It is the 24th of February 2020

Shocking Admission From Global Head Of Strategy: "Our Clients Have Given Up On Valuation As A Metric"

For all the recent concerns about an "imminent" nuclear war with North Korea (not happening, according to the head of the CIA), which prompted a stunned reaction from Morgan Stanley which earlier today observed the "70% rise in the VIX index over three days, 2% drop in global equities, and more than a few holidays disrupted", leading it to conclude "Well, That Escalated Quickly", the market continues to ignore the real risk: the upcoming central bank balance sheet taper which will have a dire and drastic impact on markets according to Citi's global head of credit product strategy, Matt King:

Markets seem optimistic that central bank plans to modestly reduce their support for markets in coming months can be achieved without disruption. We are not convinced.

Borrowing an analogy from developmental psychology, King compares the relationship between the Fed and the market to that between a (failed) parent and a child obsessed with their cell phone.

When other people’s children behave badly, the temptation is to presume it’s something to do with the parents. But then one day, even if you managed to avoid the terrible twos, your very own adolescent comes downstairs to breakfast with a look that could curdle the milk in its carton, fails even to grunt a response to your cheery good morning, and makes straight for their mobile phone. It shortly becomes clear that the mere fact of your breathing is something they find deeply offensive. Nothing in their previous twelve-or-so years of almost uninterrupted sweetness gave any hint of this. Where on earth did you go wrong?


We imagine central bankers must feel similarly underappreciated every time markets fall into similar bouts of grumpiness. Like any parent, their initial instinct is to blame some sort of “external shock” – Eurozone sovereigns; weakness in emerging markets; a drop in oil prices; too much time spent hanging out with undesirable hedge-fund types. Like any parent, we think they would do well to focus less on eliminating potentially malign influences from the playground, and more on examining what in their own behaviour has left their offspring so fragile in the first place.

In yet another fantastic piece released over the weekend, Citi's chief global strategist, King again - very patiently - explains why the markets and central bankers have misunderstood QE so profoundly, this time comparing it to the act of weening one's offspring off cell phone dependence:

Misunderstandings over the effects of QE seem to us almost as large as the gap between how parents think their adolescents ought to feel and how they feel in practice. If you tell your teen you are going to reduce their screen time steadily down to zero because you are worried it’s affecting their behaviour, they do not simply sit there full of fond gratitude for the day you gave them a phone in the first place. At some point, they snap. This may not be justified, but a combination of habituated expectations and peer comparison means it is what happens in practice.


Central bankers’ ideas about QE seem likewise to owe more to an academic view of an ideal market than to the drivers of the price movements we see on our screens every day. Of all the tens of academic and central-bank papers assessing the impact of QE and other central bank liquidity injections, not one considers the (really rather obvious) approach which is our favourite: simply adding up the global total value of securities purchased by central banks each month (Figure 1) and then comparing it with the spread movement in credit or the price movement in equities (Figure 2).

The chart below - shown previously - is one of our favorites, and demonstrates the direct impact of central banks on asset prices:

And as discussed before, it is what happens next that is most troubling:

Hardly surprising, in his latest piece Matt King once again focuses on the same point he has been pounding the table on for the past year: "why we think markets will once again prove surprisingly sensitive in coming months." His arguments: 

  • First, we argue that in assessing potential dependence on QE, central banks have largely been looking in the wrong places and at the wrong metrics: QE works globally and in terms of the flow of CB purchases, not in terms of the stock, and exhibits stronger relationships with risk assets than with government bonds.
  • Second, we argue that the primary mechanism through which QE has had an impact is an enormous squeeze on the net supply available to absorb private investors’ savings – and that following QE1, relatively little has fed through to the real economy.
  • Third, we argue that central banks would be able to make a smooth exit either if fundamentals had improved so as to justify risk assets’ lofty valuations, or if those valuations were not so lofty in the first place – but demonstrate that neither of these is the case.
  • Finally we look at the conclusion we think central banks ought to draw – and contrast it with what seems likely in practice. It can be tough to do the right thing as a parent.

While much of the above has been covered extensively here before, with the critical topic of flow's dominance over stock first explained all the way back in 2012 in "The Stock Is Dead, Long-Live The Flow: Perpetual QE Has Arrived" an article which led to the correct forecast of QE3, and QE in Japan and Europe, we'll comment more in depth on point three, while touching on bullet point 2, the "net supply" argument (further discussed two months ago in "BofA: "If Bonds Are Right, Stocks Will Drop Up To 20%"). The argument here is simple, and logical: the more securities central banks soaked up from the market, the further they pushed investors into risky assets. Here is King:

What happens in any market when you get steady net demand but zero net supply? Prices go up – regardless of the fundamentals. It sounds trite, but isn’t that exactly the pattern we’ve had across markets the past few years – be they govies or credit or equities or EM or real estate (Figure 12)? 2015 was an exception, but of course that’s exactly the period when net supply to markets did increase thanks to the drop in EMFX reserves, meaning that money that was previously being crowded into risk assets ended up absorbing increased net supply in govies.

With central banks vowing to reduce their balance sheets, the net supply to markets will increase significantly, resulting - obviously - in lower prices and higher yields (this was also discussed in "If The Fed Sells Treasuries... Who Will Be Buying? Answer: "Other.""

While the above is also hardly new, the key observation made by King in his latest piece is that not only do fundamentals no justify valuations, not only have investors been herded into risky assets at the guidance of the Fed (creating another bubble), but that "valuations are sky high", and once the Fed's training wheels come off, what happens next will be unpleasant:

The ... reason we think the transition will be difficult is simply that the starting valuations are so high already. It would be much easier for fundamentals to take over from central bank liquidity if the valuations across markets they needed to justify were not close to the highest we have ever seen. Credit spreads have basically been tighter only in 2007 (a level which many investors thought would never be revisited). Equity volatility is at its lowest since the 1950s. The cyclically-adjusted P/E ratio on the S&P has been higher only twice: at the height of the dot-com bubble in 2000, and in 1929. Those with long memories are already fretting about valuations across the board and warning investors against being greedy.

And a stunning admission by one of the world's biggest banks: investors - its clients - have effectively given up on valuation as a metric:

Many investors we speak to seem almost to have given up on valuation as a metric. Rather like real estate in London or New York or Hong Kong, they are resigned to it: it may look expensive on paper, but the price is what it is, and they buy anyway. Several told us they would rather lose lots of money in company with the rest of the market than underperform slightly in a continuing rally and then suffer a fall in assets under management as investors moved elsewhere.

The implications, also discussed previously, are profound - one could call it the bubble to end all bubbles:

Indeed, much has been written about the wave of money migrating away from active managers towards ETFs and passive index funds. In a market rallying with low single-name volatility, the only way an active manager can outperform is by throwing caution to the wind and ensuring that they are long risk relative to the index. If large numbers of managers adopt the same strategy, it will inevitably render the market vulnerable.

While King's missive against central bank manipulation touches on many more critical points, his assessment of what happens next is troubling for those who believe that central banks will keep market under control:

As a general rule, it is probably easier to reduce teens’ dependence on phones if you have not been through multiple iterations of previously trying to do so, only to give in when they then responded badly. Depending on how you add up the various episodes of global QE, in markets we are either still on iteration #1 (our global central bank liquidity metric has remained permanently positive since 2009), or conversely at least iteration #10 (three episodes of QE + Twist in the US, two distinct periods from the ECB, two from the BoE, and at least two prolonged ones from the BoJ). While at a global level there has never been any attempt to reduce the size of central banks’ securities holdings, on each occasion to date that even the flow of purchases has been reduced, first markets and then the economy have faltered to the point that central banks have given in and come back with more liquidity still.

The punchline: the impact on markets resulting from all the above would be rather devastating: at least a 100bps blow up in IG credit spreads and a 30% equity selloff:

If the historical relationships shown earlier were to hold, the relatively modest reductions planned by the Fed and likely from the ECB over the next year, coupled with the surprisingly large reduction we have already seen in purchases from the BoJ since the shift to yield targeting, would be consistent with IG credit spreads widening some 100bp and global equities selling off 30%.

Meanwhile, the Fed continues to exist inside its ivory tower, in which Yellen went so far as to say on the record two months ago that there will not be another financial crisis "in our lifetimes." In this context, we leave you with the following memorable passage from King:

Central banks have tended to ignore such risks – indeed, with Janet Yellen memorably stating she considers another financial crisis unlikely within our lifetimes – in part because they are less convinced of markets’ deviation from fundamentals than we are, but also in large part because their very definition of financial stability is one which is centred on the banking system. Stability is equated directly with leverage; if there is less leverage, there can be no risk to stability. The other factor which has helped valuations reach this point is that no one can quite imagine the specific sort of trouble the market will get itself into.


“What’s the catalyst?” we are often asked. Yet as with your children, if you wait until you can already see what sort of trouble they’re involved in, there’s a good chance you’re responding too late.


Our best guess is some combination of market sell-off associated with investor outflows. With some over $800bn having gone into fixed income mutual funds over the past five years, of which over $500bn having gone into some form of IG credit fund, it would not be especially surprising to see some combination of elevated valuations and higher real yields on deposits or other safe assets cause investors to decide to take profit. Yes, there might well be some form of external trigger (concerns about conflict with North Korea?), but this in itself might well be unrelated.


With debt/GDP at record high levels across most economies, it would be similarly unsurprising if negative wealth effects caused the resultant sell-off in risk assets to feed through to the real economy. Just because the rally in markets did not boost growth as much as central bankers were hoping does not mean that a sell-off would not affect it negatively: indeed, the fact that the benefits of market gains are narrowly distributed but losses might well be socialized means that increasing debt may well be automatically increasing the likelihood of an asymmetric reaction.


Note further that we are therefore fully expecting markets to move first, and the economic reaction to follow only thereafter. It is not that we see higher interest rates leading to a spike in corporate defaults leading to outflows and an investor sell-off; it is that default rates have been suppressed (relative to their historical relationship with GDP growth, and relative to corporate leverage) by the supply-demand imbalance and wave of investor inflows allowing corporates to roll maturities and abandon covenants, and that a reversal of those inflows – whatever its cause – might lead to the expectation of increased defaults thereafter.


This pattern may seem surprising, but of course it is exactly what happened in 2000 and 2007. It is not that a weakening economy precipitated a sell-off in the NASDAQ, or that a sudden recession dragged down the US housing market; it is that the bursting of each market bubble dragged down the economy. On each occasion it took a lower level of real interest rates to make investors change their minds about the assets they’d been buying and head for the safety of cash; on each occasion there was a higher level of debt across non-financial sectors.  


Now, there is more debt still.

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