My Financial Road Map For 2016

Happy New Year to All! May 2016 bring peace to you and your loved ones.

Over the holidays, I had the opportunity to stay away from airports and hike Runyon Canyon with my dogs. For those of you that have never traversed Runyon’s peaks and dips, they are nature’s respite from the urban streets of Los Angeles, yet located in the heart of the City of Angels. It’s a place in which to observe, reflect, and think about what’s coming ahead.

As a writer and journalist covering the ebbs and flows of government, elite individual, central bank and private industry power, actions, co-dependencies, and impacts on populations and markets worldwide, I often find myself reacting too quickly to information. As I embark upon extensive research for my new book, Artisans of Money, my resolution for the book - and the year - is to more carefully consider small details in the context of the broader perspective. My travels will take me to Brazil, Mexico, China, Japan, Germany, Spain, Greece and more. My intent is to converse with people in their respective locales; those formulating (or trying to formulate) monetary, economic and financial policy, and those affected by it.

We are currently in a transitional phase of geo-political-monetary power struggles, capital flow decisions, and fundamental economic choices. This remains a period of artisanal (central bank fabricated) money, high volatility, low growth, excessive wealth inequality, extreme speculation, and policies that preserve the appearance of big bank liquidity and concentration at the expense of long-term stability. The potential for chaotic fluctuations in any element of the capital markets is greater than ever. 

The butterfly effect - the flutter of a wing in one part of the planet altering the course of seemingly unrelated events in another part - is on center stage. There is much information to process. So, I’d like to share with you – not my financial predictions for 2016 exactly - – but some of the items that I will be examining from a geographical, political and financial perspective as the year unfolds.

1) Central Banks: Artisans of Money

Since the Fed raised (hiked is too strong a word) rates by 25 basis points on December 16^th, the Dow has dropped by about 3.5%. Indicating a mix of fear of decisive movements and a market awareness deficit regarding the impact of its actions, the Federal Reserve hedged its own rate rise announcement, noting that its "stance of monetary policy remains accommodative after this increase.”

These words seem fairly clear: there won’t be many, if any, hikes to come in 2016 unless economies markedly improve (which they won’t, or the words would be much more definitive.) Still, Janet Yellen did manage to alleviate some stress over the Fed's inaction on rate rises during the past 7 years, by invoking the slighted action possible with respect to rates. 

Projections are past reactions here. The Fed, to save face more than anything or to “appear” conclusive, raised the Fed Funds rate (the rate US banks charge each other to borrow excess reserves, of which about $2.5 billion are with the Fed anyway), to .25-.50% from 0-.25%. And yet, the effective rate stood within the old Fed target range, or at an average of .20% on December 31 for various reasons, the timing of which was not lost on the Fed. It was at .35% or so on the first day of 2016. The Fed’s rate move was tepid, and it’s possible the Fed moves rates up another 25 or 50 basis points over 2016, but less likely more than that and more likely it engages in heightened currency swap activities with other central banks as a way to “manage” rates and exchange rates regardless.

Meanwhile, most other central banks (Brazil being an extreme counter example) remain in easing mode or mirror mode to the Fed. It’s likely that more creative QE measures amongst the elite central banks will pop up if liquidity, markets or commodities head southward. Less powerful central banks will attempt to respond to the needs of their local economies while balancing the strains imposed upon them by the elite central banks.

2) Global Stock Markets

They say that behavior on the first day of the year is indicative of behavior in the year to come. If so, the first trading day doesn’t bode well for the rest. Turmoil began anew with Asian stock markets crumbling at the start of 2016. In China, the Shanghai Composite hit two circuit breakers and China further weakened the yuan.

Yes, there’s the prevailing growth-decline story, a relic of 2015 “popular opinion”, being served as a reason for the drop. But also, restrictions on short selling by local Chinese companies are expiring. Just as in last August, China will have to balance imposing fresh sell restrictions with market forces pushing the yuan down.

The People’s Bank of China will likely inject more liquidity through further reserve requirement reductions and rate cuts to counter balance losses. The demise in stock values is not simply due to slower growth, but to high debt burdens and speculative foreign capital outflows; the story of China as a quick bet is no longer as hot as it was when China opened its markets to more foreign investors in mid-2014, since which volumes and volatility increased. It will be interesting to see if China responds with more capital controls or less, and how its  “long-game” of global investments plays out.

Blood shed followed Asian into European markets. Subsequently, the Dow dropped by about 1.6% unleashing its worst start to a year since the financial crisis began. Last year's theme to me was volatility rising; this year is about markets falling, even core ones. This is both a reaction to global and local economic weakness, and speculative capital pondering definitive new stomping grounds, hence thinner and more dispersed volumes will be moving markets.

3) Global Debt and Defaults

As of November 2015, Standard & Poor’s tallied the number of global companies that defaulted at 99, a figure only exceeded by that of 222 in 2009. Debt loads now present greater dangers. Not only did companies (and governments, of course) pile on debt during this zero interest rate bonanza period; but currency values also declined relative to the dollar, making interest payments more expensive on a local basis.

If the dollar remains comparatively strong or local economies weaken by an amount equivalent to any dollar weakening, more defaults are likely in 2016. In addition, the proportion of junk bonds relative to investment grade bonds grew from 40% to 50% since the financial crisis, making the likelihood of defaults that much greater. Plus, the increase in foreign, especially dollar, denominated debt in emerging markets will continue to hurt those countries from a sovereign downgrade and a corporate downgrade to default basis.

I expect sovereign downgrades to increase this year in tandem with corporate downgrades and defaults. Also, as corporate defaults or default probabilities increase, so does corporate fraud discovery. This will be a year of global corporate scandals.

In the US about 60% of 2015 defaults were in the oil and gas industry, but if oil prices stay low or drop further, more will come. Related industries will also be impacted. In mid-December, Fitch released its leveraged loan default forecast of the TTM (Trailing Twelve Month index) predicting a 2.5% rise in default rates for 2016, or $24 billion in global defaults. That’s an almost 50% increase in default volume over 2015, and more than the total over the 2011-2013 period. Besides higher energy sector defaults, the retail sector could see more defaults, as consumers lose out and curtail spending.

4) Brazil and Argentina

Brazil is a basket case on multiple levels with nothing to indicate 2016 will be anything but messier than 2015. Even the upcoming Olympics there have reeked of scandal in the lead up to the summer games.

Brazilian corporations have already sold $10 billion in assets to scrape together cash in 2015, a drop in the bucket to what’s needed. Brazil’s main company, Petrobras, is mired in scandal, its bond and share prices took massive hits last year as it got downgraded to junk, and a feeding frenzy between US, Europe and China for any of its assets on the cheap won’t be enough to alter the downward trajectory of Brazilian’s economy. In fact, it will just make recovery harder as core resources will be effectively outsourced.

Fitch downgraded seven Brazilian sub nationals to junk, with more downgrades to come. Brazil itself was downgraded to junk by S&P with no positive outlook from anywhere for 2016. Falling revenues plus higher financial costs due to higher debt burdens will accentuate trouble. In addition, pension funds are going to be increasingly underfunded, which will enhance local population and political unrest, as unemployment increases, too.

Though Brazil will have the toughest time relative to neighboring countries, Argentina, will not be having a walk in the park under its new government either. The new centrist government removed currency capital controls in a desperate bid to attract capital. This resulted in crushing the Argentinean Peso (a.k.a. “Marci’s devaluation”) and will only invite further speculative and political volatility into the country. It could get ugly.

5) The Dollar and Gold

Despite what will be a year of continued pathways to trade and currency arrangements amongst countries trying to distance themselves from the US dollar, the fact that much of the world is careening toward global Depression will keep the dollar higher than it deserves to be. It will remain the comparative currency of choice, as long as central banks continue to fabricate liquidity in place of government revenues from productive growth.

Outside the US, most central banks (except Brazil which has a massive inflation problem) have maintained policies of rate reduction, lower reserve requirements, and other forms of QE or currency swap activities. As in 2015, the dollar will be a benefactor, despite problems facing the US economy and its general mismanagement of monetary policy. But the US dollar index and the dollar itself might exhibit more volatility to the downside this year, straying from its high levels more frequently than during 2015.

Last year, given the enhanced volatility in various markets, I expected gold to rise during the summer as a safe haven choice, which it did, but it also ended the year lower in US dollar terms. Because the US dollar preserved its strength, the dollar price of gold fell during the year - yet not by as much as other commodities, like oil.

I take that as a sign of gold finding some sort of a floor relative to the US dollar, with the possibility of more upside than downside for 2016, though in similar volatility bands to the US dollar. Gold relative to the Euro was just slightly down for 2015, relative to the approximate 10% decline in value relative to the US dollar. Considering the home currency is important when examining gold price behavior.

Also, it’s important to note that investing in gold requires a longer time horizon - months and years, rather than weeks and months - and should be done through physical gold, coins or allocated bars depending on disposable investment thresholds, not paper gold. 

In addition, as I mentioned last year, routinely extracting cash from bank accounts and keeping it in safe non-bank locations, remains a smart defensive play for 2016.

6) The People’s Economies

As companies default and economies suffer, industries will inevitably shed jobs this year around the world. The Fed’s publicly expressed optimism about employment figures and the headline figure decrease in US unemployment will be met with the realities of companies cutting jobs to pay the debts they took on during the ZIRP years and due to decreased demand.

Unemployment is already rising in many emerging countries, and it will be important to note what happens in Europe and Japan, as well as the US in that regard.  This Recession 3.0 (or ongoing Depression) could fuel further artisanal money practices that might again be good for the markets and banks, but not for real economies or jobs lost through reactive corporate actions.  

7) Oil

With Saudi Arabia and Iran pissed off at each other in a round of tit-for-tat power positioning, it’s unlikely either OPEC heavy weight will reduce oil production, this while tankers worldwide remain laden with their loads and rigs are quiet. Tankers off the coast of Long Beach in California for instance, that used to come in and unload, remain in stalling patterns away from the shoreline, waiting for better prices. This means tankers are making money on storage, but also that extra oil supplies are hovering off shore, and even if prices rise, release of that supply would have a dampening consequence on prices.

Oil futures have been a generally highly speculated product, so I’ve never believed that simple supply and demand ratios drive the price of spot oil as it relates to the futures price of oil. Only in this case, not only is there oversupply and weakening demand, but speculators are playing to the short side as well. That combination seems destined to keep oil prices low, or push them lower in the near future, but should be closely watched.

Meanwhile, signs of knock on problems are growing. In China, for instance, shipyards are struggling because global rig customers don’t need their rig model orders fulfilled.  

8) Europe

While Greece faces more blood-from-a-stone extortion tactics and none of the Troika get why austerity measures don't actually produce local revenues at high enough levels to pay expensive debts to foreign investors and multinational entities, other parts of Europe aren’t looking much better for 2016. Spain is facing political unrest, Italy, despite exhibiting a tenuous recovery of sorts, still has a major unemployment problem, and the Bank of Portugal lowered its growth estimates - for the next two years.

Mario Draghi, European Central Bank (ECB) head decided to extend Euro-QE to March 2017 from September 2016, having had the markets punish his less enthusiastic verbiages about QE late last year, because he has no other game. The Euro will thus likely continue to drop in value against the dollar, negative interest rates will prevail, and potential bail ins will appear if this extra dose of QE doesn’t keep the wheels, big banks and core markets of Europe properly greased.

9) Mexico

The Mexican Peso closed near record lows vs. the dollar for 2015. Much of the Peso’s weakness was attributed to low oil prices and Mexico’s dependence on its oil sector, but the Peso was already depreciating before oil prices dropped. If the US dollar remains comparatively high OR if oil prices continue to remain low or drop, the Peso is likely to do the same.

When I was in Mexico a few years ago, addressing the Senate on the dangers of foreign bank concentration, there were protests throughout Mexico City on everything from teachers’ pay to the opening of Pemex, Mexico’s main oil company to foreign players. The government’s promise then was that foreign firms would provide capital to Mexico as well as industry expertise that would translate to revenues. Oil prices were hedged then at 74 dollars per barrel. With oil prices at half of that, many of those hedges are coming off this year and that will cause additional pain to the industry and Pemex.

That said, though Mexico will feel the global Depression pain this year as a major player, it is still set to have a much better year than Brazil on every level; from a higher stock market to a higher currency valuation relative to the US dollar to lower inflation to lower unemployment to a better balance of trade with the US than Brazil will have with China. Plus, it has far less obvious inbred corporate-government corruption.

10) Elections and Media Coverage

It’s been a minute since the last debate or late night show fly-by from any Presidential hopeful, but this is the year of the US election. I look forward to continuing to post my monthly wrap on TomDispatch as the Democratic and Republican nominees emerge. I will be taking stock of the most expensive election in not just US history, but in the history of the World. Look for more on the numbers behind the politics later this month.

From a financial standpoint, this election has low impact on flows of capital. Given the platforms of everyone in reasonable contention (with the exception of Bernie Sanders’ platform), no one will actually touch excessive speculation, concentration risk in the banking or other critical sectors like healthcare, or meaningfully examine the global role of artisanal central bank policy, particularly as emanating from the Fed. 

Elsewhere, economic stress throughout the globe and a general sense of exasperation and distrust with politicians is putting new leaders in place that are pushing for more austerity or open capital flow programs rather than foundational growth and restrictions on the kind of flows that cause undue harm to local economies. That is a recipe for further economic disaster that will fall most heavily on populations worldwide.  

Mexico, Federal Reserve Policy and Danger Ahead for Emerging Markets

On August 27th, I had the opportunity to address the Aspen Institute, UNIFIMEX and PWC in Mexico City during a Q&A with Patricia Armendariz. Subsequenty, on August 28th, I gave the opening talk at the annual IMEF conference. The main issues of concern to local Mexican banks, as well as to Mexico's central bank, are:

1) How the Federal Reserve's (and to a lesser extent ECB's and People's Bank of China) policies and actions have, and wlil continue to impact their currency and interest rate levels, and

2) The risks posed by the structural, and ongoing problems of too-big-to-fail banks, which remain as much a US as a Mexican problem as manifested by heightened economic, market and financial stress.

I posted the slides from my talk here, including the ten main risks that Mexico (and really all countries) are facing today, as well as the four factors of volatility that I have spoke about many times before. Much uncertainly emanates from central bank policy and the associated artificial stimulation of mega banking institutions and capital markets throughout the world. There is no foreseeable remedy to the long-term damage already caused, and that will continue to grow in the future.

What follows is a related piece that I co-authored with researcher, Craig Wilson that first appeared in Peak Prosperity:

Too big to fail is a seven-year phenomenon created by the most powerful central banks to bolster the largest, most politically connected US and European banks. More than that, it’s a global concern predicated on that handful of private banks controlling too much market share and elite central banks infusing them with boatloads of cheap capital and other aid. Synthetic bank and market subsidization disguised as ‘monetary policy’ has spawned artificial asset and debt bubbles - everywhere. The most rapacious speculative capital and associated risk flows from these power-players to the least protected, or least regulated, locales.  

The World Bank and IMF award brownie points to the nations offering the most ‘financial liberalization’ or open market, privatization and foreign acquisition opportunities. Yet, protections against the inevitable capital outflows that follow are woefully inadequate, particularly for emerging markets.

The financial world has been focused largely on the volatility of countries like China and Greece recently. But Mexico, the third largest US trading partner (after Canada and China), has tremendous exposure to big foreign banks, and the largest concentration of foreign bank ownership of any country in the world (mostly thanks to NAFTA stipulations.)

In addition, the latitude Mexico has provided to the operations of these foreign financial firms means the nation is more exposed to the fallout of another acute financial crisis (not that we’ve escaped the last one).

There is no such thing as isolated “Big Bank” problems. Rather, complex products, risky practices, leverage and co-dependent transactions have contagion ramifications, particularly in emerging markets whose histories are already lined with disproportionate shares of debt, interest rate and currency related travails.

Mexico has benefited to an extent from its proximity to the temporary facade of US financial health buoyed by Fed policy, but as such, it faces grave dangers should any artificial bubble pop, or should the value of the US dollar or US interest rates rise.

There are other clouds forming on Mexico’s horizon. In the past month, the Mexican stock market has fallen 6 percent. Its highs were last seen in September, 2014. Shares in the nation’s largest builder, Empresas ICA SAB, just fell to a 12-year low as lower growth expectations.

(Source)

Because of currency misalignments based on central bank machinations, the Mexican Peso sits near all time lows vs. the US dollar. The Central Bank of Mexico just announced a currency boosting round of $8.6 billion of Pesos over the next two months, with likely more to come. This impinges upon its reserves. (Source)

Mid-level Mexican financial firms will struggle with access to credit should the air in the tires of this global liquidity boosting exercise continue to leak out. Other problems loom on Mexico’s horizon based on a host of interrelated factors.

These include the potential of capital flight, liquidity loss, over-reliance on external debt and investors, oil price declines (oil revenues account for about one-third of Mexico’s federal government budget), economic downturn in the US or Mexico, and rising volatility due to central bank policy shifts impacting interest rates and currency relationships, geo-politics, credit defaults, or additional big bank crimes.

The high concentration of large banks in Mexico and in the US presents extra systemic risk. Local Mexican firms and individuals, as well as foreign investors should consider these co-mingled factors and hedge against them for protection.

Capital Flight due to US Rate Hikes, Real or Anticipated

The possibility of US rate hikes, or even the threat of them, could freeze demand for non-US stocks and bonds - everywhere. If we learned anything from the US financial crisis, economic hardship in Greece and other Southern European countries, and the rout in the Chinese stock market, it’s that capital flight, particularly leveraged capital flight, can crucify an economy, especially high debt burdens accentuate the process.

Mexico, though somewhat protected from financial upheaval during the first leg of the 2008 financial crisis, may be the next victim of capital’s mercurial tendencies for that very reason. Mexico’s relative stability and liberalized financial markets have invited more foreign capital through these channels, which means more can leave to return to headquarter countries, or seek opportunities elsewhere, in emergencies.

In addition, heightened “de-risking” (or the reducing of counter-party agreements and cross-border remittances between the US and Mexico) will impact future remittance flows. Though de-risking practices are officially designated to thwart money launderers and drug-dealers – the true effect of the closing of bank branches or reduction of services that enable remittance flows burdens the population and the local banks that rely on them.

Big Bank Concentration and Counterparty Risk

Mexico’s domestic bank concentration problems have marginally improved since the financial crisis, but not by much. As of 2014, just five of Mexico’s private sector banks hold 72 percent of all financial assets. The top two, Banamex, a unit of Citigroup Inc., and BBVA Bancomer, a unit of Spain's Banco Bilbao Vizcaya Argentaria SA, hold 38 percent of all assets. (Source) (Source)

Concentration has accelerated in the US. Since the financial crisis, the Big Six US banks (JPM Chase, Citigroup, Bank of America, Goldman Sachs, Wells Fargo and Morgan Stanley) have grown in terms of assets, deposits, cash, trading assets and derivatives volume.

In terms of counter-party risk, from a credit and derivative perspective, the fewer banks operating in any sphere, the greater the risk that a collapse in any one of them triggers a domino effect in the others. The main foreign banks in Mexico, and those engaging in business with Mexican banks, can quickly close services and shift capital and credit from the country, or place barriers to retrieve it, in a pinch.

Ongoing US Bank Bailouts and Mexican Fallout

The US Federal Reserve buying program, though officially over, has rendered the Fed the largest hedge fund in the world, with a $4.5 trillion book of securities, more than a dozen times the figure of seven years earlier. The mortgage backed securities component remains at about $1.5 trillion, up from zero seven years ago.

Mexico was fortunate not to have been on the US bank radar screen to receive, or be induced to borrow against, the $14 trillions of dollars of toxic US-bank made assets. US bankers mostly focused on selling these subprime assets into Europe. Thus, Mexico escaped the fallout that countries like Greece and Spain felt.  

Still, Mexico’s financial conditions are showing increasing signs of weakness, despite comparatively low inflation and, as a result, the ability to keep interest rates around 3 percent (the same as in Chile) below those in Columbia and Peru.

Aside from business problems, the amount of people living in poverty in Mexico increased from 49 million in 2008 to 53 million in 2012. In addition, Mexico came in last of the 34 countries examined by the Organization for Economic Co-operation and Development OECD for inequality. The combination of poverty and inequality on the ground, plus incoming instability on a business and banking basis could prove a disastrous mix in Mexico (and in the US) in the face of possible rising interest rates, a strengthening dollar in the near-term, or enhanced volatility.

EM Debt Defaults and Bond-Stock Divergence

Credit default risk looms as well. The amount of corporate and bank debt issued since the Fed embarked on its zero-interest rate and QE policy and pushed it on the world, has escalated. Thus, rising interest rates or corporate defaults in the US would impact Mexican (and other EM) corporate bond prices and default rates.

The divergence between credit-risk as reflected by rising high-yield bond spreads (up from seven year lows in mid-2014) and equities is predominantly predicated on the 60 percent drop in oil prices this year, which as of August 20^th, hit a six and a half year low. The energy sector represents 15 percent of the high yield market.

Energy stocks have dropped nearly thirty percent. If commodity prices continue falling, other sectors and the stock markets would be more effected. Countries reliant on oil revenues, such as Mexico where 30 percent of the federal budget is based upon them, are impacted directly from profit loss and secondarily by defaults. (Source)

According to a recent report issued by the Institute of International Finance,  “Corporate Debt in Emerging Markets: What should we be worried about?”, emerging market (EM) non-financial corporate debt rose to a record high of 83 percent of GDP, up from 67 percent in 2009.  The total size of the EM non-financial corporate bond market has more than doubled to $2.4 trillion in 2014 vs. 2009.

Between 2015 and 2017, about $645 billion of that debt is set to mature with US dollar denominated bonds comprising $108 billion of that figure. Meanwhile, the volume of non-performing loans and general debt payment burdens have risen on US dollar strength, meaning EM banks, particularly those exposed to high degrees of foreign-currency lending, are increasingly in trouble.

Figure 1 - Source: BIS, IMF, OECD, McKinsey, IIF; Brazil, China, Czech Rep., Hungary, India,
Indonesia, Mexico, Poland, Russia, Saudi Arabia, South Africa, Thailand, Turkey.

The low or zero interest rate policies from the FED, ECB and even EM central banks have propelled this issuance, particularly in the EM non-financial corporate segment, even in countries where public debt issuance hasn’t also skyrocketed.

Of the $1.7 trillion EM in non-financial corporate debt raised since 2009 in  the international markets, about 30 percent ($510 billion) was in foreign currency, 80 percent of that ($430 billion) was in US dollars. The more reliant on external borrowing, the less stable a borrowing country’s financial situation becomes, and the more prone its firms are to downgrades or defaults as a result of external or internal weakening.

The report notes that higher foreign-currency risk exists in countries like Brazil, Mexico and Korea. In addition, a number of EM countries are holding cash reserves in domestic bank accounts from large percentages of proceeds raised offshore. They would be forced to withdraw from these funds to support currency weaknesses to service debt, which could increase the funding risk of EM banks.

What This All Means

This level of global inter-connected financial risk is hazardous in Mexico, where it’s peppered by high bank concentration risk. No one wants another major financial crisis. Yet, that’s where we are headed absent major reconstructions of the banking framework and the central bank policies that exude extreme power over global economies and markets, in the US, Mexico, and throughout the world.

Mexico’s problems could again ripple through Latin America where eroding confidence, volatility, and US dollar strength are already hurting economies and markets.

The difference is that now, in contrast to the 1980s and 1990s debt crises, loan and bond amounts have not just been extended by private banks, but subsidized by the Fed and the ECB.  The risk platform is elevated. The fall, for both Mexico and its trading partners like the US, likely much harder.