Beware the fragility of the global economy

Quantitative easing (QE) saved us from the 2008 crash and kick-started a recovery, but also encouraged a build-up of one-sided risk in the financial system. Are markets and the economy ready for the fallout?

The sudden rise in volatility last February shows that, despite strong growth, financial markets remain vulnerable. Since 2008, we have experienced seven flash crashes followed by sudden recoveries. Volatility has become binary with markets swinging between periods of shock and calm. While the VIX index, which measures the stock market's expectation of volatility, has traded at a median of 16 since QE, against 18 before, the spikes in volatility have become twice as frequent. This is equivalent to exchanging stable, drizzly rain in the City of London for sunny weather but with more hurricanes.

As central bankers attempt to normalize policy, the risk is a collapse of carry trades in financial markets, where an investor borrows at a low interest rate to invest in something promising a high return, with a negative spillover into the economy. 

Central banks have bought $21 trillion in government debt globally since 2008, pushing investors to search for yields in riskier markets. The result is a pyramid of trades dependent on stable interest rates: $12 trillion of government debt yields less than 1% and the yield from $11 trillion of corporate debt is nearing a record low. As cash-flows and growth rates are discounted at near-zero rates, $8 trillion of high dividend and growth stocks trade at record high valuations. At the top of the pyramid are strategies betting on stable volatility and asset correlations, which total up to $2 trillion, according to our estimates.

While carry trades have flourished, the architecture of financial markets has become increasingly fragile. In 1976, the economist Hyman Minsky wrote that a crisis can develop when financial structures amplify rather than dampen an initial shock. Today, we can identify a number of negative feedback loops in strategies which use leverage, buy illiquid assets or own a large percentage of their asset class. A bank-loan, exchange-traded fund (ETF) issues listed shares but takes between 30 and 60 days to settle a loan sale in the secondary market. There is also a systemic impact. ETFs own 3.9% of US high-yield bonds – more than the inventory of all broker-dealers put together. Passive strategies and quantitative trading together represent 60% of equity assets, according to JP Morgan research. With tighter banking regulation limiting the room for trading desks to absorb risk, markets can be caught in violent crosswinds when passive strategies unravel.

In the February sell-off, junk bond ETFs lost around 13% of their shares outstanding. Like instantaneous redemptions, these force the ETFs to sell bonds in the secondary market to redeem shares, expediting a sell-off. Because investors know this, they may be encouraged to sell, as the Bank for International Settlements wrote in a report last Sunday: 

"[T]he unique structures of ETFs might allow, or even encourage, less stable investment behaviour by owners of these products". Short volatility strategies act similarly: by selling volatility and put options in good times, they buy the dip, keeping stocks and credit within a narrow range. Lower volatility, in turn, generates profit for such trades and encourages more investors to pile into the same strategies. In a sell-off, however, the mechanism works the other way around and exacerbates the sell-off.

The result is increased fragility: if a flash crash can cripple markets during a global expansion, what will happen in a recession? And can financial market fragility translate into economic volatility?

While the Federal Reserve is normalizing policy rates, the European Central Bank and Bank of Japan remain the fulcrum for central bank balance sheets making up half of global QE assets. This means it will be more difficult for them to exit without shocks. In turn, financial shocks can hurt growth, potentially through three contagion channels.

Firstly, if QE worked through a wealth effect on asset prices and consumption, falling markets could reverse it. In the US, the top 10% of income earners account for a quarter of national consumer spending, according to the Bureau of Labor Statistics. This is also the group of people who saw their net wealth grow 24% from 2010-2016, thanks to rising asset prices, while the bottom 40% of earners experienced a decline in net wealth in the same period. In other words, income and wealth distribution has become increasingly polarized, which makes domestic consumption vulnerable to a financial market slump. 

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Secondly, easy monetary policy has reduced funding costs for corporates but has also kept "zombie companies" alive, instead of having them restructured. This weak tail of corporates are susceptible to a sharp rise in bond yields: default risks would increase materially if the five-year Treasury yield is near 3% and high-yield spreads are above 500bp, according to UBS research.

Thirdly, tighter and more volatile financial conditions tend to discourage investments and dampen sales, which, in turn, hurts growth. As research by the St Louis Fed suggests, corporate investment in 1990-2015 on average dropped by more than 10% when financial conditions were bad, while sales growth also stagnated. The deterioration in investment and sales is especially pronounced for companies with high dependence on external financing. 

Since the crisis, regulators have focused on bank capital to prevent a reoccurrence, while macro-prudential measures have overlooked market risks.

To build an anti-fragile market, regulators should encourage diversity and long-term incentives among investors, preventing negative feedback loops and promoting instruments that act as circuit-breakers in a crisis, such as convertible bank capital for banks and growth-linked debt for sovereigns. Without these measures, the risk of tail-events will remain high, and the likelihood of a full-policy normalization is low. Investors should prepare for hurricanes while the sun is still out.

BofA: This Is "The Last QE Trade"

Last week we reported that shortly after the biggest equity fund inflows on record at $43BN, retail investors were whipsawed and amid the latest spike in market vol which sent the VIX back over 20, yanked a "huge" $19.9BN in cash from equity investments, of which the $18.6BN in equity ETF outflows was the second highest on record.

And while last week may have been shortened by one day thanks to Easter, the volatility remained with US equities subject to increasingly greater swings in both price and sentiment.

As a result, according to BofA, equities closed off the quarter with another "huge" week of outflows, led by $13.1BN pulled from equities ($10.6BN from ETFs and $2.5BN from mutual funds), as well as $2.0Bn in bond redemptions. It is worth noting that already some 22% of the record YTD inflows into equities have now been unwound.

With the sharp recent reversal in sentiment, it is hardly surprising that Q1 saw the first quarterly loss in the S&P 500 since 2015 and the first quarterly decline in the FTSE All World index since the start of 2016.

And while the US was once again the focus of selling, it was not all doom and gloom. In fact, in what BofA's Chief Investment Strategist, Michael Hartnett, has dubbed "the last QE trade", Japan registered the second biggest inflows on record of $5.8bn & annualizing record $149.3bn inflows for 2018 as investors scrambled into the safety of the only central bank which has not given any indication it will be tapering any time soon.

According to the FT, it is likely that local Japanese investors took profits on overseas holdings, bringing the money home ahead of the end of the fiscal year on March 31. EPFR Global said most of the cash into Japanese equity funds was yen-denominated, while recent strength in the yen would also have made such a move attractive.

What is bizarre is that this flood into Japan counter-intuitively also coincided with testimony in a cronyism scandal involving Abe's government: Nobuhisa Sagawa, an ex-finance ministry official, said the decision to alter documents about a sale of public land was made by his staff alone and there were no orders from Abe, his wife Akie Abe, finance minister Taro Aso, or any of the prime minister's aides (some have said Sagawa was clearly lying to protect his former bosses, potentially under duress but so far there is no proof of that).

"It is a respite," said Max Gokhman, head of asset allocation at Pacific Life Fund Advisors, adding that the scandal was "an ongoing issue".

Perhaps the explanation is far simpler: the BOJ simply stepped in, guns blazing, and bought everything it could... just as the ECB did last week with European bonds. Sure enough, on Tuesday, the day of Sagawa's testimony, the Topix index added 2.7%.

In contrast Europe inflows rolling over with biggest outflows since July 2016.

In spite of big losses for big tech companies such as Facebook and Google's Alphabet in March, tech funds saw net inflows of $500m each in the past two weeks. Concerns ranging from online privacy and Donald Trump's opinion on Amazon have halted a rally in the shares of large tech companies that has been a pillar of the US bull market in equities.

Still, as Michael Hartnett adds the tech inflows may be ending: the e-commerce bubble, i.e., the "belly of tech bull market"...

... is now off 11% from March peak "as Occupy Silicon Valley policy drumbeat gets louder" still, Hartnett notes that the $18bn inflows in past 6 months dwarf $5bn prior 15 years.

Tech also represents another key danger to the market as the vulnerability of leadership in the equity sector remains: there are just 5 "sells" out of 250 FAAMG recommendations, and "at March peak market cap Facebook ($541bn) > India ($462bn)" (see:"Hedge Fund CIO: "The Market Generals Are Dead"). Furthermore, at 24%, the tech share of US EPS has rarely been exceeded.

Meanwhile, the pillar that has been carrying equities for years (courtesy of cheap debt-funded buybacks) appears to be cracking as bond funds took a $1.9bn hit in the latest week.  In fact, as BofA points out highlighting the "crack in credit", we just saw a "rare week of outflows across IG, HY & EM debt; in contrast 10th straight week inflows to Treasuries."

This is a classic risk-off move, or as Max Gokhman said, commenting on the interest in short-term government debt, "I would look at that as straight-up de-risking. People may see short duration [assets] as a safe haven given all the recent volatility."

In Unprecedented Move, China Plans To Pay For Oil Imports With Yuan Instead Of Dollars

Just days after Beijing officially launched  Yuan-denominated crude oil futures (with a bang, as shown in the chart below, surpassing Brent trading volume) which are expected to quickly become the third global price benchmark along Brent and WTI, China took the next major step in the challenging the Dollar's supremacy as global reserve currency (and internationalizing the Yuan) when on Thursday Reuters reported that China took the first steps to paying for crude oil imports in its own currency instead of the US Dollars.

A pilot program for yuan payment could be launched as soon as the second half of the year and regulators have already asked some financial institutions to "prepare for pricing crude imports in the yuan", Reuters sources reveal.

According to the proposed plan, Beijing would start with purchases from Russia and Angola, two nations which, like China, are keen to break the dollar's global dominance. They are also two of the top suppliers of crude oil to China, along with Saudi Arabia.

A change in the default crude oil transactional currency - which for decades has been the "Petrodollar", blessing the US with global reserve currency status - would have monumental consequences for capital allocations and trade flows, not to mention geopolitics: as Reuters notes, a shift in just a small part of global oil trade into the yuan is potentially huge. "Oil is the world's most traded commodity, with an annual trade value of around $14 trillion, roughly equivalent to China's gross domestic product last year." Currently, virtually all global crude oil trading is in dollars, barring an estimated 1 per cent in other currencies. This is the basis of US dominance in the world economy.

However, as shown in the chart below which follows the first few days of Chinese oil futures trading, this status quo may be changing fast.

Superficially, for China it would be a matter of nationalistic pride to see oil trade transact in Yuan: "Being the biggest buyer of oil, it's only natural for China to push for the usage of yuan for payment settlement. This will also improve the yuan liquidity in the global market," said one of the people briefed on the matter by Chinese authorities.

There are other considerations behind the launch of the Yuan-denominated oil contract as Goldman explains:

• A commercial benchmark and hedging tool. Until now, Chinese oil imports were based on FOB benchmarks, with long-term procurement contracts settling off Platts Oman/Dubai or Dated Brent. The INE contract has therefore the potential to become the pricing reference for CIF China crude oil, enabling corporate financial hedging. Its warehouse structure is however likely to limit its use for physical crude delivery and may in fact at times reduce its hedge efficiency.
• A new investment vehicle for onshore investors. The majority of China commodity futures trading volumes are from retail investors, yet these had until now little ability to trade oil futures. China's capital control was the main bottleneck  to trading contracts like Brent as authorities only allow $50,000 outflow a year per person. While several petrochemical and bitumen contracts already trade in China, INE will be the first contract for crude oil, likely drawing significant interest.
• Direct access to China's commodity markets for offshore investors. China offers deep and liquid commodity markets to its onshore investors. Due to China's tight capital controls, however, foreign investors have so far only been able to trade these through qualified onshore subsidiaries. The INE contract opens up the first channel for offshore investors to trade in its onshore commodity market, with both the USD deposit and capital gains transferable back to offshore accounts. The government further announced last week that it would waive income taxes for foreign investors trading these new contracts for the first three years. The obligation to trade in Yuan will also add a currency risk exposure to offshore investors. We illustrate in Exhibit 6 a likely template (amongst others) of how overseas investors will be able to access INE liquidity.

The danger, of course, is that such a shift would also boost the value of the Yuan, hardly what China needs considering it was just two a half years ago that Beijing launched a controversial Yuan devaluation to boost its exports and economy.

Still, in light of the relative global economic stability, Beijing may be willing to take the gamble on a stronger Yuan if it means greater geopolitical clout and further acceptance of the renminbi.

Which is why restructuring oil fund flows may be the best first step: as of this moment, China is the world's second-largest oil consumer and in 2017 overtook the United States as the biggest importer of crude oil; its demand is a key determinant of global oil prices.

If China's plan to push the Petroyuan's acceptance proves successful, it will result in greater momentum across all commodities, and could trigger the shift of other product payments to the yuan, including metals and mining raw materials.

Besides the potential of giving China more power over global oil prices, "this will help the Chinese government in its efforts to internationalize yuan," said Sushant Gupta, research director at energy consultancy Wood Mackenzie. In a Wednesday note, Goldman Sachs said that the success of Shanghai's crude futures was "indirectly promoting the use of the Chinese currency (which, however as noted above, has negative trade offs as it would also result in a stronger Yuan, something the PBOC may not be too excited about).

Meanwhile, China is wasting no time, and Unipec, the trading arm of Asia's largest refiner Sinopec already signed a deal to import Middle East crude priced against the newly-launched Shanghai crude futures contract, which incidentally is traded in Yuan.

The bottom line here is whether Beijing is indeed prepared and ready to challenge the US Dollar for the title of global currency hegemon. As Rueters notes, China's plan to use yuan to pay for oil comes amid a more than year-long gradual strengthening of the currency, which looks set to post a fifth straight quarterly gain, its longest winning streak since 2013.

In a sign that China's recent Draconian capital control crackdowns have sapped market confidence in a freely-traded Yuan, the currency retained its No.5 ranking as a domestic and global payment currency in January this year, unmoved from a year ago, but its share among other currencies fell to 1.7 percent from 2.5 percent, according to industry tracker SWIFT.

A slew of measures put in place in the last 1-1/2 years to rein in capital flowing out of the country amid a slide in yuan value has taken off some its shine as a global payment currency.

But the yuan has now appreciated 3.4 percent against the dollar so far this year, with solid gains in recent sessions.

"For PBOC and other regulators, internationalization of the yuan is clearly one of the priorities now, and if this plan goes off smoothly then they can start thinking about replicating this model for other commodities purchases," said a Reuters source.

Still, it will be a long and difficult climb before the Yuan can challenge the dollar and for Beijing to shift the bulk of its commodity purchases to the yuan because of the currency's illiquidity in forex markets. According to the latest BIS Triennial Survey, nearly 90% of all transactions in the $5 trillion-a-day FX markets involved the dollar on one side of a trade, while only 4% use the yuan.

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Still, not everyone is convinced that the new Yuan-denominated contract will create a "petro-yuan" as the following take from Goldman highlights:

The launch of the INE contract is not just about oil, as it will also be the first Yuan denominated commodity contract tradable by offshore investors. Such a set-up meets the PBOC's monetary policy committee goal to raise the profile of its currency in the pricing of commodities. It has raised however the question of whether the INE contract is an incremental step in achieving the currency reserve status for the Yuan. We do not believe so.

While the INE launch does represent an additional step in the CNY internationalization, the CNY denomination of the INE contract does not in itself imply CNY investments. The INE contract does not represent an opening of China's capital accounts since foreign deposits operate in a closed circuit, deposited in designated accounts and not to be used to purchase other domestic assets. In practice, the collateral deposit and any capital gains can be transferred back to offshore accounts. The potential for greater foreign ownership of Chinese assets is therefore not impacted by CNY oil invoicing and would require instead oil exporters to recycle their proceeds in local assets, for example. The incentive to do this has not changed with the introduction of the INE contracts. In particular, most Middle East oil producers still have currencies pegged to the dollar and limited ability to hedge CNY exposure.

Whether or not Goldman is right remains to be seen, however it is undeniable that a monumental change is afoot in global capital flows, where the US - whether Beijing wants to or not - will soon be forced to defend its currency status as oil exporters (and investors in this highly financialized market) will now have a choice: go with US hegemony, or start accepting Yuan in exchange for the world's most important commodity.