Deutsche Bank Explains The Five Biggest "Market Conundrums"

While pundits contemplate whether the bitcoin bubble is bigger, smaller or the same size as the dot com bubble, few are willing to admit that day to day events in the equity market are just as ridiculous, bubbly and bizarre as what takes place in the crypto realm. To address this lack of coverage, yesterday Bloomberg was nice enough to publish an article titled "What to Worry About in This Surreal Bull Market" which however only barely touched the surface of just how truly insane capital markets have become, a market which as Citi said last week, even central bankers are worried they have lost control over.

So overnight, as human traders no longer comprehend what is going on in a market dominated by machines and controlled by central bankers, and only know to BTFD, Deutsche Bank's Masao Muraki took it upon himself to explain five of the most prevalent, and confusing, market conundrums.

We present his analysis below in its entirety for the sake of (carbon-based) traders' sanity.

Market upsets: Rationally explaining five conundrums

Change in market tone since September: From 2016 through August 2017, global interest and forex rates and stock prices were strongly influenced by 10y UST yield movements. This led investors globally to focus on US rates. However, since September this simple landscape has changed, creating headaches for bond, forex, and stock market investors. In this report, we highlight five conundrums (questions) and our proposed explanations for them. Rationally explaining recent market moves will be essential to forecasting next year's market.

Our global financial research team's view is that "the current combination of strong economic conditions, low interest rates, low inflation, and narrow credit spreads are supporting a rise in value of risk assets.", "If the risks (such as difficulties with negotiating a higher US debt ceiling as 8 December approaches) do not materialize, and conditions remain stable (though the path would gradually narrow), then risk asset prices will likely keep rising."

The key focus for 2018 will be the sustainability of low interest-rate/spread/volatility conditions and the Goldilocks market

Five market conundrums 

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex) 

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium) 

Question 3: Ongoing yield-curve flattening 

Question 4: Ongoing decline in interest-rate and stock-price volatility 

Question 5: Ongoing tightening in credit spreads 

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)

90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.

Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model. Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3-4, 20). At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again. Recently volatility decreased, and stocks have begun to diverge upward from our model again.

See Figures 4-6. Since September, stock-market volatility has been a major factor behind TOPIX's divergence from our model. This appears to be because some of the funds that flowed into the market during this year's Japan stock rally (from macro hedge funds, CTA etc.) have adjusted risk positions (stock positions) based on implied volatility in option-marke . In our view, the determinants of present Japanese stock-price levels appear to be (1) US stocks (particularly the Dow Average), (2) USD/JPY, and (3) implied volatility of stock prices in US and Japan. We think the third factor in particular should be uppermost in investors' minds, though its sustainability is questionable.

* * *

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)

Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.

Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7-10, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.

Question 3: Ongoing yield-curve flattening

Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11-12). Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.

Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13). If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.

Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.

Question 4: Ongoing decline in interest-rate and stock-price volatility

As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding. In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.

In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17). There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.

Question 5: Ongoing tightening in credit spreads

Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.

The default rate (Figure 30) clearly shows that the corporate credit cycle reversed. The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end.

The $76 Trillion Bond Market Just Flashed A Major Warning...

This year, (2017) was the year that the financial system moved from fearing deflation to expecting inflation.

You can see this in the breakout in inflation expectations. From 2013 until mid-2016, the financial system's expectations of future inflation were in a downtrend. Mid-2016 this changed as expectations began to rise, breaking this downtrend in early 2017.

They've since continued to rally. Bouncing off support.

This trend has since strengthened with Producer Prices spiking in every major economy in the world.

H/T Jeroen Blokland

As you can see, Producer Prices are spiking in China, the EU, Japan and the US: four countries accounting for over two thirds of global GDP.

And the bond market has finally taken note, with bond yields rising above their downtrends in Japan, the UK, the US and Germany.

Put simply, BIG INFLATION is THE BIG MONEY trend today.

The Fed's Built a Financial "Maginot Line"

An economic meltdown at least six times the size of the subprime mortgage collapse...

The Fed's too busy fighting the last crisis to prepare for the next one...

There are three "snowflakes" that could trigger the next financial avalanche...

In the national defense community, military commanders are known for fighting the last war. They study their prior failures in preparation for the next conflict. The problem is that each war inevitably involves new tactics for which they're completely unprepared.

The most famous case was the backward-looking Maginot Line in the 1930s.

In response to Germany's rapid advances in WWI, France built a line of concrete and steel fortifications and obstacles on their border to buy time to mobilize if Germany tried to invade again.

Hitler made the Maginot Line irrelevant by outflanking it and invading France through neutral Belgium. The French were unprepared. A few weeks later, German forces occupied Paris.

The same mistake is made in financial circles. Financial regulators are no different than military commanders. They fight the last war. The last two global meltdowns, in 1998 and 2008, are cases in point.

In 1998, a financial panic almost destroyed global capital markets. It started in Thailand in June 1997 and then spread to Indonesia and Korea. By the summer of 1998, Russia had defaulted on its debt and its currency collapsed. The resulting liquidity crisis caused massive losses at hedge fund Long Term Capital Management.

LTCM were losing hundreds of millions of dollars per day. Total losses over the two-month span were almost $4 billion.

But that wasn't the most dangerous part.

LTCM losses were trivial compared with to the $1 trillion of derivatives trades we had on our books with the biggest Wall Street banks. If LTCM failed, those trillion dollars of trades would not have paid off and the Wall Street banks would have fallen like dominoes.

Global markets would have completely collapsed.

LTCM negotiated a bailout with the leaders of the 14 biggest banks including Goldman Sachs, JPMorgan and Citibank. Eventually, they got $4 billion of new capital from Wall Street, the Federal Reserve cut interest rates and the situation stabilized.

But it was a close call, something no one ever wanted to repeat.

It was a valuable lesson, because soon after, regulators set out to make hedge fund lending safer.

Regulators believed this would prevent the next crisis. When the panic of 2008 hit, however, they were surprised that problems were not in hedge funds but in something new — subprime mortgages. The mortgage market collapse quickly spun out of control and once again brought global capital markets to the brink of collapse.

After the 2008 debacle, regulators again set out to fight the last war.

They made mortgage lending much safer with a number of regulations. But once again, regulators today are fixing the last problem and totally ignoring the next one.

The next financial collapse will not come from hedge funds or home mortgages but from somewhere they're not looking. And I agree it'll be here soon...

In a recent book has ben used 2018 as a target date primarily because the two prior systemic crises, 1998 and 2008, were 10 years apart. Extending the timeline 10 years into the future from the 2008 crisis to maintain the 10-year tempo, we arrive at 2018.

Only this time the Fed will have much less ability to respond to this crisis the way it has before. It's mostly out of "dry powder."

A benchmark writer of mine spoke to a member of the Board of Governors of the Federal Reserve a couple of years ago and said, "I think the Fed is insolvent."

This governor first resisted and said, "No, we're not."

But he pressed her a little bit harder and she said, "Well, maybe." And then he just looked at her and she said, "Well, we are, but it doesn't matter."

In other words, here's a governor of the Federal Reserve admitting to him, privately, that the Federal Reserve is insolvent, but that it doesn't matter.

It doesn't matter? Really?

When the next crisis hits, the Fed will soon realize that it does matter. A lot.

The Last Time This Happened Was Just Months Before The Start Of The Great Depression

One week after Goldman's chief equity strategist David Kostin predicted a three-year bull market of "rational exuberance", lifting his 2018 S&P price target from 2,500 to 2,850 rising to 3,100 in 2020, and stating that should the exuberance turn "irrational", the S&P could rise as high as 5,300 by the end of 2020, another Goldman strategist, Christian Mueller-Glissmann, has decided it may be a good idea to play bad cop and cover all bases.

And so, in a report released on Tuesday "The Balanced Bear - Part 1: Low(er) returns and latent drawdown risk" this now bearish Goldmanite warns that in the medium-term, the two likely scenarios are either i) a "slow pain" deflation scenario of low yields and high valuations "which persist as macro is stable but there are less windfall gains from rising valuations and less carry - as a result, returns are likely to be lower across assets", or ii) a "fast pain" drawdown scenario in which there is "either a material negative growth or inflation/rate shock, or a combination of both, which drives a drawdown in 60/40 portfolios."

For those confused, don't worry - you read it right. While on one hand Goldman is predicting nothing but blue skies for the "medium-term" of the next three years, predicting no recession and double digit equity upside, at the very same time, the very same Goldman is also forecasting either a "slow" or "fast" pain scenario, which while different, share one thing in common (as the name implies): "pain."

No surprise, Goldman talking out of both sides of its mouth, the only question being while the client-facing "research" is obviously crap and meant to get clients to do the opposite of what Goldman's prop traders are doing, it remains debatable on what side Goldman's prop is axed. Is the bank pulling a CDO and shorting everything it sells to its clients, or has the bank assured further S&P upside, even as valuations no "longer make sense" to quote, well, Goldman? 

We don't know the answer, nor do we care. For those who do, here is Mueller-Glissmann summary: 

We think a period of low(er) returns (scenario 1) is more likely than a full-fledged bear market in 60/40 portfolios (scenario 2), at least in the near term. But there will likely be a balancing act with slowing growth and rising inflation. And at current low yield levels and with the 'beginning of the end of QE', bonds might be less effective hedges for equities and are likely a larger drag on balanced portfolios. And rising inflation could move the central bank put 'more out of the money', requiring a larger 'growth shock' for central banks to ease policy. Also current easing options are more limited for central banks as rates are still low and QE purchases have only just been reduced. 

And once the balanced bear comes, it might be larger and faster. Duration risk in bond markets is much higher this cycle and vol of vol in equities has increased since the mid-80s. While we think investors should lower duration and run higher equity allocations in scenario 1, they should consider hedging at least the risk of smaller equity drawdowns in the near term. We like shorter-dated S&P 500 put spreads. In part 2, we intend to explore different strategies to enhance balanced portfolio returns while managing drawdown risk in case of a bear market.

Ultimately, like every other forecast to come out of Goldman, it's garbage: want bullish, read Kostin; want bearish - either a little or lot - stick to Glissman. Just remember to use your friendly, Goldman salesperson who will gladly collect the trade commission whatever you do.

That said, there was one useful data point in the 26 page pdf: a chart showing that not only are we nearing the longest 60/40 bull market without a 10% return drawdown, but that the last time we were here was sometime in the late 1920s... and the Great Depression would follow in just a few months. 

As Goldman observes: "we are closing in on the longest 60/40 bull market in history - there has been no 10% drawdown in real terms since 2009. A passive long-only balanced portfolio has delivered attractive risk-adjusted returns since the 90s. A favourable 'Goldilocks' macro backdrop, supported by the 'Great Moderation' and the central bank put, has boosted returns in both equities and bonds. However, after the recent 'bull market in everything', valuations across assets are as expensive as they have been this century, which reduces the potential for returns and diversification in balanced portfolios.

Some more statistics:

We are nearing the longest bull market for balanced equity/bond portfolios in over a century - a simple 60/40 portfolio (60% S&P 500, 40% US 10-year bonds) has not had a drawdown of more than 10% since the GFC trough (8.7 years) and has delivered a 143% return (11% p.a.) since then. 

And when was the last time a balance portfolio had such a tremendous return? Goldman answers again: 

"The longest run has been during  the Roaring 20s, ending with the Great Depression. The second longest run was the post-war 'Golden age' in the 50s - the 90s Boom has been in third place but is now fourth, after the current run.

In other words, one would have to go back to some time in early 1929 to be looking at the kind of returns that a balanced "60/40" portfolio is generating today.  In fact, the current period of staggering returns without a 10% total drawdown is now 8.7 years. How long was the comparable period in the 1928s? 9.1 years. Which means that if history is any guide, the second great depression is just around the corner. 

Morgan Stanley Turns Apocalyptic On Credit: "A Cycle Turn Is Closer Than Many Believe"

While many have repeatedly warned over the past year that the record gains in credit are simply too good to stay - especially in Europe where yields and spreads have collapsed largely thanks to the ECB's relentless purchases of corporate debt, with the central bank announcing on Monday it held a record €127.7bn in bonds under its CSPP program - few are as bearish on credit as Morgan Stanley, which today issued ots 2018 US Credit Outlook which is, in a word, "dire." In the report titled "When the Levee Breaks" strategist Adam Richmond list the three biggest headwinds for credit as follows: "Fed policy should become a material headwind, markets seem very late cycle, and valuations look extremely rich" and details each below:

An unprecedented central bank unwind... We think there is way too much complacency regarding what is a notable and growing shift in central bank policy globally. Remember, monetary policy has been massive in this cycle, and extremely supportive for credit markets. The Fed is now tightening in an untested way, through the balance sheet, while also pushing rates near restrictive territory. Markets expect a seamless unwind. We do not.

 

...with markets late cycle, and very dependent on ultra-easy liquidity... It is not a coincidence that fundamental problems are becoming more apparent in one sector after the next, as the Fed withdraws liquidity. In fact, we see late-cycle risks popping up all over the place, and as is often the case near a top, these risks are mistakenly (we think) being rationalized as purely 'idiosyncratic' problems. Defaults should remain low in 2018, but that is expected. Credit markets anticipate defaults one year ahead of time, and we think a cycle turn is closer than many believe.

 

...and valuations very rich: Spreads are near all-time tights, adjusting for the quality deterioration in the indices over time. Yes, the technicals have been strong, but that may change as the Fed's balance sheet shrinks faster. We note, a recession is not necessary to see negative excess returns, especially in the second half of a cycle, and particularly late in a Fed tightening cycle. Credit markets have not experienced three straight years of positive excess returns in over 20 years.

Looking at the technicals, Morgan Stanley echoes what we said last month when he showed the collapse in spreads to 2007 levels, and warns that "credit spreads are very rich nearly any way we slice the data. Spreads adjusted for leverage are back to 2007 levels in high yield, and 1997 levels in IG."


Exhibit 20 shows our fair value model for IG, HY and loans. In short, we estimate that IG, HY and loan spreads are 41bp, 197bp, and 111bp rich to fair value, respectively, using long-term default, downgrade, and risk-premium assumptions. And as we show in Exhibit 21 below, if we adjust for the deterioration in quality of the IG index over time, we find spreads are only 9bp wide of the all-time tights.

One of the main reasons for Richmond's bearishness, is the "complacency" about the Fed's tightening, which of course is applicable to all asset classes. He explains:

More than anything else, we firmly believe that central banks have been THE driver of credit in this cycle, stimulating markets like never before. Now they are attempting to tighten in a completely untested way, and yet credit is pricing in a seamless unwind. At the least, we expect a bumpier 2018, with a tougher setup anyway we slice it. Growth will decelerate, while the Fed continues tightening into a low-inflation environment, driving a completely flat yield curve (per our rates forecasts). Additionally, the year is beginning with booming confidence, as hopes for tax cuts rise, thus the bar to positively surprise is high, while "Goldilocks" is firmly in the price across most risk assets.

 We would not rule out the scenario in which financial conditions could tighten materially next year as the Fed withdraws stimulus in this unprecedented way, especially if growth expectations decline at the same time, pushing us from late cycle to end of cycle (though not our economists' base case). And for those expecting the Fed to come to the rescue any time volatility picks up, remember that, with the balance sheet now effectively set on "auto-pilot," reversing course, in our view, is a last resort.

 Taking a step back, per our forecasts, the Fed will hike 3 times in 2018. While gradual on the surface, this rate-hike cycle needs to be put in context. In other words, as we show in Exhibit 3 this time around, the Fed began hiking much later in an expansion, when GDP growth was weaker and corporate leverage higher vs. the start of past rate-hike cycles. In fact, given the drop in the neutral real Fed funds rate over time, monetary policy is already not that far from restrictive territory

As a result, we believe markets can withstand less tightening than a low absolute level of rates might suggest (exhibit 4). And remember, this is a unique rate-hike cycle. One, tightening began not when the Fed first hiked rates in December 2015, but when they began tapering in early 2014. In this regard, the Fed has arguably already tightened policy by a similar amount as in past cycles (Exhibit 5), a point when credit spreads tend to widen on average (Exhibit 6). Two, along the same lines, the Fed is continuing to tighten, not just by hiking rates, but also through reverse QE.

In fact, we believe investors are focused primarily on the "gradual" pace of rate hikes, treating the balance sheet as an afterthought. But the numbers are large. For example, the Fed will shrink its balance sheet by ~$400bn in 2018 alone. In our view, credit investors underestimated the tailwind from QE in this bull market. Similarly, they may now be underestimating the headwind from reverse QE. And while global central banks will still be adding liquidity next year, even they will be doing so at a slower pace, with the ECB cutting their purchases in half in 2018 and likely ending QE altogether around September of next year, while the BOJ hikes their long-term rate target in 3Q18.

We see "quantitative tightening" as a clear catalyst for weaker technicals – i.e., fixed income demand needs to rise to absorb the additional supply or prices have to adjust somewhere (supply/demand 101). Why not expect the opposite of what happened when the Fed was expanding its balance sheet in this cycle (one-way flows into US credit), as the Fed begins its unwind, at least at the margin?

Assessing rate risk, MS says that while the Fed may in fact be successful at threading the needle, an outcome that is likely already priced into markets. However, the bank warns that "at the least we can be certain that as the balance sheet shrinks more rapidly, so will the "liquidity buffer" in markets, which should magnify any negative catalyst that pops up along the way."

Another major risk factor for Morgan Stanley is that the US economy is now very late in the cycle, to wit:

Markets are very late cycle, in our view, and if anything these risks have risen compared to this time last year. That we are in a late-cycle environment is a consensus view, but "late cycle" can mean different things to different people. To be more specific, we think there is a good chance that markets peak for the cycle in 1H18 and price in rising defaults in a bigger way throughout the year. But even if our timing continues to be too early, remember, late-cycle environments are often not great for credit returns regardless, with equities often outperforming. (Note, as we discuss further below, we believe the very late-cycle signal where credit/equities diverge is already happening, focusing on CCC-rated HY credit.) A recession is not necessary for credit spreads to widen late in a cycle. In fact, credit markets have not had three straight years of positive excess returns since 1996.

Here Richmond takes offense with the argument that weak growth for much of this cycle has prevented "excesses" from building, and hence an already long cycle can last even longer. As he says "we disagree and see excesses all over the place, driven in part by years of ultra-low rates." He notes the following specific details:

Credit markets have grown by 116% in this cycle, and leverage is at unprecedented levels for a non-recessionary environment.
Low quality BBB issuance was 44% of total IG supply in 2017, a record as far back as we have data, and B rated or below loan issuance is now two thirds of total loan supply.
LBOs levered over 6x are now a higher percentage of new LBO loans than in 2007. Covenant quality is considerably weaker than pre-crisis, while the debt cushion beneath the average loan is much lower.
Investors have reached for yield in fixed income in this cycle in a massive way. Foreign flows have flooded into the asset class, arguably treating US credit as a rates product, while liquidity needs have risen, with mutual fund/ETF ownership of credit now over 19% vs. 11% pre-crisis.
Excesses are apparent even outside of corporate credit, with underwriting quality deteriorating in auto lending in this cycle, while non-mortgage consumer debt is at a high, and CRE prices are ~25% above prior-cycle peaks.
Stock-buyback activity has been substantial in this cycle, credit valuations have rarely been richer, and consumer confidence has not been this high since 2000.

Summarizing, and "cutting through the details" Morgan Stanley says that it has high conviction in the following two points:

Excesses have to be out there, given what central banks have done in this cycle – i.e., rates near or below zero for nearly a decade and round after round of QE globally, and the excesses are always difficult to spot as markets are rising, and then become obvious after the turn (how did I miss that?). We think this time is no different. To be clear, excesses are not everywhere. For example, credit quality did not deteriorate in places like housing and US financials in this cycle. 

However, this simply tells us that the problems of the last cycle will not be the same as the problems of the next.

As a result, 2018 is when the critical mass of excesses finally spills over, or, to reuse the title, "the levee finally breaks":

While the excesses may be out there, that has arguably been the case for a while. The difference, we think, is that more cracks are now forming under the surface, which in our view, means a turn is closer than the consensus believes. For example, outside of corporate credit, we have seen signs of weakness and tighter credit conditions in places like commercial real estate. Consumer delinquencies are rising across products (i.e., autos, credit cards, and student loans). And in corporate credit, one sector after the next is exhibiting "idiosyncratic" problems (e.g., Retail, Telecom, and Healthcare to name a few). All of this is consistent with a late-cycle environment where the yield curve is flattening, correlations in markets are dropping, the economy is at (or arguably through) full employment, the Fed is well advanced in its tightening cycle (we think), and equity multiples are expanding.

To Richmond, these dynamics are "late-cycle 101. Problems pop up early on in the areas that experienced the most severe deterioration in fundamentals in the bull market. Investors initially treat those issues as "idiosyncratic." The problems then spread when credit conditions tighten more broadly. And along these lines, we think it is not a coincidence that weaker-quality high yield credits are underperforming, as the Fed is hiking faster and quantitative tightening is now being set in motion."

If that wasn't enough, Morgan Stanley highlights two further risks: one having to do with the incremental impact of tax cuts, should they pass...

And as a side note, tax cuts would not extend the cycle in our view – they risk doing the opposite. Very simply, credit markets will benefit from anything that keeps the cycle going – modest growth and a patient Fed. Tax cuts that come when the unemployment rate is 4.1%, which drives an overheating labor market, forcing a more aggressive Fed, if anything could cut off the cycle sooner.

... and the inevitable rise in default intensity:

We think there is a high likelihood that defaults will start rising again late next year and into 2019. Without going into the details here, in our view, CCC HY bonds are already "sniffing out" these budding default risks with their recent weakness. This should continue as tighter central bank policy exposes the fundamental challenges in the asset class (the problems are easier to hide when markets are flooded with liquidity). And the fundamental issues are broad-based. Not only is leverage high across sectors, but we also estimate that almost 30% of the HY market is either in secular decline or has clear operational challenges (Exhibit 16), with declining revenue growth over the past five years. Thinking about it more quantitatively, as we show in the default section below, based on the lag between when the cycle indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today, 2019 could be a year of materially higher defaults.

Wrapping up the above, Morgan Stanley's conclusion is the following:

Adding everything up, we see three key challenges in 2018: 1) Credit markets have been hugely reliant on central banks in this cycle, and now the Fed is withdrawing liquidity in an unprecedented way. We think markets are underestimating the risks of a mistake. 2) This liquidity withdrawal is happening while late-cycle risks (we think) are popping up all over the place. 3) Investors are buying credit at valuations that almost guarantee poor long-term returns, with the assumption that they will be able to time when to get out before the turn.

... or stated even simpler, "get out now."

More Evidence BoJ Desperate To Steepen Yield Curve

We highlighted how Bank of Japan officials have been briefing Reuters about reducing its monetary stimulus earlier than markets had been expecting – around 1Q 2018 rather than later in the year. In particular, the yield curve control (YCC) is likely to be eased from the current target of zero percent for 10-year JGB yields. It seems the BoJ became frustrated that markets had failed to respond to his hints about the "reversal rate", i.e. that central banks can lower rates too far and damage financial institutions and the provision of credit in the economy. The one (former) BoJ official who was prepared to go on the record explained.

"Reversal rate is a pretty shocking word to come out of the mouth of a BOJ governor. It's unthinkable the BOJ would insert it in Kuroda's speech without any policy intention," said Takahide Kiuchi, who was a BOJ board member until July.

The BOJ may allow long-term rates to rise more by shifting its long-term rate target to five-year yields from 10-year yields around the first quarter of next year, Kiuchi said. "The BOJ could put a positive spin on the move by saying it can more effectively reflate growth by keeping short-term borrowing costs low while allowing longer yields to rise."

We might assume that the BoJ is becoming obsessed with steepening the yield curve and we got confirmation of this overnight. A story which flashed up on Bloomberg about the BoJ tapering bond purchases at the super long end.

BOJ Bond Cut Shows Desire to Steepen Yield Curve: Merrill Lynch

Bank of Japan's slight cut in buying of bonds maturing in more than 25 years suggests its desire to steepen the yield curve, says Shuichi Obsaki, chief rates strategist for Japan at Bank of America Merrill Lynch.

Yield curve has been flattening of late and the BOJ is probably sending a message that it wants the super-long yield curve to steepen.

In terms of the mechanics, the BoJ today cut its purchases of bonds maturing in more than 25 years to 90 billion Yen from 100 billion yen at the previous offer on 17 November 2017. This was the first cut since March. JGB yields rose on the news in Friday trading, as Bloomberg reports.

JGB yields rose across the curve after the BOJ trimmed outright debt purchase in the super long sector.

BOJ reduced purchases of bonds with maturity of more than 25 years by 10b yen to 90b yen; it was the bank's first cut in the sector since March.

Purchase volume for the 10-to-25-year zone was unchanged at 200b

JGB futures closed regular day down 0.13 at 151.02; key futures suffered the biggest intraday loss since Oct. 2, losing as much as 0.21

10-year cash bond yield rises 0.5bp to 0.025%; 20-year yield gains 1bp to 0.57%; 30-year climbs 2.5bps to 0.830%

Falls in JGB futures were exaggerated by sharp rise on Wednesday

It appears that the BoJ had become panicked by the yield curve flattening after reports that the government might reduce the issuance of super-long bonds in the next fiscal year, i.e. to March 2019. On Wednesday, there was a meeting between officials from Japan's Ministry of Finance and primary dealers to discuss the plans for issuance in the next fiscal year.

While inflation is remains far below its 2% target, the BoJ is being forced into a policy reversal due to the damage its NIRP/ZIRP policy is doing to the financial sector. However, it's portraying its defeat as a victory via the supposed reflationary signalling of steepening yield curve. It's utter nonsense and a shameful reflection on the depths which central bankers will stoop to.

This Is A Paralyzed Market": Hedge Fund Turnover Drops To All Time Low

Back in July, B. Reynolds put out a contrarian piece which broke with numerous conventional wisdom norms about the state of the market, key among which was that traders are not complacent, but rather - in light of collapsing trading volumes, something which has plagued bank income statements in the past 2 quarters - simply paralyzed, as they no longer have a grasp of financial "logic" when it is all superceded by central bank liquidity injections, and as such most trades feel fake, forced and just part of the FOMO charade to avoid losing one's job. 

As Reynolds explained, "Investors are not complacent. Their stances range from extremely aggressive to bearish" and added that these "opposing forces have led to a compression of volatility. When stocks have rallied strongly, they have then been met with investor selling. When stocks sell off, the buybacks have picked up after the selling runs its course. That has been the case for more than eight years. Those forces have led to an equity bull market that moves higher in fits and starts, with some brief pullbacks from time to time. Given the positioning of equity investors and continued flows into credit, we do not see that pattern changing for some time." Meanwhile, sandwiched inbetween these two trends, investors - both retail and institutional - find themselves in trade limbo, and the outcome is a gradual decline in trading volumes "which is more reflective of paralysis than complacency among equity investors."

And while one can posit theories explaining this bizarre market until one is blue in the face, the most vivid confirmation of Reyonld's "paralysis" thesis emerged in the latest batch of hedge fund 13Fs, which was analyzed by Goldman earlier this week, and noted here in "These Are The Top 50 Hedge Fund Long And Short Positions." 

In the report, Goldman highlighted various notable outliers, such as the latest record high in hedge fund leverage...

... coupled with the recent plunge in short interest (which as a share of S&P 500 market cap sits just below 2.0%, matching January of this year as the lowest level since 2012)...

... even as hedge fund "crowding" in a handful of top names hits an all time high: 

But the most interesting to us, and the hedge fund community, we believe is the following chart, which shows that hedge fund portfolio turnover continued its downward trend and reached a new record low in the third quarter Across all portfolio positions, turnover registered 26% in 3Q. Turnover of the largest quartile of positions, which make up the vast majority of fund portfolios, fell to just 13%.

This means that once hedge funds have established positions, they no longer trade in and out, but simply lean back and let it ride. And why not: with the most popular hedge fund positions this year being also the best performing ones, namely Facebook, Amazon, Alibaba, Alphabet and Microsoft, why ever both selling. Indeed, as the next chart shows, the bulk of the collapsing turnover is largely due to tech stocks:

Of course, this strategy of loading up on winner and letting them ride is a two-edged sword. while it is the best strategy on the way up, it also becomes a quasi private equity strategy, in which the price formation is created on the margin with increasingly less volume. And, since such tech holdings are becoming ever more illiquid, the threat is what happens once the narrative shifts and instead of buying, hedge funds start to sell these most concentrated of growth names. One could say that a tech selloff is emerging as one of the more concerning black - or at least gray - swans in the market. In fact, we are did say just that...

Facebook, Amazon, Alibaba, Google, Microsoft are the 5 most widely held HF stocks. Tech selloff = black swan

China Deleveraging Hits Corporate Bonds As Cascade Effect Begins

Following the market lockdown during October's Party Congress, many commentators were disturbed by the continued rise in Chinese government bond yields as we returned to "business as usual", with the 10-year rising to 4%. People noted a useful insight from the Wall Street Journal.

An important anomaly to note about the bond rout: as government bonds sold off, yields on less-liquid, unsecured Chinese corporate bonds barely moved.

 That is atypical in an environment of rising rates – usually, bond investors shed their less-liquid holdings and hold on to assets that are more easily tradable, like government debt.

The question was…why had corporate bond yields barely moved? The answer, according to the WSJ, was that China's deleveraging policy led to redemptions in the shadow banking sector, e.g. in the notorious $4 trillion Wealth Management Products (WMP) sector. Faced with redemptions, shadow banks had to sell something…quickly…and highly liquid government bonds were the "easiest option". Furthermore…and this is potentially significant…the WSJ noted.

Meanwhile, the nonbanks have held on to their higher-yielding corporate bonds, which at least have the benefit of helping them to maintain high returns.

Not any more (see below).

We agreed with the WSJ's explanation at the time, but noted that the government bond sell-off was actually a sign of the unravelling of the WMP Ponzi scheme. The Chinese authorities are wise to the Ponzi which is why they announced the overhaul of shadow banking and WMPs last Friday (see "A 'New Era' In Chinese Regulation Means Turmoil For $15 Trillion In China's 'Shadows"). However, the new regulations don't kick in until mid-2019, a sign to us that when they looked "under the bonnet", they didn't like what they saw.  

We doubt that China can achieve an orderly restructuring of its shadow banking sector, never mind its much larger credit bubble. A sign that we have taken another step towards China's "Minsky moment" is that the bond sell-off has spread to the corporate bond market. The chart shows how spreads versus sovereign bonds have blown out during the last few weeks.

Bloomberg noted how the 10-year yield on China Development Bank notes, a quasi-sovereign issue, closed above 5% for the first time since 2014 today while, in another report, it put the corporate bond sell-off in a wider context.

China's deleveraging campaign is finally starting to bite in the nation's corporate-bond market, a shift that will make 2018 a clearer test of policy makers' appetites to let struggling companies fail. Yields on five-year top-rated local corporate notes have jumped about 33 basis points since the month began, to a three-year high of 5.3 percent, according to data compiled by clearing house ChinaBond. Government bonds, which have far greater liquidity, had already moved last month as the central bank warned further deleveraging was needed.

With more than $1 trillion of local bonds maturing in 2018-19, it will become increasingly expensive for Chinese companies to roll over financing — and all the tougher for those in industries like coal that the nation's leadership wants to shrink. Two companies based in Inner Mongolia, a northern province that's suffered from a debt-and-construction binge, missed bond payments on Tuesday, in a demonstration of the kind of pain that may come.

Bloomberg tries to put a positive spin on the corporate bond sell-off, defaults are healthy in terms of differentiating good and credits.

In the long haul, that all may be good for China. Allowing more defaults could see its bond market become more like its overseas counterparts, with a greater differentiation in price. And that could mean it channels funds more productively. "The deleveraging campaign and the new rules on the asset management industry will further differentiate good and bad quality credits, and make the onshore credit market more efficient," said Raymond Gui, senior portfolio manager at Income Partners Asset Management (HK) Ltd. "Weaker companies will find it harder to roll over their debts because funding costs will stay high." Gui predicts yields will keep climbing. The average for top-rated corporate bonds is already 2.2 percentage points above what investors demanded to hold them in October last year.

The rise comes as authorities show greater determination to shift the economy onto a more sustainable footing, with less debt. The latest move was a plan to discipline the asset-management industry, including banning guaranteed rates of return. People's Bank of China Governor Zhou Xiaochuan graphically depicted the risk of excess leverage, by evoking a "Minsky moment," or sudden collapse of asset values. Key to that endeavor will be scaling back some of the implicit credit guarantees that have backed a broad swathe of Chinese borrowers. The country only started allowing corporate defaults in 2014. Last year there was a record, coming in at at least 29. It's unclear yet whether that total will be met in 2017.

Bloomberg spoke to an analyst who also believes the recent sell-off in Chinese bonds is more to do with separating the "wheat from the chaff", rather than anything more profound.

"We expect the divergence of performance between different bond categories (Chinese government bonds, policy bank bonds and credits) to become more prominent into 2018," Albert Leung and Prashant Pande, rates strategists at Nomura Holdings Inc., wrote in a note Wednesday.

We disagree. From our perspective, it looks like early signs of cascading sell-offs within Chinese financial markets, which have long been abused by excessive leverage and Ponzi characteristics. Talking of which, the Shanghai Composite Index suffered its biggest one-day drop since June 2016.

What caused the sell-off? According to some commentators it was fear that the local bond rout was getting out of control…hence "cascade". We noted that traders had been stunned by the official warning from Beijing that some stocks – in this case Kweichow Moutai – had risen "too far, too fast". Zhengyang Shen, a Shanghai-based analyst at Northeast Securites commented.

"The decline in Moutai has triggered selloffs in some of this year's best performing stocks."

Which sounds an awful lot like another example of cascading selling…

11 Charts Exposing The Madness Of The Stock Market Crowd

Summary

• There's more to stock market valuations than the current level of interest rates.
• In this article, 11 charts are presented which expose the extraordinary level to which stock prices have dislocated from a range of economic aggregates.
• The height of these charts should send shivers down the spine of anyone concerned with minimizing losses.

One of the very few good reasons left to buy equities now is historic low interest rates. Broadly speaking, this is not a recent phenomena as it has been the case, from a valuation standpoint applying a more "normal" level of interest rates, for at least the last three years. Many are not making decisions based on hopes and dreams are aware of this fact, but nonetheless maintain a relatively high allocation toward equities out of necessity.

The necessity of a decent return in this historic low interest rate environment has resulted in a desperate chase for yield, often motivated by the current spread between earnings and bond yields.

The chase for yield also demonstrates a lack of investment opportunities since newly printed money has acted more to drive up prices in the secondary market rather than fueling additions to capital goods. This has doubtlessly helped prolong the bull market in stocks as it has had a dampening effect on the business cycle.

But there is more to stock market valuations than the current level of interest rates. Further declines in nominal interest rates are limited, while the upside potential is tremendous in percentage terms. The best one can hope for is perhaps that rates remain near historical lows for a long period of time. Placing your bets solely on interest rates remaining low however requires a portion of delusion.

The nominator in any prudent appraisal of stock prices also matters, though it appears to play a minimal role these days as exposed in the charts below. Most of these charts have one thing in common – they compare stocks to a range of economic aggregates related to corporate sales and with it earnings. After all, earnings per share, no matter how "earnings" are calculated, cannot forever increase or even be maintained due to cost cutting and share repurchases alone.

Ten charts are demonstrating the 2017 Stock Market Euphoria, and one doesn't. Bulls should therefore be pleased as the only thing those charts have demonstrated is that the market has valued low interest rates and positive sentiment more than other fundamentals combined ever since.

But for those of you concerned with probabilities and minimizing losses, and for those not posing in the glorious light of hindsight, the charts below should send shivers down your spine even more so today than nine months ago, especially given the savings disaster this year which have helped drive U.S. economic activity and stock prices.

Chart 1. Wilshire 4500 & Disposable Personal Income

Chart 2. Wilshire 4500 & Commercial Banks' Equity

Chart 3. Russell 3000 & Productivity (Real Output per Hour)

Chart 4. Wilshire & Retailers Sales

Chart 5. Wilshire 4500 & Manufacturers' New Orders

Chart 6. Households Net Worth & Disposable Personal Income

Chart 7. Wilshire US Mid-Caps & M2 Money Supply

Chart 8. Wilshire 5000 & GDP

Chart 9. Russell 3000 & Personal Saving.

Chart 10. Market Cap of U.S. Companies & Gross Private Saving

Chart 11. Wilshire 4500 compared to a combination of the Money Supply and a Leading Economic Indicator

*  *  *

Bonus Chart: The U.S. Stock Market Risk Indicator.