Financial Gravity

InvestMy Comments: It’s easy to get upset by what is happening to the stock market, the bond market, and trying to make sense of it all. You either quit thinking about it or try to get your brain around it so that it fades into the background. Or not.

Most think the crash of 2008-09 was caused by too many sub-prime home mortgage loans. We’re now looking at a glut of sub-prime auto loans and there’s likely to be a similar outcome.

My expectation is the Federal Reserve will finally start to raise interest rates. That’s going to be painful, but it has to happen, and the sooner the better. The following words come from a Porter Stansberry whose digest can be subscribed to. I find it far more helpful than a subscription to the Wall Street Journal.

“I believe that some combination of rising interest rates, rising defaults in the corporate bond market, and global currency/trade wars will likely cause the U.S. stock market to decline substantially. No, I don’t know the exact timing of such a move. But I believe it will happen within the next few months. Downward reversion to the mean will play a role.”

The Dow Jones Industrial Average has plunged more than 1,500 points since Porter wrote those words about six weeks ago. He followed them up with a detailed explanation a few weeks later in the August 14 Digest

For many years, subscribers have asked us (Stansberry Research) about the inflation/deflation debate. In our minds, there was never a debate. The greatest contribution the “Austrian” school of economics made to financial thought was the proper definition of inflation.

Most people, however, still do not understand that inflation isn’t necessarily the increase of prices according to an index. Often, credit inflations do not cause rising prices at all… They frequently cause falling commodity prices. The proper definition of inflation is the creation of credit in excess of savings and foreign investment. And by that definition, the Federal Reserve has initiated one of the greatest inflations in history.

The Fed has provided $4 trillion in additional credit to the U.S. Treasury. Saving didn’t create this credit. It was created out of thin air. That’s a perfect example of inflation. For the last six years, this immense amount of credit has artificially reduced the cost of capital across our entire economy – lowering it to almost zero. It’s as though the Fed suspended “gravity” in our economy. And not surprisingly, a boom erupted where this credit landed.

This cheap credit is responsible for the “Bernanke Asset Bubble” we’ve discussed many times. But it hit some areas of the economy particularly hard…

The two most popular beliefs in the credit markets back in 2009 guided where most of the credit went. Back then, even sophisticated people on Wall Street (including Warren Buffett and GMO Financial founder Jeremy Grantham) genuinely believed we were running out of oil.

The performance of car loans during the crisis had convinced lenders that consumers wouldn’t default on car loans because they had to have the vehicles to get to work. (The line back then was that you couldn’t drive your house to work, so you’ll default on your mortgage, but not on your car loan.) A related trend was the government’s efforts to essentially guarantee all student loans. Presto… the credit flowed there, too.

In the short term, these policies have stimulated our economy. Texas led employment growth following the last recession. Outside of employment related to oil investments, employment hasn’t grown at all in the U.S.

Likewise, the two other booming areas of our economy have been auto sales (which neared an all-time high last year with 17 million new cars sold) and capital investment in higher education. Drive through any major university and you will see plenty of cranes. It’s no surprise that the only forms of consumer credit that have grown since 2009 are student loans and car loans. Total outstanding car loans just passed $1 trillion for the first time ever.

While the result has been an economic boom, Porter says it’s due to a “phony” signal. And it encouraged a lot of investing and borrowing that otherwise never would have happened without cheap credit.

Or as Porter put it, with financial “gravity” near zero (super-low capital costs), almost anything will “fly.” But when gravity returns, these same “investments” will head back to earth in a hurry…

A lot of the money invested in the oil business, for example, has gone into projects (like the oil sands) that aren’t economic and aren’t likely to be in a lifetime. A lot of cars were built and sold to people who can’t actually afford them. These people will eventually default. Sooner or later, soaring car loan defaults will drive down the prices of used cars, making it difficult to sell new ones at a profit.

That’s the downside to a phony boom. Since these investments weren’t financed with actual savings, there won’t be enough demand to sustain the debts that have been created. You can think of savings and investment as a see-saw. Without roughly the same amounts on either side, you’re going to have a problem.

For the last six years, that has meant our economy was on “tilt” in a way most people think of as positive: Huge investments in oil, plenty of credit for consumers. Now, the opposite kind of “tilt” looms right in front of us. The boom, as it was not financed with savings, will surely lead to a bust of similar magnitude.

Some folks have questioned why we’ve been following the oil sector so closely. This is why…  As Porter explained, problems in the oil sector are likely to be one of the big reasons for the return of higher capital costs…

Both car loans and oil investments are beginning to sour. These poor investments and poor lending decisions involved hundreds of billions of dollars in bonds and loans that have been packaged into bond-like securities. The worsening performance of these debts will eventually “spill over” into other areas of the bond market.

Here’s how Bank of America high-yield credit strategist Michael Contopoulos explained the situation in a recent report…

We think we’re seeing a pattern very similar to the late ’90s emerge today. High yield typically overbuilds in one industry before realizing stress in that sector – think telecom then, commodities now. Over time, this develops into a risk aversion that spills into the broader market.

The stress has yet to make a meaningful impact to non-commodity sectors, but we view this lack of movement not as a positive, but just a delay of the inevitable. With heightened sensitivity to earnings, coupled with rate risk and further commodity weakness, we think poor fundamentals and demand for higher compensation for illiquidity will soon be reflected in prices.

Porter recommended keeping a close eye on high-yield bonds for clues on what’s coming next…

As I’ve been warning since 2013, the high-yield bond market reached completely unsustainable levels thanks to the Fed’s massive credit inflation.

As this credit bubble deflates, “gravity” will return to our economy. Capital costs will begin to grow. Terms for credit will get tougher. The rising cost of capital will result in bad loans, bankruptcies, repositions, unemployment, softer demand, and lower securities valuations. Winter is coming, friends.

You can see commodity-related credit defaults have begun to hurt the market for high-yield bonds. Record levels of subprime auto loan defaults will be next…


Justin Brill
Baltimore, Maryland
August 24, 2015