The world was stirring today over the UK decision to leave the European Union. Here are a few things to keep in mind. As we discussed earlier in the week, the repercussions of the Brexit are very different than those that were feared over the potential “Grexit.” Greece was threatening to leave the euro. It would have had major and immediate financial complications, which could have quickly paralyzed the financial system.
The Brexit is more political than economic (not financial). And any retrenchment in the banking system because of uncertainty can be immediately quelled by central bank intervention. Not only were the central banks out in front of the potential exit outcome, promising to provide liquidity to the banking system, but they were also in last night stabilizing currencies, and likely bond yields as well.
As we said, there are also huge differences between now and 2008. When Lehman failed and global credit froze, we had no idea how policy makers might respond and how far they might go. Now we know, they will “do whatever it takes.”
The market volatility surrounding the Brexit may actually be a positive for the global economy. Seven years into the global economic recovery, global central banks have thrown the kitchen sink at the crisis, and they’ve proven to be able to stabilize the financial system and the global economy, and restore confidence. And that has all indirectly created an economic recovery, albeit a slow and sluggish one. But they haven’t been able to directly stimulate meaningful economic growth (the kind you typically see coming out of recession) because of the nature of the crisis.
Fiscal stimulus has been the missing piece of the puzzle.
Governments have been reluctant to spend, given the scars of the debt crisis. This may give policy makers an excuse to green light fiscal stimulus. After all, growth (or the lack thereof) is the primary driver of the public discontent – not just in the UK, but globally. Growth has a way of solving a lot of problems.
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As we said yesterday, we’ve seen a slew of threatening events come and go over the course of the past seven years, and with each passing of those events, the heightened scrutiny of the economy comes and recession predictions. Each has been wrong. The Brexit vote is just the latest.
With the UK referendum results looming (as of this writing), today we want to revisit some of our bigger picture perspective on the U.S. economy. The data just doesn’t support the gloom and doom scenarios.
The Fed has manufactured a recovery by promoting stability. And they’ve relied on two key asset prices to do it: stocks and housing. Today we want to look at a few charts that show how important the stock and housing market recoveries have been.
While QE and the Fed’s ultra easy policy stance couldn’t directly create demand in a world of deleveraging, it did (and has) indirectly created demand by promoting stability, which restored confidence. Without the confidence that the world will be stable, people don’t spend, borrow, lend or hire, and the economy goes into a deflationary vortex.
But by promising that they stand ready to act against any futures shocks to the economy (and financial markets), investors feel comfortable investing again (stocks go higher). When stocks go higher and the environment proves stable, employers feel more confident to hire. This all fuels demand and recovery. And, of course, the Fed has pinned down mortgage rates at record lows, which promotes a housing recovery, and gives underwater homeowners (at one point, more than 25 million of them) a since that paper losses will at some point be overcome, and that gives them the confidence to spend money again, rather sit on it.
Along the path of the economic recovery, the Fed (and other key central banks) has been very sensitive to declines in stocks. Why? Because declining stocks has the ability to undo what they’ve done. And it confidence breaks again, it will be far harder to restore it.
The first chart here is the S&P 500. Stocks bottomed in March of 2009, when the Fed announced a $1 trillion QE program.
Sources: Reuters, Billionaire’s Portfolio
Stocks surpassed the pre-crisis highs in 2013 after six years in the hole. But even after the dramatic rise you can see in the chart the damage from the crisis is far from restored. If we applied the long term annual rate of growth of the S&P 500 (8%) to the pre-crisis highs of 1,576, the S&P 500 should be closer to 3,150.
How does housing look? Of course, bursting of the housing bubble was the pin that pricked the global credit bubble. Housing prices in the U.S. have been in recovery mode since 2012. Still, housing has a ways to go. This is a very important component for the Fed, for sustainable recovery.
Sources: Reuters, Billionaire’s Portfolio
Housing prices have bounced 37% off of the lows (for 20 major cities in the index) – but remains about 10% off of the pre-crisis highs.
How has the recovery in stocks and housing reflected in the broader economy?
As stocks surpassed pre-crisis highs in 2013, so did U.S. per capita GDP.
Sources: Reuters, Billionaire’s Portfolio
While debt continues to be a big structural problem for the U.S and the rest of the world, growth goes a long way toward fixing that problem.
And growth, low interest rates, higher stocks and higher housing prices goes a long way toward restoring household net worth. As you can see in the chart below, we have well recovered and surpassed pre-crisis levels in household net worth…
Sources: Reuters, Billionaire’s Portfolio
What is the key long-term driver of economic growth overtime? Credit creation. In the next chart, you can see the sharp recovery in consumer credit since the depths of the economic crisis (in orange). This excludes mortgages. And you can see how closely GDP (economic output) tracks credit growth (the purple line).
Sources: Reuters, Billionaire’s Portfolio
What about deleveraging? It took 10 years to build the global credit bubble that erupted in 2007. Based on historical credit bubbles, it typically takes about as long to de-lever. So 10-years of deleveraging would put us at year 2017.
You can see in the chart below, the average annual growth rate of consumer credit over the past 55 years is 7.9%. Over the past five years, consumer credit growth has been solid, just under the long term average. Meanwhile, FICO scores in the U.S. have reached an all-time high.
Sources: Reuters, Fed
With any volatility in stocks, there comes increased scrutiny on the economy and people like to wave the red flag anywhere they find soft economic data. But consumption makes up more than 2/3 of the U.S. economy. And you can see from the charts above, the consumer is in a solid position. Still, stocks and housing remain key drivers of the recovery. The Fed is well aware of that. With that, don’t expect the Fed, in the current economic environment, to do anything to alter the health of the housing and stock markets.
Have a great night.
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Tomorrow is the UK vote, where UK citizens will vote on whether to ‘stay’ or to ‘leave’ the European Union. In this post-Lehman (failure) era, we’ve had no shortage of fear and doubt. Remember the Fiscal Cliff, Sequestration, Cyprus, several chapters of the drama in Greece, Italy and Spain were threatening default, China’s slowdown – the list could go on.
Along the way, the message in the media has always had little substance, but one very common word to promote and validate fear: the word, “uncertainty.”
But throughout this entire post-Lehman era, the world has been a very uncertain place. Whether times have been relatively good or not so good, given the state of the world seven years ago, and given the unprecedented policies it has taken to get us here, uncertainty is the new normal. But what is certain, following the near apocalypse of the global economy, is how policy makers will respond. We know, without a question, they will do ‘whatever it takes’ — their own words. And they’ve proven that their actions can avert disasters and promote confidence and recovery.
With all of this in mind, let’s dig in a little bit and talk about the UK vote.
First, to be clear, there are a lot of comparisons made to the Greek vote last year (the “Grexit”). The UK vote (the “Brexit”) is very different.
The notion of Grexit threatened the existence of the second most widely held currency in the world, the euro. That was a much, much bigger deal. The UK, of course, is part of the European Union, but not part of the currency union. They did not adopt the euro. They have their own currency and their own monetary policy. The UK vote is about trade, immigration, ability to work and live in other EU countries — perhaps mostly about control and politics.
The polls have been broadly building the story for an exit, though they are also broadly deemed unreliable. Meanwhile the bookmakers have had the chances of an exit, along much of the way, as slim (at about 70/30 favoring the ‘stay’ camp). Still, at the peak of the frenzy last week, that number had narrowed to 56/44 favoring ‘stay.’ But when the pendulum of sentiment swung, so did the bookmakers odds of a ‘leave’ vote winning. They are putting the chances of an exit at just 25% as we head into tomorrow’s vote.
As we said, we’ve seen a number of events over the course of the past several years that have introduced fear and doubt into the minds of investors (and especially the media). Something to keep in mind: Any and all of the dips in markets associated with those flare-ups have proven to be extremely valuable buying opportunities. As we noted yesterday, some of the best spots to buy the dip this time around will likely be German and Japanese stocks.
Have a great night.
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Last week we talked a lot about the German bund yield, the most important market in the world right now. Today we want to talk about how to trade it.
The best investors in the world love asymmetric bets (limited downside and virtually, if not literally, unlimited upside). That’s the true recipe to building huge wealth. And there is no better asymmetric bet in the world right now than the German 10-year bund.
With that in mind, in recent weeks, we’ve revisited Bill Gross’ statement last year, when the 10-year government bond yields in Germany were flirting with zero the first time. He called it the “short of a lifetime” to be short the price of German bunds – looking for yields to bounce back. It happened. And it happened aggressively. Within two months the German 10 year yield rocketed from 6 basis points to over 100 basis points (over 1%). But even Gross himself wasn’t on board to the extent he wanted to be. The bounce was so fast, it left a lot of the visionaries of this trade behind.
But over the past year, it’s all come back.
Is it a second chance? German yields are hovering just a touch above zero — threatening to break into negative yield territory for one of the world’s most important government bond markets.
As we said on Friday, the zero line on the German 10-year government bond yield is huge psychological marker for perceived value and credibility of the ECB’s QE efforts. And that has huge consequences, not just for Europe, but for the global economy.
Given the importance of this level (regarding ECB credibility), it’s no surprise that the zero line isn’t giving way easily. This is precisely why Bill Gross called it the “short of a lifetime.” With that, let’s take a look at the incredible risk/reward this represents, and a simple way that one might trade it.
There is a euro bund future (symbol GBL) that tracks the price of the German 10-year bund. Right now, you can trade 1 contract of the German bund future at a value of 164,770 euros by putting up margin of 3,800 euros (the overnight margin at a leading retail broker). If you went short the bund future, here are some potential scenarios:
If you break the zero line in yield, the euro bund future would trade up to about 165.50 (it currently trade 164.77). If you stopped out on a break of zero in yield, you lose 730 euros (about $820 per contract). If the zero line doesn’t breach, and yields do indeed bounce from here, you make about 1,500 euros for every 10 basis point move higher in the German 10-year bund yield.
For example, on a bounce back to 32 basis points, where we stood on March 15th, the profit on your short position would be about 4,600 euros (or about $5,200). If German bund yields don’t breach zero and bounce back to 1%, where it traded just a year ago, you would make about 15,000 euros ($16,900) per contract on your initial risk of $820 – a 20 to 1 winner. Of course, there are margin costs to consider, given the holding period of the trade, but in a zero rate world, it’s relatively small.
If you’re wrong, and the German 10-year yield breaches zero, you’ll know it soon.
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On Wednesday we talked about the most important market in the world, right now. It’s German bunds.
The yield on the 10-year German bund had traded to new record lows, getting just basis points away from the zero line, and thus from crossing into negative yield territory for the 10-year German government bond. That has inched even closer over the past two days, touching as low as 1 basis point today.
Not surprisingly, stocks sold off today. Volatility rose. Commodities backed off. And the broader mood about global economic stability heads into the weekend on the back foot. For perspective, though, U.S. stocks ran to new 2016 highs this week, and are sniffing very close to record highs again. Oil and commodities have been strong, and the broad outlook for the economy and markets look good (absent an economic shock).
What’s happening? Of course, the vote that is coming later this month in the UK, on whether or not UK citizens will vote to ‘Stay’ in the European Union or ‘Leave’ continues to bubble up speculation on the outcome. That creates uncertainty. But the real reason rates are sliding is that the European Central Bank is in buying, not just government bonds, but now corporate bonds too. The QE tool box has been expanded. That naturally drives bond prices higher and yields lower. But the question is, will it translate into a bullish economic impact (i.e. the money the ECB is pumping into the economy resulting in investing, spending, hiring, borrowing). As we discussed on Wednesday, it’s the anticipation of that result that sent rates higher in the U.S. when the Fed was in, outright buying assets, in its three rounds of QE.
With that, the most important marker in the world for financial markets (and economies) in the coming days, remains, the zero line on the German 10-year government bond yield. Draghi has already told us, outright, that they will not take benchmark rates negative (as Japan did). That makes this zero line a huge psychological marker for perceived value of the ECB’s QE efforts.
With this in mind, we head into a Fed meeting next week. The Fed has done its job in managing down expectations of a hike next week. With that, they have no risk in holding off until next month so that they can see the outcome of the stay/leave vote in the UK. And, as we’ve discussed, the Bank of Japan follows the Fed on Wednesday night with a decision on monetary policy. They are in the sweet spot to act, not only to reinvigorate the weak yen trend and strong stock trend in Japan, but to add further stimulus and perception of stability to the global economy. We think we will see that happen.
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As we head into the Memorial Day weekend, we want to talk today about the G7 meeting that took place this week Japan, and how these meetings tend to effect financial markets (namely the key barometer for global markets in this environment, U.S. stocks). It’s a big effect.
If we look back at the past seven annual meetings of world leaders, there is clearly a direct correlation between their messaging and the resulting performance of stocks.
For context, we’re talking about a period, from 2009-present, that has been driven by intervention and careful confidence massaging by global policymakers. So it shouldn’t be surprising that coming out of these meetings, post-Lehman, things happen.
Let’s take a look at the chart of the S&P 500 and highlight the spots where a G7 meeting wrapped up (note: this was actually the G8 prior to 2014, when Russia was ousted from the group).
If you bought stocks following the meeting in Italy, in 2009, you’ve made a lot of money. The next year, in Canada, same result. Of course, the world was in very bad shape at the time, and the messaging from both meetings was unambiguously focused on the economy, restoring stability and growth.
By May of 2011, the message was that the recovery was becoming “self sustaining” (a positive tone). Stocks didn’t push higher, and then fell back later in the year when the European debt crisis spread to Italy, Spain and France.
In 2012, the meeting was hosted in the Washington D.C. The European debt crisis was at peak crisis. Greece exiting the euro was on the table and it was stoking fear that Italy and Spain were next to crumble and destroy the European Monetary Union. The first line of the communiqué was about Europe and the need for economic stimulus. Stocks went higher and two months later, ECB head Mario Draghi further fueled stocks by stepping in and averting disaster in Europe by saying they would do “whatever it takes” to save the euro.
In 2013, G7 leaders, plus Russia met in the UK. The second statement in the 33 page communiqué focused on economic uncertainty and promoting growth and jobs. Stocks went higher.
In 2014, the meeting was hosted by the European Union. Russia had been ousted earlier in the year from the G8 for break of international law for its actions in Ukraine. The primary focus was on Russia and promoting freedom and democracy. The tone on the economy was somewhat upbeat. Stocks went up for a few weeks and then ultimately fell back later in the year in a sharp correction/then sharp recovery.
In 2015, Germany hosted. The communiqué led with a focus on the refugee crisis. Stocks followed a similar path to 2014.
Finally, today the 2016 meetings concluded in Japan. The focus was on the economy. “Global growth remains moderate and below potential, while risks of weak growth persist.” And they discuss rising geo-political conflicts as a further burden on the global economy.
So if we look back at these meetings, clearly there is a G7 (G8) effect. If the headline focus is the economy, it tends to be very good for stocks.
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Buffett’s famed annual letter is due to be released this weekend. With that, today we want to talk a bit about his record, his philosophy on markets and successful investing and the high conviction stocks that he has in his $130 billion plus Berkshire Hathaway stock portfolio.
First, only one living investor has a length of track record that can compare to Buffett’s. That’s fellow billionaire Carl Icahn. Icahn actually has a better record than Buffett, and it spans a little longer. But he gets a fraction of the attention of the man they call the Oracle of Omaha.(more…)
Today the rebound in oil led a significant turnaround for stocks. With that, the broader sentiment of uncertainty across markets tends to abate. Broader commodities swung from negative to positive. And yields on the U.S. 10-year Treasury, which were in deep decline this morning, swung to positive territory by the afternoon.
If you own stocks, a house, have a job or need to eat, you should cheer for higher oil prices.
As we’ve talked about quite a bit in recent weeks, cheap oil, at this point in the global economic recovery, is a catalyst to destabilize the global economy. While consumers gain a few bucks from cheaper gas, the oil industry leans closer to the edge of bankruptcies and weak oil exporting countries toward default. That would be very bad news (global financial crisis, round 2). So the longer we’re down here, and the more persistent these low levels appear, the riskier the world looks. And when the world looks risky, people sell stocks, and other relatively risky assets and they hold cash or buy U.S. Treasuries (which pushes yields lower).
For proof, here’s a look at the 10-year yield on the U.S. Treasury note.
Keep in mind, the Fed raised rates in December! They did so when the 10 year was trading at a yield of 2.20%. The yield is now 45 basis points lower. And even though a voting Fed member said yesterday that in her view, a second hike was still on the table for next month, the market has still virtually priced out the possibility of any further hikes for the rest of the year.
Why? Because other parts of the world are moving (or are moving deeper) into negative rate territory, because economic conditions continue to soften, mostly driven by sentiment and weakening inflation prospects. A big driver of that mix is the oil price crash.
In the next chart, you can see how yields, despite the December rate hike, have tracked oil lower.
Again, when people think the world looks risky, they pile into the safest parking place for capital on the planet, U.S. Treasuries –and that drives yields on Treasuries lower. While that flow of capital has certainly occurred, the pressure on yields from speculators is also a big component.
If you recall, we discussed a couple of weeks ago how markets can have it wrong – sometimes very wrong. If indeed, the market is wrong on this one, there is a tremendous opportunity to ride yields back to the 2.25% area. And it may be a violent move.
But oil will be the driver.
As we said, oil turned the tide for stocks today. Here’s a look at the relationship of oil and stocks over the past three months.
In this longer term chart above, you can get perspective on where oil prices stand relative to history. You can see in this chart the sharp rise, the sharp fall and the rebound from the depths of the global financial crisis.
That rebound was all China. China stepped in and used their three trillion dollars in foreign currency reserves AND their massive fiscal stimulus package to gobble up cheap commodities.
And you can see this most recent price crash was triggered by move by the Saudis to block an OPEC production cut in November 2014. It was the night of the Thanksgiving holiday in the U.S. and oil was trading about $73. We haven’t seen that price since.
The low at the depths of the financial crisis was 32.40. That’s about where oil closed today. We’ve made the case in recent weeks that, if OPEC refuses to cut production (likely), the central banks could/should step in and buy oil (the ECB, BOJ and/or China).
Bryan Rich is a macro trader and co-founder of Billionaire’s Portfolio,a subscription-based service that empowers average investors to invest alongside the world’s best billionaire investors.
The word China is often thrown around to explain why markets are in turmoil. China doing well was a threat to western civilization. China doing poorly is now a threat to Western civilization.
Which one is true?
First, a bit of background. Over the past twenty years, China’s economy has grown more than fourteen-fold! … to $10 trillion. It’s now the second largest economy in the world.
During the same period, the U.S. economy has grown 2.5x in size.
So how did China achieve such an ascent and position in the global economy? One word: Currency.
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For a decade, China maintained a fixed exchange rate policy — the yuan was pegged against the dollar. One U.S. dollar bought 8.27 yuan. This allowed China to undercut the rest of the world, churning out cheap commoditized goods, competing on one thing: Price.
But in 2005, China changed its currency policy. It abandoned the peg.
After political tensions rose between China and its key trading partners, namely the U.S., China adopted a “managed float.” Under this policy China agreed to let the yuan trade in a defined daily trading band, while gradually allowing it to appreciate. This was China’s way of pacifying its trading partners while maintaining complete control over its currency.
Over the next three years the Chinese yuan climbed 17 percent against the dollar, enough to ease a politically sensitive issue, but far less than the relative economic growth would warrant. In fact, China’s economy grew by 43 percent while the U.S. economy grew only 10 percent.
That timeline leads us up to the bursting of the global credit bubble. What caused it? The housing bubble can be credited to a key decision made by the government sponsored credit agencies (Fitch, Standard and Poors, Moody’s), all of which stamped AAA ratings on the mortgage bond securities that Wall Street was churning out.
With a AAA rating, massive pension funds couldn’t resist (if they wanted to keep their jobs) loading up on the superior yields these AAA securities were offering. That’s where the money came from. That’s the money that was ultimately creating the demand to give anyone with a pulse a mortgage. That mortgage was then thrown into a mix of other mortgages and the ratings agencies stamped them AAA. They rinsed and they repeated.
But where did all of the credit come from in the first place, to fuel the U.S. (and global) consumption, the stock market, jobs, investment, government spending … a lot of the drivers of the capital that contributed to the pin the pricked the global credit bubble (i.e. the U.S. housing bust)? It came from China.
China sells us goods. We give them dollars. They take our dollars and buy U.S. Treasuries, which suppresses U.S. interest rates, incentives borrowing, which fuels consumption. And the cycle continues. Here’s how it looked (and still looks):
The result: China collects and stockpiles dollars and perpetuates a cycle of booms and busts for the world.
That’s the structural imbalance in the world that led to the crisis, and that problem has yet to be solved. And the outlook, longer term, for a solution looks grim because it requires China to move to develop a more robust, and consumer led economy. That structural shift could take decades. And going from double digit growth to low single digit growth in the process is a recipe for social uprising of its billion plus people.
In the near term, the likelihood that China will fight economic weakness with a weaker currency is high. We’ve seen glimpses of it since August. And the hedge fund community is ramping up bets that it’s just starting, not ending.
Above is a look at the dollar vs the yuan chart (the line going lower represents yuan appreciation, dollar depreciation). Longer term, China’s weak currency policy is a threat to economic stability and geopolitical stability. But short term, it could be a shot in the arm for their economy and for the global economy.
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When housing prices stalled in 2006 and then collapsed over the next three years, the subprime lending schemes quickly became exposed.
Mortgage defaults led to a banking crisis. Due to the highly interconnectedness of banks globally, the problems quickly spread to banks around the world. A banking crisis led to a global credit freeze. When people can’t access credit, that’s when it all hits the fan. Companies can’t meet payroll, don’t have the liquidity to make new orders. Jobs get cut. Companies go bust. Finally, the microscope on overindebtedness of consumers and corporates, turns to countries. Deficits leads to debt. Debt leads to downgrades. Downgrades leads to defaults.
For the most part, defaults were averted because central banks and governments stepped in, in a coordinated way, to backstop failing banks, failing companies and failing countries. From that point, continued central bank stimulus has 1) enabled banks to recapitalize, 2) foiled additional shock events, and 3) restored confidence to employers (to hire), to investors (to invest) and to consumers (to spend again).
As we’ve discussed in the past two weeks, persistently low oil prices represent a risk on par with the housing bust. And in recent days we’re seeing the signs of another global financial and economic crisis creeping uncomfortably closer to a “part two.”
As we’ve said, this time would be much worse because governments and central banks have exhausted the resources to bailout failing banks, companies and countries. But central banks, namely the Bank of Japan and/or the European Central Bank do have the opportunity to step-in here, become an outright buyer of commodities (particularly oil), as part of their QE programs, to avert disaster. But time is the oil industries worst enemy and therefore a big threat to the global economy. The longer policymakers drag their feet, the closer we get to the edge of global crisis — a crisis manufactured by OPEC’s price war.
Unfortunately, there are the building signs that the market is beginning to position for the worst outcome…
Key bank stocks in Europe are trading at levels lower than in the depths of both the global financial crisis (2009) and the European sovereign debt crisis (2012).
Source: Reuters, Billionaire’s Portfolio
The credit default swap market for key industries is sending up flares. This is where default insurance can be purchased against a company or country – and the place speculators bet on a company’s demise. Billionaire John Paulson famously made billions betting against the housing market via credit default swaps. Now the fastest deteriorating companies in Europe are banks. And the fastest deteriorating companies in North America are insurance companies (a sector that tends to have investments in high yield debt … in this case, exposure to the high yield debt of the oil and gas industry).
Source: Markit
The early signal for the 2007-2008 financial crisis was the bankruptcy of New Century Financial, the second largest subprime mortgage originator. Just a few months prior the company was valued at around $2 billion.
On an eerily similar note, a news report hit this morning that Chesapeake Energy, the second largest producer of natural gas and the 12th largest producer of oil and natural gas liquids in the U.S., had hired counsel to advise the company on restructuring its debt (i.e. bankruptcy). The company denied that they had any plans to pursue bankruptcy and said they continue to aggressively seek to maximize the value for all shareholders. However, the market is now pricing bankruptcy risk over the next five years at 50% (the CDS market).
Still, while the systemic threat looks similar, the environment is very different than it was in 2008. Central banks are already all-in. On the one hand, that’s a bad thing for the reasons explained above (i.e. limited ammunition). On the other hand, it’s a good thing. We know, and they know, where they stand (all-in and willing to do whatever it takes). With QE well underway in Japan and Europe, they have the tools in place to put a floor under oil prices.
In recent weeks, both the heads of the BOJ and the ECB have said, unprompted, that there is “no limit” to what they can buy as part of their asset purchase program. Let’s hope they find buying up dirt-cheap oil and commodities, to neutralize OPEC, an easier solution than trying to respond to a “part two” of the global financial crisis.
