By Francesco Filia of Fasanara Capital
The Last Castle to Fall: the S&P
What narratives behind S&P resilience. Can they be sustained.
In the last few years, several markets/asset classes have shown signs of weakness, if not outright implosion: EU banks, EU stocks, Base Metals, Energy Commodities, Japan stocks, EM stocks and currencies. The bubble built in them by the excess liquidity provided by Central banks, as they were busy fighting structural deflationary trends (and crowding the private sector out of bonds), has deflated in most parts of the market, except two: US equity and G10 Real Estate.
One down after another: returns for different assets, normalized as of Jan 2009
Below we briefly look at the motives/narratives behind the resilience of the S&P, and why they may give in at some point in the next few months:
1. The S&P is resilient because the economy is strong —-> Argument: a tight labour market, signs of recovery in inflation rates may prelude to the economy finally approaching ‘escape velocity’, after years of false dawns —-> Counterargument: last Non Farm Payroll shocker puts this theory to test, for the first time in years, as it projects a declining trend of late (233k in February, 186k in March, 123k in April, 38k in May). Data needed soon to prove this NFP was just an outlier.
2. The S&P is resilient because ‘bad news is good news’ —-> Argument: a weaker than expected economy will force monetary authorities into more QE, lower rates, more ‘financial doping’ for the bubble in markets justification of their disconnect from fundamentals. Counterargument: this theory works only if Central Banks ammunition arsenal is large enough and their policy credible, it works less after 6 years of failed attempts and diminishing returns. Case in point Japan and the EU.
3. The S&P is resilient because there is so much liquidity on the side-lines —-> Argument: US corps sitting on $1.3trn liquidity, pension funds/incos forced to look out for returns (down the credit scale, longer down the duration scale, deeper down in illiquids). Counterargument: there are reasons for hoarding of cash / investing inertia, in the lack of positive expected returns at a time of widespread negative rates and un-anchored inflation expectations the world over. In the same vein, S&P 500 buybacks ran at 165bn$ in Q1 (strongest quarter since QE 2007, second strongest ever in history), but announced buybacks dropped by 250bn$ (40%) on a trailing 12 months basis, which may translate in 40bn$ per quarter of reduced demand for equities (JPM’s Kolanovic estimation). Corporates desire for leverage, buybacks and M&As, may also eventually decelerate as leverage ratios are now high (the median credit rating for S&P companies is now BB and declining, for a median net debt/ebitda above 3), regulation changes (inversion trades), pricing power is weak, excess capacity abounds.
4. The S&P is resilient because it climbed the wall of worry. —-> Argument: the failed activation of known catalyst events (China credit crisis, oil implosion, EU banks’ credit events) helped fuel market complacency —-> a failed activation of Brexit could help next in the short-term. Counterargument: structural imbalances are still building up, all catalyst may stay as accidents waiting to happen: European banks, Chinese renminbi devaluation, oil secular decline, chronic commodities oversupply on a stagnating economy, structural deflation all are left uncured.
Conclusion: market-wise, economy-wise
- Best of QE’s impact on markets is past us.
- Market to remain choppy, unstable, unreliable, until a new phase kicks in, made of fiscal expansion/helicopter money. Our take on the subject is available here: The Market Economy in 2020: a visualization exercise. (The Emergence of a New Monetary Orthodoxy).
- Question is where are we going to see that first (we think Japan), and whether or not we need a big crisis to get there (we wonder Europe).
Conclusion: strategy-wise
- Being short the SPX offers value, as small potential upside is a mismatch against large potential downside.
- Disengaging from low-yielding highly-volatile markets seems a legitimate choice. Allocation to cash and cash alternatives above 50% has today its lowest ever opportunity costs, while helping keeping the portfolio healthy enough so to be able to capture opportunities as they arise on volatility spikes.
- At negative risk-adjusted expected returns a change in the investment approach is warranted. Old investment styles badly cope with end-of-cycle exhausted markets and extreme experimental policymaking in the making.
- Rehab from Carry: differently than what held true for decades, it may now help not to sit on risk while waiting for coupon clipping and dividend yields intake. After 40 years of declining rates, we may not have another 40 years in front of us. Nowadays, net short positions become the new positive carry strategies.
- Asset allocation alone does not suffice as high cross asset correlation and big Beta to the downside remain defining features of the current market structure for the foreseeable future. Certain asset classes slowly become unusable: such as corporate bonds, as liquidity dries up (desertification), such as government bonds, as yields are negative (often facing both negative duration and negative convexity issues).
- An opportunistic approach to benefit from market volatility as opposed to be damaged by it, a multi-asset multi-dimensional low-vol stance seems preferable, to us, in a market that moves from one storm to the next.
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