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. 

Synopsis:

• 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 MacroCharts.pro we also used in several conversations:

Correlation 0.938, R2 0.881 - source MacroCharts.pro

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 MacroCharts.pro

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
stocks

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

Stay tuned!