Deflation at the Gate

"Let's call this NFL game balls for dummies.  Oh, don't take offense. Up until a few days ago, when the Deflategate "scandal" broke, we were all dummies when it came to the esoterica of NFL ball rules. Hell, let's be honest; we were imbeciles.  Now, we're learning all sorts of fancy things about the league's regulations and how teams and referees handle footballs before and during a game. For instance, did you know the ball must be a "prolate spheroid"? And did you know that before today, the term "prolate spheroid" had appeared on CNN.com only four times in its history? - Blog posted by Eliott McLaughlin of CNN

It seems that we finally have Deflategate in the rear view mirror.  Despite the scandal the Patriots retained their crown so in all honesty it was once again a media frenzy that resulted in nothing.  So with nothing but blue skies ahead of the NFL I thought I would turn to the actual Deflategate issue that is front and center; "Deflation at the Gate."  

Not a day goes by without some talk about raising interest rates so I thought I would do a review of the global markets to get a sense of what is happening in the world.  My data points to something far from an increase in interest rates in the near future.  Rather it shows alarming signs of a potential global deflationary spiral.  Reviewing data from the Economist magazine shows that of the 41 countries listed in their economic indicators page, 12 or almost 30% have printed a negative number in the inflation column (this includes the United States).  A total of 19 or nearly 50% of all major economies in the globe have inflation running below 0.5%.  This is hardly the type of market where interest rates should start to climb!  Looking at the countries with double digit inflation and you have only 3, Russia, Venezuela and Egypt; none of these are world economic leaders and all have serious structural economic issues that will not vanish overnight.

Taking a look at interest rates and specifically each country's 10-year note and using the United States as the benchmark for risk free debt shows 20 of the 38 countries that have data with interest rates below the United States' 2.24% rate.  So more than 50% of the globe have rates lower than the United States and most of them have far worse economic problems than the United States.  No wonder the dollar is gaining strength almost daily!  Should the United States raise interest rates the dollar would explode higher and growth would dive even more dramatically than it is currently.  Furthermore with oil and most raw materials priced in dollars, prices would fall precipitously across the board driving prices even lower and causing a global deflationary spiral.

So I took the liberty to research the last time the globe as a unit was gripped by deflation and not surprisingly there has not been a time in history where all major economies have simultaneously struggled with deflation.  A lot of countries have had spates with the issue but never globally.  The data certainly shows me that global deflation is more than a vague probability but could very easily take hold.  Raising interest rates at this stage in the game might be the catalyst to cause the global outbreak and while I am no Federal Reserve fan I have to believe that even they have worked this one out.  As such I think that this talk is just that and the reality is low interest rates are here for at least the next twelve to 24 months.

The Debt Debate

"Am I in debt?  I'm a true American." - Balki Bartokomus

"Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best -
God! But the interest." - A poem by Paul Laurence Dunbar

As the levels of global debt increase a debate that has raged for many years is growing in volume.  Currently total global debt stands at almost three times total global GDP.  This is a staggering number and one that is not getting any smaller.  With many governments around the world awash with debt and businesses and consumers seemingly hooked on it, the prospects for debt levels decreasing any time soon seems dim.  This is worrying most economists due to the expectation that interest rates will start to rise at some point in the future and when they do, servicing this massive debt burden will have a large negative drag on economic growth.  Furthermore with seemingly ever person, company and government agency up to their eyeballs in debt not only will the impact be felt by consumers and businesses but governments will find a massive hole blown in their budget plans.

Interestingly though most first world economies treat debt with reverence in that debt payments receive a subsidy in the form of tax relief.  While a lot of advocates harp on the loopholes in tax law or farming and oil subsidies few discuss the subsidy that is the ability to deduct interest payments as a pre-tax expense.  This benefit is not only provided to companies who can deduct interest as an expense before tax but consumers can deduct the interest paid on their mortgages from their income earned.  It is estimated that this subsidy drains roughly  $800 billion a year in lost tax revenues from the United States Treasury alone.  This is more than the amount spent on defense each year.  As the current budget deficit is roughly that number, removing this subsidy would almost instantly balance the budget.  Furthermore studies have shown that the main beneficiaries from this subsidy are the wealthy as they are more than likely to have a loan (or the ability to obtain one), so in effect this $800 billion is a large cause of the inequality gap being seen across the globe.

One of the main proponents of the subsidy is to encourage home ownership.  It is argued that without this subsidy home ownership in the United States would fall precipitously.  This would drag down home prices and impact the entire home industry from DIY stores to Realtors to builders.  The impact is expected to be so large that it is almost unthinkable to remove the subsidy.  Taking a look at economies that do not provide this subsidy have shown that while there would be an initial sell off, home prices would only fall roughly 10% and subsequently recover.  The study found that not only do people naturally wish to own their home but that once prices fall to a certain level investors snap up the inventory and create a rental portfolio of properties. Therefore it is thought that the impact of removing this subsidy would be less dire than once thought and would be temporary.

Removing the luxury of deducting interest from company income statements would result in a restructuring of many companies balance sheets particularly the balance sheets of banks.  As interest is currently a pre-tax deduction, moving it below the tax line would remove the luster.  Companies might view debt very different as suddenly the thought of adding debt or issuing equity becomes a more evenly debated topic.  As a company can stop paying dividends without being forced into bankruptcy it is thought that many would curtail borrowing in favor of issuing equity.  The risk of adding more debt, which is less forgiving than equity, would push companies to add more equity rather than debt reducing the probability of another financial crisis.

As an example during the popping of the NASDAQ bubble more than $4 trillion of wealth evaporated.  In comparison the banks lost $2 trillion during the 2008 crisis and we are still trying to recover from that problem whereas the lost equity, while devastating to a lot of people, did not create the same economic after shocks as the financial crisis has.  Transferring the risk of investments from the banks and governments onto the equity investor seems like a lost art as every year since the Great Recession less and less money has been raised through the stock markets while the preferred funding source of debt spirals higher.  Changing this course seems to make sense but it will only happen once the subsidy is removed.

Against this positive effect is the cry that a number of companies would be driven out of business due to this lost benefit.  Furthermore many mergers and acquisitions not to mention leveraged buy outs would suffer.  While some of these deals do create value the majority result in a large payout to the funds putting the deal together with little benefit to the company and their employees so to me this is an argument with limited merit.

So while all may be well it is a sure thing that problems will arise from the debt gluttony once interest rates start to rise.  As it appears that interest rates will remain low for a while it could be a good time for governments around the world to quietly remove some or all of these subsidies.  Not only will this have the lowest level of impact right now but it will provide the safety net against another debt lead crisis.  Leaving the subsidy in place will have the double effect once interest rates rise of not only reducing government tax revenues due to the increased subsidy given to companies and consumers bu their deficits will spiral out of control as they will be required to service their gargantuan debt levels with ever larger amounts of borrowed money!  Lower tax revenues and higher deficits at a time when no government has the ability to handle any more financial stress, sounds like a great plan and one we are surely stuck with.  So while it may seem like a small bridge to cross for a large payoff there is no politician on earth that would try to push that policy through parliament until it is too late.  Pity as we could use a safety net rather than more interest.

Up, Up and Away

"Would you like to ride, in my beautiful balloon .... Up, up and away, in my beautiful balloon" - words from the song Up, Up and Away, written by Jimmy Webb

It is really amusing to me to see that once again it is a Friday and once again we are breaking through to new highs.  It seems like every Friday afternoon the market magically recovers from the slump of Monday and Tuesday to end the week on a positive note.  In fact the last 5 of 6 Fridays were good for the market; not that you should trade this statistic as it is certainly not a trend that can be maintained but it is remarkable.

Enough of trivia and turning my attention to the markets it has been a pretty rocky rode for government bonds around the world.  After reaching record low yields traders suddenly seemed to decide that enough was enough and that the hot coal could no longer be passed to the next chump so they dumped bonds en masse driving yields higher.  This was then followed by a surge in buying which has stabilized the yields but did not return them to their former lows.

It is interesting to note that during this frenzy world stock markets followed in the same path, first turning down and then resuming their meteoric rise.  Not all of them have acted as well as the S&P 500 but they have recovered from the sell off.  It is not often that you see bond prices moving in lock step with stock prices so this is a clear indication that the markets around the world are currently heavily reliant on cheap money to fuel their rise. It is also clear from the recovery in bonds that the world continues to believe that low interest rates are here for an extended period.  It also shows that any spike in yields will be met by huge demand as the world is desperate for higher interest on their savings and investments.

It was also interesting to watch the silver and gold markets which appear to have broken out of their trading range, jumping higher and breaching their 200 day moving averages.  This is interesting as typically these commodities run on fear or inflation so could these be signalling a move away from the slow growth and low inflation environment of the past years and into a more frenetic period of higher growth and inflation?  With oil prices above $60 a barrel and well above their lows recorded only a few months ago, there is a chance that inflation could be creeping back into the picture but it is far too early to say for certain.

If inflation is making a come back, which undoubtedly it will at some point in time, will it remain under control or take off like wild fire?  I have to believe that at least for the remainder of the year there is little chance of runaway inflation.  Unemployment is far too weak and oil prices are still miles from their peak but, if the consumer is forced to spend more on goods and services caused by higher prices there may be a small boost in spending and this might surprise a few economists and possibly the Federal Reserve.  Should this occur, the chance of the Federal Reserve raising rates increases and, as I believe that this would be a premature move, should they fall for the false signal it would put a bullet right through the heart of the market much like popping a balloon.  Would you like to ride in my beautiful balloon?

Deja Vu? Maybe, but with a Twist

"How come I love having an episode of deja vu? Its akin to an out-of-body experience, I would think.  It sits with me, happily, begging me to delve into my memory to find its match point." - Rachel Nichols

Is it just me but it certainly appears that we have seen this before.  Stocks flying higher on the back of supposedly good unemployment numbers and the expectation that the economy will rebound in the second half of the year.  Stock valuations are at their second highest level in history and yet they seem to continue higher.  The Federal Reserve wants us to think all is well with the economy so it continues to hint that higher interest rates are coming "soon" and that it will exit from its strategy of creating liquidity out of thin air, magically evaporating $4 trillion without any impact to the markets.

While on the surface things do appear to be headed in the right direction when compared to original expectations it is clear things are very different.  Every report that comes out either beats sharply lowered expectations or is revised lower once the real data is known.  Take for example first quarter GDP growth.  At the beginning of the year first quarter GDP growth was forecast to come in at 1.9% but this was relatively quickly revised down to 1.4%.  Subsequent to this the Bureau of Economic Analysis reduced its estimate to 0.2% but today's report on inventories showed an increase of only 0.1% instead of the estimated 0.6% so this will take the GDP data lower.  I would not be surprised to see GDP contract in the first quarter but this does not seem to bother the markets.

What does matter is low interest rates and on this front there is no end in sight.  Even with the newly printed unemployment numbers coming in at 5.4% the Federal Reserve will still not be required to raise rates any time soon as the anemic GDP growth shows a complete lack of economic traction which should keep inflation at bay.  Furthermore while the unemployment numbers are clearly heading in the right direction it appears that businesses have little desire to add more workers as production levels were stable as was the work week and earnings.  This leaves little doubt that the consumer will not be a catalyst for growth in the second half of the year, resulting in continued slow growth and no chance of an interest rate hike.  Furthermore the thought of raising interest rates blowing the budget deficit into orbit is not something that anyone can stomach particularly in this run up to the presidential elections so to me these rates (outside of an unknown catastrophic event) should remain mute.

In fact with rates in Europe below zero (you pay to have them hold your money) and debt across the globe continuing to spiral higher it seems that Deja Vu is back.  Therefore to me it is not whether the stock market will collapse it is just from what altitude.  Looking at the S&P which sits just below its all time high at 2116, there is no reason to believe that 2500 or 3500 is out of the question.  As long as interest rates stay low, which I believe that they will, the market seems content to rally higher, poor economic data or not.  The issue then is that if it is overvalued at 2116 and could correct to at least 1500 on the downside then if it does get to 3500 and corrects to 1500 the pain will be far greater.  This will be the same story of 2000 and 2008 repeating itself but there is a twist.

In the past the market buckled to local pressures which were normally related to higher interest rates slowing the economy too quickly.  The solution was to lower interest rates and free up liquidity.  This time around, with the world awash with debt and interest rates at unsustainably low levels, there is no safety valve.  This is what makes this time around Deja Vu with a Twist.  What concoctions can they come up with next time to "save" us from their mess?  I came up with the solution a few years ago which was laughed out of the room; but I will repeat it here and - the global bond.  In fact the more I see the madness the more I am sure that this will be the result.  If there is a global meltdown caused by global debt the only solution would be to sweep the balance sheets clean by rolling the whole lot into one massive global bond supported by the goodwill of all the countries of the globe.  Next to impossible I can hear you say, but what choice will they have and, if that ever happens, you will be able to say "Now that is Deja Vu with a Twist!"

A Bubble in China?

"Globalization has created this interlocking fragility.  At no time in the history of the universe has the cancellation of a Christmas order in New York meant layoffs in China." - Nassim Taleb

Over the last few years there has been plenty of speculation that the miracle that is China's economic growth would become undone and that in the very near future China would fall into a recession dragging the rest of the world with it.  The thought was that with all the over building and excess manufacturing capacity combined with rife political nepotism and its resulting inefficiencies mixed in with poor economic oversight and mismanagement, the economy would soon collapse.  Even with their massive trade balance and capital surpluses China would not be able to handle a slow 6% to 7% GDP growth. So the world held its breath as China's economic growth slowed during the recession and then speculated for a number of years that the economic spending on useless projects would soon backfire; but with China entering another year of slower GDP growth (potentially sub 7% GDP growth) it is interesting to uncover reasons that reduce the fear of an imminent collapse.

The first metric is a look at some of the cities that were essentially ghost towns a few years ago.  Zhengzhou as an example was desolated in 2013 and now is teaming with people, businesses, universities and schools.  This is not to say that housing, which was the main economic driver, will resume its ascent.  Housing prices fell 6% last year and could fall even further this year.  For this reason many builders have placed their projects on hold and are waiting for a more favorable housing environment before completing them.  This will take some of the pressure off prices and with sales of houses increasing more than 20% in 2014 over 2013 it will not be long before building resumes.

The second potential problem is their ever increasing public and private debt level.  Looking at the debt as a number it certainly shows signs of being a massive problem but digging a little deeper reveals that a lot of the debt is concentrated in government entities, construction  and property developers.  While still high, owing money to yourself is a problem that can be sorted out over time (the United States is certainly betting on this theory as well) rather than being forced upon you by outside creditors.  That said should a few large property developers who are currently in the throws of defaulting spook the market, a problem could ensue but for now it appears that these problems are contained.

The third metric is China's consumption-led growth.  With the burgeoning middle class starting to gain traction, China's consumer led consumption is on the rise.  With more and more new jobs being created in the service sector, even a slower GDP growth can be tolerated as consumer consumption can offset investment led consumption once again allowing China to handle a slower growth rate than was previously estimated.

So while it seemed like China was on the verge of collapse is appears that it may be able to dodge a bullet.  That said China's weak and flawed economic foundations still require a lot of work.  It is still difficult to move money around the country or invest abroad, options for savers and investors are limited largely to state controlled enterprises, municipalities have limited ability to control their finances or change tax structures essentially handcuffing them economically and, while they are trying to crack down on bureaucratic self dealing there is still a lot of work to be done.  All in all though it appears that things are headed in the right direction and this is a good thing for the rest of the world particularly when the global economy has become so interwoven.  So while there may still be a bubble in the Chinese stock market there is hope that the economy will be able to withstand slower growth.