CRISIS OF CONFIDENCE / CREDIT BUBBLE BULLETIN

Crisis of Confidence

Doug Nolan


Global markets are indicating heightened vulnerability. Thursday trading saw the S&P500 decline 1.54%, the second biggest decline of 2017. The session also saw the junk bond market under pressure. A notable $2.18bn of junk fund outflows this week spurred the headline, “Risk Exodus Gets Real With Biggest Fund Redemptions in 6 Months.” Currency markets are increasingly unstable. The euro traded to 1.1838 on Monday and fell to a trading low of 1.1662 on Thursday. The dollar/yen rose to 110.95 on Wednesday before reversing course to a near nine-month low of 108.60 during Friday trading. Gold traded to $1,300 in early Friday trading, the high going back to the election. Early-week market relief over the North Korean situation quickly shifted to unease over festering domestic issues.

August 16 – Wall Street Journal (Gabriel Wildau): “One of the most influential analysts of China’s financial system believes that bad debt is $6.8tn above official figures and warns that the government’s ability to enforce stability has allowed underlying problems to go unchecked. Charlene Chu built her reputation as China banking analyst at credit rating agency Fitch, where she was among the earliest to warn of risks from rising debt, especially in the country’s shadow banking system… In her latest report, Ms Chu estimates that bad debt in China’s financial system will reach as much as Rmb51tn ($7.6tn) by the end of this year, more than five times the value of bank loans officially classified as either non-performing or one notch above. That estimate implies a bad-debt ratio of 34%, well above the official 5.3% ratio for those two categories at the end of June… ‘What I’ve gotten a greater appreciation for is how everything is so orchestrated by the authorities,’ she said. ‘The upside is that it creates stability. The downside is that it can create a problem of proportions that people would think is never possible. We’re moving into that territory.’”

As is typical, China’s Credit expansion slowed during the month of July. Growth in Total Aggregate Social Finance declined to about $180bn. New loans increased $124bn, the slowest rise since last November - but still stronger-than-expected and much stronger than July 2016. In a data point to follow closely, loans to households (mostly mortgages) slowed from June’s strong pace. Shadow banking contracted during June (first since October), although y-o-y growth remained a robust 16.5%. At 9.2%, y-o-y money supply growth was the slowest in decades.

It’s worth mentioning that Chinese data generally disappointed this week. Retail sales (up 10.4%) were down marginally from June and were below estimates (10.8%). Growth in Fixed Investment (8.3%) and Industrial Production (6.4%) were similarly down m-o-m and below forecasts.

August 13 – Bloomberg: “China’s home sales grew last month at the slowest pace in more than two years amid regulators’ moves to rein in soaring prices. The value of new homes sold rose 4.3% to 779 billion yuan ($117bn) in July from a year earlier… The increase is the smallest since March 2015, when the home market started to take off on policies to encourage demand from buyers.”

There is significant uncertainty associated with Chinese Credit and economic prospects.

Through July, the growth in Total Aggregate Finance is tracking 20% above 2016’s record level. The first-half boom in Chinese Credit growth – especially household mortgage borrowings – goes a long way in explaining economic resiliency. There are certainly indications that Chinese officials are increasingly concerned with overall system Credit growth, but there is also the view that no tough measures will be adopted that would risk instability heading into this fall’s communist party gathering.

August 15 – Financial Times (Tom Mitchell): “China’s economy will grow faster than expected over the next three years because of the government’s reluctance to rein in ‘dangerous’ levels of debt, the International Monetary Fund warned… In an annual review of the world’s second-largest economy, IMF staff said China’s annual economic growth would average 6.4% in 2018-20, compared with a previous estimate of 6%. The IMF is also predicting that the Chinese economy will expand 6.7% this year, up from its earlier forecast of 6.2% growth. The Chinese government, which pledged to double the size of the economy between 2010 and 2020, has tolerated a rapid run-up in debt in order to meet its target. ‘The [Chinese] authorities will do what it takes to attain the 2020 GDP target,’ the IMF said. As a result, the IMF now expects China’s non-financial sector debt to exceed 290% of GDP by 2022, compared with 235% last year. The fund had previously estimated that debt levels would stabilise at 270% of GDP over the next five years.”

Looking out past the next few months, there’s significant uncertainty associated with Chinese policymaking, finance and economic performance. And before we segue to the mess in Washington, there are as well major near-term uncertainties with respect to global monetary management. There were indications this week that both the ECB and Federal Reserve lack the confidence and consensus necessary to communicate a plan for unwinding what have been years of unprecedented monetary stimulus. It’s not confidence inspiring.

August 17 – Wall Street Journal (Todd Buell): “The European Central Bank is wary of pulling the plug too soon on its large bond-buying program, and worried that any move in that direction will push the euro higher, the accounts of its latest meeting showed… The comments suggest that ECB President Mario Draghi will move with immense caution as he approaches two major public appearances in the coming weeks…”

August 17 – Bloomberg (Craig Torres): “Federal Reserve officials are looking under the hood of their most basic inflation models and starting to ask if something is wrong. Minutes from the July 25-26 Federal Open Market Committee meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth. The central bank has missed its 2% price goal for most of the past five years. Still, a majority of FOMC participants favor further rate increases. The July minutes showed an intensifying debate over whether that is the right policy response. ‘These minutes to me were troubling,’ said Ward McCarthy, chief financial economist at Jefferies… ‘They don’t have their confidence in their policy decisions; and they don’t have confidence that they can provide the right kind of guidance.’”

August 16 – Wall Street Journal (David Harrison): “New doubts over sagging inflation in the past few months are driving a split at the Federal Reserve about the timing of the next increase in interest rates. The internal debate raises the possibility that the Fed could deviate from its plans for a third rate increase this year. Soft inflation has bedeviled Fed officials, forcing them to pull back on plans to raise rates multiple times in 2015 and 2016. Minutes from the July 25-26 meeting released Wednesday reveal growing concern among some officials that recent soft inflation numbers could be a sign that something has fundamentally changed in the economy, leading them to suggest holding off on raising rates again for the time being.”

China is in an historic Bubble, and this has created extraordinary uncertainty for the future. Global central banks have been engaged in an unprecedented and prolonged monetary inflation, and this has created extraordinary uncertainty for the future. An important facet of the problem is that years of extreme monetary stimulus have ensured that way too much “money” has gravitated to highly speculative global securities and derivatives markets. This has profoundly distorted inflationary dynamics in the securities markets as well as in the global economy overall.

Central bankers are increasingly perplexed as to how to proceed with normalization. While markets remain convinced that monetary policies globally will stay loose indefinitely, I believe indecision at the major central banks creates uncertainties that will increasingly weigh on risk-taking (especially with leverage). Watch the currencies. With the backdrop set, let’s move on to Washington.

The Trump Administration now confronts a full-fledged Crisis of Confidence. Even Republican supporters are calling for radical change. And it would at this point appear that some degree of radical departure will be required for the President to muster enough support to move forward with his agenda. I assume the administration will adopt a razor-sharp focus on tax cuts and reform in an attempt to stabilize a sinking ship.

As for the stock market, this week saw the “Trump Rally” conveniently morph to the “Cohn Rally.” Rumors of a Gary Cohn departure were said to be behind market selling pressure. It would be shocking to see Cohn abandoned Washington. He may now be the second most powerful individual in the country, with the most powerful enveloped in mayhem.

Importantly, “Risk Off” is gathering some momentum. Over recent years we’ve witnessed the markets repeatedly disregard – or at least downplay – major political developments. For the most part, markets were this week generally resilient in the face of a distressing and rapidly deteriorating political landscape. So far, the monetary and economic backdrops have remained constructive.

This week saw a stronger-than-expected reading in the Empire Manufacturing Index. Monthly Retail Sales were stronger-than-expected, as was the National Home Builders Housing Market Index (although Starts and Permits lagged). The weekly Bloomberg Consumer Comfort index rose to the highest level since 2001. The Bloomberg National Economy Expectations index surged back to near multi-year highs.

It’s worth noting that 10-year Treasury yields declined less than four basis points during Thursday’s stock market swoon. For a week that saw U.S. risk markets under some pressure and the VIX spike for the second straight week, it was notable that Treasury yields rose slightly. This should raise concerns that Treasuries may not provide much of a hedge during the next bout of “Risk Off.” And if Treasury gains are limited in the event of “Risk Off,” what are the ramifications for an overheated corporate debt marketplace?

Unprecedented risk has accumulated across the markets over the past nine years. “Money” has flooded into passive strategies that are essentially a speculation that the bull market – in equities and corporate Credit – will run unabated. Myriad derivatives strategies have flourished, with the proliferation of many products that are essentially writing market insurance (“flood insurance during a drought”).

Markets have experience “flash crashes” in the recent past, so I assume there will be more. For good reason, market participants these days presume that central banks will use their balance sheets to ensure that markets remain abundantly liquid. At the same time, the reality is that global central bankers have limited policy tools available in the event of market instability. The downside of delaying policy normalization (for years) is that we’re in the late innings of a global Bubble yet rates remain at or near zero around the globe. Central banks have little room to cut interest-rates, while pressure builds to wind down extraordinary balance sheet operations.

I am somewhat reminded of when accounting fraud issues precluded Fannie and Freddie from providing the MBS marketplace a liquidity backstop. It was a pivotal development, though market players were content to ignore ramifications for several years. With booming markets anticipating liquidity abundance indefinitely, it wasn’t until the 2008 de-leveraging episode that the absence of the GSE backstop bid mattered.

I don’t want to get too far ahead of myself here, but it’s worth noting that bank CDS has begun to price in rising risk. For the most part, CDS price reversals are modest and come from multi-year lows. But bank CDS risk has been increasing now for going on a month. And on a global basis, it’s kind of the same old potential problem children that have experienced the biggest gains – Dexia, Deutsche Bank, Societe Generale, UBS, BNP Paribas and Credit Suisse. Some of the big European banks saw CDS rise to two month highs this week. U.S. banks are now also seeing a modest rise in CDS prices, in many cases ending the week at one-month highs. It’s worth noting as well that the broker/dealer equities index (XBD) declined more than 2% Thursday and was hit 1.4% for the week. Japan’s TOPIX Bank Index dropped 2.4% this week.

August 15 – Financial Times (Eric Platt): “Amazon sealed the year’s fourth-largest corporate bond sale on Tuesday as the technology and online retail group locked in $16bn to fund its takeover of premium grocer Whole Foods… The company, founded by Jeff Bezos, borrowed the $16bn across seven tranches, ranging from three- to 40-year maturities. Orders for the multibillion-dollar deal climbed to nearly $49bn as banks closed their books…”

I’ll also be closely monitoring indicators of corporate Credit risk. According to Dealogic, August’s $110 billion of U.S. corporate debt sales pushed y-t-d issuance to $1.2 TN. And while corporate debt prices for the most part held their own this week, spreads have widened meaningfully from July. Even the investment-grade market is indicating a changing backdrop.

I feel compelled to offer brief comments on the sad state of our great nation. Sure, the stock market is close all-time highs and unemployment is at multi-year lows. Business and consumer confidence are strong, which is understandable considering the prolonged Bubble period. That there are such widespread feelings of acrimony and animosity - and that our country can be so bitterly divided - in the midst of today’s economic/market backdrop must be alarming to anyone paying attention. I hate to think of the environment after the Bubble bursts – the type of hostility and insecurity that would seem to ensure an epic bear market.

It’s almost unbelievable that the November election offered a choice between about the two most divisive figures in American politics. It’s as if there are two completely divergent and irreconcilable views of how the world works, how the economy should operate and the role of the federal government. Somehow we’ve gotten to the point where there cannot even be a civil discussion – let along a meeting of the minds - on the most basic issues.

As has become a popular (Daniel Moynihan) quote to recite, “Everyone is entitled to their own opinions, but they are not entitled to their own facts.” These days, facts are in dispute and they’re often disputed hatefully. Okay, let’s assume the Administration does see some legislative success. What happens after the mid-terms?

It’s too easy to blame the political class. Yet politicians do what politicians do. There should be little doubt that the boom and bust dynamics experienced over recent decades have taken a toll on our nation’s social and economic fabric. And while many want to blame “globalization,” I believe much that we label “globalization” would be more accurately understood as fallout from years of unfettered global finance. Could NAFTA have been as destabilizing to U.S. manufacturing without endless cheap finance flooding into Mexico (and EM more generally). How dominant would China be today without essentially limitless amounts of virtually free “money” to finance over-investment the likes of which the world has never experienced?

I strongly believe that unfettered finance has been instrumental in the long period of U.S. deindustrialization – the transformation from a manufacturing powerhouse into an experiment in a consumption and services-based economic structure. Bubbling securities markets and booming Wall Street finance were integral to this fateful structural shift.

Millions of skilled jobs have been lost, replaced by millions of service sector positions where workers can toil for years and still possess skills of only marginal value. It’s now been decades of malinvestment and structural impairment. There has been profound overinvest in almost all things consumption related, which impinges both economic productivity and wage growth.

Unimaginable monetary stimulus has spurred asset inflation and spending, but we’re now left with a historic Bubble and only deeper structural maladjustment.

Understandably, much of the population feels they’ve been shortchanged or even cheated. The ongoing inequitable redistribution of wealth becomes only more conspicuous as those fortunate enough to participate in the Bubble accumulate incredible wealth. There’s a general sense that the system is unfair and untrustworthy. Too many citizens no longer trust Washington and Wall Street, and they’re as well losing trust in our institutions more generally. There’s tremendous deep-seated anger for large groups of citizens that feel cheated and marginalized. Two-decades of spectacular boom and bust dynamics have left a tremendous amount of damage.

It’s all been so frustratingly predictable. Certainly not for the first time in history, the scourge of unsound money and inflationism has been so subtle that it goes virtually undetected. Instead of being appreciated as the root cause of economic, social, political and geopolitical trouble, monetary inflation is viewed as integral to the solution. Just a little more – just one more round of monetary inflation will do the trick and we’ll get back to normal. Right… It ensures hopeless addiction – with tremendous collateral damage. It was a troubling week where the absurdity of it all seemed on full display.