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3 CREDIT BUBBLE
BULLETIN Awash with ignored
risk Commentary and weekly
watch by Doug Noland
The Federal Reserve is heading in
the wrong direction. What the central bank
describes as "unconventional monetary policy" is
creating dangerous bubbles in asset markets that
will lead to higher future inflation and is
supporting the explosive growth of the national
debt. - Martin Feldstein, Wall Street
Journal, January 3, 2013.
I applaud
Dr Feldstein's intentions, but the poor soul has a
problem: the marketplace is rather smitten with
bubbles and doesn't these days have an inflation
worry in the world. Might as well be another Mayan
prophesy. Indeed, Feldstein's warning
these days resonates about
as well as my (repeated) warnings of bubbles and
bipolar outcome possibilities. But here it goes,
nonetheless: the financial system, as we know it,
is doomed on December 21, 2013.
In all
seriousness, it is difficult to imagine a backdrop
more poised for the extraordinary. Bolstered by
unprecedented global monetary radicalism, the
global bubble gathered important momentum in 2012.
This ensures that the dysfunctional "risk on, risk
off" ("roro") speculative dynamic turns only more
unwieldy in 2013. Policy measures guarantee that
the historic "crowded trade" in international risk
markets will only more forcefully crowd the manic
crowd on one side of the crowded boat - or the
other. This implies fatter "tail risks" - with
emphasis on the "s" - the plural - of left
(bubbles burst) and right (inflating bubbles turn
much more unwieldy) "tail" developments.
Let's start with a little "right tail"
pontification. In simplest terms, how crazy could
things get this year? I recall how crazy the
Southeast Asian bubbles turned in the fateful
post-Mexican bailout year of 1996. Then NASDAQ
almost doubled in the crazy, post-Long-Term
Capital Management bailout speculative melee of
1999. And when the Federal Reserve made it clear
that it would disregard mortgage and housing
bubbles, excesses grew exponentially - 2004, 2005,
2006 ... until the bubble finally began to
collapse under the weight of subprime credit
craziness in 2007. The long history of speculative
bubbles favors the scenario where they end in
self-destructive "blow-off" excess.
According to Bloomberg, "Hedge funds on
average climbed 1.6% through November, lagging
global stocks by almost tenfold as managers were
whipsawed by market reaction to the economic and
political events ... " While not repeating the
losses suffered during a challenging ("roro")
2011, the hedge fund industry overall badly lagged
global risk market gains in 2012. Those that tried
to judiciously manage risk again suffered the
consequences. "Don't ask why, just buy!" won the
day.
This year will see thousands of hedge
funds locked in a rather ferocious fight for
survival. Human nature would dictate that managers
will increasingly err on the side of dismissing
risk - determined (for many, desperate) to instead
participate in every rally. They may be dragged
kicking and screaming, but an ongoing equities
rally would force even the more bearish hedge
fund, mutual fund, and sovereign wealth fund
managers - along with enterprising traders
everywhere - to jump aboard.
Moreover,
2012's policy-induced market divergence (weakening
fundamentals vs inflating securities prices)
pretty much pulverized those aggressively
positioned short global risk markets. This
fomented market dislocation, whereby stock prices
turned increasingly detached from fundamentals.
Importantly, if typical sources of selling
pressure (ie the "bears", "market neutral"
players, hedging strategies, etc.) have backed
away, the marketplace becomes only more
susceptible to market dislocations and speculative
"blow-off" excess.
At the same time, a low
tolerance for losses will remain a latent issue.
An even greater propensity for performance-chasing
and trend-following dynamics would seem a safe
bet. But the dilemma of "weak-handed" traders will
continue to leave markets vulnerable to sudden
(think "flash crash") market downdrafts.
Moreover, I suspect that many of the more
sophisticated market operators are in this to play
"blow-off" excesses for all they're worth - yet
with one eye planted on the exits. I'll paraphrase
hedge fund titan Leon Cooperman's apropos comments
this week from his CNBC interview: In the hedge
fund industry, if you're early you get killed. And
if you're late you get killed.
The Masters
of the Universe, naturally, believe they will
identify bearish catalysts ahead of the crowd. But
as the Masters' assets under management swell to
unimaginable dimensions, they'll have reason to
fret more about market liquidity and the tactics
of fellow Masters. But for now, with the world
awash in liquidity and the European Central Bank
president Mario Draghi Plan having smothered
European "tail risk", they may be keen to keep
playing - for "dancing". "Right tail" happenings
are not a low-probability scenario.
With
little fanfare, the broader US equity market last
week pranced to all-time record highs. Already
3.5% higher in just the first three sessions of
2013, the S&P400 Mid-Cap average enjoyed a
"break out" right through 2011 and 2012 double
tops. The small cap Russell 2000 (up 3.5%) also
traded to a new all-time high to begin 2013
trading.
It is, as well, worth noting that
the Goldman Sachs Most Short Index gained 3.9% in
the first three sessions of the year, indicating
an ongoing "squeeze" and market dislocation.
Curiously, the "New Normal" investment return
framework continues to be popular in marketplace
pontification circles. Yet last year again
supported my "Newest Abnormal" thesis of risk
market bubbles and returns detached from
underlying fundamentals.
The last thing
the world's fragile economy and financial
apparatus need today is a period of "blow-off"
excess. Indeed, it is integral to my (and others')
bubble analysis that the downside of a credit
cycle is commensurate with the excesses of the
preceding boom (I owe the crux of this analysis to
the late Dr Richebacher and other "Austrian"
thinkers). A "right tail" beginning to 2013 would
only increase the probabilities of a "left tail"
end. I'll posit that 2013 is a year of fat tail
risks, believing that the backdrop contains an
unusual confluence of factors that would seem to
increase the probability of the blow-off boom and
bust scenario.
For the past two years,
I've viewed the unfolding European crisis as a
possible/likely catalyst for a problematic bout of
de-risking/de-leveraging. I believe the worst of
the crisis is still to come, although the current
respite could prove somewhat less fleeting than
the others. The economic diagnosis is terrible -
and 2013 could see the "core" French economy
particularly susceptible. The region - certainly
including its bloated banking system - will
continue to battle with trillions (and counting)
of suspect financial claims/debt. The political
backdrop will continue to deteriorate. Italian
politics will make for good drama.
Especially if the situation continues to
stabilize, I would expect a more cautious ECB to
reconsider its expanded mandate. If Spain does
request a bailout, the markets will see the OMT
(Outright Monetary Transactions) in action. Who's
getting favorable treatment and how the pie is
being divided will ensure recurring stresses and
fractures. I still don't believe the euro makes
it. Yet Draghi changed the rules and altered the
backdrop. His bold plan to use the ECB printing
press to backstop the markets changed short-term
speculative dynamics.
The speculating
community covered their European shorts and
commenced building long exposure. This (certainly
including the powerful short squeeze) incited
robust financial flows into the region's bonds,
equities and currency. Such a backdrop opens the
possibility that the resulting dramatic loosening
of financial conditions proves constructive to
confidence and even the real economy, along with
further inflating securities markets. And these
things tend to take on a life of their own, with
unpredictable consequences.
At the same
time, this dynamic only exacerbates systemic risk
to future de-risking/de-leveraging. The global
response to last year's worsening crisis was
integral to increasingly unwieldy market bubble
dynamics all around the world. Moreover, Europe
now - with the leveraged players back on the long
side - becomes only more acutely vulnerable to a
reversal of speculative flows and associated
de-leveraging dynamics, a crisis of confidence and
capital flight. The proverbial can was kicked -
and indeed this time it appears a pretty good
wallop.
Last year saw the faltering
European economy and banking system increasingly
impinge global growth, especially in China, Asia
and the "developing" economies more generally.
Importantly, this pressured Chinese authorities,
again, to accommodate dangerous bubble excess. And
such an historic bubble will simply brush aside
timid policymaking.
The estimated 50%
year-on-year growth of China's so-called - and now
enormous - "shadow banking" complex is rather
text-book late-cycle "terminal" excess. The
consensus view is that Chinese authorities have
the situation well under control. I'm not
convinced. Last year was a period when the world
became more aware of the depth of corruption in
China. I fear there is unappreciated financial,
economic and social fragility associated with what
could be one of history's most degenerate
financial bubbles.
Bursting bubbles
inflict social hardship and provoke a search for
scapegoats and villains. We've witnessed this sad
dynamic come to life in Europe. I fear for future
Chinese and Japanese relations. The disputed
island issue heated up in 2012, with Chinese
protests against Japanese products having a
meaningful impact on Japan's frail economy. The
return of Japanese Prime Minister Shinzo Abe
assures an intense focus on fiscal and monetary
stimulus. It also comes with a harder line toward
China.
So in a year where I see
extraordinary global uncertainties, a surprisingly
unstable Japan has potential to play a prominent
role. It's my view that the yen and the Japanese
economy were major beneficiaries of the Chinese
boom. This dynamic has reversed, with unclear
ramifications and risks.
The new
government has a mandate for aggressive stimulus.
The world now watches the yen weaken meaningfully,
while watching nervously for cracks in the
nation's incredibly bloated (and mispriced) bond
market. I will now monitor Japan closely, with the
view that it has (rather briskly) moved up the
list of potential "global government finance
bubble" weak links.
In somewhat of an
adaptation of 2012, I see an increasingly
synchronized global bubble now at risk to multiple
"weak links". Europe remains fragile, while China,
Japan and the "developing" economies have turned
increasingly vulnerable. In "2012 in Review" last
month I noted the troubling dynamic of rapidly
decelerating economic booms in the face of ongoing
rampant credit expansion.
This dynamic
implies vulnerability - but it more than anything
engenders major uncertainties. Many "developing"
economies are demonstrating late-stage bubble
dynamics. As such, if the global financial
"system" proceeds into a potent "risk on" period,
the "developing" world's loose monetary backdrop
might induce a reflexive spurt of activity. At the
same time, unrelenting credit excesses foment
fragilities that ensure a painful downside cycle.
Warnings by a few of unfolding "currency
wars" resonate. The major currencies, of course,
all have major issues. The US dollar is suppressed
by the prospect of endless quantitative easing,
although the currency is these days in the running
to win on occasion the least-ugly contest. In a
world or unleashed central banks and unleashed
speculators, one would expect unstable "hot money"
financial flows - between currencies; between
developed and developing economies; between stocks
and bonds, various assets classes and individual
stocks and sectors.
A pronounced "risk on"
move might be met with a surprising jump in
sovereign yields. The potential confluence of
heightened inflation concerns, waning demand for
safe havens, greater demand for credit, and
overall policy uncertainty could prove
problematic. The Fed's convoluted policy approach
seems to beckon for market confusion and unsettled
conditions.
As a "bubble economy," I view
the US situation as also highly uncertain. With
astounding monetary policy largess and attendant
loose financial conditions, I do not dismiss the
scenario where the US recovery gains momentum.
Housing and autos are in a cyclical upturn, which
should support accelerating private-sector credit
growth. So long as corporate credit conditions
remain ultra-loose, the slow but steady increase
in employment should continue. Unrelenting fiscal
stimulus continues to bolster consumption. And,
importantly, inflating assets markets continue to
support household spending.
I have
repeatedly stated, "I'll believe fiscal austerity
when I see it." Phase one of the "fiscal cliff"
drama has passed with austerity a most notable no
show. Yet the big battles lie ahead: debt ceiling,
sequester and "continuing resolution". It could
get bloody. I would not be surprised by a
government shut-down.
The ratings agencies
will confront difficult decisions. The markets
will face crosscurrents and major uncertainties.
Especially if the markets proceed on their merry
speculative way, there will be pressure to ignore
risks and assume eventual political capitulation,
compromise and resolution. This is precisely the
backdrop with the potential to create the greatest
instabilities.
Market participants have
become increasingly numb to all varieties of risk.
Monetary policy now runs the show. Fed chairman
Ben Bernanke has already stated that he would
respond to "fiscal cliff" headwinds with
additional accommodation. And the Fed this month
commences its $85 billion monthly QE program.
"Printing"-induced numbness virtually ensures that
speculative markets resist the process of
discounting future negative outcomes.
Indeed, today's unmatched fiscal and
monetary policy environment assures that markets
become only more gamey and dysfunctional. This
year would seem poised to provide an even larger
kitty to be enjoyed by those betting most
successfully on the course of policymaking and
market reactions.
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