The Financial Monster that Ate Everything

Posted On Dec 29, 2015 By Dave Gonigam

  • The trouble with “financialization”
  • From Rickards’ lips to the Financial Times’ ears — nearly a year later
  • Is a $14 trillion debt tsunami really $20 trillion?
  • Friends in high places: The epic gas leak you haven’t heard about
  • Uber-style snow removal… why making money from Russian stocks is harder than it sounds… a reader’s cutting criticism (gasp!)… and more!

“The Wall Street Fandango,” Bill Bonner and Addison Wiggin called it in Empire of Debt — one of the foundational books that inform everything we do at Agora Financial.

“The root of the problem,” they explained, “is the nature of investing itself — at least, the public form of it as practiced by most investors and as tempted by Wall Street. The idea of it is that a man can get rich without actually working or coming up with an insight or an invention by careful study or dumb luck. All he has to do is put his money ‘in the market’ by handing it over to Wall Street, and poof! — by some magic never fully described it comes back to him 10-fold.”

In the decade since the book was first published, a word has entered widespread usage to describe this phenomenon — “financialization.” Here’s how the phenomenon manifests itself…

  • In the late 1960s, the finance sector accounted for around 20% of corporate profits. Just before the onset of the financial crisis, it was 40%. Today, it’s still more than 30%
  • Financial stocks made up 13% of the S&P 500’s market cap in 1999. Just before the onset of the financial crisis, it was 22%. Today, it’s still around 17%.

And because finance’s tentacles reach into nearly every human endeavor, the effect is to disfigure those endeavors — a “great deformation,” as David Stockman titled his book in 2013.

All of which is context for the following headline in today’s Financial Times

“Financialization Compounds Commodity Rout: Companies Struggle to Meet Debt Payments as Dollar Income Shrinks.”

Below the headline was a commentary by author and former banker Satyajit Das — who anticipated both the Panic of 2008 and the eurozone crisis of 2010-11.

He acknowledges commodities always have their ups and downs, booms and busts. But this time is different: “The downturn is exacerbated by increased financialization, which converted commodities into tradeable equivalents.

“Cash flows from future sales were monetized to raise large amounts of debt to finance expansion. The collateral value of commodities secured expansion in borrowing and trading. Derivatives allowed new participants, other than consumers and producers, to invest in and trade commodity price expectations.”

And so at year’s end, we come full circle to one of our biggest forecasts at the start of 2015 — stresses in the junk bond market that will, in later years, set off the next financial collapse.

On Jan. 14 of this year, Jim Rickards described “a $14 trillion pile of corporate debt that cannot possibly be repaid or rolled over under current economic conditions.”

That’s $9 trillion of dollar-denominated debt in emerging markets — debt issued on the assumption the global economy would stay strong and the dollar would stay weak.

Add to that $5 trillion in debt issued by energy companies — debt issued on the assumption oil would trade in a range of $80-110 forever.

None of those assumptions is working out as 2015 stumbles to a close. Global GDP growth is as weak as it’s been any time since the Panic of 2008. The dollar, relative to other currencies, is as strong as it’s been since 2003. And crude trades this morning at $37.61.

“If default rates are only 10% — a conservative assumption — this corporate debt fiasco will be six times larger than the subprime losses in 2007,” Jim ventured to say in January.

The amount of debt at risk might be even bigger than Jim said, perhaps topping $20 trillion.

Back to Satyajit Das in the Financial Times: “Global lending to the energy sector alone totals around $2.5 trillion. Between 2004 and 2014, emerging-market corporate debt increased from $4 trillion to $18 trillion, much of the increase taking place since 2008.

“A significant portion of this debt — especially in China, Russia, Brazil, Mexico and Chile — is related to commodities. Resource companies now face a testing combination of lower revenues, a shortage of U.S. dollar income to meet debt payments and currency losses on dollar borrowings.”

Well, you heard it here first.

The mainstream is still pooh-poohing this $14 trillion — or $20 trillion — debt tsunami.

Let’s revisit the chart we shared at the top of yesterday’s episode…

inner and Losers 2015

We removed some of the annotations Deutsche Bank included in its original version of this chart. One of them pointed to the 4.2% loss in U.S. junk bonds. “The turbulence in high yield was really not a big deal when compared with the performance of other risky assets, including equities,” said the commentary accompanying the chart.

Well, no. Not yet. But way back in January, Jim Rickards said he wasn’t making a near-term forecast. These things don’t take place overnight.

The global financial crisis hit full bore in September 2008… but the first really obvious hints came more than a year earlier when a European bank froze three investment funds exposed to U.S. subprime mortgage debt. (That’s when Jim Cramer was melting down on CNBC, screaming for the Federal Reserve to “open the discount window!”)

Ditto for the “quiet” crisis of September 1998, when the Russian government defaulted on its debt — taking down the hedge fund Long Term Capital Management and nearly taking down the global financial system with it. Then, too, early signs emerged more than a year earlier when Thailand ran into trouble.

“This new junk debt fiasco,” Jim said in January, “started in the summer of 2014 but will not reach its peak until 2016 or later.

“Even companies and countries with dim prospects often have enough cash on hand to make payments for a while before they actually default.”

The guidance now is the same as it was then — make sure you don’t have junk bonds in your portfolio — including, or especially, the ones hidden in any bond funds you own. If you’re in the red, well, nothing like a little tax loss selling at year-end.

If you feel adventurous, you can take a small chunk of the proceeds and put them into the recommendations of Rickards’ Intelligence Triggers — where Jim’s junk bond analysis originally appeared. His one-of-a-kind indicator takes the guesswork out of trading — showing you precise buy and sell signals.

Click here for a comprehensive trading tutorial from Jim

The holiday-duty Wall Street interns who pulled the major U.S. stock indexes down yesterday are pushing them up today. At last check, the S&P 500 is up nearly 1%, at 2,075.

At the moment, it will be down to the wire whether the S&P ends the year slightly in the green or slightly in the red. We’re not exactly holding our breath here.

Gold is steady at $1,069. Bonds are selling off, the 10-year Treasury yield at 2.27%.

Crony capitalist outrage of the day — a geyser of methane gas spewing from a natural gas storage cavern south of Los Angeles.

It’s been going on for two months, but only this week are the media outside Southern California catching onto the story — a gas leak releasing 110,000 pounds of methane every hour. More than 2,000 families have had to flee their homes.

And if it’s climate change you’re worried about, methane is 25 times more potent than carbon dioxide; the amount of gas released so far equals the amount produced by all of California’s oil refineries in a year.

Plugging the leak will take SoCal Gas at least three more months, in part because the base of the well sits 8,000 feet underground.

Aerial view from an infrared camera

[screengrab from an Environmental Defense Fund video]

“It’s not the world’s ‘biggest’ gas blowout,” says our energy maven Byron King. “We’ve had bigger and better in the Middle East and North Africa over the years. But still, it’s bad, and the story is getting traction.”

Byron points out SoCal Gas’ parent company is Sempra Energy — whose board includes one Kathleen Brown. She’s an attorney, was California state Treasurer in the ’90s, is ex-Goldman Sachs… and is the sister of Gov. Jerry Brown.

Presumably, her connections — er, excuse us, experience — will prove invaluable as the company contends with the many lawsuits filed by the storage cavern’s neighbors.

We’d say “score one for American ingenuity,” but in this case, it’s Canadian.

A fellow named Sean Griffith is launching what you might call the Uber of snow removal. He plans to make it available to at least six cities in the Atlantic provinces.

“Last year, people in this region got to the point where we just couldn’t shovel anymore,” Griffith tells The Canadian Press. “After moving into our first house, we realized that we get a lot of snow and shoveling it ourselves really isn’t working. But we still weren’t ready to commit to a yearly contract and we tried to find somebody who could do it on a one-off basis, but didn’t have much luck.”

Enter Griffith’s new business, called Plow Me Out. You sign up via website or app, answer a few questions about your driveway and you get a quote. Once you ask to be plowed out, a notification is sent to several contractors in your area.

Heh… Griffith has a good story about the genesis of his business. But we suspect part of the inspiration goes back to pre-Internet days. 1992, to be precise…

Memorable jingle: “Call Mr. Plow, that’s my name. That name again is Mr. Plow.”

Anyway, we wish Mr. Griffith all the best. But at the risk of sounding cynical, we wonder if the snowplow biz in Canada includes any entrenched players who might give Plow Me Out the same sort of trouble Uber gets from taxi operators.

“I was ‘invested in Russian stocks,’ but it wasn’t a good year for me,” writes a reader after we shared a chart of the best- and worst-performing asset classes yesterday. (We re-ran it today; just scroll up if you missed it.)

“This year, I owned some shares of the IShares ETF ERUS. It closed on Dec. 31, 2014, at $11.47 and closed on Dec. 24, 2015, at $11.42.

“Even after dividends, that’s a far cry from the 23.4% gain you report for ‘Russian stocks.’ Obviously, there are ‘Russian stocks’ and then there are ‘Russian stocks,’ so ‘owning ‘Russian stocks’ didn’t necessarily mean one had a good year.

“I am curious how someone in the U.S. could have owned the ‘Russian stocks’ that earned the reported 23.4%. I did a quick check on a few other Russia-focused ETFs, and they also missed the ‘Russian stock’ boat on a YTD basis.”

“How did I do well if I — as an American — invested in Russian stocks in 2015?” inquires another.

“Recall that the ruble traded at 57.8 per dollar on Jan. 1 of this year. It’s at 72.2 as I write this… or down roughly 25% against the dollar. So it looks like I’m flat to down for the year in Russian stocks — same as if I’d stuck with American equities. Am I missing something?”

The 5: Not at all. We should have been more specific — Russian stocks measured in the home currency. (Ditto for all the other asset classes in the chart.) Russia’s main stock index, the MICEX, started the year a touch below 1,400. As we check our screens this morning, it’s at 1,750.

In theory, it would be possible to capture those gains with one of those currency-hedged ETFs. In practice, though, there’s no such product for Russia that we’re aware of.

“Perhaps for Christmas, Santa will bring you some new ideas,” reads an email that filtered in just before the holidays.

“I know you think you are all pretty smart, but simply being critical and reading the paper to us is not insightful. Peek behind the curtain and tell us something we don’t know.”

The 5: Ouch. That stings, since one of our missions around here is to tell, as our fearless leader Addison Wiggin says, “the story no one else is telling.”

Then again, you might have unusually high standards, since your feedback came atop this exploration of Jim Rickards’ “Impossible Trinity” last week. You won’t find that in the paper!

Best regards,

Dave Gonigam
The 5 Min. Forecast

P.S. Can’t say we didn’t warn you: Standard & Poor’s said this month that fully half of energy junk bonds are at risk of default. By S&P’s calculations, that’s $180 billion in “distressed” debt.

Jim Rickards has told us all year the dangers were building. Earlier this month, a junk bond fund collapsed — the biggest mutual fund failure since 2008.

How did Jim see the trouble coming? And how can you profit from insights like these, months before they become headline news? Answers here.


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