This Is How The U.S. Market Might Crash

by: Raphael Rottgen

- We could see a non-linear break in the market.

- This would be caused by a number of potential vicious circles of selling.

- Some of these potential vicious circles are the result of recent changes in market participant structure and activity.

I have developed the conviction that we will have a non-linear break in the market in the near future, say the next 3-12 months. "Non-linear" in the sense that it will not be along the lines of losing a few percent or so every week to enter a bear market over the period of a few months, but an exponentially accelerating sell-off, similar to 1987, for example, whereby we could lose 20%+ in one trading day. This is less based on arguments along the lines that certain valuation metrics for the (U.S.) market are high (an argument that could have been made years ago) and more on arguments that a number of mechanistic pieces are now in place that could cause this type of sell-off.
So, what would we need to see such a scenario?
1. We need a trigger
We need something that tips us into selling territory far enough. Far enough to overcome the vested interest of market participants to keep the party going (this, by the way, was one of the typical pre-crash characteristics that John Kenneth Galbraith identified in his book The Great Crash, 1929. Far enough to overcome the price thresholds above which armies of automated algorithms (and also human traders) simply buy on the dip. Like in a chemical reaction, there is an activation energy threshold to overcome to get it going, and, again like in a chemical reaction, you need a catalyst.
What could be that catalyst?
First, we could have a cataclysmic event. For sure, it would have to be something very traumatic - 9/11 was on obvious example (the Dow was down approx. 14% for the week after the market reopened). If it happens, it may well be something that we did not expect at all - if we had expected it, we would have been prepared for it psychologically, practically (hedging), etc. I recently got reminded of this when the Qatar crisis started to unfold, and I contemplated the remote possibility of a war involving Saudi Arabia (I am not saying this is likely).

Second, and I think more likely (we should of course hope this will be the trigger rather than the first option), we could see a stark sell-off in some remote-seeming corner of the world of financial assets. A remote corner, but one that is sufficiently connected to the overall network of financial assets that it has the potential to spread its "sell virus" via contagion. This, of course, was the example of the crisis of 2008, which started with seemingly localized blow-ups like that of two internal Bear Stearns MBS hedge funds in June 2007. As Galbraith put it, in an eerily prescient article in January 1987: "For the loss will come. The market at this stage is inherently unstable. At some point, something - no one can ever know when or quite what - will trigger a decision by some to get out."
Or, do we need such a hard, human-rationalize-able trigger after all? Remember the flash crash of May-10 (Dow down 9% at its worst)? Remember the weird price action in tech stocks that Friday a few weeks ago? I tend to think that kind of "catalyst" would not be enough, though, as it would not push us down far enough and/or fulfill the other two conditions for the crash to which we shall now turn our attention.
2. We need perpetuation of the selling
Ideally in a self-reinforcing "vicious circle" way, where selling triggers further selling. This, too, may happen in various ways.
First, with humans as investment decision-makers in the middle. As Edwin Levèfre already said in Reminiscences of a Stock Operator, "the greatest publicity agent in the wide world is the ticker tape" and "never argue with it [the tape]." People who see prices dropping like a stone may just sell themselves, too, and ask questions later - especially if they have reasonable justifications for doing so (see next point "We need absence of significant supportive buying" below). This is also true as selling right now can be easily rationalized: we are almost eight years into a bull market (one of the longest ever in the U.S.), market valuations are high (again, in the U.S.) on most traditional metrics, QE seems to be ending, growth in many sectors is unexciting, etc. Note that against many of these points, one could elaborate counterarguments - e.g., who cares how long the bull market has gone on for? Or, regarding market valuations: high multiples are justifiable, given the ultra-low interest rates.

I, for one, will place my bet that, once a sell-off starts, few investors will stop to argue that the equity risk premium is actually correct; more likely, the majority will simply remember that the CAPE of U.S. stocks is near 30 and that we might just go back to something in the teens (the long-run mean and median) and that this will not happen via earnings catching up with prices. Lastly, with human decision-makers in the middle, most of which also tend to be employed rather than self-employed, Keynes's famous quote applies: "it is better for reputation to fail conventionally than to succeed unconventionally." Selling will be the conventional thing to do (just like continuing to buy is the conventional thing to do for now).
Second, via good old-fashioned contagion and forced selling. Once the crash starts, even if it is in some remote corner of the asset network, it will often force investors who commingle some of the affected assets with "good" assets to sell the latter ones, too, and soon, the selling may reverberate through the entire financial asset network. The exact extent and speed of contagion will depend on where the contagion starts and on the network topography, which is virtually impossible to know, but I would bet that the markets are more interlinked now than they were during the last crisis.
The more leverage, obviously, the worse, as assets pledged as collateral (including and in particular margined stocks) lose value, which then generates margin calls and, if those calls are unmet, forced sales of the collateral, leading to another vicious circle.
Third, in some perverse hard-wired, machine-driven way - which is really the same forced selling as above, but on steroids, as there are no humans in the middle and things may unfold extremely quickly. Remember the role of portfolio insurance in the 1987 crash? (Now, I am dating myself). In brief, in case of price falls, portfolios were programmed to sell a portion of the portfolio value short, via futures. That sounded like a great idea at the time until it entered a vicious circle, whereby a fall in cash equities caused the future to fall (via the portfolio insurance programmed actions) which in turn caused cash equities to fall further which in turn caused the future to fall further, which - you get the point. Here, we note that a "financial innovation" was another typical pre-crash characteristic that John Kenneth Galbraith identified in this book. The 1929 and 2008 innovations were investment trusts and MBS/CDO/etc. What could be current financial innovation that may become a culprit?
How about a class of instrument that grew at 20%+ CAGR over the last 12 years (and keeps going) and of which there are now more types (almost 6,000) than U.S. stocks of at least some reasonable size (using the Wilshire 5000 as a proxy)? I am talking about ETFs, of course (and ETPs).

Unless I am missing something, I can see how ETFs and their underlying assets could develop the same unhealthy, vicious interplay (i.e., another vicious circle) as happened between futures and underlying shares in the 1987 crash. Selling pressure may start in either place, ETF or underlying assets, but then the other instrument(s) will get dragged down via hedging activity which in turn will drag down the initial instrument(s), and so on - yet another vicious circle. Arguably, this same effect may have just happened on the way up, albeit in a slower and more controlled way as is likely on the way down.
An ETF, of course, is also often an excellent way to promote contagion, as they nearly always rather indiscriminately mix "good" with "bad" assets, interlinking them in a rigid, mechanical way, allowing the good to be dragged down with the bad (or the bad to rise jointly with the good). Although I cannot prove it, I sensed this happening recently, when in May 2017 the Brazilian market was shocked by the release of wiretaps implicating the Brazilian president in potentially criminal activities. The prominent Brazil-tracking ETF EWZ was down more than 15%, and pretty much all of its component stocks were also down roughly this percentage, albeit they represent a wide variety of companies that even cursory fundamental analysis would show to be of rather diverse quality and valuation.
The growth of ETFs has been a major, major change in market structure and may well be the cause for many a hedge fund manager's frustrated proclamations about how the market is not rational anymore. Of course, it really probably just means the market is not rational anymore on the previous time frames, now that many ETFs reinforce the prevailing trend and hence extend the trend's lifetime. But, considering how many hedge fund investors have tended to become more short-term oriented, you can see how this dichotomy between increasing periods of market irrationality (read: drawdowns/losses) and decreasing investor patience can drive hedge fund managers into returning outside money.

Galbraith mentions the emergence of investment trusts as a sign of the pre-1929 froth. I read about the first ETF of ETFs earlier this year.
Another potential source of forced selling may come to us thanks to the same folks that have brought volatility to its knees over the last few years. While again I cannot prove it with hard data, I have by now heard ample anecdotes of large institutions reaching for yield (understandable in our ZIRP world) by shorting vol. This includes, for example, me having had to listen to a senior investment management professional of an insurance company gloating about how he makes lots of yield by basically coming to the office every day writing puts. Let's see - reaching for yield via massively shorting an asset class already trading at historical lows - might we have seen this before? AIG Financial Products Group London writing CDS pre-2008? I listened to that person and thought I was looking at the guy that Steve Eisman had dinner with in Las Vegas in the movie The Big Short.
In any event, that game works fine until the day it does not work anymore. If a market drop is big enough, those institutions that are short puts will want to, and need to, cover their positions - i.e., they will either buy back the puts, which will then cause the counterparty to hedge itself by selling the underlying in the market, or more likely (as in a severe fall there may not be any people around writing puts), the institutions will just sell the underlying assets themselves. In any event, this activity will depress prices and probably set off yet another vicious circle.
3. We need absence of significant supportive buying
If things go down rapidly, where could the bid come from?
Some of them may reinforce the downward trend, by following simplistic trend-following rules. Eventually (but likely not quickly enough), many machines will probably be taken offline - which is arguably correct anyway, even, or, perhaps especially, if the machines are sophisticated machine learning-based ones - as these rely on patterns observed in past data and are plainly unreliable when faced with data points that have never been seen before or only seen very few times.

"Regular human" investors?
Given the speed with which things will unfold, they will probably fall back on time-proven heuristics rather than any sort of deep analysis. I would bet that "don't catch the falling knife" will be a widely remembered and applied heuristic. Note also that investors will be able to rationalize not buying in the same manner they rationalized selling, as elaborated above.
Risk-loving prop desks who can enter a trade early and ride out a draw-down?
Well, thanks to the Volcker rule (not debating its merit here), there are fewer of those around these days.
Central Banks?
Their balance sheets are already full of stocks - just look at the JCB's ownership of the Japanese equity market (it was a top 10 holder in 90% of Japanese shares already as of mid-2016; by the way, they also buy loads of ETFs) or even the staid, quaint Swiss National Bank, who held over $63bn of U.S. shares as of year-end 2016. However, now the trend seems to be to shrink balance sheets.
Private equity?
Yes, they are full of cash but cannot, and do not need to, act quickly enough - but they will come out having a heyday (payday?).
Failed attempt at an upbeat note
The only fact that in theory could counterbalance my pessimist view so far is that there is actually an increasing number of voices that warn about the potential of a sharp downturn in markets - e.g., Jim Rogers or Mark Yusko. If these are just the visible exponents of a much larger, silent group that shares this belief, then maybe in the end, the market is already reflecting actions reflecting that belief, and it is not vulnerable as it actually is not overbought and overvalued? Maybe without these cautious beliefs and the resulting positioning, the CAPE would be in the 30s?
I do not buy it. The difficulty is that for many investors, even if they do share the belief that the market will come down, it is in practice very difficult to act on that belief, especially if they are employed (same Keynes argument as above) and/or managing other people's money - other people who typically do not look kindly on relative underperformance (even in hedge funds!) or things like holding cash reserves (which they have to pay fees on). That is why "as long as the music is playing, you've got to get up and dance," as Citigroup's Chuck Prince famously said in 2007. And, then you are magically supposed to know exactly when to stop dancing and quit the party before drunk people trash the furniture and start a fight.

It is like a multi-player game of chicken, made worse by the high payoffs/incentives to stay in the game. As somebody more eloquent than myself, John Hussmann, has said: "The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak." Many a smart person has looked like an idiot before the peak, at least temporarily - e.g., Warren Buffett during the internet bubble and Crispin Odey more recently.
Most people do not have Warren's or Crispin's financial or psychological stamina, though.
I could go on, but I'll stop here. We have not even talked about the links to the real economy yet (the whole reflexivity thing), but that might have to be another article.
So, do you agree? If so, how are you preparing/positioning yourself?

sábado, julio 22, 2017




I’m sure you’ve heard that malls are getting killed. Pretty soon there will be no malls. Except for those with a Planet Fitness!

Source: WZZM

There has been lots of ink (and electrons) spilled over the death of retail.

Everyone knows it is only a matter of time before Amazon puts every department store, every mall, every brick-and-mortar retailer out of business. Amazon gets an infinity market cap and everyone else gets zero. Sound familiar?

That’s the accepted wisdom.

Is Amazon a great business? Yes.

Is a department store a bad business? Probably.

Does Amazon get 100% market share, with department stores getting zero? Probably not.
Amazon has over 80 million Prime subscribers in the US. It’s not quite saturated, but it’s getting close.

I admit to being a Prime member, a late adopter.

It is pretty cool. Stuff shows up on my doorstep in two days, for free. The huge poker chip set I just ordered probably weighs about 40 pounds—free shipping! And I get all the Prime movies and TV shows.

Sometimes, when I reflect on what a good deal Amazon Prime is, I think that I’m picking Amazon off. But they’re probably picking me off! 80 million customers times $100 is a lot of money.

Here is my thesis: Amazon will grow and grow, but there will always be a role for physical retailers.

A reduced role, for sure, but there will always be a role.

From a capital markets standpoint, now might be the time to put on the trade.

The Bottom

This is when I started thinking that we've reached a bottom in physical retailers: Last week, ProShares—a $27 billion ETF manager—registered to list some double short leveraged ETFs on brick and mortar retailers!

According to Bloomberg, “The ProShares UltraShort Bricks and Mortar Retail fund and ProShares UltraPro Short Bricks and Mortar Retail fund will seek to use derivatives to generate daily returns of two or three times the inverse of an index comprising the most at-risk US retailers…”


In my experience, specialty ETFs like this are usually listed at the worst possible times. Plus, you know my thoughts on leveraged ETFs.

When 2x short leveraged ETFs are being listed on physical retailers… it is probably time to buy physical retailers.

This infographic from AEI is a couple of months old. Since then, Amazon’s market cap has increased to $481 billion. Meanwhile, Macy’s market cap has fallen to a little under $6.5 billion.

Amazon is worth around 75 times more than Macy’s? That doesn’t seem right.

I hope by this point in the article I have you thinking.

I am no Macy’s fan. It is a pretty terrible business, they sell middlebrow stuff in middlebrow locations. Although their online business is actually not bad.

I used to buy ties at Macy’s, back in 2001. People laughed at those ties. I no longer buy ties at Macy’s.

But look—at a $6.5 billion market cap, Macy’s is reaching distressed levels. That means we have to put our distressed investor hat on, pick this business apart, and see if there is value—in all parts of the capital structure. Maybe we don’t like the stock, but maybe we like the bonds, for example.
And, Staples was bought by private equity recently for about 0.4 times revenue. Apply that standard to Macy’s and you get to a $10 billion valuation. They’re still kicking.

Plus, there’s an argument that this whole Internet retailing thing is just a giant bubble, according to the chart below.

Source: @bySamRo

How Do You Play It?

This is a smart trade, but it is also a dangerous trade unless you are smart.

There are two ways to do this:

1) Be a distressed investor: Look at the worst-case scenario, look at all parts of the capital structure, and find value.

2) Be a quant: Buy a basket of physical retailers, sell a basket of Internet retailers, and wait for them to converge.

The worst way to play it is just to naively buy Macy’s (or another retailer) and hope for the best.

Furthermore, I think it’s time to go dumpster-diving in Mall REITs, which is what we’re going to do in the next issue of Street Freak.

One final remark. As you look around for ideas, invest in the things that would get you laughed off the set of CNBC. I assure you, if I went on Fast Money and pitched Macy’s as a long idea, I would get laughed off the set.

Those are the best trades.

How to Squeeze China

Force ruling elites to choose between North Korea and American colleges for their kids.

By William McGurn

If the first Duke of Wellington were alive today, he might advise that the battle for North Korea will be won or lost on Harvard Yard.

Add Stanford, Yale, Dartmouth, Chicago and other top-tier private American universities so popular with China’s “red nobility” i.e., the children and grandchildren of Communist Chinese elites. For if the Trump administration hopes to enlist an unwilling Beijing to check North Korea’s nuclear ambitions, visas for the children of China’s ruling class to attend these universities offer an excellent pressure point.

Beijing has been Pyongyang’s closest ally ever since the Cold War split the peninsula after World War II. According to the Council on Foreign Relations, China provides North Korea with “most of its food and energy.” Though China has warned Kim Jong Un about his nuclear testing (which Mr. Kim has ignored), plainly it fears a free and united Korean peninsula more than a nuclear-armed North.

Revoking visas for Chinese students, of course, would not alone resolve the North Korea problem even if it did force Beijing to act. But Beijing could make life for North Korea difficult if it chose to.
Thus far most talk about U.S. options regarding North Korea has focused on economic sanctions or military action against the Pyongyang regime. The dilemma is that every meaningful option comes with big risks, including the devastation of Seoul, retaliation against U.S. troops and more suffering for innocent North Koreans. The advantage of starting with student visas is twofold: The unintended harm done would be more limited than any military strike, and visas are likely a more effective lever than sanctions.

Today 328,547 Chinese students attend American universities, according to the Institute for International Education. The Chinese represent the largest group of foreign students in America.

How many of these students are children of Chinese leaders is unclear. American universities are disinclined to provide this information. In addition, the children of Chinese government officials sometimes attend U.S. universities under assumed names.

The Chinese taste for prestigious American universities goes right to the top. Although President Xi Jinping rails against the corruption of Western values, his daughter went to Harvard, which Mr. Xi managed to swing on an official annual salary of roughly $20,000. A few years back, the Washington Post noted that of the nine members of the standing committee of China’s Politburo, at least five had children or grandchildren studying in the U.S. There are many, many more.

Officially, of course, China is an egalitarian society. In reality, hereditary favors, which now include access to top U.S. universities, are a fixed perk of Communist Chinese culture.

Put it this way: If China’s ruling elite were forced to choose between supporting North Korea and their children’s access to American universities, is it all that hard to see where they would come down? This might be especially true if we continued to allow ordinary Chinese citizens with no family connections to the party or government to come study here.

Would China retaliate? Probably. Would our universities scream? Without doubt. Would there be unfairness? Absolutely.

But if the U.S. does not act quickly, a despot who executes people with antiaircraft guns will soon have the capability to strike Seattle or Chicago with a nuclear-tipped intercontinental ballistic missile.

A White House unwilling to consider Chinese student visas as leverage to prevent this would signal Pyongyang and Beijing alike that America is not serious.

U.S. visas are the one thing we know people want. Before Ray Mabus served as Barack Obama’s secretary of the Navy, he was Bill Clinton’s ambassador to Saudi Arabia. There he championed the cause of two American women who had been kidnapped as children and taken to Saudi Arabia by their father, after he’d been divorced in the U.S. by his American wife.

To make the pressure real, Ambassador Mabus cut off all American visas for the father and his Saudi relatives. That got their attention. Unfortunately the deal for the girls’ freedom collapsed after Mr. Mabus left Riyadh and his successor lifted the hold on the visas.

China is even more vulnerable to such pressure. Perry Link, a China scholar at the University of California, notes that the family connections that lie just below the surface in Chinese Communist culture are more powerful than outsiders realize. He likens it to the Mafia.

Imposing sanctions on the offspring of China’s rulers “might raise howls in the U.S. but would be perfectly normal and rational—unexceptional—inside the culture of the people we would be sanctioning,” says Mr. Link. “They would ‘get it,’ and the pinch would be felt.

“Whether or not it would be enough to budge them from their 30-year-old position on North Korea is a different question. But I support making the try.”

Preparing for THE Bottom - Gold to Silver Ratio

By: Przemyslaw Radomski

In the first part of the Preparing for THE Bottom series, we emphasized the need to be sure to stay alert and focused in the precious metals market, even though it may not appear all that interesting. We argued that preparing for the big moves in gold that are likely to be seen later this year should prove extremely worth one’s while. In the second part of the series, we discussed when, approximately, one can expect the key bottom in gold to form (reminder: this winter appears a likely target).

In today’s issue, we would like to feature one of the signs that are likely to confirm that the final bottom is indeed in. The thing that a relatively small number of investors follow (mostly those who have been interested in the sector for some time) are the intra-market ratios. One of the most important ones is the gold to silver ratio and to be honest, it’s no wonder that this ratio is so important – after all, gold and silver are the parts of the precious metals sector that practically everyone recognizes.

Due to both metals’ popularity and the fact that different types of investors tend to focus on them (gold is more popular among institutions and, generally, big investors, while silver is particularly desired by smaller, individual investors), their relative performance can tell us quite a lot about the situation in the sector. This includes helping to detect and confirming the major turning points in gold and silver.

Let’s take a closer look at the ratio (charts courtesy of and

The first thing that comes to mind while looking at the above chart is that the tops in the ratio usually correspond to bottoms in the precious metals market - silver tends to underperform gold to a big extent in the final part of the decline. The mid-2003 spike in the ratio doesn’t directly confirm this rule (there was a local bottom at that time, though), but the 2008 spike, 2011 bottom and the 2016 spike certainly do. So, while it is not inevitable, it seems likely that the major bottom in the precious metals will be accompanied by a big upward spike in the gold to silver ratio i.e. silver’s extreme underperformance.

Having said the above, let’s move to the current trend. Despite the decline in 2016, the main direction in which the ratio is heading is still up. We marked the borders of the rising trend channel with blue lines and the ratio is still closer to the lower line than the upper one – meaning that the upside potential remains intact.

If the ratio is to continue to move higher (it’s likely, because an uptrend is intact as long as there is no confirmed breakdown below it), then we can expect the upper border of the trend channel to be reached (or breached – more on that in just a moment) before the top is in. If this is to be seen in 6 months or so (as we indicated in our previous article in this series), then we can expect the ratio to move to about 94.

This target is additionally supported by Fibonacci extensions based on the 2016 bottom, 2016 top and the 2015 top. The Fibonacci extensions work similarly to the Fibonacci retracements – they differ, because the latter provide targets between the levels that were already reached, while the former are usually used to provide targets outside of the previous trading range. In this case, we get another confirmation of 94 as an upside target.

One might ask that if the above is the case, then why didn’t we draw the target area around the 94 level, but between 94 and 100. There are two good reasons for it.

The first reason is visible on the above chart. Namely, history tends to repeat itself to a considerable extent, and during the previous steady uptrend (the 2008 lack-of-liquidity-driven spike was far from being steady) at the beginning of this century, the gold to silver ratio moved temporarily above the upper border of the trend channel (marked with dashed lines) and formed a top above it.

Consequently, the upper border of the current rising trend channel may not stop the rally in the following months. Instead, a breakout above it might indicate that the key top in the ratio and the key bottom in the precious metals market are just around the corner.

The second reason for a higher target is visible on the chart below that includes even more data than the previous one.

The tops that you saw on the previous chart appear to be the key long-term tops, but in reality, the key long-term tops are at / closer to the 100 level, while the ones from this century are not as important. Surely, they all are important long-term tops, however, we need to keep in mind that the strongest resistance will not be provided by the 2003 or 2008 tops, but by the 100 level.

Moreover, please note that round numbers tend to be important support and resistance levels as they tend to attract more attention (for instance, gold breaking below $1,000 will definitely get more attention than a breakdown below $1,032) – it would be difficult to find a rounder number for the ratio to reach than the 100 level.

Additionally, if the final bottom in the precious metals market was not reached in late 2015 / early 2016, because too many investors were still bullish at that time, then perhaps the extreme that the gold to silver ratio reached at that time was not extreme enough. The next resistance above the 2015 / 2016 tops is provided by the very long-term tops at or a little below 100.

So, should one ignore everything else and wait with the purchases until the gold to silver ratio spikes to 100? Of course not. That’s just one of the tools that one can use in order to determine the optimal entry prices. On a side note, please note that we wrote “optimal” instead of “final” lows. The reason is that it is not 100% certain that a bottom is in at a specified price (it can only be certain when one looks at the past prices after a longer while), so while it may be tempting to wait for the perfect target to be reached, it might be more prudent to place the buy order above the target price to greatly increase the chance of filling it at all – however, these details go beyond the topic of this essay.

When the ratio approaches its target area, all other signals will become more important – for instance gold reaching important support levels without the same action in silver or mining stocks - but with the gold to silver ratio at exactly 100 or only a bit below it and a couple other confirmations, it might be wise to invest at least partially in the entire trio (gold, silver and miners), as the confirmations would make gold’s reaching its target much more important for the entire sector than it would be without the confirmations. In other words, the gold to silver ratio serves as yet another tool in the investors’ arsenal that can help to determine whether or not the final bottom is in or at hand. It’s not a crystal ball, but one of the things one needs to keep in mind when investing capital in this promising sector. 

Summing up, the gold to silver ratio can provide us with an important confirmation that the final bottom in the precious metals is indeed in and while it seems that the bottom is still ahead of us, it doesn’t mean that it’s a good idea to delay preparing yourself to take advantage of this epic buying opportunity.

Donald Trump’s clash of civilisations versus the global community
Human affairs are too interwoven to be the product of purely national decision-making      
by: Martin Wolf


Donald Trump seemed to declare a clash of civilisations, in Warsaw last Thursday. Thereupon, he participated, uncomfortably, at the summit of the group of 20 leading economies. The G20 embodies the ideal of global community. A war of civilisations is the opposite. So which will it be?

The central remark in Mr Trump’s Warsaw speech was this: “The fundamental question of our time is whether the west has the will to survive. Do we have the confidence in our values to defend them at any cost? Do we have enough respect for our citizens to protect our borders? Do we have the desire and the courage to preserve our civilisation in the face of those who would subvert and destroy it?”

The speech took further the stance of two of Mr Trump’s senior advisers, HR McMaster and Gary Cohn, in an article published in May: “The world is not a ‘global community’ but an arena where nations, non-governmental actors and businesses engage and compete for advantage.” They argued that “America First does not mean America alone”. Yet the US was alone at the G20. Despite papering over of the cracks, the US was alone on climate and protectionism.

If the west is asked to unite for a war of civilisations, it will fracture, as it did over the Iraq war.

It is easy to agree that what Mr Trump calls “radical Islamist terrorism” is a concern. But to judge it an overriding existential threat is ludicrous. Nazism was an existential threat. So was Soviet communism. Terrorism is just a nuisance. The great danger is that of overreaction. This could poison relations with 1.6bn Muslims worldwide.

We must beware the self-fulfilling prophecy of a clash of civilisations, not just because it is untrue, but because we have to co-operate. The ideal of a global community is not airy-fairy. It reflects today’s reality. Technology and economic development have made humans masters of the planet and dependent upon one another. Interdependence does not stop at national borders.

Why indeed should it? Borders are arbitrary.

People are increasingly using the word “Anthropocene” to describe our epoch: this is the era when humans transform the planet. The important point about the notion of the Anthropocene is that humanity causes the harms and only humanity can deal with them. This is one reason why the idea of global community is not empty. Without it, harms will go unmanaged.

Consider peace, as well. In a nuclear age war should be unthinkable. But that does not make it is impossible. Managing frictions among nuclear-armed powers is an inescapable necessity.

Consider also prosperity. Global economic integration is not a malign plot. It is a natural extension of market forces in an era of rapid technological innovation. Such a world inevitably exposes countries to the policy decisions of others. As we all learned in 2008, the global financial system is no stronger than its weakest links. Those who depend on international trade need confidence in the terms of access to the markets of other countries.

This is why the G20’s concern over financial regulation, notably at the London summit in 2009, and the ongoing worries about protectionism are justified. Sovereignty is not the same as autarky. As the 2009 G20 communiqué rightly noted, “We start from the belief that prosperity is indivisible”.

Moreover, we are also rightly interested in the fate of other people. Development is a moral cause.

But it is also essential if migration is to be managed.

The decision to call the initial summit of G20 leaders in Washington in November 2008 was therefore inescapable. The western-dominated group of seven countries had neither the right nor the power to co-ordinate global economic affairs. The rise of the rest, above all of China and India, had made that increasingly clear. Moreover, the west contains far too small a proportion of humanity to lay any moral claim to global management.

Global co-operation will always be both imperfect and frustrating. It cannot escape differences of opinion and clashes of interest. Nor can it replace the vital foundation of good domestic policies and legitimate domestic institutions. Indeed, both are essential,

Yet humanity’s affairs are now too interwoven and their impact far too profound to be the byproduct of purely national decision-making. This truth may be painful. But it is a reality.

Within that system of global co-operation the west may still have, for a while, the loudest voice.

But even that is only possible if it is united. If the cause Mr Trump’s US now wishes the rest of the west to embrace is that of a clash of civilisations, in which the US aligns with the most reactionary and chauvinistic of contemporary European opinions, then there can be no west. If necessary, the Europeans will have to align themselves, on some vital issues, not with the US, but with the more enlightened of the rest.

How, one might ask, has this clash of civilisations now emerged, not so much between the west and the rest as within the west — a clash symbolised by the contrasting perspectives of Germany’s Angela Merkel and Mr Trump? For that tragedy I blame the rise of US “pluto-populism”. Behind this is something remarkable: the US income distribution is now more like that of a developing than an advanced country. Populism (of both left and right) is a natural consequence of high inequality. If so, Mr Trump may be no temporary anomaly.

The transformation of the US we are seeing might prove enduring. If so, the world has moved into a dangerous era. “The US”, argues former state department official Richard Haass, “is not sufficient, but it is necessary.” He is right. If the one “necessary” player is absent, disorder would appear to be inevitable.

The New Abnormal in Monetary Policy

Nouriel Roubini
. New monetary policy

NEW YORK – Financial markets are starting to get rattled by the winding down of unconventional monetary policies in many advanced economies. Soon enough, the Bank of Japan (BOJ) and the Swiss National Bank (SNB) will be the only central banks still maintaining unconventional monetary policies for the long term.
The US Federal Reserve started phasing out its asset-purchase program (quantitative easing, or QE) in 2014, and began normalizing interest rates in late 2015. And the European Central Bank is now pondering just how fast to taper its own QE policy in 2018, and when to start phasing out negative interest rates, too.
Similarly, the Bank of England (BoE) has finished its latest round of QE – which it launched after the Brexit referendum last June – and is considering hiking interest rates. And the Bank of Canada (BOC) and the Reserve Bank of Australia (RBA) have both signaled that interest-rate hikes will be forthcoming.
Still, all of these central banks will have to reintroduce unconventional monetary policies if another recession or financial crisis occurs. Consider the Fed, which is in a stronger position than any other central bank to depart from unconventional monetary policies. Even if its normalization policy is successful in bringing interest rates back to an equilibrium level, that level will be no higher than 3%.
It is worth remembering that in the Fed’s previous two tightening cycles, the equilibrium rate was 6.5% and 5.25%, respectively. When the global financial crisis and ensuing recession hit in 2007-2009, the Fed cut its policy rate from 5.25% to 0%. When that still did not boost the economy, the Fed began to pursue unconventional monetary policies, by launching QE for the first time.
As the last few monetary-policy cycles have shown, even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively.
Interest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy. And when that happens, the Fed and other major central banks will be left with just four options, each with its own costs and benefits.
First, central banks could restore quantitative- or credit-easing policies, by purchasing long-term government bonds or private assets to increase liquidity and encourage lending. But by vastly expanding central banks’ balance sheets, QE is hardly costless or risk-free.
Second, central banks could return to negative policy rates, as the ECB, BOJ, SNB, and some other central banks have done, in addition to quantitative and credit easing, in recent years.

But negative interest rates impose costs on savers and banks, which are then passed on to customers.
Third, central banks could change their target rate of inflation from 2% to, say, 4%. The Fed and other central banks are informally exploring this option now, because it could increase the equilibrium interest rate to 5-6%, and reduce the risk of hitting the zero lower bound in another recession.
Yet this option is controversial for a few reasons. Central banks are already struggling to achieve a 2% inflation rate. To reach a target of 4% inflation, they might have to implement even more unconventional monetary policies over an even longer period of time. Moreover, central banks should not assume that revising inflation expectations from 2% to 4% would go smoothly. When inflation was allowed to drift from 2% to 4% in the 1970s, inflation expectations became unanchored altogether, and price growth far exceeded 4%.
The last option for central banks is to lower the inflation target from 2% to, say, 0%, as the Bank for International Settlements has advised. A lower inflation target would alleviate the need for unconventional policies when rates are close to 0% and inflation is still below 2%.
But most central banks have their reasons for not pursuing such a strategy. For starters, zero inflation and persistent periods of deflation – when the target is 0% and inflation is below target – may lead to debt deflation. If the real (inflation-adjusted) value of nominal debts increases, more debtors could fall into bankruptcy. Moreover, in small, open economies, a 0% target could strengthen the currency, and raise production and wage costs for domestic exporters and import-competing sectors.
Ultimately, when the next recession strikes, central banks in advanced economies will have no choice but to plumb the zero lower bound once again while they choose among four unappealing options.
The choices they make will depend on how they weigh the risks of bloating their balance sheets, imposing costs on banks and consumers, pursuing possibly unattainable inflation targets, and hurting debtors and producers at home.
In other words, central banks will have to confront the same policy dilemmas that attended the global financial crisis, including the “choice” of whether to pursue unconventional monetary policies. Given that financial push is bound to come to economic shove once again, unconventional monetary policies, it would seem, are here to stay.

The Ultimate Debt Bubble Is Upon Us

by: Zoltan Ba

- Since the last economic crisis, the Western World consumer's debt deleveraging has been the only major exception to broad debt accumulation.

- The only reason we were able to cope in the US and globally is because of the lower interest rates. That trend has now come to an end.

- While the broad nature of this debt bubble can give it more longevity as the burden is spread out, it can also make the next crash more painful.

According to the US debt clock, the country pays about $2.5 trillion annually in interest expenses, within the context of an economy that has a GDP of about $19 trillion. What this means is that about 13% of the economy goes to servicing debt expenses. This of course also means that on the other side of the equation, somebody else gains an income from those interest expenses, so it is seemingly not all bad. Nevertheless, it is a problem when the interest/GDP ratio tends to grow, because the interest collecting institutions or individuals are not necessarily the ones who will contribute to consumer demand. A bank will take those interest revenues and put them towards creating lending capacity for consumers, but it will not go out and purchase houses, cars, or furniture for itself. It means that in the end, most consuming entities are paying more and more on interest, which means that we can afford less of everything else. And, when most people, companies, and governments have to settle for less of everything else, we end up experiencing an economic contraction, unless we substitute with even more debt, which leads to more interest on debt. Within this context, the burning question of our time has to be how much of an interest payment load we can bare, in the US, and globally, given that there are signs of central banks looking to tighten in order to prevent asset bubbles. Unfortunately, there is no way of knowing what that answer is until we will see this latest debt bubble burst.
Based on the debt clock data, total US debt outstanding at all levels of the economy, including governments, mortgages, corporate, business, and consumer debt stands at about $67.5 trillion.
The interest rate we therefore pay on the economy as a whole is somewhere in the 3.7% range, based on the $2.5 trillion in total interest figure. Based on the fact that back in 2007, 10-year bond yields were around 4.5%, mortgage rates were around 6.5%, we can assume that the average interest yield on the economy as a whole may have been about 6-7%, given other high-yield debts, such as credit cards. Going on this assumption, total interest on debt throughout the economy may have reached as high as 20% of GDP, just before the crash, according to data on total debt from that period, which can be found on Economics Help.

The total debt/GDP ratio reached over 300% by the time the crisis reached full-blown status and the economic contraction became severe in 2009. In the run-up to the crisis, it was about the same as it is now, or about 270-280%. Therefore, it is important to highlight the fact that the current decline in interest on the economy to about 13%/GDP from the high of as much as 20% before the crisis hit is mostly due to the years we had of people, businesses, and governments refinancing old debts at lower rates for the past seven years or so, as well as taking out new debt at much lower rates. After years of re-financing at the recent, historically very low costs, the trend is now coming to an end. In effect, there is no realistic way to take interest rates significantly lower from current levels, and as we can see lately, central banks are increasingly looking at moving rates up, even if it is not going to get back to average levels seen in the previous economic cycle.
Government and corporate business debt/GDP increasing sharply since beginning of economic recovery, while consumer debt holding stable after years of deleveraging
After the dramatic run-up in consumer debt, which drove the last economic recovery, consumers seem increasingly content to just keep pace with nominal economic growth in terms of debt accumulation, after half a decade of deleveraging.
Source: FRED
Corporate and business debt also entered a period of deleveraging during the last economic downturn, but it did not take long to get back to the business of feasting on the cheap money made available through central bank policies.
As we can see, between the end of 2010 and the beginning of 2016, the corporate and business debt level as a percentage of the size of the overall economy increased from 38.4% to 44.88%.
Government debt increased at a much faster pace when measured against the size of the economy. It went from 64% of GDP at the beginning of 2008 to over 105% currently.
Source: FRED
Looking at these separate debt/GDP numbers together and by sector, there are a number of conclusions that we can draw. The first and obvious is the fact that since the beginning of the last economic crisis, total debt/GDP is still on a growing path. The significant decline in consumer debt between 2008 and 2015 helped temper that growth, but that trend has now come to an end. At best, we can expect consumer debt/GDP to remain steady. Government and business debt are both increasing at a significant rate in proportion of the size of the economy, meaning that in the absence of interest rates somehow continuing to decline from current levels, interest on debt as a percentage of GDP is also most likely on a rising trend, given that we can no longer expect relief from declining interest rates.
If we look at the individual components of debt, we can also notice the fact that most of the decline in debt/GDP came from the debt category which generally carries a higher interest rate, namely consumer debt, while the main increase came within the category which can borrow at a lower interest rate. This trend has been one of the contributing factors which drove the interest/GDP burden in the economy down in past years. In effect, government spending has become a more effective way of stimulating the economy, because it carries a lower interest rate. Therefore, it expands the economy's total debt-carrying capacity. With interest rates not going significantly lower from current levels anytime soon, shifting debt to lower interest rate categories may be the only sustainable way forward. By sustainable, I of course mean that it is sustainable in the short to medium term. I don't think this can be sustained in the longer term, because eventually the US government, as well as other governments around the world will find it very hard to sustain their debt servicing obligations. Whether they will cut back on spending in order to pay for increasing debt servicing costs, or eventually resort to massive money printing, which can come with its own problems, including perhaps the first ever global hyper-inflation crisis, something will eventually have to give.
The global picture
One of the factors that allowed for a sustained, (even if weak) global economic recovery in the aftermath of the 2008 financial crisis was the shifting of debt accumulation to the developing world, with China in particular shouldering a very significant portion of it. It has just been reported recently that China's total debt surpassed 300% of GDP in the first quarter of 2017. It is thought that its total debt has quadrupled since 2007, far outpacing its increasingly sub-average economic growth when compared with its growth trajectory before the global crisis. A number of other developing countries have also seen quite a bit of debt accumulation, at a higher rate of growth compared with economic expansion rates.
Total global debt now stands at $217 trillion, which is 327% of global GDP. We should keep in mind that the world borrows at an average interest rate that is considerably higher than America's economy can secure on average. It's impossible to tell just how significant the interest burden is on this debt, but for the sake of mental visualization, if we assume a conservative 5% average, it is about $11 trillion per year. The reason why I say that it is a conservative estimate is because governments, consumers, and businesses pay a significantly higher interest on debt in the developing world. India's 10-year government notes yield is about 6.5% at the moment, while Brazil pays 10.5%. We should keep in mind that consumer and other debts carry a much higher average interest burden. The world's entire GDP is about $76 trillion, meaning that global interest on debt is at least 14.5%. It should be worth noting that a lot of the debt is accumulating in countries with higher interest rates, while in places like Europe, deleveraging still continues, with private sector debt declining from $103.4 trillion, to $97.7 trillion. Keeping this in mind, the total global interest burden is likely to rise at a faster pace than the total debt/GDP ratio, because the global interest rate on each net dollar borrowed, or old debt being re-financed, is likely to be higher than the current global average.
The ultimate debt bubble
The last financial crisis was in large part due to a particular sector of the economy, within a number of individual countries becoming overly saturated with debt, beyond the ability of many to cope with it. The main sector where over-indebtedness led to crisis was the consumer sector, with some sovereign issues such as was the case with Greece and other countries in Europe being exposed as a secondary effect. All data points since the recovery started suggest that we are in another debt bubble.
It is a global one, and it involves debt becoming unsustainable at government, business, and consumer levels, across much of the world. The Western consumer is the exception to this trend, and it is in large part due to the fact that we are already carrying a heavy debt load, even after the deleveraging since 2008. But even in the Western world, the consumer deleveraging story is not absolute. For instance, in Canada new record highs are being recorded pretty much every quarter when measuring household debt as a percentage of disposable income. That ratio is now at 167%, and there is no sign that there will be a trend reverse happening anytime soon.
Not to mention that Canada's new Liberal government abandoned the old goal of balanced budgets and is now running significant deficits instead.
Given the widespread aspect of this debt bubble, it is likely that the US and the global economy will prove to have significant stamina in continuing forward with this trend for a prolonged period, due to the fact that the debt accumulation is spread out, instead of concentrated to one sector, as was the case with the previous bubble. The previous bubble burst much faster, because it was concentrated disproportionally in the consumer sector of the economy, which also happens to have a lower threshold in terms of carrying capacity, compared with governments which have various tools at their disposal, including a central bank. Because debt accumulation is more widespread within the economy, it is less likely to become an immediate issue within any particular sector of the economy.

No one can possibly predict the timing of it, because there are just so many factors involved, but eventually, this trend will lead to a severe global financial crisis. And, when it does, the broad aspect of it will make it unlikely that we will be able to achieve a recovery as easily as we did the last time around, because pretty much every major sector of the global economy will be affected and will engage in a similar deleveraging trend to what we have been seeing from the US consumers in the last few years. Problem is that when everyone is forced into debt deleveraging, the deleveraging itself tends to become impossible, because it becomes a game of endlessly catching up to a constantly shrinking economy, and it may take a very long time to actually catch up. In this regard, the lesson of Greece's deleveraging experience, which led to endless rounds of austerity, due to its effect of inducing economic shrinkage, without having the desired effect of reducing the debt/GDP ratio.
While the perception that at some point, we can just hunker down and start paying down the mountains of debt we are accumulating collectively in order to get out of this vicious cycle is still relatively prominent among the general public, the reality is that a broad-based effort to deleverage throughout the local and global economy can only result in years or decades of seemingly endless misery, with any debt reduction being matched or perhaps even surpassed by economic contraction, leading to loss of resources such as income and taxes, leading to a need to cut spending even more, causing more economic contraction. While the next global economic slowdown may still be some years away, perhaps, whenever it will arrive, it is very likely that it will be the beginning of this painful process.

In China, a Strategy Born of Weakness

By George Friedman

China’s actions so far in the ongoing North Korean affair have been ambiguous. In order to try to understand China’s strategy toward North Korea, it is necessary to understand China’s strategy in general. To do that, it is important to recognize the imperatives and constraints that drive the country.

First, we need to outline China’s basic geographical parts. The country has four buffer regions that are under its control. Tibet in the southwest has seen some instability and is vulnerable to outside influences. Xinjiang in the northwest is predominantly Muslim, with a significant insurgency but not one that threatens Chinese control. Inner Mongolia in the north is stable. Manchuria in the northeast is also stable and of all four buffers is the most integrated with the Chinese core. These last two regions are now dominated by the Han Chinese, China’s main ethnic group, but they are still distinct. When you look at a map of China, you will see that a good part of what we think of China is not ethnically Chinese.

Within Han China, there are also divisions. The population is concentrated in the east because western China has limited rainfall and can’t sustain very large populations. In this sense, China is actually a relatively narrow country, with an extremely dense population. The interests within Han China are also diverse, and this has frequently led to fragmentation and civil war.

The most important distinction is the one between coastal China and interior China. Coastal China, when left to its own devices, is involved in regional and global maritime trade, while the interior has fewer commercial opportunities. Coastal China’s priority is reaching its customers, whereas the interior wants Beijing to transfer the wealth from the coast to help support the poor interior. Many other regional disagreements exist of course, but this is the source of discord between the two regions.

It is not a new problem, and left to fester, it can result in internal conflict, with coastal interests frequently seeking intervention by their customers. This was the case from the British intervention in the mid-19th century until 1947. During this time, there was endless internal conflict in China and constant foreign involvement. Mao Zedong tried to solve the problem by closing China to trade (at least somewhat), crushing the coastal elite and imposing a dictatorship. Like emperors before him, he imposed a powerful state on a unified but nonetheless very poor country.

Changing Gears

After Mao died, China embarked on a traditional Chinese strategy: It tried to build its economy by selling low-priced manufactured goods to the world without allowing divisions to arise – in other words, it wanted to have its cake and eat it too. This worked for a generation; once the state stopped undermining economic development, China surged. By 2006, exports, particularly to the U.S. and Europe, accounted for 37 percent of China’s gross domestic product. The coastal region became relatively prosperous, while the rest of China and the buffer regions lagged far behind, as they always have. But the surging economy helped raise living standards, even if it also created inequality.

2008 was a turning point. China’s major customers, Europe and the United States, went into recession, and their appetite for Chinese goods declined. Economic growth slowed dramatically, and by 2016, exports only contributed 19 percent of GDP. Although internal consumption increased, the coastal region was focused on markets in advanced industrial countries, which the interior couldn’t replace.

And in the process of maintaining weakening businesses, saving jobs and increasing domestic demand, the cost of production rose. China faced competition from other countries for markets, and the pressure on its internal system intensified.

Coastal and regional interests diverged again, and each advocated different policies in response to the crisis. The Chinese government tried to accommodate all but accommodated none. In 2012, President Xi Jinping took office and sought to put the genie back in the bottle. He imposed a dictatorship that had two goals: to take control of the Communist Party and to impose party rule over the country. His anti-corruption campaign was intended to take control of the economy and to convince the interior that he was not a pawn of the coastal region. Xi sought to maintain exports as much as possible and to re-establish centralized control with minimal effect on the economy.

He also had to deal with the United States. The United States’ consumption of exports was a major engine of China’s economy. At the same time, the crackdown on government and business officials – an essentially political act – would affect American investments and other interests in China. China had to take greater control of the economy without losing U.S. investment or imports.

But in case the worst happened, China developed a fallback strategy. It began producing a new class of high-tech products. It also had to find new markets outside the U.S. The economic solution posed a military problem.

Protecting Sea Access

In the event there was an economic falling out with the U.S., China had to consider the possibility of a military confrontation. But the key issue was the ability to guarantee China’s access to sea lanes. In this, China had a major geographic problem. The South and East China seas are ringed with small islands, spaced in such a way that passage between them can be blocked with relative ease. The U.S. Navy is far superior to the Chinese navy, and the Chinese were concerned that in some unforeseen crisis the U.S. would block access to their much needed sea lanes. Those small islands were now at the center of Chinese national interest. The Chinese could claim the entire region, but they were not in a position to seize it.

This photo taken on Dec. 24, 2016, shows the Liaoning, China’s only aircraft carrier, sailing during military drills in the Pacific. STR/AFP/Getty Images

At the same time, the Chinese devised a political solution to their strategic problem. If a country like Indonesia or the Philippines aligned with China instead of with the United States, access to the global sea lanes would be assured without having to confront the United States. The problem here is that the two strategies undermined each other. Aggressive assertion of Chinese power in the regional waters and finding accommodation with regional powers were inconsistent approaches. What’s more, they could only work if the United States was not present. And, of course, it was.

China had one other option for getting around potential U.S. actions: creating an alternative export route through Asia to Europe. This was the One Belt, One Road concept. But it, too, was flawed. First, the cost of building the requisite infrastructure was staggering. Second, it would run through countries that were unstable and, for the Chinese, unimportant customers. Add to that the speed with which One Belt, One Road needed to be enacted, and this was more posturing that policy.

China, therefore, is caught in a set of interlocking problems. Its economic miracle has matured into more normal growth rates. It has a vast population that lacks the ability to consume all that it produces. It has to contend with global stagnation and competition from other producers – and competing with high-tech producers is no small task. It is therefore afraid of internal instability and has imposed a dictatorship designed to maintain a vibrant economy without social costs. To do that, it must increase exports and control access to China’s economy, a move designed to alienate a large and dangerous power, the United States. But it can’t afford to confront the U.S., whose navy it can’t defeat.

The Chinese are caught between the need to placate the United States and to distract it with as many problems as possible. North Korea is a perfect diversion, but siding with Pyongyang is not an option. China can appear to be helping the United States while keeping the U.S. focused on Pyongyang.


This is a strategy that emerges not from a position of strength but from one of fundamental weakness. China’s internal contradiction is that prosperity creates instability, and stability is incompatible with prosperity. There are complexities and nuances of course, but this is the root of China’s problem. China is therefore trying to maintain what prosperity it can without destabilizing the system. In doing this, it is jeopardizing its overseas markets, particularly the United States, creating the opportunity for a conflict it can’t win and opening the door to regionalism and warlordism.

Unlike Japan, which moved from being a high-growth country to a low-growth country without social upheaval, China may not be so lucky. Japan had a homogeneous, socially integrated society. China is not homogenous, and it has irreconcilable social differences. Its global strategy reflects these contradictions and ultimately poses a greater risk to China itself than to others. And in such a situation, the key is to look confident and try to keep others off balance. But this can only work for so long.