Michael Jackson called it moonwalking, Cab Calloway called it backsliding and President Trump called it a secret agreement with Mexico. The danger creates the illusion of walking forward while actually moving backwards.
Hours after the Bureau of Labor Statistics announced that the US had added only 75,000 new jobs during May, the Administration announced that it would not impose punitive tariffs on Mexico after all. On Monday the president waved what he called a secret agreement with Mexico in front of the press. The Washington Post reconstructed much of the text from a serendipitous photograph, and it contained no such thing.
Sadly, the president isn’t fooling anyone. The market bid up the peso and American stocks. The question is whether the president will do something similar to China.
The peso’s recovery explains part of the S&P’s surge. The rest is explained by expectations that the Federal Reserve will cut interest rates. The expected federal funds rate 12 months from now fell from about 1.9% to 1.6% during June as the market digested a nearly unbroken diet of bad economic news.
The market’s guess for the Fed’s overnight rate a year from now stands at around 1.6%, compared to a present fed fund rates of about 2.375%. The Federal Reserve usually takes its lead from the market, fearing that a failure to meet market expectations would deliver a negative shock.
Leverage has been the lifeblood of the US stock market since the Fed began quantitative easing after the 2008 financial crash. S&P 500 companies bought back US$3.9 trillion in stock during 2014-2018, including nearly $1 trillion in 2018 alone, likely to be repeated in 2019.
The collapse of Treasury bond yields around the world has left institutional investors starving for yield, and the financial industry has responded by packaging leveraged loans (loans to companies with very high debt ratios) into $600 billion of outstanding collateralized loan obligations.
The ratings agencies claim that diversification increases the quality of the loan packages, but the opposite is true. The indiscriminate bid for credit to stuff into collateralized loan obligations has reduced the price of risk across all sectors, erasing the normal risk distinctions between loans with very different risk exposure.
My calculation shows that the price of risk in almost all the sectors of the high yield markets is now highly correlated with the index – a huge change from the state of affairs a few years ago. During the past three months, the correlation between index returns and returns to risk in every high yield sector from industrials to utilities was over 80%, and most were over 90%.
A particularly egregious case in point is the energy sector. Returns to spreads of high-yield energy bonds during the past three months showed a 90% correlation with the high yield index. The last time the oil price was this low, the correlation between high yield energy spreads and the high yield index fell to slightly more than 50%.
Equities like leverage. There is a positive correlation between equity returns and leverage among the members of the S&P 500 stock index. The correlation is low but the statistical significance is extremely high.
That is why PIMCO’s chief investment officer Scott Mather told Bloomberg last month that this is “probably the riskiest credit market we’ve ever had.” Mather was exaggerating somewhat. Back in 2007, the last time the structured credit machine turned inedible scraps of corporate credit into sausage on this scale, banks bought them with depositors’ money and 62.5X leverage. Most of the structured product before the great financial crisis came from home equity loans; now it comes from highly-levered corporations.
The difference is that institutional investors today pay cash for collateralized loan obligations, not money borrowed from depositors or from the money market.
As long as the Federal Reserve is ready to cut interest rates at every sign of market discomfort, the game can go on for quite some time. Between 2004 and 2006, then Fed Chairman Ben Bernanke raised the Fed’s overnight rate from 1% to 5.25%, before cutting it to zero after the financial crash.
The Fed’s mid-2000’s tightening helped to precipitate the financial crash. Fed Chair Jerome Powell won’t do any such thing. For one thing, CPI was rising at an annual rate above 4% during 2005-2008. Inflation remains subdued today for a number of reasons, including economic weakness.
The US economy is getting soggy, to be sure. The New York Fed’s Nowcast model puts second-quarter growth at just 1%, compared to the Atlanta Fed’s GDPNow model projection of 1.4%. That’s all the more reason for Powell to bow to market expectations and reduce interest rates aggressively. The equity market will like that.
What about the Trump moonwalk? The president was persuaded that the US economy was very strong and that the Chinese economy was very weak. In fact, US economic growth has dripped to barely above the zero line. Meanwhile, China has kept economic growth in the 6% range through a judicious mix of monetary ease, public spending and tax incentives.
A legion of industry leaders and private analysts is warning the White House about the disruption of global supply chains through the threat – let alone the actuality – of tariffs. Trump likes to play bull in the China shop, to coin a phrase. But this is the same Donald Trump that kept his reality show “Celebrity Apprentice” on the air for an astonishing 14 seasons, by devoting meticulous attention to data.
Trump followed the ratings in detail and acted swiftly to forestall any deterioration in his audience demographics. I continue to believe that he will act the same way on the current reality show, “Celebrity President.”
One risk not worth taking in the current environment is semiconductor stocks. The semiconductors led the market down today in the absence of other news, led by Micron (-4.5%). The ban on sales to Huawei has already hurt American semiconductor companies, but much worse is yet to come if the tech war continues.
As I have warned in several past articles, the tech war with China will lead to a nasty price war in the semiconductor sector. If I am wrong about equities, semiconductors will be first to suffer. I continue to recommend a barbell of highly conservative US stocks with stable cash flows and Chinese equities.