The importance of the Fed's change of heart in January

Last autumn we were confidently predicting that US 10-year yields would go above 3% and, for a short while, they did.  Today they are at 2.5% and we are equally confident they are going lower.  What has changed? The short answer is the facts.  The US Federal Reserve’s change of heart in January was in our view much more than a simple move from a tightening pathway to a more neutral position.  We think it was an admission that QE is here to stay for the long-term and that interest rates are in today’s world not able to perform their traditional function as a policy tool.  If so, that means investors have to think radically differently going forwards. Perhaps, we should first ask why?  Our friends at CrossBorder Capital think the catalyst is the frailty of corporate bond markets and particularly at the bottom end of the investment grade credits – BBB.  Institutions and corporates have been looking for safer, and perhaps higher, returns for their cash than they can receive from banks.  One response has been to invest in money market-like funds, which in turn lend to different corporates via repurchase agreements (“repos”) in order to minimise risk.  However, these repos depend on the availability of collateral in the form of ‘safe’ assets such as short-term government bonds.   Quantitative tightening means the latter are in scarce supply, accentuated by demand from some central banks (eg. Bank of Japan) for their own QE programmes.  CrossBorder’s data suggests that the average net supply of ‘safe’ assets’ over the last six years has been roughly one third of the 2010-2012 period and it is increasingly concentrated in the United States. The implications are numerous.  In the bigger picture, the Fed will use its balance sheet rather than interest rates to steer the economy.  We call that QE4.  While it may not inflate asset prices in the way that QE1, 2 and 3 did, it does provide the equivalent of a Greenspan ‘put’ for investors.  The US bond curve is likely to fall, possibly in an extreme case to levels similar to Japan, though in practice we doubt that.  In turn that may propel equity valuations higher as investors seek return. Inflation is a tougher question.  The history of QEs 1, 2 and 3 was that consumer inflation did not take off.  Today the employment background is tighter and society is less cohesive.  Governments may decide that inflation is the lesser of various evils and be prepared to accommodate some.  Far be it from us to suggest that that would also help them inflate their indebtedness away. If we are wrong, the brunt is likely to be borne by those lower down the debt hierarchy – BBB grade, non-investment grade debt and equity holders.  It’s no secret that not all BBB rated credit is worthy of its rating but if collateral for repos becomes scarce or unavailable even companies with unimpaired credit could find themselves struggling to refinance their existing corporate debt.  That could trigger a much sharper funding crisis as (shades of 2008 GFC) rating agencies find themselves re-evaluating their ratings. We see the path of the next few months as critical.  It all depends on whether the central banks are watching the right balls.  If you’d like to discuss this in further depth, please give us a call on +44 20 3637 6341. 

Lose-lose for equities?

Market trends this quarter resemble 2017: equities rising, suggesting good times ahead, and bond yields falling, predicting the opposite.  Even if the messages are more muted today, they can’t both be right.  Two years ago we commented that bonds have the better predictive record and that eventually equities would fall in line.  We would not claim to have been precisely right, as equity markets have recovered much of the ground lost at the end of 2018.  However, it’s certainly true that economic growth is flagging and investor risk appetite has fallen, according to data from our friends at CrossBorder Capital.  This time round the liquidity background is less bleak since the Federal Reserve changed tack in January, though the data shows most central banks are continuing tight monetary policy.  Despite this, low bond yields remain a key predictor of lower economic growth.  Our view is that high valuations continue to make equities vulnerable both to disappointing earnings growth and to a more general market setback.  We would back the message from bonds. Some will say that high valuations (and they are high – probably only topped in 1929, the dotcom bubble and 2018) are justified by lower bond yields.  Our view is that it’s a lose-lose situation for equity markets.  If we’re wrong about the fundamental background, bond yields will rise, putting pressure on equity valuations.  If we’re right, earnings will disappoint, with the same result. Find out more here.​

Times they are a'changing

We’ve spent most of the last two years or so marking how tight the monetary environment is.  It is not just that the US Federal Reserve and to a lesser extent other central banks have until very recently been withdrawing liquidity, it is also how the private sector has been less willing, or able, to use or extend credit.  That has been behind our bearish stance on the market and also western economies. But times they are a’changing and, in Bob Dylan’s words, ‘the slow one now will later be fast’.  Most obviously, the Federal Reserve has changed course from its path of steady tightening to a more neutral position.  That can now be seen in the end February and early March data.  More discreetly, the ECB and Bank of England have become more accommodative while the PBOC, until now the loosest central bank, is tightening.  The reasons are not hard to seek: the US economy was previously, as we have said, heading for recession while Europe is drifting in the same direction.  We’d argue, as we did in our last blog, that Abenomics needs a reboot and we can expect significant policy action from Japan too. Though equity markets have risen in reaction, we’re not sure this can be maintained.  Valuations, at least in the US, remain extremely high by historic standards.  That doesn’t mean they will necessarily revert to the mean in the short term: that may have to wait until bond yields normalise.  However, equity investors are unlikely to get more than the yield (3% globally, a juicy 5% if dividends aren’t cut on FTSE 100) +1% or so growth.  There simply isn’t room for valuation expansion and there is significant room for valuation contractions if things go wrong. So times they are a’changing but our views on equities remain biased to the negative.  In the short term we prefer investments which are priced off bond yield curves.  In other words, we remain risk off.​

The US Federal Reserve has changed its tune. Should we do the same?

At the end of January the Federal Reserve signalled that it will, at the least, be less aggressive in raising rates.  It cited inflation stable at close to its target 2% rate and greater uncertainty in global growth.  The comments didn’t rule out further rate raises but the Fed currently looks to be in neutral gear.    This was of course music to our ears, as we have been saying for almost a year that the Federal policy was too tight and would inevitably result in a recession.  But the half of the market that doesn’t read the Linchpin blog viewed it as a U-turn.  On our thinking it may still be too late to avert an economic downturn but, if this does prove to be the peak of US rates in this cycle, then the Fed. has at the last moment got it right. The consequence is that we have become a little more positive about risk assets such as equities.   We still expect one more down leg in markets but the probability now is 75% rather than 95%.  Should we change our tune and suggest to investors that it is time to buy? The straight answer is not yet.  For one, the Fed may yet raise rates, and secondly there is always a lag between the turning point in the liquidity cycle – currently rock bottom in the US on the data we look at - and moves in the market.  But we have, for the first time in three years, extracted our buying boots from the cupboard and if markets were to fall back to end-December levels we might even be tempted.​

tHE FIRST SHOE IS NOW DROPPING

We appreciate that it’s a rear-mirror view but end December data from our friends at CrossBorder shows unequivocally that investors have moved to being risk-off.  Their World Risk Exposure* index moved from approximately neutral to -37 (‘normal’ range -50 to +50), or approximately two standard deviations below trend.  We would suggest that a capitulation of this scale is a necessary pre-condition to a new bull market but we don’t believe that it is yet sufficiently sustained to send a buy signal.  Long experience tells us that bear markets rarely end in a single sell-off, though there are exceptions such as 1987. Our reasoning is primarily that funding liquidity globally remains at a level (16 on a range of 0 to 100) which is predicting recession.  No surprises that the US Federal Reserve is the biggest drag but it is worrying that the People’s Bank of China, until now the least tight major central bank, has shown signs of tightening.  It may only be a temporary phenomenon ahead of the Chinese New Year, but given that central banks are in our view far too tight in their policy already, it is not helpful.  The ECB, perhaps with the possibility of a no-deal BREXIT in its head, is now the loosest major central bank. We continue to think an economic downturn is almost inevitable and a global recession likely.   However, for investors trying to time when to dial up their risk exposure again, the first shoe is now dropping.  The second shoe will be an upturn in funding liquidity.  We’d expect that to happen in the second half of 2019. *Risk Exposure data measure the % of the global portfolio held in risk assets as against ‘safe’ assets such as cash and bonds.   

What will 2019 bring? We're going on a bear hunt

Any reader with children will be familiar with Michael Rosen and Helen Oxenbury’s delightful book of a bear hunt which ends with the bear pursuing the adventurers back to their bed at much greater speed. We see parallels in today’s markets.  Investors risk appetite is still quite elevated, particularly in the US.  ‘We’re going on a bear-hunt.  We’re not scared.’  At the same time the environment, and particularly the lack of liquidity, is highly unfriendly.  The main cause is central banks withdrawing liquidity, which on a range of 0 to 100 sat at 18.5 overall at end November.  ‘Uh-uh!  A forest! A big dark forest. We can't go over it. We can't go under it. Oh no! We've got to go through it! Stumble trip! Stumble trip! Stumble trip!’ Our view is that central banks have tightened too far against a still quite fragile world economy.  The US Federal Reserve is showing some signs of realising this, but the ECB is at maximum tightness and is on course for a major policy mistake.  We have for some time had a recession pencilled in for 2019 and we expect markets to wake up to that in the next six months.  ‘WHAT’S THAT!  One shiny wet nose! Two big furry ears! Two big goggly eyes! IT’S A BEAR!’ Equity markets may no longer be expensive but they are not cheap either.  And many investors are too young to have seen what happens in a traditional bear market, especially when political risk is elevated as now and there are structural debt problems.  ‘In to the bed.  Under the covers.  I’m not going on a bear hunt again.’    In fact, of course, bear markets throw up opportunities for canny investors.  We’d guess that the best ones are likely to come up in Asia because that is where liquidity is strongest.  The People’s Bank of China is relatively less tight, risk appetite is lower (ie. a better starting point for a new bull market) and cross-border flows continue to move away from Developed Markets. But it’s a story for late 2019.  In the first half, under the bedcovers is a sensible place to hide from the prowling bear.  We wish we could end 2018 on a merrier and happier note. To find out more, please contact us. .  

Hold on to Your hats!

I make no apologies for returning to the major question all investors have first and foremost today:  will October’s downturn become a real bear market?  I mean by that a fall in markets of 25% or more, with all the second order consequences that brings.  In my opinion the odds are now more than 90% that it will. The core reason behind this view remains the fact that funding liquidity (ie. the money and credit available to pay debts) is close to rock bottom in the West.  Only in China is the picture at all different.     The evidence is a further decline in western central banks’ liquidity position, now at 10.7 (range 0 to 100) combined with three other signals which have historically been strongly predictive.  On their own, none of them are conclusive but together they are just about as strong a signal as can be.  The first is that investors’ risk appetite, as measured by our friends at CrossBorder Capital, is high, albeit not sky-high, and a long, long way above the capitulation levels which normally signal bear market turning points; the second is similarly high levels of speculative cross border flows; the third is the flattening yield curves, long seen as a predictor of recessions. What could derail this on-rushing train?  Events evolve every day but an abrupt policy about-turn by central banks is the one which could change its direction.  China is easing, which may ameliorate some of the worst effects, but the key is the currently hawkish US Federal Reserve.  Unfortunately, the US today seems to be permeated by super-optimism and a sudden change of heart looks highly unlikely.  So our advice is to don your steel helmets and hold on to them. Find out more by contacting us at research@linchpin.uk.com.

End October liquidity data

Regular readers of this blog will be aware that the overall liquidity picture is the weakest since just before the Global Financial Crisis - and before then 1989.  The most recent end October data remains at levels which normally herald a recession.  A major factor behind this is, of course, central bank tightening.  Over 70% of central banks are running ‘tight’ policies and only the People’s Bank of China is still officially easing. It’s no surprise that, when the financial tide is running out, marginal borrowers are the first to be exposed.  Hence Emerging Markets economies are weakening faster, while the ‘core’ US remains relatively resilient.Our friends at CrossBorder who produce this liquidity data also see signs from the bond market that an economic slow-down is on its way.  Yield curves have flattened and for the real technos the position of the curvature peak within them is contracting too.   With this background, perhaps the intriguing question which has not yet been asked is whether we are coming towards the end of the current tightening cycle?  It’s probably a little early but it seems to me most unlikely that even the Federal Reserve is going to be able to follow through on its promised track of interest rate rises.So, while I confidently expect another leg down in markets, we can also see some seeds of recovery beyond that – albeit probably at the cost of inflation. To learn more about CrossBorder’s research on liquidity please click here. ​

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