly interest rates is Europe30:45So the European banks something I’ve talked about30:48Extensively for many years on real vision as the European banks have gone lower and lower and lower and I said there’s a big problem30:54Here and I know many bank analysts will say well, you know, there’s not solvency problem here. There’s you know, it’s different31:01They’ve got the right capital resources. Well, I look at the share price31:04I just look at the share price and it looks like the share prices want to go to zero31:09So the worst chart in the world31:11I’ve got a label at the GMI worst chart in the world is the European banks Index charts. It is a truly31:18terrifying chart because this is all of the banks in Europe and it looks like if31:23They break that key support then we’re going into a full banking crisis in Europe. And I think that’s a reasonable probability and31:31Here’s why you see the European banks are31:34international in nature Deutsche Bank31:36even the Swiss banks credit Swiss UBS Societe Generale in France Santander BBVA31:42All of these banks are international funded banks31:45Yes, they get their funding and the collateral with the ECB31:48but the reality is the day to day funding is the dollar euro dollar market and31:53They don’t get access to all the capital they need there’s a shortage of dollars out there, which is a problem31:58I think the dollar goes higher which creates a problem for these banks32:02If you look at that European banks index and look at it compared to the 10-year bond yield you can see the highly core32:08So as bund yields go down the banks go down, but you see the problem here is the ECB has one mandate alone32:14They’ve got the mandate of inflation and we showed you before the inflation expectations in Europe are collapsing32:20So it’s a one-trick pony the ECB can only do one thing cut rates32:24I talked to the ECB recently at a Goldman Sachs event that I was hosting in London, and I asked them32:29Okay. What are you gonna do?32:30what are you gonna do with the next recession comes and they’re like32:32Well, we can cut rates a bit more and we can do a bit more QE32:35but you can see there’s a general understanding that they can’t go that much further and32:40that’s a32:41problem for the banks because how do you stimulate so the banks are falling because these yields are really bad negative yields are bad for32:47Banks, the flattening yield curves not good for banks. The whole situation is a bad setup for the banking system and32:54The Europeans can only deal with it by cutting rates, which is bad for the banks32:58So 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 myidea is Christine Lagarde was brought in specifically for thisWhy 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 BankIt’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 weedsBut Lagarde is not thatShe is the head of the IMF. She’s a politician and she’s a lawyer andwhat does she do she negotiates andIf you put something like that in control of the ECBIt tells you that there is going to be a shift or from in the ECB which is moving towardsProbably 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 BankThat’s the you know, the poisonous one. There’s not one poisonous Apple here. It’s a whole system that’s in a messThere’s still too much debt in that European banking system. That’s not been written off properlyso if these banks are probably going to have to go in the hands of theGovernments, they’re going to probably have to wipe out the equity holders somehow and the bondholders will become the governmentSo that’s the way you stop a systemic crisisBut somebody’s gonna have to pay for all of that and that’s gonna be a ton of issuance of debtSo if somebody has to negotiate new treatiesto allow all these companies to exceed their deficits and to increase their funding and the ECB to buy more of this funding and there’sA whole load of stuff that needs to get done. There’s much more political and legal than it is34:43Than it is monetary policy. So I think that’s why Lagarde is there if you want somebody for the next recession34:49Clearly the person who ran the IMF that deals in34:52Bailouts is the right person so I get that and I think it makes sense. But Europe, that’s a tricky mess34:58This is not a quick fix overnight and it makes me concerned that this can go from not very good to very ugly very quickly35:05And I have a feeling if I look at the share price of the banks that by the end of the summer35:09We could be there already where we’re starting to see some of the real strains and where the Deutsche Bank ever gets to its full35:15Restructuring before they have to do something about it35:18My guess is hearing the story of Renaissance capital pulling its prime broking lines35:24from Deutsche Bank means that we’re potentially in the death spiral where it goes from not being a35:29Solvency problem to potentially being a solvency problem. Who knows wait and see35:33You know getting in the weeds of the banks is not my thing35:35But looking at the macro setup, I can see that this is a problem waiting to happen or is happening right now35:44The other thing I think is further to develop is the tech market I think there is a complete35:55Euphoria that has taken place in the private sector35:59Particularly within the private investment sphere. So it’s private equity and VC. I think too much money has been allocated36:07without the thought of getting the money back and I think no36:10better example than the poster child of soft bank and36:14how they put a hundred billion to work plus added leverage in and just basically36:20completely rewrote the rules of valuation of any firm out there with no clear sight of how to get out of I36:28Think there’s some huge problems with what he is signaling36:33Mercy Sun is signaling by trying to IPO the whole of the vision fund to start another fund if you’ll try IPO36:42Kind of a VC fund on this scale36:45Without actually the companies themselves going public36:48It’s telling you he doesn’t think the future IPO value is the same as the current36:54Private value and we’ve seen that with some of the recent tech issues36:58They traded higher as private companies than as it as public companies that there is a different37:04dichotomy between this and that’s telling me that things got to37:07effervescence in the private sector and it’s starting to come off and it will knock on through as37:12People realize that that the future of tech is not yet37:16not quite as bright as people thought it was and there are some really system merit37:21Systemic problems because the owner over ownership of this sector and the expected returns that’s embedded within it37:27I’m really worried about37:29Softbank I’m really worried about what it says for the world37:32So we’ll wait and see how that develops but I think there’s a tech problem37:35I 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 with37:41Google and Facebook and their battle with the DOJ and various other parts of the US government37:46I think they’re going to be treated as monopolies. I think they’re going to have shown to to have abused their monopolistic power37:53I think they are also37:56Using data in ways that people37:58Don’t want and I think their power is going to be curtailed and I’ll be broken up in various ways38:02So I think that’s coming and I think it will come over all through this next recession38:07So there is another Delta on the bad news something that can drive a little bit further38:11That worries me and I’m monitoring all of these themes as they all kind of come together38:16And it makes me worried but there’s two really big ones left38:20That I haven’t yet talked about on real vision38:22Some of you will have read it in global macro investor for those year of subscribers38:26And then recently I published much less than a publishing global macro investor. I published it in macro insiders and in think-tank38:33Wide Doom loop article and if any of you are interested in this piece38:37I think you should go back and have a look at that article38:39If you’re not subscribers sign up for a free trial and go and have a look through38:43This article and this goes through all of what I’m talking about in great length38:46I think there is something really interesting in macro insiders Julian Britton and myself38:51debated at length about38:52what this really means and whether or accession is coming and I think will probably show that later on this week as well because somebody38:57from macro insiders I think will really add value to you much like this Doom loop article, but the issue iscorporate debt39:04And this is when it gets really big39:06So bear with me and maybe get stiff drink while I sit down and talk to you about the Doom loop39:14You see every recession needs a poster child there’s always one there’s always the thing you pin it onBack in 1990 is the savings and loan crisisBack in 2000. It was the tech wreckAnd then back in 2008. It was the housing market andThis time I think there’s an even bigger and more concerning one. I think it’s the corporate debt sectorI think this is the poster child of the next recession and let me explain why firstly you’ve got to realize thatDebt is basically a function of the business cycle and you have is most cyclesYou have a super cycle and you have the normal cycleSo the normal credit cycle is very clearIf I look at the Aerie against the let’s say the hyg ETF. You can see how highly correlated they areAnd also if you look at the area’s Moody’s be double-a to triple-a credit spreadsYou can see it’s basically a function of the business cycleso the business cycle drives credit spreads and it drives theavailability of credit and it drives the excess use of credit and all of the issues that come along with it and obviously theFed Drive, the credit cycle by raising interest rates or lowering interest rates also the behavior of creditAvailability which is the credit managers and how they give out credit again is really cyclical so we can look at the index40:39against the area and we can figure out that if at Kri the business cycle turns40:44Then we’re going to see some problems emerging in all of the debt market now. Here’s an interesting chart for you. Talk about recession40:51I find hilarious that the New York Fed publishes a recession probability indexThe recession probability index is in the 30s now 30% chance of recessionIt’s ridiculous because if you look back at every single time has ever been at this levelIt’s been a recession. So when it gets to about 20 something it’s a hundred percent chance of recessionSo the Fed New York Fed is basically telling you were going into recession41:11So 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 problem41:20Because that’s what happens and we had it in 2008 and you know corporate spreads widened out and they narrowed41:25Yes the banks that was a whole different issue the bank debt and household debt. We’ve had that as well41:31But this time around it’s somewhat different see this time41:36since that previous recession the size of the global corporate debt market has41:41Exploded and in particular in the u.s41:44US corporate debt as a percentage of GDP is the highest in all recorded history by using the fed data we get about41:5247 percent of GDP in debt, but if I use other data, particularly the IMF we’re getting numbers of about41:5975% the Fed data’s on taking account off balance sheet42:02So if it’s off balance sheet derivatives and all the other debts that’s on corporate balance sheets42:06Which we know are all over the place then we get to about 76 percent of GDP in debt42:11That’s a really really high number. So in nominal terms42:16Debt is now 1042:18Trillion dollars and it’s just gone up in a straight line as I said doubling in size since the last recession and this is extraordinary42:25Amount of debt don’t forget. This is the same time. The households have been gently easing out of debtThe financial system has been easing out of debt and the government has not but the government’s been kind of relatively flatBut the corporate sector went on a massive debt orgyit was one of the largest increases of debt we’ve ever seen in history in 10 years aTruly monumental debt buildup. What do they do with this debt? Well, this debt has beenBasically used for one thing. That’s equity buybacksThey bought back more equity than any other time in history. In factThey’ve been pretty much the only buyer of the equity market if we look at all forms of other equity market ownershipThey’ve been all in decline for the last five years while buybacks have been stepping up stepping up taking into accountAll of the net sellers and pushing the market higher and there’s less liquidityAround because you’re taking more shares out of the market by buying them backso the less liquidity the more your shares go up and then when you add in passive indexation43:28It’s been pushing the markets higher from this enormous debt issuance. That’s all well and good but43:35once you start flooding the market with debt you create dynamic which is little understood and43:40That’s the lowering of overall credit quality of the entire market and this is not a u.s. Penomet43:46It’s a global phenomena, but in the u.s. Nowover 50% of the entire bond market this triple beTrouble B is essentially one large notch above junk bondsIt used to be a world where there’s a lot of triple-a credit double-a creditThey’re all falling by the waysideWhat 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 thatyou’ve got a trillion dollar so you got four trillion dollars of oftriple B and you’ve got a trillion dollars ofjunk thatjunk alone is the largest the junk bond markets ever been but the real growth in this whole thing has been44:34The triple B sector, you can see from this chart that if we put all the different types of bonds in a nice44:41stack next to each other the size of the triple B market is absolutely44:46Enormous and when you break down the u.s. Triple B debt market you can also say it’s pretty lumpy44:51there are five large beer moths that account for44:55seven hundred and seventy billion dollars of debt44:58And if you add in the US shale industry you’re talking about a trillion dollars of debt. Those companies are45:05General Electric General Motors45:08AT&T forward and Dell they account for everything here. It’s huge45:13You’re obviously there’s a massive tier of corporations behind it that triple-b45:17But really the risk comes down to five big firms just to understand how leveraged these companies are. Here’s the chart of debt-to-equityGeneral Electric is over 200% debt-to-equityGeneral Motors 250AT&T about a hundred percentFord about four hundred and fifty percent and Dell about one hundred and twenty five percent of AT&T isthe largest the most indebtedCompany the world has ever seenit is a hundred and seventy billion dollars in debt andIs over a hundred percent of market cap in debt that dynamic can change?45:58Dramatically if the share price Falls it’s digested an enormous acquisition in Time Warner46:03And if you remember a o L Time Warner was ringing the bell of the top of the last cycle46:07It kind of feels like AT&T Time Warner may be ringing the bell for this cycle – and it was a debt owed you’d allowed46:13To do it because AT&T thought fine, you know, we’re a phone company we get plenty of cash46:19The problem is is corporate cash flow is correlated to the business cycle46:23If you look at the Eckrich and look at S&P cash flow, you see they’re highly correlated46:27So what looks affordable acquisition now suddenly becomes unaffordable later if that starts to happen46:32Then you’ve got a problem and you’ve got a problem because look AT&T is not going bust46:37Well, at least I don’t think so, but it’s gonna get downgraded to junkThere is no way on earth the junk bond market can take a downgrade like AT&T46:46Realistically if you start to get in a recession46:48You should see I don’t know 10 20 % of these triple B’s get downgraded. So we’re talkinghuge numbers that have to get absorbed into that junk spaceBut there’s only a trillion dollars there and the buyers are different and this is a crucial thing herethe buyers ofJunk bonds are not the same buyers as the buyers of investment a great creditThose bars invest in great credit will have to sell if it gets downgradedSo that means that there is a huge amount of sellingBut the people in the junk bond market don’t have 30% more 40% more cash suddenly to buy this stuffso the only way of doing it is by obliterating the junk bond markSo 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 isif you look at theDebt that’s coming upIt’s a complete wall of the stuff that needs to be renewed over what looks like it’s going to be the next recessionThat’s going to be a huge problem to try and roll all this financing that all comes to you at the same timeWhen the banks aren’t gonna be particularly keen onLetting this financing out and the companies are going to be desperate to get it but their cash flows are gonna be going downSo the affordability becomes a little more problematic even with rates being cutThis is why the Fed need to cut rates and need to cut rates fast because this corporate thing is an avalancheWaiting to happen and the butterflies flapped its wings and the avalanche is starting to crumbleBut you see this issues not just the US as I mentioned a couple of times it’s globalWhen we look at the global corporate debt-to-gdpwe’re at 95%This is the same color of la-la-land levels that we had on household debt back in 2008There is an extraordinary amount of corporate debt. And the worst thing about it. Almost all of it is in US dollars globallyIt’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 collateralThat has a huge value for the system. That’s slightlyinsolventso we’ve got a huge problem because if you think about that, it’s globalized and it’s in dollar funding andThere’s not enough dollars around certainly not to roll all of this debtParticularly if the banking system in Europe is going to desperately be sucking for these dollarsWe’ve got a big funding issue to comeAnd again if the dollar starts going higherIt becomes a much bigger problemFor all of these corporates to deal with and a big big problem for the junk bond market to deal with overall and the investment-gradeMarket, see I’m not the only one talking about this Stan Druckenmiller has been talking about itthere’s a number of people who talked about it and49:29The BIS and the IMF have both warned about it much like they did ahead of the 2008 recessionThey’re saying there is a huge problem with corporate indebtedness. There’s a huge problem with the buybacksThere’s a huge problem with the dynamics that it’s creatingAnd this is the thing. It’s the knock-on effects that I’m really worried about in this whole equation a credit eventOkay, a secondly credit event really nasty but with a couple of other things thrown in like a retirement crisisThen we’ve got something really really concerning that we have to avoid the Fed have to beReally aggressive in this or we’ve got a much bigger problem than we realized. You see the bond market is supporting equity marketsI talked about before it’s all the book buyback. So here’s the graph of the buybacks that I talked about beforeThey’re basically supporting the whole marketSo if the corporate bond market gets a little bit tighter and cash flows go all of the corporates gonna stop by equity the largest50:20Bar will have left the room very quickly. So let’s go through the causation here ari widens. It starts falling south for the reasons50:27I’ve talked about it starts widening out the spreads as soon as the spread starts widening out corporate cash flow start going with Acree and50:35Corporate start going. Okay. I need to be careful here. So what they do is they stop buying back shares50:40So that’s the largest equity market buyer who’s left the room. So that’s a really big deal50:46So let’s go back to the area chart with the year on your S&P50:50The 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 terms50:57So we’re setting ourselves up for something that could be quite interesting. Now. We know that51:02Consumer confidence is pretty much tied to the equity market right now51:05and so if the equity market starts51:07falling 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 bring51:13Out the baby boomers and I’ll come on to that in a sec. So there’s another issue here51:17We had a guest on real vision who talked about the corporate bond market and the pension system51:22You see I’ve talked about the pension system a lot and I’ll come on to that in a sec again51:25but51:26the pension system has been a bar of equity but increasing bar of corporate bonds because there’s been some yield there and51:33Also as you get an aging population and people are getting closer to retirement you need more bonds51:37But they need you to take as much risk as possible51:39So they’ve bought a ton of junk and a ton of this triple B stuff. So they’ve been the big buyers51:44Now what’s been really interesting is they’ve been in a loop like the buyback loop which has been drift by tax receipts51:51you see place like, Illinois who have51:54bankrupt pension systems51:56Have been raising taxes and with that tax receipts they have been52:01Then putting it into the pension system to fill the gap the pension funds have been buying bonds52:07So you’ve got this cycle with tax receipts coming in and you’re buying bonds52:10You just create this loop the problem is is tax receipts are also cyclical52:15So once that happens and the tax receipts start falling because level of business activity is falling well52:21Then guess what the corporate debt bar goes away, too52:23So you’re creating a market where there’s no equity buyer a no corporate debt buyer because of how the pension funds operate52:31That’s a real problem. And then if anything gets downgraded to junk who’s the bar of that junk that doesn’t really exist52:37Either you can see the chart here of US state and local current tax receipts52:42Year on year and it’s basically the same as the business cycle52:44No surprise and it’s gone negative as tax receipts have been lower than expected52:50Recently and again, that should stop pushing the credit spreads wider and that brings us back to the baby boomers52:56These are the guys who all these assets are the equity investments and the bond investments53:02They’re the they’re the owner of all of this stuff and they need to sell them to53:06And they need to sell them because they’re going to retirement and if there is a risk in the system53:10They cannot take the risk of losing their money53:13Because that is their pile that they retire with and I talked about this at length in the retirement crisis video53:19so the chances are there’s a behavioral adjustment of which they become net sellers in two rallies and53:25Sellers in two dips as opposed to buyers in two dips53:29And that’s because they don’t have work or the amount of work needed or income needed to sustain an investment portfolio53:35It’s more about living expenditure. And those that retire they don’t have more money to put back into the market. That is their pool53:42They’re done. So they need to reduce risk fast. So when you’ve got a situation where53:47Everybody is a net seller. You’ve got a problem that happened in Europe and it happened in Japan53:53We’ve seen what it does it basically lowers53:57for decades the price of equities and54:00Changes the structure of markets for a long period of time and I think that is one of the potential outcomes again54:05I’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 effects54:12I’ll put them on the screen here and then I’m going to go through a bit again. Later54:15Because there was a lot of points to get across so as the triple B credits get downgraded to junk and the debt markets freeze54:21Pensions will be forced sellers and take enormous losses and were switched to Treasuries at 1% yields or less54:26This will essentially bankrupt the defined benefit pension system54:29It has to default on its promises when you throw in the net divesting of assets54:33The baby boomers will do in the next recession. You have the perfect storm. There’ll be no buyers of equity54:37There’ll be no bars of debt corporations will not be able to service the debts or roll them54:41The pension system will break then throw in the EU banking system, which is fragile and needs dollars and the entire54:47Bloody system will freeze all over again. This is why I called the Doom loop and it’s small incremental steps that create something quite quick54:56Can the Fed get in the way of it?54:58Can they stop this Doom loop because there is a cycle here because the moment you start widening credit spreads55:03You start creating selling you start creating less buybacks the equity market Falls if the equity market Falls then AT&T share price Falls55:09Then they stop and pricing default wrist or downgrade return to AT&T55:13And then what you know is the junk bond spreads widen the whole thing works in this endless cycle55:19So let me go through the points of the cycle again as well just to clarify55:22Phase 1 the business cycle weakens credit begins to widen55:27corporate cash flow worsens our tad and shares fall and volatility increases55:31I think that’s where we’ve got to now I think phase 1 we accomplished and it started really in about October55:38Phase 2 the business cycle weakens again credit widens more cash flow gets worse as do profits tax receipts fall and state pension funds55:46Stop buying debt big triple B stocks fall and bonds fall even more sharply equities fall hard55:51So 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 that55:58The Europe has a sesee up cycle right now. There’s a bit of stabilization of data56:03I have a feeling that if I’m right about the debt ceiling or the dollar breaks higher56:08Then I think we’re going to start to see56:11phase 2 come in when we start seeing phase 2 we know where this is going because then the story becomes very56:17Their face one was the alarm bells face – they strap yourselves in. Okay, let’s go into Phase three56:23This is when things get ugly the baby-boomers starts a panic to get out of equities permanently. There’s down grades of triple beads56:28Junk the EU banks can’t take the funding stress and the ECB and the government step in credit spreads explode credit seizes up entire list56:35Pension funds are forced sellers on downgrades equities going to tailspin56:38There are no natural buyers credit widens dramatically offered only no bids junk bond market56:44Overwhelmed pension funds get to trouble defaulting on obligations big famous companies are being forced towards bankruptcy56:50Unnecessarily, that’s the really ugly face and that’s the one56:55Where I think many of us have got a sense that there was an end game56:59That’s at the end of all of this if there is one it lies in the heart of that whether we get there or not57:03It’s going to be a function of what the Fed does and what the central banks do and how they deal with this57:09And there’s many outcomes for that and it is not going to be a straight battle57:12But all I do know is these things tend to accelerate much faster. I’m very cognizant of what happened in the UK57:19with57:20with Woodford’s fund and Neil Woodford’s fund and also with HC o new Texas, these are57:27these are57:28liquidity problems and we’ve talked a lot on real vision about liquidity in the lack of liquidity and markets and if you put in a57:35Bad event with low liquidity you’ve got a problem and I think we’re starting to see alarm bells coming57:40so as I said57:40We phase one let’s see what happens with phase two. The end of it is the Fed are gonna have to buy credit57:46They’re gonna have to stop this they have to stop the Doom loop57:49And the other thing they will do is underwrite the pension system57:53and this is part of the MMT and also part of the way that you get rid of the57:59quantitative easing giving money58:01to the rich or the people who need it the least the people who can borrow and58:05This way you give it to people who have a pension and there also happened to be voters huge numbers of baby58:11Boom voters you’ll be bringing back into the system58:13So it’s actually a very attractive thing for both the Federal Reserve and the government to push to do58:19So I think that’s what comes of it58:21You’re gonna have to do something about this pension plan black hole and this is probably the way to do it58:25You see Europe in the UK dealt with a lot of this in the past because they started to58:30put restrictions on what pension funds could do and the kind of risks that they could take but they’ve still got a58:36Problem with with credit for sure and I think the Europeans will be involved in having to support their own pension system as well. So58:46Where does this all leave us? Well, that’s what this week’s gonna be about58:50you can see how important this all is and this is not just58:54Doom mongering. This is the reality of the probabilities. You cannot deny that the business cycle is weakening59:00You can deny that it’s going to a recession, but we need to find out more. We need to find out from other people59:05I really want to find out I want to have that debate with people59:09because I59:11Really want to know and assess the probabilities and figure out whether my probabilities are right. So I’m gonna leave you with a few things59:19the things that really matter to me59:22I’ve given you a bunch of chance to look at that59:24You can follow I would use that your stocks banking index has one very important chart59:30You can use maybe FedEx for world trade tariffs and stuff like that. FedEx looks pretty bad59:35But I think the primary chart is the chart of truth that I’ve always called it59:39which is the bond market the59:41Thirty-year Channel and how it perfectly kind of POTUS head at the top of the channel and then reversed. It’s telling us that59:47bond yields are gonna go probably down to zero that’s ten-year bond yields if I show you the chart here of the59:55Long-term pattern of two-year bond yields. It’s very clear that they’re going to go negative and this chart suggests60:01They’re going to go to negative two percent now60:04For somebody in America that might sound outrageous60:07To anybody else in the world. It’s normal, right Europe’s had negative rates now for a long time as of Japan60:13You know all across the place we’ve seen negative rates. So get used to it. It’s the mindset of what’s coming60:20I 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 that60:27Massively built up over the short period of time and then with the wave of retirees coming and the Fed having over tightened60:34I think the dollar chart is extremely important. I think use the broad trade-weighted dollar index60:40it is a60:41Huge cup and handle formation as well. And if it breaks this 130 level then we’re going to see the final60:50Catastrophic large rise in the dollar that could break the rest of the system. I’ve been warning of this for some time60:57The dollar has been range-bound. It keeps looking like it’s going to break down then suddenly break up and then break down61:01I don’t know, but I do know it’s gonna break and it’ll be the last of the asset classes61:06To make its move if it breaks down61:09Okay, we’ve got to give ourselves some breathing space. We’re going to save emerging markets61:13We’re gonna save some of this debt situation for another day and we’ll extend. What is the longest business cycle in all history?61:20but if not61:21Then we’re going to start to accelerate all of these events and a global recession with some really nasty outcomes61:28It’s becoming more and more likely and also61:30the61:31Abxy, the Asian dollar currency index. I think that’s an important chart to keep on your screens and maybe keep your focus on the61:38EEM the equity market the emerging market ETF61:42These things are all within this basket what we need to be looking at and in the end61:46What do I think the trade is my personal view? And again, I’m gonna talk to other people about this I think61:52It is bonds if I’m right and we’re gonna get worse. We may see about a bounce in bonds now61:57I’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 biggest62:04Highest conviction trades I’ve ever had and I think that the bond market particularly the short end the Eurodollar futures in the two year futures62:11You need to leverage up and buy as much as you can of these into any bands62:15I think we’re hopefully getting a short bounce now62:17But I think once we get through and we start to see the economic data weakening once more62:24You won’t be able to buy bonds. I think I’m really interested in buying dollars. I’d like him to break62:30Once they break higher then I want to add all sorts of dollars. I62:34Don’t want to short the equity market. It’s too dangerous. It’s too difficult62:38And I think it’s a balance ii trade versus the bond market trade62:41Obviously I will be get drawn into it again62:43But every time I try get my ass handed to me, so I’m gonna try and avoid doing that one the last two62:48I’m pretty obvious one is gold because gold is an option on the end62:53So if we are going to go to extreme monetary policy, which looks like I’ve walked you through a set of pretty easy62:59Probabilities that that could happen in the next 18 months. Well, then gold has to go higher now63:04It’s sure if the dollar goes higher Gold’s gonna come back a bit but over time63:08I think the dollar on gold go higher and gold goes a lot higher over the longer run and it’s now63:13acting as that probability on this endgame and the final one is Bitcoin bitcoin is63:19Again, a probability on the ability to build a different financial future. We’re seeing noise coming out of China about building a cryptocurrency63:25We’ve seen the very interesting thing that Facebook’s done63:27It’s another thing that I will do for real vision at some point is talk about that more debt63:32Not that I think the Facebook cryptocurrency is the answer but the globalized currency and what they were doing with the globalized currency63:39I think really is very interesting some that talks about on real vision from the very beginning maybe in the first ever interview63:44They were all talking towards coming towards this moment now63:48This is why we started real vision and also this is why I do global macro investor. We’re in a very macro environment63:54It’s super interesting, but it’s also super dangerous. So me publishing global macro investor. I thought had to get this across to you64:02So everybody understands the risk ahead and can do their own work on it64:05So I’m really looking forward to taking you with me on this journey64:08There’s going to be a lot of learning. There’s gonna be a lot of debate and I’m going to bring different angles64:12I’m gonna bring people from the oil market the retail market the car market the VC market64:17I’m doing macro experts Bitcoin experts gold experts64:20I’m gonna bring everybody to the table and we’re gonna talk it all out and figure out ok64:24What the hell is going on and what the real probabilities are. Guess what we’re doing a sweepstake64:30You can get a chance to win a premium subscription to real vision, but we’re not just giving away one64:35But 10 subscriptions. All you have to do is subscribe to our real vision youtube channel like this video and comment down below on64:43August 31st will contact the ten winners. So subscribe now for your chance to gain access to our critical series on64:51Recession as well as other series on tap about gold64:55Retirement crisis and many of the aspects of economic and investing life that will affect you and your savings