The bank’s credit team said markets are flashing the same stress alerts as they did before the Lehman crisis in 2008.
“Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small,” it said in a client note.
Andrew Roberts, the bank’s credit chief, said both global trade and loans are contracting, a nasty cocktail for corporate balance sheets and equity earnings, and uncharted waters given that debt ratios have reached record highs.
“China has set off a major correction and it is going to snowball. Equities and credit have become very dangerous, and we have hardly even begun to retrace the ‘Goldilocks’ love-in of the last two years,” he said.
This is about return of capital, not return on capital. In a crowded hall, exit doors are small
Roberts expects Wall Street and European stocks to fall by 10 per cent to 20 per cent, with an even deeper slide for the FTSE-100 thanks to its high weighting of energy and commodities.
“London is vulnerable to a negative shock. All these people who are ‘long’ oil and mining companies thinking the dividends are safe are going to discover that they’re not at all safe,” he said.
Brent oil prices will continue to slide after breaking through a key technical level at US$34.40, with a “bear flag” and “Fibonacci” signals pointing to a floor of US$16.
The U.S. Federal Reserve of playing with fire by raising rates into the teeth of the storm
The bank said a paralyzed OPEC seems incapable of responding to a deepening slowdown in Asia, the swing region for global oil demand.
Morgan Stanley has also slashed its oil forecast, warning that Brent could fall to US$20 if the U.S. dollar keeps rising, arguing that oil is intensely leveraged to any move in the dollar and is now playing second fiddle to currency effects.
RBS forecast that yields on 10-year German Bunds would fall in time to an all-time low of 0.16 per cent in a flight to safety, and may break zero as deflationary forces tighten their grip.
The European Central Bank’s policy rate will fall to minus 0.7 per cent. U.S. Treasuries will fall to rock-bottom levels in sympathy, hammering hedge funds that have shorted U.S. bonds in a very crowded “reflation trade.”
China has set off a major correction and it is going to snowball
RBS issued a dire warning for the global economy in November but events have move even faster than feared. It estimates that the U.S. economy slowed to a growth rate of 0.5 per cent in the fourth quarter, and accuses the U.S. Federal Reserve of “playing with fire” by raising rates into the teeth of the storm. “There has been severe monetary tightening in the U.S. from the rising dollar,” it said.
RBS said the epicentre of global stress is China, where debt-driven expansion has reached saturation. The country now faces a surge in capital flight and needs a “dramatically lower” currency, a fresh leg of the rolling global drama that is likely to play out fast and furiously.
“We are deeply sceptical of the consensus that the authorities can ‘buy time’ by their heavy intervention in cutting reserve ratio requirements (RRR), rate cuts, and easing in fiscal policy,” it said.
Roberts said the tightening cycle by the Anglo-Saxon central banks is already over. There will be no rate rises by the Bank of England before the downturn hits, and the next action by the Fed may be a humiliating volte-face and a rate cut.
RBS is not alone in fearing trouble. UBS issued what it called a “significant change” to its house view late last week, saying policy chaos in China had unsettled markets. It cut exposure to equities from overweight to neutral on a “six-month tactical horizon.” It went underweight emerging markets.
Yet there is something strange about the latest events. Austerity is finally over in Europe and fiscal policy in the U.S. this year will be expansionary.
China’s slowdown hit bottom in June and a fitful recovery has been building, driven by extra budget spending and credit growth. While the composite PMI indicator for manufacturing and services slipped back last month, it is still higher in the summer.
The risk is that this market storms drags on long enough to hit investment, regardless of what the economic data should imply. At the end of the day, market psychology can itself become an economic ‘fundamental’.
Pessimists warn that unless there is a batch of irrefutably good data from China over the next two or three months, the sell-off could become self-fulfilling and quickly metamorphose into the next global crisis.