A strange thing happened to German 10-year interest rates last week – they rose quite sharply, by a further 0.2%. That may not sound a lot, but it is when the starting point is so low. On 20 April, they were at 0.07%, and on Friday they closed at 0.37% – for a total rise of 0.3% in 10 days.
Thus their gain since the start of the European Central Bank’s €60bn/month ($67bn) QE programme was wiped out.
This followed a similar jump in US 10-year bond yields, from 1.87% on 17 April to 2.11% on Friday – a 13% rise in 2 weeks. And the US 10-year bond is the benchmark for the global bond market, as it is supposedly “risk-free”.
Of course, this may just be the result of trading gambles as yet unreported. But as the Financial Times warned on Friday:
“While the stock of outstanding US high-grade corporate bond has risen since 2008 from $2.8tn to $5tn, the level of market turnover has tumbled to at or close to the lowest levels on record”.
Liquidity matters in financial markets. The big players need to know they can buy and sell large volumes – if they can’t do this, then volatility can suddenly increase. And a new Report from the Institute of International Finance (IIF) on Thursday highlighted how the sudden drop in liquidity has also hit emerging markets (EM):
“EM bank lending conditions tightened abruptly to their weakest level in three years in 2015Q1. The main driver was a plunge in loan demand, led by EM Europe and EM Asia. In addition, funding conditions continued to tighten, in part driven by a sharp deterioration in access to external funding in Latin America and Sub-Saharan Africa. Meanwhile, nonperforming loans maintained their upward trend, especially in EM Asia and Latin America, causing banks to continue tightening credit standards for new loans.”
The problem according to the IIF is “lack of demand, (with) demand for credit falling sharply across all 5 regions”.
These two developments confirm that the impact of China’s New Normal policies is now spreading into the financial sector. Commodity prices were first hit as China’s demand growth came to an end in H2. Now commodity exporters are running out of cash, and have few opportunities to replace the income they have lost from the downturn.
The IeC Boom/Gloom Index of market sentiment is also warning that markets are increasingly stressed. It jumped with news of the ECB bond-buying early in the year, but has since fallen back sharply, as the chart shows.
Equally important, perhaps, is that last week’s bad news on US GDP led yields to rise, not fall. If so, this could be awkward timing for markets. They traditionally slide between May to September, giving rise to the saying “Sell in May and go away”. New research shows this pattern persists in 36 of the 37 countries studied back to 1694.
The key to the slowdown is lack of liquidity:
- Historically farmers would raise cash in May to finance their harvest, and would then reinvest when they sold it
- Today, most investors take holidays over the summer, thus reducing levels of activity
Central banks have created a debt-fuelled ’Ring of Fire‘ in recent years, in their vain efforts to return us to BabyBomer-led SuperCycle growth levels. It may just be that investors are starting to realise that much of this debt can never be repaid, now the world has lost its demographic dividend and has moved into demographic deficit.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 39%. “Supply had been curtailed by exports out of the region to the US market since the end of March, and with crackers switching over to lighter feedstocks now that the winter season had drawn to a close.”
Brent crude oil, down 37%
Naphtha Europe, down 34%. “Naphtha prices have increased this week on the back of upstream Brent crude oil futures”
PTA China, down 28%. “Downstream polyester sectors in the key China markets slowed down as compared to the previous week”
HDPE US export, down 18%. “Export prices moved higher across the board in response to higher prices in Asia and Europe”
¥:$, down 18%
S&P 500 stock market index, up 8%
A major new report from consultants McKinsey confirms my concerns over the dramatic increase in global debt levels since stimulus policies began in 2008. As their chart above highlights:
- Global debt has risen by $57tn to $199tn since 2007, nearly 3x global GDP
- Government debt is up by $25tn, with three-quarters of this in the developed world
- Household debt has risen in 4 out of 5 countries, with three-quarters of this in mortgages
- China’s debt has risen four-fold, with half of the loans linked to property, and the shadow banking system having growth at 36%/year
As McKinsey warn:
“Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.
“Government debt is unsustainably high in some countries. Since 2007, government debt has grown by $25 trillion. It will continue to rise in many countries, given current economic fundamentals. Some of this debt, incurred with the encouragement of world leaders to finance bailouts and stimulus programs, stems from the crisis. Debt also rose as a result of the recession and the weak recovery.
“Household debt is reaching new peaks. Only in the core crisis countries—Ireland, Spain, the United Kingdom, and the United States—have households deleveraged. In many others, household debt-to-income ratios have continued to rise. They exceed the peak levels in the crisis countries before 2008 in some cases, including such advanced economies as Australia, Canada, Denmark, Sweden, and the Netherlands, as well as Malaysia, South Korea, and Thailand.
“China’s debt has quadrupled since 2007. Fueled by real estate and shadow banking, China’s total debt has nearly quadrupled, rising to $28tn by mid-2014, from $7tn in 2007. At 282 % of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany. Three developments are potentially worrisome: half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.”
McKinsey’s very detailed research thus completely confirms the conclusions of my own Research Notes, such as China bank lending: From $1tn to $10tn and back again a year ago.
It also confirms my fears about the fault-lines that have been created by the central banks’ misguided stimulus policies, as set out in the ‘Ring of Fire’ map below.
China’s change to its “New Normal” policies under President Xi has already opened the fault-lines in oil markets to the Middle East and Russia, and in mining to Australia, S Africa and Brazil. At the same time, the fault-line to the Eurozone is waiting to open as the Greek crisis develops, as is the fault-line to London’s over-priced housing market.
Some extraordinary things are happening in global chemical markets. They indicate something is very wrong in the real world outside financial markets. The chart above highlights some key developments since 18 August when the Great Unwinding of policymaker stimulus began:
- Brent oil prices have halved and are down 51% (blue)
- Naphtha, the main feedstock for the global industry, has also halved and is down 57% (black)
- PTA in China, a good proxy for the local economy, is down 42% (red)
- Benzene, my favourite indicator for the global economy is down 58% (green)
Yet most commentators continue to insist that everything is ‘business as usual’. Almost unbelievably, the US S&P 500 continues to float in its own bubble, and is up 5% thanks to the support from US Federal Reserve money printing.
The reason is that many analysts now only worry about the outlook for interest rates, and ignore the lack of demand in the real world. Those who argued a year ago that high oil prices meant the global economy was strong, happily argue the same for low oil prices. They believe only an upwards move in US interest rates could destabilise the economy.
Unknowingly, they highlight the insight of the classic novel Candide by the great French writer, Voltaire. It features an earlier version of these commentators, Professor Pangloss, who keeps insisting despite all evidence to the contrary, that “everything is for the best, in this best of all possible worlds”.
THE US$ IS NOW RISING SHARPLY
The second chart above looks more closely at the two key developments of the past 6 months. The blue line is the collapse of Brent oil prices, and the red line is the rise of the US$ Index versus the other major world currencies. It is impossible to over-estimate the importance of both developments.
As Ambrose Evans-Pritchard has warned in The Telegraph, the 12% rise in the US$ Index means $5.7tn of emerging market debt is now at risk:
“They have collectively borrowed $5.7 trillion in US dollars, a currency they cannot print and do not control. This hard-currency debt has tripled in a decade, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. It is comparable in scale and ratio-terms to any of the biggest cross-border lending sprees of the past two centuries.
“Much of the debt was taken out at real interest rates of 1% on the implicit assumption that the Fed would continue to flood the world with liquidity for years to come. The borrowers are “short dollars”, in trading parlance. They now face the margin call from Hell as the global monetary hegemon pivots.
“The second assumption was that China would continue to drive a commodity supercycle even after Premier Li Keqiang vowed to overthrow his country’s obsolete, 30-year model of industrial hyper-growth, and wean the economy off $26tn of credit leverage before it is too late.”
Chemical markets are the best leading indicator for the global economy. Developments in these over the past 6 months are the canary in the coal-mine that confirm Evans-Pritchard’s analysis. We are getting closer and closer to the opening of the debt-fuelled “Ring of Fire” created by the central banks.
WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 58%. “Falling upstream crude oil values and thin market participation have pulled benzene prices lower”
Naphtha Europe, down 57%. “A free fall in naphtha prices has increased the air of caution in the petrochemical markets, making buyers hold back from making additional purchases”
Brent crude oil, down 51%
PTA China, down 42%. ”Prevailing weak downstream demand has largely curbed buying interest for higher-priced materials. Ample inventories in the region have also resulted in buyers adopting a wait-and-see stance, without rushing to procure cargoes”
¥:$, down 16%
HDPE US export, down 12%. “US-made material is still priced too high to compete with Asian imports”
S&P 500 stock market index, up 5%
We can all hope that China’s ‘collateral trade’ turns out not to be as big a problem as seems likely. But history shows that this type of problem has a way of escalating once people start investigating more closely.
Thus state-owned Citic revealed yesterday that it has lost $40m in the Qingdao scandal, as half of its alumina is missing. And, of course, this is only what it knows to be missing. We also learnt that local Chinese banks may have Rmb 15bn ($2.4bn) in outstanding loans to Dezheng Resources, the company at the centre of current investigations.
The key issue is that nobody can tell today the depth of the problem:
- Maybe this is just one company, with one set of deals that went wrong?
- Maybe the vast majority of China’s commodity imports have indeed been used to create future income?
- Maybe China’s housing market is not as overvalued as it appears, and may stabilise at today’s levels?
- Maybe the government will reverse course and do another 2008-type stimulus to try and resolve the situation?
But maybe only some, or none, of the above turns out to be true? The Qingdao scandal has now been running since April, when Dezheng’s founder was first detained. And as the Financial Times reports:
“The case has cast a chill over metals trading in China, the world’s largest consumer. Chinese customers and traders are now often unable to find loans for imports as Chinese and international banks pull back from a practice once viewed as safe….
“China’s central bank ordered banks in Shandong province to approve import financing from their provincial offices, rather than their city branches, on the same day that police formally began investigating the multiple claims on the metal.
Day by day, the story refuses to die down. Instead, more and more details emerge to suggest it may get worse.
It therefore seems prudent to adopt the Scout motto of “Be Prepared” and try to identify a ’worst case’. The reason is simple – history shows, as during the sub-prime Crisis, that there is little time to react once the wider market becomes aware of the potential problem.
WHAT MIGHT HAPPEN NEXT, IN A WORST-CASE SCENARIO?
First to be hit would likely be the global commodity markets, if they wake up one morning to find that China’s vast ‘collateral trade’ is starting to unwind, perhaps rather suddenly:
- The prices for those metals and other commodities caught up in the trade would be hit first
- Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking
- Investors may put 2 and 2 together and worry, as the BBC described in February, that “China Fooled the World”
Next to be hit could be other financial markets. Complacency and low interest rates have encouraged investors to borrow heavily. Each night, therefore, they might start to receive margin calls as prices for their commodity-related investments decline:
- Some investors might decide to sell out, pushing prices further down
- Other investors might need to raise funds by selling non-commodity related investments
- At the same time, buyers might then immediately disappear for anything that appears to be high-risk
A third phase of the downturn could then develop in our globally-linked electronic world:
- These forced sellers might have to sell in more liquid markets to secure the cash they need
- This would mean selling blue-chip shares and high-quality government bonds
- In turn, investors who have borrowed heavily to invest in these markets would then start to receive margin calls
The risk is therefore that major declines could then take place quite suddenly in a number of major financial markets, just as Hyman Minsky would have forecast:
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
As in 2008, another ‘Minsky moment’ could thus occur as ‘distress sales’ start to take place.
Let us hope that none of this happens. But what would your company do, if some or all of these events start to take place? That is the key question that we all now need to answer.
CONCLUSION – THE WORLD COULD EASILY BECOME A SCARY PLACE
None of this would have happened if central banks had accepted that ageing populations inevitably lead to low levels of economic growth. The New Old 55+ generation are a replacement society, as they already own most of what they need, and their incomes decline as they enter retirement.
But the central banks didn’t want to do this. Instead, they have provided a fig-leaf behind which politicians could hide, to avoid a difficult debate with the voters about the need for pension age to rise, not fall.
The blog has warned over the past year that the world could become quite scary if it finally becomes clear that the central banks have created a debt-fuelled ‘ring of fire’.
It has long worried that China’s property bubble would prove to be the the epicentre of the global debt bubble. Today’s Qingdao scandal seems to be another, stronger, tremor warning of the potential earthquake to come.
If it is accompanied by even a limited collapse of China’s property market, then it risks opening up the fault-lines that the central banks have created around the world.
The blog’s new Research Note in the ‘Your Compass on China’ series highlights the way that China’s commodity imports have been used to finance its housing bubble. This is clearly a shock for investors, who have till now believed the imports were a sign of its superior economic policies and long-term growth prospects.
The Qingdao probe could thus become the straw that breaks the camel’s back for world markets. There are two reasons to believe this is a serious threat:
- Investors have assumed that China’s vast share of global commodity demand was due to its economic growth. Now they will slowly wake up to find it was more about supporting a housing bubble
- Similarly, they have assumed that China had become ‘middle class’ with Western living standards and incomes. Now they will be forced to realise that consumer spending has been driven by the ‘wealth effect’
The worry is that the global financial system is currently priced for perfection. and may not be resilient enough to cope with this shock. Investors, companies and individuals have been lulled into believing that central banks’ experience with the Lehman Bros collapse means they will never let markets suffer a major downturn:
- Borrowing to buy stocks in New York is at record levels
- Investors Intelligence US sentiment index at 62.2% is at danger level, above August 1987 and October 2007
- American investors so-called ‘fear index’, the VIX, is at its lowest level since 2007
The best view is always from the top of the mountain, and thus it is no surprise to see Goldman Sachs still bullish:
“If nothing unexpected upsets the stock market’s delicate balance at these lofty heights, VIX could fall to record lows.”
The Qingdao probe is exactly the type of ”unexpected” event to reveal this as simply wishful thinking. The key issue is that a large part (we don’t yet know how much), of China’s vast purchases of commodities since 2009 has not been used to build the economy. Instead, it has been used as collateral to finance a huge property bubble.
China’s new leadership clearly understand this. As the blog discussed in its February Research Note, they are now implementing a series of well-designed policies with the help of the World Bank to limit the damage from the bubble’s collapse. We can only hope they are successful.
Now, however, the rest of the world is about to discover what they already know. The blog’s fear is that this discovery will prove extremely painful, because of being so “unexpected”.
A core reason for concern is the total size of China’s corporate debt. It overtook the US in 2013 at $14.2tn, according to ratings agency S&P:
“China’s corporate issuers account for about 30% of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector. That means as much as 10% of global corporate debt, about $4tn to $5tn, is exposed to the risk of a contraction in China’s informal banking sector.”
China’s ‘collateral trade’ is at the heart of the issue. This is why the Qingdao probe is potentially so earth-shaking:
- Already some lenders are withdrawing from commodity financing in China as the risks rise
- Global market prices for copper and iron ore are declining, as informed players exit the market while they can
- The Economist notes that China’s banks are starting to become more reluctant to grant letters of credit
An investigation by the Wall Street Journal (WSJ) makes the link between the ‘collateral trade’ and housing very clear,. It appears the owner of the company at the centre of the Qingdao probe was heavily involved in real estate development:.
“In 2008, China’s government unleashed a $4 trillion stimulus package aimed at helping the economy withstand the global financial crisis. The stimulus drove a wave of credit through China’s financial system that launched a building boom in cities like Qingdao.
A real-estate company controlled by Mr. Chen currently is developing at least four projects in Qingdao, including a residential project called “Brocade City” and a large mixed-use development in the city center, according to the firm’s website.”
The WSJ adds that Mr Chen was not unique:
“Just about every trader who does collateral financing is also likely to have a real-estate development on the side, because the property sector gives higher returns,” said Jerry Chen, a metals trader at Shanghai-based Star Futures.”
It is already clear that China’s property market is entering a major slowdown, with Beijing sales down 35% so far this year. This will itself prove an enormous shock as property has been a money-making machine till now, with prices doubling every 2 to 3 years since urban property was privatised in 1998.
As property prices now fall, the ‘collateral trade’ will come to an end. In turn, investors will slowly realise that China’s economic growth has indeed been tied to a property bubble which is now beginning to burst.
There is thus a serious risk that today’s warning tremors in Qingdao will become a serious earthquake, and open fault-lines across the global financial system. Investors may now find out the hard way that central banks have instead created a debt-fuelled ‘ring of fire’, with China’s property bubble at its epicentre.
A new article by an IMF economist makes the point that in April 2008, not a single one of the mainstream economic forecasts covered by ‘Consensus Economics’ was forecasting a recession in 2009.
The IMF itself expected growth to continue, as did the World Bank and the Organisation for Economic Co-Operation and Development. Even by September 2008, the consensus view was still for continued growth, and no recession.
As the Financial Times comments, “it is an astonishing record of complete failure“.
The blog did forecast the Crisis. But, of course, most people preferred to believe the consensus. Their caution was understandable. But sometimes it is necessary to go against the consensus. And today it is essential.
The reason is simple. Central bank policies since 2008 have clearly not solved the problems of slowing growth and too much debt. Rather, they have made them worse, much worse.
Central banks have now created a debt-fuelled ‘ring of fire’ with multiple fault-lines, as the chart above shows.
Some of these fault-lines are becoming widely acknowledged. Thus the Governor of the Bank of England has warned that the record level of London house prices poses:
“The biggest risk to financial stability, and therefore to the durability of the expansion, those risks center in the housing market and that’s why we are focused on that.”
Similarly, the new Chinese leadership has recognised their economy has moved into a New Normal, and that more stimulus would cause many more problems than it would solve.
The problem is that these realisations all come too late. Policymakers have spend $33tn, and wasted 5 years, heading in the wrong direction. We could by now have begun to emerge from the Crisis with a soundly-based platform for future growth. But instead, we are faced with dealing with the same problems as in 2008, but on a much larger scale.
Even worse is the fact that most policymakers still do not accept that demographics drive demand. They do not want to admit that the ‘Demographic Dividend’ of the Boomer-led SuperCycle growth has been replaced by a ‘Demographic Deficit’ caused by ageing global populations and falling fertility rates. Instead, most prefer to indulge in wishful thinking – arguing that adding yet more debt will somehow enable growth to return.
Thus we face a ‘ring of fire’ where the tectonic plates are shifting all the time.
This is not to say we face one big earthquake. Rather, we face a period where one medium-sized earthquake will opens up cracks elsewhere. And these cracks create the potential to create another debt-related earthquake elsewhere along the fault-line.
China is the epicentre of the first earthquake, as the blog noted in February when launching its Research Note. The first economic tremors from its new policies have already moved along the fault-line, destabilising emerging economies in a wide arc from Argentina through India and Indonesia to Turkey.
The worrying feature is that these were just an early warning of the likely impact of China’s policy shifts. We are in a world where there are multiple fault-lines with the potential to crack open when stressed by tremors from another earthquake, for example:
- US financial markets are racing higher, fuelled by levels of debt never before seen in history
- The Eurozone debt crisis remains unsolved, and the recent EU elections will make it even harder to find a solution
- Russia’s establishment of a Eurasian Economic Union highlights its intention to pressure Western Europe, which depends on its energy exports
- And, of course, there is the great debt mountain in Japan, built even higher under Abenomics
There is little that any individual or company can now do to stop these earthquakes happening. Even a complete about-turn by policymakers today would only reduce their impact, not remove the risk. But we can at least try to understand why they are likely to happen, and prepare ourselves to survive them.
This will be the aim of a new series of posts, whch the blog will intends to publish over the next few weeks. Tomorrow’s post will begin the series, updating on China’s housing and shadow banking bubble. It hopes readers will find the series helpful.