“Now is the winter of our discontent.”
We held our big Q4 Macro themes call yesterday. No surprise, Keith put quite an entertaining spin on the presentation. The introduction to the second section was a spoof of the popular HBO TV show, “Game of Thrones.” We renamed it “Game of Slowing” with each major economic region represented by a specific character from the show:
- China / Emerging markets as Eddard Stark because Stark dies early and he did not come back;
- Europe as Joffrey Targaryen because Joffrey does become King, but eventually it ends poorly for King Joffrey (and by extension European equity bulls);
- Japan as John Snow, the bastard of global growth because Japanese growth continues to get worse (and worse); and finally
- U.S. as Daenerys Targaryen, which represents the goldilocks potential of U.S. growth.
Now, if you haven’t watched the show, the analogies may not mean as much to you. But suffice to say, the prevailing view of our Q4 theme presentation is that Winter is Coming for global growth. As you can see in today's Chart of the Day, we remain 50% below Bloomberg consensus for global GDP growth.
Back to the Global Macro Grind...
Related to U.S. growth, my colleague Darius Dale wrote a follow up note to the themes presentation yesterday titled, “Risk Managing the Shift to #Quad3 – Especially in Energy.” So even though we were somewhat sympathetic to the idea that the U.S. economic outlook may have the potential for a better outcome as represented by the beautiful Daenerys Targaryen, the reality is that the U.S. is likely to be mired in a shift to Quad 3 based our models.
For those that haven’t been following Hedgeye as closely, Quad 3 occurs when growth slows as inflation accelerates. Historically, the policy response in this scenario is that the central bankers are in a box because even though growth is clearly slowing, inflation is at, or surpassing their targets. Only time will tell whether the ensuing months play out like this, but one asset to stay focused on is oil. As Darius writes:
“Since most investors are not positioned for energy to lead the market higher, we thought we’d offer our detailed thoughts on this developing risk. Specifically, at 7.3% of float, energy is the most heavily shorted sector in the S&P 500. That ratio is 297bps above the aggregate market and the next closest sector, consumer discretionary, is a distant -90bps behind. Indeed, investors are still very bearish on energy.
Why has energy lead the market higher over the past month (XLE +13.2% WoW and +7.1% MoM vs. +4.7% and +2.2% WoW and MoM, respectively, for the S&P 500)? Because of the ongoing shift to #Quad3 – economic growth slowing as reported inflation readings accelerate – and the dovish response we have gotten and may continue to receive from the Fed in the ensuing months.”
So, just as the decline of energy commodities and the total decimation of certain energy related equities like MLPs has hurt many on the long side, the appropriate debate to have now in your investment committees may well be whether you should be longer of energy into year-end.
On the topic of oil, WTI is above $50 per barrel for the first time this morning. Adding to the bull case through year end is also the call out of Goldman this morning that the rally in oil is likely to reverse soon. No surprise, we would recommend taking the other side of that call, especially in light of our expectation that the Fed will be more dovish than expected and thus the USD weaker.
Switching gears for a second to China, there is a noteworthy article from Bloomberg today emphasizing the frothiness. Even as we joked with our #GameOfSlowing metaphor that Chinese economic growth may never come back, Chinese equity investors do seem to be voting that way with their dollars, flooding out of equities and into the corporate debt market.
Over the last month, yields on top rated corporate five-year paper are down 79 basis points. As a result, the spread over government securities is at 97 basis points, the narrowest since 2009. To put this all in context, globally corporate yields are at almost two-year highs, so Chinese corporate yields are moving inversely to global yields.
Currently, default rates do remain low in China, so there is likely no reason for alarm just yet. That said, credit default swaps (CDS), which are effectively insurance against corporate defaults, are also near two-year highs at around 135 basis points on average. The fact that insurance against defaults is getting more expensive should be no surprise given the stretched valuation and, also, the fact that more than 15% of the companies listed in Shanghai lose money.
Historically, of course, defaults in China have remained low, but facts are facts even in centrally planned economies. And as George Martin wrote in “A Game of Thrones”:
“Most men would rather deny a hard truth than face it.”
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.98-2.12%
Oil (WTI) 46.39-50.25
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research