One of the key dynamics to grasp when it comes to explaining why global equities and credit have rallied to nosebleed levels is the interplay between central bank liquidity and passive flows.
This is a world where central banks have created a global hunt for yield and then supercharged it by working on both the supply and the demand side of the equation. Buying up corporate bonds with freshly-printed money weighs on supply and the very act of funneling trillions into the market creates demand by driving yields into the floor.
Of course that has the effect of ultimately pushing investors into equities – especially when it reaches a point where yields on corporate bonds are lower than dividends on stocks.
Thanks to the rampant proliferation of ETFs, investors can now ride this wave via any number of passive vehicles that ostensibly offer liquidity in all corners of the market. That funneling of cash helps to make the wave even bigger and, as we outlined in “The Wave Paradox“, makes it virtually impossible for market participants to distinguish between riding the wave and creating they wave they’re riding. Recall this:
The concept is simple: market participants of all stripes are no longer able to discern whether they are capitalizing off the prevailing dynamic or creating the dynamic that they’re capitalizing on.
This can be posed as a question: “Am I making good decisions or are the decisions I’m making only turning out good by virtue of my having made them?”
That might sound like the worst kind of tautological bullsh*t, but it’s not.
If the former is true (that is, you made a good decision by getting long an asset that subsequently appreciated in value), then the fate of that asset going forward is largely independent of what you do next.
If the latter is true (that is, your decision to get long an asset was a non-trivial part of why that asset subsequently appreciated in value), then the fate of that asset going forward is in part contingent upon what you do next.
“A growing number of institutional managers, from Oaktree to Elliott to Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided,” Citi’s Matt King wrote, in a note out last month, before adding that “around $500 billion has flowed away from active managers and into ETFs over the past 12 months alone in equities where ETFs now account for over one-quarter of markets’ traded volume.”
All of this serves to create what Howard Marks has called “a perpetual motion machine” and indeed, there’s a certain sense in which this was intentional. Central banks have deliberately created an explicit, two-way communication with markets wherein markets are helping to write the policy script.
Implicit in the above is that central banks are themselves becoming giant ETFs. CB’s have long been maligned as operating massive hedge funds, but in a new note, BofAML’s Barnaby Martin notes that the ECB has become “the biggest corporate credit ETF in town.”
“The remarkable story of 2017 in credit markets has been the incessant ‘lust for yield,'” Martin writes, adding that “bar one week this year, money has flowed continuously into corporate bond funds, unperturbed by any shock — be it populism in France, an equity correction in Q2, bondholder losses in Banco Popular Espanol and bund yields which have zigzagged all year. Even last week, as populism resurfaced in the form of Catalonia, credit funds still saw a healthy $1.4bn of inflow.”
Obviously, with spreads where they are, there’s no value here at all, which is why Martin reminds you that “these inflows are much more structural in nature than opportunistic.” In a NIRP regime, everyone from households, to companies to private wealth is going to be chasing yield and so, in the absence of some kind of sea change on the rates front, the bid will continue.
Meanwhile, there’s virtually no chance of getting burned in the near-term. Why? Because again, you’re insured by a €116 billion passive ETF in the ECB’s CSPP program. Here’s Martin:
The Biggest ETF in town
Under pressure from MEPs and campaign groups, the ECB continues to enhance its disclosure of CSPP purchases. Last Friday, they provided greater clarity on the breakdown of their holdings versus the eligible bond universe (in essence, their “benchmark”). The breakdowns provided were by ratings, sector and country (charts 15 through 17 below), but not individual bond holdings. The ECB plans to update this disclosure every 6 months.
As can be seen, despite the challenges and nuances of liquidity in the Euro credit market, the ECB have done an exceptional job, we think, in remaining market-neutral across their 1000+ corporate bond purchases. This is also a key objective for the ECB with CSPP: as Draghi has said in the past, favouring some sectors over others, or avoiding some parts altogether due to ESG considerations, would ultimately weaken the pass through to the real economy of their asset purchases.
Thus, we see the CSPP as akin to a big passive ETF in the credit market. And with CSPP holdings at €116bn and growing, a big ETF at that. This also means the outlook for rising spread dispersion across the credit market looks muted for now.
So that’s “good” in the sense that they haven’t had to deviate from the parameters (a contention which is debatable depending on the time frame you want to zoom in on), but the larger point is what this means for the market more generally.
As for what happens next, well, according to BofAML’s credit clients, it’s going to be complicated…
What could go wrong?…