September 28, 2018
By Steve Blumenthal
“The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.
There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them:
- Austerity (i.e., spending less)
- Debt defaults/restructurings
- The central bank ‘printing money’ and making purchases (or providing guarantees)
- Transfers of money and credit from those who have more than they need to those who have less.”
– Ray Dalio, A Template For Understanding Big Debt Crises
Today is part II of what I believe will be a four-part On My Radar series. It’s a master class on how economies cycle, how bubbles begin, how they end, who wins, who loses and how you might better navigate the period immediately ahead. Openly shared with us by one of the greatest fund managers of all time, Ray Dalio and his team from Bridgewater Associates.
We are at the end of a long-term debt super cycle. While new to most of us, it is not new to history. We’ve been here before. Think of this study as a debt cycle road map. If we better understand where we are in cycles and how past cycles have played out, I believe we can better navigate the period ahead.
I believe we are ever so close to the next great test. But when? It has everything to do with debt and the ability to pay back debt. Last week, I shared with you my notes from Dalio’s A Template For Understanding Big Debt Crises. We can’t see it coming if we don’t know what to look for. For our investment success over the coming two to 10 years, you and I have got to get this right. And I believe we can.
From Dalio:
When money and credit growth are curtailed and/or higher lending standards are imposed, the rates of credit growth and spending slow and more debt service problems emerge. At this point, the top of the upward phase of the debt cycle is at hand. Realizing that credit growth is dangerously fast, the central banks tighten monetary policy to contain it, which often accelerates the decline (though it would have happened anyway, just a bit later). In either case, when the costs of debt service become greater than the amount that can be borrowed to finance spending, the upward cycle reverses. Not only does new lending slow down, but the pressure on debtors to make their payments is increased. The clearer it becomes that debtors are struggling, the less new lending there is. The slowdown in spending and investment that results slows down income growth even further, and asset prices decline.
Dalio’s book is a template for understanding how all debt crises work! Reiterating what I said last week, put everything else aside, this matters.
The Fed raised rates again this week and are expected to do so again in December and perhaps two more times next year. Maybe more. Dalio states, “Realizing that credit growth is dangerously fast, the central banks tighten monetary policy to contain it, which often accelerates the decline.”
I don’t think we are at the top just yet but we are seeing some cracks in the dam. Tesla comes to mind, as does the rising dollar’s choke hold on EM debt financed in dollars.
However, for now at least, overall credit conditions remain favorable. When favorable, it signals there is available liquidity to feed the system. Focus in on the bottom section in the following chart:
- Note the dotted green line. Above the line, credit conditions are favorable (green circle). Green is good.
- Note the red circle. Credit conditions are unfavorable. Red is bad.
- Next zero in on the three red/yellow circles. A drop to the “Credit Conditions Unfavorable” area has done a good job at calling each of the last three recessions. That’s typically when the fireworks go off.
Source: Ned Davis Research
To get some footing on how economies cycle, I believe this next chart does a good job at painting the picture. We are in the “Late Upswing Phase.” Note the red “We are here” arrow and the highlighted box. Thus, our need to keep close watch on the credit conditions. Again, credit conditions are currently good.
Source: ACG Advisors
What Dalio is saying is debt drives these cycles, that there are short-term debt cycles and there are long-term debt cycles. Last week was about how the economic machine works and concluded that we are at the end of a long-term debt cycle.
In Part II today, we are going to look at the first three of the seven Phases of the Classic Deflationary Debt Cycle: 1) The Early Part of the Cycle, 2) The Bubble and 3) The Top. Let’s get a handle on what this looks like and know that I’m breaking this up in chunks because there is so much for us to get our minds around. At least that seems to work best for me. Debt? How can debt be as interesting? Well, if you and I get the direction right, and we position right, we can make a lot of money. The great investment game. Let’s win by not losing, size our portfolios correctly and find a few targeted bets that may really move our needles. Grab that coffee, find your favorite chair and jump in.
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
Included in this week’s On My Radar:
- Ray Dalio’s Template for Understanding Big Debt Crises (Part II)
- The MoneyShow Dallas, Thursday, October 4 – John Mauldin and Brian Schreiner
- Trade Signals – Fed Day, Zweig Bond Signal Remains Bearish, Equity Trend Remains Bullish
- Personal Note – Ohio State vs. Penn State (White Out)
Ray Dalio’s Template for Understanding Big Debt Crises (Part II)
“When money and credit growth are curtailed and/or higher lending standards are imposed,
the rates of credit growth and spending slow and more debt service problems emerge.
At this point, the top of the upward phase of the debt cycle is at hand.
Realizing that credit growth is dangerously fast, the central banks tighten monetary policy to contain it,
which often accelerates the decline (though it would have happened anyway, just a bit later).
In either case, when the costs of debt service become greater than the amount that can be borrowed
to finance spending, the upward cycle reverses. Not only does new lending slow down, but the pressure on debtors to make their payments is increased.
The clearer it becomes that debtors are struggling, the less new lending there is.
The slowdown in spending and investment that results slows down income growth even further, and asset prices decline.”
– Ray Dalio (emphasis mine)
Following is a short summary of last week’s letter to give you a feel for why we have these short-term and long-term debt/economic cycles and how they predictably play out:
During the upswing of the long-term debt cycle, lenders extend credit freely even as people become more indebted. That’s because the process is self-reinforcing on the upside—rising spending generates rising incomes and rising net worths, which raises borrowers’ capacities to borrow, which allows more buying and spending, etc. Most everyone is willing to take on more risk. Quite often new types of financial intermediaries and new types of financial instruments develop that are outside the supervision and protection of regulatory authorities. That puts them in a competitively attractive position to offer higher returns, take on more leverage, and make loans that have greater liquidity or credit risk. With credit plentiful, borrowers typically spend more than is sustainable, giving them the appearance of being prosperous. In turn, lenders, who are enjoying the good times, are more complacent than they should be. But debts can’t continue to rise faster than the money and income that is necessary to service them forever, so they are headed toward a debt problem.
When the limits of debt growth relative to income growth are reached, the process works in reverse. Asset prices fall, debtors have problems servicing their debts, and investors get scared and cautious, which leads them to sell, or not roll over, their loans. This, in turn, leads to liquidity problems, which means that people cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down, which makes people even less creditworthy. Asset prices fall, further squeezing banks, while debt repayments continue to rise, making spending drop even further. The stock market crashes and social tensions rise along with unemployment, as credit and cash-starved companies reduce their expenses. The whole thing starts to feed on itself the other way, becoming a vicious, self-reinforcing contraction that’s not easily corrected. Debt burdens have simply become too big and need to be reduced. Unlike in recessions, when monetary policies can be eased by lowering interest rates and increasing liquidity, which in turn increase the capacities and incentives to lend, interest rates can’t be lowered in depressions. They are already at or near zero and liquidity/money can’t be increased by ordinary measures.
This is the dynamic that creates long-term debt cycles. It has existed for as long as there has been credit, going back to before Roman times. Even the Old Testament described the need to wipe out debt once every 50 years, which was called the Year of Jubilee. Like most dramas, this one both arises and transpires in ways that have reoccurred throughout history.
Okay, that doesn’t sound like good fun. Just hold it in your mind for now and know there are ways to both navigate the terrain and profit if you position your bets properly.
Now onto Dalio Part II:
Remember that money serves two purposes: it is a medium of exchange and a store hold of wealth. And because it has two purposes, it serves two masters: 1) those who want to obtain it for “life’s necessities,” usually by working for it, and 2) those who have stored wealth tied to its value. Throughout history these two groups have been called different things—e.g., the first group has been called workers, the proletariat, and “the have-nots,” and the second group has been called capitalists, investors, and “the haves.” For simplicity, we will call the first group proletariat-workers and the second group capitalists-investors. Proletariat-workers earn their money by selling their time and capitalists-investors earn their money by “lending” others the use of their money in exchange for either a) a promise to repay an amount of money that is greater than the loan (which is a debt instrument), or b) a piece of ownership in the business (which we call “equity” or “stocks”) or a piece of another asset (e.g., real estate). These two groups, along with the government (which sets the rules), are the major players in this drama. While generally both groups benefit from borrowing and lending, sometimes one gains and one suffers as a result of the transaction. This is especially true for debtors and creditors.
One person’s financial assets are another’s financial liabilities (i.e., promises to deliver money). When the claims on financial assets are too high relative to the money available to meet them, a big deleveraging must occur. Then the free-market credit system that finances spending ceases to work well, and typically works in reverse via a deleveraging, necessitating the government to intervene in a big way as the central bank becomes a big buyer of debt (i.e., lender of last resort) and the central government becomes a redistributor of spending and wealth. At such times, there needs to be a debt restructuring in which claims on future spending (i.e., debt) are reduced relative to what they are claims on (i.e., money).
This fundamental imbalance between the size of the claims on money (debt) and the supply of money (i.e., the cash flow that is needed to service the debt) has occurred many times in history and has always been resolved via some combination of the four levers I previously described. (SB here: see intro quote above for the four levers). The process is painful for all of the players, sometimes so much so that it causes a battle between the proletariat-workers and the capitalists-investors.
In this study we will examine big debt cycles that produce big debt crises, exploring how they work and how to deal with them well. But before we begin, I want to clarify the differences between the two main types: deflationary and inflationary depressions.
- In deflationary depressions, policy makers respond to the initial economic contraction by lowering interest rates. But when interest rates reach about 0 percent, that lever is no longer an effective way to stimulate the economy. Debt restructuring and austerity dominate, without being balanced by adequate stimulation (especially money printing and currency depreciation). In this phase, debt burdens (debt and debt service as a percent of income) rise, because incomes fall faster than restructuring, debt paydowns reduce the debt stock, and many borrowers are required to rack up still more debts to cover those higher interest costs. As noted, deflationary depressions typically occur in countries where most of the unsustainable debt was financed domestically in local currency, so that the eventual debt bust produces forced selling and defaults, but not a currency or a balance of payments problem.
- Inflationary depressions classically occur in countries that are reliant on foreign capital flows and so have built up a significant amount of debt denominated in foreign currency that can’t be monetized (i.e., bought by money printed by the central bank). When those foreign capital flows slow, credit creation turns into credit contraction. In an inflationary deleveraging, capital withdrawal dries up lending and liquidity at the same time that currency declines produce inflation. Inflationary depressions in which a lot of debt is denominated in foreign currency are especially difficult to manage because policy makers’ abilities to spread out the pain are more limited. We will begin with deflationary depressions.
SB here: Turkey, Venezuela and Iran are current examples of countries experiencing inflationary depressions. Many Asian countries and India have large U.S. dollar denominated debt. Many European countries have debt that was converted from local currency to the Euro and are left with no ability to control their own currency. They represent red pockets of instability in “The Growing Economic Sandpile” by John Mauldin –a piece shared with you via OMR here a few weeks ago.
Back to Dalio:
The Phases of the Classic Deflationary Debt Cycle
The chart below illustrates the seven stages of an archetypal long-term debt cycle, by tracking the total debt of the economy as a percentage of the total income of the economy (GDP) and the total amount of debt service payments relative to GDP over a period of 12 years.
(1) The Early Part of the Cycle
In the early part of the cycle, debt is not growing faster than incomes, even though debt growth is strong. That is because debt growth is being used to finance activities that produce fast income growth. For instance, borrowed money may go toward expanding a business and making it more productive, supporting growth in revenues. Debt burdens are low and balance sheets are healthy, so there is plenty of room for the private sector, government, and banks to lever up. Debt growth, economic growth, and inflation are neither too hot nor too cold. This is what is called the “Goldilocks” period.
(2) The Bubble
In the first stage of the bubble, debts rise faster than incomes, and they produce accelerating strong asset returns and growth. This process is generally self-reinforcing because rising incomes, net-worths, and asset values raise borrowers’ capacities to borrow. This happens because lenders determine how much they can lend on the basis of the borrowers’ 1) projected income/cash flows to service the debt, 2) net worth/collateral (which rises as asset prices rise), and 3) their own capacities to lend. All of these rise together. Though this set of conditions is not sustainable because the debt growth rates are increasing faster than the incomes that will be required to service them, borrowers feel rich, so they spend more than they earn and buy assets at high prices with leverage.
Here’s one example of how that happens: Suppose you earn $50,000 a year and have a net worth of $50,000. You have the capacity to borrow $10,000 per year, so you could spend $60,000 per year for a number of years, even though you only earn $50,000. For an economy as a whole, increased borrowing and spending can lead to higher incomes, and rising stock valuations and other asset values, giving people more collateral to borrow against. People then borrow more and more, but as long as the borrowing drives growth, it is affordable.
In this up-wave part of the long-term debt cycle, promises to deliver money (i.e., debt burdens) rise relative to both the supply of money in the overall economy and the amount of money and credit debtors have coming in (via incomes, borrowing, and sales of assets). This up-wave typically goes on for decades, with variations primarily due to central banks’ periodic tightenings and easings of credit. These are short-term debt cycles, and a bunch of them generally add up to a long-term debt cycle.
A key reason the long-term debt cycle can be sustained for so long is that central banks progressively lower interest rates, which raises asset prices and, in turn, people’s wealth, because of the present value effect that lowering interest rates has on asset prices. This keeps debt service burdens from rising, and it lowers the monthly payment cost of items bought on credit. But this can’t go on forever.
Eventually the debt service payments become equal to or larger than the amount debtors can borrow, and the debts (i.e., the promises to deliver money) become too large in relation to the amount of money in existence there is to give. When promises to deliver money (i.e., debt) can’t rise any more relative to the money and credit coming in, the process works in reverse and deleveraging begins. Since borrowing is simply a way of pulling spending forward, the person spending $60,000 per year and earning $50,000 per year has to cut his spending to $40,000 for as many years as he spent $60,000, all else being equal. Though a bit of an oversimplification, this is the essential dynamic that drives the inflating and deflating of a bubble.
SB here: While all of this is simple and logical, as you read, try to take a step back and watch how all of the pieces are playing out like it were a movie, but in this movie you and me, our friends, co-workers and all of our family members are in the movie. Float above it all, remove any emotion and imagine this you’ve seen this movie before which paints a high probability road map to the path the end of the current long-term debt cycle may play out. We are looking for the key players to watch, understanding probable outcomes and a better understanding of who wins and who loses.
The Start of a Bubble: The Bull Market
Bubbles usually start as over-extrapolations of justified bull markets. The bull markets are initially justified because lower interest rates make investment assets, such as stocks and real estate, more attractive so they go up, and economic conditions improve, which leads to economic growth and corporate profits, improved balance sheets, and the ability to take on more debt—all of which make the companies worth more.
As assets go up in value, net worths and spending/income levels rise. Investors, business people, financial intermediaries, and policy makers increase their confidence in ongoing prosperity, which supports the leveraging-up process. The boom also encourages new buyers who don’t want to miss out on the action to enter the market, fueling the emergence of a bubble. Quite often, uneconomic lending and the bubble occur because of implicit or explicit government guarantees that encourage lending institutions to lend recklessly.
As new speculators and lenders enter the market and confidence increases, credit standards fall. Banks lever up and new types of lending institutions that are largely unregulated develop (these non-bank lending institutions are referred to collectively as a “shadow banking” system). These shadow banking institutions are typically less under the blanket of government protections. At these times, new types of lending vehicles are frequently invented and a lot of financial engineering takes place.
The lenders and the speculators make a lot of fast, easy money, which reinforces the bubble by increasing the speculators’ equity, giving them the collateral they need to secure new loans. At the time, most people don’t think that is a problem; to the contrary, they think that what is happening is a reflection and confirmation of the boom. This phase of the cycle typically feeds on itself. Taking stocks as an example, rising stock prices lead to more spending and investment, which raises earnings, which raises stock prices, which lowers credit spreads and encourages increased lending (based on the increased value of collateral and higher earnings), which affects spending and investment rates, etc. During such times, most people think the assets are a fabulous treasure to own—and consider anyone who doesn’t own them to be missing out. As a result of this dynamic, all sorts of entities build up long positions. Large asset-liability mismatches increase in the forms of a) borrowing short-term to lend long-term, b) taking on liquid liabilities to invest in illiquid assets, and c) investing in riskier debt or other risky assets with money borrowed from others, and/or d) borrowing in one currency and lending in another, all to pick up a perceived spread. All the while, debts rise fast and debt service costs rise even faster. The charts below paint the picture.
SB here: Pause the movie and get some popcorn. You are pausing at the point in which we find ourselves today – interest rates bottomed at zero, the chase for yield into riskier asset classes, invention of new funding products, FAANG stocks… And most importantly, the level of debt relative to income (GDP) here, there and everywhere. But it sure feels good so get some more popcorn and we’ll continue. Back to the charts – bubble phase is boxed in red.
In markets, when there’s a consensus, it gets priced in. This consensus is also typically believed to be a good rough picture of what’s to come, even though history has shown that the future is likely to turn out differently than expected. In other words, humans by nature (like most species) tend to move in crowds and weigh recent experience more heavily than is appropriate. In these ways, and because the consensus view is reflected in the price, extrapolation tends to occur. (emphasis mine)
At such times, increases in debt-to-income ratios are very rapid. The above chart shows the archetypal path of debt as a percent of GDP for the deflationary deleveragings we averaged. The typical bubble sees leveraging up at an average rate of 20 to 25 percent of GDP over three years or so. The blue line depicts the arc of the long-term debt cycle in the form of the total debt of the economy divided by the total income of the economy as it passes through its various phases; the red line charts the total amount of debt service payments relative to the total amount of income.
SB here: This next chart courtesy of Ned Davis Research shows the total credit market debt in the U.S. relative to GDP. Dalio is saying bubbles see leveraging up 20 to 25 percent on average over three years or so. From 2005 to 2008, debt went up from 320% debt-to-GDP to over 375% debt to GDP. Quick side note – the yellow highlighted areas show the slowdown in various measures of growth in the U.S. based on how high debt is. And you’ll see further below that debt-to-GDP ratio greater than 300% is typically for long-term debt cycle tops.
Source: Ned Davis Research
Bubbles are most likely to occur at the tops in the business cycle, balance of payments cycle, and/or long-term debt cycle. As a bubble nears its top, the economy is most vulnerable, but people are feeling the wealthiest and the most bullish. (emphasis mine) In the cases we studied, total debt-to-income levels averaged around 300 percent of GDP. To convey a few rough average numbers, below we show some key indications of what the archetypal bubble looks like:
The Role of Monetary Policy
In many cases, monetary policy helps inflate the bubble rather than constrain it. This is especially true when inflation and growth are both good and investment returns are great. Such periods are typically interpreted to be a productivity boom that reinforces investor optimism as they leverage up to buy investment assets. In such cases, central banks, focusing on inflation and growth, are often reluctant to adequately tighten money. This is what happened in Japan in the late 1980s, and in much of the world in the late 1920s and mid-2000s.
This is one of the biggest problems with most central bank policies—i.e., because central bankers target either inflation or inflation and growth and don’t target the management of bubbles, the debt growth that they enable can go to finance the creation of bubbles if inflation and real growth don’t appear to be too strong. In my opinion it’s very important for central banks to target debt growth with an eye toward keeping it at a sustainable level— i.e., at a level where the growth in income is likely to be large enough to service the debts regardless of what credit is used to buy. Central bankers sometimes say that it is too hard to spot bubbles and that it’s not their role to assess and control them—that it is their job to control inflation and growth. But what they control is money and credit, and when that money and credit goes into debts that can’t be paid back, that has huge implications for growth and inflation down the road. The greatest depressions occur when bubbles burst, and if the central banks that are producing the debts that are inflating them won’t control them, then who will? The economic pain of allowing a large bubble to inflate and then burst is so high that it is imprudent for policy makers to ignore them, and I hope their perspective will change. (Amen to that brother Ray… all bold emphasis above and below is mine)
While central banks typically do tighten money somewhat and short rates rise on average when inflation and growth start to get too hot, typical monetary policies are not adequate to manage bubbles, because bubbles are occurring in some parts of the economy and not others. Thinking about the whole economy, central banks typically fall behind the curve during such periods, and borrowers are not yet especially squeezed by higher debt-service costs. Quite often at this stage, their interest payments are increasingly being covered by borrowing more rather than by income growth—a clear sign that the trend is unsustainable.
All this reverses when the bubble pops and the same linkages that inflated the bubble make the downturn self-reinforcing. Falling asset prices decrease both the equity and collateral values of leveraged speculators, which causes lenders to pull back. This forces speculators to sell, driving down prices even more. Also, lenders and investors “run” (i.e., withdraw their money) from risky financial intermediaries and risky investments, causing them to have liquidity problems. Typically, the affected market or markets are big enough and leveraged enough that the losses on the accumulated debt are systemically threatening, which is to say that they threaten to topple the entire economy.
Spotting Bubbles
While the particulars may differ across cases (e.g., the size of the bubble; whether it’s in stocks, housing, or some other asset; how exactly the bubble pops; and so on), the many cases of bubbles are much more similar than they are different, and each is a result of logical cause-and-effect relationships that can be studied and understood.
SB here: Memorize the players, names and overall theme of the movie we are watching. Get some more popcorn, then read on…
If one holds a strong mental map of how bubbles form, it becomes much easier to identify them. To identify a big debt crisis before it occurs, I look at all the big markets and see which, if any, are in bubbles. Then I look at what’s connected to them that would be affected when they pop. While I won’t go into exactly how it works here, the most defining characteristics of bubbles that can be measured are: 1) Prices are high relative to traditional measures 2) Prices are discounting future rapid price appreciation from these high levels 3) There is broad bullish sentiment 4) Purchases are being financed by high leverage 5) Buyers have made exceptionally extended forward purchases (e.g., built inventory, contracted for supplies, etc.) to speculate or to protect themselves against future price gains 6) New buyers (i.e., those who weren’t previously in the market) have entered the market 7) Stimulative monetary policy threatens to inflate the bubble even more (and tight policy to cause its popping)
(Notable: In the 2008 crisis in the US, residential and commercial real estate, private equity, lower grade credits and, to a lesser extent, listed equities were the assets that were bought at high prices and on lots of leverage. During both the US Great Depression and the Japanese deleveraging, stocks and real estate were also the assets of choice that were bought at high prices and on leverage.)
SB here: My two cents: 1, 2, 3, 4 (check, check, check and check). 5 (nope, but may be coming with trade wars). 6 (check) (retail all in – household equity assets as a percentage of disposable personal income at 155.99%. It was a record 153% in December 1999 and 133% in 2008. Margin debt’s at record high. Corporations have been aggressive buyers with repatriated cash and debt financing… some of which financed stock buybacks (2018 record share buybacks). Foreign buyers of U.S. equities as a percentage of foreign held U.S. financial assets: third highest level in history: 32.6% in 1967 bull market peak, 28.9% late 1999, 27.4% 2008 and 28.6% today. Lots of checks for #6. 7 (CHECK!)
As you can see in the table below, which is based on our systematic measures, most or all of these indications were present in past bubbles. (N/A indicates inadequate data.)
At this point I want to emphasize that it is a mistake to think that any one metric can serve as an indicator of an impending debt crisis. The ratio of debt to income for the economy as a whole, or even debt service payments to income for the economy as a whole, which is better, are useful but ultimately inadequate measures. To anticipate a debt crisis well, one has to look at the specific debt-service abilities of the individual entities, which are lost in these averages. More specifically, a high level of debt or debt service to income is less problematic if the average is well distributed across the economy than if it is concentrated—especially if it is concentrated in key entities.
SB here: We are reviewing the seven phases of the classic deflationary debt cycle. Today we’ve looked at the first two. Let’s conclude today’s piece with the third phase and save 4 – Depression, 5 – Beautiful Deleveraging (the one we shall pray for) and 6/7 – Pushing on a String/Normalization. 6/7 will be important. If there is enough time next week, we’ll move into specific ideas and discuss risks and timing. But let’s see how next week’s letter takes shape. Now, back to Dalio:
The Top
When prices have been driven by a lot of leveraged buying and the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal. This reflects a general principle: When things are so good that they can’t get better—yet everyone believes that they will get better—tops of markets are being made.
While tops are triggered by different events, most often they occur when the central bank starts to tighten and interest rates rise. (SB – this is where we are in the current movie.) In some cases the tightening is brought about by the bubble itself, because growth and inflation are rising while capacity constraints are beginning to pinch. In other cases, the tightening is externally driven. For example, for a country that has become reliant on borrowing from external creditors, the pulling back of lending due to exogenous causes will lead to liquidity tightening. A tightening of monetary policy in the currency in which debts are denominated can be enough to cause foreign capital to pull back. This can happen for reasons unrelated to conditions in the domestic economy (e.g., cyclical conditions in a reserve currency country leads to a tightening in liquidity in that currency, or a financial crisis results in a pullback of capital, etc.). Also, a rise in the currency the debt is in relative to the currency incomes are in can cause an especially severe squeeze. Sometimes unanticipated shortfalls in cash flows due to any number of reasons can trigger the debt crises.
Whatever the cause of the debt-service squeeze, it hurts asset prices (e.g., stock prices), which has a negative “wealth effect” as lenders begin to worry that they might not be able to get their cash back from those they lent it to. Borrowers are squeezed as an increasing share of their new borrowing goes to pay debt service and/or isn’t rolled over and their spending slows down. This is classically the result of people buying investment assets at high prices with leverage, based on overly optimistic assumptions about future cash flow. Typically, these types of credit/debt problems start to emerge about half a year ahead of the peak in the economy, at first in its most vulnerable and frothy pockets. The riskiest debtors start to miss payments, lenders begin to worry, credit spreads start to tick up, and risky lending slows. Runs from risky assets to less risky assets pick up, contributing to a broadening of the contraction.
(A negative “wealth effect” occurs when one’s wealth declines, which leads to less lending and spending. This is due to both negative psychology of worry and worse financial conditions leading to borrowers having less collateral, which leads to less lending.)
Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted (i.e., long-term interest rates are at their lowest relative to short-term interest rates), people are incentivized to move to cash just before the bubble pops, slowing credit growth and causing the previously described dynamic.
Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening. So while the central bank is still raising interest rates and tightening credit, the seeds of the recession are being sown. The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce.
SB here: I believe this is why it is so hard for investors. Perhaps a perverse sense of backwards logic. Talking heads tell you how great the economy is doing and correlate that to higher asset prices. It feels safe… feels good, but under the surface, the bubble is at its peak. What may feel good is really not good at all. Perhaps the basis for Sir John Templeton’s secret to his success. Simply, do the opposite of what the masses are doing.
Unemployment is normally at cyclical lows and inflation rates are rising. The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending. It also makes items bought on credit de facto more expensive, slowing demand. Short rates typically peak just a few months before the top in the stock market.
The more leverage that exists and the higher the prices, the less tightening it takes to prick the bubble and the bigger the bust that follows. To understand the magnitude of the downturn that is likely to occur, it is less important to understand the magnitude of the tightening than it is to understand each particular sector’s sensitivity to tightening and how losses will cascade. These pictures are best seen by looking at each of the important sectors of the economy and each of the big players in these sectors rather than at economy-wide averages.
In the immediate post-bubble period, the wealth effect of asset price movements has a bigger impact on economic growth rates than monetary policy does. People tend to underestimate the size of this effect. In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what’s to come. But the reversal is self-reinforcing. As wealth falls first and incomes fall later, creditworthiness worsens, which constricts lending activity, which hurts spending and lowers investment rates while also making it less appealing to borrow to buy financial assets. This in turn worsens the fundamentals of the asset (e.g., the weaker economic activity leads corporate earnings to chronically disappoint), leading people to sell and driving down prices further. This has an accelerating downward impact on asset prices, income, and wealth.
Let’s stop and take a breather. As I personally reflect on this work from Ray Dalio and his team at Bridgewater Associates, I find myself endlessly grateful for their master’s class teachings and their willingness to share their thousands of hours of research and collective debate. And their desire to “do good.” Share this piece with everyone you know… especially our legislative leaders here and abroad. My college roommate, fraternity brother and good friend, Charlie Dent, just retired from Congress. Charlie, read this book! And use your new position to get your former and new friends educated.
On to Part III of my notes next week. And, of course, you can download a free copy of Ray Dalio’s new book by clicking this link: www.principles.com/big-debt-crises.
And speaking of “The Great Reset,” if you are in Dallas next week, stop by The Money Show and say hello to John Mauldin. He’ll be presenting on “The Great Reset” and about “Diversifying Trading Strategies for the Next Crisis.” Info follows next.
The MoneyShow Dallas, Thursday, October 4 – John Mauldin and Brian Schreiner
A quick aside. CMG’s Chief Economist and Co-portfolio manager, John Mauldin will be speaking on Thursday October 4 in Dallas at the Money Show. He’ll be presenting on “The Great Reset” and about “Diversifying Trading Strategies for the Next Crisis.” While the Great Reset will be an even worse debt crisis than the Great Recession, investors can protect themselves by diversifying trading strategies. This is a hands-on session where John Mauldin will share his specific portfolio methodology for meeting the challenges of the coming Great Reset.
John will be signing and giving out several of his books. CMG’s Brian Schreiner will be attending and available to help answer any questions you may have. Look for John and Brian at the booth with John’s picture on it. Please stop by and say hi.
Registration is free for individuals. Click HERE to learn more. Click HERE to register.
Trade Signals – Fed Day, Zweig Bond Signal Remains Bearish, Equity Trend Remains Bullish
S&P 500 Index — 2,924 (09-26-2018)
The Zweig Bond Model signal remains bearish on high quality bonds, bond funds and bond ETFs… Continuing to signal higher rates.
The Fed raised rates 25 bps to a 2% to 2.25% target rate objective. We expect another rate increase in December and possibly two more in 2019. Higher rates are not good for high quality bond prices. We remain pleased with how well the Zweig Bond Model has called the bearish bond market trend.
There are no changes in the signals this week. The equity bull market trend remains bullish as signaled by the Ned Davis Research CMG US Large Cap Long/Flat model. Investor buying remains stronger than investor selling. Don’t Fight the Tape or the Fed is neutral.
For additional commentary, click HERE for the latest Trade Signals.
Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is jkornack@ndr.com. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note – Ohio State vs. Penn State (White Out)
I grew up at Penn State. At age six, my mother gave me her season ticket. My father and I would walk to the stadium. He’d have a transistor radio in hand, volume on high and we’d listen to the pregame show on the way. If Penn State lost, I was literally upset until the following Wednesday. I just was… I attended Penn State from 1979-1983. My father, my sisters, my brother, daughter Brianna, and now sons Matt and Kyle. To say it’s in the blood is an understatement. And honestly, to see it in them does make the old man smile.
Stepson Conner is coming home from school tonight and we’ll be on road by 6:00 am with coffee in hand, wine in the trunk (for tailgating with family and friends) and big smiles on our faces. Penn State is playing Big Ten Conference rival Ohio State and both are ranked in the top 10. Game time is 7:30 pm Saturday night.
The plan is to meet my boys, nephews Mike and Dan and stepson Tyler (Susan’s oldest), and Ty’s closest friend Chase for breakfast at 9:00 am at the Waffle House. I asked Tyler if that is too early (he drove in early today and I’m sure he’ll be having some fun tonight) and he said, “We are not here to sleep.” Love that! To life!!! The tailgate(s) start at approximately 10:00 am.
Now, if you are a Big Ten alum, unless you went to OSU, you’ve got to be rooting for Penn State. It’s just that way in the Big Ten. And if you are not a Big Ten alum, please send a little love my team’s way. I’ll be thinking about my old man and that old beat up transistor radio blasting on our walk to the stadium.
Next week finds me playing Baltusrol Golf Club on Tuesday with four advisors and meetings in New York on Thursday with good friends from VanEck. Chicago follows October 10 and 11.
Hope you have some fun plans for your weekend. Relax, enjoy and celebrate with the people you love most. Life goes by way too fast. Hold your glass up high and let’s toast “to joy!”
Wishing you the best!
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With kind regards,
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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