From Bust To Bubble, With No Recovery In Between?
The gaps between markets (credit, equity, and volatility) and economic (macro- and micro-) reality have seldom been larger. What is just as concerning as this yawning chasm is the similarity of a number of activities to the 'bubble' in credit in 2007 - from record CLO issuance to covenant-lite loans resurgence. As Citi's Matt King notes, the past fortnight’s virtual melt-up in all things high yielding has been accompanied by a growing sense that markets are breaking out of the patterns of the past few years. In the near term, there is no reason in principle why the moves cannot go further; but unless more of the central bank stimulus finds its way through to the economy, this opens up the risk of sudden corrections as markets fall back to earth. How long will it take for that to occur, and for markets to become scared once again? It is hard to tell, and yet, as we have noted numerous times, we have been in this situation before. In 2009, the divergences took 6 months before stocks corrected, in 2011 it took 4 months, and in 2012 it took just 1 month. It's not different this time.
That 2007 Feeling...
Just a shame the real economy isn't...
and it seems unemployment doesn't matter anymore...
and nor do earnings...
but we've seen that before...
Via Citi's Matt King,
It Is Not Different This Time
The past fortnight’s virtual melt-up in all things high yielding has been accompanied by a growing sense that markets are breaking out of the patterns of the past few years. Euro headlines fail to shock spreads, advocates of austerity are in retreat, and “inflation-plus” targeting by central banks would seem to herald a new era of unprecedented stimulus. Does this give cause for chasing [performance] even at these levels? While it varies by asset class, we think the answer is still “no”.
In the near term, there is no reason in principle why the moves cannot go further. Credit has, if anything, been lagging the rally in govies.
In addition, we do know that central bank stimulus drives markets up, not only through a “portfolio” demand channel but also through a massive dampening in the supply available to private investors . The liquidity injection from the BoJ should at a minimum entirely offset any tapering we get from the Fed this year, and hence goes a long way toward justifying the rally in global markets:
And yet even allowing for this, the chart suggests that markets are getting a bit ahead of themselves. Flows to date from Japanese asset managers still show profit-taking on foreign investments, not increases. While we do anticipate some rebalancing towards foreign bonds over the next few months, bottom-up analysis suggests it is unlikely to exceed $50bn or so from the life insurers, most of that directed towards govies. Flows from pensions, banks and retail may in time add to that, but seem likely to be slower because of continued profit-taking on the depreciating yen.
Worse, the gap between market levels and economic reality has seldom been larger, and it seems to be taking ever more credit growth to produce the same growth in GDP.
Unless more of the central bank stimulus finds its way through to the economy, this opens up the risk of sudden corrections as markets fall back to earth. Markets may be right that the implementation of excessive austerity is bad news for growth, and hence for sovereign solvency. But not implementing austerity seems unlikely to lead them to fare any better — a realisation which seems yet to have dawned. How long will it take for that to occur, and for markets to become scared once again? It is hard to tell, and yet we have been in this situation before.
The chart below shows Citi’s European Economic Surprise Index plotted against iTraxx (European credit). Over the past few weeks, the economic data have plummeted relative to expectations, yet spreads have continued to tighten in. Similar divergences occurred at this point in each of the past three years; in every case, after a delay, spreads moved to follow the data. In 2009-10, the divergence lasted a good six months (Oct09-Apr10); in 2011 it took four months (Jan-May); in 2012 it took just one month.
The temptation is to say that something has changed, that we are immune to these problems, after the shocks to date which have failed to move spreads. But we doubt it. Tightening valuations and increasingly long investor positions ultimately create an obstacle larger than any individual news headline.
Most likely in the near term is markets just continue to follow the liquidity – and yet here too we think they are overestimating central banks’ largesse. Recent speeches suggest that the ECB, in particular, remains anxious that action on its part may lead to inaction on structural reforms elsewhere. Our economists expect a rate cut next week, but no major relaxation of collateral requirements just yet. Indeed, the opinion penned by the Bundesbank for Germany’s constitutional court, which leaked into the press this week, is a reminder of how the backstop on which the peripheral rally is predicated rests on remarkably shaky ground.
In general, and in peripherals in particular, we see nothing to suggest this time is different.
As we sit in an increasingly unstable equilibria...
...'normal' risks may have fallen but tail-risks haven't.