"The Very Definition Of Contagion": Catching Falling Knives In Emerging Markets

Don't look now - or look - but while the US stock market trades just shy of all time highs, absent the occasional hiccup in the mighty FANGs, the rout across emerging markets is now the longest since the global financial crisis, or specifically 222 days for stocks, 155 days for currencies, and 240 days for local government bonds.

The duration of each selloff - as calculated by Bloomberg - had taken even the most ardent bears by surprise because "not one of the seven biggest selloffs since the financial crisis - including the so-called taper tantrum - inflicted such pain for so long on the developing world."

The slump and the duration, calculation in the number of days from peak to trough, has pushed some strategists to say the EM crisis is more than just a knee-jerk reaction to higher U.S. interest rates or the unfolding trade war: "It's become a full-fledged crisis of confidence for investors in developing nations."

The duration of the decline also impacts trader behavior, as lingering downtrends upend futures and options contracts, forcing traders to take losses. They also lock up investors' collateral in the form of enhanced margin calls, leaving them little room to make other trading decisions, as Bloomberg notes.

More importantly, the longer selloff also means the argument for buying the dip - one frequently made by money managers earlier this year - gives way to cautions over avoiding a falling knife.

And that, in turn, can persuade money managers who treat emerging markets as one homogeneous group to sell weak and strong markets in tandem, no matter their specific fundamentals. It's the very definition of contagion.

One strategist who would agree with the gloomy assessment that the EM crisis is in its contagion phase, is Macquarie's Viktor Shvets who in a note released today, titled appropriately "Catching falling knives & EM contagion" explains - once again - what prompted this particular EM crisis, and why it will be so difficult to exit it.

We excerpt from his note below:

EM equities are continuing to underperform; down 20% from high (Feb'18). And while immediate drivers are weaker EMs, the causes are broad & persistent: these are liquidity compression, US$ & shutdown of growth engines. CBs and China can reverse this trend; alas, at this stage not enough from either.

EM equities are continuing to underperform DMs, as vulnerable EMs refuse to accept unpalatable choices and the global & US$ liquidity continues to compress.

Despite our expectation of some relief, EMs' underperformance continued to build through the summer. Since the high (Feb'18), EMs underperformed DMs by ~15%, adding effectively another 3-4% in the last two months. The same occurred to funds flow, with Asia ex equity flows to market cap approaching 0.5% (negative) as ~US$32bn left the universe. While valuations are not yet distressed, the multiples (PER) are today trading at ~27% discount (vs historic average of ~20%). Is it the right time to get into EMs, particularly as there are already tentative signs of some return of foreign flows?

The key to determining whether the time is right is the degree of contagion from periphery to sturdier parts of the EM universe. We believe that it is totally incorrect to argue that Turkey's US$0.5 trillion of FX debt (~8% of entire EM FX debts) is not systemic. In our view, Turkey is highly systemic, from both financial & geopolitical perspective. Besides, if history is any guide, the straw that breaks the camel's back does not actually need to be critical (it could just easily have been Hungary, for example). The key to contagion is not geography or size of the initial victim but rather assessment of responses and the impact on global and regional liquidity flows. This in turn is determined by reactions of not just countries involved but also of any committee that might have been formed to 'save the world' (a la LTCM in '98, Brady bonds in '80s).

The challenge with Turkey and Argentina is not only that these two economies have unsustainable twin deficits and suffer from massively rising inflationary pressures, but also that their responses thus far were either slow or hostile. In reality both face politically unpalatable choice of either deep recession or some form of capital controls & debt renegotiation. The position of other EMs is not as extreme; but it matters little, as long as there is no change in global liquidity.

This remains the key. As long as global CBs insist on reducing liquidity while simultaneously attempting to raise cost of capital, victims would continue to float to the surface, starting with weaker players but then gradually spreading to the sturdier corners. We have already seen a significant rise in EM currency volatilities and a rise in EM and high yield spreads. In addition, investors are coming to terms with the US seeming willingness to 'weaponise' trade & US$, while technology and de-globalization are shutting down EM growth engines.

We estimate that the global liquidity growth now stands at less than 5% (not enough to cover global GDP; providing nothing for assets) while US$ liquidity is turning deeply negative, thus supporting US$.

But on the other hand, China is moving towards more stimulative position. How do we balance these factors? Unless there is a stronger private sector recovery or China becomes more aggressive, CBs must change their narrative. At this stage, we still don't see committees to 'save the world'.

The Disruption Of The Banking Sector Has Already Begun

Banking is a notoriously slow-moving industry, and even in this technology age things have tended to remain more or less the same with no radical shift in the products and services offered by financial institutions. Yet, in many parts of the world, fintechs continue to drive major innovation in the  banking industry - usually by sharpening their focus on customer experience.

Fintechs tend to thrive in regions with large unbanked populations such as China. For instance in China, Alipay, mobile banking services provider and subsidiary of Alibaba's Ant Financial, has grown so big that last year it handled more than $8 trillion in transactions--more than MasterCard's and twice Germany's GDP. The app has also become a major player in the lucrative money market fund (MMF) business and now commands a bigger share than the country's leading banks.

Alipay is such a disruptive force in China that state TV has labeled it "a vampire sucking blood from banks", while the government has enacted new banking rules to try and clip its wings.

Banking Disruption in the Developed World

While Alipay's success is simply unprecedented, banking disruption is now happening even in the developed economies of the world.

In the UK, relaxation of rules around banking licensing has seen a flurry of challenger banks spring up, mostly targeting retail banking. These 'neobanks' are mostly app-only banks--branchless, digital propositions that offer banking services at far lower costs than your typical bank. Many boast slick apps, allow freezing and unfreezing of cards at the touch of a button and can analyze customer spending in real-time and send budgeting nudges.

The banks are run solely through a smartphone or tablet with no physical branches. Partner firms plug into the apps thus creating a marketplace of services that range from investments and loans to energy and insurance.

And they are thriving, too. Founded five years ago, Britain's Revolut has amassed nearly two million customers and was recently valued at $1.7 billion during its third round of funding thus making it the first ever digital-only bank to attain unicorn status. That's nearly half as many accounts as those held by the country's much bigger TSB Bank Plc.

In the U.S., there's a dearth of fully-fledged banking startups like Revolut. Only payment apps such as Apple Pay, Amazon Pay, PayPal and Square can be said to offer services that threaten to disintermediate banks from valuable consumer spending transactions that are their lifeblood.

Research by Leading Edge Forum (LEF) comparing 10 major U.S. sectors ranked the banking industry as one of the sectors that have been relatively unchanged by digital disruption, with only insurance and manufacturing ranking lower.

Disruption Coming To U.S. Banking

There's a good reason why U.S. banks have so far been mostly immune to disruption. Following the 2008 market crash, governments across the globe increased banking regulation to prevent further shocks to the system.

But years later, many are realizing that excessive regulation has been stifling innovation and growth and have begun easing them. The UK is one such country.

Here in the U.S., banking regulation has not changed much in the post-crisis period. This year, however, something significant happened when president Trump assented to a new set of legislation that eased oversight on the industry and rolled back the crippling Dodd-Frank regulations. Essentially, the new law lessened rules on a large number of U.S. banks with assets below $250 billion.

With the shackles off, it's very likely that banks themselves will be their own biggest disruptor. They have a number of choices: replicate what fintechs have been doing by coming up with equally innovative solutions or becoming more symbiotic and less competitive with fintechs i.e. forging partnerships or a mix of these strategies.

After all, a 2017 World Retail Banking Report revealed that fintechs such as Revolut in general provide higher customer satisfaction than traditional banks. Banks can disaggregate the impact by fintechs by pursuing strategies such as open APIs and open banking

Incumbents are likely to maintain market leadership due to relatively high barriers to entry and natural inertia by customers to switch. But that does not in any way mean that things will never change.

Asymmetric Financial War And Radical US Leverage – What Will It Bring?

It seems that the Chinese leadership has concluded that the Trump Administration is determined to use its full spectrum radical leverage to hobble China as a rival, and to resurrect its own global domination – Xi seems to foresee a long struggle for position in the global future: one that will be played out geo-politically (in the jostling in the South China Sea, over North Korea, Taiwan and the BRI), as much as in the economic domain. If this is so, there is real risk of the 'jostling' spontaneously escalating into a military clash, whether limited and contained, or not.

Xi is essentially correct. Until recently, Washington subscribed to the western cultural conviction of the linear itinerary of historical 'progress' – that is to say, that the introduction of the western-style economic liberal market, under Deng Xiaoping, constituted part of an inevitable Chinese journey towards ever greater economic and political liberty (i.e. they would become like 'us'). 

But Washington DC had its 'tipping point'. It slid across, into a very different understanding. This was that China's liberal economic reforms were all about restoring China's former global economic primacy and power – and never about 'empowering the individual' in the western mode of thinking. In that context, China remaining compliant and well-behaved within the global order made sense for China – so long as it remained on course to become the global Number One, by 2049 (the CCP Centenary Year).

But, like all 'Road to Damascus' late converts, US foreign policy élites now have become fervent proselytisers for the Chinese 'threat' meme. So, the question arises: does it make sense any more for China to pursue its instinctive policy of not confronting the US, especially if Trump is known for keeping up the pressure, never backing off, and always doubling down? How can China too, stick with its 'quietist' posture if Trump ups the pressure in the South China Sea, or in North Korea, or decides to adopt Taiwan as a 'democracy cause'? Xi can't.

Russia, on the other hand, is witnessing an extremely defensive US President – a longstanding believer in good relations with Russia, but whose persistent vulnerability to the 'Russiagate' hysteria is pushing him to polish his anti-Russian credentials to the extent that he is now becoming holier than the Pope (more 'hard-on-Russia' than the Russophobes); more neocon, than the neocons. With rafts of crushing sanctions against Russia already in the Congressional pipeline (over which the US President has minimal ability to limit their implementation), Russia too must prepare for a long period of economic attrition. The depth of the American crisis is such that President Putin (like everyone) cannot guess how it may all turn out.

For Europe, Iran, Turkey, Pakistan and Venezuela, the outlook is similar: It will be a period in which the US weaponises all the leverage it has at its command to restore the US global primacy – and to bring all into line with the wider US agenda. Trump is escalating – intent, it would seem, on having the first capitulation, or political fissure to burst apart, by November. But what if that doesn't happen?

The 'market' (with a few exceptions) take the view of America's victory in the trade war as certain: the US is easily the predominant consumer market and concomitantly, it hurts US trade partners the more to be shut out from it – which is also to say, that retaliatory tariffs imposed by others will hurt US exporters the less (because US outwards exports are the lesser, in most cases).

With states such as China, its exports to the US are at least double the value of US exports to the US, therefore the US owns the leverage (in the White House view) – because there are twice as many possibilities for US to impose import tariffs as China has to impose export tariffs. Additionally, the US uses the US dollar hegemony (i.e. currency war) to create an artificially strong dollar – which weakens emerging markets, and concomitantly weakens their leverage (as their US dollar-denominated debt and interest payments, become toxically elevated, in relation to their domestic currencies).

This 'market' view of trade war somehow is a mirror of America's military zeitgeist. The US has the biggest military by far; it can outgun everyone (except Russia), so anyone challenging the US is bound to be 'a loser' (it is assumed). Indeed, the US can, and does, begin its wars with a slick show of destructive capability that pummels the adversary. But what then? Then, the US military doesn't seem to have answers to the subsequent phases: It bogs down, and then finds itself losing to asymmetric retaliation. Its only answer is the 'forever' wars.

Alastair Macleod of the Mises Institute suggests that such market sanguinity is wrong:

"Comments that China is in trouble from trade tariffs and being undermined by a strong dollar, are wide of the mark. Geopolitics dominates here. America's occasional successes in attacking the rouble and yuan are no more that transient pyrrhic victories. She is not winning the currency war against China and Russia. China is not being deflected from her strategic goals to become, in partnership with Russia, the Eurasian super-power, beyond the reach of American hegemony."

Russia and China are intent on playing – and winning – the long game. Both states, presently are sounding out Washington (prior to November) as to whether, in the words of Putin's spokesman, there is any "common ground, trying to understand if it is possible at all – and if the other party is willing at all." Beijing too is exploring whether Trump is ready to compromise on some sort of a face-saving, PR trade deal – ahead of the November midterms – or, not. This 'scenting the wind' should not be misinterpreted for weakness, or a readiness to capitulate. These states are simply doing 'due diligence' before events take them to the next stage of the conflict – in which the risks will be graver.

What is less noticed – because there has been no 'shout out' occurrence – is how much the preparations for the next phase have been incrementally unfolding (since some time). Small steps, perhaps, but of great significance nonetheless. Because the platforms for countering US financial bullying are being put into place at an accelerating pace – particularly since Trump started to sanction 'the world'.

And this old axiom is the first point to grasp: 'Every crisis is also an opportunity'. And Trump's lambasting and sanctioning of 'the world' is catalyzing a powerful push-back. When America sanctions 'the world' it is an easy 'sell' for China and Russia to push others towards de-dollarisation, and to trading in local (non-dollar) currencies. And this is happening. It is almost 'done' in respect to oil. The advent of Shanghai Futures Exchange symbolically marked the beginning of the upending of the Bretton Woods world (with Gulf States likely to succumb to the inevitable, in due course).

The 'market' sees the selling of US government debt (US Treasuries) by the PBOC as China's Damocles Sword hanging over the US; but at the same time, 'the market' believes that China will never do such a thing – as it would lower the value of its holdings. It would be counter to China's own interest. (It is never asked however, why China should want these holdings – at all – if China is debarred, by the US, from purchasing dollar-denominated assets with its US dollars).

China has always been wary of disrupting markets – that is true. But, it maybe that the 'market' is misreading China's 'war-plan'. The expectation might be that China's only resort is to sell US Treasuries (as Russia has just done). But, as usual, that would be the 'market' looking to the short-term view of China's possibilities. China however, clearly is playing the long game. Recall what Maj. Gen. Qiau Liang said in 2016: "The US needs a large 'capital return' to support the daily life of the Americans, and the US economy. Under such circumstances, [any nation that] blocks the return of capital to the US is the enemy of the US. We must understand this matter clearly … To effectively contain the United States, other countries shall think more about how to cut off the capital flow to the United States while formulating their strategies". 

And what China can – and is – doing with those US dollar assets, is to deploy them in another important way. It is not selling them, but rather is using them – without fanfare – to support its key allies, whose currencies are under periodic, concerted, Wall Street 'short' selling raids on their currencies: that is to say, China is supporting quietly Turkey and Iran (more through the purchase of its crude, in the latter case). So China is quietly subverting, and undermining Trump's strong dollar card that is intended to force Turkey and Iran to capitulate. This is asymmetric financial war for the long game.

Both these states (together with Pakistan) are key hubs of the 'Belt and Road' initiative; but more than that, they are directly strategically significant components to the national security of China. China is very concerned by the Muslim, Turkic, Uighurs of Xinjiang province, thousands of whom already fight as jihadists in Syria. China does not want the latter returned, nor does it want Muslims to be radicalised in China, or in the states to the West of China. 

President Erdogan has been significantly instrumental in their radicalisation. They want Erdogan to stop his game with the ethnic Turkic populations, in and near to China, in return for which, China is helping with the Lira. Equally, China's economy is vulnerable to America closing the Malacca Strait. To offset that vulnerability, China needs Pakistan, and its 'corridor', down to the port at Gwadar. And Iran is absolutely central to both China's and Russia's national security.

What we see therefore is China and Russia quietly sewing together the fabric of a de-dollarised, currency-swap equipped, and credit-supplied, belt across Central Asia – in opposition to America's attempt to break it up. Russia, which largely already has de-dollarised its economy, has the particular role of ensuring that Europe is not lost as a market for the Belt and Road to Trump's leveraged bullying, and that his aim to reacquire energy dominance remains no more than 'an aspiration'.

Taken in aggregate, all these quantitatively, mini-steps, represent a qualitatively significant diminution of the use of the dollar, outside of the US domestic sphere. Its depth, beyond the US homeland, is being salami-sliced away. The import of this should not be underestimated — the US enjoys the high standard of living that it has because it can buy cheap goods, paid for, in paper (fiat) US debt, that others are obliged to hold, for purposes of trading in the global reserve currency. Americans' standard of living is, in effect, subsidised by the rest of the world.

It can only afford the military it has because it can – unlike any other state – run budget deficits to pay for its outsized military, whimsically, and without concern, since foreigners (until now), simply go on filling the budget gap.

America has radical financial leverage at this moment precisely because of the 'strong dollar'. Make no mistake. This is not just the result of Fed hiking rates: Trump well understands that: "Money is pouring into our cherished DOLLAR like rarely before." Donald Trump tweeted, on 16 August. It is, of course, all about leverage.

With a strong dollar, trading partners' currencies devalue, their interest and capital payments soar – and, traditionally, they are pushed to the IMF for a dose of austerity and the sale of their national assets. This is the 'play' which Russia and China intend to end. They have set up alternatives to the Word Bank and to the IMF to which Turkey may have recourse – instead of being forced into an IMF programme.

Alasdair Macleod notes the dichotomy between Trump's 'short game' and China and Russia's 'long game':

"For now, and probably for only a few months ahead of the US mid-term elections in November, President Trump is forcing currency difficulties on his enemies by aggressive trade policies, including sanctions, and by weaponising the dollar. It is a trick that has been used by successive American administrations for a considerable time…

President Trump's actions over trade… are driving countries away from her sphere of influence. Ultimately this will prove counterproductive. Speculators buying into Trump's short-termism and the Fed's normalization policies are, for the moment, driving the dollar higher … This seems certain to lead to the dollar's downfall [in the longer term].

The dollar is rising only on short-term considerations, driven by nothing more substantial than speculative flows. Once these abate, the longer-term prospects for the dollar will reassert themselves, including the escalating budget and trade deficits… and rising prices fueled by a combination of earlier monetary expansion, and the extra taxes of trade tariffs."

This may well be Russia and China's 'long game'. For now, the strong dollar (and geo-political fear), is causing a safe-haven flight into easily marketable, US assets. The recent US Tax Bill has deepened this flow of dollars 'returning home' (through its amnesty for returning, corporate, off-shore, cash holdings). The financial leverage presently lies with the US. All looks well: the stock market is up; traders think the trade war will be an easy 'win'; and economic indicators, the Federal Reserve says, are 'strong'.

But Russia and China can be patient.Those overseas dollars "pouring in [to America], as rarely before" – are sucking out the oxygen, (i.e. dollar-liquidity) from everywhere. It will either soon exhaust itself, or will result in a contagious credit crisis (with Europe likely the prime victim), triggered precisely by the liquidity-drought engineered to give Trump more leverage.

At this point, the relative strengths between the US and Russia-China invert, and leverage flips to the latter's advantage.

These Charts Show How World Trade Has Collapsed In Just One Year

Lately, nothing seems able to shake Wall Street's bullish attitude.

Investors and the mainstream continue to still ignore the worsening trade war – which is evolving into a currency war – with China.

But since early May we have maintained that there's going to be a worldwide earnings recession sometime in summer 2019. . .

I haven't been shy writing about this topic.

If you looked at the markets enthusiasm today – and share prices – you'd think I was dead wrong.

But if you look between the lines – things are getting even worse for global corporations.

Goldman Sachs recently published some damning data that only bolsters my global earnings recession hypothesis. . .

To summarize: world trade has continually declined since early 2017 – long before the trade war talks – and the recent data only suggests this trend is worsening.

The U.S. Dollar has rallied significantly since March of this year – after declining nearly 15% between January 2017 and February 2018. 

This paired with the Federal Reserve's tightening has created chaos for the emerging markets and their currencies throughout much of 2018.

And yet, instead of weaker currencies boosting foreign exports, things have only worsened since. This signals that there's a deceleration in world wide demand. 

Just take a look at the following charts. . .

If you study the growth of 'global air and sea freight volumes' year-over-year (YoY), there's significant declines over the last 24 months – especially for air freight volume. It recently dipped into negative YoY growth.

Making matters worse – China's economy has slowed down considerably the last couple of years. This no doubt has affected world trade.

But it's not just China that's seeing a slowdown in trade activity. . .

Other major Asian cities are suffering declining container shipments.

Singapore, Shanghai, and Hong Kong all have seen weakening 'container shipment throughput' since last year.

The European Union (EU) is also seeing significant drops in their airport cargo growth.

Continuing it's decline since March 2017 from roughly 10% YoY growth – to currently negative -2%.

That's a -12% drop in the last year. . .

Goldman makes note that the key weakness stemmed from trade with Asia. . .

Finally, looking at the popular Suez Canal trade hub in Egypt – connecting the Mediterranean Sea to the Red Sea – we've seen a sharp drop in activity.

Containership net-tonnage has declined sharply over the last year. . .

All the above shows that deteriorating trade is happening worldwide. This clearly isn't just an isolated issue with one or two countries.

The data indicates that global trade volumes are screeching to a halt.

So what gives? Why's this happening?

Some will point to the first round of US-China tit-for-tat tariffs that took effect in early July. No doubt this will impact trade negatively going forward.

But it doesn't explain the deceleration in world trade that's occurred over the last year. . .

Another important factor is that over the last year, global central banks have followed the Federal Reserve and began tightening. This global financial tightening clearly impacted world trade volumes.

I remain bearish on the global economy over the next year or two.

The signs from global trade indicate that sales and exports are weakening. This will hurt corporate balance sheets overtime.

As financial tightening continues – the world's over-indebted businesses (and all borrowers) will feel significant pressure.

What I mean is: they'll be squeezed between less sales/exports – which will cause lower earnings. And higher debt servicing costs from increased interest rates – especially as the dollar rises in value.

The data above only makes the case for a global earnings recession that much more likely to happen. . .

The mainstream hasn't caught on to this – yet. So it remains a minority position.

But when being contrarian, I'd rather be early than late on something of this magnitude.

Is China Losing Control? Yuan More Volatile Than Euro For First Time Ever

For the first time, FX traders are grappling with wilder swings from China than Europe.

As Bloomberg notes, the offshore yuan has been more volatile than the euro all month after first overtaking the shared currency in July, according to 30-day realized data. And while euro uncertainty remains relatively bracketed between 6 and 8 for the last two years, yuan volatility has soared from 2 to almost 9 - the highest since 2015's devaluation.

The narrow spread (lower pane) shows China is moving to a more "flexible arrangement" when it comes to managing its currency, Bank of America analysts wrote in a note, predicting the yuan will weaken more this year.

For now it appears the temporary respite from Yuan's freefall, that 'mysteriously' occurred right before the US-China trade talks, has begun to lose momentum.

But while Yuan has become increasingly volatile, the realized volatility of gold (when priced in yuan) has collapsed to record lows...

Perhaps supporting the idea that the Chinese care more about the 'stability' of the yuan relative to gold then to the arbitrary US dollar fiat money.

So is China losing control? Or is this just as they planned?

FED TIGHTENING CYCLE TRIGGERS EMERGING MARKETS DEBT DISLOCATION

An interesting contribution to the debate on the impact of Fed balance sheet contraction on emerging markets' US dollar funding came early last month in the form of an article by Urjit Patel, the governor of the Reserve Bank of India, published in the Financial Times ("Emerging markets face a dollar double whammy" June 4, 2018).

This article argued that the combination of Fed balance sheet contraction and the increase in net Treasury bond issuance to finance the Trump administration's tax cuts, had created the unintended consequence of a "double whammy", resulting in dollar funding for emerging markets being "in turmoil".

 

THE DOUBLE WHAMMY

The RBI Governor argued that the rate of Fed balance sheet contraction is at roughly the same pace as the increase in net Treasury bond issuance. The Fed's current plan is to reduce its debt securities holdings by a cumulative US$1.05 trillion by the end of 2019 (US$30 billion in 4Q2017, US$420 billion in 2018 and a further US$600 billion in 2019, see following chart).

While the US fiscal deficit is projected by the Congressional Budget Office (CBO) to be US$793 billion in this fiscal year ending September 30 and US$973 billion in FY19, implying net issuance of government debt of US$1.17 trillion in each of these two years (see following charts).

FEDERAL RESERVE BALANCE SHEET REDUCTION PLAN

Source: Federal Reserve

US FISCAL BALANCE

Source: Congressional Budget Office

US GROSS FEDERAL GOVERNMENT DEBT

Source: Congressional Budget Office

There is very little evidence that long-term Treasury bonds are influenced by supply considerations with nominal GDP growth trends being the far more important factor.

In actual fact, based on the above data, the Fed's planned balance sheet reduction is "only" US$1.05 trillion over a 27-month period compared with a one-year projected increase in federal government debt of US$1.17 trillion. Still such statistical nitpicking aside, Patel uses the above argument to propose that the Fed should now adjust itsbalance sheet contraction to take account of the increase in net Treasury bond issuance which was not known about when the American central bank originally announced its schedule for quantitative tightening in September 2017, three months before the Trump tax cuts were passed. He wrote: "The Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in US government debt issuance. It must now do so."

There is a certain logic to Patel's argument. But it is extremely unlikely that the Fed will make such an adjustment. For one reason the Fed is raising rates and remains committed to ongoing balance sheet contraction — precisely to offset the risk posed by what most Fed governors view as excessive fiscal stimulus at this point in the American economic cycle.

Patel's argument also implies that rising Treasury bond net issuance, combined with balance sheet contraction, will lead to higher Treasury bond yields. But there is very little evidence that long-term Treasury bonds are influenced by supply considerations with nominal GDP growth trends being the far more important factor.

As is clear from the chart below, the last time Treasury bond yields were at the current low levels in the early 1950s, US Treasury securities outstanding as a percentage of GDP was also around the current high level of 80% (see following chart). While the Treasury securities to GDP ratio rose in 1980s, Treasury bond yields were collapsing. By contrast, the correlation between US nominal GDP growth and the 10-year Treasury bond yield has been 0.70 since 1980 (see following chart).

US TREASURY SECURITIES OUTSTANDING AS % OF GDP AND 10-YEAR TREASURY BOND YIELD

Source: Federal Reserve

US NOMINAL GDP GROWTH AND 10-YEAR TREASURY BOND YIELD

Source: Federal Reserve, US Bureau of Economic Analysis

It is also the case that quantitative tightening is likely to prove bullish for long-term Treasury bonds because it is another form of monetary tightening, and therefore will result in due course in a slowdown in the economy.

LIQUIDITY A MAJOR RISK FOR CORPORATE BONDS

Meanwhile, the Fed would view as an exaggeration Patel's description of the dollar funding markets as being "in turmoil". But such turmoil is certainly possible if not probable during this tightening cycle, most particularly if the US dollar rallies further, since foreign governments do not have the luxury, enjoyed by the US, of being able to print dollars.

The potential for turmoil in the fixed income world is also increased considerably by a technical factor.  That is the underlying severe lack of liquidity in credit markets, which has been a feature of the fixed income world since the global financial crisis as a result of both post-crisis regulation and the related post-2008 "de-risking" of banks' balance sheets.

This vulnerability is best highlighted by the chart below which shows, in the US context, the collapse in corporate bonds owned by brokers/dealers relative to the surge in such bonds owned by mutual funds and ETFs. The ratio of US mutual funds' and ETFs' holdings of corporate bonds over brokers' and dealers' holdings has soared from 1.7x in 2Q07 to 40x in 3Q17 and was 37x at the end of 1Q18, according to the Federal Reserves' flow of funds data (see following chart).

US brokers' and dealers' holdings of corporate bonds have collapsed by 84% from a peak of US$418 billion in 2Q07 to US$59.7 billion in 3Q17, the lowest level since 1Q95, and were US$65 billion in 1Q18. While mutual funds' and ETFs' holdings have surged by 240% from US$708 billion in 2Q07 to US$2.41 trillion in 1Q18.

RATIO OF US MUTUAL FUNDS' & ETFS' HOLDINGS OF CORPORATE BONDS OVER BROKERS & DEALERS' HOLDINGS

Note: Not including money market mutual funds. Source: Federal Reserve – Flow of Funds Accounts

But this lack of liquidity is a global phenomenon and not just an American one. It means that when everybody wants to sell the same bond there will be a lack of buyers. And remember bonds, unlike stocks, are not listed on exchanges.

 

Italy's Stagnant Economy The Most Likely Trigger To Europe's Existential Crisis

With the focus on Turkey and the potential related fallout in other emerging markets in recent weeks, it is easy to forget about the Eurozone. Yet the current Italian government is likely to trigger a renewed existential crisis in the Eurozone once the Europeans return from the beach and the Italian Government comes up with a budget for 2019 which is likely to put it in direct conflict with the Maastricht Treaty.

BROKEN BRIDGES UNDER THE EURO

The collapse of a motorway bridge in Genoa last month resulting in 43 deaths, and Italian Interior Minister Matteo Salvini's exploitation of that event by blaming Brussels-imposed austerity, is a reminder of what is coming.

Having driven over that particularly rickety bridge on more than one occasion, this writer is not surprised to hear about what happened. Similarly, driving through Italy in recent years always serves as a reminder just how poor Italy has become under the euro. Remember, Italy has recorded almost no growth since the formation of the euro at the beginning of 1999, nearly 20 years ago. Italian real GDP has risen by only an annualized 0.4% since 1Q99 and is up only an annualized 0.1% in real GDP per capita terms over the same period (see following chart).

ITALY REAL GDP AND REAL GDP PER CAPITA

Source: CLSA, Datastream

The Italian issue is raised again in part because it is timely with the end of the summer holiday season. The view here remains that a systemic event in financial markets is more likely to be triggered by Italy and the Eurozone than other candidates currently discussed by pundits, be it a Donald Trump-triggered trade war, a much anticipated (by talking heads) Chinese currency collapse or overvalued Wall Street FANG stocks.

Still, they are all interconnected phenomena since, for example, a renewed focus on the existential risks in the Eurozone is likely to put renewed downward pressure on the euro which, if what happened in the second quarter is any guide, will then lead to broader US dollar strength against emerging market currencies. This will in turn make it more challenging for China to manage the capital outflow issue.

BURNING THE BRIDGE TO EUROPE, BUILDING A BRIDGE TO THE US

Returning to the Eurozone issue it is also important to remember what is easily forgotten in the financial markets. That is that the anti-euro, anti-immigration populists in Europe now have a supporter in the White House who is openly encouraging them to pursue their agendas. This is, of course, the exact opposite of what was the case under Barack Obama who, unfortunately, intervened in the Brexit debate in Britain with negative consequences for the 'Remain' cause he was supporting.

Donald Trump could not have made it clearer that he supports the cause of those in Italy wanting to leave the euro – just as he could not have made it clearer that he supports Brexit. This is not unimportant since a potential future decision by, say, Italy to walk out of the euro looks a lot less risky politically and economically if it has the support of the American president. This will be particularly the case if that particular American president's political position has been strengthened by the outcome of the November mid-term elections. This is one reason, among many others, why those elections are becoming rather important. The base case here remains that the Republicans will maintain control of the Congress. But, clearly, that is not consensus.

It is also important to remember that Europe has its own upcoming election cycle. Grizzle refers again to the potentially hugely important May 2019 European parliamentary elections. While the focus of financial markets in the coming quarter will likely be on the Italian Government's budget, and how Brussels and Berlin will respond, next May's parliamentary elections are likely to be by far the most significant ever.

This is because the anti-euro populist parties are likely to run a far more coordinated campaign. The result could be the emergence of a populist alliance in the European parliament determined to attack from within many of the foundations of the Eurozone, be it the Maastricht Treaty in the economic sphere or 'free movement' in terms of the politically charged issue of immigration.

A reminder of this comes from reading a recent article on the growing activities in Europe of Steve Bannon, Trump's former political strategist (see International New York Times article: "In Europe, a best friend for Bannon", August 21, 2018 by Ivan Krastev). This article reported how Bannon announced in late July that he plans to establish in Europe a foundation, called The Movement, to create a formal alliance of populist right-wing parties ahead of next May's European elections.

The mooted foundation will aim to provide polling and policy support. His main ally in Europe in this venture is, according to the same article, Hungarian Prime Minister Viktor Orban who was re-elected in April for his third consecutive four-year term.

Obviously, turning such an alliance into an effective political force is easier said than done, most particularly as there will be different views on specific policies. Still, there will be an easily achieved consensus among the populists on the related issues of immigration and Islam. On this point, the same article reports that Orban intends to make next May's elections "a referendum on migration and Islam".

THE SHIFTING TIDE OF IMMIGRATION

This is where the renewed crisis in Turkey, with its focus on a collapsing currency and macro imbalances, meets the issue of European politics. This is, of course, because the main reason the flow of migrants into Europe, and in particular Germany, has declined significantly since late 2016 due to the EU-Turkey migration deal Angela Merkel negotiated with Turkish President Recep Tayyip Erdogan in March 2016.

Under the deal, the EU agreed to pay Turkey €6 billion to halt the human flow with some 3.5 million Syrian refugees remaining in Turkey. As a result, the number of asylum applications lodged in Europe declined by 44% YoY to 728,470 people in 2017 and were down 15% YoY to 301,390 in 1H18, according to the European Asylum Support Office (see following chart). As for Germany, total asylum applications declined by 70% from a peak of 745,545 people in 2016 to 222,683 in 2017 and were down 15% YoY to 110,324 in the first seven months of 2018, according to the Federal Office for Migration and Refugees (see following chart).

ASYLUM APPLICATIONS LODGED IN EUROPE

Source: European Asylum Support Office (EASO)

GERMANY – TOTAL NUMBER OF ASYLUM APPLICANTS

Note: Data up to July 2018. Source: Federal Office for Migration and Refugees

The above creates obvious leverage for Erdogan to apply against Merkel and the Eurozone. This explains why Merkel in her public comments has taken a conciliatory tone in response to recent developments in Turkey in stark contrast to the provocative posture adopted by the Donald Trump.