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Twilight of easy money

mateininvest|By Matein Khalid| In retrospect, the last six years were a unique period in global central banking, an epic monetary experiment that averted a Great Depression after Lehman’s failure and interbank/credit contagion plunged the world into recession in 2008-9. Yet the Fed (and later Bank of Japan, ECB and even PBOC) quantitative easing also led to asset bubbles, credit market excesses, currency wars and the mispricing of risk as volatility plummeted across asset classes. Ben Bernanke, Mario Draghi and Haruhiko Kuroda reflated the world’s three mission critical economies with an easy money tsunami that transformed the investment paradigm. Now what?

The Yellen Fed is “data dependent” though conscious of exogenous linkages (oil, China, emerging markets) in a fragile, hyper-volatile world where panic, as well as greed, is transmitted at the speed of light. A 150 basis point rise in the Fed overnight borrowing rate is entirely possible in 2016. After all, the Bernanke Fed raised the Fed Funds rate by 425 basis points in 2004-6 as the credit bubble raged across the world. The FOMC projects a 3.4% Fed Funds rate sometime in the next three years. The end of cheap money is a game changer event in world finance and thus my investment strategy.
Higher bank funding cost, a squeeze in liquidity, a rise in corporate and sovereign risk premiums, an aversion to leveraged balance sheets and poor corporate governance will reshape equity markets worldwide, even right here in the UAE. Bond proxies and go go momentum stocks are leprosy in the post December FOMC investing zeitgeist. I expect merger mania to accelerate as lack of pricing power in a slow growth world resurrects the Darwinian/Schumpeterian demons of capitalism.
I have consistently argued since early 2014 that the King Dollar theme argued for a sell off in commodities, de facto monetary tightening in Wall Street, a plunge in crude oil, GCC equities and an Asian flu/Mexican peso run scale disaster in emerging markets. This was the macro rationale behind my most successful macro trades in 2013-15 – short oil services index (OIH) at 50, long US dollar/Canada at 1.06, short Euro at 1.3650, short Turkish banks, short Gazprom/VTB in Russia, long Wall Street financials since 2013. Citigroup at 25, Lazards at 27. Of course I got some companies wrong, I was wrong on ICICI. India faces credit disaster. I cannot fathom the logic of Amazon.com trading above 900 PE, well beyond the lifetime of Jeff Bezos and every human on earth. I thought Emaar was a compelling buy at 6 AED but did not grasp that the post Vienna meltdown in crude would devastate all Gulf equities, blue chip or potato chip.
The Fed rate hike celebrates the rock and roll US economy, with its 5% unemployment rate, 19 million unit car sales, accelerating bank loans, consumer spending goosed by the plunge in gasoline prices. As Gulf sovereign wealth funds recycle $500 billion less petrodollars and China links its yuan to a currency basket, I expect the ten year US Treasury bond yield to rise to 2.80% next year. The highest duration equities markets – Russia, Turkey Brazil, Indonesia, Malaysia, Thailand, even India and Egypt – are most at risk when Uncle Sam’s IOU yield rises and the Fed monetary pump sputters amid FOMC rate hikes.
The strategy implications for 2016 are crystal clear to me. Embrace Taiwan, shun commodities exporters in Southeast Asia. Embrace financials and shun utilities. Leveraged property speculation? The kiss of death, exactly as it was in 2009. Skippy the Bush Kangaroo, a favourite show of my boyhood, will be an apt metaphor for the scenario I expect in Gulf without a bankruptcy code. Skippynomics!
Profit growth will be pressured by higher US rates in 2016. So dividend risk has never been higher. Default risks will rise beyond energy. Liquidity shocks will emerge like malign demons, as the Third Avenue junk bond fund just did, as Orange County, the Granite hedge fund and Metallgesellschaft did in the Greenspan Fed rate hikes of 1994. When the planet’s cost of money rises, bad things happen in the money bazaar, as they will in 2016.
Oil prices trade at $35 West Texas, a post 2008 low. A wet barrel oil trader friend tells me Basra Heavy (Iraq) and Mexican crudes trades at $25 – 28 a barrel. West Canada Select sells for a meagre $22. OPEC’s game of output chicken continues even as the oil glut overtakes global storage capacity with 90% capacity in Amsterdam/Rotterdam/Antwerp/Galveston tanks. Iran will soon sell 500,000 MBS from floating storage. Index funds selling is frenzied as oil ETF investors panic. Winter product demand in North America is awful. Russia now battles Saudi Arabia in its core Baltic markets. The endgame? Brent falls to $30 by April 2016.
Market View – Distress in high yield corporate debt will continue in 2016
I was fascinated by high yield debt ever since I first heard Michael Milken, then the maestro of Drexel Burham Lambert’s junk bond trading empire from its Rodeo Drive, Beverly Hills office, speak at Wharton. Milken was then hailed as America’s greatest financier since J.P. Morgan, the creator of the junk bond new issuance that was the high octane fuel for Wall Street’s merger arbitrageurs, hostile takeover and leveraged buyout kings and asset strippers, the Wharton MBA whose bonus alone was $560 million. A year later, Michael Milken was in Club Fed, Drexel Burnham was kaput and merger mania in deep freeze as daisy chain of junk bond financed deals culminated in Chapter 11. J.P. Morgan’s words haunted me then as they haunt me now. “Liquidity is like a cab on a rainy night in New York. It disappears when you need it the most”.
The Third Avenue Credit Focused Fund froze investor redemption and precipitated panic in a high yield debt market braced for a tsunami of energy debt defaults in 2016 as West Texas hedges end. The sector has lost its credibility after years of balance sheet leverage, go go financing and shrunken profits for high risk issuers even outside energy. As US Treasury bond yields rise 150 basis points as Wall Street prices in a yield to worst well above 9%. This means the two major high yield debt index fund (symbol HYG, JNK) are still a short on any strength.
This is not the time or place to bottom fish despite ostensibly fat coupons/spreads as default rates will continue to rise while dealer banks (thank you, Volcker, Dodd and Barney Frank!) refuse to commit capital to the embattled secondary market. This means risk premia in high yield debt will continue to spike on Wall Street in 2016 mainly in oilfield services, drillers, media, metals/mining cable/satellites, Macao gaming and even wireless telecom. Lucidus Capital demonstrates that the liquidation of high yield credit hedge funds will continue.
I can well envisage the current high yield debt bear market as the worst since the 2008 meltdown after the failure of Lehman and the 1991 crash that followed Drexel’s closure and Milken’s arrest for insider trading. No asset allocator in his right mind would allocate to high yield and private debt as investor redemptions surge while dealer bid/ask spreads widen to the size of a Patton tank. Historically, bloodbaths in high yield debt have presaged recessions in America as unerringly as an inverted US Treasury debt yield curve. This was the case in 1990, 2001 and 2008-9.
Credit spreads have widened since mid 2014 even while US economic data momentum has accelerated. The high yield debt market is the victim of a classic “liquidity shock” created by the regulatory excesses of the post Dodd Frank, Volcker Rule, Basle Three world. Sure, the pain is focused on energy/mining but contagion can easily spread to the debt netherworld of Wall Street, just as it spread to equity when Third Avenue unnerved global risk assets.
Defaults will continue to rise in 2016 and could well peak at 5%, meaning spreads have significant room to widen even from current levels. Despite juicy 8% yields, I do squat in this toxic asset class. Far easier to replicate these yields selling expensive put options on momentum darlings in the Chicago Board Options Exchange (CBOE).
Who said fairy tales do not exist in emerging markets? City of Kiev bonds rose from 40 to 90 after the IMF’s Ukraine debt restructuring even though Putin’s proxy war still rages in the Donbass. Yet I was saddened that Gulf based NRI private client investors lost at least $50 million as Private Bankerji lured them into Brazil OAS bonds, now in default with the Chairman in jail. Once again, the blind lead their trusting lambs to the slaughter after fleecing them with exploitative fees.
Brazil, Turkey, South Africa and even Saudi Arabia tell me that the sovereign credit rating cycle will turn ugly in 2016. I see a Venezuelan default as inevitable. Hot money will force a Turkish bank debt crisis. The cost of refinancing external debt will surge. Dr. Janet Yellen tells me 100 basis points of monetary tightening will happen in 2016 from the FOMC dot plot. This is nightmare for Third World debt, crude oil, Hong Kong/GCC property and offshore sovereign junk credit. Get real. Get out.
Macro Ideas – The Federal Reserve and UAE banking risk
It was no surprise the UAE Central Bank raised its Certificate of Deposit (CD) rate paid on surplus bank funds by 25 basis points after the December FOMC conclave. The logic of the UAE dirham’s dollar peg dictates that the UAE Central Bank must tighten monetary policy and shadow dollar rates higher even though the crude oil deflation shock argues for easy money.
Government deposits in the UAE have fallen by $15 billion in September as the oil price fall accelerated in the autumn. This is the cause of the current liquidity squeeze in the local bank loan market since government deposits are 25% of total banking system deposits. The three month Emirates Interbank Offered Rate (EIBOR) has risen from 0.67% last January to 100 basis points now. Since the US overnight borrowing rate could well rise 150 basis points in 2016, EIBOR could well be 280 basis points or even 3% by December 2016. UAE interest rates are now at their highest level since the 2008 global financial crisis.
Since the UAE dirham is pegged to the US dollar, the burden of macro adjustment after an oil shock falls on the local property and share markets. This is the reason I pleaded with my friends to take profits in Emaar at 12 AED and sell speculative property investments in summer 2014 when Brent crude was $110. Now Emaar has fallen more than 50% from its peak and apartment/villa prices are down 15-20% even in prime areas. Property prices are notoriously unreliable as bid/offer spreads can exceed 30% in a bear market in this highly illiquid, speculative, leveraged, bank credit sensitive asset class.
The property market’s price fall has been due to supply shocks (thousands of newly built houses with one third laying empty) and a plunge in demand from buyers from countries whose home currencies have plunged against the US dollar. This includes the Euro, the British pound, the Russian Rouble, the Indian/Pakistani Rupee, the Turkish Lira and the Egyptian Pound. The rise in US dollar and UAE dirham interest rates will boost home mortgage rates and devastate the balance sheet of leveraged non-prime property developers.
I expect UAE bank deposit rates to rise at least 150 basis points in 2016. This is great news for savers in a 4% inflation economy (IMF data) and depositors should roll over three month dirham deposits at higher rates to take advantage of Fed rate hikes. Just like GCC equities fell 30% in 1995 GCC debt and sukuk markets are now highly vulnerable to higher financing costs credit downgrades, an exodus of offshore investor capital and duration selling. Note that higher interest rates and tight bank liquidity mean GCC sovereign and corporate credit spreads will widen not compress, in 2016.
Corporate banking will be transformed in 2016. The SME sector faces a de facto credit crunch as international banks such as Stan Chart exit this segment. While oil is one third the UAE GDP, (50% of Abu Dhabi GDP, only 2% of the Dubai GDP), public sector spending dominates the local bank credit and hence business cycle.
Since one third of all UAE bank loans are to the cast, volatile property and construction sector, the angst in the property market will also tighten bank credit underwriting standards. This means bank loan growth, 9% in 2014, could well fall to 2-3% in 2016. Corporate borrowing costs will continue to rise in 2016 and the SME credit crunch will deepen.
I have not bought any UAE bank shares 2015 despite lower prices since banks face higher funding costs, more impaired loans, lower trade finance fees and lower profit growth. Deposit growth will fall from 10% in 2014 to only 1-2% in 2016. This means bank loan/deposit ratios high at 97 will rise for the first time since the 2009 credit Armageddon. The lack of organic deposit growth will force UAE banks to increase their dependence on expensive, fickle offshore funding markets.
Since UAE bank liquid assets have fallen to 25% of total assets, this means higher cost of banking risk even though Basel Tier One capital is still 15% of system risk weighted assets. A shrinkage in world trade and economic growth due to China’s hard landing also means lower fee income in trade finance, foreign exchange remittances and loan syndication.