Liquidity will inherently flow in the direction of the strongest inflationary biases. During the previous cycle that was financial assets. We don’t expect this dynamic to hold sway going forward.
Crisis dynamics often move at a glacial pace – only to suddenly accelerate at seemingly lighting speed. And crisis dynamics can appear manageable for some time – only to reach a point where fear takes hold that they might be uncontainable. China’s crisis is on such a trajectory.
Nowhere to Hide
by Doug Noland
We certainly recognize these are trying times. Few of us have been spared from what has been an all-encompassing market decline. I hope today to focus on our overarching mission of informing and educating.
This is such an extraordinary and confounding environment. My objective is to further expound an analytical framework that hopefully sheds light on such a complex macro backdrop. It is not a positive message, and I apologize for that. I would prefer not to be the messenger in such circumstances. With Q2 validating my analytical framework and thesis, my commitment to analytical integrity compels today’s cautionary message.
With that said, let’s cut to the chase: “Nowhere to Hide.” Stocks were hammered. Fixed-income fared only somewhat better. Treasuries, the iShares Treasury Bond ETF (TLT), to be more exact, returned negative 12.6% – and is down about 20% y-t-d. The iShares investment-grade corporate bond ETF (LQD) returned negative 8.40% for the quarter, and the iShares high-yield bond EFT (HYG) returned negative 9.48%.
Through mid-June, commodities had offered refuge from the pounding taken by financial assets. At its June high, the Bloomberg Commodities Index was sporting a 15.3% q-t-d gain. Crude traded up to almost $124, while natural gas surged to a 44% q-t-d gain. But commodities reversed sharply lower during the final couple weeks of the quarter. The Bloomberg Commodities Index ended Q2 with a 5.9% decline, with most of crude’s advance gone, and natural gas actually ending the quarter lower. Even safe havens gold and silver reversed sharply lower and posted Q2 losses.
And with global yields surging along with the dollar, losses continued to mount in EM currencies, stocks and bonds. Meanwhile, one of history’s great manias collapsed in spectacular fashion. Cryptocurrencies suffered catastrophic losses, with withdrawal suspensions, insolvencies, panic runs and general chaos engulfing the sector. Bitcoin sank 59% during Q2 to $18,731, with prices down 73% from November 2021 highs. Most other cryptos were hit with even larger losses.
In short, the so-called “everything Bubble” transitioned to Bubbles bursting everywhere. The backdrop beckons, at least in my eyes, for some Credit and Bubble analysis. Bubbles are a monetary phenomenon. There is invariably an underlying source of Credit expansion driving a “self-reinforcing but inevitably unsustainable inflation” – my Bubble definition. As I am fond of explaining, a Bubble fueled by junk bonds might turn a little crazy, but it would not be expected to pose major systemic risk. Because of the elevated riskiness of the underlying Credit, a junk bond issuance boom will reach a point where apprehensive buyers say, “No more junk, I’ve got enough!” – and this point of risk aversion ensures the Bubble doesn’t inflate year upon year, thereby inflicting deep structural damage.
A Bubble fueled by “money” – Credit instruments perceived as safe liquid stores of value – is a completely different animal. Unlike junk bonds, “money” enjoys insatiable demand – we literally can never get enough of it. Bubbles fueled by money-like instruments can inflate for years, in the process imparting deep structural maladjustment to market, financial and economic structures.
For real life examples, think of the late-90’s “dot.com” Bubble, which was fueled by a boom in telecom and corporate debt, along with speculative leverage. It was certainly spectacular, but excess for the most part was contained within the technology arena. It’s bursting caused ample market pain and some economic hardship. But not being systemic, aggressive Federal Reserve stimulus rather quickly reflated the system – certainly boosted by the strong inflationary biases that had developed in housing.
The mortgage finance Bubble here in the U.S. was significantly more systemic. Fueled by “AAA” money-like mortgage securities, this more prolonged Bubble went to gross excess with associated major structural maladjustment. Accordingly, the bursting episode was much more destabilizing – for the markets, financial system and overall economy – the so-called “Great Financial Crisis” (GFC). And even with an unprecedented $1 TN of QE, it took years for even radical monetary inflation to generate system-wide reflation.
With that theoretical backdrop, let’s delve into the “everything Bubble”. Appraising the Fed’s post-bubble analytical and policy framework, I began warning of the potential for the “global government finance Bubble” – the “Granddaddy of All Bubbles” – back in 2009. With the introduction of QE in conjunction with massive fiscal deficits, the expansive Bubble had finally reached the foundation of finance – central bank Credit and government debt. From my analytical perspective, it was the worst-case scenario: The Bubble was being fueled by an egregious inflation of “money” – and it all was enveloping the world.
I also introduced the concept of “moneyness of risk assets” – an expansion of my “moneyness of Credit” tenet from the mortgage finance Bubble era. Basically, the Bernanke Fed used zero rates and inflated market prices to coerce savers into stocks and bonds. Then, aggressive monetary stimulus was employed to backstop the markets, promoting the perception of safety and liquidity. “Stocks always go up”. It was all reckless inflationism that was clearly fueling dangerous asset and speculative Bubbles.
There were some serious bouts of instability along the way – 2012, 2013, 2018, 2019 and March 2020. And, in each instance, the Fed and global central bank community adopted the ever increasing radical monetary inflation necessary to sustain Bubbles. It culminated during the pandemic, with $5 TN from the Fed and similar amounts from the ECB and BOJ. There were Trillions more from central banks everywhere.
It was monetary and fiscal stimulus – inflationism – on a global basis, the likes of which the world had never experienced. And, importantly, the Bubble inflated for an incredible 13 years. History teaches that things can get crazy at the end of cycles, and we witnessed some of the craziest things ever. Readers far into the future will ponder this era, as we do the tulip bulb mania and John Law’s Mississippi Bubble. And, most unfortunately, it’s all coming home to roost now.
Last quarter, I discussed the unfolding new cycle. We believe inflation dynamics have fundamentally changed. I doubt inflation will stay above 9% for long, but I do believe the Fed will be challenged to get – and keep – inflation under control. There were some anomalies that played major roles in keeping consumer price inflation relatively contained throughout the previous cycle – technological innovation, globalization, and the historic development in China and the emerging markets, to name the most obvious. I don’t see any of these factors playing the same role in the new cycle. Also, and this is a key point, financial assets have lost the huge advantage they enjoyed over real assets throughout the previous financial boom cycle.
Now, with consumer prices unleashed and inflation psychology altered, a chastened Fed and central bank community have begun to adjust their doctrines to stress resolve in containing inflation. This is a secular sea-change. During the previous cycle, relatively benign consumer inflation nurtured monetary policy drift to a securities market focus. This created a self-reinforcing dynamic, where liquidity injected during QE operations specifically gravitated to financial assets – stoking speculative Bubbles while having limited inflationary effect on general consumer prices.
Liquidity will inherently flow in the direction of the strongest inflationary biases. During the previous cycle that was financial assets. We don’t expect this dynamic to hold sway going forward.
We can’t overstate the significance of the so-called “Fed put” during the previous cycle. This liquidity backstop – that morphed over time into “whatever it takes” zero rates and Trillions of QE – created the perception of “moneyness” throughout the financial markets. Stocks became a can’t lose, corporate debt the same, and even the cryptocurrencies. The same can be said for derivatives and Wall Street structured finance. Private equity and venture capital were a can’t lose. And you couldn’t lose with hedge funds and leveraged speculation. This central bank-induced “moneyness of everything” stoked a historic period of myriad synchronized Bubbles across the globe. History offers nothing remotely comparable.
But the game has changed, and this lies at the heart of the unfolding new cycle. The central bank liquidity backstop has turned problematic and ambiguous. In the end, I believe central banks will have no alternative than to use QE to counter the forces of bursting asset and Credit Bubbles. But inflation’s resurgence suggests the halcyon “money” free-for-all days are behind us.
We’ll return to this new cycle theme, but let’s address a few of these bursting Bubbles. I find the “Periphery and Core” instability analytical framework particularly helpful in these kinds of environments. As a cycle begins to turn, risk aversion takes hold first out at the periphery – with the more fringe regions, countries, markets, sectors and companies. When finance is loose, it’s the fringe, offering enticing speculative opportunities, that sees the greatest impact from risk embracement and liquidity excess. But when the cycle inevitably turns, the maladjusted “Periphery” is vulnerable to even subtle shifts in risk tolerance and financial conditions. Losses, de-risking/deleveraging, and waning liquidity gain momentum, leading to contagion effects that over time gravitate from the “Periphery” to the “Core.”
This dynamic attained robust momentum during Q2. Powerful de-risking/deleveraging took hold throughout the emerging markets, with currencies and bond markets under heavy liquidation. The unwind of levered EM “carry trades” fueled a self-reinforcing dynamic of dollar strength, waning liquidity and intensifying de-risking/deleveraging. To support their faltering currencies, EM central banks resorted to aggressive rate hikes, along with sales of Treasuries and other international reserve holdings. It all fed a dramatic tightening of global financial conditions for a world that until recently had the semblance of endless liquidity abundance.
China’s international reserves dropped $116bn during Q2, suggesting significant capital flight. China’s currency lost 5.4% versus the dollar. China’s bubble collapse has recently taken a turn for the worse – perhaps a decisive turn. Recall that China faced heightened instability late in Q1. Its developer bond market crisis had jumped from the “Periphery” to the “Core”, with Country Garden, China’s largest developer, seeing bond yields spike from 6.5% to surpass 30%.
Predictably, Beijing moved forward with a series of aggressive stimulus measures that temporarily calmed the developer bond market while spurring a decent stock market rally. There were Covid outbreaks, including an extended crippling lockdown in Shanghai. Beijing announced more stimulus measures, including plans for massive infrastructure spending.
Then something very important transpired. Despite all of Beijing’s measures, developer bond yields began rising again. The crisis deepened. China’s apartment bubble is one of history’s greatest bubbles. Its collapse has significant ramifications – for China’s economy and financial system, along with the global economy and the global financial system. There are clear geopolitical repercussions. Crisis dynamics often move at a glacial pace – only to suddenly accelerate at seemingly lighting speed. And crisis dynamics can appear manageable for some time – only to reach a point where fear takes hold that they might be uncontainable. China’s crisis is on such a trajectory.
Last week, a movement caught fire, where owners of uncompleted apartment units decided to stop making mortgage payments. Within a few days, developments in 100 cities were impacted. We might look back at last week and see it as a critical juncture in the crisis – a point where crisis dynamics began to turn systemic.
Keep in mind this is new territory for China’s households, developers, banks, regulators and Beijing officials, all experiencing their first housing/mortgage finance bust. It’s worth noting that Consumer – chiefly mortgage – borrowings almost doubled over the past five years – and were up four-fold in 10 years – to almost $11 TN. Chinese Bank Assets – which, by the way, were up a record $1.95 TN just during Q1 – surged 50% over the past five years – and 200% in 10 years – to an astronomical $53 TN.
Country Garden saw its bond yields surge a full 11.5 percentage points last week to a record 41%. These bonds yielded 3.25% in September. Another top five developer, Lonfor bond yields have spiked 23 percentage points in eight sessions to 126%. Sunac yields jumped to 117% and Evergrande yields to 141%. Vanke, another top five developer, is worth special attention. It is considered the financially strongest of the major private sector developers. Its bonds yielded 3.0% in September, with its credit default swaps priced at 100 bps.
Vanke yields have surged to almost 10%, with its CDS surpassing 650 bps. The market is saying China’s apartment Bubble has made it to the strongest – to the “Core”. If Vanke is in trouble, I believe China’s Bubble collapse is quickly approaching the point of no return. And we’re talking about an industry with Trillions of liabilities.
Corroborating the thesis that China’s crisis has turned systemic, Chinese bank stocks sank almost 8% last week, as Chinese bank CDS spiked higher – blowing past highs from the March instability period. Notably, China Construction Bank CDS jumped 25 bps last week to 123 bps, surpassing the March 2020 pandemic crisis spike. With over $4 TN of assets, China Construction Bank is one of the largest banks in the world. Of China’s other “Big Four,” Bank of China CDS surged to the high back to 2014. China Development Bank and Industrial and Commercial Bank CDS rose to highs back to 2017.
We can call it the “Beijing put”. China’s historic Credit and apartment Bubbles are unmitigated disasters. Yet markets have been content to look the other way, while renewing their faith in the almighty Beijing meritocracy. No issue was too big to be resolved by Communist leadership. No amount of debt too excessive. No Bubble too big. No degree of structural maladjustment too deep for Beijing stimulus. And, apparently, there’s no economic downturn that won’t be countered by boundless Beijing-directed lending and spending.
I remember the mantra in mid-1998: “The West will never allow Russia to collapse.” And then in 2006/2007, “Washington will never allow a housing bust.” Today, it’s “Beijing won’t allow financial and economic crisis – it won’t tolerate fallout from bursting Bubbles – not with its global superpower status on the line.”
And this is precisely the mindset that sets the stage for destabilizing crisis. First, faith in government control underpins sustained Credit and speculative excess and associated maladjustment. Bouts of instability resolved by government actions over the course of a cycle only embolden risk-taking. With everyone well-conditioned, confidence is sustained for a while, even as Bubbles begin to deflate.
Importantly, however, there reaches a critical juncture where speculative de-risking/deleveraging attains certain momentum, where instability forces markets to begin questioning whether policymakers actually have things under control. I refer to a “holy crap moment” – in 1998, this dynamic revealed egregious leverage at Long-Term Capital Management and elsewhere. In 2008, it was with Lehman and Wall Street finance.
The unraveling process commenced last week in China. The movement to halt mortgage payments was on the heels of some protests by depositors of failed banks. I believe there’s growing recognition that the Chinese people are being pushed to their breaking point. A most protracted Bubble period inflated many things, including expectations. The Chinese have been willing to tolerate increasingly brazen government repression because of confidence that a highly effective Beijing would continue to improve standards of living. This trust is being shattered. There is heightened recognition that Beijing has seriously mismanaged economic development. Zero-Covid is seen by many as terribly misguided government overreach. And I would imagine there are many questioning China’s “partner without limits” alliance with Putin’s Russia.
If not already, the bloom is at least coming off the rose for Beijing. Inflating Bubbles create genius, while Bubble deflation spawns blunders and incompetence. From my perspective, a crisis of confidence is unavoidable. The degree of mismanagement – especially in regard to Credit and speculative excess, its banking system – has been shocking. And with Beijing now forcing aggressive crisis lending – including to insolvent developers – how long can confidence be maintained in China’s bloated banking system?
But here’s what has me really worried. It’s not just Beijing that faces a crisis of confidence. Right now, emerging markets face sinking currencies, de-risking/deleveraging, “hot money” outflows, and a dramatic tightening of financial conditions. And it’s anything but clear what reverses these dynamics. I’ve witnessed a number of EM crises during my career, but never has there been a setup like today’s dominoes all lined up across the globe.
In Europe, the ECB raised rates 50 bps today for the first hike in 11 years. And even with its main policy rate not yet even positive, the troubled European periphery is already under acute stress. Highly indebted and dysfunctional Italy is in the crosshairs. Mario Draghi resigned earlier today, the Italian parliament was dissolved, and there will be at least two months of uncertainty, with elections now scheduled for September 25th. Crisis dynamics engulfed European periphery bonds last month, with destabilizing yield spikes in Italy and Greece.
The ECB responded with a pledge to create a so-called “anti-fragmentation” tool, which essentially means more QE directed at Italian and periphery bonds to thwart bond market collapse. A vague outline of this program was announced today. Not surprisingly, the Germans, Austrians and others are opposed to printing more money to support fiscally irresponsible governments. After all, the ECB’s balance sheet has inflated $5 TN over recent years, and now Europe faces a serious inflation problem, along with an energy crisis and economic stagnation.
It should be obvious by now that money printing will not resolve Europe’s issues. I’ve argued that, at the end of the day, I don’t expect the Germans and Italians to share a common currency. And that’s why the ECB and global markets turn so anxious when European periphery yields spike. It poses nothing short of an existential threat to European monetary integration.
The ECB faces a crisis of confidence. They are concocting a liquidity backstop mechanism for the eurozone’s periphery that, truth be told, they really hope they won’t have to use. When they are forced to employ bond support operations and its efficacy is questioned, they will then face the real prospect of a serious run on periphery bond markets and even the euro currency.
And speaking of runs on bond markets, I fear the Bank of Japan is also facing a crisis of confidence. The Bank of Japan has been creating and spending hundreds of billions to maintain its 25 bps ceiling on Japanese 10-year yields. This was a crazy bad idea to begin with, and these days, with spiking global inflation and yields, it has become untenable. The yen has sunk to 20-year lows versus the dollar, and confidence in the yen and monetary management has taken a big hit. When their misguided yield peg breaks, there will be serious risk of a major bond market dislocation and currency turmoil.
Let’s now turn our focus homeward – away from the “Periphery” and more to the “Core”. Inflation surpassing 9%, bursting Bubbles, a sour public mood, economic fragility, and a central bank facing a serious crisis of confidence of its own.
Contemplating the extraordinary backdrop, it’s critical to think secular rather than cyclical. Unfolding financial and economic crises are decades in the making. JPMorgan’s Jamie Dimon has warned of a potential “hurricane.” A Pimco manager last week said he expects more of a “shower.” I am reminded of a passage from a book I read years ago analyzing the late-twenties: It said, “Everyone was prepared to hold their ground, but the ground gave way.”
There is incredible complacency these days, especially considering the environment. Ominous developments at the global “Periphery” are easily disregarded. This is typical. The dollar is exceptionally strong, commodities prices have reversed sharply lower, bond yields are lower, and some see the Fed winding down its tightening cycle in the not too distant future – and all this supports the narrative that peak inflation has passed, and market lows have been established.
Meanwhile, global de-risking/deleveraging, illiquidity and contagion are bearing down on the “Core”. And we’ve already witnessed serious stress unfold at our own “Periphery”. The crypto Bubble is collapsing, revealing a lot of leverage and shenanigans. The corporate debt market has also taken a hit. The junk bond market has been largely shut to new issuance for weeks, and even the investment-grade marketplace has experienced a dramatic change in the liquidity backdrop.
This equates to a destabilizing tightening of financial conditions at our “Periphery” after years of the loosest Credit conditions imaginable. And this is a major structural issue for an economy driven by a proliferation of negative cash-flow and uneconomic businesses. The shakeout has begun, with some of the clearest evidence of this dynamic unfolding in the technology arena. We’ve seen some layoffs, but we’re really early. Before this is over, I expect massive restructurings and bankruptcies. This will be a quite arduous adjustment to new market, policy, financial and economic realities.
Markets are extraordinarily vulnerable here – stocks, bonds, housing, private equity, commercial real estate, and so on. We’re so early in the adjustment process. There are two interrelated critical dynamics at play in the markets. Financial conditions have tightened meaningfully, which will imperil the solvency of many companies, while pressuring household and business spending.
Meanwhile, it’s a critical issue that the “Fed put” has turned ambiguous. Market faith in the Fed liquidity backstop has crystallized for over three decades, becoming deeply embedded in market perceptions, prices and speculative dynamics. In the eyes of the markets, it has been the most consequential facet of contemporary monetary policy doctrine. The Fed liquidity backstop has been integral to Trillions flowing into perceived safe and liquid ETF shares. It has been key to Trillions of hedge fund and speculator leverage. It has been crucial for risk-taking more generally. It has been absolutely fundamental to a multi-hundreds of trillions derivatives complex. And there is today uncertainty as to how the Federal Reserve will now respond to crisis dynamics.
I’m on record forecasting a much larger Fed balance sheet. There is no alternative to central bank liquidity in the event of serious de-risking/deleveraging. I also believe newfound inflation persistence will prevent the Fed from their singular focus on market stability. I expect another round of QE – but it seems likely that this liquidity comes later and in narrower scope than markets have grown accustomed to. And later and smaller will not suffice.
Recall the portentous dynamic from March 2020. The Fed hastily responded to de-risking/deleveraging and market dislocation by announcing a major QE program. Yet market dislocations only worsened. An increasingly desperate Fed repeatedly boosted its crisis policy response until the prospect of Trillions of QE finally reversed de-risking/deleveraging and halted the run on some ETFs.
The Fed’s most recent $5 TN QE onslaught pushed leverage and speculative excess to unprecedented extremes. When serious de-risking takes hold at the “Core”, it would take Trillions of additional liquidity to rejuvenate risk-taking and leveraged speculation. And, at this point, with inflation raging and bond markets fragile, such a massive QE program would pose great risk to inflation and bond market stability, not to mention Federal Reserve credibility.
Fundamentally altered inflation dynamics are a prominent aspect of the new cycle. The era of endless cheap imports from China and Asia has largely run their course. And Russia’s invasion of Ukraine and the new Iron Curtain solidified the end of a multi-decade period of integration and globalization. And while commodity prices have retreated over recent weeks, we believe the new cycle will be an era of hard asset outperformance versus financial assets. And this dynamic will change so many things, including raising the risk that QE injections feed directly into higher commodities prices and general inflation. The job of a central banker has become incredibly more challenging.
Markets can no longer take for granted that the Fed is willing and able to ensure the perpetual bull market. Late and limited QE will not thwart financial crisis, and this new dynamic implies significantly higher market and economic uncertainty. Markets are riskier. Speculation is riskier. Leverage is riskier. The cost of market protection is higher.
And let me summarize some key aspects of the new cycle that will profoundly impact the markets. Consumer prices will have a stronger and sustained inflationary bias. Central banks will be forced back to a traditional inflation focus, rather than the experimental market-centric approach of the past cycle. Policy rates will be higher, and QE will be relegated to a crisis-fighting tool. Financial conditions will be significantly tighter on a more sustained basis. The liquidity and policymaking backdrops will be much less conducive to leveraged speculation, and risk-taking more generally. The so-called “Fed put” will remain nebulous, with QE employed more unpredictably and sparingly.
I believe we’re early in the process of markets adjusting to new cycle realities. Markets are highly volatile at cycle inflection points, and we’ve been experiencing this phenomenon. I expect even more volatility. The fundamental tightening of financial conditions is currently having its greatest impact at the “Periphery”. And while our markets have retreated, the “Core” is currently benefiting from the strong dollar and generally low market yields. This creates a mirage of liquid and sound markets. There has been meaningful tightening at the “Core’s” periphery, with waning liquidity and market losses in U.S. corporate debt markets.
But a much more perilous storm is approaching, and we need to ponder the possibility that there will be nowhere to hide – that the unfolding crisis is global, deeply systemic and uncontrollable for the global central bank community. I worry about a crisis of confidence in policymaking, in the markets and finance more generally. As I’ve said many times, contemporary finance appears almost miraculous so long as it’s expanding – as it did in historic fashion over the previous cycle. It’s unclear to me how existing market and financial structures continue to operate effectively in the new cycle. How does contemporary finance expand with financial conditions much tighter, with the central bank community’s newfound stinginess with liquidity, with significantly reduced leveraged speculation and much less faith in forever rising securities prices?
And in closing, I fear there is nowhere to hide from escalating geopolitical risk. And I’ll again underscore a most pertinent cycle dynamic. During the up-cycle boom, the economic pie is perceived as robust and expansive. Cooperation, integration and strong alliances are viewed as beneficial – both individually and collectively. But as the cycle ages, strains mount, and insecurity increasingly takes hold. Eventually, the backdrop is viewed more in terms of a shrinking pie – with a newfound zero-sum game calculus. The downside of the cycle heralds a period of fragmentation, animus and conflict.
We’re now five months into the tragic war in Ukraine. The West is determined that Russia cannot be allowed to win. Putin seems as determined as ever to ensure Russia doesn’t lose. And the more munitions arriving from the West, the more it appears Putin is adopting a scorched earth strategy of destruction in the south and terrorizing missile strikes in population centers across Ukraine.
At this point, a return to the previous world order appears impossible. From this perspective, the world appears well into the transition to a perilous down cycle dynamic. Last week, Putin referred to the Ukraine conflict as “the beginning of a radical breakdown of the American world order… the beginning of the transition from liberal-globalist American egocentrism to a truly multipolar world.”
And there’s little doubt that China has aligned with Putin’s Russia to form an anti-U.S. alliance. An altered and much less hospitable world order is fundamental to the new cycle. I fear a scenario where the West has to significantly ramp up support to preserve Ukraine as an independent nation. I’ve worried for a while now that bursting Chinese Bubbles could spur a Beijing move on Taiwan. U.S./Chinese tensions are on a troubling trajectory. It’s difficult to imagine a backdrop with greater uncertainty and greater risk – market, policy, economic, political and geopolitical. I’m a broken record on this, but it’s time to hunker down and prepare for tumultuous times. I sincerely hope my analysis proves way too pessimistic.
Original Post 23 July 2022
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