Sunday, 4 August 2013

Credit - Livin' On The Edge

"There's somethin' wrong with the world today
I don't know what it is
Something's wrong with our eyes

We're seeing things in a different way
And God knows it ain't His
It sure ain't no surprise

We're livin' on the edge" - Aerosmith 1993, Livin On The Edge

While we contended this week about the complacency in US stocks, when looking at the "great rotation" between institutional investors and private clients for the last five consecutive weeks as reported by Bank of America Merrill Lynch, we thought this week we would use a musical reference for a change, namely 1993 hit song by Aerosmith, which reflected at the time the sorry state of the world.

In this week's conversation, while everyone is enjoying a summer break and some much needed normalization in credit spreads, which has seen cash credit tightened overall by 5 bps this week in the European market on the Iboxx Euro Corporate index, we would like to focus our attention on the growing disconnect between asset prices and the sorry state of the real economy.

Indeed we would have to agree with our chosen title when looking how the US stock market has been defying gravity compared to the sorry state of the US labor market. There has been a growing disconnect between Wall Street and Main Street. On that note we agree with Bank of America Merrill Lynch's report from the 1st of August entitled "When Worlds Collide":
"From their 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion (in July the S&P 500 set a new intraday high). Policy, positioning and profits (in that order) best explain the seeming disconnect between Wall Street and Main Street. Wall Street and capitalists have enjoyed a boom, as the price of equities and bonds (and more recently real estate) have soared, while Main Street and the labor market have struggled" 
- source Bank of America Merrill Lynch

Yes recently we did indicate, "we're livin on the edge", when  not only looking at the rise of the S&P index (blue) versus NYSE Margin debt (red) but also at the S&P EBITDA growth (yellow) and as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:
No doubt to us that the current bull market which has started in March 2009 has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks. A drop in stock outstanding accounted for 25% of 2012 earnings-per-share growth in the S&P 500. Buybacks are a global phenomenon.

Capital, courtesy of ZIRP, is not only mis-allocated but also destroyed with the "de-equitization" process in order to boost even more the "infamous" wealth effect induced rally by Mr Ben Bernanke. As far as profits are concerned, companies as sitting on record amount of cash and have generated record corporate profits as indicated by Bank of America Merrill Lynch's graph below:
"Profits: corporate austerity since the Great Financial Crisis has induced record corporate profits ($1.6 trillion – Chart 3) and record levels of corporate cash ($1.2 trillion), an asset-positive, growth-negative combo." - source Bank of America Merrill Lynch

While the latest ISM / PMI releases point to some much hoped economic recovery, the latest disappointing read of the Nonfarm payroll coming at 162 K shows how much the recovery has been tepid so far whereas equities have continued their surge undisturbed.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:

But if short term wise economic data shows some sign of stabilization, the volatility in the fixed income space is very much present as displayed by Merrill Lynch's MOVE index jumping from early May from 48 bps and surging back towards the 100 bps level - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

What we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

This latest surge in fixed income volatility has put some renewed pressure on Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG - source Bloomberg:

If the fixed income space, the goldilocks period of “low rates volatility / stable carry trade environment” of these last couple of years seems to have been seriously tested, yet there remain a big disconnect between equities and fixed income. As we posited in our conversation on the 13th of June "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

For now volatility indicators in both Europe (V2X) and the US (VIX) have been fairly muted. Graph source Bloomberg:

So the big question is indeed are we indeed "Livin' On The Edge"? Here is what Bank of America Merrill Lynch posited in their 1st of August note on this subject:
"United we fall, divided we rise
Secular bears of financial assets will argue, with some justification that the worlds of Wall Street & Main Street cannot diverge indefinitely. This may well be so. But in the past 5 years this view has repeatedly missed the point that a divided world of High Liquidity & Low Growth has been the foundation of a ferocious bull market in financial assets.
And of course not all asset prices have reflated as nonchalantly and aggressively as US corporate stocks and credit. Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment. A breakdown in the Continuous Commodity Index (CCI –Chart 4) below 500 in coming weeks would discourage global growth upgrades (and stymie the recent rebound in Emerging Markets). 
It is very rare to see such outperformance of defensive stocks (up 26% over the past two years) versus cyclical stocks (down 4%) in a non-recessionary world (Chart 5).
- source Bank of America Merrill Lynch

As we argued back in April this year in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option", the downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:
Another "great anomaly" has been that low volatility stocks have provided the best long-term returns.

So yes indeed in, we do live, in an ambiguous world where low volatility provides the best returns, and with a great disconnect between equities and the real economy, with fixed income and equities. We think we are "Livin' On The Edge" and as indicated by Bank of America Merrill Lynch, but, we are not too far from "The Moment of Truth":
"Perhaps the best example of this bi-polar world is the fact that the US equity market now represents almost 50% of the world’s market cap. Despite limited support from the US dollar, US equities relative to EAFE are close to relative levels not seen since the 1960s (Chart 6), as investor positioning reflects belief in ongoing US market and macro leadership.
So moment of truth for the economy will arrive in the second half of this year. If ever the US were finally to achieve “escape velocity” it must be now. Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, and record corporate cash balances mean the US economy should meaningfully accelerate in coming quarters. Our own Ethan Harris looks for 2.0% GDP growth in Q3, 2.5% in Q4 and 2.7% in 2014.
Our investment strategy remains predicated on that outcome. In coming quarters we expect PMI’s to accelerate, job growth and bank lending to improve, higher interest rates to coincide with higher bank stock prices, and US dollar appreciation. We favor assets (such as financial stocks) and markets (such as Europe) that have lagged in the “High Liquidity-Low Growth” world of recent years." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimism on the acceleration of USD GDP growth in the coming quarters. For us, it is still muddle-through with significant risk on the downside.

US labor growth remains very weak as indicated in the below Thomson Reuters Datastream / Fathom Consulting graph:

QE and the law of diminishing returns - US QE in practice - Payrolls and Manufacturing ISM, graph source Thomson Reuters Datastream / Fathom Consulting:

In addition to this the regular economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:
"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in June, following -4.8% in May and -7.4% in April. As a readily-available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth.
Over the past 13 years’ monthly data, there has been an 83% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months (Fig. 2). In turn, this has translated into a clear relationship between air cargo and chemical industry volume growth (Fig. 1).
- source Nomura

On a final note, if you think that stocks are "Livin' On The Edge" and that a QE tapering is around the corner, then maybe you ought to think about US Treasuries again, for a very simple reason, government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". In fact the case for treasuries is also indicated in Bloomberg's recent Chart of the Day:
Investors should buy Treasuries if they anticipate the Federal Reserve will reduce its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market.
The CHART OF THE DAY shows the benchmark 10-year yield dropped and gains in the Standard & Poor’s 500 Index slowed after the Fed ended each of the prior two rounds of quantitative easing in the past four years. The yield declined 1.26 percentage points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year. The U.S. stock gauge rose 2.4 percent, compared with a 36 percent advance during QE1.
The yield slid 1.3 percentage points between the end of the second round in June 2011 and the beginning of Operation Twist in September the same year. The S&P 500 fell 12 percent after gaining 10 percent during QE2.
The Fed will taper QE not because the economy is booming but because the program has been creating excess liquidity, boosting risk assets too much,” said Akira Takei, the head of the international fixed-income department at Mizuho Asset Management Co., which oversees $37 billion and whose U.S. affiliate is one of 21 primary dealers that underwrite U.S. debt. “Ending QE is likely to trigger a correction in risk assets, driving bond yields down.”
Fed Chairman Ben S. Bernanke said on June 19 that the U.S. central bank may slow the third round of bond-buying, valued at $85 billion a month, later this year and end it entirely in the middle of 2014 if the economy achieves sustainable growth. Half of the 54 economists surveyed by Bloomberg News said the Federal Open Market Committee will decide to start taking such steps at its September meeting.
Futures traders see an almost 60 percent chance the Fed will keep the benchmark rate at a record-low range of zero to 0.25 percent through to at least the end of 2014. The 10-year Treasury yield is likely to fall to 1 percent by the end of March and may touch 0.8 percent next year, Mizuho’s Takei forecast. It was at 2.71 percent yesterday, up from 1.72 percent when QE3 was announced on Sept. 13 last year." - source Bloomberg.

Looks to us that the S&P 500 is no doubt "Livin' On The Edge".
Oh well...

"To him that waits all things reveal themselves, provided that he has the courage not to deny, in the darkness, what he has seen in the light." - Coventry Patmore, English poet.

Stay tuned!

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