Page 1 of 3 CREDIT BUBBLE BULLETIN Latent market risks
Commentary and weekly watch by Doug Noland
It was a rout: emerging markets, Treasuries, municipal bonds, mortgage-backed securities (MBS), commodities and even some stocks. The hours leading up to Wednesday's statement by the Federal Open Market Committee and Federal Reserve chairman Ben Bernanke's press conference provided good television drama. CNBC's Rick Santelli offered one of the better rants in a while: "Ben, what are you afraid of?" Mr Santelli returned minutes later with a provocative back and forth with Wall Street Journal Fed-watcher John Hilsenrath.
After Santelli challenged him to more forcefully hold Bernanke and the Fed accountable, Hilsenrath politely snapped back: "Part of
my holding people accountable is holding people like you accountable. People have been saying inflation, inflation, inflation. Show me, show me... How about the dollar? How about the dollar? ... Where are the bad things that you said were going to happen?"
As much as I appreciated the respectful exchange between Santelli and Hilsenrath, I was left disappointed that fundamental aspects of the quantitative easing (QE) debate remain unexplored. For years now, there's been this ongoing debate of the costs and benefits of the Fed's (and others') aggressive monetary easing. The supposed benefits have been easy to articulate: lower market yields and mortgage rates, higher stock and asset prices and additional stimulus for a weak economic recovery.
The costs of monetary inflation have always been more challenging to explain - only much more so in recent years. Opponents of quantitative easing, in particular, have focused on the threat of inflation and dollar devaluation. It has been difficult for this camp to sway public opinion, especially with securities markets at record levels and inflation as gauged by the Consumer Price Index relatively contained. The lurking cost of unstable financial markets hasn't been part of the discourse, although this issue jumped into the limelight last week.
I've been arguing that the greatest risks associated with Fed and global central bank inflationary policymaking have been in the realm of asset inflation, dangerous bubble dynamics and ongoing global financial distortions and economic maladjustment. This type of analysis is so removed from conventional thinking that it resonates with few and basically has no impact on the broader discussion. This is a curious dynamic, especially since I believe strongly in the value of the analysis and analytical framework.
It was quite a week. I've been arguing the "global government finance bubble" thesis for more than four years now. From my vantage point, a strong case can be made that the bubble is now in serious jeopardy - if not already bursting. There are a few important aspects to bubble analysis that may help place current vulnerabilities into context.
Total US debt ended March at US$57.0 trillion. In spite of so called "de-leveraging", total debt jumped almost $6.2 trillion over the past five years. Debt has expanded much more rapidly globally, especially in the booming emerging-market (EM) economies. Total Chinese "social financing" jumped $1.0 trillion during the first quarter alone, indicative of one history's most spectacular credit booms.
The world is awash in debt - virtually everywhere. The Fed and fellow central bankers have resorted to previously unimaginable measures to "reflate" global credit and economies. They have manipulated short-term interest-rates to near zero. They have directly purchased trillions of bonds and other instruments, in the process injecting trillions into overheated securities markets. Over time, policy measures have come to dominate markets.
This has ensured the ongoing rapid expansion of global debt, too much of it non-productive. The upshot has been unprecedented price inflation for most securities trading all over the world. Moreover, there has been the ongoing inflation in the already massive pool of speculative finance, derivatives and financial leveraging. Such bubble dynamics leave debt, securities market and economic structures acutely vulnerable to any reduction in credit growth and/or central bank liquidity.
This continuing credit expansion has exacerbated latent fragilities - vulnerabilities that have been met with unprecedented central bank market intervention. When the European debt crisis was on the brink of unleashing global crisis last summer, global central bankers responded with incredible measures. Overextended bubbles - along with attendant fragilities - inflated precariously worldwide. Global speculative excess was spurred to even more dangerous extremes. bubbles throughout the developing world turned only more unwieldy. The historic Chinese bubble's "terminal phase" of excess was pushed into precarious overdrive.
Fundamental to my bubble thesis is that tens of trillions of global debt has been mis-priced in the marketplace. Market yields have been forced lower (fixed-income prices higher), which has worked to inflate equities prices as well. Near zero returns on savings have forced trillions into assorted risk markets, certainly including EM securities and US fixed income and equities. Last week's bout of market instability reflects how quickly distorted bubble markets can succumb to illiquidity and near-panic.
In an email to CNBC, David Tepper wrote, "All the concern in the markets is because the Fed sees the economy stronger in the future."
I don't buy into this line of reasoning. Instead, I believe that key Federal Reserve officials are begrudgingly coming to terms with the reality that the risks of ongoing huge QE outweigh the rewards. This would be consistent with my view: the overall economic impact has been muted at best, while financial markets have become increasingly speculative and generally overheated. As I've argued in previous Credit Bubble Bulletins, there's been a widening gulf between inflating asset bubbles and problematic economic fundamentals. The markets' behavior last week provides important confirmation of inherent fragilities.
There are reasons to fear how things might unfold. Importantly, it appears the "sophisticated" leveraged speculating community has been caught unprepared for the abrupt market reversal. Over the years, those (hedge fund, mutual fund, sovereign wealth fund, etc) managers most adept at profiting from policymaking outperformed the markets - and in the process attracted incredible amounts of assets under management (AUM). The "sophisticated" speculator market universe became one big crowded trade.
After struggling with challenging macro analysis and unsettled "risk-on, risk off" market dynamics over recent years, European Central Bank president Mario Draghi's "do whatever it takes", Bernanke's $85 billion QE a month, and Bank of Japan governor Haruhiko Kuroda's "shock and awe" "Hail Mary" seemed to ensure a breakout "risk on" year in 2013. The enticing backdrop worked to ensure the speculator crowd became fully committed - only to now see global risk markets abruptly reverse course.
Anytime the crowd suddenly seeks the exits, risk markets will confront immediate liquidity issues. This dynamic is compounded by the fact that thousands of funds have weak hands. It wouldn't take significant market losses before redemptions and viability become pressing issues.
Troublingly, today's market liquidity issues go way beyond hedge funds and myriad sophisticated leveraged speculative bets across the globe. Over recent years, as the Bernanke Federal Reserve pressured savers out of the safety of deposits and money funds, Wall Street has been busy creating instruments to harvest this torrent of return-seeking household finance. Bloomberg used the number $3.9 trillion in quantifying the "money" that flowed to global emerging market funds. Apparently, the value of exchange-traded funds (ETFs) has swelled to $2.0 trillion.
I'll leave it to others to discuss the structural weaknesses of ETF products. For my purposes, I'll focus on ETFs as a focal point in the world of latent market bubble risks. ETF products have enjoyed incredible flows and growth. Many of the major ETFs are highly liquid, and have been the perfect instrument for speculators playing the Bernanke bubble, as well as for savers keen to escape the Fed's "financial repression". They have provided a most convenient vehicle for playing about any market, theme or sector - anywhere.
For those wanting to invest like the "sophisticated" players, there's a bevy of ETF products in which to build your "investment" portfolio. You want exposure to the latest hot emerging economy or simply a basket of the emerging markets? "Bond" funds that always return significantly more than lowly deposits? Dividend-producing equities? How about higher-yielding corporates or mortgage-backed securities? Tax-advantaged municipal debt? Would you prefer put or call options? How much leverage would you like to employ?
Well, as multi-billions flowed weekly into fixed-income funds and various ETF products - no one seemed the least bit concerned with the possibility of a significant reversal of flows. It hasn't mattered that many of the most popular ETFs hold huge portfolios of illiquid securities. It didn't matter because the "money" just kept rolling in. It matters now that serious "money" has been lost and the flows have reversed course.
As an analyst of bubbles, I have issues with financial instruments that work to distort perceptions of market risk. Bubbles, after all, always involve important market misperceptions. Over the years, I've noted that a bubble financed by junk bonds wouldn't get all that far - wouldn't expand long enough and big enough to equate with major financial and economic structural distortions. On the other hand, a bubble financed by "money" or "money"-like credit instruments ("perceived liquid stores of nominal value") have potential to inflate as long as confidence is retained in the "moneyness" of the underlying credit.
From a global bubble perspective, determined central bank market liquidity support has been instrumental in shaping market risk perceptions. On a more micro basis, the perception of liquidity and low-risk throughout the ETF complex has been crucial in funneling household savings into instruments that savers for the most part would have never purchased directly.
Never has the US household sector made such a huge bet on the emerging markets. Never have so much savings flowed indirectly into illiquid mortgage securities and municipal debt. I don't believe many "retail" investors appreciated the myriad risks associated with today's highly inflated and distorted financial markets. I suspect the vast majority made ETF purchases with the perception that risk was limited.
From my analytical framework, last week was a critical period. I believe the "sophisticated" speculators came to realize they are suddenly on the wrong side of a rapidly changing financial and economic landscape. I suspect that many of these market operators have held the view that this will all end badly - they just thought the Fed, Band of Japan and other central banks ensured they had more time to build on their vast fortunes.
Meanwhile, the less market sophisticated - that had funneled savings directly and indirectly into long-term bonds, corporate debt, MBS, emerging markets, municipal debt and equities - will come to realize there is significantly more risk in these markets than they had perceived (and been led to believe). The perception of endless liquidity now confronts the reality that global central banks and myriad financial products and speculative excesses have worked to foment very serious inherent market liquidity issues.
Yet last week was critical beyond the Fed and risk market dynamics. In a potentially momentous development, an intriguing story seemed to gain some clarity in China. Uncharacteristically, the People's Bank of China waited until short-term and inter-bank lending rates had spiked higher before providing targeted and limited liquidity injections in the Chinese money market (see "China Bubble Watch" below).
I have chronicled China's historic credit bubble for years now. I have posited that the post-2008 US, Chinese and global crisis response propelled the Chinese bubble to precarious "terminal phase" excess. As a tenet of my bubble analysis framework, I have often stated that major bubbles become impervious to "tinkering". To actually rein in bubble excess policymakers must inflict pain, alter perceptions and behaviors - and accept the inevitable consequences of bursting bubbles.
For a while now Chinese authorities have tinkered with little effect. They've implemented various measures to contain house price inflation - yet the Chinese housing (apartment) bubble has only gathered further momentum. They have watched the economy slow while Credit growth has exploded. They have surely seen enough of the surge in "shadow banking" to appreciate that they have a very serious financial issue to contend with.
There were indications last week that the new Chinese government may be very serious about reform - economic, financial, political, environmental and social. This is an enormous population that has had expectations inflated throughout the protracted Credit and economic boom. But inflationary consequences include massive debt, deep economic maladjustment, housing bubbles, inequitable wealth distribution, horrific environmental degradation and widespread corruption. The Chinese people increasingly fear they are being poisoned by toxic air, food and water. They are increasingly fed up with corruption throughout the government and economy
The conventional market view is that Chinese officials will manage the situation to ensure an ongoing economic expansion - if not 10% growth at least 7-8%. My view is that it will require some tough medicine if Chinese authorities are determined to rein in bubble excess - especially in a runaway credit inflation. I believe they're determined.
I'll assume that the new communist government is now ready to get on with it. They have stated their intention to target strategic industries for development. It would appear they have decided to move in the direction of central control over the allocation of credit. There were indications last week that they have commenced the process of restricting liquidity to segments of their financial system that they don't see as supporting their view of sound economic growth. And, best I can tell, there is an enormous infrastructure that has evolved to finance all types of assets - apartments, commercial real estate, commodities, commercial ventures and likely all kinds of fraud.
The increasingly unwieldy Chinese bubble has to end at some point. The increasingly unwieldy Bernanke Fed-induced global bubble has to end at some point. It was a bit astonishing to watch such important developments unfold last week in Beijing and Washington. And the emerging markets now face the perfect storm.
The global risk backdrop has quickly become less latent - economic and market backdrops much more uncertain. Powerful de-risking/de-leveraging dynamics are now in play. Global market yields (and risk premiums) are adjusting to new risk and liquidity dynamics. Financial conditions have tightened meaningfully, especially in the now troubled "emerging" economies. Higher yields and risk premiums put a fragile Europe back in the spotlight.
Forecasts for global growth must now come down, which implies risk to elevated earnings expectations. I would strongly argue that stock market multiples in the US and elsewhere are much too high considering extraordinary risks and uncertainties. If the global government debt bubble has begun to succumb, there are very challenging times ahead.