Thursday, June 25, 2020

The Importance Of Where And What Consumers Buy

How people spend their money has more impact on the economy than most people realize. What consumers buy matters a great deal. When looking at the policies flowing out of Washington it is clear many politicians seem to have no idea that all consumer spending and purchases are not created equal. Certain purchases result in money bouncing around a community sparking future economic growth which enriches everyone. Other purchases simply give the money wings allowing it to exit not only the community but often the country.

Many economists point to the consumer as being the lynch-pin to our economy.  Given that retail sales make up roughly 40% of personal consumption expenditures which in turn comprise roughly 70% of our GDP, their impact on the economy is important. These numbers, however, only tell a small part of the story. Sadly, because of economic laziness or ignorance, this is where the link between how and where money is spent gets lost in the noise. Ironically while President Trump decries our trade deficit he seems unable to put one and one together and understand it is shortsighted consumers driving the deficit.

A detailed breakdown of how people receiving a stimulus check would provide a great deal of information about the finances of individual Americans. It would also be very interesting to randomly delve deep into the finances of a few hundred Americans and learn the truth about where we stand. By deep, I mean looking at where they get their income, debt, total obligations, savings, retirement plans, net worth, the whole caboodle. This kind of deep economic discovery has never been done to my knowledge but instead, we tend to garner our information from superficial polls. 

An article by Lance Roberts that appeared on Real Investment Advice took a shot at explaining the bounce we just saw in retail sales at a time many consumers are tapped out. Robert wrote you should “never count the consumer out,” as they always find a way to go further into debt because psychologically, consumers are "trained” to “shop till they drop." He claims that as long as individuals have a paycheck; they will spend it. Give them a tax refund; they will spend it. Issue them a credit card; they will max it out. Give them a government stimulus check; they will spend it as well. Don’t believe me, then why is consumer debt at record levels?

The fact is, consumers should take a long look at how their purchases will impact the economy over time. Robert makes the point that most consumers will spend if they have or can borrow the money. Taking this to the next level, few people realize what is registered as growth does not necessarily transfer into economic strength. This point is something that has been covered time and time again on this blog in articles such as, Healthcare Spending Wrongly Feeds Our GDP, and Economic Growth Does Not Equal Economic Strength.

The following examples highlight this matter. Just for fun imagine the money allowing for these purchases is flowing from the recent 2.3 trillion dollar CARES Act.

  • Consumer one decides to put a new roof put on his home. This includes tear off and re-shingling. This labor-intense job pays a lot of local workers from those delivering and hauling away the old roof to those selling the shingles, those installing them, and even some folks at the local landfill. As a bonus, the shingles are made here in America. Putting even more ceiling on the cake is that it improves not only his property but raises values in his neighborhood enriching those living nearby.
  • Consumer two uses their money as a down payment on a new Hyundai. The Hyundai Motor Company is a South Korean multinational automotive manufacturer headquartered in Seoul. Hyundai builds the vast majority of its vehicles at its plant in Ulsan, South Korea. It also operates plants all over the world with one in Mexico and a plant in Alabama. When I tried to research how likely the car was to be made here I hit a wall. One thing for certain is that it is packed full of South Korean parts and with each sale a bunch of dollars heads overseas.
  • In the final example consumer three slaps, small businesses, brick and mortar retailers, and the 30 million-plus Americans recently unemployed in the face. His online purchase from Amazon of products made in China and shipped from a facility located in another state. Just like in the case of consumer two a bunch of the money heads overseas but real disaster for the community is absolutely none of the money stays there. This sets the area up for a new wave of store closings, prolonged unemployment, and declining real estate prices.
And It's Gone!

Many of our economic problems stem from the many consumers out there making poor decisions. This includes things such as paying too much for a car they cannot afford or maintain.These automobiles generally do not last long and often get put on a hook. The least responsible consumers tend not to fulfill obligations due but to take on new debt and squander every penny they can lay their hands on. Online shopping and companies such as Amazon are like heroin to an addict when it comes to promoting spending that destroys real economic strength.

Those people that have choose to skip paying the essentials such as home mortgages and rent will most likely come to regret it as they are hit with penalties and their actions come back to haunt them. The elephant in the room when it comes to growing the economy is how "the broken window theory" is spun and interpreted. The gist of this theory is that if a hooligan breaks the window of a bakery, the subsequent repair expenditures by the baker will have no net benefits for the economy. Interestingly, it is not uncommon to see destruction touted as a good thing because it promotes spending. The idea destruction is good based on this reasoning discounts several facts.

One has to do with where the money is coming from but whether it is from an insurance company or the baker it still means the money is diverted from being used on another purchase. Repairing a broken window is maintenance spending which doesn’t improve growth because it doesn’t improve productivity; it would have occurred anyway. The only thing a broken window does is it makes the maintenance spending occur earlier, lowering the use life of the window. While maintenance spending may keep the economy going it doesn’t provide a boost. Instead, it is better to invest the money in something which creates wealth by increasing productivity.

Many people and even economists have real misconceptions as to how the economy works. Where money flows and who it enriches is a key component of economics, the failure to consider this is a blind spot many people have. After years of being told everything revolves around spending, this diminishes the important role savings plays in the scheme of a balanced economy. Fans of Keynesian economics that encourage government spending to stabilize the economy during a downturn tend to discount the importance that where and how money is spent matters a great deal.

Saturday, June 20, 2020

Starry Starry Night An Ode To Idealist - We Are doomed

The images of protest and violence that fill viewing screens across the globe underline the fact we are not on the way to nirvana, a state of idyllic peace and happiness. In my younger days, I was a full-blown idealist full of optimistic thoughts of how if we all worked together we could create a wonderful world. It soon became apparent that many people were not interested in work or doing, "their fair share" just for the sake of adding to the overall health and well-being of the community. This is the fatal flaw in the socialist theory. Adding to the problem is the human-animal by nature, while considered a social creature, seems unable to agree on much of anything. This of course extends to how we live, goals, and even the kind of lifestyle we wish to live.

Click On Picture To Bring Up Video
Vincent is a song by Don McLean written as a tribute to Vincent van Gogh. It is also known by its opening line, "Starry Starry Night", a reference to Van Gogh's 1889 painting  The song, by Don McLean, in some ways, is an ode to idealists everywhere. The lyrics are a comparison to Van Gogh's actual life.

They take us on a musical journey from Van Gogh's vantage point looking out from the asylum at Saint-Remy. History shows Van Gogh to have been a troubled soul that lived in torment and spending time in the mental asylum where he painted mainly from his room or the courtyard garden. Later he went further afield to paint. Van Gogh attempted suicide by shooting himself in the chest, which ultimately led to his death two days later. 

Vincent Van Gogh  is among the most famous and influential figures in the history of Western art. In just over a decade, the Dutch post-impressionist painter created about 2,100 pieces of artwork. This includes around 860 oil paintings, many of these were done during the last two years of his life. They include landscapes, still lifes, portraits, and self-portraits, Starry Starry Night is the most famous. Most people are unaware of the fact that Van Gogh was never famous as a painter during his lifetime and constantly struggled with poverty. He sold only one painting while he was alive

Click to see more images of Van Gogh in Arles
Years ago I had the good  fortune to be able to visit the beautiful city of Arles, France where Van Gogh lived for more than a year, he experienced great productivity there before suffering from a mental breakdown. Van Gogh was a prolific correspondent and wrote nearly as many letters as he created paintings. In one of the last letters, some four days before his death, he wrote, ‘I try to do as well as certain painters whom I have greatly loved and admired.’

The most telling part of the lyrics is the line, "But I could have told you, Vincent, This world was never meant for one As beautiful as you." This can be interpreted to mean that idealists or those who see the world through rose-colored glasses are doomed to a life of disappointment and pain. This extends into most areas of life, that is why luck is such a treasured commodity. This line in the song should also be considered a warning to idealists that over time they will suffer a thousand cuts.

It would be unfair to those of you that have read to this point not to make an effort to return to the inspiration that caused me to write this article. Sadly, the cynics reading this will tell you the only thing you can count on is that those in charge will never fail to fail us. Being thrown under the bus is more common than we want to talk about. Many idealist are simply naive, this translates into their lack of experience, wisdom, or judgment as setting them up for a life of great disappointments. While it has been said, pioneers take all the arrows, it could also be said that idealists leave themselves open to a life of heartbreak.

Life is full of lessons and many of them are learned from the harsh reality that slaps us in the face each day, one of these is that a vocal minority can create chaos. Another is that those with an agenda will often gain power by devoting a great deal of their energy to this goal. After gaining power these people justify the actions they take by saying they serve "the greater good." For the many of us that have seen too much, it has gotten to the point where we should think about lowering our expectations the world will suddenly get better.

Fed's Action Obliterates True Price Discovery Mechanism

The Federal Reserve continues to destroy true price discovery in this market by executing short squeeze after short squeeze. Moral hazard be damned, the Fed's desire to support the market has overruled common sense. We have seen this time after time with well-timed announcements being made simply to fire up bullish enthusiasm and spark a rally. We recently observed this when a Fed announcement resulted in a dramatic intraday reversal causing the S&P500 to surge more than 100 points from session lows and closing above its 200-day moving average.

Fed's Action Obliterates True Price Discovery
This time it was because the Fed announced it would start to buy corporate bonds the next day. A late Bloomberg report that Trump was seeking a $1 trillion infrastructure proposal to stimulate the economy also added fuel to the fire. Trump's proposal focused on 5G and rural broadband. The report added it was still under discussion and would need the backing of Congress to move forward. Still, this is an indication the false economy continues to ramp up. Government stimulus has been a key feature of the global equities rally even as unemployment has soared and signs that a second wave of the virus has started to emerge.

Until now, the size and pace of Fed balance sheet expansion have put a floor under global equity markets and driven equities higher. Yet Powell is going out of his way to signal that more economic support is on the way. The problem with market manipulation is that once it starts, where does it end? This is an area of moral hazard that once breached is difficult to turn back. Another issue is that the Fed is not alone in playing this game, the Trump administration also has invested a great deal in keeping markets moving higher. In recent years we have witnessed more central banks and government intervention in markets. This supports the argument that true price discovery has been massively distorted.

The BOJ Buying ETFs Is Distorting Markets
In many ways, government entities investing in or buying stock, are transferring part of industry or commerce from the private-sector to state ownership or control. While the state may not choose to exercise control over various decisions a company makes the entity that owns the stocks can control perceived valuations by being the market maker that sets prices. True price discovery and properly pricing assets are the bedrock of free markets. The feedback loops between asset prices and input signals are critical in determining value, this is especially true when we focus on assets such as stocks, bonds, currencies, or paper promises that carry no utility value and can perform no useful task.

The Federal Reserve was intended to act as the “lender of last resort" but as Nomi Prins says, "As if the Fed hasn’t done enough to destroy honest markets, now it plans to start buying individual corporate bonds. It’s just another step closer to the Fed deciding the winners and losers in the market." This has forced even the most bearish of us to finally concede that, for whatever reason you want to claim, the Fed under the leadership of its Chairman J. Powell has crossed the Rubicon and the point of no return.  

Crossing the Rubicon means the point of no return. This high-level idiom comes from an event in ancient Roman history. In 49 BC Julius Caesar's army crossed the Rubicon River, this was forbidden. It was an event from which he knew  there is no way back. When Julius Caesar crossed the Rubicon, he started a five-year Roman civil war. At the war's end, Julius Caesar was declared dictator for life. Putting the Fed's recent actions into context and what it means for investors, the miserable policies adopted by the Fed, which has allowed other central banks to do the same, has created a new environment redefining risk and value. This highlights the fact there is nothing normal about what is happening, this is far from normal.

Savers, investors, and a new wave of speculators as a result of Central banks expanding balance sheets while reducing interest rates are now embracing any investment that promises yield. This combined with rising government spending has disaster written all over it, not just in America but across the globe. This and a slew of other horrible moves have created a bubble in bond and equities. Only the claim that no inflation exists and this is the only way to halt deflation allows this reckless policy to continue, however, when people realize the fallacy of this assertion it will be to late too stop the economic and financial carnage it will create.

The Shrinking Private Sector (click to enlarge)
Unfortunately, the money flowing from the Government-Financial complex is not reaching the parts of the economy where it is most needed. For a small business, the economy remains a disaster. Investors should remember the true unemployment picture has yet to reveal itself. As the government grew larger it seems to have become oblivious to the importance and fragility of many small businesses or how much it cost a community when they close. Small business has been the big loser over the last several months and hundreds of thousands will soon have to close.  With so many tenants looking at foregoing rent small landlords that don't have deep pockets also face huge problems. 

The idea we are about to experience a
“V-shaped recovery” is rubbish. Many people are afraid to fly, travel, or eat out at a restaurant. The government's solution to give the masses just enough to silence their outrage is a bizarre extension of crony capitalism. It feeds large businesses with access to cheap capital are the winners and the big losers are the middle-class, small businesses, and social mobility. All those people that want a higher minimum wage can forget that ever happening as tens of millions remain out of work. It is difficult to argue true price discovery exists and risk is not being discounted when prices fail to reflect unemployment at around 20% and ignore news of a sharp escalation in Korean tensions or the deadly clashes between Indian and Chinese border troops.

Bubbles always pop, this time is not different. Exacerbating the current situation is that many investors in these "paper promises" have become over-leveraged. This puts them at great risk if a sudden decline in the value of these assets occurs. The disconnect that has taken place between Wall Street and the economy is not logical. We are in uncharted waters and should consider the possibility the destruction of true price discovery will only add to the demise of fiat currencies across the world. I contend this will fuel the desire of people to once again hold tangible assets rather than trusting the promises now being made. To say things are messed up is an understatement.

Sunday, June 14, 2020

Inequality On Rise - Many Of 99% Dirt Poor As Rich Gain

Inequality has soared over the last several months with billionaires seeing huge gains in their wealth while many people are getting slammed. Much of the adverse effect on the average American has so far been masked by trillions of dollars flowing from the government in the way of temporary stimulus checks. The covid-19 crisis and how it has been handled by the governments and the central banks have resulted in creating a twilight-zone economy. The moment the current $600 a week federal unemployment benefits run out at the end of July, many people will find they are caught in a financial vise with few options. Getting that unemployment money is the biggest reason many people who've lost jobs are able to keep a roof over their heads. Knowing many of these people are not going back to work is a big problem. You are not alone if you are having difficulty reconciling the growing divide between Wall Street markets that seem totally ignoring economic reality.

"Most Shorted" Stocks Soar As Bears Cover
Many market watchers and pundits are troubled and confounded by the recent market action. Several explanations exist with each one having some validity but great uncertainty remains. In a manipulated environment such as we have today where markets are propped up and manipulated with no true price discovery, all investments have become risky. The markets are reflecting a V-shaped recovery that Citigroup warns may be far too optimistic.

A slew of new investors, most inexperienced, have stepped into the breach and bought the dip under the impression it will lead to prosperity. This is evident in the area of the most shorted stocks which are on such a rant as those most negative on the economy are forced to capitulate to a soaring market. This is occurring while Citi writes its model still shows that a greater than 70% probability of a down market in the next 12 months remains.

Another area where this can be witnessed is in how a newly IPO'd company has exploded to become the most valuable truck-maker in the world, despite having no sales ever. Stock in Arizona-based Electric trucking startup Nikola soared last week, more than doubling in one day. This gave the company a market value of over $30 billion. This occurred after Nikola founder, Trevor Milton, tweeted about taking in reservations for the company’s light-duty truck called ‘Badger’ starting in late June. Its medium-duty truck is due in 2021, and a heavy-duty truck in 2023.

Proposed Badger Truck Not Yet Produced
To put this in context, during 2019, Ford with a lesser market cap of $28.7 billion sold 5.5 million cars while Nikola sold none. This type of major disconnect from reality strengthens the argument that much wealth is an illusion financially manufactured and related to positioning. The idea you can become a billionaire in a matter of hours is hard to comprehend at a time many Americans are worried about losing their job. 

Many questions remain unanswered when it comes to the economy and many potential risks could affect the markets in the coming months. Biden could defeat Trump and the Democrats sweep Congress. Covid-19 could unleash a second blow setting back the reopening of businesses. Another big issue is the protest and civil unrest could grow much worse when the real impact of unemployment shows its ugly face. The fact that many older experienced traders are appalled at the stupidity and euphoria of this market does not matter. None of these issues seem relevant to those arguing that substantial Fed-induced liquidity has rendered traditional fundamental analysis moot.

Circling back to growing inequality, it is important to remember some stock indexes are making new highs at the same time NPR reports Americans are skipping payments on mortgages, auto loans, and other bills. Wealth inequality has soared in recent years and now stands at the worst it has been during the entire U.S. post-war period. Simply put, statistics show many Americans lack the money to pay for a $500 repair. Driving a decent car doesn't make a person middle-class or economically equal, especially if they are up to their eyeballs in debt to do so. While companies have temporarily put collection activities on hold due to the covid-19 pandemic, this will likely lead to a huge number of foreclosures, evictions, auto repossessions, and credit downgrades. 

The explosion in the national debt only bolsters the masses for a moment before finding its way into the pockets of the .01% that pulls the strings in Washington and controls our fate. Inequality has been growing and it is far worse for society and the world than first thought we are witnessing the further collapse of the middle class. The number of people living on government transfers of wealth has grown over the years, the National Debt Clock provides some rather shocking data concerning the number of people that are currently "receiving benefits" from the government or are unemployed. Many of the American's that are now experiencing the slip into this economic quagmire and rough times will tell you, "I never thought it would happen to me." In the end, it is likely a great number of these people will become a burden to society.

A More Recent Chart Hard To Find! click to enlarge
In a piece titled; "The Morass That Swallowed the Middle Class" Matthew Shaw delves into how much of the inequality debate focuses on the gains of  the "1%,” while far less attention has been paid to the economic well-being of others. What is broadly termed the middle class is all too often just lumped into a diverse group labeled the 99%. In truth, many of these people are dirt poor. Much of this centers around just how out of touch our "professional elite" are with the general population and the economy. By our professional elite, I refer to those who make the rules and their minions, their aids, the academics, the financial institutions, economists, and the media, all of which have tied their wagon to the status quo. Conflict and corruption also enter into this because we often find those setting the rules also tend to want a bigger piece of the pie.

This growth in inequality is a "pox on the house" of society. For decades the rich and powerful have been increasingly grabbing a larger slice of the economic pie. A great deal of growing corporate profits come from cutting back on the greatest expense businesses have to pay and that is labor. This is and will substantially increase in coming years as robots displace humans in the workforce. Robots are here and more are being deployed each day, soon this will prove to be a big deal. The topic of our future and culture always circles back and is directly linked to the issue of jobs vanishing as automation and an army of robots march into our workplace. Rest assured when push comes to shove those displaced from the job market will find they are only given enough to scrape by and ensure they remain docile and behave. If and when this becomes an issue conflict and violence will arise it is possible that someday they will be brought to heel by an army of robots designed to keep them under control. 

The reality is the vast majority of people face diminishing prospects. This concerning trend is highlighted in an IMF report focused on data showing how middle-income households have continued moving down, rather than up, as income distribution in the United States has shifted since the 1970s. The U.S. middle class has never recovered after being “hollowed out” when manufacturing jobs fled America and incomes fell. Current trends indicate the "equality gap" is not expected to narrow in the future. Growing income inequality is not just an American problem but it is an issue across the globe and no magic or silver bullet exists to address the conundrum brought about by this concentration of power and wealth. The images of cities burning and widespread looting as a result of police brutality are also being fueled by rising economic inequality. Today's social unrest reflects just how broken our culture and the economy have become. The sad thing is, many of those that have taken to the streets in protest will say that whatever actions society takes, "It ain't enough."

Friday, June 12, 2020

Kids Find Out There Is Such A Thing As A Free Lunch

EBT Cards For Kids - Click To Enlarge
Across America, kids are receiving Electronic Benefit Transfer, or EBT, cards in their names. Each card will be loaded with around $365. This is meant to provide these young people who would otherwise have access to free or reduced-price meals when schools are open with a "free lunch." The school system here where I live in Indiana and the School District of Philadelphia are just two of the districts busy reminding parents that help with summertime meals is on the way to their mailboxes.

In many school districts, all students will be receiving a card. This is being done so they will have access to meals during the summer. These are going out to both young children and high school students. If a child in Pre-K happens to be in a grade school participating in the federal free and reduced lunch program the child is included in this program and will be eligible to receive this benefit. Both the children and parents can thank the wisdom of lawmakers for this benefit while those concerned about the exploding national deficit are left to pray it will be properly used.  

There are no income requirements in areas where a high percentage of district families are low-income because it means the entire district qualifies for free or reduced-price meals. Apparently, even the legal status of the child does not affect eligibility for P-EBT. School-aged children who are undocumented non-citizens enrolled in a free/reduced lunch school program need not worry, they receive the P-EBT benefits. Any child that receives free/reduced lunch qualifies. There are no other filtered criteria. This means many school systems are busy letting parents know that help with summertime meals is on the way to their mailboxes.

Families can use the P-EBT benefit to purchase food items at EBT authorized retailers, including most major grocery stores. Many gas stations also accept EBT, but you can only use your benefits to pay for specific items. If you receive Supplemental Nutrition Assistance Program (SNAP) benefits, you can purchase food items such as cereal, dairy products, snacks, and candy, but you can’t buy prepared foods, toiletries, over-the-counter medicine, alcohol, or tobacco. Unused benefits will rollover month-to-month and must be used within 365 days. The theory is that families that don't need the benefit can simply return it.

 A lot of questions may arise concerning who will get these cards and how they will be used.  Such as, if a child's issued P-EBT card has their other parent’s name on it but you have custody of the child and that is the child's address of record with the school, you can use it for the child? The answer is yes. As to the ID requirement for using the P-EBT card at the grocery store, the Grocery Retailers Association is aware of the process for P-EBT and have been informed of the card design as well as benefit projections. By federal statute, retailers cannot ask for ID for EBT purchases if they do not request ID on regular debit card purchases.

Another Program Ripe For Abuse
During the covid-19 pandemic, many schools and groups have tried to get food to hungry children but they have failed in their efforts. Many areas used a special waiver issued by the United States Department of Agriculture (USDA) to modify the Summer Food Service Program and offer grab-and-go meals. Under this plan, families were allowed to pick up packaged meals on behalf of their children at school and in other non-congregate settings. Cities nationwide adopted this model, including New York, Los Angeles, Chicago, Atlanta, and Cleveland. Sadly, parents wouldn't even bother to pick up the meals.

This leaves many of us wondering how many kids are really sitting at home with nothing to eat. At times it seems the government is bending over backward to spend money where it does not need to be spent. The quality of what some may think is a free lunch  has yet to be determined. When all is said and done it is easy to see this program is ripe for abuse. These cards are good as gold and could even be sold at a discount for cash. Considering how many children in this country are obese, it is likely a great deal of soda pop, chips, candy, and cookies will be bought with EBT cards.

Thursday, June 11, 2020

Manipulating Value Of US Dollar Lower Is Very Risky

It appears the Fed Chairman Powell has a problem understanding how Main Street works and is more interested in shoring up those in the financial sector. His statements point to him having little interest at this time in forcing some kind of action to contain "soaring risk asset prices." While some market watchers have voiced concern the Fed may be forced into some kind of action this does not appear to be on Powell's radar. The fact is, the growing divide between stock prices and earnings expectations signal a dangerous imbalance forming in the market. If this situation spins out of control, be prepared to "watch out below" as things begin to fall like a stone.

Powell seems content in his role as the great enabler moving the global financial system forward. This may even include manipulating the dollar lower which is a very dangerous game. This is especially true at a time so many people are concerned about fiat currencies becoming worthless due to governments abusing their rights to expand the money supply by printing with abandon. Manipulating the value of the US dollar is a very dangerous game because it undermines the global currency market. In many ways, the growing popularity of cryptocurrency is rooted in central banks' decision to go down this destructive path.

The Fed Has Allowed This To Happen
A major part of the dollar's role as a reserve currency includes acting as a benchmark by which other currencies and commodities can be valued. A stable dominant  currency results in other currencies being forced to toe the line or pay a stiff price. Ignoring this economic reality translates into pain for those holding the currency of any country that abuses this economic law. This plays out in the account balances of any country that watches its currency fall as it imports far more than it brings in. Wealth tends to flow towards where it will be safe and protected.

To be perfectly blunt, none of the rapid expansion of debt and credit during the last decade could have occurred without the Fed being totally complicit. It has been the Fed that decided to allow the dollar to be used as a global prop. This trend exploded following the 2008 financial crisis when then-Fed Chairman Ben Bernanke adopted policies of massive quantitative easing (QE) to stimulate the economy when standard monetary policy began to become ineffective. Today this policy has become the lifeblood of the global financial system rather than the jolt needed to restore its health.

Across the world, central banks jumped in and allowed governments to abdicate their role in creating an environment where sustainable economies can exist. This could not have been done without the collusion of America's Federal Reserve. Central banks literally "took turns" stepping up to the plate and announced round after round of easing and lower interest rates while the Fed stood idly by. Following each announcement stocks and asset prices across the world soared. The fact that wealth can rapidly move across borders also causes problems, the inflow or outflow of capital can be very destabilizing. 

Stock Buybacks Drive Markets Higher (click to enlarge)
Low-interest rates coupled with easy money pouring into the economy through the expansion of credit tend to create an illusion of prosperity. This false economy can rapidly vanish. Proof of just how much this economy relies on the continued flow of cheap money is highlighted every time the stock market begins to wobble. We all remember how President Trump ratcheted up his attacks on Fed Chairman Jerome Powell for "ruining the party". In the past, Trump has pointed to the soaring stock market as confirmation of his skill in growing the economy and leading us forward. In truth, it is his flawed tax reform package that benefited the rich by fostering massive stock buybacks coupled with massive deficit spending has allowed the false illusion of prosperity to continue.

Circling back to the dollar, the Fed, as the dollar's protector had the power to halt this global creation of stimulus and credit by raising interest rates in America. Instead, it chose to join in and seemed to almost encourage the trend to continue. This central bank experiment calls into question the use of currencies as an economic tool going forward. It has also increased the risk that more currencies will fail as their capability to safely store wealth, is examined. As currencies morph into a tool of government they are being weaponized which takes them further away from their original role as a medium of exchange in commerce.

Click Here To Enlarge
According to the IMF, the dollar is overvalued by 8-16%. Still, this is not necessarily out of line with fundamentals since the US is growing faster than many other countries. Also, in these times of heightened uncertainty, the dollar is underpinned by safe-haven flows. On more than one occasion, Trump has voiced his desire for a weaker dollar and each time it has had less of an effect on the market. Trump envisions it would help to boost exports and support the US manufacturing sector. It would be wise for the President to understand the dollar is not a pawn to be manipulated around for his pleasure.

If overt efforts are made to lower the dollar's value, other countries would most likely make an effort to lower their currency which could result in a dangerous race "to the bottom." This is why the G20 countries have agreed not to target exchange rates for the purpose of competitive devaluation but does allow for temporary intervention to stabilize a currency. It is expected that if risk-off conditions would cause a disorderly rise in USD the probability of intervention by the Trump Administration increases significantly. The history of currency intervention shows it is a useful tool for emerging market countries that need to stabilize exchange rates but little evidence exists that it is effective for advanced economies wishing to target long-term FX competitiveness.

The US Treasury also plays a huge role in international financial policy. This is because it is responsible for managing the USD. Simply put it could intervene and guide the NY Fed's market desk to weaken the dollar by selling dollars and buying other currencies. The currencies that are used for intervention come from the Fed's holdings and the Exchange Stabilization Fund of the Treasury which is comprised mainly of the euro and Japanese yen. The two types of interventions are possible, sterilized, and unsterilized. In a sterilized intervention the NY Fed will buy or sell other securities (e.g. sovereign bonds) through open market operations which prevents the intervention from changing the monetary base and interfering with monetary policy. In an unsterilized intervention, it has the ability to influence the money supply and also can impact interest rates.

Again it must be stated, the dollar's role as a reserve currency gives it oversized importance in world markets. It is indeed the benchmark by which other currencies and commodities can be valued. When all things are considered, fiat currencies are in general a rather weak lot. This means it is best not to look too closely or the system glued together by faith and a prayer could come crashing down. Overall the dollar remains a far better currency to hold than its weak sisters, the euro, and the yen. It should be noted that currency manipulation is a slippery slope bringing into question the real value of a currency further distorting true price discovery. In our current global financial environment, additional manipulation is a very dangerous path to start down.

Sunday, June 7, 2020

EU Economy Traveling Along Same Worn Dead-end Road

With so many countries across the world facing difficulties, many people have yet to notice the Euro-Zone has become a place where hope goes to die. The last round of elections in the Euro-Zone should bring little comfort to those supporting a stronger Europe. Huge gains were made by forces seeking more power for the populist agenda. In short, it is a boost for the rights of individual nations to have more say in how they are governed.  Two of the most pressing issues are that insolvent Italy struggles with a stagnant economy and Spain is coming apart politically with Catalan separatists defying Spain's Prime Minister.

To avoid the union coming apart at the seams and a miserable future, the European Commission recently unveiled an unprecedented  €750BN CoVid-19 recovery plan. It consists of €500 billion in grants to member states, and €250 billion would be available in loans. This means they are asking for the power to borrow. This is geared to tackle the worst recession in European history and shore up Italy. It would mean transforming the EU’s central finances to allow for it to raise unprecedented sums on the capital markets and hand out the bulk of the proceeds as grants to hard-pressed member states.

The Euro-Zone was already in deep trouble before CoVid-19 hit, the weakness that started in 2017 never ended. In the fourth quarter even Germany narrowly escaped recession. This could be blamed on the Brexit or Trade War but it goes beyond that, they abandoned all structural reforms in 2014 when the ECB started its quantitative easing program (QE) and expanded the balance sheet to record-levels. In 2019, almost 22% of the Euro Zone GDP gross added value came from Travel & Leisure, a sector that will unlikely come back anytime soon. Add this to weak exports and a banking sector that is totally decimated and everything points downward.

The Dollar Remains The Only "Real Option"
Roughly 80% of the Euro-Zone's real economy is financed by the banking sector that carries more than 600 billion euro in non-performing loans. Considering that the Euro-Zone was already in contraction in the middle of the massive Juncker plan that pushed forward green policies, it is safe to assume a Green New Deal will not boost growth or reduce debt. Large investment plans that are politically directed generally do not do as well as planned. The Euro-Zone is in a state of "stagnation." Figures show that as of 2017 not a single European company ranked among the top fifteen technology companies in the world. Still, more troubling is that of the top 50 global technology companies, only four are European.

Being uncompetitive sucks, unemployment is high, almost 30% of the Euro Zone labor force is expected to be under some form of unemployment scheme for years. France, Spain, and Italy, with important rules and tax burdens on job creation, may suffer large unemployment levels for longer. Another challenge is the region lacks technological and intellectual property making them less competitive than China and the U.S. They are simply out of tools to address the unprecedented bashing put upon the economy due to CoVid-19. It would also be a bad time to add massive monetary imbalances when demand for euros globally is shrinking according to the Bank of International Settlements.

To fund this €750BN package, the EU would borrow on financial markets and put in place a suite of proposed new EU taxes and levies to pay back the debt over the coming decades. These would hit everything from tech giants to single-use plastics. Bloomberg, reports Italy stands to receive 82 billion euros in emergency grants and up to 91 billion euros in low-interest loans. Spain also hit hard by the pandemic is in line for 77 billion euros of grants and up to 63 billion euros in loans. Greece could get 32 billion euros in grants and loans and France could get 39 billion euros in grants. Such a program gaining the backing of member states would be a "watershed moment" for the bloc. Financial burden-sharing has long been one of the thorniest issues holding back deeper integration within the union. It could go a long way to silent concerns about the lack of solidarity empowering populists and threatens the EU’s very survival. 

If months ago you didn't agree that political and economic problems in Italy and Spain posed the greatest threat to the EU it would be a good time to reevaluate your opinion now that both countries have been monkey hammered by CoVid-19. Last year a post on this site argued they had the potential to topple a struggling Euro-Zone. This argument is based on Italy's debt dwarfing that of Greece. If Italy, one of the "Big Three" economies underpinning the Euro-Zone, defaulted on its debt the scale of such a crisis would be difficult to contain. Flipping attention towards Spain, the article pointed out how immigrants continuing to flow in from Northern Africa coupled with the Catalan Separatists movement has left Spain's national government in disarray.

Italy remains the weakest link in the Euro-Zone and continues to weaken. Last year, in what could be considered a bold move the Italian Prime Minister signed a historic memorandum of understanding with Chinese President Xi Jinping in Rome. The agreement made Italy the first founding EU  member, and the first G-7 nation, to officially sign on to Beijing's "One Belt, One Road" (OBOR) economic development initiative. The ramifications flowing from Italy's deal with China may, in the end, prove to be a deal with the devil that opens the floodgates and signals the end of the EU breaking apart the euro.  China and Italy inked development deals covering everything from port management, science and technology, e-commerce, and even soccer.

This deal occurred before the covid-19 pandemic and since Italy's debt situation has only grown worse. Integration into OBOR appeared to be an "any port in a storm" situation. Italy has found the EU less than supportive and lacking answers as to how they might kick-start growth. Much of the blame for this problematic alliance falls on Brussels and the EU for its failures to deal with worsening conditions within Italy. Now, adding to the problem is growing unease and fear within the EU when they look out at an expanding China that cranks out products at a cost far below those at which they can compete. Trade and deficits loom large in the minds of those watching this unfold. We can expect that China will exploit Italy and use it as a backdoor into the broader Euro-Zone market. Two omens this will go poorly for Italy are the IMF warnings of the potential of many of China's OBOR funded projects going bust and China's history of flexing its predatory business model.

 While the ECB has sidestepped a major devaluation of the euro over recent years many of us skeptics believe it will ultimately collapse resulting  in devastating side-effects for those holding the currency. Much of the problem is rooted in the fact the euro itself was constructed on a weak and flawed foundation. Any currency joining and binding states or countries together must allow for an adjustment to send back funds to its weakest part or eventually it will become so unbalanced it will fail. The United States does this by collecting taxes on a federal level and sending back money and aid to areas that are economically weak and need help. In the same way, the EU has still refused to deal with Greece’s mounting debt it, mainly Germany, cannot seem to accept that protecting the small depositors of European banks is the price to be paid for preserving social order and even the euro itself. 

The truth is that in all reality Italy went bankrupt in summer 2011. 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. More capital began fleeing to the north when Draghi started QE in 2015. The Italian central bank is dependent on the ECB and has to buy Italian government bonds. German investors have to exchange these bonds for euros in Italy and transfer the money via Target 2 to their German bank. The growing differences in the Target 2 balance sheet are the result of the Germans, who own the Italian bonds dissolving them in Italy and transferring the money to Germany. Italians have also added to the capital flight as they liquidate their bonds which increases the debt claim on the German side.

To be clear, Germany has no interest in "debt mutualization" where it would be forced to bail-out Greece, Spain, Portugal, and Italy. These claims are not covered by any securities. If Italy or Spain withdraws from the Euro-Zone, the Germans will be left holding worthless paper. Concern in Germany remains tepid only because Germans have great confidence in the Bundesbank. Draghi claimed that Target 2 has nothing to do with the movement of capital from country to country and the clearing balances cannot be overdrawn as long as no one leaves the Euro-zone. This translates into, Italy must not leave the Euro-Zone! Italy's debt amounts to 2.3 trillion euros and its liabilities in Target 2 rose in June 2018 to 481 billion euros from 164.5 billion euros in 2015. This means that Banca d’Italia owes the Bundesbank almost half a trillion euros! Target 2 is a check that cannot be cashed.

This all swings back to the delicate manipulated balance of currencies which seem to be locked in a narrow trading range with the Fed assuming the role of the great enabler. Holding up all the really bad currencies in the world is not the job of the FED but the indication is that Central Bank manipulation has gone nuclear. The dollar's strength is largely a result of  many countries having adopted even worse policies than those America's leaders have chosen to pursue but a strengthening dollar sends a signal that the global economy is unstable which is something central banks want to avoid at all costs. This accounts for why central banks are marching in lockstep using currency swaps and injecting more liquidity into the system to keep several currencies from failing.

Draghi is credited with saving the euro but may have only delayed its demise. Now the euro's fate rests on the ECB's new President Christine Lagarde. If she departs from his script, she will face fierce criticism but if she does not, the Euro-zone’s never-ending crisis will eventually spin out of control. Draghi's stand the euro is indispensable and that even discussing its abolition is harmful seems to remain intact. Draghi's attempt to save the Euro-zone by printing trillions of euros allowed Italy, Spain, and other stressed states to roll over their debts but has failed. Low-interest rates and easy money have not cured Europe's problems, expect anti-EU sentiment to continue its growth.