Mind Markets Melting Both Ways

via morningporridge:

Stock Markets are staging a Melt-up! China and the US have agreed to roll back sanctions. Whoopee! Everything is fine and dandy.  No… it’s not. Might be time to hedge with some puts.

As stocks as soared, bonds suffered. Earlier this week I asked a number of clients for their predictions on markets in 2020 – one them replied: “ I am expecting to see a massive correction in the bond markets. 10 yr UST moving above 3%, 10 yr Bunds above 1%. Credit spreads blowing out and Stock markets falling 20 to 30%. The trigger? Perhaps a deal between Xi and Trump?” A coconut is on its way to that chap for his bond comment.

This morning we have most European bonds back in positive yield territory. (I note with some amusement Greece yields less than Italy!)  10-year Treasuries flirted with 2% yesterday – now at 1.90%.

There is massive danger is a reeling bond market.  If we see rising yields morph into a serious bond market meltdown, the melt-up in stocks could split and go rancid very quickly. Rising rates have massive negative implications for corporate credit and without the juice of further central bank easing – stock markets could well lose heart.

On the back of a “trade agreement”, the short-term reactive consensus is everything about global growth and the economy favours stocks through earnings growth potential.  I’d argue we are entering a more positive economic environment – even recent European numbers have been marginally less depressing than usual. But that means market participants have to be even more careful to understand what the picture is describing.  This is still a “Danger, Danger, Danger Will Robinson” Market

Any China/US “roll back the tariffs” agreement is merely an accommodation – it’s not a peace treaty.  Nothing is essentially resolved in the big picture or the details like IP or Huawei.  In terms of the effects on global growth:

  1. A trade war standstill and unwinding recent tariffs doesn’t even take us back to where we were in 2015.  It does mean there is plenty of room for a growth      spurt/catch-up which might flatter the real outlook on growth.
  2. There is a strong chance the tariff stand-down doesn’t go further. Xi does not trust Trump.  The loss of Kentucky and Virginia to the Democrats this  week was an interesting signal.  Trump knows he has to deliver economic strength, booming stock markets and sell pork and corn to ensure he wins Nov 2020.  Xi knows that. Xi can pull levers.
  3. Global growth prospects are not simply about Trade Wars. The Global economy is complex and changing.

The real global growth narrative is far more nuanced than just trade wars:

  1. Factor in policy mistakes like central banking monetary policy since 2008 – low rates fuelled financial asset inflation, but not real investment, while      political mistakes like austerity-spending imposed massive slowdown. End that repression, and a recovery in consumer wages and spending back to      pre-crisis levels could fuel a spending boom.  That’s a short-term positive.
  2. China growth dragged global growth in its wake. As China slows as its economy turns to consumption, the world slows with it.
  3. There is no growth driver to replace the scale of China – get used to slower for longer growth.
  4. Global Supply chains are changing – as China exports have fallen, Vietnam’s have exploded. Changing supply chains will take years to resolve – and will require corporate investment – which could struggle as companies struggle with leverage after years of debt-fueled buy-back bingeing.

While the current record stock market levels will be great news for investment managers trying to close out the year on a positive, the underlying picture is far more complex.  As always, look to the bond markets for the real danger..

In Bond Markets there is truth.  This is a story you need to read: Prime Time: debt investors should heed the lessons of Casino. The story is a warning about Fallen Angels – companies that tumble from BBB into junk. Withour covenants, there is nothing to stop Fallen Angels “priming” existing bondholders by layering new debt ahead of them, effectively subordinating them. Ouch.  I’ve warned a couple of times that even a modest rise in bond yields could trigger a new bond crisis.

Imagine what happens if even just a few BBB corporates crash out of investment grade into junk. They would be like the first few few pebbles tumbling down a steep slope.  Investors would be keen to exit these names, but find liquidity is difficult in a bear-phase bond market. These few pebbles become a cascade of rocks as investors try to pre-empt other names that might become Fallen Angels. Very quickly the rush to exit BBB names becomes a full Credit Market landslip as the whole Mountain-side of near-junk Corporate debt tumbles into the Ocean below – triggering a Tsunami of destruction across Markets. Ouch, indeed.

BBB debt has been the fasting growing part of the Corporate Bond market, and now accounts for 38% of total debt, according to one report from a major investment firm. They concluded: “The growth of the size of BBB rated debt outstanding is not simply a broad-based symptom of a suffering investment-grade market…  Active management of fixed-income investments can help avoid the bad actors and focus on issuers that have the balance-sheet strength to withstand a potential economic downturn.

Sadly, that’s not the way markets work. When the panic starts, everyone gets caught in the stampede for the exit. I fear a bond market liquidity event will just be the start..

 

 

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