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MACRO: SPOTTING THE UNPOPPED BUBBLE

08-28-2019

None of the below is investment advice.
 

In consideration of big picture thinking, there are parallels in this year’s daily chart and the weekly chart (YTD) of 2008. September 2008, as you will remember, was the beginning of the end for many global economies. So what happened and what’s happening now? The clear catalyst from 2008: the interest rate was hiked 4 times by 25 bps each over the course of 2006 to 5.25%. By EOY 2008, the rate was down to 0%. The problem was refinancing the debt, as I will explain later in fairly simple terms.

 
Last year, the economy stumbled 20% from this time until the end of the year. I believe this was nearly completely caused by the spectre of a rate hike. What saved us last year, and what will save us this year, is a decrease in rates. I believe USA can afford it, and it will likely happen in early Q4 to stave off a drop, but what will be the lasting effects? This is what will determine Fed policy.
 
Macroeconomics 101 
 
We are taught that country’s competitive advantage determines the value of its currency. If the country has positive net exports, the economy and the domestic currency should appreciate relative to a control group. In America, I would wager to say that the competitive advantage is capitalism in the forms of the services and tech industries. 
 
Capitalism suits entrepreneurs well. In America, those that make the biggest decisions typically take the biggest risks and are paid the most, including those overseeing public programs. If a manger made roughly the same amount whether they performed poorly or very well, there would be no significant incentive to take risks and produce (i.e. innovate). Contrariwise, capitalism handsomely rewards the person that is most productive – the investor that makes the educated bet, the attorney that merges the largest companies, or the developer that delivers “Platforms as a Service”. The private sector in USA is set up mostly to drive the public sector and the public sector serves the private sector, whereas many other countries are prey to the reverse. 
 
Before I get too far down the rabbit hole, let’s get back on track.
 
The US dollar is relatively strong due to a relatively high (and stable) interest rate. This helps us import, but not export. Many of my colleagues discuss the beguiling $22 Trillion of debt and nearly $1 trillion budget deficit each year from here, but the question is always how do we finance it all? GDP is currently under $20 Trillion, so we have more debt than revenue (since 2015), while losing money every year. This fascination is the result of Quantitative Easing, where the Fed printed money to buy bonds, injecting new capital domestically. 
 
The issue of the trade war… the Federal Reserve has this ugly situation where the US is purportedly losing our competitive ability globally at a time where we need capital most. If we lose our competitive edge, capital sources will probably dry up. This, however, is a long term view. Currently, the US GDP is dominated by Private consumption and Private investments. If the tariffs affect these two significantly (hard to define what is significant), the house of cards might fall. Another worry is a tax cut and its affect on the budget deficit long term. Hence, going into next year’s election, politically charged decisions could extend the leverage we are observing today. Because of the US government structure, the Fed isn’t mandatorily motivated by the executive branch of the government. Thus, politics in the US has less influence on policy than in almost every other country. Based on all of these checks, US is in good shape. 
 
BUT, what about China? Reports show that total debt to nominal GDP (as reported) was just over 300%. The situation is dire, as GDP growth is decelerating at the same time that the country is trying to improve per capita GDP and the Yuan is dropping in relative value. It would appear that macro traders are voting with their capital, withdrawing from China in favor of the US. Net Exports have historically been an important part of China’s GDP growth, but so to has private consumption.
 
Here, I could talk about microeconomics; about current Texas ratios at international banks and consumer debt, but these details are highly speculative and are probably weak if not spuriously correlated to a bubble popping.
 
To wrap up the thought on China, let me drop this bomb on you: Fixed mortgage rates don’t exist in China. Everything is variable, with most at 20 year maturities, though none are interest only. Could this be the catalyst to the next global recession? I think the odds are relatively high.
 
Back to the US financing discussion…
 
Financing the debt will be the stimulus driving us away from a downturn, but financing is painful in the short run. We can afford a lower interest rate and possibly lower taxes, but very often such measures are equivalent to ‘pushing on a string’. The easiest ways out of a downturn are to redistribute wealth from the wealthy (via tax), lower interest rates, print money (if it’s still relatively valuable), restructure the debt, and/or cut government funding. 
 
To attract investors and capital, interest rates must rise more or drop less than other countries’ rates. This is true of a country, business or natural person. If the rate rises and an entity defaults, the lender makes a margin call for other assets outside of the collateral the loan was taken against or the collateral itself is seized. In this case, if the loan is large enough, a fire sale occurs as the indebted is raising capital. This creates a vicious cycle wherein the collateral is sold off to meet the demand, dropping values of similar assets by way of panic selling. This is the result of bubble formations. It’s very hard to see a bubble that hasn’t been popped.   
 
Rising rates both in England in 1993 and USA in 2006 were the [major] culprits of the recessed economies. In both cases, significant amounts of Adjustable Rate Mortgages (ARMs) became too expensive to finance and went into default, causing the vicious cycle described above. To redeem the economy in 2008, USA both printed money and lowered interest rates. Again, most professionals look at that and think we are all doing great again. This is naive capitulation.
 
Firms across the country are levering up with cheap debt. Banks are creating record loan volume, chasing higher leveraged Returns on Equity. In fact, as of August 23, there is $2.353 Billion of loans created by commercial banks, up 49% from 2008. So, Can we possibly raise interest rates? No chance. This would put those people that push the limits of debt over the edge to the destruction of the rest of us.
 
What will the aftermath of a pop look like? Based on historical evidence, it will probably last around a year and lead to a higher high for asset values in the future. However, the debt generally doesn’t go away and the new highs will be largely built on more debt, and may be financed by other countries (about 16% of US debt is foreign) 
 
As an aside, the worst place to be levered when the bubble pops is illiquid investments. You’ll be trying to sell, and there will be no buyers, even if the asset you hold has value. However, if you can arrange for a white knight to come put equity into such an asset, you have essentially refinanced the asset. This is akin to a short squeeze. The question then becomes will the underlying asset continue to lose value? Finding a white knight is critical for assets unrelated to a crisis; my grandfather’s axiom of “Always have a Plan B” comes to mind.
 
On a macro perspective, the equivalent of this is when a country raises rates significantly to attract capital rather than devalue domestic currency. This happens more frequently than you think, but two situations that stand out are England in 1993 and Russia in 1998. In both cases, a white knight couldn’t be found, and short sellers prevailed. 
 
Further Discussion in Part 2

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