Inflation Protection Should Be Theme In Markets 'Actin' Funny'

Purple haze, all in my brain.
Lately things they don't seem the same.
Actin' funny, but I don't know why.
'Scuse me while I kiss the sky.

Purple haze, all around.
Don't know if I'm comin' up or down.
Am I happy or in misery?
Whatever it is, that girl put a spell on me.

-- Jimi Hendrix, Purple Haze (live at Woodstock)

It's all a purple haze now, but 47 years ago today, I and some 400,000 other kids sat at Max Yasgur's farm in Bethel, N.Y., as Richie Havens opened Woodstock at about 5:07 p.m. with Minstrel of Gault. Jimi Hendrix would end the festival three days with a performance that included Purple Haze and ended with an encore performance of Hey Joe.

I chronicled some of my experiences from Woodstock last week in my diary, and this morning, I'd like to reflect on how the market's current strength is as surprising to me as Woodstock's enduring success had been. (And in both cases, we need to be careful about taking the brown acid!)

Let's start by looking back on this year's markets:

Don't Know If I'm Comin' Up Or Down

It's been risk-on in 2016, although the journey has been a dramatic rollercoaster ride rather than a straight line.

And like Jimi Hendrix at Woodstock, fixed income has been the the star of the show -- a dominating influence that brought us the notion of "T.I.N.A." (as in, "There Is No Alternative" to stocks).

But just as many see Woodstock as the 1960s' "the last waltz," I'd suggest that bonds' recent rising prices and falling yields might represent a last waltz for the stock market. Let's check out where we've been and where we might be heading.

Actin' Funny, But I Don't Know Why

The Dow industrials, S&P 500 and Nasdaq Composite all hit all-time highs on Thursday. Consider:

* The S&P 500 is now +21% from its Feb. 11 intraday low.

* The iShares iBoxx U.S. Dollar High Yield Corporate Bond ETF (HYG) is +14.2% from the February lows.

* The JPMorgan Global High Yield Index is +13.9% year to date on a total-return basis.

* The JPM CCC bond index is +23% on a total return basis year to date.

But amazingly, Treasuries and investment-grade bonds have also also rallied big-time even as this huge risk-on move occurred. Of course, the Bank of Japan, the European Central Bank and the Bank of England have all accelerated bond buying, while expectations for Federal Reserve rate hikes have plummeted. As a result:

* Treasuries have rallied, with the 10-year yield tumbling from a 1.66% peak on Feb. 11 to a 1.32% all-time low on July 6. The 10-year yield closed Friday at 1.51%.

* JPMorgan's Investment-Grade Bond Index is +8.9% year to date.

In fact, virtually every fixed-income sector is having a strong year. These two charts show the year-to-date total returns for various bond classes, unadjusted for foreign exchange:

But with macroeconomic data generally slowing and corporate revenues and earnings on the decline over the past few quarters, it's hard to attribute a large part of bonds' success to anything other than global central-bank activity.

After all, you might recall that the markets actually had a risk-off move at the end of 2015 and into 2016's first quarter following the Fed's December 25-basis-point rate hike and global fears about China's economy.

This accelerated the U.S. dollar's rally and commodity prices' collapse (led by oil). As this chart shows, West Texas Intermediate tumbled to a $26.21 low on Feb. 11 after the dollar had surged:

But the greenback had clearly gotten way ahead of itself in pricing in a Fed rate hike. So, as the chart above shows, the U.S. Dollar Index had already begun weakening from its 100.17 high on Nov. 30 before WTI put in its eventual bottom on Feb. 11.

Add in a blowout in high-yield spreads and the S&P 500 bottoming out 15% below its May 2015 peak by February and we got a dramatic shift in rate-hike expectations. Fed chair Janet Yellen's March 29 speech to the Economic Club of New York only confirmed that she had no desire to raise rates quickly.

Check out this slide from a friend of mine. It shows the odds that the futures market was pricing in for Fed hikes as of Jan. 11, when the S&P 500 stood at 1,924 (some 14% below today's levels):

By contrast, here's what the odds chart looks like today:

Whatever It Is, Those Banks Put a Spell on Me

British voters' unexpected decision on June 23 to back a Brexit ultimately saw just two sessions of risk-asset selling. Literally two:

* The S&P 500 sold off 5.4% between the close on Thursday, June 23 (before the results were known) and the close on Monday, June 27, two sessions later.

* High yield probably dipped three points on the higher-beta side, while WTI fell by more than 7.5%.

Even for those of us who thought the vote was hardly global economic disaster, the fact that the correct course would have been to wave in any and all financial assets since Monday, June 27, is rather unbelievable.

It's true that the Brexit vote was a huge surprise, but it enabled central banks to adopt even more extreme stimulative measures. The ECB, BoJ and now the BoE have all increased quantitative easing in recent months and are moving out the risk curve to corporate debt. (And in the Bank of Japan's case, even into stocks.)

Would we actually have had less spread compression and perhaps less of a risk-on move had the Brexit vote failed? Who knows? But I can't imagine a scenario where we would have had more.

Now, high-yield bonds' rally from their February bottom seemed to stem from the reversal of a virtually bidless environment reversing (with junk bonds briefly reaching 9.5%). But the move since the Brexit vote has felt like a huge technical move spurred on by:

* Inflows. July's first two weeks saw $6.1 billion flow into high-yield mutual funds.

* 'Reach for Yield.' The collapse of global risk-free yields has popularized a mantra that credit investors will have to "reach for yield."

* Commodity Debt. The bid for energy- and commodity-related debt has become seemingly price-insensitive due to new funds being raised and a general underweight to these sectors. This has happened even though oil prices have tumbled since early June (although they've since bounced sharply).

I wrote earlier this morning about how bonds' recent rally feels like the "last waltz" for stocks, just as Woodstock turned out to be "the last waltz" for the 1960s when the three-day festival began 47 years ago today.

Of course, the consensus in credit markets (and certainly rate markets) is that there's likely very little to alter the current course in the near term. After all, it's hard to argue that near-0% interest rates seemingly forever aren't a strong catalyst to adding risk assets left and right.

I think that's exactly what the market has done -- central banks the world over have been "front-runned" for yield in credit, as this inflows chart shows:

Markets have finally thrown in the towel on the possibility of any Federal Reserve rate hikes, as the 10-year U.S. Treasury yield recently hit an all-time low. But if we add in an apparent price bottom for oil and other commodities, I'm growing more confident that what the world's central banks might finally get for their monetary largesse is inflation.

I also think the market's near-limitless bid for high-quality debt might be reaching blow-off mode. After all, the negative-yielding bond universe has hit $13.443 trillion, according to Tradeweb.

Investment-grade issuance has also exploded -- not surprising given that absolute yields are at all-time lows. Check out this chart:

A newsletter that a research acquaintance of mine recently read noted that Microsoft(MSFT) now has $35.3 billion in debt, up from zero less than a decade ago. Apple(AAPL) also has $85 billion in debt vs. $23 billion less than four years ago, while Cisco(CSC) O has grown its debt 122% to $28.6 billion in less than three years.

Obviously, most of this debt hasn't gone to capex or other organic growth, but to dividends, acquisitions and stock buybacks. Who can blame these companies given how low borrowing costs are?

However, we might be reaching the "productive" debt crescendo here, given that corporate revenues and earnings are in decline. Check out this chart of S&P 500 earnings growth:

This doesn't even take into account the clear decline earnings "quality." Check out these excerpts from a July UBS presentation:

The Bottom Line

Add up all of the above and I believe that inflation protection should be the next theme for investors to embrace as we close 2016 and enter 2017.

After all, we're facing:

* Continuing currency debasement.

* Gold prices that are gaining momentum.

* Wage growth that's ticking up.

* Energy and other commodity prices that have seemingly bottomed out.

* U.S. fiscal spending that seems poised to gain steam.

* Both Democratic presidential hopeful Hillary Clinton and Republican rival Donald Trump are proposing huge infrastructure programs.

* Central banks decidedly erring on the side of too much stimulus vs. too little.

* European and Japanese government-bond markets that have no cushion from losses if an exogenous event hits, given that they currently have manipulated prices (i.e., negative yields).

Now if the Fed were to shift gears and definitively signal that U.S. rate hikes lie ahead, that would squash my view here. But that seems unlikely through year's end.

Still, Fed chair Janet Yellen's planned Aug. 26 speech at Jackson Hole will be interesting to hear. We'll want to see what she has to say given U.S. stocks' recent record highs and the futures market putting the odds of even one 2016 Fed rate hike at less than 50/50.