A week after markets cheered the lowest level of US unemployment since the 1960's, we are publishing a negative economic commentary for our readers, an exclusive from John Llewellyn, the former deputy economist of the Organisation for Economic Cooperation & Development in Paris, now running a London consultancy. He writes:

It is not possible to predict exactly when a crisis will eventuate, nor the precise form it will take. But it is possible to identify pre-conditions, and today the macro breeding ground is not only serious, but intensifying

Policymakers meanwhile cannot agree on what constitutes a bubble and how to regulate financial markets and new products now on offer. It has become a commonplace to say that considerable progress has been made in financial regulation. This may be true in a narrow sense, but much remains to be done.

Markets run on greed. While greed cannot be eradicated, it can be discouraged. But few financiers have been fined, and almost none have been jailed. Incentives remain unduly skewed towards risk-taking.

Banks, are now better capitalised, but still not sufficiently sound. Banks in Europe can still hold their own national sovereign debt without reserving any capital against it, sustaining the latent ‘doom loop’
between them and often barely-solvent sovereigns.

Banks also still have too much latitude to use internal models to set their own risk-asset provisioning. “Meanwhile, systemically-important non-bank intermediaries remain seriously undercapitalized, and likely have increased their share of financial activity as a result of regulatory arbitrage.

Moreover, recent policy in many countries – most notably the US – is increasingly moving towards easing financial regulations, rather than tightening them further.

So there are increasing links and interconnections between markets. Even if capital requirements are sufficient at an individual-bank level, the regulation of economy-wide leverage is insufficient.

The US is, particularly at risk. Its diffuse regulatory system remains complex and unwieldy: five separate entities oversee banks at the federal level, and many more bodies operate at the state level. No single agency has overall systemic responsibility.

Most of the attention has been focussed on banks and investment banks. But the 2008 crisis went much wider: extending to the insurance industry, hedge funds, structured investment vehicles, and beyond. The US lacks any counter-cyclical macro-prudential authority. Moreover, Congress has voted to limit the emergency loans that the Fed can make to non-bank financial institutions in extremis.

At the global level, swap lines from the Federal Reserve were one of the most important cross-border crisis responses, helping to alleviate potentially-devastating dollar funding gaps at non-US banks. “Today, such cooperation might not be politically possible. Yet the same problems remain without a solution. Post-2008 regulatory reforms can keep the same crisis from happening again. But the capacity to respond to a crisis which is a bit different is lower.

More worrying is that the next trauma – whether originating in shadow banking, cryptocurrencies, poor auditing, or whatever – will almost certainly be different. And there is scant evidence of policymakers being able to recognize the early symptoms, let alone respond.

Macroeconomic conditions are dangerous:

▪ Debt is at an all-time high. The total global debt stock now stands at $175 trillion (or 325% of GDP).
In the US alone, outstanding car loans – mostly sub-prime – total $1.2 trillion, close to the $1.3 trillion-odd of outstanding prime mortgages in 2007, while outstanding student loans total $1.4 trillion.
▪ Macroeconomic imbalances are intensifying. The US is heading for Reagan-era twin deficits; Germany’s external surplus is a huge 8% of GDP; Emerging Market dollar liabilities have doubled since the 2008 financial crisis.
▪ Financial conditions remain very easy. Long rates and term premiums are still at historical lows.
▪ Irrational exuberance is on display, especially in the US where, following unwarranted pro-
cyclical fiscal stimulus, the equity market is near an all-time high. Valuations are stretched.

Copyright: Llewellyn Consulting | 1 St. Andrew's Hill, London, EC4V 5BY | T: +44 (0)20 7213 0300
Footnote: This Global Letter has benefited enormously from discussion at a two-day meeting, 10 years after the failure of Lehman Brothers: What have we learned?, organised by the OECD in its New Approaches to Economic Challenges programme.

I add: The dramatic resignation and fraud investigation of Ravi Parthasarathy, who headed listed IL&FS, whose stock price cratered, a public-private sub of Indian state infrastructure finance body Infrastructure Leasing & Financial Services. IL&FS kept its top local credit rating despite defaults on infrastructure loans until now. But apart from the share, the collapse also mark new Indian macroeconomic risks.

IL&FS under Modi's government tolerated not only default on US$13 bn on its issued loans, but it also rewarded Mr. Parthasaraty with a 144% pay rise in the final fiscal year (to June) before his exit.

According to Moody's, its guarantees accounted for 3% of total bank loans in the last fiscal year—and for an unknown amount of credit in the unregulated shadow banking system.

With gold losing value, Indians switched to buying debt mutual funds which funded “shadow banks” among which IL&FS is numbered. These helped fill the Indian private investment gap. Now the tiny corporate bond market which benefited from the mutual funds is under a cloud, adding to the inefficiency of Indian capital markets and its inability to finance long-term investment.

India faces a $526 bn infrastructure funding gap over the next 20 years according to official New Delhi figures. Indian corporate bonds now finance only 15% of GNP according to Crédit Suisse, vs 63% for China (and 113% in the USA.) And even that low level of business lending is under a shadow because of corruption and fear of default.

While the outcome of the IL&FS probe is unknown, Mr. Parthasarathy's successor, Uday Kotak, is known for building Kotak Mahindra Bank into a large lender while avoiding the sector’s worst debt woes. The listed IL&FS sib must now undertake a huge asset liquidation program and increase its capital to repay its debts. But its top shareholders may not want to put up the new capital needed to shore up its balance sheet. And however brilliantly the new directors succeed in cleaning up the mess within IL&FS, they can do little to stop the fallout already rippling through the Indian economy.

*Before tackling India note that UK hopes of a Brexit deal are up again. I am shocked at the Financial Times' editorial attack on Boris Johnson, not because of the dirt it dregs up, but because it printed the f-word for the first time I can recall.

Our Indian and Emerging Market Funds

*Azure Power Global Ltd, which I averaged down in yesterday, is a victim of the IL&FS crisis but also suffering because a week ago it announced doing a capital increase of its own to deal with it. Off 5.47%, the AZRE share sank because it rushed to do a public offering of 14.8 mn new shares (including the greenshoe option to underwriters) at $12.50/sh, well below the $14.45 I paid to average down before I learned the dirt about IL&FS. Our local reporter did not warn us about the IL&FS mess; we got the info from Crédit Suisse. AZRE is at $12.3364 now. Abhimanyu Sisodia comforts me by noting that existing institutional holders will acquire about $150 mn of the new issue, plus 15% for the green shoe.

*Ripples from the India crisis also hit emerging markets funds across the board as they were already under a cloud over the US rate rises. The exception, because of timing, is Singapore-listed India REIT Ascendas India Trust, which lost only the equivalent of one US cent because the market closed before the IL&FS scandal was understood. ACNDF barely trades here so there is not much margin in trying to exit at 77 US cents. We bought at 73 cents and get a divvie of a penny.

*Another fund which is holding up well is highly-diversified Templeton Emerging Markets Income Fund, TEI. I have no current data on its India risk but some of those buying it may know more.

*Our Morgan Stanley Institutional Frontier Markets fund (now open-ended and not in the model portfolio, but purchased as a closed-end fund a decade ago) closed June with zero investments in India. The fund is now controlled by institutional shareholders who own 45% of the shares out, and we just go along for the ride.

*Our Western Assets Emerging Markets Debt Fund, EMD, also had minuscule (o.6% of assets) in Indian holdings at end June. It sold its rupee, forward currency contracts to JP Morgan Chase for dollars at a gain! However, it still had some un-tradable Venezuela paper.

*Nor did our SPDR FTSE International Government Inflation-Protected Bond ETF hold any rupee issues at end June. WIP did hold Turkish lire.

*Infosys which is largely held outside India, was a riser last week. It was up 1.3%. INFY launched an automation platform for students and indie developers.

*Insiders have been selling US-listed India software firm Cognizant Tech, CTSH.

Tech & Tel

*Hong Kong's Tencent continued its drop. TCEHY lost 1.11% on news it had acquired a minority stake in the tech financing sub of Philippines Long Distance Telephone alongside KKR of the US, presumably for investment purposes rather than hacking because Manila populists would not put up with leaks of voice and internet content. The big negative for TCEHY is the moves against its video gaming, banking, and chat prowess inside China, which force it to diversify into PLD

*Last week's Financial Times cheered on Japanese stocks for aging consumers and ones aimed at replacing labor with machines and tipped robotics firm Fanuc. FANUY fell.

*It tipped telco NTT Docomo, and DCMYY also fell.

*It tipped Eisai, ESALY, which also fell.

*But young Japan stock Nintendo (NTDOY, which admittedly is global in scope) rose 1.7%.

*Chinese railway robotics maker Hollysys is up. HOLI.

*Israeli chipmaker Tower Semiconductor is down, tainted with reports of Chinese trojan chips unlike to have been used by TSEM.

*Nokia of Finland is using Pixelworks chips in its new smartphone 7.1 line which boosted PXLW if not NOK, allowing it to combine 4^th generation Iris processing with Qualcomm 636 apps. NOK fell 2.5%.

Pharma

*Novo Nordisk, the Danish insulin powerhouse, faces competition from Eli Lilly and Roche's hemlibre. NVO was downrated by HSBC analysts. Its share rose 1.7%.

*RHHBY of Switzerland gained only 0.18% despite buying into a bispecific antibody from GO Therapeutics.

*This may involve an overlap with bispecific antibodies from Zymeworks of Canada. ZYME lost 5.1% in the US, last week on Saturday.

*GlaxoSmithKline backed US-UK biotech startup Orchard did funding round to raise $150 m which will fund its trials of gene therapy assets it bought from GSK, including Strimvalis to treat a rare immune disease, adenosine deaminase severely combined immunodeficiency, already on the market in the EU, and other genetic diseases like beta thalassemia, Wiskott-Aldrich syndrome, and metachromatic leukodystrophy for which there is no treatment. GSK owns 19.5% of Orchard which helped it overcome a warning by the European Medical Authority that old HIV drug dolutegravir (Tivikay) is being overprescribed.

*Israeli BiolineRX dropped nearly 2.1% a week ago when Tel Aviv was closed. Its oddball takeover has finally scared people.

*Teva fell 2.4%. It informed the market it will report on Q3 Nov. 1, but fell because Crédit Suisse analyst Dr. Vivek Divan called for the Israeli firm to rush to craft a better injection method for its Ajovy migraine drug which now causes injection-site reactions in ~45% of those treated with it, the highest level

*Nasdaq was weak-kneed a week ago so most of our startup biotechs fell along with the rest of what's listed there, in a 6-mo record sell-off. Among them is Benitec Biopharma which is seeking shareholder approval for another 10% capital increase and more options for the boys (I own both the stock and the options, called warrants down under.)

Energy and Materials

*Pengrowth Energy reported insider buying of C$2.2 mn. PGHEF.

*National Bank of Canada cut its forecast for Algonquin Power & Utilities to hold from outperform and the AQN stock lost 1.8% a week ago, on Saturday. It pays over 5% in dividends.

*Goldman Sachs tallied the alleged shortages of copper and said they are not biting yet. This took down Antofagasta of Chile in London trading. ANFGF.

*The Chilean antitrust court approved the Tianqi Lithium purchase of Sociedad Quimica y Minera de Chile with no further conditions. Good news for Nutrien of Canada, the seller.

*Oy vey. My recommendation that readers buy into Texas oil company Noble Energy because it can help link up Israeli offshore gas with Egyptian pipelines and liquefaction plants was mistaken. NBL rose sharply here because it sold part of its stake in one of the offshore Israeli gas fields, Tamar, and other CNX assets here to fund its 10% share of the 39% buy of the EMG trans-Sinai pipeline. It got NIS 340 mn on the sale of Tamar, last week, in Israel, valuing the whole NBL 43.5% position at NIS 600 mn. Globes Israel website writes that the whole is being sold.

Oppenheimer rates NBL a hold but Piper Jaffrey rates it overweight because of differing views on Colorado fracking regulations. Noble is not to be confused with Noble Holdings of Hong Kong, incorporated in the Cayman Islands which Moody's has just downrated.

Our share is 90% owned by US institutions and is very conservative, having survived since its foundation by Lloyd Noble in Oklahoma 86 years ago.

Cars

*Autoliv of Sweden won a buy rating from Jefferies on Saturday, a week ago, but it cut its pre-spinoff price target to $100.

*Tata Motors, depends on India finance for its mass car lines, dropped nearly 4%. TTM was sold.