Saturday, 18 August 2018

Macro and Credit - Hypertonic surroundings

"The advancement and diffusion of knowledge is the only guardian of true liberty." - James Madison


Watching with interest the numerous convolutions in Emerging Markets, with Gold taking the proverbial sucker punches thanks to the bloody rampage of "Mack the Knife" (King Dollar + positive real US interest rates), when it came to selecting our title analogy, we decided to return to a biology one, namely "Hypertonic surroundings" given our global macro reverse osmosis theory we discussed in our conversation "Osmotic pressure" back in August 2013 seems to be playing out for the weakest EM "cells" out there:
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
 This is the theory we put forward in terms of biology analogy at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
We also added in our July 2015 conversation the following: 
"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - Source Macronomics July 2015.
A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been the pain in EM most recently with the usual suspects such as Turkey and Argentina being first in the line of the murderous rampage of "King Dollar". 

Nota bene: Hypertonic
"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia
What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs rest of the world). Animal cells lack rigid cell walls. When they are exposed to hypertonic environments, water rushes out of the cell, and the cell shrinks. The resulting cells are dehydrated and lose most or all physiological functions while in the shriveled state. If cells are returned to isotonic or hypotonic environments, water reenters the cell and normal functioning may be restored. Cells without cell walls (capital controls) can burst when in a hypertonic condition. Too few solutes (US dollars) and the environment will become the hypertonic solution. There goes our reverse osmosis global macro analogy for you.


In this week's conversation, we would like to look at the main reasons for the start of the "unwind" of the carry trade and the pain inflicted to EM macro tourists, namely that Mack the Knife is a consequence of financial conditions tightening for many leveraged global players. 

Synopsis:
  • Macro and Credit - The Fed is tightening its financial conditions tourniquet 
  • Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions


  • Macro and Credit - The Fed is tightening its financial conditions tourniquet 
While every pundits around the financial sphere are pointing the rise of the US dollar as the main reason for the ongoing bloodbath in the EM space, we think that the rise in the greenback is a manifestation, not the main cause of Mack the Knife's rampage. The reality as pointed out by David P. Goldman in Asia Times on the 16th of August is that financial conditions are getting tighter as per his article entitled "It’s all about financial conditions":
"The collapse of the copper price by 20% from its June peak evidently is not an economic phenomenon driven by demand. Rather, it is an expression of risk aversion.
The world has gotten riskier during the past few months, for two primary reasons:
  1. There is a low-level trade war between the US and China underway that could turn into a high-level trade war; and
  2. The Italian elections put a bunch of unpredictable firebrands in charge of an economy with US$2.3 trillion in foreign debt and a dodgy banking system.
Heightened risk translates into a greater desire to hold cash balances (and that means a higher dollar, because most people pay bills in dollars and therefore hold cash balances in dollars). To get higher cash balances, market participants sell things like raw materials.
Turkey is utterly irrelevant to this shift towards risk aversion. The Turks may make the mistake of thinking that they matter but no-one else should encourage them. Turkey’s whole stock market is worth about US$30 billion at current prices, roughly the market capitalization of Monster Beverage Co. The big issues are European disintegration and Italian dyspepsia, and the US-China trade war." - source David P. Goldman - Asia Times
Because of fears of dollar scarcity, thanks to QT and the Fed turning off gradually the monetary spigot, the commodities rout has been about raising dollar cash/playing defense as indicated by David P. Goldman. As well there are the usual "known unknowns" everyone and their dog have been talking about, namely the risk of trade war escalation and of course the potential brewing internal rift between the European Commission and Italy. It's going to be interesting to say the least to see how Le Chiffre at the helm of the ECB aka Mario Draghi is going to deal with the Italians and their budget which will no doubt necessitate some helping hand in buying their bond issuance. This is what we wrote in our October 2015 Le Chiffre conversation:
"While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy." - Macronomics, October 2015
 But, hey whatever it takes...as we wrote as well in the same conversation:
"While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it." - Macronomics, October 2015
So while the US dollar is indeed on everyone's mind when it comes to EM woes and the Turkish side show, still the big European elephant in the room remains Italy. The current Fed normalization process is making Le Chiffre's balancing work even more complicated we think if he intends to remain a "forced" marginal buyer of Italian BTPs with of course Merkel's German consent.

But, moving back to our recurring themes in recent conversations, we discussed rising dispersion and large standard deviation moves. This late cycle phenomenon is attributable we think to liquidity being withdrawn thanks to QT and global financial conditions being tightened. As we saw earlier one the short-vol pigs house of straw blown away, obviously the next levered candidate were the macro-tourist pigs house of sticks such as Turkey and Argentina. 

In our March 2017 conversation entitled "The Endless Summer" we concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something. As well we commented the following in our February missive "Buckling":
"The difficulty for the Fed in the current environment is the velocity of both the rates rise and inflation, because if indeed the Fed hike rates too quickly then it will trigger some other avalanches down the capital structure (short-vol complex being the equity tranche or first loss piece of the capital structure we think). If inflation and growth rise well above trend, then obviously the Fed will be under tremendous pressure to accelerate its normalization process. It is a very difficult balancing act." - Macronomics, February 2018
The Fed is still relentless on its hiking path, particularly in the light of US CPI coming at 2.9% year-over-year, unchanged from June; the fastest pace in more than six years. As we repeated in numerous conversations, for a bear market to materialize you would need a significant pick-up in inflation for your "buckling" to occur and to lead to a significant repricing of risky asset prices such as equities and US High Yield. In recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. To repeat ourselves "Protectionism", in our view, is inherently inflationary in nature. At some point there might be a confrontation between the Trump administration and the Fed we think.

A clear sign of financials conditions tightening we think has been the unwind of the EM carry trade to the benefit of our friend "Mack the Knife" aka the US dollar. This is clearly indicated by Bank of America Merrill Lynch in their Liquid Insight note from the 16th of August entitled USD in the FX carry driver's seat:


  • "USD has been a top yielder in G10; a fundamentally-strong USD with asset status supports FX carry and further dollar gains
  • USD on the asset side and SEK on the funding side has upended correlations; FX carry beta risk is low and investors own vol
  • After the momentum surge in February-April, FX carry looks poised for another leg higher; will AUD & NZD stand in the way?

The shifting dynamics of FX carry
The US dollar resides firmly on the asset side of the FX carry spectrum, currently occupying the top yield rank (Chart of the day).

Its presence atop the yield ranking is historically atypical and a reflection of a robust US economic cycle and a steadily hiking Fed, attributes that have supported USD higher since 1Q18. USD asset status alongside SEK liability status (displacing JPY) has also sharply shifted historical FX carry correlations, resulting in long carry positions now having very low traditional “beta” (risk-on/risk-off) exposure as well as long exposure to implied volatility. FX carry investors now actually get paid to own tail risk in a robust economic cycle, which has traditionally supported carry returns. These are important shifts that enhance the attractiveness of both FX carry as an investment approach in an uncertain world as well as support the USD as principal currency beneficiary. After a strong surge in momentum through mid-April, event analysis suggests FX carry is poised to make another run higher in the weeks ahead. Of key importance will be whether recent sharp depreciation in AUD and NZD – the two other asset currencies aside from USD – moderates.
FX carry revisited
Traditional FX carry strategies involve going long currencies offering the highest yields, funded in currencies offering the lowest yields. The number of currencies on respective asset and funding sides can vary but often is symmetrically three (particularly in G10). For the sake of simplicity, our analysis uses Bloomberg’s G10 FX carry index, which uses a simple top three/bottom three construction and, in our view, is representative of the approach used by many FX carry-themed investors.
The general historical pattern of FX carry positions should be unsurprising to those familiar with the strategy. On average, since 2000, the highest ranking carry currencies have been NZD, AUD and NOK, in that order. The lowest ranking carry currencies have been CHF, DKK and JPY. Historically, USD, EUR, GBP and CAD have been positioned somewhere in the middle.
The carry spectrum today: What’s wrong with this picture?
Chart 1 shows the current FX carry spectrum based on implied three-month yield. A simple top three/bottom three FX carry strategy would currently be long USD (2.32% yield ), NZD (2.31%) and AUD (2.19%), funded in CHF (-0.80%), DKK (-0.59%) and SEK (-0.49%).

The position of USD on the asset side of G10 FX carry clearly represents a major departure from the past (Chart 2).

Moreover, its position at number one represents a full five rank positions above the historical average (about number 6). This is by far the greatest discrepancy with respect to current FX yield rank vs historical average across G10.
Additional anomalies worth highlighting are SEK, currently squarely on the funding side and two positions below its historical average; and JPY, now approaching middle-of-the pack status and two positions above its historical average (no longer a funder). Nonstandard monetary policy measures and forward guidance put in place by the ECB are responsible for low European yields, in particular that of SEK. Indeed, the Riksbank responded with aggressive measures of its own aimed at preventing unwanted exchange-rate appreciation, the practical result being relegation of SEK to the FX funding bin. Negative funding yields have clearly enhanced the spread of high yielders.
Factors affecting carry performance
FX carry has traditionally been a risk-on and implicitly short volatility strategy, essentially a reflection of relative yield providing compensation for relative perceived risk (Chart 3).

High yield also provides an incentive to fund external deficit currencies, often on the asset side of an FX carry strategy historically. Conversely, low (currently  negatively) yielding funding currencies usually exhibit safe-haven status, often due to external surpluses and correspondingly high international investment positions (IIPs). FX carry investors earn a positive return in one of two ways: (1) exchange rates remain stable or decline by less than the yield spread between the asset and funding currencies; or (2) asset currencies increase in value relative to funding currencies, hence producing capital appreciation additive to the positive carry differential. The latter scenario is the ideal one for carry seekers. FX carry investors lose money (ie, experience negative total return) when depreciation in asset currencies vs funding currencies exceeds the positive carry earned. Losses have been severe at times, as was the case during the Global Financial Crisis (GFC), when financial markets convulsed and global growth dove into recession.
Investors are likely aware that FX (forward) markets are priced such that the expected rate of depreciation in high yielding currencies relative to low yielding ones equals the positive carry earned (interest rate parity), meaning long carry investors implicitly think the FX market is incorrectly priced (generally too ‘pessimistic’). This is a key reason why FX carry traditionally suffers when risk tolerance takes a dive. With global risk appetite heavily influenced by global growth (Chart 4), FX carry performs well in periods of cyclical strength.

This makes tepid performance of the strategy all the more perplexing, particularly considering strength of the US cycle, particularly this year.
Carry momentum to re-assert
FX carry experienced a surge in momentum back in mid-April. After a protracted four month consolidation period, history suggests another leg higher in the weeks ahead. Back on 13 April, the 50-day information ratio of FX carry returns rose above 4.0, a two standard deviation event indicative of a significantly high level of carry momentum (Chart 5).

Readings of this magnitude have only happened 19 times since 2000. Of those 19 instances, 17 were higher after 100 trading days for an average total return of about 3% (vs currently only about 1% after day 87) (Chart 6).

Within this sample, 26 November 2012, stands out as having strikingly similar price action to today. This instance is 70% correlated over the last 60 trading days and 80% correlated over the last 20 trading days and suggests an impending 4% surge higher in the FX carry index to peak levels over the next few weeks. 
Carry caveat: will the antipodeans cease plummeting?
We believe USD will contribute to another leg higher in FX carry for fundamental reasons (strong cyclical position, monetary policy divergence). Our confidence in AUD and NZD – the other two currencies currently on the asset side of the strategy – is lower. Recent sharp slides in the antipodeans have been amplified by elevated global trade war, China and EM-related uncertainty. At a minimum, the pace of depreciation needs to moderate. So far, our LCBF flow data, which show four-week flows recently crossing into negative territory, for now do not support potential cessation of selling pressure. That said, speculative positioning as measured by CFTC and other data sources is very short AUD and NZD, potentially helping to contain a continued downside slide.
Note that in the recent February-April FX carry upswing, AUD and NZD trended moderately lower. But because of sharp USD strength and SEK weakness the strategy produced strong positive returns anyway. Resumption of AUD and NZD strength against SEK would clearly bode well for the FX carry strategy looking forward.
On a relative basis, our views are constructive AUD vs NZD (Greater AU and NZ divergence 15 Aug 2018). Of the three currencies currently included on the asset side of FX carry, NZD is clearly the weak fundamental link" - source Bank of America Merrill Lynch
There you go, if the USD is on a rampage, not only do we have rising dispersion among asset classes such as credit and equities but, now there is indeed a "hypertonic surrounding" situation when it comes to the swelling US dollar carry. This of course is the manifestation rest assured of QT hence the reason for the commodities bloodbath with many players busy raising their USD cash levels for protective measure.

While in our previous conversation we indicated we remained short term "Keynesian" and starting to become "Austrian" from a medium perspective, there is no doubt in our mind that there are clouds lining up on the horizon that warrants close attention. For instance from a "flow" perspective the latest Follow The Flow note from Bank of America Merrill Lynch from the 17th of August is aptly entitled "Nowhere to hide":
"Outflows from IG, HY, govies, EM and equities
It seems that investors have nowhere to hide. Almost all the asset classes we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt. Same in equities and even in money market funds. Higher risk assets volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets. Will risk aversion abate any time soon? Should the aforementioned risks not disappear, we struggle to see a structural shift in flows back to Europe especially amid dollar strength and global interest rate differentials.

Over the past week…
High grade funds flows dipped further into negative territory. Further euro weakness (vs. the dollar) has pushed more outflows out of euro funds over the past week. High yield funds were hit again by outflows, erasing the inflows we have seen over the previous two weeks. Looking into the domicile breakdown, Global and European-focused funds have recorded outflows while US-focused funds recorded inflows.
Government bond funds recorded a strong outflow over the past week; almost reversing the inflow we saw a week ago. All in all, Fixed Income funds recorded a sizable outflow; the largest in eight weeks and the first after three consecutive weeks of inflows.
European equity funds recorded outflows for the 23rd consecutive week. $55bn has left the asset class over that period.
Global EM debt funds recorded another outflow last week, amid a rapidly weakening
trend in EM FX land. Commodity funds recorded a small inflow.
On the duration front, there were outflows across all parts of the curve. It feels that outflows were more sizable on the back-end of the curve." - source Bank of America Merrill Lynch
No wonder, the winner take all mentality is taking its toll flow wise and the US powering ahead in true "Dissymmetry of lift" fashion. But good news might indeed be history as we move towards the fall. While we recently wondered about MDGA (Making Duration Great Again) from an exposure point of view, we think that it is the time to reduce some risk and starting playing defense we think. On that specific point we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 17th of August entitled "Risk off stew: QT, rate hikes, refi's dead, declining breakevens, expensive housing":
"Risk off stew: QT, rate hikes, refi’s dead, declining breakevens, expensive housing
Risk off signals are escalating. In our view, the only positive note this week was the trade war news that China will send a delegation to the US to try to resolve differences. We’re doubtful that a meaningful “fix” to a situation that has been brewing at least since China’s entry into the WTO in 2001 will be reached, but we’ll see. The Shanghai Composite closed the week at 2669, the lowest level in over two years, so market skepticism about trade war resolution appears intact. Meanwhile, the list of negatives for markets, away from trade, is getting longer, creating a risk off stew in our opinion.
QT has been accelerating: the Fed’s balance sheet is now down by $219 billion in 2018 and the 4-week rolling change of $64 billion is by far the largest decline in a 4-week period since the unwind started. 10 years after the crisis led to dramatic expansion of the Fed’s balance sheet, the unwind is picking up steam; we look for another $175-$200 billion by YE 2018. On top of that, another rate hike in September seems fairly certain, consistent with our Economist’s views. Jackson Hole or the upcoming Fed minutes seem unlikely to offer any meaningful change from the Fed’s somewhat autopilot policy tightening plans. But these events will be worth watching, as a dovish shift could alter the risk off conditions.
Another negative is recent declines in the 10-year breakeven inflation rate, which has dropped down to 2.08%. While the breakeven rate has stabilized above 2.0% in 2018, the Fed’s continued policy tightening may well challenge that stability. BofAML technical strategist Paul Ciana is now highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Based on our breakeven inflation valuation framework for securitized products, this would be consistent with our view that spread widening risk now dominates for the sector. In mortgages and housing, things are not great either. The MBA Refinancing index dropped to an 18-year low this week. Long gone are the days that increased refinancing activity provided a savings stimulus to the household sector. Instead, declining refinancing activity is consistent with policy tightening from the Fed. Meanwhile, the latest UMich consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.” This is consistent with the recent sharp drop in the MBA purchase index and is even more negative than the affordability index, which is back to 2008 levels, would suggest; given the changes in mortgage credit availability since the pre-crisis era, affordability is probably more constrained than the nominal time series suggests.
As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. If the trade war and Fed remain on their recent, market-unfriendly paths, the chances seem increasingly good that a sharp risk off rally in bonds is coming, as is more pronounced spread widening in securitized products. We’ll watch for change in the coming weeks, but, in our view, now is the time to become more defensive. We doubt either the Fed or China will meaningfully change course without more pronounced market turmoil as motivation. Most likely, spread widening in securitized products has only just begun."  - source Bank of America Merrill Lynch
From a contrarian perspective, two things stand out, not only the consensus short US Treasury Notes is stretched but if indeed we are starting to see a fall in breakevens, there could be a potential for a rebound in gold which has been relentlessly impacted by the surge of "Mack The Knife" though one could argue that given the momentum in USD FX carry, it might be still difficult to time your entry. 

In their notes Bank of America Merrill Lynch highlights the different factors pleading for a more cautious stance in the weeks ahead of us:
"This week, we survey a number of factors that argue in favor of a more pronounced risk off phase for markets in the period ahead. We began warning of this phase back on July 27 in “Soft housing data piling up: prepare for risk-off.” This week provided a hint of what we think is in store for markets in the next 2-3 months. In our view, spread widening risk in securitized products now dominates. We think defensive positioning is warranted.
Two factors could change this: a sudden change in tone from China on the trade war and the Fed on tightening policy. We think more downside in markets is likely need to create such changes, but we will watch in the weeks ahead, particularly in the upcoming Fed minutes and Jackson Hole, for signs of a shift.
Factor 1: the trade war
The simple trade war gauge we have been watching is the Shanghai Composite index. While it is heading lower, we see risk that weakness in China spills over and increases global recession risk, which will be reflected in wider credit spreads. Chart 1 shows the index closing this week at the lowest level since 2016, down 25% since the January high.

Chart 2 shows the index inverted against the IG corporate index spread. Our point with this chart is that at least some of the trade-related weakness in China is spilling over to the US.

As we write, there is a report of a possible high-level US-China trade summit in the months ahead. While this is positive news, it is a long way from resolving a host of issues that date back at least to 2001, when China entered the WTO. More downside pain in markets may be necessary to lead to true resolution.
Factor 2: the Fed balance sheet and rate hikes
It’s almost 10 years since the financial crisis led the Fed on a path of significant balance sheet expansion. 2018 has seen the start to the unwind (Chart 3): down $219 billion YTD in 2018, with the last 4 weeks seeing a drop of $63 billion.

The unwind is accelerating, as the balance sheet should see another $175-$200 billion decline by YE 2018. On top of this, the Fed maintains ambitious rate hike plans relative to the market (Chart 4).

The upcoming minutes release and Jackson Hole meeting provide opportunities for the Fed to offer new views on policy. Our rates and economics colleagues Mark Cabana and Joe Song suggest the Fed will provide “updated guidance on the longer-run operating framework, which will have implications for a potential end date to the balance sheet unwind.” See “The week in fedspeak,” 17 August 2018. Whether this will be enough to signal a meaningful shift in tightening plans remains to be seen. For now, as with trade, we’re skeptical.
Factor 3: breakeven inflation rates are declining once again
The combination of trade war and tightening policy has reversed the rise in the 10yr breakeven inflation rate (Chart 5).

We’ve seen this movie before in the past few years (2015 and 2016-2017): inflation expectations move higher and then roll over. This year has seen more stability above the important 2% threshold, which is why we have retreated from frequent discussion of our breakeven inflation valuation framework for securitized products.
Now, as the breakeven rate has dropped to its 200d moving average, BofAML technical strategist Paul Ciana is highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Our valuation framework suggests this is consistent with spread widening risk for securitized products.
Essentially, it appears as if the market has reached a critical, potential break point on factors 1 and 2 above, the trade war and Fed tightening. If there is no capitulation by either the Chinese or the Fed, the chances are good that breakevens will indeed head meaningfully lower, undoing the work that has been done to stabilize inflation expectations above 2%.
Factor 4: mortgages and housing – refi’s are dead and housing is expensive
This week saw the MBA refinancing index drop to the lowest level since 2000 (Chart 6), nearly 18 years ago.

Gone are the days when an increasing refinancing incentive created a savings stimulus for household. Instead, the Fed’s policy tightening is showing one additional sign of stimulus withdrawal, in the form of declining refinancings. Higher rates have mattered.
Similarly, the MBA purchase index has rolled over sharply in recent weeks (Chart 7), as high home prices and high mortgage rates have hurt affordability.

Confirming this, the latest University of Michigan consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.”
The sentiment is interesting, as affordability is currently at 2008 levels, which were actually better than 2006 levels. Chart 8 shows affordability along with the MBA’s mortgage credit availability index.

2006 was the lowest level of affordability in the history of the index. But it was also the year of maximum credit availability that acted as an “offset” to low affordability.
While we see potential for some loosening of mortgage credit, we see little chance of a return to pre-crisis levels of availability. The best solution to low affordability is lower rates. As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. Given the risk off stew that is brewing,  a risk off move in markets may give the mortgage and housing market what it needs." - source Bank of America Merrill Lynch
Sure housing would indeed get a respite from lower yield no doubt. It's all about Wall Street versus Main Street. Given the amount of known unknowns in these "hypertonic surroundings" we would rather take a more cautious tone and raise cash levels in dollar terms within our allocation tool box, given cash in the US thanks to the rise of the front-end is appealing again.

Finally, as per our final charts below, what could really trigger a more recessionary and bear market outlook to the current scenario would be rapid rise in oil prices with an escalation with Iran we think. As we pointed out earlier one, for a bear market to materialize you would need a significant pick-up in inflation and oil could be the match that triggers the lot. 


  • Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions
What matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.  It is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation with Iran. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 17th of August entitled "the law of large numbers". The first chart displays the surge of the US dollar since tariffs were imposed in March and the second chart displays the risk posed by oil shocks in post-war recessions:
"Since the steel and aluminum tariffs were imposed on March 1, the dollar has strengthened against many currencies (Chart 1).
Iran: oil slick?
Oil sanctions against Iran pose an almost equal risk to global growth. Recall that oil shocks have played a role in most post-war recessions (Chart 2). Given the steady shrinkage in Venezuelan supply, the large gyrations in Libyan supply, and the fact that OPEC and US fracking supply is already high, a cut-off in Iranian oil could have a major impact on prices. Iran currently exports about 2.3mn barrels of crude oil per day (b/d). Francisco Blanch and team estimate that a reduction of 1mn b/d in Iranian supply would increase Brent prices by about $17/barrel. This means that if the Trump administration pursues its stated goal of cutting Iranian oil exports to zero, Brent could rise above $100/barrel. This would be a major headwind to global growth, especially since dollar strength is pushing the non-dollar price of oil up even faster.
The Iran story is not just about global oil supply. It has created yet another split between the US and many of its allies. The sanctions could also worsen US relations with major importers of Iranian oil, including China and India, which together have purchased nearly 60% of Iranian crude oil exports this year. Although the sanctions have been imposed unilaterally by the US, they would apply to any shipping or insurance company that deals with Iranian oil. This gives the US the power to effect substantial cuts in Iranian exports globally, should it choose to do so.
A final striking aspect of the sanctions is their timing. Full sanctions on Iranian oil go into effect on November 5, just one day before the US midterm elections. In our view, this is a sign that the Trump Administration views getting tough with Iran as a winning political issue. The timing argues against a common view that the Trump Administration will moderate its policies—and reduce the risks to the markets and the economy—in the run-up to the election." - source Bank of America Merrill Lynch
We do live indeed in interesting "hypertonic surroundings" times, with of course many known unknowns to keep us entertained for the weeks ahead. What's always more worrying is the unknown unknowns but that's another story and we ramble again...
"Knowledge is not simply another commodity. On the contrary. Knowledge is never used up. It increases by diffusion and grows by dispersion." - Daniel J. Boorstin, American historian

 Stay tuned!

Friday, 10 August 2018

Macro and Credit - Maneuver warfare

"War is not an independent phenomenon, but the continuation of politics by different means." - Carl von Clausewitz


Looking with interest the rise in noncooperation around the world, with increasing trade war rhetoric between the United States and China, Turkish spiraling woes, Saudi diplomatic spat with Canada, Iranian sanctions building up against a reticent yet divided Europe and the push for additional Russian sanctions making rounds, in continuation to our war analogy used in July in our conversation "Attrition warfare", we decided to go for another one, namely "Maneuver warfare". "Maneuver warfare", or manoeuvre warfare, is a military strategy that advocates attempting to defeat the enemy by incapacitating their decision-making through shock and disruption. Given the shock and awe tactics used so far by the Trump administration with North Korea and now with Iran, not to mention the tensions rising between the US and their European allies, one can clearly make sense of the use of our chosen analogy. In "Maneuver warfare", tempo and initiative are critical to the success of the operation. According to the United States Marine Corps, one key concept of maneuver warfare is that maneuver is traditionally thought of as a spatial concept, the use of maneuver to gain positional advantage. The US Marine concept of maneuver, however, is a "warfighting philosophy" that seeks to shatter the enemy's cohesion through a variety of rapid, focused, and unexpected actions which create a turbulent and rapidly deteriorating situation with which the enemy cannot cope. The U.S. Marine manual goes on to say: 
"This is not to imply that firepower is unimportant. On the contrary, firepower is central to maneuver warfare. Nor do we mean to imply that we will pass up the opportunity to physically destroy the enemy. We will concentrate fires and forces at decisive points to destroy enemy elements when the opportunity presents itself and when it fits our larger purposes."
One can argue that in recent years the United States have decided to "weaponize" the US dollar. The continuation of the surge of the US dollar thanks to QT and a hawkish Fed on the back of the US economy heating up, with the surge of inflationary pressures is indeed wreaking havoc on over-exposed and over-leveraged Emerging Markets economies such as Turkey. We do not see any respite yet for some ailing Emerging Markets which are over-exposed to US dollar funding and rollover risk.


In this week's conversation, we would like to look at the continuation of the demand in high beta and the summer rally which is continuing for US equities mostly and ask ourselves how long it can go on as we move towards fall. 

Synopsis:
  • Macro and Credit - Asset prices - Still short term "Keynesian" but starting to feel "Austrian" again
  • Final charts - This isn't your grandfather's market


  • Macro and Credit - Asset prices - Still short term "Keynesian" but starting to feel "Austrian" again
Given the strong tone of recent earnings in the United States corporate world, we continue to advocate being overweight US versus the rest of the world. To repeat ourselves, riding the EM wave was great in 2017, and we confided bailing out in late January this year, but, 2018 is proving to validate our most recent title "Dissymmetry of lift", in the sense that the United States is powering ahead in both macro and equities, whereas so far, the rest of the world is struggling to keep up with the pace (check out MSCI World versus the S&P500, we rest our case). But, what is today's news in terms of macro data, is already yesterday. Sure earnings were strong though there are already signs, even in the US of a weaker tone in the macro data (US housing and Mortgage applications for example). The US 10 year Treasury notes yield continues to flirt with the 3% threshold. With inflationary pressures building up on global scale, if you want "real yield", even if US inflation seems to become stronger, you probably want US dollar fixed income exposure from a carry and roll-down perspective. We mentioned that 2018 marked the return of US dollar cash in the asset allocation toolbox.

When it comes to credit and asset allocation US credit and in particular the high beta space continues to benefit from the summer rally on the back of a technical bid thanks to reduced issuance. This is put forward by Bank of America Merrill Lynch in their High Yield Strategy note from the 3rd of August entitled "A Good Combination":
"HY caught in between strong earnings and weak issuance
The HY bond market performed well over the past few weeks, with spreads tightening to 340bps down from 380bps around early July. This move nearly fully offsets the earlier widening that the index has experienced in late June. A notable change that has taken place during this period of time is that IG and EM assets have rebounded, allowing HY to rally along with them. In July, our USD IG and EM IG indexes have tightened by 15bps band 17bps respectively. Modestly higher rates contributed to this backdrop, with the 10yr Treasury yield currently at 3.0%, up from 2.80-2.90 range it established earlier in the month.
BBs continue to show notable resilience against this backdrop of higher rates coupled with their disadvantage to CCCs in spreads (an average BB OAS is 230bps vs 690bps in CCCs). Despite these headwinds, BBs performed exactly in line with CCCs in terms of spread changes and total returns over the past two weeks, and they are only marginally behind CCCs over the past month.
Year-to-date, the HY market is 17bps tighter in spread terms against a meaningful 55bps rise in 10yr yields. It has generated a total return of 1.2% and excess return of 2.2%, in both cases driven primarily by CCCs outperforming earlier in the year. Loans have posted a 3.0% YTD total return.
In technicals, this past week saw a moderate volume of coupons and calls/tenders in HY, around $2.5bn on each side. This was met with little issuance to speak of, at less than $1bn. Next week brings light calls ($1.2bn) and no coupons. The week after, ending Aug 17, promises a heavy $5.3bn call volume, complemented with $3.7bn in coupons. For the full month of August, we are forecasting $15bn in HY gross issuance against $13.6bn in calls/tenders and $1.6bn in maturities. We are also expecting $7.3bn in coupons, although as we have argued here, these should not be viewed as longer-term sources of investable cash.
Ok, so what do we think here? Two factors define the current HY corporate credit market backdrop more than others, in our opinion: strong earnings growth and weak issuance. Starting with earnings, our equity strategists are tracking 2Q bottom-up S&P500 EPS at $40.52 amid better-than-expected results across all 11 sectors (led by Tech and Health Care). This represents roughly a 15% increase from estimates going into the year, the outcome largely driven by the corporate tax reform. Overall, 58% of companies have beaten analysts' expectations on the top- and bottom-line-the secondhighest proportion of beats in their data history.
Our own model of corporate earnings, initially introduced here, is currently pointing to an 18% growth in EPS over the next 12 months (Figure 1).


As a reminder, the model includes non-farm payrolls, consumer confidence, growth in corp debt and capex among key factors with leading relationships over earnings.
Credit cycles generally do not turn in the environment of double-digit earnings growthand with earnings expectations outlined above we remain generally constructive on the longevity of this cycle.
Having said that, we must acknowledge that there is a number of ways a cycle could be cut short, and we are witnessing some of those ways being tried in recent weeks and months, including trade threats and otherwise generally irresponsible actions. We continue to think that little tangible long-term policy measures come of out of all this noise, and recommend heavily discounting most of it. Nevertheless, we remain cognizant of potentially being wrong at the end as second- and third-order effects begin to accumulate.
The other defining factor of the current environment is a slow pace of HY issuance. This has been the case throughout most of 2018, and it appears to have only gained further momentum in July: a month that is otherwise among the seasonally slowest has posted $8.4bn in primary volume, half of our seasonally adjusted estimate. We are also expecting a normally seasonally slow August, at $15bn (Figure 3).


YTD HY issuance is running at $117bn, or 24% below last year’s $155bn total over the same timeframe. Slow issuance is not happening in isolation, as we documented how both retail and institutional flows in HY have turned negative in recent months (Figure 7).


In addition, albeit less relevant, coupon flows are also going through a seasonally weak part of the year with both August and September among the slowest months (Figure 4).
The next key question in our discussion is whether weak demand for HY is causing financial conditions to tighten. Once/if such tightening occurs it generally leads to meaningful repricing of credit risk as investors begin to question the ability of weaker issuers to access market liquidity to satisfy their funding needs for investment and debt management activities.
To answer this question, we refer to Figure 5 (performance of recent new issues) and Figure 6 (performance of aged issuers with no market access in recent years).



We think that when underperformance is limited mostly to recent new issues, it is more reflective of their higher secondary market liquidity aspect, and not necessarily a wholesale repricing of credit risk. In this scenario, investors sell liquid assets in order to temporarily adjust portfolio risk without necessarily taking a long-term view on a credit/sector/market.
On other the hand, underperformance in aged issuers better reflects tightening financial conditions. In this scenario, investors get out of risk even if it means selling an illiquid instrument into otherwise weak market, often at prohibitively wide bid-asks. These actions require longer-term commitment to a trade and so could lead to meaningful tightening in financial conditions, particularly for the group of aged issuers who have been out of the market for a while.
Based on what we see in Figure 5 and Figure 6 the evidence leans heavily towards the first scenario, where recent weakness is limited to newly issued and liquid instruments, and thus more likely to be temporary in its nature. It provides support to our argument that this credit cycle is not yet showing signs of cracks in its basement.
So then the next question is: if this is not yet a turn in the credit cycle, why is demand weak, both on institutional and retail sides (Figure 7)? We think the answer originates in tight valuations, both in absolute sense, and also against other major yield alternatives. At 340bps, HY spread is 18th percentile of its historical range over the past 25 years, and it has never delivered positive excess returns over a three-year horizon starting with sub 300-bps spread levels. We are not quite there yet in terms of extreme tights, but we are getting there.
And in a relative value sense, some major alternatives are now becoming available to investors, including a 4% yield on our USD IG index, 4.5% on EM IG, and a 3% yield on Italian 10yr, and 7.5% on Turkish 10yr USD bonds. As Figure 8 demonstrates, HY used to deliver more that 15% of Global Agg’s expected income two years ago, and now that share has dropped to less than 8%, returning to its normal historical range for the first time in four years.


For as long as valuations in HY remain tight in absolute and relative sense, we expect weak flows to persist, leading to soft demand for new issues.
And so we are to be dealing with to contemporaneous developments going forward: strong earnings and weak issuance, a good combination indeed. Between these two forces, the HY market should continue to experience deleveraging going forward. As Figure 9 shows, US corporate credit has been in the process of slow deleveraging for the past two years, and we expect it to persist and perhaps even accelerate going forward.
As we opined previously, high leverage in corporate credit is not an indication of the next cycle being around the corner but rather a consequence of the commodity bust of 2014-2015 showing all the hallmarks of being a credit cycle, albeit limited in scope/duration.
Figure 10 also goes on to show that US corporate issuers have slowed down their share repurchase activity in recent quarters.


Note that dividend payments plummeting to negative values are a function of foreign earnings repatriation, and thus temporary in its nature (we have previously witnessed this behavior in 2005-2006 during the previous foreign tax holiday). Regardless, these repatriated funds could be used to continue the deleveraging process if corporate managements chose to do so, a development we expect to take place.
As we mentioned previously, we find HY valuations to be on a tight side both in absolute value sense (340bps actual level vs 380bps target), and relative value sense. On the latter side, Figure 11 and Figure 12 provide some context behind this view, based on our previously introduced models described here.


Both charts are showing z-score signals of deviations in HY vs IG and CCCs vs BBs respectively. We thus find HY to be trading too tight against IG by 1 standard deviation event, or roughly 50-75bps. We also find CCCs to be modestly tight to BBs, by about 0.5x stdev event.
Note that HY vs IG relative value deviation is also consistent with our strategic targets on both asset classes, where Hans Mikkelsen maintains a 100bp target in IG (-16bps from here), and HY needs to go +40bps from current levels to reach at our target.
We view these valuation gaps as modest headwinds at this point, i.e. not extreme enough to substantiate a full-scale underweight in anticipation of outright negative returns. We think higher quality outperforms in beta-adjusted terms (2.0x for IG vs HY and 1.7x for BBs vs CCCs), but not yet in direct 1-to-1 terms. We will need to see a stronger valuation gaps to be willing to take an outright underweight in CCCs vs BBs and expect unadjusted 1-to-1 underperformance in lower quality.
Another way to think about the extent of this positioning would be to say that we a willing to take 1/3rd of the total possible extent of an underweight in lower quality vs higher quality here. We would be looking for even tighter valuation gaps to be willing to go further down that line, to 2/3rds of the full extent of an underweight. Signals that would get us to a full-scale underweight need to be as strong as those generated by our model in 2000, 2007, and 2014, all turning points in previous credit cycles (Figure 12).
Higher rates remain a key risk to this positioning, as they have been since February without much to show for their progress since then. We continue to believe that global rates should go on towards further normalization, while US rates are already approaching their peak levels for this cycle. As such we view US 10yr at 3.0% as good value, with an eye towards 3.25% as better value. We do not expect this benchmark to exceed 3.5% on a sustainable and meaningful basis.
We also note that measures of implied vol are again very low across the board – equities, rates, FX, and credit. This backdrop helps spreads grind tighter while it persists, and yet we think the low vol environment should be used to gradually reduce portfolio risk, not increase it. The time to use this dry powder of available portfolio risk allocation will come when we hit the next volatility episode, whatever the cause of it might be." - Bank of America Merrill Lynch
Given US Investment Grade so far has been lagging US High Yield, from a relative value perspective, if indeed we are looking at a "macro" deceleration thanks to the rise in "Maneuver warfare" then we could see the duration game coming back into play which would no doubt benefit more US Investment Grade versus the successful high beta game which has been performing well in 2018. We do agree with Bank of America Merrill Lynch in the sense that current low vol complacency should entice somewhat some risk reduction in less liquid high beta exposure as we move into the third quarter which is traditionally more jitterier it seems.

So what's the risk for US credit markets one might rightly ask?

As we pointed out in previous conversations, the US credit markets benefit from a strong outside support thanks to the large appetite of foreign investors in particular Godzilla the NIRP monster which is "Made in Japan". Both the ECB and the Bank of Japan are still failing there inflation mandate meaning that there is plenty of accommodation from their part. From our perspective, the biggest risk for US credit markets would indeed be a buyer strike emerging from Japan. On that point we read with interest UBS's take in their Global Credit Strategy note from the 6th of August entitled "What if JGB yields keep rising?":
"Last week’s BOJ decision to raise the 10year JGB ceiling to 20bps has attracted investor attention, particularly considering that JGB volatility has increased since their initial announcement. We believe the focus on Japan is warranted, given the sizeable outward portfolio flow generated by very low JGB yields. Japanese insurers have increased their allocation to corporate bonds steadily, from 8.7% in March 2010 to 13.6% in March 2018 (Figure 1).


Japanese pensions have been forced abroad to foreign fixed-income in size, as GPIF’s asset allocation demonstrates (Figure 2).


In a previous note, we estimated that Japan represented 25% of the total net flow, and 50% of the total non-US flow, into index-eligible IG credit over the past few years, easily surpassing Taiwan and Europe in importance.
Will the BOJ’s policy shift negatively impact credit?
As long as the BOJ credibly commits to defending the 20bps maximum on 10yr JGB yields, we believe credit flows will be relatively unaffected. The largest Japanese pension fund (GPIF) seeks a return target of 1.7% + the rate of increase in domestic wages (which has been roughly flat over the last several years). JPN insurers need 20-30yr JGB yields of around 1% to meet guaranteed interest rates on new insurance policies. At current JGB yields, there is still a strong incentive to invest abroad. In addition, both 7-10yr US IG and EU IG credit provide an attractive 50-100bp yield advantage over 30yr JGBs, even after paying funding costs to hedge back into yen (Figure 3).


Rising dollar hedging costs may shift demand from the US to Europe, but the flows to global credit in general should continue (Figure 4).
Lastly, nearly 40% of JPN life insurer portfolios are unhedged for currency risk; clearly this increases the appeal of holding US fixed income with Treasury yields near 3% and US IG corporate yields near 4%. Our conversations with local investors indicate unhedged dollar buying could increase this year, particularly with the marketing of dollar-based insurance policies to local clients. We would expect unhedged USD fixed income purchases to pick up most aggressively, after a strengthening in the yen to 100-105 vs the dollar, from 112 today, based on public reports.
What could materially derail the JPN flow into global credit? If 20-30yr JGB yields hit 1%+, we would become meaningfully more concerned (Figure 5).


This is not our base case in 2018, but it could occur with either 1) a formal change in the BOJ’s 10yr yield target (highly likely by July 2019) or 2) a bear steepening of the JGB yield curve, that the BOJ allows to aid a banking system squeezed by low rates at home and higher dollar funding costs, exacerbated by Fed hikes. Our conversations with local insurers and several public statements1 indicate that 1% long-end JGB yields would preclude the need to continue buying foreign fixed income. Importantly, even if US and EU yields increased to maintain their current yield advantage over JGBs, JPY lifers would still prefer to invest at home. 20-30yr JGBs reduce asset liability duration mismatches, better than global credit, given the long average duration of life insurer liabilities (19yrs). Investing in JGBs also clearly reduces portfolio volatility with respect to credit and FX risk; note that even insurer FX-hedged purchases of foreign bonds do not generally hedge the interest income that accrues, introducing another source of risk into future returns.
The good news? We find it difficult to fathom Japanese life insurers selling existing holdings of global credit; these bonds are needed to meet legacy insurance policy yield bogeys that are much higher than the current 1% rate. It would take a material increase in downgrade/credit risk to force outright selling.
But the lack of new flow would put pressure on US IG, and reduce a potential buyer for EU IG at a time when the ECB is ending CSPP. Any material period of issuance would likely lead to spread widening, as we experienced for much of 2018 until recently. And there is no obvious buyer to pick up the baton from Japan. Rising dollar funding costs have caused Taiwanese insurers to allocate less to 30yr US IG credit (Figure 6); this will be exacerbated by additional Fed hikes in 2018 & 2019.


In Europe, dollar funding costs of 2.8% are a problem and Solvency II prevents insurers from running unhedged positions to obtain extra yield. Lastly, while many investors have focused on US pension demand given an increase in funding ratios, we believe this overlooks the forest for the trees. Non-US investors purchased $1.4tn in US credit since 2013; US pensions purchased $350bn (Figure 7).


It seems unlikely that increased pension demand could make up for a reduction in foreign buying on its own; all US investors (including insurers and domestic funds) would need to increase their purchases, and likely in concert with a reduction in IG issuance and continued strong fundamentals, to keep IG spreads stable if the Japan bid fades.
1%+ back-end JGB yields would not only impact US IG credit. JPN pensions have also drastically reduced domestic holdings of JGB yields in order to buy foreign fixed-income (Figure 8).


But there is room to add if JGB yields rise, though the bar for pension reallocations is likely higher than for insurers. The more aggressive stance of JPN pensions this cycle would mean that high-yield would be at risk of a reduced inflow. In particular, EU HY has been the major beneficiary of separately managed account flows from JPY pensions (Figure 9).


While flows into other credit markets have been more limited, we would note that short duration US HY, a consensus favorite today, could also face negative side-effects.
Will US HY’s perfect technical storm last?
US HY spreads have effectively lapped the field in 2018. US HY spreads are -10bps tighter, far besting performance in US IG (+16bps) and EU HY (+61bps) and contrary to our expectations in Q2. In addition, lower-quality HY spreads have tightened considerably, with CCC spreads -63bps YTD. The easy answer to the above dynamic is that US growth is strong, which has led to improved earnings and healthier credit fundamentals. However, this does not appear to be the case. We are still awaiting full Q2’18 earnings releases, but B+CCC rated HY EBITDA growth through Q1'18 was a paltry 2% Y/Y, closer to an earnings recession than  to the peaks of this cycle (Figure 10).


We believe lower-quality US HY remains most vulnerable, given weaker fundamentals and outsized performance this year relative to BB’s. We estimate 36% of CCC, 30% of B, and 25% of BB issuer debt is floating-rate in nature (Figure 11).


Clearly, as the Fed keeps hiking, HY earnings growth has to pick up from current levels to prevent a worsening of interest coverage ratios, which while not precarious, are fairly weak for lower-quality names. We believe an additional 3-5 Fed hikes, given current coverage ratios and earnings trends, would be enough to increase default risks from today's low levels.
The real reason for US HY’s stellar performance is a significant technical imbalance, one of the strongest we have seen. As Figure 12 indicates, US HY supply has shrunk, which with the help of coupon payments, has offset notable fund outflows.


As previously discussed, many spec-grade rated firms are still borrowing debt, but they are migrating to the leveraged loan market where lending conditions are easier and demand is healthier for floating-rate instruments. We believe this technical backdrop will incrementally wane. We see little evidence that tax reform is impacting HY issuance; lower-quality firm supply is relatively higher even though the capping of interest tax deductibility post tax-reform is more painful for these firms. Higher LIBOR will also narrow the relative cost advantage of floating vs. fixed rate funding, which played out last cycle as HY issuance increased near the end of the Fed tightening cycle. We continue to expect gradual normalization in HY issuance to -12 to -15% for FY18.
In addition, Figure 12 even understates the positive technical we have witnessed. At the same time that supply has shrunk, US HY managers have invested more aggressively into the market. According to eVestment, US HY cash balances of 2.3% are near the lows of this cycle (Figure 13).
It is difficult to know exactly when this perfect technical storm will end, but US HY is increasingly susceptible to any slowing of growth or large market shock that raises risk premia. A conceptually similar measure of cash balances from the ICI (Liquid Assets2 Ratio) indicates that US HY cash balances are at dangerously low levels (Figure 14).


At levels below 4%, the probability of spread widening over the  next 6 months is 67%, with a 25th-75th percentile spread performance of -21bps to +152bps.
Institutional investors are souring on high-yield credit
In addition, our latest institutional flows update indicates that global investors are positioning for credit underperformance and a likely period of decompression between global high-yield and investment-grade spreads. Figure 15 provides Q2’18 nominal flows by global credit universe, while Figure 16 details investor flows by domicile, as a percentage of the total outstanding market size captured in eVestment3.


Put simply, the investor retreat from global high-yield rated credit continues. US HY and EU HY sustained -$20bn (-3.2% AUM) & -$2bn (-2.7% AUM) of outflows respectively, driven by both institutional separately managed accounts and retail fund. This continues a trend we have seen for the last 12-18 months.
The US leveraged-loan market did receive $5bn of inflows (1.4% AUM), but the attribution of buying is shifting. Loan demand has slipped from institutional investors; we believe the loan market is becoming increasingly reliant on CLO purchases (and to a lesser extent domestic retail buying). Indeed, CLO creation is up 32% YTD and CLOs own roughly 65-70% of US leveraged loans outstanding. While fundamental risks are building in the form of covenant-lite indentures, significantly elevated leverage, aggressive use of EBITDA add-backs, and a notable increase in loan-only capital structures, we believe duration fears continued Fed hikes and an absence of near-term credit risks should keep demand for this floating-rate asset class alive." - source UBS
Regardless of the fundamentals put forward, when it comes to US High Yield, there is indeed a strong technical support coming from slower issuance. As well, the Bank of Japan most recent move clearly shows that they are ready to throw the proverbial kitchen sink to maintain stability in JGB yields for the time being, providing yet a compelling support to global credit in general and US credit markets in particular. Yet there is no denying that some institutional players have started climbing the quality ladder and shed some of their exposure in recent months to US High Yield and high beta. There might be an additional case to be made for an outperformance of US Investment Grade relative to US High Yield in the coming months should the duration trade reassert itself with a lack of strength in maintaining the US 10 year Treasury Notes yield clearly above the 3% threshold. When it comes to credit markets we therefore remain "tactically" for the time being "Keynesian" yet it appears to us that cracks are appearing in the narrative hence the more defensive move being taken by institutional investors in regards to US High Yield, making them becoming more "Austrian" to a certain extent.

We pointed out that rising dispersion in credit, with investors becoming more discerning when it comes to issuer profile would make active management "fun" again. We also pointed out in our most recent note that we were seeing more and more large standard deviation moves (such as the one seen by the Facebook stock price recently). In our final charts, though volatility has been very muted for both credit and equities as of late, rising dispersion is displaying we think markets' fragility.
  • Final charts - This isn't your grandfather's market
Rising dispersion in our book is a sign of rising instability brewing. The manifestation of it comes with large standard deviation moves and marks we think the return of the "macro" players to a certain extent after years of financial volatility repression by central banks. Our final charts come from Bank of America Merrill Lynch European Credit Strategist note from the 9th of August entitled "A world of populism" and shows that when it comes to European High Yield, 2018 marks a clear return of fragility at the forefront. No wonder some are already running for the exits and reducing their high beta exposure on illiquid names in that context:
"The summer rally is the gift that keeps on giving for credit markets. Since the start of July, corporate bond spreads have retraced just under half of their Italy-inspired sell-off. And we think the rally still has legs for now…judging by the very light investor positioning reflected in our latest credit investor survey.
Yet all around there are signs that this is anything but a run-of-the-mill summer grind. The most notable trend in markets is that of performance dispersion, and examples abound almost everywhere. Take Turkey vs. Russia debt for instance, or Apple vs. Facebook shares, or value vs. growth stocks, or even US Treasuries vs JGBs. Assets that were previously well correlated, are now witnessing a much more diverse performance of late. And in credit land it’s much of the same…note the significant outperformance of single-As relative to BBBs over the summer period (chart 1), or the number of bonds dropping conspicuously across the European high-yield market (chart 2).




The end of synchronised everything…
The temptation is put these moves down to just one-offs, and there have indeed been plenty of macro shocks in ’18. Yet, rising dispersion is the clearest reflection of how the investment backdrop has fundamentally changed, in our view. The synchronisation of global growth, central bank policies and corporate fundamentals of yesteryear has given way to a more challenging world of diverse politics, economies and liquidity support.
Much – although not all – of this sea change has been instigated by the rise of populism. In our view, this has helped reshape many of the hitherto market norms.
Take “globalization”, for instance. In 2018, this theme has been chipped away at. Chart 3 shows how cross-border capital flows have evolved over the last few years, a good proxy, in our view, for measuring how globalization is changing.


While not all measures are in retreat, what looks to be suffering more is Foreign Direct Investment, which has declined from 4% of GDP in 2015 to just 2.4% recently. And note how Foreign Direct Investment into the US has slowed down over the last few quarters despite the economy’s rebound (FDI into the US in Q1 ‘18 was 45% down YoY, see appendix chart).
But such secular changes have brought big market consequences. Chart 4 shows the conspicuous drop in world trade volumes over the last few months despite a global economy that continues to hum along fairly well.
As a result, the casualties have mounted: witness the recent plunge in German factors orders (-4% MoM), even though US GDP in Q2 (+4.1%) was the strongest since Q3 ’14.
A world of corrections in ‘18
More broadly, the divergence and dispersion theme is symptomatic of a rise in the amount of market “corrections” this year. Chart 5 shows the cumulative number of market corrections over time. We look across a large sample of government bonds, equity markets, currency pairs and credit indices, and count the number of times that 4
Standard Deviation moves are being observed (both up and down).


As can be seen, 2018 has witnessed a rise in the pace of market corrections, albeit more so in government bonds, equities and credit. Conversely, there has been less of a jump in corrections in the commodity and currency space this year.
Chart 6 shows the total number of market corrections on a yearly basis. Extrapolating this year’s number suggests that 2018 will see a lot more corrections than in 2017.


In fact, 2018’s corrections shouldn’t be far off from the pace seen in 2015/16 – a period when there was genuine stress across the global economy emanating from the slowing of China’s economy, plunging commodity prices and rising default rates. And as chart 18 in the appendix shows, perhaps not suprisingly, market corrections have been common in 2018 in regions where economic growth has been more vulnerable.
Note the high number of market corrections in emerging markets and Europe this year, for instance, relative to the US (where there has barely been a pickup).
Weak hands and the rush for the doors
A rise in dispersion across markets feels like a boon for active investing. Yet, with so many market divergences – and unpredictable ones at that – risk managing portfolios can also become incredibly challenging, weakening the market’s resolve for running large positions. In the end, too much dispersion can become self-defeating…ultimately motivating a broader derisking by the market.
It’s exactly this “rush for the exit” that the corporate bond market is starting to become fearful of, based on our credit survey. And note how quickly perceptions have changed: after investors’ citing “bubbles in credit” (i.e. too much liquidity) as their biggest concern in June ‘18, their primary worry has now flipped to “market liquidity evaporating”." -source Bank of America Merrill Lynch
Rising dispersion leads to shock and disruption, hence the need for "maneuver warfare" when it comes to trading "tactically", to paraphrase Tuco from the Good, the Bad and the Ugly:
"When you have to shoot, shoot. Don't talk."
Are we seeing a case of "Making Duration Great Again"? (MDGA). For sure it seems to us that the huge short positioning on the US 10 year Treasury Notes seems overstretched from a "military" perspective, but we ramble again...

"If everyone is thinking alike, then somebody isn't thinking." - General George S. Patton

Stay tuned ! 
 
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