The Kingdom Of Denmark
John Mauldin
Mar 04, 2015
In Thoughts from the Frontline, I am in the middle of writing a series on debt. I realized on Sunday that the second installment wasn’t ready for prime time, so I will work on it some more and send it out (hopefully) this coming weekend. In the meantime, in keeping with the theme of debt, for today’s Outside the Box we have the following issue of The Credit Strategist from the ever-insightful Michael Lewitt. Michael starts out musing on debt and then shares a number of useful thoughts on a variety of market topics, with his usual panache.
“The day-to-day volatility of the stock market is a side-show; the real story is the massive build-up of debt and what it means for the value of the currencies in which those debts are allegedly going to be repaid in the future. The truth is that those debts are never going to be repaid in constant dollars. Those who understand that and act accordingly will profit enormously; those who don’t will fare very poorly.”
I appreciate Michael letting me forward this letter to you. You can subscribe to his letter at www.thecreditstrategist.com.
As I send this note I am flying from Orlando back to a much colder Dallas, but spring can’t be all that far off, can it? Better here than Boston, I guess. I am glad my travels have not taken me to the Land of the Frozen this winter.
Finally, I was saddened, as I know many were, to hear of the passing of Leonard Nimoy. He was, and always will be, Spock. He was part of the zeitgeist of my generation. The alien character he created with his acting made us think about what it meant to be human, in much the same way that Data did for later Trekkies. And while it is classified as sci-fi, Star Trek is a story about the human condition, and Spock was the perfect foil for the writers and creators of the stories.
I wrote a chapter in Bull’s Eye Investing called “Finding Your Inner Spock,” about the behavioral quirks that all investors have, suggesting that we all need to develop the ability to control our emotions in the investment process – by finding our inner Spock, so to speak.
Leonard Nimoy lived long and prospered, and now he boldly goes on to the next leg of his journey. I’m sure he will find it fascinating. I am, and will always be, his fan.
Your trying to understand debt analyst,
John Mauldin, Editor
Outside the Box
The Kingdom Of Denmark
By Michael LewittExcerpted from the March 1, 2015 issue of The Credit Strategist
“What is a debt, anyway?
A debt is just the perversion of a promise. It is a promise corrupted by both
math and violence. If freedom (real freedom) is the ability to make friends,
then it is also, necessarily, the ability to make real promises. What sorts of
promises might genuinely free men and women make to one another? At this point
we can’t even say. It’s more a question of how we can get to a place that will
allow us to find out. And the first step in that journey, in turn, is to accept
that in the largest scheme of things, just as no one has the right to tell us
our true value, no one has the right to tell us what we truly owe.”
– David Graeber, Debt: The First 5000 Years
(2011, p. 391)
In Hamlet,
Polonius advises his son Laertes as he sends him off to school: “Neither a
borrower nor a lender be,/For loan oft loses both itself and friend,/And
borrowing dulls the edge of husbandry.” Borrowers and lenders have conducted
themselves over the ensuing centuries in ways that would not have surprised
Shakespeare, who understood human nature all too well. Later in the play, Marcellus,
a soldier, warns Hamlet that “Something is rotten in the Kingdom of Denmark”
after they are spooked by the ghost of Hamlet’s father. This is a reference not
only to the murder of Hamlet’s father, the King of Denmark, but speaks to the
fouling of the relationships that govern the kingdom. Those relationships are
ones of blood and obligation; in one form or another, they are different forms
of debt. Debt is not merely a contract between two parties; it is a solemn pact
of trust. When it is sundered, not only is money lost but husbandry – the
management of society’s resources – is corrupted. We learn from Shakespeare’s
great drama that a world ruled by debt is extremely fragile.
February 13th marked the 25th anniversary of the
bankruptcy of Drexel Burnham Lambert. I remember driving to work at Drexel’s
Beverly Hills office that morning having no idea what was about to happen. My
years at Drexel in the late 1980s and those I spent managing the firm’s private
equity holdings in the 1990s were an intensive education in credit and human
nature. Twenty-five years after Drexel’s demise and seven years after a crisis
that pushed the global economy to the brink of collapse, the world is drowning
in debt and derivatives. As a point of reference, when Drexel filed for
bankruptcy, it had a balance sheet of $3 billion. When Lehman Brothers filed
for bankruptcy in 2008, its balance sheet was two hundred times larger at $600
billion. As Figure 1 below illustrates, debt has grown exponentially while the
global economy has crept along at a petty pace. Six years after the financial
crisis, interest rates have been driven below zero in much of the developed
world,2 a sign that policy makers have failed to create sustainable economic
growth. (The latest tally is that $1.9 trillion of European sovereign debt is
trading with negative yields.) They have managed to inflate financial assets
but left the real economy behind. For example, U.S. equity prices have gained
122% since 2009 while US nominal growth has grown by only 18% over the same
period.
Having exhausted their ability to employ interest rates as a policy
tool, policy makers are now shifting their sights to currencies to stimulate
growth. But currencies are themselves nothing more than a form of debt, a
promise by a sovereign. And those promises are being actively debauched in a
series of currency wars that are certain to end badly for those who depend on
fiat money for their daily bread.
Figure 1
Unsustainable
Unsustainable
Drexel and its aftermath taught me many lessons.
The most important is that the world of finance is the world of human nature in
all its terrible beauty. And that world is driven by incessant change. Drexel
was thought to be the most powerful firm on Wall Street, yet it collapsed
overnight. That taught all of us working there not only a lesson in humility
but a lesson in the fragility of all financial structures, especially those
built on leverage. Those who fail to acknowledge and adapt to change are always
flirting with failure. Today’s investment landscape is filled with investors,
strategists and media pundits who refuse to admit that we no longer live in a
world that can pay its debts or respond to monetary stimulus as it did in the
years before the financial crisis. Acknowledging these realities doesn’t mean
one has to stop investing or stop taking risk. But it does mean one better do
so with one’s eyes wide open.
U.S. Economy
Contrary to what the Federal Reserve, Wall
Street and much of the financial media are telling people, U.S. economic growth
is not robust. Uncritical focus on doctored economic data leads to the
conclusion that growth is self-sustaining and accelerating. In fact, growth is
sluggish and evidence that it can be sustained if interest rates ever normalize
does not exist. Normalized interest rates still lie far in the future, however,
so equity investors feel empowered to ignore these concerns and bid up stocks
‘til Kingdom come. But just as they did 15 years ago during the Internet Bubble
and 7 years ago during the Housing Bubble, when Kingdom comes it will come with
the Devil.
Figure 2 below, borrowed from Societe Generale’s
Andrew Lapthorne, shows that downgrades in US earnings forecasts in February
were the worst since the 2009 financial crisis. Mr. Lapthorne writes: “we
believe that despite the many equity indices hitting post crisis highs, the
message from within the equity market, and indeed from the strong performance
of the sovereign bond market, is that investors are positioning themselves for
an economic slowdown. For example, the relative and strong outperformance of
higher quality stocks within the equity market has been highly positively
correlated with the equally strong performance of sovereign bonds, both of
which have rallied on the back of weakening earnings momentum. To simply
disregard this economically consistent message as being simply a function of
low oil prices, low inflation and central bank actions may be misguided to say
the least.” (Andrew Lapthorne, Societe Generale Cross Asset Research, “Global
Earnings Estimates Analysis: Is the US heading back into recession?” February
24, 2015.) While Mr.Lapthorne may be placing too much emphasis on the
performance of sovereign bonds, whose yields are artificially suppressed by
massive central bank monetization programs, his point is well taken: earnings
momentum is fading and doing so beyond the energy sector. It appears
increasingly likely that S&P 500 revenues will experience their first
year-over-year decline since the financial crisis and earnings may follow. The
sharp drop in oil prices is a symptom rather than a cause of a global economic
slowdown that is showing up in a broad array of data.
Figure 2Ć¢¨
No Earnings Momo
No Earnings Momo
Nobody, of course, is forecasting a recession.
We are taught that recessions do not occur until the Fed tightens aggressively
and the yield curve inverts. While the yield curve has flattened significantly
over the last year, it is far from inverted.
Whether this historical rule will
apply at zero gravity remains to be seen. Trillions of dollars are counting on
it.
Washin’ the
Bullshit Down
“Whatever I was/You know
it was all because/I’ve been on the town/ Washin’ the bullshit down.” Gordon
Lightfoot
In grade school, we are taught to consider the
source of what we read in order to appreciate that all discourse is colored by
bias. Sadly, this is a lesson ignored by investors who stand to lose a great
deal of money relying on the words of central bankers, Wall Street analysts and
the financial media. Consider the bias of each of these groups as well as their
accompanying forecast records, which are appallingly bad. (I owe a head’s up to
Societe Generale’s Albert Edwards for pointing me to the studies referred to in
the following discussion in his February 12, 2015 Global Strategy Weekly.)
Recently, the San Francisco Fed published a paper entitled “Persistent
Overoptimism about Economic Growth” (February 2, 2015, FRBSF Economic Letter
2015-03) in which it found that since 2007, the Federal Open Market Committee
(FOMC) has consistently been too optimistic about U.S. growth. While that may
be stating the obvious, it bears repeating since everyo ne hangs on every word
uttered by the denizens of the Eccles Building. The authors of this paper –
themselves Fed employees (we may live in Denmark but we do not live in Russia)
– attribute these failures to several factors: missing warning signals about
financial imbalances, overestimating the efficacy of monetary policy, and extrapolating
the past into the future. To err is human; to do so repeatedly is apparently a
job requirement of central bankers.
The private sector has proven no better at
predicting recessions. The primary difference between private sector economists
and government economists is that the former are better paid to be consistently
wrong. Of course, the primary goal of private sector prognosticators is to
convince their clients to buy as many stocks and bonds as possible, so their
upward bias is not surprising. Readers looking for a comprehensive study of the
failure of private sector economists to predict recessions should look at a
presentation entitled “Fail Again? Fail Better? Forecasts by Economists during
the Great Recession” given by IMF economists Hites Ahir and Prakash Loungani at
the George Washington University Research Program in Forecasting Seminar on
January 30, 2014 (http://www.gwu.edu/~forcpgm/Ahir_Loungani.pdf).
Finally we come to the financial media, which
rarely features anything original or challenging to the bullish consensus.
Dissenting voices are either dismissed or treated as minor interruptions to an
incessant flow of happy talk. For example, Mizuho Securities USA’s Chief
Economist Steve Ricchiuto recently appeared on CNBC and told presenters Simon
Hobbs and Sara Eisen that the U.S. economy is not “accelerating” and that the
bullish consensus is nonsense. He left Mr. Hobbs and Ms. Eisen fairly
sputtering in his wake. We likely won’t see Mr. Ricchiuto back on the air any
time soon, which is a shame, because he was correct.
(Of course, CNBC was much more willing to air
the non-conforming views of one of the worst forecasters in history, former
Federal Reserve Chairman Alan Greenspan. In a February 26 interview on the
business network, Mr. Greenspan said that “Lower long term rates is [sic] not a
conundrum, it’s an indication of how weak global economic growth is” and that
“effective demand is extraordinarily weak – tantamount to the late stages of
the great depression.” Fifteen years ago, as Mr. Greenspan was steering the
economy to one bubble after another, this would have been front page news.
Today it is consigned to zerohedge.com, which is by far the most useful media
outlet for financial information on the scene today.)
With rare exceptions, the financial media
traffics in noise rather than information.
Noise is what we already know while
information is what we don’t know.
Information adds to our store of knowledge
and prompts original thinking and moves us closer to the truth. The consensus
is noise, not information. But investors need information, not noise. Valuable
analysis helps investors skate to where the puck is going rather than where
it’s been - and that means finding the flaws in the consensus and moving beyond
it. The financial media, like public and private sector prognosticators, are
noise machines. Value-added analysts are difference engines.
Figure 3 below tells us what’s really happening
in the economy. After trillions of dollars of stimulus, U.S. GDP growth is
still only 2%. People can point to the weather, lower oil prices and the strong
dollar for why the economy cannot achieve escape velocity, but the primary
reason is the suffocating weight of public and private sector debt. Even with
low (or non-existent) interest rates, an enormous amount of financial and
intellectual capital is devoted to debt service rather than more productive
uses. The result is structurally slow growth. Too much emphasis is placed on a
single data point – payrolls – which is a lagging indicator and remains far
below the levels of previous recoveries. One reason for this emphasis is that
employment is part of the Fed’s dual mandate. The employment numbers have
stabilized but they are not as robust as the headlines suggest. The broadest
measure of employment, U6, is still running above 11%. The other fi gure that
is cited to support the bullish case is GDP growth, but last year’s GDP numbers
were distorted by higher healthcare spending mandated by the Affordable Care
Act. Theoretically, helping Americans live longer and healthier lives should
lead to a more productive economy. Practically speaking, however, an economy
that can’t provide enough jobs for its healthy members may not realize the
benefits that a healthier populace would produce. Only 44% of healthy adult
Americans are members of the work force, the lowest number since the 1970s.
This is hardly the sign of an accelerating or robust economy about to take off
into the wild blue whatever.
Figure 3
Difference Engine
Difference Engine
The Deleveraging
Delusion
Last September, the Geneva-based International
Centre for Monetary and Banking Studies published a study entitled Deleveraging? What Deleveraging?
reporting that “[c]ontrary to widely held beliefs, the world has not yet begun
to delever and the global debt-to-GDP is still growing, breaking new highs.”
Going further, the report’s distinguished authors warned that, “in a poisonous
combination, world growth and inflation are also lower than previously
expected, also – though not only –as a legacy of the past crisis. Deleveraging
and slower nominal growth are in many cases interacting in a vicious loop, with
the latter making the deleveraging process harder and the former exacerbating
the economic slowdown. Moreover, the global capacity to take on debt has been
reduced through the combination of slower expansion in real output and lower
inflation.”
Now, just a few months later, The McKinsey
Global Institute has issued a report reiterating this daunting message.
McKinsey’s version, entitled Debt
and (Not Much Deleveraging), tells us that since 2007, global debt
has grown by $57 trillion, raising the ratio of global debt-to-GDP by 17
percentage points. Developing countries have accounted for half of this growth;
government debt has soared (by $25 trillion) and private sector deleveraging
has been limited. Households in the U.S., UK, Spain and Ireland have
deleveraged somewhat, but elsewhere they have not. In particular, China’s total
debt has quadrupled from $7 trillion in 2007 to $28 trillion by mid-2014,
fueled by real estate and shadow banking (but honestly, who knows what the real
numbers are?). In an anodyne statement befitting a management consulting firm,
McKinsey concludes that “(i)t is clear that deleveraging is rare and that the
solutions are in short supply.” In fact, t he solutions are not in short
supply; what is in short supply is the political and moral courage to implement
them.
Figure 4
Denmark
Denmark
Both the McKinsey and the Geneva reports
demonstrate beyond a shadow of a doubt the unsustainable and dangerous path on
which the global economy is set.
The question is whether global leaders will
let the train run off the tracks, or whether someone will demonstrate the
necessary leadership to take action. The message for investors is that they and
their money are living on borrowed time.
The currencies in which their
financial assets are denominated are being diminished in value every minute of
every day. Rather than sit passively and receive a crash course in nominal
value, they should actively be seeking ways to protect the real value of their
capital. In many cases, this will require them to abandon managers that aren’t
generating adequate absolute returns and shift their assets to those who have
demonstrated a genuine understanding of what is happening and an ability to
connect the dots. The day- to-day volatility of the stock market is a
side-show; the re al story is the massive build-up of debt and what it means
for the value of the currencies in which those debts are allegedly going to be
repaid in the future. The truth is that those debts are never going to be
repaid in constant dollars. Those who understand that and act accordingly will
profit enormously; those who don’t will fare very poorly.
Oil Update
Oil has rebounded by nearly 40% from January’s
lows but remains well below last year’s prices. (As of February 28, Brent crude
was trading at $62.58 per barrel compared to a low of $45.19 on January 13 and
a high of $115.00 in June 2014.) This has led to rebounds in some oil equities
and junk bonds. Investors are breathing a sigh of relief that oil producers are
reacting to the plunge in prices by sharply cutting back drilling.
Unfortunately, these efforts have yet to actually cut production;
year-over-year production is still up. Companies have idled rigs for 12
consecutive weeks, bringing the rig count to its lowest level in five years,
but they will need to do much more to stop the growth in production. The same
improving technology that gave rise to the fracking boom and the ability to
exploit the most promising acreage has rendered the rig count of limited use as
an indicator of future production.
Oil prices were hit by a perfect storm of
oversupply, slowing non-financial demand and sharply lower financial (i.e.
trading) demand. The last factor is particularly noteworthy because it was
triggered by concerns about global growth on the part of commodities traders in
early-mid 2014. It makes eminent sense that a world suffocating under an
ever-increasing burden of debt is going to struggle to grow. This is confirmed
by reams of economic data from around the world. Other economically sensitive
commodities such as iron ore, aluminum and copper are telling the same story.
Markets are living organisms, however, and the oil market is no exception. Oil
producers are cutting production as quickly as possible and oil prices are
stabilizing. The International Energy Agency is predicting that oil demand will
increase by 912 million barrels-per-day in 2015 and another 1.13 million
barrels-per-day in 2016. Rising demand will meet lower supply to stabilize
prices. The world w ill adjust. The only question is how much damage will be
inflicted on overleveraged companies in the interim.
Figure 5
Whoops!
Whoops!
Data shows that lower gasoline prices are still
not translating into a consumer spending boom. As I have maintained all along
(to the criticism of many), cheaper gas is unlikely to send consumers racing to
the mall when the cost of healthcare and everything else is still rising. The
Bureau of Economic Analysis, an arm of the Department of Commerce, reported
that Americans spent $21.4 billion, or 18% of all spending on goods and
services, in the fourth quarter of 2014 on healthcare.
Those expecting lower gas
prices to boost consumer spending should consider Figure 5 taken from a report
by Goldman Sachs analyst Matthew J. Fassler. It shows that “the correlation
between [Wal-Mart Stores, Inc.’s] US [same-store-sales] and gas prices has been
nearly zero” since the
beginning of 2007. (Matthew J. Fassler, “Wal-Mart Stores, Inc.:
Results troughing, outlook plodding but improving nonetheless,” Goldman Sachs
Research, February 15, 2015.) Figure 6, taken from the same report, looks at
other major retailers like Sam’s Club, Target Corp. (TGT) and Costco Wholesale
Corp. (COST) and shows only marginally more evidence that lower gas prices
translate into higher retail sales, but Goldman deems the evidence
“statistically insignificant.” On its most recent earnings call, Home Depot
(HD) also confirmed that it has seen no correlation between lower gas prices
and higher spending at its stores.
Figure 6
Statistically Insignificant
Statistically Insignificant
So where are the savings going? J.C. Penney CEO
Myron Ullman suggested that consumers are using their gasoline savings to pay
down their credit card bills or buy necessities. While many experts expect
consumers to behave as they have in the past and spend their gasoline savings
on other disposable items, perhaps they should consider that earlier periods of
sharply lower oil prices did not coincide with either higher government
mandated healthcare spending or an ecommerce revolution. Consumer behavior is occurring
in a radically different environment today and is unlikely to produce the same
kinds of consumer spending boom as it did in the past.
Credit Derivatives
in Denmark
High yield bonds performed poorly over the
second half of 2014, particularly the lowest-rated credits. Between mid-June
and mid-January, the spread on the Barclays High Yield Index widened by 185
basis points and the average bond price dropped by 7 points (performance has
since recovered). The severity of the drop was not, however, fully reflected in
the credit derivatives market; the spreads on credit default swaps (CDS) did
not widen as much as spreads on the underlying cash bonds. One possible
explanation for this anomaly is that investors are concerned that CDS contracts
will not be enforced in the manner investors expect.
The last time something
like this occurred was in 2009 when counterparty fears led investors to
question the value of CDS protection. This issue arose recently when requests
were submitted to the body that determines whether payments are required to be
made under CDS contracts in the cases of RadioShack and Caesars Entertainment
Corp. (Caesars) . This body, the ISDA Credit Determinations Committee (the
“Determinations Committee”), produced a split vote regarding Caesars even after
the gaming company defaulted on a bond payment due on December 15, 2014. This
has raised questions about the integrity of these credit protection contracts
and the stability of the markets.
Joshua Rosner of Graham Fisher & Co. has
written some excellent papers on this topic exposing flaws in the process used
to determine the occurrence of “credit events” that give rise to payments under
CDS contracts. The Determinations Committee is comprised of the 15 largest
users of credit default swaps. Ten voting members are sell-side firms and five
are buy-side firms; the list includes the usual suspects. As a result, it is
highly likely that the voting members will own a position in the instruments on
which they are being asked to vote. Further, the determinations process lacks
any of the normal procedural protections associated with what is effectively a
juridical process. The following language from the Committee’s disclosure
document highlights the problem:
The procedures of the Determinations Committees
are set forth in the DC [Determinations Committees’] Rules. A Determinations
Committee in accordance with the DC Rules may amend the DC Rules. None of the
ISDA [International Swap Dealers Association], the institutions serving on the
Determinations Committees or any external reviewers owes any duty to you in
such capacity, and you may be prevented from pursuing claims with respect to
actions taken by such persons under the DC Rules. Institutions serving on a
Determinations Committee may base their votes on information that is not
available to you, and have no duty to research, investigate, supplement or
verify the accuracy of information on which a determination is based. In
addition, a Determination Committee is not obligated to follow previous
determinations or to apply principles of interpretation such as those that
might guide a court in interpreting contractual provisions. Therefore, a
Determinations Committe e could reach a different determination on a similar
set of facts. If we or an affiliate serve on a Determinations Committee, we may
have an inherent conflict of interest in the outcome of any determinations. In
such capacity, we or our affiliate may vote and take other actions without
regard to your interests under a Credit Transaction.” (International Swaps and
Derivatives Association [ISDA] Credit Derivatives Determinations Committee
Rules, September 16, 2014 Version, http://www2.isda.org/functional-areas/legal-and-documentation/disclosures/)
To characterize this process as arbitrary would
be generous. The Committee can act without any duty to anybody, can ignore all
principles of fairness, can act in absolute secrecy, and claims to have no
liability to anybody. Investors in credit default swaps sign away all rights
when they enter into standard CDS contracts.
The members of the Committee are
authorized to act in their own interest in the name of exercising their
fiduciary duties to their own investors. Fairness and market integrity be
damned.
The Determinations Committee failed to agree
whether Caesars’ failure to make interest payments on certain bonds on December
15, 2014 constituted a default (a “credit event” in the CDS contract parlance)
that would trigger payments on $1.68 billion of notional outstanding CDS contracts
that were due to expire on December 20. While the company made it clear that it
would not make those interest payments and was planning to file for bankruptcy
pending conclusion of negotiations with bondholders, it still had a 30-day
grace period in which to change its mind and make the payment and had
sufficient cash on hand to do so.
Accordingly, some might argue that the
default did not occur until the earlier of the end of the grace period or the
date of bankruptcy filing (bondholders filed an involuntary bankruptcy petition
on January 12; the company followed with a voluntary petition on January 15).
Unable to reach a decision, the Committee is convening an exter nal arbitration
panel for the first time in six years to determine whether a “credit event”
occurred with respect to the CDS contracts that expired on December 20.
Concerns have been raised because Elliott
Management, a large Caesars bondholder that sued the company on November 25, is
one of the 15 members of the Committee. Elliott’s presence on the Committee –
indeed, the presence of any market participant on the Committee –raises serious
questions about the integrity of the determinations process. The market would
be much better served by a process that recuses interested parties from
participating in decisions involving their own investments. This would seem to
be both an obvious and an easy problem to fix; it is also an important problem
to fix in order to improve market confidence. The credit default market, while
smaller than it was before the financial crisis, is still $20 trillion in size,
large enough to pose a systemic threat.
Recently, the big banks were able to
convince Congress to keep their hundreds of trillions of derivatives contracts
inside their FDIC-insured subsidiaries. As a practical matte r, this changes
little since the size of these derivatives are so overwhelming that the
government will have no choice but to step in with some type of blanket
guarantee during the next crisis regardless of where these instruments reside.
But leaving them inside taxpayer-insured entities sends a signal that Congress
doesn’t appreciate the risk these products pose and is enabling moral hazard to
flourish. Credit default swaps constitute only 3-4% of all outstanding
derivatives yet at $20 trillion could easily wipe out the capital of the
world’s banks in the blink of an eye. The least that should be done – and done
immediately – is for an independent procedure for determining “credit events”
to be put in place. The current regime is inadequate.
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