2012 In Review

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“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Mario Draghi, president of the European Central Bank, July 26, 2012

Having singlehandedly altered the course of the European crisis, the Financial Times named Mr. Draghi “FT Person of the Year.” Yet “Super Mario” was anything but acting alone. The emboldened Bernanke Fed soon followed Draghi’s bold pronouncement with its own daring commitment to open-ended quantitative easing (in a non-crisis environment!). All throughout 2012, extraordinary monetary easings were announced by central banks around the globe. I will this evening announce the distinguished 2012 “CBB Thing of the Year” recipient: congratulations to Endless Free “Money.”

In my Issues 2012 piece from early-January, I posited that 2012 was a “Bubble year.” The Bubble might burst, with an expanding European crisis as a probable catalyst. But if it persevered, one could expect the potent Bubble to broaden and excesses to intensify. I referred to bipolar outcome possibilities – so-called left and right “tail risks.” In late-July with Spain’s 10-yr yields reaching 7.6% and Italy’s approaching 6.6% - along with the euro sinking to almost 1.20 to the dollar- the European crisis was indeed spiraling out of control. Capital flight within/from Europe and from the emerging markets was becoming a serious issue. A crisis of confidence in the European banking system was in the offing. The world economy was weakening rapidly, and the global financial system was on the brink of a destabilizing bout of de-risking/de-leveraging.

As it turned out, those with faith in all-powerful global central bankers end 2012 further emboldened. Ironically, however, 2012 was a year when monetary stimulus actually lost potency. In Europe, the ECB’s $1.3 TN Long-Term Refinancing Operations (LTRO) liquidity facility bought only a few months respite from crisis. Despite four years of unprecedented monetary stimulus, the U.S. recovery again disappointed. First quarter GDP was cut in half (from Q4) to 2% annualized, and then dropped by almost half again to only 1.3% in Q2. Ominously, growth faltered in the face of another Trillion plus fiscal deficit and robust corporate Credit growth – and despite the strongest system (non-financial) Credit expansion since 2008 (surpassing 5% in Q2).

Despite ultra-loose monetary policies around the world, global growth slowed meaningfully in 2012. Economies throughout Europe downshifted forcefully. Importantly, 2012 saw the crisis gravitate from Europe’s periphery to its core. German growth slowed from 2011’s 3.1% to less than 1% (OECD estimates 0.9%). France flat-lined after 2011’s almost 2% expansion. The Italian economy nosedived, from slightly positive growth (0.6%) to a contraction of 2.2% (OECD estimate). Spain also saw positive GDP (0.4%) succumb to recession (negative 1.3%). But it was the worsening of already alarmingly high unemployment that best illustrated Europe’s unfolding recession/depression. Spain’s unemployment rate jumped to 25% (up from less than 21% in mid-2011). Italian unemployment surpassed 11%, with France following closely behind at 10.3%. The overall eurozone unemployment rate jumped to 11.7% (as of October), from 10.0% in mid-2011. Worse yet, the region’s youth unemployment rate remained shockingly high.

Social unrest became a pressing European issue. Greece’s financial, economic and social collapse gathered momentum. More alarmingly for the continent, tensions erupted in (“core”) Spain. Throughout the region, a backlash against so-called “austerity” took hold. The socialist Hollande was elected President of France, essentially terminating the German/French European policymaking nexus (“Merkozy”). Italy’s Silvio Berlusconi was forced out, replaced by an unelected “technocratic” government headed by a Caretaker Prime Minister, Professor Mario Monti.

There were instances when European politics made Washington appear highly effective. With seemingly no political solutions to deepening problems in Greece, Spain and Italy, the MIT trained Italian economist, Mario Draghi, took it upon himself to incite dramatic change. His pronouncement of essentially unlimited ECB firepower to backstop troubled European debt markets profoundly altered the near-term risk vs. reward backdrop for periphery debt, the euro, European bank liabilities and global risk markets more generally. When it became clear that the ECB governing council was prepared to disregard the Bundesbank’s strong objections to Draghi’s Outright Monetary Transactions (OMT) plan, the markets believed they finally could enjoy an American-style “Big Bazooka” liquidity backstop. The Merkel government backed Draghi, and also made it clear that they saw intolerable risks in a Greece exit (“Grexit”). As they say, “The rest is history.”

With a determined Draghi aligned with the election-minded Merkel government and an unleashed Bernanke Federal Reserve, the market environment was suddenly transformed. Draghi explicitly warned the hedge funds to cover their European short positions – and the speculators quickly appreciated that policymakers were making it advantageous to be positioned leveraged long. European debt instruments were transformed from being the global leveraged speculating community’s preferred shorts to their best performing speculative longs. Indeed, with the ECB having negated European “tail risk,” the prevailing catalyst for global de-risking/de-leveraging had been suppressed. A period of virtual panic buying ensued – in Greek, Spanish, Italian, Portuguese bonds; in the euro; in European equities; in emerging market securities; and in U.S. corporate debt and equities. In short, an historic short squeeze spurred huge rallies throughout global risk markets. Performance-chasing and trend following markets went into overdrive.

Central banks proved, once again, the world’s hero. Heightened fears that global central banks had largely expended their bullets were supplanted with childlike enthusiasm that they essentially retain unlimited ammunition. And with traditional inflationary pressures well contained throughout much of the world, the view held that there was essentially little risk associated with extraordinary monetary stimulus. Whether it was Europe, the U.S. or Japan, the risk vs. reward equation was viewed as strongly supporting aggressive central bank reflationary measures. Along the way, global risk markets decoupled from fundamentals. A critical facet of the “right tail” scenario unfolded before our eyes: the historic Bubble strengthened and broadened – global risk market prices inflated and risk premiums deflated - even as the economic backdrop turned increasingly problematic.

The U.S. economy and corporate profits disappointed in 2012, while stock prices posted the strongest gains since the policy-induced rally of 2009. The German economy disappointed, although slightly positive GDP equated with a 29% gain in the DAX equities index. The French economy badly disappointed, so the CAC40 was limited to just a 14.6% advance. The Italian economy faltered, yet stocks were up almost 8%. Spain was a near disaster; stocks fell a mere 5%.

The big divergence between fundamentals and stock prices was not limited to the U.S. and Europe. India’s growth slowed sharply, while the Sensex Index gained about 26%. The South Korean economy disappointed, although stocks almost posted double-digit gains. Eastern European economies nearly fell prey to the European crisis, although most equities markets posted big advances for the year. In Latin America, Brazil’s economy slowed markedly, although stocks gained 7%. Argentina became a bigger mess, yet stocks were up 15%. The resilient Mexican economy spurred a 17% advance in the Bolsa Index.

It is well worth noting the 2012 dynamic where growth slowed in the face of ongoing Credit excesses. In this regard, Brazil and India were notable among major economies demonstrating late-cycle Credit dynamics. In the “old days,” the confluence of rampant Credit expansion and waning economic expansion would have provoked destabilizing capital flight – and a rather abrupt end to booms. But the new world paradigm is one of unlimited “quantitative easing” and currency devaluation from the world’s major economies. This global Bubble Dynamic sees unleashed central banks promoting unleashed “developing world” Credit systems.

As an analyst and student of Credit, I remain in awe of Credit happenings in China. First of all, Chinese economic growth also slowed meaningfully in the face of ongoing historic Credit expansion. According to Reuters, total bank lending has been on course to approach $1.4 TN, an increase of almost 14% from booming 2011. Even more amazing is the growth of non-bank Credit. According to Bloomberg, Chinese corporate debt issuance surged 54% in 2012 to $657bn. Moreover, some analysts have estimated annual growth as high as 50% for lending outside of China's normal banking channels. According to Barclay’s, the Chinese “‘shadow banking’ industry has nearly doubled in the past two years to $4.11 trillion, or more than a third of total lending.” While a complete and accurate accounting of Chinese Credit is not available, it is possible that total 2012 Chinese Credit growth approached the U.S. record of $2.5 TN posted in 2007. I have posited that Chinese authorities lost control of their Credit boom back during the aggressive 2009 stimulus period. I have similarly suggested that China is trapped in a late-cycle “terminal phase of Credit excess.” I saw only support for this thesis in 2012.

That historic Chinese Credit growth actually accelerated from 2011 levels – and that minimally regulated, high-risk and opaque “shadow banking” Credit exploded – is an important aspect of my “right tail” (Bubble grows much more precarious) year-in-review 2012 analysis. And in what I would contend is a virtual global phenomenon, Credit was expanded in larger quantities, with a riskier profile and with record high market prices. Or stated somewhat differently, global Credit became meaningfully riskier although that did not stop much of it from being re-priced at even more inflated levels.

Various recent headlines support my “right tail” analysis: “Record-setting Year for Corporate Debt;” “Record Year for Junk Bonds;” “Mortgage Bonds Soar on Fed’s Refinance Push;” “[Corporate] Sales Approaching $4 Trillion in Stimulus Repast; “A Banner Year For Riskiest Debt;” “Fourth-Quarter M&A Surge Spurs Optimism..;” “Leveraged Loan Volume: $456bn in 2012, Thanks to Torrid Fourth-Quarter Market.”

According to Bloomberg (Sarika Gangar), global corporate bond sales this year just surpassed 2009’s record $3.89 TN. “Companies from the neediest to the most creditworthy took advantage of borrowing costs that fell to a record-low 3.27% this week as central banks held down interest rates to prop up the economy… Investors also funneled $475.3 billion into bond funds as global growth, which slowed to an estimated 2.2% this year from 2.91% in 2011, prompted them to seek alternatives to equities.” The first, third and fourth quarters all posted record issuance for their respective periods. “The yield on bonds worldwide fell 1.56 percentage points this year… Borrowing costs have tumbled from an all-time high of 9.05% in October 2008… Issuance in the U.S. reached a record, climbing 31% to $1.47 trillion, exceeding the previous all-time high of $1.24 trillion in 2009… Sales of high-yield bonds… reached $354 billion. That’s 23% above the previous record of $288 billion set in 2010.” According to Forbes’ Steve Miller, U.S. leveraged loans jumped 24% from 2011 to $465bn, with lending volumes below only 2006 and 2007 levels.

Instead of the forces of de-risking/de-leveraging, Credit instruments enjoyed manic demand. It is worth noting that 2012’s record $475bn bond inflows compares to 2011’s $99bn. A virtual buyers’ panic ensured double-digit returns for corporate debt investors. And the riskier the paper, the higher the 2012 return.

When Total U.S. Mortgage Credit expanded $1.4 TN in 2005, there was no doubt that the Mortgage Finance Bubble had inflated to dangerous extremes. That did not, however, stop a fateful $1.0 TN of subprime mortgage CDO (collateralized Debt Obligations) issuance in 2006. In 2012, global central banks and governments gave the great global Credit Bubble an additional lease on life. Markets responded, not uncharacteristically, with only greater speculative excess. Speculative markets responded by only diverging further from fragile fundamentals.

Those market operators most adept at betting on policymaking enjoyed yet another year of stellar returns – along with more incredible growth in AUM (assets under management). The cautious fell only further (and further) behind. The hedge fund community lived to play another day, although with each passing year it seems to become more a story of the giants growing more gigantic. There were notable prosecutions of insider trading, yet never in history has inside knowledge of policymaker intentions provided such incredible opportunities for riches. At the Federal Reserve, policies accomplished the objective of spurring the lowly saver further into risky securities. Overall, central banks succeeded in bolstering vulnerable global securities markets. Meanwhile, it became increasingly clear throughout 2012 that years of easy money, myriad (ongoing) policy mistakes and attendant misdirected resources have taken quite a toll on the underlying structures of economies throughout Europe, the U.S., Japan, China and around the globe.

In response to deepening structural issues and in the face of ongoing global imbalances, central bankers further ratcheted up their runaway monetary experiment. Seemingly putting an exclamation point on an extraordinary year, December saw the Fed announce $85bn of monthly quantitative easing. Numbed by such incredible monetary largesse, the marketplace can be forgiven for downplaying U.S. “fiscal cliff” issues and economic vulnerabilities. In Japan, a new government was elected with a mandate to essentially “do whatever it takes” with fiscal and monetary policies to spur growth and inflation. With over two decades having passed since the bursting of their Bubble, Japan’s search for solutions has turned desperate. Globally, increasingly desperate politicians and extraordinarily accommodative central bankers make a most perilous combination.

The years pass by quickly. It remains a privilege to chronicle history’s greatest Credit Bubble on a weekly basis. I have a rather demanding “day job,” but I’ll continue to do my best to put together my weekly Bulletins. I only write on Fridays, and I never really know how much time I’ll have available. The quality will vary, and there will continue to be those tired and grumpy Fridays to contend with. But I love the analysis and I’m honored that you would take the time to read my work – warts and all. Thank you.

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About Douglas Noland