Blain’s Morning Porridge 7th February 2022 – If you are looking for truth in markets, in bonds there are fewer lies.
“Believe whatever you want about equities, but in bonds there is truth..”
This morning – The Stock Market Rollercoaster will continue a while longer, but a decisive divergence point is coming! Corporate debt is likely to crack on rising rates, price distortion, forgotten risk metrics, and rising defaults. It will signal the perilous financial health of some sectors – bursting the current bubble violently. Anyone for the last few choc-ices?
But first: a rumbustious Saturday evening in Dubai followed the Calcutta Cup Rugby Match between Scotland and England. I make that 2.5 in a row to Scotland – (I’m counting Scotland reversing a 40 point first-half deficit into second-half draw in 2019 as a win!). Interesting.. my nation of 5 million Scrappy Socialists with our paranoid fascination for blue face paint, blue flags, bagpipes and sharp pointy things, consistently thumps 60mm Englishmen who voted for Boris.
Is there a lesson in there somewhere…?
Meanwhile, back to the Unreal World, let me introduce you to a new Blain’s market mantra: If you are looking for truth in markets, in bonds there are fewer lies.
Aren’t we having fun in the equity market. Up, Down, Shake it all about. Amazon down 15% one day and up 13% the next. Facebook among the most volatile stocks on the block. Around the globe investors wake up wondering if it’s a risk on or off day, wholly uncertain what they believe about equity market uncertainty… The question is why…?
Dinnae fash! (translation: worry not….) But it’s Boy Scout time – as in Be Prepared.
Unfortunately, an uncomfortable and deeply painful truth about corporate debt defaults are coming our way… What is likely to happen very soon is a widening divergence between corporate bonds and equity markets. As it happens it will be a big sell signal.
- When the bond market is working properly then bond prices tell us important things about the economy, but also truths about how well a company is doing in terms of its balance sheet and ability to pay.
- In contrast… Equity prices just tell us what everyone else thinks… In periods when everyone is prepared to believe seven impossible things before breakfast (a period we are now slipping out of), then every fantabulous, masterful equity stories seem investible.
When it comes to equities…. I’m afraid they aren’t really that complex. Successful companies succeed on the back of great ideas, visionary management, strong corporate governance, and, most importantly, access to properly priced capital reflecting just how innovative, profitable and successful it is going to be…
At least, that was how it was supposed to work.
In the past capital was properly priced and acted as proper check on good vs stupid ideas. As a result the world was generally a happier place, and stockbroking was what we gave the idiot children of the upper middle classes who were too thick for even the clergy to do in financial markets. They would spend all day telling their “clients” which stocks to buy and sell.. Writing their scripts was the clever part.
If you listen to the pundits on last week’s rollercoaster stock market ride they are saying things like: “looking for bargains”, “attractive prices at these almost distressed levels”, “there are certainly value spots”.. and the classic “buy-to-dip opportunities are increasingly short-lived because everyone is looking for value when cheaper levels occur.”
Hah! Many in the market genuinely believe the stock market is going higher because… well why? Because stocks are cheap? Remember… the value of stocks is entirely based on what the market, as the great big voting machine it is, is telling you they are worth.
Bond prices are based on the reality of who can and can’t repay principal and interest. If even the Financial Times has noticed problems in the corporate bond – then it must be a fact: Investors brace for turbulence in US corporate bond market. The reason we are in for trouble is that large parts of the markets now implicitly believe companies don’t go bust – because for the last 12 years of monetary experimentation, distortion and insanely low interest rates have kept all those companies that should have failed and tumbled into default… sort of solvent. There are two things to worry about here:
- There are fewer and fewer old bond dogs like me around who remember what the credit markets are actually about: who will and won’t pay. (Look around your trading floor – who was there 14 years ago when credit last puked?)
- The last 14 years has seen a massive shift in credit risk from banks (the SELL side) to investment managers (the BUY side). Banks used to have whole floors of highly trained, highly motivated credit analysts examing their clients. Modern investment managers outsource and maybe have a couple of junior analysts covering the entire junk universe.
In short – the holders of corporate debt don’t necessarily understand the risk metrics of credit.
Today’s equity market is a properly confused business… everyone wondering what is good, bad or indifferent in terms of what they will be worth short, medium and long-term. As companies haven’t been going bust at normal rates since 2008 (when QE, monetary experimentation and Zero rates begain), then it’s been easy to believe that a company that has been building out its business for the last 10-years but still hasn’t made a penny of profit will ultimately be worth billions because of the position its built and the clients it’s acquired.
Not if the cheap capital that has sustained them this far suddenly were to dry up.. because… say interest rates rise or bond markets widen?
This is where the divergence will happen. Equities continue to believe growing companies will tick upside. Bond markets are waking up to the reality a tidal wave of defaults is likely coming as rates normalise and QE programmes wind down. Even the rating agencies – who remarkably failed to spot the looming sub-prime crisis in 2007, happily giving AAA ratings to any poke of worthless mortgage – agree defaults will rise this year.
Some equity analysts see it coming as well, but generally hedge the firms they’ve got their BUY recommendations on by noting cash on balance sheet, “strong capitalisation” and ease of access to bond markets (a comment that should have any investors reaching for a hard hat.)
Generally, discount most things a SELL-Side analyst says. Their business – whatever the regulations say – is to support investment banks’ fee gathering process. When 59 out of 59 Amazon analysts are saying BUY – they are saying buy so that investors in their funds will be reassured and give them more money to manage (generating more fees), or that their buy recommendation will secure some lucrative investment banking mandate. (There are a couple of important rules in winning investment banking business… be the biggest (ie no corporate treasurer ever lost their job for giving JP Morgan or Goldman Sachs their business – even though they handled so mand deals no one was special.) An obvious rule was don’t expect to win debt or M&A business if your stock pickers were saying it’s a SELL Stock.)
My warnings on the coming bond crisis have been simple:
First, there is zero liquidity in corporate bonds. Central Banks have been backstopping bonds with QE programmes – which are ending. The sell-side, the banks, don’t make markets anymore – capital regulation and the transfer of risk to the BUY-side (investment managers), means leading bond deals is just a fee business for them.. The biggest dealers are now firms like Citadel Securities which commoditises trading through programmes like buying RobinHood’s retail orderflow. When a bond crash comes the market will set like concrete.
Second, is the underlying market. Interest rates and inflation are rising. That’s bad for bonds – NSS. Central banks told us inflation was going to be “transitory” last year. Now they don’t use the word. Same thing is likely for folk who think bonds will rise a couple of basis points to a new long-term stability. The economics – like Friday’s US employment numbers – highlight stronger economic growth with serious supply chain and labour pressure on inflation – and the need for central banks to act by tightening aggressively, or letting inflation soar – which is lose/lose for bonds.
Third, corporate defaults are going to rise. That’s simple logic – for the past 12 years a growing number of profitless, cash strapped companies have skirted the bankruptcy courts only through insanely low interest rates and the ready availability of cheap money – even the deepest, darkest depths of the junk bond market have been able to find bond market funds tight spreads to treasuries. 12 years of QE and monetary experimentation leaves a vast numbers of zombie firms to be decapitated (which I believe is SOP with an Infestation of the Living Dead…)
Since 2008, (the opening salvo of the Global Financial Crisis 2007-2031), there has been a feeding frenzy in corporate bonds as low rates and insatiable demand allowed any junk companies unfettered market access. What did they do with the trillions of dollars of debt they raised? Did they spend it on new plant and equipment, or creating new jobs and markets? nope. Most of it has been spent buying back equity (share-buy-backs) which pushed up the stock price and, and coincidently, management bonuses!
This year, rising rates, chronic illiquidity and rising defaults is likely to trigger at least a storm in corporate bonds as the most exposed companies are shown as Zombies… and that’s the point the Equity market might just spot which firms are swimming without any pants at all… Seen it all before…
Five Things to Read This Morning
FT – EL-Erian: Fed and ECB still behind the inflation curve
Businessweek – The Assault on Apple Daily
BBerg – Watch Corporate Debt For Signs of Credit Distress (this is old – from Jan)
Out of time and back to the day job
Strategist – Shard Capital