TFTF

Decade of Living Dangerously, Part 2

January 10, 2020

If living dangerously is your goal, just keep adding reasonable, manageable, prudent risks. Eventually they’ll add up to serious danger.

Hyman Minsky showed how stability leads to instability. Humans have a way of reinterpreting stable periods that seemingly redefines words like reasonable, manageable, and prudent. That’s why we continue chasing yield and risk until we go too far.

To think that we have somehow eliminated recessions and risk, or that central banks and the government have somehow become adept at managing the business cycle, is simply foolish. Yet we keep doing it, every single time.

Debt seems harmless enough at first. You have reliable cash flow, repayment is no problem, and you’re going to spend the borrowed money wisely. But human nature tends to make us overdo otherwise good things. And, with debt, you may also have lenders actively urging you to borrow even more. Everything is fine… until it’s not.

Personal debt, while sometimes excessive, isn’t the main problem. Government and corporate debt are the bigger challenge and the reason we will spend the 2020s living dangerously. All that debt is ultimately personal debt, too, since most of us are either taxpayers, shareholders, or both.

In Part 1 of this forecast I described my relatively benign outlook for the next 12 months. The calm may last into 2021 and even beyond. But beneath the surface, pressure will still be increasing. It will grow slowly, almost imperceptibly, but eventually explode.

Or, to use another metaphor: We are frogs in the kettle and someone just turned on the heat. By the time we notice, our good options will be gone.

The Long Now

My friend Ben Hunt at Epsilon Theory has been writing a series called The Long Now. I won’t try to summarize because you should read it yourself. Suffice it to say, it is both thought-provoking and disturbing. A quick snippet from his introduction:

The Long Now is everything we pull into the present from our future selves and our children.

The Long Now is the constant stimulus that Management applies to our economy and the constant fear that Management applies to our politics. (Ben has a rather broad view of what he calls capital “M” Management which includes government, central banks, and others.)

The Long Now is the Fiat World of reality by declaration, where we are TOLD that inflation does not exist, where we are TOLD that wealth inequality and meager productivity and negative savings rates just “happen”, where we are TOLD we must vote for ridiculous candidates to be a good Republican or a good Democrat, where we are TOLD that we must buy ridiculous securities to be a good investor, where we are TOLD we must borrow ridiculous sums to be a good parent or a good spouse or a good child.

Ben’s point goes way beyond debt, but that’s where he starts. By definition, debt is spending that we “pull into the present from our future selves and our children.” Or as I’ve said often, debt is future consumption brought forward in time.

Debt lets you consume more now, but to repay it you (or someone) must consume less in the future. Used properly, debt can enhance growth enough to cover the eventual repayment. That’s not what is happening—and it’s a big problem in a consumer-driven economy.

However, Ben Hunt observes that the problems can simmer much longer than we usually think. Humans have an amazing ability to postpone the inevitable and—when the subject is debt—a financial incentive to do so. That’s true for both borrowers and lenders.

“The Long Now” is a good way to describe the extended simmering period. At any given moment, you’ll be able to say, accurately, the situation is stable (like right now). Since last December we have seen markets go gangbusters. If you were in US stocks, in a buy-and-hold index fund, you made money and lots of it. Even value and dividend players are scooping up big returns. Remember last week and last year I was worrying about corporate bonds? Silly me…

Not Worth the Risk

A huge amount of money is clearly turning to corporate bonds as it reaches for yield. But then again, why not? The world seems stable. We seem to finally have some progress in the US/China trade wars. The market is telling us everything is okay… much like it did in 2007. Then came 2008.

We are using this stability to justify turning up the heat by adding more debt. There’s no reason to think we will stop. The Institute of International Finance, whose Global Debt Monitor tracks the numbers, says worldwide debt climbed $7.5 trillion in the first half of 2019 to hit $250.9 trillion.


Source: CNBC

In November, IIF estimated global debt would surpass $255 trillion by year end. If so, it was a 4.8% increase for the calendar year. That’s faster than GDP growth for either the entire world or most developed countries. It’s also faster than population growth in most places.

Let’s think about that number for a second. That growth rate, which there’s every reason to think will accelerate further, means we can expect $400 trillion in global debt by 2030. That’s not counting the $120 trillion in US government unfunded liabilities. My friend Larry Kotlikoff thinks it’s closer to $200 trillion and I think it is reasonable to assume Europe is in that ballpark. They too have made pension and healthcare promises that their budgets can’t deliver without significant deficits (thus more debt) and in general, their tax systems are already stretched to the max.

While longtime readers know I’m against higher taxes, I can do the math here in the US. We are going to have to raise taxes if we want to stay anywhere within shouting distance of fiscal sanity.

That which can’t continue, won’t. It is simply not possible for per capita debt to keep growing faster than the economy in which the debtors live. There are limits. Recent experience suggests they are more distant than many of us thought, but they’re out there.

One last thought. When we do have a recession, which again I point out is likely to be after the election (the only meaningful data point between now and the end of next year), the deficit will explode to over $2 trillion per year and, without meaningful reform, never look back. That puts US debt at $35 trillion+ by the end of 2029.

Here’s a chart Patrick Watson and I made a few months back, projecting deficits at the end of the next recession. We assume CBO spending projections (which are likely low) and that tax revenue falls by the same percentage it did in the last recession.

Unproductive and Non-Linear

We worry about US government debt, and rightly so, but it’s only the beginning. Corporations have leveraged themselves to the teeth, and much of that debt could easily turn into government debt.

The last financial crisis revolved around mortgages and related derivatives. Millions learned a hard lesson and spent the next decade deleveraging. Yes, people still get in over their heads but it’s far less common now.

However, that missing mortgage debt has been replaced with additional government debt. The overall debt picture continues to worsen. For the moment, it is sustainable because the economy is growing (albeit slowly, but at least it isn’t contracting).

Lacy Hunt of Hoisington Investment Management tracks a number that ought to give us all cold chills. “Debt Productivity” is the amount of new debt associated with a given amount of GDP growth. Last quarter he found that each dollar of global debt generated only $0.42 of global GDP growth. That was down 11.1% from ten years earlier.


Source: Hoisington Investment Management

Worse, this isn’t a linear trend. We can expect it to accelerate as debt grows faster than GDP. At some point, debt becomes completely about consumption and, as noted, bringing consumption forward means less consumption later.

Debt growth isn’t linear, either. It has risen almost everywhere even without the negative events (recession, war, etc.) that historically drive it higher. We might be in better shape if corporations had, like homeowners, used the last decade to deleverage. They didn’t, in part because central banks made borrowing all but irresistible. Companies borrowed vast sums not because they needed to, but because they could. Often they used it to repurchase their own equity and further leverage their balance sheets.

My friend Peter Boockvar says we no longer have a business cycle, but a credit cycle. Central bank rate cuts encourage us to borrow, which is fun, but they can’t cut forever. Then they stop cutting, liquidity dries up, and we panic. Then we get things like the present repo crisis.

This isn’t lost on the powers that be. There is actually something of a debate going on in monetary policy circles. Some at the Federal Reserve think we are in a Goldilocks era, with everything being just about right, and thus more rate cuts and QE are fine. Others have serious concerns and more than likely really wish to pound on the podium. But decorum says they can’t.

Whatever happens, the visible result is that each recovery phase is smaller than the last. Eventually they will stop being recoveries at all until we “rationalize” the aggregate debt. That’s economist-speak for default/monetization/restructuring or whatever term you want to use. Until that happens, the word “recovery” will be meaningless. We can’t repay debt without growth. We’ll have to liquidate it in some fashion.

How do we do that? Inflation is the historically tried-and-true method. Right now central banks are struggling to generate the kind of inflation that would do this. Maybe they’ll figure it out, but I think default is the more likely outcome.

However, it won’t be the kind of default any of us have ever seen before, or even imagined.

The Great Reset

I said all the above to set up my 2020s outlook. In short, I expect we will rock along sideways in this “Long Now” period. At any given time, we’ll look at the data and think we avoided the worst. We will get some recessions and financial crises, but they’ll look “manageable” after we get through them. Indeed, we will manage them.

What we won’t see is sustained expansion of the strength necessary to finance our debt, which will continue growing as The Long Now progresses. So the debt burden will get heavier, and eventually be unbearable. Then the proverbial stuff will hit the fan.

A couple of years ago in my Train Wreck series, I described a multi-step process.

  • The Beginning of Woes: Something, possibly high-yield bonds, will set off a liquidity scramble. It will spread through the already-unstable financial system and trigger a broader credit crisis.
  • Lending Drought: Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter recession.
  • Political Backlash: Concurrent with the above, employers will be automating jobs as they grow desperate to cut costs. Suffering workers—who are also voters—will force higher “safety net” spending and government debt will skyrocket. A populist backlash could lead to tax increases that prolong the recession.

I still expect something like that sequence, though it may be more of a drawn-out, rinse-and-repeat process. I think we could see multiple sequences before a final, market-clearing Great Reset, which I expect in the latter half of the 2020s.

After each recession/crisis, and especially as technology begins to eat into middle-class jobs, expect complete political upheaval every four years at a minimum. The politicians will make promises and they will simply not be able to deliver, and a new group will make different promises that don’t work, either.

The deepening political divide isn’t just left and right. It’s also both sides being frustrated with what they consider to be “elites.” If you’re reading this letter, most of the population would probably put you in that category. Yet you probably don’t feel elite. I sure don’t. I am one of the luckiest and most blessed men in the world, but I certainly don’t think, at least from my very humble beginnings, of myself as anything approaching elite. This disconnect is a big part of the problem.

Philippa Dunne recently said in The Liscio Report that we no longer have a shared sense of reality in this country. We observe the same circumstances with our own interpretation of reality, then wonder why other people don’t see it the way we do.

I look at these problems every day and I have trouble understanding the complexities. The average person? A man hears what he wants to hear and disregards the rest. We have retreated into our social media and personal echo chambers and made them our reality, completely different than that of other groups/tribes.

In online gaming worlds, players “grind” through dungeons and zombies to gain points to move on. In my version of The Long Now, we are now entering the “grinding” phase. We just simply push forward, taking on whatever challenge comes next (whether zombies or central bank policy, which may be the same thing). Meanwhile the debt will keep accumulating, slowing growth but buying yet more “grinding” time.

Eventually we will reach The Great Reset, and it won’t just be another recession or even a depression. It will be a true, world-shaking, generational crisis. My friend Neil Howe talks about the Fourth Turning, a societal calamity that happens every 80 years or so. The last one was World War II. My good friend George Friedman has a forthcoming book titled, “The Storm before the Calm.” He sees two cycles in the geopolitical world, one 80 years and one 50 years, that converge in the late 2020s. Coincidence? Maybe, but it’s just about when I think we will have The Great Reset.

We will see political and social upheaval. The capstone: All that debt will be brought to the market, rebalanced, and the market will “clear” at some new valuation. All asset prices (and every debt is someone’s asset) will reset.

There will be winners and losers. Because we don’t know who will be in political control of any particular place when this happens, it is simply impossible to predict the winners and losers today. Plus technology could change the very nature of international currency markets.

But first we will endure The Long Now. It will look like it can go on forever, and maybe it will. I don’t know the future. But my understanding of history, my perceived reality, says it can’t continue. There will be a reckoning, after which we will see real growth and prosperity. Good times are coming. At least I think and hope so.

The Great Reset won’t hurt everyone equally, or in the same ways. The pain will be unequally distributed. As I said, a lot depends on who controls the process. Politically, populists are gaining power in both left and right wings. Their concerns and priorities differ, but both are anti-elite and both want their favored groups to have “more” and push the costs on someone else.

That sounds like a formula for violence, and it is, but eventually people tire of fighting and become willing to compromise. Or the market forces them to compromise. That will be The Great Reset—a kind of global do-over. No one will get everything they want, but everyone will get a fresh start. Then the cards will fall where they may.

The unknowable part is how much pain we will have to suffer first. It could be a lot…

The good news is that the grind of The Long Now will let you prepare for whatever comes. And we have many examples of countries going through their own individual “Great Resets.” In the case of Argentina and/or Italy, many times. I have visited both countries and they are wonderful places when they are out of crisis.

That’s exactly what I think will happen all over the world after The Great Reset. It will be a wonderful place to be.

You don’t have to be all alone in The Great Reset. Personally, I can’t think of anything better in any crisis than being part of a tight-knit group of like-minded individuals, whether that is close family or my social and business circles.

Next week, we will—for a very short time—reopen the Mauldin Economics Alpha Society to accept 100 new members. There have been some big changes since last year, so make sure to read your invitation when you receive it. As we only have a limited number of seats available this year, we are asking readers who are interested to fill out a membership application. I assure you, though, that it will be more than worth your time.

New York and the Most Optimistic Man in the Room

I’m looking for an introduction to two people – Andrew Yang and Ambrose Evans-Pritchard. If anyone can help me with this, please send me a note here. Thank you.

At some point in the next few weeks I anticipate going to New York, and several more times this year. I have no other plans to leave Puerto Rico until I finish this 1,200-pound gorilla on my back of a book.

Speaking of Puerto Rico, many friends heard about the recent earthquakes and asked if Shane and I are alright. Short answer, we are. The earthquake was on the other side of the island from us. But the southwest portion got hammered with the 6.4 magnitude earthquake early this week and many aftershocks. Quakes here have (knock on wood) been minor compared to California, but the entire Caribbean is along a slower-moving fault line, which means more small quakes and fewer large ones. Small comfort to those whose homes collapsed this week. And I vividly remember the Haiti quake which took one of my best friends.

Power is slowly coming back up. We have a large diesel generator in our garage that is keeping us going, although we have to be frugal with our electric usage. Internet service is down on much of the island, so I am using mobile phone hotspots. Restaurants and stores are generally open. Maintenance services are available.

All in all, it’s a minor price for living in paradise. Earthquakes, tornadoes, hurricanes, fires, and all sorts of disasters can strike anywhere. It just reminds you how we are not in control of everything in our lives.

I know that talking about The Long Now and The Great Reset sounds gloom and doom. But in my personal life, I am launching new businesses, making plans, investing in new ventures, and seriously contemplating an aging-focused venture capital fund. I see opportunity everywhere I look. Humanity has faced problems before. Our time will be different, but progress will continue.

I am the most optimistic man in the room, if a tad realistic about our economic landscape. I just want to make sure that I am on the other side of the island when that big future economic earthquake hits, and have backup power. Just saying…

Next week we are going to look at why we should be more optimistic than at any time in human history. Seriously. But now it’s time to hit the send button, so let me wish you a great week and the best for 2020.

Your planning to optimistically grind analyst,

John Mauldin

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Michael Wheeler

Jan. 13, 4:22 p.m.

Hi John,
I look forward to reading your excellent articles each week. In your latest you mention that the debt could continue for a while longer before we reach the great reset. But, what if all our knowledge and figures are somewhat false because we do not have all the data to compile it correctly. Let me refer to the repo problem that is ongoing. Most newspapers and reporters have given this very little mention if at all. We know that it is a big problem because the overnight rate jumped to 10%. The FED then came in and started offering (printing ) billions of dollars. This has mushroomed from $60B up to $200B per day! If it wasn’t for the excellent work of Pam and Russ Martens writing in Wall Street on Parade I doubt that many people would have any idea of the New York FED and what they have been up too. The suspicion is that one of the big 5 US banks has been swallowing up this overnight money possible JP Morgan. Wall Street on Parade have filed a Freedom of Information act (FOIA) to try and get to the bottom of who is actually benefiting from all the money. Unfortunately, the FED is not complying by refusing to give them and answers. So, the question remains, if the banks are all doing just fine what/why is the FED being so eager to keep give them such huge sums of money. One has only to think back to the last financial crisis and note that it took many years of persistent requests before we even found out that the FED had secretly pumped out $29 trillion to the big banks around the world! The only thing we do know for sure is that this is going on is because the FED’s balance sheet has once again blown out to a much larger figure than a few months ago. So, whatever is going on between the FED and the big banks it cannot be good if everyone is doing their best to keep it quite and cover it all up. I hope the other reporters also start asking serious questions about the FED and it’s Repo actions before the whole thing blows up in our faces and the poor taxpayer is once again left to pick up the pieces.

Michael Wheeler

Jan. 13, 3:52 p.m.

Hi John,

bob nicholas

Jan. 13, 12:58 a.m.

Chart GDP to debt.
None of the world’s major economies/regions are at .42.
What huge countries raise the average to 42?

mcglover925@gmail.com

Jan. 12, 2:15 p.m.

Dear John, I have read you and your colleagues´columns for many years and agree with many of your points of view.  Having experienced living in other countries, I agree completely with your conviction that a VAT tax is positive and necessary to finance and support public spending, while it allows other business and personal income taxes to be rationalized to advance national policy goals and eliminate the complicated, contradictory and sometimes corrupt tax structures that govern us today, which don´t seem to alarm our elected representatives for myriad and obvious reasons, and those need to be corrected.

I also share your concern for a carbon tax or other clear economic structure to channel business and personal investment to address climate issues, as this is desired not only by environmentalists but also by the business community to define its future risk.  Our government institutions should promote this and other environmental initiatives both internally and in world forums.

I have the suspicion that you are coming to see merit in Yang´s universal basic income proposal as the reality of AI, robotics and other technological advances will completely reshape society in the future.  The current patchwork of SS and assistance programs for retirees and those unable to function independently in our complex society is becoming unwieldy and a UBI could be the modern version of what the Social Security program was in its inception.  And there are desirable side benefits to the UBI concept, such as reinforcing rural communities, maybe unleashing personal creativity and allowing more volunteer work and currently unpaid family support.  More thought needs to be focused on this.

Ill be very interested in seeing where you’re going in your upcoming book.  Good luck..

belikemike@rogers.com

Jan. 12, 9:43 a.m.

Debt is a byproduct of the true malaise in the economy - Income Inequality. If you give a minimum wage earner an extra dollar an hour he will spend it all in the neighborhood. He won’t spend it on fancy european sports cars or an overseas vacation or buy shares in Apple or squirrel it away in the Cayman Islands. The spending of that $1 will result in a demand based recovery as opposed to the current debt based recovery.

You can’t increase taxes on the rich. They are too clever and will find a way to avoid paying taxes. Just like you can’t close the barn door after the horses have escaped.

There is a solution and the NBA has already implemented it. The luxury tax. Not a tax on profits, but a tax on inequality. There are four basic variables.

1. The level of wage inequality that results in the tax 13:1 like in the time of Ronald Reagan or 80:1 as it currently exists

2.The number of senior executives that determines the average wage of the best paid in the organization. This includes salary, bonus and unrealized gains on stock options

3. The number of low paid employees that form the denominator in our wage inequality formula. These include full-time, part-time and contract workers. Contracting out work to workers who don’t get company benefits has been the go to move for corporations to pay less wages. These include all those Gig economy workers.

4. The rate of the luxury tax and the repeat offender tax. When an NBA team goes over the luxury tax threshold they pay a tax. When they do it in consecutive years the tax doubles and then triples.  The Golden State Warriors were an example of a team facing 100’s of millions of dollars in repeat offender tax before Kevin Durant left.

I have one other idea that also can be copied from the NBA salary cap. There are two thresholds in the NBA; salary cap and luxury cap threshold. The salary cap stops teams from signing players from other teams that then puts them over the cap. So when the Brooklyn Nets signed Kyrie Irving and Kevin Durant they had to get rid of a lot of their players to make room for their salaries under the salary cap. You are allowed to re-sign your own players which is how teams get into luxury tax problems. In the corporate world when a company exceeds the salary cap they can be forbidden from paying stock options, bonuses, etc.. It is only when they exceed the luxury tax threshold that the tax would be paid.

The payment of a luxury tax would not look good in the Annual Report and would be a powerful motivator for companies to create a more balanced payroll, like the one that existed in the time of our grandparents.

I know this has a zero chance of happening because it would most affect the rule makers in our society. So I guess we will have to wait for the great reset.

Jim Gargano

Jan. 12, 6:59 a.m.

I very much appreciate these articles and all of the insight they give the reader but one thing I would love is just once John literally telling us exactly what he is invested in and what he plans to invest in for the future. That kind of information tells you far more than any opinion.

Rattan Kumar

Jan. 11, 11:59 p.m.

Dear Mr.Mauldin,
Intro: long time reader (well over a decade)and Indian.
In general, I used to have the same sort of outlook that you have. I’ve read all 4 parts of Long Now, the Three Body Problem SF novels and saw the world through similar glasses as you. Unfortunately, I think all of us are now missing the really big elephant in the room - climate.
The Great Reset as you call it will not only be of economies but also nature. Average temperatures have already risen and I don’t see any change in attitude on the part of the world to reverse the ongoing process. It’s not just fossil fuels or just plastic waste or just this or just that - it’s all of them and more.
I think dealing with climate change wont’ happen - (a) it requires every single person in the world to change his / her habits to reverse the man-made changes in progress and that is an impossibility; OR (b) the alternative is that all governments across the globe impose on their residents the kind of ‘austerity’ needed to bring it about - another impossibility given today’s capitalism / democracies and particularly as long as we, the human race, are going to measure our progress by GDP (I now think of it as Gross Destructive Product).
Tech is nowhere close to addressing the challenges. The cycles that Mr.Howe and Mr.Friedman conjure up remind of the cycles of the Technical stock investing crowd. They’re depending on the past to produce the same effects or events in the future. From a short period of human history they would like to forecast. Sure, they can be right - somebody has to be right if there are multiple viewpoints - for a while.
US, if it totally insulates itself from the world, may be rich enough to survive the changes. The rest of the world won’t be. The current Australian blaze is only the latest and not the last. A round-up from respected channels like BBC and others show under-reported events in poorer / backward areas which tell of the change in progress including Pakistan’s growing (yes, growing) glacier/s which is/are threatening its existence.
The pain caused by the need to deal with excess debt is going to be compounded by the pain of mass migrations and other problems due to climate - and I don’t know how it will affect any of us. I’m not imaginative enough. Perhaps someone can.
My point: after the Great Reset of debt, I think it highly unlikely we will return to any sort of normalcy or growth because the world will have changed physically as well.

F ALLEN MORGAN

Jan. 11, 7:36 p.m.

Mr Mauldin, I have great respect for you experiance and opinions.  You write great letters, discuss interesting topics concerning the economy and sometimes investment trends.  You have great friends who discuss similar, and you provide their insights.  However, you’ve been saying its going to “hit the fan” for a long long while now, which sometimes emphasis its going to be soon, really soon, and/or not so soon.  And I know, you know that better than I do. Being human I naturally look at my experience (over the last 40 years) and can only say It a’nt happened yet…and I expect it to continue.  In other words need more actionable intel, less bemoaning on how bad it is,how stupid we are….how about talking some scenarios?  Pick 3 most likely and how it will/could? play out what ways to protect $, make $...etc..etc.

jack goldman

Jan. 11, 4:38 p.m.

Debt is a theft. History is a 4,000 year chronicle of Kings, elites, seeking free stuff. The FANGs are stealing existing wealth with debt, printing counterfeit currency, debt notes, computer credits, to steal vast sums of time, labor, life, from Main Street transferring life to Wall Street elites with debt, as a THEFT.

Cash and carry, US Treasury gold money, Dow is down 35% over 53 years, the real value of stocks. In fake theft money, debt notes, computer credits, Dow is up 2,500% from 1966 to 2019. Debt notes, counterfeit currency, steals the lives of Main Street families and transfers that wealth to the FANGs, Wall Street, Elites, and the Fed. This is a 4,000 year old experiment. How can I get free stuff? Protect yourself. Live cash and carry. Avoid debt. Avoid being abused. Avoid stealing from the future, with go now, pay later scams. Save long term in gold money which is real US Treasury money. Don’t save in fake Federal Reserve debt notes which steal from the future.

Paul O'Brien

Jan. 11, 3:01 p.m.

John, with you 100% on this.  But a couple of quibbles.

A debt reset MUST wipe out a lot of equity.  Debt is senior in the capital structure, and if corporate debt is getting a haircut you can be sure a lot of equity is getting carried out first.  Yes, there will be TBTF balance sheets, but the outcome will likely look like Fannie and Freddie, with the Treasury taking its pound of flesh to pay others, and diluting current owners. 

This has a big asset allocation implication….own plenty of safer, senior debt claims now.  (Gold, too!)  There will be stuff to buy later.

And a small point.  Economists should never say “what” and “when” at the same time.  Your suggested timing is not obviously wrong, but a wise investor would be ready for the reset to start tomorrow.  Matthew 24:42 offers some good advice.

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