Thursday, 19 July 2018

Macro and Credit - The Decoy effect

"In a time of universal deceit - telling the truth is a revolutionary act." - source unknown

Looking at our home team (France that is) getting away with the Football World Cup for a second time in 20 years (1998-2018) hence our lack of recent posting, 8 being a lucky number it seems, we were drawn again to the parallel with 1998 with the ongoing Emerging Markets (EM) woes, whereas this time around, Asian countries are in much better shape, including Russia, while the usual suspects (Turkey, Argentina and Brazil and even South Africa) are still feeling the summer heat from the Fed's liquidity drain thanks to QT. With the escalating rhetoric of trade war between China and the US and the strong arm negotiating tactics from the Trump administration, when it came to select our title analogy, we decided to go for a marketing one, namely the "Decoy effect". In marketing, the decoy effect (or attraction effect or asymmetric dominance effect) is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. An option is asymmetrically dominated when it is inferior in all respects to one option; but, in comparison to the other option, it is inferior in some respects and superior in others. In other words, in terms of specific attributes determining preferences, it is completely dominated by (i.e., inferior to) one option and only partially dominated by the other. When the asymmetrically dominated option is present, a higher percentage of consumers will prefer the dominating option than when the asymmetrically dominated option is absent. The asymmetrically dominated option is therefore a decoy serving to increase preference for the dominating option. The decoy effect is also an example of the violation of the independence of irrelevant alternatives axiom of decision theory. Of course, it is a great tool to use when one relates to trade negotiation we think but we ramble again...

In this week's conversation, we would like to look at the rise in inflation, and trade war escalation and the impact in can have on global growth as well. Also, overweight US relative to Emerging Markets (EM) and the rest of the world, continues to be the trade du jour, with FANG still racing ahead in the rally game. 

  • Macro and Credit - Deglobalization goes hand in hand with inflation
  • Final chart - Credit versus Equities - "until death do us apart"

  • Macro and Credit - Deglobalization goes hand in hand with inflation
While we thought the ratcheting up of the trade war narrative would be bullish for gold, latest price action with the continuation of the surge in the US dollar has put a dent on this scenario playing out so far. Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple. 

Given it seems that US inflation expectations are moving upwards it seems, we like US TIPS particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment. At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument eventually. Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. 

If inflation creeps up, then companies will suffer margin compression and will be forced to raise prices which will lead to wage increases to compensate that higher price level. We have pointed in the past that trade wars could lead to a stagflationary scenario playing out, meaning lower growth and higher inflation. Are tariffs really the culprit leading to higher inflation? On that subject we read with interest UBS Global Strategy note from the 18th of July entitled "What will drive TIPS in the 2nd half?":
"What about tariffs? Do they matter? It matters much more for growth than inflation
As discussed by our economics team and shown in Figure 4, Laundry equipment prices have jumped by 12% above their January level following the implementation of 20% tariffs in early February.

That said, its impact on headline inflation is very small because of its less than 0.08% weight in CPI. Nonetheless, this clearly shows tariff do have an effect on near-term inflation. Since these early tariffs, US has implemented additional 25% tariffs on $50bn of products from China and the President has proposed 10% tariffs on an additional $200bn of imports from China with other investigations going on in parallel. Thus the scope of tariff tensions is much larger now. We estimate that the current set of announced tariffs would push up consumer prices by roughly 15bp, but with notable uncertainty on both the upside and downside. We discussed ramification of various upside tariff scenarios on growth/inflation and financial markets in Trade Wars- What is the impact on growth, inflation and financial markets? A Top Down View. Albeit, we view this document more as the upside risk scenario than our current baseline; based largely on a lower effective autos tariff and smaller Chinese retaliation is somewhat less.
Specifically, in the aforementioned note, we discuss the following scenarios and their impact on GDP inflation. The 1st scenario is ("Escalation") 25% car tariff (US/global retaliation plus an additional 10% tariff on $200bn US-China trade with proportional retaliation. In the 2nd scenario ("Trade War"), we assume 30% tariffs on virtually all US/China trade + earlier car tariff disruption. In Figure 5, we see that under the trade "Escalation" scenario, we would see near-term inflation rise by 31bp and real GDP fall by 100bp.

In Scenario 2 – "Trade War", we see inflation rising by 71bp and real GDP falling by 245bp. A key takeaway is that the hit to real growth is much larger than rise in inflation on trade tariffs. For details on these estimates, please see the Q-Series. Next, we consider what is the TIPS market priced for and how they could react to escalating trade tensions.
Is the TIPS market pricing in trade dynamics correctly?
The TIPS market is right in reacting trade war by not widening breakevens but by lowering long-end real yields. 5y and 10y real yield have declined by 3bp and 9bp since early June while 5y and 10y BEIs barely moved (Figure 6).

On the inflation impact, we think the market already seems to be priced for our escalation scenario. In Figure 7, we see that 2y ex-energy inflation (which is close estimate to implied core inflation) has risen quite sharply this year. It's near 252bp if you assume  240bp as consistent with target CPI inflation.

The market is implying that the US may have up to 10-15bp/annum of trade related inflation over the next two years. In our trade escalation scenario, we see 31bp inflation uptick over 1-year. This would imply about 15bp tick-up in 2-year core inflation and market seems to be pricing such an uptick. Thus, the market is fairly priced for the inflation uptick. For growth hit due to trade "escalation", we should have seen a bigger decline in real yields. 2y yields are basically unchanged over the past few months, which suggest the market is not assuming a growth hit at this juncture. Thus, for increasing trade concerns, we recommend receiving front-end real rates, or set up 2s5s real curve steepeners which we discuss later in the note. In general, the market is not priced for a "trade war" scenario on both real yields and breakevens." - source UBS
It seems to us that the market has been a little bit too complacent for a trade war scenario playing out. At least with TIPS with the embedded deflation floor, you have some downside protection should the global slowdown scenario play out thanks to escalating tensions. With this known unknown, we do think that the long end of the US yield curve (30 years) at current levels remains enticing from a carry and roll down perspective. We have recently started to add exposure to it on a side note.

But, in respect to the inflation risk, US inflation is creeping up, no doubt about it. This is clearly illustrated by Wells Fargo in their Economics Group note from the 11th of July entitled "Producer Prices: More Inflation to Come":
"Producer prices for final demand rose 0.3 percent in June, which was slightly stronger than expected. Core prices continue to climb higher as U.S. producers are facing rising input costs.
Broad Increases in Producer Prices in June
  • Inflation continues to gradually climb higher, with the producer price index advancing 0.3 percent in June. Gains were broad based, with food being the only major category to see prices slip.
  • Excluding food, energy and trade services (measured by margins), prices increased 0.3 percent. That pushed the year ago rate of our preferred measure of core PPI back to 2.7 percent, which is up from 2.1 percent last June.

Processing Input Cost Increases
  • Input costs continue to rise as capacity has become more constrained and businesses are grappling with tariffs. Processed intermediate goods increased 0.7 percent in June and are up 6.8 percent over the past year. While higher energy costs have led the pickup, non-energy materials for manufacturing and construction are up 6.5 percent since last June. Service inputs are up, led by fuel and labor shortages driving transport costs higher.

- source U.S. Department of Labor and Wells Fargo Securities 

June PPI report showed an acceleration in the price appreciation with year over year PPI at 3.4% and year over year core PPI coming at 2.8%. With year over year CPI up to 2.9%, meeting estimate, Core CPI printed at 2.3% beating expectations. It might be the case of the US economy running hotter than anticipated? We wonder. Wage growth are essential to validate this prognosis we think. For some other pundits such as Knowledge Leaders Capital, "The Inflation Story is Alive and Well in Five Charts".

As we pointed out in our previous conversation "Attrition warfare":
"The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off.
To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.
While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income."- source Macronomics, July 2018
This raises the question about inflation and the US consumer in general and the price at the pump in particular. What is the pain threshold one might rightly ask? On that subject we read with interest Bank of America's take in their US Economic Watch from the 11th of July entitled "High pain tolerance at the pump":
"Higher gas prices a partial offset to tax cuts benefits
Gasoline prices are up around 50 cents since the start of the year and currently hovering nationally around $3, owing to tightening global oil supply and demand balances. Our calculations suggest that the recent rise in gasoline prices increases the average cost to the consumer by $30 per month. So far, this has had limited impact on overall consumer spending as most consumers have been able to offset higher prices at the pump with the extra income from tax cuts. According to the Tax Policy Center, the median consumer is receiving roughly an extra $78 per month due to tax cuts this year.
The breakeven price: $4/gallon
At what point would higher gas prices fully offset the tax cuts? We would likely need to see oil prices jump another $60 per barrel (bbl), adding about $1 per gallon to gasoline prices. This would increase the cost of gasoline almost $60 per month, effectively wiping out the extra income from tax cuts for most consumers.
Of course there could be effects beyond these simple calculations. A common rule of thumb from Hamilton (2008) is that an oil “price shock” is when prices go above the highest level in the last three years. That seems to be happening now, although we are still below the highs of 2011-14 (Chart 1).
Francisco Blanch and team see upside risk to their crude oil price outlook should sanctions on Iranian oil exports prove binding. Higher gasoline prices could lead to “sticker price shock” at the gas pump, causing consumers to pull back spending more than one-for-one. An additional downside risk comes from the fact that the “gasoline tax” is regressive and has a bigger percentage impact on low income families (Chart 2).
From the oil rig to the gas station
Translating moves in crude oil prices to gasoline prices is fairly straight forward. According to the Energy Information Administration, crude oil represents about half the retail cost of gasoline. Indeed, looking at the relationship between the % mom in Brent oil prices and % mom in gasoline prices, we find a coefficient of roughly 0.5 suggesting that a 10% increase in the price of crude oil would be associated with a 5% increase in the price of gasoline (Chart 3).

Currently, a $60 boost would amount to a 75% increase in crude oil or 37.5% increase in gasoline prices. With gasoline currently near $3, such a shock would increase prices at the pump by over an additional $1.
From the gas station to the consumer’s wallet
Vehicles on the road in the US consumed, on average, 55 gallons of fuel per month in 2016 according to the Federal Highway Administration (Chart 4).

To put this into context, for a compact car or a medium size sedan, this works out to be a full tank of gas per week. Demand for gasoline is relatively inelastic so we can safely assume no demand response from an oil price shock in the short run. Therefore, the run up in gasoline price since the start of the year would cost the average consumer around $30 per month.
We think most consumers have been able to offset the latest increase in gasoline prices. According to the Tax Policy Center, with the exception of the bottom quintile, taxpayers are receiving at least a $30 tax cut per month due to the Tax Cuts and Jobs Act (Table 1).

However, further boost in gasoline prices could ultimately offset most of the tax cut benefits. For example, another $1 per gallon at the gas pump would cost another $60 dollars per month. All told, the extra $90 per month spending at the gasoline station would be enough to offset tax cuts for majority of consumers.
From the consumer’s wallet to consumer behavior
While demand for gasoline is relatively inelastic, marginal propensity to consume out of gasoline (dis)savings is likely greater than 1. That is, a rise in gasoline prices will force consumers to substitute away from other categories more than one-for-one and vice versa. For example, Gicheva et. al. (2007) find that gasoline expenditures rise one-for-one with gasoline prices but consumers substitute away from food services toward  groceries in order to partially offset higher gasoline expenditures. Moreover, they find that even within grocery spending, consumers substitute away from regular price products and towards promotional items. On the flip side, Alexander and Poirier (2018) calculate that the marginal propensity to consumer out of the gasoline savings in 2014- 15 was greater than 1 with most of the spending going toward discretionary spending. The upshot is that most consumers have so far absorbed higher gasoline prices in stride but further increases at the gasoline stations could start to broadly hurt consumer demand." - source Bank of America Merrill Lynch
While everyone and their dog is focusing on the flattening of the yield curve, we would rather focus on inflation creeping up and in particular oil prices as a potential lethal trigger for asset prices and a bear market to ensue. Clearly we are not there yet, but we think that the "decoy effect" of the flattening of the yield curve hides the fact that trade war rhetoric is weighting on both consumer sentiment as well as leading to higher PPI. At some point these factors will weight on growth. The continuous surge in the US dollar means that EM are still in a painful situation. In that context, cash has returned as a valid yielding tool in the allocation toolbox and so are US Tips. As we stated above the long end of the US yield curve remains enticing.

Maybe the second part of the year will favor the return of the duration trade versus the high beta. This is what Bank of America Merrill Lynch mentions in their Credit Derivatives Strategist note entitled "A bull and a bear" on the 19th of July:
"European growth headwinds, trade wars and Italian risks are taking over last year’s goldilocks. With manufacturing PMIs in Italy, Spain and France at 53 and inflation risks to the downside, this is still an environment of a patient ECB on rates. Investors are concerned about an inflation shock; we think we are far from there. The potential for an
“Operation Twist” and slower macro can flatten the curves both in cash and synthetics. We think that the CDS market is offering an attractive entry point for longs on the backend of the curve. We screen for the best singles to sell protection.
To offset our bullish view on duration we hedge the market direction with bearish risk reversals in Crossover. If trade wars escalate, growth could be hit more, and higher beta pockets would be more exposed. The recent flattening of the implied vol skew and spread tightening finds bearish risk reversals (own puts/payers vs. selling calls/receivers) attractive to own.
Softer macro = lesser risk of a hawkish ECB
Macro indicators have slowed down in Europe this year versus the high run-rate of last year. In particular, manufacturing PMIs across Europe have headed lower and inflation is only slowly recovering.
But what a slower macro backdrop means for yields and yield curves more specifically? We are using the OECD Major 7 Leading Indicators and we try to define the relationship between the economic cycle and the cycle of yield curve. In chart 3 we present a z-score analysis (in order to normalise patterns for the underlying vol and levels) and we find that there is meaningful correlation between the macro cycle and the cycle of the yield curve.

When the macro indicators improve (deteriorate) yields tend to steepen (flatten). This reflects the higher growth potential and thus the stronger outlook for inflation going forward and that ultimately is priced in via higher back-end yields and steeper curves. Should the ECB remain dovish, yield curves are more likely to continue to be under pressure, we think." - source Bank of America Merrill Lynch
Whereas the first part of the year has been great for high beta in credit and US equities, with Investment Grade lagging. There could be a possibility if the trade rhetoric escalates to see lower growth, meaning a return of the duration trade in the second part we think. One thing for sure 2018 has seen a clear divergence between equities and credit as we shall see in our final chart.

  • Final chart - Credit versus Equities - "until death do us apart"
In 2018 US high beta has had a better success than US Investment Grade credit which has been punished. EM equities have suffered as well relative to US equities in stark comparison to what unfolded in 2017. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 18th of July entitled "Going separate ways":
"Credit and equities are two sides of the same coin. However, while equities by now have rallied to within 2% of the highest close of the year (S&P 500), high grade credit spreads are 33bps, or 37%, off the 90bps tights from earlier in the year (Figure 1).

Given the timing of the beginning of this decoupling in May, clearly one of the drivers was the Italian risks that developed during the month. Given the outsized importance of the financial sector in credit, and the reliance on funding markets and bank balance sheets in fixed income, such sovereign risks should intuitively drive a wedge between debt and equity market performance. However, we think the most important driver of credit market underperformance is the shift in US monetary policy from quantitative easing – QE – toward quantitative tightening - QT (see: On the road from QE to QT, redux 15 June 2018). Mechanically that means less demand and associated widening pressures on credit spreads during times with supply pressures, as we have seen a number of times this year. From that perspective we consider the wider credit spreads an early indicator of more struggles to come as the level of global monetary policy accommodation declines in coming years." - source Bank of America Merrill Lynch
So the big "decoy effect" might be at play, are equities too high relative to credit or credit too wide relative to equities? We wonder.

"It is discouraging how many people are shocked by honesty and how few by deceit." -  Noel Coward, English author

Stay tuned ! 

Thursday, 5 July 2018

Macro and Credit - Attrition warfare

"All the business of war, and indeed all the business of life, is to endeavour to find out what you don’t know by what you do; that’s what I called ‘guessing what was at the other side of the hill." - Duke of Wellington

Watching with interest the continuation of the trade war narrative with additional weakness in Emerging Markets and some credit spread widening, with recent Yuan weakness and tit-for-tat threats made by the European Union in respect to the automobile industry being targeted, when it came to selecting our title analogy, we decided to go simply for "Attrition warfare". "Attrition warfare" is a military strategy consisting of belligerent attempts to win a war by wearing down their enemy to the point of collapse through continuous losses in personnel and materiel. The war will usually be won by the side with greater such resources. Military theorists and strategists have viewed attrition warfare as something to be avoided as the usual principles of war is to achieve decisive victories by using minimal necessary resources and in minimal amount of time (Sun Tzu comes to mind). As indicated by what Chinese officials have said, the tensions between China and the US could escalate into "Attrition warfare" as reported by our respected former colleague David P. Goldman in Asia Times on the 25th of June in his article entitled "A tragedy in the making as the US confronts China":
"A radical disparity of strategic estimates is at work. The United States still believes it is powerful enough to bully China into submission, while the Chinese believe they are strong enough to come out on top in a confrontation with the United States.
Ominously, a senior Chinese official, Trade Ministry economist Mei Xinyu, warned last week that China will pursue war on many fronts in response to American protectionism. In an interview with Germany’s leading news organization Der Spiegel, Dr. Mei was asked which measure China will take against the United States. He said, “China has responded to the first installment of US punitive tariffs by imposing countervailing duties in comparable product categories. Should the US now impose tariffs on imports of another 200 billion, China will extend the conflict to other fields,” quoting Mao Zedong’s dictum, “You fight your war your way, and I will fight mine my way.”
Chinese countermeasures might include an attack on US financial markets, Mei added: “The US and China are the largest economies and largest financial markets in the world. But in the US, the financial sector plays a much bigger role than in China. In that sense, the US is vulnerable here, so of course, that’s an option.” Der Spiegel asked, “Wouldn’t China hurt itself if it sold its dollar reserves?
The value of the dollar would fall, but China’s assets would fall as well.” The Chinese official responded, “In good times, our way of competing is to try to grow faster than the US. But when times get bad, it’s about who loses the most. That would be a financial war – and what such a financial war between the two largest economies looks like is probably beyond our imagination.”
Dr. Mei added, “When we had our first trade conflicts with the US in the 1990s, the US economy was 15 times bigger than the Chinese. Today it is 1.5 times bigger. Not that we wanted a trade war back then – we could not afford it. Today we can afford it. The export share of our gross domestic product has dropped to below 20 percent since the peak of the early 1990s. At the same time, the share of domestic consumption has grown strongly. This strengthens our position.”
Foreigners presently own about a third of America’s total public debt of more than $20 trillion. China owns about $1.1 trillion of this. The trouble is that the United States Treasury will need to borrow $1 trillion a year for the indefinite future. The US Federal Reserve has ended its program of public bond buying, and the US savings rate is extremely low; domestic buyers cannot absorb the $1 trillion annual requirement, and the US will have to borrow from foreigners. That is a long-term strategic vulnerability of which China is keenly aware, and which the United States appears not to have considered.
That is war talk for public consumption, with a degree of vehemence that no Chinese government spokesman has employed in the past. Speaking on background, a senior Chinese official told Asia Times that Beijing now believes that Trump has “betrayed” China. Beijing had sought an accommodation with the United States, offering to increase its imports of US goods and reduce the $375 billion bilateral trade deficit. US officials had discussed a plan in which China would invest in US liquefied natural gas facilities and accept long-term contracts to buy US gas, for an estimated $50 billion increase in US export to China.
But Beijing has concluded that Washington does not want specific trade concessions, the official continued, but rather wants China to abandon its economic policy of subsidizing nascent industries and acquiring advanced technology – in effect giving up its plans for economic development, in the Chinese perception." - source Asia Times, David P Goldman; 25th of June 2018
You probably understand better the use of our title analogy in the light of the risk for serious escalation between the two countries. It seems to us that the third quarter is showing more and more weakness at least in credit markets, with US High Yield finally underperforming US Investment Grade given the rise in dispersion and intensification in the risk-off environment thanks to the change in the narrative.

In this week's conversation, we would like to look again at the evolution of financial conditions given with liquidity being gradually withdrawn will certainly put some pressure in the near future and most likely in 2019.

  • Macro and Credit - The financial conditions noose is tightening
  • Final chart - Emerging Markets pain. Are we done yet?
  • Macro and Credit - The financial conditions noose is tightening
While we indicated in recent conversations that the comeback from active management against passive management was due to rising dispersion with investors overall becoming more discerning in their credit selection process. This obviously tied up to our macro reverse theory discussed at length of the very blog, which has marked not only the return of US cash in the allocation tool box but, as well is starting to affect the high beta game which so far this year in the US has been less immune than for instance Emerging Markets (EM) high yield. But though some pundits would like to point out that the ECB and the Bank of Japan (BOJ) are still providing some liquidity thanks to the continuation of their respective policies, the Fed's hiking stance in conjunction with a reduction of its balance sheet is pointing towards tighter financial conditions overall according to BNP Paribas's report from the 28th of June entitled "US: Financial conditions - boding ill for next year":
  • After loosening through 2017, financial conditions have tightened sharply this year, retracing about two-thirds of last year’s accommodation.
  • Historically, financial conditions tighten alongside Fed hiking cycles, making last year’s loosening atypical. We think financial conditions could reach longer-term neutral levels by year end.
  • Along with fading fiscal stimulus, tightening financial conditions factor into our below consensus forecast for 2019 growth of 1.4% q4/q4.
  • Persistent narrow corporate bond spreads have been a key feature of this cycle, highly leveraged corporates could be both cause and victim of continued tightening conditions.
We find financial conditions indices useful in projecting cyclical developments in the economy. Financial conditions have tightened this year after easing last, which was an unusual development, as financial conditions tend to tighten during Fed hiking cycles, which contributes, along with fiscal policy, to our above-consensus growth forecasts for this year. Next year, we expect not only the temporary boost from tax cuts to fade, but think financial conditions, in addition to their tightening thus far, could tighten further if they revert to more typical behavior of past Fed hiking cycles. This makes us more pessimistic on growth going into 2019 than consensus.
Over the first two years of the current Fed hiking cycle, we saw a substantial tightening in financial conditions according to our financial market conditions index (FMCI), by about 1.5 standard deviations from its longer-run average (about the last 30 years), bringing them to about a neutral overall level, especially in 2015. This tightening came mostly from the exchange rate but also 2s10s flattening, which typically is bearish for growth. Despite the Fed delivering three hikes over the year, 2017 saw overall financial conditions reverse course and loosen by about 1.5 standard deviations. Lower corporate bond yields, narrowing money market spreads, rising equities, and a depreciating real effective exchange rate all were drivers (see Chart 1).

This year, however, financial conditions have tightened, by about a standard deviation according to our FMCI. A strengthening dollar and tighter money market liquidity, and flat equities have driven overall financial conditions tighter. Until this year, financial conditions were behaving atypically for a Fed hiking cycle, as usually broader financial conditions tighten as the Fed hikes. If we project the typical historical relationship between fed funds and our FMCI forward through this year, we can expect another 0.5 or so standard deviations of tightening given our forecast for three more fed funds hikes, which would leave overall financial conditions at neutral levels over about the last 30 years, but around the tightest they have been in the post-crisis period (see Charts 1 and 2). The previous time we hit those readings, in late 2015, the economy came close to stalling.

We find that activity lags our FMCI by a relatively short period – about two quarters or so – while consumer prices react to our FMCI at relatively longer lags – about seven quarters or so. Roughly, we find that a one standard deviation move in our FMCI relates to about a 2.5x move in year-on-year industrial production growth and about 0.3pp on year-on-year core CPI.
Tighter financial conditions this year, along with less accommodative fiscal policy in 2019 make us think growth next year could come in substantially weaker than in 2018. We project fiscal policy to add around 1.0pp less to overall growth next year compared to this year; this, combined with the already one standard deviation tightening in financial conditions this year suggests a sizable slowdown in output growth in 2019. We see growth slowing from 3.0% q4/q4 this year to 1.4% q4/q4 next.
As financial conditions tighten, a risk-off move could accelerate tightening and possibly exacerbate a future slowdown. A distinct feature of post-crisis financial conditions has been the lowness/narrowness of corporate bond yields/spreads, which have remained more or less continuously accommodative since 2012. Corporates are by some measures historically leveraged, although in terms of debt serviceability, look less vulnerable. Still, profits could be increasingly pressured, especially as labor supply remains tight while growth slows as we expect, which higher borrowing costs could worsen. Such a combination would likely negatively impact investment spending, worsening a slowdown. Fed rhetoric, both from meetings and participants’ communication, has increasingly centered on shifting towards a neutral policy regime. Atlanta Fed President Rafael Bostic recently gave his range for neutral fed funds as 2.25-3.00%. With fed funds currently at 1.75-2.00%, this implies fed funds will be at neutral levels with just another two hikes. Once rates reach neutral levels, we think the Fed will find it difficult to press on if activity data begins to wobble; tighter financial conditions and pressure from the White House would make doing so even more difficult. Thus, we think the Fed will likely be nimble in pausing its hiking cycle in such a scenario. We see the Fed getting in another three hikes, taking fed funds to 2.50-2.75% by March, before it steps off the gas and pauses its hiking cycle." - source BNP Paribas
The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off:
"The best place to look for trouble is where no-one expects it. The US consumer is the biggest source of demand in the world economy, and real personal spending came in unchanged in May, against a consensus forecast for a 0.2% monthly gain (equivalent to a 2.4% annual rate of increase). There’s a simple explanation for the disappointing consumer report, and that is the rising oil price. Consumer budgets are so stretched that a few cents more per gallon at the pump translates into reduced spending on other items." - source Asia Times, David P Goldman, 30th of June.
To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.

While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income.

On this subject we read with interest CITI's take from their Emerging Markets Economics Outlook & Strategy entitled "The stagflation risk in EM" from the 22nd of June 2018:
"The 'stagflation' risk in EM
The outlook for EM is turning more ‘stagflationary’, in the narrow sense that growth risks have shifted decisively to the downside, while inflation risks are creeping up. This is an idea we mentioned in the essay that introduced last month’s publication, and is worth developing further. The basic problem here is capital flows. When capital flows into EM, currencies strengthen, creating disinflationary pressure. This is an idea we emphasised in our March essay, where we argued that the apparently ‘inflationless’ recovery in EM owed a lot to the disinflationary effects of nominal exchange rate appreciation. And equally, periods of capital inflow mean that the availability of external financing tends to support economic activity and confidence about the future. When capital flows go into reverse, the opposite happens: inflationary risks rise as currencies weaken, while growth comes under pressure. But there’s more going on in EM than just that, largely because the investment recovery has been particularly weak, leading to a number of disappointments in economic activity for EM, even before fx volatility started to rise in April. Those disappointments could get substantially weaker if any of three risks materialise: i) trade tensions continue to increase, ii) China’s current effort to loosen policy is ineffective, leading to a more dramatic weakness in China’s data, or iii) China’s capital account becomes destabilised by outflows. Figure 1.

The balance between inflation surprises and economic surprises among commodity exporters seems particularly bad… Figure 2. …while inflation surprises have not picked up among manufacturing exporters in such a hostile way

This ‘stagflation’ phenomenon is particularly a problem for commodity exporters. The quickest way to see this is in Figure 1 and Figure 2, which show a dramatic divergence recently between economic surprises and inflation surprises among commodity exporters (Figure 1) which is not especially evident among manufacturing exporters (Figure 2). This makes sense: it was commodity exporters that had enjoyed the biggest disinflation in 2016 and 2017 – thanks to the strengthening of exchange rates which accompanied the stabilisation of commodity prices after January 2016 – and whose economic recovery had been particularly important in pushing up aggregate growth numbers in EM. Yet the very factors that had proved disinflationary for commodity exporters – rising commodity prices leading to stronger currencies – had the opposite effect for manufacturing exporters. And while that rise in commodity prices created disinflationary pressure, it also supported economic expansion: the rise in commodity prices was the main factor which helped to end recessions in countries like Brazil, Russia, South Africa and Nigeria. All this was highly supportive for EM’s growth performance as a whole: in 2017, for example, Brazil and Russia by themselves added 35 bp to the overall increase in EM GDP growth of 68 bp.
The recovery in commodity-exporting EMs hadn’t been particularly strong to begin with. Brazil and Russia are especially striking examples. Despite rising commodity prices, increased global (especially Chinese) demand, competitive currencies and the possibility of strong base effects following two years of economic contraction, the 2017 growth rate for these two economies was a mere 40% of their positive-growth 20 year average1. In Brazil, for example, after 5 consecutive quarters of growth since the economy’s trough in Q4 2016, the economy’s GDP has recovered by a mere 2.7 percentage points, well below the average of the previous four post-recession episodes which had seen recoveries of 7.3 percentage points, ie almost three times faster than the current expansion. And thanks now to the effect of the truckers’ strike, we revise growth for this year down to 1.7%, down from the 2.4% we expected at the start of the year. The basic problem in Brazil is investment weakness, driven particularly by a continuing deleveraging process in the corporate sector (Figure 3).

In Russia investment spending has been in the doldrums since late 2013 and the recovery that started only in 2017 – boosted by large infrastructure projects, like the Power of Siberia and the Crimea Bridge – has been modest. Russian investment spending has been impeded primarily by the uncertainty related to the rising risk premium imparted into investment projects in the country. As Figure 4 shows, credit markets are not the constraint on investment in Russia as they are in Brazil.

The weakness of EM’s recovery in EM had been evident more broadly too. If we exclude year-country combinations where growth was negative from the sample, EM GDP in 2017 and 2018 is about 85% of that of 20 year average growth. This isn’t primarily caused by the structural slowdown in China; the number falls below 80% when China is excluded. Our suspicion is that the problem affecting Brazil and Russia is, to some extent, a problem shared by other countries; namely weak investment. Looking across the whole of EM ex-China, the growth rate of real investment last year was 3.8%, a far cry from the 9% average recorded during the boom years of 2003-2008. Coinciding with this – and perhaps explaining it – is the decline in net inflows of FDI to EM, which were a mere 0.7% of EM GDP last year, compared to 1.8% GDP during the boom years.
Now that external financial conditions are tightening, downside risks to growth should be taken seriously. We have argued that a change in expectations regarding the dollar would tighten financial conditions for many EM as capital becomes scarcer and more expensive and debt service costs increase. This appears to have materialised in recent weeks; increases in spreads and cumulative capital outflows are comparable in magnitude to those during the taper tantrum over the same horizon (Figure 5).

The economic effects of this capital outflow shouldn’t be devastating, however, for the simple reason that EM’s external position has improved considerably since 2013. As Figure 6 shows, the ‘basic balance’ of the ‘Fragile Five’ (Brazil, India, Indonesia, South Africa and Turkey) is considerably stronger than it was five years ago.

This means that – with the exception of Turkey and South Africa – the consequences of a ‘sudden stop’ in capital flows would require less adjustment than it did back then. So, we don’t expect many sharp contractions in economic activity (with the exception of Argentina, where a recession is likely in the middle quarters of 2018), but financing is still set to become scarcer and more expensive, and this should be a tax on growth, other things equal.
Downside risks to growth are also coming through via a trade channel. The prospect of a destabilised global trading order is obviously a risk to trade growth, and such a risk is likely to affect EM disproportionally; the many small, open economies that populate EM tend to have higher trade to GDP ratios and significant shares of EM trade take place within global value chains. A more bilateral rather than multilateral trade environment could leave smaller economies out in the cold, e.g. if China were to switch from EM to US imports as part of a bilateral understanding with President Trump. And this kind of pressure will be occurring at a time when EM’s trade volume growth is rather precarious in any case. Figure 7 shows that trade volume growth has been declining recently in most of EM, while Figure 8 shows that while the relationship between trade growth and GDP growth has recovered a bit from its collapse between 2012 and 2015, trade growth is still rather weak relative to GDP growth in early 2018.

A fall in this relationship from current levels is likely to depress growth, as it did during the 2012-15 period when global trade growth was effectively in recession. Finally, it is worth reiterating a point we made in last month’s essay: that the risk of a stronger dollar by itself could weigh on global trade and EM exports; as large shares of global trade are priced in dollars, which means that an appreciation of the dollar can make exports (to countries other than the US and those with a dollar peg) less competitive if prices do not adjust instantaneously.
Just as capital outflows restrict the availability of financing and lead to downside risks to growth, so they also create upside risks for inflation. In Emerging Markets Economic Outlook & Strategy: Is EM enjoying an inflationless recovery?, we suggested that country-specific inflation is highly correlated with FX performance, so further exchange rate depreciation should obviously raise inflationary risks. Whether that turns out to be the case relies heavily on what happens to EURUSD (Figure 9), as we’ve repeatedly argued.

For the time being, we still forecast a 2% appreciation in EMFX over a 6-12 month horizon. However, this is a significant change from just two months ago, when we predicted EMFX to stay around or even appreciate from a much stronger level. But we have already seen EM central banks – and ourselves – having to reconsider the balance of inflation risks in response to the currency depreciation that’s occurred in the past two months. Back in April, for example, we did not expect rate hikes in Indonesia until Q2 2019 and not at all (over the forecast horizon) in India. Indonesia has since hiked twice and we expect another 25bp hike this year, resulting in 75bp cumulative hikes in 2018; while India has hiked once by 25bp and we forecast another 25bp hike before year end. In addition, we have seen strong hikes to stop the free fall of the currency in Argentina and Turkey. Inflation in these countries was already high to start with, but the increase in oil prices and the dollar strengthening rendered a sharp reaction necessary. And finally, there are countries were expected (further) loosening of monetary policy did not occur. The most recent of these cases is Russia, where the central bank kept rates on hold last week amidst rising energy and fuel prices; we still predict cumulative 50bp cuts for the remainder of the year, but the downside risks to our end year forecasts have significantly risen. Already earlier, the Brazilian central bank had ended its cutting cycle earlier than expected and left rates unchanged in May.
A further source of pressure on inflation comes from commodity prices. Oil prices are up 50% compared to one year ago and our commodities team forecasts further increases by the end of the year to just under $80/bbl in the base case. Moreover, they attach a 30% probability to an upside scenario, in which oil prices rise to over $90/bbl by year end and remain over $80/bbl throughout 2019. Somewhat elevated commodity prices can be favourable for EM; they are positive for the prospects of commodity exporters, increase the recycling of petrodollar surpluses and raise confidence in the asset class. However, commodity prices are only EM positive up to a point. For commodity importers, this is quite straightforward – higher commodity prices increase import bills and production costs. But also commodity exporters do not necessarily benefit from very high prices. Many EM extract oil in rather conventional, high sunk cost/low variable cost ways. Higher oil prices then mean mostly larger profit margins and state revenues, but not necessarily increases in investment and production. A further risk comes from the rise in food price inflation that we’ve seen recently (Figure 10).

Corn, soybean and wheat markets are up 10-25% so far this year, and prices are likely to remain elevated through 2018/19 as physical balances tighten and policy pushes, such as Chinese biofuel blending, promote demand growth.
These inflationary pressures are hitting EM at a time when real interest rates are historically low compared to DM, and China remains an important risk. The pressures we’ve tried to describe here – from capital outflows and higher commodity prices – come at a time when the real interest rate differential between EM and DM is historically low (Figure 11).

It goes without saying that higher inflation expectations will push the ex ante real interest differential even lower. If one considers the real interest differential as indicating how strong the ‘magnet’ is that is sucking capital towards EM, it is easier to see how a hostile external environment and a reduction in risk appetite towards EM does not sit comfortably with a low-and-falling real interest rate differential.
China’s capital account is a puzzle, and should be considered the next big risk to watch. In late 2016 and early 2017, China introduced a raft of controls on capital outflows in an effort to prevent further loss of fx reserves, which at that time had fallen by a quarter to $3 trillion. Those controls were highly effective, in the sense that China’s reserves did indeed stabilise. But that stabilisation was also strongly supported by the weakness of the dollar in 2017 and early 2018, since the dollar’s weakness helped to push capital towards China in just the same way that it pushed capital towards other emerging economies.

So, one might expect that a period of dollar appreciation would suck capital from China, particularly at a time when economic activity in China has entered a period of undeniable weakness, which has required a loosening of both monetary and fiscal policy. Yet that doesn’t yet seem to be the case: there is no current evidence of unwelcome outflows from China. Indeed, Chinese authorities have recently acted in a way that expressed a high degree of confidence about net capital flows, announcing measures to liberalise outflows as well as inflows. But we think this is worth watching very carefully, if only because an acceleration of capital outflows while the economy is weak would likely weigh further on risk appetite towards EM. Further depreciation of the RMB would almost certainly intensify the ‘stagflationary’ biases that we see in EM." - source CITI
As a reminder this our macro reverse osmosis thesis we discussed in our conversation "Osmotic pressure" back in August 2013:
"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.
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. When capital flows go into reverse, the opposite happens, whereas QE was deflationary and supporting capital inflows into EM, QT is inflationary therefore inflationary risks rise as currencies weaken, while growth comes under pressure hence a potential "stagflationary outcome".  When it comes to China as we wrote back in February 2014 in our conversation "Crosswind", China has been succeeding so far in the "controlled demolition" of its risky shadow banking:
"Of course the Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy." - source Macronomics, February 2014
China is still busy reducing credit excesses in its shadow banking. More recently, the Yuan had a much weaker tone in the past month thanks to US-China trade tensions escalating. For China it is still a very difficult balancing act in the process hence our "controlled demolition analogy used in the past. In the current attrition warfare taking place, liquidity is being slowly drained, indicating that the credit cycle is turning and financial conditions will continue to tighten. We read with interest UBS's take when it comes to the latest briefing from the PBC monetary policy from their 3rd of July note entitled "Signs of loosening haven't boosted risk appetite":
"PBC has signalled easing, but the impact remains to be seen
The briefing statement from the PBC's Q2 monetary policy committee meeting, held on 28 June, includes a call to maintain "reasonably ample" liquidity, which echoes similar language ("maintain reasonably ample liquidity and financial stability") at the State Council's executive committee meeting on 20 June. Against this backdrop, Rmb510bn of reverse repos come due in the first week of July, followed by Rmb188.5bn of MLFs the next week, and this month will see another wave of tax payments. On the other hand, the PBC withdrew a net Rmb370bn from the system through OMO in the last week of June, though net withdrawals for the month were lower, at Rmb210bn. In our view, the net result of all this will depend on PBC operations. Given internal and external pressure on GDP growth, we think the PBC's focus on maintaining stable liquidity is unlikely to change.
RMB plunged against USD in June
The PBC lowered the USD/CNY fix by 3.5% in June. While constraints related to RMB bond issuance may have been a short-term trigger, we view this more as a one-off adjustment after rapid appreciation against non-USD currencies, and we note the RMB is still up 0.8% against the basket YTD despite the correction. While the PBC's stance has shifted, its moves seem mostly targeted in nature. Overall, we think USD price action will be the bigger driver once this one-time adjustment is behind us.
CDR setbacks haven't restored risk appetite − but inflection point is brewing
Domestic investors see monetary policy as caught in a dilemma between loosening, which could drive rising property prices and RMB depreciation, and tightening, which undermines GDP growth. In the stock market, sentiment has continued to deteriorate alongside widening credit spreads. Looking at stock market liquidity, outstanding margin debt has contracted and northbound investors have trimmed their stakes, with only industry capital investment registering net purchases in the past fortnight. However, an inflection point looks to be on the horizon. CDR offerings − the biggest near-term impediment to onshore stock market liquidity − have run into delays, while A-share valuations have dipped to 1 standard deviation below the five-year mean amid economic risk. Therefore, we think potentially faltering economic data in June/July could drive expectations of looser credit and fiscal policies and hence signal a rebound." - source UBS
It appears that the potential for the trade war to escalate is on everyone's radar.  As we posited in January 2017, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen. This overall has clearly had an impact on global financial conditions. But, if indeed the current account balance in the US deteriorates, then the US dollar could weaken going forward.

Much pain has been inflicted so far in the Emerging Markets space with significant fund outflows in some instances. Some are starting to wonder if we are due for a rebound.

  • Final chart - Emerging Markets pain. Are we done yet?
As we discussed in our June conversation "Mercantilism", trade war escalation would have a greater impact on EM than on DM given the high beta nature of EM and the macro osmosis thesis discussed prior which explains the significant inflows into EM in recent years and most recent outflows. We continue to think that the second part of the year could prove more and more challenging with the gradual liquidity spigot being turned by central banks. Rising dispersion in terms of asset allocation, in credit or equities remains the name of the game. Our final chart comes from Deutsche Bank EM and  Fixed Income note from the 3rd of July entitled "The trend is not always your friend" and displays their EM Risk Monitor, showing that it could still get worse for EM:

"The EM Risk Monitor – an EM-specific measure of risk sentiment – has also been trending in the risk negative territory for some time now, but it is still far from the levels seen in February this year. This indicates that if external conditions continue to remain unfavourable (e.g. broad dollar strength), there is potential for more negativity in EM sentiment." - source Deutsche Bank
If the "Attrition warfare" they will be many more casualties in the EM space that's a given and the stagflationary outcome would be materialize itself fairly rapidly we think. We are already seeing signs of growth deceleration (Global Manufacturing PMI at 53, 11 month low). Clearly this third quarter is not starting on a strong footing as such we have started to slightly add to our long US duration exposure. We continue to view gold favorably in that "warfare" context.
"There is no instance of a nation benefitting from prolonged warfare." -  Sun Tzu
Stay tuned !

Wednesday, 27 June 2018

Macro and Credit - Prometheus Unbound

"Trust my folly then, since it is best for a man truly wise to be thought a fool." - Aeschylus, Prometheus Bound

Watching with interest "risk-off" unfolding with Emerging Markets continuing to bleed thanks to the ratcheting up in the trade war rhetoric, leading to more market turmoil, when it came to selecting our title analogy we decided to go for the Greek tragedy reference namely "Prometheus Unbound", a fragmentary play attributed to 5th century BC Greek tragedian Aeschylus. What is not to like in this title and the tragic element? It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War"
"Prometheus Unbound" is as well a four act-lyrical drama by Percy Bysshe Shelleyn Mary Shelly's husband, first published in 1820. In the Act II Asia the daughter of Oceanus and Thetys a water nymph and Prometheus love interest, and her sister Panthea descend in Scene IV in the cave of the Demogorgon, the demon ruler of the underworld. In this scene Demorgorgon promises the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter. At the end of this act the revolution is triggered, leading to a new order but we ramble again...

Basically, current face-off between the United States and China, and also with the United States and Europe as well as internal rifts between the European Union mark a tectonic shift and validates our views that we are moving from cooperation to noncooperation. In a certain sense, the old Jupiterian order is being challenged by a new Prometheus. This is of course leading to even more instability and volatility in financial markets.

In this week's conversation, we would like to look again at the evolution of the trade war narrative and the rising instability we are seeing as well as the starts of widening spreads in credit which should put some additional pressure on equities at some point.

  • Macro and Credit - Trade war? It's on like Donkey Kong
  • Final charts - Rollover risk? New debt is becoming more expensive...

  • Macro and Credit - Trade war? It's on like Donkey Kong
As per our previous conversation, the recent turmoil seen in equities markets is a symptom of the prevailing "mercantilism" and trade war narrative:
"Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities markets are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out." - source Macronomics, June 2018
As we pointed out as well, any escalation of the trade war rhetoric would lead to some stagflationary effects, higher prices and lower growth. If indeed there are additional measures taken for example against China, Chinese President Xi Jinping said last week he will not hesitate to retaliate against the U.S. on trade. This is indeed something to take note of.

On this very subject we read with interest Deutsche Bank US Economic Notes from the 19th of June entitled "The tit-for-tat trade barbs intensify":
"Trade tensions continue to intensify
We recently noted that the Trump administration has intensified trade uncertainties on a number of fronts. Over the past week, this intensification has focused on trade relations with China, where the administration announce plans for tariffs on $50bn of goods imports. The first tranche of tariffs, covering $34bn of Chinese goods, will begin to be collected on July 6. The second set of products covering $16bn of goods will undergo further review in a public notice and comment process, including a public hearing. In addition, the Administration threatened 10% tariffs on an additional $200bn of goods in response to China’s retaliation, and potentially another $200bn if China retaliates again.
In terms of timing, recall that the Trump Administration announced tariffs on the original $50 billion of goods on March 22. The product list was then released on April 3 with public hearings held in mid-May and the tariffs are expected to be collected starting July 6. We therefore assume that it would take around two to three months for the process to proceed to the implementation stage for the next $200 billion of goods. Given that the annual Chinese party meeting will take place in October and the US midterms in early November, we would not be surprised if tensions remain elevated for the next several months.
US businesses and consumers will be the prisoners of the latest dilemma
As we outlined in a recent note in April, the initial list of $50 billion of goods targeted for tariffs was relatively benign with respect to the potential impact on US consumers. In order to expand the list of goods to $200 billion, the US Administration would be hard-pressed to avoid large sectors such as consumer electronics. As Figure 1 illustrates, computer and electronics products accounted for a substantial portion of Chinese imports last year.
In fact, as Figure 2 outlines, the top 10 product codes in the USITC classification system account for a little over $150 billion of US imports from China.
This is important because as we can see at the top of the list, cell phones are the single largest category of Chinese exports to the US by dollar value, followed by tablets and laptops. These sectors combined represent over $80 billion of imports. It is likely that sourcing these products from other countries is not a near-term option for large US companies such as Apple. Therefore, these firms will then have to choose between absorbing the higher tariff costs via lower profit margins versus passing them onto consumers.
Growth implications
In our initial detailed look at possible trade war scenarios, we concluded that a trade war light scenario in which reciprocal tariffs were enacted that target somewhere between $50 and $100bn in goods, or equivalently around $30bn in tariff revenues, would shave -0.1 to -0.2 percentage points off of US growth. The proposed tariffs target a larger sphere of goods but at a lower weighted average tariff rate than we originally assumed, raising about $32bn in tariff revenue, or about 0.16% of nominal GDP. As such, the growth impact of this scenario is likely to be only slightly larger than we assumed in our original assessment, likely on the order of -0.2 to -0.3 percentage points. There is considerable uncertainty around this conclusion, owing to the difficulty in assessing supply chain disruptions and the response of financial conditions and consumer and business sentiment to the introduction of tariffs on a broad swath of goods.
In addition, our colleagues in China have noted that the cumulative impact of an escalation of the trade dispute would subtract -0.2 to -0.3 percentage points from growth in that region. China’s Ministry of Commerce issued a short statement, which promised to retaliate with "comprehensive quantitative and qualitative measures" if the US imposes more tariffs. As they had previously discussed (reports here and here ), US firms sold US$ 448bn worth of goods and services to China in 2017, $168bn through trade and $280bn through local operation by US subsidiaries in China. China has not threatened officially to target the US firms operating in China, but as the trade tension builds up our Chinese colleagues see that risk rising.
Inflation impact
According to analysis by San Francisco Fed economists, imports account for about 13% of the core PCE price index. The $50bn of goods targeted for a 25% tariff rate accounts for about 1.7% of total imports in 2017, while the $200bn in goods targeted for a 10% tariff rate accounts for about 6.9% of 2017 imports. If we assume that the types of goods targeted by tariffs are broadly representative, we find that core PCE inflation would rise by about 15 basis points (bps) in response to the implementation of these tariffs. Importantly, this would act as a one-time increase in the price level and thus provide a mostly transitory boost to inflation that would largely unwind in the following year.
Fed implications
With growth well above potential, the labor market beyond full employment and inflation near the Fed’s target, the Fed may be willing to tolerate a modest negative impact on growth, and Fed Chair Powell’s press conference indicated that he will likely need to see the negative implications in financial markets or economic data for the Fed to respond. However, with some willingness to tolerate above-target inflation, we think the Fed would very likely look through any rise in core goods inflation as “transitory”. Monetary policy makers would be more concerned about the second order effects on growth. Powell noted reports of companies holding off on making investments and hiring due to increased trade uncertainties when queried on the topic at his post-meeting press conference last week. Indeed, in the Fed's May Beige Book, tariffs were mentioned 22 times and business contacts noted that trade uncertainty was contributing to "supply chain disruptions" and have caused some firms to tap "the brakes on projects in the planning phases." Atlanta Fed President Bostic (voter/neutral) echoed these sentiments yesterday, noting that he has shifted his balance of risks to growth on the back of the recent escalation of trade threats.
It may need to get worse before it gets better
How far the trade tensions escalate will be determined by some combination of political and market pressure that is brought to bear on the issue. At some point, the potential economic damage and uncertainty caused by the trade tensions will precipitate a meaningful pullback in risk asset prices, forcing one or both parties to the negotiating table. How much of a drop in risk may be necessary to force the two parties to a negotiated settlement? As our equity strategist, Binky Chadha has often noted, 3% to 5% pullbacks in the stock market are a frequent occurrence. At the same time, 10% corrections are rare and signal up to a 50% probability of a recession, and the market generally drops 20% or more around actual recessions. We surmise that a correction approaching 10% should be enough to terminate the trade conflict unless it has gathered substantial momentum. A smaller correction could be sufficient if it was clearly induced directly by trade policy actions, though we admit that gauging the Administration’s reaction function is difficult.
Given the sound underlying fundamentals for US output growth over the next year, overall corporate earnings growth may be somewhat impervious to escalating trade tensions with China, but only up to a point. It is difficult to come up with direct effects from a tariff on $250bn of US imports from China plus a similar tariff on China’s $130 billion imports from the US ($160 billion including Hong Kong). This exercise becomes more complicated if regulatory measures are implemented that effectively act as capital controls. The book value of Chinese foreign direct investment in the US was over $27 billion in 2016 while that of US direct investment in China was over $90 billion. Our equity strategists estimate that a 0.2 to 0.3pp drag on GDP growth translates to a 1 to 1.5% hit to S&P 500 earnings growth. In the context of 2018 EPS growth which is on track to hit their forecast of 23% and 2019 growth estimated in double-digits, a 1-1.5% drag is not particularly significant. While the indirect effects of uncertainty and hit to business confidence are harder to gauge, they see corporates responding by putting more of their cash flow towards share buybacks, the primary driver of equities in this cycle from a demand-supply perspective.
In the meantime, China's review of Qualcomm’s $44 billion bid for NXP Semiconductors and the US handling of penalties against ZTE could be a litmus test of how this dispute could play out. A related issue concerns the progress of the Committee on Foreign Investment in the US (CFIUS) Modernization Act of 2018, which has been passed in the House but has not yet been debated in the Senate. This bill would provide a broad expansion of the government’s ability to review foreign investment. Further complicating matters is the Senate’s potential challenge to the Administration's handling of the ZTE penalties. Congress still has a busy schedule ahead of the August recess, which the Senate majority leader has threatened to cancel.
Other areas of potential conflict lie waiting in the wings as well. Soundings from the Administration indicate that tariffs on trade in autos could be in the offing, and important negotiations regarding NAFTA remain well short of a satisfying conclusion. Should the Administration choose to move ahead with auto tariffs and withdraw from NAFTA, the potential for an economic downturn will intensify significantly. In short, there will likely be no rest for the weary among trade warriors and their watchers in the months ahead. - source Deutsche Bank
Both Chinese elections and US elections could be seen as a catalyst for more posturing from both countries in the search for domestic political support. This will no doubt continue to create market jitters and increased volatility in the near term. Therefore we continue to see more pain ahead for Emerging Market (EM) and overall US stock markets should continue to outperform on a relative  basis. 

From an allocation perspective, we continue to think that any escalation in trade war would be bullish for gold, which recently has been weakening. We also think as well that the US long end is starting to be enticing.

Any escalation in trade war would have various consequences. On this subject we read Bank of America Merrill Lynch's take in their Liquid Insight note from the 20th of June entitled "Implications of trade war on rates and FX":

"Trade wars: near-term lower rates and flatter curve
As trade skirmishes continue to deepen, we see increased risk to our base case year-end outlook of 3.25% 10y rates, while our flatter curve view and wider 5y inflation breakeven view appear less vulnerable. The rates market impact of an escalation of trade tensions will naturally depend on the depth and severity of tariffs and retaliatory actions, but recent rhetoric suggests trade escalation may need to get worse before it gets better.
While views vary across outcome probabilities, our Global and Chinese Economics teams see an increase in trade risks.
Should trade tensions worsen, this would likely contribute to lower levels of nominal and real rates, an initially flatter curve, wider short-dated breakevens, and a stronger USD. The Fed would likely be undeterred from near-term hikes, but increased trade friction would likely force them into a slower medium-term path and lower terminal rate for this cycle. The sharp decline in payer skew (ie, declining cost of higher-rate protection) we think confirms the shifting of market probabilities toward the escalation scenario versus a benign outcome. With 3m-5y payer skew now at its lowest since 2007 (+25bp out vs - 25bp out), contrarian traders could take advantage of historically cheap valuations to position for a near-term benign outcome.
Should trade tensions increase, we would expect rates to initially decline with more severe risk off and the curve to flatten as the Fed likely remains on course for further rate increases later this year. However, over time, we would expect that the Fed will need to react to the weaker global growth backdrop by stopping their tightening cycle and potentially cutting rates, which would allow the curve to steepen. As discussed here, this environment would be supportive of wider short-dated breakevens and we also see risks of lower real rates along with a flatter breakeven curve. We also see risks that a material increase in trade tensions could result in less foreign investor sponsorship of US Treasuries, which would contribute to higher rates and term premiums in the longer run.
Fed’s reaction: flatter curve and lower long-term rates
Overall, we think a trade war escalation is unlikely to deter the Fed from near-term hikes but would likely result in a slower medium-term path and lower terminal rate for this cycle.
We see the Fed’s response to a trade-war escalation as occurring through two phases:
  • Near term: the Fed will likely refrain from overreacting to the increase in trade tensions and aim to continue with two additional rate hikes this year. The Fed has repeatedly indicated it does not see a meaningful impact from trade tensions in the data thus far. Chair Powell responded to a question on trade in his most recent press conference by saying that “we don’t see [trade tensions] in the numbers at all. The economy is very strong. The labor market is strong. Growth is strong. We really don’t see [trade tensions] in the numbers, it’s just not there.” That said, Powell and other Reserve Bank Presidents (ex. Atlanta Fed President Bostic) have indicated risks from trade tensions are rising among their business contacts. We expect the Fed will likely refrain from altering the direction of policy until these tensions are more evident in economic data or through a sustained tightening in financial conditions.
  • Medium term: the Fed may need to reduce the total number of rate hikes over the course of this cycle and realize a lower terminal rate. Although tariffs will likely place near-term upward pressure on inflation, we expect the Fed will look through this dynamic and instead focus on underlying softening global growth and consumer demand. This would pose risks to the number of hikes the Fed delivers in 2019 or 2020 and result in a lower terminal rate for this cycle. This assumes any near-term tariff-induced increase in the price of goods would be expected to be short lived and not spill over into longer-run inflation expectations, which is our base case view. If trade tensions result in a rapid escalation of tariffs and protectionist policies, a severe trade war could suppress growth and potentially cause the Fed to consider rate cuts.
Rates reaction: lower rates, higher breakevens, flatter B/E curve
US Treasury rates would likely decline with a further material increase in trade tensions. Rate declines would be led by risk-off dynamics and lower growth expectations. Based upon our expectations for the Fed, the initial response from the rates market would be to price in a flattening of the curve as the front end responds to tightening while 10y and 30y rates remain low due to declining growth expectations and a lower pricing of the terminal rate. As the Fed shifts their reaction function, we would expect the Treasury curve to steepen due to lower expectations for rates hikes and potential concerns about overseas demand for Treasuries.
Within the composition of the rate moves, we would expect wider near-dated inflation breakevens, lower real rates, and a flatter breakeven term structure. Based on market reactions to tariffs in recent years (Table 1) including Bush’s steel tariff, Obama’s tire tariff, and Trump’s recent washing machine and aluminum/steel tariffs, the clearest market reaction is higher breakevens and a flatter breakeven curve.

This was particularly pronounced following the 2002 tariffs on steel, and on average still holds for the more recent measures. While we intuitively anticipate a decline in real rates in the face of tariffs, on a historical basis the real rate reaction has been mixed: 2y real rates tend to decline, but otherwise real rate levels increased on average following the announcement
of a new tariff.
Given these expectations, we see upside potential in our 5Y breakeven widener view. We originally recommended this view due to the economic backdrop and positive carry dynamics, but also see this position benefitting from an escalation in trade concerns. Any surprise from OPEC later this week to not expand supply would also benefit higher short-dated breakevens.
Reserve manager impact: upward pressure on rates after the initial risk-off
Trade tensions are likely to result in weaker UST demand from foreign central banks due to slower FX reserve build and less likely due to trade retaliation. From a flow perspective, a key channel between trade tensions and rates is reserve manager demand. Foreign investors accumulated roughly $6.2tn of US Treasuries over two decades as a result of international trade and market intervention, and $4tn of them are held by reserve managers. China and Japan are the biggest creditors of the US government, holding about 7% of overall marketable Treasury securities each. According to the latest TIC survey, foreign central banks hold mostly front-end to intermediate maturities (Chart 1).

After an immediate risk-off episode, the medium-term reduction in bilateral trade deficit between the US and China should result in a slowdown in China’s FX reserve build, resulting in lower Treasury demand from China. Lower global trade volumes should result in a slowdown of global reserve accumulation, less central bank demand for USTs and upward pressure on interest higher rates (Chart 2).
We think it is unlikely, however, that central banks would sell Treasuries as a retaliatory measure in trade discussions. It is unclear if Treasury selling would have the desired market impact given the mixed history. From 2015 to 2016, foreign official investors sold over $400bn in Treasuries (per TIC data), yet 5y and 10y UST rallied by 60-100bp. In theory, any sizable selling from CBs may be more concentrated in the shorter duration bucket, where the majority of central bank holdings are located. Given the significant demand in the front end this year (Chart 3, 70% of government mutual fund inflows have been concentrated in the very front end as demand for cash like assets surged), the impact of outright UST selling from CBs may not override the flight to quality bid and the repricing of Fed path, as observed in 2015-16. However, such reserve manager selling would likely serve to tighten swap spreads.
USD: accelerated appreciation
In our view, an escalation of trade war rhetoric would serve to accelerate USD appreciation that is already well underway as a result of cyclical and monetary policy divergence, with the added boost to the dollar essentially a function of the severity of perceived global trade deterioration. Under a scenario of a sharp pickup in trade policy deterioration, we would expect the dollar to sharply appreciate bilaterally against most currencies with the exception of the yen, which despite its substantial export sector tends to be supported in risk-off situations due to its large net foreign asset position. USD returns would likely be highest against the higher beta currencies of economies perceived to be most vulnerable to a slowdown in global and/or US trade, a list traditionally including CAD and AUD among others. Recent sharp deceleration in Euro Area data as a result of rising trade tensions early in the year suggests to us that EUR is also perceived to be included here." - source Bank of America Merrill Lynch
Escalation of trade war would see risks of lower real rates along with a flatter breakeven curve in the near term while obviously a rising US deficit would be negative in the long run for the US yield curve overall as foreign investors might shun purchasing additional US Treasuries.

There indeed mounting signs that in some places global trade and growth are slowing down. The trade war rhetoric is adding to this trend as of late. The risk-off environment can again be ascertained from fund outflows as indicated by Bank of America Merrill Lynch Follow The Flow note from the 22nd of June entitled simply "Cutting risk":
"Trimming longs
With credit spreads been broadly flat over the past couple of weeks, it seems that high grade investors have been trimming risk (chart 1) amid fears that Italian risk will not subside any time soon.

Notably all the major asset classes we track have recorded outflows last week, as trade wars have also supported the risk-off momentum.
Over the past week…
High grade fund flows were negative for a fifth week in a row; note that the majority of the outflow came from two funds.
High yield funds continued to record outflows (32nd consecutive week). Looking into the domicile breakdown, global and to a lesser extend European-focussed funds have recorded the largest outflows, followed closely by the US-focused funds.
Government bond funds recorded a third outflow last week; however the pace of the outflow has more than halved w-o-w.
All in all, Fixed Income fund flows were for a fifth week in negative territory, as the major individual pockets recorded outflows.
European equity funds continued to record outflows for the 15th consecutive week; over that period the asset class has suffered $39bn of outflows.
Global EM debt funds also recorded an outflow last week - the ninth in a row - with the trend deteriorating w-o-w, the dollar strength is heavily weighing on the asset class. Commodity funds recorded sizable outflows, the largest since 2013.
On the duration front, short-term IG funds recorded outflows, reversing last week’s inflow. Mid-term funds recorded their fifth weekly outflow in a row. However, long-term funds have seen inflows after a week of inflows." - source Bank of America Merrill Lynch
What is of course of interest to us from a credit perspective is the developing weakness in credit spreads. We did notice that US Investment Grade has so far clearly underperformed US high beta in the High Yield space, partly because of the Energy sector being a heavyweight in the CCC rating bucket. This disconnect has been highlighted in another Bank of America Merrill Lynch report, their latest Situation Room report from the 25th og June entitled "Let's get back together":
"Let’s get back together
Recently IG underperformance vs. HY in USD credit markets has been remarkable (Figure 1).

Reasons for IG weakness include first and foremost supply pressures in an environment of reduced demand that began in March and extended through last week, plus the Italian situation, which is about systemic risks running through the global IG financial system. Reasons for HY strength include the lack of supply, etc. Trade war risks are probably more neutral across the credit spectrum, as we saw today. We think IG spreads are somewhat predictable based on seasonal supply volumes and that we increasingly will be able to decouple from the Italian risks. That leaves IG spreads currently at the wide end of the range and with our HY strategist, Oleg Melentyev’s, outlook for wider spreads (see: High Yield Strategy: Scarcity of Yield is Now History 15 June 2018), that suggests decompression." - source Bank of America Merrill Lynch
What is of course of interest to us is that the recent in Investment Grade credit in the US in conjunction to a rising US dollar should seduce again foreign investors, and even Japanese investors, given their yield appetite. This is confirmed by Bank of America Merrill Lynch Credit Market Strategist note from the 22nd of June entitled "The return of foreign investors":
"USD corporate bonds now again offering better hedged yields than EUR
A couple of Fed rate hikes later, some spread widening and the USD corporate bond market is now again offering higher currency hedged yields for foreign investors than its EUR counterpart for most relevant maturities (Figure 6, Figure 7).

Specifically higher hedged yields can be obtained in USD credit inside 7-8 year maturities, which includes more than two-thirds of the EUR market."  - source Bank of America Merrill Lynch
Clearly, it appears to us that the divergence between US High Yield and US Investment Grade is not warranted. The recent decoupling to us should correct itself. Although high beta has been performing strongly, we think that in the second part of the year we could see a reversal with Investment Grade outperforming should a deceleration in growth materialize.

As pointed out in our most recent musing, US High Yield has had a much better performance overall than EM High Yield and even against US Investment Grade. But, US High Yield has started to look expensive. On that note we agree with Deutsche Bank's US HY Strategy note from the 26th of June entitled "USD HY looking increasingly expensive":
"In a year that has proved challenging for credit market returns, the USD HY market has proved something of a relative bright spot. In Figure 1 we show YTD total returns across the credit spectrum in local currency terms, ordering performance from best to worst. We can see that USD HY is one of the few parts of the credit market that has provided positive total returns, with CCCs and Bs, the standout performers. This is very much in contrast to the performance of USD IG credit, which has seen the worst of the YTD performance, weighed down by the extra duration and associated impact of rising Treasury yields.
The higher yields available in USD HY, particularly for lower ratings, certainly help to provide higher returns, but as we can see in Figure 2 it is also the only part of the credit market that has seen tighter spreads at an index level so far this year. It is worth highlighting that the strength of this performance is really being driven by CCCs and Bs, with the returns and spread moves for BBs much closer to what we've seen from USD IG credit, even though BBs have still outperformed IG.
Given this relative strength from USD HY we try to assess whether such outperformance makes sense and whether this part of the credit market is becoming excessively expensive.
USD HY broadly in line with volatility
In the left hand chart of Figure 3 we update our analysis comparing USD HY credit spreads against a volatility implied spread series.

(click to enlarge) 
We can see that spreads have continued to broadly track the volatility implied series, although it's clear that the reaction of USD HY credit spreads to the spike in volatility earlier this year was limited. As recently as a couple of weeks ago, the two series were in line but HY spreads have generally remained firm, even as we've seen a rise in volatility around trade tensions. The current differential has USD HY spreads around 70bps tighter than the volatility implied level. So this measure is suggesting USD HY is on the expensive side now. Interestingly, a quick comparison of the same measure with IG credit spreads shows that the opposite is currently true, with USD IG credit spreads actually wider (around 10bps) than the volatility implied level, even after the recent move higher in volatility.
HY vs. IG
We've already highlighted in terms of total returns that USD HY has comfortably outperformed USD IG. In Figure 4 we show the relative spread ratio which shows that at the start of 2018 the ratio was as high as it had been since the GFC.

This would arguably suggest that HY looked relatively cheap to IG at this point and therefore it is understandable that HY has outperformed. That said, the ratio is now towards the lower end of the post GFC range so the same indicator is now suggesting USD HY looks expensive compared to USD IG. If you remain bullish on USD HY you may point to the fact that the more domestic based issuers are less trade war sensitive than say IG companies. However if it eventually leads to a recession, these companies will eventually be hit hardest, so it is very hard to say they are a safe place to hide, in our view.
Last month we published a more detailed note considering the relative value between EUR and USD HY ( link ), and here we provide an update of the simplest part of that analysis comparing broad index spreads for USD and EUR HY. At the time USD HY spreads had been tightening relative to EUR HY spreads but at an index level were still wider. As we can see in Figure 5 that is no longer the case with USD spreads now around 20bps tighter than EUR spreads.
 (click to enlarge) 
That said, the outperformance of USD HY can, in part, be justified by the fact that on this measure in Q4 2017 EUR HY was about as tight to USD HY as it had been since the GFC. However with this differential now back in positive territory and towards the upper end of the post-GFC range, USD HY is now looking fairly expensive on this measure and this does not even take into account the lower credit quality of the USD HY market compared to EUR HY.
We've shown that USD HY has compared favourably, performance wise, to other parts of the main corporate bond markets and that this outperformance has not been entirely unjustified. However there is certainly evidence that it is looking increasingly expensive. We now compare with some other parts of the broader credit spectrum; starting with EM.
DM vs. EM (USD HY vs. USD EM HY)
It's certainly interesting to look at how these two asset classes have performed relative to one another this year. YTD total returns for EM credit are currently less than -5%. This is not only weak compared to the positive total returns produced by USD HY but also compares unfavourably with other parts of the credit spectrum we have already used for comparison.

Interestingly, through Q1, total returns for both HY and EM were around -1%, so all of the divergence has really occurred during Q2. This is fairly well highlighted in Figure 7 which looks at the relative spreads of the two asset classes. 
 (click to enlarge) 
The spread differential had fluctuated in the 20-80bps range from late 2015 to the end of Q1 2018. However over the course of the last few months this has widened from less than 30bps to more than 150bps. Whether this says something about the relative attractiveness of USD HY now is probably a little more complicated. It can be argued that these relative moves are justified by the implications of Fed actions of late. USD HY should benefit from the same growth dynamics that have allowed the Fed to hike rates and therefore it's reasonable for spreads to keep tightening or at least remain tight. At the same time higher rates in the US can have negative implications for EM currencies and expose potential economic weakness and therefore lead to spread widening for EM sovereign credits. We have seen this recently for countries such as Argentina, Brazil and Turkey. We can also look to 2013 when there was also a notable divergence. This occurred around the time of the taper tantrum with the potential for the removal of monetary accommodation a likely factor here too. The EM-DM differential went from around 0bps in Q1 2013 to nearly +200bps by the end of September and as much as +280bps during Q1 2014 before hitting a peak differential of more than 400bps in early 2015. The differential only closed at the height of the recent energy/commodity crisis.
Given the likely drivers of the divergence, we're not sure in isolation whether the underperformance of EM in recent months is a particularly strong barometer. That said, given that other measures are suggesting USD HY looks expensive then it only adds to the story.
Bonds vs. loans
One comparison that is not so flattering for USD HY is the performance compared to the loan market. Figure 8 shows YTD total returns for bonds against loans and highlights that so far in 2018 loans have outperformed bonds by more than 1.5%.

So based on this comparison with broadly similar rated securities, there is nothing exceptional about the performance of USD HY. Clearly the floating rate nature of loans has helped here but we can see that loan returns are also much less susceptible to mark-to-market volatility and have therefore provided a more steady accumulation of carry this year. Looking at relative spreads in Figure 9 we can see that despite the underperformance in returns, spreads for USD HY do not look attractive on a relative basis.

In fact, current bond spreads are tighter than loan spreads at an index level and whilst this has largely been the case for the past 18 months or so, it is actually a fairly rare event historically. So in this instance, the performance of USD HY does not standout but it still looks relatively expensive on this measure.
Based on all of the simple relationships we have analysed, USD HY looks quite expensive. Our expectation for the remainder of the year, as we highlighted in our recent outlook update , is that USD HY is likely to underperform other parts of the credit universe." - source Deutsche Bank
Simply put, there is potential for a reversal of fortune for US Investment Grade credit versus US High Yield particularly in the light of the performance in High Yield being in the high beta bucket with CCCs taking the lead. As liquidity is withdrawn by central banks and financial conditions start tightening, it will become more and more expensive to issue debt for the weakest players. Some might say that the lack of issuance will therefore continue to provide a technical bid to the asset class, given the very high correlation with the S&P 500, we do not think US High Yield will be spared as it was in the second part of 2018. 

If indeed financial conditions are tightening and liquidity is being withdrawn, then again high beta such as EM will continue to suffer as per our final charts, this mean debt is becoming more expensive. 

  • Final charts - Rollover risk? New debt is becoming more expensive...
Many pundits have pointed out the correlation between liquidity being withdrawn and tightening financial conditions. Obviously the credit spigot is being gradually closed by the Fed and it remains to be seen when corporate America's debt binge to finance buybacks will turn. On this subject our final charts come from Wells Fargo Economics Group report from the 20th of June entitled "Corporate America's Debt Binge: An Issue When Rates Rise?":
"Corporate debt has risen to 45 percent of GDP, equal to the peak of the previous expansion. Low interest rates and longer payment periods have kept corporate debt cheap, but these trends are beginning to reverse.
Nonfinancial Corporations Load on Debt
The overall U.S. economy has become less indebted since the Great Recession, with domestic debt outstanding as a percent of gross domestic product (GDP) falling to 330 percent in Q1 from more than 370 percent at the start of 2009. Shrinking debt relative to GDP is mainly due to deleveraging in the household and financial sectors, while debt has grown faster than GDP for government and nonfinancial business (below chart).

Aside from government, the largest debt gains have occurred in the nonfinancial corporate business sector. Corporate debt growth turned positive in 2011 and has averaged 5.8 percent a year since, propelled higher by low interest rates and robust investor appetite for fixed income securities. As a percent of GDP, corporate debt is currently sitting at its highest level of the cycle (45 percent) and is equal to the peak of the previous expansion.
Lower Interest Rates and Longer Payment Periods
The interest rates corporations are paying on their debt remain far below historical levels, which has helped to keep debt servicing costs low relative to the amount of debt corporations are holding on their balance sheets. We look at interest expense as a share of total short-term and long-term debt as a proxy for the average interest rate paid by corporations (below chart).

This measure fell substantially after 2009 as the Federal Reserve cut the benchmark rate, and remains below the lows of the 2001-2007 cycle for retail trade and all major manufacturing industry categories. Also limiting the corporate debt burden is a shift toward more long-term debt, which means lower principal payments due in each period (bottom chart).

Short-term debt (due in less than one year) represented 9.4 percent of debt held by manufacturing and retail corporations in Q1. This compares to over 13 percent at the end of the previous expansion.
In Q1, manufacturing corporations owed $505 billion on their debt in the coming year (short-term debt plus installments due on long-term debt), while large retail corporations owed $73 billion. These obligations amount to 19.1 percent and 12.6 percent of current assets, respectively. Even though interest rates and the short-term share of debt are lower than during the 2001-2007 expansion, high debt loads mean that debt payments coming due relative to current assets have far surpassed levels of the previous expansion.
But… Debt is Becoming More Expensive
In the past year, the short-term share of debt and the interest rate proxy have risen for corporations, reversing previous trends. Therefore, debt is set to become more expensive. Given strong economic growth and profits, leverage is not overly concerning at present. However, should investor appetite for debt wane or benchmark interest rates go up quickly, funding new debt could fast become more onerous for U.S. corporations." - source Wells Fargo.

Looks like Prometheus is indeed "unbound" and that there could be some "revolutionary" changes down the line for financial markets. For many years the Fed had your back. Not anymore. If indeed there is an escalation in trade war leading to a stagflationary outcome, then one would expect US long Treasuries and long duration Investment Grade to start outperforming again in the near term. In similar fashion to Demorgorgon promising the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter, liquidity withdrawal should be taken very seriously , particularly for EM. As we stated before, liquidity matters more than fundamentals in many instances as our reverse macro osmosis thesis discussed recently played out which is an illustration of "Sudden Stops: A Primer on Balance-of-Payments Crises" as we were reminded by this excellent article (H/T Alibey Tuncer). Things are starting to get interesting...

"The story of 'Prometheus' is the idea that if you're given a gift from the gods, do not abuse it, and do not think you can compete." -  Ridley Scott
Stay tuned !
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