On My Radar: We Will Burn the Debt - Blumenthal

On My Radar: We Will Burn the Debt - btbirkett@gmail.com - Gmail

“Cycles are inevitable. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme, and people start to say ‘this time it’s different.’” – Howard Marks The Federal Reserve cut rates a quarter percent on Wednesday. Chairman Jerome Powell assured us there will be further cuts should conditions get worse. Despite the latest cut—the third this year—President Donald J. Trump expressed dissatisfaction with the current 1.50% to 1.75% target. The president pointed to the weak manufacturing report produced by the Commerce Department on Thursday and claimed the strong dollar is hurting American exports. Let’s dig into this a little deeper. With U.S. interest rates at higher levels relative to the rest of the world, the primary beneficiary of global money flows remains the U.S. capital markets. Better to get a yield of 1.74% in the U.S. than -0.36% in Germany or -0.12% in Japan. Can you see how the large difference might attract capital into the U.S. and thus keep the dollar propped up compared to everyone else? By the same token, however, that makes American goods more expensive to the rest of the world, and slow economies don’t help presidents get reelected. When foreign buyers convert their local currencies into American dollars to buy our soybeans, wheat, or anything else, it costs them more (#StrongDollar = #WeakExports). If the price point is too high, the buyer will simply look elsewhere. On the flipside, a stronger dollar means a U.S. buyer can get more goods per dollar from an overseas seller. President Trump would like U.S. interest rates to be lower than other countries, and specifically mentioned Germany and Japan. Lower U.S. interest rates would change the global capital flow dynamics, resulting in a weaker dollar, which would help U.S. exporters (#WeakDollar = #StrongExports). Better growth, recession avoided, four more years. Thus the impetus for this particular tweet storm (and the hashtags above). Interest rate policy decisions play out globally. Setting rates, such as what the Fed did on Wednesday, is one of the levers governments can pull to speed up or slow down their economies. To give you some current footing, yields around the world look like this:

Governments everywhere are seeking to grow out of current high debt predicaments (you’ll see exactly what that looks like below). Everywhere, rates are low and even negative in some places. Is it normal? Is it healthy? That’s a resounding “No!” This is not good. To give you a sense of the insanity, ask yourself the following question: Would you park your money in U.S. Treasury bonds at 1.74%, or Italian bonds yielding 1.06%, or Greek bonds yielding 1.21%? We sit in a dysfunctional period in time. My two cents: A sovereign debt crisis awaits. The ECB now owns 40% of the Eurozone’s government bonds. Can they avert a crisis? Depends on whether Italy exits—or Portugal or Spain… But when and to what magnitude, I have no idea. Risk? Elevated. So, the hope is that interest rate manipulation will depress currencies to boost trade, and that the growth it creates will lift the economy. That’s the idea anyway. However, lower-to-negative rates have not helped Germany or Japan lift their economies so far. As Ray Dalio argues, the central bankers are “pushing on a string.” In other words: the tradition of lowering interest rates to improve the economy just won’t work anymore.  Take a look at this from Armstrong Economics: “The European Central Bank’s QE policy has failed to stimulate inflation and has begun to have a negative impact on EU members’ balance sheets. Despite failing to stimulate the European economy, the ECB announced that they will implement their bond-buying program yet again in September at a rate of 20 billion euros per month. Former Greek finance chief described it best during an interview with CNBC, ‘QE the way it has been restructured resembles an antibiotic that has stopped working because the bacteria have grown adapted to it.’ Instead of restructuring worsening policies, the ECB is searching for a scapegoat. Christine Lagarde blamed EU member states for not spending more to stimulate the European economy. ‘Why not use that budget surplus and invest in infrastructure? Why not invest in education and why not invest in innovation?’ Lagarde questioned. Lagarde will be appointed as ECB president this Friday and seems poised to carry out much of the same policies as Mario Draghi.” Which brings us back to the root cause of the global economic illness: debt. If your brother accumulates too much debt, he has less income to spend on new things. More of his money must go toward paying back what he borrowed. His personal economy slows and his stress level rises. He’s desperate to figure out how to escape his mess. For countries, creditable academic research says stress begins when the debt- to-income ratio exceeds 90%. Today the global landscape looks like this:

If 90% is that stress threshold, what on God’s green earth does 325.8% in the U.S.; 457.7% in the Eurozone; or 595.8% in Japan do to us?  Harry Truman, Doris Day, Red China, Johnnie Ray South Pacific, Walter Winchell, Joe DiMaggio Joe McCarthy, Richard Nixon, Studebaker, television North Korea, South Korea, Marilyn Monroe Rosenbergs, H-bomb, Sugar Ray, Panmunjom Brando, "The King and I" and "The Catcher in the Rye"  We didn't start the fire It was always burning Since the world's been turning We didn't start the fire No we didn't light it But we tried to fight it “We Didn’t Start the Fire,” by Billy Joel You didn’t start the fire; I didn’t start the fire. It was always burning, since the world’s been turning. We sit late in a long-term debt-accumulation cycle. It’s the root problem in virtually all of the developed world’s economies, and it is further compounded by aging demographics. The stresses we see are being played out on the stage before us. We all want growth and prosperity. To achieve it, you and I will need to figure this out. It’s complicated, but we’ll get through it. It will take some time, political will, and collaboration. We’ll need to come together to determine how to burn the debt. We’ll need to recognize, too, that along the way, it’s going to get hot. End Game The risk of all of this global financial misbehavior is inflation. As Bill White, the former chairman of the Economic and Development Review Committee at the Bank for International Settlements (BIS)—the central banker’s central bank—stated in his presentation at the Mauldin Strategic Investment Conference last May, the Fed’s “crisis-resolution tools are inadequate [this time around]…” He advised you (and me) to think through the implications of the outcome he sees: deflation first, then inflation. He concluded, “In the end, the only way out of this mess is inflation.” White added that we should put a lot more emphasis on what’s happening geopolitically, since that’s where the action is going to be taking place. His sign-off? “Good luck. You’re probably going to need it.” With an eye toward geopolitics, let’s look at China. No Deal with China Adding to the world’s slow-growth challenges is the burgeoning realization that China may not be a good partner, due to intellectual property theft and global ambitions that clash with a free world’s ideology. I’ve been writing since August about these challenges. My lights turned on during a two-hour car ride from the Bangor, Maine airport to Grand Lake Stream and the annual Camp Kotok gathering of economists, investment professionals, and former Fed officials. Two hours with Jonathan D. T. Ward and I was numb. How didn’t I see this? I wondered. I told Jonathan that this is the seminal issue of our day, and I’ve been rooting him on since. China’s Vision of Victory (the title of Jonathan’s excellent book) is not a vision of a free world. It is of a world under authoritarian rule. Jonathan’s done an excellent job at getting his message out. U.S. Secretary of State Mike Pompeo said China’s communist policies are incompatible with U.S. democracy. “We accommodated and encouraged China’s rise for decades—even at the expense of American values, and security, and good sense. We did everything we could to accommodate China’s rise, in the hope that Communist China would become more free, market-driven, and ultimately, hopefully, more democratic,” Pompeo stated. “It is no longer realistic to ignore the fundamental differences between our two systems.” Bottom line: While optimistic China trade tweets fill the ether, there will be no deal of substance. Global supply chains are shifting—and will continue to do so—as the U.S. and its free-world allies stop ignoring the differences between true democracy and authoritarian-dictatorship rule. It takes time for businesses to move away from a revenue stream and it takes time to reroute supply chains. Add this to the slowing global growth pressures. After all this, you may feel like you need a drink. Me too, my friend. I see a cold IPA in my near future. But before you crack one open, just put this data into your macro calculus. The point of this global weekly musing is to simply take a step back and do our best to identify where we sit in the economic cycle and the market cycle. Are the odds are stacked in our favor, or not?