1 Big Idea: Signs of a 2018 top are everywhere

1 Big Idea: Signs of a 2018 top are everywhere

Last night’s weekly post got me thinking about the markers for the end of economic cycle top. It was the surge in M&A activity that did it for me. Take a look at this chart from Axios:

Mergers in first half

Source: Axios

Notice how pro-cyclical the data are. M&A activity is always pro-cyclical. And right now many key drivers are:

  1. Companies’ need to chase earnings growth through acquisition to bolster stock valuations after a long business cycle
  2. Companies moving into ancillary industries to chase that growth (in organic, non-M&A terms think of Uber with UberEats or Tesla with battery manufacturing) and justify valuation
  3. A relaxed anti-trust environment
  4. Private equity companies chasing deals at higher multiples with lower margins of error
  5. Defensive responses to threats by FAANG companies, particularly in the media industry

But think of some of the other things topping out that I mentioned last week in my post about the Goldilocks economy and recession worries:

    1. Nasdaq leading the charge in setting records. Suggests people are casing growth stocks, which is early-cycle behavior but also late-cycle as well.
    2. IPOs at a  record level. Very pro-cyclical
    3. PE funds raising money at record levels. They are not going to sit on their hands. This aids the rise in multiples and deal valuations. It is a big underlying reason for record M&A activity.
    4. Headline unemployment at 49-year lows. Unemployment rates are always anti-cyclical
    5. High quarterly and year-on-year GDP numbers in both real and nominal terms. For me, it is the GDP deflator estimate of 2.4% that is most worrying in terms of the Fed’s reaction function, not the 4.1% real GDP estimate.



Why this matters: It’s the Fed’s rate hike train. I have never seen the Fed start a rate hike train this late in the cycle without eventually overtightening. The rise in rates eventually feeds through to marginal creditors, taking them into Ponzi. When they start to miss, debt refunding dries up and defaults begin.

Now, one could argue that all of these contrarian signals could continue on their existing trajectory for some time or pause and gather strength again. But, for me, the M&A chart is the worrying bit. The surge in deal flow is very suggestive of end of cycle dynamics.

Counter-point: The shale bust caused deal flow to dip in 2016 and remain flat in 2017. The Fed’s tightening cycle could end up this way too in a best case scenario. That’s what the bulls are hoping.

2. Manufacturing costs could hurt earnings

One reason I mentioned watching for what Whirlpool says in its earnings report is that the manufacturing sector has been getting buffeted by higher costs. If you’ve looked at the ISM manufacturing index in the past few months, you know that the prices paid index is always the off-the-charts high number.

The Wall Street Journal is highlighting this in its earnings preview:

Manufacturers are booking more orders and delivering higher profits in a strong U.S. economy.

But investors are worried that the good times won’t last: Costs are rising at some of the biggest industrial companies due to tariffs and a super-tight labor market.

Upcoming earnings will indicate how much of a dent those pressures are making on the bottom line. This week, 3M Co. , Harley-Davidson Inc. and Whirlpool Corp. are scheduled to report.

Industrial stocks are down around 2% this year versus a 4.8% rise in the S&P 500. Some of the biggest manufacturers are leading the decline. Shares in Caterpillar Inc. have dropped 13% this year, while 3M is down 14%.

Why this matters: It goes back to Goldman’s comments about volatility this earnings season. The macro backdrop is really good and we should expect to see that in Friday’s GDP report. Yet, from an earnings perspective, there is cause to worry about the downside.

3. Differing views on yield curve flattening

I was early to the discussion about curve flattening, as I have been discussing it at Credit Writedowns since early last Fall, and predicted early this year that we would flatten to 25 basis points by mid-year. We’re there now.

But long-dated Treasuries have been oversold for some time. So, when we hit the 25 basis point level last week, we saw some mild steepening. This steepening could have legs, especially if the earnings season isn’t too volatile.

Why this matters: The US Treasury is about to issue over $100 billion in debt paper, mostly at the short end of the curve. And expect bets on curve flattening to proliferate, with most bets for some steepening. If earnings season is as volatile as Goldman thinks, the curve flattening will resume.

Deeper take: This Friday’s GDP number is important in terms of inflation and the Fed’s reaction to it. if the GDP inflation number is solidly above 2% in this report, we should expect the Fed to further move toward a consensus for four rate hikes in 2018. And that will cause the short end of the curve to rise.

4. Bond market liquidity is a concern

As this business cycle has played out, one concern that keeps popping up is liquidity. Flash crashes in the stock market are seen not just as a sign of the pitfalls of programmed trading but also of reduced inventory by dealers who make markets.

In bonds, the same worries are evident as well. Yesterday, the Wall Street Journal ran a good piece on this:

Many bonds around the globe are becoming harder to trade, prompting some investors to shift to other markets and raising concerns about a broad decline in liquidity.

The median gap between the price at which traders offer to buy and sell, a proxy for the ability to move in and out of markets quickly, has widened this year across European corporate debt and emerging-market government and corporate bonds, according to data from trading platform MarketAxess. Trading in some derivatives has picked up as traders pull back from bond markets they view as increasingly unruly and expensive.

Why this matters: I know from when I used to be in the markets that increasing bid-ask spreads are a marker of reduced liquidity. In panics, like the LTCM crisis of 1998, high yield bid ask spreads were ridiculously wide. And when you called to sell, often times the quote was just an “indicative” price, not an actual real buyer.

Right now, we are seeing bid-ask spreads widen in the emerging markets space. Liquidity in the Italian bond market is poor. And in European high yield, bid-ask is up 24% so far this year. Everywhere outside of the US, the markers of reduced market liquidity have been rising.

Deeper take: The US is in a go it alone mode in more ways than one. On the economy and monetary policy, US conditions are different than they are elsewhere. And this divergence will cause strain for US-dollar based debtors whose revenue streams are not dollar-based, particularly in emerging markets. I continue to believe we need to be watching EM and High Yield for early signs of market stress.

That’s it for today. Happy Monday.


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