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Making Hay

Making Hay Monday - May 22nd, 2023

High-level macro-market insights, actionable economic forecasts, and plenty of friendly candor to give you a fighting chance in the day's financial fray.

David Hay

May 22, 2023

“It’s time for markets to fully digest how constrained central banks are gong to be relative to the last 30, 40 years, when every time there was a tiny murmur of a problem, you could just lower rates and print money.” -Bridgewater’s Karen Karniol-Tambour (hat tip to Jesse Felder for relaying this one)

(For those who want to cut to the investment guidance chase, don’t hesitate to go directly to that section.)

Most investors are aware that dramatically higher interest rates are stock market unfriendly and materially lower rates are upside catalysts. That’s typically true, but it’s also not the end of the story. There is another factor that is arguably even more impactful: credit spreads.

Over the years, this has been a recurring theme of mine, including in my prior newsletter, the Evergreen Virtual Advisor (EVA) and my book, Bubble 3.0. As a result, for some of you this is familiar ground and is perhaps uninteresting. However, I suspect many readers, particularly the newer ones, don’t track or understand credit spreads.

It’s been a while since I wrote on credit spreads — or simply spreads, as they’re often referred to by market pros — so I thought a refresh was in order. To wit, the spread is the extra yield a non-government bond pays over a similar maturity (or duration) U.S. government debt instrument. Therefore, if the 10-year T-note yields 3.7% and a 10-year BBB-rated corporate bond is yielding 5.7%, the spread is 2%. In Wall Street lingo, this is usually referred to as 200 over, meaning that the corporate security yields 200 basis points more than the Treasury issue. (A basis point equals 1/100th of a percentage point; thus, 100 basis points equals 1% and 200 equals 2%.)

One reason 2022 was such an excruciating year for investors is that both rates and spreads rose substantially. That is the ultimate double whammy because corporate bonds suffered nearly as much as common stocks. Accordingly, investors took a hit on their defensive as well as offensive holdings, with stocks and corporate bonds both generating negative returns of around 18%. Even Treasurys lost 12.2% last year. Basically, the only ports in the storm were cash and energy stocks. (The latter wrong-footed many investors, who were either lightly exposed to them or blocked from holding any due to ESG considerations).

Lately, longer-term interest rates have come down and spreads have also narrowed (narrower is better, wider is worse). The below chart gives you a sense of how much spreads came down since their peak last year, particularly with high-yield (aka, junk) bonds. It’s unlikely mere coincidence that the stock market began its recovery around the same time that more distant bond rates declined and credit spreads narrowed. As you can see, junk bonds troughed around June 15th of 2022 and a snappy rally in stocks followed over the next month. A second bottom occurred with both stocks and corporate bonds in mid-October, with an even stronger and more lasting subsequent recovery.

Corporate Bonds (White Line) | High-Yield (Orange)

Blue Line: Junk Spreads vs Treasurys | Orange Line: Investment- (High) Grade vs Treasurys

Yet, it’s also worth noting that spreads are once again widening. That deserves to be monitored, at least if you believe I’m right about the importance of this differential. On that point, please check out the charts above going back to 2020. That was, of course, during the pandemic panic when the stock market briefly fell nearly 40%. As you can see, spreads were simultaneously doing a moonshot. This spread explosion wasn’t as severe as 2008/2009 but, then again, that was the worst since the early 1930s. In other words, it rivaled what was seen during the greatest economic collapse in U.S. history.

Underscoring the critical role spreads play in financial markets, it was around March 23rd, 2020, that the Fed announced its radical and unprecedented plan to buy corporate bonds. (Using fake money from its Magical Money Machine, of course.) As some readers are aware, this fulfilled one of my most outlandish “anticipations” from circa 2017: that the Fed would seek to force credit spreads back down in the next crisis. The pandemic certainly qualified as a crisis, if not a global cataclysm.

Ironically, almost miraculously, the Fed only needed to acquire around $18 billion of corporate debt (a policy move many told me was illegal and, thus, it would never be implemented). This is in glaring contrast to the trillions it expended from 2008 to 2019 in an attempt to, first, stabilize the financial system, and then return the U.S. economy to trendline growth. With the benefit of hindsight, neither worked all that well.

Back in 2009, it was the combination of suspending mark-to-market accounting by financial institutions and the activation of the much-maligned but, ultimately, highly profitable TARP that turned the tide. The Fed’s first of four QEs (quantitative easings) helped somewhat. However, it missed a massive money-making — and confidence-boosting — opportunity to buy corporate bonds, as well as high-grade mortgages. As noted above, these were trading at early-1930s ultra-distressed levels. Over the next few years, junk bonds exploded higher, producing total returns better than a screaming stock market until around 2012. Unfortunately, the Fed used its QE firepower to buy the most overpriced asset on the planet back then — U.S. government bonds.

As I’ve previously written, it learned its lesson. By the time Covid shut down the world — or, at least, “enlightened” policymakers did — the Fed was ready to target credit spreads. It worked brilliantly, with both stocks and corporate bonds powerfully and almost instantly entering new bull markets in concert.

Today, though, spreads are somewhat elevated but they are far from alarming levels. However, it’s actually only by comparison to the years when the Fed and other central banks were spewing out trillions of pseudo money —“pseudough”— that spreads were meaningfully lower.

A bit ominously, they are showing signs of a new up-leg. What could send them soaring would be an actual recession. It was the fear of an economic downturn that pushed high-yield spreads up to close to 6% (600 over) Treasury rates in the fall of last year. From there they tumbled down to the low 400s before pushing back up to near 5%. Again, that’s not a shocker on a relative basis, but with Treasury rates up as much as they are, it does mean the average junk borrower is paying almost 9% for money. That’s certainly a lot more painful that it has been in many years. This, of course, puts downward pressure on profits. In turn, this makes Corporate America more inclined to cut their biggest cost which would be labor.

On that score, layoffs have already been proliferating. The Challenger Survey of terminations has spiked by over 300% in the first four months of 2023 vs 2022. Moreover, AI is playing an increasingly dark role in this, as noted in Friday’s Highlight Reel. A growing number of companies are sending out pink slips due to replacing humans with AI applications. It’s safe to say this trend is in its early days.

As I also admitted on Friday, as one who has been expecting a recession, there remain ample data points to support the soft-landing view. But just last week there was a flurry of releases that caused me to have greater confidence that this expansion is nearing its sell-by date. The fact that the Leading Economic Indicators are now down for 13 straight months is one example. There is simply no precedent for this happening without a recession waiting (barely, in this case) in the wings.

The reality is that recessions produce much higher credit spreads. Yet that’s not the only flashing-red indicator for this vital factor. Marty Fridson is one of the foremost experts on junk bonds and I’ve followed him for many years. In my opinion, his various buy and sell calls on high-yield debt justify his high standing. David Rosenberg quoted him last week as observing that, since 1997, the ratio of loan officers tightening credit standards relative to easing has never been as elevated as it is now. Per Marty, this measure alone accounts for almost half of junk bond spread variance. Here’s the kicker: the tightest high-yield spreads have been when the ratio was at its current level of 6.44% above Treasurys, or 644 over. The median spread has been 771! If high-yield is destined to soon hit that mid-point, that would mean approximately 3%, or 300 basis points, of further spread widening. If so, that is a very big deal… and one with extremely negative implications.

In seeking to explain the current complacency of the junk bond market, Marty had this to say:

The only explanation I can see for the market’s extraordinarily low perception of credit risk in the face of very tight credit is over-optimism about how soon the Fed will reverse course and start lowering interest rates.

It’s not a stretch to extend this line of reasoning to the stock market, which also is blithely whistling past the graveyard — in this case of a growing number of corporate passings. As my good amiga, Danielle DiMartino Booth, recently pointed out, there were 29 companies with at least $50 million in liabilities that bit the dust in May. That’s the highest since 2009, during what is now referred to as The Great Recession.

Accordingly, it’s my expectation that credit spreads are in the process of the type of pole-vault move they make heading into every recession. As with the yield curve, the more extreme instances of the government/corporate interest rate differential spreading out are not just predictive, they are also causative. Much higher financing costs triggering mass layoffs typically apply the coup de grâce to the prior expansion. Suffice to say, these economic phases tend to be anything but graceful. Yet, they do reward those who recognize which way the wind is blowing and position accordingly.

Champions

Following that section makes it challenging to be bullish at the present time. However, when I went through training with Dean Witter Reynolds in 1979, I had the privilege — though, it didn’t seem like it at the time — to be taught by the financial industry equivalent of a drill sergeant., He was a former top salesman at the old Reynolds Securities, co-founded by an heir to the R.J. Reynolds tobacco fortune. (Reynolds and Dean Witter had combined the year before in what was then Wall Street’s largest merger.) He’s long gone to the big boardroom in the sky, but he had the perfect name for a top producer in the brokerage industry: Leroy Gross. Let me tell you, Leroy put the fear of an avenging angel into my training class.

One thing he drilled into us was that you had to be bullish on something, even if you were bearish. Part of our experience was to get up on stage and pitch our ideas to Leroy in front of our classmates. That obviously added to the atmosphere of dread that dominated our time with him.

My plan was to hedge my bets, an investment trait that has stayed with me to this day. Actually, it’s one I’m going to follow again shortly. Because inflation and interest rates were both high and rising in the summer of 1979, I felt like the major trend was down for stocks. Adding to my admittedly inexperienced big-picture analysis, we were also facing the second severe energy crisis of that downbeat decade. As a result, even to my naïve eyes, the economy was clearly buckling. Thus, I thought it prudent to be bullish on GM puts, a bearish bet against what was the king of automakers in those days. (The increasing penetration of the American car market by more fuel-efficient Japanese companies was another factor in my negative assessment.)

Sadly, for me, Leroy shredded my attempt to be bullish on a bearish investment play. Frankly, I can’t exactly remember how he did so, but I think it has something to do with the fact that most option buyers — be they with puts or calls — lose money. As I was writing this piece, I remembered that he loved to write covered calls, where investors sell call options on stocks they own. Consequently, it was like I was trying to sell a lottery ticket to a devout Baptist.

My other idea was more appropriate to my make-believe client. Because of my economic concerns, which actually turned out to be valid — particularly, once the new Fed-head, Paul Volcker, decided to end America’s long inflationary cycle — I was on the hunt for a non-cyclical stock. Somehow, I came up with Philip Morris (PM). Back then, cigarette stocks weren’t the pariahs they are today. Further, Leroy hailed from tobacco country. Frankly, though, I don’t think I connected those dots at the time. Rather, I was impressed by PM’s remarkably consistent and robust earnings growth record. The stock was also trading inexpensively as were almost all common stocks back then (outside of energy and other commodity producers). Once Volcker went into Darth Vader mode, they were destined to become even more so.

Thanks to my PM tout, I received a bit of faint praise from Leroy. Given his cranky disposition, that was no small feat. Frankly, I think he liked that I had a Plan B in case my first pitch missed the strike zone, as it so badly did. However, after all these years, I may be giving myself more credit that I deserved.

Back to the here and now: my bearish suggestion is that readers who agree that trouble is coming to the lower-rated bond market consider puts on ETFs that are heavily exposed to the junkiest junk, like B and below. (However, there are certain B-rated credits that look to have upgrade potential.) Or, for readers who may have low-grade junk holdings, they should be reduced or completely exited, in my opinion. Counter-intuitively, CCC-rated bonds, toward the very lowest rung, have outperformed all other parts of the bond market this year. And, even though they were down in 2022, they held up a tad better than high-grade corporate bonds. Typically, it’s this segment of junk bonds that gets truly smeared in a recession as defaults and bankruptcies surge. My belief is that serious trouble is coming to junky-junk land.

The bullish side of my positioning recommendation might seem somewhat strange, given my economic worries. It certainly isn’t as defensive as was my PM pick of 44 years ago (yikes!). Frankly, I can’t bring myself to own tobacco stocks, despite that the potentially existential litigation threats from the 1990s and early 2000s have largely been resolved.

The fact is that cigarettes cause a multitude of people to die prematurely on a daily basis. But, as I’ve written in the past, particularly in one of my favorite EVA newsletters, Totally Toxic (there is a link to it at the end of this edition), PM has absolutely crushed the S&P 500 over the past decades. Since around the time of my tout to Leroy Gross (we could only go back to 1980), it is up by 89 times (not a typo) versus “only” 9 times for the S&P. On a much happier note, the U.S. farm sector helps feed the world. Without it, tens of millions would be at risk of starvation, especially with the war in Ukraine. (Fortunately, the loss of its grain exports has been much less than initially feared. However, between Russia and Ukraine, combined, they produce 19% to 30% of the planet’s wheat, barley and corn.) The productivity of the American “ag” industry is legendary and a big part of that success is due to its farm machinery manufacturers.

The Big Kahuna in that sector is obviously John Deere (DE). But a smaller competitor has caught my eye recently. Thus, far, my team and I are only checking it out, but it trades much less expensively than the company that “runs like a deer.”

Usually, recessions are tough on ag stocks, but I think this time could be different, realizing how dangerous those words are in the financial game. Last year, fears of mass starvation were pervasive but, as mentioned, catastrophe was averted and that once hot investment theme has cooled off considerably. Nonetheless, I suspect food shortages will be a recurring problem and U.S. farmers are in an enviable position to be able to help alleviate those, should they occur.

This stock is trading at a single digit P/E and a low price-to-sales (PS) ratio, at least compared to DE. However, to be fair, the P/S ratio is on the high end based on its own history. It also made an all-time new high early this year; i.e., it achieved an extremely impressive upside breakout or range expansion. Since then, it has pulled back 20%, which is not unusual, even after significant breakouts.

For those who simply want to play the sector without having to do in-depth research on a specific company, there are ETFs that provide U.S. ag exposure. Basically, I think buying a basket of stocks in America’s breadbasket is likely to be a winning strategy long-term.

Champions List:

Farm machinery stocks

Japanese stock market

Select financial stocks

Oil and gas producer equities (both domestic and international)

U.S. Oil Field Services companies

Japanese stock market

S. Korean stock market

Physical Uranium

Swiss francs

Copper-producing stocks

For income:

Certain fixed-to-floating rate preferred stocks

Select LNG shipping companies

Emerging Market debt closed-end funds

Mortgage REITs

ETFs of government guaranteed mortgage-backed securities (alternative approach)

Top-tier midstream companies (energy infrastructure such as pipelines)

BB-rated energy producer bonds due in five to ten years

Select energy mineral rights trusts

BB-rated intermediate term bonds from companies on positive credit watch

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Contenders

Large cap growth has been the most consistently favored asset class of this newsletter going back to its first publication in the summer of 2005. (For most of the last nearly 18 years, it was known as the Evergreen Virtual Advisor or EVA.) To the best of my recollection, I’ve never downgraded large cap growth to hold. Instead, I’ve danced around that by maintaining a Growth-at-a-Reasonable Price (GARP) buy recommendation. This means that if a company has grown its profits at, say, 15% and its stock is trading at 20 times profits, its price-to-earnings-growth rate is only about 1.33 times. This is also widely known as the PEG ratio, a more sophisticated measure than a simple P/E.

Of course, getting the future earnings growth rate is crucial to the accuracy of this metric. Unquestionably, that’s not a clear and simple process. A considerable amount of qualitative analysis goes into that determination. This includes market dominance, balance sheet strength, unique brand and/or intellectual property, and management track record, among many other considerations. Warren Buffett has boiled this down to whether or not a company has a strong moat around its business lines.

At this point in time, there aren’t many large cap growth stocks that qualify as being reasonably priced. Stocks like Apple and Microsoft, which not that many years ago traded at mid-teen P/Es, are now priced for a growth rate I don’t think they can deliver. That’s not to say their earnings won’t increase over time. However, as both are in the vicinity of $2.5 trillion market values and with P/Es near 30, high stock returns are going to be tougher to achieve. That’s just the math of the situation.

Another inarguable fact is that the largest growth companies are extremely popular among both retail and professional investors. Outsized returns are generated when stocks are out of favor and trading at undemanding valuations. The best scenario is when a stock moves up out of value status into the growth category. Thus, the P/E might rise from 10 to 30 while earnings also increase at a healthy clip. That’s basically what has happened to MSFT and AAPL over the last decade. That’s why both stocks have been essentially “10 baggers”, up tenfold, over that timeframe.

Consequently, with growth not being so reasonably priced presently, a downgrade to Hold/Contender status is appropriate in my view. My belief is that another rotation back into much cheaper value stocks — particularly, energy and other commodity producers — is poised to play out as it did in 2021 and for the first few months of 2022. This is the Great Rotation that was much discussed in recent years and I believe it has much further to go, particularly once the Fed returns to its much more familiar plunge protection stance. Admittedly, that’s nearly certain to require a recession, but I continue to believe natural resource prices will hold up well even when that happens. We’re clearly not at the Fed easing point yet, which is why I also feel a substantial allocation to one- to five-year Treasurys is essential for now.

U.S. GARP (Growth At A Reasonable Price) stocks

Telecommunications equipment stocks

Swiss francs

Singaporean stock market

Short-intermediate Treasurys (i.e., three-to-five year maturities)

Gold & gold mining stocks

Intermediate Treasury bonds

European banks

Small cap value

Mid cap value

Select large gap growth stocks

Utility stocks

Down For The Count

Please see my negative stance on the weakest junk bonds described in the Champions section.

Junk Bonds (of the lower-rated variety)

Homebuilders stocks

Meme stocks (especially those that have soared lately on debatably bullish news)

Financial companies that have escalating bank run risks

Electric Vehicle (EV) stocks

The semiconductor ETF

Meme stocks (especially those that have soared lately on debatably bullish news)

Bonds where the relevant common stock has broken multi-year support.

Long-term Treasury bonds yielding sub-4%

Profitless tech companies (especially if they have risen significantly recently)

Small cap growth

Mid cap growth

Haymaker