Writers are advised to avoid descriptions that read like catalogs, and instead use a few telling details that convey to the reader the essence of what’s being described. In the same vein, a few details may be all that’s necessary to understand the global economy and where it’s headed.
Detail one: the government of Portugal recently issued 12-month debt at a negative interest rate (“The Mad Euro Project Just Got A Lot Madder,” by Don Quijones). Detail two: the Chinese producer price index (PPI) has fallen for 44 straight months (“The Great Fall Of China Started At Least 4 Years Ago,” by Raúl Ilargi Meijer). Detail three: the so-called FANG stocks—Facebook, Amazon, Netflix, and Google—have accounted for the S&P 500’s entire 1 percent gain this year (as of November 20). Their market capitalizations have gone up 60 percent versus a combined increase in earnings of 13 percent. Without those four, the S&P is down 2.5 percent (“When Wall Street Gets DeFANGed———Look Out Below!” by David Stockman).
It is a truism of human psychology that a dollar today is worth more to us than a dollar in the future. To be induced to give up a dollar today, we need to be paid more than a dollar in the future. That premium is interest, and the psychological truism implies that it will always be at a positive rate. How then is Portugal able to borrow money and repay less than the amount it’s borrowing twelve months hence? It’s like seeing water run uphill.
There is an economic cult that infests central banks and believes, against all evidence, that debt powers economies and that by manipulating interest rates, economies can be manipulated. Press interest rates low enough and the economy will flourish. Businesses will borrow and invest in new productive capacity and jobs. Consumers will head to the malls. Speculators will bid up the price of financial assets and higher balances on brokerage statements will prompt more spending and investment.
It doesn’t work. While a lower interest rate may prompt an immediate increase in business borrowing, over time markets adjust to the new rate and the prevailing rate of return equilibrates to that rate. The last six years have demonstrated that taking central bank-administered rates to zero does not promote economic expansion, especially for developed world economies already overly indebted and plagued by governments addicted to economic intervention and welfare-state spending. But central bankers are like the medieval “doctors” who bled their patients to death. Having taken rates to zero they’re prescribing more leaches: negative rates. Mario Draghi, head of the European Central Bank, pledges to buy debt at negative yields. Speculators front run his pledge, buying an idiot’s ticket to ruin knowing a bigger idiot will pay a higher price. And Portugal, whose dire financials would merit double-digit interest rates in rational credit markets, gets paid to borrow.
Detail two: China joined a global debt binge after the financial crisis of 2007-2009. Debt funded booms in domestic consumption and investment in infrastructure, factories, houses, apartments, malls, and entire cities. Debt in the US and Europe funded their consumption of Chinese exports. China recycled the proceeds from its trade surpluses back into the debt of its customers—vendor financing.
China’s PPI deflation started in March 2012: producer demand shifted downward relative to supply, taking prices with it. Debt was producing diminishing returns and debt service was exacting an increasing toll on its economy. China’s “solution” has been more leaches: more debt. Chinese government statisticians dutifully count each new factory, apartment complex, and addition to infrastructure in their GDP tally. However, new facilities operate at a loss, apartments join hundreds of thousands across the country standing vacant, few cars are seen on many of the brand new roads and bridges, and some of the new cities are virtually uninhabited. China’s string of negative PPI readings offers a preview for the global economy: deflation and debt contraction.
Speculation and the rise of financial asset prices are not indicators of economic vitality. Rather, speculation is the last economic activity in which debt has produced a positive return. Negative interest rates imply that the prevailing rate of return could go negative: borrowing money to fund investments that lose money! That prospect may seem fanciful, but speculation is close to it, bearing a hugely disproportionate probability of loss.
Corporate managers are spending more on share repurchases—speculating on their corporation’s stock price—than their corporations’ free cash flow. There is a self-serving element to this. A significant share of executive compensation is stock options, but another consideration has been overlooked. Managers face a dearth of productive investments. Years of cheap debt have already funded most plausible capital projects. Commodities, intermediate, and finished goods markets are glutted and prices are falling. Debt, welfare state spending, and regulation have slowed many economies to a crawl, and put some of them in reverse. In what are managers supposed to invest? Might as well take a flier on the stock market; the potential gain of a gamble is better than a certain loss.
Detail three: capital is being destroyed or is fleeing glutted industries with burdensome debt and negative rates of return. Those characterizations apply to an ever-expanding swath of the overall economy, and are moving up the production chain from raw materials to transportation services, intermediate and finished goods, and retail. It is only a matter of time before they spread to services. The progression has been reflected in the stock market, where gains are confined to an ever shrinking number of stocks.
Investors have crowded into Facebook, Amazon, Netflix, and Google because they are among the few companies that continue to show increased profits; exemplars in a sector—high technology—that many investors hope is immune from the forces of economics. However, on a trailing twelve months basis, their price to earnings ratio is an unweighted average of 356.88, dragged down by Google’s “meager” 31.89 (all figures from Yahoo Finance). The FANG companies are wonders to behold, but their S&P-supporting valuations say nothing about the economy. They are instead an indication that, in David Stockman’s words, “[T]he gamblers are piling on the last train out of the station.” No company, not even the FANGs, are immune from the forces of economics; they are much better shorts than longs here.
Negative interest rates, glutted product markets, falling prices, shrinking global trade, plunging shipping rates, fading retail activity, and the desperate, manic piling into the FANG stocks say volumes about the economy. Winter is coming, and like the Game of Thrones version, it will be years before spring follows.
WHAT IS GREATNESS? WHY DO SO MANY
SETTLE FOR SO MUCH LESS?