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"The Global Negative Feedback Loop" - Why Investors Are Fleeing Capital Markets

The following comprehensive analysis of current market risks and concerns, represents one of the better summary assessments by both Brean Capital's Russ Certo as well as Bloomberg's market analysis team, of not only why there seems to be an increasingly more tangible sense of gloom covering global capital markets, but also why investors are increasingly withdrawing from risk, leaving central banks to duke it out among themselves.

Traders Pull ‘Singed Fingertips’ From Markets as Risks Escalate

Investors are fleeing and volumes are falling due to extreme valuations amid global uncertainties related to monetary policy and political decisions made in wake of the 2007-2009 financial crisis. It’s a flight that’s creating a negative feedback loop.

  • "First it’s China, then Japan, then the ECB. When you singe the fingertips of speculators, they don’t like to play anymore," says Brean Capital managing director Russ Certo
  • Major banks worldwide are paring trading operations as part of a push to cut costs amid rising regulatory requirements
    • Investors "are stewards of other people’s money and they don’t want to allocate capital to a pyramid scheme": Certo
  • Speculators in China have retreated as fast as they advanced as trading volumes across nation’s three biggest exchanges are now less than half of what they were at April 22 peak
  • Volume of shares changing hands on FTSE 100 Index -21% since Feb.; total volume on U.S. stock exchanges 7.1m May 12 vs 12.5m Jan. 20
  • CME Group’s recent monthly trading volume shows m/m declines across interest rate, FX, equity futures and options
    • FX futures -6.2% y/y, ~699k contracts/day, -16.2% m/m; FX options -22.5% y/y, ~70k contracts/day, -7.7% m/m
    • Rate futures +8.3% y/y, 4.2m contracts/day, -14.2% m/m; options +6.3% y/y, 1.33m contracts/day, -11% m/m
    • Equity index futures +31%, ~2.15m contracts/day, -16.5% m/m; equity index options +20.9% y/y, ~544k contracts/day, +0.5% m/m

POLICY RISKS

  • Primary risk is that global financial markets are more vulnerable to policy shocks as many assets are reaching extreme valuations; stock indexes near all-time highs and sovereign bond yields near record lows
  • Market participants are losing confidence, especially during unexpected central bank decisions like when the BOJ failed to expand monetary stimulus April 27
  • Fed: Risk Fed convinces markets it will hike in face of fragile global economic environment or hikes before market prices move; first development would increasingly weigh on risk assets, while second would create a negative shock
  • ECB: Risk QE program continue to be ineffective as O/N current account holdings, excess liquidity are near record highs
  • BOJ: Risk BOJ loses control of an appreciating JPY, still unable to generate growth or inflation and burdened with Abe’s fiscal policies that continue to be ineffective
  • Ongoing risk Basel III, sovereign regulatory rules continue forcing commercial banks to hold more high quality liquid assets (HQLA), exacerbating global liquidity shortage

POLITICAL RISK

  • Brexit
  • Uncertainty overshadowing Brexit’s impact on markets, GBP or economic policy; Treasury analysis of short-term Brexit impact will be published this month
    • Average of half of respondents in Belgium, France, Germany, Hungary, Italy, Poland, Spain and Sweden believe their own country should hold a referendum on staying in the EU, according to a poll by Ipsos Mori published May 9
    • ICM poll shows 40% of Britons would vote to remain in EU, 41% to leave; last week’s poll showed 44% stay, 45% leave
    • GBP pricing out Brexit risks may be premature; some analysts say the pound’s gain reflects greater certainty the electorate will back the “Remain” camp, though others warn this may reflect a misreading of recent opinion polls
    • Core CEE may be most vulnerable to Brexit risk as Poland largest net recipient of EU funds while U.K. 3rd largest net contributor

EUROPEAN UNION

  • Rising risk EU nations are unable to stem the flow of migrants creating rising nationalistic fervor and domestic civil strife
  • Increased risk European peripheral finances become problematic amid increasing political uncertainty, rising nonperforming loans and slowing economic growth
  • Italy: Fails to meet its debt-reduction goal, economy growing less than govt estimates; bank asset quality continues to deteriorate and Atlante fund proves to be ineffective, fund size EU4.25b, gross NPLs EU360b end-2015
  • Greece: Risk Greeks prove unable to meet terms of debt relief agreement, forces another series of renegotiations
  • Spain: Risk June 26 election creates another stalemate; also risk an anti-establishment coalition is created, unseats Prime Minister Rajoy

CHINA

  • Risk China may allow a harder landing than expected; China’s Communist Party mouthpiece, the People’s Daily, said China should put deleveraging ahead of short-term economic growth
    • China may lose control of deleveraging, which would increase risks of increased financial market volatility and/or economic hard landing
    • China may either lose control of capital outflows or be forced to allow CNY to depreciate more quickly; imports from Hong Kong surged 204%, indicated significant capital outflows
    • Risk China FX reserve selling continues; reserves rose $11b to $3.316t, though most may have been related to valuation changes to drop of USD
    • Intensity of futures trading on Chinese commodities exchanges is making some of the world’s most liquid markets look leisurely; iron ore in free fall as trading frenzy ebbs
    • Chinese companies in metals and mining or coal operations industries must repay 239.6b yuan ($36.9b) of notes in the three months through June, the biggest quarterly amount on record, according to data compiled by Bloomberg

OIL

  • Low prices may further pressure U.S. oil firms and cause more defaults that cascade into credit problems for smaller banks, private equity firms/hedge funds; this raises potential for downward pressure on other assets sold to cover losses
  • OPEC may fail to revive limits on crude output at its June meeting after the failure of talks to freeze production last month, resulting in renewed oil price weakness
    • New Saudi boss seen chasing record output to defend market share vs higher-cost shale
    • Oil price decline may force Saudis to continue selling reserves to protect FX peg, which increases speculation that the peg may fail; reserve assets are $587b from $745b in Aug. 2014
    • Russian economy, which is already enduring the longest recession in two decades, may come under more protracted stress, as oil represents the country’s chief export earner
  • EM sovereigns may face increasing pressure as public energy companies have been some of the most profligate borrowers

UNITED STATES

  • Political uncertainties aside, there’s risk that U.S. growth may slow further, causing risk asset prices to fall, which would then transmit back to more economic weakness and create downward spiral
    • With more than two-thirds of S&P 500 companies having reported earnings this season, outcome has failed to suggest a speedy recovery from what’s shaping up to be a fourth straight quarterly decline
    • S&P 500 reported earnings share through May 6 shows 1Q earnings down 7.9%; companies have churned out more than $2t of share repurchases since 2009, though grew less than 4% in 2015
    • There have been 40 corporate defaults in the U.S. as of end-April, fastest pace since 2009; there have been 53 global defaults this year vs 67 in 2009
    • Puerto Rico Governor Padilla warned bond investors face a cascade of defaults starting in July unless Congress passes legislation; concurrent concern is municipal funds like Oppenheimer that allocated 43% of its Maryland portfolio to Puerto Rican securities