Leveraged Loans and the New Shadow Banks

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Breaking: *N.Y. FED’S 42-DAY REPO OP. OVERSUBSCRIBED; $42.55B OF BIDS – Bloomberg, December 2, 2019

$42B?!

Q: Who’s the Fed financing here? Leveraged loans??? Global hedge funds???

A: Fed financing lev loans: Why wouldn’t they? Easier to soak the ground now than be trying to put out the fire later (credit fund).

Looking Down the Road Ahead

Our 21 Lehman Systemic Risk Indicator Index (LSRII) was developed in 2007. It focuses on tracking the contagion effect and provides good and bad signals in terms of effectiveness with one important finding. Like a reliable caddie in golf, the longer you’re together – the better he / she is. There was a group of revolutionaries who tried to stop the madness at the ill-fated bank, but one by one they were silenced. We explore the legendary lessons below, enjoy.

The Crow’s Nest
We know elephants leave footprints. Looking over the calm seas across markets, from the crow’s nest if a hedge fund manager David Tepper sees something meaningful risk wise, the first thing he does is takes 0.25% of this year’s p/l and deploys it at the cheapest, relative value protection. If David Einhorn joins him, Seth Klarman’s head trader as well, that’s fairly detectable. Of course, we have no idea what hedge funds are leaving the footprints, just using those three veteran investors as an example.

Our Global Bloomberg Client Chat

In daily interaction with over 300 institutional investors globally, our live Bloomberg client chat helps to provide clues throughout the year. From time to time we’ll hear about a large “print” either in HY CDX, S&P Futures, Forex vol futures, Eurodollar futures, etc. We’re attempting to measure the accumulation of hedges. More size, the more encroaching risk.

At Lehman, our team attempted to hedge the $6B ish of leveraged loans the bank got stuck with, so the origin of the idea comes from that painful experience.

Over the years, we have altered the index weightings relative to parts of the world where risk is most concentrated. In 2011, CDS on Eurozone banks (exposure to Greece debt) were an outstanding leading risk indicator for US equities, much the way US banks were in 2007-8.

Today, the index has been much more Asia focused. Italian bank CDS is still a decent Salvini political risk indicator as well. Above all it’s important to note, we’re starting to shift the focus – back on the US.

US high yield, leveraged loans, and CLOs are near $3.2T, add the $2.6T of BBBs, you get nearly $6T of risk assets. In the QT (quantitative tightening) world, the Fed cluelessly over-cooked the goose. They pulled too many dollars out of the system and tightened FCIs (financial conditions) far faster than they were aware of at the time (Q4 2018). The beast inside the market literally broke the Fed over its knee like kindling being thrown into the fireplace. It was a beautiful capitulation.

We MUST keep in mind – during the 2000-2002 credit cycle flame out, over 45% of the investment-grade universe oozed into “high yield” bond territory. Today that’s the equivalent of $1.2T of “fallen angels” (vs. $195B in 2000-2002)  – a flood of junk near unimaginable proportions. It’s no surprise the Fed caved in such embarrassing fashion, they had a large gun pointing at their legacy (head).

Today, they’ve deployed the QE fire hose (term repo + $60B/m tbills) but when the mark-to-market of say $150B (20 or so idiosyncratic events) of HY, CLOs, loans and junk IGs falls quickly, the ability of banks / hedge funds to hold these assets is highly unknown, untested. It doesn’t matter if $5.5T of the risk pool is just fine, come near year-end everyone has to put some cards on the table.

U.S. Credit Risk Rising

In our view, leveraged loan funds and ETFs are the new shadow banks, outstanding debt in this dark corner of Wall St. has surged to nearly  $1.5 trillion in the US. While Collateralized Loan Obligations are the largest buyers (about 50%), leveraged loan mutual funds and ETFs are the second-largest buyers comprising around 30% of the demand. Over the years we’ve learned, there’s a waterfall effect across credit markets. Stress in one pocket often leads to two and three fairly quickly.  Credit spread contagion MUST be meticulously monitored, especially with an accommodative Federal Reserve. After 3 rate cuts and a $400B balance sheet reversal from contraction to expansion – why are we seeing stress on the rise? Let’s explore.

A Federal Reserve, Juicing Leverage on Leverage on Leverage
As you can see above, debt to EBITDA multiples at issuance > 5x have surged dramatically. It’s clear to us, the longer the Federal Reserve doesn’t allow the business cycle to function – clearing out the bad actors – leverage on leverage continues to pile up. Look at 2019 relative to 2007, it’s screaming moral hazard at Mr. Powell. Debt multiples < 4x make-up just 10% of loan sale volumes vs. close to 30% in 2007.

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The Liquidity Mismatch

Our friend Rod Dubitsky points out, leveraged loan funds offer the promise of daily liquidity, yet the underlying asset is fairly illiquid and the time to sell could be lengthy. Leveraged loans could take up to 21 days to settle, while the funds are required to meet redemption requests within 7 days, but in practice are expected to provide liquidity in one or two days. Innovation in financial products and ETFs has incentivized the unsustainable in our view. How can ETFs and mutual funds offer realistic liquidity on financial instruments inherently illiquid?

Cash Flow Coverage Fleeting in US Loan Market

It’s a clear liquidity mismatch in our view, one that takes us back to the mid-2000s.

A Lehman Visionary

It was a morning in June 2005, one we’ll never forget. Michael Gelband, a Lehman Brothers managing director and the firm’s head of global fixed income, gave a presentation to our team of traders about the dark side of the real estate market. The meeting began just after 6:45 a.m. Each attendee was handed a dossier of about 30 pages.

In our 2009 global bestseller –  A Colossal Failure of Common Sense (now published in 12 different languages), there’s an epic scene where Gelband described the stunning proliferation of “no-doc” mortgages and other toxic loans, sold by commission-driven salesmen and then purchased by Lehman and other Wall Street banks.

Steve Jobs once said of Einstein, “talent hits a target no one else can hit, genius hits a target no one else can see”. A true visionary, Mike could see the train wreck a mile away.

“He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion in economic activity that was comprehensively false money and would never be converted into genuine economic power.”

Gelband predicted that the house of cards could soon collapse — perhaps in 2007 or 2008 — producing serious consequences for the U.S. economy.  After the meeting, Gelband didn’t stop pressing the issue. He used his position on Lehman’s executive committee to try to persuade the firm to pull back from its massive bets on the real estate market.  But warnings from Gelband and others with similar concerns were largely ignored by senior management at Lehman Brothers.

We MUST NOT ignore the current signals coming from the leveraged loan market – they are screaming loud and clear.

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Are funds set up to meet a severe liquidity challenge in a distressed environment? We agree with Rod, “no way Jose”. While there have been redemption spikes (a surge in the number of people wanting their money back) even within the last year or so, they have been fairly brief, shallow and occurred during relatively robust economic times.

Fed’s Fire Hose
In recent years, the Fed has saved the day numerous times. First on ending rate hikes after promising to march on, then on quickly shifting to rate cuts, and finally a colossal capitulation on their beloved balance sheet reductions plans ($2.5T in reduction promises to recent $400B expansion of their balance sheet). There have been runs on leveraged loan funds, but each time the Fed put out the fire with a reversal toward far more accommodation. Even so, with all the Fed love, stresses are NOT going away!

Even after 3 Rate Cuts, a Downgrade Surge
We believe the market is underestimating this liquidity risk should the market face a true, prolonged downdraft. In 2019, defaults in the U.S. leveraged loan space are approaching $30B. In October and November, defaults are nearly $10B, that’s about 40% of last year’s total in JUST two months.

Fitch Problem Loans of Concern Index

November: $112B / 8% of the market
July: $71B / 5% of the market
January: $71B / 5% of the market

*Fitch Leveraged Loan data, defaults spike to the highest level in 2 years, forecast year-end 2020 retail and energy default rates at 8% and 13%, respectively. A five-year-old can tell you the rating agencies are the last to get the joke in any default cycle.  Looking back over the last 70 years, credit cycles are littered with embarrassing flashes of rating agencies playing catch up on defaults. Hence, if the Fitch “problem loan” basket is up to $112B, it’s safe to assume that the number is substantially higher in reality.

Cash vs. Low Quality “B” Holdings

To assess the risk for redemption fails, we looked at two key measures for the top 10 leveraged loan funds (about $60B in total). Specifically, pay attention to the percentage of holdings of Single-B rated and below assets and the percentage of cash held by the fund (cash being a proxy for the ability to meet a spike in redemptions).

Houdini Liquidity, now You See it Now You Don’t
As the chart above shows, most funds have over 60% invested in single-B and lower-rated assets, yet typically have cash positions at just 5% on average. One fund held only 0.32% in cash and yet had over 70% in single-B and below assets. In a prolonged sell-off, the 5% cash would likely prove grossly inadequate in the face of reduced overall market liquidity, lengthening settle times and a spike in redemptions. In a severe downturn, it’s likely that a significant percentage of the loans would be downgraded to CCC, rendering sale much more difficult and all the while prices likely would be collapsing.

Cash Shortfall, Implications

While some funds may supplement cash liquidity with access to a line of credit and/or holdings in more liquid bonds, it’s not clear either of these would be sufficient. Lines-of-credit may not be available when needed and even if they are drawn they may create a senior claim on the remaining assets thereby amplifying risk for those who remain in the funds.

Credit Leads Equities
The Blackstone GSO credit fund is loaded with lower quality (B rated) leveraged loans. It’s interesting with stocks ripping to new highs, B rated loans are under meaningful selling pressure as downgrades mount. If credit is weakening at this pace with a U.S. economy near full employment, what will happen when stresses mount?

Redemption Risk isn’t Theoretical

There is a history both during the financial crisis and more recently of funds having to freeze redemptions due to lack of asset liquidity (most recently the Neil Woodford managed funds in the UK). In fact, in 2015 the Third Avenue Focused leveraged loan fund collapsed amidst a flood of redemptions.

Finally, cascading redemption freezes would likely reverberate through the entire leveraged loan markets including CLOs which would face greater difficulty in trading distressed loans and a deterioration in recoveries.

Rod Dubitsky has over 30 years of experience in the financial services and global development sectors.  Founder of The People’s Economist (TPE).  The bulk of his career had been spent in financial services working for rating agencies, wall street dealers, banks and money managers developing a range of market-leading, award-winning research, and analytical platforms. Frequently quoted in the media including Time Magazine, Forbes, NY Times, WSJ, FT, and Bloomberg.  While working in finance, he was a top-ranked analyst for Credit Suisse in the consumer ABS finance sector and led the newly create advisory analytics division for PIMCO with responsibility for overseeing some of the largest post-financial crisis bailout consulting engagements.

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Dollar and Election 2020, the X-Factor

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US Dollar Carrying Outsized Macro Risk Factors

In our view, just 30 counties will determine the next President of the U.S., memories of 2016 indeed. If you look closely, the U.S. dollar’s labor market sensitivity in these key regions is the most compelling development of all. This unique data offers a “looking glass” into the 2020 election outcome. With our partners at ACG Analytics in Washington, we’re spending a lot of time focused on the most revealing inputs and locations across the United States. Four years ago we made some important discoveries for clients pointing to a Trump upset win. Today, we’re looking to add alpha down a path less traveled. Let’s explore.

What’s the True Price of a Strong Dollar?

Like a loud vacuum, a strong dollar sucks important U.S. manufacturing jobs overseas. Votes in all-important States with the most significant election-outcome influence are on the line. This is a major problem for the White House and it’s receiving substantial attention around the halls of the West Wing we’re told. The higher greenback raises the price tag of U.S. manufactured goods around the world. In response, President Trump desperately wants a softer USD, and he will do just about anything to get it.

Wrecking Ball Policy Divergence
In an attempt to support the Eurozone economy, since 2014 the European Central Bank has expanded its balance sheet by $2.7T and kept its deposit facility rate between -0.20% and -0.50%, suppressing the Euro currency. If there was a score for cheating on the global trade playing field, ECB chair Mario Draghi has a perfect “10”. Over the same time period, the Fed hiked interest rates 9x and reduced its balance sheet by $600B, per Bloomberg (since this clear policy error, the Fed has recently expanded its balance sheet by $200B and cut the Fed funds rate upper bound from 2.50% to 2.00%). This bizarre policy divergence between the Fed and ECB has empowered the global wrecking ball that has become the U.S. dollar. Trump’s bid to stay in the White House hangs in the balance.

U.S. Election Risk and the Dollar

As we look down the road ahead, this factor is forging significant macro-risk. A sharp blade hangs over markets. Day after day, asset managers are asking us more and more questions. “It’s like Argentina on roids. The candidates are just as far apart, but the possible wealth destruction in the United States with an incoming left-wing government – after Trump fueled bull-market is unimaginable”, our Larry McDonald told an audience at a conference in Latin-America last week. Enormous tails indeed. Unlike previous U.S. elections, the risk-dynamics for investors are LARGE given the colossal spread between market-friendly and un-friendly candidates in 2020. We must keep a trained eye on these developments. In our view, U.S. stocks could fall more than 40% if the probability of a – Warren, Sanders, Harris – election win starts to rise meaningfully. Watch the U.S. Dollar, here’s why.

President Trump pulled off a historic 2016 Electoral College upset with a 304 to 227 margin of victory. There are a total of 538 votes in the Electoral College and a candidate must win a simple majority (270) of those votes to win the election.

*Trump garnered 304 electoral votes and Clinton 227, as seven faithless electors, two pledged to Trump and five pledged to Clinton, voted for other persons. – Wiki

The Key States and Key Counties, Electoral Votes

20 PA Pennsylvania*
18 OH Ohio
16 MI Michigan*
10 WI Wisconsin*

*That’s 64 total electoral votes in these all-important States, Trump pulled off an inside straight, winning MI, WI, and PA by just 77,744 votes (per NYT, Wiki data).

Into 2020, the Greenback is Wearing Outsized Risk Factors 
In Q3, the U.S. Dollar’s surge to its October 1st peak of 99.67 (97.28 today) did some serious damage to manufacturing jobs in MI, WI, and PA (see the image below). This places TRUMP in a meaningful risk position, far more than U.S. equities are currently pricing-in. If you do the math, Trump CANNOT win these states in 2020 with a strong dollar. U.S. equities are at grave risk unless the White House / Fed can get the greenback down, and down fast.

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The 2019 Dollar Surge Higher Comes with a HIGH Price for TrumpSimilar to 2015-2016, this year as the dollar soared, U.S. export products to other countries became far more expensive and manufacturing jobs in Michigan, Wisconsin, and Pennsylvania plunged. 

Trump Tweets and the Dollar

In August, Trump tweeted yet another message of worry focused at Federal Reserve Chair Jerome Powell. That included yet another mention of how strong the dollar is, with Trump saying “highest Dollar in US History.” It was the latest entry in Trump’s crusade for a weaker dollar, which he says will give the US a leg up in the ongoing global trade war. He’s continuously lashed out at the Fed and Powell (see October 1, 2019, above) as the reasons for the greenback’s strength.

Important Lessons from 2016
After the 2015-2016 US Dollar surge, manufacturing jobs in the U.S. came under serious pressure. We believe this factor, among others, cost Hillary Clinton the election. Heading into 2020, there are few things Treasury Secretary Steven Mnuchin and of President Donald Trump want more than a weaker Dollar.  It’s probably not too much of a stretch to say that the Dollar’s 2014-2016 surge delivered Michigan, Wisconsin, and Pennsylvania to Trump on the back of undermined manufacturing and exports (see the above image, Dead Zone). The President clearly knows this and it’s part of the reason for his regular tweets and comments lamenting Powell’s interest rate 2018 rate hikes and the strong USD. Stay tuned.

US Labor Force Size, Millions of Americans Employed

October 2019: 164.5m
November 2016: 159.5m

*Seasonally adjusted, US Bureau of Labor Statistics data.

There’s is one very large bright spot for Trump coming out of the labor market. Roughly 5 million more Americans are employed today relative to November 2016.

“Are you better off today than you were four years ago?”

In the final week of the 1980 presidential campaign between Democratic President Jimmy Carter and Republican nominee Ronald Reagan, the two candidates held their only debate. Going into the Oct. 28 event, Carter had managed to turn a dismal summer into a close race for a second term. And then, during the debate, Reagan posed what has become one of the most important campaign questions of all time: “Are you better off today than you were four years ago?” Carter’s answer was a resounding “NO,” and in the final, crucial days of the campaign, his numbers tanked. On Election Day, Reagan won a huge popular vote and electoral victory. The “better off” question has been with us ever since. Its simple common sense makes it a great way to think about elections. And yet the answers are rarely simple.

 

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The IPO Restricted-Share Unlock Schedule

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This morning WeWork junk bonds touched a 13% yield, earlier this year the brain trusts on Wall St. talked up a possible $60B valuation. Then, SoftBank purchased private shares, completed in connection with a $5B primary investment into WeWork that valued the company at $47B, more than double its previous valuation, according to Pitchbook. Today, the equity is near worthless, oh how quickly sentiment can change.  That’s the problem with leverage – when equity stands behind a colossal pile of debt, it can evaporate far faster than most realize. SoftBank better pull-out the checkbook, $10B of fresh cash is needed. In our view, WeWork has the capacity to issue a little more than $1B in secured debt and $2.56B of unsecured debt. This is substantially less than some of the estimates floating out there regarding potential loan commitments., working with Xtract Research on the numbers. Above all, we must think about the follow-on side effects in today’s equity market. These events are harbingers of things to come in our view. A meaningful re-pricing is in the works.

“If the company is unable to raise new financing before the end of November, the people said it could face something that executives within WeWork never thought was an option just weeks ago: bankruptcy.” – FT

Central Banks Funding Fraud?

We must ask ourselves. After wide-open capital markets, an endless gravy train of nearly free cash, are the side effects in venture capital playing out? How can WeWork eviscerate $50B of equity value in less than six months? What are the follow-on implications? Postmates, Lyft, DoorDash, WeWork, Peloton, Uber, and Casper will lose nearly $15B this year. A near-endless supply of cash is needed to fund many of these businesses. The financial media’s story of the year is WeWork’s implosion. The larger narrative will be found in SoftBank’s Vision Funds impairment – if the market isn’t there for them, they will have to fill the capital hole.

A Wave of Sellers

The restricted shares from the respective IPOs of Zoom Communications (ZM) and Pinterest (PINS) were ‘unlocked’ on Tuesday. Both stocks are lower despite over a 1% rally in the S&P 500. ZM is down -2.6% while PINS is down -4.4%, both are on-track for their largest volume days in months. In our view, this shows across the IPO space, there is a herd of restricted-shares just waiting to sell. See below for the restricted share expiration schedule…

The IPO Unlock Graph

Out of the $31.2B of restricted IPO shares becoming unlocked from now until the end of the year UBER is 71% of the total. ($22B vs. $31B). However, what is very interesting is the amount unlocking relative to the current float…While most unlock packages are smaller than the current float or near a 1:1 ratio, UBER’s is 4x the size! UBER float is currently 195M shares and worth $7.4B. Meanwhile, 764M shares worth $22.3B of UBER are unlocking on November 6th… That means up to 424% of the current float could be for sale.

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WeWork Contagion and a Lyft Benefit:

Given what just happened to WeWork and the performance of LYFT and UBER IPOs, you have to think a large portion of the $22B unlocking wants out… Meanwhile, some clients are thinking this will be a positive for Lyft, as the company was used as a hedge for restricted shareholders…

UBER Currently has a $49B Valuation

The series G funding round was at a $68B valuation in 2016, (FortRoss Ventures, Saudi Arabia’s Public Investment Fund). In August 2018, Toyota Motor Company came in with a $500M investment at a $76B valuation… Last man on the deal team?

Lyft Restricted-Shares Unlock

Notably, Lyft is down -42% since they announced the early unlocking of their restricted shares. Although the increase in float does not directly influence the valuation, it does bring a herd of likely-sellers.

Since August 15th

LYFT -26%
UBER -5%

*IPO Lock-Up Impact… Bloomberg data

 

Zero Sum Game
Ridesharing companies LYFT, and UBER don’t have a moat in our view. It’s like “Chinese capitalism” (that funnels lots of profits to consumers, thus poor performance in the company’s stock prices). It’s a subsidy of consumers (Uber riders) at the expense of Uber shareholders and Uber Drivers.

IPOs Shelved

Endeavor Group Holdings
Poshmark
WeWork*

In Limbo

Palantir Technologies
Postmates
McAfee

Drawdowns from IPO

Lift -53%
Slack -49%
Smile Direct -43%
Uber -36%
Peloton -18%

*Equity valuation drawdown near 80%.

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Madness of Crowds in Bonds

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June 2017

Since early 2017, the European Central Bank has purchased another $1T of assets, blowing their balance sheet up near $5T. Most of this capital has flown into government and corporate bonds with meaningful implication. Let us explore.

Each day that goes by, there are fewer and fewer bonds for investors to buy.  The ugly side effects of this experiment are now oozing through bond markets around planet earth.

It was an all you can eat buffet. Back in 2017 with the ECB distorting global bond prices, Argentina found loads of buyers for an ultra-long dated – 100 year – bond. Today, with this pile of debt approaching 36 cents on the dollar, investors have been left holding the bag to the tune of a $2B loss. That’s nothing, senior secured lenders to Argentina at the IMF are sitting on $56B of capital that has just been lit on fire, while U.S. taxpayers are on the hook for $20B of that loss.

If you sit back and think about the current dynamic playing out in the global bond markets, you see a circular beast eating nearly everything in its path. Central banks have been preventing the cleansing process of the business cycle from functioning by buying assets, near $15T between the Fed, ECB, and BOJ.  The good news is, trillions of dollars in new wealth has been created that needs a home, with the top 1% getting richer by the day.  On the other hand, with fewer choices to buy, bonds with negative yields have climbed from $5T in September to $17T today. Bottom line, investors are being “shoe-horned” into places they just shouldn’t be.

Years Argentina has been in Default

2013-15
2000-04
1980-92
1955-65
1950-51
1890-93
1826-58

Amazing, with this track record, investors bought $15B of bonds in 2016-2017. This week,  the Macri government in Argentina announced it will postpone paying $7B of short-term local debt for up to six months while pursuing a “voluntary reprofiling” of $50bn of longer-dated debt, the majority of which is owned by foreign investors. The government also said it plans to delay the repayment of loans already disbursed by the IMF. Argentine bonds plummeted to record lows on the news, with the once-popular “century bond” maturing in 2117 plunged near 36 cents on the dollar. The shorter-dated dollar debt coming due in 2021 fell below 50 cents on the dollar, pushing its yield to nearly 60%, per the FT.

A Tale of Two Countries
The double-edged sword of duration is on stage here.  Some investors like ultra-long maturities with low coupons because their prices rise dramatically when their yield falls. In the great race away from negative yields, over the last year, Austria’s long bond has doubled in value, while Silver is 32% higher, and gold up more than 29%.

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Have and Have Nots in U.S. Corporate Bonds
The junk of the junk, why has CCC-rated paper dramatically underperformed while capital is flying into BB credits in the U.S. In the middle of the ‘everything rally’ – one would expect beta-chasing to drive demand for the highest yield, worst rated high bonds. That’s NOT happening. To us, this is an important signal, we’re very close to the ugly credit saturation point. Even with colossal pressure from central banks to reach for yield, rising default risks are keeping investors away from CCCs. What does this mean for U.S. stocks?  Pick up our next report, just click on the link below.

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Yield Curve Inversion & The 90% Day


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90% Down Days

2011: 33
2010: 20
2009: 17
2012: 8
2013: 7
2014: 5
2015: 7
2016: 4
2018: 7
2019: 3

*over 90% of the NYSE stock trading volume is in Down vs Up stocks.

The Official 90% Day

Over 90% of volume went into Down vs. Up stocks on Wednesday, while the overall advance/decline was down nearly 5:1 with 8 sectors falling more than 2% with energy and financials leading the way lower.

90% volume down-days have occurred 127 times since September 2008. In the following 3 months (60 trading days), the S&P 500’s median return was +5.07%. Meanwhile, in the 95%+ volume down-days (today was 95% exactly) the median return was +7.74% in the following 60 trading days.

“There have been 32, -2.5% down days in the S&P 500 since 2010. Using those 32 past occurrences, the median number of days until ANOTHER -2.5% is only 16 days. 22 out of the 32 (68.8%) came within a month of the previous -2.5% drop.”

Bear Traps Report, August 5th, 2019

*This time only took 9 days

US 2-10 Yield Curve Spread
The 2s 10s US yield curve spread inverted for the first time since mid-2007 on Tuesday. Despite many other areas of the curve having inverted earlier this year (3-month / 10-year for example), the widely followed 2s / 10s curve had the media’s attention throughout the day and helped contribute to the significant equity sell-off. When coupled with slowing global growth and rising geopolitical tensions, markets ran-away in fear, from this classic recession indicator.

US 3-Month / 10 Year Yield Curve
Since the beginning of the month there has been significant flattening across the curve as long-end yields have continued to fall. Notably, the 3-month / 10-year spread has been pushed further into inversion, down to -37bps (the spread first went inverted in late March this year). Although the 2s / 10s curve is more commonly followed among retail investors, the 3-month / 10-year has significant importance of its own. The spread is the sole variable in the calculation of the monthly New York Federal Reserve’s Recession Probability Indicator. Importantly, the last print of the recession-probability was used the morning of the Federal Reserve’s  latest meeting and completely missed all of the flattening and inversion that has occurred in recent weeks!

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NY Fed Probability of Recession in Next 12 Months

The latest recession-probability print showed a decrease from the month prior to 31.48%, driven by the steepening in the 3-month / 10-year yield curve spread throughout July.  However, the NY Fed’s latest recession probability does not include the significant flattening seen in recent weeks. It missed out on the Fed’s recent meeting where markets reacted hawkishly, Trump’s tariff threat for September 1st, the Yuan 7-handle break, and the recent inversion!

The Probability’s Importance:

Many experienced investors would likely say the 2s / 10s yield curve spread falling just 3-5 bps on the day would not have any significant implications for equity markets. However, the S&P 500 closed lower -2.96% on the day. Of course, this was not completely driven by the inversion-scare but it is hard to deny the negative psychological effects.

In our view, when the updated recession probability prints in the first few days of September, it will have a similar psychological impact. Keep in mind, this is coming from the New York Federal Reserve,  a rising probability points directly to more rapid rate-cuts out of the FOMC.

Based on the 3-month / 10-year spread, the New York Fed’s probability is just under 40%, if we see even more steepening look for a probability pushing 50% and a significant market impact in rates, equities, the US Dollar, gold, and eurodollar futures.

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Precious Metals Not Taking a Breather

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Secular Silver Shift
This week, the ratio between the Russell 3000 Index and silver fell below its 200-day moving average, a significant event. In our view, this is a clear sign investors are shifting into asset classes which benefit more substantially from global central bank rate cuts.

With conviction in May, we had clients establish meaningful gold and silver positions, to get on our distribution list, please email tatiana@thebeartrapsreport.com.

Since the Fed’s Dovish Shift in late May

GDX Gold Miners: +40%
SIL Silver Miners: +33%
EWZ Brazil: +25%
GLD Gold: +14%
SLV Silver: +14%
SPY S&P 500: +8%
EEM Emerging Markets +8%
IWM Russell: +6%

Ever since the Fed caved on rate cuts, precious metals and miners saw parabolic rallies. As the Federal Reserve caved on its hawkish policy path and the US Dollar began to weaken, metals have crushed US equities.

Ugly Budget Coming out of Washington

U.S. budget deficit increased by $140 billion during the first nine months of this budget year to $747.1 billion as government revenues and spending both hit records. The Treasury Department reported Thursday that the deficit for the current fiscal year through June is up 23.1% over the same period a year ago with receipts rising by 2.7% while spending increased 6.6%. The Trump administration is forecasting that the deficit for the full budget year, which ends on Sept. 30, will top $1 trillion, up from a deficit of $779 billion last year.

The Recent Surge

At the beginning of June this year, metals began shooting higher once again. Capital crowded in the US Dollar finally began to leave as the Fed guided towards an end-of-July cut. Similar to the beginning of 2016, gold and silver are not taking a breather, investors have had few chances to add on a ‘pullback’.

SLV Silver TrustSilver is breaking out of an elongated downtrend to the upside. Precious metals remain one of the best risk/reward trades in the near-term, in our view. Similar to the beginning of 2016 when the Fed caved on their hawkish policy path, precious metals are not taking a breather in their rally higher. Regardless of the global growth trend, a weaker dollar is a major tailwind here. iShares Silver Trust SLV, the average daily volume in May was 6.3M shares and nearly 40M shares were traded on Tuesday. That’s some serious FOMO (fear of missing out) capital flow.

In our view, Sometime in the Next Few Years

1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak.

2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly coming due and won’t be able to be funded with assets.

In Ray Dalio’s view, (we agree) the paradigm that we are in will most likely end when;

a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better.

b) simultaneously, the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.”

% of Euro Denominated Corporate Bonds Outstanding with Negative Yields

2019: 13%
2018: 1%*
2017: 2%
2016: 5%
2015: $0
2014: $0
2013: $0
2012: $0
2011: $0
2010: $0
2009: $0
2008: $0

BofA data, BBB investment-grade bonds, nearly 3% of junk bonds trade with a negative yield. Central banks are forcing capital into places it just shouldn’t be, moral hazard squared. Over the last 40 yrs, we’ve been lectured on the relationship between gold/silver and inflation, but it’s really about price stability. Markets have been pricing in deflationary risks for much of this year. Central banks lose control of prices = precious metals tailwinds. The explosive growth in negative-yielding corporate bonds points to global deflation risk on the rise, that’s FAR from stable prices, gold and silver are sending an important message. 

*Dec 2018 data

Sovereign Defaults Piling Up last 10 Yrs

Greece
Jamaica
Belize
Puerto Rico
Iceland
Grenada
Barbados
Venezuela
Argentina
Ukraine
Ecuador
Turkey?

Mathematically unsustainable promises to voters. Populists on the left want to walk away from colossal debt obligations, on the right they want tax cuts.

Credit, Capitalists, and Socialists

At the same time, Ray Dalio points out there will be greater internal conflicts (mostly between socialists and capitalists) about how to divide the pie and greater external conflicts (mostly between countries about how to divide both the global economic pie and global influence). In such a world, storing one’s money in cash and bonds will no longer be safe.

Global Corporate Bonds at Negative Yields

2019: $623B
2018: $12B*
2017: $90B
2016: $226B
2015: $32B
2014: $0
2013: $0
2012: $0
2011: $0
2010: $0
2009: $0
2008: $0

Bloomberg, DB data
*Q4 December

Central banks are forcing capital into places it just shouldn’t be, moral hazard squared.

As the Fed Softens their Policy Path, HIGH Impact on Emerging Market Financial Conditions
Rate cuts get vaporized in a swift economic downturn. The Fed is saying (this week’s John Williams speech), if they cut now – with force – while the US economy still has momentum, we’ll actually have a chance at creating inflation, and avoid deflation and the negative rate trap in Europe and Japan.  The impact on global financial conditions, relative to Fed policy is on stage here (above). Emerging market local currency debt has caught a meaningful bid.

Investors Beware

“Bonds are a claim on money and governments are likely to continue printing money to pay their debts with devalued money. That’s the easiest and least controversial way to reduce the debt burdens and without raising taxes. My guess is that bonds will provide bad real and nominal returns for those who hold them, but not lead to significant price declines and higher interest rates because I think that it is most likely that central banks will buy more of them to hold interest rates down and keep prices up. In other words, I suspect that the new paradigm will be characterized by large debt monetizations that will be most similar to those that occurred in the 1940s war years. So, the big question worth pondering at this time is which investments will perform well in a reflationary environment? A world with large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash).  I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better-balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio. I will soon send out an explanation of why I believe that gold is an effective portfolio diversifier.”

Ray Dalio, July 2019

Gold to Silver

Although gold and silver rally in tandem, silver has historically outperformed when both are spiking (see 2016 results). Meanwhile, the ratio of gold to silver is just off 30 years highs! In our view, there is significant ground for silver to catch up here.

Gold to Silver Ratio Metals continue to be strongly bid as gold and silver miners are rallying again this week despite a stronger US Dollar. Silver also significantly outperformed gold again. We highlighted this in our client chat recap yesterday, capital flows from gold to silver, are picking up steam. As we have stressed to clients throughout the last month, overweight silver here.

Bloomberg Nickel SubindexOne reason why silver has begun to outperform gold so much is that it is following the price of Nickel. Futures in Nickel have broken out to a parabolic-like rally, up almost 20% since late June and up over 30% since December. Although the dovish Fed guidance has been a major contributor to the Nickel rally, the industry has also been supported by supply-side reductions in recent weeks. The earthquake that hit Indonesia, as well as continued production cuts from Brazil’s Vale, have added to the upside price pressure.

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A Historic Inflection Point for the US Dollar

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“With some help from Tariffs and trade war threats, the for the second time since 2015, the Fed blew up the global economy and central bankers around the world are begging for a softer U.S. Dollar policy path. The world’s economy is dysfunctionally out of balance. With a colossal $62T of GDP outside the USA and $18T inside, the Fed cannot conduct monetary policy in a traditional sense. They’re much more of the world’s central bank and June’s meeting will accentuate that point. Their policy actions simply have far too much impact on the rest of the planet. As a result, economists who are myopically focused on U.S. economic fortunes keep embarrassing themselves. At this point, a stronger Dollar will only force the Fed into even more future rate cuts. Stay long gold, emerging markets and underweight US equities.”

Bear Traps Report, June 15, 2019

On Wednesday, the Federal Reserve met and announced they would maintain the current Federal Funds Rate of 2.25-2.5%. This came despite some market expectations that the Fed would cut in June due to weakening global economic data, ongoing trade uncertainty, and dovishness from central banks abroad. Above all, the Fed delivered on the outlook side of the equation. The FOMC dramatically changed its forecast for the future of the Fed policy path, opening the door to interest rate cuts in July, September and even December. With the 2020 election around the corner, the White House needs a lower dollar, and luckily for President Trump, the global economy needs a weak dollar more than he does.

Winners with US Dollar Heading South

Since Late May

Gold Miners $GDX +25%
Silver Miners $SIL +21%
Copper and Steel Miners $XME +17%
Oil $USO +12%
China Internet $KWEB +11%
Emerging Markets $EEM +9%
Oil Production $XLE +8%
S&P 500 $SPY +7%
Financials $XLF +5%

Bloomberg data

US Manufacturing Crushed by the Strong US Dollar
There are a thousand words in this chart. As we witnessed in 2015-16, a strong US dollar hammered the US manufacturing sector and jobs were put at risk. Today, US Manufacturing PMI is essentially in recession territory (a reading below 50 signals recession). A strong US dollar has made exports far more expensive, especially in Europe with their central bank – the ECB – in currency manipulation mode for much of the last 3 years. 

S&P Rose on Fed Cave

Despite the lack of a material change in the fed funds rate, the market reacted positively to the announcement, with the S&P 500 climbing just over 1%  from when the news broke at 2:00 pm to the next day’s open. Chairman Jerome Powell took a relatively dovish tone during his post-meeting Press Conference commentary, in which he acknowledged “moderating” job growth, slowing business investment, as well as inflation beginning to detach from the 2% target. Additionally, the Fed “dot plot”, which illustrates board members’ future interest rate expectations, was revised in a dovish direction, though views are still mixed.

US Dollar, a Trend Break with Colossal Implications
Goodnight Irene, the US Dollar has broken its uptrend which started in January of 2018. This is the beginning of a meaningful leg lower. The Fed has laid a beating on the global economy with eight rate hikes and $666B balance sheet reduction, all since 2016. That’s a colossal amount of tightening compared with the rest of the world. As they unwind this experiment, the greenback is in big trouble. We believe the Dollar is putting in its top, stuck in a dynamic where it’s a victim of its own success. If the Dollar breaks out to new highs, it will find itself in a tricky balance — more global economic destruction and an even greater need to cut rates. A significant weight on the Fed in its recent meetings has been the powerful force in their embarrassing U-turn — the slowdown in global growth and the negative feedback loop back to the U.S. In recent years while the Fed was in crack smoking mode — trying to hike rates and reduce its balance sheet by trillions at the same time — trillions of Dollars ($6T to $7T in our estimates) were sucked back to the United States and the emerging market’s economic engine was the big loser. This giant ocean of capital is about to change direction and Dollars will be pouring out of the U.S.

Fed Couldn’t Stay Stubborn in Face of Global Resistance

With some help from tariffs and trade war threats, the Fed blew up the global economy for the second time since 2015 with its hike late last year. Central bankers around the world are begging for a softer U.S. Dollar policy path. With a colossal $62T of GDP outside the U.S. and $18T inside, the Fed cannot conduct monetary policy in a traditional sense and must accommodate the rest of the globe.

China touts a $13T economy and we hear the Yuan is destined to overthrow the Dollar’s reserve currency status with a mediocre 2% of SWIFT payments now being settled in CNY? What’s the problem with the U.S. Dollar the being the world’s reserve currency anyway? Foreign nations rely heavily on U.S. Dollars for all types of international trade. For instance, if Brazil sells soybeans to Australia, the country “Down Under” will most likely pay Brazil in U.S. Dollars. Because of the reliance on Dollars for trade, Brazil, Australia, and almost every other nation holds loads of Dollar reserves. Most foreign war chests are held in U.S. Treasuries, the world’s safe haven. As global trade has grown over the years, the need for Dollar savings has grown in step and has resulted in more lending to the U.S. Treasury by foreign governments. There are several reasons why a strong U.S. Dollar has evolved into a global economic wrecking ball, and this is one of them.

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Even the Market (Futures) was High Kites
Since September, Fed Funds futures have seen a dramatic shift lower. March 2021 futures have gone from pricing in 1 rate hike to nearly 4 rate cuts. Despite this, until this week’s meeting, the Fed was quite resolute in trying to set up hikes in 2020 and beyond. This is all off the table now, the previous dots were way out of tune and reality has now set in.

Dovish Dot Revision Show Massive Walk-backNine members see no rate cuts this year, eight do (of which seven see two cuts). The committee changed language from its May statement and took out the 2020 rate hike. 

Weaker Dollar Leading to Rotation into Metals and EM

Right now, the market is pricing in a 100% chance of a 25 basis point cut in July and about a 60% chance of a 50 bps cut. As the Fed cuts, the Dollar loses value, and these black clouds of USD weakness are already pushing investors into assets like Gold, Silver, and Emerging Markets (EM). On Thursday, global markets saw a strong reaction, Gold, Silver, and Emerging Markets all soared higher, outperforming the S&P 500. In our view, as rate cuts move from the realm of expectations to reality, these markets will only continue to rally.

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Gold Spiked on Powell Commentary and New DotsThe Fed’s cave led to the largest one-day volatility spike in Gold since Feb 11th, 2016. That day gold closed up 4%, consolidated its move over 2 days then continued its uptrend to a top 4 months later.

U.S. Vulnerable to Foreign Capital Flight

In our view, over the last decade, the U.S. outperformance versus the rest of the world, both in equity markets and in terms of being further along the rate normalization path, led to a flood of foreign capital into the country. However, dovish Fed expectations are causing some of this foreign investment to trickle out. If U.S. growth weakens and equity P/E multiples contract, foreign portfolio flows are going to get uncomfortable and rapidly repatriate capital. A colossal flood out of the Dollar is on our doorstep.

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