Market View – Risk is a four letter word – but then so is ruin!
Trading the financial markets has taught me that often what Dr. Kissinger (or Sun Tzu, Von Clausewitz and Lord Acton) says about geopolitics and Sigmund Freud says about death wishes matters more than what the Federal Reserve Chairman says about interest rates. Something dark and dangerous is out there even as we make money in tech/bank stocks on Wall Street. On January 1st, 2007, KT published my column “The coming global financial crash” (it is still on the Internet!). I thought the US housing mania and regional property bubbles would end in tears, as they did in 2008. I have the same gut feeling now. Why?
One, international relations is poisoned by the global wave of populism. The Arab Spring devastated entire societies and bequeathed a legacy of violence in Iraq, Syria, Yemen, Libya and Egypt. The new Italian government is a surreal coalition between the far left and the far right. Brexit has devalued sterling, the economic future of the UK and London’s role as an epicenter of global finance. Trump’s election has amplified the political polarization in Washington and the Mueller investigation could be a sword of Damocles for the most volatile, erratic White House since the Nixon era. The endgame of Mueller could have as lethal a political fallout as Watergate. Relations between Russian and the West are icier than even the geopolitical big freeze of the Cold War. In Georgia, eastern Ukraine, Crimea and Syria, Putin has not hesitated to project forces abroad, just as the USSR did not hesitate to crush revolts in Hungary, East Germany, Czechoslovakia and Afghanistan. Turkey and Iran are threatened by US sanctions. True, this is not Sarajevo 1914 or the Sudetenland 1939, yet the global zeitgeist is unsettled, xenophobic and irrational.
Two, if the last global recession emerged from Wall Street, the next one will emerge from emerging markets. Abraaj Capital, the biggest emerging market private equity firm, has just gone bust amid a multi-billion dollar daisy chain of debt, lawsuits and criminal charges. Emerging markets have to refinance more than $1 trillion, I repeat $1 trillion in US dollar debt in the next twelve months at a time when the Federal Reserve is aggressively raising interest rates to choke liquidity in an overheated economy. King Dollar has meant losses of 30 – 40% in even major emerging market currencies. My trader friends salivate that MSCI emerging markets trade at 11 times earnings but these earnings will collapse when the defaults, bank runs and sovereign debt crises begin. I will take the trauma of Russia, the Asian flu in 1998 or Turkey in 2000 to my grave. 2018-19 feels the same way.
Three, in August 2015, when the Chinese botched a mini yuan devaluation, the Shanghai Composite lost 25% in a week, Asia, Europe and US stock markets were slammed by contagion at the speed of light. Now Trump has attacked China and forced Beijing to retaliate in a trade war. The Chinese yuan has lost 7% against the US dollar since China exports $500 billion to the Land of the Brave (and promises to invests $60 billion in the Land of the Pure in CPEC – “Con Pakistan to Enrich China!)”.
China’s financial system is a credit Frankenstein, unlike anything the world has ever seen. China owns $1.2 trillion in US Treasury bonds when Trump’s tax cuts and Powell’s quantitative tightening means the US budget deficit could double to well above $1 trillion next year. The China’s debt to GDP ratio is now 300% and its growth rate has slowed to its lowest since 1990. If China has a hard landing, it will have the same impact on world finance as the simultaneous failure of two dozen Lehman Brothers. The Middle Kingdom’s financial Ponzi schemes (Bruce Lee did shadow boxing but shadow banking?) are scary. If China goes ballistic, all bets are off. Yes, this time the wolf is here and little Goldilocks must pay the price of her leveraged greed.
Four, the Volatility Index (VIX) is below 12 as I write. So Wall Street’s pendulum of risk and fear prices in none of the macro risks I track and trade in real time. This is insane. The HMS Titanic is about to hit the iceberg but nobody has even bothered to unfasten the lifeboats. I have a ghastly feeling that risk is mispriced once again in global finance. Risk is a four letter word – but then so is ruin!
Currencies – King Dollar surges amid the Turkish panic
Catastrophic events took place last week in the money souks of the Bosphorus. The Turkish lira plunged 14% against the US dollar on Friday alone. The shock waves of the Turkish lira’s free fall led to panic selling in emerging market currencies and the Euro. The financial markets have lost all confidence in President Erdogan and his son in law/Finance Minister. Erdogan has ruled out an IMF bailout and opposes central bank rate hikes even though the inflation rate is 16%. Even though the Turkish lira is has lost 40% in 2018, I am not tempted to bottom fish as tensions with Washington escalate and systemic risk in Turkish banking soars.
As a feared, US dollar short term rates have begun to rise, as the rise in LIBOR and even EIBOR in the past few months attests. There have been seven rate hikes by the FOMC since the US central bank began its tightening cycle in December 2015. In addition, the Federal Reserve has shrunk its balance sheet by $300 billion to $4.2 trillion. By year end, the Fed Funds rate target will be 2.25 – 2.50%. The Fed’s balance sheet will shrink by a cumulative $750 billion in 2018 and 2019. This will happen at the same times as Uncle Sam goes on a borrowing spree via US Treasury bill issuance. Three month LIBOR, the bellwether interest rate for global finance, is now 2.3%, the anchor behind King Dollar. I can easily envisage three month LIBOR at least a 150 basis points higher or almost 4% next summer. This will have a seismic, even traumatic impact on financial markets. For instance, a collapse of the US and UK commercial real estate market is now possible and I expect a wave of corporate defaults/bank failures in leveraged emerging market economics. Turkey is just the tip of the iceberg. A world addicted to reckless borrowing and colossal debt loads will now learn to pay the price of its leveraged greed as a rising LIBOR spawns the next credit crunch. This is a replay of 2008 and King Dollar will be the only real refuge/safe haven currency on the planet though the Japanese yen could again surge to 100.
The fall in the Euro to 1.14 is a testament to the monetary divergence between the Federal Reserve and the ECB. US economic growth has also surged while German GDP growth has disappointed relative to expectations. Political risk in Italy and an Élysée Palace scandal has also led to weakness in the Euro even though Mario Draghi has tried to talk money market rates higher. Industrial production data from Spain, the highest GDP growth, major economy in the Eurozone, was a disappointment. Unless the euro convincingly scales its 50 day moving at 1.1670, the strategic default trade de jour is to remain short the single currency against King of King Dollar, heir to Darius, Cyrus and Xerxes!