We're All Lab Rats In The Largest-Ever Monetary Experiment In Human History

...and how do things usually work out for the rat?

There are ample warning signs that another serious financial crisis is on the way.

These warning signs are being soundly ignored by the majority, though. Perhaps understandably so.

After 10 years of near-constant central bank interventions to prop up markets and make stocks, bonds and real estate rise in price -- while also simultaneously hammering commodities to mask the inflationary impact of their money printing from the masses -- it's difficult to imagine that "they" will allow markets to ever fall again.

This is known as the "central bank put": whenever the markets begin to teeter, the central banks will step in to prop/nudge/cajole the markets back towards the "correct" direction, which is always: Up!

It's easy in retrospect to see how the central banks have become caught in this trap of their own making, where they're now responsible for supporting all the markets all the time.

The 2008 crisis really spooked them. Hence their massive money printing spree to "rescue" the system.

But instead of admitting that Great Financial Crisis was the logical result of flawed policies implemented after the 2000 Dot-Com crash (which, in turn, was the result of flawed policies pursued in the 1990's), the central banks decided after 2008 to double down on their bets -- implementing even worse policies.

The Largest-Ever Monetary Experiment In Human History

It's not hyperbole to say that the monetary experiment conducted over the past ten years by the world's leading central banks (and its resulting social and political ramifications) is the largest-ever in human history:

(Source)

This global flood of freshly-printed 'thin air' money has no parallel in the historical records. All around the world, each of us is part of a grand experiment being conducted without the benefits of either prior experience or controls. Its outcome will be binary: either super-great or spectacularly awful.

If the former, then no worries. We'll just continue to borrow and spend in ever-greater amounts -- forever. Perpetual prosperity for everyone!

But if things hit a breaking point, then you had better be prepared for some truly bad times.

Excessive money printing leads to the destruction of currency. Fiat money (like the US dollar, the Euro, the Yen, and every other world currency) is a social contract and has an associated set of related agreements. When that contract and those agreements are broken by reckless expansion of the currency base, things fall apart fast. We need look no further than current-day Venezuela to understand that.

It's important to remember that money -- whether physical cash or in digital form, stocks, or bonds -- is just a claim on real wealth. Real wealth is land, clothes, food, oil…you know, real things.

We expect that our cash will be able to buy us the real things we want when we want them. We trust that our stocks give us an ownership stake in a real company producing real things for real profits. We rely on our bonds being re-paid in the future along with interest; but if not, we expect that our bond becomes a claim on valuable collateral.

Ideally, the money supply and the amount of real wealth should exist in balance. As money is a claim on "stuff", as economic output (i.e. "stuff") increases, than so should the claims. And vice-versa during periods of economic contraction.

But what happens when the claims start to far outweigh the real "stuff"? That's when things get precarious.

Note how dramatically the claims represented by just the S&P 500 index alone have quadrupaled since the start of 2009, driven by the central banks' quantitative easing programs:

(Source)

The flood of money unleashed by QE didn't result in vast amounts of new actual wealth being created (i.e. greater productive output per capita). But it did result in grotesquely-inflated financial asset prices that have helped to create the most profound wealth and income inequality seen in our lifetime (perhaps ever).

The Many Sins Of The Central Banks

The list of central bank-induced injustices is long. It reads like the rap sheet of a virulent psychopath: $trillions looted from savers and handed to the big banks and leveraged speculators, ruined pensions, shattered retirement dreams for millions, record amounts of debt in every corner of the global economy, and an increasingly unaffordable cost of living for everyone but the elite 1%.

"But we had to save the system!" cry the central bankers in their defense.

Even if that were the case (and I dispute whether the world is really better off for having saved Citibank et al.), that rescue should have ended back in mid-2009, at the latest.

But instead, the central banks ramped up their wanton ways in the years since the GFC. Did you know that their largest-ever printing spree happened over the past two years? (2016 to 2017):

The bigger the printing spree the bigger the fundamental distortions. In such a world, up becomes down, black becomes white, and right becomes wrong.

All of which means that fundamental analysis, has been all but useless as a predictor of prices. All that has mattered is the answer to the question: "How much will the central banks print next?"

In such an environment, there's no room for investors. It forces all of us to become speculators, trying to predict what a small cabal of bankers are thinking.

But among their very worst offenses has been the manipulation of sentiment. The prices of financial assets and commodities have become political and propaganda tools, which means that nothing can be left to chance. All prices have to send the "right" signals at all times, in the same way that certain news outlets pump a point of view endlessly. Repetition creates its own reality.

Because of the increasingly frequent (probably daily), interventions by central banks and their proxies, the financial markets have become ""markets"". They no provide us with any useful signals about the future or about the current health of the economy.

Instead, they only tell us what the authorities want us to hear.

To them, all that matters is strength and stability. As long as those conditions contine to be met for stocks, bonds and real estate prices, most people are content to let things ride and not probe too deeply.

But when this scam comes to its inevitable end, the crash will be spectacular when it arrives.

This reckoning is already way overdue.  At this point, we find ourselves in the odd positin of rooting for it to happen soon, as the potential energy in the system builds with every passing day. Our worry is that if the crash is delayed for much longer, its resulting carnage will be so large that it will be unsurvivable.

And while we mean that in the figurative sense for people's portfolios, it's possible that the crash could become literally unsurvivable if the political "solution" to deflect blame away from the the central banks and their DC partners-in-crime is a kinetic war.

When viewed in that light, America's histrionic attempts to demonize Russia over the past few years begin to make frighteningly more sense.

It's Time To Talk Turkey

We've been vocal of late about the numerous signs that another great financial crisis is building. The gut-punch Turkey hit global markets with this week is just one example.

Yes, it will be painful to crash from here. But once the needed correction is underway, we'll have the opportunity to make the best of it.

We can pick up the pieces and begin building towards a future we can all believe in.

Yes, there's no avoiding the pain of taking our lumps for the the past mistakes we've made. But we don't have to compound our misery by continuing to do more of exactly what got us into this mess in the first place. We simply need the courage to face the psychological burden of admitting to our prior failings.

That's doable.

It all starts with being honest with ourselves.

Look, we all know the world is finite. Infinite economic growth on a finite planet is an impossibility. We have all the data we need to make that conclusion. Every passing day where we pretend that's somehow untrue or avoidable makes the eventual adjustment that much more wrenching.

It's an intellectually simple exercise to conduct. But an emotionally impossible task for those whose internal belief systems would be hopelessly compromised by allowing that logic to penetrate their world view.

And so the future will be represented by two sorts of people: those able to face what's coming head on and prepare accordingly, and those who can't.

I sincerely hope that you're not among those deterred from preparing by the last gleaming of today's glittering stock prices. We're going to need as many prepared people as possible in the coming future.

And we may need them soon. The severe recent deterioration in the Emerging Markets threatens a contagion that could well start the next crisis.

Turkey is currently in a major currency crisis threatening to metastisize into a full-blown sovereign debt crisis. Defaults there will spill over into Europe's banking system (which has made loads of shaky loans to Turkey), and from there cause domino effects throughout the rest of the world.

But Turkey isn't the weakest or the most worrying country faltering: Italy is stumbling, as is Brazil, and even China. But Asia ex-China is the real powderkeg. Their unserviceable debts dwarf everybody else.

In Surprising Reversal, Pace Of Global Rate Hikes Approaches Pre-Lehman Period

Most of the post-Lehman era has been characterized by unprecedented easy monetary policy meant to inflate asset prices, and sure enough after 705 rate cuts, and $12.4trillion in QE, the S&P is just shy of its all time highs. However, over the past year, a different dynamic has taken place: the Fed's tightening cycle and ongoing rate hikes have resulted in a sharp drain of USD-liquidity across the globe.

Meanwhile, with the ECB set to end its QE and the BOJ taking tentative steps toward tightening while engaging in a shadow taper of its own QE, central bank balance sheets are set to shrink for the first time since the financial crisis.

It is this tightening in financial conditions in general, and dollar liquidity in particular that ultimately has been the catalyst that led to a near record divergence in FX volatility between emerging markets and developed nations, incidentally that last time we saw such deltas was just after 9/11 and the great financial crisis.

While leads us to the bigger problem: as the dollar becomes more attractive and as carry trades collapse, emerging markets are forced to respond to currency weakness with interest rate hikes to stem capital outflows. And, most concerning as the chart below shows, the pace of global central bank rate hikes has already visibly jumped since EM weakness began in February this year. In fact, the current pace of rate hikes is almost on par with the pre-Lehman period - a time where policy makers were trying to slow a global economy that felt too good to be true.

And as Bank of America's Barnaby Martin writes, not only will global economic growth slow down as a result of monetary tightness and higher interest rates, but as a result of the rapid pace of central bank hikes across the globe, "crowding" into risky assets will inevitably slow.

More ominously, it's not just an EM phenomenon: "dollar strength has emerged as a major negative for European markets too." As the chart below shows, retail inflows into Euro credit funds have fizzed-out this year, and this has coincided with the period of Dollar strength from March onwards in '18. Coupled with very attractive front-end rates on the Treasury curve, European retail money is simply leaking to the US market now and explains not only the persistent weakness of the Euro - despite the ECB's recent taper announcement - but also the ongoing decoupling between the US and the rest of the world.

Wicksell's Elegant Model (Or How This Ends)

"It's unbelievable how much you don't know about the game you've been playing all your life." – Mickey Mantle

The word discipline has two closely related applications. Discipline may refer to the instruction and nurturing of an individual. It can also carry the connotation of censure or punishment.The purpose of discipline, in either case, is to sustain integrity or aim toward improvement. Although difficult and often painful in the moment, discipline frequently holds long-lasting benefits. Conversely, a person or entity living without discipline is likely following a path of self-destruction.

The same holds true for an economic system. After all, economics is simply the study of the collective decision-making of individuals with regard to their resources. Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses.

In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal. If I can borrow at 2% and there appear to be many investments that will return more than that, I am less likely to put forth the same energy to find the best opportunity. Indeed, at that low cost, I may not even use borrowed money for a productive purpose but rather for a vacation or bigger house, the monetary equivalent of using water to hose off the patio. Less rigor is applied when rates are low, thus raising the likelihood of misallocating capital.

Happy Talk

In November 2010, The Washington Post published an article by then Federal Reserve (Fed) Chairman Ben Bernanke entitled What the Fed did and why: supporting the recovery and sustaining price stability. In the article, Bernanke made a case for expanding on extraordinary policies due to still high unemployment and "too low" inflation. In summary, he stated that "Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

To minimize concerns about the side effects or consequences of these policies he went on, "Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated." In his concluding comments he added, "We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time." During her tenure as Fed Chair, Janet Yellen reiterated those sentiments.

Taken in whole or in part, Bernanke's comments then and now are both inconsistent and contradictory. Leaving the absurd counterfactuals often invoked aside, if asset purchases were in 2010 "unfamiliar as a tool of monetary policy," then what was the basis for knowing concerns to be "overstated"? Furthermore, what might be the longer-term effects of the radical conditions under which the economy has been operating since 2009? What was the basis of policy-makers' arguments that extraordinary policies will not breed unseen instabilities and risks? Finally, there is no argument that the Fed has "the tools to unwind these policies," there is only the question of what the implications might be when they do.

In the same way that no society, domestic or global, has ever engaged in the kinds of extraordinary monetary policies enacted since the Great Financial Crisis (GFC), neither has any society ever tried to extract itself from them. These truths mandate that the uncertainty about the future path of the U.S. economy is far more acute than advertised.

Even though policy-makers themselves offered no evidence of having humbly and thoroughly thought through the implications of post-GFC policies, there is significant research and analysis from which we can draw to consider their implications apart from the happy talk being offered by those who bear no accountability. Looking back on the past 60+ years and observing the early stages of efforts to "unwind" extraordinary policies offers a clearer lens for assessing these questions and deriving better answers.

The Ghost of Irving Fisher

Irving Fisher is probably best known by passive observers as the economist whose ill-timed declaration that "stock prices have reached a permanently high plateau" came just weeks before the 1929 stock market crash. He remained bullish and was broke within four weeks as the Dow Jones Industrial Average fell by 50%. Likewise, his reputation suffered a similar fate.

Somewhat counter-intuitively, that experience led to one of his most important works, The Debt-Deflation Theory of Great Depressions. In that paper, Fisher argues that overly liberal credit policies encourage Americans to take on too much debt, just as he had done to invest more heavily in stocks. More importantly, however, is the point he makes regarding the relationship between debt, assets and cash flow. He suggests that if a large amount of debt is backed by assets as opposed to cash flow, then a decline in the value of those assets would initiate a deflationary spiral.

Both of those circumstances – too much debt and debt backed by assets as opposed to cash flow – certainly hold true in 2018 much as they did in 2007 and 1929. The re-emergence of this unstable environment has been nurtured by a Federal Reserve that seems to have had it mind all along.

Even though Irving Fisher was proven right in the modern-day GFC, the Fed has ever since been trying to feed the U.S. economy at no cost even though extended periods of cheap money typically carry an expensive price tag. Just because the stock market does not yet reflect negative implications does not mean that there will be no consequences. The basic economic laws of cause and effect have always supported the well-known rule that there is no such thing as a free lunch.

Cheap Money or Expensive Habit?

Interest rates are the price of money, what a lender will receive and what a borrower will pay. To measure whether the price of money is cheap or expensive on a macro level we analyze interest rates on 3-month Treasury Bills deflated by the annualized consumer price index (CPI).  Using data back to 1954, the average real rate on 3-month T-Bills is +0.855% as illustrated by the dotted line on the chart below.

When the real rate falls below 0.20%, 0.65% below the long-term average, we consider that to be far enough away from the average to be improperly low. The shaded areas on the chart denote those periods where the real 3-month T-Bill rate is 0.20% or below.

Of note, there are two significant timeframes when real rates were abnormally low. The first was from 1973 to 1980 and the second is the better part of the last 18 years. The shaded areas indicating abnormally low real interest rates will appear on the charts that follow.

The chart below highlights real GDP growth. The post-war average real growth rate of the U.S. economy has been 3.20%. Based on a seven-year moving average of real economic growth as a proxy for the structural growth rate in the economy, there are two distinct periods of precipitous decline. First from 1968 to 1983 when the 7-year average growth rate fell from 5.4% to 2.4% and then again from 2000 to 2013 when it dropped from 4.1% to 0.9%. Interestingly, and probably not coincidentally, both of these periods align with time frames when U.S. real interest rates were abnormally low.

Revisiting the words of Ben Bernanke, "Easier financial conditions will promote economic growth." That does not appear to be what has happened in the U.S. economy since his actions to reduce real rates well below zero. Although the 7-year average growth rate has in recent years risen from the 2013 lows, it remains below any point in time since at least 1954.

Similar to GDP growth in periods of low rates, the trend in productivity, shown in the chart below, also deteriorates. This evidence suggests something contrary to the Fed's claims.

Despite what the central bankers tell us, there is a more convincing argument that cheap money is destructive to the economy and thus the wealth of the nation. This concept no doubt will run counter to what most investors think, so it is time to enlist the work of yet another influential economist.

Wicksell's Elegant Model

Knut Wicksell was a 19th-century Swedish economist who took an elegantly simple approach to explain the interaction of interest rates and economic cycles. His model states that there are two interest rates in an economy.

First, there is the "natural rate" which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working age population and the growth in productivity. The chart of the 7-year moving average of GDP growth above serves as a reasonable proxy for the structural economic growth rate.

Second, Wicksell holds that there is the "market rate" or the cost of money in the economy as determined by supply and demand. Although it is difficult to measure these terms with precision, they are generally accurate. As John Maynard Keynes once said, "It is better to be roughly right than precisely wrong."

According to Wicksell, when the market rate is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

If the market rate rises above the natural rate of interest, then no smart businessman would be willing to borrow at 5% to invest in a project with an expected return of only 2%. Furthermore, no wise lender would approve it. In this environment, only those with projects promising higher marginal returns would receive capital. On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

To further refine what Wicksell meant, consider the poor growth rate of the U.S. economy. Despite its longevity, the post-GFC expansion is the weakest recovery on record. As the charts above reflect, the market rate has been below the natural rate of the economy for most of the time since 2001. Wicksell's theory explains that healthy, organic growth in an economy transpires when only those who are deserving of capital obtain it. In other words, those who can invest and achieve a return on capital higher than that of the natural rate have access to it. If undeserving investors gain access to capital, then those who most deserve it are crowded out. This is the misallocation of capital between those who deserve it and put it to productive uses and those who do not. The result is that the structural growth rate of the economy will decline because capital is not efficiently distributed and employed for highest and best use.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Summary

As central bankers continue to espouse policies leading to market rates well-below the natural rate, then, contrary to their claims, structural economic growth will fail to accelerate and will actually continue to contract. The irony is that the experimental policies, such as those prescribed by Bernanke and Yellen, are complicit in constraining the growth the economy desperately needs. As growth languishes, central bankers are likely to keep interest rates too low which will itself lead to still lower structural growth rates. Eventually, and almost mercifully, structural growth will fall below zero. The misallocated capital in the system will lead to defaults by those who should never have been allocated capital in the first place. The magnitude and trauma of the ensuing financial crisis will be determined by the length of time it takes for the economy to finally reach that flashpoint.

As discussed in the introduction, intentionally low-interest rates as directed by the Fed is reflective of negligent monetary policy which encourages the sub-optimal use of debt. Given the longevity of this neglect, the activities of the market have developed a muscle memory response to low rates. Adjusting to a new environment, one that imposes discipline through higher rates will logically be an agonizing process. Although painful, the U.S. economy is resilient enough to recover. The bigger question is do we have Volcker-esque leadership that is willing to impose the proper discipline as opposed to continuing down a path of self-destruction? In the words of Warren Buffett, chains of habit are too light to be felt until they are too heavy to be broken.

Fwd: MIT Computer Model Predicts Dramatic Drop In Quality Of Life To 2020, "End Of Civilization" By 2040

Is humanity approaching a major turning point?  

A computer model that was originally developed in 1973 by a group of scientists at MIT is warning that things are about to dramatically change. 

If the computer predictions are accurate, our standard of living will start to decline dramatically around the year 2020, and we will witness the "end of civilization" around the year 2040. 

Of course this is not the first time ominous predictions such as this have been made about our future. 

For years, experts have been warning that we are heading for severe shortages of water, food and oil as our limited natural resources begin to run out.  For years, experts have been warning that our economic model is not sustainable and that we are heading for a historic collapse.  For years, experts have been warning about the alarming increase in seismic activity all over the planet and about the proliferation of weapons of mass destruction. 

Society is crumbling all around us, and the elements for a "perfect storm" are definitely coming together.

So maybe this computer model is on to something.

The name of the computer program is "World One", and it was originally created by Jay Forrester…

The prediction came from a programme nicknamed World One, which was developed by a team of MIT researchers and processed by Australia's largest computer.

It was originally devised by computer pioneer Jay Forrester, after he was tasked by the Club of Rome to develop a model of global sustainability.

However, the shocking result of the computer calculations showed that the level of pollution and population would cause a global collapse by 2040.

The fact that the Club of Rome was behind Jay Forrester's work is a major red flag, because David Rockefeller and other globalists founded the Club of Rome and it has always been used to further the globalist agenda.

Could it be possible that this computer model is a glimpse into the kind of future that the globalists believe is coming?

According to the model, life as we know it is about to change in a massive way…

At this time the broadcasters addreses the audience: "At around 2020, the condition of the planet becomes highly critical.

"If we do nothing about it, the quality of life goes down to zero. Pollution becomes so seriously it will start to kill people, which in turn will cause the population to diminish, lower than it was in the 1900.

"At this stage, around 2040 to 2050, civilised life as we know it on this planet will cease to exist."

The computer model appears to be primarily concerned with natural resources, pollution and population levels, but other factors should be considered as well.

In order to have "civilization", people need to behave in a civilized manner, and we see more evidence that we are in an advanced state of social decay on a daily basis.

For example, one would think that priests would be some of the most well-behaved and "civilized" members of our society, but a new report about clergy child abuse in Pennsylvania is pulling back the curtain on incredible acts of darkness…

Horrific details have emerged about predatory behavior by priests, including those who made young boys rinse their mouths with holy water to 'purify' them after they were forced to give oral sex and one young boy made to pose naked as Jesus while other priests took pornographic pictures and shared them with other clergymen.

A bombshell report by a grand jury in Pennsylvania has extensively detailed for the first time how 300 priests sexually abused more than 1,000 children and how church leaders, some of whom are still alive, covered it up.

Remember, these 300 priests are just from one state.  There are countless other incidents of abuse all over the country, and it is a crisis that appears to be escalating.

Earlier today, I came across a story about a 22-year-old man in Michigan that approached a group of young girls in a forceful manner, but fortunately they were able to fight him off…

Four Michigan girls successfully fought off a man who allegedly intended to kidnap and have sex with one of them by punching him and flinging hot coffee in his face.

Bruce Hipkins, 22, of Tuscola County, Michigan, was charged with kidnapping, unlawful imprisonment, assault and battery and criminal sexual conduct charges following the incident which occurred Friday night.

The thin veneer of civilization that we all take for granted on a daily basis is wearing very thin, and it is all that really separates us from societal collapse, chaos and anarchy.

Ultimately, a computer model from 1973 is probably not going to be the best guide, but I do agree that enormous societal changes are heading our way very rapidly.  In fact, I wrote an entire novel about what America will start to look like as those societal changes begin to accelerate.  I am more convinced than ever that America is heading for a "perfect storm" that will bring us to our knees, but most Americans appear to have bought into the fiction that everything is going to be okay somehow even though it is exceedingly clear that virtually nothing about our society is sustainable over an extended period of time.  A day of reckoning is inevitably coming, and even a computer model from 1973 can see that.

For those of you that have stopped, it is time to start prepping again.  A major international debt crisis has started, war almost erupted in the Middle East last week, and civil unrest is starting to erupt in major cities all across America.

I believe that we are going to witness bigger changes over the next two years than we have over the last ten years combined.  The clock is ticking, and America's date with destiny is fast approaching.

As always, let us hope for the best, but let us also get prepared for the worst.

Buy Gold, Sell Small Caps - PIMCO Warns Late-Cycle Risks Are Rising

EXECUTIVE SUMMARY

• At this stage in the cycle, investors should consider inflation risk, market dispersion, recession risk and other key factors we discuss in our midyear update.

• We identify five opportunities for the near term as well as provide updated asset allocation views and positioning.

• Investment opportunities, from an asset allocation view, include shorter-maturity bonds, gold, and large cap equities.

There are ample signs of change in the wind for investors. The Federal Reserve is raising short-term interest rates, and U.S. inflation is at target for the first time since 2012. The global trade order that has existed for decades is being disrupted. Several economic indicators are running hot (see Figure 1) even as the current U.S. expansion has begun its tenth year. Volatility is higher as some investors price a dire outcome while others are more sanguine, creating relative value opportunities.

In this midyear update to our outlook, detailed in our paper "Singles and Doubles," we discuss some medium- to longer-term themes relating to late-cycle investing as well as some shorter-term opportunities arising from current market dynamics.

Four key themes

INFLATION

We see significant risk of an uptick in inflation, as detailed in our paper, "Inflation Awakening." We believe investors should understand the inflation sensitivity, or "inflation beta," of their portfolios. Traditional stocks and bonds tend to respond negatively to inflation surprises (see Figure 2), while real assets not surprisingly tend to respond positively; investors should verify and be comfortable with the inflation betas of their portfolios.

In our view, many investors are underexposed to real assets – such as commodities and inflation-linked bonds – and that strategy has generally worked well over the last several years as shocks to risk assets were accompanied by fears of deflation, vastly diminishing the diversification properties of real assets. However, this may not hold true going forward.

STOCK-BOND CORRELATIONS

When above-average inflation starts being a bigger risk than below-average inflation, bonds become a less reliable diversifier for equities and other risk assets. To be sure, high-quality bonds remain a crucial component of a portfolio allocation, in our view, because they are likely to be the best-performing assets in a recession. Also, as mentioned above, inflation-linked bonds are attractive before inflation accelerates. However, investors who count on large bond overlays to damp volatility of portfolios of risk assets may be in for some surprises. (See Figure 3. Also, recent PIMCO research focuses on the underlying mechanisms of the stock-bond relationship. For more, read "Treasuries, Stocks and Shocks.")

DISPERSION

For the last several years, investors have been paid for being long just about any asset (other than commodities) as the exceptional influence of central bank liquidity and lower long-term rates boosted valuations. At this stage in the business cycle, however, with the Fed actively hiking rates and reducing the size of its balance sheet, valuations have become stretched and we should start to see greater dispersion in returns across sectors, regions and factor styles. As is well-known in equity markets, the momentum factor tends to underperform and the quality factor outperform late in the cycle. Similarly, credit spreads tend to underperform equities on a risk-adjusted basis and commodities tend to do well overall as demand starts to outstrip supply. Some of these themes have already begun to play out.

Investors should, in our view, stress-test their portfolios at the factor level rather than asset class level to truly understand how it is likely to behave as this cycle plays out. This also underscores the importance of rigorous global research capabilities to pinpoint attractive opportunities in any sector while managing risks. The ability to better analyze the relative value between assets, countries and factors becomes more important than large beta bets.

VOLATILITY

Market volatility has been increasing for a number of reasons. To begin with, there is general uncertainty around a possible turn in the cycle. Another reason is the potential for implicit portfolio hedges (such as bond overlays) to become less predictable amid greater inflation risk, leading many investors to de-risk by selling assets and reducing leverage. In addition, the Fed is normalizing policy and perhaps re-striking the put (i.e., reassessing the state of economic downturn that would warrant a shift to easier policy or extraordinary measures). And all this is accompanied by something new: a potential change to the framework for global trade that has been in place for decades. These reasons suggest reducing portfolio volatility either explicitly or implicitly by going up in quality, reducing leverage, raising liquidity or purchasing downside hedges. Many investors avoid these strategies in the belief that they all mean reducing yield and giving up potential returns. However, in light of the uncertainties across many markets, we believe return potential over a two-year horizon will likely be better if these strategies are judiciously employed.

Five investment opportunities

With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning. Here are five investment opportunities we see.

SHORTER-MATURITY BONDS

Taking a simplified view, yield curves tend to flatten late in the cycle as the Fed hikes more than expected and then steepen in a recession as the Fed cuts rates. The yield curve has been following this playbook during this Fed hiking cycle, but for a number of reasons we think the flattening is overdone and the risk/reward trade-off favors fading this move.

Three main reasons for the flattening (in addition to late-cycle Fed hiking) are the U.S. Treasury's decision to stop extending the weighted average maturity of its issuance, the anchoring effect of low long-term global rates, and the ability for U.S. corporations to currently deduct pension contributions at the 2017 tax rate of 39% rather than the new 20% tax rate, leading to a rush to buy long-dated bonds. We feel all of these are likely to reverse as the large U.S. deficit combined with the Fed's balance sheet unwinding will supply plenty of long bonds to the market, the European Central Bank is expected to end its own quantitative easing program by the end of this year, and the Bank of Japan signals possible flexibility in its pegging of the 10-year rate at 0%. Finally, the window for the higher deduction rate for pension fund contributions ends in September.

"Shorter-term U.S. corporate bonds are offering more attractive yields than they have in years."

A simpler expression of this trade is to simply invest in shorter-term U.S. corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads. Their shorter maturity not only makes them less sensitive to higher rates, but they may also be more defensive in the event of a slowdown or recession.

BASKET OF EM CURRENCIES

Emerging market (EM) assets came off a torrid 2017, but have had a tough run in 2018 as Fed hikes, fears of tariffs and trade conflicts, and political uncertainty in Mexico, Brazil, Turkey and Argentina have weighed on the market. Emerging markets are indeed highly geared to global growth and global trade. Moreover, institutions often aren't mature enough to handle political change. Any unanticipated slowdown could lead to further underperformance. However, we feel the underperformance is overdone given current risks, and there are pockets of value in EM that rigorous research and an active management approach can uncover. As we discuss in the sidebar, there appears to be an unexplained risk premium associated with EM currencies, which leads us to conclude that a diversified and appropriately sized investment should be part of any long-term asset allocation.

GOLD

Gold is a real asset that not only serves as a store of value but also a medium of exchange, and that tends to outperform in risk-off episodes. As such, one would expect gold to outperform during the recent period of rising inflation expectations along with rising recession risk. Yet counterintuitively it has been underperforming relative to its historical average (see Figure 6).

We believe this is because in the near term, gold's properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger U.S. dollar, dominating its properties as a long-term store of value. This leads, in our view, to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.

LARGE CAP VERSUS SMALL CAP

Small cap stocks have had a good run, outperforming the S&P 500 by close to 5% so far this year. One of the rationales for this outperformance is that small cap stocks are more domestically oriented and hence less exposed to trade wars and tariffs. While this view has some merits, we feel buying lower quality, lower value, higher volatility small cap stocks is unlikely to lead to outperformance should a real trade war commence.

Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favor an overweight of large cap relative to small cap.

ALTERNATIVE RISK PREMIA

Higher volatility and stretched valuations are likely to result in lower risk-adjusted returns from traditional risk premia like equity, duration and credit. While smart beta strategies have been proliferating recently, so far these have mostly focused on equities, an asset class that has been well-mined by academics but where it is still possible to find risk premia and alpha strategies that are uncorrelated to the business cycle.

Meanwhile, there is a rich universe of strategies available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia. Including diversifying but liquid strategies is important, as many strategies that earn an "illiquidity" premium, such as private equity and venture investing, also have a high beta (correlation) to equity markets, which may not be desirable at the current phase of the business cycle.

"Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment."

Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment. While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow "caution" signal. This coupled with expectations for higher volatility suggest a regime of careful portfolio construction and opportunistic investments. In this piece we have highlighted four themes to consider when constructing portfolios and five opportunistic investments across asset classes that we believe will position investors for attractive risk-adjusted returns in the uncertain times ahead.

Your Should Fear The Emerging Market Debt Bubble

Global debt has ballooned since the financial crisis as central banks have distorted markets and fueled debt bubbles in particular.  A lot of the increase in global debt has come from emerging market (EM) economies, especially China. In fact, a record amount of EM debt has accumulated during the past decade, mostly in dollars. A large portion of that debt is therefore denominated in U.S. dollars.

That's why I've long argued that the first shoe to drop in the next crisis would likely be EM debt.

Borrowing is not a problem when dollars are cheap. Low interest rates mean the cost of servicing that debt is low.

The problem starts when the Fed raises rates or the dollar strengthens, even temporarily. The more the dollar rises, the more EM currencies and related markets fall. Dollar-denominated debt then becomes too expensive to repay or service as the dollar rises relative to EM currencies. Before long default becomes the only viable option.

This situation becomes more dangerous than even asset bubbles because debt is required to be repaid on a set schedule. If a country misses a debt payment, it could set off a chain reaction of defaults.

That's why an EM crisis could quickly become a global crisis. In today's world of financial globalization, any remote crisis can become an international problem in seconds. That's the reality of today's markets. Obviously, it could also have major ramifications for your own finances and investments.

How did we get here?

Because of the Fed's rate hike cycle and quantitative tightening (QT) stance, the dollar has become much stronger. The dollar has risen 6.8% since late January alone. And that's put emerging markets under considerable pressure.

Dollars are fleeing emerging market economies as investors are pouring into dollar assets and U.S. Treasuries.

As the Fed itself has warned about such a scenario, "If these risks materialized, there could be an increase in the demand for safe assets, particularly U.S. Treasuries."

That starts a vicious cycle that only strengthens the dollar and weakens EM currencies further. In other words, emerging markets are being deprived of dollars at a time when they need them most.

Enter Turkey.

Panic spread throughout global markets last Friday as the Turkish lira plummeted after the Trump administration announced its plan to double tariffs on aluminum and steel imports. Already down substantially this year, the Turkish lira dropped as much as an additional 24% last Friday.

Even though it's half a planet away from the U.S., the country could have a major impact. Like other emerging markets, Turkey borrowed a lot of money in U.S. dollars after the Federal Reserve initiated its zero interest rates in the wake of the financial crisis.

Turkey borrowed so much that its current foreign currency debt stands at more than 50%. Now, Turkey has a 15% inflation rate and a cratering currency.

As the Fed is raising rates, and the dollar is getting stronger, paying back that money is becoming much harder. The rise in the cost of debt payments means that defaults will become more likely.

Turkey's central bank will need to raise rates to defend its currency, placing the government and economy in a difficult position.

The lira has been holding its own these past few days, but this dynamic could take a long time to play out. Do not assume the crisis is over, and it may be some time before Turkey recovers.

European banks with exposure to Turkey, along with U.S. banks connected to those European banks could encounter serious headwinds, as will emerging market funds. Weakness in one emerging market economy leads to a loss of investor confidence in others. We've seen that movie before.

But what's happening in Turkey right now shouldn't be terribly surprising, given Fed chairman Jerome Powell's attitudes towards emerging markets.

Going back to last October, his words offer a glimpse of what was coming.

Powell was then just the number two guy at the Fed when he publicly articulated his outlook on tightening interest rates, the rising dollar and the impact of both on emerging markets.

He conceded that higher U.S. interest rates and weakening EM currencies "could cause capital to return to advanced economies." But, unlike those that actually pay attention, Powell was not worried. He believed that the "most likely outcome" of that policy shift for emerging markets "will be manageable."

Powell's statement matters. He now commands the central bank with the largest influence on assets in the world. Powell seemed to deny that the Fed is, as Zero Hedge sums it up, the "major determinant of flows of capital into developing economies."

Later on as Fed chairman, Powell reemphasized that position at an IMF and Swiss National Bank gathering in Zurich. According to Powell:

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

But Powell's argument misses a central point. What he left out was that it was the Fed's low interest rate policy to begin with that enabled countries to borrow as much as they did.

If money is cheap around the world, higher rates absolutely matter. It appears he simply did not understand the inflows of cash, which explains why he wasn't concerned about the outflows.

He believes that if the Fed raises rates ("normalizes monetary policy," which it's been doing) and causes money to flow away from the emerging-market countries, it's not his fault.

Powell was not alone in his lackadaisical approach to emerging markets.

Though the International Monetary Fund (IMF) has expressed concerns for years about the impact of a rising dollar and rates on EM markets, it recently said that a reversal of rates would be "orderly and will not take a toll on emerging markets growth."

Well, ask Turkey how orderly it's been.

But capital flows won't be the only negative for emerging markets if the Fed continues hiking rates. We could also see dollar-denominated interest on debt become squeezed if the dollar rises on the back of higher rates.

There's also considerable reason to remain wary about not just emerging markets, but governments and corporations with too much dollar exposure.

How will the current situation affect Fed policy going forward?

Despite Powell's previous comments, the current surge in the dollar gives reason to believe that the Fed won't tighten as quickly as it's said it would this year. A September rate hike, which seemed all but certain a short while ago, is now in doubt. Another rate hike right now and a stronger dollar would only throw more fuel on the fire.

Ultimately, central banks will intervene with additional easing if the crisis gets worse. That means more "dark money" will become available to prop up markets.

That also means stocks could technically continue soaring on the basis of cash or borrowed cash for an even longer period of time. Don't be surprised if stocks move higher from here. That's how dark money works to move markets.