Assumptions Equal Problems

John Mauldin


 
The future is tantalizing because it is both unknown and unknowable. At best, we can make educated guesses about tomorrow or next year. Sometimes, it’s actually hard to understand what happened in the past, much less to chart how the future might unfold.

The problem is that some guesses are more educated than others, and even the best are often not good enough. This fact of life matters because we use those guesses to make important decisions about, for instance, government tax and spending policies. Mistakes can have terrible consequences.

These are subjects on which it is hard for any of us to be truly neutral. Most people want to lower their own taxes and simultaneously see more spending on whichever services they think government should deliver. The politicians we elect know this, so they try to give us what we want. The charade never ends well, but we and they keep at it.

Today we will look back at what economists thought the federal budget and tax policy would be in 2001 and thereafter. Let’s just say the government projections were a tad optimistic.


Photo: Getty Images
 
The Best of Times


Dial your mind back to January 2001. The world had survived Y2K; the stock market was topping out; George W. Bush had moved into the White House; and the US government had a balanced budget.

Wait, say that again? Yes, the budget was balanced, and indeed we were running a surplus. Actual black ink. How did that happen? For one thing, a Democratic President Clinton and a Republican Congress led by Newt Gingrich had found ways to work together and get things done. But more important was the previous decade’s economic boom, including four consecutive years of 4.4% or better real GDP growth. Truly it was the best of times, economically speaking.


Photo: Wikimedia Commons

 
This happy situation would not last long, but many intelligent people sure thought it would. In researching this letter, I poked through news articles from the time and found a treasure trove of horribly embarrassing-in-hindsight quotes. Some were from experts quite well-respected now – perhaps in part because they learned something from being so wrong then.

Five days after the Bush inauguration, then-Fed chair Alan Greenspan testified before the Senate Budget Committee. Congress was considering how to spend a rapidly accumulating budget surplus. Jerome Powell can only wish for the chance to say something like this:

The most recent projections from the OMB indicate that, if current policies remain in place, the total unified surplus will reach $800 billion in fiscal year 2011, including an on-budget surplus of $500 billion. The CBO reportedly will be showing even larger surpluses. Moreover, the admittedly quite uncertain long-term budget exercises released by the CBO last October maintain an implicit on-budget surplus under baseline assumptions well past 2030 despite the budgetary pressures from the aging of the baby-boom generation, especially on the major health programs.

The most recent projections, granted their tentativeness, nonetheless make clear that the highly desirable goal of paying off the federal debt is in reach before the end of the decade. This is in marked contrast to the perspective of a year ago when the elimination of the debt did not appear likely until the next decade.

 
Greenspan went on to give all the usual qualifiers, but his point was clear: Paying off the debt was both desirable and possible. He was so confident of it, he described at length the practical challenges of prepaying all the outstanding long-term Treasury bonds.

In February of 2001 I wrote about the growing budget surplus; and in that letter, entitled “Greenspan Interpreted,” I and others talk about some of the problems of not having US Treasury debt for many businesses, especially financial businesses, that actually are required to hold US debt. I smile as I go back and read those letters.
 
These particularly optimistic paragraphs leap out at me:

#1. There was a remarkable exchange with the new Senator from Michigan. She was sticking to the questions her staff had prepared for her (generally good practice for freshman senators when talking to Greenspan), when all of a sudden she thought she had this brilliant insight that would support her position that tax cuts are bad. Basically, she asked, “Do I understand you to be saying that in 2005 we will only have $500 billion in surplus?” getting ready to imply that the surplus was not really going to be enough for tax cuts. (Her staff had to be cringing when she left her script.) Before she could really put her foot in her mouth, Greenspan graciously interrupted and said, “No, Ma’am, I am saying that without tax cuts the surplus will be $500 billion in ONE YEAR. There will be no debt to buy. We will have to do something with that money. Whatever it is will be a huge stimulus to the economy.” His implied threat was that he would have to raise rates, cut the money supply, or do something equally nasty to offset that type of stimulus.

Greenspan plainly said that 5–6 years ago no one could have credibly argued we would be where we are today. No one thought that we could remotely pay off the portion of the debt that is not held by Social Security and Medicare as early as 2005–2006. Then he asked throughout both hearings, as I have done over the past months, what do we do with the “excess” surplus, especially the Social Security and Medicare surplus? Put it in a lockbox? Buy corporate bonds? Buy stocks?

These are all good problems, but they are going to be problems, nonetheless. He basically insisted that Congress needs to begin to decide now what we are going to do.

As for him, he clearly favored tax cuts. It would provide a steady stimulus, rather than a massive one. It would postpone the problem of paying the debt to a manageable period.
 

In other words, Greenspan saw eliminating the federal debt as a matter of “how,” not “if” – if, as he said, current policies remained in place. Obviously, it didn’t happen that way. Congress and the Bush administration decided to cut taxes and add the Medicare Part D prescription drug benefit. Then September 11, 2001, precipitated the very costly War on Terror.

(Note: At the time Greenspan said all this, the US economy was only weeks away from entering a recession. It would be short and relatively shallow but still an honest-to-God recession. Keep that in mind when you hear today’s experts confidently predict further growth.)

The Congressional Budget Office (CBO) surplus projections Greenspan mentions are still online here. Then, as now, the economic assumptions were optimistic, to say the least.

 

 
As of January 2001, the CBO foresaw another decade of 3% real GDP growth, 3% inflation, unemployment at 5% or below, and flat-as-a-pancake interest rates. That scenario was never likely to happen, and indeed it did not. These assumptions fell apart almost immediately and the situation only worsened. But by then the assumptions had been used to justify decisions that were, for various reasons, all but irreversible.

In fairness to the CBO, their report discussed how the projections could go wrong.
They even disclosed their own historical inaccuracies. But because this was a political process and not a business or scientific one, those warnings received little heed.

I have talked about this before: All economic and budget models are based on assumptions. Those assumptions generally draw upon the past to make projections about the future. I have actually heard a well-respected Fed economist admit that using the Phillips curve for some of their projections is fraught with problems. When asked, “Then why do you keep using it?” the answer that came back was, “We have to have something that we can base our projections on. We don’t have any other better model, so we use it.” Knowing that its us is going to result in faulty predictions, they still use it anyway.

And knowing that government agencies that do budget projections are forced to make assumptions about an unknowable future, we shouldn’t be too critical of them. Then again, because they are government entities, they are disinclined to forecast recessions or anything that might be negative about the economy. Generally, government forecasts are packed with lots of rainbows and ponies.

Nevertheless, the 1990s surplus wasn’t imaginary. And it was growing. The government was taking in more cash than it was spending. The overall debt had stopped growing and may have even shrunk a little, depending how you defined it. That was good.

Now, 17 years later, the surplus is gone, and we could easily see a $2 trillion annual deficit soon. How did we get from there to here so fast?

The answer is in the assumptions.

Dashed Surplus

If your average picture is worth a thousand words, the one below is worth many more. It comes from former Treasury economist Ernie Tedeschi. On his Twitter page, Ernie pointed out that seemingly reasonable assumptions back at the time of the January 2001 surplus celebration would have added up to a $15 trillion cumulative budget surplus through 2028.

That would have been nice, and probably allowed Greenspan to be right about paying off the debt. It didn’t happen. Instead, Ernie now foresees a $28 trillion cumulative deficit. In other words, over a 27-year period the assumptions will have been about $43 trillion off, if Ernie is right. Maybe he’s not, but let’s go with his numbers for the sake of argument.

What accounts for that gaping difference? Lots of things, but they fall into three broad categories, none of which are surprising.

• Higher than expected government spending
• Lower than expected tax revenues
• Worse than expected economic growth

Ernie’s chart breaks down the effect of each wrong assumption. Note that the October 2000 long-term projections from the CBO anticipated $15 trillion in savings by 2028.


Source: Ernie Tedeschi. Reproduced with permission

 
Let’s dig into this chart. Start by finding 2011 at the bottom axis, then go up. That’s the 10-year projection period CBO published in the 2001 report linked above. It’s history now, so we can evaluate it without making further assumptions. You can see the gap at that point came in roughly equal proportions from missed spending and missed revenue estimates. GDP had a relatively small effect, even though the original projections didn’t assume the 2007–2009 recession. When all was said and done, the 10 years ending 2010 saw an average of less than 2% GDP growth per year. And all that lost growth began to show up in the form of budget deficits this decade.

As time passes, the consequences of excessive GDP optimism grow more significant, especially as the CBO now projects lower growth than it did in 2001. Lower growth shrinks revenues. When these impacts are compounded over time, the difference between 2% and 3% real GDP growth is enormous. Just as those repeated years of 4% and better growth in the 1990s added up to a stunning surplus, our recent string of 2% and worse years add up to the opposite – and will keep doing so, unless something sparks much higher growth.

GDP projections involve both revenue and spending. Lower GDP and especially recessions tend to mean higher spending as more people become eligible for unemployment benefits, food stamps, and other social programs. Congress uses recessions to justify “stimulus” spending, too.

Likewise, recessions or just lower growth mean lower revenue because our tax system depends mostly on income. Less income for people and businesses means less tax revenue for the government.

But even if the CBO were to estimate GDP on the dot, and even if tax policy stayed constant, spending is still a huge variable. The services we want government to provide change over time. So does the composition of Congress, which decides which services to provide. Spending grows under either party, but not in the same ways. Then there are occasional bolts from the blue like 9/11, which in short order led us to spend multiple trillions on wars in Iraq and Afghanistan and smaller involvements elsewhere.

We can’t blame the CBO for not knowing how much those wars would cost or how long they would last, even if it could have somehow anticipated them. To a lesser degree, that is also true of budget busters like natural disasters. We can go years without needing to spend much on them and then have several hit at once.

There are ways to handle the unexpected. Keep the budget balanced or run a small surplus, then have a “rainy day” fund for emergencies. That’s how families and businesses operate. The government could do the same if the political will existed. Obviously, it doesn’t.

Growth Is the Cure

This example of how badly assumptions can go wrong offers some valuable lessons. Forecasting the future is hard even in the best circumstances, but you must make assumptions in order to plan ahead. The key is to make conservative, reasonable assumptions and adjust them when they prove wrong.

(I am facing that problem head-on every day as I try to write my new book on what the world will look like in 20 years – knowing that I’m going to be laughably wrong at various points along the way. I hope to be right more than I’m wrong. But the problem is, I’m obliged to makes scores of forecasts. So I have to make the best assumptions I can and move forward.)

That’s not how our federal government works. It makes hasty decisions and then compounds the bad effects. As noted above, we had a giant surplus on hand when the economy entered recession in early 2001. A little stimulus via tax cuts or extra spending made sense. Was that still the case after September 2001? Or should the government have changed course to account for new circumstances? As it happened, we kept the tax cuts, added new military and Medicare spending, and did nothing to raise new revenue or cut other spending. Bye-bye, surplus. Then came the financial crisis and Great Recession, and and you know the rest.

Even with wars and two recessions, we might have avoided today’s huge deficits if GDP growth hadn’t fallen to this frustratingly low plateau. The last calendar year with real GDP growth over 3% was 2005. Some people think 2018 will be the next one. I doubt it, but even if that happens it won’t make up for the years of missed growth opportunities.

All that said, this problem isn’t unsolvable. Growth really is the key. If real GDP can jump 3% or more this year and keep doing the same thing for three or four more years after that, and we can put in place some spending reductions, we would go a long way to solving our deficit problem. We might not have a surplus, but we’d be much closer to balanced.

Unfortunately, I can’t presently imagine a scenario in which that happens. The tax cuts and deregulation are helping a little, but not enough. Picking trade wars with China or tearing up NAFTA won’t help at all. Nor will continued gridlock over healthcare, or failure to solve the public pension problem or to reform entitlement spending. On the monetary side, it’s clear the Fed has no magic bullets. So what’s the best-case scenario?

I can only imagine one event that might help: a positive bolt from the blue, one that reduces government spending and raises government revenue.

Sound like a dream? Maybe it is, but I can imagine some major healthcare breakthroughs that would do it. Cures for Alzheimer’s, cancer, and heart disease would be a huge help. So would anti-aging breakthroughs. People would be able to work longer, adding productivity to the economy while reducing Social Security and Medicare spending.

Mind you, I am not predicting those things will happen soon – but I don’t count them out, either. Smart people are working on all these challenges and making progress. A large part of the budget problem is really a healthcare problem, both directly and indirectly. Healthier workers with longer working careers will translate directly into economic growth.

Today’s debt problem traces directly back to those 2001 assumptions that proved so wrong, but that’s not all. Every subsequent Congress and administration has relied on equally flawed, implausible assumptions and made similarly flawed decisions, right up to the present one. This short-sighted, wishful thinking afflicts both parties and the nation. It is a systemic problem that requires a systemic solution. Playing the blame game will not fix it. 

The Great Reset

And just for the record, I would like to say that the $28 trillion debt projected for 2028 is going to be seen in hindsight to have been extraordinarily optimistic. I think we are at $30 trillion of total debt by the middle of the decade, and by the end of the decade we could be scaring $40 trillion. We are beginning to see the drag on growth brought about the inexorable rise of total (not just government) US debt.

As I’ve said many times, we can’t pay that debt down through any realistic budget process. We, along with the rest of the countries in the developed world, are going to have to take extraordinary measures to control and reduce our debts and interest payments. I’ve called it the Great Reset. There are several ways to reduce the debt, but they all amount to essentially changing the terms of the debt (an anathema) or some form of monetization. Making such a prediction now seems rather stark, as any of those choices will not be popular or pleasant, so they are unthinkable today. But when we have our backs to the wall, we will all start thinking about unthinkable things and actually doing some of them.

All the while, technology is encroaching on more jobs, and the politics of many countries are becoming increasingly harsh. The 2020s are going to be extraordinarily volatile in so many ways – which of course means that there will be lots of opportunities. Stay tuned.

Charlotte, Fort Lauderdale, Chicago, and Raleigh

I travel next week to Charlotte, then later in the month to Fort Lauderdale, Chicago, and Raleigh for mostly private speaking engagements. The exception is a seminar open to financial advisors and brokers and sponsored by S&P, happening in Charlotte on April 11. The event is built around the theme of strategic and tactical ETF trading strategies.

Thank you to the thousands of you who took the survey I shared last week. My team is crunching through the results as I write, but some interesting findings jumped off the page straight away. One I found particularly interesting is that a massive 82% of you prefer to receive investment information by email.

It’s wonderful to know that, some 18 years after I first started sending out Thoughts from the Frontline, you still enjoy opening it up and reading it each week. I truly do appreciate that investment of your time in an era when we’re all battling the overload in our inboxes.

And I want to thank you, too, for the time you took to share your thoughtful and detailed answers about where we go from here with both Thoughts from the Frontline and Outside the Box.

Thankfully, your vision and mine converge pretty closely. That makes me even more excited about unveiling my plan to you. I’m still dotting some i’s and crossing some t’s, as well as conducting an avalanche of meetings, but I can say for certain that I’ll be able to let you in on what’s happening within a couple of weeks. Stay tuned!  

You have a great week. I can reliably project that I will be watching the Masters this weekend. Having been at Augusta last year for the Masters, I have a much better sense of what it’s like, and that will make watching it on TV a lot more fun.

Your thinking about the Great Reset analyst,

John Mauldin


Safe Haven Assets Are Moving Strangely: Why That Should Worry Investors

Turbulent markets roil gold, U.S. Treasurys alongside stocks

By Ira Iosebashvili, Amrith Ramkumar and Daniel Kruger

The dollar has been buoyed by recent turmoil in stocks, but other havens such as U.S. government bonds and gold haven’t behaved as they normally would in times of stress. Photo: jose luis gonzalez/Reuters 


Investments that typically serve as havens in times of stress are moving in strange ways, highlighting the unsettled condition of financial markets as they head into the second quarter.

The dollar and the yen have both strengthened recently, which is typical when investors are looking to unwind risk. But other assets that usually rally for similar flight-to-safety reasons haven’t fared so well. Gold, the Swiss franc and Treasurys have fallen since the Dow Jones Industrial Average slumped 9.4% from its Jan. 26 high.





GOING THEIR OWN WAY
The Japanese yen has strengthened againstthe dollar, while the Swiss franc has grownweaker.

Source: Tullett Prebon


That divergence is confounding analysts and investors. It marks a stark reversal from other recent periods of market disruption in 2011 and late 2015-early 2016. Both those times, the dollar and yen rallied alongside Treasurys and gold when nervous investors flocked to safer assets as stocks fell, according to data from Ned Davis Research.

With many investors intent on paring risk, “the normal correlations you expect to see don’t work so well,” said Said Haidar, head of New York-based Haidar Capital Management, which manages nearly $428 million.

It is the latest sign that financial markets may be navigating uncharted territory as years of central bank stimulus start to wind down while long-dormant volatility returns and borrowing costs rise. Corporate earnings have been strong, but growth and inflation remain tepid and face threats like possible disruptions to global trade.

“The big burning question right now is ‘Where is the safe haven?’ ” said Christopher Stanton, chief investment officer at Sunrise Capital LLC, a California-based firm that manages around $250 million.

Utility and real-estate shares in the S&P 500, popular with investors seeking relative safety because of their dividend payments, have fallen less than the broader index’s 8.1% drop.





NOWHERE TO RUN?
Assets considered safer bets including gold and utilities stocks have fallen despitethe uptick in market volatility.

Source: FactSet



But U.S. government bonds have been less predictable. Yields, which rise as prices fall, hit multiyear highs earlier in 2018 even as stocks tumbled from their peak in January. Then Treasurys rallied, pulling the yield on the benchmark 10-year U.S. Treasury note down from nearly 3%, a level it hasn’t hit since 2013.

For some analysts, the clearest explanation for the divergence is the unwinding of yearslong stimulus policies.

Trillions of dollars in monetary stimulus pumped into the markets by the Federal Reserve, Bank of Japan and European Central Bank over the past few years tended to smooth out volatility and cut short market routs.

“Most of these things performed as expected before, because there were no rate hikes on the horizon,” said Joseph Kalish, chief global macro strategist at Ned Davis Research.


RANGE BOUND
The yield on the 10-year U.S. Treasury note has also stayed in a range over the past month.


Source: Ryan ALM


Expectations of rising rates tend to hurt the value of outstanding bonds issued during periods of lower rates and crimp the performance of assets like gold, which become less attractive to yield-seeking investors when borrowing costs rise.

The market is adjusting from an environment where there was little volatility in 2017 to a resurgence since February, said Quincy Krosby, the chief market strategist at Prudential Financial.

“We were trained by the Fed to buy the dips, and it worked,” Ms. Krosby said. Now that the Fed appears to be intent on raising rates and has called stocks overvalued, “the dip will have to be deeper before investors come in.”

Others point to the unwinding of popular trades in recent weeks.

Some investors had placed outsize bets on more gains in areas such as big technology stocks, while wagering against interest-rate sensitive sectors.

Now they are being forced to cut back their positions in tech, while buying back bonds, as the government increases its scrutiny of Facebook Inc. and other internet firms.

Mr. Haidar of Haidar Capital Management is now betting that prices of government bonds in places like Spain, Italy and New Zealand will rise, as he believes that a mild slowdown in global growth will force central banks around the world to become less hawkish.

Concerns about inflation and growth have hit bonds too. The gap between two- and 10-year Treasury yields recently shrank to its narrowest since 2007, a sign of weakening sentiment about the prospects for long-term growth.

At the same time, fears of a pickup in inflation, which sparked selling in bonds earlier in the year, have ebbed recently and market-based measures of investors’ expectations for price increases have retreated from recent highs.

Inflation poses a threat to the value of government bonds because it erodes the purchasing power of their fixed payments.

“It appears to be a regime shift from last year,” said Christopher Sullivan, a portfolio manager at United Nations Federal Credit Union. “The uncertainty level has compounded exponentially.”

Mr. Sullivan said he had shifted his Treasury holdings into longer-term securities, which benefit from declining expectations for growth and inflation.

The yen has added 2.2% against the dollar since Jan. 26, making it one of the markets’ best performing currencies in 2018. For years, investors have borrowed yen—because Japanese rates are comparatively low—to fund trades in riskier currencies that offer higher yields in a strategy known as a carry trade.

Now, many are selling their riskier assets and buying back yen, giving that currency a boost, said Bac Van Luu, head of currency and fixed-income strategy at Russell Investments.

The Bank of Japan’s effort to boost its economy by keeping the yen cheap has made the currency a better value than the Swiss franc, another safe haven, Mr. Van Luu said.


Follow the money as Gulf tension ratchets up

Expect very large capital flows after geopolitical realignment in the region

John Dizard


© Stocktrek Images/Alamy


“The Shanamah has a happy ending”. Iranian proverb about how good outcomes are only found in fiction.

Elite American chatter about Iran or conflict in the Gulf mostly concerns courtiers rising or falling at the White House, or Washington think-tanker moans over past or present American policy. Perhaps that is less useful than considering the sentiments of people in the region, and what they are doing with their money.

That is not a simple task, because most of the states on the Gulf have fixed currency pegs, and all of them have opaque governance and obedient media. Insider trading is not the exception but the rule. For decades, Gulf financial markets and exchange rates have been tranquil, right up to the moments when they are not.

The most openly contentious society in the region is Iran, which is riven by political feuds and increasingly volatile official and “unofficial” currency markets. One of its sworn enemies, Israel, was at one time considered a natural, even biblical, ally. The other principal enemy and former ally, the US, has the largest number of Iranians outside the country.

Other states in the region have kept these historical contradictions in mind as they consider how they align themselves in the world. Alliances can change, and I think they will do so rather quickly now. Quiet flows of money will precede the coming geopolitical realignment in the Gulf, and very large flows will follow.

At the moment the most rapid financial shifts are happening within Iran. Last week the unofficial exchange rate of the Iranian rial to the dollar crashed through the 50,800 level, widening rapidly from the official rate, which is just below 37,000 rials to the dollar. That black market price is down about a quarter over the past six months, despite the rising oil prices that have driven up the region’s other risky-asset markets.

There are other indications of political and financial uncertainty in Iran that are not rooted in White House intrigue. Predata, the data analytics firm, says its “Iran Economic Risk Prediction Signal” has been trending up since early March. The signal is based on algorithmic trawls of Iranian social media, and usually predicts major internal events such as strikes and protests about two weeks in advance.

Inward flows from non-US companies have been glacially slow. The regime’s enforcement of laws from dress codes to clerical heresy has become more hesitant and uncertain.

So if blocks of hundred dollar bills are harder to find in Iran, where did they all go? After all, Iranians have a difficult time opening dollar-denominated bank accounts. Step forward the currency pegs of the Gulf Cooperation Council states. The UAE, Oman, Bahrain have had stable currency pegs with the dollar since the 1980s. Oman had the last devaluation back in 1986.

Afghans and Iranians with unexplained wealth find some of the GCC’s local banks are very convenient and understanding. The banks know the Americans are not going to turn away the traffic in US currency.

The UAE leadership may nod vigorously when the Americans talk about isolating Iran, but know their neighbour has seven times the UAE’s population. And 80 per cent of the UAE’s population is foreign. Iranians do commercial business in Dubai, develop gasfields with Qatar, use the central bank of Oman as an intermediary, and fight alongside Iraqi militias. Kuwait is a bit more standoffish with Iran, but it is conservatively financed and not looking for another war.

That is less true for Saudi Arabia. The Saudi engagement in the proxy war in Yemen with Iran has had very mixed results. Even so, the Kingdom seems open to more direct action against Iran.

The Iranian regime has more ground combat experience than the Saudis, but the Saudis have air and missile forces that they believe could do a lot of damage, quickly, to the Iranian oil and gas industry and electricity system. Both populations are thinking this through. Predata has a “Saudi-Iran Tension” indicator based on both Persian and Arabic social media. It increases with bits of incendiary war news or “Yemini” missile attacks, and began to rapidly spike up again after March 24.

Saudi Arabia has also recently been aggressive in loosening its “macro-prudential” banking regulation. For example, loan to value ratios for housing and local businesses have been raised, with a gentle tisk-tisk from the IMF. The UAE and other Gulf states, more burnt by past booms and crashes, are keeping animal spirits somewhat in check.

The placid to non-existent forward markets tell us the Gulf states’ currency pegs to the dollar look pretty stable for at least the next couple of years. Floating exchange rates or otherwise more active monetary policies are probably beyond the administrative capabilities of the governments and central banks.

Devaluations would not do much good anyway, with the high dependence on oil income, imported goods, foreign workers, and foreign currency debt. The risks of regional war or social upheaval are more likely to be dealt with through formal and informal capital controls. Korea is chilling, but the Gulf is heating up.


Buttonwood

More market volatility seems likely

Investors should fasten their seat belts


“FASTEN your seat belts. It’s going to be a bumpy night.” Those famous lines of Bette Davis in “All About Eve” may turn out to be the motto for the markets in 2018. After the “volatility vortex” in February, sparked by concerns about inflation, markets have thrown a “tariff tantrum” after President Donald Trump sparked fears of a trade war with China.

In February stocks sank on heavy hints of American levies on imported steel and aluminium. The prospect of trade measures against China, signalled on March 22nd, again hit shares. Then reports that China and America were making progress in trade talks caused the S&P 500 index to rise by 2.7% on March 26th, its best day since August 2015. It promptly fell again by 1.7% the next day (see chart).

Further volatility seems likely, not least after the appointment of John Bolton, an ultra-hawk on foreign policy, as Mr Trump’s national security adviser. That raises the possibility of increased tension with North Korea, despite the recent suggestion of a summit between Mr Trump and Kim Jong Un. The changes of tone from the White House have been so rapid that you might think policy is being set by Twoface, a Batman villain, whose decisions are controlled by the toss of a coin.

Last year was a bumper one for global stockmarkets. Investors shook off pessimism about growth, which had led to many earnest discussions about “secular stagnation”, and enthused instead that the world was experiencing a period of synchronised economic expansion. Tax cuts passed by America’s Congress in December were the icing on the cake, boosting both the American economy and payouts to the shareholders of multinational firms.



But this year has seen a number of worries come to the fore. “The entire complexion of this stockmarket is changing before our eyes,” says David Rosenberg, a strategist at Gluskin Sheff, a Canadian wealth-management firm. Central banks are withdrawing some of the monetary stimulus that has supported the market rally since 2009. And economic data have not been quite as positive as before. Citigroup’s “surprise” index, which is based on whether actual numbers turn out to be better or worse than forecast ones, has dropped back from the high levels reached at the end of last year. The price of copper, a commodity that is particularly sensitive to economic conditions, has fallen by 9% so far this year.

The prospect of further interest-rate increases has taken its toll on bank stocks, with America’s KBW NASDAQ Bank index dropping by 8% in the week to March 23rd. The technology sector has also taken a hit. Led by the FAANGs (Facebook, Apple, Amazon, Netflix and Google), the S&P 500 Information Technology index managed a five-year annualised return of 18.5%. But controversy over the use of Facebook data in the 2016 presidential election prompted a reversal. Fears of extra regulation caused more losses on March 27th. The index has dropped by 5.2% so far in March.

All this has taken a toll on sentiment. The latest survey of investors and strategists by Absolute Strategy Research (ASR), a consultancy, shows that they have become less confident about the economy. The survey responses generate only a 43% probability of the business cycle being stronger a year from now. That is down from 55% in the first quarter of 2017.

Investors think there is a 58% probability that equities will be higher a year from now. But that is not particularly optimistic. According to the Barclays CapitalEquity-Gilt Study, American shares rose in 64% of the years since 1926. And investors expect a more testing economic climate. Both inflation and bond yields are forecast to rise over the next 12 months.

The ten-year Treasury-bond yield has already risen from 2.4% at the start of the year to 2.79%, in part because the market expects America’s tax cuts to lead to a lot more debt being issued. It is not clear how far yields can rise before they start to have a palpable economic impact. “Debt becomes more of a problem with slower growth and higher interest rates,” says David Bowers of ASR.

As a sign of tightening liquidity conditions, the ASR team also points out that the real growth rate of the global M1money-supply measure has slowed sharply, from more than 9% to less than 4%, in recent months. Another warning sign is that the gap between short-term and long-term interest rates has shrunk. In the past, a flatter yield curve has signalled an impending economic slowdown. These signals may turn out to be false alarms. But even so, investors would be forgiven for checking their seat belts.

China/Asia Economic Implosion on the Horizon?

Chris Vermeulen
Technical Traders Ltd.


PART I   
Recent news of the US enacting $60 billion in economic tariffs on China as well as reactionary tactics from China have everyone spooked.  The US stock markets and global markets tanked last week as this news hit the wires.  At www.TheTechnicalTraders.com, we have been warning of a massive upside move in precious metals as well as global market concerns for the past 12+ months.  Our recent research shows just how fragile the global markets are to external factors as well as strengths in the US and other established economies.

This multi-part special report will delve into the immediate and future risks that are associated with the fundamental and economic likelihoods of credit market contractions and economic rotations within the China, India, South East Asia markets in relation to recent news events. 

We hope to clearly illustrate the opportunities and risks that will likely play out over the next 12 to 48+ months for investors and traders.  Let’s start by trying to keep it simple with some very clear examples of what has transpired over the past 4 to 5 years and how we believe things will change in the near future.

This chart of property price cycles (advancing price cycles vs. declining price cycles; highlighted for your convenience) in Beijing, China, clearly illustrates the expansion and contraction cycles experienced in the capital city/region of China.  One can clearly see the expansion of the peaks vs. troughs as these price cycles have played out over the past 10 years.

What we find interesting about this chart is that the upper boundary appears to reside within the +8.5% or slightly greater expansion range, while the price contraction cycles continue to explore deeper and broader downside boundaries over this same range.

This leads one to consider the possibility that Real Estate prices and cycles in China may be much more speculative in nature than we may have considered in the past.  It also points to the concept that the Global Credit Crisis (2008 through 2010) may have created a consumer mentality that wealth can be created by speculating on real property throughout these cycles.



Additionally, we see some correlation to the real price valuations of Beijing property in the following chart.  Any analyst can clearly see that prior to 2008, the rotational price levels were much narrower than after 2008 (roughly 2~3% in range vs. 7 to 15% in range).  This volatility in pricing is one key factor that is leading us to our conclusion that the current downward price cycle (see the above chart) may lead to a substantially lower downside price target range in Beijing (and other areas of the world).  Our analysis leads us to believe this early stage price rotation is an excellent opportunity for investors and traders to prepare for and begin to execute trades to attempt to profit from these events.

Recently, we posted an article regarding the massive increase in pre-foreclosures in most US metros. 

Our intent was to illustrate just how dynamically this price cycle is changing and to highlight the potential for investors to be prepared for a move.  Our current research into the potential for a China/Asia market implosion is based on the assumption that the past years of easy money, quantitative easing, support for property markets across the globe and massive support for an expansion cycle are nearing an end event.  If our analysis is correct, this end event cycle will present incredible opportunities for smart investors by attempting to capitalize on early and middle stage market events.




PART TWO

In our previous article regarding the potential China/Asia Economic Implosion, we illustrated how the property market cycles in China (Beijing) are in the early stages of a potentially topping and a massive drop in value.
 
Today, we are going to try to expand on this analysis a bit further by illustrating how the US and other global established economies may have inadvertently setup certain emerging markets for another global crisis event.  Our research team at Technical Traders Ltd. has developed a unique set of skills in sourcing and evaluating current market events and predictive price modeling systems that allow us to attempt to determine future events with relative certainty.  Within this post, we will attempt to provide further evidence and supporting data as it relates to our belief that we are in a very late stage economic expansion cycle and about to enter a very early stage economic contraction cycle.  As we continue to disclose our research and findings within this multi-part article, we will close this research out by explaining how and why we believe smart investors will be able to create massive opportunities over the next 12 to 48 months from our research.
 
Please review our previous research post (Part I) of this detailed research report before you continue reading if you have not already read it.  It is important that you continue reading this post with the context of the previous research post.  Thank you.
 
You should recall from our first post that we illustrated the expanding real estate cycle events in Beijing and how they related to a downside price cycle that appears to be in the very early stages of rotation.  Today, we want to illustrate how the US market has been driving much of this expansion and speculation in China.  Below, we have highlighted the same Beijing pricing cycles over a US Real Estate Equity chart.  The point of this analysis is to clearly show that real price/equity expansion in the US market did not begin to occur until late 2012 and into early 2013.  This was the time that real estate values in the US began an upward trajectory and real equity was being earned again.  Prior to this, from roughly 2006 to the end of 2011, real estate price equity was declining or basing – with no real attrition or increase.
 


Now, if you open up Part I of this article in a separate window, you’ll see that the real price expansion in the Beijing real estate market also began in mid to late 2012 and peaked in 2014. 

Our analysis and belief is that many Chinese investors were jumping into the US and global real estate markets at this time and that the increase in prices in Beijing assist them in diversifying assets across the globe by buying foreign assets.  We believe this assumption is supported by the price decline in Beijing between mid-2014 through early 2016.  We believe the previous price advance allowed Chinese investors to leverage their gains into outside/foreign assets while chasing the easy credit allowed by many foreign central banks.
 
It was also evident that many Chinese were moving capital outside China in an attempt to source new revenue growth.  We believe this transition to outside assets was in full swing by 2013 to 2016 – when China finally started clamping down on capital flowing outside it boarders.
 


For your reference, here are a few resources to support our findings:
 
NYTimes : February 13, 2016: Chinese Start to Lose Confidence in Their Currency
 
The Strait Times: February 15, 2016: China’s rich move money our of country, joining capital exodus
 
The Wall Street Journal: December 2, 2016: China Clamps Down on Exodus of Cash
 
It is obvious from the data that Chinese investors and wealthy individuals were hungry for returns in an environment where their stock markets had recently declined more than 30% while their real estate markets were experiencing a multi-year price decline of well over 10%. 
 
What were these people to do but find outside sources for returns and move their money into foreign investments that could allow for continued revenue growth. And what better place to move their money than the US and Canada – which were experiencing massive real estate price advances.
 
Take a look at this chart of the Canadian real estate price advances over the past 15 years. 
 
Incredible.
 


But, think about this for a minute, now that many of the Chinese were investing in Chinese and foreign assets and property while at the same time investing in China ‘s shadow government, corporate and derivative investment schemes, what are they to do with all this capital tied up in markets that are nearing or entering a contraction phase?  What is their exit plan and how can they move to the sidelines fast enough to avoid the risks associated with collapse? 


Thank you for following our multi-part research (Part I, Part II) into the possibility of a China/Asia market collapse and our hypothetical analysis of what that event might consist of and how it may play out.  So far, we have discussed the Chinese housing market rotation as well as the recent trends within the past 7+ years, expansion and foreign investments made by many Chinese and successful Asian investors.  All of this research raises some interesting questions for us to consider.
  • Just how much risk exposure have these Asian/Chinese investors set themselves up with?
     
    How deep of a property price or equity price decline would be enough to set off a panic mode?

  • How tightly are the assets in China/Asia associated with equity/debt that was used to explore foreign investments and additional debt?
     
    How varied and deep do these “debt rabbit holes” go in terms of derivative assets, layered debt and more?
  • How has the expansion of credit/debt in China expanded out into other foreign markets?
  • How has the US and other central bank easing policies fostered a risk-taking role in Asia over the past 7+ years?
And finally, the BIG question:

What would it take for China/Asia to move from an investments/risk-taker mode to a protectionist/crisis mode?

One of the first things we need to consider is the expansion of credit that originated after the global market credit crisis (2008 to 2010) was still evident in China and Asia – although not quite as deep in form and structure as it was in the US, Canada, Europe and others.  Our previous research reports show that China’s property market and equities markets were not subject to the types of deep declines the US and other established economies experienced.  This was likely because China, at the time, was still experiencing a middle stage economic expansion period where China could continue to fund and export enough raw and finished materials to keep their economy running at 6%+ without much issue.  Of course, after 2015~2016, China was able to accomplish this by devaluing their currency, expending billions in reserves to build and product excess cities and finished material as well as foster and finance hundreds of large-scale projects throughout the globe (Africa, Europe, Asia, Mexico and South America).



In other words, the growth that China is experiencing is almost a shadow of the real growth because it has been enacted by shadow banking, shadow debt and leveraged expenses based on reserves while decreasing the Yuan valuation in order to maintain this economic shell game.  As long as their markets don’t contract more than a certain amount and investors are able to continue rolling their capital into this shadow banking system without any fear – nothing will likely change.  But when it does change, it should be very dramatic and quick.

Recent Chinese economic expansion has been partly a result of renewed global economic activity as well as the capacity of the Chinese government to use capital reserves to support their economic transition process – as evident by the $1 trillion in capital reserves that vanished between 2015 and 2017.




When one considers the recessionary economic cycles chart, above, as well as the US Presidential election cycle, one could explain this contraction as a general global contraction in relation to the uncertainty of a US election.  Yet, the size and scope of the capital reserve decline (over $1 trillion) within the scope of an expanding global economy, as well as expanded investment projects within China, means only one outcome could result in this reserve decline – reserves were used to support banking and finance facilities in an effort to avoid a collapse of credit/debt mechanisms.

These are tell-tale signs that the Chinese, and likely other Asian/Indian countries, are trapped in an expansive credit/debt environment that is likely very similar to what happened in the US/UK to set off the 2008~2010 global credit crisis.  The only difference this time is that it appears to be the Chinese have run themselves into this debt trap and the fragility of their economic footing is showing signs of cracking.

What would it take to cause the floor to crumble under the Chinese/Asian economies?




A deep (-32%) price correction occurred between 2015 and early 2016 that coincides with the reserve decrease as well as the property market price decline.  As our research shows, this also coincides with a mass exodus of capital from within China to outside sources (USA, Canada, UK and elsewhere).  If a decline of this nature in equities that was also associated with a property price decline resulted in a $1 trillion decline in China’s reserves, think about the potential chaos that could be associated with a new property price decline associated with an equity market decline.

PART FOUR

Our previous three segments of this research report detailed not only the history of the Chinese economic activity but also detailed some of the capital flow issues that have been active in presenting this unique instance in time as it relates to a potential implosion of economic activity in China and most of Asia.  We, the research team at Technical Traders Ltd., have attempted to clearly illustrate all of the components and facets that have existed to make up a very unique scenario where traders may be able to experience a once or twice in a lifetime trade that could result in massive returns.

Within our previous posts, we attempted to disclose what we believe to be one of the most critical and potentially damaging economic events in our future.  We urge all readers to review (Part I, Part II, Part III) of this multi-part research report to bring everyone up to speed with our thinking.  Please take a moment to our earlier posts before continuing.

In this section, we are going to explore the ongoing relationship between debt levels, shadow economic functions, global equity price levels and global economic activity all coincide at this very unique time to present a potentially massive and unprecedented event in human history – a massive economic collapse across dozens of nations and resulting in a potentially cataclysmic economic outcome.  We are certain you might be asking, “how could this happen again?”. 

Well, in some ways the recovery process in the US, Europe and other areas could have prompted a very unique and dangerous setup in China, India and the general Asian region. 

Why are these areas uniquely at risk? 

The reason is because China has become a major economic driving force in the region and has become responsible for much of the areas economic advancement.  This has been the case since the late 1990s.

In the previous section, we hinted that a downturn in the Chinese property market between 2015 till 2016 in combination with an equity price decline in excess of -15% to -20% and an outflow of capital from the Chinese economy resulting in a massive, $1 trillion, decrease in the Chinese capital reserves.  How could something like this result in a total of $1 trillion in reserves to be depleted?  The answer is that pressures on the economy at that time resulted in a number of general and corporate debt failures that, if left alone, would have pressured the entire Chinese financial/banking system into a possible crisis.  Therefore, the Chinese had to make the problem go away and they did this by diving into their reserves to wash away the debt issues while continuing to prop up their economies and banking institutes.  This $1 trillion reserve decrease was the “patch” that was needed to make sure the economic collapse was averted.

We have been watching the news and related investment research for years attempting to stay on top of these moves and keep our members aware of the potential for a market correction/reversal.  Part of our research is now warning us that we need to begin to prepare for the eventual crumbling of the economic footing of the global markets and we believe China/Asia will play a massive role in the next big move.

Chinese debt to GDP is massive compared to the US or other developed nations.

And China’s debt just keeps rising…




By our estimates, the current Chinese debt to GDP levels have increased by nearly 100% (to somewhere above 350% of total annual GDP.  Additionally, current levels are well in excess of 200% to 300% of levels found near 2005 to 2007.  If we consider 2014 levels alone, the time just before the massive $1 trillion reserve decrease, debt levels today are nearly 45% larger than debt levels in 2014.  Therefore, the fragility of the Chinese economy in terms of debt constrictions related to any proposed property market price rotation and/or any capital/equity market price correction, particularly if they happen at the same time (like before), could present a very unique collapse event.  It is our opinion that the current debt levels make the fragility of the Chinese economy even more sensitive to property market and/or equity market disruptions.

China’s shadow banking, particularly WMP (Wealth Management Products), Entrusted, Trust and loans by Financial Firms present a huge issue in regards to stability of the Chinese credit markets.  Over 4~5 short years, over $30 Trillion Yuan in these types of loans have been originated – a massive 400% increase on average.  The individual component levels range from a 100% increase to well over 650% increase.



Remember, these financial (credit) instruments are rooted in the projections that borrowers have the ability and capability to repay these loans, or that the projects they back will result in substantial real value at some point.  The loan origination data, below, shows a decent increase just after the US Presidential elections and we are certain this recent rally in the US and global markets has eased some pressure away from the Chinese and other Asian markets.  Yet, the recent price rotation (February and March 2018) could be “just enough” to crush the floor in the Chinese/Asian markets waiting for that last pin drop to start the crumbling process.

It is our belief that any contraction in any single market, Chinese property, Chinese equities or Chinese debt could likely be contained as long as the contraction range is less than 15~25% from the most recent highest valuation points.  Our range of 15~25% is just that, a range that should be considered extremely dangerous for the Chinese and Asian markets.  Should two or more of these market react in a similar manner, decreasing by 15~25% over an extended 12~24 month period, we believe the pressures of this type of move could be catastrophic for China and parts of Asia.  The simple fact that two, or more, capital markets that experience this type of valuation decline would likely put an additional $1 to $2.5 trillion (or more) in reserve pressure on the Chinese and local markets.




Additionally, this type of valuation pressure would likely result in liquidations of foreign assets at near fire-sale prices to move these asset into cash as quickly as possible.  This type of market action is called a “death spiral” for a reason.  As panicked sellers dump assets to get into cash, they are driving the property and equity valuations even lower in the process – causing others to become panicked sellers and perpetuating the cycle.  A death spiral event is one that sparks up overnight, causes runs on banks as people try to get as much cash as possible and causes wildly unreasonable price valuations simply because people are desperate to unload assets that could destroy their balance sheets.  It is better to sell it for X than to hold onto it and watch it destroy any existing capital I may currently have.

Now that we’ve gone through quite a bit of detail in describing what could happen, allow us to go into just a bit more detail with our next article showing the current equity markets and the current property markets in these regions in addition to more of our predictions.

PART FIVE

As we, the research team at www.TheTechnicalTraders.com, continue to deliver sections of this multiple part global market research report centered around China and Asia as a catalyst for an impending global market/debt collapse, we want to make sure our readers understand this process will likely play out over many months into the future.  This is not something that we should concern ourselves with right away.  This is not a warning that “the sky is falling and we need to run to our bunkers”.  This is forward-looking research that indicates a strong possibility that China and Asia, along with many other nations in this region, may experience a credit/debt market contraction that could lead to another global credit crisis and we need to be aware of it and plan to profit from it. (Part I, Part II, Part III, Part IV)

So far, we have covered the history of Chinese property and equity market growth from before the 2008-2010 global credit crisis till now and have clearly shown that the Chinese property market is rolling over (downward) after the 2016 regulations were put into place to curtail the mass exodus of capital from within China.  We have also gone over many of the correlative economic items that point to the fact that a 15~25% correction in any one market segment, property, equity, credit/debt or global markets that result in capital risks for China, could drive a contagion effect for the Chinese investors/government.  In other words, a simple 10~20% price decline in two or more of these markets could put enough pressure on the Chinese that capital reserves could diminish dramatically as well as some level of investor panic could set in to drive a “death spiral” type of event.

Even today, our researchers visited the National Bureau of Statistics in China to continue our research and found the following :

Whereas growth rate of purchases (land), commercial sales and floor space sales and growth rate of fund for development have decreased dramatically just over the past 3+ months.  When you look at this data on a year over year context, it shows mild contraction up until December 2017.  After December 2017, the contraction in Residential and Commercial real estate activity is dramatic – almost frightening.

Throughout all of 2017, the Growth Rate of Investment in Real Estate Development averaged near 8.1%.  Beginning in early 2018, this level shot up to 9.9% – the highest level in over 13 months.

Growth of Land Area Purchased over the same period showed signs of increase over 2017 – averaging near 11.2% or so throughout 2017.  The values of this indicator near the end of 2017 were above 15%..  Whereas the 2018 levels show a -1.2% growth rate.  In one month span, the level of this indicator fell -17%?

The Growth Rate of Floor Space and Sales of Commercial Buildings continued to decline throughout most of 2017.  Starting near 25~26% and ending the year near 10% – a -15% decrease.  What we found very interesting is that Sales of Commercial Buildings increased 1.6% in early 2018 while Floor Space sold decreased 3.6%.  It would appear the Chinese central bank is willing to lend to property buyers while floor space buyers are falling off the map.

Our primary concern with regards to any type of Chinese or Asian credit market collapse is that the recent 5 to 7+ years of outward capital expansion, expanding investments outside of China/Asia in support of lofty objectives and fuzzy real/return values, may have prompted a massive sub-standard debt issue that could become very dangerous for the world.  We’ve all been reading of the issues of Non-performing assets and loans in China recently.  These types of credit/debt are the same types of instruments that led to the 2008~2010 global credit crisis.



Imagine the Chinese economy as both a local organism (contained to only the China/Asia general region), but also as an international organism (depending on external sources for essential life sustaining components – like the US and UK for purchases and the other emerging markets for growth projects).  Now, imagine these external sources experience an extended 10~35% general asset decrease over a period of 3~5+ years while the US Federal Reserve, and other central banks, tighten the credit markets and push up borrowing costs.  If China is dependent on these outside sources for essential economic sustaining components, then the economic balance they depend upon could become threatened – if not even more fragile than we have already examined.

Yet, consider one additional component of this hypothetical exercise.  Consider that the Chinese property and equity markets experience a moderate contraction event (say 10~20+% lower over 2~3 years) while the US and other established economies continue to push up the borrowing costs with rising interest rates.  We have long believed that capital migrates into the most healthy and opportunistic environments, with ease, and as capital migrates to new sources of returns, it leaves deteriorating economies in a “death spiral” for a period of time.  Capital that is unable to quickly move to new opportunistic sources may become trapped in these contracting economies for many years or decades.

The signs of this hypothetical economic exercise are already starting to become evident.  Recent China housing market data shows an incredible decline in activity and pricing – about to fall into negative territory.





China’s property market cycles have topped out as well, indicating a strong potential for further contraction in the real value of property assets.




Combine this with a global central bank tightening and recently announced US/China tariffs and economic positioning and we have the making of another Global Crisis event – this time originating in China/Asia as the Chinese Dragon economy bursts.

As US mortgage rates continue to climb above 5%, the inevitable economic tightening across the US and globe will continue.  The attempt to move China away from a US Dollar based economy and become more focused on the Chinese Yuan will, in our opinion, be a difficult transition over many decades.  We believe the Chinese/Asian markets are on the cusp of a potentially dramatic collapse and the recent news of US and Chinese tariffs do nothing more than exasperate the current issues.  Pay very close attention to the surrounding Asian markets as we continue to watch for breakdown events.




In the next, and last, portion of this series, we will attempt to present our final conclusions and expectations for traders and investors.  We have attempted to clearly illustrate our detailed China/Asia market research and the potential for a dramatic price decline in the immediate future.  We’ve outlined how this incredible opportunity for investors was setup, almost perfectly, by the global recovery efforts after the 2008-09 credit crisis.  At this point, it would appear the Chinese Dragon economy is on its last leg and we are well positioned to take advantage of the next big move.