An Unsustainable Divergence

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1933 Industries

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“It’s Checkmate Mr.  Powell – There’s far too much leverage globally and domestically, as we stressed in August and September — a 25bps rate hike acts more like 75bps. With $62T of GDP outside the USA, $18T inside, U.S. economic data plays second fiddle to global credit risk, it’s that simple. U.S. economists are smoking in the dynamite shed with expectations of three to four more hikes. They were JUST AS clueless in 2015 and 2016 when they lectured us on eight rate hikes. The Fed ultimately delivered just two in those years. If the Fed plays tough guy now, equities will crash, and then they’ll be forced to cave and CUT rates! It’s checkmate, Mr. Powell. Our major concern centers around the Fed NOT shifting dovish enough. Markets now have high expectations of relief from the Fed, so they MUST deliver. We think equities rally nicely initially but then FADE hard on a Fed leaving the beast inside the market unsatisfied.”

The Bear Traps Report, December 15, 2018

Q2 2019, is it Q3 2018 in Reverse?

The beast inside the market is entering an inverse period of what occurred in the third quarter of 2018, as we look down the road ahead the implications are daunting. In Q3 2018, the global economy was effectively seeing a meaningful slowdown in growth while central bankers around the world continued to insist on “normalization” and tightening monetary policy. Fast forward to Q2 2019, there are numerous ‘green shoots’ coming to visit the global economy (positive signs) with a growth slowdown beginning to bottom, while central bankers have already thrown in the towel. Let’s take a look.

Monetary Policy Divergence to an Extreme
It’s kind of a mind-blower. Since 2014, the European Central Bank has been in accommodation mode to the tune of a $2.7T bond-buying spree (see above) found in their colossal balance sheet expansion. At the same time in the U.S., the Federal Reserve has hiked rates nine times, eight since the 2016 election and REDUCED its balance sheet by $500B. Is the U.S. economy that much stronger than Europe’s? Clearly, there’s $62T of GDP OUTSIDE the U.S. and $18T inside – so Fed rate hikes tend to do a number on the global economy which feeds back to Europe in a negative way, which then comes back to the U.S. and stopped the Fed in its tracks (in Q1 the Fed put forth one of the most significant policy reversals in the history of central banking). A five-year-old can tell you this is a broken model. You can’t have one central bank hiking rates nine times in 3 years, and another buying up nearly $3T of global assets – markets just told us this is a highly unsustainable dynamic in modern central banking. We believe the Fed, ECB, PBOC (China), BOE (UK) now get the joke. Looking forward – we see a “convergence” in global central bank policy, NOT unsustainable divergence. This will have MAJOR implications for the dollar, precious metals and emerging market equities. Pick up our latest report here. 

From the December Lows

Oil WTI: +51%
Semiconductors SOX: + 46%
China Internet $KWEB: + 34%
Nasdaq 100 NDX: + 30%
Greece $GREK: + 27%
S&P 500: + 23%
Eurozone Banks $EUFN: + 21%
MSCI World: + 20%
Retail XRT: + 19%
Copper:  +16%
MSCI Emerging Markets $EEM: + 17%
MSCI World (ex USA): + 14%
Brazil $EWZ: + 12%
Junk $JNK: + 10%
Gold: + 7%

Bloomberg terminal data

A Global Central Bank Cave-athon

Central banks have proactively shifted to a dovish policy stance trying to get ahead of economic data weakened further. Instead of waiting for economic data to truly justify caving on tightening monetary policy, central banks threw in the towel early and are now in ‘wait and see’ mode. This is a dramatic shift, and risk assets such as equities have been pricing this in, NO news here. We have gone from a world where headwinds to growth are becoming tailwinds. The Fed’s cave, China economic growth has stabilized, a weakening US Dollar (Bloomberg dollar index off 1.7% since November), and softer trade headlines on a possible deal – assets prices have been pricing in these positive developments for months. Since Q3, we have been overweight emerging markets. Six months ago, EM was dealing with a tightening Fed, a stronger US Dollar, Brexit risk and a slowing economy in China all at the same time.

Rolling 1 Year Beta to a Weaker U.S. Dollar

Gold: 3.55
Oil: 2.86
MSCI Emerging Markets: 2.45
Copper: 2.15
Swiss Franc: 1.94
MSCI Asia (ex-Japan): 1.85
Euro: 1.45
Yen: 1.20
EM FX: 0.75
MSCI World: 0.45
Topix: -0.12
S&P 500: -0.27

*Bear Traps Report data looking back to 2000. These are your weak dollar winners. In a period of headwinds for the greenback, it’s interesting to note how poorly U.S. equities perform relative to emerging markets, oil and gold.

China Yuan Currency Volatility
Today, economic demand struggles are bottoming globally, and the Yuan (China currency) is beginning to strengthen. One of our favorite global economic indicators is found in 3-month China yuan volatility. As a currency is strengthening volatility plunges, while a weaker currency is often met with a surge in forex volatility. Looking back over the last 5 years you can see – above- the powerful impact on global equities. There’s an inverse relationship between equity prices globally and China forex vol. BUT, but , but; above all, the last time China currency volatility was this low, global equities were a lot higher – see the grey circle above.

EM’s External Drivers

Emerging markets rely on two key external factors. First, the global economic cycle, which China’s $13T economy is the biggest driver. Second, the financial cycle, which the Fed is the biggest driver. In Q3 2018, those two key external variables were headwinds, now they are tailwinds. There’s an opportunity here, indeed.

Autos Show Sunshine
China’s easier economic policies transmission to consumption has not convinced so far. March jump in car sales may be the 1st sign of this happening. Car sales rose more than 10% over the month (strongest since April 2009), reversing the y/y trend growth from 22-year lows. Special thanks to our friend Patrick Zweifel and Pictet Asset Management for this observation.

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Back in the USA: Leadership, Stock Buybacks or Capex?

S&P 500 share repurchases surged 50% to an all-time high of over $800 billion in 2018, generating public debate about the use of corporate cash in Washington, DC and beyond. How US companies use cash, the motivations of executives buying back stock, and the effects of these buybacks on workers, companies, the economy, and political implications are what investors should be focused on.

“When a corporation uses profits for stock buyback it’s deciding that returning capital to shareholders is better for business than investing in their products or workers. Tax code encourages this. No surprise we have work life that is unstable & low paying.”

Senator Marco Rubio

Eye Opener: Goldman’s Look inside Buybacks and Capex

To start, William Lazonick, professor at the University of Massachusetts lays out several concerns about buybacks driving the public debate. At their core is the notion that returning cash to shareholders comes at the expense of investment. This, in turn, harms innovation as well as American workers, who, Lazonick argues, should be getting a much larger share of company profits than shareholders. He also believes that paying executives with stock distorts their incentives, motivating them to boost share prices, no matter the cost to employees, their companies’ future growth, or the economy writ large—especially as the US increasingly loses out to more innovative competitors. What’s the fix, in his view?
Ban buybacks, stop paying executives with stock and give employees their due—all of which will only be truly meaningful in a world in which the “maximizing shareholder value” ideology no longer prevails.

Capex Soaring through all the Stock Buyback Noise
Our Bear Traps Report team developed this thesis in early January – see our chart above. We’re pleased to say, NOW Goldman is backing up our work. It’s very disturbing that the main street media continues to spin a narrative which is completely false. When looking at the numbers, Goldman’s US portfolio strategists David Kostin and Cole Hunter find many of these arguments (Buybacks > Capex) don’t hold up in reality! In particular, they emphasize that even as companies return a large amount of cash to shareholders, there is sizable reinvestment; in fact, growth investment at S&P 500 companies has accounted for a larger share of cash spending than shareholder return every year since at least 1990, with the largest share repurchasers far outpacing market averages in the growth of R&D and capex spending. They also find those executives who stand to gain the most from buybacks— those whose compensation depends directly on EPS—did not allocate a greater proportion of total cash spending to buybacks in 2018 than executives whose pay was not linked to EPS.

Corporate Use of Cash
Aswath Damadoran, professor at New York University Stern School of Business, agrees that buybacks aren’t coming at the expense of investment. Rather, he argues that large, mature companies returning cash to shareholders allow that cash to be put to more productive uses; so it’s not that companies are investing less, it’s those different companies—with better growth opportunities—are investing instead.

The Walking Dead

There are colossal political implications for companies in here, Goldman does a solid job shedding light on a topic draped in fog. As for workers, Damodaran worries that constraining companies’ ability to return cash to shareholders would lead US companies to make bad investments, further damaging their competitiveness and creating more “walking dead companies” similar to what we see in Europe. This, he fears, could backfire on workers, as firms are ultimately forced to pay less, hire less, or reduce their workforce altogether. In the end, he believes banning buybacks would ironically most likely benefit corporate executives (who would now have the luxury of sitting on cash) and bankers (who will reap the gains if executives instead pursue acquisitions), while hurting workers.  Steven Davis, professor at The University of Chicago Booth School of Business, then dives into the potential implications of banning buybacks for business formation, job creation and the broader economy. He explains that such a ban will likely lead to an inefficient allocation of resources, which will ultimately shrink the overall size of the economic “pie”. And since he finds that younger and smaller businesses are an important source of jobs in the economy—particularly for workers at the lower end of the earnings distribution—he’s concerned that trapping cash in older, larger companies will reinforce an unequal distribution of the pie, aka: income inequality. In his view, the best bet to increase the size of the pie and even out its distribution is to foster a favorable environment for starting and growing businesses. That would entail simplifying the tax code, reducing labor market restrictions and regulations, and revamping local and federal regulations in other areas that create a complex and costly business environment today.

Political Implications are Profound, Beware

We believe the unintended consequences of stock buyback legislation coming out of Washington will have COLOSSAL U.S. equity market implications – could very well contribute to a crash. In our view, the S&P 500 would have a 2500 address NOT 2900 without buybacks. Per our friend Chris Cole at Artemis Capital, over $5T has been plowed into stock buybacks over the last decade. We add, over $8T of Federal Reserve – easy money – induced corporate bond sales financed this orgy.  Thank you, Bernanke, Yellen and Powell – this mess went down on your watch.

Per Vox, “Florida Senator Marco Rubio is looking at one of the Republican tax bill’s worst optical problems, corporations spending their big tax cut on inflating the price of their stocks instead of hiring workers or building new factories. US companies spent a record $1 trillion on stock buybacks in 2018.” (Media spinning a false narrative again, upselling you buybacks over capital expenditures).

Rubio’s proposal is, in essence, to tax stock buybacks more aggressively while extending a provision in the tax bill that allows companies to immediately and fully deduct the cost of new investments, thereby making it more attractive for companies to make those investments.

Rubio is framing his proposal as a necessary step for the United States to compete with China, in his view the country’s greatest geopolitical threat, but implicit in its design is a recognition the GOP bill didn’t have the desired effect on business behavior.

Experts say Rubio’s heart may be in the right place. “There’s good reason to believe companies underinvest,” said Alan Cole, a former Republican tax policy adviser now at the Wharton School. Special thanks to Vox for the Rubio coverage here.



Tesla’s Saving Grace? Washington Policy and Electric Vehicle Tax Credits

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“A cab driver will tell you Tesla is barely profitable. Most know it has a market capitalization similar to that of the world’s leading premium car makers; BMW and Daimler, who made $14B and $18B last year, respectively. The company has burned through $13B of capital over the last decade, yet it trades at 3x BMW and 7x Porsche EV/EBITDA multiple. Tesla has thrived, in large part due to ubiquitous subsidies as well as wide open capital markets. Thanks to obnoxiously accommodative central banks, an easy money gravy train has allowed this levered beast to issue more than $11B in high yield and convertible debt in the last few years. Bottom line, in a normally functioning business cycle (capital market formation) without central bank interference, the company would NOT exist in its present form. With over $750B of U.S. high yield and investment grade (leveraged loans) bond maturities in 2019 and a Fed reducing its balance sheet (QT) to the tune of $50B a month – tightening financial conditions will be the noose around Tesla’s neck.”

Bear Traps Report – January 2019

Washington Policy Will be Driving the Tesla Bus in 2019

Tesla’s best friend over the past decade has been the U.S. Government and  Elon’s (Musk) beloved tax credits for manufacturing electric vehicles. In 2009,  President Obama signed the American Clean Energy and Security Act, stipulating that EVs produced after 2010 were eligible for a tax credit up to $7,500. In his 2011 State of the Union address, he pledged $2.4B in federal grants to support the development of next-generation electric vehicles and batteries.

In January, we released a major theme-report on the Electric Vehicle industry and Tesla, find out more here.

The End of Subsidies?

These tax credits were designed to have a time limit – a financial benefit (to Tesla) acting as a melting ice cube. Per the plan, after manufacturers hit the 200,000 Electric Vehicles sold mark, their tax credits would begin to phase out. Tesla was the first manufacturer to enter the phase-out at the beginning of this year, while General Motor’s phase-out began on April 1st.

“The fate of efforts to extend the electric vehicle tax credit are most likely tied to the fate of tax extenders legislation—legislation which is very much in doubt because of divisions among House Democrats, which include, among other disagreements, whether to offset the cost of reauthorizing expired or expiring tax credits (so-called “tax extenders” legislation). The Senate Finance Committee, under the leadership of Chairman Chuck Grassley (R-IA) is less inclined to offset the costs of the tax legislation.”

ACG Analytics – April 10, 2019

Tesla Equity
Tesla stock price is on the bottom end of a sustained trend channel, as investor’s optimism slowly dwindles. However, “proposed” legislation could be the boost the equity needs to bounce off nearby support – as long as it moves quickly trhough Congress.

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 Proposed Legislation 

This week our associates in Washington have a very insightful update. In an institutional research note, ACG Analytics made the point that new legislation has been introduced with bi-partisan support for extending the tax credit wall an additional 400,000 vehicles with a slightly smaller credit of $7,000. We have an important view on the likelihood of legislation passage here, see our full report here.

Tesla 2019 EPS Estimates
This year’s earnings expectations for Tesla have crashed down from their fantasy levels. At the beginning of the year EPS expectations were over $6.00 for the year, now they have fallen over 40% to near $3.25. Expectations slid due to increased competition in Europe and the company not hitting bullish delivery estimates – the loss of tax credit did not help their bottom line. 


If the “proposed” legislation were to quickly* pass through Congress and is signed by the President, it could have large benefits for Tesla’s equity as the stock price has reflected the reality that their customers were no longer receiving thousands per vehicle from the U.S. Government.

An additional 400,000 electric vehicles on top of the existing 200,000 cap gives each manufacturer 600,000 to sell with tax credits. However, Tesla has already sold 375,000 vehicles in its history and is expected to do 300,000 more  by YEAR END.

Across the street, estimates were cut after disappointing Quarter 1 deliveries. We believe Tesla should deliver roughly 339,000 vehicles by year-end (~77k thus far). Back in January, some Street estimates were as high as 400,000. However, this would leave them with limited tax-credit-worthy vehicles IF successful legislation is delayed until the end of 2019 or beyond.

Keep in mind – almost all of Tesla’s competitors will be able to reap the benefits of these tax credits for years to come. We wrote about Tesla’s incoming supply problem back in January’s bear case.

“In the mass market, Tesla’s model 3 will face an avalanche of competition from Nissan, VW, GM, the Koreans, and the French. In this table, we only highlighted the most significant launches for the US market, which is 50% of Tesla sales.”

Bear Traps Report – January 2019

Credit LEADS Equities
In October of 2018, Tesla reported another rare profit. After 8 quarters of mounting losses, shorts were once again caught on the wrong foot (as you can see above – red circle). Why the sudden turnaround? Unlike almost any other mass car producer, Tesla delivers from their order book. With Model 3 production (finally) at adequate levels, Tesla first started delivering the top range Model 3s, which often go for ~$55K vs a $35K base price. To exemplify, Tesla makes an estimated $3,500 operating profit on the $45K version while it loses some $3,900 on the base Model 3. This is how Tesla showed a rare profit in Q3. Keep in mind, Tesla didn’t just turn profitable, it also showed positive cash flow – or more pain for shorts. This was mainly due to reversals in working capital and tax credits. All this came as huge surprise to the market and the stock ripped higher, as short sellers once again rushed to cover. We MUST look at the Tesla credit (5.3s due 2025). In late October / early November as the stock soared, Tesla’s junk bonds were NOT buying the price action in the equity and lost 4 points (early November to late December)! Sure enough, a few weeks later the stock caught up with the bonds on the downside. 

Let us know if you are interested in the detail behind the potential legislation – email .

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China Economic Bounce and Global Bond Yields

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China’s Factory Data Bounce Speaks to a Far More Rosy Global Economic Outlook than Current Expectations

Largest Surge in Seven Years from China’s Manufacturing PMI

As the March economic data starts to come in from China, in the week ahead – that sound you’ll be hearing will be a loud sigh of relief coming out of the global bond market.

China Stimulus Arrives on Stage
In Q4 2018, China threw a substantial amount of fiscal and monetary weaponry at its weakening $13T economy. Heading into the trade negotiating climax with the USA, we believe tax cuts and PBOC RRR (levels of reserves in their banking system) activity – all together – come to over $500B of stimulus. Three months later, those desperate measures are showing up in the data.

Upside Surprise

To us, the meaningful upside surprise in China’s March NBS Manufacturing PMI speaks to near term positive momentum for the industrial activity outlook for all of Asia. A trade deal with the USA will only add to these positive developments. China will extend the 3-month suspension of additional tariffs on US-made vehicles and auto parts, which expires on March 31, 2019, the tariff committee of the State Council said on Sunday.

Brent Oil likes the Data Coming Out of China
We’re seeing a Major trend breakout oil on the heals of the China PMI bounce – bullish wedge.

Negative Yield Bonds and Gold
In Q1 2019, the global economy’s struggles have powered the tally of negative yielding bond on earth to near $10T. Economic data out of China this weekend will likely turn this ship around.

Good News from China for Bond Bears
China March official composite PMI +1.6pts to 54 driven by manufacturing +1.3pts to 50.5 and non-manufacturing +0.5pts to 54.8. Could partly reflect lunar near year holiday distortions but also likely reflects the impact of China stimulus measures. “A Positive sign for Chinese and global”growth,” says AMP Capital. China delivered good news for global investors this weekend. This year, the country’s struggling demand had weighed on sectors such as auto producers and commodity exporters, worldwide – especially Germany. Likewise, with tariffs and uncertainty about whether a deal with the U.S. will be signed weighing on trade and no sign of a rebound in domestic consumption yet, there is still some work to be done in terms of getting more “buy-in” from the global investment community.

New Data is a Colossal Relief
In its largest surge since 2012, China’s manufacturing purchasing managers index rose to 50.5 from 49.2 last month, exceeding all estimates by economists – the consensus was looking for 49.6. In better news, new orders and new export orders – leading indicators which signal future activities, popped up to the highest levels in six months. Keep in mind, Germany’s economy and bond yields have a very high beta to China’s economic fortunes. As you can see above, over the last 5 years lows in German bond yields have been closely tied to periods where China’s Manufacturing PMI struggles.  This speaks to HIGHER global bond yields in the days and weeks to come – a bounce is long overdue.

China Equities Moving North – Bullish Wedge Break

Major markets in Asia surged on Monday following data released over the weekend that showed economic activity in China unexpectedly bouncing back in March. Mainland Chinese shares soared on the day, with the Shanghai composite up 2.58 percent to 3,170.36, while the Shenzhen component surged about 3.64 percent to 10,267.70. The Shenzhen composite jumped 3.571 percent to 1,755.67.Over in Hong Kong, the Hang Seng index was up 1.66 percent in its final hour of trading. – CNBC


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Analyst in Full Capitulation in Tesla

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Lackluster demand and overseas Model 3 delivery problems will weigh on Tesla’s first-quarter earnings results when the company reports in April, RBC Capital Markets warned clients Monday. – CNBC noted.

The brokerage cut its first-quarter Model 3 delivery forecast to 52,500 from 57,000 and slashed its price target to $210 from $245, a 14 percent reduction that implies more than 20 percent downside over the next year.

“We see both 2019 and 2020 revenue as down vs. the 4Q18 run-rate and, given Tesla is priced for growth, believe the valuation will come in,” analyst Joseph Spak wrote in a note to clients. “Overall, for 2019 we now forecast about 261,000 Model 3 [deliveries], down from 268,000 prior. Our 2020 forecast of 347,500 remains unchanged.”

RBC in Full Tesla Capitulation
RBC Capital Markets lowers its 12-month price target on shares of Tesla amid softer demand expectations and a delivery snag in China – new target is a 14 percent reduction to his prior forecast and implies more than 20 percent downside over the next year from Friday’s close. “We see both 2019 and 2020 revenue as down vs. the 4Q18 run-rate and, given Tesla is priced for growth, believe the valuation will come in” – CNBC Reported.

RBC’s price target on Dec 20 was $340 raised that week – up from $325. So they hiked the target 2x in Q4, now in full capitulation with 3 reductions.

MUST READ: We have a full report on electric vehicles, lithium, and Tesla here.

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Mueller Report Finality and Market Impact

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Mueller Report Market Impact via CNBC

Wall Street is scrambling to figure out what the conclusions of special counsel Robert Mueller‘s long-awaited investigation means for the stock market.

Japan Equities Plunge Sunday Night Post the Mueller Report News
Japan led off this week where US equities closed out last, in the red. The 3% plunge is equivalent to 765 dow points.

Market were NOT Taking Impeachment Risk Seriously

While many investment and equity strategists told CNBC that Attorney General William Barr’s letter about Mueller’s report relieves a persistent concern, few had expected a disastrous outcome for President Donald Trump.

Others, like The Bear Traps Report founder Larry McDonald, were more optimistic and suggested the findings could be a boon to certain sectors.

“It frees him up to focus on infrastructure and housing reform,” McDonald said. “We will rally on this but everything that took us down last week will keep rearing it’s ugly head again.”

Here are the full comments from market investors, strategists and analysts via CNBC.



Classic Signals – Fixed Income and Equities

“With a cross-asset view (emerging market currencies, eurodollar/Fed funds, gold, and silver); bets on a “one and done” Fed have dramatically outperformed U.S. equities in Q4 and are all pointing to early signs of a softer Fed policy path. Looking down the road ahead, the U.S. equity market will CRASH in 1987 style if the Fed plays tough guy (3/4 more rate hikes?!), it’s that simple. Similar to the March 2016 landscape, the market is about to embarrass the Fed yet again. As we have stressed over the last month, they will capitulate in our view.  Stay long emerging markets EEM, gold GLD and the gold miners GDX.”

Bear Traps Report, November 15, 2018

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Breaking: *AUSTRALIA’S 10-YEAR BOND YIELD DROPS TO ALL-TIME LOW – Bloomberg at 5:39ET, March 24, 2019

Using Equities to Confirm Signals coming from Fixed Income Markets

At the Bear Traps Report, we take a cross-asset view from 20,000 feet looking for important signals which can validate an investment thesis. Today, fixed income and equity markets are telling us something, and it’s time to listen.

March 2019: Ex-Fed Chair Yellen, Global Central Banks Do Not Have Adequate Crisis Tools

June 2017: Fed’s Yellen expects no new financial crisis in ‘our lifetimes’

Recent yield curve inversion has central bankers a bit uncomfortable.

Equities, Consumer Discretionary are Crushing Staples
In recent years, U.S. equities in the economically sensitive consumer discretionary XLY sector have substantially outperformed consumer staples XLP (82.6% vs. 47.9% over the last five years total return). Since June 2018, the world has changed – staples XLP have had their day in the sun (red channel above). During Friday’s 500 point swoon in the Dow Jones Industrial Average, the XLY was 2% lower – while defensive equities in the XLP were unchanged – a sign of things to come. What’s the connection here between what bonds and equities are telling us?

From the Recent Highs

Regional Banks $BKX -10.6%
Financials $XLF -6.9%
Russell $IWM -4.4%
Dow Transports -3.8%
Semiconductors $SMH -3.5%
Energy $XLE -2.9%
Dow -2.8% FANGs -2.6%
Cons Disc $XLY -2.0%
Oil -1.8%
Utilities $XLU +0.40%
Staples $XLP +1.1%

It’s far too early to draw major conclusions, but one thing is clear – economically sensitive sectors (banks, small caps) are leading the way lower for now.

Floating Rate Loans Take a Beating
When Fixed Income markets start to price in a cap on near term / intermediate term bond yields, floating rate securities begin to dramatically under-perform (bank loans BKLN).

Economic Risk Indicators

In October, Wall St.’s economists were looking for 3-4 more rate hikes. Here we are in March and they’ve thrown in the towel. Clearly, there are so many cross-currents to watch. Most are obsessed with the U.S. Treasury curve. Late this week she inverted for the first time since the start of the financial crisis, it’s the talk of the town.  Economists call this the first reliable market signal of an approaching recession and a rate-cutting cycle coming at us.

Financials Leading Stocks Lower
Since October, the 2-10s US Treasury curve has flattened from 34 to 11bps. Since March 18, the XLF Financials ETF has plunged nearly 7%, the KBW Nas­daq Bank In­dex of large lenders post­ing its big­gest one-week slide since 2016, off 10.6% since Tuesday – all with the staples XLP up 1%. Sure, we all know banks’ earnings power struggles with a flat curve and the follow on pressure on net interest margins. But, is this downdraft in the financials simply a product of a flattening yield curve? Or is something more ominous afoot?

US Corporate Bond Binge
Yields on U.S. investment-grade bonds have plunged to the lowest in more than a year.

3-Month vs. 10-Year Treasuries

After 9 rate hikes, the Fed has pushed its target rate or “upper bound” to 2.50%, this is holding up the front end of the yield curve. At the same time, global economic pressures have investors buying long-dated bonds, putting downward pressure on yields.

German Bond Yield Back to 2016 Levels
German 10-year bonds were up at 0.57% in October, they touched -0.01% this week – their lowest yield since 2016. The last time bond yields in Europe were this low the ECB was buying $60 to $80B a month of asset purchases vs. just $5 to $10B today.

Where’s the Trade?

Late this week, the spread between the three-month and 10-year U.S. Treasury yields evaporated, a rush of panic buying pushed 10’s yield to a near 15-month low of 2.40% – the 3-moth TBill yield is 2.40% as well.  In Treasuries, a three-month investment or ten years, the yield is the same. Everyone knows inversion is considered a reliable omen of a recession in the U.S., within roughly the next 12-18 months – but where’s the trade?

An Economist Worth Listening To
We have an economist (above – white line) that’s actually worth listening to. As you can see above – going back 30 years – well before U.S. recessions, consumer staples dramatically outperform consumer discretionary stocks.  When we take a close look at a recession-proof sector like the staples XLP ETF vs. a sector with a high degree of economic sensitivity, consumer discretionary XLY – we come up with eye-opening data. Notably, this ratio has historically rolled over before yield curve inversions as well. Historically, yield curve inversion only confirms what Stan’s economist is already telling us. For our full report, join us here.

Stan Druckenmiller’s Economist

We must introduce you to Druckenmiller’s Economist. Stan will tell you, looking at U.S. Treasury yield curve inversion – in isolation – relative to recession risk is a fool’s errand.

On our Real Vision platform, recently billionaire and legendary investor Stan Druckenmiller talked about clues he takes from the stock market and various economic indicators he uses to make an informed decision about where we are headed. Stan often refers to his “economist” in measuring the performance of different economically sensitive sectors. We agree, but let’s look at fixed income and equity signals together. How do the Staples XLP perform vs. the S&P 500 SPY once the Treasury curve inverts?

Fixed Income Signals in Equity Markets – Consumer Staples vs. the S&P 500
Since 1990, the 3 Month / 10 Year yield Curve has inverted twice. During 2000 to 2002 and from 2006 to 2008. Staples outperformance was substantial in these periods.

 **Notably, staples outperformance does not start immediately. For example, in the Financial Crisis, it takes over 12 months for the XLP to outperform the SPY after inversion. Though it took over a year, the relative performance accelerated quickly in 2008.

Stapes vs. S&P in a Post-Inversion Regime
Above, is the peak to which staples outperforms the S&P 500 post-inversion. If it was a fight, they’d stop it. In a late cycle, post “yield curve inversion” regime, investors want to be overweight consumer staples – and underweight the S&P 500. Bottom line, the key lessons from previous cycles must be listened to:

1) After “sustained” U.S. Treasury yield curve inversion, equity markets are unlikely to experience a meaningful recovery (price appreciation) from that point forward.

2) Yield curve inversion signals are near meaningless in isolation. We need to see early confirmation from Stan’s economist; defensive sectors’ (staples) outperformance relative to cyclicals (consumer discretionary).

** Beware of fake-outs in yield curve inversion. The 3-Month / 10-Year yield curve inverted in 1998 but only for a FEW DAYS. However, the data seen above begins when the curve consistently inverts in July 2000. In 1998, the S&P 500 rallied viciously after inverted yield curve signal – some call this the Greenspan Put – Wall St. was forced to come together with the Fed to ‘save’ Long Term Capital. This false inversion signal would have caused one to miss out on the next leg of the equity rally.


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German Mega-Merger in a Desperate Need of Cash

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Deutsche Bank and Commerzbank Confirm Merger Talks

Wall St’s oldest secret, the merger of two of the world’s most over-levered financial institutions came out of the closet today. Deutsche Bank and Commerzbank faced concerns from workers unions, Chancellor Angela Merkel’s office and top shareholders on Monday after confirming merger talks. How much capital would the German taxpayers have to put up is the question on everyone’s mind?

The concerns underline the obstacles to combining the banks, which confirmed talks about a tie-up on Sunday following months of pressure from Berlin, which has pushed for a deal amid concerns about the health of Deutsche Bank, which has struggled to sustain profits since the 2008 financial crisis.

Combined Entity


Debt: $54B
Equity: $10B

Deutsche Bank

Debt: $174B
Equity: $18B


Post Merger

Debt: $228B
Equity: $28B

German GDP: $3.6T

*Enterprise value of the combined entity is equal to 7.1% of the country’s GDP. This deal has been lingering around for months, for one reason, who’s going to come up with the $30B? With levered banks, you MUST look at “enterprise value” (Debt + Equity), NOT the meaningless stock price or equity market capitalization. See the data above.

Need for Equity

The deal has yet to go through due to the political pushback given the lack of equity relative to the massive amount of debt in the combined entity.  In our view, the merger needs to get to at least $50B in equity for regulators to accept it. This would mean a near $30B capital injection from the German Government. Keep in mind Germany is the one holding fellow EU members’ feet to the fire on fiscal spending, putting them in a further precarious position.

Leverage vs. US Banks

JP Morgan:
Debt: $230B

Equity: $350B
D/E: .66x

Morgan Stanley:
Debt: $160B
Equity: $74B
D/E: 2.16x

The New (Merged) Deutsche / Commerzbank:
Equity: $28B
Debt: $228B***
D/E: 8.14x

In Q4, Deutsche Bank’s common equity tier-one capital ratio (CET1), a key measure of financial strength, came in near 8% in the European Union-wide test of banking resilience. The bank’s CET1 ratio will compare to 7.8% in the previous round in 2016, per Reuters. In contrast,  Barclays’ CET1 ratio ended 2019 at 13.2% (December 2017: 13.3%).

Debt to Equity Ratios
The German government will probably (must) inject some state capital into the merged bank and retain an equity stake, but it would have to be substantial. We would assume the merged entity needs to at least double its equity capital. 


Deutsche Bank AG: 92k
Commerzbank AG: 50k

Another obstacle for the acceptance of a deal is the jobs it would need to destroy. The merger takes out 20-30k here, unfortunately. After a decade of downsizing, financials are still downsizing.

Global Bank CDS
Credit risk in Europe has tightened substantially since the beginning of the year. However, the CDS in Deutsche and Commerzbank remains well above the banks in the US. Pick up our latest report here





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