Next to weather, I have been tracking the global financial markets with keen interest this year. Whilst matters of weather and financial markets have consumed a fair chunk of my private time, I cannot quite recall why it is specifically these two topical and complex issues that have overwhelmingly peaked my curiosity in 2017. The staggering amounts of information I have gained in the last few months, on both subjects, cannot be fully compressed in a single post, albeit a long one.
Since the beginning of the year, or at least from the time I took an interest, an increasing list of financial experts have been sounding warnings that we are in the midst of one of the largest stock market bubbles in U.S. history. In a classic case of “putting your mouth where your mouth is,” one mystery trader has placed a $262 million bet that the stock market is going to crash by October 2017. Such a bet would seem exceedingly unusual in any other year, not in 2017 in which the ranks of “experts” predicting a massive market correction is continually being filled by some of the most credible voices.
Of course, it must be pointed out that similar warnings calls over the years have not materialized. Indeed, the last eight years has been the longest period of a bull market, even though it has evidently been driven by very few stocks – not a healthy sign of the health and performance of the stock market from a technical point of view, as is apparent in the very high stock valuations.
Academics have weighed in too. Frank Partnoy, a Professor of Law and Finance at the University of San Diego and author of ‘Fiasco: Blood in the Water on Wall Street’, in an apocalyptic article warned that the global financial system is on the precipice of a collapse bigger than that of 2007. He suggests the bane of the imminent collapse is an esoteric financial instrument known as collateralized loan obligation (CLO). Much like their infamous cousin of a decade ago — those collateralized debt obligations — CLOs bundle “risky low grade loans into attractive packages and high credit ratings.”
That’s the jargon to point out that although most loans underlying the CLOs are “junk” status, the new debt they back is triple A rated. The contradiction is familiar, and yes we once again may have to contend with those credit ratings agencies. Just as a decade ago, Portney has concluded that the central culprits in his predicted sequel are the credit ratings agencies. He specifically singles out Moody’s and S&P, pointing to their flawed models and algorithms used to assign triple-A ratings — as they apparently do not factor correlation risk (the chance that defaults may occur simultaneously).
Of course, there are detractors to this view, who remain optimistic and for now it’s this view that appears to be prevailing. Earlier today the Dow Jones reached record territory at 22,000 – an all-time high. Of course, the cynical amongst us would not hesitate to point out that the Dow Jones is an arbitrary and therefore unreliable measure of the health and performance of the stock market. For a better assessment, you would have to look at the S&P 500 index. And yes, it is rising too — albeit driven by a handful of companies.
The seeming quislings of the credit rating agencies may not be confined to financial instruments conjured by quants in hedge funds, but it appears to extend to their ratings at the sovereign paper and debt. For example, on 11 April 2017, just four days after their gloomy report on South Africa, Fitch issued a glowing report on the economic outlook of the US. A mere two months prior, and three weeks into the Trump presidency, the same Fitch had issued a dire warning — stating at the time, “The Trump administration represents a risk to international economic conditions and global sovereign credit fundamentals.”
The consequence of the threat specifically indicated possible credit downgrades for sovereign debt for some of the largest economies in the world — Canada, Germany, China, Japan and Mexico. Paradoxically, however, the US was not explicitly included as a possible target of a downgrade in the Fitch report even though it was itself the subject of the report. So it was that a mere eight weeks after their ominous warning, Fitch changed its tune and reaffirmed the sterling AAA credit rating for the US, and raised their outlook for US GDP growth, while noting in their report that “[the US economy] is judged to have (relatively) weak public finances.” The last part was an unavoidable acknowledgment of the debt ceiling which was reached on 15 March 2017.
On 15 March 2017 the Obama debt ceiling holiday, enacted in October 2015, expired. Since then, it has been frozen at $20 trillion. David Stockman, former Director of the US Office of Management and Budget, left little to speculation in his opinion of the consequences. He stated, “[After expiry of the debt ceiling] the US Treasury will have roughly $200 billion in cash. We are burning cash at a [rate of] $75 billion a month. By summer, they will be out of cash. Then we will be in the mother of all debt ceiling crises. Everything will grind to a halt. I think we will have a government shutdown. There will not be Obama Care repeal and replace. There will be no tax cut. There will be no infrastructure stimulus. There will be just one giant fiscal bloodbath over a debt ceiling that has to be increased and that no one [in Congress or the Senate] wants to vote for.” We can expect the political jostling in the US for an extension to the debt limit to heighten in a few weeks.
Stockman has been proven right so far about one thing at least — there has been no repeal and replace Obamacare. Yet even his pessimistic outlook has not put any speed bumps on the seemingly irrational exuberance of the investors who are driving up the Dow Jones and the S&P 500 indices. Yet still, something just doesn’t feel right. The bullish attitude of the investors just seems out of tune with anecdotal evidence of the health of the global economy. Ironically, it is from a credit rating agency — Fitch — that the unsettling sentiment was best described. A few weeks ago, Fitch announced that the amount of countries carrying AAA-rated debt has fallen to its lowest level in 14 years. As a percentage of all nations with rated sovereign debt, that is the worst reading ever.
At half year, I have found scarce little reassurance that the fundamentals driving health and performance of markets are sound. Yet there is much to hope for in a year that is turning out to be more peculiar than the very strange year that was 2016.