If I didn’t know any better, I’d be inclined to think that a lot of folks are actually hoping for a recession just to see what it’s like.
The cacophony emanating from the Twitter peanut gallery and the financial media is deafening and, actually, the tone of some reader comments and e-mails betrays a kind of perverse fascination with the prospect of an economic downturn and concurrent market meltdown – you masochists, you.
Back on December 4, after the 2s5s and 3s5s inverted, I suggested traders and investors were losing track of their own role in markets – getting lost in a narrative of their own construction.
Literally as I was writing that post, Nomura’s Charlie McElligott sent out a client note that underscored the sentiment. Here’s the key excerpt for those who might have missed it:
The ongoing collapse in UST yields along with concerns therein surrounding the nascent inversions in the front-end of the UST curve (3s5s, 2s5s, 2s5s swaps, 1m USD OIS 2Y-1Y fwd spread) have markets again ‘reverse-engineering’ a growth-scare. The risk is that a negative feedback loop develops where [the bond market action] is viewed both as confirming a US slowdown and ‘pulls forward’ the already extraordinarily heightened market concerns surrounding the timing of a US recession.
The yield curve obsession eventually gave way to a similarly unhealthy infatuation with credit spreads, and that infatuation has now manifested itself in a truly absurd panic to explain why spreads didn’t come in on Wednesday and Thursday despite the equity rally. Twitter and at least two mainstream financial media outlets have now convinced themselves that the lack of “confirmation” in the cash bond market is evidence that stocks are bound to start crashing again at the first opportunity. Nobody bothers to note that CDX HY had its best day in 33 months on Wednesday or that junk ETFs rallied the most in years during the same session.
And look, I’m not trying to downplay problems in credit. On the contrary, we’ve written voluminously on the myriad legitimate concerns plaguing the market, whether duration risk and downgrade worries in IG, late-cycle concerns and the reversal of the global hunt for yield in junk, and/or the bursting of the leveraged loan bubble amid deteriorating risk sentiment and waning demand for floating-rate products.
The issue now, though, is that much like the yield curve story, market participants, pundits and media outlets have become caught in their own echo chamber. That risks creating a reality distortion loop similar to that described above by Nomura’s McElligott and as expounded further by Wells Fargo’s Chris Harvey as follows:
Lower equities —> wider credit spreads —-> higher costs of capital —–> diminished access to capital ——> less investment and risk taking ——> slower economy, with the cycle repeating and feeding upon itself.
Flows out of HY and loan funds are piling up at an alarming rate as everyone increasingly believes the story they are collectively telling themselves on a daily basis.
Spreads have obviously ballooned wider to levels last seen in H1 2016, when oil prices plunged into the $20s and the world was still struggling to cope with the fallout from the yuan devaluation.
Consider what the profit backdrop looked like back then. We were mired in an earnings recession, whereas now, corporate profit growth is almost off the charts thanks to the tax cuts and stimulus. Here’s quarterly profit growth plotted with the quarterly performance of the S&P:
I know markets are forward-looking, but Jesus Christ, folks.
If you’re new to Heisenberg, you should know that I have been whatever the polar opposite of “sanguine” is when it comes to the outlook for corporate profits in 2019. If what you want is an incisive take on mounting margin headwinds and an in-depth assessment of a possible earnings recession next year, I’ve been just as cautious as anyone.
But at this juncture, it’s no longer clear to me whether market participants are pricing in those concerns or pricing in an increasingly dire narrative and then using the resultant selloff to justify that same narrative in a self-feeding insanity loop.
It’s interesting how insanity becomes contagious. The underlying force that binds everything together – this process – is that fear has become the new cognitive principle.
And fear is self-reinforcing.
If you spread fear, it looks like you have a deep knowledge of things. If you are calm, it is like being ignorant.
[Aside: the teaser image here is from one of the most frightening yet underrated films in history – if you can name it, good for you]