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What the World Doesn’t Need Now is Lower Rates

July 22, 2019

The Q2 earnings season is upon us and the risks to the rally that started after the worst December on record at the close of last year is in serious jeopardy. We received a glimpse of this with some of the current companies that have reported. For example, to understand how dangerous this earnings reporting season can be, take a look at what one of the largest US multinational firms had to say recently after it reported earnings. The Minnesota-based Fastenal, which is the largest fastener distributor in North America, reported worse-than-expected second-quarter earnings and revenue. Shares of Fastenal promptly tanked more than 4%. But what the management said about the quarter was very interesting. The company said in its press release that its strategy to raise prices to offset tariffs placed to date on products sourced from China were not sufficient to also counter general inflation in the marketplace.

In fact, companies that collect more than half their sales outside the U.S. are expected to see a 9.3% slump in second-quarter earnings, according to FactSet estimates. This quarter’s earnings overall are expected to drop by 2.3%–making it the second quarter in a row of declining EPS growth.

What I find most interesting is that we have a capital spending slowdown, a global manufacturing recession, global GDP grinding downward, US Q2 growth falling to about 1.5% from the 3% level seen last year, and an S&P 500 earnings recession. All of this is happening in the context of asset prices that are at all-time high valuations and are clinging precariously to a worldwide fixed income bubble that is destined to go supernova and obliterate asset prices.

I’ve gone on record indicating that the daggers for the bubble on Wall Street and the global bond market are inflation and recession. A recession would blow up the $5.4 Trillion worth of BBB, Junk and Collateralized Loan markets; And rising rates of inflation would leave the entire fixed-income spectrum in tatters.

But what happens if you get both occurring at the same time? What if we see the return of stagflation? What if rates undergo a massive spike due to global central bank insanity and their inability to ever come even close to normalizing interest rates; and then you also have a recession that causes multiple trillions of dollars’ worth of bonds to default? The answer is, yields would soar like a surface to air missile from the currently insane level of low rates that could only make sense in the twilight zone.

How insanely-low are interest rates you ask? There are now Junk bonds in Europe that have a negative yield, Austria recently issued a one-hundred-year bond with a yield of just 1.2%, And, almost every single country in Northern Europe and the nation of Japan have sovereign bonds with a negative yield– some of which going out ten years in duration!

Therefore, because rates have been forced down by central banks to such an insane level, a gradual normalization that is fairly innocuous for markets is virtually impossible to occur. What is more probable is a violent interest rate shock like we have never before seen; especially if we end up in an environment of stagflation that causes yields to jump by 100s of bps very quickly and destroys the global equity markets with catastrophic expediency. Speaking about the insanity of low yields, the Treasury Department recently stated the deficit grew 23% from October 2018 through June, for a total Fiscal ’19 Deficit of $747 billion with one quarter of the year still left. Annual deficits near $1 trillion are happening outside of a recession. During an economic contraction, deficits should surge towards $2.5-$3 trillion.

The global bond market suffers from a plethora of insolvent corporations and sovereigns that are issuing debt with yields that offer less than zero percent. The day of reckoning may not be imminent, but you must be fully prepared for its eventuality. It is possible to profit from it, but if you don’t anticipate its occurrence, the economic consequences will be severe.

But central banks and governments are unconcerned about these asset bubbles. Incredibly, they are printing and borrow more money. To this end, we should all be aware that the Fed no longer has a dual mandate consisting of stable prices and full employment. The Fed’s primary concern is to try and levitate asset bubbles. After all, Trump says this is the best economy ever and even members of the FOMC assent that underlying growth is very strong. The unemployment rate is at a record low, and the CPI for all items less food and energy rose 2.1 percent over the last 12 months. So, core inflation is over the Fed’s asinine target, and the jobs market is very strong at this time; initial unemployment claims are at a 50-year low.

Why then would Powell indicate during his latest testimony before congress that a rate-cutting cycle will begin later this month?  The truth is the economy is very fragile precisely because it has become 100% dependent upon perpetual asset bubbles. Powell became aware of this when stocks plunged in Q4 of last year and the Junk Bond market completely shut down. The truth is that Powell, and his merry band of counterfeiters, have become absolutely petrified about a recession because they know that it will implode the entire corporate bond market…turning an average run of the mill recession into a depression in short order.

Therefore, he will now run to the printing press at the slightest hint of a downturn. But the chances are high that a 25-basis point rate cut won’t be enough to bail out the global economy.  Nor will several more like it do the trick. It should take 100s of bps and a return to QE to push prices higher.

Are we supposed to believe that central banks are going to make this all ok by easing monetary policy further from here? After all, they have already forced $13 trillion worth of sovereign debt below zero, and the European Central Bank and the Bank of Japan already have negative rates and have been at that level for years. And the Fed only has 225bps of rate cuts available, when it usually has needed 500bps or more.

Perhaps central bankers can manage to force a few more drinks down the hatch in order to delay the inevitable hangover. But that just makes the eventual collapse all the more severe.

 

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

Will Fed Easing Turn Out Like ’95 or ‘07?

July 15, 2019

 You should completely understand that the market is dangerously overvalued and that global economic growth has slowed to a crawl along with S&P 500 earnings. However, you must also be wondering when the massive overhang of unprecedented debt levels, artificial market manipulations, and the anemic economy will finally shock Wall Street to a brutal reality.

Artificially-low bond yields are prolonging the life of this terminally-ill market. In fact, record-low borrowing costs have been the lynchpin for perpetuating the illusion. Therefore, what will finally pull the plug on this market’s life support system is spiking corporate bond yields, which will manifest from the bursting of the $5.4 trillion BBB, Junk bond and leveraged loan markets. And, for that to occur, you will first need an outright US recession and/or a bonafide inflation scare.

We already have a manufacturing recession abroad and a contraction in the US, as illustrated in the new orders data from the June the ISM report. Wall Street is now starting to understand that there will be virtually zero earnings growth for the S&P 500 for the entirety of 2019. However, what is holding up the high-yield market and, consequently, equity prices now is the view that the Fed’s new rate cutting path will allow this ersatz economy a bit of a reprieve by taking interest rates back to zero and thus suppressing junk-bond yields as well.

The answer to the question regarding when stock prices will crash back toward a fair valuation hinges upon whether or not the Fed’s return trip back to free money will be enough to levitate asset prices and the economy a bit longer. Therefore, you must determine if Jerome Powell’s quick retreat on monetary policy will be like the rate cutting exercise that occurred in 1995, or will it be more like the 2001 and 2007 FFR cutting cycle, which turned out to be far too late to save stocks.

Those three economic cycles all experienced a flat or inverted yield curve with rapidly decelerating economic growth; similar to what we find today. But unlike the relatively innocuous period of ’95, the ’01 & ’07 cycles proved that the rate cuts implemented were not nearly enough to avert a brutal stock market collapse.

Let’s look at a bit of history. After first having raised the Fed Fund Rate (FFR) by 300 bps leading up to the middle of the 1990s, the Fed then began cutting rates by February of 1995. It ended its three 25 bps rate cutting cycle by January 1996. The total amount of 75 bps of rate reductions were enough to not only steepen the yield curve and propel the economy out of its two-quarter growth recession but also launched the S&P 500 on an epoch five-year run of 140% by the year 2000. Of course, Wall Street would love for you to believe that Jerome Powell’s new-found dovishness will lead to a similar result.

In sharp contrast to what occurred nearly a quarter century ago, the Fed’s last two attempts to pull the economy out of a nose-dive ended in disaster.

The Fed began to raise interest rates in June of 1999 in an effort to put a damp cloth on the red-hot NASDAQ bubble. By May of 2000, it had undergone a total of 175 bps worth of rate hikes. Mr. Greenspan then began to lower rates in January of 2001 and finally ended his rate cutting cycle in June of 2003 after he reduced the FFR by a whopping 550 bps. Nevertheless, those rate cuts were not enough to save equity prices.  By the fall of 2002, Greenspan had already lowered the FFR by a total of 525 bps, but that didn’t stop the NASDAQ from losing 78% of its value by that time and for investors to see $5 trillion worth of their assets obliterated.

It was a similar situation regarding what occurred during the Great Recession. Chairs Greenspan and Bernanke collaborated to raise the FFR by 425 bps from June of 2003 thru June of 2006. Ben Bernanke then began cutting rates in September of 2007 with an oversized 50 bps reduction right off the bat. He then, in a rather aggressive manner, took rates to virtually zero percent by December of 2008. In other words, he slashed rates to a record low level and by a total of 525 bps, and it only took him one year and three months to do it! However, even that wasn’t enough to keep the stock and housing bubbles from crashing. By March of 2009, the Dow Jones had shed 54% of its value, and home prices plunged by 33%  on a national basis.

Again, this begs the crucial and salient question: will the hoped-for rate cutting cycle, which Jerome Powell indicated at his testimony before Congress on July 10th will probably begin on July 31st, be enough to keep the record equity bubble from imploding? Of course, nobody knows for sure, but there is a strategy to help us accurately model the answer.

First off, the rate cutting cycle in the mid-nineties was abetted by the massive productivity boom engendered by the advent of the internet. There is no such productivity phenomenon of commensurate capacity evident today. In addition, China was on the cusp of bringing 200 million of its population into the middle class by taking on $38 trillion in new debt. The building of that giant pile of debt was responsible for creating 1/3rd of global growth and cannot be duplicated again. Indeed, global growth today is careening towards the flat line rather than being on the cusp of a major expansion.

Not only this but the debt burden in 1995 pales in comparison to that of 2008 and 2019. Total Public and Private US debt as a percent of GDP was just 260% in 1995. However, by the year 2008, it had surged to 390% of GDP, and that figure still stands at 365% today. That is over 100 percentage points higher than it was in ’95.

Another comparison to view is the amount of overvaluation in the stock market between periods. In 1995 the total market cap of equities to GDP was around 70%. But by 2000, it shot up to 148% of GDP. That figure was 110% at the end of 2007 and has now climbed all the way back to 146% today.  The bottom line is the economy is much more fragile today than it was in 1995.

But perhaps even more important than the overvaluation of equities and the massive debt burden the economy must endure is the fact that the Fed could only raise the FFR to 2.25% before stocks began to falter during this last hiking cycle. Therefore, it can only cut rates nine times before returning to the zero-bound range. In each of the previous three rate-cutting cycles, the Fed had plenty of dry powder. In fact, in ’95 it had 600 bps, in 2000 it had 650 bps, and in 2008 it had 525 bps of rate cuts available to deploy.

Also, when looking at the effective number of rate hikes the Fed has engaged in during this latest tightening cycle, you get approximately the equivalent of 625 bps of hiking since 2014. This would include the wind-down of $85 billion in QE, 225 bps of nominal FFR hikes, and the $700 billion QT program – which for the first time in U.S. history saw a tremendous amount of base money destroyed. That amount of monetary tightening is absolutely extraordinary.

The unavoidable conclusion is that the efforts from Mr. Powell will not be nearly enough to thwart the market from its well-deserved day of reckoning.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Baoshang Bank Could Be China’s Indybank

June 17, 2019

For the first time in nearly 30 years, the Chinese central bank and the Banking Regulatory Commission announced it would take control of one of its banks. The troubled Mongolia-based Baoshang Bank had assets of 576 billion yuan ($84 billion), and its seizure is indicative of the deteriorating health of small-scale banks, mostly in rural areas and in smaller cities, as China’s economy slows.

The turmoil surrounding its conservatorship has led interbank lending rates to spike, forcing the Bank of China to inject billions of yuan to quell the fear of systemic contagion. For years China’s regional banks have used shadow-financing to obfuscate their exposure to precarious borrowers. While China has made an effort to rein in shadow-banking activity, this is the first time in decades that regulators have assumed control of a bank in this way. In 2015 and 2016, they recapitalized lenders and merged stronger banks with weaker ones, but these restructuring efforts were disorganized, inadequate, and didn’t address the main issue at hand…insolvency.

According to data compiled by Bloomberg, for the first four months of the year, companies defaulted on 39.2 billion yuan ($5.8 billion) of domestic bonds. This is 3.4 times the total for the same period during 2018.

With the solvency issues plaguing the smaller banks and the rise in defaults, it is becoming evident that funding needs for China’s major commercial banks are becoming intractable for Beijing. The PBOC is running low on the U.S. dollars it needs for activities both at home and abroad. In 2013, China’s four largest commercial banks had around $125 billion more worth of dollar assets than liabilities. But today they owe more dollars to creditors and customers than are owed to them.

Making things even worse for the Chinese banking system is that its problems extend beyond mainland China; there is a looming banking crisis in Hong Kong as well.

Hong Kong pegs its currency to the US dollar and therefore has been overaccommodative with their monetary policy since 2008. This has led to a massive bubble in real estate. Hayman Capital’s Kyle Bass believes Hong Kong is reminiscent of Iceland, Ireland, and Cyprus, whose banking systems imploded during the European banking crisis. The commonality was that each country had allowed their banking sectors to grow to almost 1,000% of GDP, leaving them vulnerable to the smallest economic hiccup. Bass believes that Hong Kong is in a similar situation with its banking system sitting as one of the most levered in the world at approximately “850% of GDP (with 280% of GDP being lent directly into mainland China)”.

Mainland China would be directly on the hook for Hong Kong’s failure as the two largest banks in that nation (Standard Chartered and HSBC) were once filled with British depositors, but now have mostly Chinese obligations.

China’s government has operated its economy much like a Ponzi scheme. It has been stimulating growth by printing money and issuing debt since the year 2000. This is much the same throughout the developed world. But this practice has been on steroids in since 2009. For example, M2 money supply in has skyrocketed by over 133 trillion Chinese Yuan, nearly $20 trillion during that timeframe. But during that same period, China’s annual GDP grew by approximately only $8.4 trillion—proving much of that debt issuance was of the non-productive variety. Therefore, it takes an ever-increasing supply of new money and debt to grow its economy and continue the economic charade.

China is in the midst of one of the largest financial bubbles in modern history. The ratio of banking assets to GDP is much higher than the US at the top of the housing bubble and higher than the EU right before its sovereign debt crisis in 2012.

Still, there are many in the market who believe that with the impressive $3.2 trillion pile of foreign exchange (FX) reserves held by China, nothing can go wrong. Those people should note that that figure was $4.0 trillion not long ago and is currently declining at a rate of $100 billion per month.

Kyle Bass notes that China needs $2.7 trillion of required minimum reserves just to keep trade functioning properly. Thus, making that FX safety cushion a lot narrower.

China is just now experiencing cracks in its banking system that will test their newly established deposit insurance system, making a run on the banks a real possibility. For the Chinese government to save the banks, it may have to destroy their currency in the process. As it stands right now, the yuan is getting close to breaking the all-important 7 per dollar key psychological level. If this level is indeed breached, you may see a massive flight of capital out of the Chinese yuan.

Therefore, the government is forced to continuously issue a massive amount of new currency and debt to keep the economic mirage in place. Yet, at the same time, must find a way to keep its currency afloat. This is the Achilles heel of China’s communist command and control economic model, and it is negatively affecting the yuan’s purchasing power. Consumer prices in May increased by the most in 15 months, while food inflation spiked 7.7% year over year.

Will the conservatorship of Baoshang bank be the event that finally unravels their banking system’s Potemkin Chinese Wall of solvency?  That still is not clear. But with each new iteration of stimulus, the yuan weakens–even against other currency manipulators like the Fed and ECB.

Very few investors thought back in July of 2008 that Indybank was the canary in the coal mine, which gave an advanced warning regarding the insolvency of much of the US financial system. At the time of the bank’s failure, FDIC Chair Sheila Bair assured markets not to worry and that its failure was well within the range of what they could handle. Fed Chair, Ben Bernanke, also gave assurances that the incipient subprime mortgage crisis was completely contained. It wouldn’t be until later that year when investors realized the full extent of the banking crisis that led to the conservatorship of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers, the takeover of Washington Mutual in September of 2008–and, soon thereafter, the near collapse of the entire global economy.

Given that China’s total debt has quadrupled in the past twelve years, a feat that is absolutely unapparelled in history, it wouldn’t be surprising if the collapse of Baoshang Bank forebodes the same fate for China’s economy as Indybank did for the United States.

Fed Running Out of Time and Conventional Weapons

June 10, 2019

The buy and hold mantra from Wall Street Carnival Barkers should have died decades ago. After all, just buying stocks has gotten you absolutely crushed in China for more than a decade. And in Japan, you have been buried under an avalanche of losses for the last three decades. And even in the good old USA, you wouldn’t want to just own stocks if the economy was about to enter another deflationary recession/depression like 2008. Likewise, you wouldn’t want to own any bonds at all in a high-inflation environment as we had during the ’70s.

The truth is that the mainstream financial media is, for the most part, clueless and our Fed is blatantly feckless.

The Fed has gone from claiming in late 2018 that it would hike rates another four times, to now saying that it is open to actually start cutting rates very soon.

My friend John Rubino who runs the show at DollarCollapse.com recently noted: “bad debts are everywhere, from emerging market dollar-denominated bonds to Italian sovereign debt, Chinese shadow banks, US subprime auto loans, and US student loans. All are teetering on the edge.” I would add that the banking system of Europe is insolvent—look no further than Deutsche Bank with its massive derivatives book, which is the 15th largest bank in the world and 4th biggest in Europe. Its stock was trading at $150 pre-crisis, but it has now crashed to a record low $6.90 today. If this bank fails, look for it to take down multiple banks around the globe.

The US is in bad shape, and there is little doubt about it, but the nucleus of the next crisis does not have to emanate from America. I find it incredible that so many people ignore the “melting down nuclear reactors” around the world. China’s factory data shows that the nation’s manufacturing sector is now contracting. China’s National Bureau of Statistics released official manufacturing PMI for the month of May, which fell to 49.4 from 50.1 in April. South Korean GDP shrank in Q1 by 0.4%. In case you were not aware, South Korea and copper prices both have PhDs in the global economy. Copper for its use in construction and Korea for its production of semiconductors. Both are highly sensitive to economic activity, and both are crashing.

Here is one example as to why the Fed is so deathly afraid of a recession. Wisdom Tree and Factset did a study on Zombie companies. They are defined as those with current trailing 12-month interest expenses that exceed the average of the past three years of earnings before interest and taxes. That number is now just under 23%, which is much higher than the 13% rate that what was evident in 2007 just prior to the Great Recession.

To put this in perspective, nearly 1/4 of firms in the Russell 2000 don’t even make enough money to service their debt much less pay back the debt. As economic growth begins to slow sharply, interest rates on high yield debt will start to rise, and zombie companies will get shut out of the credit market. If they cannot service the debt, they go bankrupt and close the doors. As these companies lay off their workforce, the economy will slow further, and that will push junk bond yields higher. This will cause more companies to go belly up and increase the unemployment rolls creating a death spiral of debt defaults, rising unemployment and crashing junk bond prices (soaring yields). A recession/depression would be virtually guaranteed given the record amount of corporate debt– there’s $5.4T worth BBB, junk & leveraged loans outstanding compared to $1.5 trillion sub-prime mortgages in 2007.

This means the EPS on the S&P 500 may not be anywhere close to the ridiculous $186 projected for 2020. Don’t forget; S&P 500 earnings dropped by over 80% in the last recession. Crashing EPS will most definitely pop the equity bubble, and stock prices should fall more than 50%. There will also be a rising strain on government transfer payments (welfare, unemployment, food stamps), which will cause deficits to explode well north of $2 trillion per annum.

Now let’s discuss the yield curve. Yes, it does matter, and no, it’s not different this time. The spread that most matters in the world of the yield curve is the 10year minus Fed funds. This is because of something called negative carry. The current spread between the 10year and Fed Funds Rate is minus 30bps. If shadow banks were to borrow money overnight to invest in longer-duration assets, they would be losing money on each trade. Hence, they stop borrowing; causing money supply growth to dry up quickly. At that point, banks’ profits and the economy contract at a faster pace. In reality, it doesn’t matter why the curve inverts; the effect is the same. So don’t believe the perma-bulls when they tell you the curve has inverted for technical reasons and therefore it is different this time. It matters a lot– especially to the Fed.

The Fed funds futures market is now pricing in 3-4 rate cuts over the next 12 months. It is the market that tells the Fed when it is time to cut rates because of the inverted yield curve. The Fed’s comparable minuscule intellectual capacity has no possible ability to compete with the market’s collective wisdom about where the economy is heading. That’s why we don’t need a central bank at all, especially one that has inserted itself into markets to such a degree that it has now supplanted them entirely.

The salient question is will the coming rate cut(s) be enough to pull the US out of its march towards recession and does it also save China, Japan, Korea and the rest of the maimed global economies around the globe? And, does it also rescue the European banking system as well? The answer is no. What the global economy really needs to perpetuate the growth illusion is a resolution to all the trade wars, along with rate cuts and another massive QE to re-inflate faltering asset prices.

In conclusion, here is a recent a quote from Fed chair Powell, offering more evidence that the Fed– and every other central bank on the planet–are simply slaves to the stock market and headed firmly down the path towards creating a condition of global stagflation:

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future Effective Lower Bound (ELB) spells, which we hope will be rare.”

“ELB” spells are central bank speak for when rates are brought down to zero percent and stay there for a decade they will need to not openly go back into QE, but then even find new ways to get a massive amount of money directly into the hands of consumers.

Therefore, the Fed will be forced to once again try to bail out the economy and stock market later this year. However, it only has 225 bps of easing left before the ELB is reached. It is most probable that the Fed is already too late and also does not have enough conventional weapons to stave off a depression in markets and the economy. That is why before too long, we will have to deal with the unconventional weapons of Universal Basic Income, Helicopter Money, and Negative Nominal Interest Rates.

The chances of this leading to a viable solution to markets and the economy is less than the level of where the Fed Funds Rate will end up..which looks destined to be headed somewhere south of zero.

 

A Brief History of Financial Entropy

May 17, 2019

The global economy began an experiment with fiscal and monetary alchemy when it exited the gold standard almost 50 years ago.

In 1971 the USD completely separated from the last vestiges of its tether to gold. In effect, it released the worldwide monetary system from any limitations of base money growth, as it was no longer pegged to the increase in the mine supply of gold. This is because the USD was once linked to gold and the rest of the developed world linked their currencies to the dollar. This was the case ever since The Bretton Woods agreement of 1944.

Therefore, when the U.S. severed the link to gold, the world entered into its doomed experiment with global fiat currencies and began its journey down the road to financial entropy.

A Bit of History

Paul Volcker (Fed Chair from August 1979 thru August 1987) had vanquished the inflation caused by the loose monetary policies of the Johnson and Carter Administrations by the early ’80s. But once again, the recidivism of the Fed led to rising inflation by the middle of the decade. By the first half of 1987 stock markets had been soaring, rising an astonishing 44% by late August. But by mid-October, the federal government disclosed a larger-than-expected trade deficit leading the dollar to fall further in value and markets to unravel.  By the end of trading on Friday, October 16th the Dow Jones Industrial Average (DJIA) sank 4.6%.  On the following Monday morning, investors in the US awoke to stock markets in and around Asia in free fall. This led the DJIA to crash at the opening bell, eventually plunging 508 points, which amounted to a brutal 22.6% one-day decline. Fed Chairman Alan Greenspan was quick to assure markets his Fed would serve as a source of liquidity and that he would print enough money to support the financial system. He thus encouraged financial institutions not just to remain calm but buy shares with abandon with the full sanction of the central bank.

For the first time since its inception in 1913, the Fed wasn’t just coming to the rescue of an individual bank, or even trying to tinker around the edges of stimulating economic growth; Alan Greenspan made it clear that the Fed was now in the business of directly supporting the stock market. The DJIA gained back 288 points in just two trading sessions. Back in 1987, the entire market value of equities made up just 66% of the economy. And Household Net Worth as a percent of GDP was 370%

The late 1990s ushered in new market worries such as the “Asian Contagion.” From 1985 to 1996, Thailand’s economy grew at over 9% per year. But by 1997, it became clear that much of that growth had been predicated on years of rampant credit growth that yielded an abundance of bad loans. There was also a tremendous amount of foreign borrowing of dollar-based loans and other foreign currencies that exposed the Thai economy to exchange rate risks that had been masked by longstanding currency pegs. When those pegs proved unsustainable and were forced to be broken, firms were unable to pay their foreign-denominated debt–leading many into insolvency. This collapse spread like wildfire throughout Asia and caused the IMF to offer a bailout of over $20 billion.

On the heels of the Asian crisis, Russia becomes an issue. Its weak economy, deficits, and reliance on short-term financing caused the outbreak of a severe sovereign debt crisis. In August of 1998, the Russian government shocked markets when it announced it would devalue the ruble and no longer honor its debts; financial chaos ensued. Many governments and financial institutions found themselves on the wrong side of this trade, but none more so than the highly leveraged hedge fund called Long Term Capital Management, which lost $4.6 billion in short order. Fearing a systemic financial meltdown, the Fed once again came to the rescue of markets organizing a bailout by a consortium of 14 financial firms. Of course, all underwritten by the international fiat printing press.

All of that government-sanctioned counterfeiting exacerbated the NASDAQ bubble of 2000, which soon after burst causing tech stocks to lose 78% of their value by the fall of 2002. At the peak of this bubble, the total market cap of equities as a percentage of the economy was no longer 66%, but had grown to 148% of GDP! And, Household Net Worth surged to 450% of GDP.

In the wake of the dot-com collapse, the Fed took interest rates to one percent and left them there for one year—between June 2003 June thru 2004. This engendered the real estate bubble and Great Recession of 2007 thru 2009. Just before the collapse, Household New Worth climbed to a then-record of nearly 490% of GDP.

The Fed’s response to that worst crisis since the Great Depression was to cut interest rates from 5.25% in 2007, to virtually 0% by the end of 2008; and kept them pegged there for nearly nine years. It also purchased $3.7 trillion worth of banks’ assets to push those same assets back into another bubble. This latest iteration of central bank mania has placed the economy in the position of enduring three great bubbles concurrently for the first time in history (real estate, equities, and bonds). Consequently, not only are stocks valuations back towards 1.5 times the economy but home prices are overvalued by about 35%; along with bond prices that are so distorted that governments are getting paid to borrow money. This current bubble has caused Household Net Worth as a percent of GDP to skyrocket to a record 535%!

From Order to Chaos

The salient issue is that each crisis was ameliorated by printing more money and pushing borrowing costs significantly lower than where the free market would have demanded. Rising rates would normally have cut off access to the cheap credit that keeps non-viable businesses afloat. Recessions are healthy in that they purge the economy of its malinvestments. However, by its systemic practice of artificially suppressing interest rates with increasing distortions, central banks have created massive misallocations of capital that have produced unprecedented levels of debt and asset bubbles.

As a result of this, Household Net Worth as a percentage of GDP is now 50% higher than its historical average.

A significant component of Household Net Worth is stock valuations. As you can see from the chart below, we are now at altitudes only once before ascended during the thin air of the tech bubble.

Another important component of Household Net Worth is real estate values. Here we find that US home prices have far exceeded their bubble-highs set 13 years ago at the peak of the real estate bubble.

 

Add to this calculation the price of bonds, which includes $10 trillion worth of sovereign debt with a negative yield, and you get the trifecta of the everything bubble. It was previously unfathomable to have even one dollar’s worth of negative yielding debt prior to the Great Recession.

The major consequence of all this is that the valuation of assets has now become far bigger than the underlying economy and therefore can very easily bring the whole charade crashing down.

The amount of subprime mortgage debt before the Real Estate bubble collapsed was just shy of $1.5 trillion–its demise brought down the entire global economy. Compare that figure to the amount of “sub-prime” corporate debt, and you can understand the scope of just one of these asset price distortions. When you add the total of junk bonds and leveraged loans together, you come up with a figure of $2.8 trillion. Then, if you count the surging $2.6 trillion level of BBB debt, which is just one notch above junk, you come up with a figure of $5.4 trillion worth of extremely economically sensitive business debt. By the way, this does not imply that over leveraging can only be found in business debt; as of Q1 2019 there is a record $13.6 trillion of household debt outstanding, which is nearly one trillion dollars more than the previous peak in Q3 2008. Therefore, even a small contraction in GDP could quickly snowball into an avalanche of defaults and economic chaos.

The key point here is that when the total value of equities was roughly half of GDP like it was from the mid-’70s thru the mid-’90s; the economy was able to lead the stock market. But, when money printing pushes stocks to become 1.5x the value of the economy, it is stocks that then lead GDP. Likewise, when Household Net Worth was 370% of GDP, asset prices were more a function of economic growth. But with asset prices now at 535% of GDP, it is asset prices that pull the economy. Hence, keeping equities in a bubble is now mandatory because a fall in the market can easily bring down the economy and also any political leader that happens to be in charge. Donald Trump is keenly aware of this fact. But in truth, all those in power are cognizant to this fact as well. We saw an example of this in Q4 2018 when the junk bond market froze for 41 days without any new issuance, and stock prices entered into a bear market. The Fed quickly abandoned its rate hiking plans and promised to truncate its QT program.

But, of course, this bubble just doesn’t belong to the U.S. According to Kyle Bass, the banking system of Hong Kong has now exploded to become 8.5x the island nation’s GDP. Its neighbor, China, has a massive and unproductive $40 trillion worth of debt that has quadrupled since 2007. Japan’s economy would crash in epoch fashion if the Bank of Japan (BOJ) ever began to step away from its asset bubble support. The quadrillion yen Japanese government bond market (JGBs) would become insolvent without its primary buyer the BOJ—it now owns over 50% of the entire JGB market. The BOJ also already has possession of nearly 80% of the ETF market. Therefore, at the first hint that the Japanese government was to begin removing its bid for stocks it would most likely cause the NIKKEI Dow to plunge in a manner that makes its spectacular crash of 1989 look like a bull market.

In other words, the power that once existed within free markets has now been completely usurped by governments and central banks.  These abrogators of freedom have gone all-in with their price manipulations and are now forced to perpetually engage in debt monetization, or risk a global asset price meltdown that would almost certainly engender a depression worldwide. This is the truth as to why Wall Street cares very little about earnings and the economy and instead has become completely focused upon every word that proceedeth out of the mouth of a central banker.

The linking of money to gold was a spark of human genius, but it was also the avarice nature of mankind that eventually destroyed it. The inevitable and dire consequences of which are high.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

When Overvalued and Dangerous Markets Meet Stagflation

April 29, 2019

To put into perspective how overvalued and dangerous the US market has become; I often cite the figure of total market cap to GDP—currently 145% of the economy. How high is 145% of GDP? It is a full 30% higher than it was before the start of the Great Recession. The twin sister to this metric is the Household Net Worth to GDP Ratio. Household net worth as a percent of GDP is calculated by dividing the current bubbles in home prices and equities by the underlying economy, which has been artificially inflated by interest rates that have been pushed into the sub-basement of history. This metric is now an incredible 535% of GDP, which is a record high and 19% higher than the NASDAQ bubble of 2000. To put that figure in perspective, the good folks at Daily Reckoning have calculated that the historical average is 384%.

These valuation measurements are much more accurate than Wall Street’s favorite PE ratio valuation barometer because they cannot be easily manipulated by corporate share buybacks that have been facilitated by record-low borrowing costs. And, as hinted at already, the GDP denominator of today is much more tenuous because it has become more than ever predicated on the record amount of fiscal and monetary stimulus from the government.

This begs the question: why are asset prices at an all-time high when Japan and Europe are stuck at zero percent GDP growth, U.S. growth has been cut in half, and the growth rate of China is decelerating.  What caused these bubbles is no mystery: a decade’s worth of Zero Interest Rate Policy and Negative Interest Rate Policy worldwide that led to a massive pulling forward of consumption through a record level of new debt, which in turn was primarily used to purchase (a.k.a. inflate) asset prices.

Global Central Banks have become the captains on this heavily overcrowded and doomed ship that has a woefully insufficient number of lifeboats; where investors have been forced onboard chasing risk because traditional bank deposits offer little no return.

However, this daunting game can continue skipping along until one of two daggers present themselves to annihilate these bubbles. The two catalysts are; intractable inflation or a recession/depression. I include depression as a likely outcome in the next economic contraction because the level of economic distortions has never been more manifest.

So how will inflation prick this bubble and what level will most likely accomplish this? First, it is crucial to understand that central banks cannot accurately create a certain level of inflation. Central banks are undergoing a process of trying to inflate asset prices by eroding the confidence in fiat currencies, which is ultimately what inflation is all about. They do this by printing enough money to ensure nominal bond yields are below inflation.

Therefore, it is impossible for a handful of academics that sit on the Fed Open Market Committee to accurately pinpoint where the rate of inflation will end up, much less be able to maintain it at a certain level. This is especially true given their professed knowledge of inflation matches that of an amoeba with a low IQ. One possible outcome is that inflation eventually brings the Fed back into tightening mode. This would most assuredly occur if the core level of its preferred metric, core PCE price index, reaches above 2.5% in a sustainable fashion and then continues higher from there. And, even if the Fed did not react to this inflation by increasing the Fed Funds Rate, longer-duration yields would surely begin to spike to offset the increasing loss of purchasing power over time. The already-embattled auto and real estate markets would then crater just as the consumer is crushed under rising debt service payments on the record amount of household debt. In addition, the junk bond market would implode just as equity prices crash due to the increasing competition for cash–in other words, a replay of Q4 2018 that can’t be so easily cut short and mollified just by another Fed pause. It would take rate cuts and a return to QE to have a chance at arresting the next economic and market downturn.

The other dagger is an economic contraction; which, given how far asset values have grown above the underlying economy, is virtually guaranteed to be a long and brutal one. Surging government expenditures along with falling revenue will send trillion-dollar deficits soaring above $2 trillion in short order. Annual deficits will be accretive to the $22 trillion National Debt just as the GDP denominator in the Debt to GDP Ratio heads sharply lower—causing the already dangerous 105% National Debt to GDP Ratio to surge.

The bottom line is the bubbles will break just as they have in the past. But investors must first become afraid of not only losing their profits but their ability to retire. Falling GDP, and/or spiking interest rates will accomplish this. And, given the fact that both equities and bonds are in a bubble, there is a chance that bonds and equities will collapse in price together.

Today’s market is trading at a nominal record high and record high valuations. But these prices exist in the context of unprecedented economic distortions. To be specific; there is $10 trillion worth of sovereign debt with a negative yield, global debt has surged by $70 trillion—to $250 trillion–since 2008, central banks are stuck at the zero-bound interest rate range and have already permanently monetized $14 trillion worth of debt and have destroyed the free market and the middle class in the process.

Hence, the only prudent strategy at this time is to have a robust and proven model that will identify when the inflation or the growth slowdown has reached critical mass so you can protect and profit from the next air-pocket in equity prices. As a reminder, during the last two recessions, investors lost half of their wealth. February and October of last year proved beyond a doubt how fragile this market is, and that tenuous state is the direct consequence of its artificial construction.

Wise investors will think about these facts and use this strategy to avoid getting sucked into the markets biggest black hole in history.

Global Bond Bubble’s Ultimate Culmination

April 22, 2019

Historically speaking, a normal Fed tightening cycles consist of raising the Fed Funds Rate (FFR) by 350-425bps. It is at that point that the yield curve usually inverts–thus, disincentivizing future lending and closing down the credit conduit. At that point the Fed backs off from future rate hikes. Then, about a year later, a stock market meltdown begins; and six months after that a recession ensues. During this current cycle, the Fed Open Market Committee (FOMC) has raised rates by just 250bps before turning dovish. Therefore, Wall Street takes solace in the view that this time around the Fed stopped in time before it killed the business cycle.

However, that 250bps of hiking is before you factor in the end of Quantitative Easing (QE) and the current Quantitative Tightening Program (QT), which is still an ongoing process and won’t end until September. When you factor in the tightening that occurred when the Fed ended QE in October of 2014, which amounted to $85b per month of newly printed money at its peak and added a total of $3.7 trillion to the Fed’s balance sheet, the actual amount of tightening from ending QE is probably close to 300bps. And, the QT from the Fed will end up draining nearly $1 trillion from its balance sheet and reached $40-$50 billion per month at its peak. A reduction in the Fed’s balance sheet of anything close to $1 trillion is completely unprecedented and amounted to a tremendous drain on liquidity. Nobody knows exactly the amount of rate hikes this equates to, but it most likely added another 75bps of monetary tightening.

Société Générale calculates that the Shadow Fed’s Fund Rate dropped to three percent and, therefore, the amount of rate hikes to date have been 525-550bps. 300bps more than the stated FFR of 2.25-2.5%. But that is before you add in the Fed’s QT program. Therefore, when you add it all up, you get the equivalent of 600-625bps of rate hikes in this current tightening cycle—well above the high-end of the historical range where the business cycle turns towards recession.

My friend and Director of the National Economic Council, Larry Kudlow, recently stated that interest rates might not rise again in his lifetime. He is 71 years old, and I hope he lives for a very long time, but you get the point. Larry believes interest rates won’t rise for decades to come. Vice President Mike Pence said in an interview with CNBC that the Fed should cut interest rates by 50bps and agrees with President Trump about ending the QT program immediately. Pence also said this, “There’s no evidence of inflation in this economy.” Ok, Mr. VP, you don’t have to be Sherlock Holmes to discover the evidence. Home prices have jumped 48% in the past six years, all forms of insurance coverage have skyrocketed, and college tuition has been rising 8x faster than wages. But even if he took the time to view the manipulated government data on CPI and PPI, he’d see Consumer Prices are up 1.9% year/year, and Producer Prices have risen 2.2% year/year.

Nevertheless, President Trump is pushing for a return to QE, and he may find out that he has more friends on the Fed than he currently believes. Chicago Fed President, Charles Evans, had this pithy bit of wisdom regarding how he views his responsibility to protect the purchasing power of the dollar, “Inflation is weaker than I would like,” he said recently on a TV interview. As to why more inflation would help grow the economy, these lovers of counterfeiting can never clearly articulate.

With the FFR hovering at less than half its historical level, and the Fed’s balance sheet at $4 trillion, one would hope the government would think the last thing this economy needs is to cast more doubt on the faith in the US dollar’s purchasing power.  Inflation pushes the middle class further and faster along its inexorable path towards extinction. To add to this distorted view, our President recently tweeted that the Dow would be 5-10k points higher if the Fed had not engaged in QT. One also has to wonder how much more unhinged the President wants the stock market to become in relation to the underlying economy. After all, the total market cap of equities now stands at an incredible and dangerous 1.5 times GDP. The danger to the entire economy emanating from the inevitable crash from such lofty heights is growing exponentially.

Meanwhile, the debt dung pile in Chinese debt just got a whole lot deeper. Again, I don’t blame the great people of China but rather its government for this. The March total debt number was 80% higher than the year-ago figure, and the YTD debt increase was 40% higher than the year-ago period. Aggregate financing in the first quarter amounted to 8.18 trillion yuan (US$1.2 trillion), which was an increase of 2.34 trillion-yuan year/year. As to how Wall Street believes adding to China’s debt at this point can be a viable and sustainable plan is inconceivable. After all, China’s debt has already quadrupled in the past seven years. So, it is not as if Beijing has not tried this stimulus trick before. The government has indeed levered-up many times before in a big way and has produced a more unstable and unhealthy economy with each iteration.

Turning to the US, our March fiscal year to date deficit came in at $691 billion–that is for just the 1st half or the fiscal year. So, governments around the world have unbelievably and inconceivably taken fiscal and monetary madness a giant leap further and deeper into the depths of inescapable insolvency.

Is it any wonder why stock prices are rallying? There has been an absolute deluge of promises from global governments since the market collapse of Q4 2018 that there will be more free money on offer, even though they are fully aware that taking on more debt at this point guarantees the future will be beyond bleak.

For now, the economy walks a very thin line along the cliff’s edge. Unless you believe central banks can stay at the 0 bound interest rate range forever and never cause a reduction in a currency’s purchasing power, intractable inflation is inevitable. Once achieved, it will produce an interest rate surge from all-time lows that will engender an equally disastrous plunge in asset prices. Any fixed income instrument and equity that the government is not actively purchasing will crash in price. This is exactly what occurred in October of 1987, where the Dow lost 23% of its value in one day. But unfortunately, the carnage should be much worse than 1987 given the relative level of debt and overvaluation of equities that exists today.

The number and dollar amount of business defaults occurring as a result of such a meltdown should be unprecedented. There is a real danger the economy will contract into a depression given the record level of debt it is lugging along. The US carries total debt that is worth 350% of GDP, which is the same Pre-Great Recession level. This figure was 160% of GDP in 1980 and just over 200% in 1987. But this time around central banks have little, to no room, left to reduce borrowing costs and spur on new lending.

On the other hand, a recession could begin even before inflation runs intractable. The global economy is already slowing, and earnings growth has slowed to a negative level. If the amount of Fed tightening I estimated earlier is anywhere near correct, the business cycle should soon turn south following a stock market peak and crash that is only a few quarters away. The massive re-leveraging in China has served to hold off the carnage a bit longer, but Beijing now risks a crash in the yuan.

If you are investing in this market, it is necessary to try and eke out any gains left and do so using a data and math-driven model that is built to identify when to head for the nearest emergency exit well ahead of time to ensure you find one of the few lifeboats available. Then, you can sit back and use your cash to finally pick up the pieces of good companies with solid cash flow and dividends at a fair price. It’s the only sound plan around.

LYFT Mania is Wall Street’s Dead Canary

April 8, 2019

Recently, Wall Street has been myopically focused on the IPO of a ride-sharing company called Lyft, which by the way, is hemorrhaging money. Since investors have become much less concerned about profits and valuations, this offering was an incredible 20 times oversubscribed. Meaning, the underwriters received $47 billion of orders for Lyft shares but raised $2.3 billion. The company generated $2 billion in revenue last year and lost an incredible $911 million! Investors rewarded this profligate business model with a market cap of $27 billion.

This is a great example that Wall Street has gone nuts. The Lyft IPO price was $72 per share and shot up to $88.60 on its first day of trading. But the following trading day those shares were down 24% from the high. Indeed, this is emblematic of the dead canary in Wall Street’s coal mine.

Wall Street’s mispricing of this IPO is a perfect illustration of how the yield suppression from central banks has caused another stock market mania. The LYFT IPO should provide prudent investors with a stark warning: It is crucial to ignore the lure of lemmings and groupthink. Rather, they should concentrate on the fundamentals and the data—both of which point to a massive equity bubble.

Recent data points prove that the US and the global economy are weak, at best and cannot support the stock market at this level.

The Commerce Department said recently that retail sales fell 0.2 percent in February. Over the past year, retail sales increased by a slight 2.2%. Hence, after adjusting for inflation, growth in retail sales was not evident at all. Durable goods orders for February fell 1.6%. A key measure of business investment, known as core capital goods orders, fell for the fifth time in the last seven, dropping 0.1%.

You can forget about the capital spending boom, and productivity gains hoped for from the tax cut. Ex-autos and gas the number was -0.6% vs. +0.3% expectations. Spiking prices at the pump boosted the headline retail sales number but didn’t help most consumers’ wallets. The Chicago PMI in March slowed to a reading of 58.7 from 64.7. Order backlogs fell into contraction territory, while production and new orders fell from the previous month’s level. Remember, March data is hugely important because those readings occurred after the government reopened at should show a strong rebound–if not, the economy is in deep trouble. The March ISM Services Sector PMI, which fell to 56.1, was the weakest print since August 2017 and down from 59.7 in February.

The US automotive sector is giving us another warning sign about consumers’ health. Fiat Chrysler reported a 3% decrease in U.S. Auto sales for the first quarter of 2019, while General Motors sales fell 7% in the first quarter as all four of its brands recorded losses. Toyota Motor Corp reported a 3.5% fall in U.S. sales in March and a 5% drop for the first quarter. Nissan Motor Co. posted a 5.3% drop in sales in March, and its first-quarter sales were down a significant 11.6%.

The economic slowdown is even worse in Europe. Factories in the Eurozone had their worst month for almost six years in March. The EU’s IHS Markit’s March final manufacturing Purchasing Managers’ Index declined for an eighth month, coming in at 47.5 from February’s 49.3. China’s March PMI improved to 50.8, which is barely in expansion mode. However, Wall Street ignored the horrific EU data in favor of the hopes that China can bounce back. But the truth is Red China is a debt-disabled nation with a shrinking labor force and falling productivity. China’s household debt increased by 716%, Non-financial corporate debt jumped by 400%, and total government debt climbed by 416%, all since 2008. This was the product of its past stimulus packages. It is extremely doubtful that robust and viable growth can be produced from yet another round of government stimulus.

Turning back to the US, the data does not indicate the real estate sector will be aiding to the hopes of a second-half rebound in the economy.

February made it 14 straight months of year over year declines in pending home sales. The drop in pending sales was down 4.9% from January.  The takeaway is clear: home prices have shot up well above incomes each year since 2012 due to Fed’s ZIRP. Now, home prices have become unaffordable for the first-time buyer for the most part, even though mortgage rates are coming down. Perhaps that is why we are starting to see the inexorable rise in home prices begin to reverse. The median sales price of a new home in February fell 3.6% to $315,300. The Home price/income ratio now stands at 4.4. It ranged from 3-3.5 from 1969-2001 and hit an all-time of 5.1 in 2005. Manhattan real estate sales fell for the 6th quarter in a row. That is the longest losing streak in the past 30 years.

Interest rates are falling commensurately with decelerating economic growth. Demand is down for homeownership due to affordability issues, and at the same time, banks are less incentivized to lend due to shrinking margins on new loans. The yield curve inverted recently and that inversion has led to a recession seven out of the last seven times it has occurred.

The most salient question is whether or not China’s massive stimulus efforts combined with the Fed’s abeyance with rate hikes and promise to end QT come October, will be enough to provide for viable global growth.

With all this, there are some small signs of stable data in the US, for example, the March ISM Manufacturing Index registering 55.3 in from 54.2 in February, which was a small increase. But that slight blip higher in the ISM was offset by the IHS Markit manufacturing PMI, which fell to 52.4 vs. 53 in February, which the lowest reading since June 2017.

The plain truth is the overwhelming majority of global data still points towards contraction and an anemic debt-disabled world. There is a contraction in global trade; the Baltic dry index has crashed; tax receipts are falling and, according to FactSet, there was the largest cut to Q1 S&P 500 EPS estimates since Q1 2016. EPS was cut by 7.2% to $37.33. The interesting part is that for all of last year the earnings for the S&P 500 was $161.57 & the projection for 2019 EPS is $168.19, or 4% growth. However, with Q1 projected to post just $37.33, it will take an absolute surge in global GDP and EPS to achieve anything close to that 2019 estimate. The current run-rate 2019 for full-year EPS on the S&P is below $150!

Therefore, the global equity market has priced in the environment that a return to a globally synchronized recovery is indeed already an established fact. Nearly every economist and market strategist is bullish; predicting a favorable outcome to Brexit, the trade wars, the slowdown in global GDP, the current recession in parts of Europe, the zero growth in Japan, US GDP growth slowing from 4.2% last year to 1.3% in Q1, which is projected by the NY Fed. They see no issues at all with record global debt levels and the $10 trillion worth of negative-yielding sovereign bonds; there is no fear over the threat from Donald Trump to close the southern border, or Trump imposing tariffs on autos from the EU. The level of complacency is astonishing. Only the tech bubble of 1999 can compare with the lunacy that Wall Street exhibits today.

Therefore, the only logical outcome is that disappointment lies ahead for the perma-bulls

A big drop in the stock market is inevitable. That collapse in asset prices will set the Fed up for a massive move back to ZIRP and QE along with fiscal spending that would make even Alexandria Ocasio Cortez blush, which will render the economy into a deep battle with stagflation. That stagflation will lead to some great opportunities on the long side but will also eventually set us up for a huge plunge in asset prices that will make Q4 of 2018 and 2008 look like a bull market. Such are the consequences derived from abrogating the free market in favor of the hubris of central planners.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

China Can’t Save the Global Economy Again

March 25, 2019

China has acted as part of the life support system for the global economy during the past two decades. The other part being comprised of central banks. When the Tech Bubble burst back in 2000, China began printing and borrowing an incredible amount of money to create demand for fixed assets. After the Great Recession struck in 2008, Beijing again reacted with a massive government stimulus package that helped further inflate its real estate bubble and placed a pervasive bid under global markets. It was much the same in the wake of the global slowdown and earnings recession in the U.S. in 2016. In fact, China has been a humongous tailwind for growth since 2000; taking on about $38 trillion in new debt, which amounted to an incredible 150-percentage point increase in its debt to GDP ratio.

Because of this untenable debt load, China recently began a much-needed policy of deleveraging, leaving many to speculate how long the global economy can sustain itself without its main growth engine. After all, the Red Nation had been responsible for roughly a third of global growth since 2008. However, and regrettably, China’s flirtation with austerity did not last very long. Authorities have now begun to reset priorities away from reigning in the nation’s $40 trillion worth of debt and are instead seeking to prop up the economy with yet more debt.

Some of the debt ratios in China not only exceed that of the U.S. but are also estimated to be twice as high as that of the average emerging market economy. Total debt has more than quadrupled since 2007. Total debt including household, corporate and government increased from 160% of GDP in 2008 to over 304% of GDP in 2018, according to the Institute of International Finance.

And all this begs the question: With its massive debt load, does China have the gas left to fuel the global economy, or has Wall Street misplaced its faith in an ersatz economic savior and a resolution to the trade war?

For the past three decades, China has been the global growth darling of the world and Wall Street. The communist nation has averaged GDP growth of 9.9%  from 1979 to 2010, according to the World Bank

Under its unique combination of communism and capitalism, China’s growth seemingly defied the laws of economics and the business cycle. But a cursory look beneath the surface exposes China’s economic miracle was continuously levitated by a dangerous mountain of debt.

While the central government in China holds little debt and enjoys healthy foreign currency reserves, regional government debt, household debt, and corporate debt have exploded. Regional governments in China provide schools, hospitals, and transportation services. However, they have almost no power to raise taxes and receive very little of the taxes levied in their territory. These localities balance their budget by issuing Local Government Financial Vehicles (LGFV). This type of debt is extremely opaque, making it difficult to accurately calculate the actual level of indebtedness, but it ranges between $5 trillion to $7 trillion, according to CHEN, Z. China’s Dangerous Debt: Foreign Affairs.

State Owned Enterprises or SOEs accounted for more than half of total corporate debt, or 72% of GDP in 2017 according to the International Monetary Fund (IMF). Most of these enterprises are Zombie corporations meaning they have an unsustainable business model. They exist mainly to employ people and must constantly take on new debt to pay off interest on existing debt. This type of state-directed debt is nonproductive in nature and is a primary contributor to the plunge in labor productivity.

The Private Sector Corporate debt consists of bank loans, bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock exchange.  offerings, and shadow banking activities. These debt-laden companies are even more vulnerable to a drop in asset -values and/or a rise in borrowing costs. Slowing growth and tighter regulations have recently triggered many bankruptcies in this space.

Finally, we have Chinese household debt, which has been dramatically outpacing household income for the past decade.

But debt is not the only overhang on the Chinese economy. China has a shrinking labor force and a population that is rapidly aging. In 2010, 13% of the population was 60 years old or older; but by 2030 that figure skyrockets to 25%. According to Statista, the labor force in China is shrinking by 0.2% between 2016-2026 and then it drops further from there.

All these factors prove that China’s recent economic problems have little to do with a trade war. The Shanghai Composite Index peaked two years before the first direct tariffs on China’s exports were put into effect.

Wall Street believes that resolving the trade war will become a panacea growth. But the Chinese economy has been fueled by a powerful credit bubble over the past few decades. And its credit-driven economy has become a significant growth engine for the global economy whose “recovery” is predicated on debt. Indeed, Global debt has increased by $150 trillion since 2003 and $70 trillion since 2008:

In the vanguard for this global re-leveraging process was, and is China. According to S&P Global Ratings, China’s household debt increased by 716%, Non-financial corporate debt jumped by 400%, and total government debt climbed by 416%; all since 2008. And now that immense pile of debt dung is exploding, and it just can’t be easily remedied by yet another stimulus package from Beijing.

Proof of China’s debt-disabled condition can be found in the current data. Mobile phone shipments in China totaled 14.51 million in February, a nearly 20% plunge year-on-year, according to data recently released by the China Academy of Information and Communications Technology. In addition, China Auto sales plummeted 14% year over year in February.  But last month was no aberration. Car sales were down for the 8th month in a row and have crashed by 16% in January and 13% in December. In addition, China’s Industrial Production in the first two months of this year fell to a 17-year low.

Similar to Japan in the late-1980s, China’s economic growth once appeared to be unstoppable. This mistakenly led most on Wall Street to believe that the communist nation would eventually leave the U.S. economy far behind in the dust. However, students of history know that Japan’s growth phenomenon came to a sudden halt in 1989; at the same time of its epoch market crash. Likewise, China’s economy and equity market peaked in 2015 and the Shanghai Index has fallen by 43% from that point.

By accumulating debt at such an aggressive rate, China is following in the same footsteps as its historical enemy to the east. All indications are that it will soon experience a similar fate, as the government’s debt scam implodes.

The joke here is that equity markets are banking on yet another global growth slingshot to occur very soon. But as to why the supposedly bastion of capitalism that exists on Wall Street has misplaced its faith in a communist nation’s ability to magically produce a targeted rate of growth on demand should be a mystery. Sadly, the truth can be found in that carnival barkers are always in search of a good story to tell; no matter how much fiction is involved.

Investors would be wise to use extreme caution given the fact that this global earnings and growth recession is occurring while equities are at all-time high valuations and at the same time debt levels are off the charts. Especially when central banks have either very little or in most cases, zero room left to lower the cost of debt and boost economic growth.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

 

 

 

Asset Bubbles and the Economy are Now One

March 11, 2019

 After this latest round of a deflationary recession/depression consummates, global central banks and governments will engage in an epic battle to re-inflate asset prices such as never before contemplated. Indeed, they are laying the framework for that assault right now.

Global central banks took interest rates to the zero percent range a decade ago and, for the most part, they remain there today. These confetti pushers printed $15 trillion dollars in order to push rates into history’s basement. Such an enterprise in counterfeiting has never been attempted before outside of a banana republic.

This process sent the total market cap of equities in the U.S. to 150% of GDP in the fall of last year, which was an all-time record high. Today, this most-accurate metric of equity valuations stands about 80 percentage points higher than its long-term average prior to the NASDAQ bubble of 2000. In other words, because of the unwarranted bounce in stocks at the start of this year, equity valuations have traded back to an extremely dangerous level once again.

The current bubbles in stocks, bonds, and real estate began to concern the Fed a few years back. The FOMC ended QE in October 2014 and began raising rates in December of 2015. This process of first ending QE, then raising rates 9 times, then selling $500 billion of its assets; was an honest attempt to roll back the massive and unprecedented stimulus programs deployed during the Great Recession. In fact, the new Fed Head, Jerome Powell, avowed on October 3rd of last year that his Quantitative Tightening (QT) program would remain on autopilot and that he intended to raise interest rates by another 100 basis points over the course of the next 1-2 years.

However, the cumulative effects of ending QE, draining half trillion dollars of liquidity from the economy, and raising the Funds Rate by 225 basis points eventually hit asset prices hard only a few days after his now infamous pledges. The major averages plunged by 20% and small-cap stocks cratered by nearly 30% by Christmas. It was at that point the Fed reached an epiphany. Mr. Powell and the rest of his merry band of money printers realized that asset prices and the economy had become one and the same. Whatever economic growth was experienced by the economy was completely beholden to the asset bubbles central banks created.

After all, the watershed change from hawkish to dovish was not due to the Fed’s two mandates comprised of stable prices and full employment. The December data on Consumer Inflation increased by 1.9% year over year and the January Non-farm payroll report showed a net 304k jobs were created. Therefore, it was the collapse in stock prices and the seizing up of the high-yield bond market that cowered the Fed into mush.  So now, in reality, the Fed has only one true mandate and that is a to ensure there exists a perpetual bull market in junk bonds and equities.

The sad truth is that central bankers are a group of flawed humans who have the hubris to believe they can play God with economies. Need more proof? Remember when former Fed Chair Janet Yellen promised that QT would be “like watching paint dry” and that there would not be another financial crisis in our lifetimes. Then, 16 months later the global economy began to crumble along with equity prices. Proving once again that central bankers aren’t even demi-gods—much less gods–they are just foolish and feckless individuals that have given themselves way too much power.

Therefore, the Fed is unaware what turning dovish at this juncture really means. With an effective overnight lending rate of 2.4%, Powell wasn’t even able to get the Fed Funds Rate at half the level it was at the peak of the last cycle. And, most importantly, leaving the balance sheet at a level of $3.5-$4 trillion when it ends Quantitative Tightening will mean the Fed has permanently monetized around $3 trillion worth of government debt and mortgage bonds.

The salient danger in stopping its normalization process at such levels is tantamount to admitting that asset prices and the economy are one in the same. And, the Fed is now powerless to stop their ascent without engendering an absolute and complete economic collapse. Also, the markets will soon be put on notice that real interest rates will become progressively more negative over time and that nominal rates are stuck near zero percent. Being a slave to the markets also denotes that there will never be a good time to normalize monetary policy and this condition will only grow worse over time.

As this current deflationary cycle intensifies, expect central banks to go full throttle back into QE and global interest rates to fall even further into the cellar of history. We should also expect massive fiscal stimulus programs worldwide that will add significantly to the global leverage ratio. For example, we already see China’s government force a record 4.64 trillion yuan ($685 billion) in the month of January alone into their economy! Hence, not long after this complete capitulation on the part of governments to go full-throttle with inflation, look for asset prices to grow further detached from the underlying economy and for the wealth gap to surge from its already crippling level.

In the end, it will be a brutal battle with global stagflation that eventually craters GDP, which has been artificially constructed using the printing press. The plunging faith in the fiat currency regime that underwrites a record $250 trillion of global debt will be the result.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”