In what was incredibly appropriate timing given the ‘shocktober’ market blowup, Bloomberg News invited “Black Swan” author Nassim Taleb to its set on Halloween for a discussion about the increasingly fragile market ecosystem in which we all reside, and the mounting risks that, Taleb believes, could soon ignite another financial crisis that will be even more severe than what we saw in 2008.
Taleb, dressed up as “black swan man”, wasted little time in explaining how the global economy is becoming increasingly vulnerable to a global debt crisis, how the global quantitative easing did nothing to fix the underlying problem of too much debt – instead it exacerbated it – and how the inevitable reckoning might play out in markets once the long-dreaded “inflection point” finally arrives.
Taleb began the interview by describing how the global aggregate debt burden has only climbed since the crisis. And while this debt is no longer dangerously concentrated in a single sector, like, say, the housing market, it doesn’t change the fact that the overall credit risk in the system has been amplified. And while central banks have for years managed to impose metastability in global markets, as they transition from a period of low interest rates back to “neutral”, the destructive forces that they long suppressed will surge back to the surface.
Just like he did in the run-up to the 2008 crash, Taleb isn’t trying to forecast the next crash; he’s only trying to explain how the global economy has become “more fragile today” than it was in 2007.
“You put novocaine on cancer, and what happens? The patient is going to look better, he’s going to feel better, but at some point, you pay a higher price.”
And while this debt is distributed in different ways, “you don’t get a free lunch.” In other words, just because governments and corporate balance sheets have done most of the accumulating, doesn’t mean that this debt is ‘risk-free’.
“Governments, they think they can borrow for free. But they have had to borrow a lot. We have had to borrow more than $1 trillion dollars…and we’re paying some $300 billion in interest.
This has left the US and the rest of the world on the cusp of a dangerous downward spiral.
“You can enter a spiral. In my mind, it’s when governments have to borrow more and more to pay interest – like a Madoff scheme.”
And once that spiral begins, it’s incredibly difficult to arrest the progression.
“The minute you enter that phase, there’s nothing healthy about it from an economic standpoint.”
Take the US federal government for example. Not only has it accumulated another $10 trillion in debt since the crisis, but it also has “hidden liabilities” on its balance sheet that Taleb believes should be factored in to this total. Social security is one hidden liability. Student debt, which the government will almost certainly need to backstop, is another.
“But we’ve accumulated an additional $10 trillion in debt since the crisis. Plus we have hidden liabilities that should count as debt – like social security, you have hidden liabilities when you have to bail out firms, you have hidden liabilities from student debt…you have a lot of things, if you’ve committed to some expenditures, on top of debt you have hidden liabilities that should act like debt.”
And while in the past, debt crises have been confined to emerging-market economies like Argentina, today, major developed economies like Italy are already seeing signs of strain as their populist government is hoping to expand the country’s budget deficit, adding to what is already the third-largest debt-to-GDP burden in the developed world.
“Years ago we had a debt crisis…in 82′ it started in Latin American countries…today it’s hitting the core, it’s no longer the periphery…look at countries like Italy…but it’s getting closer to us.”
In the past, the go-to fix for overwhelming debt has been inflation. But the problem with inflation – as the US experienced in the 1970s, is that, once it gets going, it can be almost impossible to control.
“In the past, the normal solution is inflation…but the minute you start to create inflation it’s an animal, you can’t control it…like we learned in the 1970s…price stability will not be there and traditionally it hasn’t been controllable.”
It wouldn’t take much to trigger a debt crisis in the US. If the Chinese and other ‘regular customers’ of Treasury debt were to step away from the market, who would take their place?
“The Chinese and the overproducing states were regular customers…maybe they’re not going to be there.”
Circling back to central banks and their strategy for averting an all-out financial collapse, Taleb pointed out that QE’s biggest accomplishment was the transfer of credit risk from individuals to the state. And with interest rates now beginning to rise, somebody is going to need to pay the price for all of this leverage.
“In 2008, we transferred debt from individuals to the states…now ten years later, we’re starting to raise rates. We have to raise rates. It’s unhealthy to keep rates at zero. So someone is going to have to pay the price.
Though debt isn’t as concentrated as it once was, the first signs of stress, according to Taleb, are already beginning to surface in real-estate, where stress that has already appeared in the high end of the market will likely spread (a trend that we have anticipated again and again and again).
“The first shoe to drop will be probably real estate. The higher end real estate has already gone down world wide, people have noticed but they’re not talking about it…it will be the higher end real estate first then the rest of the real estate market. One thing that quantitative easing did was increase inequality.”
After real estate “the next shoe to drop” will be the stock market…”though what we’re seeing today is nothing,” Taleb said. Equities cannot maintain their high valuations when interest rates are rising.
“No…what we’re seeing today is nothing…but you cannot maintain high valuations in the stock market with higher interest rates.”
“With higher interest rates we’re going to see some volatility.”
While the risks are arrayed against the average investor, there is one “miracle scenario” that could save the US economy from an extremely painful bout of deleveraging. And that would be a combination of torrid real growth with low price instability – essentially a turbocharging of the “goldlilocks” economic conditions that enabled the ever-higher highs during 2017 and 2018.
“What we need, the thing that would save us, miraculously, is real growth without debt…real growth maybe miraculously will take us out…or maybe some type of inflation that maybe wouldn’t cause so much price instability…but we’ve never seen that. Unless we have these two, we’re doomed.”
While anybody who has expressed concerns about the blowout in the US budget deficit under Trump should find Taleb’s arguments compelling, a quick glance at the S&P 500’s annualized returns over the past decade might be enough to quash these doubts. After all, why should investors listen to the doomsayers when so many crisis-era superstars, who built their reputations on the rightward bets they made during the runup to the crash, have not only failed to match their returns from 2007 and 2008, but have seen their winnings dissipate entirely in the years since?
Because, as has been demonstrated by at least one fund, the above assumption isn’t entirely accurate. Mark Spitznagel, CIO at Universa Investments, which counts Taleb as an advisor, revealed back in September that funds betting on the “end of the world” can, in fact, produce alpha and tack on a few points to a fund’s CAGR even during bull markets if the balance of allocations, and the hedging strategies employed, are calibrated in just the right way.
As he revealed in a letter to investors obtained by the WSJ back in September, Spitznagel has managed to outperform the S&P 500 by keeping the bulk of his money invested in a passive benchmark-tracker, while using a tiny sliver of his portfolio (just 3.3%) to buy up out-of-the-money put options when they’re looking cheap. This has allowed Spitznagel to book staggering profits during a handful of blowups (like the August 2015 ETF flash crash, where this strategy returned 20% in a single day).