May 17, 2019
By Steve Blumenthal
“The only outcomes are an orderly restructure or unorderly restructure [of the debts].”
– William White
Former Chief Economist of the Bank for International Settlements
The Bank for International Settlements (BIS) is known as the central banker’s banker. “Orderly or unorderly?” William White joined the BIS in 1994 and served as Economic Adviser and Head of the Monetary and Economic Department. He is famous for bringing attention to the wild behavior in the debt markets before the global storm hit in 2008. He is not bullish on our current global debt situation. Today’s problem is bigger.
The 2019 Strategic Investment Conference concluded yesterday and, once again, it didn’t disappoint. Over the next number of weeks I’ll be sharing my high level notes with you. A fast paced, cut-to-the-chase, get to the bottom line summary that will conclude with what investors should do as I try to tie it all together. You will find ideas each week and we’ll start today with Dr. Lacy Hunt’s presentation, one of the most successful mutual fund managers of all time. But before we dive in, I would like to give you a sense of the conference. Liz Ann Sonders, David Rosenberg, William White, Dr. Lacy Hunt, Louis-Vincent Gave, Kyle Bass, Felix Zulauf, Woody Brock, Mark Yusko, Carmen Reinhart, Howard Marks, Peter Boockvar, Lakshman Achuthan and more took the stage.
Six hundred savvy investors from around the world filled the conference ballroom. Twenty-six traveled all the way from Australia — a testament to John Mauldin’s global following. I think Grant Williams’ presentation has them rethinking the Australian real estate market and wondering if shorting Aussie banks might be a good play. It was great to see good friend Enrique Flynn from Uruguay. A mere 26-hour flight. Attendees included Fed economists, bankers, pension managers, family offices, consultants, advisors and individuals.
What is unique about the conference is how Mauldin and his team organized the sessions. The presenter shares his/her views and is later paired with a peer on stage. Imagine a debate between William White and Dr. Lacy Hunt or Kyle Bass, Louis Gave, Simon Hunt and Feliz Zulauf talking China, trade wars and future opportunities. Zulauf is brilliant, by the way. I really enjoyed his comments and analysis.
And it is not just the presenters’ content. What I find equally fascinating is that Rosenberg, Hunt, Zulauf and other speakers are eager attendees. They stick around to listen to what their peers have to say. They attend to learn, to reflect and test conviction. Pretty great… That just doesn’t happen at other conferences.
Financial Advisor magazine wrote, “A U.S. recession will occur within the next 12 months thanks to the Federal Reserve Board’s decision to ‘overtighten’ the funds rate by 75 to 100 basis points over the last 15 months, David Rosenberg, Chief Market Strategist at Gluskin Sheff + Associates, told attendees at John Mauldin’s Strategic Investment Conference in Dallas on Tuesday. He added that this recent Fed blunder would have severe consequences. ‘There will be a price to be paid for this,’ Rosenberg said. The former chief North American economist for Merrill Lynch, who predicted the financial crisis in 2007, was highly critical of Fed Chairman Jay Powell.”
Resolving the debt mess, recession, U.S./China trade were key issues, of course, but interesting as well were the panels on aging with Dr. Mike Roizen, Patrick Cox and Jim Mellon and the panel on real estate. Good friend, Barry Habib, discussed real estate with John Burns and Joe Anthony. More than a few ideas were shared and I’ll share them with you in the weeks to come. If you are interested, Mauldin Economics is offering you access to video replay along with the presentation decks for a fee. You can find information here. (Please know I do not get compensated in any way. I do hope to get you video replay and presentation I hosted with Peter Boockvar and Lakshman Achuthan.)
The next few weeks are going to be fun. My head is still spinning. Buckle up, there is so much to cover. Today, let’s begin with Lacy Hunt. In four to six weeks (I really need to figure out how to pull all of the content together), we’ll conclude with a summary of key findings and I’ll do my best to share my thinking with you in terms of actionable ideas and game plan.
Grab a coffee and find your favorite chair. My bullet point summary notes on Lacy Hunt’s presentation begins a four to six week OMR series. He dives deep. I do my best to try to hit the high notes and get to the bottom line in terms of what it means to you. Hint: he sees interest rates going lower with the Fed Funds rate going back to zero. The long-term bull market in bonds remains in place.
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Included in this week’s On My Radar:
- Mauldin SIC 2019: Dr. Lacy Hunt
- Trade Signals – Despite Geopolitical Risks, Equity and Fixed Income Signals Stay Bullish
- Personal Note – It’s Good to be the King
Mauldin SIC 2019: Dr. Lacy Hunt
Notes and Charts:
Confirmation of the downturn has been recognized by the Fed and the major central banks. Lacy believes two interest rate theorems explain why events have unfolded as they have and also serve as a guide to where we are going in the future.
Two Interest Rate Theorems
To answer the question as to why and where we are going in the future (in terms of interest rates):
- Federal debt accelerations ultimately lead to lower, not higher, interest rates.
- Monetary decelerations eventually lead to lower, not higher, interest rates as originally theorized by Milton Friedman.
Here is the chart he shared – it is worth reading his text…
Federal Debt Accelerations Lead to Lower Interest Rates: Debt goes UP, interest rates go DOWN
As the debt levels move higher and higher, the actual downward pressure on interest rates accelerates because of the draining effects of the increased over-indebtedness.
As a proof statement, Lacy highlighted four important case studies (these are the four most important studies – there are others). The point is, they all show, when government debt goes up, interest rates go down (see US, Japan, EU and UK).
The next slide looks at The Circular Flow of the Macro Economy
- What we spend (consumption, investing and government spending), equals what we earn (household income and corporate income), equals what we produce…
If you accept the iron-clad assumption of how the circular flow of money works, then what he is saying is that someone has to step away from the dinner table and begin to save. Lacy doesn’t see that happening. What Lacy is ultimately saying is rates will continue their long-term trend lower.
Savings and Budget Deficits
Lacy said he has never shown the next chart before. Adding, there are certain things in economics that “hold true.” This is one of the most important charts in economics:
- The green line shows the national savings rate. It is currently at 3%. It is historically 6%. We are running half of normal. The shaded area shows the private sector, which is running at 9%. That’s pretty good. The red line shows the government sector and it is running at -6% and dragging down national savings. That is where the problem lies.
- But it is not going to stay there – the government deficit is moving even lower into negative territory.
- The government deficit will continue to grow. Tax cuts and the bipartisan agreed-upon increase in spending do not lead to deficit reduction.
- Bottom line: What it says is there is an insufficiency of savings to absorb ever-larger budget deficits. National savings is not staying at 3%, it is going to decline. Real investment is going to decline. It is possible the private sector will save more but that means there will be less consumption.
- In other words, the public sector is going to constrain the private sector and the economy. (SB: Debt acts as a noose around the economy’s neck.)… and guess which sector provides the basis for better growth, the private sector or the public sector?
- In other words, the government sector’s budget deficits are too large for the level of savings.
Given the political structure of our country, it is unlikely the situation will change. Lacy added, “impossible.”
Bottom line: We simply have an insufficiency of savings and it cannot be corrected.
The Production Function – it is dependent upon technology and the three factors of production: land, labor and capital.
- The production function states that if you overuse one of the three factors of production, output will initially rise and will then flatten out and then turn down.
- In other words, there is a non-linear relationship between debt and economic activity.
- The simple-minded solution that if a $3 trillion program doesn’t work you try a $6 trillion program… that doesn’t work when diminishing returns takes effect.
- The evidence here is increasingly dire.
Latest Evidence of Diminishing Returns:
- The good news. If you want to call it that, is the US is the best in town.
- Meaning we are not as far along the diminishing returns path as the rest of the world.
Irving Fisher (1934), in perhaps his most important piece said, “When economies are highly indebted, economies slow.” He never went on to prove his statement… Lacy proved it for us by looking at the data in this next chart.
Velocity and GDP Generating Capacity of Debt Chart
- In 1916 the velocity of money was 1.7 and generated just under 0.60 cents of GDP for every dollar of new debt.
- 20 years later, the velocity of money is down 15.3% and GDP was 0.47 cents for every dollar of new debt. The marginal productivity of additional debt was down 16.1%, just as Fisher had stated.
- In other words, if you take on debt, you have to create an income stream to cover the increased interest cost and repayment of the debt. If you don’t do that, you don’t have extra money to pay the debt. Bottom line: with increased debt, productivity slows.
- In 1998, the velocity of money was 2.16 and the dollar of GDP per dollar of debt was 0.37 cents. 20 years later, velocity was down to 1.45 (a 32.7% drop) and just 0.28 cents of GDP for every new dollar of debt was produced, representing a decline of 24.3%.
- So you have this Production Function. Money multiplied by velocity equals GDP. In other words, when you become extremely over-indebted, one of the consequences is the velocity of money drops and you denude the capability of the central bank.
When one of the production functions is overused, it contaminates the other functions. Historically debt has been cyclical, averaging about 2.1% since 1949. It’s above trend during expansions and below during recessions, but look what has happened in the last three five-year intervals – further indication that diminishing returns is taking effect.
Real Per Capita GDP Growth
- A lot of people say, you know, you talk about debt but I don’t believe it. After all we don’t have a crisis. And in fact, everybody is happy… and people are clamoring for our debt since the rest of the world rates are lower than here. And our yields are low.
- The crisis is more insidious. It’s hidden. What is happening is that since we became extremely over-indebted our real growth rate is falling… we are only growing 1.2% (meaning growth per person, after inflation is now just 1.2%).
- That’s 45% less than our average annual growth rate of 1.9% from 1790-1999.
This is a crisis because it undermines the standard of living. If you compounded your growth in your personal income by 1.9% after inflation per year vs. 1.2% per year, your income would be 15% higher. That’s what is hidden. That’s the crisis to the economy. Debt steals from growth.
World Population Growth is declining in most developed countries
Population Growth: US and Japan
Notice what has happened to their population growth as debt increased. It declined. (SB here: I’m a bit confused on the relationship to debt and declining population. I re-listened to the audio tape of Lacy’s presentation multiple times and I’m going to have to call him to get a better understanding…)
Using Production Function to Indicate Longer Term Growth Patterns among Major Economies:
- The production function tells you that over the next 5, 10, 15 years, that even with our excessive use of debt, the US is going to have the highest growth rate.
- The next chart looks at Marginal Productivity of Debt and Population Growth rate. The U.S. is highest in both categories, which means the rest of the world is going to be hanging on the U.S.
The Second Theorem: Monetary decelerations eventually lead to lower, not higher, interest rates as originally theorized by Milton Friedman.
When the Fed makes changes to the monetary base, they have an impact domestically and they have an impact globally.
Another Consequence of Fed Tightening: The Yield Spread
- There has been a massive flattening – we’ve had 17 flattening cycles and 17 recessions.
- Note that an actual inversion is not necessary. It only occurred in 10 of the 17 recessions.
- When the yield curve is flat, banks typically charge less to riskier clients, making them more vulnerable to the next downturn.
World Dollar Liquidity
- The Fed created more liquidity on the global markets than they did on the domestic market.
- The Fed played a major role in allowing the rest of the world to get into deeper debt.
- World dollar liquidity is now declining at a record rate. This is a classic example of creating a policy without knowing the consequences.
If I am right, next liquidity injection by China will have a fleeting effect.
- One other important element here – it is not just money, it is the velocity of money. It is turning over 1.4 times in U.S. but only 1 time…
- Which means monetary policy is even more diluted in China, Japan and Europe.
We now have a synchronized downturn everywhere.
Perhaps the most important evidence is the decline in World Trade Volume.
- We are now declining at a level equal to the last two recessions.
- We are seeing it in all the indicators but the best one of all is global trade.
The Treasury bond rate is equal to the real rate plus expected inflation.
- We are not going to get the growth, Lacy says we are not at the bottom of the long-term trend down in interest rates.
- The inflation rate will trend down.
- Bottom line: “In other words, we are not at the end of the declining rate cycle…”
Bill White and John Mauldin hosted Q&A following Lacy’s presentation.
Mauldin began, “Bill and Lacy have never been on stage together… this is pretty cool if you are in to this wonkish type of things.”
William White summarized: The essence is what Lacy said is spot-on to what I’ve been saying for some time. The point he is making, you’ve had cycle after cycle of excessively easy monetary policy, over time what happens is you start off with the easing that generates a lot of demand, but debt itself is a headwind that grows bigger over time. There is a second aspect, over a period of time, those ultra-easy interest rates eats away at the supply capacity of the economy.
You get resource misallocation of capital. At worst, banks can’t take the write-off hit, and you end up getting zombie banks supporting zombie companies – so what you get at the end is lower rates than what you would have normally had – because the underlying strength of the economy got weaker.
What comes next when you have this increase in government debt and the lower capacity for the economy to support it… what comes next?
Lacy Hunt: McKinsey studied 24 periods of debt accumulation – in all 24 cases, the debt problem had to be solved by austerity (defined as a multiyear increase in savings). But what everybody is trying to do is come up with some sort of gimmick that we will have an increase in debt and it will somehow help the economy… but that can’t do it.
What’s going to happen?
William White: The day for simplistic notions in my view are over. We can try them again and again and they won’t work. The 10-year yield is headed lower. But I do worry about the fact that at the end this is not sustainable, there will be a growing sense of the danger of fiscal dominance and unwillingness (incapability the Fed to resist… this will show up in inflation down the road. In the end the only way out of this mess is inflation…
Lacy Hunt: I think we are going back to zero bound (Fed Funds rate to zero percent). Because we expect velocity to fall and we are concerned that we will be stuck in a quagmire with a zero percent bond for some time. Yield curve will be a lot flatter. His fund has greater than 20-year duration.
Picture will be ugly economic, we haven’t seen the low in yields.
That concludes today’s notes. More next week. This speaks to an over-allocation in Treasury bonds, an overweight to cash and an under allocation to equities. Put Lacy Hunt and William White in the same camp. You’ll see next week David Rosenberg has a similar view.
Trade Signals – Despite Geopolitical Risks, Equity and Fixed Income Signals Stay Bullish
May 15, 2019
S&P 500 Index — 2,879
Notable this week:
Notwithstanding significant geopolitical risks, such as the latest chapter in the US-China trade war and elevated risk of conflict in the Middle East, equity and fixed income market indicators remain bullish. We note that the Ned Davis Research Daily Trading Sentiment Composite declined to 33 from 51 last week, indicating “extreme pessimism,” which is typically (and counter-intuitively) short-term bullish for the S&P 500 Index. The Don’t Fight the Tape or the Fed remains at a bullish “+1” signal and the Daily Gold Model moved to a buy signal this week.
The interesting chart of the week is the NDR DJIA & DJTA and their 200-day moving averages chart. You’ll see that both averages have just dipped below their respective 200-day MAs, which is a potentially bearish signal. As with our other signals, we will keep a close eye on this chart and keep you informed.
Click here for this week’s Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – It’s Good to be the King
David Rosenberg’s and Mark Yusko’s remarks at the SIC will be the focus of next week’s On My Radar. It really helps me to sit down, review, reflect and then share my notes with you. There is just so much to digest.
To set the stage for next week, Rosenberg’s presentation was titled, “The Year of the Pig (and lipstick won’t help)” and Yusko began his presentation by taking us back to the lyrics from the Bachman-Turner Overdrive song, “You Ain’t Seen Nothing Yet.”
This chart from David really hit home with me. Look on the right-hand side at the massive amount of debt corporations have taken on to use that money to buy back shares. The left-hand side shows the decline in shares outstanding. What this does is send earnings per share (EPS) up. Corporations are pushing share prices higher.
And from Mark Yusko, “You Ain’t Seen Nothing Yet.”
“You ain’t see n-nothin’ yet, b-b-b-baby,
you just ain’t seen n-n-nothin’ yet,
here’s something that you never gonna forget,
b-b-b-baby, you just ain’t seen n-n-nothin’ yet”
Yusko shared 100 slides in 55 minutes. A fun moment was when Mauldin politely stepped in to give Mark the hook. The presenters face the 600-person audience and have a clock in front of them that counts down and then turns red when time is up. Mark looked at John and said, “Please just two minutes more…” John moved closer, put his arm around Mark and kissed him on the cheek. “For you Mark, anything.…” I’m sure that did not go over well with the backstage crew. But you know, it is good to be the king.
Following are a few photos from the conference.
Stay tuned. Next week’s post will be fun.
A big hat tip to John Mauldin. Masterfully done!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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