Blain's Morning Porridge, submitted by Bill Blain
“Better a decade of inflation that a cycle of decay.. ”
A few years ago I was on Bloomberg one morning, and said something like stocks looked overly expensive and should be due a correction if it wasn’t for the support they were getting from company buybacks and the low relative yields on bonds. The programme host asked me if I meant stocks were going to collapse, so I joshed with her – confidently predicting some random date like October 12th as the day the global stock market would tumble of out bed. I spun some yarn about my high degree of confidence that 10.30 am that day would see a crash nailed on. I figured anyone sensible watching would see I was joshing. I should have given the host a verbal sarcasm warning – I think the newscaster took me seriously…. So now I try to hedge a bit when its blindingly obvious we are poised on the edge of a precipice about to take a big step forward…
We are in the middle of a deeply unconvincing market, but this time it’s not stocks that scare me.
Yesterday’s stock market action turned out mildly positive on the back of less bad than expected numbers. The big event today will be the US Non-Farm Payrolls data – expected around 160k. Yet, despite a continuing long-term strong employment trend, rising wages and no real tension, the market buys the notion a global recession is 30-40% likely, but also that Fed Chairman Powell stands ready to deliver another bout of easing later this month – The Powell Put. That’s the stock market we’re in – reacting to daily news on trade wars and looking to be bailed out.
Fundamentally should we be scared? Yes, be a little concerned.
Meanwhile, the short-end of the US Bond market tightened as expectations of further easing rose…. (At this point please start humming the underwater menace theme from Jaws, and imagine a large shadowy shark-like form is below the boat.)
I’ve spent most of my career in the fixed-income markets. What I see today scares the shit out of me.
We are looking at 2% yields on the 30-year US T-Bond. That’s the highest bond yield in the whole developed world sovereign bond market! And the market thinks it’s a bargain because US rates are inevitable going to zero and beyond! That is not good. It really is not good. It is not normal. It means something is very very wrong.
Yet investors can’t get enough of it… delicious, yummy sub zero percent yielding bonds… September was a record month for corporate new issuance – more than $300 bln of issuance. (When I started in the market back in the 1980s, a record month would be a couple of billion!) We’ve now got governments around the globe taking about fiscal reflation and borrowing more – why not? Yields are so low a few trillion more in debt can’t hurt… can it? Of course not.. fill yer boots.
As bond yields continue to fall, the investment banks are churning out new deals as fast as they can type out the term sheets. Its even more manic in High Yield. Investment banks make higher fees from junk issues – so guess what.. the market is flooding with paper. And investors are hoovering them up – they just love the yield (ie positive), the investment bank analysts are telling them to buy, and they figure that because there is a global recession coming and Central Banks will ease rates – then why not ride the next leg of the Great Bond Rally?
Whoa. Stop. Think. There is a little word…. Risk.
Remember Blain’s Market Mantra Number 1: “The Market has but one objective – the inflict the maximum amount of pain on the maximum number of participants.”
If there is a global recession, what happens to bonds in recession? Sovereign bonds and most investment grade bonds tighten. Tick. (Well, they would tighten if they weren’t stupidly tight already..) High Yield Issuers go bust. Big X. (Consider that Lesson 1 this morning. At this point you should be thinking about the need for a bigger boat…)
One of my European chums was amazed a BB junk French laundry firm he’s never heard of, Elis, was able to raise 5-year debt at 1% last week. This would be the same company no one had previously ever heard of that caused some eyebrow raising earlier this year when it launched a covenant-lite junk bond. This time around no one even blinked. The reality is issuers are getting deals done with less investor protections and lower yields than ever.
(It’s a curious physhological thing, but those of us of a certain market cohort are very aware the more complex you make a deal, the more you can weaken the protections, and the more likely it is investors will simply scan the docs with a once-over and accept worse terms.. People like to look clever and pretend they understand difficult stuff… I was a really good bond salesman in my day)
You can understand why corporate treasurers want to get their deals done now – what’s a bit more leverage when rates are so low? (“Wafer thin mint sir?”) Corporate funding teams are not stupid – they understand pre-funding next year’s redemptions now makes sense in case markets crater. I idly wonder if anyone buying these deals listened as S&P warned European junk default rates are likely to rise to 2.8% next year? Oh – you didn’t spot that news buried in the back pages…
Consider this as Lesson 2 – as junk issuers lever up on more and more debt, then what happens if they can’t refinance because the bottom of the market falls out? They go bust… This leads neatly to Lesson 3 - if interest rates were to rise then high yield issues are more likely to go bust.
This is really simple stuff:
A recession is bad for High Yield. Falling bond yields are bad for high yield because they look less and less attractive on a relative basis, and rising yields are equally bad. What’s to like about over-leveraged junk debt? In short – high yield is high risk. Understand that or get out the junk shop! Here endeth the easy part of today’s lesson.
And now I will argue that NIRP and ZIRP negative bond yields are also bad. They achieve nothing except to fool investors. Eventually the marks will realize they are being fooled and will walk away. As I was saying yesterday, you have the issue of rising amounts of “Idle Capital” – the smart guys that see the inherent dislocation and pointlessness of zero rates in the bond market. They see 10-years of monetary experimentation, QE, asset purchase programmes have achieved precisely zero in terms of growth or inflation. They increasingly see the “decay” of markets I reference in today’s opening quote. (It was said by Oswald Toynbee (whose grandson is a porridge reader). He was Maynard Keynes’ broker – I’ve attached his obituary; it’s definitely worth a read.)
The result is increasingly Idle Capital means junk bonds are top of the potential illiquidity list – less and less money willing to refinance at stupid levels. Meanwhile, what is that Idle Capital doing? Some of it is waiting for a crash, some of it is looking at remaining in Cash. But… maybe the place to look is the stock market where dividend yields look attractive relative to bonds.
Then you have to overlay the bond market with the global reality:
That a Trump vs China and/or Europe trade war is a reality
That an oil shock as Saudi implodes or goes to war is a reality
That a messy Brexit is a possibility
Etc etc etc..
I’m sure there are lots of reasons to go into the weekend happy about markets. I’m not that worried – I take the view the sun usually rises each morning, and things are never as bad as you think… but this is a curious modern age, and I don’t think the Planet Earth User Manual has a page detailing how to deal with an infestation of Trump, Boris, Xi et al…
Have fun… stock up the bunker… (Only kidding: these new Chinese missiles don’t miss)