"A nation that forgets its past can function no better than an individual with amnesia." - David McCullough, American historian
Watching with interest the continuation of "Mack the Knife" (King Dollar + positive real US interest rates) Emerging Markets bloody rampage with Gold continuing to suffer thanks to Gibson Paradox (negative correlation between gold prices and real interest rates), and also reminding ourselves it has been ten years since the onset of the Great Financial Crisis (GFC), when it came to selecting our title analogy, we decided to go for the Korsakoff syndrome. The "Alcoholic" Korsakoff syndrome is an amnestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). This neurologic disorder is caused by lack of thiamine in the brain and is as well exacerbated by the neurotoxic effects of alcohol (or QE...). The syndrome and psychosis are named after Sergei Korsakoff, a Russian neuropsychiatrist who discovered the syndrome during the late 19th century. There are seven major symptoms of alcoholic Korsakoff syndrome (amnestic-confabulatory syndrome):
- anterograde amnesia, memory loss for events after the onset of the syndrome
- retrograde amnesia, memory loss extends back for some time before the onset of the syndrome
- amnesia of fixation, also known as fixation amnesia (loss of immediate memory, a person being unable to remember events of the past few minutes)
- confabulation, that is, invented memories which are then taken by the patient as true due to gaps in memory, with such gaps sometimes associated with blackouts
- minimal content in conversation
- lack of insight
- apathy - the patients lose interest in things quickly, and generally appear indifferent to change.
Back in 2011, in our conversation "Anterograde and Retrograde Amnesia", we commented on the dollar liquidity crisis which was brewing at the time and severely impacted EM as well as the European banking sector as whole which was saved by the ECB's LTROs late that year. The difference of course this time around is thanks to the ECB support, European financials credit spreads have not exploded à la 2011. Yet, with the Fed busy withdrawing liquidity thanks to QT in conjunction with a rising US dollar, as a reminder, a liquidity crisis always leads to a financial crisis. That simple, unfortunately.
We touched on the various form crisis could take in our long February 2016 conversation "The disappearance of MS München". While we won't go again about the various forms a crisis can take, from a currency crisis to a credit crisis, everyone not suffering from the Korsakoff syndrome is rightly asking when this already long cycle will end and what to look for.
In this week's conversation, we would like to look at the potential signs marking the end of the cycle.
- Macro and Credit - What to look for the Boom moving to Bust?
- Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...
Macro and Credit - What to look for the Boom moving to Bust?
There is no doubt that liquidity issues always lead to financial crisis. This was the case in 2011 and the ECB prevented the meltdown in the European banking system with its LTROs which was followed by Swap agreements with the Fed. The normalization process followed by the Fed in conjunction with its QT is of course validating our much vaunted global macro reverse osmosis theory discussed on numerous occasions on this very blog hence the continues pressure applied on Emerging Markets thanks to the surge in the US dollar, providing a strong headwind on gold for the time being.
Given the 10-year anniversary of the GFC, many pundits are questioning how long until the music stops given the flattening of the yield curve as a sign we are reaching the end of the credit cycle. Timing is of course everything, eventually, perma bears will be right but the question is when. On this subject, we read with interest CITI's latest Global Multi-Asset View entitled "For Whom the Clock Ticks: How Long Till End-Cycle" published on the 4th of September:
"Even a broken clock...
"A man with a watch knows what time it is. A man with two watches isn't so sure."
- Segal's law
Probably the most common question any strategist gets asked is where we are in the investment cycle. Even those who don't like our debt-equity clock seem to have a triangle or a wave or some equivalent alternative: the notion of the economic cycle, and how markets respond to it, is simply the foundation of how most people think about investing.
But recent months have revealed a problem - even for strategists purportedly using the same framework. While Rob and the equity strategists would put the hands on the clock earlier in "Phase 3" - say 7 o'clock (Figure 1) - Matt and the credit strategists argue markets are closer to Phase 4, or 9 o'clock (Figure 2) - if indeed they recommend using the clock these days at all.
Our debate mirrors parallel discussions on the shape of the US yield curve. Many economists are dismissive of its current flatness, arguing that it has been distorted by QE, and that rising inflation should soon lead to higher yields and steeper curves. But others, including the San Francisco Fed, our rates strategists and our credit strategists, argue that its steady flattening poses a genuine and immediate problem for risk assets.
Settling these questions is of critical importance. This is especially true for equity investors, who face the dangerous challenge of riding a late-cycle bull market but avoiding the end-cycle carnage when it breaks. Credit investors lose out in both stages, but somehow they seem resigned to that.
While we always receive a steady stream of such questions, recent weeks have seen the trickle turn into a torrent - perhaps fuelled both by the yield curve and this year's fading returns in most assets outside the S&P. These enquiries are coming not only from traditional asset managers but also from corporates, private equity, infrastructure and other "alternatives" investors - counterparties whom we do not speak to regularly, and who may well change their positions only once or twice a cycle.
This note is designed at least to air our differences, if not necessarily to resolve them. First, we lay out how the cycle has worked traditionally, and explain why markets seem to follow a global cycle even in the face of regional and sectoral differences in growth and in earnings. Second, we examine the many ways in which this cycle has bucked the traditional pattern. Finally, we look for guidance in history as to what really triggers the transition to Phase 4, and hence what happens next. Unfortunately it is hard to provide definitive answers: we argue that much depends on whether you think the cycle is driven by fundamentals or by market movements, and on whether this cycle's distortions have merely slowed down the clock's alarm function, or broken it entirely.
How the cycle works
Our thoughts on how the cycle is supposed to work haven't really changed over the decades. Companies go through regular phases of leveraging and deleveraging, and you can normally tell where you are in the cycle both from what they're doing with their balance sheets and from the response in credit and equity markets. Here's how we put it back in 2005:
Starting at 12 o'clock, in the depths of recessions companies go through intense periods of restructuring in order to reduce their debt burdens. Assets are spun off, dividends skipped and equity raised in order to generate cash and reduce the risk of bankruptcy by paying down debt. Once this activity gets underway, credit spreads rally sharply - the risk of default is perceived to be past its peak - even though equity markets remain in the doldrums because issuance is dilutive and earnings continue to fall.
Eventually, cost cutting and aggressive restructuring, accompanied by economic recovery, yields a rebound in profits (after 3 o'clock). In this next phase, both earnings growth and debt/EBITDA are improving, causing credit and equity to rally together. However, as the cycle matures, this progressively gives way to a period of lower quality earnings growth, in which share gains are often achieved at the expense of corporate leverage, for example through acquisitions or share buybacks (after 6 o'clock). This keeps equities rallying, but deteriorating balance sheets start to drive credit spreads higher.
Finally, the resultant balance sheet deterioration comes to a head, creating a crisis in which profits cannot be sustained, and both equities and credit sell off (after 9 o'clock). It's time to take all risk trades off. This is usually associated with a recession which induces the retrenchment which eventually allows the cycle to start all over again.
By and large, we think this framework has held up pretty well, and it is not too difficult to discern its workings in the US over multiple decades. Equities and credit are sometimes positively correlated (Phase 2 and 4) but they can also be negatively correlated (Phase 1 and 3). This is visible in terms of the alternation between credit and equity market returns (Figure 3), and in terms of the cyclical leveraging and deleveraging of nonfinancial corporates' balance sheets (Figure 4).
To be sure, not every cycle is driven by corporates, and the credit and equity market movements are not quite as regular as, well, clockwork. In the 1970s, movements in oil prices were larger drivers of the economy than corporate leverage per se, and emerging from the 1982-3 recession in particular, we cannot see a "Phase 1" in which credit rallied before equities.
But even when recessions were not actually caused by the non-financial corporate sector - as in 2008 - the broad patterns have still seemed to hold. The recession was preceded by a long period of leveraging up, in corporates as well as in households, and credit market returns turned south months (if not years) before equity market returns did. Understanding the workings of the cycle is a useful way to think about how you should invest.
Time waits for no man (but seemingly for a few corporates)
Note that we have never claimed that it has to be the same "time" for different regions, or even for different sectors. Indeed, while similar principles hold at the individual company level, with credit and equity prices responding to changes in balance sheets, different companies can employ very different strategies. For example, while US-based Apple is reducing its cash pile with the primary intention of rewarding shareholders, China's Anbang - after a previous spree of debt-fuelled acquisitions - is now making bond-friendly disposals and trying to shore up its balance sheet.
Aggregating leverage statistics across companies and sectors is as much an art as a science; we often joke that you can demonstrate that aggregate leverage is doing almost anything if only you try hard enough. To what extent when calculating net debt/EBITDA should the tech sector cash pile be allowed to offset the debt burdens shouldered elsewhere? Should you calculate median (net debt/EBITDA), median (net debt)/median(EBITDA), or use means? How as an investor in public equities should you treat the hundreds of billions in debt from private-equity-owned names?
Nevertheless, even given substantial variation at the company and sector level, it is possible to calculate overall averages (Figure 5).
It is almost remarkable how similar are the patterns those averages follow across regions and different data sources (Figure 6).
From the noise of individual companies' balance sheet decisions, there emerges a global cycle.
We can see different levels of global correlation when we look at other important variables. While GDP growth is imperfectly correlated, with the US generally considered to be ahead of other countries, EPS growth by region is more closely related, especially recently. And, despite being more volatile, actual stock price returns (Figure 9) or credit spread changes (Figure 10) are all but indistinguishable across regions. Markets are highly correlated, even if fundamentals aren't.
Beyond this, it seems to us that there is a strong element of reflexivity to the process. Company balance sheet decisions, and investor calls on what to buy and sell in credit and equities, are not taken in a vacuum: they influence one another. When Vodafone bought Mannesmann in 1999 in what was then the largest ever M&A deal, its stock continued to rally. This increased the likelihood that AOL would end up buying Time Warner. When Enron filed for bankruptcy in 2001, the environment of increased investor nervousness added to the risk that WorldCom would subsequently do so in 2002. Market movements - and investors' and corporates' responses to them - are themselves significant drivers of the cycle.
But how have markets been moving this time round, and what does that tell us about the all-important transition to Phase 4?
Who stopped the clock?
In fundamental terms, this cycle things seem to have proceeded pretty much as usual. A period in which profits were growing faster than debt, from 2009 to 2012, has been followed by one in which debt has been growing faster than profits. As a result, overall corporate leverage has risen well beyond that reached in 2008, to the highest level ever recorded outside of an actual recession (Figure 4, Figure 5, Figure 6). Presumably one reason this has been possible is that record-low levels of interest rates have made interest payments look manageable, even with record-high levels of debt (Figure 11).
When broken down by sector, the pattern is more varied, but probably no more so than normal.
The sectors seemingly most intent on leveraging up are those which it might be reasonably argued ought to be most able to bear it: Utilities, Healthcare, Consumer Staples and Telecoms. That said, in many cases they are now running with substantially more leverage than ever previously (Figure 12).
A second group of sectors - traditional cyclicals - have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13).
Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg. Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6).
Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).
A second group of sectors - traditional cyclicals - have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13). Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6). Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).
Putting these numbers together, Matt thinks aggregate leverage is higher than might be expected outside of a recession, and hence more reminiscent of late Phase 3 than early Phase 3. But low interest rates and the predominance of increased leverage amongst the more defensive sectors help explain why this has not yet been seen as a problem for markets as a whole. Moreover, there are even signs that aggregate leverage is beginning to decline given recent strong profit growth and helpful US tax cuts.
But Rob's primary reason for thinking this is Phase 3 is not based on fundamentals but more on market movements - in particular, the current outperformance of equities relative to credit is classic Phase 3. Other Phase 3 characteristics, such as narrowing market leadership, are also evident (Global Equity Quarterly: Narrowing Bull Market)." - source CITI
The reason the credit clock has been much slower than usual is of course due to the Korsakoff syndrome, namely that central banks intervention has been very supportive of credit spreads in many instances, providing as well some support to many "zombie" companies which should have been eliminated but managed to survive thanks to the low interest rates environment. Record-low levels of interest rates have made interest payments manageable even with higher leverage creeping up thanks to the distortion created by our central banking deities.
While EM have been on the receiving end of the latest summer heat thanks to the strong dollar, the S&P 500 and US stocks have been racing ahead while the rest of the world has been languishing. Credit wise both US High Yield and US Investment Grade have had a less torrid time than EM High Yield or EM equities. Indicators of aggressive issuance such as the percentage of the CCC credit bucket accessing the primary market has remained fairly stable still and revenues even for US High Yield remain overall solid as per the below Bank of America Merrill Lynch chart:
- source Bank of America Merrill Lynch
The most recent quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points that financial conditions still remain favorable. Overall credit remains fairly stable for now at least in the US as pointed out by CITI's comprehensive report:
"A central banker in the works
Most importantly, the steady leveraging-up by companies since 2012 has simply not been accompanied by spread widening on anything like the same scale as in previous cycles. Indeed, even with non-financial corporate leverage higher than the levels seen in 2008 and (on some universes) 2001-2, credit spreads are not far off traditional cyclical tights, especially in US HY (Figure 15).
The pattern in € HY and $ and € investment-grade is similar, if slightly less extreme. Even long-term charts - over which period it becomes difficult to difficult to obtain consistent universes for both spreads and leverage - suggest that something is awry (Figure 16).
If it were just credit spreads which were behaving in this fashion, the signal could perhaps be ignored, or dismissed as an excessive focus on headline debt levels rather than interest coverage and debt sustainability. Indeed, the rating agencies invoke just such an argument when asked why such high debt levels have not led to an increase in downgrades.
But the same time period - since 2012 - which has seen leverage rising and spreads tightening also reflects a breakdown in other market relationships. Equity volatility traditionally correlates with metrics designed to capture policy uncertainty (the number of references to uncertainty in the news, for example). But since 2012 uncertainty has been high, and yet volatility across markets has been setting new record lows (Figure 17).
Changes in consensus earnings expectations used to correlate with equity market moves in every region, yet since 2012 that relationship has broken down too, even if it is now beginning to re-establish itself (Figure 18, Figure 19).
Matt has argued loudly for several years that all these breakdowns are due to QE, and "too much money chasing too few assets". He thinks that as central banks pull back, both credit and equities are vulnerable, and cites in his support continuing strong correlations between global central bank purchases and market movements. As was visible in February this year, the central banks have effectively "broken" the normal clock functioning, and credit can no longer be relied upon to lead equities in the way it has done historically.
Rob sees it slightly differently. QE intentionally decoupled credit spreads (kept falling) from corporate leverage (kept rising). Even as balance sheets moved through 6 o'clock, so central bankers kept risk asset pricing back at 5 o'clock. The reason that equity volatility fell is that it is highly correlated to credit spreads (Figure 20), and QE kept spreads falling.
But now that has changed. As central banks step back, so the credit and equity markets will catch up with fundamentals. This year's rise in spreads and volatility finally marks the move into Phase 3 that, without QE, would have started in 2012. Rob thinks that QE has held the clock back, not broken it." - source CITI
One could indeed agree somewhat with Rob from CITI that, indeed the Korsakoff syndrome associated with prolonged ingestion of QE has clearly distorted the "credit clock" and slow down the normal aging process thanks to financial repression and low interest rates. Now, with QT in full swing, the tide is slowly but surely turning, with the over-leveraged players being the first one taken to the cleaners such as the house of straw of short-vol yield pigs and now the house of sticks of macro EM tourists carry pigs.
What about record high corporate margins? Surely, trade war and surging PPI will eventually put a dent in corporate margins one might argue as corporations pass on price increases onto their customers. CITI discusses as well this issue in their note:
"Time is an illusion. Lunchtime doubly so.
Unfortunately a closer examination of both market and fundamental data in this cycle does relatively little to shed light on this debate, or at a minimum can be construed as arguing in both directions.
One potential end-cycle sign is compression of corporate margins, at least as proxied by companies' unit labour costs (usually the major driver of their cost base) relative to output prices (tracked by the broad GDP deflator). In the US in 1979, 1989,1999 and 2007, labour costs rose more rapidly than output prices as the cycle matured, labour gained in pricing power and corporate profit margins were squeezed (Figure 21).
Something similar happened for the Euro area in 1999, 2007- 8 and in 2012 (Figure 22).
Each time, this was a useful warning that companies were resorting to leverage in order to support earnings growth, and of the consequent vulnerability of the equity market.
Rob agrees that you may get a rolling over in "per unit" margins in the macro data, even as overall profit margins of listed corporates keep rising. But a combination of strong volumes and high margins are enough to keep profits rising and the bull market rattling along (Figure 23).
Overall profit margins don't collapse until the recession begins, volumes fall and companies are left with excess fixed cost bases. As such profit margins are a coincident indicator with the stock market, which is why Matt doesn't like them. They don't give any prior warning; they always look great right up to the last minute.
The trouble is, this time round, while there is some evidence of margin compression in the Euro area, US unit labour costs have been oscillating without any clear trend. However you look at it, the sort of earnings growth and especially revenue growth we have seen in 2017-18 simply defies traditional models for what is "supposed" to happen at this stage of the cycle." - source CITI
There is indeed a "Dissymmetry of lift" between the US and Europe, leading to the current growth differential outcome with Europe slowing at the moment while the US showing signs of expansion with the latest ISM. Some would argue it could be a peaking sign in this credit cycle. Also as we have argued various times, a sudden acceleration and surge in oil prices would obviously ignite more inflationary expectations (or scare) and lead to a more hawkish Fed. This would of course be much more negative for asset prices overall and lead to the famous bust after the boom.
Another interesting discussion within CITI's note has been around mutual fund flows. Those who read us on a regular basis know that we look at mutual fund flows as an indicator of investors mood and confidence. This we think is quite interesting:
Yet another potentially useful late-cycle indicator is mutual fund flows. You might reasonably have expected Phase 3 to be associated with strong flows into equities. A strong rotation from bonds into equities is very visible in 1997-2000 and is notable by its absence this time round, perhaps suggesting Phase 3 has much further to run (Figure 24).
But both 1985-87 and 2005-2007 were associated with exuberance in fund flows in general - an exuberance which now seems to be running out of steam. Another way to think of fund flows is in terms of total inflows to all risky assets (bonds, equities and hybrid funds combined) relative to inflows to money market funds and deposits. This seems to follow a regular cycle with respect to deposit rates (Figure 25).
In Phases 1 & 2, emerging from recession, when deposit rates are low, and valuations are cheap, investors do most of their saving in risk assets. As the cycle matures and as deposit rates rise, they steadily move some of their savings in deposits. Eventually in Phase 4, they sell all risk assets, prices fall, deposit rates are cut and the, eventually, the cycle starts again. This year's tremors in markets may be a sign that just such a phase is being reached already.
Yet here too, the signals are ambiguous. Fund flows both influence market returns and are influenced by them (Figure 26).
While we find it quite easy to imagine a scenario in which fund outflows drive markets lower and trigger a growth slowdown, it is by no means a foregone conclusion. We seemed to be embarking on just such a negative path in February 2016, but then, an unusual (from the perspective of these charts) rally in markets - admittedly following more central bank intervention - halted the outflows and triggered two years of further inflows. While central bank easing now feels much less likely, positive market returns in equities, driven by earnings growth and share buybacks, may well suffice to spark inflows of their own
If Matt is right, further central bank withdrawal should mean the inflows fizzle out and turn to outflows, conclusively creating a bear market not just for credit but also for equities. If Rob is right, central bank withdrawal and renewed corporate releveraging should cause credit spreads to widen, but equities may yet have further to rally. They become the only game in town. But equally, it would not be that surprising - especially given the example of the Energy and Materials sectors, and the broad-based deleveraging thanks to earnings growth - for us to skip Phases 4 and 1 entirely, and go straight back to the "organic" deleveraging associated with Phase 2, in which both credit and equities rally. This is, in effect, what markets did during 2017. But was that fundamentals, or the effect of extraordinary central bank policies? Once again, this cycle defies easy categorization." - source CITI
We think, when it comes to Matt King's argument about inflows fizzling out and turning to outflows, creating a bear market is an interesting proposal. In our final chart below we would like to provide additional support to Matt King's view
Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...
To add more ammunition to this hypothesis we would like to point out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).
This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. Could that be finally a reliable "Boom to Bust" indicator?
"Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand-based narrative of credit cycles and can be useful for policymakers.
A large body of literature in macroeconomics and finance studies the link between credit markets and macroeconomic cycles. A pattern that emerges from the data is that credit booms precede downturns in macroeconomic activity. This pattern attracts considerable attention from academics and policymakers: if credit markets are at the root of macroeconomic fluctuations, then it is important to better understand what drives credit cycles and identify leading indicators to try and design policies that will moderate them.
In this paper we show that investor portfolio choice toward high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms. An increase in our measure in year t predicts credit booms marked by the other indicators in the literature in years t+1 and t+2. These other indicators include the proportion of low-quality bond issuers (Greenwood and Hanson, 2013; López-Salido, Stein, and Zakrajšek, 2017), the degree of reaching for yield in the bond market (Becker and Ivashina, 2015), balance sheet growth in financial intermediaries (Schularick and Taylor, 2012; Krishnamurthy and Muir, 2015), and various measures of credit spreads (Gertler and Lown, 1999), in particular the excess bond premium (EBP) recently proposed by Gilchrist and Zakrajšek (2012).
In addition, our measure, as a leading indicator of credit booms, positively predicts GDP growth and negatively predicts unemployment rates in years t+1 and t+2 (before they turn in the reverse direction in year t+3)." - source Wharton paper, by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein
Prolonged ingestion of QE surely is a way leading to many credit investors getting the Korsakoff syndrome such as the Macro EM tourists that piled into the 100 years bond issued by Argentina, causing them memory loss of their fiduciary duty but we ramble again...
"We live in a world where amnesia is the most wished-for state. When did history become a bad word?" - John Guare, American playwright.