Blain’s Morning Porridge: October 15th 2018

Blain’s Morning Porridge – October 15th 2018

“Slain, after all man’s devices had failed, by the humblest things that God, in his wisdom, has put upon this earth””

After last week’s stock market ructions, my market spidey senses are tingling…

In the headlights this morning: 

Saudi Arabia: forget the IPO and worry about MbS threating an oil war if the West doesn’t let him murder whomever he doesn’t like. $100 by year end?

Brexit: The next millennium bug? Very good interview on Andrew Marr show with head of Next outlined a no-deal will be less than optimal, but it won’t be a disaster. Lets get on with it.

Germany: Merkel’s affiliate party takes a pasting in Bavaria. Who is out a job first? Merkel or May?

Trumpland: It’s the Fed’s fault. “I know more about markets than anyone else..” Blahbity blah blah blah.. That man never ceases to amuse us.

Thought for the day: “It’s always about politics..”

Market Psychology

I’ve never met a stupid chief investment officer*, but market moves never cease to bemuse me. Market perceptions seldom reflect economic reality. The “group-think” that is the market’s collective mind doesn’t have the time to ponder the deeper implications of news and events – it spontaneously reacts to headlines. The group psychology of markets swings from profoundly fearful to over-exuberant in a heartbeat.

At the moment the mood remains profoundly negative – reflecting very scared traders. The stock market’s crash, the news flow, the IMF and others predicting a slowing global economy, Italy vs Brussels, Brexit – and its doom’n’gloom all round. A few bright spots of news, like Brazil, aren’t improving sentiment. The market believed we were doomed on Thursday and saved by Friday. This morning the coin flip says: “we’re all dead by Wednesday.” Risk-off then?

Contrarians believe the smart way to play these “End of the Worlds” scenarios is to put their buying boots on and start hoovering up the bargains. Sell when everyone else is buying. That’s a little too simplistic – but generally buying solid assets at distressed prices when the rest of the market is losing its head is the way to massive returns. The secret is…. Timing.

Never easy to get timing right. Is this a stock market correction before the beginning of the next leg even higher? I’ve talked to plenty of market participants who think it might be. However, many also believe we’re going to higher because there is absolutely nothing else to do with money when bond yields are heading higher and stock dividends continue to look attractive. These guys believe at some point soon – which will be when bond rates stop rising and global recession becomes apparent – then the stock market is set for an absolute thumping – the Global Stock Market reset.

Global Market Reset?

The inherent danger of a reset makes sense to me. The reason stock markets are so high might be due to expectations of higher corporate earnings, but I reckon it’s got more to do with the unintended consequences of QE; flooding markets with liquidity and forcing yield tourists out of bonds and into the equity markets. Ultra-artificially-Low interest rates have allowed corporates to borrow trillions. Have they spent it on new factories or creating new jobs? Nope.. the cash was used for stock buy-backs which inflate executive bonuses, or to leverage up private equity by converting equity into debt.. which again benefits the few – the owners!

Debt, lest we forget, is vital to growth, but not necessarily a good thing when overdone. Despite rising interest rates, the number of market comments, blogs and articles suggesting bonds look good value here is surprising. Good luck to them…

Volatility is not the threat

The key issue today is not to fear the current volatility but how to play it. Volatility is opportunity! If stock and markets are just volatile… what’s the big threat? Total Market dislocation? If things are set to turn really bad – maybe the right trade is to shift out of risk ad into.. US Treasuries?? If something happens.. then Treasuries will be bid-only.

If (and triple underline if) we are now poised at the end of the bond correction and stock markets look overbought… that spells opportunity. Clue: Stocks are far easier to exit than bonds.

The really frightening threat is what happens if everyone decided to take risk off the table?

Liquidity gridlock. What happens if/when the market discovers liquidity is a hollow god?

Liquidity will be the murder weapon

The last crisis – 10-years ago – taught us diminished liquidity triggers runs on banks while a complete absence kills them. What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous. Where did that risk go? Into the non-bank financial sector.

I suspect the Buy-Side (by which I mean funds, pension providers, insurers, credit and hedge funds, equity players, etc) are about to discover that Liquidity Risk cuts all ways when it comes to de-risking when they try to sell illiquid assets – especially in the bond market.

Risk transfer from banks to investors is yet another unintended consequence of the reaction to the last financial crisis – banks were the vector last time, so new capital regulation and investment rules means we now we face yet another classic “wake up and smell the coffee” moment as funds discover their asset valuations bear no relation to reality. Why? Because 10-year of bureaucratic handcuffing of the market’s invisible hand thru regulatory overkill means they are less liquid than ever before.

The regulators are waking up to what they’ve done – placing high quality assets like property into high-risk buckets because of their illiquidity (and as an unintended consequence making such assets even less liquid!)

Meanwhile, markets are already massively distorted by the price-bending effects of QE on asset prices. You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited, while the sell-side are muzzled by capital rules, MiFid, and all the other tosh. All these things together – successive waves of market distortion – are likely to trigger the RESET moment and the liquidity gridlock? That’s the moment cracks in the ice become holes…

Try it. Go ask for a bid for that bank capital bond you’ve got marked on your book at 100.00. If you are lucky, you might get a distressed bid back in the low 90s. Think about the Fund that’s seen massive client redemptions force it to sell portfolios of pristine assets at “distressed seller” prices. Try to sell some European Hi-Yield.. ouch. Again.. a distressed bid is the best you can hope for. Or how about Italian govies.. When you struggle to find a bid for Europe third largest economy… that’s a problem.

Treasuries might look awfully unattractive at the moment, but if a crunch comes then the flight to quality will be the most powerful market move in years. The problem for most investors is being stuck with hi-yielding illiquid assets, and being too late to move out of them..

The global financial crisis that began in 2007 taught us perfectly solid and safe assets could only generate distressed firesales prices. Same thing is going to happen this/next time. If you are in the happy position of being long cash, there will be bargains galore if/when crisis hits. At that point liquidity fearful holders will remember the old Blain market mantra: “A bid is a bid is a bid, and you should hit it harder and faster the proverbial red-headed step-child.”

(And extra points for anyone who doesn’t need to google this morning’s quote…” A lesson in not ignoring the simple and small stuff, or assuming anything about liquidity!)

Meanwhile, what about other stuff?


Three questions about Europe:

What happens in May? (as in next year, rather than within our PM’s head.) The whole of the current European Empire is in switch around. New European parliament elections (which approve all EU rules) could see populists elected to a majority of seats creating legislative gridlock, include trade agreements in the post Brexit world. And we are into new ECB discussions – who will run the world’s most powerful central bank? What are the implications.

Who will win the trade war? 

China has historically been misunderstood. The government works by delivering a stable society and get rich social contract to the non electorate. The US works by delivering growth and wealth to voters. Painful as it is to say.. Trump is delivering. Despite growth and wealth China will lose – forcing Xi to climbdown. Which model survives?

What else I’m watching: – press link to get a list of “interesting news stories..”

Back to the new day job!

(*actually…. I have, but not going to name the guilty…)

Bill Blain