The Animal Spirits Are In Full Force

The stock market had another move higher on Tuesday as my near term bearishness on the small caps and microcaps has been proven incorrect. The Russell 2000 – RUT is now up 8 straight days and the IWC microcap index is up 29 out of the past 31 days. We are certainly in one of the calmest stock market periods ever. The chart below gives you a glimpse at the animal spirits in in the bond market. As you can see, the Bank of America Merrill Lynch investment grade index has a yield spread of 106 basis points which is the lowest in 10 years. The emerging market credit spread is also tight. It’s at 418 basis points which is the tightest in over 10 years.

Obviously, the Fed plays a part in this extraordinary action. The chart below paints an amazing picture. As you can see, the Fed funds has historically risen whenever the ISM manufacturing did well. Sometimes the Fed’s response was delayed and sometimes it was muted, but it always occurred. This cycle has been unusual as the ISM has risen twice without any action from the Fed. This time it’s the highest in 13 years and there has only been a modest amount of hikes. There’s a possibility the Fed has kept rates too low, creating another bubble. It solved the previous crisis by overcompensating on monetary policy, leading to an uncertain future. There’s no comparable point in history to such policy. Rates should be lower than in the 1970s because inflation is lower, but that doesn’t excuse this extreme policy. The only thing we know for certain is that this period will be studied by monetary policy historians and policymakers for  a long time.

The biggest worry is about how easy it is to access capital. There needs to be standards when it comes to capital allocation. We can’t have too much money flowing to people/businesses who can’t pay it back. It would be like if everyone was dying to give payday loans at a 5% interest rate. That type of risk would bring systemic risk to the economy. That type of situation occurred in the 2010s with fracking companies. When oil prices fell, we saw the chickens come home to roost for the banks and investors who gave drillers money who needed oil to be at high prices to keep operations going. The oil market was small compared to what could happen during a recession. The chart below gives you an idea of the size of the potential problem. As you can see, the annualized leveraged loans are $539 billion in 2017 which is higher than the 2013 peak which was driven by energy. This sustained period of leveraged loan issuances is like repeating 2007 many times. That doesn’t necessarily mean there will be a recession of the same magnitude as 2008. It will be different, but the size of the leveraged loan market is disconcerting.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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