Thursday, 13 December 2018

Macro and Credit - Mithridatism

"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus

Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. 

The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. 

For example, the Australian Koalas' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:

Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed 
While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend Carl Hodson-Thomas Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.

In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.

  • Macro and Credit - 2019: When the central banks are no longer your "friends"...
  • Final chart -  Did the Fed already break something?

  • Macro and Credit - 2019: When the central banks are no longer your "friends"...
As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:
"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter
Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "Investors Bet $10 Billion Against Popular Bond ETFs":
"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ
Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence.  The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "Zollverein" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.

Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):
"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.

Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said."
 - source Financial Times

There is more pain to follow we think in 2019. As we pointed out in our November conversation "Zollverein", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":
"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:
- source Bloomberg - Lisa Abramowicz - twitter

The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.

In their most recent blog post on the 12th of December, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:
"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple
In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.

The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:
"Outflows have now erased the QE flow
Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE.

The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.
Over the past week…

High grade funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. High yield funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. 
Government bond funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, Money Market funds suffered again a large outflow, though half the size of last week’s.
European equity funds continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.
Global EM debt recorded a large outflow this week, the 9th in a row, in sharp contrast
with the improving trend we saw during the past 7 weeks. Commodity funds recorded a
marginal outflow.
On the duration front, we saw outflows across the entire curve, though mid-term IG
funds led the trend by far." - source Bank of America Merrill Lynch
So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.

When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:
"The Toxic Brew that threatens near term…
Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019.

2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years.

3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001.

Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch
So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.

While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.

  • Final chart -  Did the Fed already break something?
Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:
- source Bank of America Merrill Lynch

Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...

 "The true alchemists do not change lead into gold; they change the world into words."- William H. Gass
Stay tuned !

Thursday, 6 December 2018

Macro and Credit - The Sorites paradox

"Even the largest avalanche is triggered by small things." - Vernor Vinge, American writer

Looking at the pre-revolutionary mindset of my home country France, with Paris under siege as we warned about in our conversation "Last of the Romans" in mid-November, in conjunction with the very fast fading rally seen on the back of the United States and China trade war truce, when it came to selecting our title analogy given liquidity is continuing to be withdrawn by the Fed's QT, though as of late it seems they blinked, with softer global macro data including US housing, we decided to go for "The Sorites paradox". The "Sorites paradox", sometimes called the paradox of heap is a paradox that arises from vague predicates. A typical formulation involves a heap of sand, from which grains are individually removed. Under the assumption that removing a single grain does not turn a heap into a non-heap, the paradox is to consider what happens when the process is repeated enough times: is a single remaining grain still a heap? If not, when did it change from a heap to a non-heap? A common first response to the paradox is to call any set of grains that has more than a certain number of grains in it a heap. If one were to set the "fixed boundary" at, say, 10,000 grains then one would claim that for fewer than 10,000, it is not a heap; for 10,000 or more, then it is a heap. A second response attempts to find a fixed boundary that reflects common usage of a term. So the question is when is a bubble a bubble? When will QT turn the bubble into not a bubble? We wonder. Is hysteresis being the dependence of the state of a system on its history the answer? Equivalent amounts of sand may be called heaps or not based on how they got there. If a large heap (indisputably described as a heap) is slowly diminished, it preserves its "heap status" to a point, even as the actual amount of sand is reduced to a smaller number of grains. For example, suppose 500 grains is a pile and 1,000 grains is a heap. There will be an overlap for these states. So if one is reducing it from a heap to a pile, it is a heap going down until, say, 750. At that point one would stop calling it a heap and start calling it a pile. But if one replaces one grain, it would not instantly turn back into a heap. When going up it would remain a pile until, say, 900 grains. The numbers picked are arbitrary; the point is, that the same amount can be either a heap or a pile depending on what it was before the change. Also, one can establish the meaning of the word "heap" by appealing to consensus. The consensus approach typically claims that a collection of grains is as much a "heap" (or bubble) as the proportion of people in a group who believe it to be so. In other words, the probability that any collection is considered a heap is the expected value of the distribution of the group's views aka a "Quasitransitive relation", but we digress.

In this week's conversation, we would like to look at why it is increasingly important to play much more defensively as we move towards what could be a jittery 2019.

  • Macro and Credit - Don't be the last one left to pick up the "credit" tab...
  • Final chart -  Liquidity and credit spreads go hand in hand

  • Macro and Credit - Don't be the last one left to pick up the "credit" tab...
Looking at yesterday drop of 3.10% of the Dow Jones as we pointed out in our last conversation, it wasn't really that surprising given the weakening decelerating tone in global growth in general and cyclicals such as Autos and Housing in particular:
"Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end." - source Macronomics, November 2018
As well we pointed last week that if you wanted to go "short" credit, then US leveraged loans were definitely something to look at as pointed out by Lisa Abramowicz on a Twitter feed:
"Prices on leveraged loans have dropped to the lowest since 2016 even though their benchmark rate Libor has quickly risen, meaning this debt should pay out higher interest rates. This throws into question the concept of floating-rate debt as a hedge against rising rates.
 On one hand, loan investors get more income from their holdings as rates rise. On the other, the market seems to perceive the corporate borrowers as less creditworthy as their cost of financing rises. So if loan investors want to sell their holdings, they'll get a lower price." - graph source Bloomberg - Lisa Abramowicz - Twitter feed.
Indeed, liquidity is as always a "coward" and the longer you stay at the "credit" bar, the likelier you are to be shocked by "price discovery" when the credit markets will in earnest turn "South" and you will end up picking an expensive bar tab hence our call for reducing your illiquid high beta exposure.

While leverage loans are an evident target pointed out by so many investor pundits, regulators and central bankers in these days and ages, other interesting instruments such as AT1s aka called Contingent Convertibles (CoCos) as well as Corporate Hybrid bonds fit the bill when it comes to being potentially "illiquid" and harmful. Sure it's fun on the way up, pretending to generate "alpha" for your clients by playing the "beta" pure carry game, but, when the party has been extended as it has been in credit land, then again, not starting to be a little bit more "cautious" is a good recipe for asking for trouble and finding it eventually through "price discovery".

On the subject of "illiquidity" and credit we read with interest JP Morgan's Portfolio Insights note relating to the evolution of market structure. Their paper is entitled "Managing illiquidity risk across public and private markets":
"In theory, investors are compensated for this through the higher returns available in private assets over the full life cycle of the private investment. In other words, to harvest the illiquidity risk premium in private markets, investors need to be able to stay the course, weathering any variation in the cash flow profile over the full cycle. This means that cash calls would need to be funded from elsewhere in the portfolio.
The ability to accept this type of risk ranges widely across investor types. Those that may be subject to redemptions or fund withdrawals (e.g., mutual fund managers) are less able to bear uncompensated illiquidity risk than those with a long- term pool of capital to deploy (e.g., sovereign wealth investors). Further, during times of market crisis, when investors are already seeking to cut exposure to public markets, threats to liquidity are generally correlated and can compound to become a serious issue for investors. Investors could face liquidity demands arising from redemptions and a prudent desire to hold higher portfolio cash buffers. At the same time, on the private asset side there may be cash calls to finance, calls that are best covered from public assets — and thus, avoiding uncompensated illiquidity traps in public markets becomes a priority. To fully assess the illiquidity risk in a portfolio, all of these factors need to be considered holistically.
Taking high yield (HY) bonds as an example of a potentially illiquid public asset with both market and illiquidity risk, we can ask whether, over a defined time horizon, the probability of being forced to crystallize a loss under adverse liquidity conditions is appropriately compensated (see Addendum, “Modeling the cost of high yield trading under illiquid conditions”). Early in the economic cycle, when credit spreads are wide, the illiquidity premium in an asset such as high yield  credit may well offer an additional return compared with a replicating stock-bond portfolio. However, as the cycle matures and credit spreads tighten, there will come a tipping point — some breakeven level of spread — where the return in credit is not sufficient to offset the probability-weighted risk of a loss over a defined time horizon. Effectively, the illiquidity risk has at that point become uncompensated and investors may be better served expressing their desired level of market risk via a replicating stock-bond portfolio.
The scale of the potential illiquidity during times of market stress is demonstrated in Exhibit 8, again using HY credit as an example. The illiquid credit asset will suffer from wider bid-ask spreads and much reduced transaction volumes; large transactions can take considerable time to execute in markets where prices are dropping sequentially over multiple trading sessions.

Turning to private market assets, as investors have increasingly added private assets to portfolios there is commensurately more focus on the risk that they could be forced to liquidate private investments at an inopportune time to meet an additional capital call. Alternately, redemptions and other portfolio-level cash requirements may force them to exit private investments at an undesirable point. Since such events tend to occur during adverse conditions in public markets and the economy at large, the most relevant question is how bad things might really get." - source JP Morgan
Exactly, large positions can take a long time to unwind, particularly when dealer inventories are nowhere near to the level they had prior to the Great Financial Crisis (GFC).

Also as another illustration of what it would take to liquidate a sizable position of $1 billion in US High Yield in the case of a recession and where credit spreads should be to reflect that "illiquidity" premia would be significantly wider as pointed out in JP Morgan's note:
"For an investor that may need to liquidate $1 billion of high yield and anticipates any crisis to be average in its severity, credit spreads above around 270bps compensate for illiquidity risk. But if the investor’s subjective view of the probability of recession over the next year were to increase to 33%, then the breakeven credit spread required to compensate fully for illiquidity risk would jump to 320bps and as high as 398bps in a worst-case drawdown scenario. As portfolio size increases — and the potential illiquid asset trade size grows — the ex-ante breakeven spread required to compensate for illiquidity risk increases. Crucially, there is no economy of scale for illiquidity risks and, indeed, there are very apparent diseconomies of scale." - source JP Morgan
Given the significant rise in corporate credit issuance in recent years, one could conclude that current credit spreads do not reflect this "illiquidity" premium.

But, given that the Fed seems to have recently "blinked" recently following a more dovish tone at the Economics Club of NY by Jerome Powell, one could indeed think that there is still value for "credit" pickers even in US High Yield. We have long argued that as dispersion is rising in this late cycle environment, proven credit specialists in the issuer selection process would outperform the passive investment crowd. 

This effectively could dampen slightly the widening moves seen recently. On this subject we read Wells Fargo's take from their Credit Connections note from the 30th of November entitled "Honey B's":
"Credit markets continue to groan under the pressure of policy uncertainty (both monetary and fiscal), trade wars, a recent upsurge of idiosyncratic events and heavy bond supply. That said, secondary market credit spreads appear to be stabilizing after Fed Chairman Jay Powell struck a more dovish tone at his recent presentation to the Economic Club of NY. The shift was subtle and nuanced, but enough to convince markets that the Fed may slow the pace of policy tightening in the coming months. With credit spreads at year-to-date and multi-year wides, we recommend that investors start to set up for 2019 with select longs in credits poised to deleverage next year and beyond. Triple-B and double-B credits look particularly attractive to us in this environment.
The build-up of debt, increased borrowing costs and tighter monetary policy suggests that a growing number of companies will need to focus on deleveraging and balance sheet repair next year to preserve credit ratings and ensure ongoing access to capital markets. While this might not be great news for the economy it should certainly help the overall credit worthiness of the corporate sector and allow credit spreads to compress (somewhat) after a year of sustained widening. Conversely, those companies that cannot or will not address balance sheet issues will find a much less forgiving investor base and considerably higher borrowing costs. In this environment credit selection is paramount.
Funding Pressures
When considering which companies have the greatest urgency to deleverage it is helpful to look at the distribution of debt maturities. The term structure of maturities is a simple analysis to look at when companies are faced with refinancing pressures. At a high level, the amount of refinancing risk faced by IG companies is considerably greater than the risk faced by HY companies over the next three years. As the charts below show, about $2.2 trillion of investment grade debt is scheduled to mature 2019-2021.

This represents about 30% of all outstanding IG debt, with roughly 53% owed by non-financial companies and 47% owed by banks, insurers, financial companies and REITs. Maturities steadily climb over the next three years and peak in 2021 with about $800 billion of debt scheduled to mature. This stands in sharp contrast to HY. Over the same period, about $250 billion of HY debt scheduled to mature represents about 15% of all outstanding HY debt. In fact, next year HY maturities total just $40 billion.

Considering HY companies have issued about $175 billion of debt this year, refinancing pressures look particularly light next year. As a result, in the aggregate, HY companies look better positioned than IG companies to deal with tighter monetary conditions and higher interest rates over the next few years." - source Wells Fargo
Though, as pointed out by Morgan Stanley in our recent conversation, the effect of widening credit spreads on the unemployment rate is significant and positive:
"every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal." - source Morgan Stanley
The most important chart going forward? Jobless Claims vs. Job Cut Announcements (trend forming?):
- Graph source Bloomberg

Leading indicators of initial unemployment claims rose again last week to 234K (and 220K consensus) from 224K with 4 week average up to 223 K from 219K. (up from 211K average in Q3. Take notice of this! 

So from a "Sorites paradox" perspective, if wider spreads impact unemployment going forward due to balance sheet deleveraging, earnings and profitability matter as well when it comes to predicting a surge in defaults rates as highlighted by our friend Edward J Casey in his November credit commentary:
"Probability of nonfinancial corporates is a key driver of the default rates

Nonfinancial profits gained $66.2 billion in the third quarter. The annual pace of gains increased to +8.2% from -8.3% two years ago.

The US default rate declined to 3.2% in October and is expected to improve to 2% in next year.
Since the recession corporate profits have grown +8.6% annualized, well ahead of GDP of +2.3%.

One driver behind profit growth has been the massive expansion in corporate debt which has grown by +4.3%, nearly twice the pace of real GDP.
Cumulatively nonfinancial profits gained +115% compared to GDP of +23% and corporate debt of +46%." - source Edward J Casey

In our "credit" heap of sand, grains are individually removed thanks to the Fed's QT, the one question that remains is which grain will trigger the avalanche?

So if illiquidity is not "priced" correctly in credit and valuations are considered "lofty" from a consensus approach perspective, then again one may rightly ask when will it break? As pointed out by Edward J Casey, it is all depending on corporate profits rolling over, watching earnings in 2019 will be paramount:
"Equity valuations continue to outpace corporate profits. The ratio of profits to equity market cap declined to 7.7%

With credit yield headed higher, corporate profits will be facing a headwind of higher net interest expenses.

On prior occasions spikes in the cost of debt have been coincident with annual gains in corporate profits rolling over" - source Edward J Casey
If wages growth continues to accelerate in conjunction with earnings coming under pressure, then equities valuations in 2019, could be "repriced" much lower, just saying.

And when it comes to earnings we are closely watching the space. We read with interest Bank of America Merrill Lynch's Revision Ratios report from the 30th of November entitled "More cutting, less raising":
"Earnings Revision Ratio
US joins the rest of the world in negative revisions
In November, the 3-month earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest decline since April and the lowest level in nearly two years. A ratio of below 1 means more cuts than raises to earnings estimates, and this is the first time in over a year-and-a-half that analysts have taken down estimates. The US has caught up with the rest of the world with more cuts than raises. Trends have decelerated since early 2018 following tax reform as we expected, but the ratio now sits just a hair above its long-term average. We use the 3m ERR as one of five inputs in our market outlook: an above-average ratio has generally preceded strong near-term returns, whereas a ratio below average has signaled more muted near-term returns (Chart 2).
  •  In November, the three-month (3m) earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest monthly decline since April and the lowest level in nearly two years.

  • With the ratio now below 1.0, this suggests more cuts than raises to earnings estimates for the first time in over a year-and-a-half.
  • The ERR sits just slightly above its long-term average of 0.87.
  • The more volatile one-month (1m) ERR similarly fell to a two-year low of 0.73 from 0.77.
  • The ratio is below 1.0, suggesting more cuts than raises to earnings estimates for the second consecutive month.
  • In November, all sectors (except Staples) saw their 3m ERR moderate (Chart 1). Energy, Real Estate, and Technology saw the biggest deterioration.

  • Most sectors are now seeing more cuts than raises to earnings estimates amid widespread deterioration in revision trends. Energy, Utilities, and Tech are seeing slightly more positive than negative revisions to earnings estimates.
  • Utilities is the only sector with an above-average ERR, while the ratio is in line with the historical average for Financials, Health Care, Industrials, and Technology.
  •  Similarly, throughout November, most sectors except Utilities and Technology saw more negative than positive revisions to estimates.

  • Energy, Materials, and Comm Svcs had the weakest one month revision trends.-" source Bank of America Merrill Lynch

On top of the deteriorating picture for "earnings", in their report Bank of America Merrill Lynch also added the following in their report:
"Bad breadth in credit? Distress ratio ticks up
We watch revision ratios closely because “breadth” measures can sometimes be early indications of broader issues within markets. Our High Yield team’s distress ratio – the percentage of US high yield bonds with an option-adjusted spread above 1000bp – has similarly proven to be a good leading indicator of defaults. This ratio has recently worsened, and now sits at a 10-month high." - source Bank of America Merrill Lynch
Because we do not like this picture we think from a "Sorites paradox" perspective you should continue to reduce your high beta exposure and rotate from growth to consumer staples equities wise, also reduce your financials subordinated pocket (until and if a new LTRO is announced by ECB), and continue to raise cash levels and park it in the US front-end of the curve. We think as well that recent moves in the long end of the US yield curve looks enticing, we are looking at the 30 year bucket and long dated zero coupons given that the "deflationista" camp seems to make a comeback with global growth clearly decelerating.

As we pointed out earlier in our conversation, QT is indeed reducing the size of the credit heap (bubble). Trade accordingly as per ouf final chart below.

  • Final chart -  Liquidity and credit spreads go hand in hand
The tone in credit spreads has had a weaker tone in recent weeks on the back of significant outflows from mutual funds as the Fed has been continuing to withdraw liquidity in the system with QT. Our final chart comes from CITI European Portfolio Strategist note from the 22nd of November entitled "Post QE World - Bear Market, Bull Market or Kangaroo Market" and displays the relationship between central banks liquidity and Investment Grade credit spreads:
Liquidity and financial markets have been tied closely together
Citi credit strategists have shown a powerful relationship between net central bank purchases and moves in credit spreads and equity markets. By extension, reducing/reversing QE should drive credit spreads sharply higher and equity prices sharply lower. From our (equity) side, we argue that it depends very much on the nominal growth backdrop and the pace of tightening. Progressive tightening and an extending economic cycle are still likely to see credit spreads widen, but also are likely to support an extending profit cycle. Historically, there is a phase in markets where credit spreads widen but equity markets make fresh highs driven by rising EPS. This remains our base case, but we acknowledge the end cycle debate." - source CITI
Sure it was a fun and exciting long credit party but from our perspective and in respects to the "The Sorites paradox" and the risk of an avalanche, we would rather start in earnest to play "defense" given 2019 might prove to be even more problematic for risky asset prices than 2018. Just saying... 

"The one certainly for anyone in the path of an avalanche is this: standing still is not an option." - Norman Davies, British historian

Stay tuned !

Wednesday, 28 November 2018

Macro and Credit - Zollverein

"An empire founded by war has to maintain itself by war." -  Montesquieu

Watching with interest the evolution of the Brexit negotiations in conjunction with the tone down stance between Italy and the European Commission surrounding the budget, while waiting for the next G20 and potential US and China ease in trade war tensions, when it came to selecting our title analogy, we reminded ourselves of the Zollverein, or German Customs Union. The Zollverein was a coalition of German states formed to managed tariffs and economic policies within their territories, organized under the Zollverein treaties in 1833 and formally starting on the first of January 1834. The foundation of the Zollverein was the first instance in history in which independent states had consummated a full economic union without the simultaneous creation of a political federation or union. The original customs union was not ended in 1866 with outbreak of the Austro-Prussian War, but a substantial reorganization emerged in 1867. The new Zollverein was stronger, in that no individual state had a veto. The Zollverein set the groundwork for the unification of Germany under Prussian guidance. After the defeat in 1918, the German Empire was replaced by the Weimar Republic and Luxembourg left the Zollverein. The rest, as we usually say, is history...

In this week's conversation, we would like to look at what the latest widening in credit spreads mean in terms of outlook for 2019.

  • Macro and Credit - So, you want to short credit?
  • Final charts -  Change is in the air for global asset markets

  • Macro and Credit - So, you want to short credit?
While we touched in our previous conversation on the widening of credit spreads in general and the impact of falling oil prices on high beta US High Yield CCCs in particular, there has been a lot of chatter recently around the lofty valuations in leveraged loans in conjunction with the fall in prices of the asset class.

Sure no doubt US High Yield CCCs is in the line of fire when it comes to its exposure to the Energy sector:
- source Bank of America Merrill Lynch

Oil prices and US High Yield are highly connected (15%). CCC bucket is feeling the pain right now with 20.1% of exposure to the Energy sector:
- graph source Bloomberg

For sure US High Yield being "high beta" no wonder they raced ahead of the pack when it was a good time to be long Oil. Given the recent unwind of the speculative long positioning in oil and clear deterioration in the global growth narrative, no wonder credit in general and high beta in particular is starting to feel the heat and there is more "heat" to come as per the below chart from Factset displaying the S&P 500 Energy Forward 12-months EPS vs Price of oil for the last 20 years:
- graph source Factset

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will show it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg from our  November 2013 conversation "In the doldrums":
- graph source Bloomberg

There is a clear relationship we think between credit and macro from our perspective. Today the picture is more contrasted. 

While previously the data for Europe's aggregate PMI was more easily available, the below charts points to a faster deterioration in global growth in Europe (red line), while in the US given the credit cycle is more "advanced", Leveraged Loan prices have started in the US to fall faster than in Europe (blue line):
- graph source Bloomberg

Many financial pundits and central bankers are clearly worried, for good reason about the froth in the Leveraged Loan markets as we are seeing not only prices falling rapidly, but the growth of the sector has been significant as per the below chart from LCD, an offering of S&P Global Market Intelligence displaying the rapid growth in US Loan Funds Assets Under Management:
- graph source LCD, an offering of S&P Global Market Intelligence 

As we pointed out again in our last conversation, our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock".  As pointed out by the website "", outflows in both leveraged loans and high yield are starting to "bite":
"Investors Withdraw $2.2B from US High Yield Bond Funds, ETFs
U.S. high-yield funds reported an outflow of $2.19 billion for the week ended Nov. 21, according to weekly reporters to Lipper only. This result reverses positive readings in the prior two weeks, and brings the year-to-date total outflow to roughly $26.5 billion.

The year-to-date total exit continues to mark an unprecedented outflow from high-yield funds, outpacing last year’s total outflow of roughly $14.9 billion, which stands as the largest exit on an annual basis to date.
Mutual funds led the way, posting their largest outflow since February at $1.51 billion. ETFs saw another $682.4 million pulled by investors during the observation period. The four-week trailing average narrowed marginally to negative $427 million, from negative $470 million in the prior week.
The change due to market conditions was a decrease of $1.49 billion, according to Lipper. Total assets at the end of the observation period were roughly $193.4 billion. ETFs account for roughly 22% of the total, at $41.8 billion. — Jon Hemingway

US Leveraged Loan Funds See Hefty $1.7B Cash Outflow
U.S. loan funds reported an outflow of $1.74 billion for the week ended Nov. 21, according to Lipper weekly reporters only. This is the second major outflow of the past four weeks, and just the eighth negative reading of 2018.
Last week’s outflow was the heaviest since the week ended Dec. 16, 2015 ($2.04 billion) and comes just three weeks after a $1.51 billion exodus over the last week of October (this excludes a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 8, which came as the result of a reclassification at a single institutional investor).
With that, the four-week trailing average slumps to $767.8 million, its lowest level in nearly three years.
As with the other recent outflow, mutual funds led the way with $1.07 billion pulled out, while the total for ETFs was roughly $673 million. For ETFs that is the largest exit on record behind the $551.5 million loss for the week ended Oct. 31. Of note, ETF flows were positive in the weeks between, whereas mutual fund flows were negative for the fourth consecutive week.
While last week’s outflow puts a dent in the year-to-date total inflow, it remains a substantial $8.6 billion.
The change due to market conditions last week was a decrease of $774.3 million, the steepest decline since Dec. 16, 2015. Total assets were roughly $105.5 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $12.1 billion. — Jon Hemingway - source
The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost returned –0.52% in the month to date and 3.46% in the YTD. Sure some pundits would like to point out that contrary to the dismal performance of credit in 2018, in similar fashion to 2008 as indicated by Driehaus on their Twitter feed:
"YTD return is negative on each of the main US credit indexes (High Yield, Investment Grade and Aggregate). 1st time since 2008 that returns for all 3 indexes are negative through mid-November.  Lately, I find myself saying “first time since 2008” a lot more frequently" - graph source Bloomberg - Driehaus - Twitter feed.
Sure, the S&P/LSTA U.S. Leveraged Loan 100 Index is roughly around +3.5% YTD, so still overall unscathed some would argue.  Also in 2008, the index was down by a cool -28%, for perspective but we do think that if you want to go "short" credit, then indeed Leveraged Loans are a "prime" candidate" as pointed out by Peter Tchir in a July 2018 tweet:
"Many forget LCDX traded worse than HYCDX during 2008 due to positioning and then loans were more clearly senior." - source Peter Tchir, Twitter
Given the considerable size in Cov-Lite Loans in this credit cycle, then indeed, if the credit markets start unravelling, Leveraged Loans are clearly in the front line:
- graph source Bank of America Merrill Lynch

Of course Leveraged Loans, are starting to follow the painful path of other segments of the credit markets already in conjunction with global growth decelerating:

"Those of you glued to action in US equities to guide investment positions may want to devote some attention to this chart of returns to senior leveraged loans (SRLN) in excess of T-bills. Likely to be an epicenter of action in the next crisis, and currently breaking trend." - source Adam Butler - Twitter feed

Clearly if indeed credit markets start "breaking bad" in 2019, then for those of you not having the necessary ISDA to short the synthetic LCDX index could use ETFs to express their "short" view on Leveraged Loans as indicated by IHS Markit by Sam Pierson on the 26th of November in his article "ETF lending continues to thrive":
"Not all ETFs can be created out of borrowed securities, in particular those with exposure to illiquid asset classes. One such example is the Invesco Senior Loan ETF, BKLN, which consists of a basket of leveraged loans. The fund has seen increased demand from short sellers in Q4, with over $800m in current loan balances. Only a small handful of the underlying loans have any availability in securities lending, so borrowing shares from long holders of the ETF is essentially the only means of sourcing the borrow. Lenders have attempted to pass through increased rates, though the increased fees in late October and early November saw an immediate response of returned shares, driving fees lower. Once the borrow fee declined the balances picked up and fees have started to move up again. It's worth noting that BKLN has a 67bps expense ratio, which means that if short sellers can borrow for less than that rate there is an arbitrage assuming no movement in the underlying asset class. Additionally, the YTD increase in OBFR means that short selling any easy-to-borrow asset will result in a positive rebate to cash proceeds."
The $BKLN ETF is a popular way to hedge/short the asset class, in part owing the 67bps expense ratio (short sellers benefit from higher expense ratio, all else equal), though increased borrow costs over the last week may, again, dampen demand." - source Sam Pierson, Twitter feed.
As we have argued in our recent November conversation "Stalemate", Housing markets turn slowly then suddenly, same thing goes with Leveraged Loans as pointed out by Peter Tchir. 

The question that everyone is asking when it comes to credit markets as we move towards 2019 and the sell-side is sending out their outlooks is asking ourselves if we will be entering indeed a "bear" market in credit. On this subject we read with interest Morgan Stanley's synopsis and note from their 2019 Outlook for North America published on the 25th of November and entitled "The Bear Has Begun":
"We believe the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.
A more challenging macro backdrop: In 2018, weakening flows and tighter liquidity conditions served as the key headwinds in credit, but as an important offset, the US economy remained solid. In 2019, we think it gets tougher on both fronts – monetary policy will likely near restrictive territory for the first time this cycle, while the tailwind from a booming economy fades as growth decelerates and earnings growth potentially slows to a standstill. As that happens, late cycle risks may morph into end-of-cycle fears, continuing to break the weak links along the way, especially the more levered parts of corporate credit markets.
Late cycle and beyond: A turn in the credit cycle is not a specific point in time, but instead occurs in stages, over multiple years, beginning when growth is strong. With credit flows turning, financial conditions tightening, and idiosyncratic risks rising, we think that process has already started, slowly for now. And remember, the vulnerabilities in a cycle are always ignored on the way up. As this process continues to unfold and credit conditions tighten, the bull market excesses - this time centered around non-financial corporate balance sheets - should become increasingly clear.
A few silver linings: While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising fairly quickly, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. Additionally, while spreads are nowhere near where they will likely peak when the cycle fully turns, after the recent sell-off, valuations are not as extreme in places. Both of these factors help at the margin. That said, we very much stick to our bigger picture view that the credit bear market is under way, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality.
2019 forecasts: In our base case we forecast a -0.8% IG excess return, a 0.5% HY total return and a 1.3% loan total return. We expect $1.24tr, $183bn, and $436bn in IG, USD HY, and institutional loan gross issuance, respectively. Lastly, we project a 2.9% HY default rate.
Recommended positioning: In IG we prefer As over BBBs, Fins over non-Fins, the front-end of the curve, low $- priced bonds, US over European banks, and European over US BBBs. In HY and loans we remain up-in-quality, and prefer short-duration HY bonds. We have a modest preference for loans over HY, but think that view may change later in the year. In derivatives we prefer long CDX risk to cash, owning long-dated vol, positioning for decompression, and buying BBB CDS protection vs index." - source Morgan Stanley
As we pointed out in our previous note, credit mutual flows matter and it's probably matters as well for the Fed as well given the most recent dovish rhetoric coming from its chairman Jerome Powell. The latest price action in both the US dollar and Emerging Market equities is giving some much needed respite to the Macro tourists, which have been on the receiving end of the Fed's QT and hiking policy. 

Weakening flows clearly have been a trend this year in credit markets as indicated by Morgan Stanley in their long interesting outlook note:
"Restrictive Fed Policy and Decelerating Growth – a Tougher Combination
Tightening liquidity conditions should remain a headwind in 2019, at least initially, as the Fed pushes rates near restrictive territory, while continuing to shrink its balance sheet at the maximum rate, for now. Taking a step back, for most of 2018, we argued that a tightening in Fed policy, especially in the current cycle, was a material headwind for credit. In a nutshell, central bank stimulus was massive in this cycle, and highly supportive of credit. We thought the process in reverse, at the least, would weaken the flows into credit markets, driving higher volatility, with less of a “liquidity buffer” to cushion the shocks. In our view, these headwinds have materialized, just slowly and in stages. As we show in Exhibit 2 and Exhibit 3, flows into credit markets did weaken in 2018 across multiple sources.
Weakening flows clearly hit global credit markets this past year, one-by-one. For example, Exhibit 4 shows the spread widening in 2018 in US IG, in EM credit, in European credit, and most recently in US high yield, with financial conditions tightening in the process.

As we have frequently argued, fundamental issues are easier to hide when liquidity is flooding into markets, and it is not anymore. As liquidity conditions get squeezed, it is natural for dispersion in performance across asset classes, regions, sectors, and single names to pick up, with the weak links breaking first. US high yield was more resilient for most of the year than other markets, in part due to very low supply, and in part given its close ties to the strength in the US economy. But even HY, the "resilient" credit market, has only managed a roughly flat total return YTD, despite very strong earnings growth, a solid US economy, and supply down ~30%, which we think speaks to the importance of this tightening in liquidity conditions.
Looking to 2019 – two points are key to remember: 1) The liquidity withdrawal is going to accelerate, at first, and 2) unlike in 2018, it will happen as growth is decelerating. We think this will create an even more challenging backdrop, with the outperformance of higher beta credit fading as a result. On the first theme, as we alluded to above, our economists expect two more rate hikes in 2019 (after one more hike in December 2018).
We can debate where monetary policy sits in relation to neutral, but in our view, the flattening in the Treasury curve this past year, the tightening in financial conditions, as well as some of the weakness in key interest rate-sensitive parts of the economy, such as housing and autos, tells us that monetary policy is already pretty close to ‘tight.’ And remember, this tightening will not be just a US phenomenon going forward, as we see it. The ECB will be done buying bonds next year and hike in 4Q19, and the BoJ and BoE will hike in 2Q19, with the BoJ likely to reduce JGB purchase amounts as well, according to our economists.
But remember, throughout 2018, investors could consistently fall back on the idea that the US economy was booming with extremely strong earnings growth. Hence, it was easier to write off the multitude of macro headwinds (i.e, tighter Fed policy, tariffs, China/EM weakness, Italian politics, etc…) as “noise.” Going forward, these dynamics are changing. We expect US growth to decelerate notably, from 3.1% in 2018 to 1.7% in 2019, (with GDP growth of just 1.0% in 3Q19) as fiscal stimulus starts to fade, the interest rate-sensitive parts of the economy (i.e., autos/housing) continue to soften, financial conditions tighten, and tariffs weigh on business investment.

As we show in Exhibit 9, the global economy has already slowed, with the US bucking the trend so far, thanks in part to atypical late-cycle fiscal stimulus, but we think the US will converge to the downside as 2019 progresses.
Even more importantly, our equity strategists expect a material slowdown in earnings growth, with the likelihood of an outright earnings recession for a quarter or two in 2019 reasonably high. In their view, comps get very challenging next year, and margins will compress, with slower top-line growth and costs rising in many places, despite consensus expectations for margin expansion. We think markets are finally waking up to these earnings/growth risks with this recent sell-off.
Yes, 1.7% GDP growth is still manageable, and far from recessionary levels. In fact, one could make the case that this level of growth is ideal for credit – not too hot, not too cold. While we don’t disagree at a high level, we think details matter. In our view, slower growth in the middle of a cycle, which drives very accommodative central bank policy, is ideal. A slowdown in growth near the end of a cycle as a result of a restrictive Fed is not, and we think runs the risk that investors start to price in a higher likelihood that the cycle is coming to an end.
With growth slowing, and financial conditions tightening, will the Fed stop hiking? For now, we think the Fed "put" is fairly deep out of the money. Unlike at past points in this cycle, the Fed’s hands are more tied, with growth well above trend, unemployment at ~40 year lows, and core PCE now at 2%. That said, our economists expect the Fed to pause its rate hike cycle in 3Q19 and to end balance sheet normalization in Sep-19. For a short period of time, these dynamics could certainly boost sentiment. Longer term, we are not sure that they would be so bullish for markets. If the Fed stops hiking because they are at their perceived neutral rate and they believe inflation trends are benign, that may be positive. But if they stop hiking because the economy is weakening, that may be quite negative. In fact as we show in Exhibit 12, the biggest bouts of spread widening in a cycle, especially in HY, happen from the point when the Fed stops hiking, until deep into the rate cutting cycle, as that is when growth is rolling over.
Regardless of exactly when the Fed pauses, in this cycle, buying when growth is booming has not worked well (Exhibit 13), and we think this time will be no different as the macro backdrop reverts back down to, or even below, trend.
Adding everything up, we think macro challenges will grow in 2019. Monetary policy will continue tightening, with global central banks committed to removing stimulus, for now. All while the environment of very strong US growth and very robust earnings growth will fade. We think that backdrop will become even tougher for credit, especially some of 2018’s outperformers like US HY and loans, and continue to expose the fundamental challenges in the asset class built up over nearly a decade-long bull market." - source Morgan Stanley
Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end. Clearly the narrative has been changing and as we stated in our previous conversation:
"When the Credit facts change, I change my Credit mind. What do you do, Sir ..." - source Macronomics
Our final chart below indicates that change is in the air for global asset markets and that 2019 could prove to be even trickier than 2018 as the credit cycle continues to gradually turn.
  • Final charts -  Change is in the air for global asset markets
The latest "dovish" take from Fed Jerome Powell's speech is clearly enticing to trigger some short term rally , we do think that 2019 will eventually be even more challenging as global growth is decelerating. Our final charts come from Bank of America Merrill Lynch from their Commodity Strategies 2019 outlook from the 18th of November and show that there is a trend for higher interest rates and volatility ahead of us:
"Equity markets are sowing winds of change
While higher real interest rates have been a clear headwind to gold, the rise in the global risk free rate also seems to push up equity market volatility. Our equity derivatives team has been warning about this trend of higher interest rates and higher volatility for some time (Chart 134).

True, global equity markets have been a tale of two cities this year, with US equity markets rising and the rest of the world lagging (Chart 135). But the pickup in volatility suggests that change is in the air for global asset markets
A rising VIX will eventually force the Fed to slow...
It is easy to forget that the S&P500 total return index posted a Sharpe ratio of 3.0 last year, but it is running just on 0.5 this year. Of course, the large pick up in equity market volatility (VIX) is hurting risk-adjusted equity market returns (Chart 136).

But also equity markets have struggled to break higher this year on a number of factors. The most important issue for gold here, however, is that a further drop in equity market values could eventually encourage the Fed to slow down its monetary tightening path (Exhibit 6).

So higher equity vol will likely lend support to the yellow metal going forward." - source Bank of America Merrill Lynch
When it comes to our Zollverein analogy, while Italy continues to be a concern, we believe that France should clearly be on everyone's radar as the situation is deteriorating in conjunction with its public finances. It remains to be seen if 2019 will see the New Zollverein aka the European Union coming under pressure as it did in 1919, leading in Germany to the introduction of the Weimar Republic but, we ramble again...
"Look back over the past, with its changing empires that rose and fell, and you can foresee the future, too." - Marcus Aurelius

Stay tuned ! 
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