The View

The collapse in banks’ share prices helps explain why we’re caught in a death spiral

The post-2008 reflation trade stopped working late last year

PUBLISHED : Thursday, 25 February, 2016, 5:06pm
UPDATED : Thursday, 25 February, 2016, 5:06pm

“How did you go bankrupt? Bill asked.

“Two ways,” Mike said, “Gradually and then suddenly.”

Ernest Hemingway perfectly described how events unfold into a market crash in T he Sun Also Rises. When you might be in the middle of a crash, all of the market action spools out in slow motion and you won’t see it clearly until it is over.

Different viewpoints are indicating that the markets are reaching some cyclical or secular endpoint. The issue isn’t whether or not central banks have any more monetary ammunition left to save the economies. It’s that credit expansions don’t last forever. And this one is in the middle of ending, which will elevate risk levels and instability.

Some sort of 1985 Plaza Accord style currency agreement should be hammered out by central banks in order to prevent an uncontrolled currency conflict

This year’s sudden and vicious fit of ‘risk off’ happened within weeks of the Federal Reserve’s rate hike. It now appears to be a trigger for catalysing real problems lurking in the background. The world economy is slowing or not growing at a satisfactory rate. Trade and credit are decelerating. Countries are being drawn into a currency war. Weak global inflation lurches towards global deflation. China grudgingly realises that they need to promptly devalue the yuan. And by increasing rates the US only worsens the entire situation.

China risks the policy consequences of doing nothing. By allowing more capital outflow, offsetting it by selling reserves, it will be forced into a devaluation from a position of weakness when reserves run out. Some sort of 1985 Plaza Accord style currency agreement should be hammered out by central banks in order to prevent an uncontrolled currency conflict.

Last year, Larry Summer’s advanced a controversial framework about secular economic stagnation to sceptical response. Summer’s empirical observation about the life expectancy of mature economic expansion should concern investors. In a speech at the Central Bank of Chile he argued that when an economic expansion has lasted longer than five years and unemployment remains below 6 per cent, the probability of a recession within three years is over 75 per cent. And unemployment reached 6 per cent in the US 15 months ago.

Since the 2008 credit crisis quantitative easing encouraged investors to borrow money and invest in emerging markets, credit and global equities- and locally, Hong Kong properties. This macro, multi-year bet worked out well, but stopped working late last year.

The recent stock collapse- in particular, bank stocks, has been inexplicable to bankers and analysts. They can’t see any tail end risk to justify it. Deutsche Bank has taken an especially brutal beating falling 60% over the year compared to HSBC (down 35 per cent), Standard Chartered (down 65 per cent). In particular, Deutsche Bank’s price-to-book value of 40 per cent would be even more frightening if it wasn’t Germany’s biggest bank.

It effectively amounts to a crash in bank stocks. And it makes a mockery of all the new financial regulations imposed on banks up to and including Basel III capital adequacy ratios. They were supposed to communicate their margin of safety.

Perhaps banks are being re-rated after the end of quantitative easing and the start of secular stagnation. There doesn’t appear to be a new credit bubble forming or excessive risks percolating at banks. Perhaps the risk lies in the perception that central banks are more constrained than ever in how much more money they can print in the next economic crisis.

Regular visitors to Dongguan have observed more empty factories providing anecdotal evidence of a manufacturing slowdown. About 200 million migrant workers out of China’s total population of 1.3 billion need employment for basic survival.

In the US, almost 95 million people aren’t included in the official unemployment data because they have been unable to find work. Real wage improvements have not occurred in the last 10 years. Some of America’s migrant workforce can be found living in their cars and campers in the vast parking lots of Walmarts and Costco’s.

China’s migrant workers aren’t necessarily returning to mud huts in the countryside. People in most Chinese villages live comfortably and eat better than most average Americans. Their children receive a better education than any public school in most large American cities.

In the coming down cycle, western investors will be disconnected from China’s position as the world’s second largest economy and a developing market. No other country has attained this conflicting position. Its influence cannot merely be contained, ignored or sold off like other smaller emerging markets.