What are markets saying?
The good times are over! The days of extremely low volatility, with the VIX trading at 12 or 13 are now over. We may see an up day or a down day, but the volatility is now higher than it was before – perhaps permanently.
Why is that? I would say it’s because the emerging consensus gaining a foothold in asset markets is that we are headed into recession, a global recession with China at the core of the slowdown and emerging markets, Europe and North America flagging to varying degrees too. To be honest, I’m probably there too, siding with thew consensus that we are headed for recession.
But, didn’t we have a consensus at the beginning of 2018 too – the bond bear market. I wrote about it extensively. Ray Dalio told us so. Jeff Gundlach was onside. Alan Greenspan too. Bill Gross even told us the bond bear had begun 18 months ago. And that call was made a year ago. So we’re talking mid-2016 here.
That’s a consensus, folks. And look at how that’s turned out. They were dead wrong. Yields have dropped. The US Treasury yield curve is even partially inverted. So, when we’re talking about an ’emerging consensus’, w need to look quite assiduously for non-confirming data to know for sure. That;’s as true today as it was in early 2018.
How I think about recessions
So I am constantly on the hunt for non-confirming data to counteract my own confirmation bias. Right now, there’s not a lot of it though. Most of the data confirm the negative outlook.
For example, just this morning I was talking to a young finance guy who had left a big Canadian bank in October. He told me there was nothing to do in his commercial banking role because his department had decided to stop taking new corporate loans. They were running down their loan book in anticipation of increased loan losses and credit writedowns.
I found that anecdote quite alarming because it shows how credit works to create slowdowns or even recessions. The way I look at recession is via a credit lens with the rate of change of credit growth the key variable. As long as credit is growing at the same rate or higher, you are creating more deposits endogenously. Loans create deposits. And so, banks increasing their supply of credit increases deposits available for spending. When banks are running down their loan book and halting new credit, credit growth slows and that’s not good for economic growth at all.
Of course, it all depends on the pre-conditions. We saw the same story in 2015-2016 with shale oil credit and investment collapsing and that turned out to just be a mid-cycle pause. But it was one sector at risk. Now, we have multiple sectors in play, both in the US and abroad.
China’s bad debt
China is a black box for Western investors in terms of data and general knowledge of the economic terrain. People simply don’t know how much China’s command and control tendencies can arrest incipient credit crunches. China is slowing. But can the Chinese authorities reflate? This is the big question. We simply don’t know.
I have my doubts. See here, for example:
Disposals of bad debt in China are reaching levels not seen in nearly two decades as the banking sector grapples with an onslaught of poor-quality loans that amounted to about Rmb1.75tn ($258bn) last year.
The handling of non-performing loans has become a top priority for Beijing and is viewed as a threat to financial and social stability if it is not dealt with correctly. Although banks report bad debt levels of less than 2 per cent of total loans, the true figure is expected to be multiples of that.
President Xi Jinping has made the reduction of corporate indebtedness a key element of his financial agenda over the past two years. That banks are stepping up disposals of bad debt reflects a new urgency to clean up the books of many of China’s banks.
“The deleveraging campaign is now no longer as focused on credit tightening and more fixated on addressing problems in the existing stock of debt,” said Jason Bedford, a UBS analyst, in a new report on China’s distressed debt market that cites the figures.
With an estimated Rmb1.75tn in non-performing loans disposed of by banks last year, Mr Bedford noted that such sales have “reached highs unseen since the early 2000s”.
Prices, on the other hand, have plummeted to a near decade low, as a glut of debt hits the market. One reason for the drop in prices is that more debt is coming from regional banks with poor-quality loans.
China’s economic growth in 2018 slowed to levels not seen since 1990, when the country was under sanctions following the Tiananmen Square massacre. The deceleration of the economy is expected to put more pressure on the repayment of loans in the coming years.
“Given the various macro pressures in China, including trade wars and deleveraging efforts by local funding bodies, we observed that there was greater inclination by these agencies to release NPLs into the system in the second half of 2018,” said Celia Yan, head of Greater China investments at ADM Capital.
Chinese weakness as Western CBs tighten
What we do know is that China’s growth is at near three decade lows. And the Chinese authorities are pulling out the stops by trying to add both fiscal and monetary stimulus. But, again, how effective will these measures be? And how committed to them are the Chinese given the debt overhang? We don’t know.
I expect Chinese growth to flag further. Moreover, Beijing is taking on an increasingly adversarial relationship toward the West. And, right now, the US-China trade talks do not look promising. I don’t expect an agreement by the initial March deadline. So, there is a lot of downside risk from China.
Meanwhile, western central banks are still hawkish. Look at the Bank of Canada’s latest comments, for example:
Bank of Canada Governor Stephen Poloz said he is keeping a close eye on developments in the nation’s housing market, as well as global trade tensions and the impact of lower oil prices, as he gauges the timing of his next interest rate increase.
In an interview with Bloomberg TV at the World Economic Forum in Davos, Switzerland, Poloz cited those three issues as key determinants of future policy, even as he reiterated his belief that borrowing costs are still likely to go higher.
“It’s data dependent,” Poloz said. “It will depend on how the economy responds to the shocks we’ve described.”
That’s not dovish. The global economy is slowing, with the IMF downgrading forecasts. Yet Poloz is talking about higher rates? We see the same disconnect at the ECB and with the Fed.
My view
So, as much as I try, I am not finding a lot of non-confirming data. The emerging consensus about heightened recessionary risks makes sense to me, more so given the incoming data, the policy stances, and the threats from the US shutdown, Brexit and other potential policy errors.
For me, the biggest saving grace is US household balance sheets because the lack of mortgage related interest expense means there is some room to maneuver should economic conditions worsen. But, I would like to know if you’re seeing other positives that disprove the emerging consensus that recession is just around the corner, sometime in 2019. I’m not seeing them.