Recap 10-22-15: It’s Time to be Neutral or Short Risk

Let’s go over the current backdrop, which, as it stands, is really not a whole lot different from that a couple months ago. The most important aspects of the macro environment as it relates to asset prices since the beginning of the year has been the move in oil prices. That move has had two key effects. First, it has lowered inflation to zero. And second, it has caused a massive improvement in the current account deficit. Both of these have hard major impacts on the pricing of risk assets.

First, the drop in inflation means that in many sectors, pricing power has disappeared. As a result, revenue growth for corporations has declined and earnings growth even more so due to operating leverage. Obviously this is a very broad generalization across sectors but I think this is broadly accurate. Even outside materials & industrial names, earnings growth expectations have been falling for many months now, and that trend doesn’t look like it’s turning quite yet.

Second, the impact of the adjustment to the current account has also been substantial. The main reason is the ownership structure of USD assets. Essentially, as Michael Pettis likes to say, the current account deficit is the obverse of the capital account surplus. In other words, exporters to the US have been major buyers USD financial assets, especially in credit as well as treasuries. In effect, what happened in the prior cycle is that Americans have been saving or spending less on net – the saving has been done by foreigners, but in USD assets. This is a key distinction because Americans save mostly via putting cash into bank deposits, whereas foreigners save mostly via buying USD assets like corporate bonds.

Given the banking legislation introduced in the past few years, banks are now not able to change their lending standards much. What this means is that despite the increase in bank deposits, credit growth via banks (especially via the mortgage channel, and ex-student loans) has been weak. In other words, credit availability from foreigners have declined (due to the drop in the US capital account surplus) but banks were not able to offset that deleveraging. The net result is that credit costs have jumped quite sharply this year. (Note that this channel did not affect treasuries because treasuries have a zero risk weighting on bank balance sheets. In other words, banks were able to respond to foreign selling in treasuries. )

The result of both of these factors has been a sharp worsening of corporate financing conditions. Not only has revenue growth been falling, which is a negative for credit sustainability, but credit costs have moved higher as well, which means refinancing debt is no longer accretive to the bottom line. This has been especially bad for the riskiest credit sectors. HY ETF prices remain near the lows from back in 2011/2012. From a cross asset perspective, these factors apply to equities as well, though somewhat less so due to the fact that the maturity profile for large cap equities is much longer.

On top of that, real risk-free yields globally are now essentially pinned at zero. What this basically means is that there is simply very limited room for central banks to counter-cyclically ease financial conditions further. In fact, in places like Europe and Japan, the only way to push real yields much lower is by raising the market-implied inflation compensation rate. In an environment of falling / weak commodities prices, that is very difficult to do. As we’ve seen with Japan – there is a sharply diminishing return on policy action on that channel, which makes sense because it is hard to make investors pay prices that lock in negative returns.

The implication of these forces are, as you can probably surmise by now, fairly negative for risk asset prices. To be clear, it’s not recession-like bad, but they are certainly negative in that both the upside as well as downside scenarios are worse. There is less upside because earnings growth and credit costs are higher. And there is more downside because future central bank policy easing is likely to be less effective.

Now, I’m not saying these conditions are going to persist forever. Inflation is likely to pick up in 1Q as base effects drop out – but this is assuming oil prices don’t fall much from here. And assuming economic growth continues (still my base case, to be clear) a Fed lift off is likely to push real rates a bit higher, thereby providing some more cushion. If things go well, many of these factors should be alleviated at least somewhat by the end of 1Q next year. But that is still a long ways off in financial market time. To me, the key driver of these risk vectors remains oil prices. A further decline here is likely to exacerbate those channels and pressure risk assets further. And at current prices, the margin of safety by my calculations is very close zero.

A couple charts illustrate how far equity prices have ramped up relative to other growth assets the past few weeks:

S&P vs a High yield ETF: (Note that it closed flat today!)

S&P vs 1y1y WTI oil forwards:

Recap 10-09-15: A Look at the Long Term Charts

US 10y swap yields look like they are bouncing off the bottom of the 2.0-2.5% range that has broadly prevailed since 3Q 2014. I think that absent a shock of some kind, this range will probably remain until the Fed actually hikes. Breaks above or below that range should probably be faded. There was an article floating around this week about the Fed doing QE4… kind of gives you an idea of how far opinion has swung since mid year, when a Sept hike seemed certain to the market.

Corporate bond yields have actually been stable since late June, and appears to be consolidating around here. (Barclay’s US Credit Yield to worst measure below)

The S&P looks like it has made a classic W shaped bottom. ~2050 is the next resistance level as well as the 50 week moving average, which has been a strong pivot level in the past. I think we’ll see that level around month end, but how it does afterwards will depend on the broader backdrop.

Oil prices are bouncing strongly off the ~44 area. We are about halfway to the next level of resistance at ~54:

EUR continues to be in a rising wedge formation. This doesn’t mean that it will necessarily break the 1.145 level – there was a similar chart from mid 2013 to mid 2014. But perhaps we won’t see a resolution until late this year or early next year.

To conclude, it looks like risk assets are likely to continue to find sponsorship through the end of the month. After that, the picture gets murkier. It’s hard to see oil prices rallying to new highs this year given the supply backdrop. It seems like rig counts need to keep falling to keep oil prices supported. (see chart at the bottom) The EM rebalancing is still getting sorted out and we are at least several quarters away from completion on average. On the other hand, the oil rally may be enough to keep the ECB and BoJ from additional easing, and may be enough for the Fed to tilt a bit more hawkish. Corporate earnings growth remains uninspiring, which is in turn likely to limit investor enthusiasm in risk unless there is more policy action.

I think the picture will eventually resolve to higher risk prices, but it may come later than many expect. Base effects on inflation and revenue growth will drop out in 1Q next year, and historically Fed hikes have been accretive for earnings growth. Credit markets have largely already priced in a Fed lift off, so the net effect of an eventual hike is likely to be a tightening in credit spreads along with a stronger dollar.

Recap 10-02-15

I suggested in my last note that we are likely to see some weakening of the data as a result of the tightening in financial conditions the past quarter. This seems to be playing out. Given historical leads, the data weakness is likely to persist for several weeks.

One thing that I’ve found interesting is that it seems like credit and equity markets have been pricing in some nominal growth weakness ahead of the sovereign debt markets. It seems like the treasury market was fixed on the Fed lift off date, rather than the data. This all has Yellen & company’s decision to hold off looking pretty good. Barring very strong employment prints the next two months, (meaning print + revision > 240k per month) a March lift off is probably the base case now for the street, with risks skewed to later.

That leads to risk assets. What was missing from the late August price action was a drop in real rates. Usually a drop in equity prices is offset by a drop in real rates, which on net mitigates the impact on financial conditions. The price action today suggests that this is changing, at least for now. For example, shortly after payrolls, the drop in 5y USD swaps yields offset the rise in HY OAS, which means that the absolute yield for the HY market was lower.

In addition, other pro risk assets have been in the process of bottoming. Oil, CNH, BRL, China A-shares are some examples. Obviously that can change, but it’s an interesting divergence. EM equities have actually been outperforming DM equities in local terms for a while.

Calling a low in any asset is foolhardy, but I do think that we are near the low for risk. I’ve been saying for a while to watch credit, but I think that correlations are quite high now, which means that it has become a coincident, rather than leading indicator. There seems to have been several articles on credit markets in major financial outlets the past week, so I that furthers that hypothesis. (If everyone is looking at a ‘leading indicator,’ it will probably no longer lead) Risk assets have a tendency to bottom on bad news. That makes sense, because the end of a correction occurs when short term players finish selling their positions to longer term, value investors. That process tends to come to a completion on days when the news and price action is initially bad.

Analogs suggest we make a low between now and early next week. We’ll see if that holds.

Recap 09-25-15: Beginning of the End at the Top for Apple?

The WSJ reported that Apple is planning to build an electric car with a target ship date of 2019. Put differently, the world’s most valuable company is diversifying its business into a capex-intensive industry that is not its core competency. In other words, it seems to be that Apple is taking a big gamble.

This is interesting because this implies:

  • committing large amounts of capital into a project that will not see a payoff for at least 4 years, and likely longer. In other words, it is an implicit acknowledgement of a lower RoE, since a large part of that return will be plowed into R&D
  • that Apple sees low growth opportunities in its current markets. Or at least that growth opportunities in the iPhone/iPad/iMac complex will not be high enough to achieve Apple’s RoE targets

To me, this also suggests that the growth for Apple is likely to slow further in the years ahead, and likely to rates slower than the market. To be clear, I’m not saying Apples going bankrupt or anything like that. Simply that at that size, no matter how good the company is, it becomes significantly more vulnerable to disruption itself. Size doesn’t kill, but it is without a doubt a constraining factor. Apple is already the largest company by market cap. Here is a list of other companies who have made that distinction, along with the subsequent performance:

This note is obviously outside my circle of competence, so make of it what you will. Counterargument from an Apple enthusiast:

Quick thoughts on various Macro topics:

  • Analogs suggest a risk rally starting soo, but we need to see more of a recovery in credit first. That, however, is not yet apparent. HYG is back to the range that provided support in mid 2010 and mid 2011, though the OAS and outright yield levels are significantly tighter than in those periods.

    Also, price action in HY seems to have decoupled from oil. (HY OAS in white, oil in orange & inverted) It’s quite possible that other factors are now driving HY, but it will be very important to observe how credit behaves the next few weeks. The picture in investment grade credit is a bit better than HY, but not by much.

  • Expectations for and ECB extension of QE seems to be getting pushed more toward Dec given recent policymaker comments. Estimates for EU growth over the coming seems to be falling further
  • Yellen’s speech yesterday had an interesting part noting that consensus forecasts for inflation in Japan persisted at levels well above actual experience.

    This is interesting because a recent SF Fed note basically said that market based inflation forecasts in the US were not very useful, at least compared to other methods such as surveys or constants. Now, that’s factually accurate in the past for the US, but NOT for Japan. The Japanese inflation linkers market has only been around for about 10 years, but has clearly been better at prediction future inflation than consensus estimates. In other words, when inflation has been below target for an extended period of time, it clearly behooves the central bank to pay attention to market based measures in addition to forecasts.

  • Nice chart from Goldman:

  • Is reducing bank lending costs a good way to stimulate the economy? The short answer is ‘no’ — not according to credit card data:
  • Boehner probably resigned so he could allow a vote to keep the government open, rather than risk a likely government shutdown this fall that will likely negatively affect the chances of the Republican presidential nominee next year.
  • Chart of Mexico Trade balance, oil vs non oil from Goldman:

    The Non-oil balance is likely to continue to improve given the trend in MXN, while the oil balance deterioration will be bottoming out soon…

Recap 09-21-15: A Short Rant on Market Interpretation of the FOMC Meeting

I have read so many items over the past few days trying to explain why a dovish Fed caused risk assets to sell off. The consensus from those views seems to be that:

  1. The Fed lowered its forecast for growth
  2. The consensus is surprised by the lower forecast
  3. So risk assets sell off

This line of logic only works if

  • The consensus does not have strong conviction of its own forecast
  • The consensus is not aware of the weakening of the data
  • The consensus growth forecast is significantly stronger than the Fed’s

None of these assumptions apply – if anything, the opposite is true. It seems many commentators are convinced that the Fed is increasingly behind the curve, which implies that they are more convinced of their own views and that the Fed is wrong. And consensus forecasts, as well as market pricing has for very many quarters now priced in a weaker growth projection that the median SEP dots.

The much simpler explanation is that the market simply rallied on the rumor and sold off on the news, as it has tended to do for years now. Take a look at the SPX reaction following the days QE programs were announced or expanded since the end of the recession:

Obviously, the sample size is small, but it’s large enough for us to note that the 1.6% drop on Friday was not at all out of the ordinary. In fact, the usual reaction is that the S&P trades off over the following 2-3 weeks before rallying.

Recap 09-18-15: The Day After

Some thoughts:

The SEP median forecasts for the next 3 years shows unemployment rates below NAIRU and inflation rates at or below 2%. This implies that the Fed has accepted a long term disinflationary impulse, a flattening of the slope of the Phillips curve, or some combination. This seems right – the modeling work I’ve been doing suggests that we may only get a 1.5% headline inflation rate through the rest of the cycle.

The bigger question there is how it affects the Fed’s risk management perceptions. As it stands, the 5y average inflation rate is just 1.5%, the 30y breakeven is just 1.8%. A lower inflation rate and a lower inflation breakeven rate implicitly limits the Fed’s ability to reflate. With plenty of room for inflation to move above 2% and still maintain a long term average inflation of 2%, one could argue that the Fed may want to keep policy even easier than current projections.

The tightening in financial conditions since June is not yet apparent in the data. We have only seen tentative hints of it so far, such as the very weak Philly Fed print yesterday. The risk is that a weaker string of data over the next couple months causes the Fed to hold off for two more, rather than one more, quarter. Predicated on this, IMO the probability of a Dec vs March liftoff is roughly balanced.

FOMC long run dots dropped 25bps to 3.5%. There is a bit more room, IMO, for it to fall further. This is broadly supportive of my view that fair value for the 30y point is around 3%.

Historical analogs suggest that for equities, we may see one more down move before resolving higher. Historically, instances involving this much technical and sentiment damage take 3 months or so to resolve. Some may interpret it as meaning that a Fed on hold is bearish for equities, but I wouldn’t agree with that, correlations notwithstanding. As I’ve noted previously, the key here is credit. Staring in mid 2014, and partly a result of low risk free rates, investment grade issuance increased sharply. The widening of credit spreads is obviously a risk negative, so optically it may appear that dovish central banks => wider spreads => risk off. But this is not a stable relationship. Credit spreads in some cases are already at recessionary levels. In fact, the last time financial conditions (Goldman’s measure) hit these levels were in 2010, when Fed easing clearly ultimately helped tighten spreads. Now, credit spreads have tightened a bit from the wides, but are still in the process of consolidating. However, if this pause ultimately results in an unexpected jump in issuance, it could ultimately prove a risk negative.

The move in the EUR has taken it near the highs of the year. In addition, 5y5y inflation forwards are now back to levels prevailing at the end of last year. (chart below) The next ECB meeting isn’t until October 22nd, so there could be a lot of changes by then, but the ECB members surely will have a lot to think about in the interim. They’ve already upped their stated limits of purchase sizes, and have been noting that they will do more if needed, so the question is whether that will be the case in a month. Fed Funds futures are now pricing in liftoff in May 2016, so that risk will clearly be discussed by Governing Council members. If US or EU data is weak in the interim, the probability of the ECB expanding QE will be reasonably high, IMO.

The FOMC drove corrections of a number of popular USD crosses and USD related trades. The positioning wash out will probably take a few more days to complete, but this should be a good opportunity to revisit key themes. The delay of liftoff does not change the longer term fundamental trends. A few examples include:

  • US growth (and hence eventually higher equity prices)
  • European growth (and hence equity prices)
  • weaker Chinese commodities consumption (and hence Chinese Capex related assets)
  • The very long duration of many commodity supply sources means that the trends tend to last longer than almost anyone expect. A rough 1998 analog suggests further downside, still, for many commodities
  • Current Accounts in several EM countries remain unsustainably negative, despite the contraction of domestic demand and hence imports. Many of these countries also have excess debt issues that remain unresolved

The fact of the matter is that we will start to see weaker growth as well as inflation prints following the summer events. Over the past several years, this has triggered easing from central banks globally. There are many reasons to expect a repeat of that through year end. As a result, it is probably dangerous to be excessively short or underweight financial assets in aggregate.

Recap 08-27-15: Looking Good

IMO, the most important thing that happened today was the move in oil prices. Oil prices lead the way lower starting in June (see my update on 7/27) which then impacted credit spreads and then equities. (see my update on 8/21) Thus, a stabilization at these levels should allow other asset classes to re-price toward fundamentals. The price action across the oil strip today was impressive, with the ~$4 rally off of a higher low similar the bounce at the end January. Remember, we don’t need to see oil to rally, just for it to stabilize.

The Mexican Peso looks very cheap here. I think it’s pretty reasonable to expect a 15% strengthening over the next year or two.

Oh, and by the way, the S&P is now up on the week. IMO, a lot of the extraordinarily fast move lower was driven by algo driven selling that reduces exposure to higher volatility. As both implied and realized volatility falls, these programs will increase exposure again. Remember the breath taking drop and rally last October? Well, I have a hunch those are going to get more common…