Q2 2021: “Updating the Bubble Thesis.”
“Inflection point” was the theme for last quarter’s conference call. I believed there was a reasonable probability the market was putting in a major top – and I still see support for the topping process view. I held the view that inflation was posing increasing risk to the bond market and saw a spike in bond yields as a potential catalyst for a “risk off” period of de-risking and deleveraging. Instead, market yields reversed sharply lower, surprising many of us and hammering those caught short Treasuries and longer-dated bonds.
The quarter experienced wild rotations and heightened volatility – all consistent with a topping process - but at the same time ensuring major ongoing challenges on the short-side.
Importantly, one of history’s spectacular short squeezes ran unabated during the quarter. The Goldman Sachs Most Short Index jumped 14.1%, boosting one-year gains to an incredible 151%. Short stocks actually underperformed the market early in the quarter, before another powerful squeeze was unleashed. Between May 14th and June 28th, the Goldman Short Index surged 30%. Caught by the squeeze, high-profile hedge fund Melvin Capital ended the first-half down 46%.
As a disciplined manager of short exposure, I’ve for years stated that “my job is not to predict but to react” – to adhere to a sound analytical framework and risk disciplines, while working diligently to recognize and respond to evolving fundamental and market dynamics. Shorting has always demanded discipline and patience – but this cycle is without parallel.
On a daily basis – it’s really hourly –, we closely follow a mosaic of indicators. I’m monitoring for subtle changes in financial conditions and market dynamics – that could point to shifts in the risk vs. reward calculus for various short exposures. We definitely do not position based on my guess of market direction. We specifically avoid trying to time market tops. I’ve been doing this long enough to know that such guesswork is a problematic approach to managing short exposure.
The bottom line: Throughout the quarter, financial conditions remained exceptionally loose – “risk on” continued to dominate. In particular, corporate credit conditions remained incredibly loose. Companies enjoyed the easiest access to basically unlimited cheap finance throughout the quarter. Junk bond yields dropped to record lows. Both equity and bond funds were inundated with inflows during the period – in manic performance-chasing behavior. Bullish sentiment reached extreme levels – and remained highly elevated week after week. I’ve witnessed nothing quite like this in my 30 years in investment management.
We monitor credit default swap – or CDS – prices closely. Investment-grade CDS prices dropped to multi-year lows during the quarter, while high-yield CDS sank to decade lows. Myriad credit spreads also dropped to multi-year lows – both here in the U.S. and globally. Importantly, global markets – and financial conditions - remained highly correlated – corroborating the global bubble thesis.
Bond mutual funds and exchange-traded funds posted first-half inflows of about $380bn, with bond funds on pace to easily surpass both 2000’s $446bn and 2019’s record $459bn.
And I will read verbatim from a Financial Times article from last week: “Investors are pouring into global equity funds with a fervour never seen before. About $580bn has been added to the sector in the first half of 2021… [and here’s the kicker] Strategists with Bank of America estimate that if the pace of inflows continues… for the remainder of the year, equity funds will take in more money in 2021 than in the previous 20 years combined.” I’ll repeat: More money into stock funds this year than the past 20 years combined.
The amount of liquidity sloshing around global markets is unprecedented. This provides a good segue to my update of this unbelievable monetary environment. Federal Reserve credit has now inflated almost $3.9 TN over the past 70 weeks – and was up $4.3 TN – or 116% – in just 95 weeks. After beginning 2008 at $850 billion, Fed assets surpassed $8 TN during the quarter.
As of the end of May, the most recent data, M2 had expanded $4.9 TN, or 32%, over just the past 15 months to a record $20.4 TN. Institutional Money Fund assets – not included in M2 – were up another $870 billion.
Through the first two-thirds of the fiscal year, our federal government ran a deficit of $2.1 TN, with Washington borrowing 45 cents of every dollar spent. Our federal government ran a 20-month fiscal deficit of $5.2 TN, or 25% of GDP – and is on track for back-to-back $3.0 TN plus annual deficits. The 2021 deficit is projected at 13.4% of GDP, putting both 2021 and 2020 deficits at highs since World War II. It’s a shocking inflation of credit. And there is no better data to illuminate historic U.S. monetary inflation than the Fed’s own Z.1 report.
U.S. Non-Financial Debt surged almost $7.7 TN over the past 15 months. For perspective, non-financial debt expanded on average $1.8 TN annually over the previous decade. Treasury Securities jumped $4.9 TN over five quarters. After concluding 2007 at about $8.0 TN, Treasury Liabilities ended March at $26.8 TN.
Total Non-Financial Debt concluded March at $62 TN, or 281% of GDP, having increased more than 80% since the end of 2007. Non-Financial Debt ended 2007 at 230% of GDP, and was at 189% to end the nineties.
Over seven quarters, Total Debt Securities increased $8.8 TN, or 19.3%. At 247%, Total Debt Securities-to-GDP rose significantly from Q4 2019’s 218%. This ratio ended 2009 at 223%, the nineties at 158%, and the eighties at 124%.
Total Securities – combining debt and equities – ended March at a record $125 TN – with stunning one-year growth of $33 TN, or 36%. Total Securities have now inflated $77 TN, or 163%, since 2008. Total Securities-to-GDP ended March at a record 565% and compares to previous cycle peaks 387% (in Q3 2007) and 368% (in Q1 2000).
And with the value of securities inflating to unprecedented levels, Household Net Worth ended the first quarter at a record $137 TN. Net Worth inflated $31 TN over five quarters, or 30%. Household Net Worth ended March at a record 621% of GDP. This was up from previous cycle peaks 491% (in Q1 2007) and 445% (in Q1 2000).
It’s critical to appreciate runaway debt growth is a global phenomenon. For starters, combined Federal Reserve, European Central Bank and Bank of Japan holdings surged $9 TN over the pandemic to $24 TN. But perhaps the world’s most astounding monetary inflation continues to unfold in China. Aggregate Financing, China’s measure of broad credit growth, surged an incredible $8.1 TN – in U.S. dollars - over just the past 18 months.
The Chinese credit bubble is today deserving of special focus. For perspective, after ending 2004 below $5 TN and surpassing $10 TN for the first time in 2009 – Chinese bank assets are poised to surpass $55 TN this year – roughly three times GDP. And while the latest iteration of Aggregate Financing data goes back only to 2017, it has inflated more than $18 Trillion, or 64%, in four and a half years – exceeding U.S. mortgage finance bubble credit expansion.
This historic bubble is literally spiraling out of control – a reality surely not lost on Beijing. Over recent years, Chinese officials have made repeated attempts to rein in credit and speculative excess – but each time were forced by heightened bubble fragility to back off. Each pullback only further energized credit and speculative bubble dynamics.
Their credit system went into precarious overdrive during the pandemic. Officials this year appeared to adopt a newfound determination to rein in stimulus along with credit and speculative excess. It has been a centerpiece of my macro analysis that tightening measures in China would prove destabilizing – for China’s maladjusted system as well as for vulnerable global markets and economies.
China’s State Council last week directed the People’s Bank of China to reduce bank reserve requirements, an important stimulus measure freeing up capacity for bank lending. This was a hasty and unexpected policy shift.
Global equities rallied strongly Friday, apparently in response to China’s dovish pivot. The bullish narrative is that Beijing is now moving to bolster waning growth momentum. From my analytical perspective, China’s policy shift provided important confirmation of the bubble thesis.
We have been closely monitoring festering Chinese credit issues - that clearly worsened throughout the quarter. The situation took a turn for the worse over recent weeks. For example, an index of Chinese yield-high dollar bonds ended last week with yields up to 10.4%, rising about 70 bps for the week. This index traded with a yield of 8.00% as recently as May 26th. The yield surge over the past six weeks has been the sharpest since the March 2020 crisis period.
Troubled behemoth developer Evergrande – with $350 billion of assets – saw its four-year bond yields trade above 25% last week. Other developer bond yields spiked higher as well, as the marketplace increasingly questions the solvency of a number of China’s major developers.
But when it comes to heightened systemic risk, all eyes are for now on the huge “asset management companies” – or AMCs -, four major financial institutions created in late-1999 as part of a strategy for recapitalizing China’s impaired banking sector.
Troubled China Huarong has received the most media attention. After beginning Q2 at 150 bps, Huarong credit default swaps surged above 1,400 – indicating heightened default fears for this institution with upwards of $300 billion of assets and liabilities. Haurong poses a major dilemma for Chinese leadership. Beijing would prefer to impose some market discipline – discipline that has been conspicuously absent throughout China’s protracted bubble.
Reports suggest Chinese leadership is fed up. It’s time for bond investors that mindlessly financed reckless behavior by Haurong and others to suffer some pain. Yet Beijing faces a huge dilemma: basically, China’s entire $12 TN credit market trades based on the perception of implicit central government backing. A Beijing move to counter moral hazard with even a modicum of market discipline risks a more systemic crisis of confidence and bubble collapse.
China Huarong CDS jumped 137 bps last week to a one-month high and rose this week back above 1,200. Fellow AMCs China Orient’s CDS increased to a near record 250 bps and China Cinda to 230 bps, both about doubling since April.
Recent China developments are reminiscent of the U.S. mortgage finance bubble experience. Recall that the subprime crisis erupted in the summer of 2007, marking the beginning of the end for that bubble. Confidence began to wane in the perception that Washington had everything under control – manifesting first in riskier mortgage securities. However, it took about 15 months for trouble at the “periphery” to make its way to a systemic crisis of confidence afflicting the “core.”
Importantly, between the subprime and Lehman collapses, there ensued an extraordinary period of monetary disorder and market instability. Post-subprime Fed stimulus measures played a critical role in extending the boom in “core” AAA-rated mortgage securities, prolonging bubble excess. Crude prices surged to almost $150 a barrel, and a speculative U.S. stock market ran to record highs – all unfolding after the bubble had been pierced at the “periphery”. Monetary stimulus, employed to hold collapse at bay, only prolonged “terminal phase excess” - ensuring a more destabilizing bubble collapse.
I believe China’s bubble is today at serious risk of a destabilizing crisis of confidence. Faith that the great Beijing meritocracy has everything under control has begun to wane – with clear signs of this phenomenon in the pricing of higher-yielding bond instruments – China’s “subprime” “periphery.” Ominously, Chinese credit stress has erupted even in the face of incredible credit expansion and robust economic recovery.
And I’m convinced this dynamic has been a key force driving the surge in safe haven Treasury and global bond prices. This yield collapse and associated loosening of financial conditions has sustained a perilous bout of speculation and other “terminal phase” excess.
Meanwhile, the bullish narrative has become engrained that sinking Treasury yields confirm the Fed’s view of fleeting inflation. This week we saw that CPI rose 5.4% y-o-y in June, the strongest gain in 13 years. And for analysts that have issues with year-over-year base-effects, consumer inflation is up 3.3% in only five months. Producer Prices were up a data series record 7.3% y-o-y.
Clearly, there are temporary factors driving some inflation in the price aggregates. But when we analyze the inflationary backdrop, we see forces at work that point to a secular shift in inflation dynamics. We expect a protracted period of bottlenecks, shortages, hording and pricing pressures for many things. We see a secular power shift to labor over employers. And we see surging housing costs feeding through to various sectors. We believe commodities have likely commenced a powerful secular bull market. There’s a long list of factors – domestic and global - we see supporting a secular upswing in inflation dynamics.
But I don’t mean to imply that the bond market is wrong on inflation. I instead believe bond market focus shifted during the quarter away from inflation risk to the faltering Chinese bubble - with negative ramifications for myriad vulnerable bubbles across the globe.
A bond market disregarding inflation risk - as it fixates on bubble fragility - is not without precedent. Recall that crude oil and commodities went on their speculative moonshots in ‘08 – bolstered by a late-cycle confluence of robust global demand and the Fed’s post-subprime monetary stimulus measures. After peaking at 5.3% in June 2007, 10-year Treasury yields were around 4.25% in mid-June 2008. Yields trended lower through the summer – ending August ’08 at 3.80%. There was this extraordinary dynamic: Year-over-year CPI rose from 2% in August 2007 to a cycle peak 5.6% in July 2008 – yet 10-year yields sank 100 bps over this period.
Last quarter, crude gained 25%, while y-o-y CPI surged above 5% to the high since 2008. June’s ISM Manufacturing Prices Paid Index spiked to the highest point since 1979. Meanwhile, labor tightness turned acute across the economy. House price inflation accelerated, with the FHFA House Price Index registering a 15.7% y-o-y gain.
In spite of mounting inflation risk, bond yields reversed sharply lower. After ending Q1 at a 14-month high 1.74%, 10-year Treasury yields dropped 27 bps to 1.47% - and then traded as low as 1.25% last Thursday.
It’s certainly tempting to dismiss current bond yields as market insanity. But there is method to the madness. China is a historic credit accident in the making. Here in the U.S., we have runaway manias in equities, corporate credit, ETFs, M&A, cryptocurrencies, NFTs, collectables, real estate, and the like.
The Treasury market in 2008 saw a bursting mortgage finance bubble as deflationary - suspecting the Fed would respond with powerful monetary stimulus. Today, especially after witnessing a near $4.0 TN Fed pandemic response, bonds have no doubt whatsoever that a faltering bubble and crisis dynamics will be immediately met by additional Trillions of QE purchases – Treasuries, MBS, corporate bonds and ETFs.
Several years before the pandemic, I posited a seemingly ridiculous thesis that the Fed’s balance sheet would reach $10 TN come the next crisis. Unprecedented speculative leverage had accumulated across global markets, and the eventual bursting would leave only the central bank community with the wherewithal to provide a liquidity backstop.
The pandemic market crisis confirmed the thesis. The Fed and central banks acted about as expected. But something extremely troubling transpired that I did not anticipate. Rather than balance sheets employed for “buyer of last resort” post-bubble stabilization, the scope and rapidity of liquidity injections only exacerbated historic bubbles. In short, central banks unleashed parabolic “blow-off” excess.
A recent Fed staff paper included a most pertinent fact: “Hedge fund gross U.S. Treasury exposures doubled from 2018 to February 2020 to $2.4 trillion…” – data confirming an epic surge in speculative leverage heading into the pandemic. And this data captured only a fraction of the leverage. It was gathered from reporting hedge funds, which exclude so-called “family offices” and other unregulated and “offshore” entities.
I’m convinced this parabolic rise in speculative leverage only accelerated following the most extreme stimulus measures employed early in the pandemic. I believe speculative leverage has mounted across asset classes – Treasuries, MBS, corporate credit, municipal bonds, cryptocurrencies and the like. We saw from the Archegos blowup that 10 to 1 and greater leverage was employed even in stock market speculation – and that derivatives are integral to levered strategies.
Following Friday’s PBOC cut in bank reserve requirements, Bloomberg ran an article highlighting a surge in overnight “repo” funding being used to lever Chinese sovereign bonds. I have suspected over recent years that huge speculative leverage has been accumulating in Chinese credit instruments – so-called “carry trades” that borrow cheap to purchase higher-yielding Chinese securities. After all, China has offered “carry trade” paradise – high yields, a stable currency underpinned by the PBOC and essentially pegged to the U.S. dollar, and implicit Beijing backing for the entire banking system and credit market.
I believe “carry trade” leverage in China’s credit market has likely reached the Trillions. And this historic speculative bubble is acutely vulnerable today. Scores of highly levered companies are indicating stressed finances, while credit conditions have tightened markedly throughout the high-yield marketplace. Meanwhile, there are heightened concerns for the Beijing backstop – with particular worry in the offshore dollar-denominated bond market.
I believe a powerful de-risking/deleveraging has commenced in Chinese credit, beginning with the high-yield dollar bond market populated by the big developers, the AMCs, and other fragile institutions. If I’m right on this, this would be a monumental development for Chinese and global Bubbles. I have argued that China evolved into the marginal source of global credit. Moreover, speculative leverage is the marginal source of liquidity for bubble markets across the globe. As such, the Chinese credit market evolved to become central to the overarching global bubble.
I expect recent tumult in Chinese high-yield debt to infect the Chinese credit market more broadly, leading to a destabilizing tightening of credit conditions. It’s worth noting that Chinese banks expanded lending by $327 billion during June alone – with record first-half lending growth of almost $2 TN. And with Beijing’s prodding and further reserve rate cuts, Chinese banks can for a while take up the slack from an impaired bond market. But this incredible late-cycle inflation in bank lending guarantees enormous loan losses and resulting capital shortfalls for China’s banking system down the road.
We saw important evidence last week of contagion jumping from Chinese credit to Asian markets. At Friday lows, Japan’s Nikkei Index had lost 4.7% for the week and was near 2021 lows. Hong Kong’s Hang Seng Index was down more than 5% intraday and the China Financials Index 4.1%, both to lows for the year.
A “risk off” dynamic was beginning to gain traction in Europe and U.S. markets, with notable weakness in bank stocks. The VIX started to spike. Markets then rallied strongly on Friday’s Chinese policy pivot.
Today’s backdrop reminds me a lot of 2007/2008. It’s always obvious in hindsight, but I can tell you from my own experience that few at the time recognized the bubble. I was told repeatedly, “Doug, subprime doesn’t matter. It’s only $40 billion.” “Washington will never allow a housing bust.” “The Fed has everything under control.”
The problem was there were Trillions of suspect securities with prices divorced from underlying fundamentals – and too many were held by leveraged speculators or part of speculative derivative trading strategies. Faith in policy measures to sustain the boom had become way overblown.
I think back to Lehman’s predicament. They were highly levered in a portfolio of risky credits. The piercing of the bubble made their position untenable, and it was somewhat confounding that market confidence was sustained for as long as it was. But that’s the nature of financial crises - a long creeping process can suddenly careen at lightning speed.
I believe China’s historic credit bubble has likely been pierced, and this dynamic has helped fuel the global yield collapse. Yet I do vividly remember how trouble at the subprime “periphery” in 2007 spurred further “terminal phase” excess at the “core” comprised of top-tier AAA securities – MBS, Treasuries and corporate bonds.
Compared to the mortgage finance bubble, the current “terminal phase” is off the charts – fueled by egregious monetary and fiscal stimulus, along with unprecedented leveraged speculation. How much time does that buy them?
It’s difficult to gauge how much time a reserve cut buys the Chinese. I don’t believe they’ve yet thrown in the towel on efforts to rein in excess, so Beijing faces a real high-wire act ahead. There’s always an ebb and flows to faltering bubbles. Actually, it’s a thin line between panic and egregious late-cycle manic excess.
Treasury yields barely reacted to reports of much stronger-than-expected consumer and producer inflation. The Treasury market is signaling trouble on the horizon. I expect unfolding China de-risking/deleveraging to challenge over-levered Asia, along with the emerging markets that have been on the receiving end of enormous “hot money” and performance-chasing flows.
And while the finance and services-based U.S. economy is somewhat isolated from global economic factors, markets are not. It’s become one interconnected historic global bubble, financed by speculative “carry trade” leverage, derivatives and margin debt. A key link from China credit stress to U.S. market vulnerability is through the leveraged speculating community and derivatives markets.
Beyond Chinese fragility, I see vulnerability in the hedge fund and “family office” community. Booming equities and corporate credit have masked tough environments for a number of strategies. The historic short squeeze has impaired long/short - so-called “market neutral” - strategies. The yield collapse caught a lot of macro and quant funds short Treasuries and investment-grade corporate bonds. Yield curve trading strategies have similarly backfired. In general, risk hedging strategies have been problematic, with bubble markets turning increasingly dysfunctional. There’s been, as well, some wild volatility in cryptocurrencies and commodities that have hurt performance. Moreover, there is the post-Archegos tightening of prime brokerage securities finance.
But so long as securities prices are rising and speculative leverage inflating – these issues are not immediately problematic for booming markets. With $120 billion monthly Fed QE, it’s easy to dismiss liquidity concerns. I am reminded of Citigroup’s Chuck Prince and his infamous “still dancing” comment from the summer of 2007.
Things get crazy at the end of cycles. And with our view that we’re in the waning months of a historic multi-decade bubble period, we shouldn’t be surprised by any degree of manic excess. Clearly, pandemic-related stimulus extended the lives of myriad bubbles.
The Fed recently admitted to talking about talking about tapering. Our central bank is making yet another catastrophic mistake by sticking with massive QE in the face of egregious excess. It’s reckless monetary management. And I’m reminded of the old “what are they afraid of” Rick Santelli rant. To me, it’s rather clear. They witnessed firsthand how precariously over-levered and speculative markets had become by March 2020. They know it’s a bubble and are left hoping that if they delay tightening measures things can somehow resolve themselves over time.
The late Dr. Richebacher had a pithy insight - simple, controversial and brilliant: He would say, "The only cure for a bubble is to not let it inflate." No one wants to admit this is true. Wall Street clearly loves bubbles - the bigger the better. Politicians celebrate them, while central bankers prefer to ignore the entire issue. They refuse early-intervention - and they absolutely won't touch bubbles once they've inflated big and vulnerable. They want to believe the myth that macroprudential policies offer effective management.
Most unfortunately, tremendous amounts of damage can be inflected during “terminal phase excess.” And that’s precisely where we are today. Global bubbles have inflated tremendously over recent years – especially over the past year. Wildly inflated bubbles are now acutely vulnerable to any tightening of financial conditions – albeit by Beijing, the Fed or otherwise. I believe a global tightening of financial conditions has likely commenced in China, with waning market confidence in highly-levered companies and related speculative deleveraging. I believe last week’s volatility is a sign of things to come.
This bubble has been the proverbial cat with nine lives. But each resuscitation results in only more dangerous speculative bubbles and systemic maladjustment. There’s just no getting around this bubble reality. I really fear the consequences from this latest round of monetary madness. And the amazing thing is, at this point, everyone is completely numb – numb to excesses and to risk.
I spoke about how this period reminds me of ’07/’08. I am troubled as well by the parallels to 1929. These days, I think of Benjamin Strong’s infamous “coup de Whiskey” in 1927 – Fed stimulus that unleashed a final precarious speculative market blow-off to conclude a historic economic and market cycle. I also think of 1999 bubble mania craziness – but today’s speculative excess and market dysfunction are really in a league of their own.
To conclude our Bubble thesis update, I see the current environment in terms of a speculative blow-off in a historic bubble in financial assets. And the normal mechanisms that would temper excess are nowhere to be found – the old bond market vigilantes, tighter monetary policy, and general investor risk aversion. From my analytical framework, we continue to witness the absolute worst-case-scenario – and I fear financial, economic, social, political and geopolitical consequences.