March 15 2024

Sticky Optimism

Why so confident? Feeling better does not mean feeling well. Much of today’s optimism is to be found in the improving situation from the covid-stricken era, to the animal spirit of the subsequent phase. People felt free again and went out consuming. The job market is still supportive, which makes sky-high prices just tolerable, and companies’ margins all the happier. For some, it looks like the ecosystem is stabilizing on a high regime.

Markets on steroids. Sentiment is never better observed than on markets. Hard to understate a risk-on rally, when risk assets like Tech, Biotech, and Bitcoin have been rallying 22%, 23%, and 159% respectively over the past 6 months.

The valuation loftiness is most visible on the credit side, where spreads on US corporate bonds have compressed to the lowest level since June 2007. If this does not speak well to the youngest of us all, such date was on the eve of the great financial crisis. But that’s probably nothing.

The thing is that spreads compressed in the recent phase, despite the relentless rise of global corporate defaults, which tally at highest since 2009. Some positively-minded say that the refinancing wall has been successfully pushed back thanks to the recent surge of bond issuance of large corporates. My more conservative self would say that smaller companies probably don’t feel as lucky.

Similarly, it certainly didn’t escape you that defaults on credit cards are at a 10-year peak. Again, probably nothing.

What happens next? Sorry to break it out like this, but this is no science that we are overdue for a market correction, certainly on the lofty tech names. The bluff started to be called on some e.g. Tesla, Apple, Oracle, and others are on the waiting list.

On credit, savvy investors start to call US aggregate bonds “slightly tight”, while advocating for a pivot to the Eurozone. However, things look tight over there too. Of course, you might benefit from the rate cut timing-differential effect, and strengthening foreign currencies vs USD. But in the end, it is never a good sign when Italy (BBB) and Germany (AAA) trade ~100bps apart. This may mean that Germany has fallen off this pedestal. To me, it generally means that investors have become far too complacent about placing their money into weaker credits for an ever-shrinking extra penny.

Why is that investors chase risk? It is the economy stupid. It requires a yield to pay for a yield. The explanation goes in two steps:

Step one: Inflation is still hot, around 3%, and the Fed can’t decrease rates. “The 3-month and 6-month changes in core inflation continue to move higher, and this is a problem for the Fed:” Apollo’s Torsten Slok

Step two: companies and consumers pay through the teeth for goods and loans, which forces them to be more greedy on their investment returns.

The American exceptionalism has run its course. Consumers running out of steam slowly but surely, rising debt burden which yearly interests are higher than the defense budget, and looming political disorder approaching the US election are all factors that smell like downside to me.

With that in mind, investors are already pivoting to greener geographic pastures. Japan is one of them, where rising wages and some inflation open up for the first rate hike in this millennium. With this, it may trigger the unwind of the basis trade, and repatriation of money out of foreign assets i.e. USD.

Long-term investors should certainly shrug this off, but the short term calls for put protection and a good dose of hoarding in money market. With US dollar money market at $6.1 trillion and growing, many investors most probably took note already.

Stay safe out there !

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360 Advisory LLC is a Boston-based RIA managing investments