The Big Short – When will it start?

The question of when the next market correction is due has been doing the rounds in recent weeks, the bears beginning to come out of an extended hibernation, with U.S equity markets hovering at close to record levels, without being able to press ahead, the FTSE100 pushing through to 7,400 levels despite the British government planning to invoke Article 50 next week and be willing to give up access to the single market in the interest of being able to protect Britain’s borders and then there’s China.

In a recent education piece we talked of what could possibly cause the next crisis and included the U.S student loan and what some may refer to as the Trump Bubble in years to come. The 2008 crisis will certainly be remembered by many and the resulting losses will most likely bring about far more severe corrections than we have perhaps seen previously, investor nerves still a little frayed even with the 8-years of wound licking.

While the FED continues to trundle down the road towards a normalization of monetary policy, some fear that the U.S economy is unfit to absorb such shift in monetary policy. The increased borrowing costs stemming from the latest rate hike and the prospects of two further rate hikes through the year is the primary concern. The FOMC held its projections for growth unchanged for the current year, while revising upwards its forecast on inflation.

The markets have a different view for now, with U.S equities making gains following the release of the FOMC economic projections and, while companies fare better with lower borrowing costs, the markets will also be considering the prospects of a tax reform bill that is expected to offset the negative effects of rising borrowing costs for companies and let’s not forget where rates currently sit relative to historical levels…

For now consumer confidence in the U.S looks to be fueled largely by the promises of a new and inexperienced administration. The Dow’s bounce from 20,000 to 21,000 was a particularly impressive move, but how impressive will be the correction, should the administration fail to deliver on the promise of tax reforms and fiscal stimulus?

Either way, market anxiety is on the rise despite the relative lack of volatility. Various fear gauges exist in the markets today, most developed in the wake of the global financial crisis, as analysts look to baromitize human behavior in search of the next sell-off. Some of the better known include:

• The Merrill Lynch Global Financial Stress Index
• The CBOE SKEW Index
• The Credit Suisse Fear Barometer

Fear gauges have reflected rising demand for protection against market corrections and at current levels, it won’t be a surprise to many, though as the costs continue to rise, it will only be a matter of time before the option to short becomes more enticing…

This time around however, it may not be the U.S that delivers the next crisis, but China or even Europe. The debate over China’s actual economic growth figures over those published is certainly not expected to come to an end any time soon, with the Chinese government setting a 6.5% target for growth in 2017. Estimates are that the actual economic growth was nearer 3.5% in the 4^th quarter of last year, rather than the published 6.8%.

There is a vast difference between the two figures and, as we have seen in recent years, market sensitivity to China’s GDP figures is particularly high.

So, while focus may be on the FED’s path towards normalization, which may well be a long and windy one, the PBoC’s intentions to tighten monetary policy, with the government’s plans to pull back on fiscal stimulus may be of a greater concern and risk to the global economy.

Central banks have been cautiously optimistic over the global economic outlook, but few will deny that they are not concerned with China’s debt crisis and government’s plans with sectors struggling with over-capacity, the very same sectors with ballooning debt levels.

George Soros considers China to be the next catalyst for a global meltdown, Soros perhaps best known for bringing the Bank of England to its knees back in 1992, pocketing a reported $1bn going short on the pound.

While Soros believes that China has adequate reserves to weather any storm, he expects a hard-landing in China to have significant ramifications to the rest of the world, Soros believing the hard-landing to already be under way. Soros considers that China has materially inceased the risk of global deflation, to which central banks will likely have few, if any tools to counter.

Some may consider deflation as a positive, supporting consumption, but the reality is that a deflationary trend generally leads to a pause in consumption, with expectations of lower prices tomorrow causing the pause.

In Europe, Rutte’s victory in the Dutch elections led to market relief that a breakdown of the Eurozone had been thwarted, but the French elections have far more significant influence on the future of the Eurozone, while the markets neglect to consider one other driving force, Brexit. Member states will undoubtedly be watching Britain’s progress closely, once Article 50 is invoked and, if it’s looking good for the Brits, it would be hard to imagine other member states not looking to head for the exit door.

So, whether it’s the Trump bubble, a U.S student loan crisis, global deflation, a China debt crisis or an implosion within the EU, which leaves the global economy in no man’s land remains to be seen, but when looking through the markets for value, it’s certainly a challenge to now enter with conviction, bringing into play the next big short and you can be sure that the likes of Soros will be first in line, the only question seeming to be when and where, not if.