Dec 16, 2018 09:00 am
By Albert Lu
What started as a strong week for U.S. equities ended with losses, as disappointing economic data from China and Europe pushed global equities down on Friday.
The Dow Jones Industrial Average closed down by nearly 500 points on Friday.
Numbers reflecting China’s industrial output and retail sales growth missed expectations. The news sent Asian equities tumbling overnight.
PMI data out of Europe also disappointed. The IHS Markit Flash Eurozone PMI index fell to its lowest level in four years.
The news helped push European stocks, measured by the Stoxx 600, lower by 0.3%.
The move down in U.S. stocks erased gains for the week with small cap stocks among the hardest hit. Small caps, as measured by the Russell 2000 Index, have lost roughly 17% over the last 3 months. Meanwhile, the large cap S&P 500 index lost 9% over the same period.
STOCK UP ON LIQUIDITY: CREDIT DEFAULT CYCLE COMING
The recent volatility has driven some investors to seek shelter in instruments with higher liquidity. In particular, Pimco Chief Investment Officer Dan Ivascyn told Bloomberg Radio that investors should consider stocking up on lower-risk, liquid assets to defend against rising volatility and widening credit spreads.
“The credit markets, particularly the non-financial segments of the corporate credit markets, are where we see the most long-term risks.”
Ivascyn cites the tremendous amount of issuance over the last decade and a steady deterioration in underwriting standards as key concerns.
“If I was allowed one piece of research, and one piece only, a pretty good piece of research would be to look at issuance versus history. I think when you look at leveraged loans — you look at other segments of the corporate credit universe — issuance is very, very high.”
In addition to leveraged loans, Ivascyn drew attention to the prevalence of CLOs, collateralized loan obligations.
“Looking at total outstandings in the CLO market … total issuance today is pretty darn close to max outstanding [of] ABS CDOs prior to the financial crisis.”
While Ivascyn stops short of equating the magnitude of today’s CLO risk to that experienced prior to 2008, he suspects the situation has created substantial risk for down-side overshooting of fundamentals.
“Many of the participants in these markets have never gone through a default cycle. So, we’re cautious.”
In addition to raising liquidity, Ivascyn recommends investors save cash for opportunities ahead.
“You want to be nimble. You want to be flexible. You want to be liquid … That involves a lot of patience.”
BANK STOCKS UNDERPERFORM
Small cap stocks are not the only victims of recent volatility. Bank stocks, particularly regional bank stocks, have also suffered. The KBW Regional Banking Index is down nearly 17% this year, which indicates to some that investors fear a recession is near.
Morgan Stanley Analyst Ken Zerbe wrote recently, “We cannot ignore the growing risk of a bear credit market next year preceding a recession as well as the negative impact of weaker economic growth [on credit quality and as a driver of slower loan growth].”
“The carefree days of rising rates and pristine credit quality could be coming to an end.”
DEPRESSION COMING WITHIN THE NEXT 12 MONTHS
Former Congressman and presidential candidate Ron Paul pulled no punches in his recent interview on CNBC Futures Now. Paul made a strong case for the onset of depression-like conditions soon.
“I think it’s a very vulnerable position because when markets are destined to make big corrections … they don’t do it from the top, they do it from 10-15% down. So, we’re at that position.”
Citing economic problems ranging from artificially low interest rates and ballooning central bank balance sheets to trade tariffs, the former congressman stressed that understanding the conditions that caused the bubble is more important than identifying the pin that will eventually pop it.
“The precipitating factor will be that black swan — it’s coming. The situation is ready for it. It’s very precarious — the debt is too much, all the malinvestment is there.”
“You need a precipitating factor like Lehman Brothers …. But it might not be just an ordinary old-fashioned bank run … It could be international, it could be related to this tariff war we have going on.”
When asked if there was anything President Trump and Federal Reserve Chairman Powell could do to avoid the day of reckoning, his answer was clear.
“No … They actually believe they can find the neutral rate of interest. It’s a total fallacy. Nobody knows what that is … I’m predicting that they can’t solve this problem that is coming because interest rates are too low and they don’t have any room … they will go back to QE and they’ll pass out the money.”
How bad will it be?
“There’s no sign that it’s going to be mild … I think that it could be worse than 1929.”
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