Aftermath

by James Rickards

  The one condition investors don’t know how to deal with is the situation we have now. Consider this recent tale of the tape.

  The Dow Jones Industrial Average started 2018 at 24,719 and ended March 2018 at 24,103, a modest 2.5 percent loss. If that’s all the information you had, you might assume that not much had happened. Of course, investors know otherwise.

  Stocks went on a tear in January 2018, rising over 7.6 percent before hitting an interim high at 26,616 on January 26. Then the stock market party, which had been going strong through all of 2017, suddenly came to an end. Stocks plunged 12 percent to 23,446 intraday by February 9, a full-scale correction, the first since 2016.

  Then a recovery rally took the Dow up almost 10 percent to 25,760 on February 27, 2018. This was quickly followed by another drawdown, this time a 6 percent decline to 24,270 on March 2. The Dow bounced back almost 5 percent to 25,415 on March 12, only to suffer another 7.4 percent decline to 23,533 on March 23. Then the Dow staged a modest recovery to 24,103 to finish out the first quarter.

  The year 2018 ended with an even more extreme performance, including the “Christmas Eve Massacre” (Dow down over 650 points), and a Boxing Day gain of over a thousand points in the next trading session. Even this overview does not tell the full story. In the course of these rallies and drawdowns there were attempted rallies and minicrashes, including a series of five-hundred-plus point intraday rallies and skids. Volatility surged.

  What happened?

  Investor uncertainty is part of the answer. Markets can adjust to good news and bad news, but have no easy way to price true uncertainty. Still, there’s more to the market’s behavior than that. The factors affecting the market are not only uncertain, they are contradictory. The market is attempting to discount multiple inconsistent stories with no easy way to reconcile the inconsistencies. The market rallies or falls day to day based on rumors, tidbits, and tweets, with no more ballast than that to steady the ship.

  There are four major factors driving the market. The factors are growth, trade wars, geopolitics, and technology regulation. Each of the four factors has its own internal contradictions, in effect a binary outcome for each factor. This means there are sixteen possible paths the market might follow (24 = 16). It’s unsurprising that markets are confused.

  With regard to growth, the bulls expect a boost from the Trump tax cuts. They are also anticipating inflation due to strong job creation, rising labor-force participation, and a low unemployment rate. They expect interest rates to rise, yet consider this more a sign of economic strength than a cause for concern. Strong growth is good for corporate earnings, and a little inflation is usually good for nominal stock prices, at least in the early stages. The bull case for growth is a curious mixture of the Phillips Curve and the Laffer Curve.

  Bears point to an economic slowdown in the fourth quarter of 2018. This is consistent with the dismal average of 2.2 percent growth since the end of the last recession in June 2009. Stronger growth is impeded by demographic and debt headwinds and the impact of Chinese labor and technology on global pricing power. Tax cuts are not expected to help because the drag on growth caused by increased debt outweighs the stimulus from lower taxes.

  The Fed is giving a weak economy a double dose of tightening in the form of rate hikes and the unprecedented destruction of base money as they unwind QE. The Fed pushed the economy to the brink of recession before they got the message and paused rate hikes. This bearish view combines the Reinhart and Rogoff thesis on debt death spirals, with a return visit to the Fed policy blunders of 1929 and 1937.

  The trade wars are another conundrum. There is little doubt that a true trade war will reduce global growth. Are we facing a prolonged trade war or a series of negotiating postures by Donald Trump as he pursues the art of the deal? Initially, Trump imposed Section 232 tariffs on steel and aluminum imports and then immediately carved out exemptions for Canada and Mexico, pending progress on NAFTA. Next the president trumpeted a trade deal with South Korea that imposed quotas on steel imports, then almost immediately said that deal was conditional upon South Korean help in dealing with North Korea. South Korea did offer help and by September 2018 the new Korea-United States trade deal (KORUS) went into effect.

  Trump threatened over $50 billion of Section 301 penalties on China for theft of U.S. intellectual property, then within days China and the United States calmed market fears by announcing plans for bilateral trade negotiations. The China-United States negotiations initially proved fruitless, and by September 2018 the tit-for-tat tariffs escalated to cover over $450 billion of goods shipped between China and the United States. By late 2018, the reality of an extended trade war between the United States and China sank in, yet the economic impact on global growth was surprisingly muted. The stock market continued performing as if the trade war had never happened.

  Geopolitics are another on-again, off-again market driver. A strong case can be made for a coming war with North Korea. Decades of North Korean development of nuclear weapons and ballistic missiles and a rapid increase in the operational tempo of tests in recent years reveal that North Korea is determined to build an arsenal of nuclear-armed ICBMs, which pose an existential threat to the United States. For its part, the United States made it clear that North Korea will not be allowed to acquire or possess these weapons. These two views are irreconcilable and point toward war. At the same time, a rapid round of diplomacy, involving summits among North and South Korea, China and North Korea, and Japan and North Korea, all leading to the June 2018 Singapore summit between Donald Trump and Kim Jong Un, point to a possible peaceful resolution of the impasse. If you believe Kim Jong Un is dealing in good faith, you’ll be encouraged by these developments. If you believe Kim Jong Un is dealing in bad faith and playing for time as he perfects his weapons technology, then you’ll expect that war is just a matter of time.

  The final factor confounding markets is the potential for technology regulation. Investors need no reminder of the outsized impact of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) on markets overall and the NASDAQ 100 in particular.

  Suddenly Facebook is facing scrutiny because of misuse of personal customer data and acting as an accessory to Russian meddling in U.S. elections. Amazon is under scrutiny on possible antitrust grounds, alleged government subsidies for shipping, and for Trump’s visceral dislike of the “fake news” Washington Post, owned by Amazon founder Jeff Bezos. There have been congressional hearings on these matters pointing toward legislation. Will Silicon Valley lobbyists dilute the legislation? Will antitrust allegations go up in smoke? Or will populist outrage with the tech giants lead to a sea change and aggressive enforcement as we saw with the Rockefeller trusts in the early 1900s? The correct answer is no one knows. This will be a battle between corporate lobbyists and populist outrage. Usually the lobbyists win. Still, this time may be different.

  None of these four issues will be resolved quickly. It may take six more months of data before the Fed realizes the economy is weak despite tax cuts, or before the bears throw in the towel. Trade wars usually play out over years, not months. If negotiations with China produce results quickly, the trade war concerns will fade, otherwise they will only get worse as retaliation escalates. If Kim Jong Un wants peace, we will know fairly soon. If not, the countdown clock to war, currently paused, will resume ticking. The hearings and legislative process involving technology regulation will also take a year or more to play out. Members of Congress like to milk these issues for campaign contributions from both sides before resolving them, so do not expect quick results.

  The problem for investors is they have to wake up every day and commit capital whether they know the answers on these issues or not. If growth is strong, trade wars fizzle, North Korea wants peace, and the tech lobbyists prevail, then Dow 30,000 is in sight. If growth is weak, trade wars escalate, North Korea is dealing in bad faith, and popular outrage hamstrings the tech giants, then Dow 15,000 is in the cards. Of course, other c
ombinations of these factors may emerge. On the whole, the less optimistic, more bearish path is most likely. But it’s unwise to go all in on any particular outcome. Now is a time to be nimble.

  Mandibles Redux

  How bad will the worst-case scenario be?

  For many investors, the 2008 financial panic is the benchmark for a worst possible outcome. The Dow Jones Industrial Average fell 54 percent in the seventeen months from October 9, 2007 to March 9, 2009. Major investment firms including Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, and AIG either filed for bankruptcy or were rescued by government intervention after massive losses. Unemployment soared from 4.4 percent in March 2007 to 10 percent in October 2009. The S&P Case-Shiller Home Price Index fell from 182.72 in January 2007 to 133.99 in February 2012, a 27 percent plunge. Housing investors with only 10 or 20 percent equity were wiped out. Numerous hedge funds closed their doors or suspended redemptions. Investor losses were in the trillions of dollars. The contagion spread to Europe and the Middle East. Dubai World went insolvent in November 2009 and a sovereign debt crisis raged in Europe from 2010 to 2015. It was the worst financial crisis since the Great Depression.

  The financial damage did not pass quickly. From June 2009 to December 2018, the United States experienced the weakest recovery in its history. Yet the damage did pass. From March 2009 to September 2018, major stock indices more than tripled. Unemployment fell from 10 percent in October 2009 to 3.9 percent in December 2018. The S&P Case-Shiller Home Price Index rallied to 204.44 in June 2018, a new all-time high. Investors who did not sell at the bottom in March 2009 and held their positions recouped all of their losses and made substantial profits by late 2018. A bank CEO or investment maven like Warren Buffett could shrug off the entire episode.

  Yet that’s not how most investors navigated the meltdown. Investors bailed out of the stock market in late 2008 or early 2009 to preserve what capital they had left. They did not come back to the stock market until years later, if at all, missing out on much of the recovery rally. Homes were foreclosed, denying the previous owners participation in the bounceback that started in 2013. Worst of all was the loss of trust. Investors who suffered heavy losses saw bank CEOs keep their jobs and make multimillion-dollar bonuses by 2016. There were no arrests for fraud, and no accountability among top CEOs. Investors gradually returned to markets but without confidence in Wall Street research or so-called wealth managers. After 2009, investing was a self-help, dog-eat-dog pursuit where cynicism replaced confidence and bitterness replaced trust.

  It may be difficult to envision a worse scenario than 2008 and its aftermath, yet such scenarios are not infrequent—they have happened many times in U.S. history. In the Great Depression, major stock indices fell 80 percent from 1929 to 1932. In the Civil War, the Southern economy was decimated and never fully recovered until the 1970s, over a century later. The Second World War imposed massive austerity on the home front and left over 1 million Americans killed or wounded on the front lines. The Dust Bowl drought on the U.S. Great Plains from 1934 to 1939 caused an internal migration of about 3.5 million people, mostly poor, with their few belongings packed into jalopies, from Oklahoma, Arkansas, and Texas to California and other states in search of work. Thousands died from pneumonia or starvation. In short, America has seen far worse than the 2008 financial crisis.

  This implies that consideration of a true worst-case scenario must be broader than a 50 percent stock market decline and a few bank failures. The scenario should include financial disruption, yet go beyond that as the consequences of greater scale in capital markets and faster contagion among networked institutions inevitably impact critical infrastructure and, finally, social order.

  We can dismiss a few scenarios immediately. Americans have been saturated for decades with film portrayals of zombie uprisings and alien invasions. It’s great entertainment but there are no zombies. There may be some unsettled ghosts and spirits here and there, but no zombies. There’s also no hard evidence of alien contact. Based on empirical analysis, encounters with aliens are as likely to have a supernatural as intergalactic explanation. That debate need not detain us. Alien spaceship landings on the Mall in Washington, D.C., are not high on my list of bleak scenarios.

  More likely is a financial crash associated with some other catastrophic event such as a power-grid collapse or natural disaster. These double catastrophes are not as unusual as many expect; in fact, density functions make them likely. The Fukushima catastrophe in Japan in March 2011 is a perfect example; an earthquake led to a tsunami that killed thousands, disabled a nuclear power plant, and caused a partial meltdown, then finally crashed the Tokyo stock exchange. This was a case of one critical state system (tectonics), triggering phase transitions in other critical state systems (hydraulics, radiation, capital markets), until the chain of criticality ran its course.

  Linkages between critical state systems are not merely situational, as in the case of Fukushima; they can also be by design. If China intended to launch an attack on the U.S. power grid, they would not do so on a sunny day. They would wait for a day when stocks were crashing and then attack the power grid, a tactic known as a force multiplier, which heightens fears when the lights go out. Iran might see the chaos at play and decide it’s opportune to shut down part of the World Wide Web by disabling key nodes such as the data traffic hub near the airport in Fujairah, UAE. The web and power outages might accelerate the stock market crash, although a more likely outcome is that the stock exchanges would be closed, a condition that further amplifies the panic.

  Other catalysts include pandemic, war, and an out-of-the-blue failure of a major bank before the central bank ambulance can arrive at the scene. While each of these is a low probability event, the chance that none of them happens in the next several years is near zero, as illustrated by the Bernoulli process equations in the previous chapter. A catalyst triggers the cascade as one systems failure causes another and the breakdown becomes widespread to the point of paralysis.

  Sociologists and historians have documented civilization’s thin veneer. Once critical systems break down, civilized behavior lasts three days. After that, the law of the jungle prevails. Citizens rely on violence, money, remoteness, or other forms of coercion to maintain their positions. Loyalty to country is cast aside since the country is no longer holding up its side of the bargain by providing order. Tribes form based on locally shared values. Hurricane Katrina, which overwhelmed New Orleans in August 2005, is a classic example. Day one was the storm. Day two was shock and immediate survival. By day three, looting broke out, although some officials discounted the looting as no more than victims going into survival mode looking for food and water. Then armed vigilante groups formed, that shot some looters but more often shot innocent survivors who happened to end up in the “wrong” neighborhood. Our concern is not with the justice of this, but with the fact that in extreme circumstances it takes only days, not weeks, for armed quasi militias to flood the streets with violence. Civilization is barely skin deep.

  Order returns, yet what kind of order? The “barbarians” who invaded Rome in the late fifth century preserved imperial trappings and appealed to the Eastern emperor in Constantinople for legitimacy. Still patrician fortunes were confiscated and patricians were killed wholesale. Bretton Woods was a new world economic order in 1944 that rose from a collapse caused by the currency and trade wars of the 1920s and ’30s. Allied troops restored order to defeated Germany after the Second World War using martial law, but the demolished infrastructure, decimated fortunes, and dispirited citizens were all too real. Order returns, but it is not the same order as before the catastrophe. The aftermath is different.

  Investors should not focus on the cause of a collapse (it’s a long list and the timing is uncertain). The collapse itself will run its course and order will reemerge through coercion, cooperation, or sheer exhaustion. The question is where will you stand in the new order?

  The postapocalyptic genre epitomized by Cormac Mc
Carthy’s novel The Road is compelling and instructive in a metaphorical sense, but is not a case we need consider. McCarthy’s world is one that suffered an extinction-level event. Almost all life on earth had ended and the few survivors are cannibals, captives, or those defending a small homestead. This outcome cannot be ruled out. But the term “investor” will have no meaning in the complete absence of a functioning economy or the rule of law. A reversion to a pre-1870s agrarian society without cars, phones, running water, or electricity is more likely than apocalypse, yet still is not a likely case. Someone will turn the lights back on, even if the someone is the U.S. military operating under emergency powers and martial law.

  The best depiction of life after a financial collapse is found in The Mandibles, a brilliant 2016 novel by the award-winning author Lionel Shriver.3 The novel offers details of an economic collapse in 2029, but is mostly concerned with the lives of everyday people living in the aftermath. Like Anthony Burgess, Shriver invents words and phrases as needed to convey the unfamiliar. She uses Stone Age to describe a power-grid collapse that preceded the financial crash, and Dryout to describe water scarcity in urban areas.

  What is eerie about The Mandibles is not that life is apocalyptic, as in The Road, nor that life is normal, as Wall Street cheerleaders would have it, but that it’s a mixture of both. The United States has defaulted on its debts and is relying on the Federal Reserve to print money to cover interest and principal payments. A new global reserve currency, the bancor, has been launched, but the United States is excluded from this currency system. The Mexican-born U.S. president Alvarado, who delivers his speeches in Spanish, confiscates all private gold in America, a replay of FDR’s gold confiscation in 1933. Hyperinflation is 30 percent per week (something I’ve experienced firsthand traveling in Turkey), so barter is gradually replacing money. Stores still exist, but the shelves are mostly bare. Shoppers don’t buy what they want (it’s not there); they buy what others may want in the future (hardware and the like) so they can barter it for food. Police are on the streets, but they work for bribes from residents and ignore crimes perpetrated on nonbribers. Routine jobs are still around, but elite occupations in the professions and academia are being eliminated to cut costs. This results in the formerly richest members of the Mandible clan moving in with their poorer relatives, who still have a roof over their heads.