For most Americans, last week was
probably a pretty normal week. For those
of us who work in the financial markets, however, last week was something of a
nightmare. For the
past several years – since the Financial Crisis at least – the global financial
system has been tepidly moving forward despite a growing number of economic
concerns around the globe. Last week,
each one of those global concerns flared up into mini-crises that individually
would cause concern, but in concert should cause alarm. In this post, we're going to run through the top five events.
5. Turmoil in Emerging Market Economies:
Last week was a historically bad week for “Emerging Market” economies. In particular, rising inflation in Brazil led
to the largest displays of civil unrest in the country’s history. Throughout Brazil, approximately one million
citizens took to the streets to protest the government’s mismanagement of the
Brazilian economy. In India, the local
currency (the Rupee) has lost 10% of its value against the US Dollar in the
past two months, which is driving up the price of imported gold and oil and
fanning already hot inflation numbers. In
South Africa there was a combination of both, as its local currency (the Rand) has
seen an 11% drop in its value against the USD and widespread work stoppages
have continued to plague South Africa’s mining entities who are already
struggling with falling commodity prices.
4. European Sovereign Debt: Much
to Germany’s chagrin, both Cyprus and Greece – those cradles of early European
civilization – retook their place as ground zero for the EuroDebt Crisis. It has become clear that Greece is heading
towards a third default in as many years and last week brought the news that
the IMF would pull its loan package unless the other European nations
(pronounced “Germany”) kicked in an additional $3 billion of aid. At the same time, the Cypriot president published
a letter requesting to rewrite the terms of a bailout his party agreed to less
than two months ago. Any unwillingness on
the part of the Germans to support additional bailouts could put either or both
countries on a final course for leaving the Euro. As these two relatively small nations move
towards an exit, focus has returned to the other ailing EU states: Spain,
Portugal and Italy. Interest rates on
Spanish 10 year bonds crossed five percent for the first time in almost a year,
a rate that could threaten the sustainability of the country’s current debt
burden.
3. Japan’s Great Abenomics
Experiment: Over the past six months, Japan’s Prime Minister Shinzo Abe
(pronounced “ah-bay”), has embarked on an aggressive economic campaign dubbed “Abenomics.” Abenomics intends to produce inflation by converting
a large amount of Japan’s enormous government debt into newly printed Yen in
the hopes that it will spur Japan’s savers to start spending money in the
economy. The new policy has met with
some inconclusive results, but has greatly increased the volatility in what
has, for the last ten years, been a relatively stable market. In particular, recent efforts to reform some
of Japan’s more rigid employment practices have failed to gain traction in
parliament. As a result, the combination
of a rapidly aging population, a growing energy import bill due to the shutdown
of domestic nuclear power after the 2011 Tsunami, and troubling signs in China are
continuing to raise concerns about Abe’s ability to ultimately slow the
creation of new money and protect the Yen from massive inflation without any
commensurate economic growth.
2. Financial Turmoil in China:
Since 2008, nearly all of the world’s economic growth has stemmed from China. More specifically, it has stemmed from China’s
massive government stimulus program, which has brought about the largest period
of credit expansion the world has ever seen.
As the US learned in the run-up to the Sub-Prime Crisis, rapid expansion
of credit is not always a perfect recipe for sustainable economic growth; and
now China seems to be learning that lesson firsthand and on a larger scale. This past week brought rumors (verifiable
facts are scarce in China) that multiple Chinese banks had defaulted on short-term
loans, which sent interest rates spiraling to over 25% - up from just 3% a month
previously. The panic stems from – stop me
when this sounds familiar – the recent outgrowth within Chinese banks of
investment products called “Wealth Management Products” or WMPs. These WMPs function very much like short-term
certificates of deposit, except that they invest in high risk real estate ventures,
often backed by notoriously corrupt local Chinese governments. It now appears that some – maybe most – of these
WMPs were backing investment projects that carried far more risk than was
initially advertised. As a result, every
time a WMP matures – roughly every 90 days – the bank is unable to repay
investors with cash generated by the underlying investment and, instead, is
forced to pay existing investors by…issuing more WMPs! Most Americans might recognize this
investment strategy as the old teaser-rate adjustable rate mortgage, where homeowners
would take out mortgages they could not afford under the assumption that they
would refinance before rates re-set to normal levels. Or maybe you’d recognize it from Bernie
Madoff’s criminal trial. In either case,
these WMPs have grown from a sleepy backwater in 2008, when there was just
$300B worth of WMPs outstanding, to a major financial problem in 2013, when
there are now over $2 TRILLION of WMPs outstanding. This relatively new revelation, coupled with
continued weakness in Chinese growth numbers, has threatened to bring the world’s
economic engine to a grinding halt.
1. The Almighty Dollar: Last but never least we have the recent
activities of Ben Bernanke and the US Federal Reserve System. For the past two years, the Fed has embarked
on a novel policy of “quantitative easing,” which essentially means that the
Fed purchases long-term US Treasury debt at above market valuations in order to
push more cash into the financial system.
There is substantial debate about what economic effects, if any, that
this strategy produces; however, what is clear is that the global financial
markets had come to believe that quantitative easing was going to be around for
a long time – maybe forever. As a
result, investors, companies and banks rushed to issue large amounts of dollar
denominated debt with the expectation that they would easily be able to repay
the debt with newly printed dollars in the future. This investment thesis makes sense so long as
the supply of new dollars continues to be large and persistent. Last week, however, the Fed announced that it
would likely begin slowing quantitative easing by the end of this year and
halting altogether by the middle of 2014.
That announcement sent shock waves through the dollar system, as many
investors awoke to the reality that they would have to repay their dollar obligations
with money generated from operating activities, rather than just new money
printed by the Fed. Suddenly, the large
amounts of new debt seemed imminently more daunting and the prospect of holding
cash imminently more attractive. For
now, this cash hoarding activity has mostly hurt emerging markets, who have
seen massive outflows of capital as American investors begin exchanging their
foreign currencies for dollars. But the
damage is also seeping into riskier and longer term American assets: high yield
debt (“junk bonds”) have seen spreads widen this week and mortgage rates have
backed up to almost 4.5%. The rapidity
with which these rates have moved indicates how fragile the system currently is,
and it might just be waiting for the right trigger to send everyone scrambling
for cash and setting off another financial panic. The fact that this is happening at the same
time as all the previously outlined global events makes for a very perilous
situation.
So, what does this all mean for student loan borrowers? More than anything else it means don't underestimate the value of cash savings. We're going to continue to monitor these developments to see if there will be an imminent spike in the demand for dollars, but in the meantime we would encourage borrowers to think twice before using their free cash to prepay their outstanding loans.
