Back in November we reported that when combing through the hedge fund Q3 13Fs, Goldman Sachs cautioned that even as smart money turnover had tumbled to all time lows, net hedge fund leverage - both net and gross - had hit all time highs.
Today, in its latest quarterly "hedge fund tracker" this time for Q4 Goldman doubled down (we will have more on the full report shortly), and made the same observation:
LEVERAGE: Hedge funds entered 2018 with near-record leverage and maintained risk despite the correction. Funds added nearly $20 billion of net exposure in two index ETFs alone (SPY and IWM) as ETF exposure rose to 3% of long portfolios. Although the S&P 500 suffered its first 10% decline in two years, funds maintained conviction in their positions. Portfolio turnover rose slightly but remained near recent record lows at 28%.
David Kostin then notes that while "net leverage dropped briefly during the correction", Goldman"s Prime Services attribute the decline to mark-to-market dynamics in options positions, in other words hedge funds were not actively deleveraging, something Kostin confirms, stating that "both gross and net exposures currently remain close to recent highs."
We bring this up because in a section in the just released Monetary Policy Report, entirely dedicated to "financial stability", the Fed makes an explicit warning about precisely this: "there are signs that nonbank financial leverage has been increasing in some areas—for example, in the provision of margin credit to equity investors such as hedge funds." The Fed continues:
... there is some evidence that dealers have eased price terms to hedge funds and real estate investment trusts, and that hedge funds have gradually increased their use of leverage, in particular margin credit for equity trades.... such easing of price terms has taken place against the backdrop of building valuation pressures.
And speaking of building valuation pressures, this time the Fed does not mince its words, and makes a clear warning just how overvalued risk assets have become:
Over the second half of 2017, valuation pressures edged up from already elevated levels.
Visually, the Fed"s lament is shown below:
What is just as surprising is the Fed"s admission that equities are overvalued even if look at just relative to Treasury yields, i.e. the "Fed model":
In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields. In part reflecting growing anticipation of the boost to future (after-tax) earnings from a corporate tax rate cut, price-to-earnings ratios for U.S. stocks rose through January and were close to their highest levels outside of the late 1990s; ratios dropped back somewhat in early February.
Another way of stating this: US stocks no longer yield more than treasuries.
Then there was the now traditional CRE warning:
In a sign of increasing valuation pressures in commercial real estate markets, net operating income relative to property values (referred to as capitalization rates) have been declining relative to Treasury yields of comparable maturity for multifamily and industrial properties. While these spreads narrowed further from already low levels, they are wider than in 2007.
In its litany of warnings, the Fed did not spare corporate credit, and especially focused on junk bonds:
In corporate credit markets, spreads of corporate bond yields over those of Treasury securities with comparable maturities fell, and the high-yield spread is now near the bottom of its historical distribution.
For the first time, the Federal Reserve even took aim at covenant lite loan and CLO deals:
Spreads on leveraged loans and collateralized loan obligations—which are a significant funding source for the corporate sector—stayed compressed. In addition, nonprice terms eased on these types of loans, indicating weaker investor protection than at the peak of the previous credit cycle in 2007.
And in the most bizarre admission, the Fed said that risk appetite is so elevated - thanks to the Fed of course - it helped unleash the cryptocurrency bubble.
Consistent with elevated risk appetite, virtual currencies experienced sharp price increases in 2017
Looking forward, the Fed warned that rising rates could result in a serious hit to bank P&Ls:
If interest rates were to increase unexpectedly, banks’ strong capital position should help absorb the consequent losses on securities. About one-third of the losses that could be experienced by banks would affect held-to-maturity securities. While these losses would not reduce regulatory capital, they could still have a variety of negative consequences—for example, by worsening banks’ funding terms. The large share of deposits in bank liabilities is also likely to soften the effect of an unexpected rise in interest rates on banks.
Depositors, you have been officially warned: you are first on the hook when banks start suffering trillions in paper losses to the tune of $1.2 trillion for ever 100 bps...
The full report can be found starting on page 24 of the Fed"s report - link.
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