Investment Grade

If you are a stock picker, then it’s basically now or never for whatever investment discipline you might follow.  Asset class and industry correlations have taken a surprising nosedive in recent weeks, which - as ConvergEx's Nick Colas notes. should allow your strategy/blend of magic to (hopefully) shine versus the benchmarks.  Average industry sector correlations to the S&P 500 have dropped to 69.9%, by far the lowest observation for over two years.  High yield bonds now show just 16% correlation to U.S. stocks, and the numbers for Emerging Markets (58%), EAFE stocks (76%), and currencies like the Australian dollar (11%) are also plumbing new lows.  Why the sudden return to a ‘Normal’ world? Expectations that the Federal Reserve will begin to ‘Taper’ its bond buying help, to be sure.  As do actual inflows (some $8 billion last month) into actively managed mutual funds.  We’ll have to wait and see if current trends continue, but for now we welcome the return of the ‘Stock picker’s market’.  Let the dart-throwing begin...

It's only fitting that in a bizarro new normal, the news that passes for positive is either conflicting, reflexive or, well, simply bizarre. Last night was no exception as the "good" news came in the form of speculation that in order to promote its consumption tax hike, the Abe government would consider a corporate tax cut. How that helps the country with the 1 quadrillion yen in debt is not exactly clear, or how it makes consumer tax hikes any more palatable in a nation in which more people than anywhere in the world are retired and elderly, and thus removed from the corporate lifecycle, is just as nebulous. But the market liked it. Just as it liked the good ole' European cop out, of posting a surge in consumer confidence, or relying on reflexive indicators to represent an improvement in the economy, when in reality the only thing "improving" is the stock market. This happened when the German ZEW Economic Sentiment survey soared from 36.3 to 42.0 on expectations of a 39.9 print. So one must buy futures, or that's what the GETCO algo programming says.

It appears, as UBS' Stephane Deo notes, that in a rising rate environment, so-called risk-parity portfolios were susceptible to draw-down as yields 'gap' higher. As it turned out the 'equalization of risk across assets within the portfolio' failed dramatically after the Fed's June 19th FOMC statement which sent rates and stocks higher (and moreover rate volatility considerably higher) - the consequence for some risk parity funds was a significant loss. The question is whether this will happen again, or was this event a one-off? We believe this is a relatively mild foretaste of what is to come... as the 'speed limit' for rising bond yields is smashed.

Greed; corporate arrogance; lobbying influence; excessive leverage; accounting tricks to hide debt; lack of transparency; off balance sheet obligations; mark to market accounting; short-term focus on profit to drive compensation; failure of corporate governance; as well as auditors, analysts, rating agencies and regulators who were either lax, ignorant or complicit. This laundry list of causes has often been used to describe what went wrong in the credit crunch crisis of 2008-2010. Actually these terms were equally used to describe what went wrong with Enron more than twenty years ago. Both crises resulted in what at the time was the biggest bankruptcy in U.S. history — Enron in December 2001 and Lehman Brothers in September 2008. Naturally, this leads to the question that despite all the righteous indignation in the wake of Enron's failure did we really learn or change anything?

"For years, the City has spent more than it takes in and has borrowed and deferred paying certain obligations to make ends meet. The City is insolvent" - Kevin Orr

Bernanke today testifies on monetary policy before the House Financial Services Committee (formerly the Humphrey-Hawkins). The testimony will be released at 8:30 am NY with Q&A after his testimony. Tomorrow he testifies before the Senate Banking Committee but the prepared remarks are the same for both days. Indeed it’s likely that the Q&A will be where all the fun starts. As DB says, he will likely try to pull off the trick of continuing to prepare the groundwork for tapering but try to give bond markets something to help them fight off the pressure of higher yields. With no post-meeting press conference planned for the July 30th/31st FOMC, and Bernanke not scheduled to speak publicly until he appears at the Global Education Forum event on August 7th, this week’s testimony may well be the only remarks we hear directly from the chairman for some weeks.

It can't happen... It can't happen...It can't happen...  It just happened.

Given the US holiday, markets are likely to be thin today but there are some big news stories floating around at the moment.  If the fast and furious events from the past few days in a revolutionary Egypt bear a striking resemblance to what happened in the spring of 2011, it is because they are strikingly comparable. Only this time, following the ouster of yet another US-supported "leader" by the US-supported military, the country's CDS has normalized at a level that is roughly double where it was two years ago as the implicit backing of the US looks increasingly shaky, following what was yet another bungled foreign policy venture by the Obama administration. But for now, the people are celebrating, just as they did in 2011. One wonders what happens between now and the next coup, somewhere two years (or less) hence. For now focus merely on who controls the Suez - after all that is really all that matters for the US. The other major story of yesterday, Portugal, continues to be in limbo,

The volatility of recent weeks is but a mere small taste of the volatility in store for all markets in the coming months and years. The global debt crisis is likely to continue for the rest of the decade as politicians and central bankers have merely delayed the day of reckoning. They have ensured that when the day of reckoning comes it will be even more painful and costly then it would have been previously.

There is plenty of discussion of outflows but we though the following chart was perhaps the most insightful at why this drop is different from the last few year's BTFD corrections. As we noted here, corporate bond managers have desperately avoided selling down their cash holdings (since they know dealer liquidity cannot support broad-based selling and its an over-crowded trade) and bid for hedges in CDS markets. But it seems, given the utter collapse in the advance-decline lines for high-yield and investment-grade bonds that the liquidations have begun. While the selling in high-yield bonds is on par with the Lehman liquidationlevels, it is the collapse in investment grade bond demand that is dramatic (and worse than Lehman). It's not like we couldn't see it coming at some point (here) and as we warned here, What Happens Next? Simply put, stocks cannot rally in a world of surging debt finance costs.

Where's the buy-the-dip mentality? Yesterday's collapse triggered yet another Hindenburg Omen - the 7th in the last month) and it appears it is the equity market's turn for some pain as Treasuries (which initially weak) have stabilized 2-3bps higher in yield. The Dow has lost 15,000 and is down over 200 points today; the S&P 500 is testing back to its 1,600 level; but homebuilders are being battered (as clearly good is now officially bad). The S&P 500 is now the furthest below its 50DMA in 2013 - this is key as it has been critical support all the way up. Gold and Silver have been crushed (and copper and oil are following) this week so far and the USD is up 1.75% so far. Credit markets are being destroyed - investment grade spreads are 10bps wider to 90bps from FOMC.

There is no way the pensions and benefits promised in an era of financialized abundance can be paid once the wheels of financialization fall off. During the past 30 years of financialized abundance, the benefits and pensions promised to public employees were increased substantially. Public unions are a powerful political force in many states, and in eras of rising tax revenues, it's an easy political decision to increase public employee benefits and pension payouts. The rising stock and bond markets generated huge profits for the public-employee pension funds, enabling them to grow without taxpayer contributions. Alas, the 8+% annual growth rate of the boom era is now structurally unrealistic. The New Normal is bond yields of 2% or 3% at best, and equities markets that are increasingly at risk of significant sell-offs. The endgame of promises made in an era of illusory, financialized abundance will be hurried along by a collapse in the equities and bond markets.

The Fed’s zero lower bound policies have dislodged credit risk as the primary concern for investors, only to replace it with a major technical headache: interest rate risk. If rates remain too low for too long, financial stability suffers as investors reach for yield, companies lever up, and lending standards decline. The greatest of financial stability risks is probably the least discussed among those that matter at the Fed: the deterioration in trading volumes. As such, we suspect that the longer low rates persist, the worse the unwind of QE may be. And it may, in fact, already be too late. As events in the past two weeks have shown, credit markets also appear vulnerable to a rise in rates that occurs too quickly or in a chaotic fashion. Moreover, to the extent that issuers sense demand may be waning for bonds, there’s a distinct possibility the pace of supply increases precisely at the same time that demand decreases. Invariably, it’s this sort of dynamic that ends in tears.

Ongoing monetary stimulus is leading to heightened volatility, and the bull market which has been in place since 2009 is becoming overextended. The recent string of surprise downside moves in markets may be the canary in the coal mine for global investors. This is where we are today. The tide is rising for U.S. and Japanese markets and asset prices will ultimately move higher. The size and violence of each wave that advances or recedes will continue to increase due to the surge of liquidity from central banks. These tides of liquidity are strong, as are the currents underneath. We must guard ourselves from the risk of being pulled under.

Something is afoot in the land of credit markets. As we have been warning for a few weeks, credit appears to have 'turned' in the cycle suggesting equity should not be too far behind; but today's price action is rather stunning. Not only is investment grade credit spreads trading at their widest since the first day of the year, the high-to-low range of the day is huge. Aside from the extreme jump on the opening day of 2013, this is the biggest range in IG credit since Nov 2011. The last time we were at these levels was early 2011 and the rise in range then signaled the start of an extreme correction (from 80bps to over 150bps). Today's over 6bps range (from 76.9bps to 83.3bps) is extreme by any measure. Perhaps it is delta-hedging - since the low spread vol has driven many to the CDS options market for juice but whatever way one looks at it - something significant is changing (for the worse) in credit.