Why Historic Relationships in Markets Have Been Totally Upended

talk to one of my all time favorite analysts. And the reason he became one of my all time favorite analysts is because he wrote some very very interesting research in the run up to the financial crisis. You know, I think it was a few days or a week or two before Lehman Brothers collapsed, he basically wrote a note called are the Broker's Broken? Pointing out some weaknesses in the fun ending of US financial institutions. And since

then he's gone on to write more broadly about the markets. Specifically, he's written about how markets have been functioning in the era of central bank liquidity. And as you all know, this is a hot topic because the Federal Reserve is in the process of tightening monetary policy reducing its balance sheet, which puts a giant question mark over the fate of markets. Are they going to be able to stand on their own two feet without the support of the FED and

potentially some other central banks. So I won't keep you in suspense for any longer. Let's bring in Matt King. He is the global head of credit strategy at City Group. Matt, thanks for joining us, my pleasure. What a flattering introduction. Yes, I tried. I'm trying to make up for the fact that Joe isn't here, So this is my compensation. Let's start at the very beginning of how we actually got to know each other and how you became one of

my favorite analysts. Two thousand and eight. You're at City I think you are covering the banks. Then I assume, no, oh, you weren't. So I was doing credit strategy then, kind of similar to what I'm doing now. But I guess the approach that we have always taken is to try and focus on whatever it is that really seems to be driving the market. But what we don't do is say, well, here's what the economists say about the outlook, and therefore

here's what it means for our market. We always try and say, what is it really it's really driving the world, And so in O seven, I sort of had to. You know, we used to look at credit fundamentals of companies, but then in O seven we had to drop everything and suddenly start looking at sieves and conduits and structure credit. And then in two thousand and eight it seemed to me that repo financing and broker dealers were a critical issue, and so I spent a long time looking at them.

And then in more recent years it's been things like the you know, with the European sovereigns, or it's been about China and credit creation more broadly. And then the dominant theme more than anything else for us at the moment, it's just about central banks and central bank liquidity. So I love that in two thousand and eight you managed to sort of out analyze the actual banking analysts then, and that was one of the things I liked about the crisis as a financial journalist is the fact that

everyone was kind of learning at the same time. You know, no one had a really good grasp of the intricacies. Just before we move on to more contemporary topics, I want to press you on that note. So you're at City in September two eight, What were you feeling when you push the button on a research piece that basically said, hey, there's a massive funding issue at the U S. Pinks

and specifically Leaman. I could feel at the time it was probably the most significant piece that I had written, And while couldn't say we predict that Lehman will go under, there was a chart in there that made it pretty obvious, and indeed we basically predicted that all of the brokers would have to change their models, and you know, and

then Lehman happened two weeks later. I guess what was slightly surprising, and it to take me a long time to do, was that there was no particular immediate market reaction, in part because Freddie had just been rescued literally that weekend. And so while I did get quite a lot of attention, most of the attention actually came after Lehman, when people like you kind of went back and said, hey, actually

this was really significant. Look, this guy spotted it at the time, so I knew it was important, and I made a big song and dance about it internally. But even then, you know, we couldn't see all of the repercussions. More broadly, Okay, if anyone wants to know more about what we're talking about just Google, are the Broker's broken? The pdf is still floating around on the Internet. It's a really good read, even more than ten years after

the fact. Now, Matt, you mentioned muted market reaction when Lehman Brothers actually went under, and muted has kind of come to characterize the markets ever since, let's say, early two thousand nine, when the Fed first announced its big round of q E. Walk us through what changed in two thousand nine, So clearly and correctly at the time, the Central Bank stepped in with extraordinary facilities and liquidity, and to begin with this was undoubtedly a good thing.

We needed to be rescued from a sort of self fulfilling loot to the to the downside. But gradually, and I would say from two thousand and eleven or so onwards, what we started finding was we went from rescuing the system and helping fundamentals to improve to a point where almost all of my favorite fundamental valuation frameworks in credit or inequities, or just more broadly basically started breaking down.

Markets became expensive and carried on getting more expensive when previously they would have been reverted, and this prompted lots of soul searching on our side as to say, well, what's changed, what's driving things? Instead? Uh, and again I can take you through these the same At the same time, volatility again decoupled from metrics like some of the policy uncertainty in disease that are out there um and carried

on getting lower instead. And so we we had to embark on this long hunt for what was driving everything, and all lines of inquiry led back to just one place, and that's the central banks. Wait, so walk us through the specific sort of I guess indicators that you're talking about here, What is it exactly that you're looking at in terms of something that would give you knowledge of valuations or potentially portender correction. So it's basically this is

really hard to do on a radio show. You know, the relationships that we had tracked four years or decades which broke down. So, for example, I mentioned the VIX against policy uncertainty correlates beautifully until two thousand and two thousand and twelve, and then the VIX goes lower and

uncertainty goes up. Credit spreads against corporate leverage. It used to be that when companies have lots of debt, spreads were wide and companies had not much debt spreads were tight Again works quite nicely over cycles, and then round about two thousand and eleven two thousand and twelve, corporates globally but especially US corporate started leveraging up, but credit spreads, rather than widening out with them, just decoupled and tightened

in or, to take another one, credit spreads against inflation expectations. It used to be when there's a slightly higher inflation expectations, it was taken as a sign of kind of cyclical growth. Uh. And again that relationship has has sort of continued to track, but there's a break in the series in two thousand

and eleven, two thousand and twelve. Or in equities, my favorite relationship was always earnings revisions, so the change in consensus earnings expectations, and again in every market we look at across multiple cycles, consensus goes up, the market ally's consensus goes down, market sells off, and around about two thousand eleven two tho twelve, earnings expectations were revised duly lower by analysts across the street for basically the next

five years, and instead of selling off, markets rallied, so all of these breakdowns and all of them more or less at the same time. So isn't the counter argument to that just low interest rates? So, for instance, when you have increasing corporate leverage but credit spreads that are still tightening. The thing I always hear from analysts, from bullish analysts as well, you know, they can be more indebted because ultimately the debt burden will be less in

an era of low rates. So that's a good argument, but I think it only gets us so far. So specifically on corporates, Yes, there is an argument that maybe we should be looking at interest coverage rather than net debt to EBITDA. Let's say, even though it was actually net debt to EBITDA that always correlated well historically, and yes, interest coverage, So firstly, yeah, the better historical correlation is

with leverage. But secondly, interest coverage, although it did improve steadily for several years as interest rates were falling, actually that started deteriorating round about two thousand and fifteen. And again credit spreads did do some widening then, but it's not like that's an obviously better series that that that

helps explain everything. Or again, if we take volatility for example, again it's not obvious why volatility in markets should be lower just because interest rates are lower, or again, for me, it almost fits with the anecdotal evidence as I go

round and I visit investors. I mean, the way I put it is, frankly, it's been years since I went to see any investor in any asset class who was buying things because the analyst was telling the portfolio manager, Hey, I've got this really cheap asset, we should go and buy it. It's always the PM telling the analyst where we've got to put the money somewhere, And so for me or again, all of those things fit fit together.

In addition, if interest rates have so much to do with it, you know, maybe you can make this argument, but you know, why aren't pees on Japanese equity so much higher than everywhere else in the world, If if it's low interest rates that allows us to do a rerating, or if Japan is a special case, and you could make that argument, why areps in Switzerland much higher than everywhere else and so, or why in periods when the looks as though we might have broken out from this

low rate regime and yields have been backing up, has that not been associated with a D rating, and so again I think that is part of the explanation, but relative to some of the other things we look at, I find it an unsatisfying explanation. So is the simple

corollary of this just that valuations don't matter anymore? Well, certainly, if you're a professional investor and you're a slave to near term performance and you're worried that if you underperform then the money will be taken away and given to to an e t F, then that seems to be the conclusion that people are drawing. And you can see David Einhorn and an others you're making references to this, and I guess this, for me is one of the

disturbing thing um from a market's perspective. It's to see investors giving up, just capitulating and saying, I know it's expensive, but it's all because of the the inflows or or the foreign money coming in, or whatever the explanation is, and then just capitulating and feeling like they have to buy anyway. And I think what we know more broadly

is that that valuations do matter. They're indeed the most important factor, but only over the long term, and it often takes some sort of catalyst or or change in the technical for investors to return to those valuations um and again for me, it's it's this valuation is not mattering. You always say that at your peril. So how do you think the real economy factors into market behavior right now?

Because again it's getting late in the year, which means we have all the cell side analysts now releasing their two thousand eighteen outlooks, and one of the consensus themes that is emerging is that we're unlikely to get a big market correction unless we really see the economy take a hit and we see a recession, and most people think that's unlikely. So how are you viewing the actual economy at the moment. So it's hard to argue against all of the good data that's out there, the upward

divisions to people's growth expectations. Similarly on the earnings front, and so I do sympathize when people say we don't see fundamentally whether shop comes from. The natural thing is to extrapolate the good performance that we've had this year.

At the same time, I think you have to think back to that the indicators are always at their best, just before you hit a down town, whether it's two thousand and six sven or whether it and what's more, and so that doesn't mean that just because things are good, there's gonna be a sudden deterioration. But I think the specific way I put it is, are we sure that it's the economy which is driving the market rather than

the market which risks driving the economy. I mean, one of the so that the obvious examples are think back to. It's not that the economy tanks and drags down the equity market. It's the market moving first, economy following later. Same thing in No. Seven oh eight. It's not the economy driving the real estate market. It's the real estate

market driving the economy. And even with the more recent wobbles from European sovereign debt or emerging markets and oil in again, one of the striking things is that market movements which at least in theory should not have been destabilizing,

did turn out to be destabilizing. Now that still doesn't necessarily pin down the exact timing of this, but I'm much given again these expensive valuations across the board and what we think are driving them, I'm much more cautious than most people are from simply extrapolating this economic strength and then and saying okay, and therefore we're bullish on

markets even if they look a bit expensive. I feel like this is a really fundamental thing that we should know at this point, like our markets following the economy, or does the economy follow markets? Why? Why is there even a question mark over that? It's always hard to disentangle, and especially at the moment. I can see why people will make a case for the fundamentals driving markets because you can see all this good data across the board.

It's almost it's more in twenty eleven to sixteen, when earnings growth was much weaker and when GDP growth was much weaker and markets were rallying anyway, that some of the other relationships that I look at do a better

job effectively or are more obviously the only driver. So for me, the main reasons why again I'm so convinced about central bank related distortions driving things is because it's not that there's no improvement in the fundamentals, but when we look at when we look at the patterns of market movements, it's a bit less that we're following the areas where earnings expectations are being revised upwards, and it's

a bit more like an indiscriminate rally and everything. And what's more, when we do actually almost embarrassingly simple things like just plotting what the global central banks are buying each month and plotting that against the change in equity prices or the change in credit spreads, we come out with these really really good relationships without looking at any

fundamentals whatsoever. And so especially in the year like this, it's hard to tell, but at a minimum, I think this year, both the fundamentals and the central bank purchases have been a big driver of markets. And next year the central banks are significantly pulling back and the fundamentals really have to stand on their own. Yeah, so I

wanted to press you on this point. Um. A lot of people are talking about Janet Yellen's legacy now that she's set to depart from the FED, and one thing that keeps coming up as well, Actually, she's done a pretty good job of beginning the navigation of the exit. She's raised interest rates, and the Fed has embarked on its tightening of its balance sheet or the reduction of

the balance sheet. Are you implying that this is nothing and that the real test is going to be um later on, maybe when we start to see places like the e c B or the b o J actually withdrawal liquidity. So firstly, full credit to her. It's not nothing. She's already got significantly further than I previously thought would be possible. But I think there is it's it's absolutely it's maybe unsurprising that there still disagreement about how QUI

affects the economy. What's amazing to me is that after eight years into the crisis, there's still so much disagreement about how quee affects markets. And for me, a lot of the reason the FED has been able to get this far is because of the e c B and the b o J having ramped up their purchases and and so this is one of the sources of disagreement. It's is are the effects local as the central banks like to think, if only because it's convenient for them,

or are they global? Which is what all the correlations in markets that we find point to. We get much better explanations for US credit spreads or U S equities if we look at global que and same thing when we're looking at European credit spreads in European equities. It's that global pattern that fits, and that in a in a funny sense, is actually the smallest of disagreements. The bigger disagreement is between whether there are a couple more.

But but is it flow or is it stock? The central bank the central banks think that markets should not be destabilized because their policies are still super accommodative, and because in the Fed's case, it would argue the market has discounted things ahead of time because markets are reasonably efficient, and therefore they've told us about the balance sheet reduction, and that's why it can run in the background as just a little technical detail that nobody needs to to

worry about. Again, though, as we look at what has correlated in the past, what we find is that actually it's very clearly the flow that matters are not the stock, and that even if the e c B is reducing

its purchases, into its mind, is still easing. Nevertheless, that reduction in the flow, at least at a global level, has historically been associated with periods of weakness in risk assets, and so again for us, what significant is Bank of Japan purchases have already harved with the shift away from QUEI or pure que to yield targeting, and so you've got the B O J kind of having moved, and then you've got the E C B moving and the

FED moving all at the same time. And it's that combination, which again we think is potentially destabilizing or at a minimum makes it much harder than the FED would have thought from just looking at history in the U S alone. Okay, but here's my other question. If it is so easy to show that it's all about the flow of that liquidity rather than the absolute level, then why don't central

bankers realize that? Why are you the only one sort of pounding the table on this, Because while you are one of my favorite analysts, I'm sure people like Janet Yellen or Mario Droggy have a whole team of smart people who are examining exactly this kind of thing. Why aren't they coming up with the same conclusions that you are. So I don't think I'm the only Lots of people in the market will tell you it's the flow, and it's kind of obvious to them that it's the flow,

and it's obvious that it's dominating. But it's almost embarrassing to say, because we do say the same thing to the central banks, but to quote one of them that I met recently, the somehow they look at the correlations, but then they're dismissive of them. And the reason they're dismissive is because it doesn't fit with theory. It's not it doesn't fit their model of how the world is

supposed to work. And one of my colleagues cheekily said, these are doubtless the same models that have have been protecting inflation would pick up for several years now, and we're predicting that wage goes would be much higher. That's really harsh, but I think there is this. It's it's I've always I'm a strategist, not an economist, and so I don't start from the theory. I just start from what correlates in the market, and then I see if there's a

plausible explanation. And when we get a these staggeringly good correlations with the flow and be there's an associated plausible explanation, which is look at the net supply number. Central bank have basically bought all of the available net supply of

securities across global markets. In seventeen, which is a big difference from say, two thousand and six, two thousand and seven, and that creates an imbalance where people are still saving, there's still demand, but there's no supply, and so what do you get, But you get markets where prices go up. And that's exactly what we've had in every asset class on any given week. Unless there's something to panic about,

the price has been going up. Next year that doesn't fall apart entirely the the as the ECB and the and the and the FED pool back, there's about a trillion dollars more of global net supply, and we think that will make for more balanced markets. So in one sense, they should be looking more closely, and it's it's their own effect, it's the portfolio balance effect, and it's just

worked way more strongly than than they imagined. But in another sense, yes, I think they're almost completely blind to it because it's just convenient for them to continue to toe out the same theory and and it's just in the same way as they think that the super low level of rates should have been really really similated for a time now, and then every so often they're confronted by how markets actually behave, and and they're disappointed that

relatively minor changes on their part produce outsize movements in markets. And I think there's at a minimum significant risk that that is what we get again, and the outlook is not nearly so straightforward as as they would like to think. Okay, on the outlook point, we did see a sell off

in markets this month in November. It got a lot of attention, but in the end, I think it only ended up being like one five percent or something like that, which historically, you know, before the crisis, would have been relatively muted. Are we just going to have to get used to the return of volatility and the idea that asset prices can go down as well as up. Is that in our near future? I certainly hope so, because I think a more balanced market is a much more

resilient market. And I do worry that what's happened at the moment is that we the central banks have effectively created one way markets that grind higher with very low volatility and then are at risk of of large amounts

of volatility. I mean, one of the other topics I've done work on over the years is liquidity, and we've always said, and it's actually Kevin Walsh's definition, but a liquid market is one with a myriad set of participants looking at different factors, having different views, you know, the bottom up analysts, the top down portfolio manager, the long term, the short term, the value oriented, the momentum or entered,

and so on. And unfortunately, if you were a bottom up fundamental value oriented analyst or manager, you went out of business a long time ago as everything got expensive

and carried on getting more expensive. And so what we think has happened today is investors, through a mixture of regulation and above all the central bank distortions, have been forced into the same sets of trades, forced into buying risky assets which they don't really believe the valuations of, with a close eye on the global central bags and on the other investors in case, actually it's time to run for the exits. And and that gives us this.

It's not just that volatility is low, it's that volatility has bifurcated. You get extended periods of very very low volatility. But when everyone is the same way around, you're vulnerable to a you know, are much more aggressive pull back. You don't get one of two standard deviation movements, it is either zero or sixteen. Now, on the one hand, I am impressed that the little wobble that we had

last week does look to have stabilized. But on the other hand, yes, I do think that the major factor driving this has been central bank squashing all of this volatility, and that as they pull back, hopefully smoothly, we get much more two way markets with yes, significantly higher degrees of volatility or day to day volatility than we've been having at the moment. And you can see that investors.

And one of the other reasons why it's not just fundamentals is it's while day to day volatility is low, skew or or the price of out of the money options is actually very high relative to at the money options. In fact, it's at all time highs. And so again, if it were just a question of fundamental improvement, you could you have thought that the skew would have collapsed as well, and it simply hasn't. And that against suggest to me that the risk of being suppressed rather than

not being there at all. All Right, we actually managed to completely square the circle of our conversation because, of course, one of the reasons that liquidity is said to have deteriorated in the market is regulation. As you pointed out in that regulation came about because we had a bunch of banks that sort of teetered near the brink in two thousand eight, and of course Lehman Brothers did go over the edge, as you rightly predicted in your notes. So well done to us for for coming full circle.

I'm kind of impressed. Matt King, Global head of Credit Strategy at City, thank you so much for joining. It's been a pleasure. I always feel like we go to a more pessimistic place when Joe isn't around, so I'm looking forward to having him back next week. But that is it for this solo hosted edition of the Odd Thoughts podcast. You can follow me on Twitter at Tracy Allaway. Matt King is not on Twitter, but if you want to take a look at some of his notes, just

google his name again. That two eight note we were talking about is called argue Broker's Broken. And finally, you can follow our producer, Sarah Patterson at Sarah pat with two t s. Thanks for listening.