In the HBO series Game of Thrones, based on the books by George R.R. Martin, the seasons do not run for regular intervals. Instead, summer can last for years at a time, with no clear indication as to when it will end.
The coming of winter is thus a very big deal (as it can also run for years). In this the weather of Westeros bears resemblance to financial markets. Bullish or bearish “seasons” can be measured in multi-year stretches. The shift from one season to another becomes a very big deal indeed.
It is our working thesis that the season has shifted for risk assets. Summer is gone; Winter is upon us. The time of being long and buying the dips has passed (except perhaps for USD). A time of shorting (selling into rallies) has arrived.
The reason why can be explained in the popular Wall Street language of “headwinds” and “tailwinds.”
A headwind is a macro driver or fundamental force that holds prices back. Think of a trench-coated man walking into a stiff gale — bent grimly forward, hat clapped tightly to his head.
A tailwind, in contrast, is like an ocean breeze filling the sails of a catamaran. It helps propel the boat forward.
Our core reasoning for a Summer / Winter transition is straightforward:
Ever since the 2008 financial crisis, central banks, earnings prospects, and economic recovery factors were all tailwinds for risk assets — helping to propel them higher. Now they are all headwinds — holding them back.
Let’s look at each in turn. First, central banks:
In the aftermath of the 2008 meltdown, central banks embarked on the greatest experiment in monetary history — one that is still playing out. The two biggest players here were the US Federal Reserve and the PBOC (People’s Bank of China).
While the ECB (European Central Bank) and BOJ (Bank of Japan) largely sat out, Fed and PBOC efforts were heroic. China’s stimulus was insanely massive in comparative GDP terms.
If you recall the data release trends of 2009, China played the role of macro Santa Claus. The news just kept on getting better. Premature bears lost their fur as massive stimulus had a salutary economic impact.
In the years that followed, a European sovereign debt crisis and earthquake in Japan gave markets temporary fits. But the Federal Reserve countered the damage with Quantitative Easing, and a laggard ECB eventually stepped up with Draghi’s “whatever it takes” promise.
During this time, risk assets enjoyed a sort of ‘endless bid’ support from central banks, via ongoing stimulus programs and near zero interest rates. But those happy days are now, finally, gone. In the third week of June 2013, “winter” arrived.
Consider the following, via Reuters:
September could be an opportune time for the Federal Reserve to consider scaling back its assets purchase, an influential official of the U.S. central bank said on Friday, as he stressed that the Fed must take a long view of economic progress and not be blinded by the most recent data.
The remarks by Fed Governor Jeremy Stein drew the attention of economists and investors after he ticked off several examples of improvement in the labor market since the Fed launched its bond-buying program last September.
Stein’s speech, and a separate one on Friday by Jeffrey Lacker, president of the Richmond Fed, had some parallels to efforts by other Fed officials earlier this week to soothe market anxieties about a pullback in the bond purchases.
Nonetheless, Stein and Lacker took a more aggressive tone on when the central bank’s unprecedented policy accommodation might be reduced.
September might as well be the day after tomorrow, as far as Mr. Market is concerned. If the Fed is really trying to “walk back” its tightening talk, it is doing a horrible job. Sentiment driven confidence in QE was based on maintaining a semi-fragile dreamlike state. Firm words and not-far-off timelines have sent that dream away.
The market is more or less a forward-looking mechanism. Anticipating the end of Fed coddling has given the market night terrors, as we noted last week.
But it is not just the Fed contributing to “the end of the innocence.” China has become a fearsome head wind too. Via Edward Chancellor in the Financial Times (emphasis ours):
China’s financial drama, we are told, marked a deliberate attempt by the authorities to restrict excessive credit growth and to establish sound banking practices. Once Beijing has gotten its way, the liquidity spigots will reopen and economic growth will resume. Yet credit crunches often mark the turning point in the financial cycle.
China’s financial system has long been careening out of control. Total credit had expanded by more than 30 per cent of gross domestic product every year since the global financial crisis. During April total credit issuance was up an extraordinary 59 per cent on the previous year. Li Keqiang, the new premier, has said that cheap credit should no longer be used to fund speculations. Banking regulators have been ordered to purge the financial system of dodgy practices.
Much recent credit growth has happened outside the bank system. Bank loans have been sold in the interbank market with covert guarantees against losses. Other bank assets have been packaged into trust loans or corporate bonds. These loans in turn are acquired by bank-controlled investment pools, known as wealth management products (WMPs). Many of these WMPs are kept off the balance sheets of the banks although it is widely understood that banks will make good any losses to investors. Such practices allow banks to keep below the mandated loan-to-deposit ceiling and avoid regulatory restrictions on bank leverage.
Informed China banking buffs, notably Fitch’s Charlene Chu, have been warning for years about the risks building up in the credit system…
What is happening in China now is downright frightening. To a certain extent it is not an exaggeration to say the entire Chinese financial system is built on a rickety infrastructure of falsehoods, ponzi schemes and lies. China’s shadow banking system has the potential to be Enron times a thousand. Chinese speculators have leveraged up on toxic derivative products of the same sort that drove the supbrime meltdown. China’s accommodative finance measures, once such a pleasant tailwind for global growth, could now turn into a headwind of Category 5 Hurricane proportions.
Full disclosure: We are short FXI from higher levels (after taking partial profits) and gladly remain so…
Moving on to earnings: The below chart (hat tip Business Insider) highlights a worrisome trend…
Let us again go back to 2009 — the immediate aftermath of the GFC (great financial crisis) as the Aussies call it — to see how corporate earnings are transitioning from tailwind to headwind.
At the start of 2009, corporate earnings had been destroyed… but the crisis itself also delivered great opportunity. US corporations were able to cut costs massively and fire great swathes of employees, in a brutal step toward heightened efficiency. The crisis itself acted as political cover for mass layoffs — these layoffs would have been politically unpalatable without a “survival emergency” rationale.
The dramatic impact of cost-cutting, coupled with very easy look-backs on a trailing twelve month basis, fueled a powerful tailwind that lasted for years. At the same time, near-zero interest rates and super-low corporate buying costs fueled 1) a force-fed rotation into equities and 2) a surge in corporate share buybacks.
But trees do not grow to the sky, and cost-cutting measures do not sustain record corporate profit margins forever. As Jeremy Grantham has observed, if corporate profit margins (on an aggregate basis) do not mean revert at some point, then capitalism is broken. The forces threatening to bring this about are clear: Less accommodative central banks, looming China crisis, and rising bond yields impacting business and consumer spending.
The rising trend of negative pre-announcements relative to positive ones tells the tale. Then you have nuggets like this, via Bloomberg:
Corporate creditworthiness in the U.S. is deteriorating at the fastest pace since 2009 with earnings growth slowing as yields rise from record lows.
The ratio of upgrades to downgrades fell to 0.89 times in the first five months of the year after reaching a post-crisis high of 1.55 times in 2010, according to data from Moody’s Capital Markets Group. At Standard & Poor’s, the proportion has declined to 0.83 as of last week from 1 a year earlier…
Nice while it lasted…
As earnings start to deteriorate (relative to high expectations) on the back half of the cost-cutting efficiency slope, a lack of faith in central bank rescue efforts could further fuel selling.
And then, finally, there is the US economic recovery itself.
Though the patient was ill, the drug cocktail made him feel quite good. Signs of real recovery, though, mean the patient can be weaned off the drugs at some point.
This “going off the drugs” is a necessary transition step toward full recovery, and someday leaving the hospital entirely.
But in the meantime, just as the loss of morphine makes the patient less of a happy camper the day he quits, a recovery-triggered stimulus scale-back will not feel pleasant.
We made another version of this argument last year, in a piece titled “What if Recovery is Actually Bearish.”
A real problem with economic recovery — a problem for risk assets at least — is the impact of rising interest rates. The US cannot heal without yields coming off a historic floor, which is bad for a whole class of equities that benefited from the “reaching for yield” phenomenon.
Utilities are a clear example of a yield-whacked area of the market. After being bid up to lofty levels by investors hungry for anything “safe” with a dividend attached, utilities took a real beating as the yield trade reversed. We took a chunk of multi-week short-side profits out of XLU and have since re-entered the trade, as there is likely further downside to go.
A strengthening US dollar is also a problem…
As we have argued before in these pages, the USD has probably long-term bottomed.
This is a strange concept to those stuck on knee-jerk “dollar is doomed” assessments that do not take into account structural shifts, but fits the reality of the situation: The United States is in much better economic shape than the rest of the world, and thus closer to ‘normalizing’ monetary policy than anyone else.
In other words, for which country (among the world’s largest economies) are yields and economic activity most likely to heal first? It’s the USA — which puts the dollar in a bullish position. Not only that, the trend of the US dollar as a “funding currency” to buy emerging market assets is now reversed. Capital that had previously flowed into EM is reversing out, with funds repatriating back into USD.
US dollar strength is not necessarily bearish for all risk assets. Domestic US equities, for example, can actually benefit from a strong dollar trend. But commodities and emerging markets are certainly negatively impacted. And there are also legitimate concerns over currency exposure on the part of the large money center banks, which have opaque and complex debt exposures in emerging markets. (When it comes to banks, small is beautiful these days.)
US economic recovery is driving the bullish dollar trend — the flipside of persistent weakness in China and Europe. Fiscal policy is even playing a role. Via The UK Spectator:
It is true that government debt has soared under Barack Obama — but that is consistent with the successful path that Scandinavian countries pursued in the early 1990s in response to their own credit bubbles. State spending propped up these economies while voters paid off their debt, and then the resurgence in private-sector demand allowed governments to balance the books. This appears to be happening now in the United States. The US federal budget deficit has declined more dramatically in the past three years than at any time in postwar history. The Congressional Budget Office projects the federal budget deficit to fall to 2.1 per cent of economic output by 2015 — an astonishing turnaround from the 10.1 per cent figure four years ago. By the same year, Britain’s deficit will still be at 6 per cent of GDP — the highest in the western world.
American manufacturing is also on a roll. Contrary to perceptions, US factory output has been robust and productive — the problem was that it had been haemorrhaging jobs over the past few decades. No longer. Manufacturing might never be the jobs engine that it was a century ago — but it will not be a drag on job creation either. Durable goods manufacturing has added more than half a million jobs over the past three years. The intriguing question is whether this trend can continue. A 2011 Boston Consulting Group study argues it can, given that China is not quite the cheap workshop it once was (with rising wages and an appreciating yuan). The ‘rebalancing’ that Brits hear about is happening in the US, with up to three million jobs expected to be created in the next few years.
It may seem counter-intuitive for bullish economic news to be risk-asset bearish. But remember that 1) markets are a forward-looking mechanism (when functioning properly), and 2) a sick and weak real economy has long been the essential ingredient for keeping central bank ‘medicine’ flowing. A transition to genuine American strength reverses all that, while leaving public companies (with record corporate profit margins) to deal with rising interest rate problems.
But what if the US recovery is bogus, some will ask. What if it is more likely — as Bill Gross and Jeff Gundlach assert — that the US economy stays stagnant, and that Bernanke et al are premature in assuming we will lift out of this economic muck?
If that is the case — that stagnation still dominates — we still see a psychological shift in which “goldilocks” turns to “crappylocks.” Where Mr. Market once saw everything as rosy (in terms of risk asset prospects) he is now prone to be gloomy in the same assessments.
And some final food for thought, from Kimble Charting Solutions:
How fitting. In addition to 1) a transition into the second half of the year; 2) a transition to full-on bear market for EM and precious metals related assets; and 3) a transition from tailwind to headwind for central bank activity, earnings, and economic sentiment; we also get 4) a bearish-contracting-wedge style convergence of multiple chart-based inflection points going back decades.
We have multiple short positions in play and will exploit this market setup aggressively (given proper follow-through). The flipside of our bearish equity exposure is USD-bullish currency positions in various vehicles (yen, euro, canadian). In coming weeks and months, we see potentially excellent opportunity on the short side as a result of this transitional shift, with so many industries and sectors overextended and richly valued.
And, as always, if you would like to see exactly what we are doing in real time — complete with position sizing, risk management, and granular reasoning behind all our trades — check out the Mercenary Live Feed.
Ready for Winter,