I have quoted many noted market observers in my RM column over the years, but today I want to focus on a pundit better known for analyzing other industries. The late, great, Glenn Frey penned the 1984 hit Smuggler's Blues, which characterizes this market better than any other pithy comment: It's the lure of easy money, it's got a very strong appeal.
That's what has brought the S&P 500 back to a near all-time high today at 2,931 after its May and December swoons. While many observers focus on the price of credit - interest rates and the Fed's next move - the quantity of credit is actually more important to longer-term moves in stock markets.
I will lean heavily here, as I have in prior RM columns, on the work of ace economist Andrew Hunt of Andrew Hunt Economics. As an independent research provider, Andrew has no dog in the market fight and has built a career on unbiased research calls. Having worked on the sell-side I can attest that brokerage economists are sometimes pressured by the trading side of the house to goose markets in either direction. Goldman Sachs has the worst reputation for this but, really, when I hear an economist or strategist employed by an investment bank make a broad market proclamation on CNBC I turn the channel immediately.
Andrew watches a set of somewhat obscure financial indicators that have strong correlation with the performance of global equity markets. Through his own number-crunching he produces a figure for the rate of growth in total global credit. When that figure enters the area above 10%, as it did for all of 2006-2007, and again at the end of 2011 and in early 2018, that is a flashing red signal for the global equity markets. That level of credit growth is just not sustainable, and inevitably stock markets correct when the credit spigots are turned down. After falling to a near-zero level at the end of 2018, credit growth in the mid-single-digits has returned to the global markets, and thus you have 2019's broad equity market rally.
Where does that money come from? Corporate borrowing has been elevated and, after a brief turndown in the U.S. in the tightening environment of 2018, has returned to the $400 billion annualized level in 2019. That behavior has been well-flagged, and obviously the share repurchases generated by the proceeds of much of that borrowing have served to prop up the S&P 500.
It is another source of funds, however, that is less obvious but even more important. Again, as Andrew notes, investors should be focusing on the amount of credit not laser-focused on what Powell and his band of merry men and women are doing to impact the price of that credit. Powell gets all the attention, but he seems to work in close concert with Treasury Secretary Steve Mnuchin, and this is where another of Andrew's obscure data sets, the level of the U.S Treasury's General Account, gains relevance. As he noted in his newsletter today:
Indeed, in the 5 weeks leading up to the 7th June, the Treasury conspired to add $175 billion to the US monetary base through its budgetary actions - a rate of implied financial system liquidity creation that is fully three times that achieved during QE2 or QE3! Given this level of funds injection by the Treasury, it was no wonder that markets were so buoyant!
So, there's your June rally in the U.S stock market after the May pullback. Obviously, there is a slight lag between when the NY Fed makes its injections and the actual impact of those dollars on the economy, but a look at the S&P 500 chart shows that it is a quick feedback loop. Again, though, pouring $175 billion of liquidity into the economy is just not sustainable activity. The Treasury does not collect enough money in taxes to do so, and so the credit markets will have to correct.
Thus, I believe the next move in the credit markets will be a tightening of liquidity. I believe this will be caused by fears of elevated risk of default. The most widely quoted measure of risky credit, ICE BofA/ML US High Yield Master II Option-Adjusted Spread, began June at 4.70% and fell to 3.95% last week. That's too far, too fast, and does not adequately reflect the elevated risk of default for corporates in what is clearly a slowing global economy. The Treasury markets have priced in the Fed's cessation of its Quantitative Tightening program in October 2019, but the markets, especially those for equities, never seem to see credit crunches coming.
So, as I mentioned in my RM column yesterday, I have set up my new Excelsior Capital Partners portfolio to be short global equities (credit concerns,) long sovereign bonds (continued flight to safety) and long oil (intrinsic value as the implied value of paper assets declines.) That's my macro outlook, and I will delve into my micro positions in future RM columns.