Stress at the edges

Good morning. It is a pleasure having educated readers. Many of you pointed out that I swapped “immanent” for “imminent” twice in yesterday’s letter. While the idea of an immanent liquidity decline does have interesting financial and spiritual implications, it is not what I meant to say. Alert me to any other juicy errors via email: robert.armstrong@ft.com

At the margins

Unhedged’s current view of the economy can be summed up in a nature documentary metaphor: (David Attenborough voice) “While the pack is strong, the predators grow bolder, picking off more of the young, the sick and the stragglers.” There are any number of ways the fundamental robustness of the US economy might be demonstrated. The simplest is pointing to the historically low unemployment rate. But, as we’ve written, stress at the margins is visible, in the behaviour of low-income consumers, in subprime auto loan delinquencies, and in high-yield bond defaults. 

We can add a few more items to this dreary list. This week, S&P Global reported that the trend of big year-over-year increases in US bankruptcy filings continued for its sixth straight month in May (S&P’s count includes all companies with more than $10mn in assets or liabilities):

The rising bankruptcy trend is not confined to piddling little companies. My colleague Sujeet Indap reported recently that Chapter 11 filings among companies with more than $500mn in liabilities jumped in May, as well. His chart:

We know that monetary policy works with (Attenborough voice again? Why not) “long and variable lags”. So the question is how much of an acceleration in the defaults/bankruptcy trend has already been built into the economy by Fed rate tightening and liquidity withdrawal. Lotfi Karoui and his team at Goldman Sachs provide a clue. They compare the 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 rates, so those borrowers are already experiencing the effects of higher interest rates, which bond issuers will only experience when their bonds mature. Leveraged loan default rates therefore give us a sense of what bond defaults will look like soon, if rates do not fall in the interim:

Karoui notes that his charts “only incorporate available data as of April 30 and as such do not capture the cohort of loan issuers that filed for Chapter 11 bankruptcy protection earlier this week”. 

Further the theme of the interest rate increases biting after a delay, there was a fine piece by Konrad Putzier in The Wall Street Journal this week. It noted that there is $1.5tn in commercial mortgages coming due in the next three years, and many or most of them are financed by interest-only mortgages. In fact, more than three-quarters of the loans packed into commercial mortgage-backed securities in the past five years are interest-only, according to the article. This structure, combined with lower occupancy rates and building values, means the building owners will struggle to roll over their debt:

Fitch Ratings recently estimated that 35% of pooled securitised commercial mortgages coming due between April and December 2023 won’t be able to refinance based on current interest rates and the properties’ incomes and values . . . 

Xiaojing Li, managing director at data company CoStar’s risk analytics team, estimates that as much as 83% of outstanding securitised office loans won’t be able to refinance if interest rates stay at current levels.

This sounds pretty bad, though it might well lead to more renegotiations with lenders than outright foreclosures. The point is that we have not seen the full impact of higher rates yet; not nearly. 

Liquidity and growth stocks

I was extremely struck by this chart, from Strategas, which appeared in yesterday’s discussion of the imminent (note 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 added liquidity pushes investors out on the risk spectrum — which is, roughly speaking, where expensive growth stocks are. So I took Strategas’s liquidity indicator (which is simply the Fed’s asset holdings less the Treasury general account and the Fed reverse repo programme) and charted it back to 2008, plotting it against the relative performance of the Russell growth index against its value counterpart. Here is the result:

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A relationship is still visible in the longer-term chart, but the picture is more complex. In 2018-19, there was a stretch where liquidity fell and value roared ahead; and from late 2020 to mid-2021, liquidity rose and value underperformed. In markets, there is always a range of causal factors at work and there are few simple relationships. I still like the liquidity-growth stock argument, but I need to think more about the places where it breaks down.

Hedging

Again from the WSJ, a few days ago: 

Hedge funds and other speculative investors have built up a big bet that the S&P 500 will decline, marking their most bearish positioning since 2007. That is according to data from the Commodity Futures Trading Commission compiled by Bespoke Investment Group, when measured as a percentage of open futures-market interest . . . 

How best to read investor sentiment from futures or options positioning is a surprisingly controversial topic, so I asked Garrett DeSimone, head of quant research at OptionMetrics, what he thought. “There is certainly merit to this narrative,” he replied, and sent along data on out-of-the-money puts and calls, which shows that investors are leaning heavily to puts (that is, contracts to sell the S&P at a price lower than today’s, as opposed to buying it at a higher price than today’s). Here is the outstanding put interest less the outstanding call interest:

“This aligns with heightened investor engagement in downside speculation or hedging measures,” DiSimone said. Here is a question for readers, though: is heightened hedging activity a bullish or bearish sign for markets? I could see the argument working both ways. Bad sentiment is bullish, but anyone who is hedging has not sold yet, which is bearish. 

One good read

Crispin Odey.