The price and macroeconomic action of the last few weeks seems to have confirmed much of the concern that we have been highlighting that technical (flow and risk-aversion) and fundamental weakness is creeping back into global markets and more importantly, that we see US risk assets as over-priced in that context. Our prescient calls in both outright equities and in our various successful arbitrage trades have generated significant interest.
Readers have been asking for a round-up post of what we are focused on, what helped us get the insight to believe trouble was ahead, and furthermore, what we will be looking at going forward for confirmation that a downtrend remains in place. That is the goal of this post and we will try to post regular updates to summarise our views and critical aspects of the many markets we watch for useful context.
In summary, we see our top-down TAA framework indicating equities are notably over-priced (since Late-April), HY credit spreads have notably decompressed since mid Feb (gaining pace recently), secondary bond markets have seen volumes lagging and net selling accelerating, primary bond markets have seen post issuance underperformance, credit term structures have flattened, and global financial systemic risk has elevated considerably. Very little of this has been discussed in the mainstream media except by us as momentum chasers dominated headline flow seemingly – even as this under-current of concern was gaining pace.
These are all leading indicators of concern for the bottom of the capital structure – equities – and this is even more confirmed by the drop in fundamental data we have seen. Our focus was on the Citi Economic Surprise Index which while tumbling dramatically (as data after data confirmed our perceptions of lack of real sustainable growth), it was the rate of change that highlighted to us the fragility of not just global growth but of the risk asset valuations that were predicated upon that growth.
We also highlighted the significant slowdown in FCF metrics and how EPS (and its expectations) are poor proxies for real FCF and valuations in an asset-inflationary environment. The fact that EPS growth expectations for the S&P are so predicated on the Energy sector’s huge growth in the next two or three quarters is most worrisome given we see this as entirely reflexive (strong energy earnings imply rapid rises in energy costs – as opposed to slow and steady growth/demand - and a necessary margin drag on the rest of global demand which willin turn slow energy demand).
Bottom-up, equities have been on a path of their own for much of the last six months pushing the majority of sectors extremely expensive in equities relative to volatility and credit. This began to unwind in recent weeks suggesting a reversion to more normal relative-value. There has been a persistent trend of up-in-quality and up-in-capital-structure preference for much of the last two months which strongly suggests the marginal buyer, typically professional investors in this case, are increasingly risk averse.
The huge divergence in pairwise correlation among HY names relative to IG and S&P 100 names combined with its widening (increasing risk) was clear evidence that professional investors were systemically unwinding more risky positions. Furthermore, the lower correlation in IG confirmed the up-in-quality preference as investors are increasingly discriminative of which IG credits they want to hold.
More archaicly, the continued cheapness of both the HY and IG credit indices (relative to their underlying fair-value based on individual components), the decompression in the IG basis (the difference between bonds and CDS in investment grade credit) has been widening as bonds underperformed even as blanket overlays were placed, vol skews in both equity and credit have compressed (somewhat at odds with perception, the fact that skews have dropped enables more downside shifts as protection against tails risks was reduced for the last month – this is a much more effective indicator that simply looking at vol or VIX), the gappy nature of IG/HY trading in the middle of last month as we troughed in spreads was very indicative to us of short gamma exaggerations and capitulations we have seen before.
Another complex topic is the performance of the ABX and CMBX markets, which we have highlighted extensively in recent weeks. While talking heads have been saying housing has bottomed and CRE is fine, we have been seeing ABX (resi mortgages) deteriorating notably (then confirmed by the double-dip in house prices) and CMBX (commerical mortgages) tranche pricing showing an interesting pattern. The divergence between junior and senior tranche performance in CMBX is very indicative of professionals positioning for much more systemic (higher correlation) concerns. This is the first shift to this trend since pre-crisis and is very worrisome (or would be should banks have to MtM their assets) for any sustained recovery in the US.
Technically, fund flows are stalling a little. HY saw small outflows recently and with low cash levels at most fixed income mutual funds, the volatility introduced by last month’s significant HY weakness may shake ourt more retail investors and put the mutual funds in a self-reinforcing spiral of selling into an illiquid market. The virtuous circle we highlighted between new issues, basis traders, curve traders, and corporate supply is certainly a hard one to break and has been on a tear on and off for much of the period since the MAR09 lows. We suspect that the combination of event risk and reduced liquidity is stalling this process and large crowds and small doors make for significant moves in these markets.
What we are watching most closely is new issue performance in corporate bonds (how concessions change and how they break) – which will tell us if demand is really there to sustain the credit driver of cost-cutting and releveraging in corporates; the TAA framework’s debt-equity context for signals of reversion if equity continues to decline – which will tell us more systemically if the cycle has run its course; sector-specific reversion in debt-equity-vol context changes – which will tell us if this is systemic derisking among equity investors or rotation; and probably most importantly the day-to-day shifts in relative context between index and fair-value in credit, between equity and credit indices, implied correlation and volatility skews in credit and equity, and the pricing of event risks around the world (all discussed every day in our Closing Contexts).
The midday and closing updates we create are designed to highlight some or all of these aspects of the markets and provide some color as to how to interpret them (i.e. translate the hugely jargonistic world of derivatives and cash market interactions into actionable and profitable ideas). We have done that very successfully for institutional clients for years and now for individual investors.
Our ETF Arb has been a very profitable ‘trade’ a number of times in the last six months (and notably all in the same direction as we see short-term overshoots in equities relative to credit). Our ETF-based HY-IG decompression trade is handily in the money and we remain positioned for more performance. The critical understanding of why to avoid outright credit ETFs is important (given TSY/yield performance) and we have been diligent in teaching that. Our A-List and TAA framework has helped investors avoid downside (mitigate risks) while generating some performance (enhance return) through this volatile period.
Opportunistically, we have described more institutional trades in curve flatteners (HY 3s5s); basis trades (Greece for example and Portugal next); Low cost, long vol trades such as Insurers vs IG or Short ExHVOL; Main-FINLs-SovX arbitrage; HY-IG decompression; and enhanced duration adjustments in HY hedging. We remain very cautious of US financials in credit land as ‘stuck’ owners are holding out for now in the face of equity and vol moves that warrant significantly wider spreads.
We hope this post has been helpful in highlighting the many aspects of the market we look at and how we try to create a context for them all that enables a more definitive ‘view’ to be established. Our investment frameworks cover all time-frames and facets of investing from asset allocators (TAA), to long-short managers (A-List and Factor performance in equity and credit), to cross-asset-class arbitrage (ETF Arb, Company Tear Sheets, and Sector fair-value), to intraday risk comprehension thanks to our risk-basket.
We will continue to try to divine the signal from the noise as we view the entire capital market in a broader context than any other service/desk we know of – and critically, try to discern the actionable pivot of that insight. Please do not hesitate to visit our Getting Started and Professional Services section for more details on how to contact us.
In the right context, credit anticipates and equity confirms, and we are constantly searching for more creative and useful ways to find that context.