I think it’s entirely fair to say that if we ever do see equities correct and credit spreads blow out, I did my best to warn you.
Especially on credit. How many times over the past three months have I said that when it comes to complacency, credit isn’t just asleep at the wheel, it’s passed the f*ck out with its head in the toilet.
Of course I’ve also insisted for months that FX and corners of the rates market (e.g. Schatz) are perhaps the only places where political risk is being properly priced. The recent political jockeying in France and the drama surrounding the US Attorney General and his alleged ties to Russia are still further evidence that the fog of indeterminacy hanging over Western democracies from Berlin, to Paris, to Washington isn’t going to lift any time soon.
Throw in the fact that the $400 billion/quarter central bank liquidity flow is about to be materially reduced just as the Fed moves to normalize policy and you’ve got the recipe for an unwind across multiple markets.
But don’t take my word for it, consider the following from the incomparable Matt King, who lists “7 reasons the exuberance won’t last.”
While we’re not (yet!) expecting the equivalent of the fall of the Roman Republic, we are nevertheless very suspicious of the presumption that recent technical strength can continue. In a matter of weeks, the combination of a Fed hike, higher real yields, ECB tapering, reduced credit impulse from China and a renewal of European political risks could all leave the atmosphere feeling very different. Here are seven reasons we think you’re supposed to fade the risk rally – primarily in € credit but also more broadly.
- 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. Numbers in Europe have been slightly weaker than the US-dominated global totals, but the pattern is similar. 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.
- The second reason we think 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. Traditionally this is positive for risk assets; in contrast, when real yields rise, it weighs on risk assets – albeit sometimes with a lag.
- Regular readers will know that our 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.
- 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. But is this pace of credit expansion sustainable? 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.
- 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.
- 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. Regardless of the contentious arguments surrounding whether or not recent developments add to or reduce the still relatively unlikely probability of an eventual Le Pen victory, [we are] 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.
- Last but by no means least, that brings us to valuations in general. 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?