EM, Hedge Funds and Corporate Debt
by Doug Noland
February 7, 2014
A particularly unsettled week for U.S. and global markets. Global markets have turned highly unsettled. The S&P500 opened the week at about 1,783, sank to an intraday low of 1,738 on Wednesday before rallying to close the week at 1,797. The Goldman Sachs Most Short index sank 4.0% Monday, was little changed Tuesday, fell 1.6% Wednesday, jumped 1.7% Thursday and then surged 3.3% Friday. High-profile hedge fund short positions have turned wildly volatile. Green Mountain Coffee surged 33.0% this week.
Currency markets have turned treacherous. Those short the commodity currencies abruptly found themselves on the wrong side of a squeeze. The New Zealand dollar gained 2.6% this week, with the Australian dollar up 2.3%. Some EM currencies enjoyed strong weekly gains. The Polish zloty increased 3.0%, the Turkish lira 1.7%, the Hungarian forint 2.6%, the Argentine peso 2.3%, the Brazilian real 1.4%, the Russian ruble 1.1% and the Czech koruna 1.1%.
Overall, global markets these days convulse between “risk off” and “risk on” – in bloody trench warfare between market bulls and bears. Greed and fear vacillate between the two camps. The yen weakened only modestly this week, and EM equities were generally unimpressive. EM bonds for the most part held their own. Mexico’s sovereign debt rating was upgraded, which lent some support to the sector.
Bill Gross’ February piece, “Most ‘Medieval’”, provides an insightful read. He focused on a focal point of my analytical framework: “Asset prices are dependent on credit expansion or in some cases credit contraction, and as credit goes, so go the markets, one might legitimately say, and I do most emphatically say that!” “Credit creation or credit destruction is really the fundamental force that changes P/Es, risk premiums, natural interest rates, etc.” As part of his concluding comments, Gross added: “The days of getting rich quickly are over, and the days of getting rich slowly may be as well.”
It’s my view that we have reached – or, perhaps, are approaching – a historic inflection point in global Credit. Credit has tightened meaningfully in segments of China’s finance, as well as throughout EM more broadly. Yet rapid Chinese Credit growth has thus far been sustained, though the expansion is notably unbalanced and vulnerable. This has negative implications for global economic performance, as well as global securities and asset prices. But the timing of a significant Chinese Credit slowdown remains unclear.
Most analysts are quick to dismiss U.S. susceptibility to EM woes. Such complacency, while handsomely rewarded over recent years, could this time prove a major mistake. For one, I would view current EM instabilities as a major crack in what evolved over years into historic global financial and economic Bubbles. EM is global “subprime.”
In the post-2008 crisis landscape, EM economies did indeed assume the role of “global locomotive.” Less appreciated, China and EM Credit systems grew to become responsible for much of global Credit growth. Many of the major EM Credit systems experienced in the neighborhood of 20% compounded annual Credit expansion over the past five years. Emblematic, total annual Chinese Credit growth exploded and approached $3.0 TN in 2013, the greatest expansion ever experienced by an individual economy.
While astonishing amounts of new Credit inflated and distorted real economies, there is the less transparent – yet absolutely critical - issue of financial leverage. With the Fed, Japanese and other “developed” central banks engaged in unprecedented “printing” and devaluation measures, EM markets were the focal point of the expansive “hot money” financed “global reflation trade.” Unknown amounts of speculative leverage were employed in myriad “carry trades” and other speculations to capitalize on borrowing cheap in (depreciating) currencies to speculate in higher returning EM securities. There was as well unprecedented investment into EM economies and markets, pushing overall financial flows to the several Trillions.
The key point is that one should not today in anyway downplay the ramifications of bursting EM Bubbles and associated de-leveraging. There will be major unfolding consequences on global Credit growth, pricing dynamics, financial flows, speculative finance, Credit availability and economic performance. This process has commenced, although the pace of initial developments has been generally held in check by the ongoing rapid expansion of Chinese Credit coupled with Fed and BOJ quantitative easing measures.
“Is Tapering Tightening?” has become topical. From the perspective of my analytical framework, of course it’s tightening. No question about it; silly to think otherwise. The risk of leveraging in the marginal global securities markets and economies (EM) has increased; market behavior has begun to adjust; and financial conditions have started to tighten at the margin.
Since August of 2008, the Fed’s balance sheet has inflated from about $900bn to $4.1 TN. In just the past 14 months, Fed holdings have jumped $1.25 TN. It’s simply implausible that the Fed winding down such aggressive monetary inflation won’t have major impacts on U.S. and global market liquidity dynamics. After all, the “periphery” is already being pressured by the altered liquidity backdrop. While the timing and dynamics involved remain uncertain, I fully expect risk aversion and de-leveraging “contagion” to over time gravitate to the “core.”
The global “leveraged speculating community” could provide the most direct transmission mechanism from EM tumult to U.S. securities markets. As the leveraged players get caught in faltering global markets, their reduced risk appetite will impinge liquidity in U.S. and other markets. But with still significant Fed and BOJ QE, there remains the prevailing 2013 “trouble at the periphery stokes flows to the core” dynamic shaping market trading.
There are as well powerful speculative Bubble Dynamics that tend to disregard fundamental deterioration for a time. Short squeezes and the unwind of hedges also tend to incite “bear market rallies” readily interpreted as bullish market signals. So there are today powerful market crosscurrents. Over time, however, I would expect these forces to wane as the more typical “periphery to core” dynamic gathers momentum.
There is a potentially momentous development now taking shape out on the horizon. For more than 20 years, the leveraged players have operated with confidence that huge balance sheets were readily available to backstop market liquidity. GSE holdings expanded rapidly to initially accommodate speculative deleveraging back during the 1994 bursting of the bond/MBS/derivatives Bubble. The GSEs came to the markets’ defense again in 1998, 2000, 2001, and 2002. The Fed’s balance sheet then took over as marketplace backstop in 2008, 2009, 2011 and 2013.
If the Fed now holds true to its stated intention of winding down its balance sheet expansion, the marketplace in coming months will grapple with the possibility that financial markets for the first time in two decades must operate without a reliable liquidity backstop. Such an altered backdrop would imply a reduced appetite for risk and leverage, with rising risk premiums, lower asset prices, slower Credit growth and heightened economic risk.
Corporate debt could prove particularly susceptible. Leveraged holdings would be vulnerable to increasing Credit risk as well as widening spreads versus perceived safe haven Treasury and other government debt.
The hedge fund industry has enjoyed an incredible 20-year run. GSE and Federal Reserve market liquidity backstops were integral to “The days of getting rich quickly.” Billionaire “traders” sprang up like never before. The inflating “leveraged speculating community” came to play an integral role in ensuring seemingly limitless marketplace liquidity, in the process bolstering Credit Availability more generally. Ultra-loose financial market conditions were instrumental in boosting overall system Credit growth. Federal Reserve rate and balance sheet policies in concert with the leveraged players amounted to history’s most powerful monetary policy transfer mechanism.
Over recent years, the greatest market excesses unfolded in equities and corporate debt. They’ve fed on each other in an interrelated market mispricing/speculative Bubble. During 2013, in particular, QE-induced market excess gravitated to U.S. stocks and higher-yielding corporate Credits (i.e. bonds and leveraged loans). I have posited that 2013 QE operations were especially dangerous. Risk premiums generally collapsed to 2007 levels, as the gulf between inflated securities prices and deteriorating fundamental prospects widened fatefully. This chasm becomes problematic when Credit growth slows.
Over five Trillion of corporate debt has been issued since the 2008 crisis. Fed and central bank operations pushed down global yields and crushed risk premiums. I would argue that Trillions of corporate debt these days trade with varying degrees of inflated market valuation. Importantly, central bank liquidity was much more successful in terms of inflating securities prices than in inflating a general increase in global price levels. Now, with EM financial and economic Bubbles faltering, global disinflationary risks are mounting. This creates major risks to global profits and growth dynamics, risks that remain largely latent until Credit growth wanes.
The corporate debt market would now appear unusually vulnerable. I suspect large amounts of speculative leverage have accumulated over recent years throughout the corporate debt marketplace. If true, this only adds to potential debt market fragility.
February 5 – Bloomberg (Jody Shenn): “Freddie Mac may boost how much it pays bond investors to share the risk of homeowner defaults as the government-controlled mortgage-finance company plans its biggest offering of such debt, according to a person with knowledge of the deal. A $360 million portion of the transaction expected to be graded Baa1 by Moody’s may yield about 2 percentage points more than a borrowing benchmark, said the person… That compares with a spread of 1.45 percentage points on $245 million of similar securities that were part of a $630 million deal in November.”
Thus far, Credit spreads have widened only modestly from depressed late-2013 levels. Hedge funds are clearly big operators in GSE securities markets. They are expected to be big buyers in the upcoming Puerto Rico debt offering (see Fixed Income Bubble Watch). Hedge funds are commonly mentioned as major players in ABS, MBS, CMBS, CMOs, CLOs, leveraged loans, etc. Hedge funds and mutual funds have become aggressive operators in the booming market in “alternative” Credit funds that garner significant returns from “structured products” (including myriad trading and derivative strategies that involve variations of writing Credit insurance). Any forced retreat by the hedge funds would have wide market implications.
I can easily envisage a scenario of rapidly slowing global Credit growth. It’s difficult to see a case for accelerating U.S. Credit growth. Seeing eye to eye with Bill Gross, as goes Credit growth so go the markets. Granted, Fed “money” printing has since the 2008 crisis largely abrogated this fundamental relationship. The upshot has been rapid expansion of mispriced corporate debt and equities securities, along with untold speculative leveraging.
There are fragilities associated with major Bubbles inflating in the face of a deteriorating – increasingly disinflationary - global backdrop. This could prove a volatile mix in a world of faltering EM, de-risking/de-leveraging, waning market liquidity and mounting global downside risks.
Instead, traders have been rattled by the indications that global economic demand is weaker than thought. Inflation now stands at about a paltry 1 per cent in the US and Europe, and there has been a string of disappointing data on US economic activity.
In previous years, this combination of events might already have had the Fed signalling a willingness to use monetary policy to stimulate the economy. But so far in 2014 the silence has been deafening.
The Fed plans to taper its asset purchases only very gradually. Yields on long-term bonds may be affected by as little as 1 per cent. If the US economy proved unable to withstand even this featherweight touch, market optimists would lose their nerve.
The stock market has risen a very long way – shares are currently selling for fairly high multiples of company profits, by historical standards. A bear market could ensue.
Yet these fears seem overblown.
The January weakness in US employment data, and in the ISM manufacturing survey, shocked the markets, but other statistics have painted a brighter picture. The slowdown may turn out to be a blip, caused by a one-off pause while companies run down excess inventories, or the effects of extraordinary weather. If this view proves correct – and I think it will – the recovery will strengthen later in the year.
This sanguine assessment does not, however, apply to the emerging markets, where a storm is brewing.
Since the Fed began its quantitative easing, investors who could no longer earn their keep buying US government debt have ventured further afield. This has resulted in a huge influx of capital into countries such as Turkey and Brazil. But the ensuing credit bubbles were not sufficiently controlled by monetary authorities, and now that policy is being tightened in the west, they threaten to burst.
Central banks in emerging markets have been pleading for help. But these calls have been politely dismissed by both the Fed and ECB, whose job is to look after their economy at home.
Now China has decided to reverse its own huge monetary stimulus. Both of the world’s major economic powers are therefore pulling in the wrong direction for most emerging nations. They have not been helped by the collapse in the yen, which in effect cuts the price of Japanese products, or the euro area’s growing trade surplus. They have little option but to let their currencies slide, with rising interest rates and slowing growth rates looking inevitable.
In many emerging markets, monetary conditions are tightening sharply – just what these economies do not need. In the wake of a boom fuelled by cheap credit, the spectre of widespread insolvency looms.
All eyes are now on China. Few, if any, major economies have emerged intact from a credit bubble as intensive as the one in China’s shadow banking sector today. But no country has had $3.5tn of liquid reserves to fall back on either.
China’s decision in December to bail out an investment product distributed by its largest bank shows that for now the authorities would rather absorb the losses of the private sector than sow panic among investors. But before this is over there will be failures in financial institutions, just as there were in 1998 when Premier Zhu Rongji allowed the collapse of Gitic to serve as a lesson to others.
Investors are asking whether the markets can survive tapering by the Fed. The harder question is whether they can survive a monetary tightening by the People’s Bank of China. Many are betting on a bumpy landing, but one that does not involve a serious recession. They may be right, but China is where the unknown unknowns in the global economy currently lurk.
The writer is chairman of Fulcrum Asset Management and writes a regular blog on FT.com
Copyright The Financial Times Limited 2014
Reviving China’s Rebalancing
FEB 7, 2014
BEIJING – China is at a crossroads. After experiencing three decades of unprecedentedly rapid GDP growth, the country weathered the global economic crisis exceptionally well. But it sustains considerable economic imbalances, which are undermining its ability to achieve high-income status. The question is whether China’s leaders – preoccupied with challenges like financial instability stemming from risky shadow-banking activities and a heavy burden of local-government debt – have the policy space to put the economy on a sounder footing.
In the aftermath of the global economic crisis, China appeared to be on track to complete such a rebalancing. Its current-account surplus fell from more than 10% of GDP in 2007 to 2.6% in 2012, and it ran a large capital-account deficit for the first time since 1998. Moreover, China added only $98.7 billion to its foreign-exchange reserves in 2012, compared to an average annual increase of more than $435 billion from 2007 to 2011. That meant diminishing upward pressure on the renminbi’s exchange rate.
But, over the last year, China’s imbalances returned with a vengeance. Its 2013 trade surplus likely exceeded $250 billion; its capital-account surplus exceeded $200 billion in the first three quarters of the year; and its foreign-exchange reserves soared by $509.7 billion. Meanwhile, the lower current-account surplus (as a share of GDP) could be a result of its increased investment-income deficit. And, while recovery in the advanced economies boosted exports, persistent overcapacity, combined with slower household-consumption growth than in 2012, caused investment growth, though still rapid, to decline to its lowest rate in the past 11 years.
In principle, a country can run a current-account deficit or surplus continuously for decades. But China’s chronic surpluses are problematic. Given that China remains among the world’s poorest countries, with per capita income amounting to less than $7,000, its position as the world’s largest exporter of capital signifies a gross misallocation of resources.
In fact, after running twin current- and capital-account surpluses persistently for two decades, China’s foreign-exchange reserves are poised to break the $4 trillion threshold, with the marginal cost of every dollar accrued vastly surpassing its potential benefits. In this context, the continued accumulation of foreign-exchange reserves is clearly counterproductive.
Of course, rebalancing China’s economy will take time, and it will entail some risks and sacrifices. But China’s leaders must recognize that the country faces massive welfare losses, and thus should be willing to accept slower growth in the short term in exchange for a more stable long-term growth path. In fact, with a well-designed policy package, the duration and impact of the growth slowdown could be minimized.
A critical first step is for the People’s Bank of China to stop intervening in the foreign-exchange market, which would halt the growth of the country’s foreign-exchange reserves. In other words, China should adopt a floating exchange-rate regime as soon as possible.
Although this transition would have a negative impact on China’s economic growth, it would not be nearly as dire as many seem to believe. For starters, while it would likely cause the renminbi to strengthen, the consensus in China is that the current exchange rate is not far from the equilibrium level, meaning that the appreciation would likely be moderate.
Likewise, although renminbi appreciation would diminish export growth, the slowdown would probably not be dramatic, given that China’s export sector is dominated by the processing trade (specifically, the assembly of intermediate inputs imported from countries like Japan and South Korea). And the accompanying increase in imports is unlikely to damage China’s economic growth significantly; it is more likely to complement, rather than substitute for, domestic demand. In short, China can afford the costs of rebalancing.
Given that the liquidity flowing into China over the last several years was increasingly short-term capital aimed at exchange-rate and interest-rate arbitrage (so-called “hot money”), there may be a surge in capital outflows when appreciation expectations have disappeared. To prevent large-scale capital flight from threatening China’s financial stability, cross-border flows must be managed carefully.
A flexible exchange rate dictated by market forces would eliminate the opportunities for currency speculators to make one-way bets on renminbi appreciation, thereby diminishing the stock of hot money that currently accounts for the bulk of China’s capital-account surplus. Even if China’s current account remained in surplus for some time, the shift from twin surpluses to a more normal external position would boost the efficiency of resource allocation considerably.
For too long, China has delayed the necessary adjustment of its balance-of-payments structure. It is time to make a change, even if it requires bracing for some risks.
Yu Yongding was President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. He has also served as a member of the Monetary Policy Committee of the People's Bank of China, and as a member of the Advisory Committee of National Planning of the Commission of National Development and Reform of the PRC.
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