Zombieland

Summary

• Recap of the week — Cracks are emerging in the US economy.

• China’s reserve ratio requirement cut — What does this mean?

• Brexit — A dog's breakfast.

• Investment Grade Issuance — Get in while you still can.

• Dollar funding — Pricing out the foreigners.

• The week ahead — The gamma shock absorber.

Equity markets rallied on the news that talks between China and the US would take place in Washington in early October, although face to face talks is better than no talks, this development hardly indicates an end to the trade war. The odds of a comprehensive trade deal between the two nations remains elusive — as does one with Europe. The data we got last week showed some cracks in the US economy as a result of the trade war. US manufacturing slipped into contractionary territory, joining the rest of the world, and the US employment report came in below expectations. This may not come as much of a surprise but manufacturing has become an increasingly smaller portion of US nominal GDP and, as such, has become less indicative of recessions. With that said, it can not be ignored that headwinds to US growth are rising along with recession risks. Powell’s speech on Friday helped alleviate some fears but the commentary was fairly standard, rehashing the risks to the outlook and emphasizing that he’ll “act accordingly” to help sustain the expansion. Globally, data continued to disappoint with German industrial production missing woefully. In emerging markets, the central bank of Russia cut rates by 25 bps and indicated that further cuts were necessary to meet their inflation target. A similar story was told by the central bank of Chile which also cut by 25 bps. 

Along the same vein, the PBOC (People’s Bank of China) announced that it was cutting the reserve ratio (the amount of cash banks must hold as reserves) — Effectively injecting roughly US$125 billion in liquidity to bolster up the economy. Many analysts had expected to the PBOC to continue to provide liquidity to the market given the ever-growing perils of escalating US tariffs and sluggish domestic demand, but a 50bps cut was on the higher end of expectations. The latest move marks the largest easing in this cycle although, policymakers have been keen to stay away from lowering actual interest rates due to fears of a flood-like stimulus. Policymakers have successfully managed to lower borrowing costs for companies which had jumped over the past 2 years following President Xi’s push to try to reduce financial vulnerabilities. However, the problem with China’s sluggish growth doesn’t emanate from a lack of credit, but rather, weaker consumer and business confidence resulting from the trade war. The situation in Hong Kong is also not helping. The latest news that Carrie Lam, the Chief Executive of Hong Kong, had formally withdrawn the extradition bill that sparked protests 13 weeks ago should have been viewed as a positive development. Unfortunately, it appears to have been too little and too late. Many of the protestors are now demanding that anyone arrested during the conflict should be released. For the time being, it appears that protests will continue until all the demands are met or until President Xi decides enough is enough. Adding to the woes, the credit rating agency, Fitch, cut HK’s sovereign rating a notch to AA with a negative outlook. Although credit rating agencies are usually late to the party when it comes to flagging risks, the incoming data for the region does show that there is little doubt that that HK will slip into a recession later this year. As for the CNY, the market has begun to drift closer to the PBOC’s fix rather than the PBOC chasing the market. This is a positive development since any further depreciation of the CNY may well be met with further critical analysis from President Trump himself.

The UK parliament, which is suspended as of the end of next week, has managed to gain control of the Brexit agenda from Boris Johnson. Boris Johnson has had a rough week, to say the least. Putting aside the fact that his brother resigned earlier this week in protest, Johnson now has an uphill battle with opposition parties making it such that he will not be allowed to leave the EU (European Union) without a deal. If Johnson is unable to get a deal done by the deadline, he has been instructed to ask for an extension. Johnson has pushed for a snap election on the 15th of October but the opposition parties refuse to budge until an extension has been granted.  He has openly opposed the idea of an extension. As things get continually worse for Johnson, things get better for the pound, which has risen 1 percent on the week on the hopes that a no-deal Brexit does not happen. If a snap election does happen, a recent poll taken by whatukthinks shows that the UK remains split on the extension, implying that pro-Brexit parties may come very close to winning. For now, we wait and see. 

A round of applause is in order for corporate America which tapped a record US$ 74.5 billion in Investment Grade bonds in just one week. When the dust settled, there were about 50 deals done this week with even cash-rich companies like the Cupertino Fruit Company (Apple), which holds roughly US$ 200 bln, issuing US$ 7 bln in debt. The massive decline in yields throughout August has given rise to many market events. Last week's rally in equities was largely predicated on pension funds rebalancing their portfolios and, this week, much of the issuance came from Treasurers coming back from holidays and realizing issuing at these rates is a steal. With nearly US$ 17 trillion in negative-yielding debt floating around the world, investor demand for anything above zero is strong, making US corporate credit attractive for debt investors. Bloomberg reports that there is another US$ 50 bln projected for the rest of the month and activity is picking up in high-yield and leveraged loan markets. Interestingly, Bank of America was out on with a note showing how most of the debt being issued is to refinance debt rather than to support corporate buybacks or mergers and acquisitions (see chart below).

This week helps highlight something that I haven’t touched on much in my emails — the implication of zombie companies. Zombie companies are companies that are essentially insolvent and can only pay the interest on their debt, not the principal. Accommodative monetary policy (lower interest rates) force investors down the quality ladder and creates demand for the debt of companies that would otherwise not be able to find a borrower. This goes back to financial market tourism — the idea that investors are only temporarily dabbling in markets that meet their required rate of return. The ultimate irony of it all is that by central banks trying to combat lower inflation, they end up making the problem worse by giving lifelines to zombie companies. This allows companies to produce while essentially insolvent, creating a world of excess supply and deflationary pressures. The figure below shows this vicious cycle.

With all that said, I am not concerned about companies like Apple, but I am raising eyebrows at companies entering the leveraged loan and high-yield space. Last year around this time, markets began to flutter at the idea of a policy mistake, which ultimately resulted in a bear market, with many market participants concerned about the intensity of outflows in high-yield debt and leveraged loan instruments. I am not saying that we should expect the same this year but I am saying that things haven’t changed much. Trade tensions haven’t abated, the Fed has not committed to a full-blown easing cycle (despite the market pricing one in) and the dollar continues to remain firm — None of which bodes well for riskier assets.

The USD flirted with news highs this week as funding pressure in the US money markets continues. One of the key questions in September of 2017, when the Fed announced that it would begin to taper its balance sheet (reduce the purchases of Treasuries), was who would step up to fill the void left by the Fed. The answer to the question at the time was foreigners who had routinely purchased US Treasuries for their portfolios. Their participation was predicated on the ability for foreigners to purchase insurance against changes in the US, which at the time was being sold by US banks in the form of swaps. Unfortunately, this party came to an end fairly quickly once the trade war started to take shape in 2018. This set the stage for a large divergence in monetary policies as the US became one of the only central banks to continue to raise interest rates. Along with a large interest rate differential, many US companies were bringing money that was being held overseas for tax purposes back to the US — Both of these effects put upward pressure on the US dollar. With the USD continuing to appreciate, the US banks that were selling insurance on the greenback turned into buyers of that insurance, causing a spike in the cost of the insurance (since no one was selling it anymore). This has essentially priced foreigners, that are required to hedge away foreign exchange risk, out of the US Treasury market, creating a large hole in the market for Treasuries. There are other dynamics at play as well. The inversion of the yield curve has pushed investors into overnight money markets which have created some funky dynamics in the US overnight markets. All of this gets a bit technical and I won’t get into it in this email but for those interested please see here and here. What all the above means is that there are simply too many US dollar-denominated assets and not enough people to purchase them. This has the making of a fresh liquidity crisis, which helps explain why the Fed has been lowering interest rates when, on the surface, the US economy remains strong.

The ECB is stepping up to the plate this week with the market expecting a rate cut, possible introduction of some interest rate tiering system, as well as a restart of asset purchases. The recent data out of the Euro area has helped reinforce the need for stimulus, however, recent communications from the ECB make it seem as though the odds of a kickstart to an asset purchase program may be overstated. This has flared up concerns that the market may have set the bar too high for additional stimulus — the situation is ripe for disappointment. Despite the macroeconomic backdrop consistent with further accommodative policy, further accommodation is unlikely to emerge in Europe. A continuation of the bond rally would likely come from a further deterioration of the US economy, prompting the Fed to commit to an easing cycle. That seems likely to happen however, should we see a meaningful stabilization of the global economy, that may prompt central banks to lay off on the accommodation. For that to happen we would need to see the US and China cobble together a trade deal that results in the removal of the levied tariffs — a tall order indeed. Beyond that, we could see fiscal stimulus come into play. All eyes are on Germany on that front this year, but things will shift to the US next year should the democrats win the election and pursue aggressive fiscal spending (US MMT). With the US equity market back into long-gamma territory (dealer hedging will act as a shock absorber), we can expect equities to grind higher baring the absence of any sporadic tweets. Corporate buybacks will likely support equities higher over the week given that they will be entering a blackout period next week. In the US, the market will be focusing on the inflation numbers, especially given then higher than anticipated average hourly earnings print that came out on Friday. Inflation risk has, for the most part, been brushed under the rug, but that does not mean that we can’t have it snap back with a few solid prints. Meanwhile, developments in Brexit may drive sentiment in the market but the reality is Brexit remains that road that goes nowhere.

Tiago Figueiredo