After taking a three month leave of absence, Citi's Matt King has stormed right back to the front lines of financial reporting where his original perspective is very critically needed, and following up on his latest must read presentation which we posted two weeks ago and dubbed "the tipping point", overnight Citi's chief credit strategist is out with a new note titled "The race to the bottom", which focuses on the negative feedback loop world in which "liquidity breeds liquidity and illiquidity breeds illiquidity" (we are now in the latter phase), and how this impacts both global markets and the global economy, and how central banks are desperately struggling to prevent it all from crashing down.
In this note we will layout King's thoughts on the market; his observations on the economy will be presented at a later time.
From Citi's Matt King
The race to the bottom
No, we’re not talking about currency wars, though they do illustrate the phenomenon. Nor are we thinking about € credit spreads and yields rapidly converging on (and in some cases surpassing) the zero bound.
Rather, a significant theme of our research in recent years has been the tendency of investors to assume they live in a zero-sum world, only to face a rude awakening when they discover that markets think otherwise.
Think of the reaction to falling (and now rising) oil prices, for example. What ought just to be a redistribution of wealth between oil producers and oil consumers has turned out not to be. Both markets and the global economy have proved an awful lot happier when prices have been rising than when they have been falling.
The same applies in multiple other spheres. We talk about money flowing from one market to another as though there is a fixed amount of it. Yet we have argued elsewhere that it is constantly being created through credit expansion in the private sector and on central bank balance sheets, or destroyed through deleveraging and defaults, and that changes in the multipliers – as opposed to the flows themselves – are at least as important as a driver of market movements and economic growth.
On multiple fronts we fear that what was a positive-sum game previously is now turning negative, and that the potential for some recent trends to run and run is still underappreciated, with potentially far-reaching repercussions.
Liquidity breeds liquidity; illiquidity breeds illiquidity
Take market liquidity, for example. Despite near-record notional volumes on TRACE, and policymakers’ protestations that nothing has really changed, market participants continue to lament that bid-offer is misleading, and depth is not what it used to be. Worse, many managers have struggled to make money on the basis of traditional single-name fundamentals, and poor performance is contributing to a steady leakage of flows away from traditional benchmarked funds towards totalreturn funds, indices and ETFs. The shift is not unique to credit: in European equities, futures-to-cash ratios – one convenient measure of index trading versus single-name trading – have reached all-time highs, for example (Figure 1).
Traditional thinking would not read too much into this. A decline in active single-name trading by some market participants should lead to greater dislocations, and hence greater opportunities for others. As index, or asset class, or factor investing becomes more popular, so it should become harder to make money there, and money should return to single-name trading. The system should stabilize.
We are becoming more and more convinced this is wrong. In ways that were underappreciated at the time, the pre-crisis era of unlimited leverage led to a veritable bonanza for sellside and buyside alike, in which trading begat more trading, and liquidity begat liquidity. Cyclicals vs non-cyclicals. Value vs momentum. On-the-runs vs off-the-runs. Cash vs CDS. Single names vs indices. The constant arbitraging of relative value relationships led to regular patterns of mean reversion, which in turn encouraged more investors to trade.
In the post-crisis era, this process is running in reverse. Yet what started as a simple desire by regulators to curtail excesses of leverage risks is having much more farreaching repercussions. The curtailment of the hedge fund bid means that many relationships which previously mean reverted are now failing to do so, or at a minimum are doing so much more erratically. Cyclicals vs non-cyclicals. Value vs momentum. On-the-runs vs off-the-runs. Cash vs CDS. Single names vs indices.
In principle, these aberrations do constitute trading opportunities – but only for investors with sufficiently strong stomachs and long time horizons, which these days nobody has. Central bank distortions have exacerbated these movements, making investor interest more one-sided and leading one market after another to exhibit more bubble-like tendencies, rising exponentially and then falling back abruptly. As such, managers are struggling to justify their fees, while the sellside wonders whether it is really worth the continuing commitment to market-making in the face of increased capital requirements and legal and back-office overheads. Both are under severe pressure to cut costs.
Each successive exit – funds migrating from expensive single-name trading to cheaper index or asset-class trading, banks deciding to leave the fixed income trading business altogether – in principle increases opportunities for the rest. But if the resultant reduction in liquidity leads people to proclaim the market uninvestable, this thesis falls down. Having 70 or 80 or 100 percent market share might temporarily be attractive in a slow-moving industrial segment with a captive buyer base (European purchases of Russian gas, for example). But it is not attractive when fast-moving technology allows the buyer base to migrate to new alternatives, and is even less so for a financial business with limited ability to hold to maturity.
Each individual cut makes sense. But collectively, they risk being a race to the bottom.
* * *
Central Banks To The Rescue (or not)
The one type of inflation the central banks have managed to engineer is asset price inflation, yet here too the effectiveness seems to be waning. The widening in spreads over the past month probably says more about an increase in positions and the renewed hawkishness of the Fed than it does about central bank credibility. And yet credit spreads, periphery spreads and equity prices have all moved the wrong way since the inception of ECB QE. And while € credit continues to enjoy strong inflows, the buying seems more confined than we would like, with HY inflows dwindling and equities seeing outright outflows.
At a global level, the explanation still seems to be that DM QE is periodically being offset by EM outflows. We remain staggered by the continuing correlation between our aggregate CB liquidity metrics (including EM FX reserve changes, Figure 12) and credit and equities (Figure 13). The recovery in risk assets in recent months seems closely associated with the drop in EM and Chinese outflows, and these in turn probably benefited from a combination of a more dovish Fed and (hence weaker dollar) and the Chinese domestic credit surge. Both these supports now seem to be fading.
[This] points to an overall picture which is considerably more precarious than we think many investors (and central bankers) imagine, and one where seemingly extraneous influences – like China even for non-exporters, oil even for non-consumers, or hedge fund performance even for non-hedge funds – take on a disproportionate importance. Constraints on financial leverage do not just lead to liquidity settling at a lower level; they risk sparking a cycle of ever-diminishing liquidity. Banks exiting markets do not just lead to increased opportunities for the rest; they lead to a diminished pie for all. And a world of diminished credit growth may not simply stabilize at a lower level of nominal GDP; it is likely to need continued prodding so as not to consume itself in a destructive race to the bottom.