Tag Archives: Europe

Will Monetary or Fiscal Stimulus Turnaround the Next Recession?

A recession is emerging with interest rate curves inverted, the end of the business cycle at hand, world trade falling, and consumers and businesses beginning to pull back on spending.  The question is: will monetary or fiscal stimulus turn around a recession? 

In this post, we find both stimulus alternatives likely to be too weak to have the necessary economic impact to lift the economy out of a recession. Finally, we will identify the key characteristics of a coming recession and the implications for investors.

Our economy is at the nexus of several major economic trends formed over decades that are limiting monetary and fiscal options. The monetary policy of central banks has caused world economies to be abundant in liquidity, yet producing limited growth. Central bankers in Japan and Europe have been trying to revive growth with $17 trillion injections using negative interest rates.  Japan can barely keep its economy growing with an estimate of GDP at .5 % through 2019. The Japanese central bank holds 200 % of GDP in government debt.  The European Central Bank holds 85 % of GDP in debt and uses negative interest rates as well. Germany is in a manufacturing recession with the most recent PMI in manufacturing activity at 47.3 and other European economies contracting toward near-zero GDP growth.  

Lance Roberts notes that the world economy is not running on a solid economic foundation if there is $17 trillion in negative-yielding debt in his blog, Powell Fails, Trump Rails, The Failure of Negative Rates. He questions the ability of negative interest policies to stabilize world economies,

You don’t have $17 Trillion in negative-yielding sovereign debt if there is economic and fiscal stability.”

Negative interest rates and extreme monetary stimulus policies have distorted financial relationships between debt and risk assets. This financial distortion has created a significantly wider gap between the 90 % and the top 1 % in wealth.

Roberts outlines in the six panel chart below how personal income, employment, industrial production, real consumer spending, real wages, and real GDP are all weakening in the U.S.:

Source: RIA – 8/23/19

Trillions of dollars of monetary stimulus have not created prosperity for all. The chart below shows how liquidity fueled a dramatic increase in asset prices while the amount of world GDP per money supply declined by about 25 %:

Sources: The Wall Street Journal, The Daily Shot – 9/23/19

Low interest rates have not driven real growth in wages, productivity, innovation, and services development that create real wealth for the working class. Instead, wealth and income are concentrated in the top 1 %. The concentration of wealth in the top one percent is at the highest level since 1929. The World Inequality Report notes inequality has squeezed the middle class between emerging countries and the U.S. and Europe. The top 1 % has received twice the financial growth benefits as the bottom 50 % since 1980:

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

There are several reasons monetary stimulus by itself has not lifted the incomes of the middle class. One of the big causes is that stimulus money has not translated into wage increases for most workers.  U.S. real earnings for men have essentially been flat since 1975, while earnings for women have increased though basically flat since 2000:

Source: U.S. Census Bureau – 9/10/19

If monetary policy is not working, then fiscal investment from private and public sectors is necessary to drive an economic reversal.  But, will the private and public sector sectors have the necessary tools to bring new life to an economy in decline?

Wealth Creation Has Gone to the Private Sector

The last 40 years have seen the rise of private capital worldwide while public capital has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

Essentially, world banks and governments have built monetary and fiscal economic systems that increased private wealth at the expense of public wealthThe lack of public capital makes the creation of public goods and services nearly impossible. The development of public goods and services like basic research and development, education and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  

Why is building high levels of private capital a problem?  Because, as we have discussed, private wealth is now concentrated in the top 1 %, while 70 % of U.S GDP is dependent on consumer spending.  The 90 % have been working for stagnant wages for decades, right along with diminishing GDP growth.  There is a direct correlation between wealth creation for all the people and GDP growth.

Corporations Are Not In A Position to Invest

Some corporations certainly have invested in their businesses, people, and technology.  The issue is the majority of corporations are now financially strapped.  Many corporate executives have made profit allocation decisions to pay themselves and their stockholders well at the expense of workers, their communities and the economy. 

S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Source: Real Investment Advice

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

In 2018 stock buybacks at $1.01 trillion were at the highest level they have ever been since buybacks were allowed under the 1982 SEC safe harbor provision decision. It is interesting to consider where our economy would be today if corporations spent the money they were wasting on boosting stock prices and instead invested in long term value creation.  One trillion dollars invested in raising wages, research, and development, cutting prices, employee education, and reducing health care premiums would have made a significant impact lifting the financial position of millions. This year stock buybacks have fallen back slightly as debt loads increase and sales fall:

Source: Dow Jones – 7/2019

Many corporations with tight cash flows have borrowed to purchase shares, pay dividends and keep their stock price elevated causing corporate debt to hit new highs as a percentage of GDP (note recessions followed three peaks):

Source: Federal Reserve Bank of Dallas – 3/6/2019

Corporate debt has ballooned to 46 % of GDP totaling $5.7 trillion in 2018 versus $2.2 trillion in 2008.  While the bulk of these nonfinancial corporate bonds have been investment grade, many bond covenants have become weaker as corporations seek more funding. Some bondholders may find their investment not as secure as they thought resulting in significantly less than 100 % return of principal at maturity.

In a recession, corporate sales fall, cash flow goes negative, high debt payments become hard to make, employees are laid off and management tries to hold on.  Only a select set of major corporations have cash hoards to ride out a recession, and others may be able obtain loans at steep interest rates, if at all.  Other companies may try going to the stock market which will be problematic with low valuations.  Plus, investors will be reluctant to buy stock in negative cash flow companies.

Thus, most corporations will be hard pressed to invest the billions of dollars necessary to turnaround a recession. Instead, they will be just trying to keep the doors open, the lights on, and maintain staffing levels to hold on until the day sales stop falling and finally turn up.

Public Sector is Also Tapped Out

In past recessions, federal policy makers have turned to fiscal policy – public spending on infrastructure projects, research development, training, corporate partnerships, and public services to revive the economy.  When the 2008 financial crisis was at its peak the Bush administration, followed by the Obama government pumped fiscal stimulus of $983 billion in spending over four years on roads, bridges, airports, and other projects. The Fed funds interest rate before the recession was at 5.25 % at the peak allowing lower rates to have plenty of impact. Today, with rates at 1.75-2.00 %, the impact will be negligible. In 2008, it was the combined massive injection of monetary and fiscal stimulus that created a V-shaped recession with the economy back on a path to recovery in 18 months. It was not monetary policy alone that moved the economy forward.  However, the recession caused lasting financial damage to wealth of millions. Many retirement portfolios lost 40 – 60 % of their value, millions of homeowners lost their homes, thousands of workers were laid off late in their careers and unable to find comparable jobs.  The Great Recession changed many people’s lives permanently, yet it was relatively short-lived compared to the Great Depression.

As noted in the chart above, public sector wealth has actually moved to negative levels in the U.S. at – 17 % of national income.  Our federal government is running a $1 trillion deficit per year.  In 2007, the federal government debt level was at 39 % of GDP. The Congressional Budget Office projects that by 2028 the Federal deficit will be at 100 % of GDP

Source: CBO – 4/9/19

We are at a different time economically than 2008. Today with Federal debt is over 100% of GDP and expected to grow rapidly. The Feds balance sheet is still excessive and they formally stopped reducing the size (QT).  In a recession federal policymakers will likely make spending cuts to keep the deficit from going exponential. Policy makers will be limited by the twin deficits of $22.0 trillion national debt and ongoing deficits of $1+ trillion a year, eroding investor confidence in U.S. bonds. The problem is the political consensus for fiscal stimulus in 2008 – 2009 does not exist today, and it will probably be even worse after the 2020 election. Our cultural, social and political fabric is so frayed as a result of decades of divisive politics it is likely to take years to sort out during a recession. Our political leaders will be fixing the politics of our country while searching for intelligent stimulus solutions to be developed, agreed upon and implemented.

What Will the Next Recession Look Like?

We don’t know when the next recession will come. Yet, present trends do tell us what the structure of a recession might look like, as a deep U- shaped, slow recovery measured in years not months:

  • Corporations Short of Cash – Corporations already strapped are short on cash, will lay off workers, pull back spending, and are stuck paying off huge debts instead of investing.
  • Federal Government Spending Cuts – The federal government caught with falling revenues from corporations and individuals, is forced to make deep cuts first in discretionary spending and then social services and transfer funding programs. The reduction of transfer programs will drive slower consumer spending.
  • Consumers Pull Back Spending – Consumers will be forced to tighten budgets, pay off expensive car loans and student debt, and for those laid off seeking work anywhere they can find a job.
  • World Trade Declines – World trade will not be a source of rebuilding sales growth as a result of the China – US trade war, and tariffs with Europe and Japan.  We expect no trade deal or a small deal with the majority of tariffs to stay in place. In other words, just reversing some tariffs will not be enough to restart sales. New buyer – seller relationships are already set, closing sales channels to US companies. New country alliances are already in place, leaving the US closed out of emerging high growth markets.  A successor Trans Pacific Partnership (TPP) agreement with Japan and eleven other countries was signed in March, 2018 without the US. China is negotiating a new agreement with the EU. EU and China trade totals 365 billion euros per year. China is working with a federation of African countries to gain favorable trade access to their markets.
  • ­Pension Payments in Jeopardy – Workers dependent on corporate and public pensions may see their benefits cut from pensions, which are poorly funded today with markets at all-time highs. GE just announced freezing pensions for 20,000 employees, the harbinger of a possible trend that will  reduce consumer spending
  • Investment Environment Uncertain – Uncertainty in investments will be extremely high, ‘get rich quick’ schemes will flourish as they did in 2008 – 2009 and 2000.
  • Fed Implements Low Rates & QE – The Fed is likely to implement very low interest rates (though not negative rates), and QE with liquidity in abundance but the economy will have low inflation, and declining GDP feeling like the Japanese economic stasis – ‘locked in irons’.

Implications for Investors

The following recommendations are intended for consideration just prior or during a recession with a sharp decline in the markets, not necessarily for today’s markets.

Cash – It is crucial to maintain a significant cash hoard so you can purchase corporate stocks when they cheapen. The SPX could decline by 40 – 50 % or more when the economy is in recession.  Yet, good values in some stocks will be available.  At the 1500 level, there is an excellent opportunity to make good long term growth and value investments based on sound research.

CDs – as Will Rogers noted during the Depression, “I’m more interested in Return of my Capital than Return on my Capital”, a prudent investor should be too.  CDs are FDIC insured while offering lower interest rates than other investments. Importantly, they provide return of capital and allow you to sleep at night.

Bonds – U.S. Treasuries certainly provide safety, return of principal, and during a recession will provide better overall returns than high-risk equity investments. Corporate bonds may come under greater scrutiny by investors even for so-called ‘blue chips’ like General Electric. The firm is falling on hard times with $156 billion in debt. GE is seeking business direction and selling off assets. The major conglomerate’s bonds have declined in value by 2.5 % last year with their rating dropped to BBB. Now with new management the price of GE bonds is climbing up slightly.

Utilities – are regulated to have a profit.  While they may see declining revenues due to less energy use by corporations and individuals, they still will pay dividends to shareholders as they did in 2008.  Consumer staple companies are likely to be cash flow strained; most did not pay dividends to investors during the 2008 – 2009 recession. REITs need to be evaluated on a company by company basis to determine how secure their cash streams are from leases. During the 2008 – 2009 downturn, some REITs stopped paying dividends due to declining revenues from lease defaults.

Growth & Value Equities– invest in new sectors that have government support or emerging demand based on social trends like climate change: renewables, water, carbon emission recovery, environmental cleanup. From our Navigating A Two Block Trade World – US and China post, we noted possible investments in bridge companies between the two trade blocks; services, and countries that act as bridges like Australia. Look for firms with good cash positions to ride out the recession, companies in new markets with sales generated by innovations, or problem solving products that require spending by customers.  For example, seniors will have to spend money on health services. Companies serving an increasingly aging population with innovative low cost health solutions are likely to see good demand and sales growth.

The intelligent investor will do well to ‘hope for the best, but plan for the worst’ in terms of portfolio management in a coming recession.  Asking hard questions of financial product executives and doing your own research will likely be keys to survival.

In the end, Americans have always pulled together, solved problems, and moved ahead toward an even better future. After a reversion to the mean in the capital markets and an economic recession things will improve.  A reversion in social and culture values is likely to happen in parallel to the financial reversion. The complacency, greed, and selfishness that drove the present economic extremes will give way to a new appreciation of values like self-sacrifice, service, fairness, fair wages and benefits for workers, and creation of a renewed economy that creates financial opportunities for all, not just the few.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

The Mechanics of Absurdity

Over the past few decades, the central banks, including the Federal Reserve (Fed), have relied increasingly on interest rates to help modify economic growth. Interest rate management is their tool of choice because it can be effective and because central banks regulate the supply of money, which directly effects the cost to borrow it. Lower interest rates incentivize borrowers to take on debt and consume while dis-incentivizing savings.

Regrettably, a growing consequence of favoring lower than normal interest rates for prolonged periods is that consumers, companies, and nations grow increasingly indebted as a percentage of their respective income. In many cases, consumption is pulled from the future to the present day. Accordingly, less consumption is needed in the future and a larger portion of income and wealth must be devoted to servicing the accumulated debt as opposed to productive ventures which would otherwise generate income to help pay off the debt.

Today, interest rates are at historically low levels around the globe. Interest rates are negative in Japan and throughout much of Europe. In this article, we expound on the themes laid out in Negative is the New Subprime, to discuss the mechanics of negative-yielding debt as well as the current mindset of investors that invest in negative-yielding debt.

Is invest the right word in describing an asset that when held to maturity guarantees a loss of capital?

Negative Yield Mechanics

Negative yields are not only bestowed upon sovereign debt, as investment grade and even some junk-rated debt in Europe now carry negative yields. Even stranger, Market Watch just wrote about a Danish bank offering consumers’ negative interest rate mortgages (LINK).

You might be thinking, “Wow, I can take out a negative interest rate loan, receive payments every month or quarter and then pay back what was lent to me?” That is not how it works, at least not yet. Below are two examples that walk through the lender and borrower cash flows for negative-yielding debt.

Some of the bonds trading at negative yields were issued when yields were positive and therefore have coupon payments. For example, in August of 2018, Germany issued a 30 year bond with a coupon of 1.25%. The price of the bond is currently $143, making the yield to maturity -0.19%. Today, it will cost you $14,300 to buy $10,000 face value of the bond. Going forward, you will receive coupon payments of $125 a year and ultimately receive $10,000 in 2048. Over the next 29 years you will receive $3,625 in coupon payments but lose $4,300 in principal, hence the current negative yield to maturity.

Bonds issued with a zero coupon with negative yields are similar in concept but the mechanics are slightly different than our positive coupon example from above. Germany issued a ten-year bond which pays no coupon. Currently, the price is 106.76, meaning it will cost an investor $10,676 to buy $10,000 face value of the bond. Over the next ten years the investor will receive no coupon payments, and at the end of the term they will receive $10,000, resulting in a $676 loss. The lower the negative yield to maturity, the higher premium to par and the greater loss of principal at maturity.

We suspect that example two, the zero-coupon bond issued at a price above par, will be the issuance model going forward for negative yielding bonds.

Why?

At this point, after reviewing the cash flows on the German bonds, you are probably asking why an investor would make an investment in which they are almost guaranteed to lose money. There are two predominant reasons worth exploring.

Safety: Investors that store physical gold in a gold vault pay a fee for safe storage. Individuals with expensive jewelry or other keepsakes pay banks a fee to use their vaults. Custodians, such as Fidelity or Schwab, are paid fees for the safekeeping of our stocks and bonds.

Storing money, as a deposit in a bank, is a little different from the prior examples. While banks are a safer place to store money than a personal vault, mattress, or wallet, the fact is that deposits are loans to the bank. Banks traditionally pay depositors an interest rate so that they have funds they can lend to borrowers at higher rates than the rate incurred on the deposit.

With rates negative in Europe and Japan, their respective central banks have essentially made the storing of deposits with banks akin to the storage of gold, jewelry, and stocks – they are subject to a safe storage fee.  Unfortunately, many people and corporations have no choice but to store their money in negative-yielding instruments and must lend money to a bank and pay a “storage fee.”  

On a real return basis, in other words adjusted for inflation, whether an investor comes out ahead by lending in a negative interest rate environment, depends on changes to the cost of living during that time frame. Negative yielding bonds emphatically signal that Germany will be in a deflationary state over the next ten years. With global central bankers taking every possible step, legal and otherwise, to avoid deflation and generate inflation, betting on deflation via negative yielding instruments seems like a poor choice for investors.

Greater Fool Theory: Buying a zero-coupon bond for 101 today with the promise of receiving 100 is a bad investment. Period. Buying the same bond for 101 today and selling it for 102 tomorrow is a great investment. As yields continue to fall further into negative territory, the prices of bonds rise. While the buyer of a negative-yielding bond may not receive a coupon, they can still profit, and sometimes appreciably as yields decline.

This type of trade mindset falls under the greater fool theory. Per Wikipedia:

“In finance and economics, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems “foolishly” high because one may rationally have the expectation that the item can be resold to a “greater fool” later.”

More succinctly, someone buying a bond that guarantees a loss can profit if they can find someone even more willing to lose money.

Scenario Analysis

Let’s now do a little scenario analysis to understand the value proposition of holding a negative-yielding bond.

For all three examples we use a one year bond to keep the math simple. The hypothetical bond details are as follows:

  • Issue Date: 9/1/2019
  • Maturity Date: 9/1/2020
  • Coupon = 0%
  • Yield at Issuance: -1.0%
  • Price at Issuance: 101.00

Greater fool scenario: In this scenario, the bondholder buys the new issue bond at 101 and sells it a week later at 101.50. In this case, the investor makes a .495% return or almost 29% annualized.

Normalization: This next scenario assumes that yields return to somewhat normal levels and the holder sells the bond in six months.If the yield returns to zero in six months, the price of the bond would fall to 100. In this case, our investor, having paid 101.00, will lose 1% over the six month period or 2% annualized.

Hold to maturity: If the bond is held to maturity, the bondholder will be redeemed at par losing 1% as they are paid $100 at maturity on a bond they purchased for $101.

Summary

Writing and thinking about the absurdity of negative yields is taxing and unnatural. It forces us to contemplate basic financial concepts in ways that defy common sense and rational thought. This is not a pedantic white paper discussing hypothetical central bank magic tricks and sleight of hand; this is about something occurring in real-time.

Excessive monetary policy has been the crutch of growth for decades spurred by an intense desire to avoid and minimize otherwise healthy and routine economic corrections. It was fueled by the cult of personality which took over in the 1990s when Alan Greenspan was labeled “The Maestro”. He, Robert Rubin, and Lawrence Summers were christened “The Committee to Save the World” by Time magazine in February 1999.  Greenspan was then the subject of a biography by famed Watergate journalist Bob Woodward infamously titled Maestro in 2000.

Under Greenspan and then Bernanke, Yellen and now Powell, rational monetary policy and acknowledgement of naturally occurring business cycles has taken a back seat to avoidance of these economic cycles at all cost. As a result, central bankers around the world are trying justify the inane logic of negative rates.

Negative Is The New Subprime

What is nothing? What comes to mind when you imagine nothing? The moment we try to imagine what nothing is, we fail, because nothing cannot be envisioned. There is nothing to envision or ponder or even think about. Nothing is no thing.

Yes, the point above is tedious, but the value of nothing in the financial theater is the latest magic trick of the central bankers and the most vital factor governing all investments.

If I invest my hard-earned capital in an asset the guarantees a return of nothing, what should I expect as a return? Nothing is a good answer, and somewhat absurdly, there is the possibility that nothing is the best-case scenario. Let’s take it one step further to beyond nothing. In the current age of financial alchemy, there is nearly $15.5 trillion in sovereign and corporate bonds available that promise a return of not only nothing but actually less than nothing.

If I am hired to steward capital and I invest in something that returns less than nothing, I have knowingly given away some portion of the capital I invested, and I should find another profession. And yet, on this very day, there are trillions of dollars’ worth of bonds that promise a return of less than nothing. Furthermore, there are many professional investors who knowingly and willingly are buying those bonds! The table below shows the many instances of negative-yielding sovereign bonds, with U.S. yields as a comparison.

Data Courtesy Bloomberg

Warped Logic

The discussion and table above highlight just how far astray the financial system has gone in Europe and Japan. What we are witnessing is not just coloring outside the lines; it is upside down and inside out. Central bankers are frantically turning cartwheels to convince us that current circumstances, though deranged and highly abnormal, are perfectly sane and normal. More often than not, politicians, the media, and Wall Street fail to challenge these experiments and worse generally echo the central bankers’ siren song.

How do investors conclude that there will be only good outcomes as a result of what are imprudent and illogical decisions and actions? Is it prudent to expect a bright future when the financial system punishes prudent savers who are most able to invest in our future and rewards ill-advised borrowing beyond one’s means?  

The current market and economic environment beg for lucid evaluation of circumstances and intelligent, honest discourse on the potential implications. Unfortunately, most market participants would prefer to keep their head in the sand. Chasing the stock and bond markets for the past decade has produced handsome returns and, for most investment advisors, delivered praise and a generous wage. As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Compounding wealth is the most important and most difficult financial concept for investors to grasp. Over the last ten years, many investors spent significant time recouping losses from the financial crisis, and they assumed great risk in doing so. Having recovered some or all of those losses, many are back in a position of compounding wealth. At this point, they can continue to look backward and believe that irrational policies will ensure that the past is prologue, or they can exercise some independent thought and recognize that the risk of another serious drawdown is not negligible. Prudent risk management is very generous to those who elect patience over expedience. Most financial advisors will not volunteer a fee-reducing, conservative approach even though it would be in their own best interest to do so at critical times.

Entities empowered with the responsibility of directing traffic and ensuring against bad behavior that wish to “manage” markets are increasingly weighed and found wanting. They have become a part of the bad behavior they were entrusted to prevent, yet again. Actions, or the lack thereof, that resulted in the destruction of wealth in recent history have been on full display for over the past decade. However, with stock markets near record highs today, these actions (or inactions) are cloaked in an artificial façade of success.

Retrospect

It has become cliché to point back to October 1929, the dot.com bubble, and the housing bubble as a reminder of what may transpire. Bulls confidently look at the bears citing those periods, just as Monty Python’s King Arthur looks at the Black Knight after dismembering his arms and legs and says, “What are you going to do, bleed on me?”

Yet, historical episodes are the correct frame of reference. Just as in those prior bubbles, the problem today is right in front of our face. The evidence is clear and the lunacy unmistakable. The poster child in 2000 was Pets.com and the sock puppet; in 2006 it was skyrocketing home prices and negatively amortizing subprime “liar” loans. Today, it is negative interest rates.

It is not hyperbole to say that today’s instance of finance gone wild is more insane than Pets.com, neg-am liar loans and any other absurd Ponzi scheme that has ever been perpetrated, ALL PUT TOGETHER.

The dot.com market collapse cost the economy roughly $8 trillion. The estimate of the cost of the 2008-09 financial crisis is $22 trillion. The market value of debt outstanding with negative interest rates is over $15 trillion.

Data Courtesy Bloomberg

Although $15 trillion is less than the financial crisis losses, what must be considered is the multiplier effect. The losses in prior recessions were in part caused by the factors listed above but magnified by their ripple effect on other aspects of the economy and financial markets. This is the multiplier of the cause or the epicenter. Consider the following:

  • The S&P 500 Information Technology sector market cap was roughly $4 trillion in March 2000. The total market losses from the tech bubble amounted to about $8 trillion; therefore, the damage in that episode was about $2 for every $1 of exposure ($8T losses vs. $4T exposure) to the epicenter of the problem, so the multiplier was 2:1.
  • The toxic sub-prime part of the mortgage market was about $2 trillion. So, the impact of losses was $11 for every $1 of exposure ($22T loss vs. $2T exposure) to the epicenter, or a multiplier of 11:1.
  • If a problem emerged today and we are correct that the epicenter of this problem, negative-yielding debt, is further reaching than those prior mentioned episodes, then using a simple 11-to-1 ratio on $15 trillion is $165 trillion in losses, may be understating the potential problems. Even being very conservative with a 2:1 multiple yields mind-boggling losses.

This is unscientific scenario analysis, but it does provide a logical and reasonable array of possible outcomes. If one had postulated that the sub-prime mortgage market would spark even $2 trillion in losses back in 2007, they would have been laughed out of the room. Some people did anticipate the problem, made their concerns public, and were ridiculed. Even after the problem started, the common response was that sub-prime is too small to have an impact on the economy. In fact, the Fed and other central banks stood united in minimizing the imminent risks even as they were wreaking havoc on the financial system. Likewise, the “scientific” analysis currently being done by Ph.D. economists will probably miss today’s problem altogether.

European Banks

The concept of negative-yielding debt is totally irrational and incoherent. It contradicts every fundamental rule we learn and attempt to apply in business, finance, and economics.  It implies that the future is more certain than the present – that the unknown is more certain than the known!

When the investment/lending hurdle rate is not only removed but broadly disfigured in how we think about allocating resources, precious resources will be misallocated. The magnitude of that misallocation depends on the time and extent to which the policy persists.

As brought to our attention by Raoul Pal of Global Macro Investor and Real Vision, the first evidence of problems is emerging where the negative interest rate phenomenon has been most acute – Europe. European financial institutions are growing increasingly unhealthy due to the damage of negative rate policies. Currently, the Euro STOXX Bank index, as shown below, trades at levels below those of the trough of 2009 and its lowest levels since 1987. More importantly, the index is on the verge of breaking through a vital technical level to the downside. The shares of Germany’s two largest banks, Deutsche Bank and Commerzbank, are at historical lows.  Just as subprime was not isolated to the U.S., this problem is not isolated to Europe. These banks have contagion risk that, if unleashed, will spread throughout the global financial system. 

Data Courtesy Bloomberg

Summary

The market is reflecting a growing lack of confidence in the European banking and financial system as telegraphed through stock market pricing shown above.

The risk facing the global financial system is that, as problems emerge, the second and third-order effects of those issues will be both impossible to anticipate and increasingly difficult to control. Trust and confidence in the world’s central bankers can fade quickly as we saw only ten years ago.

Compounding wealth depends upon minimizing the risk of a large, permanent loss. If markets falter and the cause is monetary policy that advocated for negative interest rates, investors will have to accept accountability for the fact that it was staring us in the face all along.

Negative Interest Rate Insanity Is Behind Western Europe’s New Tallest Skyscraper

Business Insider published a piece on April 1st about plans to build Western Europe’s tallest skyscraper…in a small, rural Danish town with just 7,000 residents. After I posted it on Twitter, many of my followers thought it was an April Fool’s joke due to how absurd the idea is. Even I had to do a little research to confirm that it wasn’t a joke, but it is indeed a true story –

A 1,050-foot skyscraper soaring out of the earth isn’t exactly what you’d expect to come across in a corner of rural Denmark, and yet one may soon become a reality.

The fast-fashion giant Bestseller just secured final approval from the council of Brande, Denmark, to build its eponymous tower in the town of just 7,000 citizens.

When built, the Bestseller Tower, designed by the Danish architect Dorte Mandrup, will be the tallest building in Western Europe, beating out the Shard in London by 34 feet.

“We are very pleased that the plans have now been approved by the city council and we are extremely proud and humbled by the amount of support our project has received, especially locally. It is important for us to underline that the city council’s approval is merely one of the preliminary steps of a long journey,” Anders Krogh, Bestseller’s project manager, said in a statement.

Though the fashion company has long outgrown its roots in Brande — the owner, Anders Holch Povlsen, is Denmark’s richest man with a reported net worth of $7.2 billion — it’s hoping that the new building development will put the Jutland town on the map.

“It will be a landmark,” Krogh added in the statement. “But it will also function as an architectural attraction benefiting hotel guests, students and other users of the building.”

After reading that piece, what immediately came to mind was the fact that the construction of skyscrapers (especially record-breaking ones) is a common hallmark of economic bubbles.

During an economic bubble, credit is cheap and readily available, asset prices such as stocks and real estate are rising rapidly, people are in a good mood, and business leaders become increasingly cocky and hubristic. It is at this time that pursuing grandiose undertakings such as building massive, opulent new corporate headquarters or skyscrapers starts to appeal to business leaders. These leaders are often “bubble drunk” and forecast prosperity “as far as the eye can see.”

This complacent attitude can be seen in many indicators, including in the Multi-Asset Volatility Index that we posted in our RIA PRO subscription service (when volatility is low, investor complacency is high):

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The British historian and author C. Northcote Parkinson observed that organizations often build grandiose headquarters and other architectural projects at their very peak before they decline:

Parkinson calls in evidence a series of historical examples of architectural grandeur accompanying organizational/institutional decline. In the case of the Vatican, for example, ‘the great days of the papacy were over before the perfect setting was even planned. They were almost forgotten by the date of its completion.’ By 1933 the League of Nations was seen to have failed, and yet its ‘physical embodiment’, the Palace of Nations, was not opened until 1937. He argues that Louis XIV moved to Versailles in 1682, the year his career reached its apex, and thereafter, as the sumptuous Palace was gradually completed, so his power inexorably declined. Parkinson gives a number of British examples, including Blenheim Palace, Buckingham Palace, the Palace of Westminster and the Colonial Office, but identifies New Delhi, started in 1911, several years after the decline of British imperialism began (with the 1906 General Election), as a perfect example of his Law’s applicability.

Many famous record-breaking skyscrapers were planned and built in boom times right before a severe economic bust – this is known as the “Skyscraper Curse.” For example, the Singer Building and the Metropolitan Life Insurance Company Tower in New York were started before the Panic of 1907, the Chrysler Building was started in 1928 before the 1929 stock market crash and Great Depression, the World Trade Center and the Sears Tower were planned and built before the 1973 – 1974 stock market crash, Malaysia’s Petronas Twin Towers were completed in 1996 before the 1997 Asian financial crisis, and Dubai’s Burj Khalifa was started just a few years before the country experienced a serious real estate bust in 2008 and 2009.

I believe that Anders Holch Povlsen and his company Bestseller’s bizarre decision to build a skyscraper in a tiny town with just 7,000 residents (and Bestseller only has 1,500 employees in this town) is a byproduct of Denmark’s negative interest rates and the frothy environment that they are creating. Since 2012, Denmark has had negative interest rates and is the only country to have had such unusual monetary conditions for so long:

Because Denmark is one of the few remaining countries with a perfect AAA credit rating from Standard & Poor’s, investors have even pushed the country’s government bond yields into negative territory a few times in recent years. Denmark’s 10-year government bond currently yields just 0.017%, while the U.S. 10-year Treasury bond yields 2.48% – a dramatic difference.

When central banks like Denmark’s Nationalbank cut interest rates to ultra-low or negative levels, they create tremendous distortions, imbalances, misallocations, and malinvestments in the economy and financial markets. For example, ultra-low interest rates discourage saving (what’s the point when you actually lose money by keeping it in the bank?!), encourage borrowing, and encourage speculation in rising asset prices (Danish housing prices are up 50% since 2012, for example). Ultra-low and negative interest rates also encourage the construction of extremely speculative, grandiose projects like skyscrapers. In a world where there are few conventional investment opportunities left, speculation becomes much more appealing.

While Denmark has been the only country that has experienced negative interest rates for so long, global interest rates have been at 5,000 year lows for much of the past decade:

As a result of record low interest rates, the tremendous distortions, imbalances, misallocations, and malinvestments discussed earlier in reference to Denmark are occurring across the globe. This unprecedented monetary environment explains why stocks are soaring, corporations are borrowing heavily, scores of billion dollar startups are popping up out of nowhere, and the global billionaire population has doubled in the past five years alone. While it appears to be a boom on the surface, it is an extremely unhealthy and artificial situation that will end in the mother of all economic crises. So, even if you don’t live in, invest in, or have anything to do with Denmark, I am using this new skyscraper as an example of the kind of foolishness that is occurring globally. Thanks to globalization, we’re all tied into the same system – your investments, your job, and your way of life are all exposed to this global bubble.