Where do we stand now, economically?
“Well, we are right back at it: trying to stimulate growth through easy money. It hasn’t worked, but it’s the only tool the Fed’s got. Meanwhile, the Fed’s policies widen the wealth gap, which feeds political extremism, forcing gridlock in Washington. It seems the world is headed toward negative real interest rates on a global scale. This is toxic. Interest rates are used to price risk, and so in the current environment, the risk-pricing mechanism is broken. That is not healthy for an economy. We are building up terrific stresses in the system, and any fault lines there will certainly harm the outlook.”
-Michael Burry, Scion Asset Management (Source: Big Short Genius Says Another Crisis is Coming)
If you haven’t seen the movie The Big Short, go see it. Christian Bale plays Michael Burry in Adam McKay’s adaptation of Michael Lewis’s book about the 2008 financial crisis. Burry was one of the hedge fund managers me and my team knew well. He and others helped us to better understand the approaching sub-prime crisis. I wrote about the issue frequently back then.
Nobody knew when it would happen nor the depth of the break, but we were pretty sure it would be big. As it turned out, it was far worse than we anticipated. I never imagined the near collapse of the financial system. I should have gone short the sub-prime trade I was well aware of, or shorted Fannie Mae, or the mortgage lenders or the banks.
Back in 2007, most of the emails I received were not favorable. Steve, you’re way too bearish. It turned out I wasn’t bearish enough.
Today, it feels to me much like it did in 2006 and 2007. However, this time around I’m looking through a lens of opportunity — not worry, not fear.
If you’ve been reading my weekly On My Radar posts, you know I believe valuations are too high, the Fed is too involved and debt in the U.S. and globally is choking growth. My overall message is to hedge your equity exposure, tactically manage your bond exposure and find some liquid alternative strategies that drive a return stream with little correlation to the stock and bond markets. A broader mix of risks to hopefully provide growth and downside protection. Diversification that will allow you to pivot when valuations become attractive.
“Government intervention is causing financial investor chaos by destroying the analytical value of any economic or financial variable it touches. The extremely wide ranging fiscal and monetary policies since the AIG/Lehman default have rendered financial variables such as interest rates, yield curves, credit spreads and various money supplies useless for either assessing asset values or forecasting.”
The above quote is from a recently published book entitled, Not My Grandfather’s Wall Street: Diaries of a Derivatives Trader by David von Leib. David is a long-time friend. For me, watching a movie like The Big Short or reading David’s fine book brings back to center the reality of how things work. We’d like it to be different but for now it is not.
And unfortunately (or fortunately, if you are on the right side of the trade), we find ourselves in a place not too dissimilar to 2008. David summed up the challenge we investors face back then (and now):
“In other words, in trying to artificially prop up the world, the Fed and other global central bankers had left savvy Wall Street investors relatively confused. A culture of general artificiality had evolved where you could either bet that governments would win in the short term (but risk losing your shirt over the longer-term) or bet against governments and be ever so frustrated in the short-term (and then see if your capital under management would survive long enough to potentially still win in the longer-term). It was next to impossible to wager on both outcomes—or shift between the two views—with enough alacrity to also remain sane.”
This is the challenge we face today.
My outlook for 2016 is neutral on equities and neutral on fixed income. Nothing exciting there, but like the Fed, I’ll hedge and say it is “data dependent.” Following are the significant risks I see:
- Global Recession – Likely underway
- U.S. Recession – Possible in 2016. Probable in 2017. The largest market declines come during periods of economic recession.
- High-yield bond defaults – Rising in 2016, peaking in 2017 (tactically trade HY)
- European Sovereign debt crisis – The EU banks are loaded up on that debt (shorting EU banks or buying out-of-the-money put options may be a good equity hedge).
- Emerging Market dollar denominated debt crisis
- Watch the Fed, ECB, JCB and Chinese central bankers
- Tax and structural reform would be a positive for the markets, but unlikely in 2016
We’ll keep a close eye on the data each week in OMR and Trade Signals.
In 2007, it was about no-doc mortgages, sub-prime mortgage debt, pools of packaged mortgage debt and the derivatives that were tied to those risks. When the defaults came rolling in, it was the banks that broke and nearly collapsed the entire financial system.
This time, the nature of the debt is not mortgage debt. It is record high-margin debt (investor brokerage accounts), government debt (Europe, Japan, the U.S. and China), Emerging Market debt (based in dollars and subject to default risks due to a rising dollar) and high-yield bond market debt. But like last time, the coming default issues may likely find their way to the banks. Recall in 2008, you were impacted even if you didn’t own the bad debt. This is known as “systemic risk.”
My friend Jim Rickards, the author of Currency Wars, penned the following and I share it with you in bullet format (as you read it, think in terms of probable human behavior):
- The natural state of the world is deflationary, due to demographics, technology and debt.
- This is the outcome central banks fear most. Deflation increases the real value of debt and accelerates defaults. We’re already seeing this in energy and other junk debt.
- The defaults will soon spread to more highly rated corporate debt. Ultimately, these losses fall on the banks.
- Deflation also destroys tax collections. Taxes are imposed on nominal dollar returns, not real returns. When deflation causes prices and incomes to drop, less tax is collected, pure and simple.
- The combination of bank losses, higher real debt burdens and diminished tax collections is a government’s worst nightmare. For these reasons, central banks and governments will do whatever it takes to stop deflation.
- The current business expansion is already 79 months old — longer than the average expansion since 1980 (77 months).
- This does not mean that a recession begins tomorrow (although it might). It does mean we are late in this cycle and at a point when the Fed historically stands pat or even begins to contemplate rate cuts.
- The situation around the world is even more dire. Russia, Japan and Brazil are already in recession. Canada and Korea are close to one. China is slowing down rapidly and taking a large bite out of global GDP