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: