Three Canaries In A Coal Mine: The Global Government Bond Bust Is Finally Underway


“The larger the asset bubble,
the less people will see it.”

 


With financial market cyclical downturns occurring nearly every 7 years since 1973 and with portfolio asset ‘downward correlation’ risk increasingly high (even real estate collapsed in 2008-9), I have always been keen to hedging and protecting accumulated wealth.

My own personal investment mantra honed throughout my entire financial services career has been that the best portfolio ‘defense’ against these recurring downward market cycles is to employ a better ‘offense’ (at least for a smaller portion of capital). A holistically prudent strategy yet relatively unconventional in today’s investment world of traditional portfolio construction.

My inherent bias could stem from the fact that I live in Silicon Valley, where the highs and the lows of wealth creation to wealth destruction can be so extreme from one economic and market cycle to the next. The NASDAQ stock market index correlates so closely to everything we do here in the Valley; from our employer’s public or private stock price, to expensive real estate, to venture capital and angel investments, and even to our country club memberships. NASDAQ has historically been much more volatile both to the upside as well as to the downside than most other mainstream stock market indices.

After successfully navigating both the Technology Bust of 2000 and the Housing and Credit Crisis of 2007-9, I began taking inventory of where the next downward cycle might emanate from. Global policymakers were employing arguably the most aggressive fiscal and monetary policies in the history of the world. Regulators were seemingly pulling out all stops with perpetual zero interest rate policies (ZIRP), massive bank bailout and stimulus packages (TARP I, TARP II, P-PIP, TALF, C4C-Cash For Clunkers), unprecedented money-printing schemes (QE I, QE II, QE III, Operation Twist) and other financial acronyms that no one had ever heard of before nor likely ever will hear about again.

By mid 2012, after careful study of financial market research, global economic history, behavioral economics and various investment cycle models, I concluded that unlike prior ‘private sector’ boom-to-bust cycles experienced throughout my lifetime, the approaching cyclical market downturn would be very different.

It became increasingly clear to me that the massive debt and leverage that precipitated the Housing and Credit Crisis of 2007-9 had never went away; it had simply shifted from primarily a private sector problem to an even larger public sector one today.

Harvard economists Kenneth Rogoff and Carmen Reinhart’s notable research on sovereign debt and public sector crises found that they were commonplace throughout history; you just had to look back far enough to find them (see below). In fact, they reasoned that going back as far as early 1800, the current level of central government debt in advanced economies was now approaching a two-century high-water mark.


As I have pointed out in previous commentary and public forums, aggressive fiscal and monetary policies have essentially suspended the free market’s ‘cleansing’ process through perpetual borrow and spend stimulus, zero interest rates and central bank money-printing. This artificial ‘put’ has repeatedly created speculative malinvestment across the capital markets for the past 35 years leading to our increasingly precarious boom & bust economy and markets (see below).

In the end, these unprecedented and unsustainable credit expansionary policies were creating the next major asset bubble, the global government bond market and public sector crisis. With fiscal and monetary schemes of the world’s advanced economies losing their effectiveness and nearing exhaustion, we determined that the next economic down cycle would prove to be both costly as well as significantly longer in duration.

Furthermore, as the global economy continues to deteriorate with policymakers’ boxed into a classic liquidity trap producing little to no economic benefit, the US, Europe and Japan’s government debt to GDP solvency ratios would start to explode even higher. We predicted at the time that an eventual reemergence of the 2011 Euro Sovereign Debt Crisis was highly probable (see below).

 

 

In December of 2012, I founded our private investment firm, Strategic Preservation Partners LP (SPP). The investment objective of SPP’s flagship Strategic Preservation Fund was to offer our qualified investor network the opportunity to protect traditionally managed portfolios by attempting to maximize portfolio returns during global market cyclical downturn ahead. The Fund was established to address the unwinding of the 35-year global credit boom and resulting rising global interest rates, slowing economic growth and an investors’ ‘crisis of confidence’ in government debt and public sector solvency.

We believe that cost-push inflationary pressures (bad inflation) of a weak economy, as opposed to the demand-driven inflationary pressures (good inflation) of a strong economy are likely ahead for the global economy. The high cost of funding ‘government’ itself should put an increasingly challenging strain on the private sector economy and financial markets.

After building my professional team and institutional fund infrastructure, and as global risk markets continued to percolate higher, I became confronted with a most important decision: When should we pull the trigger and begin investing capital against our thesis? After all, my personal investment mantra of playing ‘defense’ through a better ‘offense’ works a lot better when the actual game is imminent!

For quarter after quarter, we had remained extraordinarily patient and disciplined before moving forward with our global macro investment strategy. Bullish stock and bond markets rose steadily higher towards record high while not surprisingly, market volatility and investor fear fell near record lows.

As for the question as to when the next downward cycle would commence, Ludwig von Mises and other Austrian School economists concluded long ago that the end of a credit expansionary era would likely end with major volatility in the global currency markets. SPP noted that over past two years, two of the world’s core economy currencies, the EURO and the Japanese YEN have fallen over 25% relative to the world’s reserve currency, the US Dollar.

Significant moves without a doubt, but even more alarming have been the unprecedented recent number of foreign currency debasements, or currency devaluations, in just the first 6 months of 2015 (see below). This uncoordinated currency ‘Race to the Bottom’ could easily be referred to as a currency war; and currency wars historically lead in the nearer term to an extremely volatile and unstable global financial marketplace.

 

As a result of the above, in late June of this year and over 2 1/2 years since the founding our company, we initiated our first investment positions into the Strategic Preservation Fund LP (SPF). Although our fund is not open to the general public, we believe prudent investors should take note.

We strongly suspect that we are now entering an important change in global risk market trend and investor sentiment. The Greek Crisis has reignited severe economic, political, financial and social strains across the European continent. We view the reemergence of the European public sector crisis as the catalyst to subsequent ‘rolling asset’ global crises in the months and years ahead.

It seems even U.S. central bankers are beginning to capitulate by quietly concurring with our thesis.

 

 

Global sovereign debt busts historically never happen all at once. In fact, it should be noted that although the United States has significant government debt problems, both funded and unfunded, it remains the world’s strongest safe haven destination and ‘least dirty shirt’. As a result, our initial SPF investment allocations will be part of a strategic series of global macro asset transactions seeking to capture the investment opportunities as they arise over time.

What will future history books surmise to be the primary precursory warning signs to the Government Bond Bust of the late 2010s?

In the early days of coal mining, the “Canary in a Coal Mine” referred to an early safety measure taken by coal miners. Early American folklore suggested that coal miners would bring a caged canary into mines to detect any dangerous gas build-ups. As long as the bird kept singing, the miners knew their air supply was safe. A dead canary signaled an immediate evacuation.

That said, several significant and noteworthy events have recently set off warning signs, or major ‘Canaries in a Coal Mine’ that have signaled to us that the end of our global bull market cycle and beginning of the next major market cycle downturn may be imminent.

Here are the top three ‘birds’ for you to consider:

CANARY #1 : GOVERNMENT OF GREECE  (SOVEREIGN DEBT)


“At the end of the day, this whole thing [the Euro and European bailouts] is going bust, I have no doubt.”

Nigel Farage, leader of the UK Independence Party, September 2011
On July 1st, after a near four-month impasse with its creditors, Greece became the first developed country to ever default on the International Monetary Fund in the IMF’s 70 years of formal existence. Safe haven investors who in years past looked for capital preservation in Greek government bonds have witnessed their long term bond values fall nearly 55% over the past 10 months. Greek bank stocks have faired significantly worse.


Despite the recent announcements that a new deal is in the works to keep the country afloat for up to 3 years, rising austerity and social unrest is crushing the Greek economy. With a plummeting Greek stock market (down nearly 50% over the past 18 months) adding to the crisis, the likelihood of a further decline of their local economy and future debt payment challenges is growing by the day.

The risk to the global economy is not simply the collapse of the Greek economy per se, but the risk to regional and/or even global economic contagion. Burgeoning government debt to GDP levels across Spain, Portugal, and Italy along with ultra-high youth unemployment rates provides fertile ground for contagion risk into region. Most importantly, Greece’s Prime Minister Tsipras’ populist Syriza Party is resonating throughout southern Europe as many Europeans struggle with economic hardship and social pressures. Endless austerity, rising taxes and perceived bondholder ‘servitude’ to unelected officials at the IMF, the European Central Bank (ECB) and the European Parliament is rallying Syriza Party ‘clones’ in the election polls throughout the region. Change is underway and financial markets will discount the repercussions long before the actual events manifest into reality.

Broadly speaking, even with the Euro/USD just off a 12-year low, a public sector debt bust is currently underway in Europe. It is likely that history books will look back at the 2015 Greece default to the IMF as a primary ‘Canary in the Coal Mine’ to the onset of the next downward market cycle.


CANARY #2 : COMMONWEALTH OF PUERTO RICO (MUNICIPAL BONDS)

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults. You could see 50 sizable defaults, 50 to 100 sizable defaults, or more…amounting to hundreds of billions of dollars’ worth of defaults.”
Meredith Whitney, former Wall Street    research analyst, December 2010

Meredith Whitney gained public notoriety with investors back in 2007 when she accurately predicted trouble for several major banks including an unanticipated dividend cut at Citigroup prior to the Credit Crisis of 2008-9.

Appearing on CBS-TV ’60 Minutes’ broadcast in late 2010, Whitney boldly predicted widespread defaults within 12 months in the $3 trillion municipal bond market. Although her major market call sparked a wave of institutional and retail selling in the tax-free bond market, she was later discredited, as the bond defaults never fully materialized.

Earlier this week, however, Puerto Rico defaulted on a municipal bond interest payment. It was the first time ever for a U.S. commonwealth. Outstanding Puerto Rican tax-free bonds have been in free fall, with longer-term bonds losing over 25% in value since February. Government officials and many analysts now believe that Puerto Rico is in a fiscal ‘death spiral’ with $73 billion in debt and weak economic prospects. A Puerto Rican debt default would be the largest in the history of U.S. municipal bond market.


Major municipalities across the United States and other parts of the developed world still remain in financial dire straits despite the post-2009 global market rebound. For example, large states such as Michigan, Illinois, New Jersey, Connecticut, Nevada, even California have significant outstanding debt and unfunded pension liability problems. Unlike the Federal government, these troubled state, local and participatory municipalities have no printing press.

When the economic tide rolls out once again as it always does, we will quickly learn which municipalities and debt issuers continue to swim naked. Meredith Whitney may have been early in her ‘apocalyptic’ prediction of a collapse of the tax-exempt municipal bond market – but she may still prove to be right.


CANARY #3 : GEORGE SOROS, BILLIONAIRE INVESTOR AND TRADER

“We are facing an extremely difficult time, comparable in many ways to the 1930s, the Great Depression….The best-case scenario is a deflationary environment. The worst-case is a collapse of the financial system.”

George Soros, January 2012

As a young investor myself too many years back, I learned early to watch what people actually do, as opposed to simply listening what they say.

Legendary investor George Soros is famously known as the ‘Man Who Broke The Bank of England’, profiting nearly $1 billion by shorting the British Pound back in 1992.

Recently, Mr. Soros filed statements that indicated he currently owns $1.1 billion of put options on the S&P 500. George Soros is making a major bet on a major correction (downward market cycle) on the S&P 500 stock index.

Options inherently carry significant risks, including the possibility of losing all of your investment if not properly executed in a timely fashion. George Soros has no crystal ball as they say, but his billion-dollar stock index options bet qualifies as ‘Canary in the Coal Mine #3’.


In conclusion, we are now in the midst of the 2nd longest period in the history of the U.S. stock market (S&P500) without a 10% or more correction (1404 days). US Stock Market In Deep Sleep: Historical Odds Of 10%+ Correction Very High

Over the near term, a significant financial market sell-off is highly likely with the majority of investors and traders now leaning the wrong way as is always the case late in a cycle.

As importantly from a market timing perspective, the bursting-in-progress of the Chinese stock market bubble in the world’s second largest economy is another potentially dangerous catalyst to near term contagion for the rest of the world’s economy and markets.

Longer term, we expect some significant challenges ahead for investors as traditional public sector ‘safe haven’ investments begin to disappear. Southern European government bonds and some regional commercial banks, for example, are no longer perceived to be safe. Anecdotally, wealthy Russians are said to be replacing their traditionally ‘safe’ Russian ruble bank and savings accounts with hard asset Ferrari, Mercedes, BMW, Maserati and other luxury automobiles placed in their garages.

Prior history of government bond busts and public sector crises suggests that tangible, liquid, movable assets may very well become the future of capital preservation investing in the years to follow.

                   “Bull Markets tend to climb the staircase slowly,
while Bear Markets often jump out of the window.”

As a rule, prudent investors need to move assets well before the actual downturn commences, as markets often move at light speed in a panic driven market. In general, although most investors think they ‘ll be smart enough to ‘get out’ before the markets get precarious, in reality very few actually do.

Conservative investors should consider increasing their cash and cash equivalent investment allocation now. When market downturn cycles arrive, cash always becomes ‘king’ as investor liquidity trades at a premium providing tremendous opportunities for those who are prepared.

Aggressive, sophisticated investors might consider investment alternatives that seek to capitalize on market cycle downturns. Strategies could include employing hedge funds, money managers, and/or investment vehicles that take advantage of increasing market volatility through inversely correlated investment strategies.
Kirk D. Bostrom
Chief Portfolio Manager
Strategic Preservation Partners LP

http://sppfund.com

Disclaimer: The views expressed are the views of Kirk Bostrom and are subject to change at any time based on market and other conditions. This material is for informational purposes only, and is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, the author does not guarantee the accuracy, adequacy or completeness of such information.

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