An ancient Arab fable features a Bedouin camel herder who allowed one of his camels to stick its nose into his tent. Gradually, the camel had half its body inside. And before long, the Bedouin herder realized that the entire camel was in the tent. And there was nothing he could do to get the camel to leave.
The "Camel's Nose" fable became a metaphor for those situations in which the allowance of a small, seemingly innocuous occurrence opens the door for much larger, undesirable events.
Today such occurrences are called "Black Swans." Popularized in the superb book by Nassim Nicholas Taleb. Referring to circumstances that are extremely improbable from a statistical sense, but that come to fruition nonetheless. Much to the detriment of those involved.
Today, we're tracking three potential camel's noses. Two of the three have largely been ignored by the financial media. And each appears innocuous on its own. But all three could impact markets. And were all three to simultaneously ignite? Then we might find ourselves as helpless as a lone Bedouin camel herder, far out in the desert.
Let's begin with the Fed.
Chairman Powell addressed Congress in July. The headline from the event read that he expects strong U.S. growth and low inflation (about 2 percent) for several more years. Powell sees clear economic visibility. Which should translate into corporate earnings predictability. Add low inflation to the mix, and he believes the Fed can proceed with its current rate hike course.
Equally positive, we hear a lot of consensus commentary about a U.S. recession not occurring till late 2019, or 2020.
Yet, some of the data runs counter to such a rosy, consensus outlook.
Residential housing sales, starts, and prices have declined this summer. Leading to an increase in inventories. While apartment construction has stagnated.
Further, June's durable goods orders were down. While the Big Three U.S. auto companies announced abysmal guidance for the rest of 2018. Not since 2008 have Ford, Chrysler Fiat and GM simultaneously struggled so much.
Our team tracks three primary recession indicators: The Institute for Supply Management (ISM) Manufacturing Index; short-term unemployment numbers; and the yield curve. While two of the three remain positive, the two- and 10-year Treasury bonds are separated by only 22 basis points. Because unlike the shorter-term maturities, the longer end of the yield curve has not been responding to the Fed's rate hikes. Yet, as stated, the Fed and consensus outlook remains positive. Emboldening the Fed, per the remarks of Chairman Powell, to continue with its two remaining rate hikes scheduled this year.
If those rate hikes occur and more mature yields (10- and 30-year) don't increase, causing the spread between 10- and 30-year Treasurys widen, then the yield curve will invert. And one need not be an economist to understand the history of yield curve inversions. They forecast recessions, and the equity bear markets that accompany them.
But, everyone's aware of and watching the yield curve. Almost to the point of obsession. Which tells us it's too obvious. And therefore unlikely to be the catalyst for our camel's nose.
So, let's look at China.
Since 2008, Chinese buying has been a driving factor in the biggest U.S. real estate markets. In 2014, New York's Waldorf Astoria hotel was bought at a record $1.95B from Hilton by Anbang Insurance Group. The highest price ever paid for a U.S. hotel. After Anbang's chairman was convicted of fraud in February, the firm was placed in the hands of Chinese regulators. And Beijing has ordered those regulators to begin selling facets of Anbang's large U.S. real estate portfolio.
In fact, Beijing is suddenly pressuring all Chinese real-estate investors to sell U.S. commercial holdings. The rationale is two-fold: partly to bring down debt levels in the face of a burgeoning debt crisis on the Chinese mainland. And partially as a tactic in the ongoing U.S. trade discussions. The mandate has already had an impact. For the first time since 2008, Q2 saw Chinese companies become net sellers of U.S. real estate. Selling $1.3 billion in U.S. commercial property. While buying only $126 million.
And U.S. real estate may not be the only asset Chinese investors are dumping.
With roughly $1.182 trillion held in U.S. Treasurys. China ranks as America's largest foreign creditor.
In January, senior Chinese government officials recommended slowing or halting purchases of U.S. Treasurys. Largely due to rising trade tensions.
Financial observers have long posited that China's accumulation of U.S. government bonds served as more than a safe asset accumulation. Speculating that it could also provide a source of leverage to be used when diplomatic relations sour between the two largest economies in the world.
Nor could such a tactic be employed at a worse time. With increasing trade tensions dominating headlines. The annual U.S. budget deficit set to hit more than $1 trillion. While the Federal Reserve attempts to trim its balance sheet and raise interest rates before the economy shows signs of weakening.
The thinking goes that should Beijing sell its stock of Treasurys, it would add to the bearish forces acting on the bond market. Increase future U.S. borrowing costs. As the level as U.S. borrowing hits record highs.
While China has sat on its Treasury holdings thus far, the thought of the Middle Kingdom simultaneously selling its Treasury and real estate holdings sends shivers down the spines of U.S. economists. Especially were such a ploy to occur as our third Camel's nose appeared. In a land where our Bedouin fable may have originated: Turkey.
Like all investors the last nine years, European banks have been on a desperate search for yield. Exacerbated by the fact that in 2014, the European Central Bank (ECB) enacted negative deposit interest rates and left them in place for 4 years. Forcing European banks to allocate assets elsewhere. Making higher-risk bets to boost portfolio performance.
Consequently, the banks lent money to increasingly risky endeavors in risky areas around the world. Which works in a stable environment. But we've seen increasing volatility in developed and emerging markets.
Argentina, Brazil, Russia, Hungary, India, and South Africa - all have seen their currencies fall down eight percent or more against the U.S. dollar year-to-date. Only Turkey has performed worse. With the Turkish Lira plummeting 74 percent against the dollar year to date. While Turkey's stock market has been cut in half. Falling 51 percent. This, as the ailing economy's 10-year bonds yield nearly 25 percent.
Sounds bad. But what's the point?
Now consider that 40 percent of Turkish bank assets are denominated in foreign currencies. Mainly the Euro. So, as we see rising default rates among Lira-based borrowers, the banks most likely to suffer are European. In fact, Turkish borrowers owe Spanish banks $83 billion, French banks $38 billion, and Italian banks 17 billion.
You might think that such numbers are palatable given the size of these countries. But you may be surprised to learn that - unlike their American counterparts - European banks have not cleaned up their balance sheets since the Credit Crisis ended. While U.S. banks incurred stress tests and other solvency tests, Europe's banks were permitted to become increasingly indebted. Which, faced with the deteriorating situation within one of their larger debtor nations, likens the European banking system to a straw house beside a match factory.
The banks with the biggest exposures to Turkey rank among the largest on the continent. Spain's BBVA. Italy's UniCredit. And France's BNP Paribas. Big European banks with significant operations in Turkey, and large stakes in Turkish banks. All three have traded down sharply. While Deutsche Bank, ING, and others have traded down on contagion fears. Because Europe's financial sector continues to have too much risk on the books.
Which brings us full circle. Because the European financial sector's biggest counterparty happens to be our own financial sector. That of the United States.
Like every threat rippling across the pond over the last decade, these too may dissipate without consequence. But right now, they remain largely under the radar. Rather unforeseen. Precisely where such things tend to be most dangerous.
Because while we discern one of these threats and move to prevent the camel from entering the tent, the other two may already be inside. Resting outside our field of vision. Perhaps we'll soon notice the malodorous scents emanating from behind us. Bringing us to turn and realize that it's too late. The Camel's in the tent.