The Triad

Doug Nolan

Saturday, July 4, 2015

So how big of a deal is the Triad of Turmoil unfolding in Greece, China and Puerto Rico? Thus far, general contagion has been minimal. Bullish sentiment remains resilient. In Europe, investors have been encouraged by relative market stability throughout “peripheral” bond markets (Spain, Italy, Portugal, etc.). Emerging markets have so far been largely immune to the dramatic 29% three-week Chinese stock market pummeling. In the U.S., investors have yawned at the prospect of a Puerto Rico debt restructuring. Big yawn (except for the stocks of the Credit insurers!)

I am reminded of how the VIX (equity volatility) index sank heading right into the 2008 financial crisis. After the spring of 2007 subprime bust, it took a full 15 months for market turmoil to erupt into a systemic crisis. By September 2008, a series of policy moves (including rate cuts and the Bear Stearns bailout) had engendered deeply ingrained market complacency. 

In the face of evolving Credit system fragility, market perceptions solidified that government policymakers had the situation well under control. This complacency was integral to crisis vulnerability.

The conventional view holds that the Lehman collapse was the pivotal crisis catalyst. 

Policymakers failed to appreciate the consequences of allowing a major financial institution to fail. Having learned this agonizing lesson, policymakers will ensure that such mistakes – and such crises – are not repeated. Market participants these days do not question global policymakers resolve to eradicate crises. QE infinity.

I have always contended that an ugly collapse of the mortgage finance Bubble was inevitable. 

Trillions of mispriced debt circulated in the markets. This epic mispricing (i.e. widening divergence between inflating securities prices and deteriorating fundamental prospects) would begin surfacing with the unavoidable slowdown in system Credit growth (and attendant decline in house prices/spending). Policy responses intended to “stabilize” the financial system and economy only prolonged “Terminal Phase” excesses, ensuring greater financial and economic dislocation.

From my analytical perspective, Greece, China and Puerto Rico offer important evidence of the ongoing spectacular failure of the current global financial “system”/infrastructure – additional support for the view of the abject failure of inflationism (inflationary policies). From the perspective of Credit excess; market excesses, mispricing and distortions; and economic maladjustment, today’s global government finance Bubble puts the mortgage finance Bubble to shame.

In general, policies to inflate out of debt problems only exacerbate Bubble excesses. Measures that postpone necessary financial and economic adjustment – “kicking the can” – prove only to exacerbate fragilities. Importantly, there is no inflating out of deep structural maladjustment globally, maladjustment currently coming home to roost in Greece, China and Puerto Rico. 

The Triad offer a warning of the stormy seas ahead.

It is now going on seven years of recurring bouts of “post-crisis” market scares, anxious policy responses and inflating securities prices. There’s no mystery surrounding today’s deep complacency. Yet is it crucial to appreciate that the current round of market unrest occurs in the face of zero rates, subsequent to Trillions of QE/“money” printing and generally large government deficit spending. More than $10 TN of global central bank Credit (“money”) has been created out of thin air. Larger quantities of non-productive government debt have been issued. This monetary inflation has spurred securities and asset price inflation that has stimulated spending and economic activity.

When a desperate Mario Draghi resorted to “whatever it takes” central banking back during the 2012 European financial crisis, I wrote that that latest effort to kick the can was “a pretty good wallop.” I still believe it would have been better to cut Greece loose, restructure the euro currency and commence the healing process. European and global policymakers instead pushed forward with unprecedented inflationary measures.

Well, three years of the loosest monetary policy imaginable – including ECB and concerted global QE – certainly did not resolve Greece’s dire predicament. Indeed, even the IMF admits – after repeated bailouts over the past five years – the situation has only worsened. In their Thursday report, the IMF stated that Greece needs another $70 of new aid.

“Black hole” Greece remains the poster child for dysfunctional global finance. The country is hopelessly insolvent. As with any bankrupt entity, salvaging economic value requires debt restructuring/forgiveness. Extend and pretend has run its fateful course. Yet because of European financial integration and monetary union – not to mention the age-old blunder of throwing so much “good money” after bad – there is no turning back from a failed policy course. A tragic predicament has fallen upon the Greeks, a humiliated people fuming at their loss of dignity and sovereignty. Of course they will push back against European integration and Capitalism. This could turn really ugly.

Eminent German economist and a founding father of the ECB (quoted by Bloomberg’s Jeff Black) Otmar Issing: “The illusion was, and is, that, having joined the euro, it is irreversible. Mutual trust is certainly not there any more and it will be very difficult to restore it… If the Greeks can get away with the violation of all promises, commitments, then I think it will have a contagion effect on other countries. Then we’ll be entering into a monetary union very different from what was intended. It will be the end of the zone of fiscal solidity.”

“Yes” or “No” Sunday, there will be no near-term resolution to the “Greek” crisis. On both sides, trust has been irreversibly broken. Starved of finance, the economy is on a death spiral. I don’t see how the Greeks and Germans continue to share a common currency. And, at the end of the day, I don’t see how the Italians and Germans share the euro either.

Despite Draghi’s aggressive backstop, periphery spreads widened meaningfully this week. 

Portuguese spreads to bunds surged 33 bps, Italian bonds to bunds 23 bps and Spanish yields to bunds 23 bps. Major Spain and Italy equity indexes were clobbered for more than 5.0%. European corporate bonds were bolstered by the ECB’s inclusion of corporate bonds on its list of securities eligible for QE purchases.

On the other side of the globe, Chinese policymakers are as well succumbing to desperate measures, as they attempt to control evolving financial and economic crises. The Chinese Bubble has been epic. Its collapse will be spectacular and frightening. Chinese stocks sank almost 30% in just three weeks. In the past, global markets would have been unnerved. Not these days, in this phase of terminally deep-rooted complacency.

Ominously, a series of Chinese policy measures has failed to stabilize stock prices. Confidence has been badly shaken, as one of history’s great manias falters. Yet for global markets, the perception that Chinese policymakers have things under control persists. After all, China has $3.7 Trillion (after declining another $113bn in Q1) of international reserves to use at official discretion. The central government as well has control over a massive state-sponsored financial apparatus, ensuring Credit expansion on demand.

Chinese officials have made a series of fateful errors. “Terminal Phase” Credit Bubble excess has been stoked to unprecedented extremes. While the central government certainly maintains the capacity to print, spend, cajole lending, intervene in markets, manipulate and stimulate – it has nonetheless lost control of the Bubble. There are Trillions – and counting – of bad loans. Malinvestment has been unprecedented – and counting.

Considerable study notwithstanding, the Chinese repeated key mistakes from the Japanese Bubble period. And whether they appreciate it or not, they are also replaying dynamics from the U.S. in the late-1920s. They have resorted to loose finance as a remedy to stabilize a system under the spell of Bubble Dynamics. Policy measures have been used to sustain rapid Credit expansion. They hoped their stimulus measures would drive productive investment, system reflation and reform. Predictably, as was the case preceding the 1929 Crash, liquidity flowed in stunning overabundance to an increasingly out-of-control speculative Bubble throughout the securities markets.

Closer to home, loose finance is also coming home to roost in Puerto Rico. This little island has accumulated enormous amounts of debt. This can has also been kicked down the road about as far as possible, yet another victim of dysfunctional financial markets.

I have posited that the global government finance Bubble has been pierced. In Greece, Chinese stocks and Puerto Rico I find confirmation. It’s worth noting that crude (WTI) was hammered almost 7% this week. Iron ore prices declined seven straight sessions. Brazilian stocks were hit for almost 3%. Commodity currencies were taken out to the woodshed.

The global leveraged speculating community had placed decent bets in Greece, China and Puerto Rico, seeing opportunities at the fringes in a world of zero rates, aggressive QE and determined central bank market backstops. So between the leverage in Greek and Puerto Rican bonds, and the unwind in margin debt in China, there’s now a catalyst for some self-reinforcing globalized de-risking/de-leveraging.

Typically, I would expect waning liquidity and mounting contagion effects to begin their journey from the “periphery” to the “core.” There is, however, nothing normal about this cycle. Never before have global central bankers worked in concert to sustain financial Bubbles. 

I expect air to continue to come out of the global Bubble. I expect de-risking/de-leveraging and contagion to gain momentum, though near-term market prospects are clear as mud.

I find the degree of bullishness in the U.S. almost difficult to fathom. Silicon Valley is back in full-fledged mania mode. Manhattan is not far behind. Throughout the country, there are pockets of boom and plenty of stagnation. Economic imbalances are conspicuous - upshots of now decades of flawed policies and dysfunctional finance.

Importantly, even after six years of recovery I still do not see the backdrop for a sustainable U.S. Credit up cycle. In fact, Credit growth slowed sharply during Q1 (to 2.8% annualized from 4.9%). The Credit slowdown is consistent with weakening corporate profits. Stock buybacks and financial engineering have lost much of their previous punch. For now, with financial conditions so loose, M&A booms, as asset prices generally maintain an inflationary bias. Things look somewhere between ok and good only so long as asset markets remain inflated.

I believe enormous amounts of leverage continue to accumulate throughout the securities markets. Actually, I view borrowings to finance M&A, stock buybacks, and leveraged speculation in bonds and stocks as the prevailing (unrecognized) source of Credit fuel inflating this Bubble. This type of Credit is inherently susceptible to reversals in asset prices. I suspect as well enormous amounts of finance continue to flow into U.S. asset markets from faltering Bubbles (and currencies) around the globe (China, Europe, Latin America and the Middle East). This flow of finance is similarly unstable.

As such, I discern a much greater degree of market vulnerability than the complacent consensus. Greece and China could easily become catalysts for the most serious bout of market risk-off since the financial crisis. There will come a point when markets come face-to-face with the reality that policymakers do not have things under control. 

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