Q2 2018: “Cracks in the Global Bubble”
As many of you are familiar, my thesis holds that we’re in the throes of history’s greatest global bubble. It’s also my view that the global bubble was pierced at the “periphery” during the second quarter. Global financial conditions tightened meaningfully.
I’ll offer a few data points: Let’s start with EM currencies: Argentina’s peso collapsed 30%, forcing the Argentine govt. to request a $50bn IMF bailout. Brazil’s real sank about 15%, the Turkish lira & S African rand 14%
Yields spiked throughout EM: Almost 400 bps in Turkey, 200 bps in Brazil and 100 bps in Indonesia and Hungary
In general, equities sank and risk premiums spiked throughout the emerging markets The dollar index abruptly jumped 5.2% during the quarter, catching the emerging markets, leveraged players and traders off-guard. Faltering local currencies quickly led to fears for EM exposure to dollar-denominated debt. I believe there is huge speculative leverage globally in what was a proliferation of EM “carry trades” – and many of these levered speculations have come under intense pressure.
Fragility reemerged in China: The Chinese renminbi declined 5.2%. In equities, the Shanghai Composite lost 14.7% and China’s ChiNext index sank 15.5%. China’s two largest banks saw their stocks drop 13% and 16%. China is now six months into a meaningful slowdown in credit growth.
Beijing has clamped-down on “shadow banking” and credit availability has tightened for China’s high-risk corporate borrowers. At the same time, household borrowings continue to surge as China’s runaway apartment bubble inflates to dangerous extremes.
In short, key facets of China’s historic financial and economic bubbles are indicating heightened fragility. Markets maintain confidence that Beijing has everything under control. I counter that bubbles that are left to inflate to such magnitude eventually turn uncontrollable.
It’s not discussed much, but over the past decade China has become a major trading partner and lender throughout EM. The fates of these Bubbles are now conjoined. I’ll add that the unfolding trade war comes at an especially inopportune time for both China and the emerging markets.
Currencies and equities were weak throughout Asia during Q2, as markets assumed a more cautious approach to indebted companies, countries & regions. There was a significant widening of credit spreads and indications of waning liquidity in China and throughout Asia But it was not only Asia, Latin America and Eastern Europe also experienced heightened financial stress. Almost across the board, there was significant weakness in banking and financial shares, supportive of my macro thesis. And after being on the receiving end of record inflows in 2017 and into this year, EM suffered a sharp reversal and the largest outflows since 2016’s unstable backdrop.
It’s easy to forget that 10-year Treasury yields reached a multi-year high 3.13% about halfway through Q2. The booming U.S. economy had the market contemplating more aggressive monetary tightening.
Surging yields and the stronger dollar hammered a vulnerable EM. “Hot money” abruptly moved to the exits, as de-risking/de-leveraging dynamics took hold. Underlying fragilities, having accumulated for a decade or more, were suddenly exposed.
The Institute of International Finance recently reported that global debt ended the first quarter at a record $247 Trillion, or 318% of GDP. Even after a decade of historic Credit inflation, global debt has continued to grow at double-digit rates. Global Debt Has Expanded $150 Trillion, or 150%, Over the Past 15 Years, similar to the trajectory of growth during the mortgage finance bubble period.
Global debt growth accelerated during the first quarter to $8.0 Trillion - and surged $30 Trillion over just the past five quarters – exactly the type of manic excess that sets the stage for turmoil. Worse yet, the first quarter saw emerging market debt rise by $2.5 trillion, or about 18% annualized, to a record $58.5 TN. EM Non-financial Corporate debt surged $1.5 TN, or about 25% annualized, to $31.5 TN - and now exceeds 94% of GDP – up from 63% during the 2008 crisis.
Trillions of dollar-denominated EM debt have been issued in recent years, with $900 billion said coming due by 2020. From my analytical perspective, EM experienced one final period of blow-off excess, ensuring the crisis backdrop that began to unfold during the quarter. Yet here’s where the analysis gets interesting as well as challenging.
It’s my view that cracks at the global bubble’s “periphery” have worked initially to bolster the “core” here in the U.S. The abrupt downturn in EM currencies and markets spurred a big reversal in Treasury yields, along with an untick in “hot money” flows to U.S. securities markets. This abrupt change in market dynamics caught the leveraged speculating community poorly positioned. There was a big short squeeze in the Treasury market. The reversal of hedges created a shot of liquidity that altered market dynamics. Suddenly, many were on the wrong side of scores of crowded trades. Hit with sudden losses, speculators were forced to take risk down on both long and short portfolios, as de-risking/de-leveraging dynamics took hold.
A market dynamic unfolded where the hedge fund’s favorite longs were under-performing the market, while their favorite shorts were outperforming - a big problem for many strategies. The way I see, liquidations on the long side were offset in the market by company buybacks and other inflows. Meanwhile, the reduction of short exposure placed major pressure on shorts generally and incited what developed into a major short squeeze – the aggressive buying of shares to mitigate losses.
This backdrop has ominous parallels to how the eruption of subprime back in 2007 incited a bout of monetary disorder that saw record equities and MBS prices only months before the 2008 crash.
In particular, current monetary instability stoked a rally and performance-chasing flows into some of the most liquidity-vulnerable areas of the securities markets – high-yield credit and small cap stocks.
In my nomenclature, cracks at the global “periphery” have extended the “terminal phase of excess” at the “core”. This dynamic creates a major dilemma for the Federal Reserve. Despite seven 25 bps rate increases, easy financial conditions continue to intensity the U.S. boom.
The more speculative areas of the markets are booming: Biotechs are up 21% y-t-d, the Nasdaq100 15% and the small caps 11%. Leveraged lending is red hot. Torrid M&A activity is on record pace. Home price inflation has accelerated, as hot markets rekindle memories of 2006. Commercial real estate price inflation has gone to extremes virtually across the country.
During the Q1 recap, I drew parallels between the blow-up of the “short vol” strategies and the initial eruption of subprime back in June 2007. I see the Q2 eruption of EM instability as the second phase of the unfolding bursting global bubble. The financial press is rather fixated on the U.S. yield curve, recently noting that it’s turned the flattest since August 2007. Conventional analysis holds this is an indicator of loaming recession.
Back in 2007, I viewed the flat curve as more of a warning of bubble fragility than an indicator of imminent recession. With U.S. mortgage finance at the epicenter of excess back then, the bursting bubble did coincide with an abrupt halt to U.S. Credit and economic expansions. I view today's flat Treasury curve as again signaling bubble fragility. The major difference, however, is that global finance (as opposed to U.S.) is at today's Bubble “epicenter”. Heightened fragility in China, Asia and EM, more generally, risks global financial turmoil and economic vulnerability.
From my analytical perspective, global bubble dynamics continue to follow the worst-case-scenario. Bubbles in China and throughout EM went to unprecedented extremes. Now, cracks at the “periphery” work to prolong dangerous excess at the “core” – feeding asset inflation, market misperceptions, speculative bubbles, unrelenting debt growth and deepening economic maladjustment. That cracks would appear in EM despite the still ultra-easy global monetary backdrop portends challenging times ahead.
To this point, EM has been supported by the large international reserve holdings accumulated during the boom. But these hordes can be depleted in short order. The powerful U.S. equities short squeeze creates vulnerability to an abrupt reversal. As they say, “prices up on air.” I vividly recall short squeezes preceding the 1998 global financial crisis; during Q1 2000 right before the bottom fell out of tech stocks; and in the fall of 2007 – not long before all hell broke loose.
These days, many big cap tech stocks are in manic speculative blow-offs. Along with the short squeeze, there is surely a derivatives component. With the proliferation of options trading strategies, it’s likely that speculators have been caught on the wrong side of previously “out of the money” call options – all reminiscent of early-2000. The outperformance and resulting flows into less liquid securities is also problematic. Speculative trading dynamics have created a backdrop where a market reversal could abruptly lead to illiquidity and dislocation.
I am also very concerned about the ongoing excess throughout U.S. corporate credit. In particular, the boom in BBB – the riskiest investment grade bonds – recalls the final blow-off in investment-grade mortgage credit in the months following the 2007 subprime eruption.
U.S. economic optimism remains highly elevated, despite risks of a full-fledged confrontation on trade. At the same time, underlying market and financial fragilities go unrecognized. Few appreciate how the global boom has been underpinned by unsound finance.
The extraordinary backdrop creates a major dilemma for the Fed. Financial conditions remain too loose for the overheated U.S. economy. So far, gradual rate hikes have worked only to bolster U.S. market and economic bubbles. The upshot is a stronger dollar and additional pressure on faltering EM Bubbles. U.S. market resilience likely bolsters Chairman Powell’s determination to normalize interest-rates.
I expect distress at the global “periphery” – notably EM and China – to deepen. The global backdrop is turning increasingly ominous. These are truly historic bubbles, and their unfolding demise portends momentous consequences for markets, economies, societies and geopolitics.
U.S. Markets at this point assume all’s clear at least through the midterms. These have to be the most complacent markets I’ve witnessed during my career. The world could be on the verge of unprecedented financial turmoil. The global economy may at the cusp of a major downturn with limited policy recourse - on the verge of a trade war and heightened geopolitical instability. And depending on results of the midterm elections, the U.S. could be at the brink of political mayhem and a constitutional crisis.
believe EM has succumbed to the downside of a historic financial boom. It’s my view that strains in China portend a wrenching financial and economic adjustment. As I’ve said over the years, bubbles are mechanisms of wealth redistribution and destruction. Seeing unmistakable cracks in the global Bubble, I worry increasingly about the deteriorating geopolitical backdrop.
I’m also fond of saying that “my job is not to predict - but instead to have the proper analytical framework, the intense focus and sound investment process to be able to react successfully to developments”.