Citi’s credit group is bullish; but, as they admit, for all the wrong reasons. Bullish, because they still believe that the extraordinary liquidity environment which has dominated the last four years will remain in place this year (despite tapering) and for the wrong reasons because aside from their doubts about the foundations of much of the economic recovery itself, nearly all the factors that they would normally base their view on the markets on seem to be pulling in the opposite direction. In their own words, “everything is expensive; and the market is driven purely by a variant of the Greater Fool’s Theory.”
Via Citi’s Credit group:
…We are bullish…
For the wrong reasons, because aside from our doubts about the foundations of much of the economic recovery itself, nearly all the factors that we would normally base our view on credit on seem to be pulling in the opposite direction:
Credit fundamentals are deteriorating. Although the fragile European and global recovery should support earnings, we expect leverage to rise further as companies push shareholder value.
Valuations are increasingly unattractive. Scored against 20 different fundamental metrics, credit spreads come in as ‘Tight’ or ‘Very tight’ on every single one of them at the moment. The yield offered by € IG corporate credit is in the 4th percentile looking at the last ten years – hardly a compelling case for investing if you look at credit from a total-return perspective.
The marginal money is going elsewhere. Judging by our survey, inflows into corporate credit have been on a falling trend for 18 months and are now close to neutral at a five-year low. This weakens the technical that has so often left the credit market almost impervious to negative headlines in recent years.
Market composition is deteriorating. We think the European credit market should see a record volume (~€90bn) of subordinated debt issuance next year. While some of that (the AT1 issuance) will remain outside the indices for now, the market will still have to absorb a lot of additional risk.
And to top it off, positioning in the credit market is very different. The rush into beta may have further to go, but already the rally we have seen since September has created a vulnerability through higher-beta exposure in the market. We reckon that it is at least comparable to the one that was exposed by the Fed’s change in tone on tapering in May.
We’d argue that markets may be driven by a variant of the Greater Fool’s Theory, where the underlying rationale for many would in essence be:
“I don’t like credit here, but I don’t like other assets very much either (other than, perhaps, equities). I don’t see what turns the market any time soon and I can’t afford to sit and wait for a better entry point, especially while central banks are backstopping everything. I’ll have to take more risk and then sell to someone else when I see a trigger ahead. Worst case, I’ll be in the same boat as everybody else.”
We are not arguing that this is irrational – on the contrary, for individual investors whose performance is tracked on a monthly, weekly or daily basis, this argument seems entirely rational – especially against the perception that central banks can no more afford to let the prevailing equilibrium slip today than they could in 2009.
But the sum of that individual rationality is a market with a very obvious vulnerability.
When no one sees an immediate risk of losing, when positions get ever longer and when valuations are stretched further and further as a result, less and less is needed to eventually topple the consensus. Longer-term, it is a recipe for breeding black swans.
So the inherent challenge is to predict how long the Greater Fool’s game goes on.
However, the more tension that builds up between market valuations and fundamentals and the more stretched positions get, the more likely a subsequent selloff becomes.
Where’s the value? Spreads look tight to fundamentals on every single one of the 20 metrics
By our metrics non-financial leverage has been rising for the past two years now (spreads are ignoring that)…
To strengthen the case for that link between central bank actions and market performance, we’ve regressed US credit spreads (in differences) against 1) the Fed’s holdings of long-dated securities (in differences), 2) US GDP5, 3) non-farm payrolls, 4) US economic surprises and 5) US earnings revisions. It’s pretty clear from Figure 29 below that most of the cumulative contribution to spread tightening in this simple framework is coming from the Fed’s balance sheet, rather than the fundamental economic variables.
Even in the darling asset class of the day – equities – attractive opportunities are getting harder and harder to come by.
To be clear, we do still prefer long equity versus credit strategies, where possible, but there too valuations are full, if not stretched already in many places. The rally in small-caps, for instance, has left valuations at historical extremes versus large caps in both Europe and the US.
So you decide – play the game knowing you’re a greater fool… or exit now?