Bizaro World
Perhaps the most amazing part of the past 15 years has been the inversion of cause and effect, not just in the capital markets but also in government, business, and social matters. The German stock market is a great example of this inversion.
Based on the two charts below that reflect a sharp increase in interest rates and modestly declining GDP, what would you expect returns in the equity markets to be? Using the present value of discounted cash flow and knowing the correlation between GDP and corporate cash flow is high, the rational answer is declining cash flow. Now add the sharp increase in interest rates and the present value of German corporate cash flow is lower.
The weakness in GDP can be triangulated using employment data. Employment is not growing in Germany.
Keep in mind that the foundation of finance is the present value calculation. Furthermore, the risks associated with German equities have risen over this period. As such, can someone explain the sharp rise in the value of the DAX?
Rational analysis does not support a doubling in the German stock market off the lows of 2022. There must be another explanation besides discounted cash flow.
Occam’s Razor
When faced with multiple explanations for a phenomenon, the simplest explanation is usually the most accurate – Occam’s Razor
German stocks are being manipulated higher – that’s the simplest explanation.
Since we know that German demographics are negative with fewer working age Germans to propel the economy and since we know that the Ukraine war has created a negative economic shock in the form of much higher energy prices and higher social expenses, Germany’s economic future appears grim. Furthermore, we know that the tariff war with the US is negative for the German economy.
In short, there is no reason to buy German stocks based on any rational approach to intrinsic value. Fortunately, I have a theory to offer…
What if I told you that by changing one variable, you could change everyone’s perception of the economy? What if you have almost perfect information about everyone’s trades, trading position, and liquidity at all times? What if you have the combined buying power of major government pensions and the index funds of major private fund companies on your side? Could you train investors to act like Pavlov’s Dog if you reinforced this inverted sense of value over 16 years? Can you create a feedback mechanism where investors are trained to “buy the dip?” The last 16 years would suggest that the answer is yes.
The purpose of narrative is to present us with complexity and ambiguity – Scott Turow
Bad credit is the biggest risk for the global financial system. Equity markets represent a small speck on the back of global credit. In fact, equity is little more than the residual value of an asset after creditors have been paid. As such, stocks are rightfully considered to be riskier than fixed income – in the collective.
This one factor is the key to understanding the inversion of cause/effect that we have experienced over the past 16 years in the markets. In short, governments have been able to manipulate equity markets as a means towards creating artificial confidence in the financial system.
2008 was the end of free markets. My theory is that faced with the meltdown of much of the global financial system, global central banks and national treasury departments created an evolving system that uses the lever of the short squeeze to move equity markets higher. And if you keep equity markets elevated with very low measures of risk (standard deviation of returns), you implicitly make fixed income appear less risky.
Taken one step further, if you can lower the standard deviation of returns for credit and equity, you can induce risk-averse investors to assume MORE risk, thus making the job easier. We can see this clearly from the following formula:
U = E(r) - .005Aσ²
Where U = an investor’s economic utility based on risk preferences
E(r) = expected return
.005 is a scaling convention that allows us to represent expected return standard deviation as percentages rather than decimals
A represents an investors risk aversion and
σ² represents the volatility of the asset as measured by standard deviation.
If intervention can reduce the volatility of an asset, then risk aversion declines, pulling people into assets that they would normally be averse to owning. In addition, the higher markets climb, the more we expect them to climb as we are biologically wired to overweight near-term experiences.
Furthermore, we can apply the same measures of risk in equity markets to fixed income markets. For private market transactions, we can impute risk factors from similar publicly traded entities that have similar asset bases. In other words, we can use σ² to represent the standard deviation of risk for fixed income transactions of similar economic entities.
The world has moved to quantitative portfolio management, especially large portfolios in insurance companies and government retirement plans. The more large buyers that own a certain type of asset, the more attractive that asset will be to smaller investors. This is how you can attract a greater number of investors to risky tranches of credit card debt or junk bonds.
I created the above thesis around 10 years ago to understand this global inversion of cause/effect in capital markets. If you accept it, you can understand how pure rational investors would place short-selling bets on European equities given the horrendous economic and social climate. And you can understand how a concerted buying effort by large government agents and a “trained” investing public can force formerly rational investors to close their short positions and go long over-valued and extremely risky German equities.
Role of Government Debt
Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble…to give way to hope, fear, and greed – Benjamin Graham
Not anymore Ben! While BG is the father of fundamental analysis and rational investing, he has become an anachronism in today’s trading environment where trades can be split into millionths of a second.
Let’s call my thesis a capital markets feedback system and to make it work, the underlying economy must be stable. The only way to keep it stable is to use the power of government borrowing/spending as a contrary force against the negative impulses of the private sector – an adaptation of Keynes.
We can see this in action in the chart of transfer payments below. Transfer payments represent money given to citizens without the need for work. They include Social Security, Unemployment, and Welfare, among others. Transfer payments have risen from 11% of GDP before the 2008 financial crisis, to 14% pre-Covid, to over 15% today, with a couple of massive injections in between.
The wholesale importation of illegal immigrants allows money to be allocated to the private sector while concurrently destroying labor’s bargaining leverage, thus limiting the inflation multiplier effect of that monetary allocation. Objectively, it’s a smart strategy, putting lawfulness, morality, and ethics aside.
The chart below further supports my thesis. You can clearly see how the rate of change of government debt growth spiked following the 2008 crash and spiked again when Covid shut the economy down.
Thanks to the law of diminishing marginal returns, maintaining stability of the system requires ever greater sums of money to compensate for the lack of return being generated by the private economy. This is represented by the rate of change going from the blue arrow to the yellow arrow to the red arrow. It corresponds to the arrows in the transfer payment chart above. The difference between the blue and red arrows clearly indicates the declining impact per dollar of government liquidity in the economy.
Further usage of the government credit card would require the growth rate of debt to approach the vertical axis, meaning out of control debt growth. The result would be global hyperinflation.
This helps explain why socialism/marxism no longer carries the negative stigma it once had. The more the government supports the economy, the more we move from capitalism to socialism. People like Bernie Sanders want to exercise greater influence over the way these extraordinary sums of money get spent. Conversely, it also explains why DOGE proved to be popular with the MAGA supporters.
The Trump Administration rightfully sees that they can’t go “cold turkey” on government spending as the Freedom Caucus and Elon Musk require but they must reduce the rate of change of debt growth. The only path to success requires a rapid shift from government spending to private sector spending. This will require confidence in the future which means the upward pressure on the stock market will remain – for now.
The global economy is on a knife’s edge and re-balancing the US economy won’t occur overnight. The odds are stacked against him and it’s why the odds are also stacked against the global equity markets – and credit markets by extension.
If you consider Trump’s tariff policies objectively, they represent a “beggar thy neighbor” economic plan because our trading partners are supposed to lose market share in our markets while opening-up their markets to our manufacturers. Nobody outside the US can thrive with such market share losses, especially when most of our trade partners have negative demographic dynamics. The result will be a deep, global economic downturn.
Crisis Is Inevitable
Success is often achieved by those who don’t know that failure is inevitable – Coco Chanel
The buzz from economists and strategists is that we now have too much government debt and that we have a debt crisis. At interest rates above 4%, our government debt is a problem but at 0%, it’s manageable and I expect interest rates to fall on US government debt. That’s why I find the long end of the yield curve attractive at current levels.
I expect global capital to flow to the US because it’s the one place on earth that has a chance of succeeding and while not strictly rational, I think it’s going to happen. But not without pain and not in a straight line.
Wishful thinking? Perhaps, but I watch what is going on around the world, especially China. China is in a slow but irreversible state of economic collapse. The BRICS are a bad joke for anyone who looks closely at those economies and the challenges they face. Replace the US? Not a snowball’s chance in hell!
All of the BRICS currencies are collapsing versus the US dollar. Here’s the strongest economy of the bunch – India, which just cut rates by 0.50%. Since 2011, the rupee has collapsed versus the US dollar. In 2011, it took 1.5 Brazilian real to equal $1, now it takes close to 6 real. In 2011, it took 30 rubles to equal $1, now it takes 77. The Marxists love the BRICS, but that love is misplaced.
A crisis is inevitable but I believe the worst of it will be in Asia and Europe. Despite rallying the equity markets in these regions, economic fundamentals are abysmal; both are on the edge of economic and social collapse. If you accept my above thesis, it’s easy to understand why these economic pariahs are experiencing positive stock market returns. If you don’t, I wish you luck.
No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable – Adam Smith
Data won’t tell us when China is ready to roll-over because the Chinese Communist Party or CCP is hiding anything that indicates the true situation on the ground. Every piece of economic data in China is manipulated from the local level through the national level for various reasons. Only import/export data is reliable because it can be independently verified.
I expect China to be the first major economy to decline because the underlying Chinese economy is FAR worse than the data indicates. Despite a declining population, unemployment is spiking due to market share losses in the export markets.
Today, China’s youth is “lying flat,” or just doing enough to get by. Tomorrow, they may be rioting in the street. Xi has mismanaged the past 13 years so completely that China’s youth have nothing to lose.
Early indications suggest that a silent coup has placed Xi under house arrest, where he remains the titular head of the CCP. Former Xi ally, General Zhang Youxia controls the People’s Liberation Army after dozens of Xi allies were purged. Zhang is supporting the anti-Xi forces as they work behind the scenes.
Elder CCP leaders such as Hu Jintao, Wen Jiabao, and Li Ruihan are quietly re-ordering the CCP back towards Deng Xiaoping’s reform policies. Expect a new Chinese leader after the fourth plenum later this year. This portends better relations with the West in the future but will do nothing to stem the tide of economic destruction that’s swamping China.
On average, I suspect these developments reduce the risk of China attempting to take Taiwan using military force. Failure would doom the CCP to follow the Romanov’s into exile or worse. Success or failure, the world will stop trading with China if they use force.
China’s deflationary downturn will create an vacuum in the global economy. Demand for commodities and high-end manufactured products will decline leaving the emerging markets in turmoil in addition to Germany, Japan, and South Korea. This is the EVENT that breaks the post-2008 model.
Conclusion
The pitcher will go to the well once too often – European folklore
The post-2008 economic/financial model has been an experiment that was destined to yield strange results and ultimately lead to unsustainable levels of federal government debt. I view it as a comprehensive strategy to maintain the status quo which isn’t necessarily a bad thing over short spans of time. The problem comes when you reward mediocrity and failure over the long term, the system becomes distorted; capital gets allocated in disadvantageous ways such as luxury at the expense of utility.
The world has been following this strategy for 16 years and we’re well-past the point of diminishing marginal returns. Something is going to break this year and I believe it will be China, just don’t look for the data to tell the story. It’s going to be a function of destroying the export-driven private sector which has always been at the heart of China’s economic rise.
After China goes, the dominoes will start to fall across Asia, notably Japan and South Korea, and across the emerging markets. We’ll know it’s upon us when the US dollar spikes and the price of copper plummets. Until then, we watch and prepare for the opportunity.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA