A Worrying Development for Stock Market Bulls

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GUALFIN, Argentina – We are delighted with all the back talk we got from our Diary on the absurdity of the “living wage.” The responses were lively… and entertaining. We laughed. We cried.

Many people thought that we had given priests too much money… and prostitutes not enough. We could go either way on that.

Still, we got no complaints from prostitutes, but many from doctors. They wrote in to tell us how hard they worked and how outraged they would be if they earned less than nurses. (Scroll down to today’s Mailbag for more.)

They may not have noticed how far our tongue had reached into our cheek. But what fun it is setting other people’s wages!

We even got a letter from a former resident of Communist Yugoslavia who had participated on a government board charged with setting salaries for different job classifications. He was so disgusted by it he emigrated to the U.S.

Finally, one reader probably spoke for thousands: “This is the most idiotic article in the history of articles.” We are too modest to believe it. But if it is so, it is certainly an achievement!

After all, Larry Summers and Paul Krugman write articles too. So do doctors! It is hard to believe that we could top them all.

But enough of this. We have to turn to other things… Such as the collapse of the whole world economy!

A New Global Recession

Yes, it seems to be coming. Our friend and longtime Bonner & Partners Family Office member Hense Ellis summarizes:

A new global recession has begun. The collapse in commodity prices and the slump in the emerging market economies will inevitably lead to a sharp drop in global investment and a new surge in unemployment.

Moreover, the recent stock market selloff is making matters much worse by creating a negative wealth effect that will cause consumption to fall.

Another friend, economist and author Richard Duncan, adds detail via his advisory, Macro Watch:

  • China’s economy is slowing rapidly.
  • India’s economy is more fragile than generally understood.
  • The plunge in commodity prices is taking a heavy toll.
  • The sharp drop in emerging market currencies is destabilizing.
  • The slump in global trade is a blow to corporate profits.
  • Excess industrial capacity is worsening.
  • Credit quality is deteriorating rapidly.
  • Credit availability has begun to dry up and will become much tighter.

Duncan has a theory about why these things are happening – a lack of “excess liquidity.”

As he puts it, “It’s liquidity that moves the markets. When liquidity is plentiful, asset prices tend to rise, and when it is scarce, asset prices tend to fall.”

What investors need, therefore, is some way of measuring and forecasting liquidity.

Duncan’s answer is something he calls a “liquidity gauge.”

When the Fed creates dollars through QE, it injects liquidity into the financial markets. Also, when foreign central banks invest their dollar foreign exchange reserves back into the U.S., it adds to liquidity.

On the other side of the equation, when the government borrows dollars to fund its budget deficit, it absorbs liquidity. Duncan:

When total liquidity (i.e., QE combined with the amount of dollars accumulated as foreign exchange reserves) is larger than the budget deficit, there is excess liquidity and asset prices tend to rise. But when total liquidity is less than the budget deficit, there is a liquidity drain and asset prices tend to fall.

Right now, according to Duncan’s model, liquidity will turn negative in 2015 and stay negative for every year until 2019.

This is why Duncan is warning his subscribers that this is a “very dangerous moment” for asset prices.

Broken Pumps

Yesterday, we showed how excess liquidity bubbled up in the mortgage finance market.

As money was easier to come by – thanks to low rates and rampant securitization of mortgage debt – people bought more houses at higher and higher prices.

This pushed up the value of the collateral – houses – which enabled people to borrow even more… and it drove the industry to build more houses and sell them to increasingly marginal (subprime) buyers.

Debt and equity raced each other higher and higher until both collapsed in 2007-08. Home prices plunged. And the value of mortgage debt plunged along with them.

Today, thanks largely to the Fed’s bubble, homeownership levels are back to where they were nearly half a century ago.

Now, we see the same phenomenon happening in other sectors. As we reported yesterday, student debt, auto debt, and corporate debt are all headed for trouble.

And the bigger picture is that the pumps just aren’t working the way they used to. The growth of the last 20 or 30 years came largely – maybe entirely – from expanding credit.

Banks lent. Consumers, businesses, and government borrowed.

Many of the factory orders went to developing markets, where costs were lower. This left these economies and their central banks with lots of dollar foreign exchange reserves, which they reinvested in U.S. assets.

Mike Dolan at Reuters:

According to the International Monetary Fund, the dollar value of foreign currency reserves held by all developing nations ballooned by almost $7 trillion in just one decade to a peak of some $8.05 trillion by the middle of last year.

While China was the main driver, accounting for about half of that increase, its economic boom created a commodity supercycle that flooded the coffers of resource-rich nations from across Asia to Russia, Brazil and the Gulf.

As the vast bulk of this hard cash was banked in U.S. Treasury and other low risk, rich-country bonds, they were at least one critical factor in the halving of U.S. Treasury and other Group of Seven government borrowing costs over the same period.

An Ominous Peak

You see?

Dollars borrowed out of thin air in the U.S. ended up as foreign currency reserves in the hands of foreign central banks – mainly China’s.

What could they do with them?

Buy more U.S. government debt. Drive down U.S. borrowing costs. And make it even cheaper for Americans to borrow dollars and send them overseas!

Here’s a graphic our research team created to help you get a clearer picture of what’s been going on…


So you could track much of the global growth binge by looking at China’s foreign exchange reserves. As they went up, more and more money flowed back into U.S. financial assets… and Americans borrowed and spent more and more.

But whoa, whoa, whoa! Those foreign exchange reserves have now peaked. Dolan:

Emerging market forex reserves fell by about half a trillion dollars between mid-2014 and the end of the first quarter of 2015, IMF data shows, and this is likely far from the end.

Deutsche Bank estimated on Tuesday the high water-mark of almost two decades of reserve accumulation had now been reached and central banks will by the end of next year dump as much as $1.5 trillion to counter capital outflows.

Of course, as we told you yesterday, we don’t know anything. And even as to that we have our doubts.

But it appears that the end of this cycle is in sight.

Watch out.


Bill Bonner
for The Daily Reckoning

Originally posted at Bill Bonner’s Diary, right here.

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