[rad-green] This turbocharged debt cycle will end miser ably — it’s just a matter of when.

*https://business.financialpost.com/investing/investing-pro/david-rosenberg-this-turbocharged-debt-cycle-will-end-miserably-its-just-a-matter-of-when
<https://business.financialpost.com/investing/investing-pro/david-rosenberg-this-turbocharged-debt-cycle-will-end-miserably-its-just-a-matter-of-when>Financial
Post          February 7, 2020*





*This turbocharged debt cycle will end miserably — it’s just a matter of
whenThere have probably never been as many characteristics of a top as we
are experiencing today.By David Rosenberg*

*David Rosenberg says equity markets no longer seem to trade off the
economic fundamentals.Bloomberg*

It is clear that it would have been a very hard sell a year ago that every
single risk-on asset class from equities, to corporate bonds, to
commodities would end up rallying as much as they did in 2019.

And so perhaps the message for 2020 is to fade all the optimism since
fading the pessimism a year ago paid off very well. The sharp slide in
Treasury yields this past year does not exactly comport with the risk-on
view that has morphed into the consensus forecast.

Fed policy, the trajectory of GDP growth and global economic fundamentals
in general all tell a cautionary tale. Both bonds and stocks can’t be right
at this moment in time.

We have to choose which asset class has the story right, and history sides
with the Treasury market. So, that indeed is how we are tilted for 2020.
Defensively positioned — again. In addition, from a total return
perspective, a near-20 per cent gain in the long bond not only didn’t hurt
you, but meaningfully outperformed the S&P 500 on a risk-adjusted basis and
by not having to take on any inherent equity (capital) risk.

Another year of double-digit returns on the highest quality, long duration
bonds is our expectation


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Right now, it is critically important to get as close to the truth of
clients’ risk tolerance. There have probably never been as many
characteristics of a top as we are experiencing today. At some point, as
unpopular as contrarianism can be, we all need to ponder deeply about Bob
Farrell’s Rule #4:

STORY CONTINUES BELOW

*“Exponentially rapidly rising or falling markets usually go further than
you think but they do not correct by going sideways.”*

No one really knows how far up the top is, but what happens after the top
does not fit into very many people’s risk tolerance. In the meantime,
another year of double-digit returns on the highest quality, long duration
bonds is our expectation and the interest rate risk associated with them is
entirely manageable from my perspective as a market economist.

While I cannot pick the date, I can tell you that this turbocharged debt
cycle will end miserably, not unlike 2008 and 2001. Don’t try to time the
inevitable mean-reversion trade. Just heed this first Bob Farrell rule of
investing on ‘mean reversion’ and know that it’s out there. In nearly 11
years the S&P 500 has soared nearly fivefold to multiples (on earnings,
sales and book value — take your pick) we have only seen twice in recent
history.

There really is no reason to wait for the herd to head for the exits


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Corporate bond spreads off Treasuries are squeezed to levels that fall well
short of compensating for imminent default risks, and there really is no
reason to wait for the herd to head for the exits. That time will come
sooner rather than later because Mother Nature will not tolerate leverage
and multiple-expansion supplanting corporate earnings and productivity
growth indefinitely.

We recall all too well the euphoria that followed the early 2001 and late
2007 Fed rate cuts and curve-steepening shifts, that then switched to
malaise as the recession nobody saw coming took hold in the next few
months. The lags between monetary policy and the real economy are both long
and variable. We are still feeling the effects of the tightening in Fed
policy from 2015-2018, as we were feeling the 2004-06 effects by the time
the 2008 recession kicked in.

Remember, it cannot be denied that during the summer months the
‘normalized’ New York Fed recession probability model did breach the 80 per
cent threshold, and it cannot be taken back, even if it has receded in
response to the Fed’s recent liquidity infusions. The Fed has employed both
actual rate cuts, and an aggressive QE4, which in the past two months has
more than fully funded the U.S. fiscal deficit. But, with a typical
year-long lag, a recession has ensued after the 80 per cent mark has been
crossed in the ‘normalized’ New York Fed model every single time in the
past five decades.

And, of course, there are ongoing uncertainties around the global trade
picture (not to mention the U.S. fiscal outlook) as it pertains to the
November 2020 election. I see little reason for a capex cycle to emerge in
2020 given the wide divide that has opened up on tax policy between the
Democrats and Republicans — to the point where even a centrist like Joe
Biden is now campaigning on rolling back the Trump tax cuts of 2018. What
business is going to embark on a major multi-year spending project not
knowing what the after-tax rate of return on the capital invested is going
to look like?

Lately, the equity market no longer seems to trade off the economic
fundamentals. Never before has there been such a loose relationship to
economic growth. While the GDP recession never did materialize, the median
economic sector stopped expanding mid-year and the portion of the economy
that is not the consumer has posted no growth at all in the past three
quarters.  That may well be a bit of data mining, but it is to show how
narrowly concentrated the economy has become.

Not just that, but corporate profits are set to be in a four-quarter
recession and investors have barely blinked. More like shrugged. At the
start of 2019, the consensus was for a V-shaped earnings recovery to take
hold by year-end, but instead of double-digit growth that the consensus had
once penned in, Q4 2019 is now seen as coming in at -0.3 per cent on a YoY
basis.

If corporate earnings had gone up four quarters in a row and the stock
market plunged 30 per cent, such a mismatch would make the temptation to
turn bullish irresistible. Please stand by. But what happened in 2019 was
the exact opposite. That was not in the consensus forecast at the turn of
the year, and the stock market soared by more than 30 per cent.

So, the market has rallied completely on the back of multiple expansion —
to the point where the price-to-earnings, price-to-cash flow and
price-to-book ratios are all near-one standard-deviations above their
historical norms. The price-to-sales multiple for the S&P 500 actually is
back to where it was at the 2000 dotcom bubble peak.

Leveraged credits are in an eerily similar situation to what was surfacing
out of the subprime mortgage market back in 2007


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The ratio of corporate debt-to-GDP is at all-time highs. In addition to the
unprecedented fiscal stimulus at this late stage of the economic cycle, and
accompanying trillion-dollar deficits, we also have corporate leverage
ratios at record levels. An enormous volume of corporate debt has been
issued exclusively for the purpose of buying and retiring shares. This
includes both buybacks and acquisitions of other companies. And in classic
mature-cycle fashion, we are seeing some cracks emerge in the junkiest
parts of the U.S. credit market. This is an area to be focused on as
leveraged credits are in an eerily similar situation to what was surfacing
out of the subprime mortgage market back in 2007.

In any event, we are light years away from a stable equilibrium. Leverage,
financial engineering and the restructuring of the capital structure that
followed the recent M&A wave, have become the defining features of this
bull market in risk assets — namely equities and corporate credit. The
proverbial canary in the coal mine usually resides somewhere in the credit
market (think of LBOs in 1989 and subprime mortgages in 2007).

The bottom line is that this is a stock market that is being driven by
flows rather than by economic fundamentals. The ongoing wave of stock
buybacks has taken the S&P 500 share count to two-decade lows, so to some
extent the equity market now behaves more like a commodity. This was
achieved primarily by the issuance of low-rated corporate debt. In
addition, the Baby Boomer generation has done its best in a decade-long
effort to build retirement savings, primarily in index fund purchases in
their retirement plans.

This is the Chinese Year of the Rat. Last year was the Year of the Pig, and
there was a whole cosmetics bag of lipstick that was applied, primarily by
central bankers. There is just too much air underneath equity valuations
and there is no room for credit spreads to tighten any further. The world’s
economic and financial problems have been papered over by even more debt
and we now have hit leverage ratios that look to be highly unstable and
unsustainable.

In 2020, I smell a rat


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In 2020, I smell a rat. The central bank liquidity taps are likely to be
turned on even more, but the impact at current valuation levels across the
various risk asset classes will be far more muted now than was the case a
year ago. And there is always the prospect that the monetary authorities
will stay on the sidelines and await a budgetary tax cut or government
spending response, which itself is futile given that fiscal policy in most
countries is just as tapped out as monetary policy.

There are no easy solutions and it is doubtful that we will have another
year where central banks can transform the weakest period for global
economic growth in a decade and pull another rabbit out of the hat in terms
of massive excess returns for equity and corporate bond investors.

*David Rosenberg is founder of independent research firm Rosenberg Research
and Associates Inc.*

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