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!
The short term reaction to the diplomatic spat between Saudi Arabia and Canada is to short the loonie at 1.30 for a 1.33 target. It is significant that the Canadian dollar is also underperforming most G-10 currencies after Tuesday’s classic bearish reversal. Saudi pension fund selling of Canadian dollar bonds will exacerbate loonie weakness amid illiquid August trading. However, I believe the downside risk to the Canadian dollar will be limited due to stronger than consensus economic data momentum, geopolitical/supply risk in a light crude oil market and money market expectations of a 25 basis point Bank of Canada rate hikes this autumn. This means that the loonie remains a “buy on dips” strategy as the scale of Saudi-Canada trade is too small to warrant any permanent damage to Canada’s balance of payments. Risk reversals in the foreign exchange option market do not really indicate any real demand for loonie weakness protection.
Sterling’s fall below 1.28 is due to speculation that Britain is headed for Brexit without a trade deal with the EU. This is the reason sterling has also slumped to 10 month lows against the Euro. The risk of a no deal Brexit, estimated at 60% by Trade Secretary Liam Fox, leaves sterling vulnerable to further selling in the months ahead, particularly if UK economic data momentum stalls. Chicago futures positioning data indicate that both leveraged funds and real money accounts have increased short cable bets. In this milieu, I can easily envisage 1.25 as a strategic target and ING Bank estimates the euro-sterling rate that reflects no deal Brexit risk as 0.92.
Macro Ideas – Does Copper’s fall predict global recession?
Wall Street folklore is replete with myths, false correlations (hemline and the stock market!) and even financial superstition. However, as an investor and market strategist, I am forced to act as a financial astrologer, forced to scan a tsunami of data points to grasp macro trades with an asymmetric risk-reward calculus in my favour. So I naturally track Dr. Copper on the London Metal Exchange. The red metal has a reputed doctorate in economics since its price trends allegedly predict the global economic cycle in real time. Poppycock? Not always.
Since early June, the price of copper has declined by a frightening 18%. This could be a leveraged response to a Chinese trade war, a SOS on synchronized global economic growth or panic selling of emerging market risk assets. It is ironic that copper’s free fall has coincided with a hawkish Powell Fed that has anointed US economic growth as “strong” and announced its determination to continue raising the world’s cost of capital. It is doubly ironic that copper’s plunge to $6000 per metric ton on the LME has also coincided with the world’s failure to address mine expansion and strikes in Chile.
The copper plunge is eerily reminiscent of the second half of 2008, when shorting Freeport McMoran, the world’s largest listed copper producer, was a license to print money on the NYSE. The Bernanke Fed keep reassuring Wall Street that the subprime crisis would be “contained” even as contagion spread across asset class and culminated in the failure of Lehman in September. Frankly, in 2008, Dr. Copper was a more reliable indicator of the global economic cycle than the chairman of the Federal Reserve. If history repeats itself in 2018, Dr. Copper could be an advance indicator for the onset of global recession. When Dr. Copper crashes, bad things happen on Wall Street and around the world. It is no coincidence that the Chinese stock market is down 20% and China is the world’s second largest economic colossus after the US. Economic decoupling is a myth. If the Chinese dragon bleeds, the American eagle cannot soar, despite the Fed’s growth conviction. Get real. Get out!
The strength of the US dollar and the seventh interest rate rise in this Fed monetary tightening cycle at the June FOMC has led to new lows in gold in 2018. The yellow metal trades at $1211 an ounce, down almost 40% from its $1930 high in September 2011. Gold’s high on January 25, 2018 was $1368 an ounce when the US Dollar Index was 84.6, a full 1200 points below its level now. The inverse relationship between gold and the US dollar has been statistically robust in 2018, even as the Trump-Dear Leader Singapore summit has reduced geopolitical risk. Bitcoin’s brutal bear market has not given a boost to gold. The resurgence of the King Dollar trade since April, sharply higher US short term rates, the risks of a US-China trade war, outflows from exchange traded funds and Asian central bank selling all led to the protracted bear market in gold. It is probable that the King Dollar trade will continue to pressure gold this autumn. The financial markets give 90% odds of a Fed rate hike in the September FOMC and 70% odds at the December FOMC. US Treasury bond yields will rise faster than the yields in German, UK and Japanese government debt. If US economic growth accelerates, as the Powell Fed expects after 4.1% 2Q GDP growth, the interest rate spread could widen in favour of an even stronger US dollar. This is all the more true since the ECB and the Bank of Japan will not match aggressive Federal Reserve monetary tightening. Since gold provides zero return, a rise in US dollar borrowing costs will continue to hit spot bullion, which can well fall as low as $1160.
West Texas crude oil has fallen for five successive weeks for the first time since August 2017. US inventories gained 3.8 million barrels, far above the market’s 2.8 million barrel expectation. The escalation of the US-Chinese trade war is also bearish for global growth prospects and thus petroleum product demand.
The Trump White House’s decision to re-impose sanctions on Iran has injected geopolitical supply risk into a tight crude oil market. After all, Iran has threatened to disrupt oil tankers in the Straits of Hormuz, a strategic chokepoint where tensions once escalated into naval confrontations with the US in 1988. This could mean a supply shock, as in 1979 or 1990.
