Tuesday, 19 June 2018

Macro and Credit - Mercantilism

"What generates war is the economic philosophy of nationalism: embargoes, trade and foreign exchange controls, monetary devaluation, etc. The philosophy of protectionism is a philosophy of war." - Ludwig von Mises

Looking at the strong yet short bounce in equities following market jitters on Italian wobbles (while enjoying some much needed R&R hence our lack of recent posting), indicative of our "white noise" previous analogy, given the acceleration in the trade war rhetoric in the G7, soon to be G6 by the look of it, when it came to selecting our title analogy we decided to go for the simple one of "Mercantilism". "Mercantilism" is a national economic policy designed to maximize the trade of a nation and, historically, to maximize the accumulation of gold and silver (as well as crops). Mercantilism was dominant in modernized parts of Europe from the 16th to the 18th centuries before falling into decline, although we would argue that it is still practiced in the economies of industrializing countries in the form of individual rights. High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Even if mercantilism and protectionism are applied through the same economic measures, they have opposite aims. Mercantilism is an offensive policy aimed at accumulating the largest trade surplus (China, Germany). Conversely, protectionism is a defensive policy aimed at reducing the trade deficit and restoring a trade balance in equilibrium to protect the economy (United States). Mercantilism is the economic version of warfare using economics as a tool for warfare by other means backed up by the state apparatus, that simple. In our previous conversation we reminded ourselves our thought from October 2016, namely that we were drifting towards the inevitable longer-term violent social wake-up calls: populist parties access to power, rise of protectionism, the 30’s model. Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:
"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..." - source Macronomics, January 2018
Hence our "Mercantilism" analogy or basically the reality is that we are fast moving from a cooperative world to a non-cooperative world à la 1930s. It isn't only tensions rising between China and the United States, or United States with Europe, there is as well growing tensions between European country and internal tensions rising even in Germany putting Merkel's feeble coalition at risk thanks to political tensions surrounding immigration issues. We would like to repeat what we we wrote in June 2012 in our conversation "Eastern Promises":
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."  
Remember, it is still a game of survival of the fittest after all:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.
Also in June 2012, in our conversation "The Unbearable Lightness of Credit" we argued the following:
"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries".
This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.
The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia
"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 
Could Europe allow for the adoption of the "Sinatra Doctrine"? We wonder, but nonetheless, before we enter into the nitty gritty of our long overdue new conversation, we thought it would be interesting to remind ourselves of the above given our take for Europe from our November conversation "Chekhov's gun" is still as follows:
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…)." - source Macronomics, November 2014

In this week's conversation, we would like to look at the continuous adverse effects of moving from QE to QT, and the impact is having on Emerging Markets with rising tensions as well on the trade war front. 

  • Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
  • Final charts - Capital Flows? This time it's really different.

  • Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
While the short-vol pigs house of straw was the first casualty to go in the change in the sea of liquidity provided by our "Generous Gamblers" aka our dear central bankers, Emerging Markets have been of course next in the line in the change of the narrative with the return of  "Mack the Knife" aka rising US dollar and positive US real rates. We wrote in our last missive that investors were moving back into assessing the "return of capital" rather than the "return on capital". This is creating rising dispersion thanks to investors being more "issuer credit profile" sensitive with the return as well of US cash in the allocation tool box. The rise in dispersion should continue to make active management benefit from this trend after years of being in the shadow of passive management and consequent fund inflows into ETFs.

With the receding tide of cheap liquidity, there is no doubt an intensification in the competition for capital. When it comes to credit, we have recommended to start moving up the quality spectrum and tone down the high beta game, basically meaning being more defensive that is as the game is changing.

Sure some pundits when it comes to Emerging Markets would like to point out to "fundamentals". Yes they do indeed matter particularly when looking at current accounts, but in the end, if there is spillover and contagion from the "usual suspects" with Argentina, Turkey and now Brazil, then what will matter much more is "liquidity". Right now liquidity is being drained by central banks, this will ensure financial conditions tighten. As many have pointed out, including ourselves, the Fed will hike until something breaks, and in the end, what drives the credit cycle is simply the Fed. On the matter of liquidity, which we think is paramount, we read with interest Morgan Stanley's take from their FX Pulse note from the 14th of June entitled "Liquidity Breaks Correlation":
 "Global liquidity… 
The pool of global liquidity appears to be starting to shrink. Several factors are at play here. First, the Fed's balance sheet reduction is increasing pace while the ECB and BoJ are reducing their asset purchases (Exhibit 8).

On net, global central bank liquidity is likely to turn negative over time when compared to GDP growth. Second, the global economic expansion suggests that capital will increasingly be allocated to 'real' economic uses as opposed to financial assets. A closed output gap suggests rising capital demand as spare capacity is eroded, and investment into new capacity requires financing.
Third, the flattening of the US yield curve has reduced the incentive of local financial institutions to transform short-term liabilities into long-term assets (maturity transformation). If banks are less willing to generate liquidity through the maturity transformation process, another buyer will have to step in to make up for the shortfall. Japanese banks liquidating their FX-denominated assets is evidence that demand for US assets is falling outside the US as well, meaning tighter liquidity conditions as demand for financial assets declines (Exhibit 9).
Tighter liquidity conditions suggest higher volatility as the risk-absorbing capacity of markets declines. When liquidity is ample, all boats tend to get lifted. The reverse effect may be more selective, though. EM volatility has risen sharply, but DM volatility, with the exception of some credit markets, has been relatively muted (Exhibit 10).

Indeed, US equity markets are trading near historical highs, while the 10-year Treasury yield fell back from the recent 3.12% cycle high. It seems the liquidity pool is both shrinking and becoming more concentrated, too. One explanation for the differential in volatility is that we have simply seen a rotation – out of EM and into DM – which explains why DM volatility has been relatively muted compared to EM. This too suggests that a positive outlook for US shares may no longer imply that EM assets will perform well too if they increasingly attract funds at EM assets' expense.
The feedback loop: It is likely that recent market thinking and positioning have been, at least in part, impacted by RBI Governor Patel's recent op-ed where he suggested that the Fed's balance sheet reduction, coupled with rising US public deficits and private debt levels, is leading to an absorption of offshore USD liquidity. Many EM economies experienced recessions following the US taper tantrum in 2013, which in turn resulted in balance sheet consolidation and reduced foreign funding needs. Still, EM countries require capital inflows to keep the economic expansions in place, particularly in the current environment of closed output gaps where spare capacity is increasingly scarce.

Indeed, 2017 saw record inflows into EMs, but this has turned into outflows, tightening local financial conditions and thus their economic outlooks. If not addressed, this issue could create bearish economic feedback loops where liquidity outflows worsen the growth outlook, resulting in more outflows, and leading to even more weakness.
Thus, it may be argued that the US fiscal expansion, implemented at a time when the US output gap was closed and global funding costs were at the lows (and are now rising), may actually reduce the length of the global economic cycle, sowing the seeds for financial asset volatility and investors increasingly seeking safety. Our bearish risk outlook projected for 2H18 has gained traction, we think.
The FX message: Currencies not requiring capital imports and running net foreign asset positions should perform best in this scenario, explaining our bullish JPY call. EUR and Nordic currencies offer value too in this regard. As long as markets only de-correlate but do not fall collectively, CHF should weaken, though. As noted above, the relatively low risk of its asset position suggests that it is not much exposed to waning risk sentiment; otherwise, its income balance would be far higher. Thus, CHF may benefit less than the other surplus currencies should risk sell off. CHFJPY shorts may begin to look attractive again." - source Morgan Stanley
While we got out of EM equities back in January this year following impressive performance in 2017, we continue to believe that US equities will fare much better relative to EM in 2018, contrary to what played out in 2017. Fund flows related wise, in similar to US High Yield, where there is a large contingent of retail punters, Emerging Markets are starting orderly retreat from the asset class at a rapid pace. This is confirmed by Bank of America Merrill Lynch GEMs Flow Talk note from the 14th of June entitled "EXD & LDM outflows continue… 8th straight week down; big blow for EXD":
"EPFR fund flows down: EM debt 8th consec week down
• EXD, LDM and EM Equity were all down, while blended funds were slightly up.
• 8 negative weeks in a row for overall EM debt, outpacing the large negative trend recorded at the end of 2016 (six consecutive weeks down) but still not as bad as the one registered since Oct 15 – Feb 16 (18 consecutive weeks down).
EPFR aggregate EM debt flows were down -0.3% total.
-0.1% for Local Debt (LDM), -0.5% for External Debt (EXD),
+0.1% blended funds and -0.1% EM equity.
• ETF flows were down in LDM but positive in EXD (-0.2% and +0.2%).
EXD outflows are from retail and mild vs 2013
EXD funds now have a small negative total YTD outflow after this week. They are still quite small compared to the large wave of outflows in 2013, at a time when retail investors were a larger part of the EM market (Chart 1).

We do not think they returned.
The outflows reported by EPFR have been almost entirely from small retail accounts who are less than 5% of the EXD market ($66bn AUM of the $2.4tn EXD outstanding). The remaining funds monitored by EPFR are another 5% of the EXD mutual funds in the US, SICAVs in Europe and ETFs. (Table 5).

The rest, who do not report weekly, include mainly large privately managed accounts, pension funds, sovereign wealth funds, insurance companies and banks and who are the mainstay of the EM buyer base. Our institutional managers do not report these sorts of institutional outflows at this time, and we believe there are still EM mandates expected." - source Bank of America Merrill Lynch
In a competitive system for capital allocation, with the receding QE tide thanks to QT, we are much more concerned about the "corporate sector" due to dollar funding and leverage in some instances. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure so watch what oil prices do going forward, not only what the US dollar does. It is not a surprise to see LATAM High Yield down 3.8% YTD compared to Asia High Yield only down 3.3% YTD. Overall in both EM and DM, credit has suffered more than equities when US High Yield has been much more stable relative to EM as well.

One might ask itself that if indeed the short-vol yield pigs house was made of straw, then maybe the EM yield pigs house is made up of wood and the next step could be a full blown EM crisis on our hands. Bank of America Merrill Lynch made some interesting points in their Credit Market Strategist note from the 8th of June entitled "When the tides goes out":
"EM crisis?
Other markets benefiting from QE include EM. With a rising dollar the greatest rollover risk is now for countries that have relied on external dollar denominated financing and are running deficits. Hence, this year’s worst performing countries in terms of currency depreciation and sovereign CDS include Venezuela, Argentina, Turkey and Brazil (Figure 1).

In terms of spillover risk to US credit, we would de-emphasize the EM story and focus on Italy and the European sovereign situation, which has much more cross-exposures to the US and systemic risk to the global financial system. Of course, the Italian story is also partially an outcome of QE that allowed cheap deficit financing, and made worse with the coincident timing of ECBs coming final taper (Figure 2).

Another important contributing factor has been a fixed exchange rate (euro member), which used to be how EM countries got into trouble via large current account deficits." - source Bank of America Merrill Lynch
Sure fundamentals matter, but given the receding tide in liquidity thanks to central banks turning slowly turning off the tap, more and more liquidity will matter. There is as well the L word for leverage and on that point we are worried about US corporate leverage which has been creeping up in recent years on the back of a buyback binge. To illustrate this we would point out towards another point made in Bank of America Merrill Lynch note about the state of credit fundamentals:
"Final update on 1Q credit fundamentals
Based on almost final data for 1Q (covering 97% of companies), gross leverage for US public non-financial high grade issuers increased to 3.04x in 1Q from 2.98x in 4Q, while net leverage rose to 2.67x from 2.54x. Both gross and net leverage are now the highest on record (Figure 36).

For our “core” issuers excluding Energy, Metals and Utilities gross leverage was 2.39x, up from 2.34x in 4Q but below 2.40x in 3Q-17. Net leverage increased to 1.79x from 1.59 in 4Q (Figure 37).

The coverage ratio fell to 8.23 in 1Q from 8.44 in 4Q for the full universe of issuers (Figure 38), and was a bit lower at 10.79 in 1Q compared to 10.91in 4Q for the core set of issuers (Figure 39).
- source Bank of America Merrill Lynch

It's not only the leverage which is higher in US Investment Grade credit, quality as well has been worsening in a market where secondary trading is much weaker than before thanks to low inventories on US banks balance sheet and less appetite in providing "risk" in a context where "passive" management through ETFs has exploded in terms of inflows. It isn't a good recipe for when things will start heating up, but, we are not there yet in this credit cycle. Dispersion is rising still between issuers as the competition to attract capital is ratcheting up thanks to central banks turning the liquidity spigot gradually until it hurts.

If L is for "Leverage" when looking at US credit, L is as well the word for "Liquidity". Liquidity, as many veterans from the Great Financial Crisis (GFC) know is a coward. For EM it is already the case as pointed out in another note from Bank of America Merrill Lynch, in their Emerging Markets Weekly from the 14th of June entitled "It is the "L" word...Liquidity":

"It is the "L" word...Liquidity
  • Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
  • EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high.
Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons. First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether. Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions. Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.
It is a tale of two markets ‒ before and after April 16 Before April 16, EM debt was a different market, outperforming every other debt asset class, with continued EM inflows (2%) while there were outflows from US (-4%) and non-US HY (-7%). Unlike 2013, EM inflows persisted, even during the first 75bp of the US rate rise from Sept 2017 to April 16, 2018. Since then institutional flows are somewhat offsetting the small retail outflows and EXD ETF inflows have been fairly stable. EM issuance was up 8% through April 16, while that for US IG and HY was lower by 7% and 25%, respectively (EM supply? Relax. It is not as bad as you fear). 
2017 to early 2018 large growth
EM economies are still booming and new markets have opened with new demand. First, GCC sovereign issuance and frontier markets have grown rapidly, offering investment opportunities for high credit quality crossover buyers, as well as higher yielding and promising credit stories offering diversification. In addition, China has become more than one-third of EM corporate issuance and as much as 90% of that is placed in Asia, much in China itself. Fundamentally, most of those markets have not changed in the last 2 months." - source Bank of America Merrill Lynch
Yes, in illiquid markets, size matters. No matter what some sell-side pundits would like to spin, liquidity trumps fundamentals. It is your ability to trade that matters.

Having learned quite a few things from reading over the years the research from the wise Charles Gave of Gavekal research for whom we have great respect, at this juncture from QE to QT we think we needed to reminded ourselves his wise words:
"if there is more money than fools then market rise, and if there are more fools than money markets fall"
Last year rush for Argentina 100 year bond was indeed a case of more money than fools for EM. As the tide slowly recedes and we turn from QE to QT, we will over the course of the next quarters gradually discover who has been swimming naked, given capital will flow more discerningly we think. QE was a period where money thanks to NIRP and ZIRP was chasing anything with a yield without distinction. Now with rising dispersion, there will be truly more "credit analysis" done at the issuer level. Times are changing as pointed out by Bank of America Merrill Lynch in their Credit Market Strategist note from the 15th of June entitled "On the road from QE to QT, redux":
"On the road from QE to QT, redux
We have used this title before (see: Credit Market Strategist: On the road from QE to QT 29 March 2018) and this week’s central bank meetings - Fed, ECB and BOJ - motivate us to recycle it. Quantitative easing (QE) was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed. There is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).

However, we are currently in this intermediate phase - i.e. on the road from QE to QT - where things remain orderly although technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).

Hence, we have seen higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4).

Domestic QT+ foreign QE/NIRP=OK
The reason we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5).

Thus, if US yields rose too much due to QT and rate hikes there would be large foreign inflows. Hence, US yields would not increase too much and fixed income volatility remains moderate. While this week the ECB announced the end to QE, they came out dovish by promising continued negative interest rates (NIRP) for a long period of time (Figure 6).

NIRP in the Eurozone works much like QE, as explained below, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.
How does the ECB influence the back end of the curve? It is very simple: with negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9).

That asserts bull flattening pressure on both rates and quality curves.
We have not seen this movie before
While QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years.

However, while we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020. This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate." - source Bank of America Merrill Lynch.
The escape route is somewhat less tricky for the Fed than for the ECB. It remains to be seen if Mario Draghi will rock the boat before the end of his term in 2019. We do not think he will. The Bank of Japan remains so far committed to QE, so there is still some time on the gradual tightening spigot we think.

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 market 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. On the subject of disruption from trade wars, we read with interest Barclays take from their Thinking Macro note from the 1st of June entitled "Trade war in perspective":
"US trade protectionism: Where do we stand?
This year, the US has implemented a number of protectionist trade actions. In March, President Trump announced a 25% tariff on steel (10% on aluminium) imports. The US Trade Representative (USTR) then proposed a 25% intellectual property (IP) related tariff on 1,333 Chinese goods. President Trump then asked the USTR if it was possible to impose tariffs on a further $100bn of Chinese goods. Import tariffs in the automotive sector are also being considered. Some progress has been made in trade negotiations with China (see China: Tariffs on hold, long negotiations continue, 12 May 2018). But escalation risks remain, since the steel tariff exemption will expire on 1 June and the White House said it will impose a $50bn IP tariff on Chinese products, with the list published by 15 June 2018.
We use a VAR model to quantify the potential impact of US tariffs on global growth and CPI inflation. The first year estimates are subject to high model and parameter uncertainty. We thus use second year estimates. These show that a 1% unilateral rise in US tariffs as share of US imports may reduce global growth by 0.3pp and increase inflation by 0.4pp. That said, the impact of the steel tariff, even without exemptions, would only lead to a 0.1pp decline in global growth and a rise of 0.1pp in CPI inflation, as steel is only 0.33% of US imports.
Large economic effects larger require big tariffs. If the proposed 25% tariff of $100bn of Chinese goods is added to the steel tariff, together with tit-for-tat retaliation, our model shows that such a scenario would raise CPI inflation by 1.1pp and cut growth by 0.9pp.
Our model suggests that the adverse effects of US trade tariffs on emerging markets are likely to be much larger and more persistent. This is intuitive, as these economies have been the largest beneficiaries of the most recent globalisation wave. According to our model, a 1% rise in US tariffs leads to a 1.1pp reduction in EM growth in the first year, versus 0.5pp for DM. For CPI inflation, the numbers are +1.1pp for EM versus +0.2pp for DM.
However, there are a number of mitigating factors. In the first age of globalisation, US tariff policy was very active, but large retaliations were rare. Similarly, their 70% success rate incentivises the US and EU to keep the WTO for resolving trade disputes. In addition, President Trump’s drive for deregulation, by removing entry barriers, could encourage more services trade, which may mitigate the negative effect of higher tariffs on goods. That said, any rise in services trade flows is unlikely to fully offset the impact of higher tariffs on EM countries, given the size and persistence of the effects estimated in this paper.
The impact is larger for emerging, than developed, markets
Emerging markets have likely benefitted the most from the trade hyper-globalisation of the 1990s. The abundant and competitively priced labour supply in these countries, together with free trade, led to large FDI inflows, allowing these countries to export their way up the development ladder. Intuitively, this suggests that these countries should also be more vulnerable to a rise in protectionism. In this section, we split our global real GDP growth and inflation variables into corresponding variables for emerging and developed markets, to econometrically examine if EM economies react differently to DM economies.

Figure 8 and Figure 9 shows the results for EM and DM economies, respectively. This breakdown produces several interesting results. First, EM GDP growth is likely to shrink by roughly twice as much as DM. Second, the DM GDP effect is short-lived and not statistically significant after one year, but is much more persistent in EM. Finally, the impact on EM CPI inflation is approximately five times as large as in DM. This could be due to higher USD denomination of financing flows and trade transactions, as well as different monetary policy reactions to external shocks in EM than DM.
Not surprisingly, the effect of the current US steel tariffs is much larger for EM economies (Figure 10.) than DM economies (Figure 11).

We compare first year estimates, because of a lack of statistical significance for the DM GDP response after the first year. With the steel tariff alone, our model suggests that EM (DM) GDP growth could fall by 0.3pp (0.1pp) and inflation rise by 0.3pp (0.1pp). With steel tariff retaliation, EM growth could fall by -0.7pp, with inflation rising by 0.7pp, which are sizable effects. If the US unilaterally implements IP-related tariffs on $50bn of goods from China, then EM (DM) growth could fall by 0.9pp (0.4pp) and inflation rise by 0.8pp (0.15pp). In the case of tit-for-tat retaliation, EM (DM) real GDP growth falls by 1.7pp (0.7pp) and inflation rises by 1.7pp (0.3pp). Overall, DM would only really feel any effects from tariffs in this very last scenario, while the impact for EMs is already sizable if the current steel tariffs are retaliated against.
The return of US protectionism can be disruptive
In this section, we review the main lessons from our econometric exploration of US tariffs. Modelling the impact of US tariffs on short-term global growth and inflation is challenging. Academic work has focused on the long-term effect, and uncertainty about the impact in the first year after the tariff announcement is large. Our estimates are based on a gradual tariff reduction, while the current situation is a rapid tariff rise. The estimates presented in this paper should therefore be interpreted accordingly. However, they nevertheless provide a first econometric view on how President Trump’s tariffs might affect the world economy.
Our results suggest that US tariffs act like a negative supply shock to the world economy, lowering global growth and raising inflation. However, only large tariffs produce large effects: the current US Steel tariff is only 0.33% of US imports and would reduce global growth only by 0.1pp, while raising global inflation by 0.1pp. It is only when $50bn of IP-tariffs are added and retaliated tit-for-tat that growth falls 0.6pp, while inflation rises 0.7pp.
The impact on emerging markets is much greater than on developed markets. The EM GDP growth impact is twice as large as on DM and significantly more persistent. The EM CPI inflation response is approximately five times as large as in DM. While there are a number of mitigating factors that are not accounted for, the analysis suggests that EM economies will be affected to a much greater extent than developed markets.
Overall, US protectionism could be disruptive, especially if tariffs are large and are retaliated. Emerging markets will likely be more affected than developed markets." - source Barclays
So there you go, if you think EM woes are overdone because of "fundamentals" then again you would be wrong if trade war escalates this could lead to a stagflationary outcome. Then of course, there is as well the trajectory of the US dollar and oil prices to factor in. From a liquidity perspective, we think the second part of the year will be challenging as the central banks turn off the liquidity spigot. You should continue to be overweight DM over EM on a relative basis overall. Then again, there are as well different stories and different issuer profiles. In a rising dispersion credit world, you need to go back to "credit analysis" and this is why active management should be favored right now over passive management. It is time to become more "discerning".

For our final charts, given the increasing competitive nature of capital allocation when liquidity is being withdrawn, we would like to highlight how this cycle is unique.

  • Final charts - Capital Flows? This time it's really different.
When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015 and in 2018) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
Capital flows react to real interest rates dynamic. Following years of financial repression in this cycle, the reaction and velocity of the moves we are seeing are therefore much larger from a standard deviation point of view. Our final charts come from Wells Fargo Economics Group note from the 13th of June entitled "Capital Flows Part III: This Time Is Different" and highlights the unique nature of the current economic cycle which ultimately affects capital flows as per our reverse osmosis theory stated above:
"The relationship between interest rate expectations and exchange rates has become harder to quantify, largely due to the unique nature of the current economic cycle. This changing dynamic ultimately affects capital flows.
What About Expectations?
As we have discussed in two previous reports,* capital flows respond to relative interest rate and exchange rate dynamics across borders. We now turn to the effect of expectations on our three variables. Expectations have played an increasingly important role in market participants’ reactions to global events. For example, recent Italian political developments led the euro to decline against the dollar, while Italian bond yields rose more than 100 bps (below chart).

While it is too soon to determine any effect these political tensions could have on capital flows, it is clear that expectations play a role in short-term exchange rate and interest rate dynamics. In the long run, these dynamics affect capital flows.
Expectations of central bank actions have also caused unpredictable swings in foreign exchange rates and interest rates. As previously discussed, our currency strategy team has found additional rate hikes from the Fed to be less supportive of the dollar, while at this stage, tightening on the part of foreign central banks has been more supportive of foreign currencies. Throughout much of 2017, short-term rate expectations moved in favor of the U.S. dollar, but the dollar declined (below chart).

This is likely due in part to the FOMC being further along its tightening path relative to other major central banks, and market participants having already priced in future rate hikes to a large extent. Market-implied probabilities of a rate hike are nearly 100 percent for today’s FOMC decision. Market participants likely see the FOMC as only having so many rate hikes left before reaching its terminal rate, and this means the potential for rate hike “surprises” is much lower.
In turn, the effect of interest rate expectations on exchange rates has been harder to quantify. As the Fed began to tighten policy in 2015-2016, one could theoretically identify a more direct relationship between the probability of a Fed rate hike and its effect on the dollar. However, as global central banks have engaged in unconventional monetary policy measures, the focus has turned toward perceived policy stances through actions such as quantitative easing, rather than a pure reaction to actual rate hikes.
Reviewing Past Cycles: All Else Is Not Equal for Capital Flows
The evolving relationship between interest rate expectations and exchange rates confirms why this cycle is unique. We have found that country-specific characteristics lead to volatility in capital flows, and similarly influence expectations. In the U.S. for example, prior cycles may have had a rising rate environment, but lacked a fiscal stimulus. This difference is compounded by unconventional global monetary policy and a deteriorating fiscal outlook during one of the longest economic expansions in recent history (below chart).
These differences influence investors’ relative allocation of capital, and decision makers would do well to pay attention to the unique outcomes that stem from differing market expectations."  -source Wells Fargo
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 as discussed in our "Mack the Knife" July 2015 musing to repeat ourselves. Why did past Mercantilism failed and will fail again? Just read again Adam Smith's 1776 "The Wealth of Nations" in 1776. In his book Adam Smith's argued that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He showed that trade can be mutually beneficial, an argument also made later by David Ricardo. In January 2017 in our conversation "The Ultimatum game" we argued:
"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 
Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits but we ramble again...

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country." - Adam Smith

Stay tuned ! 

Tuesday, 29 May 2018

Macro and Credit - White noise

"The real man smiles in trouble, gathers strength from distress, and grows brave by reflection." -Thomas Paine

Watching with interest, the return of volatility and consequent rise in Italian Government bond yields, in conjunction with trouble brewing yet again in Spain, following the continuous pressure and Turkey and other Emerging Markets, when it came to selecting our title analogy we decided to go for a signal processing analogy namely "White noise". In signal processing, white noise is a random signal having equal intensity at different frequencies, giving it a constant power spectral density. The term is used, with this or similar meanings, in many scientific and technical disciplines, such as physics, acoustic engineering, telecommunications, and statistical forecasting. White noise refers to a statistical model for signals and signal sources, rather than to any specific signal. White noise draws its name from white light, although light that appears white generally does not have a flat power spectral density over the visible band. White noise is as well interesting thanks to its statistical properties. Being uncorrelated in time does not restrict the values a signal can take. Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off). In statistics and econometrics one often assumes that an observed series of data values is the sum of a series of values generated by a deterministic linear process, depending on certain independent (explanatory) variables, and on a series of random noise values. Then regression analysis is used to infer the parameters of the model process from the observed data, e.g. by ordinary least squares, and to test the null hypothesis that each of the parameters is zero against the alternative hypothesis that it is non-zero. Hypothesis testing typically assumes that the noise values are mutually uncorrelated with zero mean and have the same Gaussian probability distribution – in other words, that the noise is white. If there is non-zero correlation between the noise values underlying different observations then the estimated model parameters are still unbiased, but estimates of their uncertainties (such as confidence intervals) will be biased (not accurate on average). This is also true if the noise is heteroskedastic – that is, if it has different variances for different data points. While causation of Emerging Markets sell-off can be attributed to  "Mack the Knife" aka rising US dollar and positive US real rates, it doesn't imply correlation with the sudden surge in Italian government bond yields, following the rise of a so called "populist" government at the helm of Italy. It is not that Italian issues went away, it is that there were just hiding in plain sight thanks to the strong support of the ECB with its QE program. Now that a less accommodative government has been elected in Italy, the status quo of the sustainability of the European project and European debt are being questioned again. The constant power spectral density of the ECB's QE is fading, hence the aforementioned reduction in the "White noise" and stability in European yields we think. We recently argued the following on our Twitter account: 
"Both rising US dollar and Gold may mean we have entered a period where non-yielding assets are preferable to assets such as some sovereign debts promising a yield yet future size of payment and or return of principal are starting to become "questionable". - source Macronomics, 24th of May.
As the central banks put is fading, what basically has been hiding in plain sight, has been the sustainability of the European project. Investors are therefore moving back into assessing the "return of capital" rather than the "return on capital". It seems to us that the "White noise" which in effect had hidden the reality of "risk" thanks to volatility being repressed thanks to central banking meddling is indeed making somewhat a comeback to center stage yet again given the recent bout of volatility seen on Italian bond prices and yields. When it comes to Italy's latest political turmoil we have to confide that we are not surprised whatsoever. We warned about this playing out exactly last year during our interview on "Futures Radio Show" hosted by Anthony Crudele:
"The biggest risk in Europe is still Italy because the growth is not there" - source Macronomics, May 2017 on Futures Radio Show.
On the anniversary of us voicing our concerns on Italy in this week's conversation, we would like to look at debt sustainability with rising rates as well as the risk of deceleration we are seeing in global growth as of late. 

  • Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
  • Final chart - Decline in PMI's doesn't bode well for the US bond bears

  • Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
The latest ructions in both Emerging Markets and Italian Government bond yields are a reminder that once "White noise" starts to dissipate with QT and a fading central banks put, then indeed solvency issues can return with a vengeance, such is the case with Turkey and fears on Italian debt sustainability. It is a subject we already touched in a long conversation we had back in September 2011 in our post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!". In this conversation we quoted the work of Dr Jochen Felsenheimer, prior to set up "assénagon" and now with XAIA Asset Management, was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management:
"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states." - Dr Jochen Felsenheimer.
At the time we added that the name of the current game was maintaining, at all cost, rates as low as possible, to avoid government bankruptcies hence the ECB's QE. Dr Jochen Felsenheimer which we quoted at the time also made the following comments in the letter we quoted extensively in our conversation in 2011:
 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer
The ECB has been able to provide protection against a run, alas temporarily. While the ECB acted as a lender of last resort, doing so exacerbated political tensions and is not a lasting solution as we can see unfolding right now in Italy. 

The concept of "solvency" is very sensitive to the government’s cost of funding (Turkey), and therefore to swings in market confidence.  A government with even a very large level of debt can appear entirely solvent if funded cheaply enough, which is the case for various European countries we think. There is no reassurance that solvent government will always be kept liquid, forget "leverage", end of the day in credit markets "liquidity" matters and we should all know by now that "liquidity" is indeed a "coward". We commented at the time in 2011 that liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks, particularly in peripheral countries which have extensively played the "carry trade". Therefore the sovereign/banks nexus has not been reduced by the ECB's actions, on the contrary. Net Interest Margins (NIM) for peripheral banks has been replaced by "carry trades" thanks to the ECB. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding. You probably understand more our Twitter quote from above regarding the risk for the "return of principal" when it comes to some sovereign debt which again are starting to become "questionable" hence the "repricing" for some Emerging Markets and Italy as well.

If indeed we are moving towards a repricing of risk on the back of "solvency" issues it is because the "risk-free" status of some European government bonds is coming back into center stage. We can see it in the credit markets as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 24th of May entitled "Corporates safer than governments":
"The not so dolce vita
2017 was a year of “buy the dip” galore in Euro credit markets. Few of the risks that bubbled to the surface last year caused spreads to sell-off for any notable length of time. In fact, the longest consecutive streak of spread widening in 2017 was a mere 3 days (Aug 9th – 11th). What held the market together so well? The constant stream of retail investor inflows into European credit (IG inflows in 49 out of 52 weeks).
This year, however, it’s been more of an uphill struggle for spreads. “Buy the dip” behaviour has been decidedly absent whenever risks have weighed on the market (note that spreads widened for 7 consecutive days in March). And new issuance continues to knock secondary bonds, something that was rarely seen last year.
What happened to TINA (There Is No Alternative)?
What’s changed, then, from 2017 to now? Simply, that the retail inflows in Europe have been much more muted over the last few months…and these were the “glue” of the credit market last year. What about TINA…and the reach for yield? We think the Euro credit inflow story is partly being disrupted by the attractive rates of return available on “cash” proxies in the US market. As Chart 1 shows, given the cheapening in the frontend of the US fixed-income market, US bill yields now offer more attractive returns for investors than the dividend yields on US stocks – something that has not been the case for over a decade.

Accordingly, we think some European retail inflows may be leaking into the US market at the moment, especially given the recent USD strength.
QE…and a classic liquidity trap?
But we don’t think this dynamic will stymie the inflow story forever. In fact, we remain confident that retail inflows into European credit funds will pick up steam over the weeks ahead.
As Chart 2 shows, domestic savings rates across major Euro Area countries have been rising noticeably of late, while declining in other countries such as the US and UK. Even with all the restorative work that Draghi and the ECB have done, European consumers’ penchant for conservatism and saving has not moderated.

In a classic “liquidity trap” scenario, we wonder whether low/negative rates in the Euro Area may simply be encouraging a greater effort by consumers to save for the future (and note that the Fed and BoE never cut rates below zero).
Whatever the driver, more money is being saved in Europe, and yet the prospect of material rate increases by the ECB remains a distant thing: the market has pushed back lately on rate hike expectations, with cumulative ECB depo hikes of 40bp now seen in over 2yrs time.
In this respect, Draghi is still fighting a “war on cash” in Europe. We believe this was the pre-eminent reason retail inflows into credit were so consistent last year…and we believe that this story is far from over.
The not so Dolce Vita
The ructions in Italy have contributed to another dose of high-grade spread widening over the last week: 8bp for high-grade and almost 20bp for high-yield. Testament to the weaker inflows at present, the move in credit is larger than that seen last March, pre the French Presidential election. Back then, the market was also on tenterhooks given Marine Le Pen’s manifesto pledge to redenominate France’s debt stock into a new currency, and to hold a referendum on EU membership.
5% of high-grade
For now, the ink isn’t yet dry on Italy’s first populist government – there are still the hurdles of designating a Prime Minister (at the time of writing), the President’s “blessing” on the government programme, and confidence votes in the Italian parliament. But assuming a 5-Star/Lega coalition government takes power, is this a source of systemic risk for Euro credit? We think not for the high-grade market. While Italy has a larger outstanding stock of sovereign debt than France, the picture is much different when it comes to high-grade. In fact, Italian IG credit represents just 5.4% of the market now…and that number continues to shrink as Italian corporates remain focused on deleveraging.

Where systemic risk from Italy may be of greater concern is in high-yield, as Italian credit represents 17% of ICE BofAML’s Euro high-yield index (we elaborate more on this here).
The plunge protection team
And true to form, the sell-off in the corporate bonds over the last week has been a much shallower version of what historically one would have expected to see. Chart 4 shows corporate bond spreads for peripheral financials versus 10yr BTP spreads.

They have been well correlated since early 2011. But credit spreads have moved much less over the last week than the move in BTPs would imply (and see here for a similar picture for Itraxx Main).
Populism…for real
The Le Pen populism experience quickly came and went for credit markets last year. Her insistence on drastic ideas such as “Frexit” appeared to stymie her support heading into the first round of the French Presidential elections. Her policies did not resonate with a French electorate that were broadly in favour of the EU and its institutions.
But political uncertainty, and populist sentiment in Italy, is likely to have longevity in our view. The hallmarks of populism – voter frustration and wealth inequality – are clear to see. Strong and stable governments have not been a hallmark of Italian politics since the proclamation of the Italian Republic in 1946: the country has had 65 governments.
The hallmarks of populism
Although the Italian economy has returned to growth over the last few years the magnitude of the recovery is still tepid. The IMF forecast Italy to grow at 1.5% this year, one of the lowest growth rates among Advanced Economies (the UK’s projected growth rate is 1.6% this year and Japan is forecast to grow at just 1.2%, according to the IMF).
In fact, the Italian electorate has seen little in the way of wealth gains since the creation of the Eurozone. Chart 5 shows GDP per capita trends for Italy and Germany. While GDP per capita is much higher in Germany, for Italy it remains marginally below where it was upon the creation of the Euro.

According to Eurostat, almost 29% of the Italian population were at risk of poverty or social exclusion in 2015 (and almost 34% of children were at risk). Hence the Citizenship Income mentioned in the 5-Star/Lega Government Contract.
Successive governments, of late, have focused on the fiscal side of the economy with less emphasis on structural reforms to unlock Italy’s growth potential. This has hindered private entrepreneurialism and the expansion of the corporate sector. As Chart 6 shows, Italy still has a large number of SMEs (and “micro firms”) making up its industrial base.
Sluggish long-term investment has partly contributed to this state of affairs. As Chart 7 highlights, capex intensity in Italy remains well below the levels seen between 2000- 2005, while the capex recovery has been a lot healthier in France and Germany.
A vibrant banking sector – that supports SME lending – is of course a prerequisite for greater levels of credit growth in Italy. And while Italian banks have made a lot of progress in reducing their NPLs recently (especially over the last few quarters), Chart 8 shows that there is still work to be done.

Italian banks continue to have the largest stock of non-performing loans across the European banking space. For more on the structural challenges facing Italy see our economists’ in-depth note here.
Such a backdrop is fertile ground for populist politics. Unlike in France, however, populist narratives are likely to fall on more receptive ears in Italy. As the charts below show, the Italian electorate is much less enamored with the EU than in other Eurozone countries.
Companies safer than governments?
The unknown in all of this will be the ECB. QE has been a powerful tool at controlling spreads and yields in the European fixed-income market over the last few years. But Draghi has not had to buy debt securities when Euro Area member countries have been less committed to fiscal consolidation.
And as Chart 11 shows, the ECB has been almost the only net buyer of Italian sovereign debt over the last 12m. Their impetus remains crucial.
Will higher political uncertainty in Italy alter the balance of the ECB’s asset purchases from here until year-end? Time will tell. However, in the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.
Chart 12 shows the volume of French, Italian and Spanish credits that are currently yielding less than their respective, maturity-matched, sovereign debt. Notice for Italy that close to a staggering 90% of credits now yield less than BTPs.

And while in periods of political uncertainty the market has often taken that view that corporates are “safer” than governments, this is by far a historical high for Italy (and for any Eurozone country for that matter). Moreover many Italian companies are actually “domestic” and thus have little in the way of a safety net from foreign revenues.
How has there managed to be such a substantial outperformance of Italian credits over the last few weeks? We believe a large part of this is because the ECB has upped the intensity of its CSPP purchases lately, especially with regards to Italian issuers. This gives us confidence that the ECB remains committed to buying corporate bonds for as long as politically possible. See our recent note for more of our thoughts on CSPP, the “stealth” taper, and the programme’s longevity.
Yet, Chart 12 also suggests that credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).
As a guide for investors, Tables 1 and 2 at the end of the note highlight which Italian credits trade the richest versus BTPs.
Respect the law
For the last year, the Euro credit market has not had to worry about the risk of Eurozone breakup. That ended last week, as the first draft of the 5-Star/Lega Contratto contained a reference to a Euro exit mechanism. However, in subsequent versions this was removed.
Nonetheless, as the front-page chart highlights, the market still appears nervous with regards to Eurozone break-up risk. Note the spread between 2014 and 2003 sovereign CDS contracts (The ISDA “basis”) remains high for Italy, and has ticked up again for Spain and France lately.
The 2014 sovereign CDS contracts provide greater optionality for protection buyers, relative to the 2003 contracts, both in terms of whether the CDS contracts trigger upon a redenomination event and also in terms of their expected recovery rates.
Know your bond
If redenomination concerns remain, what should credit investors look for in terms of Italian corporate bonds? In the charts below, we run a simple screen from Bloomberg on the governing law of corporate bonds in our high-grade and high-yield indices. Chart 13 shows the analysis by country and Chart 14 shows the analysis by Italian credit sector.

We rank Chart 13 by the country with the highest share of foreign law bonds (to the left) to the lowest share of foreign law bonds (to the right).
For Italy, the Bloomberg screen suggests that just 10% of Italian corporate bonds (IG and HY combined) are domiciled under domestic law (Chart 13). This is a very different situation to last March when around 60% of French corporate bonds were domiciled under domestic law.
While a legal analysis of the redenomination risks of Italian corporate bonds is outside the scope of this note, what we learnt from the Greek crisis in 2011 and 2012 was that investor focus gravitated towards the governing law of bonds (where foreign law bonds were perceived by the market to be more secure)." - source Bank of America Merrill Lynch
Of course, as everyone know and given the latest news on the Italian front, the European technocrats in Brussels have shot themselves in the foot by interfering with Italian democracy which will led to bolster even more anti-european sentiment. In October 2016 in our conversation "Empire Days" we pointed out that the statu quo was falling in Europe and we also reminded ourselves what we discussed in our November 2014 "Chekhov's gun" the 30's model could be the outcome:
"Our take on QE in Europe can be summarized as follows: 
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014
It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016
Obviously the path taken has been the road to growth / disillusion / social tensions and short-term road to heaven for financial assets as well as goldilocks period for credit. Now we are moving towards longer-term violent social wake-up calls in various parts of Europe. 

We really enjoyed our friend Kevin Muir latest excellent musing on Italian woes on his blog The Macro Tourist. He made some very interesting points in his must read note and we really enjoyed his bar-fighting economics analogy:
"Total French, Italian and Spanish assets are multiples of German assets. Italian Government BTPs are almost 400 billion and there are another 200 billion of other Italian debt securities. 600 billion represents almost 20% of German GDP. And that’s only Italy. What are the chances that an Ital-exit is confined to one nation?
Remember back to the 1930s. Nations that devalued early and aggressively generally did better economically during the ensuing depression - I like to call this bar-fighting economics - hit first and hit hard.
The ECB’s balance sheet expansion has put Germany in an extremely difficult place. They cannot afford to cut back on the expansion for fear of another Euro-crisis, yet the more QE they do, they more Germany is on the hook.
I hate to break it to Germany, but it’s even worse than it looks.
Don’t forget that ECB balance sheet expansion is only one the methods that imbalances within the European Union are stabilized. There is another potentially even more scary mechanism that occurs behind the scenes without much fanfare. Although the ECB is Europe’s Central Bank, each member nation still has their own Central Bank. Since monetary policy is set for the Union as a whole, there are times when capital leaves one European nation in favour of another. Individual Central Banks cannot raise rates to counter these flows, so the ECB stands in as an intermediary.
Let’s say capital flees Italy and heads to Germany, to facilitate the flows, the Italian Central Bank borrows money from the ECB while the German Central Bank deposits excess reserves with the GDP, thus allowing it all to balance. The individual country net borrowing/lending amounts are known as Target 2 Reserves." - source  The Macro Tourist, Kevin Muir
Target 2 issues have been a subject which has been well documented and discussed by many financial pundits. We won't delve more into this subject. But, as pointed out by Kevin Muir in his very interesting note, as a creditor Italy and being a very large one, Italy is in a much better position than the arrogant technocrats in Brussels think it is. In our book, it is always very dangerous to have a wounded animal cornered, it's a recipe for trouble. The latest European blunder thanks to the Italian president most likely instructed by Brussels to muddle with the elections result will likely lead to a more nefarious outcome down the line. Charles Gave on French blog "Institut des Libertés" made some very interesting comments when it comes to Italy's macro position:

  • Italy now runs a current account surplus of 3.5% of GDP, 
  • Italy has a primary surplus of 2 % of GDP, 
  • Italy has extended the duration of its debt in the last few years and so is less vulnerable to a rise in long rates, 
  • 72% of Italian debt is now owned by Italian entities
There has never been a better time for Italy to quit the euro. Come the autumn a fresh euro crisis is possible." - source Institut des Libertés - Charles Gave

Another expression we could propose relating to the excellent bar-fighting economics analogy from Kevin Muir and Target 2 would be as follows:
 "He who leaves the bar early doesn't pick up the bar tab" - source Macronomics
It is always about first mover advantage anyway, hence our previous positive stance on Brexit from a macro perspective when everyone and their dog were predicting a calamitous fall in growth following the outcome of the referendum.

When it comes to credit and Italian troubles, European High Yield needs to be underweight as it is at risk as pointed out by UBS in their Global Macro Strategy note from the 23rd of May entitled "How big a risk to EUR, credit and stocks":
"Credit: HY more exposed than IG to Italian stress
Italy is a risk but more so for HY cash vs. IG, in our view, where the Italian exposure is about 20% vs. 5%. As long as the risk of Italy challenging the integrity of Eurozone remains low (i.e. higher risk premium but no crisis scenario), we think the disruption in credit should remain mostly contained to Italian corps.
In a scenario of modest additional stress (c. 40bps BTP spread widening), we estimate that EUR IG and HY should widen 5-10bps and 25-30bps respectively from here, based on our fair value models and the recent performance. Our models are based on multi-linear regressions which also take into account other factors such as global growth, credit risk and conditions, as well as the ECB's CSPP.
In fact, peripheral spread widening of 30-40bps is likely the threshold when the relationship between corporate credit and peripheral spreads becomes non-linear, in our view (see Figure 5 and Figure 6). This is the threshold beyond which Italian risk should also affect EUR corporate credit markets more significantly outside of Italian issuers.
Given the uncertainties, we shift our preference for EUR HY vs. IG to neutral and prefer exposure to HY via its CDS index (Xover) which has a much lower Italian exposure at 7%. We recommend investors underweight Italian corps in IG and HY financials (largely Italian banks) and move up the HY curve from single B names to BB non-fins." - source UBS
We have recommended in our recent musings to reduce your beta exposure and to adopt a more defensive stance. If high beta is a risk and you don't like volatility, then again you are much better-off favoring non-financials over financials and you should probably maintain very low exposure to subordinated debt from peripheral financial issuers. At our former shop, a large European Asset Manager we recommended launching a Euro Corporate Bond Funds ex Financials. While the fund unfortunately did not gathered much attention AUM wise, performance wise it has been very good thanks to its low volatility profile and solid credit management. It is still boasting 4 stars according to Morningstar most recent ranking. Should Italian woes escalate high beta exposure will be hit much more, particularly financials. In that instance, for a long term credit investor, having less exposure to financials makes much more sense and we are not even discussing recovery values at this stage.  

Don't ask us about our opinion on having exposure to European banks equities again, because you will get the same answer from us. From a risk-reward perspective and long term investment prospect, it's just doesn't make sense whatsoever to get exposed to them regardless of the cheap book value argument put forward by some snake-oil sell-side salesman. You have been much more rewarded by sticking to credit exposure on European banks, rather than equities in Europe. End of the rant.

As well, we also pointed out in recent conversations that US cash had made a return into the allocation tool box and given the rise in political uncertainties and volatility, one should think about rising its cash level for protective measure. Cash can be "king" particularly with rising US yields and a strengthening US dollar marking the return of "Mack the Knife". Gold continue with it's safe harbor status. As we indicated in our earlier quoted tweet, both the dollar and gold can rise when we move in a situation where investors are moving from being more concerned about "return of capital". One would also be wise to seek refuge again in the Swiss franc (CHF) we think particularly versus the Euro (EUR). As well, a short covering on 10 year US Treasury Notes could be in the making (in size...). Watch that space because we think long end is enticing even zero coupon 25 years plus (ETF ZROZ) should we see an acceleration in the "risk-off" environment.

Moving back to "solvency" risk and sustainability of debt, namely "return of capital", as pointed out corporate credit in many instances could be "safer" than "sovereign" risk. Back in our conversation  "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!" we quoted again Dr Jochen Felsenheimer on macro and credit (our focus):
"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either." - Dr Jochen Felsenheimer
We added at the time that confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues. This brings us to the trajectory of European debt in general and Italy in particular. On this very subject we read Deutsche Bank's Euroland Strategy note from the 25th of May entitled "Pricing debt (un)sustainability" with great interest:
"Default risk pricing and bond relative value
Rising concerns over Italy’s debt sustainability can also be seen in the spreads between high coupon and low coupon bonds on the BTP curve. Over periods of stress, high coupon bonds which typically trade at a higher cash price tend to underperform lower coupon neighbours. One potential explanation for this is the risk that upon a hypothetical default the recovery rate will be based on the par value of the bond rather than the cash price an investor paid. Related to this, lower coupon, more recently issued bonds are also more likely to have CAC clauses compared to neighbours issued pre-2013.
Moreover, in times of stress participants seeking to release cash (for example insurers or pension funds with broad portfolios) might prefer to reduce holdings of higher price bonds (high coupon). Finally, even in normal times higher cash bonds may trade at a slight discount, reflecting the lower liquidity in some of these issues.
This effect is apparent in the charts below showing the positive correlations of z-spread (left) and yield differentials (right) between high and low coupon bond pairs and the IT-DE 10Y spread (which proxies for market pricing of BTP risk). As the BTP Bund spread has widened, high cash bonds across the curve (but particularly from 10Y+) have underperformed.
The non-linear dynamics of some of the bond pairs as spreads have widened are noteworthy. At the the 30Y point, the 44s-47s spread had remained elevated into the latest stress, with the 44s only beginning to underperform after the initial widening move. This may partially reflect the relatively large maturity gap between the two bonds, with 10s30s flattening at first outweighing the high cash price/low cash price effect on the bond spread.
- source Deutsche Bank

From a convexity perspective we find it very amusing that "yield hogs" when facing "redenomination/restructuring risk" see their high coupon bonds underperforming lower coupon neighbours, or to put it simply when non-linearity delivers a sucker punch to greedy investors...

While the "risk-off" mentality is prevailing thanks to Italian woes, confidence matters when it comes to "solvency" and debt "sustainability" yet, given the overstretched positioning in US Treasury Notes, if there is a continuation of troubles in European bond markets, then again, it will be interesting to see what our Japanese friends will do when it comes to their bond allocation. Our final chart deal with the current slowdown in the global economy which represents for us a clear threat to the US bond bears current positioning.

  • Final chart - Decline in PMI's doesn't bode well for the US bond bears
While we have been reluctant so far to dip our toes back into the long end of the US yield curve, given the most recent surge in European woes and extreme short positioning, we think there is a potential for a violent short covering move. Our final chart comes from CITI Global Economic and Strategy Outlook note from the 23rd of May and displays the decline from recent peak in Manufacturing PMI pointing towards a slowdown:
There is more evidence that global economic growth is slowing. Some of the drags are likely temporary, such as some payback from unusually fast growth in H2 2017 (e.g. real retail sales in the US grew by 8% annualized in Q4), and adverse weather impacts across Western Europe, Japan and the US, while the positive effects of fiscal stimulus in the US will ramp up over the course of the year. But declining business sentiment, some tightening of financial conditions and the rise in oil prices are likely to have a more persistent (if moderate) dampening effect on global growth, notably on moderating momentum in business capex (Figure 2)." - source CITI
As far as White Noise is concerned, being uncorrelated in time does not restrict the values a signal can take (Italy back in crisis mode + slowing global economic growth). Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off) can makes confidence turn on a dime. For financial markets as well as consumers, end of the day "confidence matters" for credit growth. Have we reached peak consumer confidence?

"What we obtain too cheap, we esteem too lightly; it is dearness only that gives everything its value. " - Thomas Paine
Stay tuned!
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