Some Sunday thoughts from the CIO of One River Asset Management, whose latest Weekend Notes starts off in traditional Eric Peters style, namely a mockery of the Fed...
“Wait, that’s not even part of your model?” asked the private sector, imagining itself in the presence of the Fed.
“You seriously don’t even consider the crushing weight of the pension avalanche that is bearing down on us?” And the governors shrugged.
“You don’t even take into consideration what’s happening in China?” Silence. “Do you even understand today’s world? You’re all so old, you’re from a different time.” They returned to their spreadsheets, moving dots around, what fun.
“Pensions and China are the only two things that matter!” Silence.
“Let me get this straight,” said the private sector, collecting its composure. “You’ve got this thing called China, and you don’t understand that?” The governors nodded.
“And you’ve got this other thing which is my pension liability, and you’re not modelling that?” Each nodded.
“And I’m supposed to have confidence in Fed policies?” asked the private sector. The governors put down their crayons, lifted their dot plots, displaying them proudly.
And the private sector quietly started selling its assets to buy Amazon stock, which has none of these problems.
... Continues with some additional thoughts on credit math...
“Look at it this way,” said the CIO. “If default risks are remote, and there’s a 3% return available in an asset class, investors will borrow money to buy those assets and arbitrage that 3% away.” Most assets in today’s world have an expected return of 3% or less, even negative.
“It should be obvious, but at this point in the cycle, with expected forward returns so low, you’re a complete prisoner to the cost of capital.” Early in a cycle that’s not the story. The arb between the cost of capital and expected returns is wider. Naturally, volatility is higher too.
“Credit spreads reflect the cost of capital in an economy,” continued the same CIO. “And they are reflexive; meaning tighter spreads beget tighter spreads and vice versa.”
When spreads tighten dramatically, and remain there, you can be sure the arbitrage players drive asset prices higher, lowering the expected future returns. At that point, even a modest widening of spreads closes the arbitrage, and leaves asset prices with a shortage of buyers. “You don’t need yield curves to invert to spark a cycle. You just need rates to move high enough to kill the arb."
“Let’s say the average US corporate borrows at 150-200bps over 5yr Treasury yields,” explained the CIO. “Now imagine 5yr Treasuries are 2%.”
So the average corporation borrows at 3.50%-4.00%. “Now let’s say US nominal GDP is 3.5%.” Why would corporations borrow?
“Now, let’s imagine that people rightly assume that defaults will rise. Credit spreads can quickly rise to 400bps.” Which lifts the cost of borrowing to 6% (5yr Treasuries plus 400bps). The arb reverses. “That’s why default cycles are so dangerous for highly leveraged economies.”
... and ends with the topic least understood by the Fed, reflexivity:
“When employment cycles turn, they do so violently,” said the historian.
“The same is true of credit default cycles.” Our economic system is highly integrated. One man’s liability is another’s asset. One CFO’s payable is another’s receivable. It’s a global Ponzi scheme that works wonderfully until it doesn’t.
“One default ripples through the system - by definition – causing another default, and so on. Nothing exists in isolation. This is why credit cycles turn violently. And they feed back into the employment cycles, amplifying those too.” Reflexively.