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Good morning. It is a pleasure to have educated readers. Many of you pointed out that I swapped “imminent” for “imminent” twice in yesterday’s letter. While the idea of an immanent liquidity drop has interesting financial and spiritual implications, that’s not what I meant to say. Warn me of other juicy mistakes via email: email@example.com
On the edges
Unhedged’s current view of the economy can be summed up in a wildlife documentary metaphor: (voice of David Attenborough) “While the pack is strong, the predators are getting bolder and picking up more young, sick and stragglers.” There are a number of ways in which the fundamental robustness of the US economy can be demonstrated. The simplest is pointing out the historically low unemployment rate. But, as we’ve written, stress is visible on the periphery, in the behavior of low-income consumers, in delinquencies on subprime auto loans, and in the default of high-yield bonds.
We can add a few more items to this bleak list. This week S&P Global reported that the trend of large year-over-year increases in US bankruptcy filings continued in May for the sixth straight month (S&P’s count includes all companies with more than $10 million in assets or liabilities):
The rising trend of bankruptcies is not limited to lazy small businesses. My colleague Sujeet Indap recently reported that also in May, the number of Chapter 11 filings among companies with more than $500 million in liabilities increased. His chart:
We know that monetary policy works with (Attenborough voice again? Why not) “long and variable lags”. So the question is how much acceleration in the default/bankruptcy trend is already built into the economy from the Fed’s interest rate tightening and liquidity withdrawal. Lotfi Karoui and his team at Goldman Sachs provide a lead. They compare default rates on high yield bonds and leveraged loans. Both are rising, but leveraged loans are rising faster. This is interesting because leveraged loans generally have floating interest rates, so those borrowers are already experiencing the effects of higher interest rates, which bond issuers won’t experience until their bonds mature. Leveraged loan default rates therefore give us an idea of what bond defaults will look like soon, if interest rates do not fall in the interim:
Karoui notes that his charts “only include available data as of April 30 and as such do not reflect the cohort of lenders that filed for Chapter 11 bankruptcy protection earlier this week.”
Furthermore, the theme of interest rate rises continued after some delay a fine piece by Konrad Putzier in The Wall Street Journal this week. It noted that $1.5 trillion in commercial mortgages will be paid off over the next three years, and many or most of those will be financed by interest-only mortgages. In fact, according to the article, more than three-quarters of loans wrapped in commercial mortgage-backed securities over the past five years are interest-only loans. This structure, coupled with lower occupancy rates and building values, means that the building owners will struggle to pay off their debts:
Fitch Ratings recently estimated that 35% of aggregated securitized commercial mortgages maturing between April and December 2023 will fail to refinance based on current interest rates and property income and values. . .
Xiaojing Li, general manager of the risk analysis team at data company CoStar, estimates that as much as 83% of outstanding securitized office loans cannot be refinanced if interest rates remain at current levels.
This sounds pretty bad, although it could lead to more renegotiations with lenders than outright bankruptcies. The thing is, we haven’t seen the full impact of higher rates yet; not by a long shot.
Liquidity and growth stocks
I was extremely struck by this chart, from Strategas, which appeared yesterday in the discussion of the looming (mind spelling) liquidity squeeze:
The idea that liquidity flows correspond to the relative performance of growth stocks is intellectually appealing. The liquidity theory of stock valuation basically states that additional liquidity pushes investors out of the risk spectrum – which is roughly where expensive growth stocks are. So I took Strategas’ liquidity indicator (which is simply the Fed’s assets minus the Treasury’s general account and the Fed’s reverse repo program) and plotted it back to 2008, and plotted it against the relative performance of the Russell growth index relative to its value counterpart. Here’s the result:
A correlation is still visible in the long-term chart, but the picture is more complex. In 2018-2019 there was a period where liquidity fell and value roared; and from late 2020 to mid-2021, liquidity rose and value lagged. In markets, there is always a variety of causal factors at work and few simple relationships. I still like the liquidity-growth stock argument, but I need to think more about the places where it breaks down.
From again the WSJa few days ago:
Hedge funds and other speculative investors have built a big bet that the S&P 500 will fall, marking their most bearish position since 2007. That’s according to data from the Commodity Futures Trading Commission, compiled by Bespoke Investment Group, measured as a percentage of open interest in the futures market. . .
How best to read investor sentiment from futures or options positioning is a surprisingly controversial topic, so I asked Garrett DeSimone, head of quantitative research at OptionMetrics, what he thought. “There’s definitely merit in this story,” he replied, sending data on out-of-the-money puts and calls, showing that investors rely heavily on puts (that is, contracts to buy the S&P at a price). to sell). lower than today, as opposed to buying at a higher price than today). This is the outstanding put rate minus the outstanding call rate:
“This is consistent with greater investor involvement in downside speculation or hedging measures,” said DiSimone. However, here’s a question for readers: Is increased hedging activity a bullish or bearish sign for markets? I saw that the argument worked both ways. Bad sentiment is bullish, but anyone who is hedging hasn’t sold yet, which is bearish.
A good read