Here comes Mr Hyde

Dow down a bit yesterday. Gold up a bit. No clear trend. Or, we should say, the upward trend of stock and gold prices has not yet been broken.

Looking broadly at major trends of the last 50 years, debt was the name of the game from 1980 to 2007. Is it still the most important thing?

From about 160% of GDP in 1980, total debt rose to about 360%. That was a big deal. Not the least because it meant that US businesses got trillions in income with no offsetting labour charge. Stocks, earnings, GDP, employment – with all this free money coming in, the whole shebang looked good.

As we’ve been saying, debt may be the kindly Dr Jekyll when it is expanding. But it becomes maniacal when it contracts.

Mr Hyde showed up in 2008 and the party was over. We went into a debt contraction. We’ve been living with it ever since. Until the last quarter of last year, the private sector paid down or defaulted on its debt.

But since 2008, we’ve lived with ambiguity, split personalities, and confusion. While households and businesses tried to de-leverage, the public sector leveraged up. The US government added nearly $7trn in new debt since ’07. Overall, debt to GDP shrank, but not much, from 360% of GDP down to 345%.

Deleveraging was the market’s natural reaction to excess debt. QE (quantitative easing) was the unnatural and monstrous response of the Fed. Three trillion was added to the Fed’s holdings of debt, as the bankers tried desperately to keep the debt expansion going.

From a Bank of America Merrill Lynch research report: “The US Fed’s modus operandi worked through asset prices, and animal spirits. This involved getting stock prices up, getting corporate animal spirits up by issuing cheap debt, buying back stock with cash or cheap debt to raise EPS [earnings per share], lowering government borrowing and mortgage costs, and raising consumer net worth/income ratios. Also, asset bubbles were generated in emerging markets, raising their growth, labor costs and currencies.”

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Sharp operators followed the Fed like vultures trailing a sick cow. They borrowed at the Fed’s low rates and bought stocks, real estate, contemporary art and emerging market debt. Anything that promised a higher yield.

In markets, QE was the name of the game, 2008-2014. But QE helped Wall Street, not Main Street. Just look at charts of shipping indexes, real wages, and the velocity of money. You see lines that head down in 2008 and don’t come back up.

In the last few reports, we’ve focused on the things that weigh heavily on the economy – debt and demography. We took note of a prediction, made by our secret-weapon analyst, that these things will drive US stocks down about 10% per year for the next ten years.

But we also noticed a possible spoiler – no prediction based on history has ever included the effects of QE or Janet Yellen! Eventually, we caution, everything ‘normalises’. And eventually, our analyst will almost certainly be right about stock-market performance. But eventually can still be a long way into the future.

Which brings us to our updated, revised, and improved outlook. Remember our prediction six years ago? Tokyo, then Buenos Aires, we said. The idea was that the US economy would stay in de-leveraging mode for “seven to ten years”, and then, it would be off to the races.

We suspected that the feds would get tired of Tokyo. We figured they’d be ready for some Latin-style action, a little central bank salsa, a bit of monetary mambo. We predicted that QE wouldn’t work, and that the Fed would want to be more activist – probably by giving up on QE and directly intervening in the money supply.

So, what have we learned in the last six years? How has our view changed?

The answer to both questions is “not much”. As we guessed, an ageing, deeply indebted, zombie-ridden economy will not improve by adding more debt. Instead, it is doomed to follow Japan down that long, lonesome road of low consumer prices, low growth, and high debt. This road leads to eventual destruction. But when? How?

In America as in Japan, QE does not help stimulate a real recovery. But it does help simulate a real recovery. House prices are up. The middle class has more ‘wealth’, possibly to borrow against. The rich are feeling fat and sassy. The Fed can continue modest tapering. This will produce a sell-off in the stock market.

Then, the Fed will stop tapering. But it will be too late to reverse the damage to equities. They will go down for many years, bringing us even closer to the Japanese model.

Our guess now is that this situation will persist for a few years. As long as the pain is tolerable, the Fed will not be so bold as to abandon QE or take up more daring measures.

Tokyo today. Tokyo tomorrow. After tomorrow, we’ll see.

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