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The Last Minsky Financial Snowflake Has Fallen – What Now?

Economics / Coronavirus Depression Mar 28, 2020 - 01:09 PM GMT

By: Raymond_Matison

Economics

For more than a decade financial markets had been in denial of economic reality – as long as the Federal Reserve continued supporting bubbles.  Numerous money managers and financial pundits cautioned investors in vain, as their warnings did not result in a market meltdown – until now. 

An economist of the last century, Hyman Minsky, had likened the economy and stock market to a mountainside which is slowly accumulating snow.  That snow appears stable until one last snowflake falls and it starts an avalanche.  In the last month we did not just get one financial snowflake, but a huge snowstorm in the form of the corona virus – and it, with the already overextended markets caused this real financial avalanche.


In our January publication entitled “FOMO, or FOPA, or Au?” which compares the investment thesis of “Fear of Missing Out” with “Fear of Participating in the Avalanche” and “Au” the symbol for gold we unambiguously express the need for investors to get out of the market.  Since then, the last Minsky financial snowflake has fallen.

No longer can anyone pretend that the economy is just fine or that the markets may rise again near term.   With the evaporation of one third in equity values in a month, denial is not an option anymore.  So, what now?

Simple economic principles

Starting with the very basics, let’s note first that ours is a consumer-driven economy, which is responsible for approximately 70% of the nation’s GDP.  That consumer workforce is carrying a record amount of credit card debt, auto loans, student tuition, and mortgage loans, and even is responsible for servicing and paying off our nation’s humongous national debt.  Because of the corona virus, even if the country avoids a total lockdown, business will be drastically disrupted for a long time.  As a result, business sales revenues will decline dramatically, and instead of reporting profits, most companies will report losses.  To protect their companies from bankruptcy, owners and managers will reduce its expenses by reducing their work force.  Unemployed workers will not be able to service their record total debt, creating another huge avalanche centered in credit markets.

Despite the attempt to reduce expenses, these smaller companies may not be able to service their own credit or debt either, and another avalanche sits in waiting.  Recall also that larger, public stock companies over the last several years have borrowed money by issuing bonds for the questionable purpose of repurchasing their stock.  Billions have been borrowed and spent; but now with the great market decline, everyone can see that this money was totally wasted – as stocks are substantially below repurchase prices.  The money could have been far more efficiently used by using corporate retained earnings and debt assumed to repurchase company shares to either increase base wages or to pay extra cash bonuses to employees who would then have funds to service their personal debts or to support the consumer economy with additional spending. Yet the money was wasted, and the additional debt remains, now risking a new default event for these companies. See: Capitalism Works, Ravenous Capitalism Doesn’t - http://www.marketoracle.co.uk/Article64911.html

Often Italy’s bank loan portfolios have been cited as having default rates high enough that they risk bankrupting its major banks.  Well, we no longer need to look overseas for such frightening examples – our domestic banks will have massive loan losses – enough to put many out of business.  Think of loans in the airline or cruise ship industry, oil fracking, or hospitality industry.  Over decades, liberalized bank regulation has permitted a large decline in the amount of reserves or equity banks have to hold relative to loans.  Accordingly, just a few per cent decline in loan value, or a small percent of defaults can and will destroy many banks.  Bailouts and bail-ins will save a limited number of them, before people realize that to save their deposits they have to take them private and outside the banks, hence creating a run on banks.  In addition, the rapid decline in financial markets will require major asset reallocations for the trillions of existing derivatives held by banks.  These problems are now likely to become very ugly, and long-lasting on our economy.

Market decline effects on the economy and people

So how does the market decline effect our consumer-driven economy, and our individual circumstances?  The stock market has not only made every investor substantially poorer, but the market crash has also impoverished everyone who is depending (presently or in the future), on some kind of pension income.  Those pension promises cannot now, and will not be honored in full.  See: Market Decline Will Lead to Pension Collapse, USD Devaluation, and NWO -

http://www.marketoracle.co.uk/Article65715.html 

The working consumer who does not lose his job, but is overleveraged with debt, is not likely to contribute to the consumer economy’s recovery in the near future. The current employee who may lose his job, both because of the virus or the market-devastated economy, is not likely either to help with a consumer-driven recovery.  After decades of conscientious work, no employee now looking towards retirement, or recently retired - because of the new market-destruction affecting pension underfunding and payouts, will be able to help in any economic recovery.

It is also obvious that companies which have issued high yield “junk bonds” but facing production lockdowns, or exposed to supply chain disruption will default on their debt.  Over years, corporate issues have gradually declined in quality ratings such that substantially more debt is issued at the lowest investment grade rating, leaving less of a margin of safety to investors.  Just one downgrade for these bonds will cause them to be classified as “junk bonds” and precipitate selling pressure in the bond market.  In preceding years many articles have been published regarding municipal and state budget deficits and general obligation bond issues, which are also in danger of default.  The next several year business environment will not improve issuer solidity; to the contrary, there will be some defaults – so corporate and municipal debt could become another avalanche.

At the highest quality level of debt, sovereign country debt in Europe is suspect, whose default is very likely to destroy some financially significant banks which hold plenty of the potentially defaulting sovereign bonds.  That is another potential financial avalanche – now more at risk than ever before.  And if we look at the home country, let us recognize that $23 trillion of U.S. debt, incurred by our politicians on the people’s behalf, without any approval or support from that populace, can no longer be repaid – and will need to be liquidated by some crafty means which will necessarily penalize every citizen.  This all implies debilitating inflation, or even currency failure.

Considering the confluence of these sectors, the structure of our economy is now such that it cannot be saved by the consumer.  The debt structure and amount is such that neither the consumer, corporation, state nor federal government can pay down its obligations, especially as interest rates will be forced higher by fearful investors, including formerly large foreign buyers of our Treasury debt.  The pension system on a broad scale is underfunded and will not deliver its promises.  The combined condition is more severe than what a hoped-for short recovery period can bring about.  These conditions do not describe a recessionary period, but something far more daunting.  See: What to Expect in Our Next Recession/Depression - http://www.marketoracle.co.uk/Article66308.html

Stimulus

In addition to the most powerful governments, the FED, ECB, BOE, BOJ, IMF, and other central banks are working hard to figure out how to provide more financial or fiscal stimulus to our beleaguered consumers and businesses.  Reflection will allow us to recognize that various levels of stimulus, debt issue, interest rate management, or other manipulation have been applied to consumers for decades.  Indeed such manipulation has been in place in the U.S. since the founding of our Federal Reserve System over a century ago.

Over that last century, economists and bankers based on actual observation and experience came to the conclusion that the centrally planned and controlled Communist system cannot work - and indeed the world witnessed its collapse.  Yet our brightest politicians, policy makers, Keynesian economists and bankers want to maintain the illusion that in a capitalist system of central bank control an economy can work.  What is the difference between a centrally planned and managed communist system, and a centrally planned and managed capitalist system – both are centrally planned!  We already know that central planning does not work.  What an incredible example of cognitive dissonance blinding the nation’s leaders.

Our economic history demonstrates that sometimes FED stimulus has worked, particularly when the level of debt in the system was low.  However, stimulus has been used to increase consumer debt as a means to increase consumer spending, and the level of consumer debt has risen over decades to unsustainable levels, such that stimulus no longer works. 

Consumer incomes, which on an inflation adjusted basis have not risen for nearly fifty years, are now inadequate to service the central bank stimulated record debt.  The consumer has been stimulated into a financial coma!  Think of a person who has just had a cardiac arrest – for whom an electronic fibrillator may be used to restart the patient’s heart and save his life.  But a constant flow of electricity would actually electrocute (kill) the patient.  After decades of monetary stimulus, the consumer is now being executed by continuing central bank stimulus.  To save the consumer, we need to stop the stimulus and increase his real wages such that he can service and reduce his debt load.  Government’s considering of a $1000 payment to every American is necessary and appropriate at this time – because of the long-term lack of inflation adjusted wage increases, but this will require the issuance of more debt, which accelerates the time of our currency reset.

Buy the Dip?

A study of long term market moves conveys some important lessons.  For example, if one purchased stock in 1929, it took until 1959 to break even on a nominal basis – a really long time.  If one purchased stock in 1966, it took until 1979 to break even.  With the equities market declining by one third from this year’s peak in just one month, and realistic expectations of domestic earnings declines, global production problems affecting the global material parts supply chain, and disruptive credit default problems, it is not audacious to call for a long multiyear period of continuing market decline, before it bottoms and starts to rise. 

History is a good guide for the length of time it will take to recover.  Therefore, don’t buy the dip!  The “blood in the streets” moment of investor opportunity for long-term gains is still some time, perhaps several years, away.  This former Wall Street insurance industry analyst had the opportunity to recommend high quality stocks to institutional investors selling at 4-6 price/earnings multiples with 8% dividend yields in the 1970s.  Today’s economic, credit, sovereign debt, interest rate, and even global political problems rise above those of the 1970s, so it is not difficult to foresee a continued market decline, even if interrupted by short term recoveries, and similar ample investment valuation opportunities comparable to the 1970s in the not too distant future. The market may enjoy some interim rallies, particularly when it is seen that we are winning the war on the pandemic, but it still easily decline another 30%, if not more.

Normally, the FED controls bond markets by controlling interest rates.  Its lowering of interest rates over decades has floated the bond market to ever higher heights.  We are at the breaking or opening of rising interest rate floodgates where the FED is no longer in control.  It means that the valuation of bonds will shift from FED interest rate setting prices to a risk-based valuation – which will cause all bond yields to rise dramatically.  This means that bond prices will fall!   It will cause huge increases for government to service its debt, as it will cause additional borrowings by the Treasury and money printing by the FED, and ravaging price inflation for the public.

Concerns about our future

Both due to the perceived problems stemming from the virus epidemic, and economic and market distress, the FED is already promising ever greater interventions.  For its part, government is also promoting larger fiscal support programs which will require the FED to buy more Treasury debt.  We must understand that this action is the beginning of increasing price inflation, despite the deflationary effects of our crashing economy.  The FED will accommodate the issuance of additional domestic government debt for these programs, which will cause Treasury bonds to be increasingly valued on their true credit merits.  That huge expansion of debt, presently proposed to be about $2 trillion, to accommodate these large programs will finally allow the FED to achieve and exceed its 2% inflation target.  It is also very likely that the ultimate cost of these government programs will rise to several times its original estimate. Price inflation will become serious, and confidence in our dollar currency proportionately decline.

Many countries seek to escape the dollar’s global reserve status, and are constructing institutions to help achieve insulation from its now toxic effects.  Major economic competitors, and those countries identified as America’s enemies may be, or are, actively working to now undermine the dollar.  For example, Russia which has been ravaged by U.S. sanctions, foreign money exchange operations which have trashed the ruble, and America’s influence in stopping Russia’s completion of laying a gas pipeline to Europe, has rejected OPEC’s call for a reduction in oil production as a blowback to the American oil fracking  industry, and America’s foreign policies.  China’s Belt and Road initiative, extending through Russia and Iran and other countries will develop trade which will likely not include a use of the dollar, and therefore diminish its utility and influence.  However, over the last twenty years the FED itself can be seen as the entity doing the most damage to the dollar through its interest rate policies and money expanding operations.  We are not being undermined or subdued by enemies outside our borders.  We appear to be self-destructing by forces within our borders, from our central bank, inside our Congress, our academic institutions, and increasingly by false ideologies embraced by our populace.

Currently we are justifiably concerned about the corona virus, but with time this shall pass.  Next year we may well look back and conclude that it really wasn’t that terrible.

That crisis will be behind us.  However, there is a more insidious crisis that has been building for years, accelerating with the pandemic crisis rescue programs, which will affect our economic well-being, our currency and our futures.

Raymond Matison
Mr. Matison was an Institutional Investor magazine top ten financial analyst of the insurance industry, founded Kidder Peabody’s investment banking activities in the insurance industry, and was a Director, Investment Banking in Merrill Lynch Capital Markets.   He can be e-mailed at rmatison@msn.com

Copyright © 2020 Raymond Matison - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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