Thursday, 8 November 2018

Macro and Credit - Stalemate

"In life, as in chess, forethought wins." - Charles Buxton, English public servant

Watching with interest the outcome of the US midterm elections in conjunction with a divided congress leading somewhat to a gridlock, as well as the tentative rebound in Emerging Market equities, when it came to selecting our title analogy, we decided to go again for a chess analogy on this very post (see previous chess analogies: "Zugzwang", "The Game of The Century"). "Stalemate" is a situation in the game of chess where a player whose turn it is to move is not in check but has no legal move. The rules of chess provide that when stalemate occurs, the game ends as a draw. During the endgame, stalemate is a resource that can enable the player with the inferior position to draw the game rather than lose. In more complex positions, stalemate is much rarer, usually taking the form of a swindle, a ruse by which a player in a losing position tricks his opponent, and thereby achieves a win or draw instead of the expected loss. A swindle in chess only succeeds if the superior side is inattentive. Stalemate is also a common theme in endgame studies and other chess problems. The outcome of the US midterm elections gridlock could create short term what we would call "Goldigridlock", namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. In conjunction with the return of buybacks following the blackout period of earnings, then, this obviously could be bullish equities wise we think, with high beta pulling ahead until the end of the year. For credit, we are not too sure, given a fall in oil prices with definitely put pressure on the high beta CCC bracket of US High Yield and its well documented exposure to the energy sector but, we ramble again...

In this week's conversation, we would like to look at what the US midterm election stalemate entails of asset prices in general following a very much "red October".

  • Macro and Credit - Goldigridlock for asset prices? 
  • Final charts -  The invisible hand is fading...

  • Macro and Credit - Goldigridlock for asset prices? 
The month of October was clearly a bloodbath for many asset classes and diversification didn't offer protection. While the velocity in real rates as we pointed out in our previous conversation forced a serious repricing of the Fed "put" at a much lower strike, the fact that it was a blackout period thanks to earnings reporting season and lack of buybacks, being another strong pillar in US equities rally seen in recent years was enough to wreak havoc on global markets on the back of weaker US equities. Looking at the below performance chart from Bank of America Merrill Lynch for the month of October can clearly see that, indeed, “misery loves company”:
- source Bank of America Merrill Lynch

As we pointed out in our final chart in our mid-October conversation "Under the Volcano", 2018 has marked the return of large standard deviations move, typical of late cycle behavior in conjunction with rising dispersion. 

What we also find interesting (H/T Driehaus on Twitter) is that 89% of asset classes tracked by Deutsche Bank have a negative total return YTD in USD terms. This is the highest percentage on record since 1901. Last year just 1% finished without negative total return:
- source Deutsche Bank - Driehaus Twitter feed

2018 is indeed a year where volatility and large standard deviations move have staged a comeback as the US Federal Reserve is trying to exit the stage with its Quantitative Tightening policy (QT) and its continuing hiking process. US Employment and wage growth likely to trigger another hike in December from the Fed. That’s a given. Total nonfarm payroll employment increased by 250,000 in October vs. 190,000 expected. Over the year, average hourly earnings have increased by 83 cents, or 3.1 %. Fed will remain hawkish.

With the "Stalemate" with the latest US midterm elections, what are the implications for asset prices, one might rightly ask?

First thing we would like to look at given the recent bounce from Emerging Market equities with Brazil leading ahead the bounce thanks to the hope brought by the presidential elections is the trajectory for the US dollar and what it means for "high beta". On that subject we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of November entitled "Midterm outcome":
"FX: a split Congress is bearish USD, but downside could prove limited
As we have argued, tonight’s split Congress outcome should result in dollar weakening. We think this could continue for a while yet as the first order effects of US growth deceleration and increasingly-limited monetary policy support cause a reevaluation of long USD exposure. Ultimately, second order effects could limit USD downside; however, we think that markets are likely to focus on first order effects for now.
Initially, we expect a weaker USD predicated on a further softening in US growth leading to reduced monetary policy support. US growth deceleration from the 2Q high water mark should continue as intense political gridlock precludes new stimulus measures, putting the prospect of a Fed move beyond neutral in doubt for now absent convincing evidence of inflationary pressure. Indeed, our US economics team is forecasting a gradual US growth deceleration toward 2% (around potential) by the end of next year, alongside a largely-benign inflation profile. While a Fed move beyond neutral was never in the market (the Fed is still priced to end the cycle at around the long-term median dot of 3%), a move above neutral looks increasingly less likely given the new information set. Thus, interest rate support for USD looks asymmetrically skewed to the downside, and the market’s expectation for Fed hikes next year (currently about +50bp) is at risk of compression, in our view. Positioning is net long USD – particularly in the riskier parts of the FX spectrum (Exhibit 1).

Diminished rationale for USD longs and a potential relief rally in markets post-midterm resolution suggests liquidation flow driving USD lower. Finally, we would expect modestly higher USD risk premium – reflecting a state of political acrimony in DC – to provide an additional headwind to the dollar. That said, because the Senate has remained Republican-controlled, we do not expect a material spike higher in USD risk premium arising from the expectation that House leadership could successfully remove the President through impeachment.
Looking beyond the initial reaction, however, we think that potential second round effects could serve to limit USD downside. Successful resolution of the present state of global trade policy uncertainty has become more challenging, particularly if President Trump’s negotiating position has been weakened as we suspect may well be the case. To be sure, the evolution of global trade policy uncertainty is critical to the global economic cycle. Reduced prospects for a speedy end to this uncertainty, and indeed increased risks of further deterioration, add to downside global growth risk in our view. Although hardly a recession story, US deceleration represents a potential negative impulse to the already-sagging global economy. An increase in risk aversion as markets anticipate a global downturn could thus broadly support the dollar. Finally, on a brighter note, compromise on US economic stimulus later next year is possible due to potentially overlapping interests. Democrats seem to be advocating an increase in infrastructure spending, and the President may well seek to prime the economy in advance of his 2020 reelection bid. If ultimately successful, this should support USD as it could lead to a renewed bout of US cyclical and monetary policy divergence.
Historical parallels suggest gridlock is not always so benign
The consensus among investors is that a gridlock is a benign outcome for markets. We think this may be overly optimistic. In our view, the most relevant historical precedent for the next half year may be the months following the mid-term elections of 2010 that resulted in the same configuration in Washington as the latest elections (with the President’s party controlling the Senate but the other party controlling the House). In 2011, the Republicans, upon regaining control of the House, used the debt ceiling as a lever to demand budget reduction by the Obama administration. The brinksmanship that ensued raised concerns in the market of a possible default by the US government which led to a sharp sell-off in risky assets as well as a major rally in rates (10y Trsy yields falling from 3.7% in March 2011 to 1.8% by September). The USD came under considerable selling pressure during the same period as foreign investors avoided US assets (EUR/USD rose from 1.30 in January to 1.48 by July that year). The market turmoil around the US debt ceiling crisis probably exacerbated the Eurozone sovereign crisis that occurred later that year (which saw the euro surrendering all of its earlier gains).
With the House Democrats having stated their intention to open new investigations against President Trump and with the 2020 presidential election campaign kicking off very soon, we see greater chances of brinksmanship than cooperation. History suggests that brinksmanship could mean lower rates and lower USD." - source Bank of America Merrill Lynch
With growing downside risk for growth with a notable deceleration in Europe and in global trade, there is indeed potential scope for the US yield curve to start flattening again. A conjunction of a flatter yield curve would be positive for the long end of the US yield curve and a falling US dollar would enable Emerging Market equities to continue to rally in the near term we think.

Second point, the recent fall in oil prices is as well putting some pressure on US breakevens as of late, meaning that for now a scary inflation spike has been avoided but, nonetheless, healthcare inflation, namely acyclical inflation is something to monitor closely as indicated by Bank of America Merrill Lynch in their US Economic Viewpoint note from the 5th of November entitled "Inflation in pictures":
"No scary inflation monsters
  • Procyclical inflation has moved sideways over the past year, despite the unemployment rate improving by half a percent to 3.7%. The muted inflation response highlights the flattening in the Phillips curve.
  • In No fear of an inflation curveball, we evaluated whether there was a kink in the Phillips curve at full employment. We find some, but not strong evidence, and therefore believe a strong cyclically-driven breakout in inflation is unlikely.
  • While procyclical inflation has been flat, acyclical inflation has picked up, healthcare in particular. We expect healthcare inflation to continue to accelerate, driven by hospital services.
  • In No inflation monsters under the bed, we looked at the disaggregated PCE components and found that there was an increasing share of PCE that has moved into a “low inflation” (0-2%) bucket, and a dwindling share in the “high inflation” (5-10% bucket).
  • This shift in inflation dispersion is illustrative of a structural move lower in inflation. A lower trend decreases the probability of an inflation breakout.
  • Digging into the components, we found that healthcare services accounts for much of the shift. As healthcare inflation picks up going forward, we may see some reversal of the shift, albeit into the more moderate 2-5% inflation range.
  • Another reason to expect only a gradual pickup in inflation is because of inflation expectations, which have drifted lower over the cycle and serve as an anchoring point.
  • In particular, University of Michigan 5-10yr inflation expectations have descended to a trend of 2.5%. The central tendency has also consolidated closer to the median, mostly from the 75th percentile. This indicates a greater decline in those expecting high inflation.
  • Given core inflation is likely to run above target by next year, inflation expectations could improve, presenting upside to the outlook. But even with some improvement in expectations, inflation upside would likely remain contained." - source Bank of America Merrill Lynch
In our recent conversation we hinted that housing was in earnest starting to turn "South" in the US and that housing affordability was becoming a headwind on top of US consumers using their savings and increasing their use of the credit card to maintain their consumption level. Both auto and housing, which are very cyclical in nature are clearly showing the late stage of the credit cycle in our book.  

One segment where spending rises with age is healthcare (out-of-pocket and government). Healthcare will account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases.  This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further:
- graph source Macrobond

Sure falling oil prices bring some relief to the US consumers but rising healthcare costs as well as housing costs will not be sufficient to offset the risk of "stagflation". We could see lower growth ahead and even looming recession risk.

As we pointed out in our recent conversation "Ballyhoo", Main Street has had a much better record when it comes to calling a housing market top in the US than Wall StreetIf you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:
- graph source Macrobond
Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder.

As pointed out by Lisa Abramowicz on her Twitter feed, you need going forward to monitor closely in the months ahead the rise in inventory of new unsold homes:

"The inventory of new unsold homes in the U.S. has reached the highest level since 2011, as measured in months of supply." - source Lisa Abramowicz, Twitter
In a response to Lisa's Tweet, M&G Bond Vigilantes made the following important point on Twitter:
"If you saw the Lisa Abramowicz tweet about inventory of new unsold homes reaching 7 months, you should worry. Historically that level is consistent with GDP growth of zero. This chart is from our 2007 blog."
- graph source M&G Bond Vigilantes - Twitter

Housing has always been a leading indicator in the United States when it comes to forecasting GDP growth.

To illustrate further the rift between Main Street's much more sanguine view of housing than Wall Street we would like to point towards Wells Fargo's take on the weakness in home sales from their Economics Group note from the 7th of November entitled "Home Sales Remain Soft":
"The Softening For-Sale Market Has Been Good for Apartment Owners
The magnitude and speed at which home sales have weakened is surprising, following just a three-quarter of a percentage point rise in mortgage rates. We suspect the problem is a lack of affordable product in the markets where potential home buyers would like to live. This helps explain why sales turned down well ahead of this fall’s rise in mortgage rates. The lack of inventory in desirable markets is a function of how highly concentrated economic growth has been in this cycle. Two industries, technology and energy, have accounted for a disproportionate share of job growth. While job gains have broadened more recently, a larger proportion of the high-paying, creative industry jobs are being added in submarkets closer to the central business district. By contrast, job growth in suburban markets has been slower to recover and wage gains have lagged for many occupations that are at greater risk of automation and outsourcing.
The rapid growth in higher value-added positions closer in to many major cities has fueled a housing crunch that has sent home values and rents soaring in many rapidly growing markets. The lack of developable lots closer in to the city has fueled growth of in-fill developments and teardowns, which have often removed more affordable homes from the market. The resulting battles over gentrification have also led to some political blowback, which has stymied development in some areas. Growth is also creeping back out toward the suburbs, particularly those that are developing their own urban cores. What has largely been missing, however, has been the push to develop exurban areas, where land has historically been less expensive. Such development has remained elusive, as higher development costs have largely offset any savings in raw land costs.
The same trends impacting home sales are evident in the rental market. Demand remains strong for amenity-rich apartments located near the city center or in the metro area’s second or third largest employment centers. Demand for apartments further out in the suburbs has taken longer to recover but has been doing better more recently, reflecting stronger job growth and an acceleration in wage gains. The suburbs have generally seen less development, so the improvement in demand has pulled vacancy rates lower and pushed rents higher. New suburban development remains elusive, however, and most new projects continue to cluster around pricier submarkets closer to the central business district.

We have further reduced our forecasts for home sales and new home construction following the recent string of weaker housing reports and downward revisions to previous data. We still see new home sales increasing over the forecast period but now look for just 5.6% growth in 2019 and 5.3% growth in 2020.

Much of that increase will come from more affordable homes in the South and West, which will restrain new home price appreciation. With little inventory, new home construction will continue to gradually edge higher. Apartment development is now expected to remain stronger for a little longer. There are a great deal of projects in the pipeline and a large number of proposed projects that have not yet moved forward. Demand for well located projects should remain strong, but vacancy rates will likely rise as job growth moderates in 2019 and 2020."  - source Wells Fargo
We do not share the optimism above relating to new home construction due to affordability issues coming from rising mortgage rates due to the Fed continuing its hiking path, their views being supported by the most recent employment report. Housing affordability has become a headwind, no wonder in some parts of the US prices are starting to cool down as indicated by Bloomberg on the 30th of October in their article entitled "Mortgage Rates Are Pushing U.S. Homes Out of Reach":

"While U.S. home prices have gained almost 60 percent since March 31, 2012, according to the S&P Corelogic Case-Shiller 20-City Composite Index, household income is up a little less than 30 percent in the same period, Bureau of Economic Analysis data shows. The average rate for a 30-year fixed mortgage rose from about 3.85 percent at the start of 2018 to about 4.74 percent now, reports. Next year, it’s expected to rise further.
A buyer with a $2,500 monthly housing budget has lost almost $30,000 in purchasing power this year, according to Redfin Inc., a national brokerage.
In Orange County, California, more than 30 percent of homes for sale in the metro area would become unaffordable to buyers with a $3,500 monthly budget, Redfin estimates. In San Jose, that number would be almost 40 percent." - source Bloomberg
Housing markets turn slowly then suddenly...Just a thought.

While the US elections stalemate and the return of buybacks should be supportive, US markets for many years have been levitating and defying gravitation provided by the central bank support. This support has been obviously fading during the course of 2018 with QT as per our final charts below.

  • Final charts -  The invisible hand is fading...
If October has been murderous for various asset classes thanks to the conjunction of several factors such as the velocity in the rise of real rates, blackout period leading to smaller buybacks, escalating tensions in the trade war narrative between the United States and China as well as Italian worries, our final charts from Bank of America Merrill Lynch coming from their European Credit Strategist note entitled "The hunt for red October" from the 2nd of November clearly shows that the "invisible hand" coming from the central bank is fading:
"The end of the “invisible hand”…
Last month wasn’t unique, though. We think it reflects a bigger picture theme…namely that assets are now struggling to produce meaningfully positive returns in an era of less central bank liquidity. The “invisible hand” that once propped-up market prices is now significantly smaller.
Chart 1 shows that there are precious few assets that remain above water this year. In fixed-income land, US leveraged loans have produced total returns of around 4%.

In Europe, many government debt markets – with the exception of Italy – are up for the year, albeit only by a modicum. But note that the biggest loser of all during the QE era, namely cash, has turned into one of the best performing assets of 2018 (1.5% total returns).
…the start of abnormal markets?
This spectrum of returns, however, is also far from normal. Chart 2 shows the historical percentage of assets with positive vs. negative returns on a yearly basis (our sample contains over 300 equity, fixed-income, commodity and FX indices). 

This year, we find that only 23% of assets have produced positive total returns. As can be seen, historically this is a very low number. In fact, such a number is usually only observed in periods of financial crises (2008), debt crises (2011), or just plain old recessions. And yet despite the shocks and bumps lately, the global economy is still humming along fairly nicely in 2018.
In our view, after such a big drawdown last month, markets are likely prepped for a rebound in November. Yet, we caution that bounces in risk sentiment could still be shallow ones. After all, with so many assets trending lower this year, long-only investors are finding that there are much fewer ways to help them diversify and protect their portfolios." - source Bank of America Merrill Lynch

One could argue that, no matter what "stalemate" we have reached in the United States midterm elections, the "fall" in the fall is surely indicative that at some point winter is coming. Could housing woes be seen as leaves already falling? We wonder...

“How did you go bankrupt?" 
Two ways. Gradually, then suddenly.” - Ernest Hemingway, The Sun Also Rises
Stay tuned!

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