Will stock markets see a Minsky Moment in 2020?

Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.

How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).

As in the old USSR, central banks have also abolished “bad news”.

All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.

But does this mean that stock markets will never fall again?  That is the real question as we enter 2020.

On the positive side, we know that companies have also provided major support via buybacks.  Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.

We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:

“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”

Certainly investors seem to be very positive, as the above charts confirm.  Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:

  • Apple for example, was up 32% in Q4 and nearly doubled in 2019
  • On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain

This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.

So is there a negative side?  Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?

If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned that:

  • A long period of stability eventually leads to major instability
  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt to finance ever more speculative investments

His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:

“Why not borrow, as it’s not costing us anything with today’s interest rates“.

But what happens if the earnings from the new investments are too low to pay the interest due on the debt?

That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity

Investors will then find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid.  In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place.

China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.

Another ‘Minsky Moment’ beckons for US stock markets

NYSE margin May14The West has been living with cheap money from the central banks for over 5 years.  Credit has been very easy to obtain in the financial sector, and interest rates have been at all-time lows.  The result can be seen in the chart above from Business Insider of total lending to fund stock purchases on the New York Stock Exchange (margin debt)

  • US margin debt has been at all-time record highs this year, higher even than in 2000 and 2007 (red line)
  • Rises and falls in the amount of this margin debt are 96% correlated with movements in the S&P 500 (blue)

China’s ‘collateral trade’  has also been a major part of the ‘unseen hand’ of easy credit that has propelled world financial markets to record highs since the financial Crisis began.  The risk now, as China starts to unwind this trade, is that ‘what went up together, also goes down together’.

We last saw this effect in September 2008.  The cause is simply explained by the work of Hyman Minsky:

  • His insight was that a long period of stability eventually leads to major instability
  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt, in order to finance ever more speculative investments

This, course, is exactly what is happening today.  Investors believe that the US Federal Reserve will never let stock prices fall.  And at the same time they are being given zero-cost money by the Fed with which to speculate, due to the Fed’s belief that higher stock prices will increase consumer confidence and restore economic growth.

At some point, however, as in 2008, another ‘Minsky moment’ will occur:

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

The chart also highlights one even more worrying development.  The amount of margin needed to boost the real value of the S&P 500 to its peaks (adjusting for inflation), has risen from $280bn in 2000 to $440bn in 2007, and to $465bn today.  Yet in real terms, the S&P 500 is still below its 2000 peak.  As Nobel Prize winner Robert Shiller’s data shows, the S&P 500 reached 2057 in 2000 when adjusted for inflation – versus 1763 in 2007 and its recent peak of 1900.

This highlights the fundamental instability of today’s stock market peak.  The blog fears that the second Minsky Moment may not be far away.  Then investors will find out for a third, and perhaps final time, that even the Fed cannot print enough money to maintain the speculative bubble forever.

Exchange Traded Funds (ETFs) will likely be the instrument of destruction this time, rather than subprime loans to the housing market, or over-valued dot-com shares.  As US investment magazine Barrons has warned:

ETFs will be the delivery mechanism.  There was just $531bn in ETFs at the end of 2008, so the now-$1.7tn industry has been largely untested in a major selling panic, replete with disappearing liquidity and credit system seize-ups. We suspect that these funds could exacerbate the selloff that may be impending.  Our best advice: Be vigilant, don’t get carried away, and look out below.”

China’s empty cities create global lending risk

TielingAMore details continue to surface of the wasteful spending that underpinned much of China’s GDP growth in recent years.  The empty city of Ordos (first highlighted 3 years ago in the blog) is just one example.  House prices there have recently fallen 50%, and the shadow banking system (critical for privately-owned companies) is reportedly in chaos.  Another is the city of Tieling, pictured above.

In 2009, it was told to build a satellite city 6 miles away.  Today, $bns later, the new city is a ghost town.  Affordable housing that won UN recognition for its quality is empty.  The businesses that were supposed to underpin growth by providing jobs, have simply failed to appear.

This highlights the problem facing the new leadership.  Do they stop the flow of money, or do allow spending to continue, hoping this might be the catalyst for the jobs to arrive?  Its a big decision, and for the moment it is being deferred.   Thus Tieling is spending $1.3bn this year on projects including an art gallery, swimming pool and gym.

Yet the decision cannot be deferred too long.  As Qiao Runling, a senior official with the powerful National Reform and Development Commission has warned:

“Reckless expansion of cities in China has left many of them empty.  Nearly every big or medium-sized city across China has plans to erect a new town… (and these) new towns are usually bigger than old ones and many cities are left empty as a result.”

His conclusion was stark.  “China now has an oversupply of cities, given the number of new urban districts that we have, (with) the excess of new urban districts are especially serious in medium and small-sized cities in central and western parts of the country.”

Whilst Yu Yongding, a former senior Bank of China official was even more blunt:

“Why am I so concerned about the debt issue? Because based on my experience of dealing with local governments, I am sceptical whether they are willing and are able to repay the debts,”

Nobody yet knows the size of the debts run up by local government in pursuit of this policy.  But in a sign of their mounting alarm over the issue, China’s new leadership have told the National Audit Office (NAO) to give top priority to finding out the answer.  At the same time, the country’s 4 largest banks have been told to raise $44bn in new capital, presumably to help them meet the cost of the bad debts that will be found.

Worryingly, it seems they are finding it difficult to raise this money in China itself, as market sentiment towards the banks is very bad.  Thus the Wall Street Journal (WSJ) reports they are “considering selling the debt in markets outside mainland China”.  But it is hard to see why foreign investors would be prepared to invest, if local players find the offer unattractive.

Blog readers will not be surprised by these developments.  2 years ago, when the China boom was at its peak, the blog warned that it would all unravel, just as we had seen with the US subprime boom.  One clear sign of crisis emerging is that the bank regulator felt forced to appear on national television earlier this month to reassure people that their money was safe.  Thus Shang Fulin, chairman of the China Banking Regulatory Commission, admitted that:

“Banks face a large quantity of maturing local-government debt this year (and) that important risks stem from loans to local governments and those created outside banks’ balance sheets”.

So far, as with Tieling, the banks have been allowed to indulge in the game of “pretend and extend”.  As the WSJ notes, “many Chinese banks have resorted to extending maturing loans to avoid defaults”.  The alternative, of course, would be to declare the loans a bad debt.

Thus for the moment, Mr Shang can claim, “China’s banking industry remains relatively stable and healthy.”  But his use of the word “relatively” confirms that all may not be as it seems.  We will only know the true position when the NAO has done their work.  And even more worrying is the fact that, as the Journal also notes, “based on market capitalization, four of the 10 largest banks in the world are Chinese”.

Presumably, therefore, a large number of non-Chinese banks have cross-lending commitments with these banks.  And so there is clear scope for contagion to spread across the global banking system.

Markets slow as debt worries increase

US debt Feb13.pngThe blog is becoming worried about the likely outlook for Q2. Sentiment now seems to be weakening alongside the fundamentals of supply/demand:

Fundamentals. The start of 2013 has been a disappointment. Demand has shown some recovery after the low levels seen at the end of Q4. But there have been few signs of any real tightness in global markets
Sentiment. Confidence is beginning to evaporate, causing financial markets to diverge for the first time since 2009. For example, Brent prices have risen $3/bbl since the end of January, whilst US WTI prices have fallen the same amount

Thus Linda Naylor, one of ICIS’ most experienced editors, summarised European polypropylene markets as follows during the week:
“Under these circumstances a price crash cannot realistically be expected, but production will have to remain cut back if demand does not improve.”

Similarly, Becky Zhang reported on Asian polyester markets:
“In the wake of poor margins and weak demand, close to 5m tonne/year polyester capacity in China has been left idle for the long holiday.”

The key issue is summarized in the chart, based on a new report by Pimco (the world’s leading bond fund managers), on the implications of today’s increasing debt load for the US economy:

• In the 1950s, $1.30 of new debt was needed to create $1 of GDP growth
• In the 1980s, $4 of new debt was needed to create the same amount of GDP
• By the 2000s, $10 was needed
• Today, $20 is needed to get the same result

Policy makers refuse to accept the simple truth that we are unlikely to see much GDP growth in coming years. $4 of debt might have seemed affordable in the 1980s, when the BabyBoomers were young, and had their main productive years ahead of them. But ageing populations only need replacement products, and have less money to spend as they enter retirement.

Today it is sheer folly to try and maintain growth via engineering a massive expansion of debt levels. Anyone who has ever tried to pump up a balloon knows that it will burst if one tries to add too much air. The blog worries this is the risk that we may now be facing in Q2, after last year’s major debt expansions in the US, China and Europe. As Pimco warn:

“Credit is now funneled increasingly into market speculation (instead of) productive innovation”.

Benchmark price movements since the IeC Downturn Monitor’s 29 April 2011 launch, and latest ICIS pricing comments are below:
PTA China, red, down 11%. “Polyester demand slowed down during the week as most downstream textile factories have ceased production”
Naphtha Europe, dark brown, down 10%. “Demand in Asia, and US continues to pull naphtha for gasoline blending.”
HDPE USA export, purple, down 10%. “Spot ethylene prices have dropped by 7% since the last week of January”
Brent crude oil, blue, down 6%
Benzene NWE, green, up 8%. “Market was largely rangebound this week, with the US market stalling following several weeks of bullishness”
S&P 500 stock market index, brown, up 11%