Thursday, March 20, 2014 - Stress Tests and Such

Stress Tests and Such
by Sinclair Noe

DOW + 108 = 16331
SPX + 11 = 1872
NAS + 11 = 4319
10 YR YLD un = 2.77%
OIL - .27 = 98.63
GOLD – 2.10 = 1329.50
SILV - .34 = 20.37

More sanctions for and from Russia; President Obama today expanded sanctions against Putin’s inner circle, now banning visas and freezing assets of 20; the blacklist now includes a commodity broker with a brokerage based in Switzerland, plus Bank Rossiya with about $10 billion in assets.

In response, the Russian Duma, the lower house of parliament ratified the annexation of Crimea, and Putin announced sanctions against US oligarchs, including Senators John McCain and Harry Reid, and House Speaker John Boehner. McCain said he would have to cancel his plans for Spring break in Siberia.

There is an EU summit underway, and it remains to be seen if European leaders will get tough with sanctions. German Chancellor Angela Merkel has been talking tough but the Euro-economy is still fragile, and it is doubtful sanctions will serve as a strong deterrent. This is not to say that sanctions won’t have an effect. Some of Russia's largest companies are registered abroad where they may benefit from lower tax rates.

You might not have caught this next bit of news, after all there was a lot going on today with the Russian sanctions and the breaking news on the missing plane and the basketball brackets and such; anyway, in Florida today, after talking about sanctions, President Obama called for legislation requiring equal pay for equal work.

Obama said: “Women with college degrees may earn hundreds of thousands of dollars less over the course of her career than a man at the same educational level, and that’s wrong. This isn’t 1958 -- it’s 2014.”

This is clearly a blatant attempt to draw in more female voters in the mid-term elections; still it’s true.

California is facing wildfires "outside of any normal bounds" as a historic drought turns drying brush and trees into a perfect tinderbox. Fire officals say the state recorded 665 wildfires from the start of the year through March 8, about three times the average of 225 for this time of year. Cal Fire officials warn that each day without heavy rain deepened the risks of a catastrophic fire season and made it hard to deal with more wildfires if and when they broke out. And the fires are bigger.

Even before this year's drought, forest officials were reporting a longer fire season, and more catastrophic mega-fires, in California and other western states. Half of the worst fires in recorded Californian history have occurred since 2002. This is usually the time of year when much of the state is greening up. We haven't even got into the months that historically are the worst in California – late August, September and October – so that's a big red flag right there.

The number of Americans filing for jobless benefits hovered near three-month lows last week. Initial claims for state unemployment aid increased 5,000 to a seasonally adjusted 320,000 last week.

In a separate report, the Philadelphia Federal Reserve Bank said its business activity index rebounded to 9.0 in March from -6.3 in February. Any reading above zero indicates expansion in the region's manufacturing. There was a rebound in new and unfilled orders at factories in the region. Shipments also bounced back, but inventories fell. Employers opted to increase hours for existing workers rather than expand payrolls.

The National Association of Realtors said existing home sales slipped 0.4% to an annual rate of 4.60 million units. That was the lowest level since July 2012. Inventory levels are low, while prices have been moving higher. The median price for a previously owned home rose 9.1% in February from a year earlier.

The Conference Board's leading economic index rose 0.5% in February, after a 0.1% rise in January and a 0.1% decline in December.

The Federal Reserve submitted the stress test results on the 30 biggest US banks; 29 passed, one failed. Zions Bank does not have enough capital reserves; this is not a surprise; Zions is resubmitting its capital plan after taking a charge on bank trust preferred securities which Zions tried to claim as Tier 1 capital, but the Fed did not accept that.

Anyway, the Fed figures that if the economy falls off another cliff, the banks would lose $501 billion, but they would be able to survive. The Fed defines falling off a cliff as a bad recession where unemployment spikes to 11.25%, the stock market drops 50%, and home prices drop 25%. Most sane people would call that a depression.

Previous stress tests were used to reassure investors that the big banks were not a hot mess and were financially strong, even in tough times. The problem is that the tests aren’t very realistic. Unfortunately, the Fed’s approach ignores a lot of the horrible things that actually happen in nasty downturns. For example, banks’ borrowing costs tend to rise, killing profits that could offset their losses; trouble at one bank can spread as investors wonder which others will be affected; credit freezes can force financial institutions to sell assets at a loss, setting in motion downward spirals in which falling prices and banks’ woes reinforce each other. If you start thinking about all those things, we’d be lucky if one bank could pass the test. Of course, that wouldn’t inspire much confidence, and so…

Remember not so long ago when the markets were upset about emerging markets and a slowdown in China? Just in case you forgot, Morgan Stanley has just issued a report on China. Here are some of the key points:

Morgan Stanley analysts…, “believe China’s twin excesses (excessive investment funded by excessive debt) will inevitably unwind, causing a substantial slowdown in China’s economy, significantly below market expectations. In recent weeks, a trip to the region and further research into China’s shadow banking system have convinced Morgan Stanley analysts  that China is approaching its “Minsky Moment,” which increases the chances of a disorderly unwind of China’s excesses. (that reference to “Minsky moment” refers to an economist named Hyman Minsky, from the 1930, who basically claims that the more you prop up an economy, the more likely it will eventually become unstable) The efficiency with which credit generates economic activity is already deteriorating, as more investments are made in non-productive projects and more debt is being used to repay old debts.

Based on the Morgan Stanley analysis, their baseline case is that China may slow from the current level of 7.7% Gross Domestic Product (GDP) growth to 5.0% over the next two years. A disorderly unwind could take Chinese growth down to 4% in a shorter time frame with potentially disastrous consequences for levered Chinese assets (banks, property) and the entire commodity supply chain (commodity stocks, equipment stocks, commodity-sensitive countries and their currencies).

The consensus is more optimistic and expects China’s economy to grow by 7.4% in 2014 and 7.2% in 2015. Most market participants have concluded that the Chinese economy, despite its excesses, will slow only moderately as the government successfully manages to “soft-land” the credit and investment boom and that, as a result, the impact on global GDP growth could be moderate and is not likely to derail the global developed-market-led expansion. However, one of the more controversial conclusions of their analysis is that global economic growth could be impacted severely enough to cause a global earnings recession.

They suspect China’s economy has arrived at that unstable state where speculative and Ponzi finance appear to dominate. From a macroeconomic perspective, very few economies have ever created as much debt as China has in the past five years. China’s private sector debt has increased from 115% of GDP in 2007 to 193% at the end of 2013. That 80% increase over five years compares to the U.S.’s 26% in 2000-2005. In recent years, only Spain and Ireland have achieved debt growth greater than China’s. Every year, China is now adding $2.5 trillion of private sector debt to a $9.7 trillion GDP.

There is evidence that this debt growth has become excessive and non-productive. It now takes 4 renminbi (RMB) of debt to create 1 renminbi of GDP growth from a nearly 1:1 ratio in the early and mid-2000s. After the massive stimulus and more than doubling of new bank loans in 2009, the government attempted to stabilize credit growth, but the growth of the shadow banking system exploded instead. Shadow banking now accounts for more than a fifth of total credit in China—or about 40% of GDP from a base of 12% just five years ago. The shadow banking system funnels credit to borrowers who can no longer get loans from the formal banking sector.

Defaults or near-defaults have begun to occur with regularity over the past three months and are likely to pick up in quantity significantly over the next year. As it is becoming more clear that investors may not get all of their money back, interest rates on trust products, wealth management products (WMPs), corporate bonds, and bank loans have risen by roughly 200 basis points in the last year.

The unwind of this credit boom is likely in progress, and they expect it to pick up speed over the coming months and quarters. It will likely involve a steady drip of defaults and near-defaults as insolvent borrowers finally become illiquid. Market rates for all assets except central government bonds and central bank bills will likely continue to rise, reflecting increasing market fears of default by shaky borrowers. Asset values will likely begin to deteriorate as stressed borrowers attempt to sell assets to stay afloat. As a result, banks and other financial entities could begin to increase provisioning for bad debts and to reduce credit availability by gradually tightening credit standards. This could lead to a credit crunch where credit to the economy is choked off for all but the safest borrowers. Most other analyses concludes that China could slow more than currently expected by the consensus, but that the global economy is well-positioned to withstand such a slowdown. And the Morgan Stanley report concludes that they are  a bit more pessimistic.