SERIAL BOOMS AND BUSTS / PRUDENTBEAR.COM

Serial Booms and Busts

by Doug Noland

May 2, 2014


How long can the markets ignore Ukraine, Russia and China? After beginning 1987 near 104, the U.S. dollar index dropped almost 10% in nine months. From 7.5% in late-March 1987, 30-year Treasury yields surged more than 270 bps in seven months to trade as high as 10.22% in early October. During this period of currency and bond market instability, stocks set off on a fateful speculative run. At record highs in late-August 1987, the S&P500 enjoyed a year-to-date gain of 39%. This spectacular rise was more than wiped out over a two-week self-off that culminated on “Black Monday,” October 19, 1987.

Back in 1998, an increasingly exuberant U.S. equities marketplace was happy to ignore mounting risk of a Russian collapse (“The West will never allow Russia to collapse”). From January ’98 lows, the S&P500 rallied 30% by early-August to a new record high. Completely ignoring the unfolding crisis, the U.S. bank index (BKX) rallied 40% off of January lows to trade at a record high on July 17, 1998. But as the Russian and LTCM crisis erupted, the bank index fell 43% from July highs to October 8, 1998 lows.

From the October 1998 low to the end of 1999, Nasdaq surged 200%. And after ending ’99 at 4,069 – and in the face of conspicuous Bubble excess coupled with rapidly deteriorating industry fundamentals – Nasdaq disregarded reality to trade to its still all-time high of 5,132 on March 10, 2000. From its record high, panic and collapse ensued as Nasdaq lost half its value by year-end.

Major cracks (subprime) erupted in the mortgage finance Bubble in the early-spring of 2007. Stocks suffered from heightened volatility, including meaningful self-offs in the spring and summer. Still, the S&P500 mustered a double-digit year-to-date gain and record highs by mid-October 2007. Stocks rallied back after the failure of Bear Stearns and had posted only modest year-to-date declines by mid-2008. Only a few short months later, all bloody financial market hell broke loose.

Markets are fascinating creatures. Speculative marketplaces, if not suppressed, inherently regress into wild animals. And over the years I’ve drawn an analogy between speculative Bubbles (“bull markets”) and bull fights. After the bull is penetrated by that first sword, the eventual outcome is in little doubt. Yet before succumbing he’s going to turn crazy wild and inflict as much damage as possible.

The concept of “terminal phase” excess plays prominently in my Macro Credit Analytical Framework. From a monetary standpoint, things just really run amuck at the end of long Credit cycles. The growth of Credit surges uncontrollably, while quality rapidly deteriorates. Even as problems begin to surface, the massive financial infrastructure that built up during the long boom gets stuck in overdrive. This ensures that too much “money” whimsically rides roughshod through the financial and economic systems.

To be sure, a hypothetical chart of systemic risk spikes higher. Short-term, the surge in unstable finance fuels asset price inflation, speculation and manic behavior, while dulling the senses to important fundamental developments. The market discounting mechanism malfunctions. Speculative blow-offs tend to be at least partially fueled by short squeezes (short positioning driven by worsening fundamentals), while rampant monetary expansion (including speculative leveraging) covertly exacerbates systemic dependency to readily abundant liquidity. From a monetary standpoint, I believe these dynamics help explain why markets notoriously turn highly unstable near the end of the cycle – with a propensity for destabilizing blow-off tops soon followed by collapses.

With this as the backdrop, first to China. The historic Chinese Credit Bubble has followed a troubling course. In the face of rapidly deteriorating fundamental prospects, overall Credit growth expanded at a record pace throughout 2013 (and into early-2014). In particular, mortgage-related Credit continued to expand rapidly despite weakening growth and heightened financial stress. As it turned out, the apartment Bubble’s “terminal phase” was extended. From a systemic standpoint, the ongoing rapid growth in real estate-related Credit took on added significance in the face of tightening Credit for corporations and troubled local governments. I’ve been monitoring for signs of an end to apartment price inflation – and with it a downturn in transactions. From my framework, this would mark an important juncture for Chinese Credit and economic Bubbles.

May 1 – Financial Times (Simon Rabinovitch): “The biggest concerns are focused on property, a sector that fuelled nearly a quarter of the country’s growth last year, according to Moody’s. Sales have slowed sharply just as a large supply of new homes has come on to the market. In the first three weeks of April, sales volumes in China’s 40 top cities were down 24% year on year, according to Soufun, a property information company. ‘We do not believe that economic conditions have stabilised. The biggest direct pressure on the economy is coming from the property market,’ analysts with CEBM, a Shanghai-based advisory, wrote… ‘Even big developers have started cutting housing prices by about 10-15%, and price cuts in the primary (new) home market have led to a clear worsening of the secondary housing market.”

April 30 – Dow Jones (Esther Fung): “China’s housing market saw slower growth in April as new data indicated that more cities are experiencing price declines and weaker sales, prompting some local authorities to loosen regulations originally aimed at curbing overheated property sales. Average new home prices rose 9.1% in April from a year earlier, decelerating for the fourth straight month after March’s 10.0% rise and February's 10.8% gain… Sales remained sluggish in April after a 7.7% decline in the first quarter, analysts said, as home buyer interest waned amid expectations of further price cuts and more hurdles getting mortgages as banks tighten lending requirements in the face of credit concerns and slower growth. China's property market accounted for about 23% of China’s gross domestic product last year…”

May 2- UK Telegraph (Ambrose Evans-Pritchard): “So now we know what China’s biggest property developer really thinks about the Chinese housing boom. A leaked recording of dinner speech by Vanke Group’s vice-chairman Mao Daqing more or less confirms what the bears have been saying for months. It is a dangerous bubble, and already deflating. Prices in Beijing and Shanghai have reached the same extremes seen in Tokyo just before the Nikkei boom turned to bust, when the (quite small) Imperial Palace grounds were in theory worth more than California, and the British Embassy grounds (legacy of a good bet in the 19th Century) were worth as much as Wales… The numbers of flats and houses for sale has suddenly doubled. ‘Many owners are trying to get rid of high-priced houses as soon as possible, even at the cost of deep discounts. As a result, ordinary people who want to sell homes in the secondary market must face deep price cuts,’ he said.”

When it comes to Credit Bubbles, I subscribe to a few basic tenets. These include: “They tend to go to unimaginable extremes – then double!” Collapse is unavoidable once Bubbles succumb to “terminal phase” excess. The more protracted the “terminal phase” the greater the impairment to the financial system and economic structure – and the more painful the inevitable bust. And while analysts of Bubbles are invariably viewed as “extremists,” in the end things are always worse than even the Bubble analysts had suspected.

With the above in mind, it would appear the unfolding Chinese boom turned bust may be approaching a critical juncture. Thus far, overall very strong Credit growth has been sustained. Sinking apartment prices, a change in market psychology and a resulting slowing in sales volumes would lead to an abrupt downturn in new mortgage Credit. A more general slowdown in system Credit growth would surely expose myriad problems (“When the tide goes out…”).

May 2 – Wall Street Journal (Lingling Wei and Dinny McMahon): “With credit tight in China, companies in industries beset by overcapacity are turning to an unconventional source for cash—other companies—in a new rising risk for the country's financial system. These company-to-company loans, known as entrusted lending, have emerged as the fastest-growing part of China’s shadow-banking system… Net outstanding entrusted loans increased by 715.3 billion yuan ($115.4bn) in the first three months of 2014 from a year earlier… The increase in entrusted loans last year was equivalent to nearly 30% of local-currency loans issued by banks—almost double the portion in 2012… Officials at the People’s Bank of China, the central bank, have warned that much of the intercompany lending is flowing to sectors where the regulators have urged banks to reduce lending: the property market, infrastructure and other areas burdened by excess capacity. In central Shanxi province, 56% of entrusted loans in the past few years have gone to power producers, coking companies and steelmakers, among others, according to a recent paper by Yan Jingwen, an economist at the PBOC… In an analysis for The Wall Street Journal, ChinaScope Financial, a data provider partly owned by Moody’s…, found that 10 publicly traded Chinese banks disclosed that the value of entrusted loans facilitated by them reached 3.7 trillion yuan last year, up 46% from the previous year. Compared with 2011, the amount was more than two-thirds higher.”

May 2 – Wall Street Journal (Kate O-Keeffe): “The disappearance of a Macau junket figure believed to owe up to 10 billion Hong Kong dollars ($1.3bn) is roiling the world’s largest casino market and putting a spotlight on the opaque network of middle men who drive nearly two-thirds of the Chinese territory’s gambling revenue. Unlike other gambling hubs like Las Vegas, Macau depends on junkets for many of its customers. These companies bring high-spending gamblers to the casinos from mainland China, issue them credit and collect players' debts in exchange for commissions. The system took root there because the Chinese government imposes restrictions on how much cash its citizens can take out of the mainland and because gambling debts aren't considered valid inside China.”

Shifting the analysis back closer to home, economic data this week were notably mixed. The initial estimate of Q1 GDP was a dismal annual 0.1%. And while weather had an impact, the bottom line is that relative to $1 TN of annual QE, surging stock prices, inflating real estate and asset prices, record household “wealth” and some of the loosest financial conditions imaginable – the economy performed miserably. At the same time, it’s good to see the job market improve. But considering the ongoing strong pace of corporate borrowings, the overall lack of employment growth remains ominous.

Throughout the financial markets, Bubble excess seems to turn more conspicuous by the week. From star hedge fund manager David Einhorn: “There is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it.” Obvious Bubble excess in the Credit market also garners increased attention. Bloomberg quoted Apollo Global Management co-founder Marc Rowan from this week’s Milken Institute Global Conference: “All the danger signs are there of a future crisis. We’re back to doing exactly the same things that were done in the credit markets during the crisis.”

It’s been my view that a going on six-year old “global government finance Bubble” last year suffered its first subprime-like cracks (EM and China). It’s worth recalling Citigroup CEO Chuck Prince’s infamous quote from July 2007 (via the FT): “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Why was Mr. Prince - and about everyone else - still dancing in the summer of 2007 – when it seemed rather clear the environment was in the process of changing? Because there was so much money to be made. Because the cautious were being left in the dust. Because it seemed irrational not to be participating in one of the most lucrative financial backdrops ever. Because not participating in the industry boom was career jeopardizing. Because, as Keynes noted a long time ago, if you’re going to be wrong you’d better be wrong right along with the group. The exuberant Crowd had convinced themselves that the Fed had everything under control (“Would never allow a housing bust!”)

I see ample ongoing confirmation of the “Granddaddy of all Bubbles” thesis. The stock market is reminiscent of 1999 – except today’s excesses are more broadly based (and the risks much greater!). Credit market excesses recall 2007, with record leveraged lending fueling record M&A. In total, financial asset prices have inflated to unprecedented levels – in nominal terms and as a percentage of GDP. Globally, record low bond yields in Italy and Spain are indicative of a historic Bubble in European debt and financial assets more generally. Reckless Japanese monetary inflation has made an absolute mess out of Japanese stock and bond markets. Throughout EM, I see financial asset prices that in no way reflect the huge risks overhanging vulnerable Credit systems and real economies. I believe China is an unfolding financial disaster with history’s most maladjusted economic structure. Throughout Asia, massive overcapacity portends trouble for financial assets.

But with central banks still pumping and speculators still leveraging, the mirage of unending cheap liquidity (and central bank backstops!) ensures everyone buoyantly dances the night away. I’m convinced that the ’08/‘09 crisis would have been less damaging had markets begun discounting the changing environment back when subprime first faltered in early-2007. Instead, Fed accommodation spurred another year of “terminal phase” excess and attendant distortions.

These days, “accommodation” doesn’t do justice to ongoing unprecedented monetary stimulus, which ensures that manic equities and Credit markets completely disregard major fundamental changes in the global landscape. China doesn’t matter. Ukraine and Russia don’t matter. A conspicuously underperforming U.S. economy doesn’t matter. The approaching end to QE doesn’t matter. An alarmingly deteriorating geopolitical environment doesn’t matter. As they say, “It doesn’t matter until it does.” Yet, through it all, don’t lose track of an important fact: They all matter – and together they will matter a great deal.