Will the Truly Efficient Market Please Stand Up?
by Brian Pretti CFA, Contrary Investor. January 4, 2008
Although it always seems this way, it sure feels as if we're entering 2008 with some of the most pressing issues for the financial markets and real economy we've faced in quite some time. Very important fundamental issues that for now remain very unresolved. Here's a very short list of highlighted topics:
- Balanced on the proverbial conceptual fulcrum at the moment is whether or not the US will enter recession in 2008. Maybe more importantly, if indeed a recession does lie in our future, will the true nature of US economic circumstances under such an environment ever be "published" in the headline economic stats so heavily adjusted and massaged these days? As you know, many an honored and experienced financial market pundit believes recession has already arrived domestically. Of course whether or not an official recession actually comes to pass, it's corporate earnings that ultimately count.
- The US consumer is a major question mark as we enter the New Year. After the demise of the US consumer has been predicted by so many for so long, and so many have been so wrong for so long, is this now the ultimate and perhaps most important contrarian stance as we look into the year ahead? US consumer DOA? I guess it all depends on whether you are referring to their brains or their wallets (credit usage), between which there has been quite the disconnect for some time now.
- Although the debate over potential inflationary or deflationary economic outcomes has been growing in pitch as of late, factual evidence of the moment points much more strongly toward stagflation as an important economic and financial market theme for 2008. Have the equity markets, individual sectors, or the aggregate bond market yet priced in such a possibility?
- Without question, the near consensus theme of global economic decoupling has certainly underpinned really worldwide equity prices recently. In short, this is the thought that the largely consumption driven US economy could easily slow meaningfully, but the strong foreign and emerging economies would barely flinch in reaction, continuing their movement ever northward in economic trajectory and helping to support US export sectors. Will that indeed be the case, or will this conceptual hope prove but a fantasy as the reality of the magnitude of US consumption driving approximately 20% of the global economy ultimately shift thinking regarding decoupling toward recoupling? The answer to this important question lies dead ahead.
These are but four very meaningful issues whose ultimate resolution will importantly shape investment outcomes in the year ahead. Although I could clearly spend well more than an entire discussion on each, I thought I'd highlight perhaps one of the most meaningful near term macro issues front and center as we tip toe into 2008. And that's the current dichotomy between investor behavior in the equity markets and the credit markets. Point blank, despite a multiplicity of global central bankers firing hoped for monetary "fixit" bullets directly into the global investment crowd on almost a continuous basis since last summer, credit markets remain in a good bit of distress. For now, credit markets are essentially voting that the global central banking cavalry will indeed continue charging into the valley of death, but will not be able to return to health and vibrancy the already and still to be financially wounded with any type of immediacy. Alternatively, with each central banking action, or even mere hint of action, equity markets rally in the pattern of many a historical yesterday's of our lives, implicitly conveying to us the message that in the Fed and global central bankers equity investors continue to trust to remedy any and all problems. So as we stand back and gaze at this all too apparent behavioral dichotomy in the aggregate financial markets, one very simple question stands out. Just which is the so-called truly efficient market here -- the credit market or the equity market? Which is properly discounting future economic and financial market outcomes in current price? For the dichotomy in behavioral response strongly suggests that both credit market and equity investors cannot be correct simultaneously. Hopefully by correctly identifying the true misinformed or misguided investment market participants of the moment, we can then better properly position investment structure and manage investment risk as we move into 2008.
So for now, this glaring divergence between credit and equity markets prompts points to probably the most important issue of the moment - real Fed and global central banker ability to change the current dynamics of the credit markets, and hence the economy. Importantly, please remember that non-bank credit creation has been ground zero for macro credit market largesse over the last decade-plus and remains largely the locus of current credit market turmoil. (Not that the banks have not been drawn into the vortex of credit cycle reconciliation.) Can Fed and global central bank actions act to repair non-bank financial sector balance sheets and spark credit cycle acceleration anew? Yes or no? In very simple terms, THIS is the issue of the moment, the issue over which global credit markets seem quite concerned. The asset backed security markets have been the primary vehicle by which non-banking sector credit creation has mushroomed, and now that at least a meaningful portion of this mushroom cloud has turned toxic, where to from here? From maybe $250 billion in outstanding asset backed securities in 1990, we're now looking at a $4.3 trillion market. Quite interesting, and as you'll see in the chart, current cycle annual rate of change in ABS growth peaked in late 2005. At the exact time the now clear in hindsight US residential real estate cycle of a lifetime topped out. Oh well, it's not called the asset backed securities market just for laughs, right?
Very quickly before pushing onward, the following chart will give you a sense for relative magnitude or importance of the asset backed markets. The chart below delineates the fact that over the last eighteen years, the girth of the asset backed markets, propelling non-banking system credit creation, has grown from roughly 4% of GDP to over 30% today. Likewise, the asset backed markets made up roughly 9% of total US financial sector leverage in 1990 that has grown to a 27% level today. Asset backed markets important to the US economy vis-à-vis the greater expansion of the credit cycle over the last decade and one half? No, not important, simply crucial.
But thanks to data from our friends at the Fed, we can see just how fast "confidence" in asset-backed paper is evaporating. Cutting to the bottom line, the most important point of what you see below is the continued deterioration in asset-backed commercial paper (ABCP) outstanding. Yes, the very same vehicles financing far too many CDO and SIV ventures. Since the peak in ABCP outstanding in the summer, it has been a literally uninterrupted twenty-week (through 12/26) deterioration in ABCP outstanding. Total ABCP outstanding now rests at a level last seen in the third quarter of 2005. Fed discount and Funds rate cuts have done absolutely nothing to stop this contraction. Remember, ABCP has been crucial to funding CDO and SIV investment positions for years. Not a good thing for CDO and SIV collateral values. The further the contraction in ABCP, the more investment risk banks and other sponsors of these vehicles will accept back on their own balance sheets, or be scrambling for alternative financing. You saw the Citi announcement a few weeks back of returning $40+ billion of prior off balance sheet paper right back on balance sheet. If you were wondering why, wonder no more. Likewise, the less availability of ABCP to fund CDO and SIV vehicles on an ongoing basis, the more volatility in assumed asset values of these securities. Simply wonderful for a credit market already knee deep in uncertainty. And coming just at the time audit teams will be descending upon the institutions who only wish they'd stopped "dancing" (thank you Charlie Prince) just a bit earlier.
So, we now have four discount rate cuts and three Fed Funds rate cuts under our collective belts, but many a credit market relationship rests at a level of deterioration below what was seen in August of this year. In many respects, credit market conditions are worse today than before the Fed and global central banking friends began their current monetary easing cycle adventure. As I've stated a number of times, the basic credit market problem of the moment is not liquidity per se; it's solvency and ongoing deterioration of collateral values underpinning mountains of in place leverage originally built on faulty forward collateral value growth assumptions. So will Fed Funds rate cut numero quatro, surely to be handed down this month, be the silver bullet to change current credit market circumstances? Or will yet another rate cut ultimately prove as truly ineffective as the last three, heightening in investor perceptions the thought that the Fed is quickly burning through precious monetary ammunition while completely missing the most important target - the credit markets? Either way, we're all going to find out in relatively short order.
I could drag you through a number of historical credit market charts that clearly detail the still in effect stress of the moment, but I'm sure you've probably seen more than a few across the web over the past few months. What's important as we move ahead? US credit spreads – corporate and high yield relative to Treasuries. Treasury swap spreads themselves. LIBOR relative to Fed Funds. So I'll leave you with one I'd suggest keeping an eye upon for a multiplicity of reasons. It's the TED spread. In days gone by, this was indeed a very widely quoted and followed relationship, but has fallen by the wayside a bit after the Chicago Merc dropped T-bill futures sometime back (originally a key data point in the calculation). So here's a bastardized version below using the spread between three month Eurodollar rates and the 3-month T bill yield. Again, cutting to the bottom line, the TED spread is conceptually a measure of credit risk. It's a measure of emotional credit market fear. Academically, the three month T-bill is considered the risk free rate and three month Eurodollar yields reflect credit risk of corporate borrowers. Hence, when this spread is trending higher, it's telling us the credit markets are pricing in heightened systemic credit risk as a very simple message. Do we really need to explain the current level of this relationship set against longer-term historical precedent you see below? Quite the juxtaposition relative to an equity market skipping along its merry way.
Although you are only looking at 2007 experience above, in the interest of brevity, you are going to have to trust me when I tell you that the TED spread in the summer was as high as anything seen since the 1987 equity market "hiccup," and prior to that one need venture back to the very mean twin recessions of the early 1980's to find these levels. You get the picture, or can at least imagine it. We are looking at credit market fear.
Yes, we've seen the TED spread drop recently, and this is in direct response to the recently announced global central banker TAF (term auction facility). If rate cuts won't do the trick in restoring credit market confidence, then more liquidity will, right? But there's much more than meets the eye here. First, the new TAF allows institutions to borrow below discount window rates, easing a bit of pain as well as perceptual embarrassment. Second, collateral for borrowing under this facility can be accomplished with lesser quality assets than is required in repo land. How nice of the Fed to absorb and ultimately socially redistribute (among taxpayers) increased risk. But lastly, we're convinced this vehicle was aimed at getting LIBOR rates down. Why? As you already know, LIBOR is a key index rate for so much non-banking system floating rate credit created over the last half decade to decade. Just keep in mind how many adjustable rate mortgages resetting in the next twelve months are indexed to LIBOR.
I know I've dragged you through a lot of charts already just to make a very simple point, but one last table of numbers and we can call it a day. What you see in the next table documents in basis point and yield terms various credit spreads at June 2007 month end, along with where these credit spreads now lie as of recent days. Of course, June was the month just prior to US credit market issues really becoming a front and center problem for the financial markets globally. The very simple, and I believe meaningful, point of this exercise is to show you that there remains today meaningfully heightened credit market tensions relative to what was seen in the summer of this year.
|Yield Spread Comparisons|
|Yield Comparison||June 2007||Recent|
|10 Yr UST - 2 Yr UST Spread||16bp||96bp|
|10 Yr UST - Fed Funds Spread||-27bp||-18bp|
|Moodys Aaa - 10 Yr UST Spread||70bp||134bp|
|Moodys Baa - 10 Yr UST Spread||159bp||249bp|
|Moodys Baa - Moodys Aaa Spread||89bp||115bp|
|LIBOR - Fed Funds Spread||10bp||48bp|
|30 Year Jumbo Mortgage Rate||6.53%||6.73%|
|15 Year Jumbo Mortgage Rate||6.16%||6.22%|
The conceptual dichotomy between credit market messages of the moment and the equity markets rallying on the perceived belief that further Fed rate cuts and liquidity largesse are some type of panacea that will make credit market issues simply go away is glaring. It's the credit markets that are the key, not the equity markets. Unless the Fed and global central banking comrades in arms can truly influence what is most certainly continued deterioration in credit markets up to the present, they are truly pushing on a string. Again, unless the Fed can influence credit market outcomes and change the trajectory of spread widening, it's a very good bet that at some point equity investors will wake up to this realization of impotence and begin to price that into equities. Does that mean the world is about to come to an end for the equity market? Far from it. It means that sector and geographically specific equity exposure, in addition to a well thought out risk management game plan, is key to successful investment outcomes in the year ahead. I continue to watch and respect the messages of the credit markets. Near term, the equity market may be for show, but the credit markets are for dough.
Without intentionally trying to sound melodramatic, there are no easy answers here. For even if fear in the credit markets can be mitigated to an extent ahead by the Fed and their global central banking brethren, that will surely come with a price tag – further monetary inflation. Moreover, stabilizing the credit markets is one thing, but to return to the domestic and in part global economic expansion party on the back of the secular credit cycle horse that brought us in the first place, meaningful non-banking system credit reacceleration is a must. Hard to imagine that happening when so many credit market "investors" globally (banks, institutions, hedge outfits, municipalities, etc.) have already so badly been burned by so few (US investment banks and rating agencies) who've pocketed so much in fees along the way. Misplaced trust in the credit markets is a funny thing. It's usually only restored with higher rates, not lower.
© 2008 Brian Pretti