Edgar Allan Poe was intimately familiar with our deepest, dreaded fears. In Poe’s characteristically dark The Cask of Amontillado, the murderous main character Montresor, lures the inaptly named Fortunato to his death. Montresor believes he is exacting revenge upon his noble peer for a grave insult and entices the drunken Fortunato with the promise of a select sampling of a rare vintage Amontillado.
At one portentous point in the stumbling journey to the cellars, Fortunato, dressed in a jester’s motley, makes a secret sign of the “speculative” Freemason brotherhood. Montresor does not recognize the gesture but refuses to deny that he too is a Mason. Proof is demanded prompting Montresor to produce a trowel from beneath his robes, evidence he belongs to the original Freemasons, one in the same with those who built the medieval cathedrals. Shaken, Fortunato exclaims, “You jest!” but pride blinds him to Poe’s brilliant foreshadowing. You see, that trowel would soon be used to entomb a living and breathing Fortunato making Montresor a Mason in fact.
Who knew that Poe, best known for anything but jesting, gave us “Surely you jest!” to use at times when we need to express ironic incredulity? And yet here we self-described and deeply derided nattering nabobs of naysaying sit, peering into yet another recessionary reprieve. Thanks to recent dollar weakness, U.S. manufacturers appear to have caught their breath. That same decline in the value of the greenback, which has fallen in five of the last seven weeks, has placed a floor under commodities, which have rebounded smartly. The recovery, especially in oil prices, has unleashed joyous jubilation in the junk bond and stock markets. Are we last-standing contrarians being sent to our curmudgeonous corners?
Before getting ahead of ourselves, let’s consider what triggered this relief rally in the first place. That is, dollar strength, rocket-fueled by the currency war raging among our developed country peers and turbo-boosted by the Federal Reserve’s December rate hike. The resulting growth recession in profits and pullback in manufacturing persisted for long enough to infect the U.S. services sector. That last straw, along with some depressing retail sales figures, was sufficient to scare the Fed to the sidelines, which was what the markets were jockeying for all along.
So has the world economy avoided the foolish jester Fortunato’s fate? Blackrock, which reigns supreme as the biggest money manager in the world, certainly seems to think so. Sell your Treasury holdings now, Richard Turnhill, the firm’s chief investment officer, has instructed the masses, before it’s too late. Of course, Treasuries are perceived as the ultimate safe haven asset class, after gold of course. It stands to reason that if we have no recession to fear, there’s little reason to settle for Treasuries’ paltry returns.
Mr. Turnhill is not alone in his cocky confidence. The VIX, the so-called ‘fear gauge’ tracks the risk the stock market is sniffing out in the near term. It’s recently descended to its lowest reading since last summer. The lower the level, the safer the perceived investing environment.
Market pricing in junk bonds tells a similarly benign tale. The spread on high yield bonds, or the excess over Treasury yields investors demand for taking on incremental credit risk, has taken a fully refundable round trip. After peaking at 887 basis points (bps), or hundredths of a percentage point, spreads have settled back to where they ended the year, at 695 bps.
As Merrill Lynch’s Michelle Meyer pointed out in a recent report, the surest signposts that credit stresses are contaminating the real economy just aren’t there. For one thing, the decline in high yield new bond issuance has yet to manifest in curtailed bank lending. When capital markets freeze, strapped companies are forced to tap their unused lines of credit for relief. The fact that the size of credit facilities continues to grow, however, indicates the supply of, and demand for, loans remains healthy.
The second channel through which debt distress seeps into the economy is bankruptcies that mount to a sufficient extent to cause rising layoffs. Even with what have been splashy job cut announcements in the energy sector, initial jobless claims have been running below 300,000 for 54 remarkable, consecutive weeks.
As for China, which after all, originally catalyzed global market unrest last August with an unexpected depreciation of the yuan, the worst appears to have passed. The government announced a record budget deficit to lessen the blow of softening economic growth. In addition, down payment minimums in second-tier property markets have been eased and even margin debt to prop up the stock market is once again being encouraged.
Not to be left behind, Super Mario, as in Draghi, head of the European Central Bank (ECB), is doing his fair share to shore up confidence. The ECB has gotten clever in endeavoring to push liquidity into the system by effectively paying banks to lend. If that doesn’t work, what will?
If you note a vacant seat at the what-have-you-done-for-me-lately stimulus table, that would be the one not occupied by Japan. Fresh data confirm that a strengthened yen has pushed manufacturing into contraction. With new export orders at a three-year low, it’s only a matter of time before the Bank of Japan once again rides to its own economy’s rescue.
For all of these central bank exertions, this year’s April will likely bring more than one Fool’s Day, with the International Monetary Fund (IMF) expected to lower its forecast for global growth below the 3.4-percent level it was lowered to in January.
In a recent Washington speech, The IMF’s David Lipton tied the expected downward revision to the “sharp retracement in global capital and trade data flows” over the last 12 months. His prescription: a “three pronged approach” combining bold fiscal policy, structural reform, and of course, continued support from your local neighborhood central bank.
Of course, Lipton’s tone places him in the fast-shrinking minority. None other than Olivier Blanchard, the IMF’s former chief economist, was quick to refute Lipton’s pessimism remarking that the financial markets have overreacted. For good measure, he added, “the probability of another 2008 (financial crisis) is inconceivable.”
If Blanchard is right, the sea of humanity short the U.S. stock market is about to experience some serious discomfort. In fact, the only time since 1989 that shorts, who profit from market declines, did not get caught out was 2008, when markets would retest their lows and keep falling.
Compounding matters for the worrywarts is that companies continue to buy back their own shares with abandon. According to Standard & Poor’s latest tally, one-in-four firms in the S&P 500 index used share buybacks to reduce their share count by at least four percent in the final three months of 2015.
As S&P’s perennially pithy Howard Silverblatt observed, “The report of buybacks’ death was greatly exaggerated. For the eighth quarter in a row, over 20 percent of companies are buying their earnings per share via buybacks.”
Looking ahead, companies are sitting on near record cash levels while interest rates hover close to record lows affording firms the option of using debt to finance share reductions, a practice the current era of C-suite occupants has embraced with open arms. Companies have thus retained, “the ability to set record shareholder returns,” Silverblatt added.
But what if Lipton is right? What if slowing global trade does pose a true threat to a foundering recovery? There are some signs lenders are pushing back as they typically do late in a credit cycle. Lending terms for commercial real estate loans and leveraged buyouts have tightened markedly leaving riskier borrowers at the mercy of private lenders sure to demand richer terms.
At the risk of blaspheming, a recession sooner rather than later would be the better of the two outcomes given the current starting point. If the riskiest corners of the credit markets are on the verge of reopening to yet another round of go-go lending, the stock market will be reduced to a single point of historic comparison.
You see, a rally that extends into April crowns the current run a prince, second in line only to the longest in history. In other words, the bulls are collectively betting on a repeat of the party that started in 1998 and ended with a bang in March 2000.
The difference between then and now, though, is key. In 2000, a stupidly-valued stock market presented a clear and present danger. In 2007, it was U.S. residential real estate. If this discussion is still ongoing come 2018, fiscal and monetary policymakers alike will be challenged as never before with bubbles in stock, debt and real estate markets. There won’t be a three-pronged approach strong enough to effectively address this trifecta of thrice-pricked bubbles.
Like today’s investors, Poe’s Fortunato clearly did not want the revelry to end. Despite deadened taste buds, hubris drove him to partake of one more cherished chalice. But the promised rare vintage proved to be nothing more than a murderous mirage that left him moldering, insidiously immured in a newly-troweled wall.
The absurdity of the whole situation is that investors have become their own worst enemy. If there’s one thing that will put the Fed back into play, it’s a raucous celebration in the financial markets that all but double-dog-dares the very rate hike that would end today’s fetid fete. Such is the case with bad-news-is-good-news cycles. They inevitably devolve into self-fool-filling prophesies that prove lower for longer never makes us stronger.