Stall Speed

The Fed’s foot is on the gas but the economy is losing altitude

Photo by Richard R Schünemann on Unsplash

Investors have gone all-in on the bet that the Fed and its central banking colleagues abroad will be successful in turning around a slowing global economy. The melt-up in the S&P since early last month is like Wall Street’s version of pushing your chips to the middle of the table. It’s not really surprising seeing that in October the Fed, the Bank of Japan, the European Central Bank and the People’s Bank of China all expanded their balance sheets for the first time in more than two years, giving the markets a massive shot of adrenaline.

As far as actual economic results, there aren’t many green shoots to be found around the world. Last week the U.S. reported unimpressive Industrial Production and Retail Sales numbers, dragging the Atlanta Fed’s widely watched U.S. GDP tracking model down to just a 0.4% pace for the current quarter. See https://bit.ly/2r3ifvH. China also had poor production and sales results. Japan’s economy is growing at only 0.2% and Germany just barely avoided recession with a 0.1% growth rate. Not an encouraging picture.

Given all the monetary firepower that the central banks have deployed over the past decade, they don’t have much to show for it. But the thing that sticks out to us, and the real threat to the global economy is pictured in the chart below. Despite the appearance of policy success as reflected by rising equity prices, corporate bond defaults are actually increasing. If the policy was working, that wouldn’t be happening.

The Fed can’t stop the deterioration in credit. Chart courtesy S&P.

We have written extensively on the danger that a deteriorating credit sector poses for policymakers. (See Time to BBBe Careful). Recently the IMF raised a red flag on the state of U.S. corporate risk-taking and declining leveraged loan quality. See https://bit.ly/35m9DPL. They ominously predict that in the event of an economic downturn “corporate debt at risk of default would rise to $19 trillion, or nearly 40 percent of the total debt in eight major economies.” Yes, that’s trillion with a ‘T’. The IMF also noted that “surges in financial risk-taking usually precede economic downturns.

To say that this is potentially a massive problem is the understatement of the year. The market, in this case the corporate bond market, has officially become the economy. An explosion in global debt pushed by extreme central bank policies since the 2008 recession is a burden that steals from future growth, meaning that a simple economic slowdown carries not just cyclical but systemic risks of default. It is the Fed’s greatest nightmare. And they can’t allow it to happen.

Rather than seeing the Fed’s actions for what they are, an act of disaster prevention for the credit markets, many investors are taking the dynamic of falling rates as a cue to pile into riskier trades. There’s an unshakable faith that the Fed will allow no harm to come to them. It seems like a misreading of macro conditions to us, and an unwise strategy after a 10 year-long bull run, but for now the market obviously disagrees.

It’s gotten so crazy that even one of the world’s largest mutual fund companies is urging baby-boomers to lay off the stocks. According to Fidelity Investments, more than one-third of boomers (born 1944-1964, and entering retirement) have a greater than 70% allocation to equities, and one-in-ten were invested entirely in stocks. See https://bloom.bg/2pxjvXu. This has disaster written all over it when the market eventually turns.

We’ve long said that some enormous trading opportunities will present themselves at that point when the markets lose faith in the Fed and realize that current policies will fail to stop the rot. We’re not there yet, but it’s getting close. In the meantime take the market rally as a gift to raise cash, and stay long the front end rate complex.

VIX Cheap as Impeachment Threat Grows

Markets too complacent in face of political turmoil

Photo by Markus Spiske on Unsplash

Written September 24, 2019

Despite a lack of facts, Washington has been consumed by accusations that President Trump acted improperly in a phone call with his Ukrainian counterpart, with many claiming that it qualifies as an impeachable offense.  That conclusion may or may not be true.  More will be known after acting Director of National Intelligence Joseph Maguire addresses the whistleblower complaint that sparked the controversy before the House Intelligence Committee on Thursday, September 26.

Odds for Trump’s impeachment spiked yesterday on the betting market Predictit to 57%, the highest level this year.  This matches a growing number within the Democrat caucus that believe the president should be removed.

At the same time, the S&P is trading about 1% from record highs and the broad market’s primary fear gauge, the CBOE Volatility Index (VIX Index), is near the lower end of its range.  In short, a picture of complacency.

It’s hard to see how these two conditions are mutually compatible for very long.  One side is wrong.

The hallmark of the Trump presidency has been a bull market in stocks, and any threat to his tenure would almost certainly inject a level of uncertainty that would be reflected through lower prices. While it is unknown if he will be impeached, that outcome and any potential negative fallout in the equity markets presents the more favorable risk/reward trading profile. The bet is that the markets are currently underpricing the disruption and volatility that such an event would produce.

Even though the VIX appears subdued, price action is positive.  Since spring, the VIX has been tracing out a classically bullish pattern of higher highs and higher lows (see chart below).  As long as each prior low print holds, in this case, the September 19 low of 13.30, pullbacks are buying opportunities.

Chart courtesy Bianco Research, LLC
VIX Index. Long side an excellent risk/reward profile.

The Doctor is Calling

May 22, 2019

Copper is often referred to as the metal with a Ph.D. Because of its broad range of industrial uses, Dr. Copper has a well-deserved reputation as a predictive indicator for global macroeconomic trends.

Today’s break of nearly 1.5% is noteworthy but not exactly surprising as the trade war with China expands (see Huawei), impacting supply chains and hurting demand through higher costs. A survey by the American Chamber of Commerce in China revealed that a third of U.S. companies operating in China have either delayed or canceled investment decisions, and 41% of respondents were considering relocating (or had already relocated) manufacturing operations. See https://bit.ly/2YAac54 . This is huge.

What is surprising, however, is the ability of the equity markets to shrug off a major disruption in global economic activity and the potentially negative impact on corporate earnings. Volatility remains low, reflecting a belief that the Fed can control the outcome of the business cycle. Maybe they can, but as we approach the tenth anniversary of the current expansion that bet becomes less attractive.

If 2018 taught us anything, the credit and equity sectors can depart from weakening macro trends for only so long. Though copper began breaking down in June of last year the S&P essentially ignored it until October, but the adjustment was quick and ugly (see chart below.) A similar divergent scenario appears to be unfolding, this time made worse by intensifying trade-related pressures and leaving stocks increasingly vulnerable. The Doctor’s prognosis for the markets is not good.