When the Tide Turns

Governments are fond of referring to their dumping of cash into the economy as stimulus. There has been a huge amount of cash released into people’s bank accounts, and very little economic growth. How little? About 22 cents of GDP for each dollar of “stimulus” --- showing that governments have depleted their tools. They don’t know what to do. They are now sowing the seeds of a huge price inflation, and they don’t seem to care. Instead, they point to that lack of general price increases during this past year, and they have positioned Japan as the poster child debtor nation.

What appears to have eluded their notice is that the volatility of money is approaching zero --- a symptom of the lack of demand for goods and services. People want to save. Many are afraid to spend. So even though production and productive capacity are shrinking as businesses close down permanently, demand is falling even more, and prices have not escalated to the extent the money supply has. Once people feel confident, they will begin spending. Then see what happens to price levels. So far as Japan being an example, first, the Japanese economy has been stagnating for 30 years. Secondly, they owe that money to themselves, not to foreigners, so their very high debt to GDP ratio is not the problem our lower ratio is.

There is a problem developing. Commercial real estate has high vacancy rates. Many companies have come to see that they don’t really need all that office space. Empty buildings do not have the value of fully occupied ones. Prices of commercial buildings are bound to drop, at least in real terms, if not in nominal terms. I expect many of their owners will be in financial trouble and unable to meet their mortgage payments. This will reduce the value of the mortgages. The difference between the selling price of a mortgage and the contractual cash flow from the mortgage payments determines the effective interest rate. The cheaper a series of payments is to buy, the bigger the spread between cash paid for it and cash to be collected from it, and the higher the effective interest rate.

When mortgages can produce much higher yields than bonds now do, what will happen to bonds? Investors will not be willing to pay as much as they are now. So, bonds should fall in price. Makes sense since the bond market is a bubble waiting for a pin to pop it. I suspect that a deteriorating mortgage market will be the pin. This is a major economic problem. The bond market is much bigger than the stock market, and the value of daily bond trades dwarfs stock trades. Falling bond prices means higher effective interest rates. When interest rates rise, more real estate owners will be caught in a squeeze that will wipe them out and precipitate even greater problems in the mortgage and bond markets. As the value of real estate declines, balance sheets will deteriorate and credit will tighten up.

Of course, central banks may decide to buy the mortgages and bonds, thus monetizing the debt. More inflation. More problems. No, it’s not looking good.

It is time to be liquid (in cash or in investments that can almost instantly be converted into cash). Time to consider Warren Buffett’s expectation of a stock market crash. Stock markets will not take rising interest rates very well. Neither will real estate markets. There could be blood in the streets. It’s time now to mend relationships and build new ones.

Who Pays for Our Record Government Largesse?

The Government of Canada presented its Throne Speech today --- about an hour of trying to buy most people’s votes it seems to me. It was like an extended gift opening on Christmas morning. Something for everyone ….. all bought on credit. You can look up the details.

I agree with the Conservative observation, reflecting the comments of the Premier of Quebec, that the federal government is stepping into Provincial jurisdiction. My observation has been that the Liberals do not pay much attention to the constitutional separation of powers. They seem to think they know how to run people’s lives better than the individuals do, and it is reflected into their forays into health care and education.

I do not agree with the Conservative objection that the country will be saddled with debt that will be borne by future generations. The give-aways are funded by borrowed money, but mainly borrowed from the Bank of Canada. It works something like this. The Government issues a debt instrument to the Bank of Canada in exchange for cash. Cash is a liability of the Bank of Canada. So the Government debits Cash and credits Due to Bank of Canada, while the Bank of Canada debits Government Bonds and credits Cash outstanding (a payable). The Cash in the hands of the Government is liquid, and it gets spent. The entry ends up being debit Deficit and credit Cash. The final result is Government accounts that have a debit Deficit balance and a credit Due to Bank of Canada balance. Debt for the next generation? No. What it does is make the Canadian dollar worth less. It is not the future generations paying for the goodies; it’s the holders of Canadian dollars. But since other countries are essentially doing similar things, the Canadian dollar likely will not lose much ground against most major currencies. Where it will lose ground is in terms of how much of various commodities, goods and services it can buy.

If we get into negative interest rates, which will make it easy to handle such foreign debt as we do have, the velocity of money will increase quickly and we will likely have a major price inflation as people spend, spend, spend. The loss in purchasing power of the Canadian dollar could likely be more than mitigated if the country did away with all income tax at every level and funded government solely through the creation of money, sales tax, and fees for services. I suspect the economy would be vigorous as companies moved here and the production of goods and services increased. The retention of income taxes combined with massive amounts of new money and very low, and even negative, interest rates is likely the road to an inflationary depression.

 

Stock Prices Rising as the Economy Slows?

 

Investors are elated at recent all-time highs in the S&P 500: the covid crash has been resoundingly reversed. Hmmm…..not so fast. Microtek, Facebook, Amazon, Apple, Netflix, and Google between them account for about a third of the S&P 500 because those stocks have been doing very well. They have benefitted from the pandemic --- people sitting at home and buying, subscribing, and purchasing from them and their advertisers. Easy to do when there is so much new cash on the loose. So hard have they moved the S&P 500 that we may as well think of it as the S&P 6. The other 494 stocks as a group have not had the same recovery. About half the stocks that comprise the Dow Jones Industrial Average are tech stocks, so it has done well also. 

I think that eventually, people will wake up to realize that a P/E ratio of 33 for Facebook, 80 for Netflix, and 119 for Amazon may be unwarranted. Yeah, when customers of each of these companies could be numbered only in the millions, it may have made sense to anticipate the kind of growth in earnings that would justify such large P/Es, but once you have half the world’s population as your customers, does it make sense? How much higher can your customer base grow then? Or, maybe you think that existing customers will start spending a lot more. Maybe they will. Or even more likely, maybe they will tighten their belts as the economy contracts. Once government covid subsidies cease and businesses are footing their own payroll burden, watch for huge layoff numbers. It is already happening, even with the subsidies. The disparity between a slowing economy and a rising stock market will disappear as they align for the trip down. At least that is my expectation.