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For the ill prepared, a tsunami of financial misfortune lies ahead

By David Scott | Monday 13 February 2017


 


An unexpectedly bearish BlackRock CEO Larry Fink in the week joined the likes of Bill Gross, Jeffrey Gundlach and Ray Dalio who have all similarly turned downbeat in recent weeks. All have cautioned that the U.S. economy is in the midst of a slowdown and financial markets could see a significant setback, for the same reason, that the Trumpflation trade has burnt out in recent months due to uncertainty over global trade and the Trump administration's plan to cut taxes. "I see a lot of dark shadows," Fink said adding that. "The markets are probably ahead of themselves." 

Blackrock is the world's biggest asset manager, with control of over $5.1 trillion in assets. Central banks are stuck in a permanent cycle of low interest rates and money printing that bond guru Bill Gross said eventually will blow up. In his monthly newsletter for clients, the Janus Capital portfolio manager again railed against policies from the Federal Reserve and its counterparts around the world that he said have inflated asset prices but have done little to boost economic growth. He likened the easy-money efforts to "financial methadone," in which the Fed's withdrawal of stimulus has been met with increased efforts from the European Central Bank, the Bank of Japan and elsewhere. The global central bank balance sheet has surpassed $12 trillion, Gross said. At the same time, Fitch Ratings recently reported that global sovereign debt with negative yields still surpasses $9 trillion. All of it has created a perilous situation, Gross said.
 
Donald Trump’s administration has put itself on a fresh collision course with the European Union after the president’s candidate to be ambassador in Brussels said Greece should leave the euro and predicted the single currency would not survive more than 18 months in its present form. Days after being accused of “outrageous malevolence” towards the EU for publicly declaring that it “needs a little taming”, Ted Malloch courted fresh controversy by saying Greece should have left the Eurozone four years ago when it would have been “easier and simpler”. Malloch made his comments as financial markets began to take fright at the possibility of a fresh Greek debt crisis later this year. Shares fell and interest rates on Greek debt rose after it emerged that the EU was at loggerheads with the International Monetary Fund over whether to give the country more generous debt relief.

“Whether the Eurozone survives I think is very much a question that is on the agenda,” he told Greek Skai TV’s late-night chat show Istories. “We have had the exit of the UK, there are elections in other European countries, so I think it is something that will be determined over the course of the next year, year and a half. “Why is Greece again on the brink? It seems like a Deja vu. Will it ever end? I think this time I would have to say that the odds are higher that Greece itself will break out of the euro,” Malloch said. The Brexit-supporting businessman, who has yet to be confirmed as the US president’s EU ambassador and is seen by Brussels as a provocative nominee for the post, said he wholeheartedly agreed with Trump’s tweet from 2012 saying Greece should return to the drachma, its former currency. 

Malloch said: “I have travelled to Greece, met lots of Greek people, I have academic friends in Greece and they say that these austerity plans are really deeply hurting the Greek people, and that the situation is simply unsustainable. So you might have to ask the question if what comes next could possibly be worse than what’s happening now. “The biggest unknown was not a euro exit, but the chaos it would likely engender as Greece moved to a new currency, he said The governance structure of the IMF means the US could block any deal it did not support. “If the [IMF] will not participate in a new bailout that does not include substantial debt relief, and that’s what they are saying, then that, more or less, ensures a collision course with Eurozone creditors,” Malloch added, saying it was imperative that EU member states forgave a substantial part of Greece’s mountainous public debt.

“Now we all know that primarily [puts pressure on] Germany, which remains opposed to any such actions, so I think it suggests that Greece might have to sever ties and do Grexit and exit the euro,” he said. Under bailout programmes financed mostly by Germany, Greece has been given about €336bn in rescue loans, money that Berlin and other lenders are determined to get back. The euro-denominated debt pile would be essentially erased if Greece reverted to the drachma. Malloch’s latest intervention is unlikely to be greeted with concern by EU officials, who are voicing fears that stalled bailout negotiations with creditors could pave the way for an accidental default in the summer.
 
The EU faces a looming crisis which could threaten the sustainability of the Eurozone as the International Monetary Fund has warned Greece’s debts are on an “explosive” path, despite years of attempted austerity and economic reforms. Global financiers at the IMF are increasingly unwilling to fund endless bailouts for the Eurozone’s most troubled country, passing more of the burden onto the EU – at a time when Germany does not want to keep sending cash to Athens due to the autumn elections. . The assessment opens up a fresh split with Europe over how to handle Greece’s massive public debts, as the IMF called on Europe to provide “significant debt relief” to Greece – despite Greece’s EU creditors ruling out any further relief before the current rescue programme expires in 2018.Jeroen Dijsselbloem, the Eurogroup President repeated that position on Tuesday, saying there would be no Greek debt forgiveness and dismissing the IMF assessment of Greece’s growth prospects as overly pessimistic.

“It’s surprising because Greece is already doing better than that report describes," said Mr Dijsselbloem, who chairs meetings of Eurozone finance ministers, adding that Greece was on track for a “pretty good recovery at the moment”. The renewed divisions over how to handle the Greek debt crisis has raised fresh questions over whether the IMF will be a full participant in the next phase of the Greek rescue – a key condition for backing from the German and Dutch parliaments. As Angela Merkel, the German chancellor, fights a tough re-election battle, Germany is particularly reluctant to send funds directly to Greece, with populist parties in Germany arguing that the payments amount to an unfair bailout from hard-working Germans to less deserving Greeks. Since the third bailout in as many years, Greece has lost more than 25% of its GDP due to austerity-fuelled recession, the biggest slump of any advanced western economy in modern times. Without further emergency funding from its €86bn (£74bn) rescue programme,
 
Athens could face a default in July when debt repayments of about €7bn to the European Central Bank mature. Beyond the long-running concerns over Greek debt, Europe is currently locked in a fierce internal struggle over how to “refound” the European Union in the wake of Brexit and the apparent hostility now emanating from White House.  Merkel, the German chancellor, acknowledged the calls for change from within the EU yesterday while on a trip to Poland, but said she would argue that the EU should “proceed very cautiously” on the question of treaty change as it faced down a growing number of existential threats. Reluctant EU members, led by Poland, are calling for a return to the union's founding principles, asking for a fundamental overhaul of treaties that would return power back to nation states. An EU ‘concept paper’ launched recently ahead of the 60th Anniversary celebrations of the Treaty of Rome next month has deepened divisions after it emerged that it did not contain a single mention of the member states, only the EU institutions, according to a senior diplomatic source. 

Greek GDP has started to grow, expanding by an estimated 0.4 per cent last year, but it is on a very weak path. IMF economists expect the country to grow at less than 1 per cent per year over the long-term, which is too low for it to pay down its debts. That means Greece’s “public debt remains highly unsustainable, despite generous official relief already provided by its European partners,” the IMF believes. Even if the country successfully implements all of its planned financial and economic reforms – which has been a struggle so far – its debt is projected to fall to from 179pc of GDP a year ago to 160pc of GDP by 2030 “but become explosive thereafter”. “Greece cannot be expected to grow out of its debt problem, even with full implementation of reforms,” the IMF warned on Tuesday. Despite Eurogroup protestations that the Greek bailout was sustainable, the IMF estimates that by 2060 its debts will amount to a crushing 275 per cent of GDP. The IMF said progress to date in turning the crisis around has been “significant” but also acknowledged that the deep cuts to public services and pensions had come “at a high cost to society, reflected in declining incomes and exceptionally high unemployment.”

Unemployment is currently still stuck at above 23 per cent. The IMF is very clear about who it believes should give Greece more money to try to turn this situation around. “Greece cannot restore debt sustainability through its efforts alone and needs significant debt relief from its European partners,” the IMF said. Greek finance minister Euclid Tsakalotos said the IMF’s report “fails to do justice” to the strength of the economic recovery and the improvement in the government’s books. The IMF also gives a “misleading representation” of the government’s reform efforts, he said.
 
The International Monetary Fund tried to be "ruthless truth tellers" in its assessment that Greece needs to pursue further reforms to its pension and tax systems, IMF Managing Director Christine Lagarde said on Wednesday. Speaking at an Atlantic Council event in Washington on transparency, Lagarde said that the fund would not back down from its views on Greece's economic prospects despite protests from the Greek government that they were too pessimistic. The IMF said in its first annual audit of Greece's economy in nearly four years that Greece's debt was still unsustainable even after years of grinding austerity. It recommended that Greece's pension system be refocused on supporting the poor, the tax base be broadened and tax rates lowered to help jumpstart economic growth.

In Athens, the government will not yield to "illogical demands" by the IMF for "precautionary" austerity measures in a European bailout program that no longer includes IMF money. Greece’s central bank also disputed the IMF's prescription that an additional $10 billion in bank capital buffers was needed. “We tried, in full honesty, to be those ruthless truth-tellers," Lagarde said of the IMF's report. "Yes, we are criticized occasionally and I'm sure that the Greek authorities didn't like some of the things that we said. “Lagarde said the IMF acknowledged the pain suffered by the Greek people who have borne the brunt of austerity measures enacted since the first of three Greek bailouts was launched in 2010. But she said too few people, mainly wage earners, were bearing the burden of taxation, while the pension system needed to be made sustainable and better support the poor. “Reforms are absolutely needed. Somebody can ask me the questions three times over, I will still say the same thing," Lagarde said. Greece also needs to further improve its own data transparency, Lagarde said, noting that there were frequent and significant revisions of economic data.

Asked whether data transparency issues were causing divisions among IMF board members over Greece's debt sustainability and surplus targets, she said such differences were more likely a result of "an assessment of the potential for reforms and the potential for actual economic output from those reforms. “Asked about the Fund's view of policy proposals coming from the administration of U.S. President Donald Trump, she said the IMF would evaluate the impact of actual policies that are enacted, not "slogans" or reports about them. “We need to operate in a reliable, scientific way, in order to shed light on the consequences of decisions made, not decisions that are talked about," she said. Lagarde also revealed that new IMF research shows that emerging market countries that improve data transparency see fairly quick reductions in their borrowing costs. German Finance Minister Wolfgang Schaeuble has reaffirmed his staunch opposition to slashing Greece's debt as the IMF has urged, while Greece is hoping for a breakthrough in negotiations this week. "We can't agree a debt reduction for Greece, it's ruled out by the (European Union's) Treaty of Lisbon," Schaeuble told ARD public television on Wednesday evening. “For that, Greece would have to leave the monetary union," the conservative politician said.
 
In Brussels on Thursday Greece's deputy minister of European affairs, Georges Katrougalos, said he was hopeful of reaching an agreement with Eurozone partners. "No one has any kind of interest in prolonging negotiations," he told journalists. The Eurozone wants Greece to deliver a 3.5 percent budget surplus before debt repayments, while the IMF believes it can manage around 1.5 percent. The situation will become "explosive" in the long run if not addressed, the Washington-based institution warned. But Germany's finance chief maintains said that any reduction in Greece's debt would be a breach of Eurozone rules that "no member country in the monetary union can be responsible for the debts of another. “While reducing the value of Greece's debt -- a so-called haircut -- is one option of providing debt relief, its creditors could also lower interest rates and extend the repayment period. “The pressure on Greece to make reforms and become competitive has to be maintained," Schaeuble went on. "Otherwise they won't be able to remain in the single currency. “In reaction, Katrougalos said "Schaeuble was from the beginning for a much smaller Eurozone.... This idea of an elite Eurozone does not have the support of anybody else in Europe now. “

He added that "even within Germany Schaeuble is not the only voice that matters. “But without debt relief the IMF may withhold further financing for Greece -- putting an 86-billion-euro ($92.4 billion) bailout programme agreed in 2015 in doubt. German leaders have promised voters not to offer Greece any more financial aid without the IMF -- with its reputation for competence in getting stricken countries back on their feet -- being on board. Meanwhile, the EU's European Stability Mechanism rescue fund, which oversees the Eurozone’s loans to Greece, said it saw "no reason" to be "alarmist" about Greek debt. The IMF is not taking into account the significance of the Eurozone’s pledge to help Greece, and that "solidarity with Greece will continue," the fund's managing director, Klaus Regling, said in an opinion piece in the Financial Times on Thursday.
 
According to Gallup, U.S. economic confidence has soared to the highest level ever recorded, but meanwhile a number of key economic indicators are indicating that a new recession is beginning and if the U.S. economy does officially enter recession territory in 2017, it will be a shock to many. Trump has inherited an economic mess from Barack Obama, and it was probably inevitable that we were headed for a significant economic downturn no matter who won the election. One of the key indicators to watch is average weekly hours.  When the economy shifts into recession mode, employers tend to start cutting back hours, and that is happening right now. In addition to the decline in hours, there are a number of other reasons to believe that a new recession is upon us. My favourite is that Tax receipts indicate the US is in recession, Gross private domestic investment indicates were are in a recession, Retailers are reporting that the US consumer are becoming less free spending, see Amazons comments with its results recently and tightening of lending standards, are causing a squeeze. What we do know is that US GDP growth collapsed in last quarter of last year, with a large portion of the “growth” coming from accounting trickery. In a debt-based economy, the flow of credit is absolutely critical to economic growth, and when credit starts to get tight that almost always leads to a recession.

So the fact that lending standards have now tightened for medium and large sized firms for six quarters in a row is very bad news. In addition Jobs growth at S&P 500 companies has gone negative for the first time since the last recession, and so large firms are definitely starting to feel the pressure. Tighter credit means less economic activity which means slower economic growth.  The U.S. economy grew at a dismal 1.9 percent annual rate during the last quarter of 2016, and it would be absolutely no surprise if we end up with a negative number for the first quarter of 2017.The spectacular Obama/Fed “recovery” produced no increase in real median household income in 2016 (the last year of Obama’s reign). In fact, real median annual household income in December 2016 ($57,827) was 0.9 percent lower than in December 2015 ($58,356).

 If a recession is going to happen the Trump administration should want it to occur as quickly as possible. If a recession starts a year from now, it will be much more difficult for Trump to blame it on Obama.  But if a recession starts right now, he will definitely be able to argue that it happened because of the mess that he inherited from the last administration. In addition, the sooner the next recession ends the sooner the next recovery can begin.  If a recession is still going on during the 2020 campaign, that would be really bad for Trump, but if a recovery is well underway by then that would be really good for his chances.  The 1984 campaign shows how this has played out before.  After a very difficult recession, the U.S. economy bounced back strongly and Ronald Reagan was able to ride that momentum to an easy victory. Unfortunately, once a new recession begins it may not unfolded like recessions normally do. 

But this time The U.S. government is 20 trillion dollars in debt and In addition we are in the midst of one of the biggest stock market bubbles in history. Unfortunately, a lot of people believe that all the decades of accumulated problems have now evaporated just because Donald Trump is now living in the White House and this simply is not true. If a new recession is coming Trump and his supporters should want it to happen as rapidly as possible.

In the US we have Trump, and the broad reaction is that he is good for growth, good for credit and bearish for rates. Well a lot of this is now priced in, and we are not leaving significant room for policy error or execution risk. In Europe we have a variety of elections in 2017, but the one that stands out is in France where we have the first round of the Presidential election on 23rd April followed by the deciding second round on 7th May. Polls tell us that the right wing Marine Le Pen will make it into the final round, but will fall at the last hurdle, but can we believe polls anymore? Having heard a few more of her economic plans I am acutely aware of the downside of a Front National victory, with policies such as currency redenomination already being promised. Additionally, we have the real possibility of early elections in Italy where the vote could be even closer, with similar threats of downside issues hanging around Italy’s membership of the Euro should the anti-establishment vote succeed. This was well flagged in the December constitutional referendum, but markets were willing to overlook this in favour of the Trump rally. How long will this persist?

Only those clinging to the illusion that somehow the unworkable structure of monetary union can be repaired, or that Germany will miraculously agree to fiscal union and debt pooling can believe that Greece at some time will not depart the Single Currency. Exuberant investors have focused on the potential benefits of US stimulative tax cuts, while mostly ignoring the risks from America-first protectionism and the erection of new trade barriers. Trump may be able to temporarily hold off the sweep of automation and globalization by cajoling companies to keep jobs at home, but bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces and Whilst they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off. Investors have become hypnotized by all the talk of pro-growth policies, without considering the full ramifications and Trump’s stimulus efforts could prove very inflationary, which would shock investors.

In the week Draghi again said that the Euro Is Irreversible, as Le Pen Urges a French Exit. Europe's unity project is disintegrating at an ever increasing speed. Whatever comes next, there is a toxic debt cycle that is waiting to crash down upon us with a tsunami of financial misfortune, especially with its deeply ingrained sense of privilege and entitlement. Central bank policies in the wake of the last crisis have set up Western Society for a very bad fall. Economic vibrancy among the middle class and general population has been sucked dry, and they are ill prepared to handle a new crunch in credit and the hyper inflationary/deflationary crisis that is coming. As it stands I expect it to be deflationary.

David Scott works for investment Manager Andrews Gwynne


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