Nasdaq: Devil take the hindmost

I am fond off quoting Jesse Livermore’s maxim “You don’t argue with the tape” but Livermore was a keen student of market conditions and based his decisions on far more than just price action in the market.

We are witnessing a spectacular stock market rally, driven by retail investors and hedge funds piling into the market while institutional investors are sitting on the sidelines.

The Nasdaq 100 broke through resistance at 10,000, new highs signaling a fresh primary advance. Bearish divergence on Twiggs Money Flow index may warn of selling pressure but it is hard to argue with the tape. Only a fall below 9500 would signal another decline and that seems unlikely at present.

Nasdaq 100

Even retail sales (ex food) have recovered sharply, from -15.3% in April to -1.4% in May (annual % gain).

Retail Sales (ex Food)

Light vehicle sales are more sluggish but June sales of 13.05 million are still a sizable bounce.

Light Vehicle Sales

So why are many old investment hands acting with such caution?

We know that the efforts to contain the COVID19 outbreak are struggling, with over 60,000 new cases per day, but the economy still seems in good shape.

COVID19 Daily Cases

Source JHU CSSE

Let’s look at where the money is coming from.

Federal Debt

Treasury debt has expanded by more than $3 trillion in the last four months (March 9 – July 9) as the government does everything in its power to cushion the economy from an unprecedented shutdown. Rescuing airlines, bailing out Boeing, emergency business loans, job preservation schemes, and supporting Fed purchases of a wide variety of financial assets to keep the plumbing of financial markets open. Every way they can, government has been flooding the market with money and some of that has found its way to the stock market. Whether through boosting stock purchases, enabling companies to raise debt or boosting consumer spending to buoy up sales, the market is flying on borrowed money.

Steep up-trends like this typically end in a blow-off. A trend is self-reinforcing if rising prices attract more investors who in turn bid up prices even further. A steady influx of new investors is required to sustain the trend, else it dies.

Similar self-reinforcing cycles are evident in nature, where they expand violently outward at an exponential rate until they run out of fuel. The fuel driving the event may differ, from dry tinder in a forest fire, warm ocean temperatures in a hurricane, consumable vegetation in a locust plague, …..or exposed population in a virus outbreak. The cycle expands, feeding on itself, until the fuel is exhausted.

A stock market blow-off is no different. The up-trend will continue for as long as rising prices are able to attract new investors. It will stop when the source of new money dries up. In this case, when Treasury tries to slow the unsustainable growth in federal debt. Then it becomes a case of devil-take-the-hindmost as a preponderance of sellers attempt to offload their stocks on a rapidly shrinking pool of buyers.

Coronavirus: “We are all Keynesians now”

An economic depression requires a 10% (or more) decline in real GDP or a prolonged recession that lasts two or more years.

The current contraction, sparked by the global coronavirus outbreak, is likely to be severe but its magnitude and duration are still uncertain. After an initial spike in cases, with devastating consequences in many countries — both in terms of the number of deaths and the massive economic impact — the rate of contagion is expected to drop significantly. But we could witness further flare-ups, as with SARS.

Development of a vaccine is the only viable long-term defense against the coronavirus but health experts warn that this is at least 12 to 18 months away — still extremely fast when compared to normal vaccine development programs.

The economic impact may soften after the initial shutdown but some industries such as travel, airlines, hotels, cruise lines, shopping malls, and cinemas are likely to experience lasting changes in consumer behavior. The direct consequences will be with us for some time. So will the indirect consequences: small business and corporate failures, widespread unemployment, collapsing real estate prices, and solvency issues within the financial system. The Fed is going to be busy putting out fires. While it can fix liquidity issues with its printing press, it can’t fix solvency issues.

There are three key factors that are likely to determine whether countries end up with a depression or a recession:

1. Leadership during the crisis

Many countries were caught by surprise and the rapid spread of the virus from its source in Wuhan, China. South Korea, Singapore and Taiwan were best prepared, after dealing with the SARS outbreak in the early 2000s. Extensive testing, tracing and an effective quarantine program helped South Korea to bring the spread under control, after initially being one of the worst-hit.

Daily Increase - South Korea

South Korea: Initial Cases of Coronavirus COVID-19 (JHU)

The World Health Organization (WHO) did little to help, delaying declaration of a pandemic to appease the CCP. Economic and political self-interest has been the root cause of many failures along the way, including China’s failure to alert global authorities of the outbreak (they had already shut down Wuhan Naval College on January 1st). But this was aided by failure of many leaders to heed warnings from infectious disease experts in late January/early February. When they finally did wake up to the threat, many were totally unprepared, resulting in a massive spike in cases across Europe and North America.

Testing is a major bottleneck, with the FDA fast-tracking approval of new tests, but production volumes are still limited. Abbott recently obtained FDA approval for a new 5-minute test kit that can be used in temporary screening locations, outside of a hospital, but production is currently limited to 50,000 per day. A drop in the ocean. It would take 6 months to produce 9 million kits for New York alone.

Daily Increase - USA

USA: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - UK

UK: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Germany

Germany: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Italy

Italy: Initial Cases of Coronavirus COVID-19 (JHU)

Widespread testing and tracing, social-distancing, and effective quarantine methods have enabled some countries to flatten the curve. Australia may be succeeding in reducing the number of new cases but inadequate testing and tracing could lead to further flare-ups. One of the biggest dangers is asymptomatic carriers who can infect others. Flattening the curve is the first step, but keeping it flat is essential, and requires widespread testing and tracing.

Daily Increase - Australia

Australia: Initial Cases of Coronavirus COVID-19 (JHU)

The curves for North America and Europe remain exponential. They may even spike a lot higher if hospital facilities are overrun. Success in flattening the curve is critical, not just in minimizing the number of deaths but in containing the economic impact.

2. Economic rescue measures during the crisis

Rescue measures amounting to roughly 10% of annual GDP have been introduced in several countries, including the US and Australia, to soften the economic impact of the shutdown. More Keynesian stimulus may be needed if the coronavirus curve is not flattened. Layoffs have spiked and many small businesses will be unable to recover without substantial support.

3. Economic stimulus after the crisis

This is not a time for half-measures and the $2 trillion infrastructure program proposed in the US is also appropriate in the circumstances. Australia is likely to need a similar program (10% of GDP) but it is essential that the money be spent on productive infrastructure assets. Productive assets must generate a market-related return on investment ….or generate an equivalent increase in government tax revenue but this is much more difficult to measure. Investment in unproductive assets would leave the country with a sizable debt and no ready means of repaying it (much like Donald Trump’s 2017 tax cuts).

Conclusion

Social-distancing and effective quarantine measures are necessary to flatten the curve but widespread testing and tracing is essential to prevent further flare-ups. Development of a vaccine could take two years or more. Until then there is likely to be an on-going economic impact, long after the initial shock. This is likely to be compounded by a solvency crisis in small and large businesses, threatening the stability of the financial system. The best we can hope for, in the circumstances, is to escape with a recession — less than 10% contraction in GDP and less than two year duration — but this will require strong leadership, public cooperation and skillful prioritization of resources.

—–

“We are all Keynesians now.” ~ Richard Nixon (after 1971 collapse of the gold standard)

Lessons from the Panic of 1907

I have read The Panic of 1907 (by Robert Bruner & Sean Carr) four or five times — I read it at every market crash.

The crash occurred more than 100 years ago and is one of many banking crises that beset the United States in the 19th and early 20th century. What made 1907 stand out is that the financial system was saved by the leadership of a private individual, John Pierpont Morgan, head of the banking firm that later became known as J.P. Morgan & Co. Without the 70-year old Morgan’s force of will, the entire financial system would have imploded.

John Pierpont Morgan
John Pierpont Morgan – source: Wikipedia

The crisis led to formation of the Federal Reserve Bank in 1913. The US had not had a central bank since President Andrew Jackson withdrew the charter for the second Bank of the United States in 1837. Bank clearing houses prior to 1913 were private arrangements created by syndicates of banks and were poorly-equipped to deal with the challenges of a banking crisis.

The lessons of 1907 are still relevant today. The authors of the book suggest that “financial crises result from a convergence of forces, a ‘perfect storm’ at work in financial markets.”

They identify seven elements that converged to create a perfect storm in 1907:

  1. Complex Financial Architecture makes it “difficult to know what is going on and establishes linkages that enable contagion of the crisis to spread.”
  2. Buoyant Growth. “Economic expansion creates rising demands for capital and liquidity and ….excessive mistakes that eventually must be corrected.”
  3. Inadequate Safety Buffers. “In the late stages of an economic expansion, borrowers and creditors overreach in their use of debt, lowering the margin of safety in the financial system.”
  4. Adverse Leadership. “Prominent people in the public and private spheres implement policies that raise uncertainty, which impairs confidence and elevates risk.”
  5. Real Economic Shock. “Unexpected events hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors.”
  6. Undue Fear, Greed and other Behavioral Aberrations. “….a shift from optimism to pessimism that creates a self-reinforcing downward spiral. The more bad news, the more behavior (erupts) that generates bad news.”
  7. Failure of Collective Action. “The best-intended responses by people on the scene prove inadequate to the challenge of the crisis.”

Compare these seven elements to the current crisis in March 2020:

Complex Financial Systems

The global financial system is far more complex than the gold-based financial system of 1907. Regulation has not kept pace with the growth in complexity, with many products designed to avoid regulation and lower costs. The ability to build firebreaks to stop the spread of contagion in unregulated or lightly regulated areas of the financial system is severely limited. And that is where the fires tend to start.

In 1907 the fire started with poorly regulated trust companies that dominated the financial landscape: making loans, receiving deposits, and operating as an effective shadow-banking system. A run on trust companies threatened to engulf the entire financial system.

In 2020 it started with hedge funds leveraged to the hilt through repo markets but soon threatened to spread to other unregulated (or lightly regulated) areas of our shadow banking system:

  • Leveraged hedge funds
  • Risk parity funds
  • International banks lending and taking deposits in the unregulated $6.5 trillion Eurodollar market (these banks are offshore and outside the Fed’s jurisdiction).
  • Money market funds
  • Muni funds
  • Commercial paper markets
  • Leveraged credit
  • Bond ETFs

Many of these offer the attraction of low costs and higher returns, often enhanced through leverage, but what investors are blind to (or choose to ignore) are the risks from lack of proper supervision and the lack of liquidity when money is tight.

Maturity mis-match is often used to boost returns. Short-term investors are channeled into long-term securities such as Treasuries, corporate bonds, munis or credit instruments, with the promise of easy sale or redemption when they require their funds. But this tends to fail when there is a liquidity squeeze, forcing a sell-off in the underlying securities and steeply falling prices.

Rapid Growth

We all welcome strong economic growth but should beware of the attendant risks, especially when financial markets are administered more stimulants than a Russian weightlifter for purely political ends.

Excessive use of Debt

Corporate borrowings are far higher today and rising debt has warned of a coming recession for some time.

Corporate Debt/Profits Before Tax

Public debt is growing even faster, with US federal debt at 98.6% of GDP.

Public Debt/GDP

Adverse Leadership

In the early 1900s, President Teddy Roosevelt led a populist drive to break the big money corporations through Anti-Trust prosecutions. This cast a shadow of uncertainty that fueled the sudden reversal in investor sentiment.

President Theodor Roosevelt

In 2020, we have another populist in the White House. Frequent changes in direction, spats with allies, imposition of trade tariffs, impeachment efforts by Congress, and a heavy-handed approach to trade negotiations have all elevated the level of uncertainty.

Donald Trump

Economic Shock

The great San Francisco earthquake and fire of 1906 created an economic shock that was felt across the Atlantic. The earthquake ruptured gas mains, setting off fires, while fractured water mains hampered firefighting. Over 80% of the city was destroyed. Much of the insurance was carried in London and Europe and led to a sell-off of securities in order to meet claims. The Bank of England became increasingly concerned about the outflow of gold from the UK and hiked its benchmark interest rate from 3.5% to 6.0%. London was then the hub of global financial markets and money became tight.

In 2020 we have the coronavirus impact on global manufacturing, services and financial systems: the mother of all demand and supply shocks.

JHU - CV Confirmed Cases

Undue Fear and Greed

Collapse of highly leveraged ventures in 1907 — with an attempted short squeeze on United Copper shares by connected corporations, banks and broking houses — stirred fears that a leading Trust company was going to fail. The panic soon spread and started a run on a number of trust companies.

A spike in the repo rate in September last year revealed that hedge funds had used repo to leverage their relatively meager capital into a rumored $650 billion exposure to US Treasuries. The Fed had to dive in with liquidity to settle the repo markets, lifeblood of short-term funding by primary dealers. But financial markets were on edge and concerns about funding difficulties in the unregulated $6.5 trillion offshore Eurodollar market and leveraged credit in the US started to grow.  But the coronavirus outbreak in Europe and North America was the eventual spark that set off the conflagration.

Failure of Collective Action

Tust companies failed to organize an effective defense in 1907 against a run on their largest member, The Knickerbocker Trust Company, fueling a panic that threatened to engulf other trusts. Responding to appeals for help, J.P. Morgan intervened and marshaled the banking industry and surviving trusts to mount an effective defense.

Today that role falls to the Federal Reserve. Chairman Jay Powell moved quickly and purposefully to flood financial markets with liquidity, but the Fed was forced to reach far outside their normal ambit — increasing dollar swap lines with foreign central banks (to supply liquidity to international banks operating in the Eurodollar market) and providing liquidity to money market funds, muni funds, commercial paper markets, bond funds, hedge funds (through repo markets) and more. In effect, the Fed had to bail out the shadow banking system.

One thing that strikes me about financial crises is that each one is different, but some things never change:

  • artificially low interest rates;
  • rampant speculation;
  • excessive use of debt;
  • unregulated and highly leveraged shadow-banking with hidden linkages through the financial system;
  • financial engineering (the latest examples are leveraged credit and covenant-lite loans, hedge funds running leveraged arbitrage, risk parity funds with targeted volatility, and management using stock buybacks to enhance earnings per share, support prices and boost their stock-based compensation);
  • misuse of fiscal stimulus (to fund corporate tax cuts while running a $1.4 trillion fiscal deficit);
  • misuse of monetary policy (cutting interest rates when unemployment was at record lows);
  • yield curve inversion; and
  • misallocation of investment (to fund unproductive assets)

Jim Grant (Grant’s Interest Rate Observer) sums up the problem:

“The Fed has intervened at ever-closer intervals to suppress the symptoms of misallocation of resources and the mis-pricing of credit. These radical interventions have become ever-more drastic and the ‘doctor-feel-goods’ of our central banks have worked to destroy the pricing mechanism in credit.

….[credit and equity markets] have become administered government-set indicators, rather than sensitive- and information-rich prices… and we are paying the price for that through the misallocation of resources…..

Is there no salutary role for recessions and bear markets? …..they separate the sound from the unsound, they separate the well-financed from the over-leveraged and if we never have these episodes of economic pain, we will be much the worse for it.”

We haven’t learned much at all in the last 100 years.

Bailout time

Boeing has applied to the Federal government for a $60 billion bailout. The troubled aircraft manufacturer is in need of rescuing but has indulged in $54.9 billion of stock buybacks in support of its stock price.

Former UN ambassador and ex-South Carolina governor, Nikki Halley resigned from Boeing’s board, saying that she opposes federal support for Boeing. Smart political move. Public anger is growing.

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Many corporations used stock buybacks to boost earnings per share after earnings growth slowed in 2014/15. Boeing was no exception.

Stock Buybacks and LT Debt

The company had a reputation for engineering fine aircraft but in recent years that focus has shifted to financial engineering and cost-cutting to boost earnings per share. Free cash flow was squandered on stock buybacks, dividends and executive bonuses. No reserves were accumulated for a rainy day.

Well, a rainy day finally arrived in 2018. The Boeing 737 MAX airliner, which began service in 2017, was involved in two fatal accidents, Lion Air on October 29, 2018, and Ethiopian Airlines on March 10, 2019, caused by a malfunction of the aircraft’s new MCAS automated control system. The aircraft was grounded by airline authorities around the world and Boeing suspended production in December 2019. After a software bug was discovered in January, the return to service was delayed. Despite an outstanding issue over non-compliant wiring bundles the FAA has indicated that they expect the 737 Max to return to service in the second half of 2020.

The company had to raise almost $10 billion in bonds to help it weather the setback. CEO Dennis Muilenburg was ousted in late 2019 but still walked away with a golden parachute of up to $50 million.

A hit from the 2020 Coronavirus outbreak has put the company into difficulties, with the stock getting pounded. Boeing has been forced to apply for a government bailout.

Stock Buybacks and LT Debt

The company is a strategic asset of the United States and should be protected.

But rewarding bad behavior would promote moral hazard on a wide scale. To give management and stockholders a free ride would encourage risk-taking by other companies — with the expectation that they will be bailed out if something goes wrong.

Support the company but hurt the stockholders

Management and existing stockholders need to feel the pain.

Offer support in the form of $60 billion of convertible bonds or preference shares, ranking behind creditors but ahead of stockholders. Conversion into ordinary shares should be in 10 years time but at the current stock price of $100. Stockholders and management awards will take a huge hit,  while taxpayers can look forward to a sizeable gain when the company recovers.

Support should be non-voting (bonds or prefs) to keep political interference to a minimum.

Buybacks

Preventing future buybacks is a completely separate issue that should be addressed on a national basis and not by placing restrictions on individual companies. For the record, we are against buybacks because they can be used to artificially support stock prices. Companies that need to return capital to stockholders should declare a special dividend.

Avoid a Domino-effect

There are a string of companies lining up with bailout requests. It is important to put emotions aside and save those that are still viable businesses and not just strategic assets like Boeing. Millions of jobs are at stake. And disruption to credit markets could have a Lehman-like domino effect.

Just ensure that it is on terms that favor the taxpayer, so that stockholders will think twice about future profligacy.

Irrational Exuberance

I believe this warrants a separate post:

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but the US Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

Bull Markets & Irrational Exuberance

Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:

“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.

As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.

That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”

Economy

The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.

Treasury 10 Year-3 Month Yield Differential

I rate economic risk as medium at present.

Political Disruption

US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?

Bonds & Interest Rates

I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.

Market Risk: Irrational Exuberance

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

Cracks are showing in China’s Debt Markets

“You only learn who has been swimming naked when the tide goes out…” ~ Warren Buffett

Beijing’s de-leveraging campaign, to set the economy on a sustainable path, is starting to expose some of the excesses in financial markets.

Local Government

Local governments owe some 49 trillion yuan (about $7 trillion or 50% of China’s GDP) in off-balance-sheet debt through local government finance vehicles (LGFVs). LGFVs generate no income themselves and are reliant on revenue flows from the city government to service the debt. Local governments in the past generated substantial revenue through land sales but dwindling sales make debt servicing a challenge. Many LGFVs are experiencing cash flow problems and have resorted to borrowing in shadow finance markets to meet their commitments. Interest rates are close to 10% and will simply accelerate the inevitable implosion.

This map from Rhodium highlights the most severely affected LGFVs, where debt in some cases exceeds 30 times local government revenues:

China: City Level Financial Stress

China’s Ministry of Finance (MOF) is attempting to keep a lid on the problem, offering long-term low interest loans from China Development Bank to repay shadow financing. Zhenjiang, an eastern city of Jiangsu province was one of the first beneficiaries, in March 2019. But debt substitution merely prolongs the crisis unless the city can sell off marketable assets to repay debt. Marketable assets which are, in many cases, proving hard to find.

This detailed report from Rhodium examines the problem.

State-owned Enterprises (SOEs)

We are also witnessing a $1.25 billion default by local government-owned Tewoo Group:

“China’s Tewoo Group has forced investors to take losses on a US dollar bond, marking the largest failure to repay dollar debt by a state-owned company in two decades….The commodities trader, which is wholly owned by the city government of Tianjin, completed an exchange offer this week that made investors take significant discounts on their holdings in the company’s debt.”
“The offer was ‘tantamount to a default’, S&P Global Ratings said on Thursday.” ~ FT.com

Based out of Tianjin, Tewoo is a bulk trader of commodities such as metals (ferrous & nonferrous), energy, minerals and chemicals….

In 2017, it had a turnover of $66.6 billion with profits of $122 million and was ranked 129th in the Fortune Global 500 list & 28th in the Chinese enterprises list. The company employs more than 19,000 professionals and has operations across the US, Germany, Japan and Singapore.

Tewoo’s financial challenges are closely linked to Bohai Steel Group, a business associate which has filed for liquidation due to high leverage. Bohai’s bankruptcy in 2018 triggered systemic risk in Tianjin’s financial market and Tewoo has been facing serious liquidity challenges in recent months. ~ MoneyControl

Bank Bailouts

Many small and medium-sized banks are overly reliant on wholesale markets for funding and tightening credit has left them high and dry.
Barclays Research highlighted a number of banks that had failed to submit their 2018 annual reports on time (source Zero Hedge/Macrobusiness):

China: Troubled Banks

  • Baoshang Bank underwent a state takeover in May.
  • Bank of Jinzhou was taken over by state-owned strategic investors in July.
  • Heng Feng Bank was taken over by China’s sovereign wealth fund in August.
  • Troubled Anbang Insurance Group is selling a 35% stake in Chengdu Rural Commercial Bank to “an investment firm owned by the southwestern city of Chengdu.” (Caixin)

While, according to Caixin:

“China’s Hengfeng Bank will raise 100 billion yuan ($14.21 billion) through a private placement to a group of state and foreign investors…..The troubled Shandong-based lender will issue 100 billion shares, Hengfeng said Wednesday in a statement.”

Foreign investment is simply window-dressing, with Singapore’s United Overseas Bank subscribing for 4% of the new issue. Probably with a “put” on the other state-owned purchasers.

“The bailouts for China’s troubled small banks roll on……China’s sneaky system-wide bank bailout is well underway.” ~ Trivium China

Efforts by Beijing to curb exponential debt growth are praiseworthy, but are likely to come at a substantial cost. Expect GDP growth to slow and gradual “Japanification” as the state attempts to avoid hard choices, supporting the continued existence of “zombie” companies ……and sclerosis of the Chinese economy.

Don’t fight the Fed

The Fed is again expanding its balance sheet in response to the recent interest rate spike in repo markets. The effect is the same as QE: the Fed is creating new money (reserve balances) and pumping this into financial markets.

Fed Assets and Excess Reserves on Deposit

Why is this happening?

The US government is issuing record amounts of new Treasuries to cover Donald Trump’s record deficit.

Fed Assets and Excess Reserves on Deposit

According to Luke Gromen: “US govt is on pace to issue $11.3T in USTs on a gross basis in F19.

Gregor Samsa at Macro-Monitor sums up the problem with the following diagram.

Macro Monitor - US Treasury Supply Demand Curves

If supply-demand curves do your head in, the above graph simply says that when you suppress interest rates, there will be a surplus of Treasuries. The yield is less attractive and demand from investors will fall.

Not only do we not have enough domestic buyers, foreign (Chinese?) purchases of US Treasuries are drying up. Primary dealers are required to take up the shortfall on any new issues. The recent price spike tells us they don’t want them.

10-Year Treasury Yields

So it’s all hands to the pump at the Fed. We are likely to see further balance sheet expansion in the months ahead, driving down Treasury yields and the Dollar.

And lifting equities.

The flush of new money is likely to suppress volatility.

S&P 500

And drive equities even further out along the risk curve. Breakout above 3025 would signal another advance.

S&P 500

We remain cautious. Stocks are highly-priced compared to earnings.

Corporate profits are falling in real terms.

Real Corporate Profits

And rising personal savings warn that consumption is likely to fall.

Personal Savings

It all depends on how much money the Fed will print.

Fed Assets and Broad Money

Ultra-low interest rates may lead to a ‘debt trap’

The highly-regarded Stephen Bartholomeusz warns that central bank policies may lead to a ‘debt trap’:

“….With the world apparently re-starting the use of unconventional monetary policies even before central banks have extricated themselves from the legacies of a decade of those policies, there is a real risk that the impacts and the threats posed by their side effects will swell and that the world will be caught within what the BIS has previously described as a “debt trap’’ with no exit.

The other disturbing aspect of the [BIS] report is that it repeatedly says it is too early to assess the longer-term implications of the policies the central banks have employed.

Central bankers respond to the latest data – they respond to short-term signals – but the side-effects of their post-crisis policies have already been building for a decade and will continue to build while they maintain ultra-low or negative policy rates and keep buying bonds and other fixed interest securities to depress longer-term interest rates and suppress risk premia.

How those side-effects are unwound and how the banks extricate themselves from their policies and the legacies of those policies won’t be known until they try, but the potential for another crisis has been increased by the big surge in global leverage and the elevated asset prices the policies have encouraged.

Negative rates and quantitative easing and variations on those themes might, as the BIS report says, be useful additions to central bankers’ toolboxes but the past decade has shown they aren’t by themselves a panacea for economic ills and they bring with them potentially unpleasant side effects the longer they are in place.”

Debt traps occur when the interest rate needed to service the government debt is greater than the growth rate of GDP, according to former Fed governor Robert Heller:

“…In such a situation, debt service obligations grow more rapidly than the economy; eventually, the accumulated debt can no longer be serviced properly. In other words, the dynamics of the situation become unsustainable and a death spiral ensues.”

So far, central banks have responded by driving interest rates to record lows but unintended consequences are emerging, with low interest rates leading to low GDP growth. A feedback loop is emerging:

    • Low interest rates

Australia: 10-Year Bond Yield

    • Low bank interest margins

Australia: Bank Net Interest Margins

    • Low credit growth

Australia: Credit & Broad Money Growth

    • Low inflation

Australia: Underlying Inflation

    • And low economic growth

Australia: GDP Growth

We are venturing where angels fear to tread: central banks trialing new policies without empirical evidence as to their long-term consequences.

Monetary policy should be administered judiciously, intervening only when the financial system is in dire straits, outside the realm of the regular business cycle. Instead monetary policy is treated as a panacea, the constant drip-feed building a long-term dependence on further stimulus.

The problem with ‘traps’ is that they are difficult to escape.

“If you find yourself in a hole, the first thing to do is stop digging.”

~ Will Rogers

[NOTE: I should clarify that Australia has relatively low fiscal debt and is not in any immediate danger of a debt trap. But the ‘lucky country’ would suffer severely from fallout if the US or China were caught in a debt trap.]