borrowing is an example of hedged debt. During an inflation or currency crisis, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become. Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.
3. The economy’s underlying volatility matters. Less volatile economies are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability. This is especially a problem for countries whose economies are highly dependent on commodities. Typically, commodity prices go down in bad times, making it that much harder to export profitably.
4. The structure of the investor base matters. Contagion is caused not so much by fear, as most people assume, but by large amounts of highly leveraged positions, which force investors into various forms of delta hedging, that is, buy when prices rise, and sell when they drop.
5. The composition of the investor base also matters. A sovereign default is always a political decision, and it is easier to default if the creditors have little domestic political power or influence. Unless foreign investors have old-fashioned gunboats or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals. It is also easier to default on households via financial repression than it is to default on wealthy and powerful locals.
As you can see, the structure and ownership are almost more important than absolute debt levels themselves. This has very important implications, which we will go into as we go country by country around the world.
The insight that it is better to borrow in local currency versus foreign currency is critical. The United States and the United Kingdom, for example, are able to borrow exclusively in their own currency. This acts as an important shock absorber in bad times. It also creates an incentive to use devaluation and inflation as a means of financial repression. Devaluation hurts foreign bondholders, and inflation eases payments in your own currency in the short run.
Currency wars will create massive havoc in emerging markets with dollar-denominated debt. Think 1998 on steroids.
Markets are creatures of emotion and leverage. If either one turns negative in a world where deflationary pressures are building, then the only inflation we have seen – asset price inflation – will be threatened. Even with Godzilla-sized Japanese QE. Stay tuned.
New York and, well, New York
I look at my calendar and marvel that I only have one scheduled trip, to New York November 12-14, for the rest of the year, though it seems likely that I may go back to New York in early December. I’m sure that my reduced travel schedule will change (it always does), but for now I’m looking forward to enjoying the coming holiday season at home.
Even more so because this last road trip, while providing lots of fascinating conversation and new information, was exhausting. Normally jet lag is not that hard for me, but for some reason this trip just drained the batteries. I look forward to recharging them in the next few weeks.
In the past week I had conversations with between 40 and 50 serious market participants: investors and numerous hedge fund managers (some quite large), household-name economists (at least in my household), political leaders, central bank types, and so on, from all over the world. I’m struck by the fact that there is no single takeaway – no theme or meme that seems to dominate the current conversation. Perhaps that’s due to the diverse nature of my conversational partners and differences in venues, but there seems to be more confusion and frustration than you would expect as the market goes on making new highs.
During the week, in several venues (where, under Chatham House rules, I can discuss what was said but not the names of the participants), I was somewhat taken back by the level of confidence exhibited by the central bankers and major economists with regard to their ability to generate inflation when they so desire and to keep things on an even keel. They generally dismissed the notion that there has been inflation in asset prices, because that is something they desired; and as long as it is not general price-level inflation that is affected, they don’t worry. We all like it when our stocks and real estate go up. They almost seemed to assume that the recent asset price rises were the norm and that anything else would be an aberration. Has anyone noticed that margin debt in the US is at all-time high just as the markets hit an all-time high? Shades of 1873.
The level of complacency was somewhat unnerving, given my level of general alarm and concern. The present situation strikes me as being eerily similar to 1999 and 2006. And when I point to the data, the markets seem to tell me that I am too much concerned about the wrong things and not focusing on all the good things that are happening. But that’s also what the market was telling me in 1999 and 2006. As I keep saying, the market is not as smart or prescient as it is given credit for. In fact, the market missed just about every recession up until it became clear that recession was inevitable. Still, the market has a better track record than Federal Reserve economists do!
On a personal note, I really hate writing letters like this. I am actually an irrational optimist, at least in regards to the course of human affairs in technology and society. I am merely bearish on governments. I much prefer dwelling on the ethereal and fantastical visions of the future reality that we seem to be creating even faster than our human counterparts did in the 19th century. I think the potential for economic growth after we have hit the debt reset button is at least as great as we’ve seen in the past century. The trend toward “cheaper and more abundant” is a dominant force that we should all be cognizant of. Maybe after the next crisis we can decide to do something about debt and keep it from building up so that our children won’t have to deal with another debt supercycle crisis.
I will be hosting a small gathering this coming Tuesday on election night. I don’t know that much will change after this election, but perhaps it will be a preview of changes to come. Have a great week. And if you’re in the US and haven’t already done so, go vote. Unless you’re in Chicago, where no voter identification or proof of residency is needed, and then you should vote twice. I’m told that is the ancient and usual custom.
Your preparing for a sea change analyst,
John Mauldin
