Cracks at the Core of the Core
Doug Nolan
January 15 – Bloomberg (Matthew Boesler): “The U.S. economy should continue to grow faster than its potential this year, supporting further interest-rate increases by the Federal Reserve, New York Fed President William C. Dudley said. ‘In terms of the economic outlook, the situation does not appear to have changed much” since the Fed’s Dec. 15-16 meeting, Dudley said, in remarks prepared for a speech Friday… He added that he continues ‘to expect that the economy will expand at a pace slightly above its long-term trend in 2016,’ and said future rate increases would depend on incoming economic data.”
January 15 – Reuters (Ann Saphir): “The stock market's swoon does not change the economic outlook and is merely market participants trying to make sense of global developments, San Francisco Federal Reserve Bank President John Williams told reporters… ‘As the Fed is moving gradually through a process of normalization it's not surprising that we are not going to be at the peak stock prices’ of last year, Williams said. So far swings in stock market prices have not fundamentally changed his expectation for moderate economic growth, he said.”
The world has changed significantly – perhaps profoundly – over recent weeks. The Shanghai Composite has dropped 17.4% over the past month (Shenzhen down 21%). Hong Kong’s Hang Seng Index was down 8.2% over the past month, with Hang Seng Financials sinking 11.9%.
January 15 – Reuters (Ann Saphir): “The stock market's swoon does not change the economic outlook and is merely market participants trying to make sense of global developments, San Francisco Federal Reserve Bank President John Williams told reporters… ‘As the Fed is moving gradually through a process of normalization it's not surprising that we are not going to be at the peak stock prices’ of last year, Williams said. So far swings in stock market prices have not fundamentally changed his expectation for moderate economic growth, he said.”
The world has changed significantly – perhaps profoundly – over recent weeks. The Shanghai Composite has dropped 17.4% over the past month (Shenzhen down 21%). Hong Kong’s Hang Seng Index was down 8.2% over the past month, with Hang Seng Financials sinking 11.9%.
WTI crude is down 26% since December 15th. Over this period, the GSCI Commodities Index sank 12.2%. The Mexican peso has declined almost 7% in a month, the Russian ruble 10% and the South African rand 12%. A Friday headline from the Financial Times: “Emerging market stocks retreat to lowest since 09.”
Trouble at the “Periphery” has definitely taken a troubling turn for the worse. Hope that things were on an uptrend has confronted the reality that things are rapidly getting much worse. This week saw the Shanghai Composite sink 9.0%. Major equities indexes were hit 8.0% in Russia and 5.0% in Brazil (Petrobras down 9%). Financial stocks and levered corporations have been under pressure round the globe. The Russian ruble sank 4.0%, increasing y-t-d losses versus the dollar to 7.1%. The Mexican peso declined another 1.8% this week. The Polish zloty slid 2.8% on an S&P downgrade (“Tumbles Most Since 2011”). The South African rand declined 3.0% (down 7.9% y-t-d). The yen added 0.2% this week, increasing 2016 gains to 3.0%. With the yen up almost 4% versus the dollar over the past month, so-called yen “carry trades” are turning increasingly problematic.
Importantly, the past month has seen contagion effects from the collapsing Bubble at the Periphery penetrate the Fragile Core. Japan’s Nikkei 225 index was down 7.6% over the past month. While bubbling securities markets have worked to underpin European economic recovery, now prepare for the downside. The German DAX is off 11% in the first two weeks of 2016, with stocks in Spain and Italy also sporting double-digit declines. France’s CAC 40 is down 9.2% y-t-d. And highlighting a key Issue 2016, European bonds have provided little offsetting protection against major equity market losses. So far in 2016, German bund yields are down only eight bps. Yields are little changed in Spain and Italy. Sovereign yields are up 20 bps in Portugal and 130 bps in Greece. European corporate debt has posted small negative returns so far in 2016.
Recent weeks point to decisive cracks at the “Core” of the U.S. financial Bubble. The S&P500 has been hit with an 8.0% two-week decline. Notably, favored stocks and sectors have performed poorly. Indicative of rapidly deteriorating economic prospects, the Dow Transports were down 10.9% to begin 2016. The banks (KBW) sank 12.9%, with the broker/dealers (XBD) down 14.1%. The Nasdaq100 (NDX) fell 10%. The Biotechs were down 16.0% in two weeks. The small cap Russell 2000 was hit 11.3%.
Bubbles tend to be varied and complex. In their most basic form, I define a Bubble as a self-reinforcing but inevitably unsustainable inflation. This inflation can be in a wide range of price levels – securities and asset prices, incomes, spending, corporate profits, investment and speculation. Such inflations are always fueled by some type of underlying monetary expansion – typically monetary disorder. Bubbles are always and everywhere a Credit phenomenon, although the underlying source of monetary fuel often goes largely unrecognized.
I’ll posit another key Bubble Dynamic: De-risking/de-leveraging at the Periphery is problematic, with a propensity for risk aversion and associated liquidity constraints to spur contagion effects. At the Core, de-risking/de-leveraging becomes highly destabilizing. Indeed, I would strongly argue that de-leveraging at the “Core of the Core” is tantamount to financial crisis.
It is the “Core of the Core” that now concerns me the most. It is here where Federal Reserve (and global central bank) policies have left their greatest mark. It is at the “Core of the Core” where momentous misperceptions and market mispricing have become deeply entrenched. It’s the “Core of the Core” that has attracted enormous amounts of “money” over recent years. It’s also here where I believe leverage has quietly been used most aggressively. Over recent years it became one massive Crowded Trade. Now the sophisticated players must contemplate beating the unsuspecting public to the exits.
I’ll return to “Core of the Core” analysis after a brief diversion to the “Core of the Periphery.”
Trouble at the “Periphery” has definitely taken a troubling turn for the worse. Hope that things were on an uptrend has confronted the reality that things are rapidly getting much worse. This week saw the Shanghai Composite sink 9.0%. Major equities indexes were hit 8.0% in Russia and 5.0% in Brazil (Petrobras down 9%). Financial stocks and levered corporations have been under pressure round the globe. The Russian ruble sank 4.0%, increasing y-t-d losses versus the dollar to 7.1%. The Mexican peso declined another 1.8% this week. The Polish zloty slid 2.8% on an S&P downgrade (“Tumbles Most Since 2011”). The South African rand declined 3.0% (down 7.9% y-t-d). The yen added 0.2% this week, increasing 2016 gains to 3.0%. With the yen up almost 4% versus the dollar over the past month, so-called yen “carry trades” are turning increasingly problematic.
Importantly, the past month has seen contagion effects from the collapsing Bubble at the Periphery penetrate the Fragile Core. Japan’s Nikkei 225 index was down 7.6% over the past month. While bubbling securities markets have worked to underpin European economic recovery, now prepare for the downside. The German DAX is off 11% in the first two weeks of 2016, with stocks in Spain and Italy also sporting double-digit declines. France’s CAC 40 is down 9.2% y-t-d. And highlighting a key Issue 2016, European bonds have provided little offsetting protection against major equity market losses. So far in 2016, German bund yields are down only eight bps. Yields are little changed in Spain and Italy. Sovereign yields are up 20 bps in Portugal and 130 bps in Greece. European corporate debt has posted small negative returns so far in 2016.
Recent weeks point to decisive cracks at the “Core” of the U.S. financial Bubble. The S&P500 has been hit with an 8.0% two-week decline. Notably, favored stocks and sectors have performed poorly. Indicative of rapidly deteriorating economic prospects, the Dow Transports were down 10.9% to begin 2016. The banks (KBW) sank 12.9%, with the broker/dealers (XBD) down 14.1%. The Nasdaq100 (NDX) fell 10%. The Biotechs were down 16.0% in two weeks. The small cap Russell 2000 was hit 11.3%.
Bubbles tend to be varied and complex. In their most basic form, I define a Bubble as a self-reinforcing but inevitably unsustainable inflation. This inflation can be in a wide range of price levels – securities and asset prices, incomes, spending, corporate profits, investment and speculation. Such inflations are always fueled by some type of underlying monetary expansion – typically monetary disorder. Bubbles are always and everywhere a Credit phenomenon, although the underlying source of monetary fuel often goes largely unrecognized.
I’ll posit another key Bubble Dynamic: De-risking/de-leveraging at the Periphery is problematic, with a propensity for risk aversion and associated liquidity constraints to spur contagion effects. At the Core, de-risking/de-leveraging becomes highly destabilizing. Indeed, I would strongly argue that de-leveraging at the “Core of the Core” is tantamount to financial crisis.
It is the “Core of the Core” that now concerns me the most. It is here where Federal Reserve (and global central bank) policies have left their greatest mark. It is at the “Core of the Core” where momentous misperceptions and market mispricing have become deeply entrenched. It’s the “Core of the Core” that has attracted enormous amounts of “money” over recent years. It’s also here where I believe leverage has quietly been used most aggressively. Over recent years it became one massive Crowded Trade. Now the sophisticated players must contemplate beating the unsuspecting public to the exits.
I’ll return to “Core of the Core” analysis after a brief diversion to the “Core of the Periphery.”
At $275 billion, Chinese Credit growth surged in December to the strongest pace since June.
While growth in new bank loans slowed (15% below estimates), equity and bond issuance jumped. China’s total social financing expanded an enormous $2.2 TN in 2015, down slightly from booming 2014. Such rampant Credit growth was (barely) sufficient to sustain China’s economic expansion. At the same time, I would argue that Chinese stocks, global commodities and developing securities markets in particular have been under intense pressure due to rapidly waning confidence in the sustainability of China’s Credit Bubble.
A similar dynamic is now unfolding in U.S. and other “Core” equities markets: Sustainability in the (U.S. and global) Credit Bubble - the monetary fuel underpinning the boom - is suddenly in doubt. The bulls, Fed officials and most others see the economy as basically sound, similar to how most conventional analysts argued about the Chinese economy over the past year. Inherent fragility and unsustainability are the key issues now driving securities markets – in China, in the U.S, and globally. And, importantly, sentiment has shifted to the view that policy tools have been largely depleted.
January 15 – Reuters (Trevor Hunnicutt): “Fund investors continued to sour on U.S. stocks and corporate debt during the weekly period that ended Jan 13, Lipper data showed…, as risk appetite waned in the wake of global market turmoil. U.S.-based stock mutual funds and exchange-traded funds lost $9.0 billion to withdrawals during a week that saw U.S. stocks continue one of their worst starts to a new year… The outflows also included $5 billion pulled from one ETF alone: SPDR S&P 500 ETF… Before last week, ETF investors had been bullish on U.S. stocks, pumping money in for twelve weeks straight… Corporate bond funds suffered too. Investment-grade bond funds, widely held by retail investors, extended to eight straight weeks their streak of outflows after posting $740 million in outflows during the week. The two-month run of outflows now totals $15.4 billion, about 1.8% of the assets those funds held when the trend started…”
January 15 – Barron’s (Chris Dieterich): “Money hemorrhaged from of mutual and exchange-traded funds for the second week in a row, EPFR Global data show… Global investors pulled $12 billion out of U.S equity funds and a combined $4.5 billion from high-yield bond, bank loan and total return funds in the week ended Jan. 23. Emerging-market funds shed cash for the 11th week in a row. Over the past two weeks, some $21 billion has come out of equity funds, still shy of the $36 billion during the August 2015 selloff.”
January 15 – Bloomberg (Aleksandra Gjorgievska and Fion Li): “Exchange-traded funds that hold U.S. junk bonds dropped to their lowest levels since 2009 as the global growth fears that clobbered stock markets also raised doubts about whether companies’ would continue to generate as much cash to pay their debt obligations.”
This week saw the Bank of America Merrill Lynch High Yield Energy Bond Index trade to a record17.43% yield, surpassing the December 2008 high (from Barron’s Amey Stone). “Triple C” bond yields jumped to 18.8%, the high since 2009 (FT’s Joe Rennison). The yield on the Markit iBoxx Liquid High Yield index jumped this week to the highest level since 2012.
Returning to “Core of the Core” analysis, investment-grade corporate debt has rather abruptly joined the market turmoil. After a rocky first week of 2016, investment-grade debt spreads widened again this week to a three-year high, as investment-grade funds suffered their eighth straight week of outflows.
“Triple A” MBS occupied the mortgage finance Bubble’s “Core of the Core”. GSE securities were perceived as “money”-like (“Moneyness of Credit”), with implied backings from the Treasury and Fed seemingly guaranteeing safety and liquidity. Throughout the global government finance Bubble period, I have often invoked the concept “Moneyness of Risk Assets.” With the Federal Reserve and global central banks determined to do just about anything to uphold booming securities markets, the marketplace perceived that safety and liquidity were virtually ensured. Trillions flowed into global stock and bond mutual funds, the majority into perceived low-risk U.S. equities indexes and investment-grade corporate debt products.
It is worth recalling that my tally of Total U.S. Securities (Treasuries, Agencies, Corp Bonds, Munis and Equities) ended Q2 2015 at a record $76.924 TN, or 429% of GDP. This was up $30.90 TN (77%) from 2008’s $46.034 TN (313% of GDP) – and greatly exceeded 2007’s $53.279 TN (368% of GDP).
And as securities market inflation inflated Household Net Worth, spending increases bolstered corporate profits and income growth. Booming markets, especially ultra-easy financial conditions throughout the corporate Credit market, spurred stock buybacks and incited record M&A activity. As noted above, Bubbles are self-reinforcing but inevitably unsustainable.
A similar dynamic is now unfolding in U.S. and other “Core” equities markets: Sustainability in the (U.S. and global) Credit Bubble - the monetary fuel underpinning the boom - is suddenly in doubt. The bulls, Fed officials and most others see the economy as basically sound, similar to how most conventional analysts argued about the Chinese economy over the past year. Inherent fragility and unsustainability are the key issues now driving securities markets – in China, in the U.S, and globally. And, importantly, sentiment has shifted to the view that policy tools have been largely depleted.
January 15 – Reuters (Trevor Hunnicutt): “Fund investors continued to sour on U.S. stocks and corporate debt during the weekly period that ended Jan 13, Lipper data showed…, as risk appetite waned in the wake of global market turmoil. U.S.-based stock mutual funds and exchange-traded funds lost $9.0 billion to withdrawals during a week that saw U.S. stocks continue one of their worst starts to a new year… The outflows also included $5 billion pulled from one ETF alone: SPDR S&P 500 ETF… Before last week, ETF investors had been bullish on U.S. stocks, pumping money in for twelve weeks straight… Corporate bond funds suffered too. Investment-grade bond funds, widely held by retail investors, extended to eight straight weeks their streak of outflows after posting $740 million in outflows during the week. The two-month run of outflows now totals $15.4 billion, about 1.8% of the assets those funds held when the trend started…”
January 15 – Barron’s (Chris Dieterich): “Money hemorrhaged from of mutual and exchange-traded funds for the second week in a row, EPFR Global data show… Global investors pulled $12 billion out of U.S equity funds and a combined $4.5 billion from high-yield bond, bank loan and total return funds in the week ended Jan. 23. Emerging-market funds shed cash for the 11th week in a row. Over the past two weeks, some $21 billion has come out of equity funds, still shy of the $36 billion during the August 2015 selloff.”
January 15 – Bloomberg (Aleksandra Gjorgievska and Fion Li): “Exchange-traded funds that hold U.S. junk bonds dropped to their lowest levels since 2009 as the global growth fears that clobbered stock markets also raised doubts about whether companies’ would continue to generate as much cash to pay their debt obligations.”
This week saw the Bank of America Merrill Lynch High Yield Energy Bond Index trade to a record17.43% yield, surpassing the December 2008 high (from Barron’s Amey Stone). “Triple C” bond yields jumped to 18.8%, the high since 2009 (FT’s Joe Rennison). The yield on the Markit iBoxx Liquid High Yield index jumped this week to the highest level since 2012.
Returning to “Core of the Core” analysis, investment-grade corporate debt has rather abruptly joined the market turmoil. After a rocky first week of 2016, investment-grade debt spreads widened again this week to a three-year high, as investment-grade funds suffered their eighth straight week of outflows.
“Triple A” MBS occupied the mortgage finance Bubble’s “Core of the Core”. GSE securities were perceived as “money”-like (“Moneyness of Credit”), with implied backings from the Treasury and Fed seemingly guaranteeing safety and liquidity. Throughout the global government finance Bubble period, I have often invoked the concept “Moneyness of Risk Assets.” With the Federal Reserve and global central banks determined to do just about anything to uphold booming securities markets, the marketplace perceived that safety and liquidity were virtually ensured. Trillions flowed into global stock and bond mutual funds, the majority into perceived low-risk U.S. equities indexes and investment-grade corporate debt products.
It is worth recalling that my tally of Total U.S. Securities (Treasuries, Agencies, Corp Bonds, Munis and Equities) ended Q2 2015 at a record $76.924 TN, or 429% of GDP. This was up $30.90 TN (77%) from 2008’s $46.034 TN (313% of GDP) – and greatly exceeded 2007’s $53.279 TN (368% of GDP).
And as securities market inflation inflated Household Net Worth, spending increases bolstered corporate profits and income growth. Booming markets, especially ultra-easy financial conditions throughout the corporate Credit market, spurred stock buybacks and incited record M&A activity. As noted above, Bubbles are self-reinforcing but inevitably unsustainable.
Especially with faltering Bubbles at the “Core of the Core,” wealth effects will now operate in reverse. Spending (household and corporate) will slow, with domestic issues joining international to pummel corporate profits. Significant tightening in corporate Credit will weigh heavily on both stock repurchases and M&A. And as economic prospects darken at home and abroad, there will be reinforcing downward pressure on U.S. equities and investment-grade corporate debt.
Back in 2000, Dallas Fed president Robert McTeer suggested that our economy’s ills would be rectified “if everyone would hold hands and buy an SUV.” And for the next 15 years Fed policies did the unimaginable in the name of (indiscriminately) stimulating growth of any kind possible. And if epic mortgage finance Bubble financial and economic maladjustment was not enough, the past seven years have seen the type of financial folly and egregious wealth redistribution that tear societies apart.
The bottom line is that Bubbles destroy and redistribute wealth, though the true effects are masked for a while by inflated securities and asset markets – along with resulting unsustainable spending patterns and economic activity. Regrettably, years of policy mismanagement, gross financial excess, deep structural maladjustment and the most imbalanced economy in our nation’s history will now come home to roost.
Back in 2000, Dallas Fed president Robert McTeer suggested that our economy’s ills would be rectified “if everyone would hold hands and buy an SUV.” And for the next 15 years Fed policies did the unimaginable in the name of (indiscriminately) stimulating growth of any kind possible. And if epic mortgage finance Bubble financial and economic maladjustment was not enough, the past seven years have seen the type of financial folly and egregious wealth redistribution that tear societies apart.
The bottom line is that Bubbles destroy and redistribute wealth, though the true effects are masked for a while by inflated securities and asset markets – along with resulting unsustainable spending patterns and economic activity. Regrettably, years of policy mismanagement, gross financial excess, deep structural maladjustment and the most imbalanced economy in our nation’s history will now come home to roost.
At this point, I cannot confidently forecast how quickly the bust will unfold. I do, however, believe this process has begun as Bubbles falter at the “Core of the Core.”
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