On My Radar: Global Recession A High Probability by Steve Blumenthal, Capital Management Group
“I have long made the claim that the transnational nature of Europe cannot be sustained. The divergent economic interests of EU countries, some with unemployment over 20 percent, some with it under 5 percent, meant that it was impossible for all of them to live not only under the same monetary regime, but under the same trade regime, which we cannot call free trade with agriculture, among other things, being protected. This would lead to a focus on national interest and on a resurrected nation-state.” -George Friedman
Following up on last week’s piece highlighting the catastrophe of negative interest rates created by Central Bank Policy, I found myself thinking, as I’m sure you did too, a lot about the catastrophe in Paris. Outside of the dark vs. light human battle (of which I believe light will win), I gave thought to the potential unwinding of the great European Union experiment and what it might mean for our collective financial health. Coincidentally, a great geopolitical strategist piece crossed my desk this week. I share it with you below.
Maybe I’m obsessing over what I feel is transitory faith placed in global central bankers (the Fed, ECB, JCB) but I can’t help recalling Bernanke’s “Goldilocks” quote on February 14, 2007 (New York Times) and the happy no-doc mortgage days in 2007/08. The economy was not too hot, not too cold but just right. Right?
“Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart.”
– Alan Greenspan
I felt a bit like Chicken Little in my writings back then. The “sky is falling” and all that sort of thing. Was the sky falling or was opportunity being created. It depends on your portfolio positioning at that time. It turned out to be a great opportunity if one was prepared. Wait and see what happens if Italy, Spain or Portugal pulls a Greek-like default move. Contagion being the “critical phenomenon”. I feel a little bit like Chicken Little again today.
In the book House of Cards, William Cohan exposed the corporate arrogance, power struggles and deadly combination of greed and inattention which led to the collapse of not only Bear Stearns and Lehman Brothers, but the very foundation of Wall Street. Despite Fed Chairs Greenspan and Bernanke’s inability to (admittedly) see the risks, there was abundant evidence that I and others wrote frequently about prior to the crisis. Though truthfully, in my wildest dreams, I didn’t imagine the entire financial system would come so near to collapse.
“Sort of intellectually shocked”? Gotta love his honesty.
One of the pieces I penned in late 2008 was titled “So Bad It’s Good”. It just didn’t feel good, emotionally, at the time. But with fear in heart and conviction in process, I took action and while I was a bit early, it turned out to be an exceptionally good trade. Then, yields on high yield bonds were close to 20%. That’s what I believe may present again in the not too distant future. Until then, it’s a process of participation, protection and patience.
At a recent conference, I was asked what I see as the biggest risks ahead. I answered that it is not subprime but everything that existed in 2008 from the perspective of debt levels, debt to GDP, margin balances and derivative exposure (and the related counter-party risks) is worse today than in 2008. Further, the Fed now finds itself painted into a corner with an inflated balanced sheet (QE asset purchases) and a zero interest rate policy.
So, I spoke of three big risks on the near horizon that may impact the equity and high yield markets and added that I feel like I did when I wrote about crazy high valuations in 1998 (“It’s not different this time” though I was two years too early) and in 2007 and 2008 (writing about subprime and leveraged derivative products).
All three risks have one common denominator – too much debt. Here are my big three:
- An approaching sovereign debt crisis in Europe
- An emerging market debt default cycle tied to a rising dollar and
- A coming high yield junk bond default wave of record proportion
Included in this week’s On My Radar:
- The Big Three
- The Resurrection of Old Europe
- Global Recession – Highly Probable
- A Few Equity Hedging Ideas
- Trade Signals – Excessive Optimism (ST Bearish)
The Big Three
Sovereign Debt Crisis: I believe a sovereign debt crisis will be tied to loss of confidence in government (and central bankers). That appears to be in motion. The debt to GDP ratios of the sovereign debt issuing countries are, in a word, unmanageable. Too much debt slows growth. Governments, absent the hoped for growth, raise taxes to cover increasing payables. Expect further slowing. We are in a debt deflationary cycle and the evidence, at least to me, is clear a global recession is probable if not already under way (see updated global recession watch chart below). Enter Draghi stage right. For now, it is kick the can. In the end, I believe some form of default/reorg of debt will be required.
EM Debt Crisis: With negative interest rates in Europe and the ECB talking more QE, while at the same time the U.S. exiting QE and looking to raise rates, it is advantage dollar. The balance of the developed world is in the same high debt induced low growth deflationary mess. They are all working off the same play book – devalue their currencies. Such would make their goods more attractive to foreign consumers. Advantage U.S. dollar.
However, it is the strong dollar that may trigger risk number two. Non-U.S. borrowers took out loans from dollar based lenders, then a low interest rate loan with belief that U.S. QE would further devalue the dollar. Borrow low and use their appreciated currency gains to reduce the amount of money in real terms needed to pay back. A win win.
However, just several years later, who would have imagined negative interest rates in Europe vs. higher interest rates in the U.S. More QE there vs. exit of QE here. A rising dollar means that $9.6 trillion in such loans may have to pay back $12 trillion (if the dollar rises another 20%) due to their bad dollar bet. Oops.
In comparison to subprime (call it $2 trillion at face value), this EM dollar denominated debt issue is no small issue. The next chart is a look at subprime origination pre-crisis. Roughly $1.8 trillion was originated between 2004-2007. The point I am trying to make is that $9.6 trillion is real money certainly relative to the size of the subprime crisis that tripped the blow-up wire in 2008. Big problem – number two is tied to EM dollar denominated debt. It is going to get trickier if the dollar continues upward. The Fed is painted into a corner.
High Yield Default Crisis: The third risk is tied to the $1 trillion