Submitted by Doug Noland – Credit Bubble Bulletin
The year 2015 was extraordinary. Incredibly, despite powerful confirmation of the bursting global Bubble thesis, market optimism remained deeply entrenched. All leading strategists surveyed in December by Barron’s remained bullish – some were borderline crazy optimistic.
Optimism withstood a commodity price collapse. Crude, the world’s most important commodity, crashed almost 35% to an eleven-year low, much to the peril of scores of highly leveraged companies and countries. The Bloomberg Commodities Index dropped 25%, its fifth straight year of declines. Copper fell 24%, with platinum and palladium down about 30%. In agriculture commodities, wheat fell 20%, with soybeans and corn down about 10%. Coffee sank 25%. Debacle.
Bullishness persevered through deepening EM turmoil and a crisis of confidence. The Brazilian real dropped about a third (worst year since 2002), and Brazil’s sovereign debt suffered major losses. Brazil’s corporate debt market was pummeled (Petrobras, Vale, BTG, Samarco, etc.) while confidence in the nation’s major banks and government waned. Russia and Turkey showed further deterioration. Fragility surfaced in EM linchpin Mexico. Currencies suffered generally throughout EM – Latin America, Asia, the Middle East, Eastern Europe, etc. Collapsing currency peg regimes saw almost 50% devaluations for the Azerbaijani manat and Kazakh tenge. Argentina devalued the peso 30% versus the dollar. Throughout EM, dollar-denominated debt became a market concern.
Optimism survived the major financial tumult that unfolded in China. Early 2015 stimulus efforts stoked “Terminal Phase” excess in Chinese equities, a Bubble that came crashing down in a 40% summer drubbing. An August yuan devaluation destabilized markets across the globe. Aggressive (invasive) monetary, fiscal and regulatory measures somewhat stabilized equities and the yuan, at the heavy cost of extending “Terminal Phase” excess throughout the Credit system (i.e. corporate debt and “shadow banking”). The yuan posted a 4.5% 2015 decline against the dollar, the worst performance since 1994. The “offshore yuan” trading in Hong Kong dropped 5.3%.
Bullishness endured despite the August global market “flash crash.” While the summer market dislocation provided important confirmation of mounting fragilities throughout the markets on a global basis, the bulls interpreted the event as further validating their view of unwavering central bank support and liquidity backstops. The Fed’s September flip-flop emboldened speculative excess, with U.S. equities back within striking distance of record highs by early-November.
From the perspective of my analytical framework, 2015 was momentous; not necessarily because of the year’s occurrences as much as for the far-reaching dynamics set in motion. The “Core and Periphery” analytical framework is an especially valuable tool in our efforts to decipher an easily perplexing 2015. Instability afflicting the EM “Periphery” in 2014 gravitated to the “Core.” In particular, and central to the “momentous 2015” view, faltering Bubbles in commodities and China were transmitted to the “developed” world’s markets and economies (at least at the “Periphery of the Core”).
Troubled energy and commodities companies led a surge in U.S. corporate debt troubles, with the U.S. actually accounting for 60% of global defaults (from S&P). U.S. junk bonds posted negative returns for the year. Junk bond sales slowed sharply after the August “flash crash,” with 2015 issuance down about 16% from the previous year (2014 $348bn). Leveraged loan issuance was down about 20% (from S&P Capital IQ). Confidence was further shaken by a public mutual fund (Third Avenue) barring redemptions. ETF outflows became a serious market concern.
The year ended with heavy outflows from bond funds – junk as well as, notably, investment-grade. Beyond devastating consequences for highly leveraged energy and commodities players, the tightening of financial conditions was transmitted to “Core” equities market. The volume of U.S. IPO deals fell more than 40% in 2015, with money raised sinking 65% to $30 billion (from Renaissance Capital). Global IPO volumes were down 35% from 2014 to $156 billion.
In the face of a wrenching commodities collapse, a slowing global economy, heightened risk aversion and prospects for Fed rate increases, Wall Street remained undaunted. A December 28 headline from Bloomberg: “Wall Street Predicts Corporate America’s Bond Binge Will Go on – Wall Street’s biggest dealers are forecasting that blue chip U.S. companies will sell more than $1 trillion of bonds for a fifth straight year in 2016 as corporate America’s borrowing binge endures…” In equities, investors gravitated away from the deteriorating broader market in favor of crowding securely in “FANG” (Facebook, Amazon, Netflix and Google).
For much of 2015, deterioration at the “Periphery” worked to bolster flows to “Core” markets. Investment-grade issuance jumped to a record $1.31 TN, up about 17% from 2014’s record $1.168 TN. Record low corporate yields and the Fed-induced insatiable demand for investment-grade debt sustained the historic M&A boom. For the year, global M&A reached a record $5.04 TN (from Dealogic), surpassing 2007’s record. U.S. M&A surged 56% to $2.43 TN. Despite rapidly slowing earnings growth, corporate America repurchased stock and paid dividends at record levels.
The U.S. economy likely grew about 2% in 2015, below earlier expectations and a dismal performance considering the prolonged ultra-loose monetary backdrop. Most notably, the U.S. economy turned only more unbalanced. The bust in energy and commodities gathered momentum, while Bubbles in tech and biotech inflated precariously. In general, housing markets slowed meaningfully into year-end. Yet aggregate data mask downturns in some markets and runaway booms in others. The commercial real estate Bubble inflated further. The unemployment rate dropped to 5%, yet income and wealth inequality had Americans feeling increasingly uneasy with the economic backdrop, with the Fed, government and Wall Street.
Importantly, Credit growth slowed markedly in 2015, with implications for income growth, corporate profits and the asset markets more generally. Through three-quarters of 2015, Non-Financial Credit growth slowed markedly to an annualized pace of about $1.32 TN. Assuming weak Q4 growth, 2015 will see the slowest Credit expansion since 2009 ($1.204 TN). For perspective, Credit expanded $1.843 TN in 2014, $1.608 TN in 2013 and $1.923 TN in 2012. And after three-years of major stock market-induced gains in Household Assets, 2015 will see the smallest rise in Household Net Worth since 2011.
The year was notable for the increasingly problematic central bank-induced divergence between inflating securities markets and deflating real economy prospects. Bursting commodities and EM Bubbles weighed on global growth, while QE and ultra-dovish monetary policies spurred ongoing speculative excess. As the global economy deflated (in the face of aggressive monetary stimulus), over-abundant liquidity was further enticed into the inflating global financial asset Bubble. And as speculators rushed to exit faltering markets, asset classes and individual stocks, the Crowded Trade phenomenon turned only more destabilizing. The huge bets on central bank policies left markets at high risk for abrupt reversals and trade unwinds – 2015 The Year of the erratic Crowded Trade.
The Swiss National Bank’s surprising January decision to break the swissy’s cap with the euro proved a precursor of 2015’s disorderly Crowded Trades – and the general inhospitable backdrop for leveraged speculation. Recall how the swissy moved a massive 30% as the news broke, the type of market discontinuity that blows out leveraged trades and dynamic-trading hedging strategies. While not as dramatic, currency markets again dislocated during the August “flash crash.” Later, the euro moved an immediate 4% in early-December when Mario Draghi was unable to deliver on his vow to “do what we must to raise inflation as quickly as possible.” The year saw the risk vs. reward calculus deteriorate significantly for leveraged speculation, especially in currency trading.
January 1 – Wall Street Journal (Rob Copeland): “Hedge funds start the New Year with something to prove—again. The money managers who charge some of the highest fees on Wall Street had a chance in 2015 to outperform a flat stock market and end years of subpar performance. Instead, hedge funds lost more than 3%, on average, according to early estimates from hedge-fund-research firm HFR Inc., while the S&P 500 returned 1.4%, including dividends. Managers stumbled for myriad factors, including bad wagers on energy and currencies and an overreliance on certain stocks. ‘Everything went wrong,’ said Alexander Roepers, founder of $1.5 billion hedge-fund firm Atlantic Investment Management. ‘There were very few places to hide.’”
Hedge fund travails have been well publicized. The industry overall lost money in 2015, following several unimpressive years. Several major funds suffered their worst year since the financial crisis. Many funds closed and/or returned money to outside investors. Still, investor confidence for the most part held up. The industry overall did not suffer major outflows. Yet it wasn’t only hedge funds that struggled in 2015’s unsettled market backdrop.
December 31 – Wall Street Journal (Sarah Krouse): “It is getting a lot harder to sell hedge-fund-style investing to the masses. More ‘liquid alternative’ mutual funds closed in 2015 than in any year on record, according to… Morningstar Inc., as inflows dwindled and performance weakened. The results show that enthusiasm is fading for what had emerged in recent years as one of the hottest products in asset management—funds that combine hedge-fund strategies like shorting stock with the daily liquidity of mutual funds. In all, 31 liquid-alternative funds have been closed this year, up from 22 a year earlier… ‘You had so many funds that were launched in the last couple of years and hadn’t really been tested by market volatility and you’re starting to see the cracks in them,’ said Jason Kephart, an analyst at Morningstar… Fund companies aggressively pitched liquid-alternative products, saying they could help protect investors from volatility and offer better returns. Assets in liquid-alternative funds grew to $310.33 billion at the end of 2014 from $124.44 billion at the end of 2010.”
It was certainly not the year of the “non-correlated” fund or asset class. Overall, most funds and strategies that were expected to perform well in the event of market instability failed to live up to expectations. Symptomatic of the general backdrop, too much “money” has flooded into various “liquid alternative,” “risk parity,” and sophisticated hedging strategies. Instead of providing investor protection, the proliferation of variations of model-directed, trend-following strategies only exacerbated market instability.
An overarching theme from 2015 was that the market turned increasingly unstable, while the vast majority of strategies used for market risk mitigation performed disappointingly. This is closely related to another critical market development illuminated in 2015: rapidly waning benefits to diversification. The halcyon post-crisis backdrop of holding (leveraging?) a portfolio of U.S. equities, fixed-income and global stocks & bonds – all generating positive returns – ended with a vengeance. Commodities were a disaster and EM was a minefield. Moreover, bonds were no longer providing a reliable hedge against “risk off” market turbulence. Perhaps not obviously, but the game turned much more difficult in 2015. Bloomberg: “The Year Nothing Worked: Stocks, Bonds, Cash Go Nowhere”
I didn’t adopt the terminology, but “quantitative tightening” was used (initially by Deutsche Bank) starting in August to describe the dynamic where EM outflows were forcing EM central bankers to liquidate Treasuries and “developed” sovereign debt securities. A key “virtuous cycle” dynamic from the global government finance Bubble period had been the large flow of finance into EM that was then easily/predictably recycled back into “developed” markets through the purchase of sovereign debt.
2015 marked a key inflection point for EM international reserved holdings, with important implications for EM and global market stability. The potential for big EM central bank liquidations became a significant market uncertainty. Moreover, the prevailing dynamic where “risk off” instability led predictably (great for hedging!) to aggressive buying of Treasuries (and “developed” sovereigns) was supplanted by fear that global tumult would spur EM outflows, Treasury sales and a pop in global yields. Importantly, Treasuries lost the attribute of providing a cheap and reliable hedge against faltering global risk markets. This greatly compromised popular diversification and hedging strategies.
China’s international reserve position ended November at $3.4 TN, declining from the 2014 high of $4.0 TN. Reserves were down $405bn through November. Estimates had outflows from China surging to $200 billion monthly during the summer, and perhaps remaining near $100 billion per month through the end of the year. China imposed onerous measures throughout the summer and fall that amounted to capital controls. These, along with the late-summer market crackdown on selling, short-selling and derivatives trading, ensured an international investor crisis of confidence in the course of Chinese policymaking. Crackdowns on the securities firms and what has evolved into ‘wildcat banking” significantly complicates the already fragile Chinese Credit backdrop.
Fundamental to “momentous 2015” is the thesis that the year marks a pivotal year in confidence in global policymaking generally. Clearly, the unfolding bust saw a dramatic change in perceptions with respect to the aptitude of Chinese officials. In general, confidence in the effectiveness of QE waned throughout the year. A global commodities collapse in the face of ongoing QE was unnerving.
As the year progressed, it seemed only central bankers remained confident that QE could reverse the downward trajectory of global CPI. Within individual central banks, skepticism mounted as to both the effectiveness of QE and the associated risks to financial stability. The Bank of Japan hesitated to increase QE, while market darling Draghi couldn’t deliver on what the market had believed was promised more aggressive QE. Market perceptions shifted from “whatever it takes” QE on demand to fears that current QE, while not all that effective, could be as good as it gets.
2015 developments also support the view that the bursting of the global Bubble portends serious geopolitical risk and instability. Geopolitical tensions were on the rise virtually everywhere. Strongman Putin took his show to the Middle East, a region increasingly a volatile cauldron of mayhem. Strongman Erdogan’s Turkey shot down a Russian fighter jet. Millions of refugees to Europe, further destabilizing the political backdrop. Multiple terrorist attacks. ISIS. The U.S. challenged China in the South China Sea. Strongman Xi Jinping took further measures to centralize authority and solidify power. Japan’s Shinzo Abe pushes forcefully ahead with reform and militarization. 2015 was the year of the authoritative leader – on a seemingly global basis. With pundits and traditional analysts in disbelief, Bernie Sander catches fire with an anti-capitalism and anti-Wall Street message, while the Donald Trump phenomenon takes the Republican primary season by storm. And few see the association to Credit Bubbles, unsound “money” and Credit, inflationism and resulting central bank-induced monetary disorder.
Important pillars of the bull case evaporated throughout 2015. Global price pressures weakened, the global Credit backdrop deteriorated and the global economy decelerated. Indeed, a global bear market commenced yet most remain bullish. Serious and objective analysts would view this ominously.