Posts tagged Risk
Stop us if you’ve heard this one before. As the end of the year approaches, investor attention suddenly focuses, laser-like, on China’s financial system. Share markets stumble on the Chinese mainland and in Hong Kong, leading to excited chatter about whether the negativity will spill over from the world’s second-largest economy into the global markets and throw a spanner into what was shaping up to be a most delightful and stress-free (at least from the standpoint of one’s investment portfolio) holiday season.
It happened at the end of 2015, with the S&P 500 falling apart on the last two trading days of the year and continuing the swoon through the first weeks of the new year. The majority of broad-market benchmark indexes lost more than 10 percent – the commonly accepted threshold for a technical correction – before sentiment recovered and bargain-hunters swooped in to take advantage of suddenly-cheap valuations.
Minsky Says What?
Share prices on the Shanghai stock exchange have fallen about 6 percent since reaching their high mark for the year on November 22. Hong Kong’s Hang Seng index, with a proportionately large exposure to mainland companies, is down by about the same amount. The chart below shows the performance of the SSE and the Hang Seng, relative to the S&P 500, over the past six months.
Financial media pundits were quick to remind their readers of the “China syndrome” that played out, not only during that nasty month of January 2016 but also five months earlier, in August 2015 when Chinese monetary authorities surprised the world with a snap devaluation of the yuan, the domestic currency. It started to seep into the market’s collective consciousness that the phrase “Minsky moment” had been uttered recently in connection with China, drawing parallels to the precariously leveraged financial systems that fell apart during the carnage of 2008 (the late economist Hyman Minsky was known for his observation that prolonged periods of above-average returns in risk asset markets breed complacency, irresponsible behavior and, sooner or later, a nasty and sharp reversal of fortune).
Context is Everything
At least so far, fears of a reprisal of those earlier China-led flights from risk appear to be less than convincing. As the above chart shows, the S&P 500 has blithely plowed ahead with its winning ways despite the pullbacks in Asia. Now, US stocks have shown themselves time and again this year to be resoundingly uninterested in anything except the perpetual narrative of global growth, decent corporate earnings and the prospects for a shareholder grab-bag of goodies courtesy of the US tax code. But ignoring fears of another China blow-up is, it would seem to us, more rational than it is complacent.
For starters, consider the source of that “Minsky moment for China” quote; it came from none other than the head of the central bank of…China. Zhou Xiaochuan, the head of the People’s Bank of China, made these remarks during the recent 19th Communist Party Congress marking the start of President Xi Jinping’s second five year term. The spirit of Zhou’s observation was that runaway debt creation imperils the economy’s long-term health, and that is as true for China as it is for any country. In particular, Zhou appeared to be alluding to what many deem to be dangerously high levels of new corporate debt issuers (and speculative investors chasing those higher yields).
Working for the Clampdown
That message was very much in line with one of the overall economic planks of the 19th Congress; namely, that regulatory reform in the financial sector is of greater importance in the coming years than the “growth at any cost” mentality that has characterized much of China’s recent economic history. Following the Congress, the PBOC implemented a new set of regulations to curb access to corporate debt. These regulations sharply restrict access to one of the popular market gimmicks whereby banks buy up high-yielding corporate debt and then on-lend the funds to clients through off-balance sheet “shadow banks.”
These and similar regulations are prudent, but the immediate practical effect was to sharply reduce the supply of available debt and thus send yields soaring. The spike in debt yields, in turn, was widely cited as the main catalyst for the equity sell-offs in Shanghai and Hong Kong.
If that is true, then investors in other markets are likely correct to pay little attention. China does have a debt problem, and if the authorities are serious about “quality growth” – meaning less debt-fueled bridge-to-nowhere infrastructure projects and more domestic consumption – then the risks of a near-term China blow-up should decrease, not increase. Stock markets around the world may pullback for any number of reasons, and sooner or later they most probably will – but a three-peat of the China syndrome should not be high on the list of probable driving forces.
There has been considerable chatter over the last week or two by observers and participants in the junk bond market. Prices for HYG, the iShares ETF that tracks the iBoxx US high yield bond index, started to fall sharply at the beginning of this month and continued through midweek this week, when investors mobilized for at least a modest buy-the-dip clawback. The chart below shows HYG’s price trend for 2017 year to date.
This performance has prompted the largest weekly investment outflows from the junk bond market in three years and sparked concerns among some about a potential contagion effect into other risk asset classes. It comes at a time when various markets have wobbled a bit, from industrial metals to emerging market currencies and even, if ever so briefly, the seemingly unshakeable world of large cap US equities. Is there anything to the jitters?
Pockets of Pain
We don’t see much evidence for the makings of a contagion in the current junk bond climate. First of all, the pain seems to be more sector- and event-specific than broad-based. While junk spreads in all industry sectors have widened in the month to date, the carnage has been particularly acute in the telecom sector (where average bond prices are down more than 3 percent MTD) and to a somewhat lesser extent the broadcasting, cable/satellite and healthcare sectors. The key catalyst in telecom would appear to be the calling off of merger talks between Sprint and T-Mobile, while a string of weak earnings reports have bedeviled media and healthcare concerns. High yield investors seem particularly inclined to punish weaker-than-expected earnings.
There gets to be a point, though, when spreads widen enough to lure in yield-starved investors from the world over. We have seen that dynamic already play out twice this year. As the chart above shows, high yield prices fell sharply in late February and late July, but were able to make up much of the decline shortly thereafter. So while pundits are calling November the “worst month of 2017” for junk debt, they are somewhat facetiously using calendar year start and end points that obscure the peak-to-trough severity of those earlier drops. We still have the better part of two weeks to go before the clock runs out on November, which is plenty of time for buy-the-dip to work its charms.
Bear in mind as well that there is very little in the larger economic picture to suggest a higher risk profile for the broader speculative-grade bond market. Rating agency Moody’s expects the default rate for US corporate issues to fall in 2018, from around 3 percent now to 2.1 percent next year. An investor in high yield debt will continue receiving income from those tasty spreads above US Treasuries (currently a bit shy of a 4 percent risk premium) as long as the issuer doesn’t default – so the default rate trend is an all-important bit of data.
About Those Investment Grades
Meanwhile, conditions in the investment grade corporate debt market continue to appear stable. The chart below shows yield spreads between the 10-year US Treasury note and investment grade bonds in the Moody’s A (A1 to A3) and Baa (Baa1 to Baa3) categories. Baa3 is the lowest investment grade rating for Moody’s.
Investment grade spreads today are a bit tighter than they were at the beginning of the year, and much closer than they were at the beginning of 2016, when perceived economic problems in China were inflicting havoc on global risk asset markets. In fact, investment grade corporate yields have been remarkably flat over the course of this fall, even while the 10-year Treasury yield gained almost 40 basis points in a run-up from early September to late October.
Investors remain hungry for yield and the global macroeconomic picture remains largely benign. Recent price wobbles in certain risk asset markets notwithstanding, we do not see much in the way of red flags coming out of the stampede out of junk debt earlier this week. A spike in investment grade spreads would certainly gain our attention, but nothing we see suggests that any such spike is knocking on the door.
Three years ago, one could have driven a fleet of semitrailers through the open space between the 2 year and the 10 year US Treasury benchmark note yields. While there still is some distance between the two, it would be somewhat more amenable to a single row of Priuses (Prii?) passing through. As the chart below shows, the shorter term note, which is generally more directly responsive to Fed policy, remains very close to its five year high. The intermediate 10 year yield, by contrast, has meandered along a largely directionless trajectory.
Untangling Policy, Demand and Expectations
The path of shorter term yields, for which the 2 year note is a useful proxy, is not hard to understand. The Fed began to make noises about tapering its QE policy in 2013 and then moved to a regime of reasonably explicit forward guidance on rates in 2015, resulting in the first increase at the end of that year. Despite falling sharply during the turmoil of early 2016, the 2 year resumed its upward path as conditions settled down and the case for a steady, if not spectacular, pace of economic recovery settled in as the default narrative. One should expect short term yields to continue tracking upwards in the absence of a reversal of the Fed’s stated intentions to keep raising rates.
For much of this time, the 10 year benchmark marched to a different drummer. Foreign demand was a key determinant of the consistently subdued yields experienced over this time – a trend that confounded no small number of bond pros. Rather than breaching 3 percent, as many expected, the 10 year actually set an all-time low – as in “since the founding of the American Republic all-time low” – in the immediate aftermath of Brexit.
The November election and the emergence of the so-called “reflation trade” brought about a shift in expectations, such that both intermediate and short yields moved largely in tandem. This was, as you will recall, when the prevailing mindset among investors imagined dramatic changes to the tax code and a sweeping new program of public spending on infrastructure. The spread between the 10 year and the 2 year in the weeks leading up to the election was mostly below 100 basis points, and it has not strayed very far from that level since.
Mind the Gap
The question now, of course, is whether there is still enough oomph in those reflationary expectations to send the 10 year into higher territory with a resulting steepening of the curve. This would be the putatively logical case to make for one who still believes there’s an infrastructure/tax reform pony out back with the capability to deliver the economic growth bump (however short-lived that might be) that is the administration’s central economic talking point. This view would consider the recent string of so-so hard data releases (including today’s six-of-one-half-dozen-of-the-other retail sales and inflation results) to be temporary and primed for near-term growth.
On the other hand, if the gap narrows still further – if the spread falls back into double digits as short term rates inch up while intermediates hold steady or fall again – investor brains could fall prey to the dark sentiments of an flat or inverted yield curve. That outcome would likely serve as a validation for those opining that bond yields represented the “smart view” while equity valuations soared on little more than a wing and a prayer.
The $4.5 Trillion Dollar Question
In the midst of all this is one very important and highly unpredictable variable: when and how the Fed plans to begin drawing down the $4.5 trillion balance sheet it racked up over the course of three quantitative easing programs. Observers will pay closer than usual attention to the forthcoming release of the FOMC’s minutes (scheduled for May 24) from its most recent policy meeting, scouring the language for clues about their intentions. The conventional wisdom is that the Fed believes there will eventually come a time when it needs to take rates back to zero and possibly launch another bout of QE. Having the dry powder to launch such a plan will necessitate a meaningful balance sheet reduction in the meantime. The tricky part, of course, will be to pull of this maneuver without roiling asset markets in so doing. Given the preternatural calm prevailing in risk asset markets currently, any hiccup could turn into a negative catalyst. Fed members will need to be practicing their triple-axel techniques to pull this off.
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Over the past couple weeks we have been snooping around some of the contrarian corners of the world, to see what those folks not completely enamored of the “Trump trade” have been up to (Eurozone, Brexit, what have you). While we were away, all manner of things has gone down in Washington, often in a most colorful (or concerning, take your pick) fashion. But virtually all the chief planks of that Trump trade – the infrastructure, the corporate tax reform – remain stuck in the sketchbooks and doodlings of Paul Ryan and his band of policymakers, waiting to see the light of day. By this point in his first term, Barack Obama had already passed a $1 trillion stimulus bill, among other legislative accomplishments. Is there a point at which the band of inverse-Murphy’s Law acolytes begin to question their faith that if something can go right, it will? To put it another way, does political risk still matter for asset valuation?
“Vol Val” Alive and Well
If there is a political risk factor stalking the market, it appears to have paid a call on J.K. Rowling and come away with a Hogwarts-style cloak of invisibility. For evidence, we turn to our favorite snapshot of trepidation and animal spirits – those undulating valleys of low volatility occasionally punctuated by brief soaring peaks of fear that make up the CBOE VIX “fear gauge,” shown in relation to the price performance of the S&P 500.
Since the election last November, market volatility as measured by the VIX has subsided to its lowest level since the incredibly somnambulant dog days of summer in 2014. In fact, as the chart shows, the lowest vol readings have actually occurred on and after Inauguration Day (so much for that “sell the Inauguration” meme making the rounds among CNBC chatterboxes a few weeks back). Meanwhile, of course, the S&P 500 has set record high after record high. How many? Sixteen and counting, to date, since November 9, or about one new record for every four days of trading on average.
That by itself is not unheard of though: the index set a new record 25 times (measured over the same time period) following Bill Clinton’s reelection in 1996. But 1996 was a different age, one with arguably less of the “this is unprecedented” type of political headlines to which we have fast become accustomed in the past two months. To a reader of the daily doings of Washington, it would seem that political risk should be clear and present. One of this week’s stories that caught our attention was the good times being had by London bookmakers setting betting markets for the odds of Trump failing to complete his first term (the odds apparently now sit around 2:1). So what gives with this week’s string of record highs and submerged volatility?
The Ryan Run-up
The “Trump bump”, of course, was never about the personality of the 45th president, or anything else that he brings to the table other than a way to facilitate the longstanding economic policy dreams of the Ayn Randian right, represented more fulsomely by House Speaker Paul Ryan than by Donald Trump. Looking at the rally from this standpoint perhaps explains at least in part the absence of visible political risk. So what, goes this line of thinking, if Trump were either to be impeached or somehow removed under the provisions of the 25th Amendment? Vice President Pence ascends to the Oval Office, the Twitter tornadoes subside and America gets on with the business of tax cuts and deregulation in a more orderly fashion (though not much infrastructure spending, as that was never really a Ryan thing). Move along, nothing to see here.
While we understand the logic behind that thinking, we think it is misguided, not least of all because – London oddsmakers notwithstanding – we think that either impeachment or a 25th Amendment removal from office are far out on the tail of any putative distribution of outcomes. We would ascribe a higher likelihood to a different outcome; namely, that political uncertainty will continue to permeate every sphere of activity from foreign policy to global trade to domestic unrest in a bitterly divided, partisan nation. So far we are muddling through – headlines aside, many American institutions are showing their resilience in the face of challenge. That’s good news. But not good enough, in our view, to keep political risk behind its Invisibility Cloak for much longer. We’re not prophesying any kind of imminent market cataclysm, but we do expect to see our old friend volatility make an appearance one of these days in the not too distant future.