October 21, 2015: Excerpted from Artemis Capital Management letter to investors

The arms race of devaluation is not free and has come at the cost of massive global debt expansion. There is no precedent in financial history for a robust economic recovery absent either debt reduction or rampant inflation. We never deleveraged, in fact we just doubled down. According to a recent McKinsey study the world has reached $200 trillion of debt in 2014 (286% of global GDP), which is a staggering 40% increase from 2007 levels (+$57 trillion). In China, debt has grown four times faster than GDP since 2007, and half of that debt is linked to their property market. The world has simply shifted private debt to the public balance sheet.

The private risk transfer to the public balance sheet can also be seen in the evolution of credit default swap pricing since 2007. Notice the sharp divergence between global sovereign CDS (red) and financial corporate CDS (blue) starting in 2013. The next major global crash will likely be driven by unhealthy sovereign credit rather than corporate credit. The next Lehman moment will be the financial collapse of a major developed country instead of a bank.

There are those who point to aggressive central banking of the late-1930s as the model for de-leveraging post-depression but this argument is highly flawed.

We didn’t financially engineer our way out of the Great Depression – we won a World War.

It’s extremely helpful in the de-leveraging process if you are the only capitalist industrial power left in the world untouched by utter and complete destruction. De-leveraging from the Great Depression had as much to do with the blood, sweat, and tears of American soldiers, the development of nuclear weapons, and the fact we were an ocean removed from the battlefield on both sides, as anything related to fiscal and monetary policy from the era.

I don’t think some investors are being radically honest when they omit this brutal truth in their analysis of late-1930s as model to argue for more quantitative easing. More quantitative easing is a great thing if you run a large risk parity fund but it will not help the American middle class.

Artemis Capital Management / Zero Hedge

Zero Hedge/Bawerk

Corporate foie gras

One of the arguments put forth in the bull vs. bear debate is that the solidity of US non-financial corporations have never been stronger. The amount of cash held by non-financial corporations has risen 150 per cent since the depth of the crisis in 2009. With such a massive cushion to stave off whatever the market may throw at them, they will be able to cope, or so it is held.

In addition, we know that financial corporations are flush with cash, or excess reserves held at the Federal Reserve. Throughout the various quantitative easing (QE) programs conducted by the Federal Reserve, commercial banks have been force fed cash as ducks on a foie gras farm. This has swelled their excess reserves to the unprecedented, and what would be thought unimaginable only few years’ back, level of US$2.6 trillion.

With all this cash the system should be, again according to the perma-bulls, more than ready to withstand the shock from the ongoing global deleveraging, a stronger dollar, emerging market blow-ups and the forthcoming US recession.

We beg to differ. When it comes to excess reserves they are most likely already “spoken” as a form of collateral in shadow banking chains. While the initial effect from QE on the shadow banking system was massive deflationary shock as all the high quality securities used in re-hypothecated collateral chains were soaked up by the Federal Reserve, it is a safe bet that excess reserves has to some extent filled that void.

In the non-financial sector on the other hand cash is, well, plain old cash. With more than US$1 trillion of the stuff on their balance sheet complacency is destined to be prevalent. And it is.

Credit market instruments, i.e., debt, have also risen at a tremendous rate. Net debt, that is credit market liabilities less cash, has actually never been higher. As the chart below shows, sitting at more than US$6.6 trillion, non-financial net debt outstrips even the high from 2008.

Now, if we express the gargantuan debt load as share of market value of non-financial equities outstanding things looks not only sustainable, but outright sound. At only 30 per cent the debt to equity ratio is at multiyear lows. We need to go all the way back to the peak of the dot-com folly to find today’s equal.

And it is exactly the folly of the dot-com (and went) that best epitomizes todays manic corporate debt issuance. According to Bloomberg more than US$2.7 trillion in stock buybacks has been effectuated over the last six years. We would be amiss if we didn’t mention that this spending spree, not on capital goods or R&D that will help propel future growth mind you, but on liability massaging, coincided with ZIRP.

Investors desperate for yield have more than happy to lend US Inc. trillions of dollars, even though it is used mainly to buy back own stock. Not surprisingly this also help goose the market value of equites outstanding; also known as the denominator in the ratio presented in our chart.

So more debt begets higher market value of equites which in turn improves the debt/equity ratio which gives the incentive to issue more debt ad infinitum. Or in a slightly simpler version, debt begets more debt.

We have seen the story before. In the shaded grey areas we highlight episodes when the virtuous relationship turns ferociously vicious. Remember, markets take the escalator up, but the elevator down. And the longer the escalator the further down the elevator goes.

Source: Federal Reserve Flow of Funds (Z.1), Bawerk.net

When the US recession hits (see here for more) the massive gap between the green and red line in our chart above will close in short order and the calamity will be even worse than last time, which incidentally was far worse than the time before that.

And this Ladies and Gentlemen is aggregate demand management in practice where, for some unexplained reason, the abundance of savings does not clear the market for investable funds not even at the zero lower bound.

The fact that central bank perverts capital markets and is to a large extent responsible for the very same secular stagnation central bankers believe they must fight, seems lost on today’s intelligentsia.

* * *

Back to ZH here, in addition to Bawerk’s explanation of what may be the biggest “non-financial sector” margin call ever on deck, we just wanted to underscore one of the main points made in the piece above, namely the stability – or rather lack thereof – of US Commercial banks, whose cash assets according to the most recent H.8 statement amounts to $2.8 trillion. The problem is that of this, over $2.5 trillion comes from the Fed’s excess reserves which at some point will be unwound, meaning the true cash level of US banks – when one excludes excess reserves – has not budged at all since the financial crisis, and has in fact declined to a pro forma level of just over $200 billion.

economicnoise.com : August 11, 2015

The US and world economies are frauds that are coming unraveled. The Greek bailout is the most recent example of “kick the can down the road” solutions. The US housing bubble was an attempt to cover up/recover from the dot-com bust. Now the US is in a financial bubble engineered to recover from the housing bubble debacle. Soon this bubble will burst. Only the date is unknown.

Two predictions can be made with reasonable confidence:

• The stock market is likely to be halved and that might be optimistic. Only the date is unknown.
• The economy will eventually resemble the Great Depression. Only the date is unknown.

Nothing is ever certain. An experienced CFO told me at the beginning of my career that “even the impossible has a 20% probability.” In deference to him and years of empirical evidence, I put the the above two events as virtually certain, i.e., an 80% probability.

The Current Problem

Phoenix Capital provided reasons to expect horrible outcomes:

• The REAL problem for the financial system is the bond bubble. In 2008 when the crisis hit it was $80 trillion. It has since grown to over $100 trillion.
• The derivatives market that uses this bond bubble as collateral is over $555 trillion in size.
• Many of the large multinational corporations, sovereign governments, and even municipalities have used derivatives to fake earnings and hide debt. NO ONE knows to what degree this has been the case, but given that 20% of corporate CFOs have admitted to faking earnings in the past, it’s likely a significant amount.
• Corporations today are more leveraged than they were in 2007. As Stanley Druckenmiller noted recently, in 2007 corporate bonds were $3.5 trillion… today they are $7 trillion: an amount equal to nearly 50% of US GDP.
• The Central Banks are now all leveraged at levels greater than or equal to where Lehman Brothers was when it imploded. The Fed is leveraged at 78 to 1. The ECB is leveraged at over 26 to 1. Lehman Brothers was leveraged at 30 to 1.
• The Central Banks have no idea how to exit their strategies. Fed minutes released from 2009 show Janet Yellen was worried about how to exit when the Fed’s balance sheet was $1.3 trillion (back in 2009). Today it’s over $4.5 trillion.

The cumulative effects of decades of interventions to mask economic weakness are harmful to the economy. Statistical manipulation and outright lies in government reporting of economic conditions suggest that times are becoming ever more desperate for the political class. There is not enough bailing wire in the world to hold this train wreck in check. Nor is there any way to solve the massive problems created over decades.

Mac Slavo believes we are already in a world-wide depression stating:

With stock markets in China having self destructed, Greece and Europe in another crisis, and corporate earnings for some of the world’s biggest corporations showing lackluster performance, it should be clear that the situation is rapidly deteriorating.

But for the last several years America has appeared to remain fairly insulated from overt crisis. We were told that a recovery had taken hold, jobs were returning and consumer confidence had reached new highs, propaganda which drove millions of investors back into stock markets and real estate. No one in the mainstream world, it seems, believes there’s anything to be concerned about.

Except there is.

Nassim Taleb described the problem:

Uncertainty should not bother you. We may not be able to forecast when a bridge will break, but we can identify which ones are faulty and poorly built. We can assess vulnerability. And today the financial bridges across the world are very vulnerable. Politicians prescribe ever larger doses of pain killer in the form of financial bailouts, which consists in curing debt with debt, like curing an addiction with an addiction, that is to say it is not a cure. This cycle will end, like it always does, spectacularly.

Each intervention has been bigger than the previous one. And they are needed more frequently. Bad times are here and have been despite what government says. Worse times lie ahead. Only the date is unknown.

(read the full article at economicnoise.com)