Debt Opportunities

-the trade of a lifetime

Topics: the big risk to markets and the economy is in corporate debt. What does it mean for stock prices and gold?

Discussion: the recession is in effect already here (employment, bank stocks, yield curve etc). A recession would trigger an avalanche of downgrades among corporate bonds, effectively neutering the only active buyer of stocks, thus causing stocks to crash back toward their fundamental value.

Why now: The IOER rising above the Fed Funds rate signals a hoarding of dollars, meaning banks are seeing something ugly at the horizon and thus don’t trust each other. It’s a very clear sign of danger when the Federal Reserve loses control of the price of money (The Fed has one job, and that’s it)

Implications: Gold is going to crash upward (possibly after a short term dip, but why would you ever try to time such a thing?); bitcoin could show a similar pattern. USD should spike in the short term, and just might hold its ground after that. US treasuries (stronger dollar, rate cuts, more QE) should be the preferred trade for all who just won’t buy gold, but over time there’s bound to be leakage from bonds to gold as it’s clear massive monetization of debt is the US’s only way forward.

Possibly, there will be a “re-set” of sorts, changing the price of gold overnight in a new global monetary accord. When the dust settles, junk bonds could be the trade of a lifetime (sell your gold and buy bombed out corp debt at cents on the dollar), but don’t go catching that particular knife too soon.

Key assumptions: Recession signals (bank stocks, emplyment revisions, yield curve) are for real. Four times as much near-junk debt as ahead of 2008 is a relevant risk. There is no buyer of last resort for stocks when a corp debt freeze halts stock buybacks. Central banks will pull out all the stops and investors will seek refuge in first US treasuries and then gold. The IOER/FF situation says the timing is pretty soon.

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What’s not to like?

So, the central banks are turning dovish again and stock markets are reacting favorably. What’s not to like? Money printing in the face of a weakening economy has worked (=increasing stock prices) like a charm for a decade now.

Well, the problem is that the US is finally losing its control over the price of money. What’s happened is that US banks are hoarding cash, and are using the “Excess Reserves” possibility to park their currency overnight, despite there being an arbitrage opportunity in placing it in the Fed Funds system at a higher rate instead.

Banks ignoring risk free arbitrage means they aren’t trusting each other. Hence, they must be seeing something very dark at the horizon, if they are willing to decline a perfectly good arbitrage. The Fed Funds system is supposed to be risk free, and yet the banks won’t take IOER money and place at the FF rate.

Too few dollars, due to QT, budget deficits and less international demand for treasuries

The root of the problem is a lack of USD due to the large and increasing US budget deficit, while there’s been less demand for treasuries among foreign buyers (not least China which has actively sold some of its dollar reserves). The US Fed might soon need to pick up the slack in treasury demand, by more quantitative easing, but that would definitely signal a loss of control, so the Fed will most likely hold off from QE as long as it can – on a hope and a prayer.

The SX7E is broken

European banks have issued a lot of dollars, and they’re being pressured by both the negative yield curve and the stronger dollar. The problems are evident not least in Deutsche Bank’s woes and crushed share price. But UBS, SocGen, BBVA and many more aren’t far behind. The European bank index looks almost completely broken, and if it were to fall just slightly more, technically it looks like it’s going to zero (as Raoul Pal says in his excellent piece on Real Vision).

European bank investors apparently are sniffing something out, and the banks themselves are hoarding as much cash as they can, to create a buffer for whatever iceberg is coming up ahead. Hoarding dollars by one bank means less over for the others, which creates a bidding war for dollars pushing the exchange rate upward, making dollar debts increasingly expensive. The hoarding of dollars among those that can hoard thus makes matters even worse for those that can’t.

A dollar spike could trigger a bank crisis

One possible “resolution” is through a quick dollar spike that breaks the weakest link in the European bank chain. One bank is likely to pull the others with it as falling dominos (just like in the 2008-2013 period of recurring bank rescues)

The low yield for US 10 year treasuries as well as the German 10 year Bund spells doom for bank profitability, and the resulting negative yield curve signal recession. European banks (and to some extent even the US BKX index) are acting accordingly and showing extreme weakness over all time horizons.

Negotiator In Chief at the helm of the ECB is a harbinger of doom

In an interesting turn of events, the former lawyer and head of the IMF, Christine Lagarde, the woman who’s made more for the sunscreen business than any other human alive, has been appointed the next quiet assassin of the nation state, i.e., head of the ECB. Her background is as if bespoke for negotiating wide-ranging bank bailouts, capital control, new regulation, tighter EU bank integration and so on.

It’s almost as if the powers that be for once know what they’re doing ahead of time. Well, they should, they caused it, and they’ve had more than a decade to think about it.

…and here comes the crisis, and they plan to use it to push one step further in their plan for a United States of Europe – against the will of most people, under the auspices of need, lest a systemic crash will wreak unfathomable havoc on the continent. “Give us all the power or you will lose everything!

According to people like Jeffrey Snider, a resolution could happen quite soon, as early as by the end of summer 2019 (chart pack here). How does September 2019 sound? It’s a nice round number and historically rhyming year. By the way, Mr Snider thinks The Fed will lower rates very soon. If they lower by 50 points right away, which they probably need to do, it’s a strong crisis signal (and very reminiscent of January 2001).

Recession is coming

Why is this happening? Simple: an economic downturn, if ever so slight, is straining the economy in proportion to the amount of outstanding debt and other imbalances. It’s happening now. The signals of recession are multiplying. After 5 years on artificial life support, it’s getting increasingly difficult for authorities to sustain positive growth for the economy.

Again, it’s about time, the imbalances are worse than ever, and the signals are already here

One of those signals is revisions to employment numbers. Once the revisions turn negative, the actual numbers are soon to follow. Employment statistics are first collected at one date, and then subsequently analyzed, complemented, refined and revised with more data on several occasions. Now we’ve had three months in a row with negative revisions, clearly indicating that the first stab at the number is too positive.

Among several recession signals, the New York Fed probability of recession (POR) chart stands out. It’s currently at a level which in 100% of the previous cases have been followed by a recession. The actual chart says around 30% POR, but that level has always led to recession.

Nobody died of a recession, right?

But, come on, what’s wrong with a little recession? Nothing a little Fed easing can’t handle, or?

Well…, the problem is that the financial system is in so much worse shape this time round, than, e.g., in 2008, you know, right before the great recession. Not least the level of corporate debt have exploded since 2008. Corp debt, according to the IMF, is now at 75% of GDP in the US, or around 10Tn USD vs 5Tn USD in 2008. Even more worrying the amount of near-junk debt has quadrupled from 1Tn to 4Tn.

There are two issues here. One is that a lot of that new corporate debt has been used for stock buybacks. Actually buybacks have been more or less the only net positive inflow for equities. That means that if the corporate debt market can’t keep expanding there are no stock buyers left. And if people and institutions didn’t want to buy stocks before, why would they start doing so at these levels while facing a weakening economy?

Again: No equity buyers left.

The other issue is that there aren’t enough junk bond funds to handle all the extra volume once the downgrades hit. Bond funds have rules; some can buy junk bonds, others can’t. If 4Tn of near junk start turning into junk (once enough are downgraded the others will follow, since they are all connected through the economy and the liquidity of the bond market) and trying to enter the relatively small 1Tn junk bond market, yields will explode higher (junk bond prices crash through the floor).

No junk bond buyers either

Lower cash flow or higher yields beget more of both

There are several ways to trigger this doom loop. One starts with higher yields which adversely affect cash flows, which in turn leads to downgrades, followed by (forced) bond selling from investment grade funds to junk funds, even worse cash flows and so on. No matter what the reported profits are, bond ratings are based on cash flows, meaning there really is no escaping the doom loop once it starts.

Higher yields, lower profits, downgrades, higher yields…

Should the primary bond issue market freeze up, like it did temporarily late in the fall of 2018, the tail spin will be more or less immediate. That’s how the Powell pivot late last fall came about. That particular Fed ammo, however, has already been spent.

Demographic doom dead ahead

The more or less bankrupt US pension system has been sucking up a lot of bonds, including corporate debt for the yield pick up. The process is procyclical: when the economy is growing and total income is increasing, there’s more tax money over for bond buying (due to low treasury yields, an increasing portion of pension money has been put into corporate debt).

When the cycle turns south, there’s less available funds. Sure, in the short term there could be some rotation from stocks to bonds. However, probably not that much (read: nothing) into junk or near-junk bonds. By the way, it’s exactly the rotating out of stocks you should be wary of as an investor (even if you as a citizen should be really worried about the consequences of a freezing bond market)

A bit longer term, albeit still relevant in the decade-long horizon, the large boomer generation is retiring. Due to zero interest rates on their bond holdings, and too much risk holding a large proportion of stocks as they grow older, they’ll need to (and want to) sell securities to fund retirement.

Boomers retiring is more of  a long term partial drag on the system, both for bonds and equities. However, in terms of rate of change, up until now boomers (pension funds) were buying corporate debt for the yield pick-up, due to too low yielding treasuries, but now they’ll start selling. Combined with all of the above, that spells double doom for corporate debt prices and issuance, which in turn means much less equity buybacks than the market has become used addicted to.

What about Trump and a China deal, wouldn’t that save the markets?

Sure, Trump will most likely get to a deal, some deal, watered-down as it may be, but no doubt hailed as a triumph. However, as soon as the above doom loop manifests itself, and it will, since the trade deal won’t be enough to jump start an engine with an empty gas tank, Trump will wield his tariffs wand again, and we’re back to square one, or rather minus one.

As a final thought on geopolitics, many countries have tired of Trump’s and the US’s antics, including the weaponizing of the dollar. Those countries could band together and seize the opportunity a financial crisis entails, to design a new monetary system based on gold (priced at a much higher number per ounce).

Investment implications

A dollar spike could be in the making soon, and that might mean a short-term downturn for gold (albeit that might in effect already have happened). A flight to safety from anything European and into dollars should mean both stronger US treasury prices (falling market yields) and higher stock prices (what works works, until it doesn’t). A dovish Fed could temporarily add to these developments.

Fed easing. After the initial knee jerk reaction, the more or less inevitable economic downturn leads to weakening cash flows, corp debt downgrades, higher yields, forced selling and freezing up of new debt issuance and stock buybacks. With both bonds and stocks in free fall, the Fed has to respond by cutting rates aggressively as well as turn on the Quantitative Easing taps more than ever (already prepared for by their “slope” and “effective” lower bound language).

Gold to shine. Once the flow into dollars is exhausted and the Fed is in full panic mode, the dollar can weaken again, although hard to say to what extent, given the sad state of Europe. In any case, no matter the relative movements of USD vs EUR, JPY and RMB, gold is set to shine, owing to unlimited moneyprinting and the prospects and need for a global financial and monetary system re-set, a Beijing Accord of sorts.

You never forget your first coin. More and more seasoned investors are recommending gold as the place to hide from all the turmoil. Sam Zell, e.g., a 75-year old legendary investor known for rare but bold and successful calls, said in January that he started buying gold for the first time in his career. Maybe it’s time for your first gold purchase too?

And on July 17, Ray Dalio, the head of the world’s most successful hedge fund ever, published a long article on Linked In about shifting financial paradigms over the last 100 years. He concluded that the current state of affairs regarding not least debt and market positioning, points to gold as a preferred asset:

…those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets…

I would add that sometime deep into the mayhem, maybe after 18-36 months of carnage, there’s bound to be amazing opportunities among junk bonds. Forced selling can only last so long, and once probabilities of default are more than priced in, while new junk bonds are set up, the trade of a lifetime could be found there. I almost wish I were in Howard Marks’ shoes a few years down the road. If I still were a professional investor that is.

P.S. this is all for entertainment purposes and is not a recommendation of any kind, least of all to engage in financial activities such as selling or buying securities or other assets.

Global warming? How about galactic cooling?!

Global cooling on the way? Be prepared!

The  climate is changing. We can agree on that.

The question is what is driving it, and what we can or should do about it. And possibly in which direction the wind is blowing.

In a recent short paper (by J. KAUPPINEN AND P. MALMI, June 29, 2019) the researchers demonstrate how natural changes in humidity explain, much better than, e.g., CO2 emissions, the variations in global temperatures over the last half century.

Variations in low cloud cover, and their corollary, changes in relative humidity, seem to be an order of magnitude more important for explaining both the general trend rise in global temperatures and even more so regarding the interimistic drops in temperature. The latter is of course wholly unexplained by the steadily rising levels of CO2.

The authors conclude that “During the last hundred years the temperature is increased about 0.1°C because of CO2. The human contribution was about 0.01°C,” i.e., “we have practically no anthropogenic climate change. The low clouds control mainly the global temperature

Note (Note: the paper has been criticized here). The results, however, have been corroborated by a team in Japan: “New evidence suggests that high-energy particles from space known as galactic cosmic rays affect the Earth’s climate by increasing cloud cover, causing an ‘umbrella effect’

It’s not us

So, humans aren’t doing it. Therefore there’s really no use in trying to reverse the effects by unnecessarily restricting human activity. Quite the contrary, actually. If galactic rays are causing temperatures to rise through changes in relative humidity and cloud cover, we’ll need all the human ingenuity and creativity we can muster in order to find out how to live and thrive in a much warmer world, including potentially higher water levels and frequency of extreme weather.

You can’t predict, but you can prepare

This is no joke. In fact, space weather changes could even cause a cooling before a warming, with potentially just as adverse effects. No matter which way the galactic gods lean in this respect, it’s better we come prepared, even if we can’t predict the outcome.

Winners from warming

No matter, the green revolution is still good for many things, not least combatting pollution (whether slightly warming or not), and fanning (!) innovation. So don’t give up on your recycling efforts just yet. And solar power is still our best bet long term to make sure our energy needs are met in the future, so if you like your solar companies you can keep them. The warmth of the sun is our cleanest, safest and most abundant source of energy. But we need to keep inventing better ways to capture and store it.

The corporate winners in this scenario will be solar energy capture and energy storage companies, including the entire value chain of industrial suppliers of complementary factory parts, not to mention finance companies (huge investments in storage infrastructure will be required once solar energy dominates the power supply).

However, even more interesting will be the opportunities within construction and construction materials. Imagine all the levees to be built, water-proofing solutions needed for buildings and other equipment, not to mention all the new buildings required higher up on dry land, to replace the multitude of new Atlantises being created. 

And then there is the insurance business (extreme weather, remember?).

What about losers? Well, there’s the oil industry of course. And retail: the money to pay for all the new infrastructure must come from somewhere; my guess is higher housing and insurance costs will diminish the room for non-essential shopping for the bottom 99 per cent.

Tougher times might mean higher aggregate demand (whoa, Keynes!), but the resulting higher GDP doesn’t mean ordinary people will benefit. All the extra efforts are just going toward strengthening or moving all the things we’ve already got, rather than producing new and life-enhancing stuff

Är guld historiskt dyrt eller billigt?

En ny artikel på Zerohedge förklarar hur guld är både lättare (!) och tar mindre plats än Bitcoin. En bitcoin väger t.ex. ca 1,7kg, med 8 000$ guld bara väger 200 gram.

Artikeln är underhållande, men onödigt mångordig för min smak. Ögna igenom den om du har väldigt gott om tid, samt vill höra varför “Drop Gold” bygger på tveksamma premisser.

En viktigare fråga är om guld är billigt eller dyrt i förhållande till sig självt just nu. Jag skrev nyligen en krönika för Omni på det temat, som du hittar om du följer länken. Här följer några korta utdrag:

“I dag får du lämna ifrån dig 70 gram guld för att köpa en enhet av det breda amerikanska aktieindexet S&P 500. Det är extremt mycket. Till exempel kostade det bara en femtedel så mycket, 18 gram guld/index, för bara åtta år sedan. Guldet har faktiskt haft mycket större köpkraft än så många gånger de senaste 150 åren, med priskvoter på låga 5-10 gram/index.”

“Bara det senaste halvåret har kvoten både hunnit falla och stiga med 25 procent, så visst svänger det så mycket att man kan handla på det, men trots allt utan tydlig trend. De stora rörelsernas tid är definitivt inte förbi bara för att vi lever på 2000-talet. Kanske är det dags igen nu.”

“Det finns några anledningar till att snarare tro på en fallande kvot (fallande aktier eller stigande guld) än tvärtom. Till exempel är aktievolatiliteten ovanligt låg och med vissa tendenser till plötsliga högre spikar, precis som mönstret var inför finanskrisen 2008.”

“Ett annat tecken är att värderingen av börsföretagens försäljning i dag nästan är tre gånger så hög som den historiska normen. Det såg ut på ungefär samma sätt både år 2000 och 2007, det vill säga precis innan börsen föll och guldet steg. Det trots allt stigande guldpriset de senaste tre åren ser ut att vara på väg att sniffa sig till att det är en period på gång med stigande volatilitet och riskaversion.”

Läs resten av artikeln här. Där får du bland annat perspektiv på aktietoppnivåer på >300 gram guld per S&P 500, dvs S&P på över 10 000.