Risk Off?

Submitted by Doug Noland – Credit Bubble Bulletin 

The “Granddaddy of All Bubbles” thesis rests upon the view that the world is in the midst of the precarious grand finale of a multi-decade global Credit and financial Bubble. When a Bubble bursts, system reflation requires an even larger fresh new Bubble. This has repeatedly been the case going back at least to the “decade of greed” late-eighties Bubble in the U.S. These days the world confronts the terminal Bubble phase partially because of the unprecedented scope of the China and EM Bubbles. It’s simply difficult to imagine another more far-reaching Bubble.

Also critical to the finale Bubble thesis is that the “global government finance Bubble” – encompassing unprecedented excesses in sovereign debt, central bank Credit and government market manipulation – has engulfed the very foundation of contemporary “money” and Credit. It’s again quite a challenge to envisage a new financial Bubble inflation cycle following a crisis of confidence at the heart of global finance.

As I’ve posited repeatedly, the global Bubble has been pierced. There’s more confirmation again this week.  The collapse in commodities and EM currencies along with the faltering Chinese financial Bubble mark an historic inflection point. Global policymakers have gone to incredible measures to stabilize market, financial and economic backdrops. Yet reflationary measures will continue to only further destabilize.

When policy-induced “risk on” is overpowering global securities markets, fragilities remain well concealed (and my prognosis appears ridiculous). Fragilities, however, swiftly manifest with the reappearance of “risk off.”  Rather quickly securities markets demonstrate their proclivity for illiquidity and so-called “flash crashes.” So after an unsettled week in global markets, the critical issue is whether “risk on” is giving way to “risk off” dynamics.

There is no doubt that a powerful “risk off” has again gripped commodities markets. Crude (WTI) sank 8.5% this week to $40.71, the low since the tumultuous August period. The “GSCI” Commodities Index dropped 4.0% this week, increasing 2015 losses to almost 19% while trading down to near August lows. The Bloomberg Commodities Index sank to an almost 16-year low. Copper prices this week sank 3.6%, trading to a new six-year low. Zinc also traded to a six-year low, with nickel at a five-year low. Unleaded gasoline dropped almost 10%. Wheat fell 5.3% and Corn dropped 4.0%.

With commodities succumbing to another leg in an increasingly brutal bear market, worries quickly returned to EM. The Brazilian real declined 2.1% this week and the Colombian peso sank 6.4%. The Russian ruble fell 3.5% and the South African rand declined 1.6%. Mexican stocks were hit 3.6%.

November 9 – Bloomberg (Taylor Hall): “Debt in developing markets is estimated to have reached $58.6 trillion at the start of 2015, with credit in China, Hong Kong, India, Indonesia, Malaysia, Singapore, South Korea and Thailand exceeding that of Latin America, emerging Europe and the Middle East, according to the Institute of International Finance. Emerging-market debt has grown $28 trillion since 2009, according to the IIF… Global debt has soared $50 trillion during the period to surpass a total of $240 trillion, or 320% of gross domestic product, in early 2015. While credit has increased for almost all countries included in the new monitor over the past decade, debt-to-GDP ratios in developing Asia for non-financial corporate, household and financial corporate sectors have risen the most… Non-financial corporate sector debt in emerging markets has risen $13 trillion since 2009, increasing more than five-fold over the past decade to surpass $23.7 trillion in the first quarter of 2015. The advance has been most concentrated in emerging Asia, where it rose to 125% of GDP.”

And with market attention seemingly returning to the world’s precarious debt overhang, “developing” Asian equities were hit hard this week. Stocks were down 4.2% in Taiwan (TAIEX), 2.8% in Singapore (STI), 2.8% in Thailand (SET), 3.1% in the Philippines (SE IDX), 2.1% in Indonesia (Jakarta Comp) and 1.6% in Malaysia (KLCI). Australian stocks (ASX 200) were hit 3.1% and New Zealand stocks (NZX 20) fell 1.7%. Hong Kong’s Hang Seng Financial index dropped 2.6%, increasing its 2015 decline to 30.4%.

Disappointing Chinese economic data (imports, exports, producer inflation, etc.) already had investors on edge. A (rapidly?) deteriorating corporate Credit backdrop was beginning to cause angst. And then Thursday’s Chinese Credit data was stunningly disappointing. October saw total Credit growth (“Total Social Financing”) cut by more than half. After September’s jump to $204bn, Credit growth slowed sharply to $75bn, the weakest month of Credit expansion since July 2014. New bank loans, at $81bn, were less than half of September’s $165bn. This is insufficient Credit to hold bust at bay.

In short order, confidence that Chinese policymakers have everything under control has begun to wane. The view that Beijing can simply dictate Credit growth through mandates to the big state-directed lenders is being shaken by anecdotes of increasingly nervous bankers and cautious borrowers. Suddenly there’s talk of the Chinese “pushing on a string.”

When global markets are in a bullish mood, commodities and EM currencies appear to have bottomed. Yields on energy, commodities and deep cyclical company debt around the globe seem enticing. “Developing” country debt is attractively priced. Chinese officials seem capable of ensuring 6.5% growth as far as the eye can see. China enjoys the capacity to stabilize its currency, inflation level and debt load. And stable Chinese growth will backstop commodities markets, EM markets and economies and the global economy (and markets!) more generally.

But this optimistic view of things turns flimsy in a hurry. When crude and commodities begin to tank, large quantities of debt (company, country and financial) look increasingly suspect. King dollar takes off, putting added pressure on faltering commodities and EM (currencies, debt and stocks) Bubbles. And with the Chinese currency pegged to king dollar, the markets’ view of the China Credit situation can abruptly shift from “manageable” to “potentially very troubling.”

And returning to the “Granddaddy Bubble Finale” thesis, the Chinese and EM Bubbles fundamentally changed the “producer” and “consumer” inflationary backdrops. Ultra-loose global finance has ensured massive overcapacity in too many things. It has created an unprecedented divergence between bubbling financial markets and weakening fundamental prospects. There’s way too much debt almost everywhere, a debt burden that central bankers would like to inflate away to more manageable levels. The Chinese are desperate for inflation to grow out of historic amounts of debt. They’ve been able to inflate out of debt troubles previously, and they’ve watched U.S. reflationary measures work their magic repeatedly.

The bursting global Bubble is especially problematic for China. EM currencies have been devalued, while the U.S. and Chinese currencies have skyrocketed. The old reflationary measures no longer work. Loose “money” only exacerbates overcapacity, inequalities and financial Bubbles. The strong dollar further pressures global pricing, while adding to heightened Credit stress globally (certainly including EM dollar-denominated debt). Meanwhile, China’s currency peg to the dollar ensures the already vulnerable Chinese manufacturing complex becomes further uncompetitive. It ensures major problems related to the country’s enormous lending and investing boom in global resources. The resulting Credit stress only exacerbates disinflationary pricing pressures.

In 2014 and again in August, it appeared China was to commence meaningful currency devaluation. In both instances acute financial stress forced Chinese officials to immediately backtrack. Trying to recover from the August fiasco, the Chinese have focused on currency stability. And when markets are in that optimistic state of mind, Chinese policy appears sensible and sustainable. But when “risk off” begins to take hold, China’s mountains of overcapacity and debt appear completely at odds with a strong currency – with a peg to king dollar – in a disinflationary global environment.

It wasn’t only commodities and EM that succumbed to “risk off” this week. European stocks were down about 3%. U.S. stocks had a really rough week. The S&P500 declined 3.6%, with the broader market down even more. Selling was broad-based. Credit spreads also widened, most notably in high-yield. Junk bond funds saw flows reverse to sizable outflows. There were anecdotes of waning demand for leveraged loans, high-yield municipal debt and risky Credits more generally. Puerto Rico… Hedge fund performance… This is all consistent with heightened risk aversion and self-reinforcing pressure to de-leverage.

Confidence was so high that the bulls had essentially already taken a big year-end rally to the bank. “Risk off” into December would catch the bullish consensus completely flatfooted. “Risk off” would also catch most market operators un-hedged and over-exposed on the long side. “Risk off” would also complicate life for the Fed. Just when they had finally gathered the nerve to move, global markets turn sour. And perhaps the Fed has been whipsawed by the markets one too many times. But I still think global markets are being dictated much more by China than the Fed. And at this point, Chinese officials have the much more difficult decisions. Do they bite the bullet and start devaluing? Or do they stick with the peg and hope?

My Friday writing has been interrupted by the news of terrible terrorist attacks in Paris. It’s a reminder of the increasingly hostile world in which we live. And it’s consistent with a darkening of the social mood in Europe, as well as here in the U.S. and around the world more generally. It’s also part of the troubling backdrop conducive to a problematic “risk off” when faith in global central bankers and Chinese officials wanes.

November 13 – Bloomberg (Candice Zachariahs, Anchalee Worrachate and Lananh Nguyen): “…While dislocations may provide opportunities for investors, they also bring challenges, according to… Luke Bartholomew, an investment manager at Aberdeen Asset Management… ‘The real worry about liquidity is that it behaves like a bad friend — it is there when you don’t especially need it, but as soon as you do need it, it disappears.'”