Q4 2021: “Things Went Wild. Now what?”
The quarterly string of extraordinary market environments continues – and I’m referring to Q4 and the unsettling start to 2022.
I’ve been in investment management now for over three decades – managing short exposure going back to 1990. This is the third major – arguably historic – bull market I’ve had to persevere through. I’ve witnessed some pretty extraordinary market environments and financial crises – the ’87 stock market crash, the early-nineties S&L and Banking crises, the spectacular 1991 short squeeze, the ’94 bursting bond market bubble, the ’97 Asian Tiger bubble collapses, the ’98 Russia/LTCM meltdown, the 1999 tech melt-up, Y2K, the 2000 bursting tech Bubble, the 2002 corporate debt crisis, the 2007 bursting subprime bubble, the 2008 mortgage finance bubble collapse, the Trillion-dollar QE1 experiment, the huge 2009 squeeze and market rally, taper tantrums, the Greek and Italian bond collapses, $2 TN of QE2, and the wildly speculative market environment that began in 2017.
I thought I’d seen just about everything. And then in September 2019 the Fed restarted QE - in a non-crisis environment, with the unemployment rate at multidecade lows. From August 2019 lows to February 2020 highs, the S&P500 surged another 20% - speculative excess that set the stage for the March 2020 crisis.
It’s still a challenge for me to fully grasp $5 TN of additional Fed new liquidity injections into market bubbles over the past couple years. The Fed’s original ‘08 QE program was to provide liquidity to accommodate post-bubble speculative deleveraging. The current QE program has been different in kind, in dimension and in consequence. We’re over $5 TN and still counting -- and rather than accommodating a bursting bubble and associated deleveraging, this liquidity onslaught fueled history’s greatest bubbles along with manias for the ages. Things ran absolutely wild.
Over the past seven quarters, the S&P500 surged an incredible 90% - with the Nasdaq100 up 112%. I’ve lived through some spectacular squeezes in my career – but nothing compares to the meme stock melt-up and brutal targeting of short positions.
I can report that key aspects of our macro thesis are materializing. I discussed during the last call how cracks had developed in China’s historic bubble. Over recent months, crisis dynamics have accelerated in China, which I’ll discuss. Meanwhile, inflation has become a pressing issue, with even the Fed now admitting it’s a problem they need to address. The Fed accelerated its taper and is preparing for a tightening cycle. Wall Street went from expecting no rate increases in 2022 to now seeing at least four. Moreover, the Fed is publicly contemplating reducing the size of its balance sheet – what’s referred to as “quantitative tightening”, or QT. The prospect for persistent inflation, rising short-term rates and dramatically less Fed liquidity has the bond market on edge. Ten-year Treasury yields traded last week up to 1.90%, the high since December 2019. Benchmark MBS yields are up a quick 55 bps to start the year, indicative of stress within interest-rate hedging markets. Prospects for tighter financial conditions have also begun puncturing speculative bubbles, from meme and tech stocks to the cryptocurrencies.
The title of today’s call is, “Things Went Wild. Now what?” For years, I’ve been a student of the Austrian School of Economics. It plays prominently in my analytical framework, especially my focus on money and credit, bubble dynamics and associated economic maladjustment. I believe in the precept that the pain and dislocation unleashed during the downside of a cycle - is proportional to the excesses of the preceding boom. Granted, this dynamic has been repeatedly subverted by ever increasing amounts of policy-induced monetary inflation. As such, from my analytical perspective, I think in terms of a sustained, multi-decade bubble period. While we’ve had to endure post-bubble hardship, in each instance policymakers failed to address and rectify the underlying root cause of monetary disorder and resulting recurring boom and bust instability. Instead, monetary stimulus has been the handy palliative, dialed up in increasing doses as bubbles inflated ever larger and unwieldy. In a monumental blunder, monetary inflation was viewed as the solution rather than the problem.
I believe the world has now passed a critical inflection point - commencing what will be a quite challenging and likely tumultuous transition to a secular post-bubble down cycle. Major bubbles culminate in wild excess. Think of the crazy subprime lending and derivative excesses in 2006&7, the 1999 tech speculative melt-up or, looking back further, late-eighties Japan and the manic market environment leading up to the 1929 crash.
I am not, however, familiar with any bubble blow-off in history comparable to 2021. It’s worthy of a brief over-review: Monetary inflation continued to run completely wild. Federal Reserve credit expanded $1.4 TN over the past year to a record $8.74 TN. The Fed’s balance sheet inflated an astonishing $5 TN, or 135%, in the 120 weeks since QE was restarted in September 2019. Federal Reserve assets have now inflated 10-fold since the mortgage finance Bubble collapse.
M2 “money” supply inflated another $2.5 TN to a record $21.4 TN – with reckless two-year growth of $6.2 TN, or 41%. With these numbers, the myth of QE effects remaining well contained within Treasury and securities markets should finally be debunked.
In the seven pandemic quarters through Q3 2021, Non-Financial Debt surged $9.2 TN – combining with China’s expansion for history’s greatest Credit inflation. The fiscal 2021 federal deficit reached $2.77 TN, with a historic $5.90 TN two-year shortfall – or 28% of GDP. Outstanding Treasuries ended September at $24.3 TN, up four-fold from year-end 2007. Treasuries surged $5.7 TN in seven quarters, matching the total amount of accumulated federal debt through the year 2006.
In the stock market, there were new record highs in the S&P500 – 70 times. Speculation ran absolutely wild. There was a short squeeze for the history books. Meme stock mayhem. There was the SPAC craze. A record IPO boom. Unparalleled “retail” market participation, zeal and speculative excess.
Global exchange-traded funds, or ETFs, received a record $1.22 TN of inflows last year, up 70% from booming 2020 flows. Reaching $10 TN, and having doubled since 2017, ETFs are today’s poster child of destabilizing, trend-following speculative flows. According to Bloomberg, this Monday saw a record $478 billion worth of ETF trades, almost 20% ahead of the previous high from February 2020.
Monday also saw 31.3 million put options traded, just short of Friday’s record 32.3 million. Indicative of the speculative mania that enveloped the markets, derivatives trading volumes continue on their moonshot. A few data points (WSJ):
Last year saw 9 of the 10 most-active call-options trading days ever. On average, a record of almost 39 million option contracts traded daily, almost a third higher than 2020. The daily average notional value of stock option trading reached $467 billion, exceeding the value of shares traded.
Companies globally raised a record $12.1 TN last year (from the FT) through a combination of bond and stock issuance and new loan borrowings. Global mergers and acquisitions – M&A – surpassed $5 TN for the first time, beating manic 2007’s record. U.S. M&A volumes doubled from 2020 to reach $2.5 TN.
Unprecedented asset inflation saw Household Assets (Fed’s Z.1 report) - reach a record $163 TN. Household Net Worth - Assets less Liabilities - jumped to $145 TN – more than double the previous cycle peak in 2007. Net Worth at 624% of GDP compares to previous cycle peaks 488% during (Q3) 2007 and 445% in (Q1) 2000. More specifically, Household holdings of Financial Assets reached a record 500% of GDP, up from the past two cycle peaks’ 374% and 354%.
Yet manic excess was in no way limited to the securities markets and Wall Street deal-making.
The S&P CoreLogic National Home Price Index jumped 19.1% y-o-y, with the inventory of available homes sinking to record lows. After beginning the year at about $28,000, Bitcoin traded in November to almost $69,000. Scores of new cryptocurrencies joined the fray, while non-fungible tokens mobilized in a flurry of manic activity. And I could go on and on. These are merely some of the highlights from the most spectacular bout of monetary and speculative excess the world has ever witnessed. Monetary disorder running completely amuck. Now What? The simple answer: A really, really bad hangover.
Speaking of nasty hangovers, let’s discuss China. As a macro analyst of credit, I continue to be in awe of China’s capacity to expand debt. In numbers not easily fathomed, Aggregate Financing, China’s metric of system Credit, expanded almost $5 TN last year, following 2020’s unprecedented $6 TN credit melee. Pandemic monetary stimulus pushed China’s already supercharged apartment bubble further into “terminal phase excess.” Beijing last year implemented some modest real estate finance tightening measures – and the wheels soon started coming off. I’m reminded of Japan’s belated decision back in 1989 to rein in property lending excess, marking a critical juncture for both their asset markets and bubble economy.
What started with credit stress erupting in major Chinese developer Evergrande – with its $300bn of liabilities – has now engulfed an entire industry with debts in excess of $5 TN. I’ve set up a monitor screen on my Bloomberg that includes about 30 Chinese developer bonds. It’s one of the first screens I turn to when I rise each morning. Especially over recent weeks, the ferocity of the developer bond freefall has been stunning.
Let there be no doubt: This is an epic collapse with far-reaching ramifications – that garners little attention in China, the U.S. or globally. The world remains confident that Beijing has everything under control. Developer bonds did muster a rally last week in response to rate cuts along with measures to loosen real estate finance.
But there is no cure for bubbles outside of not allowing them to inflate. Beijing has its hands full. China’s apartment sales have slowed markedly, while prices have turned modestly lower. With demand waning and tens of millions of unoccupied units, apartment construction is poised to slow sharply. China’s economy over recent months has downshifted, though it remains buoyed by booming exports. But economic growth will be stymied by insecure Chinese households reining in spending. And if I’m correct on unfolding global market instability, China’s export-dominated economy is increasingly vulnerable to a synchronized pullback in global demand.
In the short run, the Omicron variant presents significant risks. Beijing’s draconian Covid “zero tolerance” policy has protected its citizens, but at considerable and mounting cost. The average Chinese has been stung by a combination of Covid restrictions, troubling economic developments and a flurry of heavy-handed governmental mandates. Now, with Omicron threatening, a population with little natural immunity and unproven vaccinations faces the prospect of even more lockdowns and hardship. And from a global perspective, Omicron poses risks to already struggling supply-chains.
I see a Chinese population – having grown overconfident from prolonged bubble excess – that is now in an increasingly confused state. Consumer sentiment – apartment buyer optimism – and general confidence is largely beyond government control. There will be fits and starts, but I believe the bursting of China’s bubble foreshadows a deflating apartment bubble, waning economic prospects and major financial sector issues. This is an ominous development for a fragile global economy and vulnerable financial structures.
For the past decade, my analytical framework has focused on the interplay of two separate yet interdependent Chinese and U.S. bubbles. That China’s bubble is faltering significantly elevates U.S. bubble risk – and vice versa – which essentially places a world of bubbles in jeopardy. Ominously, global markets have become highly correlated. I titled last Friday’s CBB, “U.S. Market Structure in the Crosshairs.” I am increasingly concerned by developments.
I have noted recent elevated correlations between the cryptocurrencies, technology stocks, and indicators of general financial conditions. This suggests heightened risk of a bout of “risk off” selling that could portend illiquidity, panic and collapsing speculative bubbles. Some are making comparisons to the bursting “dotcom bubble.”
I recall that period vividly. At the late-stage of the nineties’ tech Bubble, many recognized the extreme overvaluation of the leading technology stocks. The bulls, convinced of a new paradigm of unending industry growth, were undeterred. Not appreciated was that inflated stock prices were but one facet of industry bubble excess. Speculation, speculative leverage, and extraordinarily loose financial conditions had fueled massive spending - over- and mal-investment - by flocks of Internet, technology, communications and media companies. Financial excess had unleashed “arm’s race” dynamics.
The current bubble has inflated so beyond the scope of late-nineties excess. Key indicators are now suggesting today’s bubble is in the process of being pierced. Stock prices have reversed sharply lower, indicative of a potentially momentous shift in speculative dynamics and the flow of speculative finance. If this proves to be the case – if de-risking and deleveraging spark a major tightening of financial conditions - an expansive industry with scores of loss-making, negative-cash flow businesses is in for one rude awakening.
While the industrywide spending boom at this point runs unabated, there is analytical rationale for the bursting of the U.S. bubble to commence in the overheated technology sphere. This is the area of greatest excess – in egregious market speculation along with incredible “arm’s race” industry spending and over-investment. I would argue that not only is the underlying finance fueling the boom highly unstable, but too much of this spending will prove uneconomic. In this regard, there are parallels to China’s bubble downfall that erupted with the over-leveraged apartment developers.
While attention has been focused on collapsing cryptocurrencies and tech shares, it’s worth noting last week’s ominous reversal in financial stocks. The Bank Index’s 10% drop actually surpassed the decline in the Nasdaq100. Goldman Sachs fell almost 10%, JPMorgan 8%, and Bank of America 6%. Bank credit default swap (CDS) prices also jumped higher, indicative of mounting systemic stress.
I monitor the financial sector closely, and interpret recent market behavior as suggestive of incipient market structure concerns. As I’m fond of repeating, as much as contemporary finance appears miraculous on the upside, it functions poorly in reverse. When Credit and speculative leverage are expanding - market liquidity will appear abundant, financial conditions will remain loose, and asset price inflation and speculation will maintain self-reinforcing momentum. But fragility lies in wait – lurking patiently just below the surface.
With our limited time, I’m not able to delve deeply into the important subject matter of “market structure”. But I’ll draw attention to three key fragile structural fault-lines – derivatives, exchange-traded funds and trend-following finance.
“Portfolio insurance” played an instrumental role in the 1987 stock market crash. Derivatives were also fundamental to market dislocations in 1994, 1998, and 2000. Hedging and leveraging strategies - through listed and over-the-counter derivative products - were integral to both the mortgage finance Bubble and its collapse. Moreover, derivative markets and the ETF complex were central to March 2020’s near meltdown.
I fear we’re heading towards another derivatives accident. All the necessary ingredients are present. But this time around, the Fed has less room to maneuver. In market dislocations all the way back to 1987, sinking bond yields provided key post-crisis stimulus.
Importantly, for three decades the Fed enjoyed great flexibility in employing increasingly aggressive stimulus measures. Greenspan’s “baby step” rate increases morphed into aggressive rate slashing, which evolved into Bernanke’s Trillion-dollar QE and Powell’s $5 Trillion. And it was all made possible because of the accommodative bond market’s unwavering support. Underpinning the great bond bull market, inflation for the most part trended lower over the past 30 years, spending much of the past decade below 2%. The Fed in March 2020 opened the floodgates for unprecedented monetary stimulus – with both the Fed and bond market operating without fear of inflationary consequences.
Well, the world has changed. There is now a serious inflation problem. And while it may subside from the recent four-decade high 7% level, there is at this point every reason to believe inflation will prove persistent. The Powell Fed is under pressure from Congress and the American people. Inflation is causing pain and consternation. So the Federal Reserve will now think twice before bailing out the markets with Trillions of additional monetary stimulus.
I believe the Fed will inevitably have no alternative than to resume its money-printing operations. Fragile market structures are a crucial consequence of a most protracted bubble period. There is too much speculative leverage, too much masking and shifting of risk through the derivatives labyrinth, and way too gargantuan trend-following speculative flows. And this structure is viable only so long as the bubble is inflating – so long as credit, leverage and speculative flows are expanding. In the event of serious de-risking and deleveraging, there is no source of sufficient liquidity to stem collapse outside of the Federal Reserve’s balance sheet. This is especially the case after two years of climactic monetary madness and manic excess.
Okay, I’m asserting the Fed will have no choice but to resort again to QE. However, today’s inflationary backdrop makes the timing and scope of Fed support unclear. And I believe the unpredictability of the Fed’s response function to incipient crisis dynamics will become troubling for the markets - and particularly problematic for derivatives.
I expect derivatives to be an epicenter of market instability. Think in terms of the derivatives marketplace as offering market risk insurance. Writing flood insurance during a drought is about as close to free money as you’ll find. With zero rates and unlimited Trillions of liquidity, the Fed and global central bank community have been able to control rainfall. Over this long cycle, low prices and readily available risk insurance have been instrumental in promoting risk-taking. The Fed’s liquidity backstop coupled with booming derivatives markets have been fundamental to ongoing bubble excess.
What I’m arguing is that, with the shift in inflation dynamics, the Fed is losing control of the weather. They can no longer just blindly print money and watch securities prices stabilize and resume their upward trajectory. Additional monetary inflation will now be destabilizing, as it risks exacerbating already robust price pressures and bond market instability.
And if the Fed can no longer predictably dictate market weather conditions, writing market protection – flood insurance – will be a much riskier proposition going forward. Protection will be more expensive and less readily available. And as risk aversion takes hold, the now customary strategy of simply holding tight with stock and bond portfolios while acquiring cheap risk protection - will be a thing of the past. Importantly, costly derivatives make it more likely that risk mitigation will require selling holdings.
And keep in mind that market losses are not “insurable” in terms of traditional insurance offering protection against random and independent events. Actuaries have years of data that allow them to rather accurately predict accidents and insured losses – auto, homeowner and life insurance policies, for example. Policies are priced accordingly, with reserves withheld to ensure the financial wherewithal to pay future loss claims.
Securities market and credit losses are neither random nor independent. They tend to arise occasionally, in unpredictable and all- encompassing waves. The players in today’s colossal derivatives marketplace for risk protection price their products with the assumption that markets will remain liquid and stable. And they don’t hold reserves for future expected losses. And this becomes – at critical junctures – one huge predicament for markets. Dealers sell derivative contracts and then have computer algorithms “dynamically hedge” their risk - depending on market direction. What this means is that when the market declines, dealers will short sell securities to protect against mounting losses. When markets accelerate to the downside, derivatives-related selling can quickly overwhelm the marketplace – leading to illiquidity. As was learned in 1987 and repeatedly since – certainly including March 2020 – these structures are prone to sparking self-reinforcing market sell-offs, dislocations and panics.
Recall that when market liquidations accelerating dangerously back in March 2020, it required multiple Fed announcements of massive liquidity support to thwart crash dynamics.
Market structure was fragile back in 2020 - and there is every reason to believe latent fragilities have become only more acute over the past almost two years. Unprecedented flows inundated the securities markets, including over a trillion dollars into the ETF complex. The flood of trend-following buying was matched by retail participation in online stock and options trading. Margin debt exploded, although this is but a small fraction of the speculative leverage that has accumulated from the hedge funds and global speculator community. And this tsunami of speculative finance fueled the loosest financial conditions ever, replete with record corporate debt sales, stock issuance, IPOs, M&A, private-equity, venture capital and such.
The vast technology universe – the usual computer and communication technologies - joined by big data and the cloud, AI, quantum computing, blockchain, robotic automation, EV and autonomous vehicles, solar and green energy, Internet of Things, 5G, virtual reality, wearable tech, 3D printing, cybersecurity, drones, biomedical and telehealth, and on and on.
It’s been such an extended period of overabundance of cheap money available for just about anything. The underlying economics of an enterprise has almost been inconsequential. The upshot has been a proliferation of tens of thousands of loss-making ventures whose very existence depends on easily accessible finance. In Austrian economic terms, it’s a “bubble economy” structure that has been feasting on ever larger amounts of cheap and indiscriminate money and credit.
While the vast majority of analysts and economist remain quite bullish on U.S. economic prospects, our financial and economic structures could not be more vulnerable. These structures are today sustained only by massive new cheap finance, the very same finance that now stokes inflation. Market and policymaking environments are currently fraught with complexity and high risk. And the very epicenter of market structural fragility lies with systematic misperceptions of safety and liquidity – with misplaced faith in the Fed’s capacity to ensure stability – the core underpinnings of bubble dynamics throughout this long cycle.
To wrap this up, I’ll take note of last week’s fascinating dynamic. The Banks and Wall Street firms were hammered. The tech-based Nasdaq100 fell 7.5%, boosting year-to-date losses to 11.5%. Bitcoin dropped 15.6% and Etherium collapsed 28%. So-called “safe haven” Treasury bonds (the TLT ETF) had y-t-d losses already approaching 5% - this following last year’s 4.6% loss. Meanwhile, the Bloomberg Commodities Index’s gained 1.8%, and has posted early-2022 gains of 7%.
Last week provided the clearest indications yet of the unfolding secular shift away from high-risk financial assets and into hard assets increasingly perceived as more reliable stores of wealth. Not only does this bode poorly for today’s historic mania and securities market bubble. The flow of finance into commodities and real things would also seem to ensure ongoing inflationary fuel for the real economy. While yields have been rising, today’s 1.80% ten-year Treasury yield still offers a deeply negative real yield. Bond markets – certainly including corporate credit - remain highly vulnerable.
And while I can see bond prices receiving some support from sinking stocks, the big test will come when the Fed is forced by market instability to restart QE - despite vigorous underlying inflationary pressures. This creates a challenge for the Powell Fed unlike anything since the days of Paul Volcker. Volcker, however, didn’t have to contend with today’s fragile financial structure dominated by erratic securities and derivatives markets, unparalleled leverage and trillions of trend-following speculative finance. It’s a troubling backdrop. From my vantage point, it’s time to hunker down and get prepared for difficult market and economic conditions ahead.