Markets crack and investors aren’t prepared
Six days ago, Jim and I told subscribers of Strategic Intelligence Australia how Chinese economic data is now propping up global markets.
Then this morning, I came across this headline on Bloomberg: ‘U.S. Says It Will Raise Tariffs After China Reneges on Vows’. Bloomberg wrote:
‘[US Trade Representative Robert] Lighthizer and Treasury Secretary Steven Mnuchin told reporters on Monday that the Chinese backsliding became apparent during their visit to Beijing last week, but that they had been reassured by their Chinese interlocutors that everything would turn out.
‘That changed over the weekend when China sent through a new draft of an agreement that included them pulling back on language in the text on a number of issues, which had the “potential to change the deal very dramatically,” Mnuchin said. At that stage about 90 percent of the pact had been finalized, he said, and the Chinese wanted to reopen areas that had already been negotiated.’
As the implied tariffs went up, the markets went down.
While the Dow Jones only dropped 0.25% overnight, the more trade-sensitive S&P 500 and NASDAQ fell 0.45% and 0.50% respectively.
Closer to home, this Chinese backpedal saw the Aussie dollar fall to US$0.69 overnight.
In contrast, the wobbles in the US market haven’t translated to falls in the Aussie market. Our major index was up 0.60% at the time of writing.
The conflicting market reactions go some way in highlighting investor complacency.
And that’s exactly what Jim deep dives into today.
The lack of reaction from international markets is lulling investors into a false sense of security.
People and markets are too comfortable with the idea that things will stay the same.
As Jim points out below, that’s exactly how investors get caught off guard.
Read on for more.
Until next time,
Investors Are Falling Into a False Sense of Security Again
Jim Rickards, Strategist
In January 2018, two significant market events occurred nearly simultaneously.
Major US stock market indexes peaked and volatility indexes extended one of their longest streaks of low volatility in history.
Investors were happy, complacency ruled the day and all was right with the world.
Then markets were turned upside down in a matter of days.
Major stock market indexes fell over 11%, a technical correction, from 2-8 February 2018, just five trading days. The CBOE Volatility Index, commonly known as the ‘VIX’, surged from 14.51 to 49.21 in an even shorter period from 2-6 February 2018.
The last time the VIX has been at those levels was late August 2015 in the aftermath of the Chinese shock devaluation of the yuan when US stocks also fell 11% in two weeks.
Investors were suddenly frightened and there was nowhere to hide from the storm.
Investors rush for the exit
Analysts blamed a monthly employment report, released by the US Labor Department on 2 February, for the debacle.
The report showed that US wage gains were accelerating.
This led investors to increase the odds that the Federal Reserve would raise rates in March, June and September 2018 (it did) to fend off inflation that might arise from the wage gains.
The rising interest rates were said to be bad for stocks because of rising corporate interest expense and because fixed-income instruments compete with stocks for investor US dollars.
Wall Street loves a good story, and the ‘rising wages’ story seemed to fit the facts and explain that market downturn.
Yet the story was mostly nonsense.
The fact is that stocks and volatility had both reached extreme levels and were already primed for sudden reversals.
The specific catalyst almost doesn’t matter.
What matters is the array of traders, all leaning over one side of the boat, suddenly running to the other side of the boat before the vessel capsizes.
The technical name for this kind of spontaneous crowd behaviour is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion.
The last one to run is mostly likely to be eaten alive.
From greed to ‘extreme greed’
Markets are once again primed for this kind of spontaneous crowd reaction.
After coming to within a fraction of an official bear market in December 2018, the Fed capitulated to markets by pausing on rate hikes and ending QT far ahead of schedule.
Financial conditions eased dramatically.
The markets rallied hard, and the stock market turned in its best first quarter in 20 years.
The S&P and NASDAQ stormed back to record highs this week, while the Dow is only about 1% away from its own previous record.
Meanwhile, CNNMoney’s Fear and Greed Index has gone from ‘greed’ to ‘extreme greed’ within the span of a week.
Good times are here again and investors are getting complacent again, just like last year.
But there are just as many — if not more — catalysts for a sharp market selloff.
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Despite April’s surprising GDP report, which is likely an outlier that doesn’t mean much, there are signs the economy is slowing down.
In March, for example, the US Treasury yield curve inverted.
The yield on the 10-year US Treasury note fell below the rate on the three-month note. That’s happened prior to each of the past seven recessions.
That doesn’t mean a US recession is imminent; it could still be another year or more away. But it is an ominous sign.
Limits of debt-fuelled growth reached
Meanwhile, a recent report revealed a record seven million Americans are now at least 90 days behind in their car loan payments.
There is also a student loan crisis unfolding.
Total student loans today, at US$1.6 trillion, are larger than the amount of junk mortgages in late 2007 of about US$1.0 trillion.
Default rates on student loans are already higher than mortgage default rates in 2007.
This time, the loan losses are falling not on the banks and hedge funds but on the US Treasury itself because of government guarantees.
Not only are student loan defaults soaring, but household debt has hit another all-time high.
Student loans and household debt are just the tip of the debt iceberg, which also includes junk bonds corporate debt and even sovereign debt, all at or near record highs around the world.
But it’s not just the US.
Other signs are appearing on the horizon also as the global economy is slowing down.
Europe and Asia are showing marked declines.
Australia is showing no signs of inflation. This will weigh on the Reserve Bank of Australia when it meets today.
China’s problems are well-known.
And while the causes may vary, growth in all of the major economies in the EU and the UK is either slowing or has already turned negative.
The world is discovering the limits of debt-fuelled growth.
US government debt is ‘in the red zone’
According to the Institute of International Finance (IIF), it required a record US$8 trillion of freshly created debt to create just US$1.3 trillion of global GDP.
The trend is clear.
The massive debts intended to achieve growth are piling on every day.
Meanwhile, many of the debts taken on since 2009 are still on the books.
The US government debt-to-GDP ratio is now 106%, the highest since the end of the Second World War.
Australian government debt-to-GDP is a moderate 41%. But personal debt is Australia’s biggest concern.
The Chinese debt-to-GDP ratio is a more reasonable 48%.
But that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.
When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.
Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through non-payment, inflation or other forms of debt repudiation.
The fact is, the world’s three largest economies — the US, China and Japan — are all now deep in the red zone.
What is striking is the speed with which synchronised global growth has turned to synchronised slowing. Indications are that this slowing is far from over.
While growth can create a positive feedback loop, slowing can do the same.
Warnings of economic collapse are no longer confined to the fringes of economic analysis, but are now coming from major financial institutions and prominent economists, academics and wealth managers.
Leading financial elites have been warning of coming collapses and dangers.
These warnings range from the IMF’s Christine Lagarde, Bridgewater’s Ray Dalio, the Bank for International Settlements (known as the ‘central banker’s central bank’), Paul Tudor Jones and many other highly regarded sources.
We have had major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000 and 2008.
That’s five major drawdowns in 31 years, or an average of about once every six years.
The last such event was 10 years ago.
So the world is overdue for another crisis based on market history.
The trouble is, most investors will never see it coming.
All the best,