The volatility of global equities was on the rise this week, with significant sell-offs on the major stock exchanges in the U.S. (Tuesday) and China (Thursday). This coincided with a downward revision of first-quarter GDP amid an array of other disappointing economic data in the States. Funds continued to crowd into the bond markets, though the precious metals still traded flat.
GOVERNMENT & POLICY
Party Like Its 1929?
“Those who cannot remember the past are condemned to repeat it.”--George Santayana
Distinguished Spanish-American philosopher and writer George Santayana was probably the first to utter this prescient wisdom in the late 19th century; the insight has been repeated in slightly different forms many times since. In spite of these widespread references to the idea of humankind being damned to repeat its follies if the lessons of history are ignored, we ironically continue to make this same error time and time again.
Santayana’s aphorism is especially relevant to today’s $20 trillion U.S. stock market. One of the parallels between the circumstances that precipitated the 1929 stock crash and the current state of the U.S. economy (and the global economy, for that matter) is an extended period of abnormally low interest rates. Throughout the bull market in stocks during the 1920s, the Federal Reserve kept benchmark rates capped. This low-rate environment helped fuel the easy credit margin buying and outright speculation that, in part, drove the enormous stock market bubble that followed.
Not surprisingly, as it became clear that equities were overheating, the Fed attempted to curb the runaway markets by raising interest rates several times in the autumn of 1929. This ill-fated decision is what sparked the bank runs, insolvencies, and other acute manifestations of the crash as investors vainly attempted to pull their money out of the sinking ship of stocks (and out of the banks so heavily invested in said stocks).
Is the unsinkable Titanic that is the U.S. stock market again headed for the iceberg of an ominous rate hike panic?
The longer the Federal Reserve waits to raise rates, the more the current scenario begins to resemble the circumstances leading up to the infamous 1929 crash–particularly in the absence of a long overdue correction in stocks. Far from being an irresponsible exaggeration, this comparison is instructive when evaluating various investment opportunities (and their risks). We can’t simply write off the possibility of a sharp–and sudden–downturn for equities, particularly when the pullback from an overheated stock market is already being seen in China.
The world markets are inextricably interconnected and interrelated. This is why financial analysts and economists have worried about the ability of the U.S. economy to withstand a serious slowdown of economic activity abroad. Fed Vice Chair Stanley Fischer recently suggested that, in the event the global economy falters, raising the federal funds rate can simply be postponed. This is in direct contradiction of Chair Yellen’s insistence that the rate hike will come sometime in the 2015 calendar year, seemingly irrespective of such external factors.
The Fed finds itself perpetually caught between the rock of protecting the stock markets from a shock and the proverbial hard place of normalizing monetary policy. Although the polarizing comments by Fischer, Yellen, et al are to be expected, the danger of waiting too long to raise rates is twofold: not only are the speculators unlikely to exit the markets until the jig is definitively up (thereby making the “delayed rate hike” strategy useless), but when rates finally are set higher, it’s unclear that a substantial flight from equities can be avoided, no matter how incremental or gradual the increase is.
Contrary to its governors’ rhetoric, the Federal Reserve cannot keep interest rates near the floor indefinitely. With no clear escape in sight for the Fed, overleveraged risk-asset investors (the banks and big investment funds) will simply have to take their lumps at some point.
News & Notes
In addition to the bevy of fines recently incurred by other financial institutions in Europe and the States, Royal Bank of Scotland (RBS) is facing a $4.5 billion penalty for the sale of distressed mortgage-backed securities leading up to the financial crisis.
After having its credit rating downgraded to junk status by Moody’s (though not by other credit rating agencies), the city of Chicago is being fiscally rescued by Wall St funds. The city must find a way to cover its pension programs, perhaps considering raising property taxes or implementing large spending cuts. With the Wall St assistance, the city will be able to sell about $800 million in new bonds, its first offering of municipal bonds in 14 months.
The Republican G.O.P. primary field continues to get crowded, with former New York Governor George Pataki joining the presidential race.
Equities, Bonds Fluctuate Amid Looming Liquidity Crunch
Trading began on Tuesday following the long Memorial Day weekend, and the markets moved against the grain of a rising dollar. As the DXY dollar index rallied more than 1% to 97.3, the precious metals (excepting palladium) were sharply lower, each losing about 1%. Part of the reason for the downward movement in the metals was the gold options expiry falling on Tuesday, prompting a minor sell-off as traders closed out or rolled over positions.
Similarly, the Dow Jones sputtered to more than 200 points in the red, threatening to cross below 18,000 for the first time in 3 weeks, as the U.S. stock indices all fell by more than 1%. Meantime, U.S. Treasuries rose, with 10-year yields settling back down at 2.14%. With the dollar’s gains, the euro fell back below $1.09 and the yen approached 123 per dollar. Crude slid about 2.5%, snuffing out its recent rally.
Despite orders for capital equipment in the U.S. rising for the second straight month, and new home sales and home prices both gaining more than expected in April, any positive data was dwarfed by the revision of Q1 GDP numbers down to -0.7%, indicating a contraction of the U.S. economy. Corporate profits were also down nearly 6% during the first quarter. Not surprisingly, this pulled consumer sentiment measures to a 6-month low in May. Weekly jobless claims generated mixed responses, as although new claims held below 300,000 for the 12th consecutive week, it was still a 5-week high for the labor market gauge.
At midweek, the dollar continued to climb toward 97.7 on the DXY. This helped pull the crude oil benchmarks further down; WTI crude was about 0.5% lower, but Brent crude tanked more than 2%, bringing the spread between the two closer. Less than $5 separated the benchmarks on Wednesday, with WTI and Brent closing at $57.75/bbl and $62.25/bbl, respectively. By Friday, prices were again moving higher, settling above $58/bbl and $63/bbl.
As the week progressed, the precious metals continued to hold their positions and trade mostly sideways after Tuesday’s losses. Wall St looked to bounce back as well, making modest gains in tech and healthcare. Losses in the energy sector helped offset some of these gains, keeping the stock indices in negative territory for the week.
A troubling trend on the stock exchanges and in the bond markets has been a drying up of liquidity. We’ve been seeing higher volatility in bonds and equities around the world coupled with lower trading volumes, indicating that many of the big institutional players are exiting the markets. (What might they know?) In addition to abnormally high Price-to-Earnings ratios across the markets, the S&P 500 is undeniably overbought: the total value of company shares is currently 10% over and above the combined value of these 500 firms’ underlying assets. Taken in tandem with the shortage of available Treasuries and other investment-grade government bonds around the world, and the situation looks even bleaker.
Signs of a potentially painful correction looming in the equities markets isn’t limited to the U.S., either. Much has been made about the overheating of the Chinese stock market, and last week’s collapse of Hanergy Solar shares is sending ripples throughout the world’s second-largest stock market. Hanergy may have coughed up some $19 billion in market capitalization in one horrible trading day, but it wasn’t even listed on a major exchange; more broadly, after notching an all-time high on Monday, the Shanghai Composite index tumbled 6.5% on Thursday. It’s been revealed that the fantastic gains for Chinese equities over the last 6 months was fueled in no small part by $300 billion in margin trades. This all has followed a series of editorials issued by the main news media outlets in the People’s Republic. Penned by an “authoritative insider,” these editorials have dubiously encouraged citizens to continue to buy stocks while at the same time accepting the “new normal” of economic slowdown.
Given these warning signs, if you aren’t holding precious metals as a hedge, keep in mind that it makes no sense to get insurance after the proverbial disaster.
By Friday, the dollar eased up about a third of a percent to 97.0 on the DXY. This pushed the euro back near $1.10, but the yen continued to fall to about 124 per dollar. Wall St sank nearly 1% in early trading before returning to about unchanged in the afternoon. The metals remained almost completely flat, with gold ($1,190/oz) extending its spread above platinum to about $70 per ounce. Meanwhile, silver held at $16.85/oz and palladium hovered near $790/oz.
GEOPOLITICS & WORLD EVENTS
G7 Meeting in Dresden Focuses on Greece
The gathering of some of the world’s preeminent financial minds in Dresden, Germany would not be complete without a mention of the debt-stricken Greek economy.
In fact, the Greek question is dominating the G7 meeting. The G7 countries (the U.S., the U.K., Canada, France, Germany, Japan, and Italy) together account for about half of global GDP, and clearly have a vested interest in the long-term health of the European economy.
In addition to Germany’s Jens Weidmann (Bundesbank president) and Wolfgang Schäuble (finance minister), IMF Director Christine Legarde and ECB President Mario Draghi are also in attendance. Moreover, finance ministers from the other G7 nations, as well as Dutch Finance Minister Jeroen Dijsselbloem (chair of eurozone finance minister meetings), are all participants in the Dresden talks.
As Greece inches closer and closer toward default on its debt obligations to the IMF and EU, the topic is simply unavoidable for those gathered at the meeting. In response to optimistic comments made recently by Greek Prime Minister Alexis Tsipras, the main outcome of the talks thus far has been a public rebuttal of that misplaced optimism.
Other government officials have parroted Tsipras’ announcement that a deal is close to being finalized. The European Commission, however, has refuted this characterization of the negotiations, while the IMF’s Legarde reiterated that virtually no progress has been made in the standoff between Greece and its creditors.
Such posturing by the Greek government has been interpreted by many observers as an effort to forestall the continued outflow of depositor funds from the Greek banking system. Although the mounting fears about the uncertain consequences of a “Grexit” from the euro area initially seemed a good strategic opportunity for Tsipras and his Syriza Party to gain leverage (and precious time) by dragging out the negotiations, circumstances have now tilted in favor of the creditors: more delays in the resolution of the debt crisis actually erodes Greece’s credibility with investors, making it increasingly difficult for the country’s central bank to secure enough funding to remain afloat.
Moreover, the feigned optimism proved ineffective, as some €300 million were withdrawn from state banks in an old-fashioned bank run on Tuesday. This placed Greek bank deposits at their lowest levels in more than a decade. It would appear that Syriza is intent on finding any means of unlocking ECB bailout funds and keeping the IMF at bay–except for the means prescribed by its creditors.
Yet, their resolve may be waning. Not only has the Syriza administration pivoted on its promise not to privatize key airports and seaports, but an unofficial vote in the Greek parliament among Syriza members revealed a 95-to-75 sentiment in favor of not defaulting on the country’s loans.
It also seems that the “Troika” of the IMF, ECB, and EC are losing their patience with the obstinate Syriza stance. Many have complained (especially German FM Schäuble) that Syriza’s election victory came at a particularly inopportune time for the negotiations, as the previous Samaras Administration was nearing an accord with the Troika.
The main point of contention for the ousted Samaras government was rejecting any austerity cuts to the country’s generous pension program. Tsipras and Syriza seem intent on maintaining this line in the sand. With less than a month before the next big repayment deadline for Greece, Deutsche Bank now estimates the odds of a Greek default as high as 70%.
News & Notes
Russia continues to receive blowback on its Western border with Ukraine, with arms likely being smuggled back across the conflict-ridden border to bands of Muslim militants in Russia.
Hang-wringing continues among Western powers over the brewing Iran-Saudi Arabia dispute.
News breaks of the rampant corruption in FIFA (a scandal involving money laundering, bribery, and wire fraud by officials of the world’s international soccer organization). The U.S. removes Cuba from its list of states sponsoring terrorism, opening up a path toward normalizing relations between the two countries.
A LOOK AHEAD:
On Sunday, Manufacturing PMI data from China and Japan will be released. On Monday, we will also see Manufacturing PMI announced in India, France, Germany, the U.K., the EU as a whole, and U.S.