1987 Redux?

It is over 32 years since Black Monday (19th October 1987) when markets fell 25% in a day.  The immediate causes were two-fold: in the United States a proposal by the House Ways and Means Committee to eliminate some of the tax breaks on lucrative M&A transactions; and in the UK a failed rights issue by BP and a hurricane-like storm across London which prevented the London Stock Exchange from functioning properly.    The underlying cause of course was different: equity valuations had stretched too far from bonds.  Behind this was a jump in global liquidity combined with a back-up in government bond yields. Global liquidity as measured by our friends at CrossBorder Capital rose from 27.2 to 84.5 (index 0-100) in 1987 and equity historic PERs rose to above 20x.  At the same time bond yields backed up by 15%, which is why the valuation elastic was ready to snap. Roll forward to 2020 and there are some eerie similarities.  The US has turned on the monetary taps: CrossBorder Capital’s most recent numbers for both US and global liquidity is over 70, having been below 20 a year ago.  It has been the sharpest US liquidity surge in 50 years and the fuel for the 2019 rally in equities and also gold, up 22% since May.  There are parallels in the trade tensions between the US and China today, and Japan then, which were partially resolved by the 1985 Plaza Accord on currencies.  If, as we rather suspect, there is a similar accord today resulting in Chinese easing, we can expect the PBoC (NB. larger balance sheet than the Federal Reserve) to join the liquidity party.  In music terms, the volume just got turned up. It all starts to look rather like 1987.  Perhaps the final bit of the jigsaw is investors’ appetites.  Today investors are reluctantly allocating to equities despite valuations much higher than 1987, simply because everything else looks even less attractive.  CrossBorder’s data indicates that they are still largely underinvested, particularly in Emerging Markets, but also in Japan, the UK and the US.  In 1987, after five years of largely rising markets, investors were wary but were dragged back to the party. We are not suggesting a new Black Monday is imminent.  Rather, the opposite.  The music is playing and we expect investors will feel they have to dance for some time yet.  We will only get nervous when we can see a clear catalyst to make the valuation elastic snap again.  There are candidates around but it is probably going once again to be something unexpected.   We will of course be keeping our usual eagle eye open for early indicators: a back-up in bond yields is the prime candidate, but look out also for heightened equity volatility.  Black Monday was preceded by a couple of mini-crashes on the stockmarkets.  There may be another tax proposal, perhaps to rein back the influence of the large tech stocks.  And we will don our flak jacket in the shape of an allocation to gold.  But 2020 may yet again prove to be a good year for investors. If you’d like to discuss this in more depth, please call us on 020 3637 6341.

It's not the economy, stupid

The sudden liquidity squeeze in the United States, where repo rates (nowadays the method of choice for overnight borrowing and lending) peaked at 7.5%, wasn’t exactly what we were expecting to happen.  But we were looking, as regular blog readers will know, at exactly the right part of the financial system.  The weak spot today is the shortage of collateral for repo lending. It explains why bond yields have gone down: demand for high quality collateral.  It explains why the Federal Reserve has twice cut rates: nothing to do with Trump or the economy, everything to do with the need for liquidity in interbank and corporate borrowing.  And it explains why markets remain jumpy. The underlying problem is not lack of cash either; there is plenty hoarded away in institutional investors and corporate balance sheets.  The problem is that liquidity is not fungible: you may have cash, and I may need it, but that doesn’t mean you’re going to lend it to me. Last week’s repo rate spike seems to have been caused by a spike in demand for cash from US corporates - presumably different ones from those with cash.  But it is a clear illustration of the difficulties many corporates will have when they need to refinance.  If readers need a couple of other very different examples of the difficulty of (re-)financing today, look at Metro Bank in the UK this week and WeWork in the US last week. In our view the Federal Reserve at least is well aware of the problem and is doing what it can to be proactive.  However, that alone does not remove the risk.  It is quite possible that whatever the Fed. does is insufficient to avert another financial crisis. It is not an easy position for investors, because the outcome is in our view close to binary.  If the liquidity squeeze results in corporate failures, markets should expect something like a repeat of 2008-9.  If the Fed is able to provide sufficient liquidity to finance those who need it, then the current not unfavourable market environment continues.  Our base case is the latter, but if we are wrong, by the time you know that, it will be too late to take much sensible action. Systemic risk should be the focus for investors and not the prospects for an economic downturn, as  commentators like to burble on about.  It’s not the economy, stupid. Find out more about the data behind our view by contacting us.​

Is the commentariat wrong (again) about a recession in the US?

The R-word is on many investors’ lips at the moment.  The combination of the US yield curve inverting – though note that it is now positive again over 30 years, if not 20 – gloomy economic data and this weekend’s attack on Saudi oil facilities has led the commentariat to assume that recession is now a virtual certainty. At Linchpin we beg to differ.  A year ago we thought a US recession was inevitable because of the Federal Reserve’s stated policy of raising rates.  However, since January there has been a sharp change of policy, and we believe the signals now point towards stronger growth and no recession. It’s not just the un-inversion of the yield curve, with US rates lower and 10 year bonds back up above 1.8%.  Liquidity, as defined by our friends at CrossBorder Capital, were back to near neutral levels at the end of August, compared to 18 (range of 0-100) in April.  It is not evenly spread, true, but cross-border flows, often a good indicator, are strong at least among Developed Markets.  And equity markets have been remarkably sanguine, suggesting investors don’t entirely believe the bond market bears. China still exhibits the weakest liquidity overall: the People’s Bank started tightening 12 months ago, we’d surmise in order to support the yuan while trade-skirmishing with Trump, and over the next nine months reduced its balance-sheet by about 10%.  Since spring, as we have chronicled, it has reversed course and been easing.  However, the August data exhibits a sharp volte-face and one big question is whether this is temporary or not.  Cross-border flows are also sharply negative out of China. So why aren’t markets flying?  The answer lies with another long-standing theme of ours: the risk to the financial system from the inability of private sector lenders to obtain ‘safe’ assets to collateralise corporate lending, combined with the short-term nature of much of it.  We don’t expect this to resolve itself but if further central bank easing results in some recovery in risk appetite then we may see steeper yield curves as investors sell Treasuries and the like.  Which in turn may mitigate the collateral squeeze on lenders. We’d therefore be more bullish on Developed Markets, without expecting a major rally and, at least in the short-term, more cautious about Emerging Markets and those linked to China.  Of course we have to give the usual caveat that geo-politics (oil prices, BREXIT, trade) can make any prediction look foolish, including ours here at Linchpin.  But the big R in the US?  We think it is now unlikely. To purchase CrossBorder’s latest analysis, please click here.​

Has Japan fallen off the map again?

It is six months since I blogged about Japan.  In March I asked whether Abenomics needed a re-boot, as Japan seemed to be sinking back into deflation and Abe’s three arrows to have run their course after six years. Six months later, rather than Japan struggling to re-join the world, it looks more as if the world has decided to join Japan.  Growth in much of Europe is zero, and bond yields globally are also falling towards or beyond zero.  Inflation is still on a different trajectory but the policy prescription is likely to be similar. That is because monetary policy loosening over ten years still has not got western economies, with the exception of the United States, anywhere near where they wish to be.  For political reasons, governments of left and right are having to look for other solutions.  A combination of some fiscal relaxation combined with more radical monetary easing seems to be the preferred flavour. As so often at times of change, the more flexible and less dirigiste Anglo-Saxon economies are in the forefront, whether the next government be of the left or right.  Europe will almost certainly be a laggard because it finds change difficult, full-stop.  I see Japan somewhere in the middle.  It has already taken Quantitative Easing further than other countries, with the Bank of Japan lending against a broader range of assets and even purchasing equity ETFs. In one sense Japan’s high participation rate (nearly 80% of all working-age adults are employed) masks the problems.  If you are employed, deflation benefits you because costs come down.  On the other hand, the Japanese economy is entwined with China’s more closely and if command-led China goes down a more radical route to support its economy, Japan will have little option.  Also, as a society, Japan has little problem with radical change once it has been decided.  Witness both the Meiji Revolution and the aftermath of the last war. Bringing this back to markets, what might fiscal and more radical monetary easing mean?  At the economic level, it should of course help domestic-focused company profits.  More importantly, though, will surplus cash go into ‘safe’ assets, driving highly-priced companies to even more extreme valuations?  Or will ‘free’ money encourage some risk-taking, helping the long tail of cheap companies?  Which matters: if the first, we will likely see a continuation of current market trends; if the second, something more akin to normalisation, with the valuation stretch reducing. If Japan has fallen off the map, it is no longer alone.  And I would put a little money on it embracing change rather faster than some other developed countries.  Could the forthcoming rugby World Cup and next year’s Olympics act as a catalyst?​

What's driving markets today?​

I’m going to start this blog with a minor blast on my own trumpet.   Over the past few months, I’ve written about slowing economic growth, sideways equity markets, falling bond yields and a rising gold price.  And so it has come to pass.   In particular I stood up at a conference in early May and said that US 10 year bond yields, then 2.5%, would certainly fall to 1.5%, and might go to Japanese levels of 1% or even negative.   There were whistles of derision all round, but where are they now?  1.68% is the answer. As regular readers will be aware, the credit should really go to my friends at CrossBorder Capital, whose work on liquidity data I find an invaluable framework.  Ultimately, whatever ‘experts’ write, what moves markets is weight of money moving in or out.    That is why following ‘funding liquidity’ (i.e. credit or cash which can be used to settle a liability) is crucial to understanding markets. There are really two major themes today.  The first is driven mainly by central banks, and especially the Federal Reserve and the Peoples’ Bank of China.    Over the past two years, for different reasons, both embarked on tightening policies.  The Fed in 2017 started to normalise interest rates; the Chinese in 2018 needed to support the yuan in the light of growing trade tensions. In 2019, both have abruptly changed course.  The Fed signalled a neutral posture in January, and cut rates in August.   The Chinese in May started to inject liquidity back into their system – the yuan’s fall below 7 yuan to US$1 is simply a consequence of easing. There’s always a lag of 12 to 15 months between liquidity tightening and economic slowdown.  It is no surprise that the world’s economy is struggling today and may indeed fall into recession.  It’s worth noting here that the Chinese multiplier is both larger and more direct than the US;  i.e. the PBoC has more control over its economy. However, the seeds of exiting the slowdown are also in place with change of monetary policy.  Both central banks have accepted that easier monetary policy is the only rational escape route, and so any recession is likely to be mild.  Call it QE4 if you want. The second major theme is to do with how the private sector refinances its debt.  There is plenty of cash sitting in corporate and institutional investors’ hands.   There are plenty of corporates out there who need finance.  The problem is the mismatch between risk appetite and what is on offer.  In other words, liquidity is not fungible.  The problem has largely been skirted by the use of repos, so that lenders to riskier ventures are collateralised with ‘safe’ assets such as US Treasuries.   Financing is short-term, requiring regular refinancing and a supply of safe assets to provide collateral. The consequence of this is that the availability of liquidity and particularly of ‘safe’ assets becomes more important than the price paid.  Ironically, the need to refinance more frequently adds to the risk of systemic problems.  That in my view is a major reason behind the Fed.’s decision to expand its balance sheet.  It’s also why US bond yields are headed downwards – price matters less than availability. Both these themes lead in the same direction: QE4 of some description, a steepening yield curve, some downside protection for equities, and at worst a mild recession.   For what it’s worth, I also believe we will wake up one morning to some form of accommodation on the trade front: neither Xi nor Trump can really afford not to.

Reflections following some enforced inactivity​

As many readers will be aware, I have had ten days of enforced inactivity after a motor accident.  It has given me time to reflect on matters near and far. Nearer to home, I am humbled by the many messages of good wishes and more from so many people.  Mankind is a social species, and friends, community, and family are – in Trump-speak – the most important.  Thank you all. The emergency services took two hours to cut me out of my Subaru car, built to old-fashioned strength specifications.  I was only conscious for part but I don’t believe I would be alive in a less strong car.  They were quite extraordinary throughout and I hope I have the opportunity of thanking them.  If I ever drive again, it will be in a Subaru car. The NHS is an organisation under immense stress.  Everybody, whether staff or contract worker, did their best as individuals to care for me, but I hardly saw the same doctor or nurse two days in a row, and the lack of information co-ordination and management led to potentially dangerous situations.  I was alert enough to avert them but others might not be.  There is an urgent need for a grown-up conversation about taxation, budgets, and prioritisation, as the current path is unsustainable.  Meanwhile, if you find yourself in my position, try to avoid Friday evenings. Meanwhile, while I have been in bed, the country has swung in a different direction.  The new Prime Minister is clearly channelling his inner Churchill, but he is doing it from a narrow powerbase instead of a national Government.  Parliamentary arithmetic may once again prove his undoing.  That said, a ‘no deal’, whether intentional or not, is now clearly a possibility, and it must be right to plan for it. Markets?  At a global level, I remain sanguine, simply because both fiscal and monetary policy is generally supportive.  Yes, institutions can flee to cash, and I shan’t be surprised if short to medium bond yields fall further, but the yield gap between equities/property/infrastructure and bonds is a powerful disincentive to selling risk assets.  Unless there is a major geo-political shock, I see markets broadly going sideways.​

Watch out for the rise!

Sorry if you thought we mean stockmarkets rising.  We don’t.  We mean liquidity.  Here end-June data from our friends at CrossBorder Capital is showing a significant jump, much in line with our predictions over the last few months.  It’s happening where investors aren’t looking – in Asia and the private sector.  In Asia, the PBoC has clearly taken its feet off the brakes again, perhaps in consequence of the slowing economy as per yesterday's headline.  There’s a sub-theme we’ve mentioned before here too – the Bank of Japan seems to be easing in line with China, bearing out our view that Japan has for several years now targeted currency stability first and foremost rather than foreign currency. The real theme of the latest data is the surge in private sector liquidity around the world but particularly the US.  This is not all good news, as it may be corporates building up cash before an economic downturn.  But it does increase the likelihood of steeper yield curves.  In theory that fits neatly with our general view predicting a bullish steepening with short term yields falling alongside US rate cuts.  However, the facts don’t all fit.  Historically, this late-cycle environment is associated with rising term premia, suggesting that longer term bond yields may in fact rise, and a bearish steepening.  At the same time, one of the worries we have had over the past few months, the fragility of corporate bond markets, seems to have eased off a bit, so the bulls expecting the US to cut rates may be premature.  So, while we expect the curve to steepen as liquidity supply increases, we are less confident which end of the curve will move. QE4 is starting but it seems that the US Fed may be the laggard rather than the leader this time round.  It suggests that Emerging Markets will, at some point quite soon, have a run of some sort but once again not all the facts fit.  CrossBorder flows of capital are running clearly away from emerging markets, and particularly the larger ones such as China, into safer havens mainly in Developed Markets.  Liquidity may well be on the rise, and highly valued US equities may be underpinned by that, but we’re not sure that adds up necessarily to further gains in global indices. If you’d like to see the underlying data, please contact the team.​

Recession or no recession?

Talk of a recession in the US is again in the air.  Last autumn, when the Federal Reserve was on its path of ‘normalisation’ by increasing interest rates, we thought a recession close to inevitable.  The authorities have changed tack abruptly, and we commented in January that it might or might not be too late to prevent a US downturn. More recently we have had that classic sign of recession, an inverted yield curve, as US longer bond yields have fallen beneath short rates.  As a result, recession talk has risen.  We have two reasons for believing that, while it is certainly a possible outcome, it is not yet baked in.  We have written before why there are technical reasons for the sharp fall in longer term US bond yields, which are more to do with the financial system’s demand for ‘safe assets’ and less to do with risk appetite.  We also note that our friends at CrossBorder’s major liquidity index at the end of May was still just above recession level, and policy stance at both the Fed and PBoC in particular are close to neutral.    That said, what we have noticed is a sharp fall in investors’ risk appetite as measured by cross-border flows and investor sentiment.  It looks as if more investors have already positioned themselves for an economic downturn, which suggests the market impact of one may be less dramatic than expected.  We also believe, as we have commented before, that the Fed would react with a new QE programme.  This would aim to limit the extent and impact, much as in 2008/9. So, recession or no recession?  We don’t know the answer and we don’t wish to sound overly complacent.  However, we are not yet convinced that a recession in the US is certain and we do believe that, if there is one, the impact on markets will be short-term rather than extended.​