These improved practices meant that emerging markets were not in the eye of the storm in the 2007–2008 global financial crisis, and the subsequent 2009–2015 European sovereign debt crisis. Those crises were mainly confined to developed economies and sectors such as U.S. real estate, European banks, and weaker members of the Eurozone, including Greece, Cyprus, and Ireland.
Yet memories are short. It has been over twenty years since the last emerging-markets debt crisis and ten years since the last global financial crisis. Emerging-markets lending has been proceeding at a record pace. Once again, hot money from the United States and Europe is chasing high yields in emerging markets, especially the BRICS (Brazil, Russia, India, China, and South Africa), and the next tier of nations, including Turkey, Indonesia, and Argentina.
The world is now at the beginning of the third major emerging-markets debt crisis in the past thirty-five years. One critical metric is the size of hard currency reserves relative to the number of months of imports those reserves can buy. This relationship is critical because emerging markets need imports of parts and components in order to generate exports. They need machinery in order to engage in manufacturing. They need to buy oil in order to keep factories and tourist facilities operating. Most major emerging-markets economies, with the exceptions of Russia, China, and Brazil, have less than twelve months liquidity in their reserve positions.
Another key metric is the gross external financing requirement, or GXFR, calculated as a percentage of total reserves. GXFR shows maturing debt as a percentage of reserves in the coming twelve months. Turkey and Argentina are both over 120 percent, which means they have more maturing debt than reserves to pay that debt. GXFR considers both maturing debt denominated in foreign currencies (including dollars and euros), and any current account deficit over the coming year.
Both metrics show a new crisis in the making. The hard currency import coverage for Turkey, Ukraine, Mexico, Argentina, and South Africa, among others, is less than one year. This means that in the event of a developed economy recession or another liquidity crisis where demand for emerging-markets exports dried up, the ability of those emerging markets to keep importing needed inputs would evaporate quickly. Turkey’s maturing debt and current account deficit in the year ahead is almost 160 percent of its available reserves. Argentina’s ratio of debts and deficits to reserves is over 120 percent. The ratio for Venezuela is about 100 percent, which is shocking since Venezuela is a major oil exporter.
These metrics don’t merely forecast an emerging-markets debt crisis in the future. The debt crisis has already begun. Venezuela defaulted on some of its external debt, and litigation with creditors and seizure of certain assets is under way. Argentina’s reserves have been severely depleted defending its currency and it has turned to the IMF for emergency funding. Ukraine, South Africa, and Chile are also highly vulnerable to a run on their reserves and default on their external dollar-denominated debt. Russia is in a relatively strong position because it has little external debt. China has huge external debts, but also has huge reserves, over $3 trillion, to deal with those debts.
The problem is not individual sovereign defaults; those are bound to occur. The problem is contagion. History shows that once a single nation defaults, creditors lose confidence in other emerging markets. Those creditors begin to cash out investments in emerging markets across the board and a panic begins. Once that happens, even stronger countries such as China lose reserves rapidly and end up in default. In a worst case, a full-scale global liquidity crisis commences, potentially worse than 2008.
A full-blown emerging-markets debt crisis is likely soon. It will spread from Turkey, Argentina, and Venezuela to other overleveraged nations, including Indonesia, South Africa, and Mexico. The panic will then affect Ukraine, Chile, Poland, and the other weak links in the chain. The IMF will run out of lending resources and will have to pass the hat among the richer members. But the Europeans will have their own problems and the United States under President Trump is likely to reply, “America First,” and decline to participate in bailing out the emerging markets with U.S. taxpayer funds. At that point, the IMF may resort to printing trillions in special drawing rights to reliquefy a panicked world.
This coming crisis is as predictable as spring rain.
An Asset for All Seasons
From the Black Death in the fourteenth century, to the Thirty Years’ War in the seventeenth century, to the world wars of the twentieth century, gold has been a reliable store of wealth. There is no reason to believe that existential events are no longer a danger.
The reader needs no reminder of the litany of risks present today. The United States is determined to prevent Iran from obtaining nuclear weapons. Iran is equally determined to develop them. Iran’s neighbors such as Saudi Arabia have said that if Iran obtains nuclear weapons, they will quickly do the same. In that case, Turkey and Egypt would follow suit. The choices boil down to a conventional war with Iran or a wider nuclear arms race in a highly volatile region.
North Korea already has an arsenal of nuclear warheads with a yield approximately the size of the Hiroshima atomic bomb, 15 kilotons of TNT, but it has tested larger weapons. It has also developed intermediate-range ballistic missiles (IRBMs) and has tested intercontinental ballistic missiles (ICBMs). Denuclearization discussions are ongoing between the United States and North Korea, yet Trump has made it clear that he will attack North Korea if it advances further toward its stated goal of having a deliverable nuclear weapon that can reach the United States. If the United States does attack North Korea, it is likely that North Korea will unleash devastating force on South Korea, and possibly launch a nuclear weapon aimed at Japan.
Venezuela is a political and humanitarian catastrophe and is approaching the level of a failed state, which could result in civil war, riots, mass refugees, and a cutoff of its oil exports, 3 percent of the world total today. Other hot spots around the world include Syria, Ukraine, Israel and its confrontation with Hamas and Hezbollah, the Saudi war with Iranian-backed Houthi rebels in Yemen, and conflicting claims in the South China Sea.
Natural disasters abound from the extreme flooding of Hurricanes Harvey and Florence to the lava flows of Kilauea on Hawaii. The Ebola virus recently reemerged in the Congo four years after a prior epidemic in West Africa caused ten thousand deaths. Other threats are ubiquitous.
New threats are emerging that are not traditionally geopolitical or natural. These include power-grid collapses, cyberwarfare, hacking, data theft, and misuse of big data, including examples such as Russian interference in U.S. elections. Killer robots, swarm attack drones, and rogue artificial intelligence applications are here or coming soon.
An investor would not be blamed for saying “So what?” The threats mentioned have been festering for years. Going back further in time would produce a different list of threats, most of which never came to fruition. Americans in particular seem safe from the worst of these threats, except for the temporary effects of a bad storm or wildfire in a specific area. To most Americans, these threats are background noise. Complacency rules the day.
Yet here’s an interesting bit of math, somewhat simplified, that might break investors out of their complacency.4 Let’s consider the much discussed “one-hundred-year flood,” which can literally be a one-hundred-year flood like Hurricane Harvey or a metaphorical rare event; a so-called black swan. Let’s call P the probability of a one-hundred-year flood in a known flood zone, and consider the odds of the flood happening or not happening each year in a succession of years. Mathematicians express this situation as:
P(100-year flood) = P(F) = 1% = 0.01
P(no 100-year flood) = P(F1) = 1-0.01 = 0.99
P(no flood for 2 years) = P(F1) • P(F1) = P(F1)2 = 0.992 = 0.9801
P(no flood for X years) = P(F1)X
Therefore, P(no flood for 30 years) = P(F1)30 = 0.9930 = 0.7397
This means that over a thirty-year period, the probability of no one-hundred-year flood is approxim
ately 74 percent, and the probability of one one-hundred-year flood is 26 percent, or more than one chance in four. This math is called a Bernoulli process. It’s a standard statistical formula. The point is that disastrous events with tiny probabilities of happening in a short time span are almost certain to happen over a longer horizon.
Let’s take the above math and consider four separate catastrophes, each equivalent to a one-hundred-year flood, with no correlation to each other. If the odds of each individual event happening in thirty years are 26 percent, the chance of any one happening in the same period is 100 percent. As we consider a longer list of one-hundred-year floods, the time frame of one event happening with 100 percent certainty goes from thirty years, to twenty years, to ten years, etc. In other words, the next one-hundred-year flood is waiting right around the corner.
Real-world experience bears out this math. When we consider recent financial catastrophes affecting U.S. investors only, without regard to other disasters, we have major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000, and 2008. That’s five major drawdowns in thirty-one years, or an average of once every six years. The last such event was over ten years ago. This does not mean you race to your fortified bunker and curl up in a ball. We wake up every morning and face the day. But the crashes mean we need to overcome cognitive biases about the future resembling the past, and calm as a good forecast for the future.
The best way to preserve wealth in the face of an extreme event is with a modest portfolio allocation to physical gold bullion. When the one-hundred-year flood does hit, it’s too late to buy flood insurance. Likewise, when the next financial crisis hits it will be too late to buy gold at today’s prices. The best time to buy flood insurance is when the sun is shining. The best time to buy gold is now, before the wall of complacency crumbles.
Conclusion
The essence of dramatic tragedy is not unhappiness.1 It resides in the solemnity of the remorseless working of things.
—Alfred North Whitehead, Science and the Modern World (1925)
In his embarrassment, all he came to understand was the one reliably sound thing to do with money: spend it on someone else.2
—Lionel Shriver, The Mandibles (2016)
Doomsday Clock
One of the most famous passages in American literature occurs in chapter 13 of Ernest Hemingway’s The Sun Also Rises. The dialogue takes place in a café in Pamplona, Spain, during the running of the bulls.
Bill Gorton, a friend of the protagonist, Jake Barnes, has just arrived from New York. Bill is in the café talking with Mike Campbell, an upper-crust Englishman, now fallen on hard times, but keeping up appearances. In the course of telling a story about his tailor, Mike casually mentions his bankruptcy. Here’s the dialogue:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
“What brought it on?”
“Friends,” said Mike. “I had a lot of friends. False friends. Then I had creditors, too. Probably had more creditors than anybody in England.”
You’ve probably seen variations of Mike’s phrase “Gradually and then suddenly.” It’s often misquoted as “Slowly at first, and then quickly.” The short version is offered as a warning that a slow, steady debt accumulation with no plan for repayment can continue longer than expected, and then suddenly descend into full-blown financial distress and a rapid collapse.
I selected the longer version to give the short quote context. The debtor, Mike, didn’t just go bankrupt. He had a lot of “friends” who relied on him for his generosity and support, with no willingness to pay him back or help him in distress.
He also displayed a lack of control with regard to his financial situation. Most debtors can see problems coming and either cut back spending or take other steps to deal with the debt. Either course brings the situation to a head sooner than later. It’s the lack of control that allows the debtor to reach the point of nonsustainable debt, the “gradually” part, and then have a crisis thrust on him all at once, the “suddenly” part. It’s how the inevitable still comes as a surprise.
This is the situation in which the United States finds itself. The U.S. national debt has accumulated slowly for decades. There is no plan to make it sustainable, just a vague wish that creditors keep expanding the debt or rolling it over. The United States has a lot of “friends,” both at home and abroad, who expect benefits in the form of entitlements, foreign aid, government contracts, or tax breaks. The café scene is complete.
The question is whether the United States is now at the point of suddenly going bankrupt. Of course, the United States won’t go bankrupt; it can print all the money needed to pay off its debts in nominal terms. Yet when does that money printing become necessary?
The “gradually, and then suddenly” dynamic is well known to physicists and applied mathematicians. In physics, it is known as a phase transition. A good example is a pot of water being boiled and then turning to steam. The flame can be applied to the pot for quite awhile with no change visible to the naked eye. The water temperature is rising, yet hot water looks like cold water. Suddenly the water’s surface becomes turbulent and quickly after that the bubbly surface bursts into steam. The water has been transformed. If no more is done, the entire pot evaporates.
In mathematics, the same dynamics are known as hypersynchronicity. That’s a technical term for everyone suddenly doing the same thing at the same time. A run on the bank is a perfect example. A bank run begins with just a few people demanding cash at the teller counter (or the digital equivalent of withdrawing deposits or redeeming money market funds). Soon word spreads, people panic, everyone wants his money back at once, and there’s not enough money to meet the demand for liquidity. This is exactly what happened in September 2008 following the Lehman Brothers bankruptcy. That crisis had been on a slow boil since August 2007, then suddenly in September 2008 the whole world wanted its money back.
I’ve been a Hemingway fan for decades, and have read almost every word he ever published, including letters and incomplete manuscripts, as well as a number of well-researched biographies. I’ve seen no evidence that he took much interest in physics or mathematics. Yet there’s ample evidence that Hemingway was a close observer of human nature and an excellent armchair economist. Hemingway learned an enormous amount about foreign exchange, inflation, and national insolvency as an expatriate reporter living and traveling in Europe in the 1920s. He saw the 1925 French hyperinflation firsthand. As an American with a dollar income, he could live in a decent apartment and afford the best wines in the best cafés because the French franc drastically devalued. His dollars were a natural hedge against franc devaluation. The French themselves suffered the consequences of hyperinflation because they were paid in francs, not dollars.
What if the dollar suddenly became as unwanted as the French franc in 1925?
Consider the evidence that the United States is now dangerously close to the “suddenly” stage of Hemingway’s bankruptcy scenario:
Congress enacted the Trump tax cut in late 2017. This legislation blows a $1.5 trillion hole in the budget deficit. The belief that tax cuts stimulate enough growth to pay for themselves is an unsubstantiated surmise shared by Larry Kudlow, Art Laffer, and few others.
Congress removed discretionary spending caps on domestic and defense spending that have been in place since 2011. At the same time, Congress reinstated “earmarks” that allow members to spend money on pet projects. These two acts add another $300 billion per year to the U.S. deficit.
Student loan defaults are now running at 15 percent per year and student loan volume exceeds $1.6 trillion, far more than the amount of junk mortgages in 2007, and with a much higher default rate. Covering these losses adds another $200 billion per year to federal deficits for years to come.
The U.S. debt-to-GDP ratio is over 105 percent. This is well past the 90 percent danger zone identified by economists Ken Rogoff and Carm
en Reinhart. Once in the danger zone, further borrowing causes growth to decline rather than acting as a stimulus.
Russia, China, Iran, Turkey, and other U.S. adversaries are stockpiling thousands of tons of gold as a hedge against the inflation they expect as the United States tries to print its way out of its nonsustainable debt.
There are other signs that the day of reckoning on the U.S. debt situation is arriving faster than experts believe. Like Hemingway’s expatriates, fiscal policy is characterized by complete indiscipline.
Hemingway’s point was that bankruptcy comes faster than anyone, especially the bankrupt himself, expects. The United States is closer to an inflection point than the Congress and the White House realize. The pot is beginning to boil. The time to hedge against the worst outcomes is now.
Riding the Bull
Seasoned stock investors know how to deal with bull markets. They increase their allocations to stocks, use margin accounts and other forms of leverage, ride out the drawdowns, buy the dips, and hopefully move to cash before the bull runs out of steam.
Investors also know how to deal with bear markets. They rotate into defensive sectors like consumer nondurables and utilities, increase allocations to cash, unwind leverage, avoid catching a falling knife, and wait patiently for clear signs of a bottom before moving back into stocks.
Aftermath Page 30