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The Case For A 'Mini-Bubble'

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by: The Heisenberg
Summary

With US equities at record highs and markets now convinced that central banks are back in the business of protecting risk assets, the "melt-up" chatter is growing louder.

The proliferation of negative-yielding debt is driving a mad scramble down the quality ladder which has manifested itself in astonishing ways across the eurozone.

In the US, tepid economic data and lingering trade concerns have cemented the case for Fed cuts, while a series of mechanical catalysts argues for more gains.

In case you haven't noticed, the global bond rally continues to accelerate at a remarkable pace, spurred along by persistent growth worries and expectations for more accommodation from central banks.

On Thursday, 10-year German yields fell to -0.41%, below the ECB deposit rate.

(Heisenberg)

The bottom pane shows the astonishing rally in Italian bonds. 10-year yields in Italy have fallen nearly 120bps since mid-May. On Wednesday, the rally was turbocharged by news that Rome will dodge EU disciplinary action in connection with Italy's notoriously problematic fiscal situation. That's an important story on its own, but for our purposes here, just note that the eye-watering rally in Italian bonds is indicative of the reinvigorated hunt for yield sparked by the promise of more ECB easing. On the heels of Mario Draghi's "whatever it takes 2.0" remarks in Sintra, the European fixed income market has become even more of a fun house mirror. 10-year yields are now negative in Belgium, France, Austria, Finland and the Netherlands.

Christine Lagarde is almost certain to carry on Draghi's legacy when she takes the reins at the ECB, which only adds to the market's conviction that another easing package is on the way across the pond. Euro IG borrowing costs are just ~0.5%. In high-grade, the options for getting more than 1% are (basically) confined to 10-year paper and hybrids. This explains why Saudi Arabia tapped the euro market for €3 billion this week - it's essentially free money.

Meanwhile, Donald Trump's latest Fed picks are likely to support lower rates in the US despite the rather stark juxtaposition between the two. Between that, a miss on China's Caixin services gauge for June, a tepid ADP report and the weakest ISM non-manufacturing print since December 2017, 10-year yields in the US fell to 1.93%. "Naturally" (and the scare quotes are there for a reason), the Dow hit a new record and the S&P rose for a fifth straight session ahead of the July 4 holiday in the US.

(Heisenberg)

Simply put, equities are being bolstered by Fed cut expectations and the data hasn't done anything to dispense with the notion that a July cut is all but inevitable.

As Goldman wrote in a noted dated Monday, "both theory and history support the argument that lower interest rates should increase the value of equities, all else equal." If you're wondering what history tells us about multiple expansion in the wake of Fed cuts, you're in luck. Here are a couple of additional excerpts from Goldman's note (which, in its entirety, is an expansive, 10-page take on falling yields and equity prices):

In seven previous Fed rate cutting cycles since 1984, S&P 500 P/E multiples expanded by a median of 3% during the 12 months following the first cut, with valuations rising in five of the seven cycles. The clear outliers were the cuts in 1998, when multiples went on to expand by 30% within the following 6 months, and 2007, which was followed by a 12-month contraction of -20% and eventual recession.

That brief passage underscores a familiar refrain. Namely that the whole "bad news is good news for stocks because it means the Fed will cut rates" narrative isn't viable if the news ends up being so bad that the economy careens into a recession.

In any case, the "melt-up" calls have grown louder over the past week, something I've documented at length over on my site. This year's rally (which now clocks in at 19.5%, by the way) has been characterized as a "flow-less" affair, lacking participation from key investor cohorts. The bull thesis relies in part on those who have missed out being "forced" in.

(Heisenberg)

Global equity funds have seen around $138 billion in redemptions this year, with the breakdown betraying a net outflow of -$41.2 billion from US funds (-$83.0 billion from active, partially offset by a +$41.8 billion inflow to passive vehicles). As Nomura's Charlie McElligott wrote this week, "there is a significant 'high cash' component which could act as fodder for a grab-in across both risk assets and further into bonds, with money market funds experiencing a massive +$195.8 billion inflow YTD, which is 93rd percentile since 2000".

Between that, the re-engagement of systematic vol. sellers (which, as Nomura noted Wednesday, serves as a "second-order catalyst" for higher stocks) and the assumption that trade tensions will continue to simmer thus keeping the Fed on its toes, some have now made a "melt-up" their base case. Barclays, for instance, wrote the following earlier this week about the prospects for a "mini-bubble":

Fed easing during past soft patches has resulted in substantial valuation-driven equity rallies. Our model-tracking estimate for S&P 500 year-end is still 2850 (using a EPS of $163 and P/E multiple of 17.5). However, from a scenario analysis perspective, we now assign a 65% probability to a 'melt-up/mini-bubble' scenario, decrease the probability of the 'escalation' scenario to 15% and retain a 20% probability of a recession scenario resulting in a probability weighted level of ~3000. This implies a 1x premium for our model based P/E multiple which we believe is reasonable. Based on this analysis, we upgrade our S&P 500 price target to 3000.

You'll note that is another reference to Fed easing prompting a multiple expansion-driven rally, similar to what Goldman described in the excerpted passages above.

When Barclays refers to the reduced probably of an "escalation" scenario, it is, of course, referring to the trade war. Long story short, the bank thinks both Trump and Beijing have incentives to keep kicking the proverbial can on the trade truce as opposed to ratcheting up the tension again.

Those interested in more on McElligott's take and Barclays "melt-up" scenario can read some additional excerpts (along with a heavy dose of my own editorializing) here, but it's enough to simply point out that between expected Fed-driven multiple expansion, near-term mechanical catalysts (e.g., funds being compelled to re-engage as stocks move higher, knock-on effects from systematic vol. selling) and, in a general sense, the prospect of record highs prompting inflows and bringing in sideline cash, the ingredients are there for another push higher.

For the time being, risk assets continue to view the bond rally as being a product of downwardly revised rate expectations and tepid inflation, as opposed to a sign that the global economy is about to fall off a cliff. As the rally in bonds runs, the global pile of negative-yielding debt grows. It's now above $13 trillion. That further incentivizes risk taking in markets. When you're taxed for holding risk-free assets, you naturally move out the risk curve. That scramble down the quality ladder acts a "rubber stamp" on risk asset returns, to quote a recent BofA note.

The result is an "everything" rally, as stocks, bonds and credit surge in tandem.

(Goldman)

All of that said, regular readers know I harbor a skeptical take on the idea that the trade tensions will ultimately be resolved in a way that's beneficial to the US economy, let alone the rest of the world.

This week brought at least two escalations on the trade front. On Monday evening, the USTR proposed tariffs on another $4 billion in EU goods in connection with the Airbus (OTCPK:EADSF) dispute. Then, somewhat alarmingly, the Commerce Department announced duties in excess of 400% on steel from Vietnam in an effort to discourage opportunistic re-routing through the country, which has been a major beneficiary of the China tariffs. Additionally, President Trump on Wednesday accused China and Europe of currency "manipulation" and suggested the US should "match" America's trade partners. That was probably nothing more than another exhortation for the Fed to cut rates, but you're reminded that last summer, rumors were flying that the administration might actively intervene in the FX market, something which has only happened twice since 1995.

Oh, and everyone will want to watch the June payrolls report on Friday. That has the potential to affect the Fed's decision calculus, and it could be especially interesting given that not everyone will be at the desk following the US holiday.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.