INSTABILITY / CREDIT BUBBLE BULLETIN

Instability

Doug Nolan


With the Turkish lira down another 6.6% in Monday trading, global "Risk Off" market instability was turning acute. The U.S. dollar index jumped to an almost 14-month high Monday, as the Turkish lira, Argentine peso, Indian rupee and others traded to record lows versus the greenback. The South African rand "flash crashed" 10%, before recovering to a 2.3% decline. Brazil's sovereign CDS jumped 14 bps Monday to a six-week high 252. Italian 10-year yields jumped 11 bps in Monday trading to 3.10%, near the high going back to June 2014, as the euro declined to one-year lows.

The Turkish lira surged 8.4% Tuesday, jumped another 6.8% Wednesday and then gained an additional 1.9% Thursday. Wild instability then saw the Turkish lira drop 3.1% during Friday's session, ending the week up 6.9%. Qatar's $15 billion pledge, along with central bank measures, supported the tenuous lira recovery.

August 17 - Wall Street Journal (Lingling Wei and Bob Davis): "Chinese and U.S. negotiators are mapping out talks to try to end their trade impasse ahead of planned meetings between President Trump and Chinese leader Xi Jinping at multilateral summits in November, said officials in both nations. The planning represents an effort on both sides to keep a spiraling trade dispute-which already has involved billions of dollars in tariffs and comes with the threat of hundreds of billions more-from torpedoing the U.S.-China relationship and shaking global markets. Scheduled midlevel talks in Washington next week, which both sides announced on Thursday, will pave the way for November. A nine-member delegation from Beijing, led by Vice Commerce Minister Wang Shouwen, will meet with U.S. officials led by the Treasury undersecretary, David Malpass, on Aug. 22-23. The negotiations are aimed at finding a way for both sides to address the trade disputes, the officials said, and could lead to more rounds of talks."

Apparently, global "Risk Off" attained a level of momentum that compelled Chinese and Trump administration officials to jointly calm the markets. After trading as low as 24,966 in Wednesday trading, the Dow rallied more than 700 points to end the (option expiration!) week at 25,669. For yet another week, U.S. markets were rewarded for disregarding mounting risk. Extraordinary market complacency is at this point No Conundrum. A Trump and Xi trade-focused meeting in late-November is conveniently timed soon after the midterms.

And while U.S. stocks rallied on happy prospects, the same cannot be said for global markets. The South African rand sank 3.8% this week to the low versus the dollar since June 2016. Brazil's real declined another 1.2% this week, trading the weakest against the dollar going back to early-2016. The Colombian peso, Chilean peso and Argentine peso all fell at least 2.0% this week. European equities were under pressure. Italian banks fell 3.2%, with European banks down 3.0%. Hong Kong's Hang Seng Financial index lost 4.1%.

The Shanghai Composite sank 4.5% this week, trading Friday at the lowest closing level since December 2014. China's renminbi traded to 6.93 (vs. $) in Wednesday trading, rapidly approaching the 2016 low of 6.96 to the dollar. The renminbi has now declined 8.7% from May 30th trading highs and 6.9% since June 14th. Increasingly fearful of a disorderly devaluation, Chinese officials implemented measures this week to support their sickly currency.

August 13 - Bloomberg: "China's broadest measure of new credit slowed, underlining concerns about the economy that have prompted authorities to start doing more to support growth. Aggregate financing stood at 1.04 trillion yuan ($151bn) in July… That was slower than the 1.39 trillion yuan in June, using the central bank's new calculation method for this data. The new index includes more types of credit and so isn't comparable to Bloomberg's survey or the data reported in previous months. New yuan loans stood at 1.45 trillion yuan, versus a projected 1.275 trillion yuan and 1.84 trillion yuan the previous month. Broad M2 money supply rose 8.5%, rebounding from record low expansion in June."

The PBOC has somewhat tweaked China's aggregate Credit data. Total Aggregate Financing for July ($151bn) was down 13% from July 2017. After 2018's first seven months, y-t-d Total Aggregate Financing of 10.137 TN yuan ($1.475 TN at current exchange rates) is running 18% below last year's comparable period. Beijing's crackdown has stopped shadow banking in its tracks, with July seeing another contraction in key shadow lending components.

And while bank lending moderated somewhat from a huge June, New (bank) Loans continue to expand rapidly. At 1.450 TN yuan ($210bn), New Loans for the month were up 76% compared to July 2017's 826 billion yuan. New Loans have expanded 10.479 TN ($1.52 TN) y-t-d, up 19% from comparable 2017. To be sure, the household borrowing binge runs unabated. At 44.756 TN yuan, China's Household Debt was up 19% over the past year and 47% in two years.

August 14 - Bloomberg: "There's no stopping China's property market. New-home prices rose at the fastest pace in 22 months in July, climbing 1.2% from the previous month… The jump in values in third-tier cities was the biggest in data going back to 2009, signaling the potential for the government to roll out more housing curbs in a cooling campaign that began more than two years ago. The dilemma for officials is how to restrain prices without tanking the property sector during a broader economic slowdown. 'A persistently high home price is going to lead to a very strong response from the government,' Phillip Zhong, a Hong Kong-based equity analyst at Morningstar… Asia, said… 'We are going to expect to see more tightening measures being put in place.'"

"China's state planning authorities pledged on Wednesday to keep debt levels under control as it expressed confidence that the year's growth target will be achieved in spite of the trade war with the US."

Accepting that growth has slowed and recognizing trade risks, the bullish consensus view holds that China retains the tools to ensure uninterrupted steady growth. Most believe China is adeptly managing Credit growth. I believe their policy dilemma is in the process of turning much more challenging.

Seemingly lost in the discussion is the reality that China's historic economic boom is turning dangerously unbalanced. While Beijing has moved aggressively to contain high-risk "shadow" lending, it has remained too timid in restraining household borrowing. Indeed, China is now facing full-fledged mortgage finance and apartment Bubbles - in the face of rapidly waning prospects elsewhere. Beijing seeks to continue cracking down on risky Credit, while pursuing measures to stimulate a slowing economy. Chinese officials would hope to spur ample productive Credit and sound economic investment to sustain the boom. The harsh reality is there are limited opportunities for both. They're stuck, for the duration, with risky non-productive Credit and additional malinvestment and overcapacity.

August 13 - Reuters (Yawen Chen and Kevin Yao): "China's property investment growth accelerated to its quickest pace in nearly two years in July, driven by faster transactions and stronger developer appetite for land as funding conditions improved. Real estate investment rose 13.2% in July from the same period a year earlier, the fastest pace since October 2016 and higher than June's 8.4% rise… It grew 10.2% in the first seven months of the year."

Runaway mortgage finance Bubbles turn increasingly precarious. Late in the cycle, systemic risk grows exponentially. As we saw unfold during the U.S. mortgage finance Bubble, there is a ("Terminal Phase") rapid acceleration of loan growth of rapidly deteriorating Credit quality. The unparalleled Chinese real estate Bubble is backed by, too commonly, poorly constructed residential complexes. If the P2P lending Bubble collapse is causing public angst, just wait until apartment prices start sinking.

While Beijing has over the years made numerous attempts to tighten real estate lending, mortgage rates have remained significantly below the rate of apartment price inflation. I would argue that China's real estate Bubble is today acutely vulnerable to an unexpected jump in rates and/or tightening of lending conditions.

August 13 - Bloomberg (Yalman Onaran): "In 1988, 9 of the 10 largest banks in the world were Japanese. Three years later the country's financial system, along with its lenders, collapsed, sending Japan into its infamous lost decade (or three, considering the country is still struggling to escape deflation and low growth). The nine Japanese companies in the top ranks by assets 30 years ago have since consolidated into four successors. Only one turns up in this year's ranking. By 2007 all of the top 10 slots were filled by U.S. and European lenders. A year later the subprime mortgage meltdown hit the U.S. The sovereign debt crisis followed in Europe. Four of the 10 had to be bailed out by their respective governments… U.S. and European economies, like Japan's, have contended for most of the past decade with low growth. It's 2018, and the rankings teem with Asian banks again. This time the top four by assets are Chinese."

There was further confirmation this week of the faltering global Bubble thesis. Monday saw acute instability in EM currencies, in particular. With the Argentine peso down as much as 4.4%, the Argentine central bank raised interest rates 500 bps (to 45%) to support the peso. Indonesia Wednesday unexpectedly raised rates another 25 bps (to 5.5%) after the rupiah sank to almost three-year lows. And with "hot money" fleeing EM, worries for the sustainability of the Hong Kong dollar peg returned.

August 13 - Bloomberg (Emma Dai): "Hong Kong's interbank borrowing costs climbed across the curve, as the city's currency interventions continued overnight, taking this week's total to HK$16.8 billion ($2.1bn). The three-month Hong Kong dollar interbank offered rate, known as Hibor, jumped by the most in more than two months… The Hong Kong Monetary Authority bought HK$14.6 billion of local dollars Wednesday…, after the currency declined to the weak end of its trading band."

At $432 billion, the Hong Kong Monetary Authority is viewed by the markets as having sufficient resources to indefinitely maintain the peg to the U.S. dollar. But with faltering global markets and increasingly nervous officials in Beijing, analysis has turned more complex. With a massive and vulnerable financial sector, along with its own formidable real estate Bubble, Hong Kong could find itself in the crosshairs of faltering global, EM and Chinese Bubbles.

August 13 - UK Telegraph (Ambrose Evans-Pritchard): "Hong Kong's housing boom is starting to fray as monetary tightening by the US Federal Reserve forces the enclave's authorities to tighten credit. A rash of home buyers has pulled out of purchases at the last moment despite losing large deposits, a sign that financial stress is biting harder or that fear is creeping into the market… This is happening as regulators in mainland China clamp down on capital outflows through interbank accounts using the Hong Kong-Shanghai Connect, aiming to stem any further fall in the yuan. The People's Bank (PBOC) is squeezing liquidity in the offshore Hong Kong market and has lifted the risk requirement ratio for forward yuan contracts to 20pc. This makes it harder to short the Chinese currency." 
The late-week rally in U.S. equities did not pull the metals out their deep funk. Copper sank 4.2% this week, pushing 2018 losses to almost 20%. "Zinc heads for Worst Week Since 2011," closing Friday down 6.2%. Lead dropped 5.2%, and Tin fell 4.1%. Aluminum declined 3.6%. Precious metals were only somewhat firmer. Platinum fell 4.7%, Silver 3.3% and Gold 2.2%.

The metals are surely not responding to currency issues in Turkey. Turkey is, after all, only symptomatic of the faltering global Bubble. This week provided important evidence of "Risk Off" dynamics turning more systemic for the emerging markets. With China's stocks and currency under heavy pressure again this week, the negative feedback loop between EM and China has turned quite threatening.


August 17 - Bloomberg: "China's government bonds declined as funding costs rebounded amid expectations of rising supply, giving the 10-year yield its biggest two-week advance since December 2016. The yield on notes due in a decade rose four bps to 3.65% Friday, taking its two-week increase to 19 bps… Bond futures also declined… The Ministry of Finance on Tuesday urged local governments to accelerate bond issuance to support economic expansion, spurring speculation that supply will jump in the coming weeks. The overnight repurchase rate surged 76 bps this week, after the People's Bank of China suspended reverse-repurchase operations for 18 days in a row… 'The previous market-supportive factors such as ample liquidity and gloomy economic outlook seem to have waned this week,' said Li Qilin, chief macroeconomic researcher at Lianxun Securities Co."

Beijing faces a huge dilemma. The faltering EM Bubble poses significant risk to the unbalanced Chinese economy. Moreover, global de-risking/deleveraging dynamics exacerbate risk to Chinese finance and the renminbi. The policymaker impulse is to orchestrate another round of fiscal and monetary stimulus. Meanwhile, China's historic mortgage finance and apartment Bubbles maintain powerful momentum. Stimulus measures at this stage of the cycle pose extreme risk. For one, it would surely push non-productive Credit growth to perilous extremes. Second, the combination of additional system liquidity and escalating systemic instability would exacerbate already significant risk of a disorderly Chinese currency devaluation.

That things look "terrible" in China, in contrast to obvious greatness in the U.S., is to provide the Trump administration a decisive trade negotiation advantage. And I can see the perceived benefit of scheduling low-level trade discussions ahead of a big trade meeting with the Chinese after the midterms. A temporary "truce" would be viewed as bolstering U.S. equities and supporting "great again" campaigning into November. I'm not, however, convinced this gambit will reverse the bursting of the EM Bubble. And I don't believe pushing serious negotiations out to November will in anyway resolve China's deteriorating financial and economic positions.

All in all, it was another ominous week for highly unstable global financial markets. Bubbles bursting, Bubbles faltering and Bubbles inflating. Global financial and economic prospects are dimming rapidly. I would be less apprehensive if U.S. equities (and Chinese apartment prices!) were adjusting to new realities. But it's not as if Bubble resilience is without precedent.

The S&P500 peaked on July 20, 1998, just weeks prior to near global financial meltdown. Back on August 25, 1987, the S&P hit a record high about six weeks before the "Black Monday" market crash. And looking back to fateful 1929, the DJIA traded to a record high on September 1st, with the Great Crash erupting the following month. Those that have studied the late-twenties should recognize ominous parallels. How on earth were they so completely blindsided?