Serious illiquidity issues were unfolding a small number of trading sessions ago, as equities and fixed-income outflows – along with derivatives-related and speculative selling – began to overwhelm the marketplace. Fed assurances reversed trading dynamics. De-risking/deleveraging has, for now, given way to “risk on.” A powerful confluence of short covering and risk embracement (and leveraging) has acutely speculative markets once again perceiving liquidity abundance and unwavering central bank support.
I titled last year’s “Issues 2018” piece “Market Structure.” A decade of central bank policy-induced market Bubbles fostered momentous market distortions and structural maladjustment. At the top of the list is the historic shift into “passive” ETF “investing.” With the ETF complex approaching $5.0 Trillion – and another $3.0 TN plus in the hedge fund universe – financial history has never seen such a gargantuan pool of trend-following and performance-chasing finance. Add to this the global proliferation of listed and over-the-counter derivatives strategies (especially options) and trading, and we’re talking about a world of unprecedented financial speculation. It’s an aberrant Market Structure, and we’re witnessing repercussions.
After powerful speculative flows and early-2018 blow-off excess, we saw the emerging markets (EM) then succumb to abrupt market reversals, destabilizing outflows, illiquidity and Crisis Dynamics. We witnessed how fragility at the “Periphery” propelled inflows to the “Core,” pushing U.S. securities markets into a destabilizing speculative melt-up (in the face of a rapidly deteriorating fundamental backdrop). This speculative Bubble burst in Q4.
The Powell Fed chose not to come to the market’s defense at the December 19th FOMC meeting. I viewed this as confirmation that Chairman Powell appreciated how previous hurried Fed measures to backstop the markets had bolstered speculation, distorted market functioning and fueled Bubbles. By January 4th, however, the pressure of market illiquidity had become too much to bear.
The Fed, once again, intervened and reversed the markets. Those believing in the indominable power of the “Fed put” were further emboldened. The resulting short squeeze and reversal of hedges surely played a commanding role in fueling the advance. And in a financial world dominated by trend-following and performance-chasing finance, market rallies can take on a wild life of their own. There is tremendous pressure on investment managers, the speculator community, advisors and investors not to miss out on rallies. All the makings for a wretchedly protracted bear market.
Serious illiquidity issues were unfolding a small number of trading sessions ago, as equities and fixed-income outflows – along with derivatives-related and speculative selling – began to overwhelm the marketplace. Fed assurances reversed trading dynamics. De-risking/deleveraging has, for now, given way to “risk on.” A powerful confluence of short covering and risk embracement (and leveraging) has acutely speculative markets once again perceiving liquidity abundance and unwavering central bank support. Dangerous.
At least at this point, I’m not anticipating a crisis of confidence in an individual institution (i.e. Lehman in October 2008) will dominate Crisis Dynamics. Rather, I see a more general unfolding crisis of confidence in market function and policymaking. A decade of reckless monetary expansion and near-zero rate policies unleashed Intractable Monetary Disorder. Among the myriad consequences are deep structural impairment to financial systems – certainly including global securities and derivatives markets. The world is in the midst of acute financial instability with little possibility of resolution (outside of crisis).
These policy-induced bouts of “risk on” bolster confidence in both the markets and real economies. Importantly, they also feed dysfunctional Market Dynamics. Upside market volatility exacerbates market instability, fueling pernicious speculation, manic-depressive flows, and destabilizing derivative-related trading dynamics. With fundamental deterioration accelerating both globally and domestically, I would argue a speculative run higher in securities prices exacerbates systemic risks – while ensuring a more problematic future dislocation.
The global Bubble has begun to deflate. Chinese data continue to confirm a serious unfolding downturn. Not dissimilar to Washington policymakers, Beijing appears increasingly anxious. In theory, there would be advantages to letting air out of Bubbles gradually. But the bigger the Bubble – and the greater associated risks – the greater the impetus for policymakers to indefinitely postpone the day of reckoning. The upshot is only worsening Monetary Disorder. With still rising quantities of Credit of rapidly deteriorating quality, systemic risk continues to rise exponentially in China (and the world).
January 14 – Reuters (Kevin Yao): “China… signaled more stimulus measures in the near term as a tariff war with the United States took a heavy toll on its trade sector and raised the risk of a sharper economic slowdown. The world’s second-largest economy will aim to achieve ‘a good start’ in the first quarter, the National Development and Reform Commission (NDRC) said… Central bank and finance ministry officials gave similar assurances. Surprising contractions in China’s December trade and factory activity have stirred speculation over whether Beijing needs to switch to more forceful stimulus measures…”
January 15 – Reuters: “Chinese banks extended 1.08 trillion yuan ($159.95bn) in net new yuan loans in December, far more than analysts had expected but down from the previous month. Analysts polled by Reuters had predicted new yuan loans of 800 billion yuan last month, down from 1.25 trillion yuan in November…”
January 15 – South China Morning Post (Amanda Lee): “China’s banks extended a record 16.17 trillion yuan (US$2.4 trillion) in net new loans last year…, as policymakers pushed lenders to fund cash-strapped firms to prop up the slowing economy. The new figure, well above the previous record of 13.53 trillion yuan in 2017, is an indication that the bank has been moderately aggressive in using monetary policy to stimulate the economy, which slowed sharply as a result of the trade war with the US. Outstanding yuan loans were up 13.5% at the end of 2018 from a year earlier… In addition, debt issued by private enterprises increased by 70% year-on-year from November to December last year, indicating that the central bank’s efforts to support the private sector are working.”
There’s a strong consensus view that Beijing has things under control.
Reality: China in 2019 faces a ticking Credit time bomb.
Bank loans were up 13.5% over the past year and were 28% higher over two years, a precarious late-cycle inflation of Bank Credit. Ominously paralleling late-cycle U.S. mortgage finance Bubble excess, China’s Consumer Loans expanded 18.2% over the past year, 44% in two years, 77% in three years and 141% in five years. China’s industrial sector has slowed, while inflated consumer spending is indicating initial signs of an overdue pullback. Calamitous woes commence with the bursting of China’s historic housing/apartment Bubble.
Typically – and as experienced in the U.S. with problems erupting in subprime – nervous lenders and a tightening of mortgage Credit mark an inflection point followed by self-reinforcing downturns in housing prices, transactions and mortgage Credit. Yet there is nothing remotely typical when it comes to China’s Bubble.
Instead of caution, lenders have looked to residential lending as a preferred (versus business) means of achieving government-dictated lending targets. Failing to learn from the dreadful U.S. experience, Beijing has used an inflating housing Bubble to compensate for structural economic shortcomings (i.e. manufacturing over-capacity). This is precariously prolonging “Terminal Phase” excess.
The Institute for International Finance is out with updated global debt data. In the public interest, they should make this data and their report available to the general public.
January 16 – Financial Times (Jonathan Wheatley): “Emerging-market companies have gorged on debt. Slower global growth and higher funding costs will make servicing that debt harder, just as the amount coming due this year reaches a record high. The result? Less investment for growth and yet more borrowing. These are some of the concerns raised by the Institute of International Finance… as it published its quarterly Global Debt Monitor… The IIF’s data show total global debt — owed by households, governments, non-financial corporates and the financial sector — at $244tn, or 318% of gross domestic product at the end of September, down from a peak of 320% two years earlier. In some areas, though, borrowing is rising. Of particular concern is the non-financial corporate sector in emerging markets (EMs), where debts are equal to 93.6% of GDP. That is more than among the same group in developed markets, at 91.1% of GDP.”
January 16 – Washington Post (Robert J. Samuelson): “Government debt has tripled from $20 trillion in 2000 to $65 trillion in 2018, rising as a share of GDP from 55% to 87%. Household debt has increased over the same years, from $17 trillion to $46 trillion (from 44% to 60% of GDP). Finally, nonfinancial corporate debt rose from $24 trillion to $73 trillion (71% of GDP to 92%)… According to the data from the IIF, emerging-market borrowers face $2 trillion of maturing debt in 2019, with about a quarter of those loans made in dollars (most of the rest are in local currency). To avoid default, borrowers must somehow raise those dollars, either from a new loan or from other sources.”
January 16 – Barron’s (Reshma Kapadia): “A record $3.9 trillion of emerging market bonds and syndicated loans comes due through the end of 2020. Most of the redemptions in 2019 will be outside of the financial sector, mainly from large corporate borrowers in China, Turkey, and South Africa. The question will be if they can refinance the debt…”
Considering the unprecedented global debt backdrop, it’s difficult for me to believe last year’s corrections went far in resolving deep structural issues throughout the emerging markets – and for the global economy more generally. “A record $3.9 trillion of emerging market bonds and syndicated loans comes due through the end of 2020…” “…Borrowers face $2 trillion of maturing debt in 2019, with about a quarter of those loans made in dollars.”
Positive headlines from Washington and Beijing engender optimism that a U.S./China trade deal is coming together. One can assume President Trump yearns for those morning Tweets lauding record stock prices. President Xi certainly has ample motivation for a deal to goose Chinese markets and the increasingly vulnerable Chinese economy.
A deal would be expected to boost U.S., Chinese and global equities. It will be curious to see how long Treasuries can observe rallying risk markets before turning nervous. So far, Treasuries, bunds and JGBs have been curiously tolerant. If the risk markets rally gains momentum, I would expect flows to be drawn out of the safe havens. A jump in global yields – perhaps accompanied by a resurgent dollar – could prove challenging for the fragile emerging markets.
Pondering the massive pool of unstable global speculative finance, I ponder how both EM and global corporate Credit will trade in the event of a more sustained recovery in global equities and sovereign yields. Bear market rallies feed optimism and perceptions of abundant liquidity. But I believe the global liquidity backdrop has fundamentally deteriorated. This predicament, however, is completely concealed during rallies – only to reemerge when the buyers’ panic runs its course and selling resumes. It would not be surprising to see liquidity issues resurface in EM currencies and debt markets. In general, the more intense the counter-trend rallies the greater the vulnerability to sharp market reversals and a return of illiquidity.
Fed officials have fallen in line with the Chairman’s cautious language. But I would not totally dismiss “data dependent.” With labor markets unusually tight, a scenario of a trade deal, speculative markets and economic resilience could possibly see the Fed contemplating a shift back to “normalization.” Market pundits were quick to highlight “hawkish” Kansas City Fed President Esther George’s newfound dovishness. Comments from “dovish” Chicago Fed President Charles Evans were as notable: “I wouldn’t be surprised if at the end of the year we have a funds rate that’s a little bit higher than where we are now. That would be associated with a better economy and inflation moving up.” It’s going to be a fascinating year.
Original Post 19 January 2019