I still remember when there was massive skepticism around QE. It was artificial, and basically just a fake leg for global markets until politics could get their shit together and fix the structural problems that had shown at the time. Those problems were pretty apparent, excessive risk taking by banks, collusion with bond rating agencies that ended up misleading investors on risk and a lack of government controls. In the wake of the financial collapse the public mood was sour and wanted vengeance. There were a lot of actors to pin this on, after all, but in the end not a single one saw any jail time. Perhaps worse, all of those problems mentioned above might as well have gotten swept under the rug and, here we are, thirteen years after the financial collapse, and the world is still completely and totally dependent on QE.

Politicians were filled with fervor in the 2008 election cycle and there was an ample backdrop for it. While it was a certainty that the dems would take it with the gop giving mccain a mercy bid he had no chance of landing, the backdrop of a global recession triggered by loose US economic policy was sure to create some change in Washington. And it did, the only problem is that, as per usual, there was zero follow-through on the part of politicians and after they figured out they could rely on central banks to prop up economies, they were able to further abdicate their responsibility of actually running the country. It was only a couple of years later that most of those policies had been repealed and by 2020, it was as if the financial collapse was a distant memory, with the economic powerhouse of the Federal Reserve creating an actual economic boom during a global pandemic with government-forced lockdowns. Reality truly is stranger than fiction.

There’ve been countless blips and starts of another crash since the financial collapse in 2008. The covid move, obviously, was one in 2020, but there were a handful of other mini-spats that put markets on edge for a couple of weeks or perhaps even months. Each time, the Fed came in to save the day, standing at the ready with more QE (March 2020) or interest rate hikes reversed into cuts just six months later (2018-2019) or perhaps even just some threats of more monetary accommodation, in some form, to keep markets from getting too bearish (2008-present).

What makes the Evergrande saga so interesting is that while, yes, it’s just another risk factor, it’s also one that could spell contagion throughout a sector and that’s something that a Central Bank might not be able to fix so cleanly. Because while Lehman was 600 billion their counterparties and total losses were way, way larger. Because contagion is a domino effect. And Evergrande is a 500b hit (200 assets + 300 liabilities) with an impact that will spread throughout Asia and into the United States.

Meanwhile, markets seem to be shrugging this off like any other risk. Sentiment remains overly bullish with equations quickly showing that stocks are still ‘cheap’ by many relative metrics from the bond market. This would appear to be a Talebian IYI situation, where something that makes sense in normal times makes absolutely zero sense here.

Is this the Pin that Pricks the Balloon?

This could lead to a situation in which the Fed loses control for a little bit. To the point where congress has to get involved and I don’t expect there to be much prudence there given that a 3.5t stimulus package is currently up for debate. The numbers don’t matter any longer, and prudence was out the window a long time ago. It will break, but not now, there’s a few more iterations of this thing before hyperinflation sets in and completely destroys the currency to the point of a reset being required. This could take hundreds of years. Or tens of years. What will decide that is the us government and just how imprudent they become.

So, this might not be an endgame type of scenario. More likely, its a 20% pullback and perhaps a 40-50% pullback to the s&p if Evergrande blows up in grande fashion. The early signs look grim but the government is going to get involved. And it’s hard to imagine that working out pristinely given that counterparties are outside of the mainland and those connections run deep throughout the global economy, so this can’t be swept under the rug as if it were relegated to wealth management products sold domestically on the mainland.

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