We were invited to discuss our views on European and US markets as part of CNBC’s Fast Money show today. The discussion was brief but premised on the fact that our insights into the credit-equity relationship was flashing a major warning light in Europe and in the US and while Apple was sustaining broad US equity markets, risk is rising dramatically for a much more broad sell-off that should be hedged to market-neutral or shorted outright. Video Link here.
Full notes below (please bear in mind these were notes for the interview and not meant for public dissemination).
HYG -1.5% for March and +1.5% YTD
SPY +2.35% for March and +11.75% YTD
Stocks move around 1.5x HY price
Fed stuck – energy prices
ECB stuck if inflation continues – tightening practically impossible – ST lending is minimal, reserve requirement changes will trigger massive capital calls now, and selling assets into the open market is broklen as non-sensitive assets (those not tied to LTRO and all the other operations) are for the first time below Excess deposits
High yield credit markets are sending warning signals of problems ahead for the equity market
$2tn of global central bank liquidity in the last 3-4 months has lifted all boats in nominal terms
High yield credit market (and US financial credits) however has begun to dislocate notably from the euphoric equity performance in the last month or so.
While HY fund flows remain solid, the major ETFs have stopped/slowed share creation – meaning there is not new demand for these ETFs over what is available – ending a two year trend.
HY market is very bifurcated – big divide between the goods and the bads – so have to be careful to compare apples with apples which is what we do.
This pattern of equities accelerating higher vs high yield occurs again and again thru history and as we like to say at Capital Context ‘Credit anticipates and equity confirms’. Credit traders are prone to momentum trading as much as any trader but there is a limiting factor in that cashflow is king and the asymmetry of the high yield bond market (limited upside vs considerable downside) makes them more cautious on chasing too hard.
The most recent short-term indication was the 35pt rip in the S&P off last Friday’s lows on the back of Merkel (firewall) and then Bernanke (QE hints) which was generally ignored by credit markets and sure enough the equity market corrected back in line with credit on Tuesday.
Q1/Q2 2011 was very similar to this – few times we saw equity rally higher while high yield credit did not and then as the summer began, high yield credit led the equity market into the abyss…
When All-in Yields Are Mostly Spread (like Today), the Beta between HY Spreads and Treasuries Is High
What is Changing? In US…
Macro data is rolling over markedly. Earnings growth is rolling over. Liquidity spigot being shut down/slowed due to energy prices. Impact of QE having less and less real economic impact. Fed’s ZIRP policy not flowing thru to payroll growth or housing still in any meaningful way. Profit margins mean-revert as deficit spending slows.
Extreme warm weather impacts that dragged forward demand have created a false sense of growth that economists and analysts have extrapolated – that is why we have seen 56% of macro indicators miss in March (compared to 42% and 35% in Jan and Feb) and 17 of the last 21 macro prints have missed specifically.
All the regional manufacturing surveys have missed now (with Kansas completing the set today) after beating in Jan and Feb and housing is disappointing after data seemed better in Jan and Feb (but was later revised).
Corporate profit margins are entirely dependent now on fiscal deficits to increase which seems like it will be under considerable strain heading into year-end.
Apple makes up over 40% of the decline in S&P 500 earnings growth – so long live Apple.
Bonds vs Stocks is a false analogy – stocks have massively larger volatility, considerably larger drawdowns (so the chances of catastrophic loss is considerable), and dividends as a support is a misnomer due to their instability (and the volatility of the stock itself) – comparing TSYs to Stocks also does not work because one is ‘risk-free’ and the other ‘risky’ by nature – perhaps comparing Corporate Bonds to Stocks is better and in that case – Corporate bonds look much more attractive…
On Interest rates – Rates will be supported by 3 factors
Uncertainty over US fiscal tightening
A lack of risk-free alternatives
The Fed’s pseudo-commitment to hold off rate increases until 2014
A zero-cost-of-money is supposed to create a “Portfolio Rebalancing Channel (PRC)”. As shown in the charts below, the channel is now playing out presumably as the Fed expected after lowering the cost of money to zero in 2008:
A flood of money goes into credit funds, lowering the cost of credit and more importantly, increasing its availability
Rising credit and equity markets create a positive wealth effect
The wealth effect leads to a rebound in spending, driven by the top 10% who account for ~30% of discretionary spending
Industrial production picks up, leading to…
A sharp rebound in S&P profits…
And a similar rebound in capital spending…
Eventually, accumulated profits and demand for goods and services leads to a rebound in payrolls…
And eventually, home prices, although this cycle is clearly quite different given the supply overhang
But, it hasn’t worked perfectly, of course. Payroll growth is still too low, home prices haven’t rebounded, and trend growth is less than 3%.
The Fed remains committed to driving this ‘channel’ but, as Cembalest points out this could easily be derailed by inflation, a bond market revolt towards funding our ‘Ecuadorean’ deficits, or the pending fiscal cliff legislated for 2013. “So the PRC keeps chugging along, until the Fed’s job is done (and Goldilocks continues), or something breaks.”
What is Changing? In Europe…
Imbalances remain massive and with Spanish budget likely to be a big miss/adjustment tomorrow, is not getting better anytime soon. Market is realizing that LTRO was a band-aid and not a solution. Liquidity is now being faded. ECB is in a corner if inflation re-appears. Firewall is irrelevant as it relies on self-support and cannot be big enough (analogy of bank loan and self-guaranteeing the loan). ECB actions in Greece and with LTRO have acted to subordinate bond holders (change the rules) and that is leaving typical market participants to flee the market.
LTRO was nothing more than QE by another name and so flooded the market with much-needed liquidity for the banks’ short-term needs.
However, it has 3 problems: 1) It encumbers bank assets to the ECB – implicitly reducing the assets that support the banks’ capital structures; 2) it slows the much needed deleveraging that banks need to do to reduce leverage and meet capital needs; and 3) it increases contagion risk by forcing the banks and the local sovereign into an even more symbiotic relationship thru the Sarkozy trade – which is now unwinding.
Italian car sales -32% in March…
LTRO Stigma (difference between LTRO banks and non-LTRO banks) is at a record high – banks being punished now for taking LTRO loans
European VIX is at its highest relative to US VIX since the rally began – has tended to drag US VIX higher.
How does European stress get to the US? – bank derivative interconnectedness (has grown massively in the last quarter), rehypothecation (quality collateral is hard to find), risk appetite (if European risk flares, flows revert to USD and TSYs/Gold which will trigger correlated algos to push stocks lower), and macro-economically (Europe looks set for a harder recession than was expected and this will slow global growth knocking into US exports).