When I began posting the CBB in 1999, I expected “Bubble” to be in the title for no longer than a year or two. It was to be the “Credit Bulletin,” inspired by Benjamin Anderson’s “Economic Bulletin” from the 1920’s. Yet here we are in 2020 with Bubbles everywhere, including in my blog title. In 1999, I would have said that was an impossibility.
There are many things that proved not as impossible as I had believed. What was deemed acceptable monetary policy badly mutated. Mutant monetary management fundamentally altered the tolerance for debt and deficits. Finance and financial markets were similarly transformed, with yet to be appreciated consequences for (grossly simplifying here) Capitalism, societies and geopolitics.
So many changes, but I’m not changing. In my initial CBB I committed to “calling them as I see them and letting the chips fall where they may.” Let them fall.
“The Bubble will either further inflate or burst.” Regular readers will surely recognize this as what has become an annual ritual of my “Issues” pieces. Some might view it as a cop out; others may be reminded of Einstein’s definition of insanity. Yet Bubbles do have defined characteristics. They are at their core creatures of increasingly powerful momentum. Stimulus will intensity and broaden inflationary effects while enlarging the overall Bubble scope. Especially in the age of unshackled central banks, the timing of their demise is uncertain. Importantly, however, that they become progressively perilous over time remains a certainty.
This year’s “Bubble Will Inflate or Die” prognosis carries a significantly direr tone than in the past. From a Bubble Analysis perspective, 2019 was an absolute fiasco. Alarmed by faltering Bubbles, central bankers were panicked into prolonging the “Terminal Phase of Bubble Excess” through the reckless administration of additional stimulus. The ECB restarted QE before many even realized the previous program had been concluded. The Fed began the year abruptly abandoning “normalization” and then ended the year with $400 billion of Q4 QE. Rather than helicopter money, envision fleets of helicopters dropping buckets of propellant on columns of bonfires.
Central banks cut funding costs and afforded speculative financial markets hundreds of billions of additional liquidity. More importantly, global central bankers granted the type of guarantee markets had only dreamed of. Monetary policy will be used early and aggressively to backstop the markets, while no amount of excess would elicit any degree of monetary restraint. The Endless Punchbowl (with free salty snacks) – the “insurance rate cut”.
Bubble markets reacted with a vengeance. Global bond markets experienced a historic “melt-up” with yields collapsing over the summer. Global equities ended the year with a fit of panic buying. Bond and equities bears were squeezed to death. By their nature, speculative blow-offs create acute vulnerability. The final euphoric outburst ensures excessive underlying speculative leverage. Price momentum becomes unsustainable, with the inevitable reversal inciting de-risking/deleveraging dynamics. Some degree of illiquidity is unavoidable. Progressively powerful policy responses become necessary to suppress panic and crisis. Trapped.
The probability of a global crisis during 2020 is the highest since 2008. The nucleus of “The Bubble” in 2008 was in U.S. mortgage finance. “The Bubble” today is global, across virtually all financial assets (sovereign debt, stocks, corporate Credit, and derivatives), real estate (residential and commercial) and private businesses. From a Credit perspective, “The Bubble” has spread to – and corrupted – the foundation of global finance (central bank Credit and sovereign debt).
How can it end other than with a systemic crisis of confidence? Mispricing of U.S. government and corporate securities is unprecedented. The excesses in Chinese finance have moved far beyond any historical Bubble episode (Japan during the eighties and the U.S. mortgage finance Bubble mere kids’ stuff). All the punditry fuss over predicting a year-end S&P500 level seems especially pointless.
What really makes this so dangerous? Markets know that policymakers know the system is acutely fragile. Central bankers are not only trapped, the situation is so dire that they have no choice but to move early and aggressively to ensure Bubbles can’t begin deflating (no corrections or adjustments allowed).
January 5 – Reuters (Ismail Shakil): “New York Fed President John Williams said… it was important for the U.S. Federal Reserve to stick to its 2% inflation target and achieve it even as low global interest rates will likely continue… ‘There’s been a process of going through the stages of grief about a low neutral rate,’ Williams was quoted as saying… ‘These factors are basically the hand we’ve been dealt for the next five to 10 years.’ ‘If inflation continues to underrun our target levels like it has, this downward trend in inflation expectations will likely continue with inflation expectations falling well below target levels,’ he said.”
I’m reminded of a salient point from Adam Fergusson’s masterpiece, “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany:” Throughout the unfolding monetary, economic and social catastrophe, Reichsbank officials insisted they were responding to outside forces. They somehow remained oblivious to their central role.
My response to Fed President Williams’ “the hand we’ve been dealt” comment: You’ve not only been the dealer, but also the manufacturer and the stacker of the cards. Slot machine odds have been fixed by your coterie. You may now have issues with casino operations, its patrons and the consequences for the community – but you central bankers own it. And, of course, you will be keen to finger local government officials for the proliferation of crazed gamblers, pawn shops, bail bond outfits, unseemly motels, alcoholism and those run-down schools. Why the unwavering support for ever more commanding casinos?
January 9 – Wall Street Journal (James Mackintosh): “Tesla Inc. shares have doubled in three months, while General Electric Co. shares are up 44%. The pair are the two most valuable loss-making companies, part of a shockingly high proportion of listed companies that have been losing money—despite, or perhaps because of, the long bull market. While Tesla and GE couldn’t be more different, they are exemplars of two trends driving the rising number of loss makers. Tesla shows a desire by investors to back disruptive companies as they build their sales. GE represents a growing number of companies struggling to make money from traditional businesses… The combination of forces has pushed the percentage of listed companies in the U.S. losing money over 12 months to close to 40%, its highest level since the late 1990s outside of postrecession periods.”
“Mal-investment” is one of these invaluable “Austrian” concepts that is both wonderfully intuitive and exceptionally difficult to quantify (vitally important yet unfitting for econometric models). “Pushed the percentage of listed companies in the U.S. losing money over 12 months to close to 40%” is sufficient. Imagine the percentage come the next recession.
Stimulus, loose finance and Bubbles ensure market malfunction, price distortions, resource misallocation and mal-investment – all Issues 2020. This fateful experiment in late-cycle stimulus/Bubble extension is prolonging the boom in uneconomic enterprises and scores of businesses that will face dire circumstances when the Bubble inevitably bursts. On the one hand, any tightening of finance will expose cash flow and balance sheet vulnerabilities. On the other, today’s booming wealth-induced demand is unsustainable, exposing a mounting number of businesses to post-Bubble waning demand and altered spending patterns.
Last year provided a hint of underlying fragilities. Junk bonds, leveraged loans and IPOs all suffered convulsions as “risk off” and illiquidity made fleeting appearances. Tesla – the most valuable automobile manufacturer ever or bankruptcy candidate? A matter of market “risk on” or “risk off.” To what extent is Tesla a microcosm of Tech Bubble 2.0, the overall U.S. economy, China’s boom and the global Bubble?
There are New Paradigm sentiments reminiscent of the Q1 2000 “tech” Bubble crescendo. After ending 1999 at 3,708 (after a one-year gain of 102%), the Nasdaq100 (NDX) surged another 30% to an all-time high 4,818 on March 24th. The NDX then traded as low as 3,107 in April, 2,897 in May and then down to 2,175 in December. Myths exposed and fallacies revealed. Much of the boom-time demand for technology components, products and services was a direct consequence of the industry’s investment Bubble. Speculative finance reversed, finance tightened, uneconomic companies lost access to finance, and the Bubble burst (not before, of course, one final short squeeze and derivative-related melt-up).
Current bullishness may even exceed early-2000. Trust in central bankers is far greater. Market pundits highlight fundamentals supportive of an ongoing bull market. The longest economic expansion on record is poised to endure. After an unimpressive 2019, corporate profit growth is to accelerate. The global economy will perk up as the year progresses. Goldilocks with central bank guardianship.
But let’s not pretend that economic activity drives the securities markets. Investment-grade Credit default swaps (5yr Markit CDS) traded Friday at 43.7 bps, right at the low since before the crisis. High-yield CDS is near all-time lows. Goldman Sachs CDS closed the week at 52 bps, down from the 135 bps January 4, 2019 high. Trillion dollar plus (5% of GDP) annual fiscal deficits. Short-term rates at about 1.5%. Ten-year Treasury yields at 1.82%. Thirty-year mortgage rates at 3.64%. A Fed balance sheet exceeding $4.0 TN and inflating. Record stock prices. Why then wouldn’t the economy be expanding and corporate profits growing?
January 9 – Bloomberg (Molly Smith, Michael Gambale, and Hannah Benjamin): “Companies around the globe, concerned that heightened tensions between the U.S. and Iran could roil bond markets, are rushing to borrow cheaply while they still can. Investment-grade firms have sold more than $61 billion of notes in the U.S. through Thursday, double the same period in 2019… Borrowers from around the Asia Pacific region sold more than $28 billion in dollar notes this week, in a record start.”
January 10 – Bloomberg (Hannah Benjamin and Priscila Azevedo Rocha): “Europe’s bond market is wrapping up its biggest week ever, with over $100 billion of new debt sales underscoring its status as a major global funding vehicle. Issuers from China, Indonesia, Japan and the U.S. joined local borrowers in tapping Europe’s super-low funding costs and increasingly mature bond market, helping push sales for the week to 92.5 billion euros ($103bn).”
January 10 – Wall Street Journal (Frances Yoon): “Chinese property companies have kicked off 2020 by selling billions of dollars of longer-dated bonds, capitalizing on a hot market to reduce their heavy reliance on short-term funding. The country’s real-estate groups sold about $8 billion of dollar bonds in the first two weeks of January, according to credit strategists at ANZ.”
So long as financial conditions remain extraordinarily loose, I don’t know why the U.S. economy can’t surprise on the upside. With momentum building throughout 2019, expect some housing market “crazy” this year. “Tech Bubble 2.0” – growing only crazier. Los Angeles Times headline: “Taco Bell Offers $100,000 Salaries and Paid Sick Time.” Good to have that sick leave. Lavish cheap “money” on an overheated economy and one thing is a given: it will be borrowed and spent.
But when things go wrong they will really go wrong. Every passing month ensures maladjusted financial and economic systems only further hooked on unrelenting loose finance. I see a high probability of a 2020 financial accident. And I know most would say this is crazy talk. But we were close in the U.S. last September and January. China began to unravel in the early summer.
ETF Trends (Tom Lyndon): “Last year, fixed income ETFs took in $330 billion in new assets, the second-best year on record. Of that massive tally, bond ETFs accounted for a record $155 billion, prompting some market observers to say 2020 will be even better for bond ETFs. When 2019 came to a close, five of the top 10 ETFs in terms of new assets were bond funds and plenty of others in the fixed income space packed on assets as well.”
The Fed’s Q4 liquidity injections only exacerbated system fragility. Before celebrating apparent stability, our central bank should ponder the ramifications of colossal speculative flows. The liquidity flooding into bond ETFs increases the probability of a destabilizing reversal of flows and resulting illiquidity. The Fed’s $400 billion liquidity add only boosted systemic dependency. The Fed’s has its planned $60 billion monthly QE for the first half. Throw in another crisis scare and the Fed’s balance sheet rather quickly lunges toward $5.0 TN.
January 8 – Financial Times (Hung Tran): “Much attention has been focused on potential stresses in the US repo market. More attention should be paid to the FX swap market, which non-US banks and other entities have relied on for short-term US dollar funding. Recent changes in supply/demand conditions for US dollar funds in that market could make it more susceptible to stresses. In particular, emerging market banks have become more exposed to risk… Meanwhile, non-US banks have relied ever more on the $3.2tn-a-day FX swap market. According to the Bank for International Settlements (BIS), non-US banks have about $14tn of US dollar assets, not all of which are funded with liabilities such as deposits, loans and bond issuance. The FX funding gap — estimated by the IMF to be about $1.5tn — needs to be covered by borrowing in domestic currencies, swapped into US dollars.”
“Repo” markets, “FX swaps,” and money markets – at home and abroad – have all become one monumental trade. Last year’s instability was a harbinger of bigger issues to come. There has never been as much global leveraged speculation. How tens of Trillions of securities are financed and hundreds of Trillions of derivatives structured is in the realm of the murkiest of murky. How many Trillions of “carry trades” (borrow in low/negative rates to lever in higher-yielding securities) have accumulated – in yen, euro, Swiss, etc. How big is the “carry” in Chinese bonds? EM debt – local currency and Dollar-denominated? European peripheral bonds? How levered are trades in low-yielding Treasuries, bunds and JGBs? What is the scope of fixed-income derivatives leverage, with dynamic trading programs feeding buying on the upside – and liquidity crisis lying in wait for the downside?
Loose global finance papers over scores of festering issues. Key Issue 2020: China is a bigger accident in the making than it was this time last year. With accelerated growth of increasingly unsound Credit, systemic risk continues to rise exponentially. Upwards of $4 TN of additional Credit, another year of housing Bubble excess, uneconomic enterprises piling on more debt, resource misallocation and only deeper structural economic maladjustment.
China was forced to again hit the accelerator, and Beijing will be compelled again to move to rein in system Credit excess. Last year’s crack in the small banking sector was a harbinger of liquidity and confidence issues I expect to inflict China’s broader banking system. The repeatedly extended mortgage and apartment Bubbles ensure a dreadful Day of Reckoning. China’s consumer borrowing boom – 2019’s savior – is on borrowed time. And how long can the renminbi withstand such egregious financial and economic excess?
Global currency market instability is an Issue 2020: For the most part, currencies have been seductively sedate. Perilous fault lines lacking pressure relief valves beckon for caution. My own theory is that a systemic global Bubble with systematic liquidity excess fosters a dysfunctional steadiness. In a world of liquidity and speculative excess backstopped by “whatever it takes” central banking, market reversals have been quickly resolved by eager speculative flows. The traditional dynamic of “hot money” reversals, de-risking/deleveraging, crises of confidence and market dislocation is contained before barely getting started.
Yet it all creates a dynamic where an abrupt bout of risk aversion risks unleashing powerful pent-up global forces. For a while, I’ve contemplated that this could end with a “seizing up” of global markets – a systemic de-risking/deleveraging dynamic and resulting globalized market illiquidity. After witnessing 2019 markets dynamics – the extraordinary correlations between international bond, equities, and derivatives markets, along with interconnected money markets, (synchronized Bubbles) – I have ratcheted up the probability of the “seizing up” outcome. I know, central bankers are there to ensure it can’t materialize. They were there in force in 2019, and their actions only exacerbated excesses and worsened fragilities.
January 3 – Bloomberg (Emily Barrett, Ruth Carson, and Charlotte Ryan): “Investors have barely set foot in the new year before getting their first reminder of the risks — the existential and the more-manageable — that could derail their plans for 2020. The U.S. airstrike that killed one of Iran’s most powerful generals raised security alerts around the world, and added to anxieties that could dominate markets this year. Money managers blindsided by the 2016 Brexit vote and U.S. President Donald Trump’s election know the price of ignoring politics. Uncertainties stemming from these events are still unresolved — trade relationships between the U.K. and European Union, and the U.S. and China still hang in the balance — and other risks are emerging.”
Geopolitical risks – where to begin. From my analytical perspective, geopolitical risks in 2020 are the greatest since WWII. Not appreciated is the role that geopolitics have played of late in perpetuating Bubbles. In the increasingly heated battle for global supremacy, strongmen leaders Trump and Xi are keenly focused on the critical roles played by finance, the markets and economic growth. And I would add that the rise of the strongman leader globally is no coincidence – and it is undoubtedly linked to the instability and insecurities associated with decades of unsound money and Credit (with its recurring booms and busts, growing inequalities and myriad stresses).
Not only have geopolitical considerations perpetuated Bubble excess. As Bubbles have continued to inflate, geopolitical rivalries have grown more intense. As was abundantly clear in 2019, the risk of confrontation has risen significantly. Meanwhile, highly inflated Bubbles greatly increase the risk of a geopolitical event sparking market dislocation. Don’t let the markets relatively calm response to the past week’s Iranian developments fool you into complacency. Markets are today extraordinarily vulnerable.
Geopolitical is a key Issue 2020. A U.S./Iranian military confrontation is a real possibility. Recent U.S./China calm could prove short-lived. An accident in the South China See is a possibility, as is a mishap with Russia’s increasingly aggressive military. The entire Middle East remains a precarious tinderbox. China could become more confrontational with Taiwan, drawing U.S. ire. There are as well scores of potential flashpoints.
If there weren’t enough global uncertainties, there are pivotal U.S. elections in November. 2016 elections were crazy; expect 2020 to be even crazier. The President is vulnerable, a vulnerability that would increase in the event of market, economic or climate shocks. Booming markets currently envisage a second Trump term. Things get interesting if a geopolitical event and market disruption throws the election into disarray. Abruptly, the pro-market Trump candidacy could find itself in trouble, boosting the odds for the democrat – potentially an anti-market – candidate. With a deeply divided nation in such a volatile environment, November’s election could go down to the wire between two diametrically-opposed agendas.
It’s destined to be a fascinating year. If we’re lucky, I’ll be prognosticating about the risk of a bursting Bubble in Issues 2021. There will surely be unexpected developments that shape market and economic backdrops. There are some more obvious catalysts for piercing global Bubbles. Chinese Credit remains at the top of the list.
Despite today’s amazing bullishness, there is a lengthy list of EM vulnerabilities. There are cracks in India, Indonesia and Turkey, to name a few. Asian finance, in particular, is hopelessly unsound. The huge banking systems in Hong Kong and Singapore offer potential for negative surprises. Similar to Chinese finance, the “offshore” financial centers are accidents in the making. I wouldn’t bet against global money market problems. The world is one serious bout of “risk off” deleveraging away from exposing massive leverage and chicanery. It’s difficult for me to see the year pass without serious market liquidity issues. That’s the way I see Issues 2020. I restrained myself.
Original Post 11 January 2020
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Categories: Doug Noland