Belly of the Beast

Doug Nolan

We’re at an important juncture for the global Bubble. There are growing divergences and anomalies. Market signals are increasingly conflicting and confounding: European equities in melt-up and U.S. markets at record highs, while China falters. Bond yields rising and commodities sinking. Talk of derivative issues and leveraged player struggles. Often discordant economic data providing fodder for bulls and bears alike.

Let’s begin at home. While recovering somewhat from March’s huge disappointment, at 16.81 million annualized (SAAR) units, April vehicles sales were significantly below estimates (17.1 million). This supports the view of tightened lending standards in auto finance. Also supporting the bear case, the ISM Manufacturing Index dropped to a weaker-than-expected 54.8, down from March’s 57.2 and February’s 57.7. March Personal Spending was reported flat versus estimates of up 0.2%. Non-farm Productivity was reported at a stinkball down 0.6% (est. down 0.1%).

At the same time, those anticipating stronger Q2 growth were this week heartened by a slew of data points (market now sees 100% probability of June rate increase). Most notably, the ISM Non-Manufacturing Index bounced back strongly from March weakness. At 57.5, the index almost recovered back to February’s 56.7, the high going back to October 2015. The ISM Manufacturing Price Paid Index remained elevated at 68.5, and New Orders were a strong 57.5. Durable Goods Orders were stronger-than-expected. And an indicator I’m monitoring closely these days, mortgage purchase applications, increased last week to approach the strongest level since 2009. And, of course, at 194,000, non-farm payrolls bounced back briskly from March’s (revised) 79,000. As a reminder of how services these days so dominate U.S. economic structure, April saw only 6,000 manufacturing jobs added.

Examining the data, it’s not difficult to explain this week’s upward trajectory in equities and downward pressure on bond prices. Ten-year Treasury yields increased six bps this week to 2.35%. Meanwhile, the S&P500 and Nasdaq Composite ended the week at all-time highs. Spanish stocks jumped 3.9%, and Italian equities surged 4.2%.

More intriguing, yields and equities rose as commodities came under heavy selling pressure. Crude sank $3.11 this week, trading below $45 for the first time since November. WTI ended the week at $46.22, after trading as low as $43.76 overnight. There was more to the sell-off than OPEC and American shale production. The week saw nickel drop 2.1%, tin 1.3% and lead 1.1%. Shanghai Aluminum fell 1.9%. The Chinese iron ore collapse continued, while Shanghai steel sank 6%. Copper lost 3.0%, trading to a 2017 low. Silver sank 5.7% and Platinum fell 3.5%.

It’s not all that astounding that markets disregard troubling issues unfolding in Chinese finance. The bullish narrative is focused on Trump administration tax cuts, deregulation and infrastructure spending. Throw in a European recovery and hope for EM. Talk is clearly not of a historic global Bubble vulnerable to a massive and fragile Credit Bubble in China. That is an analytical perspective markets avoid like the plague.

Market apathy notwithstanding, there are important developments to monitor. Let’s start with China’s economy, where it appears the past year’s Credit-induced thrust in activity has begun to wane. China’s Caixin Manufacturing PMI dropped to a weaker-than-expected (and barely expanding) 50.3 in April, the low since last September’s 50.1. Perhaps more ominously, the month-on-month decline in the Caixin Services index was even steeper. It dropped to 51.5, the weakest reading in almost a year.

The Shanghai Composite dropped 1.6% this week, trading to the low since mid-January. China’s growth-oriented ChiNext index fell 1.8% (down 7.3% y-t-d) to near multi-year lows. Notably, Hong Kong’s Hang Seng Financial index sank 2.7%.

May 4 – Bloomberg: “Signs are emerging that the Chinese government’s renewed drive to curb financial leverage is starting to bite. The number of wealth-management products issued by Chinese banks slumped 39% in April from the previous month, while trust firms distributed 35% fewer products, according to data compilers PY Standard and Use Trust. Sales of negotiable certificates of deposit, a popular instrument of interbank lending known as NCDs, tumbled 38% from a record, figures compiled by Bloomberg show. The system-wide contraction is a result of a flurry of government measures over the past month that included ordering banks to bolster risk controls, stepping up scrutiny of shadow financing and cracking down on malfeasance among senior bureaucrats. While the moves have rocked China’s financial markets, the government is sending a clear signal of its determination to curb the estimated $28 trillion debt pile that poses a risk to economic stability.”
May 3 – Financial Times (Gabriel Wildau in Shanghai and Peter Wells): “A key Chinese money-market rate matched a two-year high on Wednesday after the central bank drained cash from the banking system, part of an ongoing effort to tame financial risks by squeezing liquidity. Authorities are facing the tricky task of increasing regulation of risky financial instruments without spooking investors or raising borrowing costs in the real economy. Short-term lending rates have climbed since President Xi Jinping told a politburo meeting last week that financial security was ‘strategically important’ for economic and social development. Investors interpreted his remarks as a sign that monetary policy will tighten. The benchmark seven-day repo rate hit a two-year high of 3.18%...”
May 1 – Reuters (Adam Jourdan): “China's level of leverage is rising at an ‘alarming pace’, particularly in the finance sector, a senior central bank official said in a commentary, amid growing concern by the country's senior leaders over financial security. The official Xinhua news agency… cited Xu Zhong, head of the People's Bank of China's (PBOC) research bureau, as saying the country needed to deleverage at a ‘proper pace’ to reduce financial sector debt and avoid systemic financial risk. ‘China's overall leverage level is reasonable but is rising at an alarming pace, especially in the financial sector,’ Xu said.”

Chinese policymakers appear determined to harness the expansion of its booming financial sector. The apparent plan is to apply constraints in a manner so to not unduly risk economic weakening or financial instability. Over recent years, officials have attempted various measures to rein in overheated real estate markets as well as speculative commodities, equities and bond markets. A couple times policymakers even came close to bursting Bubbles, before abruptly reversing course. In the end, the overall timid approach ensured the ongoing ballooning of China’s now mammoth financial sector and Credit Bubble more generally.

The problem confronting Beijing – and global policymakers more generally – relates to the old “Austrian” analysis that Bubbles are sustained only by ever-increasing quantities of Credit creation. Inflate a Credit Bubble – with resulting elevated price structures throughout the real economy, asset markets and the financial sphere – and these various inflated price levels become progressively vulnerable to any meaningful and sustained slowdown in Credit creation.

There remains this dangerous misperception that economies can simply grow/inflate their way out of debt problems. This is at odds with reality. Especially late in the cycle, liquidity is funneled into inflating asset markets rather than to the real economy (suffering from overcapacity and waning profit opportunities). It becomes easier to make returns in finance than in goods and services. Meanwhile, policy measures to sustain the unstable boom further incentivize leveraging and speculating.

To this point, Chinese officials have “succeeded” in ensuring ever-increasing amounts of Credit. The upshot has been only more outrageous real estate (largely apartment) Bubbles, rapid Credit deterioration and deeper structural maladjustment.

Beijing understands that it has a problem and appears to have a new approach: They’re going to the Belly of the Credit Beast – “shadow banking” and, more specifically, “wealth management products” (WMP). They’re cracking down on “insurance” companies.

I often refer to a Credit Bubble’s “Terminal Phase.” Systemic risk rises exponentially at the end of the cycle – rapidly escalating quantities of increasingly risky Credit. And contemporary finance is replete with products and vehicles to transform high-risk Credit into perceived safe and liquid (money-like) financial instruments. We saw this dynamic in the U.S. at the late-stage of the mortgage finance Bubble, with “AAA” ABS/MBS, derivatives and the like. In China, frightening amounts of high-risk Credit have been intermediated through a labyrinth of WMP and shadow banking.

This week saw some justified fear that Chinese measures may cripple shadow bank risk intermediation, slow system Credit growth, spur speculative deleveraging and spark illiquidity. The notoriously leveraged and speculative Chinese commodities sector proved the weak link. And a bout of intense deleveraging in this space raised fears that an unwind of leverage and resulting Credit instability could turn its sights on the mighty and mighty vulnerable apartment Bubble. How vulnerable is Chinese mortgage Credit these days to a tightening of Credit Availability and a self-reinforcing decline in home prices?

Of course, everyone knows that Beijing will not tolerate things getting out of hand. Much like the end to the ECB’s QE program, speculative markets are content to downplay China risks perceived to be at least a number of months into the distant future.

Chinese stocks retreated in Shanghai and Hong Kong as concerns mounted over Beijing’s efforts to reduce financial system leverage - along with worries that a selloff in commodities and spillover into equities could negatively impact economic confidence.

Friday from Bloomberg: “The Hang Seng China Enterprises Index led declines in Asia, sliding 1.6% at the close local time. Back on the mainland, the Shanghai Composite Index slipped 0.8%, taking its drop in the week to 1.6% and briefly breaking a key support level of 3,100 points. The gauge has fallen for four straight weeks… Northeast Securities Co. and Sinolink Securities Co. fell at least 5.8%. Brokers in Shenzhen received notice from regulators that they must stop combining funds raised from various wealth-management products into a single pool and investing them as one portfolio… Investors worry the regulation on asset-management pooling in Shenzhen might expand to brokers nationwide, said Capital Securities analyst Liao Chenkai.”

Beijing’s intentions notwithstanding, there’s high risk that things do spiral out of control. Shadow Banking has been the marginal source of risk intermediation during the recent Credit onslaught. This Credit avenue appears to be tightening rapidly, which creates a serious dilemma for various groups of risky borrowers. Moreover, heightened stress in the “repo”/money markets impinges the small and medium sized banks that have aggressively borrowed short-term finance for high-risk lending and financial speculation (at home and abroad). Meanwhile, Chinese authorities have begun to target the insurance industry, most certainly a bastion of all things ugly late-stage Credit Bubble.

This amounts to an unfolding serious tightening of Credit and financial conditions. Sure, Beijing can, once again, lean on the enormous state banks to pick up the slack. Here’s where things turn fascinating – if not comforting. China’s big banks stepping up at this point to support the scope of system Credit growth necessary to hold bust at bay (say, to the tune of $3.5 TN annually) places these mammoth financial institutions in direct harm’s way. Waning confidence in China’s big banks would have major global market ramifications.

Returning to the “important juncture for the global Bubble:” The bulls are feeling “break out,” with the S&P500 playing catch-up to Nasdaq (Comp up 13.3% y-t-d), technology (MHS up 18.8%) and biotech (up 18.7%). Are things at the brink of turning even crazier, or does a bout of risk aversion catch everyone unprepared?

I’ll be on the lookout next week for indications of waning “Risk On.” Perhaps China worries spur some contagion effects in Asia. Weakness in Asian financials would offer a clue. As the biggest beneficiary of Chinese reflation over recent months, EM would seem susceptible to contagion.

Further energy and commodity price weakness would reawaken concerns for commodity-related Credit. The yen declined 1.1% during this week’s generally “Risk On” backdrop. 

Fledgling “Risk Off” would be expected to provide a yen boost, likely at the expense of Japanese equities. With Emanuel Macron poised to win big in Sunday’s French election, I expect market attention to pivot back to Asia. That said, an abrupt reversal to “Risk Off” would catch global markets by surprise, certainly including the speculative Bubbles that have inflated throughout European securities markets. 

0 comentarios:

Publicar un comentario