One of the reasons buy and hold strategy may not make sense… General Electric

One of the greatest financial tragedies of our time.  It’s bigger than Bernie Madoff… Enron… or the collapse of Lehman Brothers.

And yet, most Americans still have no idea what actually happened.

We’re referring to the massive, decades long fraud (and cover-up) at former market-darling General Electric (GE). 

GE was just days away from collapse when the U.S. government stepped in to guarantee its debts in November 2008.

However, while the government’s actions saved GE from imminent failure, it didn’t actually resolve any of its problems. Which meant, sooner or later, there would still be hell to pay.

GE still holds billions in financial assets of dubious quality, financed by more than $130 billion in debt. Meanwhile, the company’s cash return on assets is only 1%… But that’s not the big problem. The big problem is what lies at the center of this company, hidden in those financial assets, is an enormous fraud.

The latest example is a $6.2 billion charge in its insurance unit… that will require another $15 billion in reserves over the next seven years. The charge and the demand for new reserves came from a Kansas Insurance Department investigation.

State insurance regulators require companies to post collateral to prove that they can fulfill their promises to pay. Essentially, Kansas called GE out for having preposterously little capital… and required it post another $15 billion in capital…

 

What else is hidden in those billions of dollars of financial assets the company holds?

And what are they really worth? Investors are going to want to know. And sooner or later, the government will have to come off the bench and start to do its job. GE can’t hide the truth forever.

On Thursday, accounting expert Harry Markopolos issued a scathing report on GE. If Markopolos’ name doesn’t sound familiar, it should: He famously warned regulators about Bernie Madoff’s massive Ponzi scheme years before anyone else.

In the report, Markopolos called GE “a bigger fraud than Enron.” As financial news network CNBC reported…

The financial investigator, who was probing GE for an unidentified hedge fund, writes that after more than a year of research he has discovered “an Enronesque business approach that has left GE on the verge of insolvency.”

Markopolos alleges that GE has a “long history” of accounting fraud, dating to as early as 1995, when it was run by Jack Welch.

“It’s going to make this company probably file for bankruptcy,” Markopolos told CNBC’s “Squawk on the Street.” “WorldCom and Enron lasted about four months… We’ll see how GE does.”

In particular, Markopolos pointed to problems in the same insurance unit cited by Kansas investigators last year.

According to his research, the company will need to raise reserves by at least another $18.5 billion, in addition to the $15 billion already announced. Markopolos also estimated the company’s already lofty debt to equity ratio of 3-to-1 would soar to an astronomical 17-to-1 if it reported its financials accurately.

GE dropped 11% on this news.

And the bond market now appears to be getting worried, too. GE’s debt is officially rated BBB-plus, the lowest tier of investment grade. However, following Thursday’s report, some of its debt is now trading well below that level.

According to MarketAxess data, GE’s 5% 2049 bond is trading at 369 basis points (“bps”) over U.S. Treasury debt. The average spread for BB debt – the highest-tier of non-investment grade debt – is just 270 bps today.

In other words, it appears the bond market now believes GE is at serious risk of a downgrade into “junk bond” territory.

 

World Economies

More evidence of just how dire the global economic slowdown has become keeps rolling in. Some of the latest data comes from the OECD, the 36-member intergovernmental economic organization. The OECD’s gauge of economic health for some of the world’s biggest economies has fallen to levels not seen since 2009.

The gauge is designed as a leading indicator, and it warns that the US economy will continue to lose momentum over the next six to nine months.

Data like this has helped to stoke fears that a US (or global) recession is now on the horizon.

 

Copper and Iron Ore

Copper is everywhere and a vital component in modern life. It is found in your cell phone, your car, your laptop, and all around your house. The red metal is so widely used across industries and in thousands of products that it has earned the title Dr. Copper—it has a PhD in economic forecasting. When the price of copper declines, it often reflects investor concerns of an economic slowdown dead ahead that will cut demand for the metal.

The copper price has so far dropped about 12% from its April high. This is not so much a huge loss as it is a swift loss, as heightened risk of a US recession has investors reaching for their anxiety medication. A falling copper price is not a reliable recession predictor by any stretch. But it has a pretty good track record of warning that weaker economic activity is likely in the pipeline.

Iron ore prices just entered a bear market, having skidded 20% from its July high of $117 per ton. Australia is by far the world’s largest exporter of iron ore, and lower ore prices will hit the country particularly hard.

The economics of lower ore prices has been compounded by bad weather and production setbacks. Those, and other forces, are forecast to deliver the first drop in iron ore exports in 18 years. That is a real threat to an Australian economy that is already struggling to keep its head above water. Its economy is growing at the weakest rate since the global financial crisis. The weak Aussie economy has also pushed the value of its currency to the lowest exchange rate against the US dollar in 10 years.

 

Negative Interest Rates

Central banks in Europe and Japan already have policy rates below zero, governments are issuing negative rate bonds and at least one bank in Denmark is offering a negative rate mortgage. There is every reason to think this virus will spread to the US, possibly soon, so we should all understand its risks. They are considerable.

Key Points:

  • The definition of an interest rate: the value discount applied to delayed satisfaction of a want compared to an earlier satisfaction of the same want. This “originary” interest rate cannot be zero or negative.
  • Newer theories dispute this definition, stating the natural interest rate can be below zero, and these ideas have found their way into monetary policy.
  • Negative rate policies are attractive to some because they let financially ailing governments and businesses reduce their debt burden at creditors’ expense.
  • Many so-called “market” interest rates are in fact highly manipulated. Those that have dropped below zero did not do so naturally.
  • If anyone can get a loan at negative interest, then we can expect everyone to want such loans. Credit demand will thus get out of hand. Central banks will have to resort to credit rationing.
  • A central bank that can determine who gets loans is effectively the top manager of a centrally planned economy, a role they are unlikely to handle well.
  • Negative rates will also drive asset price inflation higher by raising the present value of future payments. Gigantic speculative bubbles will follow.
  • The logical end of this is capital destruction (the opposite of capital formation).
  • Negative yields may be taking their toll on investor demand, as the world’s first 30-year bond offering a zero coupon struggled to find buyers on Wednesday. Germany sold only €824M of the notes maturing 2050, falling far short of its €2B target.

 

Global Bond Yields – August 21, 2019

Japan -0.24%, U.S. 2-year Treasury Note 1.54%, U.S. 10-year Treasury Note 1.57%, U.S. 30-year Treasury Bond 2.05%, German Bunds -0.68%, German 30-year -0.30%, France -0.41%, Italy 1.33%, Turkey 15.92%, Greece 2.00%, Portugal 0.12%, Spain 0.09% and UK Gilts 0.46%. 

Bottom Line

The destructive effects of negative rates are not obvious to most people because they may initially coincide with an apparent economic upturn. They will eventually cause chaos as the Western world’s welfare democracy model becomes impossible to sustain. Central bankers appear to think they can manage the process well enough to avoid that outcome. They had better be right.

 

Iran

The September 5 deadline Iran has set for leaving the 2015 nuclear deal is receiving little attention but could dominate headlines in the coming months.

Any escalation in Iran’s nuclear activity could draw an Israeli military strike, making Iran attack regional oil facilities in retaliation. This would have dramatic market consequences.

This relates also to China, which is buying much of Iran’s diminished oil exports. Iran is another point of potential escalation in the US-China trade dispute.

 

Yield Curve Inversion…Update

As you can see, the economic recessions of the 1980s, 1990s, and 2000s all followed a pattern. When yields inverted, a recession followed.

Think about it… An inverted yield curve means that the rate paid on short-term bonds is greater than that of long-term bonds. That’s a sign that something is going seriously haywire with the U.S. economy.

Normally, bonds follow a simple rule:

Short-term bonds yield less than long-term bonds.

It makes sense… When you buy a U.S. government bond, you’re loaning your money to Uncle Sam. Loaning the government money for two years is a lot less risky than loaning it for 10 years. As such, the rate paid on the shorter-term loan is low.

Naturally, longer-term loans command a higher rate. The risk is still low, but it is a little higher than the two-year. And it’s more inconvenient to tie your money up for 10 years, too.

 

Market Data

According to Market Watch, “Turns out hiring wasn’t nearly as strong in 2018 and early 2019 as the government initially reported — by about a half-million jobs. The economy had about 501,000 fewer jobs as of March 2019 than the Bureau of Labor Statistics initially calculated in its survey of business establishments. That’s the largest revision since the waning stages of the Great Recession in 2009. … The average 223,000 monthly increase in employment in 2018 — the strongest in three years — could be trimmed to 180,000 to 185,000, economists estimate.

 

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