The Black Swan that Breaks the Camel’s Back

By: Uri Estrin - August 19, 2020 12:08pm EST
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The Black Swan that breaks the camel's back
The Black Swan that breaks the camel's back

The bets are on (literally) that the recent stimulus plus additional to come, are enough to suture the bleeding and allow the markets to repair and regain enough broad self-propelling lift, to repair themselves similar to the 2008 outcome.

We at MacroTOMI however believe that the enormity of the current situation is so gigantic, that that solution is very short term. While Covid has been acute, the underlying systemic issues have not only been exacerbated, but have underpinned an inevitable deleveraging and correction – just the Fed has been so great at reflating the inevitable away.

Actually, it has been quite amazing at how well the Fed has been able to stabilize the markets after March’s rout.

We however potentially see a new ‘black swan’ coming along to disrupt these efforts. When, is anyone’s guess. Hypothesizing is always a risky and inaccurate business, so take that into consideration when you read this - but at the very least – we hope to raise a few scenarios onto your radar in which to be wary of:

1. Emerging Markets / Sovereign default 

We see this as a highly probably ‘black swan’ event and an exogenous shock to US markets that few are considering. Fitch recently downgraded Oman to ‘BB-’ and Moody’s downgraded Laos to ‘Caa2’. These are small economies and like Lebanon, a sovereign default would have muted impact on the world economy. But they are symptomatic of a much wider problems. There is 1 country in particular that we have our eyes on; that would be Turkey.

The Turkish currency markets are under severe strain and could precipitate a capital account issue, especially with the Turkish Central Bank trying to prop up the Lira and depleting reserves. A leader reluctant to go to the IMF in an emergency increases the risk profile. Even if Turkey were not to default, European Banks have large Euro and Dollar loan exposure that would be almost impossible to repay should the currency depreciate enough – similar to Iceland’s 2008 baking crisis – the Turkish government left with insufficient foreign exchange to bailout the foreign loans. These defaults to European and International banks could potentially create enough contagion to spread throughout European and then world markets. A Turkish sovereign default would pretty much guarantee it.

The other countries to keep an eye on are Brazil, Mexico, Russia, South Africa, India – although these appear currently stable as compared to Turkey, their low sovereign debt ratings and high debt loads mean that contagion could spread from any of these countries globally. (read our article: The Unraveling of the Emerging Market)

2. US Corporate Default

The other likely contender would be a US default of an enormous US Corporation – such as Boeing for example which S&P recently downgraded to BBB-, which is just above junk, with a negative watch. A large US Corporate default could trigger an aha! moment stunning the markets. Another scenario is a wave of smaller, multiple defaults. While the market impression is that everything is taped back together, a sudden string of corporate defaults all falling one after one another could dent sentiment to the point of triggering wider contagion. (read our article: Don't Underestimate the Fed's Playbook)

3. Treasury Auctions / Yield Blowout

The recent 30Yr Treasury auction made a lot of people (not us) nervous. (read our article: Why the Treasury Auction wasn't so Ugly). While the last auction was still more than 2x over subscribed, we see little risk of a complete yield blowout. But with more stimulus piled on, there could potentially come a point when the market will force long term yields considerably higher in order to attract uptake. We see this scenario as a short term event. Higher yields would be catastrophic for the US economy which is such a debt overburdened and struggling economy. It would send many Corporates into distress and default and could most likely cause ructions in the equity markets. Should these ensue, depression would be inevitable, then forcing long term yield considerably lower. Either way, we see at least part of the yield curve going negative (read our article: The Unusual Situation of Negative Rates may be not so Unusual Soon) in the short to medium term, if not all of the curve.

4. Political Discourse

We are approaching an important election with a very divided country. Any fallout would be extremely negative to the equities market and even yields (again for the short term). Failure to issue more stimulus could also stymie Gold and Equities’ one way bet and force the US economy deeper into recession (which should be good for long term lower yields).

Short term, we believe that Fed ,together with new stimulus from the Treasury will be able to kick the can further down the road. More debt, will bring lower yields (read our article:  No inflation, No stagflation, Yields and Bonds) and may be able to placate the equities markets and the Gold Bugs. But if any of the above scenarios take root (especially the Top 2) – the fallout will be uncontrollable and the Fed, no matter how much QE, just won’t be able to backstop everything and everyone – there must be a point where debt is deleveraged, and that could very well be it.


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