Surprises in store….Jan 28, 2016·Alasdair Macleod
The month of January has been a wake-up call for complacent equity investors.
From the peaks of last year stock indices in the major markets have fallen 10-20%, give or take. On their own, these falls could be read as healthy corrections in an ongoing bull market, and doubtless there are investors hanging on to their investments in the hope that this is true.
The conditions that have led to the fall in equities are tied up in the realization that global economic activity has contracted sharply. This is now reflected in the performance of medium and long-dated US Treasury bonds, where yields have declined, despite a rise in the Fed Funds Rate. The problem equity markets face is not just a reaction to growing evidence of recession, it is that the normal Fed solution, lower interest rates, is exhausted. The Fed's put option is now being questioned.
Far from this being an equity correction in the early stages of a credit cycle, which is what the small step towards normalization of US interest rates would have had us believe, the evidence points to a developing debt crisis, whose future course we can now tentatively map, though there are important differences to observe compared with a normal credit cycle.
In a normal credit cycle, bank credit stimulated by artificially low interest rates leads to rising consumer prices and rising bond yields. The recovery in nominal GDP growth supports equity prices, which will have already anticipated recovery, and benefited from the lower interest rates set earlier by the central bank. Eventually the equity bull market starts to lose momentum, when it becomes apparent that monetary policy favours tightening. Interest rates are then increased by the central bank to the point where demand for money is curtailed and the economy stops growing due to debt liquidation.
The dynamic that is missing from this simplistic description of an orthodox credit cycle is the level of outstanding debt. The higher it is, the less of a rise in interest rates is required to trigger a downturn in economic activity. So over a long period of increasing accumulations of outstanding debt, the levels of interest rate peaks on successive credit cycles will decline. This is clearly evident in the chart below of the yield on 13-week US Treasury bills.
The pecked line shows these declining peaks, and that a short-term interest rate of less than 3% today would now appear to be enough to trigger a downturn. With such a small margin for error, it is clear that any increase in the yield spread between this, the highest quality debt, and corporate debt yields could trigger a cyclical debt liquidation. Bear in mind that this credit cycle has seen an acceleration of corporate debt issuance, in order to enhance earnings to stockholders without requiring an underlying improvement in operating profits. The result of this financial engineering has been to increase the growth rate of corporate debt and significantly reduce the interest-rate level that will result in widespread corporate debt defaults.
Bare information on corporate bond yields confirms the danger is now acute. Over the last year, the Finra-Bloomberg Investment Grade Index yield has risen from 3.25% to 4.2%, while the High Yield index yield has risen from 5.75% to 9%. While there is no precise level at which rising interest rates will result in debt defaults, it is clear that the margin over the sub-3% interest rate trigger in the chart above is already exceeded by a significant margin.
The financial condition of US companies is therefore under considerable pressure. Corporate America has raised its operational gearing by increasing its debt-to-equity ratio to enhance earnings per share, and is facing adverse economic conditions that will undermine the ability to finance the debt burden. Increased gearing enhances profits, but it also enhances losses. Cost-cutting measures are becoming an urgent priority for over-geared corporations, leading to rising unemployment, which should become evident in the coming months.
Bankers are acutely sensitive to these developing problems. They are already faced with dollar-denominated commodity-related loans that have gone sour, particularly in energy. In order to preserve their own capital and control risk, the banks are likely to reduce leverage by calling in other loans where they can. So we have a classic financial bust in the making with a notable difference: instead of the Fed raising interest rates to take the steam out of the economy, the sheer weight of debt is enough to trigger a slump on its own.
This is an outcome which is becoming more likely every day and impossible to avoid. Thankfully, since the financial crisis of 2008, the commercial banks in the US have limited their operational gearing, mostly through moderating the expansion of bank credit. That moderation will certainly persist in an economic downturn, and probably intensify further into outright contraction. The Fed will feel it has no option but to expand its own balance sheet to compensate. To get the Fed's newly-issued money into the non-financial economy can best be achieved through accelerated debt issuance and maintaining government spending, assuming whacky ideas like helicopter drops can be dismissed.
The US Government in a presidential election year will certainly be keen to maintain spending and to dismiss talk of austerity. And with declining tax revenues from a deteriorating economy, the deficit to be financed can be expected to increase, placing a floor under medium and long-term US Treasury yields. Furthermore, these difficulties might even force the Fed to briefly consider the introduction of negative interest rates, to kick-start reflation.
So much for the Fed's difficulties, more of which later. There are two other major economies of a similar scale measured on a purchasing-power parity basis, the Eurozone together with its periphery, and China. We will look at the Eurozone first.
The time available to repair the Eurozone's financial system since the Lehman crisis has been wholly wasted. Eurozone governments have refused to address their parlous finances, and the banks have done little to improve their balance sheets, with an average assets-to-equity ratio according to the ECB's figures of 24:1, admittedly including off-balance sheet obligations. The ECB's attempts to stress-test the banks have been bogged down in politics and vested interests, with banks, such as Dexia, actually collapsing soon after being declared sound. Furthermore, the share prices of key Eurozone banks appear to be discounting yet more financial turbulence.
This is hardly surprising. The Eurozone banks have always been the principal channel through which profligate European governments finance themselves. The regulators under Basel III have supported this relationship by deeming that government debt requires no risk-weighting. This is why the stress-tests failed to identify Dexia's troubles, because Dexia had overloaded itself with highly-rated but worthless Greek debt. The politics say Eurozone sovereign debt is inviolate, and politics triumphs over financial reality.
The function of Eurozone politicians has become solely to prolong the fairy-tale of never-never land, and with their electorates equally divorced from financial reality, they have succeeded remarkably well. Greece has been covered up, and is out of the headlines, for the moment. The rebellions against austerity in Spain, Italy and Portugal are fudged, and France, which on any dispassionate analysis is a financial basket-case, keeps her head down. The Eurozone is like a dysfunctional family living in a house which is about to collapse, and no one wants to admit it, let alone fix it.
There are at last signs that this bizarre situation is beginning to fail. The Italian banking system is in a developing crisis, as is Portugal's. Even Germany has a well-publicised problem with its largest bank. It is also a certainty that government deficits will increase, as the Eurozone economy begins to be affected by the global slump. The likely consequence is that yields on Eurozone government debt will start rising this year, exposing highly-geared banks, including the ECB itself, to portfolio losses that will quickly wipe out their inadequate capital.
This looks like being the year when the Eurozone could plunge the world into a second financial crisis, eight years after America's sub-prime crisis ignited the first. This time, the Eurozone's financial condition is the obvious catalyst, rather than China which is discussed next.
The general opinion in western capital markets is that China is the greatest danger to global financial stability. China's stock markets continue to slide, despite government attempts to ban or restrict selling. Her debt bubble, which is unwinding, has been a massive economic distortion. And while Keynesian economists seem to think the consequences of a credit bubble can be ignored in western economies, they have no hesitation in pointing an accusatory finger at China's.
Western financial analysts are hardly consistent in their approach to monetary matters, which is a bad start. It is more sensible to look at things from the Chinese Communist Party's point of view, and what matters to it is the long-term health of the economy. Last year China was on course ahead of the new five-year plan, gaining SDR status for its currency. We know that the CCP's long-term objective is to foster the industrial revolution of the whole Asian continent. The yuan is now positioned to be the argent Asiatique, accepted by nearly four billion people in place of the US dollar. Only this week we saw President Xi Jinping visit both Iran and Saudi Arabia, sworn enemies, but with a common desire to trade with China, doubtless settling in yuan.
For the yuan to be the currency of Asian trade, it must be stable. Western analysts who think China will devalue to "save the economy" ignore this vital point. China is not only prepared to maintain the yuan rate within a fairly narrow band against a basket of currencies, she sees a sound currency as a necessary condition for evolving from low-value trade and for the redeployment of scarce capital and labour resources in favour of her strategic objectives.
China does not share with western economies many of the financial problems of a deflating credit bubble, because the banks are state-owned and will not fail. Furthermore, it is a Chinese tradition to wind down obligations before the new year, so Chinese demand for dollars to pay down debt should diminish from now on. There are problems nonetheless, and while it would be a mistake to dismiss them, it should be noted that the Chinese government has the control required to manage its planned economic transition. And more so than most governments, she spins her own statistics, which will continue to be spun through the planned transition, making it difficult for yuan bears to attack the currency.
It should not surprise us if China's economy shows greater than expected resilience in the coming months, typical with the start of a new year. There will be more bankruptcies in legacy industries for sure, but the demand for and importation of industrial commodities will soon begin to pick up as the thirteenth five-year plan starts to be implemented.
The effect on global markets should be significant, given the overwhelming bets on a bullish dollar. Commodity prices, particularly for energy, will surprise on the upside. That is why President Xi visited both Iran and Saudi Arabia, to secure oil supplies. And when the threat of a further collapse in commodity prices is removed, the dollar can be expected to weaken, particularly against the emerging economy currencies. Shorting the yuan, or the Hong Kong dollar for that matter, is likely to prove to be very costly.
China's economy will probably begin to stabilise after the Chinese new year, which will wrong-foot bears of industrial commodities, and therefor bulls of the US dollar. This being the case, expectations of further falls in precious metals prices will be dashed, and based on dollar weakness alone, the current rally in gold and silver prices looks set to continue.
While a return to rising commodity prices, particularly for energy, will be positive for emerging market currencies, the destruction of extraction capacity heretofore is likely to push oil and commodity prices significantly higher by the end of 2016. The unwinding of bull positions in the US dollar is an additional factor that will unexpectedly increase prospective price inflation in the US. The Fed is therefor faced with the medium-term prospect of developing stagflation, a combination of an economy hampered by the unwinding of corporate debt together with the rise in unemployment this infers, while price inflation gathers steam. It remains to be seen if the Fed will have the courage to raise interest rates sufficiently to address price inflation, while deliberately bankrupting borrowers unable to pay high nominal interest rates. This will be a problem in sharp contrast to China, which should be on the road to an investment-led recovery, with a currency gaining in international status. If so, it will leave the US dollar vulnerable to even greater weakness. Currency traders will quickly realise that the risk is in holding dollars, and not yuan as commonly supposed today.
The Eurozone is the most immediate systemic danger, with a banking system creaking badly, and wildly overvalued government bond markets. Either a rise in US Treasury yields or a threatened sovereign default could set off a systemic crisis in the banking system. Furthermore, if the UK referendum for an EU exit is held mid-year and, as current polls suggest is possible, the UK votes for an exit, the European experiment will be dealt a mortal blow.
The phoenix rising from the ashes of 2015 will be comprised of China, the yuan and gold, a wholly unexpected outcome for mainstream financial analysts who are betting heavily the other way. Meanwhile equity markets in the developed world will have to struggle against stagflation, and the prospect of rising interest rates to curb the dollar's falling purchasing power. By the end of the year it should be clear that the dollar has finally had its day, along with its hegemony and the currencies tied to it.
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