Everyone’s favorite incorrigible bear has broken what, for him, is a land speed record by penning two notes in the space of seven days. In short: Albert Edwards is making “global strategy weekly weekly again.” #MGSWWA. Someone should make some red hats (and red would most assuredly be an appropriate color for a Albert might wear).
On Wednesday (these notes usually hit on Thursday), Edwards is out with what amounts to a list of factors he believes might be signaling trouble ahead and while he touches on a number of things, one of the points that gets a lot of attention is the apparent market revolt against a lack of balance sheet discipline. He calls this “rustlings of discontent.”
If you follow Edwards and his colleague Andrew Lapthorne, you could have seen Albert’s note coming on Monday. Andrew has been harping on the extent to which equity markets have been punishing weak balance sheets for months on end and in his weekly note (out on Mondays), he revisited his favorite topic.
“We have been highlighting for some time now the risks associated with highly leveraged US companies [and] our message has been clear; US corporate leverage is abnormally high for this stage in the cycle and a handful of cash-rich mega caps are masking significant problems elsewhere,” Lapthorne wrote, adding that “aversion to highly leveraged companies is increasingly visible; over the last few weeks the beta of bad balance to good balance sheet companies has been negative.”
This has ties to the GOP tax bill – specifically, to the interest deductibility debate. “On average interest cost as a % of EBIT remains very healthy (as you would expect with record low interest rates),” Lapthorne continued in the same noted cited above, before warning that “once you peel away the biggest and strongest US companies, the picture is entirely different [with] interest cover for smallest 50% of US companies near record lows, at a time when interest costs are extremely depressed and when profits are at peak.”
Ok so clearly, that could be exacerbating the jitters that have fed the recent selloff in junk, where spreads have begun to decouple notably from equities:
After citing Lapthorne’s note, Edwards flags the high yield selloff, noting that “the recent weakness in US high yield bond prices [has] diverged notably from stock prices which continue to make new highs.”
This is – or at least it could be – a manifestation of the market’s waning patience with another glaring disconnect. Namely, that between spreads and leverage. Here’s Edwards:
And we think the high yield corporate bond market should have been revolting against balance sheet debauchment some time ago. That would be the normal state of things with net debt/profit ratios so very high (see chart below but note bottom-up data shows a far higher peak than this top-down Fed data but peaks normally occur as profits fall in recession).
All kinds of people have flagged this over the last six months including the IMF, Moody’s, and Citi, with the latter weighing in as follows a couple of months ago:
As corporates lift leverage, we would normally expect the credit clock to enter phase 3. Spreads should widen to reflect higher Net debt/EBITDA ratios. But that hasn’t happened in this cycle. In the last 18 months, corporate leverage has risen but credit spreads have fallen. It seems that the corporate leverage clock has marched on to Phase 3, but the central banks have managed to held the credit spread clock back in Phase 2.
Right. And speaking of central banks and this dynamic, Edwards weighs in on that too:
We continue to highlight that it is not QE per se that has caused US companies to debauch their balance sheets. Japan is awash with QE but balance sheets are in relatively good shape. The problem in the US is how QE has worked its way through the financial complex.
Other warning signs Edwards flags include the following from Dana Lyons:
Today’s Chart Of The Day provides perhaps further confirmation of the data’s continued validity as a sentiment tool. Critics of that notion, again, take exception to the argument on the basis of the structural downtrend in mutual fund assets. “Call us when bullish assets rise to an extremely high level”, they say. Well, you can start dialing because Rydex bullish fund assets just hit their highest level of the entire market cycle, going back at least 10 years. (Note: this chart measures the total assets in the 1X and 1.5X leveraged long S&P 500 funds and the 1X and 2X leveraged Nasdaq 100 funds as they have been historically by far the largest of the Rydex long funds.)
And of course there’s the ubiquitous Investor Intelligence Sentiment Survey, where the bull-bear spread has been making “since 1987” highs for weeks (more on that here).
There are some further musings about Germany in light of this week’s blockbuster GDP print (see here), but the upshot is simply this, again from Albert:
At the end of October we ran through a list of things that could go wrong to prick the current complacency bubble that prevails in financial markets. Investors mostly agree that they should be fully invested as they cannot see anything on the horizon to de-rail the current bullishness.
Many of these same investors, however, tend to agree with us on a two year view that things are likely to end very badly.
Yes, “things are likely to end very badly.” For you. But not for Albert. Because given how long he’s been saying that, it’s safe to assume that he is well prepared.