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Digital Ponzi and BBB/EUR debt slump (not China-US tension) will be recession catalyst

Modern history (and the media) conditions us to believe that it is Fed tightening or incompetence, sometimes coupled with exogenous shock, which ends business cycle expansions. 

      Yes, the Fed may suspect, far away from the last trough, that a slowdown is occurring.  But its hands (to stimulate) may be tied by current, high goods and services inflation or concern at rampant speculation in asset markets. Even if untied, and policy easing occurs promptly, recessionary forces may overpower the Fed’s counter-cyclical efforts. 

      Other times, the Fed fails to diagnose (in real time) that a sudden, significant slowdown has started, and when it eventually catches up, policy easing is too feeble to resist a strong recessionary momentum.

 

How cyclical downturns without Fed tightening occur

        In principle though, it is quite possible for a cyclical expansion to come to an end with very little (if any) effective monetary tightening.  In this case, the Fed’s big mistake (if there has been one), may be in the past and not the present. There could be an accumulation of hangovers from earlier in the cycle – specifically from a monetary binge at that time.

        That is most likely how this present cycle in the US and other advanced economies will end. 

        The hangovers are so large that they will be more powerful in effect than any belated attempt by Fed fine tuners to prolong the cycle, taking their cue for gradual interest rate adjustments from their reading of the stars.

        Historical examples of US business cycle expansions coming to an end, without the Fed playing a key role by continuing with tight monetary policy (when no longer appropriate or having to abstain from stimulus because of present high inflation), are hard to find.

        Note however, that the sample size of business cycles under the post-1914 fiat money regime is small.  Perhaps the most relevant example is the sharp recession (the “Roosevelt Recession”) from May 1937 to June 1938. 

        The vast QE operations of the Roosevelt Fed through 1934-5/6 (as gold inflows following the dollar devaluation were monetized) had resulted in very high speculative temperatures by 1936 in stock markets and commodity markets.  

       The Fed responded with a very gentle tightening of monetary conditions from late 1936 (reserve requirements rising in stages in the context of huge excess reserves and short-term rates rising slightly from around zero). 

       On the first signs of market weakness (equity market faltered in early 1937 as long government bond yields edged towards 2.75% from 2.35-2.50% previously), President Roosevelt and his Treasury Secretary pressed the Fed to ease, which it did, also intervening to lift government bond prices.

        An economic slowdown was already emerging, though largely as yet undetected and hardly attributable to the slight previous monetary tightening.  The equity market re-bounded through the Spring (1937) and early summer. 

        Then geo-political conditions darkened (Japan’s invasion of mainland China in particular).  The domestic political climate in the US became unhelpful to business confidence (the landslide victory of Roosevelt in November 1936 led on to tough pro-labour union legislation and overcoming of obstacles, placed by the Supreme Court to the New Deal’s implementation).

         There followed (late August to October 1937) one of the greatest crashes on Wall Street; in turn this fanned a sharp downturn in capital spending which accompanied a severe recession (with a start date that the NBER dates from May). 

 

Exogenous shock not a cycle-turner – Xi-Trump watchers beware

       Sometimes, an exogenous shock seems to play an important role in leading a business cycle downturn.

       Historically, one may think of the Smoot-Hawley tariff’s role in the Great Depression, the Japan invasion of China as above in July 1937 in the Roosevelt Recession, or the Oil Shock in the Great Recession of November 1973 to March 1975. 

     The late Jude Wanniski cites the preliminary passage of the tariff through a sub-committee in Congress as the catalyst to the 1929 October Crash.

        On closer examination, it is hard to make the case that any of these events were decisive to the business cycle dynamics at the time.  The Great Recession would most likely have emerged without their occurrence.

         Now the question is whether “China-US trade war” could be such an exogenous shock in the present cycle. 

        There are grounds for scepticism.

        Yes, the news about Google and various US chipmakers withdrawing from the Huawai supply chain is dramatic, and may lead on to radical change in the geographic structure of the mobile phone industry (Chinese demand met more fully by local suppliers, with Huawai adopting its own operating system rather than Android, building a China and European based app board alongside); there is nothing here to precipitate a US recession. 

         More generally, US tariffs on Chinese imports are not a general tool of protection, but a means towards hopefully persuading Beijing to reform its economy and its international economic and commercial relationships in ways which would bring it into line with key norms of a global free trading system. 

     One could imagine a final deal, not so far into the future, which would mean a better international trading relationship, not worse.  No pain, no gain. 

      The Chinese trade relationship may be crucial for Wall Street and Big Tech, but it is far from being the largest element in global trade.

     We hear a lot of banging of the table by the losers, but not the gainers, from the “tariff war”.  But gainers there surely are.  Think of competitive producers to China and US firms who did not commit large parts of their production chain to China.

     If indeed the present US and global growth cycle downturns are proceeding down a path which leads to recession or depression, the Xi-Trump relationship has not much to do with it.  The dangers lie elsewhere.  Let us elaborate further.

 

Monetary hangovers now in the global economy

      There is now a huge hangover in the global economy from years of radical monetary experimentation, led by the Federal Reserve and amplified through the even more extreme policies of the Bank of Japan, ECB and Bank of China. 

      We can identify these hangovers both in the real and financial economy. 

       In the real global economy, we have overspending and malinvestment which spells weakness for the future.

       We can think of the over-building, promoted by real estate and credit bubbles across much of both the Asian emerging markets and the small advanced economies (in those regions); in some cases, there has been unsustainable growth in consumption fanned by consumer credit alongside.

       In the US during this cycle, we have had capital spending booms first in the shale oil/gas sector and then in Big Tech, both of which were fuelled in part by credit and asset market inflation, which has produced distorted capital market pricing.

      Strength of private consumption means that many households are ignoring a fundamental fragility in their provisions for old age, likely to be made worse by potential bubble-bursting in the future.  Areas of consumer durable spending, housing and autos, have also had elements of non-sustainability in their cyclical pattern. 

      Meanwhile, in the export industries we have had much non-sustainability – including patterns of rapid export growth in China and the wider emerging market region in Asia, where demand has been driven by the credit bubble.  Japan and Europe have been at the forefront here (and of course Asian emerging and small advanced economies vis-à-vis each other). 

       We can add to the list, unsustainable construction booms across some commercial and residential real estate sectors in various advanced economies, some of which have already started to reverse (for example Australia), but elsewhere (for example Germany) not so.

      Alongside these patterns of real economic non-sustainability are “financial instabilities” or more broadly irrational financial behaviour driven by monetary radicalism, which will reverse at some point.



 

Insurance companies in the next debt bust

        Examples of such irrational paper here include the vast accumulation of borderline investment grade bonds (mainly corporate) bought by investors in their frantic search for yield. 

        Insurance companies (in particular, Europe and Japan) are vastly overweight in these, compared to positions which they would normally hold on the basis of sober risk-return optimization, especially at present wafer-thin margins. 

      Yes, the very long business cycle expansion brought about by incessant monetary stimulus has meant that actual defaults remain low; but pumped up long cycles (an unnatural creation of monetary inflation as discussed in the last Viewpoint) end up badly. 

       One can think of the huge accumulation of non-German (overwhelmingly, France, but also Spain and Italy) European sovereign debt by Japanese institutional investors, where despite thin margins (and in the case of OATs and BTPs with yields well below US Treasuries – despite a bleak future for the euro), the money keeps coming in, much taking the form of “yield curve plays”.

       Then there are the suspected bubbles in Silicon Valley and private equity – with much trepidation as to how they will end.

       Related, but different from the private equity bubble, is the sharp run-up of corporate leverage (disguised in part by high equity valuations).

      A common theme behind these examples of financial instability is “Ponzi” finance.  This term is used in ways which depart from the strict legal and conceptual definition. 


  data from Bloomberg                                                                              

 Ponzi-like finance in this cycle: Shiller and beyond

       Robert Shiller introduces his readers to practical non-rigorous forms of this scourge.

        In his book “Irrational Exuberance” he defines the strict legal concept as a person (Mr. Ponzi) who takes in cash from participants on the pretext that there is a grand scheme for making high profits (in Ponzi’s case arbitrage in postal stamps) but in fact makes no real investment.  Instead, high returns for the original contributors are paid out of new contributions.  Illusory (some would say fraudulent) accounting does not distinguish investment returns from such cash transfers.

      Eventually, demand for pay-outs outruns new inflows, as suspicions (always present) of unsoundness become more prevalent.  Mr. Ponzi may or may not have fled to a place of safety from prosecution, by that point.

     Some commentators have described Silicon Valley unicorns as Ponzi-schemes.

      For example, consider two taxi-ride IPOs in recent weeks.  Both companies have no prospect (according to the pundits and indeed the prospectuses) of making profits in coming years.  Instead, huge losses continue.  But high valuations in the unicorn market reflected expectations that credulous investors would pay a high price at public launch – and in any case, the legal documentation had given the founders a big advantage, vis-à-vis later investors to join the party, even though these may not have been widely appreciated.

     Even so, the Ponzi-likeness is in dispute.

     The founders may not have been total cynics about their enterprise and its future.  Some may truly believe fervently in the narrative of a wonderfully profitable future, whatever the widespread doubts.

      In addition, the money has actually been invested; no-one is disputing the huge capital spending programs to date, even if much of this relates to expenses up front (advertising, payment to drivers etc). 

     Some point to the real benefits which consumers have already reaped.  This counter claim (to Ponzi-like behaviour) is dubious, though.

     Consumers, like investor participants, might suspect that the lead narrative is incredible.  But they take advantage of the great service which is meanwhile available (thanks to the credulous investors pouring money into the business never mind present losses) to provide the fast-growing service – where the growth is marketed as further evidence of the enterprise’s future potential as Eldorado. 

     What looks fine, from a micro-perspective of the household (taking advantage of unbelievably cheap or extensive services whilst the funding is there), is not so benign at a macro-level.  This near-Ponzi operation might in the process be destroying a wide span of conventional competitors.  Furthermore, by the time the Ponzi scheme unravels, much of that competition and its resources would have been destroyed.

      When sound monetary conditions return (if ever!), there is much capital re-construction to be done.  Yes, some readers might see some Ponzi elements in the ascent of Amazon, notwithstanding its present profits in the cloud (where many analysts see growing competition and huge capital requirements).    

     Robert Shiller helps guide us in this Ponzi diagnosis.

     He introduces us to a world of Ponzi-like businesses (but not legally Ponzi), some of which may only be on the borderline of this phenomenon.

      Who can tell whether the insiders and founders have total faith in their enterprise, rather than counting also on an exit route, by selling to future investors before feared flaws become evident?

      This lack of total faith is in some degree normal and acceptable, in a capitalist economy. All is a question of degree.

     As Shiller writes:

    “The value of most investments depends on expectations for the near to distant future, something that cannot be seen clearly today, and so a public focussing of attention on investments creates an opportunity for deception and misrepresentation.

     “During a boom, opportunists try to find some ways of profiting from the public’s speculative attention by pretending to be the epitome of capitalistic success, and also pretending, one way or the other, to be the advance guard to the great new economy. 

      “More common than the examples of criminal behaviour are the examples of people who stayed entirely within the law and exploited a boom, building businesses that they did not themselves believe in.  These are cases of disingenuity rather than fraud”.     

        Shiller makes reference to the dotcom bubble in this connection, with the many near but not actual Ponzi-type schemes.    He proceeds to describe speculative bubbles as naturally occurring Ponzi schemes:

       “Speculative feedback loops can be the basis of naturally occurring Ponzi schemes without the contrivance of a fraudulent manager.  Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere.

       “When prices go up a number of times, investors are rewarded sequentially by price movements in these markets, just as in Ponzi schemes.  There is no reason for the stories to be fraudulent; they need only emphasize the positive news and give less emphasis to the negative. 

       “The path of a naturally occurring Ponzi scheme will be more irregular and less dramatic, since there is no direct manipulation, but the path may sometimes resemble that of a Ponzi scheme when it is supported by naturally occurring stories”. 

       Shiller is not a fan of monetary analysis and does not root his ideas of bubble and boom in any particular monetary observations.  Even so, he would surely accept that the desperation for yield, generated by radical monetary policies, plays a role in the phenomenon.

        When the bust comes, there are huge revelations of mal-investment.  Still it is very difficult to estimate the total cost, as this involves comparing actual economic outcomes with potential outcomes (much better) under an alternative sound money regime.

        The dotcoms, the unicorns, and the related economic activity, can come to a sudden halt without any significant tightening of monetary policy.

        Rather, the truth gets out; or alternatively, the credulity of the public diminishes for whatever reason.  One of these can be even bigger losses than anticipated, due to an incipient economic downturn.

 

Ponzi-like schemes in financial sector

      The notion of Ponzi-like schemes is not confined to real enterprise ventures.  They also exist in the private and public finance area.

        Think of insurance companies gathering in present premiums and prospectively paying out pensions and life assurance claims over decades to come.

        Solvency may seem apparent on the basis of BTPs, OATs, and BBB corporates, remaining at present inflated prices for ever.

        But what happens if the feared collapse occurs?

        The later claimants will not get what they might have expected. 

         Indeed, it is the potentially perilous state of insurance industries in Europe and Japan (after years of negative rates and financial repression), that is the basis of reasonable expectations that savings rates in these countries would rise far into a post-crash scenario.  

 

    On the other hand, there might be so much demand for capital re-construction (after the revelation of massive mal-investment), that real equilibrium interest rates could start to rise.

       Another potential Ponzi-like scheme on the Shiller definition may be identified in the private equity arena. 


Private equity bubble – the Shiller/Buffet critique

       A feature here is the flood of new money into this sector drawn by advertised high returns to data; this is in practice much more than the industry can absorb (find real opportunity to match). 

       Warren Buffet is not the only critic of how all this is accounted for – and the justifiability or not of fees being paid out to the founders and managers on idle cash.

      Moreover, past high returns in private equity (based on high leverage rates during asset inflation, when companies previously taken private can be sold off at dazzling prices) are no guide to the long run. 

       Surely, many of the participant passive investors in this industry realize this, in their heart of hearts.  But they are looking forward to the continued buy-outs, at ever rising prices.    

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Executive Summary

Exogenous shock – including so-called trade war (a misleading term for present China-US situation) – has never been the key catalyst to recession in the small sample size which makes modern business cycle history.  Much more important is the hangover from earlier monetary binge, including what Robert Shiller describes as bubble-Ponzi finance.  This cycle is not likely to prove an exception.

Interconnected risks related to potential slump ahead for BBB corporate bonds and BTPs are a key factor to monitor in assessing financial quake risks.  This quake would shake the yen this time, unlike in the earlier asset inflation cycle of this century.  Japan and Europe are plagued by Ponzi-finance risks in their insurance sectors.

Gold has lost lustre under influence of China devaluation fears, strong dollar, and risk back-on.  All of this is transitory.