Blain’s Morning Porridge – June 25th 2019

Blain’s Morning Porridge  – June 25th 2019

“They agreed that it was neither possible nor necessary to educate people who never questioned anything.” 

In the headlines this morning:

Apologies about y’day’s outstandingly bad Typo! I was wrong when I wrote the volume of negative yielding Global Debt is around $12.5 bln. It is around $13 trillion! What’s a few zeros between friends? To make up for y’day’s mistake, a new edition of Blain’s Alternative Asset Outlook will be hitting the wires today. I’ll post a link to the website when it is up.

Back to reality..

These are thin and dangerous markets… We are marking time ahead of Friday’s G20 meeting. Then it will be summer. By then we will be anxious about Europe, Iran or whatever the next thing is. Traders have too much to worry about and too little to do. The geopolitical strains, fretting what Trump might tweet next (yesterday’s all-out assault on the Fed and calling it a “stubborn child” was sublime), or this week’s trade meeting at the G20 – which I expect will seriously under-deliver on market hopes. Remember – Hope is never a Strategy!

I do think we need to think a little more about the Trump effect on stability. The US ain’t doing so bad around 2.5% growth (3.1% Q1). Only an idiot would mistake a soar-away stock market with economic stability. A Dow a couple of “thousands points higher” would be massively overbought, and just a higher number to correct, and if “the Fed doesn’t know what its doing”.. well who does? Trump is noise. Get over it.

Yesterday’s lowlight wasn’t his infantile rant about the Fed – but his comments about pulling out the defence treaty with Japan. Hang on. This is a man contemplating economic war against China, and he wants to kick it off by sacking his most effective regional ally. Is it any wonder the Chinese are confused by the messages he’s sending?

Strip out the noise, and the market picture hasn’t really changed. Everyone is trying to arbitrage ultra-low rates. That’s why folk are buying bonds – they expect lower-for-longer and ease from the ECB and FED. That’s why people are buying stocks – they expect a demand boost from lower rates fueling a further round of corporate buybacks and more yield tourist money.

But a few cracks are appearing. We are beginning to see a measure of risk pricing back in the markets as junk bond relative spreads start to widen. I particularly like the quote: “We are deep into the credit cycle, with increasing leverage on Corporate balance sheets and fewer safeguards to protect against a worsening backdrop”. NSS award on its way to Citi’s credit strategy team. Even more interesting is the other side of debt coin – issuers rushing to issue before it breaks.  There is a deluge of low-grade junk debt hitting the US market.  Junk issuance is up around 16% over last year as companies look to fund at advantageous rates – and investors are biting today. They might not tomorrow.

The real issue isn’t just the worryingly toppy slew of supply at ultra low rates – it’s what happens when the market reverses. Let’s assume we do get a surprise trade agreement down the line, or the global economy isn’t so dire as bond markets seem to hope. Let’s assume the numbers get better. And the Fed doesn’t cut US rates in the face of signs of recovery. Let’s just wonder what happens when rates start to rise.. Ouch!

And… at that point.. the bond market has a massive coronary. What happens then? Everyone will try to exit – it will be 2007 again. Then everyone was trying to unload bank paper. This time it will be mispriced corporate debt. It will prove utterly and completely illiquid. There will be tears, but there will be bargain hunters.

Illiquidity has become a market theme lately – some very good articles about illiquid investments held by funds including Woodford, GAM and now, French fund H2O. The story is simple: in each case it looks like fund managers have been juicing returns in open-ended funds by buying illiquid assets that have proved difficult to sell. As soon as the market started to question their liquidity, these assets set like concrete. In Woodford’s case it was small cap equity. It was illiquidity and gating its Absolute Return fund that sank GAM last year – but it was a whole series of investments, including a large financing for the acquisition of a hydro-electric and aluminium smelter by an Indian commodities firm, that triggered the alarms.

Last week I warning these examples of ignoring liquidity are likely to trigger significant regulatory action – and it looks to be happening. It will get increasingly difficult for any investor to purchase “illiquid” investments – which will further distort investment efficiency. When the crash comes, anyone holding long-term “alternative” style assets will find the market is likely to be closed – locked shut. Most Alternative buyers get that – they want uncorrelated risk. A panicked sell-off of illiquid assets is exactly what happened to esoteric assets in 2007/09. There was fear – and some speculators made off like bandits with illiquid, but perfectly performing assets.

The correct alternative investment strategy is to seek assets less distorted by QE and buy uncorrelated, delinked alternatives on an absolutely honest basis – and do the due diligence very carefully. The market will lock down again. In a market where distortions cause high-yield junk bonds at levels more appropriate to AA corporate risk, illiquidity is inevitable.

I suppose the bright side is that any rushed regulation of liquidity will simply make illiquid assets cheaper, and then even more attractive to buy!

Out of time, and back to the day job…

Bill Blain

Shard Capital