A Multi-Decade Credit Bubble Is Coming To An End

Crude has rallied about 5% off of last month’s low. The Brazilian real closed Friday at 3.90, having posted a decent rally from the January closing low of 4.16 to the dollar. Brazilian equities have bounced about 10%. This week saw Brazil’s currency rally 2.4%. In general, EM currencies and equities have somewhat stabilized, notably outperforming this week. Stocks posted gains in Brazil, Turkey and China. From Bloomberg: “Yuan in Longest Weekly Rally Since 2014 as China Raises Rhetoric.” The dollar index this week dropped 2.6%, which most would have expected to lend some market support.

If crude, commodities, EM, the strong dollar and the weak yuan were weighing on global market confidence, why is it that global financial stocks have of late taken such a disconcerting turn for the worse?

Thursday headlines: “Credit Suisse posts first loss since 2008”; “Credit Suisse shares crash to 24-year low.” This week saw Credit Suisse sink 15.2%, pushing y-t-d losses to 30.4%. European financial stocks continue to get hammered, some now trading near 2009 lows. Notably, Societe Generale this week fell 8.7% (down 25% y-t-d), Credit Agricole 6.1% (down 21%) and Deutsche Bank 5.2% (down 30%). From Bloomberg’s Tom Beardsworth: “Credit-default swaps tied to subordinated debt issued by Deutsche Bank rose to the highest since July 2012…” The STOXX Europe 600 Bank Index dropped 6.2% this week, boosting y-t-d declines to 19.9%. FTSE Italia All-Shares Bank Index sank 10.1%, increasing 2016 losses to 30.6%.

February 4 – Bloomberg (Tom Beardsworth): “European banks and insurers’ financial credit risk rose to the highest in more than two years, following a $5.8 billion loss at Credit Suisse Group AG and signs of a slowdown in the global economy. The cost of insuring subordinated debt climbed by 19 bps to 254 bps, the highest since July 2013, based on the Markit iTraxx Europe Subordinated Financial Index. An index of credit-default swaps tracking senior financial debt jumped six bps to 110 bps. Both indexes have risen for six days in a row…”

Here at home, the banks (BKX) sank 3.9%, trading this week at an almost 30-month low (down 16% y-t-d). The broker/dealers (XBD) fell 4.0%, sinking to the lowest level since December 2013 (down 18.7% y-t-d). Citigroup and Bank of America both have y-t-d (five-week) declines of 23%.

Why didn’t the weaker dollar this week support financial stocks – and equities more generally? For one, long dollar is perhaps the most Crowded Gargantuan Trade around. And those EM currencies and equity markets outperforming this week had become popular shorts. With the leveraged speculating community now under intense pressure, there’s especially low tolerance/capacity for pain. It’s one eye on the exit time. At this point, rather than supporting stabilization, dollar weakness spurs further de-risking/de-leveraging – commodities and EM not withstanding. It’s reached the point where there is almost no place to hide. In the mirror image of financials, gold stocks are rather abruptly transforming from Crowded short to coveted store of value (HUI up 22% this week).

Financial stocks have mutated from market darlings to shorts. Such sensational shifts in market psychology are devastating for stock prices, market confidence and liquidity more generally. As “Risk Off” appeared to attain critical momentum, this week saw heightened panic out of Crowded favorites. The Nasdaq 100 (NDX) fell 6.0%, increasing y-t-d losses to 12.4%. The biotechs (BTK) sank 5.4%, raising 2016 losses to 28.1%. The Morgan Stanley High Tech Index was hit 7.2% (down 15.7% y-t-d). The small cap Russell 2000 lost 7.2% this week (down 13.2% y-t-d).

The ongoing worldwide collapse in financial stocks provides powerful support for the bursting global Bubble thesis. After a brief respite, this week saw contagion effects return with a vengeance. Last year’s commodities and EM downfall anticipated the faltering Chinese Bubble. These days, “developed” markets have begun to discount the vulnerability of Europe, the U.S. and the rest of the world to Bubble contagion effects originally emanating from the China/commodities/EM downturns. The dominos have started falling.

Few are yet willing to accept the harsh reality that the world has sunk back into crisis. The VIX ended the week at a somewhat elevated but non-crisis 23.38. Credit spreads have widened meaningfully but for the most part remain at a fraction of 2008 crisis levels. Indeed, markets remain hopeful that “whatever it takes” central banking is waiting in the wings to trigger rallies at the moment things turn disorderly. My view that crisis has reemerged is based on the analysis that de-risking/de-leveraging dynamics have reached a point of self-reinforcing momentum beyond the control of central bank policies. In short, The Adjustment Cycle has commenced and there’s little left at this point to hold it back.

A multi-decade Credit Bubble is coming to an end. The past seven years has amounted to an incredible blow-off top – China; EM; global government debt; “whatever it takes” central bank inflationism; QE infinity; zero and now negative rates; a $3.0 TN hedge fund industry; a $3.0 TN ETF complex; unprecedented global corporate bond excess; historic M&A, stock buybacks and financial engineering; derivatives Bubble resurrection; and tech and biotech Bubbles 2.0 (to name only the most obvious). Importantly, global financial and economic imbalances – already unmatched by 2008 – went to even more precarious extremes.

Bubbles inflate both perceived wealth and future expectations. Meanwhile, in the real economy sphere, myriad Bubble facets work to destroy wealth. Mal-investment, over-investment and associated wealth destruction remain largely concealed so long as financial asset inflation persists. This is true as well for wealth redistribution. The unfolding adjustment process will deflate asset prices so as to converge more closely with deteriorating underlying economic fundamentals.

Marking down Chinese debt to a more reasonable level will leave a gaping hole – in bank capital, in government finances and in household savings. This will set back China’s transformation from production to a services/consumption-based economy by decades. Mark down European debt and asset prices to sensible levels and the banking system is insolvent and Europe’s economy is right back in the ICU. Indicative of a faltering Bubble, European periphery spreads widened significantly this week (Greece, Portugal, Italy and Spain). Europe would be in much better shape today had it taken its medicine in 2012.