Thursday, 19 July 2018

Macro and Credit - The Decoy effect

"In a time of universal deceit - telling the truth is a revolutionary act." - source unknown

Looking at our home team (France that is) getting away with the Football World Cup for a second time in 20 years (1998-2018) hence our lack of recent posting, 8 being a lucky number it seems, we were drawn again to the parallel with 1998 with the ongoing Emerging Markets (EM) woes, whereas this time around, Asian countries are in much better shape, including Russia, while the usual suspects (Turkey, Argentina and Brazil and even South Africa) are still feeling the summer heat from the Fed's liquidity drain thanks to QT. With the escalating rhetoric of trade war between China and the US and the strong arm negotiating tactics from the Trump administration, when it came to select our title analogy, we decided to go for a marketing one, namely the "Decoy effect". In marketing, the decoy effect (or attraction effect or asymmetric dominance effect) is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. An option is asymmetrically dominated when it is inferior in all respects to one option; but, in comparison to the other option, it is inferior in some respects and superior in others. In other words, in terms of specific attributes determining preferences, it is completely dominated by (i.e., inferior to) one option and only partially dominated by the other. When the asymmetrically dominated option is present, a higher percentage of consumers will prefer the dominating option than when the asymmetrically dominated option is absent. The asymmetrically dominated option is therefore a decoy serving to increase preference for the dominating option. The decoy effect is also an example of the violation of the independence of irrelevant alternatives axiom of decision theory. Of course, it is a great tool to use when one relates to trade negotiation we think but we ramble again...

In this week's conversation, we would like to look at the rise in inflation, and trade war escalation and the impact in can have on global growth as well. Also, overweight US relative to Emerging Markets (EM) and the rest of the world, continues to be the trade du jour, with FANG still racing ahead in the rally game. 

  • Macro and Credit - Deglobalization goes hand in hand with inflation
  • Final chart - Credit versus Equities - "until death do us apart"

  • Macro and Credit - Deglobalization goes hand in hand with inflation
While we thought the ratcheting up of the trade war narrative would be bullish for gold, latest price action with the continuation of the surge in the US dollar has put a dent on this scenario playing out so far. Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple. 

Given it seems that US inflation expectations are moving upwards it seems, we like US TIPS particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment. At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument eventually. Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. 

If inflation creeps up, then companies will suffer margin compression and will be forced to raise prices which will lead to wage increases to compensate that higher price level. We have pointed in the past that trade wars could lead to a stagflationary scenario playing out, meaning lower growth and higher inflation. Are tariffs really the culprit leading to higher inflation? On that subject we read with interest UBS Global Strategy note from the 18th of July entitled "What will drive TIPS in the 2nd half?":
"What about tariffs? Do they matter? It matters much more for growth than inflation
As discussed by our economics team and shown in Figure 4, Laundry equipment prices have jumped by 12% above their January level following the implementation of 20% tariffs in early February.

That said, its impact on headline inflation is very small because of its less than 0.08% weight in CPI. Nonetheless, this clearly shows tariff do have an effect on near-term inflation. Since these early tariffs, US has implemented additional 25% tariffs on $50bn of products from China and the President has proposed 10% tariffs on an additional $200bn of imports from China with other investigations going on in parallel. Thus the scope of tariff tensions is much larger now. We estimate that the current set of announced tariffs would push up consumer prices by roughly 15bp, but with notable uncertainty on both the upside and downside. We discussed ramification of various upside tariff scenarios on growth/inflation and financial markets in Trade Wars- What is the impact on growth, inflation and financial markets? A Top Down View. Albeit, we view this document more as the upside risk scenario than our current baseline; based largely on a lower effective autos tariff and smaller Chinese retaliation is somewhat less.
Specifically, in the aforementioned note, we discuss the following scenarios and their impact on GDP inflation. The 1st scenario is ("Escalation") 25% car tariff (US/global retaliation plus an additional 10% tariff on $200bn US-China trade with proportional retaliation. In the 2nd scenario ("Trade War"), we assume 30% tariffs on virtually all US/China trade + earlier car tariff disruption. In Figure 5, we see that under the trade "Escalation" scenario, we would see near-term inflation rise by 31bp and real GDP fall by 100bp.

In Scenario 2 – "Trade War", we see inflation rising by 71bp and real GDP falling by 245bp. A key takeaway is that the hit to real growth is much larger than rise in inflation on trade tariffs. For details on these estimates, please see the Q-Series. Next, we consider what is the TIPS market priced for and how they could react to escalating trade tensions.
Is the TIPS market pricing in trade dynamics correctly?
The TIPS market is right in reacting trade war by not widening breakevens but by lowering long-end real yields. 5y and 10y real yield have declined by 3bp and 9bp since early June while 5y and 10y BEIs barely moved (Figure 6).

On the inflation impact, we think the market already seems to be priced for our escalation scenario. In Figure 7, we see that 2y ex-energy inflation (which is close estimate to implied core inflation) has risen quite sharply this year. It's near 252bp if you assume  240bp as consistent with target CPI inflation.

The market is implying that the US may have up to 10-15bp/annum of trade related inflation over the next two years. In our trade escalation scenario, we see 31bp inflation uptick over 1-year. This would imply about 15bp tick-up in 2-year core inflation and market seems to be pricing such an uptick. Thus, the market is fairly priced for the inflation uptick. For growth hit due to trade "escalation", we should have seen a bigger decline in real yields. 2y yields are basically unchanged over the past few months, which suggest the market is not assuming a growth hit at this juncture. Thus, for increasing trade concerns, we recommend receiving front-end real rates, or set up 2s5s real curve steepeners which we discuss later in the note. In general, the market is not priced for a "trade war" scenario on both real yields and breakevens." - source UBS
It seems to us that the market has been a little bit too complacent for a trade war scenario playing out. At least with TIPS with the embedded deflation floor, you have some downside protection should the global slowdown scenario play out thanks to escalating tensions. With this known unknown, we do think that the long end of the US yield curve (30 years) at current levels remains enticing from a carry and roll down perspective. We have recently started to add exposure to it on a side note.

But, in respect to the inflation risk, US inflation is creeping up, no doubt about it. This is clearly illustrated by Wells Fargo in their Economics Group note from the 11th of July entitled "Producer Prices: More Inflation to Come":
"Producer prices for final demand rose 0.3 percent in June, which was slightly stronger than expected. Core prices continue to climb higher as U.S. producers are facing rising input costs.
Broad Increases in Producer Prices in June
  • Inflation continues to gradually climb higher, with the producer price index advancing 0.3 percent in June. Gains were broad based, with food being the only major category to see prices slip.
  • Excluding food, energy and trade services (measured by margins), prices increased 0.3 percent. That pushed the year ago rate of our preferred measure of core PPI back to 2.7 percent, which is up from 2.1 percent last June.

Processing Input Cost Increases
  • Input costs continue to rise as capacity has become more constrained and businesses are grappling with tariffs. Processed intermediate goods increased 0.7 percent in June and are up 6.8 percent over the past year. While higher energy costs have led the pickup, non-energy materials for manufacturing and construction are up 6.5 percent since last June. Service inputs are up, led by fuel and labor shortages driving transport costs higher.

- source U.S. Department of Labor and Wells Fargo Securities 

June PPI report showed an acceleration in the price appreciation with year over year PPI at 3.4% and year over year core PPI coming at 2.8%. With year over year CPI up to 2.9%, meeting estimate, Core CPI printed at 2.3% beating expectations. It might be the case of the US economy running hotter than anticipated? We wonder. Wage growth are essential to validate this prognosis we think. For some other pundits such as Knowledge Leaders Capital, "The Inflation Story is Alive and Well in Five Charts".

As we pointed out in our previous conversation "Attrition warfare":
"The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off.
To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.
While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income."- source Macronomics, July 2018
This raises the question about inflation and the US consumer in general and the price at the pump in particular. What is the pain threshold one might rightly ask? On that subject we read with interest Bank of America's take in their US Economic Watch from the 11th of July entitled "High pain tolerance at the pump":
"Higher gas prices a partial offset to tax cuts benefits
Gasoline prices are up around 50 cents since the start of the year and currently hovering nationally around $3, owing to tightening global oil supply and demand balances. Our calculations suggest that the recent rise in gasoline prices increases the average cost to the consumer by $30 per month. So far, this has had limited impact on overall consumer spending as most consumers have been able to offset higher prices at the pump with the extra income from tax cuts. According to the Tax Policy Center, the median consumer is receiving roughly an extra $78 per month due to tax cuts this year.
The breakeven price: $4/gallon
At what point would higher gas prices fully offset the tax cuts? We would likely need to see oil prices jump another $60 per barrel (bbl), adding about $1 per gallon to gasoline prices. This would increase the cost of gasoline almost $60 per month, effectively wiping out the extra income from tax cuts for most consumers.
Of course there could be effects beyond these simple calculations. A common rule of thumb from Hamilton (2008) is that an oil “price shock” is when prices go above the highest level in the last three years. That seems to be happening now, although we are still below the highs of 2011-14 (Chart 1).
Francisco Blanch and team see upside risk to their crude oil price outlook should sanctions on Iranian oil exports prove binding. Higher gasoline prices could lead to “sticker price shock” at the gas pump, causing consumers to pull back spending more than one-for-one. An additional downside risk comes from the fact that the “gasoline tax” is regressive and has a bigger percentage impact on low income families (Chart 2).
From the oil rig to the gas station
Translating moves in crude oil prices to gasoline prices is fairly straight forward. According to the Energy Information Administration, crude oil represents about half the retail cost of gasoline. Indeed, looking at the relationship between the % mom in Brent oil prices and % mom in gasoline prices, we find a coefficient of roughly 0.5 suggesting that a 10% increase in the price of crude oil would be associated with a 5% increase in the price of gasoline (Chart 3).

Currently, a $60 boost would amount to a 75% increase in crude oil or 37.5% increase in gasoline prices. With gasoline currently near $3, such a shock would increase prices at the pump by over an additional $1.
From the gas station to the consumer’s wallet
Vehicles on the road in the US consumed, on average, 55 gallons of fuel per month in 2016 according to the Federal Highway Administration (Chart 4).

To put this into context, for a compact car or a medium size sedan, this works out to be a full tank of gas per week. Demand for gasoline is relatively inelastic so we can safely assume no demand response from an oil price shock in the short run. Therefore, the run up in gasoline price since the start of the year would cost the average consumer around $30 per month.
We think most consumers have been able to offset the latest increase in gasoline prices. According to the Tax Policy Center, with the exception of the bottom quintile, taxpayers are receiving at least a $30 tax cut per month due to the Tax Cuts and Jobs Act (Table 1).

However, further boost in gasoline prices could ultimately offset most of the tax cut benefits. For example, another $1 per gallon at the gas pump would cost another $60 dollars per month. All told, the extra $90 per month spending at the gasoline station would be enough to offset tax cuts for majority of consumers.
From the consumer’s wallet to consumer behavior
While demand for gasoline is relatively inelastic, marginal propensity to consume out of gasoline (dis)savings is likely greater than 1. That is, a rise in gasoline prices will force consumers to substitute away from other categories more than one-for-one and vice versa. For example, Gicheva et. al. (2007) find that gasoline expenditures rise one-for-one with gasoline prices but consumers substitute away from food services toward  groceries in order to partially offset higher gasoline expenditures. Moreover, they find that even within grocery spending, consumers substitute away from regular price products and towards promotional items. On the flip side, Alexander and Poirier (2018) calculate that the marginal propensity to consumer out of the gasoline savings in 2014- 15 was greater than 1 with most of the spending going toward discretionary spending. The upshot is that most consumers have so far absorbed higher gasoline prices in stride but further increases at the gasoline stations could start to broadly hurt consumer demand." - source Bank of America Merrill Lynch
While everyone and their dog is focusing on the flattening of the yield curve, we would rather focus on inflation creeping up and in particular oil prices as a potential lethal trigger for asset prices and a bear market to ensue. Clearly we are not there yet, but we think that the "decoy effect" of the flattening of the yield curve hides the fact that trade war rhetoric is weighting on both consumer sentiment as well as leading to higher PPI. At some point these factors will weight on growth. The continuous surge in the US dollar means that EM are still in a painful situation. In that context, cash has returned as a valid yielding tool in the allocation toolbox and so are US Tips. As we stated above the long end of the US yield curve remains enticing.

Maybe the second part of the year will favor the return of the duration trade versus the high beta. This is what Bank of America Merrill Lynch mentions in their Credit Derivatives Strategist note entitled "A bull and a bear" on the 19th of July:
"European growth headwinds, trade wars and Italian risks are taking over last year’s goldilocks. With manufacturing PMIs in Italy, Spain and France at 53 and inflation risks to the downside, this is still an environment of a patient ECB on rates. Investors are concerned about an inflation shock; we think we are far from there. The potential for an
“Operation Twist” and slower macro can flatten the curves both in cash and synthetics. We think that the CDS market is offering an attractive entry point for longs on the backend of the curve. We screen for the best singles to sell protection.
To offset our bullish view on duration we hedge the market direction with bearish risk reversals in Crossover. If trade wars escalate, growth could be hit more, and higher beta pockets would be more exposed. The recent flattening of the implied vol skew and spread tightening finds bearish risk reversals (own puts/payers vs. selling calls/receivers) attractive to own.
Softer macro = lesser risk of a hawkish ECB
Macro indicators have slowed down in Europe this year versus the high run-rate of last year. In particular, manufacturing PMIs across Europe have headed lower and inflation is only slowly recovering.
But what a slower macro backdrop means for yields and yield curves more specifically? We are using the OECD Major 7 Leading Indicators and we try to define the relationship between the economic cycle and the cycle of yield curve. In chart 3 we present a z-score analysis (in order to normalise patterns for the underlying vol and levels) and we find that there is meaningful correlation between the macro cycle and the cycle of the yield curve.

When the macro indicators improve (deteriorate) yields tend to steepen (flatten). This reflects the higher growth potential and thus the stronger outlook for inflation going forward and that ultimately is priced in via higher back-end yields and steeper curves. Should the ECB remain dovish, yield curves are more likely to continue to be under pressure, we think." - source Bank of America Merrill Lynch
Whereas the first part of the year has been great for high beta in credit and US equities, with Investment Grade lagging. There could be a possibility if the trade rhetoric escalates to see lower growth, meaning a return of the duration trade in the second part we think. One thing for sure 2018 has seen a clear divergence between equities and credit as we shall see in our final chart.

  • Final chart - Credit versus Equities - "until death do us apart"
In 2018 US high beta has had a better success than US Investment Grade credit which has been punished. EM equities have suffered as well relative to US equities in stark comparison to what unfolded in 2017. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 18th of July entitled "Going separate ways":
"Credit and equities are two sides of the same coin. However, while equities by now have rallied to within 2% of the highest close of the year (S&P 500), high grade credit spreads are 33bps, or 37%, off the 90bps tights from earlier in the year (Figure 1).

Given the timing of the beginning of this decoupling in May, clearly one of the drivers was the Italian risks that developed during the month. Given the outsized importance of the financial sector in credit, and the reliance on funding markets and bank balance sheets in fixed income, such sovereign risks should intuitively drive a wedge between debt and equity market performance. However, we think the most important driver of credit market underperformance is the shift in US monetary policy from quantitative easing – QE – toward quantitative tightening - QT (see: On the road from QE to QT, redux 15 June 2018). Mechanically that means less demand and associated widening pressures on credit spreads during times with supply pressures, as we have seen a number of times this year. From that perspective we consider the wider credit spreads an early indicator of more struggles to come as the level of global monetary policy accommodation declines in coming years." - source Bank of America Merrill Lynch
So the big "decoy effect" might be at play, are equities too high relative to credit or credit too wide relative to equities? We wonder.

"It is discouraging how many people are shocked by honesty and how few by deceit." -  Noel Coward, English author

Stay tuned ! 

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