Unpublicized Risks to Global Economy and Financial Markets

by Victor Sperandeo with the Curmudgeon

Introduction:

Victor identifies several risks that the mainstream print and on-line media have either ignored entirely or have not objectively disclosed and discussed.  The Curmudgeon notes the problems US banks are facing as they add to loan loss reserves and continue to experience profit pressures from low interest rates (yes, the Fed is way behind the curve).  Victor concludes with words of wisdom for your portfolio and a conundrum of a quote for all of us to ponder.

Analysis of Unpublicized Risks:

1.  Derivative Exposure:

This is perhaps the biggest risk to the world economy, yet it's rarely if ever mentioned by the mainstream media.  Why not? From the excellent July 21st presentation by Greg Weldon, "Understanding the Real Value of Gold in Today's Market" (subscription required):

"The International Monetary Fund /The World Council (IMF/TWC) estimate of the (worldwide) Gross Derivative Notional value ranges from a low of $630 Trillion to a high of $1,200 Trillion.”

Curmudgeon Notes:  

1.  As of March 31, 2016, Citigroup alone had over $55.6 Trillion in total derivatives according to this post.

2.  According to a CBS Marketwatch blog post by Sue Chang:

"Funds invested in derivatives alone total $1.2 quadrillion. In fact, there is more money in derivatives than in all the stock markets combined, which is a comparatively paltry $70 trillion.

As for money owed by every single person and country in the world, the grand total is $199 trillion, with some 29% of it borrowed since the 2008 financial crisis."

Who will cover the losses if derivatives blow up and cause a chain reaction? The FDIC (US) couldn't even cover 0.0001% of the low estimate! The high estimate is $1200 trillion or $1.2 Quadrillion.  Do you get the picture?

Any mistakes by global governments and/or central banks would make the 2008 financial crisis look like a picnic.  In particular, Lehman Brothers could have been saved with “only” $60 Billion?  What would it take now to “fix” an avalanche of derivative blow-ups by large global banks?

Also note that total world debt is $199.0 Trillion, according to IMF/TWC.  How much of that might be defaulted on?  One can see that a small problem with debt and/or derivatives could have monstrous ramifications for the global economy.

2.  The China built Islands in South China Seas:

These are manmade islands that China claims as their own, despite territorial claims from other Asian nations.  The Hague international court tribunal ruled against China, but Beijing's rejected the ruling.

So what is the end result? Economic, or a “hot war” seems like the only possible outcomes.  As the latter is not likely, the West vs the East could be involved in an arduous economic battle.... That seems like the endgame. 

A boycott of China goods by the Western countries would be horrendous for world trade and might result in a depression. What else can global governments do against a nation with 1.4 billion people and an estimated 260 nuclear warheads?

China island building and its control over disputed territories could turn into a world problem of horrendous significance at any time on any day.

3. The EU will likely break-up:

Another European nation that asks for a referendum to "leave" will cause turmoil as contagion of Brexit spreads.

Consider the next French presidential election which is scheduled to be held in April and May 2017.  The current front runner is Marine Le Pen (who thinks like Donald Trump), head of France’s far-right National Front party.  Le Pen has said she will ask the French people to vote on pulling out of the EU if she is elected president in 2017.  With an approval rating that's almost triple incumbent President Francois Hollande, Le Pen is likely to be elected France's next president. 

The French people are applying for gun licenses at never before seen rates (they don't have a 2nd Amendment like in the US).  

If France leaves the EU, there will not be an EU anymore. Thereby, it is highly likely the EU experiment is a dead nation walking within a year. How that might affect the global economy is anyone's guess, but it's not likely to be a pretty picture.

4.  ECB (Euro-zone Central Bank) Public Backstop for Non-Performing Loans:

The ECB is buying all kinds of debt within Europe at the rate of 80 billion euros per month.  When ECB President Draghi was asked if it included NPL's (Non-Performing Loans), he said "if they would follow the rules."  Draghi told reporters last week     that a public backstop for NPLs would be “very useful,” laying out a potential three-pillar approach that would include regulatory supervision, legislation that would allow the development of a “fully functioning NPL market” and the possibility of a public backstop.

So the ECB will be buying debt that is in default? The world is burning, and being destroyed, and we can now see similarities to Nero (Rome Emperor in 64 AD who played the fiddle when 70% of Rome was destroyed by fire).

It should also be noted that all the countries in the EU will now have to pay more in taxes to belong to “CLUB EU.” This is why other EU country departures will result in government budget problems.

5. US Dollar Rises:

As yields of 10 year notes hit all time historic lows (e.g. Germany sold a 10 year note at a negative yield on July 13th), the US still has a positive yield on its sovereign debt.  Therefore, foreign investors are buying dollars to buy US Treasury notes and bonds.  The rise in the dollar is causing commodities to decline along with emerging market (EM) debt. 

Curmudgeon Note:  US multinational company profits will be hurt by a stronger dollar.  And that's after five consecutive quarters of NEGATIVE year over year earnings reported by S&P 500 companies (most of which are multinationals).  

6. 1920 Germany-like set-up:

Talk of a "cashless society" and "negative interest rates" continues unabated, even though those policies have effectively failed.  When something doesn't work, why keep trying more of same? Isn't that one definition of insanity?

Also, "Helicopter Money" and/or Perpetual Bonds (non-marketable bonds with no maturity date and no yield have been bought by the BoJ from the Japanese government). 

The Curmudgeon noted that in last week's post: “I have never seen such a mania in global government bonds (especially the $10T in negative yields, BoJ buying perpetual JGBs, and 30 year US T bond yielding < ½ of its pre-financial crisis all time low yields).” 

These and similar schemes are all listed in the history of world manias, best chronicled in the famous book "Extraordinary Popular Delusions and the Madness of the Crowds," by Charles McKay.  To understand today's economic environment, I suggest you read/re-read this book.

7.  The Middle East Wars:

This problem has improved somewhat, but the area is still a tinderbox that could explode at any time.

Curmudgeon Note:  There are regional conflicts or civil wars ongoing in Syria, Iraq, Yemen, Libya, Egypt (despite military strong man President el-Sisi's iron grip on that nation).  Let's also not forget hostilities due to Hamas' control of Gaza and recent Palestinian attacks in Israel.                                     

Turkey is a more recent example of flare ups. The NATO member country is now in a state of emergency after a failed coup attempt that left many dead and scores more injured.  That followed a meticulously planned ISIS terrorist attack at Turkey's principal airport in Istanbul. Turkey holds ~50 Nuclear Bombs owned by the US.  -->What would happen if those bombs were to fall into the hands of a terrorist inspired group?

8.  Italian Banks on the brink of collapse?

Italian banks are in terrible shape.  They are struggling with a burden of bad debt and loans that are unlikely ever to be repaid fully.  Any recession, due to Brexit or other causes, could bring down a big Italian bank.

http://im.ft-static.com/content/images/85b05128-483e-11e6-b387-64ab0a67014c.img

At his most recent monthly press conference, ECB head Draghi (formerly Italy's finance minister) backed a public bailout of Italy’s troubled banks “in exceptional circumstances.”  That's even as he hailed the Euro-zone for its resilience in the aftermath of Britain’s decision to quit the EU and left interest rates on hold.

Curmudgeon Comment:  Draghi continues to talk the talk that the ECB will do “whatever it takes to save……..???”

9.  Central Bank Incompetence:

Goldman Sachs former employees are running Central Banks in England (BoE's Mark Carney), the Euro-zone (ECB's Mario Draghi), and the New York Fed (Bill Dudley). These Keynesians are all thinking alike. As we have seen recently, they’ve guessed very wrong on monetary policy.  The UK has voted to leave the UK, the Euro-zone is not growing despite massive ECB QE and negative interest rates, while the Fed has been whipsawed on "raising rates" vs not "raising rates.”

Are all these bankers going to be wrong at the same time? We'll see, but if one fails they all will in my humble opinion.

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Curmudgeon Add-on Risk -- Deteriorating Health of US Banks:

It's been said that a strong economy and financial markets depend on a solid banking system.  It's ironic that US financial markets have soared to epic mania proportions at the EXACT time that the US banking system is getting weaker!

The Saturday, July 23rd Wall Street Journal (on-line subscription required) reported that US big banks are putting more money away to cover possible losses on consumer loans. Lenders including JP Morgan Chase & Co., Wells Fargo & Co., Capital One Financial Corp. and Discover Financial Services said on earnings calls this month that they have bolstered their reserves—in some cases for the first time in years—to prepare for an uptick in loan losses.

Capital One said Thursday that it added $290 million in reserves for its domestic credit-card business, a move that was driven both by growth in customers’ outstanding balances and by the expectation that more would default. The bank also added to auto-loan reserves, partly because of growth in loan volume that included a higher portion of sub-prime borrowers. The bank said that this year it has increased auto lending to borrowers with lower credit scores.

Saturday's Journal also noted that US banks’ profit margins on loans are falling again after a brief boost from the Federal Reserve’s rate increase late last year.  Net interest margin, a measure of how much a bank earns from the difference between what it pays on deposits and what it takes in on loans and investments, fell at all six of the largest US retail banks by assets that reported 2nd quarter earnings this month.  At those lenders— JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, US Bancorp and PNC Financial Services Group —the profitability metric or the most comparable figure dropped to 2.62% in the 2nd quarter from 2.67% at the end of 2015. The figure is at or below where it was at all but one of the banks when the Fed announced its rate increase in the fourth quarter.

Regional banks’ profitability is expected to stay under pressure if rates remain low.  The Curmudgeon has repeatedly stated that ultra-low short term interest rates hurt banks, savers, retired folks living off interest income.  They also encourage all sorts of financial engineering by companies to artificially boost their stock prices.

Richard Davis, CEO of Minneapolis- based US Bancorp, last year likened his bank’s situation waiting for interest rates to rise with the last few grueling moments of a gym-class test, hanging on a pull-up bar for 90 seconds.

Last week, on a call with investors, Mr. Davis extended the bar-hang analogy further, saying that with rates staying lower for longer, the bank is now “grimacing like crazy. Both the knuckles are white. But we’re hanging in there.”

The Curmudgeon wonders how long banks can “hang in there,” before one or more fails and needs another government bail-out or “bail-in?”

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Victor's Conclusions:

Many other risks (to the global economy and financial markets) are present, but those described above are the most important currently.  At least as far as I'm concerned.  However, information alone won't help your portfolio -only diversification and Gold.

Let's end with the brilliant words of Ruben Blades-  Panamanian singer, song writer, actor and activist:   

"I think we risk becoming the best informed society that has ever died of ignorance."

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

 

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

Copyright © 2016 by the Curmudgeon and Marc Sexton. All rights reserved.

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