Mish's Global Economic Trend Analysis

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• Apocalypse Illinois: IOUs Projected to Hit $10.5 Billion, $163 Billion Total Accumulated Liabilities
• China's Art of Propaganda: Future So Bright You Need Sunglasses Inside
• CME Fedwatch and Bloomberg Rate Hike Odds Still Wrong; Deflationary Bust Coming

Apocalypse Illinois: IOUs Projected to Hit $10.5 Billion, $163 Billion Total Accumulated Liabilities Posted: 11 Sep 2015 12:33 PM PDT Flat Out Broke Illinois is in serious fiscal trouble. Unpaid bills will hit about $10.5 billion later this year, counting unpaid lotto winners and state university bills. Lotto is a small problem overall, yet symbolic of the mess the state is in. Because Illinois has no current budget, the state does not pay lotto winners. Instead it sends the winners IOUs. Yesterday, two Illinois lottery winners filed a class action lawsuit over unpaid prizes. Promises, Promises Unpaid bills do not count additional promises that politicians seek. For example, Chicago Mayor Rahm Emanuel wants a half billion dollars from the state to shore up the Chicago school budget. Where is that supposed to come from? The list of "wants" is endless; the reality is "Illinois is flat out broke". When will multiple downgrades from Moody's, Fitch, and the S&P hit the overall state, not just the city of Chicago? Drowning in Red Ink In a big understatement of Illinois' problem, a Crain's Chicago headline reads Illinois IOUs Growing Fast, Could Pass $8.5 Billion by Yearend. Slowly but surely, Illinois government is beginning to drown in red ink, State Comptroller Leslie Munger said today, as the cost of the continuing Springfield budget war steadily worsens the already bad condition of state finances. Without legislative action to adopt a balanced budget, the state's backlog of unpaid bills will hit $8.5 billion in December—not counting an additional $4 billion in spending for state universities, lottery winners and other purposes that has been indefinitely deferred, Munger said. If the bill backlog indeed hits $8.5 billion in December—and you include half of that $4 billion in other spending, since December is the midpoint of the state's fiscal year—that would put the cumulative backlog at what appears to be an all-time high of $10.5 billion. As best as I can tell from consulting with state finance insiders, the highest the backlog ever reached in non-inflation-adjusted dollars was in 2010, early in the days of the Pat Quinn administration, when it hit $9.9 billion. Humorous Solution My favorite comment to Crain's article comes from "Earl" who sarcastically asks "Why not try not spending money the state does not have?" Indeed. Let's try that. Well, actually Illinois has been doing that for years. And bad as $10.5 billion sounds, it's but a small drop in the cumulative bucket. Apocalypse Illinois Drum roll please: In January, Illinois' total cumulative liability was $159 billion. Counting $4 billion in spending for state universities, lottery winners, etc., the total cumulative liability is on the order of $163 billion today, and growing more rapidly than ever. A study released this past January called "Apocalypse Now" discusses the "Consequences of Pay-Later Budgeting in Illinois". Deficit Spending IOUs The stack of IOUs. The term "legacy costs" is sometimes used to describe obligations to pay for services purchased by the state in previous years. Figure 1 shows that the state of Illinois has run deficits in every fiscal year since 2001. A portion of these shortfalls were covered by asset sales and other one-time revenue sources, but most were covered by some form of borrowing. We look first at the total value of these legacy costs in Illinois, separated by type: Pension obligation bonds. Illinois issued bonds in FY 2003, 2010 and 2011 to cover scheduled contributions to its pension funds. At the end of FY 2015, the remaining principal on these bonds will be $12.7 billion. Unfunded liabilities for pensions. As of the end of FY 2014, the state of Illinois' five retirement systems had assets to cover only 42.9 percent of liabilities, leaving an unfunded liability of $104.6 billion. Unfunded liabilities for retiree health costs. As of the end of FY 2013, the state had unfunded liabilities for retiree health costs of $34.5 billion. Short-term inter-fund borrowing in FY 2015. Authorizing legislation for FY 2015 permits the General Funds to borrow $650 million from other funds to be paid back within 18 months. Unpaid bills. As of December 2014, unpaid bills for services already provided to the state totaled $6.5 billion. The total value of these obligations to pay for past deficits is $159 billion. Budget Gap Figure 2 shows a projected deficit of $9 billion for FY 2016 to 2022. Illinois is projected to have total sustainable revenue in FY 2016 of $65 billion, but a much smaller amount represents state-controlled revenue. If we eliminate federal grants, health provider fees (linked to Medicaid spending), and the portion of sales, income, and other taxes transferred back to local governments, the state's own share of total revenue in FY 2016 is only $36.3 billion. The $9 billion deficit represents 25 percent of that revenue. Raising all of Illinois' taxes and fees by 25 percent would be extremely difficult politically. Crowding Out Pay-later budgeting has been perpetuated by a political willingness to ignore the fact that every dollar borrowed to pay the bills in one year must be paid back with interest, thus crowding out what the state can spend on other priorities in future years. Illinois' fiscal problems are huge, structural, and escalating quickly. The state's deficits cannot be eliminated by quick, temporary fixes, or by waiting for the economy to grow. Digging out of our accumulated fiscal problems also requires changes in awareness and expectations. Being saddled with paying off IOUs for past years' bills means that Illinois' citizens must reduce their expectations for the services that they can expect from government and be prepared to pay more for government now and in the future. Decision makers need to understand — and act on — the fact that pay-later financing hurts the state's residents and businesses in future years. Estimating Crowding Out Effects Not Included in the Fiscal Futures Model Some of the legacy costs detailed above have pay-off schedules and are included in the deficit projections, but others do not. The lack of a pay-off schedule can conceal but does not change the fact that legacy liabilities will crowd out other spending. In order to illustrate the magnitude of those "hidden" effects of past deficits, we use the Fiscal Futures Model to simulate of effects of specified pay-off schedules for the "hidden" liabilities. Figure A1 shows the result of adding these three payment schedules to the Fiscal Futures Model. Accumulated Debts Per Capita The US Census Bureau reports the Illinois population is on the order of 13 million and growing slowly if at all. The accumulated bill amounts to $12,538 per every man, woman, and child. But children don't pay bills or taxes. So let's do the calculation based on the census estimate of 4,772,723 households. That accumulated bill amounts to $34,152 per household. Problem Understated I propose the Apocalypse Now study hugely understates Illinois problems. What About? What about aging infrastructure? Boomer demographics? Chicago schools? Business flight? Taxpayer flight? Bond downgrades and higher borrowing costs? Untenable pension plan assumptions? Possibility of a significant stock market decline?  Sobering View I discussed point eight in detail on July 21 in SuperBull Club: RBC Ups Morgan Stanley, Says Bull Market to Continue 6 Years; Sobering Alternative View from GMO. Sobering Alternative View from GMO In contrast, to the SuperBulls, I present the 7-Year Real Return Forecast of GMO. *The chart represents real return forecasts for several asset classes and not for any GMO fund or strategy. These forecasts are forward‐looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Forward‐looking statements speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update forward‐looking statements. Forward‐looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in forward-looking statements. U.S. inflation is assumed to mean revert to long‐term inflation of 2.2% over 15 years. Rain on the SuperBull Party Note that GMO expects negative real returns in US stocks, on average, for a full seven years. I hate to ruin a SuperBull party with forecasts that have been historically among the best in the world, but so be it. Reforms, Not Tax Hikes Tax hikes are not the answer. Tax hikes will just cause more Illinois taxpayers and businesses to flee. Business exodus is already a serious problem.  For details, please see Get Me the Hell Out of Here. Massive reforms are the only thing that can possibly save this state. Meanwhile, Debt downgrades from Moody's, Fitch, and the S&P are just around the bend, and deservedly so. Mike "Mish" Shedlock Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific.

China's Art of Propaganda: Future So Bright You Need Sunglasses Inside Posted: 11 Sep 2015 12:10 PM PDT The future of China is so bright you need to wear sunglasses inside to see. That's the essence of recent propaganda from China, where the state promotes good lies with discussion of the bad truth strictly forbidden. Please consider Don't Fret About the Data, China's GDP Forecast to be Good News. "The focus for the month of September will be strengthening economic propaganda and . . . promoting the discourse on China's bright economic future and the superiority of China's system," the party's propaganda department said in a directive to national media outlets. A photograph of the latest directive was posted online by California-based China Digital Times, which monitors Chinese media and internet censorship. "They want to control how the media frames and interprets [economic data], making sure that they all focus on positive things," said Xiao Qiang, CDT founder. CDT also posted a notice from the chief editor's office at the Xinhua news agency, dated September 7, that reiterated the need to "stabilise expectations and inspire confidence". The Xinhua notice instructed staff to "please plan related reporting" and send their story ideas to the agency's Creative Planning Center. This week, Chinese leaders went on a public relations offensive, having stayed largely silent during both a controversial stock market intervention launched in July and last month's "one-off" devaluation of the renminbi. China's central bank remained silent for two days after devaluing the renminbi 1.9 per cent against the dollar on August 11 and adjusting its mechanism for setting the currency's daily dollar "reference rate". David Bandurski, at the University of Hong Kong's China Media Project, said it was rare for the propaganda department to issue written rather than oral directives for fear they might leak. "Economic troubles have been a focus of concern in the party's news and propaganda work lately," he added. "The content of these purported propaganda instructions fits with what official state media have been pushing for the last few months." An official whose name and phone number appeared on the Xinhua notice declined to comment. The party propaganda department could not be reached for comment. Say the right things and you move up the party line. Say the wrong things and you are put in prison or shot. China has no human rights, appalling property rights, illiquid bond markets of insufficient size, and a pegged currency it can no longer control smoothly. Capital controls round out the mess. Yet, people think the Yuan will "soon" become the world's reserve currency, replacing the US dollar. I have heard these yuan reserve currency "soon" stories for at least a decade. What a joke. Mike "Mish" Shedlock Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific.

CME Fedwatch and Bloomberg Rate Hike Odds Still Wrong; Deflationary Bust Coming Posted: 11 Sep 2015 01:56 AM PDT As of September 10, the CME has the odds of a September hike by the Fed at 24%. Bloomberg says the probability of a move is 28%. Bloomberg Rate Hike Odds CME Fedwatch Odds Both Models Wrong What's wrong with both models is they still presume a quarter point hike. Neither Bloomberg nor the CME allows for the possibility of a Fed hike to precisely 0.25% or to a smaller tighter range. Given the effective Fed Funds Rate is 0.14% (see upper right of Bloomberg chart), resetting the rate to a flat 0.25% from the current range of 0.00-0.25% (now at 0.14%), would be both a "move" and a "hike". Tighter Range The Fed could also use ranges as Bloomberg and CME imply, but target ranges in 1/8 of a point increments rather than 1/4 point increments. For example the Fed could target a range of 0.25% to 0.375%. I suspect the odds of a move to a flat 0.25 or a range (0.25% to 0.375%), are far greater than Bloomberg's "probability of a move" set at a mere 28%. I went over this before, on August 19, in Plotting the Fed's Baby Step 1/8 Point Hikes; Yellen vs. Greenspan "Measured Pace". I updated my charts today. Flattening of Rate Hike Expectations Using Fed fund futures from CME, I calculated implied interest rates through December 2017. The line in Blue shows what futures implied on August 19. The line in red is from September 10. Note the flattening of the curve. This has been happening pretty much all year. The market initially penned in hikes for January. The hikes then shifted to March, then June, then September, and now December by both the Bloomberg and CME models. Range Watch Curve Watchers Anonymous is closely watching the implied baby steps in the Fed fund futures. Incrementally, the hikes appear as follows. Month Fed Funds Future Rise in Implied Rate Aug-15 99.863 Sep-15 99.835 0.028 Oct-15 99.805 0.030 Nov-15 99.765 0.040 Dec-15 99.720 0.045 Jan-16 99.685 0.035 Feb-16 99.645 0.040 Mar-16 99.610 0.035 Apr-16 99.560 0.050 May-16 99.520 0.040 Jun-16 99.480 0.040 Jul-16 99.435 0.045 Aug-16 99.385 0.050 Sep-16 99.350 0.035 Oct-16 99.295 0.055 Nov-16 99.230 0.065 Dec-16 99.170 0.060 Jan-17 99.135 0.035 Feb-17 99.055 0.080 Mar-17 99.020 0.035 Apr-17 98.970 0.050 May-17 98.915 0.055 Jun-17 98.875 0.040 Jul-17 98.830 0.045 Aug-17 98.780 0.050 Sep-17 98.740 0.040 Oct-17 98.700 0.040 Nov-17 98.650 0.050 Dec-17 98.615 0.035 Baby Steps Plotted Fed fund futures imply a very slow tightening of 3-6 basis points a month. The only exception is January to February of 2017 where the incremental rise is 8 basis points (0.080 percentage points). The Fed does not set policy every month. Instead it does so about eight times a year. FOMC dates are not yet set for 2017, but futures imply something like the following. Fed Rate Hike Expectations Through 2017 Yellen vs. Greenspan The above market expectations are clearly similar to Greenspan's famous statement: Hikes will be at a "pace that's likely to be measured". The Yellen expected "pace" is half as often. The Yellen expected "measure" is half as much. Just Get On With It! Via email, Albert Edwards at Society General writes: The clamour for the Fed not to enact the long-awaited ¼% rate hike next week is growing by the day. Misgivings come not just from reputable mainstream commentators, but now also the World Bank has repeated the IMF's recent words of caution in advising delay. What a load of nonsense! My esteemed colleague Kit Juckes characterises the current consensus thinking as "If the Fed hikes, pestilence, plague and never-ending deflation will follow." Well even those like me who see a deflationary bust awaiting think the Fed should hike next week – because the longer you leave it, the bigger the financial market excesses become, and the bigger the risk of financial dislocation and global recession ensuing. Have we learned nothing from the 2008 Great Recession? Just get on with it! Exactly! A deflationary bust is coming and there is nothing the Fed or any central bankers can do about it. And when the bubble busts, Paul Krugman, Larry Summers, the World Bank, and Christine Lagarde at the IMF will all be singing the "I told you so" tune. The irony is Krugman, Summers, the World Bank and the IMF are all wrong. The seeds of the upcoming deflationary bust were planted, watered, and over-fertilized by central bankers everywhere, all in the asinine name of "price stability" and deflation fighting. For further discussion on the sheer ridiculousness of price stability policy, see Cross-Border Deflation: US Export Prices Collapse Most Since July 2009; How Damaging is Price Deflation? Mike "Mish" Shedlock Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction. Visit http://www.sitkapacific.com/account_management.html to learn more about wealth management and capital preservation strategies of Sitka Pacific.

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