‘Run Screaming For The Hills’: Presenting The Fallacy Of Disaggregation

Let me just say, by way of introduction to the excerpts you’ll read below, that it is absolutely beyond me how any investor (whale, minnow, institutional, buyside, sellside, E*Trader, former Target manager-turned vol. seller, etc.) could fail to understand how we got to where we are.

The QE effect is manifest. I’m going to quote myself here which is fine because I asked myself and myself gave myself permission to use the following verbatim excerpt from a previous post and nothing says hopelessly arrogant like a guy who incessantly quotes himself:

It is absolutely critical that you understand the extent to which dumping $14 trillion in liquidity at the top of the quality ladder (as central banks have done since 2009) drives people down that quality ladder and out the risk curve. That isn’t a “theory”, and if it was a theory prior to 2009, it has certainly moved into the realm of “fact” since. You don’t just drive rates on risk-free assets to zero and below without pushing people into riskier assets like junk bonds and stocks. The only way creating a scarcity of available assets doesn’t drive up the price on those same assets is if there’s a concurrent drop in demand. Absent an offsetting drop in demand, shrinking the size of the asset pool drives up asset prices. That’s just all there is to it.

Relatedly, central banks are by definition operating on the demand side of the equation as well. Buying assets drives the yields on those assets lower thereby creating insatiable demand for lower quality assets where the yield is higher and that demand drives yields on those assets down causing people to chase still riskier assets, and on and on. In the final act, the reach for yield starts to manifest itself in absurdities like high yield managers “diversifying” into stocks. Recall this from Bloomberg’s Lisa Abramowicz‏:

If you peel back the hood on this year’s most successful corporate-debt funds, one thing becomes apparent: The more risk they took, the better they did.

While in some cases that meant diving into lower-rated credit, in others it meant leaving the junk-bond world entirely and just buying more stocks. Indeed, the best-performing fund in the high-yield debt category so far this year, as ranked by Morningstar Inc., is the Fidelity Capital & Income Fund, which boosted its equity allocation to more than one-fifth of its fund earlier this year.

As Lisa goes on to write in that same piece, “there is nothing inherently untoward about this trend, but the implications are significant.”

Yes, “the implications are significant” and what it “implies” about markets is that we’ve reached the point where everyone is now very nearly out of options. The only thing left is stocks. As BofAML’s Michael Hartnett put it in his year ahead preview, it’s a “full capitulation into risk assets.”

Have a look at this chart from Deutsche Bank which serves as a stark reminder of how perverse the fixed income landscape has become:

And don’t forget this one from BofAML which shows you that the world has lost a truly incredible $25 trillion in fixed income yielding over 4% since 2008:

It’s with all of that in mind that we bring you the following excerpts from a new note from Ashmore, presented without further comment…

Via Ashmore

Everyone knows that the next crisis will not look like the last one. Everyone knows investors will miss the warning signs because they will be looking in the wrong place. We do not claim to see what others cannot see, but there is at least one glaring lacuna in investors’ current efforts at spotting the next crash, namely that most still seem to be looking for sector problems when the real issue may be macroeconomic in nature. The fact is that over the past thirty years investors have become accustomed to looking for bubbles within particular sectors of the economy, because every major upheaval over this period has, without exception, been sector specific in nature. Famous examples include savings & loans, telecoms, dotcom, banks or subprime housing. By contrast, conventional macroeconomic problems, such as inflation, declining productivity, overvalued exchange rates and generalised mispricing of assets — economy wide bubbles — have not been in evidence since the 1970s. The market regularly gets jitters about particular sectors; last week’s US high yield jitters being a perfect case in point. However, so far no single sector has been identified as vulnerable enough compared to other sectors to warrant specific concern. Yet, we would argue that the mere fact that investors fail to spot trouble in a single sector should not be grounds for comfort: the reason why no single sector stands out may be that all the sectors are mispriced.

Statisticians are fond of using the term ‘fallacy of composition’ to describe the practice of wrongly inferring to the whole what is true for a single part. However, it is also possible to have the opposite of fallacy of composition, call it fallacy of disaggregation, which means a failure to infer to the group level what is true at the level of the individual parts. We think fallacy of disaggregation may well be pervasive at this moment in time. Mispricing of assets is pervasive across the entire financial space within developed markets after years of direct stimulus into financial markets via Quantitative Easing (QE). Neglect of economic reforms has only worsened the problem of mispricing. If investors mainly evaluate risks in one sector by comparing pricing to that in another sector they are likely to miss the generalised mispricing problem caused by QE, because all the sectors are mispriced. QE has pushed all asset prices deeply into overvalued territory, be they bonds, stocks, currencies, credit.

If you feel sceptical about this, stop for one second and consider the following statistics: In 2007 a German 30 year bond yielded 3.5%, today the yield is 1.3%. Real yields are negative across trillions of dollars of developed market bonds. In fact, yields are so low that should yield curves return to their 1990-2007 average it would wipe out 11 years of carry in US 10 year bonds, 71 years of carry in German 10 year bonds and 766 years of carry in Japanese 10 year bonds. The problem is not just confined to government bonds. In 2007 US junk bonds yielded 8.3%, today they yield 5.6%, but with twice the default rate. In 2007 the S&P 500 was 1525, today stocks trade at 2585 at a P/E just shy of 22. In 2007, the broad Dollar index was 80 today it is 94, yet the US debt stock has now hit 107% of GDP compared to just 60% at the turn of the century. Average growth rates have also declined by nearly 40% in real terms as productivity growth has declined sharply. As if that was not enough, central banks have almost no room to cut rates, certainly not enough room to cure a recession, and politics has become far more populistic with negative consequences for the quality of economic policies. If the value proposition currently on offer in developed markets had been offered to a rational investor in 2007 he or she would have run screaming to the hills. Yet, today everyone acquiesces in these valuations.

There is still a failure to recognise that QE was the largest and most distortionary intervention ever made by governments in financial markets. The four central banks bought 15% of all outstanding bonds in the entire world, but they did not buy pro-rata across all the world’s bond markets. Rather, they only bought their own government bonds. This triggered a highly selective rally in a subset of global financial markets, notably in US stock markets, in the Dollar and in European bonds. As QE is now slowly being reversed the most overvalued assets offer far less scope for capital gain and many offer no yield at all. Hence, the best way to trade the unwinding of QE is to simply reverse the QE trades. The only markets in the world, which did not benefit from QE — in fact suffered outflows under QE — were Emerging Markets. In direct contrast to the QE sponsored markets in the developed world, EM markets today offer the best technicals, stronger growth, higher yields and more currency upside. Ultimately, they are less risky. This is why we continue to expect EM asset classes broadly to outperform the QE markets over the next few years, as indeed they have done this year and in most of 2016 too