In a prior post, I mentioned the growing divergence between HY and CDS spreads. I got really nervous about something big coming when Morgan Stanley indicated that we shouldn’t worry about the effect of DXY on Asian external debt. I calmed down when RBS said a major EM crisis was coming. This speaks to an age-old investing question. No, the question is not “which of these freaking sharks can I possibly trust?” The question is “Is this a tail risk event or just a brief sell-off?”
This is one of the toughest investing questions around. It is a tough question because there is no sharp and definitive answer.
EM credit provides a case study. Have a look at EM and North American CDS spreads (prior to yesterday’s EM index roll) to see the story. There are some technical factors due to the roll, but all the same through the middle of January, these two indices were pretty closely coupled together. After through early March, EM sold off, while HY tightened. The market look like it is now at decision time. We will soon see if EM will recouple to HY and see some spread compression, or if the break between emerging markets and domestic North American speculative debt will be complete.
If the spread stabilizes then the variance is transitory and somewhat cosmetic. There wasn’t any decoupling, just a slowing of the global growth cycle which effects more cyclical EM more than HY. Money will lick its wounds and go forward chastened and a bit wiser. If the divergence is caused by a tail event, then all bets are off as to how wide spreads will go as markets fundamentally re-price. A persistent trend is the difference between an ordinary sell-off and a tail risk event.
We define a tail risk event in a very credit-centeric and rough way: extreme and generalized price action. The extreme is often measured in standard deviations, anything above 3-sigma being a tail event and anything above 4-sigma being not “normal” in the Gaussian sense. By generalized it is meant that all emerging markets experience big price moves—maybe not individual 4-sigma move, but the ensemble average is.
You can nearly always count on some beta in Indonesian debt, but not in a rising star like Malaysia. Under a tail event scenario, you would see both corporate and sovereign bonds sell off hard. This implies that rolling correlations move to the extreme. You don’t see this at this instant, and across the times series, you see erratic and unstable relationships.
Distinguishing between a sell-off and a tail risk event is one part detective work and one part guess work. The detective role comes in because it is essential to establish a future outcome based on present information, given no one acted to change it. The guess work comes in trying to anticipate how and what intervention will occur if the future outcome is a bad one.
The guess work is necessary because market players and the systems they collectively build interact, create positive and negative feedback. It is also necessary because modern central banking is an incredibly powerful force in the market ecosystem: in times of crisis a completely price-insensitive buyer of financial assets. Central banks also set the cost of money through interest rates since there is no private sector alternative to fed funds. So a successful solution requires navigating between two cosmic extremes, manifested concretely in special cases as public activity versus private activity, sometimes politics versus markets, action versus passivity, eros versus logos, etc.
Distinguishing between a sell-off and a tail risk event
Regarding the detective work, there are five drivers that have potential to lead to a tail risk event as opposed to some proverbial licking of the wounds, each interconnected. Probably if left unattended, you would see them realize some real financial destruction. As long as central banks can intervene, they will not left to follow their own devices. So it is important to weigh both the effect and the likelihood of the mechanisms. They are:
Continued dollar strength over present levels
Deleveraging and policy efforts to reverse it
Bank regulations destroying sourced liquidity
Demographics
Intractable Complexity
USD
A necessary but not sufficient condition for a tail risk event in EM is continued USD strength. It will be a significant drag on the US economy, the global economy, and lead to an EM meltdown. Sustained DXY over 100 (just a rough guesstimate which actually varies by country) would create real stress in external EM debt and trigger an FX crisis.
The US does not want this and the US will not tolerate USD strength much above what we are seeing now if anything can be done about it. FX intervention either from the Fed or the Treasury Department has been effective in the past, so a sustain drive up in the dollar from present levels is not guaranteed.
Regarding the effect of interest rates on dollar levels, Fed futures have fully priced in an interest rate rise this year and more hikes coming in 2016. Unless your view is that benign rate rises will actually be aggressive rate spikes, then the USD will see no more bounce from this channel. Given that a strong dollar cools inflation, the rationale behind a rate increase isn’t there.
Finally, long USD is a massively crowded trade. The feeling in the market is that there is no stopping the USD rally, which typically leads to the opposite. For these reasons, I’m not seeing much more upside for the dollar, at least based on conventional explanations.
Other drivers are needed, like deleveraging.
The Credit Universe is One Gigantic Reach for Yield
Deleveraging is caused by four very strong deflationary factors, all based on diminished demand. One is persistently anemic global growth. Weak growth translates to difficulty in servicing the high global indebtedness levels (which have gone up since the financial crisis). Arguably the miserable fundamentals have led to very poor global demographics since no one feels secure enough to have kids anymore. Rapidly aging populations pretty much everywhere other than sub-Saharan Africa, the Middle East and India) just add to the financial stresses on public budgets and tax burdens of people that actually work.
This is why funding costs remain ridiculously cheap. It’s an absurd little cocktail mixed buy our central bankers, like something made with ridiculous whipped cream flavored vodka. So the Fed continues with the crazy girls drinks, loaded with sugar so you can’t taste the alcohol. At all. Until you wake up.
This extraordinarily loose monetary policy, meant to stave off the effects of these deflationary factors, has unintended consequences. It has set off an enormous misallocation of capital driven by state sponsored mispricing of capital. The result is excessive and increasing debt, and even more excessive financial asset price speculation at the expense of any benefit to the real economy.
This is the great hoax of the age. Central banks can do all kinds of stuff, but they can’t make indebted, chastened people spend their money on things we don’t want or need. Let alone make us borrow to do so. Players in an over-indebted economy are sensitive to even small shifts in interest rate expectations because it will affect their decision to invest or consume. Higher expected rates mean that debt repayments and interest charges that will reduce future consumption. Lower than anticipated inflation means the burden of repayments on households is greater in real terms. So there is muted interest in borrowing.
But if there is no borrowing then deflation is an inevitable fact. Cheap interest rates do appeal to a last class of credit-worthy, post-crisis borrowers. Central banks stimulate demand not in their local developed markets, but rather in the emerging world. Emerging market countries have taken on debt—USD debt—to unprecedented levels since the crisis. A part of this is no doubt financial deepening, but another part is unsustainable bubble.
So the default setting is inadequate demand and moribund growth unless buoyed by financial bubbles that quickly evaporate. The real interest rates needed to achieve such bubbles is now so low that central banks cannot lower nominal rates enough given the zero interest rate lower bound. So at the extreme, economies become trapped in a state of semi-permanent depression with bubbles the only relief. So bubbles it is, and the only credit with carry potential are HY and EM assets.
Monetary policy settings have little room to be more accommodative between the Fed, the ECB, and the BOJ, maybe not in degree but in kind. But they can keep up the status quo. However, emerging markets do have potential to sustain their debt bubbles in local currency debt. I am confident that policy makers will use this potentiality to keep their parts of the complex from blowing into a tail risk event.
Bank Deleveraging
There are supply factors that impact emerging market credit as well. Look at banks’ balance sheets over the last 20 years in Europe alone, they have gone from around 120 per cent of GDP to 400 per cent of GDP, far outpacing economic growth. The last two decades of enormous expansion of the banking system is contracting. This means that capital will be hard to come by as the banking system heals itself.
Banks are further screwed by Basel III. Basel III is a Rube-Goldberg device that attempts to replicate a well-capitalized and liquid balance sheet by applying value adjustments to illiquid assets. Basel III buttresses the forces of deleveraging by accelerating bank balance sheet shrinkage. If this causes too rapid liquidation, then regulation moves from being a necessary but painful step to having an exaggerated effect on growth and employment. If de-levering does not happen quickly enough it will exacerbate the existing structural problems in the credit space. Either way, bank funding becomes much more expensive. This carries over to bank lending.
Basel III also attempts to quantify the capital required to absorb unforeseen shocks to a bank balance sheet—which is ridiculous. Centuries of financial evolution selected equity, not regulation to deal with unforeseen shocks. Regulations often make things even worse, getting in the way of deploying available capital to loss-absorbing equity. Note that Solvency II requirements and other regulation on insurance companies and pension funds, meaning they must reduce risk and not invest as much in equities.
There is a resulting need to replace banks as sources of funding, which has been good for the bond business as it implies increased business diversity in the bond market ecosystem. The challenge associated with refinancing loans and rolling debt accumulating on corporate balance sheets with bond issuance is that rates are so low that the market accepts higher operating leverage, generating ever-increasing overhangs of periodic refinancing requirements.
This means balance sheet deterioration for good credits. These issuers by and large have easy access to credit and the terms they command generate little carry for investors and incent borrowers to run inefficiently. The lack of financing discipline is due to bank deleveraging as borrowers are forced to move to bonds as substitutes for loans. Emerging market companies get crowded out by the refinancing wall, and in general financing in all fronts becomes more risky. There will always be more forward looking offensive needs for capital to finance acquisitions, growth, and investment, yet profitability comes from margin enhancement from efficiency gains and cost-cutting. Since cheap debt works counter to this, organic cash-flow fed growth will be rare going forward. This is not a positive story for emerging market debt.
Demographics
Population decline causes economic distress because the older generation's increased medical expenses and their state-sanctioned retirement pensions have to be paid for. They are paid for by the younger generation currently in the workforce. As those numbers decline, the percentage of burden gets higher and higher on each working member of society because the government confiscates more and more of their earnings. So those workers have less and less disposable income to use and spend in the economy. Countries like Russia, Japan, and Germany are going to face serious economic problems due to large elderly populations with small working age populations. Throw in a generous social welfare state and the fiscal problems will be tremendous in such a situation.
Although this is increasingly a problem for emerging markets, it is also drastic demographic change either through marked increase or decrease that presents economic challenges. No sensible person would ever suggest that a massive population boom, like say in Nigeria, is a positive.
There is a way out of this trap. Technology as a labor-saving mechanism can offset these problems to some degree. However, meaningful advances are largely restricted to the developed world, not emerging markets. Total amounts of many resources like food and energy may be limited, they are also subject to the technology and opportunity cost. It is not just a question of cheap financing. The technological know-how to unlock these opportunities is at present the domain of developed countries, not emerging markets. The know-how is in a sense leased and not owned by emerging market nations and companies.
Complexity
The interplay of the public and private creates complexity, a recurring theme around this website. Complexity reduces to there being no definitive causal explanation in the real sense, only educated guesses—which are in most cases better than relying on no priors at all.
What happens is purely the consequence of the fact that financial markets can be seen as a large interconnected complex system and tail risk events happen some times. The other consequence is that mediocre fundamentals can and do reverse themselves in a spontaneous way. Technology can be significantly deflationary in terms of the cost of goods and even services and it can also alleviate a demographic crunch as the global population structure ages. Globalization can mean that some global workers have little or no pricing power. But it can also raise living standards for other global workers.
There is a lot that we do not understand about our world and we rely upon somewhat inaccurate narrative as a default understanding. The narrative of overpopulation persists even though it is really just talking point used to implement social engineering. The fact is that you could put every man woman and child on earth (7 billion) in North America (9,450,000 square miles or 604,800,000 acres) and they could each have an average of .864 acres of space. A family of four then could have almost 3.5 acres, and that would allow for depopulating the rest of the entire planet. We just prefer to have someone tell us what to believe rather than admit that we can at best only stumble about, groping for the answer.
Traffic flow is a complex system. Individual cars with their drivers, respond to the local factors of nearby cars braking, accelerating, and changing lane. An accident further up the road creates a traffic jam. There are also “phantom” traffic jams on motorways, which occur and dissipate simply due to erratic behavior. People applying mascara, looking to see if that blue-haired girl is really Kylie Jenner, texting @70mph… so close to the razor edge every day. This is due to the collective behavior of a traffic flow, resulting in braking waves and occasional jams with no individually identifiable cause. The traffic jam in former case is a consequence of a clearly defined event with clearly understood implications. It will be resolved only by external action that gets the wreaked cars off the road and the debris cleaned up. In the latter case, it happened because the stochastic process governing driver behavior exhibits heavy dependencies on other drivers. Braking begets braking and speed begets speed.
In the same sense, bond buying and bond selling feeds on itself in a self-reinforcing way. You need central banks to step in to clear the debris given concrete events to make markets run smoothly again, or it will be long and painful wait before some collective action resolves the problem. Even without concrete events, sell-offs and melt-ups can happen, just like those phantom traffic jams that make going to and from work so miserable. The path to market recovery would start with a random impulse which drives self-reinforcing buying until normality resumed.
Probably the most defensible explanation is the complex systems argument is simply that observed behavior is an emergent property of the system, with an intractable causal explanation. Imagine trying to predict a traffic jam. The best one can do is determine when conditions are favorable for it, be it rain or heavy traffic. No way we are ever going to figure out bonds markets with any better precision.
Such foresight would make you God. News Flash: you are not God. I understand He likes variety and is OK with chaos. Your Financial plight? Not so much.