The Everything Bubble Cash-Out Strategy: How to Smartly Exit Code Red Investments Now
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Code Red:
• ‘A condition of heightened alertness or preparedness, especially to guard against imminent danger.
• ‘A warning of or signal indicating imminent danger.’
Dictionary.com
Code Red is a term used by the military, medical professionals, emergency services, and even climate scientists.
When a situation escalates from bad to worse, the public is alerted to the hazards we are likely to face and what we should be doing to prepare for the probable eventuality.
Yet, when it comes to markets, no such alarms are raised by the (so-called) responsible authorities.
To illustrate just how dangerous market conditions have become, I’ve taken the liberty of adding two further standard deviation markers to what is ‘probably the best single measure of where valuations stand at any given moment’…the Buffett Indicator.
Source: Advisor Perspectives
Corporate Equities to GNP is almost four standard deviations away from the mean…that is ridiculous.
The golden rule of maths and markets is…‘mean reversion’.
After the dotcom boom and US housing bubble, the Buffett Indicator followed the golden rule…on both occasions the indicator reverted to the mean.
Why can’t that happen again?
The Everything Bubble Cash-Out Strategy: How to Smartly Exit Code Red Investments Now By Vern Gowdie, Editor
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And, if it did, this is the sort of financial carnage we’d be looking at.
US GNP is approximately US$22 trillion, therefore…
The ‘air pocket’ between current value and the mean amounts to a staggering US$28.6 trillion.
That’s more than one year of US economic activity at risk of being atomised.
Yet, we have no official warning of this probable catastrophe.
One, that should it hit, has the destructive capacity to adversely impact millions of lives.
And not just in the US…
The distortions created by the Fed’s experiment in interest rate control — to pursue its ‘wealth effect’ theory — have become so glaringly obvious.
And this ‘wealth effect’ is not just confined to the stock market this time.
There are Code Reds in pretty much EVERY asset market It’s just in the stock markets where most of the wealth is sitting.
Why aren’t people being warned of this wealth risk?
That’s a rhetorical question.
We know the answer.
When it comes to matters of wealth, it’s every man and woman for themselves.
Crescat Capital recently published the following table on 15 valuation models and where current readings are in relation to historical averages.
The higher the percentile reading, the more dangerous the conditions.
Of the 15 models, 11 are at 100%. The other four are registering 91%, 97%, 97%, and 98%.
This is a market that’s at risk of serious meltdown.
Source: Crescat Capital
Crescat went back through history and found the same near-100% readings were in existence prior to previous market disasters:
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Do you ignore these warnings OR take defensive action?
The Fed’s misguided and short-sighted experiment in interest rate suppression has created a monster…one that’s magnitudes greater than any previous bubble.
When this thing bursts and tens of trillions of dollars are shredded, the switch from speculative fervour to panicked fever will be flicked.
Without the tailwind of investor speculation, the Fed’s grand plan is going to be exposed for the fraud that it is.
As always, the market will again provide the solution to the Fed’s self-inflicted problem.
What follows is what I believe are four key areas you should be most concerned about. In terms of a) the direct exposure you may have and b) the wider implications these Code Reds may have for the whole financial system.
CODE RED 1: Tech stocks Dr Michael Burry was one of the few who identified the last huge Code Red correctly. I won’t repeat his story here, you’ll have read or watched or at least heard about The Big Short. Showing how he famously created the ‘credit default swap’ to bet against the housing market in the run up to the subprime mortgage crisis in 2007.
In 2021, Burry has been at it again. This time his ‘big short’ is tech. And he’s been warning of the ‘mother of all crashes’ with ‘losses the size of countries’.
He’s taken out a huge $534 million short position against another big tech player — Tesla. And he’s spent 2021 loading his hedge fund with ‘anti-tech’ companies. Real asset holdings now make up 60% of his portfolio.
Most recently — he took out a huge short on the most famous tech growth fund in the world, ARKK Innovation.
According to Seeking Alpha:
‘ ARKK invests in high-growth, high momentum stocks with a focus on innovation/disruption. The fund trades for a full 125x the estimated 2022 earnings of its components.’
In short, ARKK has punted heavily on the tech and crypto sector. And, up until earlier this year, the bet paid off…big time.
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The exponential rise of ARKK’s share price peaked in February 2021…since then, it has started to underperform the broader market:
Source: Yahoo! Finance
Michael Burry is someone who is NOT buying what ARKK is selling.
Burry obviously thinks the current share price leak is going to turn into a torrent…which, ironically, will sink the ARK.
What most people don’t realise is that BEFORE the headline of ‘CRASH ON WALL STREET’ becomes mainstream news, the smart money is quietly taking money off the table.
So what’s ARKK selling?
ARKK is essentially a war wagon of tech companies haemorrhaging cash. And on the outer limits of valuation.
As you can see, while the stock market kept roaring, smart investors have been jumping from the ARKK ship all through 2021:
Source: Google Finance
You’d think a mass exodus from the most popular growth tech ETF in the world would have gotten more headlines…right?
Smart money’s bailing because it’s not dumb.
According to a recent investigation by Fortune magazine, in order for ARK to be worth its valuation, its holdings would ‘need to soar out of a $169 million hole and add almost $2.4 billion in profits’.
If that’s not a Code Red, what is?
But what is Burry actually betting against? ARKK has holdings in the big tech monsters like Twitter, Facebook, Netflix, and PayPal.
He’s also betting against the ‘stay-at-home’ techs — whose revenues are plunging now the world is getting out of lockdown: the likes of Zoom, Teledoc, Shopify, and Peloton.
The bulk of the ARK portfolio Burry’s betting against are smaller biotechs. A lot of them have never made any money at all.
Burry’s new big short has had him going head-to-head with another superstar investor, Head of Ark Invest, Cathie Wood.
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She countered his move with a predictably dismissive response. Wood tweeted this when Burry’s short on her went public:
‘ I do not believe that he understands the fundamentals that are creating explosive growth and investment opportunities in the innovation space.’
But that’s not stopping a small number on Wall Street from quietly joining Burry’s Scion Asset Management. To date, five more hedge funds have taken out similar short positions.
Keep in mind Burry’s publicly stated overall position…
He believes the whole shebang — the entire Everything Bubble — is a going down.
He’s called it:
‘ The greatest speculative bubble of all time in all things by two orders of magnitude.’
Dr Michael Burry
Just like 2008, Burry now says the market is ‘dancing on a knife’s edge’.
Look at these monsters:
Source: Standard & Poor
These are the ‘can’t go wrong’ FAANGMs — Facebook, Amazon, Apple, Netflix, Google, and Microsoft.
These six bloated behemoths now account of the 25% of the S&P 500.
The other 494 stocks in the index make up the remaining 75%.
When markets run hot, investors tend to gravitate towards stocks that’ll fast track the growth of their capital. Hence, the term ‘growth’ stocks.
According to Investopedia:
‘ Growth stocks are those companies that are considered to have the potential to outperform the overall market over time because of their future potential.’
Whereas value stocks are considered more stodgy and steady-as- she-goes-type investments.
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The following chart (as of 28 September 2021) tells a similar story to the ones above. It tracks the performance of growth versus value relative to the S&P 500 Index.
Note the similarity in the divergence between the dotcom peak and now:
Source: Yardeni Research
Investors, in greater numbers, gravitate to the hot sector/s holding the promise of high risk/high return.
A pile on towards the peak is human nature doing what human nature does…thinking about how much money is going to be made releases all those feel-good chemicals.
This next chart is one of the best I’ve seen on just how far above trend the value of the tech-dominated US market has been stretched.
In my imagination, what I see are two opposing forces.
The one above the 0% line is positive and the one below is negative.
They are in a constant tug of war.
Source: RIA
Prima facie, it looks like the positive side (with much higher percentages) wins easily on a points decision.
However, the maths tells a different story.
When market forces go deep into negative territory, they can inflict serious losses.
Since the late 1990s, the negative side has been hobbled by the Fed’s progressive intervention in price discovery.
The ‘tech wreck’ and GFC temporarily released the positive side’s grip on the valuation rope.
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Then the Fed intervenes. Adding more steroidal stimulus muscle to aid the positive team’s efforts.
The sheer weight of the Fed’s support has stretched valuations beyond any historical precedent.
To summarise: Tech is the spearhead of the ‘Everything Bubble’ We have a combination of extremes on confidence, margin debt, IPOs coming to market, growth versus value performance and valuations.
This market is best characterised as one of very high risk offering very low to negative returns.
Current extremes could be taken to even higher levels.
If it does, that’ll only make things worse.
All indicators point to the end of this phase in the sentiment cycle being nigh…and if it is, any remorse about missing out will be quickly forgotten.
CODE RED 2: Tether The concept of decentralisation is one we should all wholeheartedly endorse…along with world peace and an honest political class.
The problem is these admirable ideals only exist in a world of make-believe.
In the real world, greed, power, and self-interest mean we have to settle for outcomes that are far less than ideal.
The Everything Bubble, I believe, has lulled people into a false sense of security when it comes to cryptos.
And the Achilles’ heel, as I see it, is Tether [USDT].
I just don’t get how people can remain blind to this massive fraud that’s hiding in plain sight.
This is the amount of Tether that’s been (magically) manufactured into existence since March 2020:
Source: CoinMarketCap
This is the Bitcoin [BTC] price since March 2020.
Take note of what’s happened to bitcoin since Tether stopped creating more stablecoins in late May 2021:
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Source: CoinMarketCap
Is this almost identical pattern between the two just coincidence? Or could Tether be the real power behind the throne of the king of crypto?
We know Tether lied about its financial backing. We know Tether window dresses its financials to look good at a given moment in time. We know the crypto faithful couldn’t give a flying fig about any of this.
But it’s important you understand the correlation between Tether’s coin creation and bitcoin’s price, and just how brittle the foundation really is upon which Tether’s US$60 billion edifice sits.
Tether: A disaster in the making On 17 April 2021, Gary Gensler was sworn in as the new chair of the US Securities and Exchange Commission (SEC).
You have to wonder what sins Gary committed in a past life to be appointed to this role, at this moment in history.
With rampant speculation (and the accompanying fraud) in meme stocks, SPACs, cryptos, and corporate debt, Gary and his team of regulatory sleuths must surely be burning the midnight oil…and this is before the bubble bursts.
The US Senate has taken particular interest in bringing order to the crypto wild west. As reported by CNBC on 11 August 2021 (emphasis added):
‘ [US Senator Elizabeth] Warren, a member of the Senate Banking Committee and chair of its Subcommittee on Economic Policy, has also called on the Financial Stability Oversight Council to use its authority to take the lead to develop a comprehensive and coordinated approach to regulating cryptocurrencies.’
Senator Warren’s call to arms was, in part, prompted by an address the new SEC Chair gave to the Aspen Security Forum on 3 August 2021.
In his address, Gary Gensler shared some details of his background…
‘Before starting at the SEC, I had the honor of researching, writing, and teaching about the intersection of finance and technology at the Massachusetts Institute of Technology. This included courses on crypto finance, blockchain technology, and money.’
When it comes to cryptos, it appears Gensler comes to his new role with a good deal of knowledge and experience.
And to show he had an open mind on the matter, he went on to say…
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‘ In that work [done at MIT], I came to believe that, though there was a lot of hype masquerading as reality in the crypto field, Nakamoto’s innovation is real. Further, it has been and could continue to be a catalyst for change in the fields of finance and money.
‘At its core, Nakamoto was trying to create a private form of money with no central intermediary, such as a central bank or commercial banks.’
He then outlined the fundamental differences in the properties of fiat money and cryptos:
‘…public fiat monies fulfill the three functions of money: a store of value, unit of account, and medium of exchange.
‘No single crypto asset, though, broadly fulfills all the functions of money.’
He also omitted (for obvious reasons) that it’s highly unlikely any developed or developing world government or central bank will relinquish their monopoly on those three functions.
The one and only function of crypto at this point is (emphasis added):
‘ Primarily, crypto assets provide digital, scarce vehicles for speculative investment. Thus, in that sense, one can say they are highly speculative stores of value.’
And it’s the highly speculative nature of cryptos that’s put them on the SEC radar. Gensler didn’t mince his words (emphasis added):
‘ Right now, we just don’t have enough investor protection in crypto. Frankly, at this time, it’s more like the Wild West.
‘ This asset class is rife with fraud, scams, and abuse in certain applications. There’s a great deal of hype and spin about how crypto assets work. In many cases, investors aren’t able to get rigorous, balanced, and complete information.’
That last paragraph pretty much sums up my views about this so- called ‘investment’ class.
Hype. Fraud. Scam. Misinformation. I read, watch, and listen to lots of spin and techno babble about this new world of DeFi, but until there’s ‘a store of value, unit of account, medium of exchange and regulation’, this is all pie-in-the- sky stuff.
At present, cryptos are a punter’s playground for con artists to go their hardest…without fear of reprisal.
If Gensler has anything to say in the matter, it’s unlikely to remain that way…
‘ In my view, the legislative priority should center on crypto trading, lending, and DeFi platforms. Regulators would benefit from additional plenary authority to write rules for and attach guardrails to crypto trading and lending.
‘ Right now, large parts of the field of crypto are sitting astride of — not operating within — regulatory frameworks that protect investors and consumers, guard against illicit activity, ensure for financial stability, and yes, protect national security.
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‘ Standing astride isn’t a sustainable place to be. For those who want to encourage innovations in crypto, I’d like to note that financial innovations throughout history don’t long thrive outside of our public policy frameworks.’
He also touched on the concerns we raise in this Code Red topic…
‘ How do you trade crypto-to-crypto? Usually, somebody uses stablecoins.
‘ In July, nearly three-quarters of trading on all crypto trading platforms occurred between a stablecoin and some other token.’
Which brings us to the highly coincidental pattern between Tether’s minting of stablecoin tokens and the bitcoin price, and those two charts I showed you earlier:
Source: CoinMarketCap
Source: CoinMarketCap
Which begs the question…
Is Tether pushing or pulling bitcoin’s price? ‘Is Bitcoin Really Untethered?’ is an article written by John M Griffin and Amin Shams, published 15 June 2020.
If you want detailed information on the operation of Tether, this is an excellent read.
The authors — just like Gary Gensler — acknowledge both the ideal and appeal of cryptos…
‘ To many, Bitcoin and other cryptocurrencies offer the promise of an anonymous, decentralized financial system free from banks and government intervention.
‘ The conception of Bitcoin corresponds to the 2008 to 2009 financial crisis, a time of growing disdain for government intervention and distrust of major banks. The promise of a decentralized ledger with independently verifiable transactions has enormous appeal, especially in an age when centralized clearing is subject to concerns about both external hacking and internal manipulation.’
The promise of ‘an anonymous, decentralized financial system free from banks and government intervention’ is such a great sales pitch.
Why wouldn’t you buy it?
The problem is the product is being promoted by some pretty dodgy characters for their own means.
As the authors of the research paper noted (emphasis added):
‘ Ironically, new large entities have gained centralized control over the vast majority of operations in the cryptocurrency world, such as centralized exchanges that handle the majority of transactions and stable coin issuers that can control the supply of money like a central bank.
‘ These centralized entities operate largely outside the purview of financial regulators and offer varying levels of limited transparency. Additionally, operating based on digital stable coins rather than fiat currency further relaxes the need for these entities to establish a legitimate fiat banking relationship. Trading on unregulated exchanges, specifically on cross-digital-currency exchanges, could leave cryptocurrencies vulnerable to gaming and manipulation.’
The naivety of the crypto faithful makes me chuckle.
The very thing they loathe — centralised control — is exactly how the cryptocurrency world operates with one major exception… ‘these centralized entities operate largely outside the purview of financial regulators and offer varying levels of limited transparency.’
While the crypto faithful might be pure of heart and champion a noble cause, the ‘whales’ running the show are not quite so upstanding in character.
That was a nice way of saying they are conmen, frauds, criminals, and sleazebags. People I wouldn’t trust with my spare change jar.
It’s not like we haven’t seen this movie before with those ‘holier- than-thou’ evangelical ministries.
The charismatic preacher hides their real intent — which is to rip- off the congregation and live a life of debauchery — behind a story they know the flock will swallow hook, line, and sinker.
Griffin and Shams’ research paper looks at the role Tether played in the 2017 crypto boom.
To quote (emphasis added):
‘ In this study, we examine the role of the largest stable coin, Tether, on Bitcoin and other cryptocurrency prices. Tether, which accounts for more Bitcoin transaction volume than the U.S. dollar (USD), is purportedly backed by USD reserves and allows for dollar-like transactions without a banking connection, which many cryptoexchanges have difficulty obtaining or keeping.’
The researchers were seeking to identify whether Tether is being pulled (driven by demand for the coins) or pushed (driven by the supply of coins).
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This extract explains the difference:
‘ Under the pulled hypothesis, Tether is driven by legitimate demand from investors who use Tether as a medium of exchange to enter their fiat capital into the cryptospace because it is digital currency with the stability of the dollar “peg”. In this case, the price impact of Tether reflects natural market demand.
‘ Alternatively, under the “pushed” hypothesis, Bitfinex prints Tether regardless of the demand from cash investors, and additional supply of Tether can create inflation in the price of Bitcoin that is not due to a genuine capital flow.’
If Tether is pulled (demand driven), then investors eager to buy bitcoin would be exchanging their US dollars for stablecoins. In that case, Tether would have full USD backing.
On the other hand, if it’s pushed, then Tether is creating coins out of thin air — no different to the central bankers we loathe and despise — to pump up the price of bitcoin.
With regards to the pushed hypothesis, the authors suggest:
‘ In this setting, Tether creators have several potential motives.
‘ First, if the Tether creators, like most early cryptocurrency adopters and exchanges, have large holdings of Bitcoin, they generally profit from the inflation of the cryptocurrency prices.
‘ Second, coordinated supply of Tether creates an opportunity to manipulate cryptocurrencies—when prices are falling, the Tether creators can convert their large Tether supply into Bitcoin in a way that pushes Bitcoin up and then sell some Bitcoin back into dollars in a venue with less price impact to replenish Tether reserves.
‘ Finally, if cryptocurrency prices crash, the founders essentially have a put option to default on redeeming Tether, or to potentially experience a “hack” or insufficient reserves whereby Tether-related dollars disappear.’
When we’re talking about the opportunity to run a scheme where the ‘house’ can rake off billions of dollars from creating an artificial market, what do you think the outcome of the research might be…is Tether pulling or pushing?
Here’s what the researchers concluded (emphasis added):
‘ Our results are generally consistent with Tether being printed unbacked and pushed out onto the market, which can have an inflationary effect on asset prices.
‘ While other tests do not speak to capital backing, the EOM [end of month banking] patterns are inconsistent with the “pulled” hypothesis since they indicate a lack of dollar reserves.’
From the research, we know stablecoins are a major link in the crypto chain…
‘ Tether, which accounts for more Bitcoin transaction volume than the U.S. dollar (USD).’
And from Gary Gensler:
‘ In July [2021], nearly three-quarters of trading on all crypto trading platforms occurred between a stablecoin and some other token.’
Knowing the importance stablecoins play in crypto transactions, it makes sense to me to understand how strong the link really is.
On the evidence presented so far, it appears when the Tether ‘push’ (pardon the pun) comes to shove, that link is at risk of snapping like a dry twig.
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Tether is lacking in backing Since the Griffin and Shams research paper — it seems kind of apt a fellow named ‘Shams’ researched the crypto sham — was published in June 2020, Tether released an end of quarter reserves breakdown report as of 31 March 2021.
On 27 May 2021, The Gowdie Advisory looked at this breakdown. This is an extract:
‘ Here’s the breakdown…
Source: FT
‘ The blue pie chart shows that 75.85% of Tether’s reserves are in “Cash & Cash Equivalents”.
‘ I can tell you from my time in this business, whenever I see “Cash Equivalents” a shiver goes up my spine.
‘ The smaller pie chart provides a breakdown of those “Cash & Cash equivalents”.
‘ Actual cash — cash and Treasury Bills — is 6.81% of 75.85%… which means Tether has only a 5.16% cash backing.
‘ As reported in The Financial Times on 14 May 2021 (emphasis added):
“ The reserve analysis also shows that Tether’s assets are made up mainly of various forms of long and short-term corporate debt.
“ We do not know if this debt is secured or unsecured, nor what the assets backing it are (if there are any). And we have no idea who the borrowers are, except that long-term loans are not made to Tether’s ‘affiliates’.
“ The reserves are thus exposed to unknown levels of credit and liquidity risk. I would have expected to see far higher levels of genuine cash equivalents such as T-bills and insured deposit accounts in a reserve report for a financial institution that claims to guarantee redemption at par.
“ There is a very real possibility that in the event of a run on USDT, Tether would be unable to realise sufficient real USD to meet redemption requests. The 1:1 peg to the USD is therefore not remotely credible.”
‘ When push comes to shove, and markets get stressed…only cash is cash. All the other “equivalents” prove not to be all that equal to cash.
‘ I’ve seen this before with unlisted property trusts and mortgage funds. Everything is good while people believe the asset backing is there to provide liquidity.’
The story so far…
• By its own admission, Tether is NOT fully (or even remotely) backed by a USD reserve.
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• There’s fairly conclusive proof Tether manipulates the price of bitcoin for its own benefit.
• The authorities are (finally) starting to get serious about regulating the crypto casino…unfortunately, I think they are going to be too late. A crunch on Wall Street is likely to come before they can act.
When that happens and investors rush to the exit and seek the safety of cash (USD), the Tethers of this world — like the fleeing Afghanistan president — will press the button on their exit plan:
‘ …if cryptocurrency prices crash, the founders essentially have a put option to default on redeeming Tether, or to potentially experience a “hack” or insufficient reserves whereby Tether- related dollars disappear.’
When the epitaph is written on this latest and greatest bubble, the researchers can save themselves a whole lot of time and simply substitute the terminology of — mortgage-related securities, CDOs, and CDS — with crypto, Tether, and bitcoin.
The conditions we have today are almost identical to those of 2007…with one major exception.
This bubble is SO much bigger.
Whenever I hear ‘the institutions are getting involved in crypto’, it brings a wry smile to my face.
From my experience, institutional involvement in a hot product is driven by a desire to ‘make some serious hay while the sun shines’, rather than an endorsement of the long-term value of the investment.
When this market reaches the end of its tether, I’m thinking it’ll be the end of Tether.
CODE RED 3: Bonds The bond market is where government and corporate borrowers go to raise money. The credit quality of the issuer (usually) determines the interest rate paid for the duration of the bond.
A triple-A rated borrower can borrow at a far lower rate than say, a triple-C rated (junk) borrower.
A higher paying junk debt offering, can, at certain times in the market cycle, look very appealing.
Why accept a measly 1.5% from a 10-year US government bond, when you can get 4%, 5%, or even 8% from a junk bond?
Yes, I know you know that ‘you get nothing for nothing’ and that this extra few percent must come with a catch.
However, when investors are confident nothing bad can happen (or, if it does, the Fed will save the day), then you’d be silly not to take the higher return.
Take this headline from the 19 September 2021 edition of The Wall Street Journal:
Source: WSJ
Investors are obviously seeing nothing but blue skies ahead. However, history does tend to indicate there is a ‘calm before the storm’.
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The Federal Reserve Economic Data (FRED) produces a chart tracking the differential (spread) between high-yield (riskier) bonds and US government (risk-free) Treasury bonds.
In times when there’s no perceived risk in reaching for the higher returns, the differential between the risk-free and riskier bonds, shrinks…into the 2.5–3% range.
Then something ‘unexpected’ happens.
Suddenly, investors realise there’s a potential price to pay for the higher return. And that price is the possibility of default.
The riskier borrower might declare bankruptcy.
The FRED chart — dating back to 1997 — shows what happens to the spread when concerns over future interest payments AND return of capital become heightened:
Source: FRED
Only a matter of months before the GFC hit, investors in high-yield debt were happy receiving a spread of just 2.5%.
At the peak of the Global Financial Crisis, junk bond investors demanded a reward that would adequately compensate them for the risk…the spread widened to 20%.
Over the past decade, there’ve been other events that have ‘rattled the cage’ of investors.
Most recently, it was the economic uncertainty created by the initial outbreak of COVID-19.
Fearing an economic slowdown would send overindebted corporate borrowers to the wall, investors reacted swiftly…the spread widened to more than 8%.
With those racing pulses now calmed, the differential between risk-free and riskier bonds is — ominously — back around the level it was in late 2007.
The difference between now and then?
US corporate debt has risen by almost US$5 trillion:
Source: FRED
For some perspective on US Corporate debt growth, this is from Forbes in April 2021 (emphasis added):
‘ In 1980, the level of US corporate bonds outstanding was $468 billion, about 16% equivalent of U.S. Gross Domestic Product. Forty years later, the amount of corporate bonds outstanding has grown by over 2,000% to $10.6 trillion; this is 50% of equivalent of GDP. This level of corporate bond debt is the highest in the history of U.S. companies. The amount of corporate bonds is rapidly approaching the level of mortgage backed securities. The total level of corporate debt is
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actually much higher, because the aforementioned numbers only include fixed income debt and do not include loans and different lines of credit.
‘ Of total corporate debt issuance…today, below investment grades are 18% of the total.’
18% of the official corporate figure puts junk bond debt at approximately US$2 trillion.
For reference, in 2007, subprime lending was around US$350 billion…about one-sixth of the current junk bond debt.
When markets get nervous about a borrower’s capacity to repay, existing bondholders can suffer significant losses.
As evidenced by the plight of indebted Chinese property developer, Evergrande.
Evergrande has borrowed in excess of US$300 billion.
For example purposes, part of the company’s debt load is this bond offering.
Issue date: 28 Jun 2017
Maturity date: 28 Jun 2025
Size of debt offering: US$4.68 billion
Interest rate: 8.75%
Source: Bondsupermart
In a nutshell, Evergrande (a junk-rated corporate entity) offered to pay 8.75% per annum for eight years on US$4.68 billion.
The price of the bond had been trading above and slightly below the US$100 level for almost four years:
Source: Bondsupermart
After receiving two years of interest, an original investor could have sold out in (say) mid-2019 for US$100.
The investor who bought the bond, received the rights to the remaining six years of interest payments at 8.75% per annum.
All was going well until mid-2021.
Then, when the drumbeat on Evergrande’s solvency grew louder, investors were only prepared to pay US$60 for the rights to the remaining four years of interest payments.
IF Evergrande avoids bankruptcy and IF Evergrande can meet its (principal and interest) debt obligations, the investors buying at US$60 are going to clean up.
They’ll receive US$8.75 (8.75% on original US$100) per annum… which equates to 14.6% on US$60.
Plus, on maturity, they’ll be paid the original bond value of US$100…a capital gain of 67%.
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However, in the event Evergrande can’t be salvaged, then their US$60 bond will be worthless.
Obviously, buyers at US$60 are punting on Evergrande being rescued sometime between now and when the bond matures in June 2025.
Maybe. Maybe not.
As someone once famously said, ‘There’s never just one cockroach.’
There are other Evergrandes in China’s corporate debt pile, Europe’s corporate debt pile, and the US corporate debt pile.
When the ‘Everything Bubble’ does meet its pin, corporate debt defaults will start cascading through the bond market.
Highly leveraged junk bonds will be the first, but certainly not the last, to go.
As we’ve witnessed recently with Evergrande and also during other bouts of global uncertainty, high-yield debt can be rerated very quickly.
Interest rates soar because new investors are no longer prepared to pay 100 cents in the dollar for debts issued by companies that may or may not survive a prolonged and severe economic downturn.
This is the scenario I believe is soon to become our reality.
Legendary bubble-spotter Jeremy Grantham recently issued this warning (emphasis added):
‘ Right now, signs of a bubble are everywhere. Various measures of debt and margins are at peaks, trading volume is signalling bullish sentiment and volumes on call option volume and over-the-counter penny stocks are at records.
‘ “The last 12 months have been a classic finale to an 11- year bull market,” Grantham said. “Checking all the necessary boxes of a speculative peak, the US market was entitled historically to start unravelling any time after January this year.”
‘ It’s particularly dangerous now because the bond, stock and real estate markets are all inflated together, Grantham added, noting that even commodity prices are surging.
‘ “That trifecta-and-a-half has never happened before anywhere — the closest before was Japan in 1989,” he said. “The consequences for the economy were dire and neither land nor stocks have yet returned to their 1989 peaks!”’
When the greatest bubble in financial history finally bursts, the bond market is going to be disaster zone.
But just like it was in late 2007, no one is yet pricing in this outcome.
CODE RED 4: China At the time of writing this report, the guessing game is still on.
Is China’s Evergrande the next Lehman Brothers?
Will the debt-laden property developer be thrown a lifeline at the 11th hour? If it is, what signal does that send about greed and moral hazard?
Get your enterprise into the ‘too-big-to-fail’ league and the State will be obliged to save you.
Or are the authorities going to stand back and allow it to sink? If they do, will the fallout be one of contagion or containment?
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There are lots of questions being asked and the newswires are full of opinions on what Xi Jinping may or may not do. Will this modern-day emperor give the thumbs up or down?
Memories of what happened in 2008 has caused Wall Street to suffer a few panic attacks lately.
Is this that time in the life cycle of a bubble where Jeremy Grantham (as mentioned in the September 2021 issue of The Gowdie Letter) defined as…‘the air starts to leak out slowly because tomorrow is a little less optimistic than yesterday. And gradually, people begin to pull back.’?
Quite possibly. There does appear to be a topping process going on. Money is being taken off the table.
Evergrande could be the headline-grabbing event which brings on full-blown bouts of hyperventilating panic. We’ll just have to wait and see.
Sooner or later, this bubble is destined to burst. Of that I’m certain. My concern is what happens after the collapse.
And the China Code Red is of extreme importance to Australia’s economy…and to your own investment portfolio…
The secret to China’s economic success Evergrande, like Lehman Brothers, is a by-product of a grander plan…an unhealthy obsession with debt-fuelled growth.
After 2008/09, China’s willingness to borrow excessively almost single-handedly saved the global economy.
In 2008, China’s official total debt was 150% of GDP.
Today, it’s knocking on 300%...on par with the US and Euro area:
Source: CNBC
As a percentage to GDP, China has doubled its debt load.
However, since 2008, China’s debt — in USD terms — has increased almost US$40 trillion:
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And these are the numbers from the official data.
How much more debt that’s not on the books is unknown.
According to CNBC:
‘ …the composition of China’s debt is unlike the U.S. and Japan.
‘ The corporate sector in China accounted for a large proportion of total debt at more than 160% of GDP, according to BIS data.’
At 160% of GDP, Corporate China is in the tin for a whopping US$24 trillion. For comparison purposes, total US corporate debt is just over US$11 trillion.
We know Corporate America — with half of China’s debt load — has not invested all of this debt wisely. Share buybacks. Propping up dividends. Borrowing from Peter to pay Paul.
Which makes you wonder how much malinvestment has gone on with China’s corporate debt.
Evergrande debt totals US$300 billion.
What’s hiding in the remaining $23.7 trillion debt pile?
And then there’s the opaque local government debt market.
As reported by Forbes on 30 September 2021 (emphasis added):
‘ The real worry concerning the China Evergrande default drama is the inevitable where-there’s-smoke-there’s-fire paranoia that accompanies debt stumbles.
‘ The most worrisome such blaze, say analysts at Goldman Sachs, is surging local government debt levels that President Xi Jinping’s men have done their best to hide. The
default troubles at the globe’s most indebted property development seem like small embers compared to the $8.2 trillion worth of local government financing vehicles outstanding.
‘ And that’s just the LGFVs we know of. The data that Goldman’s Maggie Wei highlights is as of the end of 2020. Clearly, the tally is higher now—perhaps markedly. Ten months ago, these shadowy investment schemes had reached 53 trillion yuan, up from 16 trillion yuan, or $2.47 trillion, in 2013. They now amount to roughly 52% of China’s gross domestic product, topping the official amount of outstanding government debt.’
Local government and corporate borrowing binges are the secret to China’s so-called miracle economy.
With a slower global economy pivoting from globalisation to nationalisation, servicing these debt loads has become a lot tougher in recent times.
Which means access to new lines of credit also becomes difficult.
Back in July 2021, Reuters reported (emphasis added):
‘ China is stepping up restrictions on financing to local government financing vehicles (LGFVs) to mitigate risks from hidden debt, the official Securities Times reported on Monday.
‘ In future, banks and insurers will refrain from providing fresh liquidity to those platforms that enjoy implicit guarantees from local governments, and will prevent hidden debts from increasing, the report said.
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‘ Some projects backed by local governments have already been halted after failing to obtain bank loans due to tighter scrutiny, it said.’
Reining in corporate and local government debt — which combined, accounts for two-thirds of China’s official debt load — will put the brakes on China’s economic growth.
The changing narrative Knowing this background helps explain why Xi has changed the narrative.
As reported by The Wall Street Journal on 18 August 2021:
Source: WSJ
To quote from the article (emphasis added):
‘ China gave priority to economic growth for most of the past 40 years. Now, Xi Jinping is signaling plans to more assertively promote social equality, as he tries to solidify popular support for continued Communist Party rule.
‘ The push is captured by a catchphrase, “common prosperity,” now appearing everywhere in China, including in public speeches, state-owned media and schools—and in comments from newly chastened business tycoons like Jack Ma.’
Shifting national focus to ‘common prosperity’ is recognition that the debt-funded economic growth model cannot keep pumping out the above-average GDP numbers.
The people need to be conditioned to a different normal.
Xi’s rhetoric is being backed by public action.
Xi has shown Jack Ma (Alibaba’s billionaire founder) and others where the real power lies.
China’s regulatory crackdown — on the tech sector, private education firms, and property developers — has put the skids under the share prices of some of China’s largest corporations. Investors are second-guessing which sectors and/or companies are next.
As reported by the BBC on 12 August 2021 (emphasis added):
‘ The Chinese government has unveiled a five-year plan outlining tighter regulation of much of its economy.
‘ It says new rules will be introduced covering areas including national security, technology and monopolies in the world’s second largest economy.
‘ The plan comes soon after Beijing started targeting the technology and education industries.
‘ The plan also said the Chinese government aims to tackle monopolies and “foreign-related rule of law”.
‘ Regulations relating to China’s digital economy, including “internet finance, artificial intelligence, big data, cloud computing etc,” will also be reviewed.
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‘ The announcement raised fresh concerns that Beijing’s crackdown on technology and private education companies is set to continue and expand in years to come.
‘ Shares in many Chinese companies listed in the US, Hong Kong and mainland China have fallen sharply this year as investors’ concerns grow over the crackdown.
‘ Beijing has already launched anti-monopoly investigations into some of the country’s biggest technology firms and taken action against a wide range of other businesses.
‘ In April, technology giant Alibaba accepted a record $2.8bn (£2bn) fine after an investigation found that it had abused its dominant market position for years.
‘ Last month, Tencent was told to end exclusive music licensing deals with record labels around the world.’
Coming down hard on corrupt officials, profiteers, and the ultra- rich helps create the optics of closing the income inequality gap. More for the poor and less for the rich.
In another nod to slowing economic output, Xi has declared China’s commitment to address its carbon emissions.
According to Reuters (emphasis added)
‘ China’s President Xi Jinping on Saturday targeted a steeper cut in rates of carbon emissions relative to economic activity by 2030 and set new goals for growth in renewable energy and forest stock, as the country looks to reach the peak of its emissions before the end of the decade.
‘ “Today, I wish to announce some further commitments for 2030,” told Xi a one-day virtual U.N. summit on climate change via video before announcing the targets.
‘ “China always honours its commitments.”
‘ “China, the world’s biggest greenhouse gas emitter, will cut its carbon dioxide emissions per unit of gross domestic product, or carbon intensity, by more than 65% from 2005 levels by 2030”, said Xi.’
The China of tomorrow is shaping up to be very different to the one of yesterday.
The insolvency legacies of the debt-funded excesses need to be addressed…not papered over and/or added to.
Therefore, on all the evidence to date, it would appear China is unlikely to save the world when the next debt crisis hits.
Perhaps, in cracking down on Chinese corporates and wiping out billions of dollars of shareholder value, Xi is playing the long game…taking pre-emptive action to cushion the Shanghai Index from the worst of a rout on Wall Street.
China’s changing demographics The other notable change in China is its demographic profile.
The effects of the one-child policy are evident in the following chart:
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Source: Gavekal Research
The debt-fuelled economic growth model works well when you a) come off a low debt base and b) when you have a growing workforce.
As of 2020, China’s working age population went into decline.
More people competing for employment helped keep employment costs low. China’s cheaper labour costs exported deflation/low inflation around the world.
Therefore, less people in China’s workforce (forcing up employment costs) combined with less globalisation and more nationalisation (domestic wage pressures), has an inflationary feel about it.
My thinking is a fall of some significance on Wall Street is going to be a deflationary force.
Absent China’s efforts to boost Western economies, the Fed, ECB,
BoJ, Bank of England, RBA, et al, will go into stimulus overdrive.
The likely consequence is going to be inflation…but that could take a little while to reveal itself.
The way I see it, we’ll have a window of opportunity to transition from cash to (hopefully, discounted) harder assets with higher yields and/or inflation protecting properties.
Making that transition is easier said than done.
While Evergrande is capturing headlines, it really is only part of a much bigger story. China is transforming itself.
Counting on the Middle Kingdom to once again save our overpriced housing market and overly indebted household sector is, in my opinion, a serious error of judgement.
IN SUMMARY: Any of these Code Reds could be a ‘pin’…or something else entirely… Having been in this business for 35 years, I’ve been through several highs and lows.
The 1987 melt-up and then meltdown.
1990/91 recession…the one ‘we had to have’.
The dotcom boom and bust.
US housing bubble.
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During those previous positive and negative ‘bubbles’, you wondered how and when they would end.
At the time, the 1990/91 recession seemed to be never ending. There were queues outside some of the smaller banks. New clients wanting to invest were as scarce as a hen’s teeth. I recall Melbourne property prices were languishing in the doldrums… would the Melbourne real estate market ever recover? Laughable now, but it was no laughing matter back then.
Good times do not last forever, nor do the bad times.
At present, the ‘Everything Bubble’ has captured the hearts and minds of investors.
Thanks to the Fed’s Put, there is an entrenched belief this bubble is a permanent, not temporary, fixture.
To those who think the bull will continue in perpetuity, Ray Dalio, founder of Bridgewater Associates, offers this sage advice:
‘ The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.’
When you boil it down to the basics, markets are nothing more than a representation of human nature.
Man, by and large, lacks the capacity to think in cyclical terms. We tend to look at life in a lineal fashion.
We believe the future is going to be a clone of our recent past.
It might be.
The 1930s were an entirely different decade to the 1920s.
The inflationary 1970s were not repeated in the 1980s.
Conditions are continually changing.
Demographic shifts. Birth rates rising or declining. Debt loads being added to. A greater or lesser appetite for risk taking. Price/ Earnings ratios expand and contract. Interest rates up or down. Geopolitical tensions and shifting alliances.
There are so many moving parts that can alter the dynamics between one decade and another.
In my opinion, we’re on the cusp of a seismic shift away from the ever-rising asset price post-GFC decade to one where extremely overvalued markets are going to be placed under enormous stress from the economic pressures that come with an ageing population, the greatest debt load in history and a shift from globalisation to nationalisation.
Where the majority see Code Green, we see signals warning of imminent danger…this is Code Red.
Regards,
Vern Gowdie, Editor, The Gowdie Letter
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