Pack up your white pants, roll up your sleeves, and get down to business.
We just passed the slowest time of the year for the markets, and we’re heading into what is shaping up to be a messy, confusing fall.
We’re also two weeks away from the eighth anniversary of the stock market sell-off of the Great Recession.
Outside of a couple corrections, which subsequently corrected themselves back up, the U.S. stock market slow-motion melt up we’ve seen for years, especially the last five quarters(!) of falling sales and revenue, just ain’t natural.
We’ve never seen a market act like this in our lifetimes. I’m pretty sure no one ever has in all of history, but verifying that seems kind of pointless since it changes nothing for us in this modern market, not to mention it seems very tedious.
Central banks are way out on a limb too. More like a limb of a limb, considering they are increasingly finding that their solutions (QE) have no solutions of their own.
A big part of investing is keeping your eye on the horizon. Minor changes to our behavior now are virtually painless, and the worst case scenario of being completely blindsided can tank a lifetime of gains.
The debt markets are a great way to gauge what is coming our way, and within just a couple minutes we can cover a wide swath of aggregated risk analysis and sentiment.
On a case-by-case basis, none of the three warning signs we’ll look at is screaming “Panic!”, but the question is how many different concerns can be stacked together before it becomes a collectively big issue.
At the very least, they are signaling a volatile, fragile fall season for investors.
Diverging Rates
First up, we have the LIBOR rate.
We all remember this one: the bank-to-bank short-term interest rate index used to set virtually all other interest rates, and provide insight into how willing banks are to trust and lend to other banks, is climbing fast.
At the start of 2015, it was at 0.3%. By early November, it had doubled. Now it has doubled again, to 0.8%. This is a pretty steep divergence from the underlying central bank rates that it had been pegged to for years.
Money market rules are changing, which seems to be driving down demand, but the widening spread between LIBOR and the Fed funds rate shows a real disconnect between the two closely related debt markets.
That, in turn, shows a potential disconnect in the influence of central banks on debt markets, which could signal a failure to properly interpret information, and/ or potentially a loss of control, during very delicate times.
Down, Down, Down
More troubling is the insanely depressed 30-year U.S. swap spreads. In real English, these are agreements to exchanging floating payments for fixed payments.
In good — or more accurately, not bad — times the spread should be positive. Floating rates have credit risk, and Treasuries don’t (in practice.)
The spread is lower than it has been for the last couple decades, even during the Great Recession.
Some regulatory changes are adding to this effect, but the effect is the same regardless of the reason behind it.
This is a pretty strong indicator that long-term bond yields will be pushed down even further.
With over $10 trillion in bonds with negative yields, and countries stubbornly keeping negative interest rates even though all they do is debase currencies and erode financial institutions further, this is only adding to the most abhorrent aspect of debt markets today.
Up, Up, Up
Finally, we get to the corporate debt side of this mess.
U.S. investment-grade companies are effectively sitting on more debt these days than they have since 2002.
If you look at the leverage ratios, net leverage has been steadily climbing since 2013, while gross leverage has been climbing since 2011, with an accelerating pace in the last couple years.
This eats into cash flows and erodes revenues. Debt has been cheap to date, but we will inevitably see higher rates. An increasing leverage ratio shows that companies are, in aggregate, only adding to their debt and rolling existing debt over.
The day will come when this has to change, which will only eat into already very weak capital investments and earnings.
With second-half earnings being revised downward, and the previously mentioned five quarters of shrinking sales and revenues, we’re looking at a future of weak performance across multiple metrics.
Truly the New Normal
None of these, on their own, warrants a change of behavior on our part. However, combined, they hint at a troubling trend.
The “New Normal,” which everyone hoped wouldn’t be the norm for long, has settled in. What was meant to be short-term intervention in markets has settled in for the long haul.
It’s now gone on long enough that the paradigm has been completely exploited, and the markets are primed for an inevitable, painful transition.
Central banks can’t change course to build up any padding for the next economic problem.
Quite frankly, they are proving they don’t even know how to do that anymore. They’ve painted themselves into a corner.
And they’ve clearly picked a pretty crappy corner to be stuck in as well. Unfortunately, they’ve dragged us with them and we’re stuck there too.
We do have options though, and they’re increasingly being used. Have you noticed that the snarky vitriol about gold investing is gone from business news?
As these trends have accelerated over the course of this year, people have rediscovered that gold has a critical role in the market.
The thing is, there really isn’t much room for investors to pile in. The gold market is a tiny fraction of the stock and bond markets. Even a tiny fraction of hedge positions and diversification will create a massive upside for investors with existing positions.
If you want to delve deeper into how this will pan out, check out Gerardo’s research.
