“It is a mind-numbing exercise for investors who see the cognitive dissonance”: CIO at Guggenheim Partners.
By Wolf Richter for WOLF STREET.
This market has been an astounding experience for people who’ve traded through the prior stock market bubbles and the last three crashes, who’ve seen a national and several regional housing bubbles form and implode, who’ve seen the subprime-auto-loan Asset Backed Securities bubble blow up in the mid-1990s and again during the Financial Crisis, and now it’s starting to head the same direction again. But no one can remember ever having seen markets like these that have formed the Everything Bubble.
It’s a phenomenon where nearly all asset prices are inflated. It’s not a secret. There are signs all over the place. Yesterday, the government sold 30-year bonds at a yield of 2.06%, below the rate of inflation as measured by CPI (2.5%). The Fed is fixated on driving inflation higher. But to beat the current CPI with a little bit of a margin that might evaporate over the next few months, you have to take fairly big risks and go to the low-end of investment-grade corporate bonds, to BBB-rated bonds, which are just above junk bonds (here is my plain-English cheat sheet for the corporate credit rating scales), and their average yield is 2.96%.
Earnings growth has been lousy, for the companies that even have earnings. And one issue after another comes along, and markets just continue to inflate, and markets that normally balance each other out, with one going up while the other is going down, such as the bond market and the stock market, have been going up in lockstep.
And now comes the coronavirus. China’s and global reactions to it are in the process of taking down temporarily much of the second-largest economy in the world – with many factories and stores closed, with the transportation system partially shut down, with entire mega-cities locked down. US companies have started to announce that this will impact their revenues, their earnings, their supply chains, etc. Yet, nearly all markets have risen, bonds and stocks in lockstep.
This is a particular issue for money managers.
Money managers – at least those with some experience and open eyes – see this too. But they have to invest their clients’ money. They can’t just send it all back. And they can’t just put it in Treasury bills and earn less on them than they charge in fees. So what should they do?
They can lament, but they have to play the game. Scott Minerd, Global CIO at Guggenheim Partners, which has over $275 billion in assets under management, eloquently expressed his frustration with this puzzle, particularly the credit market, and particularly the high-yield segments of it, such as junk bonds and leveraged loans, that I have been marveling at for a while.
“The cognitive dissonance in the credit market is stunning,” he started out his letter to clients to put them into the mood.
“In the markets today, yields are low [bond prices are high], spreads are tight, and risk assets are priced to perfection, but everywhere you look there are red flags,” he wrote. “The latest red flag is the coronavirus.”
The reaction in China and around the world to the virus is whacking China’s economy. “Our estimate is that China’s Gross Domestic Product (GDP) growth for the first quarter could be slashed to -6% annualized,” he said. And given’s China’s size, it would slash global GDP growth by about 2 percentage points.
And the markets? They shine brilliantly, driven by “cognitive disconnect between current asset prices and reality.”
Here are some excerpts from Minerd’s lament:
“The average BBB bond yields just 2.9 percent. A recent 10-year BB-rated healthcare bond came to market at 3.5 percent and subsequently was increased in size from $1 billion to $1.7 billion due to excess demand.”
“For those investors who perceive the disconnect between risk assets which are priced for a rosy outcome and the reality of the looming risks to growth and earnings, any attempt to reduce risk leads to underperformance. It is a mind-numbing exercise for investors who see the cognitive dissonance.”
“The frantic race to accumulate securities has cast price discovery to the side. In the world of corporate bonds and asset-backed securities, issuers are launching deals and then tightening spreads to Treasurys by 25 basis points or more relative to where the last similar new issue was priced just a day before. They are also upsizing deals, as it has become common to see new issue bond underwritings ten times oversubscribed.”
“The giant flood of liquidity is driven by virtually every central bank in the world injecting reserves into the system.”
“And many investors today don’t even buy individual bonds, they purchase a basket of bonds that can be traded versus an exchange-traded fund (ETF). The quality of the bond doesn’t matter; no one is actually negotiating a rate or a price.”
“In the ETF market, prices are set by pricing services that frequently use stale data when no price discovery has occurred. The result is a non-market price determining where a security is trading and there is no additional price discovery, meaning nobody is negotiating individual bond prices. If it is in the index, buy it! This is what price discovery has become.”
“This will eventually end badly. I have never in my career seen anything as crazy as what’s going on right now. It was crazy in 2006 when I was pounding the table saying we were going to have a financial crisis of biblical proportions. And it was crazy in 1997, when high yield spreads got as tight as 239 basis points over Treasurys in October of that year, and then zigzagged their way higher for five years, until they peaked at 1,036 basis points in October 2002.”
“The coronavirus is just one example of exogenous events that could prick the bubble,” he said. But it could drag on “for another year or more” before the financial day of reckoning arrives.
“So what is an investor to do in an era of cognitive dissonance? Buy the highest-quality securities possible that reach some target threshold return. I accept the fact that we may be investing money at levels that don’t make sense, but we invest for the long-term and to preserve capital, and as the cash flows in it must be spent.”
“We are either moving into a completely new paradigm, or the speculative energy in the market is incredibly out of control. I think it is the latter. I have said before that we have entered the silly season, but I stand corrected. We are in the ludicrous season.”