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.

Synopsis:

• 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!