EM, HEDGE FUNDS AND CORPORATE DEBT / PRUDENTBEAR.COM

EM, Hedge Funds and Corporate Debt

by Doug Noland

February 7, 2014


A particularly unsettled week for U.S. and global markets. Global markets have turned highly unsettled. The S&P500 opened the week at about 1,783, sank to an intraday low of 1,738 on Wednesday before rallying to close the week at 1,797. The Goldman Sachs Most Short index sank 4.0% Monday, was little changed Tuesday, fell 1.6% Wednesday, jumped 1.7% Thursday and then surged 3.3% Friday. High-profile hedge fund short positions have turned wildly volatile. Green Mountain Coffee surged 33.0% this week.

Currency markets have turned treacherous. Those short the commodity currencies abruptly found themselves on the wrong side of a squeeze. The New Zealand dollar gained 2.6% this week, with the Australian dollar up 2.3%. Some EM currencies enjoyed strong weekly gains. The Polish zloty increased 3.0%, the Turkish lira 1.7%, the Hungarian forint 2.6%, the Argentine peso 2.3%, the Brazilian real 1.4%, the Russian ruble 1.1% and the Czech koruna 1.1%.

Overall, global markets these days convulse between “risk off” and “risk on” – in bloody trench warfare between market bulls and bears. Greed and fear vacillate between the two camps. The yen weakened only modestly this week, and EM equities were generally unimpressive. EM bonds for the most part held their own. Mexico’s sovereign debt rating was upgraded, which lent some support to the sector.

Bill Gross’ February piece, “Most ‘Medieval’”, provides an insightful read. He focused on a focal point of my analytical framework: “Asset prices are dependent on credit expansion or in some cases credit contraction, and as credit goes, so go the markets, one might legitimately say, and I do most emphatically say that!” “Credit creation or credit destruction is really the fundamental force that changes P/Es, risk premiums, natural interest rates, etc.” As part of his concluding comments, Gross added: “The days of getting rich quickly are over, and the days of getting rich slowly may be as well.”

It’s my view that we have reached – or, perhaps, are approaching – a historic inflection point in global Credit. Credit has tightened meaningfully in segments of China’s finance, as well as throughout EM more broadly. Yet rapid Chinese Credit growth has thus far been sustained, though the expansion is notably unbalanced and vulnerable. This has negative implications for global economic performance, as well as global securities and asset prices. But the timing of a significant Chinese Credit slowdown remains unclear.

Most analysts are quick to dismiss U.S. susceptibility to EM woes. Such complacency, while handsomely rewarded over recent years, could this time prove a major mistake. For one, I would view current EM instabilities as a major crack in what evolved over years into historic global financial and economic Bubbles. EM is global “subprime.”

In the post-2008 crisis landscape, EM economies did indeed assume the role of “global locomotive.” Less appreciated, China and EM Credit systems grew to become responsible for much of global Credit growth. Many of the major EM Credit systems experienced in the neighborhood of 20% compounded annual Credit expansion over the past five years. Emblematic, total annual Chinese Credit growth exploded and approached $3.0 TN in 2013, the greatest expansion ever experienced by an individual economy.

While astonishing amounts of new Credit inflated and distorted real economies, there is the less transparent – yet absolutely critical - issue of financial leverage. With the Fed, Japanese and other “developed” central banks engaged in unprecedented “printing” and devaluation measures, EM markets were the focal point of the expansive “hot money” financed “global reflation trade.” Unknown amounts of speculative leverage were employed in myriad “carry trades” and other speculations to capitalize on borrowing cheap in (depreciating) currencies to speculate in higher returning EM securities. There was as well unprecedented investment into EM economies and markets, pushing overall financial flows to the several Trillions.

The key point is that one should not today in anyway downplay the ramifications of bursting EM Bubbles and associated de-leveraging. There will be major unfolding consequences on global Credit growth, pricing dynamics, financial flows, speculative finance, Credit availability and economic performance. This process has commenced, although the pace of initial developments has been generally held in check by the ongoing rapid expansion of Chinese Credit coupled with Fed and BOJ quantitative easing measures.

“Is Tapering Tightening?” has become topical. From the perspective of my analytical framework, of course it’s tightening. No question about it; silly to think otherwise. The risk of leveraging in the marginal global securities markets and economies (EM) has increased; market behavior has begun to adjust; and financial conditions have started to tighten at the margin.

Since August of 2008, the Fed’s balance sheet has inflated from about $900bn to $4.1 TN. In just the past 14 months, Fed holdings have jumped $1.25 TN. It’s simply implausible that the Fed winding down such aggressive monetary inflation won’t have major impacts on U.S. and global market liquidity dynamics. After all, the “periphery” is already being pressured by the altered liquidity backdrop. While the timing and dynamics involved remain uncertain, I fully expect risk aversion and de-leveraging “contagion” to over time gravitate to the “core.”

The global “leveraged speculating community” could provide the most direct transmission mechanism from EM tumult to U.S. securities markets. As the leveraged players get caught in faltering global markets, their reduced risk appetite will impinge liquidity in U.S. and other markets. But with still significant Fed and BOJ QE, there remains the prevailing 2013 “trouble at the periphery stokes flows to the core” dynamic shaping market trading.

There are as well powerful speculative Bubble Dynamics that tend to disregard fundamental deterioration for a time. Short squeezes and the unwind of hedges also tend to incite “bear market rallies” readily interpreted as bullish market signals. So there are today powerful market crosscurrents. Over time, however, I would expect these forces to wane as the more typical “periphery to core” dynamic gathers momentum.

There is a potentially momentous development now taking shape out on the horizon. For more than 20 years, the leveraged players have operated with confidence that huge balance sheets were readily available to backstop market liquidity. GSE holdings expanded rapidly to initially accommodate speculative deleveraging back during the 1994 bursting of the bond/MBS/derivatives Bubble. The GSEs came to the markets’ defense again in 1998, 2000, 2001, and 2002. The Fed’s balance sheet then took over as marketplace backstop in 2008, 2009, 2011 and 2013.

If the Fed now holds true to its stated intention of winding down its balance sheet expansion, the marketplace in coming months will grapple with the possibility that financial markets for the first time in two decades must operate without a reliable liquidity backstop. Such an altered backdrop would imply a reduced appetite for risk and leverage, with rising risk premiums, lower asset prices, slower Credit growth and heightened economic risk. 

Corporate debt could prove particularly susceptible. Leveraged holdings would be vulnerable to increasing Credit risk as well as widening spreads versus perceived safe haven Treasury and other government debt.

The hedge fund industry has enjoyed an incredible 20-year run. GSE and Federal Reserve market liquidity backstops were integral to “The days of getting rich quickly.” Billionaire “traders” sprang up like never before. The inflating “leveraged speculating community” came to play an integral role in ensuring seemingly limitless marketplace liquidity, in the process bolstering Credit Availability more generally. Ultra-loose financial market conditions were instrumental in boosting overall system Credit growth. Federal Reserve rate and balance sheet policies in concert with the leveraged players amounted to history’s most powerful monetary policy transfer mechanism.

Over recent years, the greatest market excesses unfolded in equities and corporate debt. They’ve fed on each other in an interrelated market mispricing/speculative Bubble. During 2013, in particular, QE-induced market excess gravitated to U.S. stocks and higher-yielding corporate Credits (i.e. bonds and leveraged loans). I have posited that 2013 QE operations were especially dangerous. Risk premiums generally collapsed to 2007 levels, as the gulf between inflated securities prices and deteriorating fundamental prospects widened fatefully. This chasm becomes problematic when Credit growth slows.

Over five Trillion of corporate debt has been issued since the 2008 crisis. Fed and central bank operations pushed down global yields and crushed risk premiums. I would argue that Trillions of corporate debt these days trade with varying degrees of inflated market valuation. Importantly, central bank liquidity was much more successful in terms of inflating securities prices than in inflating a general increase in global price levels. Now, with EM financial and economic Bubbles faltering, global disinflationary risks are mounting. This creates major risks to global profits and growth dynamics, risks that remain largely latent until Credit growth wanes.

The corporate debt market would now appear unusually vulnerable. I suspect large amounts of speculative leverage have accumulated over recent years throughout the corporate debt marketplace. If true, this only adds to potential debt market fragility.

February 5 – Bloomberg (Jody Shenn): “Freddie Mac may boost how much it pays bond investors to share the risk of homeowner defaults as the government-controlled mortgage-finance company plans its biggest offering of such debt, according to a person with knowledge of the deal. A $360 million portion of the transaction expected to be graded Baa1 by Moody’s may yield about 2 percentage points more than a borrowing benchmark, said the person… That compares with a spread of 1.45 percentage points on $245 million of similar securities that were part of a $630 million deal in November.”

Thus far, Credit spreads have widened only modestly from depressed late-2013 levels. Hedge funds are clearly big operators in GSE securities markets. They are expected to be big buyers in the upcoming Puerto Rico debt offering (see Fixed Income Bubble Watch). Hedge funds are commonly mentioned as major players in ABS, MBS, CMBS, CMOs, CLOs, leveraged loans, etc. Hedge funds and mutual funds have become aggressive operators in the booming market in “alternative” Credit funds that garner significant returns from “structured products” (including myriad trading and derivative strategies that involve variations of writing Credit insurance). Any forced retreat by the hedge funds would have wide market implications.

I can easily envisage a scenario of rapidly slowing global Credit growth. It’s difficult to see a case for accelerating U.S. Credit growth. Seeing eye to eye with Bill Gross, as goes Credit growth so go the markets. Granted, Fed “money” printing has since the 2008 crisis largely abrogated this fundamental relationship. The upshot has been rapid expansion of mispriced corporate debt and equities securities, along with untold speculative leveraging. 

There are fragilities associated with major Bubbles inflating in the face of a deteriorating – increasingly disinflationary - global backdrop. This could prove a volatile mix in a world of faltering EM, de-risking/de-leveraging, waning market liquidity and mounting global downside risks.