It has been a painful, bruising intellectual exercise for BofA’s HY credit strategist Michael Contopoulos, who after starting off 2016 uber-bearish, was – together with every other money manager and advisor – taken to the woodshed, and forced to flip bullish, kicking and screaming, and advising BofA clients to buy the same junk bonds he told them to sell just a few months prior. Now, thanks to Trump, he may be finally seeing a glimmer of the bearish light returning, and in a note published this morning, Contopoulos asks whether the US is looking at a replay of 2014 and 2015, when as a reminder, a false dawn turned out to be an ugly dusk, and forced first the BOJ, then the ECB to intervene aggressively with even more QEasing.
As BofA admits, “the last two weeks have further underpinned our belief that the market has had misplaced optimism in the new administration’s reform agenda, while we find more and more evidence that suggests the macro environment echoes that of 2014 and 2015. Meanwhile, the market environment has closely tracked that of late 2013 and early 2014, when expectations for higher rates, low defaults and strong fundamentals caused a bid for risk that sent yields to sub-5% until geopolitical risks shocked investors (a plane being shot down over Ukraine). Once cracks were exposed in 2014, and illiquidity concerns replaced a FOMO (fear of missing out) attitude, the ensuing collapse in crude left investors woefully unprepared for the troubles of the next year and a half.”
What will be the catalyst that unleashes the next move lower? Here the answer according to BofA is simple: Trump. “If the Trump administration and the GOP are ineffectual in their agenda, would the US be looking at a replay of 2014 and 2015? From a macro perspective, could small business optimism return to pre-election levels or could consumption and capex finally take hold, and drive productivity and growth higher regardless of policy?”
And this is where the negative bid comes into play: because, while not there entirely, BofA says it is “beginning to become concerned that bigger forces are at work in the US economy and that, without the implementation of tax reform and infrastructure spending, these issues will be exposed as potential problems.”
In short, when it comes to the economy, this is what is keeping BofA up at night:
1. Zombie Companies And Massive, Rising Debt Loads
For one, there is evidence that inefficient companies have been incentivized to not invest over the last 7 years as cheap credit has allowed them to survive without the need to improve operations and invest. On the macro front, student loan debt has weighed on millennial consumption…
… retirees are less likely to spend in an environment of meager fixed income returns and prime age workers’ real wages are increasing at sub 1% (Chart 6).
Additionally, as Ally Financial, Synchrony and Capital One have all noted, net credit-card charge-offs and write-downs of auto debt are accelerating at a surprisingly fast clip.
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2. Sliding Used Car Prices, Rising Delinquencies And Subprime Defaults
Falling used car prices have begun to impact suppliers and manufacturers, while banks have reportedly started pulling back on subprime auto debt as delinquencies creep higher. What’s more, commercial real estate is arguably at peaks while the Fed hammers on lending standards and the retail sector is in disarray; affecting brick and mortar establishments, mall REITs and CMBS.
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3. Declining Loan Growth, Lack of commodity rebound and tighter balance sheet
Loan growth is now negative and has only been at these levels around a recession (Chart 8), while tighter financial policy and a reduction of the balance sheet continues to be the rhetoric at the Fed. Corporate leverage remains high and commodity prices have not really recovered. For example, the average price of WTI for the last year has been $48.6/bbl while in 2015 it was $48.76/bbl; yet in 2015 high yield had a negative return and in 2017 the market is up 4.2% as of May 17th. To be fair, coming down from a high level is much worse than leveling off, and 20% of the market did default; having said that, we once again have first time issuers coming to market in Energy.
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4. Lack of Investment, No Small Business Creation And No EPS Confirmation
Finally, small business formation continues to be weak while capex has remained anemic (Chart 10). Yet the S&P 500 is at near record levels despite the fact that EPS hasn’t really changed in 3 years (Chart 9).
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Of course, with the vix in the single digits, with stocks at all time highs, and central banks injecting record liquidity even now, BofA had to add some caveats:
One could argue that the size of the auto loan market is not enough to impact growth in a meaningful way, that student debt could get better as the labor market continues to improve and that weak consumer spending was more a function of autos, spending on utilities and the effect of delayed tax returns: not necessarily an indicator of economic weakness. And although total consumer debt is now at record levels, the savings rate has increased so much that balance sheets have still improved. Additionally, non-commodity capex increased relative to trend in Q1, the Fed is unlikely to make a hawkish mistake given how careful they have been throughout the recovery – especially given the political uncertainty – and the global backdrop has arguably improved. Although China remains a concern, and oil has recently shown signs of weakness, neither seems to be as dire a situation as in 2015, in our view.
Still, one can feel the urge in Contopoulos’ writing to go back to the dark side. Here is his conclusion:
So which economy is going to show up later this year and in 2018? We think the jury is still out. Much will depend, in our view, on whether or not the administration can pull together with the GOP to produce tax reform and restore what we think will be eroded confidence. If they’re unable to do this, however, we think a 2014/2015 macro environment is the most likely scenario. Regardless, without a large sector rolling over, like Energy, and absent a recession, high yield likely muddles along, where longer duration and higher quality paper outperforms.
And with that, it’s now up to Trump to make or break this market.
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Post-script: we are well on our way. Moments after this report was released, bank of America slashed both its Q1 and Q2 GDP forecasts, from 0.7% to 0.5% and 3.1% to 2.6%, respectively, after today’s poor inventory and advance goods trade deficit data.