World leaders are taking investors down a dangerous economic path

Now let’s turn to Brexit, the U.K. referendum on exiting the EU. Ironically, the U.K. doesn’t have half the problems that most EU nations are going through. Because it is not part of the EMU, it has retained its currency and its central bank.

The U.K.’s main dissatisfaction with EU membership stems from the immigration issue. Because treaties have turned the EU into a borderless union, when Germany accepted refugees from the Middle East and Northern Africa, it basically made a unilateral decision on behalf of all EU members to accept those refugees to all EU countries. High unemployment, wage stagnation and terrorism are now endemic in the EU, and you can see how the U.K.’s citizenry might have a problem with this.

After the Brexit vote, the financial media lit up with opinions on its consequences for the EU and the global economy. They’ve varied from “Brexit is a nonevent” to “This is a Lehman moment for the global economy,” referring to the Lehman Brothers bankruptcy that almost brought the financial system to a halt in 2008. The arguments on both sides are quite convincing.

The argument for Brexit’s being a nonevent is simple and straightforward. The U.K. maintained its currency, and the pound’s  decline in the aftermath of the referendum will help cushion any negative fallout on the British economy. The U.K. and the EU will forge new trade treaties. There is a fear that the EU may impose trade sanctions on U.K., not so much to punish the U.K. but to threaten other EU members that exit will come at a stiff economic cost (effectively turning this voluntary club into a prison). However, the U.K. is a net importer of goods from the EU; thus any sanctions will hurt remaining EU members more than the U.K.

The Lehman moment argument is less simple, but not unimaginable. Brexit may provide the spark that will ignite already gasoline-soaked ground. Though the EU and EMU were supposed to unite Europeans, they may have had the opposite effect — causing a groundswell of nationalism.

In all honesty, Italy is more concerning than the U.K. Italy is the third-largest economy in the EU, and its debt stands at 132% of GDP, second only to Greece (171%). Seventeen percent of Italian bank loans are noncurrent. In the depths of the financial crisis, that number was 5% in the U.S. Italian lenders account for nearly half of bad debt in the EU.

If Italy was not part of the EMU, it could just print lire and bail out its banks. But it gave up that luxury when it joined the single currency. To make things worse, in 2014 the EU passed a law that prohibits governments from bailing out their banking systems; thus the shareholders, debtholders, and depositors may bear the brunt of the eventual bailout. Unless the EU passes a new law that bends the 2014 law — or the Italian government takes matters into its own hands, violating EU rules — we may see Italian debtholders and depositors hit with the cost of bank bailouts take to the streets and demand “Italexit.”

Nationalism is a highly emotional, zero-sum, us-against-them sort of business. Add immigration concerns on top of economic ones, and it’s not hard to see how Europe has turned into a highly combustible mixture looking for a match. And because emotions are often antilogical, future decisions by EU countries may not necessarily be beneficial to the European Continent.

Given that the situation in Europe is so complex and combustible, it’s unclear whether Brexit will be just another match that simply burns out or the one that starts the fire. Will it trigger other exits? Will it slow down EU growth, thus straining an already leveraged system? No one knows.

Meanwhile, China is the world’s second-largest economy and is experiencing the largest debt bubble we’ll probably ever see in our lifetimes. From 2007 to 2014, the country’s debt quadrupled, to $28 trillion from $7 trillion. Over the same period, China’s economy grew to $10.5 trillion from $3.5 trillion. These numbers are staggering and point to one indisputable fact: All Chinese growth since 2007 has come from borrowing. There was no miracle in it.

But it gets worse, much worse. The numbers also show that every $1 of new debt brought only pennies of GDP growth. In the absence of skyrocketing debt, the Chinese overcapacity bubble, which was already fully inflated pre-2007, would have burst years ago.

As the government continues to engineer growth by borrowing, every yuan of debt will bring less growth. The laws of economics have not been suspended in China. American economist Herbert Stein’s law states that things that cannot go on forever, won’t. When its debt bubble bursts, China will become a headwind for global growth.

This brings us to Japan. It is the most-indebted developed nation in the world, with a debt-to-GDP ratio of more than 230%. Japan is the proof of Stein’s law — its economy is still suffering a hangover from what at the time seemed like an endless real estate party (bubble) that lasted from the mid-1980s into the early 1990s. Japan has been on the quantitative easing and endless stimulus bandwagon longer than anyone else and has nothing (except a lot of debt) to show for it.

Japan also has the oldest population in the world — 26% of its people are older than 65 (in the U.S. the figure is 15%). Rising debt and an aging population are a double negative for the economy, as debt per capita is rising at an even faster rate than total debt. And since the working population is declining at an even faster rate than the population as a whole, debt per working person is growing at an even faster rate.

Given this reality, you might think Japan is paying the highest interest rates in the world, perhaps somewhere in the high teens. Wrong. The Japanese 10-year goverment bond carries a negative yield.

This is an overview of the challenging environment facing investors around the world. It’s evident that stock market performance has not been driven by the improving health of the global economy. Just as negative interest rates are not a positive for the continued health of the economy, current stock market performance does not augur rosy future returns for stocks. In fact, the opposite is true.

So, how does one invest in this overvalued market? Our strategy is spelled out   in this fairly lengthy article.

Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing” (Wiley) and “The Little Book of Sideways Markets” (Wiley). Read more on Katsenelson’s Contrarian Edge blog.

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