Reflexivity, Bubbles and Profits

By: Doug Noland | Sat, Aug 23, 2014
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Market "risk on" - in the face of a risky and unstable world.

My analytical framework owes a debt of gratitude to, among others, George Soros. His 1987 classic "The Alchemy of Finance," particularly his Theory of Reflexivity, has profoundly influenced the way I view the markets, economics and the world.

From Wikipedia: "Economic philosopher George Soros, influenced by ideas put forward by his tutor, Karl Popper (1957), has been an active promoter of the relevance of reflexivity to economics, first propounding it publicly in his 1987 book The Alchemy of Finance. He regards his insights into market behaviour from applying the principle as a major factor in the success of his financial career. Reflexivity is inconsistent with equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles. An example Soros cites is the procyclical nature of lending, that is, the willingness of banks to ease lending standards for real estate loans when prices are rising, then raising standards when real estate prices are falling, reinforcing the boom and bust cycle."

In simplest terms, I explain reflexivity as "perceptions creating their own reality." I would argue that the concept of "reflexivity" has never been as important as it is these days. The self-reinforcing nature of Credit cycles has played prominently throughout history. I have argued for years that the move to market-based Credit instruments (i.e. securitizations vs. bank loans) has profoundly exacerbated the inherent instability of Credit, market and economic cycles. Moreover, the instability and fragility of contemporary market-based Credit has over time engendered progressively more "activist" governmental market manipulation and intervention.

The headline certainly caught my attention: "George Soros bets $2B-plus on stock market collapse." At less than 17% of fund assets, I don't want to get too carried away with Soros' bearish bet/hedge. At the same time, it does support my view that the sophisticated market operators have begun to pare some risk. Further confirmation came in Thursday's Wall Street Journal article "Nervous Hedge Funds Turn Defensive on Concerns Over Asset Prices."

Also, interestingly, from Thursday's Wall Street Journal (Kirsten Grind): "Investors Pour Into Vanguard, Eschewing Stock Pickers. Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren't run by stock pickers or star managers. The inflow has pushed the mutual-fund giant to almost $3 trillion in assets under management for the first time. The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners... Investors poured a net $336 billion into passively managed stock and bond funds in 2013, handily beating the $53 billion invested in traditional mutual funds of the same type, according to Morningstar. So far this year through July, investors put a net $177 billion into those passive funds, compared with $74 billion in actively managed funds... Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds..."

The contrast between hedge fund risk aversion and "money" flooding into index products stimulates the analytical brain. Certainly, the notion of "distribution" from the sophisticated market operators to the less sophisticated comes to mind. Yet so-called "dumb money" doesn't do justice when it comes to explaining the incredible $500bn that flooded into (largely ETF) index products over the past 18 or so months. Wow.

Credit Bubbles and financial manias are most fascinating. The written history of some of the more notorious Bubbles too successfully paints monetary fiascos as events driven largely by manic obsession with tulip bulbs or various financial instruments. As a student of the monetary inflations/distortions that underpin market Bubbles ("manias"), I take a differing view.

As much as Bubble episodes seem absolutely ridiculous in hindsight (Internet stocks 1999, subprime 2006), they do not appear as such in real time. Indeed, the perceived rationality of participating in the boom is integral to Bubble Dynamics. By 1999, it had become obvious that technological innovation was changing the world - and that tech stocks only went up. By 2006, who could argue against the view that home prices only rose and loan losses were a non-issue? Was borrowing at historically low rates to buy a home irrational? How about speculating in higher-yielding MBS? After all, and as was clearly understood throughout the economy and markets (thanks to various bailouts and market interventions), Washington and the Fed would never allow a housing bust. These days, it's not irrational for "money" to flood into funds indexed to equities and corporate Credit. At this point, there is absolutely no doubt that Washington, the Fed and global central banks would never allow a securities market bust.

To better appreciate today's Bubble, it is first necessary to understand previous Bubbles and the evolution of policymaking and market perceptions. Frankly, I am astonished by the almost complete lack of understanding of key mortgage finance Bubble dynamics. And the more time that passes the greater historical revisionism's sway. The Fed insists that monetary policy and interest-rates were not responsible. It was instead a case of overzealous lending and regulatory failure - all correctable; won't happen again.

I would strongly argue that the so-called "worst financial crisis since the Great Depression" was at its root caused by momentous financial distortions that incentivized a historic expansion of mispriced mortgage Credit. The Fed's extremely low pegged interest rates incentivized aggressive lending and leveraged speculation. Importantly, the Fed and Washington validated the market's perception that Fannie and Freddie securities were free of default risk. The perception of unlimited cheap liquidity coupled with a Federal Reserve market liquidity backstop completely distorted the pricing of mortgage Credit throughout the system. The Fed-induced backdrop simply made it too easy to garner profits in lending, securities speculation and home buying. In terms of "reflexivity," the perception of unending mortgage Credit growth, housing price gains, economic growth and robust financial markets ensured a (fatefully) protracted boom.

The Fed, the GSE's and the government more generally made mortgage lending and housing appear virtually risk-free; mortgage securities became "money"-like. I have argued that during the ongoing global government finance Bubble this dynamic evolved to encompass virtually all asset markets. The fundamental issue of "Moneyness of Credit" distortions throughout mortgage finance evolved to "Moneyness of Risk Assets" virtually across all asset classes on a globalized basis. This is the essence of why I focus on the "Granddaddy of All Bubbles," while most see a healthy bull market.

Mounting systemic fragility went virtually unnoticed during the mortgage finance Bubble period. Late-stage financial and economic vulnerabilities were masked by what was perceived as extraordinary opportunities to profit from the boom. It went unrecognized that profits throughout both the real economy and financial system would transform into massive losses come the inevitable bursting of the Credit Bubble.

The conventional view holds that a market Bubble is defined by asset prices diverging from underlying fundamentals. To most, Bubbles are simply about overvaluation. My analytical framework holds that Bubbles are fueled by some underlying monetary disorder that actually works surreptitiously to inflate "fundamentals." The stock markets didn't appear significantly overvalued in 2007 - or 1929 for that matter. In 1929, 1999 and 2007 virtually everyone was extrapolating ongoing prosperity. These days, it is taken for granted that corporate profits will grow steadily for years to come. I believe strongly that inflating "profits" are the centerpiece of today's Bubble, similar to how inflating home prices were the cornerstone of the mortgage finance Bubble.

First of all, I always believed that Washington monkeyed with home prices at its own peril. As beguiling as rising home prices and affordable mortgages were for politician and voter alike, policies that stoked home price inflation and "affordable housing" were playing with (Bubble) fire. As history proved, housing market stability is integral to a sound financial system and economy. I believe stability in the backdrop for corporate profits is similarly essential for financial and economic stability. Should it be within the Fed's mandate to monkey with profits - hence securities prices and wealth distribution?

The Fed specifically targeted mortgage Credit for its post-"tech" Bubble reflationary policies. An even more incredible effort to inflate equities (and risk markets) has been the centerpiece of the Fed's post-mortgage finance Bubble efforts. While not generally appreciated, various Washington policy measures have worked in concert to inflate corporate earnings. Massive deficit spending was instrumental in funneling purchasing power throughout the real economy, in the process significantly boosting corporate cash-flows and profits. Meanwhile, Fed policies have inflated corporate profits in various ways, some more obvious than others. Clearly, the collapses in the Fed funds rate and market yields dramatically reduced debt service costs - hence boosted profits - throughout corporate America. For the household sector, the Fed-induced fall in mortgage borrowing costs reduced debt service for homeowners, in the process providing additional spending power (and corporate profits!).

There are myriad other facets of monetary policy that have had a major, if not appreciated, inflationary impact on profits. I believe QE has had a profound impact on corporate cash flows, earnings and balance sheets. Fed liquidity injections have created purchasing power throughout the economy, while also stocking asset prices and attendant "wealth effects." Moreover, by dramatically manipulating market yields lower while inflating market liquidity, the Fed has provided extraordinary incentives for financial engineering and M&A. Unprecedented stock buybacks, in particular, have been instrumental in boosting stock prices and earnings-per-share.

Perhaps most importantly for this cycle, the Fed's move to unlimited quantitative easing emboldened the market perception of infinite central bank liquidity support. This perception has manifested most directly into a powerful collapse in risk premiums, with profound self-reinforcing effects on Credit availability, debt service costs, profits and securities valuation for U.S. and global corporations.

Total Non-Financial Debt growth surpassed $1.0 TN for the first time during booming 1999 (nineties annual avg. $721bn). Non-Financial Debt growth surpassed $2.0 TN annually for the period 2004-2007. The doubling in mortgage Credit had a profound inflationary effect on home prices, along with spending and corporate profits. I have argued over recent years that the mal-adjusted U.S. Bubble economy requires about $2.0 TN of annual Credit growth for the appearance of a sustainable boom. Importantly, this amount of system Credit expansion is necessary to sustain inflated corporate profits.

The big issue I have - and why I am convinced in the Bubble thesis - is that I don't believe $2.0 TN of Credit growth is sustainable. Supposedly, the Fed will soon be concluding its historic balance sheet expansion (monetary inflation). To this point, the perception holds that the recovery is on track and global central banks will continue to backstop the markets and global economy. And as long as "money" continues to flow to risk markets and the speculators keep the faith, then booming markets (underpinned by massive buybacks and M&A) support spending, economic activity and corporate profits. I'm the first to admit that the now protracted global government finance Bubble has attained significant momentum.

There is ample support for my view that financial speculation and securities market leveraging are today unprecedented on a global basis. On the one hand, this financial Credit has been instrumental in both inflating securities prices and fueling the Bubble in profits. The inflation of the Fed's (and other central banks') liabilities ("money") has been fundamental in incentivizing securities speculation. Just as the Fed was never to tolerate a housing bust, it is now taken on faith that central banks would never allow a securities market liquidity crisis. The 2008/09 market dislocation and crisis were manifested by market recognition that the Fed could not sustain the mortgage finance boom.

I expect the next crisis to likely revolve around the harsh reality that central banks cannot guarantee robust and liquid markets. Actually, reflexivity ensures that perceptions of limitless cheap liquidity and market backstops ensure the type of excess that inevitably ends in liquidity crisis. When this historic Bubble bursts, corporate profits will be one of the more prominent casualties. And in the fascinating world of Bubble analysis, I can confidently posit that the Fed is oblivious to the unfolding financial stability problem. They clearly don't appreciate the Bubble they have induced in corporate profits and the ramifications for the true overvaluation of corporate securities generally - both equities and bonds.

Soros has taken a bearish position through the purchase of put options on the S&P 500. Surely he is not alone in looking at relatively inexpensive market insurance for downside protection (as myriad risks become increasingly apparent). These types of instruments tend to exacerbate market volatility. In market declines, those that have sold/written market insurance must dynamically hedge this exposure, which can lead to self-reinforcing selling. At the same time, these types of bearish bets also provide buying power when markets reverse course and rally. This helps to explain why markets (think 1999 or 2007) tend to go into speculative melt-up mode right into the face of deteriorating fundamentals.

It's also worth noting that the hedge fund industry is generally struggling with performance again this year. Ironically, all the "money" slushing into index products only makes the job of generating "alpha" from stock picking all the more challenging. There are many reasons I suspect the markets have entered a period of heightened volatility.

 


For the Week:

The S&P500 jumped 1.7% (up 7.6% y-t-d), and the Dow gained 2.0% (up 2.6%). The Utilities rose 1.3% (up 10.3%). The Banks surged 3.0% (up 2.6%), and the Broker/Dealers advanced 2.2% (up 3.8%). The Transports gained 2.0% (up 13.9%). The S&P 400 Midcaps jumped 2.2% (up 6.2%), and the small cap Russell 2000 gained 1.6% (down 0.3%). The Nasdaq100 rose 1.6% (up 12.8%), and the Morgan Stanley High Tech index jumped 2.3% (up 10.1%). The Semiconductors rose 2.4% (up 19.6%). The Biotechs gained 1.4% (up 26.7%). With bullion down $25, the HUI gold index was hit for 3.1% (up 20.4%).

One- and three month Treasury bill rates closed the week at two bps. Two-year government yields jumped nine bps to 0.49% (up 11bps y-t-d). Five-year T-note yields were 12 bps higher to 1.66% (down 8bps). Ten-year Treasury yields gained six bps to 2.40% (down 63bps). Long bond yields increased two bps to 3.24% (down 81bps). Benchmark Fannie MBS yields gained six bps to 3.15% (down 46bps). The spread between benchmark MBS and 10-year Treasury yields was little changed at 75 bps. The implied yield on December 2015 eurodollar futures jumped 10 bps to 1.01%. The two-year dollar swap spread was little changed at 22 bps, and the 10-year swap spread was about unchanged at 15 bps. Corporate bond spreads were mostly narrower. An index of investment grade bond risk declined two to 58 bps. An index of junk bond risk dropped eight to 314 bps. An index of emerging market (EM) debt risk fell seven to 282 bps.

Ten-year Portuguese yields sank 27 bps to 3.24% (down 289bps y-t-d). Italian 10-yr yields dipped a basis point to 2.58% (down 155bps). Spain's 10-year yields slipped two bps to 2.38% (down 177bps). German bund yields gained three bps to 0.98% (down 95bps). French yields gained three bps to 1.37% (down 119bps). The French to German 10-year bond spread was little changed at 39 bps. Greek 10-year yields declined two bps to 5.85% (down 257bps). U.K. 10-year gilt yields were up eight bps to 2.41% (down 61bps).

Japan's Nikkei equities index gained 1.4% (down 4.6% y-t-d). Japanese 10-year "JGB" yields were unchanged at 0.50% (down 24bps). The German DAX equities index jumped 2.7% (down 2.2%). Spain's IBEX 35 equities index rose 2.7% (up 5.9%). Italy's FTSE MIB index gained 2.2% (up 5.0%). Emerging equities were mostly higher. Brazil's Bovespa index jumped 2.5% (up 13.4%). Mexico's Bolsa gained 1.7% (up 6.2%). South Korea's Kospi index slipped 0.3% (up 2.3%). India's bubbly Sensex equities index gained 1.2% to another all-time high (up 24.8%). China's Shanghai Exchange rose 0.6% (up 5.9%). Turkey's Borsa Istanbul National 100 index jumped 2.9% (up 16.4%). Russia's MICEX equities index gained 1.5% (down 3.8%).

Freddie Mac 30-year fixed mortgage rates declined two bps to 4.10% (down 41bps y-o-y). Fifteen-year rates slipped a basis point to 3.23% (down 31bps). One-year ARM rates increased two bps to 2.38% (down 26bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down three bps to 4.55% (down 16bps).

Federal Reserve Credit last week declined $3.7bn to $4.373 TN. During the past year, Fed Credit inflated $784bn, or 21.8%. Fed Credit inflated $1.562 TN, or 56%, over the past 93 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt fell $3.1bn last week to $3.322 TN. "Custody holdings" were down $31.7bn year-to-date, while posting a one-year increase of $38.7bn.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $843bn y-o-y, or 7.5%, to $12.028 TN. Over two years, reserves were $1.495 TN higher for 14% growth.

M2 (narrow) "money" supply declined $8.7bn to $11.426 TN. "Narrow money" expanded $667bn, or 6.2%, over the past year. For the week, Currency increased $1.2bn. Total Checkable Deposits sank $62.8bn, while Savings Deposits jumped $46.8bn. Small Time Deposits slipped $1.6bn. Retail Money Funds rose $7.5bn.

Money market fund assets gained $6.7bn to $2.584 TN. Money Fund assets were down $134bn y-t-d and dropped $53bn from a year ago, or 2.0%.

Total Commercial Paper fell $14.0bn to $1.023 TN. CP was down $23bn year-to-date, while being little changed from a year ago.

Currency Watch:

The U.S. dollar index jumped 1.1% to 82.34 (up 2.9% y-t-d). For the week on the downside, the Japanese yen declined 1.5%, the Swiss franc 1.2%, the euro 1.2%, the Danish krone 1.2%, the Swedish krona 1.1%, the South African rand 0.9%, the New Zealand dollar 0.9%, the Brazilian real 0.8%, the British pound 0.7%, the Norwegian krone 0.5%, the Mexican peso 0.5%, the Canadian dollar 0.4%, the Singapore dollar 0.3%, the South Korean won 0.1% and the Australian dollar 0.1%.

Commodities Watch:

The CRB index slipped 0.4% this week (up 3.0% y-t-d). The Goldman Sachs Commodities Index declined 0.7% (down 4.6%). Spot Gold dropped 1.9% to $1,280 (up 6.2%). September Silver slipped 0.3% to $19.46 (up 0.5%). October Crude dropped $1.67 to $93.65 (down 4.8%). September Gasoline gained 1.5% (down 2%), and September Natural Gas rallied 1.7% (down 9%). September Copper jumped 3.2% (down 5%). September Wheat was little changed (down 9%). September Corn was about unchanged (down 13%).

U.S. Fixed Income Bubble Watch:

August 22 - Wall Street Journal (Mike Cherney): "U.S. corporate-bond issuance is hurtling toward a record for the third consecutive year, as companies take advantage of a surprising interest-rate decline to stock up on cash. Companies around the globe have sold about $994.9 billion of bonds in the U.S. this year as of Thursday morning, according to... Dealogic... That is up more than 4% from a year ago, with sales on pace to cross the $1 trillion mark at the fastest clip on record... Acquisitions have about doubled in the U.S. from last year to a recent $1.1 trillion, and U.S. bond sales earmarked for capital spending -- purchases or upgrades of long-lived assets such as plant and equipment -- have risen 90% from a year earlier to $40 billion, Dealogic said."

August 22 - Bloomberg (Sridhar Natarajan and Christine Idzelis): "U.S. high-yield bond funds recorded the biggest weekly inflow of 2014 as investors returned to the riskiest corporate debt following an unprecedented withdrawal at the start of August. Mutual funds and exchange-traded funds that buy junk bonds attracted $2.2 billion in the week ended Aug. 20, according to data provider Lipper. That's the second straight week of inflows after investors pulled $7.1 billion in the five days ended Aug. 6, extending redemptions to as much as $12.6 billion over a four-week period."

August 18 - Bloomberg (Lisa Abramowicz): "Hedge funds dislike junk bonds so much that they're willing to pay 48 times more to short the debt using exchange-traded funds than at the end of last year. A prime example is BlackRock Inc.'s $12.4 billion fund that trades under the ticker HYG, which allows traders to borrow a certain proportion of shares to wager that prices will decline. The daily cost for financing such activity was $342,000 a day in the week ended Aug. 5, up from $7,000 at the end of December... This shows a couple of things. First, that traders have really hated high-yield debt ETFs in recent weeks. And second, that ETFs, often thought of as tools for individual investors, are increasingly dominated by a hedge-fund type crowd, particularly in less-traded asset classes like junk bonds. 'It seems like maybe these ETFs are acting as canaries in a coal mine for possibly a broader selloff,' said Chris Benedict, director and lead analyst of DataLend."

U.S. Bubble Watch:

August 16 - New York Times (James Stewart): "After a nearly uninterrupted five-year rally in stocks and bonds, some investors seem to be getting nervous. On July 31, the Dow Jones industrial average dropped 317 points, wiping out the year's gains. Last week, junk bond funds experienced record withdrawals and junk bond interest rates spiked. Such gyrations may be healthy, a reminder that there are risks and that markets go down as well as up. But they could also be the harbinger of something more worrisome, which would be renewed financial instability as the Federal Reserve brings to an end its extraordinary easy money policy. The Federal Reserve has said it expects to raise interest rates in 2015 for the first time since the financial crisis."

Federal Reserve Watch:

August 22 - Bloomberg (Jeff Kearns and Craig Torres): "Federal Reserve Chair Janet Yellen said she still isn't satisfied with the U.S. labor market. Deciding when she is won't be easy. 'The labor market has yet to fully recover,' Yellen said today... at the Kansas City Fed's annual conference in Jackson Hole, Wyoming. While the five-year expansion has put more Americans back to work, 'a key challenge is to assess just how far the economy now stands from attainment of its maximum employment goal.' ...She said policy makers will have to look at a 'wide range' of indicators to make that assessment, adding that there's 'no simple recipe' for deciding when to raise interest rates for the first time since 2006."

Europe Watch:

August 21 - Bloomberg (Alessandro Speciale): "Euro-area manufacturing and services activity slowed in August, signaling that the economy of the 18-nation region remains vulnerable to weak inflation and rising tensions with Russia... While the gauge has signaled growth for more than a year, economic expansion in the euro area unexpectedly halted in the second quarter amid weakness in the region's three largest economies. With inflation below 1% since October, unemployment near record highs and rising political tensions, the European Central Bank unveiled a stimulus package in June that policy makers say will take months to show results."

August 21 - Reuters (Gavin Jones): "Italian Prime Minister Matteo Renzi denied on Thursday that his government planned to raise taxes, cut pensions or adopt corrective measures to rein in the budget deficit this year. There have been repeated media reports this summer that the government will need to pass a mini-budget to hold the deficit inside European Union limits after the economy unexpectedly slipped back into recession. 'Anyone talking about pension cuts or mini-budgets is talking about things that are not on the agenda,' Renzi said..."

Global Bubble Watch:

August 20 - Financial Times (Tracy Alloway and Michael Mackenzie): "In March of last year, Kyle Bass, founder of the hedge fund Hayman Capital Management, made a startling proclamation: aggressive young bankers in Japan were pushing complex over-the-counter derivatives similar to those that rapidly soured during the financial crisis of 2008... That warning appears sagacious, with investors once more chasing levered returns via certain types of US credit derivatives that Wall Street is willingly providing in the current climate of low interest rates and moribund volatility. Some market participants say the rise of these derivatives raises questions about the effectiveness of financial reform undertaken since 2008. While standardised derivatives such as interest rate swaps are now transacted in exchange-type venues and centrally cleared, the flourishing area of opaque products are not, and moreover there are few records of activity that regulators can monitor. 'We've reformed nothing,' says Janet Tavakoli, president of Tavakoli Structured Finance. 'We have more leverage and more derivatives risk than we've ever had."

August 22 - Wall Street Journal (Laurence Fletcher): "Some hedge funds are cutting back on their riskier positions because of fears that certain assets may have become overpriced and concerns about the conflicts in Ukraine and Iraq. Nervous funds have reduced their bets that equities will keep rising, have increased wagers on falling bond prices and have bought protection for their portfolios in case the crises escalate further... Favored recent trades include buying 10-year U.S. Treasurys, seen as a haven, and buying 'put' options that rise in value when stock markets fall. Hedge funds have also been buying credit-default protection on Italy, Spain and Portugal or on banks in those countries to protect themselves from more upheaval there. 'You definitely are seeing managers reduce risk levels,' said Robert Duggan, managing director at fund-of-hedge-funds investor Skybridge Capital... 'It has been in the last four to six weeks that you've seen a bit of a sentiment shift. 'Cautious' or 'more defensive' are clearly things you hear when you speak with managers."

August 19 - Bloomberg (Abigail Moses): "The biggest overhaul to the $19 trillion credit derivatives market in more than a decade will seek to solve flaws that have stopped some contracts paying out as buyers anticipated. The changes come too late for investors in the junior debt of Banco Espirito Santo SA, whose credit-default swaps were devalued this month when the Portuguese lender was rescued and restructured by the government. Since the contracts are tied to the majority of a company's debt, if the borrower is reorganized the swaps don't necessarily stay tied to the securities they're meant to protect. Investors will start signing up to convert outstanding trades into new contracts as early as this week after the International Swaps & Derivatives Association rewrote the documentation to address the weaknesses."

August 18 - Bloomberg (Michael Heath): "A deepening gloom across the largest developed economy to escape recession during the global financial crisis is shaping up as one of the toughest challenges yet for Reserve Bank of Australia chief Glenn Stevens. Australia's misery index -- the sum of unemployment and inflation rates -- is at 9.0, the highest since 2008, when the collapse of Lehman Brothers Holdings Inc. froze credit markets around the world and triggered the deepest recession in the U.S. since the Great Depression."

August 18 - Bloomberg (Jillian Ward): "London home sellers cut asking prices by the most in more than six years this month, adding to signs that the property market in the U.K. capital is coming off the boil. London values fell 5.9% from the previous month to an average 552,783 pounds ($922,300), the biggest drop since December 2007, property website Rightmove Plc said... Nationally, prices declined 2.9%, a record for an August... Tougher new mortgage rules introduced by Bank of England Governor Mark Carney, as well as anticipation of higher interest rates, are putting pressure on the market after a surge in values raised concerns that a bubble may develop."

August 19 - Bloomberg (Neil Callanan): "Monaco, the tax haven on the French Riviera, is experiencing a luxury-housing boom that includes the world's most expensive penthouse as developers prepare for an influx of millionaires and billionaires escaping higher taxes or a loss of banking privacy. A 'flow' of new residents is emigrating from Switzerland, where financial-secrecy laws are crumbling, said Jean Claude Caputo, managing director of broker Savills Plc's French Riviera unit. They're drawn by the principality's 'security, sophistication and climate,' he said -- as well as for financial reasons... The Tour Odeon, a double-skyscraper being built by Groupe Marzocco SAM near Monaco's Mediterranean seafront, will contain a 3,300 square-meter (35,500 square-foot) penthouse with a water slide connecting a dance floor to a circular open-air swimming pool. The apartment may sell for more than 300 million euros ($400 million) when it goes on the market next year..."

EM Bubble Watch:

August 22 - Bloomberg (Camila Russo and Charlie Devereux): "First came the default, then a proposed debt swap aimed at circumventing a U.S. court ruling that could normalize Argentina's relations with foreign investors. Now traders foresee a devaluation for the second time this year. Argentina's peso sank 1.3% this week to 8.3932 per dollar, the biggest drop since the government devalued the currency 15% in the week ended Jan. 24. In the black market, where Argentines go to avoid government limits on purchases of U.S. currency, the peso weakened to a record 13.95 per dollar... The plan means it's less likely President Cristina Fernandez de Kirchner will negotiate a deal with holdout creditors that would lift the court order that has prevented the country from servicing its obligations, according to Bank of America Corp. Prolonging the default would then restrict Argentine borrowers' access to international markets, putting pressure on policy makers to allow the peso to weaken as dollars become scarce."

August 21 - Bloomberg (Charlie Devereux and Camila Russo): "Argentina's attempt to circumvent a U.S. court order to pay its overseas bondholders is threatening to prolong the nation's isolation from international markets and sink its economy deeper into recession. President Cristina Fernandez de Kirchner said on Aug. 19 that Argentina will let holders of foreign-currency bonds swap into new securities governed under local law after a U.S. ruling blocked payments and triggered its second default in 13 years. The plan comes in direct conflict with orders from U.S. District Court Judge Thomas Griesa, who ruled that Argentina must first resolve unpaid debts from its 2001 default before it can make any other payments and said such a swap would be illegal. The announcement is also the clearest sign yet Argentina would rather remain cut off from overseas debt markets than compromise with creditors led by billionaire Paul Singer's Elliott Management ... At a time when the country's reserves are tumbling, the debt dispute may shave as much as 5 percentage points from growth next year if left unsettled, Bank of America Corp. said."

August 18 - Bloomberg (Vladimir Kuznetsov and Olga Tanas): "Russia's central bank widened the ruble's trading band and reduced the amount of foreign exchange it will buy and sell as the world's largest energy exporter moves away from managing its currency. Policy makers increased the corridor within which the dollar-euro basket can trade to 9 rubles from 7 rubles and abandoned all interventions while the exchange rate moves within this band..."

Geopolitical Watch:

August 22 - Bloomberg (Jake Rudnitsky): "Trucks carrying what Russia says is humanitarian aid reached the embattled eastern Ukrainian city of Luhansk, after crossing the border in what the government in Kiev denounced as an 'invasion.' Tension escalated as Oana Lungescu, a spokeswoman for NATO, said by e-mail that since the middle of this month the alliance had received 'multiple reports' of direct involvement of Russian airborne, air defense and special operations forces in eastern Ukraine... The U.S., European Union and the North Atlantic Treaty Organization denounced the convoy's entrance into Ukraine, with a Pentagon spokesman saying Russia continues to add troops near the border with Ukraine. The convoy is a 'flagrant violation of Ukraine's sovereignty,' White House Deputy National Security Adviser Ben Rhodes told reporters..."

August 22 - Associated Press (Robert Burns): "The Pentagon says a Chinese fighter jet conducted a 'dangerous intercept' of a U.S. Navy aircraft three days ago off the coast of China in international airspace. The Pentagon press secretary, Rear Adm. John Kirby, said Friday that Washington has lodged a protest to China through diplomatic channels. Kirby said the Chinese jet made several close passes by the Navy P-8 Poseidon plane, coming within 30 feet of it. He said the Chinese jet did a roll maneuver over the top of the Poseidon and also passed across the nose of the Navy plane, exposing the belly of the fighter in a way apparently designed to show that it was armed."

August 22 - Financial Times (Emily Cadman): "Geopolitical threats are starting to weigh on executives' confidence in the global economic recovery, according to the latest FT/Economist Global Business Barometer survey. The proportion of executives who believed the global economic environment would worsen over the next six months has nearly doubled to 18%, nearly one in five respondents, from just 9% at the end of last year. There was another rise in the number of executives citing political risk as one of the biggest threats to their business to 43%, the highest level since the survey began in 2011."

August 19 - Bloomberg (Cynthia Koons and Michael Riley): "Chinese hackers stole social security numbers, names and addresses from 4.5 million patients of Community Health Systems Inc., the second-biggest for-profit U.S. hospital chain... The attacks occurred in April and June, the... company said... The hacker group originated from China and bypassed the company's security system, making off with non-medical information from people who visited doctors' offices associated with the company. 'Unfortunately, we have joined numerous American companies and institutions who have been victimized by highly sophisticated, criminal cyber-attacks originating out of China,' Tomi Galin, a spokeswoman for Community Health, said..."

August 20 - Bloomberg: "China found a dozen Japanese auto-parts makers guilty of price fixing and doled out the biggest antitrust fines in the country since relevant rules came into effect six years ago. Total fines amounted to 1.24 billion yuan ($200 million)... While China follows the U.S., Europe and Japan in punishing parts makers, the fines come as foreign businesses increasingly voice concerns that an era of heightened regulatory scrutiny is dawning on the world's second-largest economy. Global Car manufacturers, technology companies and food companies have faced antitrust probes in the country since last year."

China Bubble Watch:

August 13 - Bloomberg (Clement Tan): "China's broadest measure of new credit plunged to the lowest since the global financial crisis and industrial output unexpectedly slowed, adding risks to growth as the government grapples with a property slump. Aggregate financing was 273.1 billion yuan ($44.3bn) in July, the central bank said... 'The July data is certainly a warning sign,' said Chen Xingdong, chief China economist at BNP Paribas SA in Beijing. While it may be too soon to turn pessimistic on growth, 'if the situation continues for another two or three months, there will be serious liquidity problems,' Chen said... The People's Bank of China said the drop in financing resulted from recent regulation and financial institutions' enhanced control of risks. Aggregate financing compared with the 1.5 trillion yuan median estimate of economists, while new local-currency loans of 385.2 billion yuan were half of projections... The decline in property sales accelerated in July, with data for the first seven months showing an 8.2% drop from a year earlier, after a 6.7% fall in the first half. Floor space of newly started property construction declined 12.8% in the January-July period from a year earlier, easing from the 16.4% drop in the first half."

August 18 - Bloomberg: "China's new-home prices fell in July in almost all cities that the government tracks as tight mortgage lending deterred buyers even as local governments eased property curbs. Prices fell in 64 of the 70 cities last month from June..., the most since January 2011 when the government changed the way it compiles the data. Beijing prices fell 1% from June, posting the first monthly decline since April 2012. 'The falling trend of China's property market has no sign of improving,' Shen Jian-guang, Hong Kong-based chief Asia economist at Mizuho Securities Asia Ltd., said... 'The key issue is the mortgages, despite all types of local government easings. The high rate is damping sentiment of owner occupiers.' China's property market has become a drag on the world's second-biggest economy, prompting cities to start easing local curbs in June... The International Monetary Fund has urged China to target slower expansion in 2015, saying the economy faces a 'web of vulnerabilities' from rising debt and financial institutions' exposure to real estate."

August 21 - Bloomberg (Christopher Langner): "A Chinese manufacturing gauge fell more than analysts estimated in August as a credit slowdown and property slump add to risks the world's second-largest economy will miss its growth target this year. The preliminary Purchasing Managers' Index from HSBC Holdings Plc and Markit Economics was at 50.3, trailing all 22 estimates in a Bloomberg News survey... The measure dropped from July's final reading of 51.7..."

August 19 - Financial Times (Gabriel Wildau): "Chinese banks have been ramping up lending to developers in recent months, even as falling sales and weaker prices ratchet up the risk of these loans souring. New home prices in China fell 0.9% in July from June..., the third straight monthly drop. Sales volume and construction activity have also slowed as potential buyers adopt a cautious approach ahead of expected further price declines. Despite this weakness banks, under pressure from the government to prop up the property market, lifted lending to residential real estate developers by 26.9% year on year in the first six months of 2014 to Rmb3.1tn ($504bn). That is a marked increase over the 19.3% year-on-year pace of growth in the first quarter... Nearly half of the increase went to affordable housing. That leaves banks exposed to highly indebted local governments, which finance such projects largely through off-budget financing vehicles."

August 21 - Bloomberg (Christopher Langner): "After three years of experimenting with municipal bonds, China's debt market is still failing to price in any additional risk over central government notes. Zhejiang province sold five-, seven- and 10-year securities yesterday at yields one basis point higher than those on similar Ministry of Finance paper, while Qingdao city a day earlier paid a maximum five-basis-point premium... Premier Li Keqiang is allowing regional authorities to raise money directly, after they accumulated 17.9 trillion yuan ($2.9 trillion) in debt in an effort to avert a slowdown in the world's second-largest economy. He has called for markets to play a greater role in pricing risk and allowed the nation's first onshore bond default in March amid the slowest economic growth in 24 years."

August 22 - Bloomberg (Christopher Langner): "Chinese companies renting debt ratings from state-owned banks when raising funds in U.S. money markets are fueling credit concerns as bad loans mount. Including the first program guaranteed by Bank of China Ltd. in New York in 2012, eight firms have set up $2.6 billion in short-term fundraising backed by standby letters of credit, giving them the same ratings as the lender for a fee... Unrated China International Marine Containers Group Co. has a $600 million program. China Power International Development Ltd., which had a junk score until Fitch Ratings withdrew it in 2012, has a $300 million plan... The use of credit sweeteners for shorter-dated commercial paper is now bringing unrated Chinese borrowers to the low-risk U.S. money market. 'The only reason why a company needs a standby letter of credit is because in many situations, the underlying credit is a challenging one,' said Raymond Chia, the... head of credit research at Schroder Investment Management Ltd., which oversaw $464 billion in assets as of June 30. 'Over a longer term, such risky companies and sectors could still pose fundamental issues for the guarantee bank.'"

August 18 - Bloomberg: "China's biggest banks, already poised for the weakest profit growth in more than a decade, risk a further erosion in earnings from record share sales intended to boost their capital after a credit binge. Industrial & Commercial Bank of China... and its listed peers this year proposed selling $63 billion of preferred and common stock, exceeding U.S. and European banks' combined $56 billion... Selling preferred stock will saddle the banks with expensive dividend payments, an extra drag on retained profits. Shares of China's lenders, trading at the cheapest price-to- earnings valuations among global banks, are already constrained by rising bad loans, a faltering economy and prospects of more equity sales."

August 19 - Bloomberg (Clement Tan): "Falling property prices in China's eastern city of Wenzhou triggered 6.4 billion yuan ($1 billion) of bad loans as buyers abandoned homes and stopped making mortgage payments... Purchasers of 1,107 properties halted payments as prices dropped for 34 straight months, the Xinhua News Agency- affiliated magazine said... China's slumping property market is a drag on the world's second-biggest economy and banks' profits, with lenders' soured loans increasing for almost three years. New-home prices fell last month in 64 of 70 cities tracked by the government. In Wenzhou, about 56% of the homes were abandoned due to falling values and most were high-end apartments... Homes were also abandoned by borrowers left with liabilities after making guarantees for companies in financial trouble, the report said."

August 20 - Bloomberg (Clement Tan): "Aviation Industry Corp. of China, the state-owned fighter-jet maker, plans to spend as much as 120 billion yuan ($20bn) to build aerospace-themed amusement parks as it seeks to woo Chinese looking for leisure activities... China's leaders are seeking to spur a shift toward a consumption-driven economy in a country where the World Bank estimates household consumption expenditure accounted for 35% of the gross domestic product in 2012, compared with 69% in the U.S... 'There will be a big market for leisure activities and AVIC can't be left out as new leisure products emerge and aviation becomes a way of life for many,' Lin Zuoming, who heads AVIC, said..."

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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