Fed QE is over for now but might not matter that much for a few months. Treasury crowding out last time showed up with a curve inversion and its a little hard to invert the curve at ZIRP, but anything below 40-50bps on the 10yr I would see as major warning sign. In fact any break below 60bps.
But other CBs still expanding so USD may slightly rise over summer?
In the short term today we had the quad witching and with VIX in low 30s and dealers rebuilding theta it should drop next week and technicals push the market higher. I would really like to see the VIX in the teens and CTAs fully long in the next move higher.
S&P might break through the resistance at 3214 which is the January low it was struggling with but normally you get a risk off in the summer holidays, then perhaps a bounce into election as both sides promise deficit spending, but then not make a new high while internals weaken.
Many other assets might not rally much from here. Look for a flattening TSY curve, reasonably supported USD and peripheral assets start to flatline.
In 1929 the market bounced for about 5 months after the initial sell off, and that was under a hard money standard with no QE.
I have no idea how many of the jobs losses will be recovered in 3-6 months but it will be far less than 100%, even 60-70% would be a borderline miracle and after that, it will be the slow grind that can take years.
After the election, Trump, who I assume wins, doesnt really need to care about the stock market, he has the real economy to worry about and he cant magic up corporate margins during the worst recession since 1929. Particularly when it becomes clear the recovery is drawn-out, defaults are picking up and Schumpeter comes back from the dead like the ghost from Christmas past.
Low rates, QE, fiscal deficits have forced institutions up the risk curve and down the liquidity one in this cycle and two of the worst areas, in my opinion, are LBOs and blue-chip CRE yielding 4-5%, particularly in 'Global Gateway Cities' like London which are so inflated ordinary people can't afford to live in them.
We were late-cycle before Covid hit. I don't actually think Covid is that big a deal if you are not vulnerable -we don't shut the economy down every Winter due to flu. But the lock-downs initially to stop ICUs being overwhelmed with otherwise survivable working-age patients, has now transformed into a huge recession and soon a solvency and default cycle.
So I think this year corporate margins will fall heavily and then not fully recover. Additionally, the demand for CBD office space will permanently fall. The exodus of ordinary people from Gateway cities will be accelerated etc. Potentially decades of change are being catalyzed by a few weeks shutdown and its aftermath.
So what should the impact be on these two popular LP plays, LBOs and blue-chip CRE?
LBOs have been done recently at 11-12x pro-forma EBITDA, late cyle, with more or less peak margins.
I present a few charts below from the prior blogs:
Longer run average after-tax
profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019, i.e. 5%
after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6%, from 8.7% in Q3 19, profits would fall 41%, after the recovery.
EDITDA is not as sensitive as after-tax profits, but let's assume a 41% profit drop equates to roughly a
30% EBITDA drop for an average LBO company.
Let's assume a recent LBO with
$1 of EBITDA was done at $11 enterprise value, financed with a $5.50
senior loan and $5.50 of equity. Then after a downturn the loan market
is only willing to finance LBOs at 8.5x EBITDA.
Using the $1 of current EBITDA,
this drops to 70c. At 8.5x the 70c EBITDA the company is worth just
$5.95. But the senior debt was $5.50, so the equity residual has fallen
to just 45c, vs the original LP commitment of $5.50; that's over a 90%
loss of equity driven by a fall in margins and a fall in mulitples.
So you would assume this would breach loan covenants and the deal would be toast?
But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not
blown up and the issue is more the amount of debt/ EBITDA, then the GP's
have a huge incentive to keep a bad deal alive.
Over 5-10 years, as nominal GDP grows, most companies should see
substantial revenue and therefore EBITDA growth, so by keeping a bad
deal alive, even if it involves drip-feeding more equity in after a
the downturn, it keeps management fees coming to the GP, a positive carry
option for the GP on recovery and avoids difficult conversations with
LPs, but all at the cost of the fund IRR and liquidity to the LP.
In conclusion, with the incentives and ability of the GPs to keep bad deals alive, this looks more like a land of the living dead outlook for LBO LPs.
The situation is broadly similar in blue-chip CRE.
With 4-5% yields recently and 7-8% post-GFC for several years. Land Securities in the UK predict a 20% drop in rent values as a function of remote working lowering overall demand levels.
Setting aside whether I think 20% is a big enough rent drop:
Building rent: $1
4.5% yield value: $22.20
60% LTV CM: $13.30
40% equity: $8.90
Building rent: $0.80
7.5% yield value: $10.70
60% LTV CM: Capital loss of $0/ -$2.60 if no Directors Guarantee
40% equity: -$2.60 if there is a Directors Guarantee
In a 50% debt, 50% equity capital structure the debt would still be under the water by $0.40.
This scenario ignores anything like skipped rents this year leading to non-payment of mortgages, rental drops of more than 20%, occupancy slumps, auctions changing hands for higher yields than 7.5% yield or Class B or C properties performing worse or going empty...
In conclusion, Commercial Real Estate looks more like a money heaven scenario - for existing investors.
So far in May its only really the Nasdaq that is up. So its a fairly narrow market post the April bounce.
The Corona shutdown fall out is starting to hit the headlines.
For example a Reuters report showed 10% of Spanish businesses closed in March.
If it creeps lower for now and then starts to sell off, people will panic sell and we could easily punch through the March lows.
This chart shows Business Loans in the US.
Prior to Covid they had fallen to almost flat YoY.
Business loans normally shrink in a recession.
But now they are growing almost 30% YoY.
That is debtor in possession type financing whether it is PPP type loans or revolvers being drawn, its debt (a liability and part of the capital structure) being used to cover lost cash flow (an asset and part of the current flow/ activity of the business).
Basically businesses are being bled dry and will have to drastically cut costs, which makes a second leg of contraction more likely than even a U-shaped stabilisation.
Additionally, some of the most hit areas like Casual Dining or Hotels will take a lot of time to get back to prior operating volumes, so are likely to be defaulting in Q4.
The PMIs suggest that global industrial output is collapsing. Global supply chains are part of this, but put simply if you have one part missing for a valuable product you cant produce it. Your output goes to zero. Thats worse than even 1929.
China ended their lockdowns starting 10th March yet by the end of April the Caixin PMI survey showed industrial output was still flattish/stabilizing, not recovering and supply chain disruptions were a key factor.
At the same time they are collapsing output, the governments via furlough schemes are trying to maintain demand via credit expansion...
Wiki has a short summary of how the 1929 crash unfolded.
After the initial selling took the Dow from around 380 down to just below 200 it then rallied from mid November 1929 to mid April 1930, about a 50% rally, recovering about half of the loss.
It then staged multiple further sell offs until 1933 as the credit cycle contracted and the recession deepened, but each one saw a rally after that revovered around half of the loss.
You can also see the equivalent of the Plunge Protection Team trying to prop the market up at the start.
Liaquat Ahamed's excellent Lords of Finance book does a great job describing the precursors to the crash - the Treaty of Versailles and the destabilisation of the gold standard that led to the roaring 20s and subsequent bust.
Yet what have we witnessed since 2008 except new Lords of Finance? Only these ones have a printing press while in 1929 the local money supply was determined by gold availability.
If the US 10 does go negative, given the Primary Dealers have to buy, even though the Fed has rates at zero, they will be negative carry and swamped with sales/ reverse repo/ Treasury new issuance.
Two key charts: US 10yr breaking out and equities just scuffed the bottom of the retracement target box I drew up based on prior bear market rallies:
In terms of the next leg down being on us now, we had the initial liquidity crack in March leading to a 1 month sell off. We then had a 1 month relief rally driven by technicals. Historically the next leg down should start pretty much now and take out the March lows and take place over a similar 1 month time horizon.
So looking at late last week this week so far:
Equities starting to roll over
USD index starting to break out
Yen and Euro showing signs of capital repatriation
US 10yr breaking out
Oil imploding into delivery
Gold fading the rally
High yield looking like its starting to fade the rally
So I looked through the Treasury TIC data on who owns what fixed income/ credit assets in the US.
The US has run a Current Account deficit this cycle of about $450bn a year, so around $5Tn cumulatively since 2009. A couple of points:
Someone had to fund that with their savings
The Gross funding data is bigger as US investors also buy assets abroad
Financials, especially banks own duration funded short term, in many cases the FX basis swap rolls every 3 months, so while in theory they can hold investment grade debt to maturity, in reality at least part of the funding needs to be rolled quarterly.
So since 2009 US GDP has gone from $14.45Tn to $21.4Tn or +$7Tn, +48%.
to June 2018 there has been about a $10Tn increase or 47% of 2019 GDP increase in
foreign holdings of US securities. Roughly 50/50 split equity and debt. The CA
deficit has been running at about $450bn a year on average.
Foreigner owned corp debt looks to have grown about 70% from $2tn to $3.4tn in 2018
Net position deteriorated:
Foreign holdings of Corp debt, $1.9Tn to $3.4Tn. So a 15% price drop would be about a $510bn margin call:
Held by the obvious holders:
In Corporate debt bank and financial debt is the most common holding:
They owned 28% of corporate debt:
Using the monthly TIC data, the EU and UK/ City has been two of the big cumulative funding sources:
Japan also bought bank debt and I believe this excludes CLOs/ loans:
Using the monthly data foreign holdings of US debt rose $1Tn YoY to January and US corporate debt holdings rose to $4.2Tn by January 2020. But foreigners have been Corporate bond net sellers since last August, ie since the US curve inverted:
Cross border data is a bit harder to get but the TIC data has some and the BIS also does.
The table below summarises what I understand is TIC data showing US bank to foreign financial firm USD repos; they have grown 200% in this cycle but collapsed 40% in 2008:
BIS reported cross-border bank lending has been growing over 10% recently, but shrank after 2008:
BIS US bank cross-border loans to non-bank financials:
US bank liabilities to Japanese entities:
So is one of the weak links US corporate debt, including US financial debt, held 3-month xccy basis currency swapped, by EU and Japanese banks and insurers, whose own balance sheets are leveraged 10-20x?
Perhaps, the data I could find is not that granular, but we know QE leakage from Japan and EU caused xccy FX basis spreads to widen out precisely because of this imbalance.
Seems like a 15% price drop is the equivalent of a $600Bn quarter end margin call. This might help explain the scale of the sell off of US investment grade credit in March. But I don't feel like the bottom is in yet. It does not feel like there has been enough forced selling or a big enough bankruptcy yet.
Either way foreign holders of US corporate debt have been selling since last August, and attracting a lot of net Treasury investment at near zero yields might be a struggle. The US has a $400bn pus CA deficit to finance. All of this points towards a much weaker US Dollar in Trump's likely second term.
I have had the view that at least since late March markets have been trading on technicals, not really even news flow. Question is when does QE induced technicals take a back seat to economic reality?
In the last couple of days equities and junk bonds have stopped rallying and traded around their Fibonacci retracement lines. While I do think there is a chance at a bit more upside for a few more days, most of the technical rebound had been had. Yet at the same time Treasury yields have broken lower and the USD has started to try to move higher again, which if it continues, I believe is the start of the next move lower, the proper liquidation event.
The next leg down I think is catalysed by the realisation there is no V-shaped recovery from Corona, that the lock down disruption will drag on a bit longer and that in Q2 going into Q3 we will see the peak pessimism on the outlook.
While the Fed can magically control a large part of the fixed income markets, in the end default and earnings expectations combined with a lack of market making capacity drive credit and equity valuations with exaggerated moves in both directions now part of the market normal.
In prior posts I have looked at prior shocks and recoveries and also prior bear market rallies. In bear market rallies only a partial retracement happens and it tends to happen over a similar time horizon as the sell off, in this case about 1 month. Well we are roughly a week from the start of the current bear market rally, the 23rd, so next week might be pivotal for risk assets.
US 10 year has broken lower from its wedge:
USD has broken higher from its short term wedge:
And is on medium term support and breaking higher:
Equities are a little short of the 3000 level/ 200 day MA/ 62% retracement but we still have a few days yet:
JNK which is a bit closer to the direct effects of QE is hovering around the 62% retracement:
If the compression of the US yield curve restarts QE repatriation, look out below:
The Fed has magically caused a recovery in investment grade credit. But ultimately it cant buy a meaningful amount of corporate credit directly unless the Treasury massively expands the recently created Secondary Market Corporate Credit Facility (which it will):
Here is a link to the note: Global Money Notes #29 U.S. Dollar Libor and War Finance
I thought this Zoltan note was interesting. The Fed has basically fixed the plumbing in Treasury, Repo, OIS, FX swap markets. But that says nothing of IG corp credit or worse quality assets and we know the intermediation problems during risk off in credit. But the US has had about $5Tn in CA deficit funding this cycle and a lot of that is xccy QE leakage from EU, Jap, Asian banks and insurers who themselves are 10-20x balance sheet leveraged. I dont have data for how much corporate credit risk they hold but its not zero. I also understand that much of the FX hedges are done on a 3 month basis. So they are borrowing short and lending long and do have mark to market USD funding risk on the 3 month FX swap rolls (to my understanding).
As such I think the case for a renewed risk off is economic expectations deteriorating for Q3 over the coming weeks, and some initial selling cascading into a stop out run from the top with IG being liquidated and that spreading out into higher risk assets.
After that the Fed/ Treasury will be under pressure to do much more in IG credit, probably via a much bigger Treasury backstopped corporate credit vehicle. It will probably have to be $1Tn or so in promised size, the existing SMCCF has only $25bn in equity from the Treasury, so that would need to be upsized 5-10x I think.
I would have thought the USD index and 10yr yield would get wind of this in advance. So far US 10 yr has gone sideways this month, more or less, but is developing a breakout wedge formation and USD is on a big support line and should bounce if its risk off. The Yen might also start to move if the US 10yr breaks 60bps on the downside to yields.
Nevertheless, in the meantime equities can probably try for the 3000 mark on the S&P as Trump tries to map out a reopening of the economy and then declares total victory.
The next leg down, which I assume starts late this month or in May... we should see what floats to the surface in terms of big, realised, end of cycle losses.
I think the next leg down will be driven by a mix of the corp cycle and leveraged xccy carry holders of IG fixed income being stopped out. Primarily I think Japanese and EU banks and insurers. That is the real weak link, the sub-prime of this cycle; large quantities of overpriced assets held by weak holders. Some of the assets they own lost 10-12 years of carry in points loss in March before many of these areas started to rebound. But I think they will resell off again in the next sell off.
As the market sells off and these investors start to stop out, it will force people holding BBB, HY or Equity to sell as well.
So Raoul Pal's USD wrecking ball view, while somewhat true for Emerging Markets facing a trade shock combined with USD liabilities, isn't quite that for Developed Markets. In DM it is instead the Eur and Yen rallying as QE leakage is stopped out and repatriated and the wrecking balls smashes asset markets downwards from the top. Remember the banks and insurers are typically 10-20x leveraged to their own equity.
So what QE giveth, QT taketh away and it never seemed to do all that much for the real economy anyway.
As Chaucer said, 'now up, now down, like a bucket in the well.'
The self-inflicted recession of Q3 coming up. S&P hasnt quite figured it out yet, but should sometime later this month or early next and drive the next, liquidation phase.
If Trump can get a truce on the oil war (since writing this he tweeted a deal with Russia and Saudi) and oil up to $45 or so that would help HY credit and probably help the S&P upside bounce for a couple more weeks. But after that reality should set in.
And per this doctor, the all societal lock down is basically unnecessary.
We have another case of supposed experts, with their claims and projections propagandised by a failing media Fourth Estate, all talking their book with an eye on research funding/ ad revenues and distorting public policy at great cost to everyone else.
The continued and repeated failure of leadership by career politicans with little knowledge, experience or confidence outside of their narrow world is a disaster.
The true Corona mortality rate will be a fraction of 1% once ARDS patients (young people dying of their own auto-immune response that can be treated with HCQ, zinc, anti-virals and zpack) & those already dying of chronic illness are excluded from the numbers.
Most of those <1% fatalities will be retirees with existing health conditions. Certainly they should self isolate.
The bulk of the 2008 sell off happened from early September to mid-November, so about 2 1/2 months, followed by a month and a half relief rally and a further sell off in Q1 for about 2 months until the market turned in early March.
This 2020 crash seems to be happening at least 2x as fast. We have had a major sell off and then a partial recovery all inside 5 weeks. So when might the next leg down come? This faster process might put the second sell
off in May or even late April with a bit more upside consolidation/ hopium first if the Corona numbers improve as the weather warms and the shut downs work and markets look for better economic data in Q3. I had thought that the 200 day MA at about 3000 could be a target but a 50% retracement would be nearer to 2800 and is perhaps more realistic a target. A second leg down over the course of about a month would take the total fall to about 45% would put the S&P in the mid-1800s by the end of June. This is a similar level of drop to the 2000 and 2008 crises.
However as the reality of a typical corporate recession and retrenchment sets in and as markets write off chances of a Q3 recovery (which seems to
be the great hope at the moment, plus Fed buying) then markets should sell off again.
The US economy was almost in recession before Corona and the oil MAD war, which Trump obviously wants to end.
the recession drags on then there can be more than one relief rally
followed by more disappointment. If you own a long term viable SME and need cash,
whats the quickest way to get it? Sell investments. The Central Banks
are bidding fixed income and some areas of IG credit, but there is no
buyer of last resort in risky credit or equities....
The example of the late 60s to early 80s also shows that equities sell off significantly when earnings fall double digits only to rally again as the cycle turns.
Trump possibly implementing a $2Tn infra stimulus later and the cyclical
recovery as Corona impact passes, I would hope would see a sustained
recovery later in the year, but the Democrat controlled Congress wont want to give too much away before the election.
So to wheel out that Chaucer phrase again: now up, now down, like a bucket in a well.
2008, One brutal sell off, one 25% or so bounce, another brutal sell off, then over:
2020 so far: a brutal one month sell off followed by a fairly quick rally:
2000: a more drawn out slump. The big sell offs were followed by 20-25% or so bounces and the smaller rallies were about 8-10% in size: