Doug Noland: A Decisive Quarter

Members:  I sent an email recently that touches on aspects of Doug’s article below and how I view it from an investment point-of-view.  An important point to repeat is the concept that tightening US monetary policy in today’s globally integrated world has some perverse effects. 

As US policy tightens it is first felt in emerging markets and weaker developed countries all of which are under intense pressure today. The perversion is that as the global risk-off effect occurs money flows to the safe-haven US markets. The US is the core of the global financial system backed by the world’s reserve currency that can be printed with abandon to avoid defaults.  

So while the Federal Reserve attempts to tighten US policy, foreign funds flow into US treasuries and corporate bonds to escape risk thus pushing US interest rates down (monetary easing).  This delays the full effects of US policy similar to an avalanche building while the ski town parties on.

As Doug Noland has stated previously, the financial sphere and the economic sphere need to be viewed separately.  I believe both fiscal and monetary policy will induce a financial crisis long before measurable effects are felt in the economy.  This is the price of financializing the global economy and spending a decade focusing monetary policy on repairing the financial system’s damage caused by previous policy follies.

Michael H. Bond



A Decisive Quarter

Doug Noland

June 29 – Financial Times (Peter Wells): “The buck is back. Tighter domestic monetary policy and global trade turmoil have set the US dollar for its best quarterly performance since December 2016. The DXY index, which tracks the US currency against a weighted basket of global peers, was up 5.2% in the three months to June 29. That has been achieved via a three-month winning streak, its first such run since December 2016, too.”

Chicken or the egg? U.S. dollar strength or emerging market weakness? It’s most likely a mix of both, but either way it was a quarter where “Periphery and Core Analysis” offered insight. Global financial conditions tightened significantly during the quarter.

The U.S. dollar gained 5.2% against the euro, 4.0% versus the Japanese yen, 6.7% versus the Swedish krona, 6.5% against the New Zealand dollar, 5.8% versus the British pound, 3.8% against the Norwegian krone, 3.7% against the Swiss franc, 3.6% versus the Australian dollar and 1.8% against the Canadian dollar.

There were large moves in “developed” currencies, though the larger drama played out in the emerging markets. The Argentine peso collapsed 30%, forcing the Macri government into an unpopular $50bn IMF aid package. Political uncertainty heading into fall elections, sinking stocks, destabilizing labor unrest and general strife led to a 14.7% drop in the Brazilian real. Surging inflation, a faltering boom, excessive debt and strongman President Erdogan’s threats on central bank independence were behind the Turkish lira’s 13.9% fall for the quarter. Vulnerable as well, the South African rand fell 13.7% versus the dollar.

Especially late in the quarter, Asian currencies were under heavy selling pressure. Declines for the quarter included the Thai baht’s 5.8%, the Indian rupee’s 4.8%, the South Korean won’s 4.6%, the Taiwanese dollar’s 4.5%, the Malaysian dollar’s 4.3%, the Indonesian rupiah’s 3.9% and the Singapore dollar’s 3.7%.

While not garnering much attention, “developing” Europe faced significant currency weakness. Losses included the Hungarian forint’s 10.0%, the Russian ruble’s 8.9%, the Polish zloty’s 8.7%, the Czech koruna’s 7.5%, the Iceland krona’s 6.5%, the Romanian leu’s 5.3%, the Bulgarian lev’s 5.2%, the Serbian dinar’s 5.0% and the Croatian kuna’s 4.5%.

In Latin America, the Venezuelan bolivar sank 48.5%, the Mexican peso 8.7%, the Chilean peso 7.7% and the Colombian peso 4.6%.

Headlines capture the dramatic change in market perceptions that unfolded during the pivotal second quarter. From Morningstar back in mid-April: “ETF Investors Favour Emerging Markets in 2018.” And Thursday afternoon from CNBC: “Global stocks see biggest loss of investor cash since the financial crisis.”

A quarter that began with the trumpeting of “synchronized global expansion” ended with increasing fears of EM-induced global recession. After beginning the year in speculative melt-up mode, emerging equities fell back to earth in Q2.

Chinese stocks led the rout. The Shanghai Composite sank 10.1% during the quarter. The small cap CSI 500 lost 14.7%, and the CSI Midcap 200 fell 12.5%. China’s growth/tech ChiNext index was slammed 15.5%. Hong Kong’s Hang Seng financials index dropped 10.7% during the quarter, led by losses from the Chinese securities firms. As for China’s two largest banks, Industrial and Commercial Bank of China dropped 12.6% during the quarter and China Construction Bank lost 15.5%. Trouble brewing in Chinese Credit. Unfolding capital flight issue? Losing 1.75% in the final week of the quarter, the Chinese renminbi dropped a notable 5.2% during Q2.

June 29 – Bloomberg (Denise Wee): “Asia junk bond spreads blew out further this week as concerns about Chinese issuers mounted amid a selloff in that nation’s shares and currency. Yield premiums on the notes spiked 25.3 bps on Thursday, leaving them poised for a 45.5 bps jump this week, the sharpest in more than five months… Adding to concerns in Asian credit markets this week, people familiar with the matter said that China is slowing approvals for offshore bonds and weighing whether to ban short-dated issuance in dollars.”

June 29 – Bloomberg: “Asian high yield dollar bonds are set to post the biggest quarterly loss since 2013, with Chinese companies leading declines, as heavy pipeline of new bond deals and rising defaults dented market confidence. Asian junk bonds are set to post negative returns of about 3.3% in 2Q after a loss of 1.1% in 1Q, making it the worst quarter since 2Q 2013, when returns were negative 4.5%, according to Bloomberg Barclays Asian High-Yield Dollar Bond Index… Eight out of the 10 worst performers this quarter were Chinese firms compared to just three in 1Q.”

Japan’s TOPIX Bank Index fell 4.8%, though Japan’s Nikkei rallied 4.0% during the period (on yen weakness). The quarter saw equity market losses of 4.9% for South Korea (KOSPI), 4.7% in Singapore, 10.2% in Thailand, 9.2% in Malaysia, 6.3% in Indonesia, 9.9% in Philippines and 18.2% in Vietnam. Not all was red in Asia. India’s stocks (SENSEX) gained 7.5%. Stocks gained 7.6% in Australia and 7.5% in New Zealand.

Big bank stock losses were not limited to Asia. There was carnage in Brazil, home to Latin America’s largest banks. Banco do Brasil sank 30.2%, Banco Bradesco dropped 30.3% and Itau Unibanco fell 21.4%. Brazil’s Ibovespa index sank 14.8% during the quarter (27.3% in U.S. dollars).

Bank losses led European indices on the downside. European Banks (STOXX600) dropped 6.9% during the quarter, increasing y-t-d losses to 12.4%. Interestingly, German banks led on the downside, with Deutsche Bank dropping 41.9% and Commerzbank sinking 34.3%. Other losses included Bankia’s 19.6%, ING’s 19.6%, ABN Amro’s 17.4%, Danske’s 17.3%, Credit Agricole’s 17.1% and Societe Generale’s 16.1%. European and Latin American banks competed during the quarter for the largest jumps in Credit default swap prices.

Despite the weak banking sector, developed European equities indices for the most part posted gains for the quarter (supported by currency weakness). Major indexes were up 8.2% in the UK, 3.0% in France, 1.7% in Germany, 0.2% in Spain and 1.5% in Sweden. Italy’s MIB index dropped 3.5% during the quarter.

Meanwhile, instability reemerged throughout European bonds markets. After beginning the quarter (and May) at 1.78%, Italian yields spiked to 3.13% in late-May. For the quarter, Italian yields rose 89 bps to 2.67% (2-yr yields up 103bps to 2.64%!). Spain’s 10-year yields rose 17 bps and Portugal’s 18 bps. Spreads widened significantly versus German bunds. The quarter saw bund yields drop a notable 19 bps to 30 bps. German two-year yields declined six bps to negative seven bps (traded as low as negative 77bps in late-May).

U.S. treasuries saw their share of volatility. Ten-year yields began the quarter at 2.73%, jumped to 3.13% on May 17th, before reversing back down to 2.78% on May 29th – before ending the quarter at 2.86%. The first half of the quarter saw yields respond to a booming U.S. economy, the second half to a bursting EM Bubble and the rising prospect of protectionism afflicting a vulnerable global economy.

Local currency EM bonds were hammered. Ten-year yields rose 393 bps in Turkey (to 16.17%), 214 bps in Brazil (11.62%), 123 bps in Hungary (3.60%), 107 bps in Indonesia (7.69%), 86 bps in South Africa (86 bps), 76 bps in Romania (5.17%), 75 bps in Peru (5.57%), 63 bps in Russia (7.66%), 51 bps in India (7.90%), and 27 bps in Mexico (7.58%). It’s worth highlighting a few big moves in dollar-denominated EM bonds: Yields surged 200 bps in Argentina (8.65%), 109 bps in Brazil (5.96%) and 95 bps in Turkey (6.79%).

The surging dollar, fading global growth prospects and trade issues made for an interesting quarter in the commodities. WTI crude surged 14.2%, and NYMEX gasoline gained 8.0%. Meanwhile, the strong dollar pressured the precious metals. Golds fell 5.5%, silver 1.5% and Platinum 8.5%. Copper declined 1.3%. Agriculture commodity prices moved all over. Wheat jumped 10.3%, while corn dropped 9.7%. Soybeans sank 17.8%.

And saving the most intriguing for last, U.S. equities. A Friday Bloomberg headline: “Wall Street Left Reeling as 2018 Upends Almost Every Bet.” A long central bank-induced bull market ensured too much “money” swirling around global markets. Crowded Trades were faltering left and right throughout the quarter.

The S&P500 rose a solid but un-noteworthy 2.9% during the quarter. The noteworthy lurked below the surface. The unloved retail stocks (XRT) surged 9.6%. Tiffany gained 34.8%, Macy’s 25.9% and Kroger 18.8%. Q2 saw a rather spectacular short squeeze, with the Goldman Sachs Most Short Index gaining 15.0%. Notable quarterly gains included Twitter (50.5%), AMD (49.2%), Under Armour (46.9%), Trip Advisor (36.2%), Chipotle (33.5%), Netflix (32.5%), Tesla (28.9%), and Facebook (21.6%). A big energy sector short squeeze saw Chesapeake Energy gain 73.5%, Ensco 65.4%, Oasis Petroleum 60.1%, Diamond Offshore Drilling 42.3% and Hess 32.1%. The New York Arca Oil index surged 14.3%.

The higher-risk sectors generally outperformed. The Nasdaq Composite jumped 6.3%, the Nasdaq100 7.0% and the Biotechs (BTK) 5.5%. Relatively removed from EM and global trade concerns, broader U.S. equities outperformed. The small cap Russell 2000 jumped 7.4% and the S&P400 Midcaps rose 3.9%. The REITs gained 6.8%. While the unloved surged higher, the darling financial stocks were under moderate pressure. The banks (BKX) declined 2.5% for the quarter, and the NYSE Financials fell 3.1%.

June 29 – Bloomberg (Molly Smith): “Blue-chip corporate bonds are on track to be the worst-performing U.S. asset class this year, and money managers caution that it may be too soon to start looking for bargains… It’s not clear how much longer the pain will persist for investment-grade bonds. Issuance is likely to slow down in the second half of the year, cutting into supply, and foreign buyers may be more inclined to buy now as the U.S. dollar appreciates… Investment-grade corporate debt has fallen 3.3% this year through June 28 on a total-return basis, on track for the worst first half of a year since 2013…”

June 29 – Financial Times (Alexandra Scaggs): “Investment-grade US corporate bonds recorded a second negative quarter in the three months to the end of June, marking the first back-to-back losses since the financial crisis, as the Federal Reserve raised interest rates and foreign buyers of corporate bonds retreated in the first half of this year… The spread between yields on corporate credit and comparable Treasuries widened to 130 bps from 90 bps in early February, according to ICE BofAML index data. Spreads widened as the pace of investment-grade bond issuance from US companies remained unexpectedly persistent this year, while rising hedging costs dented demand from non-US investors, previously a major buyer group, compared to 2017… The volume of investment-grade bond issuance in the first half of 2018 was just 5% lower than last year… This has confounded strategists’ predictions of declines in issuance of as much as 16%.”

Investment-grade bonds (LQD) returned negative 1.14% for the quarter, notably underperforming junk bonds (HYG) that returned positive 1.21%. Interesting to see investment-grade and junk bond spreads diverge. With cracks forming at the global Periphery (EM), flows gravitated to Core (US) securities markets. This worked to overpower the rise in Treasury yields. The reversal lower in market yields supported U.S. equities generally, which spurred quite a short squeeze at the “Periphery of the Core” (the fringe of U.S. securities). This tended to bolster more fundamentally-challenged U.S. equities, in the process also supporting higher-risk bonds. And as higher beta and the fundamentally challenged began outperforming the S&P500, the Performance Chase was on.

There’s nothing like a short squeeze and perceptions of loose corporate Credit to spur speculative fervor. I would urge caution. I view the performance of the investment-grade market as the single most important market indicator for prospective U.S. equities returns. At this point, I would discount the outperformance of “short” stocks, the small caps, the higher beta sectors, big tech and high yield. This week’s selling in the banks, brokers and transports portends challenges ahead.

The faltering Chinese and EM Bubbles abruptly altered global market dynamics, catching many players poorly positioned (over their skis in some areas and significantly underweight others). My sense is that many hedge funds suffered a challenging quarter, as their longs generally underperformed the market while their shorts significantly outperformed. This dynamic was instrumental in Q2’s short squeeze. De-risking forced cutting back on favorite longs and reducing favorite shorts – with a plethora of Crowded Trades on both sides. Fascinating yes, but none of this is bullish.

The U.S. currency and equities market were beneficiaries of the rapidly deteriorating global backdrop. This market dynamic stoked the booming American economy. I would argue there is a clear downside to bubbling U.S. markets and economic output: For one, the environment emboldens both the Fed and President Trump. The Powell Fed is emboldened to follow through with rate and balance sheet normalization. The President, meanwhile, is emboldened to push through with his aggressive trade and political agendas – prominently with plans for major tariffs and additional tax cuts.

Booming markets ensure imaginations run wild. Importantly, reality began to gain the upper hand during the quarter. The global Bubble faltered. The world is not robust – there are, indeed, fragilities everywhere. EM is a potential disaster. China is increasingly vulnerable. China and Asian debt has become a huge global risk. I worry about Brazil.

And this age of populism and the “strongman” politician actually does matter to the markets. Trump Tariffs. China ready to “punch back.” Erdogan to dictate Turkish rate policy? The new Italian government to play hardball with the EU. Immigration becoming a pressing political issue from Washington to Frankfurt. A new leftist President in neighboring Mexico. Well, booming markets were content to disregard the global rise of populism, divisiveness and autocracy. Faltering markets will now amplify these troubling trends. All the makings for savage bear markets.

It was A Decisive Quarter: The world became more divided; the “Atlantic Alliance” became more divided; Europe became more divided; Asia became more divided; North America became more divided; and the United States turned only more divided. U.S. stock performance during the quarter should not distract from the ominous storm clouds forming globally – in the markets, economically, socially and geopolitically. Global markets were also more divided, though I would expect Contagion from the Periphery to now make more discernable headway toward the Core.


Original Post 30 June 2018

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Categories: Doug Noland, Perspectives