Major Recession Alarm Sounds

This post Major Recession Alarm Sounds appeared first on Daily Reckoning.

Red, red, in every direction we turn today… red.

The Dow Jones shed 800 scarlet points on the day.

Percentage wise, both S&P and Nasdaq took similar whalings.

The S&P lost 86 points. And the Nasdaq… 242.

And so the market paid back all of yesterday’s trade-induced gains — with heaps of interest.

Worrying economic data drifting out of China and Germany were partly accountable.

Chinese industrial production growth has slackened to 4.8% year over year — its lowest rate since 2002.

And given China’s nearly infinite data-torturing capacities, we are confident the authentic number is lower yet.

Meantime, the economic engine of Europe has slipped into reverse. The latest German data revealed second-quarter GDP contracted 0.1%.

Combine the German and Chinese tales… and you partially explain today’s frights.

But today’s primary bugaboo is not China or Germany — or China and Germany.

Today’s primary bugaboo is rather our old friend the yield curve…

A telltale portion of the yield curve inverted this morning (details below).

An inverted yield curve is a nearly perfect fortune teller of recession.

An inverted yield curve has preceded recession on seven out of seven occasions 50 years running.

Only once did it yell wolf — in the mid-1960s.

An inverted yield curve has also foretold every major stock market calamity of the past 40 years.

Why is the inverted yield curve such a menace?

As we have reckoned prior:

The yield curve is simply the difference between short- and long-term interest rates.

Long-term rates normally run higher than short-term rates. It reflects the structure of time in a healthy market…

Longer-term bond yields should rise in anticipation of higher growth… higher inflation… higher animal spirits.

Inflation eats away at money tied up in bonds… as a moth eats away at a cardigan.

Bond investors therefore demand greater compensation to hold a [longer-term] Treasury over a [short-term] Treasury.

And the further out in the future, the greater the uncertainty. So investors demand to be compensated for taking the long view.

Compensated, that is, for laying off the sparrow at hand… in exchange for the promise of two in the distant bush.

But when short- and long-term yields begin to converge, it is a powerful indication the bond market expects lean times ahead…

When the long-term yield falls beneath the short-term yield, the yield curve is said to invert.

And in this sense time itself inverts.

Time trips all over itself, staggered and bewildered by a delirium of conflicting signals.

In the wild confusion future and past collide… run right past one another… and end up switching places.

Thus an inverted yield curve wrecks the market structure of time. It rewards pursuit of the bird at hand greater than two in the future.

That is, the short-term bondholder is compensated more than the long-term bondholder.

That is, the short-term bondholder is paid more to sacrifice less… and the long-term bondholder paid less to sacrifice more.

That is, something is dreadfully off.

It suggests an economic winter is coming…

We fretted and moaned recently that the 10-year Treasury and the 3-month Treasury inverted.

But many believe the 10-year versus 2-year sector of the yield curve is the one to watch.

Its recession-forecasting talents overmatch all others.

And now…

For the first instance since 2007, the 2-year Treasury note and the 10-year Treasury note have inverted.

That is, yields on the 10-year have dropped beneath yields on the 2-year.

Its significance is not “fake news,” as explains Justin Walters, co-director of research and investments at Bespoke Investment Group:

Given prior inversions of other curves… the fact that the 2-year note and the 10-year note has now inverted isn’t “fake news.” Inversions are not a good sign for the economic outlook, having preceded prior recessions with frightening regularity.

Bank of America Merrill Lynch strategists claim today’s inversion means “the equity market is on borrowed time.”

The question then becomes:

How much borrowed time?

But the question is easier asked than answered.

An inverted yield curve is not necessarily an immediate scourge.

History reveals the grim effects of an inverted yield curve may not manifest for 12–18 months — or longer.

Of course… they may also sting earlier. The hour and minute are truly on the knees of the gods.

But how badly might recession batter the stock market?

The BAML strategists ransacked the numbers.

They reveal the S&P often attains maximum height 7.3 months after a 2-year/10-year inversion — on average.

The S&P may therefore run higher through next March.

But once the inevitable recession comes hammering down…

Data indicate recession claims some 32% of the S&P’s value — again — on average.

Are you prepared for a 32% trouncing?

Would you like to know who is not?

The president.

The gale might blow straight through the 2020 presidential election.

Given how he pins his reelection on a roaring stock market… President Trump had better hope the recessionary forecast is false.

Below, Robert Kiyosaki shows you why it is more important to own gold — “God’s tears” — than ever. Read on.

Regards,

Brian Maher
Managing editor, The Daily Reckoning

The post Major Recession Alarm Sounds appeared first on Daily Reckoning.

China: Paper Tiger

This post China: Paper Tiger appeared first on Daily Reckoning.

China’s shock currency devaluation last week begs the following questions: Is China a rising giant of the twenty-first century poised to overtake the United States in wealth and military prowess? Or is it a house of cards preparing to implode?

Conventional wisdom espouses the former. Yet, hard evidence suggests the latter.

IMG 1

Your correspondent in the world famous Long Bar on the Bund in Shanghai, China. The Long Bar (about 50-yards long) was originally built in 1911 during the heyday of foreign imperialism in China just before the formation of the Republic of China (1912-1949). Bar regulars were divided into “tai-pans” (bosses who sat near the window), “Shanghailanders” (who sat in the middle), and “griffins” (newcomers who sat at the far end).

I made my first visits to Hong Kong and Taiwan in 1981 and my first visit to Communist China in 1991. I have made many visits to the mainland over the past twenty years and have been careful to move beyond Beijing (the political capital) and Shanghai (the financial capital) on these trips. My visits have included Chongqing, Wuhan, Xian, Nanjing, new construction sites to visit “ghost cities,” and trips to the agrarian countryside.

I spent five days cruising on the Yangtze River before the Three Gorges Dam was finished so I could appreciate the majesty and history of the gorges before the water level was lifted by the dam. I have visited numerous museums and tombs both excavated and unexcavated.

My trips included meetings with government and Communist Party officials and numerous conversations with everyday Chinese people, some of who just wanted to practice their English language skills on a foreign visitor.

In short, my experience with China goes well beyond media outlets and talking heads. In my extensive trips around the world, I have consistently found that first-hand visits and conversations provide insights that no amount of expert analysis can supply.

These trips have been supplemented by reading an extensive number of books on the history, culture and politics of China from 3,000 BC to the present. This background gives me a much broader perspective on current developments in China and a more acute analytical frame for interpretation.

An objective analysis of China must begin with its enormous strengths. China has the largest population in the world, about 1.4 billion people (although soon to be overtaken by India). China has the third largest territory in the world, 3.7 million square miles, that’s just slightly larger than the United States (3.6 million square miles), and only slightly behind Canada (3.8 million square miles).

China also has the fifth largest nuclear arsenal in the world with 280 nuclear warheads, about the same as the UK and France, but well behind Russia (6,490) and the U.S. (6,450). China is the largest gold producer in the world at about 500 metric tonnes per year.

China has the second largest economy in the world at $15.5 trillion in GDP, behind the U.S. with $21.4 trillion, and well ahead of number three Japan with $5.4 trillion. China’s foreign exchange reserves (including gold) are the largest in the world at $3.2 trillion (Hong Kong separately has $425 billion in additional reserves).

By way of contrast, the number two reserve holder, Japan, has only $1.3 trillion in reserves. By these diverse measures of population, territory, military strength and economic output, China is clearly a global super-power and the dominant presence in East Asia.

Yet, these blockbuster statistics hide as much as they reveal. China’s per capita income is only $11,000 per person compared to per capita income of $65,000 in the United States. Put differently, the U.S. is only 38% richer than China on a gross basis, but it is 500% richer than China on a per capita basis.

China’s military is growing stronger and more sophisticated, but it still bears no comparison to the U.S. military when it comes to aircraft carriers, nuclear warheads, submarines, fighter aircraft and strategic bombers.

Most importantly, at $11,000 per capita GDP, China is stuck squarely in the “middle income trap” as defined by development economists. The path from low income (about $5,000 per capita) to middle-income (about $10,000 per capita) is fairly straightforward and mostly involves reduced corruption, direct foreign investment and migration from the countryside to cities to purse assembly-style jobs.

The path from middle-income to high-income (about $20,000 per capita) is much more difficult and involves creation and deployment of high-technology and manufacture of high-value-added goods.

Among developing economies (excluding oil producers), only Taiwan, Hong Kong, Singapore and South Korea have successfully made this transition since World War II. All other developing economies in Latin America, Africa, South Asia and the Middle East including giants such as Brazil and Turkey remain stuck in the middle-income ranks.

China remains reliant on assembly-style jobs and has shown no promise of breaking into the high-income ranks.

In short, and despite enormous annual growth in the past twenty years, China remains fundamentally a poor country with limited ability to improve the well-being of its citizens much beyond what has already been achieved.

With this background and a flood of daily reporting on new developments, what do we see for China in the months and years ahead?

Right now, China is confronting social, economic and geopolitical pressures that are testing the legitimacy of the Communist Party leadership and may lead to an economic crisis of the first order in the not distant future.

In contrast to the positives on China listed above, consider the following negative factors:

Trade wars with the U.S. are escalating, not diminishing as I warned from the start in early 2018.

Trump’s recent imposition of 10% tariffs on the remaining $300 billion of Chinese imports not currently tariffed (in addition to existing tariffs on $200 billion of Chinese imports) will slow the Chinese economy even further.

China retaliated with a shock devaluation of the yuan below 7.00 to one dollar, a level that had previously been defended by the People’s Bank of China. Resorting to a currency war weapon to fight a trade war shows just how badly China is losing the trade war.

But, this currency war counterattack will not be successful because it will incite more capital outflows from China. The Chinese lost $1 trillion of hard currency reserves during the last round of capital flight (2014-2016) and will lose more now, despite tighter capital controls. The spike of bitcoin to $11,000 following the China devaluation is a symptom of Chinese people using bitcoin to avoid capital controls and get their money out of China.

The unrest in Hong Kong is another symptom of the weakening grip of the Chinese Communist Party on civil society. The unrest has spread from street demonstrations to a general strike and shutdown of the transportation system, including the cancellations of hundreds of flights.

This social unrest will grow until China is forced to invade Hong Kong with 30,000 Peoples’ Liberation Army troops now massed on the border. This will be the last nail in the coffin of the academic view of China as a good global citizen. That view was always false, but now even the academics are starting to understand what’s really going on.

International business is moving quickly to move supply chains from China to Vietnam and elsewhere in South Asia. Once those supply chains move, they will not come back to China for at least ten years if ever. These are permanent losses for the Chinese economy.

Of course, lurking behind all of this is the coming debt crisis in China. About 25% of China’s reported growth the past ten years has come from wasted infrastructure investment (think “ghost cities”) funded with unpayable debt. China’s economy is a Ponzi scheme like the Madoff Plan and that debt pyramid is set to collapse.

This cascade of negative news is taking its toll on Chinese stocks. This weakness began in late June 2019 when the summit meeting between U.S. President Trump and President Xi of China at the G20 Leaders meeting in Osaka, Japan failed to produce substantive progress on trade disputes.

Since then, the trade wars have gone from bad to worse and China’s economy has suffered accordingly. My expectation is that a trade war resolution in nowhere in sight and the trade war issues have been subsumed into a larger list of issues involving military and national security policy.

The new “Cold War” is here. Get used to it.

Regards,

Jim Rickards
for The Daily Reckoning

The post China: Paper Tiger appeared first on Daily Reckoning.

Why China’s a Paper Tiger

This post Why China’s a Paper Tiger appeared first on Daily Reckoning.

Markets are still digesting last week’s Chinese devaluation that sent the Dow crashing over 700 points last Monday.

And as everyone knows by now, the Trump administration labelled China a currency manipulator.

The ironic part of it is that China has been manipulating its currency to strengthen it against the dollar.

Here’s the dynamic you need to understand…

The Chinese yuan is softly pegged to the dollar. To maintain the soft peg, the People’s Bank of China (PBoC) sells dollars and buys yuan.

That props up the yuan. It’s basic supply and demand economics.

One of the primary reasons China tries to strengthen the yuan is to prevent capital flight out of the country. If the yuan depreciates too rapidly, massive amounts of Chinese money would look to flee abroad where it can get much higher returns.

After all, would you want to hold a rapidly deteriorating asset that constantly loses value? Or if you were a Chinese investor, would you try to convert your money into a currency that holds its value?

That’s the question Chinese investors have been facing.

A capital drain could devastate the Chinese economy, which badly needs the capital to remain in China to support its massive Ponzi schemes, ghost cities and overinvestment.

That’s why the PBoC has been trying to support the yuan, even though a cheaper yuan helps Chinese exports.

That’s the conundrum China faces. It wants a cheap yuan — but not too cheap.

I wouldn’t call last Monday’s devaluation  the sort of “max devaluation” I’ve warned my readers about before. That would have been a devaluation of 5% or more in a single day, and that’s not what happened last week. I would classify it as a “red line” devaluation.

The yuan temporarily broke through the 7.00:1 “red line” dollar peg. It has since returned to normalized levels.

It’s actually ironic that China is being labelled a currency manipulator, if manipulating your currency means cheapening it.

That’s because China was manipulating its currency to strengthen it against the dollar. And when the yuan/dollar exchange rate crossed the 7.00:1 “red line,” that meant China temporarily stopped manipulating its currency higher.

If China didn’t manipulate the yuan higher, it would depreciate even more against the dollar. And the exchange rate stabilized last week when China resumed the manipulation. In other words, when China strengthened the yuan.

Welcome to the currency wars! They take on a logic all their own. In many ways it’s a race to the bottom.

I explained it all years ago in my 2011 book Currency Wars.

As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. China’s case is complicated by its desires for both a strengthened and weakened yuan.

But the ultimate reality is that currency wars produce no winners, just continual devaluation until they are followed by trade wars. That’s exactly what has happened in the global economy over the past 10 years.

Currency wars and trade wars go hand in hand. Often they lead to actual shooting wars, as I have repeatedly pointed out.

Let’s hope the currency wars and trade wars don’t turn into shooting wars as they have in the past.

But below, I show you why China is more of a paper tiger than an actual one. Why do I say that? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post Why China’s a Paper Tiger appeared first on Daily Reckoning.

EXPOSED: Another Currency Manipulator!

This post EXPOSED: Another Currency Manipulator! appeared first on Daily Reckoning.

Currency manipulator!

Today we point an indignant and accusing finger at the latest currency manipulator.

Let all proper authorities take notice.

The accused is not China — incidentally.

But we cannot proceed without first noting another manipulated market…

The stock market presented a distressed scene this morning.

Plunging bond yields are the explanation widely on offer (falling yields reflect a poor economic outlook).

Yields on the 10-year Treasury slipped to 1.595% this morning — lowest since autumn 2016.

The Dow Jones was down 589 points before an invisible hand intervened, stabilized the bond market… and redirected the stock market.

The index nonetheless lost 22 points on the day.

Both S&P and Nasdaq gained on the day.

Meantime, gold spins into delirium — gaining another $25 today — to $1,509.50.

But now that the administration has hung a “currency manipulator” sign from China’s neck… we are duty-bound to expose the latest currency manipulators.

Our spies have marshalled the evidence. It is circumstantial evidence, we freely concede.

It is nonetheless damning — more than sufficient to empanel a grand jury.

Who are these latest currency swindlers?

Here we refer to the dastardly Swiss.

The Swiss are currency manipulators.

Our spies inform us…

That Swiss sight deposits — bank deposits that can be withdrawn immediately without notice — surged 1.6 billion francs in the week ending Aug. 2.

This anomaly follows a 1.7 billion increase one week prior.

Add one to the other and the conclusion is clear: The Swiss National Bank (SNB) has been monkeying in the currency markets.

It has been printing francs to purchase euros. Why?

To cheapen the franc… to advantage their exports… and to lift their tourism industry.

Evidence suggests Swiss manufacturing has already sunk into recession.

And the European Central Bank (ECB) is preparing to reopen the monetary faucets in September. The ensuing flow would depress the euro.

In comparison, the Swiss franc would tower high as the Matterhorn.

It is already at its highest peak since June 2017.

And so the Swiss authorities are purchasing euros — on the quiet — to cushion the blow.

That is the case we argue today.

Here we introduce our first witness, Credit Suisse economist Maxime Botteron:

I think the SNB was intervening in the market last week — this was the biggest weekly increase in sight deposits since May 2017. This is a clear sign the SNB was active in the market.

Witness No. 2 presently enters the witness stand, a certain Thomas Stucki.

Let the record indicate Mr. Stucki is former manager of the SNB’s foreign currency reserves:

When the ECB statement was published at 1.45 p.m. last Thursday the euro lost value against the dollar, but not against the franc… Any move by the SNB to buy euros with newly created francs would bolster the single currency [euro]. It is possible that the SNB is behind this development.

It is likewise possible that night will follow day… that a dropped apple will plunge groundward… that a senator of the United States will disgrace his office.

In conclusion we summon the testimony of Mr. Karsten Junius, chief economist at J. Safra Sarasin:

“The SNB are definitely in the market.”

The prosecution rests. The Swiss are currency manipulators.

And we consider the case jolly well closed.

When will the roars of protest come issuing from Brussels?

But let us now switch lawyerly roles… and leap to the defense of a currency manipulator wrongly accused:

China.

The recent charges against China are not only false. They are precisely, exactly, 180 degrees false.

That is, China has been labelled a currency manipulator not because it has manipulated its currency.

China has been labelled a currency manipulator… because it temporarily ceased manipulating its currency.

Here is the dynamic in operation…

China pegs its yuan softly to the dollar. But the dollar packs vastly more muscle than the yuan.

In order to maintain its peg, China manipulates the yuan higher — not lower.

That is, the People’s Bank of China buys yuan… and sells dollars.

And since last April alone, the yuan has appreciated 10% against the dollar.

A 7:1 exchange ratio is widely considered the “line in the sand.”

But this past Monday China temporarily let go of the yuan… and let it slip to 6.97 (the yuan presently trades at 7.06 per dollar).

The United States subsequently labelled China a currency manipulator — for failing to manipulate its currency.

Ponder the loveliness, the blinding brilliance… the staggering beauty of the charge.

Could Mr. George Orwell have improved upon it?

We can identify another term for currency manipulation.

It is a euphemism… designed to take much of the curse off “currency manipulation.”

That term is monetary policy.

The Federal Reserve runs its own.

And it has destroyed 96% of the dollar’s value since 1913…

Regards,

Brian Maher
Managing Editor, The Daily Reckoning

The post EXPOSED: Another Currency Manipulator! appeared first on Daily Reckoning.

The Swiss Battle to Cheapen the Franc

This post The Swiss Battle to Cheapen the Franc appeared first on Daily Reckoning.

One of the crucial insights in currency trading that many investors fail to grasp is that currencies don’t go to zero, and they don’t go through the roof. That’s a generalization, but an important one. Here are the qualifications:

This observation applies to major currencies only — not to currencies of corrupt or incompetent countries like Venezuela or Zimbabwe. Those currencies do go to zero through hyperinflation.

The observation also applies only in the short-to-intermediate run. In the long run, all fiat currencies also go to zero.

Yet over a multiyear horizon, major currencies such as the dollar (USD), euro (EUR), yen (JPY), sterling (GBP) and the Swiss franc (CHF) retain value and do not go to extremes. Instead, they trade in ranges against each other. That’s the key to successful foreign exchange trading. Trading profits are the result of catching the turning points.

Jim Rickards

Your correspondent in Zurich, Switzerland, during a recent visit. In analyzing the complex dynamics of foreign exchange markets, it is essential to visit the countries whose currencies are being studied. Foreign visits offer the opportunity to meet with government officials, bankers, business executives and everyday citizens of the affected countries to gain insights that are not available through digital and media sources.

Stocks can go to zero when a company goes bankrupt. Enron, WorldCom and a host of dot-com stocks in the early 2000s are all good examples. Bonds can go to zero when a borrower defaults. That happened to Lehman Bros. and Bear Stearns.

But major currencies do not go to zero. They move back and forth against each other like two kids on a seesaw moving up and down and not going anywhere in relation to the seesaw.

The EUR/USD cross-rate is a good example. In the past 20 years, the value of the euro has been as low as $0.80 and as high as $1.60. There have been seven separate instances of moves of 20% or more in EUR/USD in that time period. But EUR/USD never goes to zero or to $100. The exchange rate stays in the range.

Turning points in foreign exchange rates are driven by a combination of central bank interventions, interest rate policies and capital flows. The old theories about “purchasing power parity” and trade deficits are obsolete.

Foreign exchange trading today is all about capital flows driven by policy intervention, sentiment and interest rate differentials.

Another good example is the Swiss franc (CHF). If you look at its exchange rate with the dollar, an exchange rate of 0.80 francs per dollar indicates a strong franc. An exchange rate of 1.05 francs per dollar indicates a weak franc. Right now the exchange rate is 0.97, which leans towards a weak franc relative to the dollar.

CHF has traded in a range of 0.87–1.03 for the past six years. One move that stands out is the spike on Jan. 15, 2015, when CHF surged from 1.02 to 0.86, a nearly 20% move in a matter of hours. CHF then backed off that high of 0.86 and declined to its more recent trading range of 0.91–1.03.

The spike on Jan. 15, 2015, was caused entirely by the decision of the Swiss National Bank (SNB) to remove a cap on the Swiss franc relative to the euro intended to protect Swiss exports.

The Swiss economy is heavily dependent on exports of precision equipment, luxury goods such as Swiss watches and food including cheeses and chocolates. The Swiss economy also depends on tourism, which is akin to a service export sold to foreigners. All of these exports suffer when the Swiss franc is too strong.

The SNB has been enforcing the cap by printing francs and buying euros to put downward pressure on the franc. The problem with this policy is that the world wants francs as a safe haven.

That was especially true during the European sovereign debt crisis of 2010–2015. The SNB balance sheet was becoming top-heavy with European debt purchased with printed francs at a time when the European debt itself was in distress.

Eventually, SNB threw in the towel and allowed market forces to determine the value of CHF. This produced an immediate spike in CHF against the euro and the dollar, which has since moderated into a trading range.

But the franc is currently at the 1.09 level versus the euro, on expectations of monetary easing in both the euro zone and the United States have set in.

So the SNB has been buying euros in an attempt to get out ahead of the curve. It’s trying to cheapen the franc to keep its exports and tourism industry competitive. You see evidence for this in its so-called sight accounts. Sight account can be transferred to another account or converted into cash without restriction.

There has been a recent surge in these accounts lately, which indicates the SNB has been actively intervening in the currency markets.

With rising market uncertainty and hot money in search of safe havens, what does the future hold for the Swiss franc?

The single most important factor in the analysis is that hot-money safe-harbor inflows are clashing with the SNB’s cheaper franc policy.

The demand for Swiss francs will be driven by the lack of palatable alternatives. Investors are increasingly concerned about sterling because of conditions imposed by the EU, Ireland and others in the Brexit process. Brexit is irreversible, but satisfying all of the demands of interested parties to achieve Brexit will weaken the U.K. economy and sterling.

Likewise, the dollar and yen are both the cause of investor concern because of out-of-control debts. The Japanese debt-to-GDP ratio is over 250% and the U.S. debt-to-GDP ratio will soon be 110%. Any ratio higher than 90% is considered a danger zone by economists.

Almost all Japanese government debt is owned by the Japanese people, so there’s a higher threshold for panic in Japan than in the U.S. The U.S. debt is about 17% owned by foreign investors who could choose to dump it at any moment. Still, both Japan and the U.S. are on unsustainable paths and have shown no willingness to tackle their debt problems or reduce their debt-to-GDP ratios.

The euro offers better debt-to-GDP ratios than Japan or the U.S. in the aggregate. However, the European Central Bank is getting ready to pursue more quantitative easing and near-negative interest rate policies. The euro is also plagued by lingering doubts about the individual debt situations in Greece and Italy, a legacy of the 2010–2015 European debt crisis.

Meanwhile, the Swiss debt-to-GDP ratio is about 30%. In fact, Keynesians complain that its debt levels are far too low!

Russian rubles and Chinese yuan are unattractive for major global capital allocators because their markets lack liquidity and they do not have satisfactory rule-of-law regimes behind their currencies.

With dollars, yen, sterling, the euro and emerging-market currencies all unattractive for different reasons, the primary safe havens for global investors are Swiss francs, gold, silver and some of the smaller currencies such as Australian or Canadian dollars.

Many investors won’t allocate to gold because of investment restrictions or simple bias. This leaves the Swiss franc first in line to absorb huge global capital flows looking for a home.

The SNB may keep trying to knock down the Swiss franc by buying stocks, bonds, euros and anything else that’s not nailed down, but in the end it won’t be enough. Global capital will continue buying francs for lack of a better alternative.

Eventually the SNB will once again throw in the towel as they did in 2015 and allow the franc to appreciate sharply.

Having a strong currency is desirable. But in today’s world outside of a gold standard, having too strong a currency can actually be a curse.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Swiss Battle to Cheapen the Franc appeared first on Daily Reckoning.

RIP: Fiscal Responsibility

This post RIP: Fiscal Responsibility appeared first on Daily Reckoning.

Republicans and Democrats have stowed their axes, sunk their differences… and agreed to raise the debt ceiling.

The government will remain in funds for the next two years — beyond the 2020 election, not coincidentally.

The Wall Street Journal reads the truce terms:

Congressional and White House negotiators reached a deal to increase federal spending and raise the government’s borrowing limit, securing a bipartisan compromise to avoid a looming fiscal crisis and pushing the next budget debate past the 2020 election.

The deal for more than $2.7 trillion in spending over two years… would suspend the debt ceiling until the end of July 2021. It also raises spending by nearly $50 billion next fiscal year above current levels.

Failing a deal, the Capitol lights would have winked out Oct. 1. And the federal government would have slammed its door on the noses of the American people.

Chaos and Old Night would have descended upon these shores…

A Rain of Horrors

The ranger at Glacier National Park would have been thrown into idleness…

The Federal Theatre Project would have been thrown into darkness…

And the bright-eyed sixth-grader from Duluth would have been thrown from the Smithsonian.

The last government shutdown (December 2018–January 2019), stretched 35 impossible days.

How we endured those black, unlit times… we cannot recall.

Yet our representatives at Washington have spared the grateful nation a sequel.

Absent a deal…

They would have been required to hatchet spending $120 billion flat, all around.

The arrangement instead raises spending caps some $50 billion this year… and another $54 billion the next.

Both Sides Claim Victory

The president declared the deal “a real compromise in order to give another big victory to our Great Military and Vets!”

With straight faces Nancy Pelosi and Chuck Schumer announced:

With this agreement, we strive to avoid another government shutdown, which is so harmful to meeting the needs of the American people and honoring the work of our public employees.

Democratic Sen. Patrick Leahy gushed the agreement will “stave off economic catastrophe.”

It will furthermore reverse “unsustainable cuts in nondefense discretionary spending.”

Just so.

The Real Meaning of Bipartisanship

The late Joe Sobran labeled Democrats “the evil party.” Republicans were “the stupid party.”

Thus he concluded that “bipartisanship” yields outcomes both evil and stupid.

Perhaps Sobran hooked into something…

Under the deal Republicans get their guns. Democrats get their butter.

And the taxpayer gets the bill.

He pays now through higher taxes — or later through higher interest payments on the debt.

But pay he will.

And so fiscal responsibility lies dead beyond all hope of recall.

“No!”

We expect Democrats to spent grandly and gorgeously.

Since FDR it has read the identical electoral blueprint.

But Republicans traditionally existed for two purposes: to lower taxes — and to square the books.

You wished to spend money you did not have? And throw open the Treasury to the public?

“No!” was the answer you could expect.

Like a sour old schoolmarm with steel in her eye and a rattan in her hand… they might not have been popular.

But you knew where they were. And you could trust them with the checkbook.

But these Republicans are no more.

They have gone the route of fedoras, monocles and spats.

What Happened to the Old-time Religion?

They turned away from their old-time fiscal religion, made their peace with Big Government… and got elected.

They labelled the old religion “root canal economics.”

Republicans instead sat at the feet of Mr. Arthur Laffer, with his famous curve.

They could spend like Democrats without touching the taxpayer.

Deficits do not matter in the new catechism.

Only a few Republican holdouts remain… to keep the tablets.

Reports the Journal:

Fiscal hawks panned reports of the proposed deal Monday before many of the details had been released, warning it could add trillions of dollars more to projected government debt levels over the next decade. 

But they sob in vain…

Drowning in Debt

United States public debt excels $22.4 trillion… and swells by the day, by the month, by the year.

Federal debt presently rises three times the rate of revenue coming in.

To simply maintain current debt levels, CBO estimates Congress would have to increase revenues 11% each year… while simultaneously hatcheting the budget 10%.

Will Congress spend 10% less each year?

We have just received our answer.

For the long-term consequences we turn to the Brookings Institute:

Sustained federal deficits and rising federal debt, used to finance consumption or transfer payments, will crowd out future investment; reduce prospects for economic growth; make it more difficult to conduct routine policy, address major new priorities, or deal with the next recession or emergencies; and impose substantial burdens on future generations.

Deficits to the Horizon

Meantime, the present economic expansion is officially the longest on record.

Can the economy peg along another decade without a recession? Or even half so long?

We already detect smoke rising from the engine, and oil leaking out below.

Trillion-dollar deficits are already in sight.

In the certain event of recession, authorities will flood the economy with money borrowed from the future — deficit spending.

Deficits could double… or possibly triple.

What a Surprise

The only surprise about this debt ceiling deal?

That anyone could be surprised by this debt ceiling deal.

Republicans and Democrats might stage a splendid combat for the crowd. They batten upon each other with savage and vicious blows.

Mr. Trump’s gladiatorial presence makes the show grand beyond comparison.

But watch closer…

The combatants do not strike at the vitals. And the blood is fake.

When it comes to borrowing and spending… Republicans and Democrats are as united as any lovers could hope to be.

Threaten to cut them off.

Then watch the warfare immediately halt… and the hands of peace come extending from both sides.

This we have just witnessed. The debt ceiling is raised.

And so today we drop a mournful tear on the ashes of fiscal responsibility.

As we have noted before, Republicans once defended the approaches to the United States Treasury.

But they have since sold the pass.

And both parties have sold us all down a river…

Regards,

Brian Maher
Managing editor, The Daily Reckoning

The post RIP: Fiscal Responsibility appeared first on Daily Reckoning.

Expect Buybacks to Sustain Markets

This post Expect Buybacks to Sustain Markets appeared first on Daily Reckoning.

With uncertainty swirling around the financial markets right now, many are warning about a financial storm brewing and how to navigate through it.

Let’s consider the storm elements in the world right now. The ongoing trade war is obviously a major concern, which is nowhere near being resolved. Growth is slowing in many parts of the world and central banks are preparing to begin cutting rates again.

Geopolitical tensions are also rising again, especially in the Persian Gulf. Late last week, Iranian forces seized a British-flagged tanker in the Strait of Hormuz, one of the world’s most important chokepoints. Britain has demanded the ship’s release.

On the U.S. domestic front, we are facing government dysfunctional, trade war uncertainty and a looming debt ceiling deadline. A deal will likely be reached, but that is not a guarantee. If a deal isn’t reached, the federal government would run out of money to pay its bills.

That’s why you should consider the tactics of Warren Buffett along with the strategy used by some of the most skilled sailors.

Buffett, one of the most successful investors in history, has made billions by knowing how to steer through storms. One of my favorite Buffettisms has to do with keeping your eye on the horizon, a steady-as-she-goes approach to investing. It also happens to relate to sailing.

As he famously said, “I don’t look to jump over seven-foot bars; I look around for one-foot bars that I can step over.”

What that means is that you should carefully consider what’s ahead and choose your course accordingly. Buffett doesn’t strive to be a hero if the risk of failing, or crashing against the rocks (in sailing lingo), is too great.

In a storm, there are two possible strategies to take. The first one is to ride through it. The second is to avoid it or head for more space in the open ocean. In other words, fold down your sails and wait it out until you have a better opportunity to push ahead.

While there is no perfect maneuver for getting through a storm, staying levelheaded is key.

We are at the beginning of another corporate earnings season, which is the period each quarter when companies report on how well (or poorly) they did in the prior quarter.

The reports can lag the overall environment but still give insight on how a company will be positioned in the new quarter. But to get the most out of them requires the right navigation techniques.

This season’s corporate earnings results have been mostly positive so far. But what you should know is that Wall Street analysts always tend to downplay their expectations of corporate earnings going into reporting periods. That because corporations downplay them to analysts. It’s Wall Street’s way of gaming the system.

When I was a managing director at Goldman Sachs, senior members of the firm would gather together each quarter with the chairman and CEO of the firm, Hank Paulson, who went on to become the Treasury secretary of the United States under President George W. Bush.

He would talk with us about the overall state of the firm, and then the earnings figures would be discussed by the chief financial officer.

This would be just before our results were publicly disclosed to the markets. There was always internal competition amongst the big investment banks as to what language was being provided to external analysts about earnings and how the results ultimately compared with that language.

You couldn’t be too far off between “managing expectations” of the market and results of the earnings statements. However, there was a large gray area in between that was exploited each quarter.

When I was there, it was very important for Goldman to have better results than immediate competitors at the time like Morgan Stanley, Merrill Lynch or Lehman Bros.

It was crucial to “beat” analysts’ expectations. That provided the greatest chance of the share price rallying after earnings were released.

The bulk of our Wall Street compensation was paid in annual bonuses, not salaries. These bonuses were in turn paid out in options linked to share prices. That’s why having prices rise after fourth-quarter earnings was especially important in shaping the year’s final bonus numbers.

Here’s what that experience taught me: There’s always a game when it comes to earnings.

Investors that don’t know this tend to get earnings season all wrong. However, successful investors that take forecasts with a grain of salt will do better.

Years later, I realized this was also Warren Buffett’s approach to analyzing earnings. As he has told CNBC, “I like to get those quarterly reports. I do not like guidance. I think the guidance leads to a lot of bad things, and I’ve seen it lead to a lot of bad things.”

We’ll have to see how earnings season turns out. But good or bad, markets are finding support from the same phenomenon that powered them to record heights last year: stock buybacks.

Of course, years of quantitative easing (QE) created many of the conditions that made buybacks such powerful market mechanisms. Buybacks work to drive stock prices higher. Companies could borrow money and buy their own stocks on the cheap, increasing the size of corporate debt and the level of the stock market to record highs. Corporations actually account for the greatest demand for stocks..

And a J.P. Morgan study concludes that the stock prices of U.S. and European corporations that engage in high amounts of buybacks have outperformed other stocks by 4% over the past 25 years.

Last year established a record for buybacks. While they will probably not match the same figure this year, buybacks are still a major force driving markets higher.

And amidst escalating trade wars and all the other concerns facing today’s markets, executing buybacks makes the most sense for the companies that have the cash to engage in them. If companies are concerned about growth slow downs in the future, there is good reason to use their excess cash for buybacks.

What this means is that the companies with money for buybacks have good reason to double down.

As a Reuters article has noted, “the escalating trade war between the United States and China may prompt U.S. companies to shift money they had earmarked for capital expenditures into stock buybacks instead, pushing record levels of corporate share repurchases even higher.”

So buybacks could prop up the market through volatile periods ahead and drive the current bull market even further.

Of course, buybacks also represent a problem. They boost a stock in the short term, yes. But that higher stock price in the short may come at the expense of the long run. It’s a short-term strategy.

That’s because companies are not using their cash for expansion, for R&D, or to pay workers more, which would generate more buying power in the overall economy. Buybacks are not connected to organic growth and are detached from the foundation of any economy.

But buybacks could keep the ball rolling a while longer. And I expect they will. One day it’ll come to an end. But not just yet.

Regards,

Nomi Prins
for The Daily Reckoning

The post Expect Buybacks to Sustain Markets appeared first on Daily Reckoning.

Why Powell Might NOT Cut Rates

This post Why Powell Might NOT Cut Rates appeared first on Daily Reckoning.

The market’s been bouncing around lately, anxiously waiting to see it the Fed cuts interest rates next week. All indications now suggest that it will. The question is by how much?

Minutes from June’s Federal Open Market Committee (FOMC) meeting that were released earlier this month indicated support for a rate cut. Certain committee officials noted that as long as uncertainty still weighed on its outlook, they would be willing to cut rates.

And during his much-awaited biannual testimony before the House Financial Services Committee, Federal Reserve Chairman Jerome Powell hinted — strongly — that a rate cut was around the corner.

Powell told the committee, “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook. Inflation pressures remain muted.”

But the subsequent release of better-than-expected June employment figures complicated the matter of rate cut size and timing.

They raised the possibility that those positive jobs numbers would keep the Fed from cutting rates. After all, it doesn’t make a lot of sense to cut interest rates when the job market is so hot and unemployment is at 50-year lows.

But despite that concern, markets are still placing the odds of a rate cut of 25 basis points at 100%, with lower expectations for a 50 basis point cut.

This means a rate cut is already “baked into the cake.” However, the risk is that if Jerome Powell and the FOMC don’t cut rates next week, it could cause a sharp sell-off.

We’ll have our answer next week. But despite the overwhelming market expectations for a rate cut, I think there’s a chance the Fed won’t cut rates yet. That’s because Powell may still want to signal the Fed’s ability to act independently from White House pressure.

I realize that puts me in the extreme minority. But that’s OK, it certainly isn’t the first time.

But there’s something else going on right now that could trip up markets.

Earnings season is underway. Over the next few weeks, all of the S&P 500 companies will be rolling out their earnings figures. And more than a quarter of them will report earnings this week.

Firms from Google’s parent company, Alphabet, to Amazon, McDonald’s and Boeing are among the more than 130 companies that are reporting.

Even with a rate cut, poor corporate earnings could spell trouble for stocks. The trade war would be partly responsible. Certainly, there remains no resolution on the U.S.-China trade war front. And the trade war combined with slowing growth could amplify the effects of weak earnings.

As one article reports, “Stocks could struggle if the earnings message from corporate America focuses on the murky outlook for the economy and negative impacts from the trade wars.”

Earnings so far have been positive, but that can be misleading. That’s because second-quarter earnings expectations were kept low so that corporations could easily beat them.

Their actual earnings may not be underwhelming. But if they beat expectations, that’s all that counts.

And as I learned on Wall Street, corporations often talk down their earnings estimates in order to set a low bar. That way they can easily beat the forecast, which produces a jump in the stock price.

As Ed Keon, chief investment strategist at QMA explains:

No matter what the economic circumstances are, no matter what the backdrop is, there’s this dynamic that companies like to lowball and analysts like to give them headroom. The fact that numbers are coming in better than expected — it’s been the case for decades now.

Of the 114 companies that provided second-quarter guidance as of last week, 77% released negative forecasts, according to FactSet.

But it’s still early and there’s a long way to go.

Most industrial companies haven’t reported earnings yet. And they could reveal extensive damage from the trade war. As CFRA investment strategist Lindsey Bell says:

As we get more industrials in the next couple of weeks, I think that will create more volatility and drive the market lower in the near term… Chemicals and metals are two areas where I expect pressure.

We’ll see. But if markets do stumble, you can expect the Fed will be ready to cut rates at its meeting in September. That means more “dark money” will be coming to support markets, even if the Fed doesn’t cut rates next week.

And that’ll keep the bull market going for a while longer. One day the music will end. The imbalances in the system are just too great.

But we’re not at that point yet, and you can expect markets to rise on additional dark money injections.

Enjoy it while you can.

Below, I show you one major factor that will continue to support stocks this year. It doesn’t have to do with the trade war or earnings. What is it? Read on.

Regards,

Nomi Prins
for The Daily Reckoning

The post Why Powell Might NOT Cut Rates appeared first on Daily Reckoning.

Free-Riding Investors Set up Markets for a Major Collapse

This post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.

Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.

A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on.

Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.

A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example.

Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.

The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account.

Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved.

Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.

Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system?

Nothing. They just sit there like parasites and collect the benefits while offering nothing in return.

Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.

Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors.

An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets.

The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.

The benefits of passive investing have been trumpeted by the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged investors to buy and hold passive funds and ignore market ups and downs.

The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.

In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors.

Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.

What happens when the passive investors outnumber the active investors? The elephant starts to die.

Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $2.0 trillion has been withdrawn from active-strategy funds.

The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.

There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.

If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.

Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.

Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.

Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.

The elephant will die.

Regards,

Jim Rickards
for The Daily Reckoning

The post Free-Riding Investors Set up Markets for a Major Collapse appeared first on Daily Reckoning.

Robot Trading Will End in Disaster

This post Robot Trading Will End in Disaster appeared first on Daily Reckoning.

Today, stock markets and other markets such as bonds and currencies can best be described as “automated automation.” Here’s what I mean.

There are two stages in stock investing. The first is coming up with a preferred allocation among stocks, cash, bonds, etc. This stage also includes deciding how much to put in index products or exchange-traded funds (ETFs, which are a kind of mini-index) and how much active management to use.

The second stage involves the actual buy and sell decisions — when to get out, when to get in and when to go to the sidelines with safe-haven assets such as Treasury notes or gold.

What investors may not realize is the extent to which both of these decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s.

I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm.

Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market. Although even active investors receive automated execution.

In all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is the idea that “You can’t beat the market.” This drives investors to index funds that match the market. The truth is you can beat the market with good models, but it’s not easy.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well.

But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000 and 2008 — just before your retirement date will wipe you out.

But this is an even greater threat that’s rarely considered…

In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.

Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife.

Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes.

It comes back to complexity, and the market is an example of a complex system.

One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more.

This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.

Welcome to the world of automated investing. It will end in disaster.

Regards,

Jim Rickards
for The Daily Reckoning

The post Robot Trading Will End in Disaster appeared first on Daily Reckoning.