Wednesday, 1 November 2017

Macro and Credit - Euphonium

"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher

Listening to "Le Chiffre" aka Mario Draghi confirming lower QE for longer and watching a continuation of the rally with outperformance of beta, while thinking for this week's title analogy and given the start of a euphoric mood in financial markets, we decided to go for a musical reference "Euphonium". If one needs to keep dancing while the music is playing, it seems to us that the large conical-bore, baritone-voiced brass instrument deriving its name from the Ancient Greek word εὔφωνος euphōnos meaning "well sounding" or "sweet-voiced" is appropriate.  The euphonium is a valved instrument; nearly all current models are piston valved, though rotary valved models do exist.  A person or a central banker who plays the euphonium is sometimes called a euphonist. As a baritone-voiced brass instrument, the euphonium traces its ancestry to the ophicleide and ultimately back to the serpent. Our previous reference to "Ouroboros", the ancient symbol of a snake consuming its own body makes it even more interesting. On a side note, the most popular professional models of "Euphonium" in the United Kingdom are Besson Prestige and Sovereign models. It seems to us that the Sovereign models have been particularly popular with our "Generous gamblers" aka our dear central bankers, when it comes to playing the music everyone has been dancing to namely the QE tune. The euphonium has historically been exclusively a band instrument (rather than an orchestra or jazz instrument), whether of the wind or brass variety, where it is frequently featured as a solo instrument. Because of this, the "Euphonium" has been called the "king of band instruments" which fits perfectly the central banking narrative of these days. It has also been called the "cello of the band", because of its similarity in timbre and ensemble role to the stringed instrument. "Euphoniums" typically have extremely important parts in many marches (such as those by John Philip Sousa), and in brass band music of the British tradition. In many instances we think our "Generous gamblers" have been trumpeting their achievements with much fanfare and the wealth effect, this particularly loud music they have been playing with their various instruments, ZIRP, QE, NIRP and more but we ramble again...

In this week's conversation, we would like to look at consumer credit in particular and the US consumer in general given that no matter how loud our "Generous gamblers" are playing their "Euphonium", income growth is becoming a concern in the "land of the free" with rents eating a larger portion.

  • Macro - With the lack of "Income growth" is the Euphonium justified?
  • Credit - Revisiting previous record tights thanks to the Euphonium
  • Final charts - Keep up with the "melt-up" play the Euphonium via options

  • Macro - With the lack of "Income growth" is the Euphonium justified?
Back in May in our conversation "Orchidelirium", we asked ourselves if the US consumer was somewhat "maxed out":
"The "wealth effect" has globally lifted all boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. From our credit perspective, it appears to us that "cracks" in credit in the US are beginning to show up, particularly in the form of slowing loan demand. While we are not yet sounding the alarm bell, we think in the coming months it is going to be paramount to monitor credit demand and in particular consumer credit." - Macronomics, May 2017
From our credit and macro perspective, given we live in a credit world we indicated the importance of tracking loan demand as per the quarterly Fed Senior Loan Officer and Opinion Survey (SLOOs). We concluded at the time it was too early to envisage some clear headwinds for the US economy, but it is clear to us that we are late in the credit cycle. It remains to be seen how many hikes it will take before the Fed finally breaks something, but, clearly a December hike is on the cards. Yet there are growing signs that the credit cycle continues to slowly but surely turn as per the breakdown in the relationship between incomes and savings as indicated in Megan Greene, Chief Economist at Manulife Asset Management in Bloomberg's article from the 31st of October entitled "You Wanna See Something Really Scary? Try These Market Charts":
“The breakdown in the relationship between incomes and savings suggests that the consumer -- who drives every U.S. economic recovery -- may be near the end of the credit cycle.” - source Megan Greene, Chief Economist at Manulife Asset Management in Bloomberg.
We think it's too early to call it a day for the US consumer, although, no doubt, the tightening of lending standards appears to be slowly grinding tighter. Overall, financial conditions remain fairly loose. On the subject of the credit outlook for 2018 relating to consumer credit we read with interest Bank of America Merrill Lynch's take from their Consumer ABS Weekly note from the 27th of October. 
"The broader view – employment and debt service ratio are key
The level of economic activity should be supportive of credit performance of consumer debt, while the levels of consumer debt and interest rates may be less supportive. The positive trends in employment, net worth, saving, and income levels should be positive for credit performance. The level of spending and the willingness to borrow and lend remain primary factors driving consumer debt levels and credit performance.
In our view, the favorable economic environment should have positive impacts on the willingness to borrow, while weaker credit performance could have a negative impact on willingness to lend and/or lending standards in certain consumer loan segments. We believe the net impact will lead to higher levels of overall consumer debt. In other words, we still view the overall lending environment as favorable, despite some headwinds.
By loan segment, auto lenders may be willing to lend but they likely will leave lending standards unchanged to tighter, while credit card lenders likely will be willing to lend and loosen lending standards. Education loan and personal loan lenders likely will be willing to lend but will leave standards unchanged.
The growth rate for consumer debt seems to be stabilizing in the 6% to 7% range, while the rate for home mortgages has been steadily increasing since reaching a low of negative 4.6% YoY in December 2010. Some of the differences between the post-crisis growth rates can be explained by fewer opportunities, if any, for homeowners to monetize the equity in their homes.

Also, over the last few years, credit card lenders have begun to focus more on revolvers than rewards-driven convenience users. The growth in consumer debt has contributed to the increase seen in the related debt service ratio (DSR), although the ratio remains well below the peak seen in 2001.
Similar to prior periods, the willingness to borrow/lend has contributed to higher consumer debt levels (recall spending has been growing at a modest pace), which has contributed to a higher consumer DSR.

The higher consumer DSR, along with the employment situation, can have significant impacts on the level of charge-offs. We believe tighter standards are needed to slow growth in consumer debt, reduce the consumer DSR and, ultimately, lower charge-offs.

Auto loans should see lower growth as origination volume related to increasing sales of off-lease vehicles partially offsets volume lost to declining new vehicle sales and tighter lending standards. Credit card loans should see higher growth as the number of open accounts and credit limits have increased and lenders increasingly focus on revolvers. Education loans should see steady growth as expected increases in college enrollment and costs should offset expected increases in prepayments. Other or personal loans also should see steady growth as traditional lenders and relatively new “marketplace” lenders continue to offer loans and relative new products continue to gain traction (e.g., mobile device payment programs).
Consumer debt stood at record levels at the end of June 2017, after steadily increasing since June 2011 to reach $4.2tr. Among the various loan types, only auto loans and education loans have reached record levels, as relatively strong vehicle sales push auto loan origination volume to higher levels and needs-based lending standards push education loan origination volume to higher levels. The current outstandings for credit card loans is 91% of the peak seen at the end of December 2008, while the same for other loans is 78% of the peak at the end of June 2003.

Healthy economic environment but higher debt loads
The positive trends in employment, net worth, saving, and income levels should be positive for credit performance. Despite these trends, weaker standards have led to higher consumer debt balances, higher debt service ratios and, ultimately, weaker credit performance.
- source Bank of America Merrill Lynch

While overall, we cannot conclude that it's time to panic in true Halloween fashion. You would be wise to remember that the interest rate for most credit cards is floating with margins benchmarked to the related bank card issuer’s prime rate. Therefore the expectation for higher interest rates could place pressure on credit metrics.

As we stated above, how many hikes it will take before the Fed finally breaks something? This is the question Wells Fargo tried to answer this question in their Interest Weekly note from the 25th of October entitled "Is Consumer Credit a Concern with Rates on the Rise?":
"Is Consumer Credit a Concern with Rates on the Rise?

Consumer credit as a percent of disposable income is at an all-time high. With the Fed expected to continue hiking rates, readers may be concerned that an uptick in defaults could have an outsized impact in this cycle.
Dig a Little Deeper
At first blush, the below graph may raise concerns among those who correctly notice that the outstanding amount of consumer credit is at an all-time high as a percent of personal income.

This concern is perhaps more amplified against the backdrop of a Federal Reserve that is prepared to raise the fed funds rate in December and continue tightening policy through 2018. And although not all consumer credit is attached to a floating rate, delinquency rates may be expected to pick up as new credit becomes more expensive to pay back.
However, while the ratio in the top graph does has some interesting implications, it must first be acknowledged that this ratio includes a stock number (consumer credit) being divided by a flow number (disposable personal income). A stock refers to the value of a series at a point in time while a flow refers to the total value of the series over a period of time. Thus, stocks and flows are not easily comparable and therefore are not always useful in deriving conclusions.
Instead, we turn to the debt service ratio (below chart), which compares the flow of consumer credit to the flow of disposable personal income over the same period.

In this instance, the most recent data point is well below the all-time series high reached in late 2001. Despite the relatively subdued debt service ratio, the recent upward trend since 2013 is worth monitoring. The growing amount of auto and student loans being financed with credit is partially responsible for this trend as payments for these consumer debt categories continue to become due. Interestingly, the debt service ratio for mortgages has not seen an increase despite a modest rise in the federal funds rate. The fact that fixed-rate mortgages are much more common than adjustable-rates mortgages is perhaps partially responsible for the recent trend difference. Mortgage payments are consistent regardless of the interest rate environment, whereas credit card rates are largely floating.
Household debt delinquencies, largely, are still continuing their downward trend (bottom graph).

The exceptions to this are student loans, which have been essentially flat since 2013, and auto loans, which have slowly climbed for 12 consecutive quarters. As we have stated in past pieces, we do not think the auto loan market poses a threat to household finances, as auto loans comprise just 9.2 percent of total household debt. Additionally, as the Federal Reserve continues to tighten policy we would not be surprised to see delinquency rates modestly tick up and loans with floating rates become marginally more difficult to pay back. However, if the Fed continues to raise rates in the ‘slow and steady’ manner in which they have over the past year, then a sharp uptick in consumer debt delinquencies will likely not occur, all else equal, as Fed policy would likely lag income gains." - source Wells Fargo
When it comes to assessing credit, the distinction between stocks versus flows is paramount. We have made this point on numerous occasions. What matters is the rate of change of credit.

Yet, higher consumer debt balances and higher debt service ratios, make this cycle particular vulnerable to a sudden change in the narrative. As well with credit risk and duration risk extended thanks to the Euphonists at the Fed, there is a potential for heightened risk if, as we mused last week there is a sudden unexpected return of the "Big Bad Wolf" aka inflation. Put it this way, there is a very small margin for error or for a "policy mistake", the interest rate buffer is razor thin.

We are clearly not there yet. We have remained short-term "Keynesian" given the large inflows pouring into various asset classes, while longer term we do remain "Austrian". The "wealth effect" from the Euphonium has globally lifted all boats but, in our book a credit cycle's length is around 10 years. We still believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome.

While we have pointed out for the risk of an unexpected return of inflation which would trigger some acute repricing and renewed volatility as discussed last week, we also pointed out that Financial Stability matters for the various Euphorists. So far the investor crowd has been oblivious to the change of tune of their baritone-voiced brass instrument. When it comes to credit spreads, thanks to low rates volatility we are no doubt going to hit the level 11 on the amplifier in true Spinal Tap fashion.

  • Credit - Revisiting previous record tights thanks to the Euphonium
The beta rally has once again been very impressive since the market took a turn during the second semester of 2016 following a dismal first semester largely impacted by credit oil woes particularly in the High Yield sector. High beta returns so far this year have been impressive. Many are questions the hefty valuations levels reached in various asset classes. But thanks to the Euphonium tune, we do think records are made to be broken. The technical bid remain in place, particularly for the naysayer in European High Yield. This is due to the fact that there is a shrinking universe in the European junk bond market. This is the conjunction of several factors such as upgrades as well as a competition rateching up from the loan market. Bond-to-loan refinancings has the favor of private equity players coming back into play. Longer-dated fundings can be provided. This clearly shows that the table has turned at least in Europe thanks to the CLO market heating up creating a hefty demand for loans versus bonds. Structured credit is back into play.

On the subject of record being broken, while many eyes are watching the equity space march upwards, in similar fashion, things are heating up in the credit space hence our veiled analogy to a state of "Euphoria" developing in earnest. On this subject we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note entitled "Quantifying HY Risk Premiums"":
"Could we revisit previous record tights?
We do not take a sub-300bps HY spread forecast lightly. Many things need to go right for this projection to materialize and any one of them going wrong could upset it. And yet when we look at the macro environment as it exists today, we can’t help but think we are in this rare goldilocks scenario which could deliver such an unusual outcome. In a recent interview, Michael Milken described the current market environment as the “golden age for private equity”(See Bloomberg News, a story by Steve Dickenson, “Michael Milken Says Private Equity's ‘Golden Age’ Will Continue”, September 14, 2017). He went on to qualify this description by pointing out the ease at which issuers can presently get leverage in the market and borrow without covenants, allowing PE firms to achieve very unusual rates of return at times of low yields and tight spreads.
As we listened to that interview, we caught ourselves thinking how long it has been since we last heard someone in a similar position of authority and respect in our market describe it in these words. It has been about ten years or so, if memory serves us well. 
And so this is where we think the market finds itself today: as open and as supportive of credit risk, as it was in the last couple of years of the previous credit cycle. With many new deals coming as oversubscribed and priced at the tight end, we think the “golden age” description of today’s capital markets feels appropriate. Taken a step further, if one defines a default trigger not as a fundamental balance sheet issue but instead as mostly a liquidity event (in which a weak issuer is finally cut off from its ability to refinance or close a negative cash flow hole by issuing new debt), then in our opinion today’s environment presents little opportunity to see many defaults materialize. It is not that there are not enough overlevered balance sheets out there, but rather that the market is willing to provide leverage and do so on issuers’ terms.
A two-handle HY spread goes against our consciousness as long-term investors, and our best judgment of long-term value, and yet it appears appropriate in the context of the one year forecasting horizon. In fact, a question we have heard on a number of occasions recently is if the market is so accommodative, volatility remains low, and defaults continue to be rare, what is it going to take for us to retest all-time tights? It is going to take time.
This view has a precedent in the last cycle, where it took three-plus years after the volatility collapse in late 2003 for us to reach the tights in spreads in early 2007 (see the distance between grey and yellow vertical lines in Figure 7).

It has been almost two years since the last time we had a major spike in volatility in late 2015/early 2016; thus, we think time is still on our side." - source Bank of America Merrill Lynch
This "goldilocks" low rates volatility environment is exactly what is needed to have a "golden age for private equity". This could lead of course to a return of significant LBO transactions which would no doubt create anxiety for bond investors given their propensity in impacting significantly CDS spreads. Do you need to dust up the LBO screeners used in the heyday of the credit excesses of 2006-2007? Probably.

Although some sell-side pundits are pointing towards exhaustion in spread compression, we do believe that we can go further. Wells Fargo in their Global Macro Credit Outlook from the 25th of October points towards spread compression running out of steam:
- source Wells Fargo

With close to $11 trillion in negative-yielding bonds globally, you have a strong technical bid in place thanks to the mesmerizing tune from the "Euphonium". As we stated many times, the "wealth effect" is leading to flows going where all the "fun" is, namely the bond market, not really downhill, towards the "real economy", making the US recovery pretty tame in this cycle thanks to central banking meddling with asset prices. 

A lot of foreign flows into US credit are "Made in Japan". Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. Bondzilla the NIRP monster is "is a critical support of US credit markets. As we posited in our conversation "The Butterfly effect", during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. As pointed out by Wells Fargo in their report, demand for US Corporate Credit remains incredibly strong thanks to the Euphonium:
- source Wells Fargo

Strong demand, strong earnings, strong economic data, you have the recipe for a final melt-up. This bull market will continue to be the most hated bull market in history even though we agree that one can rightly question the fundamental basis of the rally thanks to a credit binge induced by the Euphorists. So, sorry for the perma-bear crowd, this hated rally, unfortunately, for the frustration of many, has more room to go as per our final charts. 

  • Final charts - Keep up with the "melt-up" play the Euphonium via options
The Euphorists are still keeping the dancing at the party with their loud music, although they have started to withdraw some of the alcohol within the credit punch, but at a very slow pace, still making the investor crowd properly inebriated. Thanks to the Euphonium and the central banking euphonists, as per our final charts, should you want to keep up with the "melt up" in equities, you might want to think about playing it through cheap options as indicated in our final charts from Bank of America Merrill Lynch from their Global Equity Volatility Insights from the 31st of October entitled "The equity melt-up may have already occurred given today's low vol":
"Sharpe Ratios near 80yr extremes suggests using cheap options to capture US equity upside
While US equity returns over the last 12 months have been far from historical highs, the Sharpe Ratios of US equities are in fact near 80-year highs for the Dow Jones Industrial Average and not far behind for the S&P 500 – a consequence of today’s near-record low volatility and low interest rates. With equity Sharpes in such “rare air” and option costs near all-time lows, we like using SPX call spreads to capture potential US equity upside into year-end with limited risk.
  • A melt-up in US equity Sharpe Ratios: Over the past 12 months, the Dow Jones Industrial Average has rallied nearly 29% (not including dividends) on 7% realized volatility, good for a Sharpe Ratio of 4 (Chart 7).

  • Since 1935, the 12M Sharpe Ratio of the Dow has been higher only 1% of the time. Similarly, the S&P 500 has recorded a Sharpe of 2.8 over the past 12 months (96th percentile; Chart 8) while generating a relatively pedestrian 12M return of 21% (77th percentile; Chart 8).

  • Moreover, with a 12M Sharpe of 2.5, the Nasdaq 100 is approaching Tech Bubble peaks in risk-adjusted returns despite nominal returns only ¼ as large.
 Ultra-low vol turning good equity returns into historically great Sharpes:
  • The common factors transforming today’s good equity returns into stellar Sharpe Ratios? Historically low equity volatility and interest rates. Chart 9 isolates all historical 12M periods since 1935 in which the S&P 500 recorded a Sharpe Ratio of at least 2.8 (= S&P Sharpe over the past 12M).

  • Among these “high Sharpe” periods for US equities, the most recent 12M period has witnessed the lowest S&P 500 price return and nearly the lowest realized volatility in history. The last historical period with higher S&P 500 Sharpe Ratios was the mid-1990s (Chart 9); while realized volatility was also in the single digits, this occurred against a different macro backdrop of flat to falling short-term interest rates (Chart 11).

  • One has to go back to the early-1960s to find a period with (i) Sharpe Ratios exceeding today’s levels, (ii) equity volatility as low or even lower on a sustained basis, and (iii) a gently rising rates cycle (Chart 10).
Extremes in Sharpe motivate using cheap options to capture further upside:
Interestingly, the mid-1990s and mid-1960s featured the three longest streaks on record of consecutive trading sessions without a 5% or more pull-back in the S&P 500 (the current streak of 339 days is fourth-longest). Curiously, the eventual 10% sell-off that ended the 387-day streak in June-1965 seemed largely driven by sentiment rather than fundamentals. Given today’s equity Sharpe Ratios are in “rarefied air”, we continue to advocate using historically cheap options to capture upside with less risk. For example, owing to low volatility and flat call skew, S&P 500 3M 40-delta / 10-delta call spreads (roughly 2600/2700 ref. 2573) cost 1%, near the lowest level recorded since Jan-2001 (Chart 12).
- source Bank of America Merrill Lynch

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. As a bonus chart to illustrate further our Euphonium analogy, the final chart below comes from Credit Suisse Gobal Cycle Notes from the 31st of October and is entitled "To Euphoria and Beyond":
"Our credit risk appetite index has moved into euphoria, and a further surge in global IP growth would, based on history, make a full-fledged global risk appetite euphoria much more likely. Of course, euphorias need not be driven by higher risky asset prices alone. Falling safe asset prices – that is, rising yields – can lead to the same place."  -source Crédit Suisse

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."
There you have it, the euphonists have been playing louder, the investor crowd is already intoxicated and even if they have been removing some of the alcohol content from the credit punch bowl, some drunk punters are still dancing to the loud music coming from the euphonium. Unfortunately they remain oblivious to the fact that some are already leaving the dance floor, but we ramble again...

"This world's a bubble." -  Saint Augustine
Stay tuned!

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