History tells us two related facts. Central banks are always defeated by markets in the end, and central bankers have a touching faith that next time they will retain control over markets. But if we accept the lessons of history, we must dismiss complacency over systemic risk to the financial system. We can go even further, and begin to expect that of all the risks that will eventually trigger a widely expected financial crisis, it will be an old-fashioned bear market in bonds.
The recent peak in profits, combined with substantially elevated P/E ratios, is likely suggesting that forward return expectations should be revised sharply lower.
At the heart of the China Commodity Financing Deals (CCFD) is the ability to leverage a letter of credit on the basis that there was some collateral somewhere that backed the risk of this rehypothecatable 'money'. Until now, the biggest concern has been "where's my copper, nickel, gold, etc..?" as the Qingdao ponzi scheme is unveiled; but, as Metal Bulletin reports, the contagion from the exposure of CCFDs ponzi has now hit Western banks. At least one western bank has stopped discount financing of copper into China after Industrial & Commercial Bank of China (ICBC) applied for the right not to settle a letter of credit it issued earlier this year, as a result of the Qingdao investigations. In other words the collateral chains were just snapped...
Will investing based on fundamentals eventually find favor once again with investors? The problem is that market participants no longer view the financial markets as a place to invest savings over the "long term" to ensure future purchasing power parity. Today, they view the markets as a place to "create" wealth to offset the lack of savings. This mentality has changed the market dynamic from investing to gambling. As Seth Klarman warned, "There is a growing gap between the financial markets and the real economy. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs." Simply put, fundamentals will matter, but only after the fact.
The biggest news in the sage surrounding Chinese evaporated collateral troubles at Qingdao, which as noted is merely the 3rd largest Chinese port, is that this scandal has now spread to a second Chinese port: Penglai, which is also located in the Shandong province. Putting some size numbers for context: Qingdao's copper inventory is about 50,000 tons, compared to 800,000 tons in Shanghai, analysts say. There's "little evidence" for now that traders in Shanghai fraudulently have pledged collateral to banks, said Sijin Cheng, an analyst with Barclays Research in Singapore. Little evidence will become "lots" in the coming days when we expect more "discoveries" at all other bonded warehouses as the relentless inflow of commodities finally reverses and the beneficiaries finally demand possession. As everyone who has followed even the simplest Ponzi schemes knows, this is the part of the lifecycle when many tears are shed by most.
Are we at the beginning of a new cycle of rising interest and rising prices? No, and here's why.
In 1933, FDR confiscated the gold of Americans. This common telling portrays it as a simple case of robbery. It makes people wonder if 1933 is a precedent. I don’t think it is so simple.
We have warned a number of times that China is a ticking time-bomb (and the PBoC finds itself between a housing-bubble rock and reflationary liquidity injection hard place) but the collapse of trust in the interbank funding markets suggests things are coming to a head quickly. The problem the administration has is re-surging house prices and a clear bubble in credit (as BofAML notes that they suspect that May housing numbers might have under-reported the true momentum in the market since local governments are pressured to control local prices) that they would like to control (as opposed to exaggerate with stimulus). As we noted here, while the PBOC may prefer to be more selective with their liquidity injections (read bank 'saves' like ICBC last night) due to the preference to control the housing bubble, when they finally fold and enter the liquidity market wholesale, the wave of reflation will rapidly follow (and so will the prices of precious metals and commodities).
A month ago, when stock markets around the globe were hitting all time highs, we wrote "The Bronze Swan Arrives: Is The End Of Copper Financing China's "Lehman Event"?" which as so often happens, many read, but few appreciated for what it truly was - the end of a major shadow leverage conduit (one involving unlimited rehypothecation at that),and the collapse of a core source of shadow liquidity. One month later, China's "Lehman event" is on the verge of appearing, and with Overnight repo rates hitting 25% last night, coupled with rumors of bank bailouts rampant, it very well already may have but don't expect the secretive Chinese politburo and PBOC to disclose it any time soon. So now that the market has finally once again caught up with reality, for the benefit of all those who missed it the first time, here is, once again, a look at the arrival of China's Bronze Swan.
In all the hoopla over Japan's stock market crash and China's PMI miss last night, the biggest news of the day was largely ignored: copper, and the fact that copper's ubiquitous arbitrage and rehypothecation role in China's economy through the use of Chinese Copper Financing Deals (CCFD) is coming to an end.
Do you think that depositors in Cyprus are being taxed? That their money is being taken from them to go to the government in Cyprus or to Europe? Most analysis of the Cyprus bailout is wrong...
The Real Bill is quite different from the bond. It isn’t lending at all. It is a clearing instrument that allows the goods to move to the gold-paying consumer before said consumer pays with gold.
From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and do not scream 'bubble'. And yet, China has been a source of worry for GMO over the past three years and continues to be one. China scares them because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models' estimation of what "normal" is. Of course, every credit bubble involves a widening divergence between perception and reality. China's case is not fundamentally different. In GMO's extensive discussion below, they have documented rapid credit growth against the background of a nationwide property bubble, the worst of Asian crony lending practices, and the appearance of a voracious and unstable shadow banking system. "Bad" credit booms generally end in banking crises and are followed by periods of lackluster economic growth. China appears to be heading in this direction.
Following Part 1 (History), and Part 2 (Interventionism), Part 3 provides a more technical look at the key features of the unadulterated gold standard. It could be briefly stated as a free market in money, credit, interest, discount, and banking. Another way of saying it is that there would be no confusion of money (i.e. gold) and credit (i.e. paper). Both play their role, and neither is banished from the monetary system. There would be no central bank with its “experts” to dictate the rate of interest and no “lender of last resort”. There would be no Securities Act, no deposit insurance, no armies of banking regulators, and definitely no bailouts or “too big to fail banks”. The government would have little role in the monetary system, save to catch criminals and enforce contracts.