From Doug Noland over the weekend:
A particularly unsettled week for U.S. and global markets.
Global markets have turned highly unsettled. The S&P500 opened the week at about 1,783, sank to an intraday low of 1,738 on Wednesday before rallying to close the week at 1,797. The Goldman Sachs Most Short index sank 4.0% Monday, was little changed Tuesday, fell 1.6% Wednesday, jumped 1.7% Thursday and then surged 3.3% Friday. High-profile hedge fund short positions have turned wildly volatile. Green Mountain Coffee surged 33.0% this week.
Currency markets have turned treacherous. Those short the commodity currencies abruptly found themselves on the wrong side of a squeeze. The New Zealand dollar gained 2.6% this week, with the Australian dollar up 2.3%. Some EM currencies enjoyed strong weekly gains. The Polish zloty increased 3.0%, the Turkish lira 1.7%, the Hungarian forint 2.6%, the Argentine peso 2.3%, the Brazilian real 1.4%, the Russian ruble 1.1% and the Czech koruna 1.1%.
Overall, global markets these days convulse between “risk off” and “risk on” – in bloody trench warfare between market bulls and bears. Greed and fear vacillate between the two camps. The yen weakened only modestly this week, and EM equities were generally unimpressive. EM bonds for the most part held their own. Mexico’s sovereign debt rating was upgraded, which lent some support to the sector.
Bill Gross’ February piece, “Most ‘Medieval’”, provides an insightful read. He focused on a focal point of my analytical framework: “Asset prices are dependent on credit expansion or in some cases credit contraction, and as credit goes, so go the markets, one might legitimately say, and I do most emphatically say that!” “Credit creation or credit destruction is really the fundamental force that changes P/Es, risk premiums, natural interest rates, etc.” As part of his concluding comments, Gross added: “The days of getting rich quickly are over, and the days of getting rich slowly may be as well.”
It’s my view that we have reached – or, perhaps, are approaching – a historic inflection point in global Credit. Credit has tightened meaningfully in segments of China’s finance, as well as throughout EM more broadly. Yet rapid Chinese Credit growth has thus far been sustained, though the expansion is notably unbalanced and vulnerable. This has negative implications for global economic performance, as well as global securities and asset prices. But the timing of a significant Chinese Credit slowdown remains unclear.
Most analysts are quick to dismiss U.S. susceptibility to EM woes. Such complacency, while handsomely rewarded over recent years, could this time prove a major mistake. For one, I would view current EM instabilities as a major crack in what evolved over years into historic global financial and economic Bubbles. EM is global “subprime.”
In the post-2008 crisis landscape, EM economies did indeed assume the role of “global locomotive.” Less appreciated, China and EM Credit systems grew to become responsible for much of global Credit growth. Many of the major EM Credit systems experienced in the neighborhood of 20% compounded annual Credit expansion over the past five years. Emblematic, total annual Chinese Credit growth exploded and approached $3.0 TN in 2013, the greatest expansion ever experienced by an individual economy.
While astonishing amounts of new Credit inflated and distorted real economies, there is the less transparent – yet absolutely critical – issue of financial leverage. With the Fed, Japanese and other “developed” central banks engaged in unprecedented “printing” and devaluation measures, EM markets were the focal point of the expansive “hot money” financed “global reflation trade.” Unknown amounts of speculative leverage were employed in myriad “carry trades” and other speculations to capitalize on borrowing cheap in (depreciating) currencies to speculate in higher returning EM securities. There was as well unprecedented investment into EM economies and markets, pushing overall financial flows to the several Trillions.
The key point is that one should not today in anyway downplay the ramifications of bursting EM Bubbles and associated de-leveraging. There will be major unfolding consequences on global Credit growth, pricing dynamics, financial flows, speculative finance, Credit availability and economic performance. This process has commenced, although the pace of initial developments has been generally held in check by the ongoing rapid expansion of Chinese Credit coupled with Fed and BOJ quantitative easing measures.
“Is Tapering Tightening?” has become topical. From the perspective of my analytical framework, of course it’s tightening. No question about it; silly to think otherwise. The risk of leveraging in the marginal global securities markets and economies (EM) has increased; market behavior has begun to adjust; and financial conditions have started to tighten at the margin.
Since August of 2008, the Fed’s balance sheet has inflated from about $900bn to $4.1 TN. In just the past 14 months, Fed holdings have jumped $1.25 TN. It’s simply implausible that the Fed winding down such aggressive monetary inflation won’t have major impacts on U.S. and global market liquidity dynamics. After all, the “periphery” is already being pressured by the altered liquidity backdrop. While the timing and dynamics involved remain uncertain, I fully expect risk aversion and de-leveraging “contagion” to over time gravitate to the “core.”
The global “leveraged speculating community” could provide the most direct transmission mechanism from EM tumult to U.S. securities markets. As the leveraged players get caught in faltering global markets, their reduced risk appetite will impinge liquidity in U.S. and other markets. But with still significant Fed and BOJ QE, there remains the prevailing 2013 “trouble at the periphery stokes flows to the core” dynamic shaping market trading.
There are as well powerful speculative Bubble Dynamics that tend to disregard fundamental deterioration for a time. Short squeezes and the unwind of hedges also tend to incite “bear market rallies” readily interpreted as bullish market signals. So there are today powerful market crosscurrents. Over time, however, I would expect these forces to wane as the more typical “periphery to core” dynamic gathers momentum.
Yep. At least until either the Fed, China or both re-stimulate. The question that matters is will that be before the economic damage done by liquidity withdrawal makes the run self-fulfilling?
