The US, Europe, and Japan have literally become the McDonald's of sovereigns over the past 40 years. For those unfamiliar with the McDonald's story, here is a good recap of what they've done. In essence, McDonald's management team has turbocharged the stock price by issuing gobs of debt to finance stock buybacks. The executives have used that liquidity to cash out of their stock options for fat gains. The surge in the stock price also coincides with the recent demand for recession-proof, safety stocks as the economy slows.
The US, Japan, and many countries in Europe are in the middle of a similar case of financial engineering. Instead of it being McDonald's balance sheet, its the sovereign balance sheet of these nations blowing out with huge deficits to finance more spending and tax cuts. The public sector's deficits become the private sector's surplus, which keeps economies stronger than they would otherwise be.
In the case of McDonald's, the extra cash from selling debt was used to buyback stock, goosing share prices.
For the sovereigns, the extra cash created from deficit spending/tax cuts, heavily monetized by QE, gooses the pocketbooks of the private sector, artificially boosting demand beyond what would naturally happen in a capitalist system. The government debt/GDP ratios have gone up sharply since 2008, as governments have been the ones taking on extra debt, taking the baton from private borrowers after the GFC.
Once these countries get such large debt to GDP ratios, they have to either engage in QE to keep bond yields low or exacerbate the problem by having to pay even more interest on the debt, creating a debt spiral where more debt needs to be issued to pay the interest.
Aging demographics is just making the problem worse, as you have more government outlays to retirees through programs like Social Security and Medicare, while you have the same or fewer working age population paying the taxes to try to balance the budget. Its a losing battle for governments, as raising retirement age and decreasing benefits is extremely unpopular, and old people love voting, so its politically toxic to even mention it.
So you will continue to see budget deficits grow in the developed economies, as entitlement programs pay out more to the retired and not have enough workers paying taxes to keep up. All of this extra cash that the government hands out by blowing out its budget ends up as savings for households and businesses. We know what happened in 2021 and 2022 when the private sector gets excess savings from an expansion of budget deficits: high inflation.
If the interest rates are set too low, the private sector will eschew investing in government debt, which causes longer term yields to rise, which forces the Fed to use ZIRP/QE to keep yields down to prevent the economy from slowing down. We've yet to reach the point where the value of labor/amount of government outlays has gone high enough to cause chronic, rampant inflation, but its much closer than people think.
Over the long term, inflation is a monetary phenomena. If you keep expanding the money supply through fiscal largess and QE, and labor supply / production can't keep up with the demand, prices need to go higher to balance supply and demand. And demand goes higher as the amount of money in circulation increases. This is guaranteed with the current political climate of populism, government handouts and pork when economies weaken. 2021/2022 was a preview of the limits to fiscal spending to boost the
economy. Beyond a certain point (definitely surpassed that point in 2021 and 2022), it just creates pure inflation and the
credibility of the central banks AND the currency come into question if
financial repression (negative real interest rates) is used to keep the economy afloat in a period of
stagflation.
The Japan experience from the 2000s to today is an anomaly. Japanese households and corporations de-levered even as interest rates were suppressed near zero, keeping the money supply growth rate at very low levels, even as the BOJ went to ZIRP, and then to QE and even NIRP. This kept inflation very low. That also coincided with a period of massive deflation coming from cheap goods being outsourced from China. That is unlikely to happen again. Also, in the West, the propensity for the public, and thus politicians to tolerate chronically low growth, near recessionary conditions is much lower than in Japan, which is basically a one party country. Politicians will always look for the easy way out, the best political strategy, and that is to spend more, and tax less. An inflationary strategy.
Just as you see the stock price of McDonald's rise along with the increase in its debt used to fund stock buybacks, you will likely to see a continued rise in the value of private sector assets as the sovereign balance sheets in the US and Europe continue to expand with more debt issuance. When those asset values rise due to an increase in the amount of money in circulation and not due to an increase in production (a logical assumption when considering the increasing incompetence and waste in the public sector as it grows, and the growing handouts to the elderly), you naturally get the price level of everything going higher. Consumer goods and service prices, along with asset prices like stocks.
While I believe that inflation will slow down a lot this year due to credit contraction and a recession, the secular inflation theme that was all the rage in 2021 and 2022 is valid for the long run. The inability or the lack of desire to tackle government debt levels among the public all but guarantee more populist policies like stimmy checks, crony capitalist pork projects, more military spending, deficit financed tax cuts and tax credits, and of course, a continuation of generous Social Security and Medicare benefits. It is purely inflationary spending. Money for nothing.
This is why you cannot consider government debt a good long term investment like you could in 1980, the last time you had an inflationary wave. The debt levels, the demographics (US, Europe, and China), and politics (much more populist now) is much more conducive to higher inflation and lower real growth. The inflation cat is out of the bag, and it will have major ramifications for the future of stocks and bonds, which just had a golden age of 40 years of spectacular compounded gains, in real dollar terms. In the future, most of gains will come from inflation, not real growth.
The markets these days are boring. Low volatility begets low volatility as there is very little motivation to trade when prices don't move. Less trading = less volatility. That is until one side stops buying/selling. Right now, its almost a stalemate, as the buying coming from corporate buybacks and vol control/systematic funds is almost equal to the selling from value investors, hedge funds, and discretionary investors. I believe the break of this stalemate will come when the volatility increases from a weakening earnings picture in the 2nd half of the year, forcing corporations to reduce buybacks, which will be front run by hedge funds and followed by systematics who will follow the trend, and also sell due to the increase in volatility. I expect it to happen suddenly, as is often the case in these slow grind environments with high SKEW levels. The options market is usually correct more than its wrong, and this time, it is starting to price OTM put options much higher than OTM call options, more than anytime in 2022.
Usually you will get a warning sign about 1-2 months before the waterfall decline, with one significant dip that gets bought, softening up the belly before the sellers strike again for the big decline. You saw that in 2011, you saw that in 2015. In October-December 2018, there was no warning sign, no softening of the belly, it just sold off. In any case, warning sign or not, I am expecting a waterfall decline within 3 months.
For the short term, the debt ceiling just doesn't mean much for the overall economy so I am leaning towards nothing burger, deal or no deal by the X-date. Even without a deal by then, the deal will happen quickly enough afterwards that its not something that will have any lasting effects. An artificially created crisis is not a real crisis if it doesn't affect the economy. And even if there are spending cuts in the deal, they will be far enough away and small enough that they won't matter anyway. If there is a selloff as investors get nervous and we start seeing headlines on it, that would be a good time to reduce short positions and even take some longs for a trade, as I would expect an immediate bounce back.
7 comments:
I don't think being short will be painful as I expect the market to trade in a narrow range before the waterfall decline. This isn't a healthy stock market or economy, so unless suddenly a bunch of liquidity gets unleashed (only likely after a big stock market drop), I am not expecting a strong rally.
So just outright shorts not puts
Yes, outright shorts, but put spreads are starting to look attractive. If I see some warning signs, I will look into going into puts.
Really good post OWL.
JF
NVDA short position killing me. time to double down or wait yet?
NVDA looks to be in the blowoff top phase, could go for a couple more weeks, at most, then I expect a sharp move lower along with the SPX and NDX. This move higher is creating a monster shorting opportunity for the summer swoon.
They have earnings coming too. Wondering if to add before or wait until after. Even a small beat may send retail crazy
Post a Comment