debt, dodd-frank, economics, eurozone, eurozone crisis, finance, finland, France, germany, investment, italian debt, italy, muni bonds, nordic, oil, oil prices, opec, politics, puerto rico, puerto rico debt crisis, spain, sweden
There’s no shortage of major economic dilemmas across the globe. The mainstream financial media has followed many stories closely, as you’d be hard-pressed to find anyone in economic or finance spheres that hasn’t heard about the Fed’s quantitative easing program, the issues with the Affordable Care Act (aka “Obamacare”), or the Greek debt crisis. Even the Chinese Fixed Asset Bubble is starting to get major attention, with CBS’s 60 Minutes doing a major piece on it back in August of 2013.
All of these issues are important and the impact of some of them still might be greater than expected. Yet, there are several more “under the radar” economic threats that are receiving little mainstream press attention. In some ways, these are the more dangerous issues, as the lack of media coverage and awareness amongst the general populace leads to a greater probability of unexpected consequences for investors, governments, and the general public.
In this article, I want to explore five major economic issues being underreported in the mainstream media. Some of these issues have potential to do major damage to the world economy, while others might be more specific to certain nations. My broader theme here is that I view the current investment environment as having above-average macroeconomic risks, in spite of the seemingly sanguine market environment, and these issues are just a hint of some of the problems lying beneath the surface.
1. The Puerto Rican Debt Crisis
Puerto Rico may be the most oft-forgotten major population center in the United States. It’s not a state and its inhabitants speak Spanish, which means the broader American public doesn’t keep up with it much. In spite of the fact that San Juan’s population density is on par with Miami and Philadelphia, Puerto Rico receives a small fraction of the media attention of even largely rural American states outside of major media markets, such as Idaho and Wyoming. Given this, perhaps it’s not surprising that most Americans have no idea that Puerto Rico is enduring a major debt crisis.
Yet, just because Americans aren’t paying attention to Puerto Rico doesn’t mean that its issues won’t impact the American economy. As it happens, American pension funds and mutual funds hold large quantities of Puerto Rican debt due to the tax advantages.
Here are some sobering stats: 77% of US municipal bond mutual funds hold Puerto Rican bonds. 180 muni funds hold more than 5% of their holdings in Puerto Rican debt. Total public sector debt for Puerto Rico is about $70 billion; almost 4 times as large as Detroit’s debt of $18 billion. Even that may be significantly understated; once you factor in underfunded healthcare and pension obligations.
The most shocking stat is that Puerto Rico’s public debt is larger than the reported debt for the State of New York. There are quite a few caveats there, and if you go by the Census figures, New York state debt is probably closer to $140 billion, with local liabilities over $200 billion. Yet, even when you factor in New York’s combined state and local liabilities; Puerto Rico’s debt load still looks frighteningly large in comparison.
Consider that New York’s population is over 5 times greater than that of Puerto Rico. Moreover, with a GDP at $1.16 trillion, New York’s economy is about 11 times larger than Puerto Rico’s, at $101.5 billion. Overall, New York’s combined state and local debt constitutes about 27% of state GDP, while Puerto Rico’s sits at around 69% using very conservative estimates. The State of New York actually has one of the highest per capita debt loads in the nation already, so you can begin to see the enormity of Puerto’s Rico debt problems.
There is one qualifying factor here: Puerto Rico is a territory and its residents aren’t subject to all US Federal taxes. For this reason, a straight-forward comparison to other state debt-loads may not be completely apt. Nevertheless, Puerto Ricans pay about $3.1 billion in Federal taxes, mostly in the form of FICA. This is roughly 3.1% of the state’s GDP. Its residents are estimated to pay $7.3 billion to the Puerto Rican government, as well; roughly 7.2%. All in all, this debt-load might seem semi-manageable if it weren’t for one problem: a dramatic underestimation of liabilities.
Underfunded state pensions are a problem all across the United States. Illinois is the most notorious offender, with its 60% underfunded teachers’ pension fund! That, in and of itself, is one of the most shocking stats in American economics. By comparison, Puerto Rico makes Illinois look like a model of fiscal sustainability.
Morningstar estimates that Puerto Rico can only cover 11.2% of its pension costs. Let me re-state that for clarity: that’s not 11.2% underfunded; that’s 11.2% funded, or 88.8% underfunded. Factoring in hidden healthcare and pension liabilities, estimates of Puerto Rico’s debt climb up to $160 billion. That’s about 145% of GDP; or in other words, somewhere between the debt burden of Greece and Italy. Add in Puerto Rico’s liabilities to the Federal government, and it’s probably about on par with Greece. Detroit’s fiscal woes seem like small potatoes compared to PR and this has the potential to do more damage to the muni bond market.
Absolutely none of this bodes well for America’s savers. There’s already a ton of interest rate pressure on retirement oriented funds, such as public employee pensions, mutual funds, and even the Social Security Trust Fund. While many have noted that large Federal budget deficits and Federal Reserve actions are inflationary, the state and local government pension problems may be a deflationary counterweight. The Fed may be pumping up asset prices through QE, but interest rate suppression, coupled with state and local debt issues, the Puerto Rican bond crisis, and entitlement program problems, have the potential to push us back towards a disinflationary, low-return scenario at some point in the future.
2. The Italian Growth Crisis
The Eurozone Crisis has received major coverage in the mainstream media, but very rarely in an insightful fashion. It’s typically spun as a “morality tale” between the fiscally prudent “Northern Block” that includes Germany, the Netherlands, Finland, and Austria, and the lazy, fiscally reckless Southern nations that include Greece, Spain, Portugal, and Italy. Every time the crisis worsens significantly, we see Germany and / or the ECB take a “band-aid” approach, bond yields in the troubled states come back in line somewhat, and the financial media declares that we’re on the “path to recovery.”
Unfortunately, this sort of analysis ignores the major issues in the eurozone. By combining the currencies of 18 nations into one big, flawed system, the eurozone has created massive trade imbalances, major asset bubbles, and fiscal crises galore. While we can certainly blame some of the fiscal problems on reckless politicians (particularly in the case of Greece and Italy), this analysis ignores the fact that some of the nations now seeing fiscal crises did most things right. Spain and Ireland, in particularly, arguably enacted some of the more prudent fiscal policies, but have been devastated by the trade imbalances and distortions within the eurozone.
In summation, the eurozone is a giant house of cards waiting to crumble. While Germany can bail out Greece, Cyprus, and even Portugal, once Italy, Spain, or France have a major crisis, we could see financial calamity on a grand scale. And eventually, one of those nations is going to succumb to a major crisis.
That brings me to Italy. By some measures, Italy is in better shape than its peers. While far from healthy, Italy’s unemployment rate is lower than that of Spain, Greece, or Portugal. Italy also seems to be faring OK in regards to trade, as its current account has shifted to a surplus recently. Even during the height of the problems, Italy’s current account deficit was never as outrageous as Greece, Cyprus, Portugal, or Spain.
Yet Italy remains the most likely trigger point for an escalation in the eurozone crisis. For starters, Italy is by far the most dysfunctional “developed nation” in the world. It’s a corrupt, high-tax state with virtually no real economic growth. Given the communist influence in Italy’s economic policies, it wouldn’t even be a stretch to say it’s more comparable to former Soviet republics and Eastern Bloc nations than the rest of Western Europe. In fact, according to the Frasier Institute’s Economic Freedom of the World rankings, that’s precisely where Italy fits in, one spot ahead of Kazakhstan, and in the same tier as Russia and China.
Italy didn’t fare much better in 2014 Heritage Foundation / Wall Street Journal rankings on economic freedom, either, placing 86th. That’s behind every other developed nation, and one spot below the Kyrgyz Republic; a part of the former Soviet Union. Let’s just say there seems to be a bit of consensus on the idea that Italy’s economy is a bit problematic. Italy is a “first world nation” that increasingly seems to have a third world economy.
None of Italy’s problems are helped by its demographic time bomb. Italy has had virtually no population growth over the past decade and the percentage of retirees is set to dramatically increases as a share of the total population. There’s no other nation in the world that I can find with an uglier population pyramid. It can’t even rightly be called a “pyramid”; it looks more like a spinning top or perhaps the upper half of the Seattle Center (famous for its space needle).
(In case you’re curious, by 2075, it will look more like a condom.)
You can see that Italy’s demographics are ugly in 2013 and continue to become uglier till sometime around 2035. Not a very bright outlook for Italy’s youth, which will be taxed at exorbitant rates to pay for all the liabilities and promises generated by the Italian state.
We can also take a look at Italy’s declining economic growth rate. In the 1960’s, Italy achieved 5.7% annualized GDP growth, using constant 2000 US Dollars. By the 1990’s, that figure had fallen all the way to 1.6%. Last decade, it was a dismal 0.4% and thus far, things aren’t really looking up for the current decade.
To provide more comparative analysis, the chart below shows real GDP, GDP per capita, and population growth rates from 1980 to 2011 for most of the world’s developed economies. I’ve ranked the nations in terms of per capita growth, however, it should be noted that for nations with higher immigration, these numbers can be pushed downwards a bit. Italy ranks 25th out of 28th in per capita growth and 27th out of 28th in overall growth. The per capita growth is particularly horrendous when you realize that Italy’s population growth rate is also 27th. Overall, Italy fares worse than every other nation on this list, with the sole possible exception of Greece.
Of course, I haven’t even gotten to the fiscal crisis yet. Italy’s debt now stands at a striking 133.3%, the second highest in all of Europe. This is a tax on future production, for an external currency user such as Italy.
To make this a bit uglier, here’s a chart showing eurozone debt maturities in 2014 and 2015, courtesy of MineforNothing. Notice that about 35% of Italy’s GDP comes due in the next 24 months; closer to 18% if we account for the fact that this is over 2 years, but still quite high.
If the Italian crisis had developed in 1971, 1983, or 1992, it probably would’ve been no more than a minor drag on world economic growth. In the 2010’s, with Italy’s economy so intertwined with that of other eurozone nations like Germany, France, Spain, Finland, and the Netherlands, it’s a good bet that it will have a much larger impact.
The Italian banks hold 89% of Italian debt, which suggests that the Italian fiscal crisis could also quickly turn into an Italian banking crisis. That said, I wouldn’t underestimate how exposed other eurozone nation banks might be here. Commerzbank (CRZBY), Germany’s second largest bank, held about $9.3 billion in Italian debt in 2011. It appears they’ve been scaling back their position since then, but given that Commerzbank’s current market cap is at $15.5 billion, it’s easy to see how an Italian default could negatively impact it. In fact, Commerzbank’s Chief Economist appears to have been worried enough about the problems to have issued a recommendation to Italy to create a massive one-time property tax. Nothing like self-serving advice!
Needless to say, all of this could end pretty badly. As you may have noted, I termed this the “Italian growth crisis”, because the root of the problems begin with Italy’s dysfunctional economy and the eurozone’s major flaws. I view the fiscal problems as an offshoot of both of those problems. If you want to read more about Italy’s troubles, I recommend the Shareholders Unite article, “The Ticking Time Bomb Under the World Economy.”
I’ve written a lot in the past few years about the Affordable Care Act in a critical fashion. I’ve argued that it would cause healthcare premiums to skyrocket (check!), and exacerbate other problems in the healthcare realm (we’re about to find out). Yet, I can’t say that the ACA is an underreported story. Most Americans are aware of Obamacare and have some understanding of it.
On the other hand, very few Americans seem to be paying much attention to other major piece of economic legislation passed by the Obama Administration: the Dodd-Frank Wall Street Reform and Consumer Protection Act. While the ACA will act as a stealth tax and hit consumers, Dodd-Frank has the potential to harm American economy in a much stealthier fashion.
It’s important to contrast the goal of an act, with its economic reality. The goal of Dodd-Frank was to protect American consumers from the banks. The economic reality of Dodd-Frank is that it forces bank to discriminate against many lower and middle income borrowers. In essence, Dodd-Frank ensures that the wealthy still have easy access to capital, but your “average Joe” and “average Jane” do not.
Consider that 75% of American wealth has been created via housing and one might begin realize that this is actually a pretty big deal. Indeed, housing is the primary savings vehicle of the average American and home equity is often used to fund retirement obligations, as well.
This is a case of the Federal government going from one extreme to the other. From the 1950’s onward, public policymakers increasingly found ways to incentive home ownership via the tax code and government subsidies. Federal programs have been created to help lower income individuals buy their own houses. Many of these programs were partly blamed for the housing crisis. Yet, instead of realizing the folly of major Federal intervention into the housing market, the Feds merely added on several new layers of intervention to counter-act the old layers.
A recent study showed that about 20% of mortgages in 2013 would not meet Dodd-Frank’s 2014 requirements. That’s a stunningly large figure and shows that this act is not merely impacting a small portion of the overall market.
Of course, the market has and will continue to react to these credit restrictions. Over the past few years, we’ve seen a trend towards large institutional buyers, such as hedge funds, private equity, and REITs, gobbling up single-family homes en masse. This may be the wave of the future as Federal regulations make it more difficult for lower and middle income consumers to obtain home loans.
Unfortunately, none of this really solves the underlying problems. The housing bubble may have been exacerbated by the Federal subsidies and intervention, but ultimately, the biggest driver of it was loose monetary policies by the Federal Reserve Bank, coupled with reckless fiscal policies (which have only become worse). Certainly Fannie Mae, Freddie Mac, and various housing subsidies deserve blame, but easy credit was fueled more by “cheap money” from the Fed than by those programs.
In the meantime, Dodd-Frank has the potential to do some significant economic damage in 2014 and the upcoming years. The chart below examines lending at a few major banks.
You can see that residential lending is a significant chunk of business for banks like Wells Fargo (WFC), Bank of America (BAC), and SunTrust (STI). It’s likely that mortgage lending suffers in 2014. Here’s another chart from Raymond James showing mortgage origination forecasts.
Note that the end of the refinancing boom would take a toll of mortgage lenders regardless in 2014 (higher interest rates = less refinancing), but Dodd-Frank will exacerbate that.
The summation is that Dodd-Frank is a stealth form of credit contraction that is largely being overlooked by the mainstream media. While I don’t expect it to single-handedly push us into recession, it certainly could help complicate the recovery, and lead to even more subdued long-term growth. It will also widen the disparities between the rich and poor in America.
To read more about issues with Dodd-Frank and the banking regulatory system, I recommend checking out this interview with Economist John Cochrane of the Richmond Fed. Here’s a small excerpt:
“I think Dodd-Frank repeats the same things we’ve been trying over and over again that have failed, in bigger and bigger ways. The core idea is to stop [bank] runs by guaranteeing debts. But when we guarantee debts, we give banks and other institutions an incentive to take risks. In response, we unleash an army of regulators to stop them from taking risks. Banks get around the regulators, there is a new run, we guarantee more debts, and so on.
The deeper problem is the idea that we just need more regulation – as if regulation is something you pour into a glass like water – not smarter and better designed regulation. Dodd-Frank is pretty bad in that department. It is a long and vague law that spawns a mountain of vague rules, which give regulators huge discretion to tell banks what to do. It’s a recipe for cronyism and for banks to game the system to limit competition.”
4. The Northern European Housing Bubbles
The various debt crises in the Southern eurozone states, such as Portugal, Italy, Greece, and Spain (aka, the “PIGS”) are well-known in financial circles. While some of these crises have their roots in poor governance (see Greece and Italy), others seem to be mostly the result of trade imbalances (see Spain).
Yet, fewer people seem to be analyzing the opposite end of this equation. Low unemployment and a booming German economy is partly a result of the eurozone’s economic distortions, as well. This is true not only in Germany, but also in nations like Denmark and Finland.
Jesse Colombo, who runs the website, “The Bubble Bubble” points out various problem areas around the world, and one of the most interesting to me is the “Nordic Housing Bubble.” Colombo not only shows the issues in eurozone nations such as Denmark and Finland, but also points out that Sweden (part of the EU, but not eurozone), and Norway (in neither eurozone nor EU) seem to be having housing bubbles. Group these crises in with the German housing bubble, and there is a lot of potential for major issues.
In both Norway and Sweden, property prices have tripled since the mid 90’s. Likewise, Finnish housing prices are up 250%. Colombo argues that Denmark may actually be in the worst shape, with banking assets as a percentage of GDP at a staggering 454% (compared to the US total of 90%).
Personally, I’m not so sure what will happen in northern Europe, but it interesting to see that while southern European nations have suffered from trade imbalances that have shocked their economies, the northern European nations are experiencing the opposite side of the imbalance, with asset bubbles galore. I still suspect that an Italian, Spanish, or French debt crisis will be the trigger point for an escalation of the eurozone crisis, but it’s worthwhile to keep an eye on the housing markets of northern Europe, which look very frothy right now.
5. The OPEC Nation Crisis
Remember back in ’07 and ’08 when you had friends predicting that oil prices would climb above $10 per gallon and ruin the US economy? Even as recently as 2011, I remember countering a Martin Hutchinson article that oil would climb above $300 per barrel. As Americans, we were fooled into thinking that ever-rising oil prices were the norm, but instead we could be headed for a long period of declining or stagnant prices. This is thanks in large part to major oil production advances in the US and Canada. Meanwhile, Mexico has also liberalized its energy market, creating yet another source of North American oil.
This is great news for American consumers, not to mention consumers and manufacturers in large swaths of the world. It’s terrible news, however, for nations completely reliant upon the production of oil at high prices to achieve economic viability. This list of nations includes Venezuela, Saudi Arabia, Iran, Russia, Nigeria, Brazil, Sudan, Egypt, and Iraq. Indeed, falling oil prices could create many other crises in the Middle East and other oil producing countries.
This could result in long recessions in some places, but could lead to revolts, or even revolutions in others. Saudi Arabia’s major reliance on high oil prices to finance its state is particularly frightening. While the Saudis have taken some actions to prepare for the “new economy”, you have to wonder if it’s really enough. Meanwhile, don’t be shocked if falling oil prices create big problems in places like Nigeria, Iraq, and Russia. Venezuela is already experiencing hyperinflation, so falling oil prices could further expose the regime there. And the great miracle next door in Ecuador could come to a grinding halt, exposing it as yet another crackpot socialist regime.
Of course, in spite of the negatives here, lower oil prices are likely to benefit even more people across the world, so this is not so much a scenario that will necessarily “damage the world economy” so much as one that will rebalance it. Nevertheless, it’s worth keeping an eye on, and it makes investment in many oil-rich countries a bit riskier.