Can US equities sustain a bull market or even current levels without central bank support? Prior to unconventional monetary policy, the last 2 bull markets lasted from 1995 – 2000, and 2002 – 2007, or roughly 5 years in each case.

What is not so easy to explain is why equities and corporate bonds have both rallied as much as they have when the Fed is no longer expanding its balance sheet and has undertaken a number of rate hikes. This stark acceleration in valuations began in early 2016 and for equities at least, has yet to find a top.

Source* Bloomberg

We ask a number of questions.

If GDP growth fails to sustain current rates or if it weakens, what policy tools can be deployed?

The Fed has never before kept rates this low for this long. While it has made 3 rate hikes to date (12 June 2017), Fed Funds stands at 1%, which was the lowest level in the last cycle before it started hiking in 2004. To cut rates, the Fed has first to raise rates and it has to raise rates with sufficient care that it does not precipitate a slowdown. With growth rates at these tepid levels and interest rates at 1%, the Fed has not much room to manoeuvre.

The Fed began with a balance sheet size of less than 1 trillion USD before the financial crisis in 2008. Multiple rounds of QE later the balance sheet stands at nearly 4.5 trillion USD. Financial conditions and growth have stabilized to the extent that the Fed now contemplates the gradual normalization of its balance sheet. Quite what the normal size of the balance sheet and how gradual the path to normalization should be is not known. The Fed has signalled that it is considering the question and could begin some sort of normalization later this year.

The Bank of Japan’s experience is comforting, in a way. From 1997 to 2005, the BoJ increased its balance sheet by a factor of 1.7X. It was able to reduce its balance sheet by 33% when the 2008 financial crisis struck. Thereafter it increased its balance sheet by almost 4X and it hasn’t stopped. Over the last 20 years, the BoJ has increased its balance sheet size by 7.7X. The one time it shrank it, a crisis emerged, admittedly not of its own doing, within 2 years. The BoJ continues to buy JGBs and has added equity ETFs to the shopping list and does not look like stopping soon. Yet throughout the BoJ asset purchases, rate cuts, and the public debt to GDP rising (from 50% in the early 1980s, to 234.7% currently), no great calamity has been suffered by Japan, except over 20 years of disinflation, and stagnant wages. Unemployment is chronically low, inflation has not risen, the currency has been relatively stable and indeed inexplicably strong, corporate profits relatively robust and bond yields have been remarkably stable.

Of course the Fed would like to achieve better than to limp along and claim that incapacity is victory over death. The US situation may not be as tractable given the open economy and open markets, especially the internationalization of the USD. The BoJ has maintained control over the interest rates because it is currently the proud owner of nearly 44% of the national debt.

Besides monetary policy fiscal policy can be engaged to support a flagging economy. However, it is often necessary to engage both fiscal and monetary policy to tackle flagging growth. Fiscal policy needs to be financed, and the US national debt, while small by Japanese standards is some 104%, which puts limits on how much it can borrow and spend before the Fed will need to help cap debt service costs.

The ECB has a repo rate of -0.25% and the BoJ has a policy rate of -0.10%. Most Eurozone countries are close to or beyond their budget deficit thresholds making fiscal policy difficult at best. The BoJ as noted earlier, is special. Neither region can sustain much negative surprises as policy is already acutely accommodative. For the BoJ, the time at which it may need to cancel some of the JGBs it holds may be drawing closer.

Do asset prices make sense?

This is a very wide and general question. Let’s begin with a few specific examples.

Does a yield of -0.75% make sense for 2 year German bunds?

How about Italian 2 year bonds at -0.36%, or Spain at -0.36%, or France at -0.56%?

Germany probably needs higher interest rates, certainly more than the -0.36% EONIA rate, but what about Italy and Spain? If we look from the point of view of what policy rates each country requires, then the periphery needs low rates to support their economies while Germany does not. If we look from the point of view of credit quality, then peripheral rates should be higher to compensate for default risk.

Does a current PE of 22X make sense for the S&P when it has historically been trading at around 18X? The S&P has only traded at or above 22X during late 1987, 1992 – 1993, 1997 – 2002, late 2009. The period in 1987 ended with a sharp correction. The period 1992 -1993 saw decent returns of circa 5% – 6% annualized. The period 1997 – 2002 saw a return of about -4.5% to -5% annualized. And in 2009, the market topped out at the end of the year and traded range bound till late summer 2010.

It is interesting to note that Nasdaq has tended to trade at high valuations, ostensibly due to the high expected growth rates. On a historical basis, Nasdaq trading at today’s 26X is less over-valued than the S&P trading at 22X. In the years prior to 2008, Nasdaq maintained a steady valuation of between 30X – 33X whereas the S&P traded at between 16X- 18X.

Does the Baa spread of 2.2% make sense given the economic cycle and credit fundamentals? The Baa spread has traded as low as 1.5% in 2007 just before the mortgage crisis. An over accommodative Fed drove spread tightening from 2002 to 2007 before the mortgage crisis all the way up to the demise of Lehman caused spreads to spike to as much as 6.2%. Corporate leverage rose from 2014 to 2016 but has since declined. Default rates remain well contained and recovery rates have stopped deteriorating. It seems that credit is expensive but not egregiously so.

How about leveraged loans? Loan coupon spreads have compressed to below 4% and 60% of the market trades above par. On average, performing loans are yielding a paltry 4.7%. While default rates are 1.3% having recently peaked at 2.17% in mid-2016, loan repricings have topped 200 billion in Q1 alone and could further dampen returns. Loan spreads were steady at 4% for most of 2014 then rose sharply in 2015 into Q1 2016. Since then spreads have come in well below the 2014 levels making the asset class definitely expensive.

Bond spreads are tight as well but whereas the continuously callable nature of loans places a limit on the loan price, so that significant proportions of loans trading above par are a clear sign of overvaluation, such technicalities do not exist for the bond market. We therefore ask if 2.4% spread between Baa corporate credit and treasuries makes sense. Surprisingly the answer is, while the bond market is not cheap, neither is it too expensive. It can be described as moderately expensive. Low end investment grade spreads ranged from between 0.70% and 3.05% from the late 1960s to the early 1980s. The low end of spreads was about 1.4% from the 1980s to 2007, before the big spike in spreads as the mortgage market collapsed. Post 2008, spreads have been trading between 2.1% to 3.5%. In this recent context, current spreads of 2.4% appear tight. However, risk in the financial system has been addressed and reduced, banks are better capitalized, risks are more ring-fenced and contagion risk diminished. Moreover, despite slow growth, corporate balance sheets have improved, companies are profitable again and growth has become more broad-based. One might assert that a central tendency of 1.8% – 2.0% is reasonable in which case the current market is moderately but not acutely expensive.

Parting comments:

The current flow of economic data seem to indicate a world of steady if moderate economic growth on the one hand and of high if not excessive asset valuations on the other. Seen in commercial and economic terms, markets appear to be properly priced in the main with a few exceptions. High valuations do not cause market corrections but imply deeper losses if and when they occur. Exogenous forces could cause a market correction, factors such as politics and policy. The acute inequality faced by many countries leads to less stable governments and less stable social contracts.

Europe is in steady recovery mode, benefiting from the delayed effects of QE.

Eurozone Purchasing Manager Indices (PMIs) have been rising across manufacturing and service industries for the last 6 months. Industrial production is growing at a steady 1.9%. Inflation has risen to 1.9% headline and 1.2% core. GDP is forecast to rise at 1.70% and has been rising at 1.70% Q1 2017.

The banking system is almost fully recapitalized and functioning. With a few exceptions in peripheral Europe, banks are increasing loan growth and net interest margins. Euro area MFI loans to non-financial corporates rising at a steady 1.6%. Euro area MFI loans to households rising at a steady 2.6%. Consumer credit rising at 4.7%. Second year of growth.

Political risk is subsiding and changing.

So far, the anti-establishment plebiscite results (Brexit, Trump), have been in staunchly capitalist and Anglo-Saxon countries. The Socialist fabric of Europe has so far held together through Dutch and French elections.

Italy is a risk. The weakest economy in Europe, Italy breeds dissatisfaction with the euro, which could turn into a focal point for elections which have to happen eventually. There is the possibility of snap elections. Reformist former Prime Minister Renzi has recently regained leadership of the Democratic Party, but an election is likely to result in a hung parliament. There is little risk in Italy exiting the euro but the consequences would be serious given how entrenched the Italian financial system is within the single currency. The banking system is weak but has made progress in recapitalizing and loan growth is picking up. Unemployment, however, is a stubborn problem.

Spain’s coalition government remains unstable. An abstention by the Socialists have allowed incumbent Prime Minister Rajoy to retain power but Pedro Sanchez’s return to leadership of the Socialists could destabilize the arrangement. The Spanish economy has so far shrugged off the political uncertainties and staged a meaningful recovery.

European unity is likely to be strengthened by the turn in its relations with the US and UK. President Trump’s nationalist agenda and cosy relations with Moscow will lead Europe to feel that it needs to be more self-sufficient economically and militarily. The departure of UK from the EU reinforces the need for Europe to remain united evermore. Newly elected French President Macron is mostly regarded as a Europhile and federalist and will likely press for greater integration.

Unity and greater integration are likely to be the focus of Europe in the face of an uncooperative US and a recalcitrant UK. This should bolster the euro and cause further convergence of sovereign bond yields between peripheral and core members. Stable to rising German inflation will raise the floor on rates and the need to maintain lower rates across the zone will place a cap on peripheral rates. The ECB may taper QE but if peripheral bonds do not behave, they may have to reinstate unconditional LTROs to absorb peripheral issuance.

Brexit presents problems for both the UK and the EU.

The UK elections on June 8 are expected to see the Conservatives extend their slim majority, although recent experience has taught us that anything can happen. There is some debate over whether a strong mandate for Theresa May means a softer or harder negotiating stance. Given May’s track record at the Home Office, a hard stance is more likely. This is damaging to the UK economy in the short run. In the long run, it is difficult to say although the general consensus is poor. The impact on Europe is also negative. In most policy debates the UK has been the pro-business lobby against the statist French and the commercial leaning but less vocal Germans and with Brexit the EU loses its most liberal, pro-competition member. The risk is of a more insular, protectionist, EU.

ECB. Which way out?

The ECB was the last major central bank to move on QE. Given the influence of the Bundesbank and the reluctance of Germany to bailout the fiscally undisciplined it was a feat to implement QE. With the European economy in fine shape it is likely that QE will be tapered. Germany needs the ECB to end monetary accommodation, while Italy needs more support. The ECB is caught in between. The Germans will not be happy to let the ECB pick and choose which bonds it buys, and the ECB is not allowed to explicitly finance a sovereign nation. Yet the differing needs of different countries means that the ECB will have to find more specific and targeted policies to deliver stability. Fiddling with the asset purchase program will be difficult politically. The most flexible tool is repo. Even this could be complicated but if there was a strong signal from Brussels that the euro would be maintained at all cost, then sovereign yields should converge, and private commercial banks would have less reason to buy bunds and more to buy Italian bonds, thus animating that convergence, allowing the Germans to have higher rates while suppressing peripheral borrowing costs.

OPEC is doing a terrible job of managing the oil price. The oil price prognosis depends on the time frame. In the very long run, oil will no longer be a viable fuel for a planet facing global warming. In the very long run, demand will disappear as cleaner, more sustainable sources of energy are found. In the long term, as opposed to the very long term, oil prices can be expected to rise. Why? Demand is fairly stationary but supply is constrained and current prices are too cheap. As a result, there is insufficient investment in capacity and long term extraction costs will rise as cheap and short cycle oil is increasingly depleted. Now for the short term. OPEC and in particular Saudi Arabia wants a higher oil price, mainly so they can flog a piece of Aramco and put a price on it. Last November, OPEC announced production cuts which caused a bounce in the oil price, a bounce sufficiently high that US shale producers were able to sell forward their production to service debt to invest in more short cycle production capacity. While US shale is about 5% of global production, the market has chosen to focus on it, following rig counts and crude, gasoline and distillate inventory changes, mostly discounting good news and sagging on bad news. OPEC meets May 25 and is expected to announce an extension of production cuts. This may support the oil price in the short term. However, feed the market what it wants and it will demand more. More cuts will be sought, more rhetoric, more assurances, more action, just to keep the oil price where it is. Any sign of hesitation and oil prices could well sell off.

This is not about production or commercial strategy, this is public relations. And OPEC is making a right mess of it. If OPEC wants to support the market and bring it into balance long enough to flog Aramco, the most logical thing to do is the following.

1. Call a closed door meeting to cut production but do not announce a production cut. Discuss technical issues and issue no signal to the market as to production plans.

2. In the OPEC report, inflate production numbers so that a gap is created between reported production and production estimated from other sources.

3. Deny that capacity has been reached and that there is a shortage of oil. It doesn’t matter if no one is alleging that OPEC is near capacity, just deny it.

Commodity markets are like any other market. They will assume the worst, that Saudi Arabia and OPEC are at capacity and unable to supply global oil demand. Within 6 months, oil will be 100 USD. By then, the long term demand and supply situation, the underlying fundamentals, will support the temporary fiction that there is a shortage of oil.

VIX, an indicator of implied volatility for the US stock market, has been chronically low, and surprisingly low given the geopolitical and economic concerns in the economy. Market consensus is that the US stock market is expensive and that growth may not be as strong as expected, especially if the expected fiscal stimulus policies of President Trump are not implemented.

VIX, however, gives an incomplete picture of market sentiment. The low level of VIX leads some investors to regard the market as complacent and therefore prone to sharp corrections. An alternative, or more accurately, complementary indicator, is SKEW. This measures the skew of the option volatility surface. Put simply, a high skew is an indication that put implieds are higher than call implieds, in other words, put options are more expensive and call options are cheaper.

Take a look:

Skew is high even though VIX is low. One possible explanation is that call writing by dividend and income mutual funds and exchange traded products is over-supplying call options while investor caution is over-demanding put options. If this conjecture is correct, it is an indication that investors are far less complacent than indicated by simply looking at VIX.

The market could grind higher for longer.

Fears of rising interest rates have motivated Asian investors to buy leveraged loans. The first real demand from Asia for leveraged loans came around the Taper Tantrum in 2013. The asset class did as it was intended and protected capital while delivering a rather unexciting return (as it was supposed to do.) Over-investment in the asset class, through ETFs and retail mutual funds led to a reversal as capital exited the asset class over 2014 and 2015 resulting in mark to market losses.

Some point to the distress in the high yield market due to the crash in the oil price but note that oil is very under-represented in the loan market. The sell off of 2015 was a technical sell off driven by over-investment in the asset class by less well informed investors. The sell off reached its apex in early 2016 when most retail money had left. Institutional capital, it should be noted, had been returning to the asset class well before this and was positioning for a recovery. 2016 saw the loan market rebound (performing loan prices which had traded into the low 90s, rebounded to par).

Today, 75% of performing loans trade above par. This is not ideal for an obligation which can be called, repaid or otherwise repriced basically on any given day. Indeed in a trillion USD market, 2016 witnessed some 100 billion USD of repricings, all occuring in the last months of the year. Repricing volume in 2017 matched all of 2016 in January alone.

In a repricing, the borrower basically renegotiates the loan at a lower coupon, with the lender, who either agrees or faces early repayment of the loan, usually with no penalty fees.

And now we get to an interesting product in the Asian market. Private banks are selling leveraged loans packaged in the form of Fixed Maturity Products. With leverage. The typical product will lock the investor in to 3 to 4 years, be invested in a pool of leveraged loans, and be leveraged between 3 top 5 times.

1. The timing is not ideal. Buying loans above par is not ideal when they can be repriced or repaid at par. And a large proportion of loans are today trading above par.

2. The structure is not ideal. Loans are low yielding, low volatility, fairly predictable credit investments. They naturally lend themselves to leverage. But if that leverage removes some of those features such as the low volatility and predictability, then it defeats the purpose of investing in loans. The ideal structure for leveraging loans is a structure whereby the loans are financed by fixed maturity liabilities with limited recourse and no mark-to-market of the underlying collateral. Pricing is based on default, recovery and basically on the actual cash flows of the loan pool. This structure has a name: the CLO or Collateralized Loan Obligation. The CLO has a bad reputatation, all of it by association. CLOs not only survived 2008/9 but outperformed stocks and bonds. Leveraging a pool of loans with a bank credit line, with the usual loan to value covenants and margin requirements, is to create an unstable cousin of the CLO.

There are a few possibilities why wealth management firms would construct and offer a leveraged product packaging loans in this fashion.

1. They cannot sell CLOs to an unsophisticated audience because the audience is unsophisticated and would not understand the benefits, or because the regulator would not allow it, or would take a dim view if the CLO later became impaired.

2. They cannot produce CLOs for whatever reason. For a bank, in-house production is ruled out by the conflict between risk retention rules and capital requirements although one cannot be sure if they got that far. Outsourcing CLO production would not have addressed the complexity issue since the bank would have had to conduct a comprehensive due diligence, and would have involved sharing of fees as well.

3. The product development progressed without realizing the CLO alternative, which would have been quite clever, but still leaves the collateral mark to market issue inresolved. Note that in the CLO space, market value structures no longer exist, a victim of mark to market and automatic deleveraging.

Caution is therefore recommended. The timing of buying leveraged loans is not ideal, and the structure of the leveraged vehicles is not ideal. Even a stable asset like leveraged loans has occasional volatility (2008, 2011, 2015) and while models can be built to estimate losses and deleveraging levels, too successful a product can create a feedback loop when prices fall.

If there is any doubt that market prices have outpaced fundamentals, consider this. Over a 12 month period ending 10 May 2017, the S&P LSTA Index of loans has returned 8.04% whereas the Blackrock Floating Rate Income ETF (FRA) and the Eaton Vance Senior Floating Rate ETF (EFR) have returned 16% and 21% respectively.