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Wednesday, January 20, 2016

Days of Wine and Neurosis

Financial Review

Days of Wine and Neurosis

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)
DOW – 249 = 15,766
SPX – 22 = 1859
NAS – 5 = 4471
10 Y – .05 = 1.98%
OIL – 1.91 = 26.55
GOLD + 13.70 = 1102.20

I remember a time, long ago and far away, where the stock market soared to record highs and we had celebrations and enjoyed milk and cookies. Today there are no celebrations, and the reward for merely surviving is more like wine and valium, or maybe just a Pepto Bismol smoothie.

Global markets were in full retreat as a relentless slide in oil prices and a weaker world growth outlook from the IMF dealt another blow to investor appetite. Hong Kong shares tumbled to their lowest levels since the depths of the global financial crisis, Japan’s Nikkei entered a bear market and equities everywhere else are deep in the red.

Investors have been looking for safe havens. Yields on U.S. 10-year Treasuries fell below 2.00%, down 29 basis points since the New Year began.

Here’s a quick rundown of global markets: China’s Shanghai Composite down 1%, The Hang Seng in Hong Kong down 4%, Japan’s Nikkei lost 3.7%; in Europe the FTSE 100 down 2.5%, The CAC in France down 2.5%, The Euro Stoxx 50 down 2.3%.

Wall Street looked more like Mr. Toad’s Wild Ride; the Dow Industrials dropped to 15,450, a drop of 565 points intraday; the S&P 500 broke support levels from August – actually a double bottom going back to October 2014 – and that leaves minor support at 1815 and the next major level of support at the 2014 lows of 1741. We might see attempts at a rally but the charts just look broken down and nasty. Even though the markets pared losses late in the session, it felt more like short covering than a real rally to the close.

Crude futures were slammed again, with U.S. oil falling to its lowest since September 2003 on worries about a global glut. The drop comes after the International Energy Agency, which advises industrialized countries on energy policy, warned on Tuesday that oil markets could “drown in oversupply”. Oil has fallen more than 25 percent so far this year, the steepest such slide since the financial crisis, piling more pain on oil drillers and producing nations alike. Yet they keep pumping more oil into an oversupplied market.

Two currency pegs have come under increasing pressure in recent days. Authorities in Saudi Arabia moved this morning to stem the tide of traders betting against the riyal’s peg to the U.S. dollar by banning local riyal forward options. Those forwards had jumped to their highest in at least two decades. In Hong Kong, local dollar forwards sunk to the weakest since 1999, forcing interbank lending rates to their highest in seven years.

The semiconductor consolidation continues…Microchip Technology has finally sealed a deal to buy Atmel, which stated last week that the former’s unsolicited bid was superior to an offer from Dialog Semiconductor. The $8.15/share cash-and-stock bid will value Atmel at $3.4 billion. Microchip also said it expects to report fiscal third quarter revenue of $552 million and .62 to .63- cents per share in earnings, slightly above consensus estimates.

Consumer prices fell again in December. The consumer price index declined by seasonally adjusted 0.1% last month. For all of 2015 inflation rose just 0.7%, the second slowest rate in 50 years. The low rate was largely the result of the biggest drop in gasoline prices in more than a decade. The cost of food also tapered off toward the end of the year because of falling prices for agricultural goods.

In December, energy prices dropped 2.4% and food costs retreated 0.2%.  Stripping out food and energy, so-called core prices rose 0.1% in December. Core consumer prices have climbed at a much faster 2.1% annual rate, marking the biggest 12-month change since 2012. Higher costs of shelter, medical care and other services have driven the increase.

Home builders cut back slightly on new construction in the final month of 2015, though they built the most homes last year since 2007. Housing starts fell 2.5% last month to an annual rate of 1.15 million, slightly below expectations. For the full year, home builders started work on 1.11 million new houses, the largest number since the Great Recession.

So, some of the economic data looks good but the markets aren’t responding to the domestic economic data. All the concerns go back to China and oil. We’re already seeing a big impact in the lack of trade across the world.

Bloomberg reports that China’s slowing growth has crushed shipping rates to such an extent that hiring a 1,100-foot merchant vessel would set you back less than the price of renting a Ferrari for a day. The Baltic Dry Index is an indicator of the cost of shipping dry bulk goods such as coal, iron ore, grains, and finished goods such as steel, but it is feted for its apparent ability to predict the world’s financial fortunes. It has now dropped to its lowest level since records began in 1985.

So why does this all matter? Well, if cargo ships aren’t shipping cargo containers, then it might be an indication that the oxygen is being sucked out of global commerce. Think of the index as the canary in the coal mine, and right now the canary is lying on the bottom of the cage. The most recent time the Baltic Dry Index crashed was just before the 2008 global financial crisis.

In 1999 the Baltic Dry slumped to 12-year lows, very soon before the dot-com bubble burst. It slumped again to another massive low in 2001, around the same time the US economy fell into a recession that lasted until 2003.

The Telegraph’s Ambrose Evans-Pritchard interviewed William White, the Swiss-based chairman of the OECD’s review committee and former chief economist of the Bank for International Settlements, and he offered one of the better explanations of how a collapse might play out. White says that easy money policy settings from the Fed, and others such as the European Central Bank and Bank of Japan, simply brought spending forward from the future, creating dangerous cycle that is now losing its potency to spur demand, which “By definition, … means you cannot spend the money tomorrow.”

Aside from pushing demand forward in developed economies, another consequence was to exacerbate asset bubbles in emerging markets such as Asia, pushing asset prices higher on the back of what was, at the time, cheap US dollar denominated debt; this pushed combined public and private debt in emerging markets surge to 185% of GDP. In OECD nations a debt boom of a similar scale also occurred, taking the overall debt-to-GDP ratio for 34-member group to 265%. China, at the epicenter of market concerns in recent months, has seen its debt loading climb from 158% of GDP to over 282%.

“It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit.” The problem, according to White is that macroeconomic ammunition to fight further economic downturns is essentially “all used up”. The central bankers have run out of dry powder. “Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief.”

Mr. White says, “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.”

Instead of pondering whether or not bankruptcies will occur, White suggests the only question that needs to be answered is “whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly”.

Now the article didn’t explain why White thinks things could get disorderly, so let me try to fill in a few blanks. And it’s not just zombie cargo ships. Much of the debt is related to the energy sector, which is the major source of income for many nations; think of the 19 nations in OPEC and then add in a few extra’s like Brazil, which is very dependent on its state owned oil company Petrobras.

And while the debt defaults might wipe out some of the weaker banks and financial institutions, the big banks are actually bigger than they were in 2008, and they are required to hold more reserves. The problem is that they also hold more derivatives. Essentially, they have placed side bets on all this new debt, in an attempt to slough off risk.

Now, we don’t’ really know the exact size off the derivatives markets, but the most widely referenced guesstimate is around $700 trillion, or about 10 time more than global GDP; although the BIS says it has come down in the past year to just $555 trillion. And we are told that we shouldn’t really count all that because that is the notional amount, in other words, many of the bets would cancel out other bets.

But that is also the problem; when the side bets start cancelling out other bets, nobody really knows which bets will pay off, and the entire credit markets freeze up. And if we look at the actual exposure to market value of outstanding derivatives, the BIS says it is around $15.5 trillion, which is enough to create a major meltdown in its own right.

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