There are certain words of wisdom that will forever endure the test of time; and my father’s landmark West Coast speech of 1970 is a prime example.
Elisabeth and I had just married a few months earlier. We went along to help as best we could. And like all those who attended, we were spellbound.
Over 500 pre-registered investors crammed into the Los Angeles Hilton ballroom, on the edge of their seats the entire time.
A crowd of non-registrants lined up in the hallway, as Elisabeth hurried to accommodate as many as she could. My job was to provide the research, take the pictures and tape the proceedings.
The topic was debt and deflation. The conclusion:
"In moderation, debts alone will not hurt us. They are not evil per se. They can help finance growth.
"Deflation alone is also not something to fear. It can make every dollar in your pocket more valuable; everything you buy more affordable.
"What we must avoid at all costs, now and in the future, is a situation in which both elements — dangerous debts and deep deflation — come together. That will be the day when everything we’ve achieved or strived for as a nation will be in jeopardy; when our economy, our government, our entire society will be turned upside down.
"It is a rare occurrence. In my lifetime, I’ve seen it only once. But when it does happen, watch out. Chrysler, already borrowing too heavily, will fail. Hundreds of America’s savings and loans will go under. Big banks will blow up. Cities, states, even entire countries, will default, restructure their debts or announce a de facto default by officially devaluing their currencies.”
In sum, the formula for tragedy was: Deflation + Debt = Disaster.
And it has played out over both shorter and longer time horizons.
Chrysler got into trouble almost immediately but didn’t sink to the brink of bankruptcy until 1979, avoiding failure thanks to a $1.5 billion government bailout. And it wasn’t until nearly our 40th wedding anniversary, in 2009, that Chrysler and twenty-four of its subsidiaries formally went under, filing a petition with the federal bankruptcy court of New York.
Meanwhile, Dad’s forecast of a savings and loan debacle didn’t come true in a meaningful way until the 1980s: Between 1980 and 1991, nearly 1,200 S&Ls went under — including giants like Lincoln, Silverado, Midwest Federal and Home State Savings Bank … precipitating statewide shutdowns of state-chartered banks in Ohio, Maryland and Rhode Island … and infecting the commercial banking sector, where another 1,500 institutions failed.
The first major municipal debt crisis didn’t strike until about five years after Dad’s L.A. Hilton speech, when New York City nearly went under.
How close did it come to outright failure? asks The New York Times in its retrospective of the crisis. "So close that the city’s lawyers were in State Supreme Court filing a bankruptcy petition. So close that police cars were mobilized to serve papers on the banks.”
Dad’s forecast of major sovereign debt crises couldn’t go wrong: India in 1972, Chile (1972, 1974 and 1983), Turkey (1978, 1982), Argentina (1982, 1989, 2001, 2014), Mexico (1982), Brazil (1983, 1986, 1990), and Russia (1991, 1998).
One big event was not in the L.A. Hilton speech. Nor was it ever one of our forecasts.
On August 15, 1971, President Nixon walked into the Oval Office, sat before a national TV audience and effectively devalued the U.S. dollar.
And this single event — the Nixon Shock — helped create persistent inflation, allowing thousands of indebted corporations and governments to reduce the value of their debt payments and avoid what otherwise might have been closer encounters with financial Armageddon.
Listen carefully to Nixon’s words that shattered the U.S. dollar’s age-old link to gold, demolished the world’s most important currency pact, and set off a decade of inflation.
But then fast-forward nearly 45 years to June 13, 2016. And take note of how radically our world has changed:
Radical change #1. Instead of fighting inflation, all major central banks are doing everything in their power to create inflation, but failing to do so. Their target is typically 2% yearly increases in consumer prices. But with rare exceptions, they have woefully missed their target year after year, struggling to keep inflation over 1%.
Radical change #2. In the 1970s and early 1980s, surging interest rates were the most painful plague, hitting big borrowers the hardest. Today, it’s near-zero interest rates that are the cash-flow curse, this time impacting lenders, investors and savers.
As Mike Larson pointed out last Tuesday, savers seeking safe yield are now being treated no better than zombies pursuing eternal life after death.
And he does not mean that just figuratively: "The finance arm of Toyota Motor," he informs us, "just sold a three-year, unsecured note with a yield of 0.001%. If that was your yield on a savings account, you would double your initial investment in approximately 69,300 years."
In other words, if you could have bought that investment 35,000 years before the last Ice Age began, you’d be close to getting there just about now.
What Mike finds even more astounding is that the average yield to maturity of all outstanding German government debt is now below zero, while investors are now being asked to buy newly issued Swiss bonds with a coupon yield of exactly ZERO.
Radical change #3. Both of the above changes are prima facie evidence that the powerful deflationary forces my father feared decades ago are now finally here — in aces and spades.
The deflationary forces explain why impotent central banks can’t get prices up.
They explain why savers are getting shoved to the ground … or corralled into high-risk yield.
And they also help solve the mystery as to how central banks can print massive amounts of money with apparent impunity — without the usual inflationary consequences.
Forty-six years ago, we could never have dreamed this could happen. But kudos to Larry Edelson for his courage to defy conventional wisdom, warn us this unique scenario was coming, and explain it as it unfolded.
(For just one of many examples, see "Myth #3: Hyperinflation is the end result of money printing" in Larry’s year-end 2013 commentary, 5 Investing Myths to Ignore in 2014.)
Radical change #4. America’s debt burden is now dramatically larger:
- U.S. interest-bearing debts: $45.7 trillion as of March 31, 2016.
(Want proof? Go to the latest summary tables of the Fed’s Flow of Funds. Scroll down to page 5, "Debt Outstanding by Sector." Then check out the number in the last line of the first column, for 2016 Q1.)
- U.S. government contingent liabilities — for Social Security, Medicare, veterans’ benefits and more — is, conservatively, more than $37 trillion, according to former U.S. Comptroller General David Walker. And with less conservative assumptions, the number is far larger.
Years ago, Mr. Walker was among the few warning that these can be nearly as problematic as outright debts. Today even organizations like the International Monetary Fund have recognized that they are a "hidden fiscal risk.”
- Even more hidden from view are big leveraged bets under the rubric of "derivatives," a close cousin to outright debt obligations. Like bets with bookies, if you lose, you’re obligated to pay, and those obligations are a form of debt.
Total net outstanding derivatives contracts held by U.S. commercial banks: $203.1 trillion, also as of March 31, 2016.
Source: U.S. Office of the Comptroller of the Currency (OCC) Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2015, page-one Executive Summary, paragraph 4. Plus, for a list of banks with the most exposure, go to page 26, "Notional Amount of Derivative Contracts, Top 25 Commercial Banks.”
Grand total U.S. debts of all kinds: $285 trillion.
Radical change #5. In the race for debt, other countries have followed — and now greatly surpassed — the United States:
- Global interest-bearing debts: Close to $250 trillion. Source: International Monetary Fund.
- Global derivatives: $518 trillion. Source: Bank of International Settlements. (Add their total for over-the-counter derivatives, 492.9 trillion to their total for exchange-traded futures and options, $25.1 trillion.)
- Global contingent liabilities: Unknown, but surely massive, given the overwhelmingly burdensome pension and health care liabilities of Japan and most E.U. countries. My rough estimate: $202 trillion, based on the conservative assumption that, in proportion to their interest-bearing debts, theirs is no larger than ours.
- Grand total for entire world: $970 trillion.
Even adjusting for inflation and taking into consideration the growth in the global economy, these debts are many times more burdensome today than they were 45 years ago.
Excluding derivatives and contingent liabilities, the $250 trillion global debt figure I cited above is more than triple global GDP (321%, to be exact).
Worse, if you include all forms of debt, the grand total comes to $970 trillion, or more than 12 times GDP (1,247%).
When Dad was giving his memorable speech 45 years ago, anything above 100% of GDP was unthinkable. Now, just the U.S. government’s officially counted, interest-bearing debt alone is over 100% of GDP.
Emerging-Market Debts Ready to Blow Up
Last fall, I was in Russia, including their deep south. I’ve also spent a good amount of time in Brazil and China recently. And, in each case, I’ve seen vividly the collision course they’re on:
In Russia, private sector debt has surged to almost 75% of GDP, including both corporations and households. While I was there, I met few people who had been laid off. But nearly everyone I know is suffering directly or indirectly from salary cuts. One good friend, an emergency-room doctor in Samara for over 40 years, says her meager salary has already been slashed twice. Another, who works in the federal court of St. Petersburg, has suffered a similar fate. Giant oil companies are on the brink. Big banks are next.
In Brazil, private sector debt recently hit a new high of 95% of GDP. As long as incomes continued to grow, no one batted an eyelash. But right now, incomes are sinking fast. The malls we’ve visited have been deserted. The entire economy is contracting at the fastest pace in over a decade. And the recent vote to start the impeachment of the president threatens to make everything many times worse.
China tops both Russia and Brazil, with private debts now up to a red-hot default-prone level of 185% of GDP. In other words, for every dollar of goods and services produced in all of China, the country’s corporations and households have $1.85 in debts outstanding.
Plus, all three countries have one huge additional problem: The value of their currencies has fallen, and in the first two, even crashed. This means that any debt payments they have to make in U.S. dollars (or euros) are taking an even bigger chunk out of their shrinking incomes.
Will federal governments come to the rescue?
Don’t count on it. Most emerging markets and advanced countries have already exhausted all the monetary and fiscal weapons in their arsenal — and then some.
They’ve already cut interest rates — often to zero. They’ve printed money up the wazoo. And they’ve already run down big chunks of their foreign currency reserves.
Moreover, the governments of the world’s largest economies have done absolutely nothing to reduce their own government debt:
At the latest reckoning the debt load of the U.S. government, even excluding all the uncounted extras, was 105% of GDP. Belgium’s was 107%; Portugal’s, 128%; Italy’s, 133%; and Greece’s, 197%.
Worst of all, Japan, the world’s granddaddy of government debt, was up to a death-defying 246%, or more than double the levels of notoriously debt-buried countries like Ireland, Spain, Cyprus and Ukraine.
Some people ask …
"If this is truly such a big deal, why
aren’t more people talking about it?"
Our response: Which planet are you living on?
The U.S. Federal Reserve, for example, implicitly forecasts inflation/deflation with its "Five-Year Forward Breakeven Inflation Rate."And as Mike pointed out back in January, it had sunk to below the lowest level of the Great Recession. Now it’s even lower.
One month later, the OECD warned that "trade and investment are weak"… "financial instability risks are substantial"… and a massive government response is "urgently needed.”
In April, the IMF warned about global growth that’s "too slow for too long.”
And just last week, The World Bank again downgraded its global growth forecast, citing "an environment of anemic growth … mounting risks, and a further slowdown in major emerging markets."
Regardless of what you may think of these organizations, how can anyone say "no one told us"?
The clincher was the jobs report that was released exactly 10 days ago. As Mike summarized that same afternoon …
- Our economy added only 38,000 jobs, or not even close to the "expert" estimates of 160,000. They were off by more than 76%.
- The Labor Department slashed April’s previously reported gain to 123,000 from 160,000 and March’s number to 186,000 from 208,000. That confirmed a marked slowdown in job growth from late 2015 and 2014.
- Job losses were not concentrated in any one sector. Manufacturing lost another 18,000 … mining lost 10,000 … construction lost 15,000 … and temporary help lost 21,000.
- The size of the American workforce plunged by 458,000, while the labor force participation rate dropped another 0.2 percentage points to 62.6%. That means over 37% of workers have now given up looking for jobs and dropped out of the labor force.
This is the uglier underside of the trends I have told you about here. So is the ever-more challenging quest for safe yield.
But it certainly doesn’t mean you have to be among those afflicted by the debt-and-deflation diseases of our time. The formula for safety — and success — in these times starts with these three steps:
Step 1. Continue to build your cash hoard.
Step 2. Follow our prescriptions for prudent hedging.
Step 3. And if you can afford some investment risk, carefully consider the unusual opportunities our editors recommend.
Good luck and God bless!