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.
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Curve Inversions & The Reality Distortion Loop Of Reverse-Engineered Growth Slowdowns
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.
(Bloomberg)
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.
(Bloomberg)
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:
(Bloomberg)
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.
Read more
‘Peak Profits’: Revisiting The Three-Headed Margin Cerberus
A Terrible Trio Of Margin Headwinds For 2019
2018’s Star Analyst Makes The Case For A 2019 Earnings Recession
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.
Jacob’s Ladder. Great film.
yay!
This is a general pattern of reaction to crisis. Crisis triggers return to the basic premises of the existing order of things, which typically tend to be only reinforced, not challenged or changed. We are currently dealing with an advanced stage of the populist response which is gradually permeating all human activities as resistance to nonsense is weakening. As theory goes, one should note a distinct pattern, present in any populist movement (not just the current one):
1) refusal to understand or engage with the complexity of the situation
2) emergence of conviction that there must be external agent (lurking behind the scene) which is responsible for the mess
3) fetishistic dimension: refusal to know — ignoring the facts (mistrusting them),clinging to the fetish
Ithink, all three check here
Is calamity the consequence of randomness, like an Indy 500 spectator hoping to see a spectacular accident, or is it an inevitable consequence of deficient leadership? The latter is a when, not if scenario, and the former is a fascination thing. Everyone I am listening to says “no recession” and we have a healthy, robust economy. It seems that the activity and forces promoting it are far from sustainable, and the commentators are talking their book. They are in in denial about the US economy legitimately generating enough growth to counterbalance a ballooning debt overhang.
Investors always do this because the future in unknown and any sign of confirmation in either way gives the investor confidence. How many times does one hear positives on the economy as stock prices rise. Where was the recession talk in Sept despite weaker autos, housing, biz spend, etc. but markets are forward looking etc. Now it is doomsday because stocks sell off and spreads go for stupid expensive to expensive. There is more to it but that is the jist of it. What matters is what CEOs and CFOs do because of their stock price and higher cost of capital. Do they cut workers, cut capex, reduce costs (R&D, advertising, travel, etc). Do they have maturities of debt that needs refinancing or are they generating a lot of FCF. And how do consumers respond to their wealth declines or possibly job losses (depending on the company) etc. is credit reduced. Sure breadth got worse through 2018 and cap spending came to a halt in Q3 so we see some of the impact of a higher cost of capital as well as tariffs and if sustained it will be a constraint going forward.
Too many investors are relative rather than absolute investors and that mindset leads to these manic depressive moments like we saw in Jan 2018 and Dec 2018. But for the wise investor the truth is usuall in the middle.