Stagflationary Crisis: Understanding The Cause Of America’s Ongoing Collapse

This report was originally published by Brandon Smith at Alt-Market.com

It is at times frustrating, but also interesting, to witness the progression of the mainstream’s awareness of economic crisis within the U.S. over the years. As an alternative economist, I have had the “privilege” of perching outside the financial narrative and observing our economy from a less biased position, and I have discovered a few things.

First, the mainstream economic media is approximately two to three years behind average alternative economists. At least, they don’t seem to acknowledge reality within our time frame. This may be deliberate (my suspicion) because the general public is not meant to know the truth until it is too late for them to react in a practical way to solve the problem. For example, it is a rather strange experience for me to see the term “stagflation” suddenly becoming a major buzzword in the MSM. It is almost everywhere in the past week ever since the last Federal Reserve meeting in which the central bank mentioned higher inflation pressures and removed references in its monthly statement to a “growing economy.”

For those unfamiliar with what stagflation is, it is essentially the loss of economic growth in numerous sectors coupled with a marked spike in consumer and manufacturing costs. In other words, prices keep going up while employment growth, wages, production, etc. decline.

I have been warning about a stagflationary crisis as the ultimate result of central bank bailouts and QE for many years. In 2011, I published an article titled ‘The Debt Deal Con: Is It Fooling Anyone?’ in which I predicted that the Fed would resort to a third round of quantitative easing (they did). This prediction was based on the fact that the previous two QE events had not resulted in the kind of results the central bankers were obviously looking for. At that time, the stock market remained a dubious mess on the verge of a renewed crash, the U.S. debt rating was about to be downgraded by S&P, true employment growth was dismal, etc. The Fed needed something spectacular to keep the system propped up, at least until they were ready to trigger the next stage of the collapse.

In that same article I also discussed the inevitable end result of this stimulus bonanza:  Stagflation.

QE3 was a dramatic con, along with Operation Twist. The Fed got exactly what it wanted — an unprecedented bull market rally in stocks and temporary stability in bond markets. As stocks jumped higher and higher despite all negative fundamental data, the mainstream simply regurgitated the fool’s narrative that a “recovery” was upon us. But now things are changing and no illusion lasts forever.

The second observation I have made is that central banking elites and their cronies tend to give warnings on great economic shifts, but only about a year before they occur. They do this for a few reasons. One, because they are the people that engineer these crisis events in the first place and it’s not very hard to predict a calamity you helped create. Two, because it makes them appear prophetic when they are not, while at the same time giving the public as little time as possible to prepare. And three, because it gives them plausible deniability when the crisis actually happens, because they can claim they “tried to warn us”, though unfortunately it was too late.

The Bank For International Settlements warned of the derivatives and credit crash in 2007, about a year before the disaster struck. In 2017, former Fed chairman Alan Greenspan warned of inevitable “stagflation not seen since the 1970s.” In later comments, he and others attributed this potential crisis to the policies of Donald Trump.

It is important to note that stagflation is entirely the fault of central bankers and not the presidency, though the White House has indeed aided the Fed in its efforts regardless of who sits in the Oval Office.

Years ago there was a rather idiotic battle between financial analysts over what the end result of the Fed’s massive stimulus measures would be. One side argued that deflation would be the outcome and that no amount of Fed printing would overtake the vast black hole of debt conjured by the derivatives implosion. The other side argued that the Fed would continue to print perpetually, resorting to QE4 or possibly “QE infinity” and negative interest rates as a means to stave off a market crash for decades (like Japan) while at the same time initiating a Weimar-style inflationary bonanza.

Both sides were wrong because they refused to acknowledge the third option — stagflation.

The Fed clearly found a way to direct inflationary pressures into certain parts of the economy while allowing deflationary pressures to weigh down other parts of the economy. They also are NOT sticking to their previous strategy of holding interest rates down while pumping up markets with talk of further QE.

Deflationary proponents used to sarcastically argue that if people really believed that inflation would be the consequence of Fed activities then they should jump into the housing market because they would make a mint on price increases. Well, this is exactly what has happened. Home prices have continued to surge despite all fundamentals, including dismal home buyer stats which hit an all time low in 2016 and have barely recovered since.

I use home prices as a prime example of stagflation because the housing market constitutes around 15 percent to 18 percent of total GDP in the U.S. Since items like food and fuel are not counted in the calculation of the CPI index, housing should be the next consideration. Signs of stagflation in housing are a sure indicator of stagflation in the rest of the economy.

The manner in which housing is calculated in the CPI and GDP is a bit odd, of course. Housing is not included in these stats in terms of home purchases annually. In fact, home purchases and improvements are treated by the Bureau of Labor Statistics as an “investment” and not as a consumer purchase, which means they are not considered a measure of inflation. However, home values in terms of their “rental cost and change in cost” are counted in CPI.

As we all know, rent prices across the country have been skyrocketing in the past few years along with home prices, while at the same time home buyers have dwindled and the millennial generation is staying at home with mom and dad rather than paying out monthly for homes and apartments. That is to say, in a normal economic environment fewer buyers should result in lower prices, but this is not what has happened. The question is, how has the Federal Reserve and QE contributed to this example of stagflation?

First, the Fed’s artificial support for Fannie Mae and Freddie Mac after the derivatives debacle allowed for the continued propping up of the housing market when bad debt should have been allowed to cycle out of the system and house prices should have been allowed to fall.

Second, the Fed’s bailout funding of Fannie Mae directly benefited companies like Blackstone, which has become a partner with Fannie Mae and one of the largest buyers of homes in the country. Blackstone has not purchased tens of thousands of homes for resale, but for conversion into rentals. Blackstone’s vast purchases of single family homes has artificially boosted home values across the nation and given the false impression of a housing recovery that does not really exist.

Third, a very interesting discovery; while the central bank under Jerome Powell has become more and more aggressive in its balance sheet reductions, a move which has directly contributed to the recent decline in stock markets, there is one asset class that the Fed has been ADDING to its balance sheet — Mortgage Backed Securities (MBS).  These purchases tend to take place directly after older MBS have been allowed to roll over, meaning, the Fed is maintaining a relatively steady number of MBS while it is dumping other assets.

MBS represent around 40 percent of the Fed’s total balance sheet, and the Fed’s continued fiat support of the MBS market helps explain why home prices refuse to fall despite negative fundamentals. It is also interesting to me that the Fed has chosen to dump certain assets that appear to be causing a downward reaction in stock markets and other sectors while maintaining assets that keep housing prices high. It’s almost as if the Fed wants stagflation…

Finally, while the Fed’s interest rate hikes do not traditionally have a direct correlation to home mortgage rates, there is an indirect correlation. Fears of inflation sometimes ironically create inflation, and as the fed raises interest rates, mortgage rates tend to track. In 2018 mortgage rates have spiked, climbing 48 basis points since the beginning of the year.

This contributes to higher home prices as well a perceived rental values according to the CPI.

The source of almost every instability within our economy can be tracked straight back to the Federal Reserve and the “too-big-to-fail” corporations they bailed out after the credit crash. The current stagflationary development is no different. Stagflation will ultimately result in extreme price increases on necessary goods and services far beyond what we have already seen while the public’s ability to keep up with those prices will falter.

The fact that this issue is FINALLY hitting the mainstream should be concerning to everyone. For when a crisis development is discussed in the mainstream, it means we are on the verge of that crisis reaching its nexus. In June the Fed will raise interest rates yet again despite failing fundamentals. The Fed will continue to cite inflationary pressures, and the Fed will continue to cut its balance sheet. There is no room for delusion on this anymore. The Fed will not stop on its current path. In the meantime, central banks will continue to blame external forces such as trade wars and Trump era policies for stagflation while ignoring the trillions in fiat they have expertly poisoned our financial system with.

All bubbles collapse, but not all bubbles collapse in the exact same way. I believe the Fed has created a perfect storm of combined deflationary and inflationary factors; an economic bomb to surpass all economic bombs.

******

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You can contact Brandon Smith at: brandon@alt-market.com

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How GDP Became A Joke, In One Chart

For all the rhetoric about above-trend US growth, one month ago UBS shattered the narrative of surging GDP by showing just one chart, which revealed that excluding contributions from energy investment, which are about to hit a brick wall now that the price of oil has peaked and is reverting lower once again, US growth for the past 2 years has been slowing.

On the other hand, things get even more complicated thank to a chart released yesterday by UBS" global chief economist Paul Donovan who makes a point we have repeatedly underscored over the past decade, namely that economic data is largely worthless, and any instant snapshot reveals more about the political and "goalseeking" climate of the agency releasing the "data" than about the underlying economy itself.

As Donovan shows, here are the no less than 6 answers one gets to the question of "how fast was the US growing at the start of 2015?."

By way of context, recall that this was the quarter when the US was blanketed by deep snow, and when every "expert" was rushing to convince those who bothered to listen that the economy would suffer a sharp slowdown as a result of the weather and nothing but the weather (and yes, that included UBS). And when the number was first reported, that was indeed the case: with Q1 2015 GDP reportedly growing only 0.2%. The problem is that within just over a year, that 0.2% initial GDP print turned to -0.7%, before subsequently surging to 2% and ultimately 3.2%!

Here is the sarcastic take of UBS" own chief economist on this GDP travesty, which is even more sarcastic  - and ironic - considering his entire job is to predict the exact number associated with said travesty:

Economic data is not very precise. Economists are trying to hit a target that is moving rapidly. Economic data is being revised more often, and the revisions are larger than in the past. The following chart shows annualized US GDP growth in the first quarter of 2015.

 

Growth was initially reported very weak, below consensus and barely moving. Then the data was revised to show the US economy was shrinking – and shrinking a lot (the number was –0.7% annualized). Then it was revised to show the economy was shrinking a bit. Then it was revised to show the economy was growing, but a long way below trend growth.

 

The growth number was then revised to be basically in line with trend growth. Now, US growth at the start of 2015 is thought to be 3.2%.

 

So which number in the range of –0.7% to 3.2% is the economist supposed to be forecasting? An economist predicting 3.2% growth when the data was first released would have been ridiculed. According to the latest information we have, that economist would have been right.

In other words, that terrible weather which at the time was used to justify why the economy ground to a halt - when in reality it was all a function of China"s credit impulse crashing - would eventually serve as a the catalyst to grow the economy at a pace that has been recorded on just a handful of occasions in the past decade.

No wonder then economists - especially those who work at the Fed but all of them really - their predictions and their analyses have become the butt of all jokes; and by implication, no wonder traders and algos no longer respond to economic "data."

China Hits A Brick Wall: For First Time Ever, Record Chinese Credit Creation Fails To Stimulate Economy

Submitted by Gordon Johnson of Axiom Capital

We believe that exhibit 1 says a lot: it shows that despite a record level of new credit issued by China’s PBoC YTD through Oct. 2017 (which stands in stark contrast to government authorities continued statements that China is de-levering), China’s economic backdrop is currently experiencing:

• (a) monthly construction new start (commercial + residential + office) growth slowing Y/Y (Ex. 2),


• (b) monthly fixed asset investment growth slowing Y/Y (Ex. 9),


• (c) monthly cement output slowing Y/Y (Ex. 5),


• (d) monthly electricity production slowing Y/Y (Ex. 6),


• (e) monthly M2 money supply growth slowing Y/Y (Ex. 7),


• (f) monthly household loan growth slowing Y/Y (Ex. 8),


• (g) monthly private fixed asset investment growth slowing Y/Y (Ex. 10), and


• (h) monthly home price growth slowing Y/Y (Ex. 12) – in fact, select data points have turned negative Y/Y.

Stated differently, while the lion’s share of our client base continues to tell us, with respect to our bearish views on China… “President Xi Jinping will simply stimulate more if/when things get bad”, we would highlight, again as detailed in Ex. 1 below, China stimulated at a record pace in 2017, yet it did not resonate in improved economic activity (in fact, the exact opposite appears to be unfolding – i.e., economic growth is slowing across a number of data points).

Furthermore, underpinning our view that China’s debt stimulus was targeted specifically at the months preceding the 19^th Party Congress in Oct. 2017 (i.e., when President Xi Jinping consolidated power to become the strongest Chinese leader since Mao Zedong), implying we may see a phase of debt fatigue, we note that in the first 10 months of 2016, incremental credit issued in China on a month-over-month (“M/M”) basis was negative three times (i.e., May, July, and Oct.), and averaged $189 billion on a monthly basis; yet, in the first 10 months of 2017, incremental credit issued on a M/M basis was positive in each month outside of Oct., and averaged $429 billion on a monthly basis (in Oct. 2017, the month the 19^th Party Congress concluded, new credit issued fell by $11.9 billion M/M).

WHAT DOES IT ALL MEAN? The broader point is… when you issue an unprecedented amount of credit targeted at a growing number of negative ROI projects multiple decades, at some point the law of diminishing marginal returns sets in (since 1/1/09, China’s credit has grown by CNY153.9 trillion while GDP has grown by a much more modest CNY 48.5 trillion, or a multiple of 3.17x, meaning a lot of bad investments have stacked up over the years) – keep in mind that China’s $3.6 trillion in credit issued in 2017 YTD through Oct. is more than the entire developed world combined. Put in the simplest of terms, at some point the incremental dollar in new credit created actually does more harm than good.

Ex. 1: China New Credit Created YTD Through Oct.

Note: Credit created = TSF + Local Gov"t Debt.
Source: PBoC; NBS; ChinaBond.

SO WHERE FROM HERE? When considering China hit the afterburners on new credit issuance in 2017, yet the impact seems to be quickly fading, it would appear we may have reached the point of “no return” (while Consensus, at this point, seems completely oblivious to this possibility, the recent sell-off across the Chinese stock markets suggest investors on-the-ground in China may be catching on).

CONCLUSION: In the face of China’s TTM 3Q17 credit as a percentage of GDP coming in at 250%, to “keep the party going”, Xi Jinping would have to force new credit issuance far in excess of $4.0 trillion in 2018 (which could trigger a number of ratings downgrades, as well as a reassessment by the IMF of China’s “market economy” status).

Moreover, given what we’ve seen this year – i.e., 101.7% Y/Y new credit issuance growth YTD through Oct. 2017 – it seems the level of credit necessary to stimulate growth in China could prove elusive at this point (we don’t recall any economist’s forecasts exiting 2016 pointing to China’s new credit issuance more than doubling Y/Y in 2017, yet that’s exactly what’s happened – had this been our base case, we would have expected all economic indicators in China to be moving substantially higher at this point in the cycle). Thus, to the thesis that rests on a view that: “Xi will just stimulate more”, we would argue that the extent of the stimulus necessary may be so high at this point that President Xi Jinping may have lost sight of how much debt he needs to “get things going again”. Should this prove to be the case, China’s economy will continue slowing, putting pressure on bulk commodity prices, and, ultimately, industrial/steel stocks (CAT, URI, FMG, RIO, X, CLF, GATX, and TRN, all of which we have SELL ratings on).

HOW’S THE DATA LOOK IN THE FACE OF CHINA’S RECORD 2017 CREDIT “BINGE”? So how do the data points look? Well, here’s a few (we feel the charts say it all)…

Ex. 2: Monthly Construction Starts (Residential + Commercial + Office)

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 3: GDP Growth Internals - China (FAI, Industrial Production, & Retail Sales)

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 4: China Monthly Steel Production by Year

Source: World Steel Association (WSA), National Bureau of Statistics (NBS), Axiom Capital Research.

Ex. 5: China Cement Output

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 6: Y/Y Growth in Electricity Production by Month

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 7: China M2 Money Growth, Y/Y% - Multi Decade Low (bearish)

Source: Peoples" Bank of China (PBOC), Axiom Capital Research.

Ex. 8: 3MMA Household Loan Growth, Y/Y%

Source: Axiom Capital Research, Bloomberg, National Bureau of Statistics.

Ex. 9: Monthly Total Fixed Asset Investment and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 10: Monthly Private Fixed Asset Investment and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 11: Private Investment in Industrial Sector and Y/Y Growth

Source: National Bureau of Statistics, Axiom Capital Research.

Ex. 12: Average Price Change of New Residential Buildings, by Tiered-Cities, %Y/Y

Source: National Bureau of Statistics (NBS), Axiom Capital Research.

In short, we feel China could be the “black swan” that ruins the stock market rally party for many in the industrials space. Caveat emptor.

David Stockman Exposes "The Illusion Of Growth"

Authored by David Stockman via The Daily Reckoning,

The Wall Street Journal published a superb example of hopium recently in a sunny-side-up story entitled “U. S. Manufacturing Rides Rising Tide, Buoyed by Global Growth, Optimism.”

Indeed, this lazy cheerleading excuse for journalism captured the sum and substance of why the punters keep buying the dips despite troubles gathering all around.

That is, as the tax bill falters, the crusade to remove the Donald from office gathers strength, the Fed moves into balance sheet normalization and instability breaks out all over the world from the Persian Gulf to the Korean peninsula.

You would think the title says it all, but the WSJ was not nearly done. It cited a 156,000 pick-up in manufacturing employment since last November, rising energy and commodity prices as evidence of a booming global economy and double digit growth in business investment earlier this year, among other things.

American manufacturing has picked up pace over the last 12 months thanks to steady global economic growth, a rise in energy and other commodity prices, and increased business confidence.

 

Although progress isn’t being felt by all industries, makers of items ranging from bulldozers to semiconductors to food products are on the upswing as various measures of spending, sentiment and employment have climbed, while stock markets have hit record highs.

Yet every one of the trends cited in the WSJ article are less than a year-old. They coincide with the Great Coronation Boom in the Red Ponzi ( the run-up to Xi Jinping’s ascension to total power at the 19th Party Congress); represent only a minor up-tick from the 2014-2015 global deflation; and in the context of the current feeble recovery from the 2008 crisis represent nothing at all to write home about.

Indeed, I am confident that as the Red Ponzi goes into a stabilization and credit containment mode, as is already evident from the October economic data (fudged as it is), that the slight lift to global activity engendered by the latest China credit impulse will quickly fade. And with it the entire trading meme reflected in that WSJ puff piece.

But short of that yet to unfold but predictable global mini-cycle, the actual data on U.S. manufacturing output trends through September reveal nothing to smile about.

In fact, overall U.S. manufacturing production is still down 4.3% from its pre-crisis high back in December 2007, and was no higher last month than it was three years ago in November 2014.

Of course, global commodity prices did perk up during the last 18 months. Not only did they rebound off the bottom in normal cyclical fashion, but the hands of China’s central bank were more than a little evident.

When they unleashed the latest credit tsunami in early 2016, the hordes of Chinese speculators dutifully bought up all the iron ore, copper, steel, diesel fuel etc that was to be had and which could be readily financed in cash and futures markets alike.

Presently, they will be selling, too, as the post-coronation signals coming out of Beijing become unmistakably clear.

Nor is the above even the half of it. If you look at output of U.S. consumer goods, which is much less attached to the global commodity/industrial cycle, the rising tide of manufacturing output is nowhere to be seen.

In fact, consumer goods production has flat-lined for the last two years, and is still below where it was at the pre-crisis peak.

The same is true of manufacturing employment. There is no “rising tide.” Thus, between October 2007 and the April 2010 bottom, the U.S. lost 2.3 million manufacturing jobs — representing a loss of 76,000 high paying jobs per month.

By contrast, during the three years since October 2014, the U.S. has recovered about one-tenth of that loss — with manufacturing jobs expanding at a rate of  just 6,000 per month. That is to say, the WSJ was essentially trumpeting statistical noise.

We are now 120 months from the pre-crisis peak in November 2007. Yet the compound annual growth rate of manufacturing is just 0.08%. Which is to say, nothing.

By contrast, every prior peak-to-peak recovery pales that tiny beep of white noise into insignificance. Thus, between July 1981 and the July 1990 peaks, industrial production expanded at 2.18% a year during the so-called Reagan boom.

Likewise, during the Greenspan tech boom of the 1990s, the compound annual growth rate (CAGR) for industrial production was 4.02%. Even during the highly artificial and unsustainable Greenspan housing boom between December 2000 and November 2007, the index rose at a rate of 1.31% per year.

So Thursday’s industrial production number for October actually signaled that the U.S. industrial economy remains dead in the water. It is floundering in a manner that is off the historical charts — and not in a good way.

But stocks keep marching higher.

In short, financial information has been totally corrupted by the distortions of monetary central planning. Accordingly, when the third and greatest financial bubble of the 21st century collapses — and it is coming soon — it will also arrive as a great surprise.

As I keep insisting, monetary central planning systematically falsifies asset prices and corrupts the flow of financial information.

That’s why bubbles seemingly inflate endlessly and massively, and also why financial crashes and economic corrections appear to come out of the blue without warning.

Back in the winter of 1999-2000, for example, we were allegedly in the midst of a “new age economy.” The revolution in technology then underway, it was claimed, meant all historic valuation benchmarks — like P/E multiples, cash flow and book values — were irrelevant to stock prices.

Likewise, in the fall of 2007 there was nary a cloud in the economic skies. That’s because the Great Moderation led by the geniuses at the Fed had purportedly engendered a “goldilocks” economy destined to expand indefinitely.

Within months of the dotcom epiphanies, however, the highflying NASDAQ 100 crashed — eventually hitting bottom 83% below its new age heights. And 15 months after the S&P 500 reached its goldilocks peak of 1570 in October 2007 it staggered around in smoldering ruins at 670 — down 57% from its housing bubble high.

Today, the so-called stock market now consists entirely of what amounts to day traders and HST (high speed trading) machines. There is no “price discovery” in the classic sense of divining the true economic and political fundamentals. The casino has become entirely a ward of the central banks.

Needless to say, we are again on the precipice of a crash and correction that no one sees coming, but this one has an added twist.

Namely, three strikes and you are out!

What I mean, of course, is that the Fed and other central banks are out of dry powder. They are now stranded near the zero bound with bloated balance sheets that have actually reached hideous girth relative to current GDP and all historical experience — meaning they will have almost no capacity to reflate the next busted bubble, as they quickly did in 2001 and 2009.

Do yourself a favor and get out of the casino now.

We"re Living In The Age Of Capital Consumption

Authored by Ronald-Peter Stöferle via The Mises Institute,

When capital is mentioned in the present-day political debate, the term is usually subject to a rather one-dimensional interpretation: Whether capital saved by citizens, the question of capital reserves held by pension funds, the start-up capital of young entrepreneurs or capital gains taxes on investments are discussed – in all these cases capital is equivalent to “money.” Yet capital is distinct from money, it is a largely irreversible, definite structure, composed of heterogeneous elements which can be (loosely) described as goods, knowledge, context, human beings, talents and experience. Money is “only” the simplifying aid that enables us to record the incredibly complex heterogeneous capital structure in a uniform manner. It serves as a basis for assessing the value of these diverse forms of capital.

Modern economics textbooks usually refer to capital with the letter “C”. This conceptual approach blurs the important fact that capital is not merely a single magnitude, an economic variable representing a magically self-replicating homogenous blob but a heterogeneous structure. Among the various economic schools of thought it is first and foremost the Austrian School of Economics, which stresses the heterogeneity of capital. Furthermore, Austrians have correctly recognized, that capital does not automatically grow or perpetuate itself. Capital must be actively created and maintained, through production, saving, and sensible investment.

Moreover, Austrians emphasize that one has to differentiate between two types of goods in the production process: consumer goods and capital goods. Consumer goods are used in immediate consumption – such as food. Consumer goods are a means to achieve an end directly. Thus, food helps to directly achieve the end of satisfying the basic need for nutrition. Capital goods differ from consumer goods in that they are way-stations toward the production of consumer goods which can be used to achieve ultimate ends. Capital goods therefore are means to achieve ends indirectly. A commercial oven (used for commercial purposes) is a capital good, which enables the baker to produce bread for consumers. 

Through capital formation, one creates the potential means to boost productivity. The logical precondition for this is that the production of consumer goods must be temporarily decreased or even stopped, as scarce resources are redeployed toward the production of capital goods. If current production processes generate only fewer or no consumer goods, it follows that consumption will have to be reduced by the quantity of consumer goods no longer produced. Every deepening of the production structure therefore involves taking detours.

Capital formation is therefore always an attempt to generate larger returns in the long term by adopting more roundabout methods of production. Such higher returns are by no means guaranteed though, as the roundabout methods chosen may turn out to be misguided. In the best case only those roundabout methods will ultimately be continued, which do result in greater productivity. It is therefore fair to assume that a more capital-intensive production structure will generate more output than a less capital-intensive one. The more prosperous an economic region, the more capital-intensive its production structure is. The fact that the generations currently living in our society are able to enjoy such a high standard of living is the result of decades or even centuries of both cultural and economic capital accumulation by our forebears.

Once a stock of capital has been accumulated, it is not destined to be eternal. Capital is thoroughly transitory, it wears out, it is used up in the production process, or becomes entirely obsolete. Existing capital requires regularly recurring reinvestment, which can usually be funded directly out of the return capital generates. If reinvestment is neglected because the entire output or more is consumed, the result is capital consumption.

It is not only the dwindling understanding of the nature of capital that leads us to consume it without being aware of it. It is also the framework of the real economy which unwittingly drives us to do so. In 1971 money was finally cut loose entirely from the gold anchor and we entered the “paper money era.” In retrospect, it has to be stated that cutting the last tie to gold was a fatal mistake. Among other things, it has triggered unprecedented instability in interest rates. While interest rates displayed relatively little volatility as long as money was still tied to gold, they surged dramatically after 1971, reaching a peak of approximately 16 percent in 1981 (10-year treasury yield), before beginning a nosedive that continues until today. This massive decline in interest rates over the past 35 years has gradually eroded the capital stock.

An immediately obvious effect is the decline in so-called “yield purchasing power”. The concept describes what the income from savings, or more precisely the interest return on savings, will purchase in terms of goods. The opportunity to generate interest income from savings has of course decreased quite drastically. Once zero or even negative interest rate territory is reached, the return on saved capital is obviously no longer large enough to enable one to live from it, let alone finance a reasonable standard of living. Consequently, saved capital has to be consumed in order to secure one"s survival. Capital consumption is glaringly obvious in this case.

It is beyond question that massive capital consumption is taking place nowadays, yet not all people are affected by it to the same extent. On the one hand, the policy of artificially reducing the interest as orchestrated by the central banks does negatively influence the entrepreneurs’ tasks. Investments, especially capital-intensive investments seem to be more profitable as compared to a realistic, i. e. non-interventionist level, profits are thus higher and reserves lower. These and other inflation-induced errors promote capital consumption.

On the other hand, counteracting capital consumption are technological progress and the rapid expansion of our areas of economic activity into Eastern Europe and Asia in recent decades, due to the collapse of communism and the fact that many countries belatedly caught up with the monetary and industrial revolution in its wake. Without this catching-up process it would have been necessary to restrict consumption in Western countries a long time ago already.

At the same time, the all-encompassing redistributive welfare state, which either directly through taxes or indirectly through the monetary system continually shifts and reallocates large amounts of capital, manages to paper over the effects of capital consumption to some extent. It remains to be seen how much longer this can continue. Once the stock of capital is depleted, the awakening will be rude. We are certain, that gold is an essential part of any portfolio in this stage of the economic cycle.

 

How Economics Failed The Economy

Authored by Umair Haque via Eudaimonia blog,

When, in the 1930s, the great economist Simon Kuznets created GDP, he deliberately left two industries out of this then novel, revolutionary idea of a “national income”: finance and advertising.

Don’t worry, this essay isn’t going to be a jeremiad against them, that would be too easy, and too shallow, but that is where the story of how modern economics failed the economy? - ?and how to understand how to undo it? - ?should begin.

Kuznets’ logic was simple, and it was not mere opinion, but analytical fact: finance and advertising don’t create new value, they only allocate, or distribute existing value? - ?in the same way that a loan to buy a television isn’t the television, or an ad for healthcare isn’t healthcare. They are only means to goods, not goods themselves.

Now we come to two tragedies of history.

What happened next is that Congress laughed, as Congresses do, ignored Kuznets, and included advertising and finance anywaysfor political reasons? - ?after all, bigger, to the politicians’ mind, has always been better, and therefore, a bigger national income must have been better. Right? Let’s think about it.

Today, something very curious has taken place.

If we do what Kuznets originally suggested, and subtract finance and advertising from GDP, what does that picture? - a picture of the economy as it actually is? - ?reveal? Well, since the lion’s share of growth, more than 50% every year, comes from finance and advertising? - whether via Facebook or Google or Wall St and hedge funds and so on? - ?we would immediately see that the economic “growth” that the US has chased so desperately, so furiously, never actually existed at all.

Growth itself has only been an illusion, a trick of numbers, generated by including what should have been left out in the first place. If we subtracted allocative industries from GDP, we’d see that economic growth is in fact below population growth, and has been for a very long time now, probably since the 1980s -  and in that way, the US economy has been stagnant, which is (surprise) what everyday life feels like.

Feels like. Economic indicators do not anymore tell us a realistic, worthwhile, and accurate story about the truth of the economy, and they never did?—?only, for a while, the trick convinced us that reality wasn’t. Today, that trick is over, and economies “grow”, but people’s lives, their well-being, incomes, and wealth, do not, and that, of course, is why extremism is sweeping the globe. Perhaps now you begin to see why the two have grown divorced from one another: economics failed the economy.

Now let us go one step, then two steps, further. Finance and advertising are no longer merely allocative industries today. They are now extractive industries. That is, they internalize value from society, and shift costs onto society, all the while, creating no value themselves. The story is easiest to understand via Facebook’s example: it makes its users sadder, lonelier, and unhappier, and also corrodes democracy in spectacular and catastrophic ways. There is not a single upside of any kind that is discernible? - ?and yet, all the above is counted as a benefit, not a cost, in national income, so the economy can thus grow, even while a society of miserable people are being manipulated by foreign actors into destroying their own democracy. Pretty neat, huh?

It was because finance and advertising were counted as creative, productive, when they were only allocative, distributive that they soon became extractive. After all, if we had said from the beginning that these industries do not count, perhaps they would not have needed to maximize profits (or for VCs to pour money into them, and so on) endlessly to count more. But we didn’t. And so soon, they had no choice but to become extractive: chasing more and more profits, to juice up the illusion of growth, and soon enough, these industries began to eat the economy whole, because of course, as Kuznets observed, they allocate everything else in the economy, and therefore, they control it. Thus, the truly creative, productive, life-giving parts of the economy shrank in relative, and even in absolute terms, as they were taken apart, strip-mined, and consumed in order to feed the predatory parts of the economy, which do not expand human potential. The economy did eat itself, just as Marx had supposed? - ?only the reason was not something inherent in it, but a choice, a mistake, a tragedy.

Again, that is just a story? - ?so let us extract the key principle, which is the main mistake, the way in which economics failed the economy. Economics? - ?let me be careful here, and say American economics? - ?made the grave mistake of supposing that whatever could be traded should be traded, and then counted as a benefit, always, to the economy. But that is patently foolish. You and I can buy guns, and while guns might help a few people hunt for food, mostly, they only help people kill. One only has to take a cursory glance at America’s off-the-charts murder rates and killing sprees. And so the net cost of guns is life itself. What can be traded isn’t always what should be traded, and even less so should what should be traded be counted only and always as a pure benefit to the economy.

I have said that the US is, ironically, the new Soviet Union, its precise mirror image. Here you see what I mean in the purest and truest way. In the Soviet Union, trade of any kind was strictly forbidden, because it was seen to always be a bad, a liability, and therefore, only the government should allocate goods. American economics made precisely the mirror image of the same mistake: trade was alwaysassumed to always be a good, in nearly every possible circumstance and case (except those against which moral crusades were launched, like sex and drugs), and was and is always counted as a benefit, even when it shouldn’t be, just as in my tiny examples of finance and advertising (and therefore, only markets can allocate resources to society’s benefit).

Do you see how both are precise mirror images of one another? Here we have two forms of exactly the same kind of extremism: one assumes that trade is always bad, the other, that it is always good, but both assume, and assume similarly totalist positions. And in that way, economics went Soviet, and so now the West is trapped in an ideological bubble, just like the Soviet Union, caught fast like a helpless fly in a web of dead theories that fail utterly to explain its own decline and stagnation, and so mystified pundits and theorists prattle on, but nothing much seems to change, or even to be understood any better than it was last year, or the year before that, even though each year the toll of those very failures mounts and mounts.

Yet the truth is simply this. Reality, like life, is messier, subtler, more complicated than saying a thing is all good or all bad. To say that a thing is always good or bad is to commit the same error: to suppose that there is no room for negotiation, for investigation, for innovation, for this difficult project that we call society to need to be, to evolve, or to grow, at all. Society can only really exist when the boundaries of what is good and bad must constantly be renegotiated, rediscovered, reimagined, and understood anew. In precisely that way, the good in society grows, and the bad, perhaps, if not shrinks, then at least doesn’t grow along with the good. And that is how prosperity truly happens.

The good is only, to the limited extent that we can see it, for human are always blind, whether life is flourishing, growing, and developing, or not. Yet life expectancy is falling, people don’t expect the next generation to do better, there are regular mass killings, and so forth, in America. Life is not flourishing, growing, or developing in a single way that I or even you can readily identify or name. And yet, the economy appears to be growing, because purely allocative and distributive enterprises like Uber, Facebook, credit rating agencies, endless nameless hedge funds, shady personal info brokers, and so on, which fail to contribute positively to human life in any discernible way whatsoever, are all counted as beneficial. Do you see the absurdity of it?

And so. It’s not a coincidence that the good has failed to grow, nor is it an act of the gods. It was a choice. A simple cause-effect relationship, of a society tricking itself into desperately pretending it was growing, versus truly growing. Remember not subtracting finance and advertising from GDP, to create the illusion of growth? Had America not done that, then perhaps it might have had to work hard to find ways to genuinely, authentically, meaningfully grow, instead of taken the easy way out, only to end up stagnating today, and unable to really even figure out why yet.

And yet, perhaps, you and I can learn from that very mistake. In the societies, economics, corporations, cities, towns that we build tomorrow, we must learn to consider the good in more sophisticated, subtle, and most important of all, more authentic ways than we did yesterday. Economics failed the economy by telling us that everything that could be traded should be traded, since trade is always beneficial to humankind, even though even a child can see that people are fleeced and hoodwinked into buying every kind of foolish device, from guns to immortality potions, every day since time itself began. They are really buying the same thing: a salve for the desperation of lives that have gone nowhere.

If we really wish to help them, the answer is not simply assuming the problem away, as both the Soviet Union and then America, ironically, following in the footsteps of its mortal enemy, did, by saying any kind of human activity is all bad, or all good - for then we have done nothing more than pretended to solve a problem, which is the most foolish blindness of all. Problems that we have pretended to solve will only have the freest license of all to grow, just as advertising and finance, by being imagined to be productive when they were only allocative, soon turned extractive, being given free rein when they should have been if not reined in, then at least set to pasture. To genuinely stretch, become, develop, and grow is the same for economies as it is for lives as it is for societies, too: doing the difficult work of reckoning imperfectly with the good, and the bad, that dwell together, somehow, in each and every human heart.

Bond Bears & Why Rates Won"t Rise

Authored by Lance Roberts via RealInvestmentAdvice.com,

Here we go again…

Since June of 2013, I have been writing about the reasons why rates can’t rise much and why calls for the end of the “bond bull market” remain wrong.

Regardless, about every 3-months or so, there is a tick up in rates and you can almost bet that soon thereafter will be a litany of articles explaining why THIS time the “bond bull market” is really dead. For example, just from this past week:

• Great Ready For The Great Bond Bust Of 2020


• The Great Bond Bull Market May Be Coming To An End


• 700 Years Of Bond Data Forewarn Of Rapid Reversal From Low Interest Rates

What is the argument from low rates will rise?

It basically boils down to simply this – rates are so low they MUST go up.

The problem, however, is that interest rates are vastly different than equities. When people go to make a purchase on credit, borrow money for a house, or get a loan for a new car, they don’t ask what the level of the stock market is but rather “how much will this cost me?” The differentiator between making a purchase, or not, is based on the simple outcome of the interest rate effect on the loan payment. If interest rates rise too much, consumption stalls, and along with it economic growth, causing rates to go lower. If economic demand is robust, rates rise to meet the demand for credit.

The trend and level of interests are the singular best indicator of economic activity. As Doug Kass recently noted:

“The spread between the two- and ten-year U.S. notes has fallen to 68 basis points — that’s the lowest print in ten years and if history is a guide it is signaling a potential domestic economic slowdown.”

“The flattening in the yield curve is happening despite a likely continued Federal Reserve tightening and a rise back to December levels for overnight index swaps (OIS). It was back in 2004 — as the Fed started its tightening cycle (that concluded in Summer, 2006) — that both the curve flattened and the five year OIS rose. At the conclusion of the tightening in the middle of 2006, a deep recession followed by about fifteen to eighteen months later.”

In other words, “It’s the economy, stupid.”

Economic Growth Drives Rates

The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period. I have compared it to the 5-year nominal GDP growth rate during the same period.

(Note: As shown, interest rates can remain low for a VERY long time.)

Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time.There have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

As you can see there is a very high correlation, not surprisingly, between the three major components (inflation, economic and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate. Not surprisingly, the recent decline in the composite index also coincides with a decline in interest rates.

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows, much of that increase has been the absorption of increased population levels.

Many of those jobs remain centered in lower wage paying and temporary jobs which do not foster higher levels of consumption. To offset weaker organic consumption, artificially suppressed interest rates, though monetary policy, gives the appearance of economic growth by dragging forward future consumption which leaves a future “void” that has to be continually refilled.

Currently, there are few economic tailwinds prevalent that could sustain a move higher in interest rates. The reason is that higher interest reduces the flow of capital within the economy. For an economy that remains dependent on the generosity of Central Bankers, rising rates are not the outcome that “stock market bulls” should NOT be rooting for.

The Implications Of A Bond Bust

If there is indeed a bond bubble, a burst would mean bonds decline rapidly in price pushing interest rates markedly higher. This is the worst thing that could possibly happen. 

1) The Federal Reserve has been buying bonds for the last 9- years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.

3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) As rates increase so does the variable rate interest payments on credit cards.  With the consumer are being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak)

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on but you get the idea.

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.

I won’t argue there is much room left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment. This idea suggests is that there is one other possibility that the majority of analysts and economists ignore which I call the “Japan Syndrome.”

Japan is has been fighting many of the same issues for the past two decades. The “Japan Syndrome” suggests that while interest rates are near lows it is more likely a reflection of the real levels of economic growth, inflation, and wages.

If that is true, then rates are most likely “fairly valued” which implies that the U.S. could remain trapped within the current trading range for years as the economy continues to “muddle” along.

The irrationality of market participants, combined with globally accommodative central bankers, continues to push asset values higher and concentrate investors into the ongoing “chase for yield.” There isn’t much guessing on how this will end, history tells us that such things rarely end well.

The End Is Near... Depopulation Is Out Of Control... So Buy Stocks (Seriously)

Authored by Chris Hamilton via Econimica blog,

The world economy is premised on a ludicrous idea - that Asia, then India, and then Africa will continue to drive economic growth. 

So as not to turn this article into a book, lets consider this idea focusing on East Asia consisting of China, Japan, North and South Korea, Taiwan, and minor others.  This region consists of 1.6 billion persons or about 22% of earths inhabitants.  However, since 2008, it is this region that is responsible for nearly 100% of the global increase in demand for oil (best proxy available for true economic growth) and having primarily driven global economic growth.  My point in this article is that the growth in this region is entirely a credit driven supernova against collapsing populations which will never be able to fill the 100+ million newly added apartments or pay back the debt incurred to achieve the "growth".  Contrarily, from an investor standpoint, this weakness is the green light to "invest" as aggressively as possible because as long as central banks exist, they have your back.

Consider, since 2000, China"s debt outstanding has risen something like 14x"s to 17x"s or from about $2 trillion to something between $30 to $35 trillion presently.  As for Japan, who knows Japan"s true debt as Japan"s central bank is buying much or most of the debt and essentially throwing it in a black hole, never to be seen again(...monetization with a capital "M").

Why the massive debt creation and central bank monetization?  Depopulation with a capital "D".  First off, consider the collapse in fertility rates for these nations (chart below).  To maintain a constant, zero growth population, the childbearing population needs to produce 2.1 children in order to replace themselves (dashed line, below).  However, as the chart below shows, E. Asian nations have seen negative fertility rates for decades (Japan turning negative in "74, S. Korea in "83, China in "92, and N. Korea in "96).

Looking at the fertility rates from 2000 (chart below), some minor rises in fertility rates have been noticed in China since "00 and since "05 in Japan and S. Korea.  However, despite the minor upticks, all nations remain solidly negative and well below the 2.1 zero decline threshold.

For those expecting East Asia to continue driving global economic growth, I have a very big problem for you.  East Asia is in the midst of a population collapse.  The East Asian childbearing population, after rising by 366 million or +125% from 1950 until peaking in 2005, is now collapsing nearly as fast.  By 2030, those of childbearing age will have fallen by 180 million or a 27% decline (chart below).  By 2050, a clean halving of the childbearing population is likely.

So, the size of the childbearing population is back where it was in 1980 and by 2050 will be almost back to its 1960 size...but hypercritically, that population in 1960 was having approximately 5 children per family versus the 2020 or 2050 versions having somewhere around 1.6.  It is unlikely anything can be done to stop the depopulation daisy chain in East Asia and the economic collapse is already assured.  The collapse in demand against record quantities of assets is a mismatch for the ages...but of course central banks will continue to step in and monetize as long as possible.

As for the rest of the population, the growth among the heart of the regions economy, the 20 to 65 year olds, peaked in 1990 and has now indefinitely turned negative (falling something like 12 million from 2015 to 2020...and hundreds of millions fewer consumers, home buyers, tax payers by 2050).  Even the growth among the 65+ year old cadre will peak about 2035 before beginning to rapidly decelerate (change per five year periods, chart below).

Lastly, even growth among the old will be shifting to the very oldest as the bulk (and then the entirety) of the growth will be among the 75+ year olds (change per five year periods, chart below).

As for investors, this is your last and greatest chance.  The depopulation issue is not confined within East Asia.  The chart below shows the diving global fertility rate falling by more than 50% since peak fertility in the mid 1960"s.

It is a global phenomenon exhibited nearly everywhere but Sub-Saharan Africa.  The chart below shows global fertility rates are universally collapsing and it is nearly solely Africa that continues the global population increases...at least for now.

Even India and/or the Middle East / North Africa (MENA) are likewise seeing collapsing fertility rates. India"s fertility rate is almost sure to be negative by 2020.  There truly are no green shoots from a population growth perspective.

Central bankers will continue to "fake it" until they "make it".  Obviously, they never will "make it" but a select few will get absolutely rich beyond belief from central banker "efforts" as they continue to "fake it" as long as possible.  So, invest accordingly.

The "Iron Coffin Lid": Why The Euphoric Surge In Japanese Stocks Is Coming To An End

Last week, Japan"s Nikkei 225 index enjoyed its longest winning streak in history which eventually ending after 16 consecutive days of gains, only to resume rising after a brief one day hiatus. And, as foreign investors once again flood the Japanese stock market, chasing the momentum which has pushed local stocks to levels not seen since 1996, the question on everyone"s lips is how much longer can this continue?

Offering a decidedly downbeat outlook on Japan"s market exuberance, Shannon McConaghy - portfolio manager at what we have in the past dubbed the world"s most bearish hedge fund, Horseman Capital Management - believes that the euphoria is about to end. The reason: the ominously sounding "Iron Coffin Lid."

In a note released late last week, McConaghy writes that there has been a lot of excitement over Japanese equities of late, with hyperbole from the sell-side, and others interested in promoting Japanese equities, becoming extreme. However, he cautions that "there is not a lot of discussion around the risks to Japanese equities from current elevated levels" and adds that "one observation I would make is that Japan has risen to these levels on a number of occasions over the last 25 years, only to fail spectacularly each time against what is referred to, by some in the Japan markets, as the “Iron Coffin Lid”. History suggests it is far better to be short Japanese equities from these levels than to be long."

So what is this Iron Coffin, why does it have a lid, and what happens next?

Below is a visualization of this "Iron Coffin Lid" effect: it shows the key resistance level in the Topix beyond which the index has failed to progress every time in the past quarter century.

There"s more than just a chart however: here is Horseman"s take on why this latest rally in Japanese stocks is also set for disappointment.

For those unwilling to outright short, I would point out that historically Japan has had meaningful underperformance following past bursts of outperformance. In these periods it is particularly appealing to short against longs in higher growth areas. Japan also provides amplified short returns during global down turns. As such it can be a low cost but high return hedge to risk-off impacting long positions elsewhere. One way to identify when Japan is about to provide its greatest periods of underperformance is when its market capitalisation exceeds its Gross Domestic Product (GDP). Again, on this measure history suggests it is far better to get short Japanese equities at current levels than to get long.

 

 

One way to think about Japan’s persistent underperformance is that past market rallies have been quickly frustrated by structurally weaker GDP growth, as opposed to other markets with more sustainable growth. Japan’s GDP only grew +1.7% over the last 10 years, a CAGR of +0.169%. It grew even less in the 10 years prior. It is no mere coincidence that the market has failed to break out during decades of weak economic activity. Once again the market is pricing in significant economic expansion to come in Japan but its demographics, the key reason for past structural weakness, are only getting worse. I expect the euphoric hope held by many in the market, that “this time is different” in Japan, will once again be crushed by the “Iron Coffin Lid” that is Japan’s structurally weak economy. Long positions in Japan will likely be buried alive again while short opportunities thrive. Yes, Japan’s GDP growth rate has been higher since 2012, during what I would consider a recovery phase. But the drivers of growth in the three largest components of GDP growth are unsustainable, exhausted and now showing clear signs of reversing. Our market views to be released over coming days will look into these three major components of recent GDP growth in more detail.

Originating from Horseman Capital, hardly known for its optimistic outlook, here is the fund"s take on why Japan is set for more pain once the current euphoria fades, and how to capitalize on this imminent decline:

As a short preview, Japan faces immense risks to its economic system from;

 

1. Declining private consumption as the number of households in Japan starts to decline. Nowcast data also shows a marked decline in household consumption in recent months.


2. A precipitous decline within the financial sector, an often forgotten component of GDP. With the Japan Financial Services Agency now reporting that most regional banks have become loss making in core businesses.


3. A roll-over in the real estate sector as residential oversupply hits, vacancy rates rise, rents fall, prices decline in some areas and contract ratios indicate more price cuts are coming.


4. Net export growth, which has been driven by a weak Yen and weak oil prices, faces a risk of the Yen strengthening 22% back to the long run real effective exchange rate, as well as continued oil price rises.

 

Short opportunities in regional banks, real estate developers, Real Estate Investment Trusts (REITs) and mid-size retailers are particularly appealing. The first three of these sectors, about which we have written over the last two years, have been noticeably weak but still offer significant downside. The retail sector, about which we have only recently began to write, has yet to turn down but was a notably weak performer in the last years of the last global  credit cycle. Importantly we believe that shorting these sectors does not require an end to the global credit cycle, but they would likely generate amplified short returns in that environment and hence afford excellent hedges to other longs elsewhere.

Finally, it"s worth recalling that as of one month ago, the BOJ already owned three quarters of all Japanese ETFs: a number which is now certainly higher, and is a non-trivial reason why Japan"s stocks have enjoyed the recent surge. Of course, with ETF supply declining rapidly and the BOJ soon to be locked out of further purchases, the question is what will stoke further "flow" into risk assets (and frontrunning of central bank purchases), and will the BOJ expand its mandate further to buy single name stocks next in the name of "price stability?"