Financial Markets: What Could Go Wrong?
Financial waters have been calm for too long. While the Trump rally blazes on, the Tweeter-in-Chief isn’t satisfied, blaming Fed Chair Jerome Powell for shackling the market. Trump tweeted,
‘If the Fed had done its job properly, which it has not, the Stock Market would have been up 5000 to 10,000 additional points, and GDP would have been well over 4% instead of 3%... with almost no inflation. Quantitative tightening was a killer, should have done the exact opposite!’
So, what could go wrong? Christopher Whalen explains in The American Conservative that Europe’s banking funk could make its way across the pond. What we can’t see we can’t worry about. Whalen explains, “Whereas the United States has a bankruptcy court system to protect investors, in Europe the process of resolving insolvency is an opaque muddle that leans heavily in favor of corporate debtors and their political sponsors.”
Whalen contends that European regulators have let, for instance, Deutsche Bank, Germany’s largest bank, muddle along with a portfolio of dud loans on a tiny thimble of capital. Whalen writes,
Prior to 2018, when the president of the European Central Bank, Mario Draghi, directed EU banks to start recognizing bad credits, international accounting rules essentially allowed EU banks to ignore bad credits. Indeed, EU banks could pretend that loan payments were still being received. Loans that defaulted prior to 2018 were not included in the directive. Thus Europe has a decade of detritus sitting in the loan portfolios of many banks that is neither disclosed nor properly valued. Whereas in the United States banks must charge-off bad assets down to some expected recovery value, in Europe we extend and pretend.
This would be okie-dokie here in the good old U.S. of A, except,
that U.S. and EU banks are enormously intertwined, particularly in terms of funding and derivatives—two areas of keen interest to U.S. regulators. But the fact of the matter is that the EU banking system and the EU economy are still too weak to shoulder the burden of a general cleanup of bad credits in EU banks.
Then there is the matter of the explosion of corporate debt in the U.S.. In a paper entitled “This Time Is Different, but It Will End the Same Way: Unrecognized Secular Changes in the Bond Market since the 2008 Crisis That May Precipitate the Next Crisis” the authors Daniel Zwirn, Jim Kyung-Soo Liew and Ahmad Ajakh explain in excruciating detail that the U.S. bond market is loaded with bonds rated just this side of junk which would have no liquidity in the case of a market meltdown.
At the end of last year’s 3rd quarter, the US bond market totaled $42.39 trillion compared to the stock market’s capitalization at the time of $30 trillion. Mortgage debt has held steady at $9.7 trillion while corporate debt has nearly doubled from 2008 to Q32018, $5.5 trillion to $9.2 trillion.
Investors looking for yield have loaded up on bond ETFs to their peril. The authors explain,
In down markets, redemption suspensions will catch corporate bond ETFs and mutual fund investors by surprise and result in tremendous confusion and possible retail investor panic as this asset-liability mismatch becomes evident. The investors in the assets—ETFs and mutual funds—will be shocked to find that they cannot quickly redeem because the underlying OTC securities will have no bids and, thus, no exits.
Stephanie Pomboy of MacroMavens addressed ETF liquidity concerns, “In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid. The upshot is that these vehicles are only liquid in one direction.”
Ms. Pomboy was recently interviewed for Real Vision by Grant Williams where she pointed out that most corporate debt was used to repurchase shares. Pomboy explained,
We had this huge obviously 24% increase in S&P earnings last year, and the rule to which that was influenced-- even notwithstanding the tax cut by the record amount of buybacks-- is so under appreciated. And it's had me worried that as we come into 2019 in that tax cut lift phase, people might start to realize, hey, the underlying fundamentals here aren't really that strong because while the S&P was reporting earnings of 24%, the broader government profit numbers were only up 7%.
That's a massive gap. And you've only seen gaps like that a handful of times in the last 50 years. And every time you've seen a gap where the S&P ran ahead of the government numbers, it's been ultimately reversed.
The Fed’s extraordinary monetary policy has put pensions in dire straits. Pomboy told Williams,
when we started this, I think we were at $3 trillion in total underfunding public and private [pensions]. And today, we're just a hair under $7 trillion. That's 33% of GDP today. And the scariest thing to me about that is that, again, this is after a decade long, almost-- decade long economic expansion and the longest bull run in stock in history. So if this is the underfunding situation now, when we're arguably at the peak of economic and financial activity, what is it going to look like when, heaven forbid, the market actually sustains a downturn or we go into a recession?
You know, the answer, if you want to look back to 2000 when we had the dot.com bust and then the 2008 episode is on average of those two cycles the funding deficit doubled. So we would go from seven to $14 trillion which, if GDP is where it is today, so you to 2/3 of the GDP.
When pensioners begin to understand their money may not be there, a run on the plans will happen like the run on the Dallas police pension a few years ago.
As for the bond market, Pomboy sees trouble ahead, and soon.
And then, of course, you know, you've got another $1.2 trillion in actual junk, and then you've got $1.2 trillion in levered loans with no covenants. So you've got about $5 trillion in corporate debt of the $9.5 trillion out there. So more than half of it that's really vulnerable to any increase in rates. And we're going to really find out who can withstand an increase in rates because we've got almost $800 billion of that debt rolling [maturing]
--this year and another $900 billion next year. So there's no relief in sight. You know, it's not like, oh, if they could just make it to the end of this year, everything is all clear.
The head of MacroMavens made the point that three-quarters of S&P 500 earnings come from only 20 percent of the companies. There is a real question whether the rest can make debt service payments, especially if rates rise.
How does Pomboy see cities and states solving the coming pension crisis? Marijuana, she says. “I think that's why it's becoming so popular to legalize, is that you can tax the hell out of that. It's a great source of revenues for a lot of cities and states.” She continued, “ that's an easy place I guess to drum up revenue really quickly. The other taxes that you're talking like wealth taxes and any effort to redistribute income just strikes me as going to destroy any entrepreneurial spirit whatsoever that's so important to keep this capitalist system thriving.”
Trump’s fate for the 2020 election likely depends on the financial markets holding together. The market gains he’s taken credit for may punish him before election day.