Thursday, 18 May 2017

Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author
Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
  • Final chart - Trumpflated

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas
We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:
"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:
"Wage wars
The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.
There is the theory
The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.
The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.
And then the data
We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.
We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch
Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:
"In similar fashion and as highlighted above in our quote from David Goldman, the United States need 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
Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:
"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).
- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":
"Current state of Japan’s labour market
Japan’s labour market is at its tightest level since the early 1990s 
Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."
- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016
We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:
"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages
The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.
Progress until now and further progress on labour reforms should help Japan’s economic recovery continue
The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.
 Back in our January conversation "The Ultimatum game", we indicated the following:
"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.
The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

  • Final chart - Trumpflated
For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:
"The deflating of the reflation trade
As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.
US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse
As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley
Stay tuned!

Thursday, 11 May 2017

Macro and Credit - Another Brick in the Wall

"Success is having to worry about every damn thing in the world, except money." -  Johnny Cash
Looking with interest at the elections of new French president maverick Macron, in effect putting another brick in the wall of worry, hence our title analogy, we reminded ourselves of Pink Floyd's 1979 rock opera with "Another Brick in the Wall being the title of three songs set to the variations of the same basic theme:  subtitled Part 1 (working title "Reminiscing"), Part 2 (working title "Education"), and Part 3 (working title "Drugs"). Part 2 was in fact a protest song which somewhat resonates clearly with the rise of populism in general leading to Brexit and Trump's election, whereas the results so far in 2017, seems to be the reverse of what has been playing out in Financial markets in 2016 where we had a dismal first part of the year and political surprises in the second part of 2016 in conjunction with a very significant rally in all things beta in the second part of 2016. 2017 so far has seen significant records being broken for equities indices, tighter credit spreads, and record low vix, which many pundits punting towards "complacency". In our previous conversations, we have indicated that while we did remain short-term "Keynesian" when it comes to our "risk-on" feeling, hence our reduction in both our gold miners exposure and duration exposure, we believe that the second part of 2017 could play as a reverse of the second part of 2016.

In this week's conversation we would like to look at a trade which has been put forward by many pundits including Jeffrey Gundlach of DoubleLine Capital, which is the case for EM equities versus the S&P 500 from an allocation and macro point of view.

  • Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
  • Final chart - Weak loan demand tends to be associated with high volatility

  • Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
While many pundits have been mesmerizing at the record low level touched recently by the "fear index" VIX, we reminded ourselves a previous conversation from 2013 entitled "Long dated volatilities: a regime change". As we posited back in 2013, it seems we are clearly back in the low regime of 2004-2007, and credit spreads as of late are also a reminder of the tightness in credit we experienced firsthand in our banking days at the time. Back in our old conversation we made some interesting comments relating to Emerging Markets and volatility which, we think, from a macro perspective are still extremely valid:
"Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum - Tokyo Presentation - August 2007).

Regime switches also lead to potentially large consequences for investors' optimal portfolio choice hence the importance of the subject." - source Macronomics, January 2013.
We also mentioned at the time that different regimes corresponds to period of high and low volatility, and long and bull market periods in conjunction with the credit cycle. At the time of our previous post we also indicated that the importance of regime change was paramount to asset allocation given:
"The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other.
  • For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks. 
  • On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
  • In a bear regime the share allocated to stocks increases with the investor’s horizon." 
- source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.
Also we mentioned at the time that retail investors had been net sellers of stocks since 2007. Yet, in recent years, it seems many have returned using ETFs as an investment vehicle of choice, shunning active management to passive management in the process.

Returning to the very subject of our conversation, there is indeed a case being made which so far year-to-date has been validated performance wise to go long EM equities versus the S&P 500. As a reminder, since the inception of the MSCI EM index back in 1988, the MSCI EM / S&P 500 ratio has experienced two significant boom/bust cycles:

Arguably there has been a significant growing gap between both indices since 2014, while the S&P 500 has been no doubt racing ahead:
- source

With the benefit of hindsight, we can summarize those two cycles in the following way:

Cycle 1 (1988-1999)
  • Boom phase (EM outperforming between 1988 and 1996): With the disappearance of the Eastern Bloc, Second and Third World countries were bound to join the First World, and mankind would reach Fukuyama’s “End of history” (1992). Trade barriers fell, stable governments became the norm, and EMs became an investible asset class. The first EM boom culminated with the 1997 Asian crisis.
  • Bust phase (S&P outperforming between 1996 and 1999): As EMs were still suffering from the aftermath of the crisis, US equities were led by the first tech bubble.

Cycle 2 (1999-Now)
  • Boom phase (EM outperforming between 1999 and 2011): Following the tech crash 2000, investors turned away from the new economy. The term itself became used derisively, as the tangible economy came back with a vengeance, introducing new investment themes: the commodities super cycle, stagflation, the Hubbert peak, etc.
  • Bust phase (S&P outperforming since 2011): In the early 2010s, the new economy finally started to become a reality, capitalizing on the huge infrastructure investments that were made during the first tech bubble. At the same time, new technologies (fracking, clean tech, electric cars…) made the developed world less dependent on energy and raw materials.

To sum up, EMs vs. S&P is not a merely a bet on global growth but put it simply a sectorial bet:
  • MSCI EMs returns are dominated by old economy industries, commodity- and more generally stuff-producing companies. EM equities are a bet on scarcity and inflation.
  • S&P 500 returns are dominated by the new economy: tech, platform companies, business services etc. The S&P is a bet on innovation, deflation and creative destruction.
One might argue that EMs are not pure old economy with the significant weight of Samsung and Tencent for example. But, one might also opine that Korea and Taiwan are not really truly Emerging Markets anymore. Though our simplified interpretation doesn't match the truly "old economy", you get our point when it comes to the sectorial bias.

After its nearly 60% correction since its 2011 heights, there are currently several factors at play indicating that we could be at the beginning of a third cycle in the MSCI EM / S&P ratio.

The CRB Industrial Metals Equity Index (CRBIX Index) has had a significant rally since January 2016:

Following the same trend until recently, there were some indications that there was somewhat a revival in the Chinese materials sector:
- source
(Correlation 0.909, R2 = 0.826, 228 months in sample).

But given our premises that EM being a sectorial bet, still dominated by old economy industries, commodity and more generally stuff-producing companies, EM does indeed appear to be a bet on scarcity and inflation. With Chinese PPI slowing down, one might rightly ask, what's the overall picture if we take into account Chinese Iron Ore spot prices?
- source
(Correlation 0.907, R2 = 0.823, 72 months in sample).

Clearly Iron Ore spot prices are very volatile particularly given the recent clamp down on the famous Wealth Management Products (WMP) by the Chinese government but also reflects a tightening in Chinese financial conditions as well.

After all, weaker commodity prices was reflected in the latest data out of China given the  producer price index (PPI) slowed more than expected in April, falling to a year-on-year pace of 6.4% from 7.6% in March.

Regarding commodities themselves, Dr. Copper, (the PhD in economics) is something we would like to look at to get some cues on this sectorial premise of ours:
- source
(Correlation 0.896, R2 = 0.802, 228 months in sample).

Australia’s terms of trade is also an interesting indicator of MSCI EM/ S&P ratio, due to Australia’s heavy reliance on commodities:
- source
(Correlation 0.932, R2 = 0.869, 228 months in sample).

After all, we are seeing tighter liquidity from China in its moves to rein in leverage which could potentially weigh on economic growth as it is attempting a "controlled demolition" of the shadow banking bubble which was let loose.

Regarding inflation, the recent increase in inflation expectations hasn’t yet been factored in by the MSCI EM vs. S&P ratio:
- source
(Correlation 0.859, R2 = 0.737, 132 months in sample).

Additionally, Chinese devaluation fears, which roiled world markets during the summer of 2015, have substantially receded since the beginning of the year:
- source
(Correlation -0.869, R2 = 0.741, 36 months in sample).

Yet the pullback in TIPS inflation "breakeven" rates with US 5 year breakeven rates trending lower have shown that the "Trumpflation" trade has been cooling as of late. Though the recent weakness in precious metals with silver getting spanked daily can be attributed to a gradual rise in real rates we think, another manifestation of Gibson's paradox as a reminder:
"Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get a bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - source Macronomics
On a side note, there has never been an episode in history when Gibson's paradox failed to operate. The real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude our side note, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates. This is clearly illustrated in the below chart from Deutsche Bank European Equity Outlook note from the 11th of May:
- source Deutsche Bank

So far in 2017, the outperformance continues to play out in favor of EM as per the chart below displaying the S&P 500 performance relative to iShares MSCI EM:

- source Bloomberg

Flow wise commodities funds according to the latest Follow the Flow note from Bank of America Merrill Lynch have seen their eighth week of inflows, however showing signs of slowing down with gold and oil prices moving lower recently. We think most of the ongoing correction in the commodity complex is tied up to the "controlled demolition" of WMP led by China. Emerging market equities have historical strong correlation to commodities, yet, investors have continued pushing emerging market equites higher.

Given the pressure on Chinese A shares, should you want to play this trade via ETFs we would agree with Bloomberg's take from the video embedded in their article  "Gundlach Says Short the S&P 500 and Buy Emerging Market ETF" from the 9th of May, that you would be better off using IEMG ETF (South Korea and no China A shares) rather than EEM ETF given the ongoing tightening pressure in China. Yet, with KOSPI rallying as well 13.6% and breaking through the 2300 at an all-time high, the rally has been significant but mostly led by Samsung. We continue to believe that overall markets are trading on expectations of structural reforms in many instances (US, France, South Korea, etc.).

In relation to Emerging Markets, if in Macro, demography is destiny, we continue to like the asset class given as shown in the recent Bloomberg graph workforces are still expanding in India, Southeast Asia, Vietnam as well has a very young population and Southeast Asia overall is offering very compelling growth prospects:

- source Bloomberg (H/T Tiho Brkan

On top of that, China's Silk Road initiative with their willingness in expanding towards the West is clearly going to spur in its surroundings economic growth and renewed demand for commodities while China is transitioning its internal imbalances towards consumption rather than domestic fixed asset investments. The long term macroeconomic impact of such endeavor should not be underestimated.

While we still believe in some continuation of "risk-on", yet we could potentially get a pullback, we are closely watching oil, being at the moment the major brick within our wall of worry when it comes to potential credit spreads widening and spillover. We continue to follow closely the credit cycle and the global credit impulse which has shown recently by China and as well from the latest US Fed Senior Loan Officer survey, continues to point towards a slowdown thanks to weaker demand as per our final chart below.

  • Final chart - Weak loan demand tends to be associated with high volatility
While markets have successfully climbed the wall of worry with the French elections angst, we continue to track the slowly but surely eroding credit cycle and credit impulse. The significant performance of risky asset classes and beta in particular since the second part of 2016 in the on-going low volatility regime thanks to central banks meddling, makes us feel a tad more nervous about the continuation of the rally in the second part of the year while we are acutely aware as we wrote recently that the final inning in a credit cycle always is often associated with a final large melt-up.

When it comes to the volatility quandary, we read with interest DataGrapple's take on the subject from their blog post from the 9th of May entitled "Is volatility a thing of the past?":
"Most of the political risk is behind us in Europe. Unless his party shows very poorly during the general election next month, Mr Macron should be in a position to at least form a coalition with the center right. In the UK, there seems to be little doubt that the Conservative will secure a strong majority in Parliament in a few weeks. In Germany, whoever comes on top in the September ballot will be a member of the current ruling coalition. So the main source of uncertainty is Italy where the 5-star movement and its anti-euro stance is leading the poll, but elections should not be held this year. We know that they will take place before May 2018, but their exact date has not been set. With talks around the restructuring of the Greek debt apparently making progress, the euro area should enjoy a period respite. That is the message sent to the market by investors who are selling options, betting on a very low realized volatility up to the September expiry. The implied volatility of options with a strike 10% out of the money are trading sub 40% on all indices for the next 5 expiries." - source DataGrapple.
Have reached peaked complacency? One might wonder. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 8th of May and displays C&I Loan demand versus the VIX index which clearly shows that often weak credit demand tends to be associated with high volatility which shouldn't be that surprising given we live in a credit based world:
"Senior loan officers vs. VIX
One of the key stories we have been tracking for most of the year is the lack of loan demand in the US across the board. That was apparent in the February Senior Loan Officer Survey as well as subsequently weekly bank asset data from the Fed. Hence not surprisingly today's fresh Sr. Loan Officer Survey showed continued very negative
growth in consumer loan demand as well as deterioration into negative territory for C&I lending. It thus appears that the key post-election story continues - i.e. while optimism is high everybody is in wait-and-see mode pending details on tax reform from the new administration. The longer this lasts the greater the risk of more weakness in hard data. It appears a great contradiction to these circumstances that the VIX closed today at 9.77 - the lowest since December 1993. Weak loan demand tends to be associated with high volatility, not low (Figure 1)."
- source Bank of America Merrill Lynch

If credit conditions are tightening in both China and the US, and we continue to see a weaker tone in the commodities space, it is hard not to start worrying about weaker aggregate demand overall and not only in oil prices. Yet another brick to keep an eye on in your personal wall of worry we think but we ramble again...

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman.

Stay tuned!

Wednesday, 3 May 2017

Macro and Credit - The Three Questions

Quote of the day: "When the bottom 50% of your population doesn't matter you can't complain when they throw political hand grenades."- H/T P.O.K. on twitter - (and by the way it works with Trump, BREXIT, French elections, etc.).

Watching with the interest the convolutions in French politics leading to a much disputed than thought second round of the presidential race, we reminded ourselves when it came to selecting this week's title analogy of "The Three Questions", a short story by Russian author Leo Tolstoy first published in 1885. The story takes the form of a parable, and it concerns a king who wants to find the answers to what he considers the three most important questions in life:
"It once occurred to a certain king, that if he always knew the right time to begin everything; if he knew who were the right people to listen to, and whom to avoid; and, above all, if he always knew what was the most important thing to do, he would never fail in anything he might undertake." - The Three Questions, Leo Tolstoy
In similar fashion, most investors are always trying to find the right time to invest, the right people to listen to, and whom to avoid, and above all, the most important thing to do, investment wise, so that they never fail in the fiduciary duty they might be undertaking.

As such we find of interest, that as we posited in recent conversations, there is a continuation in the "risk-on" mantra, even in credit markets with a strong continuation in the grind tighter for spreads for both Investment Grade and High Yield given it validates our short-term "Keynesian" stance. As we stated last week:
"For now the market wants to rally and will rally, as we often see significant rally in late stages in the credit cycle", source Macronomics, April 2017
In this week's conversation we would like to look at what to expect in the second quarter, on the back of some worsening credit trends in the US that warrants monitoring and also why we continue to be much more cautious on the second part of 2017.

  • Macro and Credit - The right time for every action?
  • Final charts - Dude, where is my vol?

  • Macro and Credit - The right time for every action?
In Leo Tolstoy very enjoyable short story, the main character the king had it proclaimed throughout his kingdom that he would give a great reward to anyone who would teach him what was the right time for every action, and who were the most necessary people, and how he might know what was the most important thing to do. Obviously many financial pundits in the investment world would be ready to pay a reward to anyone able to teach them what was the right time for every action and for similar answers searched by the king in Tolstoy parable:
"Remember then: there is only one time that is important-- Now! It is the most important time because it is the only time when we have any power" - The Three Questions Leo Tolstoy
Yet, at this juncture with earnings season in full swing, it seems to us there are many mixed signals coming from both macro data, earnings and flows. Macro wise we were not surprised by the lower US GDP print at 0.7% published last Friday. What has been somewhat a surprise has been the muted reaction in US long bonds on the news and the recent weakness in the duration play. It seems after all that for now, being the most important time, the MDGA trade (Make Duration Great Again), is a fade. This as well the signal we are getting from the allocation tool DecisionScreen, for Japan Economic Surprise:
- source DecisionScreen

It seems that whenever Japan's economic surprise index is positive, we get a negative signal for US 10 year Treasury notes.  This little binary trading rule gives you a sharpe ratio of 0.87 over 14 years worth of data and the difference of performance for US 10 year Treasury notes is 10% whenever Japan's Economic surprise index is either negative or positive. With a T stat at 3.29, there is only one chance out of 2000 it is a random result.

When it comes to Macro, the latest raft of data coming from Japan have been steering towards the strong side with the jobless rate standing at 2.8% in March at a two decade low and March output while declining by 2.1% on the month, rising 3.3% over the year as indicated by Bloomberg in their article from the 28th of April entitled "Japan Data Deluge Points to Economic Growth, Weak Inflation":
"The central bank has been unable to reach its target of stable 2 percent inflation despite four years of stimulus from Governor Haruhiko Kuroda. With only subdued inflation, workers have not seen significant pay hikes, meaning household spending has been weak. On the other hand, industrial production been increasing, thanks to a pick-up in external demand, with the central bank saying the economy was in an expansion for the first time in about nine years. This has led to high corporate profits." - source Bloomberg
Given wage and income growth remains weak, there is no way inflation can pick up without a significant break out, which would finally mark the end of the long deflationary spell of the country. While the jury is still clearly out there when it comes to assessing the potential return of Bondzilla to US shores in terms of foreign bonds allocations in general and US Treasuries in particular, while our Macro tool DecisionScreen points out to additional weakness on the back of better data coming out of Japan, flow wise, the Japanese investment crowd continues to be elusive as indicated by Deutsche Bank in their Fixed Income Weekly note from the 28th of April:
"The Japanese-Libor Connection
The lack of love shown by Japanese investors for Treasuries might be responsible for low 3m Libor fixings and the collapse in Libor/FF spreads. Japan was a net seller of foreign bonds again this week, divesting $12bn of securities. It was the third straight week of selling out of Japan, according to MOF data, and the year-to-date divestment of $66bn is so far the biggest since 2002, the first full year of
such data is available.
Profit-taking most likely explains Japan’s selling. Ten-year Treasury yields declined in April to a lower level than any previous month since the Trump election. In the process, yen cross-currency basis has tightened to levels not seen since January 2016. Japanese investors use the yen basis (or more precisely, their derivative FX forwards) to hedge the currency risk of their coupon flows from non-yen bonds. The basis tightens when there is a drop in demand to swap yen for dollar. The chart below shows a distinctive inverse relationship between cumulative Japanese purchases of foreign bonds and the 3m yen basis.

In US money markets where Japanese banks also raise dollars, the rates they’ve been paying on commercial paper and certificates of deposit have narrowed vis-à- vis the rates on they pay on repos. CP and CD rates are of course used by banks as the main input for daily Libor submissions. Three of the 17 contributing banks to USD Libor are also Japanese. The narrowing of rates Japanese banks pay to borrow dollar using CP/CDs versus repos is further evidence that unsecured funding costs have dropped, which is reflected in the tightening in Libor-FF spreads.
Our Japanese rates strategist noted this week that April typically tends to be a month when Japanese investors sell foreign assets as they take profits at the start of the fiscal year. Seasonality would suggest that Japan becomes a buyer again in May, with especially strong appetite for foreign bonds in the July to September period. Consequently, we would look for Libor-FF spreads to find some support in the coming month, especially if Treasury yields become attractive again." - source Deutsche Bank
It seems that the Fed's hiking process has somewhat dampened the appetite of Bondzilla the NIRP monster, which seems to be more reluctant than in previous years to rush into a buying spree for the time being. This is as well confirmed by the Nikkei Asian Review in an article from the 27th of April entitled "Japanese life insurers buying foreign bonds at slower pace":
"Alarmed by the prospect of U.S. interest rate hikes, Japanese life insurance companies are purchasing foreign bonds at a much slower pace and shifting more of their investment focus to real estate and infrastructure.
Japan's 10 major life insurers are expected to increase their holdings of foreign bonds by 2.9 trillion yen to 3 trillion yen ($25.9 billion to $26.8 billion) on a net basis, according to their fiscal 2017 asset management plans shared with The Nikkei. That would be down roughly 70% from growth of 8.8 trillion yen in fiscal 2016.
Domestic insurers continue to shy away from Japanese government bonds due to their rock-bottom yields. JGB holdings are forecast to fall by over 3 trillion yen on a net basis. Nippon Life Insurance and some other insurers plan to add more stocks to their portfolios.
The main reason life insurers are taking a cautious approach to foreign bonds is the expectation that the U.S. Federal Reserve Board will raise interest rates two more times this year. "Last fiscal year, we increased [currency-hedged] foreign bonds by 1.9 trillion yen, but this fiscal year will remain flat," a Nippon Life official told reporters on Wednesday. "As the FRB is seen raising rates, we will closely observe trends." - source Nikkei Asian Review
If indeed Bondzilla isn't playing the duration game, then again, we shall keep close a close look at our MDGA for the time being, though we did play it in the first quarter, from a contrarian perspective. We have also reduced our Gold/Gold Mining exposure in April following the decent run we had in the 1st quarter. It was a good first quarter for Gold as in 2016 but we are keeping some dry powder for the time being given the level of complacency as seen recently in lower lows touched by the VIX. This level of early summer lull as witnessed in the VIX is aptly described by DataGrapple in their latest post from the 2nd of May entitled "Wearing My Happy Glasses":

"Volatility has never been so low, and it is difficult to see what might change the situation. That is certainly the feeling most investors have and that is what VIX – an indicator based on the implied volatility of US equity options with a wide range of strikes maturing within 2 months – is telling us. It traded today at levels not seen since before the Great Financial Crisis. There is no stress and it is also obvious from the price action of the credit market, which rallied in a straight line from start to finish. More hedges came off across the board, as the general feeling is that Mrs Le Pen has no chance to come on top next Sunday. Investors have decided to brush aside the uncertainty surrounding the general elections that will take place in France in June and which will effective decide the composition of the government and its political orientation. They have also decided to ignore the tough negotiating stance which was endorsed by the 27 EU members in the talks regarding Brexit with the UK, to which the latter responded by saying it is bracing for a confrontation. Back from a 3-day week-end, they are wearing their happy glasses." - source DataGrapple
This is indeed a reflection of the strong "risk-on" mood experienced during the course of last month. There is indeed a certain angst created by the upcoming second round of the French elections with some financial pundits pointing out to some tail risk with Marine Le Pen, yet, it is difficult to have any proper clarity on the French elections until the parliamentary elections in June. When it comes to the significant performance of various asset classes including credit we read with interest Bank of America Merrill Lynch's take from their Euro Excess Returns for April 2017 note entitled "Rally à la française":
"Political risk has declined post the first round of French elections. Credit market valuations are reflecting the strength in equity markets and improving economic data.
Credit investors are still benefiting from a low supply backdrop, making the numbers (supply vs demand) add up. Nevertheless the ECB’s decision to reduce the pace of the
QE purchases has weakened the technical in the credit market, and higher supply amid lower political risk, will ultimately move spreads wider we think.
  • Duration outperforms. In April the back-end of the curve has outperformed significantly the front-end. 1-3yr credit posted 20bp of excess returns last month, while the +10yr bucket posted a gain of 106bp.
  • Beta outperforms. Euro-denominated high-yield credit posted almost double the excess return vs its high-grade counterpart (112bp vs 52bp, respectively). Same story within the IG space with BBBs outperforming single-As and double-Bs.
  • Sectors: Virtually all sectors posted positive excess returns last month. Insurers, real estate and utilities/energy names feature at the top of the performance table.
  • On the other side technology and industrials were at the bottom of the performance table.
  • Issuers: French credits like Credit Agricole, EDF and BNP for another month were among the best performers in April. Healthcare names feature in the bottom of the list.
Cross market performance overview
Table 1 shows April’s total return performance across various fixed income and equity markets.
  • Equity indices were at the top of the list for another month. European bank stocks topped the best performers list, followed by the French stocks, the EM and the broader European equity indices. The top 5 spots were dominated by equity indices.
  • On the flip side, UK stocks have been down last month as sterling strengthened post the announcement of the June general election.
- source Bank of America Merrill Lynch

April in many instances has seen a clear outperformance of beta, particularly in the lower rated part of the capital structure as indicated by the performance in EUR HG Financials Junior Subordinated and Tier 1 bonds, as well as in the US with the CCC segment in US High Yield. The results of the first round of the French elections saw as well a significant rally in French financial stocks as we pointed out in our previous missive, in conjunction with somewhat better macro data such as PMIs. 

On a side note we have a very strong distaste for banking stocks. We explained our reasoning in our February conversation "The Pigou effect" back in February 2015:
"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe.  You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! " - source Macronomics, February 2015
Back in 2015, while touching again on the "japanification" process of Europe, we pointed out to German Berenberg's research note on European banks turning Japanese and we agree with them at the time that from a long term perspective banks were uninvestable. To repeat ourselves, should you want to play the "japanification" process of Europe, stick to financial credit, you'll sleep better at night. Touching briefly again on this subject we would like to point out towards Berenberg very interesting note from the 30th of March entitled "But I'm holding on" relating to banks a poor investment proposal over the long term:
"History says you do not invest in banks
While past performance is no guarantee of future performance, looking back over the long term, banks have not been a great investment. The European banks have underperformed over the past 45 years, apart from the huge leverage binge during the late 1990s/2000s. While looking even further in the past, US banks have underperformed since 1800, so the recent 45 years (bar 2008-09) present some stability in terms of bank performance.

At heart there is a fundamental question to be asked as to whether banks should outperform the wider markets. While an argument could be made for those emerging markets with underdeveloped banking systems, for developed markets we struggle to believe that should be the case" - source Berenberg
For those loyal readers who have been following us for a while, we told you in our September 2015 in our conversation "Availability heuristic - Part 2" the importance of stocks versus flows:
"Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":"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." - Macronomics, September 2015
There is still €1 trillion of Nonperforming loans (NPLs) sitting on European banks balance sheet including €360 billion just for the Italian banking sector. The Fed has clearly played a much efficient game in restoring the credit impulse by dealing swiftly with the impaired assets of US banks whereas, with its numerous liquidity supports, the ECB has continued to provide funding for these impaired assets but in no way resolving the rising solvency issues such as the ones seen in the Italian banking system hence our "japanification" analogy. When dealing with NPLs, you need to act swiftly. But, to end our side note, should you want to play tactically banking stocks, you would be better off playing US banks over European banks as per the chart below from Berenberg's recent note displaying the growth in tangible book values per share as a key performance driver:
- source Berenberg.

All about "stocks" versus "flows", hence the different outcomes between the US banking sector and the European banking sector.

But moving back to "complacency" and "volatility", as we pointed out last week, from a Bayesian perspective, generally the end of low volatility periods often leads to strong and sudden crash in prices. It is hard not to feel that the market is not too complacent at the moment and it would be probably wise to start reducing gradually your beta exposure particularly in US High Yield where the beta play has been very strong as of late.

One thing for certain is that we are clearly noticing signs of a weaker tone in global credit impulse and the last 3 months trend in US Commercial & Industrials lending has been negative since the beginning of the year according to Bank of America Merrill Lynch:
31st of January: -0.1
28th of February: -0.1
31st of March: -0.6
30th of April: -0.7
- source Bank of America Merrill Lynch

Credit wise, we continue to see a gradual deterioration in the Credit Cycle hence our much more cautious tone for the second part of 2017, particularly in the light of record complacency and low VIX index for the time being.

  • Final charts - Dude where is my vol?
We have long stated that financial repression driven by Central Banks could be clearly seen in the low volatility regime set up, which could be one of the chief reason why in recent years Global Macro Hedge Funds have underperformed, making the rally in equities probably one of the most hated by many lagging fund managers, seeing in the process record outflows from active strategies towards passive strategies and the ETFs giants. For our final charts we would like to point out two charts from Bank of America Merrill Lynch Global Equity Volatility Insights note from the 3rd of May entitled "US equity vol near 90yr lows; what's driving it and how long can it last". Some telling bullet points :
  • US realized vol has only been lower 3% of the time since 1928
  • Average single stock realized vol has now fallen to the lowest level on record (data since 1990)
  • Realized stock correlation is also at lows rarely seen over the past 15yrs and is in the 25th %-ile since 1990.

"Today’s low S&P realized vol environment thus neither fully resembles the mid- 1990s or 2004-07 low vol periods. Single stock volatility is lower today than ever before. Stock correlation is not nearly as high today as in 2004-07 and postelection even fell to ultra-low mid-90s levels, which we find quite striking given the many purported drivers of structurally higher correlation today (stat arb / HF capital, passive investing, closet indexing, ETF usage) that were not present in the 90s." - source Bank of America Merrill Lynch
We do live in interesting times, and it might be after all that the king in Leo Tolstoy's short story parable could have had an interesting fourth question we think: Are we going for a Bayesian outcome? We wonder.

"The real must be postponed to a later date" - Philippe Muray, French writer.

Stay tuned! 

Tuesday, 25 April 2017

Macro and Credit - A Pyrrhic victory

“You were given the choice between war and dishonour. You chose dishonour, and you will have war.' - To Neville Chamberlain” - Winston S. Churchill

Looking at the results of the French presidential elections with keen interest given our involvement in the process, us being French, we reminded ourselves, for the title analogy of the definition of Pyrrhic victory, where the heavy toll negates any sense of achievement or profit. King Pyrrhus of Epirus suffered irreplaceable casualties in defeating the Romans at the Battle of Heraclea in 280 BC and the Battle of Asculum in 279 BC during the Pyrrhic War. In both victories, while the Romans suffered greater casualties but they had a much larger pool of replacements, so the casualties had less impact on the Roman war effort than the losses of King Pyrrhus. While financial markets are going through yet another relief rally thanks to the victory of the Media darling Macron, we would point out that, no matter what some pundits think, Marine Le Pen and her party are, to use a financial term and analogy "positive carry" (inequality and unemployment, immigration, terrorism, etc.). Let us explain ourselves. Most of the beneficiaries of what "populists" would label "crony capitalism" and the "elites" have been behind Macron's candidacy, so all in all they are today sighing with relief. Yet, we believe his upcoming victory would amount to a Pyrrhic victory, in the sense that, unless there are very important structural reforms implemented which have been postponed in France for the last 20 years (under Chirac, Sarkozy and Hollande), there is a high probability of another 5 years wasted under Macron. While the quotation we have used above from Winston S. Churchill sounds a little bit off the mark from a historical perspective, we do feel, to paraphrase Mark Twain, that history for France is not repeating itself, yet it rhymes with the troubled 30s. We could even rephrase Winston S. Churchill quote as follows when it comes to France: "You were given the choice between status quo to avoid bankruptcy and dishonour.  You chose status quo and you will have bankruptcy and dishonour. Unless we see some very bold structural changes in France, not only in order to reform inefficient and inept systems in place but with significant tax reforms and supply side policies as well, we do believe there is a very high probability that Macron's victory will be a Pyrrhic one down the line but we ramble again.

In this week's conversation we would like to look at what to expect in terms of the continuation and sustainability of the rally which climbed the most recent "wall of worry" of the French elections. 

  • Macro and Credit - Paris in Spring?
  • Final chart - Bank of Japan, the ETFs whale

  • Macro and Credit - Paris in Spring?
While this bullet point could as well be a title analogy on its own and a reference to 1935 black and white musical comedy film directed by Lewis Milestone for Paramount Pictures, the relief rally seen so far, from our perspective has been mostly a beta play, particular in the light of the performances on the Monday following the elections on French bank stocks. As we have pointed out in numerous recent conversations, we continue to remain short term "Keynesian" when it comes to us being "risk-on", yet we remain medium term "Austrian" when it comes to tracking the weakness in credit growth, surging delinquencies and the credit cycle being long in the tooth. From an equities allocation perspective, we do think that Europe and other markets offer better prospects than US markets given the most recent macro data. Yet, with the slowdown in US hard data, we think at current levels US credit offers still better prospects than European credit both for Investment Grade and High Yield for which oil prices matter a lot.

For now the market wants to rally and will rally, as we often see significant rally in late stages in the credit cycle. For the time being the allocation tool DecisionScreen for High Yield is still in the buying zone for the aggregate signal which comprises the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score), US GOV 10 Year Yield (1Y Z-Score).
- source DecisionScreen

It remains to be seen how long US High Yield will continue its upward trajectory. This of course to a large part as we discussed recently on the trajectory that will be taken by oil prices in the second quarter. 

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remains very strong as per the below chart from we also used in several conversations:
Correlation 0.938, R2 0.881 - source

Same goes for the correlation between the S&P500 and the synthetic CDS High Yield US index CDX:
Correlation 0.987, R2 0.973 - source

Of course when it comes to Bayesian learning history shows the final phases of rallies have provided some of the biggest gains. But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent), then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
So all in all, you can probably see we are not part of the "permabear" camp, though we are acutely aware of the lateness stage we are in the credit cycle. It might be "Paris in the Spring" and "risk-on" for the time being, but, we do feel more cautious as we stated about the second part of 2017.

Given we have climbed the "French wall" of worry for the time being, while European investors had already been front running their Japanese peers, we do expect higher overseas demand for US Investment Grade credit thanks to improved cross-currency basis. On this subject we read with interest JP Morgan's Credit Outlook and Strategy note from the 20th of April 2017: 
"The US election results were followed by strong market optimism that US growth and corporate results would benefit. UST yields went from 1.83% on November 7 (the day before the election) to a peak of 2.61% on March 13th. The S&P rallied 12% from pre-election to its recent peak, and JULI spreads tightened by 24bp as well, to their recent low. Currently the UST 10yr yield is at 2.23%, unwinding 37bp or 50% of its post-election move. In contrast, the JULI is just 7bp wider so has unwound 30% from the post election tightest level, and the S&P is just 2% off of its recent peak, still up 11% post election, so it has given up 15% of its post election rally.
These developments suggest that markets have become less optimistic on growth and inflation picking up, while maintaining most of the optimism that drove equities up and credit spreads down on the election results. The move lower in UST yields reflects, in part, a flight to quality with the French election and increased geopolitical tension, but this "flight" didn't meaningfully hurt risk markets. There are several factors that can explain at least part of the strength of credit and equity markets even with rates markets suggesting rising risks to growth. These include:

1) Solid earnings expectations:
Consensus equity analysts estimates are for 7.4% revenue growth and 8.9% EPS growth in 1Q17 vs 1Q16, for the S&P500. Excluding Energy revenue and earnings growth forecasts are 5.3% and 5.1%. The weaker USD so far in 2017, down 4% in trade weighted terms, is a contributing factor to better earnings, as is the recovery in Energy prices and higher interest rates helping bank earnings. These earnings forecasts are much stronger than nominal GDP growth in 1Q17, which is likely to come in at just 4.1% higher than 1Q16. This is the most straightforward driver of the outperformance of credit and equities vs. US rates. That said, if low US rates are correctly predicting a slowdown in US growth, then earnings optimism will fade as well.

2) The regulatory reforms and pro-business agenda of the new administration as a driver of better corporate earnings, separate from the macroeconomic drivers of growth. It will be difficult to quantify the earnings impact of actual and potential regulatory relief, but it is hard to argue that it is not positive for corporate earnings over time. Related to this, potential changes to Dodd-Frank and new appointments at the Fed are fueling optimism in the Financial sector for some types of regulatory relief. As the legislative path of reform continues to be challenging for the new administration it is logical to assume there will be increasing focus on reforms and appointments that the executive branch can institute without congressional approval. M&A has been quiet recently but there is a lot of M&A discussion, particularly in the TMT sector. The assumption is that the new administration will be more likely to approve transactions that might have been blocked by the prior administration. This may or not be positive for credit markets, but it is usually positive for stocks.
3) The Fed rate hiking cycle is directly supportive of US bank earnings.Net interest margin rose for most banks in 1Q17. The most recent Fed hike was on March 15 so only a small portion of its impact was reflected in higher earnings in 1Q, while 2Q will reflect the full impact of this hike, and perhaps the beginning of the next Fed hike, which we continue to expect on June 14.
4) Lower sovereign yields in Europe have increased the need to diversify and are contributing for overseas demand for US HG credit. The 10yr bund is now at 33bp, down from a 2017 peak of 48bp on January 26th. The percent of JPM’s global sovereign bond index offering a negative yield was at a recent low of 17.6% on March 13, and has since ticked up to 21%. In the first part of 2016 low global bond yields contributed to overseas demand for US credit. This impact faded in the 2nd part of 2016 and in early 2017, but has increased once again. Some of the recent move lower in European sovereign yields is tied to the risks seen around the French election so may dissipate (or get worse) after Sunday’s vote.
The FX-hedged pickup of USD credit vs European and Yen credit has narrowed recently.
For Euro based investors USD credit, hedged with a 3m FX swap, now offers a pickup of 31bp. This is on the low end of the 31-68bp three month range.

For Yen based investors this pickup is now 63bp, also near the bottom of the 58- 93bp range. Still, with sovereign bond yields so low the need for diversification remains. The decreases in spread pickup for European and Japanese investors buying USD HG corporates is primarily due to a decrease in US HG corporate yields. The annualized cost of the USD/EUR and USD/JPY 3m FX hedges has remained relatively stable recently while the absolute unhedged yield differences have decreased.

Even taking account of these factors, the extent of the difference between UST and equity/credit spread movements over the past few weeks seems extreme.
The drivers of the equity rally and credit spread rally post the election were then described as tax reform (including overseas cash tax repatriation relief), infrastructure spending and fiscal stimulus. All of these are, at a minimum, delayed, and there is growing skepticism that the magnitude of corporate tax relief and infrastructure spending will match the Administration’s goals.
Some of the macro data would support higher UST yields as well, with consumer and business confidence near multi-year peaks and PMIs also very strong. 
Global Economic Activity Surprise indices reached multi year peaks in March but have receded since then. The Fed has raised rates in 2016 and a couple of weeks ago signaled that it would change its balance sheet reinvestment policy later in 2017. These factors might have been expected to keep UST yields high, but instead they have declined.
There are countervailing factors in the macro data, which are getting the focus of the Treasury market, however. Bank lending slowed in the later part of 2016 and this trend has continued, despite the strong consumer and business confidence figures, which might have been expected to lead to more loan demand.

Auto sales have also slowed, and retail sales growth overall has been modest.

GDP growth in 1Q is coming in weak, though there has been an historical pattern of weak 1Q initial prints, which are then revised higher. CPI last month came in very weak, though again the magnitude of the drop seems overdone and may be revised in subsequent updates. This more cautious data, if truly predicting weaker growth, would be expected to impact stocks and corporate spreads, as well as Treasury yields, but this has not been the case so far." - source JP Morgan
As John Maynard Keynes aptly said:
 “The market can stay irrational longer than you can stay solvent.”
While it is indeed "Spring in Paris" with new records being broken in the equities space as we type, and pundits including us are watching with interest the divergence between hard data and soft data including retail woes, rising delinquencies and weaker credit growth in the US that portend most likely towards a weak US Q1 GDP print on Friday, you might rightly ask yourselves if indeed, when it comes to chasing this really fundamentals matter anymore. Earnings wise, no doubt the picture seems to be better, when it comes to US equities and the continuing surge. Yet, as we pointed out on numerous occasions and particularly for Fixed Income allocations, flows matter and they matter more and more particularly when you think that "Bondzilla" the NIRP monster is "made in Japan". We keep hammering this, but the Japanese investment crowd and their allocations should never be underestimated. These guys mean business when it comes to flows as we pointed out in our conversation "Drums Along the Mohawk" in early April:
"The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table below. 
 - source Bank of America Merrill Lynch
 - source Bank of America Merrill Lynch
Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation." - source Macronomics, April 2017
So yes, Macron's Pyrrhic victory in the first round of the French elections in conjunction with the recent start of Japan's new fiscal year might explain the recent rally in French debt but it is could be coming from a renewed appetite from foreign investors in particular "Bondzilla". He had offloaded a sizable chunk of French bonds in February as indicated in the table above we used in our previous post.

When it comes to Japan and their appetite for risky assets, if indeed Japan is Bondzilla when it comes to foreign bonds, for domestic ETFs it is indeed a whale.

  • Final chart - Bank of Japan, the ETFs whale
Whereas it is very important to track Japan flows, regardless of the fundamentals narrative when it comes to valuation when it comes to Fixed Income, it is interesting to focus as well to Bank of Japan who has indeed become a "Tokyo Whale" in the domestic ETFs market. On that subject, our final chart comes from Société Générale Cross Asset note from the 21st of April entitled "Where is the Tokyo Whale - Analysing the impact of equity ETF purchases by the Bank of Japan":

"The “Tokyo Whale” in the ETF market...
The term “whale” is frequently used to qualify big money participants in the market. The Bank of Japan has often been qualified as the “Tokyo Whale” since it became a major participant and holder in the Japanese government bond (JGB) market. Recently, this situation was replicated in the ETF market. At end-March 2017, BoJ’s cumulative ETF purchases were ¥13.1tn, with Japanese equity ETFs subject to BoJ purchases totalling ¥21.3tn assets. Based on the price performance of the Nikkei 225 and Topix indices and as dividends are not reinvested in Japanese equity ETFs but distributed, we can estimate the mark-to-market value of historical purchases. We assume the BoJ’s current ETF holdings stand around ¥15.7tn ($144bn), i.e. approximately 75% of the total assets in Japanese equity ETFs (orange line on below chart).
Eligible ETFs are physically replicated, which implies the ETF providers hold the underlying index constituents. From the estimated BoJ ETF holdings and index constituents list, we can deduce how much of the Japanese equity market is indirectly held by the BoJ through these ETFs.
... but also, indirectly, in the Japanese stock market
BoJ implicit holdings are quite small at the index level but significant on some specific
Comparing the BoJ’s ETF holding amounts per benchmark to each index’s market capitalisation is not relevant as many companies are common to the three (or two) indices. We have totalled the estimated amounts held for each stock through the three benchmark exposures and concluded that the BoJ may indirectly hold around 3.2% of the Nikkei 225 market capitalisation, 2.0% of the TOPIX and 3.1% of the Nikkei 400. These figures may seem quite low compared to the respective 75% and 40% estimated BoJ ownership of the Japanese ETF and government bonds markets. The impact at the stock level, however, can vary greatly from one stock to another." - source Société Générale
So you might ask yourselves, how long can this rally in equities continue? Well if indeed Central Banks such as the Bank of Japan, the SNB and others are now in the "investment business", the sky's the limit but we ramble again...

On a final note we think Macron's potential victory will be a Pyrrhic one given the growing divisions in France à la 30s and he would be wise to remember the latin words "Arx tarpeia Capitoli proxima", (“the Tarpeian Rock is close to the Capitol”) which some have interpreted to mean that "one's fall from grace can come swiftly". As a reminder to be hurled off the Tarpeian Rock was, from a certain perspective, a fate worse than mere death, because it carried with it the stigma of shame. The standard method of execution in ancient Rome was by strangulation in the Tullianum. The rock was reserved for the most notorious traitors, and as a place of unofficial, extra-legal executions such as the near-execution of then-Senator Gaius Marcius Coriolanus by a mob whipped into frenzy by a tribune of the plebs.

"History repeats itself, first as tragedy, second as farce." -  Karl Marx

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