$50bn hole appears in New York financial markets – Fed is “looking into it”

Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.

Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money.  And it was also clear that the authorities still have no idea of what is going wrong.

This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.

For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:

  • First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
  • Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.

Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.

As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”

Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“.  We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.

Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds?  Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%?  And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?

Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?

Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.

We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.

I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.

And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).

My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”.  Current developments in the repo market may be a sign that this is more likely than many people realise.  I hope I am wrong.

 

China’s renminbi and the global ring of fire

China’s property bubble puts it at the epicentre of the ring of fire © Reuters 

China’s devaluation could be the trigger for an international debt crisis, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

August has often seen the start of major debt crises. The Latin American crisis began on August 12, 1982. The Asian crisis began with Thailand’s IMF rescue on August 11, 1997. The Russian crisis began on August 17, 1998.

We fear that the renminbi’s fall below Rmb7 per dollar on August 5 will act as just such a catalyst — this time, for the onset of a global debt crisis that has long been in the category of an accident waiting to happen.

The risk is summarised in the chart below from the Institute of International Finance, showing the seemingly inexorable rise in global debt over the past 20 years

Central banks came to believe that business cycles could be abolished by the use of stimulus, first through subprime and then through quantitative easing. This would encourage the return of the legendary “animal spirits” and allow the debt created to be wiped out by a combination of growth and inflation.

© Institute of International Finance

Unfortunately, as we have argued here before, this belief took no account of demographics or the impact of today’s ageing populations in slowing demand growth.

The baby boomers, who created the growth supercycle when they moved into the wealth creator 25-54 generation, have now joined the cohort of perennials aged 55 and above. They already own most of what they need. The focus on stimulus means that policymakers have failed to develop the new social/economic policies needed to maintain soundly-based growth in a world of increasing life expectancy and falling fertility. Instead, stimulus policies have created overcapacity and today’s record levels of debt.

As William White, a former chief economist of the Bank for International Settlements, warned at Davos in 2016: “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.” Presciently, he suggested that the trigger for the crisis could be a Chinese devaluation.

Central banks have created a debt-fuelled ‘ring of fire’ with multiple fault-lines

The risk, outlined in our second chart, is that central banks have created a debt-fuelled global “ring of fire”. China has undertaken around half of all global stimulus since 2008, in effect creating subprime on steroids. As we noted here last year, its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.

As the FT reported in April, investors have already been spooked by rising levels of dollar debt in China’s property sector. This debt is set to open the global ring of fire, as US president Donald Trump raises the stakes in his trade war. The president and his advisers seem to have chosen to ignore the very real risk of currency devaluation, as markets respond to the impact of tariffs on the economy:

  • China’s property bubble puts it at the epicentre of the ring of fire
  • This is now spreading out across Asia, impacting other Asian currencies and economies
  • The Bank of Japan is about to become the largest owner of Japanese stocks
  • The end of the property bubble is causing the end of the commodity bubble
  • In turn, this is impacting Australia, South Africa, Brazil, Russia and the Middle East
  • ECB stimulus means eurozone government bonds have negative interest rates
  • Banks cannot make a profit and savers have no income
  • President Trump’s China trade war risks connecting all the dots
  • The UK’s potential no-deal Brexit in October further threatens global supply chains

The issue is the risk of contagion from one market to another. Risks in individual silos can be bad enough, but if they spread across boundaries it quickly becomes hard to know who is holding the risk. As US Federal Reserve chairman Jay Powell warned in May while discussing potential problems in the market for collateralised loan obligations (CLO):

“Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs. We know that the US CLO market spans the globe . . . But right now, we mainly know where the CLOs are not — only $90bn of the $700bn in total CLOs are held by the largest US banks . . . In a downturn institutions anywhere could find themselves under pressure, especially those with inadequate loss-absorbing capacity or runnable short-term financing.”

The CLO market is just one part of the problem. As S&P Global reported recently, more than $3tn of US corporate debt is rated triple B, with $1tn rated triple B minus, the lowest level of investment grade. US companies account for 54 per cent of the world’s $7tn total triple B debt. The risk of contagion in any sell-off is clear, as many institutions would have to sell if recession forced rating agencies into downgrades, taking debt below investment grade.

In turn, this would add to the risks in US equity markets, which are already at extreme valuations. Pension funds would be most at risk as they have been major investors in corporate debt and in recent years have entered markets such as the Asian offshore US dollar market in their search for higher yields. A downturn in their returns would risk creating a vicious circle, forcing companies to increase their pension contributions just at the moment when their earnings are already under pressure as the trade war slows the global economy.

Mr Trump may come to regret his comment that “trade wars are good and easy to win”. We envisage a testing time ahead, particularly as only those over 60 have personal experience of even the “normal” business cycles seen before the boomer supercycle began.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.

London house prices edge closer to a tumble

After the excitement of Wimbledon tennis and a cricket World Cup final, Londoners were back to their favourite conversation topic last week – house prices. But now the news has become bittersweet as the price decline starts to accelerate.

As the London Evening Standard headline confirms:

The London property slump has dramatically accelerated with prices falling at their fastest rate in a decade, official figures reveal… The latest “punishing” downward lurch means that more than £21k ($26k) was wiped from the value of the average London house over the period, according to the Land Registry… The number of sales is still in decline with just 5947 recorded in March, down from 7350 a year previously.”

‘Reversion to the mean’ is always the most reliable of investment guides, and the chart shows prices could have some way to fall before they reach this level – and, of course, prices often over-correct after the type of sharp rise that has been seen over the past 20 years:

  • Most people have to buy houses on a mortgage, where the ratio of price to income is the key factor
  • As the chart shows, prices and ratios have seen 2 distinct periods since 1971 (when records began)
  • Prices (inflation adjusted) have had an upward trend since 2000, with today’s 11% fall the worst
  • 1971-1999 saw more violent swings – eg between 1983-1993 they doubled and then halved
  • The average ratio since 2000 has been 9.3, which would bring prices down by a further 23%
  • The average ratio between 1971-1999 was 4.8, which would bring prices down by a further 60%

WHY DID PRICES RISE?
London prices have been boosted by 4 main factors since 1971:

Demographics.  Most fundamentally, the BabyBoomers (born between 1946-1970) began to move into their house-buying years. This dramatically increased demand (as I discussed last week), whilst supply was slow to respond due to planning restrictions etc.

In addition, women began to go back to work after having children, creating the phenomenon of 2-income families for the first time in history. The younger Boomers saw the benefit of this as affordability rose; those who followed them paid the price in terms of higher prices.

Buy to let. London became the capital of ‘Buy-to-let’. UK tenancy law changed in 1988 and by the mid-1990s, parents realised it would be cheaper and better to buy apartments for their student children, rather than paying high rents for shoddy lodgings. Others followed in the belief that property was “safer” than stock markets”.

Falling interest rates (they were 15% during the 1992 ERM crisis) made the mortgage payment very affordable – particularly with tax relief as well. But since 2017, tax relief has been reducing, and disappears next year. And today’s ageing UK population, where nearly 1 in 5 people are now aged 65+, means the Boomers no longer have spare cash to spend on buying property.

The global city.  After the financial crisis, London property appeared an oasis of calm as the Bank of England supported house prices by cutting interest rates to near-zero, dramatically boosting affordability. Everyone knew by then that “house prices only increased”, as memories of the 1970-1980s were forgotten, and so capital gains seemed assured.

This made London, along with other “global cities” such as New York, very attractive to Russians, Arabs, Asians and anyone else who was worried that their government might try to grab their money. Europeans also bought as the eurozone crisis developed. And then the success of the 2012 London Olympics made it the city where everyone wanted to live, especially as its financial sector was booming due to central bank stimulus programmes.

WHAT WILL HAPPEN NEXT?
The question now is whether these drivers will continue.  Brexit, of course, has already cast a shadow over the idea of the UK as an island of stability in a troubled world. And whilst the collapse of the currency since the referendum makes property more affordable for foreign buyers, it means that those who bought at the peak are nursing even larger losses.

And, of course, the fall in the actual volume of sales is another worrying sign. Volume usually leads price, up or down. And housing markets aren’t like stock markets, where you can usually trade very quickly if you want to sell. Instead you have to wait for a buyer to appear – and even then, the UK’s property laws make it possible for them to pull out until the very last moment.

All in all, it would therefore be surprising if prices didn’t continue falling, back to the average house price/earnings ratio of the past 20 years.  A temporary over-correction, where they went even lower, would also be normal after such a long period without a major fall.

Whether they go lower than this, and return to the 1971-99 ratio, probably depends on what happens with Brexit.  If those who believe it will open up a new ‘golden age’ for the UK economy are right, then  prices might well stabilise and could even rise again, after the initial disruption. But if it proves an economic disaster, then a return to the troubled period of the 1970s would be no surprise at all.

 

Stock markets risk Wile E. Coyote fall despite Powell’s rush to support the S&P 500

How can companies and investors avoid losing money as the global economy goes into a China-led recession?  That’s the key question as we enter 2019.  We have reached a fork in the road:

The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:

“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

His words confirm he equates “the economy” with the stock market, as the chart shows:

  • The Fed no longer sees its core mandate on jobs and prices as defining its role
  • Instead it has become focused on making sure the S&P 500 moves steadily upwards
  • Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue

Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards.  But now it is very close to finding itself over the cliff edge.

CORPORATE DEBT IS THE KEY RISK FOR 2019

The Fed should have realised long ago that markets cannot keep climbing forever.  Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery.  As a result:

  • Investors now have no idea if are paying too much for their purchases
  • Companies don’t know if their new investments will actually make money

We are heading almost inevitably to another  ‘Minsky Moment’ as I described in September 2008,:

“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.

This time, however, the risk is in corporate debt, not US subprime lending.  As the charts above show:

  • The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before
  • Lending standards have collapsed with most investment debt in the lowest “Triple B” grade

Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.

And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China.  And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

  • Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
  • The Bank of International Settlements has already warned that Western central banks stimulus lending means that  >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK

As the chart shows, China’s corporate debt is now the highest in the world.  Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.

The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017,  China’s central bank governor warns of ‘Minsky Moment’ risk.  The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:

“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

Companies and investors need to take great care in 2019.  China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:

  • Companies with too much debt will go bankrupt, leading to the Minsky Moment
  • The domino effect of price wars and lower volumes will quickly hit other supply chains
  • Time spent today in understanding this risk will prove time very well spent later this year

Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down. 

Why everyone ignored my warnings ahead of the financial crisis

It’s 10 years since my forecast of a global financial crisis came true, as Lehman Brothers collapsed.  I had warned of this consistently here in the blog, and in the Letters column of the Financial Times. But, of course, nobody wanted to listen whilst the party was going strong.  As the FT’s world trade editor wrote at the time, commenting on the Queen’s question “Why did nobody see this coming”:

“Why didn’t people see it coming? Some did, Ma’am. Some did. But it doesn’t mean they were listened to. And there is a long history of people in authority running up vast debts without public accountability and eventually losing their heads. Let’s just try and get through this one without a civil war, shall we?”

That rationale, I understood.  I was the “party pooper” warning of crisis for nearly 2 years.  But people didn’t want warnings.  And, of course, until we got to March 2008 and Bear Stearns collapsed, I couldn’t answer their all-important question, “When is this going to happen?”.

If you take the 4 great questions of life – Why, What, How and When – the ‘When’ question is really the least important:

  • If you know ‘Why’ something is going to happen, ‘What’ it involves and ‘How’ it will impact, then ‘When’ is simply the detail that confirms the analysis was right
  • But if you don’t want to know about a problem, its the easiest thing in the world to dismiss it by arguing “your comment is no use to me, unless you can tell me when its going to happen”

But I admit that what did surprise me, after John Richardson and I had written Boom, Gloom and the New Normal: how the Western BabyBoomers are Changing Demand Patterns, Again, was that people really liked our analysis of the impact of demographic change on the economy – but still ignored its implications for their business and the economy.

The above chart is a good example, showing the latest data from the US Consumer Expenditure Survey.  It confirms what common sense tells us:

  • Household spending is closely linked to age
  • Housing expenditure is the biggest single expense for most people, and peaks between the ages of 35-54
  • Transport and food & drink are the next largest spend, and peak at the same ages
  • Health expenditure, on the other hand, peaks as one gets older

This is critical information for central bankers, companies and investors, given that consumer spending is 60%-70% of GDP in most developed countries.

Yet the only central banker who took it seriously, Masaaki Shirikawa, Governor of the Bank of Japan, was promptly sacked after premier Abe came to power.   Printing money seemed so much easier than having difficult but essential discussions with voters about the impact of an ageing population, but as Shirikawa noted:

“The main problem in the Japanese economy is not deflation, it’s demographics. The issue is whether monetary policy is effective in restoring economic recovery. My observation is, it is quite limited.”

Equally, the second chart confirms that the US is also a rapidly ageing society, with 20m households having moved into the 55+ age range since 2000.  And whilst the 55+ group’s spending has increased over the period, this is only because many of the younger BabyBooomers are still in their 50s or early 60s.  So whilst their spend is declining, it hasn’t yet suffered the 43% fall that occurs after the age of 75 (by comparison with the peak spending 45-54 period).

Yet policymakers still insist that the 2008 crisis was all about liquidity, and had nothing to do with the impact of today’s ageing populations on spending and economic growth.  And most companies also still plan for “business as usual”.

SO WHAT HAPPENS NEXT, AS THE DEBT BURDEN GROWS?
For obvious reasons, I disagree with these views.  Of course, it would be lovely to find that today’s record levels of debt – created in the vain attempt to stimulate growth – could be made to simply disappear.  I have read analyses by learned commentators arguing that central banks can simply “write off” their debt, and it will magically disappear.

But I have never yet found a bank or credit card company prepared to “write off” any debt that I owe them in this way.  (If you know of one, please let me know, and I will pass on the details).  And most of us know from personal experience that interest costs soon mount up, if you can’t pay the debt at once and have to finance it for a while.

So its quite clear that today’s record levels of debt create massive headwinds for future growth. At $247tn, it now amounts to 318% of global GDP.  In reality, only two choices lie ahead:

  • The past decade’s borrowing brought forward consumption from the future, so repaying the debt means growth will slow very dramatically – adding to the demand deficit created by today’s globally ageing populations
  • Failing to pay back the debt risks creating chaos in financial markets, as we are starting to see with the crises in Argentina and Turkey, as lenders suddenly realise their loans cannot be repaid

But, of course, I can’t yet say exactly ‘When?’ this simple fact will finally impact the economy and markets.  For the moment, as between 2006 – March 2008, I can only tell you:

‘Why?’ it is going to happen, ‘What?’ it involves and ‘How?’ you can recognise the warning signs.

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High-flying “story stocks” hit air pockets as credit finally tightens

“Nobody could ever have seen this coming” is the normal comment after sudden share price falls.  And its been earning its money over the past week as “suddenly” share prices of some of the major “story stocks” on the US market have hit air pockets, as the chart shows:

  • Facebook was the biggest “surprise”, falling 20% on Thursday to lose $120bn in value
  • Twitter was another “surprise”, falling 21% on Friday to lose $7bn 
  • Netflix has also lost 15% over the past 16 days, losing $27bn
  • Tesla has lost 20% over the past 6 weeks, losing $13bn

These are quite major falls for stocks which were supposed to be unstoppable in terms of their market advances.

Of course, their supporters could say it was just a healthy correction and a “buying opportunity”.  And they might add that so far, other “story stocks” such as Alphabet, Apple and Amazon are still doing well.  But others might say a paradigm shift is underway, and these sudden shocks are just the early warning that the central banks’ Quantitative Easing bubble is finally starting to burst.

They might have a point, looking at the second set of charts:

  • Twitter stopped being a major growth story as long ago as 2015, since when its user growth has been relatively slow, even going negative in some quarters
  • Facebook stopped showing major growth in active users 18 months ago – and in 2018, it has been flat in N America and losing subscribers in Europe, whilst Asia and the Rest of the World are also heading downwards
  • Tesla, of course, has been a serial disappointment.  Its founder, Elon Musk, was brutally honest when founding the company in 2003, saying it had a 10% chance of success.  Since then, it has mostly failed to meet its production targets.  It was supposed to be making 5000 Tesla 3 cars a week by the end of last year, but according to Bloomberg’s Model 3 tracker, it is currently producing only 2825/week.  Around 0.5 million buyers have paid their $1k deposits and are still waiting for their car – and Tesla needs their cash if its not to run out of money
  • Netflix is another “story stock” now seeing a downturn in subscriber growth.  Yet at its peak it had a market value of $181bn, with net income for this quarter forecast by the company at just $307m.  Like Tesla, it was valued at a higher value than comparable businesses such as Disney, which have had solid earnings streams for decades.

The common factor with all 4 stocks is that they have a great “narrative” or “story”.  Elon Musk has held investors spellbound whilst he told them of unparalleled riches to come from his innovation.  This seemed to be the same with Facebook until the furore arose over the data user scandal with  Cambridge Analytica.  Twitter and Netflix have also had a great “story”, which overcame the need to show real earnings even after years of investment.

THE LIQUIDITY BUBBLES ARE STARTING TO BURST AS CENTRAL BANK STIMULUS SLOWS
In other words, reality seems to be starting to intrude on the “story”, just as it did at the end of the dot-com bubble in 2000, and the US subprime bubble in 2008.  The key, then as now, is the end of the stimulus policies that created the bubbles, as the 3rd set of charts shows:

  • Slowly but surely, the US Federal Reserve is finally raising interest rates back to more normal levels
  • And more importantly, China’s shadow bank lending is declining – H1 was down by $468bn versus 2017

Even the European Central Bank and the Bank of Japan have signalled they might finally be about to cut back on the combined $5.75tn of lending, often at negative rates, that they pumped into the markets between 2015 – March 2018.

The issue is simple. All bubbles need more and more air to be pumped into them to keep growing. Once the air stops being added, they start to burst. And for the moment, at least, Facebook, Twitter, Netflix and Tesla are all acting as the proverbial canary in the coal mine, warning that the great $33tn Quantitative Easing bubble may be starting to burst.

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