A pesar de que tenga que corregir, no hay ingredientes, desde el punto de vista macro, para que nos enfrentemos a una tendencia bajista…
The missing ingredients for a bear market
Without excessive leverage or inflation, a bear market seems unlikely.
Key takeaways
+Historically, rising inflation often forces the Federal Reserve (Fed) to raise interest rates, to the point of inverting the yield curve and eventually causing a recession.
+Once an economic expansion ends, however, the amount of built-up leverage (debt used to buy assets) in the financial system typically helps determine how bad a subsequent downturn might be.
+At this point, with inflation running well below the Fed's 2% target and a lack of widespread leverage, we’re not seeing some of the makings of a nasty bear market.
In my view, the 2 key drivers that will signal when the US expansion and bull market are ending—and how bad any subsequent downturn might be—are inflation and leverage (debt used to buy assets).
The emergence of inflation in the late stage of an economic cycle typically forces the Fed's hand in terms of the speed and magnitude of its rate-tightening cycle. If inflation pressures become bad enough to force excessive rate hikes, what often follows is an inversion of the yield curve—when the interest rates on shorter-maturity bonds rise above rates on longer-maturity bonds. History suggests this typically curtails the availability of credit, which eventually (6 to 12 months later) causes the economy to contract and a bear market to start.
A lack of inflation can mean an extended Goldilocks environment for stocks, with growth and low inflation, as has been the case for some time now. If this changes, it may mean that the Fed will have to seriously tighten financial conditions. Low borrowing costs have been 1 of the 2 powerful tailwinds (the other being strong earnings growth) propelling stocks higher since the 1st quarter of 2016, so a reversal of that tailwind would be a striking development.
If inflation reveals whether an expansion is going to end, the amount of leverage in the system might indicate how bad the subsequent downturn could be. High levels of leverage can lead to forced selling and a liquidity crisis, which turns an ordinary downturn into a crash. Forced selling helped create the kind of severe downturn we saw during the 2008 financial crisis.
So, where do these 2 drivers stand today? Inflation remains very low, so unless it sharply accelerates from here, it's unlikely to turn the ongoing expansion and bull market into a contraction and bear market.
Of course, this also depends on the speed and magnitude of the Fed cycle. One way to illustrate this is to compare the "real" federal funds target rate (using core consumption expenditures prices, excluding food and energy) to the so-called "natural real rate of interest," or "R*." R* is the rate that would keep the economy operating at full employment and stable inflation. (You can read more about R* and how it is calculated from the Fed). A Fed easing cycle tends to drive the real funds rate down to well below R*, and a tightening cycle tends to produce the opposite effect.
This can be seen in the chart, where the shading shows the difference between the real funds rate and R*. Leading up to the dot-com peak in early 2000 the real rate was several percentage points above the natural rate. That was enough to invert the yield curve and eventually cause a bear market for stocks. The same thing happened in 2007, in the run-up to the global financial crisis.
Fed Interest-Rate Cycles (1995 to 2017)
Source: Bloomberg Finance L.P., Haver Analytics, and Fidelity Investments, as of November 7, 2017.
So where are we today? Fortunately, right now the real policy rate is pretty much equal to the natural real rate, leaving the system in balance. If we assume that the market (via the fed funds forward curve) is correct (pricing in a 2% rate in 2 years) and that inflation will gradually rise to 2%, that will still leave us at a 0% real rate in 2 years, which is where R* is right now. So no harm, no foul, if the market is correct.
On the other hand, if the Fed's so-called "dot plot" (a graphic depicting all 16 Federal Open Market Committee members' individual projections of where the policy rate will be) is accurate, there will be 7 more rate hikes, plus the effects of a projected $1.25 trillion decrease in the Fed’s balance sheet. Then the funds rate could be closer to 4%, which would be +2% in real terms. If R* is still at 0% then, it could be enough to cause a downturn. However, my view is that the Fed will only go there if R* is trending higher. This is how I am thinking about the whole Fed cycle.
Leverage
The next chart is an attempt to illustrate where the so-called leverage "bubbles" are. It shows the change in borrowing over time, expressed as percentage points relative to gross domestic product (GDP). It shows changes in corporate leverage, household leverage, financials sector (banks) leverage, and government debt.
Cycles of leveraging and deleveraging (1995 to 2017)
Sources: Bloomberg, Haver, and FMR Co. as of November 2017. For illustration only.
I also show the change in the Fed's balance sheet (as a percentage of GDP), as well as US bond mutual funds and ETFs (which added $1.2 trillion in flows, arguably as a consequence to the Fed's policies). I realize that these are assets and not liabilities, but I am trying to show the various potential air pockets out there. To many pundits, this is where the bubbles are these days.
What can we learn from this chart? A few things. Leverage in the non-financial corporate sector has recently increased from 40% of GDP to its previous cycle highs of 45% in 2000 and 2007. There is also plenty of leverage in central bank balance sheets (+20 percentage points of GDP since 2009), government debt (+37 percentage points since 2008), and bond funds (+11 percentage points of GDP). However, leverage in both the financials and household sectors has declined since the financial crisis. Leverage in the financials sector is down roughly 40 percentage points, while household leverage is down some 20 percentage points.
When I add it all up, I do see pockets of excess leverage but certainly not a widespread excess. Plus, it should be remembered that neither the central banks nor the government will likely be forced to sell anything. Why is this important? Because in 2007, there was a massive buildup of household, financial sector, and corporate leverage that all had to unwind during the financial crisis. It was a catastrophic trifecta of deleveraging. We don’t have those same conditions presently. We have government debt, corporate debt, and a much larger Fed balance sheet (which, some people argue, drove bond buying by the public), but those are offset by a significant deleveraging in household and financial sector debt.
The bottom line is that with neither inflation nor widespread leverage present in the system, I do not believe we have all the ingredients for a downturn in the economic cycle.
Abrazos,
PD1: Lo que preocupa son los bonos:
The Great Crash of 2018? Look to the bond markets to trigger Mayhem!
I had the impression the markets had pretty much battened down for rest of 2017 – keen to protect this year’s gains. Wrong again. It seems there is another up-step. After the People’s Bank of China dropped $47 bln of money into its financial system (where bond yields have risen dramatically amid growing signs of wobble), the game’s afoot once more. The result is global stocks bound upwards. Again. It suggest Central Banks have little to worry about in 2018 – if markets get fraxious, just bung a load of money at them.
Personally, I’m not convinced how the tau of monetary market distortion is a good thing? Markets have become like Pavlov’s dog: ring the easy money bell, and markets salivate to the upside.
Of course, stock markets don’t matter.
The truth is in bond markets. And that’s where I’m looking for the dam to break. The great crash of 2018 is going to start in the deeper, darker depths of the Credit Market.
I’ve already expressed my doubts about the long-term stability of certain sectors – like how covenants have been compromised in high-yield even as spreads have compressed to record tights over Treasuries, about busted European regions trying to pass themselves off as Sovereign States (no I don’t mean the Catalans, I mean Italy!), and how the bond market became increasingly less discerning on risk in its insatiable hunt for yield. Chuck all of these in a mixing bowl and the result is a massive Kerrang as the gears of finance explode!
Well.. maybe..
I’m convinced bond markets are the REAL bubble we should be watching.
I’m convinced it’s going to start in High Yield.. so let’s start by talking about Collateralised Loan Obligations – the CLO market. Did you know that since the Global Financial Crisis (GFC) in 2008 only 20 out of 1392 deals have seen their riskiest tranches default? (I pinched the numbers from a Bloomberg article.) When I quoted these numbers in the office everyone was surprised.. Surely losses were greater?
Of course not.
It wasn’t just banks that benefitted from Too-Big-To-Fail. (TBTF) Most CLOs did very well. In 2008 smart credit funds realised they would benefit on the back of TBTF and did exceeding well out buying cheap CLOs from panicked sellers. As the GFC unfolded in the wake of Lehman’s default, the global financial authorities pulled out the stops to stop contagion. Banks were unwilling to realise further losses, interest rates plummeted, meaning the highly levered companies issuing the debt backing CLOs survived and were better able to repay their existing debt.
The 2008 GFC was about consumer debt – triggered by mortgages. We still have consumer debt crisis problems ahead (in credit cards, autos and student loans). There is also the fact Consumers have suffered most these past 10-yrs as massive income inequality has left them paid less and paying more for everything – which is most definitely going to come back and haunt markets at some point.
But, I do think the next Financial Crisis is likely to be in Corporate debt, and will be an credit market analogue to the consumer debt crisis of 2008. The Hi-yield market is the likely source - as markets recovered banks started lending again, and low rates forced investors out the credit-risk curve to buy returns. The funds who used to buy nothing but AAAs are now buying speculative single B names. Such is the demand for assets, these companies have been able to lever up and refinance, increase leverage and refinance further, at ever faster rates.
It’s been exacerbated by private equity fuelling returns through debt. As demand has increased exponentially, borrowers have been able to slash Covenants, making it easier and simpler for over-indebted companies to raise more and more dosh.
Where does it end?
As rates rise we’re going to see the “Toys’R’us” moment repeated on a grand scale. The rise of and fall of Zombie companies that simply can’t meet debt payments is bound to contage not just the rest of the credit market, but also stocks.
More immediately, the realisation a crisis is coming feels very similar to June 2007 when the first mortgage backed funds in the US started to wobble. (The first few pebbles rolling down the hill before the landslide?) It explains why we’re seeing the highly levered sector of the Junk bond markets struggle, and companies correlated to struggling highly levered consumers (such as health and telecoms) also in trouble.
Basically, the very little is really fixed since the 2008 financial crisis. 10-years later, here we are with the next bubble about to burst. Corporate debt watch out.
Which leads us to the UK Housing Sector…
A few days I commented on how UK house prices have risen 50% over the last 5-years – a period which has seen incomes stagnate. The result is its practically impossible for anyone on a normal salary to even contemplate ever affording their own house – a very good article in the FT yesterday saw the author explain he’d have to save 20% of his gross income for 60 years to be able to put down a deposit on the bed-sit he lives in!
In short, the great myth of the Thatcher generation is dead. The dream of home ownership in the UK won’t happen for our children’s generation.. They will be forced to rent, and that’s a very expensive market here in London. At the moment a mortgage is far cheaper than renting – but as rates rise that will correct a little.
Somehow we have to create decent rental accommodation at a cost comparable or below mortgages. After all, if you own a house you save money on accommodation, and you get all the upside from appreciation of the asset. Historically, housing has been a better performing asset to own than even stocks - so perhaps there is even a tax angle there, but one no sane politician would date to broach.
To make it happen we need to encourage public and private landlords with the where-with-all to build new quality rentals - and surprisingly this may be possible under current government polices announced yesterday such as privatising the Housing Associations. As this point regular readers will be in shock – “Blain praising the government? Pass the smelling salts”!
Insurance and pension funds will fund the assets - they know house are literally "safe as houses"! There is a clear role for Housing Associations to become even more important quality providers of rental/social accommodation.
The big risk is some political fool will decide to enhance their electoral prospects with some ill-conceived "right-to-buy" policy which will simply fuel expectations, drive up consumer borrowing, and fuel a boom market once more putting property out of reach for the masses.
Meanwhile, I suppose we should be worrying about the fact Merkel still can’t put a government together, the fact it’s now pay to get out of jail in Saudi, and all the other noise. Will anyone be listening to Theresa Maybe in Brussels today?
PD2: Se está perdiendo la costumbre de valorar los pequeños detalles. No te digo lo de comprar a la gente cosas, sino en el día a día, evitar que con nuestras actuaciones, se moleste a los demás. Te pongo ejemplos muy tontos: cerrar la puerta sin hacer ruido, caminar sin que resuene todo, distraer al concentrado, saber esperar para preguntar, dejar todo recogido, desayuno, cuarto, ducha…, sonreír al que te habla, saludar al que t encuentras… Hay miles de cosas durante toda la jornada que debemos tratar de hacer mejor.
