KW: From John Mauldisn column once more

In less than 12 months we have seen the Fed raise rates, cut rates, shrink its balance sheet, expand its balance sheet, inject liquidity, withdraw liquidity, and do who knows what else behind the scenes. Either Fed officials are confused or we are at some kind of economic turning point. Or possibly both—there is no playbook. At a minimum, I think we are at a turning point and the Fed is having to improvise policy as events dictate.

Six Bears

We’ll start by noting six events/trends, in no particular order because they’re all important.

First, worldwide economic growth is weakening, with some key markets approaching recession. This week the International Monetary Fund reduced its 2019 global growth forecast to 3.0%, the lowest since 2009 when recession was still underway. They think it will improve to 3.4% in 2020. That’s better than the alternative but not much of a recovery.

Note, that’s the global average, which would be lower without considerably above-average growth in China and India. IMF pegs US growth at closer to 2%, with Japan and most of Europe even lower. Problems in China could worsen the IMF’s outlook quickly.

Second, if you don’t want to believe the IMF (and there’s reason to be skeptical), look at global shipping trends. The economy is increasingly digitized but the movement of physical goods is still its circulatory system. The latest Cass Freight Index data shows global blood pressure is dropping, when looking at the trends on both the total shipment and expenditures basis. Shipping volume has been down for 10 straight months on a year-over-year basis (hat tip Peter Boockvar).

Third, monetary and fiscal stimulus is proving less effective. Not that it was so great last time, but it helped. It also had side effects that may have reduced its usefulness. You can’t force credit on those who don’t want or need it, even at zero or negative rates. The European Central Bank and Bank of Japan are learning this the hard way.

On the fiscal side, the 2017 US corporate tax cut helped but the trade war offset some of it. Other countries, because they don’t have the dollar’s “exorbitant privilege,” have less fiscal flexibility than the US. Hence we see, for instance, Mario Draghi practically pleading with European governments for more stimulus spending and those governments shrugging their collective shoulders. They can’t do it.

Fourth, the US budget deficit is huge and growing. As I’ve shown, a recession in the next few years will likely push it far higher as revenue drops and spending rises. The Treasury’s increased borrowing is also having an effect on credit markets.

The investors who aren’t plunging into stocks seem to be holding more cash. Money market balances have been creeping up. A little caution might seem to be in order, but it matters where investors store their cash. If it’s not available for the banking system to grease its wheels, bad things can start happening. (More on that in a minute.)

Fifth, we are starting to see confidence break in important corners of the capital markets. The WeWork IPO turned into a fiasco. In fact, the entire company looks just like the train wreck Grant Williams said it would be. I don’t see how anybody could look at the business model of WeWork and not see an obvious hustle. What does that say about the supposedly brilliant venture capitalists who threw cash at the company? Nothing good. Though maybe they knew what it was and just figured they could flip their shares to the public before it fell apart. If so, they appear to have been wrong.

But the broader point is that once-invincible Silicon Valley unicorn companies are losing their allure. It turns out business success is hard when you have to actually, you know, generate more revenue than expenses. Other WeWork-like stories are probably coming. Nor is it just unicorns; look at Boeing’s struggle to fix the 737 Max planes, and the shortcuts we are learning it took. These are bad signs for a market that needs earnings growth if it is to maintain current prices, much less see them rise further. (Note: I would not be afraid at all of flying a 737 Max on a US carrier. Just saying…)

Sixth, as I was wrapping up this letter, the latest Ambrose Evans-Pritchard column hit my inbox. He read the IMF’s latest financial stability report and came away with a distinctly darker view:

The International Monetary Fund has presented us with a Gothic horror show. The world’s financial system is more stretched, unstable, and dangerous than it was on the eve of the Lehman crisis.

Quantitative easing, zero interest rates, and financial repression across the board have pushed investors—and in the case of pension funds or life insurers, actually forced them—into taking on ever more risk. We have created a monster.

There are ‘amplification’ feedback loops and chain-reactions all over the place. Banks may be safer—though not in Europe or China—but excesses have migrated to a new nexus of shadow-lenders. Woe betide us if this tangle of hidden leverage is soon put to the test.

According to the IMF, globally there is about $19 billion of “debt-at-risk,” in which a global slowdown and/or recession would render borrowers unable to make their payments. I have written a great deal about the high-yield and leveraged loan market in the US, but globally it is much worse.

“In France and Spain, debt-at-risk is approaching the levels seen during previous crises; while in China, the United Kingdom, and the United States, it exceeds these levels. This is worrisome given that the shock is calibrated to be only about half what it was during the global financial crisis,” it said.

…In Europe, almost all leveraged loans are now being issued without covenant protection. The debt to earnings (EBITDA) ratio has vaulted to a record 5.8. Is the ECB asleep or actively promoting this?

The IMF’s directors call for “urgent” action to stop these excesses but in the same breath suggest/admit that the cause of leverage fever is the easy money regime of the authorities themselves—that is to say the central banks and their political masters who refuse, understandably, to permit debt liquidation and to allow Schumpeter’s creative destruction to run its course in downturns.

This is all going to cause precisely the crisis that I mentioned last week with pension funds. There is no way they can make the returns they need to meet their obligations. The next serious global recession/bear market will create a death spiral for many pension funds, requiring extraordinarily painful bailouts, to the point where they may simply default on the obligations. Don’t think that it can’t happen.

So that’s a quick survey of where we are. Now let’s add something else to the mix.