Approximately 10% of all companies listed on Nasdaq and NYSE fell by more than 10% over the past week. Its like a magnitude 5 earthquake happened and the entire market goes into panic mode.
During this occasion, it is fascinating to observe at a macro level the flow of money within the system.
Sources of liquidity
the white house administration has cut taxes over the past 2 fiscal years between 2017 and 2018.
the Federal reserve increase money supply through the repo market and by lowering interest rates
Central banks around the world lower interest rates
the high US dollar signals that money from around the world is flowing into the US market
High pressure areas
the price of gold moves steadily upwards
the price of US Treasury bonds signaled by the fall in US Treasury yield moves steadily upwards
the SnP hovers near all time high
Companies classified as value stocks are trading at all time high multiples
Companies classified as growth stocks are trading at huge discounts versus all time highs
Once the psychological impact of the current set of stimulus wears off and assuming the supply of money stays constant within the US market, it is very likely money will start flowing from high pressure areas to fill up the anomalous vacuum described above.
Companies are increasing shifting their service from one-off on premise licensing deployment monetization to cloud based SaaS recurring subscription models
revenue hit in the short run
increased customer LTV in the long run
affected publicly traded companies will experience short term discounts to their shares
Artificial intelligence versus Augmented intelligence
companies are increasingly shifting away from automatic insight generation to systems that help decision makers simulate and model potential outcomes when specific policies are executed
demand is shifting from insight generation to data cleaning services
Corporate adoption of artificial intelligence
CEOs are increasingly considering how to leverage AI as a tool for their trade
primary use case is figuring out how to increase their sales volume
experiencing challenge on how to apply AI on in-house data to achieve monetization goals
Rise of deep vertical data networks
EverString – provides sales lead refresh for all client companies ends up becoming a large database for decision-making executives information, approximately 6 million records
StreetSine.sg – cleans up real estate data to help agents better price houses for sale by utilizing in-house agency ends up becoming a large database of high quality real estate data
Bit coin is still the main poster child
general population still skeptical about libra
main argument is still to remove central bank controls
main adoption hurdles
writing throughput volume
a stable store of wealth
starting to be using as a means to facilitate transaction in China
Inability to increase or decrease currency supply in times of need is going to be hard as a means to provide much needed stimulation during economic recessions and inflations
US/China trade war
sources of conflict
forced technology transfer
unfair trade practices like subsidized state owned Chinese companies operating in the export markets
China is experiencing inflationary deleveraging
local farmers are not growing critical food sources
critical food supplies are imported
price of imported goods are denominated in US reserve currency
shifting of supply chain out of China to
Li Ka Shing moved funds out from Hong Kong in 2013 to Europe
raising funds for US Venture capital from China was easy prior to Chinese and US government shut down
US is experiencing deflationary deleveraging
businesses are concerned about macro environment and are reducing fixed investments
manufacturing is slowing due to decreased demand both locally and overseas
consumer spending and confidence is still strong
Chinese domestic concerns
Potential US meddling in Chinese domestic affairs – Hong Kong’s demonstration and demands
Revoking of National Education
Revoking of extradition bill
Resignations of HK Chief executive
universal suffrage: freedom to elect their own leaders
destabilized situation presents a challenge for Xi JinPing’s party to retain control of power over former Jian Zemin’s faction
US is a highly rule based system
China’s system of control is highly subjective to the individual in power. Direct government intervention in the distribution of wealth is a major source of concern
US/Mexico and world issues
NAFTA agreement was too one side and failed to take into account large imbalance between the two economies
US’s arrangement of allowing Mexican tax payers the right to claim dependents ultimately resulted into tax claims and refunds for entire extended families in Mexico. This has the effect of subsidizing Mexican’s at the expense of Americans living along the rust belts
Its observed income inequality is becoming prevalent across the entire world not just within US and China.
Noteworthy similarities in period prior to WW2 and present day 2019
Dire income inequalities where 40% of the wealth is owned by 1% of the population
Rise of populism
rise of protectionism
US launches trade war against Canada
Rise of militarism
Continue professing by politicians that there is nothing wrong with the economy
President Hoover attempts to allay fears
Extreme volatility in the financial markets
riots due to economic hardship
sudden shifts from relatively free trade and interconnected supply chains around the world to protectionism and trade war through the use of tariffs
US versus Canada trade war
Out break of war
Noteworthy case studies and observations
The war economy – Germany during WW1
GDP will tend to improve during war time as countries involved in war borrow heavily through the issue of bonds to finance production of war equipments
GDP will start to deteriorate after period of war is over as it transits back its prior state
GDP of the loosing faction will tend to be more severely affected during the post war period as they get slabbed with war reparations – WW1
Nature of loans during war period
Loans will initially be denominated in local currency due to high levels of patriotism
As war drags on and there are no signs of a positive outcome and loans becomes harder citizens will have either exhausted their loanable assets or are not confidant in the government’s ability
Further loans will need to be borrowed from foreigners which might result in loans denominated in foreign currencies
Connectedness of financial systems around the world – the 1930s Great Depression
USA 1930s deflationary deleveraging chain of events
investors buy financial assets and utilize increasing financial asset prices as collateral to buy more financial assets
government increases interest rate to tighten monetary policy and bring down inflation
brokerages increases margin interest rates
investors who cannot afford margin interest rates starts unwinding their positions leading to fall in financial asset prices
fall of financial asset prices triggers margin calls on other investors who borrowed to buy financial assets. This vicious cycle continues and confidence starts deteriorating and credit starts unwinding
bankers attempt to prop up asset prices and boost confidence by buying assets. Efforts were not enough, and asset prices continue to decline – as much as 90%
other entities are impacted
actual companies start experiencing problems getting credit
banks whose assets are in financial assets experience solvency issue due to rapidly deteriorating
bankruptcies and unemployment rate increases
government steps into prop up the market by lowering interest rate
interest rate is at all time low, investors lacking confidence is unwilling to provide credit many started withdrawing cash from banks causing bank runs. They also started hoarding gold.
There is an international shortfall of USD
Europe 1930s inflationary deleveraging chain of events
Confidence worldwide gets affected by US market deleveraging
Germany whose WW1 reparation denominated in USD experiences were mainly financed through the issuing of bonds experience difficulties finding buyers for new bonds.
investors loose confidence in ability of German government to repay bonds and start believing in the probability of a default
investors started dumping bonds and withdrawing gold from the German economy
UK have many banks with assets tied to German bonds. Investors are concerned that UK will get affected and started withdrawing gold in droves.
UK government and German government decoupled their currencies from the gold standard, lowered interest rates and allowed exchange rates to decline
USA 1930s inflationary deleveraging chain of events
USA continues to peg their currency to the gold standard but experiences continued outflow of gold because gold is now considered to be priced too cheap against USD when compared to other European currencies that have gone off the gold standard
USA bans the purchase of gold, decouples their currency from gold and allow exchange rates to float freely
This book describes how the 1997 Asian Financial Crisis transpired.
Only 2 of these three conditions can be allowed to be true without causing inflationary recession
Fixing the currency exchange rates against other reserve currencies
Control over domestic interest rates
Control over capital inflow
On foreign capital flows
huge volume of foreign capital flows into a country
economic growth rate increases
inflation rate stays low
huge volume of foreign capital flows out of country
economic growth rate decreases
inflation rate goes up
Common pattern across countries
The build up
Long periods of high export lead GDP growth attracts high levels of foreign investments. Huge volume of foreign funds originated from Japan which was having a very loose monetary policy
Countries peg their exchange rates to reserve currency to ensure stable prices for both imports of raw materials and exports value added products
Countries currencies are not reserve currency, hence foreign loans were denominated in foreign currency
Excessive leverage within the country by domestic parties who take on short term loans denominated in foreign currencies at lower interest rates to finance long term projects that generate returns in domestic currencies
Stocks are purchased with borrowed money. These stocks are then further used as collaterals to borrow more money
Real estate are purchased with borrowed money. These real estates are then further used as collaterals to borrow more money
Moral hazard due to corruption of financial system
banks are arm twisted to finance projects that are not financially viable by governments and politicians
The economic headwinds
countries face increasing export market pressure
Competition at the low end of the export markets from China
Competition at the high end of the export markets from Japan
Japanese government instructs central bank to tighten monetary policy to reduce real estate. This severely restricted liquidity from Japan and reduced availability of short term foreign loans to affected countries
Borrowers within these countries increasingly experienced difficulties rolling over their foreign denominated short term loans to finance their long term illiquid domestic projects
Many of them started defaulting on their loans
Foreign investors started getting spooked and started withdrawing their funds or refusing to allow their loans to roll over
Non-performing loans builds up amongst banks within these countries
Capital flight continues causing downward pressure on the exchange rates of these countries
Countries continued defending their exchanges rates by buying up their own currency and selling off foreign reserves (assets held in foreign currencies)
Countries deplete their foreign reserves and are unable to uphold their exchange rates. Since most debts are denominated in foreign currencies, they are not able to print money to pay off these loans.
The economy grinds to a halt and hyper-inflation occurs within their financial system at this point
domestic production stops and locally produce foods is no longer available for sale
due to shortage of foreign reserves imported products become very expensive in local currency
Countries approach IMF for loans to tide through this liquidity crunch.
IMF steps in and with a lack of understanding of the economic patterns imposes these requirements:
Countries required to impose high domestic interest rate. It has the effect of further reducing the money supply within these countries causing more defaults domestically.
Countries will reform the financial systems to remove cronyism lead financing
Riots ensures and Anti-establishment governments get elected in some countries
IMF releases the misstep in policies and relents
Countries lower their domestic interest rates to increase liquidity within their financial system
Countries allow their exchange rates to float freely
Relatively cheap asset prices within these countries starts attracting foreign investments again
After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.
Their income is thus restricted to investment banking commissions and net interest incomes.
This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.
The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.
They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates.
Events leading to massive failure
During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
De-regulation of short term interest rates which lead to increased competition by other banks for deposits. This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
Entrance of new entities
mutual funds competed for deposits
Freddie Mae and Freddie Mac competed for mortgages
SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.
Government meddling in market mechanism to further political agenda is generally a recipe for disaster
Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster