The Rising Risk of a Credit Crisis
How could you be bullish, even remotely?
It is my understanding that the U.S. is undergoing a massive boom-bust cycle of continued deleveraging that will eventually lead to a credit crisis...It might be foreign, it might be domestic. I'm not a fortune teller, but it might even happen this year.
My macro thesis is this: Short The S&P, Short Long-Duration Treasuries, and Buy The Spread.
For starters, the end of easy money and a low-interest rate environment equates to less available capital for unprofitable entities and a closed chapter on another round of speculative investing for the time being. Secondly, the two biggest buyers of 30-year treasury bonds, the United States government and the Republic of China, stepped out of that market when quantitative tightening effectively started in Q1 of 2022. Not only are geopolitical uncertainties prevalent in the market today with regards to the war between Russian and the Ukraine, a hot war between China and the U.S. cannot be ruled out for the immediate future either...What would we war about you ask? Semiconductors? Emerging technologies? Reserve currency status? Straight up ego? Take your pick.
In regards to spreads, with rates on the rise, this means that shorter-term debt will have to be re-financed at substantially higher rates than before, thus causing net interest payments for corporations and the government to rise as well. If bi-partisanship among our elected officials was high, then maybe I'd feel more comfortable about the clowns running the circus and their ability to manage fiscal policy correctly - but I don't. I'm about as bearish towards America's management team as I am about half of the companies in the stock market including Bed Bath and Beyond.
As famed investor Ray Dalio referenced in his book, The Changing World Order, the U.S. is approaching the tail-end of a long-term debt cycle. His featured chapter in Jack Schwager's Hedge Fund Market Wizards book released in 2012 summarizes the issues of the past ten years better than I could ever even attempt to summarize.
"Initially, the availability of credit expands spending beyond income levels. As Dalio explains, [This process] is self-reinforcing because rising spending generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow, which allows more buying and spending. . . . The up-wave in the cycle typically goes on for decades (2008-2020), with variations in it primarily due to central banks tightening and easing credit (which makes business cycles).
Although self-reinforcing, the credit expansion phase ultimately reaches a point where it can no longer be extended. Dalio describes this transition in the credit cycle as follows:
It can’t go on forever. Eventually the debt service payments become equal to or larger than the amount we can borrow and the spending must decline. When promises to deliver money (debt) can’t rise any more relative to the money and credit coming in, the process works in reverse and we have deleveragings. Since borrowing is simply a way of pulling spending forward, the person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000, all else being equal. . . . In deleveragings, rather than debts rising relative to money as they do in up-waves, the reverse is true. As the money coming in to debtors via incomes and borrowings is not enough to meet debtors’ obligations, assets need to be sold and spending needs to be cut in order to raise cash. This leads asset values to fall, which reduces the value of collateral, and in turn reduces incomes. Because of both lower collateral values and lower incomes, borrowers’ creditworthiness is reduced, so they justifiably get less credit, and so it continues in a self reinforcing manner. Dalio emphasizes that deleveragings are very different from recessions: Unlike in recessions, when cutting interest rates and creating more money can rectify this imbalance, in deleveragings monetary policy is ineffective in creating credit. In other words, in recessions (when monetary policy is effective) the imbalance between the amount of money and the need for it to service debt can be rectified because interest rates can be cut enough to (1) ease debt service burdens, (2) stimulate economic activity because monthly debt service payments are high relative to incomes, and (3) produce a positive wealth effect; however, in deleveragings, this can’t happen. In deflationary depressions/deleveragings, monetary policy is typically ineffective in creating credit because interest rates hit 0 percent and can’t be lowered further, so other, less-effective ways of increasing money are followed. Credit growth is difficult to stimulate because borrowers remain over-indebted, making sensible lending impossible. In inflationary deleveragings, monetary policy is ineffective in creating credit because increased money growth goes into other currencies and inflation hedge assets because investors fear that their lending will be paid back with money of depreciated value."
If we can’t stimulate markets anymore with QE because of inflation, which essentially stops the flow of money, then how can these exceptionally high debt services be repaid? With federally legalized marijuana tax revenues?
People say the U.S. can’t default on its debt because of our ability to print money, but we effectively defaulted on millions when we went off the gold standard...Am I wrong?
Short The S&P 500
In my millennial opinion, up until the mid 2000’s, Federal Reserve officials could more easily get away with straying from their reported narrative because of the absence of social media. Nowadays, everything they say and do is right there on front-street the second after it’s reported. Jerome Powell strikes me as the type of guy who sort of - dare I say - enjoys the limelight. I think JP looked ridiculous to the investing world when he slung around the narrative that inflation was transitory; and I think a man in
J. Powell’s position cannot afford to be made to look ridiculous.
After transitory inflation proved false, the Fed has since committed multiple times to their new slogan, “higher for longer,” and as far as I know that includes both the Federal Funds Rate and 10-year yields.
At the time of this writing, technicals indicate that the 10-year has another 30-40 beeps to drop before inflation concerns comes back into play. The current fight for the Fed is against wage growth (i.e. the job market), which will take a huge toll on the economy if and when it is finally defeated. Sources say that the Fed’s latest policymaker projections don’t necessarily mean the economy will fall into a recession, but they do suggest that the risk is worth it, and that the Fed has no plans of cutting rates to cushion the blow. The writing is on the wall isn't it? DON'T FIGHT THE FED!
As beautifully detailed by Bob Prince, Co-CIO of Bridgewater Associates, we still haven't seen an earnings destruction yet and demand is still too hot in the labor market therefore more quantitative tightening is a must.
“...the next shoe to drop has to be a decline in the economy, and particularly a contraction in labor markets because the core issue with inflation is wages. Wages are running too high to have a 2% inflation rate and the way you get wages down is you change the supply/demand dynamics for labor…if corporate profits are okay - you don’t lay off workers. And if you don’t lay off workers, you don’t raise the unemployment rate. And if you don’t raise the unemployment rate, you don’t bring down wage inflation. And if you don’t bring down wage inflation, you don’t bring down inflation sustainably.”
Short Long Duration Treasuries
In Howard Mark’s Q4 2022 memo to investors titled, “Sea Changes” he also acknowledged the tectonic shift markets are undergoing primarily because of the prominent end of a 40-year declining low-interest rate environment where private equity and leveraged strategies boosted up all markets until finally capitulating as a result of the 2020 COVID-19 QE3 policy regime.
The “flight to safety trade” has already begun as the majority of the smart money investors know that the S&P 500 and many other indices are not a safe place to allocate capital at the moment. With the S&P 500 trading at a P/E above 18, any undergrad can look at the monthly chart and tell you that this asset is highly overvalued with consideration to the current environment.
Since the late 60's, 2022 was the only other year in the history of the bond market that treasuries saw a decline of more than 10% (2009) finishing the year close to -30%. I feel like investors need to produce returns for their clients this year or they run the risk of having to revisit their outbound sales and fundraising process, hence the jump in equity prices to start 2023 (S&P 500: +7.72% YTD as of 2/1).
If so, the rationale here is that even if bonds don’t produce exuberant returns over the next 12-18 months, they’ll at least still outperform the broader equity markets...To me, that sounds like a pretty lousy investment strategy.
Buy U.S. High Yield Index Option-Adjusted Spreads
The re-allocation last year to short-duration products such as TIPS and T-Bills only reinforces my methodology that 30-year U.S. Treasuries are as good as monopoly money. Somebody please answer my question - who is going to fill the China-sized liquidity outflow that has taken place in the market?
Our eastern counterparts have already expressed their interest in becoming the next superpower, an aspiration that is more than conversational at this point as dictated by their strengthening relations with Russia & The Middle East, bid to purchase barrels of oil with yuan rather than dollars, experimentation with digital currencies, proposed takeover of Taiwan, and overall threat of de-globalization, which will bring instability to a number of economies including the U.S. who has a positive correlation with their productivity or lack thereof.
Now, to narrow down the focus, let's take a look at the TED Spread. The TED spread is used as an indicator of credit risk. This is because U.S. T-bills are considered risk free and measure an ultra-safe bet i.e. the U.S. government’s creditworthiness. But U.S. creditworthiness was already downgraded from AAA to AA+ in 2011, and according to State Street CEO Ron O'Hanley, we're at risk of being downgraded again.
A downturn in the economy indicates to banks that other banks may encounter solvency problems, leading banks to restrict interbank lending. This, in turn, leads to a wider TED spread and lower credit availability for individual and corporate borrowers in the economy.
In the case of a recession or economic crisis, high yield bonds are going to crack and the masses will move heavily into fixed income just like the smart money has already begun to. From a purely technical perspective, spreads are at the lowest they've ever been...How much lower and for how much longer can they really stay this suppressed?
Recession or not, the majority of people don’t have enough income. Real wages are down while everything else is up and that's been the problem since before inflation creeped into the picture. The U.S. economy is not in great shape and it probably won’t be for a very long time.
Conclusion
This post is essentially a combination of me just interpreting data and dialogue from my favorite investors and research portals. Trading and investing isn't really that hard, it's natural human behavior that causes us to overthink and thus overtrade or under execute.
Affirmation: I admire and model rich and successful people.
According to Dalio, and as alluded to before, the United States is currently in Stage 4, rapidly approaching Stage 5 of the long-term debt cycle.
Stage 1—Countries are poor and think that they are poor.
Stage 2—Countries are getting rich quickly, but still think they are poor.
Stage 3—Countries are rich and think of themselves as rich.
Stage 4—Countries become poorer and still think of themselves as rich.
Stage 5—Countries go through deleveraging and relative decline, which they are slow to accept.
This is how Dalio describes countries in Stage 4:
". . . . This is the leveraging up phase—i.e., debts rise relative to incomes until they can’t anymore. . . . Because spending continues to be strong, they continue to appear rich, even though their balance sheets deteriorate. The reduced level of efficient investments in infrastructure, capital goods, and R&D slow their productivity gains. Their cities and infrastructures become older and less efficient than those in the two earlier stages. Their balance of payments positions deteriorate, reflecting their reduced competitiveness. They increasingly rely on their reputations rather than on their competitiveness to fund their deficits. They typically spend a lot of money on the military at this stage, sometimes very large amounts because of wars, in order to protect their global interests. Often, though not always, at the advanced stages of this phase, countries run “twin deficits”—i.e., both balance of payments and government deficits. In the last few years of this stage, frequently bubbles occur. . . . These bubbles emerge because investors, businessmen, financial intermediaries, individuals, and policy makers tend to assume that the future will be like the past so they bet heavily on the trends continuing. They mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drives up their prices more and reinforces this bubble process. . . .Bubbles burst when the income growth and investment returns inevitably fall short of the levels required to service these debts. . . .The financial losses that result from the bubble bursting contribute to the country’s economic decline. Whether due to wars or bubbles or both, what typifies this stage is an accumulation of debt that can’t be paid back in non-depreciated money, which leads to the next stage."
Sound familiar?...
And Stage 5:
"After bubbles burst and when a deleveraging occurs, private debt growth, private sector spending, asset values, and net worths decline in a self reinforcing negative cycle. To compensate, government debt growth, government deficits, and central bank “printing” of money typically increase. In this way, their central banks and central governments cut real interest rates and increase nominal GDP growth so that it is comfortably above nominal interest rates in order to ease debt burdens. As a result of these low real interest rates, weak currencies, and poor economic conditions, their debt and equity assets are poor performing and increasingly these countries have to compete with less expensive countries that are in the earlier stages of development. Their currencies depreciate and they like it. As an extension of these economic and financial trends, countries in this stage see their power in the world decline."
Like Hov said, man. "You can't sell me bullsh*t, we know the prices."
With the Fed Funds rate remaining elevated and a promise of at least two more hikes to come, even nominal increases of .25 bps will be felt. The previous three to four hiking cycles were prolonged at an elevated rate for a minimum of five months (Jun ’00-Jan ’01) and a max sideways period of three years (May ’95-Oct ’98).
As if the worst inverted yield curve since the 80's wasn’t already a clear indicator, this will undoubtedly lead to a recession. CNBC analysts and Twitter have been gassing unsophisticated investors into thinking that a Fed pause or reversal is bullish - it’s absolutely not. There is literally no environment right now that’s beneficial for equities, specifically large caps due to their direct interdependence on low interest rates and loose monetary policy.
Higher Fed Funds Rate = Carnage. A higher rates means higher costs of borrowing. The system is already at its limits - cc Gilts market crash. Anything substantially higher will probably break something for sure.
Pause of Fed Funds Rate = a sideways move of the FFR still means elevated borrowing costs, which means higher interest payments that take away from cash flow.
Lower of Fed Funds Rate = the only reason the Fed will lower rates will be because they broke something and they’re playing damage control to avoid a global spread (baring that’s not what they want.)
The Fed Funds Rate is being used to flatten the inverted yield curve and the bond market is front running the pause in rate hikes and anticipated sideways movement. This could also be a flight to safety trade in lieu of the pending recession and a possible liquidity event.
The VIX is below 20 and approaching 15-16. I don't want to be buying equities here, but traders should be cautious selling as well. There will probably be a lot of sideways price action for a good minute until things set up for the sell-off finale set to take place Q2 April-Q3 September.
Q4 2022 corporate earnings are currently being announced and heavily anticipated to be negative, which is partially but not fully baked into the market. Any misses on expectations from unexpected companies will be overemphasized. Corporate earnings for Q1 2023 will probably be trash as well.
My last point here before I wrap up is an analysis of my favorite chart. The SPX*US10Y peaked at the highest levels all-time and is now steadily testing and re-testing it's 150/200-day EMA. When it breaks the 200-day and all EMAs roll over, history says to look out below. i.e. Covid-19 2020, 2018 Repo Crisis, Brexit 2016, Black Monday 2011, Flash Crash 2010, 2008 Great Financial Crisis, 2000 Dot Com Bubble, 97-98 Asian Financial Crisis, 1990 Oil Shock Post-War Recession. We are roughly 6-8 months away from the next MAJOR collapse in markets.
Final Thoughts: This entire economic climate may very well be based around the United States flexing their fiscal muscles to show China that they aren't country enough to challenge our reserve currency status, and it may also be a move to show Russia that they are still our sons - just like when we had to bail them out of the 1997-1998 Asian Financial Crisis.
+AXELGØD