"Invincibility lies in the defence; the possibility of victory in the attack."
- Sun Tzu
Looking at the bloodbath occurring in various sectors of the US equity markets during the scary month of October historically for financial markets, such as the Black Monday of October 16th, 1987, when it came to selecting this week title analogy, we decided to go towards a meteorological analogy, namely "Explosive cyclogenesis". "Explosive cyclogenesis" is also referred as a weather bomb. The change in pressure needed to classify something as explosive cyclogenesis is latitude-dependent. For example, at 60° latitude, explosive cyclogenesis occurs if the central pressure decreases by 24 mbar (hPa) or more in 24 hours. Given the velocity in which US "real rates" accelerated upwards at the beginning of the month in conjunction with the surge of the balance sheet reduction of the US Fed to $50 billion per month. The Fed's QE unwind reached $285 billion from the 6th of September through the 3rd of October, the Fed's holdings of Treasury Securities fell by $19 billion to $2,294 billion, the lowest since March 5, 2014. Given an explosive cyclogenesis occurs if the central pressure decreases rapidly, in similar fashion, the acceleration in the Fed's reduction of its balance sheet triggered the "weather bomb" on financial markets.
Many pundits have been reminding themselves of Black Monday, given it occurred during the month of October as well. Many have forgotten the Great Storm of 1987, which was a violent extratropical cyclone that occurred on the night of 15th-16th of October. That day's weather reports failed to indicate a storm of such severity - an earlier, correct forecast having been negated by later projections. On the Sunday before the storm struck, the farmers' forecast had predicted bad weather on the following Thursday or Friday, 15th-16th October. By midweek, however, guidance from weather prediction models was somewhat equivocal. Instead of stormy weather over a considerable part of the UK, the models suggested that severe weather would reach no farther north than the English Channel and coastal parts of southern England. At 2235 UTC, winds of Force 10 were forecast. By midnight, the depression was over the western English Channel, and its central pressure was 953 mb. At 0140 on 16th October, warnings of Force 11 were issued. The depression now moved rapidly north-east, filling a little as it did, reaching the Humber Estuary at about 0530 UTC, by which time its central pressure was 959 mb. Dramatic increases in temperature were associated with the passage of the storm's warm front. During the evening of 15th October, radio and TV forecasts mentioned strong winds, but indicated that heavy rain would be the main feature rather than wind. By the time most people went to bed, exceptionally strong winds had not been mentioned in national radio and TV weather broadcasts. The storm cost the insurance industry GBP 2 billion, making it the second-most expensive UK weather event on record to insurers after the Burns' Day Storm of 1990.
Following the storm, few dealers made it to their desks, and stock market trading was suspended twice and the market closed early at 12.30 pm. The disruption meant the City was unable to respond to the late dealings at the beginning of the Wall Street fallout on Friday, 16th October, when the Dow Jones Industrial Average recorded its biggest-ever one-day slide at the time, a fall of 108.36. City traders and investors spent the weekend, 17th-18th October, repairing damaged gardens in between trying to guess market reaction and assessing the damage. The 19th of October, Black Monday, was memorable as being the first business day of the London markets after the Great Storm. The trigger for the "weather bomb" in early October which led to a 10% mini-crash was a warning by Fed chairman Jay Powell that the Fed planned to push interest above the "neutral rate" to prevent overheating. So, central pressure fell rapidly, real rates shot up, and the rest is, as we say history... but we ramble again.
In this week's conversation, we would like to look at the buildup in recession signs we are seeing adding to the "reflexivity" in the tightening of financial conditions. Are the "weather" forecasts of no recession in sight justified? We wonder.
- Macro and Credit - "Reflexivity" and Recessions
- Final charts - Where is the "credit" weather bomb?
Macro and Credit - "Reflexivity" and Recessions
As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs indicate that given the large sell-off seen in October, investors' perceptions have been changing, and that maybe we have a case of "reflexivity", one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year, financial conditions tightened about 80bp over a two-week period akin to "Explosive cyclogenesis", aka a "weather bomb".
But the difference this time around, we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many think. As pointed out on Twitter by Tiho Brkan displaying a chart from J.P. Morgan, almost all asset classes have negative YTD returns (first time in 40 years):
- Graph source: J.P. Morgan, H/T Tiho Brkan
Sure "real rates" have been driving the sell-off, but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".
The rise in "real rates" triggered repricing of forward EPS and forced investors to mark a lower strike to the Fed "put". Real rates grew at the same pace as 12 months Forward EPS until the "repricing":
- Graph source: Macrobond
Given financial markets should act for many investors as a "discounting mechanism", no wonder, with liquidity being removed thanks to QT, markets have had to "reprice" forward EPS accordingly in such a short period of time. The US markets have been defying gravity way too long, and their outperformance versus the rest of the world has been significant in 2018.
When it comes to "buying the dip", Merryn Somerset Webb, in the Financial Times, makes some interesting comments:
"October shouldn't be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors perhaps) this is nasty. For the rest of us it is good news, twice over.
First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40 per cent of S&P 500 companies have reported in this earnings season and some 80 per cent of them have managed to produce a positive surprise. Digitalisation may well be about to transform productivity in developed economies. And there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)
Second, stock markets outside the US really are not that expensive anymore and pockets of them are beginning to look like they offer some value. That should please long-term investors.
It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for."
- Source Financial Times: Merryn Somerset Webb
In terms of "cheap" market outside the US, and as pointed out in her article as well, apart from the United States, Russia - regardless of US sanctions - was left pretty much unscathed relative to other Emerging Markets. Russia's equity market should be priced for a continued rebound. Forget the sanctions, rising oil prices could be very supportive, and with a P/E of around 5.2, you have very limited downside. The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors, given the extreme volatility of American politics (and thus, sanctions). Comparing Eurobond yields with Russian equity yields for the same risks will show you more "arbitrage" opportunities, so we suggest you do your homework on this...
But for sure, with rising dispersion, active management as pointed out by Merryn Somerset Webb should come back into play, given the growing rotation between value and growth:
- Source: Thomson Reuters Datastream - H/T Holger Zschaeptiz on Twitter.
The growth trade over value trade is over. That's your "great rotation" from "growth" to value" in one chart...
Moving back to the "main course", namely "Reflexivity" and Recession, we do believe that we have passed "peak" consumer confidence in the US. For instance, the University of Michigan's consumer sentiment index fell from 100.1 in September to 98.6 in October. This, we think, was "peak" consumer confidence, with cyclicals such as Housing and Autos becoming a headwind for the US consumer.
Sure, US Q3 GDP came at an annualized 3.5%, but it is because Americans save less to sustain spending as income gains cool. Americans saved 6.2% of their disposable income, matching the lowest level since 2013:
- Graph source: Bloomberg
On top of that, we can list the following "headwinds":
- Investors are selling the shares that hit quarterly earnings expectations at the highest rate since 2011. Good times are behind us...
- Early indicators show that economic conditions continue to weaken in China.
- Residential investment fell 4% marking the third straight quarterly decline. That hasn't happened since late 2008 and early 2009.
- Breaking bad? Even equity long-short hedge funds could see their worst month since the Great Financial Crisis (GFC). August 2011 level reached so far.
- U.S. investment-grade bond funds reported $1.6 billion in outflows in the past week, the fourth consecutive withdrawal for total redemptions of $7.2 billion; HY funds reported $2.1 billion of outflows, according to Wells Fargo Securities.
We could also add David P Goldman's recent comments in Asia Times that US consumer discretionary stocks have been propped up by credit card binge:
"Consumer discretionary stocks have outperformed the S&P 500 by about 10% during the past year. That may be about to change.
Consumer spending remains robust in the United States according to this morning's US data release. Personal spending was up 0.4% in September, or a 5% annual rate. The problem is that personal income rose only 0.2%, or a 2.4% annual rate.
Consumers are spending more than they earn. The past year's pop in consumer spending depended on credit cards. That's not a sustainable situation.
The chart below shows three-month changes in US retail sales vs. three-month changes in credit card debt outstanding. During the past year, the two lines look nearly identical.
Here's another way to measure the dependence of retail sales on credit cards: The six-month rolling correlation between monthly changes in retail sales and monthly changes in credit card balances outstanding has risen to about 70%.
- Source: David P Goldman - Asia Times
US consumers might not be "buying the dip", but are dipping into their savings to "sustain" their consumption, and that's something to worry about. We haven't even much growth deceleration in Europe at this stage. We recently mused around shipping indicative of a slowdown in global trade in our latest conversation "Ballyhoo" and the Harpex index as an indicator.
Apart from the clear underperformance of the exported oriented German Dax Index or the Korean Index, Anastasios Avgeriou, Chief Equity Strategist at BCA Research, pointed out on LinkedIn today a very interesting chart:
"Who would have thought that the DAX and chip stocks are more or less the same trade... Both are very sensitive to global growth and thus interest rates. In other words, rising interest rates hurts them, and vice versa..."
- Source: Anastasios Avgeriou, Chief Equity Strategist at BCA Research
Misery does loves company, one would argue. Cyclicals, such as housing, autos and even chips, have been impacted by the deceleration in global trade, hence the latest weakness seen in Europe from slower GDP growth.
As well, there are some other signs pointing towards trouble at a later stage, which will follow the "relief" rally we are seeing.
For instance, as pointed by the IIF, despite stronger earnings growth this year, many US companies struggle with debt service:
"Many companies are not generating enough earnings to cover interest expenses - despite still strong earnings growth. With growth expected to slow in 2019 and rates still rising, the problem could get worse"
- Source: IIF
In our book, credit leads equity, and we are closely watching credit drifting wider, thanks to the Fed tightening slowly but surely the credit noose, as can be seen in the below Bloomberg chart posted by Lisa Abramowicz on her Twitter feed:
Watch closely the energy sector in general and oil prices in particular, because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket.
And, of course, the problem is getting worse given rates have been rising in line with improving growth estimates as per the below chart from Bank of America Merrill Lynch:
If indeed growth is slowing, then again, the US Treasury Notes yield should be falling as well. It is difficult to play it at the moment given the rise in issuance by the US Treasury.
When it comes to "Smart Money", some have already been heading towards the exit, as pointed out by Eric Pomboy on Twitter with the below Bloomberg chart:
Someone is clearly not waiting for the explosion of the "weather bomb", it seems...
One thing is for sure, the October "Explosive cyclogenesis", aka weather bomb, was another warning shot by the Fed, but it seems no one was really listening. This effectively means that the Fed's strike price for US stocks is much lower, as it has removed the reference to monetary policy being accommodative. This is pointed out by Morgan Stanley in its Global Interest Rate Strategist note from the 26th of October, entitled "The Financial Conditions Jackpot":
"FOMC participants have been clear that the outlook for the hiking cycle is unlikely to shift simply because of equity market volatility. This sort of guidance led to interest rate vol lagging the sharp rise in equity vol. We think this is justified by fundamentals and do not yet recommend buying shorter expiry interest rate options outright. Only when the narrative of FOMC participants starts to shift will we consider paying theta. And when that occurs, we expect short-tail vol to outperform long-tail vol.
A long way to neutral?
Exhibit 47 illustrates how 1m10y vol has been lagging the spike in the VIX.
This is true of rates vol in general, which has underperformed equity vol in both realized and implied terms. We believe the main driver of this dissociation has been the general dismissal by most FOMC participants of the volatility seen in the stock market. This is an excerpt from the Q&A that followed the September FOMC press conference (our emphasis):
CHAIRMAN POWELL. So I don't comment on the appropriateness of the level of stock prices. I can say that by some valuation measures, they're in the upper range of their historical value ranges. But, you know, I wouldn't want to-I wouldn't want to speculate about what the consequences of a market correction should be. You know, we would-we would look very carefully at the nature of it, and I mean, it-really- really what hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that's a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that's a really bad situation. A simple drop in equity prices is- all by itself, doesn't really have those features. It could certainly feature-it could certainly affect consumption and have a negative effect on the economy, though.
More recent comments from FOMC participants echoed that sentiment, despite the S&P 500 index being 10% off the highs. In effect, this implied that the Fed is not close to stepping in to support the stock market by altering the path for monetary policy. In other words, the so-called "Fed Put" is still out of the money. This is likely to maintain some certainty in the rates market as to the path for rates in the near term as the Fed seems set to at least reach its estimate of neutral.
Less uncertainty about rates begets lower vol. Of course, rates are still going to see higher vol in a risk-off move as a result of investment flows as well as shifting probabilities surrounding the outlook for the Fed. But our view is that this volatility will not be both sustainable and notable until the Fed Put is in the money."
- Source: Morgan Stanley
Until the Fed Put is in the money, that is until the weather bomb has been digested by the market in similar fashion to the rapid storm experienced back in October 1987.
While many pundits are still reeling from the "bloody" October, and many are asking themselves where trouble is brewing, we do believe that some parts of US credit markets do contain some potential "weather" bombs as per our final charts below
Final charts - Where is the "credit" weather bomb?
Credit always leads equities, in our book, when eventually we will have a definitive turn of the credit cycle. For storm chasers out there, we believe that some parts of US credit markets are showing signs of fragility, and it's not only the fall in quality of investment grade credit. Our final charts come from Wells Fargo Economics Group note from the 29th of October, entitled "Which Sectors Have Driven Business Sector Debt Growth", and shows that the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector, and the tech sector:
"Business Sector Debt Is Up By Nearly $5 Trillion
In a recent report, we noted that the financial health of the U.S. non-financial corporate (NFC) sector has deteriorated, at least at the margin, in recent quarters. For example, the debt-to-GDP ratio of the NFC sector has trended up to its highest level in decades (below chart).
Not only do non-financial corporations borrow from financial institutions such as banks, but they also issue bonds in the corporate debt market. In that regard, the market value of investment grade (IG) corporate bonds has shot up from less than $2 trillion during the depths of the financial crisis to more than $5 trillion today. The value of high yield (HY) corporate bonds has mushroomed from about $400 billion in late 2008 to nearly $1.3 trillion today.
The value of corporate bonds outstanding-IG and HY-has plateaued in recent months. But, lending by commercial banks to the NFC sector continues to trend higher. Indeed, the amount of leveraged loans outstanding has grown to almost $1.1 trillion at present from about $800 in early 2016 (below chart).
In total, the value of corporate bonds (IG and HY) and leveraged loans outstanding has risen by nearly $5 trillion, which is an increase of roughly 180%, since late 2008. Is this growth in corporate debt a widespread phenomenon or does it reflect higher debt loads in just a few sectors?
We disaggregated the business sector into 11 broad subsectors, and we find that debt has increased in each of these subsectors over the past 10 years (bottom chart). So the increase in business sector debt has been generally widespread. But, not every subsector has had the same experience in terms of debt growth. The financial sector leads the pack with an absolute increase in debt outstanding in excess of $1 trillion over the past ten years (horizontal axis in bottom chart).
Although the financial sector is the largest sector in terms of total debt outstanding ($1.8 trillion in Q3-2018, which is denoted by the size of the bubble), its 132% rise in outstanding debt places it below the average in terms of debt growth over the past 10 years (vertical axis). Other subsectors with slower-than-average debt growth since Q4-2008 include utilities, transportation, basic industries, consumer cyclicals and communications.
There are three subsectors that stand out in terms of debt growth over the past 10 years. The debt in the non-cyclical consumer goods industry, which includes food & beverage, healthcare and pharmaceuticals, has experienced a 275% increase in debt outstanding to $1.2 trillion at present. Energy (400% increase to nearly $700 billion) and technology (almost 600% to roughly $650 billion) are also notable for the debt growth they have experienced. In sum, most business sectors have experienced rising levels of debt over the past 10 years, but the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector."
- Source: Wells Fargo
So there you have it, given Tech is under pressure, the energy sector is depending on the trajectory of oil prices to stay afloat (see our above point relating to interest expenses coverage), and consumer goods are depending on a more and more fragile US consumer, you can probably think that there is indeed an explosive cyclogenesis in the making... Happy Halloween!
"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
- Vincent Van Gogh