Dec 26 Weekly. S T R E T C H E D
There have been many times when trends change with the new year. A notable recent example is 2013 when both the US ten year yield and red/gold euro$ pack spread traded over 300 bps, peaking right at the end of the year and then reversing, tracing lower throughout 2014. I have never been given to using the turn of the year to forecast new themes, however, there do seem to be several examples of stretched markets at the end of 2016 which I touch upon below… not as a ‘Trade of the Year’ exercise, but just as food for thought.
The first theme is that of stocks priced in something else…a relative value idea. Again? Yes. Again. But with an additional twist this time. Below is a chart of SPX divided by the Bloomberg Commodity Index*. This chart is stark evidence of the dominance of financial assets over commodities. From the low in 2008 it’s up 4 times, and is ending 2016 pretty much at its high. I added the Federal Reserve’s balance sheet to this chart (that’s the twist), which appears to show that stocks tend to follow the Fed’s balance sheet with a lag. Causation or coincidence? I don’t know. The interesting aspect of this chart is the last two years. The balance sheet has flat-lined while stocks divided by commodities appears to have consolidated. This would be one of my themes for the next year, the idea that commodities will finally begin to outperform stocks. In terms of trades, I would in general favor long SPX puts vs long BCOM as equity index puts are fairly cheap currently.
In the chart above, I only went back ten years because that’s really when the Fed’s balance sheet came into play. But just so that it doesn’t appear as though I am data-mining, consider the chart below. This chart goes back 20 years, and importantly captures the dotcom boom of the late 1990’s. That’s when the FF target was around 5% and the dollar index was right around its current level. (A higher interest rate means higher carrying costs for commodities, but also reduces the present value of future income streams). The dotcom boom was when the promise of new technology spawned astronomical valuations. We are currently nearly double that high! Think about that for a second. The BCOM index at the start of 2016 is approximately the same level as it was at the start of 1999! But the global population is about 20% greater (6.1 to 7.4 billion). I believe it was in 1998 when Jimmy Rogers started a commodity fund, noting that bull markets in commodities tend to run for years. Giddyup.
Theme number two: Corporate spreads to treasuries are likely too tight. The first thing I would note as an aside is that the Baltic Dry Freight Index is at or near its lows from the past five years. Not exactly a ringing endorsement for the idea of growth in global trade. But now let’s consider credit quality. I am attaching a few charts here, some of which aren’t exactly up to date — I just lifted them from a Business Insider compilation (link at bottom). First, from the St Louis Fed’s FRED data base, the BAML Corp BBB Spread to Treasury.
The last reading on this graph is 166. I have taken it back only 5 years, but since 2008 the spread hasn’t been below 145. Now consider this chart in the context of a couple of others.
The first chart below shows corporate debt as a percentage of GDP. Although it’s only updated through June, it’s pretty clear that increased interest rates, should they move that way, will be somewhat problematic with respect to debt servicing. We already know that government debt as a percent of GDP is near record levels, and is likely to increase in the near term.
The second chart, below, ties into both of the themes that we have covered so far. It shows an increase in corporate defaults. Obviously, this is partially due to the severe decline in energy prices in the beginning of the year that 1) was responsible for the low level of BCOM 2) caused corporate spreads to widen (the spike to 260 on the right hand side of the BBB spread chart is associated with energy) and 3) has to do with deterioration of balance sheets due to corporates taking on debt to buy back shares.
To repeat, the thought here is that credit spreads are most likely to widen. Sure, a burst in GDP due to new policies unlocking the potential of the US economy would likely justify tight spreads, it just seems prudent to look to the future with a healthy dose of skepticism. As Mohamed el-Erian said last week “We’ve priced in no policy mistakes. We’ve priced in no market accidents, and we’ve ignored all sorts of political issues.” With respect to the last I would just mention that China has said they’re not wedded to the goal of 6.5% growth, and I would further note that Trump’s pivot away from China is raising the odds of conflict, as evidenced by new naval exercises by China’s aircraft carrier and war ships in the South Sea.
Finally, the spread between German and US yields is going out at the high of the year. In February, the spread between the Bund to UST 10y was 143 bps. From March to October it was stable between 155 and 175 bps. Friday it was 230 bps, nearly 100 bps higher than the year’s low. I have no inclination to fade this particular move. While there were some measures last week that lessened uncertainty in the financial system, there is by no means resolution of core problems. By the way, EURUSD is ending the year near the absolute low, and the Dollar Index near the absolute high. In general, it seems that turning points in the dollar typically occur in the first quarter. Should be plenty of opportunities in 2017! Good luck trading.
