The Smartest Man in Global Capital Markets on When the Music Will Stop
A secret top source provides his outlook on equities, credit markets, Asia, and how long the current market trend will last.
Our access to the "The Smartest Man in Global Capital Markets" is through Ron Quigley, Mischler's Head of Fixed Income Syndicate and Primary Sales. Ron had a chance to speak to his source recently about where the markets are going now and over the next few months, looking into 2014. What follows is quoted directly from that conversation. Enjoy! (With thanks to Ron!)
So, it's mid-March 2013 and, the S&P 500 (INDEXSP:.INX) is at 1550, right where I said it would be nine months ago. Allow me to update my thoughts as to where we go from here; vastly more relevant than where we have come from:
The three major drivers of equity index valuations have been:
1. The generational low ownership structure of the asset class.
The major brokerages went into the end of FY 2012 with about 38-40% of total assets in equity-related securities; that has crept up to about 43% in the year-to-date move we have seen to the upside. This remains meaningfully below the norm for the 1980-1990s, which was estimated around 65-70%. Of course, if one subscribes to the PIMCO mantra that the equity culture is effectively "dead": (they have been wrong), then maybe nothing changes. If, however, Washington can be functional, the equity culture will continue to resurface as that's what the Fed wants.
2. The historically overvalued nature of just about all the alternatives asset classes (i.e. fixed income).
Just about every aspect of the fixed income asset class is overvalued. From IG bonds to HY, from EM to REITs, and from MLPs to Preferreds, et al; the excessive liquidity situation has effectively arbitraged yield-to-maturity to historically low levels across all these product lines. It is quite possible, arguably likely, that this situation will persist a bit longer as the Fed maintains its QE stance and effectively provides a "backstop" to valuation deterioration. One day, this will end. We will get to that.
3. Expectations of continued upward revisions to US corporate earnings that may result in more multiple expansions, so long as Fed policy remains so accommodative.
I see virtually no evidence of deteriorating US corporate earnings profiles; most companies I meet with are reasonably bullish on profits and some are beginning to even contemplate the prospects of pricing power as the consumer has remained active.
All the talk and speculation regarding a 5-15% correction has almost assuredly postponed that eventuality. What I do see evidence of around the world is the following:
- Many investment bank clients have a "bunker mentality" regarding FY 2014. They are, as a result, expediting issuance of fixed income securities and correctly focusing lots of time and effort on capital structure optimization and balance sheet strategies consistent with building in "agility" for when things get more difficult. As I said many months ago (now prevalent in the generic financial press), analogies to the 1993-1994 credit cycle boom-bust abound. Recall that the latter 1993 credit cycle was similar to today's with excess liquidity arbitraging down spreads of income-oriented products. In February 1994, Greenspan/McDonough raised the base rate by 25 basis points and unleashed The Tequila Crisis, in which we witnessed EM spreads gap wider by 300-600 basis points in a matter of a few months. Mexico was "bailed out" by the UST as capital that had previously been invested in higher yielding, peso-denominated Tesebono Securities, raced back to the USA. Recently, the highly respected Central Bank Governor of Mexico, Augustin Carstens, spoke of this in light of current market developments. No one in the world has a better "seat" to itemize all the liquidity and uninformed capital flows into that country. Just an FYI.
- Most of the Asian financial markets are flush with excess liquidity, as was the case in 1996. Recall 1997-1998. In Korea, Consumer Installment Debt (i.e. 'Household Debt" in their lingo) is now "almost" equating to 100% of annual GDP. Korean bank CEOs are cognizant of this and it does concern them. The West has married itself to the mythology that having had its crisis in 1997-1998, Asia has learned its lesson and, "things are different" this time. They are never different! The two things that always amaze me about this industry are: 1) the short term memories of investors and, 2) the rapid, almost immediate rate at which capital markets transition from a state of perceived eternal liquidity to one of no liquidity. Of course, with central bankers all racing to devalue their respective currencies in an effort to combat deflationary forces, "1994" will not occur soon. The markets, however, will not wait for a policy change to be articulated; the markets will move well in advance. I am not a conspiracy theorist, however, when the Dow Jones (INDEXDJX:.DJI) sank 250 points a few weeks ago upon release of the Fed minutes, it was clear to me that this was very contrived. Knowing that Bernanke was testifying a few days later, and that he would "set everything right," the minutes were meant to demonstrate to Capitol Hill the legitimacy of current Fed policy and, what the likely market outcome would be to the extent the Fed detoured from current policy. We will likely see more of that in the next six to nine months as the Fed tries to condition the markets for 2014. Sort of like Peter and the Wolf: If they cry wolf too many times, the markets will become more complacent and the eventual effect of real policy change may be lessened. Conclusion: There is no way the Fed can reverse course in the absence of creating significant negative distortions in both the credit cycle (first) and, equity markets (second). Watch and see.
- It merits watching the composition of the current IPOs and secondary equity markets. Lesson: income sells. Actually, it sells quite well. So many of today's equity issues are for REITs, other forms of dividend-yielding real estate companies, MLPs, and other forms of dividend-yielding energy companies, et al. When the term structure of interest rates was low in the second half of 1993, the same was the case. It was also the case in 1993 that we saw an explosion of emerging market debt new-issuance and significant increases in volumes of hybrid capital instruments (not to mention a meaningful uptick in "product innovation" related to hybrid capital issuance). Capital flows back then were into local emerging market (EM) currency funds. Regarding income, the same can be said for infrastructure assets. Yields on most infrastructure assets have compressed through 6%. During a series of meetings with the CEOs of all the Canadian pension funds, I was consistently told that in 2012 these funds analyzed approximately 150-plus infrastructure-related investments and in many cases, pulled the trigger on maybe two or three of them. Meanwhile, lots of retail monies and genuinely uninformed capital flowed into the sector. Maintaining investment discipline (I was told) was the No. 1 challenge in FY 2013. In environments like this, investors start to "rationalize" a lot. Back in 1993, we saw the emergence of emerging market global bonds for the first time...ever. How many of you remember the first of them: $1 billion Republic of Argentina 8 3/8% of 2003!
- Unlike 1994, market structure will be a problem in the next credit crisis. In 1994, there were 30-plus banks that aspired to being global liquidity providers; all these bankers looked forward to their annual meetings wtih Greenwich Research Associates to determine whom amongst them had the best bid in the worst environment -- all in the hopes of gaining market share. Today, we have seven or eight legitimate global players (at most); these institutions are also doing increasing amounts of their business with the top 50 institutional investors globally. In fact, it is the largest investors who are telling investment bank clients globally that they, in fact, are the providers of liquidity of last resort, not the investment banks themselves. Market structure is being "triangulated"; it is an increasingly top-heavy structure that's not only effectively disintermediating the middle markets, but is one that's inconsistent with securing best-in-class pricing. Additionally, if any of you had the opportunity to speak with the respective heads of credit trading, fixed income sales or, better yet, risk management, of any of these seven or eight financial institutions, what you would learn is that none of them feel any responsibility to provide liquidity in a downturn. Their respective managements are not encouraging this. When the music stops -- some time in 2014 -- there will be no chairs. In 1994, the Fed's balance sheet was near zero as well. It should not be lost on anyone that major policy shifts by the Fed on the tightening side have almost always been accompanied by 20% equity market corrections. Regrettably, we have no precedent to help quantify the added de-leveraging precipitated by a $4 trillion central bank balance sheet. If you are an optimist and therefore believe that the inevitable policy shift will take place in early 2015, then you at least have to assume that the equity markets will start to account for that by mid-2014. If you are a pessimist, you will conclude that markets will preempt historical precedent and likely begin the adjustment process well in advance of the Fed definitively articulating its exit strategy: by early 2014 (or earlier). When the music stops, there will be no chairs.
- I had a dinner recently with an esteemed group of older-generation, traditional cash players in the US high-yield markets. For the most part, they really cared about high-yield product in the "teens." High-yield today is trading south of 6%. The point: The "gap" between where fixed income asset classes are trading and where the traditional "real money" (non-high-yield) clients "care" is very large.
In conclusion, it's true that equity markets are a reasonably accurate 4-month-plus leading indicator. It is more true that credit markets are at least two to three months ahead of equity markets. Everyone needs to almost forensically analyze the global credit markets for signs of weakness; this is going on everywhere I go. However, given the Fed's remarkable, borderline Darwinian, approach to things, it is clear to me that they will prolong their theatrics throughout FY 2013. At some point in 2014, however, they will need to seriously articulate an exit strategy; this will be done in "spurts" versus any major surprise. Bernanke hates surprises; he knows Greenspan was most upset about how things played out in February 1994. This will be telegraphed so that there is no room for misinterpretation. The markets will move very, very quickly. Issuers need to "continue" to pre-fund. Near term, the S&P has hit my March-April target of 1550-plus. If one tries to "quantify" the impact of the sequester on the S&P, it amounts to only 20-25 points arguably.
I see the S&P continuing to frustrate the majority (that is what markets do). It may hit 1560-1580 prior to actually having a legitimate correction of 5-10%. There is so much liquidity awaiting deployment upon a pullback that the pullback will be quick. Later in the year, it's very likely we'll see 1600-plus on the S&P (September-November). In my view, the market will be a good sell at that point, so will many credit products. There is no way the Fed can shift its policy stance concurrent with having to immunize a $4 trillion balance sheet going into the end of a fiscal year. 2014 is likely to be challenging.
Enjoy this while it lasts.
Also see: 12 Cognitive Biases That Endanger Investors