Periphery Fragility List
Friday, February 27, 2015
I have argued that protracted global securities market Bubbles have become increasingly fragile. As such, fledgling signs of risk aversion should be monitored closely. One of these days… Yet latent fragilities are easily masked during periods of risk embracement, speculative leveraging and attendant strong flows. It is the nature of self-reinforcing Bubbles to gain momentum over time. For good reason, market players have been convinced that persistent global fragilities guarantee that policymakers will do “whatever it takes” to sustain abundant market liquidity and risk embracement. The Greek “resolution” further emboldens the view that global markets command politics. The current backdrop of open-ended central bank liquidity ensures that once markets gather a head of steam the sky is the limit.
The powerful Periphery vs. Core Dynamic was prevalent again this week. The S&P 500 and the Dow traded at all-time highs, along with the small-caps and mid-caps. Nasdaq indices are rapidly approaching March 2000 peaks. The Bubbling “Core” is not limited to U.S. securities markets. UK’s FTSE 100 index this week surpassed the previous 1999 record level. Japan’s Nikkei equities index jumped 2.5% to a 15-year high.
“Do whatever it takes” Draghi has by this point incited a full-fledged mania in eurozone securities. The German DAX surged 3.2% this week to an all-time high – increasing 2015 gains to 16.3%. France’s CAC 40 jumped 2.5% to the highest level since May 2008. Stocks in Spain and Italy advanced 2.8% and 2.3%, respectively. Portuguese stocks surged 4.4%, Ireland 3.6%, Netherlands 3.0%, Belgium 2.5% and Denmark 3.5%. Greek stocks recovered 2.8%. It’s become a free-for-all.
Importantly, Bubble On at the Core for now encompasses the debt markets. A couple Bloomberg headlines this week made the point: “Riskiest Debt Has Busiest Start of Year as Investors Demand Higher Yields.” “Dash for Trash Back as Bonds Show Animal Spirits.” Investment-grade CDS this week traded to the lowest level since early-December. Junk CDS dropped to the lows since September. February junk bond returns were the strongest since 2013 (2.3% according to Bloomberg).
And, again, it is not just an American phenomenon. Bloomberg: “Italian Spread Shows Risk Premium Vanishing in Euro Area’s Bonds.” From my perspective, risk perceptions vanished some time ago. This week saw further astonishing yield declines. Italian 10-year yields were down 25 bps, Spain 24 bps and Portugal an incredible 40 bps. At 1.33%, Italian 10-year sovereign yields are a notable manifestation of global securities prices radically divorced from fundamentals. And then there are Japanese yields at 0.32%, French at 0.60%, Spanish at 1.26% and Portuguese at 1.81%. Simply incredible.
The booming Core easily draws attention away from the fragile Periphery. This week saw the Turkish lira slammed for 2.2% to a record low versus the dollar – pushing y-t-d losses to 6.9%. Turkey is vulnerable. The economy remains in a Credit induced boom (Istanbul home prices up 25% y-o-y!). Trade deficits have swelled and inflation has taken hold – a dynamic bolstered by the weak lira. Meanwhile, the central bank is under intense political pressure to cut rates.
February 26 – Reuters (Asli Kandemir and Orhan Coskun): “President Tayyip Erdogan’s broadside against the central bank has raised concern about the future of its governor and of respected Deputy Prime Minister Ali Babacan, an anchor of investor confidence in Turkey for more than a decade. Erdogan on Wednesday slammed the bank's monetary policy as ‘unsuited to the realities of the Turkish economy’ after it failed to meet his repeated demands for sharper rate cuts than those it had made the previous day. He questioned whether the bank was under external influence… ‘If Babacan or Basci are forced out by the Erdogan loyalists I think the market reaction would be severe and brutal,’ said Timothy Ash, head of emerging markets for Standard Bank…, predicting agencies Fitch and Moody's would consider ditching Turkey's investment grade credit rating.”
Turkey’s 10-year lira yields jumped 50 bps this week to 8.23% (high since mid-December).
Turkey has been near the top of my Periphery Fragility List. Similar to many EM economies, Turkey has luxuriated in six years of ultra-loose financial conditions. Debt has grown tremendously, too much of it dollar-denominated. Turkish bank borrowings have been instrumental in a 50% increase in external debt over the past four years.
Positioned up near the top of the Periphery Fragility List, this week provided added confirmation of mounting trouble for Brazil – the world’s seventh-largest economy. On a much greater scale than Turkey, Brazil’s six-year Credit boom has seen a dramatic increase in inflation, trade deficits and external debt. Brazilian corporations and financial institutions have added enormous amounts of dollar-denominated debt, borrowings that have become increasingly problematic with the real’s almost 20% decline against the dollar over the past year.
February 26 – Wall Street Journal (Will Connors and Paulo Trevisani): “A decision by a major credit-rating firm to downgrade to junk status the debt of Petróleo Brasileiro SA is stoking fears that Brazil’s sovereign rating could be next. Moody’s… late Tuesday slashed the debt of the company, known as Petrobras, two notches to Ba2, two steps below investment grade, on continued concern about the fallout from a corruption scandal and the state-run oil giant’s ability to pay down about $135 billion in debt. The downgrade was the third by Moody’s since October. Still, the size and timing of Tuesday’s cut surprised some analysts and sent the country’s leaders into a defensive crouch. Brazil’s largest company, Petrobras plays an outsize role in the nation’s economy, which is flirting with recession. Petrobras’s newfound junk status is ‘an unequivocal blow’ to the administration of President Dilma Rousseff , Eurasia Group analysts wrote… and ‘there is growing concern over a negative spillover effect in macroeconomic management and potentially in Brazil’s sovereign rating.’”
The Brazilian real’s big Friday bounce erased what would have been another week of losses.
Yet despite Friday’s better performance, key Brazilian CDS prices rose again this week.
Petrobras CDS traded above 610 Wednesday, up from 460 bps to end 2014 and the year ago 285 bps. Petrobras CDS averaged 185 bps during the four-years 2010-2013, a period when the company doubled its liabilities.
The expanding Petrobras fraud investigation seems to be moving closer to ensnaring the major state-directed Brazilian banks (up at the top of The Fragility List). Banco do Brasil CDS closed the week up 21 bps to 379 bps, after beginning the year at about 300 bps (2014 avg. 249). BNDES (Brazil’s national development bank) CDS jumped 11 bps to 295 bps, after beginning the year at 230 bps (2014 avg. 181). After trading above 13% during Monday’s session, Brazilian sovereign (real) yields ended the week at 12.31%. Brazilian sovereign CDS traded Friday at the highest level (253bps) since April 2009.
Foremost on the Periphery Fragility List, I have posited that dollar-denominated emerging market (EM) debt is a global Credit boom weak link. And no boom has generated external dollar-denominated debt comparable to China’s. Chinese external debt more than doubled over the past four years to approach $1.0 TN. The scope of “hot money” flowing into China in recent years to play an appreciating currency and enticing yields is unknown but surely massive. And with the historic Chinese Bubble now faltering, there are myriad forces working against the renminbi. In a period of intense currency wars, the Chinese peg to king dollar has become a major issue for China’s exporters. There is also the specter of a reversal of speculative flows, spurred on by deteriorating economic prospects and weakened Credit dynamics. And throw in the likelihood that wealthy Chinese have one eye on the exit, fully intending to exit a crumbling Bubble.
February 27 – Financial Times (Patrick McGee and Michael Hunter): “China’s renminbi has touched a 28-month low against the US dollar, the latest slide reflecting central bank activity and investment flows. On Friday the renminbi fell 0.17%, the largest downward move for the tightly-controlled currency in a month… The PBoC ‘fixes’ the currency’s mid-rate each day, allowing investors to then trade the currency 2% higher or lower. The decline in the renminbi continues pressuring Chinese companies that borrowed in US dollars and expected to benefit over time by paying back such debts via an appreciating domestic currency. The rising dollar has upended that strategy and mainland companies are paying down dollar debt to avoid incurring a loss, in turn further boosting demand for the US currency. Dariusz Kowalczyk, senior strategist at Crédit Agricole, said anecdotal evidence suggests there continues to be ‘very strong demand for dollars in the mainland market’ over recent days and weeks, pushing the currency to the low end of its trading band.’”
February 25 – Wall Street Journal (Andrew Browne): “China’s superrich are nervously watching as the Chinese currency weakens against the dollar. Because of the extreme concentration of money at the apex of Chinese society, national stability rests to an extraordinary extent in the hands of just two million or so families. They are the top 1% of urban households, and already, their confidence in China’s future under President Xi Jinping is shaky. Many are fleeing with their cash--not all of it, but enough to bid up prices of luxury real estate from Mayfair to Manhattan to Mission Bay, a waterfront neighborhood of Auckland, New Zealand. Financial authorities are trying to ensure that the remainder doesn’t disappear across the borders. A potential trigger for a disorderly exodus of capital, one that could threaten the entire fragile financial system, would be a precipitous decline in the value of the Chinese currency… There’s little doubt that the growing anxieties of China’s superrich also weigh on currency decision-making. Mr. Xi has shaken up the status quo with the fiercest campaign against corruption in modern times. That’s creating political tensions at the heart of the Communist Party. The Gilded Age is over: We’re in a new era of austerity. All this uncertainty has unsettled the owners of China’s great fortunes who are now focused on protecting their capital.”
The Chinese Credit Bubble has been historic, dwarfing the fateful Japanese Bubble from the eighties. Arguably, China’ Bubble today even exceeds its mirror image U.S. Bubble. I have also referred to the Chinese renminbi link to the dollar as the King of All Currency Pegs. The bullish consensus scoffs at notions of Chinese fragility. With an international reserve position of $3.8 TN (and shrinking), the belief is that China has more than sufficient “money” to stimulate the economy, recapitalize the banking system and support the renminbi. Yet with anecdotes suggesting mounting outflows and heightened nervousness, a destabilizing dislocation in renminbi trading becomes a real possibility.
How long will the PBOC be willing to use its nation’s reserves to allow speculators, fraudsters and Chinese elite to cash out of China at top dollar? Chinese officials confront great challenges that will require difficult decisions. So far, bullish sentiment remains impervious to the major uncertainties enveloping China’s economy, financial system and policymaking. The perception that Chinese officials have everything well under control could soon be challenged.
Meanwhile, signs of Bubble excess have become increasingly conspicuous in the U.S. – Silicon Valley, Manhattan, upper-end real estate around the country, subprime auto loans, jumbo mortgages, record corporate debt issuance, etc. Record stock and bond prices – record prices for anything that provides a yield. Record hedge fund assets, in the face of ongoing performance issues. Record ETF assets. Resurgent derivative markets. A couple other Bloomberg headlines caught my attention this week: “VIX Poised for Record Drop as Stable Oil Ignites Stocks” and “That Awkward Moment When Stocks Rise While Profits Fall.”
Friday from the New York Fed’s William Dudley, as he rationalized his cautious view toward commencing rate normalization: “If the transmission of monetary policy to the real economy is more variable and uncertain, as I believe it is, then monetary policy cannot be put on autopilot guided only by a fixed policy rule.”
Market-based Credit and discretionary monetary policy mix dangerously. Over this long cycle, market-based finance (as opposed to traditional bank lending) has come to dominate system Credit – along with market and economic performance. Policymakers have responded to resulting serial booms and busts with ever more obtrusive activism – including interest rate, liquidity, communication and monetization policies. Policy measures have reached previously unimaginable extremes - pro-speculation, pro-leverage, pro-Credit cycle and pro-maladjustment. It’s not that “the transmission of monetary policy to the real economy is more variable and uncertain.” The critical issue is instead that market-based Credit is inherently highly unstable. That the Fed and global central bankers have responded to this instability with progressively more experimental intervention and manipulation only ensures a momentous calamity. A rules-based policy approach incorporating disincentives for leveraged speculation and financial excess would over time work to restrain speculative cycles and resulting Credit booms and busts.