For a year or so MB has been warning that we’re entering dangerous territory for the global business cycle. This has been pretty obvious to those that have the eyes to see. US Fed tightening cycles nearly always ends in recessions and there is no reason to think that this one will be any different, from Goldman Sachs:
But no two business cycles are the same and this one is very different. Normally a business cycle dies of some combination of ponzi lending, inflation and higher interest rates. This time it’s dying of ponzi lending, deflation and lower interest rates, albeit with a little tightening at the end.
There are some more specific elements at work as well. As shockingly muted as it has been, the US tightening has unleashed a US dollar bull market. That, in turn, has exacerbated a commodity bear market emanating from slowing Chinese growth. That has had the knock on effect of hitting emerging markets twice over as domestic demand is hit by capital being repatriated to the US on a narrowing yield spread and external demand is hit by declining exports to China.
In January we saw this crisis come to a head in what MB describes as the Mining GFC as the collapsing oil price threatened to trigger a global high yield debt freeze across the commodity and emerging market complex. The Mining GFC was staved off by two events. First the Fed backed off its rate hikes. And second, China stimulated an old economy mini-cycle. Both of these stabilised commodity prices and a rising oil price lifted global credit.
And so it all seemed OK. Indeed, for a few days I mulled the end of the Mining GFC. But we’re suddenly heading back to where we were with a bullet. There are three forces taking us there in the second half and a comprehensive global shock is possible.
The first is Brexit. If the UK decides to depart the European Union then the economic fallout is modest, however, the fallout for the euro is grave. If the UK can leave the EU then anybody can, including France and its elections in 2017 in which the anti-euro National Front is surging. If the UK goes, there will simply be no reason for anyone to hold the euro, which may not be a great crisis in and of itself but it will again drive up the value of the US dollar.
The second force is that China is going to slow through H2. This is now locked in at the most basic level of credit issuance, which has tumbled in the past few months after the Q1 surge. It leads activity by 3-6 months:
So, just as Brexit drives up the US dollar, China is going to slow again and commodity prices resume their monstrous bear market.
The third force is oil. The stimulus in the US and China has allowed some time for the oil market to work off excess supply capacity. But a big part of that “rebalancing” has also been good fortune in the unexpected cessation of oil production in Libya, Nigeria, Venezuala and Canada, chart from Goldman:
As these outages pass, the oil market is again going to be oversupplied. Canada’s return is a certainty and if Nigeria were to join it, or some good news arrive from Venezuala or Libya, then oil is going to be vulnerable to a price relapse. Add in slowing Chinese growth, destabilation in Europe and a rising US dollar and you have the conditions under which oil could dislocate taking global high yield credit with it.
In short, the second half may see a very nasty convergence of negatives for global markets as growth slows, commodities crash, emerging market high yield debt and developed market inter-bank credit spreads blow out simultaneously, and all of that is overlaid that with another round of “quantitative failure” hand-wringing as markets fret that central banks are out of bullets. Stock markets will crash.
The only way out will be the Fed abandoning its tightening then embarking on QE4 but that can only come after the accident. And it may well come along with Donald Trump.
Of course there are many ‘ifs’ and ‘buts’ here. There’s more chance of it not happening than it doing so given all of the variables. But there are a bunch of dominoes lined up and if the Poms decide to push the first one over, then I would not be too sanguine about the outcome.
Happily, if you’ve been reading you will already be buying gold on the dips, be long bonds and short the Aussie dollar.