Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Macro and Credit - Alprazolam

"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman

Watching with interest the historical defeat of Prime Minister Theresa May relating to Brexit, in conjunction with the Chinese central bank injecting a net 560 billion yuan ($83 billion) into the Chinese banking system, the highest ever recorded for a single day given the weakening tone of the economy, when it came to selecting our title analogy we decided to go for a medical reference to "Alprazolam". "Alprazolam", also the trade name for Xanax among others, is the most commonly used benzodiazepine in short term management of anxiety disorders, specifically panic disorder or generalized anxiety disorder. It seems to us that the Chinese authorities have decided to act decisively on the very weak tone taken on their economy and the slowdown in global trade and its impact. Due to concern about "misuse", some strategists like us would not recommend "Aprazolam" as an initial treatment for panic disorder such as the MSCI China index down 23% over the past year. With the University of Michigan’s consumer confidence index falling to a more than two-year low of 90.7 in January, down from 98.3 in December, and well below expectations of 97.5, we wonder if our quote above is correct in asserting that anxiety does indeed empties today of its strength, namely consumer confidence. After all, clinical studies have shown that the effectiveness of Alprazolam is limited to 4 months for anxiety disorders but we ramble again...

In this week's conversation, we would like to look at the rising cost of attrition on the global economy, with the continuation of the stalemate in Brexit, US vs China trade/tech war, yellow jackets in France and of course the government shutdown in the United States. While Alprazolam has brought some solace to the December angst for investors, it remains to be seen how long the effect will last on the recovering "patients".

Synopsis:

• Macro and Credit - Does A for attrition equate R for recession?
• Final charts -  Mind the liquidity shock...

• Macro and Credit - Does A for attrition equate R for recession?

As we indicated in our previous conversations, "Bad News" has been the new "Good News" at least for asset prices in general and high beta in particular, the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture. 

We indicated more downside risk at least from a European perspective and we continue to have a very negative view on France given the continuation of the unrest and the "yellow jackets" movement not giving any respite to president Macron. 

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In the AFTE latest survey, there is now a clear trend in the deterioration in their operating cash situation showing up:

- source AFTE

The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average).

On this "attrition" subject we read with interest Bank of America Merrill Lynch's take from their Cause and Effect note from the 18th of January entitled "Investing in the age of the attrition game":

"Attrition bites in Europe

The “yellow vest” protest in France, which has resulted in the “worst riots since 1968” is now its 9th week. Not only it has shown no sign of ending, the number of demonstrators rebounded sharply over the past two weeks (Chart 6).

What began as a protest against fuel hikes has morphed into a broader movement of discontent with the government. President Macron has so far has refused to restore the wealth tax, one of the key demands of the protesters. This could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26). French consumer confidence has tumbled sharply and is approaching levels reached during the Eurozone crisis (Chart 7).

The slowdown within the Eurozone is spreading. Both Italy and Germany are already in a recession (“the “R” club is recruiting”, January 11). For Italy, despite the passage of the 2019 budget bill, our European economics team has observed that the busy electoral calendar and decrees (not least those implementing pension reform and an income support scheme) could challenge the current ruling majority in the first half of the year. In Spain, a new far right party is emerging and the government lacks parliamentary support to pass a 2019 budget. The latest manufacturing PMI surveys show that new orders for Germany, France, Italy and Spain, the four largest economies in the Eurozone, were all below 50 (contractionary) in December, the first time in four years (Chart 8).

In our view, the greatest risk facing Europe is that the slowing economy fuels further populist discontent, creating a vicious circle." - source Bank of America Merrill Lynch

The numerous "attrition wars" being fought on a global scale are indeed clear headwinds regardless of the latest injection of "Alprazolam". As we indicated in our previous conversation "Respite",

"As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian". 

A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think." - source Macronomics, January 2019

We also discussed in our conversation the importance of the return of "macro" and the need to "monitor" fund flows for any signs of stabilization in "credit markets" as well as the need to track oil prices relative to US High Yield given its exposure.

Flow wise, Bank of America Merrill Lynch in their Follow The Flow note from the 18th of January entitled "Just a bounce?" question the most recent positive tone in financial markets given the weakening mood coming out from the macro data:

"Light positioning and known-unknowns

This year started on a positive note. Despite further weakness on the macroeconomic data front across the globe (more here), risk assets have staged a strong bounce higher. This is not because everything is in the price and we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown. It is the fact that positioning has been very light at the end of last year and thus cash balances have been put to work in January. With slower primary and tighter spreads last week it feels that the outflow trend is slowing down. However we are skeptical for how long markets can keep ignoring the continuing deterioration in macro. We feel this rally will not last, and thus we would use this bounce higher to reduce risk.

Over the past week…

High grade funds suffered another outflow, making this the 23rd week of outflows over the past 24 weeks. However, this week’s outflow is the smallest observed over that period. High yield funds recorded another outflow, the 16th in a row, but also the smallest in a while. Looking into the domicile breakdown, Globally-focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Actually Europe-focused funds have recorded small inflow, the first in 15wks.

Government bond funds recorded a small outflow this week. Meanwhile, Money Market funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.

European equity funds recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.

Global EM debt funds continued to record inflows, the second weekly one. This confirms the improving trend observed recently as a dovish Fed has weakened the dollar. Commodity funds recorded another (albeit marginal) inflow, the 6th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch that, the significant rally in high beta should entice you to become more "defensive" and favor "quality" (rating) over "quantity" (yield). In the ongoing attrition game, it is more a question of capital preservation than capital appreciation we think.

Moving back to the "attrition game" and Bank of America Merrill Lynch's note from their Cause and Effect from the 18th of January entitled "Investing in the age of the attrition game", regardless of the positive liquidity injection from the PBOC and dovish tilt of the Fed, earnings as well are slowing down and there is more risk to US consumer confidence with the shutdown:

"Shutdown raises trade war risk

What does a destabilizing gridlock in Washington mean for the US-China trade war? Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up. The fact that he has been talking up the prospect of a deal with China in recent weeks (“I think we’re going to be able to do a deal with China,” January 14) is consistent with this hypothesis. The market has taken these upbeat remarks at face value and has been driving up EM assets, the main casualties of the US-China trade war last year.

However, it takes two to tango. Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance. With the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal. Trump set a precedent by agreeing to a 3-month extension for the next round of US tariff. Beijing might think that the Americans could be forced into giving another extension if there is no deal by March 1.

The recent US slowdown could be giving China another reason to wait. Despite the reductions in reserve requirements to decade lows (Chart 3), Chinese credit growth has so far shown no signs of picking up (Chart 4).

Beijing might have eased monetary policy even more aggressively last year if it weren’t for the fact that rate hikes by the Fed was pushing down the renminbi (Chart 5).

A much weaker renminbi might have further complicated the US-China negotiation. The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump." - source Bank of America Merrill Lynch

Unless there is a rapid resolution between the United States and China on the trade/tech war narrative which has led to a significant rally in Emerging Markets so far this year on the back of a weaker US dollar, then indeed there is a high probability that the effect of the "Alprazolam" will fade and the bounce experienced so far could end rapidly and abruptly.

Bank of America Merrill Lynch added the following in their report:

"Market implications

Developments over the past two months suggest to us that political risks are rising.
This puts us at odds with current market consensus.

The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:

The USD is vulnerable. We view the escalation of the gridlock risk in Washington as posing the greatest risk to the decoupling trade and to the USD. We are soon approaching a key support level that, if broken, will usher in further USD weakness (USD topped and target reached, but is this it? January 16). We like selling the USD especially against the JPY and the CHF. The EUR has been unable to capitalize on the USD’s retracement this year, reflecting concerns about the growth outlook for the Eurozone. If Eurozone political tension continues unabated, we may have to revisit our bullish EUR/USD forecasts.

EM rally won’t last forever. EM is rallying on Trump’s upbeat comments on the prospect of a trade deal with China. We think the risk of a no deal by March 1 is higher than expected. We also think that the inability of the EUR to gain against the USD will limit the room for further gains in commodity prices and EM. We think EM investors should not wait too long before taking some money off the table. We continue to believe that in 2019 investors need to think strategically but act tactically.

US rates vol looks cheap. Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9).

We see the sell-off as possibly overdone given the binary nature of the political risks we highlighted in this report and the increasingly binary decision the Fed is facing. The worsening supply-demand dynamics as we head into possibly debt ceiling crisis #2 will likely provide strong support to rates vol." - source Bank of America Merrill Lynch

Any spike in rates volatility would obviously be negative for asset prices given carry players, risk-parity investors and other pundits love one thing, and that's low rates volatility. Any return of volatility on the aforementioned would definitely trigger another bout in "risk-off" rest assured.

How convinced are we with the strong rally seen so far from the December "oversold" situation? Not very much, we would argue. Sure, we have seen a welcome respite with the central banking cavalry arriving late, once again to an already damaged macro situation. Given the amount of known "unknowns" and the weaker tone in the overall macro picture, yes bad news are good news again for asset prices, but, we do think that buying some protection to the downside with potential bouts of volatility is a wise move.

Remember 2018 has marked the return of "cash" in your allocation toolbox and it should be used more extensively in 2019 given the risk for even more volatility events than in 2018. Bank of America Merrill Lynch in their High Yield Strategy note from the 18th of January entitled "When Cash Becomes King" makes some compelling arguments about the current tactical rally we are seeing:

"Low-risk yields appear compelling in this macro setup

The rally in leveraged credit has taken a pause in recent sessions, with our DM USD HY index oscillating around 450bps, more or less where it stood a week ago. The same could be said of rates as well, where the 10yr remained range-bound over the past week, spending most of its time around 2.70-2.75%. Even equities exhibited low volatility, by recent standards, with S&P500 moving 10-20pts in most sessions, a sea-change from 80-100pt sessions around year-end.

So, can this be considered an all-clear signal? Perhaps. It undoubtedly adds one reason to think so, although it is hard to make it sound convincing in and of itself. We prefer to rely on more tangible events, something that would not be forgotten tomorrow if volatility were to return.

Among such new developments, we counted the following:

• China: has responded strongly to apparent signs of weakness in its economy by cutting bank reserve requirements, policy rates, and business taxes. The extent of cuts in reserve requirements now exceeds those witnessed in 2008 and 2015. Business taxes were cut to the tune of $30bn/year; for some perspective US corporate tax cuts of 2017 amounted to $600bn/10yrs, or $60bn/yr for an economy that is 1.5x larger. In other words, very meaningful policy actions out of China.
• Earnings: banks opened the reporting season with a bang despite notable shortfalls in FICC results; their other businesses appeared to be doing well. Tax-reform bump is likely to begin coming out of numbers only next quarter, and will potentially reach its peak in Q2-Q3 of 2019. So US earnings could stay artificially elevated for a couple more quarters, in our view.
• Sectors: financials led, while utilities and staples trailed in the whole S&P500 round-trip between Dec 14-Jan 15. The argument goes that financials underperform and defensives outperform into a downturn. And yet the fact that utilities underperformed through a potential PCG bankruptcy does not help the case of this not being a cyclical turn.

On the other side of the ledger, the following reasons support continued caution:

• China: would probably not be throwing this much stimulus if its economy was performing in an acceptable way. The leadership there must know something we don’t know, in our view.
• Earnings: our model for US EPS has experienced further deceleration in recent weeks, and points to +6% growth over the next year. While this is not a level consistent with a cyclical downturn, we note that earnings went from 20%+ actual yoy growth rate in Q3, to earlier estimates around +10-12% to +6% today (Figure 1). So the trajectory and the remaining cushion are a concern.

• Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). While not unheard of, we think this is too tight in today’s market environment given the shift in risk sentiment that has occurred over the past several months. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.

• Illiquidity gap: while liquid bonds have rallied and retraced a good chunk of Dec losses, illiquid paper remains marked at discounted levels (Figure 3 and Figure 4). This behavior is inconsistent with a sustainable turn in market sentiment, i.e. investors must become comfortable bidding for illiquid stuff to demonstrate their conviction. Buying HYG does not cut it.

• High dispersion: only 1/4 of all HY bonds trade within +/-100bps of overall index level; under normal circumstances, 40-50% of them trade this way. High degree of dispersion could be a function of illiquidity gap described above. Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.
• Default estimates: With most factors now fully refreshed with Dec levels, the model continues to point towards 5.5% issuer-weighted and 4.25% par-weighted default rates. Such credit losses, if materialized, imply meaningful pickup over realized levels (2.8%) and point towards wider HY spreads (500bp as a risk-neutral level).

While these data points are not yet known, and could change our thinking as they come in, we remain mindful of a scenario where this episode eventually proves itself to be a cyclical turn. As such, we find current HY valuations to be somewhat out of balance, in terms of likely ranges going forward, i.e. we think probability is higher to see spreads in high-500s rather than low-300s; these two are otherwise equal distance away from here. Given this view, we are reducing our model portfolio beta to a modest underweight at this point, which we intend to move towards a more substantial underweight if  spreads continue to grind tighter from current levels.

Think about what you believe are reasonable return expectations from here, and compare them to low-risk alternatives: Libor is at 2.75%, short-duration IG is at 3.70% yield, and short duration BBs are at 5.20%.

In the environment where the next few months carry a reasonable chance of marking the turning point in this credit cycle, we find such yields increasingly attractive. Even if the cycle overcomes all obstacles and rolls on, you can blend-average the above into 3.5-4% portfolio, with a strong likelihood of actually realizing this return, in our view.

So we are probably entering a period of time when cash is becoming king again. HY may end up showing bouts of strong performance during this time, just as it did in early January, and we remain open-minded to tactically shifting our views when opportunities present themselves. We just struggle to see how it could happen from 450bps overall index levels or from 100bps BBs-BBBs differential." - source Bank of America Merrill Lynch

Being underweight high beta is we think indeed a good recommendation at this stage. Stay nimble and get tactical. Buying HYG might not cut it for Bank of America Merrill Lynch from a "liquidity" perspective, but, from our side and as a useful "macro" defensive tool for credit exposure "hedging", we believe synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to sidestep any Investment Grade liquidity concerns. The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil with "European" banks, though we do not expect Mario Draghi to rock the ECB boat before his departure and it is highly likely the ECB will provide additional LTRO funding to the ailing banks in the European banking system, some more "Alprazolam", one would opine.

On that note, if indeed we are back into a "macro" world when it comes to "trading" then, using the rights "macro" instruments such as synthetic credit indices and options on credit indices might provide mitigation to heightened volatility over the course of 2019 and sufficient liquidity if indeed there is a "liquidity shock" when the "Alprazolam" effect will truly fade.

• Final charts -  Mind the liquidity shock...

While as we pointed out like many pundits that "liquidity" is a concern given how credit markets have swollen in recent years thanks to buybacks supported by very large issuance levels, then looking at the CDS market as a proxy for risk ahead is again warranted as pointed out by Bank of America Merrill Lynch in their Credit Derivatives note from the 16th of January entitled "The basis for a correction" with the below chart pointing out to the underperformance of bonds relative to the CDS market:

"Macro data continue to disappoint; we remain cautious

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to the year for risk assets, we think that volatility will remain a key theme for another year. Large swings and lack of clarity underpin our bearish stance on spreads and beta in the following months; we continue to advise a defensive positioning. The deterioration in macro indicators will keep market sentiment fragile, in our view.

It feels like 2015-16

2018 is likely to be remembered as the worst year since the 2008 crisis. Performance was poor and funds suffered outflows. The performance over the past 12 months resembles that of 2015-16. However, this year started on a much more upbeat note than. 2016. Nonetheless, we are concerned that several factors are reminiscent of the drivers that pushed spreads wider in January and the early part of February 2016. A macro slowdown, lack of inflation in Europe and tightening conditions that risk assets were dealing with back then are still adversely affecting markets.

Gap risks and basis

We also think that CDS is too tight to cash bond spreads and negative basis is supportive for more downside risk in the synthetics space. The “gap” wider risk for the CDS market makes us less comfortable at current levels and, as we see fewer catalysts to reverse this market weakness we would use the recent move tighter as reason to reset shorts, especially by selling receivers to own payers. We also screen for negative basis opportunities.

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. Large swings and lack of clarity underpin our stance to remain bearish spreads and beta in the coming months; we continue to advocate defensive positioning. We expect the deterioration of macro indicators to keep markets sentiment fragile, and until we see the cycle trough, we remain skeptical on how well higher risk/beta pockets will perform." - source Bank of America Merrill Lynch.

So enjoy "Alprazolam" effects while they last as we concluded in similar fashion our previous conversation. Remember that those taking more than 4 mg per day of Alprazolam have an increased potential for dependence. This medication may cause withdrawal symptoms upon abrupt withdrawal or rapid tapering, which in some cases have been known to cause seizures, as well as marked delirium.  The physical dependence and withdrawal syndrome of Alprazolam also add to its addictive nature. Alprazolam is one of the most commonly prescribed and misused benzodiazepines in the United States, benzodiazepines are recreationally the most frequently used pharmaceuticals due to their widespread availability. Alprazolam, along with other benzodiazepines, is often used with other recreational drugs such as QEs but we ramble again...

"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop

Stay tuned !

Macro and Credit - Respite

"I decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it." - Paul Samuelson

Looking with interest at the strong rebound in high beta in credit markets in conjunction with oil prices, with bad news (European macro) becoming good news for asset prices thanks to central banking intervention and dovish tilt, when it came to selecting our title analogy, we decided to steer towards a legal one "Respite". A "Respite" is a delay in the imposition of sentence but in no way modifies a sentence or addresses questions of due process, guilt or innocence. The pardon power of the United States Constitution has been broadly interpreted to include a variety of specific powers. Among those powers are: pardons, conditional pardons, commutations of sentence, conditional commutations of sentence, remissions of fines and forfeitures, respites and amnesties. Historically, presidents have granted most respites for periods of 30 to 90 days and have renewed (extended) such delays when it seemed necessary. We therefore wonder how long the current "respite" and "rebound" in asset prices will last but we ramble again...

In this week's conversation, we would like to look at the most recent bounce in asset prices in the light of the weakening tone from the macro data coming recently from Europe and indicative of the dreaded "R" word, "R" for recession. So, is good news bad news again?

Synopsis:

• Macro and Credit - Bad News is the new Good News...
• Final charts -  Macro matters again...

• Macro and Credit - Bad News is the new Good News...

With Germany on track for "technical" recession, with Italy and France slowing down markedly and with Industrial Production falling depicting a bleak picture overall for Europe (German Industrial Production fell by 4.7% in December, the biggest decline since December 2009), the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture:

- Graph source Bloomberg

Industrial production has been falling in Europe off the proverbial cliff and regardless of the continuation of the "yellow jackets" movement in France, we continue to believe that France's budget deficit for 2019 could be "North" of 4.5%. The services industry in France has been cratering and people tend to forget that services represent 80% in GDP for France versus an average of 76% in the European Union. So, yes, we do believe there is more downside from there for the European macro picture. We are not the only ones sounding the alarm. We read with interest Bank of America Merrill Lynch Europe Economic Weekly note from the 11th of January entitled "The "R" club is recruiting":

"December PMIs: closer to 50, but risks still to the downside

The final print of Euro area composite PMI came in at 51.1, down from 52.7 in November, and the weakest level in four years. A slowdown was reported in both sectors, with manufacturing PMI down to 51.4 from 51.7 in November and service PMI at 51.7 from 53.4 previously. The decline was driven mainly by core countries: French business sentiment was hit by the ‘gilets jaunes’ protests in December (PMIs for both monitored sectors fell below the 50-threshold), and in Germany manufacturing weakness is spilling over to the services sector. On the flipside, Italian PMIs recorded a small improvement in December, with composite PMI back at 50 (no-change threshold), after two months in contractionary territory. With composite PMI averaging below-50 (49.5) in Q4, growth momentum for Italy remains weak. However this improvement (in particular in the new orders balance) suggests some stabilisation in Q1.

Meanwhile hard data for 4Q is not helping either. Industrial production prints were particularly negative. We insist, the weakness goes beyond one offs. Trade data did not help either, neither in Germany nor in France. External demand lacks traction, consequence of the lagged impact of the NEER strengthening and Chinese weakness.

We still think that the Euro area data trough is only for 1Q19, foreign demand permitting. It is then when our China colleagues expect the region to start improving and, given the usual lags, when the negative impact of the NEER should start fading. But remember that Europe typically lags the rest of the world by a few months, and continued weakness in China and the ugly US manufacturing ISM print in December would suggest that foreign demand input to the Euro area is still a drag (Chart 1).

It is crucial for us to see whether the drop in US PMI was a one-off and when the impact of policy support will materialize in China. Meanwhile, we have to rely on low oil prices as a tailwind helping purchasing power and corporate profit margins in the Euro area (Chart 2).

- source Bank of America Merrill Lynch

Obviously given Germany is an export driven powerhouse, no wonder the trade war narrative which has prevailed over most of the course of 2018 has had the desired effect of not only pushing the German DAX index into bear market territory but also has had the effect of plunging Germany into technical recession.

Given the bloodbath experienced during the "Slaughter" Claus bear market of December, it is not surprising to see some sort of strong rebound in "high beta" land and for credit markets to rally particularly on the back of rising oil prices given the exposure of the US High Yield sector we have discussed in recent conversations. 

When it comes to the "Respite" and intensity of the rally in US credit, Bank of America Merrill Lynch in their High Yield Strategy note from the 11th of January entitled "HY Energy: Any Value Left Here?" made some interesting comments:

"Intensity of risk rally reaches historical records

An incredibly strong rally in credit has taken HY spreads down to 450bps from 540bps levels reached in early January. HYG has rallied 5.4% from its low prints around Christmas, the strongest such 10-day rally since Oct 2011 (post-US downgrade rebound) and March 2009 (post-GFC recovery). CCCs have outperformed BBs by 230bps in this move, and Energy was the strongest sector contributor.

As we outlined in our Jan 2 piece, a tactical bounce was likely from the oversold late- December levels as the market has done so in every episode of previous 200bp/3mo widenings. We also noted there that the average rally was 170bps within subsequent three-month horizons in such earlier episodes, and so a 90bp move so far provides a material down-payment towards that. While the market can continue to trend tighter in coming weeks, we think a pullback is possible and even likely here, just given the intensity of the move so far. In the 12 year history of HYG, it has only managed to post stronger 10-day gain in two instances: in 2011 when the market rallied from 900bps levels, and in 2009, when the market was coming out of the global financial crisis (GFC) with 1,800bps spreads. Spreads are not in 900s this time around and this is not 2009.

We continue to think that 500bps is an appropriate risk-neutral level of HY spreads here and the likely trading range around that is going to be +/-100bps. As such we view the current 450bps as somewhat tight and prefer to reduce our risk exposures towards more neutral levels from an earlier overweight. We will be looking to extend this to an outright underweight if the market continues to grind tighter from here towards 400bps levels.

We would be surprised if the index tightening deep into 3-handles in coming months. Similarly, we are inclined to move closer to home with our recent tactical CCC overweight given the move so far, which we viewed purely as a short-term reaction to oversold levels and not a fundamentally-driven position. In rates, the reversal in the 10yr yield from 2.55% low print on Jan 3rd to 2.75% recently makes us more interested in adding duration risk here again. We continue to see decent longer-term fundamental value in rates at current levels as inflation fears of 2018 fade into oblivion.

All changes to positioning described above should be viewed as a tactical reaction to very strong moves in the markets since early January, not as changes to our fundamental view this could be a turn in the credit cycle. No question, the return of risk appetite helps decrease the probability of irreversible tightening in financial conditions, but we think it would be too premature to argue conclusively that this is an all-clear signal.

Tactical rallies are perfectly natural after deep selloffs, but we will need more hard evidence that the damage to economic momentum so far is reversible. What will ultimately determine the course of history here is the direction of earnings growth. Our +10–12% US EPS growth estimate for next year provides us with the strongest argument that this cycle could roll on. However, we remain cognizant that this is a model estimate and models could be wrong. We also know that earnings growth in recent years was largely driven by technology, and recent downbeat outlooks from heavyweights like Apple and Samsung do not help this case. The best course of action here, we think, is to stay open-minded on the question of a cyclical turn." - source Bank of America Merrill Lynch

As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian".  When it comes to fund flows we read with great interest Bank of America Merrill Lynch Follow the Flow note from the 11th of January entitled "Is the worst finally behind us?":

"Some signs of relief

This year has started on a positive note. Despite further weakness on the macroeconomic data front across the globe, risk assets managed to rebound. Light positioning and the end of year sell-off allowed investors to buy the dip. Flows have shown signs of relative stabilisation with fixed income funds seeing inflows and equity funds suffering the smallest outflows in a while. However, we feel that this rally will be short lived as macro continues to disappoint and spreads need to head wider before they tighten again.

Over the past week…

High grade funds suffered another outflow, making this one the 22nd week of outflows over the past 23 weeks. However, this week’s outflow is the second smallest observed over that period. High yield funds recorded another outflow, the 15th in a row, but also the smallest in a while. Looking into the domicile breakdown, European focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Global-focused funds only marginally suffered.

Government bond funds recorded a large inflow this week, the largest in 27 weeks and the 5th over the past 6 weeks. Meanwhile, Money Market funds recorded another sizable inflow. All in all, Fixed Income funds recorded an inflow, putting an end to 18 consecutive weeks of outflows.

European equity funds saw some relief, recording a very marginal outflow this week. Still, this makes it the 18th consecutive week of outflows. During the past 44 weeks, European equity funds experienced 43 weeks of outflows. Chart 1: Risk assets fund flows managed to record a rebound in the first week

Global EM debt shifted back into positive territory this week with a sizable inflow, thus ending a series of 13 consecutive weeks of outflows. This confirms the improving trend observed recently. Commodity funds recorded another inflow, the 5th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow." - source Bank of America Merrill Lynch.

Following the December rout, it is all about damage assessment we think at this stage. The macro picture continues to display a deceleration in both global trade and global growth, now we think, it is all about the earnings picture and given the large standard deviation moves seen in some instances such as Apple, Delta Airlines, Macy's and many more, we are left wondering if indeed this rally can sustain itself on the back of a more dovish tilt from the Fed.

If indeed from a macro perspective at least in Europe it's the "R" word, for "Recession" in many instances, then we wonder if the "D" word, for "Deflation" when it comes to looking at the savage earnings revisions seen so far at a very rapid pace:

- graph source Bloomberg

On the question of the "Deflation" and earnings we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 11th of January entitled "How widespread is creeping deflation in the US stock market?":

"Companies with challenged business models account for nearly two-thirds of the S&P 500's top 50 earners

"Investors are waiting for guidance from the US-China trade negotiations, but most of all they are waiting for indications of how the economic disruptions of the past few months will affect earnings.

The slightest hint of squishier earnings guidance provokes brutal punishment. Wednesday it was telecom providers, today retailers. Fragile business models make most US market leaders risky. That’s why I don’t think a dovish Fed is enough to sustain a market rally.

Department stores led declines today, with Target bringing up the rear in the S&P 100 (-4%) and department stores taking the bottom slots in S&P 500 performance – Macy’s (-19%), L Brands (-7%), Kohls (-7%), Nordstrom (-5.4%).

Airlines took yet another beating, with American Airlines down 6.2%. It’s all about pricing power. Consumers are still spending, with real personal consumption expenditures up 1.9% year-on-year as of November, and more workers are earning a paycheck. Consumer debt service comprises the lowest percentage of personal income since the data were collected.

Yet consumer names have been battered. Apartment real estate investment trusts face falling rents, airlines face passenger pushback on price, aging brands face competition from cheaper generics, and tech companies face resistance to overpriced products, for example, Apple.

Roughly two-thirds of the top 50 S&P 500 companies (ranked by earnings before interest, taxes, depreciation and amortization) face a serious challenge to their business models.

The complete annotated ranking is shown below. Economic growth is not the only issue worrying the stock market. Most of the market leaders are aging monopolies that risk losing their grip on customers.

The biggest exception to this rule is Amazon, which is doing most of the disrupting. But the fact that Amazon is able to disrupt everyone else depends on the willingness of Amazon shareholders to live without earnings. It now trades at around 110 times trailing earnings. Netflix trades at 95 times trailing earnings.

Deflation and value destruction are bad for equity markets. Amazon eats the retail market, and the department stores crash, along with CVS, and the REITs that own the properties from which the retailers rent.

Huawei crushes Apple in the Chinese market. Sprint, T-mobile and even more aggressive discounters erode the earnings of AT&T and Verizon. Proctor and Gamble, Johnson and Johnson, General Mills, Campbell’s and Kraft-Heinz have to sell their products on an Amazon web page that conveniently flashes an ad for a generic alternative.

Taken together, companies with challenged business models generate nearly two-thirds of the earnings among the top 50 members of the S&P 500.

(click to enlarge)

- source Asia Times - David P. Goldman

Now if higher profits were somewhat "juiced" up by stock buybacks, then indeed no wonder earnings revision have been savage so far. Back in October last year in our conversation "The Armstrong limit", we quoted as well another article from David P. Goldman and discussed the "profit illusion". 

In our macro book, the "velocity" in "earnings revisions" regardless of the "Respite" due to "bad news" being "good news" again in forcing the hand of our "generous gamblers" aka our central bankers, mean that the growth outlook for the US is also at risk. This is pointed out by Bank of America Merrill Lynch in their US Economic Weekly note from the 11th of January entitled "Earnings downgrades =  GDP downgrades" and we are not even mentioning the ongoing government shutdown at this stage:

"Earnings downgrades = GDP downgrades

• Earnings estimates continue to be slashed, which suggest that further downward revisions to GDP growth are forthcoming.
• While the direction of revisions is relevant, be careful relating actual earnings growth to economic performance.
• After controlling for oil prices and the services share of the economy, economic and earnings growth become much less correlated.

Resetting expectations

Earnings estimates for 2019 are being slashed. Just this week, Macy's and Barnes & Nobles made news by cutting their profit estimates while American Airlines warned that earnings may fall short of expectations. It seems that analyst estimates may still be too optimistic even after a slew of downward revisions over the past few months. According to Savita Subramanian and team, the consensus EPS growth is 7% for this year, which is down from the 10% forecast just three months ago

What does this tell us about the economy? It is intuitive for earnings estimates to correlate with economic growth as earnings are a function of expected revenue growth. A simple scatter plot of annual EPS growth and nominal GDP growth shows the positive correlation (Chart 1) but with very low significance.

This means there is more to the story. We see three reasons that earnings will differ from US economic growth:

1. S&P 500 has greater sensitivity to global growth with 46% of sales coming from foreign markets. In contrast, only 12% of US growth is from exports.
2. Oil prices have a different impact on the S&P 500 than on the overall economy. There is a clear positive correlation for the market – higher oil prices boost earnings for energy companies. The impact on the US economy is slightly negative.
3. The S&P 500 has a greater concentration of manufacturing

We run a series of models to determine how much these factors influence the relationship between earnings and GDP growth. We first start with a regression of earnings growth as a function of US and global GDP growth which shows a statistically positive relationship between GDP growth and earnings. We then include oil prices which show up as a positive relationship with earnings and reduce the significance of US and global GDP growth. Swings in oil prices can overwhelm the impact of growth. Think back to 2015 when the decline in oil prices led to an earnings recession without an economic one. Adding in the change in services share of the economy ends up leaving US and global GDP growth as insignificant. This tells us that as the economy becomes more services based, the relationship between earnings and US growth weakens.

The sensitivity to global growth and oil prices allows earnings growth to be much more volatile with a standard deviation of 17% vs. nominal GDP growth of 2.5% (Chart 2).

This could also be explained by the fact that the sample for aggregated earnings change overtime, thus creating a bias that does not reflect the whole economy.

We revise together

While the relationship between GDP growth and earnings growth is complicated, as we argue above, we still can take signal from the forecasts for earnings. We find that the direction of earnings revisions can tell us something important about the direction of GDP revisions. As Chart 3 shows, the consensus forecast for earnings and GDP growth tend to be revised in tandem.

Looking at the evolution of forecast for the current year earnings and GDP growth over the past four years, the direction is consistent. The outlier was in 2015 when earnings were slashed more dramatically than GDP and the latter actually ended up being revised higher at the very end of the year.

Collecting all data

Given the high degree of uncertainty about the outlook, we should look at all sources of information. As Fed Chair Powell has made clear in recent remarks, on the one hand, the economic data continue to point to a solid expansion. But on the other hand, market measures have deteriorated with a sharp sell-off in equities and a flattening in the yield curve. We consider earnings estimates to be a mix of both economic and market signals.

We think they are pointing to a moderation in growth but not a contraction. We should heed Powell’s advice. Have patience until we see who is right – the data or the markets." - source Bank of America Merrill Lynch

Where we disagree with Bank of America Merrill Lynch's take is with the "solid expansion" narrative. A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think.

If 2018, with liquidity being reduced thanks to central banks was volatile, 2019 marks we think the return of "macro" and given the rise in dispersion it also marks the return of active management we think as per our final charts below.

• Final charts -  Macro matters again...

With global liquidity supply on reduction mode and with 2018 marking the return of volatility, with rising dispersion and more and more large standard deviation moves, 2019 will continue to indicate a return of macro as an important factor for returns. This means that active management, should benefit from this trend. Our final charts come from Bank of America Merrill Lynch note Why They Did What They Did from the 9th of January entitled "What's past is prologue":

Macro mattered more than fundamentals in 2018

Based on the ~40 macro factors and ~50 quantitative factors we track, macro factors had higher explanatory power on stocks’ 2018 returns than fundamental factors (average R-squared of 5% for macro factors vs. 1% for fundamental factors).

And the top 10 factors with the highest explanatory power were all macro factors – in particular, credit spreads, commodities, the USD, consumer confidence, and the VIX.
As for fundamental factors, one of the most explanatory factors on returns in both 2018 and 4Q was Beta.

Stocks less sensitive to macro (idiosyncratic stocks) have outperformed

• Some stocks tend to move more with macro factors (i.e. high systematic risk) while others move less (i.e. more idiosyncratic). In our recent report we grouped BofAML-covered US stocks based on their overall macroeconomic (i.e. multivariate) impact using a principal components (PC) regression.

• The results from the screen and a backtest of its performance over time suggested that idiosyncratic stocks (those with a below-median regression Rsquared) have outperformed systematic stocks (those with an above-median regression R-squared) since the crisis (including last year), primarily due to lower annualized volatility of the former with slightly better annual returns.

• Segments of the S&P 500 most exposed to risks around trade – in particular, multinationals with high China exposure and stocks in industries with high import costs—have seen multiples compress most (by ~20%) since trade tensions began to rise last February.

- source Bank of America Merrill Lynch

While investors have been enjoying a welcome respite in the early days of 2019, with "bad news" becoming "good news" at least from a "dovish" Fed narrative, we do not buy the strong expansion narrative put forward by many sell-side pundits, though if indeed flows return to credit markets, Investment Grade credit could thrive again at least in the near term from a "Keynesian" perspective. There is no doubt that growth is decelerating and our concern is that cooler head can prevail avoiding us from moving from the "R" word of recession towards the "D" word of depression, but that's a story for another day. Enjoy the ride while it last.

"The only safe ship in a storm is leadership." -  Faye Wattleton, sociologist

Stay tuned !