Holiday Spending Set To Hit 12-Year High Thanks To...Debt

Even though consumer confidence cooled for a second straight month in November, CNBC is reporting that holiday spending for the average American household is on track to be the highest in 12 years.

Amazingly, the CNBC All-America Survey found that the average family will spend $900 for the first time in the 12-year history of the poll, eclipsing last year"s estimate of $702 by a wide margin.

Furthermore, the survey of 800 American households - which has a margin of error of plus or minus 3.5 percentage points - found a surge in the percentage of Americans planning to spend more than $1,000. The number climbed to 29%, up from 24% last year.

But before economists and retail analysts begin recalibrating their expectations, it’s worth noting that much of this spending will be funded by debt. Another study by RentCafe which examined spending habits of American renters discovered that, in the 50 largest US metropolitan areas, the average renting family will go into debt due to holiday-related expenses, debt that must be paid off in the opening months of the following year.

Here’s what an analysis of the average renter’s household budget for November and December looks like. As the chart shows, the average American family of four can spend $5,865 during that period without dipping into savings or going into debt.

The numbers are based on the median renter household income according to the U. S. Census Bureau, November’s average rent according to Yardi Matrix, average cost of living data from the Bureau of Labor Statistics, and a survey conducted for the National Retail Federation that reveals how much American consumers plan to spend on average this holiday season.

Based on this data, RentCafe concluded that the average American family of four spends about 2.8% of their annual income on winter expenses. (See more details in the methodology).

RentCafe then broke the data down for each of the 50 largest cities in the US. They found 24 areas where the average family finishes the holiday season with a positive balance...

...they are...

Then, RentCafe tabulated which cities were the most expensive for the average family. Expenses factored in the estimated costs of gifts and holiday-related dinners.

Unsurprisingly, New York City tops the list, followed by Boston and San Francisco.

Trying to figure out where you fit in on this spectrum? RentCafe has a tool on their website for readers to calculate how they will finish the year after holiday spending.

Circling back to the CNBC data, experts pointed at the stock market - the so-called wealth effect - as one factor that might inspire people to spend more this holiday. Because, in the eyes of many Americans, the market is the economy - a fact that President Donald Trump seems to have latched on to.

"The holiday spending outlook is stronger than it has been in over decade," said Micah Roberts from Public Opinion Strategies, the Republican pollster for the survey. "People are more comfortable with where the economy is and where it"s heading, prompting them to spend money this holiday season and help boost the economy as well." Jay Campbell of Hart Research served as the Democratic pollster.

As Stocks Soar To Record High, Americans" Consumer Confidence Tumbles In November

Despite soaring stock market values and an endless array of postive survey data from various estabishment-based entities, University of Michigan confidence tumbled in November.

Consumer sentiment in the U.S. cooled for a second month. While current conditions managed to improve, expectations for the future slumped...

“Perhaps the most important changes in early December were higher income expectations as well as a higher expected inflation rate in the year-ahead,” Richard Curtin, director of the University of Michigan consumer survey, said in a statement.

“The rise in inflation expectations in early December was a surprise, and confidence in this finding must await confirmation in the months ahead before any inferences are drawn.”

In The Past 50 Years, Americans Have Seldom Been "More Confident" Than Today

The Conference Board"s survey of Americans" Consumer Confidence surged to its highest since November 2000 in November, with both current and furture expectations spiking.

In th epast 50 years, Americans have - apparently - seldom been more confident than they are now...

Does that sound right?

Additionally, confidence in a soaring stock market is back near record highs...

Morgan Stanley Turns Apocalyptic On Credit: "A Cycle Turn Is Closer Than Many Believe"

While many have repeatedly warned over the past year that the record gains in credit are simply too good to stay - especially in Europe where yields and spreads have collapsed largely thanks to the ECB"s relentless purchases of corporate debt, with the central bank announcing on Monday it held a record €127.7bn in bonds under its CSPP program - few are as bearish on credit as Morgan Stanley, which today issued ots 2018 US Credit Outlook which is, in a word, "dire."

In the report titled "When the Levee Breaks" strategist Adam Richmond list the three biggest headwinds for credit as follows: "Fed policy should become a material headwind, markets seem very late cycle, and valuations look extremely rich" and details each below:

An unprecedented central bank unwind... We think there is way too much complacency regarding what is a notable and growing shift in central bank policy globally. Remember, monetary policy has been massive in this cycle, and extremely supportive for credit markets. The Fed is now tightening in an untested way, through the balance sheet, while also pushing rates near restrictive territory. Markets expect a seamless unwind. We do not.

 

...with markets late cycle, and very dependent on ultra-easy liquidity... It is not a coincidence that fundamental problems are becoming more apparent in one sector after the next, as the Fed withdraws liquidity. In fact, we see late-cycle risks popping up all over the place, and as is often the case near a top, these risks are mistakenly (we think) being rationalized as purely "idiosyncratic" problems. Defaults should remain low in 2018, but that is expected. Credit markets anticipate defaults one year ahead of time, and we think a cycle turn is closer than many believe.

 

...and valuations very rich: Spreads are near all-time tights, adjusting for the quality deterioration in the indices over time. Yes, the technicals have been strong, but that may change as the Fed"s balance sheet shrinks faster. We note, a recession is not necessary to see negative excess returns, especially in the second half of a cycle, and particularly late in a Fed tightening cycle. Credit markets have not experienced three straight years of positive excess returns in over 20 years.

Looking at the technicals, Morgan Stanley echoes what we said last month when he showed the collapse in spreads to 2007 levels, and warns that "credit spreads are very rich nearly any way we slice the data. Spreads adjusted for leverage are back to 2007 levels in high yield, and 1997 levels in IG."

Exhibit 20 shows our fair value model for IG, HY and loans. In short, we estimate that IG, HY and loan spreads are 41bp, 197bp, and 111bp rich to fair value, respectively, using long-term default, downgrade, and risk-premium assumptions. And as we show in Exhibit 21 below, if we adjust for the deterioration in quality of the IG index over time, we find spreads are only 9bp wide of the all-time tights.

One of the main reasons for Richmond"s bearishness, is the "complacency" about the Fed"s tightening, which of course is applicable to all asset classes. He explains:

More than anything else, we firmly believe that central banks have been THE driver of credit in this cycle, stimulating markets like never before. Now they are attempting to tighten in a completely untested way, and yet credit is pricing in a seamless unwind. At the least, we expect a bumpier 2018, with a tougher setup anyway we slice it. Growth will decelerate, while the Fed continues tightening into a low-inflation environment, driving a completely flat yield curve (per our rates forecasts). Additionally, the year is beginning with booming confidence, as hopes for tax cuts rise, thus the bar to positively surprise is high, while "Goldilocks" is firmly in the price across most risk assets.

 

We would not rule out the scenario in which financial conditions could tighten materially next year as the Fed withdraws stimulus in this unprecedented way, especially if growth expectations decline at the same time, pushing us from late cycle to end of cycle (though not our economists’ base case). And for those expecting the Fed to come to the rescue any time volatility picks up, remember that, with the balance sheet now effectively set on "auto-pilot," reversing course, in our view, is a last resort.

 

Taking a step back, per our forecasts, the Fed will hike 3 times in 2018. While gradual on the surface, this rate-hike cycle needs to be put in context. In other words, as we show in Exhibit 3 this time around, the Fed began hiking much later in an expansion, when GDP growth was weaker and corporate leverage higher vs. the start of past rate-hike cycles. In fact, given the drop in the neutral real Fed funds rate over time, monetary policy is already not that far from restrictive territory

 

 

As a result, we believe markets can withstand less tightening than a low absolute level of rates might suggest (exhibit 4). And remember, this is a unique rate-hike cycle. One, tightening began not when the Fed first hiked rates in December 2015, but when they began tapering in early 2014. In this regard, the Fed has arguably already tightened policy by a similar amount as in past cycles (Exhibit 5), a point when credit spreads tend to widen on average (Exhibit 6). Two, along the same lines, the Fed is continuing to tighten, not just by hiking rates, but also through reverse QE.

 

 

In fact, we believe investors are focused primarily on the "gradual" pace of rate hikes, treating the balance sheet as an afterthought. But the numbers are large. For example, the Fed will shrink its balance sheet by ~$400bn in 2018 alone. In our view, credit investors underestimated the tailwind from QE in this bull market. Similarly, they may now be underestimating the headwind from reverse QE. And while global central banks will still be adding liquidity next year, even they will be doing so at a slower pace, with the ECB cutting their purchases in half in 2018 and likely ending QE altogether around September of next year, while the BOJ hikes their long-term rate target in 3Q18.

 

 

We see "quantitative tightening" as a clear catalyst for weaker technicals – i.e., fixed income demand needs to rise to absorb the additional supply or prices have to adjust somewhere (supply/demand 101). Why not expect the opposite of what happened when the Fed was expanding its balance sheet in this cycle (one-way flows into US credit), as the Fed begins its unwind, at least at the margin?

Assessing rate risk, MS says that while the Fed may in fact be successful at threading the needle, an outcome that is likely already priced into markets. However, the bank warns that "at the least we can be certain that as the balance sheet shrinks more rapidly, so will the "liquidity buffer" in markets, which should magnify any negative catalyst that pops up along the way."

Another major risk factor for Morgan Stanley is that the US economy is now very late in the cycle, to wit:

Markets are very late cycle, in our view, and if anything these risks have risen compared to this time last year. That we are in a late-cycle environment is a consensus view, but "late cycle" can mean different things to different people. To be more specific, we think there is a good chance that markets peak for the cycle in 1H18 and price in rising defaults in a bigger way throughout the year. But even if our timing continues to be too early, remember, late-cycle environments are often not great for credit returns regardless, with equities often outperforming. (Note, as we discuss further below, we believe the very late-cycle signal where credit/equities diverge is already happening, focusing on CCC-rated HY credit.) A recession is not necessary for credit spreads to widen late in a cycle. In fact, credit markets have not had three straight years of positive excess returns since 1996.

Here Richmond takes offense with the argument that weak growth for much of this cycle has prevented "excesses" from building, and hence an already long cycle can last even longer. As he says "we disagree and see excesses all over the place, driven in part by years of ultra-low rates." He notes the following specific details:

• Credit markets have grown by 116% in this cycle, and leverage is at unprecedented levels for a non-recessionary environment.


• Low quality BBB issuance was 44% of total IG supply in 2017, a record as far back as we have data, and B rated or below loan issuance is now two thirds of total loan supply.


• LBOs levered over 6x are now a higher percentage of new LBO loans than in 2007. Covenant quality is considerably weaker than pre-crisis, while the debt cushion beneath the average loan is much lower.


• Investors have reached for yield in fixed income in this cycle in a massive way. Foreign flows have flooded into the asset class, arguably treating US credit as a rates product, while liquidity needs have risen, with mutual fund/ETF ownership of credit now over 19% vs. 11% pre-crisis.


• Excesses are apparent even outside of corporate credit, with underwriting quality deteriorating in auto lending in this cycle, while non-mortgage consumer debt is at a high, and CRE prices are ~25% above prior-cycle peaks.


• Stock-buyback activity has been substantial in this cycle, credit valuations have rarely been richer, and consumer confidence has not been this high since 2000.

Summarizing, and "cutting through the details" Morgan Stanley says that it has high conviction in the following two points:

1. Excesses have to be out there, given what central banks have done in this cycle – i.e., rates near or below zero for nearly a decade and round after round of QE globally, and


2. the excesses are always difficult to spot as markets are rising, and then become obvious after the turn (how did I miss that?). We think this time is no different. To be clear, excesses are not everywhere. For example, credit quality did not deteriorate in places like housing and US financials in this cycle. However, this simply tells us that the problems of the last cycle will not be the same as the problems of the next.

As a result, 2018 is when the critical mass of excesses finally spills over, or, to reuse the title, "the levee finally breaks":

While the excesses may be out there, that has arguably been the case for a while. The difference, we think, is that more cracks are now forming under the surface, which in our view, means a turn is closer than the consensus believes. For example, outside of corporate credit, we have seen signs of weakness and tighter credit conditions in places like commercial real estate. Consumer delinquencies are rising across products (i.e., autos, credit cards, and student loans). And in corporate credit, one sector after the next is exhibiting "idiosyncratic" problems (e.g., Retail, Telecom, and Healthcare to name a few). All of this is consistent with a late-cycle environment where the yield curve is flattening, correlations in markets are dropping, the economy is at (or arguably through) full employment, the Fed is well advanced in its tightening cycle (we think), and equity multiples are expanding.

To Richmond, these dynamics are "late-cycle 101. Problems pop up early on in the areas that experienced the most severe deterioration in fundamentals in the bull market. Investors initially treat those issues as "idiosyncratic." The problems then spread when credit conditions tighten more broadly. And along these lines, we think it is not a coincidence that weaker-quality high yield credits are underperforming, as the Fed is hiking faster and quantitative tightening is now being set in motion."

If that wasn"t enough, Morgan Stanley highlights two further risks: one having to do with the incremental impact of tax cuts, should they pass...

And as a side note, tax cuts would not extend the cycle in our view – they risk doing the opposite. Very simply, credit markets will benefit from anything that keeps the cycle going – modest growth and a patient Fed. Tax cuts that come when the unemployment rate is 4.1%, which drives an overheating labor market, forcing a more aggressive Fed, if anything could cut off the cycle sooner.

... and the inevitable rise in default intensity:

We think there is a high likelihood that defaults will start rising again late next year and into 2019. Without going into the details here, in our view, CCC HY bonds are already "sniffing out" these budding default risks with their recent weakness. This should continue as tighter central bank policy exposes the fundamental challenges in the asset class (the problems are easier to hide when markets are flooded with liquidity). And the fundamental issues are broad-based. Not only is leverage high across sectors, but we also estimate that almost 30% of the HY market is either in secular decline or has clear operational challenges (Exhibit 16), with declining revenue growth over the past five years. Thinking about it more quantitatively, as we show in the default section below, based on the lag between when the cycle indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today, 2019 could be a year of materially higher defaults.

Wrapping up the above, Morgan Stanley"s conclusion is the following:

Adding everything up, we see three key challenges in 2018: 1) Credit markets have been hugely reliant on central banks in this cycle, and now the Fed is withdrawing liquidity in an unprecedented way. We think markets are underestimating the risks of a mistake. 2) This liquidity withdrawal is happening while late-cycle risks (we think) are popping up all over the place. 3) Investors are buying credit at valuations that almost guarantee poor long-term returns, with the assumption that they will be able to time when to get out before the turn.

... or stated even simpler, "get out now."

"I Was Expecting Many More People": Black Friday Tumbles To 3rd Spot In Busiest Shopping Days Of The Year

It has been an odd year for retail: with an estimated 6,000 store closures, and 65,000 fewer retail jobs than at the start of the year, many have said shorting retail, and especially malls, is the next "big short" trade. Indeed, one look at the performance of the mall heavy CMBX 6 BBB- tranche confirms that the bottom has fallen out of the legacy "bricks and mortar" space.

And yet, despite what should be a furious race to the bottom for market share by all still solvent non-Amazon retailers, this has not happened in what appears to be a strange manifestation of rational pricing. In fact, according to Market Track, last year the discounts were 6% deeper than this year across 17 categories in Black Friday circulars, the WSJ reports, and notes that only three of 10 major retailers the firm measured had better prices this year.

This was obvious to potential buyers like Delaney Dauchy, 15, who was shopping with her mother at a mall in Thousand Oaks, Calif., and told the WSJ that the deals aren’t as good this year. She recalled a seven-for-$28 deal on underwear at Victoria’s Secret last year; this year, she said it was five-for-$28. The Dauchys said there were smaller crowds than past years and Black Friday deals have been going on all week. “I’m not sure it seems extra special,” Anne Dauchy, 47, said.

?? Black Friday alert! ?? The 10 toys we"re tracking are cheapest at Target, where they cost $849.80. For more info: https://t.co/BVIi10s1A7 #BlackFriday pic.twitter.com/m4Ki5dnDuH

— WSJShoppingElf (@WSJShoppingElf) November 24, 2017

To be sure, there are still deals to be had: on Friday, retailers dangled the usual promotions, many of which were identical to last year, including 30% off at Coach and 50% off at the Gap. By Thanksgiving Day, shoppers were already taking advantage of the bargains. Kevin Krause, 27, was first in line waiting outside the Kohl’s store in Medford, Ore., Thanksgiving afternoon. The store opened its doors at 5 p.m., but by 3:15 there was already a line forming.

However, as the WSJ confirmed, lines at many other locations were far shorter - if present at all - compared to prior years, such as this Best Buy at the Fair Lakes Shopping Center in Fairfax Country, VA, where there was virtually no excitement opened this years, especially when compared to 2011.

Then (in 2011)...

... and now.

A similar comparison with Macy"s, which the WSJ compares between 2011 and now. The difference is self-explanatory.

Naturally, in light of the smaller bargains, the lack of shopper euphoria is understandable: yet what is surprising is why there aren"t bigger bargains? After all, neither the industry, nor the economy has turned on a dime. Speculating on the reason, the WSJ writes that "even as this year has proved one of the most challenging for retailers, analysts are predicting robust holiday sales, underpinned by rising wages, low unemployment and strong consumer confidence."

What rising wages? Aside from various "soft" surveys, and management expectations, wage growth remains abysmal, and real wage growth has been negative for three months!

What the WSJ probably means is that between near record low personal savings and a surge in credit card usage, Americans are spending like there"s no tomorrow... they are just not spending their own money.

Anyway, the always optimistic National Retail Federation expects sales to increase as much as 4%, to $682 billion in November and December, compared with the same period a year ago, which would make it the strongest season since 2014. The delusion about US households" spending power continued: "I’d be fully expecting people to be thinking about spending more, not be holding back as much as in the past,” said Andrew Duguay, a senior economist at Prevedere, a predictive analytics company.

Spending more of what?  Here is America"s savings rate: unfortunately people don"t have "more" to spend... 

And yet, maybe the NRF is on to something. In an interview with the WSJ earlier this week, Neiman Marcus Group CEO Karen Katz attributed a jump in the luxury retailer’s gross margin in the latest quarter to stronger full-priced sales. “We’ve gotten our inventory in perfect alignment with our sales,” Katz said.

That could change in the days leading up to Christmas. Shoppers have been trained to wait for deals—a practice made easier by online price comparisons. If they hold off on making purchases, retailers will likely slash prices more than planned as the season progresses.

To be sure, the lack of deals now may mean even greater discounts in the coming months:

In a Long Island, N.Y., Wal-Mart Thursday evening, Andre Valadas said it had been hard to snag one of the discounted Sharp TVs being sold at the store or at a Best Buy across the parking lot, but glanced at his phone often to text with friends nearby looking for a similar deal.

 

The 34-year-old software engineer expects prices to fall further. “I hope that if they don’t have deals right now they will have a them in a few weeks closer to Christmas,” Mr. Valadas said.

 

Retailers still have to contend with headwinds that include a shift in consumer spending away from apparel and accessories and toward dining, travel and entertainment, as well as the explosive growth in online sales.

The above is bad news for bricks and mortar retailers, who may have gotten a brief reprieve only to lose even more customers to online alternatives like Amazon.

And speaking of, Adobe Systems said online sales on Thanksgiving increased 17% as of 5 p.m. to $1.52 billion. It also expects online sales to increase 14% to $107.4 billion during the November-December period, compared with the previous year. Amazon said Thanksgiving was one of its biggest mobile shopping days, as orders placed through its app increased 50% over last year. Best selling items included Keurig coffee makers and its Echo speaker devices.

Indeed, no matter what happens to traditional retail, Amazon is likely to be winner. The online retailer, whose stock hit another all time high, is expecting a big Black Friday as more shoppers choose to skip the stores.

“If you go back to the creation of Black Friday, it was this amazing opportunity for customers to get great deals,” said Dorion Carroll, vice president of mobile shopping at Amazon, in an interview earlier this week. “So they would flock to the stores and all of that would be great, until it wasn’t. It got too crowded.”

In fact, it may come as a surprise to some, that Black Friday is no longer the busiest shopping day of the year. It ranks No. 3, behind the Saturday before Christmas and Cyber Monday, according to the consulting firm Customer Growth Partners.

Several dozen people still gathered in line early Friday morning to be the first inside a Target store in Houston when it opened at 6 a.m., though some said the crowds were notably smaller than years past. Once inside, shoppers like Freddy Cespedes, 42, owner of a small security company, found the best advertised stuff was already picked over the night before.

“I was expecting a lot more people,” said the Black Friday novice though he acknowledged he, like many people nowadays, primarily shops online.

UMich Consumer Confidence Slides In November As Faith In Stocks Falters

Having hit the highest level since Jan 2004 in October, November"s final print shows the University of Michigan Consumer Sentiment index fell from 100.7 to 98.5, as both hope and current conditions slipped.

Expewctations for inflation dipped. Consumers saw inflation rate in the next year at 2.5 percent after 2.4 percent the prior month. Inflation rate over next five to 10 years seen at 2.4 percent, lowest since May, after 2.5 percent in October

“Increased certainty about future income and job prospects has become a key factor that has supported discretionary purchases,” Richard Curtin, director of the University of Michigan consumer survey, said in a statement.

 

“The data indicate that neither changes in fiscal nor monetary policies have yet had any noticeable impact on consumer expectations.”

The data signal consumer spending will rise 2.7 percent in 2018, adjusted for inflation, as well as “the best runup to the holiday shopping season in a decade,” the report said.

Finally we note that faith in the stock market faltered modestly...

7 Reasons Why Stocks No Longer Care About Political Shocks, And 2 Why They Should

From Nicholas Colas of DataTrek Research

Why do global equity markets ignore political shocks like Brexit, President Trump’s election or the news that Angela Merkel failed to form a government in Germany? There are plenty of good reasons, actually, which we review below.

News that German Chancellor Angela Merkel failed to form a new government was the big shock of the day. It is unclear if the country will have a minority coalition or call fresh snap elections. The New York Times quoted a Der Spiegel deputy bureau head as saying “This is Germany’s Brexit moment, its Trump moment”.

Capital markets agreed with the Trump/Brexit comparison, sending the DAX up 0.5% on the day. Every other major European bourse closed in the green as well. As did the US.

All of this got us thinking (again) about why stock markets ignore politics and government when it comes to “Crisis moments”. It wasn’t too hard to come up with several explanations.

Reason #1: The Brexit vote and Trump election are fresh in investors’ minds, and they feel they know the “Crisis playbook” well at this point. Buy any notionally negative political headline first, look for the silver linings later. Muscle memory is a powerful behavioral force.

Reason #2: Global equities remain in rally mode, with investors still more afraid of missing out than looking for reasons to sell. Every major global index (S&P, EAFE, Emerging Markets) is either at or near their one-year highs. And with just a few more weeks left in the year, plenty of investors are playing catch up to their ever-rising benchmarks.

Reason #3: US corporate earnings still enjoy positive momentum. With Q3 earnings season almost over, FactSet reports that the most recent quarter showed 6.2% earnings growth. The companies of the S&P 500 even managed to show a little margin expansion (10 bp) in the quarter, and Q4 estimates still show a 10% bottom line growth rate.

Reason #4: Any political crisis is a potential catalyst for central banks (especially the ECB in the case of today’s headlines) to remain accommodative, with Eurozone QE supporting ultra-low long term interest rates and equity valuations. German 10 Year Bunds still yield just 36 basis points, well off their July highs of 60bp. Today’s news was worth all of 0.3 bp to the German yield curve.

Reason #5: Consumer confidence is still good across the US and Europe. Markets rightly feel that any “Crisis” that leaves consumer sentiment untouched is no crisis at all. OECD data on German confidence shows it at one-year highs as of October after drifting lower in prior months.

Reason #6: Energy prices are still moderate. The one sort of crisis that gets investor attention ties headline-worthy events to the price of gasoline. Despite rumblings out of the Middle East, WTI crude prices are still comfortably below $60/barrel.

Reason #7: Tech stocks have driven a lot of the performance in large cap US and EM this year, and this sector enjoys strong secular tailwinds. As we have outlined in prior reports, the Technology sector represents 25% of the S&P 500 by weighting, and 30% of the MSCI Emerging Markets Index. Neither the US President nor the German Chancellor (or any other global leader we can think of) have any impact on how many people stream videos, use social media, shop online, or buy new smart phones.

* * *

Now, does all this mean global markets will remain impervious to political headlines? Of course not. A few thoughts on what might shift the market’s sentiment:

Real Crisis #1: An absence of global leadership on tough geopolitical problems. With Angela Merkel sidelined, Europe has no single political figure to guide the region’s policy on global issues. President Trump, while still popular with his base, is a divisive figure abroad. China’s President Xi is trying to step into the role of a truly global leader, but that’s a tall ask when it comes to American or European democratic sensibilities.

So who is in charge when if/when a geopolitical crisis arises? For the moment, this is not a question investors seem to ponder much. That doesn’t mean it’s not important. It’s just not important right now. Once North Korea/Iran/some other problem gets to a boil, things will be different.

Real Crisis #2: Political fissures can swallow up positive catalysts. As we outlined in yesterday’s note, the Democrats may be able to retake the majority in the House during midterm elections. That makes passage of tax reform in the current Congress an imperative for US equity markets. Past November 2018, Washington may be back in gridlock mode until January 2020.

Summing up, there are plenty of reasons why notional “Crises” have so little effect on global equity prices. Overall economic conditions are still good enough to spur profit growth, and interest rates remain low. Yes, things seem brittle on the political front everywhere from Stuttgart to Seattle. But until a real crisis comes along to break investor confidence, it is hard to see global equities letting any crisis go to waste

Gresham"s Law

Authored by Ted Rivelle via TCW.com,

This year’s Nobel prize in economics was awarded to Richard Thaler, a pioneer of behavioral economics. But there is a tale told by a lesser known Nobel laureate, Kenneth Arrow. As a World War II weather officer, he was tasked with analyzing the reliability of the army’s long-range weather forecasts. His conclusion: statistically speaking, the forecasts weren’t worth the paper they were printed on. Captain Arrow sent along his report only to be told, “Yes, the General is well-aware the forecasts are completely unreliable. But, he needs them for planning his military operations.”

Okay, maybe you don’t actually need a Nobel prize to know that rationality in the decision-making department is often lacking. Case in point: the capital markets. While subtle and ingenious in construction, the capital markets are, nonetheless, driven by the mass action of millions. They are a reflection of ourselves and necessarily express both the summit of our knowledge as well as the pit of our fears, and everything else in-between. And, this brings us to the subject at hand: Gresham’s Law. Sir Thomas Gresham was a financier in the time of King Henry VIII and his name is, of course, attached to the principle that “bad money drives out good money.” Coin collectors of a certain age are familiar with the near immediate disappearance from circulation of all silver American coins once Congress had mandated the use of base metals beginning with the 1965 vintage. While all coins – silver and copper alike – carried identical legal tender value, it was the silver coins that vanished. Perhaps you are wondering what this has to do with bond investing? Everything!

Consider the state of financial markets as witnessed by metrics of implied volatility:

VIX Index

Source: Bloomberg

MOVE Index

Source: Bloomberg

Both indices hover at generational low levels. If markets were “run” today by humanity’s better angels of wisdom and rationality, you would have to conclude that Mr. Market has drawn on his collective insight and pronounced the capital markets to be safer now than at any other time in the past quarter-century. That is a stunning conclusion! But if rationality can’t explain a 25-year trough in expected risk, then we must necessarily conclude that there must be some other, less rational explanation. How about this: investors are, by and large, famished for yield and willing to underwrite most any risk to get some income. In short, the marginal price setter is “irrationally exuberant”, or dare we say it out loud? “Greedy.”

So, the age old tension that presents itself is this: there are those investors, the “value tribe”, that resists the general lowering in underwriting standards that comes with the aging cycle. The value guys believe that their principal is always precious and is best “wagered” when the return/risk profile is asymmetrically biased in favor of the investor.

The “momentum tribe”, in contrast, tends towards a belief that your capital must be kept working, otherwise “yield” is “needlessly” sacrificed.

Does it not stand to reason that, late in the asset price cycle, that the “momentum” money drives out the “value” money? Yes! Capital that lowers its hurdle rate of return and adapts itself to loose underwriting criteria will necessarily bid up asset prices to levels that become inconsistent with the criteria applied by the more discriminating pools of capital. The “clad” underwriting drives out the “silver.”

Now, admittedly, a win is a win, and momentum has been the winning trade. Whether intrepid or fool-hardy, “risk on” has won the year 2017. But do trees ever grow to the skies? Did Minsky not elucidate how extended periods of low volatility have the effect of masking financial pathologies, allowing them to metastasize throughout the system? Indeed! While the central bankers dream of a never-never land where wise scholars can direct the flow of irrational humans, the real world that the rest of us inhabit is decidedly messier.

How so? Long periods of low volatility often mean that some traders and fund managers become less concerned with closely scrutinizing what they own. Credit analysis is hard, and in an environment where prices become inelastic to the “fundamentals,” some conclude that the work involved in analyzing bonds is a case of the juice not being worth the squeeze. Low volatility environments remove incentives to trade, thereby degrading the quality of price information. Meanwhile, the low rate / high asset price environment removes the impetus for corporate frame breaking changes, and so low productivity businesses are “allowed” to just muddle along, restraining the Shumpeterian forces necessary for growth. In short, fundamental problems are systemically ignored by the collective. So, if you happen to see an emperor strolling about, happy and stark naked, you just shrug and move on.

But the worm will turn. It always turns. The collective gets jolted out of its slumber and suddenly realizes that capital is surrounded on all sides by clear and present dangers. The torrent of capital that flooded in under the FOMO banner may well become the most formidable ebb tide!

Before concluding one of our typical (i.e., informative and cheery) discussions, it’s worth a brief reminder that markets “vote” in the short-run and “weigh” over the long-run. Equities, real-estate, and bonds with “hair” have all voted, and we know how that has turned out. Meanwhile, we may not have heard enough from one of the most reliably smart guys in the financial markets. He seems to do a pretty good job of “weighing” and has one of the better (though far from perfect!) track records of forecasting recessions. Never heard of him? Oh, yes you have: he’s the yield curve, of course:

U.S. Treasury Yield Curve

Source: Bloomberg

Stocks roar to new highs. Tax cuts advance in Congress, I think. Consumer confidence revs while unemployment plumbs its lowest levels in decades. Yet, the yield curve just doesn’t seem to be buying it. Perhaps he has lost his mojo. On the other hand, even if he has misplaced his crystal ball, a flattening yield curve does more than just signal that growth and inflation prospects are viewed skeptically.

A flatter curve squeezes the term premium out of the equation for virtually all financial intermediaries. Less term premium means less net interest margin (NIM). Less NIM dis-incentivizes credit formation. Indeed, should term premia continue its vanishing act, we might find that it was the yield curve that helped put the “de” back into “de-leveraging.” Proceed with caution!

Consumers Are Both Confident And Broke - The Last Time This Happened...

Authored by John Rubino via DollarCollapse.com,

Elliott Wave International recently put together a chart (click here to watch the accompanying video) that illustrates a recurring theme of financial bubbles:

When good times have gone on for a sufficiently long time, people forget that it can be any other way and start behaving as if they’re bulletproof.

 

They stop saving, for instance, because they’ll always have their job and their stocks will always go up.

Then comes the inevitable bust.

On the following chart, this delusion and its aftermath are represented by the gap between consumer confidence (our sense of how good the next year is likely to be) and the saving rate (the portion of each paycheck we keep for a rainy day).

The bigger the gap the less realistic we are and the more likely to pay dearly for our hubris.

Where are we today?

Worse than in 2006 and nearly as bad as 1999.

Both of those years were followed by several really bad ones.

Consumer Confidence Unexpectedly Drops On Inflation, Rate-Hike Fears

UMich consumer sentiment declined from 100.7 to 97.8 in the preliminary November print, disappointing expectations of a small rise as anticipation of a pickup in inflation and higher interest rates weighed on the gauge.

Even with the decline, sentiment was the second-highest since January, reinforcing other reports that Americans remain optimistic about employment and the economy.

Other highlights include:

• Consumers saw the inflation rate in the next year at 2.6 percent, up from 2.4 percent the prior month


• Consumers expected an annual income gain of 2.1 percent for the second straight month, the best two-period average since 2008


• Inflation rate over next five to 10 years held at 2.5 percent


• Six in 10 consumers saw stock-market gains as likely in the year ahead


• References to low mortgage rates fell to 32 percent in early November from 40 percent last month

Consumers (and policy makers) have four key concerns: prospective trends in jobs, wages, inflation, and interest rates. An improving labor market was spontaneously mentioned by a record number of consumers in early November, and anticipated wage gains recorded their highest two-month level in a decade. These favorable trends were countered by a slight rise in year-ahead inflation expectations and a growing consensus that interest rates will increase during the year ahead.

Americans are as exuberant about their wealth effect as they were at the peak ahead of the last crisis...

“While the majority judged current conditions in the economy favorably and consumers anticipated continued growth on balance, consumers judged the outlook less satisfactory, and were equally divided about whether the expansion would last another five years,” Richard Curtin, director of the University of Michigan consumer survey, said in a statement.

Bank Of America: "This Could Send The Nasdaq To 10,000"

Last weekend, One River"s CIO Eric Peters explained what he thought would be the nightmare scenario for the next Fed chair, who as we now know will either be Jerome Powell or John Taylor, or both (with an outside chance of Yellen remaining in her post). According to the hedge fund CIO, the "worst case scenario" is one in which despite an improving economy, yields simply refuse to go up, leading to the final asset bubble and Fed intervention that "pops" it:

“if we don’t see a sustained cyclical jump in wages, then yields won’t go up. And if yields don’t go up, then the asset price ascent will accelerate,” continued the strategist. “Which will lead us into a 2018 that looks like what we had expected out of 2017; a war against inequality, a battle for Main Street at the expense of Wall Street, an Occupy Silicon Valley movement.” He paused, flipping through his calendar.  "Then you’ll have this nightmare for the next Federal Reserve chief, because they’ll have to pop a bubble.”

While Peters never names names in his pieces, the "strategist" in the weekend letter was BofA"s Michael Hartnett, who several days after Peters penned the above, followed up with some thoughts of his own on precisely this topic, and in a note released this week, described what he believes is the "biggest market risk" for the market. Not surprisingly, it is precisely what Peters was referring to in the above excerpt.

Responding to the question of "What is the biggest market risk", Hartnett writes that "in our gut, it’s that the two most important investment trends of the past decade, central bank liquidity & technological disruption, ends in a bubble for tech stocks (Chart 7), & High Yield & EM bonds, the epicenters of the “scarce growth” & “scarce yield” themes.

As with Peters, for Hartnett it all comes down to one thing: inflation and higher yields, specifically among long-dated yields: 

Multi-year lows in unemployment, multi-year highs in consumer confidence, soaring global PMIs, soaring profits, a doubling of the oil price, fiscal stimulus…little wonder the world is short bonds in 2017.

 

And yet inflation & bond yields refuse to rise.

The reason is simple: in attempting to stimulate wage growth, and thus benign inflation, the Fed continues to target the symptom of a condition which it no longer has any control over. Remember: Deflation = Debt + Demographics + Disruption? Well, they"re back. Quote Hartnett:

Aging Demographics and excess Debt remain structural impediments to higher inflation. But the biggest impediment is technology, and the potential for the labor market to be permanently disrupted, as AI and robotics crush wage expectations, particularly in the service sector.

For now the bond market still gives the Fed the benefit of the doubt, with 10Y yields occasionally pushing higher when the nearly extinct bond vigilantes make a surprise appearance, pushing rates up at least until the next deflationary scare emerges. But what happens if the bond vigilantes finally throw in the towel? Well, that"s what unleashes the final bubble... and sends 30Y yields toward 2% and the Nasdaq  to 10,000.

Capitulation of bond bears would send 30-year Treasury yields toward 2%, the Nasdaq toward 10,000, and high yield & Emerging Market bond spreads 100bps tighter (all-time lows…241bps in the US, 179bps in Europe, 139bps in EM). The outperformance of “deflation” versus “inflation” could turn exponential (Chart 8).

And while the market may or may not have a major correction in the coming months (Hartnett also predicted last week that the next major market drop will take place between Thanksgiving and Valentine"s Day), the longer-term implications as this tension is finally resolved either way, most likely with the intervention of the Fed - whose next chair will have no choice but to burst the bubble - will define the market for the next generation, or as the BofA strategist puts it:

"“Icarus Unleashed” in coming quarters would then set-up 2018/2019 as a period of volatility, aggressive Fed tightening to pop bubbles, and more hostile War on Inequality & Occupy Silicon Valley politics, setting the stage for the end of the bull market as Icarus crashes back to earth."