Friday, April 21, 2023

End Of An Era, Transiting From Permagrowth To Permaflat - Part One

This will be a series of posts on a subject that is of great concern to me as a father: how to create a better, more sustainable world for our children.  I have long thought about starting the series but I kept putting it off.  It is now time to start, no more excuses.


Back when I was a chemical engineer (it only lasted 2 years after college) I was involved in the design of a corn-to-ethanol plant.  Several such plants were built in the US Corn Belt as a response to the oil crisis in the early 1980s, and were heavily dependent on federal subsidies for gasohol (a blend of gasoline and alcohol).  But it wasn't the economics of the plant which created a lasting impression on me - rather, it was the chemistry/bioprocess itself.

Corn ethanol is produced by fermentation using enzymes, aka yeast, living microorganisms that convert sugars contained in the grain into alcohol. In simple terms, they eat corn and excrete alcohol as their waste.  The process takes place in chemical reactors aptly called "digesters", and it relies on constantly maintaining an optimum balance between healthy enzymes (the critters), corn (their food) and ethanol (their waste).  

And it has to be a balance because if there is too much food the critters will multiply uncontrollably, produce too much alcohol - which is actually a poison for them -and  will die from exposure to their own waste.  Conversely, if there is too little food they will turn on each other and become critter cannibals. Also, if the fermentation is allowed to run too fast and too hot (it is exothermic) the critters will die off, since they cannot tolerate high temperatures. The trick, therefore, is to introduce food (corn) and extract waste (alcohol + CO2+heat) in a carefully calculated balance to keep the critters healthy and happy.  

Does this sound familiar? 

Of course it does: we humans are the enzymes, the Earth is our reactor vessel and we consume its  resources to fill it with our waste.  But, there is a crucial difference: The Earth is a closed system with limited resources (with the important exception of incoming solar radiation) and no way to extract excess waste/heat. Also, we too are prone to cannibalism (war). 

What's our saving grace? We got critter brains - but even that is a double-edged sword, as we know from the likes of  Caligula, Attila, Hitler, Mao and many more such nasty "critters".  And no matter how smart, at some point the deleterious effects of exponential growth overcome our capacity to deal with them.

Signs of  such a Tipping Point are everywhere: Global warming, climate change, species and habitat  collapse, massive pollution and, very worryingly, a trend towards lifestyle diseases and habits, resulting in poor health and sudden life expectancy drops in wealthy countries like the US.  We even got a global deadly pandemic, a war and “critter arm wrestling” between the world’s two largest critter colonies (US vs China). The alarm bells are ringing, that's for sure.

I think the physical, scientific evidence on the ground is overwhelming.  But what about finance - what is happening there?

This will be the subject of Part Two.

Tuesday, April 11, 2023

Brave New Overleveraged World

 A loyal reader asked a pointed question: is this the worst market mispricing ever? (Thanks AKOC).

Perhaps it is. Why? 

Because the entire global economy is grossly overleveraged on a fundamental basis.  

When we think of markets and leverage we think of margin debt, derivatives, corporate debt, etc.  This was certainly the case in 2007-10 during the Great Debt Crisis, which was "resolved" when the US and EU central banks and governments stepped in and assumed the debt. Private sector debt became government debt, with lots of it sitting in central bank balance sheets. The problem was - literally - papered over.

Then came deflation (thank you China and you cheap manufacturing juggernaut), interest rates went to zero or lower, and for almost a decade everyone forgot that debt carries a servicing cost (interest). Even the worst serial bankrupt in Europe came back and tapped markets for fresh debt (Greece).  It had to mortgage its silverware for 99 years, but.. it did.

COVID changed everything: American, European and Japanese governments panicked and printed money like never before.  They made 2008-10 QE look like a statistical aberration by comparison (see charts below).

United States Federal Reserve  Balance Sheet Assets

European Central Bank Balance Sheet Assets

Bank of Japan Balance Sheet Assets

Looking at the charts we can draw only one conclusion: the West is fundamentally extremely overleveraged.  Central banks are financing the economy - take that out and what remains? Let's remember that central banks are regulators and lenders of last resort, not day to day financiers.  By trying to stay in the economic race the West is shooting itself in the foot.

Who is doing things differently?  The second largest economy in the world - China.  Its economy is growing rapidly - yes, it created a real estate lending bubble of its very own in the process - but, in general, it has kept its central bank's nose clean (see chart below).  

Back in 2006-07 I started this blog by posting just a few charts of debt going through the roof. They seemed self evident to me, but it took a couple of years until the doodoo hit the fan.  Today, the first three charts seem just as self evident, so I'll leave it at that.

Monday, April 10, 2023

Are Markets Whistling Past The Graveyard?

 It's the Monday after Easter Sunday and all markets are closed in Europe in deference to Christ's miraculous rise from the dead.  In some ways, then, it's apropos - if a bit sacrilegious - to mention graveyards.

Here's what's been nagging me for a long time now (at least a year): 

  • There's a major war in Europe which keeps escalating. People are using the word "nuclear weapons" with increasing frequency.
  • Tensions between US and China are high and rising.  The proximate cause is Taiwan, but the major issue here is nothing less than global supremacy.
Both of the above are clear and present dangers, and they are here and now.
  • Climate change is accelerating but no one is really doing anything about it in a practical manner.
The latter is forever talked about as a "future" threat, but I'm increasingly worried that the tipping point is much closer than our society thinks.

IMHO markets are completely (and willfully?) ignoring these risks when pricing ALL securities, from bonds and stocks all the way to commodities and derivatives.  I get the feeling that no one in the mainstream is willing to develop a model to take these into account, perhaps fearing that he/she will be branded a loonie.  

How about this model, then?

Pnwu  = Probability of nuclear weapon use(decimal  0.00 - 1.00)   
Pucc    = Probability of USA/China conflict 
Ptp      = Probability of tipping point within 5 years 

Enwu   = Effect of nwu on equity markets  (+/- %)
Eucc    = Effect of ucc on equity markets 
Etp      = Effect of tp on equity markets 

Cumulative Effect = (Pnwu)x(Enwu) + (Pucc)x(Eucc) + (Ptp)x(Etp)

Plug in your own probabilities and likely effects and you'll come up with something a bit more concrete than "um, let's not worry about it right now".

I'm not doing it, they'll call me a loonie -  Well, at least I'm not doing it in public (ha, ha).

Friday, April 7, 2023

OPEC+ Was Not Amused

 A week ago OPEC+ (essentially, Saudi Arabia and Russia) announced a wholly unexpected cut in crude oil production and took everyone by surprise.  Prices immediately jumped from $75 to $80 per barrel.  Why did they do it?

I think it was a response to the new round of dollar "printing" by the Fed, engineered to salvage (once again) the US banking system.  How are the two connected? Simple: crude oil is priced in dollars  - when there are immediately more dollars around producers of "hard" goods are encouraged to hike their prices. 

The Fed had started reducing its balance sheet (QT) - but then sharply reversed course and "printed"  overnight as many dollars as it had withdrawn in the last 6 months (QE) - see chart below. And a week later... OPEC+ hiked prices.  I don't know about you, but I don't believe in coincidences.

It seems to me that the negative effects of unwise money creation to the real economy are becoming ever more rapid and obvious, even to the untrained eye.  From another perspective, demand for luxury goods and services by even the merely rich (not to mention the HNW and UHNW) is continuing unabated.  I can speak from personal experience, observing how American tourist bookings abroad are booming, particularly in the luxury sector.  There is just too much money sloshing about and it does not really matter how high interest rates go, until consumer deposit rates go significantly higher than inflation.