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Jahangir Hajiyev, former chairman of the International Bank of Azerbaijan, used a tangled web of shell companies to move millions out of the bank. Now, decades after his scheme began, the astounding details of his brazen fraud are starting to come to light.

On a salary of just $70,650 in 2008, Hajiyev had amassed himself “four mansions in the English countryside, a $42.5 million Gulfstream jet, a $13 million golf club outside London and a villa in Sardinia,” according to Bloomberg. His wife dropped $20 million on diamonds and designer handbags as he borrowed, in addition to looting the bank, to support his lifestyle. 

It was in 2015 when reality started to hit. The directors of Hajiyev’s company, Lumea 2014 PTC, set up to control his assets, realized that creditors were circling while its cash balances were dwindling. 

On his board were two attorneys with Dentons, the world’s biggest law firm. One of those directors advised the others in 2015 that Hajiyev was “in the middle of reorganizing his personal wealth and finances, which has restricted cash flows” and that the process “should be completed within the next 60 days, when liquidity issues should be resolved.”

Three months later, he was charged in his home country with raiding the bank he ran since 2001 and was sentenced to 15 years in prison. 

His fortune was at one point believed to be more than $100 million – and he did it all using two dozen shell companies. One of them, a family office called Werner Capital, helped move Hajiyev’s money into expensive British real estate. The firm was led by a former HSBC private banker named Tomas Mateos Werner and it wasn’t registered with the U.K.’s Financial Conduct Authority. Dentons lawyer Francois Chateau and Philip Enoch, a consultant for the firm’s U.K. branch, also played big roles in advising Hajiyev.

Hajiyev’s ties to his advisers go back to 2005, when he paid $5 million for a villa in Costa Smeralda in Sardinia. He bought the property through an Italian shell company, Rufus S.R.L., where his daughter, Leyla Mahmudova, is listed as an administrator. Rufus was owned by a Luxembourg company named Tiara S.A. Khagani Bashirov is listed as Tiara’s administrator.

Bashirov was also listed as director of the Sardinian winery that was purchased in 2014 and director of the U.K. company that owned Hajiyev’s private jet. The 59 year old Bashirov holds a French passport, lives in Luxembourg and has offices in London. He had been arrested in Azerbaijan in 2010 for failing to repay $109 million in loans from International Bank of Azerbaijan. He was released 5 days later. 

Bashirov is linked to company that have moved tens of millions out of Azerbaijan. Some of the companies have been traced by the Organized Crime and Corruption Reporting Project to the Azeri Laundromat, an alleged $2.9 billion money-laundering scheme.

63 year old Chateau joined Dentons in 2013 and Lumea was set up in May 2014. Lumea minutes revealed that the directors, during 2014 to 2016, were busy “developing and flipping mansions in two of the world’s most exclusive luxury-housing estates”.

Duncan Hames, director of policy at Transparency International UK said: “Business is supposed to provide a first line of defense against money laundering, and yet time and time again we see firms facilitating it instead. Faced with suspicious activity, senior partners in a global law firm should not be disregarding red flags and continuing to offer services.”

“We are committed to strict compliance with all laws, regulations and professional standards of the jurisdictions in which we operate, which includes compliance with anti-money-laundering policies and standards,” a spokeswoman for Dentons said. 

By 2016, Lumea was focused on selling assets to try and raise cash:

By February 2016, the mood among Lumea’s directors had darkened. Bankers at EFG were running out of patience, the minutes show. Unpaid bills and stalled building projects meant that its 13 million pounds in loans were in jeopardy. Three days before that month’s meeting the Swiss bank had directed Lumea to sell one of Hajiyev’s mansions, Robin Hill, to one of its own clients for 4.5 million pounds — 2 million pounds less than the purchase price. But that wasn’t enough. EFG was also demanding that all creditors be paid and 1 million pounds be placed on secured deposit with the bank.

British authorities obtained court orders in 2018 freezing some of Hajiyev’s wealth in an attempt to stop the estimated 100 billion pounds in “dirty money” that makes its way to Britain every year. 

Andrew Mitchell, a Conservative MP and former minister, said: “Money launderers are always one step ahead of us. If the enablers don’t take their responsibilities seriously, then we should throw the book at them.”

And with the recent pullbacks in the market, we wonder if we’re going to be hearing any similar stories anytime soon.

It was just a matter of time before the ongoing financial and economic crisis spawned by the coronavirus pandemic morphed into a political intervention to save capital markets from evil short sellers, and sure enough, one day after Italy botched a quarantine of over 15 million people, effectively locking out all of Northern Italy while threatening any quarantine violators with up to 3 months in prison, moments ago Italy’s former co-Prime Minister and current MP, Mattel Salvini, called for a short selling ban.

🔴 In vista della riapertura domani dei mercati finanziari chiedo siano vietate le operazioni di vendita “allo scoperto” anche con l’uso di strumenti derivati. (1/3)

— Matteo Salvini (@matteosalvinimi) March 8, 2020

Non è tollerabile che qualcuno approfitti di un’emergenza nazionale speculando a danno dei risparmi degli Italiani. Confido che la Consob reprima ogni tipo di abuso con la massima severità. (3/3)

— Matteo Salvini (@matteosalvinimi) March 8, 2020

Translated:

In view of the reopening of the financial markets tomorrow, I ask that the “short” sale of transactions be prohibited even with the use of derivatives.

In situations such as these sometimes very few earn huge sums to the detriment of everyone, we remember for example the case of Soros in 1992 who built his fortune with downward speculation against Italy.

It is not tolerable for someone to take advantage of a national emergency by speculating to the detriment of the savings of the Italians. I am confident that Consob will pursue all abuses with the utmost severity.

So when does a lightbulb go over Donald Trump’s head, and he instructs Steven Mnuchin to do the same.

Authored by Michael Wilson, Morgan Stanley chief equity strategist

Almost two years ago, we published a report titled The Great Cycle Debate. In that report, I argued that US equities were likely to experience a cyclical bear market that would take several years to complete. This bear market would play out as a consolidation rather than a wipeout, affecting different stocks and sectors at different times. I later called it a rolling bear market that would leave both bears and bulls unsatisfied.

I always viewed last year’s 4Q rally as more about liquidity than fundamentals and thought it could last into April/May when the Fed was scheduled to curtail its latest balance sheet expansion program.  However, the unexpected COVID-19 outbreak has brought that timing forward, and the recent correction in equity markets makes the entire rally since last October look like a false breakout.

Such technical patterns are troubling because they highlight capital that came in late at bad prices, creating overhead resistance around 3100 on the S&P 500. If that signal is right, it suggests that the original consolidation/rolling bear market has unfinished business.

Most investors, economists and market strategists believe the unfortunate outbreak of COVID-19 is a temporary shock to the economy that won’t persist much beyond the first half of this year. There’s also an expectation that a 2H20 snapback will be aided by fiscal and monetary stimulus, which is already taking place. I would concur.

However, I also believe it may be a mistake to look at the coronavirus in isolation when thinking about the potential damage to the economy and risks to the equity market. COVID-19 is the fourth economic shock in the last two years:

• Fiscal stimulus that led to cost issues and margin pressure for US companies, resulting in an ongoing US earnings recession, especially for small-/mid-caps.
• The Fed’s aggressive monetary tightening cycle in 2017-18, which worked with a two-year lag.
• Tariffs – the Phase 1 deal was a de-escalation but left existing tariffs in place, along with uncertainty.
• The coronavirus – a direct hit to the US consumer, the linchpin of the economy.

In other words, growth concerns are about the cumulative effect of all four shocks and whether COVID-19 finally pushes the US economy into a recession, which has always been defined as one thing only – a cycle of layoffs and rising unemployment.

Obviously, that cycle of layoffs and unemployment hasn’t happened yet, but the ongoing margin pressures and the uncertainty surrounding trade policy, the US election and now COVID-19 increase the risks significantly, particularly given the fragility of the global economic recovery and weakened corporate cash flows and confidence in the US. It’s also concerning that the US$8.8 trillion global travel and leisure industry, hit the hardest by the outbreak, supports close to 10% of all jobs in the global economy.

One of the main reasons I remained more cautious about the recovery in 2020 is that I viewed the economy as later cycle than most, with these other headwinds potentially exacerbating any further disappointment. To me, this explains the markets’ strong reaction to COVID-19, which most economists and strategists still view as a temporary shock. Nowhere has the reaction been more dramatic than in the US Treasury market, which has moved in ways rarely seen outside of an actual recession. The same holds true for our US equity cyclical/defensive ratio, commodity prices and other economically sensitive assets.

The Fed is paying attention and took aggressive action last week. However, emergency intra-meeting Fed cuts historically have not been constructive for equity markets over the following 6-12 months after initial 1-3-month rallies (Exhibit 1). Of the eight intra-meeting cuts, seven either preceded a recession by a few months or accompanied one.

The only exception was the successful mid-cycle insurance cut in October 1998, but last week’s move essentially confirms that last summer’s cuts weren’t insurance at all but the start of a full-blown easing cycle. We would argue that the recent cut resembles the January 2001 episode in terms of where we are in the economic cycle and other parallels with today’s markets, most notably an extraordinary concentration of market cap in technology stocks.

Bottom line, I always thought the cyclical bear market that began in 2018 had unfinished business once the liquidity surge ended. COVID-19 provided the spark for its completion, which means pricing in a greater likelihood of US recession. We believe equity markets will struggle until policy-makers get back ahead of the curve with more interest rate cuts and an extension of the current balance sheet expansion and/or an official quantitative easing program – something we think is likely coming.

We still see another 10% downside for US equities from current levels, which is slightly worse than our year-end 2750 bear case S&P 500 target. The downside is likely greater for the NASDAQ, which has priced in less recession risk than other indices and is still very crowded. Credit also still looks vulnerable relative to other economically sensitive assets. The good news is that once this correction is complete, the consolidation/rolling bear market should be over and the next leg of the secular bull market can begin in earnest.

President Trump’s re-election campaign has sued CNN over “false and defamatory” statements about seeking Russia’s help to win the 2020 election, according to Fox News.

“The complaint alleges CNN was aware of the falsity at the time it published them but did so for the intentional purpose of hurting the campaign while misleading its own readers in the process… the campaign filed this lawsuit against CNN and the preceding suits against The New York Times and The Washington Post to hold the publishers accountable for their reckless false reporting and also to establish the truth,” Senior Legal Adviser to Donald J. Trump for President, Inc. Jenna Ellis told Fox.

The complaint, filed in the US District Court for the Northern District of Georgia where CNN is located, claims that CNN said Trump’s campaign “assessed the potential risks and benefits of again seeking Russia’s help in 2020 and has decided to leave that option on the table.”

The complaint said that CNN was well aware the statements were false “because there was an extensive record of statements from the Campaign and the administration expressly disavowing any intention to seek Russian assistance” but promoted the claim anyway.

The complaint said that Trump’s legal team sent CNN a request to retract and apologize last month but CNN executives refused. The Trump campaign now seeks “millions of dollars” through litigation. –Fox News

“The Campaign therefore was left with no alternative but to file this lawsuit to: publicly establish the truth, properly inform CNN’s readers and audience (and the rest of the world) of the true facts, and seek appropriate remedies for the harm caused by CNN’s false reporting and failure to retract and apologize for it,” reads the complaint.

The article referenced by the lawsuit was written by Larry Noble and published by CNN on June 13, 2019, titled “Soliciting dirt on your opponents from a foreign government is a crime. Mueller should have charged Trump campaign officials with it.” It states that Trump’s campaign “assessed the potential risks and benefits of again seeking Russia’s help in 2020 and has decided to leave that option on the table.”

According to the complaint, “The Defamatory Article claims, among other things, that the Campaign ‘assessed the potential risks and benefits of again seeking Russia’s help in 2020 and has decided to leave that option on the table,” adding “The Defamatory Article does not cite to any facts or reasoning in support of this claim. The Defamatory Article is false.”

The complaint notes that the Trump campaign “has repeatedly and openly disclaimed any intention to seek Russian involvement in the 2020 election” and “examples of this are too numerous to fully enumerate.”

Trump recently filed similar lawsuits against The New York Times and Washington Post. –Fox News

“False statements are not protected under the U.S. Constitution; therefore, these suits will have no chilling effect on freedom of the press. If journalists are more accurate in their statements and reporting, that would be a positive development, but not why these suits were filed,” said Ellis.

The lawsuit adds that “Noble has written numerous articles accusing the President of criminal activity, and of campaign finance and ethics violations, and has lodged a complaint against a Super-PAC which supports the President,” adding “CNN clearly had a malicious motive in publishing the Defamatory Article, and acted with reckless disregard for the truth.“

When we discussed Saudi Arabia’s shocking decision on Saturday to reverse on years of prudent oil policy following Friday’s stunning collapse of OPEC+, with the kingdom now set to obliterate the OPEC cartel by flooding the market with heavily discounted oil in hopes of sending its price plunging, crippling competitors (such as US shale producers) and capturing market share (a repeat of what Saudi Arabia unsucessfully attempted back in Nov 2014), we made the following assessment on what the Saudi decision could to the price of oil once oil resumed on Sunday:

According to preliminary estimates, with Brent trading at $45, a flood of Saudi supply as demand is in freefall, could send oil into the $20s if not teens, in a shock move lower as speculators puke on long positions in what Goldman calls periodically a “negative convexity” event…. Oil traders are looking to historical charts for an indication of how low prices could go. One potential target is $27.10 a barrel, reached in 2016 during the last price war. But some believe the market could go even lower.

… those wondering what is the worst case scenario for oil prices, consider that Brent traded at an all time low of $9.55 a barrel in December 1998, during one of the rare price wars that Saudi Arabia has launched over the last 40 years… similar to just now.

In retrospect, one difference between the oil supply shock of 1998 and now, is that back then there was no concurrent demand shock. Instead, to find the last combo of both a positive oil supply shock and a massive negative demand shock, one would have to go to the depths of the Great Depression as Rapidian Energy notes in a WSJ article:

It’s the very rare combo of a massive negative #oil demand shock, positive supply shock & no swing producer that makes #crude ‘s looming price implosion as historic as deep. Last time this terrible trifecta happened – 1930-1931. @RapidanEnergy https://t.co/yNMBr0WAui pic.twitter.com/RVrNDEszRE

— Bob McNally (@Bob_McNally) March 8, 2020

This suggests that the worst case scenario is potentially even more dire than that observed in 1998. Furthermore, considering the high number of Brent net specs, there is the potential for an even more violent puke as countless speculators are stopped out of margined underwater positions.

Of course, we will know for sure what happens in just a few hours when Brent reopens but first, moments ago Goldman’s commodities team just blasted out a note titled “The Revenge of the New Oil Order”, which has some very bad news for oil longs: Goldman now sees Q2 and Q3 2020 Brent prices plunging to $30/bbl from its previous forecast of $47/$53 for Q2/Q3,  “with possible dips in prices to operational stress levels and well-head cash costs near $20/bbl.”

In short (as we also said on Saturday): there will be blood… perhaps literally.

Below are the highlights from the Goldman note which, if correct, would spell the apocalypse for the US shale sector and potentially result in millions of unemployed shale workers in the coming months coupled with a catastrophic selloff in junk bonds, because as Vital Knowledge’s Adam Criasfuli writes, “energy is the ‘FANG’ of high-yield, accounting for >10% of the entire market, the extreme stress facing credit is shaking the foundations of the whole financial system.”

Here is Goldman’s summary:

We believe the OPEC and Russia oil price war unequivocally started this weekend when Saudi Arabia aggressively cut the relative price at which it sells its crude by the most in at least 20 years. This completely changes the outlook for the oil and gas markets, in our view, and brings back the playbook of the New Oil Order, with low cost producers increasing supply from their spare capacity to force higher cost producers to reduce output.

In fact, the prognosis for the oil market is even more dire than in November 2014, when such a price war last started, as it comes to a head with the significant collapse in oil demand due to the coronavirus. This is the equivalent of a 1Q09 demand shock amid a 2Q15 OPEC production surge for a likely 1Q16 price outcome. As a result, we are cutting our 2Q and 3Q20 Brent price forecasts to $30/bbl with possible dips in prices to operational stress levels and well-head cash costs near $20/bbl.

While we can’t rule out an OPEC+ deal in coming months, we also believe that this agreement was inherently imbalanced and its production cuts economically unfounded. As such, we base case for now that no such deal occurs, with any response only likely at sharply lower prices anyways. In fact, we expect this Revenge of the New Oil Order to be swifter than its first foray given the already distressed state of the shale industry, likely reducing the likelihood of another quick policy reversal.

And the details:

1. At its core, the decision from Russia to unwind the artificial price support that OPEC+ had created since 2016 is rational. As we argued previously, these cuts to defend prices instead of market share defied the economic incentive of large low-cost producers without pricing power, with Russia’s economy able to cope with lower oil prices. Since November 2016, OPEC and Russia production was cut by 4.4 mb/d while the rest of the world increased output by 5.7 mb/d. Media reports over the weekend relayed that Russia’s decision was indeed squarely targeted at the shale sector given its current financial distress but also at the US administration in response to recent US sanctions on its Nord Stream 2 gas pipeline and Rosneft.

2. Such a sanction motivation, Russia’s comment on Friday to continue cooperation within the OPEC+ charter, Saudi’s aggressive OSP retaliation and the stress that low oil prices would create on its economy (itself already on weaker footing than in 2014) all suggest that a reversal in coming months could be possible, bringing us back to our post-coronavirus price forecast. While we can’t rule out such an outcome, we also believe that the OPEC+ agreement was inherently imbalanced and its production cuts economically unfounded. The aggressive cut to Saudi’s OSPs and Russia’s reluctance to be pushed into a deal on Friday both also point to a low probability of an immediate agreement. As such, we base case that no such deal occurs in coming quarters, with any response only likely at sharply lower prices anyways.

3. The oil market is now faced with two highly uncertain bearish shocks with the clear outcome of a sharp price sell-off. While there is so much that we still don’t know about oil fundamentals in coming months, we also know very well from 2015-16 how such a rebalancing will take place. Our initial attempt to frame this supply vs. demand divergence points to a 2Q20 record large surplus of c. 2.9 mb/d. This reflects the “price war” scenario we laid out on Friday, with an 1.0 mb/d aggressive ramp-up in core-OPEC and Russia output through 2Q, similar to what occurred in both 2014 and 2016 (and consistent with news reports that Saudi Arabia is already looking to lift April production well above 10 mb/d). On our quantitative pricing model, this would point to Brent prices averaging $30/bbl in the quarter with clear risks that prices at times overshoot to the downside.

4. Such price levels will start creating acute financial stress and declining production  from shale as well as other high cost producers. Specifically, we assume legacy production decline rates outside of core-OPEC, Russia and shale increase by 3% to 5% to return to their 2016 highs. In the case of shale, we assume a negligible response in 2Q but with production falling sequentially in 3Q by 75 kb/d and with declines increasing to 250 kb/d qoq in 4Q20. This will not, however, prevent a 3Q20 surplus of 1.2 mb/d and inventories peaking above their 2016 highs and Brent spot prices staying at $30/bbl on average. In fact the negative feedback loop of lower oil prices on energy exporting economies could exacerbate the decline in oil  demand. At that point, the fundamental rebalancing could require oil prices falling to operational stress levels for high cost producers with well-head cash costs near $20/bbl.

5. Assuming no change in production policy, we would expect a market deficit to start in 4Q20 and that would run down excess inventories through 2021, with the outlook for draws helping prices rebound that quarter to $40/bbl like they did in the spring of 2Q16. Our 2021 quarterly Brent price forecasts are now $45/bbl, $50/bbl, $55/bbl and $60/bbl with a long-dated price of $45/bbl Brent. This lower equilibrium reflects a lower marginal cost of production in coming years due to steady growth in core-OPEC and Russia production (from their spare capacity initially and new drilling subsequently). The significant level of spare and disrupted capacity (each more than 3 mb/d) as well as resilient non-OPEC growth above $60/bbl Brent were ultimately the reasons why we didn’t expect upstream under-investment to become bullish for oil prices for another few years. This Revenge of the New Oil Order, while bearish initially, will finally start the clock on such a binding under-investment, with a clearer line of sight on higher equilibrium prices in 2 to 4 years.

6. Reusing our template from 2015-16, we expect this fundamental rebalancing to occur in three phases: 1) the survival phase, with the capitulation of large producers in dropping investment; 2) the inflection phase where inventories peak and the least fit producers engage in significant capital restructuring, including shuttering of assets; and 3) eventually the regeneration phase of a new industry with stranded assets ultimately shuttered or optimized.

7. While phases 1 and 2 played out over more than a year last time around (Nov-14 to Apr-16) and phase 3 never happened, we expect a much faster rebalancing this time around as shale and high-cost oil producers were already facing sharply higher costs of capital over the past year due to persistently poor shareholder returns. For example, as of last Thursday before the collapse of the OPEC+ agreement, US HY Energy credit spreads were already above 1000 bps, a level they had last traded at in March 2016 when WTI prices were trading at $35/bbl. This faster rebalancing – which may in fact be even quicker than our first path given the ongoing coronavirus-led contraction – may itself be the catalyst for Russia to hold off on any output agreement until it is completed and may help explain why this market share battle is happening now. In particular, there is no longer a wave of long-cycle projects coming online, with the last of these projects starting in 2020. Illustrating this point, our new global 4Q20 supply forecast ends up being lower without a OPEC+ cut than our prior expectations which featured a 1 mb/d cut from 2Q20.

8. From a market perspective, we expect the price decline to play out in two steps. First, already started large inventory builds will lead to a sharp steepening of the forward curve into contango to cover the quickly rising costs of storing all these barrels. We therefore recommend closing the long Dec-20 vs. Dec-21 Brent timespread trade that we initiated on 3-Feb-20 but keeping the accompanying long Jun-19 $49/bbl Brent put position added on 14-Feb-10, with the portfolio so far performing positively. Second, reflecting the structural nature of this repricing, long-dated prices will also fall to the market’s new clearing marginal cost of production likely initially near $40/bbl for Brent. During the inflection phase when inventories are at their peak, we could see a flattening of the forward curve near the trough in prices, the typical sign of producer capitulation and distressed hedging. This inflection phase is also a period where we would expect price volatility to surge to potentially new highs. From there, the path to a rebalanced market will eventually lead to sustained backwardation.

9. From a crude differential perspective, we expect the initial sell-off to come alongside a sharp compression of the WTI-Brent differential to potentially near parity like experienced in Jan-16, reflecting the cheaper cost of storing crude in the US and the lack of buying of uncontracted US crude by foreign refiners facing both weak demand and cheap seaborne Middle East crudes. From a product market perspective, we expect highly volatile cracks given the diverging forces of collapsing demand and surging excess crude supply. After a likely rebound on the first days of the crude price collapse, cracks should retrace given the ongoing demand shock (especially since refiners respond to % margin incentives against a backdrop of lower crude prices). Once refiners cut run, we would then expect the crude surplus to prevail and help margins recover even if the demand recovery remains shallow.

10. The impact of this structural shift will of course be felt well beyond the oil market, with likely significant distress for energy exposed sovereigns and sectors. In particular, we don’t expect the gas market to be spared. If Russia is indeed responding to both the competition from shale and the US sanctions on its new EU gas pipeline, we would expect its gas exports to Europe to rise as well. Such risks of higher Russian flows just make an already unsustainable balance potentially worse. As a result, we now base-case that the oversupply in the EU gas market will require a shut-in of the US LNG exports, and ultimately a shut-in of Appalachia gas production. Admittedly, this is a less surprising outcome than for oil since the global gas market has been heading that way following the collapse in Chinese demand due to the coronavirus, a notable surge in US LNG exports in February and the impact of a very warm winter on heating-related gas demand.

11. With a collapse in shale oil drilling, we are however increasingly comfortable forecasting a tightening US gas market and rising Henry Hub prices in both 2021 and 2022, with new Appalachia and Haynesville drilling required to balance the US market. That is because even if Russia raised export levels in Europe, we would expect the global LNG market to still sequentially tighten from its 2019-20 oversupply (assuming normal winters ahead) and allow for steadily rising US LNG exports. Based on these views, we are cutting our 2Q and 3Q20 Henry Hub forecast to $1.50 and $1.75 but raising our 4Q20-1Q21 forecast to $3.00/mmBtu with our 2021 summer forecast now up to $2.75/mmBtu. Our 2Q-3Q20 TTF price forecast is now $2.10 and $2.40 with winter staying at $4.70/mmBtu. Our 2Q-3Q20 JKM price forecast is now $2.40 and $2.70 with winter staying at $5.80/mmBtu.

So now what? We’ll leave readers with our conclusion from yesterday, which now seems even more apropos:

With 10Y Breakevens driven almost entirely by the price of oil…

… once Brent craters on Monday to the mid-$30s or lower, the accompanying implosion in 10Y yields could make the record plunge in yields seen on Friday a dress rehearsal for what could be the biggest VaR shock of all time. And since QE will only send yields even lower, perhaps it’s time for the Fed to add oil futures to stocks among the expanded securities it plans on purchasing as part of QE-5 to avert the next deflationary crisis which may have just started.

Submitted by Guy Haselmann, Principal at FETI Group

Overview

Today’s global economic system is more intertwined than at any point in history. For the past 30 years in particular, globalization and the Theory of Comparative Advantage have been alive and well. Technological advancements and transportation improvements have truly ‘shrunk the world’, allowing more countries to participate and benefit from international trade.

The globalized world economy has become a vast network of complex supply chains, interconnectedness and co-dependence. The benefits have been wide-spread and done more to lift the human condition, and more people out of poverty, than any development in history. However, this increase in economic complexity has magnified global vulnerabilities, opening up the risk of rapid and large-scale failure and contagion: a period of anti-globalization. COVID-19 is the catalyst that is triggering a supply-side crisis; one that is further exacerbated by a simultaneous demand-side shock.

Consensus View

The consensus view seems to be that the COVID-19 will die out with warmer weather; after all this is what typically happens with the common flu. In terms of markets, most believe that governments and central banks will come to the rescue with proactive stimulus which will be exceptionally good for markets, because the economy is viewed to be on solid footing already.  The stimulus will come to be viewed as an over-reaction that merely serves to provide more economic fuel, particularly once the Coronavirus sputters away. This scenario is logical and possible, but not a view that I share.

US Coronavirus Response

The US has a relatively low number of confirmed cases, but it is in direct proportion to the low number people tested. There is a shortage of testing kits and slow distribution to provide more. This is likely intentional. Trump is on Twitter bragging about the low number of positive cases in the United States as being a result of his administration’s actions. There are reports that only a few thousand tests have even been conducted in the US. Even after the US ships millions of test kits the US can only test a few thousand per day.

Regardless, most should be in agreement that in the near term the virus will become more widespread with a deepening impact on normal societal behaviors. Music festivals, business conferences, schools and sporting events have already been impacted, closed or cancelled. In several cases companies have asked not essential staff to work from home. These actions should certainly help limit the spread.

Governments have a vested interest to limit panic, but should not do so by misinformation or limiting confirmed infections by inadequate testing. The Fed has tried to be proactive, but an interest rate drop of 50 basis points is basically ineffective, reactionary, and whiffs of panic.

In thinking about where markets are headed, for this note I am more focused on the supply and demand shocks currently in motion particularly against the backdrop of the state of our economy. An understanding of the path of financial markets in recent years will also be helpful to thinking about where they may go next.

A Globalized World

In a globalized world economy with highly complex lines of production, there are many critical links that tie production to delivery, and ultimately to world trade. Most people take simple things for granted: grocery stores and pharmacy shelves being stocked; money accepted in exchange for goods and services, the train arriving on time, and their mobile phone and internet working.

People notice the immediacy of things, but not the conditionality from which it emerges. People rarely think about, or see, the constraints to critical infrastructure or the factors that provide for social stability.

A global pandemic is good reason to shift one’s thinking to consciously considering them. No one wants to test the legitimacy of the old adage that we are only nine meals from anarchy. The worst case scenario of a pandemic causing a simultaneous supply and demand shock could be so highly disruptive that it is something that every market participant and fiduciary must give thought to.

Certainly, there are groups of individuals who need to go to work to provide services that support critical infrastructures. What happens if not enough of them go to work? What happens if manufacturing plants or parts factories close? What are the demand impacts when people are told not to go anywhere where a large number of people gather? What happens, for  instance, if truckers do not receive their normal supplies for delivery, or if they refuse to deliver to towns with a high percentage of confirmed COVID-19 cases? All kinds of spillover effects could happen within a few days: food shortages, hospital supply shortages, garbage piling up, US mail stopping, gas shortages, power grids and sewer system troubles, ATM’s running out of cash etc.

I believe Liebigs’s Law of the Minimum can be used to understand a globalized world with its highly-precise and efficient supply chains. Today’s extreme efficiencies mean that it would take only one failure in the chain to stop or impact production and delivery. On average businesses have around 15-20 days of inventory. Production is not limited to the total  level of resources, but rather by the scarcest resource. You can’t build a car without the tires or the rubber used to make them. COVID-19 has already dramatically impacted supply-chains as factories in China and elsewhere have shut.

A Ford F-150, for example, has well over 10,000 parts. Their parts suppliers have, say, 1000 suppliers of their own, who in turn have, say, 100 suppliers. This is a crude calculation, but that is a permutation of 1 billion pathways. Dun & Bradstreet reports that 5 million companies have a tier  one or tier-two supplier in the Wuhan region. A shut parts factory in China could easily lead to the closing of a manufacturing plant in another country.

A more precise example comes from a friend of mine who was a U.S. Air Force officer responsible for extracting intelligence from aerial photography. He told me the story of his training from WWII photos from near the end of the War showing many German aircraft sitting idle – and no one could figure out why. After the US invaded Germany, they found out that the planes had everything they needed to be operational except the ball bearings; a direct result of the ball bearing factory in Schweinfurt being bombed.

As fears grow and governments impose restrictions against human gatherings, demand shocks will follow. The result will have a cascading effect across businesses, economies, markets and society. Such disruptions do not proportionately or linearly increase with time, but rather cause spillover effects that accelerate disruptions. A classic contagion.

2008 Financial Crisis vs. COVID-19

The 2008 financial crisis and policy responses should not be compared too precisely to the potential crisis developing from a COVID-19 pandemic. The crises are quite different.

In 2008, interbank lending dried up, partially due to uncertainties around the size of bank’s offbalance sheet SPVs (Special Purpose Vehicles) and the amount of structured product (e.g. CDOs) they held. The Fed and Treasury acted to unclog the plumbing by cutting rates to 0% and by putting in a series of targeted lending and purchasing facilities. These measures prevented severe contagion after Lehman failed, and helped to bail out several firms including AIG and their huge counter-party exposures. While the official response to the 2008 crisis prevented a full market meltdown and potentially a new great depression, it sowed the seeds for making today’s crisis much worse!

A good deal of the risks from 2008 were displaced to sovereigns via enormous deficits and bank guarantees. Basically, the response of 2008’s ‘too much debt’ has been even more debt, as evidenced by massive increases in global indebtedness that is several multiples greater today than 2008 levels.

Simply stated, the actions taken in 2008 cannot fix today’s socio-economic and behavioral disruptions currently stemming from COVID-19. The financial system is in a much more precarious position due indebtedness being far higher, central banks having less fire power and credibility, and asset valuations bubbling near historical extremes. Central bank tools are worn. Interest rates are not only already near rock bottom in most places, but further action may be counterproductive and therefore there may be a loss of faith in more ‘bazooka, whatever-it-takes’ band aids (think ECB).

Equally importantly, China, the epicenter of the COVID-19, is an important cog in global supply chains today. It’s share of global GDP has risen from around 5% in 2008 to 16% today.

True Coordinated Policy Responses Unlikely

There have been several interest rate cuts by central banks with more cuts likely. However, at the bigger governmental level, conflicting perceptions of the crisis and risk-reward frameworks means a lower likelihood of a true global coordinated response. Why? Because varying degrees of desperation could press local demands forward and give rise to “nationalism” and desire to ‘protect our own’. Impulses like these would exacerbate broken supply chains and are antiglobalization at their core!

MMT Revised?

The Fed and other major central banks might attempt to act as the ‘lender of first resort’ and try to recapitalize the world to save it from the mess their own prior actions created (i.e, “everything bubble”). In theory, the Fed has an unlimited balance sheet from which it could guarantee every liability. However, this suggests that the Fed’s backstop is its ability to print infinite amount of money, but at some level it must know that to try to do so would destroy confidence in the value of the fiat USD. Devaluing one’s currency and ‘beggar-thy-neighbor’ policies don’t typically work when an indebted world is all in the same boat. If they did work, it would be at the expense of hyper-inflation.

The Catalyst For a Catastrophic System Failure?

COVID-19 could possibly be the catalyst for a double-whammy supply and demand shock that breaks extreme market valuations and breaks the smooth functioning of the financial system.

Slow response time and misleading early information by governments and their institutions (particularly in China and Iran) have, and will, significantly damage the effectiveness of the policy actors who are attempting to manage the crisis. Distrust of official information can be highly damaging. COVID-19 has the potential to lead to catastrophic system failure. Markets, international trade, economic output, and social stability are all at risk.

Global Indebtedness Impact on Markets

Despite central banks efforts to centrally control prices and market liquidity, banks and lending still play a critical part. System confidence in money and credit is the basis of all economic activity. A slowing economic landscape that is already over-borrowed can easily start to deleverage, quickly triggering a negative feed-back loop. As such expectations take hold, loans retire or are defaulted on, money and credit supply drops further and quicker than goods and services are produced.  The COVID-19 could easily be the shock that sets a debt deflation economic collapse in motion.

Raising debt in order to rollover existing debt will no longer becomes an option, so defaults will skyrocket and businesses will close. The result will be asset prices falling and unemployment rising quickly. Money velocity will fall in a reinforcing downward spiral.

The BIS has written extensively about how over-indebtedness damages economic growth. The Fed’s decade of negative real rates, ever-ballooning balance sheet and extraordinary accommodation has been partially to prevent an Irving Fisher style debt deflation cycle. Yet, in trying so drastically to prevent it, the Fed may have provided the dry kindling that made it inevitable. No doubt, the second order effects of Fed’s excessive accommodative policies have been soaring indebtedness, wild market speculation and financial asset bubbles.

According to the IIF, global debt to GDP reached an all-time high of 322% in Q3 2019. Government intervention would increase debt but without addressing corporate insolvency. And, central bank actions have already been riddled with ever declining marginal results, and as mentioned, at some point their actions simply become counter-productive.

High Yield Bonds, aka Junk Bonds

55% of the entire corporate bond market is rated BBB. Many of these companies will be downgraded by at least one notch pushing many of them into junk bond status. (Junk bonds are now nicely referred to as ‘high-yield’, despite really being ‘medium yield’.) The aggregated number of BBB bonds is around $3 trillion or 4x the entire size of the junk bond market.

A downgrade into junk status means that these bonds automatically get kicked out of all investment grade indexes. In addition, some investors are constrained by regulation from investing in non-investment grade bonds; the combination means forced selling will occur. There is not enough liquidity or balance sheet room to find buyers at economic prices.

Historically junk spreads trade on average 4%-6% above treasury yields, but during a crisis with rising defaults and inadequate liquidity, these spreads will soar to much high spread levels. The fact that we have just finished a decade of extreme yield seeking will increase the severity.

Markets

Financial markets are following an extraordinary decade of exceptionally high returns. I’ve written extensively about how global central banks have been borrowing from future returns by making today’s return’s better. The Fed has encouraged corporations to borrow cheaply to buy back their own shares. Corporate executives are immune to high valuations and incentivized to buy back shares, because decreasing the number of shares increases earnings per share (EPS), which in turn inflates performance related pay. However, it should be noted that this financial engineering also weakens the corporate balance sheets by increasing debt levels.

The Fed has basically fueled speculation and moral hazard by keeping rates ‘too low’ and showing that it will act during any signs of market trouble. The ‘Fed Put’ is real and alive. Thus, market have had a fear of missing out (FOMO). The result is valuations that have gotten to more and more extreme levels – near all-time high valuations. All bubbles pop, the key is knowing the timing.

In recent years, while I have stated that perpetual bubble blowing is unsustainable, I thought the only thing that might derail the equity bull market was when real rates went positive and the Fed balance sheet began to shrink; OR, a recession. I will now add a pandemic to the list. Thus, the timing is now.

Financial assets represent the expected claim on future economic growth with valuations determined by the discounted value of those future cash flows. A drop in interest rates (the discount rate) makes the future cash flow worth more in today’s terms. Yet, a drop in interest rates does not change the cash flow itself. Economic growth is necessary for earnings  and positive cash flows. Growth is going to be severely impacted from the COVID-19 shock. I do not believe that it will merely cause ‘delayed demand’ as some suggest. In others words, that a drop in Q2 will be offset by equal increases in Q3.

Equities: I expect COVID-19 to cause a drop in US equity markets of at least 40%. Valuations are way too high. The “E” will fall faster than the “P”, and dip buyers will be incentivized to wait and not try to ‘catch a falling knife” with so much uncertainty around COVID-19 and the upcoming US election.

Bonds: In 2014, I predicted that the long bond would trade with a 1% handle. I argued that Treasuries demand would surpass high levels of supply due to three main factors: 1) the Fed was hoarding so many; 2) Treasuries were the high-yielder relative to other developed world sovereigns so foreign demand would remain high; and 3) the PBGC rule changes for private pensions and its strong incentives for LDI investing would increase long end demand.

Recently, I have been asked a lot about my opinion of Treasuries. I’ve stated that Treasuries will continue to fall to new record low yields initially – in the short term – but I have turned negative in the medium term.

[Let me start by saying that I believe the Fed will be forced to cut rates toward 0% but will refrain from ever moving official nominal yields into negative territory, due to our highly developed and important money market sector. And, I don’t believe the Fed should cut or go to 0% because I believe rates below a certain level, say around 2%, are counter-productive. Nonetheless, they will cut from fear of looking as if it is not doing enough. I also believe the flight to Treasuries will continue in the near term dropping long rates at least another 25 bps.]

However, I believe the disruption in global supply chains and nationalistic impulses will eventually cause a type of stagflation. Forget the Philips Curve which the Fed still references, it was debunked in the 1970’s. Globalization has reached its peak and a period of anti-globalization will manifest, reversing some of the benefits such as efficient low cost production. A supply chain disruption that causes a shift to the second lowest cost producer can have a dramatic impact on final prices. These pressures along with growing deficits will place greater pressure on Treasuries particularly as nominal Treasury yields approach the zero lower bound.

Conclusion

Some experts believe the Coronavirus will manifest as the worst to strike since the 1918 Spanish flu. The Coronavirus is highly disturbing due to its high infectiousness and level of severity. As it worsens, global media outlets will show more depressing stories about closings of schools, factories, and events. They will show stories about production failures, panicked markets, government feebleness, food insecurity, and factors that spread and amplify fear and uncertainty.

Financial markets are unlikely able to hold such high valuations. Why? With a current all-time low unemployment rate of 3.5%, unemployment only has one way to go – up. Debt to income levels are already unsustainably high and income levels will drop as production is ratcheted lower. Paying down debt will become a challenge and credit will become scarcer. Inflation will rise even in the face of system collapse. The frailties of system dependencies will be exposed. Behaviors will change as socio-economic fragmentation occurs. Consumer confidence will materially drop leading to further economic contraction.

A financial system and supply chain cross-contagion could easily enter a re-enforcing negative feedback loop that has to recalibrate to a new stable state after collapse. Once production lines and trade are impacted for a period of time, they are not easily turned back on. It is not like turning on a light switch.

Final Thought

My intent with this note is not invoke fear, but rather to assess the difference between best-case (consensus) and worst-case scenarios. Fringe warnings like the ones outlined above are never popular. People often defer to authority opinion when consensus views are challenged. Unfortunately, governments are incentivized to maintain order with rosy announcements while experts today are still trying to understand what they are even dealing with.

Humans typically seek group affirmation. Market participants believe being wrong in a consensus is safer than being right with the risk of facing social shaming. After the 2008 crisis, most funds that lost near the same as the S&P 500 of 39%, often said, “no one saw this coming”. This is simply not true, but did allow most to keep from losing their jobs.

I have written this because I believe markets have learned little about risk management since the financial crisis. On the contrary, the “Fed put” has made many complacent and unworried about downside risk. Too many have worried so much about seeking return and hunting for yield that they have forgotten that what matters is return per unit of risk. The upside potential versus downside risk of today’s market with a potential pandemic looming is highly skewed to the downside. Investors should immediately shift from FOMO to actions that help preserve capital until uncertainties materially dissipate.

Piglet prices in China soared to record highs on Thursday (March 5) amid supply chain woes that persist from the Covid-19 breakout. Farmers have been attempting to rebuild their herds as supplies remain tight after African swine fever decimated 40% of the country’s pig supply in 2019. 

Chinese spot prices for piglets jumped to a record high of 126 yuan ($18.11) per kilogram last week, nearly a 600% increase since the start of 2019. The latest surge in prices was attributed to supply chain disruptions as transportation networks across China remained closed due to virus containment measures, which prevented farmers from shipping piglets to meat markets, said Financial Times. 

The virus crisis complicates things for Beijing, who has attempted to arrest soaring food inflation via the release of thousands of tons of pork from state reserves. However, with quarantines still in effect across the country, this has prevented farmers from expanding herds and supplying local markets. 

“The record price is because of scarce supplies of piglets,” Lin Guofa, senior analyst at Bric Agriculture Group, a Beijing-based agriculture consulting firm, told Bloomberg. 

Yang Zhenhai, the head of the ministry’s animal husbandry bureau, told reporters last week that a shortage in pigs across the country has been due to lack of creating new pig farms, restocking herds, and the ability to transport animals to markets following the virus outbreak.

Ernan Cui, a Chinese consumer analyst at Gavekal Dragonomics, predicts that the next dilemma for farmers is the risk of herd infections from wild boars. If another breakout of African swine fever begins, China could force farmers to cull herds once more.

On Tuesday of last week, China’s agriculture ministry found seven infected boars dead in Hubei province, the same region of the Covid-19 outbreak.

The fact that a resurgence of the African swine fever could be imminent, along with continued supply chain disruptions not allowing farmers to increase herd size and or transport pigs to markets, has created a perfect storm and more upward pressure on pork prices that could be the breaking point of Chinese consumers. Surging pork prices have made many people hangry, and this could result in social destabilization. 

For a few days at the end of February, traders were stumped when instead of surging – as it normally does during risk off days – the Japanese Yen tumbled alongside stocks, sending the USDJPY to the highest level in nearly a year even as markets were rocked by early coronavirus fears.

In retrospect, that initial reaction (and countless “hot takes” on the topic) turned out to be dead wrong, because since then, the USDJPY has cratered, and is now down nearly 8 big figures in the span of two weeks, with the JPY once again a full-blown “risk off” currency.

And while we wait for equity futures to resume trading at 6pm, the USDJPY is down 1.1% to 104.20, continuing its recent freefall, hinting that between soaring coronavirus fears and the anticipated imminent crash in oil, futures will be a bloodbath… again.

It’s not just everyone’s favorite carry currency that is exploding higher amid a global risk off in early Sunday trading: the carry pairs – Loonie, Aussie and Norwegian Krone are all getting carted out feet first:

• USD/CAD RISES 0.5% IN EARLY TRADE AFTER ARAMCO OIL DECISION
• USD/NOK RISES 0.7% IN EARLY TRADE AFTER ARAMCO OIL DECISION
• AUD/USD DROPS AS MUCH AS 0.5% IN EARLY TRADING

And visually:

Finally, with the Euro having become a carbon copy of the Yen, some now speculate that the common currency is traders’ next favorite carry currency thanks to the ECB’s record low negative rates, and sure enough, all those carry traders who had the EUR as one of the FX pair legs, are scrambling to get out of their positions, sending the EURUSD soaring in recent days, and another 0.7% on Sunday, reaching its highest level since July.

Incidentally the topic of the Euro as a carry currency was touched upon in Albert Edwards’ latest note, and he had some very ominous words of warning if indeed that is the case (which it clearly is):

One of the key lessons from the 2008 GFC was to avoid a strong currency. Japan’s economy suffered a terrible slump, falling some 9% in just a year  almost meeting the semi-official definition of a depression. This was around twice that of the drop in GDP in the US and Europe. 

The main reason why this slump in the Japanese economy occurred in 2008 was that a seeming successful low interest rate policy blew up in the Japanese policymakers faces. That same fate may just be about to befall the ECB and the eurozone. In the run-up to the GFC, the BoJ interest rate remained close to rock bottom while rates were raised in Europe and the US. Japanese rates were, by some way, the lowest in the G7 and so the yen weakened firstly due to these wide interest rate differentials, and secondly as a weakening yen encouraged carry trades  where investors borrow in a low interest rate, depreciating currency (yen) and invest the money in a higher yielding or rising assets abroad. This created a virtuous loop where the yen declined (dollar rallied) through 2005-mid 2007 (see chart below). Then as the asset prices collapsed, investors were forced to close out the carry positions, driving the yen sharply higher as the currency part of the trade was unwound.

The same issue might be set to overwhelm the ECB, which has also been successful in driving down the euro against the dollar by lowering interest rates to a negative 0.5% and being more aggressive with its QE. There is evidence emerging from the BIS that the euro may have become a funding currency for carry trades due to its rock-bottom interest rates, just like the yen did in 2005. To the extent this has occurred it has likely underpinned dollar  strength as money has flowed into what is a higher yield, ‘safe’ investment home.

A surge in the euro might occur irrespective of any additional ECB easing deeper into negative territory. Another 50bp ECB cut is irrelevant compared to the potential losses on assets in a market meltdown. Further ECB rate cuts may occur despite the obvious damage this is doing to the eurozone banking sector. In my view trying to stop a surging euro will be a far higher priority to the ECB than the chronic damage to eurozone bank margins from negative rates.

The priority will be to avoid a strong euro causing a slump in the already fragile eurozone economy and a move into outright deflation. Another deep recession would almost certainly trigger another euro crisis.

And the punchline:

If a carry trade unwind does cause the euro to surge uncontrollably against the dollar towards the $1.2-1.3 zone, the impact on the fragile eurozone economy could be devastating. For despite the euro’s weakness against the dollar, other countries have also been pursuing weak currency polices. As a result, the euro effective exchange rate (ie measuring the euro against a basket of currencies) is much stronger than the headline euro/$ exchange rate suggests. A surge in the euro from current levels as the carry trade unwinds could crush the eurozone economy. Indeed it could threaten the euro’s very existence.

Ooops.

Finally, since we know that the question on everyone’s lips is where does oil open (we laid out some thoughts yesterday), according to CNBC’s Scott Wapner, who cites trader Mark Fisher, oil is reportedly indicated to open below $32 a barrel, nearly $10 below its Friday closing price (although it is unclear what “indications” Fisher is looking at so take this with a big grain of salt).

Mark Fisher tells me oil indicated to open below $32 a barrel tomorrow – a stunning $9.50 below where it closed on Friday. Sounds like it’s full on bananas in the oil markets…

Have to watch high-yield and the banks.

— Scott Wapner (@ScottWapnerCNBC) March 8, 2020

Following three consecutive days of oversubscription in both the Fed’s overnight repo…

… and term repo operations…

… we warned that “this continuing liquidity crunch is bizarre, as it means that not only did the rate cut not unlock additional funding, it actually made the problem worse, and now banks and dealers are telegraphing that they need not only more repo buffer but likely an expansion of QE… which will come soon enough, once the Fed hits 0% rates in 2 months and restart bond buying.”

We then asked if that will be enough to stabilize the market, responding that for now, we don’t know, but in light of the imminent corona-recession, on Tuesday Credit Suisse’s Zoltan Pozsar repo guru published a lengthy – and especially ominous – research report whose conclusion – at least on the liquidity front – is that the Fed should “combine rate cuts with open liquidity lines that include a pledge to use the swap lines, an uncapped repo facility and QE if necessary.“

To which, our conclusion was that “a liquidity avalanche is coming to prevent a market crash. It’s only a matter of time.“

A few days later, JPMorgan agreed with us that some very substantial cracks have appeared in the credit and funding markets, with the bank’s strategist Nikolaos Panigirtzoglou writing in his latest “Flows and Liquidity” report that “we see initial signs of emerging credit and funding stress” and cautions that “if these shifts in credit and funding markets are sustained over the coming weeks and months, especially in the issuance space, credit channels might start amplifying the economic fallout from the COVID-19 crisis.”

This, incidentally, is precisely why on Friday we said that the Fed now must step in to prevent a “catastrophic” credit crash as the surging VIX, which briefly hit the highest level since the financial crisis on Friday, will have dire consequences on bond spreads, potentially resulting in a collapse in not just the junk bond market, but triggering a wave of downgrades in the BBB-space, launching the long awaited “fallen angel” crisis as trillions in investment grade bonds are suddenly downgraded to junk.

While not nearly as “doom and gloomy” as Credit Suisse’s Zoltan Pozsar who now expects nothing less than a liquidity tsunami from central banks to reverse the ongoing funding squeeze, Panigirtzoglou starts off by pointing out that the “supply chain disruptions and the demand shock caused by the COVID-19 crisis are likely already creating cash flow problems for certain businesses in particular smaller companies and those belonging to sectors most affected by the crisis, e.g. travel, transportation, leisure, lodging”, something we showed yesterday with the following chart.

In response, central banks or governments are already hinting to providing credit support. For example, the JPM strategist notes that “Boston Fed’s Rosengren on Friday suggested that the Fed could consider a facility that could buy a broader set of assets.” Separately, the Bank of England’s next Governor hinted that the BoE could get involved in providing supply chain finance. But unless that credit support by central banks and/or governments is “broad, fast and direct, we note credit markets are facing an increased risk of the cycle turning with a lot more downgrades or even defaults over the coming months”, according to JPMorgan.

Panigirtzoglou then first looks at a debate that has been raging for the past three years, namely whether trillions in BBB-rated (i.e., the lowest investment grade bond rating) are about to be downgraded to junk, unleashing a crash in the high yield space, one which could then quickly migrate to the IG space, and the entire credit market.

Considering that defaults are subtracting from HY investors’ returns, the JPM quant writes that “rating downgrades or fallen angels are important for HG investors because they drive a wedge between spread returns and total returns as the managers who are only allowed to hold investment grade bonds are forced to offload their downgraded bonds.”

Which leads to the next obvious question: how much of that downgrade or fallen angels, i.e. corporate bonds downgraded from investment-grade status to high-yield, is materializing already, and how will the covid pandemic impact it in the future?

According to JPM’s HY team the number of fallen angels has risen sharply by 5 in February bring the Jan/Feb total to 6. Annualizing that number brings the 2020 fallen angels to 36 not far from the previous highs of 40 in the 2015 cycle. In other words, if the YTD pace is sustained the downgrade force would exert similar pressure on credit markets to that seen during 2015. Of course, if Brent indeed plunges to the low-$30s (or lower) now that Saudi Arabia has unleashed a scorched earth price war and effectively destroyed OPEC, expect the downgrades to explode as countless E&P companies face an immediate funding and operational crisis as nobody is prepared for oil below $35.

What is especially worrisome is that the negative impact that downgrades and fallen angels typically exert on credit returns has started to show up in credit returns, and that’s even before the crash that will result from the plunge in oil prices. Pointing to the next chart, Panigirtzoglou notes that the wedge between total vs. ex-ante returns for the Global Agg corporate bond index shrank over the past two months as downgrades outweighed upgrades.

That said, “this pressure appears to be still at an early stage as the wedge between total and ex-ante returns remains far from the negative territory seen in previous credit cycles. In other words, downgrades and fallen angels have yet to exert a strong negative impact on credit returns, and the YTD downgrade/fallen angel impulse would have to be sustained for the remainder of the year for 2020 to look like 2015.” Of course, with the oil now the key catalyst for both the viability of countless junk bond-funded companies, and inflation breakevens…

… the fallen angel impulse is about to explode.

This brings us to the next question posed by Panigirtzoglou, arguably the one at the heart of the credit bubble debate, namely “are current concerns by market participants about rating downgrades/fallen angels justified?” To which his answer is “yes… if one looks at simple credit fundamentals such as median debt-to-income ratios”, thereby validating all those – like this website – who have for years warned that the real credit crisis will come once the fallen angel avalanche kicks in.

To justify his answer, the JPM quant writes that “a visual inspection of median debt-to-income ratios across the universe of companies behind corporate bond indices reveals a highly problematic picture ahead of the COVID-19 crisis. Figure 3 to Figure 6 show the median net-debt-to-EBITDA ratio for companies behind J.P. Morgan’s HG and HY indices in both the US and Europe up until 2019. This leverage metric has been rising steeply over the past decade to levels that are higher than those seen at the peaks of the previous two cycles in 2007/2008 and 2001/2002. In other words, companies are currently much more vulnerable to a decline in incomes and/or a rise in corporate bond spreads and yields than in the previous two recessions. This is especially true for US credit and for Euro HY given the absence there of the backstop from the ECB’s corporate bond program that solely benefits Euro HG.”

With fundamentals flashing a red alert due to the “highly problematic picture” the massive debt loads reveal, the next question is perhaps even more important: what about issuance and funding market?

As the JPM quant responds, on the issuance front there are signs of an overall decline in net issuance by non-financial corporates, i.e. gross issuance minus maturities. This is shown in the next chart which depicts weekly net issuance by non-financial corporates across the US, Europe, Japan and EM. As we pointed out previously discussing the paralysis in the primary market, “net bond issuance has been predominantly negative for two consecutive weeks pointing to emerging signs of funding stress.”

Furthermore, there are signs of stress in Yankee issuance as well, the report said, noting that it tends to be more sensitive to funding concerns because non-U.S. companies can find it harder to raise dollar funding relative to domestic U.S. companies in periods of stress. The chart below shows that slowing Yankee issuance in the US HG corporate bond market during February and March relative to Domestic issuance which has been a lot more resilient: “This implies that some non–US companies might start finding it more difficult to issue in US dollar funding markets.”

It is therefore not surprising that the dollar cross currency basis has jumped sharply into more negative territory, a traditional indicator of funding stress. Reduced Yankee issuance is likely associated with more negative dollar basis to the extent that Yankee issuance is substituted by synthetic dollar funding, and vice-versa.

Next, the JPMorgan strategist looks at the clearest indication of funding market stress, the one we highlighted at the very top, namely the recent surge in demand for Fed liquidity via repo, and writes that “the shift in the dollar cross currency basis is also consistent with signs that the previous dollar shortage seen in the US banking system during 2019, is re-emerging following the market stress of the past two weeks.” He then adds that “the recent spike in Fed’s repo operations take suggest that the market stress of the past two weeks is raising banks’ overall need for reserves (Figure 14). One potential channel could emanate from the payments businesses of banks which might come under stress as companies face cash flow problems from the coronavirus crisis.” It is this particular aspect of “supply chains being funding chains in reverse” that has spooked Pozsar the most, and why he believes central banks will need to step in with their entire artillery to avoid a systemic crash.

Finally, this week’s spike in both SOFR rates…

…. and the all important FRA-OIS spreads…

… is consistent with the idea of dollar reserve shortage and/or funding and credit stress emerging in US money market space, Panigirtzoglou warns, and follows up with precisely what we said earlier this week, namely that “these signs suggest that the Fed could again become aggressive in injecting reserves into the US banking system in a similar fashion to last September.”

Alternatively, woe to markets if the Fed does nothing in the next 24hours.

And while JPMorgan’s conclusion is somewhat more balanced, the implication is the same: “in all, we see initial signs of emerging credit and funding stress. If these shifts in credit and funding markets are sustained over the coming weeks and months, especially in the issuance space, credit channels might start amplifying the economic fallout from the COVID-19 crisis.“

In other words, if you think the equity plunge so far has been bad, just wait until the credit markets fully seize.

Peter Schiff appeared on the Quoth the Raven podcast (iTunes, Spotify, YouTube) on Friday, where he and host Chris Irons discussed the impact of the coronavirus on the economy, gold, bitcoin and why he thinks the Fed is not going to be able to stop the upcoming collapse of the financial system. Here are a couple of Schiff’s thoughts from the interview and a link to the full podcast.

Schiff on Gold

“I’ve never seen a less loved bull market in gold than the one we have now,” Schiff says. “The gold traders are so afraid of this rally, they don’t believe in it, they think gold is going to fall any minute now. Meanwhile, we just keep on rising.”

Schiff says in the past, when you don’t see gold miners confirm the rally in gold that it could be a harbinger of bad news. But “gold just keeps rising” Schiff notes, despite that. “I was buying more gold stocks on Friday. I thought it was just an incredible opportunity to increase an allocation that I already had.”

“I don’t think there’s any real money yet” in gold, he says. “There’s day traders in there. But I don’t think you’ve seen pension funds or endowments make any strategic shift into mining stocks,” Schiff says.

“The physical buyers of gold are basically safe haven buyers. When you’re in an environment where central banks are printing money, if you really just want to play it safe, if you want to be out of stocks and out of bonds, what do you buy? You buy gold. You buy real value. Real money.”

Schiff on The Coronavirus and The Fed 

Schiff says that the coronavirus is going to lead to stagflation: “Stagflation is what’s coming and the coronavirus is the pin. The important thing is the bubble that the pin pricks. We know that every bubble eventually finds its pin.”

He continued: “The Fed has erected this extremely leveraged economy and the reason we all have so much debt is because every time we try to have a recession, the Fed interferes. Instead of having a healing recessions, where debts are paid down and balance sheets are improved, we just keep levering up.”

“They keep saying we need to print more money. What is that going to do? That’s not going to cure the virus. That’s not going to put more products on shelves. All that’s going to is destroy the dollar, which is going to make prices go up,” Schiff says. 

Schiff on the Coming Election

“Donald Trump is probably not going to get re-elected,” Schiff says about the election. “A run of the mill Democrat like Biden – there’s no way he’s going to lose if we’re in a recession on election day.”

He continues: “If you think we’re printing a lot of money now, imagine how much larger they’re going to be with a Democratic president in the middle of a recession. Deficits are going to be $3 trillion, $4 trillion.”

“And by the time Biden takes office, rates will be at 0%,” he concludes.

You can listen to the full hour long interview here:

*  *  *

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