By Felix Zulauf (via Itau Global Connections).
The U.S. has run an ever increasing deficit in her trade and current account since the early 1980s. She has thereby provided tremendous stimulus to the rest of the world by allowing other countries to export to an increasing extent. Some have accepted this opportunity with pleasure and have built a powerful export industry due to their competitive labor costs. The U.S. policy of increasing monetary and often also fiscal stimulus has allowed countries like China to build up their economies and become large and competitive economic powers. The U.S. behavior really triggered the rise of the emerging economies to a very large degree.
Like an oil supertanker that turns very slowly when changing direction, the U.S. is improving to smaller deficits in her trade and current account (Chart 1). The main reasons are a domestic energy production boom (and much cheaper energy prices than in other parts of the world), cheap and more competitive labor (due to a weak U.S. dollar over the last 15 years) and the end of a leverage-driven consumption boom. Smaller deficits by the largest economy have unpleasant implications for many other nations. Of course, foreign oil producers will earn less income, but foreign exporters selling to U.S. markets are also being hurt. Simply speaking, what once was ever-increasing economic stimulus provided to the world is now turning into restraining factors for the rest of the world.
For the U.S., it means she is now losing less growth to the rest of the world and keeping more for herself, which is growth positive. That is one of the reasons why the U.S. is performing relatively better than other economies, although still well below an average recovery. While I completely disagree with the consensus about the “normalization” of the world economy and the reacceleration thesis, if one economy can achieve the forecasts, it will be the U.S.
Credit Booms Are Followed by Busts
As Chart 1 shows, China’s surpluses are declining and therefore trade data for many other economies are deteriorating. At the same time, many of the EM economies have gone through a tremendous boom in recent years, driven by their previous success story and large capital inflows. As I outlined in the second quarter of last year in my piece “Butterfly Effect,” we have witnessed many years of a virtuous cycle. The inflow of capital (Chart 2) revalued those currencies, and while many central banks intervened to dampen the revaluation, the liquidity thereby created fueled a domestic investment and consumption boom. It was a great success story leading to a credit and real estate boom of large proportions virtually everywhere. In the last five years, Hong Kong real estate has doubled in price, Singapore’s has increased by 70% and China’s has more than doubled. It was felt throughout the whole Asian region and also in selected EM economies in other parts of the world. Of course, they and many Western commentators interpreted this as “normal” because they all believed clocks tick differently in those economies. While some may have better demographics and less government debt, they have created private sector credit bubbles of historic proportions (Chart 3). Most importantly, they are exposed to cycles as everybody else. And that is exactly the point.
The problem with credit booms is that they always end badly, although they usually go further and last longer than rational minds expect. The weakest links are breaking first, as always. Completely mismanaged economies like Argentina and Venezuela are already in deep crisis, but that was no surprise. Next follow the deep and chronic deficit countries like Turkey or South Africa, which have already seen their currencies declining sharply. Both have little foreign exchange reserves and virtually no tools to defend the currency except for raising interest rates, which will trigger a recession. Whatever these countries do, they will end in a recession because that is the way balance-of-payment crises are resolved. It is Ying and Yang, action and reaction; booms will be followed by busts, particularly when built on quicksand of phony money and credit creation. These are of course also the unintended consequences of many years of quantitative easing (QE) in the major economies spilling over to emerging economies.
Now, markets have become aware of the problem and are attacking the imbalances. Research on private sector credit booms over the last 20 years show that whenever credit to the private sector expanded by 30% or more within a 10-year period, a banking crisis and recession resulted without any exception. The following countries are all far above that danger level today and candidates for a banking crisis: Hong Kong, China, Thailand, Brazil, Turkey and Singapore. And recently even Korea, Romania, Ukraine and even Russia have broken the danger level. This is quite a long list, and the big EM economies are all part of it except India that has other deficiencies.
Now, these economies differ from each other, of course, but they share a common disease, namely a previous economic boom built on excessive credit. Most have chronic deficits in their external accounts that were unimportant as long as foreign capital flowed in at large. The response to current problems – which have been with us since the tapering was announced last summer – also differs as some simply cannot intervene in the currency market due to the lack of enough foreign exchange reserves (Turkey, South Africa) while others do intervene due to large reserves, like Brazil or Russia. Some are struggling due to the compounding effect of political trouble (Turkey) and some like Russia due to spending their foreign exchange reserves on weak political allies, in this case the Ukraine. All of them will end up with higher interest rates, a weaker economy and a weaker currency, eventually.
The Mother of All Bubbles
While some may understand the mechanism of a balance of payment that is seriously out of line and its ultimate adjustment process, most investors don’t. That’s why most voices one hears do not, in our view, address the problem properly and think it is an isolated case. While some may understand a case like Turkey, most disagree when it comes to China. While I am as impressed as others by China’s economic performance over the last 2-3 decades, we shouldn’t overlook the fact that, particularly since 2008, the economy enjoyed the most dramatic credit boom ever seen in modern history.
China became the second largest economy in a very short period. In the last five years, China’s total credit outstanding more than doubled and grew more than the equivalent of the total U.S. commercial banking sector, namely the equivalent of $14 trillion. That is equivalent to 150% of their current GDP. Moreover, the balance sheet of the Chinese central bank showed the biggest balance sheet expansion since 2000 of all central banks, which is testimony of an ultra-easy monetary policy.
Credit growth in the years leading to the bursting of previous bubbles has been 40%-50%, as was the case in the U.S. from 2002-2007, in South Korea in the mid-90s and in Japan in the late 80s. China’s credit growth has been by far higher than all of those. Now, we see all the signs one usually sees before the bubble bursts. For instance:
– Large expansion and acceleration of credit not matched by GDP, as credit growth is still 2.5 times faster than GDP but slowing.
– An aggressive expansion of a shadow banking system (wealth management products WMP) that has similarities to the U.S. subprime loans.
– Massive investments in property leading to a bubble in many locations. Tier 3 and 4 cities already see real estate prices declining, while prices are still rising in tier 1 and 2 cities.
– Weak risk management at financial institutions similar to U.S. and European banks before the Great Financial Crisis. There are recurring stories of banks in trouble in China and the government throwing money at them. Recently, some shadow banking institutions went bust and investors lost money.
– Finally, a heavily state-directed financial and corporate sector, which in China is a given, primarily in banking. In the U.S. it was Freddy Mac and Fanny Mae.
– Rising interest rates driven by competitive bidding for funding, not by central bank tightening. We saw this first in spring 2013, then in December of last year and now again.
China is facing the ugly choice of either deflating the bubble, hopefully in a controlled way, or of re-inflating even more, leading to an even bigger debt crisis further down the road. Continuing on the current path and procrastinating would mean even more waste investment than has already occurred and would be rather stupid. Hence, I think the chances are better than 50:50 that China will try to deflate in a controlled way, although it would be a hesitant approach at the beginning. Whether it would remain controlled is another question as it would lead to bankruptcies, an economic crisis of some sort and big problems in the financial, real estate and construction sectors. It is clear that such an outcome in the second largest economy of the world wouldn’t remain a domestic affair but impact the rest of the world. At particular risk are those financial institutions exposed with large loan portfolios to China, including WMPs. Hong Kong is at extreme risk, with bank loans amounting to almost 150% of GDP. The U.S. will certainly be impacted the least, as I have outlined above.
If the Chinese try to procrastinate by throwing more liquidity at the problem, capital would flow out and weaken the yuan despite capital controls. If China tried to support her currency, she would face a situation similar to Russia today. Supporting your own currency by intervention drains liquidity from your domestic credit system, and that’s why Russia is facing a banking crisis at present. Hence, if China chose this route, her currency would weaken and compound the structural problems due to capital outflow weakening the banking system’s deposit base. A weaker yuan could trigger the next problem as it would hurt Asian competitors in particular. Japan’s weakening of the yen was an important trigger to weaken many other Asian competitors, recently. If China would follow suit, it would simply be another deflationary hit for many others, probably the world as a whole.
While the timing of this described process is open as is the way the Chinese will choose, we must expect it to begin at any time and last many quarters if not years. The message is that problems in emerging economies are not over, and weakness in currencies, bonds and equities are in general not an opportunity to buy, yet. What investors should be aware of is that the problems in Turkey, South Africa or Russia are only sideshows compared with what’s out there in China and its implications for the world, which in our view are still not understood and not priced in by markets.
As we don’t live in an isolated world, there will be knock-on effects. Emerging markets ex China account for virtually 1/3 of total global imports, similar to the European Union, while the U.S. accounts for approximately 15% and China for only 10%. Arthur Budaghyan of BCA, Montreal, who does excellent work on emerging markets, recently published Chart 4, showing the high correlation and leading function of emerging equity markets’ relative performance to global industrial production. Moreover, Chart 5 illustrates so clearly how weakening currencies in emerging economies will eventually lead to sharp declines of imports. Those imports are of course someone else’s exports.
The mechanism, in simple terms, has been QE in the developed world leading to capital flows into emerging markets, triggering an investment and consumption boom built on cheap credit. The boom led to rising wages, reduced competitiveness, less household income after inflation, taxes and rent (which rose sharply due to the real estate boom). Now, domestic and external demand is weakening while inflation is high and external accounts are imbalanced. Hence, the world will see the next chapter of the unintended consequences of QE, namely many economies going through a balance-of-payment crisis leading to recessions and banking crises and hurting global economic growth. The U.S. will be hurt too, but is the least exposed.
Fragile Euro Zone
The big winner in equity markets in recent quarters has been the euro zone, the periphery in particular. Those yield-hungry investors who previously bought emerging market bonds have switched to buying peripherals driving the yield down to almost half the level of what prevailed in 2012, when many feared an immediate euro breakup. U.S. and Japanese investors were at the margin quite active due to the strengthening euro and the “normalization” of yields. The thesis has been sharply reduced risks due to stabilization and expected recovery.
Indeed, some like Spain have made some progress but the fundamental problems of the monetary union have not been resolved. Part of the stabilization is due to less austerity leading to growing public sector deficits again. At present, nobody cares about it and believes the situation will heal over time. It won’t, in my view. Problems have a habit to stay and grow bigger and not right themselves without proper tackling. It is true, some indicators have improved, but most of them are sentiment-based, like PMIs. As long as short-term improvements are not supported by monetary aggregates – and they are definitely not, with total credit shrinking by more than 4% year over year in the euro zone – upticks are simply coincidental and no indication of a new trend. There is no change on the horizon, as the banking industry continues to shrink its balance sheet in view of the upcoming stress test.
The ECB has recently decided not to sterilize its bond purchases any longer, which is a slight easing move. It was supported only by the Bundesbank to prevent other more aggressive steps, of course. While some may think this step will lead to a better European economy, I rather see it as too little, too late to make a change.
Risk aversion will rise again, once investors find out the world has entered another deflationary episode, with many balance-of-payment crises that are only now beginning. Yes, it may look far away in the emerging world, but it will have knock-on effects and slow down the global economy much more than expected and hurt particularly multinationals’ revenues and profits. Nowadays, the emerging world is half of the world economy, and the world economy is more intertwined than ever before.
Changing Market Character
“As January goes, so goes the year” has an accuracy of 73% for the U.S. equity market, according to the Trader’s Almanac. I don’t rely on such statistics, but what is clearly visible is the changing character of the market. This correction so far is already the most vicious in many months. Importantly, sharp short-term sell-offs could not attract new buying, as was the case all of last year, but triggered renewed selling. Some important momentum and trend indicators are breaking down (Chart 6), and divergences built up over many months are now forcing the indices down. In Chart 7, we also witness fewer and fewer markets with rising 200-day moving averages (71%) and less and less trading above that moving average (59%). A break below 60% in the first in combination with a break below 50% in the second usually confirms a global bear market underway.
The well-performing markets in Europe and the U.S. didn’t see any new negative news, but they were so overheated and overbought that markets were selling off without. Markets had entered a highly speculative stage, with sentiment indicators hitting multi-year extremes. U.S. margin debt as a percentage of GDP has now hit 2.6%, the same extreme as in 2007 at the peak and close to the all-time high of 2.8% in 2000.
In discussions with European investors in recent months, it was unbelievable how bullish they have become. Picking the right stock was all they cared about, since in their view it was a given that stock prices could only rise as long as central banks pursued easy money and low interest rate policies. Any word of caution was moved to the side. I spoke at a conference recently, before this sell-off really began, and was looked at like somebody from another planet, as all others were so indiscriminately bullish. They didn’t even care about asset allocation. Equities were simply the only game in town – no bonds, no cash, no gold, no real estate, just equities. Frothy markets by themselves may not make a top, but they indicate high vulnerability for corrections.
The most important fundamental change at the margin is the “tapering” by the Fed. There have been intense internal discussions at the Fed, and the way I am reading the tea leaves, the Fed is tired of money printing and wants out. Hence, I am expecting their tapering to continue and to be complete later this year, provided no major accident happens in the financial markets in between. This is equivalent to raising interest rates from minus two percent to zero. And while zero is still low, it is in my view a step by step removal of stimulus and therefore a regime shift in monetary policy at the most important central bank of the world. This is a strong message. Unfortunately, we have no experience with “tapering” and therefore do not know when and how it impacts markets. However, such a change in combination with frothy markets has now triggered a serious correction that in our view has more to run. Since developments in the developed world will not lead to an immediate economic downturn, opportunity hunters will appear and buy the dip, perhaps several times. Hence, it could be a step by step correction during this quarter followed by another upside attempt, particularly in the U.S. and Europe.
In our reading, the current weakness is led by emerging equity markets, and most of them are already deep in their second downleg of this cyclical bear market, while for most equities in developed markets it is only the first downleg of a new bear market. There is an outright chance that once this downleg ends, a few indices may make it back to the highs or even marginally above, but now is not the time to decide that. Now, the message for investors simply is to pursue defensive strategies.
The sell-off has now created an oversold situation at a time when the U.S. and European markets reached the December lows, while Japan is a bit weaker. Hence, some attempts to bounce off these levels are likely in the short-term. If recovery attempts remain weak and do not lead far, which is my hunch, we may be facing the right shoulder of a head and should top, from where markets could break down further thereafter.
Strong Dollar
In the currency arena, the U.S. Dollar has been firming for quite some time against virtually all others except the euro family of currencies. I expect the stronger dollar trend to continue despite some interest rate hikes in selected emerging economies. Those economies have to be rebalanced through a full-fledged balance of payment crisis that does include a recession. While the extremes of last week may lead to a temporary pause in EM currencies, I expect them to continue weak later.
The euro is a deflation currency with the same characteristics of the Japanese yen until the regime change in the country of the rising sun. We see chronic current account surpluses, a stagnating and aging population and a deflationary economic policy mix with economic stagnation. This condition must change, similar to Japan in late 2012. We don’t know when, but further disappointments this year will create rising stress in the euro zone. The recent change at the ECB of withdrawing the sterilization of bond purchases amounts to some easing and a weakening of the euro; however, it will not be enough to improve the economy. Hence, we see the upside of the euro against the U.S. unit as very limited and expect a weaker euro in coming months and lasting well into next year, as the ECB will at some point be forced to do a lot more.
The big surprise for the world will in our view be a temporary strengthening of the yen. The world is short yen, as it has been used as a funding currency that declines in value and costs extremely low interest. Moreover, the Japanese have outlined their goal of weakening the currency to end deflation. The economy will do well up until April 1, when the VAT will be hiked by 3%. This will lead to CPI inflation of close to 4% while wages will only be raised by 1%-2%, leading to an income shortfall in real terms. Hence, the economy will most likely be quite weak in the 2nd and 3rd quarters. The Bank of Japan is aware of this and has recently stopped buying JGBs to make room for more aggressive steps later. Hence, I expect the world to be forced to cover their yen shorts, as Abenomics will look like a failure. We expect the Japanese to launch another stimulus program, including aggressive monetary easing, that will most likely start sometimes in the second half and trigger the next phase of yen weakness, but only after a temporary correction that could amount to approximately 10% from recent extremes versus the U.S. dollar and more versus other major currencies.
Bonds Offer a Safe Haven
We share the view that bond yields of perceived quality borrowers have terminated their 30-year secular decline and are in a multi-year bottoming process. Within this bottoming, our hunch is that the cyclical rise from the secular low in 2012 has ended. As outlined, we are expecting another deflationary episode and see in particular U.S. Treasuries with maturities of 10 years and longer as offering attractive trading opportunities over the next 6-12 months, whereby 10-year yields could decline to around 2%. This may not be attractive in the eyes of many, but in view of medium- and most likely cyclical declines in equities, Treasuries offer a safe haven.
While yields on German Bunds or some other selected quality bonds may also decline, I think U.S. paper will be the most attractive and offer the best total return potential, as capital will be returning from virtually all other parts of the world and thereby strengthening the currency, which will not be the case for others.
Restrained Bottoming Attempt for Gold
In the scenario outlined, economic-sensitive commodities are unattractive and at risk of further declines. I would exclude them from portfolios.
Gold has disappointed so many that it is hard to see how Western investors who have sold are getting back into gold anytime soon. Rising deflationary risks could hinder a gold recovery despite its deeply oversold cyclical position. In fact, I wouldn’t be surprised to see gold breaking $1,180 first for a final washout before the recovery starts, most likely from late spring onwards, when rising risk in the global credit system will become more visible. It is reasonable to expect citizens in those countries directly impacted to store part of their wealth in gold instead of paper currencies, which are losing value virtually every day.
Since the gold market is very oversold from a cyclical point of view after declining from $1,920 to $1,180 in more than two years, investors should take a constructive and contrarian view of gold and accumulate step by step on weakness. It may take a few more months until the dimension of risk in the credit system become more visible, but I expect this to be on the table in the second half at the latest, when the price of gold should be higher again. Even gold mining stocks can be purchased with a 12-month view, as they have been beaten down badly and are cheap on a valuation basis. They are, however, not for widows and orphans.
In general, we expect another deflationary episode leading to systemic risks and economic disappointments. Hence, it is time to structure portfolios much more conservatively and put capital preservation ahead of aggressive return strategies. In contrast to last year, 2014 will hardly be a year with a powerful and easy trend to ride. Instead, it will bring much more volatility but also plenty of trading opportunities for flexible investors.
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