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.​

Whither markets? Are we looking at QE 5, 6, 7, 8...?

We pondered the different messages coming from equities (generally rising) and bond yields (falling) three months ago, and concluded that bonds were more likely to be right in predicting a downturn.   We have consciously shifted our ground since then - we make no apologies for doing that.  For us the importance lies not so much in the Fed’s short-term shift to a neutral position, which makes a benign outcome more likely.  Instead we are more focused on the longer-term message the Fed is giving: that normalisation of interest rates is going to take a great deal longer than you first thought. In our view the key implication is that the Fed is less concerned about inflation, and more so about risks to the financial system, in particular the lack of ‘safe’ assets such as T-bills which are used as collateral across a range of wholesale transactions.   If that is the case, whither markets?  We suggested a month ago that US bond yields would fall further, perhaps dramatically so, and the 10 year yield has responded by dropping 40bps in four weeks.  It is still well above the 1.5% yield reached in 2016 but looks headed that way.  We’d like to think that the shortage of ‘safe’ assets is behind this buying and that it is not a precursor to an economic downturn.  But bonds have a strong record of predicting recessions and the yield curve is not far off flat at the time of writing.  So we are wary of positing that this time it is different.   If there is a significant downturn, it seems to us almost inevitable that the Fed will turn on the printing taps again with QE4, 5, 6 or whatever it takes.  That makes us more confident that 10 year US bond yields will, at least initially, carry on falling, quite possibly to new lows. And equities?  On the one hand lower or negative economic growth should depress stocks, especially as valuations are (sky) high.  On the other hand, lower bond yields may force income-seeking investors to purchase blue-chip equities as they did in 2015 through 2017.  Our best guess is that, in the absence of geo-political convulsions (trade wars etc), they broadly trade sideways.  Any dip would be fairly quickly covered by buying but the upside is limited by low dividend growth and valuations. Perhaps the most troubling aspect of not normalising is the distortions that cheap money brings to markets.  Asset prices such as housing remain excessive, zombie companies are not put out of their misery, while the incentive for profitable companies to invest in new capital reduces because returns are competed away.  The new normal may seem more comfortable than an old-fashioned recession but it is certainly not nirvana.​

Could US 10 year Treasuries fall to 0% yields?

OK, we are being more than a bit provocative and the thought comes from our friends at CrossBorder Capital.  But they have form in this - before the 2008 crisis they predicted that interest rates would fall to close to zero. Their approach is based on the ‘liquidity’ data they collect every month, which over time has proven a strong predictor for many variables and particularly at turning points in markets.  Last autumn they suggested that the Fed funds rate had peaked at 2.5%.  At that time the Fed was still talking an upward path of many more rises. CrossBorder’s conclusion was based on a severe restriction in the amount of liquidity available, suggesting that monetary conditions were already far tighter than the consensus believed. Since the GFC there has been a shortage of ‘safe’ assets such as Treasury bills and commercial paper, and they are increasingly concentrated in the US.  They are needed, as we wrote last month, to collateralise the wholesale funding markets which - since solvency rules have made it so much more difficult for banks to lend - underpin much of the world’s finance today.      The shortage of these ‘safe’ assets is creating demand for assets further out on the maturity and credit scale.  That is why US (and some other G7) bond yields have fallen along the curve.  It is also in our view why the Fed changed tack so abruptly in January: if the wholesale markets freeze from a shortage of ‘safe’ collateral assets, it would cause systemic risk to the commercial funding system in a way not dissimilar to what happened to mortgage markets in 2007/8. So could US 10 year Treasuries fall to 0% yields?  If demand for these ‘safe’ assets becomes a panic, it could indeed push yields down to German or Japanese levels.  On the flip side, governments of both left and right are using fiscal policy as a lever and that implies greater supply.  But we do expect yields to continue to go significantly lower.  If they do reach 0%, remember you heard it here first! To find out more, please contact us.​

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.​

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