2014 vs. 2007
by Doug Noland
July 11, 2014
Action at the "periphery of the periphery." “The job of an economist, among many other duties, is to put things into perspective. So, because I am an economist, among other duties, here is a little perspective on the recent turmoil in the stock and bond markets. First, when the story of this turbulence is reported, the usual explanation mainly has to do with some new loss in the subprime mortgage world. Here is the first instance in which proportion tells us that something is out of whack: The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14% is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5% is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion… The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger… This economy is extremely strong. Profits are superb. The world economy is exploding with growth. To be sure, terrible problems lurk in the future: a slow-motion dollar crisis, huge Medicare deficits and energy shortages. But for now, the sell-off seems extreme, not to say nutty. Some smart, brave people will make a fortune buying in these days, and then we’ll all wonder what the scare was about.” Ben Stein, “Chicken Little’s Brethren, on the Trading Floor,” New York Times, August 12, 2007
I couldn’t help but to recall Ben Stein’s summer 2007 article, as pundits were this week dismissing that tiny little Portugal could have any bearing on the juggernaut U.S. economy and booming financial markets. And thinking back to August ’07, Mr. Stein looked pretty smart for a while, with stocks rallying back from that month’s selloff to post all-time highs in mid-October. On the surface, things did look pretty good – “This economy is extremely strong. Profits are superb. The world economy is exploding with growth.” Unappreciated back then was the acute fragility inherent to massive quantities of mispriced finance and speculative leverage. So flawed was market faith that Washington would never tolerate a general housing downturn.
From my perspective, 2014 and 2007 share troubling similarities. Both periods feature overheated securities markets, replete with the rapid issuance of securities at inflated valuations. Both are characterized by investor exuberance in the face of deteriorating fundamentals – and in both cases central bank policymaking was fundamental to heavily distorted market risk perceptions. It’s no coincidence that today’s overheated backdrop – record securities issuance and meager risk premiums/record high prices – readily garner statistical comparison to 2007.
This year’s booming M&A market has posted the strongest activity since 2007. Second quarter global M&A volume of $1.06 TN was up 72% from the year ago period. Here at home, M&A more than doubled year-on-year to $473 billion, pushing record first-half volume to $749 billion.
The proliferation of deals was fueled by the loosest Credit conditions in years. First-half global corporate bond issuance hit an all-time high $2.29 TN. A record $286 billion of junk bonds were issued globally, as average junk yields traded to the lowest level ever. At $642 billion, first-half U.S. investment-grade company bond sales easily posted an all-time high. The first six months of 2014 also saw record issuance of collateralized loan obligations (CLOs). A record number of global IPOs were sold in the first half, with $90.6 billion of offerings 54% above comparable 2013. Led by technology and biotechnology issues, U.S. IPO sales enjoyed the strongest first-half since the height of the technology bubble back in 2000. According to Dealogic, year-to-date total global sales of corporate stock and equity-linked securities reached an unmatched $510 billion, outpacing 2007’s record pace.
Various measures of market risk perceptions – from corporate risk premiums to the VIX equities volatility index – have this year sunk back to 2007 Credit Bubble heyday lows. Ominously reminiscent of the second-half of 2007, Treasury yields have unexpectedly turned lower in the face of overheated risk markets. I have posited that respective rate “conundrums” can both be at least partially explained by safe haven buying in anticipation of mounting market vulnerability. Recalling 2007, market exuberance is these days fueled by the perceptions of endless cheap liquidity and adroit policymakers with everything under control. Quite simply, it is taken as indisputable fact that global central bankers will not tolerate a return to financial crisis.
The major problem now midway through 2014 is that global central bankers do not have things under control. Yes, they can continue to aggressively create “money” and stoke runaway global securities booms. But this in no way helps to rectify structural economic impairment. In no way has rampant monetary inflation worked to correct global financial and economic imbalances. As such, central bank liquidity and market intrusion have set the stage for inevitable problematic market adjustments.
I certainly don’t believe Draghi’s “do whatever it takes” market intervention resolved Europe’s deep structural problems. I don’t even think it “bought time.” Loose “money” instead bought another Bubble. The Draghi ECB (in concert with the Bernanke Fed and Kuroda BOJ) forced sweeping short covering of bearish bets throughout Europe – and then incentivized leveraged speculation throughout the euro zone.
The resulting historic collapse in European periphery yields was nothing short of miraculous. Unfortunately, this market moonshot may have enriched the speculator community but it did little to ameliorate structural maladjustment. I suspect that when Bubble ebullience and greed subside, fear for the soundness of the European banking system could hastily reemerge. Indeed, the divergence between bubbling securities markets and poor economic prospects has created acute latent fragilities.
Fragilities erupted this week with issues in the Portuguese banking sector. Troubles at Banco Espirito Santo, one of Portugal’s largest banks, quickly spread throughout European equities and debt markets. Portugal’s PSI All-Share Index was slammed for 9.1%. Fears of a potential bank bailout pressured Portuguese sovereign bonds. Portugal 10-year yields jumped 28 bps this week.
Nervousness quickly spread throughout periphery markets. Spanish stocks were hit for 4.3%, with 10-year yields up nine bps. In Italy, stocks were slammed for 4.4%, as yields rose five bps. Greek 10-year yields jumped 33 bps. And with German 10-year bund yields sinking six bps to near 2012 lows, yield spreads (to bunds) widened meaningfully throughout Europe.
It’s also worth noting that the euro vs the yen this week traded to the lowest level since early-February, ending the week down 65 bps. So called “carry trades” – short bunds or the Japanese yen to finance higher-yielding peripheral bonds – suffered a rough week. And perhaps it was only a coincidence that commodities markets got walloped and Treasuries caught a strong bid.
A couple Bloomberg headlines were worth highlighting: “Espirito Santo Rocks Bonds from Sao Paulo to Rio” and “Complacency Disrupted by Portugal to Puerto Rico.” It may be early to get too excited about contagion effects. Yet the colossal global leveraged speculating community is a likely transmission mechanism from Portuguese debt to the world’s risk markets. Europe’s market Bubbles would appears at this point a high-risk proposition.
In the face of unprecedented monetary stimulus and surging securities markets, the continent’s economy will struggle to post positive growth this year. In particular, the second (France) and third (Italy) largest economies might actually contract, while the great German economic machine has begun to sputter. National government debt as a percent of GDP is approaching 100% in France and 135% in Italy. In Portugal, government debt of 130% is dwarfed by corporate debt at 250% of GDP. Portugal’s economy will likely contract again in 2014. It will post another large fiscal deficit, with a stubbornly high 15% unemployment rate. Bubbling securities markets have been masking a lot of economic, social and political angst throughout the continent.
From the perspective of my analytical framework, Portuguese markets reside at “the periphery of the periphery” – a marginal borrower susceptible to inflection points in the market backdrop for risk-taking and liquidity. So I’ll take this week’s developments seriously. There is the possibility that markets might now confront the initial onset of de-risking/de-leveraging dynamics.
Late-stage speculative Bubbles grow into wild animals. There is always a fine line between manic speculative blow-off excess and problematic cracks appearing in the underlying Bubble. As was certainly the case in early-2000 and late-2007, deteriorating fundamental prospects and resulting shorting (and hedging) provide combustible tinder for squeezes and destabilizing market advances. Moreover, upside market dislocations in the face of dimming fundamental prospects create divergences and latent fragilities.
I have argued that (reminiscent of 2007) we’re in the midst of an especially precarious environment. The now full-fledged Global Government Finance Bubble has spurred Bubble markets encompassing virtually all asset classes in markets all around the world. Many markets have succumbed to “blow-off” squeezes and excess – with religious zeal for the power of central bank liquidity. Risk markets have also become highly correlated.
I have argued that the next round of “risk off” will be problematic. The Fed is now only several months from ending liquidity-creating operations. If a bout of market turbulence forces the leveraged players to de-risk, it’s not clear who’s left to buy. Markets should not dismiss the global ramifications from Portuguese bank problems (or Puerto Rico debt issues).
Here at home, corporate debt spreads widened somewhat this week. More interestingly, spreads widened meaningfully for the Credit insurers. MBIA, Radian, Assured Guarantee and MGIC all saw debt spreads widen at least 30 bps. Fundamental issues are at work. There’s mounting nervousness for insurers of Puerto Rico debt, while proposed rules from the Federal Housing Finance Agency to boost the strength of the mortgage insures also weighed on the sector. Operating with extreme leverage to potential systemic Credit issues, I have always viewed the risk insurance industry as the “periphery of the periphery” of the U.S. Credit Bubble.
As an analyst of Bubbles, I appreciate that it is virtually impossible to predict the timing of their implosion. But that doesn’t dissuade me from diligently monitoring for “weak links” and potential catalysts. And like 2007, highly speculative markets fixate on fun and games and instant gratification, while steadfastly refusing to discount mounting systemic risk (in ebullient markets, it’s referred to as “resilient”). Thus far, markets have performed consistent with the “Granddaddy of all Bubbles” thesis.
Compared to 2007, today’s excesses are more extreme. U.S. equities have jumped from 2007’s $25.6 TN to today $34.5 TN. I have in previous CBBs highlighted that total marketable securities (debt & equities) surpassed $72 TN in Q1, up 36% from booming 2007. I would also contend that the global economy was in relatively much better shape in ‘07/'08. Europe is today much weaker and China is much more vulnerable. Emerging market economies and Credit systems, in particular, suffer from six years of unwieldy finance on an unprecedented scale. Today’s geopolitical mess makes 2007 look like outright peace, tranquility and global solidarity. And I would argue that the maladjusted U.S. economy is today more vulnerable to “risk off” securities market tumult than ever.
What really worries me is the huge growth since 2007 in trend-following and performance-chasing finance (i.e. the leveraged speculating community and the ETF industry). It’s this “Moneyness of Risk Assets” issue (see last week’s CBB). The world believes central banks will ensure ample marketplace liquidity – the never-ending bull market. In my eyes, it has all regressed to a precarious confidence game of epic proportions. And so long as speculative leverage increases and funds continue to flow freely into stocks and bonds, bullish perceptions of endless cheap liquidity and unending growth in corporate earnings (adjusted for stock buybacks, of course) endure.
Chair Yellen last week dazzled the bulls with simple dovishness. This week, regional Fed Presidents Esther George, Charles Plosser and James Bullard all suggested rate increases may be closer than the market today anticipates. Which brings to mind an important contrast to 2007: The entire committee was ready to fall in line behind Dr. Bernanke, as the learned professor formulated his response to the unfolding crisis. Today, the Fed has shot its bullets, while deep philosophical differences within the Fed will surely complicate its response to faltering market Bubbles. A lot of market misperceptions and misguided faith will be at risk come the next serious bout of “risk off.” I was almost expecting David Tepper to show up on CNBC this week and warn of another round of Nervous Time.
I couldn’t help but to recall Ben Stein’s summer 2007 article, as pundits were this week dismissing that tiny little Portugal could have any bearing on the juggernaut U.S. economy and booming financial markets. And thinking back to August ’07, Mr. Stein looked pretty smart for a while, with stocks rallying back from that month’s selloff to post all-time highs in mid-October. On the surface, things did look pretty good – “This economy is extremely strong. Profits are superb. The world economy is exploding with growth.” Unappreciated back then was the acute fragility inherent to massive quantities of mispriced finance and speculative leverage. So flawed was market faith that Washington would never tolerate a general housing downturn.
From my perspective, 2014 and 2007 share troubling similarities. Both periods feature overheated securities markets, replete with the rapid issuance of securities at inflated valuations. Both are characterized by investor exuberance in the face of deteriorating fundamentals – and in both cases central bank policymaking was fundamental to heavily distorted market risk perceptions. It’s no coincidence that today’s overheated backdrop – record securities issuance and meager risk premiums/record high prices – readily garner statistical comparison to 2007.
This year’s booming M&A market has posted the strongest activity since 2007. Second quarter global M&A volume of $1.06 TN was up 72% from the year ago period. Here at home, M&A more than doubled year-on-year to $473 billion, pushing record first-half volume to $749 billion.
The proliferation of deals was fueled by the loosest Credit conditions in years. First-half global corporate bond issuance hit an all-time high $2.29 TN. A record $286 billion of junk bonds were issued globally, as average junk yields traded to the lowest level ever. At $642 billion, first-half U.S. investment-grade company bond sales easily posted an all-time high. The first six months of 2014 also saw record issuance of collateralized loan obligations (CLOs). A record number of global IPOs were sold in the first half, with $90.6 billion of offerings 54% above comparable 2013. Led by technology and biotechnology issues, U.S. IPO sales enjoyed the strongest first-half since the height of the technology bubble back in 2000. According to Dealogic, year-to-date total global sales of corporate stock and equity-linked securities reached an unmatched $510 billion, outpacing 2007’s record pace.
Various measures of market risk perceptions – from corporate risk premiums to the VIX equities volatility index – have this year sunk back to 2007 Credit Bubble heyday lows. Ominously reminiscent of the second-half of 2007, Treasury yields have unexpectedly turned lower in the face of overheated risk markets. I have posited that respective rate “conundrums” can both be at least partially explained by safe haven buying in anticipation of mounting market vulnerability. Recalling 2007, market exuberance is these days fueled by the perceptions of endless cheap liquidity and adroit policymakers with everything under control. Quite simply, it is taken as indisputable fact that global central bankers will not tolerate a return to financial crisis.
The major problem now midway through 2014 is that global central bankers do not have things under control. Yes, they can continue to aggressively create “money” and stoke runaway global securities booms. But this in no way helps to rectify structural economic impairment. In no way has rampant monetary inflation worked to correct global financial and economic imbalances. As such, central bank liquidity and market intrusion have set the stage for inevitable problematic market adjustments.
I certainly don’t believe Draghi’s “do whatever it takes” market intervention resolved Europe’s deep structural problems. I don’t even think it “bought time.” Loose “money” instead bought another Bubble. The Draghi ECB (in concert with the Bernanke Fed and Kuroda BOJ) forced sweeping short covering of bearish bets throughout Europe – and then incentivized leveraged speculation throughout the euro zone.
The resulting historic collapse in European periphery yields was nothing short of miraculous. Unfortunately, this market moonshot may have enriched the speculator community but it did little to ameliorate structural maladjustment. I suspect that when Bubble ebullience and greed subside, fear for the soundness of the European banking system could hastily reemerge. Indeed, the divergence between bubbling securities markets and poor economic prospects has created acute latent fragilities.
Fragilities erupted this week with issues in the Portuguese banking sector. Troubles at Banco Espirito Santo, one of Portugal’s largest banks, quickly spread throughout European equities and debt markets. Portugal’s PSI All-Share Index was slammed for 9.1%. Fears of a potential bank bailout pressured Portuguese sovereign bonds. Portugal 10-year yields jumped 28 bps this week.
Nervousness quickly spread throughout periphery markets. Spanish stocks were hit for 4.3%, with 10-year yields up nine bps. In Italy, stocks were slammed for 4.4%, as yields rose five bps. Greek 10-year yields jumped 33 bps. And with German 10-year bund yields sinking six bps to near 2012 lows, yield spreads (to bunds) widened meaningfully throughout Europe.
It’s also worth noting that the euro vs the yen this week traded to the lowest level since early-February, ending the week down 65 bps. So called “carry trades” – short bunds or the Japanese yen to finance higher-yielding peripheral bonds – suffered a rough week. And perhaps it was only a coincidence that commodities markets got walloped and Treasuries caught a strong bid.
A couple Bloomberg headlines were worth highlighting: “Espirito Santo Rocks Bonds from Sao Paulo to Rio” and “Complacency Disrupted by Portugal to Puerto Rico.” It may be early to get too excited about contagion effects. Yet the colossal global leveraged speculating community is a likely transmission mechanism from Portuguese debt to the world’s risk markets. Europe’s market Bubbles would appears at this point a high-risk proposition.
In the face of unprecedented monetary stimulus and surging securities markets, the continent’s economy will struggle to post positive growth this year. In particular, the second (France) and third (Italy) largest economies might actually contract, while the great German economic machine has begun to sputter. National government debt as a percent of GDP is approaching 100% in France and 135% in Italy. In Portugal, government debt of 130% is dwarfed by corporate debt at 250% of GDP. Portugal’s economy will likely contract again in 2014. It will post another large fiscal deficit, with a stubbornly high 15% unemployment rate. Bubbling securities markets have been masking a lot of economic, social and political angst throughout the continent.
From the perspective of my analytical framework, Portuguese markets reside at “the periphery of the periphery” – a marginal borrower susceptible to inflection points in the market backdrop for risk-taking and liquidity. So I’ll take this week’s developments seriously. There is the possibility that markets might now confront the initial onset of de-risking/de-leveraging dynamics.
Late-stage speculative Bubbles grow into wild animals. There is always a fine line between manic speculative blow-off excess and problematic cracks appearing in the underlying Bubble. As was certainly the case in early-2000 and late-2007, deteriorating fundamental prospects and resulting shorting (and hedging) provide combustible tinder for squeezes and destabilizing market advances. Moreover, upside market dislocations in the face of dimming fundamental prospects create divergences and latent fragilities.
I have argued that (reminiscent of 2007) we’re in the midst of an especially precarious environment. The now full-fledged Global Government Finance Bubble has spurred Bubble markets encompassing virtually all asset classes in markets all around the world. Many markets have succumbed to “blow-off” squeezes and excess – with religious zeal for the power of central bank liquidity. Risk markets have also become highly correlated.
I have argued that the next round of “risk off” will be problematic. The Fed is now only several months from ending liquidity-creating operations. If a bout of market turbulence forces the leveraged players to de-risk, it’s not clear who’s left to buy. Markets should not dismiss the global ramifications from Portuguese bank problems (or Puerto Rico debt issues).
Here at home, corporate debt spreads widened somewhat this week. More interestingly, spreads widened meaningfully for the Credit insurers. MBIA, Radian, Assured Guarantee and MGIC all saw debt spreads widen at least 30 bps. Fundamental issues are at work. There’s mounting nervousness for insurers of Puerto Rico debt, while proposed rules from the Federal Housing Finance Agency to boost the strength of the mortgage insures also weighed on the sector. Operating with extreme leverage to potential systemic Credit issues, I have always viewed the risk insurance industry as the “periphery of the periphery” of the U.S. Credit Bubble.
As an analyst of Bubbles, I appreciate that it is virtually impossible to predict the timing of their implosion. But that doesn’t dissuade me from diligently monitoring for “weak links” and potential catalysts. And like 2007, highly speculative markets fixate on fun and games and instant gratification, while steadfastly refusing to discount mounting systemic risk (in ebullient markets, it’s referred to as “resilient”). Thus far, markets have performed consistent with the “Granddaddy of all Bubbles” thesis.
Compared to 2007, today’s excesses are more extreme. U.S. equities have jumped from 2007’s $25.6 TN to today $34.5 TN. I have in previous CBBs highlighted that total marketable securities (debt & equities) surpassed $72 TN in Q1, up 36% from booming 2007. I would also contend that the global economy was in relatively much better shape in ‘07/'08. Europe is today much weaker and China is much more vulnerable. Emerging market economies and Credit systems, in particular, suffer from six years of unwieldy finance on an unprecedented scale. Today’s geopolitical mess makes 2007 look like outright peace, tranquility and global solidarity. And I would argue that the maladjusted U.S. economy is today more vulnerable to “risk off” securities market tumult than ever.
What really worries me is the huge growth since 2007 in trend-following and performance-chasing finance (i.e. the leveraged speculating community and the ETF industry). It’s this “Moneyness of Risk Assets” issue (see last week’s CBB). The world believes central banks will ensure ample marketplace liquidity – the never-ending bull market. In my eyes, it has all regressed to a precarious confidence game of epic proportions. And so long as speculative leverage increases and funds continue to flow freely into stocks and bonds, bullish perceptions of endless cheap liquidity and unending growth in corporate earnings (adjusted for stock buybacks, of course) endure.
Chair Yellen last week dazzled the bulls with simple dovishness. This week, regional Fed Presidents Esther George, Charles Plosser and James Bullard all suggested rate increases may be closer than the market today anticipates. Which brings to mind an important contrast to 2007: The entire committee was ready to fall in line behind Dr. Bernanke, as the learned professor formulated his response to the unfolding crisis. Today, the Fed has shot its bullets, while deep philosophical differences within the Fed will surely complicate its response to faltering market Bubbles. A lot of market misperceptions and misguided faith will be at risk come the next serious bout of “risk off.” I was almost expecting David Tepper to show up on CNBC this week and warn of another round of Nervous Time.
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