“We Have Only Seen This Market Anomaly Twice Before: In 1999 And 2006”
May 29th, 2017 by Jason B. Vanclef
With one bank after another – including Goldman, JPM and BofA – quietly urging investors in recent weeks to head for the exits in a time when the Fed is not only hiking rates but warning about “vulnerabilities from elevated asset positions“, over the weekend the latest bank to join the bearish chorus was Citi, and specifically Jeremy Hale’s cross-asset team, which in a moment of surprising honesty writes that “eight years into the cycle – and one where QE has been the asset market driver – virtually every market appears rich“, including stocks, bonds and credit.
According to Hale, this pervasive lack of value “presents the biggest challenge in setting medium term asset allocation tilts” and reminds his readers that as a result he has adopted a fairly defensive approach to the reflation trade, by going overweight cash.
More important still is his observation that at this juncture, even Citi’s own internal projections have become contradictory, and notes that “views and the input forecasts from our asset class specialist colleagues have started to diverge somewhat. Note how EA credit spreads are seen to widen whilst EA equity returns are still strongly positive in our forecast horizon.” This is important because as the Citi analyst writes, “with our credit colleagues worried about ECB taper at rich valuations and equity strategists focused on earnings, such a divergence may well happen, but historically is somewhat of an anomaly.”
How much of an anomaly? Well, “the only recent time we have seen such a direction of travel is late cycle in 1999 and 2006. In both episodes, credit essentially signaled that the final equity blow out was occurring.”
And while Citi lays out numerous familiar reasons that substantiate its call for caution, including central bank tightening, China’s credit impulse sliding, the collapse of the reflation trades, stretched PE multiples, the risk of higher yields, what we found most interesting is the bank’s discussion of what to monitor to determine if the cycle is finally ending. Here’s Citi:
More and more questions are being asked about the length of the current cycle and whether we are approaching end-cycle should US fiscal stimulus not be forthcoming.
One factor we monitor in this respect is corporate borrowing. Here, on both the Fed’s Flow of Fund data set, as well as on commercial and industrial loan data, corporates are recently less willing to re-leverage further (Figure 15).
In past cycles, when corporate leverage turns over, so too do equity redemptions, thus changing demand and supply dynamics in favor of credit over equities. Thus the peak in the black line in Figure 15, LHS tends to coincide with the peak in the red line and has a short lead to the peak in the blue line (relative market performance). Note also that once leverage turns over, we are usually only a few quarters from the end of the business cycle.
Of course, the data is also pretty volatile and leverage peaks are only really visible for sure after the event. The latest data for Q4 may be contaminated by Electoral/ tax reform uncertainty, the impact on energy company borrowing of low oil prices and equity bulls argue that earnings are more able to finance capex anyway now. But this is certainly worth monitoring with the next Flow of Funds print for 2017 Q1 due around mid-June. A sustained decline in corporate leverage would, in our view, warrant a move to overweight credit vs. equities.
Which is a simpler way of saying that at the end of the day, any Keynesian system (such as this one) is contingent on debt: debt creation means the system grows, and debt destruction means economic contraction, recession, deflation, and general turmoil. According to the chart above, we are this close from the debt destruction phase…