December 4, 2020
By Steve Blumenthal
“People and politicians are now at each other’s throats to a degree
greater than at any time in my 71 years,” Dalio wrote.
“How the U.S. handles its disorder will have profound implications
for Americans, others around the world, and most economies and markets.”
– Ray Dalio,
Co-Chairman & Co-Chief Investment Officer,
Bridgewater Associates (LinkedIn post)
William White was Chief Economist of the Bank for International Settlements (BIS). Think of the BIS as the central bankers’ central bank. He worked for central banks for almost 50 years, until 2008. He was one of the few officials who had warned of a looming financial crisis. His criticism: “They have pursued the wrong policies over the past three decades, which have caused ever higher debt and ever greater instability in the financial system.” He believes central banks have no way out but to keep doing what they are doing, but by doing that, they are making it all worse.
I’m frequently asked how this is going to end. The truth is I don’t know. What policy makers will be in place? Can they find compromise? Yellen and Powell will team up, but will Congress get its act together and pass fiscal legislation? A “make America’s infrastructure great” legislation would be a productive use of newly minted money/debt. Will we try to print our way out of this mess? Will there be major debt restructuring in our future? If so, what will it look like? We just don’t yet know.
This week’s missive examines what the period ahead could be like and considers the probabilities of various outcomes. You’ll get a sense of how complex and fragile the system truly is. And you’ll find a few recommendations from Ray Dalio. Recommendations such as, “First, worry as much about the value of your money as you worry about the value of your investments. You don’t want to own the thing you think is safest—cash. Second, know how to diversify well. That includes diversification of countries, currencies, and assets, because wealth is not so much destroyed as it shifts. When something goes down, something else is going up so you have to look at all things on a relative basis. Diversify well and worry about the value of cash.”
If you are a long-time reader, you know I’ve written about William White before (check out this letter from May 2019). He said then that we would see deflation first, and that inflation would likely follow, and advised us to keep a keen eye on the geopolitical stuff—as that’s where the action would be taking place. He concluded, “It’s an unhappy story that I’m telling today; I guess the only thing I can finish with is ‘Good luck. You’re probably going to need it.’”
Remembering that, I was particularly interested to hear what Bill is currently thinking. So, let’s begin today’s On My Radar with my notes from a recent William White interview. I share his insights because I believe he understands what the end game may look like better than most. In an in-depth conversation with themarket.ch, Bill shared his views on what should be done.
He believes the current crisis should be used to rethink things in order to build a more stable economic system, one in which fiscal policy plays a greater role and there is more reliance on productive investment.
This is really important stuff, and I promise you’ll get a lot out of today’s post. Let’s first set the stage, taking a look at the current environment, and conclude with what Bill thinks is the best way out of this mess:
- Governments have relied on monetary policy starting in 1987, with Alan Greenspan as Chairman of the Board of Governors at the Federal Reserve. It became the instrument of choice for all kinds of crises.
- But monetary policy has become increasingly ineffective in promoting real economic growth. Every crisis was met with monetary easing that caused debt and other imbalances to accumulate over time, and that caused the next crisis to be bigger than the previous one. The next crisis then needed more of a punch from central banks. However, since interest rates were never raised as much in upturns as they were lowered in downturns, the capacity to deliver that punch was decreasing.
- It’s true, the Fed had no choice but to step in to prevent a financial meltdown (in March 2020). But this meltdown only happened because of the monetary policy instituted over previous years.
- You see, by keeping interest rates too low as a means of stimulating economic growth, central banks are inducing corporations and households to take on more debt.
- To a large extent, this debt is not used for productive investments, but for consumption or, especially in the U.S., for the buyback of shares.
- This creates a debt trap, as well as increasing instabilities in the financial system. These instabilities broke out in March, and the Fed responded adeptly to stop the panic. But the point is: Central banks create the instabilities, then they have to save the system during the crisis, and by doing so they create even more instabilities. They keep shooting themselves in the foot.
- Governments should use the current environment to borrow long and lock in cheap money while they can.
- This is not the time for austerity due to the pandemic crisis, but governments should set clear guidelines about how they intend to get debt levels down in the future. They should reevaluate budgets and use of funds, e.g., cut subsidies that often go to special interest groups that don’t deserve them.
Asked if central banks have reached the end of the road, Bill replied:
- Just read what Bill Dudley, the former president of the New York Fed, wrote in Bloomberg a couple of weeks ago. He warns that central banks have run out of firepower, and that the side effects are getting worse. I agree with every word. That is the most dangerous effect of the past 30 years of monetary policy: Debt levels have constantly been building up, and so have the instabilities in the financial system.
- This is exactly my definition of the debt trap: Central banks know they can’t leave interest rates as low as they are, because they are inducing still more bad debt and bad behavior. But they can’t raise rates, because then they would trigger the very crisis they are trying to avoid. There is no way out but to keep doing what you are doing, but by doing that, you are making it worse.
- In 2008, the ratio of global household, corporate and government debt-to-GDP was 280%. Early 2020, this ratio had grown to 330%. And it’s not just the quantity of that debt, it’s the quality.
- Most of the new corporate debt is BBB-rated, covenant-light, low-quality stuff. The reason for that is the ultra-easy monetary policy we have seen post-2008.
- Governments made the mistake of embracing fiscal austerity too early. By doing that, they made it the job of the central banks to frantically try to create economic growth. This is a mistake we must avoid after this crisis. Fiscal policy will have to play a much larger part going forward.
- There is no return back to any form of normalcy without dealing with the debt overhang. This is the elephant in the room. If we agree that the policy of the past 30 years has created an ever-growing mountain of debt and ever-rising instabilities in the system, then we need to deal with that.
The Institute for International Finance said global debt would break new records in the coming months, reaching $277 trillion by the end of the year. Among advanced nations, debt surged above 432% of GDP in the third quarter—a 50 percentage-point increase from 2019. Bill was asked how we deal with the debt overhang. He said, in theory, there are four ways to do it. We’ll take a look at them here.
Grab that coffee and find your favorite chair. The debt issue is our biggest obstacle to growth. We are nearing what my partner, John Mauldin, calls “The Great Reset.” When you click on the orange On My Radar button (if you are reading this in your email inbox) or scroll down (if you are reading this online), you’ll also find my notes from Ray Dalio’s recent post on LinkedIn via MarketWatch and a few thoughts on how to approach investing.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- William White – Four Ways Out
- Ray Dalio’s Recent Missives
- The Lack of Value by Mark Grant
- Trade Signals – Are Bond Investors Jumping on the Risk-on Bandwagon?
- Personal Note – Ski Season
“It ain’t the things that you don’t know that get you,
it’s the things that you know for sure, that ain’t so!”
– Mark Twain
In theory, there are four ways to get rid of an overhang of bad debt, which John Mauldin laid out in a Forbes piece titled, “What Do We Do With All This Debt?” They are as follows:
- Households, corporations, and governments try to save more to repay their debt. But we know that this gets you into the Keynesian Paradox of Thrift, where the economy collapses. So this way leads to disaster.
- You can try to grow your way out of a debt overhang, through stronger real economic growth. But we know that a debt overhang impedes real economic growth. Of course, we should try to increase potential growth through structural reforms, but this is unlikely to be the silver bullet that saves us.
- This leaves the two remaining ways: Higher nominal growth – i.e., higher inflation – or
- Get rid of the bad debt by restructuring and writing it off.
Bill believes we will see a combination of three and four. He added, “It’s fairly obvious that a number of policy makers will try to inflate the debt away. This was how they did it after World War II, through what we now know as financial repression: Get inflation above interest rates, and then the debt ratio gradually comes down. It’s just very hard to engineer the kind of inflation that is just right for this process.” (Source)
His advice: go with option number four (that’s the one I would strongly advise as well): Approach the problem, try to identify the bad debts, and restructure them in as orderly a fashion as you can. But we know how extremely difficult it is to get creditors and debtors together to sort this out cooperatively. Our current procedures are completely inadequate.
Bill shared two examples:
- It was clear that the best way forward for Greece after their crisis of 2010 was comprehensive debt relief in exchange for structural reforms. However, policy makers in Berlin and Brussels never agreed to the level of debt relief that was needed, and so they pushed Greece into a destructive austerity spiral. One can also look at government debt in Sub-Saharan Africa today: A lot of it has to be written off. Otherwise, these countries are going to be forced to continue to try to pay, and they will do it at the expense of healthcare and so on. That’s a recipe for human disaster.
- We are dealing with public, private, and Chinese creditors, who are competing to be paid. Why should a Western private creditor give up his claim if the Chinese don’t? Unfortunately, recent legal rulings like NML Capital versus Argentina have taught creditors that it’s best to hold out. So, all over the world creditors don’t agree to restructurings but rather extend and pretend that the debt is still viable. And it’s all made superficially viable by easy monetary policy.
In response to “It almost seems the easiest way is to just keep doing what we are doing,” Bill said,
- You are right. My colleagues at the BIS and I have been warning of this debt trap issue for 20 years. I am reminded of the economist Herb Stein who once said that if something cannot go on forever, it will stop. To which Rudi Dornbusch quipped: “Yes, but it will go on for a lot longer than you anticipate.”
- One of the reasons for not changing anything is indeed the argument that it has worked so far. What is needed now is agreement that our policies of the past 30 years have created an ever-rising level of debt and ever-increasing instabilities.
- Should it be agreed upon that this path is not sustainable, as it leads to ever bigger crises, it’s an absurd proposition to stay on that path.
What could derail the current system?
- I don’t know. One of the conclusions of the complexity literature is that the trigger itself is irrelevant. If the system is unstable, anything could be a tipping point, even if the instability goes on without incident for years. Again, take the episode of March 2020, when these corporate giants in the U.S. were wobbling.
- The Fed stopped the panic. What if markets at that point had lost confidence in the ability of the Fed? We only know in hindsight that it worked. But we don’t know how the system will react in the future.
- In fact, we know much less than we think we do, which is something that both Hayek and Keynes commonly described as being at odds, totally understood.
- Central bankers, indeed, all macroeconomists, should be much humbler than they are.
A few final thoughts:
- We are dealing with a complex adaptive system, full of tipping points, and we should not assume that we can understand and control it.
- On the one hand, in depressed circumstances, it might prove impossible to raise inflation.
- On the other hand, given enough fears of fiscal dominance, you might get a lot more inflation than you bargained for.
- The idea that price stability is sufficient for economic stability? Wrong.
- That easy money always stimulates demand? Wrong.
- That the economy is self-adjusting, and will go back to a full employment equilibrium? Wrong.
- That financial markets are efficient and bad things can’t happen? Wrong.
- That wealth will trickle down to all levels of society? Wrong.
Bill concluded, “These are big beliefs. And false beliefs are dangerous. You know the saying attributed to Mark Twain: ‘It ain’t the things that you don’t know that get you, it’s the things that you know for sure, that ain’t so!’” Never forget: We think we know much more than we really do.
“One of the greatest problems is that everybody’s fighting for their cause.
When the causes people are fighting for are more important to them than the system
that binds them together, the system is in jeopardy. This seems to now be happening.
Everybody has their cause and they’re almost losing sight of the overall picture.
Democracy depends on compromise. It’s the notion of compromise and working together
and being able to have a negotiation to get what the most people want rather than have one
side beat the other.”
– Ray Dalio
I began this week’s OMR talking about Bill White. The idea is to understand the options we have to solve the debt and pension challenges we now find ourselves facing. The moves we make depend on central bankers, elected officials, and us—the ones who elect them. There are no good choices. But some may be less painful than others.
I think Bill White is right. The better of the “no good choices” and the highest probability strategy in my view is a combination of massive fiscal spending and debt restructuring. Imagine your government and corporate bond funds dropping 50% seemingly overnight. One person’s debt is another person’s asset.
Ray Dalio is one of the great thinkers of our time. And he’s been handsomely rewarded. Ray went from broke to billions and today his hedge fund, Bridgewater Associates, is the largest hedge fund manager in the world. He is what is called a global macro investor, meaning he invests globally and can bet up or down on equities, fixed income, commodities, and currencies. His job is to look forward and align his portfolio bets accordingly.
Fortunately, he openly shares his research conclusions. Read the following just to get a feel for what to keep your eye on and how you may position yourself to profit. Ray concludes with some investment positioning advice.
The following is from Ray, courtesy of MarketWatch. I chose to include certain passages in bulleted form from the interview. I’ve also provided you with the links below, so you can read the full posts.
- “The United States is at a tipping point in which it could go from manageable internal tension to revolution and/or civil war,” says Ray Dalio, the billionaire founder of Bridgewater Associates, sounding the alarm in his latest LinkedIn post on the class and power struggles that are tearing the country apart.
- “People and politicians are now at each other’s throats to a degree greater than at any time in my 71 years,” he wrote. “How the U.S. handles its disorder will have profound implications for Americans, others around the world, and most economies and markets.”
- Dalio used a chart to show how the U.S. is on the downside of its economic power, while China is in the midst of inflating its debt bubble: manufacturing index, the economy is cooling off notably. And the surge in COVID-19 case counts clearly is at play, along with fresh restriction measures at the local government level.
- “[America] is in this stage when there are bad financial conditions and intensifying conflict,” Dalio wrote. “Classically this stage comes after periods of great excesses in spending and debt and the widening of wealth and political gaps and before there are revolutions and civil wars.”
- While the outcome isn’t inevitable, Dalio said that America, perhaps more than ever before, needs to “understand the full range of possibilities” by taking a hard look at its past.
- “The lessons and warnings of history are clear if one looks for them,” he wrote. “Most people don’t look for them because most people learn from their experiences and a single lifetime is too short to give them those lessons and warnings that they need.”
Above bullet points from MarketWatch article titled, “Post-election political estrangement has landed U.S. at ‘tipping point’ warns world’s biggest hedge-fund manager.”
Here’s more from Dalio, also via MarketWatch:
- I look at it mechanically, like a doctor looking at a disease. If asked what is the issue here, I would say that it is a certain type of disease that has certain patterns which are timeless and universal, and the United States is broadly following that progression.
- There are three problems that are coming together, so it’s important to understand them individually and how they collectively make a bigger problem.
- There is a money and credit cycle problem,
- a wealth and values gap problem, and
- an emerging great power challenging the existing dominant power problem.
- What’s going on is an economic downturn together with a large wealth gap and the rising power of China challenging the existing power of the United States.
- It’s a fact that there has been a weakening of the competitive advantages of the United States over the last couple of decades. For example, the United States lost a lot of the education advantage relative to other countries, our share of world GDP is reduced, the wealth gap has increased which has contributed to our political, and social polarization.
- But we haven’t lost all of our competitive advantages. For example, in innovation and technology, the United States is still the strongest, but China is coming on very strong and at existing rates will surpass the United States. Militarily, the U.S. is stronger but China also has come on very strong and is probably stronger in the waters close to China that include Taiwan and other disputed areas. Finances for both countries are challenging, but for the U.S. more so.
- The world is going to change in the next five years in shocking ways in relation to the three big issues we have been talking about.
The U.S. is in the late stages of a debt cycle and money cycle in which we’re producing a lot of debt and printing a lot of money. [SB here: emphasis mine.]
- That’s a problem. As a reserve currency status, the U.S. dollar is still dominant though it’s being threatened by its central bank printing of money and increasing the debt production problem.
- If you look at the history—for example, the Dutch Empire, the British Empire—both experienced the creation of debt and the printing of money, less educational advantages, greater internal wealth conflict, greater challenges from rival countries. Every country has stress tests. If you look at British history, the development of rival countries led them to lose their competitive advantages. Their finances were bad because they had accumulated a lot of debt. So, after World War II, those trends went against them. Then they had the Suez Canal incident and they were no longer a world power and the British pound is no longer a reserve currency. These diseases almost always play out the same way.
- The United States’ relative position in the world, which was dominant in almost all these categories at the beginning of this world order in 1945, has declined and is exhibiting real signs that should raise worries.
- There’s a lot of baggage. The U.S. has a lot of debt, which is adding to the hurdles that typically drag an economy down, so in order to succeed, you have to do a pretty big debt restructuring. History shows what kind of a challenge that is.
- I just want to present understanding and facts. There’s a life cycle. You’re born and you die. As you get older you can see certain things that are symptoms of being later on in life. To know the life cycle and to know that these symptoms are emerging is what I’m trying to convey.
- The United States is a 75-year-old empire and it is exhibiting signs of decline.
- If you want to extend your life, there are clear things you can do, but it means doing things that you don’t want to do.
Dalio was asked, What would be a smart, proactive strategy for investors to both protect a portfolio and take advantage of market opportunities?
- First, worry as much about the value of your money as you worry about the value of your investments. The printing of money and the debt should make you aware of that. That’s why financial asset prices have gone up — stocks, gold — because of the debt and money creation. You don’t want to own the thing you think is safest — cash.
- Second, know how to diversify well. That includes diversification of countries, currencies and assets, because wealth is not so much destroyed as it shifts. When something goes down, something else is going up so you have to look at all things on a relative basis. Diversify well and worry about the value of cash.
Above bullet points from MarketWatch article titled, “Billionaire investor Ray Dalio on capitalism’s crisis: The world is going to change ‘in shocking ways’ in the next five years.”
SB here: Ten-year Treasury Notes yielding 0.94%, high grade corporate bonds yielding 1.84%, and high yield junk bonds yielding just 4.54%? Worry about the value of bonds too. Totally agree with Dalio’s view on cash.
My team and I continue to favor stocks that pay high and growing dividends, as well as diversifying trading strategies that risk manage and can position globally. As you’ll see in the Trade Signals section below, the equity signals across the dashboard remain green.
“I assert, currently, you are not getting paid for credit risk and
this is certainly a major consideration when you look at your portfolios.”
– Mark Grant
Let’s delve a little deeper into my view on bonds. Here is a great piece from my friend Mark Grant. Worth the short read…
In the bond markets, in my opinion, there is no value left. This is true from both angles, “Absolute Value” and “Relative Value.” On an absolute basis we are just off our all-time low yields. Yes, the 10-year Treasury has backed up some but, as it did, the credit markets tightened as everyone, and his brother, scrambles for yield.
Bloomberg sets their U.S. Treasury Index at 0.628% with a duration of 7.13 years. In the meantime, their U.S. corporate bond index has tightened to 1.842% with a duration of 8.75 years. This is a spread of just 121.4 basis points for bonds with a credit risk. More remarkable is their high yield index. It is yielding just 4.56% which is just 393 bps to Treasuries and 272 bps to investment grade corporate bonds.
I assert, currently, you are not getting paid for credit risk and this is certainly a major consideration when you look at your portfolios. Neither do I see it changing any time soon. U.S. yields continue to be the highest for virtually all major countries, and that will continue to be a source of buying power for American debt for the foreseeable future, in my view. As a matter of fact, the European Central Bank has virtually assured us that they are going to add to their assets in December which will drive down yields in the European Union even further.
Between “Absolute Value,” and “Relative Value,” many people, and institutions, are caught in a major squeeze play. I deal with a number of major institutional money managers. The life insurance folks, I am told, cannot make any money on their portfolios at these levels and yet they cannot go too far afield because of their regulators and their fear of being downgraded by the ratings agencies. They are trapped, and there is just no getting around it.
I have made some suggestions to them which will help at the periphery but their core holdings, and their traditional buying patterns, are under assault. This is all being caused by the Fed, and the other major central banks, who are helping the nations they represent with historically low yields but, at the same time, they are causing havoc for investors.
Our “Borrower’s Paradise” continues to be a “Fixed Income Investor’s Hell” and, with the Fed promising very low yields, for the next several years, this problem will not be going away anytime soon. What will be quite interesting, as our new Administration takes power, is how much heat will be put on the Fed to buy a broader range of securities and to drive down yields, like the European Union, Switzerland, and Japan, into negative yielding territory. Each increase in Federal spending is going to turn up the heat and, in my opinion, the American deficit is going to expand, next year.
A view of where we might be headed is illustrated by the 2-year sovereigns, listed below:
U.S. 0.160 %
Australia 0.110 %
Belgium -0.735 %
Denmark -0.622 %
France -0.692 %
Germany -0.729 %
Italy -0.406 %
Japan -0.124 %
Netherlands -0.721 %
Spain -0.582 %
Sweden -0.371 %
U.K. -0.031 %
If America approaches the levels of these other countries then our banks, insurance companies, pension funds, university endowments and retirees are in for real trouble, in my opinion. It is not just profits but lifestyles, that will diminish, and you can expect a howl of protests from all of those who are affected. You can hear the anguish now, but the cries for help are likely to increase in volume.
One of my fears here is that our seniors and retirees could get into major trouble, as they leave the bond markets for riskier bets. Any kind of downturn in equities, as one example, could send these people into major problems, which may result in political fallout. Having grandma and grandpa forced from their homes will not be a welcome occurrence for anyone, of either party.
Investing for a little above nothing is one thing. Investing for less than nothing is another thing altogether, and far worse.
“Watch out now, take care… Beware of greedy leaders that take you where you should not go…” -George Harrison, Beware of Darkness
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley Financial
December 2, 2020
S&P 500 Index — 3,653 (open)
Notable this week:
No changes to the equity, fixed income, gold, or sentiment indicators since last week’s post.
Notably, momentum appears to be pushing bond investors to sell and jump on the equity risk-on bandwagon. Yesterday, yields on the 10-year Treasury popped by more than 9 basis points to 0.938%, the highest level since November 12. We call your attention to the right side of the chart below.
From Axios’ Dion Rabouin, “Bond investors have largely been incredulous about the prospects for U.S. growth and inflation — but recent good news on COVID-19 vaccines, global manufacturing data and U.S. holiday retail sales helped push yields on the 10-year Treasury note up by the most in nearly a month.”
We continue to keep the watch as significant geopolitical and economic challenges persist. However, it’s nearly impossible to ignore the persistent drum beat of the Street’s bulls.
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.
Click here for this week’s Trade Signals.
“Success is not final; failure is not fatal;
it is the courage to continue that counts.”
– Winston S. Churchill
Susan and I built a late afternoon fire in the pit outside and spent much of Thanksgiving Day on our back porch, reading. This year, our children were away, so we passed on turkey. I made onion and mushroom soup (Susan told me what to do), and we shared sourdough bread dipped in olive oil and a bottle of red wine. It was a peaceful, happy, and quiet day for us.
We’ve had some pretty good weather the last month. Warm enough for golf and spending time outside. However, rain is in the weekend forecast and the temperatures in the Northeast are dipping into the 30s. It’s finally time to put the outside furniture away for the winter. Honestly, that is always a bit of a bummer for me. The good news is that ski season is here. Furniture in, skis out. An ok trade.
I hope this note finds you safe and healthy. We seem to be nearing the light at the end of the long COVID-19 tunnel. Still, more and more, I’m hearing of friends with COVID-19. Some cases mild, some not so good. What a mess. More patience required, along with the courage to continue… Ever forward.
With ski season is here, I’m hoping for some of this:
Have a great weekend!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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