Would That, Fear, Provoke?

Remember when everyone said
That Jay and his friends at the Fed
Would taper their buying
While still pacifying
Investors, lest screens all turn red?

Well, what if before the Fed spoke
That Evergrande quickly went broke?
Would traders still bet
The buying of debt
Will end? Or would that, fear, provoke?

Fear is in the air this morning as concerns over the status of China Evergrande’s ability to repay its mountain of debt seriously escalate.  Remember, Evergrande is the Chinese property developer with more than $300 billion in debt outstanding, and that has said they will not be repaying an $84 million loan due today, with the prospect for interest payments due this Thursday also gravely in doubt.  One cannot be surprised that the Hang Seng (-3.3%) reacted so negatively this morning, after all, that is the Evergrande’s main listing exchange.  Other property developers listed there came under substantial pressure as well, with one (Sinic Holdings Group) seeing its price fall 87% before trading was suspended.

Of equal interest to the fact that equity markets are trembling on the Evergrande story is the plethora of press that continues to explain that even if Evergrande goes bust, any fallout will be limited.  Columnists and pundits point to the damage that occurred when the Fed allowed Lehman Brothers to go bust and explain that will never be allowed again.  And while I’m certain they are correct, financial officials have exactly zero interest in allowing that type of situation to repeat, it remains far from clear they can prevent it.  That is, of course, unless the Chinese government is going to step in and pay the debts, something that seems highly unlikely.  As I continue to read and hear how this situation is nothing like Lehman, having had a front row seat to that disaster, I cannot help but see a great many parallels, including many assurances that the underlying cause of that contagion, subprime mortgage loans, was a small portion of the market and any fallout would be controlled.  We all know how well that worked out.

Remember, too, that Chinese President Xi Jinping has been aggressively attacking different sectors of the Chinese economy, specifically those sectors where great wealth (and power) was amassed and has implemented numerous changes to the previous rules.  This is the key reason the Shanghai stock market has underperformed the S&P 500 by 25% over the past year.  One of Xi’s problems is that property development has been a critical part of the growth of China’s economy and a source of significant income to all the provinces and cities.  Proceeds from the sales of property have funded infrastructure as well as helped moderate taxes.  If Evergrande goes under, the impact on the entire Chinese economy seems likely to be significant.  And all this is happening while the growth in China’s credit impulse has been declining rapidly, portending slower growth there anyway.

History has shown that situations of this nature are rarely effectively contained and there is usually fallout across numerous different areas.  Consider that global equity market indices have been hovering just below all-time high levels with stretched valuations on any measure on the basis of TINA and FOMO.  But between the two key emotions evident in investing, fear and greed, I assure you, fear is by far the more powerful.  While anything can still happen, fear is starting to spread more widely today than last week as evidenced by the sea of red across all equity markets today.

If you think that the Fed is going to taper their asset purchases into a period of market weakness, you are gravely mistaken.  The combination of slowing growth and market fear will induce a call for more support, not less, and history has shown that ever since October 1987 and Alan Greenspan’s response to Black Monday, the Fed will respond with more money.  The question this time is, will it be enough to stop the fall?  Interesting times lie ahead.

Most of Asia was on holiday last night, with only Hong Kong and Australia (ASX 200 -2.1%) open.  But Europe is open for business and the picture is not pretty.  The FTSE 100 (-1.55%) is the best performing market today with the continent (DAX -2.15%, CAC -2.1%) emblematic of every market currently open.  US futures, meanwhile, are the relative winners with losses ‘only’ ranging from the NASDAQ (-1.1%) to the Dow (-1.6%).  Now, don’t you feel better?

It can be no surprise that bonds are in demand this morning as risk is undeniably ‘off’ across all markets.  Treasury yields have fallen 3.6bps amid a flattening yield curve, while European sovereigns have all seen price gains as well with yields there slipping between 2.6bps (OATs) and 3.2 bps (Bunds).  In every case, we are seeing yield curves flatten, which tends to imply an increasing expectation of weaker economic activity.

Commodity prices are broadly under pressure as well this morning, with oil (-2.0%) leading the way but weakness across industrial metals (Cu -2.0%, Al -0.65%, Sn -1.2%) and agriculturals (corn -1.6%, wheat -0.9%, soybeans -1.0%) as well.  Gold (+0.2%) on the other hand, seems to have retained some of its haven status.

Speaking of havens, the dollar, yen and Swiss franc remain the currencies of choice in a crisis, so it should be no surprise they are today’s leaders.  Versus the dollar, the yen (+0.4%) and franc (+0.2%) are the only gainers on the day.  Elsewhere in the G10, AUD (-0.55%), SEK (-0.5%), CAD (-0.5%) and NOK (-0.4%) are the worst performers.  Obviously, oil’s decline is weighing on the krone and Loonie, but AUD is feeling it from the rest of the commodity complex, notably iron ore (Australia’s largest export by value) which has fallen to $105/ton, less than half its price on July 15th!

In the emerging markets, RUB (-0.8%) is feeling the heat from oil, while ZAR (-0.55%) has metals fatigue.  But every EMG currency that was open last night or is trading right now is down versus the dollar, with no prospects of a rebound unless risk attitude changes.  And that seems unlikely today.

On the data front, aside from the Fed on Wednesday, it is a housing related week.

Tuesday Housing Starts 1550K
Building Permits 1600K
Wednesday Existing Home Sales 5.88M
FOMC Rate Decision 0.00%-0.25%
Thursday Initial Claims 320K
Continuing Claims 2630K
Flash PMI Manufacturing 60.8
Friday New Home Sales 710K

Source: Bloomberg

As well as the Fed, on Thursday the Bank of England meets and while there is no expectation of a policy move then, there is increasing talk of tighter policy there as well.  Again, if fear continues to dominate markets, central banks are highly unlikely to tighten, and, in fact, far more likely to add yet more liquidity to the system.  Once the Fed meeting has passed, the FOMC members will get back out on the circuit to insure we understand what they are trying to do.  so, we will hear from five of them on Friday, and then a bunch more activity next week.

Today’s watchword is fear.  Markets are afraid and risk is being tossed overboard.  Absent a comment or event that can offset the China Evergrande led story, I see no reason for the dollar to do anything but rally.

Good luck and stay safe
Adf

Things Went Awry

A decade has passed since the day
That Lehman collapsed all the way
It sank several banks
And brought us Dodd-Frank
In effort to curb foul play

And during those ten years gone by
A number of things went awry
Some xenophobes won
And they’ve overrun
Attempts, good ideas, to apply

The upshot is markets worldwide
Have started to feel the downside
Of higher Fed rates
While there are debates
If euros or dollars will slide

Despite a number of ongoing stories that may ultimately impact markets, notably the US-China trade situation, Italian budget discussions and Brexit negotiations, movement overnight in the FX market has been benign. This morning, the broad dollar index is lower by about 0.25%, with most G10 currencies having strengthened by similar amounts, but the EMG bloc remains under pressure with TRY (-1.5%), INR (-0.75%), KRW (-0.5%) and ZAR (-0.5%) all leaning in the other direction. However, when stepping back to get perspective, the situation can fairly be summed up by saying EMG currencies have been weakening pretty consistently for the past six plus months, while the G10 has barely moved at all since the end of May when the dollar’s sharp rise came to a halt.

Given the relatively uninteresting state of markets this morning, and the fact that there is virtually no data of note until Wednesday this week, I thought I might take a short retrospective look at how things have changed since the financial crisis ten years ago.

Remarkably, last Friday was the tenth anniversary of Lehman Brothers bankruptcy filing. The ensuing ten years has brought about significant changes in the way markets behave, regulators oversee things and investors approach the process. Arguably, the bigger question is what will the next ten years look like. And while there is no way to be sure, there do seem to be several trends that have further to run.

The hardest thing to understand is how a debt fueled crisis resulted in policies designed to increase debt further. While during the immediacy of the extremely deep recession in 2009 there were few complaints about central bank policy trends, which were seen as emergency measures, the first eyebrows were raised when interest rates went negative in Sweden, and then followed throughout Europe and then finally in Japan. But even that would likely have been seen as generally reasonable if the interest rate cycle had been of a more normal duration. Instead, central bankers around the world collectively decided that expanding global money supply inexorably for ten years was the prudent thing to do. Consider that despite global growth chugging along at about 3.5%, global money supply has risen more than 100% since 2008, which means it has grown at nearly an 8% annual clip. As evidenced by the large gap between economic and monetary growth, it is clear that some great portion of that new money found a home outside the ‘real’ economy.

In fact, it is this situation that has defined market activity since 2008, while simultaneously confusing half the economic community. That money has found a home in global debt and equity markets, causing massive inflation there, while only trickling into the real economy and thus allowing measured price inflation, like CPI or PCE, to remain subdued. Most market analysts understood this concept within months of the process beginning, but mainstream economists and policymakers claimed to be puzzled by the lack of inflation, and so were willing to maintain ‘emergency’ policy for ten years, despite rebounding global growth. Now, clearly through this period there were areas in the world that had slowdowns (notably Europe in 2011 and China in 2015), but the idea that flooding the market with funds and then leaving them in place for nigh on ten years was economically prudent seems hard to swallow.

And of course, there were real consequences to these actions, not simply numeric arguments. Income and wealth inequality exploded, as those already rich were the main beneficiaries of the global stock and bond market rallies. At the same time, lower skilled labor found themselves under enormous pressure from a combination of technological improvements in production, reducing the demand for labor and globalization increasing the supply of labor. In hindsight, it should be no surprise at all that we have seen a significant increase in the number of nationalists being elected around the world, especially in the G10. After all, it is much easier to demonize foreign workers than industrial robots, especially since they don’t vote.

The thing is that while the Fed has, at least, made some strides to finally reduce the money supply, both raising rates and allowing their balance sheet to actually shrink, they remain the only central bank doing so. And even though the ECB is slowing its QE purchases, they are still adding funds, while both China and Japan continue to add money to the system indefinitely. Current forecasts show that global money supply will not start to shrink until the end of next year at the earliest based on current policy trajectories and expectations. However, that makes the heroic assumption that when money supply starts to shrink, financial markets will be unaffected. And that seems highly unlikely given how crucial those excess funds have been to financial market performance for the past decade.

Summing up, the Lehman bankruptcy triggered a global crisis that was built on excessive leverage, notably in the US housing market. The crisis response was to cut short-term interest rates dramatically while flooding the markets with cash in order to drive down long-term interest rates. The consequences of this policy, which was repeated around the world once the Fed led the way, was a massive rally in both equity and fixed income markets, and a modest rebound in economic growth. Financial engineering became the norm (issue cheap debt to repurchase shares and drive up EPS and stock prices while increasing balance sheet leverage), whereas R&D and Capex shrank in comparison. The dollar, meanwhile, initially rallied sharply as a safe haven, and despite periodic bouts of weakness, it has continued its long-term uptrend, thus pressuring export industries to move production offshore. And the result of all that economic and financial change has been the rise of nationalist political parties around the world as well as significant pressure on the global free trade movement amongst nations.

There is a great irony in the fact that for many years after the crisis, central bankers were terrified of global deflation, and sought aggressively to push inflation higher. Well, now they have done so in spades, and it will be quite interesting to see how they respond to this more traditional monetary phenomenon. As the Fed continues on its current policy path, we are seeing an increasing number of EMG central banks forced to raise rates as well, despite suspect economic growth, as inflation is breaking out all over the bloc. Friday saw Russia raise rates in a surprise, and all eyes are on Brazil and South Africa this week. My fear is that ten years of emergency monetary accommodation has left the world in a precarious position, one where the future will see even bigger problems than the crisis ten years ago. Ask yourself this, how will global markets respond to a debt “jubilee”, where debt is simply erased from the books and investors are left in the lurch? Don’t think it can’t happen.

And with that as a backdrop, let’s quickly look ahead to a very limited week of data as follows:

Today Empire Manufacturing 23.0
Tuesday TIC Flows $65.1B
Wednesday Housing Starts 1.23M
  Building Permits 1.31M
Thursday Initial Claims 210K
  Philly Fed 16.5
  Existing Home Sales 5.36M

With the FOMC meeting next week, all eyes are going to turn in that direction. While expectations are universal for a 25bp rate hike, the question is how hawkish or dovish will they sound. The interesting thing is that recent comments by Fed speakers have been far more focused on the potential of the ongoing trade issues to negatively impact the economy. (Secretly I believe that they are actually quite happy with this as if things turn south they will be able to blame someone else and the market will accept that explanation.) At any rate, the data of late has been mixed, with the wage data showing stronger than expected growth, while CPI was actually soft. Given the dearth of important data this week, I expect that the dollar will continue its recent wishy-washy performance, with some days of modest rallies and some days of modest declines, but no new trend evolving.

Good luck
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