Global Financial Crisis 2.0

Back in 1992, George Soros successfully broke the Bank of England by launching a massive speculative currency attack against the British pound. The resulting collapse forced the British government to pull the pound from the European Rate Mechanism (ERM).

Fast forward 24 years, and another speculative attack against a currency is building. And this one could leave the global economy in shambles.

You see, China has been struggling to contain an economic downturn that risks forcing the country to make choices its leaders are completely unprepared to make. But any failure on the part of the Chinese leadership to act could lead the country into a crisis that dwarfs the American financial crisis of 2008.

And evidence of the gathering storm is growing as Wall Street speculators are betting heavily against the Chinese renminbi – bringing to mind the British crisis in 1992. Recent filings indicate hedge funds are making significant bets that will pay enormous dividends if the yuan and the Hong Kong dollar fall over the next couple of years.

This has led some speculators to suggest the Chinese currency could plummet by as much as 40% over the next three years. While that seems overly pessimistic, it’s likely we’ll see devaluations of at least 15-20%. In either case, such a devaluation would be catastrophic for the global economy.

You see, any such move by the Chinese will inevitably guarantee cheaper Chinese goods flooding the globe. This will lead to pressure on Emerging Markets (EM) to devalue their own currencies in an effort to compete. From there, it’s a race to the bottom.

The bottom line is that there is a price to pay for Keynesian foolishness. China allowed its total debt load to swell to 280% of its GDP in an effort to bring prosperity to the masses. And all they have to show for it are millions of empty apartments and other unused capital assets.

They have no choice but to devalue. The alternative is politically unthinkable. The only question that remains is to what extent their folly decimates the world economy.

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Can the Fed Really Raise Rates?

Most Wall Street pros expect to see the Fed Funds rate rise between 300 and 375 basis points over the course of the next couple of years. At least that’s their belief…

The problem, though, is that it’s complete gibberish.

You see, the Fed front loaded an historic market rally beginning in March 2009. The financial mismanagement of Ben Bernanke and Janet Yellen was a concerted effort to create a wealth effect.

Unfortunately, their combined efforts have been an abysmal failure.

Here we are six years later and economic growth remains tepid at best – earning this recovery the title of most sluggish economic recovery in history. Worse, the current business cycle is now at 78 months. This is longer than 29 of the 33 previous expansions after a recession since 1854.

And the data indicates this expansion is on its last legs, as illustrated by the Atlanta Fed’s GDP NOW chart below…

A-gdpnow-forecast-evolution

Sans a miraculous turnaround in economic data, the U.S. economy is clearly heading for recession. And the Fed is completely helpless to stop the progression.

You see, the Fed has no ammunition at its disposal. Despite the recent rate hike, the Fed has no real room to lower rates. Now, they could go forward with negative rates like much of Europe, but there’s no reason to expect the Fed would fare any better than the ECB at generating economic activity.

No, the Fed is utterly impotent.

So what does this mean for investors?

A market selloff is in the cards in the very near future.

The markets are heavily priced. They are trading at roughly 19 ½ times earnings without any organic ability to grow their top or bottom lines.

It’s a recipe for disaster.

At best, the markets will trade flat for the next year. But believe me when I say that’s a best case scenario. A more likely scenario calls for the S&P 500 to see a 10-20% correction by 2Q2016.

But that doesn’t mean it’s time to flee the market.

You see, for the first time in several years, investors will be required to conduct real fundamental analysis when picking stocks. An accommodative Fed policy will no longer raise all the boats in the harbor.

In the end, that’s the way it should be. Price discovery depends on free and open markets without insulated government bureaucrats muddying the waters of economic discovery.

Don’t get me wrong, the Fed will continue to lead most people astray – it’s what they do best. And sadly, most Wall Street analysts will continue following the Fed right off the cliff.

But investors courageous enough to use fundamental analysis to find fairly priced stocks of companies growing their bottom lines will achieve lasting success.

Good hunting…

Fracker Defaults on the Rise!

A few short months ago, we warned our readers that a wave of defaults would be emerging from the oil fracking industry.

You see, fracking projects make economic sense when the price of oil stays above $60 to $65. But anything below $60 a barrel for oil and the projects become significantly less economically feasible.

In our initial report, we stated the opinion that it would take upwards of a year for our thesis of greater defaults in the fracking industry to play out. In the meantime, we expected many frackers to expand production successfully while at the same time making deep cuts in spending.

It turns out we were spot on with our analysis.  But we went on to say that production gains would be nothing more than a delay of the inevitable without a quick reversal in oil prices.

Now that oil prices remain near $35/barrel, even the most cost efficient firms are having significant trouble staying afloat. Growing numbers of bankruptcies are starting to emerge and many more are on the way in 2016.

In fact, we estimate that total losses could exceed $1 trillion this year alone.

Unfortunately, the pain is just beginning and it will not be contained to the energy sector. About $99 billion in face value of high-yield energy bonds are trading at distressed prices, according to Bloomberg Intelligence analyst Spencer Cutter.

The Bank of America-Merrill Lynch U.S. High Yield Energy Index has given up almost all of its gains since 2001. And with yields reaching their highest levels relative to the broader market in more than a decade, it’s easy to see further deterioration in liquidity, which will put some banks in significant distress before all is said and done.

Prudent investors can avoid some of the upheaval by avoiding high-yield bonds and financial stocks with exposure to frackers.

702(j) Plan for Retirement?

The internet is full of crackpots and knaves.

And this is especially true of financial newsletter writers attempting to grow their subscription lists by giving misleading or downright fraudulent investment advice.

My inbox has been deluged of late by several newsletter writers advancing the idea of a retirement plan based on the Tax Reform Act of 1986.

The writers are calling these plans by several names, such as the “770 Plan,” “702(j) Plan,” or “Income for Life.” Of course, there are no such plans in existence. These writers are simply attempting to prevent potential subscribers from searching google for the tax code reference (U.S. Tax Code Title 26 Subtitle F Chapter 79 Section 7702: Life Insurance Contracts).

In short, a 7702 plan is a life insurance contract. More specifically, it’s a life insurance policy in which a death benefit is combined with a living benefit (savings account). The plans are known as whole life insurance.

Now, by definition, whole life insurance policies are not investments. It is a violation of insurance laws to call any life insurance product an investment or retirement plan. Just ask Prudential Insurance Company of America which was forced by regulators to pay $2.7 billion in restitution to more than a million customers. What were Prudential agents doing?

They were selling whole life and universal life insurance policies as retirement plans. And to convince buyers to take action, the agents used policy illustrations that projected outrageous interest and dividend accumulations as foregone conclusions (insurer dividends are paid only by mutual insurers and are not equivalent to stock dividends). In the 80s, it wasn’t uncommon to see agents use policy illustrations showing potential returns of 12% – 15% on a life insurance policy. It was patently absurd.

To fight this type of fraud, a whole slew of laws were passed more than a decade ago to prohibit insurers and agents from selling life insurance as an investment or retirement plan. Today, any agent or insurer engaged in any such activity is violating the insurance code of every state.

At this point it’s important to draw a distinction. I’m not saying there are no legitimate uses for whole life insurance to provide income in retirement. Like other financial products, life insurance is a tool in the bag of a financial professional to accomplish specific goals of an individual or business.

But, there is no whole life/universal life insurance product sold in the United States that can be called a retirement plan or investment. No exceptions. Period.

So this begs the question…

How are these newsletter writers promoting a life insurance policy as a retirement solution?

To answer that question, you must have a basic understanding of how a whole life policy works (a universal life policy works almost identically with a few exceptions that aren’t relevant to our discussion).

A whole life policy consists of two components – a death benefit and a living benefit.

A death benefit pays a sum of money to a beneficiary in the event of an insured’s death. The cost of the insurance protection is based on the insured’s age at the time the policy starts. Whole life insurance is relatively expensive (about 450% – 600% more expensive than term life insurance).

The living benefit is nothing more than a savings account attached to the policy. The policy is designed so that the cash value will be equal to the face amount of the policy at age 100 (the maximum age for life insurance).

This means that if an insured survives to age 100, an insurance company will write a check for the face amount of the policy. For example, a 45-year old man buying a $500,000 whole life policy will receive a check for $500,000 should he survive to age 100. The policyholder will owe taxes on the amount of the payout that exceeds the cost basis of the policy.

As you might expect, the interest grows relatively slowly over the life of the policy. Insurers contractually guarantee minimum interest rates in the policy, but they rarely exceed 2% – 4%. Interest credited to the account is tax deferred similar to interest accruing in a qualified retirement plan such as a 401(k) or IRA.

In addition, policyholders can ‘borrow’ the cash value at any time. The policyholder can use this money for any purpose without regard to taxes. This is because borrowed money is not taxable. On the other hand, if the policyholder fails to pay back the loan with interest, the amount of the loan in excess of the cost basis is taxable. If a policyholder dies before paying the loan back, the insurer will pay the beneficiary the face amount of the policy less the loan amount and any accrued interest.

Of course, the odds of a man living to age 100 are not very good. So if the insured should die before age 100, the insurer will pay the beneficiary the face amount of the policy – $500,000 in the example used above. Death benefits on a lump sum distribution from life insurance are not subject to income taxes. But if a beneficiary chooses an alternative payout (i.e. interest only or period certain), the interest portion of any payout would be subject to tax.

Now, when average Americans buy whole life insurance, they do so on a forward basis. By this, we mean the agent helps identify the amount of insurance protection an individual needs and designs a policy around those needs. The agent attempts to provide the maximum protection based on the insured’s ability to pay premiums.

Here’s where newsletter writers diverge from the norm…

You see, they promote the purchase of life insurance on a reverse basis. That is, they advise buying a whole life policy based on the amount of premium an individual can pay with no regard to the face amount of the policy. It is most commonly done by businesses and older wealthy clients.

Here’s how the plan works…

An insured makes large payments into a whole life policy for between five and ten years on average. We’re talking about large payments that frequently range from $5,000 to $50,000 annually.

To keep the policy legal (as an insurance contract), an insurer must provide a death benefit commensurate with the annual premiums. For example, a 60-year old man could deposit $50,000 with an insurer. To avoid the deposit being treated as an investment under current law, an insurer would have to provide a death benefit to the insured.

In this case, the death benefit might be roughly $600,000 depending on the health of the insured. So the insured immediately owns a whole life insurance policy of $600K with an instant cash value of some $43,000. The policy will mature 40-years later at age 100.

Now, you might ask why the savings account doesn’t have the full $50,000. The answer of course is agent commissions and the cost of the insurance protection.

But the policyholder now has $43,000 that will grow tax deferred. In addition, the policyholder could borrow the money from the account without incurring a tax liability. Should the owner borrow the entire $43,000 of cash value and fail to repay the loan, no tax liability would be incurred because the loan proceeds are less than the cost basis ($50,000).

In future years, the owner could make additional payments. After five or more years of additional payments, including earned interest and dividends (mutual insurer only), the owner will likely have a policy with a cash value equal to or greater than the amount deposited.

In addition, the face amount of the policy will also be higher to maintain compliance with the modified endowment contract rules (7-Pay Test). These are the rules that the Tax Reform Act of 1986 created that require equilibrium between cash values and death benefits in whole life insurance.

Of course, the policyholder can borrow the cash value while alive without incurring a tax liability. But remember, should the loan not be repaid, taxes will be owed on any loan proceeds in excess of the cost basis. In the event of death, a beneficiary would receive the face amount of the policy less any loans and accrued interest.

At the end of the day, whole life policies are tools for accomplishing specific financial planning goals. But whole life policies are wholly inadequate for retirement planning. The costs make these plans financially inefficient. They weren’t designed to fund a retirement and make a poor substitute in doing so.

Life insurance was developed as a method of transferring risk of premature death. Any calls for using whole life as a retirement plan are short-sighted and potentially illegal. Run, don’t walk from anyone espousing these plans as a way to get rich in retirement on a tax-free basis.

Junk Bond Selloff

High Anxiety Liquidity Trap: Selloff in Junk Continues, Follows Largest Drop Since 2011 on Friday

In financial markets, rot starts at the periphery and spreads to the core. For weeks, rot has been visible in the junk bond market and that rot has deepened sharply recently.

JNK – Barclays High Yield ETF

HYG – iShares iBOXX High Yield Corporate Bond Fund

Liquidity Trap

A potentially destabilizing run on junk debt has weighed on the bond markets. Investors in one fund are totally locked out of redemptions. Effective yields have soared.

Please consider The Liquidity Trap That’s Spooking Bond Funds.

The debt world is haunted by a specter—of a destabilizing run on markets.

Last week, this took on more form even if there weren’t concrete signs of panic. Only one mutual fund manager, Third Avenue Management, has said it would halt redemptions to forestall having to dispose of assets in a fire sale. The rest of the industry has been quick to say that while redemptions are elevated, particularly in high-yield bond funds, there doesn’t seem to be a rush to for the exits.

Goldman Sachs, for one, put out a note Friday warning Franklin Resources “is most at risk” given the large high-yield holdings of its funds, poor performance and large outflows. On Friday, its shares fell sharply. Meanwhile, there were unusually large declines Friday in the value of exchange-traded funds that track high-yield debt.

The idea of a “run” on mutual funds might sound strange. Typically, runs are associated with highly leveraged banks engaged in maturity transformation, funding long-term loans with short-term debt. Nearly all the programs designed to avoid destabilizing runs—from deposit insurance to the Fed’s discount window to liquidity requirements—are built for banks.

But unleveraged investors, including mutual funds, can also give rise to runs. That is because there is a liquidity mismatch in mutual funds that hold relatively illiquid assets funded by investors entitled to daily redemptions.

Similar to what can happen in a bank run, investors in open-end funds holding relatively illiquid assets have an incentive to withdraw early to avoid being last out the door.

The problem is potentially more acute when it comes to funds that invest in corporate bonds, which don’t trade frequently, as opposed to stocks. That is an even greater concern today given questions about bond-market liquidity.

Mutual-fund fragility was highlighted in a speech last year by then-Fed Governor Jeremy Stein and a related paper prepared for a Fed policy forum. Mr. Stein noted fund managers were likely to sell more-liquid holdings to meet the earliest redemptions. This leaves remaining investors even more exposed to illiquid bonds.

Panic Early

The message here is clear. If you are going to sell be the first. In short, panic before anyone else does.

That advice is especially important for junk bond ETF holders as managers tend to sell liquid issues first, presumably holding the most illiquid and likely junkiest of junk on the books.

High Anxiety

Why Now?

It is absurd that CCC-rated debt, right on the verge of default would ever yield as little as it did. In regards to that point, I have noted the bubble in junk bonds numerous times over the past couple years.

Why this took so long to sink is anyone’s guess, but undoubtedly the FED’s QE played a part.
Bubbles nearly always go on longer than one might think.

But here we are. And here’s another important point, equity selloffs frequently begin with bond market dislocations or deteriorating equity-market breadth.

Be forewarned. Today we see both, at a time the stock market is more overvalued than ever.

In regards to point one, the Fed after warning about “Macroprudential Tools”, does not even realize QE and interest rate policy are the bluntest of blunt instruments, both prone to bubble-blowing episodes. Once bubbles get big enough or attitudes change enough, tools no longer work. And the opposite tool (in this case ending QE and hiking rates) might have an oversized effect.

In regards to point two, Fed timing could hardly be worse, but the only alternative is even bigger bubbles that would pop on their own accord anyway.

Mike “Mish” Shedlock