“Forgiveness is the fragrance that the violet sheds on the heel that has crushed it.” – Mark Twain
Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named “Lethe”. The river of “Lethe” was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness.
In similar fashion, every investors drinking again from the “river of liquidity” provided by central banks including the large infusion from China’s PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means “oblivion”, “forgetfulness”, or “concealment”. It is related to the Greek word for “truth”, aletheia (ἀλήθεια), which through the privative alpha literally means “un-forgetfulness” or “un-concealment”. While the privative “alpha” might means “un-forgetfulness”, the on-going rally is purely of one of “high beta” given the return of the “carry” trade thanks to low rate volatility and global central banking dovishness.
In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again…
In this week’s conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.
Synopsis:
Given the definition of “oblivion” is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of “goldilocks” will last following the baby bear market we saw during the fourth quarter of 2018.
Sure it’s a great start in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good “proxy” for global trade, has seen recently unemployment surging to 4.4%.
No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups reported this week.
No surprise the “D” for “Deflation” trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the “Lethe” river flowing again.
If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed’s latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.
While investors took another bath into the central banking river of “Lethe”, when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all “recessions” are “deflationary” in nature, and most central banks have been powerless in anchoring solidly inflation expectations.
When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled “The Hidden Costs of Risky Auto Loans to Consumers and Our Communities“:
“The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.
The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.
– source US PIRG, February 2019
In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less “senior” when it comes the recovery value potential.
As we pointed out in October 2017 in our conversation “Who’s Afraid of the Big Bad Wolf?“, credit cycles die because too much debt has been raised:
“When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting “maxed out”, then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion.” – Macronomics, October 2017
This is why on this very blog we follow very closely financial conditions and the Fed’s quarterly SLOOs as well a fund flows.
Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:
Given that the auto industry is notoriously cyclical, and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.
On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo’s Economics Group Weekly Economic and Financial Commentary from the 22nd of February:
“Canary in the Camry?
Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?
Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute.” – source Wells Fargo
Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven’t seen in the last 25 years? We wonder.
If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled “Spreads stall heading into SFIG”:
“Consumer Portfolio Services, Inc (CPSS or CPS) – sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn
Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.
The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.
The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.
The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction.” – source Bank of America Merrill Lynch
To repeat ourselves, credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly “S&P500 dependent”, the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the “Lethe” liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the “illiquid stuff” such as the now “famous infamous” leveraged loans regardless of their recent “strong” performance.
For now, investors have dipped again into “Lethe” hence the return of the “goldilocks” narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure “goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:
“The Trouble with ‘Goldilocks’The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.
We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities.” – source Morgan Stanley.
A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.
Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their “The Inquirer” note from the 18th of February entitled “Is Global Monetary Reflation here?”:
“In
the last week, it seems like global central banks have started a possible
process of monetary easing, in line with our views (The Inquirer: Planet Earth
to Policymakers: Please Reflate 31 December 2018). If so, this would be very
positive for Asia/EM stocks.
In the
US, Fed governor Lael Brainard raised the possibility of ending balance sheet
contraction by year-end 2019, ahead of schedule; in Europe, the possibility of
a TLTRO came from Commissioner Benoit Coeure, and China printed a massive
January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018,
above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn.
Global monetary reflation is possibly on the way. As of now, we remain bullish.
We expect the world’s central banks to reflate monetary policy, a view we have
held since late last year.
Paraphrasing
Mike Tyson, everyone’s got an investment strategy, until they get punched in
the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity
analysis (different from “fund flows”) was popular in financial
markets three decades ago. We remember having a standalone research product in
the mid-1990s called “Liquidity Analysis” replete with central bank
balance sheets, commercial bank entrails, and the net supply and demand for equity.
These days, eyes glaze over when we bring up base money growth, money
multipliers, and monetary velocity. However, as the last decade has taught us,
we should pay attention to this stuff. Our global strategist, Michael Hartnett,
has maintained a consistent focus on liquidity and central bank balance sheets
as part
of his toolkit.
1) We
think the biggest risk to equities in Asia and EMs is the potential
mismanagement and premature contraction of central bank balance sheets.
Conversely, it is also the most lucrative opportunity. The correlation of EM
equities with the major central banks balance sheets is 0.94 in the past three
years. World equities have a similar correlation of 0.94 since 2009. Central
bank balance sheets are the most important driver of stock prices, in our view,
by lowering risk premia, and cutting off deflation risk. The rest is detail, in
our view.
2) We think the Fed is the most flexible in course correcting – they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.
3) However, we worry that in Europe, Japan, and most importantly, China – a total of USD40tn in GDP, or half the world’s total – a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.
The world monetary base is shrinking, only the sixth time since 1980 – each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession.
Why
should this time be different? The US Fed’s projected balance sheet contraction
of about USD40bn a month will likely reduce the US monetary base 13.8% this
year (after contracting 10.7% last year), and the global real monetary base by
1.6%. After spending seven years telling us that the Fed B/S expansion was
equivalent to rate cuts, we are now told that the opposite – B/S contraction is
like “watching paint dry”. Ostensibly, this comes from heroic assumptions
of a rise in the US money multiplier, even a potential doubling in three years.
The Lael Brainard “end-QT earlier” is helpfully walking back some of
this prior aggressive QT fervor. And that’s a good thing -that’s the main
impetus to growth in old, indebted and unequal societies.
4)
Apart from China, which has control over its money multiplier through the high
reserve requirement ratio, most large economies have seen falling money
multipliers for the last two decades. Stopping QE – or slowing the QE-induced
growth of the monetary base – will likely lead to a sharp drop in M2 growth (M2
is simply the monetary base multiplied by the money multiplier). Couple that
with the secular drop in monetary velocity from the declining incremental
productivity of debt, and slower nominal global GDP (and EPS) growth is highly
likely. Rising indebtedness globally, demands a stronger money supply growth
rate to maintain a desired level of economic (and earnings
growth).
This is an identity, not a theory. This is increasingly true for China, with
its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to
impose more severe costs on growth there. The world’s central bankers seemed
oblivious to this until last week, and even now it is not clear where they
stand. Welcome back to the secular stagnation debate. And the potential threat
of a “too tight policy mistake”.
Chair Ben Bernanke during his testimony about the Federal
Reserve Board’s semiannual report on monetary policy said that he equated
$150-200 billion of QE as being equivalent to a 25bps reduction in short term
rates. So 600billion in QE2 was equivalent to a 75bps reduction.
httpss://www.c-span.org/video/?298238-1/monetary-policy-report
(at 32 minute)
Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)” – source Bank of America Merrill Lynch
It seems to us that Jerome Powell has finally done the math hence the “u-turn” as seen in the increasing use of “patience” in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the “Lethe” river thanks to the rescue of central banks.
Another strong support as well to the “high beta” rally narrative and “risk-on” environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political “left” side.
Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled “Buybacks on pace for another record year” and shows that in similar fashion to 2018, the return of buybacks on top of the central banking “Lethe” river provides additional support to the “oblivious” crowd of investors jumping with both feet on the high-beta wagon:
“Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1).
The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels.” – source Bank of America Merrill Lynch
If “R” is for Recession and “L” is for Leveraged then “G” is for Gold. With the recent return of the river of unmindfulness, no wonder, the strong “bull” market has been “reincarnated” and the zombie companies can continue to “live” another day but we are ranting again…
“To err is human; to forgive, divine.” – Alexander Pope, English poet
Stay tuned !
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