Authored by Christopher Cole via Artemis Capital Management,
Read Part 1: Fragility In The Market’s Medium, here…
Read Part 2: Volatility Reflexivity and Liquidity, here…
Read Part 3: The Medium Is Liquidity… And It’s Vanishing, here…
Flows over fundamentals…
When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.
Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the onetime wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.
The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing. Meanwhile, China is executing a stealth devaluation of the Yuan which, since 2015, has been a reliable signal of turbulence in global markets.
Artemis predictive models have been consistently bearish through June and July, and as a result we have tactically increased tail exposure in S&P 500 index options and VIX. A higher than average exposure to tail risk has contributed to negative performance the last few months as volatility has remained in the low-teens.
Equity volatility is underperforming credit risk trend by some of the widest margins in history in both the U.S. and in Europe (see below).
The year-to-date performance of global equity markets shows one outlier country in the sea of red (see chart). The US is now the only developed market in the world that has a positive year-to-date return (+3.22 % for S&P 500 and +11% for NASDAQ).
U.S. equities have risen for nine years and the economy is entering its 10th year of expansion, the second longest bull-market in history, even as China as slipped back into a bear market.
What is keeping the U.S. afloat while the rest of the world is struggling to find water?
The earthquake of one-time Trump tax reform has resulted in a multi-trillion dollar tsunami in repatriated assets and corporate activity that will make any sizable correction in U.S. equities highly unlikely in 2018. U.S. companies are poised to spend an all-time record $2.5 trillion on share buybacks, dividends, and mergers and acquisitions in 2018. This amounts to 11% of the total capitalization of the overall market. In the first two months alone, U.S. companies spent almost $200 billion on share buybacks, more than all of 2009, effectively erasing the February swoon. As Artemis has discussed at length, buybacks serve as a price insensitive buyer underneath markets, dampening volatility and encouraging additional buying pressure from implicit short volatility strategies such as volatility control funds, risk parity, and low volatility factor investing.
Naturally, the ebb and flow of volatility tracks the corporate buyback cycle as evidenced by the chart to the below.
The historic volatility collapses occurring between August-September 2015, June 2016, and February 2018 all coincided with heavy resumption of buyback activity. It is well-known that in 2016 and early 2018 buybacks were the major flows causing the market to rebound from sharp losses. Despite systemic risks building in the market, it is very hard to see a meaningful decline in equities (-10% of more) with sustained volatility in 2018 so long as this wall of money in there.
Beyond buybacks, venture capital funds are spending cash at the highest levels since the dotcom era with $58 billion invested this year alone. Another dot-com era retro stat, 76% of the IPOs in 2017 were unprofitable, the highest level since 2000.
When does this all end?
If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.
A crisis-level drought in liquidity is coming between 2019 to 2022 marked by a perfect dust storm of unprecedented debt supply, quantitative tightening, and demographic outflows.
Quantitative easing has caused the natural relationship between corporate debt expansion and default rates to break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d). This is not sustainable. Years of cheap money has led scores of investors to buy debt at levels that do not reflect credit risk. The poster child is the 2017 issuance of 100-year Argentina bonds (USD denominated) that were oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where Argentina has not defaulted, much less a century. That medium of bond market demand has already begun to show signs of cracking.
Starting in 2019-2021 a dustbowl of debt re-financings will hit markets when they are most vulnerable to a liquidity drought. Annual combined U.S. government and corporate debt supply is expected to exceed $2 trillion each year between 2019 and 2022 (Deutsche Bank). Leveraged corporations will need to roll $1.2 trillion of high yield debt starting in 2019 and peaking in 2023 (Bank of America). For the first time in modern history the U.S. government will require a massive supply of debt to finance fiscal deficits during a period of tighter monetary policy. The irony is we are simultaneously pursuing trade wars with the main foreign buyers of that debt (China and Japan).
As if all that is not enough, demographics will become a major factor driving outflows from financial markets for first time in modern U.S. history further exacerbating the liquidity drought. The Baby Boom generation that formed after World War II (Mid-1940s to 1962) drove massive in-flows into financial markets when they starting working and saving in the 1980s. Following 30 years of financialization all that Baby Boomer money will now start flowing out of markets to support their golden years. As Boomers age, they will draw down on their retirement assets and spend less, and this includes redemptions of about $17 trillion in 401(k) and IRA accounts. The U.S. tax code requires 401(k) account holders to begin selling assets at 70 ½ years old, and the first wave of Baby Boomers began these forced redemptions starting last year. In 1980 there were 19 U.S. adults age 65 and older for every 100 citizens. By, 2017 the number of older adults increased to 25 for every 100, and this number is expected to climb to 35 for every 100 by 2030, and 42 by 2040. Deteriorating demographics is a global phenomenon and by 2030 Canada will have 40 retirees for every 100 people, Germany 44, Japan 58, and China 22. Social Security is now reaching into the trust fund for the first time since 1982.
Demographics in the developed world will have a major negative impact on capital market flows right as passive investing, which relies entirely on flow, becomes dominant.
How is the water over there?
An entire generation of investors takes the medium of liquidity for granted, and the rest may be experiencing cognitive dissonance. It is odd but understandable, if you are paid a flat salary as a portfolio manager at a highly political investment institution, it doesn’t behoove you to know what water really is… you are incentivized to adopt the largest and cheapest institutionally accepted practices regardless of any greater reality. As social animals, we are punished for calling out any abstraction that is not confirming to status quo reality. Contrarians are punished economically and socially. A common refrain for any contrarian position is, “how can you be right if you’ve been wrong all along”. It’s a stupid argument if the regime shift happens, but the same reason why irrational exuberance can continue for extended periods.
For a fish it is very difficult to perceive a world beyond the water… if you want to change you have to crawl out of the ocean… find a way to breath… and evolve into a new reality.
“The immediate point of the fish story is that the most obvious, ubiquitous, important realities are often the ones that are the hardest to see and talk about.”
Volatility is the failure of the medium… the crumpling of a reality we thought we knew.
What is water in markets? Here are my best guesses…
Exchange traded markets are liquid and safer than over-the-counter derivatives
Technology is disrupting the world so the old rules of valuation no longer apply
Stocks and bonds are anti-correlated and provide excellent diversification
Stocks and real estate will always go up if you hold them for long enough
Passive investing offers higher returns at lower cost
Central banks can support markets indefinitely
Volatility accurately measures risk
Liquidity will always be there
Debt can be refinanced
Money creates value
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