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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