Monday, 10 June 2019

Macro and Credit - The Numbers Game

"Nobody trusts anyone in authority today. It is one of the main features of our age. Wherever you look, there are lying politicians, crooked bankers, corrupt police officers, cheating journalists and double-dealing media barons, sinister children's entertainers, rotten and greedy energy companies, and out-of-control security services." - Adam Curtis
Watching with interest the trade war escalation with Mexico, leading to de-escalation, triggering more volatility in already jittery markets, in conjunction with more dovishness expectations from Central Banks, and with the prospect of the introduction of the so-called “mini-BOT” scheme, named after Italy’s Treasury bills in Italy, when it came to selecting our title analogy in continuation to our previous Chinese game of "Banqi" reference, we decided to go for the Italian game of the "Numbers Game". The numbers game, also known as the numbers racket, the Italian lottery, or the daily number, is a form of illegal gambling or illegal lottery played mostly in poor and working class neighborhoods in the United States, wherein a bettor attempts to pick three digits to match those that will be randomly drawn the following day. For many years the "number" has been the last three digits of "the handle", the amount race track bettors placed on race day at a major racetrack, published in racing journals and major newspapers in New York. 

What we find of interest, before we enter our usual "Macro and Credit" musing is that closely related is a policy, known as the policy racket, or the policy game. 

There is more to our title that meet the eye given Peter Navarro wrote in 1984 (the famous "dystopian" year) a book entitled "The Policy Game: How Special Interests and Ideologues Are Stealing America". 

Peter Navarro being Trump's top trade adviser we find it interesting in the light of the current trade war developments to look more closely at his change of views as put forward by AXIOS in June 2018 in their article entitled "Peter Navarro's radical transformation":
"People think of Peter Navarro, the top White House trade adviser, as President Trump’s mind-meld on tariffs — the most hardline protectionist in the White House. But Navarro used to preach very different ideas in his early career as an economist.
The bottom line: In his 1984 book, "The Policy Game: How Special Interests and Ideologues are Stealing America," that's no longer in print — Axios got a copy from a university library — Navarro sounds a lot like the very administration officials he's sparred with on trade policy. And he argues that tariffs will inevitably send the global economy into crisis.
We asked Navarro what prompted the radical change in his views, and he explained how he went from a free trader to an economic nationalist. In response to "The Policy Game," specifically, Navarro told Axios:
It borders on the comical that Axios would spend so much time on a book written 34 years ago and completely ignore the insights of my later works like the 2006 Coming China Wars, the 2011 Death By China, and the 2015 Crouching Tiger.  Together, these books explain at length why the globalist Ricardian free trade model is broken and urgently needs fixing in the name of both the economic and national security of the United States.
— Peter Navarro
From the book...
"The clear danger of this trend [protectionism] is an all-out global trade war; for when one country excludes others from its markets, the other countries inevitably retaliate with their own trade barriers. And as history has painfully taught, once protectionist wars begin, the likely result is a deadly and well-nigh unstoppable downward spiral by the entire world economy.
If the world is, in fact, sucked into this spiral, enormous gains from trade will be sacrificed. While such a sacrifice might save some jobs in sheltered domestic industries, it will destroy as many or more in other home industries, particularly those that rely heavily on export trade. At the same time, consumers will pay tens of billions of dollars more in higher prices for a much more limited selection of goods. Sacrificed, too, on the altar of protectionism will be the very heart of an international world order that since World War II has successfully changed the aggressive struggle among nations for world resources and markets into a peaceful economic competition rather than a confrontational political or military one."— "The Policy Game," pg. 55
There are multiple passages in "Policy Game" that directly argue against Navarro's current positions. Navarro's go-to argument defending the White House's trade moves has been national security. In a June New York Times op-ed, he wrote:
"President Trump reserves the right to defend those industries critical to our own national security. To do this, the United States has imposed tariffs on aluminum and steel imports. While critics may question how these metal tariffs can be imposed in the name of national security on allies and neighbors like Canada, they miss the fundamental point: These tariffs are not aimed at any one country. They are a defensive measure to ensure the domestic viability of two of the most important industries necessary for United States military and civilian production at times of crisis so that the United States can defend itself as well as its allies."
But Navarro's own book topples that argument as well:
"On the benefit side, protectionism within certain basic industries like autos, steel, and electronics helps to create and sustain an industrial base that, in times of war or national peril, can be shifted to defense purposes, However, this national security argument — and the existence of any benefits resulting from protecting these industries — can be legitimately called into question for several reasons.
First, the existence of any sizable benefits rests on the assumption that import competition in our defense-related industries would not only reduce the size of these industries but also shrink them to the point where they would be too small to support our defense needs. The threshold of danger is a matter of some dispute. How big, after all, do our auto, steel, or electronics industries have to be to keep our borders safe? In spite of this uncertainty, few analysts would argue that import competition is likely to push a nation with as large and mature an industrial base as ours anywhere close to that threshold.
Second, it is highly possible that our defense capability might actually be enhanced — not damaged — by import competition. Without the umbrella of protectionism, our defense-related industries would be forced to operate at lowest cost, engage in more research and development, aggressively innovate to stay one step ahead of the competition, and modernize their plants at a faster pace. Thus, while import competition might shrink these industries, they would be leaner, tougher, more efficient, and more modern and in all likelihood outperform a bigger and inefficient (protected) version of those same industries.
On the national security cost side, the major effect of protectionism is to threaten the stability of the international economic order through a global trade war..."
— "The Policy Game," pg. 82
Navarro lauded the impact of tariffs on saving American jobs in a May op-ed in USA Today, writing:
"There can be no better way to make America — and American manufacturing — great again than to start to rebuild those communities of America most harmed by the forces of globalization. These new facilities will stand as shining testimony to the success of tough trade actions, smart tax policies and targeted worker-training programs."
But he warned against the harmful longer-run effects of tariffs on jobs in his 1984 book:
"American protectionism threatens employment and profits in the export-dependent nexus because it invites retaliation from our trading partners ...
From these direct and indirect effects, it is clear that over time, the major benefits of protectionism — more jobs and higher profits — are largely and perhaps completely offset by a reduction in jobs and profits in export and linkage industries and in those industries vulnerable to the 'end run.' Therefore, the argument that protectionism serves as a jobs and income assistance program must be discounted."
— "The Policy Game," pg. 79-80
And Navarro has emphasized that tariffs won't hurt American consumers, saying on CBS' "Face the Nation" in March that the Trump administration's moves' effect on the prices of consumer goods will be "negligible to nothing."
In 1984, Navarro held a very different view:
"The biggest losers in the protectionist policy game are consumers. Even here. however, 'consumers' do not constitute a monolith, for there are several different consumer categories.
Bearing the greatest burden of protectionism are American retail shoppers who pay over $70 billion annually in higher prices (and reduced consumption) for products ranging from autos, bicycles, and color TVs to shoes, shirts, and cutlery."
— "The Policy Game," pg. 65
We find it very interesting given we already discussed the trend of "de-globalization" in this blog on numerous occasions, particularly again in January 2018 in our post entitled "The Twain-Laird Duel":
"In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening.
Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". " - source Macronomics, January 2018
It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:
“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian
Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith
Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election.

For those wondering what comes next, as discussed in January 2018, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder.

We indicated in January 2017 in our conversation "The Woozle effect" the following:
"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017
This we think has the potential to happen in the coming week/months provided there is no deal between China and the United States. The trajectory of real yields matter when it comes to gold.

In this week's conversation, we would like to look at a potential turn in the credit cycle, given the very weak tone coming from the latest US employment report and nonfarm payrolls coming at 75 K on a back of the blunt use of tariffs as economic policy which is already neutering gains from tax cuts.

Synopsis:
  • Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.
  • Final charts - Fed it taking it "easy" not "easing" yet.

  • Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.
On the question of the "misuse" of tariffs as economic policy we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 7th of June entitled "How I nailed the May payroll bust":
"Today’s data is a warning to the Trump Administration about the misuse of tariffs as a blunt instrument of economic policy.  The uncertainty generated by the threats to global supply chains from China to Mexico discourages capital investment. The tariffs already in place have taken back almost the whole of Trump’s $930 tax cut for the average American family, according to research by the New York Federal Reserve. That explains why retail sales are growing just 1% a year in real terms.
America’s growth spurt during the past two years has been Donald Trump’s great success. Tax cuts and deregulation (as well as the promise of more deregulation) revived the animal spirits of small business and produced an employment boom. But the president’s reliance on tariffs threatens to undo his good work, and prejudice his chances for re-election in 2020.
Paradoxically, the terrible, horrible, no-good, very bad payroll report is very good news for equities. It will strengthen the position of those among Trump’s counselors who have warned him that tariff wars are bad news for the economy. Sadly, the equity market depends more on how the president reacts to economic news than on the economic news itself." - source David P. Goldman, Asia Times
Already the trade war rhetoric is taking its toll on employment levels with US automakers coming under pressure recently. From China to the U.K., Germany, Canada and the U.S., companies have announced at least 38,000 job cuts in the past six months. Auto demand is increasingly becoming collateral damage when it comes to the ongoing tensions between the United States and China. As we pointed out in our last conversation, Germany is greatly exposed to the rising tensions. This can be ascertained by the latest industrial production print for April falling by 1.9%, the most since August 2014 and four times more than expected. 

As well, inflation expectations have been trending down, particularly in Europe with oil prices down 22% since its April high and as we stated before, where oil prices go, so does US High Yield and in particular the Energy sector as per the below chart from Bank of America Merrill Lynch for the month to date returns for May 2019, with CCCs being highly exposed to oil prices woes (Energy sector = 20.4% of face value, 15.1% of market value):
- source Bank of America Merrill Lynch


As the trade war intensifies, this doesn't bode well for both CAPEX and employment levels. Leaders from G20 countries will convene in Osaka on June 28 and 29 and markets are hoping for a deal between China and the United States.

In a context of weakening macro data on top of exogenous factors such as rising geopolitical tensions, no wonder the Fed has adopted a more dovish stance leading to market pundits expecting significant cuts to come during the summer hence the significant bounce we are currently seeing on the back as well of the end of the most recent true "Mexican standoff".

But what about the inverted yield curve and the potential for a recession ahead of us, one might rightly ask. On this subject we read with interest Nomura's take from their Japan Navigator note number 826 from the 3rd of June entitled "Inverted yield curve in UST market and monetary policy conduct":
"Many FOMC members have indicated that they would allow inflation rates in the 2.0-2.5% range during an economic recovery, but they are not willing to use average inflation rates from the past to constrain future policy conduct. They have also stated that monetary policy should not be used to pop asset bubbles. We believe that this question of whether the Fed should tolerate an inverted yield curve in the UST market will be a critical subtextual theme (discussed below). However, we believe that Fed Chair Jerome Powell and other mainstream Fed officials do not buy into this idea.
We expect the US-China trade dispute to reach the next stage between 4 June and the G20 meeting on 28 June, where Presidents Trump and Xi could meet. We sense that with every day that passes, markets become more convinced that an agreement between the two countries will prove difficult and a fourth round of US tariffs is on the way. Nevertheless, semiconductor stocks, which are more likely to be directly influenced, began to halt their fall this week, which suggests that the market has priced this scenario in to a considerable degree.

We do not think that a fourth round of tariffs alone would have an impact sufficient to trigger a global economic downturn. Moreover, judging from the actions of Chinese policymakers, they seem to have determined that weakening RMB would represent a risk for China as well (due to capital flight), and there are no signs that they will guide RMB to weaker levels. Unlike many economists, we believe that if negotiations essentially break down and the US goes ahead with more tariffs, China will beef up its subsidies to export companies rather than taking measures aimed at expanding domestic demand, and in this case the damage to China and the global economy would be lower than a simple estimate premised on a reduction in Chinese exports and other countries serving as substitutes. This is because Chinese companies would absorb most of the hit from tariffs and continue to export goods. No matter how much China bolsters domestic demand measures, it is difficult to paint a growth strategy for China’s economy that does not depend on US markets. Moreover, from a US perspective, it is easier to play up a “success” if tariff revenue increases and Chinese companies, rather than US consumers, are forced to bear the load. This kind of scenario suggests a high risk that US rates, which have priced in an economic downturn, will rise. This upturn could occur when the US government officially announces a fourth round. At this point, we expect EM currencies and equities as well as USD/JPY and Japanese equities to rebound, so investors should prepare for this scenario.
If the Fed cuts rates to correct inverted yield curve, it would essentially be trying to fix a problem it created itself
The Fed’s dovish members, centered on Vice Chair Clarida, view an inverted yield curve in the UST market as an important sign presaging an economic downturn, and advocate policy conduct that would avoid such an inversion. In fact, if we look at the three economic cycles since 1980, the yield curve inverted, with yields on 3m Treasury bills higher than 10yr UST yields, followed by an economic downturn (Figure 2).

We believe this inverted yield curve is not simply significant as a sign, but also indicates a situation in which a deterioration in financial institutions’ earnings environment is likely to set off a credit crunch. However, there are many problems with simplifying this issue and arguing that monetary policy should be conducted to avoid an inverted yield curve. 1) Inverted yield curves occur when the market begins to anticipate a future rate cut, but the market tends to almost automatically move in this direction when the Fed sends the message that it will end rate hikes. 2) In past cycles, there has been a lag of at least six months to two years before the economy enters a downturn after the end of rate hikes (Figure 3).

3) There have been cases, such as in 1998, when the yield curve has inverted, but the yield curve has returned to normal levels as the economy recovered. In other words, if the Fed itself decides to cut rates to correct the yield curve, which inverted in response to the Fed’s own message, it would essentially be fixing a problem of its own making. Of course, if the Fed can accurately predict the economy’s cycle (i.e., even if it stops raising rates, an economic downturn in the near future is inevitable), the Fed could probably use policy to minimize the damage of an economic downturn. However, if this is not the case, a premature rate cut could exacerbate the asset bubble and worsen the damage done by a future economic downturn. In fact, in the aforementioned 1998 example, the IT bubble worsened after the Fed cut rates.
Does the bond market have better foresight?
In addition, the theory that an inverted yield curve leads to an economic downturn tends to lead to the erroneous perception and belief that the bond market is better at predicting the economy than equities and other risk assets. However, this is simply due to differences in these financial instruments, and does not indicate any particular capacity for judgment. While bonds tend to perform better in economic downturns and periods in which inflation is falling, most risk assets are just the opposite. As a result, in economic recoveries, risk assets, not long-term yields, tend to identify the signs of a recovery and rise accordingly. Moreover, as noted above, the time lag from the inverted yield curve to an economic downturn differs considerably depending on the cycle. For example, in the cycle in the 2000s, after the yield curve inverted (from July 2006), the economy continued to expand for almost two years, and during this period long-term UST yields fell and then rose again, reaching their highest point in this cycle (June 2007). The subsequent subprime (Paribas) shock in August 2007 all but guaranteed an economic downturn (it officially began in December 2007), and we very much doubt that bond market participants predicted this shock and acted accordingly all the way back in 2006, when the yield curve began to invert.
We believe 10yr UST yields peaked at 3.23% in this cycle, but…
In this cycle, we believe that the Fed raised rates last in December 2018 and 10yr UST yields peaked just before this, in November 2018 (3.23%). As a result, in this cycle as well, observers will likely credit the bond market with having predicted an economic downturn before the risk asset market and acting accordingly (with an inverted yield curve a sign of an economic downturn). However, the bond market has not already accurately predicted the kind of event or shock that would ensure an economic downturn, which we expect to occur in the future. We suspect that, while bond investors continue to price in a rate cut and test out the market, they will coincidentally reach this kind of event. The period of time from now until the economic downturn is not predetermined, and before this event occurs, we expect to see a period (2019 H2) in which the market reverses its excessive rate cut expectations. For this reason, we believe it would make sense to wait for 10yr UST yields to rebound to about 2.60% rather than chasing yields down to 2.30% and buying." source Nomura Japan Navigator No. 826 June 2019
From a tactical perspective, we do believe that the long-end of the US yield curve has been "overbought" and we are already seeing signs of exhaustion, so no surprise to see somewhat a pullback in our favorite proxy being ETF ZROZ (strips of 25 years plus zero coupon). As well, gold is also marking a pause which can be ascertained by a bounce in real yields and the "risk-on" tone prevailing today.

When it comes to our title and the "policy game" being played, we think we are far from any meaningful "cease fire" between the United States and China. Volatility will continue to run high we think and in that context, we continue to view quality credit such as US Investment Grade as more protective than currently high beta, which in the case of US High Yield is tied up to the direction of oil prices. 

As we stated before, we would rather continue playing it on the defensive side given the many uncertainties surrounding a potential trade deal. With this ongoing "Numbers Game", while we might see unfolding a tactical bounce, fundamentals are rapidly deteriorating with this lingering confrontation. On the potential outcome we read with interest CITI's take from their Global Strategy and Macro Weekly note from the 10th of June entitled "Trade Wars: Game Theory Suggests Escalation Risk is Underestimated":
"The uncertainty around the negotiations makes for a challenging backdrop for investors. Recession risk is rising. As our Global Macro Strategy team points out; the 3m10y yield curve inverted on a closing basis for the first time this cycle at the end of May. This, they believe, could start the clock towards a recession mid- 2020. The tailwinds of fiscal policy are fading. Trade wars could be the additional shock that break the resilience of global, and US, economies (see: Global Macro Strategy Weekly: Trade War = Recession).
The GMS team offers three scenarios: (i) a trade deal at the G20; (ii) no trade deal and no Fed easing and (iii) no trade deal and aggressive Fed cuts (75bp quickly). Our current assessment is that we are in Scenario 2 but may be transitioning to Scenario 3.
Scenario One: Trade Deal at G20
  • Equities sharply higher with EM significantly outperforming as so much more is priced here for slower global trade growth. SPX~2900
  • Yields higher, probably parallel shift higher or bear flattening. 10y yields ~2.5%
  • Gold lower, maybe $1300
  • USD lower with risk on but not much as Fed easing would likely be priced out to some degree.
Scenario Two: No Trade Deal and No Fed Cuts
  • Equities sharply lower, probable full scale bear market. SPX to 2350
  • Yields sharply lower with curve twist/ bull flattening. 10yr UST to 1.50%, maybe
  • lower
  • Gold higher. $1600+
  • USD higher bar JPY
Scenario Three: No Trade Deal, Fed Cuts (75bp or more)
  • SPX higher; new highs. Other equities mixed.
  • Yields lower with bull steepening 10yr UST 1.75-2.0%
  • Gold higher on lower rates and lower USD. Target $1500
  • USD lower as carry is eroded. EUR/$ 1.15
- source CITI

We think that, right now investors are displaying two cases of "overconfidence", one being the pace and number of rate cuts coming from the Fed, second being a clear resolution between China and the United States when it comes to this much discussed trade war. Fiscal policy results are starting to be obliterated by the blunt use as economic policy instrument of tariffs. They are being used way too much by the Trump administration and it is starting to bite, not only on the employment front but, as well on earnings.

Sure the Fed might be providing some much needed support to the strains already showing up in credit markets such as rising dispersion, but the continuation of the trade war could push the US economy and the rest of the world towards recession and led to a stagflationary outcome in conjunction with wider credit spreads and that would mean trouble ahead we think. We have not reached that point but, playing this trade war game into overtime is a recipe for disaster. In that context, gold prices look likely do well if the trade war escalates further. 

The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar. On the subject of the US dollar's trajectory we read with interest Deutsche Bank's take from their FX Special  Report note from the 5th of June entitled "What happens to the dollar if the Fed cuts rates?":
"We have been worried about global growth and have positioned our FX Blueprint portfolio accordingly for nearly a month now. But what happens if the Fed cuts rates as soon as July or September? How would this impact our views and what does this mean for the dollar? In this special report, we show that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker.
Near-term, the dollar almost always weakens in the run-up to Fed rate cuts. But dollar weakness usually does not follow through. We argue that the Fed would need to cut rates by at least 100bps for a sustained, large move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the dollar mixed with the JPY and CHF continuing to be the primary beneficiaries (they remain our favourite longs), Asia FX the primary casualty (we remain very bearish), and the EUR stuck, though vulnerable to a squeeze higher given market positioning.
If the Fed ends up cutting by a lot more, these conclusions would change however. In the event of a full Fed easing cycle, we would expect EUR/USD to head back beyond 1.20 and dollar weakness across the board, with the possible exception of Asia. Our portfolio at the moment is more closely aligned to the former, rather than the latter scenario.
Low growth tends to be good for the dollar
The dollar has been part of our defensive portfolio together with the Swiss franc and Japanese yen. Historically, the dollar tends to do well in global slowdowns. First, the US is one of the most closed economies in the world so that global slowdowns tend to be asymmetrically reflected in the rest of the world (chart 1).

Second, even though the dollar can’t claim the huge positive internal investment positions of the franc and yen (chart 2), it benefits from the shortage of dollar funding that has been well documented by the BIS, among others .

Fed rate cuts are not always bearish for the dollar
Does the dollar lose its safe-haven status when the Fed cuts rates? The short answer is, sometimes, but certainly not always. We start by looking at the last five instances of Fed easing. Two of these instances were Fed “insurance” cuts (1995 and 1998) while three were full-blown easing cycles (1989, 2001, 2007). The clear conclusion is that while the dollar nearly uniformly weakens into a Fed easing, the subsequent performance is far from consistent. Indeed, the dollar has ended up strengthening in 3 of the last 5 Fed easing cycles. The conclusion is valid for both EM and DM (charts 3 and 4).


What other central banks do matters
So, if Fed rate cuts are not a consistent driver of the dollar what else matters? The interest rate differential is a useful starting point. If the Fed is cutting but the rest of the world is cutting even more it may well be that interest rate differentials drive the dollar higher. This was indeed the case during the 1995 and 1998 insurance cuts which saw rates move sharply in favour of the USD even though the Fed cut (chart 5).

Is this a risk today? Highly unlikely. The US- rest of world differential is already sitting at record extremes and almost every other DM central bank is constrained by the zero lower bound. If the Fed is cutting rates, the rate differential should be worsening for the dollar.
The level of rates also matters
Is a narrowing interest rate differential enough to turn the dollar? It is a necessary, but not a sufficient condition. Take 2001 when the Fed started an easing cycle and rates collapsed against the USD. The dollar continued rallying for a year until it finally turned. What helped? First, the absolute level of US rates which made the dollar a high-yielder (chart 6).

Second, the continued strength in the US basic balance, with the dollar only peaking once the US current account deficit turned sharply wider and the dollar became a low yielder (chart 7 and 8).

Indeed, the broad dollar cycle tends to be more correlated to the absolute level of US yields that the relative changes.
Lessons for today
The dollar is in a remarkable global position today holding the developed world’s highest yields. Never before in the history of free-floating FX has the dollar held such a preeminent position. How much does the Fed need to cut for this to stop being the case? Assuming other central banks follow the forwards, the Fed would have to cut rates by 125-150 bps to a little below 1% for the dollar to lose its high-yielding preeminence. With the rates market pricing a terminal Fed funds of 1.3% we are still one or two rate cuts away from that level. This of course also assumes that central banks with high rates such as the RBA and RBNZ would not cut more than the forwards.
An alternative approach to answering this question is to look at when the dollar lost its sensitivity to changes in yields, i.e. when did the absolute level of rates start dominating over the changes in the rate differential? Looking at the beta of EUR/USD to the EU-US rate differential we note that the sensitivity of rates to FX peaked in 2017, just when the 5-yr rate differential crossed 2%. This differential is now back at 2.3%  so we are still about 30bps away from the relative changes in yields reasserting themselves in importance. Overall, we reach a similar conclusion to the previous analysis: we need to price 1 or 2 more cuts for the level of US yields to again become "low".
Two other important observations
Interest rates aside we would make two other observations. First, the developed market dollar is already at the upper end of its historical valuation bounds (chart 9).

Valuation is a powerful medium-term anchor and a natural constraint to further dollar appreciation. The conclusion is different for the dollar including EM, mostly due to the undervaluation of USD/CNY (chart 10).

This valuation discrepancy between EM and DM would support a conclusion that the dollar has far more room to strengthen against EM – especially Asia, given the nature of the global trade war – even if the Fed cuts rates. The second observation is that US flow dynamics are not sending a particularly strong signal. The dollar is strong but so is the underlying US basic balance, without any large movement either way. In other words, the market is already overweight dollar assets but there are no clear shifts either higher or lower for now.
Conclusion
Putting it all together, we conclude that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker. We argue that the Fed would need to cut rates by more than 100bps for a broad-based and sustained move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the broad dollar mixed with the JPY and CHF continuing to be the primary beneficiaries of weaker growth, EM FX (especially Asia) the primary casualty, and the EUR stuck in the 1.10s.
These relative moves are already broadly in line with our forecasts, but these would change in the event of a full-fledged easing cycle from the Fed back down to zero. In this instance, we would expect the EUR in particular to more broadly participate in a dollar down-cycle, a topic which we will investigate in a future publication." - source Deutsche Bank
If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained.

When it comes to market expectations, and the Fed in this "Numbers game" as per our final charts below we think the Fed is "data" dependent and has noticed the slowdown but is not yet ready to go full on the brakes as the market is expecting in "overconfidence".

  • Final charts - Fed it taking it "easy" not "easing" yet.
Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war. Our final charts below comes from Wells Fargo's Weekly Economic and Financial Commentary from the 7th of June and shows the growing hints of the slowdown in conjunction with the appropriate pace of policy firming:
"Growing Hints of a Slowdown
In the midst of rising prospects of a prolonged and more pronounced trade war, data this week seemed to lend some credence to the idea that the domestic economy is beginning to succumb more materially to all the uncertainty. Nonfarm employers added just 75,000 jobs in May, missing even the lowest forecast, while downward revisions shaved off a further 75,000 from prior months’ reported gains. Average hourly earnings also missed expectations, up 0.2% on the month and 3.1% over the year, the slowest rise since September. The bond market reaction was swift; yields on both the two-year and 10-year immediately fell more than six bps, likely out of a belief that the growing hint of labor market weakness may force the Fed’s hand and induce a rate cut.

Indeed, the market has come to view a cut this year as a foregone conclusion; futures markets have priced in around 75 bps of easing this year. A more defiant stance from the Trump administration towards China and the threat of a new volley of tariffs directed against Mexico are likely driving the pessimism and risk-off attitude. Despite high-level negotiations regarding the U.S.-Mexico border situation this week, 5% tariffs on all imports from Mexico are slated to go into effect Monday, and could rise as high as 25% by October. This latest escalation more than doubles the total value of goods subject to tariffs to around $700 billion and, perhaps more worryingly, brings into stark view the willingness of the administration to use tariffs as leverage for political or diplomatic concessions, dropping even the pretense of an economic rationale. See Topic of the Week for more detail.
The question for the Fed, then, is whether markets are overreacting to trade uncertainty by expecting three cuts in a 3.6% unemployment rate economy. Noted dove James Bullard kicked off the Fedspeak on Monday, stating that a cut “may be warranted soon”, and noted that even if growth does not succumb to trade tensions significantly, lower rates would help bring inflation up to target more quickly. Chair Jay Powell took the baton on Tuesday, saying, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion”. Markets took these comments and ran with them, as the S&P 500 surged 2.1% on the day and remained buoyant the rest of the week. We would suggest a more leveled view, as his comments are not anything new, per se. Expectations of a ‘Powell put’ may be a bit premature, if we resist reading into his comments too deeply, and in light of Robert Kaplan’s call for patience amidst trade threats that could be reversed as quickly as the president can tweet. John Williams similarly suggested staying on the path of data dependence.

To that end, the ISM manufacturing survey fell 0.7 points to a 31-month low of 52.1, while the non-manufacturing survey rose 1.4 to 56.9, offering some evidence that the divergence between the manufacturing and the much larger service sector is persisting; in other words, the slowdown in the trade and global growth-exposed manufacturing sector has yet to spill over into the broader economy in a major way.

Still, the majority of economic data lags. The cyclical parts of the economy are already slowing, and the uncertainty over the entire economy is already here." - source Wells Fargo
To conclude we see two cases of "overconfidence", one is the pace and number of rate cuts coming from the Fed, the second is a clear resolution between China and the United States. We therefore think it is premature to bet in the "Numbers Game" run by the Fed and we would rather stick to defense and watch a little bit from the sideline rather than going again "all in" on a supposed return of the famous "infamous" Fed put. We don't think we are there yet and what matters for the Fed is financial stability overzealous markets racing ahead we think.

"The more people rationalize cheating, the more it becomes a culture of dishonesty. And that can become a vicious, downward cycle. Because suddenly, if everyone else is cheating, you feel a need to cheat, too." -  Stephen Covey
Stay tuned!

Tuesday, 28 May 2019

Macro and Credit - Banqi

"Life is not always like chess. Just because you have the king surrounded, don't think he is not capable of hurting you." - Ron Livingston
Looking at the results in the European elections promising more turmoil ahead between Italy and the European Commission, on top of the continuation of the trade war narrative between China and the United States (which has started to impact business confidence on top of EPS it seems), when it came to selecting our title analogy we reminded ourselves of the Chinese game of Banqi, also known as "Dark Chess" or "Blind Chess". Banqi is a two player Chinese board game played on a 4X8 grid. 

Most games last between ten and twenty minutes, but advanced games can go on for an hour or more. While Banqi is a social game usually played for fun rather than serious competition, it seems to us that the current confrontation between the United States and China is getting more serious by the day. In the game of Banqi, the game ends when a player cannot move, and that player is the loser. Most often, the game is lost because all of a player’s pieces have been captured and so he has no pieces to move. 

However, it is possible for one player to surround all of the other player’s remaining pieces in a manner that makes it impossible for them to move. It is worth noting that a stalemate threat occurs when one player forces an endless cycle of moves. In a typical stalemate, the instigator repeatedly attacks, but cannot capture, an enemy piece. The legality of stalemating varies by culture: 
  • Some players consider stalemate illegal. This is consistent with the rules of Chinese Chess, which require the instigator to cease the continual attack, else the victim wins.
  • Some players consider stalemate a legal strategy. The ability to instigate a stalemate in an otherwise losing game is one of the ways that skill can overcome luck, since the victim must accept either a drawn game or the loss of a piece. Handling a stalemate situation requires skill for the winning player, as well — the necessity of heading off a potential stalemate adds spice to an otherwise overwhelming victory. And deciding whether you can still win, even without that piece, requires great expertise.

When it comes to the game of Banqi and the BREXIT situation leading to the resignation of Prime Minister Theresa May, it is worth noting that in the Chinese game of Banqi a player may simply resign if the game seems lopsided. Also in the game of Banqi, some players derive pleasure from making it as difficult as possible for the opponent to actually coerce the win. Others make a game of seeing how many opposing pieces they can capture before their demise. Some just resign when defeat becomes evident, and start a new game. but we ramble again...

In this week's conversation, we would like to look at the escalating trade war and what it entails in terms of positioning and growth outlook

Synopsis:
  • Macro and Credit - China versus the United States? A numbers game
  • Final charts - Take it IG (Investment Grade), Japan's got your back...

  • Macro and Credit - China versus the United States? A numbers game
As we argued in our last conversation, it seems to us that China and the United States are heading towards the famous "infamous" Thucydides Trap", namely the rise of Athens and the fear it instilled in Sparta.

Before heading into the "nitty gritty" of the trade war implications from a market perspective we would like to point out towards the astute analysis of  our former esteemed colleague David Goldman's recent post in Asia Times from the 26th of May entitled "The Chinese tortoise and the American hare":
"China is outspending the US in quantum computing, including $11 billion to build a single research facility in Hefei. By contrast, the US allocated $1.2 billion for quantum computing over the next five years. Overall, federal development funding in the US has fallen from 0.78% of GDP in 1988 to 0.39% in 2016.

China remains behind the US in most key areas of technology, but it is catching up fast. In the last several years China has
  • Landed a probe on dark side of moon;
  • Developed successful quantum communication via satellite;
  • Built a 2,000-kilometer quantum communication network between Beijing and Shanghai;
  • Built missiles that can blind American satellites;
  • Developed surface-to-ship missiles that can destroy any vessel within hundreds of miles of its coast; and
  • Built some of the world’s fastest supercomputers.
China’s investment in education parallels its investment in high-tech industry. Today China graduates four times as many STEM (science, technology, engineering and mathematics) bachelor’s degrees as the US, and twice as many doctoral degrees, and China continues to gain. A third of Chinese students major in engineering, vs 7% in the US. Eighty percent of US doctoral candidates in computer science and electrical engineering are foreign students, of whom Chinese are the largest contingent. Most return to China. The best US universities have trained top-level faculty for Chinese universities. American STEM graduate programs reported a sharp fall in foreign applications starting in 2017, partly because Chinese students no longer have to come to the US for world-class education.
China’s household consumption has risen 17-fold since 1986 and its GDP in US dollars has risen 35-fold. China has moved 550 million people from countryside to city in only 40 years, the equivalent of Europe’s population from the Urals to the Atlantic. China has built the equivalent of all the cities in Europe to house the new urban dwellers, as well as 80,000 miles (nearly 130,000 kilometers) of superhighway and 18,000 miles (29,000km) of high-speed trains.
China’s debt-to-GDP ratio stands at 253% (47% government, households 50%, corporate 155%). That is about the same as America’s 248% (98% to government, households 77%, corporate 74%). The high corporate debt number is due to the fact that state-owned enterprises fund a great deal of infrastructure building with debt that is counted as corporate rather than government. China’s debt problem is no worse than ours." - source David P. Goldman, Asia Times
On a side note, one of the main reasons we are so negative on our home country France, is the continuous fall in education standards and the very poor level of basic economics grasp, which will lead to even more "socialism" rest assured.

But, returning to the core subject of China versus the United States, it is indeed a numbers game in this "Banqi" confrontation as highlighted by Bank of America Merrill Lynch in their Global Liquid Markets Weekly note from the 20th of May entitled "Is the trade war just about trade?":
"Is the trade war just about trade?
Economically, America is not as great as it used to be...
Greatness is a relative concept, measured often against oneself but also against others. In that regard, America has facilitated the rise of China by turning free trade into a global public good. Yet trade theory suggests that hegemons can maximize their income by applying optimal tariffs under certain conditions. The astonishing irruption of China in global commerce following her entry in the WTO has deeply transformed the global economy. For starters, America’s share of global trade has rolled down for two decades to make room for a rapid rise in Chinese exports and imports (Chart 1).

Importantly, China’s economy is now close to (in USD) or even bigger (in PPP) than America’s, depending how you measure it (Chart 2).

In economic terms, China is the rising power and the global hegemon is finally starting to feel the heat. We have looked into the issues further and found that several historical conflicts between an established and a rising power were preceded by major trade disputes.
 ...as incomes have stagnated in the past decades...
It has taken some time, and a major shift in domestic politics, for US foreign and trade policy to catch up with the geopolitical challenges of a rising China. Following the Global Financial Crisis, Washington had too many problems to focus on China’s growth. Plus the Chinese were the driving force behind global GDP and debt creation after 2008 (Exhibit 1) in a world hungry for growth.

The European sovereign debt crises of 2011 and 2012 made Chinese economic activity an even more important pillar of the world economy. Neither the US nor other world leaders had the appetite or the domestic support to confront China’s trade practices back then. But now the paradigm has changed. Incomes have been stagnant in real terms in the US for decades and voters are demanding a different course for policy (Chart 3).

In contrast to that, Chinese real incomes and wages have been rising at one of the fastest rates in the world for five decades now. In that sense, Chinese policymakers and business leaders seem to have delivered for their people what democratically elected politicians in the West have not.
...but it still leads the world in trade and profits...
In our view, America is also experiencing a renaissance of its own at the moment. Buoyant equity markets, the longest economic expansion in history, and the lowest unemployment rate in 48 years have emboldened US policy makers to tackle China. One key issue that has captivated voters is the narrative that American workers’ income is going overseas. This world view largely ignores the effects of technology. But in politics perception is reality. So the ongoing breakdown of global supply chains is just the start of a long trend, in our view. In any case, America’s economic power is still unmatched. Even if followed by China, the US still produces the vast amount of corporate profits in the world. No other country comes close (Chart 4.).

Similarly, the US leads the world by share of global trade ahead of China, with Germany in a relatively close third position (Chart 5).
...and has become energy independent in the past year
In some ways, President Trump has picked a good time to start his trade battle: America is in a position of strength and there is bipartisan consensus that China is getting too close for comfort. Another important point to understand is the structure in the foreign trade balances of both China and the US. Energy has been a crucial driver of foreign policy decisions in Washington for a long time. The new angle here is that America’s reliance on foreign energy has drastically reversed in the past ten years (Chart 6), opening the door to a renewed battery of sanctions and tariffs against US foes.

Energy  independence has also given Washington the confidence that the US economy will be roughly insulated from global oil price swings. Meanwhile, China’s foreign fuel dependency has increased in USD terms as the economy expanded (Chart 7), creating a major Achilles heel for the rising power.
China’s fast growth was fueled by America’s imports...
China’s spectacular economic ascendance can be traced to a number of factors. Massive domestic savings and huge capital accumulation, coupled with rapid urbanization and fast rising exports, have all been key drivers of China´s growth. Policy makers in China have also been exceptionally adept at implementing multi decade plans and building infrastructure at a staggering speed. Why is the White House so focused on China? In part, America’s current account balance has been the mirror of China’s for the last 20 years (Chart 8).

But even as America has improved its trade balances with the rest of the world helped by an energy renaissance, the annual US trade deficit with China has worsened from 84bn in 2000 to 420bn at present. As such, the drop in US energy imports was replaced with manufactured imports from China in the past decade (Chart 9.).

No one in Washington seemed to notice until voters sent a loud and clear message.
...as well as by its technology and intellectual property...
For most of its history, China has forced foreign companies to transfer technology by setting up Chinese-controlled joint ventures in its domestic market. These rules, coupled  with the promise of access to one of the world’s largest domestic markets, encouraged US corporations to transfer technology and turn a blind eye on intellectual property rights violations. Partly as a result of that, China has caught up with the US in terms of patents applications per head in the past decade (Chart 10).

True, China is only filing about half the patent applications per head that America delivers, but given its population size, China is now the world leader in total patent applications (Chart 11).

This extraordinary surge in patent applications has surely risen eyebrows in DC.
 ...but also by enormous foreign commodity purchases
Another crucial factor for China is its dependency on foreign raw materials. China is the world’s largest commodity importer and this dependency is reflected in the relative weight of raw materials in its goods imports (Chart 12).

For example, China is the world’s largest importer of oil, coal, iron ore, copper and soybeans. This massive dependency on foreign raw materials has become a growing weakness. This is particularly true now that China’s strategic competitor has become the largest producer of energy in the world. In contrast, China does not import many services from around the world, neither in the financial or telecommunications sectors (Chart 13.).
The rise of China has created a strategic competitor...
China’s growth has been fueled by a huge surge in manufacturing exports and a very large increase in raw material imports. But contrary to the market’s perception, China’s dependency on international trade has been dropping as a share of GDP (Chart 14).
Since we have established that Chinese export growth in the past two decades was very strong, it follows that the falling export dependency is largely the result of China’s GDP growing so quickly. As such, China’s reliance of foreign trade today is only somewhat larger than America’s. Note that the US enjoys one of the lowest foreign trade dependencies as a share of GDP in the G20, only slightly above after Argentina and Brazil (Chart 15).

This means that both the US and China could be labelled large, closed economies in international trade jargon. Germany would be on the opposite end of this spectrum. In practical terms, this relatively low trade dependency suggests that a protracted trade war would not likely have devastating consequences for neither China nor the US. Unlike Germany, both have large, deep domestic markets they can rely upon.
...that is constrained by a very different set of rules
China’s policies have encouraged the rapid development of manufacturing at home. As a result, Chinese exports are primarily concentrated in the manufacturing goods sector (Chart 16).

China has been so effective at squeezing out manufacturers that it has ended up in a position of weakness, with limited ability to retaliate against the United States in a trade conflict. This strategic vulnerability is also visible on another angle of the trade war: the telecommunications sector. Even though China is not a large services exporter, most of Chinese services exports originate from the communications sector (Chart 17).

Not surprisingly, the two largest Chinese companies operating in this sector, Huawei and ZTE, have become targets of US government action in recent months. By lifting tariffs on Chinese manufactures and imposing restrictions on the telecommunications sector, the White House has effectively encircled China’s main sources of foreign exchange. The implication is that China’s limited dependency on US goods and services has become a liability, rather than an asset. Now China has limited leverage to retaliate against the US on trade.
Demographics are becoming a headwind for China
Another factor that may have propelled Washington to take a more aggressive trade stance with China now rather than later is demographics. For the most part, working age population is contracting in developed markets and expanding at a healthy pace in emerging markets. In this respect, both the US and China are the exceptions to their respective OECD and non-OECD peers. China’s labor force peaked last year and its population is set to peak by 2030 (Chart 18).

In contrast, the aging population problem in Developed Markets is mostly confined to Japan and Europe, while the US actually has still a growing population of working age (Chart 19).

With diverging demographic trends and a larger economy, a modest slowdown in the rate of Chinese economic growth could enable the US to retain its title as the world’s largest economy and military spender for decades to come. Put differently, the faster China turns into Japan, the less of a geopolitical challenge it would pose to the US.
The US-China trade war could continue for years...
So what will happen next? By taking a broad historical perspective of clashes between rising powers and established powers, we can easily conclude that the ongoing trade war between the US and China has been a relatively small scale conflict for the time being. The Harvard Thucydides Trap Project championed by Professor Allison has identified 16 instances where established powers were challenged by rising powers in the last 500 years and concluded that war emerged in 12 of these occasions. On our  end, we have extended this analysis to look at the trade issues involved in various cases and concluded that some kind of trade conflict was present rather consistently throughout the history of conflict between ruling powers and rising powers,
The main reason why the trade war could keep going for some time is Washington’s leverage over Beijing, coupled with the respective concerns and pride of the actors involved. China needs to keep expanding its machinery and manufactured goods exports to pay for its commodity imports (Chart 20), but US policy is now poised to make it more difficult.

Meanwhile China’s service exports as a share of its GDP are unlikely to increase much, given the US push against Chinese telecommunications giants (Chart 21).

As such, China is in a bit of a bind at the moment, as a return to autarky is not really an option. While pride is often the enemy of rational thinking, in our view the more logical course of action for Beijing would be to keep supporting the development of its domestic market and, if possible, continue to seek allies through its Belt and Road Initiative.
...riding on both Beijing’s pride, Washington’s fears
Concerns of a rising China, coupled with US domestic politics, have already elicited a sharp increase in average US tariffs (Chart 22).

But it is important to observe that the White House strategy is shifting. Initially, Trump’s tariffs on steel and aluminium were indiscriminate and included allies. Now most of the incremental tariffs have been directed at China, with the US negotiating with Canada, Mexico, Japan, or Europe in the past few months. This subtle but meaningful turn suggests to us that strong geopolitical linkages, rather than rent-seeking behavior of uncompetitive domestic industries is driving policy making. True, at 1.9% China still spends less on military than the US both in absolute terms and relative to its GDP. However, US spending as a share of GDP has declined since the 1960s (Chart 23).

Simple math suggests that China will become the largest military spender in the world within a decade, assuming robust GDP growth and a constant spending as a share of income. Slower Chinese economic growth would likely slow down this process..
Given the current point in the global business cycle…
What does this geopolitical pivot point mean for markets? Global manufacturing PMIs have nosedived in recent months, but the world economy is still held up by services (Chart 24).

A synchronous slowdown economic growth could hurt both the US and China, as both rely heavily on domestic credit to the private sector as a % of GDP (Chart 25).

However, it is easy to see how China would likely be hurt more on economic warfare than the US. America’s tariffs on Chinese manufactures and telecommunications services will damage Chinese exporters but could help US companies and US allies. In turn, China’s retaliatory strategy of tariffs on US commodities will further erode its manufacturing competitiveness. On a net basis, these measures will keep hurting global GDP growth at the margin, keeping a lid on global rates markets. However, economic activity could recover among US allies as a trade war with China intensify, offering relative value opportunities for rates investors. Also, while energy and iron ore prices have rallied mostly on the back of supply issues, non-ferrous metals and agricultural commodities could continue to seep lower. Gold on the other hand could benefit from increased geopolitical risk.
...increased tensions may impact markets severely
Globalization has been a big contributor to S&P500 net margin expansion in the past 15 years (Chart 26), so any reversal here is likely to reduce margins in some equity sectors (see “Peace, Cold War or Hot War: economic and market implications” for more detail).

Also, our economists have recently explained (see “When the best case is no longer the  base case”) that different trade war scenarios will lead to very different economic outcomes for the Eurozone and the world. However, the most important point to grasp is whether the trade war is just about trade or instead we are just witnessing the early innings of the most important geopolitical conflict of our time. China’s population is declining irreversibly, while US population growth will continue in the years ahead. On our estimates, even a modest reduction in the rate of Chinese GDP growth from the current levels would prevent China from surpassing the US economically and militarily (Chart 27).

In other words, the ongoing trade war could enable the US to remain the hegemonic power for decades. Prof. John Conybeare argues that the correlation between hegemony and free trade is poor on both time series and cross sectional evidence for the 20th century. Assuming the costs remain relatively modest, it is easy to see why China may well be the only issue that Democrats and Republicans can agree on."  - source Bank of America Merrill Lynch
While Bank of America Merrill Lynch indicates that simple math suggests that China will become the largest military spender in the world within a decade, as shown by current Russian military assets, it's not the overall quantity of spending that matters but the "quality". As indicated by our friend David P. Goldman, China has already built missiles that can blind American satellites. We will not go into more details about the "spending" surrounding the F-35 jet or other additional "programs", but you get our point. Both China and Russia are currently spending in a much "smarter" way. So, to postulate that the ongoing trade war could enable the US to remain the hegemonic power for decades is preposterous we think.

In a protracted trade war of this "Banqi" game, while it would not likely have devastating consequences for neither China nor the US, Germany we think and others would definitely be at the receiving end. While there are two tectonic plaques colliding, we also think that Europe is more likely to face more collateral damage from the trade confrontation. The German "mercantilist" policies are likely to be a significant drag on the German growth outlook particularly in the light of its weak domestic consumption levels. 

On Europe's exposure we read with interest Credit Suisse's Global Cycle note from the 24th of May entitled "The trade war's trenches":
"Euro area
Euro area IP momentum rebounded to 3.4% in March after troughing at - 5.8% in January, ending the longest stretch of sub-trend growth since the sovereign debt crisis. This improvement is consistent with our previous forecast that manufacturing growth would reaccelerate as trade-related headwinds and erratic shocks that dragged activity in H2 of 2018 gradually abate. Indeed, production of autos, pharma and chemicals recovered in recent months as drags from new auto emissions tests and low water levels in the Rhine receded (Figure 27). Export growth rebounded in Q1.

But this improvement is likely to be short-lived. First, the detailed breakdown of trade figures shows that much of the improvement in exports in Q1 was due to UK’s stockpiling ahead of a potentially disruptive Brexit in April. Given that Brexit was delayed until October, exports to the UK are likely to weaken in Q2 as British inventories normalize. Extremely weak manufacturing surveys in Q1 are a further suggestion that hard data were boosted by erratic factors. (Figure 29).

Second, the recent escalation in the US-China trade dispute is likely to deliver another negative shock to the euro area goods sector. Although the euro area is not directly affected, its extremely high current account surplus (mostly Germany’s) makes it particularly sensitive to developments in global trade. As Figure 30 shows, almost 3% of euro area value added is exported to the US, China and Asia, representing one-third of total euro area exports.

There are two main channels through which tariffs could weigh on euro area export growth. First, higher tariffs mean that Chinese imports of intermediate goods from the euro area used to produce goods that are re-exported to the US are likely to weaken. And second, weaker domestic demand in the US, China and the rest of Asia as a result of the trade dispute implies that exports of euro area final goods to those countries are likely to moderate as well. Euro area goods demand has remained surprisingly resilient in recent quarters, but continued uncertainty and weak external growth present a risk (Figure 31).

Investment goods demand was flat in Q4 2018 after growing on average 0.9% QoQ in the first three quarters of the year. However, the weakness was due to a contraction transport equipment investment, which is often volatile, whereas machinery and equipment investment continued to grow. Firms’ investment intentions are holding up: the latest round of European Commission survey from April showed that euro area manufacturers still intend to raise investment in 2019 by the same amount as they planned to late last year (Figure 32).

But the longer weak foreign demand and trade uncertainty goes on, the more likely it is to start affecting business investment." - source Crédit Suisse
Exactly, the longer the Banqi game lingers, the more profound the impact on business investment and growth and employment outlook. We do think Germany remains particularly exposed and so does Japan to the ongoing tussle being played.

From a credit perspective and allocation, we have argued in previous presentations that there was a solid case from rotating from "quantity" (high yield and high beta) towards "quality", not only due to the less volatile proposal of investment grade credit over high yield but also thanks to the overseas support at least for US credit markets from Japan and the Government Pension Investment Fund (GPIF) and its "Lifers" friend. As well as the overseas support, our prognosis of additional credit risk being taken by Japanese investors and others has been vindicated flow wise as reported by Bank of America Merrill Lynch Follow The Flow note from the 24th of May entitled "Central banks superior to Trade wars":
"Resilience
Inflows into high-grade funds continue despite the recent risk-off. Trade wars, geopolitical risks are “ruining the party”, but still high-grade funds continue to record inflows. Not only that, but the pace has also accelerated. The lower the bund yields are heading the higher the need for “quality” yield for fixed income investors (more here).
With central banks across the globe committed to support the global economic recovery, investors are still happy to allocate in credit. On the contrary the risk-off hits hardest the “growth/beta pockets”: EM debt and high-yield funds have suffered sizable outflows for a second week in a row.
Over the past week…
High grade funds saw an inflow for the twelfth week in a row and the largest inflow ever recorded. We note that a decent proportion of that inflow (a quarter) was driven by a single fund. Even when we exclude this single fund, the pace of weekly inflows still ticked up over the past weeks.

High yield funds recorded their third straight week of outflows. Looking into the domicile breakdown, whilst outflows were recorded across all regions, European-focused funds suffered the lion’s share of outflows, while US- and globally focused funds suffered less.
Government bond funds registered another inflow last week, the second in a row. Money Market funds recorded a significant inflow, the second largest of the year, benefiting from the broader risk-off sentiment. All in all, Fixed Income funds enjoyed another weekly inflow – the twentieth in a row. European equity funds continued to record outflows – the 15th in a row, albeit at a slower pace than last week.
Global EM debt funds recorded another outflow, the first back-to-back outflow this year, highlighting the strength of the US dollar and the trade war-related uncertainty. Commodity funds saw a marginal inflow last week.
On the duration front, inflows were recorded across the curve, with short-term funds enjoying the bulk of the inflow." - source Bank of America Merrill Lynch
As they say, go with the "flow" we continue to see US long duration investment grade credit as an overweight proposal. As well we continue to expect a significant rally in the long end of the US yield curve from a tactical perspective.

How exposed is high beta in the case of a longer than usual "Banqi" game? For UBS from their Global Macro Strategy note from the 16th of May entitled " Credit Perspectives: Could tariffs ignite the end of the credit cycle?", the key risk is indeed trade escalation:
"The key risk is trade escalation. While our base case assumes the two sides will ultimately find a path to a negotiated outcome, the timeline is likely to extend beyond the G20 meeting June 28-29 and the likelihood of a downside tail event has increased. The breakdown in negotiations reflects deeper disagreements over China's IP sponsorship, future Chinese import levels and deal enforcement. The desire to strike a deal is likely dependent on negative feedback from domestic firms and/or markets. If they cannot reach an agreement, our US economists estimate tariff expansion to all imports would further reduce US real GDP by 75-100bp, in effect lowering GDP growth from c2% to c1% in late '19/ early '20 (depending on timing). And our China economists expect tariff escalation would likely subtract an additional 80-100bp from growth, reducing '20 GDP growth from 6.1% to 5.5 – 6% (assuming offsetting stimulus).
A 1% US real GDP growth rate but no recession would be consistent with a 51 Composite ISM and US HY spreads in the 680 – 730bp context. We believe prior to the sell-off market expectations on trade were quite benign (e.g., 0-10% probability of material escalation). Assuming we are right on our estimate of severity of the trade escalation scenario (c300bp, or 700bn vs. 396bp current), US HY spread widening of 40bp in May roughly implies the market implied likelihood of trade escalation has increased roughly 10-15% and stands near 15%. In our view, this premium still looks too low. Our prior view had been for US HY spreads near-term to trade at 375bp and end 2019 at 435bp. Based on probability weighted outcomes, we shift up our near-term target to 435bp given rising downside risks and higher severities.
Is the market pricing of future rate cuts foreshadowing future downside for US credit spreads? While our economists expect no hikes in '19 and '20, the market is now pricing in about 1.5 cuts over the next year and 2 through year-end '20. Historically, credit spreads tend to widen when the Funds rate falls, but the impact on spreads ceteris paribus is limited and depends on the degree of rate cuts (e.g., our US HY model suggests on average a 25bp cut in the FF rate results in 6bp of widening). However, the relationship is not always linear. In past cycles, periods when more than 1 rate cut was initially priced in over one year (e.g., May  '95, Aug '98, Sep '00, Aug '06 ) US HY credit spreads in the next 3mo were little changed excluding recessions (+9bp, +10bp, +211bp, -25bp, respectively). For comparison, in periods when market pricing shifted from more than 1 cut to more than 2 cuts (e.g., May to Nov '95, Aug to Sep '98, Sep to Nov '00, Aug to Sep '06), HY credit spreads in 3mo were moderately wider ex-recessions (+30bp, +57bp, +191bp, -8bp, Figure 10). In short, we think this question effectively boils down to a call on the credit cycle discussed earlier." - source UBS
 As per last week's conversation the latest Fed quarterly Senior Loan Officer Opinion Survey do not yet point out to a turn of the credit cycle. Yet, no doubt the credit cycle is slowly but surely turning. When it comes to the US, all eyes should be focusing on the state of the US consumer. We do believe that the current direction of the US Treasury 10 year notes is a reflection of slowering US growth for Q2 hence the significant fall in yield since the beginning of the year.

In our final chart below we make a case of continuing to be overweight US Investment Grade given the continuous strong support coming from "Bondzilla" our famous "infamous" NIRP monster.
  • Final charts - Take it IG (Investment Grade), Japan's got your back...
Given that now negative yielding bonds amount to around $10.7 trillion according to Bloomberg, it is not a surprise to see that during the Chinese year of the pig, we continue to see a very strong appetite for "quality" yield regardless of the "Banqi" game being played. The overseas support for US credit markets continues to be clearly "Made in Japan". Our final chart below comes from Bank of America Merrill Lynch Credit Market Strategist note from the 24th of May entitled "Five weeks to go" and displays US corporate yields compression to JGBs as well as hedging costs for Japanese yen investors:
"The case for foreign buying remains strong
IG credit investors are always going to be somewhat yield sensitive, but in the present environment much less so than in the past. This is how 2019 thus far is shaping up as a lower interest rates, tighter credit spreads kind of year. What makes the market less sensitive to interest rates is the presence of sizable foreign buying. While foreigners tend to be very yield sensitive, and the compression of US to local yields could be a problem that is mitigated by more benign expected future dollar hedging costs. For example 7-10 year BBB-rated US corporate yields have compressed about 62bps to 30- year JGB yields this year (Figure 1).

At the same time dollar hedging costs have declined just 10bps. However, the fed funds futures market has shifted from pricing in a half rate hike (over the following 12 months) at the turn of the year to now pricing in nearly two eases (Figure 2).

That feeds directly into expected future dollar hedging costs and implies 60bps of savings one year out. Net-net foreign buyers can thus rationally expect to be about 10bps better off now than at the turn of the year – despite lower rates.
In Figure 3 we illustrate that point. Most focus tends to be on the blue line, which shows the yield pickup in 7-10 year BBBs relative to 30-year JGBs, dollar hedged by rolling 3-month forward FX rates, which is typical.

However, it is based on the current cost of that rolling dollar hedge – so not at all representative for what is more important to investors, namely how expensive the hedge is expected to become in the future. As such, the orange line, which uses dollar hedging costs (driven by Fed rate hikes) priced into the market 12-months out, is the more relevant one. Clearly, after last year when the US corporate bond market looked unattractive to foreign investors (and they net bought only $6bn), this year it looks even more attractive than in 2017 (when they net bought $331bn). Also note how the compression of US corporate yields to local yields does not subtract relative value for foreign investors, as again it is mitigated by anticipated lower dollar hedging costs with the Fed expected to ease rates. So we look for foreign buying of US corporate bonds to continue at meaningful levels." - source Bank of America Merrill Lynch
While we continue to think equities will remain volatile for the time being, in continuation to our previous conversation, we continue advocating favoring a rotation into quality (Investment Grade) over quantity (High Yield). Since the beginning of the year the feeble retail crowd has been rotating at least in the high beta space from leveraged loans to US High Yield and that is continuing flow wise, although now we are seeing this very crowd leaving somewhat US High Yield on the back of more pronounced volatility. Quality credit as we concluded our previous conversation, continues to offer more stability which is warranted given that the "Banqi" game is going into overtime. Oh well...

"China is a sleeping giant. Let her sleep, for when she wakes she will move the world." -  Napoleon Bonaparte
Stay tuned ! 
 
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