Part III: The Unfolding

by Doug Noland

I look at the world today and see things spiraling away from the control of central bankers and policymakers.

China’s historic bubble is collapsing. One of history’s great speculative manias – Chinese apartment units – has begun the crash phase. And while China’s spectacular Credit Bubble continues to inflate, even egregious amounts of new Credit are not enough to sustain the boom.

Chinese bank assets reached $55 TN this year, after beginning 2009 at about $9,0 TN. It’s frightening to ponder the quality of Chinese bank assets. We’ve already witnessed a spectacular Chinese developer bond collapse – an industry with several trillion dollars of liabilities. China also has serious Credit issues with multi-trillion local government debt instruments and the multi-trillion AMCs, or “asset management companies,” created to clean up after the nineties bust.

Importantly, the Chinese currency is showing vulnerability, down over 10% y-t-d versus the dollar. Country Garden, China’s largest builder, only months ago viewed as a sound Credit, saw its bond yields today surge to a record 53%.

China would already be in full-fledged financial crisis, if not for one thing: There’s still faith that Beijing controls the weather.

Europe faces war, an acute energy crisis, a tumultuous winter, high inflation, recessionary forces, and major debt issues. Yet, so far faith holds that the ECB still controls the weather (“Believe us, we control the weather”).

European peripheral debt markets are a fragile fault line. When yields spiked in June – even in the face of zero rates and ongoing QE – the ECB concocted a so-called “anti-fragmentation tool” for purchasing periphery bonds in the event of a disorderly yield spike. Bond yields reversed sharply lower on the news, but are now right back near June highs. Italian yields spiked 23 bps Wednesday – and are up 18 bps today – on a Moody’s warning of an Italian debt downgrade if the new right-wing coalition government doesn’t stick with spending commitments.

Truth be told, the ECB really doesn’t want to use its anti-fragmentation tool. If they employ it and it flops, they immediately face a serious crisis of confidence. And what’s at stake is nothing short of European monetary integration and the survival of the euro currency. I’ve had a long-held view that, at the end of the day, I don’t expect the Germans and Italians to share a common currency. An unfolding periphery debt crisis risks financial, economic, social and political crises.

Let’s shift to Japan. I have tremendous respect for the Japanese people. They endured a bursting Bubble and prolonged stagnation. As a society, they held things together. For years, I even defended Japanese policymaking. While they terribly mismanaged monetary policy during their Bubble period, they got through the downturn without resorting to reckless monetary inflation. The yen remained strong. But then Ben Bernanke convinced the Bank of Japan to start printing money and, predictably, they’ve not been able to wean themselves from rank inflationism.

The Bank of Japan went so far as to continue enormous monetary inflation as part of a policy to place a 25 basis point ceiling on 10-year government yields. The yen has sunk to a 24-year low, and the Japanese are paying a lot more for a lot of things. I fear Japan is another accident in the making. In a world of surging inflation and spiking market yields, markets are questioning how long the BOJ can continue manipulating the weather. I fear the dam will break when the BOJ yield peg collapses.

Emerging markets are always vulnerable to tightening financial conditions. The high-risk periphery is notoriously on the receiving end of “hot money” speculative flows during Bubble periods, but then faces crisis dynamics when “risk off” deleveraging spurs illiquidity and dislocation.

Crisis dynamics have been in play, though so far this cycle has some nuance. This was a most protracted global Bubble period, and over the years EM countries built significant dollar reserves. These reserves have provided firepower for EM central bankers to stabilize their currencies, which has underpinned general confidence. But EM countries are rapidly burning through these reserves, and a crisis of confidence appears unavoidable. Moreover, when EM central banks sell reserves, such as Treasuries, to bolster their currencies, this puts upward pressure on Treasury and global yields. It’s a “doom loop”.

Eastern European nations face obvious risks. Asian emerging market economies are over-levered and acutely vulnerable to the confluence of tightening financial conditions and Chinese and Japanese crises. Latin America is always vulnerable, with a critical Brazilian presidential election only a few weeks away.

I worry these fragile global fault lines – China, Europe, Japan, EM and others – are poised to succumb in unison.

And in no way do I believe the U.S. is immune. No market experienced comparable speculative excess. No economy feasted so on years of essentially free “money”. U.S. market structure is acutely vulnerable. Our economic structure is extremely vulnerable to tightened Credit and liquidity conditions. In particular, the long boom period saw a proliferation of uneconomic, negative cash-flow businesses and enterprises. In Austrian Economics parlance, it’s been epic malinvestment.

And in no country has there been such faith that the central bank has everything under control – that it controls the weather. The problem today is that the Fed faces a serious inflation problem. Our central bankers appreciate that financial conditions must tighten before price pressures and inflationary psychology spiral out of control.

Meanwhile, our entire financial structure has been underpinned for years by the perception that the Fed will do “whatever it takes” to support the markets and grow the economy. The view holds that the Fed won’t allow a crisis. It will cut rates and deploy as much QE as necessary to thwart financial crisis.

But there’s a big problem: The Bubble has inflated to the point that it will take Trillions of additional QE to accommodate a serious de-risking/deleveraging. Recall again how it required several Fed announcements of additional massive QE to thwart market collapse in March 2020. Five Trillion of QE later, and the Bubble had inflated only bigger and more unwieldy.

And the inflation problem is much more severe and deeply rooted. This means the Fed liquidity backstop has turned uncertain. I expect more QE, but the Fed will respond more slowly and cautiously. And I do not expect this to suffice in the markets.

There are many myths and misperceptions at stake. And I fear the “holy crap” moment – markets hit with the harsh reality that the Fed and global central bankers don’t have everything under control.

In particular, I fear concurrent crises of confidence in policymaking and market structure. De-risking/deleveraging will feed illiquidity and market dislocation. Global derivatives markets will be severely tested.

I’ll also briefly speak to today’s alarming geopolitical backdrop. The Ukraine war, deteriorating relations with China, Taiwan, North Korea, Iran and such. Why are so many things coming to a head right now?

Keep in mind that boom periods engender perceptions of an expanding global pie. Cooperation, integration and alliances are viewed as mutually beneficial. But late in the cycle, perceptions begin to shift. Many see the pie stagnant or shrinking. Zero sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances and conflict take hold.

I see no end in sight for the extremely challenging market environment. We’ll have to continue to navigate through de-risking/deleveraging dynamics and chaotic market instability. The extraordinary environment demands intense daily focus, discipline, and a risk-management focus. It is time to be on alert and as prepared as possible.

Original Post 8 October 2022

TSP Smart & Vanguard Smart Investor is working to navigate serious and reluctant investors through the “unfolding” situation

Categories: Perspectives