You Can Either Surf, or You Can Fight

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.