What We Know

Heightened global market instability has began to be transmitted to U.S. securities markets. There’s much that we simply don’t know. There is as well a lot we know with an important degree of confidence.

Some months back I highlighted an exceptional Bank of America Merrill Lynch research report, “Pig in the Python – the EM Carry Trade Unwind” (Ajay Singh Kapur, Ritesh Samadhiya and Umesha de Silva). In light of recent market developments, it’s a good time to revisit this thesis and highlight some of their data.

From “Pig in the Python,” February 2014: “Since 3Q2008, the US Federal Reserve QE has unleashed a massive $2 TN debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by $2.7 TN from end-3Q 2008), their monetary bases (by $3.2 TN), their credit and monetary aggregates (M2 up by $14.9 TN), consequently boosting economic growth and asset prices (mainly property and bonds). As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound.”

Most standard analysis on the balance of payments recognizes external debt as issued by residence, not by the nationality of the issuer. Given the proliferation of EM banks and corporates borrowing in offshore bond and inter-bank markets, and using BIS data, we rectify this. It makes a huge difference… For externally-issued bonds, $1042bn has been raised by the nationality of the EM borrower since 2009, $724bn by residence of the borrower – a gap of $318bn, or 44%. This undercount is $165bn in China, $100bn in Brazil, and $62bn in Russia. External bond-issuing EM non-financial corporates are behaving as quasi-financial intermediaries, executors of a vast carry trade.”

I agree completely with the “Pig in the Python” thesis that “Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years.” I closely monitored and studied all three. The first ended in the spectacular collapse of the Asian Tiger Bubble Economies in 1997 and the second with the 2008 global financial crisis. The post-crisis EM Bubble has been fundamental to my “Granddaddy of them all” “global government finance Bubble” thesis. There has been nothing remotely comparable in history – built, by the way, on increasingly suspect premises.

For starters (from “Pig in the Python” data), outstanding external EM bonds doubled since the end of 2008 to $2.051 TN. In addition, outstanding EM banking system international bank borrowings jumped 39% to $2.992 TN. As such, Total EM International (“external”) Borrowings increased almost $1.9 TN (59%) in five years to surpass $5.0 TN. Never have EM governments, corporations and banks piled on so much debt, much of it denominated in dollars or other foreign currencies. And keep in mind that this borrowing and lending binge unfolded in a world anticipating aggressive Federal Reserve stimulus, ongoing dollar devaluation, rising commodity prices and a general global reflationary backdrop. It just didn’t play out as expected, so there will now be a huge price to pay.

Looking first to Asian data, outstanding Asia (ex-Japan) external bonds jumped 112% in five years to $921bn. By country, we see China’s external bonds were up $194bn, or 421%, to $240bn. Including bank international forex borrowings, total China external debt jumped $642bn, or 310%, since the end of 2008 to $849bn. Hong Kong external bonds jumped $49bn, or 71%, to $117bn (total up $223bn, 63%). Elsewhere in Asia, Indonesian external bonds jumped 197% to $70bn (total up $67bn, 101%), Singapore 82% to $93bn, Malaysia 59% to $53bn, South Korea 58% to $179bn and India 73% to $74bn (total up $86bn, 54%).

Russia external bonds jumped 85% in five years to $263bn, with total external debt up $104bn, or 32%, to $424bn. Turkey’s external bond borrowings surged 63% to $83bn, and Poland saw external bonds jump 73% to $70bn. South African external bonds rose 51% to $57bn.

In Latin America, the region’s outstanding external bonds jumped 126% in five years to $562bn, with extraordinary increases in debt almost across the board. Notably, Brazil saw external bonds jump 141% to $296bn. Including international bank borrowings, total external debt increased a remarkable 104% to $487bn. Mexico external bonds jumped 87% to $164bn, with total external debt up 47% to $164bn. Chile external bonds rose 220% to $32bn, Colombia 123% to $40bn (total up 109% to $32bn) and Peru 178% to $30bn. It’s as if the region’s sordid financial past was completely erased from history.

Now examining recent market performance, we see that the Brazilian real was this week hit for 2.1%, the Colombian peso 2.3%, the Mexican peso 1.8%, the Russian Ruble 1.9%, the South African rand 1.3% and the Turkish lira 1.2%. One-month performance is even more telling. The Russian ruble was down 7.6%, the Brazilian real 6.6%, the South African rand 4.9%, the Turkish lira 4.3%, Colombian peso 4.3% and Polish Zloty 3.5%. There seems to be a rather striking correlation between recent currency weakness and the countries that piled on huge amounts of international debt over recent years.

On the bond side, this week saw Brazilian (local) yields surge 26bps to 11.88% (yields traded as high as 12.19% intraday Friday), with yields up almost 100bps from early September trading lows. Mexico’s (local) yields rose 16bps this week to an almost four-month high 6.09%. Turkish (local) yields jumped 38 bps this week to 9.55%, the high since April, with yields also up more than 100 bps from late-July lows.

So what else do we know? We know many commodity prices have been hammered, closing the week near multi-year lows. This week’s small decline boosted the Goldman Sachs’ Commodities Index’s 2014 loss to 7.9%, closing Friday at the lowest level since mid-2012. Many price collapses have been nothing short of brutal. Corn prices have sunk 37% from April highs, with wheat down about 36% and soybeans almost 40%. Cotton prices are down 27% from May highs and sugar 18% from June highs. Crude prices are down 11% from June highs, with natural gas down 17%. Silver was down 19% from June highs, Platinum 14% and gold 9%. Palladium prices were down 13% in four weeks.

What else do we know? We know that China is a financial accident in the making.

September 25 – Bloomberg (Jake Rudnitsky and Anton Doroshev): “China uncovered almost $10 billion in fraudulent trade nationwide as part of an investigation begun in April last year, including many irregularities in the port of Qingdao, the country’s currency regulator said… Companies ‘faked, forged and illegally re-used’ documents for exports and imports, Wu Ruilin, a deputy head of the State Administration of Foreign Exchange’s inspection department, said… The trades have ‘increased pressure from hot money inflows and provided an illegal channel for criminals to move funds,’ Wu said… ‘Some companies used the trade channel to bring in hot money,’ said Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group… SAFE’s investigation ‘will likely further cool down hot money inflows and commodity imports could slow as banks will likely conduct more careful checks on documentation.’”

We can safely assume that the $10bn of uncovered fraud in the commodities financing area is the tip of the iceberg. I feel comfortable with my assumption that the financial world has never seen fraud and malfeasance to the extent that has manifested throughout China over the past decade, particularly during the post-crisis stimulus fiasco.

We also know that weak commodities prices, massive industrial overcapacity and faltering corporate earnings have exacerbated market concerns over Chinese financial and economic stability. At the same time, we know that the powerful “too big to fail” dynamic still permeates Chinese financial markets. We know that bond prices for the big property developers have rallied, despite rapidly deteriorating housing fundamentals. Risk premiums have actually increased for fringe developers and manufactures, on the view that Beijing would prefer to impose a little market discipline. At the same time, the vast majority of corporate and bank bonds benefit from the perception that the central government has absolutely no tolerance for a crisis. Chinese stocks have rallied on expectations of more aggressive stimulus measures. International markets have remained amazingly accommodative to Chinese borrowers.

We know that Chinese total Bank Assets have increased about $17 TN, or 168%, since the end of 2008 to an astounding $27.3 TN (from Bloomberg data). On various levels, the unprecedented inflation of Chinese Credit has been at the nucleus of a historic investment boom and “global reflation trade.” Rapidly expanding Chinese consumption created a huge increase in global commodities demand. At the same time, Chinese companies with virtually unlimited access to cheap finance (bank loans, domestic and international bond issuance) scoured the world to amass vast commodity holdings.

We also know that enormous amounts of “hot money” finance flowed into China through commodity-financing vehicles. With attractive yield differentials and a semi-pegged currency being steadily revalued higher against the dollar, Chinese Credit has offered an extraordinarily favorable risk vs. reward "carry." We know that Chinese authorities began to devalue their currency earlier in the year, before rather abruptly altering course this summer. Perhaps it was mere coincidence that authorities changed their mind on devaluation just as significant problems surfaced within China’s vast “commodities” financing scheme (spurring worries of “hot money” flight).

And I know the bullish view that stress in China will be met with limitless fiscal and monetary stimulus. We know that the Chinese central bank is sitting on Trillions of reserves. But I also believe that the tightly intertwined Chinese and EM booms at this point represent history’s greatest financial and economic Bubble. And there are serious cracks – cracks in China, cracks Russia, cracks in Brazil and throughout EM generally, along with cracks in commodities and, increasingly, currency markets.

King dollar has begun inflicting self-reinforcing stress and instability. Struggling Chinese industry is hurt by a strengthening renminbi (pegged to the King), while the values of Chinese commodity and related assets around the globe suffer at the hands of falling prices. Key Chinese trade partners are seeing their currencies falter and bond yields rise, placing highly levered banks and corporations at mounting risk. At this point, it appears the feared “hot money” exodus away from increasingly fragile EM economies and financial systems has gained important momentum.

I found myself this week thinking back again to the extraordinary year 1998. Keep in mind that just the previous year all bloody hell had broken loose. The collapse in the Thai baht incited a domino breaking of currency pegs that unleashed incredible collapses in Thailand, Indonesia, Malaysia, Philippines and South Korea. The financial, economic and social upheaval wrought from these bursting Bubbles was nothing short of horrific.

By mid-1998, at least in the U.S., all was forgiven and forgotten. I was convinced that Russia was vulnerable to similar Bubble dynamics that had brought down the Asia Tiger “Miracle” economies. Yet U.S. and global markets were incredibly complacent.

There were a couple key market misperceptions at work. One was the view that the West would never allow a Russian collapse. Secondly, after a perilous 1997, global policymakers were on the case and would not allow the reemergence of crisis dynamics. The perception that authorities were there to backstop the risk markets ensured the type of egregious risk-taking and speculative leverage that almost brought the global financial system down with the near-simultaneous collapses of Russia and Long-Term Capital Management. From a record high on July 20, 1998, the S&P500 traded down 22% to the low posted on October 8th. The bank index (BKX) traded down 42% from July 17th highs to October 8th lows.

I raise the subject of 1998 because global market participants these days are remarkably confident that Chinese, U.S., Japanese, European and other global policymakers will not allow a major crisis.

They will all “Do Whatever it Takes.” They will print “money” and they will spend “money” – without constraint and without a conscience. And it is this now deeply embedded complacency that has ensured the type of lending, speculating, leveraging, investing and spending excesses that basically ensure one very problematic global crisis. As always, the bursting of a Bubble is near-impossible to time. At the same time, various cracks are increasingly apparent. That we know.

I also think I know a couple likely transmission mechanisms from increasingly unstable global markets to highflying U.S. securities. Interestingly, there was talk of hedge fund liquidations pressuring stock prices lower during Thursday’s swoon. With performance struggling, much of the hedge fund industry may be at risk of the weak hands dilemma. Faltering markets would force many to move quickly to cut losses.

We know that back during the summer of 2013 “tapper tantrum” global market “risk off” was transmitted to U.S. markets through outflows and resulting liquidations of ETF holdings, notably from corporate and municipal debt funds (often with liquidity-challenged underlying holdings). We know that some incipient instability and liquidity concerns have returned to the U.S. corporate debt marketplace. Headlines this week included from Dow Jones, “Junk-Bond Investors Start to See Warning Signs.” From Bloomberg “BlackRock Junk-Bond ETF Sinks as Debt Yield Spikes to 2014 High” and “BlackRock Says ‘Broken’ Corporate Bond Market Needs Change.” In the markets, junk bond CDS jumped 33 bps this week to a near eight-month high.

Market liquidity is a fascinating – often robust, occasionally fleeting - thing. When markets perceive liquidity abundance, attendant risk-taking and speculative leveraging ensure an easy-flowing liquidity environment (reflexivity!). We know that ultra-loose financial conditions have provided seemingly endless cheap finance for stock buybacks, M&A, LBOs and all kinds of financial engineering. And we know that incredibly loose corporate Credit conditions have fueled exuberance and Bubbling equity prices. It would appear we’re at the tenuous stage of the cycle where borrowers line up as far as the eye can see.

Yet a bout of de-risking/de-leveraging – especially if it incites a big reversal of flows away from fixed-income funds – would appear a reasonable catalyst for general market liquidity issues. A weakened corporate debt market would hurt stock market sentiment – and faltering stock prices would further weigh on vulnerable debt market confidence. And when the legendary founder and head of one of the world’s largest “bond” funds suddenly departs for another shop, well, this creates yet another layer of complexity on an already highly complex backdrop. Looking at markets at home and abroad, it’s now difficult for me to envisage a backdrop were liquidity is not a growing concern. We know without a doubt that this is one heck of a fascinating market environment. 

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