The month of January has been a wake-up call for complacent equity
investors.
From the peaks of last year stock indices in the major markets have fallen
10-20%, give or take. On their own, these falls could be read as healthy
corrections in an ongoing bull market, and doubtless there are investors
hanging on to their investments in the hope that this is true.
The conditions that have led to the fall in equities are tied up in the
realization that global economic activity has contracted sharply. This is now
reflected in the performance of medium and long-dated US Treasury bonds,
where yields have declined, despite a rise in the Fed Funds Rate. The problem
equity markets face is not just a reaction to growing evidence of recession,
it is that the normal Fed solution, lower interest rates, is exhausted. The
Fed's put option is now being questioned.
Far from this being an equity correction in the early stages of a credit
cycle, which is what the small step towards normalization of US interest
rates would have had us believe, the evidence points to a developing debt
crisis, whose future course we can now tentatively map, though there are
important differences to observe compared with a normal credit cycle.
In a normal credit cycle, bank credit stimulated by artificially low
interest rates leads to rising consumer prices and rising bond yields. The
recovery in nominal GDP growth supports equity prices, which will have
already anticipated recovery, and benefited from the lower interest rates set
earlier by the central bank. Eventually the equity bull market starts to lose
momentum, when it becomes apparent that monetary policy favours tightening.
Interest rates are then increased by the central bank to the point where
demand for money is curtailed and the economy stops growing due to debt
liquidation.
The dynamic that is missing from this simplistic description of an
orthodox credit cycle is the level of outstanding debt. The higher it is, the
less of a rise in interest rates is required to trigger a downturn in
economic activity. So over a long period of increasing accumulations of
outstanding debt, the levels of interest rate peaks on successive credit
cycles will decline. This is clearly evident in the chart below of the yield
on 13-week US Treasury bills.
The pecked line shows these declining peaks, and that a short-term
interest rate of less than 3% today would now appear to be enough to trigger
a downturn. With such a small margin for error, it is clear that any increase
in the yield spread between this, the highest quality debt, and corporate
debt yields could trigger a cyclical debt liquidation. Bear in mind that this
credit cycle has seen an acceleration of corporate debt issuance, in order to
enhance earnings to stockholders without requiring an underlying improvement
in operating profits. The result of this financial engineering has been to
increase the growth rate of corporate debt and significantly reduce the
interest-rate level that will result in widespread corporate debt defaults.
Bare information on corporate bond yields confirms the danger is now
acute. Over the last year, the Finra-Bloomberg Investment Grade Index yield
has risen from 3.25% to 4.2%, while the High Yield index yield has risen from
5.75% to 9%. While there is no precise level at which rising interest rates
will result in debt defaults, it is clear that the margin over the sub-3%
interest rate trigger in the chart above is already exceeded by a significant
margin.
The financial condition of US companies is therefore under considerable
pressure. Corporate America has raised its operational gearing by increasing
its debt-to-equity ratio to enhance earnings per share, and is facing adverse
economic conditions that will undermine the ability to finance the debt
burden. Increased gearing enhances profits, but it also enhances losses.
Cost-cutting measures are becoming an urgent priority for over-geared
corporations, leading to rising unemployment, which should become evident in
the coming months.
Bankers are acutely sensitive to these developing problems. They are
already faced with dollar-denominated commodity-related loans that have gone
sour, particularly in energy. In order to preserve their own capital and
control risk, the banks are likely to reduce leverage by calling in other
loans where they can. So we have a classic financial bust in the making with
a notable difference: instead of the Fed raising interest rates to take the
steam out of the economy, the sheer weight of debt is enough to trigger a
slump on its own.
This is an outcome which is becoming more likely every day and impossible
to avoid. Thankfully, since the financial crisis of 2008, the commercial
banks in the US have limited their operational gearing, mostly through
moderating the expansion of bank credit. That moderation will certainly
persist in an economic downturn, and probably intensify further into outright
contraction. The Fed will feel it has no option but to expand its own balance
sheet to compensate. To get the Fed's newly-issued money into the
non-financial economy can best be achieved through accelerated debt issuance
and maintaining government spending, assuming whacky ideas like helicopter
drops can be dismissed.
The US Government in a presidential election year will certainly be keen
to maintain spending and to dismiss talk of austerity. And with declining tax
revenues from a deteriorating economy, the deficit to be financed can be
expected to increase, placing a floor under medium and long-term US Treasury
yields. Furthermore, these difficulties might even force the Fed to briefly
consider the introduction of negative interest rates, to kick-start
reflation.
The Eurozone
So much for the Fed's difficulties, more of which later. There are two
other major economies of a similar scale measured on a purchasing-power
parity basis, the Eurozone together with its periphery, and China. We will
look at the Eurozone first.
The time available to repair the Eurozone's financial system since the
Lehman crisis has been wholly wasted. Eurozone governments have refused to
address their parlous finances, and the banks have done little to improve
their balance sheets, with an average assets-to-equity ratio according to the
ECB's figures of 24:1, admittedly including off-balance sheet obligations.
The ECB's attempts to stress-test the banks have been bogged down in politics
and vested interests, with banks, such as Dexia, actually collapsing soon
after being declared sound. Furthermore, the share prices of key Eurozone
banks appear to be discounting yet more financial turbulence.
This is hardly surprising. The Eurozone banks have always been the principal
channel through which profligate European governments finance themselves. The
regulators under Basel III have supported this relationship by deeming that
government debt requires no risk-weighting. This is why the stress-tests
failed to identify Dexia's troubles, because Dexia had overloaded itself with
highly-rated but worthless Greek debt. The politics say Eurozone sovereign
debt is inviolate, and politics triumphs over financial reality.
The function of Eurozone politicians has become solely to prolong the
fairy-tale of never-never land, and with their electorates equally divorced
from financial reality, they have succeeded remarkably well. Greece has been
covered up, and is out of the headlines, for the moment. The rebellions
against austerity in Spain, Italy and Portugal are fudged, and France, which
on any dispassionate analysis is a financial basket-case, keeps her head
down. The Eurozone is like a dysfunctional family living in a house which is
about to collapse, and no one wants to admit it, let alone fix it.
There are at last signs that this bizarre situation is beginning to fail.
The Italian banking system is in a developing crisis, as is Portugal's. Even
Germany has a well-publicised problem with its largest bank. It is also a
certainty that government deficits will increase, as the Eurozone economy
begins to be affected by the global slump. The likely consequence is that
yields on Eurozone government debt will start rising this year, exposing
highly-geared banks, including the ECB itself, to portfolio losses that will
quickly wipe out their inadequate capital.
This looks like being the year when the Eurozone could plunge the world
into a second financial crisis, eight years after America's sub-prime crisis
ignited the first. This time, the Eurozone's financial condition is the
obvious catalyst, rather than China which is discussed next.
China
The general opinion in western capital markets is that China is the greatest
danger to global financial stability. China's stock markets continue to slide,
despite government attempts to ban or restrict selling. Her debt bubble,
which is unwinding, has been a massive economic distortion. And while
Keynesian economists seem to think the consequences of a credit bubble can be
ignored in western economies, they have no hesitation in pointing an
accusatory finger at China's.
Western financial analysts are hardly consistent in their approach to
monetary matters, which is a bad start. It is more sensible to look at things
from the Chinese Communist Party's point of view, and what matters to it is
the long-term health of the economy. Last year China was on course ahead of
the new five-year plan, gaining SDR status for its currency. We know that the
CCP's long-term objective is to foster the industrial revolution of the whole
Asian continent. The yuan is now positioned to be the argent Asiatique,
accepted by nearly four billion people in place of the US dollar. Only this
week we saw President Xi Jinping visit both Iran and Saudi Arabia, sworn
enemies, but with a common desire to trade with China, doubtless settling in
yuan.
For the yuan to be the currency of Asian trade, it must be stable. Western
analysts who think China will devalue to "save the economy" ignore
this vital point. China is not only prepared to maintain the yuan rate within
a fairly narrow band against a basket of currencies, she sees a sound
currency as a necessary condition for evolving from low-value trade and for
the redeployment of scarce capital and labour resources in favour of her
strategic objectives.
China does not share with western economies many of the financial problems
of a deflating credit bubble, because the banks are state-owned and will not
fail. Furthermore, it is a Chinese tradition to wind down obligations before
the new year, so Chinese demand for dollars to pay down debt should diminish
from now on. There are problems nonetheless, and while it would be a mistake
to dismiss them, it should be noted that the Chinese government has the
control required to manage its planned economic transition. And more so than
most governments, she spins her own statistics, which will continue to be
spun through the planned transition, making it difficult for yuan bears to
attack the currency.
It should not surprise us if China's economy shows greater than expected
resilience in the coming months, typical with the start of a new year. There
will be more bankruptcies in legacy industries for sure, but the demand for
and importation of industrial commodities will soon begin to pick up as the
thirteenth five-year plan starts to be implemented.
The effect on global markets should be significant, given the overwhelming
bets on a bullish dollar. Commodity prices, particularly for energy, will
surprise on the upside. That is why President Xi visited both Iran and Saudi
Arabia, to secure oil supplies. And when the threat of a further collapse in
commodity prices is removed, the dollar can be expected to weaken,
particularly against the emerging economy currencies. Shorting the yuan, or
the Hong Kong dollar for that matter, is likely to prove to be very costly.
Conclusion
China's economy will probably begin to stabilise after the Chinese new year,
which will wrong-foot bears of industrial commodities, and therefor bulls of
the US dollar. This being the case, expectations of further falls in precious
metals prices will be dashed, and based on dollar weakness alone, the current
rally in gold and silver prices looks set to continue.
While a return to rising commodity prices, particularly for energy, will
be positive for emerging market currencies, the destruction of extraction capacity
heretofore is likely to push oil and commodity prices significantly higher by
the end of 2016. The unwinding of bull positions in the US dollar is an
additional factor that will unexpectedly increase prospective price inflation
in the US. The Fed is therefor faced with the medium-term prospect of
developing stagflation, a combination of an economy hampered by the unwinding
of corporate debt together with the rise in unemployment this infers, while
price inflation gathers steam. It remains to be seen if the Fed will have the
courage to raise interest rates sufficiently to address price inflation,
while deliberately bankrupting borrowers unable to pay high nominal interest
rates. This will be a problem in sharp contrast to China, which should be on the
road to an investment-led recovery, with a currency gaining in international
status. If so, it will leave the US dollar vulnerable to even greater
weakness. Currency traders will quickly realise that the risk is in holding
dollars, and not yuan as commonly supposed today.
The Eurozone is the most immediate systemic danger, with a banking system
creaking badly, and wildly overvalued government bond markets. Either a rise
in US Treasury yields or a threatened sovereign default could set off a
systemic crisis in the banking system. Furthermore, if the UK referendum for
an EU exit is held mid-year and, as current polls suggest is possible, the UK
votes for an exit, the European experiment will be dealt a mortal blow.
The phoenix rising from the ashes of 2015 will be comprised of China, the
yuan and gold, a wholly unexpected outcome for mainstream financial analysts
who are betting heavily the other way. Meanwhile equity markets in the
developed world will have to struggle against stagflation, and the prospect of
rising interest rates to curb the dollar's falling purchasing power. By the
end of the year it should be clear that the dollar has finally had its day,
along with its hegemony and the currencies tied to it.
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