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Portuguese Bank Jitters Intrude on QE-Induced Euphoria

Despite unimpressive and often mixed economic data, market prices in a wide range of financial assets have continued to grind higher. And the results that cheered pundits are hard to square. For instance, Floyd Norris in the New York Times today scratches his head over how inconsistent recent employment gains are with the first quarter GDP contraction at an annualized 2/9% rate. It’s also hard to reconcile with reports of weak retail sales and falling in-store traffic. Similarly, China has become concerned enough about growth that it’s started pump priming again. Even so, car sales dropped by 3.4% in June. And in Japan, machinery orders plunged by 19% in May. And despite the recent discussion of Eurozone recovery, recent reports have put a dent in cheery forecasts. As Ambrose Evans-Pritchard noted:

Data released on Thursday showed that industrial output for May fell 1.7pc in France and 1.2pc in Italy. It has fallen for three months in a row in Germany, hit by Russia’s recession and weakness in China and Japan.

“The German economy is highly leveraged to world trade and that is in contraction,” said Dario Perkins, from Lombard Street Research. “The CPB’s World Trade Monitor has been negative for the past two months on a three-month moving average, and we haven’t seen anything like that since the collapse before the Lehman crisis.”

But financial markets have brushed off all sorts of causes for concern: the confrontation over Ukraine, rising hostilities in the Middle East, first in Iraq, and now in Gaza as well, the simmering tension in Asia as China’s expanding territorial claims put it more and more at odds with its neighbors. But the prospect of the failure of a bank in Portugal that is part of a larger conglomerate structure rattled investors yesterday. Even US markets swooned early in the day but staged a partial reversal later on.

While the bank, Banco Espírito Santo SA, isn’t systemically important, its rapid deterioration spooked investors. As the Wall Street Journal noted:

The broad, sharp market moves were reminiscent of the euro zone’s debt crisis in 2011: A shock in a small country spread across the continent, pulling down every major stock index in Europe, trickling over into Wall Street and sending investors scurrying for the perceived safety of gold and U.S. and German government bonds. The 10-year German Bund traded at its strongest level since May 2013.

Portugal’s benchmark index led the declines, falling 4.2%. Exchanges in Spain and Italy were each off close to 2%, and the broad Stoxx Europe 600 fell 1.1%. The Dow Jones Industrial Average closed down 70.54 points, or 0.4%, at 16915.07, after falling as much as 1.1% earlier. Amid the market turmoil, some southern European companies postponed planned stock and bond offerings, and investors were left wondering whether the problems were confined to Portugal or presaged a wider reassessment of Europe’s recovering but still fragile banking system.There is worry about contagion,” said Thomas Roth, a government bond trader at Mitsubishi UFJ Securities (USA) Inc. “The theory is that it could lead to bank failures and throw us back into recession,” he added. Nick Lawson, a London-based stock trader at Deutsche Bank AG, spoke of “the memories of 2011 coming back.”….

It has been more than a year since fears about the health of a European bank rattled markets, and investors, bankers and regulators have been growing increasingly confident about the continent’s financial system. Regulators have hoped the banking industry’s improving health would shine through on so-called stress tests they are conducting on more than 120 large banks.

I’m still amazed that anyone takes the stress test exercise seriously; the market reaction may be a tacit acknowledgement that investors understand their limits quite well.

Today, markets in Europe are in better shape, but the Wall Street Journal today pointed out that issuers had had to postpone both bond and stock offerings, indicating that investors are still nervous. And Bloomberg described the size of the moves in credit instruments:

The events are triggering turmoil in debt markets from London to New York, renewing concern the financial system remains vulnerable six years after central banks began flooding their economies with cheap cash to break free from the global credit crisis. The same policy makers that helped drive bond yields to unprecedented lows, have warned investors are becoming too complacent about risks…

A derivatives index that gauges the credit risk of banks and insurers in Europe jumped yesterday for a fifth day after a company linked to Portugal’s second-biggest bank missed payments on commercial paper. Shares in Espirito Santo were suspended after dropping 17 percent as investors shunned risk assets on concern that financial problems within the Espirito Santo group would spread.

The Markit iTraxx Europe Senior Financial Index of credit-default swaps insuring 25 banks and insurers rose to 72 basis points yesterday from a more than six-year low of 57 basis points last month. Yields on 10-year Portuguese and Greek government bonds surged at least 20 basis points.

In the U.S., credit swaps tied to the nation’s six-biggest banks reached the highest in almost three months. The average cost of the contracts has climbed 9.7 basis points to 68.1 basis points since June 25, the day Puerto Rico’s governor proposed the law allowing public utilities such as the commonwealth’s main power authority to negotiate with bondholders to reduce their debt loads.

Now this is all fairly standard market patter. But based on a reading of the major financial press organs, several elements are striking. One is that most acknowledge complacency about risk, and how widely used measures of risk like the VIX are at unheard-of low levels. That of course is correctly attributed to the tender ministrations of central banks, which have labored mightily to sever the connection between financial asset prices and real economy performance, in the hopes that goosing the former would help the latter. We haven’t seen much evidence of that. There’s also ample discussion of the obvious trigger, concerns about bank risk in Europe.

But what was in surprisingly short supply was the obvious reason why investors should be concerned about risk: that valuations are strained. The continued appreciation of financial assets shows the impact of bad incentives among asset managers. Even though the risk/return tradeoff in many financial markets has looked more and more dubious, institutional investors feel that can’t afford to exit a successful momentum trade early due to the impact on their competitive standing. Trying to eke out the last bit of performance is more important than preserving capital, particularly since investors are measured on a relative basis. Better to get whacked along with everyone else than stand out in a bad way by selling too early.

The second “this ought to be obvious” issue that was sorely absent from the commentary I saw was the failure to acknowledge that austerity is the reason for the weakness of the so-called recover, and low-at-best economic growth means debt burdens remain high, keeping states and banks unhealthy. But the neoliberal orthodoxy is so deeply entrenched you see perilous little questioning of it in our supposedly balanced reporting.

In 2007, it was obvious that things were going to end badly and that virtually all credit instruments were in a bubble. Here, with the Fed acting as if it is committed to an exit from QE and eventual tightening, but widely understood to be unwilling to take too much in the way of adverse market reactions, we are in truly uncharted territory. When investors finally recognize that and sober up a bit, however, remains to be seen.

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35 comments

  1. Ptup

    Not to worry so much, or, at least not as much as ’07-’08. There is too much cash stashed. If there are “crashes” or “corrections” in asset prices, they’ll just bounce back. Look what happened yesterday. “Buying opportunity”. The Chinese bubble should be the world’s concern right now. That’s a doozy. They are well beyond the saturation point of condos, malls, and high speed trains for a while.

    1. monday1929

      Yes, corporations have record amounts of cash. This of course reflects how zero interest rates destroys capital; they see no fruitful means to deploy that cash.
      The fact not so often mentioned is the fact that corporations also have record levels of debt, a lot of it accumulated so they can buy back their own shares, which boosts C-Suite bonuses, which boosts spending,which….. well, you get the idea, a “Virtuous Cycle”- for about .1%.

      1. Ptup

        Yeah, but that debt is cheap. Zuckerberg has a mortgage on his house! I mean, why spend that cash when you can borrow at what will be the cheapest rates for maybe decades. All of that cash will be a huge cushion for those that own it when the stuff hits the fan.

  2. Ignacio

    The Espirito Santo effect demonstrates that the so-called recovery is only an attempt to boost morale.

  3. monday1929

    One can argue austerity Vs printing, but the reason for the weakness is the Trillions of bad debt in Europe that will never be re-paid. As in the US in 2007, the only question is who pays those Trillions, and we know that is no longer a question- the citizens will pay it with shortened life-spans and mean, brutalized lives.
    The European banks are as insolvent as the US banks were, despite the WSJ ” weak but Recovering” meme.
    The US Markets may limit their losses to 20-40%, and even rally on flight capital (including hundreds of billions from high-ranking Chinese looters) as money flees collapsing Europe, but Europe is doomed to 80-90% losses.
    Whatever ones opinion, Yves’ observation about the uncharted nature of the current juncture, and unprecedented Central Bank desperation, combined with valuation peaks and complacency readings near or at historic extremes, should be cause for more than mild concern.

    1. Moneta

      Here in Canada, when friends were about to take on huge debt or mortgages, I sued to probe them… what if you lose your job? They’ll find a new job or sell the house… What if rates go up? They can’t raise the rates because if I’m in a pickle, that means a whole whack of people will be in a pickle… they can’t raise rates or they will generate a recession. And anyway, banks don’t want to own so much real estate…

      When the general population bases it’s financial plan on such rhetoric, you know the day of reckoning WILL come.

      1. cnchal

        they can’t raise rates or they will generate a recession.

        That is reality. The central banks have painted themselves into a corner and for good measure, now waterboard themselves for pleasure.

        When that day of reckoning comes, the current depression will be fondly remembered as great times.

        1. Moneta

          Not sure that’s the case in Canada… BoC can keep rates low but market can have another idea and wreak havoc with credit spreads…

        2. Moneta

          As soon as CMHC limits what it insures, banks change their lending criteria. Low rates for all homeowners are due to CMHC interference. If real estate weakens, maybe government will create some kind of program to keep mortgage rates low but once the market gets whiff that Canada is in trouble, foreigners will drop our dollar like a hot potato… and if CMHC props up a tanking market, markets will penalize Canada even more.

          I am not betting for these low rates to last in Canada…

          1. cnchal

            Higher rates will pop the gigantic Toronto and Vancouver housing bubbles, and other cities will see declining house prices.

            I view CMHC as a subsidy to Canadian banks. They will lend, lend, lend and there is no risk for them. A sure thing, for the banks. For the rest of us, not sure at all.

            If real estate weakens, maybe government will create some kind of program to keep mortgage rates low but once the market gets whiff that Canada is in trouble, foreigners will drop our dollar like a hot potato… and if CMHC props up a tanking market, markets will penalize Canada even more.

            This is not a given. If BoC raises rates, the perceived value of the Canadian $ would climb, enticing foreigners to buy even more, particularly if other central banks keep their rates the same.

            1. Moneta

              Yes and then rates will have climbed! And if our treasury yields climb that means CHT yields will climb too and make CMHC rate protections even more costly.

              When our real estate weakens, I think we will be in for one rude awakening. The global economy is not structured for the average Cdn household to be richer than the American ones one for long stretches.

              1. cnchal

                The global economy is not structured for the average Cdn household to be richer than the American ones one for long stretches.

                Why?

                With a population of 30 million and the resources within Canada, I put Canadians as the luckiest, and wealthiest people on the planet. A bonus is that we don’t need a military to protect it. The US does that for us.

                1. Moneta

                  1. To import added value goods we need to export a lot of low added value resources. How can economies based on resources get ahead over the long term? You’ve got to sell one heck of a lot of resources to stay ahead… never run out and not create too many restoration funds that will price your product out of the market.

                  2. Our resources are badly distributed. Oil in Alberta and it does not want to share…. This means that to work for the people, Canada needs socialism to redistribute but our leaders are slowly cutting the social net and a good percentage of Canadians also want it cut.

                  3. We know that the wealth squeeze is moving up the population curve. The next squeeze is probably about to hit the top 10-20% of the US population…. 10% of US = 30M Americans … that’s the whole population of Canada… I am betting that those top 20% of Americans will eat our lunch.

    2. craazyman

      holy smokestacks — 80-90%? That’s not just “sky-is-falling” melodrama, that’s like a direct hit from planet Niburu. If anybody here knows what Niburu is you get brownie points at the Magonia Café. Hash brownie points.

      80-90% would be a shocker for sure. If it gets that bad then some folks will see big gains on a relative basis.

      When the market falls what else falls? That’s a weird question. The sky doesn’t fall but something falls. What falls? If you think about that with Magonia hash brownies you get even more brownie points. There’s a reality in there that actually does make sense. But math-ing it with a “closed form expression” is not trivial.

      You need new math. Math that integrates probability waves from additive psychological wave form compositions and then derives tipping points that result in jump-cut wave form transformations. If you can understand that, you need more brownies.

  4. Moneta

    I don’t talk much about this stuff with people around me because after a decade of being called a pessimist, I realized that, unfortunately, most people will only understand when they live it or need to understand it. Most of the time, when people agree with us, it’s not because we are great influencers but usually because we are preaching to the converted.

    I also realized that misery loves company… when the people you warned lose, they won’t want to see you because they’ll want to avoid your “I told you so”. They will bond with the losers like them. So you will have been ostracised during the upside and will also be during the downside. And chances are they won`t remember your predictions. They’ll just remember you were a negative person so they won’t want to be with you during their hard times.

    All this to say, that people here in Canada don’t talk about the markets if you don’t talk about it. I am pretty sure they think Canada is special since it averted the US ordeal and have no idea what kind of risks are lurking in the horizon.

    1. Ptup

      Well, I said just after ’08 that the world had changed and we would never see asset highs soon like we just lived through, gingerly telling friends that had lost a big chunk in equities that they were probably screwed, and should have escaped to bonds early like myself. Silly me.

      1. Moneta

        Most will get to live more roller coaster rides… they tend to make me nauseous but many love the excitement it seems. ;-)

      2. Moneta

        Another point…. in my mind, the credit crisis was a clarion calling households to clean up their act.

        However, what I have noticed is that most retirees/near retirees around me have not changed a thing. They are still living and planning for 60K+ income retirements when they should be budgeting for 30-40K.

        The market propping measures have left them feeling comfortable and most have seen NO need to change their lifestyles.

  5. BruceNY

    Countries are all still running budget deficits, albeit at a slightly lower percentage than in years past. Is that what you mean by austerity – the rate of change in deficit-spending has slowed? Could that decrease in the defecit be almost entirely because taxes in those countries have increased (incl. US) to “close the gap”, however mildly that gap has indeed closed? Ie, government spending hasn’t decreased, but tax collections have increased, thus reducing disposal income for both consumption and savings? I am pretty sure Europe especially has seen a lot of one-off types of flat taxes that affect even lower-income brackets, and of course France -which has increased taxes tremendously- appears to be suffering worse than most.

    In China at least, I think the slowdown is due to an unwinding of shadow-banking leverage for commodities and housing. Wouldn’t you agree that’s a good thing? And since so much of the world trades with China, many countries are affected by China’s leverage reduction efforts. Or put another way, the “boom” many countries experienced was created by increased speculation enabled by leverage, it was just “fake demand”.

    A third factor in the slowdown is undoubtedly a combination of “max debt” and “no incremental demand” at the corporate and consumer level. I believe I read somewhere that corporates in the US are at their highest leverage ever, and are primarily using the additional debt to fund stock buy-backs and dividends (eg Apple). They aren’t investing in adding capacity. Meanwhile US consumer age-cohorts that spend -the traditional “driver” of much of the wrold’s economy- remain heavily indebted from a variety of sources (student loans/housing), see that their real income stream isnt keeping up, and/or are anticipating the need to spend (increased healthcare costs, college tuition) and so are “saving more” by different forms of down-sizing (smaller cars, fewer babies, coupon-ing, even smaller homes, etc.).

    A fourth factor is that banks, partly because of new capital rules and regulation, but maybe also because it’s just very costly to implement and they figure credit cards will do, aren’t lending much to the real small-biz economy.

    Perhaps government spending -as opposed to the rate of the increase in government spending being curtailed- has been actually curtailed to some extent somewhere (I don’t know where, but maybe it has), and that has contributed to the overall malaise, but I think there are number of other factors that are contributing in greater proportion to the overall slowdown.

    And I don’t think that increasing government spending is going to do much, other than in the short run. First, because most of that spending is captured by corporations, so it won’t trickle down. Second, because at a certain point in time most people will understand (or experience) at some level that just emitting money will eventually create inflationary effects and so will try to downsize even more to reduce their cost base affected by inflation (see Japan). Maybe just cutting individual taxes/withholding would probably provide a more immediate jump in consumption, and allow some debt to be paid down, but even that would eventually be subject to the second effect. People really, really don’t like inflation – and they will cut in order to avoid it much quicker than expected.

    1. Moneta

      Austerity does lead to deficits. A lot of people think that austerity is cutting fat… but that fat is still GDP. The thing is that austerity usually leads to cutting muscle. Over the last 40 years, take a hard look at how cuts have been implemented…

      My 20 year career, has revolved around restructurings and none were to make the work place more efficient. These were to change a structure so a coupe of people could get rich (new business units to measure compensation) or short-term window dressing.

      In an ideal world, we would get good austerity with good printing. In our current world we get muscle cutting and deficits funding malinvestment.

    2. Ben Johannson

      The problem with reliance on tax cuts (unless the tax in question is highly regressive) is the benefits aren’t well distributed. A tax reduction for a New York banker does little to aid an unemployed African American man in Alabama. The most effective way to provide assistance is to give him a job along with everyone else who wants to work, thereby creating upward pressure on wages from the bottom of the wage structure. Not only will this boost effective demand and greatly reduce social dysfunction, it is non-inflationary as employers are forced to divert income from profits. Spending power is distributed from the top to the bottom while everyone in between also benefits.

      In every way this is a superior approach to welfare and government pump-priming.

  6. flora

    “failure to acknowledge that austerity is the reason….”
    They won’t talk about that anymore than they will talk about the Bush tax cuts costing $6.6 trillion dollars over the last 12 years. $48,000 per tax payer. As David Cay Johnson wrote last week:

    “Had that $6.6 trillion shortfall been realized as income, it would have been enough to pay off all the student loans in United States ($1.26 trillion), all the automobile loans ($892 billion) and all the credit card debt ($827 billion). After paying all that debt off and taking taxes into account, Americans still would have more than $2.4 trillion left in their pockets and bank accounts.”
    http://america.aljazeera.com/opinions/2014/7/economy-bush-taxcutsgrowthjobs.html

  7. Plantman

    How does this end?

    Isn,t that the question everyone is asking?
    Presently, investors are too confident which translates into low volatility. But they are overconfident because the Fed has shown a willingness to backstop the entire market and a desire to push stock prices higher.
    So where,s the glitch in their plan?

    Why would stock prices fall if the Fed is planning to step in a prop up every bank and financial institution that starts to teeter?
    Is there a crisis so big that money printing can,t resolve it?
    Investors appear to think the answer to that question is NO.
    Are they wrong?

    1. Moneta

      Here in Canada, when the crisis hit, debt-to-GDP was at 40%. So deficit spending was very easy to justify. Now I think it’s close to 100%… but that’s not even counting all other debts.

      Anyways… we know that the economy always ends up slowing every 3-7 years… we are starting year 6. This cycle is getting long in the tooth. When the economy slows, this time there are not rates to cut, meaning no refis to prop up the walking dead.

      This means that in the next downturn, governments will need to deficit spend and increase already high debt-to-GDP ratios…. I’m pretty sure Canada won’t WILLINGLY go above 100% before the US does.

      1. Ptup

        “Anyways… we know that the economy always ends up slowing every 3-7 years… we are starting year 6. This cycle is getting long in the tooth.”

        That’s the problem. This is not your parent’s cycle economy. Re: Japan. Twenty plus years, and still at ZIRP. Who knows, that may be the next thirty years or more for the world economy. They were just first. Maybe just a long, slow grind, as the third world joins the labor force in the billions, and, at the same time, the march of the robots destroy any hope of entry into the middle class for most as billions are discarded along the way.

        1. Moneta

          Perhaps. The thing is Japan might have been first but it was a blip… 130M amid a sea of boomers about to hit their peak spending years. Today, we’ve got 1B+ hitting a wall and expectations are that emerging markets will pick up the baton? In my analysis, emerging markets have been built up to feed us not to pick up the baton… the last thing we need is for emerging markets to consume the oil and resources we need to maintain and grow our infra!

          On top of that, Japan was a net exporter of top quality added value products. The cash flow generated could finance their booming retiree population… they could sit on their laurels for a couple of decades and they did just that.

          They forgot about their young ones and now they are in trouble… I think we are headed in the same direction.

      2. Mark Yairi

        Our federal government likes to confuse us with these numbers. If you take total public debt according to the IMF definition to make things comparable, then Canada’s total public debt was 80% of GDP before the crisis and is around 100% now. Sort of like the US. Recall that unlike US states, Canadian provinces can borrow. Quebec has a debt/GDP ratio of 56%, Ontario of 46%.
        Private debt/GDP in Canada is approximately the same as in the US before the crisis. It’s lower in the US now.

        1. Moneta

          You’re right… I did mix apples with oranges… but I maintain that at the next crunch time, Canada will not have the same leeway it had in 2008-2009.

  8. Moneta

    Yesterday I read a few reports on why high yield debt is not in bubble mode. They went on about how it’s not that HY yields are low, it’s that treasury yields are too low. The next argument revolved around how credit spreads are not too low and well cover delinquencies.

    But they never questioned a potential change in the market environment which could change the level of delinquencies…. During the real estate bubble, market pundits were using something like 3-4% delinquency rates on real estate but these ballooned to 12% or so…

    Over the last 40 years, at every downturn, companies could refi at lower rates. But with rates now at zirp… that option is gone. We could very well have 10 golf clubs that currently look well capitalized by historical measures but what if over the next decade or 2 there is only enough room for 4 or them? What happens to that debt? Nobody seems to be considering the event that we are maybe on the cusp of a structural overhaul.

  9. curlydan

    Just looks at the spreads for a lot of government bonds to see how much happiness there is. Spain, Brazil, and other countries where you’d think investors could see major long-term issues can now sell their bonds low interest rates. There was a link here or maybe at Jesse’s Crossroads recently saying that Brazil just issued bonds at 4.4%–they’re doing cartwheels in the office corridors at those rates.

    It’s funny that Corzine’s bet on Spain’s and others’ distressed bonds was right (they did make a comeback)…funny that the lil’ plutocrat couldn’t come up with enough collateral to make good on his bet before he got busted with his clients’ money.

    The desperate search for yield in a ZIRP environment is a little scary to chickens like me

  10. Chauncey Gardiner

    As in the not-so-distant past, there are poster children. Why, just this morning I was looking to see if trading had opened in CYNK, a development stage social media stock of a company headquartered in Belize City, Belize. Looking at their income and balance sheet numbers on Yahoo, they don’t appear to have much in the way of either income or assets. Yet the stock chart for the company on Yahoo! shows their shares traded over $20 share yesterday before closing at $13.90 and a $4 billion market capitalization at the close per Yahoo.

    See: http://finance.yahoo.com/q/pr?s=CYNK+Profile

    What was that tale Yves told a few days ago about “trading sardines”? :-)

    It is difficult to see how this market episode will end well, but in terms of the real economy I am encouraged by the weekly U.S. and Canadian freight rail data from AAR.org. The Baltic Dry Index is another story, though.

    1. craazyman

      I see it’s run by a man named Marlon, which sounds like Marlon Brando. Isn’t that worth a few hundred million in the market cap? If the company has only 1/10th the success achieved by Marlon Brando, it’s going to be a 10-bagger from here.

  11. kevinearick

    when the demographics turn, so does leverage;
    they are still efficiently burning up natural resources, but getting further off course;
    they have no idea what to do;
    they know that increasing rates will pull the clutch, but have no idea where the gear is that they need, and are running out of gears to re-engage.

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