‘The Frogs Were Boiled’, So What’s Next?

Back in November of 2017 (and on at least another couple of occasions that I can remember), SocGen rolled out the fable of the boiling frog to describe US equity investors.

“In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the ‘good’ Trump, investors continue to push asset prices, volatility and leverage to historical extremes,” the bank wrote.

SocGen, you’re reminded, takes a Dr. Jekyll/ Mr. Hyde approach to the US president. “Good” Trump is this guy (from a recent note):

He was driving growth through (unfinanced) spending, trying to rebalance global trade, increasing energy production at the expense of OPEC and deregulating, a policy reminiscent of the Reagan years.

“Bad” Trump (who SocGen warned in January is likely to here to stay), is this person:

The bad Trump is the one who, in spite of a budget deficit already at 5%, is asking for even more spending; who alienates many of the US’s traditional geopolitical partners; who breaks major treaties that have formed the backbone of the global peace process since 1945.

Getting back to the “boiling frog” piece from late 2017, here are some excerpts from that note which, in light of what happened last year, sound remarkably prescient:

The parable of the boiling frog refers to how a frog in a pot can get slowly boiled alive without even realizing it. The frog is so comfortable as the water gradually warms up that it is unaware of the danger it faces and ends up cooked. Today’s current dynamics put the US equity market at a similar risk as the frog.

Over the next 12-18 months we do not expect the market to crash or a financial crisis to ensue. However, we believe that the S&P 500 is showing an asymmetric risk/reward profile and we expect a flat price movement from here. A bear market is not so far in the distant future though, as we forecast a decrease in the S&P 500 to 2000 by end-2019.

Although that 2,000 mark on SPX hasn’t panned out, SocGen was correct on all the other points. The short vol. blowup came just a little over two months after those passages were written and after an abysmal Q4, 2018 ended up being a year to forget for assets of all stripes. In fact, USD cash outperformed more than 90% of global assets.

(BofAML)

The frog was boiled, so to speak. So, what happens now?

Well, SocGen sets out to answer that question in their latest US equity strategy piece appropriately entitled “The frog has been boiled…now what?”

The bank sets the stage as follows:

Like the proverbial frog in slowly boiling water, markets were lulled into complacency by the reflation trade that started in February 2016. Bathing in the warmth of low interest rates, ample liquidity and steady growth, they failed to fully take on board the switch ahead from QE to QT, signaled by the Fed’s balance sheet policy guidance in June 2017. The wake-up call came in October 2018. This marked a paradigm shift, with the perception of (overly) aggressive monetary policy normalisation by the Fed and US economic data offering limited potential. Fears of a looming recession, worries over the ongoing China/US trade war and a succession of disappointing PMI prints across the board, forced investors to re-evaluate their portfolio risk and positioning in 4Q18. Now that the frog has been boiled, what comes next?

Essentially, SocGen thinks this will be a tale of two halves with market “pros” dominating in H1 and “cons” taking control of the narrative in H2. Here’s a table that summarizes those pros and cons:

(SocGen)

Obviously, the Fed’s dovish pivot is hard to ignore and the sharp de-rating that played out in Q4 brought multiples back down to earth. But the ferocity of the YTD bounce raises questions about how much gas is left in the tank.

For SocGen, “the outlook for earnings and margins will be key, rather than fear of material P/E contraction” and the bank says investors should probably “maintain a tactically bullish bias on US equities near term to take advantage of the Fed’s monetary policy turnaround and a rangebound-scenario for 10y Treasuries.”

Suffice to say “rangebound” might no longer be an apt descriptor when it comes to Treasurys after Friday (10-year yields sank 10bps, the most since the Italian bond meltdown last May). And when it comes to earnings, you’re reminded that corporate profits are set to shrink in Q1 before (hopefully) rebounding a bit into the back half of the year.

SocGen acknowledges the risk to earnings and the bank has been overtly cautious when it comes to the prospect that markets start pricing in a US recession starting later this year. Their tone in this particular piece is a bit more upbeat, predicated (in part anyway) on the Fed.

“We stand ready to cut our position at the first signs of an earnings and margins squeeze in a US recession scenario”, the bank writes, before noting that “in contrast to previous economic cycles, we think the new framework of a Fed funds rate at or just below neutral coupled to an outsized Fed balance sheet should put a ‘safety’ floor under US equity prices – a view we extend to the relative safety of US equities versus other equity markets in the event of a crash.”

Here’s a summary of the bank’s view which they describe as “bullish, but not foolish”.

(SocGen) 

SocGen proceeds to delve a bit further into things and there are a couple of points worth highlighting.

In case you didn’t surmise this from the above, they think it’s too early to be “overly bearish”. They of course mention the rising probability of a recession and if you’re in the camp that thinks a downturn stateside is imminent, you probably feel vindicated after Friday’s 3M-10Y inversion.

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Again, you should note that the de-rating in Q4 meaningfully reduced both trailing and forward multiples and closed the gap between the two.

(SocGen)

After noting that calling a top in the S&P while the hard economic data continues to hold up reasonably well isn’t generally a good idea if history is any guide (i.e., there’s a lag between tops in the hard data and stock market peaks), SocGen reiterates the notion that US equities have a built-in Fed “safety net.”

“As the Fed becomes more data-dependent than ever – making the concept of market reflexivity all the more important – market participants are likely to be willing only to price in one hike at a time in the most hawkish scenario”, the bank writes, adding that “we cannot ignore the massive liquidity injections from central banks after the 2007 GFC, which provided a safety net against massive defaults and a systemic crash.”

Finally, the bank talks at length about positioning (and there’s a pun in there if you look hard enough). Under-exposure/lack of participation by key investor groups has been a defining feature of the 2019 bounce and one argument why there’s room to run higher hinges on the idea that eventually, FOMO will take hold in earnest and pull folks in.

After a wave of inflows in the prior week, equities saw massive outflows in the week through March 20 ($20.7 billion according to EPFR). Meanwhile, positioning across the fundamental/discretionary universe remains low and the vol. targeting crowd is still underinvested.

For their part, SocGen notes that money managers’ net short positions “reflect the nervousness of ‘fast money’ investors following the equity market turmoil and could add some fuel to the current rally over the next few months.”

Specifically, the bank says that if you look at history, “whenever S&P 500 net positions reach a -30,000 bottom, the index tends to rebound in the following six months” barring some manner of catastrophic shock.

(SocGen)

Finally, the bank notes that margin debt plunged to a two-year low in December as the Q4 wipeout triggered massive deleveraging.

(SocGen)

What, ultimately, does all of this mean?

Well, it seems as though SocGen is striking a similar tone to some of the other analysis we’ve read of late with regard to the notion that 2018 might have been the “main event”, so to speak, when it comes to a correction.

That’s not to say it’s going to to be smooth sailing from here – far from it. Rather, it’s just to say that many people appear to believe that with the “frogs” having been “boiled” and with any recession “likely to be shallow and relatively uneventful” in the absence of “significant imbalances and low prospects of forced deleveraging” (to quote a Friday note from Deutsche Bank), another harrowing bout of market madness may not be in the cards.

Throw in a Fed that appears inclined to be protective of risk and is now set to end runoff and you come away thinking the prospects for a proper “crash” may well be diminished.

Or at least that’s the narrative.

“When all is said and done, we are on the other side of a market correction and headed toward the next recession, but we think that any movements could prove less abrupt than in the past, especially for the S&P 500”, SocGen concludes.

Now enjoy your frog legs.

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