Who’s Had the Worst Week Ever? Pretty Much Everybody.

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.