The Real Economy Cannot Support the Financial One – A Way To Play Coming Defaults

Quotable

“In skating over thin ice our safety is in our speed.”

Ralph Waldo Emerson

Commentary & Analysis

The Real Economy Cannot Support the Financial One – A way to play coming defaults

If we assume financial assets represent a claim against real assets, then it’s not a stretch to say financial asset valuation is way out of whack relative to the real economy.  Consider these numbers, globally, five years after the credit crunch as discussed inShadow Dancer Part II:

  • Government debt increased $30 trillion (+65%)
  • Central bank balance sheets have grown by $10 trillion (+150%)
  • Private debt increased $22 trillion
  • Stock market capitalization increased $26 trillion (84%)

Total increase in financial assets = $88 Trillion

  • Global GDP increased $8 trillion

Total increase in real assets = $8 Trillion

Claims on real assets have increased 11:1 ($88T divided by $8T) since governments and central bank began providing stimulus. [Source: Leto Research]

The winners in this game have been holders of financial assets. This is not a surprise.  In fact, the Fed wanted to push up financial asset values in order to stimulate demand through the so-called “wealth effect.” The problem is the “wealth effect” is a myth.  It does not stimulate demand; it instead enriches those who own financial assets to the relative detriment of those who own only their labor.

“During the run-up of stock and home prices over the past three years, the year-over-year growth in consumer spending has actually decelerated sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2.”

Van R. Hoisington & Lacy H. Hunt, Ph.D.; Q3 2013 Review & Outlook

                                   Source: Hoisington Economic Research 

So if the “wealth effect” is as mythical as it seems to be, and real economy growth continues to stagnate, or possibly reverse, one would expect the huge increase in claims against the real economy will be extremely difficult to pay back.

Therefore, I don’t think it is a stretch to expect lots of defaults and bankruptcies if this trend is not turned around quickly.  And I don’t see much on the horizon to be optimistic about a quick turnaround.  So, maybe a good trade for those who believe there is a rising probability of lots of future defaults, as I do, would be to pair junk bonds (short) against US Treasury bonds (long)…let’s take a look at what happened to these two assets classes (using two exchange traded funds) during the credit crunch as an analogy:

JNK (Junk bond ETF) 3/17/08 to trough 3/9/09 = down 40.4%

TLT (20-yr+ Treasury ETF) 3/17/08 to peak 12/19/08 = up 27.6%

Net difference = 68%

Granted, we aren’t going to pick troughs and peaks without the gift of hindsight. But you can see clearly this was a good trade idea during the credit crunch.  Just think how good it might be during another crisis knowing what we now know: the government and Fed cannot get the economy moving again by increasing the burden of claims against the real economy.  The market must clear.  And if it does, the process of clearing likely means lots of defaults and big money stampeding into Treasuries as the only place to hide.