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     Oct 21, '13

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Terminal phases
Commentary and weekly watch by Doug Noland

Upon last week's legislation to reopen the US government and raise the debt ceiling, the president stated that there were "no winners." Yet equities (and, more generally, financial asset) investors and speculators did just fine. Last week saw the S&P500, the S&P 400 Mid-Cap Index and the small cap Russell 2000 all trade to record highs. The week's 2.8% advance increased the small caps' year-to-date gain to 31.3%. Google added about 140 points and $38.5bn of market cap last week (to $338bn) to reach an all-time high (up 43% year-to-date). The more speculative "beta" stocks continue to outperform. Chipotle rose 15% last week, increasing 2013 gains to 71%, and First Solar

jumped 8.7% to boost year-to-date gains to 82%. The NASDAQ 100 (up 3.7% last week), Morgan Stanley High Tech Index (up 2.6%) and The Interactive Week Internet Index (3.4%) all traded to the highest levels since 2000. Treasury, MBS, and corporate debt prices were higher as well.

The QE-enhanced 2013 version of "how crazy do things get?" is outshining even the 1999 speculative melee. The (post-LTCM bailout) year 1999 saw the small cap Russell 2000 Index jump from 422 to 505 (19.7%). This year, it has already run from 849 to 1,114 (up 31.3%). The S&P400 Midcap Index jumped from 392 to 445 in 1999 (13.5%). With more than two months to go, so far it's 1,020 to 1,290 for the midcaps (up 26.5%).

It was not only US investors that were enriched from Washington dysfunction. Germany's DAX equities index added 1.6% to a new all-time high (up 16.5% year-to-date). Italian stocks jumped 2.1% (up 18.4% year-to-date) and Spanish stocks surged 3.5% (up 22.5%), both to more than two-year highs. Australian stocks gained 1.7% (up 14.5% year-to-date). Despite major economic issues, India's stock market jumped 1.7% to within a couple percent of new highs. Stocks jumped 4.2% in Brazil and 4.3% in Argentina. Indonesian stocks rallied 4.5%. Around the globe, most equities markets pushed higher. Fueled by huge ETF flows, total equity mutual fund inflows this past week jumped to a whopping $12.7bn (from AMG/Lipper).

On a weekly basis, I track global central bank International Reserve Assets (data from Bloomberg). This data provide a decent proxy for global financial flows, especially to the emerging markets (EM). From US$6.63 trillion back in April of 2009, International Reserves surged to a record $11.415 trillion. Reserves have inflated 330% in ten years.

Reserve Assets showed atypically slow growth between May 10 ($11.124 trillion) and September 20 ($11.174 trillion), not coincidently a period a heightened EM instability. Courtesy of the Fed, BOJ, and Chinese, the "money" spigot was reopened. Though the data tends to be lumpy, it is worth noting that Reserves jumped $240 billion over the past month. Indonesian 10-year yields have declined about 100 basis points (bps) since September 30 to 7.34%. Yields in Turkey are down about 130 bps from August highs to 8.70%. In general, EM markets have bounced back strongly from May/June tumult. The Fed's taper deferral and China's retreat from Credit tightening reversed the "hot money" EM exodus - for now.

China's International Reserves jumped a notable $164 billion during the third quarter to a record $3.660 trillion (from $250 billion when Dr Bernanke joined the Fed back in 2002). This compares to Q2 Reserve growth of $54 billion. The People's Bank of China stated that trade and capital-related inflows were again bolstering excess: "The pressure for monetary and credit expansion is still large." Myriad data, including stronger-than-expected 7.8% Q3 growth, support the view of a meaningful pickup in Chinese activity. And while the consensus sees China's recovery as fundamental to a bullish global backdrop, I'll offer a contrary opinion.

My Macro Credit thesis holds - and there is ample fundamental support for - the view that we're now five years into history's greatest global Bubble. I have posited that China is deep into its "Terminal Phase" of Credit excess. With China's 1.35 billion people and Trillions of unrestrained Credit expansion, I'll argue China's "Terminal Phase" is integral to the overall "Terminal Phase" of a most protracted and dangerous global Credit Bubble. In general, post-2008 global monetary inflation pushed EM to precarious "Terminal Phase" Bubble excess, leaving deep wounds of economic maladjustment and financial fragility.

I believe the initial cracks in the EM Bubble developed this spring. Market turbulence from May and June provoked further global monetary accommodation, which somewhat reshuffled the deck in the global liquidity chase. And I wouldn't be surprised if history looks back at this period as a final manic speculative blow-off in US and global equities.

Despite generally bullish sentiment, I continue to believe that China faces serious imminent issues. Chinese officials in early June moved belatedly to try to rein in runaway Credit excesses. Not surprisingly, an increasingly powerful Credit expansion and attendant asset Bubbles had been impervious to cautious attempts to restrain mortgage and local government borrowing. When they resorted to more aggressive actions in June, financial and economic fragilities forced officials to quickly retreat from tightening measures. And, again not surprisingly, Credit excess bounced right back as powerful as ever.

The value of China's September residential apartment sales surged 34% from August to $113 billion. Year-to-date sales are running up about 35% from 2012. After bouncing back strongly in August (almost doubling July), September's total system Credit growth ("social financing") was reported at a stronger-than-expected $230 billion. This puts year-to-date "social financing" at about $2.25 trillion, a pace almost 20% above a record 2012. Some reports have mortgage Credit growing at a rate about 50% faster than last year. Additionally, forecasts are calling for Q4 corporate bond issuance to jump to $135 billion from Q3's $40 billion.

There are multiple facets of "Terminal Phase" Credit Bubble excess at play today in China. In asset-based lending Bubbles, the rapid growth in both transactions and prices combine for exponential growth in underlying mortgage Credit. It's worth recalling that annual US mortgage Credit growth increased annually from 1997's $313 billion to 2003's $1.011 trillion to 2006's $1.410 trillion. Importantly, along with the exponential rise in mortgage borrowing comes a corresponding spike in the riskiness of late-cycle lending booms. Indeed, and fundamental to Credit Bubble analysis, "Terminal Phase" excesses foster an unsustainable parabolic rise in Credit and economic risks. Systemic stability becomes a major concern anytime circumstances dictate that officials prolong the "Terminal Phase."

The surge in risky Credit tends to have myriad distorting effects on financial and economic systems. On the financial side, increasingly creative/aggressive risk intermediation is required to transform progressively risky mortgage debt into more "money"-like instruments palatable to savers, speculators and institutional holders. In the US and now in China, so called "shadow banking" came to play an instrumental role.

Here in the US, 2006's $1.0 trillion of subprime CDOs (collateralized debt obligations) provided a key and fateful risk intermediation mechanism. In China's historic "shadow bank" Bubble, there is huge ongoing growth in trust deposits and various "wealth management" vehicles. A rapidly expanding chasm - between the perceived safety of "money"-like deposits/savings vehicles and the mounting risks inherent in system Credit - is fundamental to "Terminal Phase" processes and fragilities.

There is another key "Terminal Phase" dynamic at work in the Chinese Bubble, as was (and remains) the case in the US and elsewhere. As late-cycle financial and economic Bubble risks grow exponentially, policymakers turn increasingly timid. Powerful Bubble Dynamics become impervious to policy "tinkering," while officials come to see the environment as too risky to implement the type of stringent (pain-inflicting) tightening measures required to quash (now well-entrenched) inflationary biases and rein in increasingly destabilizing excess.

The above reference to "serious imminent issues" reflects my expectation that the Chinese are likely gearing up for another stab at restraining Credit Bubble excess. It's reasonable to presume they won't do anything that would cause serious disruption. Yet, from my perspective, if they are serious about disrupting an increasingly destabilizing Bubble, there is no way around major global ramifications. And with international securities markets turning more intensely overheated by the week, this creates a potentially volatile dynamic.

There were more rumblings out of Beijing last week. At this point, it's difficult to gauge whether they are more frustrated with Congress or the Federal Reserve. One of these days they may even be willing to rein in their Credit system and let the global chips fall where they will. Perhaps even one of these days global policymakers may actually part ways in what has been to this point concerted efforts to reflate global economies and markets. Over time, when monetary inflation's fog begins to break, those on the losing end of inflationary processes begin to see things a little more clearly.

The dollar was hit relatively hard. Newfound dollar weakness may prove an important market development - perhaps even a crucial inflection point. Many speculators were positioned bullish the dollar, expecting a safe haven bid in the midst of unfolding emerging market instability. Months back I posited that a huge bearish short position had accumulated betting against the Japanese yen. There are mixed opinions as to how much the yen short has been reversed. Things could turn more interesting if dollar weakness spurs a short-covering rally in the Japanese currency.

Above I noted the possibility of a somewhat "reshuffled deck" in the resurgent global financial Bubble. While the liquidity high tide has so far elevated most markets, I would be surprised by a sustained reemergence of a generalized EM Bubble. We'll closely monitor for a destabilizing "periphery" and "core" dynamic, expecting finance to flood into the inflating "core" (ie China) at the expense of the fragile "periphery" (ie Brazil, India, Turkey?). And there has been another out of "periphery" (EM) and into "core" (Europe) dynamic at play over recent months. Euro strength has been further bolstered by Washington dysfunction and resulting dollar weakness. Strong financial flows have been positive for European stock and bond prices (Spain and Italy, in particular), although a euro at about 1.37 to the dollar is particularly unhelpful for export competitiveness in struggling Italian, Spanish, Portuguese and French economies. Might dollar weakness push the ECB to counter with more aggressive monetary stimulus?

It's been only about three weeks, but the fourth quarter has already shown itself worthy of the history books. If the leveraged speculating community can hold gains through year-end, the ranks of billionaires will surely inflate further. No winners?

The S&P500 jumped 2.4% (up 22.3% year-to-date), and the Dow gained 1.1% (up 17.5%). The S&P 400 Midcaps gained 2.3% (up 26.5%), and the small cap Russell 2000 jumped 2.8% (up 31.3%), both to new record highs. The Morgan Stanley Consumer index rose 2.2% (up 26.1%), and the Utilities gained 0.7% (up 8.4%). The Banks surged 3.1% (up 27.8%), and the Broker/Dealers jumped 3.0% (up 50.6%). The Morgan Stanley Cyclicals were up 2.2% (up 29.2%), and the Transports rose 2.7% (up 28.7%). The Nasdaq100 surged 3.7% (up 26.0%), and the Morgan Stanley High Tech index advanced 2.6% (up 23.5%). The Semiconductors gained 1.8% (up 31.9%). The InteractiveWeek Internet index jumped 3.4% (up 31.9%). The Biotechs rose 3.3% (up 39.7%). With bullion gaining $44, the HUI gold index rallied 6.6% (down 49.1%).

One-month Treasury bill rates ended the week down 17 bps to less than a basis point, and three-month rates closed down 3 bps to 2.5 bps. Two-year government yields were 4 bps lower to 0.31%. Five-year T-note yields ended the week down 9 bps to 1.33%. Ten-year yields fell 11 bps to 2.58%. Long bond yields dropped 11 bps to 3.64%. Benchmark Fannie MBS yields dropped 11 bps to 3.25%. The spread between benchmark MBS and 10-year Treasury yields was unchanged at 67 bps. The implied yield on December 2014 eurodollar futures declined 4 bps to 0.475%. The two-year dollar swap spread was little changed at 13 bps, while the 10-year swap spread increased one to 14.5 bps. Corporate bond spreads narrowed. An index of investment grade bond risk declined 6 to 71 bps. An index of junk bond risk sank 25 to 345 bps. An index of emerging market (EM) debt risk fell 9 to 312 bps.

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