Odd Lots - Why Historic Relationships in Markets Have Been Totally Upended

Episode Date: November 27, 2017

This month we saw a small sell-off in markets that got big attention. How did we get to the point where a 1 percent fall in the S&P 500 over the course of a week is huge news? And are we about to enter a time when it becomes much more normal to see markets fall? Matt King, global head of credit strategy at Citigroup Inc., has never shied away from the big picture questions. In this episode of the Odd Lots podcast, he predicts we'll see more wobbles in the future, and walks us through some of the biggest and most fundamental changes that have taken place in markets over the past few years.See omnystudio.com/listener for privacy information.

I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law, and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars and policy experts to break down what the rulings really mean. We do this every weekday,

then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day, and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. Hello and welcome to another edition of the Oddlots podcast. I'm Tracy Allaway. My co-host, Joe Wisenthall, is not with me today. Mr. Wisenthal has gone off to Washington to do some very important Bloomberg related things, which means he's going to miss out on an episode that I am personally very excited about. Today we are going to talk to one of my all-time favorite

analysts. And the reason he became one of my all-time favorite analysts is because he wrote some very, very interesting research in the run-up to the financial crisis. I think it was a few days or a week or two before Lehman Brothers collapsed. He basically wrote a note called Are the Brokers Broken, pointing out some weaknesses in the funding of U.S. financial institutions. And since then, he's gone on to write more broadly about the markets. Specifically, he's written about how markets have been functioning in the era of central bank liquidity. And as you all know, this is a hot topic because the Federal Reserve is in the process of tightening monetary policy, reducing its balance sheet, which puts a giant question mark over the fate of markets.

Are they going to be able to stand on their own two feet without the support of the Fed? and potentially some other central banks. So I won't keep you in suspense for any longer. Let's bring in Matt King. He is the global head of credit strategy at Citigroup. Matt, thanks for joining us. My pleasure. What a flattering introduction. Yes, I tried.

I'm trying to make up for the fact that Joe isn't here, so this is my compensation. Let's start at the very beginning of how we actually got to know each other and how you became one of my favorite analysts. 2008, you're at City. I think you were covering the banks then, I assume. No. Oh, you weren't.

So I was doing credit strategy then kind of similar to what I'm doing now, but I guess the approach that we have always taken is to try and focus on whatever it is that really seems to be driving the market. What we don't do is say, well, here's what the economist says about the outlook, and therefore here's what it means for our market. We always try and say, what is it really driving the world? And so in 2007, I sort of had to, you know, we used to look at credit fundamentals of companies, but then in 2007, we had to drop everything and suddenly start looking at sieves and conduits and

structured credit. And then in 2008, it seemed to me that repo financing and broker dealers were a critical issue. And so I spent a long time looking at them. And then in more recent years, it's been things like the, you know, with the European sovereigns, or it's been about China and credit creation more broadly. And then the dominant theme more than anything else for us at the moment is just, about central banks and central bank liquidity.

So I love that in 2008, you managed to sort of out-analyze the actual banking analysts then. And that was one of the things I liked about the crisis as a financial journalist is the fact that everyone was kind of learning at the same time. You know, no one had a really good grasp of the intricacies. Just before we move on to more contemporary topics, I want to press you on that note. So you're at City in September 2008. what were you feeling when you push the button on a research piece that basically said, hey, there's a massive funding issue at the U.S. Pinks, and specifically Lehman?

I could feel at the time it was probably the most significant piece that I'd written. And while we couldn't say we predict that Lehman will go under, there was a chart in there that made it pretty obvious. And indeed, we basically predicted that all of the brokers would have to change their models and then Lehman happened two weeks later. I guess what was slightly surprising, and it had taken me a long time to do, was that there was no particular immediate market reaction, in part because Freddie had just been rescued literally that weekend.

And so while I did get quite a lot of attention, most of the attention actually came after Lehman when people like you kind of went back and said, hey, actually, this was really significant. Look, this guy spotted it at the time. So I knew it was important, and I made a big song and dance about it internally. But even then, you know, we couldn't see all of the repercussions more broadly.

Okay. If anyone wants to know more about what we're talking about, just Google are the brokers broken? The PDF is still floating around on the internet. It's a really good read even more than 10 years after the fact. Now, Matt, you mentioned muted market reaction when Lehman Brothers actually went under. And Muted has kind of come to characterize the markets ever since, let's say, early 2009 when the Fed first announced its big round of QE. Walk us through what changed in 2009. So clearly and correctly at the time, the central bank stepped in with extraordinary facilities and liquidity.

And to begin with, this was undoubtedly a good thing. we needed to be rescued from a sort of self-fulfilling loop to the downside. But gradually, and I would say from 2011 or so onwards, what we started finding was we went from rescuing the system and helping fundamentals to improve to a point where almost all of my favorite fundamental valuation frameworks in credit or inequities or just more broadly basically started breaking down.

Markets became expensive and carried on. getting more expensive when previously they would have mean reverted. And this prompted lots of soul searching on our side as to say, well, what's changed, what's driving things instead. And again, I can take you through these at the same time, volatility, again, decoupled from metrics like some of the policy uncertainty indices that are out there, and carried on getting lower instead. And so we had to embark on this long hunt for what was driving everything. And all lines of inquiry led back to just one place, and that's the central banks. Wait, so walk us through the specific sort of, I guess, indicators that you're talking about here.

What is it exactly that you're looking at in terms of something that would give you knowledge of valuations or potentially portend a correction? So it's basically, this is really hard to do on a radio show, you know, the relationships that we had tracked for years or decades which broke down. So, for example, I mentioned the VIX against policy uncertainty. correlates beautifully until 2011-2012, and then the VIX goes lower and uncertainty goes up. Credit spreads against corporate leverage. It used to be that when companies have lots of debt spreads were wide and companies had not much debt spreads were tight, again, works quite nicely over cycles. And then around about 2011-2012, corporates globally, but especially U.S. corporate started leveraging up,

but credit spreads, rather than widening out with them, just decoupled and tightened in. Or to take another one, credit spreads against inflation expectations. It used to be when there's slightly higher inflation expectations. It was taken as a sign of cyclical growth. And again, that relationship has sort of continued to track, but there's a break in the series in 2011, 2012. Or in equities, my favorite relationship was always earnings revisions. So the change in consensus earnings expectations,

and again, in every market we look at across multiple cycles, consensus goes up, the market rallies, consensus goes down, the market sells off, and around about 2011, 2012, expectations were revised steadily lower by analysts across the street for basically the next five years, and instead of selling off markets rallied. So all of these breakdowns, and all of them more or less at the same time. So isn't the counter argument to that just low interest rates? So for instance, when you have increasing corporate leverage, but credit spreads that are

still tightening, the thing I always hear from analysts, from bullish analysts, is well, you know, They can be more indebted because ultimately the debt burden will be less in an era of low rates. So that's a good argument, but I think it only gets us so far. So specifically on corporates, yes, there is an argument that maybe we should be looking at interest coverage rather than net debt to EBITDA, let's say, even though it was actually net debt to EBITDA that always correlated, well, historically. And yes, interest coverage. So firstly, yeah, the better historical correlation is with leverage. Secondly, interest coverage, although it did improve steadily for several years as interest rates were falling, actually that started deteriorating around about 2015.

And again, credit spreads did do some widening then, but it's not like that's an obviously better series that helps explain everything. Or, again, if we take volatility, for example, again, it's not obvious why volatility in markets should be lower just because interest rates are lower. or again, for me, it almost fits with the anecdotal evidence as I go around and I visit investors. I mean, the way I put it is, frankly, it's been years since I went to see any investor in any asset class who was buying things because the analyst was telling the portfolio manager, hey, I've got this really cheap asset, we should go in and buy it. It's always the PM telling the analyst, well, we've got to put the money somewhere. And so for me, again, all of those things fit together. In addition, if interest rates have so much to do with it, you know, maybe you can make this argument, But why aren't PEs on Japanese equities so much higher than everywhere else in the world if it's low interest rates that allows us to do a re-rating?

Or if Japan is a special case, and you could make that argument, why aren't PEs in Switzerland much higher than everywhere else? Or why in periods when it looks as though we might have broken out from this low rate regime and yields have been backing up, is that not been associated with a de-rating? And so, again, I think that is part of the explanation, but relative to some of the other things we'll. look at, I find it an unsatisfying explanation. So is the simple corollary of this just that valuations don't matter anymore? Well, certainly if you're a professional investor and you're a slave to near-term performance and you're worried that if you underperform, then the money will be taken away and given to an ETF, then that seems to be the conclusion that people are drawing. And you can see David Einhorn and others, you know, making references to this.

And I guess this for me is one of the disturbing things from a market's perspective. It's to see investors giving up just capitulating and saying, I know it's expensive, but it's all because of the inflows or the foreign money coming in or whatever the explanation is, and then just capitulating and feeling like they have to buy anyway. And I think what we know more broadly is that valuations do matter. They're indeed the most important factor, but only over the long term. And it often takes some sort of catalyst or, or change in the technical for investors to return to those valuations.

And again, for me, it's this valuation's not mattering. You always say that at your peril. So how do you think the real economy factors into market behavior right now? Because again, it's getting late in the year, which means we have all the sell side analysts now releasing their 2018 outlooks. And one of the consensus themes that is emerging is that we're, unlikely to get a big market correction unless we really see the economy take a hit and we see a recession. And most people think that's unlikely. So how are you viewing the actual economy at the

moment? So it's hard to argue against all of the good data that's out there, the upward revisions to people's growth expectations, similarly on the earnings front. And so I do sympathize when people say, we don't see fundamentally where the shop comes from. The natural thing is to extrapolate the good performance that we've had this year. At the same time, I think you have to think back to the indicators are always at their best just before you hit a downturn, whether it's 2006, 2007, or whether it's a totology, isn't it? And what's more, and so that doesn't mean that just because things are good, there's going to be a sudden deterioration. But I think the specific way I'd put it is, are we sure that it's the economy which is driving the market rather than the

market which risks driving the economy? I mean, one of the, so, The obvious examples are, think back to 99, 2000. It's not that the economy tanks and drags down the equity market. It's the market moving first, the economy following later. Same thing in 0708. It's not the economy driving the real estate market. It's the real estate market driving the economy. And even with the more recent wobbles from European sovereign debt or emerging markets and oil in 2015, again, one of the striking things is that market movements, which at least in theory should not have been destabilizing, did turn out to be destabilizing.

Now, that still doesn't necessarily pin down the exact timing of this, but I'm much, given, again, these expensive valuations across the board and what we think are driving them, I'm much more cautious than most people are from simply extrapolating this economic strength and saying, okay, and therefore we're bullish on markets even if they look a bit expensive. I feel like this is a really fundamental thing that we should know at this point. Like, are markets following the economy or does the economy follow markets? Why is there even a question? question mark over that. It's always hard to disentangle and especially at the moment I can see why people will make a case for the fundamentals driving markets because you can see all this good data across the board. It's almost, it's more in 2011 to 16 when earnings growth was much weaker and when GDP growth was much weaker and markets were rallying anyway, that some of the other relationships that I look at do a better job effectively or are more obviously the only driver. So for me, the main

reasons why, again, I'm so convinced about central bank related distortions driving things, is because it's not that there's no improvement in the fundamentals, but when we look at the patterns of market movements, it's a bit less that we're following the areas where earnings expectations are being revised upwards, and it's a bit more like an indiscriminate rally in everything. And what's more when we do actually almost embarrassingly simple things like just plotting what the global central banks are buying each month and plotting that against the change in equity prices or the change in credit spreads, we come out with these really, really good

relationships without looking at any fundamentals whatsoever. And so especially in a year like this, it's hard to tell. But at a minimum, I think this year, both the fundamentals and the central bank purchases have been a big driver of markets. And next year, the central banks are significantly pulling back and the fundamentals are really have to stand on their own. Yeah. So I wanted to press you on this point. A lot of people are talking about Janet Yellen's legacy now that she's set to depart from the Fed. And one thing that keeps coming up is, well, actually, she's done a pretty good job of beginning the navigation of the exit.

She's raised interest rates and the Fed has embarked on its tightening of its balance sheet or the reduction of the balance sheet. Are you implying that this is nothing and that the real test is going to be later on, maybe when we start to see places like the ECB or the BOJ actually, withdraw liquidity. So, firstly, full credit to her. It's not nothing. She's already got significantly further than I previously thought would be possible.

But I think there is, it's maybe unsurprising that there's still disagreement about how QE affects the economy. What's amazing to me is that, you know, after, you know, eight years into the crisis, there's still so much disagreement about how QE affects me. markets. And for me, a lot of the reason the Fed has been able to get this far is because of the ECB and the BOJ having ramped up their purchases. And so this is one of the sources of disagreement. It's, are the effects local, as the central banks like to think, if only because it's convenient for them, or are they global, which is what all the correlations in markets that we find point

to. We get much better explanations for US credit spreads or US equities if we look at global QE. And same thing when we're looking at European credit spreads and European equities. It's that global pattern that fits. And that, in a funny sense, is actually the smallest of disagreements. The bigger disagreement is between, well, there are a couple more, but is it flow or is it stock? The central banks think that, you know, markets should not be destabilized because their policies are still super accommodative. And because in the Fed's case, it would argue the market has discounted things ahead of time because markets are reasonably efficient and therefore they've told us about the balance sheet reduction. And that's why it can run

in the background as just a little technical detail that nobody needs to worry about. Again, though, as we look at what has correlated in the past, what we find is that actually it's very clearly the flow that matters and not the stock, and that even if the ECB is reducing its purchases into its mind is still easing, nevertheless that reduction in the flow, at least at a global level, has historically been associated with periods of weakness in risk assets. And so again, for us, what's significant is Bank of Japan purchases have already halved with the shift away from QE or pure QE to yield targeting. And so you've got the BOJ kind of having moved and then you've got the ECB moving and the Fed moving all at the same time. And it's that combination which, again, we think is potentially destabilizing or at a minimum makes it much harder than the Fed would have thought from just looking at history in the U.S. alone.

Okay, but here's my other question. if it is so easy to show that it's all about the flow of that liquidity rather than the absolute level, then why don't central bankers realize that? Why are you the only one sort of pounding the table on this? Because while you are one of my favorite analysts, I'm sure people like Janet Yellen or Mario Draghi have a whole team of smart people who are examining exactly this kind of thing. Why aren't they coming up with the same conclusions that you are? So I don't think I'm the only one. Lots of people in the market will tell you it's the flow and it's kind of obvious to them that it's the flow and it's obvious that it's dominating. But it's almost embarrassing to say because we do say the same thing to the central banks. But to quote one of them that I met recently, somehow they look at the correlations, but then they're dismissive of them. And the reason they're dismissive is because it doesn't fit with theory. It doesn't fit their model of how the world is supposed to work. And one of my

colleagues cheekily said these are doubtless the same models that have been protecting inflation would pick up for several years now and we're predicting that wage growth should be much higher. That's really harsh. But I think there is this it's I've always I'm a strategist, not an economist. And so I don't start from the theory. I just start from what correlates in the market. And then I see if there's a plausible explanation. And when we get A, these staggeringly good correlations with the flow, and B, there's an associated plausible explanation. nation, which is look at the net supply numbers. Central banks have basically bought all of the available net supply of securities across global markets in 2016 and 2017, which is a big

difference from, say, 2006, 2007. And that creates an imbalance where people are still saving. There's still demand, but there's no supply. And so what do you get? But you get markets where prices go up. And that's exactly what we've had in every asset class on any given week, unless there's something to panic about. The price has been going up. Next year, that doesn't fall apart entirely. as the ECB and the Fed pull back, there's about a trillion dollars more of global net supply, and we think that will make for more balanced market. So in one sense, they should be looking more closely, and it's their own effect. It's the portfolio balance effect, and it's just worked way more strongly than they imagined.

But in another sense, yes, I think they're almost completely blind to it, because it's just convenient for them to continue to tout the same theory and it's just in the same way as they think that the super low level of rates should have been really, really stimulative for a long time now. And then every so often they're confronted by how markets actually behave. And they're disappointed that relatively minor changes on their part produce outsized movements in markets. And I think there's at a minimum a significant risk that that is what we get again. And the outlook is not nearly so straightforward as they would like to think. Okay.

On the outlook point, we did see a sell-off in markets this month. in November, it got a lot of attention. But in the end, I think it only ended up being like 1.5% or something like that, which historically, you know, before the crisis would have been relatively muted. Are we just going to have to get used to the return of volatility and the idea that asset prices can go down as well as up? Is that in our near future? I certainly hope so because I think a more balanced market is a much more resilient market. And I do worry that what's happened at the moment is that we, the central banks have effectively created one-way markets that grind higher with very low volatility and then are at risk of larger amounts of volatility. I mean, one of the other topics I've done work on over the years is liquidity.

And we've always said, and it's actually Kevin Walsh's definition, but a liquid market is one with a myriad set of participants looking at different factors, having different views. You know, the bottom-up analyst, the top-down portfolio manager, the long-term. turn the short term, the value-oriented, the momentum-oriented, and so on. And unfortunately, if you were a bottom-up fundamental value-oriented analyst or manager, you went out of business a long time ago, as everything got expensive and carried on getting more expensive. And so what we think has happened today is investors, through a mixture of regulation and above all the central bank distortions, have been forced into the same sets of trades, forced into

buying risky assets, which they don't really believe the valuations of, with a close eye on the global central banks and on the other investors in case actually it's time to run for the exits. And that gives us this, it's not just that volatility is low, it's that volatility is bifurcated. You could extend periods of very, very low volatility. But when everyone is the same way around, you're vulnerable to a much more aggressive pullback. You don't get one of two standard deviation movements. It's either zero or 16. Now, on the one hand, I am impressed that the little wobble that we had last week does look to have stabilized.

But on the other hand, yes, I do think that the major factor driving this has been central bank squashing all of this volatility, and that as they pull back, hopefully smoothly, we get much more two-way markets with, yes, significantly higher degrees of volatility or day-to-day volatility than we've been having at the moment. And you can see that investors, one of the other reasons why it's not just fundamentals is it's, while day-to-day volatility is low, skew or the price of out-of-the-money options is actually very high relative to, and, the money options, in fact, is it's at all-time highs. And so, again, if it were just a question of fundamental improvement, you'd have thought that the skew would have collapsed as well, and it simply hasn't. And that, again, suggests to me that the risks are being suppressed rather than not being there at all. All right, we actually managed to completely square the circle of our conversation, because, of course, one of the reasons that liquidity is said to have deteriorated in the market is regulation, as you pointed out, and that regulation came about because we had a bunch

of banks that sort of teetered near the brink in 2008, and of course, Lehman Brothers did go over the edge, as you rightly predicted in your notes. So well done to us for coming full circle. I'm kind of impressed. Matt King, Global Head of Credit Strategy at City, thank you so much for joining. It's been a pleasure. I always feel like we go to a more pessimistic place when Joe isn't around, so I'm looking forward to having him back next week, but that is it for this solo hosted edition of the Oddlots podcast. You can follow me on Twitter at Tracy Alloway. Matt King is not on Twitter, but if you want to take a look at some of his notes, just Google his name. Again,

that 2008 note we were talking about is called Are the Brokers Broken? And finally, you can follow our producer, Sarah Patterson at Sarah Pat with two T's. Thanks for listening.