What an interesting and humbling year it’s been. After 2017, expectations were ripe for a reset, and that sure has happened. Amazing what paradigm shifts can do.
Many readers are probably suffering from “2019 Forecasts” fatigue, so I will try to keep things brief. As always, disagreements & criticisms are not only appreciated, but requested from readers!
The slowdown in money growth is being felt globally. Of the big 3, the European and Chinese economies are facing particularly tough conditions because the banking systems are undercapitalized relative to its balance sheets. This means that without central bank liquidity, money supply growth slows dramatically. Until that changes, it will be difficult to bet on a sustained re-acceleration. The US is in a much better spot in that regard, but even there, the impact of higher interest rates is clearly impacting rates sensitive sectors. The consensus view is that we are now late cycle and a recession is likely in 2020. I think this is a too early, unless Fed Funds hit 3% before the end of 2019.
Central Banks & Rates
It’s worth noting that the tightening in financial conditions is the entire point of Fed hikes. Similarly, the market pressure on Italy’s fiscal situation during its negotiations with the EU is part of the ECB’s goal. So neither should be seen as sufficient conditions on their own for the two central banks to reverse course. What has changed in 4Q is that the data has clearly started to turn lower, and the size of the financial tightening implies that the slowdown is likely to extend further.
The European data started slowing first, which suggests the ECB will move earlier than Fed – subject to the Italians & Brits, of course. I think there will be some serious constraints on ECB actually hiking, but the current market pricing is not all that attractive to fade given the headline risks, IMO. Readings for ECB hikes north of 50bps provides good opportunities for mid-curve receiver positions, IMO, where roll down to premium exceeds 3x.
The US data WILL slow further, however, so it’s just a matter of time before the Fed reacts to that. But the market is currently only pricing in 18bps of hikes for all of 2019. With growth still positive and well above zero, that number just seems too low. In fact – using OIS swaps over the next two years, the market is now pricing in more hikes by the ECB (32bps) than the Fed! (23bps) Recall that unemployment is at 8.1% in Europe and 3.7% in the US. From a modal perspective, there is clearly a disconnect. Mathematically minded readers will note that one reason explaining the disconnect is that the ECB is much closer to the zero bound than the Fed. After all, if a recession does hit, the market can price in a lot more cuts for the US than Europe. But if we assume that the Fed cuts to zero in a recession and the ECB keeps the deposit rate unchanged, the implied probability of a recession over the next couple years relative to the SEP baseline is about 1 in 3. There are lots of ways we can further quantify whether that makes sense, but to me, that seems too high. Betting on a more hawkish Fed like a good proposition. The question on timing is, as usual, paramount. Ultimately, the question for rate markets is: at 2.25% Fed Funds, have we reached the terminal level for the cycle? If the answer is yes, then the current market pricing is justified. But I think that is a question that the market won’t be able to answer until growth rates bottom and can re-accelerate. And given that financial markets are driving the deceleration this time, we should probably wait for risk assets to stabilize for a period before entering. A bit obvious, perhaps, but it can be easy to forget obvious things when things are volatile.
Also – for those that missed it, the changes in the Fed’s FRB/US model was very interesting, and should have an impact on your expectations for the Fed’s reaction function. Note that inflation variables in the model now has significantly lower sensitivities to shocks. Per the Fed:
Although the sensitivity of the inflation process has declined in the new model, the smaller short-term responses of the inflation variables reflect not so much the changes to the model as they do the re-estimation of the wage-price block equations over a longer sample period that now extends through 2017… A second noticeable feature of the responses between the models is a faster convergence of the response of many variables back to the original baseline in the long run.
Credit & Equities
Credit spreads have been affected by a couple of things this quarter: first the downgrade of GE, which was a shock due to the size of its stock of debt, how widely it’s held, and the speed of the downgrade. Secondly, the decline in WTI oil prices below 50 drove renewed concerns around the default risk of energy companies. When combined with the generally poor liquidity of the corporate bond market, slowing profit growth and the record high debt / EBITDA measures, spreads widened dramatically relative to what the economic data alone would suggest. In addition, the year end illiquidity is likely having a supportive effect on where some small credits are marked. Some credit managers have suggested to me that there could be a jolt lower for these prices in the new year as the bonds finally clear. We’ll see.
The Equity Risk Premium is pretty high – cheap by >10% for major equity indices by my calculations, and not seen since Feb and before than Oct 2016. There is a disconnect between equity and credit prices here. Either credit should weaken further or equities should be higher. Will the new year turn things around, as risk takers start with a fresh slate and PnL? I think so, but think this is also the consensus view. So if there ISN’T a rally in January – watch out!!
One factor for the size of the equity sell off is almost certainly because to the reduction in market liquidity. As documented by Goldman (below) and others, single stock and S&P futures liquidity & market depth is at the lowest level in years. This is undoubtedly a result of the move into passive instruments. This instance can certainly be different, but note that historically these periods of illiquidity have all been good buying opportunities for equities.
I think that the 1987 narrative is may be somewhat illustrative of current conditions. Economic growth was decent in 1986, and looked likely to get stronger in 1987. Unemployment had dropped rapidly and were not far from making 10 year lows. This prompted a hawkish Fed and a jump in yields. (in orange below) The 200bps jump in 10y yields from June to Oct, in conjunction with portfolio insurance programs, drove a 33% peak to trough sell off. While that was a major financial shock, growth remained strong. The Fed cut rates but had fully reversed the cuts 6 months later, and 10y yields were broadly range bound for the next few years. Equities made new highs in mid 1989, about 2 years after the prior peak.
This time around, the Fed is similarly concerned about overheating (financial overheating at least) and were guiding yields higher. The 3.24% print on 10y yields was the highest in 7 years. Furthermore, the combination of low liquidity from algorithmic market making, (see charts above) substantial increase in passive investment vehicles, and the prevalence of volatility driven investment systems provides an accelerant for the risk off move similar to the portfolio insurance programs in 1987.
S&P earnings per share is up +19% YoY. (sorry there was a typo before) S&P Prices are down -9%. That’s a -28% differential. Differentials that big have been pretty infrequent historically – we’ve only seen worse than -25% swings 5 times before over the past 40 years. 1984, 1988, 1994, 2002, 2010. The returns of the next years were: +26%, +27%,+34%,+26%,+0%. The returns in 2011 weren’t so hot because that was during the EU crisis, when people thought the Euro was going to implode.
Note that it is also year 3 of the presidential cycle, which has historically delivered much bigger returns than in the other years. The media reports that Trump views the stock market as an indicator for his presidency, so it shouldn’t be a shock to see some additional fiscal stimulus coming down the pipe. Whether that will be positive over the long run is questionable of course, but is certainly an upside risk in the near term.
FX & Commodities
The dollar has been quite muted over the past couple months. Looking at the charts alone, it would be hard to see that we’ve had the biggest risk off move in a couple years this quarter. From a market tone perspective, I think that means the bias for the dollar is lower. Weak EU growth and an reticent ECB is already in the price here. A stabilization of global growth, even at low levels, has a good chance of propelling the dollar weaker. The possibility of further US fiscal stimulus is another dollar bearish risk. Finally, BAML’s fund manager survey has long dollars as a crowded/most-loved trade. (see chart) As noted elsewhere, the EU (mainly Germany) current acct balance is now very high, and that is changing the sensitivity of the EUR/USD cross to risk conditions. This is something that will be important to monitor, I think.
The 1y1y WTI strip is now around $50 which is reportedly below the cost of production for a lot of shale sources. In theory, that will cause a lot of supply to close up and bring the oil market back into balance. Certainly, that was the case in 2015 and 2016. However, it’s important not to forget that the shale producers wound up figuring out lots of ways to increase efficiency then, meaning that the true level for “break-even” in mid 2016 wound up being notably lower than the assumptions made in 2015. Ultimately, the oil market will probably need to see some stabilization in the inventory builds before there can be confidence that the supply is really adjusting sufficiently. That may be starting to play out, but it’s still early days.
Chinese growth is weak – no news there. What’s different is that there just hasn’t been a sizable monetary response like we saw in previous cycles. One of our Chinese academic contacts has noted that unemployment and economic distress is actually quite widespread, and in no way reflected in the reported data. Again, not shocking, but given the context of the slowdown and the trade war, there are a number of legitimate questions about what the economic plan really is. With Xi’s power unquestioned, the trade war in full swing, and the prevalence of large amounts of non-economical debt broadly recognized, it’s quite possible that China is finally attempting to do necessary to rebalance its economy. The need to reduce debt while at the same time limiting reliance on net exports and reorient GDP towards consumption, all with a declining labor force is an extremely difficult task. In this context, Chinese government bond yields look too high.
Also worth noting is that the outlook on EM stocks is now the most bullish in 10 years, according to BAML. Valuation measures like CAPE are certainly supportive, but the secular changes that have taken place, along with the institutional challenges, remain quite worrying.
After a number of years in my current seat, I am now actively hunting for a new role. If any readers know of a position that could use a global macro and/or asset allocation mind set, in either an advisory or portfolio management role, I would sincerely appreciate the opportunity to discuss it. Thanks for reading and Happy Holidays!