Citigroup's crack trio of credit analysts, Matt King, Stephen Antczak, and Hans Lorenzen, best known for their relentless, Austrian, at times "Zero Hedge-esque" attacks on the Fed, and persistent accusations central banks distort markets, all summarized best in the following Citi chart...
... have come out of hibernation, to dicuss what comes next for various asset classes in the context of the upcoming paradigm shift in central bank posture.
In a note released by the group's credit team on March 27, Lorenzen writes that credit's "infatuation with equities is coming to an end."
What do credit traders look at when they mark their books? Well, these days it is fair to say that they have more than one eye on the equity market.
Understandable: after all, as the FOMC Minutes revealed last week, even the Fed now openly admits its policy is directly in response to stock prices.
As the credit economist points out, "statistically, over the last couple of years both markets have been influencing (“Granger causing”) each other. But considering the relative size, depth and liquidity of (not to mention the resources dedicated to) the equity market, we’d argue that more often than not, the asset class taking the passenger seat is credit. Yet the relationship was not always so cosy. Over the long run, the correlation in recent years is actually unusual. In the two decades before the Great Financial Crisis, three-month correlations between US credit returns and the S&P 500 returns tended to oscillate sharply and only barely managed to stay positive over the long run (Figure 3)."
What is the reason for this dramatic pick up in cross-correlations? A familiar one, of course (see the top chart): "Much of the correlation not just between these two, but also with many other asset classes seems closely associated with the ongoing central bank balance sheet expansion."
However, now that global central banks are entering the tightening phase, and as the balance sheet slows, "or even begins to reverse over the coming quarters, we expect the negative impact on credit will be more than proportionate."
Lorenzen also warns that while things might not quite revert to the historical norm, to our minds, there are at least three reasons to suspect that the relationship between debt and equity won’t stay this cozy for much longer:
- Risk/reward is skewed heavily in favour of the equity market at these valuations.
- The cycle is maturing.
- And central bank distortions are diminishing.
To be sure, it's not just central bank manipulation of markets: one key factor mentioned by the Citi credit strategists is the maturity of the cycle which will increasingly put capital structure into play.
One reason for that is that "credit and equities are impacted equally by the changing mix of fundamental drivers during the cycle. Both credit and equities very obviously benefit from the natural improvement in earnings that tends to occur early on in an economic expansion. However, as the expansion matures, growth in operating earnings tends to fade (Figure 6), Companies wishing to maintain the momentum in their share prices increasingly resort to releveraging, be it through investment, M&A or share buybacks to make up for fading organic growth. However, this capital structure arbitrage obviously has a very different (i.e. negative) impact on credit.
Well, maybe in theory, but in practice spreads and yields remain stubbornly tight, and thus beckong corporate management to keep engaging in financial engineer. Citi admits as much in saying that "in that sense, this cycle has perhaps been atypical, in that US corporates have resorted to share buybacks much earlier in the expansion than normal. This was in part a response to the glaring gap between the cost of equity and the cost of debt, but also a defensive reaction to a lack of investment opportunities in a recovery characterised by weak demand and a lack of pricing power. Credit is more susceptible to an end to unconventional policies."
However, that does not mean that eqities are impervious to cycle shifts. If anything, the belated response in risk assets will simply mae the eventual drop that much more acute, as increasingly more have been observing the "feedback loop" between equity prices and selling vol (see Friday's WSJ piece on the topic).
Which, incidentally. brings us to the topical conclusion: as we discussed when commenting on the "feedback loop" piece, it is all made possible by central banks pressing down on vol and being the "buyer of last resort" whenever a market correction takes place. Citi admits as much and reverts to the original topic of the conundrum of "why the strong correlation between and debt and equity markets still holds.
To our minds, the obvious explanation is central banks. Without turning this into yet another essay on QE and negative rates, we think their policies have overridden normal market behaviour in response to the evolving cycle.
Citi then shows how a wide spectrum of asset classes has been exceptionally correlated since the end of the GFC when viewed on a normalised basis. "The common factor in all of these (approximated by a simple average) in turn correlates remarkably well with the rate of expansion in central bank holdings of securities (Figure 8)."
And while Lorenzen writes that he does not want to turn his latest report into "another essey on QE", he does just that:
This suggests there may be distortions in all. But to our minds credit is clearly more distorted than most others, like equities, are – especially in Europe. Policies intended to flatten the curve and bring long-dated real interest rates down have left total return buyers with precious little return potential from taking rates risk. Taking credit risk instead has been an obvious choice, encouraging inflows and, in turn, spread tightening.
The punchline: "It’s no accident that this rise in return correlations between equity and credit (Figure 3) occurred almost exactly at the time when the central banks effectively ‘took over’ markets."
While that worked as long as central banks were bidding everything up starting in 2009 (again, see top chart) now that said period is ending, the "unwind is underway":
However, with the Fed now tightening faster than the market anticipated not long ago, and our economists expecting that it will cease to reinvest maturing securities in its portfolio from December this year, the unwind is underway. To us, this adds to the asymmetry in risk/reward between credit and equities here.
Even so, Lorenzen says not to panic just yet:
Perhaps the very short-term correlations between equity levels and credit spreads can be sustained. We’d argue that the credit trader should spend as much time, if not more, looking at Bunds as EuroStoxx these days. But that does not preclude a high degree of correlation if the equity trader does the same.... However, what cannot be sustained indefinitely, in our view, is the correlation in medium-term returns for all the reasons we outlined above.
In other words, the closer we get to December, or whenever the Fed begins renormalizing the balance sheet, the greater the trader angst, and impetus, to undo all the trades that worked in the time when central banks had "taken over the markets."