Recently, global credit risks peaked while inflation bottomed. In the past, when liquidity was removed to tame growing global inflation at the top of credit cycles, a higher than expected level of credit risk that built up over the preceding benign inflation period was exposed to market participants. The resulting epiphany led to massive and sudden financial dislocations.
By John Serrapere - Foster Holdings, Inc.
Guest Commentary: May 26, 2006
 The
illustration by Daniel Guidera that accompanies Eric Janszen’s
original piece on credit market risk "Financial Markets are Polluted with Risk" depicts credit risk
as a toxin stored in a 30-gallon drum at the bottom of the sea.The way I see it, credit risk is always present to some degree, as is inflation risk. At times, it gets stored away like hazardous waste and forgotten like the drum in the illustration; risks are not discounted, such as in 1994, 1997-98, and 2000-02. When a financial market storm eventually arrives, the seas become so turbulent that the drum bursts. Gales and tides carry the poison far and wide, contaminating global markets. Recall the Peso Factor and the Asian Contagion. The former precipitated the Peso and Orange County crises and the bursting of the emerging and high-yield markets in 1994, the latter the Thai Baht Crisis, Russian Debt Default, and near collapse of Long Term Capital Management in 1997 and 1998. Both events were catalysts for severe emerging and high-yield market declines. We need only recall the 17%- 20% yields on low quality credit instruments in October 2002 to be reminded of the re-pricing of credit risk near the most severe domestic equity price trough since 1937. At times, investors place greater emphasis on credit and at other times on inflation risk. From 1968 through June 1997, investors were more concerned about inflation risk, as evidenced by a +0.60 correlation between stocks and bonds. Since June 1997, this correlation has been -0.60. Negatively correlated financial markets dominate during times of low inflation that are interspersed with bouts of frequent and severe credit default. Waves of extreme credit risk concern and complacency have ebbed and flowed since June 1997, the last peak in corporate earnings. We can measure credit default concern via yield differentials between 10-year T-Notes and Baa Corporate Bonds, our measure of the credit spread. Figures 1 and 2 show credit spreads widening by 130% from February 2000 through October 2002, and then narrowing by 52% from October 2002 through December 2005.1  Credit risk needs to be respected, and capital protected, when spreads are as tight as they were in February 2000, at 165 basis popints (165 bps).  Recent spreads are the narrowest since 1984. The spread from Treasuries to the Credit Swiss High Yield Index was recently 320 basis points (bps) while the long-term average spread has been 546 bps with the all-time widest spread being 1126 bps on October 10, 2002 [The spread between the average high yield bond and a comparable Treasury is employed to determine the spread, Mainstay Investments, Market Outlook, April 2006.]. Under current conditions corporations must grow free cash-flow that is tethered to earnings growth. The 10-year T-note minus Baa Yield spread was 167 bps at the end of April 2006, which is 40%-63% below normal (based upon similar economic and market conditions found in Tables 2 and 4) and a mere 1 bp wider than it was at the end of January 2000. Tight spreads are odd given a flat yield curve, higher all-items inflation, rich equity valuations, and an aged business cycle. Narrow credit spreads under these conditions have been indicative of extreme risk. The stakes for high credit risk in this cycle are especially serious because of severe consumer indebtedness and structural financial imbalances resulting from U.S. domestic trade and federal deficits. The wide credit spreads that happened between February 2000 and October 2002 depicted in Figure 1 were warning investors to underweight or hedge assets with high correlations to the S&P 500 and high correlations to credit risk. Narrow credit spreads that happened between October 2002 and December 2005 as shown in Figure 2 indicate the contrary. The credit spread measures market liquidity and default risk. When spreads are extremely tight, there is excess liquidity with low default rates. When spreads are very wide, risky assets trade at wide bid to ask prices with rising default rates on high-yield bonds. For the sake of brevity, we will focus upon a novel indicator that I developed, The PPI/CPI Differential, which is closely tied to crude oil prices. Figure 3 was recently published in The Journal of Indexes. It shows a strong relationship between weaker earnings and times when The Producer Price Index (PPI, the price index of finished goods) is higher than Consumer Price Index (CPI, the price index of all items). Positive net results from PPI minus CPI over periods longer than 12-months predates weaker earnings and higher credit spreads. This predictive metric has a lead time of 12 to 24 months.  Click to Enlarge
It's said that imitation is the most sincere form of flattery. Assuming that the staff at the Leuthold Group, LLC studied the above chart while reading my latest article “Black Gold…Texas Tea” in the Jan/Feb-2006 issue of The Journal of Indexes makes me assume that the attention that they paid to the same findings is verification of my work. Below is a reprint from their April-2006 issue of “perception…FOR THE PROFESSIONAL” (page 19).
This is good stuff. This indicator predicted the greatest collapse in earnings since The Great Depression (-54%), occurring from September 2000 through August 2002. It also was a harbinger of 19% and 37% earnings declines in 1990-1991 and 1982 respectively. The only false positive occurred when earnings fell by only 13% in 1985. An indicator that predicts significant earnings declines will also call future strains on corporate cash-flow, which in turn will warn us of an increased credit defaults. When one attempts to forecast credit markets, they are also forecasting economic growth as measured by Gross Domestic Growth, Nominal GDP and Real GDP, RGDP. Economic growth is highly correlated to credit yields. The Treasury Yield Curve has been one of the best predictors of future growth. Inverted curves are most ominous when annual inflation remains above 3.5%. Tables 1 and 3 show the relationship between 12-month trailing GDP, forward 12-month GDP and RGDP during low and high inflation periods. Here is evidence that since 1940, Treasury yield inversions have been about 20 bps and 45 bps during low and high inflation periods respectively, while being associated with 4% and 2% RGDP growth 12-months after T-note yield inversions.  Tables 2 and 4 show the relationship between forward 12-month stock, gold, and Dollar returns, credit spreads and PPI/CPI differentials. Tables 1 and 2 represent low inflation times. Tables 3 and 4 record periods of high inflation. Tables 2 and 3 dissect asset class performance when stocks record earnings yields (EY) less than 5.6%.  The bold face highlights in Tables 2 and 4 are 12-month forward credit spreads and spreads at the time of inversions. Table 2 displays credit spreads as normally being 62%-63% wider than today’s spread, T-note minus Baa Yields, which is about one-half as wide as what has prevailed during similar conditions. Consequently, we can not expect spreads to widen by only 3% to 4% as they have in the past. If inflation stays below 3.5% annualized, credit spreads are more likely to rise from their current 170 bps level to a 250-300 bps spread.  However, due to ample liquidity and low credit standards and absent event risk, spreads are not expected to widen to these levels until some time in the first quarter of 2007. The recent global market turmoil since May 10, 2006 indicate that panic selling precipitated by an end to the Yen carry trade may initiate wider spreads sooner. We also found that 12-month forward stock returns were close to 5% while gold rose 14%, and the Dollar declined close to 4% (see Table 2). The assets that perform best when PPI exceeds CPI are commodities, gold, foreign securities, and small to mid-cap stocks. The worst performers are bonds, the Dollar, and large-cap stocks.  The biggest difference between Tables 2 and 4 is the PPI/CPI differential. PPI is more often less than CPI when inflation is low. However, when inflation is high or it is about to climb significantly higher, PPI is more frequently higher than CPI. The volatility of the differential is nearly six times greater in low versus high inflation periods. Unlike low inflation times, credit spreads are narrow when yields invert, but they widen significantly (46% on average) 12-months after inversions. This supports the relationships shown in Figure 3 and it contributes to the inference that all-items inflation will remain north of 3.5%. Given historic trends, CPI should exceed 3.5% by December 2006 or in early 2007, which is 12-months after recent inversions. Although the inversions seen from mid December 2005 through March 2006 were small, ranging from 1 to 27 bps, they are historically significant, especially if they are a prelude to a sustained period of CPI greater than 3.5% annualized. Recent evidence suggests that CPI is heading higher. Over the last 12-months, all-items CPI has persistently been higher than at any time since the June 1991 to March 1992 period; 12 month readings average 3.54%. In addition, recent year over year (YOY) wage growth has been 3.6%, the highest since 2001. Precedent indicates that persistent all-items inflation greater than 3.5% eventually results in core CPI greater than 2.5%, which was the peak seen for this measure in 2005. Treasury yield inversions will negatively impact markets if we see core CPI >2.5%. If precedent is prelude, it looks like a pause in the Federal Funds rate at a 5.0% -- a market expectation -- will be brief. It is more likely that Fed Funds will climb higher than 5.25%, because historically the Fed Funds rate has been 2.7% higher than core CPI (Figure 4). If so, heavy consumer debt and domestic burdens resulting from global imbalances could cause RGDP to fall to about 1.50% annualized. YOY RGDP could turn negative due to extremely widening credit spreads, the resulting liquidity drain. In the past, these conditions have resulted in subsequent market seizures. Portfolio Diversification & Credit Spreads The benefits of asset class and manger style diversification are derived from an investor's ability to hedge total portfolio losses during periods of heightened credit or default risk and low liquidity. We are all familiar with the summer of 1998, when Russian debt defaults precipitated severe losses in emerging markets and low quality credits. This was the worst of times for hedge funds. Hedge fund indices posted about 10% in losses while domestic stock indices declined a little over 15%. Losses were magnified by the leveraged bets placed by Long-Term Capital Management (LTCM), a hedge fund that nearly failed. It proved to be too large to fail. LTCM was saved after the Fed orchestrated a bail-out from Wall Street firms that might have suffered $100s of billions in losses. The dominate thought is that LTCM’s collapse would have triggered a cascade of counter-party defaults. Corporations have generally rebuilt their balance sheets since the 8-11% default rates seen in 2001 – 2002. However, individuals and the Federal government have the weakest balance sheets on record when adjusted for where we are in the economic cycle. Gross domestic debt dwarfs nominal GDP (Figure 5).  It is highly likely that widening credit spreads will usher in a resumption of the secular bear market that was initiated in February 2000. It is my view that the bull seen since October 2002 has been a counter-trend rally driven by extremely low nominal interest rates, negative real rates, lax credit standards, and complacency. All of which fostered excessive liquidity supporting all asset prices, which in turn bred low volatility, which in turn begets additional mal-investment. All assets with high correlations to stock and high yield markets, including most hedge funds, will not protect capital from losses. It is widely known that the small but looming possibility of credit default renders the expected return distribution for financial products containing credit risk to be highly skewed and fat tailed.2 Campell & Forbes found that asset class returns behaviors are dependent upon the timing and magnitude of their declines.3 During periods of persistently positive mean returns, volatility is low and correlations to risk assts are below long-term historic norms. However, the size of asset returns increases as credit spreads widen (Figure 1); their correlations strengthen and grow stronger near decisive turns in their price direction. Extremely narrow spreads occur when all asset classes display low volatility, which is when investors are ripe for mal-investment. Bubbles continue to expand as long as hot air (excess liquidity) is blown into them. During periods of persistently negative returns, volatility is extremely high, and correlations are higher than their historic norms. As the size of returns increase, correlations strengthen and grow stronger near return troughs. The catalyst for bursting Bubbles is a drain in liquidity. The primary symptom is very wide credit spreads. The picture below was sent to me from Rob Arnott, CFA and president of Global Fundamental Research Affiliates. On March 29, 2006, Mr. Arnott witnessed the solar eclipse while on vacation in Egypt. For me, this picture illustrates widening credit spreads blocking out rays of excessive exuberance. Like all eclipses, extremely wide credit spreads are brief (lasting no more than 6 to 24 months). However, during the last episode from mid 2001 to mid 2003, an investor's recovery rate from nearly $300 billion in high-yield debt losses were half of the historic norm.4  Below is a direct quote from Eric Janszen’s “Financial Markets Polluted with Risk” posted at the Internet site, www.ITulip.com.
We close with an excerpt from Former Federal Reserve Chairman Paul Volcker’s 2005 speech at Columbia University.
“There's been a price to pay for Greenspan's aversion to negative
shock therapy, traditionally the Fed's responsibility. The price has
not yet been paid in terms of economic growth, nor in the volatility of
economic growth. Nor has it been paid (until recently) in terms of a
higher or more erratic inflation rate. Instead, the price has been met
through a progressive increase in uninsured risk and vulnerability to
shocks thanks to a rise in debt.”
Lastly, as Eric Janszen might also advise: “This is not a great time to be a lender, because when credit is tight… first, the borrower goes broke, and. then, when the lender goes to collect, he finds that he is broke, too.” John Serrapere Investment Analyst & Strategist Foster Holdings, Inc. Mr. Serrapere has been advising investors since 1986. He currently is the Investment Analyst & Portfolio Strategist for Foster Holdings, Inc., a large Pittsburgh, PA based family office. His firm also consults other investors seeking alternative investment options. Mr. Serrapere was formerly a principal of Rydex Leveraged Hedges, LLC in Rockville, MD where he designed registered and non-registered products. Mr. Serrapere has published in The Journal of Indexes, Global Financial Data, Corporate Finance Review (Warren Gorham & Lamont, NY, NY), The Retirement Planning Journal (Commerce Clearing House, Chicago, IL) and has presented for Information Management Network (NY, NY). Discuss this... Footnotes 1. In "What a Hedge Fund Bust Would Look Like" (Part 2, May 9,2006), Bridgewater Associates, Inc. shows a need for greater understanding that today’s hedge funds hold much higher systemic market risk than in 1994, 1998, and 2000/01. Return 2. Huisman, R. & Koedijik, K.G. & Pownall, R.A.J., 1998. "VaR-x: Fat Tails in Financial Risk Management," Return Papers 98-54, Southern California - School of Business Administration 3. Rachel Campbell & Catherine S. Forbes & Kees Koedijk & Paul Kofman, 2003. "Diversification Meltdown or the Impact of Fat tails on Conditional Correlation?" Monash Econometrics and Business Statistics Working Papers 18/03, Monash University, Department of Econometrics and Business Statistics. Return 4. Lewitt, Michael E., “Understanding credit cycles and hedge fund strategies.” Chapter 16, page 221, www.harchcapital.com. Return |
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