Capital Markets

Seven years ago today, Lehman Brothers failed. But it is what took place just over two weeks prior that is of interest for the scope of this article.

In short, activist Fed policy is both ineffective and reckless (and the historical data bears this out), and that the Federal Reserve has pushed the financial markets to a precipice from which no gentle retreat is ultimately likely. Similar precipices, such as 1929 and 2000, and even lesser precipices like 1906, 1937, 1973 and 2007 have always had unfortunate endings. A quarter-point hike will not cause anything. The causes are already baked in the cake. A rate hike may be a trigger with respect to timing, but that’s all. History suggests we should place our attention on valuations and market internals in any event.

Europe's refugee crisis is getting worse by the day. Less than 24 hours after Germany announced it would impose border controls with Austria, followed promptly by the Czech Republic, Slovenia and now the Netherlands, German vice chancellor Sigmar Gabriel predicted that as many as 1 million refugees may arrive by the end of the year as other nations moved to fortify their frontiers. In the meantime, however, Europe is dramatically escalating measures to halt the influx and as AFP reported earlier today, the European Union has now approved military action against human traffickers in the Mediterranean Sea.

"The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow."

"While we are increasingly convinced that the market needs to see lower oil prices for longer to achieve a production cut, the source of this production decline and its forcing mechanism is growing more uncertain, raising the possibility that we may ultimately clear at a sharply lower price with cash costs around $20/bbl Brent prices."

This level of global inter-connected financial risk is hazardous in Mexico, where it’s peppered by high bank concentration risk. No one wants another major financial crisis. Yet, that’s where we are headed absent major reconstructions of the banking framework and the central bank policies that exude extreme power over global economies and markets, in the US, Mexico, and throughout the world. Mexico’s problems could again ripple through Latin America where eroding confidence, volatility, and US dollar strength are already hurting economies and markets. The difference is that now, in contrast to the 1980s and 1990s debt crises, loan and bond amounts have not just been extended by private banks, but subsidized by the Fed and the ECB.  The risk platform is elevated. The fall, for both Mexico and its trading partners like the US, likely much harder.

Exactly one month ago, in the aftermath of the Chinese devaluation announcement, we made a simple prediction. "Biggest immediate loser from China's devaluation: Brazil" Today, following the overdue, long anticipated, and yet "shocking" downgrade of Brazil by the S&P to junk, this prediction is coming true.

Bank profitability will remain under pressure for some time to come in light of the new capital regulations currently in the works. This will make it more difficult for banks to generate new capital internally, so they will have to tap the capital markets and dilute their shareholders further. It is no wonder that bank stocks remain way below the valuations they once commanded (we actually wouldn’t touch these stocks with a ten-foot pole). From a wider economic perspective, the new capital regulations are rendering banks moderately safer for depositors (as long as the markets don’t lose faith in government debt that is), but they also contribute to their ongoing “zombification”. Bank lending is going to remain subdued. This wouldn’t represent a big problem, if not for the fact that it is likely to provoke even more government activism.

In a word, the official unemployment rate is now in what has been the macroeconomic end zone for the past 45 years. Might this suggest that the emergency is over and done? Self-evidently, the only “incoming” information that can matter between now and next Wednesday is the stock market averages.  If the Fed takes no action in September, it’s hard to imagine any economic or jobs report that wouldn’t support ZIRP or near-ZIRP in the minds of the money printers and the Wall Street gamblers they pleasure.

The fallout from the demise of the petrodollar is becoming impossible to sweep under the rug even as Gulf states are keen to downplay the severity of the budget crunch. For the Saudis, who need crude at $100 to plug a budget deficit that’s projected at a whopping 20% of GDP, the situation is becoming particularly acute. For Qatar, the situation isn't quite as dire but that doesn't mean the country's officials aren't acutely aware that the world is now scrutinizing the budgets of petrostates in the wake of collapsing crude and indeed on Monday, Qatari Finance Minister Ali Sherif al-Emadi was at pains to reassure the market.

For anyone who (still) believes that Canada has a diversified economy...

To summarize: in order to get the Saudis to "agree" to the Iran deal, all the US had to do is remind King Salman, that as long as oil is where it is to a big extent as a result of Saudi's own record oil production, crushing countless US oil corporations and leading to the biggest layoffs in Texas since the financial crisis, the country will urgently need access to yield-starved US debt investors. If in the process, US corporations can invest in Saudi Arabia (and use the resulting assets as further collateral against which to take out even more debt), while US military corporations sell billions in weapons and ammo to the Saudi army, so much the better.

"there is a sense that policy is being priced to “fail” rather than succeed... why should equities always rise in value? Why should debt holders be expected to afford their debt burden? There are plenty of alternative viable equilibria with SPX half its value, longevity liabilities in default and debt deflation in abundance. In those equilibria traditional QE ceases to work and the only road back to what we think is the current desired equilibrium is via true helicopter money via fiscal stimulus where there are no independent central banks.

More debt begets higher market value of equites which in turn improves the debt/equity ratio which gives the incentive to issue more debt ad infinitum. Or in a slightly simpler version, debt begets more debt.  We have seen the story before. In the shaded grey areas we highlight episodes when the virtuous relationship turns ferociously vicious. Remember, markets take the escalator up, but the elevator down. And the longer the escalator the further down the elevator goes.