Risk Off?

Doug Nolan

The “Granddaddy of All Bubbles” thesis rests upon the view that the world is in the midst of the precarious grand finale of a multi-decade global Credit and financial Bubble. When a Bubble bursts, system reflation requires an even larger fresh new Bubble. This has repeatedly been the case going back at least to the “decade of greed” late-eighties Bubble in the U.S. These days the world confronts the terminal Bubble phase partially because of the unprecedented scope of the China and EM Bubbles. It’s simply difficult to imagine another more far-reaching Bubble.
Also critical to the finale Bubble thesis is that the “global government finance Bubble” - encompassing unprecedented excesses in sovereign debt, central bank Credit and government market manipulation - has engulfed the very foundation of contemporary “money” and Credit. 
It’s again quite a challenge to envisage a new financial Bubble inflation cycle following a crisis of confidence at the heart of global finance.

As I’ve posited repeatedly, the global Bubble has been pierced. Again this week, there's more confirmation.  The collapse in commodities and EM currencies along with the faltering Chinese financial Bubble mark an historic inflection point. Global policymakers have gone to incredible measures to stabilize market, financial and economic backdrops. Yet reflationary measures will continue to only further destabilize. When policy-induced “risk on” is overpowering global securities markets, fragilities remain well concealed (and my prognosis appears ridiculous). 
Fragilities, however, swiftly manifest when “risk off” reappears. Rather quickly securities markets demonstrate their proclivity for illiquidity and so-called “flash crashes.” So after an unsettled week in global markets, the critical issue is whether “risk on” is giving way to “risk off” dynamics.

There is no doubt that a powerful “risk off” has again gripped commodities markets. Crude (WTI) sank 8.5% this week to $40.71, the low since the tumultuous August period. The “GSCI” Commodities Index dropped 4.0% this week, increasing 2015 losses to almost 19% while trading down to near August lows. The Bloomberg Commodities Index sank to an almost 16-year low. Copper prices this week sank 3.6%, trading to a new six-year low. Zinc also traded to a six-year low, with nickel at a five-year low. Unleaded gasoline dropped almost 10%. Wheat fell 5.3% and Corn dropped 4.0%.

With commodities succumbing to another leg in an increasingly brutal bear market, worries quickly return to EM. The Brazilian real declined 2.1% this week and the Colombian peso sank 6.4%. The Russian ruble fell 3.5% and the South African rand declined 1.6%. Mexican stocks were hit 3.6%.

November 9 – Bloomberg (Taylor Hall): “Debt in developing markets is estimated to have reached $58.6 trillion at the start of 2015, with credit in China, Hong Kong, India, Indonesia, Malaysia, Singapore, South Korea and Thailand exceeding that of Latin America, emerging Europe and the Middle East, according to the Institute of International Finance. Emerging-market debt has grown $28 trillion since 2009, according to the IIF… Global debt has soared $50 trillion during the period to surpass a total of $240 trillion, or 320% of gross domestic product, in early 2015. While credit has increased for almost all countries included in the new monitor over the past decade, debt-to-GDP ratios in developing Asia for non-financial corporate, household and financial corporate sectors have risen the most… Non-financial corporate sector debt in emerging markets has risen $13 trillion since 2009, increasing more than five-fold over the past decade to surpass $23.7 trillion in the first quarter of 2015. The advance has been most concentrated in emerging Asia, where it rose to 125% of GDP.”
With market attention seemingly returning to the world’s massive debt overhang, “developing” Asia equities were hit hard this week. Stocks were down 4.2% in Taiwan (TAIEX), 2.8% in Singapore (STI), 2.8% in Thailand (SET), 3.1% in the Philippines (SE IDX), 2.1% in Indonesia (Jakarta Comp) and 1.6% in Malaysia (KLCI). Australian stocks (ASX 200) were hit 3.1% and New Zealand stocks (NZX 20) fell 1.7%. Hong Kong’s Hang Seng Financial index dropped 2.6%, increasing its 2015 decline to 30.4%.

Disappointing Chinese economic data (imports, exports, producer inflation, etc.) already had investors on edge. A (rapidly?) deteriorating corporate Credit backdrop was beginning to cause angst. And then Thursday’s Chinese Credit data was stunningly disappointing. October saw total Credit growth (“Total Social Financing”) cut by more than half. After September’s jump to $204bn, Credit growth slowed sharply to $75bn, the weakest month of Credit expansion since July 2014. New bank loans, at $81bn, were less than half of September’s $165bn. This is insufficient Credit to hold bust at bay.

In short order, confidence that Chinese policymakers have everything under control has begun to wane. The view that Beijing can simply dictate Credit growth through mandates to the big state-directed lenders is being shaken by anecdotes of increasingly nervous bankers and cautious borrowers. Suddenly there’s talk of the Chinese “pushing on a string.”

When global markets are in a bullish mood, commodities and EM currencies appear to have bottomed. Yields on energy, commodities and deep cyclical companies around the globe seem enticing. “Developing” country debt is attractively priced. Chinese officials seem capable of ensuring 6.5% growth as far as the eye can see. China enjoys the capacity to stabilize its currency, inflation level and debt load. And stable Chinese growth will backstop commodities markets, EM markets and economies and the global economy (and markets!) more generally.

But this optimistic view of things turns flimsy in a hurry. When crude and commodities begin to tank, large quantities of debt (company, country and financial) look increasingly suspect. 
King dollar takes off, putting added pressure on faltering commodities and EM (currencies, debt and stocks) Bubbles. And with the Chinese currency pegged to king dollar, the markets’ view of China’s Credit situation can abruptly shift from “manageable” to “potentially very troubling.”

And returning to the “Granddaddy Bubble Finale” thesis, the Chinese and EM Bubbles fundamentally changed the “producer” and “consumer” inflationary backdrops. Ultra-loose global finance has ensured massive overcapacity in too many things. It has created an unprecedented divergence between bubbling financial markets and weakening fundamental prospects. There’s way too much debt almost everywhere, a debt burden that central bankers would like to inflate away to more manageable levels. The Chinese are desperate for inflation to grow out of historic amounts of debt. They’ve been able to inflate out of debt troubles previously, and they’ve watched U.S. reflationary measures work their magic repeatedly.

The bursting global Bubble is especially problematic for China. EM currencies have been devalued, while the U.S. and Chinese currencies have skyrocketed. The old reflationary measures no longer work. Loose “money” only exacerbates overcapacity, inequalities and financial Bubbles. The strong dollar further pressures global pricing, while adding to heightened Credit stress globally (certainly including EM dollar-denominated debt). 
Meanwhile, China’s currency peg to the dollar ensures the already vulnerable Chinese manufacturing complex becomes further uncompetitive. It ensures major problems related to the country’s enormous lending and investing boom in global resources. The resulting Credit stress only exacerbates disinflationary pricing pressures.

In 2014 and again in August, it appeared China was to commence meaningful currency devaluation. In both instances acute financial stress forced Chinese officials to immediately backtrack. Trying to recover from the August fiasco, the Chinese have focused on currency stability. And when markets are in that optimistic state of mind, Chinese policy appears sensible and sustainable. But when “risk off” begins to take hold, China’s mountains of overcapacity and debt appear completely at odds with a strong currency – with a peg to king dollar – in a disinflationary global environment.

It wasn’t only commodities and EM that succumbed to “risk off” this week. European stocks were down about 3%. U.S. stocks had a really rough week. The S&P500 declined 3.6%, with the broader market down even more. Selling was broad-based. Credit spreads also widened, most notably in high-yield. Junk bond funds saw flows reverse to sizable outflows. There were anecdotes of waning demand for leveraged loans, high-yield municipal debt and risky Credits more generally. Puerto Rico… Hedge fund performance… This is all consistent with heightened risk aversion and self-reinforcing pressure to de-leverage.

Confidence was so high the bulls had seemingly already taken a big year-end rally to the bank. 
“Risk off” into December would catch the bullish consensus by completely flatfooted. “Risk off” would also catch most un-hedged and over-exposed to the long side. “Risk off” would also complicate life for the Fed. Just when they had finally gathered the nerve to move, global markets turn sour. And perhaps the Fed has been whipsawed by the markets one too many times. But I still think global markets are being dictated much more by China than the Fed. 
And at this point, Chinese officials have the much more difficult decisions. Do they bite the bullet and start devaluing? Or do they stick with the peg and hope?

My Friday writing has been interrupted by the news of terrible terrorist attacks in Paris. It’s a reminder of the increasingly hostile world in which we live. And it’s consistent with a darkening of the social mood in Europe and well as here in the U.S. and around the world more generally. It’s also part of the troubling backdrop conducive to a problematic “risk off” when faith in global central bankers and Chinese officials wanes. 

November 13 – Bloomberg (Candice Zachariahs, Anchalee Worrachate and Lananh Nguyen): “...While dislocations may provide opportunities for investors, they also bring challenges, according to... Luke Bartholomew, an investment manager at Aberdeen Asset Management... 'The real worry about liquidity is that it behaves like a bad friend -- it is there when you don’t especially need it, but as soon as you do need it, it disappears.'"

In the long shadow of the Great Recession

It may be hard to avoid crises but it is vital to make them both small and rare
James Ferguson illustration©James Ferguson
The US and Europe still live with the legacies of the financial crisis of 2007-09 and the subsequent eurozone crisis. Could better policies have prevented that outcome; and, if so, what might they have been?

A recovery is under way, but only in a limited sense. The change in gross domestic product of crisis-hit countries is now almost universally positive. But GDP remains far below what might have been expected from pre-crisis trends. In most cases, growth has not recovered, mainly because of declines in productivity growth. In the eurozone, GDP was still below pre-crisis levels in the second quarter of 2015. In crisis-hit members, a return to pre-crisis output is still far away. They will suffer lost decades.
From a sample of 23 high-income countries, Professor Laurence Ball of Johns Hopkins University concludes that losses of potential output ranged from zero in Switzerland to more than 30 per cent in Greece, Hungary and Ireland. In aggregate, he concludes, potential output this year was thought to be 8.4 per cent below what its pre-crisis path would have predicted.
This damage from the Great Recession is, he notes, much the same as if Germany’s economy had disappeared.
A central finding of the work by Prof Ball and, more recently, by Antonio Fatás of Insead and Lawrence Summers of Harvard, is that estimates of potential output track actual output. This suggests that “hysteresis” — the impact of past experience on subsequent performance — is very powerful. Possible causes of hysteresis include: the effect of prolonged joblessness on employability; slowdowns in investment; declines in the capacity of the financial sector to support innovation; and a pervasive loss of animal spirits.
This year Jason Furman, chairman of the US Council of Economic Advisers brought out the impact of low post-crisis investment: after the crisis, the contribution of investment labour productivity fell to very low levels (see chart). This was strikingly so in US, where the estimated impact actually was negative.
The hysteresis hypothesis is not universally accepted. There are at least three other explanations for the enduring post-crisis collapse in output.

First, it is argued that credit booms raised pre-crisis estimates of potential output far above sustainable levels. One objection to this is that the expansion in credit raised asset prices far more than it fuelled actual spending. Adair Turner, former chairman of the UK’s Financial Services Authority, makes this point in his book Between Debt and the Devil . A further objection to this argument is that it confuses the contribution of debt to the structure of demand with its effect on overall supply.

A second explanation for the post-crisis collapse in output is that the impact of new technologies on output is being underestimated. Yet, even if this were true (which is possible), it would not explain the sharp slowdown in the growth of productivity after the financial crisis. The difficulty of measuring the impact of new technologies also did not suddenly increase in the UK (the country worst affected by a post-crisis slowdown in productivity growth) relative to the US (the home of these new technologies, yet relatively less affected by the productivity slowdown).

A final explanation is that productivity growth slowed before the crisis. In the US, this does seem to be the case. But it is less obviously true elsewhere.
On balance, then, the hysteresis hypothesis retains substantial force. This is why it is so important that we avoid huge crises and respond strongly to any that occur, to minimise their economic impact. Otherwise, the bad cycle might permanently damage the trend.

This raises two further questions: could the adverse impact of the crisis have been smaller?

And can it still be reversed? The answer to the first must be yes. But it would have required stronger fiscal and monetary responses, and more aggressive restructuring of damaged financial institutions. The eurozone, in particular, should have done far better. Yet, even today, it lacks the will and the institutions it needs.

The answer to whether the losses in output levels and growth rates can be reversed must again be yes.

By the early 1960s GDP per head in the US had regained the level indicated by a continuation of pre-1929 trends. Unfortunately, the fiscal boost from the second world war was a deus ex machina for policy. It cannot be repeated in peacetime. Even so, it might at least be possible to return to pre-crisis trend rates of growth. A mix of ag­gressive support for demand and contributions to long-term supply — notably via far higher levels of public investment — would hit both objectives at once.

The evidence, then, is that festering recessions have prolonged effects on prosperity. One conclusion is that it is vital to act swiftly to restore demand. Moreover, the evidence is now clear that the big high-income countries enjoyed the policy space needed to act decisively. Whatever many so foolishly said in 2010, they never faced the slightest risk of turning into Greece. The US and, still more, the eurozone should have responded far more aggressively.

Experience indicates something else no less important. It may be hard to avoid crises but it is vital to make them both small and rare. Financial crises lead to deep recessions and prolonged slowdowns, partly because policymakers fear making sufficiently strong responses. For this reason the regulation of finance simply had to be tightened. The question is only whether it has been tightened in the right way.

Oops The Feds Did it Again- Are They Setting up The Masses for Another Stimulus Program

By: Sol Palha

"I guess the definition of a lunatic is a man surrounded by them." 
 Ezra Pound

Is the Fed playing mind games with the masses or is it simply another version of Britney Spears hit song "Oops I did it again"? Only this time they did not. They keep mouthing off that they are ready to raise rates and then suddenly just before the moment to pull the trigger draws near; some unforeseeable event springs up, and they kick the can down the road again. Two questions comes to mind.

Why the intense focus on what the Fed might or might not do; has the press run out of real stories to focus on. Come on we are talking about a measly 0.25% hike. In the worst of scenarios, this should be treated as a hiccup and not a major tragedy.

Secondly, history indicates that the markets tend to trend higher for up to two years after the first rate hike. Thus, a rate hike should be viewed as a positive event as it would indicate all was well. But perhaps all is not well, and that is why the crowd is panicking at the mere thought of a hike.

We, however, believe that this boring Fed might raise rates story is a non-event and have said so many times in the past.

The Fed is hesitating so much in raising rates because they know that the economy is not really strong. However, what is more, important is they are trying to gauge if the public is buying the nonsense that the outlook is improving via all the manipulated data that is being put out? If they sense that the public is buying this nonsense, then they will initiate a tiny rate hike. To some degree, it appears that the public is buying this nonsense. Whatever move the Fed makes; their ultimate aim is to find a way to embark on another wave of QE. Look at the World's markets; while the US markets look okay, the emerging markets are taking a beating and its just a matter of time before the contagion spreads to the U.S. The only way to prevent this is to flood the markets with hot money. ~ Market Update Oct 2nd, 2015.

The Fed is still trying to gauge if the crowd has bought into their drug induced theme, which states that all work and no play makes Jack a smart chap. We used to use the word sadly, but is that really the appropriate word to use; if the crowd does the same thing over and over again. Perhaps instead of saying sadly, we should instead begin the sentence with; insanely the crowd appears to be buying into this theme. Is the economy really improving?. ~ Market Update Oct 17, 2015

The most recent jobs numbers masked a dark story. Unemployment held steady at 5.1%, but only 59.2% of Americans have a job. The difference is the unemployment rate only counts people who don't have a job and are actively looking for one. The labor force participation rate is perhaps a more accurate gauge of the economy. It includes people who've given up, don't want to, or can't work, and it fell to 62.4% last quarter Full story

If this story is taken at face value, the economy should be in tatters and people should be rioting.

Instead, all appears calm; the masses suffer silently and lay the blame on forces they claim to have no power over. As long as they take this approach that is exactly how things will play out.

It is, for this reason, the Fed is not raising rates; they know that they have just barely managed to create the illusion that things are stable. They are in no hurry to pop this bubble. While many call the Fed stupid and short-sighted; the truth is that at every twist and turn of the road, they have walked away unscathed. While the gold bugs wait for their day in glory (many have already passed away waiting for that glorious day to dawn), they do not understand that even if Gold moves to 10,000 which it will not, the Fed has, is and will still win the game.

Even if Gold could miraculously surge to $100K it would mean nothing; if you control the printing press, you just push the pedal to the metal and print a lot more and problem solved.

Never get caught up in any battle, for a battle is one of many in a war. The idea should be to win the war and not the battle. Before engaging your opponent, look around, gauge the situation and plan a course of action. The masses are frozen, they bitch and moan about how bad things are, but when push comes to shove, they opt for being shoved, instead of pushing back. In the end, their role as history indicates is that of cannon fodder. Do not feel sorry for the masses and do not attempt to educate them. Should you decide to undertake this unworthy venture, your reward will be a fistful of pain.

The masses are infamous for punishing the wrong person for the wrong crime. There is no such thing as a good Samaritan in the land of investing. A good Samaritan is usually a dead Samaritan and heroes usually have very short life spans. Pay attention to history, you will never see the masters of deceptions or the shadowy elite players move out of the shadows and try to play the role of a hero or a good Samaritan. These roles are created for the masses; they are sold a bag of lies, and they gladly buy into this mumbo jumbo.

No matter what the nuts out there state; the Fed is not hell bent on raising rates, they are not scared or nervous about anything, and they backed into a corner. They have backed everyone else into a corner, and the ones that are scared are the ones makes these idiotic proclamations.

The Fed might raise rates, but their goal is to find an excuse that the masses will buy hook line and sinker, to come out with another round of QE. The whole purpose of this experiment is to find out just how far the crowd can be pushed with the proper brainwashing. Right now they are taking notes so that the central bankers of the future can build on these lessons and push the envelope even further. The reason there is no repeat of 1929 is because they took notes and learned from their mistakes. These guys are nefarious geniuses. They give the impression of being impotent, but they are omnipotent. So how do you win?

The answer is simple. Throw your silly emotions and bias out of the window and ride on their coattails. End of story.

"It is wrong to think that misfortunes come from the east or from the west; they originate within one's own mind. Therefore, it is foolish to guard against misfortunes from the external world and leave the inner mind uncontrolled."  

Germany loses key ally in Portugal as austerity regime crumbles

'We don’t have a coup here: we have democracy. Whoever lacks the votes in the national assembly cannot govern,' says the leader of the Left Bloc

By Ambrose Evans-Pritchard

The secretary-general of the Portuguese Socialist Party, Antonio Costa, during his speech after the results that give the victory to the PSD - CDS/PP coalition, Lisbon, Portugal, 04 October 2015

Portugal's incoming leader Antonio Costa is the son of a Communist poet from Goa Photo: EPA

Portugal’s Communists and radical Left Bloc are poised to take power in a historic departure as part of an anti-austerity coalition led by the Socialists, despite being branded too dangerous for office by the country's president just 11 days ago.
While it is not a replay of the "Syriza moment" in Greece last January, the ascendancy of the Left marks a clear break with the previous austerity regime and with the policies of the now-departed EU-IMF Troika.
“Political risks are rising,” said Alberto Gallo from RBS. While Portugal has been a model of good behaviour in the eurozone until now, largely immune to radical politics, it has extremely high debt levels. He warned that the country may be skating on thin ice.
The bond markets reacted badly to news that the three rival parties had overcome bitter differences and struck a definitive deal on a detailed governing programme. Yields on 10-year Portuguese bonds jumped 21 basis points to 2.86pc. The risk-spread over German Bunds has risen 68 points since March.
A Socialist-led government under Antonio Costa will deprive Germany of a stalwart ally in its efforts to uphold fiscal discipline and drive reform in the eurozone. It has always been crucial to the German political narrative of the EMU debt crisis that the pro-austerity arguments should be made for them by political leaders in the peripheral states.
The change of regime in Lisbon could usher in a clean sweep by Left-leaning forces across southern Europe if the Spanish Socialists unite with the country’s new insurgent parties to dislodge the Right in the country’s elections next month. The race is currently too close to call.

Total non-financial debt is 370pc of GDP, the highest in the world after Japan

There would then be an emerging "Latin bloc" with the heft to confront Germany and push for a fundamental overhaul of EMU economic strategy. At the very least, the political chemistry of the eurozone would change beyond recognition.

Portugal’s Left-wing alliance won a majority in the country’s parliament last month but was initially rebuffed by President Anibal Cavaco Silva, who insisted on re-appointing a conservative government even though it had lost its working majority, and even though the political centre of gravity in the country has shifted markedly to the Left, and austerity fatigue is palpable.

In an incendiary speech he incited Socialist deputies to break ranks with their own party and the support the Right, arguing that it was in effect a national emergency. This high-risk gambit failed totally. The triple-Left has held together, overcoming bitter differences in the past.

Most contentiously, President Cavaco argued that anti-euro and anti-Nato elements of the Left should legitimately be shut out of power to avoid rattling financial markets or endangering euro membership, without seeming to realize the full gravity of what he was suggesting.

“In 40 years of democracy, no government in Portugal has ever depended on the support of anti-European forces, that is to say forces that campaigned to abrogate the Lisbon Treaty, the Fiscal Compact, as well as to take Portugal out of the euro, in addition to wanting the dissolution of NATO,” he said.

“This is the worst moment for a radical change to the foundations of our democracy. It is my duty, within my constitutional powers, to do everything possible to prevent false signals being sent to financial institutions and markets,” he said.

The Socialist leader accused the president of “usurping the powers of parliament” at the time.

He has since offered an olive branch as events move his way, and power comes within grasp.

Catarina Martins, the Left Bloc’s leader, said the will of the people had prevailed. “We don’t have a coup here: we have democracy. Whoever lacks the votes in the national assembly cannot form a government,” she said.

As expected, the Communists have agreed to drop their demands for euro exit and a return to the escudo, while the Left Bloc has toned down its eurosceptic language and will no longer push for debt relief.

Mr Costa has pledged to abide by EU rules, but the coalition’s spending ambitions are ultimately incompatible with the Fiscal Compact, and go against the grain of market reforms.

Public sector wages cuts and the pension freeze for state workers are to be reversed. Structural reform is frozen. Plans to privatize the national water group (EGF) and the rest of the airline TAP are to be halted, and a scheme to open transport in Lisbon and Oporto to private competition is on hold.

Pedro Passos Coelho, the outgoing premier, described the plans as the “politics of ruin” and warned the Portuguese people that austerity is not a choice but an absolute imperative if they wish to remain part of the European order.

Portugal's trade profile has improved enormoulsy but the gains are thinning and it is not enough pay down foreign debt

Federico Santi from Eurasia Group said the Left alliance, also allied to the Greens, is likely to be highly unstable, with a “recurring flashpoint” each year as the new budget is passed. “Risks to the fiscal outlook are increasing,” he said.

EU officials are dismayed by plans to raise the minimum wage to €600 a month – plus two months’ bonus – a level that would cover 25pc of all employees. Labour economists say this is extremely high and will entrench unemployment, as well as stifling small business.

“It is very negative and will reduce the dynamism of the economy,” said an EU expert who has had close dealings with the country.

“I am very worried about the way this is going. They are still a poor country. They have not restored competitiveness, and they don’t have the entrepreneurial culture of Greece, but they now think they are safe. I fear there could be a fresh crisis within two or three years,” he said.

Portugal is shielded from the bond vigilantes as long as the European Central Bank is buying its debt under quantitative easing but it is far from clear whether it really has restored full viability within EMU.

Public and private debt is 370pc of GDP, the second highest in the world after Japan. The budget deficit is still 4.7pc of GDP deep into the country’s Lost Decade, and the net international investment position is minus 116pc and has been getting worse. It is far beyond the -30pc safety line used by the International Monetary Fund.

The IMF says the export miracle is not quite what it seems since there has been a large rise in re-exports with little value added. The country remains acutely vulnerable to any external shock. “A durable rebalancing of the economy has not taken place,” it said.

Paris Attacks Suggest Shift in Islamic State’s Strategy

Terror group’s claim of responsibility, if true, represents a departure from militant group’s concentration on creating a state in Syria and Iraq

By Yaroslav Trofimov

French police officers stopped a vehicle at a check point at the French-Italian border on Saturday, as European capitals reinforced security checks following a series of coordinated attacks in and around Paris late Friday that left more than 120 people dead.

French police officers stopped a vehicle at a check point at the French-Italian border on Saturday, as European capitals reinforced security checks following a series of coordinated attacks in and around Paris late Friday that left more than 120 people dead. Photo: Agence France-Presse/Getty Images

Friday’s attacks in Paris, if Islamic State’s claim of responsibility proves correct, represent a major departure for the militant group that until now concentrated on creating a state in Syria and Iraq rather than directly targeting the West.
Such a turn also heralds a dramatic escalation in the perils faced by civilians in Europe and the U.S., the “crusader nations” in Islamic State’s cross hairs. Islamic State, after all, is far more indiscriminate in its targeting than al Qaeda: It considers pretty much anyone in the West as legitimate prey.
The Paris massacre occurred as Islamic State was suffering military setbacks in Syria and Iraq, losing territory to the Kurds in both nations and being subjected to an intensified air campaign by both the U.S.-led coalition and, since recently, Russia.

“Islamic State is on the defensive and so it is shifting toward terrorist activity, particularly in Europe, because that is an accessible area for them. This is the way to make sure people keep speaking about them, and to appear as an attractive group that remains capable of spectacular action,” said Camille Grand, director of the Fondation pour la Recherche Strategique, a Paris-based defense and security think tank.
While the Paris massacre wasn’t the first terrorist act in the West claimed by Islamic State, it is by far the deadliest and most sophisticated. It came two weeks after Islamic State claimed to have brought down a Russian passenger jet in Egypt.
Until now, most of its attacks in the West, such as the January assault on a Paris kosher supermarket and the December hostage-taking in a Sydney coffee shop, were believed to be the work of Islamic State sympathizers rather than people acting on direct orders from the militant group, also known as ISIS and ISIL. 
“If this was indeed directed by ISIS Central, it represents a major change from an earlier focus on state-building: They have made a decision that they will punish anyone who stands in the way of the expansion of their state,” said William McCants, an expert on radical Islam at the Brookings Institution and author of a recent book, “The ISIS Apocalypse.”
The initial claim of responsibility from Islamic State didn’t name the Paris attackers or provide video evidence of the kind usually released following bombings in the Middle East. Terrorism experts, however, increasingly believe Friday’s killings were unlikely to have been the work of lone wolves.
France deployed soldiers to secure strategic areas in Paris while European leaders met to address security measures in their own countries. WSJ's Shelby Holliday has the details on Europe's response to the Paris attacks.

“The complexity of the operations we have seen in Paris shows that we are facing an organization, something that was not just incited but also organized,” said Mr. Grand.

As long as Islamic State retains control over a huge territory in Syria and Iraq, and enjoys the legitimacy this control confers on it in the eyes of many radical Muslims, more such attacks are likely soon.
“Let France and all the nations following in its path know that they will continue to be at the top of the target list for Islamic State, and that the scent of death will not leave their nostrils.…Indeed, it is just the beginning,” Islamic State said in its claim of responsibility for Friday’s attack.
Given just how simple it is to kill random civilians in a Western city, that isn’t an idle warning. Its also one that calls into question the U.S.-led policy of using limited means to contain, rather than decisively defeat, Islamic State. 

“Without a doubt, this is a whole new threat to humanity, and it is really hard to imagine how it could be contained,” said Hassan Hassan, a fellow at the Royal Institute of International Affairs in London and author of a recent book, “ISIS: Inside the Army of Terror.” “I don’t think it could be restrained without effectively defeating it in Syria and Iraq.”
In fact, Islamic State is far more dangerous than al Qaeda in the immediate future, many experts say. Unlike Islamic State, al Qaeda exercises relative restraint and pursues a political agenda that, for example, doesn’t call for an outright genocide of Shiites. During the January attack on Charlie Hebdo magazine in Paris, claimed by al Qaeda, the perpetrators didn’t shoot random bystanders—the victims of Friday’s rampage.
“Al Qaeda chose symbolic targets,” said Stephane Lacroix, a specialist in radical Islam at Sciences Po university in Paris. “But Islamic State views this as an almost existential conflict, which translates into far more indiscriminate methods of action. And that makes its attacks much more difficult to stop.”

What to Expect After the Nov. 13 Paris Attacks

Update (6:00 CST): According to French media reports, French security forces have stormed and secured the Bataclan theater. The attackers apparently used grenades inside the main concert hall, Aujourd'hui Paris reported Nov. 13. Details are still emerging.

As many as 60 people died Nov. 13 in multiple terrorist attacks throughout Paris. At least five gunmen – likely jihadists judging from witness's accounts – conducted the attacks.

Timeline of the Attack

The attacks, which were clearly coordinated, took place in multiple locations and involved different methods. In the first wave, two suicide bombers detonated their explosives at locations near the Stade de France, where a soccer match between France and Germany was taking place. (French President Francois Hollande himself was at the stadium at the time of the attack. He was escorted from the scene and met with French Interior Minister Bernard Cazeneuve in a closed meeting shortly thereafter.) It is unclear whether grenades or other explosives were used, and it is possible a suicide bomber may have been involved.

Meanwhile, gunmen also opened fire, reportedly with Kalashnikov rifles, on a tightly packed Cambodian restaurant in a drive-by shooting. Shots were also fired at the Bataclan concert hall, where a hostage situation is now underway.

Roughly 25 minutes later, gunmen also opened fire on Rue de Charonne. And about an hour after the initial attacks, attacks by other terrorist cells took place at the Louvre and Les Halles.

Special police units, including RAID, a police intervention unit, have been rapidly mobilized and are currently securing the areas around the stadium, the bars and restaurants in the area of the 10th and 11th arrondissement, a part of Paris popular with young people and tourists, and the Bataclan concert hall, where at least some of the gunmen, allegedly armed with explosives, are reportedly located and holding up to 100 hostages.

Events in Paris could evolve rapidly – the standoff with the gunmen at the Bataclan concert hall could end at any moment if the French special police units believe that the gunmen are going to harm the hostages.

Though shocking, the attacks are not completely surprising. Multiple individuals from France and other European countries have traveled to Syria to join extremist groups there. As the Charlie Hebdo attacks have also demonstrated, there is a persistent risk of terrorist attacks within Europe. An important question going forward is whether the attacks were entirely grassroots in nature or whether the assailants received instruction or assistance from abroad from groups such as the Islamic State or al Qaeda. Furthermore, the recent influx of refugees into Europe from places such as Syria highlights the risk that jihadist groups could have placed some of their members among the large refugee flow in order to conduct attacks in Europe.

In an address to the nation, French President Francois Hollande said that the country will close off its borders. The French government will prioritize immediately locking down the city, protecting civilians and capturing the attackers. The next piece of that will be to close down transportation and the borders to prevent any perpetrators from escaping. Finally they will begin to investigate to uproot the parties responsible for the attacks. Notably, Hollande has officialy declared a state of emergency.


Political Fallout

The attacks will surely have political consequences. They come five days before France's only aircraft carrier, the Charles de Gaulle, is due to set sail for the Persian Gulf for actions against the Islamic State in Iraq and Syria. France has been carrying out airstrikes in Syria since late September.

Should the attacks be traced back to the Islamic State's core area of operation, France will probably deepen its involvement in anti-Islamic State operations in Syria and Iraq at a time when the Syrian battlefield in particular is becoming crowded and complicated.
From a political perspective, the attacks are a reminder of France's longstanding ethnic frictions following several months in which the focus has been on neighboring Germany. High numbers of migrants have been entering Germany from the east and south, with very few carrying on to France.
As a result, France has kept a relatively low profile in the attempts to stem the flow of migrants, though it has been present at the numerous summits on the issue and has supported Germany's push for a relocation of asylum seekers across Europe. Nevertheless, this event can be expected to strengthen the argument of those groups that have been calling for a halt in the flow of immigrants and the closing of borders in countries such as Germany, Sweden and much of Central and Eastern Europe
In the wake of these attacks, Marine Le Pen and her far-right National Front party could see their popularity rise. Le Pen kept a low profile after the Charlie Hebdo shooting in January and still saw an increase in her party's popularity because of its longstanding anti-immigration message. Hollande also saw a brief uptick in popularity after the Charlie Hebdo attack because of his reaction to the events, but a repeat of this trend is not expected because people will now question whether the anti-terrorism measures that were approved this year actually worked.

The leader of the center-right Republicans Party, Nicolas Sarkozy, also has a history of taking a strong stance on security issues; he was campaigning on the subject only last week. He is expected to battle the milder Alain Juppe for his party's nomination in the 2017 elections, and voters may swing to his side in the wake of the attacks.

Can China Reflate Its Economy?

- China now has 43 consecutive months of negative PPI.
- Chinese companies have borrowed more than $1 TRILLION denominated in dollars.
- China had a 20.4% plunge in imports last month, confirming a true and accelerating economic contraction.

China now has 43 consecutive months of negative PPI (wholesale prices). That's important deflation, and will spread to the rest of the world.

Now the global institutions think it is better to issue warnings rather than continue hiding the big problems. Only Wall Street analysts still play the "let's pretend all is well" game.

We hear all the time that China cannot have a crisis because it has $3.7 TRILLION in reserves.

We disagree with that for several reasons. First, who has counted that? Is this Chinese accounting? It may have accumulated over the years, but hasn't it been spent on extravagant and unproductive governmental projects, such as building cities where no one except the street sweepers live?

There have been huge "mal-investments" by the government over the past 5 years. There is no "return on investment" on that. Here is a great video on China's empty cities and empty shopping centers:

Furthermore, although the China government may not have lots of foreign debt, Chinese companies have borrowed more than $1 TRILLION denominated in dollars. Now that debt is rising in terms of the yuan, just as imports and exports are plunging, it becomes difficult to service that debt. That's what causes deep recessions or depressions.

China's largest coal mining company, which has a labor force of 240,000, announced that it would cut 100,000 jobs or 40% of its entire 240,000-strong labor force.

While the perma-bulls on China try to get investors to buy the China stocks, I think it is important to take a look at the true China economy, not what the China government and their mouthpieces tell you.

On October 13, the news out of China was a 20.4% plunge in imports. This is serious. It confirms a true and accelerating economic contraction.

If you consider that about 50% of world economic growth, and 80% of world commodity demand growth, came from China in the last 15 years, then you know how critical the current China crisis is to the world.

As we wrote three years ago in our book, "The Coming China Crisis", when China finally goes into recession, it will cause a Tsunami throughout the financial world.

China's Q3 GDP growth dropped a miniscule amount from 7% to 6.9% in the last quarter. How is that possible with such miserable economic statistics? No surprise for us. China has to show the world that the stock market crash didn't affect the economy, even if they have to fudge the numbers more than normal.

Amazingly, many comments from analysts were exactly what the China government wanted, namely that this is "proof" that all is well in China.

But Marketwatch.com wrote: "Analysts for years have expressed doubts about China's official data, but there was particularly intense distrust on Monday."

As you know, we look at much more important numbers in China, such as electrical consumption, rail car loadings, credit market conditions, etc. These are extremely negative.

They confirm our statements for months that the private sector in China is in a RECESSION!

Below is a chart of some these numbers, courtesy of AJ Bell.

Rail shipments in China (red line) are now down a hefty 15% on a year-over-year basis. Look especially at the drop in rail freight traffic. It is now declining at a big 15% rate. That is a better indicator of economic conditions than GDP.

China's stock markets are now seeing continued liquidation. There is basically one big buyer now, the government, through the financial entities it supports. Because sellers, such as financial firms, have seen their top executives arrested for the "crime" of selling stocks, and short sellers are arrested for "financial crimes," there is no incentive to buy.

Foreign financial firms won't buy under these conditions either, and are more interested in getting out than in getting in. The only buyers are the small speculators who think that the speculative market of earlier this year will revive. The vast majority of these speculators have little or no education, they don't look at fundamentals, and just buy a stock because it went up yesterday. They focus on the China Next Market (NYSEARCA:CNXT). The P/E ratio of this index is at a lofty 90, about five times richer than the 25 biggest China stocks.

The chart of the SHANGHAI INDEX shows the big rise in the June top propelled by government policy. The goal was to provide conditions to let the big government-owned firms refinance their excessive debt by selling shares. These firms are totally mismanaged because they are controlled by the family members of the highest officials. The boom eventually caused the bust. Almost $5 TRILLION in wealth was wiped out in the crash, equivalent to over 40% of annual China GDP.

China's private companies, not the large government-owned firms (SOEs), are in the middle of a huge credit crunch. The popular financing methods, often called the "shadow banking system", are basically closed. Therefore, companies defer payments to suppliers, which causes a negative ripple effect of defaulting loans.

US analysts tell us that China's private sector economy is recovering strongly. And then they quote some double-digit annualized gains over the past month, which to us looks like the typical "dead cat bounce" after a shock. It's meaningless.

China has been trying desperately to make the transition from an economy highly dependent on governmental "investments" to a consumer-driven economy.

About 10 years ago, 46% of the economy was the consumer. Now, after 10 years of boosting that percentage, it has actually plunged to 35%. Yes, even a communist dictatorship can't control the economy.

Bottom Line: China's "hard-landing" has arrived. The private sector economy is already in recession. The credit crunch is enormous. When a small firm can't get credit, the next step is closing down.

Governmental efforts to push "liquidity" into the system will be just as ineffective as it has been in Europe and the US. Small interest rate cuts and lower reserve requirements only work when lenders are willing to lend. But when loan defaults soar, bankers don't lend.

The stock market will be shunned by international investment firms for a long time. When a government prohibits selling of stocks during a plunge, how can any money manager defend buying the stocks for his investors?

The Global Economy is in Worse Shape than You Think

Justin Spittler

Saudi Arabia is sliding toward a crisis…

As you likely know, the price of oil has crashed since last summer. In June 2014, oil peaked at over $106/barrel. Today, oil trades at just $44…good for a 58% decline.

The oil crash has crushed oil stocks. Exxon Mobile Corporation (XOM), America’s largest oil company, has dropped 19% since July 2014. Chevron Corporation (CVX), America’s second-largest oil company, has dropped 29% over the same period. The SPDR® S&P® Oil & Gas Exploration & Production ETF (XOP), which tracks the performance of the largest U.S. energy companies, has fallen 35% in just the past year.

Things are probably going to get worse for the oil sector before they get better. As we’ve explained, oil companies have already shut down $200 billion worth of projects this year. But more shutdowns are likely coming. Energy consulting company Wood Mackenzie estimates that a stunning $1.5 trillion worth of oil projects in North America can’t make money at $50 oil.

• Saudi Arabia is the world’s largest oil producer…

It supplies 13% of the world’s daily oil production…or more than one in eight barrels produced worldwide.

No other country depends on oil money as much as Saudi Arabia does. Oil sales account for 80% of the Saudi government’s revenue. And Saudi officials have used oil revenue to pay the country’s bills for years…

High oil prices have helped Saudi Arabia earn far more than it spends. Over the past decade, the government averaged an annual budget surplus equal to 13% of the country’s gross domestic product (GDP).

• But due to the oil collapse, Saudi Arabia is now facing its first budget deficit since 2009…

The International Monetary Fund (IMF) expects the Saudi government to run a budget deficit equal to 22% of its GDP this year…and another deficit of 19% of GDP next year.

For comparison, the U.S. hasn’t run a deficit that large since World War II. Even during the worst of the 2008 financial crisis, the U.S. deficit never got higher than 9.8% of GDP.

• These huge deficits are a disaster for Saudi Arabia…

In its Middle East Economic Outlook Report, the IMF says Saudi Arabia could run out of money by 2020.

Saudi Arabia has built up a huge pile of savings from selling oil. It currently holds almost $650 billion in foreign reserves. However, the Saudi Arabian Monetary Agency has already spent $70 billion to make up for the drop in oil revenue. The nation’s foreign reserves hit a three-year low in September...and they’re likely to keep falling.

Saudi Arabia may even have to borrow money in the global bond market for the first time ever. Yesterday, Financial Times reported:

Saudi officials say the kingdom could increase debt levels to as much as 50 percent of gross domestic product within five years, up from a forecasted 6.7 per cent this year and 17.3 per cent in 2016.

• However, Saudi Arabia says it won’t stop pumping oil...

On Monday, Financial Times reported that Saudi Arabia’s state-owned oil company, Saudi Aramco, won’t stop pumping oil while prices are low. Instead, it will keep pumping oil to maintain its share of the global oil market. Unlike some countries, Saudi Arabia has oil projects that can still make money at low prices.

Another Middle Eastern country, the United Arab Emirates (UAE), also doesn’t plan to cut production while oil prices are down. Yesterday, the UAE said it will not abandon efforts to expand its oil production capacity. UAE is the world’s sixth-largest oil producer. Oil makes up 47% of its exports.

The country plans to increase its capacity from 2.9 million barrels-per-day (bpd) to 3.5 million bpd over the next two or three years. Like Saudi Arabia, UAE refuses to dial back production for fear of losing market share.

Saudi Arabia and UAE are key members of the Organization of the Petroleum Exporting Countries (OPEC), a cartel of twelve oil-producing countries. On December 4, OPEC will meet in Vienna to discuss how much oil its members will produce going forward.

It’s a bad sign for oil prices that two key members have promised to not cut production…

• E.B. Tucker, editor of The Casey Report, thinks these oil-rich countries have no choice but to keep pumping

Here’s E.B.:

Oil is the foundation of the entire Gulf region. It would be economic suicide for these countries to cut production.

Giant state-run oil companies continue to pump because oil is about the only thing these countries produce. This is why global oil production is still near record highs even though the price of oil has been cut in half. Many oil-rich countries have actually increased production.

Global oil output reached the highest level in at least 25 years in 2014, according to the U.S. Energy Information Administration.

Global oil supplies remain near record highs despite the huge drop in the price of oil. Russia, the world’s third-largest oil producer, has actually increased its oil output this year. And oil supplies in the U.S. remain far above five-year averages.

• Moving along, the world’s largest shipping company says the global economy is in worse shape than it looks...

A.P. Møller-Mærsk A/S (AMKAF), also known as Maersk, is the world’s largest container shipping company. It moves about 15% of all the consumer goods shipped around the world. This is why many investors consider it a bellwether for global trade...

Last week, the company reported a 61% drop in profits for the third quarter. It also said it was eliminating 4,000 jobs. The massive layoffs will cut Maersk’s global workforce by 17%. The company also canceled orders for several new ships.

Maersk’s CEO, Nils Smedegaard Andersen, says he had to make the cuts because the global economy is stalling.

We believe that global growth is slowing down...Trade is currently significantly weaker than it normally would be under the growth forecasts we see.

On October 6, the International Monetary Fund lowered its global GDP forecast from 3.3% to 3.1%.

The organization also lowered its growth forecast for 2016 from 3.8% to 3.6%. Andersen thinks these new forecasts are still too optimistic.

• Maersk’s warning is the latest sign of a slowing global economy...

China, the world’s second-largest economy, grew at its slowest pace since 2009 last quarter.

Meanwhile, Brazil’s currency, the real, has plummeted 32% against the U.S. dollar over the past year.

And the country’s stock market has crashed. iShares MSCI Brazil Capped ETF, which tracks 85% of Brazilian stocks, is down 35% this year.

On top of that, South Korea, a country many investors consider a “canary in the coal mine” for the global economy, recently reported a huge decline in exports.

The slowing global economy is a huge problem for Maersk and other shipping companies that move consumer goods. But there’s one segment of the shipping industry that’s booming despite the economic slowdown...

• Oil shipping companies haven’t made this much money in over seven years...

Oil shipping companies move oil from one port to another. These companies make money based on how much oil they move. Their rates are not directly tied to the price of oil.

Right now, the industry is booming because the world is flooded with oil. All that oil has to go somewhere…and it’s the oil shippers’ job to move it from sellers to buyers.

Shipping rates for oil tankers have doubled in the past 18 months. Bloomberg Business reports that rates hit a seven-year high last month.

Day rates for ships delivering Saudi Arabian crude to Japan, a benchmark route, reached $106,381 on Oct. 5, the most since July 2008, data from the Baltic Exchange in London showed. That’s about 10 times more than operators need to cover daily running costs including crew, repairs and insurance, according to estimates from Moore Stephens, an industry consultant.

E.B. Tucker, editor of The Casey Report, thinks oil-shipping rates will stay high as long as there’s a surplus of oil. He also thinks owning an oil shipping company is the best way to profit from the global oil glut.

E.B. recently told readers of The Casey Report about his favorite oil tanker company. The company has one of the largest and newest fleets in the world. It’s also paying a 13% annualized dividend.

You can get in on this investment with us by taking a risk-free trial of The Casey Report. Click here to learn more.

Chart of the Day

Unlike oil shipping rates, dry goods shipping rates haven’t recovered since the financial crisis...

Today’s chart shows the performance of the Baltic Dry Index, or BDI, since 2007. The BDI measures the price of shipping raw materials such as steel, coal, and copper. The index accounts for 23 different shipping routes and four ship sizes.

Many analysts think the BDI is one of the most important economic indicators in the world.

In February, the BDI sunk to its lowest point since 1985. The index rebounded a little in the spring before crashing again over the summer.

Today, the BDI is down 95% from its 2008 high. Meanwhile, the shipping rates for oil tankers recently hit an eight-year high.

When Financial Markets Misread Politics

Dani Rodrik
 Glasses on newspaper featuring markets and crossword. 

CAMBRIDGE – When Turkey’s Justice and Development Party (AKP) defied pundits and pollsters by regaining a parliamentary majority in the country’s general election on November 1, financial markets cheered. The next day, the Istanbul stock exchange rose by more than 5%, and the Turkish lira rallied.
Never mind that one would be hard pressed to find anyone in business or financial circles these days with a nice thing to say about Recep Tayyip Erdoğan or the AKP that he led before ascending to the presidency in 2014. And make no mistake: Though Turkey’s president is supposed to be above party politics, Erdoğan remains very much at the helm.
Indeed, it was Erdoğan’s divide-and-rule strategy – fueling religious populism and nationalist sentiment, and inflaming ethnic tension with the Kurds – that carried the AKP to victory.
Arguably, it was the only strategy that could work. After all, his regime has alienated liberals with its attacks on the media; business leaders with its expropriation of companies affiliated with his erstwhile allies in the so-called Gülen movement; and the West with its confrontational language and inconsistent stance on the Islamic State.
And yet financial markets, evidently placing a premium on stability, hailed the outcome. A majority AKP government, investors apparently believed, would be much better than the likely alternative: a period of political uncertainty, followed by a weak and indecisive coalition or minority administration. But, in this case, there was not much wisdom in crowds.
It is true that the AKP had a few good years after first coming to power in late 2002. But the party’s room for mischief was constrained by the European Union and the International Monetary Fund abroad and secularists at home. Once those limits were removed, Erdoğan’s governments embraced economic populism and authoritarian politics. Investors’ apparent optimism following the AKP’s victory recalls Einstein’s definition of insanity: doing the same thing over and over and expecting a different outcome.
Turkey certainly isn’t the only case where financial markets have misread a country’s politics.
Consider Brazil, whose currency, the real, has been hammered since mid-2014 – much worse than most other emerging-market currencies – largely because of a major corruption scandal unfolding there. Prosecutors have revealed a wide-ranging kickback scheme centered on the state-owned oil company Petrobras and involving executives, parliamentarians, and government officials. So it may seem natural that financial markets have been spooked.
Yet the most important outcome of the scandal has been to highlight the remarkable strength, not weakness, of Brazil’s legal and democratic institutions. The prosecutor and judge on the case have been allowed to do their job, despite the natural impulse of President Dilma Rousseff’s government to quash the investigation. And, from all appearances, the probe has been following proper judicial procedures and has not been used to advance the opposition’s political agenda.
Beyond the judiciary, a slew of institutions, including the federal police and the finance ministry, have taken part and worked in synch. Leading businessmen and politicians have been jailed, among them the former treasurer of the ruling Workers’ Party.
Financial markets are supposed to be forward-looking, and many economists believe that they allocate resources in a way that reflects all available information. But an accurate comparison of Brazil’s experience with that of other emerging-market economies, where corruption is no less a problem, would, if anything, lead to an upgrade of Brazil’s standing among investors.
Going back to Turkey, leaked recordings of telephone conversations have directly implicated Erdoğan and his family, along with several government ministers, in a hugely lucrative corruption ring involving trade with Iran and construction deals. It is an open secret that government procurement is being used to enrich politicians and their business cronies. From all indications, corruption reaches higher and is more widespread than in Brazil.
But today it is the police officers who led the corruption probe against Erdoğan who are in jail. Some of the media outlets that supported the probe have been closed down and taken over by the government.
The AKP argues that the police officers are adherents of the Gülen movement and that the investigation was politically motivated, aiming to unseat Erdoğan. Both claims are most likely true.
But neither justifies the blatant lawlessness with which the AKP government has clamped down on the corruption allegations. The upshot is that Turkey’s institutions, unlike Brazil’s, are being captured and corrupted to an extent that will hamper economic growth and development for years to come.
Nor is Turkey the only country where large-scale corruption is left unchecked. In Malaysia, Prime Minister Najib Razak has been at the center of a major political scandal since nearly $700 million in unaccounted funds was found in his bank accounts. Billions of dollars are said to be missing from the government investment fund 1MDB, which Najib controlled. Najib has promised a full reckoning, but he has sacked Malaysia’s attorney general, who was investigating 1MDB.
In Latin America, Argentina and Mexico both rank among the bottom half of countries in controlling corruption and maintaining transparency – much lower than Brazil. The dramatic abduction and gruesome killing in 2014 of 43 students north of Mexico City is only the latest example of collusion among the country’s criminal gangs, police, and politicians.
We know from painful experience that financial markets’ short-term focus and herd behavior often lead them to neglect significant economic fundamentals. We should not be surprised that the same characteristics can distort markets’ judgment of countries’ governance and political prospects.

The $630 Trillion Derivatives Market: A Snowflake Away From Complete Meltdown?

- The over-the-counter derivative market is huge on a notional contract basis and is dominated by large cap universal banks. 
- Some investors perceive this as a "black swan" event risk that one day will potentially wipe out the capital of the whole banking system. 
- Are those fears grounded in reality or is it just misguided interpretation by not so well-informed investors? 
- In this article, I will endeavor to tackle this question heads on.
Albert Einstein once commented:

If the facts don't fit the theory. Change the facts.

When it comes to the OTC derivatives market, the headline size in excess of $600 Trillion dollar seems to downright frighten some investors. Perhaps it's the sheer size of the market coupled with somewhat fresh memories of Lehman Brothers collapse and AIG (NYSE:AIG) mishaps - it seems to me though, that some investors prefer to ignore the facts and readily believe that the derivatives market will be the culprit for the next financial crisis.

In a recent and popular editor's pick article named "Deutsche Bank: Just A Snowflake Away" - the author focused on the risks apparent with Deutsche Bank's (NYSE:DB) 52 Trillion euro notional derivative exposure as of the end of 2014. The author than explains that he is shorting the stock on that basis and as a hedge against a black swan event. For many unsophisticated investors (who are not banking experts), the article reads really well - in fact, if I didn't understand the facts either I might have joined the author in shorting the stock (as some other commenters seem to have done).

The issue with the article though, is that the author is not an expert on derivatives (self-admittedly so) and thus perhaps inadvertently, largely misinterpreted the facts and associated risks.

Additionally, in my most recent Citigroup (NYSE:C) article, one of the readers noted the followings:
I haven't looked at the Derivative pile in a while. Last I did it was about $750 Trillion of notional paper. We presume the vast majority of that is hedged/offset, although the credit side of it cannot be fully hedged ( the round robin argument, for example, is how do you assign a credit risk to Citi as a counter-party when you don't know what Citi is "worth"?). Even if we assume as little as 10% of the $750 Trillion is naked (no, nobody would EVER do that...would they?) and then we assume even that 10% of that 10% fails due to some unknown event, guess what? The entire bank industry capital is wiped out...and then some! 
That is the sort of risk thinking which you need to apply to these zombie banks in order to understand why they trade at "arguably" cheap valuations.
The views articulated above are not uncommon and even the pros seem to reinforce these - for example, in a 2013 Time magazine piece, the author suggested that "derivatives may be the biggest risk for the global economy" - essentially running similar arguments to above.

Clearly, many believe the risks of "big numbers" derivatives will come home to roost one day and that the banks that generate the lion share of notional derivatives contracts [including JP Morgan (NYSE:JPM), Citigroup, Bank of America (NYSE:BAC), DB, HSBC (NYSE:HSBC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and Barclays (NYSE:BCS)] are therefore not investable.

Are these fears grounded in reality or just a tempest in a tea cup?

Let's delve into the detail.

The Global OTC Derivatives market

The Bank for International Settlements (BIS) periodically releases OTC markets' statistics - as of the end of 2014, their report revealed the followings:

(click to enlarge)

A few explanations relating to above charts:
  • The left-most chart represents the 'scary' number of $630 Trillion of notional principal derivatives contracts.
  • The middle chart represents a snapshot of gross market values(in other words, gross sum of mark-to-market of existing derivatives contracts). This is a fraction of the notional exposure that people fear so much.
  • The right-most chart reflects the gross credit exposure post netting of legally-enforceable bilateral contracts
So the net exposure after netting is just over $3 Trillion (that is assuming all market counterparties one deals with actually default).

But what about collateral?

Most OTC derivatives contracts are governed by a master agreement published by the International Swaps and Derivatives Association (ISDA). In the majority of cases, ISDA also includes a Collateral Securities Agreement (CSA) that governs the posting of collateral by the parties to the contract. As such, if the mark-to-market of a contract moves adversely than the affected party must post collateral (typically in the form of cash or other marketable securities). Hedge funds for example, are typically required to provide a margin security upfront.

ISDA, in a June 2013 report, highlights the followings impact of collateralization:

(click to enlarge)

Considering December 2012, figures - the gross credit exposure (after netting) is estimated to be $3.6 Trillion. However, once collateral posted is included the gross credit exposure further reduces to 1.1 Trillion.

In the same report as above, ISDA highlights losses (Credit exposure only) made by U.S. banks in 2007-2011.

(click to enlarge)

Note that the Lehman exposure is reflected in the 2008 numbers whereas $1.6 billion exposure to monoline has been included in the 2011 figures - clearly, not material amount to the industry.

Explaining interest rate swaps

As can be seen from above, more than 80% of the notional derivatives contracts relate to interest rates derivatives. A simple example of that, is a plain vanilla interest rate swap - where counterparty A may be paying LIBOR + 1% to counterparty B, who in turn pays counterparty A a fixed 2% periodic payments. The agreement will be based on a notional amount, say $1 billion and typically, the parties may hedge their interest rate risk with another counterparty or simply seek to hedge an underlying exposure. Should there be a significant move up in interest rates, than it is probable that counterparty A will need to post collateral (given its variable payments over life of the contract will increase).

There is really nothing controversial with these type of OTC derivatives and are part and parcel of the efficient operations of capital markets. These form the lion share of the OTC derivatives markets (over 80%).

How about the regulators?

To think that in today's intrusive banking regulation environment - the powers to be would allow such a ticking bomb of an exposure (as some would have you think), sounds rather naive to me. In fact, Basel III specifically deals with counterparty risks (by increasing capital requirements) and further incentivizes the use of clearing houses for derivatives trading (by specifying lower capital charges compared with uncleared derivatives).

Finally, the banks themselves actively monitor and manage their market and counterparty risks - there are very large middle and back-office teams in banks that daily value these exposures and ensure any credit and market risks are within well-defined limits.

Final thoughts

Evidently the OTC derivatives market is not very well-understood by ordinary investors. It is important to note that the large reported notional exposures are just that (large notional numbers) and have very limited relational connection to actual risks.

In fact, when I consider the investment case in the large cap banking space - I am much more concerned with the good old credit cycle as opposed to losing sleep over notional derivatives numbers.