In the Trenches: Bridge Out?



  • Heed the sign posts. The global economy is visibly slowing as developed market central banks have become marginally less accommodative. Emerging market (EM) economies have paid the price for higher U.S. short-rates and will continue to do so. As the ECB tapers, Europe’s structural flaws have once again become visible. U.S. housing is slowly crumbling, and large and important parts of U.S. corporate credit market are at frothy extremes.
  • A deceleration in global growth – partially driven by higher funding costs – combined with a plethora of levered IG credits (especially BBBs), a now frothy commercial and industrial (C&I) loan market, and a growing maturity wall in U.S. high yield (HY) is likely to create 2019 credit stress. This stress has challenged and will continue to challenge global equity market returns.[1]
  • While a Santa Claus will likely arrive and deliver a late-year rally for market participants holding U.S. equities, market participants ought to sell U.S. equities on strength (especially on any S&P rally above 2,800).
  • Whilst the end of the bull market is likely upon us, central banks are unlikely to ignore the signs. They will react quickly if they sense a collision is imminent. It appears that the Fed is beginning to sense the danger, and it has walked back its hawkishness in recent communications.[2]


Previously, In the Trenches stated: “It’s a matter of when rather than if – the Minsky moment is becoming more palpable. The stability caused by a decade of central bank financial suppression has led to the unintended consequence of creating a more fragile global financial system – one more vulnerable to shocks. The next shock is likely to be one of central banks’ own collective design” in the form of a harmonized withdrawal of extraordinary stimulus. [3] It bears repeating that negative real rates globally, as a product of both traditional and extraordinary monetary policy measures, have been responsible for the lack of financial asset volatility. Global central banks went to great lengths to keep the global financial system from crashing. They introduced many new safety features after the crisis, making market participants feel safer. Those include QE at-the-ready and overnight swap lines that the Fed can elect to extend to foreign counterparts and banks. Unfortunately, these new safety features have encouraged drivers to take more risk… and the drivers haven’t changed, albeit perhaps the average age is a bit younger. This has arguably created nothing more than an illusion of safety. Market participants have become even more reliant on driver-assist, and they may be prone to ignore the signs.

Caution: Hazards Ahead

So, what are these sign posts? There are at least four, the first of which we began the year sharing with anyone who would listen: capital outflows from EMs. Because U.S. rates have been on the rise, capital has flowed out of emerging markets and growth has slowed this year, and this will matter to developed markets.[4] Emerging markets currencies were the first, observable casualty of the Fed’s interet rate hikes. We simply thought they’d be weaker even earlier. We were overly bearish of emerging market currencies and equities in 2017, but our concern was realized in 2018. In 2017, we underappreciated just how titillating the synchronized global growth narrative would be for dedicated, emerging market investors looking for an excuse to pile in. In 2017, there was a critical regime shift from the usual relationship between developed market rates and EM asset performance. Figure 1’s top panel shows the positive correlation between EM equities and DM rates under the 2016 – 2017 regime versus the 2018 regime, which shows emerging market assets are once again correlating negatively to higher U.S. short rates. The latter paradigm is more often the norm. What is the catalyst for capital flows back into EM economies? With even just another two rate hikes from the Fed, EM markets should continue to experience capital outflows and pressure on their currencies as other developed market central banks continue the normalization experiment. The smaller the EM the more sensitive its currency will tend to be to higher developed market rates; weaker currencies force EM central banks to raise rates to prevent inflation. In turn, growth slows.

Figure 1: EEM Performance versus U.S. 2-year 2016 – 2017 (top) and 2018 (bottom); 
Source: Cantor and Bloomberg HRA

Second, Europe’s structural governance issues are becoming more visible in light of a less accomodative ECB. The European Union has structural flaws related to the monetary-only nature of the union. The necessary move towards a fiscal union (or at least fear of it) is resulting in the spread of populism –even France is not immune. Moreover, even the monetary union itself has a number of chinks is its armour. In particular, all sovereign debt issued within the union – regardless of country of issue – receives the same collateral treatment within the each country’s banking system. The result has been a mispricing of some European severeign debt. Only recently, for example, have Italian BTP spreads begun to widen relative to Bunds. The current tussle between the Italian government and Brussels is the beginning of an existential struggle to maintain the dream of a unified Europe. The ECB faces a hobson’s choice this week as it decides whether or not to end QE. If it does so, it should likely lavish the communication with dovish overtones. If not, who is likley to buy the €300 billion in Italy’s 2019 maturing debt? Its decision comes at the same time the Eurozone economy slows appreciably, as shown in Figure 2. The European statistics agency lowered growth for the third quarter from .7% to .6%. Could it be possible the Fed is walking back its hawkishness in recent weeks to give the ECB some room to end QE despite the weakening economic data?

Figure 2: European PMIs Have Rolled Over

The third signpost is U.S. housing. The median income houshold can no longer afford to buy a home, per Cantor’s proprietary home affordability indicator. In part, this has been caused by artificially low inventories of existing homes caused by homes removed from inventory by HARP refinancings. HARP refinancers are effectively living in subsidized homes they would not otherwise be able to afford, and thus, they have little incentive to sell. An artificial dearth of supply has led to higher prices. As usual, unintended consequences of intervention ultimately present themsleves. Of course, it had also been caused by years of ultra-low interest rates, which have now begun to rise. The 30-year mortgage rate has risen from under 3.5% to recently just under 5%, increasing housing expenses for new entrants by almost 43%. The combination of extended and amended mortage obligations for 3.3 million homeowners and low long-rates facilitated by prolonged QE have produced the illusion that consumers are unlevered. With homeownership rates still stuck below historical averages at ~64%, rent obligations are not captured by debt-to-disposable income statistics. Lastly, consumer sentiment and spending has been unsupported by real wage growth, which has hovered around only 1%, well below post-recession averages. Instead, access to debt (outside the mortgage market) has driven spending and sentiment. This is likely unsustainable.

The final signpost is ‘the bubble’ we see in U.S. corporate credit in the form of corporate commercial and industrial (C&I) loans. Not only have banks aggressively lent to corporations, but companies have also issued record amounts of low-investment grade debt to investors hungry for duration and yield. Sovereign wealth funds (SWFs), which used to buy risk-free U.S. debt, have generally shifted to corporate loans and bonds as they have searched for yield. With the U.S. 2-year yield approaching 3%, and return bogies for many funds in that vicinity, we might expect a rotation out of corporates and equities and into less risky substitutes that represent better risk-adjusted return opportunities. U.S corporate debt-to-GDP is at an extreme that for the past three economic cycles has always resulted in a corporate spread widening, an increase in equity market volatility and ultimately recession. Figure 3 shows this relationship.

Figure 3: Default Rates Spike When Corporate Debt-to-GDP Exceeds 44%;
Source: Cantor, Bloomberg and S&P

Central Banks See the Signs

Central banks won’t sit idly by while the global economy careens off the road. Not unlike the safety systems of the modern automobile, central banks have become more sophisticated when it comes to collision avoidance.  In early October, Fed Chairman Powell confirmed his optimism on the U.S. economy during his interview with PBS’s Judy Woodruff when he said that “there’s no reason to think this cycle can’t continue for quite some time, effectively indefinitely.” He characterized policy as a “long way from neutral,” even based on what is now an unnaturally low neutral rate. Of late, he has seemingly dialed back his optimism. In our previous note, we felt the Fed would likely to stay the course and raise rates relatively aggressively into 2019 based on domestic economic health – largely fueled by the impact of misguided and temporary fiscal policy – at exactly the same time the rest of the world slows. Recent risk-asset voaltility has proven this concern warranted, but we’re less sure now that the Fed will continue to plod on with normalization. As Chairman Powell’s statement at his recent appearance at the Economic Club of New York suggested, rates were ‘just under neutral,’ walking back some of his previously hawkish statements.

Nonetheless, the cat is out of the bag when it comes to developed markets’ central bank policy normalization. In response, EM central banks have been forced to tighten to control capital outflows. Moreover, as we often point out, global central bank balance sheet growth has stalled in dollar terms and is now flat on the year. As we wrote previously: “Market participants have been lulled to sleep by ‘fake news’ based on temporary U.S. fiscal stimulus and the strong U.S. data it is producing. Like a bodybuilder on the wrong side of a steroid cycle, the U.S. economy will struggle if Congress exercises even a modicum of fiscal restraint.  When U.S. consumers feel this good, it’s rarely a good thing.” Whilst the end of the bull market is likely upon us due to the impact of past and current policy normalization, central banks are unlikely to ignore the signs. They will react quickly if they sense a collision is imminent. It appears that the Fed is beginning to sense the danger, and it has walked back its hawkishness in recent communications. Look to the ECB on December 13th as the next bridge global risk assets must cross. We doubt the bridge will be closed, but we are cautious on the overall outcome given the slowdown in Europe and the implications ECB action has as the marginal supplier of global liquidity.

[1]  We began 2018 with an understanding that it would be a far more volatile year, yet we felt it was a bit too early to call the end of the cycle. Thus, we maintained a modestly bullish disposition of the S&P 500. As global central banks became marginally less accommodative, our S&P target has been well-below consensus for most of the year at 2,805.

[2]  Our view is for a hike this week and for only one hike for all of 2019 (in the first half).

[3]  We ended the note by saying that “with the S&P touching 2,600 today, we’d suggest it’s time for a rally, as funds are forced to chase returns into year end. But, make no mistake, this is now a sell-the-rally market.”

[4]  Even with modest capital inflows in November, net foreign capital outflows are on track to be the largest since the GFC. With one month left in 2018, year-to-date outflows totaled $US26.1 billion. Read more at

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Sources: Cantor Fitzgerald & Co. and Bloomberg


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