I would love to do a post on fractals, power laws and tail risk. But I don’t have enough time today to develop my thoughts on the subject coherently. So I am going to concentrate on the news flow today and what it tells us about where this financial crisis is headed. Given the last mini-crisis we had in emerging markets was overcome relatively quickly, the present crisis doesn’t have to persist for that long. We still don’t know where things are headed. For now, however, there is an increasing amount of contagion and flight to safety.
Below are a few stories I think are important, some of which I don’t have a firm view on but still remain relevant.
David Wessel linked out to this post, noting that the German 10-year government bond yield had fallen to 0.594%, a record low. I had mentioned yesterday that “bunds are stretched here. Why own German Bunds when you could own Treasurys, Canadian government bonds or British Gilts, all of which are backed by central banks with more degrees of freedom than the ECB?” The same goes for JGBs, which I noted on Twitter yesterday were yielding 0.36%. The answer I think has to do with the move to safe assets. I don’t have good enough an answer beyond this. But the fact that Bunds are trading much more like JGBs today than like Gilts or Treasurys as they were one or two years ago doesn’t speak well to the deflation risks in Europe
The title is a bit overly aggressive here, but the content is solid. I think the point of this post is that we live in an interconnected world and that, as in previous oil declines, petrodollar recycling will be a big factor. It’s not clear to me, however, what impact the removal of petrodollars will have in terms of private portfolio preferences, market liquidity or valuation. Speculatively, I would say that we should expect oil production levels to remain in place, putting additional downward pressure on oil prices into 2015. And this will mean fewer petrodollars because margins will be much lower.
China’s wages have already made them less competitive from an export perspective. The fact that the renminbi is tethered to an appreciating dollar makes this more problematic. Even so, wage growth is declining in China as growth declines. This story, however, reminds me of my speculation about the relevance of a Lewis Turning Point in China. I have brought this up a number of times in the past. Basically, industrial wages rise quickly when the supply of excess labor dries up. Michael Pettis told me that he thinks this is not an issue in China because slowing growth will make it less relevant. Recent data suggest he is right. Nonetheless, the WSJ article here does suggest that labor rates have already risen enough to hurt China from a global wage arbitrage perspective, making export-led growth more difficult going forward.
It’s not clear how much of China’s foreign reserves are deployable to defend the country’s currency. In a worst case scenario, the reserves could be exhausted much sooner than we think if much of it is committed to long-lived projects. If the Ruble collpase continues, this will be a relevant fact.
Yesterday, I wrote that “the [Canadian] finance minister Joe Oliver claims the government is sticking to its pledge to balance the budget despite these [oil] headwinds. I believe him and so that means monetary policy is left to do the heavy lifting. This is bearish for the Canadian dollar, which I expect to weaken further.” This article confirms what I have been saying on this front. But note that everywhere you look there is fiscal weakness in Canada due to oil, not just at the federal level. Newfoundland is projecting a $1 billion deficit for fiscal year 2014-2015 which ends in March. The 2014-2015 budget for Newfoundland and Labrador was based on oil at $105 a barrel. It now forecasts $86.49. A Canadian follower on Twitter tells me that Newfoundland and Labrador were net contributors to fiscal equalization, meaning there will be federal shortfalls associated with weaknesses at the province level. Allegedly the old Finmin Flaherty has left a hidden $3.7 billion fix to help Harper to get to a balanced budget. I don’t think we get there without spending cuts though.
The Greek yield curve is inverted as the three year went to levels approaching the highest since the 2012 default. This highlights the political risks in Greece and the lack of confidence around the original restructuring as Greece has never recoupled the way all the rest of the periphery has. Greece is now seen as a n outlier. And unlike in 2012, where what happened in Greece had serious contagion consequences for the rest of the periphery, now anything short of euro exit and redenomination is not going to produce contagion unless we see political changes elsewhere in Europe. Privately an Italian investment manager tells me she thinks that Italy is the weak link in all of this because of the government’s dithering on structural reform. I would agree that Italy is the elephant in the room because of the size of its bond market and economy. An Italian default or euro zone exit is unmanageable. Bit the situation in Italy is still deteriorating and growth is weak, whereas it has turned around elsewhere in the periphery. This is why I expect sovereign quantitative easing to occur early next year. But, without growth, the Italian situation will remain the biggest problem for Europe.
“Brazil’s real dropped to its weakest level in almost 10 years against the US dollar after the collapse of the Russian rouble spurred on a wider emerging market rout, as investors sought refuge in safe-haven assets. Countries such as Turkey, an importer of oil that should benefit from the plunge in crude prices, were also hit, with the lira weakening to a record low against the dollar during intraday trading. India, another oil importer, saw the rupee fall to its lowest level in more than a year. Stock markets in Dubai and Saudi Arabia both lost 7.3pc, continuing a plunge that has ravaged the Gulf this month. ”
Contagion is a major reason I see what is happening now as a crisis. The areas where markets have been impacted are large and growing. What can we take away from this? First, to the degree this crisis ends like the last EM crisis in January and February, the crisis can only weaken EM growth going forward, making debtors there more vulnerable the next go around. Second, the weaknesses in EM tell us that global growth really is slowing, and this will reduce demand for oil and industrial commodities. And third, to the degree that Europe also remains weak because of its policy framework, the US is really the buyer of last resort. There is no one else available to pick up the slack. At the margin, this keeps the strong dollar move in place. But it also exposes the global economy fully to weakness in the US domestic economy as there are no other buffers globally.
I expect to hear more stories like this. Another fund at Kopernik is also said to have made massive losses on its Russia holdings. David Iben was in the news in September touting his investment in Russia. He is looking at this as a long-term play, so he could still win. Nevertheless, it points out the pitfalls here. And I expect to hear a lot about some funds taking massive losses on oil and Russia. If the drop continues, we could see a major player taken away on a stretcher. But let’s remember this. According to Mebane Faber, in 1998, oil was down 40% and Russian stocks were down 90% from peak. By comparison, in 2014, oil is down 40% and Russian stocks are down 75% from peak. He asks, “What happened in 1999?” Russian stocks were up over 150%. As I said in the last post about Russia, the analysis we are getting on TV and in print is skewed by bias. This is the right way to think about this situation. At some point, the value in Russia will be great enough to reward you for the risk once the volatility dies down. I’m not sure we’re there yet though.
Note the following regarding the contagion we are seeing:
“High-grade energy spreads have gapped out more than 35bp in the last 10 days, but the rout has been felt across the market. According to one trader, spreads in the telecom, media & technology (TMT) space were 5bp–10bp wider mid-morning. Amazon’s recently issued 3.8% December 2024s were quoted at 164bp, 9bp wider from the 155bp pricing on December 2. Industrials were about 1bp–3bp wider on higher-rated names and 3bp–5bp wider on riskier high-beta credits.”
Only when this kind of contagion reverses, do we know the crisis is over. Fior now, contagion is increasing.
“A nearly 50% drop in crude oil prices since the summer drained the debt-laden Calgary-based company of cash and was starting to hurt its ability to fund ongoing projects. That, in turn, pushed down the value of Talisman’s shares by more than half.”
This is the last entry here. I think Repsol was right to snap up the Talisman asset now while the company was distressed. As in any crisis situation, you are going to see huge drops in valuation as distress builds. This is a buying opportunity for long-term investors.