Wednesday, 13 March 2019

Macro and Credit - The Queen of Spades

"Luck is believing you're lucky." - Tennessee Williams


While enjoying a much needed short break from blogging, hence our uncommon silence, we still managed to follow the macro news such as February’s anemic 20,000 new jobs creation in the United States from the latest nonfarm payroll report (when 180 K was expected). With global negative yielding bonds increasing by $509Billion in the last three-day trading to $7.437 trillion, given the global weaker tone in the growth outlook, no wonder the D word for "deflation" fears has staged a comeback. Given the recent dovish tone taken by our "Generous Gambler" Mario Draghi we also like to call "Le Chiffre", and that we do have "Sympathy for the Devil" because as we said on numerous occasions, "The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist", so, when it came to selecting our title analogy, we decided to go for both a great literature reference and another card game reference. "The Queen of Spades" is a short story by Alexander Pushkin about human avarice and was written in the autumn of 1833 and was first published in 1834. The story was also the basis of an opera by Pyotr Ilyich Tchaikovsky in 1890. It tells the story of Hermann, an ethnic German, who is an officer of the engineers in the Imperial Russian Army. He constantly watches the other officers gamble, but never plays himself. One night, Tomsky tells a story about his grandmother, an elderly countess. Many years ago, in France, she lost a fortune at the card game of faro, and then won it back with the secret of the three winning cards, which she learned from the notorious Count of St. Germain. Hermann becomes obsessed with obtaining the secret:
"The countess (who is now 87 years old) has a young ward, Lizavyeta Ivanovna. Hermann sends love letters to Lizavyeta, and persuades her to let him into the house. There Hermann accosts the countess, demanding the secret. She first tells him that story was a joke, but Hermann refuses to believe her. He repeats his demands, but she does not speak. He draws a pistol and threatens her, and the old lady dies of fright. Hermann then flees to the apartment of Lizavyeta in the same building. There he confesses to have killed the countess by fright with his pistol. He defends himself by saying that the pistol was not loaded. He escapes from the house with the aid of Lizavyeta, who is disgusted to learn that his professions of love were a mask for greed. 
Hermann attends the funeral of the countess, and is terrified to see the countess open her eyes in the coffin and look at him. Later that night, the ghost of the countess appears. The ghost names the secret three cards (three, seven, ace), tells him he must play just once each night and then orders him to marry Lizavyeta. Hermann takes his entire savings to Chekalinsky's salon, where wealthy men gamble at faro for high stakes. On the first night, he bets it all on the three and wins. On the second night, he wins on the seven. On the third night, he bets on the ace — but when cards are shown, he finds he has bet on the Queen of Spades, rather than the ace, and loses everything. When the Queen appears to wink at him, he is astonished by her remarkable resemblance to the old countess, and flees in terror. In a short conclusion, Pushkin writes that Lizavyeta marries the son of the Countess' former steward, a state official who makes a good salary. Hermann, however, goes mad and is committed to an asylum. He is installed in Room 17 at the Obuhov hospital; he answers no questions, but merely mutters with unusual rapidity: "Three, seven, ace! Three, seven, queen!" " - source Wikipedia
The card game of faro also plays an important role in Pushkin's story. The game is played by having a player bet on a winning card. The dealer then begins turning over cards, burning the first (known as 'soda') to his left. The second card is placed face up to his right; this is the first winning card. The third card is placed face up in the left pile, as a losing card. The dealer continues turning over cards, alternating piles until the bet has been won or lost. A reading of The Queen of Spades holds that the story reveals the Russian stereotype of the German, one who is cold and calculating person bent on accumulating wealth (Germans increasing savings at the expense of consumption, which depresses economic activity), one might wonder if indeed the "uber" mercantile policies followed by Germany versus the rest of the world in general and its European peers in particular such as France and Italy will eventually spell its downfall, but we ramble again. After all Pushkin’s Queen of Spades is an "eternal" tale of gambling and avarice, such as the current financial markets we see in front of our very own eyes.


In this week's conversation, we would like to look at the additional dovishness coming from the ECB which we think in Europe will continue to reward more actively the financial sector credit markets over equities. 


Synopsis:
  • Macro and Credit -  Betting on the ace in European Rent-seeking credit markets
  • Final charts - ECB rates on Japanese path

  • Macro and Credit -  Betting on the ace in European Rent-seeking credit markets
Given our "Generous Gambler" aka Mario Draghi known as Le Chiffre fired his "Chekhov's gun" and unleashed QE in Europe, the consequences have been fairly simple. We have long been declaring that in that case credit would outperform equities when it comes to financials which is what we posited in January 2015 in our conversation "Stimulant psychosis":
"Rentiers seek and prefer deflation - European QE to benefit credit investors:
"In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity
The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura
Given the performance of European financial credit over equities, we are not surprised. On this very blog we have been advocating favoring exposure to credit markets when it comes to financials in Europe because of the "Japanification" process facing Europe. The recent dovish tone from "Le Chiffre" still at the head of the ECB is a reminder. The new TLTRO will continue to favor rent-seeking investors but probably less strongly than during the last decade following the Great Financial Crisis (GFC).

On that note we read with interest Bank of America Merrill Lynch The European Credit Strategist note from the 8th of March entitled "A decade of hubris":
"A decade of hubris
A decade ago, on March 12th 2009, European credit markets were on their knees, and companies faced extinction. But of course, the Armageddon never came, and years of exceptional monetary support from global central banks instead ignited a decade of significant returns across credit. Secular “winners” in the post-GFC era have been LT2 banks (102% cumulative total returns), transport (71% total returns), media (67%) and tech (66%). The “losers” on the other hand, have been healthcare (60%), energy (58%), autos (51%), and senior banks (48%). Secular contrarians would buy the “losers” as a catch-up trade. In fact, senior banks should reap the benefits of yesterday’s TLTRO announcement from Mr Draghi.
10yrs ago, on March 12th 2009, European credit markets were on their knees. High-grade spreads had peaked at 403bp (high-yield at 2147bp in mid-Dec ’08) and companies faced extinction…with spreads implying default rates of 7% for high-grade and 40% for high-yield. Years of exceptional monetary support from global central banks instead ignited a decade of phenomenal returns across the corporate bond market (chart 1).
Secular “winners” in the post-GFC era have been LT2 banks (102% cumulative total returns), transport (71% total returns), media (67% total returns) and tech (66% total returns).
The “losers” on the other hand, have been healthcare (60%), energy (58%) given oil price ructions, autos (51%) given trade tensions, and senior banks (48%) partly given the emergence of TLAC.
Secular contrarians would buy the “losers” going forward, as a catch-up play. In fact, senior banks should reap the benefits of yesterday’s TLTRO announcement from Mr Draghi – as historically has been the case (see our “who wins” under a TLTRO analysis)." - source Bank of America Merrill Lynch
From a Macro and Credit perspective, as posited by our Friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":
"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013
As concluded as well in this previous 2013 by our friend Paul:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013
Do not focus solely on the current low default rates when assessing forward credit risk. Trying to estimate realistic future default rates matter particularly when there are more and more signs showing that the cycle is slowly but surely turning in both CRE and consumer credit. Fed hiking cycles and tighter bank lending standards have historically been preconditions for recessions. By tracking the quarterly Senior Loan Officers Surveys (SLOOs) published by the Fed you can have a good view into credit conditions. As we told you recently, next publication of the SLOOs will be essential in assessing credit conditions. Please also note that jobless claims are one of the best indicators of a regime shift, because they generally start to rise about a year before the economy enters a recession. 

But if "D" is for "Deflation", then again, looking at the growing concerns from credit investors about US companies' leverage, the biggest risk, for equities is a slowdown in buybacks and a cut in CAPEX spending and dividends for some companies to address leverage issues put forward by many investors. This would make credit more favorable than equities from an allocation perspective due to "Japanification" concerns.

Some might be expecting the Queen of Spades and a return to "goldilocks" when it comes to credit markets, yet we think you shouldn't expect a continuation of such a strong rally in high beta we have seen so far this year given the macro backdrop regardless of the strong dovishness playing out.

On the subject of "complacency" in the current market set up, we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 8th of March entitled "Complacency Breeds Opportunity":
"Rebound loses momentum as unresolved risks resurface
Risk assets continued to struggle this week, as there appeared to be few takers interested in holding, let alone adding risk at current levels. For the HY market, the invisible wall demarcating poor value appeared to be somewhere around 400bps on the OAS scale, as the asset class has been oscillating around these levels for three weeks now, unable to meaningfully break through this barrier. The liquid benchmarks have been going nowhere for even longer, with HYG currently trading half a point away from its closing levels on Jan 30th, the day of the Fed meeting that marked the policy pivot. So what stands in the way of better risk appetite here? We think two key factors: high asset prices and unresolved risks. We have written extensively in recent weeks about high prices/tight spreads being the most important hurdle that would make it difficult for HY to continue to show outsized performance. Simply put, strong bids for HY usually don’t come at three-handle spreads.
The second set of factors describing the risk backdrop has improved materially since Q4, and it unquestionably helped market sentiment earlier this year. The list was in fact unusually long in late 2018 – ranging from trade talks falling apart to the US government shutdown to European economies slowing to the Fed potentially making a policy mistake to oil prices falling sharply to large IG issuers losing investor confidence to EPS growth slowing to financial conditions tightening. Given the length of this list and the potential severity of some of these issues, it is little surprise that even a modest pullback in those concerns created a powerful backdrop for improving risk appetite.
But that is all history; now is the time to reassess these risks and get a better sense – with the benefit of hindsight and all the new information we have learned since then – what we got wrong back in Q4 and how much room there is for new mistakes at this point.
We think some of these risks have, in fact, been largely addressed. For example, the US government has been reopened and we think the latest experience has taught both sides of the political spectrum not to go there again, reducing the probability of a repeat occurrence. The chance of a serious Fed policy mistake – never high to begin with, in our opinion – has been reduced to effectively zero. Oil prices are no longer falling; and while we do not claim to possess a particular skill to forecast this volatile commodity, we find sufficient comfort in a simplistic thinking that it has less room to go lower from $55 than it had from $75.
The rest of risks on our list have also subsided, but we would stop short of calling them addressed. For example, all signs continue to point toward some sort of a trade agreement to be signed between the US and China in coming weeks, which should have a limited market impact at this point given that it has been well telegraphed. We remain doubtful that this event resolves most residual concerns about trade, however. Europe appears to be next on the “to-do” list for trade talks, with auto imports likely presented as a threat to US national security, as our economists describe here.
Assuming European negotiations end with some form of an agreement, an eventual outcome we have little doubt in, the larger question remains whether we can expect trade flows to return to their pre-2018 levels on the other side of all this. We have doubts that an average corporate executive committee planning the location of strategic supply chain elements for coming years is comfortable assuming most trade frictions will be resolved by then. A rational decision here should err on the side of caution by postponing/reducing cross-border investments.
On the other side of all this, the US trade deficit increased to $620bn in 2018, up 25% since the Trump administration made its reduction a key focus. It is hard to describe this outcome as a surprise if one takes into account the expected likely response functions on the other side of each trade channel. What were the chances of foreign consumers becoming more interested in US products in this environment? Not far from zero. Could the nominal signing agreements with China and/or Europe change this attitude in foreseeable future? Unlikely.
The slowdown in Europe is another risk that rose in Q4 but was subsequently swept under the rug of a tactical market rebound. The ECB has reminded us of that risk earlier on Thursday, by slashing its growth estimates, postponing its intentions to begin normalizing rates later this year, and reintroducing new measures of policy support (TLTROs). None of this should be particularly surprising, as Barnaby Martin, our European credit strategist, has been discussing these expectations for weeks now (for full details of his latest views on EU credit, see here). One of the key arguments he makes is still not fully appreciated by consensus, in our opinion: even if Presidents Trump and Xi sign a trade deal, and China agrees to buy more of US goods – a widely expected outcome – shouldn’t this also imply they will have to buy less elsewhere? And if so, isn’t Europe poorly positioned along this particular geopolitical scale? We think the consensus view of trade disruption as a non-risk is still failing to connect these important dots.
The risk of IG issuers losing investor confidence has receded as well, with several key names in the BBB space announcing strong measures in response to the market wakeup call they received in Q4. Their intentions are ranging from suspension of share buybacks to dividend cuts to asset sales, with proceeds promised to be directed toward debt reduction. This change of heart potentially represents great news for bondholders in each particular cap structure in question. What the market may be overlooking here is the aggregate impact of all these measures, i.e., if all large BBBs decide to delever simultaneously, what would that mean for their aggregate capex spending, earnings growth, and M&A appetite?
Our estimates suggest that gross share buybacks may have been responsible for up to a half of cumulative EPS growth of many of these issuers over the past five years. Such a contribution must be smaller going forward, assuming BBB issuers maintain their deleveraging discipline. So EPS growth – currently standing at +12% yoy for all S&P 1,500 issuers (large + small caps) – is poised to come under pressure going forward from at least three sides: tax reform comps turning into a headwind, fewer share buybacks, and slower global macro.
The last risk on the list from Q4 – tightening in financial conditions – has naturally improved since year-end; however, it remains elevated by the standards of last year when HY spreads were pushing into low-300s. As we discussed last week, cracks remain visible, particularly in the CCC space, where one-third of all names still trade at distressed levels and the extent of dispersion (proximity to average index levels) has actually increased since year-end. Wider dispersion implies less reliable risk appetite, as the rebound so far has only increased the gap between potential winners and losers.
Taking all of the above arguments into account, we think that while various risks culminated in late 2018 and have been addressed or reduced in recent weeks, some of them still remain in place. The most important among them are disruptions to trade  flows coupled with deleveraging among the largest IG names and tax reform coming out of yoy comps, all leading to negative earnings impacts. We think many investors remained complacent about these interconnected risks, and – until most recently – were willing to hold risk despite high asset prices. This behavior may have started to change over the past couple of weeks, but it remains largely in place.
Complacency on the part of other investors creates opportunity for those who share our view of the world. We think these issues are likely to resurface in coming weeks and months, and when they do, more appropriate pricing of risks should reestablish itself. We think this potential path is inconsistent with HY spreads going deeply into the three handles, and as such we continue to advocate an underweight position with an eye toward more significant levels of risk reduction if spreads were to grind tighter. Importantly, we think HY is likely to generate meaningful negative excess returns at some point in coming weeks and months from current levels, although we find it impractical to try to pinpoint the exact turning point.
Our default rate indicator continues to produce 5.25% issuer and 4.25% par estimates over the next 12 months. We realize this is an out-of-consensus view, and as such we continue to constantly question our confidence level around it. It remains firm so far, with all the improvement in risk appetite earlier in the year captured by model inputs. 
Importantly, we advise our readers to think about this model estimate more in terms of its directional view and the order of magnitude, rather than a simple point on a scale. The critical argument here is not whether the par number happens to be 4.25% or 3.75%, but rather that the lows in defaults for this credit cycle are most likely behind us, a legacy of 2018, and that future credit losses are likely to be meaningfully higher.
The risk taking mentality in leveraged credit must therefore undergo a significant change, particularly at current tight spread levels. We recommend continued up-inquality positioning coupled with increased cash balances at these levels. We will be looking to redeploy this capital at more attractive levels in the future." - source Bank of America Merrill Lynch
We agree with Bank of America Merrill Lynch that going forward, fewer share buybacks, and slower global macro will weigh more on equities than credit and given the recent direction taken by US Treasury notes, long dated Investment Grade credit should benefit as well from the most recent move. 


As we stated before if it's D for "Deflation" and "Deleveraging", then it's good for credit markets in a "Japanese" fashion. So all in all yield "hogs" will benefit more in this Chinese year of the pig relative to equities we think. Dovish tone by central banks equals reach for yield again across credit, that simple.

When it comes to the validation in playing defense recent fund flows points towards a reach for quality (Investment Grade) over quantity (High Yield) as indicated by Bank of America Merrill Lynch in their Situation Room note from the 7th of March entitled "Monetary stimulus vs. global weakness":
"Outflow from risk
Inflows to US high grade mutual funds and ETFs remained strong at $4.68bn this past week ending on March 6, compared with a $5.01bn inflow a week earlier. On the flip side, outflows from risker asset classes such as high yield accelerated to $0.93bn this past week from $0.09bn one week earlier. This as flows also turned negative for loans and equities to $0.13bn and $5.83bn of outflows, respectively, following $0.05bn and $6.00bn of inflows a week ago. Hence inflows to all fixed income declined to $2.74bn this week from $5.72bn in the prior week (Figure 3).

The inflow to high grade funds increased to $4.24bn from $3.54bn one week ago, while the inflow to high grade ETFs declined to $0.44bn from $1.47bn (Figure 4).

On the other hand, the maturity breakdown of high grade inflows remained about evenly split between short-term (to +$2.55bn from +$2.70bn) and ex. short-term (to +$2.13bn from +$2.31bn). Flows improved for global EM bonds and money market funds to $1.61bn and $30.43bn, respectively, from $1.06bn and $3.29bn the prior week. Government bonds experienced $1.95bn in outflows following $0.75bn in outflows the prior week. Munis and mortgages both reported smaller inflows to $0.76bn and $0.23bn, respectively, from $1.24bn and $0.58bn one week ago." source Bank of America Merrill Lynch
We do watch with great attention fund flows when it comes to gauging risk appetite as our readers already know by now given fund flows have a tendency to follow total returns.


Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. For instance we were not surprised to read from Nomura Quants Insight report from the 13th of March entitled "How sustainable is this algo-supported goldilocks market?" that Risk Parity Funds have slightly increased their exposure to Investment Grade bonds:
"Nomura’s estimates that a raising portfolio leverage ratio by risk parity investors should have some effect on DM rates markets. When risk parity funds increase their leverage ratio to reach their target portfolio volatility level (usually set at ~10%), their activities tend to create buying pressure on a wide range of asset classes.
As a result, the market environment is similar to a "Goldilocks" state on its surface. However, we note that the portfolio exposure of a typical trend-following program like CTAs or risk parity funds continue to skew towards the long-side of DM bonds, which also means that DM bond markets gradually become vulnerable to unexpected increases in interest rate volatility." - source Nomura

As long as interest rates volatility remains muted, it's hard to be negative on credit markets. Also the slowdown in global growth in conjunction with weaker macro data overall have led to even more dovishness which has been highly supportive of the strong "high beta" rally seen. Yet, we do think that in a context where investors are starting to put pressure on leveraged players, an allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances. Again, in this late cycle we are seeing rising dispersion. It doesn't mean there are no opportunities, it means you need to ensure you get smarter with your issuer selection process. 

When it comes to the different paths taken by Europe and the United States, given the ongoing woes for the ailing European financial sectors as per our final points below we still believe in the "Japanification" process of Europe and continue to be much more supportive for financial credit over financial equities. That simple, no need to point to us book value or any additional snake oil salesman tricks when it comes to European banks stock prices, we are simply not buying any of it.


  • Final charts - ECB rates on Japanese path
Back in August 2016, in our conversation "The Law of the Maximum", we indicated that the outcome for Europe would be different than in the United States:
"Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!
The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics, September 2015" 

What is very clear to us is that the Fed and the ECB have been following different path, which obviously have led to different "growth" outcomes in recent years. The lack of "credit impulse" in Italy for instance, leading to lack of economic growth is entirely due to the capital constraints put on already stretched balance sheets of Southern European banks which had no choice but to collapse their loan books, in effect, the credit crunch in Europe was a self-inflicting wound." - source Macronomics August 2016
Our final charts come from Bank of America Merrill Lynch The European Credit Strategist from the 26th of February "Is it Japan all over again?" and shows clearly the "Japanification" at play in Europe:
"After a mega January for returns, February, by contrast, has felt more pedestrian. That said, high-grade spreads have still been able to grind 10bp tighter on the month (high yield 25bp) as the earnings season has driven the customary drop-off in supply. We remain of the view that March will be a tougher time for spreads given seasonally high issuance, coupled with the weaker firepower that investors now seem to have.
While spreads have tightened this year, the European manufacturing data has remained glum (albeit, with services the bright spot). Our favoured indicator – PMI manufacturing new orders – slipped further into recessionary territory last week. At 46.2, it is now far below the levels reached during the China growth scare in ’15, and now not far from the lows seen during the 2011 Eurozone periphery crisis.
The upshot of this is that spreads continue to look very dislocated from the reality of the economic data, in our view (see appendix chart). And while the Eurozone momentum should improve in the following quarters – buoyed by China stimulus, Germany/France fiscal loosening, and domestic wage growth – it seems to us that credit markets have already priced much of this in, if not more. The risk is that a protracted war of words on trade between Trump and the EU results in a shallower Eurozone recovery than the base case…leaving Euro credit spreads looking priced for perfection.
Is it Japan all over again?
The dovish pivot by central banks has undoubtedly made the rally this year. Even ECB members have sounded more concerned about the growth and inflation outlook, despite bringing QE to an end only 8 weeks ago. Accordingly, interest rate vol in Europe has fallen to a record low (now sub 40) and is yet again driving a conspicuous reach for yield across credit markets. After all, Draghi dovishness has almost always been a precursor to tighter credit spreads, since July 2012.
See you in 2033!
In our latest credit survey, we noted plenty of references to “Europe is Japan…” given how quickly the ECB appears to have altered its tune. While such a debate is clearly more complex, the comments, we think, are nonetheless prescient…as 20yrs ago to the month (Feb 12th ‘99) the BoJ first cut interest rates to zero. And with the exception of a few years in between, Japanese interest rates have barely moved since.
While history is never meant to repeat itself, it does seem to be coming close. Chart 1 shows that the progression of Japanese and ECB interest rates has been eerily similar when overlapping the two time series to match the point of zero interest rates (ECB deposit rates fell to zero in July ’12).
A crude extrapolation of chart 1 implies that ECB deposit rates will still be broadly at today’s levels in 2033!
History says…a policy error
Note, as well, that a crude extrapolation of chart 1 suggests that the ECB will raise interest rates towards the end of this year, in line with the current view of our Eurozone economics team (albeit they have frequently noted the risks to no hike given the recent data weakness.
Back in July ‘06, the BoJ raised rates by 25bp after 5 successive quarters of positive growth. The feeling was that Japan had moved away from the spectre of deflation (the BoJ statement at the time said: “Japan’s economy continues to expand moderately, with domestic and external demand and also the corporate and household sectors well in balance”). But this turned out to be premature. Post the Global Financial Crisis, the BoJ cut interest rates from 0.5% back down to 0.1% (and subsequently cut them to -10bp in late Jan ’16).
Eerie similarities
But it hasn’t just been interest rates that seem to be mimicking each other across Japan and the Eurozone. In fact, we find eerie similarities in many other areas. For instance:
• Chart 2, shows the progression (months) in headline inflation rates for Japan and the Eurozone.
Again, we overlap them at the point at which interest rates for both countries first hit zero (“Month=0”, in the chart). The correlation of Japanese and Eurozone inflation since then has been 52%.
• Likewise, chart 3 shows the progression of 10yr government bond yields for Japan and the Eurozone. The correlation between the two (from “M=0”) has been a eerily impressive 76%.

• And chart 4 shows the progression of Japanese and Euro high-grade credit spreads. Here, the correlation has been 50%. Note that Japanese high-grade spreads are roughly the same today as they were in February ’99.
But conspicuously high correlations alone don’t do justice to the debate of Europe is heading to Japanification, in our view. The story of Japan is one of huge debt growth and fiscal spending as governments have attempted to banish deflation demons. But an ageing population has been Japan’s Achilles heel for many years. Chart 5 shows that during the ’81-’91, and the post-GFC economic expansions, Japan has witnessed both low inflation rates and high growth in the percentage of the 65-year old plus population." - source Bank of America Merrill Lynch.
In their interesting note Bank of America Merrill Lynch indicates that the best performing sector, after 6m of a new TLTRO were senior financials (20% spread tightening) and likely reflected two themes: first, that with liquidity support the default risk and deposit flight issues for the banking sector are minimized. Second, given that TLTROs have usually been cost-effective funding for banks, the expectation of senior supply falls.

Finally, we still think that the more repressed the volatility by our central bankers, the more instability is brewing so in relation to our title analogy, on the first QE , investors bet it all on the three cards and won the "high beta" game. On the second large QE by the ECB, investors won on financials credit. on the third time, which is right now, investors risk betting on the ace - but when cards will be shown, they might find out that they had bet on the Queen of Spades, rather than the ace, and loses everything, but we ramble again...

"Diligence is the mother of good luck." - Benjamin Franklin
Stay tuned!

Saturday, 23 February 2019

Macro and Credit - Lethe

"Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." - Mark Twain
Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named "Lethe". The river of "Lethe" was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness. 

In similar fashion, every investors drinking again from the "river of liquidity" provided by central banks including the large infusion from China's PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means "oblivion", "forgetfulness", or "concealment". It is related to the Greek word for "truth", aletheia (ἀλήθεια), which through the privative alpha literally means "un-forgetfulness" or "un-concealment". While the privative "alpha" might means "un-forgetfulness", the on-going rally is purely of one of "high beta" given the return of the "carry" trade thanks to low rate volatility and global central banking dovishness. 

In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again...

In this week's conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.


Synopsis:
  • Macro and Credit - The road to oblivion?
  • Final chart - It's not only central banks, buybacks got your back...

  • Macro and Credit - The road to oblivion?

Given the definition of "oblivion" is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of "goldilocks" will last following the baby bear market we saw during the fourth quarter of 2018. 

Sure it’s  a great start  in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good "proxy" for global trade, has seen recently unemployment surging to 4.4%.

No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups  reported this week.

No surprise the "D" for "Deflation" trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the "Lethe" river flowing again.

If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed's latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.

While investors took another bath into the central banking river of "Lethe", when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all "recessions" are "deflationary" in nature, and most central banks have been powerless in anchoring solidly inflation expectations. 

When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled "The Hidden Costs of Risky Auto Loans to Consumers and Our Communities":
"The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.
  • Auto lending rebounded from the Great Recession in part because of low interest rates (fueled by the Federal Reserve Board’s policy of quantitative easing) and a perception by lenders that auto loans had held up better than mortgages during the financial crisis. As one hedge fund manager noted in a 2017 interview with The Financial Times, during the recession, “consumers tended to default on their house first, credit card second and car third.”
  • A 2014 report by the Federal Reserve found that a consumer’s perception of interest rate trends had as strong an effect on the decision of when to buy a car as more expected factors like unemployment and income.
  • Low-income borrowers are particularly sensitive to changes in loan maturity according to a 2007 study, suggesting that the longer loan terms of recent years may have been an important spur for the rapid rise in auto loans to low-income households.
  • A 2018 study by researchers at the University of California, Los Angeles, tied the fall in transit ridership in Southern California to increased vehicle availability, possibly supported by cheap auto financing.
The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.

  • Americans are carrying car loans for longer periods of time. Of all auto loans issued in the first two quarters of 2017, 42 percent carried a term of six years or longer, compared to just 26 percent in 2009. Longer repayment terms increase the total cost of buying an automobile and extend the amount of time consumers spend “underwater” — owing more on their vehicles than they are worth.
  • Many car buyers “roll over” the unpaid portion of a car loan into a loan on a new vehicle, increasing their financial vulnerability in the event of job loss or other crisis of household finances. At the end of 2017, almost a third of all traded-in vehicles carried negative equity, with these vehicles being underwater by an average of $5,100.
  • The increase in higher-cost “subprime” loans has extended auto ownership to many households with low credit scores but has also left many of them deeply vulnerable to high interest rates and predatory practices. In 2016, lending to borrowers with subprime and deep subprime credit scores made up as much as 26 percent of all auto loans originated.
  • Auto lenders — and especially subprime lenders — have engaged in a variety of predatory, abusive and discriminatory practices that enhance consumers’ vulnerability, including:
  • Providing incomplete or confusing information about the terms of the loan, including interest rates.
  • Making loans to people without the ability to repay.
  • Discriminatory markups of loans that result in African-American and Hispanic borrowers paying more for auto loans.
  • Pushing expensive “add-ons” such as insurance products, extended warranties and overpriced vehicle options, the cost of which is added to a consumer’s loan.
  • Engaging in abusive collection and repossession tactics once a consumer’s loan has become past due.

- source US PIRG, February 2019


In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less "senior" when it comes the recovery value potential. 

As we pointed out in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?", credit cycles die because too much debt has been raised:
"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion." - Macronomics, October 2017 
This is why on this very blog we follow very closely financial conditions and the Fed's quarterly SLOOs as well a fund flows. 

Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:

  • "7% of auto loans are 3+ months delinquent . Auto loan delinquencies climbed to $9 billion in 2018. 
  • Transportation is the second-leading expenditure for American households, behind only housing. Approximately one hour of the average American’s working day is spent earning the money needed to pay for the transportation that enables them to get to work in the first place.
  • Americans owed $1.26 trillion on auto loans in the third quarter of 2018, an increase of 75 percent since the end of 2009.
  • The amount of auto loans outstanding is equivalent to 5.5 percent of GDP — a higher level than at any time in history other than the period between the 2001 and 2007 recessions." - source US PIRG, February 2019
Given that the auto industry is notoriously cyclical,  and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.

On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo's Economics Group Weekly Economic and Financial Commentary from the 22nd of February:
"Canary in the Camry?
Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?
Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute." - source Wells Fargo
Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven't seen in the last 25 years? We wonder.

If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled "Spreads stall heading into SFIG":
"Consumer Portfolio Services, Inc (CPSS or CPS) - sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn
Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.
The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.

The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.

The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction." - source Bank of America Merrill Lynch
To repeat ourselves, credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly "S&P500 dependent", the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the "Lethe" liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the "illiquid stuff" such as the now "famous infamous" leveraged loans regardless of their recent "strong" performance.

For now, investors have dipped again into "Lethe" hence the return of the "goldilocks" narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure "goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:
"The Trouble with ‘Goldilocks’The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.
We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities." - source Morgan Stanley.
A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.

Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their "The Inquirer" note from the 18th of February entitled "Is Global Monetary Reflation here?":
"In the last week, it seems like global central banks have started a possible process of monetary easing, in line with our views (The Inquirer: Planet Earth to Policymakers: Please Reflate 31 December 2018). If so, this would be very positive for Asia/EM stocks.
In the US, Fed governor Lael Brainard raised the possibility of ending balance sheet contraction by year-end 2019, ahead of schedule; in Europe, the possibility of a TLTRO came from Commissioner Benoit Coeure, and China printed a massive January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018, above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn. Global monetary reflation is possibly on the way. As of now, we remain bullish. We expect the world's central banks to reflate monetary policy, a view we have held since late last year.
Paraphrasing Mike Tyson, everyone's got an investment strategy, until they get punched in the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity analysis (different from "fund flows") was popular in financial markets three decades ago. We remember having a standalone research product in the mid-1990s called "Liquidity Analysis" replete with central bank balance sheets, commercial bank entrails, and the net supply and demand for equity. These days, eyes glaze over when we bring up base money growth, money multipliers, and monetary velocity. However, as the last decade has taught us, we should pay attention to this stuff. Our global strategist, Michael Hartnett, has maintained a consistent focus on liquidity and central bank balance sheets
as part of his toolkit.
1) We think the biggest risk to equities in Asia and EMs is the potential mismanagement and premature contraction of central bank balance sheets. Conversely, it is also the most lucrative opportunity. The correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years. World equities have a similar correlation of 0.94 since 2009. Central bank balance sheets are the most important driver of stock prices, in our view, by lowering risk premia, and cutting off deflation risk. The rest is detail, in our view.

2) We think the Fed is the most flexible in course correcting - they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.

3) However, we worry that in Europe, Japan, and most importantly, China - a total of USD40tn in GDP, or half the world's total - a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.

The world monetary base is shrinking, only the sixth time since 1980 - each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession.

Why should this time be different? The US Fed's projected balance sheet contraction of about USD40bn a month will likely reduce the US monetary base 13.8% this year (after contracting 10.7% last year), and the global real monetary base by 1.6%. After spending seven years telling us that the Fed B/S expansion was equivalent to rate cuts, we are now told that the opposite - B/S contraction is like "watching paint dry". Ostensibly, this comes from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years. The Lael Brainard "end-QT earlier" is helpfully walking back some of this prior aggressive QT fervor. And that’s a good thing -that’s the main impetus to growth in old, indebted and unequal societies.
4) Apart from China, which has control over its money multiplier through the high reserve requirement ratio, most large economies have seen falling money multipliers for the last two decades. Stopping QE - or slowing the QE-induced growth of the monetary base - will likely lead to a sharp drop in M2 growth (M2 is simply the monetary base multiplied by the money multiplier). Couple that with the secular drop in monetary velocity from the declining incremental productivity of debt, and slower nominal global GDP (and EPS) growth is highly likely. Rising indebtedness globally, demands a stronger money supply growth rate to maintain a desired level of economic (and earnings
growth). This is an identity, not a theory. This is increasingly true for China, with its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to impose more severe costs on growth there. The world's central bankers seemed oblivious to this until last week, and even now it is not clear where they stand. Welcome back to the secular stagnation debate. And the potential threat of a "too tight policy mistake".
Chair Ben Bernanke during his testimony about the Federal Reserve Board’s semiannual report on monetary policy said that he equated $150-200 billion of QE as being equivalent to a 25bps reduction in short term rates. So 600billion in QE2 was equivalent to a 75bps reduction.
https://www.c-span.org/video/?298238-1/monetary-policy-report (at 32 minute)
Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)" - source Bank of America Merrill Lynch
It seems to us that Jerome Powell has finally done the math hence the "u-turn" as seen in the increasing use of "patience" in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the "Lethe" river thanks to the rescue of central banks.

Another strong support as well to the "high beta" rally narrative and "risk-on" environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political "left" side.


  • Final chart - It's not only central banks, buybacks got your back...
Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled "Buybacks on pace for another record year" and shows that in similar fashion to 2018, the return of buybacks on top of the central banking "Lethe" river provides additional support to the "oblivious" crowd of investors jumping with both feet on the high-beta wagon:
"Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1).

The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels." - source Bank of America Merrill Lynch
If "R" is for Recession and "L" is for Leveraged then "G" is for Gold. With the recent return of the river of unmindfulness, no wonder, the strong "bull" market has been "reincarnated" and the zombie companies can continue to "live" another day but we are ranting again...


"To err is human; to forgive, divine." - Alexander Pope, English poet

Stay tuned !

Tuesday, 12 February 2019

Macro and Credit - Cryoseism

"Praise out of season, or tactlessly bestowed, can freeze the heart as much as blame." -  Pearl S. Buck
Watching with interest the weakening tone in February in credit markets following the stellar month of January, in conjunction with confirmation of a global slowdown, and with no resolution in sight between China and the United States in relation to their trade spat, and also with the weaker tone for financial conditions coming out of the quarterly Fed Senior Loan Officer Opinion Survey (SLOOs), when it came to selecting our title analogy, given the lower than usual temperature experienced in various part of the world including ours, we decided to go for "Cryoseism". "Cryoseism" also known as an ice quake or a frost quake, is a seismic event that may be caused by a sudden cracking action in frozen soil or rock saturated with water or ice. As water drains into the ground (liquidity in asset markets), it may eventually freeze and expand under colder temperatures (global growth and trade deceleration), putting stress on its surroundings. This stress builds up until relieved explosively in the form of a cryoseism. Cryoseisms are often mistaken for minor intraplate earthquakes.  Initial indications may appear similar to those of an earthquake with tremors, vibrations, ground cracking and related noises such as thundering or booming sounds. Cryoseisms can, however, be distinguished from earthquakes through meteorological and geological conditions. Cryoseisms can have an intensity of up to VI on the Modified Mercalli Scale. Furthermore, cryoseisms often exhibit high intensity in a very localized area (such as leveraged loans) in the immediate proximity of the epicenter, as compared to the widespread effects of an earthquake. Due to lower-frequency vibrations of cryoseisms, some seismic monitoring stations may not record their occurrence. Although cryoseisms release less energy than most tectonic events, they can still cause damage or significant changes to an affected area. There are four main precursors for a frost quake cryoseism event to occur: (1) a region must be susceptible to cold air masses, (2) the ground must undergo saturation from thaw or liquid precipitation prior to an intruding cold air mass, (3) most frost quakes are associated with minor snow cover on the ground without a significant amount of snow to insulate the ground (i.e., less than 6 inches), and (4) a rapid temperature drop (global trade) from approximately freezing to near or below zero degrees Fahrenheit, which ordinarily occurred on a timescale of 16 to 48 hours.


In this week's conversation, we would like to look at what the latest Fed's quarterly Senior Loan Officer Opinion survey means for credit in general and high yield/high beta in particular. 

Synopsis:
  • Macro and Credit - This recent rally is not on solid ground
  • Final chart - Credit pinball - Same player shoots again?

  • Macro and Credit - This recent rally is not on solid ground
In our most recent conversation, we pointed out to the cautious tone from investors, urging CFOs in the US to take the "deleveraging" route given the continuous rise of the cost of capital, which appears to be somewhat validated by the latest Fed Senior Loan Officer Opinion Survey (SLOOs). The Fed’s latest SLOOs points towards tightening financial conditions: "demand for loans to businesses reportedly weakened."  But, we think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield.

In our early January conversation "Respite", we pointed out to our 2018 call, namely that analyst estimates were way too optimistic when it comes to earnings for 2019. If indeed Europe is a clear case of Cryoseism, with so much liquidity injected and not very much to show for macro wise in terms of growth outlook making it a very bad grade for the confidence tricksters at the helm of the ECB vaunting in recent days the great success of QE, the savage earnings revision pace we have seen so far clearly show the recent rally is not on solid ground. On the subject of earnings revision we read with interest Morgan Stanley's take from their US Equity Strategy Weekly Warm Up from the 11th of February entitled "Earnings Recession Is Here":
"Earnings expectations for 2019 have fallen sharply, but consensus still embeds a material reacceleration in 2H19. History tells us to expect further downward revisions, higher volatility and a drag on prices. We lower our base case 2019 S&P 500 EPS growth forecast to 1%.
Our earnings recession call is playing out even faster than we expected. When we made our call for a greater than 50% chance of an earnings recession this year, we thought it might take a bit longer for the evidence to build. On the back of a large downward revisions cycle during 4Q earnings season, it's becoming more clear. Consensus numbers have already baked in no growth for 1H19 (1Q projected growth is actually negative) with a hockey stick assumed in 2H19 that brings the full year growth estimate to ~5%.
History says be skeptical of the inflection forecast. The projected y/y EPS growth in 4Q19 is ~9.5%. This compares to an average projected rate of growth of 1% over 1Q - 3Q19, an inflection of ~8.5%. Since the early 00s, we have seen this kind of inflection happen a few times, but these inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate. Neither of those forces are at play this year. In fact, it's the opposite making the achievability of these estimates even more unlikely.
When consensus is embedding an inflection further out, downward revisions, some drag on price returns and higher volatility are all to be expected. We examined what tends to happen when consensus embeds a big jump in growth 4 quarters out compared to the next three quarters. We found that the numbers for all 4 quarters ahead tend to fall but the growth quarter tends to fall the most. If current estimates move in line with history, we could see a full year decline of ~3.5% in S&P earnings. There is a wide range of potential outcomes though, so today we only take our base case forecast down to 1% y/y growth. We also found that equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility tends to rise meaningfully., with average year ahead price volatility realizing ~5% more than the full period average.
Lowering our earnings forecast. On the back of this work, we lower our Base Case 2019 S&P 500 EPS growth forecast to 1% from 4.3%. While our earnings numbers are coming down, our bull, base, and bear case year end price targets remain unchanged as a lower rate environment provides support for year end target multiples. The bottom line--our base case year end target of 2750 is a lot less exciting than it was a month ago." - source Morgan Stanley
In their executive summary of their interesting note Morgan Stanley indicates the velocity in the earnings revisions as of late. This rapid move clearly shows that the euphoria seen in January where anything high beta rallied hard is not on solid ground. Debt-financed buybacks after all fell to 14% of the total among US companies at the end of last year, the lowest level since 2009 according to JP Morgan data. Buybacks since 2012 has been an important "pillar" in terms of support to US equities in recent years thanks to multiple expansion rest assured.

On top of that there are an increasing percentage of companies with negative earnings: S&P 500 - 7%; Nasdaq - 47%; Russell 3000 - 28%; Russell 2000 - 37%. For us, "high beta" is very "junky". If fundamentals are deteriorating such as global trade and global growth and earnings revisions are "savage" then regardless of central banks' u-turn, it isn't enough we think to provide the same support we saw in recent years and quarters. The cavalry was indeed late after the December massacre, but the overall macro picture ain't rosy.

Given the velocity in earnings revision/recession Morgan Stanley have drastically revised their outlook according to their note:
"Earnings Recession Is Here; Adjusted EPS Forecast Lower
With 4Q18 results season nearing completion we have been taking a closer look at 2019 guidance. Downward revisions have come even faster and steeper than we expected and the full year earnings growth number now sits just above 5% with a material upward acceleration projected in the 4th quarter of the year. At the start of a downward revisions cycle, history tells us not to count on that kind of upward inflection.
On the back of the recent downward revisions, we lower our earnings forecasts for 2019 as we think it is becoming increasingly clear we are in the midst of the earnings recession we called for in our year ahead outlook. Specifically, we are adjusting our 2019 EPS growth number down to 1% (from 4.25%) while noting that despite support from buyback accretion and a weaker dollar by year end, risks skew to the downside. We make minor changes to our 2020 growth assumptions and bull/bear case earnings estimates as well. Our revised forecasts are shown in Exhibit 1.


While our earnings numbers are coming down, our bull, base, and bear case price targets remain unchanged as a lower rate environment provides modest support for year end target multiples. With a more dovish Fed and our Interest Rate Strategy colleagues now projecting a year end 10Y UST yield of 2.45%, we revisit our Equity Risk Premium / 10Y yield matrix (Exhibit 2).

We highlight our target range of ~15 - 16.5x forward PE for the S&P. Our range below has a diagonal tilt as we believe lower yields will be accompanied by higher uncertainty on growth leading to a higher ERP while higher yields may reflect a more optimistic outlook on growth, allowing for ERP compression.
Don't Count on a 4Q19 Inflection in EPS Growth
We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into 4Q19 estimates is unlikely to happen. A modest further decline in earnings will deliver the earnings recession we called for. Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility will likely rise meaningfully. So in essence, we are still looking at a bumpy, range bound market at the index level and think investors should continue to try and take advantage of the swings in price in both directions.
The Market Needs a 4Q19 Growth Inflection To Support Full Year EPS Growth
In our year ahead outlook we argued that 2019 had a greater than 50% probability of seeing an earnings recession defined very simply as two consecutive quarters of negative y/y earnings growth. Following a steep downward revisions cycle over the last few months, consensus forecasts are quickly getting there. From the end of November, earnings growth expectation on the S&P fell from ~9% to their current level of around 5%. With an expectation of negative y/y growth in 1Q19 and very marginal growth in 2Q19, the mid-single digit full year number embeds a heavy ramp up of earnings growth in the back half of the year, and in 4Q19 in particular (Exhibit 3).

Importantly, since consensus bottom-up numbers are really just a reflection of company guidance this earnings slowdown could have real knock-on effects to corporate behavior like spending and hiring which then puts further pressure on growth.
Furthermore, company managements tend to be an optimistic group. As such, we're not surprised they are calling for a trough in 1Q. However, we would advise against taking too much comfort in these calls for a trough in 1Q19 of the down cycle from the same people who didn't see it coming in the first place. In addition to a trough in 1Q, consensus estimates are now forecasting a big second half inflection in growth.
Anything is possible, but we have little confidence in such an inflection given sharply falling top line growth and disappointing margins in the face of very difficult comparisons for the rest of this year
. If we accept that an earnings recession is here, the key questions are how deep will it be and how long will it last? Again, it's hard to know, but we can look to history for some context on how expectations for a large upward inflection in earnings usually play out." - source Morgan Stanley
Again, analysts going into 2019 have been way too optimistic when it comes to earnings. A usual trend but given the amount of liquidity injected into the system by central banks no wonder we are seeing growing risks of "cryoseism" in 2019. Volatility is firmly back.

As we stated before, where oil prices goes, so does US High Yield and in particular the CCC ratings bucket given its exposure to the Energy sector. No wonder Energy rallied strongly over the month of January:
- graph source Bank of America Merrill Lynch (click to enlarge)

In its January 2019 Senior Loan Officer Survey, the Fed said that a net positive percentage of domestic banks reported increasing the premiums charged on loans to large and middle-market firms. Historically, this tends to be a reliable signal of a pending recession. Both the supply and demand for household and business credit is either slowing or contracting. This is yet another "Cryoseism" sign that the epic high beta rally seen during the month of January is not on solid ground. So sure the rally in US High Yield has been very significant but, if indeed financial conditions continue to deteriorate, it doesn't bode well for the asset class down the line.

As we mentioned on numerous conversations, like any good behavioral psychologist we tend to focus more on flows than on stocks. We stated as well at the end of the year that for a rebound in credit markets, fund flows need to see some stabilization the latest dovish tilt from central banks globally have enabled such a bounce as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 8th of February entitled "Reaching for yield":
"Equities record first inflow, HY inflow surpass $1bn
Dovish central banks globally have instigated a risk assets rally. The reach for yield is back amid lower government bond yields. Inflows into high-yield funds have strengthened over the past weeks and equity funds recorded their first inflow in a while as light positioning has become a tailwind for the asset class.
Over the past week…
High grade funds flopped back to negative territory. Last week’s outflow reversed part of the inflow from week ago, ending a two week streak of inflows. However, the outflow was driven by one single fund and removing it would result into a $1.1bn inflow. High yield funds on the other hand continued to see stronger inflows w-o-w.
We note that last week’s inflow was the largest since September last year. Looking into the domicile breakdown, US-focused funds recorded the lion's share of the inflow, while Europe-focused funds recorded a more moderate inflow. Note that the inflows into global-focused funds were marginal.
Government bond funds recorded a decent inflow this week; the third in a row. Money Market funds recorded a strong inflow last week. All in all, Fixed Income funds recorded another inflow, though the pace has slowed down w-o-w.
For a change European equity funds recorded their first inflow after 21 consecutive weeks of outflows. Note that during this period total outflows reached $45bn.

Global EM debt funds continued to record inflows, the fifth weekly one. Note that last week’s inflow was the strongest since July 2016. Dovish Fed and lower dollar has become a tailwind for the asset class recently. Commodity funds recorded another inflow, the ninth in a row.
On the duration front, we find that the belly underperformed recording the vast majority of the outflow last week. Long-term and shot-term IG funds also recorded outflows last week, but to a lesser extent." - source Bank of America Merrill Lynch
A dovish Fed in conjunction with lower rate volatility have led to Emerging Markets benefiting from the return of the "carry" trade.

Given that bad news has become good news again during the month of January, given the dovish tilt taken by most central banks, high beta has come back to the forefront thanks to the central banking cavalry. 2019 has clearly started on a very strong tone as indicated by Bank of America Merrill Lynch in their European Credit Strategist note from the 8th of February entitled "Play it again Sam":
"As the expression goes…it’s always darkest before dawn. Year-to-date, high-grade spreads have rallied 18bp and high-yield has tightened by 72bp in Europe. These are impressive moves. For the investment-grade market, 2019 is shaping up to be one of the best ever starts to a year outside of 2012 – a time when the ECB’s life-saving LTROs energised a huge rally across the market.
An epic central bank “blink”
In 2018, only 13% of assets across the globe posted positive total returns…and only 9% of assets managed to outperform US 3m Libor. Jump to 2019 and the picture couldn’t be different. As Chart 1 shows, 98% of assets across the globe have positive total returns so far this year (the second best outcome since 1990).

The clearest instigator for such a bullish reversal, in our view, is that central banks are now undergoing one epic reversal in their monetary policy stance. In 2019, the Fed has already pivoted to being on-hold, the ECB has moved the balance of risks to the downside, Australia has stopped hiking and India has delivered a surprise rate cut.
When the most important central bank in the world changes tack, others must follow…or risk unwanted currency appreciation. True to form, as Chart 2 shows, the number of global central bank rate cuts over the last 6m is now greater than the number of central bank rate hikes (although the picture is less dramatic when excluding Argentina).

And when central banks flip-flop, so do markets. With interest rate vol at record lows now in Europe, this means a green light for carry trades and a return of the thirst for yield.
Cash spreads can still squeeze…but watch out for March indigestion
In credit land, the Street looks particularly offside in this tightening move, reflective of low inventory levels. And with earnings blackout still in place, cash bonds could still squeeze tighter in the short term (especially non-financials). We think the real challenge for the credit market will emerge in March, given that supply is seasonally highest then (14% of yearly issuance). A €50bn+ month of supply, for instance, could herald a return of big new issue premiums and widening pressure on secondary spreads.
Hubris 101– it never ends well
We’ve seen this central bank movie too many times in the past, though, to forget that markets always overshoot amid a yield grab. And that’s exactly what we worry about this time. After all, 30yr Bund yields at 72bp, 5y5y Euro inflation swaps at 1.48% (the lowest since Nov ’16) and rising BTP spreads signal the market’s doubt over the efficacy of another dose of monetary support, in our view.
Our concern is that Euro credit spreads are now increasingly dislocated from European economic data, and at best are pricing-in a Euro Area recovery that may take longer to materialise than the consensus thinks.
Chart 3 shows that European high-yield spreads have closely tracked the Eurozone manufacturing PMI New Orders index over the last 20yrs (72% correlation of levels, since mid-98).

New Order indices are a more forward-looking, and relevant, indicator in our view. But note that this index is still falling and is now far below the 50 recessionary threshold (47.8). Yet, with the market having rallied strongly year-to-date, our regressions point to Euro high-grade spreads being roughly 20bp too tight, and Euro high-yield spreads a more concerning ~200bp too tight.
China…China…China!
Credit spreads are likely discounting a revival in the Eurozone cycle. Our economists expect Euro Area data to begin rebounding as we approach 2H ‘19. But the point is we’re not there yet…and the data flow thus far – especially industrial production – suggests that the Euro Area rebound may, if anything, take longer to materialize.
As an open economy, the Eurozone needs a thriving global economy to grow strongly. Germany, in particular, is exposed to non-European export markets. And given how Germany is integrated into other European countries’ supply chains, German weakness means a broader spill-over to Eurozone growth. But the external environment has been very unfriendly to Germany of late. Chart 4 shows how non-Euro Area trade has faded, with trade wars and China’s slowdown being culprits.

Weaker non-EZ trade means less of a buffer for the Eurozone to counter rising political uncertainties.
That means Euro credit markets need to see two things pretty soon to justify today’s spreads: firstly a US-China trade “agreement”, and secondly signs that China’s stimulatory efforts are finally paying dividends (and supporting broader Asian growth).
  • While a US-China trade compromise is our base case, it’s not yet clear whether the US administration has moved on from their concerns over European car imports. On this front, investors should keep an eye on the US Department of Commerce’s Section 232 report on the national security threat of motor vehicle and auto part imports. Bad news here would weigh further on global trade volumes to the detriment of the Eurozone.
  • While China has engaged in a number of stimulatory measures lately (RRR cuts, tax cuts for small businesses and a perpetual bond-for-bill swap), credit growth dynamics have yet to materially rise. Chart 5 shows that the ratio of China Total Social Financing to China M2 remains subdued, for instance.

  • And importantly, while US and Euro credit markets have seen a material tightening in 2019, (high-grade) credit spreads in China remain elevated.
QE Infinity, and the real meaning of “pushing on a string”
The dovish leanings of policy makers this year have been manna for financial markets. For over a decade, central banks have been able to cajole asset prices higher with their repeated interventions. In fact, Chart 7 shows how effective the ECB has been since 2009 in propping up sentiment: growth in the ECB’s balance sheet has always been enough to counter spikes in European policy uncertainty.

But after ~$11tr. in central bank balance sheet growth since The Global Financial Crisis (GFC) (using the “big 4”), the limits of monetary policy are being reached. Central banks have much less capacity to effect economic change this time around. 
Chart 8, for instance, shows where interest rates would be if central banks repeated their post-Lehman easing cycle, from today.

Understandably, some of the numbers would be far out of the realms of possibility. Hungarian interest rates, for instance, would drop to -10%, Eurozone deposit rates would fall to -4% and US interest rates would be heavily in negative territory (-2.5%).
Moreover, as the expression “pushing on a string” reflects, successive rounds of stimulus over the last decade look to have produced incrementally less economic growth, we think.
In Chart 9, we show what has happened historically to (1) global GDP momentum; and (2) global debt-to-GDP levels, in periods when global central bank balance sheets have expanded notably. Since 2006, we find five such periods.

Since then, however, periods of central bank balance sheet expansion look to have produced a much weaker impulse to the global economy.
  • The second round of stimulus post-GFC (‘10/’11) was followed by a decline (-0.9%) in the OECD Lead Indicator, which was driven by strong deleveraging (-9pp in the global debt/GDP ratio),
  • And the short, but visible increase in global central bank balance sheets between late ’17 and early ’18 was not even enough to propel growth upwards: the OECD Global Lead Indicator fell by 0.3% over the following 12m.
In summary, we caution that markets should not get carried away by central banks’ newfound dovishness. After so much support already, and with $58tr. of global debt being added since the GFC, recreating the impact of past support now looks much tougher for central banks." - source Bank of America Merrill Lynch
We agree with Bank of America Merrill Lynch, "carry on" but do not get "carried away". If financial conditions will gradually continue to tighten as per the latest SLOOs, there is more potential for "Cryoseism". No matter how much liquidity has been injected by central banks, the massive issuance in credit markets in recent years have led to the illusion of "liquidity". For this illusion, you just have to check the secondary market in credit markets to gauge its depth. The next quarterly SLOOs will be paramount as per our final chart below.

  • Final chart - Credit pinball - Same player shoots again?
Are we seeing yet another case à la second part of 2016 which saw a significant rally in credit markets and in particular in high beta US high yield thanks to the recovery in oil prices and a more dovish tone from central banks? One might wonder. Our final chart comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 8th of February entitled "Happy New Year, welcome back" and displays the SLOOs versus US Investment Grade corporate spread. Is this a similar situation to the early recession fears of 2016 or is this time different? We wonder:
"Lather, rinse, repeat
Back in late 2015/early 2016 US recession fears were overblown as investors extrapolated from weak manufacturing data a high recession risk. This exact same scenario played out late 2018/very early 2019 as markets forgot that the manufacturing sector is only 17% of the US economy and the remainder is strong (see: Fool me once, fool me twice). Back then the Fed’s senior loan officer survey showed in response a shift toward tightening lending standards. The same thing is understandably happening this time as the survey period for the fresh Fed survey was the last half of December, which represented the height of recession fears (Figure 7). Like back in 2016, as recession fears are proven wrong, this will pass and banks will once again go through a period of loosening lending standards well before the next downturn. For banks the problem is a lack of loan demand, as the cost of debt has increased materially. Absent recession that means banks will soon be back to loosening standards and undercutting yields in the corporate bond market in order to gain business." - source Bank of America Merrill Lynch
Earnings were decent but the outlook is deteriorating fast. Also financial conditions seems to be tightening, We have seen stabilization in fund flows but this rally is not on solid grounds particularly with weakening buy-backs as CFOs are urged to become more defensive by investors of their balance sheet. You have been warned. It is still capital preservation time. Carry on but don't get carried away...

"Sometimes the early bird gets the worm, but sometimes the early bird gets frozen to death." - Myron Scholes

Stay tuned ! 
 
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