Get ready for another major worldwide credit crunch. Today, the entire global financial system resembles a colossal spiral of debt. Just about all economic activity involves the flow of credit in some way, and so the only way to have "economic growth" is to introduce even more debt into the system just a few days ago the IMF warned regulators to prepare for a global "liquidity shock". And on Friday, Chinese authorities announced a ban on certain types of financing for margin trades on over-the-counter stocks, and we learned that preparations are being made behind the scenes in Europe for a Greek debt default and a Greek exit from the eurozone. On top of everything else, we just witnessed the biggest spike in credit application rejections ever recorded in the United States. All of these are signs that credit conditions are tightening, and once a "liquidity squeeze" begins, it can create a lot of fear.
The bottom line is that we are starting to see the early phases of a liquidity squeeze.
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The flow of credit is going to begin to get tighter, and that means that global economic activity is going to slow down.
This happened during the last financial crisis, and during this next financial crisis the credit crunch is going to be even worse.
If a liquidity shock is coming, the stockmarket doesn't see it. Prices are still near all-time highs. Why?
High profits, you say? Yes, but where do the profits come from? Households have less money to spend than they did 15 years ago. And corporations cannot make money just by selling things to each other.
The only explanation is that customers including the US government continue to borrow money and spend it. Corporations borrow money to buy their own shares. Consumers borrow to buy products. Either way, the money comes out of nowhere' and falls on balance sheets like manna from heaven.
Today's question: where is nowhere?
US households appeared to reach 'peak debt' in 2007. Now, the corporate and government sectors not to mention students and car-buyers are pulling up to their maximum debt loads too.
"Everybody including every corporation and government has a capacity limit for debt," says owner and president of Zulauf Asset Management Felix Zulauf. Once they reach capacity, they stop buying. Then, the additional sales turn to additional inventories, employees turn to jobless statistics, and profits turn into losses.
Maybe the cycle will reverse soon. Maybe it won't. But profits already at record highs are unlikely to go much higher. And without the hope of higher profits in the future, why pay so much for a dollar's worth of today's earnings?
You might also explain high stock prices as a feature of low interest rates. What's an investor to do but reach for dividends and capital gains; otherwise he'll get nothing. But here again, stocks are supposed to look ahead.
You don't buy a stock in anticipation of getting back the same thing you paid. You buy hoping to get more. And if prices have gone up because interest rates have gone down, what will they do now that interest rates are already down near all-time lows? How much lower can they go?
We'll leave that question for tomorrow. I think you'll be surprised.
In the meantime, let's keep our eye on the stockmarket. Why are stocks and assets, generally so high?
Nowhere' has provided a lot of money. No one earned it. No one saved it. But here's our prediction: someone will miss it when it is gone!
If the money supply were a deck of cards, the US has been slipping in extra aces for the last 44 years. Between 1980 and 2008 these showed themselves in the form of current account deficits. We bought more from overseas than we sold, and financed the difference on credit.
The money went to overseas suppliers. Their central banks took the cash and sent much of it back to the US, where it was used to buy stocks and bonds. The amount averaged about $400bn per year, from about 1990 to 2008. This money, according to economist Richard Duncan, was the source of the Nasdaq bubble and then the housing/finance bubble.
When those bubbles popped, the feds came up with another source of liquidity: quantitative easing (QE).
Take the current account, add QE, subtract government borrowing (which drains off liquidity) and you have Duncan's 'Liquidity Gauge'. Follow the liquidity gauge, he says, and you will know how loaded this deck really is.
In 2013, for example, the combination of low government borrowing and high QE meant near record levels of liquidity. The S&P showed this liquidity with a 30% gain.
And for 2015? It doesn't look good. In the first place, US federal government deficits are supposed to stay over $500bn per year until 2020. This will absorb liquidity, using it to pay zombies. Also, the US has backed off from QE. If the Fed sticks to its position, there will be some liquidity seeping in from European and Japanese QE, but it will be fairly modest.
The only major source of liquidity will come from the aforementioned current account surpluses. But world trade has slowed, greatly reducing the trade deficits and the US financial surpluses (the dollars coming back into the US) that add to liquidity. The IMF shows rising flows into the US. Duncan believes they will be flat. Either way, the net result will be negative net liquidity for the next five years.
The bad news begins in the third quarter, he says. The second quarter always brings in tax revenue to the US government, reducing its need to borrow and leaving liquidity available to the stock and bond markets. Then, in the third quarter, net liquidity should turn negative and the stockmarket should correct.
What then?
Most likely, the Fed will panic and announce QE IV and other measures.
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