It was almost exactly 10 years ago that then Citibank boss, Chuck Prince, unintentionally highlighted the approach of the subprime crisis with his comment that:
‘We are not scared. We are not panicked. We are not rattled. Our team has been through this before.’ We are ’still dancing’.”
On Friday JP Morgan’s CEO, Jamie Dimon, provided a new and more considered warning:
“Since the Great Recession, which is now 8 years old, we’ve been growing at 1.5% – 2% in spite of stupidity and political gridlock….We have become one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid s— we have to deal with in this country. And at one point we all have to get our act together or we won’t do what we’re supposed to [do] for the average Americans.”
The chart above, from OECD data, highlights one key result of the dysfunctionality that Dimon describes:
Central bank stimulus has proved to be a complete failure, as it cannot compensate for today’s “demographic deficit”
UK debt as a percentage of GDP has more than doubled from 51% in 2007 to 123% last year
US debt has risen from an already high 77% in 2007 to 128% last year
Japanese debt has risen from an insane 175% in 2007 to an impossible-to-repay 240%
Debt is essentially just a way of bringing forward demand from the future. If I can borrow money today, I don’t have to wait till tomorrow to buy what I need. But, I do then have to pay back the debt – I can’t borrow forever. So high levels of debt inevitably create major headwinds for future growth.
Unfortunately, central banks and their admirers thought this simple rule didn’t apply to them. They imagined they could print as much money as they liked – and then, magically, all the debt would disappear through a mix of economic growth and inflation. But as the second chart shows, they were completely wrong:
In April 2011, the IMF forecast global GDP in 2016 would be 4.7%
In April 2013, they were still convinced it would be 4.5%
Even in April 2015, they were confident it would be 3.8%
But in reality, it was just 3.1%
And meanwhile inflation, which was supposed to help the debt to disappear in real terms, has also failed to take off. US inflation last month was just 1.6%, and is probably now heading lower as oil prices continue to decline.
In turn, this dysfunctionality in economic policy is creating political and social risk:
The UK has a minority government, which now has to implement the Brexit decision. This represents the biggest economic, social and political challenge that the UK has faced since World War 2. But as the former head of the UK civil service warned yesterday:
“The EU has clear negotiating guidelines, while it appears that cabinet members haven’t yet finished negotiating with each other, never mind the EU”. He calls on ministers to “start being honest about the complexity of the challenge. There is no chance all the details will be hammered out in 20 months. We will need a long transition phase and the time needed does not diminish by pretending that this phase is just about ‘implementing’ agreed policies as they will not all be agreed.”
The US faces similar challenges as President Trump aims to take the country in a completely new direction. As of Friday, 6 months after the Inauguration, there are still no nominations for 370 of the 564 key Administration positions that require Senate confirmation. And last week, his Secretary of State, Rex Tillerson, highlighted some of the challenges he faces when contrasting his role as ExxonMobil CEO with his new position:
“You own it, you make the decision, and I had a very different organization around me… We had very long-standing, disciplined processes and decision-making — I mean, highly structured — that allows you to accomplish a lot, to accomplish a lot in a very efficient way. [The US government is] not a highly disciplined organization. Decision-making is fragmented, and sometimes people don’t want to take decisions. Coordination is difficult through the interagency [process]…and in all honesty, we have a president that doesn’t come from the political world either.”
Then there is Japan, where Premier Abe came to power claiming he would be able to counter the demographic challenges by boosting growth and inflation. Yet as I noted a year ago, his $1.8tn of stimulus has had no impact on household spending – and consumer spending is 60% of Japanese GDP. In fact, 2016 data shows spending down 2% at ¥2.9 million versus 2012, and GDP growth just 1%, whilst inflation at only 0.4% is far below the 2% target.
As in the UK and US, political risk is now rising. Abe lost the key Tokyo election earlier this month after various scandals. Voter support is below 30%, and two-thirds of voters “now back no party at all” – confirming the growing dysfunctionality in Japanese politics.
WOULD YOU LEND TO A FRIEND WHO RUNS UP DEBT WITH NO CLEAR PLAN TO PAY IT BACK?
So what is going to happen to all the debt built up in these 3 major countries? There are already worrying signs that some investors are starting to pull back from UK, US and Japanese government bond markets. Over the past year, almost unnoticed, major moves have taken place in benchmark 10-year rates:
UK rates have nearly trebled from 0.5% to 1.3% today
US rates have risen from 1.4% to 2.3% today;
Japanese rates have risen from -0.3% to +0.1% today.
What would happen if these upward moves continue, and perhaps accelerate? Will investors start to agree with William White, former chief economist of the central bankers’ bank (Bank for International Settlements), that:
“To put it in a nutshell, if it’s a debt problem we face and a problem of insolvency, it cannot be solved by central banks through simply printing the money. We can deal with illiquidity problems, but the central banks can’t deal with insolvency problems”.
White was one of the few to warn of the subprime crisis, and it seems highly likely he is right to warn again today.
Companies and investors have some big decisions ahead of them as we start the second half of the year. They can be summed up in one super-critical question:
“Do they believe that global reflation is finally now underway?”
The arguments in favour of this analysis were given last week by European Central Bank President, Mario Draghi:
“For many years after the financial crisis, economic performance was lacklustre across advanced economies. Now, the global recovery is firming and broadening…monetary policy is working to build up reflationary pressures…we can be confident that our policy is working and its full effects on inflation will gradually materialise.”
The analysis has been supported by other central bankers. The US Federal Reserve has raised interest rates 3 times since December, whilst the Bank of England has sent the pound soaring with a hint that it might soon start to raise interest rates. Most importantly, Fed Chair Janet Yellen told a London conference last week that she:
“Did not expect to see another financial crisis in our lifetime”.
The chart above from Nobel Prizewinner Prof Robert Shiller confirms that investors certainly believe the reflation story. His 10-year CAPE Index (Cyclically Adjusted Price/Earnings Index) has now reached 30—a level which has only been seen twice before in history – in 1929 and 2000. Neither were good years for investors.
Even more striking is the fact that veteran value-investor, Jeremy Grantham, now believes that investors will have “A longer wait than any value manager would like, including me” before the US market reverts to more normal valuation metrics. Instead, he argues that “this time seems very, very different” – echoing respected economist Irving Fisher in 1929 who suggested “stock prices have reached what looks like a permanently high plateau“.
But are they right?
One concern is that central bankers might be making a circular argument. We saw this first with Fed Chair Alan Greenspan, who flooded stock markets with free cash before the dot-com crash in 2000, and then flooded housing markets with free cash to cause the subprime crash in 2008. His successor, Ben Bernanke continued the free cash policy, arguing in November 2010 that boosting the stock market was critical to the recovery:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The second chart highlights how the Fed’s zero interest rate policy has driven the rally since the US S&P 500 Index bottomed in March 2009:
Margin debt in the New York market (money borrowed to invest in stocks) is at an all-time record of $539bn ($2017)
It has increased 197% since March 2009, almost exactly matching the S&P’s rise of 216%
Stock market capitalisation (the total value of stocks) versus GDP is close to a new all-time high at 133%
Meanwhile, the Bank of Japan now owns 2/3rds of the entire Japanese ETF market (Exchange Traded Funds). And the Swiss National Bank owns $100bn of US/European stocks including 26 million Microsoft shares.
Unsurprisingly, given central bank policies, the world is now awash with debt. New data from the Institute of International Finance shows total world debt has now reached $217tn – more than 3x global GDP. As a result, respected financial commentator Andreas Evans-Pritchard argued last week:
“The Fed caused the dotcom bubble in the 1990s. It caused the pre-Lehman subprime bubble. Whatever Ms Yellen professes, it has already baked another crisis into the pie. The next downturn may be so intractable that it calls into question the political survival of capitalism. The Faustian pact is closing in.”
Evans-Pritchard’s concern is echoed by Claudio Borio, head of the central bankers’s bank – the Bank for International Settlements (BIS). Under his predecessor, William White, the BIS was the only central bank to warn of the subprime crisis. And Borio has warned:
“Financial booms can’t go on indefinitely. They can fall under their own weight.”
WHO IS RIGHT – THE CENTRAL BANKS OR THEIR CRITICS?
This is why companies and investors have some big decisions ahead of them. Of course, it is easy to assume that everything will be just wonderful, when everyone else seems to believe the same thing. Who wants to spoil the party?
But then there is the insight from one of the world’s most famous analysts, Bob Farrell, captured in the headline to this post. The chart of The pH Report’s Boom/Gloom Index highlights how the concept of the Trump reflation trade has sent the S&P into an exponential rally – even whilst sentiment, as captured in the Index, has been relatively subdued.
You could argue that this means the market can continue to go higher for years to come, as Grantham and the central banks believe. Or you could worry that “the best view is always from the top of the mountain” and that there are now very few people left to buy. And you might also be concerned that:
Political uncertainty is rising across the Western world, as well as in the Middle East and Latin America
Oil prices are already in a bear market
China’s growth and lending is clearly slowing
And Western central banks also seem set on trying to unwind their expansionary policies
We can all hope that today’s exponentially rising markets continued to rise.
But what would happen to your business and your investments if instead they began to correct – and not by going sideways? It might be worth developing a contingency plan, just in case.
The chemical industry is the best leading indicator that we have for the global economy. It has an excellent correlation with IMF data, and also benefits from the fact it has no “political bias”. It simply tells us what is happening in real-time in the world’s 3rd largest industry.
Sadly, the news is not good.
As the chart shows, based on the latest American Chemistry Council data, Capacity Utilisation (CU%) fell to just 78.4% in October. This is only just above the lowest reading ever seen, of 77% at the bottom of the sub-prime crisis in March 2009. The pattern is also worryingly familiar:
Then the CU% peaked in May 2007 at 95.1%, before declining to 88% by October 2008, and collapsing to 77%
This time, the CU% peaked at 80.7% in December 2015 and has been falling ever since, month by month
Given that the industry is normally around 8 – 12 months ahead of the wider economy, due to its early position in the supply chain, this means it is highly likely that the global economy will move into recession during 2017
Of course, nobody ever wants to forecast recession. And there are always plenty of reasons why something might be “different this time”. But it would certainly seem prudent for companies and investors to develop a Recession Scenario for their business for 2017. given the track record of the CU% indicator.
Indeed, there are a number of reasons to suggest that any recession might be severe. Bill White, the only central banker to warn of the subprime crisis, warned in January that “the world faces wave of epic debt defaults“, and then added in September that:
“The global situation we face today is arguably more fraught with danger than was the case when the crisis first began. By encouraging still more credit and debt expansion, monetary policy has ‘‘dug the hole deeper.’’…In practice, ultraeasy policy has not stimulated aggregate demand to the degree expected but has had other unexpected consequences. Not least, it poses a threat to financial stability and to potential growth going forward….the fundamental problem is not inadequate liquidity but excessive debt and possible insolvencies. The policy stakes are now very high.”
When White spoke, the implications of the UK’s Brexit vote were still only just beginning to be recognised
Since then, US President-elect Donald Trump has announced his 100-Day Plan to reshape America’s world role
Major uncertainty is building in Europe with Italy’s referendum plus Dutch, French and German elections
India’s economy is weakening as the currency reforms have taken 86% of its cash out of circulation
Plus, there are ever-present risks from China’s housing bubble, and the potential for a trade war with the USA
Of course, many of the same people who said that Brexit would never happen, and that Trump would never win, are now lining up to tell us everything will still be the same in the end. But they should really have very little credibility.
What many investors also seem to be forgetting is that Trump has been a long-time CEO. And new CEOs normally write-off everything in their first year of office. This gives them the double bonus of being able to (a) blame the previous CEO and (b) then take credit for any improvement.
As Trump would no doubt like a second term of office from 2021, he has every incentive to “clear the decks” in 2017.
Trillions of dollars have been spent on stimulus by central banks in the developed world since the financial crisis began in 2008. Clearly these policies haven’t worked – but they are now lining up to do more of them.
In this interview with Tom Brown, deputy editor of ICIS news, I argue that their analysis is fundamentally flawed – how can central banks possibly control the economic fortune of the world’s 7.3bn people? I also worry that the same people who tried to warn about the 2008 crisis are now giving urgent warnings about likely problems ahead.
William White, former chief economist of the central bankers’ bank (Bank for International Settlements) is now warning (his emphasis):
“If you think about a crisis period as a period of deleveraging, in fact this has not happened and we’ve gone in the very opposite direction. Now, on the household side, clearly there have been some improvements made but on the corporate side in the US, things have gotten significantly worse – the debt ratios for corporations have gone up very substantially as has government debt…
“More importantly – again, when I say the situation is worse today than it was in 2007 – in 2007 this debt problem was essentially confined to the advanced market economies. Since then, the debt ratios – the private debt ratios in particular – have exploded in the emerging market countries and so we now have in a sense a global problem whereas in 2007 you might say we had a regional problem with the advanced market economies. But now it’s basically everywhere so, yes, I do think that the situation is worse than it was then…
“When I first came to the BIS in 1994, we started warning about the credit flows into Southeast Asia well before the Asian crisis happened and… it was in the early 2000s that we really started to focus on what was going on in the advanced market economies… The story that we were telling then was really one of the Greenspan put starting in 1987 and every time there was a problem, the answer was to print the money or ease monetary conditions and the debt ratios ratcheted up and up and up…
“So we had this problem in ’87 and the answer was easy money; then we had this problem in 1990-1991 and, again, the answer was easy money. The response to the Southeast Asian crisis was, don’t raise rates even though all sorts of other indicators said you should. Then it was easy money again in 2001 and, of course, in 2007… every time the headwinds of debt have been getting higher and higher and the monetary easing required to overcome that has had to get greater and greater and the logic of that takes you to the point where you say, well, in the end, monetary easing is not going to work at all and… that’s where I am today… Unfortunately, we are still, as far as I can tell, both the BIS and myself are still talking to a brick wall…
“To put it in a nutshell, if it’s a debt problem we face and a problem of insolvency, it cannot be solved by central banks through simply printing the money. We can deal with illiquidity problems, but the central banks can’t deal with insolvency problems…In a way, I think the economists have made what the philosophers would call a profound ontological error. They have assumed that the economy is understandable and they have therefore assumed that if they can understand it they can control it.”
Similarly, Bill Gross – formerly of PIMCO and now at Janus – warns as follows in his latest update:
“And that’s not the end of it. If negative interest rates fail to generate acceptable nominal growth, then the Milton Friedman/Ben Bernanke concept of helicopter money may be employed. …Can any/all of these policy alternatives save the “system”? We shall find out, but current evidence of the past 7 years’ experience would support only a D+ report card grade. Barely passing. As an investor though – you should be aware that our finance based economic system which like the Sun has provided life and productive growth for a long, long time – is running out of fuel, and that its remaining time span is something less than 5 billion years….
“Summer, for our credit based financial system, is past and a shorter winter-like solstice is in our future. Be prepared for change.”
Central bankers remain in Denial about the failure of their stimulus policies. Yet new IMF data for global GDP shows GDP fell by $3.8tn in 2015 – the biggest fall on record – as the world hits the “demographic cliff”. We have now seen 2 record falls in 6 years, as the previous record was $3.3tn in 2009.
This confirms that the fault lines are now opening in the ‘Ring of Fire’, as discussed on Monday. As William White has warned:
“The global financial system has become dangerously unstable and faces an avalanche of bankruptcies that will test social and political stability. The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up.”
Sadly, today’s central bankers are just as blind to his warnings as they were in 2007-8. Thus European Central Bank head Mario Draghi set off another mini-rally in shares and oil markets on Thursday, promising he would print more money to boost financial markets. He made the same promise last month, also causing markets to rally sharply.
Yet common sense tells us that you cannot have the same levels of growth today as in the past. As the chart shows, the world has now reached the “demographic cliff“. We now have 1bn people moving into the low-spending, low-earning New Old 55+ generation for the first time in history. They will be more than 1 in 5 of the population by 2030, twice the percentage in 1950.
So as White warns, the next recession will reveal that many of today’s debts will never be repaid:
- White mentions a major Chinese devaluation as one potential cause of recession
- The European refugee crisis is anther potential flashpoint, with the President of the European Commission continually warning that “a single currency does not exist if the Schengen (open European border Treaty) fails“. This problem is increasingly urgent, as more and more countries re-introduce border controls, and public opinion polarises after the Paris and Cologne attacks
- Then there are potential flashpoints in the Middle East and, of course, in Eastern Europe
- Plus, there is the vast debt associated with US financial markets, which complacently believe the central banks will never let prices fall
I am sure White is right again this time. It is very hard to see how this debt can possibly be repaid, as the global economy continues to slow under the influence of its rapidly ageing population. Historically, as he says, debt Jubilees used to occur every 50 years, going back to Sumerian times, and were when all debts were forgiven.
This will have to happen again in our society. McKinsey’s report last year highlighted the vast debt that has been built up since 2007 – which is now 3x world GDP. A simple calculation reveals the scale of the problem:
- McKinsey estimated world debt increased by $57tn between 2007 – 2014
- Global GDP grew by $19.8tn from $57.5tn to $77.3tn over the same period (IMF data)
- It therefore took $2.9tn of debt to add $1tn of GDP growth
- To put it another way round, $1 of debt gave only 35 cents of GDP growth
- In the 2000-7 period, each $1 of debt gave 45 cents of growth – so the trend is clearly getting worse
And yet, of course, central bankers still insist that adding more debt is the way to solve today’s crisis. They seem to be in total Denial about the fact that if $1 of lending creates only 35 cents of growth, you are effectively wasting the other 65 cents. I therefore fear that White’s warning supports the forecast in my 2016-18 Budget Outlook:
“2016 will see China putting its foot hard on the brakes of the Old Normal economy – whilst Western policymakers compete to ramp up stimulus to compensate. It could easily prove to be as difficult a year as 2008. Companies owe it to themselves to plan ahead for this Scenario. ’Flash crashes’ take place in a flash, not over months. It could prove too late afterwards to regret that you had failed to put the necessary contingency plan in place.”
Only one central banker spotted the subprime crisis before it occurred – William White. Now he is warning that the world will have to revive the Old Testament concept of “debt jubilees“, with much of today’s debt being written off:
“Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief. Emerging markets were part of the solution after the Lehman crisis. Now they are part of the problem, too.
“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something. The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”
Long-standing readers will remember that White was one of my guides in 2007-8, when forecasting the subprime crisis. He was then Chief Economist for the central bankers’ bank (the Bank for International Settlements). I summarised his July 2007 Report in ‘4 risks to the world economy’, and the July 2008 Report as ‘The difficult task of damage control’. Unfortunately, I was one of the few to take him seriously.
Today, he is Chairman of the OECD Review committee and continues to speak his mind. His analysis parallels my own concept of the ‘Ring of Fire’ created by central bank stimulus policies, set out in the map above:
- It focuses on the massive changes underway in China, where President Xi has cut back dramatically on stimulus lending since taking office
- Xi has particularly squeezed the shadow banking sector, responsible for most of the speculative property lending that has done such damage to China’s economy
- As a result, commodity-based companies around the world, and countries, are in crisis
- Mining company shares have been in freefall for months, as investors wake up to the fact that stimulus has created vast surpluses in key products
- Even worse is that China’s slowdown is creating major recessions in countries in a wide arc from Brazil through South Africa, Asia, Australia, the Middle East and Russia
I will look at the potential implications of White’s analysis in more detail on Wednesday.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 72%
Naphtha Europe, down 64%. “European petrochemical producers are maximising propane cracking because of the co-products derived from it”
Benzene Europe, down 58%. “Prices have risen sharply this week, with players now seeing product short for January and early February.”
PTA China, down 47%. “Overall buying appetite continued to be thin in the market”
HDPE US export, down 42%. “Chinese end-users still showed strong resistance to the relatively firm-priced cargoes”
¥:$, down 16%
S&P 500 stock market index, down 3%