Why Corporate America Can’t Prop Up Stocks Much Longer

By Justin Spittler

Corporate America is bracing for tough times. Since you’re reading an investment newsletter, you likely own stocks. And if you’re like most investors, you keep up with how the companies you own are performing. You might even listen to quarterly “earnings calls,” which are when CEOs present results and give their outlook on the business.

Most of the time, CEOs act as cheerleaders on these calls. If business is bad, they’ll say business is good. If business is good, they’ll say it’s great. And CEOs are notoriously optimistic about the economy. After all, thousands of investors and analysts listen to these calls. CEOs know their stock can crash if they’re pessimistic about the business or economy. Because many CEOs will say anything to make their stock go up, we don’t put much stock in their words. We pay much more attention to their actions. And right now, large U.S. companies are acting like very tough economic times are ahead.

Business investment fell 2.2% last quarter..…
This metric measures how much companies spend on property, plant, and equipment. It was the third straight quarter that business investment fell. That hasn’t happened since the 2008-2009 financial crisis. We wouldn’t see this if the economy was headed in the right direction. Companies would be building more factories. They’d be buying more machinery. They’d be spending more money on research and development.

Instead, companies have cut back on investments. This tell us they don’t see many good opportunities. That’s a bad sign for the economy, yet stocks keep rallying. The S&P 500, Dow, and NASDAQ have all recently hit new record highs. At this point, you’re probably wondering what’s keeping stocks afloat if it’s not the economy.

Companies have spent about $2.5 trillion on “share buybacks” since the financial crisis..…
A buyback is when a company buys its own stock from shareholders. This can lift a company's stock price.
According to investment bank Goldman Sachs (GS), buybacks have been the biggest driver of U.S. stock performance since the financial crisis. Buybacks also reduce the number of shares that trade on the market.

This boosts a company’s earnings per share. But buybacks don’t make a company more profitable. They only make profits look bigger “on paper.” Companies have been buying up their own stock for two reasons: 1) They don’t see many growth opportunities. And 2) it’s incredibly cheap to borrow money.

The Federal Reserve has held its key interest rate near zero since 2008..…
The Fed cut rates to encourage households and businesses to borrow and spend more money. Mainstream economists thought this would “stimulate” the economy. It didn’t work. The U.S. economy has grown at an annualized rate of just 2.1% since 2009. This makes the current “recovery” the slowest by far since World War II.

The Fed did get folks to borrow huge sums of money. U.S. corporations have borrowed more than $10 billion in the bond market since 2007. Last year, they issued a record $1.5 trillion in bonds.
Buybacks are a big reason companies borrowed so much. MarketWatch reported last week:

Companies have been taking on piles of debt to finance buybacks, leading the total debt on the S&P 500 to grow 56% during the past five years.

According to Yahoo! Finance, companies in the S&P 500 funded 22% of last year’s buybacks with debt. This year, debt paid for 39% of share buybacks.

Corporate debt is now dangerously high..… 
According to Barron’s, corporate debt now equals 45.3% of gross domestic product (GDP). The only time this key ratio has ever been higher was in 2009, when it hit 45.4%. If the economy was doing well, this wouldn’t be such a big problem. Companies would be making enough money to pay their debts.

But right now, Corporate America is struggling to make money. Profits for companies in the S&P 500 are on track to fall for the fifth straight quarter. That hasn’t happened since the 2008-2009 financial crisis.
There’s no telling when this earnings drought will end either. According to research firm FactSet, analysts expect third quarter corporate profits to fall 1.7%. The third quarter ends on September 30.

Keep in mind, the U.S. economy is technically in a “recovery” right now. Imagine what will happen to corporate profits during the next recession. The more profits fall, the less money companies will have to prop up their shares with buybacks.
  
Companies have already started to cut back on buybacks..…
According to Business Insider, buybacks fell 18% last quarter. This sharp decline in buyback activity followed a near record breaking first quarter, in which companies in the S&P 500 spent an incredible $166 billion on buybacks. That’s the second most ever, and the most in one quarter since 2007. We don’t know exactly why companies are suddenly spending less on buybacks.

Maybe it’s because corporate profits are drying up. Maybe companies are starting to realize they have too much debt. Or maybe it’s because stocks are expensive. According to the popular CAPE ratio, stocks in the S&P 500 are 62% more expensive than their historic average. Since 1881, U.S. stocks have only been more expensive three times: before the Great Depression, during the dot-com bubble, and leading up to the 2008-2009 financial crisis.

Like any investment, buybacks only make sense when stocks are a good deal. With stocks as expensive as they are today, buybacks are a terrible use of money.

Without buybacks, there won’t be much to keep U.S. stocks from falling..…
If you own stocks, take a good look at your portfolio. We recommend that you get out of any company that needs buybacks to retain shareholders. We also encourage you to put 10% to 15% of your wealth in gold. As we often say, gold is real money. It’s preserved wealth for centuries because gold is unlike any other asset. It’s durable, easy to transport, and easily divisible.

Gold is also the ultimate safe haven asset. It’s survived economic depressions, stock market crashes, and full blown currency crises. When investors are nervous about stocks or the economy, they buy gold.
The price of gold has jumped 27% this year. It’s beat the S&P 500 4-to-1.

If you don’t already own gold for protection, we encourage you to do so immediately..…
According to Casey Research founder Doug Casey, the financial system is held together by “chewing gum and bailing wire” right now. When the public wakes up and realizes this, “they’ll flock to gold… just as they’ve done for centuries.” Doug thinks this could cause the price of gold to easily soar 200% in the coming years.

You could make 2x, 5x, or 10x that much money in gold stocks..…
Yesterday, we showed you how leverage works in the resource market. As we explained, this powerful force is why gold stocks can soar even if the price of gold doesn’t rise by that much. This year, gold’s 27% jump caused the VanEck Vectors Gold Miners ETF (GDX), which tracks large gold miners, to soar 128%.

Some folks might see that and think they missed their chance to buy gold stocks. But regular readers know gold stocks can go many times higher. During the 2000-2003 bull market, the average gold stock rose 602%. The best ones returned more than 1,000%. We expect even bigger gains in the coming years. To learn why, watch this short presentation. In it, Doug explains why we’re headed for “the biggest gold mania” he’s even seen.

By the end of this video, you’ll know why there’s never been a better time to own gold stocks. You’ll also learn how to make the most of this new gold bull market. We’re talking gains of 1,000%...2,000%...even 5,000%. Those kind of returns might sound impossible. But as you’ll see, Doug's hit many “home runs” like this throughout his career. And for the first time ever, he's showing the world exactly how he did this.

To learn Doug’s SECRET to making giant gains in gold stocks, watch this free video.

How Will Negative Interest Rates, the War on Cash, and “Helicopter Money” Affect the Markets?

Today, we have something special to share with you. Instead of the usual “Chart of the Day,” you’ll find a six-minute video presentation put together by our colleagues at Palm Beach Research Group.

In the video below, Palm Beach Research Group co-founder Tom Dyson and Palm Beach Letter editor Teeka Tiwari discuss how radical government policies are affecting global financial markets. As Tom and Teeka explain, these central bank “experiments” will have severe side effects. They could even push the price of gold to $5,000. To learn why, watch the video below.

If you like what you saw from Tom and Teeka, we encourage you to sign up for their “speed round” training series. Click here to get started.

The article Why Corporate America Can’t Prop Up Stocks Much Longer was originally published at caseyresearch.com.

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The “Bloodbath” in Canada Is Far From Over

By Justin Spittler

The oil price crash continues to claim victims…and many of them are in Canada.The price of oil hovered around $100 for most of last summer. Today, it’s trading for less than $45. Weak oil prices have pummeled huge oil companies. The SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which tracks the performance of major U.S. oil producers, has declined 36% over the past year. The Market Vectors Oil Services ETF (OIH), which tracks U.S. oil services companies, has declined 30% since last November. Weak oil prices have even pushed entire countries to the brink. Saudi Arabia, which produces more oil than any country in the world, is on track to post its first budget deficit since 2009 this year. If oil prices stay low, the country could burn through its massive $650 million pile of foreign reserves within five years.

Oil’s collapse is also creating big problems for Canada’s economy.....

Canada is the world’s sixth largest oil producer. Oil makes up 25% of its exports. Last month, The Conference Board of Canada said it expects sales for Canada’s energy sector to fall 22% this year. It also expects the industry to record a net loss of about C$2.1 billion ($1.6 billion) in 2015. That’s a drastic change from last year, when the industry booked a C$6 billion ($4.5 billion) profit.

Major oil firms are slashing spending to cope with low prices. Last month, oil giant Royal Dutch Shell plc (RDS.A) said it would stop construction on an 80,000 barrels per day (bpd) project in western Canada. The company had already abandoned another 200,000 bpd project in northern Canada earlier this year. The Canadian Association of Petroleum Producers estimates that Canadian oil and gas companies have laid off 36,000 workers since last summer. Most of these layoffs happened in the province of Alberta.

For the past decade, Alberta was Canada’s fastest growing province.....

Its economy exploded, thanks to the booming market for Canadian tar sands. Tar sand is a gooey sand and oil mixture that melts down with heat from burning natural gas. More than half of Canada’s oil production comes from tar sands. In Alberta, they account for 75% of oil production.

Tar sand is generally more expensive to produce than conventional crude oil. Canadian tar sand projects made sense when oil hovered around $100. But many of these projects can’t make money when oil trades for $45/barrel. Last year, Scotiabank (BNS) said the average breakeven point for new Canadian oil sand projects was around $65/barrel. This is why giant oil companies are walking away from projects they’ve spent years and billions of dollars developing.

All these cancelled oil projects are making Alberta’s economy unravel.....

Alberta lost 63,500 jobs from the start of year through August. It hasn’t lost that many jobs during the first eight months of the year since the Great Recession. The decline in oil production is also draining government resources. Last month, Reuters reported that Alberta was on track to post a $4.6 billion budget deficit this year. Economists say it could be another five years before Alberta runs a budget surplus. The crisis isn’t confined to the oil patches either.

A real estate crisis is unfolding in Calgary.....

Calgary is home to 1.2 million people. It’s the largest city in Alberta and the third largest in Canada. On Tuesday, Bloomberg Business reported that Calgary’s property market is starting to crack:

Vacancy is already at a five-year high in Calgary and rents are the lowest since 2006 after thousands of office jobs were cut. In downtown Calgary, the vacancy rate jumped to 14 percent in the third quarter, the highest since 2010 and compared with 5 percent for downtown Toronto, according to CBRE Group Inc. .... That doesn’t include as much as 2 million square feet of so-called "shadow vacancy" or space leased but sitting empty, which would push vacancy to 16 percent, the most since the mid-1980s.

Demand for office space is falling because of massive layoffs in the oil industry. That’s because oil companies didn’t just lay off roughnecks. They also laid off oil traders and middle managers, which means they need a lot less office space. According to Bloomberg Business, a principal at one Calgary real estate office called the situation “a bloodbath” and said “we’re at the highest point of fear and uncertainty now.”

Casey readers know the time to buy is when there’s blood in the streets.....

But it looks like Calgary’s property crisis is just getting started. Bloomberg Business reports that the city has five new office towers in the works. These projects will add about 3.8 million square feet to Calgary’s office market over the next three years. More office space will only put more pressure on rents and occupancy rates. Real estate developers likely planned these projects because they thought Canada’s oil boom would last. It’s that same thinking that made oil companies invest billions of dollars in projects that can’t make money when oil trades for less than $100/barrel.

Doug Casey saw this coming.....

In September, Doug went to Alberta to assess the damage first-hand. E.B. Tucker, editor of The Casey Report, joined Doug on the trip. Doug and E.B. spoke with the locals. They even tried to buy a Ferrari. They shared their experience in the October issue of The Casey Report.

E.B. went on record saying Canada was in for “a major wakeup call.” He still thinks that’s the case. In fact, he thinks the situation is going to get a lot worse.

When we were in Alberta, we heard over and over again "It'll come right back...it always does." It's not coming back. I expect the situation to get worse. And I see the Canadian dollar going much lower.

When that happens, E.B. thinks Canada’s central bank might do something it’s never done before:

Vacancy rates are rising in Canada’s heartland cities. Jobs in Alberta are disappearing. Unemployment is climbing. And there’s still a global oversupply in oil. None of this bodes well for Canada’s economy. Canada’s economy is in a midair stall. The locals certainly didn’t grasp this when we visited Alberta last month. That's usually the case when things are going from bad to a lot worse. If you’re a central banker in Canada looking at the data, there’s only one decision: print.

E.B. says Canada’s central bank will launch its own quantitative easing (QE) program.....

QE is when a central bank creates money and pumps it into the financial system. It’s basically another term for money printing. Since 2008, the Fed has used QE to inject $3.5 trillion into the U.S. financial system. If the Fed’s experience with QE is any indication, money printing wouldn’t help Canada’s “real” economy much. But it would inflate asset prices. That, in turn, would only make Canada’s economy even more fragile. E.B. is confident the situation in Canada will get worse. And he can’t wait to go back to Canada to collect on bets he made during his last visit:

Doug and I made a lot of side bets with business owners during our visit. One of them promised to sell us a Ferrari if things got worse...that's how sure he was that we were wrong. Looks like we'll be headed back to collect on that one.

You can read all about Doug and E.B.’s visit to Alberta by signing up for a risk free trial of The Casey Report. You’ll even discover how to make money off the oil industry, despite the collapse in the price of oil. Click here to learn more.

The article The “Bloodbath” in Canada Is Far From Over was originally published at caseyresearch.com.

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The Options Market Has Changed and Here's Why

As you know, bigger changes in the market bring potential for bigger profits. This isn’t a new concept. However, I bring it up because our trading partner Doc Severson just released a new video tutorial detailing a major change making its way through the options.

Check This Out

In fact, Doc, a world renowned Options trader, traveled to Chicago to get a first hand account of what’s happening. And here’s why his trip is important to you:

He discovered that the big institutional investors aren’t gaining an advantage this time. Instead, the change underway is bringing a unique advantage to retail traders like you and me. About time, right? But unfortunately, too many traders are using strategies that don’t match today’s market conditions.

That’s why you must watch Doc’s presentation right away. He’s showing you how to adapt, so you can make a consistent weekly income as a trader and prepare for today’s “new normal” market. Doc gives you the full scoop in this tutorial.

Click here to watch....and of course it's free.

See you in the markets,
Ray's Stock World

P.S. What we’ve seen lately with how the global economy has affected U.S. markets is only part of the story....Get the full story here.

Hate Mail, Crumbling Factories, and Sinking Stocks

By Tony Sagami 

The bulls are mad at me. I’ve been heavily beating the bear market drum in this column since the spring. The S&P 500, by the way, peaked on May 21, and this column has been generating a rising stream of hate mail from the bulls as the stock market has dropped. My hate mail falls into two general categories: (1) you are wrong, and/or (2) you are stupid.

Well, I may not be the sharpest tool in the Wall Street shed, but I haven’t been wrong about where the stock market was headed. This column, however, isn’t about me. It’s about protecting and growing your wealth—and that’s why I have been so forceful about the rising dangers the stock market is facing.

Make sure you watch this weeks new video...."500K, Profit and Proof"

One of the themes I’ve repeatedly covered in this column is the rapidly deteriorating health of the two most basic economic building blocks of the American economy: the “makers” (see August 25 column) and the “takers” (see July 14 and August 4 columns).

There are thousands of economic and business statistics you can look at to gauge the health of the US economy, but at the economic roots of any developed country is the prosperity of its factories (makers) and transportation companies (takers) delivering those goods to stores.

This week, let’s look at the latest evidence confirming the piss poor health of American factories.

Factory Fact #1: The Institute for Supply Management released its latest survey results, which showed a drop to 51.1 in August, a decline from 52.7 in July, below the 52.5 Wall Street forecast, and the weakest reading since April 2009.

NOTE: The ISM survey shows that raw-materials prices dropped for 10 months in a row. If you own commodity stocks—such as copper, oil, aluminum, or gold—you should consider how falling raw materials prices will affect the profits of those companies.

Factory Fact #2: Despite all the crowing from Washington DC about the improving economy, US manufacturing output is still worse today than it was before the 2008-2009 Financial Crisis, according to the Federal Reserve.

Factory Fact #3: Business inventories increased at the fastest back to back quarterly rate on record. Inventories increased 0.8% in Q2, following a 0.3% increase in Q1, and now sit at $586 billion. That’s a 5.4% year over year increase!

Remember, there are two reasons why businesses accumulate inventory:

• Business owners are so optimistic about the future that they intentionally accumulate inventory to accommodate an upcoming avalanche of orders.

OR

• Business is so bad that inventory is starting to involuntarily pile up from the lack of sales.

Factory Fact #4: The Manufacturers Alliance for Productivity and Innovation (MAPI), a trade association for US manufacturers, is none too optimistic about the state of American manufacturing.
The reason for the pessimism is simple: US manufacturers are struggling.

• U.S. manufactured exports decreased by 2% to $298 billion in the second quarter, as compared with 2014.

• The US deficit in manufacturing rose by $21 billion, or 15%, compared with the second quarter of 2014.

“The US $48 billion deficit increase in the first half of the year equates to a loss of 300,000 trade related American manufacturing jobs, and the deficit is on track for a loss of 500,000 or more jobs for the calendar year,” said Ernest Preeg of MAPI.

So what does all this mean?

When I connect those dots, it tells me that American manufacturers are struggling. Really struggling.
Take a look at the Dow Jones US Industrials Index, which peaked in February and started to drop well ahead of the August market meltdown.

You know what’s really nuts? The P/E ratio for this struggling sector is almost 19 times earnings and 3.3 times book value!

Is there a way to profit from this slowdown of American factories? You bet there is.

Take a look at the ProShares UltraShort Industrials ETF (SIJ). This ETF is designed to deliver two times the inverse (-2x) of the daily performance of the Dow Jones US Industrials Index. To be fair, I should disclose that my Rational Bear subscribers have owned this ETF since June 16, 2015, and are sitting on close to a 15% gain.

Critics could say that I am “talking up my book,” but I instead see it as “eating my own cooking.” My advice in this column isn’t theoretical—we put real money behind my convictions. That doesn’t mean you should rush out and buy this ETF tomorrow morning. As always, timing is everything, so I suggest you wait for my buy signal.

But make no mistake, American “makers” are doing very poorly, and that’s a reliable warning sign of bigger economic problems.

Tony Sagami

30 year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Hate Mail, Crumbling Factories, and Sinking Stocks was originally published at mauldineconomics.com.

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A Five Year Forecast: Is this a Tsunami Warning?

By John Mauldin

It is the time of the year for forecasts; but rather than do an annual forecast, which is as much a guessing game as anything else (and I am bad at guessing games), I’m going to do a five year forecast to take us to the end of the decade, which I think may be useful for longer term investors. We will focus on events and trends that I think have a high probability, and I’ll state what I think the probabilities are for my forecasts to actually happen. While I could provide several dozen items, I think there are seven major trends that are going to sweep over the globe and that as an investor you need to have on your radar screen. You will need to approach these trends with caution, but they will also provide significant opportunities.

There is a book in here somewhere, but I do not intend to write one today. In fact, my New Year’s resolution is to write shorter letters in 2015. Over the last decade and a half, the letter has tended to get longer. A little more here, a little more there, and pretty soon it just gets to be a bit too much to read in one sitting. That means I need to either be more concise, break up my topics into two sessions or, if further writing is necessary, post the additional work on the website for those interested.

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So I’m writing today’s letter in that spirit. Each of the major topics we’ll be covering will show up in other letters over the next few months. I would appreciate your feedback and any links to articles and/or data points that you think I should know about regarding these topics.

But first, this is generally the most downloaded letter of the year. I want to invite new readers to become one of my 1 million closest friends by simply entering your email address here. You can follow my work throughout the year, absolutely free (and see how my prognostications are turning out). And if you’re a regular reader, why not send this to a few of your friends and suggest they join you? At the very least, Thoughts from the Frontline should make for some interesting conversations this year. Thanks. Now let’s get on with the forecasting.

Seven Significant Changes for the Next Five Years

Let’s look at what I think are six inexorable trends or waves that will each have a major impact in its own right but that when taken together will amount to a tsunami of change for the global economy.

1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous. The Bank of Japan is effectively exporting the island nation’s deflation to its trade competitors like Germany, China, and South Korea and inviting a currency war that could shake the world. I’ve been saying this for years now, but the story took a nasty turn on Halloween Day, when the Bank of Japan announced it was greatly expanding and changing the mix of its asset purchases. The results have been downright scary, and a major slide in the JPY/USD exchange rate is almost certain over the next five years. I give it a 90% probability. All this while the population of Japan shrinks before our very eyes.

2. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012 – and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries. After all these years of struggle, the structural flaws in the EMU’s design remain; and now major economies like Italy and France are headed for trouble. In the very near future we will finally know the answer to the question, “Is the euro a currency or an experiment?” The changes required to answer that question will be wrenching and horrifically expensive. There are no good answers, only difficult choices about who pays how much and to whom. Again, I see the deepening of the Eurozone crisis as a 90% probability.

3. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society. The world is simply not prepared for China to experience an outright “hard landing” or recession, but I think there is a 70% probability that it will do so within the next five years.

And the probability that China will suffer either a hard landing OR a long period of Japanese style stagnation (in the event that the Chinese government is forced to absorb nonperforming loans to prevent a debt crisis) is over 95%. To be sure, it is still quite possible that the Chinese economy will be significantly larger in 2025 (ten years from now) than it is today, but realizing that potential largely depends on President Xi Jinping’s ability to accomplish an extremely difficult task: deleveraging the debt overhang that threatens the country’s MASSIVE financial system while rebalancing the national economy to a more sustainable growth model (either through either a vast expansion of China’s export market or the rapid development of “new economy” sectors like technology, services, and consumption; or both).

This will not be the end of China, which I’m quite bullish on over the very long term, but such transitions are never easy. Even given this rather stark forecast, it is still likely (in my opinion) that the Chinese economy will be 20 to 25% bigger as 2020 opens than it is today; and every other major economy in the world (including the US) would be thrilled to have such growth. At the very least, though, China’s slowdown and rebalancing is going to put pressure on commodity exporters, which are generally emerging markets plus Australia, Canada, and Norway.

4. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging market countries more difficult to pay back. And given the amount of debt that has been created in the last few years, it is likely that we’ll see a series of crises in emerging-market countries, along with an uncomfortably high level of risk of setting off an LTCM-style global financial shock.

My colleague Worth Wray spoke about this new era of volatile FX flows and growing risk of capital flight from emerging markets at my Strategic Investor Conference last May, and he has continued to remind us of those risks in recent months (“A Scary Story for Emerging Markets” and “Why the World Needs the US Economy to Struggle”).

Now that Russia has tumbled into a full-fledged currency crisis with serious signs of contagion, Worth’s prediction is already playing out, and I would assign an 80 to 90% probability that it will continue to do so, as a function of (1) the rising US dollar and a reversal in cross border capital flows, (2) falling commodity prices, or (3) both. This massive wave is going to create a lot of opportunities for courageous investors who are ready to surf when countries are cheap.

5. I do not believe that the secular bear market in the United States that I began to describe in 1999 has ended. Secular bull markets simply do not begin from valuations like those we have today. Either we began a secular bull market in 2009, or we have one more major correction in front of us.

Obviously, I think it is the latter. It has been some time since I’ve discussed the difference between secular bull and bear markets and cyclical bull and bear markets, and I will briefly touch on the topic today and go into much more detail in later letters. For US focused investors, this is of major importance. The secular bear is not something to be scared of but simply something to be played. It also offers a great deal of opportunity.

If I am right, then the next major leg down will bring on the end of the secular bear and the beginning of a very long term secular bull. We will all get to be geniuses in the 2020s and perhaps even before the last half of this decade runs out. Won’t that be fun? Let’s call the end of the secular bear a 90% probability in five years and move on.

6. Finally, the voters of the United States are going to have to make a decision about the direction they want to take the country. We can either opt for growth, which will mean a new tax and regulatory regime, or we can double down on the current direction and become Europe and Japan. I’ve traveled to both Europe and Japan, and they’re both pleasant enough places to live, but I wouldn’t want to be a citizen of either Japan or the Eurozone for the rest of this decade. (I particularly love Italy, but it is beginning to resemble a basket case, with last year’s optimistic drive for reforms seemingly stalled.)

However, I would rather live and work and invest in a high-growth country, with opportunities all around me, a country where we reduce income inequality by increasing wealth and opportunities at the lower end of the income scale instead of trying to legislate parity by increasing taxes and imposing government mandated wealth redistribution, which slows growth and squelches opportunity for everyone.

A restructuring of the US tax and regulatory regime does not mean a capitulation to the wealthy, big banks, or big business. Properly conceived and constructed, it will allow the renewal of the middle class and result in higher income for all. Sadly, it is not clear to me that either the Republican or Democratic parties are up to the task of making the difficult political decisions necessary. They each have constituencies that tend to opt for the status quo. But I see hope on both sides of the political spectrum that change is possible. The course they set will give us an idea where we will want to focus our portfolios in the decade of the ’20s. It is a 100% probability that we will have to make a decision. It is less than 50% that we will make the right one – or at least the one that I think is the right one.

7.  We have entered the Age of Transformation. We’re going to see the development of new technologies that will simply astound us – from increasingly capable robots and other applications of AI to huge breakthroughs in biotechnology.

The winners are going to be those who identified the truly transformational technologies early on in their development and invested wisely. While riskier (potentially far riskier) than most of your investments should be, a basket of new-technology stocks should be considered for the growth part of your portfolio. I see the Age of Transformation as a 100% probability.

Just for the record, I also see a continuation of the global deflationary environment and a slowing of the velocity of money until we have some type of resolution concerning sovereign debt. Central banks will continue to try to solve the “crises” I mentioned above with monetary policy, but monetary policy will simply not be enough to stem the tide. Central banks can paddle as hard as they like into the waves of change, but they cannot reverse their powerful flow.

Now, let’s look further at each of the waves that are forming into a potential tsunami.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: A Five-Year Global Financial Forecast: Tsunami Warning was originally published at mauldineconomics.com.

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Q3 GDP Jumps 5%; Ha! The Crap Behind the Numbers

By Tony Sagami

I was raised on a farm and I’ve shoveled more than my share of manure. I didn’t like manure back then, and I like the brand of manure that comes out of Washington, DC, and Wall Street even less. A stinky pile of economic manure came out of Washington, DC, last week and instead of the economic nirvana that it was touted to be, it was a smokescreen of half truths and financial prestidigitation.


According to the newest version of the Bureau of Economic Analysis (BEA), the US economy is smoking hot. The BEA reported that GDP grew at an astonishing 5.0% annualized rate in the third quarter.
5% is BIG number.

The New York Times couldn’t gush enough, given a rare chance to give President Obama an economic pat on the back. “The American economy grew last quarter at its fastest rate in over a decade, providing the strongest evidence to date that the recovery is finally gaining sustained power more than five years after it began.”



Moreover, this is the second revision to the third quarter GDP—1.1 percentage points higher than the first revision—and the strongest rate since the third quarter of 2003.



However, that 5% growth rate isn’t as impressive if you peek below the headline number.

Fun with Numbers #1: The biggest improvement was in the Net Exports category, which increased by 112 basis points. How did they manage that?  There was a downturn in Imports.

Fun with Numbers #2: Of the 5% GDP growth, 0.80% was from government spending, most of which was on national defense. I’m a big believer in a strong national defense, but building bombs, tanks, and jet fighters is not as productive to our economy as bridges, roads, and schools.

Fun with Numbers #3: Almost half of the gain came from Personal Consumption Expenditures (PCE) and deserves extra scrutiny. Of that 221 bps of PCE spending:

• Services spending accounts for 115 bps. Of that 115, 15 bps was from nonprofits such as religious groups and charities. The other 100 bps was for household spending on “services.”
   
• Of that 100 bps, the two largest categories were Healthcare spending (52 bps) and Financial Services/Insurance (35 bps).

The end result is that 85% of the contribution to GDP from Household Spending on Services came from healthcare and insurance! In short… those are code words for Obamacare! While the experts on Pennsylvania Avenue and Wall Street were overjoyed, I see just another pile of white collar manure and nothing to shout about.

Fun with Numbers #4: Lastly, the spending on Goods—the backbone of a health, growing economy—declined by 27 bps.

In a related news, the November durable goods report showed a -0.7% drop in spending, quite the opposite of the positive number that Wall Street was expecting.

Of course, Wall Street doesn’t want little things like facts to get in the way of their year-end bonus. As we close out 2014, the stock market marched higher and ignored things like:

• The reaction of the bond market to the 5% number. Bonds should have softened in the face of such strong economic numbers, but the “adults” (the bond traders) on Wall Street saw the same manure that I did.
   
• If the economy was as healthy as the BEA wants us to believe, the “patience” and “considerable time” promise of the FOMC should soon be broken…...right?

I spend most of the year in Asia, including China, and I am seeing the same level of numbers massaging by our government as China’s. In China, the government leaders establish statistical goals and the government bean counters find creative ways to tweak the data to achieve those goals.

Zero interest rates.

24/7 central bank printing.

See no evil analysts.

Financial smoke and mirrors.

That’s the financially dangerous world we live in, and I hope that you have some type of strategy in place to deal with the bursting of what’s becoming a very big, debt-fueled bubble.

Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Q3 GDP Jumps 5%; Ha! The Crap Behind the Numbers was originally published at mauldineconomics.com.

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The Broken State and How to Fix It

By Casey Research

The United States of America is not what it used to be. Unsustainable mountains of debt, continuous meddling by the government and Fed to “stimulate the economy,” and the U.S. dollar’s dwindling status as the world’s reserve currency are very real threats to Americans’ standard of living. Here are some opinions from the recently concluded Casey Research Fall Summit on the state of the state and how to fix it.

Marc Victor, a criminal defense attorney from Arizona and a staunch liberty advocate, says there’s really no such thing as “the state”—“it’s just some people bossing other people around.”

Not everyone wants to fix things, he says; the bosses like the status quo. For example, aside from drug lords, DEA agents are the ones benefiting most from the “War on Drugs.”

Victor believes that democracy and freedom are incompatible, since “democracy is majority rule, and freedom is self-rule.” If you want to bring true freedom to America, he says, winning hearts and minds is the only way to reboot this country and create a free society.

Paul Rosenberg, adventure capitalist, Casey Research contributor, and editor of “A Free Man’s Take,” views America’s future similarly. He thinks the United States is in a state of entropy.

The bad news, says Rosenberg, is that there will be no revolution. The good news is that the peak of citizens’ obedience to the state is behind us, and people are getting fed up with the government’s shenanigans.

Real change is slow, he says, so we must work persistently to create a better world.

Stephen Moore, chief economist at the Heritage Foundation, says the problem is liberal economic policy: Red states in the US, he says, have blown away blue states in job creation since 1990. Texas alone accounts for the entire net growth of the US economy over the past five years.

As another proof point in favor of a free market economy, Moore emphasizes that both Obama and Reagan took office during terrible economic times. While Obama has raised taxes and instituted Obamacare, Reagan cut taxes and regulation. As a result, the Reagan economic recovery was almost twice as robust as the Obama “recovery.”

One of the US’s biggest problems, says Moore, is that companies can’t reinvest profits because dividend, capital gains, and income taxes all have increased under Obama. Corporate taxes in the rest of the world have dramatically declined in the last 25 years, but in the US, they haven’t budged. The average corporate tax rate around the world is 24%—in the US, it’s 38%.

Overall, though, Moore is bullish on the U.S. economy. American companies, he says, are the best run in the world, if only the US government would adopt less economically destructive policies.

Doug Casey, chairman of Casey Research, legendary speculator, and best-selling financial author, isn’t so optimistic. First of all, he says, we’re in the Greater Depression right now, which began in 2008. He fears it’s too late to repair America, but says if anyone would attempt to do so, the following seven step program would help:

• Allow the collapse of “zombie companies” (companies that are only being held up by government handouts and other cash infusions).

• Abolish all regulatory agencies.

• Abolish the Federal Reserve.

• Cut the size of the military by at least 90%.

• Sell all US government assets.

• Eliminate the income tax.

• Default on the national debt.

Of course, says Casey, that’s not going to happen, so individual investors shouldn’t hope for a political solution or waste their time and money trying to stop the inevitable collapse of the U.S. economy. The only way to save yourself and your assets is to internationalize.

He recommends owning significant assets outside your home country: for example, by buying foreign real estate. You should also buy and store gold, “the only financial asset that’s not simultaneously someone else’s liability.”

Casey’s suggestions include going short bubbles that are about to burst (like Japanese bonds denominated in yen), selling expensive assets like collectible cars and expensive real estate in major cities, as well as looking toward places like Africa as contrarian investment opportunities.

Nick Giambruno, senior editor of International Man, agrees that internationalizing your wealth—and yourself—is the most prudent way to go for today’s high net worth investors. It ensures that “no single government can control your destiny,” and that you put your money, business, and yourself where they are treated best.

You should internationalize each of these six aspects of your life, says Giambruno: our assets; your citizenship; your income/business; your legal residency; your lifestyle residency; and your digital presence.
Regarding your assets, you can find better capitalized, more liquid banks abroad, and using international brokerage accounts can provide you access to new investment markets.

To hear all of Nick Giambruno’s detailed tips on how to go global, as well as every single presentation of the Summit, order your 26+-hour Summit Audio Collection now. It’s available in CD and/or MP3 format.

Learn More Here

The article The Broken State and How to Fix It was originally published at Casey Research.

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Hoisington Investment Management: Quarterly Review and Outlook, Second Quarter 2014

By John Mauldin

This week’s Outside the Box is from an old friend to regular readers. It’s time for our Quarterly Review & Outlook from Lacy Hunt of Hoisington Investment Management, who leads off this month with a helpful explanation of the relationship between the U.S. GDP growth rate and 30 year treasury yields. That’s an important relationship, because long term interest rates above nominal GDP growth (as they are now) tend to retard economic activity and vice versa.

The author adds that the average four quarter growth rate of real GDP during the present recovery is 1.8%, well below the 4.2% average in all of the previous post war expansions; and despite six years of federal deficits totaling $6.27 trillion and another $3.63 trillion in quantitative easing by the Fed, the growth rate of the economy continues to erode.

So what gives? We’re simply too indebted, says Lacy; and too much of the debt is nonproductive. (Total U.S. public and private debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.) And as Hyman Minsky and Charles Kindleberger showed us, higher levels of debt slow economic growth when the debt is unbalanced toward the type of borrowing that doesn’t create an income stream sufficient to repay principal and interest.

And it’s not just the US. Lacy notes that the world’s largest economies have a higher total debt to GDP ratio today than at the onset of the Great Recession in 2008, and foreign households are living farther above their means than they were six years ago.

Simply put, the developed (and much of the developing) world is fast approaching the end of a 60-year-long debt supercycle, as I (hope I) conclusively demonstrated in Endgame and reaffirmed in Code Red.
Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub adviser of the Wasatch-Hoisington U.S. Treasury Fund (WHOSX).

Some readers may have noticed that there was no Thoughts from the Frontline in their inboxes this weekend. As has happened only once or twice in the last 14 years, I found myself in an intellectual cul-de-sac, and there was not enough time to back out. Knowing that I was going to be involved in a fascinating conference over the weekend, I had planned to do a rather simple analysis of a new book on how GDP is constructed. But as I got deeper into thinking about the topic and doing more research, I remembered something I read 20 years ago about the misleading nature of GDP, and I realized that a simple analysis just wouldn’t cut it.

Rather than write something that would’ve been inadequate and unsatisfying, I decided to just put it off till next week. Your time and attention are quite valuable, and I try not to waste them. But there will be no excuses this weekend.

The conference I attended was organized by Great Point Partners, a hedge fund and private equity firm focusing on medical and biotechnology. I really had not seen the program until I arrived and did not realize what a powerful lineup of industry leaders would be presenting on some of the latest technologies and research. The opportunity was too good to pass up, as it is so rare that any of us get to sit down with people who are responsible for the science we all read about.

I had breakfast with a small group of 11 readers/investors one morning and learned a lot by asking them what their favorite investing passion was. Although everyone had concerns, they all had areas in which they were quite bullish. I find that everywhere I go. It was interesting, in that they all expected me to be far more negative about things than I am. I guess when you write about macroeconomics as much as I do, and there’s as much wrong with it as there is, you kind of end up being labeled as a Gloomy Gus. I am actually quite optimistic about the long-term future of humanity, but I’ll admit there will be a few bumps along the way. Given how many bumps there have already been, just in my own lifetime, and given that we seem to have gotten through them, I can’t help but be optimistic that we’ll get through the next round.

It was a fascinating weekend, made all the more so by my very gracious hosts, Jeff Jay and David Kroin, Managing Directors of Great Point. They and their staff made sure I could enjoy my time on Nantucket Island. It was my first visit to the area, and I hope it won’t be the last.

Last night I had dinner with Art Cashin, Barry Ritholtz, Jack Rivkin, and Dan Greenhaus. It was a raucous, intellectually enlivening evening, and our conversation ranged from macroeconomics to our favorite new technologies. Jack Rivkin is involved with Idealab, and one of his favorites is that he sees the eventual end of Amazon as 3-D printing becomes more available. Given how Bezos has adapted over the years, I’m not so sure. Jack and Barry will join me in Maine in a few weeks, where we will again join the debate about bull and bear markets.

Now let’s go to Lacy and think about the intersection of velocity and money supply and what it says about future growth potential. I have two full days of meetings with my partners and others here in New York before I return to Dallas, and then I get to stay home for a few weeks. There are lots of new plans in the works. And lots of reading to do between meetings. Have a great week!

Your hoping to be able to stay optimistic analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com

---

Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2014

Treasury Bonds Undervalued

Thirty year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty year treasury bonds, but a business rate of interest such as BAA corporates.



As chart one attests, interest rates below nominal GDP growth helps to accelerate economic activity and vice versa. Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post war expansions.

Fisher's Equation of Exchange

 

Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year over year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.

An Alternative View of Debt

 

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.

Scholarly studies using very sophisticated analytical procedures conducted in the U.S. and abroad document the deleterious effects of high debt ratios. However, the use of a balance sheet measure can be criticized in two ways. First, income plays a secondary role, and second, debt ratios are not an integral part of Keynesian economic theory.

We address these two objections by connecting the personal saving rate (PSR) which is at the core of Keynesian economic analysis, and the private debt to GDP ratio that emerges from non-Keynesian approaches. Our research indicates that both the “Non Keynesian” private debt to GDP ratios, as well as the “Keynesian” PSR, yield equivalent analytical conclusions.

The Personal Saving Rate (PSR) and the Private Debt Linkage

 

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement. When the PSR (income statement measure) rises, savings (balance sheet measure) increases unless debt (also a balance sheet measure) declines, thus the gap between the Keynesian income statement focus and the non-Keynesian debt ratio focus is bridged.



The PSR and private debt to GDP ratio are, indeed, negatively correlated (Chart 2). The correlation should not, however, be perfect since the corporate sector is included in the private debt to GDP ratio while the PSR measures just the household sector. We used the total private sector debt ratio because the household data was not available in the years leading up to the Great Depression.

The most important conceptual point concerning the divergence of these two series relates to the matter of the forgiveness of debt by the financial sector, which will lower the private debt to GDP ratio but will not raise the PSR. The private debt to GDP ratio fell sharply from the end of the recession in mid-2009 until the fourth quarter of 2013, temporarily converging with a decline in the saving rate. As such, much of the perceived improvement in the consumer sector’s financial condition occurred from the efforts of others. The private debt to GDP ratio in the first quarter of 2014 stood at 275.4%, a drop of 52.5 percentage points below the peak during the recession. The PSR in the latest month was only 1.7 percentage points higher than in the worst month of the recession. Importantly, both measures now point in the direction of higher leverage, with the PSR showing a more significant deterioration. From the recession high of 8.1%, the PSR dropped to 4.8% in April 2014.

Historical Record

 

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5% (Chart 3). The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.



In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over saving. What Keynes failed to note was that the under consumption of the 1930s was due to over spending in the second half of the 1920s. In other words, once circumstances have allowed the under saving event to occur, the net result will be a long period of economic under performance.
Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

Implications for 2014-2015

 

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery. [reference: Atif Mian and Amir Sufi,. House of Debt, University of Chicago Press 2014]
Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.

U.S. Yields Versus Global Bond Yields

 

Table one compares ten-year and thirty year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.



With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty year yields in the Japanese and German economies, respectively, currently stand.

Van R. Hoisington
Lacy H. Hunt, Ph.D.
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The article Outside the Box: Hoisington Investment Management: Quarterly Review and Outlook, Second Quarter 2014 was originally published at Mauldin Economics

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Can Central Planners Revive China’s Economic Miracle?

By John Mauldin

For years, when asked whether I thought China would experience a hard landing, I would simply answer, “I don't understand China. Making a prediction would be pretending that I did, so I can’t.” The problem is that today China is the most significant macroeconomic wildcard in the global economy. To understand both the risks and the potentials for the future you have to reach some understanding of what is happening in China today. Last week we started a two part series on what my young associate Worth Wray and I feel is the significant systemic risk that China poses to global growth.

The first thing in my inbox this morning here in Tuscany was a note from a friend about the growing scandal in Quingdao. For a long time many of us have known that there has been “double counting” in the commodities trade sector in China, where local “entrepreneurs” create multiple warehouse receipts on which to borrow money cheaply, and then invest in what are essentially subprime securities that pay higher rates. Everyone “knows” that the government is not going to let anyone lose money on investments, so what could possibly go wrong? It turns out that Chinese warehouse officials are now emigrating in significant numbers to parts unknown around the world, armed with only their passports and whatever money they made through producing such bogus receipts.

My sources suggest that the size of the problem is approaching $1.3 billion (far greater than the number being bandied about in public reports). Since one of the guiding principles operative in any scandal is that there is never just one cockroach, I expect the ultimate losses to be far larger. And it appears that the People’s Bank of China is finally going to let people lose money on these fraudulent schemes. Good for them. But to suggest there is no risk in cleaning up corruption and fraud misses the point of our own subprime crisis. In a world where global economic trade and international banks are so intricately linked, trying to determine the actual risk to the system is difficult. And as I will note in my “final thoughts” section, corruption is a very real issue.

We are going to try gamely to finish with China today, having left at least three or four letters worth of copy on the editing floor. There is just so much information and misinformation to cover. I’m going to turn it over to Worth and then follow up with a few final thoughts of my own. (Please note that this letter will print exceptionally long as there are a number of charts and other graphics.) Now let’s do a deep dive into part two.

Can Central Planners Revive China’s Economic Miracle?

By Worth Wray
In my Thoughts from the Frontline debut this past March (“China’s Minsky Moment?”), I highlighted the massive bubble in Chinese private-sector debt and explored the near-term prospects for either (1) a reform-induced slowdown or (2) a crisis-induced recession. Unfortunately, it was not an easy or straightforward analysis, considering the glaring inconsistencies between “official” state compiled data and more concrete measures of all real economic activity, which is why I suggested that China is simultaneously the most important and most misunderstood economic force in the world today.

With the stakes now higher than ever, I returned to Asia’s “miracle” last week (“Looking at the Middle Kingdom with Fresh Eyes”) and probed deeper into the shadows (including China’s shadow banks) with the help of my new friend Leland Miller and a few illuminating excerpts from his Q1 2014 China Beige Book (the largest and most comprehensive survey series ever conducted on a closed or semi-closed economy).
Pulling back the Bamboo Curtain, Leland’s data revealed aspects of the Chinese economy that John and I could have only guessed at before, giving us a rare opportunity to explore regional contrasts in Chinese economic activity, to survey the modest (but still insufficient) rebalancing among sectors, and to identify a series of pressure points within the credit markets that suggest last summer’s interbank volatility may return in 2014.

Unfortunately, Leland’s key insights confirmed our fears that China’s consumption-repressing, debt-fueled, investment-led growth model is slowing down and starting to sputter… but not collapsing (at least not yet). 

What happens next – with huge implications for global markets – depends largely on the economic wisdom and political resolve of China’s central planners, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while also rebalancing the national economy toward a consumption driven growth model.

Finessing the challenges will require not just one but a series of miracles.

Like Every Other Investment-Driven Growth “Miracle” 

After 34 years of booming economic growth averaging over 9% per year (the longest sustained period of rapid economic growth in human history), China’s credit-fueled, investment-driven growth model is exhausted and increasingly unstable. As you can see in the chart below, the Middle Kingdom’s credit boom is well past the point of diminishing marginal returns; and no one can deny that the misallocation is widespread, with capacity utilization now below 60%. (I should also note that Societe Generale’s Wei Yao has consistently published some of the best research on China in recent quarters; personally, I won’t be surprised to see her vault to rock-star status as the People’s Republic decelerates.)


Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.

Moreover, state perpetuated distortions in the cost and availability of financing are (1) funneling huge amounts of capital toward increasingly unproductive, state directed investments, and (2) pushing household and private business borrowers into the shadows, where the burden of substantially higher interest rates drags on household consumption.


Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.

It doesn’t require much imagination to connect the dots. Structural distortions in Chinese financial markets are a major cause of debt fueled overinvestment; and without sweeping structural reforms (along with a major crackdown on corruption at all levels of government), captive capital will continue to flow toward unproductive investments, capacity utilization will continue to fall, and China’s investment boom will continue its march toward a mega Minsky moment.

This kind of structural distortion is a classic symptom of an overextended investment boom and a warning sign that rebalancing – whether it’s induced by voluntary reforms or an involuntary debt crisis – will not be easy. The critical adjustments – gradual deleveraging and structural rebalancing – will require a greater slowdown in economic growth and a sharper fall in still-bubbly asset prices than China’s policymakers are letting on.

“This is not an easy task,” The Daily Telegraph’s Ambrose Evans Pritchard says, in a truly brilliant article published this week, “not least because land sales and taxes make up 39% of state revenue in China, and the property sector employs 20% of workers one way or another. It is clearly a bubble of epic proportions and already losing air. Mao Daqing from Vanke – China’s top developer – says total land value in Beijing has been bid up to such extremes that is on paper worth 61.6pc of America’s GDP. The figure was 63.3pc for Tokyo at the peak of the bubble in 1990.” Yikes.

As Peking University professor Michael Pettis explains in his 2013 book, Avoiding the Fall: China’s Economic Restructuring, “Every country that has followed a consumption-repressing, investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led to either a debt crisis or a lost decade of very low growth.”
China’s “miracle” is no different from any other investment-driven growth binge where high levels of leverage (directly or indirectly paid for by the household sector), combined with high levels of fixed investment, eventually result in excessive and unsustainable debt loads. Pettis elaborates:

While these policies can generate tremendous growth early on, they also lead inexorably to deep imbalances. As demonstrated by the history of every investment-driven growth miracle, including that of Brazil, high levels of state-directed subsidized investment run an increasing risk of being misallocated, and the longer this goes on the more wealth is likely to be destroyed even as the economy posts high GDP growth rates. Eventually the imbalances this misallocation created have to be resolved and the wealth destruction has to be recognized. What’s more, with such heavy distortions imposed and maintained by the central government, there is no easy way for the economy to adjust on its own…. [Furthermore], Beijing [will] not be able to raise the consumption share of GDP without abandoning the investment-driven growth model altogether.

In other words, the world’s second largest economy is approaching its debt limit and the end of the line for investment led growth… but China’s financial system is structurally designed to prevent capital from flowing freely toward more productive uses. One way or another, the world’s largest contributor to global economic growth must slow down – either because Beijing has the foresight, resolve, and political capital to pursue aggressive economic and financial market reforms or because party elites fail to address the country’s structural imbalances and policy-induced distortions before the credit bubble pops. “Debt,” Pettis explains, “as we will learn over the next few years in China, has always been the Achilles’ heel of the investment-driven growth model…”

Which Way to Sustainable Growth?

Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national economy toward a more sustainable, consumption-driven growth model.

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The article Thoughts from the Frontline: Can Central Planners Revive China’s Economic Miracle? was originally published at Mauldin Economics

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Mining and the Environment — Facts vs. Fear

By Laurynas Vegys, Research Analyst

“I would NEVER invest in a mining company—they destroy land, pollute our water and air, and wreck the habitat of plants and animals.”


These were the points made to me by a woman at a social gathering after I told her what I do for living. She prided herself on her moral high ground and looked upon me with obvious disdain. It was clear that as a mining researcher, I was partly responsible for destroying the environment.

I knew a reasonable discussion with her wouldn’t be possible, so I opted out of trying. (As Winston Churchill said, “A fanatic is one who can’t change his mind and won’t change the subject.”) She left the party convinced her position was indisputably correct. But was she?

Not at all.

In fact, with few exceptions, today’s mining operations are designed, developed, operated, and ultimately closed in an environmentally sound manner. On top of that, considerable effort goes into the continued improvement of environmental standards.

My environmentalist acquaintance, of course, would loudly disagree with those statements. Many people may feel uncomfortable investing in an industry that’s so closely scrutinized and vehemently criticized by the public and mainstream media—whether there’s good reason for that criticism or not. This actually is to the benefit of those who dare to think for themselves.

So let’s examine what mining REALLY does to the environment. As Doug Casey always says, we should start by defining our terms…

How Do You Define “Environment”?

In modern mining, the term “environment” is broader than just air, water, land, and plant and animal life. It also encompasses the social, economic, and cultural environment and, ultimately, the health and safety conditions of anyone involved with or affected by a given mining activity.

Armed with this more comprehensive view of the industry’s impact on the environment, we can evaluate the effects of mining and its benefits in a more holistic fashion.

Impact on the Economy

According to a study commissioned by the World Gold Council, to take an example from mining of our favorite metal, the gold mines in the world’s top 15 producing countries generated about US$78.4 billion of direct Gross Value Added (GVA) in 2012. (GVA measures the contribution to the economy of each individual producer, industry, or sector in a country.) That sum is roughly the annual GDP of Ecuador or Azerbaijan, or 30% of the estimated GDP of Shanghai, China. Here’s a look at the GVA for each of these countries.

Keep in mind that this doesn’t include the indirect effects of gold mining that come from spending in the supply chain and by employees on goods and services. If this impact were reflected in the numbers, the overall economic contribution of gold mining would be significantly larger. Also, it’s evident that gold mining’s imprint on national economies varies considerably. For countries like Papua New Guinea, Ghana, Tanzania, and Uzbekistan, gold mining is one of the principal sources of prosperity.

Another measure of economic contribution is the jobs created and supported by businesses. The chart below shows the share of jobs created of each major gold-producing country.

The four countries with the highest numbers of gold mining employees are South Africa (145,000), Russia (138,000), China (98,200), and Australia (32,300). The industry also employs 18,600 in Indonesia, 17,100 in Tanzania, and 16,100 in Papua New Guinea. (As an aside, it’s quite telling that South Africa employs more gold miners than China, but China produces more gold than South Africa.)

Note that these employment figures don’t include jobs in the artisanal and small-scale production mining fields, or any type of indirect employment attributable to gold mining—so they understate the actual figures
For many countries, gold mining accounts for a significant share of exports. As an example, gold merchandise comprised 36% of Tanzanian and 26% of Ghana’s and Papua New Guinea’s exports in 2012.

Below, you see a more comprehensive picture of gold exports by 15 major gold-producing countries.

Other, often overlooked ways in which the mining industry supports the economy include:

• Foreign Direct Investment (FDI). The three mining giants—Canada, the United States, and Australia—have been dominating this category for a number of years, both as the primary destinations for investment and as the main investor countries.

• Government revenue. All mining businesses, regardless of jurisdiction, have to pay certain levies on their revenue and earnings, including license fees, resource rents, withholding and sales taxes, export duties, corporate income taxes, and various royalties. Taken all together, these payments make up a large portion of overall mining costs. For example, estimates suggest that the total of mining royalty payments in 2012 across the top gold-producing countries worked out to the tune of US$4.1 billion. This, of course, doesn’t account for other types of tax normally applied to the mining industry.

• Gold products. Gold as a symbol of prosperity and the ultimate “wealth insurance” is very important to many nations around the globe—especially in Asia and Africa. Gold jewelry is given as a dowry to brides and as gifts at major holidays. In India, the government’s ban on gold purchases by the public led to so much smuggling that the incoming prime minister is considering removing it. Chinese, Vietnamese, and peoples of India and Africa may all be divided across linguistic lines, but they all share the view of gold being a symbol of prosperity and ultimate insurance against life’s uncertainties.

It’s also important to note that jobs with modern mining companies are usually the most desirable options for poverty stricken people in the remote areas where many mines are built. These jobs not only pay more than anything else in such regions, they provide training and health benefits simply not available anywhere else.
Mining provides work with dignity and a chance at a better future for hundreds of thousands of struggling families all around the world.

Let’s now have a look at the most debated and contentious side to mining.

Impact on the (Physical) Environment

In previous millennia, humans labored with little concern for the environment. Resources seemed infinite, and the land vast and adaptable to our needs. An older acquaintance of ours who grew up in 1930s Pittsburgh remembers the constant coal soot hanging in the air: “Every day, it got dark around noon time.” Victorian London was famous for its noxious, smoky, sulfurous fog, year round.

Initially, the mining industry followed the same trend. Early mine operations had little, if any, regard for the environment, and were usually abandoned with no thought given to cleaning up the mess once an ore body was depleted.

In the second half of the 20^th century, however, the situation turned around, as the mining industry realized the need to better understand and mitigate its impact on the environment.

The force of law, it must be admitted, had a lot to do with this change, but today, what is sometimes called “social permitting” frequently has an even more powerful regulatory effect than government mandates. Today’s executives understand that good environmental stewardship is good business—and many have strong personal environmental ethics.

That said, mining is an extractive industry, and it’s always going to have an impact. Here’s a quick look at some of the biggest environmental scares associated with gold mining and how they are confronted today.

Mercury

Symbol: Hg

Occurrence in the earth’s crust: Rare

Toxicity: High

Mercury, also known as quicksilver, has been used to process gold and silver since the Roman era. Mercury doesn’t break down in the environment and is highly toxic for both humans and animals. Today, the use of mercury is largely limited to artisanal and illegal mining. Industrial mining companies have switched to more efficient and less environmentally damaging techniques (e.g., cyanide leaching).

Developing countries with a heavy illegal mining presence, on the other hand, have seen mercury pollution increase. The United Nations Industrial Development Organization (UNIDO) estimates that 1,000 tons of mercury are annually released into the air, soil, and water as a result of illegal mining activity.

To help combat the problem, the mining industry, through the members of the International Council on Mining & Metals (ICMM), has partnered with governments of those nations to transfer low- or no-mercury processing technologies to the artisanal mining sector.

Sodium Cyanide

Mining compound employed: NaCN

Occurrence in nature: Common

Toxicity: High

This is one of the widely used chemicals in the industry that can make people’s emotions run high. Historically considered a deadly poison, cyanide has been implicated in events such as the Holocaust, Middle Eastern wars, and the Jonestown suicides. Given such associations, it’s no wonder that the public perceives it with alarm, without even adding mining to the equation.

It is important, however, to understand that cyanide:

• is a naturally occurring chemical;
• is not toxic in all forms or all concentrations;
• has a wide range of industrial uses and is safely manufactured, stored, and transported every day;
• is biodegradable and doesn’t build up in fish populations;
• is not cumulative in humans and is metabolized at low exposure levels;
• should not be confused with Acid Rock Drainage (ARD; see below); and
• is not a heavy metal.

Cyanide is one of only a few chemical reagents that dissolves gold in water and has been used to leach gold from various ores for over a hundred years. This technique—known as cyanidation—is considered a much safer alternative to extraction with liquid mercury, which was previously the main method used. Cyanidation has been the dominant gold extraction technology since the 1970s; in Canada, more than 90% of gold mined is processed with cyanide.

Despite its many advantages for industrial uses, cyanide remains acutely toxic to humans and obviously is a concern on the environmental front. There are two primary environmental risks from gold cyanidation:

• Cyanide might leach into the soil and ground water at toxic concentrations.
• A catastrophic spill could contaminate the ecosystem with toxic levels of cyanide.

In response to these concerns, gold mining companies around the world have developed precautionary systems to prevent the escape of cyanide into the environment—for example, special leach pads lined with a plastic membrane to prevent the cyanide from invading the soil. The cyanide is subsequently captured and recycled.

Further, to minimize the environmental impact of any cyanide that is not recycled, mine facilities treat cyanide waste through several processes that allow it to degrade naturally through sunlight, hydrolysis, and oxidation.

Acid Rock Drainage (ARD)

Target chemical: Sulfuric acid

ARD occurrence in nature: Common

Toxicity: Varies

Contrary to popular belief, ARD is the natural oxidation of sulfide minerals such as pyrite when these are exposed to air and water. The result of this oxidation is an increase in the acidity of the water, sometimes to dangerous levels. The problem intensifies when the acid comes into contact with high levels of metals and thereby dissolves them, which adds to the water contamination.

Once again, ARD is a natural process that can happen whenever such rocks are exposed on the surface of the earth, even when no mining was involved at all. Possible sources of ARD at a mine site can include waste-rock piles, tailings storage facilities, and mine openings. However, since many mineral deposits contain little or no pyrite, ARD is a potential issue only at mines with specific rock types.

Part of a mining company’s environmental assessment is to conduct technical studies to evaluate the ARD potential of the rocks that may be disturbed. Once ARD has developed, the company may employ measures to prevent its spread or reduce the migration of ARD waters and perhaps even treat the water to reduce acidity and remove dissolved metals.

In some places where exposed sulfide minerals are already causing ARD, a clean, modern mine that treats all outflowing water can actually improve water quality.

Arsenic

Symbol: As

Occurrence in the earth’s crust: Moderate

Toxicity: High

Similar to mercury, arsenic is a naturally occurring element that is commonly found as an impurity in metal ores. In fact, arsenic is the 33rd most abundant element in the earth’s crust and is present in rocks and soil, in natural waters, and in small amounts in all living things. For comparison, silver (Ag) is 47th and gold (Au) 79th (see the periodic table of elements). Arsenic is toxic in large doses.

The largest contribution of arsenic from the mining industry comes from atmospheric emissions from copper smelting. It can also, however, leach out of some metal ores through ARD and, when present, needs to be removed as an impurity to produce a saleable product.

Several pollution-control technologies have been successful at capturing and removing arsenic from smelting stacks and mine tailings. As a result, between 1993 and 2009, the release of arsenic from mining activities in Canada fell by 79%. Similar figures have been reported in other countries.

Mythbusters

Now, here’s our quick stab at dispelling the three most widespread myths environmentalists commonly bring up in their rants against the mining industry.

Myth 1: Mining Uses Excessive Amounts of Land

Reality: Less than 1% of the total land area in any given jurisdiction is allotted for mining operations (normally far less than that). Even a modest forestry project affects far more trees than the largest open-pit mine. Mining activities must also meet stringent environmental standards before a company can even get a permit to operate.

The assessment process applied to mining operations is very detailed and based on a long string of policies and regulations (e.g., the National Environmental Policy Act in the US). Environmentalists may claim that the mining industry is rife with greedy land barons, but there’s more than enough evidence to the contrary.

Myth 2: Mining Is Always Detrimental to the Water Supply

Reality: Quite the opposite, actually. Before mine operations start, a mining company must submit a project proposal that includes detailed water utility studies (which are then evaluated by scientists and government agencies). Many companies even install water supply systems in local communities that lack easy access to this basic resource. It’s also common for the rocks to be mined to be naturally acid-generating—a problem the mine cleans up, by its very nature.

Some die hard zealots blame the mining industry for consuming huge amounts of water, but in fact it normally only uses +1% of the total water supplied to a given community, and 80% of that water is recycled continuously.

Myth 3: Mining Is Invasive to the Natural Environment

Reality: Yes, mining activity in certain countries has led to negative outcomes for certain plants and animals—not to mention the rocks themselves, which are blasted and hauled away. However, the industry has progressed a long way in the last few decades and, apart from rare accidents, the worst is behind us now.

The key determinant here is compliance. All mining activity must comply with strict environmental guidelines, leading up to and during operations and also following mine closure. After mining activity ends, the company is required to rehabilitate the land. In some cases, the land is remediated into forests, parks, or farmland—and left in better condition than before.

It’s worth reiterating that in some cases—where there’s naturally occurring ARD or where hundreds of years of irresponsible mining have led to environmental disasters—a modern mine is a solution to the problem that pays for itself.

Can You Be Pro-Mining and an Environmentalist? Absolutely.

Gold mining (and mining in general) is extractive and will always leave some mark on our planet. Over time, however, the risks have been mitigated by modern mining technologies. This is an ongoing process; even mining asteroids instead of planet Earth is now the subject of serious consideration among today’s most visionary entrepreneurs.

Meanwhile, the (vastly diminished) risks associated with mining are far outweighed by the economic contribution and positive effects on local communities and the greater society. This net positive contribution is here to stay—unless our civilization opts for collective suicide by sending us all back to the Stone Age.

Right now, gold and gold stocks are so undervalued that you can build a sizable portfolio at a fraction of what you would have had to spend just a few years ago. To discover the best ways to invest in gold, read Casey Research’s 2014 Gold Investor’s Guide—Get it for Free Here.

The article Mining & Environment—Facts vs. Fear was originally published at Casey Research

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