Boeing Boeing Gone

Just a few newsletters ago we warned of the risk inherent in Boeing’s market capitalization.

The Aerospace & Defense sector has seen valuations for the sector rise without a corresponding growth in cash flows over the past decade. Lockheed Martin (LMT) traded at 10x FCF with a 5% dividend yield, and today it trades for roughly twice the valuation despite minimal growth in annual profitability over the past 10 years. Boeing (BA) has seen more growth given its higher relative exposure to true aerospace customers; however, they are still trading at eye-popping valuations on current cash flows, and an insanely expensive valuation when factoring in its historical cyclicality.

Given its exposure to the commercial aerospace sector, Boeing has rode the emerging markets wave up, but they will eventually ride it down too. We noted the elevated valuations and how investors were stretching for yield in what has always been a defensive, dividend paying, liquid sector.

We also noted that the inflationary trends from the Defense sector from the past 5-10 decades are unlikely to persist given the obvious mathematical dilemmas that occur when the government reduces tax receipts and increases its debts and deficit at the peak of the economic cycle while interest rates skyrocket higher. At some point the math just doesn’t work. Now, the news of today that sent Boeing (BA) down >8% wiping 150bps off the Dow along with it is entirely unrelated to our bearish long-term thesis. They spent a ton of capital to develop a new plane. The plane crashed. It was a brand new Boeing 737 MAX 8 jet operated by Lion Air. Now the market is baking in a slight possibility that there are serious costs to retool and fix manufacturing problems and/or 1-time litigation payments.

The market is also incorporating the risks that tariffs could threaten their growth rates given they export 80% of what they build and 90% is built domestically.

This could easily be a pre-cursor for a long term Boeing bear market. Ultimately investors in Boeing need to incorporating the risk of a dividend cut. When you have 1 major customer (the U.S. government), and that customer cannot pay you and also can legally restrict you from selling your products to others, that becomes a major problem. When you combine that with a cyclical decline in the emerging markets, which historically have been the most volatile geographic sector of the macro-economy, that becomes the recipe for GE style dividend cuts. Savers who bid up BA shares over the past decade assuming they are a bellwether, nifty-fifty name will be shocked just like GE shareholders were in 2018.





Dan Shainberg

BLOODBATH!

Daniel Shainberg
10/26/18

BLOOODBATH! 

Not from the bomber, but in the market.

Our timing of this bearish newsletter warning of impending recession and subsequent market meltdown was completely random in terms of its inauspicious timing. Global capital markets are down now for 5 weeks in a row with a total loss of nearly $9 trillion of investor’s equity from its peak. This was the most brutal and steepest drop since Lehman.

And as we warned previously, the credit markets will not be a safe haven as they have been during volatility induced equity selloffs over the past decade. Risk parity funds will not work, we warned.

Gundlach similarly warned last week, and today again,  that yields are headed much higher. Such a move would have the effect of crushing the price of bonds as they move inversely to yields. He warned of two key concerns: “First is interest rate risk, which clearly has not been a positive now for a couple of years. You've not made money by price gains, you've actually had price declines. So you want to position yourself so that you're not so exposed to these price declines… Then the other thing you have to worry about is how much credit risk do you want. And I would argue that this is not a time to have a much of that either. So you need to be defensive against credit as well. So you're doubly defensive right now in the bond market.”

When looking at the equity markets, the pain in the indexes is most troublesome when you consider the extremely lofty valuations of the Tech sector and it’s recent pull-down effect on overall valuations. Given the low-rate environment of the past decade, investors have piled into anything that was “moving in the right direction,” namely art, bitcoin, bonds, startup app developers, cannabis and overvalued tech stocks. Now that investors can see the light at the end of the tunnel promising a reasonable yield on their savings, those funds are being rerouted from “hype” to “yield” or sitting on the sidelines until yields rise enough. 

Even Tesla is starting to finally come under scrutiny for their accounting and Twitter shenanigans as the FBI capitulated and decided it’s well overdue for an investigation. Don’t be surprised if they find Enron-esque, WorldCom-esque and Tyco-esque restatements.

There won’t be anywhere to hide this time. Unlike the past cycle that saw financial executives heading to B-schools to ride out the recession, this one could take years to unwind and may feel more like paint slowly cracking. The student loan bubble will pop as interest rates head higher. 

Howard Marks of Oaktree Capital has been famously warning about the bubblish environment for years, along with many other “experts.” Today he warned investors about being too risk averse. Interesting change on just a blip in the markets. Things can get a lot worse. But then again, not all of us have $9 billion of committed capital waiting on the sidelines to buy up distressed assets!

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Was that the Pinprick?

Daniel Shainberg
October 12, 2018

The art investor and collector community was stunned last week when immediately after Sotheby’s completed the auction of Banksy’s Balloon Girl the piece started self-destructing. Of course the notoriety of the surprise is believed to have actually increased the value of the piece! One might call it “art in motion.” 

Unlike Balloon Girl, the economic bubble will eventually pop, and it won’t increase the equity value of its stakeholders. 

  

The big debate currently roiling the financial news is whether or not the spike in volatility this week was the pinprick that will bust this cycle’s bubble or just standard volatility that re-entered the markets after a dull “low-vol” start to 2018.

• Peter Schiff: “The Recession is Coming”

• Howard Marks: “No Signs of an Imminent Correction or Crises”

• Ray Dalio: “War With China is Coming”

• Jeffrey Gundlach: “Something Bad Must be Happening”

• Larry Kudlow: “Normal Correction in a Bull Market”

• Scott Minderd: “More Inflation in the Pipeline”

• Mnuchin: “Yield Curve is Normalizing”

Everyone wants to predict where the market is going. It makes us sound smart. Of course nobody knows…. At least in the short term. 

The technical crash through the moving averages is not a good indicator for those bullishly exposed. The fact that the global markets have been rocked year-to-date while the U.S. was an outlier until this week likely as a hangover from the Trump tax cuts is not a good sign. The elevated level of volatility as measured by the VIX index is not a good sign. The likelihood that the move down is correlated to rising rates is not a good sign either.

As we noted in yesterday’s podcast, if the market is starting to reflect the anticipation of higher rates, then equities will demand a spread commensurate for its higher risk. And with the 10 year on a straight trajectory to 4% within the next 12-18 months, equities simply cannot trade at 20x earnings unless justified by material economic growth. And that just becomes a harder and harder sell when the economic growth we have been experiencing was largely due to one-time tax cuts, one-time global-trade wins upon the threat of tariffs and an end to the interest rate cycle. Nobody can predict daily moves or accurately predict where the market’s are heading next week. It’s just too tough. But when you consider all of the noted artificial stimulus that buoyed the market up, and the fact that they are all turning now, it just gets harder and harder to believe this bull cycle is just witnessing a bump in the road. And we haven’t even discussed margin debt!

Dallas Fed Chief Robert Kaplan recently addressed NYSE margin debt as it hit another record high. The reason this matters so much is that when markets tank, investors with margin exposure become forced-sellers. The lenders require them to liquidate their equity positions to repay their loans as their assets drop below minimum coverage ratios relative to their liabilities accounts. This has the effect of magnifying market selloffs. It becomes an excellent and ripe ground for value oriented investors, but only once the full brunt of the forced-selling waves is complete.

While we have listed true market indicators in this newsletter previously, NYSE margin debt reversals are excellent warning signs to the next bear market. Even FINRA warned in January that investors may be underestimating the risks. The chart below shows how the current market cycle could see a record forced-selling blowout as NYSE margin debt is ~50% greater than the peak of the 2008 market precipice. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

You Can’t Handle the Truth

Daniel Shainberg
October 11, 2018

• President Trump blames the Fed for the market drop 
• Economists largely agree the Fed is making the right moves
• Some economists argue the Fed is actually too late in raising rates

With the recent growth spurt in the economy, combined with tight employment, the Fed is predicting the recent wave of labor related inflation to increase. That is it. It’s not about politics. They have a dual mandate to keep employment and inflation in-check. If employment is tight and inflation starts taking off too much, they aren’t doing they’re jobs properly.

The truth is that Fed is not acting “reckless” as President Trump stated. He just needs an outlet to blame the sudden shock of equity losses onto someone else prior to the important mid-term elections. 

Guggenheim’s CIO Scott Minder likened the current economy to the Titanic, “full steam ahead with an iceberg.” It’s tough to disagree. While we have been forecasting this volatility and market selloff since the newsletter began last month we were focused on a few very simple concepts. There are a ton of speculators commenting on fancy charts and research. But it’s quite simple. 

What is the truth?

The truth is that for the past decade post-crises the Fed has been in an accommodating stance, and the phrase “don’t fight the Fed” worked for bulls. But as balance sheets expanded and the flood of liquidity made its way into market caps and the general economy, employment tightened and inflation began ticking up. The genie is always harder to put back in the bottle, so in anticipation of a major liquidity crises, which may happen anyway, the Fed is starting to be responsible. There are some like Peter Schiff who think that the level of monetary stimulus has totally corrupted the economy to the point where there is no turning back, and the U.S. dollar is doomed. 

If we take the Fed at its word, for those of us without such a hyperbolic stance, the story is quite simple: The truth is that it all boils down to math. When the risk-free 10-year yields 1-2%, holding such paper won’t beat inflation. So you as an investor throw your capital into art, stock in Tesla, bitcoin, cyclical equities, real estate, iPhone apps and cannabis frauds. You may even pay 20x EPS through your Betterment account to own the S&P 500 because why wouldn’t you earn a 5% yield. 

But once rates start rising all of those hyped up nonsense “investments” get scrutinized more. Do you really want to risk your capital in these bubbles and unproven momentum stories when you can actually earn a risk free return on your capital? 

Even if you answer yes, the required return still rises because of the alternative return offered to you. When the S&P 500 trades at 20x earnings which is where it was for the past few years, you are essentially earning a 5% yield excluding growth. That represents a decent spread to compensate for elevated risks relative to risk-free government bonds. 

Gundlach expects the 30-year to rise to over a 4% yield. Why would anyone buy the S&P 500 at or near cyclically peak earnings for only a 100bps spread? They won’t. And that repricing of risk is what the market is digesting currently. 

While there are always buyers to step in short term, I’d expect this regurgitation to continue in the coming quarters until the equity spread increases sending the S&P 500 multiple towards a more reasonable 15x earnings level. That would call for another 20-30% correction in the markets.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Bloodbath Continues After Hours

With the ugliest day on Wall Street in a long time, the “bounce-back” may elude us tomorrow as the Dow is down another 1,000 points after hours. 

What’s going on? 

Well if you have been reading this newsletter then you would have already been informed of the macro themes that continue to present compelling and material downside risks to this market. The interesting thing about today’s selloff, and the continuation in the after-market, is that there was no significant single news event, no change in rates, no spike in oil, no new tariff news. 

It seems to simply be an unexpected pocket of air that hit the markets without any warning. The reassurances from the White House about the “strength of the economy” will prove meaningless to investors who have their own cash on the line. What equity investors finally picked up on was that the economic readings suggesting strong growth are driven by the low rate environment. And since rates have been spiking up quickly, the stock market as a forward indicator is incorporating its expectations for the future impact of these rate hikes. 

The market is not liking what it’s seeing! 

Nedbank's strategists Neels Heyneke and Mehul Daya explain why "we are approaching historical thresholds", where Fed tightening traditionally becomes the "straw that breaks the camel's back" for the equity markets and why "this time should be no different." 

According to Dennis Gartman, “the U.S. economy has close to a 100% change of entering a recession.” Gartman noted that the catalyst will almost certainly be the Fed.

As of now, he seems to be right. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

The Yield Curve

What the bond markets are predicting is that the next recession is already set in place from a long period of inflation and the distortion of global interest rates for far too long. With a record deficit combined with rising rates the U.S. government will not have the same ammunition to attack the powerful forces of economics that struck in 2008. Economics will strike again. Bubbles can last longer than expected, but when debt is run-up, money is printed without concern for its effects and debt is assumed in excess, bubbles form. 

But they eventually pop.

Today we are living way beyond our means. The only way to determine the timing of the end is by researching prior cycles. Increasing rates are the first sign, but it does not necessarily act like a pinprick to an oxygen filled balloon. Since most reasonable analysts agree that our first premise is accurate, in that we have had years of excess artificially induced growth, let's focus on the very difficult to determine question of timing. The phrase "economic indicator" should be reserved for economists. We want to understand real stock market indicators. What are the signs that the stock market cycle is ready to turn from a bull into a bear? 

The Yield Curve

When the economy is healthy, longer dated bonds demand a premium return. Investors naturally demand more money to compensate the extra time, risk and inflationary impact involved in having their capital tied up for a longer period of time. The yield curve notes the difference between the 10-year and 2-year yield on U.S. government bonds. This has been a reliable accurate signal for a looming recession over history. Inverted yield-curves are when the yield on 2-year bonds exceeds that on 10-year bonds which is a counter-intuitive situation. Normally if an investor locks her capital up for a longer period of time, that should be compensated for with a higher yield. But when the short term yield is larger than long dated bonds, that suggests that the credit market is forecasting a "top" nearing. 

Recently the spread between the 10-year government bond and the 2-year bond has shrunk, suggesting traders are concerned about growth. Grey areas below are U.S. recessions, you can see that the yield spread has dipped below zero before each one. 

After careful analysis of this chart one can see that when the spread shrinks towards the horizontal black line where investors demand the same return for 2-year and 10-year government bonds, a recession follows, but not always immediately. In both 1984 and 1994 the recession hit a few years after the signal was triggered.

Every recession over the past 60 years was preceded by an inverted yield curve according to research from the San Francisco Fed. Inversions correctly signaled all nine recessions since 1955 and had only one false positive in the mid-1960s but that period witnessed a true economic slowdown even though it did not reach the status of an official recession. Keep an eye on the spread. The chart is updated and can be viewed here:

https://fred.stlouisfed.org/series/T10Y2Y

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

"Oh Don't Worry, We Can Spot the Next Downturn"

The title of today's newsletter is a quote from a close friend and portfolio manager in the long/short hedge fund industry. Like most hedge funds, he tries to ride momentum stocks up, and for those with bearish momentum, down. 

Every time I passionately tell him about a new and exciting investment thesis with a value oriented, defensive businesses, shockingly still available in this overvalued market, he questions why "there is no momentum." He doesn't care about cash flow, buybacks, dividends, return on capital, market share or cyclical exposure. You can offer him a fantastic business with a 20% free cash flow yield. He doesn't care. He just wants to see a stock on-the-move. If it has momentum, either up or down, then he's interested. 

The popular trend-trading style of investing can work, at least for a period of time. I'm not saying it's fundamentally flawed. But the idea that one can spot when Pets.com turns down permanently, instead of just exhibiting volatility... well that's nonsense. Impossible. Bitcoin, apps, tech, VC, crypto, cannabis, high yield, and eventually FANG stocks... They all have a ride-up that includes volatility. And then they crash. That's the nature of markets. 

The idea that one can forecast whether an overvalued asset is experiencing temporary volatility instead of a permanent redirection is just utter nonsense. You cannot predict what the equilibrium of the entire market will do. There's an inherent price-setting osmosis in the markets determined by the collective push and pull of the bulls and bears. Nobody can predict the future outcome just based on technical chart trends. 

Which is why it's so important to focus on fundamentals and solid research in this period of elevated valuations, stretched cycles, record low rates and peak margins. This is precisely what investors in the market today are NOT doing! Everyone is still chasing growth and momentum leaving phenomenal value oriented opportunities out there as David Einhorn recently lamented in his quarterly letter.

The problem today is that even if one could predict whether a market shock is temporary volatility or a permanent trend reversal, the risk of an immediate 1987 shock is increasing. The S&P 500 Ex Financials index witnessed its member companies more than double borrowings to $5 trillion over the past decade. There is a wave of corporate maturities in 2019-2021 that more than triples the maturities of 2018, and rates are rising. 

But the big behemoth metric that is not calculated in any corporate financial statement is the national debt. With rising rates on top of record debt, the future economic environment is resting on very shaky legs making the theory of trend-trading that much more impossible to succeed.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

The Debt Cycle

With the deficit ballooning and rates rising a recurring topic is being discussed more and more often: The Debt Cycle.

The Debt Cycle is characterized by a period of lower rates which precipitate increased lending and use of credit throughout the economy. This monetary injection shoots an injection of growth as companies can borrow at minimal rates to repurchase stock and perpetuate a "wealth effect" or invest in growth initiatives. That growth spending combined with consumer spending increases economic activity and the velocity of money. Too much money printing and increased velocity of money leads to the final stage when investors are over-leveraged from phase 1 and 2 yet can no longer support their interest payments as rates rise, credit refinancing transactions have higher hurdle rates for approval and general economic activity declines.

At the end of the debt cycle loose monetary policy has considerably less of a direct correlation on impacting the economy. The past two times this century when interest rates hit zero, the central banks kicked into "quantitative easing," which is a fancy term for "buying assets." So what's next?

QE is no longer effective, asset prices are elevated and our political situation (tariffs) is increasing global tensions. If the economy continues to grow, the rate hikes will be less detrimental, and the cycle can last longer. But if the economy proves incapable of managing the rate hike headwinds, our next downturn can really cause tremendous pain. The wealth gap and political divide in America will prove to be nothing compared to the strife that comes with a lack of opportunities.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Dow and S&P 500 Drop After Today's Rate Pop

• US 10-year yield jumps to a fresh 7-year high 
• Unemployment rate falls to lowest in 49 years
• September job creation falls to its lowest level in a year
• But unemployment rate drops to lowest level since December 1969

These headlines are geared to spook investors. Everyone expects rates to rise. The Fed has been clear on their guidance. They provided a dot plot chart that outlines all the upcoming rate hikes, but CNBC and the mainstream media need eyeballs to make money, so they try to spook investors and individuals into thinking that today's rate hike is "news." 

The truth is that today's hike is just another reminder of how overvalued these FANG stocks and hyped up Tesla/Roku/Crypto/Apps/Cannabis "businesses" have become. The S&P 500 is dominated by a handful of growthy tech stories. As interest rates rise investors will naturally shift allocations from story stocks to actual return oriented investments. When interest rates are zero, it makes more sense to speculate on art and other risky investments that are temporarily moving with a bull market tailwind. But once rates start rising, there is both a cost to borrowing to fund the speculation, and there are real opportunities to earn yield in traditional asset classes. Lastly, there are bigger obstacles for these growthy companies to actually fund their growth as their venture capital liquidity pools dry up.

David Einhorn has been frustrated by the continued multi-year drag on performance from this growth-first trend. But at some point over the next 5-10 years, there is no doubt that the true value oriented opportunities offered up in this market will generate much better performance than the momentum story stocks that carry insane valuations and tremendous risk.

"The current market view is that profitless companies with 20-30% top-line growth are worth 12x-15x revenues, while profitable companies that lack that level of opportunity are worth only 5x-8x after tax earnings. As an arithmetic exercise, if you pay 12x revenues for a company that eventually makes a 10% after tax margin and trades at a 20x P/E, the company has to sustain a 25% growth rate for 8 years for you to break even, and for 12 years for you to make an 8% IRR (requiring 15x revenue growth). If the company is increasing the share count by paying employees in stock, the math gets worse."

The bottom line is that the tech sector has grown to dominate the S&P 500 both because of low interest rates and from low cost ETFs that allow novices to throw their capital at this self-fulfilling bull market index. Investors have no clue that these super low cost mobile platforms are really just pushing them into a handful of super growthy tech stocks that can easily crater as rates rise and more nimble investors shift to value before its too late.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

x

"Too Much Money Chasing Too Few Deals"

The seven worst words in the world (for an investor) is "Too Much Money Chasing Too Few Deals" according to Howard Marks of Oaktree Capital.

When investors bid up assets to premiums unjustified by traditional risk mitigation practices, the return opportunities inherently diminish and may not justify the potential risk for a loss of principal. 

Marks is justifiably neutral on the economic outlook with a risk averse inclination. He recognizes the underlying strength in the economy. But he wants investors to respect valuation and shift their risk profile into a more stringent phase. He admits he is still making investments, but he is still prepping for the next downturn. Oaktree has been raising distressed funds for 3 years and running, so they are admittedly early, but eventually they will be right. Some would argue that Marks is attempting to sell more of his new book "Mastering the Market Cycle" with Peter Schiff-esque scare tactics, and they might be right. After all, it's easy to claim a recession is coming without ever having to nail down the timing!  

What we are seeing now is the "Fed put" reversing course into a "tightening" phase. Federal Reserve Chair Powell said "we're a long way from neutral on interest rates" indicating that more hikes are coming. 

With a plethora of new money, new funds, new first time funds and new non-bank lenders, there is an unofficial requirement for investors to "put money to work" while at the same time the opportunities for good investments shrink as the Fed tightens. The Federal Open Market Committee (FOMC) is likely to take the funds rate to 3.4% before pausing. This is all a recipe for disaster. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Booming Boeing

Daniel Shainberg

October 3, 2018

What is it with these Defense stocks? 

They used to trade at 10x free-cash-flow with 5% dividend yields. Over the past few years earnings have not grown too much for this sector, at least relative to other industries. This is an industry tied heavily to a handful of large countries and aerospace customers. It is natural to not grow as quickly in a booming economy or decline as much as typical cyclical companies with a recessionary economy. 

A few years back we had the big "sequestration" which Lockheed Martin's (LMT) investor relations predicted accurately as "just a big news headline that wasn't impacting their outlook much." These days, the large-cap defense names trade at much higher multiples relative to those warranted by historical levels. Boeing (BA) for example has a market capitalization and enterprise value of over a quarter trillion dollars. Their stock price is up 53% over the past year! Business is booming. 

What are investors willing to pay for such a business? In their last annual report Boeing (BA) reported EBITDA and free cash flow of just over $12 billion and $11.6 billion, respectively. That puts their EV/EBITDA at a whopping 19x, well above the defense sector's historical levels of 8-9x. The dividend yields have compressed as well versus the industry average 4-5%. Boeing's dividend now yields half of what you can earn owning a risk free 10-year U.S. treasury bond. The free cash flow yield for Boeing is 4.6%, and if you generously assume that all of their capital expenditures are growth oriented, they still trade at an eye popping 19x their latest annual cash flow generated from operations.

So what happened and is this a trend worth following? What happened is a few things: 

1. Investors bid up the reliable and recession resistant income stream. Yield oriented investors who were forced out of traditional fixed income instruments like munis, high yield and leveraged loans had to look elsewhere for stable income. The defense sector was a perfect alternative. It has recession resistant and predictable cash flows with very liquid customers, there are plenty of large-cap liquid securities to choose from, they like to pay shareholders large dividends and many even use excess cash flows to repurchase stock. So instead of being viewed as a boring low-growth industry, the defense sector turned into a bond proxy. But why then is the sector still booming recently while interest rates rise? That is because they shifted at the right time from just an income oriented asset class to a growth industry. 
2. Growth stocks can trade at insane valuations... for awhile. As long as the industry grows, and new exciting headlines are released, investors can at times be very generous with regards to expecting that gravy train to continue forever. Who isn't excited about the opportunity to explore Space? When President Trump announced this initiative, Boeing became an obvious target to reap the benefits. Right now there are also lots of tensions globally with Trump's trade policies. The number of potential conflict areas on the global theater are forcing nations like Russia and China to build up their defense sectors. Trump is also a heavy favorite of increasing military spending. So you have a growth industry in a sector that used to be viewed as stable. This can last only as long as our budget allows for it. 
3. The commercial aerospace sector is booming as middle-income consumers in key emerging markets demand access to air travel. While this is a long term bullish trend, and Boeing has excellent market share tied to this trend, it is also a much more cyclical and economically correlated segment of Boeing's business, ripe for a turn-down in the next global recession. 

How long can the budgets allow for growing defense spending? Well that is the key question, and one that investors in these stocks are completely ignoring. 

I am not stating that Boeing or Lockheed Martin are imminent short candidates. They can continue riding these growth waves. But when you have investors that ignore traditional risk mitigation analysis in favor of short-term trends or alternative forces pushing them into an investment, it becomes ripe for an overvalued investment. And that is precisely what is happening now. 

With a record $20 trillion deficit and a record $2.1 trillion spent last year by the federal government, we are in the "no limit" spending phase of the cycle. But as interest rates rise along with the deficit, at some point in the future, our defense budgets will have to take a material hit or we will risk massive inflation. There is no other way out of the deficit. 

Projecting a continuation of the current path, we are set to pay more in interest on the national debt than on the military, Medicaid or other social programs. This run-up in the interest tab is due to rising rates, Trump's increase in deficit spending and his tax cuts. That all adds up to more expenses with less revenues, and no politician will ever willingly fix that broken formula unless an emergency bust demands it. 

But once that equation changes, the only realistic fix is a massive cut to the largest component of our national expense... Defense. 

And the time will come. See our article on the "20 forgotten lessons from 2008" as a reminder. When that comes, these headlines that helped buoy the defense sector will inevitably flip, and this newly minted "growth" sector will return to attracting "value" oriented investors who will be willing to pay significantly less. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Italian Inferno

Daniel Shainberg

October 2, 2018

As we have warned previously the Eurozone is specifically at risk for serving as the catalyst for the next global recession. Excess sovereign debt may not cause the recession, but it certainly can fuel it, exacerbating the trough and limiting the monetary toolkit for bankers, especially when debts are denominated in foreign currency. This is what we published on September 16, 2018:

"Italy is in the European Union and has a debt/GDP ratio of 130%. Typically any country with over 100% debt to GDP is in big trouble. Given Italy's interconnected economy to the rest of Europe, a blowup in Rome could easily cause a nasty contagion effect whereby the ECB assumes their sovereign debt and imposes austerity or the Eurozone breaks apart. In either situation an economic crush would likely follow" (Recession Resister Newsletter: "The Next Recession" 9/16/18).

This chart shows the increase in leverage in Italy. 

Last weekend I traveled to Yosemite National Park and listened while on a guided tour to a young park ranger enthusiastically explain how the forest actually needs fires to survive. She stated that European settlers who arrived over a hundred years ago mistakenly thought the fires they witnessed were killing the Sequoia trees, so they implemented expensive fire suppression techniques. That is until they realized the forest was eroding even faster. Then they hired a scientist to study the problem and make recommendations. His conclusion was that the Sequoias needed the fires to clear out brush so their seeds have room to grow, and quite contrary to popular belief, the Sequoias are naturally fire resistant. Natural forest fires are healthy in the long run. The problem is if you suppress the natural fires. Then you get tinder, shrub, moss and other fuel that can quickly turn a mild fire into a raging uncontrolled wildfire. That is what we have been experiencing recently, and those types of forest fires are unhealthy for the Sequoias as they can burn dozens of feet up the trees, sometimes reaching the canopy, exhausting the tree's natural defenses. 

After years of excess sovereign debt inflation we are entering a point where the leverage is no longer a common cyclical non-issue. It is growing out of control and could act as the tinder for the next global recession turning what should be a standard recession into a global meltdown. 

Excess sovereign leverage is not a great predictor of the timing of the downturn, but it can identify the potential degree of harm, and what we see now is a record breaking uncontrolled fire on the horizon. Nobody rings a bell at the top, and the recent and corporate earnings and macro-economic reports are meaningless. They express past results that are largely induced by the excess debt injected into the global economy. Earnings reports are malleable. They can move drastically and quickly as we saw in 2008 and 2009. But the debt doesn't disappear. Robert Shiller and Edward Chancellor are expressing concern.

Everyone is assuming earnings will rise forever, and traditional credit analysis is being thrown out the window to save market share. These are classic investor-psychology warning signs of a peak. Chancellor argues that record low interest rates since the financial crisis produced zombie companies that are surviving only because of low rates. Normally recessions clear out the weak companies and force austerity on overly leveraged nations. These mini-recessions clear out the brush and garbage. It forces investors to reallocate capital to healthier productive enterprises similar to how natural forest fires clear out the forest so the Sequoias can spread their seeds and attract enough sunlight to grow. Failure is essential to the rebound. Equally, business failures are essential to a recovery. But what we are seeing now in the global economic system are central bankers acting like the early European settlers in Yosemite, wasting lots of resources in a manner that is sure to backfire at some point.

Today the market may have finally started incorporating this risk as global stocks slumped led by a European selloff. The Euro dropped relative to the U.S. dollar as Italy’s bond yields shot up to multi-year highs. Recognizing the obvious Claudio Borghi said that Italy should have its own currency which is a fancy way of saying "we ain't gonna be able to pay you back." Borghi said that the euro is not sufficient for Italy to solve fiscal issues. No kidding! 

The Italian 10 year yield rose to 3.438%, the highest level since early 2014.

Even the Wall Street banks are starting to come around: "While our economists do not expect systemic implications for the global economy, contagion risks have risen. We think European risky assets remain vulnerable, and there is potential for negative spillovers to the Euro area given the high trade exposure to Italy" (Goldman Sachs).

Dan Shainberg

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