With spreads at post-crisis tights, equities making new highs, and new issues oversubscribed, markets are clearly exuberant. But could it be rational this time? We’re not convinced.
- Citi's Matt King
In a surprisingly bearish report, Citi's Matt King has issued a new, long-awaited note in which he asks rhetorically "what’s a manager supposed to do when by early March your asset class has already exceeded your expectation for full-year returns? Take profit and take the rest of the year off, of course! And if it carries on rallying, go outright short!" And yet, he adds, "somehow nobody seems to want to." The reason for that, according to King is that as we showed demonstrated last week using JPM and BofA data, "the rally owes more to inflows and short covering than to institutional investor exuberance. And part is that the economic data do seem genuinely to be improving."
Nonetheless, King's assessment of the current environment is downbeat and to the point: "sell we think you should, not only in € credit (as we advised a couple of weeks ago) but also more broadly."
He then lays out seven reasons "not to trust your inner Trump", which are as follows:
1. The Fed may stop the inflow party
The Citi strategist begins by noting that "perhaps the best reason to remain long is that institutional investors seem not to be." He adds that the vast majority of the FI investors we have seen in recent weeks still believe in secular stagnation, and further notes that "to judge from our survey, overall positions have been creeping longer, but this is due overwhelmingly to positions among $ investors: those in € and £ credit have actually been falling (Figure 1)."
King joins the strategist bandwagon pointing out to the source of recent inflows and states that "the principal driver of investors’ buying seems to have been a response to mutual fund inflows. Not only equity funds but also bond (including both credit and EM) mutual funds have had their biggest 4-week run of inflows since 2013 (Figure 2). Numbers in Europe have been slightly weaker than the US-dominated global totals, but the pattern is similar."
There is a problem with that: "But while this too might normally be a reason for bullishness, we doubt that the current pace is sustainable."
Quite apart from the historical inability to maintain this flow rate for long, there is the small problem of the Fed. While at this point a hike on March 15 has been so well telegraphed that it ought not to cause a 2013-style tantrum, we do think much of investors’ willingness to pile into risky assets stems from the lack of return on cash. Each and every additional bp in risk-free yield is likely to make investors think twice about the risk they are running in order to generate return elsewhere.
It is also worth noting that over the past two weeks, BofA has caveated that while retail inflows are seemingly relentless, institutions and hedge funds have recently turned sellers into the rally, and are aggressively offloading to retail, traditionally a market-top indicator.
2. A rise in real yields should weigh on risk assets
King's second reason why he thinks the rally has been so strong is that real yields have remained surprisingly low. Even as nominal yields have risen since the US election, almost all of the action has been in inflation (and growth) expectations (Figure 3). Traditionally this is positive for risk assets; in contrast, when real yields rise, it weighs on risk assets – albeit sometimes with a lag (Figure 4).
Citi suspects that what has made this move possible is the market’s willingness to focus on all the potential growth positives and yet shrug off the increasing signs of hawkishness from the Fed. "Such a position seems increasingly untenable on two counts. First, rates markets have now finally adjusted to the new mood music from the Fed, and seem increasingly likely to be confronted with an actual hike; second, the rally in credit was starting to look out of whack even with today’s real yield levels, never mind following any proper adjustment to follow."
3. Central bank support is set to diminish
While it is no secret that King has long been a closet adherent to Austrian Monetary Theory, in his latest piece King reminds regular readers that one of his favourite model for markets’ behaviour in recent years is their correlation with central bank liquidity. While the scale of their purchases over the past half-year or so has been close to record highs, it is already diminishing, and set to diminish further (Figure 5).
He brings attention to BoJ purchases, which in recent months have almost halved since their shift to yield targeting; furthermore ECB purchases will be reduced by one quarter from this month on. In EM, FX reserves have held up well since February last year, and in recent months have been propped up as EM portfolio inflows have gone a long way towards offsetting a worrying trend towards net FDI outflows.
But this too we suspect was aided by the Fed being on hold, and is liable to face renewed pressure as it returns to rate hikes. Besides, the extent of the rally once again seems excessive even for today’s level of CB purchases, never mind relative to its likely future trajectory (Figure 6).
In short, absent a material shift in central bank posture, the traditional driver of risk asset upside will be gone for the foreseeable future.
4. It’s the stimulus, stupid
And then there is China.
As a recent NY Fed report pointed out, "China Accounts For Half Of All Global Debt Created Since 2005." This echoes what we have been writing about for years, starting back in 2013 showing "How In Five Short Years, China Humiliated The World's Central Banks", when we showed that in just the brief period since the financial crisis "Chinese bank assets (and by implication liabilities) have grown by an astounding $15 trillion, bringing the total to over $24 trillion. In other words, China has expanded its financial balance sheet by 50% more than the assets of all global central banks combined."
This, too, is a worry for the Citi strategist, who writes that "continuing with the idea that market strength owes more to a wave of technical support than to fundamentals, we remain convinced that the recent explosion of credit in China – visible in the monthly total social financing numbers – is of greater global significance than is widely recognized."
King posits that while it is hard to prove empirically, at an anecdotal level almost every place you visit from San Francisco to Sydney seems to be awash with stories of Chinese investment propping up prices. While most of this is in real estate, King thinks the effects of credit creation spill over from one asset class to another, and increasingly from one region to another also.
The punchline: "fully 80% of the world’s private sector credit creation at present is occurring in China. The evolution of this global total bears at least a passing resemblance to global asset prices (Figure 7)."
Which leads us to the $64 trillion question: is this pace of credit expansion sustainable? Citi's answer: "we rather doubt it."
Chinese numbers tend to reach a seasonal high in January as new lending quotas are granted but then to fall off sharply thereafter. And the positive impulse from the recent acceleration in credit creation in China will in any case be hard to sustain just because the absolute rate of growth is already so high. If anything, the recent tendency towards renewed FX outflows – even in the face of tightening capital controls – speaks to a reduction in demand for investment in China itself (Figure 8), itself encouraged by a series of measures designed to introduce brakes on lending, in the property sector in particular. To our minds the wave of recent strong data in China, and associated run-up in many commodity prices which has itself fuelled optimism about a global reflation trade, owes less to a durable upswing in growth – and more to an unsustainable temporary resurgence in credit – than has been reported.
At this point it is worth reminding readers of a recent note from UBS which likewise looked at the global credit impulse and found that it had "suddenly collapse to negative", primarily as a result of an annualized slowdown in Chinese credit creation.
There is some hope that US or DM credit stimulus would be able to take over even if Chinese stimulus wanes – and indeed, exactly such a hope would seem to be one of the drivers of both the rally and the improvement in much DM survey data. The hope here is that abnormally high savings rates in various developing nations would propel a spending surge. However, King then quickly shoots down the suggestion saying that such an alternative source of credit creation "seems unlikely." His skepticism is borne from a simple problem of scale: "Corporate balance sheets are already highly levered. Besides, the sheer scale of Chinese borrowing – $3tn/year relative to a mere $800bn in US and Europe combined – makes it difficult to see how these could substitute."
5. Just how strong are growth prospects really?
To provide a counterpoint to his bearish points, King then asks "what of the counterargument to all this, namely that markets are merely responding to a marked pick-up in global growth prospects, sending secular stagnationists like ourselves scurrying for cover and raising the prospect of a longawaited return to ‘normal’ growth?" He admits that there has been a pickup in both growth and inflation data, and indeed in corporate earnings. And we do buy the argument that, while corporate capex has been weak relative to profits and to GDP, in outright terms it is not perhaps as moribund as pessimists (ourselves included) sometimes make it sound.
Alas, for the Citi strategist, this may be as good as it gets when it comes to global growth, which as DB warned several weeks ago has already started to revert lower, and furthermore as we have been pounding the table for weeks, the improvement has been mostly focused in "soft", survey-based data:
We are much more skeptical of the likelihood of a continued and self-reinforcing cycle of growth from here. Economic surprises have a natural tendency towards mean reversion and in the US are already starting to come down. A number of commentators are starting to point to the fact that the improvement in economic numbers is heavily skewed towards survey data as opposed to actual production and consumption numbers. US jobless claims at 40-year lows in any case suggests that further hiring may begin to contribute more to inflation than to real GDP
Meanwhile, on the corporate side, while leverage has been declining, recent reports fail to show any evidence of significant revenue growth – one of the vital missing ingredients that could conceivably lead to an acceleration of capex (Figure 11). Perhaps revenues were crimped by $ strength, but overall this suggests that the EPS growth everyone is getting excited about owes more to further cost cutting and perhaps currency moves (helping explain why the pick-up is greater in Europe than in the US) than it does to anything that will sustainably buoy the economy.
As King notes, the market internals already point to this:
Sadly, there are even signs that the equity market itself recognizes this likelihood. While the S&P has continued to rally at a headline level, our equity strategists have pointed out that it is again being driven by defensive sectors, not cyclicals – something historically more consistent with a rally in Treasury yields and a global reach-for-yield than with a growth-led reflation
And then there is the political front: Citi writes that its take on the Trump speech to Congress – with its repeated reference to infrastructure spend but general lack of detail – is that prospects for widespread fiscal reform remain so contentious, even among Republicans, that the likelihood that they drive a significant near-term boost to growth is actually dimming. "Once again, this suggests that markets may be getting ahead of themselves."
6. The beast that refuses to die – European political risk
And then there is Europe, and especially France where over the past few days, the market promptly assumed that any Le Pen risk overhang has been eliminated. Not so fast, according to King:
To judge from the recent rally in OATs, you could be forgiven for thinking that Macron had been elected already, and that euro break-up risk was once again off the table. Without wanting to get too involved in the labyrinthine twists and turns of what is already turning out to be a decidedly antagonistic campaign, we doubt very much that this risk is gone for good.
Citi then highlights four factors which keep it convinced European periphery risk and French domestic-law bonds are still a ‘sell’ here – and that renewed periphery widening may yet upset markets more broadly.
- First, we still think there is the potential for significant nervousness among real money investors in the run-up to, and immediately after, the likely first-round Le Pen victory. Notwithstanding demand from domestic institutions for bonds that others wish to sell, experience suggests that there is nevertheless a point where domestics become full.
- Second, we still meet too many investors convinced that the ECB will somehow come to the rescue, or even that the market would shrug off a Le Pen victory in the same way as it did Brexit. We could not disagree more strongly.
- Third, even a Macron or Fillon victory seems unlikely to us to consign European political risk to the dustbin of history in the way some have been arguing. Populists everywhere still feel as though they are in the ascendant – just look at the disarray among Democrats in the US, or the heated response to Sir John Major’s and Tony Blair’s stands on Brexit in the UK.
- Fourth and most persuasively, almost regardless of what you think the actual probabilities of euro break-up are, we still see too little by way of premia across markets to compensate investors for the potential risks. Central banks appear to have succeeded in squashing the volatility and fear out of markets without removing the underlying risk factors themselves. The more markets rally, the greater is the potential vulnerability.
7. Finally, Valuations
Last but by no means least, King brings up the most sensitive topic for the market: massively stretched valuations. His rhetorical question is simple: "Do you really want to be buying credit at post-crisis tights, or the S&P at a cyclically-adjusted P/E which has been exceeded only in 1998-2000 and 1929?"
He then notes that the "only metrics on which € credit does not look expensive in our regular Valuations Report are those that are survey-based" and cautions that to the extent that investors want such upside, "we think they would be better served targeting assets that rallied less hard in the first place – albeit in small doses. And yet there, too, our outright inclination is more towards reduction and waiting for a better entry point than towards adding at current levels."
Having taken a several month sabbatical, the bearish Matt King is officially back: "To sum up, markets seem increasingly to be pricing all of the upside and none of the downside. When there was a risk premium in spreads, and when a wave of central bank and private credit creation seemed likely to carry everything tighter regardless of underlying fundamentals, we were happy to run with that. But we think that risk premium has long gone, and that markets’ strength owes more to those technicals than is widely recognized."
And a farewell anecdote from the bank's leading strategist:
When in the days of the Roman Republic generals were awarded the highest honour the Senate could bestow – the right to lead a “triumph”, or parade of the spoils of war, into the city – it is said that a slave was required to stand at their side and whisper constantly into their ear that they too were merely mortal. With the Ides of March approaching – and, rather neatly, coinciding both with an FOMC meeting and with the Dutch elections – we think the timing would be good for investors too to remember to what they owe their improvement in fortunes. We don’t think it’s the arrival of a new emperor.