Turning A Donkey Into A Butterfly

The clear message from the doctors this week is that they plan to keep administering the pills, in larger quantities if necessary, until the donkey turns into a butterfly. Citi’s Matt King reminds us though that they failed to mention the associated risk that the donkey dies of the side effects first (apart, that is, from Dr Osborne, who urged the other doctors to ignore any such possibility entirely). For investors, King notes the immediate implication is that the central banks would like the party in any and all risk assets to carry on. This raises the spectre of a rally back to 2007 valuations, made all the more dizzying this time by the lack of any accompanying justification in the state of the economy…

Via Citi’s Matt King,

Party Like It’s 2006

…[ interest rates] are the one asset class which is at least following fundamentals. Both extra central bank liquidity and poor economic data contrive to send yields lower.


It feels a lot like the environment last year. In theory, lower yields and the threat of negative deposit rates are supposed to spur lending. In practice, they aggravate the hole in pensions, and exacerbate an already self-reinforcing cycle in which the premium on ‘safe’ assets merely serves to highlight the riskiness of the overall macro picture.


The only difference between now and then is the way in which the ECB has succeeded in getting peripheral govies reclassified from ‘risky’ to ‘safe’, regardless of their fundamentals. The effect has been strongest among peripheral banks, who have clearly decided that the best way to make use of abundant liquidity is through large increases in their government bond holdings. Other investors have consequently been forced to follow suit.


Credit, sadly, is just a passenger in this story. One reason the rally has proved so painful for many investors is that it has been so exclusively concentrated [in the most obviously risky instruments and entities]. And yet if those [positions] continue to rally, it remains easier even now to squeeze the remaining shorts than it is to force any reduction in the real risk positions out there.


Had all this been accompanied by any substantive improvement in economic prospects and underlying sovereign and corporate solvency, it would have been worth it. But of that there remains precious little sign. Despite the system being flush with liquidity, actual lending to non-financial corporates is contracting. Even if some degree of unprecedented risk-taking by the ECB or BoE manages to reignite such lending, the obvious riskiness of the environment means that the temptation for corporates and banks is to take advantage of the liquidity to engage in financial engineering of one form or another – not to do anything rash like actually hiring people. Even Apple, presented with the option of virtually free cash and at the forefront of technological innovation, seemingly can’t think of anything better to do with it than to give it back to shareholders.


For investors, the easiest option here is to capitulate. The mad scramble to sell protection on the [credit] indices, reflected in record negative skews, and the steady reduction in interest in tail risk hedges, even as we have rallied, suggests that many have been doing just that. We expect more to do the same in buying the wave of IG and HY issuance that is slowly but surely materializing – not to finance economic growth, but as corporates re-engage in M&A and share buybacks, and private equity do the only rational thing and take advantage of record low yields to line their (and, to be fair, their investors’) pockets through dividend recaps.


And yet we have played this game before, and it does not end well. Ideally at some point the central banks realize that the donkey is just a donkey, realize that their sole focus on their inflationary (& employment) mandate is blinding them to the risks of asset price inflation, and re-emphasize the limits on their powers and the necessity of bigger reforms elsewhere. This week suggests such a point is not particularly close. Alternatively they drive the donkey off a cliff to encourage it to fly, and at some point investors look down and recognize that many of the things they have been buying are far riskier than they thought.


Investing in such an unpleasant environment is fraught with difficulty. For now, the lack of obvious immediate catalysts, the shortage of assets to buy, the short-term focus of investors and the encouragement of the central banks make it likely that it this still 2006, not 2007. And yet the point of looking down will almost certainly be impossible to identify in advance, and may well not take as long as it did last time.


To paraphrase a certain former CEO, when the central bank music is playing, investors are compelled to get up and join the party. Yet we know how that one ends…


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