Right so, part and parcel of the whole “wealth effect” meme is the notion that higher asset prices will inflate the value of things like 401ks and thereby embolden the American consumer whose purchases account for three-fourths of economic growth.
Or that’s how it was supposed to work. Deliver a multi-trillion dollar defibrillator shock to financial assets and in the process, hope the resulting paper gains are enough to make people forget about the enormous destruction of wealth that occurred in 2008.
Needless to say, the jury is still out on that.
Well wait. The jury isn’t out on whether a multi-trillion dollar liquidity tsunami inflates financial assets. That’s settled. Rather, the jury is still out on the extent to which that can ultimately revive an economy that took a Mike Tyson haymaker to the chin.
The problem now is that we’re late cycle and we never really seemed to have hit escape velocity. That is, it kinda, sorta seems like the crisis may have permanently impaired the economy. We may, in other words, need to rethink what “healthy growth” is. Because if we keep comparing the post-crisis world to the pre-crisis world, the word “recovery” may have remain in scare quotes indefinitely.
That of course leads directly to what is perhaps the most important question of them all: if the purpose of accommodative policy was to revive the economy by inflating asset prices but the economic revival never fully materializes, then what are we left with?
The answer is simple: asset prices that are disconnected from economic fundamentals.
One asset where this dynamic is readily observable is HY, a favorite punching bag of ours. If you need a refresher on why the junk rally is likely out of gas, we encourage you to read “This Is A Bubble” and work your way back from there.
Well on Thursday, BofAML is basically calling a top in HY. And the accompanying color reflects everything said above about the disconnect between asset prices (in this case HY credit) and the underlying economy which, as noted, has been a bit of a Dr. Jekyll/ Mr. Hyde story.
In March, when repeal and replace of the Affordable Care Act fell apart and skeptics of President Trump’s agenda used the inability to find consensus among the GOP as a reason to sell, we wrote that the widening was not the catalyst we were waiting for in high yield. In fact, we wrote the opposite: that with now attractive valuations FOMO would come back, with healthcare reform put to bed (at least seemingly at the time) and cheaper valuations, investors would ultimately buy the dip and have renewed faith in tax reform. However, with the recent political headlines, we believe conditions are now more in-line with the tune we have been singing all year.
Our base case remains one where, after a period of widening, possibly beginning as soon as this month or next, investors take comfort in a low default rate and cheaper valuations but neither bid up risk nor cause it to sell off further over the last 3-4 months of the year; resulting in a return of 5-6% for 2017. However, we also think investors need to consider the possibility that under the noise of Washington and optimism for growth, the possibility exists that US high yield has approached its peak for this cycle.
Does the political uncertainty continue or die down? The first and perhaps most important question we have is will the political uncertainty continue or has it reached its apex? The initial months of the Trump administration have been notable for considerable political turmoil. Interesting, however, has been the lack of vol in risk assets. Given the market’s fascination with stability, and the apparent lack thereof in DC, one could be excused to think Washington noise doesn’t matter to equity or credit valuations. We think some investors may have unfortunately been lulled to sleep, however.
We are beginning to become concerned that bigger forces are at work in the US economy and that, without the implementation of tax reform and infrastructure spending, these issues will be exposed as potential problems. For one, there is evidence that inefficient companies have been incentivized to not invest over the last 7 years as cheap credit has allowed them to survive without the need to improve operations and invest.
On the macro front, student loan debt has weighed on millennial consumption, retirees are less likely to spend in an environment of meager fixed income returns and prime age workers’ real wages are increasing at sub 1%. Additionally, as Ally Financial, Synchrony and Capital One have all noted, net credit-card charge-offs and write-downs of auto debt are accelerating at a surprisingly fast clip.
Falling used car prices have begun to impact suppliers and manufacturers, while banks have reportedly started pulling back on subprime auto debt as delinquencies creep higher. What’s more, commercial real estate is arguably at peaks while the Fed hammers on lending standards and the retail sector is in disarray; affecting brick and mortar establishments, mall REITs and CMBS.
Loan growth is now negative and has only been at these levels around a recession (Chart 8), while tighter financial policy and a reduction of the balance sheet continues to be the rhetoric at the Fed. Corporate leverage remains high and commodity prices have not really recovered. For example, the average price of WTI for the last year has been $48.6/bbl while in 2015 it was $48.76/bbl; yet in 2015 high yield had a negative return and in 2017 the market is up 4.2% as of May 17th. To be fair, coming down from a high level is much worse than leveling off, and 20% of the market did default; having said that, we once again have first time issuers coming to market in Energy (Table 2).
Finally, small business formation continues to be weak while capex has remained anemic (Chart 10). Yet the S&P 500 is at near record levels despite the fact that EPS hasn’t really changed in 3 years (Chart 9).
So which economy is going to show up later this year and in 2018?
We think the jury is still out.