1/ HOW TO UNDERSTAND WHAT'S GOING ON IN FINANCIAL MKTS. Western world built up a debt bubble of stunning proportions over past ~50yrs. It's deflating now, just as it tried to do in 2008, 2001, 1997, 1994, 1987, 1981 & 1974. Each time, tho, there was enuf balance sheet capacity...
2/ ...to reinflate the system by pumping more debt into it. In other words assets still existed that hadn't yet been encumbered by debt (directly or indirectly)--meaning the countries were SOLVENT. That's why their fiat currencies had value--assets were still available...
3/ ...that lenders didn't yet have a claim upon (ie, assets not yet mortgaged). Important to understand that when debt expands, liquidity grows--& mostly it just pushes up financial asset prices (for vrs. reasons). Reverse is also true. Debt has grown for ~50 CONSECUTIVE years...
4/ ...but peppered by deleveraging periods when the total debt outstanding actually shrinks (eg, 2008 & now). Typically, mainstream economists call for central banks & govts to offset that credit contraction by creating new debt (monetary & fiscal stimulus) to fill the hole...
5/ ...What they're really doing is back-filling for shrinking debt by creating new public sector debt, in an attempt to counter the financial asset price correction that inevitably accompanies a credit contraction (aka debt deflation). That's what we're seeing now...
6/ ...The shrinking debt is caused by capital destruction, where capital was consumed by businesses that earned a return less than their cost of capital. Entire industries have done that (housing going into 2008, shale producers going into 2020, etc)--& in these debt deflations..
7/ ...the magnitude of the capital destruction that was building all along is revealed (it just wasn't obvious bc new debt injections were able to paper over it). Why wasn't it evident as it was building? Bc interest rates are mispriced--artificially low--& this is why you see...
8/ ...entire industries making the exact same (bad) biz decisions at exact same time. Example: let's say a biz invests in a project expected to return 10% has a weighted avg. cost of capital (WACC) of 8%. No prob--it would earn real economic value of 2% x the capital invested...
9/ ...But what if the WACC were really 12% instead of 8%? Recall the expected return was only 10%, which thus means the project destroyed capital (2% x the capital invested). The project never should have been pursued! How did the biz make such a bad mistake? Bc mkts misled it...
10/ ...Bc mkts mispriced its cost of borrowing. How? Bc interest rates were held artificially low--by central bank policy trying to rev up the economy. So, what they thot was a good project turned out to be bad. Every single co in the industry invested badly at the same time...
11/ ...every single competitor made the exact same mistake, in same direction. They weren't idiots--their mistake was believing the flow of artificially cheap money wld last. And why not? It lasted for ~50yrs. Every time trouble came, they were bailed out by govt action...
12/ ...(either monetary or fiscal stimulus--actually both in recent crises). But the prob=the magnitude of such stimulus needed to revive the system keeps growing, since the amplitude of crises keeps growing. Mkts have now shrugged off MASSIVE stimulus of both types...
13/ ...&this time, the hole that the Fed & the govt are trying to backfill is much bigger than in 2008. Why? Bc debt ballooned since then, so this credit contraction much bigger. For perspective, debt in US nonfinancial sectors (households, biz, govt) went up 10% in past 2 yrs!!!
14/ ...Yep. TOTAL DEBT SHOT UP A WHOPPING 10% IN THE U.S. JUST IN PAST 2 YEARS!!! That's $83.3 trillion of total debt in the US nonfinancial sectors at year-end 2019, up from $75.8 trn in 2017 (I exclude financial debt bc that's mostly just a pass-thru to nonfinancial sectors).
15/ ...Here's the data. I've been tracking it ever since 2008. That's when I learned how the US economy had been hollowed out by decades of bad economic decisions (by both political parties). The US was consuming more than we produced & borrowing to do it. federalreserve.gov/releases/z1/20…
15/ ...So, to put this week's multi-trillion$ monetary & fiscal stimulus into perspective, how much of that $7.5 trn of new debt in just 2 yrs do u think produced a real economic return? Prob not much. Prob most of it=destroyed capital. Ponder whether all the corporate debt...
16/ ...issued to finance stock buybacks at much higher stock prices generated a real return? Or the massive misallocation of capital in energy industry?) This is why the Fed's "bazooka" $1.5 trillion stimulus--stunningly large--hasn't worked & is just pushing on a string...
17/ ...Bc the debt bubble is even more staggering in size. One of my hero analysts--Doug Noland--predicted last Fall that the Fed's balance sheet would swell from $4 trn to $10 trn in the next financial crisis. Well, it's here. At the time I tweeted his estimate was too low...
18/ ...& I hope you see why now--bc writing off just the last 2 years of bad debt alone wld need a $10 trillion Fed balance sheet to fill the hole! What does this mean? Strap in for some serious volatility. We ain't seen nothin' yet. I've read a lot of history abt what happens...
19/ ...when credit systems die. The volatility is staggering. The 5% swings in both directions we're seeing now is nothing! Try 20%. In one example, near the end the swings were 50%. YES, 50% INTRADAY SWINGS UP & DOWN!! Will that happen here? Dunno, but don't be surprised if yes.
20/ ...But realize life doesn't end in these situations, which are restructurings during which the control of the factors of production moves from weak hands to strong hands--from the hands of destroyers of capital to the hands of producers of capital. That's a necessary outcome.
21/ ...Sounds scary & it is. I'm NOT saying this is the end of the credit system--just laying out that possibility. The cost of re-inflating the system once again=a lot more than $10 trillion of stimulus this time, imho--& even if it works, the cost will only be bigger next time.
22/ ...Tomorrow I'll record a podcast w/ @APompliano & we'll discuss solutions. Thank goodness alternative systems for storing your wealth exist! If you're willing to read history to understand all this + take time to educate yourself about the alternatives, you'll feel better!
23/ ...These situations favor those who embrace change & ignore the advice of those stuck in the old paradigm. Huge opportunities are already opening up! Take care of your loved ones & neighbors & stay safe out there folks! 🙏
