Michael Burry was one of the few who saw the 2008 financial crisis coming. Through his hedge fund, he made a big bet against the market in 2007 by buying credit default swaps on mortgage bonds.
The trade earned Burry’s investors $750 million, and he pocketed $100 million for himself. Michael Lewis wrote a book about him that was later adapted into the movie titled The Big Short.
Burry is a guy we should all be paying attention to.
He doesn’t share his thoughts often. When he does these days, it’s usually through Twitter.
Today, Burry is predicting that “the mother of all crashes” is coming. He says the market is dancing on a knife’s edge and recently tweeted this about the markets.
More speculation than the 1920s. More overvaluation than the 1990s. More geopolitical and economic strife than the 1970s.
Burry is doing more than just tweeting. He’s dumping most of his stocks.
In his hedge fund Scion Asset Management, he cut his portfolio from more than 20 stocks down to just six at the end of the third quarter.
I say “markets” because I am talking about the stock market and the much bigger corporate bond market.
With that said, it’s hard to argue that both the U.S. stock market and bond market are not in bubbles today.
The stock market (as measured by the S&P 500 Index) is up more than 200% since before the last financial crisis in 2009… Until last week’s sell-off, the stock market was hitting record highs on almost a weekly basis. It’s now up roughly 40% from before the pandemic, including being up about 25% this year.
Meanwhile, corporate debt has nearly doubled to around $11.5 trillion from $6 billion before the last financial crisis. This is an almost unfathomable number.
Corporate debt, just like consumer debt, can be divided into two general groups.
With consumer debt, you have prime and subprime debt… Subprime borrowers have much lower credit ratings and much higher credit risk.
With corporate debt, you have investment-grade and non-investment grade (or “junk”) debt.
Investment-grade borrowers are like prime borrowers. Junk borrowers are like subprime consumer borrowers.
If you split junk debt in half by their credit ratings, the lower half ‒ in other words, the worst of the worst ‒ makes up 35% of all junk-rated debt today. Leading up to the last financial crisis, that percentage was only around 15%.
It’s even worse with investment-grade debt.
More than half (57%) of all investment-grade debt is in the lowest-rated tier (BBB-rated). This is the highest percentage of BBB-rated debt ever.
What that means is that this debt is one level away from being considered junk. And when debt gets downgraded to junk, prices generally fall hard… they crash.
Keep in mind, companies are earning these poor credit ratings with interest rates near record lows, so the cost of debt is not as great as in higher-interest-rate periods. Investment-grade companies are paying less than 2% on their debt. Most junk-rated companies are paying less than 5%.
Still, around one out of every four companies in the U.S. can barely pay the interest on their debt… so-called “zombies.”
In short, corporate debt is at a record high, while credit quality is at a record low.
This is what a bubble looks like.
The bubble would have already popped last year if the Federal Reserve hadn’t injected trillions of dollars of stimulus money into the financial system, including buying corporate bonds for the first time in its history.
The Fed essentially gave junk-rated companies a “get out of jail free” card. And they’ve used it to borrow record amounts over the past two years.
Even zombies have been surprised by how easy it has been to borrow. As David Bernstein, chief financial officer of cruise-ship operator Carnival (CCL), told the Wall Street Journal…
“Somehow I managed to raise $6.5 billion… I was amazed.”
The Fed’s unprecedented actions just inflated the bubble even further. But like all bubbles, you can’t keep inflating them forever.
Recognizing a bubble is one thing. Predicting when it’s going to pop is much harder.
Michael Burry believes 2022 will see stock and bond bubbles burst.
That’s because the Fed is out of bullets.
The Fed
Last week, the Federal Reserve confirmed that it will be rapidly removing monetary stimulus next year. Now the fiscal spigot is getting shut off as well.
Economists sharply raised their inflation forecasts for next year
The first full (25 bps) rate hike is now priced in for May of next year
But there is now less certainty in the market about rate increases over the following 12 months.
Nonetheless, Credit Suisse expects three hikes next year and four in 2023.
The reasons inflation kicked into higher gear stem from the pandemic, ultra-loose monetary conditions, stimulus checks in the hands of idle, homebound consumers, and supply and labor shortages. In other words, extra money is chasing fewer goods and services. The combination has put upward pressure on prices.
After months of saying otherwise, Federal Reserve Chair Jerome Powell finally admitted that inflation is no longer “transitory”… and will last “certainly through the middle of next year.”
We all know prices for basic products go up over time. That’s because the money supply expands over time… It’s why a $0.45 Big Mac in 1967 now costs around $5.65.At the same time, technology tends to get cheaper over time thanks to human ingenuity. For instance, monthly smartphone plans – to use a powerful mini-computer – now cost less than what a mobile voice service alone cost 20 years ago… Technology is a disinflationary force.
So it’s not a question of whether prices are going up… In general, prices are always going up. The question is, at what rate are prices going up?
Where the rate of inflation goes from here will largely depend on how fast supply chains normalize from the pandemic… At this point, it’s not anywhere near the double-digit numbers of the 1970s and 1980s.
The Fed has two choices to fight inflation.
It can decrease the money supply or raise interest rates…
Either one will pop the credit bubble.
Don’t expect the Fed to try to decrease the money supply anytime soon. The only way it can do this is by selling Treasurys – something it’s currently not even discussing – or requiring banks to tighten credit.
Both options would result in higher interest rates and much tighter credit… more than enough to pop the credit bubble.
We already know the Fed is planning on fighting inflation by slowly raising interest rates, and I mean slowly. It is doing this in two ways:
It’s doing it indirectly by reducing (or “tapering” in Fed-speak) its purchases of Treasurys. The central bank began tapering its purchases by $15 billion per month in November and will up that to $30 billion now. The Fed had been buying around $80 billion to $100 billion worth of Treasurys every month since the beginning of the pandemic… Its purchases accounted for around 60% to 80% of all Treasury purchases.
Without the Fed’s artificial demand, Treasury prices will no doubt fall. And when Treasury prices fall, interest rates rise… including five-year, 10-year, and 30-year rates.
The Fed also raises interest rates directly by raising the one interest rate it controls ‒ the federal-funds rate. This is a short-term rate banks charge other banks to lend overnight.
The Fed recently said it will raise this rate three times next year… and three times in 2023. The planned rate hikes are small… only 1.5 percentage points by the end of 2023.
The Fed has to move slowly. It knows it can’t raise rates too fast. If it does, it will turn a recovery into a recession.
But at that rate, it will take years for the Fed to raise rates enough to catch up with inflation.
But persistently high inflation won’t allow the Fed to go slow.
It’s going to have to go even faster if it’s serious about fighting inflation.
Energy
The “biggest story no one is talking about” is how Russia has essentially stopped sending natural gas to Europe. The reasons may be more geopolitical than economic, but the shortage is nonetheless having an economic effect. The Dutch gas benchmark is up more than 8X this year, with much of that happening just this month.
The European energy crisis continues to worsen as temperatures fall and Russia shuts off flows of natural gas.
Natural gas prices have gone vertical, jumping by over 20% in one day.
Europe competes with Asia for LNG, and it recently became more profitable for exporters to sell into Europe.
Source: World Oil Read full article
Here is an Asia-bound US LNG tanker turning around and heading for Europe.
Source: @financialtimes, h/t Walter Read full article
European electricity prices have been soaring, which will show up in higher business costs and ultimately in consumer inflation.
US LNG exports are hitting record highs, but for now, the increase is not sufficient to meet the global demand for natural gas
China’s gas demand is rapidly outpacing domestic production.
Source: Gavekal Research
Prices of “used” LNG vessels keep climbing.
Source: VesselsValue Read full article
Global crude oil inventories continue to fall.
Source: @antoine_halff, @Kayrros
US Economy
- Job openings on Indeed continue to climb.
- The quits rate suggests that the unemployment rate should be much lower.
- Fewer businesses are participating in the government’s jobs survey, creating volatility and large adjustments in the official employment data.
- Morgan Stanley expects labor force participation to keep climbing over the next couple of years.
- The current account deficit hit a 15-year high last quarter.
- Supply bottlenecks are starting to ease, which could reduce inflationary pressures.
- Here is Baltic Dry (dry bulk shipping price index).
- Leading indicators point to downside risks for manufacturing.
- The Conference Board’s consumer confidence indicator ticked higher despite the omicron concerns.
- Existing home sales were strong in November, well above 2019 levels.
- Inventories remain exceptionally tight.
- US population growth dropped to a record low this year. A lesson from Japan is that it’s challenging to maintain economic expansion when your population growth stalls.
- And it will be especially difficult as the US working-age population declines.
Market Data
- The only down year for the S&P 500 this decade was when the Fed raised rates above 1%.
- Tech stocks tend to underperform during periods of high inflation.
- Tech stocks have often lagged after the leading economic indicator (LEI) peaked.
- However, relative earnings have not grown as fast this year, and Deutsche Bank expects further flattening.
- Investment managers have become more cautious this month, reducing their average exposure to US stocks.
- The S&P 500 dropped below the 50-day moving average.
- Investors remain cautious, with the Fear & Greed Index in fear territory.
- Momentum stocks have widened their underperformance.
- Cyclical sectors have massively underperformed defensives this month.
- The S&P 500 appears extremely overbought relative to Treasuries.
- Stocks rallied sharply on Tuesday, as US “reopening” shares rebounded.
- Volatility surged this month, bucking the year-end historical trend
- The Russell 2000 is at resistance again.
- By the way, the percentage of consumer staples stocks trading above their 50-day moving averages reached 90% last week, while fewer than 25% of Nasdaq stocks managed to hold their medium-term trends.
Thought of the Week
Recipe for true joy!
- Fill your mind with truth
- Fill your life with service
- Fill your heart with love
Picture of the Week
Obese children (globally):
An Empire State builder hanging on a crane above New York City, 1930
All content is the opinion of Brian J. Decker
