The World Has Become Obdurate

December 1, 2014

There is a perfect word that describes the current condition of governments and consumers around the world today. The word is obdurate, and it means to be stubbornly persistent in wrongdoing.

The word comes to mind when witnessing the renewed enthusiasm of central banks to re-inflate old asset bubbles and to endlessly debase their currencies with the misguided belief that inflation will engender sustainable economic growth.  In the case of the Fed, it has so far to date made at least three QE efforts and six years of ZIRP to achieve this goal. But what it has actually achieved is to create asset bubbles and render the nation insolvent. Governments have failed to grow economies in any viable manner.  But today’s central bankers have become the very embodiment of the word obdurate, as they stubbornly persist in the effort to pursue inflation as a panacea, despite all available evidence that it will fail to achieve their desired results. 

Leading the way on this front is Japan, perhaps the paragon of obdurate thought and action.  Abysmal GDP numbers produced by Japan’s economy has brought the nation back into an official recession for the second time in past two years.   This should have served as a wakeup call, proving Abenomics and its three Keynesian arrows failed to hit their target.  However, Abe and his cohorts at the BOJ are not about to let the facts get in the way of their borrowing and printing fairy tale.  On the contrary, Prime Minister Abe has stated he is now more convinced than ever to aggressively pursue the dangerous course of deficit spending and currency debasement; and clearly will not stop until Japan is in full-blown currency crisis. 

Amusingly, Paul Krugman has emerged as Abe's chief champion and apologist, proposing Europe follow in Abe’s footsteps. He suggests that, "Europe needs something like Abenomics only Abenomics, I think, is falling short, so they need something really aggressive in Europe." As if the problem with Abenomics is only in its failure to be bold and audacious enough!

Spanning the globe, we have China, whose local government debt levels have soared to almost $3 trillion (up 70%) in less than three years.  Yet, despite the fact that its municipal debt is spiraling out of control, the People’s Bank of China recently cut interest rates—perhaps to encourage the building of additional empty cities. 

Following through with this specious reasoning, the Keynesians might suggest that Japan can exit its recession by starting a pretend war with China--blowing up some of its empty cities so China has a great excuse to rebuild them, thus making the communist nation’s predetermined GDP easier to achieve.  I am sure this will be mentioned in Paul Krugman’s next op-ed.    

Unfortunately, America is far from immune to this world-wide obdurate behavior.  Let’s start first with the U.S. investor, whom the Fed has once again left starving for yield.  They are back to pursuing high-yielding investment vehicles whose risks they overlook with alacrity.  Rabid speculation now abounds in Treasuries, municipal bonds, leveraged loans, student debt, collateralized loan obligations, et al.

Take Master Limited Partnerships (MLPs) in the oil service industry for instance.  With bond yields at historic lows, MLPs have been averaging 6.7 percent.  That’s an extremely tempting yield. However, what investors fail to realize is these investments are tied more to the commodity price than they were led to believe.  If oil stays below $80 a barrel for a protracted period of time, many of these MLP’s will stop paying that sizable dividend and will therefore substantially decrease in market value.  

Investors struggling for income to offset near-zero interest rates have also piled into high-yield (junk) bonds. The value of these bonds in the Bank of America Merrill Lynch Global High Yield Index has soared to more than $2 trillion. It took 12 years for the gauge, which began at the end of 1997, to get to $1 trillion. And only 4 years to add that additional $1 trillion.

On average since 1993, U.S. companies that lack investment-grade ratings defaulted on 4.4 percent of bonds, according to Moody’s Investors Service. The current default rate is projected to jump about 100 basis points in the next few months. However, at the height of the credit crisis in 2009, almost 15 percent of high-yield bonds defaulted. Investors are woefully unprepared for such losses once economic reality returns to markets.

The most concerning obdurate behavior of all is evident in U.S. borrowers and the predatory lenders who enable them. This mutually irresponsible conduct brought the economy to the brink back in 2008.   Loose-lending practitioners, a la the mortgage market circa 2007, have reemerged on Wall Street. But this time they have surfaced in the subprime auto loan sector. Opportunists in financial institutions have once again organized shady lenders, who are making near usurious loans at an interest rate of 20 percent and at 115 percent of the vehicle’s value, to consumers who are essentially one paycheck away from default.

The subprime lending market shrunk from more than $125 billion, at the bubble peak in 2007, to only about $60 billion by 2009.  But re-fueled by the Fed’s ZIRP policy, it has now come roaring back to $120 billion. And by the end of this year it is projected to be at all-time highs. The sad truth is that the resurgence of auto sales, much like the record pace of new home sales before the Great Recession, is being built on the back of unpayable debt.

Fittingly, Fannie and Freddie aren’t about to stand by and let auto lenders have all the post-crisis fun.  In an attempt to get back in the aggressive lending game, these Government Sponsored Enterprises (GSEs) have drawn up new rules aimed at loosening lending standards. In order to make mortgages easier to obtain for those who can’t afford to pay the loans back, these GSEs, which are still in conservatorship from past transgressions, will once again require just a 3 percent down payment on new mortgages.  The new guidelines come with some inherent risks, but rest assured, Fannie Mae executives are confident they can responsibly administer the lower equity requirement to ensure it is an effective tool for increasing access to credit.  This is tantamount to a raging alcoholic, who has only been sober for a few years, being confident he can handle his new position as a wine taster. 

Once again we have central bankers and governments hell-bent on creating inflation and turning a blind eye to the asset bubbles they create.  Once again we have yield-starved investors looking to over extend themselves with credit. And once again we have eliminated any semblance of prudent lending standards in order to accommodate a massive accumulation of record debt. 

Government and consumer behaviors have become obdurate--a stubborn persistence in wrongdoing.  But it is insufficient to claim that we have merely continued on with past errors. More accurately, we have become much better at doing everything we did wrong in the past.   


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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

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