Saturday, February 14, 2015

Farmland Prices Fall In 2014

Farmland was one of the few assets to come through the 2008 credit crisis unscathed, and prices went parabolic soon after the crash. The Fed reported this week prices declined in 2014, which was the first annual price decline since 1986! There's not another asset on the planet that has experienced that kind of uninterrupted run over the past three decades.

With many agriculture prices recently experiencing major declines (which directly impacts the top line revenue a farm produces) it is likely land prices will continue downward through 2015. While I am not personally a buyer of farmland (yet), I began accumulating corn and wheat in mid 2014.

See Corn & Wheat Prices Destroyed: Buying Opportunity?

The Obscene U.S. Defense Spending Continues

I guess you can applaud the reduction in the size of America's annual defense spending, but it would be like applauding a child for bringing home a D- in school instead of a F. 

Although the total size of the U.S. defense budget has fallen, America is still spending more than the next nine largest military budgets combined

The Growth In The Size Of American Homes

The following graphic shows the incredible growth in the size of American homes from 1950 to 2011. While the number of people living in homes has fallen, the space per individual has grown enormously. Click for larger view:

Friday, February 13, 2015

Irrational Exuberance: Robert Shiller Discusses The Bond Bubble

I'm currently reading the third edition of Robert Shiller's masterpiece "Irrational Exuberance." He updates where we are today in the cycles for stocks, real estate and bonds. I'll have more discussion coming on the book as I work through it, but I found this piece in the introduction particularly worth noting:

"Once you draw your attention to the risks people are not so confident during a growing bubble. (Confidence) was actually exceptionally low at the all-time U.S. stock market peak in early 2000. People were certainly aware at some level of risks.

Moreover, in a survey of home buyers that Karl Case and I have been conducting over the years, we pose the following question to recent home buyers directly: Buying a house in this area today involves:

1. A great deal of risk

2. Some risk
3. Little or no risk

The answers are puzzling. In 2004 when the housing market was showing its fastest price increases, only 19% said "little or no risk." It is not as if everyone thought that "home prices can never fall" during the bubble, though they are often accused of having thought that. In the 2009 survey, at the depths of the worst recession since the Great Depression of the 1930s, the percentage of respondents choosing that option was 17.2%. 

During bubbles, it seems that the psychological ambiance is rather one of public inattention to the though prices could fall, rather than firm belief that they can never fall."

As we look around the world today that last sentence sums up the bond market perfectly. Investors are not holding cocktail parties discussing their incredible bond portfolio returns or opening up day trading accounts to trade bonds around the world (as we imagine them doing at bubble peaks). They are simply not paying attention to the fact that bond prices are sitting at all time record highs going back to the 1800's, just as they were for stocks in 2000 and real estate in 2006.

More from Shiller:

Thursday, February 12, 2015

Global Currency Pegs

After the Swiss incident a few weeks ago (see Historic Overnight Move In The Currency Markets), it is interesting to take a look at a global heat map showing how much of the world is pegged to a currency or region. As the currency wars escalate and turmoil in the foreign exchange markets continues to rise there will be relentless pressure on other nations to remove "promises" previously set in place by central banks.

Jim Grant Discusses Weather & Deflation

Wednesday, February 11, 2015

The Revolving Door Between Wall Street & The Regulators

Lehman Brothers collapsed over six years ago bringing the financial system to the brink and taking down the global economy. For the first few years after the collapse individual citizens wanted to know how it happened and what was going to be done to make sure it did not occur again. 

Today those thoughts are all but gone. People are once again focused on the out sized returns of their 401k and the monthly rise in their home's value on Zillow. Who cares what those banks are doing now because life is good again, right?

Some of us are still paying attention and what is taking place is now is essentially more of the same only on a larger scale. The big banks have consolidated, grown in size, and become more "Too Big To Fail." While many U.S. banks have deleveraged significantly since 2008 (definitely a good thing), their derivatives portfolios (off balance sheet bets made in the dark) have mushroomed in size. While they may not hold trillions of dollars worth of mortgage risk on their balance sheet, their new structure with Fannie Mae and Freddie Mac involves the "sharing" of losses during the next crisis. 

How about the regulators that have been put in charge to watch the banks? People found out after the crisis that a revolving doors existed between the banks and regulators to incentivize them to look the other way in order to help their own job prospects in the future. Since the crisis this revolving door has only grown more common:

When confidence evaporates from the debt markets again you will see the emperor still wears no clothes. A larger problem or question to ask would be; what if the confidence evaporated behind the government debt markets which are the backstop standing behind the Too Big To Fails?

A bubble and the ensuing crisis usually never expand and implode in the same place it did the last time (Gold in 1980, Japanese stocks in 1990, Internet stocks in 2000, Mortgage bonds in 2007, Government bonds in 201X?). 

More Insanity In Global Bond Yields: Corporate Bonds Go Negative

Governments are not the only entities now able to borrow at negative yields. Corporate giant Nestle recently issued a bond with an expiration in October 2016 and the interest rate on the bond locked in below zero. This means investors are paying Nestle to take their money. 

This may only be the beginning. Above Avalon discussed this week what is now taking place in the bond market for Apple:

"Apple just raised $1.35 billion of Swiss-franc denominated debt in two tranches (0.28% and 0.74% implied yields), according to the WSJ, Apple is raising debt to fund its capital return program. In what can only be described as being at the right place at the right time, Apple is essentially getting paid to raise debt. 
Apple may enter currency swaps to effectively convert Swiss Franc-denominated notes to U.S. dollar-denominated debt, which would increase the effective "cost" of the debt. Even taking this cost into consideration, Apple is in a position to earn a small profit by issuing debt. By raising debt, Apple is able to use borrowed cash to buy back AAPL shares, thereby saving on dividend expense. All else equal, and assuming an estimated $13 million after tax currency swap cost, Apple would make a profit of $1 million by raising $1 billion of debt at a 0.28% interest rate."
Unlike some of the bankrupt governments borrowing at today's insane yields, I have no doubt Apple has the ability to pay back this debt in the future (the same goes for Nestle). This makes these bond sales far less ridiculous than a Japanese 10 year bond yielding 0.30% because a 5th grader with a calculator can clearly figure out Japan will never, ever pay back their debt without massive devaluation and/or default. Apple has a cash hoard larger than the total GDP of some countries. Japan is beyond bankrupt in every sense of the word.

However, it is only at the peak of a 80 year debt super cycle mega bubble that you will see investors pay companies to hold their money. We have arrived at that peak.

For more see: A Look Behind The $57 Trillion Increase In Global Debt Since 2007

Studying History & Watching It Repeat

A quick summation of how this writer and many of the long time readers here feel watching what is taking place around us today.

Sunday, February 8, 2015

A Look Behind The $57 Trillion Increase In Global Debt Since 2007

The McKinsey Global Institute released an excellent study this week on the growth of global debt since the financial crisis began in late 2007. Total debt has grown by $57 trillion since Q4 of 2007, led by a $25 trillion surge in government debt. 

Every country has a different debt story so it is impossible to explain or even predict how the next crisis will unfold using a simple, blanket explanation. For example, Japan's record setting total debt to GDP (over 400% - see chart below) is due in large part to their ridiculous government debt levels (over 250% of GDP). China on the other hand has seen their total debt grow from $7 trillion in late 2007 to over $28 trillion today due in large part to real estate and shadow banking debt.

The chart below tracks the change in total debt by country in relation to their GDP (total size of their economy) since 2007 on the vertical axis and tracks the total debt to GDP on the horizontal axis.

The global debt explosion began in 1971 when the dollar was removed from the gold standard and currencies had the ability to free float around the world. This opened up the potential for banks to provide an unlimited amount of credit and simultaneously allowed governments to issue an unlimited amount of debt. The chart below shows the key moment in 1971 and does not include financial (bank) debt:

Political leaders made a decision back in 1971 that it would be up to the markets to determine when countries had issued too much debt or printed too much currency (reflected by rising interest rates as investors sold bonds). These leaders were told the markets are a perfectly efficient weighing machine, meaning investors would pull back when there was too much borrowing by a particular nation or if inflation were too high. Like the gold system, they believed this would auto-correct debtor countries to begin paying down their debts and allow more responsible countries to borrow more.

We know now, as we can see in the charts above, the market's auto-correct function has been turned off for about 35 years. The bond vigilantes did not arrive, and investors (up until now) have only wanted debt more as countries became more and more irresponsible.

Markets do not provide an accurate measurement of health within an economy or an asset class because markets are an interconnected system run by the emotion of humans. This system, as we have witness throughout history, creates a boom and bust cycle not a daily accurate measurement of value. 

The global markets valued U.S. subprime bonds at 100% par value with interest rates at record low levels entering the summer of 2007. Just a few trading weeks later subprime bonds were valued at 90% (or more) less than par value and most could not be purchased at any interest rate. Did something fundamentally change with their value over those few weeks? No, confidence behind the paper assets just disappeared overnight.

This the problem with politicians or central bankers using the financial markets as a gauge to when they should be issuing more debt or printing more money. By focusing on the blue skies in the rear view mirror they cannot see the storm approaching

Governments look at the interest rates on their debt sitting at all time record lows around the world and believe they are doing everything just fine. Through the widespread adoption of Keynesian economics throughout the world, most political leaders look at rates today and conclude the problem is not enough debt is being issued.

The same applies for central banks, which use inflation as their gauge. They see that after 7 years of zero percent interest and endless QE money printing programs inflation has not yet appeared. Their programs have caused asset bubbles in the financial markets, but the money has not made its way into the real economy (which would reflect in the consumer price index). Their conclusion is that more QE is needed to try and force feed inflation through the financial system into the real economy. This is why we have crisis-level monetary policies in place at a time when the global economy is not in a crisis. Meanwhile, malinvestments are now everywhere as the insane monetary policies have led businesses, individuals and governments to take on an extraordinary amount of additional debt since 2007.

The next crisis will involve the peak and subsequent collapse in government debt around the world. Government bonds do not have to move like a U.S. subprime mortgage bond did in 2007-2008 (go from 100% value to 0% value) in order to spark a crisis. If a 10 year yield moves from 30 basis points in Germany to a more historical normalized rate of 3.0%, investors who purchased that paper at 0.30% will be massively underwater on the investment. As we discussed last weekend, the majority of those purchases are occurring with massive leverage so the unwind will be catastrophic.

This does not factor in the hundreds of trillions of dollars of insurance contracts created in the derivatives market now betting on interest rates staying low forever. Just as in 2007, investors believe their government bond purchase at 30 basis points is safe because they have an insurance policy on the bond which covers losses after a certain threshold. These insurance contracts are what allow the massive leverage to take place because their computer models show protection against any scenario that should occur.

The problem, as it was in 2008, is counter-party risk. The insurance company (hedge fund, bank, etc.) may not have the capital to step in and cover the losses when they arrive. Just as no major bank had the value of real estate falling more than 5% in 2006, no one has government bonds falling rapidly in price at any point this decade.

While AIG almost destroyed the financial system with their insurance bets on subprime mortgages in the early 2000's, there are probably 10 AIG's that exist throughout the financial system today backing the broader bond market against losses. Most of these companies will not have the capital in place when the crisis arrives and the derivatives implosion will begin. How do we know this? There are no regulations in place to track these insurance contracts or the capital that is supposed to be in place behind them to cover losses. The derivatives market exists in the shadows. A one quadrillion market based solely on the trust in the paper contracts.
When the day of reckoning arrives, everyone will be just as shocked as they were during the last financial crisis. Only this time it is far easier to see.

One morning we will wake up and have reached the peak in confidence surrounding the global debt supernova. When the leveraging gears begin to slow down, then stop, then begin deleveraging the other direction the panic moment will arrive when investors discover central banks are powerless to stop the collapse. They will learn that hundreds of trillions of dollars in derivatives based on counter-party trust alone is not a healthy structure for a financial system.

How quickly can the bond market turn?

In mid 2014 oil was trading over $100 and by the end of the year it was in the $40's. Almost no investment trading or energy firm in the world had a collapse of that speed and magnitude built into their models. The result has been chaos in the energy sector.

The same will occur in the bond market, only the ingrained belief that it is impossible to happen is far deeper. 

For more see: The Global Government Bond Bubble Enters The Final Blow Off Stage