Macro and Credit - Fuel dumping

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." -  Arnold H. Glasow, American author

Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("Dissymmetry of lift" in August 2018, "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). 

Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. 

As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal yet it seems that as we pointed out in our October conversation "Explosive cyclogenesis":

"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks.

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense". "- Macronomics, October 2018

The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".

In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...

Synopsis:

• Macro and Credit - 2019: "Mean" mean reversion?
• Final charts  - What the Fed see and what they don't...  

• Macro and Credit - 2019: "Mean" mean reversion?

In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.

In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":

"More outflows and no more CSPP

Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.

Over the past week…

High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. High yield funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.

Government bond funds recorded an inflow this week, the 2nd in a row. Meanwhile, Money Market funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.

European equity funds recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.

Global EM debt recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.

On the duration front, mid-term IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch

 When the trend in outflows is not your friend...

As per our November conversation "Zollverein", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per LeveragedLoan.com outflows have been significant and accelerating in the asset class:

"Leveraged loan funds log record $2.53B outflow

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.

This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.

Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.

The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com

If this isn't "fuel dumping" then we wonder what it is:

"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg 

- graph source Bloomberg

It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".

For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "Zollverein":

"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch

 Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:

"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."

- source Bloomberg - Lisa Abramowicz - twitter

Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.

But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":

"Executive Summary

The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth

Stress Appears in the Leveraged Loan Market

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1).

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities 

Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the  past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.

Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?

Does the Leveraged Loan Market Have Broader Macro Implications?

When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?

Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. 

Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.

C&I lending accounts for less than 20% of total bank credit. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well.

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.

In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, the overall financial health of the non-financial corporate sector has deteriorated over the past few years. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.

Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth." - source Wells Fargo

After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.

Yet, when it comes to C&I loans, change in the last three months have been significant we think:

- graph source Bank of America Merrill Lynch

As we mused in our conversation "Ballyhoo" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".

This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":

"Getting ahead of the shocks

One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”

To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2).

The shocks are run individually through FRB/US and sustained through the simulation period.

The results of the stylized exercise are presented in Table 1. There are several points worth noting:

• Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.
• The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.
• Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2
• The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.

What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch

While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "The Amstrong limit" was probably lucky:

"Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.

We wondered at the time if we had reached the "boiling point". In retrospect we did.

The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "Bold Banking" we used another aeronautics reference:

"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013

For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.

• Final charts  - What the Fed see and what they don't...  

With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":

"Caught Between A Rate Hike and A Hard Place

Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.

The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.

Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.

The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.

The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo

It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...

We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.

as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Stay tuned !

Macro and Credit - Mithridatism

"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus

Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. 

The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. 

For example, the Australian Koalas' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:

Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed 

While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend Carl Hodson-Thomas Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.

In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.

Synopsis:

• Macro and Credit - 2019: When the central banks are no longer your "friends"...
• Final chart -  Did the Fed already break something?

• Macro and Credit - 2019: When the central banks are no longer your "friends"...

As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:

"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter

Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "Investors Bet $10 Billion Against Popular Bond ETFs":

"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ

Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence.  The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "Zollverein" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.

Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):

"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.

Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said."

 - source Financial Times

There is more pain to follow we think in 2019. As we pointed out in our November conversation "Zollverein", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":

"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:

- source Bloomberg - Lisa Abramowicz - twitter

The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.

In their most recent blog post on the 12th of December, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:

"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple

In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.

The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:

"Outflows have now erased the QE flow

Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE.

The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.

Over the past week…

High grade funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. High yield funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. 

Government bond funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, Money Market funds suffered again a large outflow, though half the size of last week’s.

European equity funds continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.

Global EM debt recorded a large outflow this week, the 9th in a row, in sharp contrast
with the improving trend we saw during the past 7 weeks. Commodity funds recorded a
marginal outflow.
On the duration front, we saw outflows across the entire curve, though mid-term IG
funds led the trend by far." - source Bank of America Merrill Lynch

So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.

When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:

"The Toxic Brew that threatens near term…

Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019.

2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years.

3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001.

Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch

So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.


While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.

• Final chart -  Did the Fed already break something?

Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:

- source Bank of America Merrill Lynch

Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...

 "The true alchemists do not change lead into gold; they change the world into words."- William H. Gass

Stay tuned !

Macro and Credit - The Sorites paradox

"Even the largest avalanche is triggered by small things." - Vernor Vinge, American writer

Looking at the pre-revolutionary mindset of my home country France, with Paris under siege as we warned about in our conversation "Last of the Romans" in mid-November, in conjunction with the very fast fading rally seen on the back of the United States and China trade war truce, when it came to selecting our title analogy given liquidity is continuing to be withdrawn by the Fed's QT, though as of late it seems they blinked, with softer global macro data including US housing, we decided to go for "The Sorites paradox". The "Sorites paradox", sometimes called the paradox of heap is a paradox that arises from vague predicates. A typical formulation involves a heap of sand, from which grains are individually removed. Under the assumption that removing a single grain does not turn a heap into a non-heap, the paradox is to consider what happens when the process is repeated enough times: is a single remaining grain still a heap? If not, when did it change from a heap to a non-heap? A common first response to the paradox is to call any set of grains that has more than a certain number of grains in it a heap. If one were to set the "fixed boundary" at, say, 10,000 grains then one would claim that for fewer than 10,000, it is not a heap; for 10,000 or more, then it is a heap. A second response attempts to find a fixed boundary that reflects common usage of a term. So the question is when is a bubble a bubble? When will QT turn the bubble into not a bubble? We wonder. Is hysteresis being the dependence of the state of a system on its history the answer? Equivalent amounts of sand may be called heaps or not based on how they got there. If a large heap (indisputably described as a heap) is slowly diminished, it preserves its "heap status" to a point, even as the actual amount of sand is reduced to a smaller number of grains. For example, suppose 500 grains is a pile and 1,000 grains is a heap. There will be an overlap for these states. So if one is reducing it from a heap to a pile, it is a heap going down until, say, 750. At that point one would stop calling it a heap and start calling it a pile. But if one replaces one grain, it would not instantly turn back into a heap. When going up it would remain a pile until, say, 900 grains. The numbers picked are arbitrary; the point is, that the same amount can be either a heap or a pile depending on what it was before the change. Also, one can establish the meaning of the word "heap" by appealing to consensus. The consensus approach typically claims that a collection of grains is as much a "heap" (or bubble) as the proportion of people in a group who believe it to be so. In other words, the probability that any collection is considered a heap is the expected value of the distribution of the group's views aka a "Quasitransitive relation", but we digress.

In this week's conversation, we would like to look at why it is increasingly important to play much more defensively as we move towards what could be a jittery 2019.

Synopsis:

• Macro and Credit - Don't be the last one left to pick up the "credit" tab...
• Final chart -  Liquidity and credit spreads go hand in hand

• Macro and Credit - Don't be the last one left to pick up the "credit" tab...

Looking at yesterday drop of 3.10% of the Dow Jones as we pointed out in our last conversation, it wasn't really that surprising given the weakening decelerating tone in global growth in general and cyclicals such as Autos and Housing in particular:

"Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end." - source Macronomics, November 2018

As well we pointed last week that if you wanted to go "short" credit, then US leveraged loans were definitely something to look at as pointed out by Lisa Abramowicz on a Twitter feed:

"Prices on leveraged loans have dropped to the lowest since 2016 even though their benchmark rate Libor has quickly risen, meaning this debt should pay out higher interest rates. This throws into question the concept of floating-rate debt as a hedge against rising rates.

 On one hand, loan investors get more income from their holdings as rates rise. On the other, the market seems to perceive the corporate borrowers as less creditworthy as their cost of financing rises. So if loan investors want to sell their holdings, they'll get a lower price." - graph source Bloomberg - Lisa Abramowicz - Twitter feed.

Indeed, liquidity is as always a "coward" and the longer you stay at the "credit" bar, the likelier you are to be shocked by "price discovery" when the credit markets will in earnest turn "South" and you will end up picking an expensive bar tab hence our call for reducing your illiquid high beta exposure.

While leverage loans are an evident target pointed out by so many investor pundits, regulators and central bankers in these days and ages, other interesting instruments such as AT1s aka called Contingent Convertibles (CoCos) as well as Corporate Hybrid bonds fit the bill when it comes to being potentially "illiquid" and harmful. Sure it's fun on the way up, pretending to generate "alpha" for your clients by playing the "beta" pure carry game, but, when the party has been extended as it has been in credit land, then again, not starting to be a little bit more "cautious" is a good recipe for asking for trouble and finding it eventually through "price discovery".

On the subject of "illiquidity" and credit we read with interest JP Morgan's Portfolio Insights note relating to the evolution of market structure. Their paper is entitled "Managing illiquidity risk across public and private markets":

"In theory, investors are compensated for this through the higher returns available in private assets over the full life cycle of the private investment. In other words, to harvest the illiquidity risk premium in private markets, investors need to be able to stay the course, weathering any variation in the cash flow profile over the full cycle. This means that cash calls would need to be funded from elsewhere in the portfolio.

The ability to accept this type of risk ranges widely across investor types. Those that may be subject to redemptions or fund withdrawals (e.g., mutual fund managers) are less able to bear uncompensated illiquidity risk than those with a long- term pool of capital to deploy (e.g., sovereign wealth investors). Further, during times of market crisis, when investors are already seeking to cut exposure to public markets, threats to liquidity are generally correlated and can compound to become a serious issue for investors. Investors could face liquidity demands arising from redemptions and a prudent desire to hold higher portfolio cash buffers. At the same time, on the private asset side there may be cash calls to finance, calls that are best covered from public assets — and thus, avoiding uncompensated illiquidity traps in public markets becomes a priority. To fully assess the illiquidity risk in a portfolio, all of these factors need to be considered holistically.

Taking high yield (HY) bonds as an example of a potentially illiquid public asset with both market and illiquidity risk, we can ask whether, over a defined time horizon, the probability of being forced to crystallize a loss under adverse liquidity conditions is appropriately compensated (see Addendum, “Modeling the cost of high yield trading under illiquid conditions”). Early in the economic cycle, when credit spreads are wide, the illiquidity premium in an asset such as high yield  credit may well offer an additional return compared with a replicating stock-bond portfolio. However, as the cycle matures and credit spreads tighten, there will come a tipping point — some breakeven level of spread — where the return in credit is not sufficient to offset the probability-weighted risk of a loss over a defined time horizon. Effectively, the illiquidity risk has at that point become uncompensated and investors may be better served expressing their desired level of market risk via a replicating stock-bond portfolio.

The scale of the potential illiquidity during times of market stress is demonstrated in Exhibit 8, again using HY credit as an example. The illiquid credit asset will suffer from wider bid-ask spreads and much reduced transaction volumes; large transactions can take considerable time to execute in markets where prices are dropping sequentially over multiple trading sessions.

Turning to private market assets, as investors have increasingly added private assets to portfolios there is commensurately more focus on the risk that they could be forced to liquidate private investments at an inopportune time to meet an additional capital call. Alternately, redemptions and other portfolio-level cash requirements may force them to exit private investments at an undesirable point. Since such events tend to occur during adverse conditions in public markets and the economy at large, the most relevant question is how bad things might really get." - source JP Morgan

Exactly, large positions can take a long time to unwind, particularly when dealer inventories are nowhere near to the level they had prior to the Great Financial Crisis (GFC).

Also as another illustration of what it would take to liquidate a sizable position of $1 billion in US High Yield in the case of a recession and where credit spreads should be to reflect that "illiquidity" premia would be significantly wider as pointed out in JP Morgan's note:

"For an investor that may need to liquidate $1 billion of high yield and anticipates any crisis to be average in its severity, credit spreads above around 270bps compensate for illiquidity risk. But if the investor’s subjective view of the probability of recession over the next year were to increase to 33%, then the breakeven credit spread required to compensate fully for illiquidity risk would jump to 320bps and as high as 398bps in a worst-case drawdown scenario. As portfolio size increases — and the potential illiquid asset trade size grows — the ex-ante breakeven spread required to compensate for illiquidity risk increases. Crucially, there is no economy of scale for illiquidity risks and, indeed, there are very apparent diseconomies of scale." - source JP Morgan

Given the significant rise in corporate credit issuance in recent years, one could conclude that current credit spreads do not reflect this "illiquidity" premium.

But, given that the Fed seems to have recently "blinked" recently following a more dovish tone at the Economics Club of NY by Jerome Powell, one could indeed think that there is still value for "credit" pickers even in US High Yield. We have long argued that as dispersion is rising in this late cycle environment, proven credit specialists in the issuer selection process would outperform the passive investment crowd. 

This effectively could dampen slightly the widening moves seen recently. On this subject we read Wells Fargo's take from their Credit Connections note from the 30th of November entitled "Honey B's":

"Credit markets continue to groan under the pressure of policy uncertainty (both monetary and fiscal), trade wars, a recent upsurge of idiosyncratic events and heavy bond supply. That said, secondary market credit spreads appear to be stabilizing after Fed Chairman Jay Powell struck a more dovish tone at his recent presentation to the Economic Club of NY. The shift was subtle and nuanced, but enough to convince markets that the Fed may slow the pace of policy tightening in the coming months. With credit spreads at year-to-date and multi-year wides, we recommend that investors start to set up for 2019 with select longs in credits poised to deleverage next year and beyond. Triple-B and double-B credits look particularly attractive to us in this environment.

The build-up of debt, increased borrowing costs and tighter monetary policy suggests that a growing number of companies will need to focus on deleveraging and balance sheet repair next year to preserve credit ratings and ensure ongoing access to capital markets. While this might not be great news for the economy it should certainly help the overall credit worthiness of the corporate sector and allow credit spreads to compress (somewhat) after a year of sustained widening. Conversely, those companies that cannot or will not address balance sheet issues will find a much less forgiving investor base and considerably higher borrowing costs. In this environment credit selection is paramount.

Funding Pressures

When considering which companies have the greatest urgency to deleverage it is helpful to look at the distribution of debt maturities. The term structure of maturities is a simple analysis to look at when companies are faced with refinancing pressures. At a high level, the amount of refinancing risk faced by IG companies is considerably greater than the risk faced by HY companies over the next three years. As the charts below show, about $2.2 trillion of investment grade debt is scheduled to mature 2019-2021.

This represents about 30% of all outstanding IG debt, with roughly 53% owed by non-financial companies and 47% owed by banks, insurers, financial companies and REITs. Maturities steadily climb over the next three years and peak in 2021 with about $800 billion of debt scheduled to mature. This stands in sharp contrast to HY. Over the same period, about $250 billion of HY debt scheduled to mature represents about 15% of all outstanding HY debt. In fact, next year HY maturities total just $40 billion.

Considering HY companies have issued about $175 billion of debt this year, refinancing pressures look particularly light next year. As a result, in the aggregate, HY companies look better positioned than IG companies to deal with tighter monetary conditions and higher interest rates over the next few years." - source Wells Fargo

Though, as pointed out by Morgan Stanley in our recent conversation, the effect of widening credit spreads on the unemployment rate is significant and positive:

"every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal." - source Morgan Stanley

The most important chart going forward? Jobless Claims vs. Job Cut Announcements (trend forming?):

- Graph source Bloomberg

Leading indicators of initial unemployment claims rose again last week to 234K (and 220K consensus) from 224K with 4 week average up to 223 K from 219K. (up from 211K average in Q3. Take notice of this! 

So from a "Sorites paradox" perspective, if wider spreads impact unemployment going forward due to balance sheet deleveraging, earnings and profitability matter as well when it comes to predicting a surge in defaults rates as highlighted by our friend Edward J Casey in his November credit commentary:

"Probability of nonfinancial corporates is a key driver of the default rates

Nonfinancial profits gained $66.2 billion in the third quarter. The annual pace of gains increased to +8.2% from -8.3% two years ago.

The US default rate declined to 3.2% in October and is expected to improve to 2% in next year.

Since the recession corporate profits have grown +8.6% annualized, well ahead of GDP of +2.3%.

One driver behind profit growth has been the massive expansion in corporate debt which has grown by +4.3%, nearly twice the pace of real GDP.

Cumulatively nonfinancial profits gained +115% compared to GDP of +23% and corporate debt of +46%." - source Edward J Casey

In our "credit" heap of sand, grains are individually removed thanks to the Fed's QT, the one question that remains is which grain will trigger the avalanche?

So if illiquidity is not "priced" correctly in credit and valuations are considered "lofty" from a consensus approach perspective, then again one may rightly ask when will it break? As pointed out by Edward J Casey, it is all depending on corporate profits rolling over, watching earnings in 2019 will be paramount:

"Equity valuations continue to outpace corporate profits. The ratio of profits to equity market cap declined to 7.7%

With credit yield headed higher, corporate profits will be facing a headwind of higher net interest expenses.

On prior occasions spikes in the cost of debt have been coincident with annual gains in corporate profits rolling over" - source Edward J Casey

If wages growth continues to accelerate in conjunction with earnings coming under pressure, then equities valuations in 2019, could be "repriced" much lower, just saying.

And when it comes to earnings we are closely watching the space. We read with interest Bank of America Merrill Lynch's Revision Ratios report from the 30th of November entitled "More cutting, less raising":

"Earnings Revision Ratio

US joins the rest of the world in negative revisions

In November, the 3-month earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest decline since April and the lowest level in nearly two years. A ratio of below 1 means more cuts than raises to earnings estimates, and this is the first time in over a year-and-a-half that analysts have taken down estimates. The US has caught up with the rest of the world with more cuts than raises. Trends have decelerated since early 2018 following tax reform as we expected, but the ratio now sits just a hair above its long-term average. We use the 3m ERR as one of five inputs in our market outlook: an above-average ratio has generally preceded strong near-term returns, whereas a ratio below average has signaled more muted near-term returns (Chart 2).

•  In November, the three-month (3m) earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest monthly decline since April and the lowest level in nearly two years.

• With the ratio now below 1.0, this suggests more cuts than raises to earnings estimates for the first time in over a year-and-a-half.
• The ERR sits just slightly above its long-term average of 0.87.
• The more volatile one-month (1m) ERR similarly fell to a two-year low of 0.73 from 0.77.
• The ratio is below 1.0, suggesting more cuts than raises to earnings estimates for the second consecutive month.

• In November, all sectors (except Staples) saw their 3m ERR moderate (Chart 1). Energy, Real Estate, and Technology saw the biggest deterioration.

• Most sectors are now seeing more cuts than raises to earnings estimates amid widespread deterioration in revision trends. Energy, Utilities, and Tech are seeing slightly more positive than negative revisions to earnings estimates.
• Utilities is the only sector with an above-average ERR, while the ratio is in line with the historical average for Financials, Health Care, Industrials, and Technology.

•  Similarly, throughout November, most sectors except Utilities and Technology saw more negative than positive revisions to estimates.

• Energy, Materials, and Comm Svcs had the weakest one month revision trends.-" source Bank of America Merrill Lynch

On top of the deteriorating picture for "earnings", in their report Bank of America Merrill Lynch also added the following in their report:

"Bad breadth in credit? Distress ratio ticks up

We watch revision ratios closely because “breadth” measures can sometimes be early indications of broader issues within markets. Our High Yield team’s distress ratio – the percentage of US high yield bonds with an option-adjusted spread above 1000bp – has similarly proven to be a good leading indicator of defaults. This ratio has recently worsened, and now sits at a 10-month high." - source Bank of America Merrill Lynch

Because we do not like this picture we think from a "Sorites paradox" perspective you should continue to reduce your high beta exposure and rotate from growth to consumer staples equities wise, also reduce your financials subordinated pocket (until and if a new LTRO is announced by ECB), and continue to raise cash levels and park it in the US front-end of the curve. We think as well that recent moves in the long end of the US yield curve looks enticing, we are looking at the 30 year bucket and long dated zero coupons given that the "deflationista" camp seems to make a comeback with global growth clearly decelerating.

As we pointed out earlier in our conversation, QT is indeed reducing the size of the credit heap (bubble). Trade accordingly as per ouf final chart below.

• Final chart -  Liquidity and credit spreads go hand in hand

The tone in credit spreads has had a weaker tone in recent weeks on the back of significant outflows from mutual funds as the Fed has been continuing to withdraw liquidity in the system with QT. Our final chart comes from CITI European Portfolio Strategist note from the 22nd of November entitled "Post QE World - Bear Market, Bull Market or Kangaroo Market" and displays the relationship between central banks liquidity and Investment Grade credit spreads:

Liquidity and financial markets have been tied closely together

Citi credit strategists have shown a powerful relationship between net central bank purchases and moves in credit spreads and equity markets. By extension, reducing/reversing QE should drive credit spreads sharply higher and equity prices sharply lower. From our (equity) side, we argue that it depends very much on the nominal growth backdrop and the pace of tightening. Progressive tightening and an extending economic cycle are still likely to see credit spreads widen, but also are likely to support an extending profit cycle. Historically, there is a phase in markets where credit spreads widen but equity markets make fresh highs driven by rising EPS. This remains our base case, but we acknowledge the end cycle debate." - source CITI

Sure it was a fun and exciting long credit party but from our perspective and in respects to the "The Sorites paradox" and the risk of an avalanche, we would rather start in earnest to play "defense" given 2019 might prove to be even more problematic for risky asset prices than 2018. Just saying... 

"The one certainly for anyone in the path of an avalanche is this: standing still is not an option." - Norman Davies, British historian

Stay tuned !