Last night Argentina defaulted on its huge debts for the second time in 13 years. This reminds me of news stories today about the hundredth anniversary of WWI. One wonders if the default will trigger more problems in other EM countries like the June, 2013 Taper Tantrum where the Federal Feserve damaged EM countries by announcing an eventual reduction in Quantitative Easing. The EM countries have never restructured to an internally generated demand model and instead are still using the old model of simply exporting to affluent Developed countries who buy more than they can afford by going into debt. Such a policy has reached its limits and is thus extremely vulnerable to another “Taper Tantrum”. The typical EM recession occurs when their artificially low interest rate caused their currency to collapse and then EM citizens can’t pay debts denominated in foreign hard currency. If a Taper Tantrum results in outflows of foreign capital from EM countries it will trigger another crisis like the one in Asia in July, 1997 and in other EM countries. That one led to a huge drop in global interest rates.
David A. Levy, who oversees the Levy Forecast, is a bearish economist. He said on 7-22-14 newsletter the 10 year Treasury yield will be below 1% in 2015 as a future EM crash hurts U.S. Really shocked by his statements; he said similar comments in Barron’s a few month ago and they were very watered down. Next recession 2015 or 2016 per him, probably sooner; implies stock crash early 2015. Short term rates to stay low until 2018; it’s a 10 year “contained depression” in 2008-18. I think reading his article yesterday and reading on 4-18-14 Barron’s Rob Arnott article (see my post) and recent Welling article with Arnott shows bear case is true and correct and is not a fantasy proposed by unschooled amateurs.
Some people may worry the dollar will become worthless and that foreign countries are somehow magically better run than the U.S. Instead it is just the opposite as other countries are much more prone to deficit spending including having less of a Tea Party anti-deficit influence. Further other countries have a much less restrictive banking system which enables more reckless and inflationary lending in the private sector; also US is more entrepreneurial and more accepting of immigration.
Recently Rob Arnott said there is an 80% correlation PE10 with next 10 years of stock returns – I think that’s huge to get such a high correlation. I think masses of consumers and advisors are structured to have confirmation bias in favor of bullish advisors and a bearish advisor has a less easy time recruiting clients, thus society is brainwashed by a bullish Wall St. propaganda machine.
I agree with Levy that balance sheets need to grow for profits to grow and that profit declines are a crucial explanation of how recessions start, so one should watch for declining profits. My own observation is that when a borrower is overstretched then any minor reduction in income or profits makes the borrower’s (either corporate or personal) debt unserviceable, then defaults occur like a stack of dominos, followed by a credit crunch, leading to more recessive outcomes.
The current expansion has now become older than usual and is heavily dependent on continued low interest rates and easy credit, which could be quickly cut off in a minor panic either caused by inflation or caused by a decline in credit quality.
The reason debt kept growing so much for the past 30 years was because interest rates were coming down from very high levels of 22% in 1981 so today’s low rates made it possible to handle much higher loan balances. The rate decline was assisted by globalization including dumping of goods by EM exporters which lowered U.S. inflation, further encouraging low interest rates. Then the huge dotcom bubble crash led the Fed to cut rates in 2002-03. Further, the deceptive mortgage bubble of 1997-2007 provided artificially low rates to unqualified borrowers who should have been charged much higher rates to reflect the true high risk status. Had these borrowers not accessed low cost Easy Qualifier loans then the growth of credit in 1997-2007 would have been lower.
Now there is no way that interest rates can go much lower (except for Treasuries) and even if they did the amortization of principal is a curvilinear formula which means that as rates decline then more of the payment goes to principal and thus the borrower doesn’t experience a direct linear cut in his payment. So the 30 year continuous expansion of debts has hit a wall and thus the economy is deprived of an important source of growth.
To prepare for the crash one should reduce holdings of below investment grade bonds, loans, etc., reduce holdings of stocks and real estate with an emphasis on getting rid of the lowest quality, riskiest assets such as small caps, growth stocks, tech stocks, high PE stocks, natural resource stocks, etc. Investors need independent financial advice about the risk of a stock crash. I wrote article “Is Emerging Markets debt riskier than it appears?”