2013 in Review

by Doug Noland

December 27, 2013

Quite a year. All 2013 year-to-date price changes are as of the December 27th , but will be updated after the close on December 31st.

In a CBB titledDo Whatever it Takesback in August 2012, I discussed a television program I had viewed (sometime back) that provided an intellectual framework for better understanding the escalation of aerial attacks against civilians during World War II.

From “Do Whatever it Takes:” “In September of 1939, President Roosevelt issued an “Appeal… on Aerial Bombardment of Civilian Populations” to the governments of France, Germany, Italy, Poland and Britain”… As the war commenced, efforts were indeed made by most belligerents” to limit aerial attacks to military targets away from innocent civilians. It wasn’t long, however, before civilian deaths mounted as bombs were unleashed ever closer to population centers. And then not much time elapsed before industrial targets were viewed as fair game, with civilians paying a progressively devastating price

Somehow, an increasingly desperate war mindset saw targeting population centers in much less unacceptable terms. Soon it was perfectly acceptable. War-time justification and rationalization saw conventional bombing of civilian targets regress into direct firebombing and incendiary raids on major cities in Europe and Asia. Less than six years passed between President Roosevelt’s Appeal” and the dropping of nuclear bombs on Hiroshima and Nagasaki.”

My worst fears from the summer of 2012 central banker Do Whatever it Takeschorus came to fruition in 2013. The Fed injected a Trillion dollars (BOJ providing somewhat less) of new moneydirectly into overheated financial markets in a non-crisis environment. And following several years of mind-numbing escalation, this year’s egregious monetary inflation was met with nary a protest. To be sure, “war timerationalizations and justifications turned more creative and sophisticated, as previously unimaginable monetary measures were heralded as “enlightened.”

For the year, the Fed’s balance sheet ballooned 37% to surpass $4.0 TN. Bank of Japan assets surged 42% to exceed $2.0 TN. From my analytical framework, it can be described only as “a year living dangerously.” As he led the Federal Reserve deeper into the untested waters of contemporary monetary inflation, chairman Bernanke took time to proclaim Japan’s parallel inflationary policy a case of “enrich thy neighbor” (in contrast to Depression-erabeggar thy neighbor”).

As destabilized, speculative markets tend to do, they mounted an unpredictable reaction to the Trillions of new global liquidity. In most cases, global bond prices actually declined (yields rose). Emerging markets (EM) generally performed unimpressively at best. Back in 2012, QE2 funneled liquidity into the hot Treasury, MBS and emerging markets. In striking contrast, QE3 hit with cracks surfacing in bonds and EM. This ensured liquidity raged into Bubbling equities – the new speculative vehicle of choice. On the one hand, central bank liquidity accommodated record bond fund outflows, ensuring yield increases were contained and that markets did not dislocate. On the other hand, the new white-hot asset class (equities) could enjoy huge (“great rotation”) flows without fretting over a possible bursting bond Bubble market accident.

Despite massive Fed buying, Treasury and MBS yields moved upward. After beginning the year at 1.76%, 10-year Treasury yields surged 124 bps to 3.00%. Treasury long bond yields jumped 99 bps to 3.94%. Benchmark 30-year MBS yields surged 138 bps to 3.61% (30-year conventional mortgage borrowing rates up 113 bps y-o-y to 4.48%). Not even short rates were immune to upward pressure, as two-year government yields rose 14 bps to 0.39% and five-year T-note yields jumped 101 bps to 1.74%.

Rising yields was a global phenomenon. Canadian 10-year yields jumped 100 bps to 2.77%. U.K. 10-year sovereign yields jumped 125 bps to 3.07%. German bund yields jumped 64 bps to 1.95% and French 10-year yields gained 57 bps to 2.57%. Australian 10-year yields jumped 100 bps in 2013 to 4.27%, and New Zealand yields surged 121 bps to 4.75%.

There is a misperception that inflation was a nonissue in 2013. Yet throughout key EM economies, advancing inflation was among the problematic manifestations arising from protracted Credit and speculative excesses. In short, EM economies generally saw inflationary pressures rise as real growth slowed markedly in the face of ongoing rapid Credit expansions. This created an unappealing environment for global investors, with the more sophisticatedhot moneyheading toward the exits.

Brazil’s local (real) sovereign yields surged 393 bps in 2013 to 13.10%, while some major bankruptcies took a heavy toll on Brazilian corporates. Political instability contributed to the 379 bps jump in Turkish (lira) 10-year yields, to 10.35%. Mexican yields rose 116 bps to 6.50%. Indonesia was an EM problem child, as 10-year yields surged 314 bps to 8.33%. India confronted a worsening inflation backdrop, with 10-year yields jumping 91 bps to 8.95%. Inflationary pressures also hurt Russian bonds, as 10-year sovereign yields jumped 91 bps to 7.81%.

For the most part, EM currencies suffered. On the downside, the Argentine peso declined 24.3%, the Indonesian rupiah 20.1%, the South African rand 19.5%, the Turkish lira 17.2%, the Brazilian real 12.3%, the India rupee 11.1%, the Chilean peso 8.6%, the Peruvian new sol 8.7%, the Colombian peso 8.4%, and the Philippine peso 7.6%. Importantly, with pressure on their currencies and securities markets, EM central bank selling of international reserve holdings (certainly including Treasuries) became an important factor in the upward pressure on global yields.

EM equities for the most part also underperformed. Brazil’s Bovespa dropped 15.9% and Turkish equities were hit for 18.3%. Stocks in Indonesia (down 2.4%) and Thailand (down 6.7%) posted 2013 declines. South Korean equities were little changed. Meanwhile, India (up 9.1%), Taiwan (up 10.9%) and Hong Kong (up 2.6%) posted modest gains. Eastern European equities were mostly lower. On the downside, Ukraine stocks fell 10.3%, with Russian equities down 5.3%. Stocks were mixed in Poland and Hungary, while declining in the Czech Republic. Stocks rose in Bulgaria and Romania.

As “King of EM”, circumstances in China deserve special attention. First and foremost, Chinese Credit and economic Bubbles inflated to new extremes in 2013. After a couple years of cautious measures (“tinkering”) intended to restrain housing inflation and general Credit excess, Chinese authorities were compelled in June to move more forcefully to rein in Bubble excess. As is always the case, missing the timing for needed monetary policy restraint comes with a price. And by this past June, China’s Bubble economy had begun to slow in the face of rising inflation and escalating financial excess. Belated efforts to rein in a runaway Bubble immediately confronted acute financial and economic fragilities – and policymakers quickly reversed course. The Chinese Credit Bubble then bounced back as strong as ever. And as the year came to a close, it appeared Chinese officials were again attempting to impose some restraint.

In one of history’s most spectacular Bubbles, total 2013 Chinese Credit growth will approach $3.0 TN. The year will see record mortgage Credit growth and likely record growth in China’s ballooning shadow bankingsystem. On a hypothetical chart of systemic risk, surging volumes of progressively riskier loans ensure a parabolic spike in risk during the lateTerminal Phase” of Credit Bubble excess. 

Clearly, much of China’s risky Credit has been intermediated through trust deposits,” “wealth managementinstruments and other opaqueshadow bankingvehicles. Indeed, 2013 saw an increasingly dangerous disconnect between the deteriorating quality of Credit and the perception of safety by holders of myriad liabilities throughout the Chinese banking system – both traditional and “shadowvarieties.

It’s worth noting that Chinese market yields rose in 2013. After beginning the year at about 60 bps, China sovereign Credit default swaps (CDS) spiked to a high of 140 in June (before ending the year at 79). Chinese sovereign yields jumped 100 bps to 4.62%. Notably, Chinese corporate yields jumped to multi-year highs as the world began to take a dimmer view of Chinese micro and macro fundamentals.

For China, 2013 was the year of the “tions”: inflation, pollution and corruption. There were growing pockets of unrest, as segments of the population increasingly questioned the quality of their air, food, government and lives. Dissent was met with a harsh crackdown on bloggers, journalists and dissidents. The new Xi Jinping government moved to combat corruption while planning for deeper economic reform, hoping to placate a population that has seen expectations inflate right along with its Credit system, apartment prices and economy.

The long-awaited audit report detailing local Chinese government debt is said to be imminent. The Chinese Academy of Social Sciences think tank this week reported that local government debt had doubled in two years to end 2012 at $3.3 Trillion.

Here at home, the Federal Reserve once again badly missed its timing and, in the process, further emboldened precariously speculative markets. From November trading lows to mid-May highs, the S&P 500 surged 25% (small caps up 32%). Excess throughout the corporate debt market were similarly conspicuous by the spring. The Fed needed to immediately conclude QE – and chairman Bernanke did state in May the Fed’s intention to begin winding down the program. Yet not only did some market tumult have the Fed abruptly reversing course, chairman Bernanke went so far as to state the Fed would be ready to “push back” (with only larger QE) against any tightening of financial conditions. This was another costly policy blunder. The Fed’s $85 billion of monthly market liquidity coupled with Bernanke’s promised market backstop provided the ultimate flashing green light for equities speculation. From June trading lows, the S&P 500 surged another 18% in just over six months (small caps up 23%).

The Fed’s skittish tapering reversal put an exclamation point on five years of unprecedented market interventions and distortions. The Federal Reserve and global central banks have provided profound advantages to speculating on the long side while severely impairing the shorts. On the one hand, a major squeeze (shorts forced to buy back stocks at rising prices to close out losing positions) has provided important fuel for the equities rally. On the other, with the depleted shorts largely out of the way, the emboldened longs could easily push stock prices higher - confident of an atypically limited supply of stock to be sold in the marketplace. It was all too reminiscent of late-‘90’s market speculation, dislocation, manipulation and melt-up. Why not buy large quantities of out-of-the-money call options and then gun the stock market into year-end?

It was definitely the year of the short squeeze. The Goldman Sachs Most Short index surged 45.1%. Herbalife, surely the highest profile squeeze of 2013, enjoys a 2013 gain of 138%. The heavily-shorted solar stocks enjoyed big squeezes. Sunpower gained 414%, Solarcity jumped 377% and SunEdison 299%. The marketplace was equally smitten with 3D printing. 3D Systems jumped 155% and Stratasys rose 61%. Elsewhere, Netflix jumped 296%. Zillow rose 191% and TripAdvisor 95%. Micron Technologies jumped 239% and Best Buy 239%. Facebook advanced 108% and Yahoo! 103%. Tesla surged 346%.

In my now 24 years in the industry, I’ve witnessed my share of market exuberance and excess. Yet 2013 took speculation to a new level. I have argued the breadth of excess throughout U.S. equities surpassed even 1999. The S&P 500 returned (including dividends) 31.9%, while the S&P400 Midcaps returned 32.8% and the Russell 2000 small caps returned 38.5%. The Value Line Arithmetic (average stock gain) posted a 2013 advance of 37.7% (compared to 1999’s 10.6%). The NYSE Arca Securities Broker/Dealer index gained 68.5%. The NYSE Arca Biotechnology index rose 51.5%. The Dow Jones Transports surged 38.5%, and the Morgan Stanley Cyclical Index gained 40.6%. The Philadelphia Semiconductor Index jumped 38.0% and the KBW Bank Index rose 34.7%. The Nasdaq Composite surged 37.8%, with the Nasdaq Industrial Index up 42.4% and the Nasdaq Bank Index gaining 39.3%. It will take a strong Q4 to push real 2013 U.S. GDP to 3%.

Somewhat ironically, it became an almost ideal backdrop for corporate Credit excess – perhaps the “perfect (speculative) storm.” With Treasury, MBS and muni yields moving higher, bond funds suffered huge (over $70bn, surpassing ‘94’s record) outflows. Yet Fed liquidity was there to readily finance the “great rotation” into corporate equities and debt securities, in the process providing a major boon to corporate Credit. The ongoing global yield grab ensured abundant liquidity flowed to junk, leveraged loans and other higher-risk corporate Credits. Rising rate concerns also stoked major flows into floating-rate debt funds and products, further bolstering the corporate liquidity bonanza. Unconventionalbondfunds, profiting handsomely from collapsing corporate risk premiums and other derivative bets, also enjoyed big inflows.

Measures of corporate Credit risk collapsed to levels last seen during booming/“still dancing” 2007. A widely followed index of investment-grade Credit default swap prices sank to 63 bps (low since 10/’07) after beginning the year at 95 bps. And index of junk CDS collapsed 175 bps to 312 bps (low since 6/’07). The corporate debt market literally succumbed to panic buying, and I’ll assume that the booming corporate Credit derivatives marketplace played a prominent role. Writing corporate Credit (“flood”) insurance was an extraordinarily profitable undertaking in 2013. Leveraging in high-yield corporate debt was a home run. The Fed, the leveraged speculators and our desperate savers created a backdrop of essentially unlimited cheap corporate Credit availability. And borrowers lined up.

The year 2013 saw record ($1.52 TN from Bloomberg) U.S. corporate debt sales. For the second straight year, investment-grade debt issuance set annual an annual record ($1.125 TN). Junk bond issuance ($360bn) set a new record, with record sales of payment-in-kind (PIK) and “cov-light bonds. Junk-rated loan volumes surged to a record $683 billion, surpassing 2008’s $596 billion (according to Standard & Poor’s Capital IQ Leveraged Commentary and Data). Total global corporate bond issuance surpassed $3.0 TN. Global speculative-grade bond sales approached an unprecedented $500 billion (from S&P). Global IPO volumes jumped 37% from 2012 to $160 billion (from S&P).

At $233bn, private-equity buyouts reached their highest level since 2007 (Dealogic). The U.S. IPO market enjoyed its strongest issuance year since 2007. A total of 229 deals raised $61.7bn, with dollars raised up 31% compared to 2012. And it’s certainly worth noting that hedge fund assets increased more than $360 billion during the year to reach a record $2.70 TN (from Prequin), despite ongoing (“crowded trade”) performance issues.

And, of course, the more conspicuous the financial Bubble the more boisterous the bullish propaganda arguing that Bubble talk is ridiculous. Our central bank has clearly learned nothing from earlier crises. Rather than moving to tighten monetary policy, the FOMC near year-end stated their intention to pump at least another $500 billion into the markets, while promising to keep rates at near zero for some time to come.

U.S. corporate debt growth should approach 9.0% during 2013, the strongest pace since 2007’s 13.5%. But even with heady corporate borrowings, total U.S. non-financial debt growth will likely slow in 2013 to less than 4% (down from 2012’s 4.9%). With municipal bonds posting their worst year since 1994, Credit conditions tightened throughout much of muni finance. And with the Household sector still reluctant to take on significant additional debt, the overall Credit backdrop remained potentially problematic for economic growth, corporate earnings and inflated asset markets. Yet for 2013, the Fed’s $1.0 TN monetary inflation again countermanded normal system behavior and relationshipsmost notably further inflating securities and asset prices.

In the end, over-liquefied and booming financial markets, with attendant massive inflation of perceived household wealth coupled with extremely loose corporate Credit, provided some momentum to the real economy. The Fed remained fixated on potential fragilities, again choosing to completely turn its back from the type of Bubble Excess responsible for what have become hopelessly interminable fragilities.

The OECD forecasts only 2.7% global growth for 2013. Cracks in China, Brazil, India and other EM economies, the previous globalgrowth locomotives,” have created a tenuous backdrop. The popular global reflation trade came under intense pressure in 2013. Gold bullion sank 28%, with the NYSE Arca Gold BUGS Index (HUI) collapsing 55.4%. Resilient energy prices contained losses to the major commodities indices. Yet corn sank 39%, silver 34%, Canola 29%, wheat 22%, soybean oil 19%, coffee 19%, nickel 17% and aluminum 16%. The “commoditiescurrencies were hit, with the South African rand down 19.5%, the Australian dollar 14.7%, the Brazilian real 12.3%, the Norwegian krone 9.5% and the Canadian dollar 7.3%.

The dismal performance of the commodities complex in the face of massive QE caught most by surprise. My own view holds that 2013 saw major cracks develop in the global Bubble with the onset of financial and economic fragilities in China, Brazil and EM more generally. Fed and BOJ liquidity only exacerbated instabilities. Increasingly powerful equities Bubbles in New York, Tokyo and Frankfurt added to the magnetic pull away from EM, while fostering greater uncertainty for developed world economic prospects. To be sure, QE had a profound impact on the performance-chasing and trend-following global leveraged speculating community with assets measured in the many Trillions. As equities took off, cautionalong with gold and other perceived safe havens – were thrown to the wind.

Surging Japanese stock prices were fueled by enormous Bank of Japanmoneyprinting and the resulting 17.5% yen (vs. the dollar) devaluation. Japan’s Nikkei equities index posted a historic advance (up 55.6%).

Despite ongoing economic stagnation, 2013 saw European markets somewhat win by default. The euro was the strongest performing major global currency (up 4.2% vs. the dollar). The German DAX equities index jumped 26% to a record high, with the CAC 40 gaining 17.5% in the face of a weak French economy. Especially after faltering EM bond markets fell out of favor, “peripheryEuropean bonds (backstopped by the Draghi ECB) became a favored high-yield target for the global speculator community. Greek bond yields sank 226 bps this year (to 8.21%), with 10-year sovereign yields in Spain down 106 bps to 4.21%; Portugal down 70 bps to 5.96%; and Italy down 29 bps to 4.21%. Despite moribund economies, Spanish equities were up 21.1% in 2013 and Italian stocks gained 16.5%. I’d be curious to know the scope of leverage in European debt (and elsewhere!) financed by borrowing in or shorting the yen (“yen carry trade”).

As an analyst of Credit, Bubbles and markets, 2013 was extraordinary. There was historic Credit growth (China), historic central bank monetary inflation (Fed, BOJ) and incredible speculative excess (U.S. equities & corporate debt, Japanese equities...). The year provided abundant confirmation of the global Bubble thesis. In particular, the May/June period of market tumult illuminated mounting vulnerabilities. Five years of extreme monetary stimulus have spurred Trillions of flows into markets, products and instruments with significantly greater risk than generally perceived. There has as well been a proliferation of perceived low-risk strategies that incorporate varying degrees of leverage.

The May/June period gave a hint of how quickly latent instabilities can manifest when market downturns incite a reversal of flows. In particular, some ETFs and various risk paritystrategies demonstrated how quickly perceived highly liquid markets can prove liquidity-challenged. Central bank liquidity provided a great deal of market balm throughout 2013. It also further inflated dangerous Bubbles that will ensure a fascinating 2014.