Zombies And The End Of The "Global Synchronized Recovery"

Several economic indicators have turned to the south at the beginning of this year. They clearly indicate a slowing economic momentum (see this, this and this). This is something that was not supposed to happen. The tax cuts by president Trump and the long-awaited recovery of Eurozone should have carried us to a new phase in global growth. At least, that is how the narrative went.

In June 2017, was warned that the global economic expansion was on its final leg and that signals from China and the US indicated a slowing economic momentum. Was showed that China is closing the limits of its growth model because its investments are turning increasingly unproductive and its credit has grown at unsustainable rate for several years. In the US, the credit impulse was in a clear decline which, in a mature business cycle, tends to foretell of an economic downturn. But the business-friendly policies of president Trump, the economic stimulus ahead of the 19^th National Congress of the Communist Party in China and the "liquidity tsunami" launched by global central banks kept the global economy humming till the end of the 2017.

At the beginning of this year, everything changed. China started to actively curb its excessive credit creation, the quantitative tightening of the Fed started in earnest and the geopolitical risks re-surfaced. Thus, the main pillars of the "global synchronized recovery" started to falter. However, the main trigger of the sudden slowdown is likely to come from the zombified global economy.

Central banks and zombies

In September 2017, was warned that the unorthodox central bank policies had created an ever-growing number of unprofitable  "zombified" firms. A zombie company is a firm that is unable to cover its interest payments from its operating profit (stricter criteria also exist). The zombie firms survive if credit is plentifully available at a cheap price. After 2008, the global central banks created such an environment with very low interest rates and quantitative easing programs.

What the zombie firms do is that they crow out the birth of new productive firms. Arecent study shows that while the Outright Monetary Transactions, or OMT -program, launched by the European Central Bank in 2012, improved the health of the banks on the periphery of Eurozone, those banks extended their loans mostly to low-quality borrowers to which they had a pre-existing lending relationship. This is understandable because if these companies would have failed, they would have taken the banks with them. However, this also greatly increased the number of the zombie firms and obstructed the creation of healthy new firms by diverting bank lending to the 'zombies'. Moreover, the credit misallocation and market distortions created by the OMT program collapsed the overall productivity in industries where the fraction of the zombies  was high. The historical example of Japan shows that if the ailing firms are provided with cheap credit, the job creation is depressed and the overall productivity growth is hindered.

The 'zombification' of the world economy is visible in productivity growth. Since 2008, the total factor productivity (TFP) has been in constant decline except the minor increase in 2010. This is the longest decline in TFP ever seen. We can safely assume that the zombie companies, created by the central bank policies, are the main source for this.

The recovery that never happened

The "global synchronized growth" was nothing more than a pipe dream driven by the unsustainable credit expansion in China and the equally unsustainable bond buying operations by the global central banks. The fact is that the world economy never really recovered from the financial crisis. This is the simple message of the feeble productivity growth.

The central banks pulled all the stops in their efforts to prevent the financial crisis from turning into global deflation. They succeeded, but at the same time they created an unsustainable recovery which gave birth to the hordes of the ailing zombie firms fed by the excess credit and liquidity. The zombie companies cannot survive when the interest rates rise and this is exactly what happened when the Fed enacted its QT-program. Dollar liquidity started to withdraw and Libor-rates started to rise creating a global liquidity and credit shocks.

Therefore, we are likely to face a dramatic slowdown in global growth during the coming quarters, followed by a worldwide wave of corporate defaults ending the "global recovery" narrative which has been supporting the asset markets lately. Thus, the bull market will end and over-valued capital markets are in a serious risk of a crash as was warned in December. Asset market crash would ignite a global financial crisis and lead the world economy to a depression. No one probably thought that a zombie apocalypse would be quite something like this, but we should start to prepare for it nonetheless.

Uncharted Territory For Stock Valuations

Another month and another new high in equity valuations, at least relative to sales.

Indeed, the median company in our developed world index (which covers the top 85% of companies in each country) just achieved a price to sales ratio that eclipsed the 2000 peak.

There are of course fundamental reasons for this ranging from low interest rates to high profit margins, but the fact that valuations today exceed peak bubble valuations of 2000 is a tough nut to swallow for equity investors expecting to achieve an historically average 7% annual rate of return.

What's more, unlike in 2000 when the median valuation was driven higher primarily by tech stocks, leaving plenty of "value" areas to flock to, valuations today are extended across the board, from staples, to industrials to tech to materials.

Save energy as the one sector without peak, or near peak valuations.

This scenario should put ever more importance on stock picking and risk management going forward.

VIX Crashes To A 14 Handle

If only there was an ETF that enable traders to place leveraged bets on lower volatility...

VIX has tumbled for 5 straight days, crashing back to a 14 handle for the first time since March 9th...

 

The VIX term structure is still steeper than it was prior to the XIV collapse...

 

And as the cost of equity protection tumbles, the cost of High yield bond protection has collapsed...

Back to the old normal.

One quick question - bank trading revenues jumped as VIX rose above 20... so what happens when VIX tumbles back to single-digits again?

How Libor's Surge Will Help Pop The Global Bubble

Four years ago, was wrote a piece for Forbes called "This New Libor 'Scandal' Will Cause A Terrifying Financial Crisis," in which was explained that the "real" Libor scandal wasn't the Libor rigging scandal, but the fact that that Libor interest rates were simply too low for too long, which was helping to fuel dangerous economic bubbles around the world. It was frustrating that, despite all the attention the Libor rigging scandal had received, almost nobody was paying attention to the even larger crisis that was looming. It's not that it was trying to minimize or trivialize the Libor rigging scandal; it's just that we believed that the mainstream financial world was missing the forest for the trees. As explained, the Libor rigging scandal caused tens of billions of dollars worth of losses, but the eventual popping of global bubbles that formed as a result of ultra-low Libor rates would gut the global economy by trillions of dollars. We still firmly believe that.

"Libor" is an acronym that stands for "London Interbank Offered Rate," which is an important benchmark interest rate that is used to price loans across the globe. As explained in 2014:

As the world's most important benchmark interest rate, approximately $10 trillion worth of loans and $350 trillion worth of derivatives use the Libor as a reference rate. Libor-based corporate loans are very prevalent in emerging economies, which is helping to inflate the emerging markets bubble that we are warning about. In Asia, for example, Libor is used as the reference rate for nearly two-thirds of all large-scale corporate borrowings. Considering this fact, it is no surprise that credit and asset bubbles are ballooning throughout Asia.

Like other benchmark interest rates, when the Libor is low, it means that loans are inexpensive, and vice versa. As with the U.S. Fed Funds Rate, Libor rates were cut to record low levels during the 2008-2009 financial crisis in order to encourage more borrowing and concomitant economic growth. Unfortunately, economic booms that are created via central bank manipulation of borrowing costs are typically temporary bubble booms rather than sustainable, organic economic booms. When central banks raise borrowing costs as an economic cycle matures, the growth-driving bubbles pop, leading to a bear market, financial crisis, and recession.

The chart created in the original Forbes piece shows how historic bubbles formed during periods of low Libor rates (also, low Fed Funds Rates, as the two are highly correlated). What is particularly concerning is the fact that Libor rates have remained at record low levels for a record length of time, which I believe is helping to inflate a global bubble that is more extreme and potentially ruinous than humanity has ever experienced.

Similar to the U.S. Fed Funds Rate, the Libor has been rising for the last several years as central banks raise interest rates. While rising interest rates haven't popped the major global bubbles just yet, it's just a matter of time before they start to bite.

While most economists and financial journalists view the rising Libor as part of a normal business cycle, I'm quite alarmed due to my awareness of just how much our global economic recovery and boom is predicated on ultra-low interest rates. With global debt up 42 percent or over $70 trillion since the Global Financial Crisis, interest rates do not need to rise nearly as high as they were in 2007 and 2008 to cause a massive crisis.

Though we are obviously concerned about rising Libor and Fed Funds Rates, we are realist and pragmatist when it comes to investing and trading; I'm not a "permabear." As showed recently, most U.S. stock indices are still in an uptrend despite the volatility of the past several months. This is a time to be a nimble trader with a finger on the "sell" button if and when the primary trend breaks down in a serious way.

"Go With The Flow" - Trader Warns "The Market's Not Ready To Be Properly Understood Yet"

One glimpse at the pumps and dumps in Small Caps over the last few weeks and it is clear that volatility is back.

But as former fund manager Richard Breslow notes, for all the much anticipated fun of having volatility back, it has proven to be a really tricky time to trade.

It isn't that this is the bad kind instead of the good. Which is a sort of euphemism for not really having a handle on what is going on.

But, frankly, no one can be faulted for looking at this environment and struggling to keep up with the narrative thread.

So rather than trying to shoehorn a coherent and all-encompassing explanation of current price action, this is one of those times where you may just need to go with the flow. Even if at times those flows seem wholly at odds with each other.

Via Bloomberg,

This is a trading not an investing market. Very few of us are having great thoughts that facilitate making money now. Open mindedness and flexibility are usually valuable traits in investing. Never more so than now. Wishing things to be so won't change the numbers. And guessing where things are headed over the long haul is interesting but not more than that. To add insult to injury for those struggling to find their groove, put together what people are bemoaning and it comes down to: what they want to trade isn't moving, what should be going down is creeping higher and what should be going up finds itself trying to scale a greased pole.

This is all oddly, if annoyingly, appropriate.

Forget for the moment the major geopolitical issues, investors are tying themselves into all sorts of analytical knots over issues that should be a trader's bread and butter. I read an excellent article last night that successfully argued that the European economy was going gangbusters even as it is markedly slowing. That reform within the EU is gaining speed while things are hopelessly deadlocked. That the ECB needs to be preemptive in its normalization efforts but should let things run hot so it all doesn't crash and burn. And it all made perfect sense.

Strangely enough, my favorite chart at the moment is EUR/USD, even as the cross is being roundly cursed for refusing to move. But it isn't moving in the context of being absolutely trapped for the best part of the last three months between the 50% and 61.8% retracement levels of the big move down from the 2014 high to the 2017 low. What a story it will weave when it breaks out and you won't get a better proxy for where the dollar overall is likely headed. In the meantime there's a 3.5% band to play back and forth.

The dollar index is turning into a real heart breaker, looking serially constructive or moribund and sucking people into trades with seemingly malicious intent. Lessen the noise, there's too much of it. The dollar writ large is unlikely to make a move and leave the euro standing still.

The S&P 500 has sprinkled gray hairs around many a trader's head. But the reality is it has been doing an impressive job of trying to prove that whenever the dust seems to settle down the grind move continues to be higher. Watch how it trades into resistance just above 2700. That will give a hint if this is corrective or getting painfully interesting.

As for my personal bete noire, 10-year Treasuries need to get moving or face a renewed exploration of levels I expected not to see again. A move back below 2.80% will not be of indifference to bears. On the other hand 2.90% is an equally decent pivot. You can't cut it tighter than that, but that's bonds for you.

There is one thing to take comfort in. The counterparty to your last trade doesn't know something that you don't.

Even US Government Economists Predict Trouble Ahead - Fannie Mae forecasts an economic slowdown by 2019

Doug Duncan is not your average beltway economist.

The chief economist for Fannie Mae is surprisingly outspoken about the troublesome outlook for the US economy. He's worried about the rising cost of debt service as outstanding credit continues to mount at the same time interest rates are starting to ratchet higher, too.

He predicts the US will enter recession within a year, concurrent with a topping out of America's real estate market. It wouldn't surprise him to see the stock market falter, too, as central banks around the world begin a coordinated tightening of monetary policy and -- similar to the thoughts recently expressed within our podcast with Axel Merk -- Doug expects Jerome Powell to be much more reluctant to intervene in attempt to support asset prices. Having met personally with Powell, Doug thinks the Fed is now happy to see some of the air come out of the Everything Bubble (just not too much and not too fast) -- a market change from past Fed administrations:

Our forecast definitely sees slowing economic activity, particularly in the second half of '19. Part of it has to do with the length of the expansion. Just because an expansion is long doesn't mean it's going to end; but they all have eventually ended, and this one is getting pretty old. I think if it's not the second longest, it's getting to be the second longest that we've ever had shortly.

The tax bill was viewed differently by different parties, but the capital markets initially took that -- plus the $300 billion agreement to get past the expiration of government funding plus the budget agreement -- they took all those things as inflationary. The tax bill itself has a lot of temporary provisions – some of them don't expire for up to seven years – but some start expiring as soon as three years out. Like, on occasions, take actions today which they see having benefits up until that time of the expiration of those terms, plus the spending component – the $300 billion – also will likely take place in the next four quarters. That suggests that the second half of '19 we may well see the impulse from those things starting to fade. And that will be happening at the same time as the Fed, if it does what it says its going to do, will be continuing its tightening(...)

So,what keeps me up at night? Well, I don't like the idea that we have a debt to GDP ratio of 100 percent. I don't think we're Japan because we have a more entrepreneurial economy, not a mercantilist economy, but that doesn't mean that debt doesn't reduce your flexibility. It definitely reduces your flexibility, so it raises risks from that perspective.

The trade negotiations, obviously, are of a concern. Milton Freeman said a good free trade agreement can be written on one page. NAFTA was two thousand pages. It would be silly to suggest Trump doesn't have a point that there's not something in that two thousand pages that didn't work against American interests. On the other hand, if you're going to throw $150 billion of tariffs at the second largest economy in the world, you should expect a reaction. Those who read the history books and the Smoot Hawley tariffs and the Depression and have some understanding of the relationship between the two of those have to be a bit nervous. The Fed, I'm sure, is looking at that.

And the domestic economy, the thing that probably troubles me more than anything else is the decline in new business formation. It's been underway for thirty years. I've got staff that are working just trying to understand that. There's a couple reasons why I worry about that. I just make a comment about ours being an entrepreneurial economy which means it is 'dynamic' – people don't care if the average income is higher than theirs if theirs is the median. If they expect that there's an opportunity for them to grow and gain one of those high incomes, then they're OK. But if they lose that hope, that leads us to some different possible political economy outcomes which I don't view as particularly optimal.

But from a self-interested perspective -- remember that we're in the housing and new business formation space – it used to be the case that a when small business would start, it couldn't afford to pay the same wage rate as a large business did because it didn't have the scale or the output or that kind of thing. But what the worker who got the lower wage job also got was training on how to get to work on time, how to work a full day. They would pick up some skills and some behaviors that worked broadly in the employment market. Over time they would move up, and most of them would eventually get to the middle class and buy a house. That's breaking down.

If that engine of growth for people has been cut off, then we could be facing a permanent underclass which carries a whole different set of connotations for a society which, to me, is pretty troubling.

No Better Signal Than The Yield Curve

Remember back a few years ago when all the hard-money advocates were complaining about how the Federal Reserve was distorting the economy with their zero interest rate policy?

Hedge fund managers like Greenlight Capital's David Einhorn constantly harped about the artificial "sugar high"the aggressive monetary policy stimulus was inflicting on both markets and the economy. These disciples kept pushing for higher rates. Immediately. Like yesterday.

Well, they got their wish. After six years of leaving rates basically at zero, in 2016 the Federal Reserve embarked on a tightening campaign and rates have been marching higher ever since.

I can already hear the complaints from the hard-money crowd about why this isn't good enough - the Federal Reserve is raising rates, but it's been at a glacial pace. And no doubt they are correct. This has been one of the slowest tightening cycles on record. And let's face it - two hundred basis points of tightening in two and a half years is not that much.

Yet, the reason for the dawdling pace of rate raises can best be summed up by one of Forest for the Trees' Luke Gromen's tweets:

Never has the world been this indebted. To think this massive debt burden won't affect the economy's sensitivity to rate hikes is just naive.

I have no desire to engage in a discussion about the correct course of Fed action. I have my opinion, but it means squat. I am much more interested in figuring out what the market believes.

During the past two years, the whole LIBOR curve has been pushing higher. For example, here is the Eurodollar 3-month future yield curve today and one year ago:

Easy to understand. The whole curve has shifted higher as the Federal Reserve has raised rates.

But the developments of the past month are much more interesting.

Rates at the front end of the curve have risen, but instead of the whole shifting higher, the long-end has fallen in yield. Stop and think about that development.

Although we are miles away from being inverted as the front part of the curve is still relatively steep, the market is sending signals that the end of the tightening cycle might be in sight.

Eventually, at one the FOMC meetings, the Federal Reserve will raise rates and everything but the short-end of the yield curve will rally. At that point, the Federal Reserve will have hiked rates into the next recession.

And make no mistake. The market will know before any Federal Reserve official. There is no better signal than the yield curve.

Don't ignore the shot across the bow that this recent flattening of the LIBOR curve is flashing.The current economic cycle is already one of the longer ones on record, and even though the Federal Reserve has been slow in raising rates, it might take fewer rate hikes than in previous cycles. Don't bother arguing with the hard-money gurus about the correct policy course. Just watch the yield curve. The market is smarter than all of us.