A Twitch of a Toe

In our recent update on credit spreads we proposed to use the seemingly deceased  Monty Python parrot Polly as a stand-in for the suspicion of creditors in today’s markets.  The question was whether Polly was indeed dead or merely in a deep coma. Depending on this, one should be able to gauge how powerful a miracle will be required to resurrect her.

 

Meet Polly. Is she alive?

 

In the first half of November there was actually a small sign that Polly is perhaps not completely dead just yet. Essentially one of her toes could be seen twitching a little bit. In short, credit spreads started to widen, eventually challenged nearby resistance, but failed to overcome it.

 

US junk bond spreads – the red lines represent the lateral resistance area that needs to be watched. In early November it was challenged for the third time since the sideways move began. As we have discussed previously, historical data suggest that when junk bond spreads become extremely compressed, a move above nearby resistance that is sustained after a retest is all it takes to trigger an avalanche – click to enlarge.

 

There is no cause for alarm yet, as resistance has obviously held – but past examples of similar situations suggest that it won’t take a great many tests of resistance before a breakthrough actually happens. In other words, it is time to pay close attention.

It is worth noting that there was no obvious “reason” for the recent move. The ECB’s announcement in late October that it would run its printing press at half-speed from the beginning of next year and offset that (once again) by letting the purchase program run longer than originally planned, was seen as dovish by the markets – spreads initially tightened further. They only began widening about a week later. The way we see it is as follows: once spreads begin to move sideways at an extremely compressed level, the distribution phase is underway.

As an aside, keep in mind that junk bond yields were never lower in absolute terms. It is a good bet that the “smart money” is busy selling to those who erroneously think European junk bonds shouldn’t yield more than US treasury bonds. Here is what happened with credit spreads in the euro area:

 

Euro area junk bond spreads tested initial resistance as well, which has also held for now – click to enlarge.

 

Lastly, spreads on the lowest-rated junk bonds corrected the most and actually breached initial resistance briefly. Note that they have already diverged bearishly from the rest of the junk bond universe this year on several occasions, by making higher lows concurrently with spreads on higher rated junk bonds reaching new lows for the move.

 

Spreads on US junk bonds rated CCC and lower – there is a subtle difference in the behavior of these spreads and those on better rated junk bonds. From experience we know that such subtle signals in retrospect often turn out to have been important – which is why we prefer to discuss them sooner rather than later – click to enlarge.

 

While these spreads have also moved back below the upper bound of the initial resistance area since then, the fact that they briefly peeked above it represents yet another subtle warning sign.

We should point out that in the euro area, other types of bonds have either not corrected at all, or have already fully recovered from the recent correction (mainly covered bonds and unsecured bonds issued by banks), but problems always begin in specific areas of credit-land.

 

Relying on Investor Confidence

In the US, the growth rate of bank lending to businesses has declined sharply from roughly Q4 2016 to Q1 2017 and has remained utterly anemic ever since. Growth in total corporate liabilities has decreased at a much slower pace. In absolute terms, corporate liabilities actually keep growing in almost linear fashion (approximately averaging $250 billion per quarter since 2014), so the mild decline in their year-on-year growth rate is essentially just a base effect.

 

Total US corporate liabilities (bank debt, outstanding bonds, lease obligations, etc.) essentially keep rising linearly in recent years. Since the trough at $12.90 trillion at the end of Q4 2009 they have grown by more than $6 trillion to $19.16 trillion as of Q2 2017. The growth rate initially accelerated after the GFC, peaking at 8.13% in Q2 2015.   Since then it has slowed to 4.53% as of Q2 2017, but in absolute terms the increase amounted to roughly $1 trillion per year since 2013. A large chunk of this money is used for stock buybacks and dividend payments, i.e., financial engineering. This boosts “per share” earnings growth at the cost of impairing balance sheets. In many cases the latter consequently tend to be at their most vulnerable at the worst possible time  – click to enlarge.

 

The conclusion is that companies have merely altered their funding mix by increasingly replacing bank loans with capital market debt, while continuing to expand their overall debt levels (the most recent y/y growth rate of corporate liabilities stood at 4.53%, compared to the far more anemic 1.07% annual growth rate in C&I lending by banks).

However, this type of lending does not boost money supply growth. The money supply can only grow if A) commercial banks create new deposits of uncovered money substitutes by engaging in inflationary lending, or if B) the central bank directly monetizes debt securities held by non-bank entities by purchasing them with money it creates literally from thin air or C) a combination of the two methods.

When non-bank investors increase their lending to companies by buying more of their bonds, the money supply is not affected at all. The implication for the current situation is that companies have become more dependent on the fickle confidence of investors, just as a sharp slowdown in money supply growth practically ensures that economic activity and corporate earnings will come under pressure fairly soon.

 

The Calm Before the Storm

So far neither economic data nor the yield curve show any convincing signs that a turning point in economic activity has been reached. However, the flattening of the yield curve has accelerated in the course of this year, which typically happens as the peak of a boom is coming into view. Recently there was a lively bounce in the 10yr. minus 2yr. treasury yield spread, but this does not yet represent evidence of a major turning point – it is far too small for that at this stage.

Every such bounce should be closely watched though – as we have mentioned on previous occasions, Japan’s experience indicates that once a ZIRP regime has been instituted, a full inversion of the yield curve is no longer a sine qua non precondition for economic downturns. Usually a noticeable flattening of the yield curve followed by a sharp reversal toward steepening seems to suffice.

 

The 10yr. – 2yr. spread as a proxy for the steepness of the yield curve. Flattening has accelerated throughout this year, but there was an upturn very recently – whether it is meaningful remains to be seen (note: meaningful reversals tend to be followed by  relentless steepening) – click to enlarge.

 

The next chart illustrates why we refer to the tranquility in economic data as the “calm before the storm”. It shows an overlay of the y/y growth rate of the broad true US money supply (TMS-2) compared to the Wilshire total market cap index.

 

Annualized growth rate of the true US money supply (TMS-2) compared to the stock market (Wilshire total market cap index). The final blow-off phase in asset bubbles typically coincides with a sharp slowdown in money supply growth. The lagged effects of the preceding inflation of the money supply continue to play out, while investors increasingly throw caution to the wind due to the persistence of the uptrend in asset prices – click to enlarge.

 

Typically we will see asset bubbles expand in accelerated fashion just as the most important prop shoring them up is taken away. The various effects of both accelerating and slowing money supply growth always arrive with a lag, but they  most definitely will arrive. In a way it is actually quite funny that investors tend to become most enamored with stocks just as a painful reminder of why they are sometimes called “risk assets” is basically lurking just around the corner.

Note that there is nothing anyone can do to prevent the lagged effects of the recent slowdown in money supply growth from playing out – and given that the sharp decline from the last interim peak in the y/y growth rate of TMS-2 started more than a year ago, economic activity and asset prices could easily begin to founder at any moment.

One should keep in mind that the specific historical circumstances characterizing the current era are quite unique, mainly due to the systemic bankruptcy revealed by the 2008-2009 GFC and the monetary policy experiments conducted by major central banks since then in order to paper it over. The fact that the governments of most developed nations have concomitantly spent money like drunken sailors, amassing levels of debt not usually associated with peacetime is an unusual wrinkle as well.*

Economic laws are unchangeable and it is clear that money printing cannot increase the amount of real capital in the economy. Every boom built on the quicksand of credit expansion is destined to meet the same fate. Which concrete warning signals will emerge prior to the adjustment process is one of the things that are not necessarily cast in concrete though.

There is already some tentative evidence that things are likely to play out slightly differently in this respect compared to previous post WW2 era business cycles. Nevertheless, one should keep an eye on the most important traditional data-based signals – many of them will undoubtedly work the same way they always have.

 

Conclusion

We have recently focused on corporate credit spreads because we believe that corporate debt is the Achilles heel of the current cycle, just as consumer debt (including mortgage debt) was the Achilles heel of the previous cycle. Incidentally, we expect problems in sovereign debt to reemerge as well, but that will likely only happen once a bust is well underway.

Credit spreads and stock market valuations are the two areas in which the distortions caused by money printing are most obvious. We find it quite amusing in this context that awareness of “yield chasing” and the massive overvaluation of stocks and bonds is actually quite widespread, but investors still seem to be convinced that they will somehow escape unscathed this time.

The financial media are brimming with rationalizations day after day – in the face of bonds bereft of yields, and a Shiller P/E ratio (or CAPE) that has finally streaked to a mere sliver below the manic level attained at the 1929 peak (it currently stands at roughly 31). Elevated risk appetites can trump concerns over valuations for extended time periods, but the combination of extreme valuations and slowing money supply growth is sooner or later invariably fatal.

The investor class as a whole can definitely not escape the consequences of the boom-bust cycle. Only very few investors will actually manage to avoid painful drawdowns by selling in time, after which others will take losses in their stead. All stocks and bonds (and bitcoins for that matter) are owned by someone at all times, regardless of whether their prices are rising or falling; securities don’t become mysteriously unowned when they are traded.

If one wants to be among those who manage to board the limited number of life rafts in good time, one has to leave the party while the supply of greater fools is still ample. Credit spreads were very useful for assessing the state of the pool of greater fools** in the past; it is a good bet that they will continue to serve this purpose. That is why one should not lose sight of Polly’s recently twitching toe. Once the darn bird is fully awake and squawking, it will be too late.

 

Polly lives, even if she looks a bit tattered.

 

 Charts by: St. Louis Fed, StockCharts

 

Footnotes:

 

* Note in this context is that historical post-war environments were often marked by significant economic deregulation, as the command economy structures adopted during the war were cast off (the aftermath of WW2 is particularly instructive in this regard, obviously with the exception of the countries that became part of the Soviet sphere of influence).

Currently one gets the exact opposite impression: there is a noticeable trend toward increased regulation and political centralization, coupled with ubiquitous surveillance and the promotion of ideologies and political programs opposed to free market ideals (and individual liberty more generally). Largely apathetic populations don’t seem to care much, hence significant pushback is rare – and  when it occasionally emerges, it is often misguided and in support of even more restrictive policies (from Bernie Sanders to Syriza to Marine Le Pen, most of the politicians and parties attracting protest votes routinely seem to consist of dyed-in-the-wool central planners; typically they promise their supporters more free cheese, which they aim to generate by means of policies that have demonstrably failed whenever and wherever they have been tried).

Try to think of a single Western government that is planning to implement major deregulation measures, intends to cut both taxes and spending, unequivocally praises free markets and isn’t constantly proposing to meddle with the economy in some shape or form. It is disconcerting when the anti-free trade Trump administration is the only government in the developed world that seems to even consider cutting taxes and doing away with some regulations (even if its plans tend to suffer from assorted flaws).

 

** we are hereby trademarking the expression “pool of greater fools” ™  preemptively :)

 

 

 

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