Sunday, 19 February 2017

Macro and Credit - Hypomania

"Knowledge is marvelous, but wisdom is even better." -  Kay Redfield Jamison, American psychologist

Looking at the unabated records being broken in US equities markets, with the S&P 500 having had 47 consecutive trading days without a 1% move, we reminded ourselves for our chosen analogy title of the mood state of "Hypomania", well known in psychiatry. Hypomania (literally "under mania" or "less than mania") is a mood state which is characterized by persistent disinhibition and pervasive elevated (euphoric) with or without irritable mood but generally less severe than full mania (Tulip mania...). In 19th century psychiatry, when mania had a broad meaning of craziness, hypomania was equated by some to concepts of "partial insanity". Looking at financial markets today, one would ask if we have indeed reached that threshold to some extent in this long credit cycle. What we find of interest is that the state of "Hypomania" may occur as a side effect of pharmaceuticals prescribed for conditions/diseases other than psychological states or mood disorders such as the "opioids" like QE dear to our central bankers. We find interesting that as of late Fed's Harker said that opioid abuse is one cause of low labor participation by prime-age men. Maybe the Fed's opioid abuse is also the cause of stock market melting up thanks to "multiple expansion" due to record buybacks funded by cheap credit leading therefore to a "hypomanic" state of affairs? We wonder.

In those instances, as in cases of drug-induced hypomanic episodes in unipolar depressives, the hypomania can almost invariably be eliminated by lowering medication dosage (tapering), withdrawing the drug entirely (stop QE for good), or changing to a different medication if discontinuation of treatment is not possible. The funny thing with "Hypomania" is that it may also be triggered by the occurrence of a highly exciting event in the patient's situation, such as a substantial financial gain or recognition. In other words, "Hypomania" can be associated with "narcissistic personality disorder". The DSM-IV-TR defines a hypomanic episode as including, over the course of at least four days, elevated mood plus three symptoms OR irritable mood plus four symptoms, one of which being foolish business investments but we ramble again...or are we really? Because if indeed "Hypomania" can be associated with "narcissistic personality disorder", one has to wonder where we are currently located on Brean Capital Head of macro Strategy Peter Tchir's Maslow's Hierarchy Of Credit Bubble:
- source Brean Capital

If indeed, credit investors are showing traits of "narcissistic personality disorder", then it validates even more our "Hypomania" title analogy and the fact that the credit cycle is slowly but surely moving into the final inning number 9 (or 9 years?) Place your bets accordingly.

In this week's conversation we will be wondering whether or not we could be facing an inflexion point, namely that a correction in equities might start to weight on credit and in particular High Yield, currently "priced for perfection".

  • Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
  • Final charts - US Consumers yet to feel "Hypomaniac"

  • Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
While clearly the equities markets in the US have been in a state of "Hypomania" as of late, so far the environment has been pretty supportive of credit spreads, and not only thanks to the ECB's buying spree. But, while credit has always been leading equities, one could wonder if this time around a sell-off in equities could impact credit spreads this time around, contrary to what we have seen in 2016 where the widening in credit spreads in the energy sector finally had an impact on equities at the beginning of the year.

From our perspective when it comes to "Hypomania", greed and the potential for a sell-off or the start of a bear market, we reminded ourselves of our 2014 conversation "Equity bear markets tend to coincide with high global core inflation":
"High global core inflation as a risk-off signal
Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.
High inflation leads to mean reversion for currencies
Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust? 
Inflation matters when inflation is high
Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies." - source Bank of America Merrill Lynch / Macronomics, June 2014
At the time we also mused around a phenomenon we saw in 2008 in relation to core inflation in the US:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source

Given January CPI rose 2.5% y-o-y, the strongest gain since early 2012 (core CPI up 2.3% y-o-y), and with Janet Yellen taking a more hawkish tone recently in the latest FOMC, one might be wondering if indeed the current "Hypomania" and global rising core CPI will not lead to some sort of "accident" in the not too distant future (like a rate hike in March...). Clearly the inflationary "build up" is putting stress on the QE infinity camp. We indicated in our recent conversations as well that the cozy relationship between central bankers and politicians was as well coming under renewed pressure (Germany). So overall, there is no doubt to us that we are seeing a dwindling support for central bankers. The QE backstop is slowly but surely fading on top of the buildup of inflationary pressures globally.

So of course, as anyone else we are watching inflationary pressure building up very closely. On this subject we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 10th of February entitled "The day of max inflation":
"The day of max inflation
WTI oil prices have more than doubled since reaching the low close of $26.21 a year ago on 2/11/2016 (Figure 1). This means that, if oil prices remain stable, headline inflation is peaking (at least locally) today. However, because economic data is reported on a delayed basis – and only monthly, not daily – we should continue to see oil prices driving up headline inflation numbers above core when reported for January (next week) and February.

- source Bank of America Merrill Lynch

As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.

In this "Hypomania" environment we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":
"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer
From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:
"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer
Given the risk of a surge in trade wars with the new US administration, where it becomes interesting is that in our global competing systems, it seems we are moving away from "cooperation". This could of course have nasty consequences to say the least, for global trade, and would therefore continue to be bullish for gold (hence our late December positioning on gold miners as a reminder). As we pointed out on numerous occasions when discussing gold matters, has been the return of the Gibson paradox which we mused about in our October 2013 conversation:
"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics
Real interest rate is the most important macro factor for gold prices. US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. You might be wondering what has led four our switch to our positive stance towards gold/gold miners at the end of December 2016, it all had to do with real rates as indicated by Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax":
"Imports to CPI to breakevens: a perfect pass-through?

That a border tax has been interpreted as a stagflationary shock is apparent when one looks at the inflation market since the markets attention shifted to it post the Dec hike. Roughly about 11% of CPI is tied to imports using input-output tables. A 20% border tax would push 1y inflation up by 220bp immediately with a follow through impact of 40bp on 5y breakevens. It is no coincidence that since the December Fed hike, 5y breakevens went up 30bp, 5y real rates went down by 50bp and the DXY was weaker by 3% – a classic stagflationary shock priced in by the markets.
However, in our view it is too optimistic to expect the market to price in a perfect passthrough to breakevens without the any currency adjustment. Our analysis has shown that a border tax of 20% could be wiped out by a 25% likely rally in the dollar. Also, likely if a border tax were, implemented, it would be delayed and staggered over several years, making the impact on very front-end breakevens unclear. Ultimately, as highlighted in detail here and summarized in Chart 2, we see the border tax adjustment proposal largely playing out as a higher dollar and flat-lower breakeven trade.

Recent price action proves real rate a better short
To us, last week’s price action post the euphoria, proves exactly why real rates offer a better protected short than breakevens. While the upside may not all be captured in a rate selloff, any unwind of the Trump trade is far more likely to hurt breakevens than real rates. Consensus was expecting four hikes over the next two years even six months ago, when the odds were favoring a gridlocked Congress, a continued Yellen Fed and no fiscal stimulus. This suggests that the unwind of the post-election euphoria is likely to manifest as an unwind of the reflation trade as opposed to the unwind of the Fed hike trade, in our view. We maintain our short real rates recommendation across the curve."- source Bank of America Merrill Lynch
We agree with the deflating Trumpflation trade, and we also agree with Bank of America Merrill Lynch's recommendation for "shorting" real rates. There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":
"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.
The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.
The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.
During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up.

So moving back to how inflation can play out ultimately on credit spreads, it is most likely through a sell-off induced in equities which could be triggered by a "preemptive hike" by the Fed in March. On this subject we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 17th of February entitled "Equities not rates":
"Equities not rates
As highlighted by this week’s tightening of credit spreads amidst increasing rate hiking risks (Figure 1), higher interest rates and inflation are not the biggest near term risks to our bullish view on credit spreads.

With the continued rally in equities instead we are getting to the point where we are most concerned in the near term about scenarios that lead to a correction in stocks (Figure 2) – especially if interest rates decline materially in sympathy. Two leading candidate scenarios for this include US policy risk – including most prominently, but not limited to, disappointments around tax reform – and developments ahead of the French election.
Border adjustment tax
The key uncertainty in US tax reform is the border adjustment tax (BAT) from House Speaker Ryan’s blueprint. As we have argued, should the BAT – against our house view – be included, chances are that tax reform gets delayed significantly, as the scheme creates many losers that will push back (and winners – but losers tend to complain more than winners cheer), both domestically and internationally. As much of the recent rally in risk assets hinges on tax reform such delays could be troublesome. Perhaps we will know more on or before February 28th when President Trump addresses a joint session of congress.
To see this note that from an international trade perspective taxing imports, but exempting exports, is the equivalent of imposing an import tariff and giving out an export subsidy. There are three key effects of this. First it creates winners and losers domestically (see: Equity Strategy Focus Point: Death and tax reform 29) which again, as we have seen, translates into pushback against the plans. Second it creates losers and winners internationally as well. Potential losers and winners include countries that are net exporters to (Figure 3) and importers from (Figure 4) the US, respectively. Because the US is running a large trade deficit in goods and services ($490bn in 2016) of course there are more losers than winners abroad. That ensures significant pushback against the BAT abroad as well and the risk of trade war.

Third, the BAT issue is particularly sensitive as about two thirds of the US trade deficit is with just one country – China – which creates a particularly high risk of retaliation. In terms of possible responses, to mitigate the impact of a US border BAT for example China could choose to devalue the Renminbi against the dollar, which is very deflationary globally through commodities (Figure 5) and would bring back the memories of some of the biggest sell-offs in risk assets we have seen the past couple of years (Figure 6).

There are many reasons why the Trump administration might want to implement a BAT scheme, including that it creates significant revenue to help mitigate the impact of lowering the corporate tax rate. This is because the net effect of the border adjustments is effectively to tax the trade deficit by the new corporate tax rate – for example, a 20% tax on a $500bn trade deficit translates into $100bn in new tax revenue annually. Hence, taking out the BAT creates the need to find $100bn annually elsewhere, which may constrain the ability to lower tax rates." - source Bank of America Merrill Lynch
The conjunction of all these factors in an environment where "Hypomania" has reigned supreme, makes us particularly more nervous as we move towards March and a potential rate hike on the back of a stronger than expected January CPI and retail sales data. We also note that from a flow perspective, there have been some significant inflows into High Grade funds and ETFs as put forward as well in Bank of America Merrill Lynch's note:
"Flows refocus on stocksInflows to US equity funds and ETFs reached $13.13bn this past week (ending on February 15th) – the highest weekly inflow in two months – compared to a $1.95bn inflow the week before and $8.81bn inflow for the week ending on February 1. The pickup in inflows is consistent with the recent stock market rally. At the same time inflows to bonds moderated to $5.06bn from a high $8.04bn inflow in the prior week, mostly due to lower inflows to high grade." - source Bank of America Merrill Lynch
We don't think that "Hypomania" is warranted when the reliance in "opioids" is fading. On top of that, as we pointed out in our previous conversation, the latest Federal Reserve Senior Loan Officer Survey shows a weakening demand for credit overall, with Commercial Real Estate feeling the brunt.

  • Final charts - US Consumers yet to feel "Hypomaniac"
Whereas in the financial sphere, "Hypomania" is clearly running high, the US consumer it seems is less "euphoric". If indeed it is "Hypomania" for Wall Street, Main Street seems much more prudent as per our final charts from Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax" displaying a decline in December in Consumer Credit which is consistent with declining Credit and Auto loan demand reported in the Senior Loan Officer Survey (not to mention rising delinquencies in subprime auto loans as of late...):
"In wait and see mode
While most often the Federal Reserve Senior Loan Officer Survey is closely monitored for color on bank lending standards, the most striking aspect of Monday’s report was weak loan demand across the board (see: Situation Room: The French Connection 06 February 2017). Perhaps this is due partly to rising interest rates, which would make sense for mortgages. However, one would certainly expect that development to play a smaller role for consumer loans and business loans. Tuesday’s Fed Consumer Credit expansion of $14.6bn in December (Figure 9), the lowest since June, is consistent with the sizable contractions in credit card and auto loan demand reported in the Senior Loan Officer Survey (Figure 10).

For more timely data the Fed’s weekly H.8 data allows us to come up with good estimates for January 2017 bank loan growth. We estimate that in January US banks experienced only a 0.6% annualized increase in consumer lending, down from 5.3% in December and the lowest reading in two years (Figure 11).

Furthermore C&I lending remained weak in January at 0.9% (Figure 12).

While bank profitability stands to benefit from higher NIMs as interest rates go up, nothing yet suggests animal spirits – in fact US consumers and businesses appear presently stuck in wait-and-see mode." - source Bank of America Merrill Lynch
So if indeed US consumers are closed to being "maxed out", then if the Fed is ready to pull the "hike trigger" in March, things could become interesting in "Hypomania" land we think. Can you spell "Policy Mistake"? Because we can...

"Mistakes can be corrected by those who pay attention to facts but dogmatism will not be corrected by those who are wedded to a vision. " - Thomas Sowell, American economist

Stay tuned!

Saturday, 11 February 2017

Macro and Credit - The Carrington Event

"Faith may be defined briefly as an illogical belief in the occurrence of the improbable." -  H. L. Mencken, American writer

Watching with interest US stocks markets reaching new record levels, while investors are pondering what are the risks coming up in the horizon such as a potential trade war initiated by the Trump administration, China credit bubble bursting, an end of the euphoria in US High Yield, upcoming European elections in Holland, France and potential elections in Italy, we reminded ourselves for our chosen title analogy of the 1859 Carrington Event, a perfect solar superstorm and arguably the most underpriced risk in the world. At 11:18 in the morning on September 1st 1859, English astronomer Richard Carrington in his observatory saw two patches of intensely bright and white light breaking out as he wrote in his report "Description of a Singular Appearance seen in the Sun". The massive solar flare had the energy of 10 billion atomic bombs and hit our planet a couple of hours later wreaking havoc to the nascent global telegraph system. Today such natural "Electromagnetic Pulse" (EMP) disaster would inflict considerable damages to critical infrastructures around the globe. Extreme solar storms pose an existential threat to all forms of high-technology and create widespread power blackouts, disabling everything that plugs into a wall socket. According to NASA from their 23rd of July 2014 article entitled "Near Miss: The Solar Superstorm of July 2012", a similar storm to the Carrington Event of 1859 would exceed $2 trillion or 20 times greater than the costs of a Hurricane Katrina according to a study by the National Academy of Sciences. We find it interesting that the more technology and connected we are the more fragile we have become, the thesis of Nassim Taleb's "antifragile" theory. Furthermore as per our long fascination with "Rogue Waves" and risk, depicted in our February 2016 conversation "The disappearance of MS München", what apparently seemed to be an oddity in terms of probabilities, isn't in terms of frequencies as discovered by scientists studying the phenomenon to their dismay. In similar fashion, a solar superstorm appears to many people to be an extremely rare type of event with a low probability. It isn't. As per NASA's article to paraphrase Taleb, we are fooling ourselves with randomness: 
"In February 2014, physicist Pete Riley of Predictive Science Inc. published a paper in Space Weather entitled "On the probability of occurrence of extreme space weather events." In it, he analyzed the records of solar storms going back to 50+ years. By extrapolating the frequency of ordinary storms to the extreme, he calculated the odds that a Carrington-class storm would hit Earth in the next ten years. The answer is 12%. "Initially, I was quite surprised that the odds were so high, but the statistics appear to be correct", says Riley. "It's a sobering figure"." - source NASA
To paraphrase Donald Rumsfeld, while in financial markets today they are known unknowns, when it comes to solar superstorms it represent an unknown known, yet simply ignored by so many.  Such an event, if it hits Earth would cost several trillions of dollars, with a potential lasting recovery time given we are much more reliant on technology these days. Therefore we are way more vulnerable to these types of "rare" event than in the past, same goes with financial markets. Central banks meddling with assets prices have rendered the system much more "interconnected" therefore much more fragile and unstable. Globalization as well, has rendered economies much more entangled than in the past.

You might be wondering where we are going with our analogy. It seems to us that 2016, the many pundits that made the case for catastrophic events for BREXIT and Trump election got not only the outcome wrong, but also got the results wrong when it came to predict the impact on financial markets. In the case of 2016 we had "bad news" (on the back of "fake news") leading to "good news" for financial markets, we are wondering if in 2017 will not be "good news" (on the back of "real news") leading to "bad news" for financial markets.

In this week's conversation we will look at if indeed the "Trumpflation" story is not losing some steam and also what it entails in terms of allocation.

  • Macro and Credit - 2017 - From optimism bias to realism bias 
  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

  • Macro and Credit - 2017 - From optimism bias to realism bias 
2016 for "credit" performances was a story of "bad news" leading to "good news", with the first part of the year plagued by the widening in the energy sector thanks to oil woes and spilling over to equities. Clearly the second part of the year saw a dramatic reversal of fortunes with US High Yield and in particular the energy sector leading the way, while investors extended both their credit exposure and duration exposure. While 2017 continues to see a rally in both US equities reaching new height and credit continuing its strong pace thanks to very significant inflows. This is particular the case for fixed income which is clearly seeing no sign of the "Great Rotation" story playing out, from bonds to equities that is. In fact, what is of interest is that this "great rotation" is happening with significant inflows into High Yield, most likely out of Government bond funds. As we have commented before on numerous occasions, we believe we are moving into the last inning of the credit cycle and at this stage we do not think High Yield could easily repeat its 2016 feat.
When it comes to "reaching for yield", whereas 2016 saw an extension of both credit risk and duration risk, 2017 so far is seeing somewhat a more defensive play when it comes to duration, but in terms of credit risk, High Yield has been seeing some significant flows as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 10th of February 2017 entitled "Reach Higher (yield), go Shorter (duration):
"No losers; everyone benefitting so far
Rising rates are not deterring investors from allocating more into fixed income funds. In fact last week’s inflow into the asset class was the strongest in 28 weeks. Inflows were strong mainly in the higher yielding part of the market, i.e. HY and EM debt funds, but also into high grade ones; predominantly on the short-dated part looking for a “shield” against rising rates. In other words investors are seeking high-yielding instruments and shifting into low-duration IG to protect against rising rates. Rising uncertainty is also favouring flows into commodity (particularly gold) funds.
Over the past week…
High grade funds continued on a positive trend for the third week in a row. The weekly inflow was also the highest in six weeks. High yield funds saw inflows for the tenth consecutive week, and the latest inflow was the largest since March ‘15. Looking into the domicile breakdown, the inflow last week came largely from US domiciled and globally-focused funds. Nevertheless the European-focused funds inflows improved from the previous trend.
Government bond funds had their third week of outflows despite rising rates. Money market funds weekly flows were positive after three weeks of outflows. Overall, fixed income funds recorded an even stronger week of inflows than the previous one, the highest in 28 weeks and the seventh positive in a row. The asset class is rapidly approaching the $20bn mark of inflows YTD. European equity funds flows were positive for a third week but with marginal volumes.
Global EM debt fund flows continued on the positive trend for a second week; and the latest inflow was the highest in 28 weeks. Commodities funds flow remained positive for a fourth week in a row, with the inflow pace going up again.
On the duration front, inflows continued in short-term IG funds for the eighth week in a row. Note that last week’s inflow was the highest since July ‘14. Mid-term funds’ flows flipped back to negative territory after last week’s strong inflow. On the other hand, flows into long-term funds moved back to positive after two weeks of outflows." - source Bank of America Merrill Lynch
Given such powerful flows as of late, it is hard to see what could be the catalyst that will finally derail this long in the tooth credit cycle. We are wondering what could potentially be the Carrington Event for credit. In the meantime, the rally runs unabated thanks to solid macro data and reasonable earnings for the time being. As we indicated earlier one, we wonder if 2017 will not be the reverse of 2016, namely that we will have a solid first half and probably a more difficult second half of the year. It is very difficult to assess what lies ahead with so many political events lining up for the year. In this context, we have raised our cash levels, and continue to play the gold mining theme while we are waiting for more clues from the Japanese crowd before being enticed again towards US Treasury notes. On the subject of tail events, we read with interest Bank of America Merrill Lynch Relative Value Strategist note from the 9th of February entitled "Always looking on the bright side of life":
"The anti-climax of tail events
In our view, the biggest financial misjudgments in 2016 were not about underestimating the probability of certain political events. We believe the larger error, in hindsight, was overestimating the immediate severity of the market’s reaction should they come to pass. So while we had two unexpected outcomes in Brexit and the US election results, both of which were viewed negatively in their respective run-ups, the aftermath has been quite anti-climactic in our view. The market has chosen to focus on the bright side of things, building up policy proposals that it favors like lower taxes and fiscal stimulus, while casting aside those like border adjustment taxes and renegotiating trade deals that could be detrimental to asset prices. While this may eventually prove to be the right call, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way.
As it stands, there seems to be widespread optimism that tax reform, deregulation and fiscal expansion this year will spur strong growth and inflation in the US. While this may eventually prove to be true, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way. This speaks to some complacency in our view, with not enough weight being given to medium-term policy uncertainty. 
Uncertainty is high. Stay liquid. Be hedged.
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and favor CDX HY over indices referring cash bonds, as the basis is unlikely to compress much further." - source Bank of America Merrill Lynch
As per our last conversation, we would side again with Bank of America Merrill Lynch in regards to favoring the liquidity of CDX HY over cash bonds particularly in the light of the compression seen so far in US High Yield since the beginning of the year (European High Yield as well has had a solid run):

But, nonetheless, a barbell strategy of quality investment grade including short duration High Yield, could still represent an attractive investment proposal, particularly in the light of continuing widening in European Government bonds and the convexity risk for long dated investment grade securities.
"Stay liquid: long CDX HY over HY cash
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun – SPX is down 0.5% in the last two weeks, while IG is 2bp wider. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and prefer CDX HY over indices referring cash bonds.

The CDS-cash basis is unlikely to go much higher
The CDS-cash basis has reverted towards its pre-2015 levels. The BAML HY index, H0A0, now trades just about 50bp wider than CDX HY (Chart 1). (Note it was 38bp wider until IHRT was removed from HY27 post default.)

As Chart 2 shows, the IBOXHY cash index has consistently outperformed its CDX counterpart for a year now. We think there is limited upside to this now i.e. the basis is unlikely to compress all the way back to 2012 levels thanks to some amount of liquidity premium embedded in high yield cash bonds after the events of the last two years.
Liquidity, liquidity, liquidity
CDX HY offers a better value, liquid long here than HY cash in our view. In the event of a macro shock, the synthetic index might initially underperform cash, but if the weakness persists, bonds will eventually catch-up. More importantly, we think the level of uncertainty regarding policy and the prospect of a flare-up following this period of extremely low volatility demands a higher allocation to liquid products.
Hedge against rate risk
This switch to CDX or a positive basis trade (long CDX, short cash spread) will also perform well as a hedge against a sharp rate rise, should one materialize.
US equities outperformed European equities while volatility continued to decline in both
markets (Table 4). Equity vol in the US currently stands at 11 vol points, near the lows
seen over the past 10 years:

 (Click to enlarge)
- source Bank of America Merrill Lynch

What is of interest to us in the case of US High Yield is the very slow deteriorating trend as shown per the Q4 Fed Senior Loan Officer Survey which has been recently released. On this subject we read with UBS latest Global Credit Strategy note from the 7th of February entitled "Has US High Yield priced too much good news?":
"Has US high-yield priced too much good news?
One of the most critical questions that portfolio managers face when investing relates to what is priced into the market. We have tackled this question before. One year ago, we highlighted to investors that it was not attractive to short US high-yield, as spreads near 850bps implied a US recession was imminent, while underlying fundamental data suggested otherwise. Fast forward one year, and we are in a very different world. US high-yield spreads sit at 400bps, only 43bps above cycle tights in July 2014. US highyield has returned a superb 21.2% over the last 12 months, one of the strongest rallies ever outside of a post-recession recovery. The key question for investors: Is there still room for US high-yield to rally?
It’s certainly possible. In our recent client meetings, we have heard the strong current of institutional pressure dragging active managers into the market to stem client outflows and reduce what has been an exceptionally difficult period of active manager underperformance vs. the broader index (Figure 1). We think this theme is dwindling as cash balances are falling, but it cannot be discounted from extending further . In addition, if developed market central banks remain dovish (i.e. only 2 Fed hikes in 2017, ECB keeps Taper talk to a minimum, BOJ keeps 0% 10yr JGB yield target), we believe that would be a positive near-term for setting the marginal price of credit.
However, it is becoming impossible to ignore downside fundamental and political risks that are more elevated than when high-yield last traded at such levels. Bank and nonbank lending standards are not easing, credit card and auto loan delinquencies are rising, bank C&I loan growth has stalled, and more protectionist sentiment is being underprized in our view as a macro risk. We believe investors should protect gains at current levels, with both high-quality (BB) and low-quality (CCC) high-yield credit at expensive prices. We suggest investors own junk credit through CDX to protect against illiquidity risk in cash bonds. Investors can also bet on a widening Cash-CDX HY basis as a downside hedge with very attractive risk-reward characteristics. Lastly, we reiterate our 2017 preference for US investment-grade credit and leveraged bank loans over US high-yield.
We believe the main conclusion that investors should take away is the following: While US high-yield has rallied to near cycle peaks, fundamental data highly correlated to US high-yield has not followed suit. Today’s release of the Q4 Fed Senior Loan Officer Survey highlighted a net 0% of banks tightening standards on small firm C&I loans, marginally worse than the -1.5% of banks easing conditions in Q3 (Figure 2). While 0% is not terrible, we need to remember that in the sweet spot of the cycle, a net -5% to -10% of banks typically ease conditions. It should be rather disappointing to bullish investors that one of the strongest high-yield rallies in history has been unable to induce banks to ease standards on CI loans.
Even more important than the headline number, we found only a net 7.4% of banks tightened spreads on C&I loans (average across large and small firms). This reduction of spreads is very modest in light of the massive spread tightening seen in the high-yield bond market. In context, this reading is worse than that experienced in Q2’98 and Q2’07. Put simply, banks are not passing on the decrease in market funding costs to their customers, at least not to the same extent as in the high-yield bond market. Given that these two lending indicators empirically lead both high-yield spreads and default rates, we keep our year-end forecasts for HY credit spreads, default rates, and total returns unchanged (YE 2017 HY spread: 570bps, 2017 HY Default Rates: 3.6%, 2017 HY total returns: 0.1%). For more details on our overall credit forecasts, please see our 2017 outlook pieces. In addition, the rather mixed performance of the lending survey was not limited to C&I loans; a net 23.8% of respondents tightened standards on CRE loans, a net 8.3% tightened on credit cards (worst post-crisis) and 7.3% tightened on auto and other consumer loans (worst post crisis) (Figure 3).

The Q4 Senior Loan Officer Survey also asked two sets of special questions regarding the future outlook for 2017 lending standards and delinquencies. The results here again are mixed, but mixed is not good enough with prices so high. On the former, it is true that a net -16.4% of banks expected lending conditions to ease for C&I loans to small firms, assuming economic activity progresses in line with consensus forecasts. This is the most bullish reading in the SLOS survey for credit investors and if it came to fruition could indicate the credit cycle is restarting. However, at the same time, a net 10.5% of banks expected to widen spreads on small firm C&I loans over the next year. This expected level of spread widening is empirically inconsistent with the forecasted easing in lending conditions, given the strong correlation between the two (Figure 2). To put in context, 10.5% of banks widening spreads is consistent with late 1999 and 2007 levels.
Significant numbers of banks indicated continued tightening for CRE (23.6%) and consumer loans (0% credit cards, 5.1% auto loans next year) as well in 2017. The outlook for delinquencies was also rather mixed. C&I loans only saw a small improvement, with a significant fraction of banks expecting rising NPLs in credit cards and auto loans (Figure 4).

This weakness in the consumer area remains a key source of concern. Our recent Evidence Lab primary survey on the US consumer suggested that rising post-election optimism was balanced out by households stating they were more likely to default on a loan over the next 12 months. Bottom line, there is clear potential for winners and losers post-election, rather than all winners.
The divergence of spreads relative to fundamentals goes beyond bank lending. Non-bank liquidity continues to tighten, largely flying under the radar of most investors. This has continued to tighten since we wrote our initial warning piece on the credit cycle in 2015 (Figure 5).

Non-bank trade credit (i.e. the financing of working capital) in particular continues to struggle, as improvement in the CMI trade-credit index has been modest and highly focused on better-quality names. (The favorable component of this series is currently at 60.8, the highest since July 2015). More stressed firms are under pressure however, with the unfavourable component of the CMI index at 49.5 in January, in contraction territory. The divergence of high-yield spreads versus weaker trade credit is now gaping. Figure 6 highlights that high-yield spreads are tightening rapidly at a time when the usage of collection agencies to collect on unpaid debt continues to grow.

When high yield spreads were at similar levels in 2014, the prospect of collection agencies was not even a remote concern. The CMI Index highlighted that retail names in the service sector were facing the most pressure, consistent our preference for underweighting this sector in US HY.
Another hole in the rally is how high-yield spreads have decoupled from underlying bank C&I loan growth (Figure 7).

Despite the well-publicized increase in consumer confidence and business optimism post the US election, bank C&I loan growth has stalled. We think this is not normal for an economy that is expected to hit mid 2% to 3% growth rates in 2017. In fact, the current growth rate of bank C&I loans is more consistent with levels seen just before recessions. Historically, high-yield spreads lead loan growth, as banks take time to restructure old loans and new firms wait to see evidence of consumer spending before borrowing anew. But this is typically an argument made after a recession. It is difficult to reconcile why bank loan growth has slowed already, since it is now generally established that the prior increase in credit spreads and funding costs did not impact US real GDP broadly to a meaningful extent. Could non-bank financing be crowding out bank financing to skew these numbers lower? This may matter somewhat, but many small US businesses with no access to capital markets must rely on bank financing if they wish to expand their businesses. Bottom line, we need to see loan growth picking up again.
Lastly, we believe there is significantly more political risk than many investors are appropriately pricing. We see the prospect of future protectionist policies from the new administration has the potential to be a key headwind, and our conversations with clients suggest this is not being taken seriously enough. A September 2016 paper by now Commerce Secretary Wilbur Ross and National Head of Trade Council Peter Navarro indicates a desire to reduce the US trade deficit meaningfully. The authors wrote in this report that “Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war.” On the concept of tariffs, Mr Ross and Navarro wrote that “tariffs will be used not as an end game… Trump will impose appropriate defensive tariffs to level the playing field.” The authors believe that deregulation, lower taxes, lower energy costs, and a strong US bargaining position would offset any price increases and retaliation from increased protectionism, leading to a boom in US growth. However, we view any aggressive move to reduce the US trade deficit near-term via perceived protectionist measures would likely create considerable volatility in financial markets." - source UBS
You probably understand by now why our bullet point is entitled "From optimism bias to realism bias". It is important at this stage of the credit cycle to keep a heavy dose of realism. As we mentioned as well in numerous conversations we are tracking closely US Commercial Real Estate (CRE) particularly in the light of significant tightening financial conditions as depicted in the most recent Senior Loan Officer Survey. In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%. As a reminder in our February 2016 conversation "The disappearance of MS München", we discussed the significant headwinds for the retail sector and in particular series 6 for the CMBX index due to its larger retail exposure. We recently read with interest from an article from Matt Scully in Bloomberg from the 9th of February entitled "Deutsche Bank Says Next Big Short Is on CMBS as Malls Suffer":
"Analysts at Deutsche Bank AG, one of the biggest underwriters of bonds tied to U.S. commercial mortgages, say now it’s time to bet against the securities.
The bonds are vulnerable because they are supported in part by leases from retailers, a lagging part of the economy, wrote Ed Reardon and Simon Mui in a note this week. A combination of bankruptcies and closures could lead to faster-than-expected mortgage defaults for stores and malls, as long-term pressure from internet competitors wears many companies down, the analysts wrote.
Deutsche Bank recommends that investors bet against two series of indexes of commercial mortgage bonds: one from 2012, and another from 2013, a trade that amounts to shorting the underlying securities. Those indexes have larger exposure to malls than their more recent counterparts.
The lender famously recommended betting against real estate before. Before the financial crisis, traders led by Greg Lippmann shorted residential mortgage bonds, which helped the lender weather the global banking meltdown. His efforts were portrayed in the book and movie “The Big Short.”
Falling Index
In this week’s note, Deutsche Bank advised buying credit default protection on the parts of CMBX indexes that are a single step above junk, known as the BBB- tranches. Morgan Stanley recommended betting against portions of those indexes last week. The BBB- rated portion of the 2012 Markit CMBX price index, known as the series 6, has been falling since the end of January.
That index traded at 90 cents on the dollar on Wednesday, compared with 95.2 cents on the dollar on Jan. 27, according to data compiled by Bloomberg. The price has dropped as wagers on the index have climbed in recent weeks, reaching $2.3 billion at the end of last week, according to Depository Trust & Clearing Corp. data.
Deutsche Bank was the biggest underwriter of commercial mortgage bonds in 2012 and 2013, selling about a fifth of the deals, according to trade publication Commercial Mortgage Alert. Buying default protection on the CMBX indexes from those years amounts to betting against many of the bonds the bank sold during that period.
Commercial mortgage bonds that the bank underwrote have performed worse than those of many rivals, said Don McConnell, a senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. Of property securities that are delinquent, 40 percent were underwritten by Deutsche Bank, the highest of any lender, even though it is the second-biggest underwriter, he said. JPMorgan Chase & Co., the biggest underwriter, accounts for 10 percent of delinquencies.
Failing Malls
More losses may be coming. The Hudson Valley Mall went into foreclosure last year after Macy’s Inc. and J.C. Penney Co. left the mall. The mall liquidated last month at a $42 million loss to investors -- by far the largest realized loss since the CMBS market restarted in 2010, according to Morningstar Credit Ratings. Sears Holdings Corp.’s credit rating was recently cut further into junk territory after sales in stores open at least a year fell 12 to 13 percent during the holidays.
“Big mall loans have outsize losses for investors,” said Morningstar analyst Edward Dittmer. “We expect the stores like Sears, Macy’s and Penney to close more stores later this year and next year, and as they close, there will be knock-on effects that lead to other mall tenants leaving. This can start the cycle of blight.”- source Bloomberg

While CMBX Series 6 saw it prices recover somewhat following the volatile first semester of 2016, the recent price action in conjunction with the weaker Senior Loan Officer Survey does suggest that there is indeed more pain coming for the sector and it is already playing out in this particular CMBX series. This as well documented in Bank of America Merrill Lynch's latest Securitized Products Strategy Weekly note from the 10th of February;
"Recap & relative value
With benchmark conduit spreads unchanged, no private label deals pricing and only one conduit transaction in the marketing process, the majority of this week’s conversations remained focused on the retail sector. Over the past two weeks short-risk interest in lower-rated CMBX6 tranches surged (Chart 45), fueled by a consensus among some hedge funds that retail and regional mall problems will accelerate in the coming months.
As a result, lower-rated CMBX6 tranches, which are collateralized by about 37% retail exposure, have borne the brunt of the pain (Chart 46), falling by as much as 3.5 points since the beginning of the month.
Although retail sector problems will likely continue to unfold over the coming months and years, it is important to understand what sparked the recent selloff. Over the past two weeks there has been some negative retail-related news (Wet Seal, LLC, filed for bankruptcy on Feb 2, Hudson’s Bay Co. approached Macy’s about a takeover, etc.) and the recent broader-market risk-rally stagnated as evidenced by range bound equity markets and falling 10-year Treasury yields and breakevens (Chart 47).
Ultimately, however, we think the recent move lower in the CMBX wasn’t based on new, fundamental information. Despite the selloff among lower-rated CMBX6 tranches over the past few weeks the underlying cash reference obligations have held in extremely well: there has been little client selling and cash bond spreads have barely moved. As a result, the BBB-minus and double-B cash/synthetic spread differential gapped sharply negatively (synthetics underperformed the similarly rated cash bonds) and (Chart 48) and are now testing, or through, their tightest historical ranges.

This isn’t to say that problems don’t exist. The regional mall space is likely to consolidate over the coming years, which may put pressure on some of the loans collateralized by these assets. Aside from those investors that are using lower-rated CMBX6 tranches to hedge their long-risk books (as some distressed investors do), in order for the “short CMBX6.BBB- or CMBX6.BB” trade to work successfully for an investor that is selling risk outright, the retail sector would need to experience a significant, large shock that has systemic implications to serve as a catalyst. The most commonly mentioned catalyst by many investors would be a near-term bankruptcy of a large retailer. Among retailers, Sears tends to be one that many investors focus on, given the company’s broad-based regional exposure in regional malls and the difficulties that it has experienced over the past few years.
Over the past few weeks, however, no new negative announcements have been made by the company that could have sparked renewed downward pressure on the CMBX. In fact, the company today issued a press release in which it announced it initiated a restructuring program targeted to deliver at least $1 billion in annualized cost savings in 2017. This is not to say that all is fine: although 4th quarter earnings were better than expected, total comparable store sales for the fourth quarter declined 10.3%, comprised of a decrease of 8.0% at Kmart and a decrease of 12.3% at Sears Domestic.
Ultimately, there are several independent “variables” that need to play out simultaneously for an outright short-risk CMBX6 trade to work as well as many hedge fund investors hope it will. In all likelihood, we think this is unlikely to happen. Instead, we think lower-rated CMBX6 tranches will trade in a wide range over the upcoming months and be exposed to potentially significant price fluctuations – both higher and lower – as investors react to headlines. At this point, following the magnitude of the recent move, which began at the end of January (Chart 49), we think the lower-rated CMBX6 tranches are over-sold and could rally as investors get short squeezed.

Given the lack of material, significant fundamental news, this week’s move seems largely technically driven. Over the past few weeks we’ve analyzed the regional malls collateralizing the CMBX6 and last week looked at loss severities for mall loans that were liquidated last year (Regional mall rhetoric has become too negative). One additional data point that we didn’t discuss, but which we think is important, relates to the timing between when loans first show signs of stress and when they were ultimately liquidated. Although this may not matter for investors shorting CMBX6 as a trade, it is important to investors shorting the index outright, since losses would need to be crystalized in order to receive a payout. On average, for the loans liquidated in 2016 that were collateralized by regional malls, it took approximately 48 months between when loans first began to show signs of stress and when they were ultimately liquidated" - source Bank of America Merrill Lynch
So, while no doubt, when it comes to the retail sector there is blood in the water and sharks are starting to circle, it appears to us that in this particular case "someone" is effectively "talking his book". While some pundits might eagerly follow the "Optimism bias" course of action with that "short" trade idea, we would rather side with Bank of America Merrill Lynch and play the "Realism bias" given the potential for the enthusiastic punters to get "short-squeezed" in very short order on that move.

For our final chart and when it comes to being more a "realist" the recent significant widening in French yields have been explained by many pundits by the sudden rise in the political risk in French from seeing Marine Le Pen getting elected at the next presidential election in France. For us, as we have been explaining in numerous conversations, when it comes to European government yields, you seriously need to track the flows from Japan.

  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends
In 2016, in numerous conversations we have indicated the importance of tracking Japanese flows from the Government Pension Investment Fund (GPIF), their Lifers friends and Mrs Watanabe playing it through the famous Uridashi retail funds. We believe that in 2017, following Japanese flows is paramount when it comes to assessing yield movements in European government bonds. While the political rational might be enticing for some, for us it is simply a question of flows, or lack thereof, from the voracious 2016 Japanese investors which have been on a diet as of late. Our final chart comes from Bank of America Merrill Lynch Japan Rates and FX Watch note from the 8th of February and displays the cumulative purchase of European sovereign bonds by Japanese since 2012 (JPY trn):
"FDI and portfolio outflow offset current account surplus
Today Japan's Ministry of Finance (MoF) released international balance of payment statistics for December and a preliminary portfolio investment report for January (based on reports from designated institutions). The seasonally adjusted current account surplus was ¥1,669bn, somewhat lower than in November (¥1,780bn), but still a high level. The current account surplus for CY2016 was ¥20.6trn, and direct investment deficit of ¥14.6trn cancelled out most of this. The ¥30.5trn deficit in portfolio investment is sizable, but a significant part of this portfolio investment should have been hedged. This pattern of investing surplus funds overseas and using the profits to fund the home country reflects Japan’s status as an aging developed country. Also, due to the rising number of foreign visitors to Japan, a surplus of ¥1,339.1bn was recorded in the travel account, the largest such surplus since 1996.
The Trump shock’s aftereffects and Europe’s political risk
The rise of US yields following the US presidential election appeared to settle down around the beginning of 2017, but Japanese investors continued to sell a net ¥1.62trn of foreign bonds in January. Banks were the main sellers. They were net sellers of ¥1.97trn in one month. Life insurers, who had been net sellers along with banks in the previous month, switched to a net purchase of ¥159.8bn in January. Details of flow for January have not been released yet, but we do know from December figures that the net sale of US Treasuries was ¥2.39trn that month, the largest since May 2013." - source Bank of America Merrill Lynch
So if indeed in the Land of the Rising Sun, the sun is in fact setting on their appetite for European sovereign bonds, then no doubt you might get your equivalent of a Carrington Event and solar storm in European bond land we think. It might simply be that "Bondzilla" the NIRP monster might have a serious case of "bond" indigestion after his epic fest of 2016, but we ramble again...

"The world is divided into two classes, those who believe the incredible, and those who do the improbable." -  Oscar Wilde

Stay tuned !

Friday, 3 February 2017

Macro and Credit - The Sokal affair

"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." -  Isaac Newton

Looking at the recently released minutes of the Fed's latest FOMC and its dovish impact on the US dollar in conjunction with the new US administration war of words, not only validating our solitary contrarian stance so far against the US dollar bullish crowd but, as well rewarding us for our late December gold/gold miners positioning, made us reminder for our chosen title analogy the Sokal affair, 

Given our fondness in recent musings in anything relating to hoaxes, the Sokal affair, also called Sokal hoax, was a publishing hoax perpetrated by Alan Sokal, a physics professor at New York University and University College London. In 1996, he submitted an article to Social Text, an academic journal of postmodern cultural studies, to test the intellectual rigor and, specifically to investigate weather "a leading North American journal of cultural studies - whose editorial collective includes such luminaries as Fredric Jameson and Andrew Ross – [would] publish an article liberally salted with nonsense if (a) it sounded good and (b) it flattered the editors' ideological preconceptions". The article, "Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity", was published in the Social Text spring/summer 1996 "Science Wars" issue. It proposed that quantum gravity is a social and linguistic construct. At that time, the journal did not practice academic peer review and it did not submit the article for outside expert review by a physicist.  On the day of its publication in May 1996, Sokal revealed in Lingua Franca that the article was a hoax, identifying it as "a pastiche of left-wing cant, fawning references, grandiose quotations, and outright nonsense ... structured around the silliest quotations [by postmodernist academics] he could find about mathematics and physics."

The hoax sparked a debate about the scholarly merit of "humanistic commentary" about the physical sciences; the influence of postmodern philosophy on social disciplines in general; academic ethics, including whether Sokal was wrong to deceive the editors and readers of Social Text; and whether Social Text had exercised appropriate intellectual rigor. In response to the heavy criticism received by the editors of Social Text, Sokal said that their response illustrated the problem he highlighted. Social Text, as an academic journal, published the article not because it was faithful, true, and accurate to its subject, but because an "Academic Authority" had written it and because of the appearance of the obscure writing:
"My goal isn't to defend science from the barbarian hordes of lit crit (we'll survive just fine, thank you), but to defend the Left from a trendy segment of itself. ... There are hundreds of important political and economic issues surrounding science and technology. Sociology of science, at its best, has done much to clarify these issues. But sloppy sociology, like sloppy science, is useless, or even counterproductive."
You are probably asking yourself once again, where we are going with this analogy of ours, but, it appears to us that the Fed, and other central bankers, are "making it up" as they go along. Given most of them are "Academic Authorities", so, when it comes to the Fed's FOMC latest statement we reminded ourselves of the "wise" words of former Fed supremo Alan Greenspan:
"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant"
In similar fashion, in relation to our central bankers and their hoaxes, sloppy economics beliefs based on sloppy "science" is useless, even counterproductive to paraphrase Sokal.  On that very subject we recommend you read John Mauldin's recent article "Post-Real Economics". 

As one of our loyal readers "kertch" commented in our recent musing "The Woozle effect" on Seeking Alpha, more and more "Academic Authorities" in central banks are indeed making claims that are entirely contrary to the basic principles of economics:
"Wozzle is a much more specific and descriptive term. It was revealed recently that the entire decades-long crusade against saturated fat was based on a Wozzle and has no basis in fact. I also now see economists make claims that are entirely contrary to the basic principles of economics. When will we see scientists make claims that are entirely contrary to the laws of physics? (Actually that has already begun - don't get me started!) It seems that the principles of logic and mathematics (statistics) that apply to basic research have become irrelevant relics of another time and social paradigm. Scientific method in our culture is badly in need of a Renaissance."
By now you probably understand where we are going with our Sokal affair analogy given that the same "Academic Authorities" which are at the helm of central banks are less and less challenged in their economic assertions by the Mainstream Media (MSM). Furthermore, on our recent musing "The Ultimatum game", same reader "kertch" made some very interesting points in relation to principles of economics and scientific rigor that is badly lacking in economics nowadays:
"I think once again economists have jumped to the same mistaken cause/effect conclusions with the idea of "Aging Nations Like Low Prices Over High Incomes" as they did with the Phillips Curve. They go on to link the phenomenon to a decreased demand for durable goods and property. I have seen no evidence of this in countries with an aging population. In fact the opposite appears to be the case. First, it is premature to conclude that demographics is the culprit. It is more likely that economic development drives demographic trends and the accumulation of capital assets, as every nation that has achieved a high level of economic development develops almost the exact same trends. Perhaps when economists stop seeing the economy as some rigid machine where moving a lever causes a knob to turn, and turning the knob causes said lever to move, they will start paying attention to cause and effect, and asymmetric, non-reversable functions. As I've said before, it's a field were logical and scientific rigor is sadly lacking."
Exactly, in similar fashion, one could argue that Thomas Piketty much vaunted book "Capital in the Twenty-First Century", lack logical and scientific rigor but we would be rambling again in that instance...

In this week's conversation, we will look again at what the rise of protectionism entails in terms of allocation and risk and why so far we think our solitary contrarian stance (short US dollar, long gold/gold miners, long volatility) and defensive stance has more to run.

  • Macro and Credit - Trump told you so folks
  • Final charts - Deglobalize me

  • Macro and Credit - Trump told you so folks
In recent musings we have delved into the "optimism bias" of the "consensus crowd" being long the US dollar, long oil, short volatility, short US Treasury notes to name a few. We have argued we were not "buying" it, hence us playing the "devil's advocate" or as some left wing pundits would argue the "Trump advocate". 

As reality settles in given "Mack the Knife" aka King Dollar + positive real US interest rates is year to date down 4% and our gold mining stance up around 16% (GDX) as we type, we think it is high time you reconsider the risk of trade war escalation and what it entails for a variety of asset classes.

On the rising risk posed by US protectionism we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 2nd of February entitled "Playing with fire - the FX implications of US trade protection":

"He told us so
What if Trump does what he has said on trade policies? The so-called Trump trades, and particularly the USD, have seen a correction this year, as President Trump’s rhetoric has shifted toward trade protection. Our baseline assumes the US will avoid such policies, but we also see risks and markets could get more concerned in any case. This is consistent with a volatile but still upward USD trend. However, it is worth discussing the possible market reaction to potential US trade protection and how to hedge. This is just a first look, as a lot would depend on policy details and the potential reaction of the rest of the world.
We recommend hedges that could do well even in our baseline scenario of no trade protection. We consider three main scenarios of de-globalization: higher US trade protection; a global trade war; and a major repatriation of flows. Our analysis suggests that JPY, USD, and NOK would benefit in most cases, particularly against AUD, CAD, MXN and KRW—USD/JPY would weaken. However, for investors who do not expect such extreme scenarios but would still like to hedge their long Trump trades, our analysis supports being long the USD against AUD and CAD in G10, and against KRW in EM.
Trade protection and the Trump trades
The so called Trump trades, and particularly the long USD trade, have seen a correction this year. This is to a large extent because President Trump has gone back to his tough pre-election rhetoric against free trade. In one of his numerous recent tweets on the subject, he warned that “car companies and others, if they want to do business in our country, have to start making things here again. WIN!” In his inaugural speech, he said "we will follow two simple rules: buy America and hire America," adding "protection will lead to great prosperity and strength." This week, Trump and members of his administration accused Germany and Japan of manipulating their currencies to keep them weak. Indeed, the market correction started after President Trump’s first press conference after the elections, on 11 January, where he used strong rhetoric against US companies that invest abroad and then export to the US. This contrasts with his speech after he won the November elections, when he focused on fiscal stimulus and other market-friendly policies.
Our view is that the market is still pricing a benign scenario, in which the new US administration delivers fiscal stimulus and deregulation, but does not go ahead with trade protection. The market remains long the USD, despite the recent adjustment. The VIX index is at historically low levels, despite its latest increase. Global equities remain at historical highs, even after its correction this week. EM FX has been somewhat volatile, but without a clear trend this year. If anything, our flows reflect some buying in EM FX.
This is consistent with our baseline as well, but we do see risks. We have been arguing that the balance between fiscal stimulus and trade protection in the first 100 days of the Trump administration will determine the outlook of the Trump trades and of the USD. We remain constructive on the USD, as we expect President Trump to deliver on fiscal policy and not turn to trade protection. However, even in this scenario, we do not expect a substantial further USD rally, as the USD is already strong and the US government would also push against an excessively strong USD. Moreover, we have been flagging high uncertainties, as we are increasingly concerned about the strong rhetoric against free trade and free FDI coming from the US. Our baseline expects a volatile USD path upward. USD bulls should be more tactical, in our view.
In this context, we discuss which of the G10 and major EM currencies could be at risk in a scenario where we are wrong and President Trump does what he has said on trade policy and increases protection. Of course, a lot would depend on the details and on how the rest of the world reacts in this case. This is a first and very basic approximation but one that can provide insights even for a scenario in which the US does not increase trade protection but markets get more concerned about such a risk.
“What-if” scenarios of trade protection
Global trade is already on a declining trend. Following an almost smooth upward trend in recent decades, the share of global trade to GDP is now below what it was 10 years ago (Chart 1). After a V-shaped move following the global crisis, it has been falling recently.

This is a concern, as empirical evidence suggests international trade and economic growth reinforce each other. A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off.
Focusing on US trade policies, trade protection would hurt Mexico and Canada the most. China and the Eurozone export more to the US (Chart 2).

However, as a share of their GDP, Mexico and Canada stand out (Chart 3).
We believe MXN already reflects Trump policy risks, but we have been arguing that CAD underestimates such risks.
If we consider a very adverse scenario, in which protectionist trade policies in the US potentially trigger a global trade war, KRW, MXN and CAD could be affected the most.
• Looking at openness to trade as defined by the share of total exports and imports to GDP, the countries most vulnerable to a potential pull-back of global trade include Hungary, Czech Republic, Switzerland, Korea, Poland, Sweden and the Euro zone (Chart 4).

However, most of the European trade is intra-regional and it is safe to assume that protection within Europe will not increase—the region could still suffer if global supply chains get significantly disrupted. Excluding Europe, Mexico and Canada also stand out.
• Looking at the FDI net inflows as a share to GDP, the countries that will be affected the most by a pull-back include Switzerland, the Euro zone, Hungary, Brazil, Australia, Canada and the Czech Republic (Chart 5).

• Combining these two measures, this analysis will suggest negative risks for CAD, MXN and KRW, particularly against USD and JPY (Chart 6).
HUF, CZK, CHF, PLN, and EUR could also be at risk if global protectionism affects European exporters—our CEE baseline is bullish, as these currencies are undervalued and will benefit from a hiking cycle.
Considering an even worse scenario, in which trade protection triggers a repatriation of flows, Norway, Switzerland and Japan would receive most of it as a share of their GDP (Chart 7).

These are the economies with the largest net international investment positions relative to GDP by far. We would therefore expect NOK, CHF and JPY to appreciate in such a scenario, particularly against NZD, AUD, MXN and TRY.
Bottom line
Putting everything together, our analysis suggests investors who would like to hedge a tail risk scenario of a move away from globalization and toward trade protection should be long JPY, USD, and NOK against AUD, CAD, MXN and KRW. USD/JPY would also weaken in this case.
As the scenarios we have considered are extreme and mostly tail risks, we would prefer to focus on hedges that can do well even if these risks do not materialize and the USD rally continues. In this context, we would be long the USD against AUD and CAD in G10 and against KRW in EM. We remain constructive in CEE and we would avoid shorting MXN, as it could do well in a free-trade scenario." - source Bank of America Merrill Lynch
Obviously our contrarian stance sits opposite to Bank of America Merrill Lynch's baseline scenario and the "optimism bias" of the long US dollar "herd mentality". In prolongation to what we posited in our last missive, we would tend to agree with their tail risk scenario, in the sense that the dislocation in volatility between EURJPY versus USDJPY has been at the cheapest levels relatively in past decade as indicated by Bank of America Merrill Lynch previously quoted FX Vol trader note entitled "USD vols are relatively overvalued". Regardless of the Fed's monthly FOMC "Sokal" hoax, we tend to focus on what is "cheap" from a "relative basis" perspective to what is "crowded" such as long US dollar from a positioning perspective. As we pointed out last week:
"If indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think" - source Macronomics, January 2017.
While at this juncture, FX wise we have recommended going against the dollar bullish consensus, in relation to the "Big Short" aka the short US Treasury speculative short positioning, we have yet to fall meaningfully enticed to the other side for the time being, at least until we see the Japanese GPIF, Lifers and others coming back to play in size, but obviously this is depending on some adjustment in the currency basis.

Moving on to "credit", as we pointed out in last week's final chart, it seems to us that currently High Yield is indeed "priced for perfection". As we indicated, we will be tracking very closely what credit spreads will do in the coming weeks. Yet, flows remain supportive for now and so does the shape of the CDX High Yield CDS index, a proxy for High Yield in the derivatives space. As pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of January entitled "So far so good...inflows across the board", investors have continued playing the "beta" game:
"YTD flows – inflows across the board
So far this year, amid a rising rates environment, investors have favoured higher yielding pockets of the fixed income world. Both EM debt and HY funds recorded strong inflows YTD. However, the ECB QE backdrop remains positive for IG and government bond funds; at least for now. Equities have started on the positive territory, but the pace is still slow (Chart 1).

Over the past week…
High grade funds continued on a positive trend for the second week in a row. However the flows trend remains below what we have seen before tapering fears emerged. High yield funds saw inflows for the ninth consecutive week, and the asset class has accumulated more than $4bn of inflows since the start of the year. However, looking into the domicile breakdown, as Chart 13 shows, the inflow last week came only from US domiciled and globally-focused funds, while the European-focused funds inflows were very marginal.

Government bond funds had their second week of outflows amid rising rates; albeit very small. Money market funds weekly flows were negative for the third week in a row, while the outflow trend is strengthening. Overall, fixed income funds recorded a strong week of inflows, the highest in 27 weeks and the sixth positive in a row.
European equity funds flows were positive for a second week showing signs of moderate strengthening. Last week’s inflow was the highest in 11 weeks. However note that this pace is much slower than the inflows strength seen during 2015.
Global EM debt fund flows flipped back to positive territory after a brief week of outflows. Last week’s inflow was also the strongest in four weeks. Dollar weakness has been beneficial for the sector. Commodities funds flow remained positive for a third week in a row, but the inflow pace has slowed down.
On the duration front, inflows continued in short-term IG funds for the seventh week in a row. However the pace of the inflows has slowed down notably over the past weeks. Mid-term funds’ large outflow couple of weeks ago was partially reversed recording the biggest inflow in 13 weeks. On the other hand, flows into long-term funds remained downbeat recording an outflow for a second week." - source Bank of America Merrill Lynch
It is no surprise to see, credit investors playing "defense" and rotating into shorter duration funds given that last year, during the second part they had increased both credit risk and duration risk as well. As we mentioned earlier, we are very wary about Japanese flows and appetite for foreign bonds which have been dwindling as of late following a record 2016 take up. Data from Japan’s Ministry of Finance confirmed this week that Japanese investors sold around ¥1.3 trillion ($11.54 billion) in foreign bonds between Jan. 21 and Jan. 28, taking net sales for the last 12 weeks to over ¥3.7 trillion, the largest amount since April 2014 according to the Wall Street Journal. This is as well confirmed by the latest Nomura JPY Flow Monitor note from the 2nd of February 2017:
"MOF international weekly capital flow data (22 - 28 Jan)
Japanese investors were net sellers of foreign bonds again last week for the second week in a row. The net selling accelerated to JPY1359bn ($11.9bn) from the previous week (JPY538bn), recording the biggest net selling since March 2016.

Uncertainty on the US policy stance remains high, while US yields have been rising again since mid- January, which has likely discouraged Japanese investors from increasing their foreign bond investment for now. Seasonally, foreign bond investment by insurance companies tends to slow in Q1 too, as the fiscal year-end approaches. January foreign portfolio investment by investor type data are scheduled next Wednesday, which will show the major contributors to the relatively large net selling of foreign bonds last week.
Japanese investors resumed their purchases of foreign equities for the first time in two weeks. They bought JPY125bn ($1.1bn) of foreign equities last week. This suggests the underlying Japanese appetite for foreign assets remains strong, although they had been large net sellers of foreign bonds over the past two weeks.
Foreign investors continued selling Japanese equities for the second week in a row (JPY144bn or $1.3bn), although the pace slowed from the previous week (JPY376bn). Their fixed income investment was mixed, purchasing long-term Japanese bonds (JPY446bn or $3.9bn) while selling short-term bonds (JPY586bn or $5.1bn)." - source Nomura
This could have serious implications should this trend continue. It represents not only a headwind for immediate further compression on US Treasuries yield, but, as well, it is adding pressure on the US dollar and could as well generate, contrary to what is expected by many, a rebound in the Euro in short order.
Furthermore, when rates move up, while it can be even more supportive for Euro High Yield, it represents a significant headwind for already expensive European Investment Grade thanks to the convexity factor credit wise. In conjunction with rising inflation, it is in short a bad recipe. This is clearly explained by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 1st of February entitled "When rates move up":
"Rising rates are supportive for high yield credit
Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade as flows into high grade funds were accelerating vs flows into govies. We find that there is a strong correlation between the rates trajectory vs. the flows differential between high-grade and government bond funds. We also find that flows tend to exhibit a “barbelling” trend, when rates advance, and vice-versa. Amid a rising rates backdrop, we see that the balance of flows in the fixed income market will likely favour high yield and govies more than flows into high grade funds.
High yield credit tends to beta-outperform its high grade counterpart in a rising rates environment. We prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Crossover.

Rising peripheral risks are under-priced in credit
European credit spreads have always been well correlated to peripheral risks (chart 1). The recent move higher in BTPs vs Bunds has not been unprecedented; it has been experienced before the PSPP-era, but also briefly in late November 2016. The common ground in both cases was that credit spreads were a lot wider. Even compared to last November levels, credit spreads were ~10bp wider, when Italian 10y yields were at the wides vs Germany. We feel that the move in rates is under-priced in credit spreads at these levels. This is also taking place as Greek government bond yields are rising again over the past couple of days.
Rising rates and credit performance
The world economy is in sync mode. Global QE across the Fed, ECB, BoJ and BoE, have resulted in a well synchronised rebound in economic data. Surprise indicators are also pointing to the strongest rebound globally. The reflation trade is strong across Europe and US with rates moving higher. The global QE is reaching “peak strength” this quarter. However, the reflation knock on effect is ultimately negative for credit, according to our analysis. Credit spreads tend to react negatively in periods of rising inflation. Fund flows are also pointing to the downside, as higher rates hit high-grade fund flows more than flows into government bond funds and high-yield debt. Barbelling your portfolio in risk-terms can be the solution. High yield credit tends to beta-outperform its high grade counterpart.
Can a policy mistake be the driver of a trend shift?
Inflation is picking up; but unfortunately it is not the core inflation trajectory that is trending higher. Headline inflation is picking up over the past months on the back of higher commodity, and more importantly oil prices. As our economics team has been highlighting this is the “bad” inflation that is decoupling and surprising to the upside. Low and sticky nominal wage growth means that purchasing of consumers suffers again very soon; and populism continues to rise. 
The recent ECB meeting highlights the discrepancy between a very dovish message and a hawkish monetary policy (QE tapering from April), we think. Should headline inflation keep trending higher on the back of higher energy prices; we see higher risks of another policy mistake.
The credit market has historically been very well correlated to inflation trends.
• In chart 7, we find that the year-on-year changes in core inflation across Eurozone countries and the year-on-year changes in iTraxx Main non-fins 5y spreads are well synchronized. This has been the case especially in the period since the GFC were the central banks started unleashing their quantitative easing programmes.
• The same stands for headline inflation trends. However, should one look at the trend of headline inflation, there is a clear decoupling over the past year from that of credit spreads (chart 8).
It is notable that the credit market is still focusing on core rather than headline inflation. But at current levels, we fear that a policy mistake, like the one of the forthcoming April tapering decision, will ultimately be negatively received by credit investors.
Credit is mispricing the current headline inflation pick up
Chart 8 is depicting the decoupling between inflation and credit spreads trajectories.

To normalise these moves we employ a z-score analysis, presented in chart 9.

We find that the current “richness” of credit spreads trend vs. that of headline inflation is the highest it has been in almost a decade.
Looking back in times when this dislocation - between credit spreads and HICP - has been that strong, we find that the future credit market performance was not that positive. The previous peaks in “richness” have been in October-07, March-10 and March-11, as per chart 10. Remember that subsequently post reaching these peaks, credit spreads have always moved wider over the following months.
Downside risks on credit flows as rates move higher
The forthcoming “peak” of the QE positive backdrop is not our only source of concern. Fund flows into high-grade funds are negatively impacted amid a rising rates environment too. In our analysis we find that the higher the yield one can source from the government bond market - deemed as “risk free” - the lower the need to hunt for “quality yield” via the IG credit market.
We compare cumulative flows trends in high-grade and government bond funds vs. the level of “risk-free” rates. For the fund flows we use EPFR data as per our weekly Follow the Flow publication, and we use the 5y bunds generic yield to track the trends in the European rates market.
Historical evidence shows that:
• Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade according to our analysis (chart 11).

Note that there is a strong leading indication (6 months) of the rates trajectory vs. the flows differential between high-grade and government bond funds (in relative terms, % of AUM).
• There is a critical level in the rates market that prompts a shift into “quality yield” (i.e. high-grade credit) we think. This force kicks in when 5y bunds dip below the 1% handle (chart 12) it seems.

At the end of 2011, at the heights of the sovereign crisis, the lack of yield in the “risk-free” market (i.e. bunds) and the subsequent OMT moment, six months later, prompted a strong reach for “quality yield” and inflows accelerated into IG bond funds. We are still far from that level, but the trend is clear from here.
The solution to higher rates = barbell your portfolio
In 2016 we saw the lowest in yields and spreads. We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe. We expect that as rates will continue higher from here in the years to come (more in the latest Global Rates weekly) this will have a strong effect on flows across fixed income pockets. We think that flows  into govies and HY credit funds will fare better than flows into high-grade ones." - source Bank of America Merrill Lynch.
While both the Fed and the ECB might continue with their Sokal hoaxes, it appears to us that the recent shift from investors towards shorter duration is clearly a manifestation of a defensive stance, which could be further validated by the weakness in the support from overseas investors such as Japanese investors. Where we slightly disagree with Bank of America Merrill Lynch's take is that, if indeed there is some short term correction in equities, it is hard for us to expect that a move wider in European High Yield could be avoided thanks to its inherent strong correlation to stock movements. Though, from a convexity perspective, High Yield should be less immune than Investment Grade with rising sovereign yields, should equities remain stable in the coming weeks.

As a reminder from our August 2013 conversation "Alive and Kicking":
"Moving on to the subject of convexity and bonds, how does one go in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.
The downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages.
Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.
With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger... " - source Macronomics, August 2013
Therefore you now understand why Bank of America Merrill Lynch prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Itraxx Crossover. We totally agree on this and it makes perfect sense.

Finally for our final chart, rising populism has gone hand in hand with protectionism (that 30s feeling we talked about...) hence renewed inflows into the "barbaric relic" aka gold which, we hinted, we had been adding since late December.

  • Final charts - Deglobalize me
In numerous convcrsations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Our final charts come from Bank of America Merrill Lynch from their European Credit Strategist note from the 2nd of February and entitled "Unwinding globalization". The first chart displays the eerie calm in the VIX index while gold inflows have been surging. The second chart shows the growing theme of protectionism in Developed Markets (DM):
"Unwinding Globalization
Protectionism has been the buzzword over the last few weeks, and much of the narrative has been emanating from the US. Since President Trump’s inauguration, executive orders have been signed to repeal free trade deals and to temporarily restrict certain forms of US immigration. Add to this the growing comments from the Republican administration around foreign countries’ weak currencies, and perhaps the post-Lehman vision of globalization has never felt more challenged. And as the rest of the world looks on, the risk of retaliatory protectionist rhetoric – or actions – grows.
While stocks and corporate bonds have rallied year-to-date, we see a very “incongruous” kind of calm in the markets at present. Note, that while equity volatility is still hovering around record lows, inflows into gold funds year-to-date in Europe have surged (chart 1).
In reality, the trends of protectionism – or “deglobalization” – have been bubbling for a while. Plenty of protectionist measures have in fact been put in place by countries around the world in the aftermath of the Global Financial Crisis – albeit ones not as dramatic as directly repealing free trade agreements. Rather than just tariffs and trade defense measures, governments appear to have become more imaginative in avoiding WTO disciplines. And over the last few years, more overt trade spats and protectionism have been seen (such as the EU’s and China’s issue over solar panels in 2013).
Chart 2 shows the countries that have implemented the most protectionist measures since 2005. Note that the US and the EU head the list. Moreover, the WTO’s trade monitor from June last year highlighted that for the 2015-2016 reporting period, trade restrictive measures had jumped to the highest monthly average on record.

Yet protectionism, in our view, is inherently inflationary in nature. As Chart 3 shows, just as globalization is being challenged by leaders, the world is more “connected” than ever at present.
Corporate supply chains have branched out across the globe over the last 10 years. And free movement of goods, services and labour have been an additional boon for corporate profit margins.
But if protectionism cuts back the tentacles of global supply chains – be it through higher tariffs, border checks or restricting worker migration – then corporates stand to be made less efficient via a rising cost base. Thus to preserve corporate margins, output prices will need to rise…" - source Bank of America Merrill Lynch

So, all in all, regardless of the Sokal monthly hoaxes from our central bankers, can you spell "stagflation"? Because we certainly can...

"Truth emerges more readily from error than from confusion." -  Francis Bacon

Stay tuned!

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