The emerging market capital structure trap; Comdols beware!

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“A wise man proportions his belief to the evidence.”

--David Hume

Commentary & Analysis

The emerging market capital structure trap; Comdols beware!  

According to Professor Michael Pettis, the primary cause of crises in emerging markets (or less developed countries—LDCs) flows primarily from a mismatch within a country’s capital structure.  He refers to this as the capital structure trap.   

Prof. Pettis’ capital structure trap idea aligns closely with economist Hyman Minsky’s “financial instability hypothesis.”  Pettis explains it this way:                

“Minsky sees an economy as a system in which endogenous processes can generate ‘incoherent states.’ ‘Cycles and crises,’ he says, ‘are not the results of shocks to the system or of policy errors.  They are endogenous [having internal cause or origin].’”

So, accordingly, Minsky argues that crises are not caused “because of external events or bad policy choices force a revaluation of asset values but are instead determined inside the system.”  Pettis utilizes this framework built by Minsky to argue that a country’s capital structure is vitally important to how it reacts to external shocks and if country’s funding strategy does the following two things it is more exposed to crises:

1.      It links financial or debt servicing costs to the economy in an inverted way.

2.      More dramatically, it locks the borrower and its creditors into a self-reinforcing behavior in which small changes, good or bad, can force a players to behave in ways that exacerbate that changes.


“The capital structure trap consists of an inverted liability structure in which an external shock can force both the borrower’s revenue and its debt servicing expense to move sharply in an adverse direction. This occurs to such a degree that it forces a sharp increase in the probability of bankruptcy, which, by changing the behavior of investors, then forces the capital structure to move even more strongly in an adverse direction.  This is what makes the trap different from an ‘ordinary’ badly designed capital structure.  A typical badly designed capital structure simply fails to take advantage of risk-reduction structures—in itself it does not add volatility.  The capital structure trap, on the other hand, exists when the capital structure itself incorporates a feedback mechanism that causes the domestic impact of the external shock to feed on itself until the debt burden spirals out of control.

                                    Michael Pettis, The Volatility Machine

So what major external shock has been delivered to emerging markets?  The same that has hit all countries: the credit crisis of 2007-2008.  But it has been particularly vicious for emerging markets as:

  1. The price of EMs key export component—commodities—have plummeted since Apr 2011; after the initial rebound from the credit crisis (as the cost of dollar funding has risen)…

2. Demand for their goods from both the developed world and China has fallen…

So, the profitability of EM-based corporations and cash flow to EM governments continues to fall, even as its debt levels and corporate leverage continue to soar….

This is from The Bank of International Settlements 5 February 2016 [my emphasis]:

“The growth of debt in the emerging economies has been dramatic, as shown in Graph 1 [below]. The left-hand panel shows the level of private credit as a proportion of GDP in the emerging economies compared with that in advanced economies. We see that although the level of private credit is higher in the advanced economies, the growth trajectory in the emerging economies has been very steep. Since 2009, the average level of private credit as a proportion of GDP has increased from around 75% to 125%. The slightly declining line of the advanced economies’ non-financial private sector debt hides significant differences among countries. Among the G20 economies, two have decreased private debt by 20 percentage points of GDP or more, while seven countries have increased debt by 20 percentage points of GDP or more. The centre panel of Graph 1 plots the steep upward trajectory for the growth of private credit as a proportion of GDP for Brazil and China. The trend is especially striking for the debt taken on by nonfinancial companies (Graph 1, right-hand panel). The debt of non-financial companies in emerging market economies (EMEs) has grown so rapidly that in 2013 it overtook that of advanced economies, as a proportion of GDP. Since then, the corporate debt of EMEs as a proportion of GDP has pulled ahead of that in the advanced economies even further.”

And on the EM corporate side of the fence, leverage is rising as profitability is falling…

“As we see from Graph 2, corporate leverage in emerging economies has risen in general. This does not only reflect the increased debt of commodity producers, as seen by the fact that the leverage of companies producing non-tradable goods has risen even more than that of those producing tradables (centre panel). Moreover, the increase in leverage is most marked in the highly indebted segment – the 75th percentile in the graph. This is presumably the lower-rated segment. Increased leverage would be less of a concern if debt is used to finance productive and profitable investments. However, the profitability of EME non-financial companies has fallen. Traditionally, EME firms have been more profitable than their advanced economy peers, but this is no longer the case, as we see in the right-hand panel of Graph 2. The profitability of EME corporates has fallen markedly in recent years, and has fallen below that of advanced economy firms.”

And though the graph below is a bit old, as of June 2014, EMs were sitting on about $6 trillion of US dollar credit [graphic below far right]. Yikes! 

…and that dollar credit cost is rising as the US dollar appreciates and US market interest rates creep higher.  Additionally, it’s not going to be easy to replace this dollar credit with euro funding as the Eurozone has its own host of troubles, not the least of which is Deutsche Bank.

I think this qualifies as a capital structure trap as defined by Mr. Pettis.  If so, the question is when will the crisis begin? 

So far, the level of complacency seems amazing as investors continue to bid up emerging market stocks and bonds:

Sound financial analysis is likely not the driving force of investor complacency in emerging markets; I think we can chalk it up to the ubiquitous stretch for yield.  Thanks again Janet & Company. 

From a currency perspective, there has been a fairly decent positive correlation between emerging market stocks and commodity currencies as you can see in the chart below:

So, if you suspect emerging markets are vulnerable, but you also like the yield produced by holding the Comdols (Aussie and Kiwi more specifically), beware.  If the good professor is correct, Comdols are due for another bath it would seem.                                      

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Jack Crooks

President, Black Swan Capital




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“And what would you do, if you could rule the world for a day? I suppose I would have no choice but to abolish reality.”

--Robert Musil

Commentary & Analysis


Janet & Company just couldn’t do the deed.

Given that Janet & Company sounded so “hawkish” when they were sipping wine and eating cheese in Jackson Hole, reporters at the recent Fed press conference asked if waiting till after the election to hike rates might be politically motivated. “Oh no”, she said.  “We never discuss politics.”  I take Janet at her word.  Why would the Reserve Board need to “talk” politics?  I think most of them are big government-loving leftists anyway. Has anyone else got the feeling the Fed’s credibility has lurched even deeper into the laughable zone thanks to the last press conference?  Dot-plot anyone…what the heck is that mess anyway… 

Dollar bull market or will the dollar disappear?

My son asked yesterday, with his tongue firmly planted in his cheek, if I was able to sleep at night knowing “world money” was about to replace the US dollar by the end of next week? 

Given the global macro backdrop and the potential for:

1)      A significant mark-down in Chinese growth prospects as both banking and real estate concerns loom.

2)      Real potential for a significant risk-driven fall in the euro as:

a.       Germany weakens politically (Mrs. Merkel disastrous refugee policy coming home to roost) and economically (big decline in German exports on falling global demand)

b.      An Italian referendum looming

3)      The US economic demand globally still weak despite some bright spots

4)      Emerging market debt in the ozone with hair trigger international investors ready to dump EM bonds on the first sign of trouble…

...all usually bullish for the reserve currency, I told my number one son: Yes, I am able to sleep just fine.  But even if am wrong on the direction of the dollar, I still suspect it will act as the global reserve currency well past the end of the month.  

If you are confused here, let me bring you up to speed on this: A major newsletter house currency charlatan guru is guaranteeing the dollar is doomed and will “in fact” be replaced by “world money” at the end of this month.  [I am not kidding.  Promos and videos galore are supporting this hallucination.]

But despite said charlatan’s  guru’s warning, I am sticking with my call for another leg up in the US dollar bull market before it is over.  But, with this caveat: If those overseas dollars are being gathered up by the secret “world money” administrators (I guess they go door-to-door to collect these things, but not sure) and start showing up packed in tractor trailer trucks at our ports, I will change my mind. 

George Orwell said: “Advertising is the rattling of a stick inside a swill bucket.”  In this case, I think he nailed it.

New Zealand Dollar: Finally?  Maybe?

I have been trying to short the New Zealand dollar off and on for a while now; with very little success, and mostly failure.  But just maybe something is clicking this time.  And if something interesting happens with risk assets (i.e. a big dump in the stock market) I think the New Zealand dollar can tumble. 

I shared these three rationales for reasons to go short Kiwi with our Black Swan Forex subscribers:

1)      NZD is tightly correlated with price action in emerging stock markets

2)     NZ$ vs. US$ relative yield spread has been falling

3)     Our Elliott Wave chart analysis

You can view the full report here…

Kiwi breaking a bit today…fingers crossed.

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Hopefully, Black Swan represents the anti-guru approach to trading and investing.

Have a great weekend.

Thank you.

P.S. Jerry—I just tried 10-year Benromach for the first time (yesterday); really good stuff.  Ralfy’s 2014 whisky of the year

Jack Crooks

President, Black Swan Capital




Time for central bankers to find a spine…

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“If you don't know where you are going, any road will get you there.”

 --Lewis Carroll

 Commentary & Analysis

Time for central bankers to find a spine… 

After the Bank of Japan (BOJ) did what it did, a boatload of economics Ph.D. descended on the airwaves and internet blogs this morning to share their usual inside baseball stuff in an effort to explain the “bold” move by the Bank of Japan—targeting the yield curve.  But outside the minds of economists who actually condone such tinkering will any of this matter? 

Japan has blazed the trail to zero rates and beyond.  Suckers in Europe have followed because it has worked so well for Japan.  This action on the part of the CBs begs the question: To what good have any of your policies done, short of providing liquidity to help stabilize the banking system and credit markets in the midst of the crisis?  The BOJ has been at this game of ZIRP off and on (mostly on) for the last 20+ years.  Growth in Japan is still morbid.  Debt to GDP is off the charts.  And deflation is still the order of the day.

Some seers are saying the BOJs decision not rely on increases in the money supply, and just maintain its current level of quantitative easing, is a hint to the Japanese government that monetary policy isn’t getting the job done and structural reforms are needed in order to change the economic trajectory. 

To review, Prime Minister Abe was elected in December 2012.  Upon taking office he enunciated a three arrow strategy in order to break the grip of deflation in Japan and grow the economy.  These three arrows were: 1. the pressuring of Bank of Japan into launching unprecedented aggressive monetary easing and setting a target of 2% inflation to support a target of 2% real GDP growth (4% nominal growth); 2. a blowout deficit-financed supplemental government budget filled with new public works spending; and 3. a program of reforms to achieve growth through stimulating private investment.  The third arrow, the most important if you aren’t a hedge fund manager, is the most important. And so far this arrow hasn’t left the quiver. 

Why?  Simple answer: Crony capitalism doesn’t want real reform (Brexit a perfect summary of that.) Big business doesn’t want real competition.  This is why CEOs of our major corporation are joined hand-in-glove with our political leaders. Big investors love the financial asset bubble; why make changes?

I am not sure if the BOJ is implicitly sending a message to the Japanese political class.  But I do know it is past time all central bankers reach back and find their spines, assuming they ever had such a thing to begin with, and explicitly tell their respective governments—we can do no more.  Financial repression isn’t working for most of our citizens; save those with access to capital.  Is there any wonder why hedge fund manager extraordinaire Ray Dalio, and his cronies, are constantly creating all kinds of arguments why the Fed shouldn’t raise rates—“OMG, they can’t raise rates.”  Hell, I think if Ludwig von Mises were pulling down a cool $500+ million a year, as did Dalio in 2015, he’d be all for financial repression too. 

Add to this shit-show the fact no one yet understands the potential unintended consequences of negative rates.  The prospect of an estimated $12 trillion in paper issued at negative rates is an anathema to a market system that allocates finite resources through proper price signals, and should terrify anyone with a logical brain cell left in their head. 

Time for real structural reform, or to put it another way, time for Mr. Market to start clearing away the dead wood so fresh entrepreneurial growth can resume is way past due.  That signal for the entrepreneur is sent first and foremost through the rate of interest (the signal now being sent to the market will be responsible, at some point, for the trillions of dollars in capital flowing straight down the rabbit hole).  But instead of CBs doing what we know works (does anyone remember a man named Paul Volcker), let’s just keep stumbling along in monetary and fiscal wonderland, keeping those political contributors happy, and expecting everything to work out for the best.  It’s such a grand idea it requires a Ph.D. in economics to understand it.   

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Thank you.

Jack Crooks

President, Black Swan Capital




Dollar Reserve Currency Confusion – Or just snake oil salesmen…

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“Surely nobody would be a charlatan, who could afford to be sincere.”
--Ralph Waldo Emerson

Commentary & Analysis
Dollar Reserve Currency Confusion – Or just snake oil salesmen…

There seems to be a lot of confusion about the US dollar reserve currency status.  The biggest fallacy is the belief the US $’s reserve status bestows some great benefits on the US economy.  It doesn’t.  In fact it’s quite detrimental.  I am penning this piece now because I noticed the snake oil salesmen (aka pundits and gurus who like to scare people using the dollar as their boogeyman) are out in force yet again. 


In their never-ending series of dollar doom (DD) forecasts, predictions, confusions, hallucinations, lies, and manipulations (I will let you pick which of the words you wish to attach to your favorite double-D guru) I must say the latest incarnation they are peddling from the back of their wagon is a real whopper. 


The DD punditry is now providing not only a specific reason why (“world money” will replace the dollar), but an exact date (the end of this month) to their crystal-ball-ology. I am not making this up—really.  Of course the go to trade, once again, is gold.  $10,000 an ounce on the way…again!


I’d like to share a few reality bites in effort to help you understand why you need not fear the Charlatan Choo-Choo of DD which seems to be racing down the tracks of gullibility…


Rationale/Fallacy #1: The dollar will be confiscated by international authorities who will be issuing “world money” and sending dollars back to the US in shipping containers.  LOL…Now seriously, if I have to explain why this is total crap, you shouldn’t be wasting your time reading Currency Currents anyway. And don’t think this forecast is based on some miraculous issuance of International Monetary Fund Special Drawing Rights (SDR).  SDRs are a claim on currency (they are not currency); and there is only a miniscule amount available anyway relative to the needs of the global monetary system.  And guess what:  The US dollar is the largest weight of the currency basket on which said SDRs are based. [Could one-day the SDR play a bigger role in the global monetary system?  You bet.  Is that one-day anytime soon?  No way, as evidenced by the complete fecklessness of the G-20.  Would a bigger role for the SDR be bad for the US economy—nope…in fact it would be very good for the US economy, which leads us to fallacy #2…

Rationale/Fallacy #2: The US dollar world reserve currency status will be challenged.  This is one of the most consistent “go to” snake oil salesman rationales in the book.  Every DD worth his weight in yuan pulls this one out of their basket of confusion when needed.  But then again, most of the PhD’s in economics buy into this fallacy (no surprise there I guess). 

Let’s use the US-Chinese relationship as our standard for understanding the detrimental role of the reserve currency at it relates to excess foreign reserves invested in US Treasuries:

Remember these key contentions.  Foreign buying of US Treasuries…

  1. Doesn’t help out the fiscal deficit in the US, but in fact makes it worse.
  2. Doesn’t help push interest rates in the US down, but in fact pressures rates higher if anything.
  3. Doesn’t help US employment, but in fact hurts it.

Okay, here we go with the example, I will do this in bullet point format in order to help simplify because it is confusing (balance of payments accounting is supposed be so simple):

  • China has excess savings and it shows up in its current account surplus as such.  (Now we need to make a clear distinction between a country’s savings and individual savings—they are two different animals).  Excess savings is another way of saying production exceeds consumption; or domestic demand cannot handle all the production therefore China has to find it elsewhere.  Thus, China exports these savings in the form of purchasing US Treasuries, as said in order to grab demand from the US. 
  • So let’s look at the equation….
    • China buys US$’s; then buys US Treasuries with those dollars…
      • $ buying by China forces up the relative value of the US$ compared to the Chinese yuan.
        • An appreciating US$ (and falling Chinese yuan) tends to put downward pressure on US manufacturing, as the goods manufactured become relatively less competitive …
          • Pressure on manufacturing puts downward pressure on employment, i.e. it increases unemployment and it in turn creates a feedback loop of lower relative investment from manufacturers in the US.
  • Now, one of two things can happen:
    • Chinese investment in Treasuries can be borrowed by businesses for investment purposes and to a degree negates impact of a lower dollar on employment; i.e. business investment creates new jobs (a positive outcome).  But, as indicated above, this doesn’t usually happen because the rising US dollar makes manufacturing relatively less competitive and the feedback loop of lower employment reduces domestic demand.
    • Government increases the supply of bonds to mitigate impact falling tax receipts.  The US government attempts to mitigate the negative impact of China grabbing US demand, as described, through increased borrowing and spending to help alleviate impact of unemployment (falling tax receipts from workers and manufacturing sector); in short more government spending in order to replace lost local demand because of Chinese buying Treasury bonds.  This is usually the case.    
  • Now, it is precisely this additional borrowing by the US government which increases the supply of bonds which in turn pressures interest rates higher.  [Additional private borrowing to support the prior standard of living also creates problems of its own as this borrowing is primarily spent on consumption and/or real estate—neither of which produce a cash flow to retire the debt.]
  • To simplify, remember that a rising current account deficit means lower tax receipts to government.


 Net foreign buying of US bonds:

  1. Slows US growth
  2. Increases debt
  3. It does not lower interest rates
  4. Foreign buying increases fiscal deficits
  5. Adds to the current account deficit

So, where is the great privilege here?  Why do other countries get so worked up when someone starts buying their bonds, as they buy US bonds?  For example Japan makes sure it sterilizes any impact of China buying its bonds by turning around and buying a similar amount of US Treasuries to neutralize the impact.  If this reserve status was so great why would Japan not embrace China’s buying of its bonds?

A French finance minister, Valéry Giscard d'Estaing, coined the phrase “exorbitant privilege” to explain the role of the US dollar in the global monetary system (even though the French, and the rest of Europe for that matter, piggybacked on artificially low exchange rates relative to the dollar after the War and never revalued—talk about no good turn goes unpunished.)

But Mr. Giscard should have known better.  He would have had he read anything from economist Robert Triffin who expressed this warning about a US dollar replacing gold in the monetary system: 

In 1960, Triffin testified before the United States Congress and warned of serious flaws in the Bretton Woods system. His theory was based on observing the dollar glut, or the accumulation of the United States dollar outside the US. Under the Bretton Woods system, the US had pledged to convert dollars into gold, but by the early 1960s, the glut had caused more dollars to be available outside the US than gold was in its Treasury. As a result, the US had to run deficits on the current account of the balance of payments to supply the world with dollar reserves that kept liquidity for their increased wealth.

Despite the end of Bretton Woods, the dollar’s role is still hugely dominant as the reserve currency.  And guess what: the US runs a large and chronic current account deficit with the rest of world. 

So, if another country took on the burden of reserve currency status, or some incarnation of Keynes idea at the Bretton Woods conference—the bancor—is reincarnated, the US economy will be much better off.   

So, the next time Mr. Snakeoil tries to scare you with the usual “loss of reserve currency status” canard, tell them:  That’s great! I am investing in America.   

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Thank you.

Jack Crooks

President, Black Swan Capital




Long bond comments

News & Comment
9 Sep 2016/7:29 a.m. 

If you have been following our Key Market Strategies issues, we have been expecting a sell-off in US long bonds (higher yields) based on the developed wave setup---a triangle pattern (which is a continuation pattern)--as you can see in the chart below using the exchange traded fund (TLT - 20-yr bond index) as the measure :

30-yr Treasury Bond Futures off 24/32nds today (almost a full point)....2-yr Notes flat....

The implication is the dollar regains yield cover; and it may increase sentiment/expectations for a future Fed hike.  This in turn should be dollar bullish.  The additional takeaway is if, and a big if, this move in bonds roils the stock market (and I suspect it will) then the dollar gets a risk bid added to the yield cover.  This is a big part of why we remain dollar bullish despite the palpable change in sentiment from some quarters.   

If we do get a break in stocks, we would suspect the usual:

- USD/JPY to remain supported and maybe EUR/USD too
- Comdols and the pound to get hit; comdols the most