Policy-induced market overvaluation is building, will end badly
It is now patently clear that US equity and corporate bond markets are overvalued. Much of the overvaluation has to do with low discount rates and the risk-on signal easy Fed policy has sent investors for over five years. Yet again, signs of weakness like falling profit growth are mounting. But the Fed is tightening as opposed to adding more stimulus as in prior lapses during this economic cycle. Therefore, a sharp market downturn at this cycle trough is increasingly likely.
Think back to 2010 and 2011 and 2012. The Fed had already dropped rates to zero and had provided huge levels of liquidity to beat back a financial panic. But the economy was still fragile in the US and globally. By April 2010, SocGen analyst Albert Edwards was telling us the “global economy was going to roll over in six to nine months’ time.” He said that was bearish for shares. Indeed, economic growth rates plummeted and shares swooned later that year. That’s when the Fed began QE2. And this put a floor under asset prices, allowing the tepid recovery to continue.
The very next year, the exact same events unfolded. And as I predicted in May 2011, a global slowdown hit by summer. But of course, the Fed stepped in again with its third round of easing in August 2011. Chastened by all the talk about expanding its balance sheet, the Fed opted for a different strategy, using forward guidance to anchor rate hike expectations as it changed the composition of its balance sheet instead of adding to the balance sheet. The results were the same, a weak recovery sustained by high flying asset prices.
Again in 2012, it was like Groundhog day. A weak recovery started to peter out. And the Fed moved back to stimulus. The Fed operated on four fronts: lengthening maturities, buying mortgage debt, extending zero rates for longer and leaving its buying open-ended – very aggressive. This is what I wrote a the time: “Central banks around the world are taking the lead on reflation where fiscal agents refuse to do so. And the policy stances have become increasingly aggressive. Right now, every major central bank is supporting domestic growth with very aggressive monetary and currency policy. In Europe, the ECB is doing “whatever it takes” by offering unlimited liquidity in support of periphery debt. In Britain, the Bank of England has repeatedly added liquidity in the form of government debt purchases despite above-target inflation rates. In Japan, the Bank of Japan is still in the midst of a decade long easing campaign as the economy fights deflation. In Switzerland, the Swiss National Bank has renewed its pledge to support the economy by pegging an upper bound on the Swiss France – Euro exchange rate, with unlimited intervention if necessary. This is the most aggressive monetary blitz the world has ever seen.”
So that is the history of this recovery. Now, 2013 was the first time when the recovery was strong enough that the Fed didn’t feel a need to add to stimulus. This is in part because the last stimulus campaign was so aggressive. Remember that QE3 was open-ended unlike the other campaigns which had ended before the next economic growth slowdown began. And also remember that the Fed wasn’t just buying Treasuries as it had in QE2 and operation twist. The Fed was also buying mortgage bonds as it had in QE1, the difference being that it was not supporting dislocated markets as in QE1. The Fed was simply trying to goose the economy to counteract the economic drag of tighter fiscal policy.
In 2013, the Fed actually tightened with its talk about tapering asset purchases in the spring and its actual asset purchase tapering in the fall. So, as we enter 2014, we see a tighter monetary policy. What’s more is that policy is getting tighter. The move from QE to forward guidance has always been about normalizing policy. But now the forecasts of the FOMC members shows a clearly hawkish tilt. Aggregate expectation are for rates at 1% by the end of 2015 and 2.25% by the end of 2016 given an aggregate expectation of between 5.5 and 5.9% unemployment by the end of 2015. That means that 6.0% has effectively become a trigger for rate hikes – the FOMC’s de facto target for when higher inflation expectations could become embedded in markets.
So we see a Fed that became more aggressive on monetary policy in 2012, pushing out expectations for rate hikes, lengthening maturities, buying up mortgage-related debt, and leaving an open-ended commitment to QE. This engendered a very pro-risk, pro-leverage mentality in the markets that led to sky-high equity prices and record low junk bond spreads. As the Fed tightens, we should expect this risk-on mentality to come under assault. And as it does so we will have to contend with it doing so at a time that earnings growth is declining as evidenced by this chart from Albert Edwards.
As I wrote on Friday, bond investors like Jeff Gundlach are de-risking now. He says, “there is interest-rate risk that’s just being masked by fund flows holding up the prices of junk bonds.” Junk has returned 148% since 2008, pushing the size of the market up to $1.97 trillion globally from just $1 trillion in March 2009 at the cycle trough. If you include leveraged loans, there was nearly $1 trillion in junk and leveraged loans issued in 2013 alone.
In terms of quality, it is poor.Average debt to EBITDA on leveraged loans in 2013 was 6.21, the highest since 2007 when the last crisis broke.
The average covenant-quality score for high-yield bonds in North America dropped to 4.36 last month from 3.84 in January on Moody’s five-point scale, in which 1 denotes the strongest investor protections and 5 the weakest.
As of Jan. 31, the share of loans in the S&P/LSTA Leveraged Loan Index without maintenance covenants grew to a record 50.04%, from 46% at the end of 2013. Clearly, financial covenants – once a hallmark of secured loans – haven’t been the norm for the new-issue market for some time. In January, 53% of new-issue institutional volume launched was covenant-lite, down from 68% in December.
Back in January, the US banking regulator warned of a bubble in leveraged loans. But the taper of asset purchases has hit the risk-on sentiment. In early February, junk funds lost assets. We should be watching for asset sales as a sign that this market has stalled. For now, I think investors remain complacent. If anything, the volatility in emerging markets caused some investors to rotate into junk and out of EM. In the three weeks to March 7, $3 billion more flowed into junk.
Despite the US regulator’s warning of a bubble, PIMCO is relying on the historically low default rates now prevailing at the top of the cycle. They had a piece out last month recommending “investors with low tolerance for volatility and more interest rate sensitivity may emphasize loans, while investors with greater risk tolerance and a more benign outlook for rates may look to high yield”. And banks issuing these bonds are resisting the regulator’s insistence on tightening standards. Even if the regulator steps in now, things are so far out of control, that this will end very badly.
Moreover, Claus’ post today points to a big disconnect between leverage and spreads as investors reach for yield. He put up the following chart
Claus notes that the net debt/equity vs. the quick ratio “is telling us that spreads and leverage are now disconnected” because higher debt correlates to lower liquidity while spreads belie this connection. Ever since QE3, spreads have been collapsing while Net debt to EBITDA has been rising.
Source: Citgroup, Matt King (March 2014)
That tells you that investors are reaching for yield.
I should note as well that the ABS sector is showing the same frothy signs with auto sales now slumping and inventories climbing. See my post on inventory builds and subpriming of auto market showing problems in US. Auto companies are heavily discounting to move inventory. Americans are still borrowing record amounts to buy cars though.
So the bond markets are marked by a pronounced collapse in spreads, driven by a flight from quality as investors reach for yield. But the real economy signs suggest we are at the top of the cycle where default rates are lowest and demand for product is highest. Smart investors are de-risking and moving toward safer assets.
In equities, cyclically adjusted P/E ratios using Robert Shiller’s methodology show stocks at 25.5x trailing earnings. If one looks at data going back to 1881, this is a figure 54% higher than mean. And a mean-reverting dynamic suggests that equities will have to underperform over the next 7-10 years in order to get that metric back in line. Indeed, this is exactly what value investors are saying.
Jeremy Grantham says the Fed’s actions, far from helping recovery, have hindered recovery:
It’s quite likely that the recovery has been slowed down because of the Fed’s actions. Of course, we’re dealing with anecdotal evidence here because there is no control. But go back to the 1980s and the U.S. had an aggregate debt level of about 1.3 times GDP. Then we had a massive spike over the next two decades to about 3.3 times debt. And GDP over that time period has been slowed. There isn’t any room in that data for the belief that more debt creates growth.
n the economic crisis after World War I, there was no attempt at intervention or bailouts, and the economy came roaring back. In the S&L crisis, we liquidated the bad banks and their bad real estate bets. Property prices fell, capitalist juices started to flow, and the economy came roaring back. This time around, we did not liquidate the guys who made the bad bets.
My interpretation of what he is saying is that when this excess is unwound, the damage to the real economy will be significant and it will cause the US to recover less than if the Fed had not propped up asset prices with easy money. But Grantham thinks the market will go higher.
We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market’s mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.
Grantham’s colleague James Montier says you need to de-risk and move toward cash now though.
When we look at the world today, what we see is a hideous opportunity set. And that’s a reflection of the central bank policies around the world. They drive the returns on all assets down to zero, pushing everybody out on the risk curve. So today, nothing is cheap anymore in absolute terms. There are pockets of relative attractiveness, but nothing is cheap or even at fair value. Everything is expensive. As an investor, you have to stick with the best of a bad bunch…we are slowly selling our high quality positions. We are by the way also reducing our overall equity weight gradually as this year goes on. We have already taken about five points out, and we are at 50 percent now. By the end of the year we’ll probably be at around 39 percent.
My conclusion here is that the Fed’s easy money has engendered a risk-on sentiment which has caused all asset classes to rise. We see that particularly in risky assets as investors leverage up, reach for yield, and take on risk. This has been favourable for junk bonds and equities in particular. But the winds are blowing in a different direction now. The Fed is tightening and signalling that it wants to raise rates. As the taper continues, the question will be: does the Fed blink, does the incoming data worry the Fed enough to push out its rate hike timetable? I think tapering is a done deal. The Fed will continue to reduce QE. But rate hikes are another story. In any event, none of this looks good from a value standpoint. Markets are well overvalued because of the excessive risk-on sentiment easy money has engendered. And a market pullback is likely to be severe when this cycle troughs. The longer the Fed delays, the worse the pullback will be.