Bearish signals: Yield curve flattens, spreads widen, China devalues as Fed prepares hikes
Yesterday I mentioned markers of economic and financial weakness that I believe show cracks in the facade of benign economic data out of the US and Europe. Today I want to briefly go through a few of these data points and highlight what they could mean in the context of a cyclical bull market in equities and broad-based growth in the developed economies.
The first point to make here is that I have been consistently bullish on both US and European growth outside of Greece. For example, on Europe, see my May piece on continued European growth and the Greek outlier in which I argue European growth would diminish leverage for Greece in the bailout negotiations with Europe. On the US, see my July post saying that US growth in 2-3% range is dollar bullish but EM bearish because of policy divergence. In sum, the US and Europe are doing reasonably well. And nothing on the immediate horizon changes the fundamentals at work within those economic zones.
But let’s talk about downside risks here. The fundamental issue from a macro perspective is that the US has now moved to a divergent policy regime that supports a strong dollar just as China has abdicated its role as global buyer for raw materials of last resort. I believe this combination will be the genesis of market dislocations and economic problems going forward and the markers of market stress highlight potential trigger points.
First, in bond markets, we have already seen a record $253 billion of long-dated issuance this year. That’s a record. Even Petrobras, a company I mentioned as a potential black swan in April, was able to get off a 100-year $2.5 billion issue. This is remarkable. Alberto Gallo at RBS gives a downbeat assessment to why we are seeing this anomalous environment:
Borrowers are taking out longer-term debt because yields are very low, and yields are very low because the market is pricing in a prolonged low growth, low inflation environment. Take corporates. If they believed the economic outlook was positive and markets were distorted you might see them taking advantage by borrowing cheaply and then using that money to invest. But you’re not seeing that. They are issuing the debt and using the money to buy back stocks.
There is something to Alberto’s musing regarding the lack of capital investment and the record buybacks. But my own focus here is on the risk this represents in an environment in which US interest rates are rising. Irrespective of whether growth is low, risk spreads are low. We’re not talking about a bid for safe assets here. These are riskier corporate bonds. And to the degree low growth turns to negative growth, we should expect those spreads to widen. Thus, I take the record issuance of long-dated bonds as a bullish assessment of the outlook i.e. a prediction of low but positive growth without a major recession. The risk, of course, is that we get both a strong US dollar AND a recession, increasing the cost of US dollar liabilities as well as increasing risk spreads.
And indeed risk spreads are already widening. Here’s how Bloomberg puts it:
As far as credit markets are concerned, U.S. stock investors have lost touch with reality.
That’s seen in the extra yield bond investors demand over Treasuries. The spread has expanded by 0.48 percentage point from a year ago, the most since 2012, even as the Standard & Poor’s 500 Index rallied.
While not without precedent, instances when anxiety in bonds didn’t seep into equities are rare. More than 70 percent of the time since 1996, as spreads widened as much as they have since April, the S&P 500 has fallen, with the average decline exceeding 10 percent, data compiled by Bloomberg show.
“This is something that sooner or later is going to impact the stock market,” said Russ Koesterich, global chief investment strategist at New York-based BlackRock Inc., which oversees $4.7 trillion. “Credit market conditions have not been benign and easy as where they were last summer.”
Bearish signals are flashing in a stock market where five years of earnings growth is at risk of ending and two industries account for all this year’s gains. Stocks just slid for the second week in three amid the worst selloff in cable-television and movie companies since the financial crisis.
Now, if we go back to the capex vs. buyback issue, we can see where a large degree of the divergence between bonds and equities come from. Since buybacks increase as the economic cycle advances, we should expect divergence near the end of the cycle, Stocks will be saying one thing because buybacks will be buoying equities ‘artificially’, while credit spreads will be sending a bearish signal. And while I believe this economic cycle has legs, I am only talking about the next 3 to 6 months. By this time in 2016, we could be in a completely different environment, The equities-credit spread divergence is a marker.
Second, the yield curve is flattening. Rates out to 6 months are increasing as the Fed signals it is prepared to hike interest rates. At the same time, long-dated yields are declining. A flattening yield curve — especially one that flattens due to both short-yield increases and long-yield decreases — is a signal of economic weakness. It says that, despite the Fed’s imminent moves, the economy is not strong enough to have those yield increases push out the curve beyond the first year. The signal is that the Fed’s hike campaign will stall as it meets a deteriorating economic environment.
Look at this on a month-over-month basis: we see the 30-year down 35 basis points, while the 6-month yield is up 15 basis points. That’s a flattening of 50 basis points – a compression in bank net interest margin that we should expect to lead to earnings weakness in financial services if it persists.
And let’s remember that while long-dated Treasury yields are declining, corporate spreads are moving in the opposite direction. That is a truly bearish signal.
Third, as the Bloomberg article notes, the behaviour in equity markets has become more erratic. Bloomberg notes that healthcare and consumer-discretionary stocks are leading the indices higher. Yet, at the same time, credit spreads in those industries have reached the highest levels since 2012. Since equities are a residual claim below bonds, when the market signals are divergent, it pays to side with the bond signal – which is risk-off at the moment. Bloomberg highlights a perfect example:
McDonald’s Corp. shares have climbed 2.9 percent since saying on May 4 that it would return as much as $9 billion to shareholders this year. S&P lowered its credit rating, citing the potential for rising leverage, and Moody’s Investors Service put its A2 rating on review for a downgrade.
Let’s also remember that equity market leadership has narrowed – another bearish signal. For example, in late July, the Wall Street Journal highlighted the fact that just six companies – Apple, Google, Amazon, Netflix, Gilead Sciences and Facebook accounted for more than half of the increase in market capitalization of Nasdaq Composite stocks. That’s an amazingly narrow level of leadership. This is occurring at the same time that the advance-decline line has fallen into negative territory, further confirming the narrowing of leadership.
Finally, if we look at currencies, the China devaluation is a bearish sign. It says that the Chinese government is so concerned about growth that they are willing to risk a political backlash in the middle of a heated and xenophobic Republican pre-election presidential primary campaign in the US. In terms of markers, I am most concerned abut Dollar-Euro because I believe the US and Eurozone economies are close in terms of potential economic growth in the coming quarters. And to the degree that the euro weakens against the US dollar, it would signal a destabilizing level of policy divergence despite similar economic trajectories. Euro-Dollar weakness means the US tightening campaign is becoming excessive and will destabilize emerging markets, commodities, and energy and shale producers. We already see the pain in Canada, where Stephen Harper has tacitly admitted to recession. For commodity-dependent countries, euro weakness means more Fed tightening and that means pain.
In sum, the near-term outlook for the largest two developed economy economic blocks is positive. But, the markers of financial dislocation and economic distress are growing. The Chinese move to weaken the Chinese currency assures us that the distress will grow.