Officially on “Periphery” Contagion Watch

Doug Nolan


This week saw all-time highs in the S&P500, the Nasdaq Composite, the Nasdaq100, and the Philadelphia Semiconductor Index. Microsoft market capitalization reached $1 TN for the first time. First quarter GDP was reported at a stronger-than-expected 3.2% pace.

So why would the market this week increase the probability of a rate cut by the December 11th FOMC meeting to 66.6% from last week’s 44.6%? What’s behind the 10 bps drop in two-year yields to 2.28%? And the eight bps decline in five-year Treasury yields to a one-month low 2.29% (10-yr yields down 6bps to 2.50%)? In Europe, German bund yields declined five bps back into negative territory (-0.02%). Spain’s 10-year yields declined five bps to 1.02% (low since 2016), and Portugal’s yields fell four bps to an all-time low 1.13%. French yields down to 0.35%. Why would markets be pricing in another round of ECB QE?

In the currencies, king dollar gained 0.6%, trading above 98 for the first time in almost two-years. The Japanese yen outperformed even the dollar, adding 0.3%.

April 22 – Financial Times (Hudson Lockett and Yizhen Jia): “Chinese stocks fell on Monday amid concerns that Beijing may renew a campaign against shadow banking that contributed to a heavy sell-off across the market last year. Analysts pinned much of the blame… on a statement issued late on Friday following a politburo meeting chaired by President Xi Jinping in Beijing. They were particularly alarmed by a term that surfaced in state media reports of the meeting of top Communist party leaders: ‘deleveraging’. That word set off alarm bells among investors still hurting from Beijing’s campaign against leverage in the country’s financial system last year. Those reforms focused largely on so-called shadow banking, which before the clampdown saw lenders channel huge sums of money to fund managers who then invested it in stocks.”

And Tuesday from Bloomberg Intelligence (Qian Wan and Chang Shu): “The Central Financial and Economics Affairs Commission (CFEAC) – the Communist Party’s top policy body headed by President XI Jinping – is focused on ongoing structural reform and deleveraging, citing proactive fiscal policy and prudent monetary policy as key tools. Officials set a pragmatic growth target of 6.0%-6.5% for 2019. The government plan also indicated credit growth in line with that of nominal GDP in 2019, echoing the People’s Bank of China’s statement of ‘maintaining macro leverage.’”

The Shanghai Composite was hammered 5.6% this week. After last year’s scare, markets have good reason to fret the prospect of a return of Chinese “deleveraging” and the PBOC restricting the “floodgates.” I would add that if Beijing actually plans to manage Credit growth to be in line with nominal GDP, the entire world has a big problem. Over the past year, China’s nominal GDP increased about 7.5%. Meanwhile, Chinese Aggregate Financing expanded at a double-digit annualized rate during Q1. This would imply a meaningful deceleration of Credit growth through the remainder of the year. Don’t expect that to go smoothly.

April 23 – Bloomberg: “The debt pain engulfing some of China’s big conglomerates has intensified in recent days with more bond defaults, asset freezes and payment uncertainties. China Minsheng Investment Group Corp. said last week cross defaults had been triggered on dollar bonds worth $800 million. Lenders to HNA Group Co.’s CWT International Ltd. seized control of assets in Singapore, China and the U.S. after the unit failed to repay a loan… Citic Guoan Group Co., backed by a state-owned company, isn’t certain whether it can pay a bond coupon due on April 27. The increased repayment stress sweeping some of China’s biggest corporations is a sign that the liquidity crunch -- induced by a two-year long deleveraging campaign -- is far from over despite an improving economy. Bonds from at least 44 Chinese companies totaling $43.7 billion faced repayment pressure as of last week, a 25% jump from the tally at the end of March… ‘The debt crisis at conglomerates can have more of a contagion impact on the corporate bond market compared with an average corporate default because those issuers typically have more creditors and large amount of outstanding debt,’ said Li Kai, a multi-strategy investment director at Genial Flow Asset Management Co.”

Chinese officials surely appreciate the risks associated with rampant debt growth. They have carefully studied the Japanese experience, and they have surely studied the history of financial crises. Beijing has had ample time to research Bubbles, yet they still have limited actual experience with Credit booms and busts. China has no experience with mortgage finance and housing Bubbles. They have never before managed an economy with a massively leveraged corporate sector – with much of the borrowings via marketable debt issuance. They have no experience with a multi-trillion (US$) money-market complex – and minimal with derivatives. They have zero experience with a banking system that has inflated to about $40 TN – financing a wildly imbalanced and structurally impaired economy (not to mention fraud and malfeasance of epic proportions).

I’m not confident Beijing comprehends how deranged Credit can become late in the cycle. A system dominated by asset Bubbles and malinvestment over time evolves into a crazed Credit glutton. Keeping the historic Chinese apartment Bubble levitated will require enormous ongoing cheap Credit. Keeping the incredibly bloated Chinese corporate sector afloat will require only more ongoing cheap Credit. Ditto for the frighteningly levered local government sector. And the acute and unrelenting pressure on the banking system to support myriad Bubbles with generous lending terms will require massive unending banking balance sheet expansion. Worse yet, at this late “terminal phase” of the cycle it becomes impossible to control the flow of finance. It will instinctively flood into speculation and non-productive purposes. Has China studied the late-twenties U.S. experience?

If Beijing is serious about managing risk, they have no option other than to move to rein in Credit growth. Last year’s market instability, economic weakness and difficult trade negotiations forced officials to back off restraint and instead push forward with stimulus measures. This had characteristics of a short-term gambit.

Chinese officials will not be slamming on the brakes. But if they’re serious about trying to manage Credit and myriad risks, it would be reasonable to expect the imposition of restraint upon the completion of U.S. trade negotiations. Indeed, there are indications that this transition has already commenced.

If this analysis has merit, the global market backdrop is near an important inflection point – potentially one of momentous consequence. Chinese Credit growth is about to slow, with negative ramifications for global market liquidity and economic expansion. I would further argue that the synchronized global “Everything Rally” has ensured latent fragilities even beyond those that erupted last year. The conventional view that China is now full speed ahead, with stimulus resolving myriad issues, could prove one of financial history’s great episodes of wishful thinking.

It’s worth recalling the 2018 market backdrop. After beginning the year with a moonshot (emerging markets trading to record highs in late-January), EM turned abruptly lower and trended down throughout much of the year. The Shanghai Composite traded to a high of 3,587 on January 29th, only to reverse sharply for a two-week 14% drop. By July, the Shanghai Composite had dropped 25% from January highs – and was down 31% at October lows (2,449).

And for much of the year, de-risking/deleveraging at the “Periphery” supported speculative flows to “Core” U.S. securities markets. U.S. equities bounced back from February’s “short vol” blowup and went on a speculative run throughout the summer (in the face of mounting global instability). After trading below 90 for much of April, the Dollar Index had risen to 95 by late-May and 97 in mid-August.

While the Fed raised rates 25 bps in June and again in September, financial conditions remained exceptionally loose. Ten-year Treasury yields traded down to 2.80% (little changed from early-February), held down by global fragilities and the surging dollar. High-yield debt posted positive returns through September. Ignoring rapidly escalating risks, the S&P500 traded right at all-time highs to begin the fourth quarter (10/3). The dam soon broke, with crisis Dynamics coming to fully envelop the “Core.”

After a several month respite, I’m back on “Crisis Dynamics” watch, carefully monitoring for indications of nascent risk aversion and waning liquidity at the “Periphery.” Last year’s market and economic developments provided important confirmation of the Global Bubble Thesis – including the fundamental proposition that major Bubbles function quite poorly in reverse. Years of zero rates and QE had inflated myriad Bubbles and a highly unbalanced global economy surreptitiously addicted to aggressive monetary stimulus. As tepid as it was, policy “normalization” had engendered latent fragilities – though this predicament remained hidden so long as “risk on” held sway over the markets.

A speculative marketplace gleaned its own 2018-experience thesis confirmation: central bankers won’t tolerate bursting Bubbles. The dovish U-turn sparked a major short squeeze, unwind of bearish hedges and, more generally, a highly speculative market rally. And in global markets dominated by a pool of Trillions of trend-following and performance-chasing finance, rallies tend to take on lives of their own. With 2019’s surging markets and speculative leverage creating self-reinforcing liquidity, last year’s waning liquidity – and December’s illiquidity scare – are long forgotten.

But I’ll offer a warning: Liquidity Risk Lies in Wait. When risk embracement runs its course and risk aversion begins to reappear, it won’t be long before anxious sellers outnumber buyers. When “risk off” De-Risking/Deleveraging Dynamics again attain momentum, there will be a scarcity of players ready to accommodate the unwind of speculator leverage. And when a meaningful portion of the marketplace decides to hedge market risk, there will be a paucity of traders willing to take the other side of such trades.

And there’s an additional important facet to the analysis: Come the next serious “risk off” market dislocation, a further dovish U-turn will not suffice. That trump card was played – surely earlier than central bankers had envisaged. Spoon-fed markets will demand rate cuts. And when rate cuts prove insufficient, markets will impatiently clamor for more QE. Powell’s abrupt intermeeting termination of policy “normalization” carried quite a punch. Markets were caught off guard – with huge amounts of market hedges in place. Now, with markets already anticipating a rate cut this year, one wouldn’t expect the actual Fed announcement (in the midst of market instability) to elicit a big market reaction.

The Fed is clearly preparing for the next episode where it will be called upon to backstop faltering markets. Our central bankers will undoubtedly point to disinflation risk and consumer prices drifting below the Fed’s 2% target. I’ll expect markets to play along. But without the shock effect of spurring a big market reversal – with attendant risk embracement and speculative leveraging – it’s likely that a 25 bps rate cut will have only ephemeral impact on marketplace liquidity. Markets will quickly demand more QE – and Chairman Powell is right back in the hot seat.

I’m getting ahead of myself here. But the reemployment of Fed QE should be expected to have unintended consequences depending on relative U.S. versus global growth dynamics and market performance. If, as was the case last year, king dollar and speculative flows to the “Core” temporarily boost U.S. output, it would be an “interesting” backdrop for restarting QE.

But let’s get back to the present. Happenings at the “Periphery of the Periphery” seem to support the Global Liquidity Inflection Point Hypothesis. The Turkish lira fell 2.1% this week, with 12-month losses up to 31.5%. Turkey’s 10-year lira bond yields surged 30 bps to 17.75%, the high since October. Turkey sovereign CDS jumped 24 bps this week to 461 bps, the high going back to September 13th. Turkey’s 10-year dollar bond yields surged a notable 51 bps this week to 8.08% - the high also since mid-September instability. Turkey is sliding into serious crisis.

April 26 – Financial Times (Adam Samson and Caroline Grady): “Turkey’s central bank has confirmed it began engaging in billions of dollars in short-term borrowing last month, bulking out its reserves during a time when the lira was wobbling amid contentious local elections and concerns were growing over its financial defences. The central bank said… its borrowing from swaps with a maturity of up to one month was $9.6bn at the end of March. Friday’s report precisely matches figures first revealed last week by the Financial Times, which intensified concerns among investors about what they say is a highly unusual practice for a country’s reserve position. Turkey’s use of these transactions, in which it borrows dollars from local banks, ramped up dramatically following a sharp fall in the country’s foreign currency reserve position during the week of March 22.”

Also this week at the “Periphery of the Periphery,” Argentina’s peso sank 8.8% to an all-time low versus the dollar, increasing y-t-d losses to 17.9%. Argentine 10-year dollar bond yields jumped 26 bps Friday and 73 bps for the week to a multi-year high 11.53%. As the market increasingly fears default, short-term Argentine dollar bond yields surged to 20%. Argentina’s sovereign CDS surged a notable 263 bps this week to 1234, a three-year high. A whiff of contagion was seen in the 10 bps rise in El Salvador and Costa Rica CDS. The MSCI Emerging Markets Equities Index declined 1.3% this week.

For the week, the Colombian peso dropped 2.4%, the South African rand 2.3%, the South Korean won 2.1%, the Chilean peso 1.8%, the Hungarian forint 1.5%, the Iceland krona 1.3%, and the Polish Zloty 1.2%. The Russian ruble, Indonesian rupiah and Czech Koruna all declined about 1% against the dollar. Problem child Lebanon saw 10-year domestic yields surge 31 bps to 9.84%.

Hong Kong’s Hang Seng Financial Index dropped 2.4% this week. China’s CSI 300 Financials Index sank 5.0%. China Construction Bank dropped 4.7%, and Industrial and Commercial Bank of China fell 4.5%. Japan’s TOPIX Bank index declined 1.3%. European bank stocks (STOXX 600) dropped 2.3%, led by a 3.2% fall in Italian banks. Deutsche Bank sank 6.7% on the breakdown of merger talks with Commerzbank. Deutsche CDS jumped 12 bps this week to near two-month highs.

Reminiscent of about this time last year, U.S. bank stocks were content this week to ignore weak financial stocks elsewhere. US banks (BKX) jumped 1.6% this week, trading near the high since early December. Powered by a notable $5.8bn of fund inflows, investment-grade corporate bonds (LQD) closed the week at highs going back to February 2018. High-yield bonds similarly added to recent gains, also ending Friday at 14-month highs.

With animal spirits running high and financial conditions remaining loose, the “Core” remained comfortably numb. But we’re now Officially on “Periphery” Contagion Watch. No reason at this point to expect much risk aversion in exuberant “Core” U.S. securities markets. Indeed, the drop in Treasury yields has been feeding through into corporate Credit, in the process loosening financial conditions. But I would expect risk aversion to begin gathering some momentum globally, with De-Risking/Deleveraging Dynamics ensuring faltering liquidity and contagion for the more vulnerable currencies and markets.

April 26 – Bloomberg (Sarah Ponczek): “As equities surge to all-time highs, volatility has all but vanished. Hedge funds are betting the calm will last, shorting the Cboe Volatility Index, or VIX, at rates not seen in at least 15 years. Large speculators, mostly hedge funds, were net short about 178,000 VIX futures contracts on April 23, the largest such position on record, weekly CFTC data that dates back to 2004 show. Commonly known as the stock market fear gauge, aggressive bets against the VIX are, depending on your worldview, evidence of either confidence or complacency.”

When “risk off” does make its return to the “Core,” don’t be surprised by market fireworks. “Short Vol” Blowup 2.0 – compliments of the dovish U-turn? It’s always fascinating to observe how speculative cycles work. Writing/selling put options has been free “money” since Powell’s January 4rd about face. Crowded Trade/“tinder” And if we’re now at an inflection point for global market liquidity, those gleefully “selling flood insurance during the drought” should be mindful of a decided shift in global weather patterns.


Can cryptocurrencies recover?

Flaws in Bitcoin make a lasting revival unlikely

The latest boom and bust invite comparisons with past financial manias




“BE MORE BRENDA,” said the ads for CoinCorner, a cryptocurrency exchange. They appeared on London’s Underground last summer, featuring a cheery pensioner who had, apparently, bought Bitcoins in just ten minutes. It was bad advice. Six months earlier a single Bitcoin cost just under $20,000. By the time the ads appeared, its value had fallen to $7,000. These days, it is just $4,025 (see chart).

While the price was soaring, big financial institutions such as Barclays and Goldman Sachs flirted with opening cryptocurrency-trading desks. Brokerages sent excited emails to their clients. The Chicago Board Options Exchange (CBOE), one of the world’s leading derivatives exchanges, launched a Bitcoin futures contract. Hundreds of copycat cryptocurrencies also soared, some far outperforming Bitcoin itself. Ripple rose by 36,000% during 2017.

The bust has been correspondingly brutal. Those who bought near the top were left with one of the world’s worst-performing assets. Cryptocurrency startups fired employees; banks shelved their products. On March 14th the CBOE said it would soon stop offering Bitcoin futures. Bitmain, a cryptocurrency miner, appears to have pulled a planned IPO. (Miners maintain a cryptocurrency’s blockchain—a distributed transaction database—using huge numbers of specialised computers, and are paid in newly minted coins).



The speed with which the bubble inflated and then popped invites comparisons with past financial manias, such as the Dutch tulip craze in 1636-37 and the rise and collapse of the South Sea Company in London in 1720. Cryptocurrency enthusiasts like to claim a more flattering comparison—with the 1990s dotcom bubble. They point out that, despite the froth, viable businesses emerged from that episode. But the cryptocurrency fiasco has exposed three deep and related problems: the extent of genuine activity is hugely exaggerated; the technology does not scale well; and fraud may be endemic.

Consider the overstatement of activity, first. Ten years after their invention, using cryptocurrencies to pay for goods and services remains a niche pastime. Bitcoin is the original cryptocurrency and still the most popular. In January Satoshi Capital Research, a cryptocurrency firm, declared that Bitcoin transactions in 2018 added up to $3.3trn, more than six times the volume handled by PayPal. But such figures include an awful lot of double-counting, mostly related to the way Bitcoin handles change, says Kim Grauer at Chainalysis, a firm that analyses Bitcoin’s blockchain. Strip that out, and Chainalysis reckons that Bitcoin accounted for around $812bn of genuine transfers of value.

Of that, Ms Grauer reckons, only a fraction was used to buy things. Around $2.4bn went to merchant-service providers, which handle payments for businesses—a piffling sum compared with the $15trn of transactions in 2017 on Alipay and WeChat Pay, two Chinese payment apps. Darknet markets, which sell stolen credit-card details, recreational drugs, cheap medicines and the like, made up $605m, and gambling sites $857m. Most of the rest was related to speculation.

Even for speculators, business is less brisk than it seems. “Wash trading”, in which traders buy and sell to each other (or themselves) to create the illusion of volume, is widespread. Bitwise Asset Management, a cryptocurrency-fund manager, analysed 81 cryptocurrency exchanges for a presentation on March 20th to the Securities and Exchange Commission, an American financial regulator. The firm estimated that 95% of trading volume could be artificial. The Justice Department is investigating claims of price manipulation.

The second problem is that the technology is too clunky to operate at scale. Cryptocurrencies are unlikely ever to achieve mass adoption, says Nicholas Weaver, a computer scientist at the University of California, Berkeley. Unlike Alipay or WeChat Pay, cryptocurrencies are intended as new financial systems rather than extensions to the current one. But they have serious design flaws.

Bitcoin’s pseudonymous creator, Satoshi Nakamoto, wanted it to be resistant to control by tyrannical governments and banks. Payment records are therefore not held centrally, but broadcast to all users. A new batch of Bitcoin is issued every ten minutes on average. That limits the network to processing about seven transactions per second (Visa, by contrast, can handle tens of thousands per second). In 2017, as the crypto-bubble was inflating, the system became clogged. To ensure that transactions went through, users had to pay miners—at one point, as much as $50 per transaction.

Moreover, Bitcoin is designed such that only 21m Bitcoins will ever be created, making it inherently deflationary. Mining, essentially a self-adjusting lottery in which participants compete to buy tickets, is energy-hungry. At the height of the boom it was thought to consume as much electricity as Ireland (these days, it merely consumes as much as Romania).

The final problem is fraud. Transactions are irreversible—a boon for con-artists. Ponzi schemes are common, as is incompetence. Cryptocurrency exchanges often collapse or are hacked. In February QuadrigaCX, a Canadian exchange, filed for bankruptcy, saying it had lost $165m in deposits when its founder, Gerard Cotton, died, since only he had known the encryption keys protecting QuadrigaCX’s deposits. But on March 1st Ernst & Young, which was appointed to handle the bankruptcy, said that the deposit addresses seem to have been empty for at least eight months before the date Mr Cotton is said to have died.

When Lambos?

Attempts are under way to get round some of these limitations. Some Bitcoin enthusiasts are testing an add-on called the Lightning Network, which tries to speed things up by moving many transactions off the blockchain. Stablecoins, whose value is supposedly pegged to something else, are touted as a way to rein in speculation. Once again, promise often falls short of reality. On March 14th Tether, the most popular stablecoin, with $2bn-worth in circulation, said that it might not be fully backed with dollars after all. None has achieved even Bitcoin’s limited take-up.

Most fans simply want cryptocurrency prices to start rising again. In 2017 John McAfee, a cryptocurrency enthusiast who made his money in antivirus software, said that if Bitcoin was not worth $1m in 2020 he would eat an intimate part of his anatomy on television. On March 20th he tweeted that losing that bet was “not mathematically possible”. Last year Jack Dorsey, Twitter’s boss, said he thinks Bitcoin will be the world’s “single currency” within a decade. Facebook is working on some kind of cryptocurrency project. Market analysts and pundits provide cheery reassurance that the currency will soon soar again.

Mr Weaver is sceptical, at least in the short term. The very visible boom and bust, and more attention from regulators, have probably cut the number of willing new punters, he says. But boosters are trying their best. They have taken to referring to the post-bust period as a “crypto winter”. The intended analogy is with artificial intelligence: the “AI winters” were funding crunches in the 1970s and 1980s after hype outstripped reality. The implication is that, one day, summer will return.

The American Populist Reckoning

The most likely outcome of Donald Trump's presidency will be slower growth, further increases in inequality, and erosion of public services. And America’s ability to out-innovate others, including China, will take another blow.

Simon Johnson




WASHINGTON, DC – Populism is an approach to government that relies on lavish promises that ultimately cannot be met. The most prominent historical cases since 1945 were, for a long while, mostly found in Latin America. There are always apologists who claim that a new source of economic miracle has been discovered. But the ending is always the same: some form of crisis and disaster. Populism today is again in the ascendancy, but now one of the most virulent forms is in the United States – and with the credibility of the central bank very much on the line.

Argentina under Juan Perón (1946-1955 and 1973-1974) and his successors is often held out as the canonical example of populist misrule. Each iteration of populism has its special features, but the general pattern is this: unsustainable wage increases, an overvalued exchange rate, and massive foreign borrowing (enabled by local recklessness and foreign short-sightedness). Critics are persecuted, experts disparaged, and ridicule piled onto anyone with any kind of reasonable concern. Central banks and other independent governmental bodies, such as courts, are always subverted through personnel changes and other pressures.

Then the reckoning comes, with some combination of inflation, significant exchange-rate devaluation, and a deep recession (or worse). All too often, the cycle then starts again with another round of promises that cannot possibly be met. The central bank’s credibility, once dismantled, does not easily return.

Looking around the world today, Venezuela is an obvious Latin American example that experienced a recent version of populism (though sustained by oil revenues for longer than usual). With Venezuela now experiencing a classic populist collapse, who else is displaying obvious symptoms today?

The United Kingdom is one prominent potential case. It is entirely possible that Britain can still avoid the disaster of leaving the European Union in a way that avoids a massive disruption of trade. The worry, of course, is that the path to a soft landing remains unclear – and it is very late in the day, relative to the politically established deadlines (for the EU and for the UK).

Some British political leaders, mostly on the right, continue to play the populist card to a disconcerting degree. It remains to be seen whether they need to cause a collapse before the hollowness of their promises becomes self-evident.

The good news is that key UK institutions, including the Bank of England, remain strong and reasonably independent. Let’s hope that this remains the case, regardless of what happens within the Conservative Party and to Prime Minister Theresa May’s government.

A much bigger problem looms in the US, where President Donald Trump has combined disregard for the fiscal impact of tax cuts with an apparent desire to start trade wars. Now comes his most dangerous move to date: increased pressure on the Federal Reserve to stimulate the economy.

The pressure on the Fed is understandable in political terms, because the temporary sugar high of the tax cuts enacted at the end of 2017 is wearing off, and there is insufficient congressional support to cut taxes further. Expanding deficits already stretch as far as the eye can see. Although US economic growth is satisfactory, it is naturally slowing as the country reaches full employment. As a true populist, Trump has promised growth rates that are unattainable except through extraordinary and unsustainable measures – such as significant easing of monetary policy.

The Fed is weak politically today because it has had a bad 15 years. First, it not only oversaw but actually cheered on the breakdown in consumer protection that made rapacious real-estate lending possible in the run up to 2008. Then the Fed completely failed to understand how the structure of derivatives could amplify risks, so that what should have been a mild downward correction in house prices became a system-wide (and global disaster). Subsequently, the Fed attempted to make amends by easing credit to an unprecedented degree. Unfortunately, “cleaning up” in this fashion proved difficult and the damage to millions of lives remains all too tangible.

The defense mounted by Fed leaders at the time was that crises happen and nothing can be done about it. That view is entirely wrong. The US avoided serious financial crises from the 1940s to the early 2000s because good enough regulation remained in place.

Leading congressional Republicans spent a decade aiming their rhetorical fire at the wrong target within the Fed’s sphere of activities, claiming that its post-crisis policies were “too loose” and would cause inflation. The Republican critique proved entirely without merit: inflation remained low. But the political damage was done, and now Trump’s pressure for much looser monetary policy is being supported by members of Congress who previously argued for the exact opposite.

Now the Fed is weak, and Trump is clutching at straws, desperate to jack up growth by any means until the 2020 presidential election. He is packing the Fed’s Board of Governors with people who want to say yes to him and will mobilize his base against Fed staff and regional bank presidents if they resist easing monetary conditions.

Could pumping up the economy in this fashion clear Trump’s path to reelection? Trump has been lucky before, and the global economy looks relatively benign (unless Brexit brings bad surprises). And while all of Trump’s macroeconomic promises will prove as ephemeral and fleeting as those of Perón, populism always lasts longer than most people think possible.

The reckoning, when it comes, will likely be different from that in Argentina or Venezuela. The US has a stronger, more diversified underlying economy with a better track record over the past century. And the dollar is used widely around the world, as reserves for central banks, as a private-sector store of value, and to invoice most international trade. The most likely outcome will be slower growth, further increases in inequality, and erosion of public services. And America’s ability to out-innovate others, including China, will absorb another blow.

Trump will leave the scene soon enough. Will his legacy be even more populism, made possible by the destruction of the Fed’s political legitimacy? Such an outcome looks entirely posible.


Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with Jonathan Gruber of Jump-Starting America: How Breakthrough Science Can Revive the Economic Growth and the American Dream.

Argentina’s century bond caught in dash for exit

Just two years ago investors rushed to snap up 100-year debt sold by Buenos Aires

Colby Smith in New York


Markets are now pricing in a 56 per cent chance of default © AFP


In June 2017, investors clamoured for a piece of Argentine history: a dollar-denominated bond maturing in 100 years. Just two years and one record-breaking IMF programme later, investors are dumping the so-called “century bonds” amid a big sell-off of the country’s assets.

On Thursday the 100-year debt traded as low as 66 cents on the dollar, before making a modest recovery on Friday. Yields, which move inversely to prices, rose as high as 10.79 per cent. Bonds maturing long before the century bonds’ 2117 due date also came under pressure, with the yields on short-term government debt trading near distressed levels at one point.

The dash for the exits came as investors began to take seriously the prospects of former leftist president Cristina Fernández de Kirchner edging out pro-reform president Mauricio Macri in the upcoming presidential elections in October. This also prompted big falls in the country’s stock market, which was down about 10 per cent for the week, while the currency stretched away as the world’s worst performer this year.

Meanwhile, fresh polling data showing a path to victory for Ms Fernandez, and dwindling approval ratings for Mr Macri, helped to push the cost of insuring against an Argentine debt default up above 1,000 basis points, one-fifth higher than last week’s levels. Markets are now pricing in a 57 per cent chance of default.

“If Cristina wins, it would be a disaster,” said Win Thin, global head of currency strategy at Brown Brothers Harriman in New York. “Macri is doing his best to unwind her bad policies.”

Not too long ago, investors were eager to own Argentine debt. They cheered the country’s return to the international capital markets in 2016, after a 15-year stand-off with creditors over its 2001 default. Many of those same investors rushed to snap up a piece of the $2.75bn worth of 100-year bonds the country sold about a year later.

“Back then, there was a widespread feeling that President Macri had the willingness and the ability to implement a reform programme that was good for Argentina,” pointed out one international investor. “Policymakers felt emboldened to issue a 100-year bond as a symbol of a ‘new Argentina.’”

Now it looks “too show-offy”, said the investor.

According to Bloomberg data, BlackRock, RBC and Fidelity are among the largest holders of the country’s century bonds.

Despite the support of a record $56.3bn bailout programme from the IMF, Argentina’s economy continues to contract. Making matters worse, inflation is running rampant at an annualised rate of almost 55 per cent, and the peso has weakened 16 per cent against the dollar this year alone.

“Macri has all the right motivations and wanted to bring the country back to the markets, and he did,” said Bill Rhodes, a former Citigroup executive who has helped to restructure Argentina’s debt on multiple occasions. “But you have to have a strong economic programme and implement it on a timely and upfront basis.”

Mr Macri’s government initially supported a gradual economic adjustment, which many said helped to incite last summer’s currency crisis. In order to receive more cash upfront, Argentina pledged in September to accelerate the process of attaining a primary fiscal surplus and rebalancing its external position.

On both counts, Argentina has met its targets. For the second month in a row, the country posted a positive primary fiscal balance in March. On the external front, it recently recorded a $1.18bn trade surplus for the same month, a large swing from the $554m trade deficit it was running this time last year.

For this reason, Federico Kaune of UBS Asset Management says the recent market volatility is not about a lack of resources. “The government needs to let this situation play out and avoid spending money intervening in the currency for now,” he said.

A victory for Mr Macri would resolve many of the problems plaguing Argentine assets today, said Amer Bisat at BlackRock.

“If we can get through the political test over the next few months, the current policies are helping to create an economy that is significantly healthier than in the past and can recover after this period of wrenching recession and crisis,” he said. “We are happy to participate in that recovery.”

The Case For A Melt-Up

by: The Heisenberg
 
Summary
 
- Another week of gains for US stocks raises familiar questions about whether a rally that has equities up an astounding 17% YTD can possibly run further.

- Although the story is familiar and the arguments largely unchanged, it's all worth recapping in detail precisely because the issues remain unresolved.

- " Where to from here?" has been an unanswerable, intractable question for weeks.

 
 
Anyone with a penchant for skepticism had a leg up in 2018, when, for the first time in a long time, caution paid off.
 
A simple "buy the dip" strategy failed for the first time in 16 years.
 
(Morgan Stanley)
 
 
While the media has variously trotted out Morgan Stanley's Mike Wilson as the poster boy for "nailing it" (based on his prescient "rolling bear market" thesis), the only analyst I'm aware of who actually hit it right on the head last year wasn't an equities analyst at all. Rather, it was Deutsche Bank's derivatives strategist Aleksandar Kocic, who, in the course of documenting the Fed's efforts to re-strike the vaunted central bank "put", suggested the S&P (SPY) would eventually find itself sitting between 2,300 and 2,400.
 
Kocic's call wasn't the product of some deep-seated skepticism or propensity to dislike the longest bull market in recorded history. Rather, it was the natural outgrowth of his analysis of the Fed's transition to the role of convexity manager, versus convexity supplier, with the latter being the mode the Fed operated in for the entirety of the post-crisis years until the normalization push got going in earnest.
 
But, again, you needn't have been actually brilliant (like Kocic) to have looked smart last year.
 
You needed only have been cautious about a scenario that found the Fed pigeonholed into hawkishness and thus predisposed to pushing financial conditions inexorably tighter until something finally snapped.
As you may or may not be aware, SocGen has been somewhat skeptical of equities for a while, and as such, some of the bank's calls ended up looking smarter than those emanating from the street's more bullish strategists last year. It's fair to say their skepticism has carried over into 2019, although that characterization comes with the obvious caveat that there are bulls at every bank and not every piece of research they produce is designed to push a bearish outlook.
 
Earlier this month, for instance, the bank suggested investors should avoid the FOMO temptation. To wit, from an early April note:
Our analysis shows the balance of risks is still broadly titled to the downside for risk assets and we recommend investors gear their portfolio allocations for the tug-of-war between bad cyclical indicators and more policy loosening.
That underscores the tension in 2019. On one side is a global economy that's nowhere near out of the proverbial woods after last year's deceleration, and on the other side are central banks, determined to "reflate" (as it were).
 
So far, the coordinated dovish pivot from policymakers (which continued apace this week with the Riksbank pushing out the next hike and the Bank of Japan enhancing their forward guidance) combined with recent signs of stabilization in the Chinese economy have prevailed over the economic malaise evidenced in Europe and Asia. As poorly as virtually every asset (save USD "cash") performed last year, 2019 has been equally indiscriminate on the upside, with virtually everything posting positive returns in Q1.
 
I doubt this is necessary, but just in case, here's how badly assets of all stripes were trounced last year by cash:
(BofAML)
 
 
And here's what Q1 brought in terms of cross-asset performance:
(Goldman)
 
 
It has not, generally speaking, been a pleasant experience for those who decided to sit things out on the assumption that Q4's drawdown was just the beginning of something worse.
 
If that's you (i.e., if you were too shell-shocked from December to risk hitching your wagon to the Fed's dovish pivot in January), you can at least take comfort in the fact that you're hardly alone.
 
Q1 was variously described as a "flow-less" rally, lacking figurative and literal buy-in by key investor cohorts, whose assumed participation going forward is a key part of any bullish thesis.
 
EPFR data shows $91 billion coming out of global equities funds and $120 billion flowing into global bond funds YTD. Here is a set of visuals from Nomura's Charlie McElligott which illustrate the extent to which exposure is low and positioning light.
 
(Nomura)
 
 
There's a sense in which asking whether some of the investor groups who haven't participated "should" get involved is an exercise in question-begging. Part and parcel of the bull thesis going forward is that left-behind cohorts will indeed be "forced" in (and you can take that figuratively in the sense of FOMO getting the best of fundamental/discretionary investors and literally in the sense that if volatility remains suppressed and markets remain "in-trend", systematic strategies will mechanically re-leverage).
 
But if the viability of the bull thesis relies on you (actually, several yous, plural) participating, then it's impossible to evaluate that thesis.
Well, with all of this in mind, SocGen is out with a brand new US equity strategy piece and the title is "A near-term melt-up to 3,000 is possible, but move fast".
 
Most of the points are familiar, but given all the "melt-up" talk engendered by the prospect of flows turning a corner and positioning finally inflecting, it's worth highlighting some of the key passages.
 
SocGen reiterates the notion that while an acute lack of liquidity (i.e., a dearth of market depth) can make the situation worse on the way down (as it did in Q4 and at various other intervals last year), it can also exaggerate upside moves following a rebound. I talked about this at length in a post here last week and one of the points I made was that buybacks hitting in a low-liquidity environment could very well help explain why the rebound in Q1 was so dramatic.
 
"The low liquidity feature of the S&P 500 futures market exacerbates bullish and bearish moves", SocGen writes, adding that if you ask the bank, "it may have [both] amplified the sell-off at end-2018, but also may have supported the rally in early 2019."
 
They go on to note the obvious, which is that scarce liquidity and buybacks will "continue to play an important role in US equities’ performance".
 
As far as the above-mentioned under-positioning and lackluster flows dynamics are concerned, SocGen underscores the glaring discrepancy between large outflows from equities and inflows to bonds. If you look at the chart in the right pane below, you can see that the situation for equities is perhaps starting to turn around.
 
(SocGen)
 
 
Additionally, managed money net positioning has recently moved back to (basically) neutral, suggesting folks are tentatively inclined to become at least marginally comfortable with the rally.
When it comes to what could go "right" from here, the story is always the same. Nearly every analyst you care to consult will tell you that it all depends, at least to a great degree, on whether the recent inflection in China's activity data proves sustainable.
 
And with that, comes a paradox.
 
I talked at length here on Monday about how good news on the economy has become "bad" news for Chinese equities because the better the data, the less likely Beijing is to deploy kitchen-sink-type stimulus. Subsequently, Reuters reported that Chinese officials are squarely on "pause" when it comes to RRR cuts and the PBoC's move to roll out of another round of targeted medium-term lending (on Wednesday) quite clearly indicates that a piecemeal approach is the default option going forward (as opposed to indiscriminate liquidity injections).
 
By Friday, it was a rout on the Mainland. This was the third-worst week for the Shanghai Composite going back to the doldrums of early 2016 and the proximate cause was the fear that better data means less stimulus.
 
(Heisenberg)
 
 
With that in mind, consider the following from the same SocGen note:
Taking the previous two episodes of Chinese government stimulus, in 2012 and 2015, we calculate the change in US and World ex-US 12m forward EPS, several months before and after the U-turn in China’s credit impulse indicator. The results are striking – global earnings expectations tend to rebound after China stimulates its economy. 
  (SocGen)
 
As you can see, a turn in China's credit impulse is mission critical (if that's too strong, let's just say that in this case, correlation probably does equal causation) for forward global earnings.
 
The question, then, is what happens in the event China's economy merely "stabilizes" at a low level, leading to a scenario where Beijing takes a kind of wait-and-see approach, continuing to eschew kitchen-sink stimulus for targeted measures that don't pack the same kind of punch? If you're looking for hints as to what the answer to that question might be in risk assets, I would refer you to the chart of the Shanghai Composite above.
 
SocGen's take is constructive, though. "Even if we believe that the extent of Chinese policy easing will be much less than during previous years – to avoid another equity bubble and growth in shadow banking credit, it should be enough to stabilize earnings expectations", the bank writes.
 
Between that benign take, buybacks, the prospect of flows and positioning starting to turn and an S&P that, to SocGen anyway, doesn't look particularly expensive, there's scope for things to run further from here. On the valuation bit, the following chart shows the bank's principal component analysis which uses the dollar, earnings growth, earnings momentum, CPI, CAPE, dividend yield spreads, EPS and buybacks to model the index:
 
(SocGen)
 
 
The amusing thing about all of the above (and I don't mean "amusing" in a pejorative way), is that it feels like a lot of effort to go through to determine that the S&P might "melt-up" to 3,000. As of Friday's close, we're already at 2,940.
 
But the actual "target" isn't the point. Rather, the point is that the debates outlined above continue to define the market narrative. To the extent all of this is an effort to answer the question "Where to from here?" consider the issue largely unresolved.

America’s Stock Market Exceptionalism Can’t Continue Forever

Relative to the size of the economy, U.S. corporate earnings are at steep levels

By Mike Bird




The S&P 500 is back at a new record high, while stocks in most of the rest of the world are yet to return to 2018’s peaks. But the rampant outperformance of U.S. equities can’t last forever.

Low interest rates and eye-watering valuations have been credited with driving the U.S. bull market, but financial conditions haven’t been so different elsewhere. The big reason why U.S. stocks have beaten those in almost every other country during the past decade—and why the trend has limits—is more basic: profits.

Since the beginning of 2008, earnings per share for U.S. equities have risen by 80%, according to FactSet data. Over the same period, Japanese earnings have risen by half as much in dollar terms, emerging-market earnings are flat and European companies are yet to see profits recover to their level before the financial crisis.




The postcrash economic expansions in Europe and Japan have been weak relative to the U.S. recovery, which has been helped by the global success of Silicon Valley. China’s slowdown has pinched emerging markets.

This divergence could continue, but other parts of the picture look harder to replicate. Above all, U.S. corporate profits have surged relative to the size of the economy. For the second half of the 20th century, corporate profits after tax typically ran to around 6% of output, and almost never rose above 8%. Now, the figure runs to 10%, helped by last year’s tax cuts. It would have to rise to unprecedented levels, double its precrisis average, to repeat the trend of the past decade.

Low interest rates and eye-watering valuations have been credited with driving the U.S. bull market. Photo: Spencer Platt/Getty Images


Japanese corporate profits have also grown as a share of the economy, largely due to a wholesale shift in corporate governance, which unlike a tax cut may fuel sustained earnings growth. In many European countries, meanwhile, the profit share of GDP has yet to return to precrisis levels.

Shifting guidance on interest rates has contributed to the recent rally, too. But since the Federal Reserve is now expected to hold fire on further increases for two more years, it’s difficult to see how it can boost stocks further without actually cutting rates.

Those factors don’t mean equities elsewhere are about to start steaming ahead of U.S. stocks. Equities in the rest of the world have their own problems.

But they do suggest that investors can’t expect such dramatic outperformance in future. After an amazing run, those with significant exposure to U.S. stocks would do well to take a trip overseas.


In Turkey, Political Gains Come at a Cost

Erdogan’s recent economic interventions are beginning to take their toll on the country’s finances.

By Xander Snyder

 

On Sunday, Turks will go to the polls for municipal elections. While he’s not on the ballot himself, President Recep Tayyip Erdogan has been campaigning vociferously in support of candidates from his Justice and Development Party, or AKP. The vote is a litmus test of Erdogan’s management of the economy, and the results will help him assess how much political capital he has left for dealing with the mounting challenges facing the Turkish economy.

Having registered two consecutive quarters of contraction, the economy is now officially in recession. Inflation reached 20 percent in February, leading to drastic increases in the cost of living for average Turks. While Erdogan has overseen meaningful growth in the Turkish economy during his tenure, much of that growth has been fueled by external debt, and the weakness of the lira, driven by credit-fueled inflation, is now coming home to roost.

Erdogan’s response has been, unsurprisingly, to blame everyone from grocers to bankers. With food prices rising and people struggling to afford basic staples, Erdogan blamed greedy, “treasonous” grocers for profiting unduly from the country’s economic woes (even though grocery stores are a notoriously low-margin business). In an attempt to curb food inflation, the government has instituted price controls on a number of items and police have been dispatched to supermarkets to ensure compliance. Ankara has also begun purchasing food on its own dime and opening government-run food stalls that sell produce at prices below what grocers can afford. This has the added benefit of making the government look like the good guy.

Earlier this week, in classic diversionary form, Erdogan blamed JPMorgan Chase for the decline in the lira. He said it wasn’t a result of years of external debt-fueled growth combined with current account deficits but rather JPMorgan’s mere prediction of a decline in value. Though Turkey was able to stem last year’s currency slump after the central bank raised interest rates in September, the lira again fell more than 5 percent last Friday when new data showed a greater-than-expected decline in the country’s net international reserves – a drop of about $10 billion in the first three weeks of March to $24.7 billion. Turkish officials have claimed this week that the decline in reserves was expected, resulting from the central bank’s sale of foreign currency to energy-importing firms to facilitate the purchase of foreign energy (another example of how fluctuating oil prices impact economies worldwide).



 

In the run-up to this weekend’s elections, Erdogan has again intervened in the economy, this time by restricting Turkish banks from lending money to short sellers of the lira. This move could have serious long-term consequences. Short selling a currency requires first borrowing it, selling it for a profit, then repaying the amount borrowed at a lower price. The result of Erdogan’s restriction has been a radical rise in the overnight borrowing rate of the lira to over 1,200 percent (by the end of the day, the rate settled at 750 percent, and now is back closer to 30 percent). The logic behind the move is that, if short sellers can’t borrow liras in the first place, then short selling will be limited and the downward pressure on the currency will be minimized, thereby preventing another major currency slide before the elections. But the measure is also trapping a number of foreign investors; if their investments are denominated in lira, they can’t cash out, since banks are not allowed to provide lira liquidity.
 

 

Though this intervention is “designed to be temporary,” according to an anonymous Turkish official who spoke to Bloomberg, its long-term ramifications might not be. Turkey, as we’ve discussed, has accumulated substantial external debt to fund its economic growth. That puts the country on shaky ground; if the lira declines, it becomes more difficult to repay debt denominated in foreign currencies. Turkey, therefore, needs more foreign capital inflows to fill its foreign reserves, which serve as a buffer against external debt. Yet after interventions like this, investors will likely feel that their Turkish positions are particularly insecure and poorly insulated from near-term political pressure, which in turn is likely to restrict the flow of foreign investment into the country. Erdogan is making a dangerous tradeoff: short-term political gain for a long-term economic cost.

A similar tradeoff exists with food price controls. While providing cheap food might give the AKP a boost in ratings before the election, doing so for too long risks driving grocers out of business. If this travels up the supply chain, then food producers may also be in danger. The government will end up footing the bill one way or another – either by paying for imports or subsidizing farmers and grocers. These sorts of palliative measures are not sustainable in the long run, as Venezuela so clearly shows.

How, then, should we interpret Erdogan’s decision to intervene in a way that further weakens the bedrock of Turkey’s economy? It’s possible that Erdogan is simply ignorant of basic economic theory and is pursuing politics that will benefit himself and his party. Yet, given that Erdogan is arguably the most powerful Turkish leader since Mustafa Kemal Ataturk and that this level of power could only be achieved by a shrewd operator, this explanation doesn’t make sense. Erdogan must know that these moves will damage the Turkish economy. His willingness to undertake these sorts of interventions to improve his party’s position in the arguably less important local elections is a sign that the AKP’s grip on power in Turkey is wavering. It’s also an indication that Turkey’s economic vulnerabilities will constrain its leaders’ ability to exercise political power in the years to come.

Cheap food and near-term measures to keep the lira from plunging may well work in the AKP’s favor this Sunday. If the AKP prevails, expect a greater push by Erdogan in the next four years to significantly weaken the opposition, either by persecuting opposition leaders (and Erdogan is already going after the pro-Kurdish opposition party) or by undermining institutional checks and extending term limits on the presidency.


Buttonwood

How emerging-market local-currency bonds might fit in your portfolio

Their appeal lies in their distinctiveness




IN THE FIRST episode of “Cheers”, a 1980s television comedy, Diane Chambers, a graduate student, intends to elope with Sumner Sloan, a literature professor. In stark contrast to the genial barflies at Cheers, a Boston watering-hole, Sloan is well-educated and middle-class—but also, it turns out, vain and deceitful. He’s goofy, says Sam Malone, the bartender whose on-off romance with Diane is the show’s dramatic axis. “He’s everything you’re not,” she retorts.

And so is Diane. That she and Sam are dissimilar in personality and social background is one reason why “Cheers” is so funny. The yoking of opposites is a dependable ploy in situation comedies. It is also a useful trick in investing. The injunction not to put all your eggs in one basket can be found in any finance textbook. But there is more to diversification than that. The ideal diversifier is not just something other than what you own, but something that contrasts with it.



Suppose your investments are tilted heavily towards the S&P 500 index of America’s leading shares, a principal character in global capital markets. Where can you find a Diane Chambers to balance your Sam Malone? Emerging-market government bonds in the issuer’s own currency may be the contrast you are seeking. They are not stocks, they are not denominated in dollars and they are not widely owned by foreigners. They are everything your existing portfolio is not.

Investing in emerging markets opens up a broader set of opportunities. GDP growth is generally faster, as there is greater scope to benefit from existing know-how than in rich economies. The business cycle is different, too. There is a spectrum of risk assets to choose from. The cautious prefer hard-currency bonds, which pay in dollars and are issued by governments and firms.

Further along the spectrum are racier bets. Shares carry the same hazards in emerging markets as anywhere else. Stockholders are behind bondholders in the queue to be paid, should earnings falter. But there is an additional exchange-rate risk: a fall in local currencies would be a money-loser for rich-world investors.

For those willing to take on foreign-exchange risk, government bonds issued in local currency might have more appeal. Government bonds are in general a hedge against equity risk. And while indices of emerging-market stocks lean heavily towards Asia, and thus to China’s supply-chain, bond indices have broader regional balance, says Yacov Arnopolin of PIMCO, a big bond firm. Expected returns are decent. For instance, the yield on the J.P. Morgan GBI-EM index of biggish issuers is 6.2% (see chart). That is considerably higher than the yield on Treasury bonds.



This yield spread is a buffer against currency risk. A bet on local-currency bonds is in essence a bet against the dollar. Ideally you would gain on both the bonds and the currency. But at the very least, you hope the “carry” (extra yield) will make up for any exchange-rate losses. An important consideration is whether the currencies you are buying into are overvalued. It is not obvious that they are. Real exchange rates in most big emerging markets are either close to their ten-year averages or below them.

A burst of inflation would alter the calculation. Currencies would then need to fall to keep the real exchange rate steady and exports competitive. Yet there has been a notable drop in inflation in emerging markets. Partly this is down to the adoption of inflation targets by central banks; partly it is more disciplined fiscal policy, says Jan Dehn of Ashmore, a fund manager. Of the 25 emerging markets listed on the indicators page of The Economist, only three (Argentina, Egypt and Turkey) have inflation in double digits. For most, it is below 3%.

Of course, the fate of the dollar is also a key consideration. Shifts in risk appetite will make the dollar jumpy. It tends go up against most currencies when traders fret about the world economy. But the Federal Reserve has indicated that it is not inclined to raise interest rates in America for a while. That militates against further dollar strength.

To buy local-currency bonds is to bet on a falling dollar. That might seem reckless. In fact, such bonds are a counterweight to the typical equity portfolio, which is groaning with American stocks and thus heavily exposed to dollar risk. They tend to have a low weight in rich-world bond portfolios, says Mr Dehn. Local-currency bonds sit as awkwardly among “safe” Treasuries or Bunds as Sumner Sloan in a blue-collar Boston bar. In short, they are quite unlike everything you already own.