WorldoutofWhack

Summary

In the next downturn, default rates will increase to very high levels and defaults to very high dollar amounts.

There is also now clearly high correlation between high-yield bond returns and the stock market, with the correlation rising well above 70% since 2008-2009.

All indications are that the benign credit cycle will continue through 2019 and possibly beyond.

Read full article below

https://seekingalpha.com/article/4284691-edward-altman-credit-cycle

Martin Armstrong writes in his blog….

The IMF has continued to assume that the zero-bound on interest rates can be a serious obstacle for fighting recessions on the part of the central banks. The IMF maintains that the zero-bound is not a law of nature; it is a policy choice. The latest in the IMF papers argue that tools are available to allow central banks to create deep negative rates whenever needed to reverse recessions. They claim that maintaining the power of monetary policy in the future to end recessions within a short time will require deep negative interest rates.

IMF Recommends “DEEP” Negative Interest Rates as the Next Tool

KKR writes in their Global perspectives https://www.kkr.com/global-perspectives/publications/hot-spots

So, what should investors know about what we learned during our journey to key “hot spots” around the globe in 2019, and what does it mean for our asset allocation framework?

1. As one might expect, trade was the topic du jour across both continents. Our key takeaway was that there may or may not be a headline win around trade eventually, but the global competitive landscape has shifted permanently, in our view. From what we can tell, there is a growing nationalist movement amongst politicians to usher in a collective disarmament of the World Trade Organization. In many instances supporting national champions is now more important than sourcing the lowest cost supply chains. It is one of the reasons that we have always believed that President Trump would threaten to implement Round IV of tariffs (see mid-year outlook Stay the Course for full details). Consistent with this view, we see a Berlin Wall-type scenario now unfolding across global technology standards – one that flies in the face of what the WTO and other organizations that promote open standards have attempted to achieve for nearly three decades. Already, Western players such as Google, Facebook, Twitter, and WhatsApp have had difficulty in China, and in their places, Baidu, Ren Ren, Weibo, and WeChat are now thriving. Not surprisingly, we see 5G as the next chapter in this global bifurcation of technology standards/providers. Meanwhile, several foreign firms with whom we spoke during our time in Beijing indicated some sort of an acceleration in supply chain diversification away from China in order to reduce operating risks. Thailand, Vietnam, Mexico, and even the United States and Europe, were all mentioned during our visits as key beneficiaries of this rerouting, a migration pattern my colleague Frances Lim has been arguing for some time. At the same time, the trend towards insourcing within China is now a very viable one for investors to consider backing with their capital. The decision-makers with whom we spoke in Beijing confirmed that the trend towards insourcing is broad-based, spanning the industrial, technology, and healthcare sectors. So, our bottom line is that, even if there is positive headline news around trade negotiations (e.g., China buying more oil or soybeans) in the coming months, rule of law and national security concerns represent longer-term issues that are not easily fixable, particularly as the geopolitical and strategic importance of technological prowess across industries increases. If we are right, then a different investment playbook than what worked for the last 25 years is now required.
2. In terms of the global inflation outlook, our travels lead us to believe that we are stuck somewhere between disinflation and deflation. As a team at KKR, we are firmly in the camp that demographics, technological change, and excess capacity are likely to keep a lid on inflationary trends for the near future. Consistent with this view, we now estimate that the Federal Reserve needs to engineer 40-50 basis points of inflation annually just to keep inflation stable, given that deflation is actually playing out in many key sectors such as Autos, Technology, and Consumer Goods. Hence, as we describe below in more detail, we remain of the view that rates are likely to stay lower for longer, which has huge investment implications for both individual and institutional savers. In the world we envision, upfront yield becomes more important to credit allocators, while pricing power becomes more important to investors in equity securities. Importantly, China’s recent decision to let its currency weaken only strengthens our conviction in our thesis.
3. China continues to be the most innovative technology market that we visit each year, while Europe is trying to close the gap. Driven by 330 million millennials that are coming of age, the opportunity around Big Data, Artificial Intelligence, and 5G remains outsized within both the consumer and corporate segments of China. From our vantage point, it is hard to overstate how important getting up to speed on Chinese technological innovation is to any global investor who allocates capital to the Technology and/or Consumer sectors. This knowledge base is also critical to a better understanding of the current U.S.-China trade debate, and why we believe this debate is much more significant than just the world’s two largest economies arguing about terms of trade. Meanwhile, in Europe we think that Berlin has clearly emerged as the Continent’s Silicon Valley, and the significant opportunity set that we see across private Technology investments in the region make us even more bullish that European Private Equity can handily outperform European Public Markets. Further details below.
4. We expect more geopolitical volatility ahead, and we now assign a 50% probability to a Hard Brexit. The potential temporary dysfunction from a disorderly departure, particularly as it relates to business uncertainty in the private sector, likely deserves more attention than it is getting from investors. Therefore, we are of the mindset that U.K. investments should demand one of the highest risk premium of any developed economy today, and as such, we are encouraging hedging the majority of one’s positions in the currency market.
5. Given the uncertainty, we think that the opportunity to buy complexity at a discount remains outsized. Interestingly, though, Asia seems to be gaining on Europe in terms of the ability to transact. Beyond just acquiring positions through the public markets (which is becoming a more relevant opportunity set for PE firms), our conversations in Beijing with senior executives now lead us to believe that there is a forthcoming wave of deconglomeratization in China that could soon rival what we are seeing in Europe these days. Simply stated, multinationals are increasingly of the mindset that doing business in China as a foreigner is getting tougher, not easier. If we are even partially right, this opportunity could be quite meaningful to Private Equity, Real Estate, Credit, and Infrastructure over the next five to seven years, we believe Looking at the bigger picture, our asset allocation tilts towards investments that are linked to nominal GDP, have collateral against them, and generate upfront cash flow. As a result, we remain overweight Real Assets, Global Infrastructure in particular. We also remain constructive on more flexible mandates across both liquid and illiquid investments, and as such, maintain our increased allocations to both Actively Managed Opportunistic Credit and Special Situations. Finally, we continue to overweight Private Equity in size (300 basis points), as our work shows that the value of private investments grows more important later in the cycle.

Summary…..

There is a reason why experience is so important in investing. You don’t want to make all the possible mistakes yourself in order to learn, which is why I am sharing mine with you. Keep the following in mind to help steer you away from trouble in investing:

·        Be highly suspicious of companies that have free cash flow that is significantly below earnings for a long period of time. Unless the company is making verifiable investments likely to produce attractive returns, you are better off passing.

·        Don’t believe what managements tell you they will do. Instead, rely on what they have done.

·        Be wary of companies that are all story and no numbers. If the story is so great, shouldn’t there be plenty of numbers to back it up?

·        Read financial statements carefully. No, it’s not always fun. But if you are going to be a serious investor and think that you are too busy to carefully read the footnotes, watch out. You might be setting yourself up for a big loss. If it turns out that you could have caught it by studying the financials carefully, you will have nobody but yourself to blame.

·        The price of the investment always matters. I was so busy celebrating my good call to exit shares of OM Group at $70 before the collapse that I never seriously re-assessed the investment at the new price of $4. That was a mistake – the stock eventually went up 10x from those levels. Keep your mind flexible and keep re-evaluating investments as the circumstances and the prices change.

https://www.forbes.com/sites/garymishuris/2019/07/17/how-i-spotted-a-fraud-before-it-was-too-late/amp/?__twitter_impression=true

Doug Noland writes…..

In the People’s Bank of China’s (PBOC) Monday daily currency value “fixing,” the yuan/renminbi was set 0.33% weaker (vs. dollar) at 6.9225. Market reaction was immediate and intense. The Chinese currency quickly traded to 7.03 and then ended Monday’s disorderly session at an 11-year low 7.0602 (largest daily decline since August ’15). While still within the PBOC’s 2% trading band, it was a 1.56% decline for the day (offshore renminbi down 1.73%). A weaker-than-expected fix coupled with the lack of PBOC intervention (as the renminbi blew through the key 7.0 level) rattled already skittish global markets.

Safe haven assets were bought aggressively. Gold surged $23, or 1.6%, Monday to $1,441, the high going back to 2013 (trading to all-time highs in Indian rupees, British pounds, Australian dollars and Canadian dollar). The Swiss franc gained 0.9%, and the Japanese yen increased 0.6%. Treasury yields sank a notable 14 bps to 1.71%, the low going back to October 2016. Intraday Monday, 10-year yields traded as much as 32 bps below three-month T-bills, “the most extreme yield-curve inversion” since 2007 (from Bloomberg). German bund yields declined another two bps to a then record low negative 0.52% (ending the week at negative 0.58%). Swiss 10-year yields fell two bps to negative 0.88% (ending the week at negative 0.98%). Australian yields dropped below 1.0% for the first time.

It’s worth noting the Japanese yen traded Monday at the strongest level versus the dollar since the January 3rd market dislocation (that set the stage for the Powell’s January 4th “U-turn). “Risk off” saw EM currencies under liquidation – with the more vulnerable under notable selling pressure. The Brazilian real dropped 2.2%, the Colombian peso 2.1%, the Argentine peso 1.8%, the Indian rupee 1.6% and the South Korean won 1.4%. Crude fell 1.7% in Monday trading. Hong Kong’s China Financials Index dropped 2.5%, with the index down 4.4% for the week to the lowest level since January. European bank stocks dropped 4.1%, trading to the low since July 2016.

A Monday Bloomberg headline: “China Retaliation ‘11’ on Scale of 1-10, Wall Street Warns.” Global markets were shocked Beijing would interject the renminbi into tit-for-tat trade retaliation. Trade war morphing into currency war? The White House was not impressed.

August 5 – Reuters (Susan Heavey and Dan Burns): “U.S. President Donald Trump slammed China’s decision to let its yuan currency breach the key seven-per-dollar level for the first time in more than a decade, calling it ‘a major violation’ and jabbing the U.S. central bank. ‘China dropped the price of their currency to an almost a historic low. It’s called ‘currency manipulation.’ Are you listening Federal Reserve? This is a major violation which will greatly weaken China over time!’ Trump tweeted.

The U.S. market selloff intensified after President Trump’s tweet, with the S&P500 ending the session down 3.0% – 2019’s biggest one-day decline. The Nasdaq100 dropped 3.6%, with the Semiconductors slammed 4.4%. The Bank index was hit 3.6%. Junk bond spreads widened 40 bps in Monday trading to 437 bps, trading near the highest level since January – weighed down by the energy sector. Investment-grade corporate and bank CDS rose, though not the dramatic moves suffered in high-yield.

Tuesday morning from PBOC Governor Yi Gang: “As a responsible big country, China will abide by the spirit of the G20 leaders’ summit on the exchange rate issue, adhere to the market-determined exchange rate system, not engage in competitive devaluation, and not use the exchange rate for competitive purposes and not use the exchange rate as a tool to deal with external disturbances such as trade disputes.” Yi’s statement along with the PBOC’s Tuesday “fix” at 6.9683 – a smaller decline versus the dollar than markets had expected – helped calm fears of a destabilizing devaluation.

By Thursday, fear of renminbi dislocation becoming a catalyst for global “risk off” had subsided. The renminbi gained 0.21% against the dollar in Thursday trading, as Asian and EM currencies posted modest gains. The Shanghai Composite recovered almost 1%. European stocks rallied sharply, with Germany’s DAX gaining 1.7% and France’s CAC40 jumping 2.3%. The S&P500 rallied 1.9%, with the Nasdaq100 up 2.3%.

Curiously, the safe havens were happy to disregard bouncing risk markets. Treasury yields declined two bps Thursday to 1.72%, while the yen and Swiss franc both posted small gains. Gold gave back hardly anything.

The VIX surged to 24.81 during Monday trading, the high since January 3rd. By Thursday’s close, the VIX was back down to 17. Option players were betting that the worst of the selling was likely over for the near-term – the critical time horizon for option traders. It has been a recurring pattern: a spell of “risk off” trading spurs hedging and put option buying. And after a flurry of put option purchases, the game then becomes getting to option expiration with as little value as possible left in these instruments.

Large quantities of outstanding put options (and other hedges) create the potential for a self-reinforcing self-off, where the writers of hedges are forced into the marketplace to aggressively sell futures and ETFs to offset mounting losses on the options they had previously sold. Yet market players have been conditioned to believe policymakers are keenly attuned to derivatives meltdown risk. After Monday’s scare, the bet is both President Trump and Beijing will avoid rocking the markets next week (U.S. options expiration Friday).

And while the VIX closed the week below 18 (17.97), Friday’s session was not without its share of drama. The S&P500 traded down 1.3% in early-Friday trading. After stating “We’re not going to be doing business with Huawei,” the President’s comments were later clarified. The U.S. will be moving ahead with its special licensing process for Huawei’s U.S. suppliers. The S&P500 traded back to little changed on the day, before reversing lower into the close.

The collapse of Italian bond yields has been one of the more dramatic global market moves. After trading to almost 3.60% last October, Italian 10-year yields ended Wednesday trading at 1.42%. For a country so hopelessly over-indebted ($3 TN plus), Italian bond prices are arguably one of the more distorted assets in a world of distorted asset markets. Italian yields reversed sharply higher at the end of the week, rising 12 bps Thursday and a notable 27 bps on Friday – on political instability after Deputy Prime Minister Matteo Salvini called for early elections (breaking with its Five Star Movement coalition partner). Italian stocks were hit 2.5% in Friday trading, ending the week down 3.4%. Global “risk off” could prove an especially challenging backdrop for vulnerable Italian assets.

August 9 – Bloomberg (Sophie Caronello): “Britain’s pound ended the week at its lowest closing level versus the greenback since Margaret Thatcher was ensconced in No. 10 Downing Street. Sterling posted a fourth straight-weekly decline, sliding 1.1% to $1.2033 in a five-day period that witnessed mounting concern over the country’s exit from the European Union and a report indicating that the British economy shrank for the first time in six years.”

Italy, the U.K., China, India, Brazil and many others… Global central bank-induced liquidity excess has kept numerous remarkably leaky boats afloat in recent years. There will be systemic hell to pay when the dam finally breaks.

I’ll assume Monday’s global market convulsions will have the U.S. administration and Beijing treading cautiously next week. Yet I expect it will prove more difficult this time to squeeze the genie back into the bottle. To see such high cross asset correlations around the globe is disconcerting. And we saw Monday how critical a stable renminbi has become to global finance. It’s not a stretch to say this global party comes to rapid conclusion the moment markets fear a disorderly Chinese currency devaluation.

August 6 – Bloomberg (Michelle Jamrisko, Anirban Nag, and Karlis Salna): “It used to be that a buildup in foreign reserves was seen as a bulwark against currency shocks and swift turns in investor sentiment. Those days seem far away — and that defense less robust — as the trade conflict between the U.S. and China evolves into a full-blown currency war that’s threatening emerging markets globally. Reserves of central banks in developing Asian nations, which have risen to almost $5 trillion this year, will now be put to the test as currencies slide. ‘The key lesson from 2008 is that you can never have too much reserves,’ said Taimur Baig, chief economist at DBS Group… ‘But they were for fighting a fire in a conventional world,’ noting that today’s environment is quite unconventional.”

China’s $3.0 TN of reserves are less imposing than in the past. Indeed, reserves throughout EM will likely become a market focus. My sense is analysts have little grasp of potential capital flight risk, for China or EM more generally. How much “carry trade” leverage (borrow in low-yielding currencies to fund purchases in higher-yielding instruments) has accumulated during this most-protracted of speculative cycles? What other “hot money” vulnerability lurks (i.e. ETF outflows, derivatives…). Such issues garner little notice when “risk on” is bubbling and liquidity is flowing abundantly. But we were reminded Monday how abruptly “risk off” de-risking/deleveraging can erupt – and how quickly fears of illiquidity and dislocation can take hold.

I’ll stick with the analysis that global markets are moving toward a very problematic scenario. Having witnessed previous EM crises (i.e. Mexico in ‘94/’95, Southeast Asian ’97, Russia ’98 and Brazil ‘01/’02), it’s worth recalling how currency market dislocations become instrumental in systemic crises. Rapid drawdowns in international reserve holdings stoke fears of illiquidity, leading to a destabilizing “hot money” exodus. Rapidly shrinking reserve holdings then force central banks to raise interest rates to support domestic currencies, with the resulting rapidly tightened financial conditions bursting fragile financial and economic Bubbles.

EM central bankers learned from past predicaments. Over this cycle, it became increasingly common for central bankers to support their currencies in the derivatives marketplace, a mechanism whereby vulnerable currencies could be bolstered without resorting to precious international reserve holdings. Central bank derivative operations successfully stabilized currencies during previous fleeting bouts of “risk off”. The repeated rapid recovery of global liquidity abundance reassured – policymakers along with the markets – that these derivative trades could be unwound with little notice. Recurrent EM resilience emboldened the view that large reserve stockpiles had fundamentally upgraded EM risk profiles.

Like so many aspects of this long boom, it works miraculously – until it doesn’t. At this point, the key analysis is that reserve holdings surely overstate resources available for countries to combat a more enduring period of “risk off” capital flight. Moreover, the perception of EM resilience has ensured unprecedented Credit and speculative excess throughout a systemic EM Bubble.

August 6 – Reuters (Winni Zhou and Andrew Galbraith): “China’s major state-owned banks have been active in the yuan forwards markets this week, sources said, using swaps to curb greenback supply as authorities sought to slow the currency’s decline after its break past the key 7 to the dollar threshold… Four sources with knowledge of the matter told Reuters that state banks were seen swapping yuan for dollars in onshore forwards market to support the Chinese unit. ‘Yesterday big banks were all selling one-year onshore forward swaps, then in the afternoon the spot dollar-yuan fell,’ said a trader… in Shanghai.”

China’s major state-owned backs can support the renminbi through clandestine derivatives trading, while supporting the faltering small bank sector with liquidity and capital injections along with bolstering the faltering Chinese Bubble with aggressive Credit growth. This, as well, is an ostensible miracle – until it all blows up. To repeat: How large is the “carry trade” in higher-yielding Chinese securities? Add to this: How large are the big Chinese banks’ derivatives positions in support of the renminbi?

I am clearly not alone in the view that Beijing took a huge gamble in moving to devalue the Chinese currency this week. They today have a large international reserve position. Over the coming weeks and months, I expect analysts to increasingly question the adequacy of these reserves in light of extraordinary financial and economic vulnerabilities.

The key take-away from another critical week: As the marginal provider of global liquidity and economic growth, Chinese finance has become the epicenter of crisis dynamics. Global markets are highly correlated; speculative dynamics remain extraordinarily synchronized. At this point, a bet on global risk markets is a bet on China – a bet on the ongoing inflation of China’s historic Bubble. Developments – market, policy, economic and geopolitical – are corroborating the analysis that it’s very late in the game. I’ll assume the flow of “Hot Money” away from global risk markets has commenced.

http://creditbubblebulletin.blogspot.com/2019/08/weekly-commentary-hot-money-watch.html