Monday, 5 June 2017

Macro and Credit - Voltage spike

"The trouble ain't that there is too many fools, but that the lightning ain't distributed right." - Mark Twain

Watching with interest continuous records being broken in the surge in equities indices in conjunction with continuing flows in credit and tightening credit spreads, we reminded ourselves for our title analogy of what a "Voltage spike" is. While an energy spike, is measured not in volts but in joules; a transient response defined by a mathematical product of voltage, current, and time, the current melt up in asset prices is measured daily by the indices reaching new record highs. Yet, hard macro data at least in the US continues to be on a soft side hence the continuation in the flattening of the yield curve.

In this week's conversation, we would like to look at the flattening of the US rates market which followed a somewhat disappointing Nonfarm payrolls number last Friday.

  • Macro and Credit - Is the rates market pricing the end of the US cycle?
  • Final charts - Econ 101 - Higher demand leads to tighter credit spreads

  • Macro and Credit - Is the rates market pricing the end of the US cycle?
The slightly weaker tone coming as of late from the US job market has led to somewhat a "Voltage" spike" in the sense that there is indeed a growing disconnect between what the US rates curve is currently telling us and the unabated run in risky assets as investors have truly decided to "carry on". 

As we have clearly highlighted in our recent musings, as the credit cycle is slowly but surely turning, we do expect a significant final melt-up in asset prices. Until inflation rears again its ugly head and central banks have to counter it by hiking aggressively, it is difficult with current inflows and apart from an exogenous event to be bearish in the short term. Therefore we remain "Keynesians" as the animal spirits switch to "euphoria", yet we are also medium term "Austrians". As we have repeated in numerous conversations, we are more concern with the second part of 2017., Italian elections in the 3rd quarter will be important to scrutinize particularly in the light of unresolved issues with the Italian banking sector and their nonperforming loans (NPLs) woes. 

Clearly as of late, some financial pundits have been puzzled by the significant rally in both bonds and equities in a sort of goldilocks scenario playing out for the leveraged crowd and "risk-parity" players alike. This "Voltage spike" warrants close monitoring and maybe some sort of "surge protection" being set up given the level of complacency in this low volatility environment. In relation to the growing disconnect between the US yield curve and equities, we read with interest Bank of America Merrill Lynch's Global Liquid Markets Weekly note from the 5th of June entitled "Let's hope the rates market is wrong":
  • The rates market is pricing in a high risk of the end of the US cycle. The stability of rates markets could be a warning rather than a reassurance for carry trades.
  • •Either way, the high implied end of cycle risk in US rates is not just at odds with equities, but is a risk for commodities, EM, breakevens and the periphery. Internal inconsistencies
The rates market is pricing in a considerable chance of the US economy rolling over. The fact that UST 10y rates have traded in a very tight range for the last two months has been interpreted as a reassuring signal for carry trades everywhere. In fact it should be a warning signal. Rates are where they are, not because the world economy is in a sweet spot with growth neither too hot nor too cold, but because the market is caught between having to reprice rates lower (a high implied risk of rate cuts for next year) or higher (price out end-of-cycle risks, price in an active Fed and a deteriorating supply-demand gap for fixed income). If the US rates market is right, then the rest of the FICC space, let alone equity markets, are mispriced.

Commodities don’t do well in a slow-down
Commodities are cyclical, and our bullishness in crude is predicated in part on the cycle remaining intact – but moving beyond this tautology, we analyse the performance of commodity strategies below. Commodity beta works best in high and rising nominal rates macro regimes, but underperforms in rising real rate environments. Commodity alpha strategies on the other hand would be at risk in a scenario where inflation fails to get traction. Commodity alpha is therefore exposed to the global reflation trade being aborted, while commodity beta would be at risk even if the cycle remains intact, but the Fed moves ahead of the curve.
EM is goldilocks squared
In our recent discussions on EM we have primarily focused on the risks to EM from higher rates, given our short duration bias. However, the end-of-cycle risks priced by the US rates market are an even bigger risk to EM. For the EM carry trade to remain successful, rates need to stay low, which given the secular shift in supply demand dynamics for fixed income, and the US in particular, is a tall order, longer term. Crucially, however, pricing out the end-of-cycle risks in US rates, by themselves, would be a challenge to EM. And not pricing them out would suggest that the cyclical support for a bullish EM story falls away.
EUR breakevens are hoping for global reflation
Following the US election, long-dated EUR breakevens repriced as aggressively in the euro area (EA) as in the US and remain close to the ECB’s target. We have been bearish breakevens all year, since we believe the ECB is exiting policy accommodation prematurely and do not see any reason to be optimistic about a trend change in the EA’s inflation dynamics. But if the cycle in the US is slowing down, as suggested by the US rates market, then there is even less reason to be hopeful that this repricing of EA inflation risks to be sustained – leaving aside the fact that even for the US our economists see headline inflation slow considerably. The EA remains leveraged to global growth (Chart 2).

Periphery, still caught between a rock and a hard place
We have been bearish the periphery since last autumn, arguing that the ultimate victim of a more hawkish ECB would not be the Bund market, but BTPS. The periphery faces a mechanical repricing as the ECB steps away from artificially supporting prices, as well as higher risk premia given questionable debt dynamics on an inflation trajectory below the ECB’s target. However, what has supported the periphery so far is the fact that activity data has outperformed on a global basis. But as argued in the inflation discussion above, the euro area remains a highly leveraged bet on global growth. If the cyclical outlook in the US deteriorates as implied by the rates market, the last remaining argument for being constructive on the periphery would fade very quickly." - source Bank of America Merrill Lynch.
Obviously the price action particularly in the long end of the US yield curve in conjunction with serious inflows into Investment Grade credit as well, has put back into the forefront the MDGA trade (Make Duration Great Again) which we mentioned back in April in our conversation "Narrative Paradigm".  Clearly, if indeed the bond markets is not buying the "reflation" story anymore and US data continue to veer on the soft side, then indeed from a tactical allocation, it makes sense to turn more positive on the duration front.

In this credit cycle, clearly investors not only have taken on more duration risk but, given the performance of beta and in particular the beta segment such as in High Yield CCC, credit risk has been embraced in full making sensitivity to price movements much more significant to "Voltage spike". We agree with Bank of America Merrill Lynch's take from their note in relation to the growing disagreement between rates and equities, someone eventually is wrong:
"Not sustainable
Rates and equities are pricing two very different scenarios for the US and the world economy more generally. Rates are pricing a very slow pace of Fed hikes and the end of the tightening cycle after only one more hike next year, with a relatively high probability for a US recession. Equities, on the other hand, are the only Trump trade still alive and, at all-time highs, are pricing fast growth ahead. Implied market volatility is also at historic lows, suggesting no concern about a sharp adjustment. US data is mixed and do not give a clear indication of whether rates or equities will have to adjust. The FX market is more consistent with what the rates market is pricing, or the USD should have been stronger, in our view.
However, this is clearly not sustainable, in our view. We expect a reality check in the months ahead, most likely after the summer. We have been warning that although market volatility could remain low this summer, it will increase right after, as this fall is packed with events—more Fed hikes (or not), unwinding Fed balance sheet, possible Yellen replacement, US tax reform, ECB QE tapering and policy sequence, German and possibly Italian elections, and Brexit negotiations. In a good case scenario, the USD will have to appreciate against the JPY and rates will sell off. In a bad case scenario, equities and EM assets will sell off." - source Bank of America Merrill Lynch
We do share similar concerns for the second part of 2017. For the time being, markets have climbed numerous wall of worries so far in 2017 (French elections) and apart from an exogenous factor such as a geopolitical event, it is hard to turn significantly bearish. As John Maynard Keynes aptly put it: 
"The market can stay irrational longer than you can stay solvent."
While no doubt in our minds that eventually the "perma-bear" crowd will be right, namely that China will face some credit crisis at some point, markets will tank and what is overvalued will deflate accordingly, credit will widen and distress credit will show up again, at the moment, we do think we are moving towards the "euphoria" stage. 

Whereas as in our late 2015 musings it was evident that the shape of the high yield credit curve was pointing out to trouble ahead for credit in early 2016 and by extension equities thanks to the rapid depreciation in oil prices and weaker earnings, as things currently stand, regardless of the narrative of some doomsday pundits, it is hard for us for time being to see the catalyst. If inflation rears back its ugly head, it will be a different story for many asset classes rest assured. 

Looking at several indicators we track such as indicators of aggressive issuance such as the ones published by Bank of America Merrill Lynch, clearly CCC issuers have regained access to the primary market for the time being including shale players it seems (16.4% face value of the market):
- source Bank of America Merrill Lynch High Yield Chartbook

Another indicator we look at is Cov-Lite issuance as a percentage of market size. Since 2014, the market seems to have been cooling-off slightly (we are not talking about the much discussed subprime auto-loans here):
- source Bank of America Merrill Lynch High Yield Chartbook

Inflows are still pouring in Fixed Income including in the beta play such as High Yield simply because the percentage of negative yielding assets remain elevated at 17% based on Global Fixed Income Index (GFIM):
- source Bank of America Merrill Lynch High Yield Chartbook

High Yield fundamentals have improved with nearly all issuers reporting Q1 earnings and EBITDA growth is much better with ex-commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain according to Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch High Yield Chartbook

The on-going "Voltage spike" clearly shows that 2017 is playing out as a reverse 2016, namely strong performance in the first half of the year and much more caution for the second part. That's our scenario and it seems to be playing out accordingly so far. We do share with Bank of America Merrill Lynch's High Strategy team their cautious stance for the second part as indicated in their strategy note from the 2nd of June entitles "Looks aren't everything":
"High yield fundamentals continue to improve
With nearly all issuers having reported Q1 earnings, we once again take the opportunity to examine credit fundamentals across the high yield universe. For the 5th consecutive quarter, year over year revenue growth improved and jumped from 2.36% to 8.90%, the best reading in 3 years. Energy saw the biggest improvement with 31% top line growth, although Technology (+21%) and Commercial Services (+11%) saw double-digit gains as well. On the opposite end of the spectrum, Transportation, Capital Goods, and Media saw declines of 11%, 4%, and 1% respectively (Chart 1).

EBITDA growth proved resilient as well with ex-Commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain. This translated into a modest natural deleveraging across the ex-Commodities universe, where net debt to EBITDA levels fell to 4.18x compared to 4.52x at their peak last year. Finally, the US HY issuer weighted default rate continued to fall and now stands at 4.53%, just slightly above our 4.0% forecast for the end of 2017. Given this improving fundamental backdrop—the best we have seen in several years—do we think high yield’s 15 month long rally will extend into the 2nd half of this year?
Don’t eat the forbidden fruit
We view this as unlikely. Although healthy fundamentals may create temptation to invest in riskier pockets of the market, we think political uncertainty and an economy that struggles to gain momentum will likely cause a selloff later this summer. With 0.5% real wage growth, falling used car prices, negative C&I loan growth, and little capex investment, we find many similarities between today’s economy and that of 2013/2014 and question the ability for additional compression in such an environment. Additionally, given rich valuations, we think upside is limited here, particularly in high beta/lower quality paper. Instead, our bias is to reduce exposure to CCC risk and move profits into higher quality paper." - source Bank of America Merrill Lynch
As we indicated last week, we monitor very closely consumer credit trends in the US for the time being. Also we have voiced our concerns as well in various conversations with the negative trend in C&I loan growth more indicative on how the "real economy" is behaving. Given the significant outperformance of beta in the credit space and in particular the CCC bucket, we do have difficulties in seeing more upside from there but clearly Keynes earlier quote comes to mind in a NIRP world. 

In our book, when it comes to the slowly but surely turning of the credit cycle, the sequence always starts with a flattening of the US yield curve, then, financial conditions grind tighter and some highly leverage players credit start widening, before the impact reach more players and credit spreads start to widen, defaults rates start creeping up and then of course the rosy tainted glasses eternal optimist crowd in the equity space finally gets the story right, and equities reprice in the end. Obviously, we are not there yet. Liquidity providers aka central bankers are still deeply involved in the "wealth effect" game, which makes this current "bull market" still the most hated in history particularly with the latest "Voltage spike" we are seeing with new record levels being reached.  

Credit wise we continue to expect credit spreads to go tighter, that is until the flow of liquidity provided by our generous gamblers diminishes. Clearly we are not there yet as per the final chart below.

  • Final charts - Econ 101 - Higher demand leads to tighter credit spreads
When it comes to looking at additional indicators of interest when it comes to "Voltage spike", while we already discussed some fundamental indicators, we continue to look at inflows in the asset classes as an indication of the direction of credit spreads. Our final chart comes from Bank of America Merrill Lynch Credit Market Strategist note from the 2nd of June entitled "All news is good news" and displays the record inflows being the driving force for tighter credit spreads:
"Econ 101
Economics 101 dictates that under certain assumptions higher demand creates higher prices (tighter credit spreads) and increased supply. The US high grade corporate bond market satisfies these assumptions, as inflows to HG bond funds and ETFs are tracking a record $130bn YtD, up about $85bn from the same period last year (Figure 27).

Supply for the first five months of the year is $650bn, just $25bn above last year’s pace. Acknowledging that this story is highly simplified, it nevertheless represents one of the key reasons high grade credit spreads have tightened 11bps this year to 119bps – making good progress on the path to our year-end target of 105bps (Figure 28).
 - source Bank of America Merrill Lynch

Given Bondzilla the NIRP monster is "made in Japan" and is finally back after 5 months of uninterrupted selling with the most recent weekly capital flows data showing Japanese investors bought 732 billion yen ($6.6 billion) of foreign bonds last week, bringing total buying in the past four weeks to 3.696 trillion yen ($33.3 billion) you shouldn't be surprised by the "Voltage spike" in US Treasury yields and credit either. So get ready to MDGA, just a thought...

"I just go where the guitar takes me." -  Angus Young AC/DC

Stay tuned!

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