Unsound Finance

Doug Nolan


With Emanuel Macron and Marine Le Pen moving on to next Sunday’s (May 7) runoff French presidential election, first-round results proved right in line with the polls. One would typically expect “as expected” results to elicit minimal market reaction. But we live in the age of derivatives, hedging and speculation. Markets – especially European – were buoyed, once again, this week by the reversal of hedges and short positions.

In Europe, the French CAC 40 index surged 4.1%. Italian stocks (MIB) jumped 4.4%, with Spanish equities (IBEX) up 3.3%. Germany’s DAX rose 3.2%. European bank stocks (STOXX 600) advanced 4.8%, with Italian banks up 7.6%. French sovereign CDS collapsed 22 to a five-month low 33 bps. Italian CDS declined 18 to a one-month low 168 bps. Here at home, the S&P500 gained 1.5%, trading Wednesday within a whisker of all-time highs. The week saw record highs for the Nasdaq composite, the Nasdaq 100, the Morgan Stanley High Tech index, the small cap Russell 2000 and the large-cap Russell 3000. The VIX collapsed to a near three-year low. With the yen sinking 2.2%, Japan’s Nikkei 225 jumped 3.1%.

I start with a simple definition: “A Bubble is a self-reinforcing but inevitably unsustainable inflation.” Bubble terminology is used in various contexts and means different things to different folks. To most analysts, talk of a “Bubble” connotes something that is about to burst. I take a different approach, working to identify initial factors and characteristics that are favorable for Bubble formation - and then monitoring and analyzing its development and ramifications. I covered the mortgage finance Bubble from every angle on a weekly basis for over six year, after initially warning of its development in early-2002. It’s now been over eight years analyzing the global government finance Bubble – the “Granddaddy of All Bubbles.”

There’s an interesting dynamic that I’ve lived through a few times now. These Bubbles inflate for years – much longer than would seem reasonably possible. And the longer they survive the more dismissive conventional analysts (and the business media) become to Bubble analysis. At the same time, over time as a Bubble gains momentum there becomes overwhelming evidence and analytical support for the Bubble view. My feelings these days recall 1999 and 2007 experiences: I have great conviction in the analysis, while conventional analysis turns increasingly bullish and dismissive of what have become increasingly conspicuous (and precarious) market distortions and excesses.

Unsound Finance gets to the heart of the issue. Looking back historically on early economic thought, the recurring issue that perplexed deep thinkers was how an economy that appeared robust could suddenly run so amuck. Economic busts would invariably focus analytical attention to “money,” debt and banking.

While discerned by few, Credit turns progressively less stable over the course of an economic upcycle. Especially during the late-cycle boom phase, there would be a huge divergence between general confidence and the underlying deterioration in the quality of rapidly expanding Credit. At some point the boom begins to falter, resulting in a tightening of bank lending. Latent fragilities were soon exposed, traditionally leading to fear, panic, bank runs and such.

My fundamental premise is that we’re in the late-stage of a historic global experiment in unfettered finance. From a historical and analytical perspective, Credit is inherently unstable. Today’s Credit is acutely unstable on a global basis as never before. The bullish counter argument holds that central bankers will ensure financial and economic stability. And with central banks willing to employ negative rates and limitless massive monetization, confidence in the bullish view is higher than ever. As such, today’s divergence between confidence and the underlying soundness of finance has never been as wide – ever. The bullish view holds that central banks are the solution. They’re undoubtedly the problem.

Especially with the view that the Trump Administration will aggressively pursue tax cuts and deregulation, optimism is running high that pent up real economy potential is about to be unleashed. Despite a weak Q1, some forecasts call for 3% GDP growth in Q2. Monitoring increasingly overheated real estate markets and stubbornly low bond yields, I would not be surprised by a decent economic uptick. Yet there are myriad fault lines that could bring this party to an abrupt end.

The Dilemma of Unsound Finance prevails just about everywhere – most notably China, Japan, Europe, EM, Canada, the U.S, Australia, etc. There are numerous potential flashpoints – where Unsound Finance has turned acutely vulnerable. While central bankers talk employment and CPI, I believe fear of global financial instability has been the true impetus behind “whatever it takes.”

April 28 – Bloomberg: “New shadow banking measures may be unveiled and China’s central bank will probably continue to raise money-market rates after President Xi Jinping met with the country’s top officials over risks to the financial system this week, according to Nomura Holdings Inc. Xi gathered with members of the Communist Party Politburo and the chiefs of China’s four financial regulators April 25, ordering them to prevent systemic risks. Concern over a regulatory crackdown has whipsawed Chinese assets over the past two weeks. ‘We expect stricter financial regulatory measures to be rolled out, which we believe should be seen as targeted tightening, particularly in the shadow banking system, to de-leverage financial speculation and reduce capital outflows,’ Nomura analysts Zhao Yang and Wendy Chen wrote…”

Chinese officials are grappling with an epic Credit Bubble and the resulting greatest expansion of finance in history. This week saw further pressure on Chinese stocks and bonds. Last year’s measures to stabilize the country’s collapsing stock market, slow enormous capital flight and juice the faltering economy pushed China’s housing Bubble to ridiculous extremes. Chinese officials will now attempt to impose more strenuous measures to rein in financial excess without slowing the economy or bursting Bubbles. Global markets for the most part remain sanguine – not that they expect policymaker success but rather because they are confident that Beijing will not risk bursting Bubbles. Markets believe they have time.

April 23 – Wall Street Journal (Carolyn Cui, Ian Talley and Ben Eisen): “Emerging-market companies are binging on U.S. dollar debt and that could become a source of trouble in some parts of the world if growth slows, interest rates rise or the dollar resumes its ascent. Governments and companies in the developing world sold $179 billion in dollar-denominated debt in the first quarter, the most dollar debt ever raised in the first quarter and more than double the amount raised during the same period last year, according to… Dealogic. In all, U.S. dollar debt stood at $3.6 trillion in emerging markets through the third quarter of 2016, an all-time high... Including local currency debt, and emerging-market companies have increased their borrowing by a staggering $17 trillion since 2008, according to the Institute of International Finance.”

I have argued for a while now that EM Finance is Unsound. Over the past year, Chinese reflation coupled with global QE spurred a major short squeeze followed by on onslaught of (performance-chasing) EM inflows. As always, EM economies show alluring potential – so long as international inflows boost asset prices, lending and investment. To have EM binging again on dollar-denominated debt should be a troubling development for anyone paying attention.

It’s worth noting that Germany’s DAX index has gained 8.3% y-t-d, increasing one-year gains to 20.5%. Booming European equities are not limited to Germany. France’s CAC 40 has risen 8.3% so far this year (18.9% 1-yr), Spanish stocks 14.6% (15.6%) and Italian 7.2% (8.6%). Euro zone consumer price inflation has rebounded to about 2% annualized, while corporate risk premiums have declined to near three-year lows. Meanwhile, March broad money supply (M3) jumped to 5.3% y-o-y, the strongest monetary expansion since 2009. Yet the ECB Thursday held firm with about $65bn monthly QE and short-rates at zero or lower. European bank stocks jumped 4.8% this week, increasing 2017 gains to 8.0%.

European periphery debt spreads narrowed this week. French to German 10-year yields collapsed 16 bps. Spanish bond spreads narrowed 11 bps, and Portuguese spread narrowed 26 bps. Notably, Italian spreads narrowed only 4 bps, remaining close to multi-year wides. European debt markets have evolved into huge Bubbles. How much speculative finance has shorted German bunds to fund higher-yielding bonds from Italy, Spain and Portugal? How large is the “carry trade” – short zero-yielding Japanese instruments to leverage in higher-yielding European periphery corporate and sovereign debt?

The yen dropped 2.2% this week. The yen continues to provide an intriguing “Risk On vs. Risk Off” indicator. Not only has the Bank of Japan’s (BOJ) open-ended QQE created massive amounts of liquidity to bolster Japanese and global securities markets. BOJ policy has incentivized speculators to short yen instruments for cheap finance to acquire higher-yielding bonds around the globe – likely including European, Chinese and EM instruments.

My opening paragraph noted we live in the age of derivatives. To what extent these “carry trades,” and leveraged speculation more generally, are accomplished through derivative transactions is an important issue. Not only would such imbedded leverage create latent fragilities, it also creates transparency issues. There is ample evidence that huge amounts of finance have exited Europe, Japan, China and EM over recent years to participate in king dollar. Yet I believe such flows are not adequately reflected in Fed data. Could the explanation be that the proliferation of derivative strategies has distorted traditional flow data?

I go down this path because I was asked this week by an astute observer of the world how the bursting of the global Bubble might play out. I contemplate various scenarios and tend to look at this most extraordinary backdrop and think “expect the unexpected.” Nevertheless, I’ll throw out a possible scenario.

After years of astounding expansion, China’s leading banks occupy the top four spots in the list of the world’s largest banks (by assets). Chinese finance has become hopelessly Unsound, with a Credit Bubble fueling epic malinvestment, asset Bubbles, fraud and deep financial and economic structural impairment.

A bursting Bubble would rather quickly see a crisis of confidence throughout China’s opaque financial system, certainly including “shadow banking” and “repo” finance more generally. I would expect collapsing real estate prices and economic dislocation to spur capital flight. There would be enormous pressure to unwind “carry trades,” greatly pressuring the Chinese currency. A collapsing currency would further impair Chinese borrowers, especially those (banks) exposed to dollar-denominated debt. Chinese officials would see no alternative than to impose strict capital control. The Chinese crisis would spur global “Risk Off” – de-risking, de-leveraging dynamics that I would expect to be particularly problematic for Europe and EM.

A “Risk Off” spike in European periphery yields and a widening of spreads would be a major issue for the thinly capitalized European banks. And with the European banking organizations having become such major players in derivatives, securities finance and EM, a crisis of confidence in European finance would quickly become a systemic issue globally.

This scenario could be viewed as positive for king dollar – and perhaps, to some, even favorable for U.S. securities markets and the American economy more generally. The perception is that U.S. finance is sound and the economy stable. I have serious doubts, believing deeply unsound finance has inflated a Bubble U.S. economy with latent fragilities.

I would expect global “Risk Off” to illuminate enormous amounts of speculative leverage throughout U.S. securities markets, most notably in corporate Credit. I would not be surprised if global markets freeze up – a “flash crash” that would be more than a flash in the pan. Illiquid global markets would be perilous to derivative trades that rely on dynamic trading strategies to hedge portfolio exposures. This would curtail the cheap market “insurance” that has been instrumental in bolstering risk-taking throughout the securities markets. A resulting sharp tightening of financial conditions would expose the degree to which uneconomic enterprises have flourished in the almost nine years of free “money.” Corporate America would have huge exposure to a faltering global economy, with the major financial institutions all caught up in the global crisis of confidence in derivatives and counter-party issues. And there’s the issue of Trillions that have flowed into perceived highly liquid ETFs. Now that’s some Unsound Finance.

But it’s not necessary to ponder the future to see how Unsound Finance comes back to haunt the system. This week the Trump Administration released a broad outline of its plan for tax cuts and reform. Eight years of zero rates, ultra-low Treasury yields, record stock prices and booming asset markets have fed the dangerous delusion that deficits don’t matter. The central bank blank checkbook has salivating politicians believing they enjoy a similar luxury. And while one article raised the “bond vigilante” issue, for the most part markets remain happy to oblige.

It’s not difficult to present analysis showing 3% (why not 4 or 5%?) growth creating ample revenues to offset major tax cuts. But after eight years of egregious monetary stimulus, one can easily envisage a scenario where growth surprises to the downside. And it’s not a totally crazy notion to ponder growth faltering concurrent with a rise in Treasury borrowing costs. Such a scenario would likely see a bursting of assets Bubbles and a resulting collapse in revenues throughout the government sector. There’s as well all the entitlements and unfunded pension plans. When things turn sour globally, we’ll be spending a lot more on national defense. 
 
Unsound Finance always comes back to bite. The worrying part is that the world has never experienced anything comparable to the past 30 years.

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