|By Matein Khalid| Every global recession since the OPEC oil shocks of 1973-74 was triggered by a contraction in the $17 trillion US economic colossus. The failure of Lehman Brothers, the meltdown in US subprime mortgages, the impotence of the implicit “Fed/Uncle Sam” put, the ice age in the commercial paper and interbank money markets all tipped the US economy into recession in late 2008 and triggered a global economic slump and financial market bloodbath. The impact on the Middle East was catastrophic. Brent crude fell from $148 in July 2008 to less than $40 six months later. Dubai’s Nakheel declared a standstill agreement with its creditors and precipitated stress in the corporate credit market. There was a depositor run on a major Kuwaiti bank. Gulf property and share prices plunged 50 – 70% in 2009-11.
Yet as I scan the world of late summer 2015, I am convinced the next global recession will originate from the $10.4 trillion Chinese economy, whose growth rate has slumped to its slowest pace since 1990. China’s trillion dollar shadow banking system, Marxist-Leninist wealth management Ponzi schemes and Beijing/local government borrowing have built up the biggest debt load in the history of humankind, now a staggering 250% of GDP. The $4 trillion bloodbath in the Chinese stock market this summer has not been amplified by draconian state intervention that included banning sales by strategic shareholders, stock manipulation, price rigging and trading suspensions of listed companies in Shanghai/Shenzhen. Unfortunately, this “Beijing put” will not prevent a Chinese economic bust and history’s first “Made in China” global recession.
President Xi Jinping has consolidated more political power than any Chinese leader since the death of Deng Xiao Ping. Yet his frequent purges (not even Politburo apparatchiks, Party princelings or Cabinet Ministers are immune), economic restructuring and anti-corruption campaign has had a chilling impact on consumer spending/capex at a time when the People’s Republic’s most savage leveraged stock market bubble has just blown up. Think October 1929 in New York, December 1989 in Tokyo. Not even monetary largesse from the PBOC will prevent a growth decline in China and a “Chinese lost decade” that will transform the global economy, asset prices, power politics and financial markets.
China had periodic boom bust cycles/cash crunches in the 1980’s and 1990’s, the reason the Big Four banks were recapitalized by the Communist Party thrice in a decade under Premiers Zhu Rongji and Wen Jiabao. Yet China’s domestic economic convulsions had minimal global impact since China’s economy had not yet joined the WTO, or become $10 trillion monster that is the largest export destination for 40 countries worldwide, the world’s largest importer of copper, coal and steel. In 2014, China contributed 38% to global growth. As the vicious bear market in the crude oil, Dr. Copper and iron ore ($190 a metric ton two years ago, $48 now), the Middle Kingdom is going bust. History will rank the Chinese stock market bubble in 2014-15 in the same league as Kuwait’s Souk Al Manakh crash, Dutch tulip mania, the Nikkei Dow bubble, dotcom craze in late 1990’s +Silicon Valley or the Jazz Age financial madness on Wall Street. Only the Chinese bust will trigger a global recession.
This is the deflation SOS flashed by West Texas crude, Dr. Copper, Brazil, Taiwan, South Korean industrial production/exports and the Australian dollar. Readers of this column know I have been consistently negative on emerging market commodity exporters since 2012 while the poor souls who believed in them lost vast fortunes as punishment for their collective macro idiocy.
An asset class where the Russian rouble, Columbian peso, Brazil and Turkish banks all fell 30% in twelve months is an asset class in deep financial distress – and the global recession has not even begun. J.P. Morgan was so right. “Liquidity is like a cab on a rainy night. It disappears when you need it the most”. The liquidity shocks will come when the Yellen Fed raises rates amid China’s hard landing.
This is the 1998 scenario all over again for emerging markets. Currency depreciation means squat when world trade shrinks. I expect corporate defaults (Walter Energy just filed Chapter 11), stock market crashes, commodities meltdowns, bank failures as the malign ghosts of 2008 are resurrected to haunt Wall Street. This time the wolf is here and wolf is from Beijing.
Currencies – A ECB policy shock will slam the Euro below parity!
There is now no doubt that world financial markets have embraced the King Dollar theme, as it scales March highs. Yet the real macro disaster in the past two months has been in commodity currencies, not the Euro, sterling or the yen. West Texas crude has fallen 25% since its recent $61 peak, leading to 8 – 11% losses in the Norwegian kroner, Canadian dollar, Russian rouble and the Aussie dollar. The latest Greek deal with the Troika has not led to any Euro strength. Au contraire, in fact. The currency gnomes have no confidence in the Euro even though German IFO business confidence and credit growth data exceeded consensus. Ironically, despite the uber-dovish monetary jawboning of the Yellen Fed since last autumn, Planet Forex has bid up the US dollar, mainly since the oil shock, China carnage and US data momentum are all greenback bullish.
However, real ballast behind my King Dollar macro idea was the Bank of Japan’s “October shokku” and the ECB’s historic QE program, both unthinkable without the oil shock. The Euro has no less than a 57% weight on the US Dollar Index. So it was no surprise that Dr. Draghi’s monetary regime change on QE and the spectacular fall of the Euro from 1.40 to 1.09 makes him the godfather of the King Dollar trade. Dr. Draghi knows that deflation in Europe has a structural component (50% youth unemployment rates in the Club Med, French trade unions and a derigiste Socialist in the Élysée Palace, German/Benelux demographics, Greek banking panic etc), making a trillion dollar asset purchase program essential.
In essence, Draghi ECB has cut the Euro’s umbilical cord with the hard money zealots of the Deutsche Bundesbank. Yet Mario Draghi would not have been able to exorcise the Weimar obsessed ghosts of the Bundesbank without the oil shock or the HICP below zero. This is a seminal moment in the evolution of the ECB since unconventional monetary policy was taboo (verboten und unmöglich, mein herren!) in Jens Weidmann’s Bundesbank and Angela Merkel’s Reich Chancellery. This was the “January shock”, the $1.6 trillion asset purchase program, announced by the Draghi ECB, scheduled to continue until September 2016. This was hugely Euro negative and the election of Syrizia added a maverick dimension to Athens-Berlin debt politics. However, now that German data has improved and the HICP inflation data has ticked higher to 0.9% last month, the Bundesbank has shortened the maturity of its bond purchases. In short, Dr. Weidsmann has just announced a monetary taper in Frankfurt even though Planet Forex has virtually ignored his move.
The Bundesbank move comes against another savage fall in crude oil. Even though West Texas has fallen to $47, US shale oil production has risen 500,000 from its 9.1 MBD level last November. Saudi Arabia, Russia and Iraq alone are producing almost 26 MBD a time when Chinese demand has gone bust. I reiterate my call that Brent will test its 2009 lows at $40.
Dr. Draghi’s target of a 1.5% Eurozone inflation rate in 2016 is totally unrealistic. Dr. Draghi has a MIT doctorate in economics and so knows that the Black Death in crude oil/copper is flashing a deflation SOS that will slam West Europe. Economists estimate that another $5 fall in Brent crude could cause Eurozone inflation to fall 25 basis points after a one year lag. The conclusion is unmistakable. Sometime this autumn, Dr. Draghi will be forced to announce a “shock and awe” increase in his bond purchases, exactly as the Kuroda Bank of Japan did in October 2014. The yen slumped from 105 to 120 against the US dollar after the “October shokku”. I think the coming “Draghi QE shock” will slam the Euro below parity, possibly down to Wim Duisenberg era levels below 0.9.
The Chinese State Council’s statement suggesting a wider trading band for the Renminbi (RMB) led to another meltdown in Shanghai, Shenzhen and Hong Kong H share equities. The Politburo’s market rigging scheme has failed and valuations in Chinese A shares are still loonie tune. Investors ignore the 15 – 17% fall in year on year Indian, Taiwan, Thai and Indonesian exports at their own peril. Dr. Copper fell 10% in July. Crude oil lost a shocking 19% in July. My global deflation scenario is not a midsummer night’s nightmare.
Stock Pick – Citigroup shares now trade at post crisis highs!
Citigroup shares have more than doubled from 27 when CEO Vikram Pandit was ousted in a boardroom palace coup in November 2012 to almost $60 a share in late July 2015. The second quarter 2015 EPS of 1.51 easily beat most sell side Wall Street bank analyst estimates. This was the second successive quarter of blowout earnings. Operating leverage in Citi’s business model is bullish for investors as revenues rose 5% while expenses fell 1%. Year to date returns on assets (ROA) has reached 103 basis points, making it highly probable that ROE will hit 10%. Citigroup has also performed brilliantly in capital markets, generating $3.7 billion in revenues, thanks to strong foreign exchange, debt underwriting, syndications, equities and derivatives businesses. Investment banking naturally benefited from Wall Street’s current merger mania and the pipeline in debt/equities capital markets.
Citigroup could well generate $6 a share in 2016 EPS. America’s third largest bank has finally rerated since 2012, exactly as I predicated in successive columns and now trades just below tangible book value. However, EPS in 2015 should be in the 5.50 range and Citigroup therefore trades at 10.6 times current earnings. Citigroup has a beta of 1.83 and is highly vulnerable to a risk aversion spasm on Wall Street, a flattening of the Treasury bond yield curve and litigation risk Citigroup is also hugely exposed to emerging markets consumer banking, where NPL’s will rise as central banks defend free falling currencies with higher interest rates. Citi Holdings assets, 360 billion in early 2011, are now below $100 billion. The Fed approved Citi’s 2015 capital plan and the board has approved the $7.8 billion common stock buyback plan. For the next six months, I would not be surprised to see Citigroup trade in a 52 – 62 range as long as the world financial markets remain immune from the China ignited global recession, to which I assign a non-trivial probability. If China triggers a global recession, all bets are off for Citigroup and every other money centre bank stock listed in New York (or Zurich!). The money laundering probe at Banamex and the LIBOR rate rigging scandal are also potential swords of Damocles on the stock price.
Credit Suisse was the best performing stock in Europe after Tidjane Thiam hosted his first earnings call at the new CEO of Switzerland’s second largest universal bank. The former CEO of Prudential has reinforced the capital markets’s hope that Credit Suisse will scale back its commitment to high risk, complex, capital intensive structured product and investment banking businesses. The capital markets want Credit Suisse to mimic UBS’s capital light, recurrent fee based, capital generative, high return on assets business model. I reiterate my view that Credit Suisse would be a value buy at 25 Swiss francs for a 32 CHF target. Valuations are compelling at 9 times forward earnings and the bank trades at book value at 27 CHF. While Credit Suisse’s ROE is 9.6% and therefore lower than both Julius Baer and UBS, there is clearly potential for a significant valuation rerating.
However, even if Monsieur Thiam slashed the investment bank (which I doubt he will), the capital that will be released will not be returned to shareholders (the Weber/Ermotti model at UBS) but will need to be accumulated to boost the bank’s Basle Tier One ratio. Credit Suisse is also vulnerable to any safe haven panic buying in the Swiss franc as its cost base Switzerland is far too high. Turmoil in the financial markets this autumn would be negative for the “One Bank” three core franchises – private banking, asset management and investment banking. The Brunetti Report could also force management to boost capital, reduce leverage and pay surcharges to reduce systemic risks to Switzerland. I am also worried about margin compression risk at the Credit Suisse Private Bank. Earnings euphoria has lifted the shares above CHF 28 but I would wait for a retest of the CHF 25 levels to deploy new money to Credit Suisse.
