Macro Comment: False Beliefs or Cautionary Inclinations?
The Phenomenon of Triple-Layered Leverage
It's really spooky how much this radiates with the same intense fear that I have for today. Back then, the biggest one week rally in the S&P in five years eliminated all of the Fund's P&L for the year. My largest longs proved defiantly uncorrelated with movements in the broader indices - of course they did ! The previous month had seen near panic in the oil market, but a melt-up in the price for front contracts was not matched by contracts for delivery the following year.
Now let's return to the letter...
If there are any known unknowns in the universe, then the timing of a US economic recession led by a retreating over-leveraged consumer is the most obvious. But prescience is one thing. The two year Treasury yield has actually traded at a discount to the Fed Funds rate since last July. Historically low yields on the 10 year Treasury have justified elevated stock markets and encouraged our private equity brethren to be more expansive.
However, rising asset prices frustrate the Fed from easing in a timely manner (early). Every major stock market correction since the early 1970s has been preceded by a year of underperformance from the financial sector and the US Broker Dealer Index peaked against the S&P back in January 2006. Further, with the tumult in the US mortgage market, interest rates could arguably have been reduced already.
Indeed this could prove to be the worst of all worlds. For at a time of economic uncertainty, this potent mix is encouraging what Gerard Minack calls ‘the big leverage swap’. In the 1990s un-leveraged investors (pension funds) owned leveraged companies (especially telecoms). But since 2002 un-leveraged companies have been bought by leveraged private equity and hedge fund investors.
Today, in order to ward off takeovers, listed companies are re-leveraging their balance sheets to buy back their own stock. The stock market is being propelled by leverage-on-leverage: geared investors, geared companies. But that is not all; the corporate sector is reliant on you and I continuing to spend. That is to say, the profit cycle rests upon the highly indebted household sector. As credit lines are withdrawn by the banks from non-prime mortgages and credit cards consumers should begin to retrench and a deflationary event should occur.