"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill
- Macro and Credit - It's a question of flows versus stocks
- Final chart - Could Japanese equities be antifragile in 2017?
- Macro and Credit - It's a question of flows versus stocks
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one:
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth.
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
The big failure of QE on the real economy at least in Europe has been in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
As we have argued before QE in Europe is not sufficient enough on its own to offset the lack of Aggregate Demand (AD) we think.
"Is it the stock or the flow of QE that matters?
Essentially, central banks tend to think in "stock" terms
“Reduce the quantity available to investors & prices will lift permanently”
To us, QE flows seem very important empirically
Reduce the QE flow by just ~1/3 & markets are quite likely to fall
That makes an asset not priced to fundamentals but to policy …
… prone to non-linear reactions when perceptions of policy change" - source CITIAs we have seen in recent weeks, and as we have remarked in our conversation "Critical threshold", higher yields leads to material fund outflows in the short-term as indicated by Bank of America Merrill Lynch Follow the Flow note from the 2nd of December entitled "Where's the money going?":
"High grade funds had their fourth week of outflows, and the third that exceeds the $1bn mark. High yield funds recorded their fifth week of outflows in a row; so far this year they have lost more than $10bn. As chart 13 below shows, the outflows this time came mainly from European and global funds, where on the other hand US high yield funds recorded an inflow.
Government bond funds had yet another outflow, the eighth in a row, reflecting rising QE-tapering risks. Money market weekly fund flows were relatively subdued recording a negative flow. Overall, fixed income funds flows remain largely negative, and over the past four weeks almost $20bn has flown out of European domiciled funds.
European equity funds flows switched aggressively to the negative side again, post a short stint of inflows. Last week the asset class had its biggest outflow in eleven weeks. Outflows so far this year are just shy of $100bn.
Global EM debt fund flows remained negative for the fourth week in a row; nonetheless we note a significant improvement in the trend, with the latest outflow being significantly smaller than that of the previous two weeks. Commodities funds also were in negative territory for a third week, as higher inflation expectations support reflation trades.Whereas central banks tend to focus their attention on "stocks", we'd rather focus ours on "flows", from a macro perspective as well as from a fund perspective. Evidently the consequences of "Mack the Knife" aka King Dollar + positive real US interest rates can also be seen in the "Great Rotation" from Europe and Emerging Markets towards the US hence validating our "macro osmosis process":
On the duration front, short-term IG funds flows remained negative for a second week. Mid-term funds had their fourth outflow in a row but riding an improving trend; while long-term funds recorded a marginal inflow." source Bank of America Merrill Lynch
"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.
"EPFR weekly fund flows
• EPFR measures mutual funds and ETFs (AUM about $225bn)
• This week’s outflows were less than last week which was less than the prior week.
• EPFR outflows in the 3 weeks since the election were:
-4.0% for EXD
-3.7% for LDM
• Part of that is ETFs, whose outflows since the election as a % of ETF AUM were:
-8.1% for EXD
-7.3% for LDM
2013 lessons were learned well, take fast action
• Outflows have been faster than in 2013 (Chart 1)
• Largest 3 week outflow in 2013 was only -4.2% for all currency funds.
Foreign holdings of local debt sharp drop – $40bn implied
• We track $640bn of foreign holdings of local debt
• We observed 6.2% outflows for the month of November in 4 countries (India,
Indonesia, Hungary and Turkey) with foreign holdings of $107bn.
• If all countries had the same average outflow of 6.2%, then applied to the $640bn
of foreign holdings, this implies we could have had a $40bn total outflow in Nov.
Since the election – $35bn potential outflow
• We observed 5.5% outflow since the election.
• If we apply this rate to the $640bn foreign holdings, it implies a $35bn total
outflow in the few weeks since the election." - source Bank of America Merrill Lynch
"We examine two of the most pressing issues facing Asia investors in the Post-Trump election victory world.
The first, is how much capital reversal and outflow in Asia is yet to run amid USD strength, rising yield differential with the US and CNY depreciation. Thus far, some USD24bn in foreign bond and equity portfolio flows are being unwound and compares with the maximum drawdown of USD55bn during the GFC – see front page chart.
The countries that we find are at the sharp end of this outflow are Korea, India, Indonesia and Malaysia.
The second is how investors should evaluate Asia FX and rates vulnerability to the tail risk of rising trade protectionism and confrontation. The brief answer to this is that China, Korea, Taiwan and Thailand appear most vulnerable, while Indonesia and India may be the least.
Ultimately, the combination of capital outflows and rising trade protectionism discussed in this report, suggests that FX risk premiums and volatility for CNY and KRW will rise. From an FX hedging strategy perspective, we continue to recommend low delta 6M USD call, CNH puts such as our year-ahead top trade recommendation for USD/CNH 7.60 strikes.
Portfolio drawdowns – how much more to go?We highlight the maximum drawdown Asian markets have previously seen in terms of outflows. This gives us a sense of the worst case scenario as far as outflows are concerned relative to FX reserves. The bottom line is:
• The largest outflow Asia saw on a cumulative basis was ~USD 55bn during 2008. In comparison to this, Asia has seen about USD 24bn of outflows since October 2016 (see Chart 1 for cumulative outflows during other risk off periods).
• Equity outflows so far have been around 9.9bn USD since October 2016, led by. India, Taiwan and Thailand. When compared to historical drawdowns, the larger equity markets of Korea, Taiwan and India stand to lose the most, although only in Korea’s case does the worst case scenario account for a substantial portion of FX reserves (19%, see Table 1).
• Bond outflows, so far have been about 14bn USD since October 2016, with most seeing outflows of at least 2bn USD. When compared to historical drawdowns, Malaysia stands to lose the most, with the worst case scenario representing about 6.3% of current FX reserves (see Table 2).
- source Bank of America Merrill Lynch
"Barbell when repression is at risk of being wound down
Belly of the credit curve holds disproportionate amount of unpaid β" - source CITI
"The last month has presented something rather rare: a truly decoupled global credit market. For instance, US high-grade spreads went 2bp tighter in November, while Euro high-grade spreads went 16bp wider. And the phenomenon seeped into high-yield credit too: US spreads tightened by 24bp in November, while European spreads widened by 47bp. After the moves of the last month, headline IG spreads in Europe are now wider than US high-grade spreads out to almost 10yrs in maturity.
“Politics” has been the undoing of European credit lately. Italy heads to the polls on Sunday amid a climate of rising global populism. And ECB tapering noises have driven a pattern of rising rates and wider spreads in Europe over the last month (note, though, BofAML base case is for an €80bn QE extension until Sep-17).
Yet, even with all the political hiccups that Europe has encountered over the last 5yrs, genuine decoupling of credit markets has not been common. Chart 2 shows that there have only been 3 periods over the last 10yrs when European and US credit spreads went in different directions.
Decoupling – the new norm for ‘17
We think decoupling between US and European credit will be a lot more common in 2017 though. In fact, our US credit strategy colleagues forecast US high-grade spreads to tighten by 20bp next year. In Europe, we expect high-grade spreads to widen by 20bp.
Much of the divergence in views is simply down to technicals – which shouldn’t come as a surprise given how technicals have been the be-all and end-all of credit markets for the last few years. In the US, we expect Republican tax proposals to lead to a big drop in US high-grade net supply next year. But in Europe, we expect shareholder-friendly activity (M&A, in particular) to broaden out in 2017, and contribute to a further jump in supply. This should leave the Euro market with too many bonds and not enough buyers.
Get in quick…
In fact, lingering QE tapering noises may just coax European companies to speed up their spending and issuance plans, for fear of missing the (low-yield) boat. This means the risk of supply being front-loaded in the first half of next year, leading to some heavy indigestion for the Euro credit market.
Recall that this is not too dissimilar to what US companies did in 2014 as the Fed drew closer to their first interest rate hike. As chart 3 shows, US M&A volumes were brisk in the middle of 2014. Then, as better US data pushed yields higher, issuers moved quickly to fund the M&A backlog, leading to some big months of US high-grade supply in September and November 2014.
This also caused a big decoupling in credit markets: US high-grade spreads widened by almost 40bp in the second half of 2014, while European high-grade spreads went slightly tighter. We fear the same bad technicals could be at work in Europe next year if companies rush to issue ahead of any potential QE tapering." - Bank of America Merrill Lynch
- Final chart - Could Japanese equities be antifragile in 2017?
"Success breeds complacency. Complacency breeds failure. Only the paranoid survive." - Andy Grove, former CEO of Intel.