Tyndall Monthly Commentary
Not Just the Fall of a Tall Poppy - JP Morgan and the Fall of the BRICs
Tuesday, June 5th 2012, 9:46AM
by Andrew Hunt
Last Friday we took the red-eye back from New York following some meetings with quite senior staff at some of the "Masters of the Universe" institutions and on landing we found that we had been volunteered by our domestic management to man a stall at the school fair.... To pass the time and keep awake we found ourselves flicking through a tatty copy of Tom Wolfe's Bonfire Of The Vanities, which, following our trip and the situation that we had uncovered following the JP Morgan (JPM) trading debacle, seemed oddly appropriate, if not a little concerning.
Without going into the details of JPM's travails, we believe that following what started as a rational, well-advised and probably notionally very profitable hedge on corporate risk in the Euro crisis became rather too large and as a seemly exit from the position became impossible, an offsetting hedge (that is, selling insurance on US corporate default risk) was concocted but, partly as a result of the mathematics of the derivatives, this too became an overly large position that now also cannot easily be reduced. Unfortunately for JPM, the markets now all know the sizes and compositions and hence are proving adept at trading against the company and thereby creating if not the prospect of an open-ended loss, at least the prospect of a very large one.
It is not, however, the reaction of the press to the JPM incident that is significant here. Instead, it is the attitude of the Federal Reserve's regulators to the event. As we understand it, from the official side it is not just the SEC that has become involved in investigating the incident but also the Federal Deposit Insurance Corporation and, most of all, the supervisory departments of the Federal Reserve, who are now moving through JPM's and the other banks' systems with a fine-toothed comb. Moreover, when we have asked industry insiders as to whether this type of reaction by the authorities matters to JPM or to others in the industry, we have found that the response has been rapid and at times even bordering on emotional: the JPM trading losses and most of all the authorities' natural reaction to them have already unleashed a process that is likely to curtail not only JPM's activities in the securities markets but also those of others for a significant period of time.
We have over recent months been at pains to point out that there probably were now only half a dozen really significant "players" left in terms of the all-important credit creation within the financial markets. As of today, JPM may have been sent to the "sin bin", Deutsche is presumably preoccupied with events within Europe, UBS is not as active as it was, Mizuho has been active but the recent performance of Japanese bank shares and rumours that the bank has already achieved its foreign asset quota for the year make us wonder whether they are also now withdrawing and we are not really sure how active State Street have been. In practice, this may only leave HSBC in the game (and their board does now have more a trading/markets bias in terms of its composition) but even this bank may now be experiencing some fallout from China's economic problems and therefore be in a less strong position to continue the leverage game that has been so important to determining asset prices over the last 18 months or so.
Amongst our list of key players, it was always HSBC and JPM that were the standout principal players and hence what has happened at JPM must be significant to the leverage process in markets even if it does not lead the other players to become more cautious in their own dealings (although once again, sources are already suggesting a higher level of risk aversion across the industry that may be unrelated to events in Euroland).
Consequently, Jamie Dimon's fall from grace and the reaction of both the press and most of all the regulators may be closing down the primary transmission mechanism from the central banks' notionally easy monetary policies to the financial markets and the albeit narrow part of the real economies that these affected. Consequently, the potential impact of this event on the global financial system and on asset prices should not be underestimated, particularly within the Emerging Markets and the now capital-hungry BRIC economies.
As long-standing bears on China's current rate of growth, who already believed that the economy had experienced a hard landing, we were not surprised by the latest very soft tone of much of China's recent economic data. For us, the standout data with regard to China, though, has been the speed with which other countries have experienced a sharp drop in exports to the PRC. Although economists may still be debating (pointlessly in our view) whether China will or will not suffer a hard landing, the simple fact is that those countries that export to China are already reporting deep recessionary levels of activity. The rest of the world has already experienced a Chinese hard landing in terms of their ability to export to China and the fact that China's own data is now beginning to confirm this fact is interesting but it is not new news.
What has attracted our attention of late has not been the slowdown in China's economy but instead the recent equally worrying arrival of that enemy of financial markets called "stagflation" in both India and Brazil. It would therefore seem that all the BRICs are beginning to suffer a degree of economic weakness that must impact not only their own markets but also the financial systems of those countries, such as Australia, that had become heavily linked with the whole BRIC growth theme.
Specifically, the problem for India and Brazil can be summarised easily in a rather politically incorrect phrase that we adopted in the mid-1990s to describe Asia's pre-crisis economic situation: they had become "capital dependant economies". Prior to the GFC and then in the Quantitative Easing phases of 2009-2011, these countries apparently benefited from what were unprecedented levels of capital inflows from theme-hungry Western investors and it was not long before these countries became overly accustomed to these flows. In fact, the Brazilian and Indian banks became so adept at recycling foreign inflows to the local currencies into extreme rates of bank credit growth that the private sectors of these countries became equally accustomed to the easy credit conditions, with the result that they then started to spend significantly more of their incomes and to save less, since they apparently no longer faced a budget constraint.
Similarly, within the public sectors, budget deficit reduction plans fell by the wayside as credit conditions eased and, particularly in India's case, the deficit started to expand as the funding constraint previously implied by the finite pool of domestic savings supply was lifted.
Therefore, although India was gaining income streams from outsourcing and Brazil enjoying a massive terms of trade improvement on the back of higher commodity prices, the national savings rates of these economies all but collapsed during the capital-inflows-initiated boom, as their domestic economies over-absorbed goods and services while under the intoxicating effects of the seemingly endless capital inflows. This excessive expenditure might well have caused inflation to rise but as it transpired the currencies appreciated under the impact of the capital inflows, with the result that import prices were held down and inflation rates became the dogs that did not bark as the capital inflows dependency cycle took hold. As the savings rates fell and imports surged, though, the countries began to experience large current account deficits in their trade accounts, despite their enhanced export performances. Hence, they became dependent on the continued capital inflows.
The analogy noted above may be distasteful to some but it is accurate and in our view the whole cycle was simply a redux of Asia's capital-inflows-driven 1990s economic cycle, albeit with rather larger economies and absolute sums. Soaring capital inflows initially lifted the currencies and provided for a boom in credit that made the economies appear to be the new wealthy but these cycles have a nasty habit of both creating a dependency and of reversing rapidly when capital inflows retreat and currencies fall, as Asia discovered spectacularly in 1997.
Today, Brazil is facing the mounting prospect of a significant terms of trade shock that will in all probability widen its current account deficit automatically to around 3-4% of GDP in what is now quite a large economy. India's service sector earnings meanwhile seem to be topping out in the weaker global economy and hence in both cases the masks that helped hide some of the extravagant behaviour are beginning to slip away and hence reveal just how great the capital inflow dependency has become. Unfortunately, despite these problems, the governments still seem to be in denial. India's fiscal authorities seem to have completely dropped the ball and Brazil's central bank recently reduced interest rates so as to prevent the private sector savings rate from rising once again.
By becoming addicted to high levels of capital inflow, India and Brazil have in effect made themselves warrants on global capital market and credit conditions and, while the perceived "cheapness of markets" relative to safe havens may allow them some respite in the very near term, as the chart above shows their domestic credit conditions and hence their effective purchasing power are now merely endogenous high beta plays on global credit conditions, which are slowly but surely trending down, in part due to recent events at JPM. We therefore expect further 5-10% falls in these countries' currencies this year and for rising inflation to threaten current policy settings.
The BRICs may well prosper eventually but at present they, and implicitly their suppliers such as those in Australasia, are simply warrants on what are now declining global credit conditions as a result of events half way around the world in a small office situated only a few yards behind the Bank of England's headquarters in London.
International Economist, London
New Global Fixed Interest Manager
Tyndall is pleased to announce the appointment of Goldman Sachs Asset Management (GSAM) to manage its global fixed income assets. Tyndall's global fixed income portfolio was established in March 2002 and has grown to approximately NZ$160 million.
Established in 1988, GSAM is one of the world's leading asset managers with US$702 billion in assets under management. GSAM's Global Fixed Income Team manages US$306 billion of global fixed income assets and has a breadth of investment management expertise with over 200 investment professionals. The globally integrated team has independent strategy teams capturing value across top down (duration, cross sector and country) and bottom up (investment grade credit, high yield, MBS/ABS, government/agency and emerging market debt) strategies.
Andrew Hunt International Economist London
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