Recap 2014-10-01: Update on Equities, ECB ready and willing to move

Commentary:

First – the WSJ reported that people have been selling TIPS due to concerns that Pimco may well them. About 10% of the $222 billion Pimco Total Return Fund was in TIPS. But the article also noted that TIPS price have been falling (and real yields rising) even before the Gross news hit the tape. Anyway, that may or may not have something to do with the inflation observations I’ve made recently.

With respect to equities, clearly my expectations of a short term low last week was incorrect. I think there are two factors driving the continuation of the sell off – a peak in manufacturing acceleration and de-risking in low grade credit.

With respect to the first, note that peaks in ISM prints (defined as a print above 58 followed by a decline) have historically proceeded periods of equity congestion or weakness:

Chart of ISM and S&P PE:

There are good reasons for this. ISM is one of the best leading indicators of manufacturing activity, which itself is strongly correlated to corporate earnings. In fact, historically, ISM has lead earnings growth by several quarters. In addition, historically supply chain management visibility has been limited, which means that a jump in output capacity (i.e. high ISM prints) has usually meant overbuilding, which in turn leads to mid cycle slowdowns (i.e. ISM prints below 50) as manufacturing activity decelerates to absorb the new production capacity.

These issues are certainly still a concern this time around, but there are reasons to believe that the effects may be muted. First, with the improvement in supply chain management over time, the cycle of over production followed by under production has declined. In other words, the ISM range over the cycle has been lower. Note that in the last cycle, ISM only dipped once below 50 until just before the recession. Second, the rally in equities over the past several years has been largely driven by an expansion in the P/E ratio (due to the decline in long term discount rates) rather than in earnings growth. This suggests that earnings concerns may only have a short term impact on the price. After all, that’s what we saw this Jan, when ISM tanked 5.2 points from 56.5 to 51.3.

Another factor that has likely affected equities has been the sharp de-risking in the riskiest parts of the fixed income market. High Yield bonds, especially the weakest credits, have been hit very hard last month, despite little fundamental news. Significant real money outflows were clearly a driver, and it appears that managers have decided to lighten up on the weakest credits first. Anecdotal reports are that the sell off is about as bad as it was in mid 2011. No doubt, the low levels of dealer inventory and market liquidity likely also had an impact. Also likely impacting the move is the news that the Fed is stepping up its oversight of leveraged loans, going so far as doing a deal-by-deal review after its previous industry-wide guidelines were largely ignored by the banks. In any case, the phenomenon of de-risking the weakest subsector has also been seen in the equities market, where the smallest stocks have underperformed sharply. The rise in financing costs for these names no doubt impacted the perceived riskiness of equities as a whole.

There may be some positive news on that front, however. As I noted last week, HY CDX is near range highs, and is now retracing – current levels are around 30bps below intraday highs made just 2 days ago.

In aggregate, according to my narrative, both of these factors are likely near term, but fading headwinds. In general, per BAML’s survey, managers continue to hold elevated levels of cash in their portfolios, even as liquidity continues to rise. I expect that ultimately that will contain any near term sell offs (I don’t think it’s a coincidence that since cash hit elevated levels in mid 2013, sell offs have been limited to 4-6%) and provide the fuel for the next leg higher for stocks.

Separately, recent events suggest that the ECB has both the will and room to be bolder. The weak PMI prints, with a sub 50 (!) print in Germany is one. 5y5y inflation below 1.95% is another. And there is mounting evidence that the current strategy of sovereign fiscal consolidation during a downturn is not feasible. Both France and Italy announced that they their fiscal consolidation targets will not be met as planned, (again) with France delaying by 2 years and Italy delaying by 1. Furthermore, despite the dissents at the last meeting, the FT reported that the ECB’s executive board will propose to the Governing Council that the ECB buy sub-IG ABS – a move that will undoubtedly generate dissents by the Germans since it exposes the ECB balance sheet to credit risk. (Cynics could argue that this is just the first step to an eventual ECB backing of all EU sovereign debt) This all suggests that rally in EUR-denominated debt isn’t over, especially since the US is beginning to decelerate as well.

Notable:

  • US ADP rose 213k vs 205k exp and 204k prev.
  • UK Mfg PMI declined to 51.6 vs 52.7 exp and 52.5 prev. Italy improved to 50.7 vs 49.5 exp and 49.8 prev. Germany was revised below 50 to 49.9 from 50.5 prev, while France was stable at 48.8
  • ISM declined to 56.6 vs 57 exp and 58 prev, while the Markit measure was revised lower to 57.5 vs 57.9 prev
  • China Mfg PMI was stable at 51.1 as exp
  • AU Retail Growth slowed to 0.1% vs 0.4% exp and prev
  • The Federal Reserve is stepping up its oversight of high-risk leveraged loans, shifting to a deal- by-deal review after its previous industry-wide guidelines were largely ignored by banks… Until now, supervisors collected loan data in an annual survey, and last year told banks they needed better adherence to standards they put forth in guidelines in March 2013. Over the past several weeks, they have shifted tactics and are examining loans as they are made… In March of last year, the Fed and other regulators released guidance saying debt levels of more than six times … Ebitda, raises concerns… Regulators asked banks to show better compliance with the guidance. They later acknowledged that banks had largely ignored those efforts. Starting in September of last year, the Fed and the Office of the Comptroller of the Currency sent letters to banks giving them 30 days to come up with a plan for tighter policies, four people familiar with the missives said at the time… “Terms and structures of new deals have continued to deteriorate in 2014,” Todd Vermilyea, senior associate director at the Fed Board’s Division of Banking Supervision and Regulation, said in a May 13 speech in Charlotte, North Carolina. “Many banks have not fully implemented standards set forth in the inter-agency guidance.” Covenant-light loans — which lack requirements that protect lenders such as limits on debt levels relative to earnings — are on track to exceed 70 percent of issuance this year, according to a Barclays report dated Sept. 5. That would be a record. Total debt levels for large leveraged buyouts have risen to 6.26 times Ebitda in the third quarter from 5.89 times in the first half of this year, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. That compares with an average of 6.23 times Ebitda in 2007, the year the credit crisis began… While identifying leveraged loans as a potential area of froth, regulators are focusing on underwriting rather than trading, which is still conducted away from exchanges, in telephone calls, faxes and e-mails. Even though many investors increasingly consider the debt in tandem with high-yield bonds as a way to boost returns, loans aren’t regulated as securities and take weeks to change hands, increasing the risk of a market seizure in the case of accelerated withdrawals… “We are closely monitoring developments in the leveraged- loan market,” Yellen told the Senate Banking Committee July 15. “Valuations appear stretched and issuance has been brisk.” – BBG
  • FT reports ECB plan to buy sub-investment-grade ABS as part of its purchase plan. This morning, the Financial Times reports that the ECB’s Executive Board will propose to the Governing Council that sub-investment-grade assets should be bought as part of the ECB’s purchase programme.
  • France and Italian Governments both announced that fiscal consolidation plans will be delayed to 2017
  • JPM: The IMF just released their Q2 COFER report, which shows the currency composition of FX reserves. Total reserves are now just over $12.0tn, up more than sixfold from $1.9tn in 2000. Further, reserves grew by 7.8% yoy, the highest growth rate since 4Q11, suggesting a reacceleration in FX reserve accumulation.
  • Polls released yesterday show Brazil’s Rousseff’s lead widening. If Brazil’s election were held today, Ms Rousseff would win in a likely second round with 49 per cent of votes, an eight percentage point lead over Ms Silva with 41 per cent, according to the Datafolha poll. This compared with 47 per cent for Ms Rousseff versus 43 per cent for Ms Silva in the previous poll on September 25-26. FT
  • The yen weakness is increasingly becoming a concern to industry leaders who had previously welcomed its decline. "It does not benefit the country or industry," Yasuchika Hasegawa, chairman of the Japan Association of Corporate Executives told a news conference Tuesday, expressing his concern about the weak yen. Nikkei
  • According to the NYT, Hong Kong’s CEO and his inner core, backed by Chinese support, have decided that their best strategy is to wait and hope that the ongoing disruption to daily life saps support from the movement. HK officials won’t use force but also won’t hold formal negotiations. There hasn’t been any serious talk of HK’s CEO resigning.

Upcoming:

  • Wed: Australia New Home Sales, Building Approvals, Trade Balance
  • Thu: ECB, US Jobless Claims, Australia Service PMI, China Non-Mfg PMI, Japan Service PMI
  • Fri: EU Services PMI, UK Services PMI, US Employment, Service PMI, ISM Non-Mfg
  • Mon: RBA,
  • Tue: CanadaBuilding Permits
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