Politicians and central bankers tend to blame the coronavirus for the current economic crisis. Nothing could be further from the truth. Apart from the fact that most of the recent economic pain is the direct result of governments overreacting, the global economy was already stalling before corona emerged, and the virus is only being used as a scapegoat to cover up government incompetence.
The current crisis is the result of several decades of mismanagement, that started in 1971, when President Nixon ended convertibility of the USD to gold. This set the stage for unlimited central bank money printing and the accumulation of huge amounts of debt.
The Great Financial Crisis (GFC) of 2007-09 was a warning shot that things must change. But instead of enacting painful but necessary reforms in line with free market principles, authorities preferred creating billions of new money ex nihilo and reducing interest rates to zero or even below. As a consequence, global debt has soared to new heights and the world is now in worse shape than it was at the start of the GFC.
According to the Institute of International Finance (IFF), in the first quarter of 2020 global debt reached USD 258 trillion or 331 % of global GDP. Such figures are already shocking, but the actual situation is far worse. First, not all forms of borrowing are fully included, such as shadow banking, peer-to-peer lending, non-bank leasing, seller installment contracts, as well as the use of pawn shops and loan sharks. Second, unfunded public liabilities for medical services, pensions, etc. are not taken into account, as contrary to private companies, governments don’t have to report them.
Debt in general is not necessary a bad thing, if loans are used for activities that will generate high returns in the future. Governments are therefore justified to borrow money for smart investments in infrastructure or education, and private companies can use loan proceeds to start new business activities with good growth and profit outlook. However, nowadays loans are more likely used to pay back maturing debt, increase leverage for risky financial investments, or finance consumption. Consequently, the return on debt is rapidly declining. Whereas in the past 1 additional USD or EUR of debt increased GDP by a factor well above 1, it is now generating only cents to the USD or EUR borrowed.
It is obvious that the existing debt pile can never be repaid, at least in real terms (i.e. adjusted for inflation). To prevent the economy from blowing up, interest rates have to be kept at artificially low levels and easy credit must always be available to failing entities. This requires massive market interventions by governments and central banks. The price mechanism has been disabled, misallocation of resources and malinvestment are rife, and in many sectors fair competition is a thing of the past. Still the economy languishes and is very vulnerable to external shocks like the coronavirus.
The behavior of our politicians and central bankers resembles that of a drug addict, who needs to gradually increase the daily dose in order to achieve the same level of “comfort”. Whenever a problem pops up, more money is created and more debt is taken on. Ballooning asset prices, increased risks for banks and insurance companies, and the long-term decline of the real economy are accepted as “necessary” side effects.
Reckless central bank policies
Over the past two decades central banks have developed an array of bizarre unconventional monetary policies to counter economic decline. In 2001 the Bank of Japan (BoJ) first introduced Quantitative Easing (QE), which is a more sophisticated wording for printing money ex nihilo and using it to purchase assets. It now holds Japanese government bonds worth roughly 90% of the country’s GDP, is a main investor in the Japanese stock market, and has a balance sheet larger than 115% of GDP.
The U.S. Federal Reserve (FED) started QE in 2008 by buying U.S. Treasuries and debt obligations issued by Fannie Mae and Freddie Mac, whose reckless behavior had substantially contributed to the GFC. Between 2008 and 2018 the FED balance sheet grew from below USD 1 trillion to USD 4 trillion. Following a short period of reduction, since March of this year the balance sheet has exploded to USD 7.0 trillion or 33% of GDP.
Even though the European Central Bank (ECB) was last to jump on the QE bandwagon in 2015, it did so with an enormous vigor previously unthinkable of any EU institution. Within 4 years it bought assets worth EUR 2.8 trillion, mostly government debt, but also corporate debt, asset-backed securities and bonds. In the past few months ECB’s balance sheet has gone vertical and is now at EUR 3.6 trillion or 37% of GDP.
The BoJ not only spearheaded QE, but in 1999 was the first central bank to introduce a Zero Interest Rate Policy (ZIRP). However, it was overtaken by central banks in Europe, that spearheaded a Negative Interest Rate Policy (NIRP). Sweden started in 2009, followed by Denmark in 2012. But the big bang came in 2014, when the EZB started NIRP on a much larger scale.
For those of you, who face an intellectual barrier to understand what negative interest rates mean, here a short explanation: You have to pay someone to borrow money from you. For instance, you lend someone 1,000 EUR on the condition that you will get back 980 EUR in five years, resulting in a guaranteed loss of 20 EUR even without considering inflation and the risk of losing part or all of your principal. If you think this is insane and defies logic …… well, then you are obviously unqualified to be a central banker or politician.
NIRP was quickly adopted by the Swiss National Bank (SNB) and the BOJ. These days there are bonds worth more than USD 14 trillion or 16% of world GDP, that carry a negative yield. Among them are about USD 1 trillion from private corporations.
That this is a worrying development was pointed out by Claudio Borio, Head of the Monetary and Economic Department at the Bank of International Settlements (BIS), which is often called the central bank of central banks, as the BIS is owned by 60 central banks around the world. In an official podcast given on 19 September 2019 Mr. Borio remarked: “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”
Financial institutions are undeterred in buying negative yielding bonds, hoping to sell them before maturity for a much higher price. It goes without saying, that the buyer then confronts an even lower negative interest rate, and will have more difficulties in finding a new buyer to generate a profit. Holding the bond to maturity is not an option, due to the guaranteed loss. Usually there is always another “investor” willing to buy a bad product …… until there isn’t.
More ingenious measures such as Helicopter Money (= free money for all) are in the pipeline. And according to the Modern Monetary Theory (MMT), our governments will in the future rely on the central banks to finance limitless debt. Why did humanity have to wait thousands of years to find out, that eternal prosperity can be created out of nothing?
Asset bubbles everywhere
The impact of desperate unconventional central bank measures has been positive only on the surface. Boosted by readily available cheap money, prices of stocks, bonds and real estate have skyrocketed.
In spite of the fact that global GDP is expected to drop somewhere between 3% and 5% in 2020, global stocks are near or above historical peaks. The NASDAQ Composite index, that comprises mostly Tech companies, is up over 700% from the GFC low. The S&P 500 in the USA is up by 375%. And even the STOXX Europe 600 has somehow managed to rise by 125%. The real economy in Western countries has grown by less than 50% since the GFC.
Many Tech companies with questionable business models and substantial losses have achieved market valuations in the tens or even hundreds of billions of dollars. In the old days, the large majority of stocks were bought and sold by active investors, who based their decisions on an in-depth analysis of the underlying assets. Nowadays Exchange Traded Funds (ETFs), that replicate a specific index, and automatic computer based algorithmic trading dominate the market. Stock exchanges that used to be places of true price discovery, have degenerated into gambling dens. They are rigged by central banks and big financial institutions, resulting in stock quotations severely out of touch with the real world.
With everyone expecting more central bank bond buying in the future, their prices have continued to go up. As higher bond “prices” go along with lower bond “yields”, this has allowed corporations to borrow money at very low or even negative rates. Even companies with low credit standing can now sell their “junk bonds” at rates close to those of allegedly risk-free government bonds.
Traditional requirements for strong loan covenants and adequate financial disclosure have been diminished to the point, that a large part of so-called “investment grade” debt is now “covenant-lite” and appraised by the rating agencies as BBB which is just one level above junk status. Considering the rating quality of the same agencies prior to the GFC, it can safely be assumed that many BBB bonds are in fact already junk. Similar to the stock market, the bond market is a disaster waiting to happen.
Real Estate prices in the U.S. and many European countries tanked during the GFC. Some people who had bought a new home on credit just before the crisis, were all of a sudden “underwater”, as the market value of their property plummeted below the value of the mortgage principal. Many families lost not only their homes but also all their savings, and some of them are still paying off their debts today.
By now real estate prices in many countries have not only recovered, but thanks to a never-ending stream of cheap money gone well above their previous peaks. Price increases of over 100 % are not uncommon. Particularly the housing market in Canada and New Zealand is in bubble territory, closely followed by Sweden, Norway, and Australia. But valuations in many other countries in Europe as well as in the U.S. have also approached levels, that give reason for concern.
China is truly in a league of its own. According to the Chinese Academy of Social Sciences, at the end of 2018 average home prices across China reached 9.3 times average income. This compares to 8.4 in San Francisco, a city which is not particularly known for the low value of real estate. It doesn’t come as a surprise, that China’s household leverage ratio hit a record high of 58% in the first quarter of 2020 (China’s total debt to GDP ratio is 317%). Irrespectively private investors continue to pour money into apartments, that they never intend to live in or to rent out, as they believe in further price appreciation due to unlimited state support. These days you find whole condos or even districts in China, that are virtually empty.
Looming risks for banks and insurance companies
Central bank activities have caused the share of the finance sector in the overall economy to grow from about 3% to over 8% at the expense of the “real” economy. Nevertheless, due to the negative effect of very low interest rates and the growing risk of loan defaults, solvency of many banks is low.
In particular banks in Europe are in a precarious position and bankruptcies can be expected, once the economic downturn accelerates. Savers, who already suffer from low/negative interest rates, are likely to see their savings further diluted or completed wiped out by so-called bail-ins. With this legal instrument, that is already statutory in the U.S. and Europe, insolvent banks can use the money of unsecured creditors (such as savers), to restructure their capital so they can stay afloat.
If you think this won’t happen in the Western World, just look at Cyprus, that is a member of the EU since 2004 and a member of the Euro area since 2008. As part of a 10 billion bailout by the ECB and the International Monetary Fund (IMF), Cyprus agreed to accept a bail-in at two of its insolvent banks, resulting in substantial losses for deposits above 100,000 EUR. Don’t count on any government “guaranteed” deposit insurance scheme to protect your assets.
Life Insurance companies are also vulnerable. Their business model is based on achieving decent capital returns over the long term. ZIRP and NIRP have caused them havoc. Insurance managers in Europe are forced by government regulations to invest in negative yielding government papers, even though it is clear from the beginning, that the insurance company (and eventually those insured) will lose money, if the investment is held to maturity.
Falling bond yields have forced many insurance companies to invest in risky “investment-grade” assets, to maintain their capital returns. Many of them are junk and once they blow up, so might your insurance company. As with the banks, don’t count on the government to bail you out.
Life insurance policies have always been marketed as a safe investment that generate a decent return. This might have been true in the past. But under current monetary conditions, most life insurance products generate negative returns after inflation, and also bear a high default risk.
Decline of the real economy
When we look at the real economy that is producing actual goods and tangible services, the situation is not as rosy as stock and bond prices make you believe. Cheap money has induced many large companies to go deep into debt, making their balance sheets much more vulnerable in case of an economic downturn. Instead of investing money into research and development, companies nowadays prefer to increase dividend payments, buy other companies at inflated prices, and purchase back their own shares.
Analyst justify rising stock prices with continued growth in profitability, but a closer look at the annual reports of many corporations reveals, that profits are in most cases stagnant or declining. Instead of real profits, that are based on generally accepted accounting standards, most analysts use “adjusted” profits. Those are calculated by adding back one-time taxes, acquisition and restructuring costs, impairment and litigation charges, as well as stock-based compensation to the real results. On the other hand, extraordinary positive effects are seldom deducted. By cooking their books, companies can easily improve their profit by ten, twenty or more percent and even turn a loss into a profit.
Another reason for growing stock prices is the widespread use of debt funded stock buybacks to boost Earnings Per Share (EPS). As EPS have a huge impact on top management compensation, CEOs and CFOs have a strong incentive to borrow cheap money to buy back shares. Even if total earnings stay flat, EPS will go up. It is a clear sign of the depraved ethics of our business community, that top management gets paid for increasing their company’s future cost and risk.
Margins of many good businesses are squeezed by so-called zombie companies. These are enterprises, whose profits do not cover their interest expenses, let alone allow for the repayment of loan principals. Even before the corona crisis there were estimates, that they amounted to 10-15 % of listed companies in the Western world and roughly 20% in China. Instead of allowing zombie companies to go bust, governments and central banks are artificially perpetuating their existence, thereby stifling innovative competitors who would otherwise create new jobs and increase productivity.
Prospects for most small and start-up companies are bleak. Banks are reluctant to lend them money and issuing low yielding bonds is not a valid option for them. They face heavy competition from larger enterprises with easier access to cheap money. Nowadays not the best but the biggest wins, resulting in higher concentration in many industry sectors. Consumers suffer by paying higher prices and getting lower service.
A bubble in asset prices coupled with a sluggish economy has had a very detrimental impact on income and wealth distribution. The Rich who own most of the stocks, bonds and real estate have gotten richer. The rest of the population has been faced with stagnant or declining salaries (at least in real terms), falling income from savings and life insurance policies, as well as higher mortgages for the purchase of an apartment or house, that are only partially offset by lower interest rates. The divide between the Rich and the Poor is rapidly growing and the middle class, whose consumption is the main driver of the economy, has become increasingly indebted and decimated in size.
From the above it is evident, that the global economy was already in a bad state at the beginning of this year. When the coronavirus struck, governments worsened the problem by implementing stringent lockdowns. Whether they succeeded in stopping the virus is highly debatable. However, it is apparent, that by severely curtailing business activity, politicians have further damaged the economy.
To remedy the disastrous consequences of their own actions, authorities have implemented vast stimulus packages. Billions of dollars in loans were given to zombies or other overleveraged companies. Hardly anyone in academia and the press questioned the rationale of fighting a debt problem by adding more debt.
The coronavirus has given authorities an excuse, to shed any restraint and take full control of large parts of the economy. Politicians decide, what companies are bailed out. Central bankers determine, what private bonds are bought. Together they pick the winners and losers.
Prepare for the imminent reset
History has taught us two lessons. First that excessive debt usually does not end well, and second that authorities don’t succeed forever in manipulating markets. They can postpone a crisis, but they can’t suppress market forces indefinitely.
Within the next decade we are bound to experience a severe economic downturn, that will not only slash the wealth of most middle-class citizens, but also cause political and social upheaval. Act now by diversifying globally and holding some of your assets outside the current fiat monetary system. Once the worst is over, you will be able to invest in many underpriced securities with exceptional profit potential.
If you haven’t already done so, now might be your last chance to build a balanced portfolio. If you are unsure what to do, contact us at email@example.com.