Tag: Financial Markets

Turning Japanese

Photo by Nicki Eliza Schinow on Unsplash

The Fed’s response to COVID will zombify corporate America for a generation

Written June 21, 2020

In “The L-Shaped Recovery“, we predicted that a combination of demand destruction, job market uncertainty, rising debt, and a shift in consumer behavior would hinder the economy from achieving a rapid recovery from the COVID pandemic.

Since that writing, the Fed has taken the unprecedented step of intervening directly in support of the credit markets, producing a spectacular V-shaped rebound in the financial markets. But as we all know, the market is not the economy.

The economic template that the current public health crisis is most often compared to is the Great Depression of the 1930s, but a more instructive precedent for what the future holds might be that of Japan, which is still trying to shake off the effects of the financial market bubble that popped in 1989.

To put the excesses of 1980s Japan in context, it was said that the 280 acres of land within the walls of the Imperial Palace in central Tokyo was worth more than the entire state of California. At the time, this became the benchmark against which all other insane real estate and lending valuations were linked. When it inevitably crashed, Japan, Inc. tried borrowing their way out of trouble. More than 30 years later, and after racking up an eye-watering debt-to-GDP ratio of 279%, they’re still trying to find a way out.

In Japan, bankruptcy is not seen as a financial tool deployed to clear the decks of bad debt but rather as a cultural stain, one of humiliation and loss of face. So corporate Japan, and the country itself, stumbles onward like a zombie, burdened by mountains of legacy debt, unable to reap the benefits of innovation that leaner balance sheets would enable. This interminable trap is so ubiquitous that it even has its own name: Japanification.

Unfortunately, the Fed is headed down a similar path. Not only by backstopping the credit markets but by actively pushing prices higher, the Fed has allowed almost every corporation access to cheap money. It may be necessary, but just like the never-ending policy of quantitative easing destroyed the price discovery function in the equity markets, the unintended consequence of credit intervention is doing the same to the bond market. Normally where good corporate governance is rewarded and bad decisions are punished, everybody now gets a trophy.

In my day job as an editor for a financial news service, I spend a large portion of my time reading press releases from companies tapping into an almost unlimited supply of liquidity in the credit markets, with most of it going to refinance revolving bank debt incurred during the pandemic. Borrowing is literally exploding.

While this widespread refi effort is tactically beneficial in the near term to bridge the gap in cash flow created by the virus lockdown, the long term risk is that it will allow bad capacity to remain on the books, keeping unproductive companies alive and leaving little room for innovation and for fresh entities to thrive.

Corporate America was already running record levels of debt and leverage before the pandemic hit. Half of the investment-grade bond market is precariously rated BBB, just one notch above junk. Wide-scale bankruptcies and credit downgrades are indeed a systemic threat in a weakened economy, and it is forcing the Fed’s hand to prevent the entire system from snowballing downhill and out of control. But, like Japan, the unintended consequence of today’s policies will be a debt burden that will take years, if not decades, to climb out from under.

In a note to clients last week, Bridgewater Associates’ Ray Dalio warned of a “lost decade” for the equity markets as profit margins get squeezed by debt servicing costs. See here https://bloom.bg/3hMBVtC.

We tend to agree and would use this recent rebound in financial markets to reduce risk exposure while sticking with core long positions in the US dollar, short-term treasuries, and gold.

Debt explosion (courtesy Federal reserve bank of St. Louis)
Sharp rise in unproductive debt (courtesy Deutsche Bank)

China: Red Flag Rising

Photo by Alejandro Luengo on Unsplash

Despite a quick reopening, a crack in the Chinese currency suggests things are about to get worse for the world’s second-largest economy.

Written May 24, 2020

The Chinese yuan finished last week near its lowest level in more than a decade as investors began to bet with their feet, heading for the exits over concern that the country is compounding its economic problems with geopolitical moves that are already generating widespread condemnation and even greater uncertainty.

The post-pandemic economic landscape presents a test for the regime that has long prided itself in delivering on an unspoken bargain where one-party rule is tolerated in exchange for consistent economic growth.

However, a sure tell that the government’s grip is slipping was its failure to set an economic growth target for the upcoming year during last week’s National People’s Congress, the annual planning meeting of the Chinese Communist Party. It might seem like an insignificant detail, but for the first time since it began providing GDP estimates in 1990 the central body declined to be bound by a projection that it may not be able to meet. It is a big deal, and the obvious conclusion is that the economy on the mainland is worse than it outwardly appears.

China’s recalcitrance in dealing with COVID-19 has also turned global public opinion against it. As a result, doing business with the Chinese in the future is going to come under much more scrutiny than in the past.

Despite the allure of 1.4 billion potential consumers, it now won’t be so easy to turn a blind eye to the tilted playing field China has erected to their advantage, as much of the world has done since China’s inclusion into the World Trade Organization in 2001.

The U.S. Senate took the first step last week by passing a bill by a 100-0 margin requiring Chinese firms to adhere to American accounting standards or risk being delisted from our exchanges, also a big deal. Other measures will follow.

The pandemic exposed many countries’ over-reliance on Chinese manufacturing and is forcing most to reconsider basing their supply chains elsewhere. Japan even earmarked part of its economic stimulus fund specifically to help its manufacturers shift production out of China.

The bottom line is, the rules of international trade are being rewritten and China is not going to like the changes.

Further complicating matters, China is lashing out at the west’s insistence on an investigation into the origins and handling of the virus. Within the space of a few weeks they’ve made moves to block certain Australian exports, threatened to cut off the supply of critical pharmaceutical ingredients to the U.S., and imposed their own national security laws on Hong Kong. So much for the idea of “one country, two systems” that was the founding principle agreed to by both parties when the British turned Hong Kong over to China in 1997 and that has allowed the former colony to thrive as an international financial center.

Not content to stop there, the Chinese navy is scheduled to begin live-fire military exercises later this month as part of an amphibious assault training operation on an island controlled by Taiwan. As the Wall St. Journal asked in a May 21 op-ed titled “China Moves on Hong Kong”, is Taiwan next?

At the risk of stating the obvious, political isolation from global trading partners can only be seen as a negative for the economy.

Plan A for Chinese authorities to counteract these economic headwinds is with traditional fiscal and monetary stimulus, along with a heavy dose of infrastructure spending. But the effectiveness of that approach is questionable as the country is already swimming in overcapacity, and debt. It’s the demand side of the equation that is lacking.

Plan B would be a devaluation of the currency, which the market is beginning to sniff out. In theory, this would spur demand by making Chinese-produced goods more competitively priced. In reality, it would propel the dollar higher, unleashing a deflationary wave on a world already under enormous pressure from falling prices.

The Fed and other central banks have done an impressive job of rescuing the credit and equity markets from the depths of the pandemic panic in March, but a Chinese devaluation would slam the lid on any hopes of reflating the global economy.

Our core portfolio positions remain long of the US dollar, front-end treasuries, and gold.

The Biggest Trade in the World

Photo by Vance Osterhout on Unsplash

The largest position in the history of the financial markets is about to get squeezed.

Written April 27th, 2020

Successful traders are always asking themselves two questions in the course of analyzing markets: 1) given a set of known inputs, are markets behaving as expected? and 2) if not, why not?

Since the COVID-19 pandemic crashed the world’s financial markets last month, central banks have responded with extraordinary measures to stabilize markets and prop up their respective economies.

For its part, the Fed has undertaken policies on a scale unprecedented in the history of finance, radically expanding their balance sheet and going so far as lending directly to municipalities and buying junk bond ETFs in the open market. Essentially printing money, but on steroids.

The equity markets have responded favorably, much as one would expect given the deluge of liquidity. It’s a reflexive response conditioned by a decade of the Fed propping up asset prices every time the markets stumbled. Will it last? Nobody knows.

However, the part of this scenario that is not going according to plan is potentially the most consequential for the financial markets. The US dollar needs to weaken. Big time. For a global economy staring at a tsunami of deflation, it is the most critical element to achieving a durable reflation of commodities and equity prices and restoring confidence in many regions of the world, especially the emerging markets.

This is not lost on central bank officials. In fact, if you were asked to come up with a policy to destroy your own currency, moves by the Fed and the Treasury over the past month to explode the federal deficit would be it.

The speculative trading community initially took the cue. According to CFTC data, the specs began shorting the dollar in the middle of March as rates went to zero and the money printing presses began working overtime.

But since then, not only hasn’t the dollar gone down, it is higher instead.

The latest study by the Bank for International Settlements estimates the world’s short position in the dollar at about $13 trillion, much of it based on dollar debt held by offshore banks and corporations, representing the largest aggregate position in the financial markets by far.

Currency swap facilities instituted and expanded by the Federal Reserve with the intention of ensuring these entities access to dollar funding helped settle the markets late last month, but the currency’s appreciation since then is a sure sign that it won’t be enough. For many of these foreign corporations, swap lines are of little value if their respective central banks don’t have sufficient reserves to swap or US Treasury securities to pledge as collateral.

Also, printing trillions won’t do much good if there is no turnover, or velocity, of that money due to the collapse in business activity. It just ends up in the vaults of institutions that don’t need it, crowding out the weaker borrowers.

Against all expectations, the steady grind higher in the dollar in recent weeks is a red flag that this massive short trade is about to get squeezed.

The implications will be felt everywhere. The risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.

As we’ve been recommending for more than a year, stick with long positions in the dollar and front-end treasuries. In our last piece “The L-Shaped Recovery“, we suggested adding physical gold and taking advantage of near-term strength in equities to reduce exposure. If the dollar starts to accelerate, things could get ugly. Quickly. And despite the Fed’s insistence on not taking interest rates negative, it’s not impossible that this will end up being their next move.

US Dollar Index (DXY)