29/11/17: Four Omens of an Incoming Markets Blowout

Forget Bitcoin (for a second) and look at the real markets.

Per Goldman Sachs research, current markets valuation for bonds and stocks are out of touch with historical bubbles reality: https://www.bloomberg.com/news/articles/2017-11-29/goldman-warns-highest-valuations-since-1900-mean-pain-is-coming. As it says on the tin,

“A portfolio of 60 percent S&P 500 Index stocks and 40 percent 10-year U.S. Treasuries generated a 7.1 percent inflation-adjusted return since 1985, Goldman calculated -- compared with 4.8 percent over the last century. The tech-bubble implosion and global financial crisis were the two taints to the record.”

Check point 1.

Now, Check point 2: The markets are already in a complacency stage: “The exceptionally low volatility found in the stock market -- with the VIX index near the record low it reached in September -- could continue. History has featured periods when low volatility lasted more than three years. The current one began in mid-2016.”

Next, Check point 3: Valuations are not everything. In other words, levels are not the sole driver of blowouts. In fact, per Goldman, valuations explain “less than half the [markets] variation since 1900.” But, when blowouts do happen, involving 60/40 portfolios “over the past century [these] amounted to 26 percent in real terms on average, lasting 19 months. It took two years to get back to previous peaks, on average.” And the problem with this is that there might be no firepower to fight the next blowout. “Central banks “might not be able or willing to buffer growth or inflation shocks.” They also face fewer options to ease monetary policy given low rates and big balance sheets.”

So to sum the above up: levels of market valuations are screaming bubbles in both bonds and stocks; investors are fully bought into the hype of rising valuations; and there might be a shortage of dry powder in store at the Central Banks.

Goldman’s team, predictably, thinks the likeliest unwinding scenario from the above will involve, you’ve guessed it… a soft landing.

Now to Check point 4:

Source: ZeroHedge

Observe the following simple fact: the rate of the ‘balanced’ portfolio appreciation in the current cycle is sharper than in the 2002-2007 cycle. And it is sharper, in cumulative terms (both nominal and real), than any other cycle in modern (post 1970s - end of Bretton Woods and stagflationary environments) period.

So the Check point 5 adds strong bubble dynamics to bubble signals of levels of out-of-touch valuations, investors complacency and risks to the Central Banks’ commitment.

This is, put frankly, ugly. Because all four components of a major market blowout are now in place. So while the froth might still run for some weeks, months, quarters, … and may be even a year or two, the longer it runs, the worse the fallout will be. And the fallout is coming.

17/6/16: Credit markets on the ropes?

In their research note, titled aptly “Credit Metrics Bode 1ll”, Moody’s Analytics produced a rather strong warning to the corporate credit markets, a warning that investors should not ignore.

Per Moody’s: “The current business cycle upturn is in its latter stage, aggregate measures of corporate credit quality suggest. The outlook for the credit cycle is likely to deteriorate, barring improved showings by cash flows and profits, where enhanced prospects for the latter two metrics depend largely on a sufficient rejuvenation of business sales.”

In other words, unless corporate performance trends break to the upside, credit markets will push into a recessionary territory.

“Recessions materialized within 12 months of the year-long ratio of internal funds to corporate debt descending to 19.1% i n Ql -2008, Ql-2000, and Q4-1989. As derived from the Federal Reserve's Financial Accounts of the United States, or the Flow of Funds, the moving year long ratio of internal funds to corporate debt for US non-financial corporations has eased from Q2-2011's current cycle high of 25.4% to the 19.1% of Ql-2016.”

Moody’s illustrate:

Now, observe the ratio over the current cycle: the peak around the end of 2011-start of 2012 has now been fully and firmly exhausted. Current ratios sit dangerously at 4Q 2007 and close to 1-3 quarters distance from each previous recession troughs.

The safety cushion available to the U.S. corporates when it comes to avoiding a profit recession is thin. Per Moody’s: “The prospective slide by the ratio of internal funds to corporate debt underscores how very critical rejuvenations of profits and cash flows are to the outlooks for business activity and credit quality. Getting profits up to a speed that will keep the US safely distanced from a recession has been rendered more difficult by the current pace of employment costs."

Here’s the problem. Employment costs can be cut back to improve profitability in a normal cycle. The bigger the cut back, the more cushion it provides. But in the current cycle, employment costs are subdued (do notice that this environment - of slower wages and costs inflation - is the same as in 2004-2007 period). Which means two things:

1. U.S. corporates have little room to cut employment costs except by a massive wave of layoffs (which can trigger a recession on its own); and
2. U.S. corporates have already front-loaded most of the risk onto employment costs during the Great Recession. Which means any new adjustment is going to be even more painful as it will come against already severe cuts inherited from the Great Recession and only partially corrected for during the relatively weak costs recovery period since then. 

Moody’s are pretty somber on the prospect: "As inferred from the historical record, restoring profits through reduced labor costs is all but impossible without the pain of a recessionary surge in layoffs. Thus, barring a recession, employment costs should continue to expand by at least 5% annually."

That’s the proverbial the rock and the hard place, between which the credit markets are wedged, as evidenced by the recent dynamics for both Corporate Gross Value Added (the GDP contribution from the corporate sector) and the nominal GDP:

Again, the two lines show steady downward trend in corporate performance (Corporate GVA) and slight downward trend in nominal GDP. In terms of previous recessions, sharp acceleration in both trends since the end of 4Q 2014 is now long enough and strong enough to put the U.S. onto recessionary alert.

Per Moody’s: "As of early June, the Blue Chip consensus projected a 3.2% annual rise by 2016's nominal GDP that, …signals a less than 3% increase by corporate gross value added. [This]... implies a drop by 2016's profits from current production that is considerably deeper than the - 2.5% dip predicted by early June's consensus. Moreover, as inferred from the consensus forecast of a 4.4% increase by 2017's nominal GDP, net revenue growth may not be rapid enough to stabilize profits until the second-half of 2017, which may prove to be too late for the purpose of avoid ing a cyclical downturn."

In other words, there is a storm brewing in the U.S. economy and the credit markets are exhibiting stress consistent with normal pre-recessionary risks. Which is, of course, somewhat ironic, given that debt issuance is still booming, both in the USD and Euro (a new market of choice for a number of U.S. companies issuance in response to the ECB corporate debt purchasing programme):

Just as the corporate credit quality is deteriorating rapidly:

You really can’t make this up: the debt cornucopia is rolling on just as the debt market is flashing red.

20/10/2013: Oscillator: Long and Short-run Cycles

Some months ago I gave a presentation at the Science Gallery on the topic of cyclicality in social and economic data. I focused on more philosophical issues and longer cycles. Someone just sent me the link to the video... http://www.youtube.com/watch?v=ChiVez1IlMc

FISCAL CYCLE: FROM NANOSECOND TRADING TO GENERATIONAL OSCILLATIONS