ECONOMIC ACCELERATION & DECELERATION IMPACT IS LONG TERM
As chickens are coming home to roost in the Junk Bond Markets in the US the threat of a contagion impact across asset classes is now increasing. The fall in crude oil prices was welcomed as a positive development as till now it has created a massive $ 2 Trillion of savings for the global economy by putting extra money in the pockets of consumers. However as I had mentioned earlier a fall is very good but a crash will always have some negative side effects. We see those side affects play out now in the Junk Bond Market in the USA.
Out of a total of $ 1.3 trillion of Junk bonds raised over the last few years nearly $ 550 billion has been by oil exploration and related service providers to the US Shale gas investment cycle. This cycle has created a huge impetus to parts of the US economy and helped the US reduce dependence on imported oil significantly. However the crash in price of US Crude to levels of $ 58 which is lower than the average breakeven level of Shale Oil of $65 has the potential of triggering off a crisis. Some level of sell off has started again and the ripples of that are being felt across the entire asset value chain.
On one hand we have the “Junk Bond” markets and on the other hand we have the market of Bonds that are priced AAA when they possibly should be valued Junk. When the US Federal Reserve started its cycles of Quantitative Easing it was actually successful in bringing long term rates down while bringing short term rates around the policy rates. On the gross basis the US FED is sitting on significant mark to market profits at this stage. How it will behave in the future is a matter of debate. However the bigger risk comes from the Euro Zone where countries like Italy and Spain (Lets not talk Portugal, Greece etc) today borrow at interest rates which are lower than the rate at which AAA borrowers can borrow. This is despite no structural improvements in their economies and recessionary economies. The ECB is moving on its new asset buy program at a time when the prices of those assets are already distorted much beyond fundamental. No one was willing to lend to these countries at 7% plus two years back and now they are borrowing at 2% for 10 year money. The probability of the ECB ending up with huge losses on its Balance Sheet is extremely high as it accelerates its new Asset Buy program. Financial Markets now used to continuous doses of drugs are unable to fathom the risk that lies ahead.
Credit Market risks do not only flow from the US and European Markets. There is this case of borrowings of Oil Export Revenue dependant economies where the probability of default in some cases in increasing. Last week the probability of default of Venezuela went upto as high as 93%.
The Sovereign Wealth Funds of large Oil exporting countries have also been huge providers of capital across the world. As Oil prices collapse, export revenues reduce and the Budgets move into Deficit most of these countries at this stage could stare at actually removing liquidity from Global Equity and Bond assets from a scenario where their flows continuously increased over the last 10 years.
The risk of implosion of Chinese Wealth Management products that are extremely opaque has been talked off over the last 2-3 years. However defaults in China have been muted and have not been of any systematic risk till date. However these things come to fore much more as Economic Activity slows which results in an increase in Non Performing Assets. It is now a reality that Chinese Growth is going to slow. The impact this has on Chinese Local Government Debt as well as other opaque wealth products will need to be seen going forward.
In conclusion we have seen that Equity Markets have reached all time highs across markets in the month of November. We have seen a selloff in Emerging Market currencies start a few months back. A vast majority of EM currencies are now at multi year lows. The Equity Markets of some of the commodity dependant EM’s have also sold off significantly. With an improving US growth outlook and probability of rate increases going forward we could see a further strength in the US Dollar and sell off in EM currencies. This has happened at a time when growth has been faltering everywhere but the US. On top of this we now have issues that have come up in the Credit Markets which have the potential to create huge volatility and potentially a global market selloff.
While long term potential remains high in India the short term risks are high and growing. It should play out over the next few weeks.