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So act that you use humanity, whether in your own person or in the person of any other, always at the same time as an end, never merely as a means - Immanuel Kant's Formula of Humanity

Sunday, March 29, 2020

Survival of Financial Capitalism

When I wrote my earlier article last week, the US Fed funds rate was 1% and I accurately predicted they are going to 0 sooner than we think. Even I didn't expect that to happen within the next 6 hours. The Fed jumped in and reduced the rates to zero in one go (Hasn't happened in history) and relaunched QE. Not only that - 1.5 trillion stimulus program and a daily 1 trillion repo. The stock market completely ignored this. In fact the fall in that week was the biggest fall for a week since 2008 - when the financial crisis was at its peak. It managed to recover more than 20% this week.

The COVID-19 pandemic is sweeping the world big-time. Human tragedy is beyond the definition of sadness. The threat from COVID-19 really looks like a lifetime event for many of us. Natural calamities like these are unavoidable as nature dictates them. Looking at the economical angle - it looks lot bleaker.We will focus on the economic aspects alone here.

The world economy was so vulnerable in the build up to this crisis, it just happened to be the coronavirus that exposed the underlying mal-investments of the last decade. 

The layoffs have started in the US. The initial job less claims was more than 3.2 million. The All time high of that number is 660,000. The million number - is unheard of in history. Once the pandemic fear recedes, these jobs will definitely return but not all of them would. That is the worry. The GDP is also set to contract because of the virus. There are dire predictions floating around like negative 24%. We just have to wait as it unfolds. Singapore initial estimates on first quarter GDP is a negative 10% which is little more than what was witnessed during the financial crisis of 08.

The world has seen this many times - public property being privatized and private property being nationalized. This happens when existing economic models get transitioned. Mikhail Gorbachev in 1984, privatized what were government managed industries for decades. Private player rushed to buy it. However It did not stop the collapse of the Soviet Union. It was just a transition from one form of economic model that was failing to an alternative model which is perceived to be "working". Bottom line - It is just a transition from one form of society to another form of society because of the obvious signs of lack of productivity in existing human labor. What is happening in the US today of nationalization of loss-making private entities, is no different from what Gorbachev did in 1984 for USSR except that it is exact reversal.

Many things were common
  1. Heavily indebted Federal government
  2. Decreased labor productivity - service sector industry focused economic model finally ran out of steam, proved by the fact that more women in labor force than men and a LOT of part-time jobs and not enough full time jobs
  3. Majority of the population with no savings
  4. Lack of confidence in government entities 
When the Soviet union failed economically in the 80s and 90s, it had a warhead of 10,000 nuclear arsenal. Always a proof that military might is not a replacement for mass labor productivity of the country.

The US government does not want the stock market to go down. It is well aware, if the stock market goes down, private companies would fail. With all the pension funds, global investment money into the US market - it will send all the fund values spiraling down. This will lead to mass exit of capital from the US market. Ben Bernanke very famously told during the 2008 economic crisis - the reason for ZIRP and QEs was to create the "wealth effect". When the markets go down in confidence and sells off - this wealth effect is lost causing a downward spiral.

The truth is no matter what they do, they cannot alter the trend of the market in anyway. If it goes higher - they can make it go little over., if it goes lower - they can slow it down. That is all they can do. Trend cannot be reversed.

The last thing that is holding the US economy together is the VALUE of the US dollar. The dollar index (DXY) is floating around the 100 mark. It was around the 95 handle just couple of weeks ago. The sell-off in the market has triggered a liquidation, and there is a natural need for the dollar as most financials are denominated in dollars. With the "Cash is King" mentality setting in, that money is going to look for alternative investments. If the US stock market continues to go down - the cash will not go there. With the Covid-19 situation getting worse by the day across the globe including the US, the cash is not going into risky assets. Eventually it needs to chase an investment - this could possibly be gold. When that ride happens - it would signal the demise of the dollar. When dollar loses confidence and goes to say the 70 handle (we were there in 2011 post financial crisis) - we are going to see a sea change in the movement of big money across the globe. With the currency risk not hedged by investment from Europe, Japan and Asian investment firms in the last decade there is going to be serious losses for them as their local currency gain value against the dollar. For example, Switzerland Sovereign fund is one of the top 10 investors in apple shares. Apple shares have tanked 25% in the last month. The fund has gone down by a quarter. If the dollar falls and the local currency (Swiss Francs) appreciates against dollar, the loss accelerates because of the currency exchange. With a stable or appreciating dollar the investment is better off and it is beneficial. But the fund cannot withstand a dollar depreciation scenario. Ideally huge investment funds, hedge their investment against currency risks, but the last decade of easy money policy has left them too complacent to follow it. When these loses happening, the global rush outside of the dollar will happen causing more problems for the US markets.

Even though the political establishments can blame the coronavirus for the current state., people who were aware of the bad economic policies of the past decade can easily see, that the virus is just a trigger. The Covid-19 situation will be gone 4-5 months from now. We are seeing Wuhan already returning to normal. As the virus situation recedes what is left is - the huge debt and the economy in its terminal state. The 1.2 Trillion stimulus programs will try to keep the economy afloat, but what happens if they don't work. Inflation will go beyond 3%. Once that is consistently higher, the existing bonds that yield less than 3% are going to be clobbered. Fed will buy it to create a market - but it won't work.

The rest of the world particularly the Asian economies will recover sooner as they are in a better place than the US.

Merely printing money for economic boom never works. If that was the case - every country in the world that can print its own money and can avoid economic set backs. US dollar being a global currency does not give the nation a right to print their way out. Money is just a medium of exchange for productive goods and productive labor. Without the underlying productive entity - the money itself is of no use. Sending $1200 check to all its citizens cannot work. At the peak of the financial crisis, Bush sent these stimulus checks. That did not stop the collapse of Lehman Brothers in September of 08 and the subsequent financial crisis. Similarly this check would also vanish in memory. Believe me - every country wants to send its citizen a check, but there is a small problem with that - no country can afford that.

US government is the biggest debtor in the history of this world. It's plan to bail out other smaller players would have worked in 2008., and will not work this time. The bottom might come out of the US dollar causing general currency issues. With all fiat money in play - all currencies of the world will lose confidence. We are going back to the gold standard.

Lenin very famously told - The best way to destroy the capitalist system is to debauch the currency. The capitalistic west will eventually realize that and it just might be too late. 

Sunday, March 15, 2020

The start of the end

In February all US stock market indexes were at an all time high. The time was right for President Trump to go to Congress for the State of the Union speech and declare victory over the economy. He would once again justify how awesome the economy is and why the prosperity of the people in the last three years of his Presidency was the best ever in US History. He glorified the rise of the stock market and took full credit for it. Little did he knew then, that the very market he glorified will tank into the bear market in record time. In fact, all indexes hit the bear market territory in the first two weeks of March. Market going to bear market was nothing new but the pace at which it got down from the peak into the bear market is unprecedented. The fear of Coronavirus (Covid-19) becoming a pandemic and dangerously spreading across the world swiftly, triggered the collapse of the markets.

As of today 15-March, We are seeing wide swings on daily trading swinging between + or - 4% on any day. In the process we have almost 10% down and up days within a week. The major indexes haven't seen this kind of swings unless you want to go back to the 1929 era of the great depression.

President Trump's reelection is almost 100% dependent on a good economy in build up to the elections in November. If the economy is in recession, it is almost certain that he will end up as one-term President. To avoid that - Trump would be ready to do extreme intermediate steps to postpone the crisis. The mere idea of payroll tax cut or a tax holiday is a direct reflection of that.

The US Federal reserve has kept the economy on cheap money post financial crisis of 2008, and it never managed to get back to normal interest rate in the last 12 years. They couldn't do it, because they were well aware doing that would cause a recession. Chairman Powell however did manage to get to 2.5% mark - almost half of historic average. Once the late rate rise was too much for the economy to manage, he had to pull it back to 1.5%. As stocks began to tank in the first week of March, the yield on the longer term treasuries began to tank. As the 10-year was dangling around the less than 1% mark, he really didn't have a choice but to make a unplanned 50 bps of emergency cut and bring the Fed funds rate to 1%. What scared chairman Powell the most was there were 7 days market freeze for the investment grade corporate bond. There were no buyers and hence no sellers. Within a week, the yield has further dropped down to 0.3% and back up to the 1% mark. The bond market is still pricing in a 50 bps points on the March 18th Fed meeting. They will cut it further I think. Sooner than we think, they are going back to zero percent. As stocks tanked the bond market crated with yields rising for non-government bonds. The spread looks lot scarier. The Fed has also promised to jump in to buy everything with its $1.5 Trillion QE program announced last week. The TARP in 2008 was $700 billion and it was very famously rejected by Congress initially. The bailout fund this week is almost double of that. This essentially is an admission that the problems are bigger than 2008. What is really interesting is - Can the Fed play its card this time. The last time it worked was because - Bernanke, the Fed Chairman then told Congress - the QE was not debt monetization but was TEMPORARY. But from past experience the QE programs always is repeating and every program dwarfs any previous programs in dollar value. The recent announcement of $1.5 Trillion QE programs is all previous QE program combined in dollar terms. They plan to bail out every industry possible. What needs to be observed is - the dollars don't make business viable but the productivity of the labor makes a business useful, viable and hence profitable.

President Trump is unleashing a "Bailout nation" in the guise of National Emergency because of the Covid-19 pandemic. The bond market went up in smoke last week. Trump really didn't have a choice. He had to come and put a floor to the fall. With fiat currency system in place, these government bond yields don't make sense. In fact these government papers trading at the lower yield is not an issue. The pressing issue is the opposite trade. The yield on the junk bonds are rising more than the fall in the US treasuries. That is the worrying part. The corporate bond market is so leveraged that it cannot handle rising rates. Corporate bonds that have junk status and have ratings just above junk are doomed to fail big time. With this trade "We will buy anything out there in the bond market" is the Fed's new rhetoric. They will go on to say, that it is temporary and they will sell it out during the good time. They couldn't do it fully last time, they will never be able to do it next time as well. Will the market buy it, is the $1.5Trillion question.

In the build up to the 2008 financial crisis - falling house prices was the pin that pricked the debt bubble. The bursting of the bubble exposed the over-leveraged debt market primarily mortgage debt. The mortgage debt market exploded initially in the subprime sector and then it spread to the entire mortgage market. The financial companies - that were part of the industry got burnt first like countrywide and then it spread to Fanie mae and Freddie mac - the quasi government enterprises., finally targeting the banking hierarchy from local & regional banks to international banks like Citi. This will solved by government bailouts to the financial sector.

The bailouts from the last great recession and the subsequent building up of national, corporate and household debt has created a far bigger crisis now than in 2008.

The plot that is playing now, is the Coronavirus is the pin that pricked the debt market, which is many fold bigger than what it was in 2008. First it would hit the easy targets and then finally the full scope of the economy. People ask that FANG stocks are doing ok, in spite of the big market correction. My answer to them is - first the soldiers get killed and then the generals. They are all highly leveraged and substantially over-valued. They will go down significantly as well.

The irrational exuberance on steroids of the last decade finally seems to have started to end.

What to look for? What will confirm this? Looks at the weekly jobless claims numbers. It has to go beyond the 255K number. The jobs number for April and May are getting important. With the economic activity almost coming to a standstill on the fear of contracting the virus., that number should go up. If you seen the job reports numbers from the last 10 years, bulk of the jobs were created in the hospital and leisure sector of the economy. With this sector annihilated - there should be thousands and thousands of job losses. With US job market dominated by women workforce (non-labor intensive) that men, the jobs would disappear sooner.

Bailouts would work, if a part of the economy is struggling and the other part is doing good. With the entire stand-still happening, bailouts won't work. Open ended bailout commitment is a sign of weakness and not strength. Moreover the US government is the biggest debtor in the planet. It offering to bailout other smaller debtors just insults rational intelligence.