Worried About The Current Financial Environment? Here’s What You Need To Know

November 21, 2017

Worried About The Current Financial Environment? Here’s What You Need To Know

  • Today, we’ll discuss the sustainability of developed financial systems as they are now.
  • We’ll also take a look at the much talked about Chinese slowdown.
  • I’ll finish with a take on gold and what could happen.



Introduction

In today’s article, I’ll discuss the financial environment we are living in.

It’s very important to see the fundamental trends and forces surrounding what looks like a stable and strong financial system. The fundamental forces are crucial because in the long term, those forces eventually prevail and have a huge impact on all financial assets.

Given the short-term orientation of financial media, it’s easy to lose focus from the things that really matter because if one thing is certain on financial markets, it’s that nothing is ever stable and there has never been nor with there ever be a ‘new normal.’

I’ll start today with the St. Louis FED’s financial stress index which measures 18 weekly data series—like available short term liquidity or interest rate spreads—to show if financial conditions are difficult or easy. I’m sure you won’t be surprised by the fact that financial stress is at historically low levels.

Figure 1: St. Louis FED financial stress index. Source: FRED.

The ease of getting financing means that many inefficient businesses manage to survive, which creates a distorted situation that grows as long as the trend is self-reinforcing, only to crash very quickly when control is lost. This is similar to what happen back in 2008.

Corporations are increasingly taking advantage of such a situation because, a) increased debt is the only way many can survive, and b) low interest rates lead them to take more risk, and thus create more long term financial instability.

It’s interesting how U.S. junk bond yields haven’t even changed in relation to lower corporate cash flow to debt ratios.

Figure 2: Corporate net debt in relation to cash flow. Source: Societe Generale.

If and when interest rates increase, corporate debt costs will increase above a level that leads to growth and we will have an inevitable recession. The FED knows this and that is why they have been shy of increasing interest rates in the past 8 years even though inflation has been present in many sectors like the stock market, housing, art, etc.

A recent art sale shows just how worthless money has become and how there is a big distortion between statistical inflationary measures and actual inflation. The sale was of Leonardo da Vinci’s painting “Salvator Mundi” which recently sold for $450 million.

Figure 3: Leonardo da Vinci’s painting. Source: Wall Street Journal.

So there are two worlds that are diverging, fixed assets value skyrocket while real asset prices fall. The agricultural commodities index continues to struggle which means that those involved in producing don’t really see the benefits of quantitative easing, on the contrary, it promotes inefficiency which isn’t good for the long term.

Figure 4: Bloomberg agricultural index in the last 5 years. Source: Bloomberg.



Alongside energy, this is what keeps inflation low and we all know both sectors are cyclical. When the cycle eventually turns, it’ll be difficult for highly indebted inefficient corporations and countries to refinance their debt.

The Situation In Europe Is Even Worse

The situation in Europe is even worse because negative interest rates are a must to prevent many European countries from going bankrupt. For example, the Italian budget deficit has been negative for the last 20+ years and only negative interest rates keep the country from defaulting given the government’s 120% debt to GDP ratio.

Figure 5: Italian government budget deficit. Source: Trading Economics.

The funny thing is that Italian 2-year Treasuries are less risky than U.S. 3-month T-bills.

Figure 6: The Italian 2-year yield is negative. Source: Investing.com.

But perhaps I’m wrong and the older Italian population will be willing to work harder to repay their current debt. At least there will be lots of elderly people as by 2030, 28.5% of the Italian population will be over 65.

Figure 7: By 2030, 28.5% of the Italian population will be over 65. Source: Wall Street Journal.

What About A Slowdown In China?

Last week’s news was all about China slowing down and the consequences that slowdown will have on the world economy. It’s important to put these things into perspective first.

Figure 8: Despite the slowdown, China is still growing at staggering rates. Source: ABC News.

I believe any developed country would immediately sign up for such a slowdown. What few understand is that as long as China grows, it will continue to put pressure on commodities and other things necessary to grow its huge economy. This might lead to global inflation which would put developed countries in trouble.

On top of everything, the Chinese slowdown seems self-created as the government is still doing lots of restrictive activities in the real estate and lending markets.

What this China slowdown also does is lead the focus away from other Asian countries that are booming. Indonesia, which has a population of 260 million, is growing at 5%, Bangladesh with 160 million is growing at 7% per year. This is something important to follow as it will create a lot of change in the global markets over the next 20 years.

A Look At Gold

What’s important to know about gold is that it’s all about sentiment in the short term but all about fundamentals in the long term. However, it’s funny to watch the short term volatility and how the herd moves around news.

At the beginning of this month, I was finding extremely bearish headlines related to gold.

Figure 9: Gold headlines. Source: Bloomberg.



However, not even two weeks later, most headlines were suddenly bullish again about the metal as there have been some delays in the new tax bill which made gold rise close two $1,300.

Figure 10: Gold prices in the last month. Source: Bloomberg.

I’m mentioning gold here because practically nothing significant has changed in the gold environment in the last 30 days, but there has been some volatility. Therefore, my point is that we can only imagine what will happen to gold prices when the things we’ve discussed above unravel.

Therefore, if you aren’t already, be hedged for anything that can happen. The funny thing is that you can be hedged very cheaply as the financial stress index is at historical lows and everyone is complacent.

© 2017 Investiv