James Bianco: The markets are trying to tell us that there is a severe issue out there

An  interview with strategist Jim Bianco and Gisiger, Christoph  published in the Swiss Business newspaper Finanz und Wirtschaft, excerpts posted with permission

Meanwhile China is trying to move heaven and earth to calm down the markets. Do you think China’s economy can avert a hard landing?

China is a communist country. They’re communists and when their economy started to misbehave and when their markets started to get upset they went right into their communist thinking. They started throwing speculators in jail and  billionaires turned out missing. But this is not the way you handle a volatile market. The incompetent mismanagement of the Chinese markets and economy by the Chinese government makes it even worse. And by making it worse they make people lose their confidence. So this gross mismanagement results in a loss of confidence in the Chinese government of the wealthy. That’s why you have a giant capital outflow out of China.

How concerning is this flight of capital?

No one disputes the capital outflow. But the innocuous, “so I don’t get thrown in the Gulag”-way of saying it is: “The volatility in the markets are scaring investors out of China.” What’s been happening in China in the last couple of weeks is that as the markets have gotten volatile they have stepped up their market interventions, including last Thursday intervening in the currency market with the largest amount of money they have intervened with in the last three years. They’re trying to hold the currency steady but Chinese stocks were still down 2% on that day. They’re trying to make us all believe that there is nothing to see here. But there is still a lot of stress. You see it in the collapse of the Hong Kong Dollar to its lowest level in twelve years.

Tensions are also high in the energy sector. What’s going to happen if oil hovers around $30?

In the oil industry you have misallocation of capital, in part by seven years of zero interest rates. Especially in the United States the energy sector was grossly overbuilt with horizontal drilling and fracking. A lot of those companies borrowed a lot of money and have put themselves into a bad place. They have no choice but to keep drilling. In July of 2014 the price of crude oil was $107 per barrel and the US was producing 8.4 million barrels per day. Today, with the price at around $30 production is 9.3 million barrels per day. So more oil. If these companies stop drilling, they’re out of business. But if they keep drilling they are going to drive the price so low that they’re going out of business, too. In the oil industry the phrase to describe what’s happening now is called “dead man drilling”. That pretty much sums it up.

How low can oil go?

At the heart of the collapse of the oil price has been a slowdown of demand. That’s why we’re seeing inventories around the world blown up to the highest level ever. So to get a real bottom in oil prices we need to take production out of the market. That’s an euphemistic way of saying that oil companies have to go away. There has to be massive liquidation. For that, the oil price doesn’t have to go any lower. It doesn’t need to go to $20 or $15. If in June the oil price is at $35 it will be still too low for most of these companies and it will do the damage. It needs to get into the high forties for the industry to have a chance to survive. At this point this means it has to go up almost 70%.

The fear of bankruptcies in the oil patch is putting a lot of pressure on high yield bonds. How dangerous could this get for the financial sector?

Part of this misallocation of money in the oil industry was that a lot of these companies bought into the high yield market, partly because the Federal Reserve drove yields down so low. That made it economical enough for a risky project like oil drilling to finance itself.  Today, energy is maybe 7% of the high yield market. But at the high of July 2014 it was around 20%. That’s what happens if you kill the market: It is no longer a big weighting in the market. But the problem is it was a big weighting. And now you’ve got chaos in the high yield sector driven largely by the error investors have made in energy.

So what are the ramifications of that?

Many experts pretend that this is no big deal. But the same experts also said subprime doesn’t matter, Greece doesn’t matter, the Yuan doesn’t matter or volatility in the stock market doesn’t matter. Well, some of those things mattered and some mattered a lot. This is the way all these crises have started. They always start with something you think is small and then they metastasize in ways you cannot begin to understand. This is going to impair everybody in the high yield market from borrowing. Everybody is going to pay a higher cost of capital because of the energy error in high yield. How much does it affect everybody? Well, tell me when it stops. I don’t know how much wider spreads on high yield bonds are going to get. But I think they’re going to continue to get wider. We’re not done yet.

Full interview here