Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Checkpoint: 115 Months of recovery, where are we?

In February 2018 I noted that the recovery had reached 105 months (I must have been off in my count, as the WSJ today calls it 115 months so far, with the longest in US history being 120 months), and asked what could end the recovery. I listed nine possible scenarios that could crack investor confidence sufficiently to cause a sustained market downturn or crash. How have those nine held up over the past ten months, and has the level of risk increased or decreased?

If we should take any lesson from the passage of the past 10 months, it should be that we are closer to the storm, not that we have avoided it.

There has been, with the US mid-term elections, both a reduction in the level of risk and potentially, a major increased risk event. More about that below.

As a recap, the nine potential issues (one removed, one added) that could bring about an end to the US recovery include:

1. Interest Rates;
2. Inflation shock; 
3. Budget deficits;
4. External Shock;
5. Housing market;
6. Automotive Loans default rates; 
7. Credit Card delinquency rates;
8. Environmental event; 
9. Mid-term elections

After years of single-direction trajectory for the markets, the February correction jolted people from their complacency, but concerns were short-lived as the markets recovered and eventually reached new highs in early October. Then there was the October market shock, and now it appears a post-election bump.

Being very clear, I still do not know if the top has been reached, or is there more headroom in this market. I have no idea. None. Also being clear, while the discussion focuses on the US markets, there is nothing in here that either does not have or is not impacted by events and economic situations in other countries.

If the markets continue their advances, how far can they go, and for how long? Is the US in the "demographic sweet spot" that I wrote about in August 2017? I asked if the fall in the US labour market participation rate had been strong enough to create sufficient pools of surplus labour to allow for multi-year growth as that surplus labour drip-feeds into the workforce. If it is, then there may actually be a few more years of growth in the economy and the markets. If not, then the third longest recovery in US history may come to a sudden end.

So having presented all the caveats that matter, the question remains; when will the recovery end, what factors could cause a market rout, and how close are we to that happening?

Interestingly, almost all of the nine catalysts has deteriorated over this year, increasing the chances of any one of these reaching a tipping point, and with contagion, bringing about a multiple Black Swan event stream.

In February I wrote “Most important, there is not one situation that will cause the coming crash, and all are interlinked and interdependent. Each can, and probably will, impact and potentially exacerbate another or multiple others.” That assessment remains true, and the deterioration of each potential catalyst since then has only increased the probability of such contagion.

Below I look again at each, with a potential update on the current situation.

1. Interest Rates: Fed rates hikes have continued through the year, and there is an expectation that there will be another rate hike in December 2018. I predicted that the Fed rate would continue to rise, and it has. More importantly, the 10-year Treasury, hovering then around 2.9% up from a low of 2.06% only six months previously, is now in the 3.2% range, and will go up further with additional rate hikes. Eventually, returns on “zero-risk” assets will move closer to the returns that can be expected (minus the desired margin for risk) from risk assets. When that happens, there may be a flight to Treasuries. There continues to be the additional risk of tipping point in consumer credit growth due to increases in interest rates. Interest rates remain a potential cause of a sudden drop in confidence.

2. Inflation shock: While the years of QE, QEII, Twist, Abenomics, and ECB purchases did not create the inflation shock that should be expected from too much cash chasing too few assets, there are signs of inflation beginning to creep in – in employment costs. Surplus labour is being consumed, and the dearth of skilled workers is beginning to be felt. While demographically the US may have a deep lake of workers waiting to return to work, the decade of reducing participation rate has stripped many of these workers of skills that are required in an economy that has changed so significantly in that decade.

3. Budget deficits: the official 2018 US federal budget deficit is $779 billion, and has jumped 17% since 2017. This, of course, is not the actual US federal budget deficit and total borrowing by the federal government, because it only includes “budget” items, and does not include a wide range of additional spending that has resulted in the US federal government actually borrowing $1250 billion. A Congressional Budget Office projection stating that servicing of the national debt will exceed 8% of the 2019 federal budget (from a current 6% of the federal budget)? As interest rates increase, so does the interest payment obligations of the US government. At some time, there will be a confidence shock related to the budget.

4. External Shock: In the past 10 months there are been plenty of External Shocks, and defying expectations, none seem to have actually impacted levels of confidence in the US economy (and it is the US economy and markets that will crash the rest of the world). Turkey has crashed, as has Argentina, and Venezuela continues to perform to form. Equally unsurprising, there has not been a war with North Korea (not that there ever was going to be a war with the Norks – and yes, The Donald was played like a cheap fiddle). 

Yet potential external shocks remain, and the most “predictable” today include the Italian budget, Brexit, and China. None is a war, but we shouldn’t discount the possibility, with Iran being vocally belligerent (with the threat to Oil supplies and price) after the imposition of the extremely harsh sanction by the US, and an accident could spike tensions in the South China Sea at any time. Extreme but highly unlikely events might include the fall of the current Crown Prince in Saudi Arabia and an associated short civil war.

5. Housing market: The US housing market is turning, even though it has had a very strange 6 months, with months of good starts, contacts and completions for both new and existing homes, and months of badness in the numbers. The latest information suggests that optimism is gone from the market. Optimism drives the market, as without consumer optimism major purchases, and a home is one of the largest purchases most people will ever make, will be postponed. 

6. Automotive Loans default rates: This is one area where the numbers appear to be improving, with auto loan default rates reducing marginally in the previous quarter. Current default rates are increasing, and the total outstanding loan period is also at a record high. In 2018 the most common car loan term was 72 months, and average new car loan monthly payments have reached a record high of $531/month. In addition, over 30% of used car trade-ins are under water. Combine the two, and the consumer is likely to become trapped in the vehicle they are in, and with that trap will come a reduction in car sales, and an expectation of future poor performance by the automotive section.

7. Credit Card delinquency rates: The American binge on consumer credit continues, and in fact never really stopped. Net savings rates are at historic lows of around 2% (average across the entire economy) while credit card debt continues to rise. This is unsustainable. However, so far delinquency rates are not rising, and remain cyclically low at around 2.47%, and in fact remain lower than before the GFC.  None the less, with consumers continuing to splurge on consumer debt, it is only a matter of time before delinquency rates start to climb again. 

8. Environmental event: In a strange twist, the hurricanes and fires that have caused so much damage and misery across the American south and west are now beginning to show up as increased economic activity. The latest retail and home improvement sales have shown a nice jump, probably due to rebuilding activity. Unfortunately, like wars, this is false economic growth, as the country and the people spending the money are paying to return to something less than their pre-event status.

9. And, the Mid-term results: And of course there is now the new situation that could result in longer term (18 months at best) stability, or could result in a US national trauma that spills over into markets and globally; the Mid-term results. It is a given that there will be investigations, indictments, and quite possibly an impeachment, or at least the start of an impeachment process. We will enjoy the drawn-out process of the President attempting to keep his tax returns secret, and fighting subpoenas all the way to the highest court, if he can.

We will also see any market setback being blamed on a Democratic House refusing to go along with his additional tax cuts. A government shutdown is also possible.

One thing is certain, legislative gridlock and a shutdown in the passage of meaningful legislation to help the economy.

Whatever the trigger, when the fall in the markets come, it will be steep and quick, followed by months if not quarters of a cyclical bear market. And while I am writing based on the US economy and markets, the same issues highlighted above are true for so many economies, and any individual large economy could provide the trigger for a global rout.

103 Months of recovery, what could end it

After years of single-direction trajectory for the markets, the recent correction has jolted people from their complacency. Well, many people. The subsequent rallies are proof to one set that pressure has been taken out of the markets, and the upward track can restart. To others, the expression "dead cat bounce" continues to be the phrase of the week.

Being very clear, I do not know if the top has been reached, or is there more headroom in this market. I have no idea. None. Also being clear, while the discussion focuses on the US markets, there is nothing in here that either does not have or is not impacted by events and economic situations in other countries.

If the markets continue their advances, how far can they go, and for how long? Is theUS in the "demographic sweet spot" that I wrote about in August 2017? I asked if the fall in the US labour market participation rate had been strong enough to create sufficient pools of surplus labour to allow for multi-year growth as that surplus labour drip-feeds into the workforce. If it is, then there may actually be a few more years of growth in the economy and the markets. If not, then the third longest recovery in US history may come to a sudden end.

So what happens when this recovery comes to an end, and the US enters recession? At 103 months as of writing, this recover is the third longest since the end of theGreat Depression, and only 4 months short of being the second longest. The fourth longest was only 92 months, and the fifth a mere 73. This recovery is almost a year longer than its number four, and two and a half years longer than the fifth. Interestingly the longest lead up to the “dot-com” bubble and subsequent crash. Does this recovery have another 17 months, another year and a half, of additional steam, to tie the longest recovery? And if so, will we see continued growth in bubbles that we saw leading up to 2000? Or, do we have enough bubbles already?

Again, I cannot answer that because I simply do not know. The recent market "correction" was a wake-up call, and a reminder that it is not all "sunshine and lollipops". There are systemic pressures building up, and one day, the markets will switch from Bull to Bear. What might make that happen?

There are a number of potential catalysts that could provide the tipping point, and with that a sustained downward trajectory for the markets. The following list is not complete by any means, but gives an idea of the range of potential situations that could, once the fall is well underway, be pointed to as the catalyst.

Most important, there is not one situation that will cause the coming crash, and all are interlinked and interdependent. Each can, and probably will, impact and potentially exacerbate another or multiple others. If housing starts collapse, so will house prices, and with that the “wealth effect” tripping over into consumer credit (although in this example, consumer credit may stabilise instead of continuing to grow) and potentially rising default rates.

I will delve deeper into each one of these in coming posts, but for now, the following outline of each should serve to set the scene, so to speak.

Interest Rates: Off the back of rate hikes by the Fed, the Feb rate could reach as high as 3.25% or even 3.5% by late 2018. This will flow into the 10-year Treasury, already hovering around 2.9% up from a low of 2.06% only six months ago. Should the rate continue to rise, the flow-on effects will be felt throughout the debt-driven economy. At some stage, the forward potential negative impact on consumer credit creation and utilization capability will strike, and with that a sudden loss of confidence.

Inflation shock: Years of QE, QEII, Twist, Abbenomics, and ECB purchases has flooded the system with new money. Where has it gone, what why hasn't inflation appeared as so frequently predicted? Countering the assumption that the new money should be driving inflation, there is an argument that surplus labour is keeping wage inflation in check, and with the, general economy-wide inflation. If they are not making more money, then the average worker cannot drive up prices. What happens when a really bad inflation number prints - in the US, UK or Germany for example?

Budget deficits: But what is the single event that is used by media pundits to 20/20 explain what happened. Could it be a Congressional Budget Office projection stating that servicing of the national debt will exceed 8% of the 2019 federal budget (from a current 6% of the federal budget)? Or could it be a projection for $1 trillion budget deficits for the next four years? After all, no one believes the projected temporary increase in spending followed by a drop to a balanced budget level.

External Shock: Or maybe the markets will react to an external event or geopolitical risk event, such as a US strike against the nuclear capabilities or Iran or North Korea. The intervention in northern Syria by Istanbul has already resulting in a sharp drop in the Turkish stock markets. Such a shock could undermine confidence in international trade or fuel expectations of increased in input costs and commodity costs. The markets have been remarkably resilient to geopolitical risk over the past year, so any shock will probably need to be a big one. Ultimately, the list of potential geopolitical shocks is as long as you wish to spend reading or writing.

We should not forget that there are a number of major economies each under their own strains, with many of those strains being similar to those witnessed in the US economy. The UK has suffered a 5.7% drop in year on year private auto sales, with predictions for a further drop in car sales in 2018. And before saying "but they are a small country" remember that they represent 65 million people, and that this slowdown will impact German auto makers as well, providing some stress, albeit minor, to the German economy. 

Housing market: Bad news in the housing market could tip the scales, and send the marketing into a self-reinforcing negative spiral. This potential shock is tied closely to underlying interest rates, inflation, and the Wealth Effect based on an ever-raising stock market. A multi month sustained drop in housing starts, completed sales, or house prices could shock the markets, and become the 20/20 hindsight event that causes a crash.

Automotive Loans default rates: Current default rates are increasing, and the total outstanding loan period is also at a record high. In 2016 the average outstanding car load was 5.5 years. It is possible to get an auto loan at 72 or even 84 months duration. In addition, over 30% of used car trade-ins areunder water. Combine the two, and the consumer is likely to become trapped in the vehicle they are in, and with that trap will come a reduction in car sales, and an expectation of future poor performance by the automotive section, a sector that accounts for X% of the US economy.

Credit Card default rates: The American binge on consumer credit continues, and in fact never really stopped. Net savings rates are at historic lows of around 2% (average across the entire economy) while credit card debt continues to rise. This is unsustainable. The only questions are, what is sustainable and when will the bubble pop, and will we recognise that it has popped. A failure in confidence that consumers will be able to afford the current credit load will not come as a slow dawning, but will come as a sudden shock, and that shock could rock the markets.

Productivity: Linked so closely with that credit crisis is the concept that worker productivity will continue to improve. Yet for the past few quarters that has not been the case, or has been true at a much reduced level. A failure to continue to increase productivity will directly impact worker wages, company profitability and therefore achievement of earnings expectations. Again, a sudden realisation of future down-trend impact on company values may arrive as a shock, and may be the catalyst for a market collapse.

Environmental event: To this point I’ve focused purely on potential economic events or situations, and have avoided environmental events. These could range from the hurricane that breaks the insurance industry, storms in Europe that result in a short term economic downturn, or a major earthquake on the West Coast of the US. I’m ruling out volcanos and meteors, as the probability is simple too low. I’m not ruling out Climate Change related events or situations, major droughts, or resource depletion such as a collapse of the water table in the San Joaquin valley of California.

Maybe the "dead cat bounce" is just a slightly longer bounce, and the fall is already coming.

Whatever the trigger, when the fall in the markets come, it will be steep and quick, followed by months if not quarters of a cyclical bear market. And while I am writing based on the US economy and markets, the same issues highlighted above are true for so many economies, and any individual large economy could provide the trigger for a global rout.