The Brutally Cold Chill of Deflation?
RBS has advised clients to brace for a “cataclysmic year” and a global deflationary crisis, warning that major stock markets could fall by a fifth and oil may plummet to $16 a barrel.Indeed, this sell-off can easily become self-fulfilling and if it does, I expect central banks around the world, including the Fed which made a huge mistake raising rates in December, to come out shortly with a massive coordinated response to help calm jittery markets.
The bank’s credit team said markets are flashing stress alerts akin to the turbulent months before the Lehman crisis in 2008. “Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small,” it said in a client note.
Andrew Roberts, the bank’s research chief for European economics and rates, said that global trade and loans are contracting, a nasty cocktail for corporate balance sheets and equity earnings. This is particularly ominous given that global debt ratios have reached record highs.
“China has set off a major correction and it is going to snowball. Equities and credit have become very dangerous, and we have hardly even begun to retrace the 'Goldlocks love-in' of the last two years,” he said.
Mr Roberts expects Wall Street and European stocks to fall by 10pc to 20pc, with even an deeper slide for the FTSE 100 given its high weighting of energy and commodities companies. “London is vulnerable to a negative shock. All these people who are ‘long’ oil and mining companies thinking that the dividends are safe are going to discover that they’re not at all safe,” he said.
Brent oil prices will continue to slide after breaking through a key technical level at $34.40, RBS claimed, with a “bear flag” and “Fibonacci” signals pointing to a floor of $16, a level last seen after the East Asia crisis in 1999. The bank said a paralysed OPEC seems incapable of responding to a deepening slowdown in Asia, now the swing region for global oil demand.
Morgan Stanley has also slashed its oil forecast, warning that Brent could fall to $20 if the US dollar keeps rising. It argued that oil is intensely leveraged to any move in the dollar and is now playing second fiddle to currency effects.
RBS forecast that yields on 10-year German Bunds would fall time to an all-time low of 0.16pc in a flight to safety, and may break zero as deflationary forces tighten their grip. The European Central Bank’s policy rate will fall to -0.7pc.
US Treasuries will fall to rock-bottom levels in sympathy, hammering hedge funds that have shorted US bonds in a very crowded “reflation trade” (click on image).
RBS first issued its grim warnings for the global economy in November but events have moved even faster than feared. It estimates that the US economy slowed to a growth rate of 0.5pc in the fourth quarter, and accuses the US Federal Reserve of “playing with fire” by raising rates into the teeth of the storm. “There has already been severe monetary tightening in the US from the rising dollar,” it said.
It is unusual for the Fed to tighten when the ISM manufacturing index is below the boom-bust line of 50. It is even more surprising to do so after nominal GDP growth has fallen to 3pc and has been trending down since early 2014.
RBS said the epicentre of global stress is China, where debt-driven expansion has reached saturation. The country now faces a surge in capital flight and needs a “dramatically lower” currency. In their view, this next leg of the rolling global drama is likely to play out fast and furiously.
“We are deeply sceptical of the consensus that the authorities can ‘buy time’ by their heavy intervention in cutting reserve ratio requirements (RRR), rate cuts and easing in fiscal policy,” it said.
Mr Roberts said the tightening cycle by the Anglo-Saxon central banks is already over. There will be no rate rises by the Bank of England before the downturn hits, and the next action by the Fed may be a humiliating volte-face and a rate cut.
RBS is not alone in fearing trouble. UBS issued what it called a “significant change” to its house view late last week, saying policy chaos in China had unsettled markets. It cut exposure to equities from overweight to neutral on a “six-month tactical horizon”. It went underweight emerging markets.
UBS said it is a precautionary move, insisting that the current global credit cycle has not yet peaked. Low oil prices should ultimately feed through to higher consumer spending and boost growth.
Larry Summers, the former US Treasury Secretary, said it would be a mistake to dismiss the current financial squall as froth. Markets often sense a gathering storm when policy-makers are still asleep at the wheel. He has long argued that the world economy is so far out of kilter that it takes permanent financial bubbles to keep growth going, an inherently unstable structure.
Yet there is something strange about the latest events. Austerity is finally over in Europe and fiscal policy in the US this year will be expansionary (click on image).
China’s slowdown hit its bottom in June and a fitful recovery has been building, driven by extra budget spending and credit growth. While the composite PMI indicator for manufacturing and services slipped back last month, it is still higher in the summer.
David Owen, from Jefferies, said there is a “weird disconnect” between the economic fundamentals and the market malaise.
“There is no evidence of anything rolling over in the US. Europe is clearly recovering and the M3 money supply in Germany is growing at almost 10pc, which normally means stronger activity,” he said.
Bank of America said panic selling had triggered its “contrarian buy signal”, since 88pc of global equity indexes are now trading below their 200-day and 50-day moving averages. The "Bull & Bear" index is at an ultra-negative level of 1.3 (click on image).
It said a “big tradable multi-week rally awaits” but requires catalysts, above all a stabilisation of the Chinese yuan and oil, better PMI data and a halt to the rising dollar.
The risk is that this market storm drags on long enough to hit investment, regardless of what the economic data should imply. At the end of the day, market psychology can itself become an economic "fundamental".
Pessimists warn that unless there is a batch of irrefutably good data from China over the next two or three months, the sell-off could become self-fulfilling and quickly metamorphose into the next global crisis.
Ambrose Evans-Pritchard has been wrong calling for the end of the deflation supercycle and writing about elite funds preparing for reflation. I can tell you a lot of hedge fund gurus betting big on a global recovery are getting annihilated early this year.
But investor pessimism has reached extreme levels and I'm expecting a bounce in the near term. In fact, here is just a sample of the stocks I track in the global recovery story (click on image):
As you can see, early Thursday morning, a lot of these commodity and energy stocks are bouncing back strongly after getting clobbered earlier this week, providing some relief to hedge fund gurus like Carl Icahn who is getting killed in his big holdings of CVR Energy (CVI), Cheniere Energy (LNG), Freeport-McMoran (FCX), Chesapeake Energy (CHK) and Transocean (RIG).
Ironically, Icahn came out at the end of September last year to warn of a looming catastrophe ahead after he bought a huge stake in Freeport-McMoran, a copper miner and leveraged play on global growth. Either he regrets that move or he's trying to scare retail investors.
I mention this because I'm tired of listening to gurus on television scaring people. George Soros, the undisputed god of hedge fund managers, came out recently to warn of another 2008 crisis. Really George? Can I see your entire book along with all the swaps trades you have to determine whether you're really net long or short these markets?
You will also notice in my list above Arch Coal (ACI), was delisted because it filed for bankruptcy. Go back to read my quarterly review of top funds' activity where I went over George Soros supposedly buying Arch Coal shares in what looks like another massive hedge fund PUMP & DUMP trade on coal stocks.
All this to say that I honestly couldn't care less of what hedge fund gurus are stating to the media or even if they're buying positions in some beaten down stock. I use my own judgment on markets to go long, to add, to short or to stay put.
I still stick with my Outlook 2016 on the global deflation tsunami, but unlike RBS, Carl Icahn, or George Soros, I don't see a cataclysmic deflationary crisis any time soon and think the Fed and other central banks stand ready to intervene in a massive way to prevent further damage.
Having said this, I continue to steer clear of Chinese (FXI), emerging markets (EEM), energy (XLE), Metals and Mining (XME), Oil & Gas Exploration (XOP) and commodities (GSG) in general because downside risks remain too high.
This however doesn't mean there won't be tradable rallies in these and other sectors that got killed early this year. Experienced traders will make a fortune buying the dips and selling the rips in 2016.
But most people are not experienced traders and these are brutal markets which can test the intestinal fortitude of even the most experienced stock traders. Personally, at this stage, barely two weeks into the year, I think there's a massive overreaction to what's going on in China and the deflation crisis which is looming but not here yet (unless we see a crisis developing in emerging markets).
And I'm putting my money where my mouth is and beginning to scale back into small biotechs (XBI) which have gotten hammered as the algos went RISK OFF early this year (click on image):
But biotechs are insanely volatile, just look at one of the stocks I track closely, La Jolla Pharmaceuticals (LJPC):
Or look at Bill Miller's favorite biotech, Intrexon (XON):
OUCH!!! I can show you about a hundred other biotech shares that look just as bad, if not worse! The sell-off in biotech shares (IBB and XBI) is a bloodbath. Still, I see huge opportunities in this sector going forward but you have to be very selective and very careful trading or investing in biotechs, especially in these RISK ON/ RISK OFF markets.
On that note, I'm going back to trading and watching my screens. Should you sell everything at this point? HELL NO!!! Just look at the tweet I posted on Twitter and StockTwits for Howard Lindzon (founder of Stocktwits) on Wednesday after the close (click on image):
Never let emotions dictate your investment decisions. Stay cool, calm and collected. These schizoid markets swing like crazy but don't listen to investment banks or hedge fund gurus trying to scare the crap out of you or pump you up with hype. If you can't stand the heat, listen to Wim Hof, aka the Ice Man, and take several long freezing cold showers throughout the day. Trust me, it's brutal at first, but once you get used to it, you'll feel a lot better. Just don't forget to breathe!
Also, while medical advances that seem like science fiction are helping people live longer lives, don't forget about the little things that you can do on daily basis to increase your odds, says Dr. David Agus, a leading cancer specialist to the stars whose patients included the late Steve Jobs and Lance Armstrong. Listen to his comments below and don't forget, "sitting is the new smoking," so get up and move!