In his latest letter, Elliott Management's Paul Singer reached new levels of bearishness, warning that the "bond market is broken", the loss of confidence from the failure of central bank actions "could be severe" and that "the ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense, and large."
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Overnight, one of the best credit analysts, Citi's Matt King, followed up on Singer's gloomy observations with a presentation showing seven signs why markets are deeply dysfunctional, highlighting the numerous "broken relationships" that have emerged as a result of central bank meddling, "from profits to political uncertainty, and spreads to standard deviations, traditional market relationships are being turned on their heads" and admits that "yes, it’s monetary policy we demonstrate is driving everything. And yet here too, there are worrying signs of what may become a breakdown."
For the benefit of those who are still stuck trading in the "market" we present King's entire must read presentation "Seven signs markets are deeply dysfunctional", which we doubt will lead to smarter investing decisions, will at least provide some perspective on what we have dubbed since 2009, is a thoroughly broken market, something even the WSJ recently admitted.
Distortion breeds dysfunction
From Bill Gross’ dirty engine oil to Paul Singer’s broken bond market, investors are bemoaning a breakdown in normal market functioning. Cynics might say they’re apologizing for underperforming straight bond and equity indices – except that just about every market participant we speak to feels the same way, no matter what their asset class and no matter how stellar their returns. Just about the only people who aren’t convinced are the central banks.
Unfortunately that gulf in world view runs so deep that we doubt anything anyone says will change it – even as central banks are increasingly admitting that their models aren’t working. But here are seven reasons why we side with the investors.
And just to make things absolutely clear, no, that doesn’t mean we think the solution is for central banks to double up. “Pound for pound”, corporate bond purchases and other forms of even more extreme policy, rather than fixing things, will lead to even more dysfunction in our view. Twice zero is still zero – or, perhaps better – two times a negative is an even greater negative.
1. Is macro really this important?
As many a fundamental analyst has found to their cost, macro factors are more important these days. But should they really be more important now than they were at the height of the financial crisis? Our equity quants find that they are (Figure 1).
When there’s only one factor dominating markets, it inevitably forces investors the same way round. No wonder the quants’ macro factor correlates with the IMF’s cross-market herding metric (Figure 2).
2. Defaults don’t matter
With macro this dominant, credit no longer seems bothered by defaults. S&P pointed out this week that YTD defaults have now equalled last year’s full-year total, and are running at their highest pace since 2009. Once upon a time, that would have been associated with spread widening (Figure 3). But not this year.
There are mitigating factors, of course. More than half the defaults have been in the energy sector, so perhaps the broader market has no reason to fret. Spreads do usually lead defaults somewhat, so perhaps the default rate is about to plummet. But it’s hard to avoid the feeling that normal spread movements have been suppressed.
In Europe the history is much shorter – but here too, an unusually tight spread (never mind yield) is currently accompanied by a decidedly average level of defaults (Figure 4).
3. Fundamentals don’t matter
It’s not just in high yield where this is happening. Corporate spreads traditionally follow corporate leverage. Yet ever since 2011, the correlation has broken down (Figure 5).
You might argue that that’s because interest coverage is still fine. But it’s interesting that equity correlations with their own fundamentals broke down at more or less the same point. Pre-2011, downward revisions to consensus earnings expectations were accompanied by market sell-offs. Post 2012, they haven’t seemed to matter (Figure 6).
This relationship – and its subsequent breakdown – holds in just about every equity market. But there are signs of it re-establishing itself, particularly in the Euro area and Japan – a point we’ll return to later.
4. Uncertainty doesn’t matter
Perhaps it’s just the bottom-up newsflow the markets are ignoring. But no, on at least some metrics it turns out that macro news doesn’t matter either.
The Baker, Bloom & Davis economic policy uncertainty indices – which track, among other things, the number of references to “uncertainty” in the news – have for years had an almost uncanny correlation with spreads. This year, it’s broken down (Figure 7).
If you’re tempted to argue that that’s just a Brexit effect, note that the same seems to be happening in the US, albeit to a lesser extent (Figure 8). Besides, does it really make sense that the FTSE 250 is within a whisker of pre-Brexit levels? Just how many foreign acquisitions of UK midcaps are you expecting? At least in credit (where spreads have since rallied some 50bp) we have the excuse of the BoE propping up the market.
5. Traditional relationships have reversed
Almost the first thing we learned about credit spreads was that they were negatively correlated with rate movements. Repeat after me: “Economy does well – spreads do well – rates do badly. Economy does badly – spreads do badly – rates do well.” Indeed, that negative correlation (and the correspondingly high Sharpe ratio on total returns) has been the foundation for many an investment in credit.
Woe betide anyone who’s been counting on that recently. While it’s never completely clear-cut, these days what’s good for rates is good for credit (and equities) too. Either it all rallies, in a gigantic reach for yield – or it all sells off. The benefits of diversification just went completely out of the window. No wonder investors are hiding in alternatives: at least they don’t have to mark to market.
Along the way, some other long-held correlations seem to be reversing too. Drops in inflation expectations used to be bad news for spreads, but since the start of this year they’ve looked more like good news (Figure 11). The only exception is in financials, where yield curve flattening is still associated with underperformance.
Similarly for the correlation geeks, it used to be that when markets were all moving together in response to some macro shock, volatility would rise too. Now they’re all moving together and yet vol just seems to have died (Figure 12).
6. Vol has been suppressed
Is such a lack of volatility normal? Last time we were at these levels, in 2014, cross-asset correlations were much lower. And yet with the exception of $/¥, £/$ and perhaps rates vol, the pattern is the same everywhere (Figure 13).
The next three months will see US elections, an Italian referendum which could possibly see the government fall, the potential for helicopter money in Japan, and a combination of negative growth and fiscal stimulus in the UK. What factor could possibly be so overwhelming that it makes none of this worth hedging against?
7. It’s all about monetary policy (and even this is wearing thin)
The answer, of course, is monetary policy. As all these fundamental relationships have broken down, in one market after another we’ve found that what’s replaced them has been global central bank liquidity (Figure 14). Portfolio managers are buying not because their analysts tell them assets are cheap; they’re buying because they have inflows. And when the central bank liquidity taps are turned on, they figure there are still more inflows to come.
That, though, is why markets are so badly broken.
A properly functioning market is a heterogeneous one: one where some investors are top-down, yet others are bottom-up; some invest long-term, others invest short-term; some look at fundamentals, others look at technical. That’s what makes for a two-way, continuous market. A market where all investors are forced to look at the same factor will inevitably be dysfunctional – grinding tighter today, yet prone to sudden reversals tomorrow when the inflows dry up. And yet anyone trying to hedge against such an eventuality inevitably underperforms.
All that said, there do seem to be some cracks appearing. Central bank liquidity no longer refreshes all the parts it used to. There are inflows to credit, but not really to equities. € credit spreads are rallying sharply, but only because the ECB is buying them directly (Figure 17 left); the same applies in £. Both the Euro Stoxx (-9% YTD) and the Nikkei (-13%) are struggling, ongoing QE programmes notwithstanding (Figure 17 middle). Inflation breakevens – the most direct reason for central banks buying risky assets – are falling further still (Figure 17 right).
Most doctors – and even patients – know that when a course of drugs seems not to be working, you don’t simply keep on doubling the dosage. This applies particularly when the patient, if no longer as sprightly as they used to be, is nevertheless doing more or less fine. The side effects of such a course are more likely to kill than to cure. Yet this is what central banks now seem intent on doing. They have too much invested in their models to consider changing them in our view.
If all goes well, this should produce more of the same: ever tighter spreads; ever more handwringing over a stagnating global economy; ever greater dysfunction in markets. That is indeed our forecast.
And yet the more stretched all these relationships become, and the more extreme the central banks’ policies, the greater is the tail risk, and the more nervous we become about investing in line with these forecasts. It’s not just the risk of Bill Gross’ “sputtering engine”; it’s the risk that Paul Singer is right, and that the end of the current environment proves “surprising, sudden, intense, and large”.