Ten Years after the Crisis, Here’s a Look at What’s Around the Corner

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Here’s our interview with the Swiss business newspaper Finanz und Wirtschaft. 

Larry McDonald, Editor of the Bear Traps Report, predicts a full-blown crisis in the emerging markets and outlines why this also could offer some promising opportunities for investors. Keep in mind, McDonald is NO perma-Bear, The Bear Traps Report with Larry McDonald; Capitulation Climax in Energy – August 18, 2017-2.

See the latest on The Bear Traps Report with Larry McDonald; Late Cycle Mojo in Energy – March 28, 2018_4

His book has been published in 12 languages, over 650,000 copies sold.

Pressure on emerging markets has been rising for months. For the past decade, a river of easy money rushed into developing countries. Now, that trend is reversing. Rising interest rates and trade wars are creating havoc. The Turkish lira and the Argentine peso have crashed. China’s stock market is stuck in a bear market. For Larry McDonald, that’s only the beginning of a full-blown crisis. The renowned editor of the macro research platform Bear Traps Report knows what he’s talking about. As a former distressed bond trader at Lehman Brothers, he experienced the emergence of the 2008/09 financial crisis at the center of the storm. Now, his biggest concerns revolve around the massive debt binge which took place in the emerging markets. He warns that mega-cap tech stocks like Apple, Amazon and Google will be the most vulnerable when the crisis spreads to the financial markets of the developed world.

Mr. McDonald, as a former bond trader at Lehman Brothers you were one of the early voices (profits of over $120m) warning of the subprime mortgage crisis. Where do you spot the most dangerous risks in the financial markets today?

China on Steroids Now Facing Tariffs
In our view, the new subprime risk is found in the emerging market’s embedded leverage. There is a lot of concern about emerging markets debt, especially about the amount of Dollar denominated debt. For instance, the Chinese banking system is $44 trillion in size. That’s almost three times the US banking system and the Chinese economy is already weakening. Total global debt (sovereign, corporate and household) has surged by nearly 75% since Lehman’s failure ten years ago, per the McKinsey Global Institute. The great enablers, Central Banks have blood on their hands in my view.

Tariffs and Leverage

Since Lehman, government debt in China is 73% higher to near $40 trillion, with corporate debt and shadow leverage surging 65% to $75 trillion, per BofA above. We’re at the point where, if China keeps growing at 6-8% per year, that growth has to come from somewhere. G8 developed market countries (like the US) have finally figured out they’re holding the bag, they want that growth back. So, you have a highly leveraged situation where you’re putting tariffs on. I don’t think the Trump administration is aware of how dangerous this is. When you pull cash flows (tariff impact) from a highly leveraged entity, bad things happen.

China Manufacturing Leverage Panic

Manufacturing is under substantial stress. After a multi-year rally, plunging revenue and sharply declining profit growth led to a poor showing in the latest Beige Book in China. Manufacturing’s deteriorating sentiment has taken place before any meaningful American tariffs have been imposed. Without a trade deal, this situation will likely get worse. The pace of borrowing is near 42% percent of firms, that’s the highest since 2012. It sure smells a lot like panic indeed.  China fiscal and monetary stimulus is on the way, but so far we have NOT seen it in the data.

Why is this situation so dangerous?
It’s not just China. It’s Turkey, it’s India’s banking system*, it’s Brazil, it’s all these countries which have issued so much debt.  Since Lehman, there are trillions and trillions of new Dollar and Euro denominated debt issued globally and now it’s starting to come into a massive default cycle. Ten years after Lehman’s failure, global debt levels have surged from $170 trillion to $250 trillion, per BofA. At the end of the day, the Federal Reserve and the European Central Bank are going to get the blame because they have been far too accommodative. In the U.S., corporate credit quality is in the worst shape.

India Credit Risk on the Rise
*India’s banking system’s overhang of (near $400B in our view) bad loans is another full-blown crisis that stymies growth and shows no signs of an early resolution.

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What could trigger this wave of defaults?

The Dollar plays a key part. It’s like a global wrecking ball: when the Dollar moves up and emerging markets currencies drop their interest costs are exponentially more difficult to pay off. In the case of Turkey, the currency is down around 40% against the Dollar this year. So, if you’re a Turkish company and the interest payment was 1 million Dollars per quarter you are looking now at a payment of 1.4 million Dollars per quarter.

Emerging Markets, Taking a Beating

There has NEVER been this much capital hiding out in the USA.

Global Surge in Bond Yields in 2018

Turkey: 11.59% to 20.30% +871
Russia: 7.73% to 8.71% +117
Italy: 1.74% to 2.83% +112
India: 7.16% to 8.08% +92
Brazil: 10.94% to 11.78% +84
China: 3.44% to 3.69% +35
Canada: 2.09% to 2.43% +34
US: 2.80% to 3.06% +26
Germany: 0.30% to 0.46% +16

Move in basis points, Bloomberg terminal data

How dangerous is this for the global financial system?

When we talk about financial conditions we’re talking about the tightness of credit and the speed of the tightening of credit. Right now, financial conditions globally are tightening at the fastest pace since 2015 when we had the Chinese currency devaluation. At the Bear Traps Report, we also measure currency volatility and credit default spreads on emerging market banks versus US banks. In this area, we’re looking for divergences. Our Index of 21 Lehman Systemic Risk Indicators is rising at the fastest pace since 2011. For example, during a healthy “risk on” period, when everybody is taking risk, you typically don’t see divergences in credit quality globally. In contrast to that, in a market that’s about to turn “risk off” many times you see dramatic credit divergences ahead of it. Right now, the credit quality of European and Asian banks is substantially weakening relative to US banks, NOT a good sign at all.

Yield: Bonds vs. Stocks, Far More Competitive

US 10 year Treasury vs. S&P 500 Dividend

2018: +1.30%*
2016: -0.84%**

*Fresh seven-year high yield advantage for bonds, Bloomberg data
**July 1st 2016, post-Brexit rush into bonds

As bond yields rise, future cash flows thrown off by FAANGs are far less attractive. During the February bond yield surge, FAANGs dropped 12-14%.

What does this mean for investors?

Today, everybody in the US is hiding out in FAANG stocks like Facebook (FB), Apple, Amazon, Netflix (NFLX), Google and Microsoft (MSFT). That’s really concerning because there are more than six hundred ETFs which own 8 stocks – far too much wealth is concentrated in just a handful of stocks. The thinking is that the FAANGs are a safe investment because the US has decoupled from the rest of the world. But what’s happening is that the more money goes into passive investments the more these FAANG stocks get pumped up. For instance, think about the QQQ ETF which is based on the Nasdaq 100 Index. If a billion Dollars goes into the QQQ ETF than close to 400 million Dollars MUST BE squeezed into the FAANGs. That’s insane.

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Why?

Ten years ago, we were lectured again and again that the emerging markets had decoupled from the US and that our money was safe in emerging markets. That’s because as opposed to the developed markets like the United States, the so-called BRIC countries Brazil, Russia, India and China were growing at 8 or 9%. So, they were considered to be safe places to invest. The thinking was that their growth is so powerful that even if the US goes into recession the global economy is going to be OK. Literally, every single TV program, magazine, and newspaper were preaching this garbage.

But as a matter of fact, economic growth in the emerging markets was quite impressive over the last decade.

True, but the EEM iShares MSCI Emerging Markets ETF lost 60% of its value from 2008-2009. It’s ironic that today, basically the exact same story is being pitched to investors again. But now, the U.S. is the safe place and has “decoupled” from the rest of the world. So, there is safety in these FAANG stocks, the story goes. But that’s complete garbage. All these ETFs are a bit like shadow banks. They are like the CDOs on the eve of the financial crisis. There are so many people in them that there is not going to be enough liquidity when things turn bad. We saw this when Facebook dropped $122 billion in one day. That has never happened before. No one stock has EVER wiped out that much wealth in one day, not even during the financial crisis, not even during the dotcom era.  Our models point to this event as a large tremor BEFORE the quake.

How bad is it going to get?
We are going to see this across all the FAANG stocks. It’s going to get really ugly and it’s probably going to happen in the next six to nine months. It’s going to be close to a 20% drawdown for the entire US stock market. But the FAANGs, these crowded stocks, are going to drop 30 to 40%.

The last big stock market crash in the US happened ten years ago. What goes through your mind when you think back at the failure of Lehman Brothers?

Thanks to central bankers around the world, asset prices in the U.S. are pumped up on steroid levels. People blame Wall Street for the financial crisis of 2008. That’s fine. But the largest misconception has to do with the central banks. The Lehman senior management team never ever would have taken that much risk if the Federal Reserve was aggressively raising rates. In 1994, the Fed pre-emotively raised rates 50bps (0.50%). A surprise move like this might have prevented much of the aggressive risk-taking that brought Lehman down.  Central bankers have put us in such a bad place and now they have done the same thing again. If you look around the world, overall there is around $45 trillion of new debt* that wasn’t on the planet ten years ago (thanks to central bankers).

*tradeable debt in the public markets NOT private, Bloomberg Barclays Credit Agg data.

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What exactly happened at Lehman in the time leading up to the financial crisis?

I remember being on the trading floor in 2006 and 2007 and they were telling us, “take more risks, take more risks.” So, I was asking one of the senior guys, “why are they telling us to take more risks?” He said, “the Fed had kept interest rates super low for almost three years and then raised rates very slowly with too much visibility going forward.” This was the reason why the Lehman managers were going around and giving us orders to take more risk. They were doing it because the Fed had laid out an obnoxiously transparent policy path. But here’s the key: There is a beast in the market and in capitalism in general. So, the Fed gave the capitalist beast far too much visibility on monetary policy. In other words, when monetary policy is so visible it creates more risk-taking. And that’s happening again today. The central banks have created a dynamic where if things are starting to soften they are trying to contain the risk (see February 2016). But each time all they’re accomplishing is a build up of more risk.

How did the fall of Lehman Brothers change Wall Street?

There were so many bad apples on Wall Street at that time, but Lehman gets a crazy amount of the blame. Other banks were even more screwed up. For instance, Citi and Merrill Lynch were a total disaster, their bad assets were 6x Lehman’s. So, the most important change is that the major banks are much less leveraged today. Also, there are more people working at hedge funds, mutual funds and other asset management firms than there are people working at banks. This means there has been a transfer of talent from the banks over to money management firms.

Where do you spot the biggest risks in the global financial system in case of another crisis?

A lot of banks are exposed globally to this emerging market debt. Deutsche Bank (DB) could go down, but they had like ten years to prepare for this. So, it’s probably going to be financial institutions in Asia, Australia, and Canada which will get into trouble. But it’s not going to be one big Lehman situation. It’s going to be much more of a spread-out globally.

Junk Bond Orgy is Long in the Tooth
The Great Risk Transfer: Over the last ten years, all the risk has been transferred from the large US investment banks like Lehman, over to corporate (companies, BBBs above) and sovereign (government) balance sheets.

US  – Near Junk Rated – Corporate Bond Debt Binge

2018: $3.1T
2008: $0.5T

Ice Data, Bloomberg

Maturity Wall Beware
While the White House is playing games with tariffs and the global economy, $1.3 trillion of US corporate debt is coming due in the next two years. McDonald HAS NEVER seen a maturity wall of redemptions of this colossal magnitude.

How come?

Over the last hundred years inside financial markets, we’ve found in each crisis there’s a transformation into another serpent, a far different beast. In the 1970’s it was runaway commodity prices, a real energy crisis. In the 1980’s, it was Savings and Loans. The 1990’s brought us a currency crisis in Mexico, sovereign credit defaults (Russia) and the dot-com blow up. By 2008, a full-blown subprime mortgage crisis was upon us. At that time, the small banks were fine, but the big banks got into trouble. So, each financial crisis is followed by a metamorphosis into another beast and the next crisis is going to look much more like the one in 1998. It’s not going to look like anything like 2008.

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What could this mean for a global financial hub like Switzerland?
Right now, the most leveraged organization on earth might be the Swiss National Bank. They own all these FAANG stocks and it’s really concerning because the people of Switzerland are going to lose a lot of money when this crowded trade blows up. Just look at how much of that central bank’s money is in equities. It’s obscene. They don’t understand. In the last five years, $2 trillion has gone into passive asset management and there’s an untested liquidity mechanism when people head for the exits. A lot of that money has to go into the FAANGs. So, the Swiss National Bank has made a lot of money because of this passive revolution. They probably think they’re really smart. But they’re just benefiting from this move here in the United States where so much money has gone into passive strategies. Now, the Swiss National Bank is sitting on all these profits and they are going to look like complete imbeciles when the FAANGs blow up.

 

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Wage Pressures Driving North – Fed Tied in a Box

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The US economy took on more jobs than expected in August, and wage growth touched a post-recession high.  Nonfarm payrolls grew by 201,000 in August. Economists surveyed by Reuters expected a 191,000 increase.

Fed Impact?

The question remains, with emerging markets in flames  (currency volatility at ten-year highs), what does this do the policy path of the Federal Reserve?  More rate hikes and a stronger US dollar will only add fuel to the emerging market’s fire (EM equities are 20-40% off this year’s highs, they’re in flames).  Our investment thesis is laid out in our most recent note, join us here.

US Midterm Election Impact?

Ahead of the 2016 election, wages moderated lower in key swing States, but they’ve averaged nearly 2.8% in 2018, up from 2.4% the prior 3 years. The Atlanta Fed, which tracks the same workers over time, reported a 3.3% annual gain in wage growth in July.  We MUST connect the DOTS here.  What’s the impact of rising wages on the U.S. midterm elections in November?

First Midterm Election, Seats Won+ or Lost- in the House

2010 Obama: -63*
1994 Clinton: -54*
1982 Reagan: -27
1978 Carter: -15
1990 Bush: -8
1962 Kennedy: -4
2002 Bush W: +8
1972 Nixon: +12

*Lost control of the House Wikipedia.  We can talk about Russians and family separation all day long, but we MUST weigh the impact of surging wage growth.

Wage Pressures Driving North
Average hourly earnings jumped by 2.9 percent, above the 2.7 percent increase expected.  The unemployment rate held near a generational low of 3.9 percent.  The wage growth was the highest since April 2009.

Out of the Deadzone

Long-awaited wage growth posted its biggest increase of the economic recovery in August while payroll gains beat expectations and the unemployment rate held near a generational low of 3.9 percent, according to a Bureau of Labor Statistics report Friday.

Fiscal Stimulus in the USA Ends 15 Year Down Trend in Nominal GDP, now up at +5.4% Growth
Average hourly earnings rose 2.9 percent for the month on an annualized basis, while nonfarm payrolls grew by 201,000. Economists surveyed by Reuters had been expecting earnings to rise 2.7 percent, payrolls to increase by 191,000 and the jobless level to decline one-tenth of a point to 3.8 percent.

Working with CNBC.

 

 

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Summer of 2018 in Italy

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Special Thanks to ACG Analytics in Washington 

The latest clash between Rome and Brussels, which erupted over the handling of a ship transporting migrants moored in Sicily, has investors worried that given the tensions, Italy is on track to break the 3% budget deficit limit imposed by the EU when it presents its 2019 budget this fall.

Greece Style Drama Building in Italy
Italy vs. German 10-year bond yield spread is NOW through the Memorial day weekend wides, what a way to end the summer.  The VIX Chicago Board Options Exchange Volatility Index touched 17 during the late May drama out of Italy, compared to less than 14 today.

Funding?

Deputy PM Luigi Di Maio stated that Italy would withhold funding to the EU 28 bloc next year unless other member states accepted the migrants. The European Commission dismissed the threat, stating that the Union “operates on the basis of rules, not threats.” The new Italian administration uses unusually aggressive statements to move towards its policy goals, which may portend to upcoming budget talk negotiations. Investors in the Italian bond market anticipate a possible market turndown and yields across Italian government bonds show significant volatility. After recovering from an 8 basis point slump on August 28th, the Italian 10-year government bond yield sank 6 basis point in one day on August 29th.  On the other hand, the Italian government downplays the possibility of wider market selloff, stating that the country will maintain the agreed debt-to-GDP ratio on a downward path. However, the yields across the Italian government bond yield curve are higher than they were a month ago, when ECB chief Mario Draghi warned Italy that the ECB would not adjust its policy to allow for a more spending oriented Italian budget.

A Rare Refusal

European Commissioner for Budget Guenther Oettinger stated in response to the Italian administration that the move would make Italy the first member state in EU history to refuse to pay budget contributions: “This would result in late payment interests. And a breach of Treaty obligations leading to possible further heavy sanctions,”Oettinger responded. ACG Analytics foresees the Lega-M5S administration adopting a rigid line against Brussels in an attempt to bend fiscal target rules this fall.

Catalyst Dates

On September 27th, the government will present its budget update note, followed by the presentation of the budget draft on October 20th. The European Union is also expected to give its opinion on the budget draft in October. Regional elections in Trentino Alto Adige will be held on October 21st and in Basilicata in November.

Cost of Default Protection
As the cost of credit default protection exploded higher on Italian banks in late May, the Five Star Movement’s (M5S) Luigi di Maio and Lega’s Matteo Salvini reached an accord on their coalition’s program.  Likewise, the structure of a future cabinet and the candidate for the premiership were on the “Italy First” agenda.   Over Memorial Day Weekend, discussions took a sharp turn for the worse as all sides failed to agree on a new finance minister.  Some in Lega party leadership insisted on a Euroskeptic head of finance, others want a more centrist figure.  Together, the M5S and the League (Lega) have an impressive majority of 37% in the 630-seat Chamber of Deputies, though a slimmer edge in the Senate.  Their standing is up over 200% in recent years as the Populists have been able to steal political market share from center-left parties in Italy.  See our The Bear Traps Report with Larry McDonald; Tocqueville’s Italy – January 25, 2018_

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Justice for All

 

 

The SEC describes stock manipulation as “intentional conduct designed to deceive investors by artificially affecting the market for a security by spreading false or misleading information about a company. Those who engage in manipulation are subject to various civil and criminal sanctions.”

Credit Leads Equity, Watch the Tesla Capital Structure Carefully
Tesla equity investors obsessed with the stock price are measuring risk-reward with just a piece of the picture.  Those you are NOT on top of the entire capital structure are sadly mistaken.  In early April, with Tesla junk bonds (5.3% due 2025) near 87 3/8 the equity was trading at $252, today the relationship is 87 3/8 vs. $319, that’s a $70 premium in the equity vs. the credit.   After just one-quarter of positive free cash flow since the fourth quarter of 2013, Tesla has $1.3B in debt maturity wall over the next 12 months.  After the ferocious burn, cash in the bank is down to $1.3 after backing out $942 million of customer deposits on cars.

Is there no better example of such stock price manipulation than Elon Musk’s recent tweetstorm?   Around mid-day on August 7, the sleep-deprived CEO of Tesla tweeted that he was considering taking Tesla private, with the compelling byline “funding secured”. Immediately following his tweet, Tesla surged higher but the company itself remained quiet. After three hours Musk sent an email to Tesla employees, clarifying his tweet. Tesla stock ended the day 31.6 dollar (+10.7%) higher, and just above $387 per share. His tweet had boosted the Tesla market cap by $5.3bl that day. The board appeared to have been completely blindsided as were Tesla’s junk-bond selling investment bankers. They confessed that they had no idea the company was working on anything like this.

Musk justification, in his email to employees, for privatizing Tesla was because “wild swings in our stock price [ ] can be a major distraction for everyone working at Tesla.“ He also blamed the shorts, which always seem to be the bane of Musk’sexistence. Musk noted that “as the most shorted stock in the history of the stock market, being public means that there are large numbers of people who have the incentive to attack the company.”

In the weekend following this tweet, and the stock still around$350 per share, Musk was allegedly on the phone non-stop, frantically soliciting investors for his privatization. This was based on the dubious claims from Azalea Banks who stayed at the Musk residence that weekend. On Sunday night Tesla released a cryptic blog statement in defense of Musk’s ill-fated “funding secured” tweet.

According to the statement, Musk had several going private talks with the Saudi wealth fund over the years. After his tweet, the Saudi manager of the fund expressed support for proceeding with a privatization subject to financial due diligence and their internal review process for obtaining approvals.” In other words, The Saudi manager had not seen Tesla’s books nor did he know if the fund’s Board would even approve funding such privatization. By then the market started to realize Musk’s initial claim was based on hope rather than an actual commitment. In the meantime, the SEC had announced an investigation into Musk’s tweet and shareholder claims started to surface as well.

But the real bombshell came on Thursday night when the NY Times published an interview with Musk that demonstrated the mercurial state of Tesla’s beleaguered Chairman/CEO. Musk claims that he typed the fateful tweet while driving to the airport and no one had seen or reviewed it before he posted it. Moreover, the article claimed that funding was anything but secured because the Saudi fund had not committed to providing any cash, according to people briefed on the discussions. The article also noted that the Tesla’s board and Musk had received SEC subpoenas, and preparing to meet with SEC officials in coming weeks.

The following day, the stock dropped 8%, erasing all the gains from the go-private speculation. Investors’ concerns were not limited to the validity of the privatization but also about the mental state of Musk. In the interview, he appeared to be breaking down several times and lamented about having to work 120 hours per week and frequently taking Ambien to be able to fall asleep.

A frantic week followed, with Tesla in full damage control. The company named the line-up of investment banks that would advise the go-private transaction. But by the end of the week, the company threw in the towel. In a dramatic U-turn, issued at 11pm on a summer Friday, Musk claimed that it behooved Tesla stay public, never mind the claims to the contrary two weeks prior.

In hind site, this entire saga appears to be a giant ruse to squeeze the Musk-reviled short sellers out of the stock. Elon Musk had gone out of his way in recent months to attack critics, going as far as trying to get a Tesla provocateur on Twitter fired by threatening his boss. In addition, Musk tweeted a meme that compared hedge fund managers to Nazi-Germany leadership and publicly mocked Greenlight’s David Einhorn, who is short the stock.

The SEC has a history of pursuing many cases of insider stock manipulation. The focus of the latest investigation into Tesla is whether Musk violated the critical anti-fraud SEC rule 10b-5. This rule specifically prohibits any scheme to defraud by misstating material information that affects the value of the stock. Among the penalties would be the SEC barring Musk to be a director or officer of a public company. A violation is not limited to prior intent, the SEC could penalize Musk based on actions that are “a significant departure of a proper standard of conduct”. To add insult to injury, with Tesla now in receipt of multiple Wells Notices (SEC enforcement letter), it’ll be increasingly difficult to raise badly needed capital. In general, companies that are under undisclosed SEC investigations do not raise capital.

We are eager to see whether the SEC succeeds in its investigation and pursues legal action against Musk. The SEC has punished many CEO’s for lesser violations but Musk thus far has demonstrated to be above the law. Numerous NTSB investigations into self-driving vehicle accidents have amounted to nothing. The SEC is already investigating Tesla about its disclosure of production issues while whistleblowers are alleging spying of employees and drug dealing on the factory floor.

We are increasingly witnessing the presence of a two tiered-justice system, where lady justice looks the other way with malfeasance by the business and political elite. The SEC has an obligation to show us that Tesla and Musk are no longer above the law and get the same treatment as the general public.
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Global Credit Risk Rising

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Central Banks have Lit Emerging Markets a Fire
The emerging market foreign exchange basket just witnessed its largest 4D drawdown since Lehman.  That’s a -5.3% shift for a 5.2 standard deviation move over a ten year period.  This is an exceptionally powerful move which has NOT come to us without follow-on implications.

Blinders On

Over the last hundred years inside financial markets, we’ve found in each crisis there’s a metamorphosis, a transformation into another serpent, a far different beast.  In the 1970’s it was runaway commodity prices, a real energy crisis.  In the 1980’s, it was Savings and Loans.  The 1990’s brought us sovereign credit defaults (Russia / Long Term Capital) and the dot-com blow up.  By 2008, a full-blown sub-prime mortgage crisis was upon us.   The sad fact remains, central bankers along with regulators are often caught looking in the rearview mirror.  They’re literally oblivious to risk – we call them academics with blinders on.   Lost in the woods, this crowd has done a great job at taking leverage down inside large banks.   Yet, all they’ve really accomplished is a transfer of the leverage onto both sovereign (country) and corporate balance sheets.  Over long periods of time, when you prevent the cleansing process of the business cycle from functioning, capital oozes around the world into all the wrong places.  Bottom line, nice work central bankers (FOMC, ECB, BOJ, BOE, PBOC), you lit the fuse and now it’s about to explode.

Cost of Credit Default Protection on Turkey
Turkish Credit Default Swaps – a key instrument investors use to insure against financial turbulence – surged to their highest since the 2008 global financial crisis as the lira took another sharp dive in world currency markets. Five-year Turkish CDS jumped 78 basis points to 529 basis points, data from IHS Markit showed.

Why a Strong Dollar Matters?

1994 to 2017 Global Debt

$41T to $234T*

*$64T dollar-denominated, nearly all issued over the last 10 years.

BIS, Bloomberg

Turkey, A Large Default is Near, Contagion Upon Us

Late this week, the cost of insuring against a debt default in Turkey overtook that of Greece, which is rated four notches lower by the “brain trusts” at Moody’s.  At the same time, investors sliced exposure to emerging markets as Turkey’s currency meltdown fueled contagion concerns and a host of global hot points added to the exit from riskier assets.

A Price to Pay
There’s a “Price to Pay” for the easy money Gravy Train which has come out of central banks.  Thanks to a Reckless Fed and ECB, Turkey was able to pile up loads of debt – NOT denominated in Lira BUT Dollars and Euros, TURN OUT the Lights.   The likeness of 2018’s Turkish credit crisis and the Asian credit crisis of 1997 is very real.  If you think of Turkey’s external debt near $450B, that’s nearly 57% of GDP.  Next, add on colossal corporate debt layers (see above) – you’re in a HIGHLY unsustainable neighborhood, near 70% of GDP.  Back in 1997, Thailand’s external debt was $110B or 64% of GDP, the panic that followed rocked global markets.  Over the last month against the US dollar, Turkey’s lira -48% (since July 6th) while one month into the Asian financial crisis the Thai baht was -24% against the US dollar.  In rare company – the lira’s recent collapse exceeded daily losses during Russia’s 1998 default and Brazil’s 1999 real crisis.

India’s  Rupee, Now through Taper Tantrum Levels
In June, in a rare public tongue-lashing, the Bank of India governor pleaded for the US central bank to relax balance sheet tightening plans, they didn’t listen.

Emerging Market Dollar (Corporate Bonds) Denominated Debt Sales

2017: $495B
2016: $450B
2015: $300B
2013: $360B
2011: $220B
2009: $58B
2007: $124B

WSJ data

Credit Risk Surge – Cost of Default Protection
The Turkish Lira has plunged against the dollar to record lows this week, fueled by concern about the nation’s worsening relationship with the U.S. and authorities’ ability to anchor the nation’s assets.  With close to $250B of US Dollar and Euro denominated DEBT, every 1% move lower in the Turkish currency brings a nasty 5 billion Lira interest coverage problem, it’s good night Irene.

2018 = 1998
In nearly every substantial macro-driven risk-off period, as the crisis kicks off US equities ignore the drama.  There’s a beautiful point in every market cycle; macro takes over lazy thinking. It’s a unique, special place in which all participants have to dig deeper into what’s actually going on within the solar plexus of the global economic system. WE ARE THERE RIGHT NOW, peace.  Clients are asking if this is 1998 all over again?  We say yes.   A Lira move near seven (close to a 6 handle now) wipes out most of the equity in Turkey’s banking system, and that’s on a $1T economy.  Contagion?  EU banks are 7% – 10% lower this month!

“MSCI’s developing-nation currency measure was headed for its biggest drop in almost two months, while an index tracking equities sank the most in a week. The lira collapsed more than 11 percent on Friday and government bond yields jumped to an all-time high as traders waited to see if a speech by Turkish President Recep Tayyip Erdogan would slow the exodus. The currencies of eastern Europe were dragged lower as the euro weakened on a report that the European Central Bank was concerned about possible risks for banks.”

Bloomberg

Turkey’s $250B of US Dollar and Euro Denominated Debt is Coming Home to Roost
Europe is facing BOTH US sanctions and tariffs on their major trading partners (China, Turkey, and Russia).  Above all, Europe’s banks are holding the bag – that’s the problem.  Here are the bag holders.  As of Q1 2018 Spanish bank exposure to Turkey 82.3bn dollars, France 38.4, UK 19.2, US 18, Germany 17.1 Italy 16.9 Japan 14. Switzerland 6.3 Canada 1.2 Austria 1.1. Portugal 0.3.  Turkey’s Lira touched a record low of 7.23/USD, the Argentina peso and Brazil’s real reached their weakest point in a month, while the Russian ruble plunged to its lowest level in two years – DEFAULT risk is RISING fast.

Turkey / Italy Bond Connection
There’s clearly a flight to quality into German bunds, more disturbing is the price action in Italy’s yields moving higher on the heels of Turkish drama.  Yields on two-year securities climbed to the highest levels in more than a week as stocks worldwide declined following a 29 percent tumble in Turkey’s lira this month.  Bloomberg noted the Italian 10-year spread over German bunds hit the highest since May.  Deputy Prime Minister Luigi Di Maio was reported as saying in an interview Monday that his country won’t be subject to an attack by speculators.

Dear Mr. Draghi, Take Notice
Foreign banks in Turkey are exposed to the local government debt for $120 billion: French and English banks are first in line, with $40.4 and $23.9 billion respectively. – BIS Data.  At the same time, momentum is building in the US Senate for additional sanctions punishing Russia for election-meddling. The run-up to the U.S. midterms in November is a critical period for U.S.-Russian economic relations.  There’s clearly a Euro impact here.  Not to mention Germany’s largest trading partner in China facing tariff risk.

Global Equities: The World’s Trading Partners are in Some Pain
Too many investors are hiding out in US equities.  Tariffs on China, US sanctions on Turkey and Russia – that’s over $15T of global GDP under substantial stress.   It would be nice if the US equity market was on an island, protected from the global economy – but that’s not the case.  Turkey’s exports to Russia soared 52.5% last year, up to nearly 6% of GDP.  As a result, US sanctions on Russia just add to the Turkish economic dilemma, it brings DOUBLE trouble default risk.  US Russia sanctions + Turkey Sanctions = Rising Credit Risk.

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The Dark Side of FAANGs, Crash Warning at DEFCON One

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This blog was published on July 20th, on July 26th Facebook plunged 22% on record volume, $120B was wiped out in one day – the largest single stock incident of wealth destruction on record.

Market breadth — “a method used in technical analysis tries to determine the direction of the market. Positive market breadth occurs when more stocks are advancing than are declining and suggests that the bulls are in control of the market’s momentum. Conversely, a disproportional number of declining securities is used to confirm bearish momentum.”

-Investopedia

“If I could avoid a single stock, it would be the hottest stock in the hottest sector”

Peter Lynch, Portfolio Manager of the Fidelity Magellan Fund 1977-1990

The Fab Five: FAANGs Equities (Facebook, Apple, Amazon, Netflix, and Google)

One of the golden rules of market analysis is found in true underlying breadth.  Looking at U.S. equities today, there’s burning question; how many stocks have really been invited to this party? Every day we hear about markets hitting new highs, despite the fact that the S&P has been wrapped around 2800 since January.   Above all, beneath the surface, there’s something far more disturbing.  Our Index of 21 Lehman Systemic Risk Indicators has risen to its HIGHEST level since the summer of 2015.

Enjoy our segment on CNBC with an analysis of the FAANGs.

S&P 500 Index Price

July 20: 2800
June 13: 2800
Mar 13: 2800
Jan 16: 2800

Bloomberg terminal data

The Fatal Passive Overdose, BEWARE!

Since 1993, capital shifting into passive asset management is up 161x, this compares to only 7x for active management.  Nearly $7T is now positioned in passive asset management, over $2T of this money has arrived in the last five years.  Why does this matter?  Passive asset management is simple ownership of the market through index funds, the capital MUST be fully invested and has been the fuel behind the toxic run-up in FAANG equities.  Let us explain.

One Large Beast

Looking at the passive asset management orgy, there’s no better example than the Fidelity Magellan Fund.  Famously known as the largest mutual fund on earth in the 90s, what became of this beast is nothing short of remarkable.   With assets north of $100B back in the year 2000, today he sits as just a shell of his former at $17B.  The most shocking part of this story is found in the explosive asset formation in Fidelity’s S&P 500 (Passive) Index Fund.  Assets in this giant have climbed to more than $153B, with $21B forced into  FAANG equity ownership.  As a market-weighted, passive index fund there is no choice or selection process, this beast MUST own these FAANGs – a colossal failure of common sense indeed.  It’s NOT Fidelity’s fault, they’re just offering another index fund the mad mob wants to invest in.  This is just another example of a classic, late-cycle development often found in tired bull markets – the hot money chase indeed.  As more and more capital flows into passive index funds, more and more FAANG shares MUST be owned.  Returns appear far better than the rest of the market’s offerings, so even more capital flows in – it’s a toxic, self-fulfilling cycle – when broken the declines will be HISTORIC.

Largest Weekly Fund Capital flows into Technology Equities All-Time

Jan 2018: $2.4B
May 2018: $2.2B
Dec 2017: $1.9B
Nov 2017: $1.2B
Nov 2016: $1.0B
Jan 2012: $900m

EPFR data

While FAANGs Boom, the Rest of the Market is Left BehindIn early June, the number of NYSE stocks at their 52-week highs started to move sharply lower, breaking the trend (see above) with the price of the FAANGs equities (Facebook, Apple, Amazon, Netflix, and Google).  Since January, while Netflix and Amazon have gone up 67% and 38% respectively, while the number of NYSE stocks at their 52-week highs has declined from 341 to 177 in June – to now just 71!  Bottom line, the divergence between the few (just 5 stocks) FAANG equities, and all the rest of the market presents a crystal clear example of negative breadth. This growing disparity in the markets extends to real economic terms as well.

Profits in the Hands of the Few

According to an analysis conducted by the Wall St. Journal, in 1978 the percentage of profits coming from America’s 100 largest companies was near 46%, today we’re approaching 85%!  The inequality decade has some very ugly side effects, doesn’t she?  The clock is ticking here, G10 countries have VERY large aging populations.  Indeed there are some bills to pay.  In the U.S., Medicare will run out of money far sooner than most expected, and Social Security’s financial problems can’t be ignored either.  This month, the U.S. government said in a sobering checkup on programs vital to the middle class – Medicare’s available cash is dwindling at an alarming rate.   Per the LA Times, the report from the program trustees says Medicare will become insolvent in 2026 — three years earlier than previously forecast. Its giant trust fund for inpatient care won’t be able to fully cover projected medical bills starting at that point.  As populism continues to march forward, we expect the FAANGs to have a VERY large target on their back in the months and years to come.  Somebody has to pay for these mathematically unsustainable promises made by politicians, and we’re looking at you FAANGs.

Is that Your Fair Share Amazon?

Even with the dire straights of U.S. unfunded liabilities (Medicare, Medicaid, Social Security), only 12.9% of Amazon’s profits went to federal, state, local and foreign taxes from 2007 through 2015, per S&P Global Market Intelligence.  In ugly fashion, that’s half the average amount S&P 500 companies paid over the same period.  Look for populism’s surge to take a large bite out of Amazon in the near future.

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Jumping into Bed with a Greater Fool

At the very end of the day, an investment in FAANG equities today involves jumping into bed with the greater fool theory.   Sure, there’s always late cycle dumb money pushing prices higher, but 2018’s toxic ingredients have come together and forged an atrocious risk-reward in these overstuffed equities.

Wall St.’s Research, a Lesson in Crowded Trades

General George S. Patton once said, “if everyone is thinking alike, then SOMEONE isn’t thinking.”  Wall St.’s “brain trusts” have 182 buys on FAANG equities and just 7 sells, this gives a colossal failure of common sense new meaning.  Highly reminiscent of the late 1990s indeed.

Wall St.’s Change in 12 Month Price Target in 2018*

January vs. Today

Facebook $FB: $210 v $228
Amazon $AMZN: $1305 v $1930
Apple $AAPL: $189 v $199
Netflix $NFLX: $212 v $371
Goole $GOOGL: $1180 v $1270

*Consensus of over 35 analysts, Bloomberg data.  One of the biggest problems with Wall St. equity research is found in their favorite past time, performance chasing.  In terms of job security, they believe there is safety in numbers.  As a result, the sheep move in lockstep together.  Analysts tend to move up their price targets as the bull market picks up steam.  At the end of the day, often times the little guy is left holding the bag as price targets rise, and rise again.  More and more of the crowd gets sucked in at higher prices.  There’s little focus on risk-reward at nosebleed price levels.

Wall St., A Love Affair with the Few

“The market cap of the five biggest stocks in the S&P 500 is now almost exactly equal to the market cap of the smallest 282 S&P 500 companies. Both come to just under $5.1tn. Today’s chart of the day shows that a six-member FAANMG sector (FAANGs + Microsoft) would at this point be comfortably bigger than any of the 11 economic sectors into which the S&P is divided.”

-Financial Times

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FAANGs Crushing the Rest of the S&P 500

This speaks to fleeting market leadership and above all, a very unattractive risk/reward facing investors today. We’re talking about an indicator of market health here and for right now, even with all the glorious headlines, we’re looking at a sick patient.

In our view, the FAANG stocks are massively overvalued and thus ripe for a massive roll-over.  before year-end in our view.  Even a relatively minor downturn in the market as a whole could wreak havoc on the FAANGs.  And as stated earlier, the disproportionally high number of equities declining in price is hidden by the FAANGs.  What’s worse is that such a rollover would have massive implications for some of the market’s largest asset management firms.

Inflows of into Passive Management Funds and ETFs (Exchange-traded-funds)

There are 605 ETFs which hold FAANG equities as a top 15% position in the fund!!!!  This has to be the most crowded trade in the history of financial markets – just five stocks make up most of the ETF universe, lookout!

ETF Ownership of FAANG Equities

2018: 605
2017: 501
2016: 430
2015: 332
2014: 277
2013; 230
2012: 175
2011: 101
2010: 62
2009: 14
2008: 9

Just five stocks as a top 15 holding in 605 ETFs, think about that… ETFDB data

 In January Alone – Passive Asset Management Inflows
2018: $105B
2017: $68B
2016: $18B
2015: $22B
Each month as capital flows in, FAANGs must be purchased.
Dislocated from Reality

Around 20 years ago, nearly all of asset management was active. Fund managers would buy and sell equities using personal judgment and research.  In the last five years, trillions have flown into passive management, where managers place funds into market-cap-weighted ETFs and indices in an attempt to capture the momentum of the market, without doing research. While equally-weighted indices own all stock equally, market cap weighted-funds are more heavily weighted to larger-cap stocks (S&P (passive) Index Funds, for instance, are heavily weighted to FAANG stocks.  A closer look shows; 3.8% Apple, 3.1% Amazon, 3.1% Google A 3%, Google C 3%, 2% Facebook and nearly 1% Netflix.  That’s 16% of the index in just five stocks). Thus, the rise in passive management has made FAANG stocks more dislocated from reality, as passively-managed funds are disproportionately forced to own them. Thus, the explosion of capital into passive funds has been forcing more and more capital into fewer and fewer stocks.  This will end in tears – SELL Mortimer SELL!

Facebook’s Largest Holders
Vanguard 170m shares
BlackRock 147m shares
Fidelity 122m shares
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UK Political Risk: Points to a May Summer Exit

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Resignations in May’s Cabinet will Topple Government in Our View

This weekend was punctuated by news of major resignations from within British Prime Minister Theresa May’s cabinet by Secretary of State David Davis and Foreign Secretary Boris Johnson. These came in response to Friday’s controversial “Chequers Agreement,” which many pro-Brexit figures saw as a betrayal and an arrangement that kept the UK far too close to the EU and its regulatory power.

Bearish Bets on the Pound Mounting
Net shorts are piling in, bets against Sterling on the rise.

Elections in the Offing?

This strong rebuke from two high-profile members of the “Leave” camp demonstrates in the strongest possible manner a continued dissatisfaction amongst more hard-line Conservative MP’s on the Prime Minister’s handling of Brexit. We believe this also foreshadows a “no confidence” vote within the next three months, the removal of Theresa May from office, and potentially a new round of General Elections.

Theresa May Exit Date Odds:
Betfair: 1/1 (by Sep. 2018)
SkyBet: 10/11 (by end 2018)
Ladbrokes: 4/6 (by end 2018)
Coral: 4/6 (by end 2018)
$markets: 5/6 (by end 2018)

“The betting on her exit date has moved very sharply from a 26% chance on Betfair [Sunday] morning that she’d be out this year to a 55% chance now [on Monday].” -politicalbetting.com

UK General Election in 2018 Odds:
Betfair: 6/4
SkyBet: 13/8
Ladbrokes: 7/4
Coral: 7/4
$markets: 23/10

Pound Breaks its Recent Trend
We take a negative view on the GBP and UK Equity for the next six months. The Pound (GBP) has taken a significant hit recently on the back of uncertainty regarding the status of negotiations on the EU-UK post-Brexit agreement. The increased risk of a domestic government meltdown and a May exit will only serve to further compound this bearish trend.

No Confidence

A “no confidence” vote in the House of Commons from May’s own Conservative MP’s will have a substantial market impact, as it would hint toward a “harder,” more pro-Brexit successor. Such a person would almost certainly be more opposed to the UK remaining in the EU common market, causing even greater upset to the UK market due to greater trade worries.

If the Conservative Party (Tories) is unable to agree on a pick for Prime Minister following a successful “no confidence” vote, general elections will follow. We determine that the risk of a Labour victory will weigh on UK Equities and the Pound in such a scenario, as a government under big-government, high-tax Labour leader Jeremy Corbyn would prove unfavorable for markets. Such a scenario could also imperil the current state of affairs when it comes to Brexit negotiations, with substantial market impact.

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