ALL THE MAKINGS FOR A MAJOR TOP / PRUDENTBEAR.COM

All the Makings for a Major Top

August 23, 2013

by Doug Noland



An unfolding EM crisis, higher Treasury yields, a short squeeze and various market mayhem.

The thesis has been that unconstrained global Credit inherently fuels serial boom and bust cycles. In particular, the dramatic policy response to the 2008/09 collapse of the Mortgage Finance Bubble incited unprecedented financial and economic excess in China and throughout the “developing” economies. Double-digit Credit growth has been compounding over recent years in China, Brazil, India, Turkey and, generally, throughout Asia and Latin America. I have referred to such a late-cycle dynamic as the “terminal phase” of Credit Bubble excess.

For going on five years now, unprecedented “hot money” has inundated emerging market (EM) financial systems and economies. And as “money” flooded in, EM central banks “recycled” much of this liquidity right back into U.S. Treasuries, German bunds, and sovereign debt around the world.

This massive flow of finance into EM also spurred a spectacular expansion in sovereign wealth funds (SWF), hedge funds and the “global leveraged speculating community” more generally. The rapid growth in both EM central bank reserve assets, as well as the global pool of speculative finance, solidified the perception of unlimited cheap global liquidity. Repeated – and increasingly desperate - central bank measures over recent years have further crystallized the perception that global markets enjoy a powerful liquidity backstop. Accordingly, speculation has run roughshod through the global markets.

A strong case can be made that recent years have seen the greatest episode of global securities mispricing in history. Global yields collapsed throughout, although nowhere has this mispricing been more pronounced than with EM bond markets. For example, Brazilian (dollar-denominated) bond yields collapsed from above 25% in 2002 to a record low 2.5% last year (currently 4.8%). After averaging about 7% for the period 2003-2011, Turkish (dollar-denominated) bond yields sank to a record low 3.17% in November 2012 (currently 5.6%). After last year sinking to record low 2.84%, Indonesian dollar bond yields have jumped back to 6.12%.

The bullish EM case has been premised on superior fundamentals compared to the developed world. The bear case is that EM markets have been at the heart of historic Bubble excess. I posit that EM securities markets have provided the most extreme case of misperceptions, speculative excess and a general mispricing of risk throughout. I would further argue that the EM Bubble has begun to burst. Moreover, I would expect that global markets have likely commenced a problematic “periphery” to “core” Credit and economic crisis – where risk aversion, de-leveraging and resulting liquidity issues gravitate from one market to the next. This dynamic has been held somewhat at bay by massive Fed and BOJ QE and Draghi’s liquidity backstop.

So far in 2013, the Brazilian real has declined 12.66% and the Argentine peso 12.59%. India’s rupee has dropped 13.25%. The Turkish lira is down 10.26%, the Indonesia rupiah 11.44%, the Malaysian ringgit 7.35%, and the Thai baht 3.96%. The South African rand has lost 17.28% and the Russian ruble 7.51%.

Over the past three months, the Brazilian real has declined 12.98%, the Indian rupee 12.32%, the Indonesian rupiah 11.53%, the Malaysian ringgit 8.10%, the Turkish lira 7.11%, the South African rand 6.98%, the Argentine peso 6.42%, the Thai baht 6.09% and the Philippine peso 5.63%.

Market action in recent months has caught many participants by surprise, including some of the most sophisticated market operators. In particular, instead of rallying on heightened EM instability, “core” sovereign bonds have been hit by unexpected selling pressure. Treasury yields have surged 82 bps during the past three months and bund yields have jumped 50 bps. Recent atypical correlations between “core” (perceived safe haven) bonds and EM risk markets have thrown a monkey wrench into many investment/speculation strategies (including variations of popular “risk parity” models).

August 22 – Financial Times (Robin Wigglesworth): “Central banks in the developing world have lost $81bn of emergency reserves through capital outflows and currency market interventions since early May, even before the recent renewal of turmoil in emerging markets. The figure, which excludes China, is equal to roughly 2% of all developing country central bank reserves, according to Morgan Stanley analysts, who compiled the data from central bank filings for May, June and July. However some countries have suffered more precipitous drops. Indonesia has lost 13.6% of its central bank reserves between the end of April and the end of July, Turkey 12.7% and Ukraine burnt through almost 10%. India, another country that has seen its currency pummelled in recent months, has shed almost 5.5% of its reserves. ‘It’s a real regime change compared to what we have been used to for the past decade,’ said James Lord, a Morgan Stanley strategist. ‘We saw huge reserve accumulation as emerging markets tried to stem currency appreciation, but now we’re seeing the exact opposite.’”

The flood of “hot money” finance into EM spurred years of domestic Credit system excess and attendant destabilizing loose “money.” The reversal of “hot money” flows has now instigated a problematic tightening of finance. Importantly, years of historic loose finance created Credit systems and economic structures vulnerable to any meaningful tightening of financial conditions. Over recent months, this latent fragility has been increasingly on display.

I have argued that the dramatic policy measures from one year ago (Draghi’s “do whatever it takes” and the Fed’s $85bn monthly QE) were in response to heightened global fragilities – and that such desperate measures would only work to further destabilize already disorderly global finance. As for EM, unwieldy flows over the past year have, I believe, only created greater fragilities. In Europe, Draghi’s OMT (“outright monetary transactions”) backstop was instrumental in both a loosening of finance and a general political backtracking from financial and economic reform (especially at the troubled “periphery”).

In the U.S., open-ended QE has had minimal impact on the unemployment rate, while exerting dramatic effects on stock prices, corporate debt issuance (especially riskier debt) and home prices (particularly at the upper-end). Going on five years of near-zero short-term rates and bond market interventions have coerced an unprecedented shift of saver assets from the safety of “money” to the risk market wolves. The belief that the Federal Reserve and global central banks would continue to backstop risk markets has been fundamental to epic market mispricing.

Moreover, Trillions have flowed into myriad perceived “money-like” products, strategies and funds (ETFs, hedge funds, SWFs, “bond” and “total return” funds, and various “structured products” and other derivatives) where investors have little appreciation for the degree of associated price, Credit and liquidity risks. The protracted period of massive flows significantly impacted the markets in the underlying securities acquired through these strategies, in particular distorting perceptions of marketplace liquidity (in particular for EM securities and U.S. municipal debt). Misperceptions coupled with significantly inflated securities prices create latent market fragilities.

It’s not difficult for speculators and investors alike in U.S. markets to disregard the unfolding EM crisis along with market risk more generally. After all, ignoring global macro issues has been rewarded handsomely for some time now. Moreover, with the Fed and Bank of Japan (BOJ) combining for about $160bn of monthly QE, ample (developed) marketplace liquidity has seemingly been ensured. And increasingly unstable “periphery” markets also seem to ensure rotation from EM to developed markets, especially U.S. stocks. This is particularly the case with the highly inflated (performance-chasing and trend-following) “global pool of speculative finance.” Indeed, the confluence of acute EM fragilities, $85bn monthly QE and highly-speculative markets has spurred progressively more dangerous speculative excess throughout the U.S. equities marketplace.

August 21 – Wall Street Journal (Juliet Chung and Rob Barry): “Short sellers are facing their worst losses in at least a decade, a Wall Street Journal analysis has found, as many of the rising stocks they bet against have only continued to soar. That has stung several high-profile hedge-fund managers, including William Ackman and David Einhorn, who have placed prominent short bets. In the Russell 3000 index, the 100 most heavily shorted stocks are sharply outperforming the average returns of stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ. The shorted stocks are up by an average of 33.8% through Aug. 16, versus 18.3% for all stocks in the index. The gap between the performance of the most-shorted shares… and the market as a whole is wider than it has been in at least a decade ‘It’s actually more painful now than it was in '99,’ said veteran short seller Andrew Left of Citron Research.”

My “Issues 2013” premise was that an increasingly distended “global government finance Bubble” was susceptible to significant bipolar risks: an intensified Bubble might either begin to falter or it would become a case of “how crazy do things get.” Well, at this point, there are cracks to go along with a lot of craziness. Comparisons to 1999 speculative excesses resonate. And while it is easy for most to dismiss (or, better yet, relish) the pain being inflicted upon those caught short, the bludgeoning of the bears is indicative of a highly speculative marketplace that has become disconnected from underlying fundamentals.

Global markets have become keenly sensitive to Fed “tapering” risks. On the one hand, the unfolding EM crisis has sparked de-risking and de-leveraging dynamics. “Hot money” has begun to flee EM, in the process initiating the self-reinforcing downside to what has been a historic Credit boom. EM central banks have been forced to sell international reserves (Treasury, bund, etc.) to bolster their flagging currencies and vulnerable debt and securities markets. Resulting higher yields have forced de-risking and de-leveraging in (“safe haven”) Treasuries, which has worked to pressure U.S. MBS and muni debt, in particular.

On the other hand, Fed QE is fueling major market distortions. The Fed liquidity backstop has provided a magnetic pull for global “hot money,” giving a competitive advantage to U.S. risk assets, stocks, corporate debt and, ultimately, the U.S. economy.

In a replay of the late-nineties, the “king dollar” dynamic has been exacerbating EM outflows and attendant fragilities. Meanwhile, the supposed inevitable winding down of QE provides an incentive for EM central banks and the speculator community to commence de-risking prior to the withdrawal of the Federal Reserve’s market liquidity backstop. If bonds trade this poorly in the face of the Fed’s $85bn monthly purchases, who is content to wait and see the marketplace liquidity profile when our central bank is no longer a huge buyer.

The unfolding tightening of EM financial conditions portends trouble for the global economy. EM markets have begun to adjust to harsh new realities. Developed markets, if they were functioning normally, would have begun to adjust to mounting risks to global financial and economic systems.

Instead, market players assume heightened fragilities will only extend the period of unprecedented developed central bank “money printing” and market intervention. This view was bolstered by Bernanke’s comments that the Fed would “push back” against any tightening of financial conditions.

The upshot has been a late-cycle speculative melt-up in U.S. equities, in particular. Popularly shorted stocks have been targeted for “squeezes” the most aggressively since 1999. So-called “high beta” stocks have become market darlings like it’s 1999. Stocks with minimal earnings (hence, little risk of earnings disappointments) have become the target of market game-playing and shenanigans to an extent not experienced since 1999.

The excesses from 1999 set the backdrop for a major market Bubble top in early-2000. Yet the late-nineties Bubble was relatively contained, chiefly impacting a narrow group of stocks, the technology sector and only a segment of the U.S. and global economy. The now well-entrenched “global government finance Bubble” has become deeply systemic in the U.S. and abroad. The Bubble essentially enveloped all risk market and myriad strategies. It has fueled conspicuous speculative excess in risky strategies. It has, as well, fueled unappreciated excesses throughout perceived low-risk strategies.

The Bubble has spurred excessive issuance and mispricing in high-risk junk bonds, leveraged loans and risky municipal debt. It has also spurred massive over-issuance of perceived high-quality Treasury securities and “money-like” debt instruments. It has spurred a boom in perceived liquid and low-risk ETF products, funds that loaded up on illiquid securities as “money” flooded in. It has fueled record assets in hedge funds and sovereign wealth funds. It has spurred incredible concentration of assets in the hands of a group of sophisticated financial operators most adept at playing policy-driven speculative markets.

As an analyst of Bubbles, I readily admit it is impossible to accurately predict the timing of their demise. Even in hindsight, I have no idea why technology stocks put in Bubble highs in March of 2000. It’s not clear why stocks peaked again when they did in 2007. It’s never been clear to me why the U.S. equities Bubble cracked when it did in late-1929.

But all those major market tops were put in after speculative market melt-ups pushed the divergence between inflated securities price Bubbles and deteriorating fundamentals to precarious extremes. And all three speculative melt-ups were fueled in part by powerful short squeezes, squeezes made possible by traders shorting securities in response to deteriorating fundamental backdrops. A similar environment exists for a major top in 2013.