Steinhoff Disintegrates As Biggest Shareholder Caught In Margin Call "Death Spiral"

The stock of scandal-plagued retailer Steinhoff plunged for the third consecutive day, bringing its total drop in the past 3 days to over 50%, as its biggest shareholder and former Chairman, Christo Wiese, was caught in a vicious margin call, and increased the amount he has raised from selling shares in various related entities such as food retailer Shoprite Holdings Ltd. to 3.3 billion rand ($259 million) as his net worth continues to disintegrate amid the accounting scandal which some - this website included - have likened to a modern-day Enron.

Christo Wiese: largest Steinhoff shareholder and 4th richest South African

Wiese’s liquidation of assets comes as Steinhoff’s stock extended its drop this month to 93%, fueled by the resignation of CEO Officer Markus Jooste after auditors refused to sign-off on the furniture and clothing company’s 2017 earnings.

Things deteriorated two days ago when the company - whose bonds were recently purchased by the ECB - announced its lenders were pulling credit lines, and added that it isn’t yet able to assess the magnitude of financial irregularities disclosed two weeks ago. Steinhoff also said it didn’t know when it would be able to publish audited results for 2017 and 2016, nor whether additional years will need to be restated, prompting the liquidity exodus.

Meanwhile, the liquidations continues as both the company and its shareholders scramble to obtain liquidity to cover securities thay have margined with company assets. Steinhoff, which is run from South Africa but has its main stock listing in Germany, faces a potential fire sale of its global retail holdings as it battles for survival according to Bloomberg. Wiese, the chairman of Shoprite, sold 1.1 billion rand of the grocer’s shares on Tuesday, according to a statement, following the sale of stock worth 2.2 billion rand in the last week.

Weise is caught in a classical - and accelerating - margin call death spiral, where he has to liquidate increasingly more assets to meet liabilities following the more than 90% decline in the value of his holdings in Steinhoff. In other words, the more he sells, the more he has to sell, and as the chart below shows, he is doing just that.

Meanwhile, a unit of Barclays Africa separately applied for liquidation of a company called Mayfair Speculators Pty Ltd., which owns racehorses, property and Steinhoff shares and is linked to former CEO Jooste, Bloomberg reports. Mayfair is being probed by the bank for moving 1.5 billion rand of assets to its holding company in August ahead of information about Steinhoff’s accounting irregularities being released, according to the documents.

And while both the company and its largest shareholders are caught in a "death spiral" which ends with the stock hitting zero, there is still no news whether the ECB has finally sold its Steinhoff bonds which have a distinct chance of ending up totally worthless.

Doug Noland: There Will Be No Way Out When This Market Bubble Bursts

Authored by Adam Taggart via PeakProsperity.com,

This week Doug Noland joins the podcast to discuss what he refers to as the "granddaddy of all bubbles".

Noland, a 30-year market analyst and specialist in credit cycles, currently works at McAlvany Wealth Management and is well known for his prior 16-year stint helping manage the Prudent Bear Fund.

He certainly shares our views that prices in nearly every financial asset class have become remarkably distorted due to central bank intervention, first with Greenspan"s actions to backstop the markets in the late-1980"s, and more recently (and more egregiously) with the combined central banking cartel"s massive and sustained liquidity injections in the years following the Great Financial Crisis.

All of which has blown the biggest inter-connected set of asset price bubbles the world has ever seen.

Noland foresees tremendous losses as inevitable, as the central banks lose control of the monstrosity they have created:

This is the granddaddy of all bubbles. We are at the end a long cycle where the bubble has reached the heart of money and credit.

 

There will be no way out. We"re not going to get enough private credit growth to reflate things when this bubble bursts. It"s going to have to come from central bank credit; it"s going to have to come from sovereign debt.

 

When this bubble bursts, it will shock people how far the central banks will have to expand their balance sheet just to accommodate the deleveraging in the system. And they won"t really be able to add new liquidity to the market; they"re just going to allow the transfer of leveraged positions from the leveraged players onto the central bank balance sheets.

 

When you get to that point, when the market sees that transfer occurring, I predict there"s going to be fear of long-term financial instruments. We"ll see rising yields. That"s when things will become problematic.

 

There will be losses. Of this global bubble, I think European debt is about the most conspicuous. Sure, European junk debt is nuts, too. It currently trades at 2%. Why? Because the ECB is buying large amounts of corporate debt. The ECB has kept rates either at 0% or negative. The perception is that the ECB will keep those markets liquid.

 

But look at Italy. It"s rapidly approaching 135% in terms of government debt to GDP. That debt will not get paid back. But yet, the market is willing hold that debt at 1.7%. This is debt that has traded at over a 7% yield back in 2012. But here it is today at 1.7%. I mean, Europe is just grossly mispricing its huge debt market. The excesses that have unfolded in European debt across the board are just staggering.

 

So when we get to that point when the central banks begin aggressively expanding their balance sheets (again) but the bond markets are not happy about it, then the central banks will finally have to decide if they want to continue to inflate or if they"re going to focus on trying to keep market yields down. This will be a very, very difficult situation for central bankers when it unfolds.

Click the play button below to listen to Chris" interview with Doug Noland (54m:31s).

The Perfect Storm (Of The Coming Market Crisis)

Authored by Lance Roberts via RealInvestmentAdvice.com,

It is always refreshing to step away from the keyboard for a few days and hit the “reset button,” which is exactly what I did last week. My wife and I took a quick trip to Mexico to get a little sun on our face while we wiggled our toes in the sand.

I came back astonished.

Over my 30-odd years of working with money in various capacities, I learned to “shut-up and listen.” This is particularly the case when you are in an airport lounge or packed like sardines in a missile-shaped tube hurling through the air at 35,000 feet.

People love to talk…if you let them.

I had a dozen “listening sessions” with a wide variety of people who each told me roughly the same thing summarized as follows:

1. The market is a “can’t lose” proposition.


2. So is “Bitcoin” (even though they had no idea what it really is when I asked them.)


3. The market is only going higher from here because the Fed won’t let it go down.

You get the idea.

And just when I thought I was sure I had the most bullish views wrapped up – Kevin Matras fro Zack’s Research hit my inbox with the following:

“The S&P will double. And not just eventually. But over the next 5 years (or sooner).

 

Sounds like a Herculean task on the surface, but it’s really not. In fact, the market only needs to gain on average of 14.9% per year in order to do so. That’s not such a stretch given the market has been averaging 14.9% per year since this bull market began in early 2009, even though GDP (prior to this year) has only been increasing at an anemic 1.48% annual rate.

 

My 5-year doubling thesis also means that we won’t see another recession until stocks double again, nor will we see another bear market until stocks double again.“

So, there you have it.

No bear market until the market racks up another 2600 points and dwarfs every other economic growth cycle in history.

Meanwhile….Back On Earth

Before I go further, let me clarify one thing.

As a portfolio manager, I am neither bullish nor bearish. I don’t really care which way the market is headed personally. If it is rising, as it is now, I am long equities. When it reverses that trend, I will either be short equities and long bonds and cash.

That’s my job.

My job is also to pay attention to the risks that could quickly remove large chunks of investment capital from my client’s portfolios. Like any professional gambler knows, you can only play the game as long as you have a “stake” to play with. Lose your capital, and you lose the game. 

The Perfect Storm Cometh

In the movie, “The Perfect Storm,” George Clooney plays the Captain of the “Andrea Gail.” The Captain, after having a bad start to the fishing season, convinces his crew to go out one last time and they venture well past their usual fishing grounds leaving a developing thunderstorm behind them. After ignoring repeated warnings, a desperate Captain, and crew, head into a confluence of two powerful weather fronts and a hurricane in order to cash in on their bounty.

They all died.

Investors today, after having missed out on the first few years of the current bull market cycle, have now decided to throw all caution to the wind and ignore the repeated warnings in hopes of attaining the “riches” they have been promised.

And, like the “Andrea Gail,” they are currently heading into a perfect storm.

Storm One

Currently, there are many articles pointing our various risks in the market. One that caught my attention over the weekend was a note on the volatility index by Kevin Muir.

“For the longest time, I felt the concerns from the VIX were overblown. For years, market pundits have been bandying about charts meant to scare investors about the potential dislocation in the VIX market. I even wrote a piece called, The VIX Article no one will like.”

He is right.  For the last several years, each time the volatility index hit new lows, there were fears of a massive reversal on the horizon. Yet stocks marched higher while the volatility index made even lower lows.

But Kevin goes on to make an important point:

“Yet the frenetic pace of VIX shorting has intensified to a level that frightens me. There is now $1.2 billion of market cap of the inverse VIX ETF XIV, with another $1.3 billion of SVXY (another inverse ETF). This is insanity.

 

If we get a sharp move higher in VIX, there will be a snowball effect. If it is big enough, monster positions, like $2.5 billion of short VIX ETFs will have to be bought back in a hurry. And let me break it to you, there is no one large enough to take the other side of that trade. At least no one willing to do it without extracting many pounds of flesh first.”

Kevin is absolutely correct.

The only question is how far does it have to rise before the “margin calls” begin to occur. More importantly, volatility runs very long cycles which, unsurprisingly, follow the psychological investment cycles of the market from fear to greed back to fear.

But that is not the only problem.

Storm Two

Once the $VIX trade begins to fail, investors will find themselves almost immediately confronted the “high-yield bond storm.”

American corporations are levered to the hilt with total corporate debt surging to $8.7 trillion – its highest level relative to U.S. GDP (45%) since the financial crisis. In just the last two years, corporations have issued another $1 trillion of new debt NOT for expansion but primarily for share buybacks to boost bottom line earnings per share.

Note: This is also why “repatriation” won’t lead to massive economic growth, wages or employment. Instead, it will go to share buybacks, dividends, and executive compensation. 

For the last 9-years, the Fed’s “zero interest rate policy” have left investors chasing yield and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows.

I have written for some time that during the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds are an entirely different issue. When “high yield,” or “junk bonds,” begin to default, as they always do, which is why they are called “junk bonds” to begin with, investors will face sharp losses on the one side of their portfolio they “thought” was supposed to be safe. 

Let the panic selling begin.

As shown below, when the rout begins, the yields on junk bonds sharply deviate from that of the U.S. Treasury bond. Again, the 10-year Treasury rate is not going higher anytime soon, but everything else likely will.

Storm Three – The Hurricane

Of course, as investors begin to get battered by the “volatility and junk bond storms,” the subsequent decline in equity valuations begins to trigger “margin calls.” 

As the markets decline, there will be a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of those “losses” mounts until individuals seek to “avert further loss” by selling.

There are two problems forming.

The first is leverage. While investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return.

It is often stated that margin debt is “nothing to worry about” as they are simply a function of market activity and have no bearing on the outcome of the market.

That is a very short-sighted view.

By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While “this time could certainly be different,” the reality is that leverage of this magnitude is “gasoline waiting on a match.”

When an “event” eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point which triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

That Sinking Feeling

Unwittingly, investors have compounded their risks by piling into exchange-traded funds under the mistaken assumption it is an “easy way to invest.”

Over the past 9-years, the number of ETF’s available to investors has now eclipsed the number of stocks available for them to invest in. This leads to a liquidity problem and the risk of a “disorderly unwinding of portfolios.” As the head of the BOE, Mark Carney, warned:

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”

The issue of liquidity is not a small one.

Investors mistakenly assume there is ALWAYS a buyer at the price at which they wish to sell. 

This is wrong.

While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

At some point, that reversion process will take hold. It is at that point where the storms all collide into a massive wave of panic driving selling. It will not be a slow and methodical process, but rather a stampede with little regard to price, valuation or fundamental measures.

It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s, junk bonds, and option pricing. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don’t believe me? It happened in 2008 as the “Lehman Moment” left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough. 

Where the majority of mainstream punditry gets it wrong, in my opinion, is they keep saying we “can’t have another ‘great financial crisis’ again” because things are different.

That’s true.

NO market “mean reverting” event has EVER been based on the same issues that caused the previous event.

The next event won’t be the same as any past event either.

Only the outcomes remain the same.

The “perfect storm” is coming.

Chinese Liquidity Dries Up: Stocks Hit 3-Month Lows, Tumble Most Since June 2016

It appears The National Team is taking a well-earned break as Chinese stocks extend their losses from late last week in the biggest 3-day drop since June 2016.

 

Breaking below a key technical support level...

Chinese shares were already on a shaky footing after last week when investor confidence was sapped by fresh government steps to reduce financial risks, and a rout in the bond market; but three straight days down with no aggressive "management" buying is unusual...

 

With the Shanghai Composite back to its lowest since August (when China"s National Team - aka state-backed investor China Securities Finance Corp - announced it had boosted its stake in the entire brokerage sector)...

 

At the same time, short-term liquidity markets are showing serious signs of strain as 1-month HKD HIBOR spikes to its highest since Dec 2008...

 

And South Korean stocks plunged most in 3 months...as tech shares slumped following an analyst’s report suggesting the memory chip “super cycle” would soon fade, led lower by Samsung Electronics.

 

Something has changed!

Citi"s Shocking Admission: "There Is A Growing Fear Among Central Bankers They"ve Lost Control"

Earlier we showed a variation on a VIX chart from Citi"s Hans Lorenzen which, if it doesn"t impress, or scare you, then nothing probably will.

However, leaving readers unimpressed - and unscared - will not satisfy Lorenzen, which is why the credit strategist who works together with the godfather of rational doom, Matt King, and has been warning for weeks that now is the time to sell credit, unloads in one of the more effusive missives of dripping negativity to hit during this holiday week when one after another equity sellside analyst has been desperate to outgun each other with their ridiculous 2018 year end S&P forecasts.

And while Lorenzen touches on many things, at its core, his warning is straight out of Shumpeter: the longer nothing changes, the greater the crash will ultimately be, a topic which DB"s Aleksandar Kocic dissected over the summer, even defining an entirely new term in the process: metastability.

 

So without further ado, here is Lorenzen explaining why "embellishing the status quo will be the market’s undoing.

Ultimately, extreme valuations, the lack of risk premia, and a lack of responsiveness to tail risks are merely symptoms. The real question is what the skewed incentive structure resulting from that backstop has done to the fabric of markets after so many years. To our minds the answer is that trades and strategies which explicitly or implicitly rely on the low-vol environment continuing, are becoming more and more ubiquitous.

 

Realised historic vol is de facto an exogenous input to much of the risk management framework that underpins modern finance. With lookbacks extending a few years, an extended period of market stability reduces VaR measures and improves Sharpe ratios. Both allow / encourage investors to take more risk – driving valuations higher and vol lower still, creating a self-reinforcing dynamic. Intuitively, returns should follow flows – money is deployed and the asset price goes up. But in the real world the causation works the other way.

What this means in real-world terms:

Long periods of one-way markets breed survivor biases. The fund manager with lots of beta outperforms, the cautious fund manager underperforms. Either the latter gets on the bandwagon or soon enough outflows from the fund will ensue. Over time, fewer and fewer “critics of the regime” are left standing.

 

In an asset class where the upside is constrained, like in credit, that dynamic is further reinforced by the fact that a fund manager has to take more and more beta relative to benchmark in order to sustain the level of excess carry that will merely cover costs. The lack of volatility and the super high correlations between credits and the index (Figure 24), leave precious little scope for alpha (Figure 25).

Here we can add another piece to the short vol conundrum, because the closer spreads get to the lower bound, the more explicitly being long credit in itself becomes a short-vol position. With less and less upside remaining, owning credit risk become a question of generating a small amount of carry (or premium) for taking future downside risk – essentially, akin to selling a put option.

Meanwhile, as spreads collapse, as dol implied and realized vol, we are all “happily” ignoring that more risk is being issued into the market than ever before (Figure 26) and that the credit quality of the market keeps slipping – for the first time ever the market cap of the BBBs is about to overtake the rest of the € IG index (Figure 27).

What happens next should be familiar from the last financial crisis: the infamous step up in risk:

When the conventional asset class of choice no longer offers a “decent” return potential, money looks to the next one on the quality spectrum for a pickup. IG funds holding BBs and AT1. DM funds buying EM debt. European and Asian funds holding more and more $ fixed income. Corporates moving their liquidity from money markets to short-dated IG credit funds. Mandate creep in the investment criteria. Even synthetic structured credit is making something of a comeback. The list of tourist trades goes on and on. Most of these too are predicated on the status quo - if volatility and risk premia were to rise, retrenchment back towards the original / natural asset allocation would be swift and uncompromising.

And then, one day, the market will finally discount that the central banks are no longer set to injection trillions in liquidity: that"s the moment the public finally begins to admit the emperor is not wearing any clothes.

You could rightly argue that many of these factors are generic to every bull market. The fact that volatility clusters is exactly because of these (and other) selfreinforcing dynamics. But the implicit ceiling on vol / cap on downside from the central bank backstops has, in our view, allowed them to run for much, much longer than would have been possible in a market operating on its own devices.

 

You could argue that there is nothing to worry about as long as fundamentals remain strong. But those looking at the economic data, corporate earnings or leverage trends to indicate the next turn in markets are looking in the wrong place, if you ask us. Over the last 50 years, only 2 out of 19 corrections in US credit were led by a recession. 12 had no overlap with a  recession at all. In half the corrections, there wasn’t even a discernible turn in the leading economic indicator beforehand. Plainly, there is a long history of market corrections being triggered by other factors than fundamentals – Black Monday in 1987 and the correlation crisis in 2005 are two obvious examples.

Still, judging by the current state of the market, Citi writes that traders "evidently don’t expect a sharp market correction to happen tomorrow."

While the probability of a next-day loss still feels quite low there is an obvious temptation to stay invested a little bit longer for professional investors, tasked not with delivering a return of money, but a return on money and with high frequency. The process of judging that near-term probability manifests itself in the frenzied search for “triggers”. Surely, if one could just get a slightly better call on the next trigger, then it’d be possible to get out just in time before everyone else jams the exit? We don’t dismiss the importance of triggers. Indeed,  when you look back at the last fifty years, nearly every major correction in credit can be associated with a triggering event (Figure 28). With hindsight everything is easy.

Here Citi has some advice: don"t look for triggers; instead focus on the big picture.

We are sceptical that hunting for the next trigger is worth the effort. If a trigger seems obvious, then it’s probably obvious to everyone and chances are it will be too late. Triggers are often latent – the long-term problem is obvious, but it is ignored until suddenly it explodes without much warning (think the Greek sovereign debt crisis). Multiple factors often have to  combine to create a triggering event – the GFC wasn’t just about sub-prime, it was about excessive leverage, inadequate regulation, unchecked financial innovation, misaligned rating methodologies, inadequate backstops and a host of other things. The last couple of years have seen several widely peddled “triggering events” crystallise with remarkably little shake out.

So what about the big picture? Here one can argue that in recent years the market simply wasn’t vulnerable with so much central bank money behind it. However, Lorenzen believes that "2018 is different." As we see it, it is now increasingly vulnerable to a mid-cycle, “technical” correction, based on what we have discussed above:

• Central bank asset purchases are set to be the smallest in a decade (Figure 29). A $1tn of incremental demand versus 2017 is needed from private sources.


• At least in the US, the opportunity cost of not being invested in credit (i.e. the yield differential to 3m LIBOR) is likely to be the smallest since 2007.


• The perception of a backstop has facilitated a multitude of trades and strategies that are contingent on a low level of volatility in an increasingly crowded space. Now that backstop is moving “out the money”.


• Vol is near historic lows and has been so for longer than ever before. More risk than ever before is being issued into a credit market where spreads, on a like-forlike basis, are close to the 2007 tights and where breakevens are wafer thin.

Lorenzen then branches into some chaos theory for good measure:

In the context of a self-reinforcing, herding market, the pivot point where the marginal investor is indifferent between putting more money back into risk assets and holding cash instead is fluid. But when the herd suddenly changes direction, the result is a sharp non-linear shift in asset prices. That is a problem not only for us  trying to call the market, but also for central bankers trying to remove policy accommodation at the right pace without setting off a chain reaction – especially because the longer current market dynamics run, the more energy will eventually be released.

And while not intended to be a conclusion, or even a punchline, the next line from the Citi strategist should scare the living daylights out of anyone: it is a direct admission that central bankers have now lost control.

That seems to be a growing fear among a number of central bankers that we have spoken to recently. In our experience, they too are somewhat baffled by the lack of volatility and concerned about the lack of response to negative headlines.... Our guess is that sooner or later in the process of retrenchment they

will end up going too far – though that will only be obvious with

hindsight.

Frankly, that"s about the scariest admission from one of the world"s biggest banks that we have read in a long time.

* * *

As for how this period of cataclysmic metastability ends, here is Lorenzen"s dire conclusion:

In a fairy tale, turning points come suddenly and unexpectedly. Everything that has long been taken for granted is suddenly in pieces. In that sense markets are not all that different. People have gotten used to the paradigm that has been built up since the Great Financial Crisis. It has been tested on several occasions – 2011, 2012 and 2015 – and on each occasion central banks have overcome the challenge, thus ultimately reinforcing the regime.

 

The emperor in Andersen’s story was only able to parade around naked because the social norms, customs, conventions and vested interests that had built up over time were so strong that even the blatantly obvious was better left unspoken.

 

Similarly, the low risk premia, the low level of volatility, the lack of responsiveness to tail risk and spillover of systemic events, the reluctance to sell etc. to us are all indications that the market now has an almost Pavlovian response to central bank liquidity. The mere thought of it is enough to still leave us salivating, even when it is patently in the process of being turned off. Yes, excess liquidity will remain in the system even after central bank net asset purchases fall to zero, but as we have argued, if that money has chosen to stay out of the securities  market now, then why should it seamlessly come flowing in at these valuations when the backstop is moving out the money?

 

While our conviction in the exact timing and magnitude of the paradigm shift is admittedly low – hence the deliberately very wide range in the scenario forecasts – it is unwavering  when it comes to the broader point that central bank asset purchases will remain the key driver of markets. Exactly because trades and strategies have been built up around an assumption of the status quo, we fear that the inflection point, if / when it comes will be anything but smooth and linear. Indeed, the longer we remain in the current paradigm, the greater the chance that it  ends up being both sharp and painful.

 

One of our favourite quotes pertains as much to markets as it does to economics:

 

“In economics, things take longer to happen than you think they will, and then they  happen faster than you thought they could.”

    ? Rudiger Dornbusch

 

Surely, that is a sentiment which the emperor who had his vanity and pride shattered so abruptly from the least likely angle would recognise all too well?

We end with one of our favorite pictures: the one we call Yellen"s moment of epiphany haw it all ends.

No wonder the Fed chair can"t wait to get the hell out...

Traders Puzzled After Chinese Media Warning Triggers Market Selloff

Overnight we highlighted that despite a massive weekly net liquidity injection by the PBOC (which ended on Friday when the PBOC drained a net 10bn in liquidity) Chinese stocks failed to hold on to Thursday"s gains, and resumed their slump...

 

... headed for their worst week in 7 months.

 

However, it was more than the simply a question of liquidity flows, because it once again appears that Beijing is involved in micromanaging daily stock moves, only unlike the summer of 2015 when China blew a huge stock bubble in a few months, which then promptly burst leaving China scrambling for the next year to figure out how to avoid contagion, this time Xinhua had a different message: sell.

According to Bloomberg, the reason why Chinese stocks - led by Shenzhen shares - slumped on Friday, is due to a warning by state media that one of the nation’s hottest stocks was climbing too fast, which in turn triggered a selloff. And while the SHCOMP closed down 0.5%, the Shenzhen Composite Index closed down more than 2%, with liquor makers and technology companies that had outperformed this year among the biggest losers.

The catalyst that sparked the selloff? China"s biggest liquor maker, Kweichow Moutai, which plunged 3.9% - after tumbling as much as 5.8%, its largest decline since August 2015 - after Xinhua News Agency said its China’s biggest "should rise at a slower pace." Other liquor makers fell in sympathy, Wuliangye Yibin slid as much as 5.3% in Shenzhen, the most since July 2016, and Luzhou Laojiao fell 4.7%, although the stocks, which have more than doubled this year, pared their losses by the close.

In commentary published in the state-owned newspaper, the author said "short-term speculation in Kweichow Moutai shares will hurt value investing and long-term investment will deliver best returns."

The bizarre and unusual critique - traditionally China"s media mouthpieces have only urged stocks to go higher, never lower - capped a week that saw a rout in Chinese sovereign bonds spill into the equity market amid concern about a government deleveraging campaign and faster inflation. For the week, the Shenzhen gauge fell 4.2%, its worst loss since May 2016. The Shanghai benchmark declined 1.5 per cent.

“The Xinhua warning was the last straw,” said Ken Chen, a Shanghai-based analyst with KGI Securities Co. “Expectations of worsening liquidity conditions are also hurting stocks.”

In retrospect, perhaps the Xinhua warning was not so strange: after China"s debt-fueled stock market bubble burst in 2015, wiping out $5 trillion of value, Chinese policy makers have acted to restrain excessive speculation in equities.

“Xinhua is concerned that a runaway rally in a heavyweight like Kweichow will hamper the stability of the overall market,” said Hao Hong, chief strategist at Bocom International Holding Co in Hong Kong.

And while one can wonder why China is suddenly so concerned about even the hint of potential vol spike in the stock market - suggesting that even a modest selloff could have dramatic consequences for the Chinese financial sector - it is certainly strange that whereas even China is acting to restrain the euphoria of its citizens over fears of what happens during the next bubble, in other "developed" countries, the local central bankers, politicians and TV pundits have no problem in forcing retail investors to go all risk assets when the market is at all time highs.

As for China, it will have truly gone a full "180", if in a few months time instead of arresting sellers as it did in the summer of 2015, Beijing throw stock buyers in prison next.

Mauldin: The Next Crisis Will Reveal How Little Liquidity There Is

Authored by John Mauldin via MauldinEconomics.com,

This is something I’ve been pondering for some time. I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space.

Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century.

However, when the prices of massive amounts of high-yield bonds that have been stuffed into mutual funds and ETFs begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.

My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen. And he has 25 years of experience as a high-yield trader.

There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again.

But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.

But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box (subscribe to this free weekly publication here). He sees additional sources of weakness coming from other areas, too.

Frankly, the lack of volatility is beginning to scare me a bit. Minsky constantly reminded us that stability begets instability. Stability is a pretty good word to describe the current markets.

But such stability always ends in a "Minsky moment." We don’t know when; we don’t know where it starts; but we know it’s coming.

What Will the Next Crisis Look Like?

By Marko Kolanovic, PhD, and Bram Kaplan
October 3, 2017

Next year marks the 10^th anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50^thanniversary of the 1968 global protests against political elites. Currently, there are financial and social parallels to both of these events.

Leading into the 2008 GFC, some financial institutions underwrote products with excessive leverage in real estate investments. The collapse of liquidity in these products impaired balance sheets, and governments backstopped the crisis. Soon enough governments themselves were propped by extraordinary monetary stimulus from central banks. Central banks purchased ~$15T of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2018. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis. We will call this hypothetical crisis the “Great Liquidity Crisis” (GLC). The timing will largely be determined by the pace of central bank normalization, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006. We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis:

• Decreased AUM of strategies that buy Value Assets: The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The ~$2T rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.

• Tail Risk of Private Assets: Outflows from active value investors may be related to an increase in Private Assets (Private Equity, Real Estate and Illiquid Credit holdings). Over the past two decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private Assets increased by ~20%. Similar to public value assets, private assets draw performance from valuation discounts and liquidity risk premia. Private assets reduce day-to-day volatility of a portfolio, but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis.

• Increased AUM of strategies that sell on ‘Autopilot’: Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~$1T over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.

• Trends in liquidity provision: The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion), to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.

• Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multi-asset portfolios. An analogy is with the 2008 failure of endowment models that assumed Emerging Markets, Commodities, Real Estate, and other asset classes are not highly correlated to DM Equities. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk. Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models.

• Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks. Sign of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial crypto- coin offerings’ that in many cases have very questionable value.

We believe that the next financial crisis (GLC) will involve many of the features above, and addressing them on a portfolio level may mitigate the impact of next financial crises. What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor (e.g., see here). Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.

*  *  *

Every week, celebrated economic commentator John Mauldin highlights a well-researched, controversial essay from a fellow economic expert. Whether you find them inspiring, upsetting, or outrageous… they’ll all make you think Outside the Box. Get the newsletter free in your inbox every Wednesday.

These Are The Top Geopolitical Risks According To The World"s Largest Asset Manager

Like many others, the world"s largest money manager with $5.9 trillion in (ETF) investments, BlackRock, is not too worried about a market which no matter what, promptly rebounds from any and every selloff, and seems to close at all time highs day after day as if by magic. To be sure, BlackRock"s employees are delighted: the less the volatility, and the higher the S&P goes, the more likely retail investors are to hand over their cash to BlackRock. So far so good. Still, not even Blackrock can state that after looking at this chart, which unveils unprecedented economic policy uncertainty at a time when equity uncertainty has never been lower...

... that everything is ok.

And it doesn"t: in a blog post by BlackRock"s Isabelle Mateos y Lago, Blackrock"s chief multi-asset strategist writes that while markets may be a sea of calm, geopolitics are anything but. As a result, the world"s biggest ETF administrator has its eyes on 10 geopolitical risks and is tracking their likelihood and potential market impact, as it wrote recently in the firm"s Global Investment Outlook Q4 2017.

The "world of risk" map below is a quick snapshot of all

Among the Top risks tracked by Blackrock are:

• North American trade negotiations


• Russia-NATO conflict


• South China Sea conflict


• US-China tensions


• Escalations in Syria and Iraq


• North Korea conflict


• Fragmentation in Europe


• Gulf conflicts

Of the risks listed above, which are the ones BlackRock is most worried about? According to Mateos y Lago, the top three right now: North American trade negotiations, a North Korea conflict and U.S.-China tensions, with the second and third particularly interrelated.

The details:

North American trade negotiations

The fourth round of North American Free Trade Agreement (NAFTA) renegotiations ended this week, with Mexico and Canada rejecting what they view as harsh U.S. proposals. Still, news reports did suggest apparent progress on less contentious parts of the agreement, and the negotiations aren’t over. The next round of talks are scheduled to take place in Mexico next month.

Our base case is that successful negotiations will be completed in early 2018. However, our hopes for this outcome have recently diminished given tough positions from U.S. negotiators and threatening rhetoric from U.S. President Donald Trump that has resulted in greater uncertainty. Market risks are biased to the downside given that a good outcome is priced in, in both Canadian and Mexican markets.

* * *

North Korea

We view North Korea’s missile and nuclear weapons program as a major threat to regional stability, U.S. security and nuclear non-proliferation. The possibility of armed conflict has risen, we believe, given North Korea’s missile launches over Japan, a nuclear test and an intense war of words. This has raised the chance of misstep or miscalculation, and we could see limited action such as the shooting down of missiles.

Yet we currently see a low probability of all-out war; the costs are too high on all sides. Instead, we expect the U.S. to intensify its “peaceful pressure” campaign, evident in imposing unilateral sanctions and leaning hard on China to participate. We see the crisis straining U.S.-China relations just as economic tensions are rising.

* * *

Deteriorating U.S.-China relations

We see frictions between the U.S. and China heating up over time. The countries risk falling into the “Thucydides Trap,” a term coined by Harvard scholar Graham Allison to describe clashes between rising powers and established ones. We see trade and market access disputes straining an increasingly competitive U.S.-China relationship in the long run, and believe markets have yet to factor in this gradual deterioration.

In the short term, tensions could rise if Chinese President Xi Jinping pursues an even more nationalistic agenda in the wake of the National People’s Congress. Economic tit for tats could lead to an erosion of relations—and have sector-specific effects.

U.S. military action against North Korea and/or an accidental clash in the South China Sea would deal a blow to the relationship, in our view, and hurt risk assets. But our base case is that the U.S. and China avoid these land mines in the short term, and try to use President Trump’s upcoming visit to emphasize cooperation.

Taking the above in context, what is BlackRocks recommendation for portfolios? The good news, according to the author, is that most geopolitical shocks have short-lived market impacts, except in regions directly affected. For those who wish to hedge, Blackrock recommends government bonds as useful diversifiers against volatility and equity market selloffs sparked by such shocks.

* * *

Meanwhile, in a separate observation, Rick Rieder, Blackrock"s global fixed income CIO pointed out another recurring, and ominous trend: "major central banks flooded global financial system with near $10T in liquidity since 2008, but now we’re beginning to unwind"

Indeed, major central banks flooded global financial system with near $10T in liquidity since 2008, but now we’re beginning to unwind pic.twitter.com/utyHoZZeco

— Rick Rieder (@RickRieder) October 19, 2017

... which leads to the question: "will others (foreign-exchange reserves, banks) step in to provide liquidity, so the transition doesn’t derail growth?"

Question is: will others (foreign-exchange reserves, banks) step in to provide liquidity, so the transition doesn’t derail growth? (3/4) pic.twitter.com/lKimYZRIVi

— Rick Rieder (@RickRieder) October 19, 2017

The answer: it all depends on China.

We think so; financial condition drivers (monetary base, USD, money multiplier) should be supportive, yet so much depends upon #China (4/4) pic.twitter.com/lr7kSKzsJO

— Rick Rieder (@RickRieder) October 19, 2017

$1 Trillion In Liquidity Is Leaving: "This Will Be The Market's First Crash-Test In 10 Years"

In his latest presentation, Francesco Filia of Fasanara Capital discusses how years of monumental liquidity injections by major Central Banks ($15 trillion since 2009) successfully avoided a circuit break after the Global Financial Crisis, but failed to deliver on the core promise of economic growth through the "wealth effect", which instead became an "inequality effect", exacerbating populism and representing a constant threat to the status quo.

Fasanara discusses how elusive, over-fitting economic narratives are used ex-post to legitimize the "fake markets" - as defined previously by the hedge fund - induced by artificial flows. Meanwhile, as an unintended consequence, such money flows produced a dangerous market structure, dominated by both passive-aggressive investment vehicles and a high-beta long-only momentum community ($8 trn and rising rapidly), oftentimes under the commercial disguise of brands such as behavioral Alternative Risk Premia, factor investing, risk parity funds, low vol / short vol vehicles, trend-chasing algos, machine learning.

However as Filia, and many others before him, writes, only when the tide goes out, will we discover who has been swimming naked, and how big of a momentum/crowding trap was built up in the process. The undoing of loose monetary policies (NIRP, ZIRP), and the transitioning from "Peak Quantitative Easing" to Quantitative Tightening, will create a liquidity withdrawal of over $1 trillion in 2018 alone. The reaction of the passive community will determine the speed of the adjustment in the pricing for both safe and risk assets.

And, echoing what Deutsche Bank said last week, when it warned that central bank liquiidty injections will collapse from $2 trillion now to 0 in 12 months, a "most worrying" turn of events, Fasanara doubles down that "such liquidity withdrawal will represent the first real crash-test for markets in 10 years." 

Filia concludes that "the big opportunity in today"s markets is to position for such moment of adjustment, as it is totally priced out despite its potential for severe disruption, thus offering the most pronounced asymmetric profile."

Below are the key slides from Fasanara"s presentation:

The full, must read presentation is below (link):

"The End Of The QE Trade": Why Bank of America Expects An Imminent Market Correction

Last Friday, when looking at the historic, record lows in September volatility and the daily highs in US and global equity markets, BofA"s chief investment strategist Michael Hartnett said that the "best reason to be bearish in Q4 is there is no reason to be bearish."

That prompted quite a few responses from traders, some snyde, a handful delighted (some bears still do exist), but most confused: after all what does investors (or algo) sentiment have to do with a "market" in which as Hartnett himself admits over $2 trillion in central bank liquidity has been injected in recent years to prop up risk assets.

To explain what he meant, overnight Hartnett followed up with an explainer note looking at the "Great Rotation vs the Great DIsruption", in which he first reverted to his favorite topic, the blow-off market top he dubbed the "Icarus Rally", which he defined initially nearly a year ago, and in which he notes that "big asset returns in 2017 have been driven by big global QE & big global EPS."

But mostly "big global QE."

And with global QE continuing, Hartnett, who two months ago predicted a volatile fall (and winter), now sees that Icarus “long risk” trade extended into autumn "by low inflation, big liquidity ($2.0tn central bank buying), high EPS, and promise of US tax reform."

As a result, Hartnett"s "blow off top", or Icarus, targets for Q4 are: S&P 2630, Nasdaq 6666, 10-year Treasury 2.85%, EUR 1.15. At this rate, the S&P could hit BofA"s target in about 3-4 weeks, and thus Hartnett lays out the following 11th hour trade recos for Q4

• long US$ vs EM FX,


• long oil,


• long barbell of uber-growth (IBOTZ, DJECOM) & uber-value (BKX) = Icarus trade;


• further unwind of extended “long disruptor, short disrupted” trade likely (i.e. death of old Retail, Media, Autos, Advertising by Tech Disruptors);


• rotational outperformance of oil>credit, EAFE>EM,


• value/growth

But if Hartnett"s "Icarus" is here, then the just as popular "Humpty Dumpty" must be set to follow, and sure enough Hartnett goes back to square one, and his contention that since there is "nothing to be bearish about", it"s time to take profits. Below are the various reasons why the BofA strategist expects the long-overdue market top is just around the corner.

• Global stock market cap up a massive $18.5tn (= US GDP) since Feb’16 lows


• 3P’s (Positioning, Profits, Policy) thus closer to peak than trough: BofAML Bull & Bear Indicator was 0 in Feb’16, now 6.9; global EPS growth was -6% YoY in early- 2016, now 14% YoY; $2.0tn of asset purchases by central banks YTD but Fed & ECB will taper next 6 months


• Q4 “top” in equities and credit driven by:
  
  • a. pricing-in of US tax reform (= peak Policy),
  
  
  • b. rise in MOVE index (= peak Positioning),
  
  
  • c. rally in oil + trough in Chinese RMB + upgrades to global GDP (= peak Profits)
  
  


• Tax reform = “peak policy” = buy rumor, sell fact; passage of reform or cuts = quicker Fed balance sheet reduction + less share buybacks as capex accelerates; US equities lose 2 big tailwinds next year (since 2009 lows S&P equity market cap up $15.3tn, Fed’s balance sheet up $4.5tn, share buybacks up $3.5tn)


• Big jump in the MOVE index of US Treasury market volatility (i.e. “bond shock”) catalyst for cross-asset volatility (QE has neutered impact of bond volatility on equity prices but the negative correlation will return as monetary policy normalizes)

Lastly, BofA reminds us not to ignore China, where financial conditions have tightened of late (explcining this weekend"s targeted RRR-cut), and a further leg higher in US bond yields will mean an unwind of EM “carry-trade” another source of Q4 cross-asset vol (Chart 3); note CNY has troughed.

Summarizing BofA"s thesis:

In short, correction late-17 driven by “as good as it gets” narrative; magnitude dependent on CNY, MOVE, tax reform & degree of “forced selling” by ETFs & quant (7 ETFs accounted for 41% of volume of the top 20 most actively traded US issues in 2017; quant hedge funds & CTAs = $1.3tn AUM = 40% of industry total); right now feels more likely single- than double-digit.

It"s not just the imminent correction, however. Hartnett also takes a longer look, and specifically what "the end of the QE trade" will look like. Here are his thoughts:

• Tech disruption & central bank liquidity have been the most important themes past 10 years; CBs have caused Wall St asset prices to boom, technology has constrained wages on Main St


• Relative asset price performance next year will be highly dependent on speed & magnitude of liquidity withdrawal; since Bear Stearns event, expanding Fed balance sheet has led the outperformance of High Yield versus Treasuries, of Growth versus Value, of US equities versus RoW equities and so on.


• Table of QE winners & losers below illustrates the excess returns from 2 secular themes of “growth” & “yield”; low economic growth has boosted “growth” stocks, e.g. biotech, tech; low interest rates have  boosted “high yielding” assets such as high yield bonds.
  


• Fed balance sheet about to reverse and global balance sheet same in 2018; and the massive outperformance of “QE winners” versus “QE losers” had frayed in recent months (e.g. growth>value) & quarters (e.g. US>RoW)

• The strong Q4 tactical case for asset/regional/style rotations ultimately dependent on inflation & interest rates rising (e.g. 10-year Treasury yield moves toward 3%) as low unemployment rates in the US, UK, Germany, Japan finally cause wages to accelerate and the Fed & ECB to tighten more aggressively in 2018; we strongly doubt this is the secular base case, however.


• Thus we fear Disruption, Demographics, Debt continue to prove deflationary, tying the hands of the central banks & keeping rates low (e.g. 10-year Treasury hugs 2%); if so, speculative bubbles in the bull market leadership of Tech, EM debt, High Yield are likely to occur.