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MatlinPatterson: Divergences Converge – Global Capital Flows Begin To Shift

Divergences Converge - Global Capital Flows Begin To Shift by Ashwin Bulchandani, MatlinPatterson

In our last letter, we drew attention to the gap between U.S. credit and equity markets that had been developing since June of last year, as previous such occurrences in 1998 and 2007 were particularly discomforting. That gap is now starting to close, mainly driven by the recent lurch downward by the U.S. equity market. The other divergence we highlighted – between the U.S. equity market and other global asset markets – has also started to close with great ferocity.

The stated catalyst for the U.S. equity market’s recent swoon seemed to be an acknowledgement by investors that Emerging Market (EM) equity declines can infect a healthy U.S. market. This occurs either via simple financial market contagion as people de-risk their portfolios, or via changing earnings expectations given that almost a third of U.S. corporate revenues are sourced from outside the U.S.

Currency Contagion?

But, in our view, the proximate cause for the recent equity market weakness is the changing global currency framework. As currency pegs fall (Kazakh Tenge), or are deliberately weakened (China’s Yuan), it is becoming increasingly evident that patterns of global capital flows that prevailed prior to the 2008 credit crisis are starting to shift. An apparent calm prevailed while the Fed provided more and more liquidity to the global financial system, but once that Fed-supplied liquidity – lifeblood for the status quo – was removed, cracks began to appear in the financial bedrock.

The most telling sign that we were all too dependent on Fed largesse was the Taper Tantrum of 2013 when the Fed announced that it could imminently reduce asset purchases, or, heaven forfend, even tighten liquidity conditions. Almost immediately, the U.S. Dollar rallied, rates rocketed higher, and Emerging Market bonds suffered a nasty downturn, including longer-dated Brazilian bonds, which fell more than 30 points. (An occurrence that allegedly led to some headline-grabbing West Coast personnel changes)...