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Priced for perfection

Commentaries & Views

The stock market has now priced in a perfect resolution for all of its erstwhile perils. Wall Street Shills would have you believe that since the Fed has turned dovish it will always be able to push stocks higher. The trade war is about to reach a peaceful conclusion and that will be enough to fix all that ails the global economy. A no-deal Brexit is off the table and a smooth transition out of the EU will occur. Peace will soon break out in Hong Kong and its troubled economy will have no contagious global economic effects. And, there will be a sharp rebound in EPS growth from the current earnings recession because…well…just because we need one.

However, beneath the surface of this economic charade the carcass is rotting and the stink can be smelled by anyone who isn’t willingly holding their nose. To this point, the leveraged loan market, which consists of loans made to highly indebted and barely solvent entities, has seen an increase of 100% since 2007, according to the Bank for International Settlements.

There are about $16 trillion worth of U.S. business debt, about 1/3rd of which is comprised of leveraged loans and bonds that are rated junk. Half of the bonds that are in the category of Investment Grade have a rating that is BBB, which is just one level above junk. If that isn't scary enough, dealers are willing to hold in inventory $12 billion of these types of loans, according to Bloomberg.

The salient question is: what will happen come the next recession when panicked holders try to sell trillions of dollars' worth of distressed debt to a market that currently provides liquidity for just .075% of the market?

The Conference Board’s Leading Economic Index declined for a third consecutive month in October, and its six-month growth rate turned negative for the first time since May 2016. Meanwhile, Washington D.C. is mired in self-destruct mode. There is still no passage of a phase one trade deal even though one was announced on Oct. 11th with much fanfare. No passage of the USMCA trade deal, even though it has been sitting on Nancy Pelosi's desk for a year. No passage of a budget deal; and so, the government is forced to fund operations by passing continuing resolutions. This C.R. that was just passed only funds the government until Dec. 20th.

Maybe we should be happy that Washington is broken because when it works all they can agree on is how to spend a lot more money. To this point, October government spending hit a record $380 billion, which led to a 34% jump in the year over year deficit and caused $134.5 billion worth of red ink to be spilled in one month. The U.S. is mired in permanent QE, is posting trillion-dollar deficits without end, has waring political parties and operates its government without a budget. We are sadly looking more like a banana republic every day.

Investors have placed their faith in a Fed that has continuously proven its incompetence. Former Fed Chair Janet Yellen avowed not too long ago that there would not be another financial crisis in our lifetimes. However, she is now warning, "... the odds of a recession are higher than normal and at a level that frankly I am not comfortable with,” she was quoted saying this at the World Business Forum on Nov. 21st. What I find most disturbing about her comments made was what she said about retirees and savers. Yellen actually bemoaned the fact that people are forced to save money in the bank and get nothing for doing so. In fact, she was actually concerned that they are getting penalized for doing the right thing and falling further behind inflation. What!?

Ms. Yellen raised interest rates just 50 bps in her total four-year tenure at the Fed. But only now she is worried about savers and the Fed’s role in fostering the wealth gap? But what she has not, and cannot admit to, is how bad the next recession is going to be. While she did elude to the fact that central banks no longer have room to lower borrowing costs, she fails to understand that her willingness to keep offering free money for many years likely means her recession prediction is really a depression forecast. This is based on the record debt levels and historic asset bubbles that have been engendered by the Fed's actions.

As the march towards global recession proceeds onward, the composite EU PMI for both manufacturing and services released last Friday fell to 50.3 from 50.6. Orders fell for the third straight month, and employment growth also slowed. The Australia, UK and Japan PMIs all show these economies are still contracting. The Official NBS Manufacturing PMI in China fell to 49.3 in October, from the previous month's 49.8. Any reading below 50 shows economic contraction. The only slightly better news was found in the U.S. flash services sector purchasing managers index in November. It rose to 51.6 from 50.6, but still is indicative of an economy that is barely growing. Even the “Better than expected” Durable Goods orders being pumped on financial news networks isn’t the real story. While the headline month over month reading for October climbed by 0.6%, the year over year number declined by 0.7%. And, the important Core Capital Goods New Orders figure fell by 0.8% YoY. Falling capital goods means business are not investing in productive assets and GDP growth will indeed suffer as a result.

Wall Street shills keep wishing for a turn in the global economy in 2020 because a booming rebound has already been priced into equities. But the only turn we are getting so far is one to the downside. That is going to be really bad news for the buy and hold crowd.

I want to close with a bit of central bank hypocrisy. The following is an excerpt from a paper published by two economists at the St. Louis Fed, Scott A. Wolla and Kaitlyn Frerking. They warned about the potential dangers involved when a nation's central bank buys its own debt.

“A solution some countries with high levels of unsustainable debt have tried is printing money. In this scenario, the government borrows money by issuing bonds and then orders the central bank to buy those bonds by creating (printing) money. History has taught us, however, that this type of policy leads to extremely high rates of inflation (hyperinflation) and often ends in economic ruin.”

The paper published this month never acknowledges that this is exactly what the Fed has done and continues to do to this day. Not just a little bit but in a big way. The Fed has already permanently monetized nearly $4 trillion worth of debt and it is just getting started down this pernicious path. This strategy is a page taken from the how-to-be-a-banana-republic playbook and has been repackaged by some far-left politicians and Sudo-economists and renamed as the Modern Monetary Theory. MMT is just a euphemism for debt monetization. Nevertheless, no matter what you call it; creating new money from nothing to purchase government debt has never worked in the history of economics and has always led to economic ruin.

There will be times when debt will be explicitly restructured (deflation) and other secular periods consisting of inflationary defaults (MMT, QE, Helicopter Money or whatever name Jerome Powell is willing to put on it.

Investors need to model these dynamics to make sure they are on the correct side of the cycle depending upon how the government is defaulting on this debt.

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