Sunday, May 27, 2018

Liquidity Trap's Wild Potential To Unlease Inflation - Part 2

In a liquidity crisis, people who feel they cannot get reasonable returns on physical or normal financial investments place their assets in short-term cash bank accounts, high-risk stocks, or hoard it rather than making long-term investments. This means a high savings rate with the key issue here contained in the words, "people who feel they cannot get reasonable returns on physical or normal financial investments" get pushed in a corner. While low-interest rates are a sign of a liquidity trap they alone do not define it. Another sign is a lack of bondholders wishing to keep their bonds and investors choosing strict cash savings over bond purchasing. Still in what, and how, and where people stash their wealth does matter and it has the potential to make any recession even more severe. This has several components that sooner or later all feedback into a loop that disrupts the flow of credit and impacts the real economy. When things cross over this tipping point the return on loaning your wealth to banks, governments, and others is simply not worth the risk!

Low-Interest Rates Coupled With A Lack Of Faith
Nobody wants to loan money if they feel it most likely will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants. This is when it rapidly becomes apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward.  When this happens we are at the end game, which is the subject of the last part of this article.

Money Must Move Or A Trap Can Form
 In normal times central banks stimulate the economy by supplying and increasing the monetary base or lowering interest rates. This usually results in increased borrowing and lending, consumption, and growth in investment. When the relevant interest rate is already at or below zero lowering it to stimulate the economy losses impact. Since central banks inject new money through institutions such as banks when they do not loan it out or borrowers refuse to take new loans the capital becomes trapped. The term. "helicopter money" is often credited to Milton Friedman's suggestion that monetary authorities can bypass this trap by giving stimulus money directly to consumers or businesses. This can be done in several ways such as a tax cut or directed through programs like "cash for clunkers" that target and bolster a weak sector of the economy.

John Maynard Keynes, 1883 – 1946, a British economist, is usually considered the father of the liquidity-trap theory. It was his view that when financial speculators begin to fear the possibility of losing capital losses on non-money assets they would turn to holding money instead because it is far more liquid. This type of situation tends to develop after a financial crisis such as that associated with the Stock Market Crash of 1929 which resulted in the Great Depression. In such a situation if interest rates are extremely low and there is no place for bond yields to go but up locking in rates by purchasing bonds only creates future loses for investors. At this point, further injections of cash into the private banking system by a central bank will fail to decrease interest rates making monetary policy ineffective.

 Printing Money Has Not Solved Japan'sProblem
A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Japan is often viewed as the poster child for liquidity traps because as a result of the country's economic bubble having burst it has suffered for decades. Since its crash, Japan has been struggling with persistent deflation and slow growth. The Nikkei sat at 7,054 in 2009, down more than 80% from its peak., even today it is still far below the all-time high it set in December 1989. Today even after several periods of booms that went busts, the powerful combination of Abenomics, Draghi's bazooka, the Federal Reserve pouring out trillions of dollars in excess liquidity Japan's economy has failed to bring Japan out of its funk.

While the Japanese story has led some people to believe that simply expanding the central bank’s balance sheet isn't inflationary it does not tell the whole story. The world economy has a huge number of moving parts and I contend the primary reason that inflation has not raised its ugly head to become a major economic issue is that we as a society are pouring such a large percentage of our wealth into intangible products or goods including currencies. If faith drops in these intangible "promises" and money would suddenly rush into tangible goods seeking a safe haven inflation will soar. So much money has been created over the last decade that the flight to tangibles would not only spike the cost of living but leave the poor and unprotected in dire straits.

The policy of rapid credit expansion often brings with it negative consequences. China is an example of this, there we have witnessed the extra GDP growth generated by each infusion of money drop. This should be taken as a warning that economic exhaustion and overcapacity results from continually priming the pump. The total credit in China's financial system is estimated to be as high as  221% of GDP and has jumped almost eight-fold over the last decade. This means companies will have to pay out $1 trillion in interest payments this year. Chinese corporate debt burdens are much higher than those of other economies. Much of the new money that is being created to keep liquidity in the system is being used to repay debt rather than to finance output. The fact that new investment in factories has ground to a halt is probably a good thing because China is awash in overcapacity with many new factories idle because of weak demand. This has resulted in a large-scale capital outflow of hot money from China that has disrupted markets across the world.

Several things can get the economy out of a liquidity trap such as raising interest rates which encourages people to invest and save their cash, instead of hoarding it also encourages banks to lend since they'll get a higher return. This also increases the velocity of money simply put, the future reward has to become greater than the risk. As prices fall to such a low point that people just can't resist shopping they will buy both durable goods and assets like stocks. An increase in government spending can also create confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and hoarding. Even financial innovation helps an economy escape the trap by creating entirely new markets and new places to invest.

Still, the bottom-line remains, why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? This means rejecting bonds that pay little, nothing, or have a negative rate. We have abused the large amount of wiggle room in our economic system and only proved "those in power will put off the day of reckoning until they can't!" Unfortunately, collecting a debt that you are owed can be similar to a mirage that keeps moving away each time you approach it. Also, do not forget the small print that governs most contracts often tells us rules can be changed which means people and companies can become instantly insolvent. Modern society has become very good at kicking the can down the road and delaying the consequences of bad policy but at some point, the return on loaning wealth in the form of money is simply not worth the risk!

Readers of my blog will be familiar with this argument and my strong warning that when the only lenders are those who print the money that nobody wants the only safe place to store wealth will be in "tangible assets." This fear could unleash inflation across the glode. While a liquidity trap can and often does lead to no growth and deflation it is not a certainty. The wild card, in my opinion, is related to the diminished confidence so many people have towards fiat currency. Again I want to point out that never before has the world seen so much wealth held in some form of paper promises and IOUs. This means that two key areas to watch in the future are currency markets and relevant value rather than inflation or deflation. A lack of confidence in currencies has grown over the years since President Nixon cut the link between gold and the dollar which tied the dollar's value to tangible assets that is why as we print more and more it has become worth less and less.

Footnote; This is part two of a two-part series. Part one explores how a "liquidity trap" differs from the standard liquidity problem where money is just expensive or unavailable. In many ways a liquidity trap it is just the opposite. This causes a great deal of confusion and can be a difficult concept to comprehend. The link below takes you to part one that looks at the ramifications flowing from each as they play out and how they affect the economy.

Tuesday, May 22, 2018

EU Banks Remain Massive Problem

While the US and the UK were mired in political chaos during 2017 the EU claimed it was experiencing improved economic conditions. It appears this did little to move Europe in the direction of implementing long-needed EU and eurozone reforms, instead it merely fueled the complacency that has haunted the region for so long and has set the stage for another crisis down the road. How can anyone claim the situation is under control when a story in Reuters in the middle of last year claimed officials in Europe actually think that telling the public that they will not have access to their funds, even funds covered by official deposit insurance was somehow helpful to addressing Europe’s troubled banking system.  

This is a reminder to anyone thinking that Europe is anywhere close to adopting an effective approach to dealing with failing banks that they may want to think again. The policy that has been in the works for some time was floated out for a reaction less than two months after a run on deposits at Banco Popular contributed to the collapse of the Spanish lender. Judging by the continued reaction by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector. That could be why even today the European Central Bank is having difficulty raising rates and has been unable to discontinue its program of asset purchases.

EU Will Not Address "Bank Failures"
All this makes a strong argument that nothing is really better or has been fixed in the Euro-zone and that the area continues on life-support. Why would the ECB leave its refinancing rate at 0%, and the rate paid on deposits parked overnight at the bank at negative 0.4% and the rate on the deposit facility at 0.25% if indeed the economy was on sound footing? The ECB even repeated that it expects rates to remain at present levels "for an extended period of time, and well past the horizon of the net asset purchases." While some Wall Street analysts started encouraging investors to jump into EU bank stocks last year, the fact is that there remains nearly €1 trillion in bad loans within the European banking system.  

This represents around 6.5%  of the EU economy.  That compares with non-performing loans (NPL) ratios in the US of 1.7% and 1.6% of gross domestic product in Japan. Circling back to the issue of the banking sector and public faith in these institutions, the idea that the banking public would ever be denied access to cash virtually ensures that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble. The US learned the hard way in the 1930s and again with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation.

Until the EU is prepared to do “whatever is necessary,” to paraphrase ECB chief Mario Draghi, in order to protect retail bank depositors, the EU will remain far from being a united political economy. The truth is the Europeans appear to be playing a very dangerous game. On the one hand, EU officials talk publicly about getting tough on insolvent banks and even suspending access to funds for retail depositors.  On the other hand, EU governments are continuing to bail out banks and large creditors in a display of cronyism and business as usual. Making matters worse is that there appears to be a significant number of officials in Europe who seriously believe that denying retail bank customers access to funds covered by deposit insurance does not result in financial contagion.

In the US, the Federal Deposit Insurance Corporation (“FDIC”) begins to market troubled banks before they fail and makes an effort to execute bank closures and sales on a Friday to avoid frightening the public.  The branches of the failed bank are then open on the following business day as part of a solvent institution without any interruption in customer access to funds. The important thing is that all insured depositors are always paid out by the FDIC when the failed bank is closed in order to avoid precipitating runs on other institutions.   

In the same way, Eurozone politicians still refuse to deal with Greece’s mounting debt they cannot seem to accept the fact that protecting the small depositors of European banks is necessary to prevent the same sort of bank runs they saw in Cyprus and Greece. If this is not done runs on banks could intensify and spread to other countries in Europe.  Imagine that a large bank failure occurs in Italy and Italian officials would tell retail customers that they will not have access to any funds for several weeks. It is not difficult to see how this would expand concern about banks in other countries. It seems that regardless of the cost guaranteeing the banks are sound and depositors money is safe is the price that must be paid for preserving social order and the EU itself.

Monday, May 21, 2018

Italy Update - How Italy Got Into Its Current Mess

With Italy's bonds taking a hit and the country facing political turmoil this piece presents an overall look at how things got this bad. For years the world has focused on the "Greek Tragedy" that is far from over. While the ongoing misery of Greece continues to play out our eyes have been diverted from economic problems that fester and brew in Italy. Many people have failed to notice the Euro-zone debt crisis has taken a heavy toll on Italy where consumption and investment are expected to remain weak. The country’s economy has shrunk by around 10% since 2007 and output has regressed to levels not seen in more than a decade. While overall unemployment is around 12%-13%, with youth unemployment hovers around 40%. To worsen the overall situation an increasingly large number of refugees from North Africa are landing on Italy's shores.  

Smaller enterprises that are the country’s backbone continue to suffer from low sales, declining profitability, and lack of financing. Italy's banking system reflects the problems hampering future growth. Italian banks carry on their books around 200-300 billion euros of bad or doubtful loans, which has exposed inadequate capital and reserves. While counterparts in the U.K. and the U.S. have been able to deal with such loans Italian banks have been unwilling or unable to confront the asset quality problem. This has affected their ability to lend. Large companies can use capital markets for financing, but this option is less available to crucial smaller companies. This lack of credit in combination with the general erosion of Italy’s industrial structure creates little hope of a recovery and paints a grim picture going forward.

Italy Is One Of Several Nations With A Heavy Debt Load
Italy is the third largest economy of the Euro-zone after Germany and France, unfortunately, it holds the largest public debt totaling over 2 trillion euros. While Italy talks about its commitment to fiscal reform it continues to run a budget deficit of 3%. With government debt standing at $2.4 trillion dollars around 140% of GDP other problems are sighted. We see a government slow to pay its suppliers and weak in its ability to collect taxes, each year there is an estimated $160 billion in taxes uncollected.

Still, while this debt is a major factor hampering growth Italy’s problems are deep-rooted and fundamentally the economy has grown little since the introduction of the euro in 1999. It is clear that Italy still suffers from the legacy of its powerful Italian Communist Party in the time following World War II. This left Italy with rigid, high labor costs and multiple barriers to hiring and firing workers. A long-running government regulation requires the state to pay laid-off workers up to 80% of their normal salary while their employer restructures. Productivity improvements are also slow.  Italy’s economy is increasingly unbalanced. High-end producers, such as those in luxury products, and also advanced manufacturing have benefited from demand from emerging markets while other sectors, such as standard automobiles, domestic appliances and low-priced fabrics and clothing have found it difficult to compete with rivals from those countries.

Domestic appliances or white goods exemplify Italy’s decline. In 2007, Italy, once a world leader in the sector, produced 24 million appliances. By 2012, that was down to 13 million, the output of washing machines, dishwashers, refrigerators, and cooking appliances were down, respectively, by 52%, 59%, 55% and 75%. Italian manufacturers have been forced to shift production to lower-cost countries, resulting in large job losses. Italy ranks 65th out of 189 countries for ease of doing business in recent World Bank studies. Several key sectors are an issue, infrastructure, is in need of renewal lagging that of leading economies, and energy costs are high. Italy spends less than 5% of GDP on education, compared with a 6.3% average across OECD countries. As a result, only one-in-five Italians aged 25-34 completes higher education versus 39% for the broad OECD. 

In addition to Italy's other problems. it is burdened with a large corrupt and bureaucratic public sector. Italy is ranked 69 out of 175 countries by Transparency International in perceived levels of public corruption, comparable to Romania, Greece, and Bulgaria. Tax and other revenues are around 46% of GDP. According to the World Bank, the effective Italian corporate tax burden is around 65%. The European average tax on corporations is around 41%, with only France (64% and Spain (58%) in a comparable range. Switzerland and Croatia, both located close to Italy, have tax rates of 29% and 20%, respectively, which diverts investment from Italy. Even with high taxes, the quality of public services remains poor. Enforcement of a contract in Italy takes around three years, versus an OECD average of 18 months. Civil lawsuits take more than eight years to complete, compared to under three years in Germany.

Italy A European Debt Bomb Waiting To Explode
The truth is that in all reality Italy went bankrupt in summer 2011. Back then we saw interest rates on the national debt spike going out of control and Italy lost access to the financial markets. At that time the ECB and political authorities in Europe agreed to create around the country’s finances an artificial market to give the impression of stability and the appearance that Italy could work its way through its problems.

Italy, it appears is now forced to stay on this artificial support until the economic conditions improve and confidence is restored to where the country will have again access to real and normal credit markets. This most likely will never happen because not only is the country mired in debt but it is also a mess politically. The truth is not only the size of debt but the quality of the debt meaning the ability to repay it is an important issue. Because of the sheer dimensions of Italy as an economy and as a debtor, it dwarfs the problems posed by other countries that make up what has been referred to as the Euro-zone PIGS that have received so much attention in the past. All countries are not equal in size and the reason for their woes vary, however, propping up an economy is not a long term fix and the ECB loaning money to banks to have them purchase government-issued bonds is a scheme and instrument that allows international investors to over the years exit Italy in an orderly fashion.

All in all, it might be fair to say Italy is a European debt bomb waiting to explode. This is not sustainable and the country is held together only because of the direct intervention of the ECB which made over 102 billion euros of Italian bond purchases in 2011-2012 alone. This has continued since then and the sum has gotten much larger. Only through the LTRO have the finances of the Italian state been kept afloat. Way back in 2011 Nouriel Roubini warned that Italy needed to pursue an orderly restructuring of its debt to avert a default in coming years. Almost everyone agrees that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a default, but as usual in the Euro-zone no action is happening. In many ways for Euro-skeptics Italy remains the Achilles heel of Europe, these skeptics are quick to point out that, once foreign investors withdraw, Italy will crumble under the weight of its debt.

Sunday, May 20, 2018

"Liquidity Trap" Differs from Standard Liquidity Problem

"Liquidity Trap" Versus A Liquidity Problem
A "liquidity trap" differs from the standard liquidity problem and this causes some confusion. That is why it is important to look a little closer at these two terms and what they represent. To many people the idea that to much money could make it a worthless commodity is abstract and difficult to comprehend. A  'Liquidity Trap' is a Keynesian idea and a term flowing from the Great Depression of the 1930s. The term, liquidity trap describes a situation in which policy interest rates, having reached the zero bound, are unable to stimulate demand. When expected returns from investments in securities or real plant and equipment are low, investment falls, and it is very difficult to generate growth by adding additional stimulus. 

A sign that the financial sector is constructing such a trap is the appearance of a great deal of malinvestment, leverage, and speculation. On the other hand. the standard liquidity problem resulting from a lack of money flowing into a market is something we are more familiar with and easier to get our heads around. It generally forms at times of uncertainty or when the risk becomes so great the cost of capital flowing into a market becomes too high and investors lose faith they will see a return on their investment. Simply put when faith exits the marketplace liquidity often follows so closely it leaves us debating which left first. While it may seem subtle at first the difference between a liquidity problem and a "liquidity trap" is important in that each impact the economy in very distinct ways.

 Interestingly the subject of a liquidity problem brewing has been raised by both the IMF and mentioned in a recent editorial by John Mauldin. The Mauldin piece titled, "A Liquidity Crisis of Biblical Proportions Is Upon Us" in which he warns of two serious problems
  • Corporate debt and especially high-yield debt issuance have exploded since 2009.
  • Tighter regulations discouraged banks from making markets in corporate and HY debt.
In his article, Mauldin sights a fascinating article written by Gavekal’s Louis Gave  titled, “The Illusion of Liquidity and Its Consequences.” In his article Gave pulled the numbers on corporate bond ETFs and compared them to the inventory, trading desks were holding and found dealer inventory is not remotely enough to accommodate the selling he expects as higher rates begin to take their toll. This is what both these fellas indicate may leave bonds in a situation where they collapse in a panic wave of selling when it comes time for companies to payback or rollover the massive amount of debt they have accumulated.

The crux of this piece is not only to point out the difference between the illiquid situation above but to point out how this has the potential to become the kind of "liquidity trap" we have been warned about. The fact that central banks across the globe have all signed on to and deployed " loose money policies" for almost a decade has made them even more impotent than they were in the 1930s. Part of understanding all this comes to how we define the terms "cash or reserves" and to wrap our heads around what debt really means. Economics is a rather puzzling science where plans often go awry when released into the markets and the real world where unintended consequences play havoc with wishful thinking. In reality,  this could be the result of few economists having a deep understanding of debt and the true magnitude of risk it transfers to the lender. This all flows into the bigger issue of how the promises of pension funds and annuity payments play into our debt structure.

A liquidity trap occurs when a central bank feeds cash into the private banking system and that money is hoarded, rather than being put to constructive use this can raise concerns about the likelihood of deflation and falling demand. Currently, huge infusions of cash from the Federal Reserve by way of its quantitative-easing programs have not created real growth and the job market has yet to recover to the point where all of those who lost their jobs as a result of the financial crisis have been drawn back into find full-time employment. I use the term "drawn back into" because without enough incentive to work or as a result of changes within our society many people have chosen to sit on the sidelines which gives us our current figures of low unemployment.

The low participation in the workforce has been used by those of us questioning narrative that all is well. Thus far, much of the money we have pushed out into the economy has not been used or deployed in the way central banks desire resulting in a buildup of capital in the reserves of depository institutions. This means depository institutions alone have accumulated massive excess reserves, this is money that is sitting on the sidelines rather than being loaned out into the economy. It should be noted that banks holding more in reserves does little to make the true economy, which is measured on Main Sreet more robust. Also, much of the money has been funneled into the stock market or speculation that props up the value of assets rather than into private sector growth.

The European Central Bank embarking on a similar course when President Mario Draghi announced that the ECB decided to lower the key interest rate as well as opening a €400 billion ($542 billion) "liquidity channel" to boost bank lending. The ECB has also undertaken an asset-purchase program, similar to the Federal Reserve's bond-buying agenda. Japan with its program known as "Abenomics" has also unleashed a massive quantitative-easing program and so has China. This means the world's leading economies are slipping into a liquidity trap increasing the risk that any sort of shock to demand or supply could send the entire global economy into a tailspin.   Usually, in a crisis, this forces investors and people in general into the ugly situation of having to sell which reinforces the reality that in a bear market you sell what you can, not what you want to.

Footnote; This is part one of a two-part series. Part two explores the way a liquidity trap might play out and explore who could be the big winners and losers. The link to part-two can be found below.

Tuesday, May 15, 2018

Often Mentioned 2008 Crisis Chiefly Forgotten

While reading an article about the economy and how things are different this time it occurred to me that while we constantly refer to it the often mentioned "2008 crisis" it has been chiefly forgotten and we have learned very little. By this, I'm pointing to the harsh reality and the details. The so-called great recession blamed by many on a crisis in housing is now so far in the rearview that many people see it as merely a reset from which we have moved on. We should not forget the auto sector also slammed into the wall because it was mired in debt and because of its ability to produce far too many vehicles.

On the other hand, it is possible to argue we have never moved on but have merely muddied the water with a mind-boggling amount of stimulus and newly printed money. Those in the financial sector of the economy in many ways have raped and plundered their way forward. A glaring example of this is how GM was saved throwing its bondholders under the bus. While supporters praise the solution as courageous, brave, and the "best solution" to an ugly problem they have chosen to forget the carnage that was left in the wake of the actions of the Obama administration. As proof, their action was the correct "thing to do" they point to how the company has performed since.

GM Bondholders Were Thrown Under The Bus! (click here for larger)

For a reminder and details of just one of the events that unfolded during that ugly time in our economy see the following article which appeared in 2009:

GM bankruptcy: End of an era

(CNNMoney – General Motors filed for bankruptcy protection early Monday, a move once viewed as unthinkable that became inevitable after years of losses and market share declines capped by a dramatic plunge in sales in recent months.
The bankruptcy is likely to lead to major changes and job cuts at the battered automaker. But President Obama and GM CEO Fritz Henderson both promised that a more viable GM will emerge from bankruptcy.
In the end, even $19.4 billion in federal help wasn’t enough to keep the nation’s largest automaker out of bankruptcy. The government will pour another $30 billion into GM to fund operations during its reorganization.
Taxpayers will end up with a 60% stake in GM, with the union, its creditors and federal and provincial governments in Canada owning the remainder of the company.
GM will shed its Pontiac, Saturn, Hummer and Saab brands and cut loose more than 2,000 of its 6,000 U.S. dealerships by next year. That could result in more than 100,000 additional job losses if those dealerships are forced to close.
Assembly lines at a plant in Pontiac, Mich., which make full-size pickup trucks, will be closed later this year. A Wilmington, Del.-based facility that makes roadsters for the Pontiac and Saturn brands will also close later this year.
Pain for retirees, investors
More than 650,000 retirees and their family members who depend on the company for health insurance will experience cutbacks in their coverage, although their pension benefits are unaffected for now.
Investors in $27 billion worth of GM bonds, including mutual funds and thousands of individual investors, will end up with new stock in a reorganized GM worth a fraction of their original investment.
Owners of current GM (GM, Fortune 500) shares, which closed at just 75 cents a share on Friday, will have their investments essentially wiped out.
In 2008 both GM and Chrysler were headed for bankruptcy but if they had gone bankrupt under chapter 11, most of their factories would have stayed open and they would have continued making and selling cars. Stockholders would have lost the value of their stocks, but bond owners who have the first claim to company assets and profits would have been paid off, if not in whole then at least in part. With Obama's decision to “bail them out” by taking them over stockholders still lost everything as did Chrysler’s bondholders and GM bondholders were also shortchanged. This is a lesson of government can and will change the rules without warning.

Now fast forward to this week where an article that recently crossed my desk contained the great line, "brutal assessment of the world economy is fascinating, but not for the faint of heart." In a rather of matter fact tone, the article outlined a slew of structural issues and problems we have papered over and failed to address. The thought those forgetting the lessons of the past are doomed to repeat it rapidly comes to mind. Welcome to our current economy, little has changed.

Tuesday, May 8, 2018

Stronger Dollar Is A Problem For Global Growth

Near the end of 2015, I wrote a piece that indicated a great deal of wealth would be flowing into America seeking protection from the ravages fostered upon it. A great deal has happened since then. Between Trump and many others talking down the dollar, the threat of trade wars, and the introduction of several cryptocurrencies the dollar has backed off a bit. Still, the dollar remains relatively strong and has again started to strengthen after the euro experienced a bit of strength based on the false narrative Euro-zone growth would be picking up. As for the yen's strength, I feel much of it has to do with money leaving China via Japan. Still, the dollar remains strong, this is driven by the fact many countries have even worse policies than those America's leaders have chosen to pursue.

Huge Number Of Short Positions Against Dollar Exist!
The world is currently engaged in a massive game of speculation that contains a lot of risks. A massive number of short positions have formed against the dollar which will cause it to strengthen as they begin to unwind. A stronger dollar acts like a magnet pulling wealth towards America and away from countries already having problems. If this turns into a self-feeding loop the dollar may soon get much stronger. Throughout history, strong currencies have attracted wealth and this means money and wealth from all over the world could be headed towards our shores. The money coming into America would flow into both bonds and stocks supporting lower interest rates and the stock market. Those of you who have read other articles I have written know I think the market is overvalued and the bond market is a bubble ready to pop, but as long as we remain the best and safest place to hide money do not discount the dollar.  

The dollar is the linchpin of global finance and has guaranteed itself a place at the table until dethroned. This means that countries like Japan and China which hold a lot of American bonds and thus dollars will be able to offset some of the pain of a weakening national currency, unfortunately, most countries are not in such a position. Making matters worse countries that are mired in debt often have tied or pegged that debt to the dollar this translates into a lot of economic pain if the dollar grows stronger and many will find themselves under a great deal of pressure just to survive.  Markets love stability and stable currencies because it provides an environment that yields the most benefits by reducing overall risk. The strengthening dollar may be sending a signal that the global economy is unstable.

Currencies are under assault in places where the economy is weak and the issuer is buried in debt they can never repay at real market interest rates. As the excessive flow of cheap U.S. dollars into emerging markets suddenly reverses and funds return to the U.S. looking for safer assets the pressure is ramping up. The central bank “carry trade” of low-interest rates and abundant liquidity used to buy “growth” and “inflation-linked” assets in emerging markets is unwinding. A global slowdown combined with rising interest rates in the U.S. and the Fed’s QT (quantitative tightening) has resulted in emerging markets losing their lifeline of inflows. These countries now face massive outflows made worse because they have squandered much of the inflows over the years rather than using it to strengthen their economies. The Argentine peso, Turkey's lira, and the Russian ruble are examples of this. Many Latin American and emerging market economies are also in this trap. The high fiscal and trade deficits financed by short-term dollar inflows have turned into time bombs.

We must add the stronger dollar to the problems the Federal Reserve and its new Chairman, Jerome Powell faces at home because it threatens the global economy. Part of the current Fed strategy to ease this pressure has been to whack at the idea interest rates will soon rise but lately, the dollar has been edging its way higher and predictions of strength or weakness to come are in full swing. With this in mind, the central banks appear to be making every effort to reinforce feelings of economic stability by keeping currencies trading in a "quiet" range. It is in their advantage that people think the global economy is on sound footing as central banks across the world continued to print and pump out money in search of the "ever-elusive growth" that never quite arrives.

Drawing Money Like A Magnet
Do not underestimate the power of cross-border money moving into a country as a powerful economic force. While the dollar has been described recently as the cleanest dirty shirt in the closet, or the best house in a bad neighborhood, both place it as the least worse option. The reality is other options fail to pass the smell test. This means what is coming to America is wealth and money seeking a "safer" place to take refuge from the coming storm. Today America has become a money magnet, Lady Liberty the symbol of America that stands in the harbor of New York while a bit tarnished is still giving people hope even if Washington is not overwhelming us with the same glowing feeling.

The dollar has a huge advantage over other currencies because of its role as the world's reserve currency. This makes it the "default currency" and by the size of its market, float, and liquidity the currency by which all others are weighed, measured, and often pegged. The chickens are coming home to roost for countries that face growing debt and policies that make them uncompetitive. Some of these countries are increasingly looking at ways to confiscate the wealth of their citizens, it is only logical that as people begin to realize the dead-end path taken by their homelands they take action to move their money to a safer place.  

Very Important Chart In Understanding The Dollar
The chart to the left is very important. Today four major currencies dominate the world stage, they are the pound, the euro, the yen, and of course the dollar. The remaining currencies remain small bit players in the overall scheme of things. John Maynard Keynes said, By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. As the central banks print like crazy to control interest rates on bonds they devalue the currency. While there are not many Bond Vigilantes there is a slew of  Currency Vigilantes and they are ready to make their presence known.

History has shown countries can steal wealth by way of various Trojan horse methods such as monetizing debt through printing massive amounts of new currency or new taxes. If you look close you will see the currency markets are beginning to reflect diminished confidence in the system central banks have created and as the currency games continue to ratchet ever higher it is becoming more apparent that much of the world financial structure is built on shifting sand as the schemes bankers have used for years to hide and transfer debt are coming under attack. If the current system crumbles it will culminate in a reset of the economic system across the globe. If people all over the world try to get out of their home currencies a surge in the value of the dollar is logical. In the end, this would not be the salvation of America or its economy but it sure would create a lift that we would be wise to take advantage of.

Friday, May 4, 2018

U.S. Companies Have Little Reason To Bring Jobs Home

Will Lower Corporate Taxes Bring Jobs Back?
The ugly truth is American companies have little reason to bring jobs home, the logic that lowering corporate income tax will create a massive flow of jobs to our shore is flawed. The structural issues that haunt America's competitiveness far outweigh the benefits of lower taxes. This means that we should not be surprised when the effort Washington has made to cut and reform taxes does not create a huge flow of jobs returning to our shores. Reality can have an ugly edge so it is best to not look too close or you may be disappointed. In this case, at the end of the day, the pathetic GOP tax bill boils down to borrowing more than a trillion dollars from the American public and exploding the deficit in order to pay higher dividends to wealthy private stockholders.

The tax bill does little to level the playing field when it comes to issues such as healthcare cost and over-regulation. This means the following continue to act as barriers to doing business in America.

  •        High Healthcare Cost
  •        Over-Regulation
  •        Unenthusiastic workforce
  •        Legal System And Litigation
  •        Environmental Protection

Healthcare costs remain one of the biggest factors US companies can point to as a reason to steer clear of manufacturing goods in America. Following healthcare is the issue of litigation and the army of attorneys lurking in the nooks and crannies always ready to spring an expensive lawsuit on American companies. These two impediments to doing business are two of the largest cost disadvantages America faces but a slew of others such as government regulations on the treatment of employees and pollution still haunt America. While tax reform was recently front and center we should not forget Washington has fallen short in many of these other areas.

For many years companies have offshored production and shipped jobs abroad but lowering the tax rate is simply not enough to bring the jobs back home. Of course, while we hoped and were told tax reform would mark a major shift in companies deciding to keep jobs here in America may not happen. This narrative that helped to win passage of the legislation and the many assertions made by politicians and their allies in the world of economics will not in itself lead to more investment. The higher productivity and the increased economic growth many expect could fail to materialize as capital flows into stock buybacks, real estate, commodities and speculative areas such as cryptocurrencies rather than flowing into equipment and factories.

Pulling factories back from overseas coupled with the threat of a trade war is causing people to question whether we are witnessing the end of what appeared to be harmonious global growth. The narrative that everyone is pulling together to generate a synergy that lifts all boats higher has been behind forecast of glowing growth going forward. Money reparated to America and jobs being created is something which many bulls were counting on to move the markets higher. Still, the idea that we are finally ready to kick on all cylinders is a myth rooted in desperation that tries hard to deny the fact that almost every economy across the globe faces some special problem.

While we were told tax reform would mark a major shift in companies deciding whether to keep jobs here or even bring them back to America that may not happen. This narrative that helped to win passage of the legislation and the many assertions made by politicians and their allies in the world of economics will not in itself lead to more investment. Corporate investment decisions are based upon the cost of capital and the prospective equity returns that new investment can generate, not how much capital is available. In our current cheap and easy money, environment capital is basically free. The problem is not funding new investments, but finding endeavors in which to deploy this capital. The economists who largely control the major central banks in the industrialized nations may be able to manipulate markets and cancel excessive debt through open market operations, but they cannot manufacture attractive investments. Sadly for several reasons stock buybacks has been moved to the front the list of corporate priorities joining other investments that are not productive investments.

The focus of this article is more about the tax reform and why it may not yield all the growth and promises many people feel it will generate. In the defense of many people who got cranked up on what the bill would accomplish we must remember the written details of the plan were not even available until just before the actual vote so they really did not know the devil hidden in the details. While over the years US companies have off-shored their tax books not only because they could but by doing so they saved a huge amount in taxes. Tax rulings have not only allowed this but have also made it easier by allowing legal sheltering schemes like having an Irish subsidiary own the technology patents and then charging your US tax entity a stiff royalty for their use. 

It also appears that wrapped inside and hidden within the tax bill is that any past violations of US tax laws can lead to both civil fines and criminal prosecution for the corporate managers and their legal counsel who designed some of the schemes companies have used in the past. this could prove very important in that the IRS is looking closely at many of the somewhat fraudulent scams used in the past for which no statute of limitations exists. Many analysts have failed to reflect the true nature of offshore tax schemes and how problematic it will be to reverse these complex transactions. To be clear, when the IRS disallows a sham offshore transaction it can be catastrophic and even result in a company having to declare bankruptcy. The implication of the 2017 tax law so far is that it begins a new era for future corporate taxes, but it may also compel recognition of huge past-due tax liabilities in coming years as many previously existing offshore corporate tax avoidance scams become exposed to IRS review. 

An article published by The National Interest delved into what it viewed as a false narrative about lower corporate taxes resulting in the repatriation of trillions in offshore cash. It claims many economists will be surprised to learn that the new tax bill does not actually require repatriation of offshore cash but instead it employs something called "deemed repatriation," which means the IRS taxes you on your unrepatriated foreign earnings whether a company brings the cash back to the US or not. This opens the door to the idea the process of reconciling offshore revenues with an IRS pushing a strong level of enforcement will be very painful for those who have aggressively avoided taxes in the past. Being forced to pay for past sins is unlikely to result in a wave of new corporate investments which increase productivity and economic growth. 

This will become a compliance nightmare for many companies that have participated in past tax avoidance transactions. Many corporate managers and their legal counsel may even approach the IRS and try to cut a deal, it may even result in a "formal tax amnesty" being proposed by the Trump administration. Most likely the government would consider offering an amnesty program only if corporations begin to display a real fear that they are about to be caught up in this vice begin to start screaming at the top of their lungs. It seems Treasury is already working on the implementing regulations for this “virtual repatriation.”

The earnings return provisions of the tax bill are of the highest priority followed by the anti-base erosion provisions, and then the worldwide system on Global Intangible Low Tax Income that sports the great acronym, “GILTI.” The Treasury is putting the "deemed repatriation rule" into place to raise the roughly $200 billion over ten years they need to move to a system which excludes most foreign-sourced active business income from US taxation. This aptly named “participation-exemption system” is something the American business community has been lobbying to get for years. As things stand the Treasury is hell-bent on collecting this money. So much for the idea that the new tax legislation will result in a cash repatriation bonanza that will benefit stock prices and the overall economy.

Wednesday, May 2, 2018

Stupid To Hold Cash? I Think not!

This post most likely would of never have been finished or seen the light of day if it had not accidentally been published while in the very early stage of a draft. Seeking Alpha on occasion republishes my articles and while checking comments on the site I noticed a story from The Heisenberg Report titled; Ray Dalio And the "Pretty Stupid" Cash Holders. The Heisenberg piece grew up around a statement made during a January 23, interview where Ray Dalio told CNBC that people holding cash are going to end up feeling "pretty stupid." The main reason I have returned to this subject and decided to carry finish this article is because the draft I deleted immediately upon seeing was really no more than a note or a piece of embarrassing incoherent dribble.

Banks Can Cut Credit Lines At Any Time
I found the statement made by Dalio intriguing not because I agree with it but because in many ways I disagree. Apparently, when he made the statement Dalio mistakenly thought the market was ready to pop big time and investors would lose if not "all in." A very important part of the last sentence was the word, "mistakenly," However, my disagreement is based not on whether he was making the correct call which is something we must always worry about before taking such advice but rather because I'm a fan of keeping cash in reserve and available whenever possible. Another reason is that while not a coward the "all in" thing take us one step too close to the notion we are gambling rather than investing and this tends to scare the hell out of me.

Cash Is King!
When someone uses the term cash I tend to think of it as money that is easily and rapidly assessable, wealth that is not tied up in an investment. This does not mean stuffing hundred dollar bills into a can and buried in the backyard or hidden away under the mattress. At times most of us are cash rich or cash poor depending on circumstances at the time.  Not being over fond of banks and being rather independent my experience has been that being able to do a deal fast without having to worry about it being contingent on getting a loan has a lot of merit. The ability to, "do it now" can yield far more than an investment based on hope or a prayer. In my line of work I do a great deal of negotiating and I have found one word people wanting to reach an agreement don't want to hear is "IF"!

We never know what the future will bring but if it is a financial crisis liquidity is generally one of the first things to dry up and when it does cash is king. This is why I will never call the holder of cash stupid unless it is during a long period of massive inflation. Cash is the big dog it gives the holder options. Cash can protects us from the many unexpected problems that can spring up in our path. When push comes to shove banks are not the friend of the common man and relying on their sense of decency is not a good idea. The agreements most of us are forced to sign when borrowing money is filled with little details and the devil hides between the lines. Cash is liquidity and holding it is generally not as stupid as allowing yourself to be hung out to dry when it suddenly grows scarce.

Footnote; An article exploring the relationship between currencies and the value of tangible assets is linked below.