The Daily Update - Equity YTD Returns Erased and "Huge Deterioration" in Loans

Yesterday, for the second time this month the S&P 500 fell more than -3%. What had been 11% year-to-date return in the first three quarters is down to just 0.88% this month; though most of those who moved into equities during 2018 will now be holding losses (unless the timed their entry on one of the only 21 of 206 trading days that the index has been lower than where it is now). With 14 down-days and only 4 up-days so far in October, markets are looking around guessing how many are ready enough to call the bottom, and confident enough to risk catching a falling knife. Even as more earnings continue to beat expectations this season it seems that markets just doesn't care right now. Last season forecast-beating EPS reports on average led to a 1-day boost of 1.2% in market value; so far this quarter the number before the decimal is zero, with the average only 0.2%.

Increasingly, the data points to weaker lending standards across the US as the current administration loosen the regulatory handcuffs (or perhaps more accurately remove the safety barriers). Now former Fed Chair Janet Yellen has spoken to the FT about her concerns that “there has been a huge deterioration in standards; covenants have been loosened in leveraged lending” and that she is “worried about the systemic risks associated with these loans.” Yellen stressed that, “it is what [banks] do that can create risks to the entire financial system. That lesson to me seems to have been lost” and that “if we have a downturn in the economy, there are a lot of firms that will go bankrupt”.

With such a shaky October this is the third day this month the VIX has topped 25. And even though European markets point to a rebound in the short-term, these latest losses sets in stone 2018 to be a vastly different year for equities from their steady rise in both 2017 and 2016. If deteriorating lending standards and investor blasé at strong corporate earnings continue, then three for -3% this month looks all the more likely along with the possibility of negative performance on the year for the S&P. Though of course it’s not the next down-day that concerns markets, but the one after that; and not a repeat of 2015 and 2011 flat performance but a repeat of markets losing confidence in banks and whoever ends up holding these leveraged loans. For if regulations loosen too far and if the necessary macroprudential regulatory tools fail to materialise, the US government may realise that one can’t trade confidence for growth, because long-term growth requires confidence.

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