Glencore; Meltdown or Death Spiral?

While the UK markets attention has been dominated by the Rate Debate and Volkswagen, we have a rather serious problem brewing on our own doorstep. Glencore is in meltdown and with its 5 year CDS trading on Friday either side of 600bps it is a wisp away from a death spiral. That’s the point when, ‘get me out I’m not having this in my portfolio when it goes down,’ PM’s jump ship and their numbers outweigh the bargain hunters. Investors who subscribed to the recent rights issue, and wouldn’t I love to see the crib sheet and FAQ sheet written for the salesmen by corporate finance for that one, will be feeling that maybe ‘cheap,’ wasn’t quite the right word to be banded around at 125p.

Whatever valuations analysts put on Glencore, equity investors may be about to be reminded that equity is at the bottom of the capital structure. Following the announcement earlier this month of the company’s $10bn recapitalisation plan through a rights issue, dividend suspension, asset sales, capex cut and production cut; Moody’s put the company on negative watch on its Baa2 rating, (just above junk). The market is beginning to question if the $10bn recap is sufficient to guarantee the survivability of the company and the whole asset structure is consequently having convulsions.

The problem becomes acute if Glencore is downgraded to junk. At that point we have a potential Lehman / AIG scenario in the commodity space. While Glencore is the biggest listed leveraged bet on the price of copper and the Chinese economy through its mining operations, it is also one of the world’s biggest commodity trading firms. A downgrade to junk could trigger forced selling from PM’s not able to hold junk paper, collateral liquidations and market counter parties slamming the doors shut. The complex daisy chain of OTC derivative contracts have an unquantifiable market risk. At the minimum, fear of a bad thing happening is enough in this fragile environment to unsettle the broader market. Risk managers and regulators must surely have Glencore front and centre on their radar this weekend.

Goldman have suggested in a recent note that it would take only a further 5% drop in commodity prices to tip Glencore over the edge. Bernstein meanwhile apparently think it is cheap.  Sure, the company will announce asset sales, like its agri business, and the shares may enjoy big % temporary spikes. My view however, is investors have no business touching this stock unless they have a near term blue sky view for copper and Chinese growth to which it has a high sensitivity. As neither are likely to be forthcoming investors should take a wide berth. Better to catch the turn in the commodity cycle when it comes with companies who are ahead of the game rather than behind it and examine Glencore only when it recovers its rating and financial health. Better to pay more for something with longevity than to bet at the roulette table in a casino on fire, which is exactly what an investment in the company is now.

Markets; Beware Sharks

If you invest in, work in, regulate or comment on markets you should watch the video above. If by chance you were ambling along in life thinking that those who should know better learn from their mistakes then you're not thinking.

We find ourselves again at or near the peak of a market cycle in which bubbles have been allowed to grow and mature. The end game will be every bit as ugly, if not more so, than those we've seen before.

We are about to see a series of cycle turns occur simultaneously over the next 30 trading days, which include a Fibonacci Cluster turn window with 10 observations. Within this 30 trading day period are a number of very unusual astrological events, which can affect markets. In the past, I have pointed out that major trend turns often come around the spring equinox, which this year arrives within the above Fibonacci Cluster, on March 20th, 2015.

Within this cluster turn period,  we also have a rare Total Solar eclipse (also on March 20th, 2015), the first day of the Hebrew calendar, (Nissan 1, evening also on March 20th), and a New Moon on March 20th. March 20th is also a quadruple witching hour on Wall Street.

Also within this Fibonacci cluster turn period, on April 1st, 2015 is a phi mate turn date, and on April 4th we see a Bradley model turn date, which is also Passover, and also has a Full Moon - not just any Full Moon, but a Blood Moon, the third of four in the 2014-2015 tetrad, a very rare event, that has the additional extremely rare occurrence that all four of these Blood Moons fall on the Hebrew Holy days of Passover and the Feast of Tabernacles (Genesis 1:14). Tell me none of this matters. 

For those who care, 

US economic surprises are at their lowest since 2009. On Friday the Atlanta Fed lowered its Q1 GDPNow forecast to 0.,6% from 1.2%. Investment Bank forecasts are way off the beat here.

Source; US Census Bureau; the blue mark indicates the level when Lehman happened. The uptick is not good.

Source; US Census Bureau; the blue mark indicates the level when Lehman happened. The uptick is not good.

Retail sales, wholesale sales and rail traffic are all at multiyear recessionary lows while the wholesale inventories to sales ratio is at levels which usually spark an equity correction. In fact, we haven’t seen some of this data sink to these levels since Lehman. Earnings estimates point to a 4.9% decline in Q1 which is the largest drop since 2009, yet the market then anticipates a dramatic recovery. Insider selling meanwhile has leapt to warning levels. With this backdrop the Fed’s response will of course be closely watched with many fingers on hair triggers. If they play safe and delay rate rises to start later than expected a period of market turmoil will follow.

The reason the dollar is so strong is quite simply because the US is in better shape than is either Europe, China or Japan and that’s not saying very much. Japan has become one big old peoples home and is currently, in financial terms, eating itself with the only JGB bid coming from the BoJ and public debt at 240% of GDP. Just to orientate you, 40% of tax recepits go on interest on public debt with the 10 year yield at 0.4%. Interest rates at normal levels would absorb all tax receipts and lead to a brutal tax burden on the remaining workforce that hasn’t yet retired. There are words to describe Japans situation, professional courtesy precludes their use here. Europe is mired in centralist socialism and China has just gone through an epic and badly handled credit boom.

The madness in Europe speaks for itself. The ECB is now literally destroying the Euro in a disastrous quest to restart economic growth by monetising $1.2 trillion of mostly European government debt. But Europe’s stagnation is not due to  insufficient private sector borrowing or interest rates that discourage it. The problem is a state sector that has reached nearly 50% of GDP and is thereby smothering entrepreneurs and investment everywhere on the continent. It also  means a public debt burden so high that prohibitive levels of taxation are unavoidable. Stated differently, Europe’s economic growth problem is structural and was the result of statist policies over many decades.  The only thing Draghi will accomplish with his massive bond buying campaign is to drive the Euro to par and below; and enable Europe’s government, all of which can now borrow long-term money at 1% or less, to kick the can down the road, thereby insuring that Europe’s eventual day of fiscal reckoning will be oh so cataclysmic.

 All of these will experience financial disorder and turmoil at some point but for now, let’s take a quick look at just one of those, China. I’m a long time China bear in that I’ve never bought into the “China will save the world,” view that some have promulgated over recent years. Yes, China has kept pricing low and created demand for exports but actually, it takes a very long time to transform an economy and China now is running straight into problems resulting from its credit boom.

While analysts have been lowering Chinese growth estimates those estimates are coming down from a very high level. Current estimates of 7% growth are still too optimistic. Is China turning into Japan? That’s the new topic. Chinese debt stands at $30 Trillion, up $9 trillion since 2008 and debt is 200-300% of GDP counting Shadow Banks.  If the average interest rate is 7% (banks 6% shadow banks 10%), the economy would need to grow 21% in real terms to service the debt and that’s not happening.

Since that cannot happen, banks cannot make loans without injections from PBOC. A fundamental problem is 100% of new credit goes to rollovers. This creates a Zombie economy effect with no credit demand. Steel demand is down, electricity is down, cement demand is down and growth is likely to be sub-zero this quarter. The economy is not growing.

 Moreover, there is massive overcapacity in petrochemicals, construction machinery, steel, cement, aluminium, and housing. The housing excess is extreme with 70 million units of new housing in the pipeline. It will take years of growth to fill capacity.

Aluminium official said privately debt Is $1 trillion, profit 20 billion. Local governments force mills to open because smelters cannot make payments, banks have NPLs. Smelters are capital, not labour intensive.

 The  consumer sector is tracking close to 0% growth as well, average days of clothing inventory is 174 days, electronics 123 days. Consumer companies on the China exchange decline in gross revenue is 2% for the year, 6% third quarter.

 QE3 created a flow of speculative money into China. That tap is shut off and capital flight is accelerating and is a growing problem. Policy now is not about jobs but about keeping money flowing and all capital is used to avoid defaults. We may therefore happily anticipate more defaults, a substantial devaluation, more anti-corruption raids, (especially in financial services), and a clamping down of foreign influence. The consequent demand shock will continue to ripple out. Be prepared not to be surprised by China and if you have money in there I’d mostly be getting it out.

 As China comes closer to a crash landing, the China-dependent EM economies are rapidly faltering. Brazil will suffer sequential years of GDP decline for the first time since 1930-1931.  In fact the China-led global commodities and industrial production boom is cooling so fast that global CapEx in mining and energy, materials processing, manufacturing and shipping is on the verge of a huge downward correction. That will also hit the high end machinery and engineering exporters like Germany and the US, creating a further negative loop in the gathering deflationary crisis.

These ricocheting impacts from the China implosion will drive the dollar still higher. That’s because Chinese companies have borrowed something like $1.5 trillion in external dollar markets, and the EM economies which boomed from the China trade also borrowed trillions in dollar markets, owing to the cheap dollar interest rates manufactured by the Fed, and the global scramble for “yield”  by dollar based money managers.

The flood of cheap dollar based capital which flowed into China and the EM appeared to fuel economic miracles in countries like Indonesia, Brazil and Turkey. Unfortunately, the financial boomerang is flying back at them at devastating speed.  As China and the EM struggle against global deflation, their economies are faltering and exchange rates are sinking. Accordingly, they are desperately trying to hedge their immense dollar exposures, a process which drives the USD steadily higher.

There is a message here in it’s the most important I can see. That is, a soaring dollar is not good on any level and it is certainly not reflecting stability. Rather, because other regions are in a bigger mess than is the US the rising dollar is a red flag which is screaming that instability is hurtling down the track toward us.

 

QE2, Lower Gold and a Higher Dollar......?

In the next in a series of guest financial pieces, Mark Tinker from Axa-Framlington discusses the anticipated next round of quantative easing in the US and how the outcome might not fit most current market expectations.

 

 

Many people have been scratching their heads about the wisdom behind QE2, seen now as almost a certainty by markets. We know that you need to trade on the basis of what you think will happen, rather than what you think should happen, but even so the logic seems very flawed. To recap, QE1 was effectively the US authorities stepping in to prevent meltdown in the US financial system in 2008. In effect the Fed had to undo the damage caused by the Treasury and the regulators, who in their wisdom had managed to paralyse an entire section of the shadow banking system. By insisting that everyone had to sell so called toxic assets while not allowing anybody to buy them, the politicians created a need for a buyer of last resort. Step forward the Fed. Thus the job of QE1 was effectively to supply liquidity to undervalued but almost totally illiquid assets and the Fed balance sheet expanded by $1.3trillion, almost all of which was mortgage backed securities

QE2 however seems aimed at doing something completely different; buying the most liquid and expensive (as opposed to the least liquid and cheapest) assets in the world; US treasuries. The apparent thinking here is that by reducing the cost of capital (yet) further, the Fed can stimulate growth in the US economy. Now this is dubious on a number of levels. First, for all the politicians Banker bashing, these policies are doing nothing to improve the supply of credit. Credit is what small businesses need to survive and prosper and it comes from the banking system (shadow or otherwise). Making it very cheap to raise money in capital markets is good for large businesses, but they are not the ones that drive employment growth, indeed they continue to shed labour. Equally, making it cheap for banks to borrow at the short end and then encourage them via your “Risk” policies to buy government bonds simply sucks investment capital away from the productive economy.

In reality, all that has happened so far is that as the MBSs run off, largely because they were not at all toxic and have been redeemed at par, but also because the very policy of driving down long rates encouraged refinancing and pre-payment, the Fed has simply rolled that liquidity into other fixed income products (mainly Treasuries) so as not to tighten policy. Somehow, this has been whipped into an hysterical bandwagon (encouraged by uber-keynesians like Krugman) that the Fed should spend $1trilion, $2 trillion or even $3 trillion on buying US Treasuries in order to stimulate the US economy. Never mind that the Leading Indicators are turning positive, never mind that employment is a lagging indicator (which incidentally your own policies are making even more lagging), hurry up and get employment going, encourage inflation, push up asset prices and everybody will be happy!

Now this all seems very strange, not only because it seems to be a repeat of the very asset bubble issues  that we swore not to repeat, but because the unintended consequences (if that indeed is what they are) are clearly evident already. Most notably the liquidity is flooding out of the $ and into real assets, notably commodities and emerging markets. The huge binary allocation of expensive bonds (buy with leverage because the Fed will buy them off you at a profit) and expensive emerging market equities (buy with $’s because not only is this where the growth is but the currency is only going one way) had, until recently left the rest of the equity markets looking ridiculously cheap with almost all large cap stocks trading at a dividend yield above their own corporate bond yield. Thus even the talk of QE2 has produced a dramatically weaker $ and risks of a bubble in commodity prices, treasuries and emerging market equities and no discernable effect on employment.

Now generally I prefer cock-up to conspiracy, but for once, let’s give the US authorities a bit of credit. Say you wanted the Chinese to revalue their currency, or even scrap the peg (now we know this is not the reason for the deficit, but we have seen this movie before with the Japanese), suggesting that you will dramatically lower the cost of capital and thus drive their monetary policy is a very credible threat, for as we know from 2007, the liquidity goes straight to Asia via the peg – a smart bomb straight into the heart of Chinese economic policy. Say too that you know from 2007 that a key vehicle for this transmission is the $ itself, a weak $ correlates to high commodity prices and we know that the Chinese are far more sensitive to imported food and energy prices than the US is. But of course this is not one sided, the Chinese have moved to tighten policy and also they can try and offset the weak dollar impact on their export economy by buying Yen and Euro, and then allowing a Yuan appreciation. To do this of course they effectively sell down the $ as well. Now they are not the only players in markets, momentum traders in $ are shorting and shouting, about debauching the currency and the  $ as a one way bet. Their equivalents in the commodity markets are also shorting $ to buy oil and metals, particularly gold. Other emerging economies are really struggling with capital inflows and instability is rising everywhere from Indonesia to Brazil.

So maybe these unintended consequences are actually intended. Now that the Yuan has revalued (at least somewhat), maybe the US backs off? Tim Geithner has started to make comments about wanting a stronger $ (something China’s EM competitors would also like) and, interestingly, a number of Fed Chairman from around the country are making increasingly hawkish (ie sensible) noises on QE2, not least concerned with the reality that higher energy prices in the US are a deflationary thing – as essentials they crowd out other disposable income. Come November the 3rd of course, the Fed oversight committee will likely be chaired by a republican $ hawk. But, and here is the final twist, how about Bernanke simply muses that the US might consider selling some of its physical gold reserves?  Gold would drop like the proverbial, almost certainly taking other commodities with it, meanwhile the $ would soar, reducing all those unpleasant emerging market tensions and reducing the price of gasoline to boot. Oh and John Paulson would get hosed (which would be nice)

Go on Tim, tell me it’s a plan.