The $233 Trillion Dollar Dark Cloud Of Global Debt

Global debt has reached record heights without any signs of relief. While central bankers try to explain away the phenomenon of these out-of-control numbers, it's not much of a mystery. Immediate consumption with the promise of repayment sometime in the future has consequences.

Global debt is staggering to the point most of it will never be repaid. Certainly not in our generation. Perhaps by our grandchildren, but as global debt keeps mounting, the picture is doubtful.

The per capita global debt is $30,000. Who, exactly, will be making repayments?

Economists insist that the 2007 financial crisis could not have been predicted. Yet, all the signs of out-of-control credit where there. Today, economists are repeating the same mantra, despite the spiraling world debt. The question is not if the next bubble will strike. It's a matter of when.

The math is fairly simple. The more a country increases its debt to simply stay afloat, the more like the increasing debt will cause a tightening of credit. The next step in the equation is a burst bubble and economic crisis. This is what happened in 1929, happened again in 2007, and it's happening now. Past behavior is the best predictor of future behavior.

Out-of-control credit will undoubtedly slow down the US's current economic growth.It probably won't cause an outright crisis. Other countries may not be as fortunate.

Countries such as China, Belgium, South Korea, Australia, and Canada are experiencing an unprecedented credit bubble, with few systems in place to control it.The resulted inflation or simply write-offs of debts could result in a global financial disaster we have not seen before. The current economic upswing is unlikely to continue.

Prior to 2007, globalization, the exchange of goods and services between countries, was at its highest level. Since then, globalization has leveled off. We may have seen the peak of globalization. Emerging countries, benefiting from globalization, have raised their standard of living and cheap goods are no longer crossing borders with the same abandon. Countries are instituting nationalistic protectionist measures to protect their own economy. Globalization is giving way to "islandization," where the movement of capital and good across borders is being limited instead of expanded. This limited global trading, along with rising geopolitical tensions, will negatively affect global economic expansion, while the global debt is still spiraling out of control.

The global economy is also currently suffering from limited growth in productivity. The reasons for this are wide-ranging, from an aging labor force, reduced investments, neglected infrastructures, reduced entrepreneurship and the general uncertainty how to resolve these problems.

If a global crisis is to be averted, leaders need to act instead of remaining complacent. Proper skills training and greater emphasis on investments can lead to the productivity growth that can create the global expansion necessary to tame the current debt cycle.

If leaders make the right choices, our grandchildren may not face the economic crisis which currently appears to the only legacy they will inherit.

Oil is setting up for a turbulent year.

In an industry that is always full of contradictions, 2018 has been a particularly complicated and divisive year for the global oil markets–and it looks like it won't be letting up any time soon.

For months, the Organization of Petroleum Exporting Countries (OPEC) has been pushing for a dramatic decrease in production in the interest of bolstering prices at the pump. They've even managed to get major OPEC outsiders like Russia and the oil cartel to agree to production cuts. While the original deal is due to expire at the end of March, 2018, OPEC has just extended the production caps to the end of the year in an attempt to counterbalance the global glut of crude oil.

However, despite OPEC's best efforts, some countries are not stemming the flow of crude, and some are even ramping up production and even opening new major oil fields. Nigeria, for example, is talking out of both sides of its mouth, promising compliance with OPEC in the same year that it has pushed its output to the highest level in more than two years and is set to start up production in a new large-scale oil field by the end of the year, their first in half a decade.

Now, another major issue has arisen. British Petroleum (BP), which has long expected their mature oil fields to naturally plateau and then decrease in production, has now announced that their legacy fields are increasing output, to the great surprise of experts in the field and BP executives alike. An astonished Bob Dudley, BP's chief executive officer, told an interviewer at the CERAWeek by IHS Markit energy conference in Houston that he, "cannot remember ever in my career having seen a negative decline rate."

This unprecedented increase from mature fields adds another problem to OPEC's plan on top of the already major issue of the shale boom. And BP isn't the only supermajor contributing to the problem. Shockingly high results from legacy fields have also been observed by mega-producers including Shell Plc and in areas like Norway, the North Sea, and Russia (all regions highlighted by the International Energy Agency (IEA) for their remarkable recent output) creating a major headache for Saudi Arabia, who was shouldering the major brunt of OPEC cutbacks, cutting a jaw-dropping 1.8 million barrels per day in a desperate attempt to recalibrate the market price of oil.

While BP has had the most dramatic turnaround by a wide margin, other companies have still reported some pretty impressive findings, creating quite an upset for OPEC's master plan. While mature oil fields' production did drop last year, it was the smallest drop in a decade of collected data at just 5.7 percent, according to figures from the IEA.

The slowing decline in these fields is a huge surprise in any scenario, but it's made all the more confounding by the fact that the oil industry radically decreased spending during the pricing downturn of the last three years–a downturn that they were just finally coming out of. Since mature wells are usually a huge money pit in terms of maintenance, OPEC had been extremely hopeful and even dependent on the expectation that mature wells would decline significantly without major investment–especially since these legacy wells still account for more than half of the world's oil production.

According to some supermajors, however, the economic downturn had exactly the opposite effect. As explained by Wael Sawan, the executive vice-president focused on deep water at Shell, thriftier times have called for a re-strategizing and getting back to basics. This means focusing on existing wells and mature oil fields instead of drilling and prospecting in a short-term effort to get more oil more cheaply and efficiently.

It's all a response to the same issue — low oil prices — but with exactly the opposite approach from OPEC, setting oil up for a turbulent year as income-boosting strategies clash. OPEC is trying to keep its eye on the horizon, with long-term goals to increase global oil prices not just for this year, but going forward, but all of the production cuts are for naught if private companies continue to act in their own short-term best interest, increasing their income by putting more and more oil into an already saturated market. 

"Where To From Here": Why Goldman's Client Are Confused

Badk in early February, after the great volatility explosion which sent the VIX to 50, killed the XIV ETF and which we now know was precipitated by the market's misreading of the sharp January rising average hourly earnings print (which just as we said at the time, was due to a drop in the workweek and little else as the latest BLS data revisions confirmed), Goldman's clients wanted to know one thing: "how much worse will it get?" In response, Goldman's chief equity strategist David Kostin answered "not much", and indeed so far he has been proven correct as not only is the Nasdaq back to all time highs, but the S&P has recouped virtually all of its 10% correction.

One month later, with the market once again soaring, things are even more confusing because while the vol scare may have come and gone for now, two other risks remain, namely rising interest rates and the escalating trade conflict, both of which according to Goldman "have ended the "Goldilocks" environment of 2017." And yet, as Citi lamented overnight, the markets remain oblivious.

Adding to this, a somewhat puzzled Kostin writes in his latest Weekly Kickstart, that "with 10-year Treasury yields now at 2.9% and new tariffs on steel and aluminum formally ordered this week, the ratio of return/realized volatility has declined from 3.3 in 2017 (22% / 7%) to 0.3 YTD. The S&P 500 nonetheless remains in positive territory."

This confusion appears to be spreading, and has in turn prompted Goldman's clients to ask, "where to from here?"

Kostin's answer is two-fold, first focusing on the move higher in rates, and why there may be less to it than some bears insist:

Interest rates present a more substantial risk to equity valuations than they do to earnings. Because corporate borrow costs are historically low and interest coverage is still elevated, we estimate that a 100 bp increase in 10-year Treasury yields would reduce S&P 500 return on equity ("ROE"), excluding Financials, by less than 50 bp (from a current level of 19%). Financial earnings benefit from high rates, so the overall impact on S&P 500 profitability is  surprisingly small.

The speed of rising interest rates poses a more immediate risk to equities than does the level of rates. This week we published an analysis of the relationship between bond yields, corporate growth, and equity valuations. One key observation from our analysis was that S&P 500 prices typically stop increasing when rates rise more quickly than a standard deviation in a month (currently equating to a rise in Treasury yields of roughly 20 bp), and equity prices decline when yields rise by more than two standard deviations (40 bp). This relationship has held true during the last 50 years irrespective of whether rising yields were driven by inflation or real rates.

The level of Treasury yields eventually also matters for equities, even if the change occurs gradually. Our dividend discount model framework suggests that 10-year Treasury yields above 4% – which would require substantial Fed tightening from current levels and/or inflation expectations well above the 2% target – would outweigh any potential reduction in the equity risk premium ("ERP"), and therefore lead to lower equity valuations.

Incremental medium-term growth needed to offset change in bond yields and ERP

Concluding the rates discussion, Kostin reminds clients that Goldman economists expect 10-year Treasury yields to gradually rise to 3.25% by the end of 2018 and 3.6% by the end of 2019.

"The combination of eight Fed rate hikes by the end of 2019, rising inflation expectations, and a higher term premium will lift the yield curve."

Unless, of course, the move is not a gradual, linear levitation but a sharp, staccato spike a la the Taper Tantrum, in which case all bets are off.

What one can also highlight here, is that after an initial scare following the sharp move to just shy of 3.0% a month ago, equities have indeed eased back, and now interpret any gradual increases in the 10Y rate as a neutral, if not benign development. The question of course, is what happens once 3.0% is breached and whether what has been a moderate selloff re-accelerates, once again slamming risk assets.

* * *

Which brings us to the second, and more material recent development, which is proving to be a bigger source of confusion for Goldman clients, namely the growing trade conflict and why do stocks refuse to go down as a result? 

As a reminder, the steel and aluminum tariffs signed by President Trump this week will go into effect on March 23. The order also exempts Canada and Mexico as leverage during the Nafta negotiations, and leaves open the possibility for other country and product exemptions.

From a fundamental perspective, and echoing what Barclays said two weeks ago, Goldman reiterates that these tariffs should have a de minimis effect on aggregate US economic and earnings growth. In fact, together the steel and aluminum industries account for just 0.1% of national employment and 1% of industrial production. In aggregate, Kostin notes that "these commodity inputs equate to just 1% of total US private industry gross output (i.e., revenues), meaning even significantly higher steel and aluminum input costs would have a limited impact on aggregate US corporate profits."

That said, as Goldman cautioned one week ago, downstream users of the metals including autos and machinery stocks will likely face margin pressures from higher domestic input prices. In general, industries with high material intensity and low margins (the bottom right of Exhibit 2) face the highest risk from rising commodity costs, whether due to tariffs or other causes.

And if a direct threat to the US economy as a result of Trump's trade war is - as of now - nonexistant, what is the danger? Here Kostin once again echoes Barclays, and writes that the larger threat to corporate earnings and equity valuations is the potential for escalating trade conflict in response to these tariffs.

Our economists believe retaliation by US trading partners is likely, particularly in the form of tariffs on US metals, luxury consumer goods, and agriculture. Our commodity analysts highlight soybean exports as particularly vulnerable to retaliation from China. In addition, the upcoming release of the US Section 301 investigation regarding intellectual property may lead to further conflict with China, potentially jeopardizing US corporate sales to and supply chains in China.

And here a paradox: just like Citi's Matt King continues to rage against the market's seemingly infinite complacency when faced with shrinking central bank balance sheets, prompting him to ask "we know what central banks are doing... why are we so slow to price that in?", so the advent of a trade war has so far prompted nothing more than a yawn from investors, who appear convinced that there is no threat to risk assets as a result of potential trade war escalation. Here's Goldman:

Although equity prices have moved in reaction to the proposed metals tariffs, investors do not appear concerned about escalating trade conflict. Firms that our analysts have highlighted as vulnerable to rising steel and aluminum  input costs have underperformed the Industrials sector by more than 300 bp in the last two weeks. However, the share prices of agriculture firms, luxury consumer companies, and TMT firms with high imported COGS have generally demonstrated no signs of concern (see Exhibit 3).

Even more bizarre is that contrary to conventional wisdom, "baskets of US stocks with the largest international sales in general and specific exposure to Europe and China have all outperformed the S&P 500 in recent weeks" (see Exhibit 4), almost as if the market is rewarding those companies that are on the front line of the trade war

Finally, Goldman claims that the outperformance of the domestic-facing Russell 2000 over the S&P 500 by 300 bp this month, is not due to trade concerns, but rather "positioning and earlier underperformance appear more likely causes."

* * *

So, going back to the original question posed by Goldman clients, "where to from here", the answer appears to be more of the same, with new S&P all time highs imminent.

Here, Kostin underscores that despite the sharp VIX moves, the rising rates, and trade conflict, "strong economic and earnings growth should continue to lift US equity prices during 2018. Our economists' Current Activity Indicator signals a 4.8% current pace of US economic activity, and consensus expects that next month S&P 500 firms will report year/year EPS growth of 17% in 1Q."

This "strong growth environment" helps explain the return of the honey badger market which is ignoring any potentially adverse news, as well as the resilience of equity prices and investor sentiment.

* * *

Looking forward, Kostin believes that the S&P 500 will rise a further 4% by year end to 2850 "on the strength of earnings growth rather than P/E multiple expansion."

It's not all good news: "uncertainty surrounding interest rates and trade conflict suggests that the return and volatility environment will look more like it has in recent weeks than during the "Goldilocks" environment of 2017."

But the biggest winner of the recent market moves is none other than Donald Trump, who - due to luck or otherwise - managed to not only broaden his populist appeal by launching a (very limited) trade war (which so far excludes Canada and Mexico) and at the same time, has not only kept his favorite metric of the success of his presidency - the stock market - from crashing, but at this pace, stocks appear on track to make new all time highs in the coming days.

QE Unwind Is Too Slow, Says Fed Governor, Thus Launching First Trial Balloon

"The very slow pace may still be contributing to a buildup of various financial imbalances."

So we have the first Fed Governor and member of the policy-setting FOMC who came out and said that the QE Unwind that began last October with baby steps isn't fast enough. And because it's so slow it may actually contribute to, rather than lower, the "financial imbalances."

In her speech, Kansas City Fed President Esther George pointed at the growth of the economy, the tightness in the labor market, the additional support the economy will get from consumers and companies as they spend or invest the tax cuts, etc., etc. And despite this growth, "the stance of monetary policy remains quite accommodative," she said.

She cited the federal funds rate – the overnight interest rate the Fed targets. The Fed's current target range is 1.25% to 1.50%, which is "well below estimates of its longer-run value of around 3%," she said.

The Fed would have to raise rates at least six more times of 25 basis points each, for a total of at least 1.5 percentage points, to bring the federal funds rate to around 3% and get back to neutral. If the Fed wanted to actually tighten after that, it would have to raise rates further. So far, so good.

And then came her concerns about the Fed's balance sheet.

Under QE, the Fed acquired $1.7 trillion in Treasury securities and $1.78 trillion in mortgage-backed securities, for a total of about $3.5 trillion. After QE ended in October 2014, the Fed then maintained the levels by replacing maturing securities.

But in October last year, it commenced the QE-Unwind and started to not replace some maturing securities. This has the effect of shrinking its balance sheet. Just like the Fed "tapered" QE by phasing it out over the course of a year, it is also ramping up the QE-Unwind over the course of a year.

But the pace of the QE-Unwind has been too slow, according to George – and this may be destabilizing the financial markets:

By the end of this year, however, only about a quarter of the increase to the Fed's balance sheet resulting from the first round of large scale asset purchases will be unwound.

These holdings of longer-term assets were intended to put downward pressure on longer term interest rates. Many investors responded, as would be expected, by purchasing riskier assets in a reach for higher yield. As a result, asset prices may have become distorted relative to the economic fundamentals.

The reference to "distorted" asset prices is the same verse we've heard from other Fed governors: Asset prices have become inflated. Since assets are leveraged, they have become a risk to financial stability. Then she adds:

The very slow pace of our balance sheet normalization may still be contributing to a buildup of various financial imbalances.

In other words, because the QE Unwind is so slow, it doesn't really work as an unwind but continues to inflate asset prices, which would be the opposite of what the Fed wants to accomplish:

While until recently, financial markets remained remarkably stable, it is not uncommon to see volatility rise when asset prices become inflated and investors struggle to find a new equilibrium.

And there she left us hanging at the edge of the cliff, without saying more about the QE Unwind and where it should go. Instead, she reverted to less treacherous territory of interest rates. But later, at the very end of the conclusion, she fired her final shot:

Given the current momentum in the economy, the FOMC will need to carefully calibrate its policy to lean against a potential buildup of inflationary pressure or financial market imbalances.

Let me repeat this: the Fed will "need to carefully calibrate its policy to lean against … financial market imbalances."

Esther George has been one of the more hawkish FOMC members. So it's probably her job to launch the first trial balloon about speeding up the QE Unwind.

The whole idea of unwinding QE was launched by trial balloon, one after the other, even as people said that QE could never be unwound, that in fact these assets would have to remain on the Fed's balance sheet permanently. But gradually, it sank in that the Fed was seriously thinking about shedding those assets. In June 2017, it announced the mechanics. In September, it announced the amounts and timing. It took over a year to get there. And because it was rubbed in so gently, the markets barely reacted to it.

George is in a non-voting slot on the FOMC this year. So she is a safe bet to launch the first trial balloon. The markets won't take her seriously – just another Fed governor talking. But this is how it starts. The Fed no longer administers "monetary shocks," the way it used to in order to knuckle its monetary policies into the recalcitrant markets. Now it's all jawboning and "forward guidance" and trial balloons.

But it does show that there is some thinking behind the scenes about speeding up the QE-Unwind. Once the pace is ramped up to full speed by October this year, the Fed will shed up to $50 billion a month in securities — up to $30 billion in Treasuries and up to $20 billion in MBS — for a maximum of $600 billion a year.

But any significant acceleration is impossible to achieve by just allowing maturing securities to "roll off" without replacement: In most months, there are only about $30 billion to $35 billion of Treasuries on the Fed's balance sheet that mature. For example, in March, $31.2 billion mature; in April, $30.5 billion. MBS come on top of that.

So if she is proposing to increase significantly the pace, it would have to be done by outright selling securities into the market, which would further change the dynamics of the market, just when the US Treasury will be issuing a record amount of new debt to finance the growing deficits. In order to find buyers for all those Treasuries that would flood the market, the yields would have to rise to be very appealing, so that investors would buy Treasuries rather than other securities. When yields rise, by definition bond prices fall. This would ricochet throughout the market with a substantive repricing of all assets.

And it would come at the same time that the ECB will have stopped its QE purchases and that the Bank of Japan is starting to think out loud about an "exit," as they call it. And this would make for an interesting confluence of factors.

Investors in the corporate bond market, particularly in junk bonds, are still blowing off the Fed. But not much longer.