Leveling the Playing Field

February 29, 2016

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Congratulations, you get an extra Monday newsletter for the leap year. Youre welcome.
A client once asked me what I had learned from the 2008 crisis. I didnt have to think long and
hard because I had three distinct takeaways:
1. Cash is king when the sh*t hits the fan
2. Excessive debt will prevent you from weathering the storm
3. When in doubt, sell everything and figure the rest out later
I wonder if we are seeing similar mentalities play throughout the markets right now. CLO and
CMBS markets have seized up as investors and lenders have backed off dramatically. Its not
because of a belief that we are in the middle of a collapse, but rather a fear of what could be
coming. Rather than wait for the collapse, investors and banks are pulling back (lessons 1 and 2
above). Holders of existing bonds are selling (lesson 3). The lessons from 2008 are too fresh to
have been forgotten.
Bear Stearns Subprime Collapse of 2008 vs Eurozone Crisis of 2012
I was on the trading floor when the first Bear Stearns subprime hedge fund went under on June
22, 2007. One of our swap traders told me this was bad a credit crisis creates the worst
recessions. I had no idea (and I doubt he did either) of what was coming. But I distinctly
remember sending out a newsletter entitled, Warning Shot Across the Bow?
When I hear CEOs try to reassure us that everything is just fine, I am reminded of Bear Stearns
Chairman Ace Greenbergs quote from May 2007, a month prior to the collapse. The subprime (issue) has been blown completely out of proportion. Thats almost as intelligent as
moving your entire 401(k) into WB stock in September 2008 on the back Bob Steeles
recommendation
We are in an election year once again and markets are jittery. No one forgets 2008, but the short
term pain of 2012 has faded. That was the height of the Eurozone crisis, when peripheral
countries were on the verge of going under. Spreads here blew out, just like they have done
recently (covered in last weeks newsletter). Ultimately, things settled down and the world
moved on.
The question, therefore, could be: is this election year like 2008 or 2012?
As Ben Carson might say, lets look at the fruit salad of the economy

GDP 2008 vs 2012

Fridays GDP may lead some to conclude that all is right in the US. But GDP is a lagging
indicator and undergoes dramatic revisions for several months after initial release. I wouldnt
read too much into Fridays print except it serves as temporary cover fire.
A negative print would have sent panic shockwaves through the market. The 1% headline
number was strong enough to at least get markets to turn its attention elsewhere for the time
being.
But as you can see in the graph below, we had positive GDP prints well after the Bear Stearns
closure and we had negative prints after the Eurozone crisis.
GDP is lagging, dont read too much into Fridays number.

Non-Farm Payrolls 2008 vs 2012

We can debate all day about the quality of jobs during this recovery, but the job growth cant be
viewed as recessionary right now. A sharp downturn into monthly job losses will likely be
needed before we can view NFP as evidence of a recession.
Today: 12 month average of 222k (no months of job losses)
2007: 95k (two months of job losses)
Eurozone Crisis: 186k (no months of job losses)
Note that I took NFP from 2007, not the end of 2008 when the market was hemorrhaging jobs. I
wanted to see if NFP had any predictive value for an upcoming recession. If there is a takeaway
from 2007, it is that there was no consistency to the numbers. One month had a gain of 240k
jobs, another month had a loss of 33k jobs.

If we consider the twelve month period from June 2007 to June 2008, however, we see a
different story. Remember, banks had not collapsed yet. Wachovia CEO Ken Thompson was
fired on June 2, 2008 as the severity was becoming apparent but the government hadnt bailed
anyone out yet. From June 2007 to June 2008, the average was a loss of 11k jobs per month,
with six of those months reporting losses.

Core CPI 2008 vs 2012

This is not one of those pretty graphs that helps prove a point. Perhaps one takeaway is that
inflation climbed after the start of a recession, peaking well after the collapse.
In other words, just because we see inflation climb in the coming months, it should not be seen
as proof that we have avoided a recession.

ISM Manufacturing 2008 vs 2012

This one is perhaps the most worrisome and in no doubt effected by the strengthening dollar and
weakness in China. Notice how sharp the drop was in 2008. It wasnt a gradual slowdown - it
fell off a cliff.
A more dramatic move lower in manufacturing could portend a sharp downturn across all
economic measures domestically.

Inverted Yield Curve LIBOR vs 10 Year Treasury

As even my grandmother knows, an inverted yield curve has successfully predicted a recession
100% of the time historically. Take a look at 2008 the curve inverted before Bear. Well done
bond market.
It flattened substantially during the Eurozone crisis, but never got close to inverting (obviously in
part because LIBOR was basically 0%).
Can the curve invert today with LIBOR so close to zero? With German bunds yielding 0.14%,
why not? Does an absence of an inversion suggest no recession? Is it a coincidence that the
yield curve has flattened to Eurozone crisis levels? Will I keep asking rhetorical questions?

OIS-LIBOR Spread
This is the spread used to measure the health of the banking system and market liquidity. It
suggests that conditions have tightened, but there has not been a dramatic spike.
This spread spent most of 2015 right around 15bps. It is currently at 23bps.
To put this into perspective, the all-time high was 364bps on October 10, 2008. In the months
leading up to that spike, it was trading in the 75bps range.
During the Eurozone crisis it peaked at 52bps.
Financial conditions have definitely tightened, but we arent anywhere close to those levels.
Again, this feels like markets pressing the pause button to see if there might be a collapse rather
than a view of already being in the middle of collapse. If we see a run up north of 50bps, it
would suggest growing concern over bank strength and market liquidity, but at current levels the
market doesnt seem to be screaming run! even though bank stocks are taking a beating.

Takeaway
We all like patterns. It simplifies things, especially for state schoolers like me. If a quick review
of those graphs left you feeling like there wasnt any pattern, congratulations. I wonder if the
current market lacks a distinct pattern because we are just muddling along rather than moving in
a nice linear fashion (higher or lower). Some data suggests strength while other suggests
weakness.
An argument can be made that the world is about to end while an opposing view could argue
things are fine. This is a perfect example of why the Fed cant respond to every knee jerk
reaction. If youve been reading this newsletter over the last few months, youve probably
noticed that we have said market probability of a rate hike has oscillated too much after one set
of data or event occurs. The probability of hikes jumped too high in December, collapsed too
low last month, and even Friday jumped too high again after GDP came in relatively strong.
The Fed has a longer term view than the swap or Treasury trader trying to avoid getting
steamrolled by the market.
Admittedly, there is a heightened sense of caution. Everyone is on edge, afraid of repeating
2008. Isnt this a healthy thing? I havent heard of 100% LTVs based on aggressive projections
with interest only payments and no recourse. Tight spreads suggest a lower return, but is the
system at risk like it was in 2008?
The S&P has started the year with 23 days of +/- 1% movement, unprecedented volatility. For
the 10th week in a row (and 14 out of 15), the US oil rig count declined. Nat gas hit a 16 year
low. Global trade plunged 14% last year, the first contraction since 2009. More than $7T (with
a T) of global sovereign debt is trading with negative yields.
Our argument isnt that everything is great, but the fact that everyone is talking about it makes
me feel marginally better
This Week
Initial reports out of the G20 meeting in Shanghai this weekend look mildly disappointing.
There was hope for a Shanghai Accord of sorts, basically global central bank coordination. As
this is written, the meetings are still taking place but it certainly sounds like no such dramatic
statement is forthcoming. This could be bad for stocks Monday morning.
Lots of data this week, culminating with Fridays job reports. Expect another knee jerk reaction
to FF probabilities if the number is an outlier

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