Off to an Interesting Start

Doug Nolan

 
 
It’s been only two weeks, but 2017 is off to an interesting start. It’s certainly quite a contrast to last year’s “worst market start in decades.” Fear and risk aversion held sway a year ago. The great Chinese Bubble was at risk of imploding, and such a cataclysmic could have pulled global markets and the economy right along with it. Moreover, central banks were running low of ammunition.

New year 2017 begins with an astonishing degree of optimism and risk embracement. The S&P 500 has advanced 1.6% in the first two weeks of the year, although those gains are overshadowed by the higher-risk NDX (up 4.0%), Morgan Stanley High Tech index (up 4.4%), biotechs (up 5.7%) and broker/dealers (up 4.0%). From the FT: “‘Fang’ stocks add $83bn to their market value over 7 days.” Facebook sports a 2017 gain of 11.6%, Apple 2.8%, Netflix 8.0% and Google 4.7%.

Enthusiasm goes beyond just a bout of central bank-induced market euphoria. Confidence at this point has made strong inroads throughout the real economy – consumers, small business and company management. It’s been awhile since I’ve heard such positive sentiments conveyed during big bank quarterly conference calls. Inflationism has worked its magic, for now. Folks have really bought in.

Bubble analysis for a while now has highlighted the divergence between inflating securities prices and deflating economic prospects. A case could be made these days that this gap is in the process of narrowing. I would counter that economic prospects have brightened only due to prolonged extraordinary global monetary inflation and resulting asset inflation.

It’s an especially challenging period to put into perspective. From the Bubble (global government finance – Granddaddy of All Bubbles) perspective, all the pieces are fitting into place. Things certainly do turn crazy near the end – and 2016 was consistent with this thesis. Record stock prices were spurred by central bank responses to early-2016 market fragilities. Brexit and the Trump phenomenon arose from deep public dissatisfaction. Today’s confidence may have notable breadth, yet I question its depth.

Global markets are unstable, economies are unstable, societies are unstable, democracies are unstable and the geopolitical backdrop is unstable. Yet for going on nine years (incredible or what?) instabilities have been harnessed by the powerful triad of low borrowing costs, central bank electronic printing presses and literally Trillions of “money” with apparently no other purpose than to inflate securities and asset prices. Moreover, monetary disorder on such an unprecedented global scale has been around for so long that it passes as normal. And with so much uncertainty in the world the only thing certain is that global central banks will soldier on with QE and near zero rates. That’s been enough for the markets, trumping myriad uncertainties and fragilities.

January 11 – CNBC (Patti Domm): “The corporate debt market is kicking off the new year with a bang. Companies have issued a whopping $65 billion in high-grade debt so far since Jan. 2, the most ever for this time of year. The beginning of the year is normally an active period, but the amount issued so far is already more than half the $125.6 billion issued during the full month of January 2016 — and that was also a record… As of last Friday, the first week of the year saw $52 billion in investment-grade issuance, a record first week. ‘It was led by financials,’ said Informa analyst Chris Reich. ‘Financials accounted for 85% of the total of weekly volume.’”
It’s not that markets are oblivious to risk. After only two trading weeks, the Turkish lira is already down 5.4%, the Mexican peso 3.5% and the British pound 1.3%. Turkey and Mexico both confront difficult geopolitical challenges, and both are on the list of EM economies with large quantities of dollar-denominated debt. For the most part, however, EM has maintained the momentum it enjoyed later in 2016. In general, and despite king dollar, EM is viewed as benefitting from heightened global inflationary impulses.

It’s only been a couple weeks, but things have already turned intriguing in China. The bursting of the Chinese Bubble was held at bay by record 2016 Credit expansion (December growth in total social financing a stronger-than-expected $236bn). Such reckless late-cycle (“Terminal Phase”) excess comes with dire consequences – a perilous real estate Bubble, “shadow banking” pandemonium, deeper economic maladjustment and acute currency vulnerability. Chinese officials have some very tough decisions to make.

January 8 – Bloomberg: “As China’s top leaders tallied the cost of another year of debt-fueled growth at a December meeting, the imperative for stability as a leadership reshuffle loomed later this year prompted an unexpected conclusion. The price was too high, the leaders agreed, according to a person familiar with the situation. The buildup of debt used to fuel smokestack industries from steel to cement had helped win the short-term battle for growth, but the triumph itself undermined the foundations of long-term expansion, the leaders decided… What followed was an order to central and local government officials that if they are forced to choose this year, stability must be the priority while everything else, including the growth target and economic reform, is secondary, said another four people familiar with the situation.”

If reports are accurate, Chinese officials have decided to (at least somewhat) bite the bullet and (again) attempt to get their financial Bubble under control. This would typically have global markets (stocks, Credit, commodities and currencies) on edge. Yet we’ve heard it all before – repeatedly. A broken record: “talk tough and lose nerve.” And they could very well be seriously determined this round to stick with tough measures. Perhaps they finally accept that timid not only doesn’t work – it makes things worse. But after last year’s panicky heavy-handed government interventions, markets are understandably skeptical. Does the Chinese government have the stomach for the type of dislocation that reining in excess at this stage of the Bubble would entail?

They’re going to have to do something. Curiously, Chinese officials ushered in the new year with a decent currency short squeeze (echoes of Thailand, June, 1997?). After ending the year at 6.945 and trading as high as 6.964 on January 3, the renminbi (vs. dollar) rallied 1.3% to 6.869 on January 4th. The renminbi closed this week at 6.90, up 0.6% y-t-d.

January 8 – Bloomberg: “China’s foreign currency holdings fell for a sixth month in December, bringing last year’s drop to $320 billion as the yuan posted its steepest annual slide in more than two decades. Reserves decreased $41.1 billion to a fresh five-year low of $3.01 trillion… The central bank’s effort to stabilize the yuan was the main reason for the drop last year, the State Administration of Foreign Exchange said… The world’s largest stockpile has fallen for 10 straight quarters from a record $4 trillion in June 2014…”
January 12 – Bloomberg: “China has asked some banks to stop processing cross-border yuan payments until they balance inflows and outflows, people familiar with the matter said, as authorities step up a campaign to curb a record amount of money leaving the nation in the local currency. The directions, given verbally on Wednesday, require the lenders to show at the end of every month that the amount of outgoing yuan matches the sum that comes in… The People’s Bank of China guidance will apply to transactions involving both companies and individuals, the people said.”
Chinese officials are tiptoeing guardedly toward capital controls. Chinese international reserves will fall below $3.0 TN this month, and it’s just very difficult to see what will cool the desire to get “money” out of the country. Money and Credit continue their historic inflation, leading to only deeper maladjustment while creating added liquidity for outflows. And while the Chinese economic expansion for now continues to feed off record Credit growth and asset inflation, their entire system is acutely vulnerable to any slowing of lending and speculative leveraging.

Chinese officials appear to understand the gravity of tolerating ongoing financial excess, though I’m not convinced they appreciate the degree of lurking fragility. They must look with dismay at the monthly drawdown in their international reserve position. Beijing would prefer a weaker currency to stimulate their vast export engine, but they must increasingly fear an avalanche of destabilizing outflows and speculation against the renminbi. There’s increasing chatter of a “free-floating yuan.” A surprise major devaluation – along with capital controls – may look increasingly tempting compared to the ineffective gradual devaluation approach. But Chinese leadership has the new Trump Administration – that is already aghast with the level of the renminbi - to contend with.

January 8 – Bloomberg (Narae Kim): “Donald Trump wasn't the first U.S. presidential candidate since the century began to blast China for manipulating its currency for trade advantage, but it's increasingly likely he'll be the first to follow through on the threat… That's the perspective of economists at Bank of America Merrill Lynch, led by Helen Qiao, chief Greater China economist at the bank in Hong Kong… ‘It has been increasingly difficult to dismiss concerns that President-elect Trump will adopt protectionist trade policies that may hurt trading partners as well as the U.S. itself,’ Qiao and her colleagues wrote… While designating China an official manipulator of its exchange rate for the first time since 1994 poses some technical hurdles… it may be a more appealing option than some of the alternatives. Trump once broached the idea of a 45% tariff on imports from the largest Asian economy, something the president has the power to do…”
January 12 – Bloomberg (David Tweed): “China’s state media rebuffed a suggestion by President-elect Donald Trump’s nominee for secretary of state that Beijing must be denied access to reclaimed reefs in the disputed waters of the South China Sea. ‘Unless Washington plans to wage a large-scale war in the South China Sea, any other approaches to prevent China access to the islands will be foolish,’ the Communist Party-run Global Times newspaper wrote… The English-language China Daily took a similar line: ‘It is certainly no small matter for a man intended to be the U.S. diplomat in chief to display such undisguised animosity toward China.’"
The media may be fixated on some Trump and Putin bromance, but the key relationship for 2017 is that of President Trump and President Xi Jinping. China is uncharacteristically vulnerable. Trump is emboldened. China will surely be even more belligerent than usual. Does Trump ever back down? Early indications have the Trump Administration taking a hard line on both Chinese trade and the South China Sea islands. I fully expect China to push back hard. Taiwan, the South China Sea and trade are hot buttons, surely to stoke rising nationalism. And while the Chinese media somewhat erupted this week, Chinese officials have thus far reacted cautiously.

Considering the major issues that China must confront, perhaps top leadership will see some potential advantage from confronting the Trump Administration. For a while now they’ve been laying the groundwork to point fingers at Japan, the U.S. and the “West”. Blame the foreigners! A trade war initiated by Donald Trump, or perhaps even a skirmish in the South China Sea, might actually play well in China. The rising nationalistic tide in China coupled with a seemingly small U.S. constituency advocating the importance of the China/America relationship leaves me concerned that this is a flash-point in the making.

But similar to rising rates and waning QE, a potential confrontation with China (trade and/or otherwise) is something ebullient markets are happy to disregard for now. With highly speculative markets currently over-liquefied, the focus is on opportunities and all things Trump. Still, this week saw an initial crack in market confidence in the Trump agenda (or at least his unconventional approach). Traders will certainly tune in whenever our new President nears a microphone. Will President Trump continue to tweet? How often and how inflammatory? No President has ever enjoyed such a bully pulpit. Powerful.

Markets prefer stability, predictability and the status quo. They, at least traditionally, loath uncertainty. The markets were fearful of Trump for a reason. Change, perhaps even radical change. Drain the swap. Make America Great Again – My Way. Incredible unpredictability. So many issues that come with such a personality.

Dow futures were down about 1,000 points election night. Trump said kind things about Hillary and emphasized a major infrastructure spending plan. Markets took off, and the bullish narrative quickly turned to de-regulation, tax cuts and a comprehensive pro-growth agenda. You either turned optimistic or were run over. The view took hold that securities markets would hold the same sway (or more!) under Trump as they did under Obama, Bush and Clinton.

For a while now I’ve believed that to make America great again would for starters require a rebuilding of our nation’s depleted manufacturing base. Decades of trading new financial claims for imports has been a recipe for economic maladjustment, serial boom and bust cycles and societal restiveness. Over time it passed for sustainable only through monetary inflation the likes the world had never experienced.

I have expected the impetus for a major economic restructuring would likely be financial and economic crisis. I hope the Trump plan succeeds, rather than my expectations coming to fruition. But markets are delusional if they believe there will be a free lunch. Trump’s focus will be on the real economy, rather than the financial economy that has risen to incredible prominence throughout this prolonged period of deindustrialization and inflationism. To make America Great Again will require the U.S. retaking a bigger slice of the global pie. Not coincidently, countries around the globe are as well keenly focused on the size of their respective slices. And decades of inflationism and maladjustment ensure that the pie is not expanding as it had previously.

Trump is surely tickled that markets have rallied on his election win. But I’ll assume he senses that it’s unsustainable. Team Trump at this point seems to have a real determination to do what they said they’d do. Candidate Trump often referred to the “Bubble”. He is clearly no fan of Yellen or Federal Reserve monetary policies more generally. They’re a big part of the problem he’s endeavoring to fix.

And today none of this matters a lick to the markets. The marketplace assumes they’ll hold Trump hostage just like they did those before him. If he wants infrastructure, he needs the bull market. If he wants growth and jobs… The threat of financial crisis has for some time now hamstrung Presidents, central bankers and policymakers more generally on a global basis. But my hunch is that Trump and his inner-circle are determined to move forward whether the markets like it or now.

It could be a short honeymoon. Things will get interesting when the markets decide to protest or throw a tantrum. I wouldn’t be surprised if Team Trump believes a crisis-type backdrop might even provide an environment more conducive to radical change, but let’s not get ahead of ourselves. I’m ready for a fascinating year.       

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