Friday, September 11, 2015

Weekly Commentary: China Hardens Peg and Brazil Goes to Junk

Let’s this week begin with a cursory glance at the world through the eyes of the bulls. First, the global backdrop provides the Fed convenient cover to delay “liftoff” at next week’s widely anticipated FOMC meeting. Even if they do move, it’s likely “one and done.” While on a downward trajectory, China’s $3.5 TN international reserve hoard is ample to stabilize the renminbi. Chinese officials clearly subscribe to their own commanding version of do “whatever it takes” to control finance and the economy. One way or another, they will sufficiently stabilize growth - for now. The U.S. economy enjoys general isolation from China and EM travails. Investment grade bond issuance – the lifeblood of share buybacks and M&A – has already bounced back robustly. The U.S. currency, economy and securities markets remain the envy of the world. “Money” fleeing faltering EM will continue to support U.S. asset markets along with the real economy.

September 10 – Financial Times (Netty Idayu Ismail): “The European Central Bank will ensure its policy stance remains as accommodative as needed amid financial-market turbulence, according to Executive Board member Peter Praet. ‘The Governing Council will remain vigilant that recent volatility does not materially affect the broad array of financial conditions and therefore lead to an unwarranted tightening of the monetary-policy stance,’ Praet said… ‘It has emphasized its willingness and ability to act, if warranted, by using all the instruments available within its mandate.’”

The ECB’s “unwarranted tightening of the monetary-policy stance” comes from the same playbook as Bernanke’s (the Fed’s) “push back against a tightening of financial conditions.” In a world where financial markets dictate general Credit Availability as never before, central bankers have essentially signaled open-ended commitment to liquidity injections as necessary to counteract risk aversion. Such extraordinary market exploitation underpins the fundamental bullish view that global policymakers have things under control.

On a near-term basis, policymakers retain tools to stabilize markets, though officials at the troubled Periphery are rapidly running short of policy flexibility. September’s “triple-witch” expiration of options and futures is now only a week away. Between the passing of time and the pull back in put premiums (“implied volatility”), bearish hedges and directional bets have lost tremendous value over the past two weeks.

The apparent stabilization in China has been integral to calmer global markets. Clearly, Chinese officials are in full-fledged crisis management mode. A series of measures and determined official support have stabilized the wobbly Chinese currency. Wednesday from Reuters: “Chinese Premier Li Keqiang said… that the recent adjustment in the yuan was ‘very small’ and that there is no basis for continued devaluation in the currency.”

And Thursday from the Financial Times (Jamil Anderlini): “Chinese Premier Li Keqiang… sought to reassure investors over the health of China’s economy… ‘China is not a source of risk but a source of growth for the world,’ Mr Li said in a speech to the World Economic Forum… ‘Despite some moderation in speed, the performance of the Chinese economy is stable and it is moving in a positive direction.’ …In a meeting with global business leaders at the forum, Mr Li dismissed the suggestion that China had been the trigger for instability in global markets in recent months. ‘The fluctuations in global financial markets recently are a continuation of the 2008 global financial crisis… Relevant Chinese authorities took steps to stabilise the market to prevent any spread of risks. Now we can say we have successfully forestalled potential systemic financial risks … what we did is common international practice and is in keeping with China’s national conditions.’”

“Steps to stabilize the market” have included arresting journalists and other rumor mongers accused by the central government of “destabilizing the market.” There has been a hard crackdown on hedge funds and other “manipulators”. Beijing has imposed a series of onerous measures against currency and securities markets derivatives trading. The Chinese government has also put in place controls to help impede financial outflows. Meanwhile, the state-directed “national team” has spent over $200bn buying stocks. The central bank has cut rates, slashed reserve requirements and injected enormous amounts of liquidity.

The bullish viewpoint holds that economies dictate market performance. As such, draconian measures from Chinese officials support the perception that Chinese policymakers have regained control over their markets and economy – in the process removing a major potential catalyst for global systemic dislocation. Though appalling, most take quiet comfort that Chinese-style “whatever it takes” works in the best interest of U.S. markets and the economy. The long-term rather long ago lost much of its relevance within the bull camp.

For me, it boils down to fundamental disagreement with the bulls on how the world actually works. For starters, finance is king. Credit and the financial markets drive economic activity - and not vice versa. My bursting global government finance Bubble thesis rests on the premise that global finance has by now suffered irreparable harm. Confidence is being broken and faith is being shattered. A difficult new era has begun, and it will be a long time before confidence returns to EM. De-risking/de-leveraging has taken hold, with contagion gaining momentum. And China can use all the duct tape in the world – including strips to silent the mouths of naysayers – to try to holds its stock market and Credit system together. The damage is done.

For a while now, global investors and speculators have been willing to ignore China’s shortcomings. In general, a world of over-liquefied markets tends to disregard risk while allowing a sanguine imagination to run absolutely wild. And the more finance that flooded into China and EM the more the optimists reveled in the “developing” world’s pursuit of the fruits of Capitalism. The Chinese talked a good commitment to steady free-market reform. Their aspirations for global financial and economic power seemed to ensure that they would adhere to the rules of Western finance.

In the past I gave Chinese officials too much Credit. They devoted a lot of resources to the endeavor, and at one time I believed the Chinese had gleaned valuable insight from the study of the Japanese Bubble experience. But Bubbles are both seductive and incredibly powerful, especially at the hands of authoritarian communist regimes. Massive post-2008 stimulus stoked runaway Bubble excess. Later, Chinese markets scoffed at timid little central bank measures meant to tenderly rein in excess. And the longer the Bubble inflated the greater the financial, economic, social and political risks.

In the end, the major lesson drawn from Japan’s experience was the wrong one. It was much belated, but the Japanese actually moved to pierce their Bubble. Chinese officials not only let their Credit Bubble run, they adopted the Fed’s approach to using the stock market as an expedient for system-wide inflation. That policy blunder was the Chinese Bubble’s proverbial nail in the coffin.

I’ll assume that after priority number one – stabilizing its currency – the Chinese will implement even more aggressive fiscal and monetary stimulus. EM policymakers notoriously lose flexibility at the hands of faltering currencies and attendant financial outflows (“capital flight”). Contemporary finance also ensures that deflating Bubbles entice bearish hedges and speculations that can so swiftly overwhelm already liquidity-challenged markets. The Chinese were confronting just such a scenario, before abruptly changing the course of policymaking. The adoption of onerous derivative market regulations and other measures are akin to loose capital controls – punishing measures to take pressure off the Chinese currency. After initially seeking benefits associated with greater currency market flexibility, market tumult instead forced the Chinese into a rigid yuan peg to the dollar.

So long as the peg to the dollar holds, China retains significant control over state-directed finance. It will run big fiscal deficits, print “money” and dictate lending and spending by the huge banks, financial institutions, local governments and industrial conglomerates. But can it at the same time somehow harness all this finance and keep it from fleeing the faltering Bubble? Only through capital controls.

The Shanghai Composite rallied 6.1% this week. There were some spectacular short-squeezes as well, certainly including the Nikkei’s 7.7% Wednesday surge, “The Biggest Gain Since 2008.” Copper jumped 6.3% this week. U.S. tech and biotech bounced hard. In the currencies, the Australian dollar jumped 2.7%, the South African rand 2.2%, and the euro 1.7%.

It was not, however, an encouraging week for EM’s troubled economies. Brazil’s real slipped further after last week’s 7% plunge. The Indonesia rupiah declined another 1.1%, and the Malaysian ringgit fell 1.3%. The Turkish lira dropped 1.2%. On the back of weak crude prices, the Goldman Sachs Commodities Index slipped 0.4% this week.

The crisis is taking a decisive turn for the worse in Brazil. On the back of S&P downgrading Brazilian debt to junk, the country’s CDS surged to multi-year highs. The Brazilian banking and corporate sectors have been in a six-year debt-fueled borrowing binge. It’s all coming home to roost.

September 10 – Bloomberg (Michael J Moore): “Banco Bradesco SA and state-owned Banco do Brasil SA were among 13 financial-services firms in Brazil that had their global scale ratings lowered by Standard & Poor’s after the nation’s credit grade was cut to junk. The two banks were reduced to speculative grade with a negative outlook, S&P said… Itau Unibanco SA and Banco BTG Pactual also were among lenders that faced downgrades.”

September 10 – Bloomberg (Denyse Godoy): “A plunge in Petroleo Brasileiro SA, the world’s most-indebted oil producer, to a 12-year low put the Ibovespa on pace for a second week of losses. The state-controlled company extended a three-day slide to 11% after Standard & Poor’s cut its credit rating to junk, adding to speculation it will struggle to shore up its balance sheet.”

Many question how an EM crisis could possibly have a significant impact on U.S. markets. Well, for starters, Brazil has big financial institutions. The Brazilian financial sector has issued large amounts of dollar-denominated debt, while borrowing significantly from international banks. Enticing Brazilian yields have been a magnet for “hot money” flows. Now, Brazil faces the terrible prospect of a disorderly run from its currency, its securities markets and its banking system. Market dislocation would have global ramifications for investors, derivative counterparties, multinational banks and the leveraged speculating community.

The degree of market complacency remains alarming. The bullish view holds that Brazil, China and others retain sufficient international reserves to defend against crisis dynamics. But with EM currencies in virtual free-fall and debt market liquidity disappearing, it sure looks and acts like an expanding crisis.

So far, it’s a different type of crisis – market tumult in the face of global QE, in the face of ultra-low interest rates and the perception of a concerted global central bank liquidity backstop. It’s the kind of crisis that has so far been able to achieve a decent head of steam without causing much angst. And it’s difficult to interpret this bullishly. If Brazil goes into a tailspin, it will likely pull down Latin American neighbors, along with vulnerable Indonesia, Malaysia, Turkey and others. And then a full-fledged “risk off” de-risking/de-leveraging would have far-reaching ramifications, perhaps even dislocation and a collapse of the currency peg in China. China does have a number of major trading partners in trouble. It's simply hard to believe the sophisticated players aren’t at this point planning on slashing risk.

For the Week:

The S&P500 (down 4.8% y-t-d) and the Dow (down 7.8%) both rallied 2.1%. The Utilities gained 1.4% (down 9.4%). The Banks recovered 2.0% (down 3.8%), and the Broker/Dealers rose 1.7% (down 6.2%). The Transports rallied 3.3% (down 11.9%). The S&P 400 Midcaps gained 2.0% (down 2.6%), and the small cap Russell 2000 rose 1.9% (down 3.9%). The Nasdaq100 jumped 3.3% (up 2.1%), and the Morgan Stanley High Tech index rose 2.7% (down 0.5%). The Semiconductors jumped 3.0% (down 10.3%). The Biotechs surged 5.3% (up 15%). With bullion down $14, the HUI gold index declined 1.3% (down 34.6%).

Three-month Treasury bill rates ended the week at three bps. Two-year government yields were unchanged at 0.71% (up 4bps y-t-d). Five-year T-note yields rose four bps to 1.51% (down 14bps). Ten-year Treasury yields gained seven bps to 2.19% (up 2bps). Long bond yields rose seven bps to 2.95% (up 20bps).

Greek 10-year yields dropped 47 bps to 8.33% (down 142bps y-t-d). Ten-year Portuguese yields rose 10 bps to 2.59% (down 3bps). Italian 10-yr yields fell four bps to 1.83% (down 6bps). Spain's 10-year yields added three bps to a nine-week high 2.10% (up 49bps). German bund yields slipped two bps to 0.65% (up 11bps). French yields rose five bps to a nine-week high 1.06% (up 23bps). The French to German 10-year bond spread widened a notable seven to a two-month high 41 bps. U.K. 10-year gilt yields added a basis point to 1.83% (up 8bps).

Japan's Nikkei equities index rallied 2.7% (up 4.7% y-t-d). Japanese 10-year "JGB" yields declined two bps to 0.34% (up 2bps y-t-d). The German DAX equities index gained 0.9% (up 3.2%). Spain's IBEX 35 equities index lost 0.9% (down 5.3%). Italy's FTSE MIB index jumped 1.4% (up 14.5%). EM equities were mostly higher. Brazil's Bovespa index slipped 0.2% (down 7.2%). Mexico's Bolsa was little changed (down 0.8%). South Korea's Kospi index rallied 2.9% (up 1.3%). India’s Sensex equities index gained 1.6% (down 6.9%). China’s Shanghai Exchange recovered 6.1% (up 3.6%). Turkey's Borsa Istanbul National 100 index dropped 2.2% (down 16.8%). Russia's MICEX equities index gained 1.2% (up 23%).

Junk funds this week saw outflows of $714 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates increased a basis point to 3.90% (up 3bps y-t-d). Fifteen-year rates added a basis point to 3.10% (down 5bps). One-year ARM rates were up a basis point to 2.63% (up 23bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates unchanged at 4.05% (down 23bps).

Federal Reserve Credit last week increased $1.6bn to $4.439 TN. Over the past year, Fed Credit inflated $61.3bn, or 1.4%. Fed Credit inflated $1.628 TN, or 58%, over the past 148 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt dropped $11.6bn last week to $3.335 TN. "Custody holdings" were up $41.9bn y-t-d.

M2 (narrow) "money" supply jumped $17.5bn to a record $12.186 TN. "Narrow money" expanded $729bn, or 6.4%, over the past year. For the week, Currency increased $4.0bn. Total Checkable Deposits dropped $16.4bn, while Savings Deposits expanded $16.4bn. Small Time Deposits increased $2.0bn. Retail Money Funds gained $6.9bn.

Money market fund assets fell $15.6bn to $2.663 TN. Money Funds were down $70bn year-to-date, while gaining $70bn y-o-y (2.7%).

Total Commercial Paper rose $10.9bn to $1.043 TN. CP increased $35.8bn year-to-date.

Currency Watch:

September 6 – Bloomberg (Onur Ant, Ryan Chilcote and Alaa Shahine): “Central bank Governor Fahad Al-Mubarak said Saudi Arabia will stick with its currency peg as long as oil underpins the economy, dismissing speculation that the country’s currency system is coming under pressure. Investors have increased bets that Saudi Arabia and others in the region will be next to drop their pegs after China devalued the yuan and Kazakhstan allowed its currency to float. One-year forward contracts for the Saudi riyal, an indicator of where investors expect it to trade, are near the highest since 2003.”

The U.S. dollar index dropped 1.1% to 95.18 (up 5.4% y-t-d). For the week on the upside, the Australian dollar increased 2.7%, the Swedish krona 2.4%, the South African rand 2.2%, the Norwegian krone 1.9%, the British pound 1.7%, the euro 1.7%, the Mexican peso 0.6%, the New Zealand dollar 0.5% and the Swiss franc 0.2%. For the week on the downside, the Japanese yen declined 1.3% and the Brazilian real fell 0.6%.

Commodities Watch:

The Goldman Sachs Commodities Index slipped 0.4% (down 13.1% y-t-d). Spot Gold lost 1.2% to $1,108 (down 6.5%). December Silver was little changed at $14.57 (down 7%). October Crude dropped $1.28 to $44.77 (down 16%). October Gasoline sank 3.1% (down 7%), while October Natural Gas gained 1.1% (down 7%). September Copper rallied 6.3% (down 13%). December Wheat recovered 3.7% (down 18%). December Corn surged 6.6% (down 2.5%).

Global Bubble Watch:

September 10 – Bloomberg (Ye Xie): “This time last year, it looked like Goldman Sachs Group Inc.’s selection of emerging market up-and-comers was ready to fill the void left by shrinking investment returns in Brazil, Russia, India and China. Share prices in these ‘Next 11’ countries -- places like the Philippines, Turkey and Mexico -- were trading at all-time highs as foreign investors flooded their markets with cash. Inflows into Goldman Sachs’s U.S.-domiciled Next 11 equity fund sent assets under management to twice the level of the firm’s BRICs counterpart. Now, though, the Next 11 countries are looking even worse for investors than the larger markets they were supposed to supplant. MSCI Inc.’s Next 11 equity gauge has tumbled 19% this year, versus a 14% slump for the BRIC index. Foreign capital is rushing out, with the Goldman Sachs fund shrinking by almost half as losses deepened to 11% since its inception four years ago.”

September 10 – Bloomberg (Juan Pablo Spinetto and Julia Leite): “Brazil’s plunge into junk status may be far from finished. On Wednesday, Standard & Poor’s stripped Latin America’s biggest country of its investment grade, lowering it to BB+ and keeping a negative outlook on its debt. With Brazil headed for its longest recession since the 1930s, bond traders are bracing for more rating cuts as political gridlock stymies desperately needed economic reforms. Brazil’s borrowing costs have soared and its $2.15 billion of bonds due in 2023 now yield just 0.06 percentage point less than similar-maturity debt from Bolivia… The advantage is the smallest on record… It also now costs 0.22 percentage point more to protect Brazil’s debt securities than those issued by Russia, a nation battered by sanctions and plunging oil prices… Brazil’s three rating cuts in the past 18 months have triggered a wave of corporate downgrades. Excluding financial firms, there have been 186 ratings cuts this year, more than double last year’s record tally of 69…”

September 10 – Bloomberg (Peter Millard, Boris Korby and Julia Leite): “There’s a new king in the $2 trillion global junk bond market. Brazil’s state-owned oil producer Petroleo Brasileiro SA, with $56 billion of outstanding securities, has become the world’s largest non-investment grade corporate issuer after Standard & Poor’s cut its credit rating seven months after a similar move by Moody’s… The Rio de Janeiro-based company tops Sprint Corp.’s $31 billion of bonds and Venezuelan energy giant PDVSA’s $36 billion of speculative grade notes… ‘The pool of holders is decreased because all those investment-grade funds can no longer buy Petrobras debt,’ said Rafael Elias, a managing director at Cantor Fitzgerald… The downgrade is hitting Petrobras, once a darling of emerging market issuers, as it tries to navigate the oil-price rout and a mushrooming graft scandal that has sent some of its suppliers into bankruptcy protection.”

September 9 – Wall Street Journal (Fiona Law and Carol Chan): “Improving market sentiment has Chinese banks and companies restarting their offshore-debt engines—but given the economy’s struggles to revive, this comes at a price. Chinese U.S.-dollar bonds dominate Asia’s $874 billion bond market, but issuance ground to a halt for almost a month… As China’s stocks began to rebound this week—lifting equities around the region—windows reopened for Chinese businesses from lenders to highway operators to tap funds in the offshore debt market… Yields on Chinese corporate bonds have been climbing since the stock-market rout began in June; the spread over the benchmark U.S. Treasury yield has widened in that time to 3.5 percentage points from 3 percentage points, according to the J.P. Morgan Asia Credit Index… Dim-sum bonds, or offshore debt denominated in yuan, lost 3.4% since the currency devaluation in mid-August, according to HSBC Offshore Renminbi Bond Index.”

September 10 – Financial Times (Netty Idayu Ismail): “Hedge funds are piling into bets that the dollar will strengthen against emerging-market currencies, especially those vulnerable to falling commodity prices, according to a money manager who invests in the funds. The popularity of the trade will fuel volatility in those currencies should such funds adjust their positions, said Sam Diedrich, a director at Pacific Alternative Asset Management Co., which oversees about $9.5 billion in hedge-fund investments. ‘It’s become a crowded trade, Diedrich… said… ‘Long term, I still think the trade works, but you could see some large swings.’”

China Bubble Watch:

September 7 – Reuters (Nathaniel Taplin and Kevin Yao): “China's foreign exchange reserves posted their biggest monthly fall on record in August, reflecting Beijing's attempts to halt a slide in the yuan and stabilize financial markets… China's reserves, the world's largest, fell by $93.9 billion last month to $3.557 trillion… The drop left market watchers questioning how sustainable China's efforts to support the yuan are, as capital flows out of the country due to fears of an economic slowdown and prospects of rising U.S. interest rates. ‘Frequent intervention will burn foreign reserves rapidly and tighten the onshore market liquidity,’ said Zhou Hao, senior economist at Commerzbank…”

September 11 – Reuters (Nathaniel Taplin): “Chinese banks extended 809.6 billion yuan ($127.04bn) of new loans in August, less than expected as the impact of the government's massive stock market rescue on the financial system faded. Economists polled by Reuters had forecast banks made 900 billion yuan of new loans last month as the stock market rout showed signs of easing. Banks had made 1.48 trillion yuan ($232.24bn) of new loans in July, the highest monthly reading since 2009. Economists believe that figure was heavily inflated by Beijing's move to pump billions into equity markets through banks and other agencies to avert a full-blown crash, and did not signal any improvement in weak loan demand in the broader economy. Indeed, loans extended to non-bank financial institutions skyrocketed to 886 billion yuan ($139.03bn) in July, accounting for the lion's share of new lending (60%) that month. Excluding such loans, new lending actually fell month on month in July.”

September 9 – Reuters: “China has instructed banks to bolster management of foreign exchange transactions and identify ‘abnormal’ cross-border fund transfers to ease pressure on capital outflows, two sources told Reuters… The State Administration of Foreign Exchange (SAFE) has released a document, asking banks to pay attention to suspicious FX transactions involving large amounts and frequent payments… Banks are required to log transactions where more than five individuals have bought and transferred a total of over $200,000 or the equivalent to one account or institution outside of China within the past 90 days, said a source… ‘Capital outflow pressure looks heavy now and the SAFE is hoping to use these counter-cyclical measures to stem outflows,’ said the source, who declined to be identified…”

September 9 – Financial Times (Jamil Anderlini): “China has tightened its capital controls, in a sharp reversal of its market liberalising rhetoric, as it struggles to contain the fallout from last month’s devaluation of the renminbi. The August 11 devaluation unleashed turmoil on global stock markets and policy confusion at home, forcing the central bank to spend up to $200bn to support the currency… The State Administration of Foreign Exchange (Safe), the unit of the People’s Bank of China in charge of managing the currency, has in recent days ordered financial institutions to step up checks and strengthen controls on all foreign exchange transactions, according to people familiar with the matter…”

September 5 – Bloomberg (James Mayger): “Zhou Xiaochuan, governor of China’s central bank, said three times to a G-20 gathering that a bubble in his country had ‘burst,’ Japanese Finance Minister Taro Aso said. It came up in his explanation Friday of what is going on with China’s stock market, according to a Japanese finance ministry official. A dissection of the slowdown of the world’s second-largest economy and talk about the equity rout which erased $5 trillion of value was a focal point at the meeting of global policy makers in Ankara. That wasn’t enough for Aso, who said that the discussions hadn’t been constructive. Chinese stocks have plunged almost 40% since a June peak, triggering unprecedented intervention from the authorities.”

September 9 – New York Times (Edward Wong, Neil Gough and Alexandra Stevenson): “The police have been dropping in on investment firms and downloading their transaction records. Senior executives at China’s biggest investment bank have been arrested on suspicion of illegal trading. A business journalist has been detained and shown apologizing on national television for writing an article that could have hurt the market. The Communist Party’s response to China’s monthslong stock market crisis has been swift and forceful. In addition to spending as much as $235 billion to buy shares and bolster prices, the authorities have imposed a range of extraordinary restrictions on the sale of stocks — and backed them with the full weight of a security apparatus usually more focused on political dissent than equity trades… The crackdown on short-selling and other trading strategies has been particularly disruptive for hedge funds, which depend on such trades to balance risks and limit losses. ‘They seem to be harassing anybody that they thought was selling or was short,’ said one hedge fund manager in Hong Kong… ‘Hello, it’s a hedge fund — they are long and short — but China is only looking at the short side.’”

September 6 – New York Times (Amie Tsang): “When the Chinese Ministry of Public Security arrested nearly 200 people at the end of August for ‘spreading rumors,’ one of the most prominent targets was Wang Xiaolu, a reporter for the respected business magazine Caijing. Mr. Wang was compelled to confess on television before going to trial. Dressed in a green polo shirt and looking downcast, he told viewers of China Central Television, the main state network, that he had gathered information using private sources ‘through abnormal channels,’ then added to this his ‘own subjective views.’ The article in question, Mr. Wang said, was a ‘sensational’ and ‘irresponsible’ report on the stock market. That the state would take aim at a publication like Caijing came as a surprise to many. The magazine has a strong reputation for hard-hitting investigations and pushing the boundaries of what the government might deem permissible.”

September 8 – Wall Street Journal (Andrew Browne): “Nobody could have predicted the sequence of disasters striking when it did. With just weeks to go before a military extravaganza on Tiananmen Square to mark victory over Japan in World War II, the stock markets collapsed, speculators bolted for the exits after the currency fell, taking billions of dollars with them, and a chemical explosion ripped a huge crater in the port of Tianjin. Many global investors lost faith in the Chinese leadership’s vaunted ability to steward the world’s second largest economy. Suddenly, President Xi Jinping looked like he was on the losing side. But on the day itself, reviewing the parade from a ‘Red Flag’ limousine, Mr. Xi rode over all these concerns. He needed a boost; goose-stepping soldiers, tanks, drones, missiles and jets gave him one. Though the war against Japan ended 70 years ago, the Chinese Communist Party keeps demonstrating that the surest way to rally the country at times of crisis is to go after the old enemy. This was how the party recovered from its near-downfall in 1989 during the Tiananmen protests.”

September 8 – Bloomberg (Kyoungwha Kim): “Add the world’s biggest stock-index futures market to the list of casualties from China’s interventionist campaign to stop a $5 trillion equity rout. Volumes in the country’s CSI 300 Index and CSI 500 Index futures sank to record lows on Wednesday after falling 99% from their June highs. Ranked by the World Federation of Exchanges as the most active market for index futures as recently as July, liquidity in China has dried up as authorities raised margin requirements, tightened position limits and started a police probe into bearish wagers. While trading in Chinese equities has also slumped amid curbs on short sales and an investigation into computer-driven orders, the tumble in futures volumes may cause even greater damage because of their central role in the investment strategies of domestic hedge funds and other institutional money managers…‘It is further evidence that the Chinese authorities are not yet ready to commit to freely trading markets,’ said Tony Hann, a… money manager at Blackfriars Asset Management… ‘Fully functioning developed financial markets in China will take many years.’…Chinese policy makers, intent on ending a selloff that has eroded confidence in their management of the economy, are targeting the futures market because selling the contracts is one of the easiest ways for investors to make large wagers against stocks.”

September 7 – Bloomberg (Kana Nishizawa): “China’s government has spent 1.5 trillion yuan ($236bn) trying to shore up its stock market since a rout began three months ago, according to Goldman Sachs Group Inc. The ‘national team’ expended about 600 billion yuan in August alone, with the total now equivalent in value to 9.2% of China’s freely-traded shares, strategists including Kinger Lau wrote… Investor concern about what will happen when the government starts to pare these holdings is overdone, they wrote, citing past experiences in Hong Kong and in the U.S. The Shanghai Composite Index has tumbled 41% since its June high to erase $5 trillion in value from mainland bourses as leveraged investors fled amid signs of deepening weakness in the economy. To stop the plunge, officials armed a state agency with more than $400 billion to purchase stocks, banned selling by major shareholders and told state-owned companies to buy equities. The rout, coupled with a shock devaluation of the yuan, has roiled global markets.”

September 8 – New York Times (Neil Gough): “China’s industrial slowdown is showing signs of worsening, as the country’s trade slump deepened further in August in the face of weaker demand from overseas buyers. Once seemingly indomitable as the world’s workshop, China is now facing its most protracted decline since the global financial crisis. Overseas shipments fell 5.5% last month compared with a year earlier… It is a sign that the country’s sprawling manufacturing sector is losing competitiveness: Labor costs are rising relentlessly and the currency, the renminbi, remains relatively strong despite its devaluation last month. Despite the currency move, Chinese goods are notably more expensive for foreign buyers than they were even a year ago. At the same time, China’s imports are falling even more sharply, declining last month for the 10th month in a row, with a drop of 14% by value.”

September 8 – Bloomberg: “China will open its domestic foreign-exchange market to overseas central banks, making it easier for other nations to hold yuan assets as Asia’s biggest economy pushes for the currency to win reserve status at the International Monetary Fund. The country will keep the yuan stable at a reasonable, equilibrium level, Premier Li Keqiang said while announcing the easing of controls during a speech at a World Economic Forum… The nation doesn’t want a currency war… Overseas monetary authorities have already been granted access to China’s interbank bond market. ‘The participation of foreign central banks will make the onshore yuan’s exchange rate more globally recognized,’ said Banny Lam, co-head of research at Agricultural Bank of China International Securities… ‘Allowing direct access gives the central banks more flexibility and control over costs, compared with going through local banks for trades. In general, it’s a positive move for yuan internationalization.’”

September 6 – Bloomberg: “China’s banks are getting less strict in recognizing bad loans, failing to include some debts that have been overdue for at least 90 days, according to Moody’s… The ratings company cited its analysis of the first-half results of 11 listed banks including Industrial & Commercial Bank of China Ltd. and China Construction Bank Corp., in a statement… Moody’s argues that the pace of the increase in loans overdue for at least 90 days isn’t being reflected in increases in overall bad-loan numbers in a struggling Chinese economy. The Moody’s assessment highlights investors’ concerns that Chinese lenders’ bad debts may be understated…”

September 8 – Bloomberg: “China’s government this year has bought up stocks to stem an equities rout, orchestrated a debt swap for local government to switch loans into bonds, and spent reserves to support the yuan. Now, a provincial government is stepping in to the property market to snap up unsold homes. An eastern coastal province will buy small and medium-sized residential properties and convert them into public rental homes, according to a Shandong government statement… The government will also purchase or lease commercial buildings that can’t be sold for a long time and convert them into kindergartens and schools. The move highlights efforts to prop up the property market, which with related sectors accounts for about a quarter of the nation’s economy. ‘The real estate sector is the pillar industry of our national economy,’ Shandong’s government said… The province has accumulated 160 million square meters of unsold properties, which would take 27.3 months to sell at the current pace…”

September 9 – Reuters (Michelle Price and Saikat Chartterjee): “The Hong Kong securities watchdog is investigating whether brokers and hedge funds in the financial centre violated their operating licences in creating and trading China investment products, three people with direct knowledge of the matter said. The investigation began about two weeks ago and is focussed on how international brokers and Hong Kong subsidiaries of Chinese brokers used more than $100 billion (65.1bn pounds) in China investment quotas to create products allowing hedge funds to trade stocks and bonds in mainland markets. China controls foreign access to its markets through closely monitored programmes, such as by issuing investment quotas. Hong Kong's Securities and Futures Commission (SFC) has not been detailed its concerns with the financial firms it has approached for information. But two sources said it is conducting its investigation to help China's stock market watchdog, the China Securities Regulatory Commission (CSRC). The CSRC has been cracking down on what it has called ‘malicious’ trading activities blamed by Chinese authorities for a 40% slump in the mainland’s stock markets since June… ‘They are basically clutching at straws,’ one executive at a foreign institutional broker in Hong Kong said… ‘They have to be seen doing something and it is an extension of the crackdown on hedge funds in the mainland.’”

Fixed Income Bubble Watch:

September 9 – Bloomberg (Michelle Kaske): “Puerto Rico plans to present a debt-restructuring offer in a few weeks to address a projected $13 billion shortfall in bond payments due over the next five years that the commonwealth says it can no longer afford to pay. ‘We’ll be ready with a first proposal as to how to make the $18 billion worth of contractual debt service fit to the available resources we have under this plan,’ Jim Millstein, the island’s chief restructuring adviser, said… Puerto Rico said it only has $5 billion available for the payments. Prices of some of the commonwealth’s bonds, which have been trading at distressed levels, fell after Puerto Rico made it clear in the proposal that it would seek to force losses on most debt investors. It also pursue a moratorium on principal payments for several years, according to Melba Acosta, the island’s main debt official. The proposal paints a dire picture of Puerto Rico’s finances and the consequences to the island’s 3.5 million residents.”

September 8 – Bloomberg (Matt Scully Jody Shenn): “The pitch arrived with an iconic image of the American Dream: a neat house with a white picket fence. But behind that picture of a $2.95 million home in Manhattan Beach, California, were hints of something darker: liar loans, those toxic mortgages of the subprime era. Years after the great American housing bust, mortgages akin to the so-called liar loans -- which were made without verifying people’s finances -- are creeping back into the market. And, like last time, they’re spreading risks far and wide via Wall Street. Today’s versions bear only passing resemblance to the ones that proliferated in the mid-2000s, and they’re by no means as widespread. Still, they reflect how the business is starting to join in the frenzy that’s been creating booms in everything from subprime car loans to junk-rated company bonds. The Manhattan Beach story -- how the mortgage on that house was made and subsequently packaged into securities with top-flight credit ratings -- recalls a time when borrowers, lenders and investors all misjudged the potential danger.”

Central Bank Watch:

September 10 – Financial Times (Netty Idayu Ismail): “The European Central Bank will ensure its policy stance remains as accommodative as needed amid financial-market turbulence, according to Executive Board member Peter Praet. ‘The Governing Council will remain vigilant that recent volatility does not materially affect the broad array of financial conditions and therefore lead to an unwarranted tightening of the monetary-policy stance,’ Praet said… ‘It has emphasized its willingness and ability to act, if warranted, by using all the instruments available within its mandate.’”

U.S. Bubble Watch:

September 4 – Reuters (Sinead Carew): “Slowing growth in emerging markets and currency fluctuations in anticipation of a U.S. interest rate hike may push third-quarter revenue and earnings estimates lower this month. Wall Street expects a 3.4% decline in earnings for the S&P 500 for the quarter. Estimates have already fallen for 9 out of 10 of the benchmark index's sectors so far this year, according to Thomson Reuters data. S&P revenue is expected to fall 2.8% for the quarter… As companies tend to revise guidance around the end of the quarter, estimates may become even less optimistic. ‘Analysts will likely be pulling in their reins going into the quarterly reports and the pre-announcement season. This could happen fairly quickly,’ said Tim Ghriskey, chief investment officer of Solaris Group…”

September 7 – Financial Times (Ed Crooks): “US shale producers reported a cash outflow of more than $30bn in the first half of the year, in a sign of the challenges facing the US’s once-booming industry as the slump in oil prices begins to take effect. The shortfall points to a rise in bankruptcies and restructurings in the US shale oil industry, which has expanded rapidly in the past seven years but has never covered its capital expenditure from its cash flow. Capital spending by listed US independent oil and gas companies exceeded their cash from operations by about $32bn in the six months to June, approaching the deficit of $37.7bn reported for the whole of 2014…”

September 6 – Financial Times (Ed Crooks): “The world may run on oil, but the oil industry runs on capital, and for US shale producers that capital is starting to dry up. Earlier in the year it was still relatively easy for US exploration and production companies to raise capital by selling debt or equities, in spite of last year’s oil price crash caused by a global glut. Now those sales have slowed sharply, and the financial strain on the industry is growing. The next turn of the screw is approaching, in the shape of another round of redeterminations of ‘borrowing bases’: the valuations of companies’ oil and gas reserves used by banks to secure their lending… ‘In retrospect, easy money and a difficult time for finding the right thing to invest in led to an overshoot in US [oil] production growth,’ says Edward Morse, global head of commodities research at Citigroup. ‘Companies that should never have been brought to life were brought to life.’ Now that overshoot is heading for a correction. Analysts expect a wave of asset deals, acquisitions and corporate bankruptcies, as weaker companies struggle to avoid collapse, not always successfully. Already 16 US oil production companies have defaulted this year, according to Standard & Poor’s…”

September 8 – Wall Street Journal (Robbie Whelan): “A shortage of glass is taking a toll on the nation’s commercial building boom, adding millions of dollars to the cost of new skyscrapers and halting some projects midway through construction. Demand is soaring for the metal-framed glass panels, or curtain wall, used to sheath skyscrapers. Those buildings need a lot of glass—hundreds of thousands of square feet for a typical high-rise office tower. Glass manufacturers and fabricators can’t keep up. Many glass makers mothballed their operations or went out of business in 2008 and 2009, during the recession, which hit the construction industry hard. Now, however, apartment buildings are sprouting up at their briskest pace in decades, and new office towers are rising in major markets like Manhattan at the fastest rate since the early 1990s… Scott Kinter, a senior vice president in Boston with AvalonBay Communities Inc., one of the largest U.S. apartment-builders, said his team began hearing about glass-related delays about a month ago, and he expects a significant curtain-wall shortage in the fourth quarter of 2015 and into early 2016. Prices are up between 35% and 45% from 2013, he said.”

Europe Watch:

September 8 – Reuters (George Georgiopoulos): “Greek banks' bad loans, which peaked after capital controls were imposed in late June, have dipped to around 45% of their loan books and are likely to fall further, daily newspaper Kathimerini said…, citing bankers' estimates. The figure for bad loans - defined as credit more than 90 days in arrears or likely to fall into that category - was 40.8% at the end of the first quarter…”

September 11 – UK Guardian (Ashifa Kassam): “Nearly 1.5 million Catalans took to the streets of Barcelona on Friday to rally for independence, as the region’s politicians launched their campaigns for a looming election billed as a make-or-break moment for Catalonia. ‘This is the most important campaign of our lives,’ said Raul Romeva of the pro-independence Junts pel Sí (Together for Yes) party. A coalition made up of the Catalan leader Artur Mas’s conservative CDC party and the leftwing Catalan Republic Left, Junts pel Sí is seeking to turn the 27 September regional ballot into a quasi-referendum on independence. ‘We are asking the people what they want to be and where they want to go,’ said Romeva.”

September 8 – Financial Times (Tobias Buck): “Catalan leaders will take their campaign for independence from Spain to a new level, with a plan to establish the region’s own diplomatic service, central bank, tax authority — and possibly even its armed forces. The plan could be put into practice as soon as next month, provided that voters in the prosperous northern region hand a sufficiently large majority to pro-independence parties in a regional election on September 27. ‘This is not about declaring independence immediately. This is about starting a process that leads to an independent Catalan state,’ Artur Mas, the Catalan president, said… ‘One crucial task for the next government will be to create the state structures that will succeed those of the Spanish state: the tax authority, for example, which we have already worked on for the past year and a half, or social security or the central bank,’ he added. The idea of building a state within the Spanish state — sure to infuriate Madrid — comes after the central government has repeatedly rejected pleas from Mr Mas and others to allow a formal referendum on Catalan independence.”

September 6 – Wall Street Journal (Bertrand Benoit and Nicholas Winning): “Praise for Germany’s handling of the thousands of refugees pouring into the country is giving way to domestic and international criticism of Berlin’s open-arms policy. The criticism, though still muted, could spell trouble for German Chancellor Angela Merkel once the outpouring of sympathy that has greeted the migrants since late last week subsides and Berlin resumes its push to distribute them more broadly across Europe. The chancellor’s decision on Friday night to let thousands of migrants traveling through Hungary into the country ‘sends a completely wrong signal in Europe,’ Bavarian Interior Minister Joachim Herrmann told public television… ‘This must be corrected.’ Leaders of the Christian Social Union, Bavaria’s ruling party and an ally of Ms. Merkel’s Christian Democrats, unanimously criticized the decision as wrongheaded…”

EM Bubble Watch:

September 11 – Reuters (Faul Kilby): “Pessimism about Brazil deepened this week after Standard & Poor's downgraded both the sovereign and Petrobras to junk status, reigniting fears of forced selling in a country sinking fast into high-yield territory. The other agencies are expected to follow suit soon, further clouding the picture for Brazil, which is undergoing its worst economic crisis in decades. ‘We shouldn't underestimate the follow-up impact we could see when Fitch or Moody's converge with S&P,’ said Patrick Esteruelas, a sovereign analyst at Emso… About US$80bn in Brazilian corporate debt could ultimately be cut to junk - at least partially - as agencies take the sovereign lower, said Anne Milne, managing director for emerging markets corporate research at Bank of America Merrill Lynch. Such a move would rebalance the country's corporate credit profile, qualifying 85% of such debt as high-yield versus just 15% fully eligible as investment-grade, she said.”

September 10 – Bloomberg (Y-Sing Liau): “Malaysia’s ringgit rounded out its worst run of weekly losses in more than four decades as a drop in oil exacerbated the currency’s decline amid capital outflows from emerging markets. The currency fell for a 12th week, the longest stretch in Bloomberg data going back to 1971… The ringgit is Asia’s worst-performing currency this year, weighed down by a political scandal involving Prime Minister Najib Razak.”

September 10 – Bloomberg (Y-Sing Liau): “Indonesian sovereign bonds fell this week, pushing the 10-year yield to the highest level since 2010, as the rupiah dropped amid worsening sentiment toward emerging markets. The currency has lost 5% over the past month, the most in Asia after Malaysia’s ringgit… Shortfalls in Indonesia’s current account and the government’s budget, as well as relatively high levels of foreign ownership of its debt, make the country vulnerable to external shocks.”

September 9 – Wall Street Journal (Bradley Hope and Tom Wright): “The corruption scandal around an economic-development fund in Malaysia is spilling beyond the country’s borders, as officials at a United Arab Emirates state investment vehicle raise questions about more than a billion dollars in money that they said is missing. Abu Dhabi has long been a source of support for the fund, 1Malaysia Development Bhd., which was set up six years ago by Malaysian Prime Minister Najib Razak to develop new industries in the Southeast Asian country. Now, as 1MDB tries to fend off a cash crunch, its backers in Abu Dhabi are asking what happened to a $1.4 billion payment the fund said it made but which they never received, two people familiar with the matter said.”

September 7 – Bloomberg (Christopher Langner): “Investors selling the rupiah on concern Indonesia will suffer a debt crisis risk a self-fulfilling prophesy. The rupiah has slumped to its lowest level since the peak of the Asian financial crisis, when Indonesia was bailed out by the International Monetary Fund. Its nine-week decline is the longest since June 2004. That’s unfortunate timing for the nation’s government, banks and companies that owe a record $304 billion in foreign debt, almost three times the country’s $105.4 billion of international reserves… Indonesia’s currency has plunged 13.3% this year, Asia’s worst performing after Malaysia… Bonds denominated in the U.S. currency have lost 3.9% over the last three months…, as companies face a vicious cycle of higher debt servicing costs, falling earnings and slumping asset prices. Only Mongolia’s debt fared worse in Asia.”

Brazil Watch:

September 9 – Bloomberg (Filipe Pacheco and Blake Schmidt): “Brazil’s sovereign rating was cut to junk by Standard & Poor’s, taking away the investment grade the country enjoyed for seven years, as President Dilma Rousseff’s struggles to shore up fiscal accounts amid a faltering economy. The country’s rating was reduced one step to BB+, with a negative outlook, S&P said… Brazil’s largest U.S. exchange-traded fund tumbled 6.6% in late trading along with American depositary receipts for Petrobras, the state-controlled oil company. The downgrade, and S&P’s warning that another cut is possible, puts pressure on the economic team led by Finance Minister Joaquim Levy to win passage of measures that would shore up the country’s fiscal situation by cutting spending or raising taxes. Rousseff has been unable to find support for her initiatives amid an investigation into corruption at the state-controlled oil company that allegedly occurred while she was its chairman, sending her popularity to a record low and generating calls for her impeachment. ‘The downgrade could be a wakeup call but the political situation is so bad that it’s difficult to resolve, so its a dark path ahead,’ Daniel Weeks, the chief economist at Garde Asset Management, said…”

September 10 – Bloomberg (Filipe Pacheco and Paula Sambo): “Petroleo Brasileiro SA was downgraded to junk by Standard & Poor’s, which signaled the possibility of more cuts to come. The world’s most-indebted oil producer’s rating was cut two levels to BB, a day after S&P reduced Brazil’s sovereign debt to speculative grade for the first time in seven years… S&P joins Moody’s… in moving Petrobras to junk amid a wide-ranging investigation into alleged kickback schemes at the company, which has ensnared some of the company’s biggest businesses and prominent politicians. Because of internal rules, some institutional investors such as pension funds can’t hold securities rated junk by at least two agencies, which could lead to a selloff in Petrobras’s $56.5 billion of dollar-denominated debt.”

September 10 – Bloomberg (Filipe Pacheco): “Brazil canceled an auction of local bonds for the second time in a week as the cut in the nation’s credit rating to junk by Standard & Poor’s pushed yields to a six-year high. The Treasury said… it wouldn’t auction fixed-rate real-denominated local bonds Thursday as scheduled, citing market conditions… While the government doesn’t disclose the size of the auctions before they are held, the most recent offering of fixed-rate notes on Aug. 27 raised 9.7 billion reais ($2.5bn).”

Geopolitical Watch:

September 11 – Reuters (Christian Lowe): “Russia called on Friday for Washington to restart direct military-to-military cooperation to avert ‘unintended incidents’ near Syria, at a time when U.S. officials say Moscow is building up forces to protect President Bashar al-Assad's government. The United States is leading a campaign of air strikes against Islamic State fighters in Syrian air space, and a greater Russian presence would raise the prospect of the Cold War superpower foes encountering each other on the battlefield. Both Moscow and Washington say their enemy is Islamic State. But Russia supports the government of Assad, while the United States says his presence makes the situation worse.”

September 10 – Financial Times (Sam Jones): “One of the world’s most sophisticated hacking groups, linked to the Russian government, has been accused of hijacking vulnerable commercial satellite communications, using hidden receiving stations in Africa and the Middle East to mask attacks on Western military and governmental networks. The group, which operates Ouroboros — the virulent malware also known as ‘Snake’ or ‘Turla’; — was outed last year as having mounted aggressive cyber espionage operations against Ukraine and a host of other European and American government organisations over nearly a decade. In a report released on Wednesday, digital security and intelligence firm Kaspersky Lab, which was among the first to analyse the Ouroboros hackers’ activities in 2014, said it had identified a new ‘exquisite’ attack channel being used by the group that was virtually untraceable.”

September 7 – Bloomberg (Nafeesa Syeed, Mohammed Hatem and Mohammed Sergie): “Gulf Arab nations are expanding the ground war in Yemen, pouring more troops into the country to defeat Houthi rebels they say are backed by regional rival Iran. About 1,000 troops from Qatar entered Yemen on Sunday from the Wadia post on the border with Saudi Arabia, the Qatari-owned Al Jazeera television reported. The soldiers, backed by armored vehicles and missile launchers, were on their way to Yemen’s oil-rich central Marib province, it said… The deployment comes after 45 troops from the United Arab Emirates and 10 Saudi soldiers were killed in Marib on Friday, the worst setback to date for the Saudi-led coalition since it began its offensive in March.”

September 11 – Reuters: “Kurdish militants shot dead a waiter and wounded three police officers in a restaurant in southeast Turkey on Friday, as the region descended further into the worst bloodshed it has seen since the 1990s. Turkish jets bombed Kurdistan Workers Party (PKK) targets in northern Iraq for a fifth straight night, while the leader of Turkey's pro-Kurdish opposition accused security forces of a shoot-to-kill policy in another town, Cizre… Hundreds of militants and members of the security forces have died since hostilities resumed between the PKK and the state after the collapse of a ceasefire in July, shattering a peace process launched in 2012 to end a three-decade conflict.”