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International Selection

«The markets are trying to tell us that there is a severe issue out there»

Christoph Gisiger, New York
James Bianco, president of Bianco Research, expects more turmoil to come and warns that there will be no easy way out of zero interest rate policy.

The sigh of relief could be well heard on Wall Street. After days of heavy selling the stock market has calmed down somewhat at the end of last week. But according to Jim Bianco it’s too early for an all-clear signal. The influential market strategist from Chicago who is highly regarded among institutional investors expects equity prices to drop further. He’s also quite skeptical about the heavy-handed interventions of the authorities in China. With respect to the United States, he believes that there is going to be a massive liquidation in the oil patch.

Mr. Bianco, stocks have taken a big hit. Is the sharp drop in equity prices justified or is it an emotional overreaction?

There is an old line in the market, first coined by the economist Paul Samuelson. It says that the stock market has predicted nine of the last five recessions. There is some truth to that phrase. But I would also point out that predicting nine of the last five recessions is a much better track record than the consensus of economists. We wish they were that accurate, but they’re far worse. Every time the financial markets get volatile and messy like this it deserves attention because the markets are trying to tell us that there is a severe issue out there. It’s been coming from all over the place: We got a collapse in commodity prices and we got financial markets across the globe selling off, including in the United States. So I’m going to pay a lot of attention to it.

What are the markets so worried about?

Two things: First, what they are worried about is a global slowdown. It’s a global slowdown in manufacturing. You see it in commodity prices, you see it in the GDP numbers out of China and you see it in the manufacturing numbers in the United States.

And second?

The heavy-handedness of central planning is going to be a lot harder to get rid of than people think. The big difference between now and any other hard sell-off since the financial crisis is that the Fed is raising rates. In 2011 for instance, the markets sold off a lot harder than they did now. But what did it take to end it? The Federal Reserve gave us Operation Twist which was a precursor to QE3. Now, that the markets are selling off the Fed is raising rates. So it’s doing exactly the opposite. Warren Buffett has a line that you don’t know who’s swimming naked until the tide goes out. We don’t know how dependent markets are on central bank policy until they start to reverse it. And now, as the Fed starts to reverse it, we’re finding it out and it’s a bigger problem than we think.

Meanwhile China is trying to move heaven and earth to calm down the markets. Do you think China’s economy can avert a hard landing?

China is a communist country. They’re communists and when their economy started to misbehave and when their markets started to get upset they went right into their communist thinking. They started throwing speculators in jail and  billionaires turned out missing. But this is not the way you handle a volatile market. The incompetent mismanagement of the Chinese markets and economy by the Chinese government makes it even worse. And by making it worse they make people lose their confidence. So this gross mismanagement results in a loss of confidence in the Chinese government of the wealthy. That’s why you have a giant capital outflow out of China.

How concerning is this flight of capital?

No one disputes the capital outflow. But the innocuous, “so I don’t get thrown in the Gulag”-way of saying it is: “The volatility in the markets are scaring investors out of China.” What’s been happening in China in the last couple of weeks is that as the markets have gotten volatile they have stepped up their market interventions, including last Thursday intervening in the currency market with the largest amount of money they have intervened with in the last three years. They’re trying to hold the currency steady but Chinese stocks were still down 2% on that day. They’re trying to make us all believe that there is nothing to see here. But there is still a lot of stress. You see it in the collapse of the Hong Kong Dollar to its lowest level in twelve years.

Tensions are also high in the energy sector. What’s going to happen if oil hovers around $30?

In the oil industry you have misallocation of capital, in part by seven years of zero interest rates. Especially in the United States the energy sector was grossly overbuilt with horizontal drilling and fracking. A lot of those companies borrowed a lot of money and have put themselves into a bad place. They have no choice but to keep drilling. In July of 2014 the price of crude oil was $107 per barrel and the US was producing 8.4 million barrels per day. Today, with the price at around $30 production is 9.3 million barrels per day. So more oil. If these companies stop drilling, they’re out of business. But if they keep drilling they are going to drive the price so low that they’re going out of business, too. In the oil industry the phrase to describe what’s happening now is called “dead man drilling”. That pretty much sums it up.

How low can oil go?

At the heart of the collapse of the oil price has been a slowdown of demand. That’s why we’re seeing inventories around the world blown up to the highest level ever. So to get a real bottom in oil prices we need to take production out of the market. That’s an euphemistic way of saying that oil companies have to go away. There has to be massive liquidation. For that, the oil price doesn’t have to go any lower. It doesn’t need to go to $20 or $15. If in June the oil price is at $35 it will be still too low for most of these companies and it will do the damage. It needs to get into the high forties for the industry to have a chance to survive. At this point this means it has to go up almost 70%.

The fear of bankruptcies in the oil patch is putting a lot of pressure on high yield bonds. How dangerous could this get for the financial sector?

Part of this misallocation of money in the oil industry was that a lot of these companies bought into the high yield market, partly because the Federal Reserve drove yields down so low. That made it economical enough for a risky project like oil drilling to finance itself.  Today, energy is maybe 7% of the high yield market. But at the high of July 2014 it was around 20%. That’s what happens if you kill the market: It is no longer a big weighting in the market. But the problem is it was a big weighting. And now you’ve got chaos in the high yield sector driven largely by the error investors have made in energy.

So what are the ramifications of that?

Many experts pretend that this is no big deal. But the same experts also said subprime doesn’t matter, Greece doesn’t matter, the Yuan doesn’t matter or volatility in the stock market doesn’t matter. Well, some of those things mattered and some mattered a lot. This is the way all these crises have started. They always start with something you think is small and then they metastasize in ways you cannot begin to understand. This is going to impair everybody in the high yield market from borrowing. Everybody is going to pay a higher cost of capital because of the energy error in high yield. How much does it affect everybody? Well, tell me when it stops. I don’t know how much wider spreads on high yield bonds are going to get. But I think they’re going to continue to get wider. We’re not done yet.

Wider spreads on junk bonds are usually also a sign for trouble in the economy.  How robust is the economy in the United States?

Most economists will tell you that the US economy is okay and everything looks good. That is correct if you take a view backwards. But the market is telling you that from this moment forward things are maybe not as good as we think they are. Forward looking measures are not that good and one of the best forward looking measures are earnings which are terrible right now. So the question is: Is the marketplace telling us that going forward from here we should expect a different type of economy? The low interest rates on treasury bonds, the falling expectations for inflation that the tips market is showing us and the volatility in the stock markets makes me believe that the answer is yes. We should expect something different.

What does that mean for the Federal Reserve?

The Fed wanted to get out of the market manipulation game. They knew that QE didn’t work anymore for the economy. It just served to push up stocks and they didn’t want to be in that game. So a month ago they raised rates and they promised us that they were going to raise rates four times this year according to the dot chart. But nobody else believes that they are going to move four times. So the Fed has a very difficult choice in front of them: Do they cave to market expectations and then be forever branded as being reactionary to the financial markets. Or do they stick to their guns and then be branded as the people that caused undue market stress. There is no win in this situation. I don’t know which way they are going to go on this. But I wouldn’t be surprised if we saw some kind of moderation out of the Fed so that they talk about less rate hikes.

What does all this mean for the outlook on the stock market?

Ironically, one of the better performing markets has been the S&P 500. The index had its low point on the 20th of January when it was down 14% from its peak. Nevertheless, it’s been performing a lot better than most of the other stock markets around the world, Most of them are down more than 20% which is the general definition of a bear market. I suspect that in the first half of this year the S&P 500 will get to  that, too. Maybe we’re ready to have a little bit of a relief rally over the next couple of days or a week. But we have yet to find a situation where the markets sells off for ten days real hard. So at the minimum we will revisit the lows of last Wednesday one more time.