… Focused on the obvious and unimportant.”
– Former Senior Economist, Federal Reserve Bank, Camp Kotok, August 6, 2017
- The biggest mistake investors make is to believe that what happened in the recent past is likely to persist
- An Emotionally Intelligent CEO
Atop the “what matters most” list is debt. Specifically, global sovereign debt: U.S., Europe, Japan and China. We are at the end of a long-term debt cycle. Borrow, spend and grow is good for the economy. Credit is money. It is a multiplier that enables you to spend more than you have. But a point is reached when you can’t borrow anymore and what you previously borrowed must be paid back.
Credible academic studies show the point of diminishing returns begins when the debt-to-GDP ratio exceeds 90%. Today, the global debt-to-GDP ratio exceeds 325%. A record high though we may, of course, go higher. Yet, throughout history, rich and poor countries alike have been lending, borrowing, crashing and recovering their way through an extraordinary range of financial crises.
Most of us have never experienced a long-term debt cycle peak. The last one occurred in the mid-1930s. A sovereign debt crisis followed as did war. We face similar risks today.
How we deal with the coming deleveraging can be good or it can be bad. We don’t yet know how we will behave (voters, politicians and central bankers). Political resolve and global cooperation will be required. Let’s hope we’ve learned from history.
Economic stresses can lead to currency wars, protectionism and trade wars. Scan the global news headlines and tell me what you see.
I see no evidence of anything that might halt a debt crisis. The system is highly leveraged. To me, debt is critical issue #1. There are solutions. What will we do?
I was fortunate to be invited to Camp Kotok. It is a gathering of some of the world’s brightest economists and investment managers. To say there were more than a few strong views would be an understatement. To stress test those views amongst your peers in an open and trusted setting was priceless. I loved the dialogue and felt like a kid in a candy store.
On Saturday evening, with wine in hand, I spoke with a former senior Fed economist, who shall remain unnamed. I asked direct questions and he was direct in his responses to me.
A quick aside – each summer I ask our CMG interns to read Ray Dalio’s “How the Economic Machine Works.” There is a short 20-minute video and there is a longer 300-page paper. It is a blueprint for understanding economic cycles. I tell my interns, mostly finance and business majors, to study the paper and use it as their base understanding when they get lost in the theory that they’ll learn in school.
Dalio founded Bridgewater Associates in the 1970s and it has grown to become the world’s largest hedge fund. The firm manages approximately $150 billion and clients pay them management fees of 2 percent, as well as incentive fees. They have an outstanding performance record and were profitable in the last financial crisis (2008). Dalio’s piece is about money and credit and short-term and long-term debt cycles. It drives much of their investment thinking. Dalio shared it publicly in order to help educate policy makers and you and me.
Question #1: Is the Fed talking to investment firms like Bridgewater? Yes. Question #2: Do they talk to traders and market makers to understand what motivates them, to understand liquidity, to understand speed of play? Yes. Questions #3 and 4: Do they understand the derivatives markets and interconnectivity of counter-party risk embedded in such instruments and the risks of a Sovereign Debt crisis arising in Europe or China? Do they understand the history of debt? Yes and yes.
“Steve,” he replied, “We have 17,000 people on the Fed’s payroll. We talk to everyone, but,” and he paused, “the problem is at the top. The leadership is focused on the obvious and the unimportant.”
During breakfast I asked my new friend if Trump’s coming Fed appointments might change the culture at the top. He again said yes, but narrowed his eyes and raised a finger, “Imagine changing the culture of a large corporation like Coke. It can be done but it won’t happen quickly and it won’t be easy.”
The obvious and the unimportant! I was glad I went fishing.
A “beautiful deleveraging,” as Dalio calls it, requires coordinated effort between policy makers (law makers) and central bankers. Burn the tally sticks or monetize a meaningful portion of the debt? It will take global cooperation to make beautiful happen. To that end, protectionism, tariffs and currency manipulation are not good things on the way to beautiful. We watch, hope and pray.
I’m on vacation this week and the weather has been perfect. High 70s with a warm ocean breeze. The beach is again calling my name. I want to spend some more time reflecting on what I learned in Maine and hope to share more with you next week.
Participate and protect and keep those stops in place so you too can take a vacation without worry.
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Included in this week’s On My Radar:
- On North Korea
- A Few Notable Charts
- Trade Signals — August 9, 2017
- Personal Note
On North Korea
I thought this was an insightful piece on CNBC from retired Gen. Wesley Clark.
“The U.S. has only one option on North Korea’s nuclear threat now,” Commentary by Gen. Wesley Clark, CNBC, Aug. 10, 2017.
- North Korea has miniaturized nuclear warheads for its missiles and might soon be capable of striking the United States.
- What we need right now is steady leadership, not bellicose rhetoric in deterring North Korea.
- We have to be strong and resolute, and not engage in some risky, ill-advised military action.
Here is the link to the full piece.
A Few Notable Charts
Following is an interesting set of charts from Jill Mislinkski, published at Advisor Perspectives, that will resonate with those of us who follow economic and market cycles.
Imagine that five years ago you invested $10,000 in the S&P 500. How much would it be worth today, with dividends reinvested but adjusted for inflation?
- The purchasing power of your investment has increased to $19,354 for an annualized real return of 13.28%.
- Had we posed the same question in March 2009, the answer would have been a depressing $6,654. The -8.12% real return would have cut the purchasing power of your initial investment by a third.
Here’s how to read the chart:
- Focus in on the dark red line. It is a plot of the rolling 5-year annualized total return.
- The light red horizontal line sits at 6% return. Note the periods above and below that line over time.