tag:blogger.com,1999:blog-85543474482999844072024-03-13T16:26:19.463+00:00MacronomicsPersonal comments on Macro trends, Macro news and views. All rights reserved.
Disclaimer:
Information provided on this blog does not constitute a recommendation or advice to purchase any investment, product or service listed or mentioned on this blog. Information displayed on this blog is not intended as specific investment advice and should not be relied on for making investment decisions.Anonymoushttp://www.blogger.com/profile/16670415818064368635noreply@blogger.comBlogger574125tag:blogger.com,1999:blog-8554347448299984407.post-85564751457866824942019-06-21T17:15:00.002+01:002019-06-21T17:15:38.883+01:00Macro and Credit - Klondike<div dir="ltr" style="text-align: left;" trbidi="on">
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"Having patience is one of the hardest things about being human. We want to do it now, and we don't want to wait. Sometimes we miss out on our blessing when we rush things and do it on our own time." - Deontay Wilder</blockquote>
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Looking at the latest FOMC decision, leading to further compression of US yields in conjunction with rising negative yielding bonds to the tune of $12.3 trillion, making credit and high beta risky assets TINA (There Is No Alternative) again, when it came to selecting our title analogy, we decided to continue with the theme of games and playing cards this time around. Klondike (North America) or Canfield (traditional) is a patience game (solitaire card game). In the U.S. and Canada, Klondike is the best-known solitaire card game, to the point that the term "solitaire", in the absence of additional qualifiers, typically refers to Klondike. Elsewhere the game is known as American Patience. </div>
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The game rose to fame in the late 19th century, being named "Klondike" after the Canadian region where a gold rush happened. With the FOMC (Federal Open Market Committee) holding interest rates steady on Wednesday while opening the door to a cut by dropping its commitment to being "patient" in its policy statement, in similar fashion to the name of the card game of Klondike also known as "patience", the Fed conceded to more accommodation to come in July in the form of a rate cut. No wonder it led in similar fashion to a "Klondike" leading yet to another "gold rush" it seems as anticipated somewhat in our previous musing. What we find of interest in the game of "Klondike" played by the Fed is that from a probability perspective, about 79% of the games are theoretically winnable, but in practice, human players do not win 79% of games played, due to wrong moves that cause the game to become unwinnable. In addition to this probabilistic feature, some games are "unplayable" in which no cards can be moved to the foundations even at the start of the game; these occur in only 0.25% (1 in 400) of hands dealt. </div>
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Also, there is a modified version of the game called "Thoughtful Solitaire", in which the identity of all 52 cards is known. Because the only difference between the two games (Klondike and Thoughtful) is the knowledge of card location, all "Thoughtful" games with solutions will also have solutions in "Klondike". Similarly, all dead-ends in "Thoughtful" will be dead ends in "Klondike". However, the theoretical odds of winning a standard game of "non-Thoughtful Klondike" are currently not known exactly. The inability of theoreticians to precisely calculate these odds has been referred to by mathematician <a href="https://math.washington.edu/events/2009-10-23/shuffling-cards-and-adding-numbers">Persi Diaconis</a> as "one of the embarrassments of applied probability but we ramble again...</div>
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<span style="background-color: white; font-family: inherit;">In this week's conversation, we would like to look at what the latest Fed decision entails as we think that we are on the cusp of a final melt-up which could be given an additional boost from some cease-fire agreement between China and the United States when it comes to the lingering trade war.</span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - Is the Fed ready for "easing" after being "easy"?</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final charts - Fed "easing" should undermine the US dollar.</b></i></li>
</ul>
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<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - Is the Fed ready for "easing" after being "easy"?</li>
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Given the global "dovishness" now being actively espoused globally and with the Fed conceding to what the financial markets want, we view a continuation of the "Japanification" playing out, meaning that credit spreads will continue to perform and compress, and the corporate debt bubble to inflate in this Chinese year of the pig. The appetite for yield hungry investors will continue to push even more government bonds yields to absurd level and even more European corporate yields into negative territory. </div>
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From an allocation perspective, as we pointed out before, where oil price goes, so does US High Yield, clearly since the beginning of the year US Investment Grade has outperformed US High Yield, respectively up 10% and 9%. Our defensive stance favoring quality (Investment Grade) over quantity (US High Yield has been vindicated. As well our preference for the long-end of the US yield curve is paying decently with long-term US Treasuries ($TLT) up by 11%. Year to date the ETF ZROZ we follow is up by a decent 14.4%. Gold is rising again in a very much "Klondike" way with gold miners racing ahead thanks to the return of the "D" word of "Deflation" and "D" for "Dovishness".<br />
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As we highlighted in our most recent musing, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder. The trajectory of real yields matter when it comes to gold:<br />
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"The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar." - source Macronomics, June 2019</blockquote>
We also added:<br />
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"If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained." - source Macronomics, June 2019</blockquote>
Given the latest tone down from the Fed with rate cut expectations in July, and a possible form of resolution between the United States and China with the upcoming G20, there is indeed a potential for an additional melt-up, and in this scenario, high beta would therefore start to outperform again strongly.<br />
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A weaker US dollar is as well highly beneficial to the Emerging Markets complex. Should you therefore "buy" the proverbial dip? Obviously credit continues to benefit from "Bondzilla" the NIRP monster close to $13 trillion. In that context yield hunt will resume its trajectory.<br />
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When it comes to the much discussed "leveraged loans" we continue to see the "great rotation" playing out from the feeble hands of retail, namely them leaving the asset class and investing into US High Yield. This is clearly indicated by <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/outflow-streak-hits-30-weeks-as-leveraged-loan-funds-see-686m-withdrawal">LeveragedLoan.com part of S&P Global Market Intelligence</a>:<br />
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"Outflows from mutual funds and ETFs that invest in U.S. leveraged loans totaled $686 million for the week ended June 12, according to Lipper weekly reporters. That's less severe than the $1.47 billion withdrawal a week ago, but marks the 30th straight net outflow from the investor segment, for a total of slightly more than $30 billion over that span.</blockquote>
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<a href="https://1.bp.blogspot.com/-sO1xLDw-F10/XQyxZzYqz_I/AAAAAAAAWXw/TJ5tnjvatq4OKvbEAxJNv8K-d2eSW0y5QCLcBGAs/s1600/Leveraged%2BLoan%2B-Loan%2Bfund%2BFlows%2BJune%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="281" data-original-width="420" height="214" src="https://1.bp.blogspot.com/-sO1xLDw-F10/XQyxZzYqz_I/AAAAAAAAWXw/TJ5tnjvatq4OKvbEAxJNv8K-d2eSW0y5QCLcBGAs/s320/Leveraged%2BLoan%2B-Loan%2Bfund%2BFlows%2BJune%2B2019.jpg" width="320" /></a></div>
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Retail investors have beat a steady retreat from the floating rate asset class as prospects of a Fed rate hike have evaporated, and as expectations of rate hikes solidify.</blockquote>
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The record for consecutive withdrawals from U.S. loan funds is 32 weeks, for a streak that ended March 2, 2016, though outflows during that time totaled only $17.6 billion, according to Lipper.</blockquote>
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Mutual funds provided the bulk of the outflow over the past week, at $572 million, while loan ETFs saw a withdrawal of $114 million. The four-week average is now a net $781 million outflow. The change due to market conditions over the past week was positive $56 million.</blockquote>
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Year to date, including the week ended Jan. 2, outflows from the segment now total $16.5 billion. Assets at U.S. loan funds stand at $78.6 billion, of which $8.2 billion are via ETFs, according to Lipper." - source S&P Market Intelligence</blockquote>
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At the same time, the feeble retail investors crowd did put $602M into US High Yield funds, the second straight week of inflows. YTD: +$8.9B $HYG $JNK according to S&P Market Intelligence:<br />
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<a href="https://1.bp.blogspot.com/-J2NtbabB-qU/XQyymMmAK5I/AAAAAAAAWX8/-QzrahksZC4NSGoFYpa3LuKeMfSdiLmbQCLcBGAs/s1600/Leveraged%2BLoan%2B-%2BHY%2Bfund%2Bflows%2B20-06-2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="454" data-original-width="680" height="213" src="https://1.bp.blogspot.com/-J2NtbabB-qU/XQyymMmAK5I/AAAAAAAAWX8/-QzrahksZC4NSGoFYpa3LuKeMfSdiLmbQCLcBGAs/s320/Leveraged%2BLoan%2B-%2BHY%2Bfund%2Bflows%2B20-06-2019.jpg" width="320" /></a></div>
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- source S&P Market Intelligence</div>
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With the market now pricing in a 100% probability of a rate cut in July, from a "Klondike" perspective, we do think there is a potential for more melt-up in the high beta space.<br />
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So what's our current view on the US 10 year yield you might rightly ask?<br />
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<span style="background-color: white; font-family: inherit; line-height: 16.9px;">As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:</span></div>
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<span style="font-family: inherit;"><b style="background-color: white; line-height: 16.9px;">"<span style="color: red;">Government bonds are always correlated to nominal GDP growth</span></b><span style="background-color: white; line-height: 16.9px;">, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you." - Macronomics, December 2015, <a href="https://macronomy.blogspot.com/2015/12/macro-and-credit-ghost-of-christmas-past.html">The Ghost of Christmas Past</a></span></span></blockquote>
So if indeed US GDP growth is decelerating, then, obviously the US 10 year yield is right where it should be given FOMC change in real GDP for 2019 is around 2.1%. Case closed.<br />
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Giving the global dovishness from our "generous gamblers" aka our dear central bankers, when it comes to this game of Klondike and asset implications we read with interest UBS take from their Global Macro Strategy note from the 20th of June entitled "Fed, ECB Promise Insurance: Asset Implications":<br />
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"<b>Rates: Lower long end real; front end sits oddly with financial conditions</b></blockquote>
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The market has celebrated the readiness from the Fed to provide insurance and bull steepened the curve. Compared with the beginning easing cycles over the last 30 years, inflation is marginally lower today, but financial conditions are significantly looser (Figure 1). </blockquote>
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<a href="https://1.bp.blogspot.com/-ICJ7CIXeU94/XQzi487oFoI/AAAAAAAAWYI/L--kr86kH-g2moWM1RL6-ExoLfmzoMTUACLcBGAs/s1600/UBS%2B-%2BMacro%2Band%2BMarkets%2Benvironment%2Bbefore%2Bprevious%2Bfour%2BFed%2Bcutting%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="278" data-original-width="816" height="109" src="https://1.bp.blogspot.com/-ICJ7CIXeU94/XQzi487oFoI/AAAAAAAAWYI/L--kr86kH-g2moWM1RL6-ExoLfmzoMTUACLcBGAs/s320/UBS%2B-%2BMacro%2Band%2BMarkets%2Benvironment%2Bbefore%2Bprevious%2Bfour%2BFed%2Bcutting%2Bcycles.jpg" width="320" /></a></div>
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Our Economic team's view is now for a 50bps cut in July, (64% priced), which may take some deterioration in financial conditions to be fully priced. Based on the current information, and with 76 bps already priced till year end, we would not be receiving the very front end here, and would rather position through long 5-year breakevens and receiving long-end real rates. The Fed Chair cited concerns over fall in 5y5y breakevens several times as a reason for the material shift lower in dots." - source UBS</blockquote>
What is indeed striking to use as we mused in our previous conversation is that financial conditions, while tightening already in some parts are not as tight as in previous cycles as highlighted by UBS table above. This is what we had to say in our previous conversation:<br />
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"Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war." - source Macronomics, June 2019</blockquote>
Though we were steering towards a more cautious side, given flash U.S. Composite Output Index just came out 50.6 (50.9 in May), a 40-month low, we would not dare to "fight" the Fed and we'd rather probably switch slightly to "offense" from "defense". Credit wise, European Investment Grade remains unattractive with European yield at 0.55% (Barclays EuroAgg Corporate ISMA Yield). So all in all, we'd rather stick with US Investment Grade than European Investment Grade. In Europe we prefer European High Yield in that context. As far as US High Yield is concerned, just follow oil prices.<br />
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For the "perma bear" out there, it's the velocity of oil prices that matter on the way up as well as on the way down when it comes to "high beta". We still think that eventually the spark of a "crash" will be ignited by a sudden spike in inflation à la 2008. We are not there yet, and on that front, it could come from a "geopolitical exogenous" factor.<br />
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Clearly as highlighted by Société Générale in their 20th of June report "On Our Minds" entitled "The Fed loses patience and ready to act", the game of Klondike comes to mind:<br />
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"Summary: The Fed lost patience in June. Dropping this key word and announcing they will closely monitor incoming information strongly suggests rate cuts. Timing and magnitude are the questions. We see two cuts in 2019 matching a heavy weighting of the dots offered in the June Summary of Economic Projections.</blockquote>
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<b>Median held in 2019—but large mass of dots imply two rate cuts</b></blockquote>
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The Fed announced they are monitoring information closely. They dropped their reference to patience. The news implies they are at willing to make insurance cuts to keep the expansion intact. The first cut likely at the next FOMC meeting in July.</blockquote>
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<b>FOMC revises up GDP and lowers the unemployment projections</b></blockquote>
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The US growth outlook alone does not immediately justify rate cuts, but with inflation low and risks and uncertainty increasing, Fed officials appear willing to make one to two cuts.</blockquote>
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<b>Insurance cuts that the Fed foresees pulling back eventually</b></blockquote>
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The Fed median does not fully grasp the number of Fed officials willing to cut by 50bps. Cuts are likely sooner than the median implies Yet hikes into 2021 imply the Fed will pull back these insurance cuts. The Fed does not yet appear back a full rate cut cycle.</blockquote>
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<a href="https://1.bp.blogspot.com/-K2fQ1x4jzfE/XQz59dZQOEI/AAAAAAAAWYU/pQqR3CnGIkse6Km2CgI3JnsRbCKo_fwLQCLcBGAs/s1600/SG%2B-%2BFed%2Bdot%2Bplots%2BJune%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="485" data-original-width="899" height="172" src="https://1.bp.blogspot.com/-K2fQ1x4jzfE/XQz59dZQOEI/AAAAAAAAWYU/pQqR3CnGIkse6Km2CgI3JnsRbCKo_fwLQCLcBGAs/s320/SG%2B-%2BFed%2Bdot%2Bplots%2BJune%2B2019.jpg" width="320" /></a></div>
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<b>Fed insurance cuts vs full rate-cut cycle</b></blockquote>
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The Fed dot plot assumes one to two cuts and then rates are held steady and eventually hiked again. This would follow a pattern more akin to insurance cuts that achieve a soft landing.</blockquote>
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Markets are priced for more. Eventually we view the US economic situation as requiring more. We now foresee the Fed following up with insurance cuts in 2019 and highlight July and September for the moves that reduce the fed funds rate by 25 bps each. The magnitude and timing remain sensitive to the G20 meetings and trade talks between the US and China. Additionally, incoming US data with strong US consumers and still solid employment influence timing.</blockquote>
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We still see a need for more aggressive rate cuts eventually as sigs of US economic weakness are more pronounced. US manufacturing is currently soft, but that may be needed to reduce inventory overhang. US consumption and employment remain solid for now. Our preliminary call for June non-farm payrolls is for a 175k increase. We still have 3.6% unemployment rate, but that rate can still drop further due to the pace of hiring.</blockquote>
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The FOMC revised up its GDP estimate for 2020! Further, the FOMC reduced their unemployment rate projections. These projections do not reflect major risks. Rather it is the low inflation rate along with risks that allow the Fed to make insurance cuts.</blockquote>
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<a href="https://1.bp.blogspot.com/-mawYh8NgfP0/XQz6ikZwuWI/AAAAAAAAWYc/PsU5cO5ShJkcOaW-qnzKIQ9QAyisc_uzQCLcBGAs/s1600/SG%2B-%2BFed%2Bremains%2Brelatively%2Bconfident%2Bon%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="377" data-original-width="893" height="135" src="https://1.bp.blogspot.com/-mawYh8NgfP0/XQz6ikZwuWI/AAAAAAAAWYc/PsU5cO5ShJkcOaW-qnzKIQ9QAyisc_uzQCLcBGAs/s320/SG%2B-%2BFed%2Bremains%2Brelatively%2Bconfident%2Bon%2Bgrowth.jpg" width="320" /></a></div>
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<b>Low inflation </b>– the Fed lowered their headline and core inflation readings for 2020, is a major driver in the Fed’s willingness to cut rates. Fed officials foresee uncertainty, global sluggishness and a stronger dollar as over-riding domestic labor markets in shaping the outlook on inflation." - source Société Générale.</blockquote>
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Given in the game of Klondike the issue is that a wrong move cannot be known in advance whenever more than one move is possible, we remain agnostic about how aggressive the Fed will be as it has clearly shown us to be "data dependent". Is the recent weakness transitory and mostly due to the trade war narrative being extended into overtime? We wonder.<br />
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For our final chart, the big known unknown remains the trajectory of the US dollar. We continue to think though there is more weakness ahead.<br />
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<li style="line-height: 20.8px; text-align: justify;"><i><b>Final charts - Fed "easing" should undermine the US dollar.</b></i></li>
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Our final chart below comes from Deutsche Bank FX Special Report from the 18th of June and entitled "A unique Beast". It displays the trajectory of the US dollar surrounding Fed easing cycles:<br />
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"<b>The FX market.</b> </blockquote>
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In the 3m after easing the dollar TWI tends to continue the pre-easing trend (up or down!) rather than automatically start weakening. In this cycle unique features include: i) low/negative rates elsewhere; and, ii) the unusual US rate-spread advantage across short and back-end yields. It will then take multiple Fed rate cuts to undermine the USD’s rate advantage, generating even more USD resilience than usual.</blockquote>
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<a href="https://1.bp.blogspot.com/-_qDkBvociVw/XQz-4BpsMYI/AAAAAAAAWYo/uX1Jx-l117UebFmtjbdWtW8E2tJney3aQCLcBGAs/s1600/DB%2B-%2BUSD%2BBIS%2Bnarrow%2BTWI%2Bperformance%2Bsurrounding%2BFED%2Beasing%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="411" data-original-width="557" height="236" src="https://1.bp.blogspot.com/-_qDkBvociVw/XQz-4BpsMYI/AAAAAAAAWYo/uX1Jx-l117UebFmtjbdWtW8E2tJney3aQCLcBGAs/s320/DB%2B-%2BUSD%2BBIS%2Bnarrow%2BTWI%2Bperformance%2Bsurrounding%2BFED%2Beasing%2Bcycles.jpg" width="320" /></a></div>
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Fed easing will undermine the dollar's upside on a TWI basis, but the central bank will have to deliver more than the 50bps of cuts by Dec meeting to kick start EUR/ USD meaningfully higher.</blockquote>
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<a href="https://1.bp.blogspot.com/--dSJgi_N0NY/XQz_Pdf8xGI/AAAAAAAAWYw/gP6yyjisaTkwkDMJIIsDImMYsm_osqI6ACLcBGAs/s1600/DB%2B-%2BEUR%2B-%2BUSD%2Bsurrounding%2BFed%2Beasing%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="413" data-original-width="557" height="237" src="https://1.bp.blogspot.com/--dSJgi_N0NY/XQz_Pdf8xGI/AAAAAAAAWYw/gP6yyjisaTkwkDMJIIsDImMYsm_osqI6ACLcBGAs/s320/DB%2B-%2BEUR%2B-%2BUSD%2Bsurrounding%2BFed%2Beasing%2Bcycles.jpg" width="320" /></a></div>
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Momentum trading has had a record of doing poorly in easing cycles.</blockquote>
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<a href="https://1.bp.blogspot.com/-3MyuX1Fmcq8/XQz_jQnpa0I/AAAAAAAAWY4/o433uBSQZe488zyOEOXE0RpOZz9v4jTOgCLcBGAs/s1600/DB%2B-%2BMomentum%2BIndex%2Bsurrounding%2BFEd%2Beasing%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="557" height="226" src="https://1.bp.blogspot.com/-3MyuX1Fmcq8/XQz_jQnpa0I/AAAAAAAAWY4/o433uBSQZe488zyOEOXE0RpOZz9v4jTOgCLcBGAs/s320/DB%2B-%2BMomentum%2BIndex%2Bsurrounding%2BFEd%2Beasing%2Bcycles.jpg" width="320" /></a></div>
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Value currency investing does better especially a year after easing cycles begin.</blockquote>
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<a href="https://1.bp.blogspot.com/-kknuR44mjBg/XQ0AAUSdkPI/AAAAAAAAWZA/gRfFzIoatOYOdTBApBEJJT5GF_hR2Q4zACLcBGAs/s1600/DB%2B-%2BGold%2Bperformance%2Bsurrounding%2BFed%2Beasing%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="557" height="226" src="https://1.bp.blogspot.com/-kknuR44mjBg/XQ0AAUSdkPI/AAAAAAAAWZA/gRfFzIoatOYOdTBApBEJJT5GF_hR2Q4zACLcBGAs/s320/DB%2B-%2BGold%2Bperformance%2Bsurrounding%2BFed%2Beasing%2Bcycles.jpg" width="320" /></a></div>
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This favors short base metals – long precious metals." - source Deutsche Bank</blockquote>
From a "Klondike" perspective and an additional "gold" rush, it remains to be seen how aggressive the Fed will be in July. While we do expect at least some short-term pull-back on gold prices, it really depends if the Fed decides to throw early in the kitchen sink and the trajectory of "real yields (<a href="https://en.wikipedia.org/wiki/Gibson%27s_paradox">Gibson's paradox</a>) and obviously the G20 outcome surrounding the US-China tug of war. American patience is, it seems, the name of the game...<br />
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<blockquote class="tr_bq">
"Just be patient. Let the game come to you. Don't rush. Be quick, but don't hurry." - Earl Monroe</blockquote>
Stay tuned !</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-67518059356750933062019-06-10T22:40:00.002+01:002019-06-10T22:40:03.731+01:00Macro and Credit - The Numbers Game<div dir="ltr" style="text-align: left;" trbidi="on">
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<span style="font-family: inherit;">"Nobody trusts anyone in authority today. It is one of the main features of our age. Wherever you look, there are lying politicians, crooked bankers, corrupt police officers, cheating journalists and double-dealing media barons, sinister children's entertainers, rotten and greedy energy companies, and out-of-control security services." - Adam Curtis</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the trade war escalation with Mexico, leading to de-escalation, triggering more volatility in already jittery markets, in conjunction with more dovishness expectations from Central Banks, and with the prospect of the introduction of the so-called “mini-BOT” scheme, named after Italy’s Treasury bills in Italy, when it came to selecting our title analogy in continuation to our previous Chinese game of "<a href="http://macronomy.blogspot.com/2019/05/macro-and-credit-banqi.html">Banqi</a>" reference, we decided to go for the Italian game of the "Numbers Game". The numbers game, also known as the numbers racket, the Italian lottery, or the daily number, is a form of illegal gambling or illegal lottery played mostly in poor and working class neighborhoods in the United States, wherein a bettor attempts to pick three digits to match those that will be randomly drawn the following day. For many years the "number" has been the last three digits of "the handle", the amount race track bettors placed on race day at a major racetrack, published in racing journals and major newspapers in New York. </span></div>
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<span style="font-family: inherit;">What we find of interest, before we enter our usual "Macro and Credit" musing is that closely related is a policy, known as the policy racket, or the policy game. </span></div>
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<span style="font-family: inherit;">There is more to our title that meet the eye given Peter Navarro wrote in 1984 (the famous "dystopian" year) a book entitled "<a href="https://www.amazon.com/Policy-Game-Interests-Ideologues-Stealing/dp/0669141127">The Policy Game: How Special Interests and Ideologues Are Stealing America</a>". </span></div>
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<span style="font-family: inherit;">Peter Navarro being Trump's top trade adviser we find it interesting in the light of the current trade war developments to look more closely at his change of views as put forward by AXIOS in June 2018 in their article entitled "<a href="https://www.axios.com/uk-conservative-party-leadership-candidates-theresa-may-brexit-7374f218-383c-4152-9a40-6c3a16523f1e.html">Peter Navarro's radical transformation</a>":</span></div>
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<span style="font-family: inherit;">"People think of Peter Navarro, the top White House trade adviser, as President Trump’s mind-meld on tariffs — the most hardline protectionist in the White House. But Navarro used to preach very different ideas in his early career as an economist.</span></blockquote>
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<span style="font-family: inherit;">The bottom line: In his 1984 book, "The Policy Game: How Special Interests and Ideologues are Stealing America," that's no longer in print — Axios got a copy from a university library — Navarro sounds a lot like the very administration officials he's sparred with on trade policy. And he argues that tariffs will inevitably send the global economy into crisis.</span></blockquote>
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<span style="font-family: inherit;"><b>We asked Navarro</b> what prompted the radical change in his views, and he explained how he went from a free trader to an economic nationalist. In response to "The Policy Game," specifically, Navarro told Axios:</span></blockquote>
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<i><span style="font-family: inherit;">It borders on the comical that Axios would spend so much time on a book written 34 years ago and completely ignore the insights of my later works like the 2006 Coming China Wars, the 2011 Death By China, and the 2015 Crouching Tiger. Together, these books explain at length why the globalist Ricardian free trade model is broken and urgently needs fixing in the name of both the economic and national security of the United States.<br />— Peter Navarro</span></i></blockquote>
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<b><span style="font-family: inherit;">From the book...</span></b></blockquote>
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<i><span style="font-family: inherit;">"The clear danger of this trend [protectionism] is an all-out global trade war; for when one country excludes others from its markets, the other countries inevitably retaliate with their own trade barriers. And as history has painfully taught, once protectionist wars begin, the likely result is a deadly and well-nigh unstoppable downward spiral by the entire world economy.</span></i></blockquote>
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<span style="font-family: inherit;"><i>If the world is, in fact, sucked into this spiral, enormous gains from trade will be sacrificed. While such a sacrifice might save some jobs in sheltered domestic industries, it will destroy as many or more in other home industries, particularly those that rely heavily on export trade. <span style="color: red;">At the same time, consumers will pay tens of billions of dollars more in higher prices for a much more limited selection of goods. Sacrificed, too, on the altar of protectionism will be the very heart of an international world order that since World War II has successfully changed the aggressive struggle among nations for world resources and markets into a peaceful economic competition rather than a confrontational political or military one</span>."</i><i>— "The Policy Game," pg. 55</i></span></blockquote>
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<span style="font-family: inherit;"><b>There are multiple passages</b> in "Policy Game" that directly argue against Navarro's current positions. Navarro's go-to argument defending the White House's trade moves has been national security. In a June New York Times op-ed, he wrote:</span></blockquote>
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<i><span style="font-family: inherit;">"President Trump reserves the right to defend those industries critical to our own national security. To do this, the United States has imposed tariffs on aluminum and steel imports. While critics may question how these metal tariffs can be imposed in the name of national security on allies and neighbors like Canada, they miss the fundamental point: These tariffs are not aimed at any one country. They are a defensive measure to ensure the domestic viability of two of the most important industries necessary for United States military and civilian production at times of crisis so that the United States can defend itself as well as its allies."</span></i></blockquote>
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<span style="font-family: inherit;"><b>But Navarro's own book</b> topples that argument as well:</span></blockquote>
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<i><span style="font-family: inherit;">"On the benefit side, protectionism within certain basic industries like autos, steel, and electronics helps to create and sustain an industrial base that, in times of war or national peril, can be shifted to defense purposes, However, this national security argument — and the existence of any benefits resulting from protecting these industries — can be legitimately called into question for several reasons.</span></i></blockquote>
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<i><span style="font-family: inherit;">First, the existence of any sizable benefits rests on the assumption that import competition in our defense-related industries would not only reduce the size of these industries but also shrink them to the point where they would be too small to support our defense needs. The threshold of danger is a matter of some dispute. How big, after all, do our auto, steel, or electronics industries have to be to keep our borders safe? In spite of this uncertainty, few analysts would argue that import competition is likely to push a nation with as large and mature an industrial base as ours anywhere close to that threshold.</span></i></blockquote>
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<i><span style="font-family: inherit;">Second, <span style="color: red;">it is highly possible that our defense capability might actually be enhanced — not damaged — by import competition. Without the umbrella of protectionism, our defense-related industries would be forced to operate at lowest cost, engage in more research and development, aggressively innovate to stay one step ahead of the competition, and modernize their plants at a faster pace.</span> Thus, while import competition might shrink these industries, they would be leaner, tougher, more efficient, and more modern and in all likelihood outperform a bigger and inefficient (protected) version of those same industries.</span></i></blockquote>
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<i><span style="font-family: inherit;">On the national security cost side, the major effect of protectionism is to threaten the stability of the international economic order through a global trade war..."<br />— "The Policy Game," pg. 82</span></i></blockquote>
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<span style="font-family: inherit;">Navarro lauded the impact of tariffs on saving American jobs in a May op-ed in USA Today, writing:</span></blockquote>
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<i><span style="font-family: inherit;">"There can be no better way to make America — and American manufacturing — great again than to start to rebuild those communities of America most harmed by the forces of globalization. These new facilities will stand as shining testimony to the success of tough trade actions, smart tax policies and targeted worker-training programs."</span></i></blockquote>
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<span style="font-family: inherit;"><b>But he warned against</b> the harmful longer-run effects of tariffs on jobs in his 1984 book:</span></blockquote>
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<i><span style="font-family: inherit;">"American protectionism threatens employment and profits in the export-dependent nexus because it invites retaliation from our trading partners ...</span></i></blockquote>
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<i><span style="font-family: inherit;">From these direct and indirect effects, it is clear that over time, the major benefits of protectionism — more jobs and higher profits — are largely and perhaps completely offset by a reduction in jobs and profits in export and linkage industries and in those industries vulnerable to the 'end run.' Therefore, the argument that protectionism serves as a jobs and income assistance program must be discounted."<br />— "The Policy Game," pg. 79-80</span></i></blockquote>
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<span style="font-family: inherit;">And Navarro has emphasized that tariffs won't hurt American consumers, saying on CBS' "Face the Nation" in March that the Trump administration's moves' effect on the prices of consumer goods will be "negligible to nothing."</span></blockquote>
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<span style="font-family: inherit;"><b>In 1984, Navarro held a very different view:</b></span></blockquote>
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<i><span style="font-family: inherit;">"<span style="color: red;">The biggest losers in the protectionist policy game are consumers</span>. Even here. however, 'consumers' do not constitute a monolith, for there are several different consumer categories.</span></i></blockquote>
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<i><span style="font-family: inherit;">Bearing the greatest burden of protectionism are American retail shoppers who pay over $70 billion annually in higher prices (and reduced consumption) for products ranging from autos, bicycles, and color TVs to shoes, shirts, and cutlery."<br />— "The Policy Game," pg. 65</span></i></blockquote>
<span style="font-family: inherit;">We find it very interesting given we already discussed the trend of "de-globalization" in this blog on numerous occasions, particularly again in January 2018 in our post entitled "<a href="https://macronomy.blogspot.com/2018/01/macro-and-credit-twain-laird-duel.html">The Twain-Laird Duel</a>":</span><br />
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<span style="font-family: inherit;">"In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "<a href="http://macronomy.blogspot.com/2018/01/macro-and-credit-bracket-creep.html">Bracket creep</a>", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening. </span></blockquote>
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<span style="font-family: inherit;">Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". " - source Macronomics, January 2018</span></blockquote>
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<span style="font-family: inherit;"><span style="background-color: white;">It is a theme we approached in January 2015 in our conversation "<a href="http://macronomy.blogspot.com/2015/02/credit-pigou-effect.html">The Pigou effect</a>" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. </span>Hedge Fund manager Crispin Odey given in an <a href="http://www.theguardian.com/business/2015/feb/20/crispin-odey-debt-deflation-downturn-predictions">interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February</a> 2015:</span></div>
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<span style="font-family: inherit;">“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.</span></div>
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<span style="font-family: inherit;">“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, <b><span style="color: red;">if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from</span></b>. And <b><span style="color: red;">there will come a point where the productivity gains from the cheapest also decline</span></b>, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian</span></div>
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<span style="font-family: inherit;">Sir Jimmy Goldsmith's <a href="https://www.youtube.com/watch?v=4PQrz8F0dBI">great 1994 interview following the publication of his book "The Trap" which was eerily prescient</a>. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.</span></div>
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<span style="font-family: inherit;">In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "<a href="http://bit.ly/1zWAHNA">The Response</a>" (link provided):</span></div>
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<span style="font-family: inherit;">"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that <b><span style="color: red;">the purpose of the economy is to serve society, not the other way round</span>. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation</b>. " Sir Jimmy Goldsmith</span></blockquote>
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<span style="font-family: inherit;">Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election.</span></div>
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For those wondering what comes next, as discussed in January 2018, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder.<br />
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<span style="font-family: inherit;">We indicated in January 2017 in our conversation </span><span style="text-align: left;">"</span><a href="http://macronomy.blogspot.com/2017/01/macro-and-credit-woozle-effect.html" style="text-align: left;">The Woozle effect</a><span style="text-align: left;">"</span><span style="font-family: inherit;"> the following:</span></div>
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<span style="font-family: inherit;">"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017</span></blockquote>
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This we think has the potential to happen in the coming week/months provided there is no deal between China and the United States. The trajectory of real yields matter when it comes to gold.</div>
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<span style="background-color: white; font-family: inherit;">In this week's conversation, we would like to look at a potential turn in the credit cycle, given the very weak tone coming from the latest US employment report and nonfarm payrolls coming at 75 K on a back of the blunt use of tariffs as economic policy which is already neutering gains from tax cuts.</span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - T</b></i><b><i>ariffs as a blunt instrument of economic policy? Handle with care.</i></b></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final charts - Fed it taking it "easy" not "easing" yet.</b></i></li>
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<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.</li>
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On the question of the "misuse" of tariffs as economic policy we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 7th of June entitled "<a href="https://www.asiatimes.com/2019/06/article/how-i-nailed-the-may-payroll-bust/">How I nailed the May payroll bust</a>":<br />
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"Today’s data is a warning to the Trump Administration about the misuse of tariffs as a blunt instrument of economic policy. <span style="color: red;">The uncertainty generated by the threats to global supply chains from China to Mexico discourages capital investment</span>. The tariffs already in place have taken back almost the whole of Trump’s $930 tax cut for the average American family, according to research by the New York Federal Reserve. That explains why retail sales are growing just 1% a year in real terms.</blockquote>
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America’s growth spurt during the past two years has been Donald Trump’s great success. Tax cuts and deregulation (as well as the promise of more deregulation) revived the animal spirits of small business and produced an employment boom. But the president’s reliance on tariffs threatens to undo his good work, and prejudice his chances for re-election in 2020.</blockquote>
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Paradoxically, the terrible, horrible, no-good, very bad payroll report is very good news for equities. It will strengthen the position of those among Trump’s counselors who have warned him that tariff wars are bad news for the economy. Sadly, the equity market depends more on how the president reacts to economic news than on the economic news itself." - source David P. Goldman, Asia Times</blockquote>
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Already the trade war rhetoric is taking its toll on employment levels with US automakers coming under pressure recently. From China to the U.K., Germany, Canada and the U.S., companies have announced at least 38,000 job cuts in the past six months. Auto demand is increasingly becoming collateral damage when it comes to the ongoing tensions between the United States and China. As we pointed out in our last conversation, Germany is greatly exposed to the rising tensions. This can be ascertained by the latest industrial production print for April falling by 1.9%, the most since August 2014 and four times more than expected. </div>
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As well, inflation expectations have been trending down, particularly in Europe with oil prices down 22% since its April high and as we stated before, where oil prices go, so does US High Yield and in particular the Energy sector as per the below chart from Bank of America Merrill Lynch for the month to date returns for May 2019, with CCCs being highly exposed to oil prices woes (Energy sector = 20.4% of face value, 15.1% of market value):</div>
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- source Bank of America Merrill Lynch</div>
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As the trade war intensifies, this doesn't bode well for both CAPEX and employment levels. Leaders from G20 countries will convene in Osaka on June 28 and 29 and markets are hoping for a deal between China and the United States.</div>
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In a context of weakening macro data on top of exogenous factors such as rising geopolitical tensions, no wonder the Fed has adopted a more dovish stance leading to market pundits expecting significant cuts to come during the summer hence the significant bounce we are currently seeing on the back as well of the end of the most recent true "Mexican standoff".</div>
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But what about the inverted yield curve and the potential for a recession ahead of us, one might rightly ask. On this subject we read with interest Nomura's take from their Japan Navigator note number 826 from the 3rd of June entitled "Inverted yield curve in UST market and monetary policy conduct":</div>
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"Many FOMC members have indicated that they would allow inflation rates in the 2.0-2.5% range during an economic recovery, but they are not willing to use average inflation rates from the past to constrain future policy conduct. They have also stated that monetary policy should not be used to pop asset bubbles. <b>We believe that this question of whether the Fed should tolerate an inverted yield curve in the UST market will be a critical subtextual theme </b>(discussed below). However, we believe that Fed Chair Jerome Powell and other mainstream Fed officials do not buy into this idea.</blockquote>
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We expect the US-China trade dispute to reach the next stage between 4 June and the G20 meeting on 28 June, where Presidents Trump and Xi could meet. We sense that with every day that passes, markets become more convinced that an agreement between the two countries will prove difficult and a fourth round of US tariffs is on the way. Nevertheless, semiconductor stocks, which are more likely to be directly influenced, began to halt their fall this week, which suggests that the market has priced this scenario in to a considerable degree. </blockquote>
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<span style="color: red;">We do not think that a fourth round of tariffs alone would have an impact sufficient to trigger a global economic downturn</span>. Moreover, judging from the actions of Chinese policymakers, they seem to have determined that weakening RMB would represent a risk for China as well (due to capital flight), and there are no signs that they will guide RMB to weaker levels. Unlike many economists, we believe that if negotiations essentially break down and the US goes ahead with more tariffs, China will beef up its subsidies to export companies rather than taking measures aimed at expanding domestic demand, and in this case <b>the damage to China and the global economy would be lower than a simple estimate premised on a reduction in Chinese exports and other countries serving as substitutes</b>. This is because Chinese companies would absorb most of the hit from tariffs and continue to export goods. No matter how much China bolsters domestic demand measures, it is difficult to paint a growth strategy for China’s economy that does not depend on US markets. Moreover, from a US perspective, it is easier to play up a “success” if tariff revenue increases and Chinese companies, rather than US consumers, are forced to bear the load. This kind of scenario suggests <b>a high risk that US rates, which have priced in an economic downturn, will rise. This upturn could occur when the US government officially announces a fourth round</b>. At this point, we expect EM currencies and equities as well as USD/JPY and Japanese equities to rebound, so investors should prepare for this scenario.</blockquote>
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<b>If the Fed cuts rates to correct inverted yield curve, it would essentially be trying to fix a problem it created itself</b></blockquote>
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The Fed’s dovish members, centered on Vice Chair Clarida, view an inverted yield curve in the UST market as an important sign presaging an economic downturn, and advocate policy conduct that would avoid such an inversion. In fact, if we look at the three economic cycles since 1980, the yield curve inverted, with yields on 3m Treasury bills higher than 10yr UST yields, followed by an economic downturn (Figure 2). </blockquote>
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<a href="https://1.bp.blogspot.com/-6rgJG_Yanb8/XP54wqd2aqI/AAAAAAAAWQc/tVq3FM0TTjcFDeyGVYVZI76WFkkoj2i5QCLcBGAs/s1600/Nomura%2B-%2Bend%2Bof%2Bfed%2Brates%2Bhikes%2Band%2BUST%2Byields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="423" data-original-width="821" height="164" src="https://1.bp.blogspot.com/-6rgJG_Yanb8/XP54wqd2aqI/AAAAAAAAWQc/tVq3FM0TTjcFDeyGVYVZI76WFkkoj2i5QCLcBGAs/s320/Nomura%2B-%2Bend%2Bof%2Bfed%2Brates%2Bhikes%2Band%2BUST%2Byields.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
We believe this inverted yield curve is not simply significant as a sign, but also indicates a situation in which a deterioration in financial institutions’ earnings environment is likely to set off a credit crunch. However, there are many problems with simplifying this issue and arguing that monetary policy should be conducted to avoid an inverted yield curve. 1) Inverted yield curves occur when the market begins to anticipate a future rate cut, but the market tends to almost automatically move in this direction when the Fed sends the message that it will end rate hikes. 2) In past cycles, there has been a lag of at least six months to two years before the economy enters a downturn after the end of rate hikes (Figure 3).</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
3) There have been cases, such as in 1998, when the yield curve has inverted, but the yield curve has returned to normal levels as the economy recovered. In other words, if the Fed itself decides to cut rates to correct the yield curve, which inverted in response to the Fed’s own message, <b>it would essentially be fixing a problem of its own making</b>. Of course, if the Fed can accurately predict the economy’s cycle (i.e., even if it stops raising rates, an economic downturn in the near future is inevitable), the Fed could probably use policy to minimize the damage of an economic downturn. However, if this is not the case, <b>a premature rate cut could exacerbate the asset bubble and worsen the damage done by a future economic downturn</b>. In fact, in the aforementioned 1998 example, the IT bubble worsened after the Fed cut rates. </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Does the bond market have better foresight?</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
In addition, the theory that an inverted yield curve leads to an economic downturn tends to lead to the erroneous perception and belief that the bond market is better at predicting the economy than equities and other risk assets. However, this is simply due to differences in these financial instruments, and does not indicate any particular capacity for judgment. While bonds tend to perform better in economic downturns and periods in which inflation is falling, most risk assets are just the opposite. As a result, in economic recoveries, risk assets, not long-term yields, tend to identify the signs of a recovery and rise accordingly. Moreover, as noted above, the time lag from the inverted yield curve to an economic downturn differs considerably depending on the cycle. For example, in the cycle in the 2000s, after the yield curve inverted (from July 2006), the economy continued to expand for almost two years, and during this period long-term UST yields fell and then rose again, reaching their highest point in this cycle (June 2007). The subsequent subprime (Paribas) shock in August 2007 all but guaranteed an economic downturn (it officially began in December 2007), and we very much doubt that bond market participants predicted this shock and acted accordingly all the way back in 2006, when the yield curve began to invert.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>We believe 10yr UST yields peaked at 3.23% in this cycle, but…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
In this cycle, we believe that the Fed raised rates last in December 2018 and 10yr UST yields peaked just before this, in November 2018 (3.23%). As a result, in this cycle as well, observers will likely credit the bond market with having predicted an economic downturn before the risk asset market and acting accordingly (with an inverted yield curve a sign of an economic downturn). However, the bond market has not already accurately predicted the kind of event or shock that would ensure an economic downturn, which we expect to occur in the future. We suspect that, while bond investors continue to price in a rate cut and test out the market, they will coincidentally reach this kind of event. The period of time from now until the economic downturn is not predetermined, and before this event occurs, we expect to see <b>a period (2019 H2) in which the market reverses its excessive rate cut expectations</b>. For this reason, we believe it would make sense to wait for 10yr UST yields to rebound to about 2.60% rather than chasing yields down to 2.30% and buying." source Nomura Japan Navigator No. 826 June 2019</blockquote>
<div style="text-align: justify;">
From a tactical perspective, we do believe that the long-end of the US yield curve has been "overbought" and we are already seeing signs of exhaustion, so no surprise to see somewhat a pullback in our favorite proxy being ETF ZROZ (strips of 25 years plus zero coupon). As well, gold is also marking a pause which can be ascertained by a bounce in real yields and the "risk-on" tone prevailing today.</div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
When it comes to our title and the "policy game" being played, we think we are far from any meaningful "cease fire" between the United States and China. Volatility will continue to run high we think and in that context, we continue to view quality credit such as US Investment Grade as more protective than currently high beta, which in the case of US High Yield is tied up to the direction of oil prices. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As we stated before, we would rather continue playing it on the defensive side given the many uncertainties surrounding a potential trade deal. With this ongoing "Numbers Game", while we might see unfolding a tactical bounce, fundamentals are rapidly deteriorating with this lingering confrontation. On the potential outcome we read with interest CITI's take from their Global Strategy and Macro Weekly note from the 10th of June entitled "Trade Wars: Game Theory Suggests Escalation Risk is Underestimated":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"The uncertainty around the negotiations makes for a challenging backdrop for investors. Recession risk is rising. As our Global Macro Strategy team points out; the 3m10y yield curve inverted on a closing basis for the first time this cycle at the end of May. This, they believe, could start the clock towards a recession mid- 2020. The tailwinds of fiscal policy are fading. Trade wars could be the additional shock that break the resilience of global, and US, economies (see: Global Macro Strategy Weekly: Trade War = Recession).</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The GMS team offers three scenarios: (i) a trade deal at the G20; (ii) no trade deal and no Fed easing and (iii) no trade deal and aggressive Fed cuts (75bp quickly). Our current assessment is that we are in Scenario 2 but may be transitioning to Scenario 3.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Scenario One: Trade Deal at G20</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Equities sharply higher with EM significantly outperforming as so much more is priced here for slower global trade growth. SPX~2900</li>
<li>Yields higher, probably parallel shift higher or bear flattening. 10y yields ~2.5%</li>
<li>Gold lower, maybe $1300</li>
<li>USD lower with risk on but not much as Fed easing would likely be priced out to some degree.</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Scenario Two: No Trade Deal and No Fed Cuts</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Equities sharply lower, probable full scale bear market. SPX to 2350</li>
<li>Yields sharply lower with curve twist/ bull flattening. 10yr UST to 1.50%, maybe</li>
<li>lower</li>
<li>Gold higher. $1600+</li>
<li>USD higher bar JPY</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Scenario Three: No Trade Deal, Fed Cuts (75bp or more)</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>SPX higher; new highs. Other equities mixed.</li>
<li>Yields lower with bull steepening 10yr UST 1.75-2.0%</li>
<li>Gold higher on lower rates and lower USD. Target $1500</li>
<li>USD lower as carry is eroded. EUR/$ 1.15</li>
</ul>
</blockquote>
<div style="text-align: center;">
- source CITI</div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
We think that, right now investors are displaying two cases of "overconfidence", one being the pace and number of rate cuts coming from the Fed, second being a clear resolution between China and the United States when it comes to this much discussed trade war. Fiscal policy results are starting to be obliterated by the blunt use as economic policy instrument of tariffs. They are being used way too much by the Trump administration and it is starting to bite, not only on the employment front but, as well on earnings.</div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
Sure the Fed might be providing some much needed support to the strains already showing up in credit markets such as rising dispersion, but the continuation of the trade war could push the US economy and the rest of the world towards recession and led to a stagflationary outcome in conjunction with wider credit spreads and that would mean trouble ahead we think. We have not reached that point but, playing this trade war game into overtime is a recipe for disaster. In that context, gold prices look likely do well if the trade war escalates further. </div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar. On the subject of the US dollar's trajectory we read with interest Deutsche Bank's take from their FX Special Report note from the 5th of June entitled "What happens to the dollar if the Fed cuts rates?":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"We have been worried about global growth and have positioned our FX Blueprint portfolio accordingly for nearly a month now. But what happens if the Fed cuts rates as soon as July or September? How would this impact our views and what does this mean for the dollar? In this special report, we show that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Near-term, the dollar almost always weakens in the run-up to Fed rate cuts. But dollar weakness usually does not follow through. We argue that the Fed would need to cut rates by at least 100bps for a sustained, large move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the dollar mixed with the JPY and CHF continuing to be the primary beneficiaries (they remain our favourite longs), Asia FX the primary casualty (we remain very bearish), and the EUR stuck, though vulnerable to a squeeze higher given market positioning.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
If the Fed ends up cutting by a lot more, these conclusions would change however. In the event of a full Fed easing cycle, we would expect EUR/USD to head back beyond 1.20 and dollar weakness across the board, with the possible exception of Asia. Our portfolio at the moment is more closely aligned to the former, rather than the latter scenario.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Low growth tends to be good for the dollar</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The dollar has been part of our defensive portfolio together with the Swiss franc and Japanese yen. Historically, the dollar tends to do well in global slowdowns. First, the US is one of the most closed economies in the world so that global slowdowns tend to be asymmetrically reflected in the rest of the world (chart 1). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Second, even though the dollar can’t claim the huge positive internal investment positions of the franc and yen (chart 2), it benefits from the shortage of dollar funding that has been well documented by the BIS, among others .</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>Fed rate cuts are not always bearish for the dollar</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Does the dollar lose its safe-haven status when the Fed cuts rates? The short answer is, sometimes, but certainly not always. We start by looking at the last five instances of Fed easing. Two of these instances were Fed “insurance” cuts (1995 and 1998) while three were full-blown easing cycles (1989, 2001, 2007). The clear conclusion is that while the dollar nearly uniformly weakens into a Fed easing, the subsequent performance is far from consistent. Indeed, the dollar has ended up strengthening in 3 of the last 5 Fed easing cycles. The conclusion is valid for both EM and DM (charts 3 and 4).</blockquote>
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<a href="https://1.bp.blogspot.com/-3eluCGPgNXA/XP6-nj4Oa4I/AAAAAAAAWRI/04Fl4cnchKohf_kpTA0-H-5CwdlpkMS2gCLcBGAs/s1600/DB%2B-%2BEM%2Bdollar%2Bperformance%2Balso%2Bmixed%2Baround%2Bthe%2BFed%2Bcuts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="341" data-original-width="407" height="268" src="https://1.bp.blogspot.com/-3eluCGPgNXA/XP6-nj4Oa4I/AAAAAAAAWRI/04Fl4cnchKohf_kpTA0-H-5CwdlpkMS2gCLcBGAs/s320/DB%2B-%2BEM%2Bdollar%2Bperformance%2Balso%2Bmixed%2Baround%2Bthe%2BFed%2Bcuts.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>What other central banks do matters</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
So, if Fed rate cuts are not a consistent driver of the dollar what else matters? The interest rate differential is a useful starting point. If the Fed is cutting but the rest of the world is cutting even more it may well be that interest rate differentials drive the dollar higher. This was indeed the case during the 1995 and 1998 insurance cuts which saw rates move sharply in favour of the USD even though the Fed cut (chart 5). </blockquote>
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<a href="https://1.bp.blogspot.com/-aThQzIbz2ww/XP6-7KYvW5I/AAAAAAAAWRU/WMhW8GfsJH4G4wQNgEAYNDr9Ed5Z0h2aACLcBGAs/s1600/DB%2B-%2BWhen%2BFed%2Bcut%2Bin%2B1995.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="338" data-original-width="401" height="268" src="https://1.bp.blogspot.com/-aThQzIbz2ww/XP6-7KYvW5I/AAAAAAAAWRU/WMhW8GfsJH4G4wQNgEAYNDr9Ed5Z0h2aACLcBGAs/s320/DB%2B-%2BWhen%2BFed%2Bcut%2Bin%2B1995.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
Is this a risk today? Highly unlikely. The US- rest of world differential is already sitting at record extremes and almost every other DM central bank is constrained by the zero lower bound. If the Fed is cutting rates, the rate differential should be worsening for the dollar.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>The level of rates also matters</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Is a narrowing interest rate differential enough to turn the dollar? It is a necessary, but not a sufficient condition. Take 2001 when the Fed started an easing cycle and rates collapsed against the USD. The dollar continued rallying for a year until it finally turned. What helped? First, the absolute level of US rates which made the dollar a high-yielder (chart 6). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Second, the continued strength in the US basic balance, with the dollar only peaking once the US current account deficit turned sharply wider and the dollar became a low yielder (chart 7 and 8). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Indeed, the broad dollar cycle tends to be more correlated to the absolute level of US yields that the relative changes.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Lessons for today</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The dollar is in a remarkable global position today holding the developed world’s highest yields. Never before in the history of free-floating FX has the dollar held such a preeminent position. How much does the Fed need to cut for this to stop being the case? Assuming other central banks follow the forwards, the Fed would have to cut rates by 125-150 bps to a little below 1% for the dollar to lose its high-yielding preeminence. With the rates market pricing a terminal Fed funds of 1.3% we are still one or two rate cuts away from that level. This of course also assumes that central banks with high rates such as the RBA and RBNZ would not cut more than the forwards.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
An alternative approach to answering this question is to look at when the dollar lost its sensitivity to changes in yields, i.e. when did the absolute level of rates start dominating over the changes in the rate differential? Looking at the beta of EUR/USD to the EU-US rate differential we note that the sensitivity of rates to FX peaked in 2017, just when the 5-yr rate differential crossed 2%. This differential is now back at 2.3% so we are still about 30bps away from the relative changes in yields reasserting themselves in importance. Overall, we reach a similar conclusion to the previous analysis: we need to price 1 or 2 more cuts for the level of US yields to again become "low".</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Two other important observations</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Interest rates aside we would make two other observations. First, the developed market dollar is already at the upper end of its historical valuation bounds (chart 9). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Valuation is a powerful medium-term anchor and a natural constraint to further dollar appreciation. The conclusion is different for the dollar including EM, mostly due to the undervaluation of USD/CNY (chart 10). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
This valuation discrepancy between EM and DM would support a conclusion that the dollar has far more room to strengthen against EM – especially Asia, given the nature of the global trade war – even if the Fed cuts rates. The second observation is that US flow dynamics are not sending a particularly strong signal. The dollar is strong but so is the underlying US basic balance, without any large movement either way. In other words, the market is already overweight dollar assets but there are no clear shifts either higher or lower for now.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Conclusion</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">Putting it all together, we conclude that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker</span>. We argue that the Fed would need to cut rates by more than 100bps for a broad-based and sustained move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the broad dollar mixed with the JPY and CHF continuing to be the primary beneficiaries of weaker growth, EM FX (especially Asia) the primary casualty, and the EUR stuck in the 1.10s.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
These relative moves are already broadly in line with our forecasts, but these would change in the event of a full-fledged easing cycle from the Fed back down to zero. In this instance, we would expect the EUR in particular to more broadly participate in a dollar down-cycle, a topic which we will investigate in a future publication." - source Deutsche Bank</blockquote>
If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained.<br />
<br />
When it comes to market expectations, and the Fed in this "Numbers game" as per our final charts below we think the Fed is "data" dependent and has noticed the slowdown but is not yet ready to go full on the brakes as the market is expecting in "overconfidence".<br />
<br />
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Final charts - Fed it taking it "easy" not "easing" yet.</li>
</ul>
<div style="text-align: justify;">
Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war. Our final charts below comes from Wells Fargo's Weekly Economic and Financial Commentary from the 7th of June and shows the growing hints of the slowdown in conjunction with the appropriate pace of policy firming:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Growing Hints of a Slowdown</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
In the midst of rising prospects of a prolonged and more pronounced trade war, data this week seemed to lend some credence to the idea that the domestic economy is beginning to succumb more materially to all the uncertainty. Nonfarm employers added just 75,000 jobs in May, missing even the lowest forecast, while downward revisions shaved off a further 75,000 from prior months’ reported gains. Average hourly earnings also missed expectations, up 0.2% on the month and 3.1% over the year, the slowest rise since September. The bond market reaction was swift; yields on both the two-year and 10-year immediately fell more than six bps, likely out of a belief that the growing hint of labor market weakness may force the Fed’s hand and induce a rate cut. </blockquote>
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<a href="https://1.bp.blogspot.com/-3U_FHSeT5iA/XP7Ko39KV_I/AAAAAAAAWSQ/ScFNWF3u1PQXFBvHEDFe6objoXYg7OiBACLcBGAs/s1600/WF%2B-%2BDiffusion%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="338" data-original-width="444" height="243" src="https://1.bp.blogspot.com/-3U_FHSeT5iA/XP7Ko39KV_I/AAAAAAAAWSQ/ScFNWF3u1PQXFBvHEDFe6objoXYg7OiBACLcBGAs/s320/WF%2B-%2BDiffusion%2BIndex.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Indeed, the market has come to view a cut this year as a foregone conclusion; futures markets have priced in around 75 bps of easing this year. A more defiant stance from the Trump administration towards China and the threat of a new volley of tariffs directed against Mexico are likely driving the pessimism and risk-off attitude. Despite high-level negotiations regarding the U.S.-Mexico border situation this week, 5% tariffs on all imports from Mexico are slated to go into effect Monday, and could rise as high as 25% by October. This latest escalation more than doubles the total value of goods subject to tariffs to around $700 billion and, perhaps more worryingly, brings into stark view the willingness of the administration to use tariffs as leverage for political or diplomatic concessions, dropping even the pretense of an economic rationale. See Topic of the Week for more detail.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The question for the Fed, then, is whether markets are overreacting to trade uncertainty by expecting three cuts in a 3.6% unemployment rate economy. Noted dove James Bullard kicked off the Fedspeak on Monday, stating that a cut “may be warranted soon”, and noted that even if growth does not succumb to trade tensions significantly, lower rates would help bring inflation up to target more quickly. Chair Jay Powell took the baton on Tuesday, saying, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion”. Markets took these comments and ran with them, as the S&P 500 surged 2.1% on the day and remained buoyant the rest of the week. We would suggest a more leveled view, as his comments are not anything new, per se. Expectations of a ‘Powell put’ may be a bit premature, if we resist reading into his comments too deeply, and in light of Robert Kaplan’s call for patience amidst trade threats that could be reversed as quickly as the president can tweet. John Williams similarly suggested staying on the path of data dependence. </blockquote>
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<a href="https://1.bp.blogspot.com/-mI4uts0s9fw/XP7K_IbJsvI/AAAAAAAAWSY/xTEFAvnZpCglFTSuEb2XjQ-h6MmcmylpACLcBGAs/s1600/WF%2BAppropriate%2Bpace%2Bof%2Bfirming.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="328" data-original-width="451" height="232" src="https://1.bp.blogspot.com/-mI4uts0s9fw/XP7K_IbJsvI/AAAAAAAAWSY/xTEFAvnZpCglFTSuEb2XjQ-h6MmcmylpACLcBGAs/s320/WF%2BAppropriate%2Bpace%2Bof%2Bfirming.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
To that end, the ISM manufacturing survey fell 0.7 points to a 31-month low of 52.1, while the non-manufacturing survey rose 1.4 to 56.9, offering some evidence that the divergence between the manufacturing and the much larger service sector is persisting; in other words, the slowdown in the trade and global growth-exposed manufacturing sector has yet to spill over into the broader economy in a major way. </blockquote>
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<a href="https://1.bp.blogspot.com/-SQVLGPGHr5w/XP7LLkW7sRI/AAAAAAAAWSc/Th56SQlrDMcNML_moXTvE2g7O3lbHBjEACLcBGAs/s1600/WF%2B-%2BISM%2BManufacturing.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="367" data-original-width="451" height="260" src="https://1.bp.blogspot.com/-SQVLGPGHr5w/XP7LLkW7sRI/AAAAAAAAWSc/Th56SQlrDMcNML_moXTvE2g7O3lbHBjEACLcBGAs/s320/WF%2B-%2BISM%2BManufacturing.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Still, the majority of economic data lags. The cyclical parts of the economy are already slowing, and the uncertainty over the entire economy is already here." - source Wells Fargo</blockquote>
<div style="text-align: justify;">
To conclude we see two cases of "overconfidence", one is the pace and number of rate cuts coming from the Fed, the second is a clear resolution between China and the United States. We therefore think it is premature to bet in the "Numbers Game" run by the Fed and we would rather stick to defense and watch a little bit from the sideline rather than going again "all in" on a supposed return of the famous "infamous" Fed put. We don't think we are there yet and what matters for the Fed is financial stability overzealous markets racing ahead we think.</div>
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<br /></div>
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<blockquote class="tr_bq">
"The more people rationalize cheating, the more it becomes a culture of dishonesty. And that can become a vicious, downward cycle. Because suddenly, if everyone else is cheating, you feel a need to cheat, too." - Stephen Covey</blockquote>
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<span style="font-family: inherit;">Stay tuned!</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-55406259389226230672019-05-28T23:53:00.000+01:002019-05-29T08:50:08.801+01:00Macro and Credit - Banqi<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"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</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">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. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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: </span></div>
<div style="text-align: justify;">
</div>
<ul>
<li><span style="font-family: inherit;">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.</span></li>
<li><span style="font-family: inherit;">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.</span></li>
</ul>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">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...</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<div style="background-color: white;">
<span style="font-family: inherit;">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</span></div>
<div style="background-color: white; color: #333333;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - China versus the United States? A numbers game</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final charts - Take it IG (Investment Grade), Japan's got your back...</span></b></i></li>
</ul>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - China versus the United States? A numbers game</span></li>
</ul>
<div>
<span style="font-family: inherit;">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.</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">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 "<a href="https://www.asiatimes.com/2019/04/opinion/the-chinese-tortoise-and-the-american-hare/">The Chinese tortoise and the American hare</a>":</span></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"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.<br /><br /><span style="font-family: inherit;">China remains behind the US in most key areas of technology, but it is catching up fast. In the last several years China has</span></span></blockquote>
<div>
<div>
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">Landed a probe on dark side of moon;</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Developed successful quantum communication via satellite;</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Built a 2,000-kilometer quantum communication network between Beijing and Shanghai;</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Built missiles that can blind American satellites;</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Developed surface-to-ship missiles that can destroy any vessel within hundreds of miles of its coast; and</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Built some of the world’s fastest supercomputers.</span></li>
</ul>
</blockquote>
</div>
</div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">China’s investment in education parallels its investment in high-tech industry. <span style="color: red;">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</span>. 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.</span></blockquote>
</div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">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. <span style="color: red;">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</span>.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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. <span style="color: red;">China’s debt problem is no worse than ours</span>." - source David P. Goldman, Asia Times</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">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.</span></div>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">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?":</span><br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Is the trade war just about trade?</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">Economically, America is not as great as it used to be...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-MhdoS_74vhA/XO06o3uDpCI/AAAAAAAAV6k/2mevW-4UFBgEYj96CKhMeqYp4PNVGuuOgCLcBGAs/s1600/BAML%2B-%2Bdrop%2Bin%2BUS%2Bexports.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="392" height="248" src="https://1.bp.blogspot.com/-MhdoS_74vhA/XO06o3uDpCI/AAAAAAAAV6k/2mevW-4UFBgEYj96CKhMeqYp4PNVGuuOgCLcBGAs/s320/BAML%2B-%2Bdrop%2Bin%2BUS%2Bexports.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-zIBh8o9MAwE/XO061lf3R2I/AAAAAAAAV6o/IFEXHoXWaXMb5TIP9W_kybrqI3IEUQdfQCLcBGAs/s1600/BAML%2B-%2BChina%2Bclosing%2Bthe%2Bgap%2Bon%2Bthe%2BUS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="394" height="246" src="https://1.bp.blogspot.com/-zIBh8o9MAwE/XO061lf3R2I/AAAAAAAAV6o/IFEXHoXWaXMb5TIP9W_kybrqI3IEUQdfQCLcBGAs/s320/BAML%2B-%2BChina%2Bclosing%2Bthe%2Bgap%2Bon%2Bthe%2BUS.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;"> ...as incomes have stagnated in the past decades...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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. </span></blockquote>
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<a href="https://1.bp.blogspot.com/-yVc_GFwx_9s/XO07PCjK9jI/AAAAAAAAV60/J0SlT7KBOd8JnV0_xdTAIxSvn9da_wS9QCEwYBhgL/s1600/BAML%2B-%2BThe%2BChinese%2Bhave%2Bbeen%2Bthe%2Bdriving%2Bforce%2Bbehind%2Bglobal%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="317" data-original-width="392" height="258" src="https://1.bp.blogspot.com/-yVc_GFwx_9s/XO07PCjK9jI/AAAAAAAAV60/J0SlT7KBOd8JnV0_xdTAIxSvn9da_wS9QCEwYBhgL/s320/BAML%2B-%2BThe%2BChinese%2Bhave%2Bbeen%2Bthe%2Bdriving%2Bforce%2Bbehind%2Bglobal%2BGDP.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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</div>
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<a href="https://1.bp.blogspot.com/-Q9CI6SnTbII/XO07fq_F0YI/AAAAAAAAV68/lx1LyWWFt5wQewmAiC7Wa8c1zYGiNRUcQCLcBGAs/s1600/BAML%2B-%2Bincome%2Bstagnant%2Bin%2Bthe%2BUS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="313" data-original-width="392" height="255" src="https://1.bp.blogspot.com/-Q9CI6SnTbII/XO07fq_F0YI/AAAAAAAAV68/lx1LyWWFt5wQewmAiC7Wa8c1zYGiNRUcQCLcBGAs/s320/BAML%2B-%2Bincome%2Bstagnant%2Bin%2Bthe%2BUS.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...but it still leads the world in trade and profits...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-iMJ1fmvFfy4/XO08YVbjxSI/AAAAAAAAV7I/yC-VXMRJu48yt-GNcYxy87JS_yfBcMdRQCLcBGAs/s1600/BAML%2B-%2BThe%2BUS%2Bdelivers%2Bthe%2Bmost%2Bcorporate%2Bprofits%2Bin%2Bthe%2Bworld.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="308" data-original-width="392" height="251" src="https://1.bp.blogspot.com/-iMJ1fmvFfy4/XO08YVbjxSI/AAAAAAAAV7I/yC-VXMRJu48yt-GNcYxy87JS_yfBcMdRQCLcBGAs/s320/BAML%2B-%2BThe%2BUS%2Bdelivers%2Bthe%2Bmost%2Bcorporate%2Bprofits%2Bin%2Bthe%2Bworld.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Similarly, the US leads the world by share of global trade ahead of China, with Germany in a relatively close third position (Chart 5).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-jLrSr-d0HbU/XO08nQSqqCI/AAAAAAAAV7M/LvbAawygy-4jCGzwQBU1awiF5RqLF30QQCLcBGAs/s1600/BAML%2B-%2BSimilarly%2Bthe%2BUS%2Bleads%2Bthe%2Bworld%2Bby%2Bshare%2Bof%2Bglobal%2Btrade.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="311" data-original-width="392" height="253" src="https://1.bp.blogspot.com/-jLrSr-d0HbU/XO08nQSqqCI/AAAAAAAAV7M/LvbAawygy-4jCGzwQBU1awiF5RqLF30QQCLcBGAs/s320/BAML%2B-%2BSimilarly%2Bthe%2BUS%2Bleads%2Bthe%2Bworld%2Bby%2Bshare%2Bof%2Bglobal%2Btrade.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...and has become energy independent in the past year</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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. </span></blockquote>
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<a href="https://1.bp.blogspot.com/-gFv9c98wAuE/XO09DU_prKI/AAAAAAAAV7Y/V8wGcQ-BUy0iHj4Pm6hq6Ys_T4v7wJuygCLcBGAs/s1600/BAML%2B-%2BAmerica%2527s%2Breliance%2Bon%2Bforeign%2Benergy.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="313" data-original-width="392" height="255" src="https://1.bp.blogspot.com/-gFv9c98wAuE/XO09DU_prKI/AAAAAAAAV7Y/V8wGcQ-BUy0iHj4Pm6hq6Ys_T4v7wJuygCLcBGAs/s320/BAML%2B-%2BAmerica%2527s%2Breliance%2Bon%2Bforeign%2Benergy.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-G2WjP8BQw-M/XO09ceKADTI/AAAAAAAAV7g/sAqEUCiPh1sLbYNJtUvr8NdynVcz_wzbwCLcBGAs/s1600/BAML%2B-%2BChina%2527s%2Bforeign%2Bfuel%2Bdependency.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="317" data-original-width="378" height="268" src="https://1.bp.blogspot.com/-G2WjP8BQw-M/XO09ceKADTI/AAAAAAAAV7g/sAqEUCiPh1sLbYNJtUvr8NdynVcz_wzbwCLcBGAs/s320/BAML%2B-%2BChina%2527s%2Bforeign%2Bfuel%2Bdependency.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">China’s fast growth was fueled by America’s imports...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-G-xwroDz4hU/XO091LRiaqI/AAAAAAAAV7o/BaeBBVz-aRsA1Cl4TqQFFYcTvMbsOjsvgCLcBGAs/s1600/BAML%2B-%2BAmerica%2527s%2Bcurrent%2Baccount%2Bbalance.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="317" data-original-width="382" height="265" src="https://1.bp.blogspot.com/-G-xwroDz4hU/XO091LRiaqI/AAAAAAAAV7o/BaeBBVz-aRsA1Cl4TqQFFYcTvMbsOjsvgCLcBGAs/s320/BAML%2B-%2BAmerica%2527s%2Bcurrent%2Baccount%2Bbalance.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-e9BuXvBNbEs/XO0-GZBGaUI/AAAAAAAAV7w/7ioxEH3zhGMZpJ_-hekG662p44bNrmU7QCLcBGAs/s1600/BAML%2B-%2Balthough%2Bthe%2BUS%2Btrade%2Bdeficit%2Bspecifically%2Bwith%2BChina.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="317" data-original-width="386" height="262" src="https://1.bp.blogspot.com/-e9BuXvBNbEs/XO0-GZBGaUI/AAAAAAAAV7w/7ioxEH3zhGMZpJ_-hekG662p44bNrmU7QCLcBGAs/s320/BAML%2B-%2Balthough%2Bthe%2BUS%2Btrade%2Bdeficit%2Bspecifically%2Bwith%2BChina.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">No one in Washington seemed to notice until voters sent a loud and clear message.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...as well as by its technology and intellectual property...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-zcB6Usq2ImE/XO0-py3lv0I/AAAAAAAAV74/DxXs6TPnmjEX18H__NKoprkOgbghL7LFgCLcBGAs/s1600/BAML%2B-%2BChina%2Bhas%2Bcaught%2Bup%2Bwith%2Bthe%2BUS%2Bin%2Bterms%2Bof%2Bpatents%2Bper%2Bhead.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-zcB6Usq2ImE/XO0-py3lv0I/AAAAAAAAV74/DxXs6TPnmjEX18H__NKoprkOgbghL7LFgCLcBGAs/s320/BAML%2B-%2BChina%2Bhas%2Bcaught%2Bup%2Bwith%2Bthe%2BUS%2Bin%2Bterms%2Bof%2Bpatents%2Bper%2Bhead.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-o74a4yWl1SQ/XO0-6ULM72I/AAAAAAAAV8A/IQn-J91vSaIiP-fGGn6ngoFr97IXeF-5wCLcBGAs/s1600/BAML%2B-%2Band%2Bis%2Bnow%2Bthe%2Bworld%2Bleader%2Bin%2Btotal%2Bpatents.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-o74a4yWl1SQ/XO0-6ULM72I/AAAAAAAAV8A/IQn-J91vSaIiP-fGGn6ngoFr97IXeF-5wCLcBGAs/s320/BAML%2B-%2Band%2Bis%2Bnow%2Bthe%2Bworld%2Bleader%2Bin%2Btotal%2Bpatents.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">This extraordinary surge in patent applications has surely risen eyebrows in DC.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;"> ...but also by enormous foreign commodity purchases</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-4bT6pWpFw2M/XO0_VX2G_9I/AAAAAAAAV8I/b6jUfnL7okkmCy_kUcXVhp-KjvHKXnWlQCLcBGAs/s1600/BAML%2B-%2BChina%2Bis%2Bthe%2Bworld%2527s%2Blargest%2Bcommodity%2Bimporter.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="307" data-original-width="389" height="252" src="https://1.bp.blogspot.com/-4bT6pWpFw2M/XO0_VX2G_9I/AAAAAAAAV8I/b6jUfnL7okkmCy_kUcXVhp-KjvHKXnWlQCLcBGAs/s320/BAML%2B-%2BChina%2Bis%2Bthe%2Bworld%2527s%2Blargest%2Bcommodity%2Bimporter.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-5knKKxcGLr4/XO0_23F3mqI/AAAAAAAAV8Q/8c04HBEyxng-mK8WIzM6ypoPNPtdvINpQCLcBGAs/s1600/BAML%2B-%2Bin%2Bcontrast%2BChina%2Bdoes%2Bnot%2Bimport%2Bmany%2Bservices%2Bfrom%2Baround%2Bthe%2Bworld.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="388" height="250" src="https://1.bp.blogspot.com/-5knKKxcGLr4/XO0_23F3mqI/AAAAAAAAV8Q/8c04HBEyxng-mK8WIzM6ypoPNPtdvINpQCLcBGAs/s320/BAML%2B-%2Bin%2Bcontrast%2BChina%2Bdoes%2Bnot%2Bimport%2Bmany%2Bservices%2Bfrom%2Baround%2Bthe%2Bworld.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">The rise of China has created a strategic competitor...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-h1haLs7suYc/XO1ATi6lmiI/AAAAAAAAV8c/teuKDIypz385DPqGbNDOF1mfY9nogBrUACLcBGAs/s1600/BAML%2B-%2BContrary%2Bto%2Bthe%2Bmarket%2527s%2Bperception%2BChina%2527s%2Bdependency%2Bon%2Binternational%2Btrade.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="387" height="251" src="https://1.bp.blogspot.com/-h1haLs7suYc/XO1ATi6lmiI/AAAAAAAAV8c/teuKDIypz385DPqGbNDOF1mfY9nogBrUACLcBGAs/s320/BAML%2B-%2BContrary%2Bto%2Bthe%2Bmarket%2527s%2Bperception%2BChina%2527s%2Bdependency%2Bon%2Binternational%2Btrade.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-Wv3wsrQM9ds/XO1A3gFLO5I/AAAAAAAAV8k/jZDAENZx3r0bSsXvnD8-IxtbWajtH4iIwCLcBGAs/s1600/BAML%2B-%2BAs%2Bas%2Bresult%252C%2BChina%2527s%2Breliance%2Bof%2Bforeign%2Btrade%2Bis%2Bonly%2Bsomewhat%2Blarger%2Bthan%2BAmerica%2527s.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-Wv3wsrQM9ds/XO1A3gFLO5I/AAAAAAAAV8k/jZDAENZx3r0bSsXvnD8-IxtbWajtH4iIwCLcBGAs/s320/BAML%2B-%2BAs%2Bas%2Bresult%252C%2BChina%2527s%2Breliance%2Bof%2Bforeign%2Btrade%2Bis%2Bonly%2Bsomewhat%2Blarger%2Bthan%2BAmerica%2527s.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...that is constrained by a very different set of rules</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-_RiEiw_hXwc/XO1BcfKUQNI/AAAAAAAAV8w/H__UwHY3VIs8SKrIewIartFXAcWUiBLmACLcBGAs/s1600/BAML%2B-%2BChina%2527s%2Bexports%2Bare%2Bprimarily%2Bconcentrated%2Bin%2Bthe%2Bmanufacturing%2Bgoods%2Bsector.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="310" data-original-width="386" height="256" src="https://1.bp.blogspot.com/-_RiEiw_hXwc/XO1BcfKUQNI/AAAAAAAAV8w/H__UwHY3VIs8SKrIewIartFXAcWUiBLmACLcBGAs/s320/BAML%2B-%2BChina%2527s%2Bexports%2Bare%2Bprimarily%2Bconcentrated%2Bin%2Bthe%2Bmanufacturing%2Bgoods%2Bsector.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-7Qq1b3Kc69w/XO1B1TlmWzI/AAAAAAAAV84/J5MaJTUnQXY5OjtzDfbPgSy9dd3_-beGwCLcBGAs/s1600/BAML%2B-%2Blarge%2Bservices%2Bexporter.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="307" data-original-width="387" height="253" src="https://1.bp.blogspot.com/-7Qq1b3Kc69w/XO1B1TlmWzI/AAAAAAAAV84/J5MaJTUnQXY5OjtzDfbPgSy9dd3_-beGwCLcBGAs/s320/BAML%2B-%2Blarge%2Bservices%2Bexporter.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Not surprisingly, the two largest Chinese companies operating in this sector, Huawei and ZTE, have become targets of US government action in recent months. <span style="color: red;">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</span>. 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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">Demographics are becoming a headwind for China</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-iKYBKjq1Jhw/XO1C0gKH-hI/AAAAAAAAV9E/SFeNJY9KAhIHYVhVIlTN3DbhbwrPWCJbQCLcBGAs/s1600/BAML%2B-%2BChina%2527s%2Blabor%2Bforce.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="318" data-original-width="390" height="260" src="https://1.bp.blogspot.com/-iKYBKjq1Jhw/XO1C0gKH-hI/AAAAAAAAV9E/SFeNJY9KAhIHYVhVIlTN3DbhbwrPWCJbQCLcBGAs/s320/BAML%2B-%2BChina%2527s%2Blabor%2Bforce.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-SowMCUGydJs/XO1DFbTVubI/AAAAAAAAV9M/oBeG6BL0uYU5jczaxIXot75bqF-sWmyngCLcBGAs/s1600/BAML%2B-%2BDemographics%2Bprojects%2BUS%2Bpopulation%2Bto%2Bkeep%2Bexpanding.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="314" data-original-width="394" height="255" src="https://1.bp.blogspot.com/-SowMCUGydJs/XO1DFbTVubI/AAAAAAAAV9M/oBeG6BL0uYU5jczaxIXot75bqF-sWmyngCLcBGAs/s320/BAML%2B-%2BDemographics%2Bprojects%2BUS%2Bpopulation%2Bto%2Bkeep%2Bexpanding.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">The US-China trade war could continue for years...</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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,</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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. </span></blockquote>
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<a href="https://1.bp.blogspot.com/-8HOX30qnSiQ/XO1D1PKk1bI/AAAAAAAAV9Y/bM7FMM78CqUuQOOElJtnu2-BczzaCNiUgCLcBGAs/s1600/BAML%2B-%2BChina%2Bwill%2Blikely%2Bneed%2Bto%2Bkeep%2Bexpanding%2Bits%2Bmachinery%2Band%2Bmanufactured%2Bgoods%2Bexports.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-8HOX30qnSiQ/XO1D1PKk1bI/AAAAAAAAV9Y/bM7FMM78CqUuQOOElJtnu2-BczzaCNiUgCLcBGAs/s320/BAML%2B-%2BChina%2Bwill%2Blikely%2Bneed%2Bto%2Bkeep%2Bexpanding%2Bits%2Bmachinery%2Band%2Bmanufactured%2Bgoods%2Bexports.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-Hjamsys6KYo/XO1EG6bmSmI/AAAAAAAAV9g/IUrz29RdtSYz31grkiJXVhM3s62dLKEvACLcBGAs/s1600/BAML%2B-%2Bwhile%2BChina%2527s%2Bservice%2Bexports%2Bas%2Ba%2Bshare%2Bof%2Bits%2BGDP%2Bare%2Bunlikely%2Bto%2Bincrease.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-Hjamsys6KYo/XO1EG6bmSmI/AAAAAAAAV9g/IUrz29RdtSYz31grkiJXVhM3s62dLKEvACLcBGAs/s320/BAML%2B-%2Bwhile%2BChina%2527s%2Bservice%2Bexports%2Bas%2Ba%2Bshare%2Bof%2Bits%2BGDP%2Bare%2Bunlikely%2Bto%2Bincrease.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...riding on both Beijing’s pride, Washington’s fears</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Concerns of a rising China, coupled with US domestic politics, have already elicited a sharp increase in average US tariffs (Chart 22). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-vMl3qKhvuoQ/XO1EeJO6y-I/AAAAAAAAV9o/hRc7OWH7htM9geYE3dd2Q8jhHKxFW53mQCLcBGAs/s1600/BAML%2B-%2BChina%2Bconcerns.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="386" height="252" src="https://1.bp.blogspot.com/-vMl3qKhvuoQ/XO1EeJO6y-I/AAAAAAAAV9o/hRc7OWH7htM9geYE3dd2Q8jhHKxFW53mQCLcBGAs/s320/BAML%2B-%2BChina%2Bconcerns.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-BpC2Fk75VoA/XO1Erhm5L1I/AAAAAAAAV9s/luQ8O2CYW2YGIqFSX1leK1PRxPq6Mvq5ACLcBGAs/s1600/BAML%2B-%2BMilitary%2Bspending.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="387" height="251" src="https://1.bp.blogspot.com/-BpC2Fk75VoA/XO1Erhm5L1I/AAAAAAAAV9s/luQ8O2CYW2YGIqFSX1leK1PRxPq6Mvq5ACLcBGAs/s320/BAML%2B-%2BMilitary%2Bspending.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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..</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">Given the current point in the global business cycle…</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-Y-pfsLDmaqs/XO1E_0cPerI/AAAAAAAAV94/qNdVSFb2skUO5lNE6NPfmBo6Jjm1PDwUgCLcBGAs/s1600/BAML%2B-%2BGlobal%2Bmanufacturing.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="389" height="250" src="https://1.bp.blogspot.com/-Y-pfsLDmaqs/XO1E_0cPerI/AAAAAAAAV94/qNdVSFb2skUO5lNE6NPfmBo6Jjm1PDwUgCLcBGAs/s320/BAML%2B-%2BGlobal%2Bmanufacturing.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-lEmj64PtWSc/XO1FNsp_f8I/AAAAAAAAV98/ZPybKtjANEcy_KgO_p5NCqhIcXylbmloACLcBGAs/s1600/BAML%2B-%2BA%2Bsynchronous%2Bslowdown.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="388" height="250" src="https://1.bp.blogspot.com/-lEmj64PtWSc/XO1FNsp_f8I/AAAAAAAAV98/ZPybKtjANEcy_KgO_p5NCqhIcXylbmloACLcBGAs/s320/BAML%2B-%2BA%2Bsynchronous%2Bslowdown.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">...increased tensions may impact markets severely</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-68XobbSiLdc/XO1Fsc2F4lI/AAAAAAAAV-E/w05O0I7Ad4oI9vs2rgs2T2up0zWQuGtuwCLcBGAs/s1600/BAML%2B-%2BGlobalization%2Bhas%2Bbeen%2Ba%2Bbig%2Bcontributor%2Bto%2BSPX.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="284" data-original-width="390" height="233" src="https://1.bp.blogspot.com/-68XobbSiLdc/XO1Fsc2F4lI/AAAAAAAAV-E/w05O0I7Ad4oI9vs2rgs2T2up0zWQuGtuwCLcBGAs/s320/BAML%2B-%2BGlobalization%2Bhas%2Bbeen%2Ba%2Bbig%2Bcontributor%2Bto%2BSPX.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-WbZx4oFW_C8/XO1F_c4UHwI/AAAAAAAAV-M/ajlMM92RWJQ2OJW28Dp1ULP6cszdFcxZgCLcBGAs/s1600/BAML%2B-%2BA%2Bmodest%2Bdrop%2Bin%2Bthe%2BChinese%2BGDP%2Bgrowth%2Brate%2Bwould%2Bprevent%2BChina%2Bfrom%2Bsurpassing%2Bthe%2BUS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="309" data-original-width="393" height="251" src="https://1.bp.blogspot.com/-WbZx4oFW_C8/XO1F_c4UHwI/AAAAAAAAV-M/ajlMM92RWJQ2OJW28Dp1ULP6cszdFcxZgCLcBGAs/s320/BAML%2B-%2BA%2Bmodest%2Bdrop%2Bin%2Bthe%2BChinese%2BGDP%2Bgrowth%2Brate%2Bwould%2Bprevent%2BChina%2Bfrom%2Bsurpassing%2Bthe%2BUS.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: red;">In other words, the ongoing trade war could enable the US to remain the hegemonic power for decades</span>. 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</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">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.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Euro area</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-6uTtwBf_uzA/XO2qgRv3JYI/AAAAAAAAV-g/o_-AWesP0bUY7Rxq-AygvEReKxTSwMHlACLcBGAs/s1600/CS%2BIP%2Bmomentum.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="329" data-original-width="390" height="269" src="https://1.bp.blogspot.com/-6uTtwBf_uzA/XO2qgRv3JYI/AAAAAAAAV-g/o_-AWesP0bUY7Rxq-AygvEReKxTSwMHlACLcBGAs/s320/CS%2BIP%2Bmomentum.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-OZ2InkGn3x0/XO2q6HTYyMI/AAAAAAAAV-o/tPgPDdBAQkIUiq7j0j1oCgP7cE4OkWDeACLcBGAs/s1600/CS%2B-%2BEuro%2Barea%2Bexports%2B-%2Ban%2Bimportant%2Bdriver%2Bof%2Bthe%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="324" data-original-width="390" height="265" src="https://1.bp.blogspot.com/-OZ2InkGn3x0/XO2q6HTYyMI/AAAAAAAAV-o/tPgPDdBAQkIUiq7j0j1oCgP7cE4OkWDeACLcBGAs/s320/CS%2B-%2BEuro%2Barea%2Bexports%2B-%2Ban%2Bimportant%2Bdriver%2Bof%2Bthe%2Bgrowth.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-T438T3ZWYZc/XO2rMm0EMTI/AAAAAAAAV-w/1vl7OHTJTdM6GDln7ED4XGvzs_CGn3LBwCLcBGAs/s1600/CS%2B-%2BAlmost%2B3%2Bpct%2Bof%2Beuro%2Barea%2Bdomestic%2Bvalue%2Badded%2Bgoes%2Binto%2Bexports.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="323" data-original-width="390" height="265" src="https://1.bp.blogspot.com/-T438T3ZWYZc/XO2rMm0EMTI/AAAAAAAAV-w/1vl7OHTJTdM6GDln7ED4XGvzs_CGn3LBwCLcBGAs/s320/CS%2B-%2BAlmost%2B3%2Bpct%2Bof%2Beuro%2Barea%2Bdomestic%2Bvalue%2Badded%2Bgoes%2Binto%2Bexports.jpg" width="320" /></span></a></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-_abh27idtcE/XO2r5T9uzaI/AAAAAAAAV-4/HJ14hgXttxcfHO0FlWuVbDgACckRmpG-QCLcBGAs/s1600/CS%2Buncertainty%2Band%2Bweak%2Bglobal%2Btrade%2Bpresent%2Ba%2Brisk.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="298" data-original-width="390" height="244" src="https://1.bp.blogspot.com/-_abh27idtcE/XO2r5T9uzaI/AAAAAAAAV-4/HJ14hgXttxcfHO0FlWuVbDgACckRmpG-QCLcBGAs/s320/CS%2Buncertainty%2Band%2Bweak%2Bglobal%2Btrade%2Bpresent%2Ba%2Brisk.jpg" width="320" /></span></a></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-w7WtCFLcyuA/XO2swKrBUKI/AAAAAAAAV_A/F5r0OtCMK-4Tz8KqdXkuUOdz0k5-zDaYgCLcBGAs/s1600/CS%2B-%2BFirms%2Binvestment%2Bintentions%2Bremain%2Bstable.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="309" data-original-width="390" height="253" src="https://1.bp.blogspot.com/-w7WtCFLcyuA/XO2swKrBUKI/AAAAAAAAV_A/F5r0OtCMK-4Tz8KqdXkuUOdz0k5-zDaYgCLcBGAs/s320/CS%2B-%2BFirms%2Binvestment%2Bintentions%2Bremain%2Bstable.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">But the longer weak foreign demand and trade uncertainty goes on, the more likely it is to start affecting business investment." - source Crédit Suisse</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">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.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Resilience</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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). </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">Over the past week…</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>High grade</b> 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.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-nnJKGZm9mDE/XO2wmHBziJI/AAAAAAAAV_M/JUsYDwwSy6E3fnqfexchZz_dIPMSz2uCwCLcBGAs/s1600/BAML%2B-%2BHG%2Bhas%2Bbeen%2Ba%2Bclear%2Bwinner.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="264" data-original-width="524" height="161" src="https://1.bp.blogspot.com/-nnJKGZm9mDE/XO2wmHBziJI/AAAAAAAAV_M/JUsYDwwSy6E3fnqfexchZz_dIPMSz2uCwCLcBGAs/s320/BAML%2B-%2BHG%2Bhas%2Bbeen%2Ba%2Bclear%2Bwinner.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>High yield </b>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.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Government bond</b> funds registered another inflow last week, the second in a row. <b>Money Market</b> funds recorded a significant inflow, the second largest of the year, benefiting from the broader risk-off sentiment. All in all, <b>Fixed Income</b> funds enjoyed another weekly inflow – the twentieth in a row. <b>European equity</b> funds continued to record outflows – the 15th in a row, albeit at a slower pace than last week.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Global EM debt</b> 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. <b>Commodity </b>funds saw a marginal inflow last week.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">On the <b>duration front</b>, inflows were recorded across the curve, with short-term funds enjoying the bulk of the inflow." - source Bank of America Merrill Lynch</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">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.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">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:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>The key risk is trade escalation.</b> 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).</span></blockquote>
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<span style="font-family: inherit;">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.</span></blockquote>
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<span style="font-family: inherit;"><b>Is the market pricing of future rate cuts foreshadowing future downside </b><b>for US credit spreads? </b>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. <span style="color: red;">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</span> (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</span></blockquote>
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<span style="font-family: inherit;"> 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.</span></div>
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<span style="font-family: inherit;">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.</span></div>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - Take it IG (Investment Grade), Japan's got your back...</span></li>
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<span style="font-family: inherit;">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:</span></div>
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<span style="font-family: inherit;">"</span><b>The case for foreign buying remains strong</b></blockquote>
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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). </blockquote>
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<a href="https://1.bp.blogspot.com/-gUCa3eFDJsk/XO22yLvhZ5I/AAAAAAAAV_Y/GLRayxICleA3QzVkQ4fWSUs37itcBRJ0wCLcBGAs/s1600/BAML%2B-%2BUS%2Bcorporate%2Byields%2Bhave%2Bcompressed.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="300" data-original-width="380" height="252" src="https://1.bp.blogspot.com/-gUCa3eFDJsk/XO22yLvhZ5I/AAAAAAAAV_Y/GLRayxICleA3QzVkQ4fWSUs37itcBRJ0wCLcBGAs/s320/BAML%2B-%2BUS%2Bcorporate%2Byields%2Bhave%2Bcompressed.jpg" width="320" /></a></div>
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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). </blockquote>
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<a href="https://1.bp.blogspot.com/-KsI3a9HAbrs/XO23GilR1kI/AAAAAAAAV_g/-JMhnIQPM9EBoLnjz8VA1DtUh0rgUuypQCLcBGAs/s1600/BAML%2B-%2Bhedging%2Bcosts%2Bvs%2Bmarket%2Bimplied%2BFed%2Brate%2Bhikes.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="327" data-original-width="388" height="269" src="https://1.bp.blogspot.com/-KsI3a9HAbrs/XO23GilR1kI/AAAAAAAAV_g/-JMhnIQPM9EBoLnjz8VA1DtUh0rgUuypQCLcBGAs/s320/BAML%2B-%2Bhedging%2Bcosts%2Bvs%2Bmarket%2Bimplied%2BFed%2Brate%2Bhikes.jpg" width="320" /></a></div>
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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.</blockquote>
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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. </blockquote>
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<a href="https://1.bp.blogspot.com/-uAZWoQ6E3YM/XO23rBZvkkI/AAAAAAAAV_s/Hg6YgYvWK4cRfSj6uLMHRh08WNU8Dxe1ACLcBGAs/s1600/BAML%2B-%2BForward%2Bhedged%2BUS%2Bcorporate%2Bbond%2Byields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="326" data-original-width="533" height="195" src="https://1.bp.blogspot.com/-uAZWoQ6E3YM/XO23rBZvkkI/AAAAAAAAV_s/Hg6YgYvWK4cRfSj6uLMHRh08WNU8Dxe1ACLcBGAs/s320/BAML%2B-%2BForward%2Bhedged%2BUS%2Bcorporate%2Bbond%2Byields.jpg" width="320" /></a></div>
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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</blockquote>
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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...</div>
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"China is a sleeping giant. Let her sleep, for when she wakes she will move the world." - Napoleon Bonaparte</blockquote>
<span style="font-family: inherit;">Stay tuned ! </span></div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-58095965417496488342019-05-17T09:51:00.000+01:002019-05-17T09:51:14.147+01:00Macro and Credit - The Lady, or the Tiger?<div dir="ltr" style="text-align: left;" trbidi="on">
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<span style="font-family: inherit;">"In waking a tiger, use a long stick." - Mao Zedong</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the collapse of the China trade deal with the US triggering the return of much muted volatility, as the fear of the "sell in May" motto settles in, given the rising tensions between the two powers, when it came to selecting our title analogy, we decided to go for a literary analogy, "The Lady, or the Tiger?". It is a much-anthologized short story written by Frank R. Stockton for publication in the magazine The Century in 1882. </span></div>
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<span style="font-family: inherit; text-align: left;">The short story takes place in a land ruled by a semi-barbaric king. Some of the king's ideas are progressive, but others cause people to suffer. One of the king's innovations is the use of a public trial by ordeal as an agent of poetic justice, with guilt or innocence decided by the result of chance. A person accused of a crime is brought into a public arena and must choose one of two doors. Behind one door is a lady whom the king has deemed an appropriate match for the accused; behind the other is a fierce, hungry tiger. Both doors are heavily soundproofed to prevent the accused from hearing what is behind each one. If he chooses the door with the lady behind it, he is innocent and must immediately marry her, but if he chooses the door with the tiger behind it, he is deemed guilty and is immediately devoured by it.</span></div>
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<span style="font-family: inherit;">The king learns that his daughter has a lover, a handsome and brave youth who is of lower status than the princess, and has him imprisoned to await trial. By the time that day comes, the princess has used her influence to learn the positions of the lady and the tiger behind the two doors. She has also discovered that the lady is someone whom she hates, thinking her to be a rival for the affections of the accused. When he looks to the princess for help, she discreetly indicates the door on his right, which he opens.</span></div>
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<span style="font-family: inherit;">The outcome of this choice is not revealed. Instead, the narrator departs from the story to summarize the princess's state of mind and her thoughts about directing the accused to one fate or the other, as she will lose him to either death or marriage. She contemplates the pros and cons of each option, though notably considering the lady more. "And so I leave it with all of you: Which came out of the opened door – the lady, or the tiger?"</span></div>
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<span style="font-family: inherit;">Obviously for those who remember our June 2018 conversation "<a href="https://macronomy.blogspot.com/2018/06/macro-and-credit-prometheus-unbound.html" style="color: #999999; text-decoration-line: none;">Prometheus Unbound</a>", we argued the following:</span></div>
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<span style="font-family: inherit;">"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by <a href="https://www.theatlantic.com/international/archive/2015/09/united-states-china-war-thucydides-trap/406756/" style="color: #999999; text-decoration-line: none;">Graham Allison</a> former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:</span></blockquote>
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<span style="font-family: inherit;"><span style="font-family: inherit;"><i>"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War" </i></span><span style="background-color: transparent;"> </span></span></blockquote>
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<span style="font-family: inherit;">- source Macronomics June 2016</span></blockquote>
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<span style="font-family: inherit;">Also, in our September 2018 conversation "White Tiger" we indicated that maverick hedge fund manager Ray Dalio came to a similar prognosis in his musing entitled "<a href="https://www.linkedin.com/pulse/path-war-ray-dalio/">A Path to War</a>" on the 19th of September. With our chosen title, we reminded ourselves that "The Lady, or the Tiger?" has entered the English language as an allegorical expression, a shorthand indication or signifier, for a problem that is unsolvable and we are not even talking again about BREXIT here...</span></div>
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<span style="font-family: inherit;">In this week's conversation, we would like to look at Financials Conditions, given we recently took a look at the latest quarterly Fed Senior Loan Officer Opinion Survey.</span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
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<li style="color: #333333; line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - Financial Conditions? It's a "Slow grind"</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i style="color: #333333;"><b><span style="font-family: inherit;">Final charts - </span></b></i><span style="color: #333333;"><b><i>The credit market cycle is very well correlated to the macro cycle.</i></b></span></span></li>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - Financial Conditions? It's a "Slow grind"</span></li>
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<span style="color: #333333; font-family: inherit;">Back in February, in our conversation "<a href="https://macronomy.blogspot.com/2019/02/macro-and-credit-cryoseism.html">Cryoseism</a>" we indicated the following in relation to the SLOOs:</span></div>
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<span style="background-color: white; color: #333333;"><span style="font-family: inherit;">"We think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield." - source Macronomics, February 2019</span></span></blockquote>
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<span style="font-family: inherit;">The latest publication of the SLOOs point towards a slowly but surely turning credit cycle. Yet, with the most recent easing stance of the stance, there are indeed clear signs of slow deterioration. With around 8.1% of credit-card balances held by people aged 18 to 29 being delinquent by 90 days or more in the first quarter of the year, the highest share since the first quarter of 2011, we believe it is essential to monitor going forward any weakness coming from the Fed's SLOOs.</span></div>
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<span style="font-family: inherit;">On the subject of SLOOs we read with interest Bank of America Merrill Lynch's take from their Credit Strategist Note from the 12th of May entitled "<span style="text-align: left;">BBBonvexity in IG":</span></span></div>
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<span style="font-family: inherit;"><span style="text-align: left;">"</span><b>April Senior Loan Officer Survey: Back to easing</b><span style="text-align: left;"> </span></span></blockquote>
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<span style="font-family: inherit;"><b></b>Not surprisingly, given the sharp decline in uncertainties this year, as the Fed abandoned the rate hiking cycle/QT and the US economy not going into recession any time soon, banks are now back to easing lending standards for large and medium sized firms (neutral for small firms). The Fed’s fresh April senior loan officer survey released today also showed continued weak demand across the board for C&I, CRE, residential mortgage, auto and credit card loans. In addition, the April survey added special questions on foreign exposure with a moderate fraction of banks expecting deteriorating loan quality from current levels over the remainder of 2019. C&I and CRE loans</span></blockquote>
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<span style="font-family: inherit;">A net 4.2% of banks reported easing lending standards for large/medium C&I loans in April, a reversal from a net 2.8% reporting tightening standards in January, while lending standards for small C&I loans were unchanged in the April survey after a net 4.3% of banks reported tighter lending standards in January (Figure 20).</span></blockquote>
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<a href="https://3.bp.blogspot.com/-RaQe4n6138s/XN2NqzTG1dI/AAAAAAAAV3A/wn7JkUCZhMQllaV0xxb5LDlIYaXCQ679wCEwYBhgL/s1600/BAML%2B-%2BLending%2BStandards%2BMay%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="594" data-original-width="782" height="243" src="https://3.bp.blogspot.com/-RaQe4n6138s/XN2NqzTG1dI/AAAAAAAAV3A/wn7JkUCZhMQllaV0xxb5LDlIYaXCQ679wCEwYBhgL/s320/BAML%2B-%2BLending%2BStandards%2BMay%2B2019.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"> At the same time, the net share of banks reporting tighter standards on CRE loans declined to 10.8% in April from 12.3% in January. Please note that the CRE value reported here is the average for the three separate questions on loans for construction and land development, loans secured by nonfarm nonresidential structures, and loans secured by multifamily residential structures.<span style="text-align: left;"> </span></span></blockquote>
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<span style="font-family: inherit;">Loan demand continued to weaken as the net shares of banks reporting weaker large/medium, small C&I and CRE loan demand increased to 16.9%, 10.3% and 16.9% in April, respectively, from 8.3%, 10.1% and 11.0% in January (Figure 21).</span></blockquote>
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<a href="https://2.bp.blogspot.com/-sH9_0rQkt7k/XN2Nx0TX5YI/AAAAAAAAV3E/AcgiM97n714YgZZhsLNlDCxF7_isFwRqACLcBGAs/s1600/BAML%2BLoan%2Bdemand%2BMay%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="590" data-original-width="784" height="240" src="https://2.bp.blogspot.com/-sH9_0rQkt7k/XN2Nx0TX5YI/AAAAAAAAV3E/AcgiM97n714YgZZhsLNlDCxF7_isFwRqACLcBGAs/s320/BAML%2BLoan%2Bdemand%2BMay%2B2019.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"><b>Mortgages</b><span style="text-align: left;"> </span></span></blockquote>
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<span style="font-family: inherit;"><b></b>Net 3.2% and 4.6% of banks returned to easing lending standards for GSE-eligible and QM-jumbo mortgage loans in the April survey, respectively, following net unchanged standards for GSE-eligible mortgages and 1.6% of banks reporting tighter standards for QM-Jumbo loans in the January (Figure 22). </span></blockquote>
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<a href="https://2.bp.blogspot.com/-GzmQx7cN1Ns/XN2OEqtWzcI/AAAAAAAAV3Q/4o9VQ9qPuPkhUCg4AEJhImJvtz12ZbyHQCLcBGAs/s1600/BAML%2BLendind%2BStandards%2BMortgages.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="588" data-original-width="766" height="245" src="https://2.bp.blogspot.com/-GzmQx7cN1Ns/XN2OEqtWzcI/AAAAAAAAV3Q/4o9VQ9qPuPkhUCg4AEJhImJvtz12ZbyHQCLcBGAs/s320/BAML%2BLendind%2BStandards%2BMortgages.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">At the same time, the net share reporting weaker demand for GSE-eligible and QM-Jumbo mortgages declined to 17.5% and 12.3% in April, respectively, from net 41.0% and 31.7% in January (Figure 23).<span style="text-align: left;"> </span></span></blockquote>
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<a href="https://2.bp.blogspot.com/-qFD4QmZIXWw/XN2Olyvb8FI/AAAAAAAAV3s/UIX4TV4ltew7GACS7nCQMA_LejzfzAW9ACLcBGAs/s1600/BAML%2Bloan%2Bdeman%2Bfor%2Bmortages%2B.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><b><span style="font-family: inherit;"><img border="0" data-original-height="562" data-original-width="746" height="241" src="https://2.bp.blogspot.com/-qFD4QmZIXWw/XN2Olyvb8FI/AAAAAAAAV3s/UIX4TV4ltew7GACS7nCQMA_LejzfzAW9ACLcBGAs/s320/BAML%2Bloan%2Bdeman%2Bfor%2Bmortages%2B.jpg" width="320" /></span></b></a></div>
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<span style="font-family: inherit;"><b>Consumer loans</b><span style="text-align: left;"> </span></span></blockquote>
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<span style="font-family: inherit;"><b></b>Net 15.2% and 1.8% of banks reported tightening lending standards for credit card and auto loans according to the fresh April survey. This compares to net 6.4% and 1.9% of banks tightening lending standards on credit card loans and auto loans in the prior January survey (Figure 24). </span></blockquote>
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<a href="https://2.bp.blogspot.com/-b_Nx8DQFPp0/XN2OJXHwsyI/AAAAAAAAV3g/mCEq9WH5_rsr_JxyoSqpmmC4BrJCMBpJgCEwYBhgL/s1600/BAML%2BLending%2BConsumer%2Bloans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="590" data-original-width="772" height="244" src="https://2.bp.blogspot.com/-b_Nx8DQFPp0/XN2OJXHwsyI/AAAAAAAAV3g/mCEq9WH5_rsr_JxyoSqpmmC4BrJCMBpJgCEwYBhgL/s320/BAML%2BLending%2BConsumer%2Bloans.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Meanwhile, the net shares of banks reporting weaker demand for auto and credit card loans declined to 6.8% and 1.8% in April, respectively, from 17.4% and 18.2% in January (Figure 25). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-coRHTkW1YtE/XN2PaXkXYXI/AAAAAAAAV38/HmCnIxPB3MgXhnz-b5mBH76OHtOdT78fQCLcBGAs/s1600/BAML%2BLoan%2Bdemand%2BMay%2B2019%2BGraph.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="598" data-original-width="750" height="255" src="https://1.bp.blogspot.com/-coRHTkW1YtE/XN2PaXkXYXI/AAAAAAAAV38/HmCnIxPB3MgXhnz-b5mBH76OHtOdT78fQCLcBGAs/s320/BAML%2BLoan%2Bdemand%2BMay%2B2019%2BGraph.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
<span style="font-family: inherit;"><br /></span>
<div style="text-align: justify;">
<span style="font-family: inherit;">Overall, there is tepid loan growth on the back of rising delinquencies, not only from the younger generation but, as well for older generations. Delinquency rates are trending up again, and not just for younger consumers. <a href="https://www.axios.com/credit-crisis-banks-us-debt-4b77bbc4-395b-4c1e-9be4-b29d72548315.html">The report found that seriously delinquent credit card balances have also risen for consumers aged 50–69</a>. For borrowers aged 50–59 and 60–69, the 90-day delinquency rate increased by nearly 100 basis points each. It is indeed a "slow grinding" process when it comes to financial conditions. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Tracking financial conditions is paramount when it comes to assessing "credit availability. The very strong rally seen in credit in general and high yield in particular, even in Europe where macro data has been very disappointing in the first part of the year. Clearly the rally in European High Yield has been based not on fundamentals but mostly due to strong "technicals" such as issuance levels overall. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">We would like to reiterate what we discussed earlier in 2018 in our conversation "<a href="https://macronomy.blogspot.com/2018/02/macro-and-credit-buckling.html">Buckling</a>" in when it comes to our views for credit markets at the time:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<span style="text-align: left;">As long as growth and inflation doesn't run not too hot, the goldilocks environment could continue to hold for some months provided, as we mentioned above there is no exogenous factor from a geopolitical point of view coming into play which would trigger an acceleration in oil prices. " - source Macronomics, February 2018.</span></span></blockquote>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">Unfortunately, as of late, we have seen plenty of deterioration from a geopolitical point of view such as the unresolved trade war between the United States and China, or rising tensions with Iran hence the heightened volatility seen so far, in some way validating somewhat the "sell in may" narrative.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">While the rally in high beta has been significant, in our most recent musings we have been 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.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">From the same Bank of America Merrill Lynch's Credit Strategist Note from the 12th of May entitled "BBBonvexity in IG" the "defensive" rotation has been confirmed:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Outflows from risk</b><span style="text-align: left;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b></b><span style="color: red;">US mutual fund and ETF investors sold stocks and high yield and bought high grade and munis following the recent pickup in volatility</span>. Hence over the past week ending on March 8th investors redeemed $13.71bn from stocks – the biggest outflow since the week of March 20th. A week earlier stocks instead saw a small $0.36bn inflow. On the other hand buying of bonds increased to $3.85bn from $2.12bn (Figure 26), as stronger inflows to high grade, government bonds and munis more than offset outflows from high yield and leveraged loans.</span></blockquote>
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<a href="https://2.bp.blogspot.com/--PvHL4W3aVc/XN2VbTmqUVI/AAAAAAAAV4M/ZBZ3171nzKERWHJATpCz4u7wHGDDGgzAgCLcBGAs/s1600/BAML%2BFund%2BFlows%2BMay%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="572" data-original-width="980" height="186" src="https://2.bp.blogspot.com/--PvHL4W3aVc/XN2VbTmqUVI/AAAAAAAAV4M/ZBZ3171nzKERWHJATpCz4u7wHGDDGgzAgCLcBGAs/s320/BAML%2BFund%2BFlows%2BMay%2B2019.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="text-align: left;"><span style="font-family: inherit;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Inflows to high grade accelerated to $3.10bn from $2.47bn. The increase was entirely driven by inflows to short-term high grade rising to $0.92bn from $0.30bn. Flows ex. short-term remained unchanged at $2.17bn. Inflows to high grade funds declined to $1.98bn from $2.97bn, while ETF flows turned positive with a $1.12bn inflow this past week after a $0.50bn outflow in the prior week (Figure 27). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-vI1x403DVDA/XN2Vhia2zRI/AAAAAAAAV4Q/pnIaVE5ZFDomy9psLzvfGFzp2tMdstDeQCLcBGAs/s1600/BAML%2BHG%2Bfund%2Bflows%2BMay%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="492" data-original-width="720" height="218" src="https://1.bp.blogspot.com/-vI1x403DVDA/XN2Vhia2zRI/AAAAAAAAV4Q/pnIaVE5ZFDomy9psLzvfGFzp2tMdstDeQCLcBGAs/s320/BAML%2BHG%2Bfund%2Bflows%2BMay%2B2019.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Flows also improved for munis (to +$1.31bn from +$0.92bn) and government bonds (to +$0.04bn from -$1.54bn). On the other hand high yield reported a $0.28bn outflow after a flat reading a week earlier, while outflows from loans accelerated to $0.21bn from $0.17bn. For global EM bonds inflows declined to $1.03bn from $2.36bn. Finally money markets had a $16.32bn inflow this past week and a $13.83bn inflow in the prior week." - source Bank of America Merrill Lynch</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">The most recent heightened volatility, at least in credit markets, is more due to exogenous factors than solely fundamentals such as financial conditions, given that what we are seeing so far is much more akin to a "slow grind" than a complete change in the narrative and the turn in the credit cycle. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">From a "flow" perspective, we continue to monitor the appetite in particular of Japanese investors, which remain very supportive in particular of US credit markets. As we commented in numerous conversations, they have decided to add on more credit risk on a unhedged basis. We therefore think that FX volatility should be monitor closely and in particular any move in the US dollar against the Japanese yen for instance.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: left;">
<span style="font-family: inherit;">On the subject of Japanese flows we read with interest Nomura's <span style="text-align: left;">Matsuzawa Morning Report from the 16th of May entitled "</span>Banks hold off on foreign bond investment, while lifers continue to shift to credit":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"While the stock market remains unstable, the credit market was solid globally. In this respect, there were no signs that the market is looking to price in an economic downturn, and in fact it seems to be looking for the right time and catalyst to return to a risk-on flow. We expect Japanese investors to continue shifting out of government bonds to credit both in Japan and overseas. The April International Transactions in Securities data showed that lifers bought foreign bonds in line with levels in typical years, but we see this as a surprise given the drop in foreign yields and flattening along the curve. We believe this is reflected in the gradual, ongoing widening in USD/JPY and EUR/JPY basis since the start of the fiscal year (Figure 1). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-KC4aHGYTKew/XN5qzth3eDI/AAAAAAAAV4k/tSr9wq9y1bc6ZEit1r72O9SH6DyBJIXWgCLcBGAs/s1600/Nomura%2BCurrency%2BBasis%2BMay%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="722" data-original-width="932" height="247" src="https://3.bp.blogspot.com/-KC4aHGYTKew/XN5qzth3eDI/AAAAAAAAV4k/tSr9wq9y1bc6ZEit1r72O9SH6DyBJIXWgCLcBGAs/s320/Nomura%2BCurrency%2BBasis%2BMay%2B2019.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: red;">By taking credit risk, they are trying to cover currency hedging costs, in our view.</span><span style="text-align: left;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><br />The International Transactions in Securities data for the week of 6 May, released this morning, showed that Japanese investors were net buyers of foreign bonds at only JPY20.8bn (Figure 2). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-IcRn95_j1IU/XN5rIIKjXRI/AAAAAAAAV4s/-9QHFlxtxvI7GpMD4pD6ur_ShF8qEbq1QCLcBGAs/s1600/Nomura%2BJapanese%2Binvestors%2Bforeign%2Bbonds.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="564" data-original-width="1502" height="120" src="https://3.bp.blogspot.com/-IcRn95_j1IU/XN5rIIKjXRI/AAAAAAAAV4s/-9QHFlxtxvI7GpMD4pD6ur_ShF8qEbq1QCLcBGAs/s320/Nomura%2BJapanese%2Binvestors%2Bforeign%2Bbonds.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Given that they were net sellers in the previous two weeks, they remain cautious. In the week of 6 May, foreign yields fell sharply in response to President Trump’s tweets, but Japanese investors do not yet seem to be trading on the issue of the US-China trade conflict. However, we believe that banks’ short-term trading, not the aforementioned lifers, are primarily responsible for this trend. Banks were net sellers throughout April, and seem to be seeking to lock in profits in the near term. Foreign investors’ net buying of yen bonds remains high, at JPY553.5bn. In addition to the drop in foreign yields (currently, 10yr Bund yields are materially below 10yr JGB yields), widening currency basis also seems to support this trend." - source Nomura</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">"Bondzilla" the NIRP monster is still very much supportive of global allocation into fixed income and particularly in credit markets given the current levels of Japanese JGB yields and the German Bund 10 year yield.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">This is what we recommended in our April conversation "<a href="https://macronomy.blogspot.com/2019/04/macro-and-credit-easy-come-easy-go.html">Easy Come, Easy Go</a>":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white; text-align: left;"><span style="font-family: inherit;">"As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured." - source Macronomics, April 2019</span></span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">As we stated in our most recent conversation, Investment Grade is as well a far less volatile proposal and as indicated by Nomura, the stock market remains unstable whereas the credit market continues to be solid globally. Sure the trend in the SLOOs is not very positive with rising delinquencies and interest rates levels on credit cards for the US consumer, but, we do not think the credit cycle has finally turned as per our final chart below.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><span style="color: #333333;">Final charts - </span><span style="color: #333333;">The credit market cycle is very well correlated to the macro cycle.</span></span></li>
</ul>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;">After all our blog has been dealing with "Macro" and "Credit" since 2009, and there is a reason for this which can be resumed in the title of our final chapter in this conversation. The credit market cycle follows very closely the macro cycle. Our final chart comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 15th of May entitled "Keep calm and carry (on)" and displays the relationship between the credit cycle and the macro cycle:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>The cycle of risk assets</b><span style="text-align: left;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b></b>The credit market cycle is very well correlated to the macro cycle. As the chart below illustrates, a weakening economic backdrop is typically associated with wider spreads and a weakening market trend. To the contrary, when the economic cycle recovers spreads tend to tighten and market trends to improve.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-ek_hiys2wAI/XN5xM7xr9YI/AAAAAAAAV44/s4qVM4hPCOUFa-960p_M66wGEQLGv-K2QCLcBGAs/s1600/BAML%2BCredit%2BMarkets%2Band%2BMacro.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="700" data-original-width="1080" height="207" src="https://1.bp.blogspot.com/-ek_hiys2wAI/XN5xM7xr9YI/AAAAAAAAV44/s4qVM4hPCOUFa-960p_M66wGEQLGv-K2QCLcBGAs/s320/BAML%2BCredit%2BMarkets%2Band%2BMacro.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>The cycle of “ratings” beta</b><span style="text-align: left;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b></b>The macro cycle is not only a great tool to assess credit spread trends, but also a tool to track the cycle of “ratings” beta (chart 6). We define “ratings” beta as the slope between the monthly total return observed in high-yield vs. that in high-grade credit market (rolling twelve months). We then present in the chart below the trend of that beta (slope of returns) via a z-score analysis (12m z-score). When the macroeconomic backdrop improves and bounces from the lows, investors can realise higher (than average) betas in the high-yield market.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-XuzLAB5a8QE/XN5xvSyIdOI/AAAAAAAAV5A/HEcKO9b1R5wme32FahUcPvjZcWTc2ihqQCLcBGAs/s1600/BAML%2BMacro%2Band%2BBeta%2Bcycles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="680" data-original-width="1054" height="206" src="https://4.bp.blogspot.com/-XuzLAB5a8QE/XN5xvSyIdOI/AAAAAAAAV5A/HEcKO9b1R5wme32FahUcPvjZcWTc2ihqQCLcBGAs/s320/BAML%2BMacro%2Band%2BBeta%2Bcycles.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>The cycle of “subordination” beta</b><span style="text-align: left;"> </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b></b>Last but not least, the macroeconomic data cycle is also valuable to assess the trends seen in subs vs. senior bonds space. Using the typical pair of IG corporate hybrids vs. senior non-financial senior bonds, to capture subordination premium trends, one can observe similar patterns between the macro cycle and the “subordination” beta cycle. When the macro cycle rebounds from the lows, subs can realise higher betas (than average). Subsequently, betas tend to normalise as the cycle becomes more mature.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-RCdPCJaOByg/XN5yODBF86I/AAAAAAAAV5M/9Fp_1ypK1JICILdeV5jzps9AiF7uBAD3gCLcBGAs/s1600/BAML%2Bmacro%2Bcycle%2Band%2Bsubordination%2Bcycle.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="688" data-original-width="1068" height="206" src="https://1.bp.blogspot.com/-RCdPCJaOByg/XN5yODBF86I/AAAAAAAAV5M/9Fp_1ypK1JICILdeV5jzps9AiF7uBAD3gCLcBGAs/s320/BAML%2Bmacro%2Bcycle%2Band%2Bsubordination%2Bcycle.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- source Bank of America Merrill Lynch </span></div>
<span style="font-family: inherit;"><br /></span>
<div style="text-align: justify;">
<span style="font-family: inherit;">Financial conditions overall remain fairly accommodative, the issues we are seeing rising again as of late are from an exogenous nature such as "The Lady, or the Tiger?". Can China and the United States resolved their trade issues? Which door investors should choose? We wonder, but, in a volatile environment such as this one, quality credit markets offers more stability we think at this very moment given the Chinese "tiger" is yet to be tamed.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"An infallible method of conciliating a tiger is to allow oneself to be devoured." - Konrad Adenauer</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Stay tuned ! </span></div>
</div>
</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-22601807931529751162019-04-27T22:28:00.000+01:002019-04-28T13:51:26.043+01:00Macro and Credit - From Dysphoria to Euphoria and back<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart." - Alan Greenspan</blockquote>
<br />
<div style="text-align: justify;">
Looking at the very strong rally experienced so far this year in the high beta space nearly erasing the pain inflicted in the final quarter in 2018, when it came to selecting our title analogy, we reminded ourselves about "Dysphoria" being a profound state of unease or dissatisfaction. In a psychiatric context, dysphoria may accompany depression, anxiety, or agitation, whereas the opposite state of mind is known as "Euphoria". As well, this post is a continuation of our November 2016 conversation "<a href="https://macronomy.blogspot.com/2016/11/macro-and-credit-from-utopia-to.html">From Utopia to Dystopia and back</a>", given the continuing reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally which we think will materialize even more in the upcoming European elections next month. But, from our much appreciated behavioral psychologist approach to macro and credit perspectives, we reminded ourselves the wise words of our friend Paul Buigues in his 2013 post "<a href="http://macronomy.blogspot.com/2013/03/guest-post-long-term-corporate-credit.html">Long-Term Corporate Credit Returns</a>":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), <b><span style="color: red;">initial spreads explain nearly half of 5yr forward returns</span></b>." - Paul Buigues, 2013</blockquote>
<div style="text-align: justify;">
Returns are related to starting valuations and are <b>more volatile during transitional states regimes</b>, this is a very important point for credit investors we think going forward: </div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors." - Paul Buigues, 2013</blockquote>
Also, "dysphoric and euphoric" moves in markets are regular features we think in late cycles:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this <b>manic-depressive behaviour</b> (which can also be related to Minsky’s model of the credit cycle). " <span style="text-align: justify;">- Paul Buigues, 2013</span></blockquote>
<div style="text-align: justify;">
Another great illustration of this manic-depressive behaviour from credit investors was the very significant rally in high beta credit during the second part of 2016 and in particular in the CCC bucket in US High Yield thanks to its exposure to the energy sector and to the rebound seen in oil prices at the time.<br />
<br />
<br />
<br />
<div>
<span style="font-family: inherit;">In this week's conversation, we would like to look at the start of the deleveraging in US corporate credit and what it entails, a subject we already approached in January 2019 in our conversation "<a href="https://macronomy.blogspot.com/2019/01/macro-and-credit-zeigarnik-effect.html">The Zeigarnik effect</a>" as well as in April 2012 in our conversation "<a href="https://macronomy.blogspot.com/2019/01/macro-and-credit-zeigarnik-effect.html">Deleveraging - Bad for equities but good for credit assets</a>".</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Macro and Credit - Under reconstruction</b></i></span></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final chart - </b></i><b><i>In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets</i></b></li>
</ul>
</div>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - Under reconstruction</span></li>
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Given "Deleveraging" is generally bad for equities, but good for credit assets, one might wonder if indeed credit might in the near term start outperforming equities with CFOs become more defensive of their balance sheet. This would of course lead to less support to some US equities with reduced buybacks and even dividend cuts in some instances. Obviously buybacks have been highly supportive of the ongoing rally seen in US equities over the years thanks to multiple expansion. When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out, that simple.<br />
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An illustration of the above was pointed out by Lisa Abramowicz from Bloomberg on the 24th of April relating to AT&T:<br />
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<a href="https://3.bp.blogspot.com/-ii796bfIg4Q/XMSfWWpY8iI/AAAAAAAAVxE/3NB8IVSaQQUbMIKwBCD71HatSc1ElP4wQCLcBGAs/s1600/BBG%2B-%2BATT%2Bbond%2Binvestors.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="336" data-original-width="680" height="158" src="https://3.bp.blogspot.com/-ii796bfIg4Q/XMSfWWpY8iI/AAAAAAAAVxE/3NB8IVSaQQUbMIKwBCD71HatSc1ElP4wQCLcBGAs/s320/BBG%2B-%2BATT%2Bbond%2Binvestors.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"What's good for AT&T's bond investors is bad for its stock holders. The company is losing subscribers as it cuts debt, leading to a stock slump. Its bonds, however, are soaring." - source Bloomberg</blockquote>
This is exactly the risks we highlighted back in January 2019 in our conversation "<a href="https://macronomy.blogspot.com/2019/01/macro-and-credit-zeigarnik-effect.html">The Zeigarnik effect</a>"<br />
<blockquote class="tr_bq">
"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." - source Macronomics, January 2019</blockquote>
While the rally in high betas have been very significant so far this year with even the CCC bucket for US High Yield delivering around 8.8% return YTD, flows points towards "quality" (Investment Grade) over "quantity" (US High Yield) it seems as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 26th of April entitled "Reaching for quality yield":<br />
<blockquote class="tr_bq">
"<b>IG funds flows continue uninterrupted</b></blockquote>
<blockquote class="tr_bq">
Another week of the same it seems. Fixed income investors continue reaching for “quality yield” via high-grade paper, while reducing risk in the government bond market. With government bond yields still close to the lows, it comes as no surprise to us that investors are looking to source non-negative yielding instruments. At the same time the lack of clarity on global growth is deterring investors from adding risk in equities.</blockquote>
<blockquote class="tr_bq">
<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq">
<b>High grade</b> funds saw an inflow for an eighth week in a row, extending the longest streak of inflows since 2017. We note that the slower pace w-o-w could be attributed to the short week due to the Easter holidays. Should we adjust this week’s inflow (for only three business days) it is almost at the same level as the inflow seen a week ago.</blockquote>
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<a href="https://3.bp.blogspot.com/-84c31jis76s/XMSp9hkzkxI/AAAAAAAAVxQ/r-mdunkvpzoug7UwthrmNkhHTD1r83xxACLcBGAs/s1600/BAML%2B-%2BThe%2Breach%2Bfor%2Bquality%2Byield.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="285" data-original-width="530" height="172" src="https://3.bp.blogspot.com/-84c31jis76s/XMSp9hkzkxI/AAAAAAAAVxQ/r-mdunkvpzoug7UwthrmNkhHTD1r83xxACLcBGAs/s320/BAML%2B-%2BThe%2Breach%2Bfor%2Bquality%2Byield.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
<b>High yield </b>funds recorded an inflow last week, the third in a row. Looking into the domicile breakdown, European-focused funds recorded the bulk of the inflow followed by Globally-focused funds. US-focused funds saw an outflow.</blockquote>
<blockquote class="tr_bq">
<b>Government bond</b> funds registered an outflow for the second week in a row. We note that the pace (despite the short week) has more than doubled w-o-w. <b>Money Market</b> funds recorded a sizable outflow last week, the second largest ever recorded. All in all, <b>Fixed Income</b> funds enjoyed their sixteenth consecutive week of inflows.</blockquote>
<blockquote class="tr_bq">
<b>European equity funds</b> continued to record outflows; the eleventh in a row. Note that over the past 59 weeks the asset class has recorded only two weeks of inflows.</blockquote>
<blockquote class="tr_bq">
<b>Global EM debt</b> funds recorded a small outflow, only the second this year, reflecting the appreciation of the USD over the past couple of weeks. Commodity funds saw an outflow last week, the third in 2019.</blockquote>
<blockquote class="tr_bq">
On the <b>duration front</b>, even though there were inflows across the curve, mid-term IG funds saw the bulk of the inflow." - source Bank of America Merrill Lynch</blockquote>
Back in early April in our conversation "<a href="https://macronomy.blogspot.com/2019/04/macro-and-credit-easy-come-easy-go.html">Easy Come, Easy Go</a>", we pointed out to the return of "Bondzilla" the NIRP monster and the returning appetite from Japan's <span style="text-align: left;">Government Pension Investment Fund GPIF and their friends Lifers, shedding hedging and adding more credit risk in their allocation process. Therefore it is not a surprise to us to see an increase in allocation to Investment Grade credit in terms of fund flows.</span><br />
<span style="text-align: left;"><br /></span>
<span style="text-align: left;">The appetite for foreign bonds for Japanese Lifers is indicated by Nomura in their Matsuzawa Morning Report from the 23rd of April entitled "Pension funds continue to build portfolios premised on an economic downturn":</span><br />
<blockquote class="tr_bq">
<span style="text-align: left;">"L</span>ifers continued to buy super-long JGBs at relatively high levels in March<span style="text-align: left;">. Buying generally tends to increase in January-March, but the fact that they are </span><span style="text-align: left;">continuing to buy even as yields drop significantly, suggests that their shift to other assets </span><span style="text-align: left;">such as foreign bonds is not sufficient. Four of the nine major lifers had released their </span><span style="text-align: left;">FY19 investment plans as of yesterday. They are divided on Japanese bond investments, </span><span style="text-align: left;">with two lifers intending to increase and two planning to reduce Japanese bonds. </span><span style="text-align: left;">Compared with last year, they are not in favor of hedged foreign bonds (particularly </span><span style="text-align: left;">USTs). <span style="color: red;">They mention shifting instead to unhedged foreign bonds and, even among </span></span><span style="text-align: left;"><span style="color: red;">foreign assets, moving out of government bonds to credit and alternative investments</span>, but </span><span style="text-align: left;">it is not clear how far these can go as substitutions. Most of the lifers forecast USD/JPY </span><span style="text-align: left;">rates around 108-110 at end-FY19, with all expecting rates to be about the same as at </span><span style="text-align: left;">present or JPY somewhat stronger. The lifers predict 10yr UST yields in a 2.30-2.70% </span><span style="text-align: left;">range, anticipating neither a rate hike nor a rate cut. Given these projections for the </span><span style="text-align: left;">overseas environment, we believe lifers are unlikely to reduce the amounts left idle in </span><span style="text-align: left;">Japan for lack of other options compared with FY18, but they could increase these </span><span style="text-align: left;">amounts." - source Nomura</span></blockquote>
To repeat ourselves, like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.<br />
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Also something to take note is that as dispersion is rising (which is a late credit cycle feature) some investors are playing it more "defensive" hence the reach for "quality". As well as pointed out by another Nomura Matsuzawa Morning Report from the 25th of April entitled "Flows return from EMs to US", it is worth noting what is happening in Emerging Markets credit wise:<br />
<blockquote class="tr_bq">
"Overseas markets were risk-off overall on Wednesday. While flows were concentrated in the US, it looked to us like money was being pulled out of EMs. In the FX market, DXY increased significantly for a second day and USD/JPY reached the 112 range. At the same time, JPY was strong across the board in cross pairs, indicating that the market’s risk sentiment is weak—emblematic of unfavorable USD strength. EM currencies were also weak. Germany’s IFO came in below forecast, forcing investors to unwind their trades made hastily on the premise of Europe’s economic recovery. This makes sense to us, but we do find it interesting that Australia’s weak CPI not only triggered an AUD sell-off, but devolved into a risk-off flow that spilled over into EM and Japanese markets as well. It seems to us that market sentiment on EMs and resource-rich countries is beginning to deteriorate, so that even a small factor causes a major response in the market.</blockquote>
<blockquote class="tr_bq">
The CDS spread in EMs widened relatively significantly and reached the highest level since 3 January (Figure 2). </blockquote>
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<a href="https://2.bp.blogspot.com/-gxFt7JlxTbQ/XMS0-cFlmaI/AAAAAAAAVxg/-Ai72VseNSIwQn4hgKPYk3rNTLA_BlEFQCLcBGAs/s1600/Nomura%2B-%2BCanary%2Bin%2Bcredit%2Bmarket%2527s%2Bcoal%2Bmine.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="332" data-original-width="800" height="132" src="https://2.bp.blogspot.com/-gxFt7JlxTbQ/XMS0-cFlmaI/AAAAAAAAVxg/-Ai72VseNSIwQn4hgKPYk3rNTLA_BlEFQCLcBGAs/s320/Nomura%2B-%2BCanary%2Bin%2Bcredit%2Bmarket%2527s%2Bcoal%2Bmine.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
However, spreads on other instruments that act like canaries in a coal mine for the credit market, such as <span style="color: red;">US high-yield bonds and European financial institutions’ subordinated bonds, are relatively stable, which leads us to surmise that these wide spreads can be attributed to an issue specific to EMs (supply/demand? fundamentals?) rather than to a risk-off flow in the entire credit market</span>. In terms of supply/demand, we believe hedge funds locked in profits during the EM rally in January- March and are timing their return to the US to coincide with US companies’ strong earnings results. We see few factors that would prolong and deepen this flow, unlike the flows returning to the US due to the intensification of the US-China trade dispute last year. In terms of fundamentals, Chinese policymakers’ moves toward a more neutral policy stance could be having an impact. Yesterday, the People’s Bank of China (PBoC) injected liquidity via a targeted medium-term lending facility (see the 24 April edition of Asia Insights). This is seen as an alternative to lowering the reserve requirement ratio, and after this supply was announced, additional easing expectations declined, causing short-term rates (SHIBOR) to rise and Chinese equities to fall.<span style="color: red;"> If the PBoC were to rush into a more hawkish stance at this point, we believe risk-off flows in EMs would intensify</span>. In any case, during Japan’s 10-day holiday to mark the imperial succession, we expect EMs to be the focus. In addition to Japan’s holiday, China will have its May Day holiday on 1-3 May, and this could restrain the market’s movements. In addition, the release of China’s manufacturing PMI on 30 April could change economic sentiment.</blockquote>
<blockquote class="tr_bq">
Ironically, the concentration of flows in the US as economic conditions there improve has pushed down US bond yields as well, and the market reflects higher Fed rate cut expectations. In fact, <span style="color: red;">Japanese investors seem to be playing a role in this, and the International Transactions in Securities released this morning show that they were major net buyers of foreign bonds for a second straight week in the most recent week</span> for which data is available (week of 15 April; Figure 1). </blockquote>
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<a href="https://1.bp.blogspot.com/-OVtFs8bY4rE/XMS0vvWrtaI/AAAAAAAAVxc/oL_5YfapBXkxRSW3o6e56UJRpiwYAQ89ACLcBGAs/s1600/Nomura%2B-%2BJapanese%2Binvestors%2Bforeign%2Bbond%2Btransactions%2Band%2Bforeign%2Binvestors%2Byen%2Bbond%2Btransactions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="298" data-original-width="813" height="117" src="https://1.bp.blogspot.com/-OVtFs8bY4rE/XMS0vvWrtaI/AAAAAAAAVxc/oL_5YfapBXkxRSW3o6e56UJRpiwYAQ89ACLcBGAs/s320/Nomura%2B-%2BJapanese%2Binvestors%2Bforeign%2Bbond%2Btransactions%2Band%2Bforeign%2Binvestors%2Byen%2Bbond%2Btransactions.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
Expectations for a Fed rate cut by end-2019 rose to 63% (56% on the previous day). Given that US economic sentiment has improved since April, it seems strange to us that a rate cut in 2019 should be part of the market’s main scenario, but as noted above, this can also be seen as a sign that investors are preparing for a credit event stemming from EMs during Japan and China’s national holidays. However, in this case, US bond yields would have room for a reactionary rollback once this period has passed without event." - source Nomura </blockquote>
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The overseas support from Japanese investors to US credit markets should not be underestimated. They provide significant support to US credit markets hence the importance of tracking their investment and flows from a credit and macro perspective. as per the chart below from Nomura FX Insights report from the 24th of April entitled "Lifers still look for foreign assets":</div>
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<a href="https://2.bp.blogspot.com/-zqEljsAio-w/XMS34viY8OI/AAAAAAAAVxw/Ay29z1RD1JUHpT1i7xNkq2tC7LPcuAhmgCLcBGAs/s1600/Nomura%2B-%2BCumulative%2Bforeign%2BLT%2Bbond%2Binvestment%2Bby%2Blifers.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="391" data-original-width="396" height="315" src="https://2.bp.blogspot.com/-zqEljsAio-w/XMS34viY8OI/AAAAAAAAVxw/Ay29z1RD1JUHpT1i7xNkq2tC7LPcuAhmgCLcBGAs/s320/Nomura%2B-%2BCumulative%2Bforeign%2BLT%2Bbond%2Binvestment%2Bby%2Blifers.jpg" width="320" /></a></div>
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- source Nomura</div>
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This is chart we think is very important we think from an allocation perspective as explained by Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Party like it’s 2016</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
During the years 2015-2017 foreigners and bond funds/ETFs bought all net supply of US corporate bonds (Figure 1), creating excess demand and driving spreads much tighter starting in February 2016. </blockquote>
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<a href="https://4.bp.blogspot.com/-8v0dziAI7LI/XMS4lN2oFiI/AAAAAAAAVx8/6bUYgdlLw0YBh0QGuQUfWO3watOjRUL3QCEwYBhgL/s1600/BAML%2B-%2B2019%2Bis%2Bexpected%2Bto%2Blook%2Blike%2B2016.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="333" data-original-width="519" height="205" src="https://4.bp.blogspot.com/-8v0dziAI7LI/XMS4lN2oFiI/AAAAAAAAVx8/6bUYgdlLw0YBh0QGuQUfWO3watOjRUL3QCEwYBhgL/s320/BAML%2B-%2B2019%2Bis%2Bexpected%2Bto%2Blook%2Blike%2B2016.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Then in 2018 the Fed engineered a disorderly rate hiking cycle and a yield shock, as they were the only major central bank hiking and at the same engaged in QT. As a result, the corporate bond market lost the foreign buyer and inflows to bond funds/ETFs plummeted – hence the big 112bps increase in corporate yields during 2018 was necessary in order to attract other buyers, specifically pension funds (the majority of which state and local).</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Given the Fed’s capitulation on monetary policy tightening this year we think 2019 will look much like 2016 as far as corporate bond demand goes, with foreigners and bond funds/ETFs once again buying all net supply. While the outlook for demand this year thus is similar to 2016, we expect ~$250bn less net supply ($100bn less gross supply, $150bn more maturities). Hence, we are unable to escape thinking that demand-supply technicals will remain positive and supportive for spreads for a while. Just like in 2016, although spreads this time are tighter so the rally cannot continue as long (Figure 2).</blockquote>
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<a href="https://4.bp.blogspot.com/-jkvM9iTe6xY/XMS42sfVKvI/AAAAAAAAVyA/Y_2ZxvAq0JkFDl6mP3OUGkNjW65K4p7hwCLcBGAs/s1600/BAML%2B-%2BRally%2Blike%2Bit%2527s%2B2016.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="377" data-original-width="527" height="228" src="https://4.bp.blogspot.com/-jkvM9iTe6xY/XMS42sfVKvI/AAAAAAAAVyA/Y_2ZxvAq0JkFDl6mP3OUGkNjW65K4p7hwCLcBGAs/s320/BAML%2B-%2BRally%2Blike%2Bit%2527s%2B2016.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>2019 vs. 2016</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Foreign buying – as reflected in negative net-dealer-to-affiliate volumes – has been running very strong this year at a pace matching what we saw in 2016 YtD (Figure 3). </blockquote>
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<a href="https://1.bp.blogspot.com/-wcBjY6ifuHs/XMS5PTVhB7I/AAAAAAAAVyI/yg0lexc0Vbw3U0dGH3WM7Z6a5dXpttirACLcBGAs/s1600/BAML%2B-%2BForeign%2Bdemand%2Brunning%2Bon%2Bpar%2Bwith%2B2016%2Bytd.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="333" data-original-width="383" height="278" src="https://1.bp.blogspot.com/-wcBjY6ifuHs/XMS5PTVhB7I/AAAAAAAAVyI/yg0lexc0Vbw3U0dGH3WM7Z6a5dXpttirACLcBGAs/s320/BAML%2B-%2BForeign%2Bdemand%2Brunning%2Bon%2Bpar%2Bwith%2B2016%2Bytd.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
Given that peak weakness in 2016 was on February 11, i.e. later in the year than the January 3rd wides this time, not surprisingly inflows to IG bond funds and ETFs are running well ahead of 2016’s pace YtD (Figure 4). </blockquote>
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<a href="https://4.bp.blogspot.com/-jfHesRlOm5M/XMS5eqz3B3I/AAAAAAAAVyM/_54AwcZZRT4P9LsN5UjXlkXMHY2WMQUAwCLcBGAs/s1600/BAML%2B-%2BIG%2BBond%2Bfund%2B-%2BETF%2Binflows%2Bpicking%2Bup.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="302" data-original-width="385" height="251" src="https://4.bp.blogspot.com/-jfHesRlOm5M/XMS5eqz3B3I/AAAAAAAAVyM/_54AwcZZRT4P9LsN5UjXlkXMHY2WMQUAwCLcBGAs/s320/BAML%2B-%2BIG%2BBond%2Bfund%2B-%2BETF%2Binflows%2Bpicking%2Bup.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
However, on adjusting for the difference in timing within each year clearly inflows this year following the wides is ramping up much faster that we saw following peak spreads in 2016. Finally gross new issuance is running at the exact same pace this year YtD as in 2016 (Figure 5). </blockquote>
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<a href="https://4.bp.blogspot.com/-4dtq75QiSXk/XMS5tux5jFI/AAAAAAAAVyU/vkS5zomurioY8yOjX40_DC4YJG9cy5PHACLcBGAs/s1600/BAML%2B-%2BIG%2Bgross%2Bsupply%2Bvolumes%2Brunning%2Bneck-to-neck%2Bwith%2B2016.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="302" data-original-width="524" height="184" src="https://4.bp.blogspot.com/-4dtq75QiSXk/XMS5tux5jFI/AAAAAAAAVyU/vkS5zomurioY8yOjX40_DC4YJG9cy5PHACLcBGAs/s320/BAML%2B-%2BIG%2Bgross%2Bsupply%2Bvolumes%2Brunning%2Bneck-to-neck%2Bwith%2B2016.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
For 2016 we originally forecast about $1.2tr of supply and ended up getting almost $100bn more ($1.289bn). For 2019 we are also forecasting about $1.2tr, and with the decline in yields and wide open markets, clearly the risk this year is again to the upside relative to our forecast first published in a very different environment in 4Q18. Should we again get about $100bn up upside, keep in mind that net supply will still be down $150bn this year due to more maturities." - source Bank of America Merrill Lynch</blockquote>
Indeed, we could see a continuation of the "melt-up" at least in credit markets thanks to the strong technical support in conjunction with overseas interest from the likes of Japanese investors.<br />
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But, returning to our main story of "Deleveraging" by CFOs, this we think could provide even more support to credit markets and translate into more "sucker punches" à la AT&T as illustrated earlier in our conversation. This would favor even more credit investors over equities investors we think. So, yes we are "bullish" credit. On that very subject of "Deleveraging by CFOs, we read with great interest Bank of America Merrill Lynch's take in their Credit/Equity Strategy note from the 22nd of April entitled "The Age of Balance Sheet Repair":<br />
<blockquote class="tr_bq">
"<b>A formula for growth in a low-growth environment</b></blockquote>
<blockquote class="tr_bq">
Low growth, low interest rates and low equity valuations in recent years have pushed US corporations to search for new drivers of financial performance. Many of them gravitated to a formula of tapping their balance sheet capacity to issue cheap debt and fund M&A and share buybacks. In only the last five years, companies repurchased $2.7trln of shares, paid $3.3trln in dividends, all while increasing their debt by $2.5trln. For some perspective, their combined capex budgets stood at $9.6trln during this time.</blockquote>
<blockquote class="tr_bq">
<b>About 30% of EPS growth driven by gross buybacks</b></blockquote>
<blockquote class="tr_bq">
Buybacks have been seen as the savior of a lackluster profits cycle: US stocks (proxied by the Russell 3000 ex-Financials/Utilities/Real Estate) have seen EPS growth of 45% over the last five years, but gross share buybacks contributed 12ppt, ~30% of that growth (with the net buyback impact about half of that, or 6ppt). Over the same period, net debt doubled. An elevated equity risk premium and a low cost of debt encouraged debt-funded buybacks, and a scarcity of real revenue growth made this more compelling.</blockquote>
<blockquote class="tr_bq">
<b>The age of balance sheet repair is here</b></blockquote>
<blockquote class="tr_bq">
<span style="color: red;">Late 2018 was the turning point in this cycle of expanding debt balance sheets, buying growth and rewarding shareholders, in our opinion. Interest rates have risen and the market dislocation in Q4 played the role of a wake-up call to the largest bond issuers. </span>This message was particularly loud and clear as it related to BBB issuers, many of whom saw their spreads north of 200bps, levels normally reserved for HY bonds. <span style="color: red;">Given their sizes – many in excess of $20bn in bonds, higher than any existing HY issuer – the message was also critical: delever, or else expect material risk premiums if downgraded to HY</span>. We include screens for largest BBB issuers, those with greater ability to delever and those with greater degree of dependence on capital markets.</blockquote>
<blockquote class="tr_bq">
<b>Reset your expectations lower from here</b></blockquote>
<blockquote class="tr_bq">
Today, the game has changed. <span style="color: red;">Three times as many investors want companies to pay down debt than to buyback stocks, and the cost of equity capital reflects this: the relative multiple of levered companies vs. cash-rich companies is now at a 7% discount to history</span>. We expect a return to normalcy: recall that buyback-driven EPS growth was largely a post-crisis phenomenon, and pre- 2009, companies were mostly net issuers. Based on these and other considerations, our S&P 500 EPS forecast for 2020 of $180 (7% growth) incorporates no net buyback effect, and <span style="color: red;">we see downside risk to per share growth going forward from dilution, not net share count reduction</span>. Sectors where buyback activity is most likely to continue (Fins and Tech, where leverage is still historically low) may be unduly rewarded as the buyback theme grows scarce.</blockquote>
<blockquote class="tr_bq">
<b>Strong balance sheets are good for all investors</b></blockquote>
<blockquote class="tr_bq">
The key takeaway here is that times are changing. <span style="color: red;">After years of transferring value from bondholders to shareholders companies may now be forced to instead defend their balance sheets at the expense of shareholders</span>. Our findings suggest that initial negative reaction in share prices is often short-lived, and eventually equities benefit from stronger balance sheets too." - source Bank of America Merrill Lynch</blockquote>
You have been warned, the fourth quarter was a wake-up call for many US CFOs and given the euphoria we have seen as of late in high beta, we would rather side with the "cowards" aka credit markets over "equities" in the second half of this year, particularly given Investment Grade is as well a far less volatile proposal.<br />
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The leverage "situation" is described in more details in Bank of America Merrill Lynch's note:<br />
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"<b>Low growth, low interest rates, low equity valuations</b></blockquote>
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In the years that passed since the Global Financial Crisis (GFC), many historical norms that were established over previous decades came into question. Economic growth has slowed with the trailing-10yr real US GDP growth bottoming out at 1.5% annualized in 2011-2018, a post-great depression low. This growth pattern also compares to 3.6% 10yr trailing average in the 2003-2006 cycle, and 4.2% in the mid-1990s. Inflation has also dropped to 60-year lows, as measured by core PCE. The Fed responded to this predicament by keeping real interest rates at negative levels for several years in a row.</blockquote>
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For US corporations, this backdrop implied two new factors: their earnings were unusually difficult to grow organically, and their debt was unusually cheap (Figure 1). </blockquote>
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<a href="https://4.bp.blogspot.com/-RoQlguX6vnM/XMTBOd2tySI/AAAAAAAAVyk/sDa6sV7Kpmk7VnVJwHSCV9_NF1JSvmQ_ACLcBGAs/s1600/BAML%2B-%2BCorporate%2Byields%2Bat%2Brecord%2Blow%2Blevels%2B-%2BUS%2BHG%2Bcorporate%2Byield.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="318" data-original-width="387" height="262" src="https://4.bp.blogspot.com/-RoQlguX6vnM/XMTBOd2tySI/AAAAAAAAVyk/sDa6sV7Kpmk7VnVJwHSCV9_NF1JSvmQ_ACLcBGAs/s320/BAML%2B-%2BCorporate%2Byields%2Bat%2Brecord%2Blow%2Blevels%2B-%2BUS%2BHG%2Bcorporate%2Byield.jpg" width="320" /></a></div>
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Their managements have responded to this macro backdrop in a predictable way, by borrowing cheap debt and using its proceeds to buy back shares, thus improving EPS, and funding M&A (Figure 2).</blockquote>
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<a href="https://4.bp.blogspot.com/-ElaDV6_BsFE/XMTBe3QZN8I/AAAAAAAAVys/vRZPbei64lMBxtd8akxs0GveObL6p3bMQCLcBGAs/s1600/BAML%2B-%2BM%2Band%2BA%2Band%2Bbuybacks%2Bvs%2BUS%2BHG%2Bborrowing.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="323" data-original-width="388" height="266" src="https://4.bp.blogspot.com/-ElaDV6_BsFE/XMTBe3QZN8I/AAAAAAAAVys/vRZPbei64lMBxtd8akxs0GveObL6p3bMQCLcBGAs/s320/BAML%2B-%2BM%2Band%2BA%2Band%2Bbuybacks%2Bvs%2BUS%2BHG%2Bborrowing.jpg" width="320" /></a></div>
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Fast forward to today, and we are looking at corporate balance sheets that are carrying cyclically high levels of debt leverage, a development that usually happens after credit cycle turns and EBITDAs drop.</blockquote>
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The large credit expansion over the last decade was supported by both strong demand and ample supply of corporate bonds. On the demand side investors were forced to reach for yield in US credit as a function of inability to achieve their income targets in other fixed income markets. On the supply side companies were put their balance sheets to use by borrowing at the historically low interest rates, while also satisfying the growing demand for their bonds.</blockquote>
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While borrowing to enhance shareholder returns and acquire new businesses is not a new phenomenon, it has reached new highs over the past decade (Figure 2). Looking more broadly at US nonfinancial corporate business, corporate bond borrowing covered 58% of net spending on buying equities. This includes both share buybacks and M&A activity (Figure 3).</blockquote>
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<a href="https://1.bp.blogspot.com/-ttuupfV36Eg/XMTBzpmOphI/AAAAAAAAVy0/QecS2PjkOvkKb4LknSkPjwWpQcd26ZFwgCLcBGAs/s1600/BAML%2B-%2BBorrowing%2Bhas%2Baccounted%2Bfor%2B58pct%2Bof%2Bequity%2Breduction%2Bover%2Bthe%2Blast%2B5%2Byears.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="302" data-original-width="508" height="190" src="https://1.bp.blogspot.com/-ttuupfV36Eg/XMTBzpmOphI/AAAAAAAAVy0/QecS2PjkOvkKb4LknSkPjwWpQcd26ZFwgCLcBGAs/s320/BAML%2B-%2BBorrowing%2Bhas%2Baccounted%2Bfor%2B58pct%2Bof%2Bequity%2Breduction%2Bover%2Bthe%2Blast%2B5%2Byears.jpg" width="320" /></a></div>
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<b>Reaching the limits of releveraging</b></blockquote>
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The demand and supply dynamics are now turning less favorable to releveraging. On the demand side Fed’s hiking cycle in 2018 made it more difficult for foreign investors to buy US corporate bonds due to higher FX hedging costs. At the same time higher interest rates and the corresponding bond price declines weakened inflows to high grade bond funds and ETFs. The result was a notable decline in demand for corporate bonds in 2018, although it has improved this year. In terms of supply, higher corporate bond yields mean borrowing costs have increased for US companies.</blockquote>
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On top of that after years of cheap credit a number of issuers have reached their balance sheet limits. For US non-financial issuers leverage is currently around cyclical highs (Figure 4).</blockquote>
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<a href="https://3.bp.blogspot.com/-mX4v3bMqndo/XMTCRvYoFQI/AAAAAAAAVzA/sm7odieSQcoGNcxBjJuL2o4RkRNDdxw2ACLcBGAs/s1600/BAML%2B-%2BLeverage%2Bfor%2BUS%2Bnon-financial%2BHG%2Bissuers.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="302" data-original-width="385" height="251" src="https://3.bp.blogspot.com/-mX4v3bMqndo/XMTCRvYoFQI/AAAAAAAAVzA/sm7odieSQcoGNcxBjJuL2o4RkRNDdxw2ACLcBGAs/s320/BAML%2B-%2BLeverage%2Bfor%2BUS%2Bnon-financial%2BHG%2Bissuers.jpg" width="320" /></a></div>
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Based on BofA Merrill Lynch Global Fund Manager Survey, equity investors are now more focused on balance sheet repair that at any other point in this credit cycle (Figure 5). </blockquote>
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<a href="https://2.bp.blogspot.com/-KDBpnR_FhQc/XMTCfeBXwPI/AAAAAAAAVzE/pAkDqxDswLgz1iNg2sUu2L61qnr-cfpwwCLcBGAs/s1600/BAML%2B-%2BEquity%2Binvestors%2Bwant%2Bcompanies%2Bto%2Bimprove%2Bbalance%2Bsheets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="302" data-original-width="385" height="251" src="https://2.bp.blogspot.com/-KDBpnR_FhQc/XMTCfeBXwPI/AAAAAAAAVzE/pAkDqxDswLgz1iNg2sUu2L61qnr-cfpwwCLcBGAs/s320/BAML%2B-%2BEquity%2Binvestors%2Bwant%2Bcompanies%2Bto%2Bimprove%2Bbalance%2Bsheets.jpg" width="320" /></a></div>
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Investors have grown disenchanted with buyback driven per share growth and are more interested in balance sheet improvement. Almost half (43%) of investors want excess cash used to improve balance sheets, a post-crisis high, compared to just 33% desiring increased capex and a paltry 16% desiring cash return to shareholders. The chart also shows strong cyclicality and previously has reached this level of credit-related concerns only in 2008 and 2002.</blockquote>
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A preference for clean balance sheets is evident in valuations, where we find that levered companies within the S&P 500 have de-rated to trade a historical discount to cash-rich peers (Figure 6).</blockquote>
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<a href="https://3.bp.blogspot.com/-E_QQNmZscws/XMTDKM22i1I/AAAAAAAAVzQ/kQTBCyry4EQTGraO1jAn-eTiuddjesWagCLcBGAs/s1600/BAML%2B-%2BS%2Band%2BP%2B%2B500%2Bmedian%2Bforward%2BP-E.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="302" data-original-width="535" height="180" src="https://3.bp.blogspot.com/-E_QQNmZscws/XMTDKM22i1I/AAAAAAAAVzQ/kQTBCyry4EQTGraO1jAn-eTiuddjesWagCLcBGAs/s320/BAML%2B-%2BS%2Band%2BP%2B%2B500%2Bmedian%2Bforward%2BP-E.jpg" width="320" /></a></div>
- source Bank of America Merrill Lynch.<br />
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If indeed equity investors are getting "Dysphoria" being a profound state of unease or dissatisfaction, and want companies to improve their balance sheets, then indeed it should lead to more "Euphoria" from credit investors we think.<br />
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Strong technicals on the back of overseas demand and a 2016 issuance level situation does indeed make us bullish for now on credit markets and in particular for US Investment Grade thanks to a dovish Fed as per our final chart below<br />
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets</li>
</ul>
<span style="text-align: left;">While a strong source of demand for US credit markets comes no doubt from "overseas" in general and Japan in particular, the dovish tilt from the Fed on the back of strong technicals such as issuance make it very supportive for credit markets for now as per our below chart displaying the fall in interest rate risk coming from </span>Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":<br />
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<b>"Crucial ingredient for the rally: Re-pricing the Fed</b>We want to end by discussing the key sources of demand driving the present environment of strong technicals in IG – bond funds and ETFs and foreigners. The key development for both is this major shift in monetary policy expectations. The below chart shows that the Fed funds futures market went from pricing in three rate hikes over the coming twelve months to now pricing in about one ease (Figure 11). </blockquote>
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<a href="https://1.bp.blogspot.com/-822xMVgI8kA/XMTGujAtWdI/AAAAAAAAVzc/vz_bU7bZ0do_ARU6ZErVRKt-YkkzxWHzgCEwYBhgL/s1600/BAML%2B-%2BDeclining%2Binterest%2Brate%2Brisk.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="308" data-original-width="527" height="187" src="https://1.bp.blogspot.com/-822xMVgI8kA/XMTGujAtWdI/AAAAAAAAVzc/vz_bU7bZ0do_ARU6ZErVRKt-YkkzxWHzgCEwYBhgL/s320/BAML%2B-%2BDeclining%2Binterest%2Brate%2Brisk.jpg" width="320" /></a></div>
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There are two key consequences of this: 1) dramatic decline in interest rates and 2) a much more benign outlook for dollar hedging costs for foreign investors." - source Bank of America Merrill Lynch</blockquote>
So if indeed we have seen a lot of "Euphoria" in the rally so far seen this year particularly in the high beta space with the start to year for the S&P since 1987 (+17%) , with Oil up 35%, Small Caps by 19% and High Yield up by 9% (HYG) and Investment Grade (LQD) up a cool 7%, given the current "Dysphoria" feeling about the level of leverage for US corporate balance sheet, rest assured that they are more potential for additional AT&T sucker punches being delivered. One would be wise to trade accordingly and rotate towards the credit part of any US issuer at risk but we ramble again...<br />
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"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher</blockquote>
Stay tuned!</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-43118257866247943542019-04-17T16:50:00.002+01:002019-04-17T16:50:49.628+01:00Macro and Credit - Showdown<div dir="ltr" style="text-align: left;" trbidi="on">
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"In every battle there comes a time when both sides consider themselves beaten, then he who continues the attack wins." - Ulysses S. Grant</blockquote>
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Watching with interest the lingering Brexit saga playing on in conjunction with the much commented trade war between China and the United States, when it came to selecting our title analogy, we decided to go for yet another poker card game reference (previous ones being "<a href="https://macronomy.blogspot.com/2018/08/macro-and-credit-poker-tilt.html">Poker tilt</a>", "<a href="https://macronomy.blogspot.com/2015/10/macro-and-credit-le-chiffre.html">Le Chiffre</a>", "<a href="https://macronomy.blogspot.com/2015/05/credit-optimal-bluffing.html">Optimal bluffing</a>", the "<a href="https://macronomy.blogspot.com/2013/01/credit-donk-bet.html">Donk bet</a>", to name a few in no particular order). In the game of poker, the "Showdown" is a situation when, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner or winners. To win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not. Cards speak for themselves: the actual value of a player's hand prevails in the event a player mis-states the value of his hand. Because exposing a losing hand gives information to an opponent, players may be reluctant to expose their hands until after their opponents have done so and will muck their losing hands without exposing them. Robert's Rules of Poker state that the last player to take aggressive action by a bet or raise is the first to show the hand - unless everyone checks (or is all-in) on the last round of betting, then the first player to the left of the dealer button is the first to show the hand. </div>
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If there is a side pot, players involved in the side pot should show their hands before anyone who is all-in for only the main pot. To speed up the game, a player holding a probable winner is encouraged to show the hand without delay (Brexit comes to our mind). Any player who has been dealt in may request to see any hand that is eligible to participate in the showdown, even if the hand has been mucked. This option is generally only used when a player suspects collusion or some other sort of cheating by other players. When the privilege is abused by a player (i.e. the player does not suspect cheating, but asks to see the cards just to get insight on another player's style or betting patterns), he may be warned by the dealer, or even removed from the table. There has been a recent trend in public cardroom rules to limit the ability of players to request to see mucked losing hands at the showdown. One would probably think a similar rule should be applied to Brexit negotiations but we ramble again...</div>
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<span style="font-family: inherit;">In this week's conversation, we would like to look at US consumption and consumers, following the significant rally in the high beta segment of asset classes as we believe monitoring the state of the US Consumer in the coming months will be paramount. </span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Macro and Credit - Secular stagnation or secular strangulation?</b></i><b><i> </i></b></span></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final charts - Yes, Europe is turning Japanese</b></i></li>
</ul>
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - Secular stagnation or secular strangulation? </span></li>
</ul>
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With U.S. consumer prices increasing by the most in 14 months in March to 1.9% thanks to Energy prices climbing by 3.5% and accounting for about 60% of the increase, in conjunction with The University of Michigan’s preliminary consumer sentiment survey falling to 96.9 in April, from 98.4 the previous month, one might wonder what is the state of the US consumer.</div>
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On a side note, given the recent rise of the MMT crowd we read with interest <a href="http://www.hoisingtonmgt.com/pdf/HIM2019Q1NP.pdf">Dr Lacy Hunt's take in his latest 1st Quarter review</a>. We highly recommend you read it, for those of you in the "Deflationista" camp. The Keynesian camp might be somewhat part of the "Inflationista" camp given their preference for 2% inflation and beliefs in the much antiquated "Phillips curve" (we have said enough on this subject on this very blog). It seems to us the MMT crowd, as rightly pointed out by Dr Lacy Hunt, could make us all fall into the "hyperinflationista" camp with their monetary prowess and "promises".</div>
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As well we have seen many recent conversations surrounding the fact that in many instances in Developed Markets (DM) the "middle-class" has been hollowed out. This has been discussed at length by the OECD in their recent paper entitled "<a href="https://www.oecd.org/fr/social/under-pressure-the-squeezed-middle-class-689afed1-en.htm">Under Pressure: The Squeezed Middle Class</a>".</div>
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Back in December 2014, in our conversation "<a href="https://macronomy.blogspot.com/2014/12/credit-qe-macguffin.html">The QE MacGuffin</a>" we pointed out the following Societe General's take from their FX outlook on central banks meddling:</div>
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<i><span style="line-height: 20.79px;">"It’s broken, and they don’t know how to fix it. </span><span style="line-height: 20.79px;">It is remarkable that after so many years of super easy monetary policy, the global economy </span><span style="font-family: inherit; line-height: 20.79px;">still feels wobbly. On the positive side the US continues to recover and the lower oil price will </span><span style="font-family: inherit; line-height: 20.79px;">provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much </span><span style="font-family: inherit; line-height: 20.79px;">weaker still than they have been historically, highlighting a lack of confidence, be it because of </span><span style="font-family: inherit; line-height: 20.79px;">post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.</span><span style="line-height: 20.79px;">‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth </span><span style="font-family: inherit; line-height: 20.79px;">has dropped; 2) there is a global excess of supply, or a chronic lack of demand</span><span style="font-family: inherit; line-height: 20.79px;">. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet </span><span style="font-family: inherit; line-height: 20.79px;">supply at full employment, central banks may need to run exceptionally easy monetary policy </span><span style="font-family: inherit; line-height: 20.79px;">‘forever’.<b> In other words, real short-term rates need to remain very low, if not negative.</b></span></i></blockquote>
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<i><b><span style="line-height: 20.79px;"><span style="font-family: inherit;">Life below zero. At the ZLB, central banks do what they know: they print money. But such </span></span><span style="font-family: inherit; line-height: 20.79px;">policy seems to follow a law of diminishing marginal returns. It has worked well for the US, </span><span style="font-family: inherit; line-height: 20.79px;">because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy </span></b><span style="font-family: inherit; line-height: 20.79px;"><b>and a swift clean-up of the household and bank balance sheet.</b> The BoJ and ECB aren’t as </span><span style="font-family: inherit; line-height: 20.79px;">lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields </span><span style="font-family: inherit; line-height: 20.79px;">lower, central banks force investors into riskier assets, boosting their prices. But trees don’t </span><span style="font-family: inherit; line-height: 20.79px;">grow to the sky. And the wealth effect on spending is constrained by high private and public </span><span style="font-family: inherit; line-height: 20.79px;">debt. 2) The latter also gravely impairs the lending channel. And <b><span style="color: red;">with yields already so low, </span></b></span><span style="font-family: inherit; line-height: 20.79px;"><b><span style="color: red;">it’s questionable what sovereign QE can now achieve</span></b>. 3) The FX channel. <b><span style="color: red;">This is where the </span></b></span><span style="font-family: inherit; line-height: 20.79px;"><b><span style="color: red;">currency war starts, as central banks try to weaken their currency to boost exports and import </span></b></span><span style="font-family: inherit; line-height: 20.79px;"><b><span style="color: red;">inflation. It however is a zero-sum game that won’t boost world growth</span></b>.</span><span style="font-family: inherit;"><span style="line-height: 20.79px;">-The battle to win market shares highlights a fierce competitive environment, which tends to </span></span><span style="font-family: inherit; line-height: 20.79px;">depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and </span><span style="font-family: inherit; line-height: 20.79px;">agriculture, currently add to the deflationary pressure. That leads central banks to get ever </span><span style="font-family: inherit; line-height: 20.79px;">bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB </span><span style="font-family: inherit; line-height: 20.79px;">would be far more effective than covered and government bond purchases) and get proper </span><span style="font-family: inherit; line-height: 20.79px;">support from governments (fiscal policy, structural reforms)." -source Societe Generale</span></i></blockquote>
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High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, <b>l</b><strong>ow inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike</strong>." source Macronomics, December 2014</blockquote>
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The central banking "Showdown" is still going on we think. The "Global Savings Glut" (GSG), has been put forward by many defenders of Keynesian policies. </div>
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<span style="font-family: inherit;">We would like to add a couple of comments to the above relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "<a href="https://macronomy.blogspot.com/2016/02/macro-and-credit-disappearance-of-ms.html">The disappearance of MS München</a>" on this subject:</span></div>
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<span style="font-family: inherit;">"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "<a href="http://www.bis.org/publ/work395.pdf">The financial cycle and macroeconomics: What have we learnt?</a>":<br /><i>"<span style="color: red;">The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies</span>. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. <span style="color: red;">This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income</span>." - source BIS paper, December 2012</i></span></blockquote>
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<span style="font-family: inherit;">Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.</span></blockquote>
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<span style="font-family: inherit;">Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016</span></blockquote>
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<span style="font-family: inherit;">Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. </span>But, returning to the wise note of Dr Lacy Hunt, he puts another nail in the coffin of this "Savings Glut" theory put forward by Dr Ben Bernanke:</div>
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<div style="text-align: justify;">
<blockquote class="tr_bq">
"Secular stagnation is basically the rebirth of the over-saving theory. However, after WWII the U.S. balanced the budget, contrary to Keynes’s recommendation, and the economy boomed, permitting the U.S. to rebuild and open U.S. markets to the world’s exporters. What Keynes missed is that the national saving rate averaged over 10% during WWII, and the U.S. had a strong balance sheet. The private sector drew down their saving, and this propelled the economy higher. In 2018, the national saving rate was 3%, less than half the long-term average since 1929 and one-fifth the level of 1945. There is no excess saving to be drawn down (Chart 5)."</blockquote>
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<span style="text-align: justify;">- source Hoisington, Dr Lacy Hunt</span></div>
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<br /></div>
<div style="text-align: justify;">
Given the worrying trend for the middle-class in DM countries, you probably understand by now our chosen title of "Secular strangulation". For instance the "yellow jackets" (gilets jaunes) movement in France is an illustration of the fear of downgrade for many middle-class families which have been eviscerated by continuous fiscal pressure over the years. End of our parenthesis on the GSG.</div>
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<div style="text-align: justify;">
Returning to the paramount subject of the state of the US consumer, with the volte-face made by the Fed, mortgages rates have fallen in sympathy giving some much needed respite to the US housing market. Existing-home sales climbed nearly 12% in February from the month before, reaching an annual rate of 5.5 million, according to the National Association of Realtors, which attributed the growth partly to interest rates. Of course lower interest rates for home mortgages buoy the housing market. In 19 weeks since November, the rate on a 30-year mortgage dropped from 4.94% to 4.06%, the most rapid decline since 2008. But, given "Shelter" comprises 40% of the Consumer Price Index, we might see some erratic readings in the coming months. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As illustrated recently by Bloomberg, an excess of 7 million Americans were at least three months behind on their car payments at the end of 2018:</div>
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- graph source Bloomberg</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Given the rapid deterioration in financial conjunctions in conjunction with housing headwinds thanks to rising mortgages rates in the final quarter in 2018, we think that this conjunction of factors on top of falling equity prices managed to spook enough the Fed to generate the aforementioned volte-face.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Obviously this welcome respite has managed to trigger an incredible rally for high beta thanks to global dovishness from central banks overall. Yet, we do think that the current housing bounce we are seeing is only temporary and providing some short term relief to the US consumer increasingly using revolving credit aka it's credit card to maintain his consumption. On top of that, rising oil prices might be good news for US High Yield but, should gas prices continue to surge, it might start again to become a slight headwind for US consumers. This would point to overall weaker growth for the remainder of 2019 in the United States we think.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When it comes to the US Housing situation we read with interest Bank of America Merrill Lynch's take from their Housing Watch note from the 12th of April entitled "A brief housing pop":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Get ready for some good data…for now</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
All signs are pointing toward a short term boost to housing activity following a difficult end to last year. At the end of last year, mortgage rates were the highest since early 2011, the stock market was selling off and confidence in the economy was declining. Prospective homebuyers sat on the sidelines, uncertain about their future finances and concerned about affordability.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
It has all changed since then. Mortgage rates have tumbled, returning to levels last seen in January 2018, the stock market has recovered and confidence has returned. If buyers were hesitant last year, this environment has lured them back into the housing market. Indeed, mortgage purchase applications have climbed, pending home sales have improved and existing home sales in February were very strong. Survey measures, including our own proprietary survey, show more favorable perceptions around housing with people noting that buying conditions have improved (Chart 2, Chart 3). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Similarly, homebuilders feel more confident with the NAHB housing index improving and realtor confidence surveys ticking higher. In our last housing watch in January, we argued that we would see a “brief period of stronger housing data.” We are doubling down on that view and now revising up forecasts for home sales in 2Q (Table 1).</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Why are we looking for just a short-term boost to home sales rather than a more persistent recovery? Importantly, affordability challenges still remain. While the drop in mortgage rates provides a jolt to housing, housing is still overvalued given the strong rise in prices over the past several years (Chart 4). In addition, we see evidence that existing home sales have reached an equilibrium level based on the historical relationship between sales and the labor force. Of the people in the work-force, we are<br />
at a historically “normal” rate of existing home sales (Chart 5).</blockquote>
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<a href="https://2.bp.blogspot.com/-iJxIISLOB-E/XLTKOkOttRI/AAAAAAAAVsk/IJ7f1HVVdscS9KEm8PsyZqFBzWVvRRxRwCLcBGAs/s1600/BAML%2Bratio%2Bof%2Bsingle%2Bfamily%2Bhome%2Bsales.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="312" data-original-width="385" height="259" src="https://2.bp.blogspot.com/-iJxIISLOB-E/XLTKOkOttRI/AAAAAAAAVsk/IJ7f1HVVdscS9KEm8PsyZqFBzWVvRRxRwCLcBGAs/s320/BAML%2Bratio%2Bof%2Bsingle%2Bfamily%2Bhome%2Bsales.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
There are greater opportunities for new home sales than for existing given that the recovery for new construction has been lackluster. Builders have been shifting away from the high-end of the market where inventory is higher toward the more affordable part where there is still incremental demand. This can be seen through the average size of a new single family home slipping lower and a drop in new homes sold over $300,000<br />
(Chart 7, Chart 8).</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
Of course, housing dynamics are going to differ by region. A good way of understanding the relative strength or weakness in housing conditions is to track migration. </blockquote>
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<a href="https://1.bp.blogspot.com/-h9E4Ibcml6Y/XLTMJ5vZnqI/AAAAAAAAVtA/3ay18Z5jVOYdWKIthWKQuLONWnCSaRn2ACLcBGAs/s1600/BAML%2B-%2BWhere%2Bare%2Bpeople%2Bmoving.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="322" data-original-width="407" height="253" src="https://1.bp.blogspot.com/-h9E4Ibcml6Y/XLTMJ5vZnqI/AAAAAAAAVtA/3ay18Z5jVOYdWKIthWKQuLONWnCSaRn2ACLcBGAs/s320/BAML%2B-%2BWhere%2Bare%2Bpeople%2Bmoving.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
We find that people continue to leave Northeast, the Midwest and the California to move to Texas, Colorado as well as other areas in the West and South." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
Given affordability is stretched, we agree with Bank of America Merrill Lynch, namely that the recent fall in mortgage rates is only providing some short term respite. When it comes to Main Street it has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising in recent quarters. Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Housing activity is leading overall economic activity, housing being a sensitive cyclical sector.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The big question was that rising interest rates were starting to choke the US consumer hence the dovish tilt from the Fed following the horrific final quarter of 2018. </div>
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<br /></div>
<div style="text-align: justify;">
On the state of the US consumer we read with interest Wells Fargo's take from their note from the 2nd of April entitled "U.S. Recession? How Do We Count the Ways?":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Are Consumer Finances in Good Shape?</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Household leverage generally, and mortgage debt specifically, was at the epicenter of the last downturn. Although the severe repercussions of consumers getting over-extended a decade ago may still be fresh in the minds of borrowers, lenders and regulators, overall household leverage has fallen substantially over the past decade (Figure 1). As Mark Twain said, however, history does not repeat, but it often rhymes. Are there other areas in consumer balance sheets that pose a risk to the economy from an extensive build up in debt and deterioration in lending standards?</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
While mortgage debt has fallen over the past decade, Figure 1 also shows that leverage of other types of consumer debt, including autos, credit cards, and student loans, is at an all-time high. </blockquote>
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<a href="https://4.bp.blogspot.com/-RsMKoSVcuQ0/XLTuuW7M82I/AAAAAAAAVtQ/Z5J6J3OFrIwmToAWh0t_-930l1tkrvzmACLcBGAs/s1600/BAML%2B-%2BHousehold%2Bdebt%2B-%2Bconsumer%2Bmortgage.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="329" height="268" src="https://4.bp.blogspot.com/-RsMKoSVcuQ0/XLTuuW7M82I/AAAAAAAAVtQ/Z5J6J3OFrIwmToAWh0t_-930l1tkrvzmACLcBGAs/s320/BAML%2B-%2BHousehold%2Bdebt%2B-%2Bconsumer%2Bmortgage.jpg" width="320" /></a></div>
<div style="text-align: center;">
- Source: Federal Reserve Board and Wells Fargo Securities</div>
<blockquote class="tr_bq" style="text-align: justify;">
Yet unlike housing debt in the 2000s, the increase has not been exponential. Leverage for consumer credit is also only a quarter of the size of housing-related leverage at the height of the housing bust. What’s more, debt service remains exceptionally low. Historically low interest rates and longer repayment terms have kept households’ monthly financial obligations ratios near levels last seen in the early 1980s (Figure 2).</blockquote>
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<a href="https://2.bp.blogspot.com/-If7kxBnzVtw/XLTvBgKUOwI/AAAAAAAAVtY/B1y37jPBObgHyFRfXQkg7-tqg0KbtFcEgCLcBGAs/s1600/WF%2B-%2BFinancial%2Bobligations%2Bratio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="329" height="268" src="https://2.bp.blogspot.com/-If7kxBnzVtw/XLTvBgKUOwI/AAAAAAAAVtY/B1y37jPBObgHyFRfXQkg7-tqg0KbtFcEgCLcBGAs/s320/WF%2B-%2BFinancial%2Bobligations%2Bratio.jpg" width="320" /></a></div>
<div style="text-align: center;">
- Source: Federal Reserve Board and Wells Fargo Securities</div>
<blockquote class="tr_bq" style="text-align: justify;">
Notably, the most significant driver of the increase in consumer credit has been student loans. Given that educational debt is nearly impossible to discharge and primarily backed by the federal government, we view student loans as a sustained, long-term headwind to other types of spending rather than a mass credit event that could cause the financial system to seize up like the subprime mortgage crisis. <span style="color: red;">In short, we do not think that consumer debt problems will trigger a recession in the foreseeable future</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Corporate Sector Debt: Keep an Eye on This Space</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Where leverage may be more concerning is in the non-financial corporate (NFC) sector. As measured as a percent of GDP, debt in the NFC sector is at a record high. With corporate profit growth slowing, the ability to service debt likely will deteriorate somewhat over the next few quarters. At the same time, a shift in investor sentiment could weigh on asset values, which up until recently had been keeping pace with debt.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The financial health of the business sector has deteriorated since 2015, and significant further deterioration would be worrisome (Figure 3). </blockquote>
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<a href="https://1.bp.blogspot.com/-Geh0SpENClE/XLTwxq6TtLI/AAAAAAAAVtk/ufV-zF7zPTwjgoTdL-PxgcX3pBdLw9ZygCLcBGAs/s1600/WF%2B-%2BCorporate%2BFinancial%2BHealth%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="276" data-original-width="329" height="268" src="https://1.bp.blogspot.com/-Geh0SpENClE/XLTwxq6TtLI/AAAAAAAAVtk/ufV-zF7zPTwjgoTdL-PxgcX3pBdLw9ZygCLcBGAs/s320/WF%2B-%2BCorporate%2BFinancial%2BHealth%2BIndex.jpg" width="320" /></a></div>
<div style="text-align: center;">
<span style="text-align: center;"> - Source: Federal Reserve Board and Wells Fargo Securities</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
Firms that are stretched financially may be more reluctant to invest and hire. In addition, if companies start having trouble servicing their debt due to slower growth and/or higher interest costs, rising charge-offs and loan losses could disrupt credit growth. However, the current health of the non-financial corporate sector does not seem particularly dire at present when compared to the late 1980s or ahead of what we consider to have been the business-led recession of 2001.3 Interest rates have been rising from a historically low level and are unlikely to rise much further this cycle, while companies have locked in historically low interest rates by holding more long-term debt.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
One segment of business sector debt that bears particularly close watch is the leveraged loan market. </blockquote>
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<a href="https://2.bp.blogspot.com/-HhbQulVrMsY/XLTw9buLxlI/AAAAAAAAVto/nCJFU3jrVZEXIT0fIT1oFzMhhszKO_LTwCLcBGAs/s1600/WF%2B-%2BLeveraged%2BLoans%2BOutstanding%2BApril%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="331" height="266" src="https://2.bp.blogspot.com/-HhbQulVrMsY/XLTw9buLxlI/AAAAAAAAVto/nCJFU3jrVZEXIT0fIT1oFzMhhszKO_LTwCLcBGAs/s320/WF%2B-%2BLeveraged%2BLoans%2BOutstanding%2BApril%2B2019.jpg" width="320" /></a></div>
<div style="text-align: center;">
<span style="text-align: center;"> - Source: Federal Reserve Board and Wells Fargo Securities</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
Leveraged loans are made to companies with high debt-to-cash flow ratios that are typically rated less than investment grade. Loans outstanding in this sector have grown 35% since 2016, twice as fast as total NFC debt. Slower economic growth this year could make servicing that debt more difficult and lead to weaker demand from investors, which would weigh on credit growth to the business sector and therefore the broader economy. Yet leveraged loans are floating-rate instruments, and, with the Fed currently on hold, interest costs are not expected to shoot markedly higher. <span style="color: red;">As a result, we do not see the leveraged loan market as an immediate threat to the economy</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Is There Overbuilding in Construction?</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The bursting of the U.S. housing market bubble precipitated the Great Recession but it does not seem that lightning will strike twice, at least not in the current cycle. As noted above, households have de-levered over the past ten years. <span style="color: red;">The value of mortgage debt outstanding among households is down 4% relative to its peak in early 2008</span>. But disposable personal income is up 50% over the past ten years, giving households better ability to service that mortgage debt than they had at the height of the housing bubble. Furthermore, single-family housing starts are roughly 50% lower than they were at the height of the housing boom (Figure 5). </blockquote>
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<a href="https://3.bp.blogspot.com/-XMifEW3H7o8/XLTxW0efpwI/AAAAAAAAVt0/fVxUqP4zF6YLJHlyP5ztepEPyHGjTKISwCLcBGAs/s1600/WF%2B-%2BHousing%2BStarts%2BApril%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="279" data-original-width="341" height="261" src="https://3.bp.blogspot.com/-XMifEW3H7o8/XLTxW0efpwI/AAAAAAAAVt0/fVxUqP4zF6YLJHlyP5ztepEPyHGjTKISwCLcBGAs/s320/WF%2B-%2BHousing%2BStarts%2BApril%2B2019.jpg" width="320" /></a></div>
<div style="text-align: center;">
- Source: Federal Reserve Board and Wells Fargo Securities</div>
<blockquote class="tr_bq" style="text-align: justify;">
Although the level of multifamily starts is a bit higher today than it was a decade ago, apartment vacancy rates are low and rent growth remains solid.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Despite indications of robust activity in commercial construction, we do not think that commercial real estate (CRE) is an accident waiting to happen, at least not in the foreseeable future. As we wrote last autumn, the underlying fundamentals in the CRE market appear to be strong. Despite appearances of robust construction activity, the level of real non-residential construction spending is only 16% higher today than it was before the economy tumbled into recession in late 2007. At the end of the expansion in the 1980s, real non-residential construction spending was more than 60% higher than its previous peak. Commercial banks hold nearly $1.7 trillion worth of commercial mortgages, an all-time high. However, this amount represents less than 11% of their total financial assets, which is not out of line in a historical context (Figure 6).</blockquote>
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<a href="https://2.bp.blogspot.com/-rNriGT9IgFQ/XLTxl7KneBI/AAAAAAAAVt4/jd-L1uF70IcYdQPjqEJ4fgLcOGLd8eb3ACLcBGAs/s1600/WF%2B-%2BBank%2Bexposure%2Bto%2BCommercial%2BMortgages.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="276" data-original-width="337" height="262" src="https://2.bp.blogspot.com/-rNriGT9IgFQ/XLTxl7KneBI/AAAAAAAAVt4/jd-L1uF70IcYdQPjqEJ4fgLcOGLd8eb3ACLcBGAs/s320/WF%2B-%2BBank%2Bexposure%2Bto%2BCommercial%2BMortgages.jpg" width="320" /></a></div>
<div style="text-align: center;">
<span style="text-align: center;"> - Source: Federal Reserve Board and Wells Fargo Securities</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Whereas it might be a little premature to call for a decisive turn of the credit cycle, to repeat ourselves, the next Fed Quarterly publication of the Senior Loan Officer Survey will be extremely important to monitor.<br />
<br />
For now the US consumer is still holding on apparently. This is indicated by Bank of America Merrill Lynch in their BofA on USA report from the 11th of April entitled "The consumer spring into Spring":<br />
<blockquote class="tr_bq">
"<b>Strong consumer spending in March</b></blockquote>
<blockquote class="tr_bq">
The long-awaited rebound in consumer spending has arrived. According to BAC aggregated credit and debit card data, retail sales ex-autos jumped 1.5% month-over-month (mom) seasonally adjusted in March, partly reversing the decline over the prior three months. This recovery supports our view that the recent drop was largely due to temporary distortions rather than a fundamental weakening in consumer spending.</blockquote>
<blockquote class="tr_bq">
We see evidence that the timing of tax refunds pushed spending from February into March, specifically for lower income households. Those households receiving the Earned Income Tax Credit saw a significant delay in tax refunds, resulting in lower spending in February. Once tax refunds were received at the end of February, these households were able to spend, boosting activity in March. We see this notable swing in the data in the Chart of the Month. </blockquote>
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<a href="https://4.bp.blogspot.com/-vpI67F0SqfE/XLct41l5L2I/AAAAAAAAVvA/mT8NqHWTQbQxdKkM3_JTdTQxCfGqXKWpQCLcBGAs/s1600/BAML%2B-%2BChart%2Bof%2Bthe%2BMonth%2Bretail%2Bex%2Bauto%2Bspending%2Bby%2Bincome%2Bgroup.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="228" data-original-width="512" height="142" src="https://4.bp.blogspot.com/-vpI67F0SqfE/XLct41l5L2I/AAAAAAAAVvA/mT8NqHWTQbQxdKkM3_JTdTQxCfGqXKWpQCLcBGAs/s320/BAML%2B-%2BChart%2Bof%2Bthe%2BMonth%2Bretail%2Bex%2Bauto%2Bspending%2Bby%2Bincome%2Bgroup.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
It was the most apparent in the “discretionary” spending categories such as clothing, furniture and lodging. Interestingly, we did not see a big gyration in spending in restaurants which is typically sensitive to income changes. To be expected, spending at grocery stores was fairly steady over the prior two months (Chart 2).</blockquote>
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<a href="https://3.bp.blogspot.com/-zjqfNT1Yfpo/XLcuIz_J0vI/AAAAAAAAVvI/XYVLemuRzL4dzem-eS0msaT0gG2iM5GiwCLcBGAs/s1600/BAML%2B-%2BChart%2B2%2B-%2BSpending%2Bgrowth%2Bby%2Bsector%2Bfor%2Bthe%2Blow%2Bincome%2Bgroup.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="313" data-original-width="389" height="257" src="https://3.bp.blogspot.com/-zjqfNT1Yfpo/XLcuIz_J0vI/AAAAAAAAVvI/XYVLemuRzL4dzem-eS0msaT0gG2iM5GiwCLcBGAs/s320/BAML%2B-%2BChart%2B2%2B-%2BSpending%2Bgrowth%2Bby%2Bsector%2Bfor%2Bthe%2Blow%2Bincome%2Bgroup.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
We examine our tax refund data to see if the tax legislation, which capped state and local tax (SALT) deductions, altered refunds across the different states and income tiers. We focused on the top 10 states in terms of the SALT deduction and found that tax refunds were indeed down sharply for upper income households in these states – down 10% year-over-year (yoy) vs. an average of 1.7% increase over the three years prior (Chart 4). </blockquote>
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<a href="https://1.bp.blogspot.com/-bMH_KF8T0-g/XLcuXxoaGfI/AAAAAAAAVvM/UqK4s4oUqu8aEdOUzisWwt46eN9_VMpLACLcBGAs/s1600/BAML%2B-%2BTax%2Brefunds.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="328" data-original-width="389" height="269" src="https://1.bp.blogspot.com/-bMH_KF8T0-g/XLcuXxoaGfI/AAAAAAAAVvM/UqK4s4oUqu8aEdOUzisWwt46eN9_VMpLACLcBGAs/s320/BAML%2B-%2BTax%2Brefunds.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
In contrast, upper income households in the states with the most favorable tax laws saw little change in tax refunds relative to prior years. How does the decline in tax refunds among the upper income population in high SALT states impact spending? It isn’t obvious that it will have much of an impact since the upper income population tends to have more disposable income and are therefore less dependent on tax refunds to finance expenditures. Nonetheless, it could possibly weigh on confidence and curb purchases of bigger ticket items.</blockquote>
<blockquote class="tr_bq">
Bottom line: the consumer finally showed up in March, offsetting part of the decline at the turn of the year. We think we should see further improvement in spend going forward as consumers respond to higher wage growth amid solid job creation.</blockquote>
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- source Bank of America Merrill Lynch </div>
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While it's difficult to validate yet a bounce as per Bank of America Merrill Lynch's internal data, while University of Michigan Consumer Confidence remains high, it remains to be seen if there is indeed a change in the narrative:<br />
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<a href="https://4.bp.blogspot.com/-z72KSbZAtZQ/XLdEvR041JI/AAAAAAAAVvo/LkONXNMO-Yo883C1Gl8U-OuLQXP4wk50gCLcBGAs/s1600/Michigan%2BUS%2Bconsumer%2Bconfidence.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="960" height="228" src="https://4.bp.blogspot.com/-z72KSbZAtZQ/XLdEvR041JI/AAAAAAAAVvo/LkONXNMO-Yo883C1Gl8U-OuLQXP4wk50gCLcBGAs/s320/Michigan%2BUS%2Bconsumer%2Bconfidence.jpg" width="320" /></a></div>
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<a href="https://www.ibtimes.com/infographic-us-consumer-sentiment-fell-april-impact-tax-cuts-fade-2785942">- source IBT - University of Michigan</a></div>
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Something as well worth of interest when it comes to US Consumers given they make 70% of US GDP, has been the rise of Millenials and change of consumer habits as pointed out by another interesting report from Bank of America Merrill Lynch BofA on USA from the 17th of April entitled "Consumer, my how you have changed":<br />
<blockquote class="tr_bq">
"<b>Two numbers: age and income</b></blockquote>
<blockquote class="tr_bq">
The Millennials - who are currently aged 23 to 38 – make up 28% of retail sales ex-autos based on BAC internal card data, slightly outpacing the 26% from Baby Boomers. The wallet of Millennials is growing, with the average number of monthly transactions up 16% from 2012 vs. the 5% increase of Boomers. Millennials also live differently, with 51% of food consumption done at restaurants vs. Boomers at 34%. </blockquote>
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<blockquote class="tr_bq">
There are also differences by income, as we find that 30% of spending is made by the >$125k income cohort while the <$20k group only constitute 10% of total retail ex-auto spending." - source Bank of America Merrill Lynch</blockquote>
Overall, while it is too early to turn negative on US consumers, in the coming months ahead it will be essential to monitor closely the situation we think.<br />
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We have long posited that Europe was becoming more and more "Japanese" hence our frequent use of the word "Japanification". Our final charts below goes more into the similarities.<br />
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<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;">Final charts - Yes, Europe is turning Japanese</li>
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Looking at the trajectory of policy rates and government bond yields in Japan, it looks to us more and more that Europe is becoming more Japanese and we are not even mentioning the slow pace of resolving the issue of nonperforming loans plaguing the European Banking system. Our final charts come from Deutsche Bank Thematic Research report from the 9th of April entitled "How Europe is looking like the next Japan":<br />
<blockquote class="tr_bq">
"In February this year, the Bank of Japan celebrated an ominous anniversary: 20 years since it first cut interest rates to zero. Despite a few abortive attempts to raise policy rates, they have never again exceeded 1% and remain stubbornly stuck around zero. Likewise, Europe has seen a few false dawns but again looks set for a long period of short-term rates being stuck at or below zero. More recently, long-term bond yields have fallen as well, with ten-year bund yields dipping into negative territory again over the last month. As such there are ever-growing similarities between the Europe of today and the Japan of the past two to three decades.</blockquote>
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<blockquote class="tr_bq">
<span style="color: red;">The consensus forecast is for the ECB to hike its policy rate from zero by the end of next year but this forecast has been repeatedly pushed back and markets are increasingly sceptical</span>. Much like in Japan, there are now increasing concerns that ‘lift-off’ will never actually happen and Europe will be stuck in a world of ultra low growth and negative yields for years to come. Is this realistic? Well, as we know, it happened in Japan and it is therefore worthwhile examining in more detail the similarities and differences between the two economies with a suitable lag." - source Deutsche Bank</blockquote>
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<span style="text-align: justify;">Given in a "Showdown", t</span><span style="text-align: justify;">o win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not and that Cards speak for themselves, it is clear to us that any form of normalization by the ECB will be repeatedly pushed back à la Japan.</span><br />
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<blockquote class="tr_bq" style="text-align: justify;">
"In battle it is the cowards who run the most risk; bravery is a rampart of defense." - Sallust</blockquote>
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<span style="text-align: left;">Stay tuned !</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-2806876927576922582019-04-01T14:33:00.002+01:002019-04-02T10:54:23.273+01:00Macro and Credit - Easy Come, Easy Go<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"There are many harsh lessons to be learned from the gambling experience, but the harshest one of all is the difference between having Fun and being Smart." - Hunter S. Thompson</span></blockquote>
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<span style="font-family: inherit;">Looking at the return of the "D" trade, "D" for "Deflation" that is with the return of the strong "bid" for bonds, marking the return of the duration trade on the back of "goldilocks" for "Investment Grade" which we foresaw, pushing more inflows into fixed income relative to equities, when it came to selecting our title analogy, we decided to go for a cinematic analogy "Easy Come, Easy Go". It is a 1947 movie directed by John Farrow, who won the Academy Award for Best Writing/Best Screenplay for Around the World in Eighty Days and in 1942, and was nominated as Best Director for Wake Island. "Easy Come, Easy Go" is the story about Martin Donovan, a compulsive gambler. His gambling habits leave him constantly broke and under arrest from a gambling-house raid. He places bets as well for the tenants of his boardinghouse, who lose their money and ability to pay the rent. Martin, came upon a sunken treasure but his philosophy is "easy come, easy go," promptly squanders all the loot. Looking at the various iterations of QE and the return to more dovishness from central bankers around the world, which lead no doubt to rise of so called "populism" with the asset owners having a field day, particularly the renters through the bond markets, over "Main Street", it is clear to us that the "treasured" support provided by central bankers to politicians has been all but "squandered". For example, French politicians have done meaningless structural reforms leading to unsustainable taxation creating the rise of the "yellow jackets" movement hence our pre-revolutionary stance. As we say in France, c'est la vie. As in the move, with Martin's daughter Connie not knowing what else to do, she tries to solve her dad's debts by taking bets on a horse race. In similar fashion, central bankers have decided to add more dovishness on more debt, resulting in even more debt being created. Caveat creditor but we ramble again...</span></div>
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<span style="font-family: inherit;">In this week's conversation, we would like to look at the return of Bondzilla the NIRP monster made in Japan given Japan's <span style="text-align: left;">Government Pension Investment Fund GPIF is likely to come back strongly to the Fixed Income party.</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Macro and Credit - </b></i><b><i> Once again </i></b><b><i>the money is flowing "uphill" where all the "fun" is namely the bond market.</i></b></span></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final charts - The deflation play is back in town</span></b></i></li>
</ul>
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<span style="font-family: inherit;"><br /></span></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - Once again the money is flowing "uphill" where all the "fun" is namely the bond market.</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">In our most recent conversation we pointed out again that we advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. To repeat ourselves, we continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength. You have to become much more selective we think in the issuer profile selection process.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
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<span style="font-family: inherit;">"Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan" as we pointed out again in our most recent conversation. We also indicated as well:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Back in July 2016 in our conversation "<a href="http://macronomy.blogspot.com/2016/07/macro-and-credit-eternal-sunshine-of.html">Eternal Sunshine of the Spotless Mind</a>" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk. <span style="text-align: justify;">" - source Macronomics, March 2019</span></span></blockquote>
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<span style="font-family: inherit;">"Bondzilla" the NIRP monster should not be underestimated in our macro allocation book. On this particular point we read with interest Nomura's FX Insights note from the 29th of March entitled "GPIF: sustained aggressive foreign buying more likely":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Annual plan for new FY unveiled</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The Government Pension Investment Fund’s (GPIF) annual plan for the new fiscal year suggests the fund can manage its portfolio more flexibly. This should allow the fund to continue purchasing foreign bonds aggressively, while reducing exposure to negative yielding domestic bonds. This shift is also likely to lead a higher share of foreign bonds in the updated target portfolio, which will be announced by end-March 2020. Given the significant size of the GPIF’s AUM, this flexible stance will be crucial for Japan’s financial market and yen-crosses. We expect pension funds’ foreign bond purchases to support yen-crosses during the new fiscal year.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The GPIF announced its annual plan for the new fiscal year. In the annual plan, the GPIF noted that it will manage its portfolio according to the basic portfolio, as usual. However, the GPIF added two important points for its portfolio strategy in the new fiscal year, in relation to the allowable range of the target portfolio.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">First, the GPIF repeated that automatically reinvesting redemptions from exposure to domestic bonds may not be appropriate in the current market environment. Thus, for now, the fund will manage its domestic bond portfolio more flexibly in relation to the allowable range. The fund will maintain the total amount of domestic bonds and cash within the allowable range of domestic bonds (25-45%). The GPIF has already announced the temporary deviation in domestic bond exposures from the allowable range last September and thus, this point is not entirely new (see “Equity flows supporting yen-crosses”, 26 September 2018). However, flexibility has now been extended into the new fiscal year that commences next week, and the fund can continue to reduce exposure to domestic bonds for a longer amount of time.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Second, the GPIF added a new sentence, stating: “the fund will examine the application of allowable range for asset classes as necessary, as the fund is formulating its new target portfolio (Figure 1). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-dMD3JBaRmHo/XKESwUn9qNI/AAAAAAAAVmg/0aYaz2ya6D0pp8X-iAckQ3p9bKWN5_u_gCLcBGAs/s1600/Nomura%2B-%2BGPIF%2Ballocation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="253" data-original-width="817" height="99" src="https://3.bp.blogspot.com/-dMD3JBaRmHo/XKESwUn9qNI/AAAAAAAAVmg/0aYaz2ya6D0pp8X-iAckQ3p9bKWN5_u_gCLcBGAs/s320/Nomura%2B-%2BGPIF%2Ballocation.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In April 2014, the GPIF stated that it would flexibly manage its portfolio in relation to the allowance rage, as it started reviewing its target portfolio for the next medium-term plan (see “GPIF: Time for whale-watching”, 4 December 2018). Owing to the increased flexibility, the fund could begin investing in equities and foreign bonds before it announced the new target portfolio in October 2014. Although the communique this year differs from five years ago, this additional comment could provide the fund with more opportunity to manage the portfolio more flexibly in the new fiscal year.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">We think these statements are significant for Japan’s financial market and yen-crosses this year. As of end-December, the share of domestic bonds had declined to 28.2%, closer to the lower bound of the current allowable range (25%, Figure 2). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-TDSG_3mhAcQ/XKETHQbEb_I/AAAAAAAAVmo/V3zjkSteMtsiSkDtQhYeVHlEs-JlY9tegCLcBGAs/s1600/Nomura%2B-%2BGPIF%2Bportfolio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="385" data-original-width="405" height="304" src="https://3.bp.blogspot.com/-TDSG_3mhAcQ/XKETHQbEb_I/AAAAAAAAVmo/V3zjkSteMtsiSkDtQhYeVHlEs-JlY9tegCLcBGAs/s320/Nomura%2B-%2BGPIF%2Bportfolio.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In contrast, the share of foreign bonds increased to 17.4%, closer to the upper range of the current allowable range (19%). <span style="color: red;">The fund has recently been purchasing foreign bonds aggressively, as it likely judges negative-yielding domestic bonds as unattractive</span> (Figure 3). Historically, the pace of foreign bond purchases in Q4 last year was at the highest pace (see “Three important JPY flow stories”, 1 March 2019). Without the two additional points above, the GPIF would need to start liquidating foreign bonds, while accumulating exposures to domestic bonds again. </span></blockquote>
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<a href="https://2.bp.blogspot.com/-QFnwacGrpn0/XKEThzRZ2XI/AAAAAAAAVmw/Q1wVM9i2MAYqSS6e8lT-rrji2bZZ09gHACLcBGAs/s1600/Nomura%2B-%2BEstimated%2BGPIF%2Binvestment%2Bflows.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="387" data-original-width="403" height="307" src="https://2.bp.blogspot.com/-QFnwacGrpn0/XKEThzRZ2XI/AAAAAAAAVmw/Q1wVM9i2MAYqSS6e8lT-rrji2bZZ09gHACLcBGAs/s320/Nomura%2B-%2BEstimated%2BGPIF%2Binvestment%2Bflows.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">However, as the fund can manage its portfolio more flexibly in the new fiscal year, it should be able to continue purchasing foreign bonds, even if the share exceeds the upper limit (19%).</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: red;">As the BOJ’s negative rate policy will be extended further, in our view, we think it would be reasonable for the GPIF to continue reducing the fund’s exposure to domestic bonds, while shifting into foreign bonds</span>. At the moment, both domestic and foreign equity shares central of the GPIF’s target portfolio are at 25%, but the central target for foreign bonds is just 15%. Thus, <span style="color: red;">there is room for the fund to further shift from domestic bonds into foreign bonds</span>.</span></blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
The GPIF will release its new basic portfolio by end-March 2020, while the announcement could take place by end-2019. We see a strong probability that the GPIF would raise the share of foreign bonds then, and its flow could lead to JPY selling.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
As of end-December, total AUM managed by the GPIF was at JPY151.4trn (USD1.4trn), and 5% portfolio shift into foreign bonds could generate JPY7.6trn (USD65-70bn) of JPY selling.<br />
In comparison with 2014, market interest in the GPIF portfolio change seems much lower (Figure 4). </blockquote>
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<br />
<blockquote class="tr_bq" style="text-align: justify;">
Nonetheless, we believe the annual plan released today shows the fund’s investment in foreign bonds will remain significant this year, and the diversification should support cross-yens well (Figure 5).</blockquote>
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<blockquote class="tr_bq" style="text-align: center;">
- source Nomura</blockquote>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">So, from an allocation perspective, you probably want to "front run" the GPIF and its lifers friend, given they play "Easy come, Easy Go" particularly well in adding US dollar credit exposure we think.</span></div>
<span style="font-family: inherit;"><br /></span>
When it comes to flows, and all the "fun" going into the bond market, it is already happening as per Bank of America Merrill Lynch's note from the 29th of March entitled "Bonds over stocks":<br />
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Dovish central banks revive the bond market</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
As global central banks continue on their dovish path, more money is flowing into credit and fixed income funds more broadly. </blockquote>
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<br />
<blockquote class="tr_bq" style="text-align: justify;">
It feels that this trend is here to stay amid low inflation and lack of growth in Europe, and continued political headwinds (Brexit, trade wars). As macroeconomic data trends are bottoming out and central banks continue to remain dovish, we think that credit gap wider risks are limited.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<br />
<b>High grade</b> <span style="color: red;">funds recorded an inflow for the fourth week in a row, albeit at a slower pace than last week</span>. However we note that one fund suffered an outflow of almost $1bn. Should we adjust for that the inflow would have been more than $2.7bn.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>High yield</b> funds enjoyed their fifth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the inflows, with the other half favouring US-focused funds more than European-focused funds.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Government bond</b> funds saw inflows for a second straight week, while <span style="color: red;">the pace has been ticking up over the past couple of weeks</span>. <b>Money Market</b> funds recorded an outflow last week, the strongest over the last five weeks. All in all, Fixed Income funds enjoyed another week of strong inflows.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>European equity</b> <b>funds </b>continued to record outflows; the seventh in a row. Note that the pace of outflows shows no sign of slowing down.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Global EM debt</b> funds recorded their fifth consecutive week of inflows. Note that <span style="color: red;">last weekly inflow was the largest in seven weeks</span>. Commodity funds saw another inflow last week, the fourteenth over the past sixteen weeks.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
On the <b>duration </b>front, <b>short-term IG funds</b> underperformed whilst <span style="color: red;"><b>mid and long-term IG funds</b> recorded strong inflows amid a broader reach for yield trend</span>." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Follow the flow as they say, but follow Japan when it comes to credit markets exposure, given that they are no small players when it comes to global allocation.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">So should you play "defense" allocation wise or continue to go "all in"? On that very subject we read with interest Morgan Stanley's Cross Asset Dispatches note from the 31st of March entitled "</span>Improving the Cycle Indicator – Countdown to Downturn":<br />
<blockquote class="tr_bq">
"<b>Cycle inflection argues for more cautious portfolio tilt – pare back exposure in US stocks and HY, add allocation to US duration, RoW stocks</b></blockquote>
</div>
<blockquote class="tr_bq" style="text-align: justify;">
<b>But just because a shift in our cycle indicator is imminent, it doesn't mean that broad asset rotation needs to occur now</b>:</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Looking at the optimal allocation for the ACWI/USD Agg porfolio, we find that weighting between global equities and bonds doesn't really change materially until a downturn starts. However, rotation within asset classes occurs throughout expansion and into the cycle turn – for example, US equities see weighting fall throughout expansion in favour of RoW stocks, and fixed income portfolios rotate towards long-duration away from intermediate maturities over the same time. <b>In other words, downturn may trigger the broad cross asset allocation, but investors should still look to tilt more defensive within asset classes throughout expansion.</b></blockquote>
<blockquote class="tr_bq">
What would this defensive tilt look like? Examining the optimal allocations for: i) USD Agg/ACWI; ii) Multi-asset; and iii) USD Agg portfolios through various cycles over the past 30 years, using realised next one-year returns, these shifts need to occur for a more defensive positioning:</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Pare back equity risk, especially US versus RoW: Optimal weight to stocks tends to fall from expansion to downturn as stocks go from seeing a boost in returns to a drag.</li>
<li>Reduce US HY to max underweight: Allocation to lower-quality (BBB and HY) corporates typically collapses in expansion, given the unattractive returns profile; downturn only sees performance deteriorate further, taking HY (and BBB) to its lowest weighting in the cycle.</li>
<li>Tilt towards long-duration in late-cycle, add cash: UST and cash combined have the largest allocation in downturn.</li>
</ul>
</blockquote>
<br />
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<a href="https://3.bp.blogspot.com/-jpAjTSvKmF4/XKHgrbAU7nI/AAAAAAAAVng/0OJPw1tzU5UCbFv2Ip0pS-vdUscovQxLQCLcBGAs/s1600/MS%2B-%2BOptimal%2Ballocation%2Bfor%2Ba%2Bdownturn.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="393" data-original-width="735" height="171" src="https://3.bp.blogspot.com/-jpAjTSvKmF4/XKHgrbAU7nI/AAAAAAAAVng/0OJPw1tzU5UCbFv2Ip0pS-vdUscovQxLQCLcBGAs/s320/MS%2B-%2BOptimal%2Ballocation%2Bfor%2Ba%2Bdownturn.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
These are largely in line with our current recommendations, based on our cross-asset allocation framework of which the cycle indicator forms one of the three pillars, along with long-run fair value models and short-run expectations from our strategy colleagues. </blockquote>
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<br />
<blockquote class="tr_bq" style="text-align: justify;">
With long-run capital market assumptions which are below average for most assets, unenthusiastic 12-month forecasts from our strategists and a cycle model that's about to turn, we reiterate our stance to be EW in stocks, with a preference for ex-US equities, EW in bonds, with a tilt towards USTs, and UW in credit, in particular low-quality corporates. For investors looking for late-cycle hedges, we also recommend vol trades like buying credit puts, USDJPY puts and long Eurostoxx calls versus S&P calls to take advantage of dislocations in the vol space." - source Morgan Stanley.</blockquote>
<div style="text-align: justify;">
Of course everyone is looking at the inverted US yield curve as a good predictor of a downturn to show up and markets are already pricing rates cut from the Fed. From a lower volatility positioning, it makes sense to be overweight US Investment Grade and adding duration and somewhat reduce exposure to US High Yield. In Europe, when it comes to financials, credit continues to benefit from the ECB support, financial equities, not so much, regardless of the price to book narrative put forward by many sell-side pundits. We continue to dislike financials equities and rather play exposure through credit markets, even high beta offers better value. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But what about the cycle? Is it already turning in the US given the inversion of the US yield curve? On that specific point Morgan Stanley in their note pointed out the following:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>New cycle indicator, still same old cycle (for now)</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Our revamped US cycle indicator suggests that the market is still in expansion. But our model also says there's a high chance (~70%) of a shift to downturn within the next 12 months.</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Our market cycle indicators are a central part of our cross-asset framework, launched with our initiation of coverage nearly five years ago. While prior builds have served us well over this time, generally pointing to continued cycle expansion amid bouts of volatility, we have looked to continually improve these indicators. This is the latest iteration.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The main changes to the methodology revolve around index composition, weighting system and the way we systematically categorise cycle phases, relying on breadth of change across metrics instead of moving averages. The result is, in our view, <b>an improved cycle indicator which can better flag turns in real time, with greater confidence and less lag. Currently, the revised US cycle indicator ('v2019') ( Exhibit 22 ) points to continued expansion</b>, driven by many key macro indicators being above-trend ( Exhibit 23 ).</blockquote>
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<a href="https://1.bp.blogspot.com/-Wu3iJLjyg7w/XKHlEshZ73I/AAAAAAAAVn4/b7bV99jd99YqxHE5hEPk8kPtg1JaxF_ogCLcBGAs/s1600/MS%2B-%2BUS%2Bcycle%2Bindicator%2Bcomponents.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="331" data-original-width="834" height="127" src="https://1.bp.blogspot.com/-Wu3iJLjyg7w/XKHlEshZ73I/AAAAAAAAVn4/b7bV99jd99YqxHE5hEPk8kPtg1JaxF_ogCLcBGAs/s320/MS%2B-%2BUS%2Bcycle%2Bindicator%2Bcomponents.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<b>…but a market cycle peak is imminent</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>We don't think that this expansion can be sustained for long:</b> </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Exhibit 26 shows our real-time downturn probability gauge, which estimates the chance of our cycle model inflecting to downturn from expansion within the next 12 months, based on historical experience. </blockquote>
<br />
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<a href="https://4.bp.blogspot.com/-VjYve2z7L8I/XKHl4XCN7YI/AAAAAAAAVoE/SvLeY1PYooo0lSPAcrwmUt7a_KasO0E8gCLcBGAs/s1600/MS%2B-%2BProbability%2Bof%2BUS%2Bcycle%2Bindicator.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="288" data-original-width="409" height="225" src="https://4.bp.blogspot.com/-VjYve2z7L8I/XKHl4XCN7YI/AAAAAAAAVoE/SvLeY1PYooo0lSPAcrwmUt7a_KasO0E8gCLcBGAs/s320/MS%2B-%2BProbability%2Bof%2BUS%2Bcycle%2Bindicator.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
What this chart suggests is that, <b>given the level of the cycle indicator, the chance of a shift to downturn over the next 12 months is elevated at close to 70%</b>, up from ~60% from end-2017 when we last checked up on the cycle.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>What's been behind this prediction? The strong unbroken run of improving data over the last year has been the main 'culprit':</b> </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Since April 2010, we've not had a six-month period where a majority of the components of the cycle indicator were not improving; it is, to our knowledge, the longest streak in history ( Exhibit 27 ). </blockquote>
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<a href="https://1.bp.blogspot.com/-YJGbhZSMjiQ/XKHmIX5xh3I/AAAAAAAAVoM/rXhiNe3WIMoSgVC-k1EUgp43i1AGnhoAACLcBGAs/s1600/MS%2B-%2BUS%2Bcycle%2Bindicator%2Bimprovement.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="272" data-original-width="409" height="212" src="https://1.bp.blogspot.com/-YJGbhZSMjiQ/XKHmIX5xh3I/AAAAAAAAVoM/rXhiNe3WIMoSgVC-k1EUgp43i1AGnhoAACLcBGAs/s320/MS%2B-%2BUS%2Bcycle%2Bindicator%2Bimprovement.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
Historically, such an environment of data improvement breadth and depth (with the likes of unemployment rate and consumer confidence hitting extreme levels in recent months) has meant a high probability of cycle deterioration in the next 12 months – after all, what goes up must come down. Indeed, the latest disappointing consumer confidence data pushes the number of cycle indicator components deteriorating over the last six months to seven now – enough to be considered 'critical mass'. If such deterioration persists, our rules-based approach to identifying cycle phases could very well call a switch from expansion to downturn as early as next month. <b>At any rate, our market cycle indicator and the probability gauge are very clear – an inflection from expansion to downturn is on the horizon.</b>" - source Morgan Stanley</blockquote>
<span style="font-family: inherit;">As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured.</span><br />
<span style="font-family: inherit;"><br /></span>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">It doesn't mean equities cannot rally further, there is still the on-going US-China trade spat yet to be resolved. Right now Macro continues to deteriorate, particularly in the Eurozone with its Manufacturing PMI falling to 47.5 (49.3 - Feb). Germany and Italy were notable contributors to the stronger decline:</span></div>
<div style="text-align: justify;">
</div>
<ul>
<li>Germany : 44.1 vs 47.6-Feb</li>
<li>France : 49.7 vs 51.5-Feb</li>
<li>Italy : 47.4 vs 47.7-Feb</li>
<li>Eurozone : 47.5 vs 49.3-Feb </li>
</ul>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;"></span></div>
This is a reflection of world trade growth further slowing as highlighted by DHL's Global Trade Barometer from March 2019:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"Key findings:<br />
<ul>
<li>Overall GTB index for global trade falls by -4 points to 56 compared to December, signaling only a slight growth and coming ever closer to stagnation.</li>
<li>Prospects weakening for most surveyed countries – but remain above neutral 50, still indicating positive growth, apart from South Korea</li>
<li>Outlook for global air trade is sluggish, dropping by -3 to 55 points. Growth of global ocean trade is also slowing down, reflected in an index value of 56, a decrease by -5.</li>
</ul>
</blockquote>
<br />
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<br />
<blockquote class="tr_bq" style="text-align: justify;">
According to the latest three-months forecast by the DHL Global Trade Barometer (GTB) global trade is foreseen to grow only slowly. The overall growth index decreased by -4 points compared to the last update in December, scoring 56 points in March. The slowdown is especially attributed to the significant decelerating growth prospects of India (-18) and South Korea (-12).</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Also in the US, trade growth is expected to lose momentum (-5 points), whereas the GTB forecasts for China (-1), Germany (+2), Japan (-2) and the UK (+2) are largely in-line with the previous update.</blockquote>
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<a href="https://2.bp.blogspot.com/-zSAqLMa682g/XKH85v6WyuI/AAAAAAAAVog/_mp2iGe-UX8lCRk4NgnLLbGqr3vEs533ACLcBGAs/s1600/DHL%2B-%2BGlobal%2BTrade%2Bbarometer%2Bfor%2Bthe%2Bworld%2BMarch%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="209" data-original-width="362" height="184" src="https://2.bp.blogspot.com/-zSAqLMa682g/XKH85v6WyuI/AAAAAAAAVog/_mp2iGe-UX8lCRk4NgnLLbGqr3vEs533ACLcBGAs/s320/DHL%2B-%2BGlobal%2BTrade%2Bbarometer%2Bfor%2Bthe%2Bworld%2BMarch%2B2019.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
The outlook for global air trade is sluggish, dropping -3 to 55 points. All surveyed countries are forecasted to slowdown in air trade except for Germany (+9). The largest declines are expected for South Korea (-14), India (-13) as well as Japan (-5). China and US dropping moderately with -3 and -2 points. Moreover, the index for South Korea and UK air trade drops below 50 points, suggesting a contraction of air trade growth.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Global ocean trade outlook is also modest, seeing decelerated growth (-5 points to 56). The largest downturns are found in India (-20), South Korea (-10) and US (-7). German ocean trade further weakened, as the country’s index falls slightly by -2 to 46 points. China (-1 point) is forecasted to decelerate slightly. Meanwhile, ocean trade in the UK (+4 points) and Japan (+2 points) is picking up some steam." - source DHL - Global Trade Barometer, March 2019</blockquote>
<div style="text-align: justify;">
With China’s Caixin March manufacturing PMI beating expectations at 50.8 from 49.9 last month (50.0 expected), optimism that China can once again provide the heavy lifting for global growth has been renewed, hence the latest positive tone from financial markets. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Could it be that we will see weaker growth for longer? In that case bonds could continue to perform in that environment where bad news is good news again thanks to the renewed "Easy Come, Easy Go" stance from central banks.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We can therefore expect US Treasury Notes 10 year yield to fall further in that context. It seems that bond bears were a little bit too hasty in 2018 in the demise of the long duration trade.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We have been asked recently by one of our readers on the rise in interest rate volatility seen recently through the <span style="font-family: "times new roman" , serif; font-size: 12pt; text-align: left;">MOVE gauge index responding by posting its </span><a href="https://www.bloomberg.com/news/articles/2019-03-26/treasury-swings-jump-like-it-s-2016-as-calm-goes-way-of-dodo" itemprop="StoryLink" itemscope="itemscope" style="font-family: "Times New Roman", serif; font-size: 12pt; font-stretch: inherit; font-variant-east-asian: inherit; font-variant-ligatures: inherit; font-variant-numeric: inherit; line-height: inherit; overflow-wrap: break-word; text-align: left;" target="_blank" title="Treasury Swings Jump Like It’s 2016 as Calm ‘Goes Way of Dodo’"><span style="border: 1pt none windowtext; padding: 0cm; text-decoration-line: none;">biggest two-day gain
since 2016</span></a><span style="font-family: "times new roman" , serif; font-size: 12pt; text-align: left;">. We replied that it didn't change our recommendation of playing "quality", Investment Grade that is, over "quantity", US High Yield. On that specific point we read with interest Barclays US Credit Alpha note from the 29th of March entitled "Rates Moves Dictates Credit Moves":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Rates Moves Dictating Credit Moves</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Interest rate volatility remains high, with consequences for the credit market, as spreads have widened modestly. In addition to the decline in yields, the 3m10y Treasury spread has inverted, and the market is implying a rate cut by the Fed for the first time since the beginning of 2013. The last time 3m10y was inverted and the market implied a significant rate cut was in late 2006, as the prior economic cycle reached maturity. As Figure 2 shows, equities rallied at that point, and credit spreads held in despite concerns about a weaker economy. </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
An obvious question is whether the current inversion signals the end of the cycle, since, in the past, recessions have occurred on average four quarters after the 3m10y inverts. However, the 2y10y curve has typically already been inverted, which is not the case today. We believe more caution is warranted based on recent curve moves, consistent with our forecast for wider spreads at year-end.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Digging deeper into the relationships of credit markets around the 3m10y inversions in 2000 and 2006, we notice significant differences compared with this year. In both instances, high yield was outperforming investment grade and the BBB/A spread ratio was flat or lower. <span style="color: red;">This seems to support our short-term view that BBBs should outperform their beta</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
We had also been advocating owning BBBs versus BBs recently, and the gap between those spreads has moved almost 20bp higher from the recent lows. While a sizable move, it still does not make BBs look particularly cheap. However, we think that differences in trading conventions for the high yield and investment grade markets are behind a lot of the BB underperformance and expect some bounce-back for BBs in spread terms as soon as rates stabilize. Traders are quoting BB prices broadly flat over the past week, as rates rallied and spreads moved 20bp wider. In contrast, BBB bonds are quoted more or less unchanged on spread, but their prices jumped more than a point. Underscoring the technical nature of the move, we note that even within capital structures that have both BBB and BB rated bonds, such as Charter Communications, the basis spiked. As a result, we believe there could be some near-term tactical spread outperformance for BBs." -source Barclays</blockquote>
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We could see a continuation in the high beta rally yet it doesn't seem to us vindicated by recent flows, so we would rather stick with our defensive call for the time being.</div>
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Given all of the above, we are more inclined towards credit markets and "coupon clipping" and playing it safe through Fixed Income and credit markets as warranted by current fund flows we are seeing and Japanese support coming from overseas. As well our final chart displays the defensive positioning as we enter the second quarter.</div>
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Final charts - The deflation play is back in town</li>
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<span style="font-family: inherit;">Looking at the dismal macro data which has tilted central banks towards a much more dovish stance, the positioning and fund inflows for the second quarter appear to be more geared towards "deflation assets". Our final chart comes from Bank of America Merrill Lynch The Flow Show note from the 28th of March entitled "Pavlov's Dog Bites Fed" and shows "Deflation vs Inflation flows":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"</span><b>Positioning into Q2:</b> consensus starts Q2 long “secular stagnation” & “deflation”; YTD $87bn inflows into “deflation assets” e.g. corp & EM bonds & REITs, and $42bn redemptions from “inflation assets”, e.g. EAFE equities & resources (Chart 4); investors are discounting neither recession (they love corporate bonds) not recovery (they don’t like cyclical equities).</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>Weekly flows:</b> $8.6bn into bonds, $0.4bn into gold, $12.5bn out of equities.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Credit inflows:</b> $5.2bn into IG, $2.2bn into EM debt, $0.9bn into HY.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Max deflation:</b> record redemptions from TIPs ($1.3bn).</blockquote>
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<b>Equity outflows:</b> $7.7bn out of US, $4.8bn out of EU, $2.0bn out of EM.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Cyclical outflows:</b> $1.5bn out of financials, $0.4bn out of consumer, $0.2bn out of<br />
tech.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Q2 catalyst:</b> Positioning & Policy were positive catalysts in Q1; Profits will be the catalyst in Q2; we say consensus global EPS numbers remain too high (BofAML Global EPS model forecasts -9% EPS growth in the next 12 months vs. analyst consensus 0% - Chart 5).</blockquote>
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<b>Q2 scenarios:</b> evolution of BofAML global EPS model forecasts will determine whether Stagnation, Recession, Recovery the dominant Q2 outcome.</blockquote>
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<b>Stagnation:</b> global EPS forecast stagnates @ -5-10% as US growth dips below 2%, global PMIs vacillate around 50, US rates fall toward anchored/negative Japanese & Eurozone rates, secular “Japanification” trade of past 10 years hardens; the big tell...credit bid, volatility offered; the big trades...long 30-year UST, biotech, short resources, volatility.</blockquote>
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<b>Recession: </b>global EPS forecast drops to -15% as surge in US unemployment claims indicates US consumer joining manufacturing recession in China, Japan & Eurozone where PMIs drop to 45; the big tells...oil <$50/b, JNK <$33, INJCJC4 >300k; the big trades...short tech & corporate bonds, long T-bills, US dollar & VIX.</blockquote>
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<b>Recovery:</b> global EPS forecast turns positive as “green shoots” in Asian exports (Chart 1) & Chinese growth blossom, while lower US rates boost US housing data; credit spreads prove once again they are better lead indicator for risk assets than government bond yields (Chart 6); the tells...SOX >1450, XHB >$42, KOSPI >2350, yield curve steepens; the trades...long global banks, short bunds & US dollar.</blockquote>
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<b>Next up:</b> big 5 datapoints in coming week to set course for Q2 (see table 1); tactically we are in Q2 “Recovery” camp; H2 we expect big top in markets before debt deflation/policy impotence leads risk assets lower." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">"Easy Come, Easy Go", we believe that US equities face headwinds coming from a more defensive stance from CFOs ready to defend their balance sheet and start reducing buybacks, CAPEX and even dividends in some instances. This would be more beneficial in that context to credit investors. Earnings are already facing EPS "headwinds". The continuation of the rise in oil prices though is still supportive for US High Yield. Yet, given the "high beta" nature of High Yield, we would prefer to play it safe rather than going all in à la Martin Donovan. </span></div>
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<blockquote class="tr_bq" style="text-align: justify;">
"There is no gambling like politics."- Benjamin Disraeli, British statesman</blockquote>
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<span style="font-family: inherit; text-align: left;">Stay tuned ! </span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-24458219514281587862019-03-22T22:54:00.001+00:002019-03-22T22:54:26.945+00:00Macro and Credit - Inflationism<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"For the merchant, even honesty is a financial speculation." - Charles Baudelaire</blockquote>
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Watching with interest the Fed's additional dovishness with the continuation in the rally in high beta and in particular credit, marking the return of "goldilocks at least for this asset class, when it came to selecting our title analogy, given the potential stagflationary outcome thanks to the Fed being S&P500 dependent, we decided to go for "Inflationism". "Inflationism" is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy. The contemporary Post-Keynesian monetary economic school of Neo-Chartalism, advocates government deficit spending to yield full employment, is attacked as inflationist, with critics arguing that such deficit spending inevitably leads to hyperinflation. Neo-Chartalists reject this charge, such as in the title of the Neo-Chartalist organization the Center for Full Employment and Price Stability. Also, a<span style="text-align: left;"> related argument is by Chartalists, who argue that nations who issue debt denominated in their own fiat currency need never default, because they can print money to pay off the debt similar to what we are hearing these days from the MMT supporters. Chartalists note, however, that printing money without matching it with taxation (to recover money and prevent the money supply from growing) can result in inflation if pursued beyond the point of full employment, and Chartalists generally do not argue for inflation. It also worth noting that </span><span style="text-align: left;">Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:</span></div>
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<blockquote class="tr_bq" style="text-align: justify;">
"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]<br />
"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." </blockquote>
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Keynes explicitly pointed out the relationship between governments printing money and inflation:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." </blockquote>
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The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "<a href="https://www.asiatimes.com/2019/03/article/fearing-slower-growth-fed-says-no-rate-hikes-this-year/">Fearing slower growth, Fed says no rate hikes this year</a>":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">This is a market that rewards cowardice</span> – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times</blockquote>
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This is clearly a market favoring "coupon clipping" we think but we ramble again.</div>
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<br /></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">In this week's conversation, we would like to look at the growing "stagflation" risks, which have been on this very blog a scenario we highlighted could happen.</span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Macro and Credit - </b></i><b><i> The return of the "yield" hogs in the Chinese year of the pig</i></b></span></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b style="font-family: inherit;">Final charts - </b><b>Oh my God they killed</b><b style="font-family: inherit;"> Macro volatility again!</b></i></span></li>
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - The return of the "yield" hogs in the Chinese year of the pig</span></li>
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In our previous conversation we highlighted the fact that "Deleveraging" and Deflation were good for credit markets. As expected, the additional dovish tone from the Fed is leading towards a reach for yield across credit. We also indicated that as long as interest rates volatility was remaining muted, it would be hard to be negative on credit markets. Given last Tuesday, Merrill Lynch's Move index, which tracks implied volatility on one-month Treasury bill options fell to a reading of 43.68, the lowest since the index’s inception in 1988, no surprise to see a continuation of the rally in high beta credit.<br />
<br />
Rentiers seek and prefer deflation and fixed income investors continue to benefit from central bankers accommodative stance in that context. This definitely doesn't put us into the perma bear camp but more into the "realistic" camp we think hence our "japanification" stance.<br />
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Looking at the latest data coming out of Europe in general and Germany in particular, with Eurozone Manufacturing PMI coming at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10 year German bund is going again negative. As well, France Services PMI fell to 48.7 from 50.2 and expectations of 50.6 and Manufacturing PMI declined to 49.8 from 51.5 clearly pointing towards recession for the Eurozone.<br />
<br />
Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":<br />
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"<b>Dovish central banks and uncertainty favour quality</b></blockquote>
<blockquote class="tr_bq">
The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.<br />As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.</blockquote>
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<blockquote class="tr_bq">
<b>Over the past week…</b></blockquote>
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<b>High grade</b> funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.<br /><b>Government bond </b>funds saw inflows following two weeks of outflows.<br /><b>Money Market</b> funds recorded an outflow last week, reversing a two-week streak of inflows.<br />All in all, <b>Fixed Income</b> enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.<br /><b>European equity funds </b>continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.<br /><b>Global EM debt</b> funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.<br />On the <b>duration </b>front, <b>long-term IG funds</b> were the laggards as <b>short</b>- and <b>mid-term</b> IG funds recorded inflows." - source Bank of America Merrill Lynch</blockquote>
Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:<br />
<blockquote class="tr_bq">
"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!<br />Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "<a href="http://macronomy.blogspot.com/2016/03/macro-and-credit-unobtainium.html">Unobtainium</a>" analogy of last week:<br /><span style="font-family: inherit;"></span></blockquote>
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<i><span style="font-family: inherit;">"</span><span style="background-color: white; font-family: inherit; line-height: 16.9px;">Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016</span></i></blockquote>
<blockquote class="tr_bq">
This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".<br />One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.</blockquote>
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<div style="text-align: justify;">
If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.<br />
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This is what we suggested in our previous conversation:<br />
<blockquote class="tr_bq">
"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019</blockquote>
Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.<br />
<br />
We have also recently advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. We continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength.<br />
<br />
On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":<br />
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"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1). </blockquote>
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<blockquote class="tr_bq">
As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.</blockquote>
<blockquote class="tr_bq">
Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.</blockquote>
<blockquote class="tr_bq">
<span style="color: red;">Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement.</span> To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).</blockquote>
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<span style="color: red;">About one-third of all CCCs continue to trade at distressed levels, whereas for most of last year that proportion stood at 20% or below.</span> This outcome suggest that investors remain cautious in reaching for credit risk among the names that otherwise would have the highest upside from here if a low-default scenario were to play out in coming months.<br />Note that reopening in the CCC new issue market has done little so far to alleviate concerns surrounding these two real-time indicators (dispersion and distress). Perhaps, the newly minted CCCs are yet again viewed as carrying relatively stronger credit profiles compared to the rest of that space, although any comps here are particularly challenging given the highly idiosyncratic nature of this segment. In addition, the B3/below segment in leveraged loans also experienced a sharp slowdown around yearend and has only recovered modestly since then. The latest-3mo pace of activity here is running at less than one-fifth of its peak levels reached in the middle of last year.<br />Lastly, Moody’s has reported 17 global HY defaults in the first two months of 2019, of which 12 were among US issuers. These counts are the highest over the past year and compare to an average of 2.7 default events per month in the second half of 2018." - source Bank of America Merrill Lynch</blockquote>
Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.<br />
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When it comes to the support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan".<br />
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Back in July 2016 in our conversation "<a href="http://macronomy.blogspot.com/2016/07/macro-and-credit-eternal-sunshine-of.html">Eternal Sunshine of the Spotless Mind</a>" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":<br />
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"<b>Japan 101</b></blockquote>
<blockquote class="tr_bq">
It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view. </blockquote>
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Going forward, we can expect Japanese selling in a narrow window around fiscal year-end (March 31), where they tend to repatriate money (Figure 2). </blockquote>
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<a href="https://1.bp.blogspot.com/-E1jyJDyeO3s/XJUqkrWgpXI/AAAAAAAAVjE/e1T0dkGmHeIRkbhEgagh1JWaPS5ScQI9wCLcBGAs/s1600/BAML%2B-%2BSeasonal%2BJapanese%2Bfiscal%2Byear-end%2Bsales%2Bof%2Bmedium%2Band%2Blong%2Bterm%2Bforeign%2Bbonds.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="390" data-original-width="383" height="320" src="https://1.bp.blogspot.com/-E1jyJDyeO3s/XJUqkrWgpXI/AAAAAAAAVjE/e1T0dkGmHeIRkbhEgagh1JWaPS5ScQI9wCLcBGAs/s320/BAML%2B-%2BSeasonal%2BJapanese%2Bfiscal%2Byear-end%2Bsales%2Bof%2Bmedium%2Band%2Blong%2Bterm%2Bforeign%2Bbonds.jpg" width="314" /></a></div>
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It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.</blockquote>
<blockquote class="tr_bq">
<b>EUR bonds and JGBs for life</b></blockquote>
<blockquote class="tr_bq">
Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.</blockquote>
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<b>Who let the doves out?</b></blockquote>
<blockquote class="tr_bq">
<span style="color: red;">However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed.</span> Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.</blockquote>
<blockquote class="tr_bq">
While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged. </blockquote>
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<a href="https://2.bp.blogspot.com/-OyoYRcN6XTk/XJUrUypul-I/AAAAAAAAVjQ/u7S7RwpdAGEW6VLMez1fER-NXeAuk-XRACLcBGAs/s1600/BAML%2B-%2BUS%2Bcorporate%2Byields%2Band%2Bdollar%2Bhedging%2Bcosts%2Bhave%2Bdeclined.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="393" data-original-width="384" height="320" src="https://2.bp.blogspot.com/-OyoYRcN6XTk/XJUrUypul-I/AAAAAAAAVjQ/u7S7RwpdAGEW6VLMez1fER-NXeAuk-XRACLcBGAs/s320/BAML%2B-%2BUS%2Bcorporate%2Byields%2Band%2Bdollar%2Bhedging%2Bcosts%2Bhave%2Bdeclined.jpg" width="312" /></a></div>
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Instead, the main driver is the Fed’s dovish capitulation. The most common dollar hedging strategy for foreign investors involves a maturity mismatch with the underlying assets, as they roll short term – such as 3-month – forward fx rates. The cost of such strategy is driven by the difference between short term interbank rates, which in turn is driven mainly to relative monetary policy rates.<br />In early 4Q18 the Fed was the only major central bank hiking rates (3x priced in in 12months), as the BOJ and ECB were on hold. Foreign investors buying US corporate bonds rationally expected to be rolling into prohibitively expensive dollar hedges in 2019, leaving expected future yields after hedging costs on par with 90bps for 30-year JGBs (Figure 4). </blockquote>
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<a href="https://1.bp.blogspot.com/-QqlddiolUic/XJUrmBAtXtI/AAAAAAAAVjY/dmxuZyziba0nYbb2GTj2ACPw9h2sVAVDwCLcBGAs/s1600/BAML%2B-%2BCorporate%2Bbonds%2Bunattractive%2Bin%2B4Q18%2Bnow%2Bonly%2Bgame%2Bin%2Btown.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="418" data-original-width="388" height="320" src="https://1.bp.blogspot.com/-QqlddiolUic/XJUrmBAtXtI/AAAAAAAAVjY/dmxuZyziba0nYbb2GTj2ACPw9h2sVAVDwCLcBGAs/s320/BAML%2B-%2BCorporate%2Bbonds%2Bunattractive%2Bin%2B4Q18%2Bnow%2Bonly%2Bgame%2Bin%2Btown.jpg" width="297" /></a></div>
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<blockquote class="tr_bq">
Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.</blockquote>
<blockquote class="tr_bq">
<b>Here to stay</b></blockquote>
<blockquote class="tr_bq">
<span style="color: red;">We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time</span>. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch</blockquote>
Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.<br />
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For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.<br />
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This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":<br />
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"<b>Lifers opt for credit rather than anticipating weak JPY</b></blockquote>
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In an interview with Bloomberg last week, a major life insurer stated that it was offsetting the impact of currency hedging costs by selling FX call options (partly giving up the advantages of weak JPY), and by taking credit risk, generating returns of about 1% even after fully hedging. This former approach resembles that taken by two other major lifers interviewed recently (see page 7 of the 5 March Navigator), but this lifer seems to be more concerned about the minimal room JPY has to weaken than worried about the risk of stronger JPY. Regarding the latter, credit spreads are not only wider overall in the US than in Japan, but the yield curve is steepening (Figure 5), and as a result, lengthening maturities have a greater effect in improving yields. </blockquote>
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For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, <b>we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again</b>." - source Nomura</blockquote>
In relation to our "gold" outlook, while we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the <b><span style="color: red;">real interest rate is the most important macro factor for gold prices. </span></b> Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.<br />
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Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen <a href="http://www.leveragedloan.com/us-leveraged-loan-funds-see-606m-withdrawal-outflow-streak-hits-17-weeks/">17 Weeks of outflows totaling $21.8 billion</a>. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":<br />
<blockquote class="tr_bq">
"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.</blockquote>
<blockquote class="tr_bq">
Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.</blockquote>
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First, speaking to the growth (or lack thereof) in HY par outstanding since 2016, and what that may imply, we think some often forget that this has been a very long ten-year cycle. The HY market, in fact, has grown substantially (+112% since the end of 2008, based on the index we track), just all that growth took place in the first six years. </blockquote>
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<blockquote class="tr_bq">
Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.</blockquote>
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Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal. </blockquote>
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<a href="https://2.bp.blogspot.com/-s8gAWQbkgj0/XJVcHJYbnPI/AAAAAAAAVj8/JvdU2Cl1t6YmHSlNdw7rOoExn3q1rZFSQCLcBGAs/s1600/MS%2B-%2BThe%2Bgrowth%2Bin%2Bleveraged%2Bdebt%2Boutstanding%2Bhas%2Bshifted%2Bover%2Bthe%2Bcourse%2Bof%2Bthe%2Bcycle.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="258" data-original-width="383" height="215" src="https://2.bp.blogspot.com/-s8gAWQbkgj0/XJVcHJYbnPI/AAAAAAAAVj8/JvdU2Cl1t6YmHSlNdw7rOoExn3q1rZFSQCLcBGAs/s320/MS%2B-%2BThe%2Bgrowth%2Bin%2Bleveraged%2Bdebt%2Boutstanding%2Bhas%2Bshifted%2Bover%2Bthe%2Bcourse%2Bof%2Bthe%2Bcycle.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.</blockquote>
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<a href="https://4.bp.blogspot.com/-k2I9zVa4SeQ/XJVcXN6_OxI/AAAAAAAAVkE/pEO0FfBNd2EgGc2eXMOk0Ar2wPeiPHWLQCLcBGAs/s1600/MS%2B-%2BLoans%2Balso%2Bdrove%2Bthe%2Bgrowth%2Bin%2Bleveraged%2Bdebt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="248" data-original-width="382" height="207" src="https://4.bp.blogspot.com/-k2I9zVa4SeQ/XJVcXN6_OxI/AAAAAAAAVkE/pEO0FfBNd2EgGc2eXMOk0Ar2wPeiPHWLQCLcBGAs/s320/MS%2B-%2BLoans%2Balso%2Bdrove%2Bthe%2Bgrowth%2Bin%2Bleveraged%2Bdebt.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.</blockquote>
<blockquote class="tr_bq">
Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).</blockquote>
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<a href="https://4.bp.blogspot.com/-cc187oqEIBA/XJVc1b_EpLI/AAAAAAAAVkM/QY756Zkz3p0E-RpSNJWTmW9zSRwX30VVQCLcBGAs/s1600/MS%2B-%2BFundamental%2Bchallenges%2Bare%2Bless%2Bappreciated%2Bin%2BHY.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="312" data-original-width="530" height="188" src="https://4.bp.blogspot.com/-cc187oqEIBA/XJVc1b_EpLI/AAAAAAAAVkM/QY756Zkz3p0E-RpSNJWTmW9zSRwX30VVQCLcBGAs/s320/MS%2B-%2BFundamental%2Bchallenges%2Bare%2Bless%2Bappreciated%2Bin%2BHY.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002). </blockquote>
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<blockquote class="tr_bq">
Some still argue while that may be true, 2016 in particular, was unique due to the collapse in oil prices, which is a much lower risk in the future. In our view, any hope that HY would be more resilient in the next growth scare (or outright recession) should have been thrown out the window after witnessing the price action in 4Q18. After all, once the weakness in 2018 became about growth/earnings growth rolling over, the resilience of HY ended. At that point, spreads widened by almost 250bp, and HY underperformed the leveraged loan market, despite seemingly weaker fundamental metrics in the latter. </blockquote>
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<a href="https://3.bp.blogspot.com/-ohtER8PdUtY/XJVdn4tWfBI/AAAAAAAAVkY/zKaHsbWy5fEar-s2OIPJyMJauhaXOn-LQCLcBGAs/s1600/MS%2B-%2BWhile%2Bfundamentals%2Bare%2Bweaker%2Bin%2Bthe%2Bloan%2Bmarket%252C%2BHY%2Bis%2Bstill%2Bhigh%2Bbeta.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="260" data-original-width="382" height="217" src="https://3.bp.blogspot.com/-ohtER8PdUtY/XJVdn4tWfBI/AAAAAAAAVkY/zKaHsbWy5fEar-s2OIPJyMJauhaXOn-LQCLcBGAs/s320/MS%2B-%2BWhile%2Bfundamentals%2Bare%2Bweaker%2Bin%2Bthe%2Bloan%2Bmarket%252C%2BHY%2Bis%2Bstill%2Bhigh%2Bbeta.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
<span style="color: red;">We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.</span></blockquote>
<blockquote class="tr_bq">
Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley</blockquote>
Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.<br />
<br />
With a return of ultra dovishness from our generous gamblers aka our dear central bankers, given the new record low in rates volatility as per the Move Index cited earlier on in our long conversation, as per our final charts below it seems to us that macro volatility has been somewhat "killed" again...<br />
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<br />
<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b style="font-family: inherit;">Final charts - </b><b>Oh my God they killed</b><b style="font-family: inherit;"> Macro volatility again!</b></i></span></li>
</ul>
Back in November 2012, in our conversation "<a href="https://macronomy.blogspot.com/2012/11/why-have-global-macro-hedge-funds.html">Why have Global Macro Hedge Funds underperformed</a>", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:<br />
<blockquote class="tr_bq">
"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.</blockquote>
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<i>"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse</i></blockquote>
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Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018). </blockquote>
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<a href="https://1.bp.blogspot.com/-h-SaySSEaPY/XJVlSKW1giI/AAAAAAAAVkw/jWS0A4jSpSAuwSrBQjb_HhEoHgqiZ65eQCLcBGAs/s1600/HSBC%2B-%2BStandard%2Bdeviation%2Bof%2BGDP%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="266" data-original-width="536" height="158" src="https://1.bp.blogspot.com/-h-SaySSEaPY/XJVlSKW1giI/AAAAAAAAVkw/jWS0A4jSpSAuwSrBQjb_HhEoHgqiZ65eQCLcBGAs/s320/HSBC%2B-%2BStandard%2Bdeviation%2Bof%2BGDP%2Bgrowth.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.</blockquote>
<blockquote class="tr_bq">
The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.</blockquote>
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<a href="https://1.bp.blogspot.com/-rznbMrvJaFs/XJVlnMlr2pI/AAAAAAAAVk4/WZCXvNSS-Vgn5VAyipPhQIROGacTVSF_gCLcBGAs/s1600/HSBC%2B-%2BStandard%2Bdeviation%2Bof%2Bheadline%2Binflation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="294" data-original-width="596" height="157" src="https://1.bp.blogspot.com/-rznbMrvJaFs/XJVlnMlr2pI/AAAAAAAAVk4/WZCXvNSS-Vgn5VAyipPhQIROGacTVSF_gCLcBGAs/s320/HSBC%2B-%2BStandard%2Bdeviation%2Bof%2Bheadline%2Binflation.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.</blockquote>
<blockquote class="tr_bq">
The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.</blockquote>
<blockquote class="tr_bq">
But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle). </blockquote>
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<a href="https://4.bp.blogspot.com/-raVOE5uwR7Q/XJVl-p2dp1I/AAAAAAAAVlA/U2outUahsJUz5byeqRtDV9c2CBNBkp51QCLcBGAs/s1600/HSBC%2B-%2BEM%2BAsia.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="304" data-original-width="606" height="160" src="https://4.bp.blogspot.com/-raVOE5uwR7Q/XJVl-p2dp1I/AAAAAAAAVlA/U2outUahsJUz5byeqRtDV9c2CBNBkp51QCLcBGAs/s320/HSBC%2B-%2BEM%2BAsia.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).</blockquote>
<blockquote class="tr_bq">
Better stay nimble…" - source HSBC</blockquote>
So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...<br />
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<blockquote class="tr_bq">
"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." - Henry Ford</blockquote>
Stay tuned !</div>
</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-10503540799406342992019-02-23T20:49:00.000+00:002019-02-24T18:30:20.648+00:00Macro and Credit - Lethe<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." - Mark Twain</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named "Lethe". The river of "Lethe" was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness. </span></div>
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<div style="text-align: justify;">
<span style="font-family: inherit;">In similar fashion, every investors drinking again from the "river of liquidity" provided by central banks including the large infusion from China's PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means "oblivion", "forgetfulness", or "concealment". It is related to the Greek word for "truth", aletheia (ἀλήθεια), which through the privative alpha literally means "un-forgetfulness" or "un-concealment". While the privative "alpha" might means "un-forgetfulness", the on-going rally is purely of one of "high beta" given the return of the "carry" trade thanks to low rate volatility and global central banking dovishness. </span></div>
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<div style="text-align: justify;">
<span style="font-family: inherit;">In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again...</span></div>
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<span style="font-family: inherit;"><br /></span></div>
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<span style="font-family: inherit;">In this week's conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.</span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - The road to oblivion?</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final chart - It's not only central banks, buybacks got your back...</b></i></span></li>
</ul>
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<span style="font-family: inherit;"><br /></span></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - The road to oblivion?</span></li>
</ul>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Given the definition of "oblivion" is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of "goldilocks" will last following the baby bear market we saw during the fourth quarter of 2018. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Sure it’s a great start in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good "proxy" for global trade, has seen recently unemployment surging to 4.4%.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups reported this week.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">No surprise the "D" for "Deflation" trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the "Lethe" river flowing again.</span></div>
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<div style="text-align: justify;">
<span style="font-family: inherit;">If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed's latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">While investors took another bath into the central banking river of "Lethe", when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all "recessions" are "deflationary" in nature, and most central banks have been powerless in anchoring solidly inflation expectations. </span></div>
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<span style="font-family: inherit;">When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled "<a href="https://uspirg.org/feature/usp/driving-debt">The Hidden Costs of Risky Auto Loans to Consumers and Our Communities</a>":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li><span style="font-family: inherit;">Auto lending rebounded from the Great Recession in part because of low interest rates (fueled by the Federal Reserve Board’s policy of quantitative easing) and a perception by lenders that auto loans had held up better than mortgages during the financial crisis. As one hedge fund manager noted in a 2017 interview with The Financial Times, during the recession, “consumers tended to default on their house first, credit card second and car third.”</span></li>
<li><span style="font-family: inherit;">A 2014 report by the Federal Reserve found that a consumer’s perception of interest rate trends had as strong an effect on the decision of when to buy a car as more expected factors like unemployment and income.</span></li>
<li><span style="font-family: inherit;">Low-income borrowers are particularly sensitive to changes in loan maturity according to a 2007 study, suggesting that the longer loan terms of recent years may have been an important spur for the rapid rise in auto loans to low-income households.</span></li>
<li><span style="font-family: inherit;">A 2018 study by researchers at the University of California, Los Angeles, tied the fall in transit ridership in Southern California to increased vehicle availability, possibly supported by cheap auto financing.</span></li>
</ul>
</blockquote>
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<a href="https://2.bp.blogspot.com/-_bsYji31HRE/XHFuWodyghI/AAAAAAAAVak/p5YePlsoFxs_DcWoUIOmR79j8r0aXLIjACLcBGAs/s1600/US%2BPIRG%2B-%2BPercent%2Bof%2BUS%2Bauto%2Bdebt%2Bthat%2Bis%2B90%2Bplus%2Bdays%2Bdelinquent.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="847" data-original-width="1003" height="270" src="https://2.bp.blogspot.com/-_bsYji31HRE/XHFuWodyghI/AAAAAAAAVak/p5YePlsoFxs_DcWoUIOmR79j8r0aXLIjACLcBGAs/s320/US%2BPIRG%2B-%2BPercent%2Bof%2BUS%2Bauto%2Bdebt%2Bthat%2Bis%2B90%2Bplus%2Bdays%2Bdelinquent.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.</span></b></blockquote>
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<span style="font-family: inherit;"><br /></span></div>
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</div>
<ul style="text-align: left;">
<li><span style="font-family: inherit;">Americans are carrying car loans for longer periods of time. Of all auto loans issued in the first two quarters of 2017, 42 percent carried a term of six years or longer, compared to just 26 percent in 2009. Longer repayment terms increase the total cost of buying an automobile and extend the amount of time consumers spend “underwater” — owing more on their vehicles than they are worth.</span></li>
<li><span style="font-family: inherit;">Many car buyers “roll over” the unpaid portion of a car loan into a loan on a new vehicle, increasing their financial vulnerability in the event of job loss or other crisis of household finances. <span style="color: red;">At the end of 2017, almost a third of all traded-in vehicles carried negative equity, with these vehicles being underwater by an average of $5,100</span>.</span></li>
<li><span style="font-family: inherit;">The increase in higher-cost “subprime” loans has extended auto ownership to many households with low credit scores but has also left many of them deeply vulnerable to high interest rates and predatory practices. In 2016, lending to borrowers with subprime and deep subprime credit scores made up as much as 26 percent of all auto loans originated.</span></li>
<li><span style="font-family: inherit;">Auto lenders — and especially subprime lenders — have engaged in a variety of predatory, abusive and discriminatory practices that enhance consumers’ vulnerability, including:</span></li>
</ul>
<blockquote class="tr_bq">
<ul style="text-align: left;">
<li style="text-align: justify;"><span style="font-family: inherit;">Providing incomplete or confusing information about the terms of the loan, including interest rates.</span></li>
</ul>
<ul style="text-align: left;">
<li style="text-align: justify;"><span style="font-family: inherit;">Making loans to people without the ability to repay.</span></li>
</ul>
<ul style="text-align: left;">
<li style="text-align: justify;"><span style="font-family: inherit;">Discriminatory markups of loans that result in African-American and Hispanic borrowers paying more for auto loans.</span></li>
</ul>
<ul style="text-align: left;">
<li style="text-align: justify;"><span style="font-family: inherit;">Pushing expensive “add-ons” such as insurance products, extended warranties and overpriced vehicle options, the cost of which is added to a consumer’s loan.</span></li>
</ul>
<ul style="text-align: left;">
<li style="text-align: justify;"><span style="font-family: inherit;">Engaging in abusive collection and repossession tactics once a consumer’s loan has become past due.</span></li>
</ul>
</blockquote>
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<span style="font-family: inherit;">- source US PIRG, February 2019</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less "senior" when it comes the recovery value potential. </span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">As we pointed out in October 2017 in our conversation "<a href="https://macronomy.blogspot.com/2017/10/macro-and-credit-whos-afraid-of-big-bad.html">Who's Afraid of the Big Bad Wolf?</a>", credit cycles die because too much debt has been raised:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion." - Macronomics, October 2017 </span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">This is why on this very blog we follow very closely financial conditions and the Fed's quarterly SLOOs as well a fund flows. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:</span></div>
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<a href="https://1.bp.blogspot.com/-DKeqRzHzKXM/XHF26-RZhyI/AAAAAAAAVaw/xgzvOBjN-mEWW7zmc0rA3EVWH4EBgNzbwCLcBGAs/s1600/US%2BPIRG%2B-%2BAuto%2BDebt%2BOutstanding.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="849" data-original-width="1035" height="262" src="https://1.bp.blogspot.com/-DKeqRzHzKXM/XHF26-RZhyI/AAAAAAAAVaw/xgzvOBjN-mEWW7zmc0rA3EVWH4EBgNzbwCLcBGAs/s320/US%2BPIRG%2B-%2BAuto%2BDebt%2BOutstanding.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li><span style="font-family: inherit;">"7% of auto loans are 3+ months delinquent . Auto loan delinquencies climbed to $9 billion in 2018. </span></li>
<li><span style="font-family: inherit;"><span style="color: red;"><b>Transportation is the second-leading expenditure for American households, behind only housing</b></span>. Approximately one hour of the average American’s working day is spent earning the money needed to pay for the transportation that enables them to get to work in the first place.</span></li>
<li><span style="font-family: inherit;">Americans owed $1.26 trillion on auto loans in the third quarter of 2018, an increase of 75 percent since the end of 2009.</span></li>
<li><span style="font-family: inherit;"><b><span style="color: red;">The amount of auto loans outstanding is equivalent to 5.5 percent of GDP — a higher level than at any time in history other than the period between the 2001 and 2007 recessions</span></b>." <span style="text-align: center;">- source US PIRG, February 2019</span></span></li>
</ul>
</blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Given that the auto industry is notoriously cyclical, and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.</span></div>
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<span style="font-family: inherit;">On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo's Economics Group Weekly Economic and Financial Commentary from the 22nd of February:</span></div>
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<span style="font-family: inherit;">"<b>Canary in the Camry?</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?</span></blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b><span style="color: red;">Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt</span></b>. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute." - source Wells Fargo</span></blockquote>
<span style="font-family: inherit;">Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven't seen in the last 25 years? We wonder.</span></div>
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<span style="font-family: inherit;">If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled "Spreads stall heading into SFIG":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Consumer Portfolio Services, Inc (CPSS or CPS) - sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.</span></blockquote>
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<span style="font-family: inherit;">The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-tSacGgdpWy4/XHGG5cdE0vI/AAAAAAAAVa8/XKxHrru1ULEfHdlP_VyQYXtzYlTI4MsNQCLcBGAs/s1600/BAML%2B-%2BAuto%2Bloan%2Bportfolio%2Bbalances%2Band%2BYoY%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="305" data-original-width="391" height="249" src="https://2.bp.blogspot.com/-tSacGgdpWy4/XHGG5cdE0vI/AAAAAAAAVa8/XKxHrru1ULEfHdlP_VyQYXtzYlTI4MsNQCLcBGAs/s320/BAML%2B-%2BAuto%2Bloan%2Bportfolio%2Bbalances%2Band%2BYoY%2Bgrowth.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-Frxj3YCsfBM/XHGHHMwLVII/AAAAAAAAVbA/V1swBcvJE6Qz7VQZZsRhYRppWD4i_T5MACLcBGAs/s1600/BAML%2B-%2BAuto%2Bloans%2Bcredit%2Bperformance.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="312" data-original-width="391" height="255" src="https://2.bp.blogspot.com/-Frxj3YCsfBM/XHGHHMwLVII/AAAAAAAAVbA/V1swBcvJE6Qz7VQZZsRhYRppWD4i_T5MACLcBGAs/s320/BAML%2B-%2BAuto%2Bloans%2Bcredit%2Bperformance.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction." - source Bank of America Merrill Lynch</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">To repeat ourselves, <span style="text-align: justify;">credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly "S&P500 dependent", the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the "Lethe" liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the "illiquid stuff" such as the now "famous infamous" leveraged loans regardless of their recent "strong" performance.</span></span></div>
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<span style="font-family: inherit; text-align: justify;">For now, investors have dipped again into "Lethe" hence the return of the "goldilocks" narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure "goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>"The Trouble with ‘Goldilocks’</b>The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-Wh8XvAnjyMI/XHGdWEzO0rI/AAAAAAAAVbQ/azthY7JyWycBhG2aORmfPnERF1qg_qP9QCLcBGAs/s1600/MS%2B-%2BFundamentals%2Bdata%2Bis%2Bweakening%2Bacross%2Ba%2Bvariety%2Bof%2Bmetrics.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="427" data-original-width="777" height="175" src="https://2.bp.blogspot.com/-Wh8XvAnjyMI/XHGdWEzO0rI/AAAAAAAAVbQ/azthY7JyWycBhG2aORmfPnERF1qg_qP9QCLcBGAs/s320/MS%2B-%2BFundamentals%2Bdata%2Bis%2Bweakening%2Bacross%2Ba%2Bvariety%2Bof%2Bmetrics.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities." - source Morgan Stanley.</span></blockquote>
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<span style="font-family: inherit;">A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.</span></div>
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<span style="font-family: inherit;">Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their "The Inquirer" note from the 18th of February entitled "Is Global Monetary Reflation here?":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"In the last week, it seems like global central banks have started a possible process of monetary easing, in line with our views (The Inquirer: Planet Earth to Policymakers: Please Reflate 31 December 2018). If so, this would be very positive for Asia/EM stocks.</span><br />
<span style="font-family: inherit;">In the US, Fed governor Lael Brainard raised the possibility of ending balance sheet contraction by year-end 2019, ahead of schedule; in Europe, the possibility of a TLTRO came from Commissioner Benoit Coeure, and China printed a massive January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018, above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn. Global monetary reflation is possibly on the way. As of now, we remain bullish. We expect the world's central banks to reflate monetary policy, a view we have held since late last year.</span><br />
<span style="font-family: inherit;">Paraphrasing Mike Tyson, everyone's got an investment strategy, until they get punched in the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity analysis (different from "fund flows") was popular in financial markets three decades ago. We remember having a standalone research product in the mid-1990s called "Liquidity Analysis" replete with central bank balance sheets, commercial bank entrails, and the net supply and demand for equity. These days, eyes glaze over when we bring up base money growth, money multipliers, and monetary velocity. However, as the last decade has taught us, we should pay attention to this stuff. Our global strategist, Michael Hartnett, has maintained a consistent focus on liquidity and central bank balance sheets</span><br />
<span style="font-family: inherit;">as part of his toolkit.</span><br />
<span style="font-family: inherit;">1) We think the biggest risk to equities in Asia and EMs is the potential mismanagement and premature contraction of central bank balance sheets. Conversely, it is also the most lucrative opportunity. The correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years. World equities have a similar correlation of 0.94 since 2009. Central bank balance sheets are the most important driver of stock prices, in our view, by lowering risk premia, and cutting off deflation risk. The rest is detail, in our view.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-a3bpQyFtvJg/XHGos57tfcI/AAAAAAAAVbc/w_zO9hOcSFsefwsuLg6aGzgl3M3uZQErgCLcBGAs/s1600/BAML%2B-%2BThe%2Bmajor%2Bcentral%2Bbanks%2Bbalance%2Bsheet%2B-%2Bthe%2Bmain%2Bthing.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="323" data-original-width="394" height="262" src="https://4.bp.blogspot.com/-a3bpQyFtvJg/XHGos57tfcI/AAAAAAAAVbc/w_zO9hOcSFsefwsuLg6aGzgl3M3uZQErgCLcBGAs/s320/BAML%2B-%2BThe%2Bmajor%2Bcentral%2Bbanks%2Bbalance%2Bsheet%2B-%2Bthe%2Bmain%2Bthing.jpg" width="320" /></span></a></div>
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<a href="https://3.bp.blogspot.com/-mlMozOVT5Kg/XHGowFjqT6I/AAAAAAAAVbg/UE5zqkg8MMYpuEpVdNgDyABtw-w0PxosQCLcBGAs/s1600/BAML%2B-%2BThe%2Bmajor%2Bcentral%2Bbanks%2Bbalance%2Bsheet%2B-%2Binvestors%2Bneed%2Bto%2Bwatch.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="322" data-original-width="391" height="263" src="https://3.bp.blogspot.com/-mlMozOVT5Kg/XHGowFjqT6I/AAAAAAAAVbg/UE5zqkg8MMYpuEpVdNgDyABtw-w0PxosQCLcBGAs/s320/BAML%2B-%2BThe%2Bmajor%2Bcentral%2Bbanks%2Bbalance%2Bsheet%2B-%2Binvestors%2Bneed%2Bto%2Bwatch.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">2) We think the Fed is the most flexible in course correcting - they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-4jODJF1RyzQ/XHGqdPoDDnI/AAAAAAAAVb8/HZsrB5rNBQgQgRL2Aeig99C7WTZXtFWjACLcBGAs/s1600/BAML%2B-%2BCentral%2BBank%2BTotal%2BAssets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="416" data-original-width="391" height="320" src="https://3.bp.blogspot.com/-4jODJF1RyzQ/XHGqdPoDDnI/AAAAAAAAVb8/HZsrB5rNBQgQgRL2Aeig99C7WTZXtFWjACLcBGAs/s320/BAML%2B-%2BCentral%2BBank%2BTotal%2BAssets.jpg" width="300" /></span></a></div>
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<span style="font-family: inherit;">3) However, we worry that in Europe, Japan, and most importantly, China - a total of USD40tn in GDP, or half the world's total - a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-LWr1Q61MLPc/XHGqi0uVqdI/AAAAAAAAVcA/I3_mZzCaGSQBPXd6OIX2KaTsAYUhnX5gQCLcBGAs/s1600/BAML%2B-%2BDiscussions%2Babout%2Bchanges%2Bin%2Bthe%2Bcentral%2Bbanks%2Bbalance%2Bsheet.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="383" data-original-width="563" height="217" src="https://3.bp.blogspot.com/-LWr1Q61MLPc/XHGqi0uVqdI/AAAAAAAAVcA/I3_mZzCaGSQBPXd6OIX2KaTsAYUhnX5gQCLcBGAs/s320/BAML%2B-%2BDiscussions%2Babout%2Bchanges%2Bin%2Bthe%2Bcentral%2Bbanks%2Bbalance%2Bsheet.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The world monetary base is shrinking, only the sixth time since 1980 - each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession. </span></blockquote>
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<a href="https://2.bp.blogspot.com/-KuZpZ1LO0e0/XHGp7eqhREI/AAAAAAAAVbw/srhJYtMHhuAw_HM5ZNEndAVOr1DzKYmwQCLcBGAs/s1600/BAML%2B-%2BReal%2BGlobal%2BMonetary%2Bbase%2Bshrunk%2B2.2%2Bpct%2Bin%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="409" data-original-width="529" height="247" src="https://2.bp.blogspot.com/-KuZpZ1LO0e0/XHGp7eqhREI/AAAAAAAAVbw/srhJYtMHhuAw_HM5ZNEndAVOr1DzKYmwQCLcBGAs/s320/BAML%2B-%2BReal%2BGlobal%2BMonetary%2Bbase%2Bshrunk%2B2.2%2Bpct%2Bin%2B2018.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Why should this time be different? The US Fed's projected balance sheet contraction of about USD40bn a month will likely reduce the US monetary base 13.8% this year (after contracting 10.7% last year), and the global real monetary base by 1.6%. After spending seven years telling us that the Fed B/S expansion was equivalent to rate cuts, we are now told that the opposite - B/S contraction is like "watching paint dry". Ostensibly, this comes from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years. The Lael Brainard "end-QT earlier" is helpfully walking back some of this prior aggressive QT fervor. And that’s a good thing -that’s the main impetus to growth in old, indebted and unequal societies.</span><br />
<span style="font-family: inherit;">4) Apart from China, which has control over its money multiplier through the high reserve requirement ratio, most large economies have seen falling money multipliers for the last two decades. Stopping QE - or slowing the QE-induced growth of the monetary base - will likely lead to a sharp drop in M2 growth (M2 is simply the monetary base multiplied by the money multiplier). Couple that with the secular drop in monetary velocity from the declining incremental productivity of debt, and slower nominal global GDP (and EPS) growth is highly likely. Rising indebtedness globally, demands a stronger money supply growth rate to maintain a desired level of economic (and earnings</span><br />
<span style="font-family: inherit;">growth). This is an identity, not a theory. This is increasingly true for China, with its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to impose more severe costs on growth there. The world's central bankers seemed oblivious to this until last week, and even now it is not clear where they stand. Welcome back to the secular stagnation debate. And the potential threat of a "too tight policy mistake".</span></blockquote>
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<a href="https://2.bp.blogspot.com/-o0aHTcU3kN0/XHGrZbfddzI/AAAAAAAAVck/awibGeEOaKkBfNMg-UtIhlaDG816a2WnwCLcBGAs/s1600/BAML%2B-%2BOur%2Bnew%2Bdiscovery.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="407" data-original-width="542" height="240" src="https://2.bp.blogspot.com/-o0aHTcU3kN0/XHGrZbfddzI/AAAAAAAAVck/awibGeEOaKkBfNMg-UtIhlaDG816a2WnwCLcBGAs/s320/BAML%2B-%2BOur%2Bnew%2Bdiscovery.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<i><span style="font-family: inherit;">Chair Ben Bernanke during his testimony about the Federal Reserve Board’s semiannual report on monetary policy said that he equated $150-200 billion of QE as being equivalent to a 25bps reduction in short term rates. So 600billion in QE2 was equivalent to a 75bps reduction.</span></i><br />
<span style="font-family: inherit;">https://www.c-span.org/video/?298238-1/monetary-policy-report (at 32 minute)</span></blockquote>
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<a href="https://3.bp.blogspot.com/-hqOM4PYHns0/XHGryNFdNWI/AAAAAAAAVcs/-VhltlqBXvw-MHhldM_E3GpX1YjI8bw2ACLcBGAs/s1600/BAML%2B-%2BFed%2BBalance%2Bsheet%2Bcontraction%2Bnot%2Bwatching%2Bpaint%2Bdry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="395" data-original-width="536" height="235" src="https://3.bp.blogspot.com/-hqOM4PYHns0/XHGryNFdNWI/AAAAAAAAVcs/-VhltlqBXvw-MHhldM_E3GpX1YjI8bw2ACLcBGAs/s320/BAML%2B-%2BFed%2BBalance%2Bsheet%2Bcontraction%2Bnot%2Bwatching%2Bpaint%2Bdry.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)" - source Bank of America Merrill Lynch</span></blockquote>
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<span style="font-family: inherit; text-align: justify;">It seems to us that Jerome Powell has finally done the math hence the "u-turn" as seen in the increasing use of "patience" in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the "Lethe" river thanks to the rescue of central banks.</span></div>
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<span style="font-family: inherit; text-align: justify;">Another strong support as well to the "high beta" rally narrative and "risk-on" environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political "left" side.</span></div>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - It's not only central banks, buybacks got your back...</span></li>
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<span style="font-family: inherit;">Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled "Buybacks on pace for another record year" and shows that in similar fashion to 2018, the return of buybacks on top of the central banking "Lethe" river provides additional support to the "oblivious" crowd of investors jumping with both feet on the high-beta wagon:</span></div>
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<span style="font-family: inherit;">"Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1). </span></blockquote>
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<a href="https://1.bp.blogspot.com/-juWeTHKpI2Y/XHGu0DJRrPI/AAAAAAAAVc4/ADJ7qlseSB4bkszLL8Q-BK8RKs8e7SXsQCLcBGAs/s1600/BAML%2B-%2Bbuybacks%2Boff%2Bto%2Ba%2Bstrong%2Bstart%2Bin%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="276" data-original-width="522" height="169" src="https://1.bp.blogspot.com/-juWeTHKpI2Y/XHGu0DJRrPI/AAAAAAAAVc4/ADJ7qlseSB4bkszLL8Q-BK8RKs8e7SXsQCLcBGAs/s320/BAML%2B-%2Bbuybacks%2Boff%2Bto%2Ba%2Bstrong%2Bstart%2Bin%2B2019.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels." - source Bank of America Merrill Lynch</span></blockquote>
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<span style="font-family: inherit;">If "R" is for Recession and "L" is for Leveraged then "G" is for Gold. With the recent return of the <span style="text-align: justify;">river of unmindfulness, no wonder, the strong "bull" market has been "reincarnated" and the zombie companies can continue to "live" another day but we are ranting again...</span></span></div>
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<span style="font-family: inherit;">"To err is human; to forgive, divine." - Alexander Pope, English poet</span></blockquote>
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<span style="font-family: inherit;">Stay tuned !</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-56006273477934267282019-02-12T21:40:00.000+00:002019-02-12T21:40:09.208+00:00Macro and Credit - Cryoseism<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Praise out of season, or tactlessly bestowed, can freeze the heart as much as blame." - Pearl S. Buck</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the weakening tone in February in credit markets following the stellar month of January, in conjunction with confirmation of a global slowdown, and with no resolution in sight between China and the United States in relation to their trade spat, and also with the weaker tone for financial conditions coming out of the quarterly Fed Senior Loan Officer Opinion Survey (SLOOs), when it came to selecting our title analogy, given the lower than usual temperature experienced in various part of the world including ours, we decided to go for "Cryoseism". "Cryoseism" also known as an ice quake or a frost quake, is a seismic event that may be caused by a sudden cracking action in frozen soil or rock saturated with water or ice. <span style="text-align: left;">As water drains into the ground (liquidity in asset markets), it may eventually freeze and expand under colder temperatures (global growth and trade deceleration), putting stress on its surroundings. This stress builds up until relieved explosively in the form of a cryoseism. </span><span style="text-align: left;">Cryoseisms are often mistaken for minor intraplate earthquakes. </span> Initial indications may appear similar to those of an earthquake with tremors, vibrations, ground cracking and related noises such as thundering or booming sounds. Cryoseisms can, however, be distinguished from earthquakes through meteorological and geological conditions. Cryoseisms can have an intensity of up to VI on the Modified Mercalli Scale. Furthermore, cryoseisms often exhibit high intensity in a very localized area (such as leveraged loans) in the immediate proximity of the epicenter, as compared to the widespread effects of an earthquake. Due to lower-frequency vibrations of cryoseisms, some seismic monitoring stations may not record their occurrence. Although cryoseisms release less energy than most tectonic events, they can still cause damage or significant changes to an affected area. There are four main precursors for a frost quake cryoseism event to occur: (1) a region must be susceptible to cold air masses, (2) the ground must undergo saturation from thaw or liquid precipitation prior to an intruding cold air mass, (3) most frost quakes are associated with minor snow cover on the ground without a significant amount of snow to insulate the ground (i.e., less than 6 inches), and (4) a rapid temperature drop (global trade) from approximately freezing to near or below zero degrees Fahrenheit, which ordinarily occurred on a timescale of 16 to 48 hours.</span></div>
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<span style="font-family: inherit;">In this week's conversation, we would like to look at what the latest Fed's quarterly Senior Loan Officer Opinion survey means for credit in general and high yield/high beta in particular. </span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
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<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - This recent rally is not on solid ground</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final chart - Credit pinball - Same player shoots again?</b></i></span></li>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - This recent rally is not on solid ground</span></li>
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<span style="font-family: inherit;">In our most recent conversation, we pointed out to the cautious tone from investors, urging CFOs in the US to take the "deleveraging" route given the continuous rise of the cost of capital, which appears to be somewhat validated by the latest Fed Senior Loan Officer Opinion Survey (SLOOs). The Fed’s latest SLOOs points towards tightening financial conditions: "demand for loans to businesses reportedly weakened." But, we think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield.</span><br />
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<span style="font-family: inherit;">In our early January conversation "<a href="https://macronomy.blogspot.com/2019/01/macro-and-credit-respite.html">Respite</a>", we pointed out to our 2018 call, namely that analyst estimates were way too optimistic when it comes to earnings for 2019. If indeed Europe is a clear case of Cryoseism, with so much liquidity injected and not very much to show for macro wise in terms of growth outlook making it a very bad grade for the confidence tricksters at the helm of the ECB vaunting in recent days the great success of QE, the savage earnings revision pace we have seen so far clearly show the recent rally is not on solid ground. On the subject of earnings revision we read with interest Morgan Stanley's take from their US Equity Strategy Weekly Warm Up from the 11th of February entitled "Earnings Recession Is Here":</span><br />
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<span style="font-family: inherit;">"<b>Earnings expectations for 2019 have fallen sharply, but consensus still embeds a material reacceleration in 2H19. History tells us to expect further downward revisions, higher volatility and a drag on prices. We lower our base case 2019 S&P 500 EPS growth forecast to 1%.</b></span></blockquote>
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<span style="font-family: inherit;"><b>Our earnings recession call is playing out even faster than we expected.</b> When we made our call for a greater than 50% chance of an earnings recession this year, we thought it might take a bit longer for the evidence to build. On the back of a large downward revisions cycle during 4Q earnings season, it's becoming more clear. Consensus numbers have already baked in no growth for 1H19 (1Q projected growth is actually negative) with a hockey stick assumed in 2H19 that brings the full year growth estimate to ~5%.</span></blockquote>
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<span style="font-family: inherit;"><b>History says be skeptical of the inflection forecast. </b>The projected y/y EPS growth in 4Q19 is ~9.5%. This compares to an average projected rate of growth of 1% over 1Q - 3Q19, an inflection of ~8.5%. Since the early 00s, we have seen this kind of inflection happen a few times, but these inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate. Neither of those forces are at play this year. In fact, it's the opposite making the achievability of these estimates even more unlikely.</span></blockquote>
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<span style="font-family: inherit;"><b>When consensus is embedding an inflection further out, downward revisions, some drag on price returns and higher volatility are all to be expected.</b> We examined what tends to happen when consensus embeds a big jump in growth 4 quarters out compared to the next three quarters. We found that the numbers for all 4 quarters ahead tend to fall but the growth quarter tends to fall the most. <span style="color: red;">If current estimates move in line with history, we could see a full year decline of ~3.5% in S&P earnings</span>. There is a wide range of potential outcomes though, so today we only take our base case forecast down to 1% y/y growth. We also found that equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility tends to rise meaningfully., with average year ahead price volatility realizing ~5% more than the full period average.</span></blockquote>
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<span style="font-family: inherit;"><b>Lowering our earnings forecast. On the back of this work, we lower our Base Case 2019 S&P 500 EPS growth forecast to 1% from 4.3%.</b> While our earnings numbers are coming down, our bull, base, and bear case year end price targets remain unchanged as a lower rate environment provides support for year end target multiples. The bottom line--our base case year end target of 2750 is a lot less exciting than it was a month ago." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">In their executive summary of their interesting note Morgan Stanley indicates the velocity in the earnings revisions as of late. This rapid move clearly shows that the euphoria seen in January where anything high beta rallied hard is not on solid ground. Debt-financed buybacks after all fell to 14% of the total among US companies at the end of last year, the lowest level since 2009 according to JP Morgan data. Buybacks since 2012 has been an important "pillar" in terms of support to US equities in recent years thanks to multiple expansion rest assured.</span><br />
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<span style="font-family: inherit;">On top of that there are an increasing percentage of companies with negative earnings: S&P 500 - 7%; Nasdaq - 47%; Russell 3000 - 28%; Russell 2000 - 37%. For us, "high beta" is very "junky". If fundamentals are deteriorating such as global trade and global growth and earnings revisions are "savage" then regardless of central banks' u-turn, it isn't enough we think to provide the same support we saw in recent years and quarters. The cavalry was indeed late after the December massacre, but the overall macro picture ain't rosy.</span><br />
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<span style="font-family: inherit;">Given the velocity in earnings revision/recession Morgan Stanley have drastically revised their outlook according to their note:</span><br />
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<span style="font-family: inherit;">"<b>Earnings Recession Is Here; Adjusted EPS Forecast Lower</b></span></blockquote>
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<span style="font-family: inherit;">With 4Q18 results season nearing completion we have been taking a closer look at 2019 guidance. Downward revisions have come even faster and steeper than we expected and the full year earnings growth number now sits just above 5% with a material upward acceleration projected in the 4th quarter of the year. At the start of a downward revisions cycle, history tells us not to count on that kind of upward inflection.</span></blockquote>
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<span style="font-family: inherit;"><b>On the back of the recent downward revisions, we lower our earnings forecasts for 2019 as we think it is becoming increasingly clear we are in the midst of the earnings recession we called for in our year ahead outlook.</b> Specifically, we are adjusting our 2019 EPS growth number down to 1% (from 4.25%) while noting that despite support from buyback accretion and a weaker dollar by year end, risks skew to the downside. We make minor changes to our 2020 growth assumptions and bull/bear case earnings estimates as well. Our revised forecasts are shown in Exhibit 1.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-yGxMg1kJ4HA/XGGZW8E7Y9I/AAAAAAAAVWs/angBqmnwrIEppXK-JJeAy38l7S_jIc5EQCLcBGAs/s1600/MS%2B-%2BOur%2Bupdated%2BEarnings%2BForecasts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="169" data-original-width="527" height="102" src="https://2.bp.blogspot.com/-yGxMg1kJ4HA/XGGZW8E7Y9I/AAAAAAAAVWs/angBqmnwrIEppXK-JJeAy38l7S_jIc5EQCLcBGAs/s320/MS%2B-%2BOur%2Bupdated%2BEarnings%2BForecasts.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"><b>While our earnings numbers are coming down, our bull, base, and bear case price targets remain unchanged as a lower rate environment provides modest support for year end target multiples.</b> With a more dovish Fed and our Interest Rate Strategy colleagues now projecting a year end 10Y UST yield of 2.45%, we revisit our Equity Risk Premium / 10Y yield matrix (Exhibit 2). </span></blockquote>
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<a href="https://4.bp.blogspot.com/-5NOmNhwL2XA/XGGazFrDQKI/AAAAAAAAVW4/kFETaOpQdqkDg26VBtamS6NhHJ98R-s-gCLcBGAs/s1600/MS%2B-%2B15-16%2Brange%2BFWD%2BEPS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="197" data-original-width="543" height="116" src="https://4.bp.blogspot.com/-5NOmNhwL2XA/XGGazFrDQKI/AAAAAAAAVW4/kFETaOpQdqkDg26VBtamS6NhHJ98R-s-gCLcBGAs/s320/MS%2B-%2B15-16%2Brange%2BFWD%2BEPS.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">We highlight our target range of ~15 - 16.5x forward PE for the S&P. Our range below has a diagonal tilt as we believe lower yields will be accompanied by higher uncertainty on growth leading to a higher ERP while higher yields may reflect a more optimistic outlook on growth, allowing for ERP compression.</span></blockquote>
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<b><span style="font-family: inherit;">Don't Count on a 4Q19 Inflection in EPS Growth</span></b></blockquote>
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<span style="font-family: inherit;">We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into 4Q19 estimates is unlikely to happen. A modest further decline in earnings will deliver the earnings recession we called for. Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility will likely rise meaningfully. So in essence, we are still looking at a bumpy, range bound market at the index level and think investors should continue to try and take advantage of the swings in price in both directions.</span></blockquote>
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<b><span style="font-family: inherit;">The Market Needs a 4Q19 Growth Inflection To Support Full Year EPS Growth</span></b></blockquote>
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<span style="font-family: inherit;"><b>In our year ahead outlook we argued that 2019 had a greater than 50% probability of seeing an earnings recession defined very simply as two consecutive quarters of negative y/y earnings growth. Following a steep downward revisions cycle over the last few months, consensus forecasts are quickly getting there.</b> From the end of November, earnings growth expectation on the S&P fell from ~9% to their current level of around 5%. With an expectation of negative y/y growth in 1Q19 and very marginal growth in 2Q19, the mid-single digit full year number embeds a heavy ramp up of earnings growth in the back half of the year, and in 4Q19 in particular (Exhibit 3). </span></blockquote>
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<a href="https://4.bp.blogspot.com/-y_oMgLJXRtg/XGGewM3xgXI/AAAAAAAAVXE/3b-zV3-5wZEXpAaK6qRe0gx0v1f5RP4LACLcBGAs/s1600/MS%2B-%2BFull%2Byear%2Bexpectations%2BEPS%2Bwill%2Bneed%2Bto%2Binflect%2Bmuch%2Bhigher%2Bin%2B4Q19.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="339" data-original-width="527" height="205" src="https://4.bp.blogspot.com/-y_oMgLJXRtg/XGGewM3xgXI/AAAAAAAAVXE/3b-zV3-5wZEXpAaK6qRe0gx0v1f5RP4LACLcBGAs/s320/MS%2B-%2BFull%2Byear%2Bexpectations%2BEPS%2Bwill%2Bneed%2Bto%2Binflect%2Bmuch%2Bhigher%2Bin%2B4Q19.jpg" width="320" /></span></a></div>
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<b><span style="font-family: inherit;">Importantly, since consensus bottom-up numbers are really just a reflection of company guidance this earnings slowdown could have real knock-on effects to corporate behavior like spending and hiring which then puts further pressure on growth.</span></b></blockquote>
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<span style="font-family: inherit;">Furthermore, company managements tend to be an optimistic group. As such, we're not surprised they are calling for a trough in 1Q. However, we would advise against taking too much comfort in these calls for a trough in 1Q19 of the down cycle from the same people who didn't see it coming in the first place. <b>In addition to a trough in 1Q, consensus estimates are now forecasting a big second half inflection in growth.<br />Anything is possible, but we have little confidence in such an inflection given sharply falling top line growth and disappointing margins in the face of very difficult comparisons for the rest of this year</b>. If we accept that an earnings recession is here, the key questions are how deep will it be and how long will it last? Again, it's hard to know, but we can look to history for some context on how expectations for a large upward inflection in earnings usually play out." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">Again, analysts going into 2019 have been way too optimistic when it comes to earnings. A usual trend but given the amount of liquidity injected into the system by central banks no wonder we are seeing growing risks of "cryoseism" in 2019. Volatility is firmly back.</span><br />
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As we stated before, where oil prices goes, so does US High Yield and in particular the CCC ratings bucket given its exposure to the Energy sector. No wonder Energy rallied strongly over the month of January:<br />
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<a href="https://1.bp.blogspot.com/--MRRN9wI0-c/XGKddLKkMoI/AAAAAAAAVXQ/PaznRXV6cd8WWlazlqPJ8soMw01P4cxRwCLcBGAs/s1600/BAML%2B%2B-%2BUS%2BHY%2BJAN%2BRally.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="348" data-original-width="882" height="126" src="https://1.bp.blogspot.com/--MRRN9wI0-c/XGKddLKkMoI/AAAAAAAAVXQ/PaznRXV6cd8WWlazlqPJ8soMw01P4cxRwCLcBGAs/s320/BAML%2B%2B-%2BUS%2BHY%2BJAN%2BRally.jpg" width="320" /></a></div>
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- graph source Bank of America Merrill Lynch (click to enlarge)</div>
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In its January 2019 Senior Loan Officer Survey, the Fed said that a net positive percentage of domestic banks reported increasing the premiums charged on loans to large and middle-market firms. Historically, this tends to be a reliable signal of a pending recession. Both the supply and demand for household and business credit is either slowing or contracting. This is yet another "Cryoseism" sign that the epic high beta rally seen during the month of January is not on solid ground. So sure the rally in US High Yield has been very significant but, if indeed financial conditions continue to deteriorate, it doesn't bode well for the asset class down the line.<br />
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As we mentioned on numerous conversations, like any good behavioral psychologist we tend to focus more on flows than on stocks. We stated as well at the end of the year that for a rebound in credit markets, fund flows need to see some stabilization the latest dovish tilt from central banks globally have enabled such a bounce as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 8th of February entitled "Reaching for yield":<br />
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"<b>Equities record first inflow, HY inflow surpass $1bn</b></blockquote>
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Dovish central banks globally have instigated a risk assets rally. The reach for yield is back amid lower government bond yields. Inflows into high-yield funds have strengthened over the past weeks and equity funds recorded their first inflow in a while as light positioning has become a tailwind for the asset class.</blockquote>
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<b>Over the past week…</b></blockquote>
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<b>High grade</b> funds flopped back to negative territory. Last week’s outflow reversed part of the inflow from week ago, ending a two week streak of inflows. However, the outflow was driven by one single fund and removing it would result into a $1.1bn inflow. <b>High yield</b> funds on the other hand continued to see stronger inflows w-o-w.<br />We note that last week’s inflow was the largest since September last year. Looking into the domicile breakdown, US-focused funds recorded the lion's share of the inflow, while Europe-focused funds recorded a more moderate inflow. Note that the inflows into global-focused funds were marginal.<br />Government bond funds recorded a decent inflow this week; the third in a row. <b>Money Market</b> funds recorded a strong inflow last week. All in all, <b>Fixed Income</b> funds recorded another inflow, though the pace has slowed down w-o-w.<br />For a change <b>European equity funds</b> recorded their first inflow after 21 consecutive weeks of outflows. Note that during this period total outflows reached $45bn.</blockquote>
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<blockquote class="tr_bq">
<b>Global EM debt</b> funds continued to record inflows, the fifth weekly one. Note that last week’s inflow was the strongest since July 2016. Dovish Fed and lower dollar has become a tailwind for the asset class recently. Commodity funds recorded another inflow, the ninth in a row.<br />On the <b>duration</b> front, we find that the belly underperformed recording the vast majority of the outflow last week. Long-term and shot-term IG funds also recorded outflows last week, but to a lesser extent." - source Bank of America Merrill Lynch</blockquote>
A dovish Fed in conjunction with lower rate volatility have led to Emerging Markets benefiting from the return of the "carry" trade.<br />
<br />
Given that bad news has become good news again during the month of January, given the dovish tilt taken by most central banks, high beta has come back to the forefront thanks to the central banking cavalry. 2019 has clearly started on a very strong tone as indicated by Bank of America Merrill Lynch in their European Credit Strategist note from the 8th of February entitled "Play it again Sam":<br />
<blockquote class="tr_bq">
"As the expression goes…it’s always darkest before dawn. Year-to-date, high-grade spreads have rallied 18bp and high-yield has tightened by 72bp in Europe. These are impressive moves. For the investment-grade market, 2019 is shaping up to be one of the best ever starts to a year outside of 2012 – a time when the ECB’s life-saving LTROs energised a huge rally across the market.</blockquote>
<blockquote class="tr_bq">
<b>An epic central bank “blink”</b></blockquote>
<blockquote class="tr_bq">
In 2018, only 13% of assets across the globe posted positive total returns…and only 9% of assets managed to outperform US 3m Libor. Jump to 2019 and the picture couldn’t be different. As Chart 1 shows, 98% of assets across the globe have positive total returns so far this year (the second best outcome since 1990).</blockquote>
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<a href="https://2.bp.blogspot.com/-ITAQQ1k34Lc/XGLSVmihcTI/AAAAAAAAVXs/K_UrkhQFuqIoMou7PLmI-9BtXlnk2DkwQCLcBGAs/s1600/BAML%2B-%2B98%2Bpct%2Bof%2Bassets%2Bacross%2Bthe%2Bglobe%2Bare%2Bup%2Byear-to%2Bdate.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="311" data-original-width="391" height="254" src="https://2.bp.blogspot.com/-ITAQQ1k34Lc/XGLSVmihcTI/AAAAAAAAVXs/K_UrkhQFuqIoMou7PLmI-9BtXlnk2DkwQCLcBGAs/s320/BAML%2B-%2B98%2Bpct%2Bof%2Bassets%2Bacross%2Bthe%2Bglobe%2Bare%2Bup%2Byear-to%2Bdate.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
The clearest instigator for such a bullish reversal, in our view, is that central banks are now undergoing one epic reversal in their monetary policy stance. In 2019, the Fed has already pivoted to being on-hold, the ECB has moved the balance of risks to the downside, Australia has stopped hiking and India has delivered a surprise rate cut.</blockquote>
<blockquote class="tr_bq">
When the most important central bank in the world changes tack, others must follow…or risk unwanted currency appreciation. True to form, as Chart 2 shows, the number of global central bank rate cuts over the last 6m is now greater than the number of central bank rate hikes (although the picture is less dramatic when excluding Argentina). </blockquote>
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<a href="https://1.bp.blogspot.com/-XG5F_uxfJNc/XGLSSjrOquI/AAAAAAAAVXo/Ut44o6NL8kM0gNgTBqvjSQcdAl80ecJzgCLcBGAs/s1600/BAML%2B-%2BGlobal%2Bcentral%2Bbanks%2Bpivoting%2Bback%2Bto%2Ban%2Beasier%2Bstance.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="311" data-original-width="391" height="254" src="https://1.bp.blogspot.com/-XG5F_uxfJNc/XGLSSjrOquI/AAAAAAAAVXo/Ut44o6NL8kM0gNgTBqvjSQcdAl80ecJzgCLcBGAs/s320/BAML%2B-%2BGlobal%2Bcentral%2Bbanks%2Bpivoting%2Bback%2Bto%2Ban%2Beasier%2Bstance.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
And when central banks flip-flop, so do markets. With interest rate vol at record lows now in Europe, this means a green light for carry trades and a return of the thirst for yield.</blockquote>
<blockquote class="tr_bq">
<b>Cash spreads can still squeeze…but watch out for March indigestion</b></blockquote>
<blockquote class="tr_bq">
In credit land, the Street looks particularly offside in this tightening move, reflective of low inventory levels. And with earnings blackout still in place, cash bonds could still squeeze tighter in the short term (especially non-financials). We think the real challenge for the credit market will emerge in March, given that supply is seasonally highest then (14% of yearly issuance). A €50bn+ month of supply, for instance, could herald a return of big new issue premiums and widening pressure on secondary spreads.</blockquote>
<blockquote class="tr_bq">
<b>Hubris 101– it never ends well</b></blockquote>
<blockquote class="tr_bq">
We’ve seen this central bank movie too many times in the past, though, to forget that markets always overshoot amid a yield grab. And that’s exactly what we worry about this time. After all, 30yr Bund yields at 72bp, 5y5y Euro inflation swaps at 1.48% (the lowest since Nov ’16) and rising BTP spreads signal the market’s doubt over the efficacy of another dose of monetary support, in our view.</blockquote>
<blockquote class="tr_bq">
Our concern is that Euro credit spreads are now increasingly dislocated from European economic data, and at best are pricing-in a Euro Area recovery that may take longer to materialise than the consensus thinks.</blockquote>
<blockquote class="tr_bq">
Chart 3 shows that European high-yield spreads have closely tracked the Eurozone manufacturing PMI New Orders index over the last 20yrs (72% correlation of levels, since mid-98). </blockquote>
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<a href="https://1.bp.blogspot.com/-gMvfsDY2lns/XGLS6EqjiEI/AAAAAAAAVX4/bCqzEgYV0j8vguJgwKqlUZ3A97v1vOZrACLcBGAs/s1600/BAML%2B-%2BSpreads%2Bovervalued%2Bfor%2Bweakening%2BEZ%2Bdata.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="265" data-original-width="391" height="216" src="https://1.bp.blogspot.com/-gMvfsDY2lns/XGLS6EqjiEI/AAAAAAAAVX4/bCqzEgYV0j8vguJgwKqlUZ3A97v1vOZrACLcBGAs/s320/BAML%2B-%2BSpreads%2Bovervalued%2Bfor%2Bweakening%2BEZ%2Bdata.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
New Order indices are a more forward-looking, and relevant, indicator in our view. But note that this index is still falling and is now far below the 50 recessionary threshold (47.8). Yet, with the market having rallied strongly year-to-date, our regressions point to Euro high-grade spreads being roughly 20bp too tight, and Euro high-yield spreads a more concerning ~200bp too tight.</blockquote>
<blockquote class="tr_bq">
<b>China…China…China!</b></blockquote>
<blockquote class="tr_bq">
Credit spreads are likely discounting a revival in the Eurozone cycle. Our economists expect Euro Area data to begin rebounding as we approach 2H ‘19. But the point is we’re not there yet…and the data flow thus far – especially industrial production – suggests that the Euro Area rebound may, if anything, take longer to materialize.</blockquote>
<blockquote class="tr_bq">
As an open economy, the Eurozone needs a thriving global economy to grow strongly. Germany, in particular, is exposed to non-European export markets. And given how Germany is integrated into other European countries’ supply chains, German weakness means a broader spill-over to Eurozone growth. But the external environment has been very unfriendly to Germany of late. Chart 4 shows how non-Euro Area trade has faded, with trade wars and China’s slowdown being culprits. </blockquote>
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<a href="https://2.bp.blogspot.com/-7oY2rAfu3WU/XGLTTdSNa8I/AAAAAAAAVYE/I1S-kS4Za8o8JRwsN6OOVeVuDk1r3j23QCLcBGAs/s1600/BAML%2B-%2BEurozone%2BYoY%2Bexport%2Bgrowth%2Band%2Bcontributions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="268" data-original-width="391" height="219" src="https://2.bp.blogspot.com/-7oY2rAfu3WU/XGLTTdSNa8I/AAAAAAAAVYE/I1S-kS4Za8o8JRwsN6OOVeVuDk1r3j23QCLcBGAs/s320/BAML%2B-%2BEurozone%2BYoY%2Bexport%2Bgrowth%2Band%2Bcontributions.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
Weaker non-EZ trade means less of a buffer for the Eurozone to counter rising political uncertainties.</blockquote>
<blockquote class="tr_bq">
That means Euro credit markets need to see two things pretty soon to justify today’s spreads: firstly a US-China trade “agreement”, and secondly signs that China’s stimulatory efforts are finally paying dividends (and supporting broader Asian growth).<br /><ul>
<li>While a US-China trade compromise is our base case, it’s not yet clear whether the US administration has moved on from their concerns over European car imports. On this front, investors should keep an eye on the US Department of Commerce’s Section 232 report on the national security threat of motor vehicle and auto part imports. Bad news here would weigh further on global trade volumes to the detriment of the Eurozone.</li>
<li>While China has engaged in a number of stimulatory measures lately (RRR cuts, tax cuts for small businesses and a perpetual bond-for-bill swap), credit growth dynamics have yet to materially rise. Chart 5 shows that the ratio of China Total Social Financing to China M2 remains subdued, for instance. </li>
</ul>
</blockquote>
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<a href="https://3.bp.blogspot.com/-uVtPiM5K6EY/XGLUXHndPaI/AAAAAAAAVYQ/VgOX7QzMBFgyn3XiyJOBpQbkj0VdPuBQwCLcBGAs/s1600/BAML%2B-%2BChina%2Btotal%2Bsocial%2Bfinancing%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="293" data-original-width="394" height="237" src="https://3.bp.blogspot.com/-uVtPiM5K6EY/XGLUXHndPaI/AAAAAAAAVYQ/VgOX7QzMBFgyn3XiyJOBpQbkj0VdPuBQwCLcBGAs/s320/BAML%2B-%2BChina%2Btotal%2Bsocial%2Bfinancing%2B2019.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
<ul>
<li>And importantly, while US and Euro credit markets have seen a material tightening in 2019, (high-grade) credit spreads in China remain elevated.</li>
</ul>
</blockquote>
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<a href="https://1.bp.blogspot.com/-vPLUuYW2_AU/XGLUaXWHXnI/AAAAAAAAVYU/YA2k_x1l5IkCb-vy0ncYKdiGTv4b6FLBgCLcBGAs/s1600/BAML%2B-%2BChina%2Bcredit%2Bspreads%2Bstill%2Bwidening.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><b><img border="0" data-original-height="293" data-original-width="391" height="239" src="https://1.bp.blogspot.com/-vPLUuYW2_AU/XGLUaXWHXnI/AAAAAAAAVYU/YA2k_x1l5IkCb-vy0ncYKdiGTv4b6FLBgCLcBGAs/s320/BAML%2B-%2BChina%2Bcredit%2Bspreads%2Bstill%2Bwidening.jpg" width="320" /></b></a></div>
<blockquote class="tr_bq">
<b>QE Infinity, and the real meaning of “pushing on a string”</b></blockquote>
<blockquote class="tr_bq">
The dovish leanings of policy makers this year have been manna for financial markets. For over a decade, central banks have been able to cajole asset prices higher with their repeated interventions. In fact, Chart 7 shows how effective the ECB has been since 2009 in propping up sentiment: growth in the ECB’s balance sheet has always been enough to counter spikes in European policy uncertainty.</blockquote>
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<a href="https://3.bp.blogspot.com/-buURN0AJJ2w/XGLVZOUvb4I/AAAAAAAAVYk/Aey0nN-qszoSDeJUUepKWBN-exvEyObiACLcBGAs/s1600/BAML%2B-%2BECB%2Bintervention%2Bhas%2Balways%2Bbeen%2Benough.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="332" data-original-width="391" height="271" src="https://3.bp.blogspot.com/-buURN0AJJ2w/XGLVZOUvb4I/AAAAAAAAVYk/Aey0nN-qszoSDeJUUepKWBN-exvEyObiACLcBGAs/s320/BAML%2B-%2BECB%2Bintervention%2Bhas%2Balways%2Bbeen%2Benough.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
But after ~$11tr. in central bank balance sheet growth since The Global Financial Crisis (GFC) (using the “big 4”), the limits of monetary policy are being reached. Central banks have much less capacity to effect economic change this time around. </blockquote>
<blockquote class="tr_bq">
Chart 8, for instance, shows where interest rates would be if central banks repeated their post-Lehman easing cycle, from today. </blockquote>
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<a href="https://3.bp.blogspot.com/-lOeJPhcv02w/XGLVlDULjBI/AAAAAAAAVYo/k27cs0ORDdwJtqpnkCidwe-r6FblRLVIQCLcBGAs/s1600/BAML%2B-%2BWhere%2Bwould%2Binterest%2Bbe.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="329" data-original-width="391" height="269" src="https://3.bp.blogspot.com/-lOeJPhcv02w/XGLVlDULjBI/AAAAAAAAVYo/k27cs0ORDdwJtqpnkCidwe-r6FblRLVIQCLcBGAs/s320/BAML%2B-%2BWhere%2Bwould%2Binterest%2Bbe.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
Understandably, some of the numbers would be far out of the realms of possibility. Hungarian interest rates, for instance, would drop to -10%, Eurozone deposit rates would fall to -4% and US interest rates would be heavily in negative territory (-2.5%).</blockquote>
<blockquote class="tr_bq">
Moreover, as the expression “pushing on a string” reflects, successive rounds of stimulus over the last decade look to have produced incrementally less economic growth, we think.</blockquote>
<blockquote class="tr_bq">
In Chart 9, we show what has happened historically to (1) global GDP momentum; and (2) global debt-to-GDP levels, in periods when global central bank balance sheets have expanded notably. Since 2006, we find five such periods.</blockquote>
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<a href="https://4.bp.blogspot.com/-KsRM4Xkm6OE/XGLVwhKESXI/AAAAAAAAVYw/jarj9t0_3SIOc_SUs9N7yJXizI-xLYcaACLcBGAs/s1600/BAML%2B-%2BPushing%2Bon%2Ba%2Bstring.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="346" data-original-width="527" height="210" src="https://4.bp.blogspot.com/-KsRM4Xkm6OE/XGLVwhKESXI/AAAAAAAAVYw/jarj9t0_3SIOc_SUs9N7yJXizI-xLYcaACLcBGAs/s320/BAML%2B-%2BPushing%2Bon%2Ba%2Bstring.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
Since then, however, periods of central bank balance sheet expansion look to have produced a much weaker impulse to the global economy.</blockquote>
<blockquote class="tr_bq">
<ul>
<li>The second round of stimulus post-GFC (‘10/’11) was followed by a decline (-0.9%) in the OECD Lead Indicator, which was driven by strong deleveraging (-9pp in the global debt/GDP ratio),</li>
<li>And the short, but visible increase in global central bank balance sheets between late ’17 and early ’18 was not even enough to propel growth upwards: the OECD Global Lead Indicator fell by 0.3% over the following 12m.</li>
</ul>
</blockquote>
<blockquote class="tr_bq">
<span style="color: red;">In summary, we caution that markets should not get carried away by central banks’ newfound dovishness</span>. After so much support already, and with $58tr. of global debt being added since the GFC, recreating the impact of past support now looks much tougher for central banks." - source Bank of America Merrill Lynch</blockquote>
We agree with Bank of America Merrill Lynch, "carry on" but do not get "carried away". If financial conditions will gradually continue to tighten as per the latest SLOOs, there is more potential for "Cryoseism". No matter how much liquidity has been injected by central banks, the massive issuance in credit markets in recent years have led to the illusion of "liquidity". For this illusion, you just have to check the secondary market in credit markets to gauge its depth. The next quarterly SLOOs will be paramount as per our final chart below.<br />
<br />
<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Credit pinball - Same player shoots again?</span></li>
</ul>
Are we seeing yet another case à la second part of 2016 which saw a significant rally in credit markets and in particular in high beta US high yield thanks to the recovery in oil prices and a more dovish tone from central banks? One might wonder. Our final chart comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 8th of February entitled "Happy New Year, welcome back" and displays the SLOOs versus US Investment Grade corporate spread. Is this a similar situation to the early recession fears of 2016 or is this time different? We wonder:<br />
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<a href="https://3.bp.blogspot.com/-U7uyUE6mp18/XGLdti3YkWI/AAAAAAAAVZA/dBz3yns5SfY8AuoxbVGP2Nr7ji3E9ky3wCLcBGAs/s1600/BAML%2B-%2BSLOOs%2BC%2Band%2BI%2Bloan%2Bdemand%2Bvs%2BIG%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="377" data-original-width="530" height="227" src="https://3.bp.blogspot.com/-U7uyUE6mp18/XGLdti3YkWI/AAAAAAAAVZA/dBz3yns5SfY8AuoxbVGP2Nr7ji3E9ky3wCLcBGAs/s320/BAML%2B-%2BSLOOs%2BC%2Band%2BI%2Bloan%2Bdemand%2Bvs%2BIG%2Bspreads.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"<b>Lather, rinse, repeat</b></blockquote>
<blockquote class="tr_bq">
Back in late 2015/early 2016 US recession fears were overblown as investors extrapolated from weak manufacturing data a high recession risk. This exact same scenario played out late 2018/very early 2019 as markets forgot that the manufacturing sector is only 17% of the US economy and the remainder is strong (see: Fool me once, fool me twice). Back then the Fed’s senior loan officer survey showed in response a shift toward tightening lending standards. The same thing is understandably happening this time as the survey period for the fresh Fed survey was the last half of December, which represented the height of recession fears (Figure 7). Like back in 2016, as recession fears are proven wrong, this will pass and banks will once again go through a period of loosening lending standards well before the next downturn. For banks the problem is a lack of loan demand, as the cost of debt has increased materially. Absent recession that means banks will soon be back to loosening standards and undercutting yields in the corporate bond market in order to gain business." - source Bank of America Merrill Lynch</blockquote>
Earnings were decent but the outlook is deteriorating fast. Also financial conditions seems to be tightening, We have seen stabilization in fund flows but this rally is not on solid grounds particularly with weakening buy-backs as CFOs are urged to become more defensive by investors of their balance sheet. You have been warned. It is still capital preservation time. Carry on but don't get carried away...<br />
<br />
<blockquote class="tr_bq">
"Sometimes the early bird gets the worm, but sometimes the early bird gets frozen to death." - Myron Scholes</blockquote>
<br />
<span style="font-family: inherit;">Stay tuned ! </span></div>
</div>
</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-56242025824119171612019-01-30T23:25:00.001+00:002019-01-30T23:25:26.781+00:00Macro and Credit - The Zeigarnik effect<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"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</blockquote>
<br />
<div style="text-align: justify;">
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...</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<br /></div>
<div>
<div style="background-color: white; line-height: 20.8px; text-align: justify;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - R is for "recession" and D is for "deleveraging". </b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final charts - Central banks to markets: let's be friends again...</b></i></span></li>
</ul>
</div>
<div style="text-align: justify;">
<br /></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - R is for "recession" and D is for "deleveraging". </li>
</ul>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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:</div>
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<a href="https://3.bp.blogspot.com/-sPhrR7dLSto/XFHvudpD9WI/AAAAAAAAVTw/yNvhmigTvQYPkTLjrCVJVvApimAxBXmegCLcBGAs/s1600/BBG%2B-%2BFrance%2BPMI%2Bservices%2BJanuary%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1221" data-original-width="1535" height="254" src="https://3.bp.blogspot.com/-sPhrR7dLSto/XFHvudpD9WI/AAAAAAAAVTw/yNvhmigTvQYPkTLjrCVJVvApimAxBXmegCLcBGAs/s320/BBG%2B-%2BFrance%2BPMI%2Bservices%2BJanuary%2B2019.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Bloomberg</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is what we had to say about France in our last conversation about France:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"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</blockquote>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
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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":</div>
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"<b>The (soft) floor on credit fundamentals</b></blockquote>
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<span style="color: red;">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</span>. 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).</blockquote>
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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). </blockquote>
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<a href="https://1.bp.blogspot.com/-dmO_TYBI2F4/XFILVE0iSEI/AAAAAAAAVUA/0djoEVSJOBgogNBSnrPt0LGIsuxloqsBwCLcBGAs/s1600/BAML%2B-%2BTelcos%2Bhas%2Boutperformed%2Bsince%2BATT%2Bdowngrade.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="373" data-original-width="529" height="225" src="https://1.bp.blogspot.com/-dmO_TYBI2F4/XFILVE0iSEI/AAAAAAAAVUA/0djoEVSJOBgogNBSnrPt0LGIsuxloqsBwCLcBGAs/s320/BAML%2B-%2BTelcos%2Bhas%2Boutperformed%2Bsince%2BATT%2Bdowngrade.jpg" width="320" /></a></div>
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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</blockquote>
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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.</div>
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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:</div>
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"<b>Credit Strategy/Equity Strategy: Who are the refi “losers”?</b></blockquote>
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<b>From the era of hubris… to the reality check</b></blockquote>
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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.</blockquote>
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<b>A walk into the future - who are the refinancing "losers"?</b></blockquote>
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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.</blockquote>
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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.</blockquote>
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<b>The canary in the credit mine for stocks</b></blockquote>
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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.</blockquote>
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<b>Defend the debt…not the dividend</b></blockquote>
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<span style="color: red;">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. </span>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.</blockquote>
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<b>Who are the refi "winners" still?</b></blockquote>
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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.</blockquote>
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- source Bank of America Merrill Lynch.</blockquote>
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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.</div>
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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?":</div>
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- source Barclays</div>
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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":</div>
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"<b>Canary in the credit mine for stocks</b></blockquote>
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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).</blockquote>
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<a href="https://3.bp.blogspot.com/-8wnjgc-UAeI/XFIULRgDtZI/AAAAAAAAVUk/HXraC3APKLcwlwyOcq65dP8TVgWX2YgMgCLcBGAs/s1600/BAML%2B-%2BRise%2Bin%2Binterest%2Bexpense%2Bcould%2Bpressure%2BEuropean%2Bearnings.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="309" data-original-width="389" height="254" src="https://3.bp.blogspot.com/-8wnjgc-UAeI/XFIULRgDtZI/AAAAAAAAVUk/HXraC3APKLcwlwyOcq65dP8TVgWX2YgMgCLcBGAs/s320/BAML%2B-%2BRise%2Bin%2Binterest%2Bexpense%2Bcould%2Bpressure%2BEuropean%2Bearnings.jpg" width="320" /></a></div>
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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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
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Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).</blockquote>
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<a href="https://1.bp.blogspot.com/-HU4lmG_uRDs/XFIU3MxWniI/AAAAAAAAVU8/4lU69VnNa4c7OMAAYCxTPUal7vp03oeCQCLcBGAs/s1600/BAML%2B-%2BCorporate%2Bleverage%2Bis%2Bthe%2Bchief%2Bconcerns%2Bamongst%2BFund%2BManager%2BSurvey%2BInvestors.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="294" data-original-width="394" height="238" src="https://1.bp.blogspot.com/-HU4lmG_uRDs/XFIU3MxWniI/AAAAAAAAVU8/4lU69VnNa4c7OMAAYCxTPUal7vp03oeCQCLcBGAs/s320/BAML%2B-%2BCorporate%2Bleverage%2Bis%2Bthe%2Bchief%2Bconcerns%2Bamongst%2BFund%2BManager%2BSurvey%2BInvestors.jpg" width="320" /></a></div>
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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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors.</span> 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).</blockquote>
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<b>The credit market-equity market nexus</b></blockquote>
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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</blockquote>
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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. </div>
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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. </div>
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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":</div>
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"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). </blockquote>
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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. </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
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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.</div>
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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":</div>
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"<b>High grades to IG</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
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. </blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
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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. </div>
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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".</div>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - Central banks to markets: let's be friends again...</span></li>
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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":</div>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>All indicators point to weak global growth, and suggest EASING monetary policy</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
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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...</div>
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<blockquote class="tr_bq" style="text-align: justify;">
"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.</blockquote>
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Stay tuned!</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-58200344070286699542019-01-19T19:53:00.001+00:002019-01-19T19:53:07.117+00:00Macro and Credit - Alprazolam<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman</blockquote>
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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...</div>
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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".</div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - Does A for attrition equate R for recession?</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final charts - Mind the liquidity shock...</b></i></span></li>
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<b><i><br /></i></b></div>
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - Does A for attrition equate R for recession?</li>
</ul>
<div style="text-align: justify;">
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. </div>
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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. </div>
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In our conversation "<a href="http://macronomy.blogspot.be/2012/06/credit-european-crisis-greatest-show-on.html">The European crisis: The Greatest Show on Earth</a>", we indicated:</div>
<blockquote class="tr_bq" style="text-align: justify;">
<em>"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."</em></blockquote>
In the <a href="https://www.afte.com/sites/default/files/documents/2019-01-COE-AFTE.pdf">AFTE latest survey</a>, there is now a clear trend in the deterioration in their operating cash situation showing up:<br />
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<a href="https://4.bp.blogspot.com/-PExY6AOrZhc/XENMiiWriFI/AAAAAAAAVRc/CpQMywpOVKk1BRtuYjoDAUxo55Fc0a9JQCLcBGAs/s1600/AFTE%2B-%2Bevolution%2Bof%2Bcash%2Bposition%2BJanuary%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="367" data-original-width="398" height="295" src="https://4.bp.blogspot.com/-PExY6AOrZhc/XENMiiWriFI/AAAAAAAAVRc/CpQMywpOVKk1BRtuYjoDAUxo55Fc0a9JQCLcBGAs/s320/AFTE%2B-%2Bevolution%2Bof%2Bcash%2Bposition%2BJanuary%2B2019.jpg" width="320" /></a></div>
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- source AFTE</div>
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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).</div>
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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":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Attrition bites in Europe</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
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<a href="https://1.bp.blogspot.com/-GyDMnq_43Fk/XENOUvlU38I/AAAAAAAAVRo/7bEmAZ0V7s0hNF1ctvo9fQczUV19GhEuQCLcBGAs/s1600/BAML%2B-%2Bestimated%2Bnumbers%2Bof%2Bdemonstrators%2Bin%2BFrance.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="290" data-original-width="373" height="248" src="https://1.bp.blogspot.com/-GyDMnq_43Fk/XENOUvlU38I/AAAAAAAAVRo/7bEmAZ0V7s0hNF1ctvo9fQczUV19GhEuQCLcBGAs/s320/BAML%2B-%2Bestimated%2Bnumbers%2Bof%2Bdemonstrators%2Bin%2BFrance.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
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).</blockquote>
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<a href="https://4.bp.blogspot.com/-qjDO3acdvXA/XENOhl20qbI/AAAAAAAAVRs/Z7VvO-V9d6sS6L4JFPgxuGULhPP_7jTjgCLcBGAs/s1600/BAML%2B-%2BConsume%2Bconfidence.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="298" data-original-width="381" height="250" src="https://4.bp.blogspot.com/-qjDO3acdvXA/XENOhl20qbI/AAAAAAAAVRs/Z7VvO-V9d6sS6L4JFPgxuGULhPP_7jTjgCLcBGAs/s320/BAML%2B-%2BConsume%2Bconfidence.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
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. <span style="color: red;">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 </span>(Chart 8). </blockquote>
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<a href="https://4.bp.blogspot.com/-amiXpucldt8/XENO-cw6SUI/AAAAAAAAVR4/4rtEOhTNiP0yXTPybLD46PMPAljVU44hQCLcBGAs/s1600/BAML%2B-%2BThe%2Bnumber%2Bof%2Bthe%2BEurozone%2Bbig%2Bfour%2Bwhose%2Bmanufacturing%2Bnew%2Borders%2Bare%2Bbelow%2B50.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="300" data-original-width="508" height="188" src="https://4.bp.blogspot.com/-amiXpucldt8/XENO-cw6SUI/AAAAAAAAVR4/4rtEOhTNiP0yXTPybLD46PMPAljVU44hQCLcBGAs/s320/BAML%2B-%2BThe%2Bnumber%2Bof%2Bthe%2BEurozone%2Bbig%2Bfour%2Bwhose%2Bmanufacturing%2Bnew%2Borders%2Bare%2Bbelow%2B50.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
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 "<a href="http://macronomy.blogspot.com/2019/01/macro-and-credit-respite.html">Respite</a>",<br />
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<blockquote class="tr_bq" style="text-align: justify;">
"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. </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="text-align: justify;">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". </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="text-align: justify;">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</span></blockquote>
<div style="text-align: justify;">
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.</div>
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<div style="text-align: justify;">
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:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Light positioning and known-unknowns</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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 <span style="color: red;">we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown</span>. 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. <span style="color: red;">We feel this rally will not last, and thus we would use this bounce higher to reduce risk</span>.</blockquote>
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<a href="https://3.bp.blogspot.com/-kt3_Z8CT0xw/XENUtWamK6I/AAAAAAAAVSE/EarBcHPk4mArmK8jWl8IgAgNmiY5yKejwCLcBGAs/s1600/BAML%2B-%2BLatest%2Bmonthly%2Bdata%2Bconfirm%2Bthat%2Bthe%2Blast%2Byear%2Bwas%2Bthe%2Bworst%2Bever%2Bfor%2Brisk%2Bassets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="269" data-original-width="518" height="166" src="https://3.bp.blogspot.com/-kt3_Z8CT0xw/XENUtWamK6I/AAAAAAAAVSE/EarBcHPk4mArmK8jWl8IgAgNmiY5yKejwCLcBGAs/s320/BAML%2B-%2BLatest%2Bmonthly%2Bdata%2Bconfirm%2Bthat%2Bthe%2Blast%2Byear%2Bwas%2Bthe%2Bworst%2Bever%2Bfor%2Brisk%2Bassets.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>High grade</b> 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. <b>High yield </b>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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Government bond</b> funds recorded a small outflow this week. Meanwhile, <b>Money </b><b>Market </b>funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>European equity funds</b> recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Global EM debt</b> 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
On the <b>duration </b>front, <b>short-term</b> IG funds led the negative trend by far. <b>Mid-term</b> funds saw a small outflow while <b>long-term</b> funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
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.</div>
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<div style="text-align: justify;">
Moving back to the "attrition game" and <span style="text-align: justify;">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:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Shutdown raises trade war risk</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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. <span style="color: red;">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</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
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<a href="https://1.bp.blogspot.com/-OxvcZ1deEUM/XENW5AWQWVI/AAAAAAAAVSU/UV29q3cB7Zs5H9xt_NHzkiLhYDx7HjSTwCLcBGAs/s1600/BAML%2B-%2BCredit%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="288" data-original-width="389" height="236" src="https://1.bp.blogspot.com/-OxvcZ1deEUM/XENW5AWQWVI/AAAAAAAAVSU/UV29q3cB7Zs5H9xt_NHzkiLhYDx7HjSTwCLcBGAs/s320/BAML%2B-%2BCredit%2BGrowth.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://3.bp.blogspot.com/-zuBnw-SXeuk/XENXHGLwPaI/AAAAAAAAVSY/8X1RSBcsL54byuMLlT2RwEWx4-chaPPAgCLcBGAs/s1600/BAML%2B-%2BUSD-CNY%2Band%2BUS%2BChina%2Binterest%2Brate%2Bdifferential.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="270" data-original-width="523" height="165" src="https://3.bp.blogspot.com/-zuBnw-SXeuk/XENXHGLwPaI/AAAAAAAAVSY/8X1RSBcsL54byuMLlT2RwEWx4-chaPPAgCLcBGAs/s320/BAML%2B-%2BUSD-CNY%2Band%2BUS%2BChina%2Binterest%2Brate%2Bdifferential.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
<div style="text-align: justify;">
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.</div>
<br />
Bank of America Merrill Lynch added the following in their report:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Market implications</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Developments over the past two months suggest to us that political risks are rising.<br />This puts us at odds with current market consensus.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>The USD is vulnerable.</b> 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>EM rally won’t last forever</b>. 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>US rates vol looks cheap.</b> Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9). </blockquote>
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<a href="https://4.bp.blogspot.com/-eXNSAqLfxyE/XENaLpaMzoI/AAAAAAAAVSk/M08M-OfgZCQTeQHKafz2uKCpo6qaTOeewCLcBGAs/s1600/BAML%2B-%2BUS%2Bswaption%2Bvol.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="292" data-original-width="521" height="179" src="https://4.bp.blogspot.com/-eXNSAqLfxyE/XENaLpaMzoI/AAAAAAAAVSk/M08M-OfgZCQTeQHKafz2uKCpo6qaTOeewCLcBGAs/s320/BAML%2B-%2BUS%2Bswaption%2Bvol.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Low-risk yields appear compelling in this macro setup</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Among such new developments, we counted the following:</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>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.</li>
<li>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.</li>
<li>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.</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
On the other side of the ledger, the following reasons support continued caution:<br /><ul>
<li>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.</li>
<li>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.</li>
</ul>
</blockquote>
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<br />
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). <span style="color: red;">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</span>. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.</li>
</ul>
</blockquote>
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<a href="https://4.bp.blogspot.com/-m_v4NUzpgGs/XENjaX2D3qI/AAAAAAAAVS8/FJN941Ic5NYk_i40PdG84q_KYJX7w8rDACLcBGAs/s1600/BAML%2B-%2BBBs%2Bare%2Btrading%2Bonly%2B100bps%2Bback%2Bof%2BBBBs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="291" data-original-width="383" height="243" src="https://4.bp.blogspot.com/-m_v4NUzpgGs/XENjaX2D3qI/AAAAAAAAVS8/FJN941Ic5NYk_i40PdG84q_KYJX7w8rDACLcBGAs/s320/BAML%2B-%2BBBs%2Bare%2Btrading%2Bonly%2B100bps%2Bback%2Bof%2BBBBs.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>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). <span style="color: red;">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</span>.</li>
</ul>
</blockquote>
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<a href="https://1.bp.blogspot.com/-ELxGr4PGBRc/XENj6qkk-ZI/AAAAAAAAVTE/jdEPeWYRevsxO4sX-_yJiLnhq1DLzfT0wCLcBGAs/s1600/BAML%2B-%2Bbut%2Bleft%2Billiquid%2Bpaper%2Bbehind%2Bmarked%2Bat%2Bdiscount%2Blevels.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="290" data-original-width="390" height="237" src="https://1.bp.blogspot.com/-ELxGr4PGBRc/XENj6qkk-ZI/AAAAAAAAVTE/jdEPeWYRevsxO4sX-_yJiLnhq1DLzfT0wCLcBGAs/s320/BAML%2B-%2Bbut%2Bleft%2Billiquid%2Bpaper%2Bbehind%2Bmarked%2Bat%2Bdiscount%2Blevels.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>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. <span style="color: red;">Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns</span>. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.</li>
<li>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).</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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. <span style="color: red;">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</span>; 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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%.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">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</span>. 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
So <span style="color: red;">we are probably entering a period of time when cash is becoming king again</span>. 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</blockquote>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - Mind the liquidity shock...</span></li>
</ul>
<div style="text-align: justify;">
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:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Macro data continue to disappoint; we remain cautious</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
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<blockquote class="tr_bq" style="text-align: justify;">
<b>It feels like 2015-16</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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. <span style="color: red;">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</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Gap risks and basis</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">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.</span> 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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
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<a href="https://2.bp.blogspot.com/-VQuvMVeScJ0/XEN17AGmtRI/AAAAAAAAVTc/R3WrmAGgpCI1AykL8QS457SdRbEuOTvIwCLcBGAs/s1600/BAML%2B-%2BLatest%2BOECD%2Bdata%2Bpoint%2Bto%2Ba%2Bweaker%2Bmacro%2Bbackdrop.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="292" data-original-width="521" height="179" src="https://2.bp.blogspot.com/-VQuvMVeScJ0/XEN17AGmtRI/AAAAAAAAVTc/R3WrmAGgpCI1AykL8QS457SdRbEuOTvIwCLcBGAs/s320/BAML%2B-%2BLatest%2BOECD%2Bdata%2Bpoint%2Bto%2Ba%2Bweaker%2Bmacro%2Bbackdrop.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. <span style="color: red;">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</span>. 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.</blockquote>
<div style="text-align: justify;">
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...</div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop</blockquote>
<div style="text-align: justify;">
<span style="text-align: left;">Stay tuned !</span></div>
</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-19931802851105588132019-01-13T13:58:00.002+00:002019-01-13T13:58:37.703+00:00Macro and Credit - Respite<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"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</blockquote>
<div style="text-align: justify;">
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...</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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?</div>
<div>
<div style="background-color: white; line-height: 20.8px; text-align: justify;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - Bad News is the new Good News...</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final charts - Macro matters again...</b></i></span></li>
</ul>
</div>
<br />
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - Bad News is the new Good News...</li>
</ul>
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:<br />
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<a href="https://2.bp.blogspot.com/-ZWpOAF_yOIs/XDoIyZCiJdI/AAAAAAAAVPE/Cls2UjcniXE6ErLbUNTCYskv7GKrYjmAQCLcBGAs/s1600/BBG%2B-%2BEurope%2BGloomy%2Boutlook.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="348" data-original-width="620" height="179" src="https://2.bp.blogspot.com/-ZWpOAF_yOIs/XDoIyZCiJdI/AAAAAAAAVPE/Cls2UjcniXE6ErLbUNTCYskv7GKrYjmAQCLcBGAs/s320/BBG%2B-%2BEurope%2BGloomy%2Boutlook.jpg" width="320" /></a></div>
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- Graph source Bloomberg</div>
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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":</div>
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"<b>December PMIs: closer to 50, but risks still to the downside</b></blockquote>
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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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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). </blockquote>
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<a href="https://4.bp.blogspot.com/-Jnzau5P8a18/XDoTzQUsE3I/AAAAAAAAVPQ/ttHhlVsbdE4iV5wUBCQ-aCUeL6OF8-buwCLcBGAs/s1600/BAML%2B-%2BEuro%2Barea%2BPMIs%2Bfollow%2Bglobal%2BPMIs%2Bwith%2Ba%2Blag.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="296" data-original-width="381" height="248" src="https://4.bp.blogspot.com/-Jnzau5P8a18/XDoTzQUsE3I/AAAAAAAAVPQ/ttHhlVsbdE4iV5wUBCQ-aCUeL6OF8-buwCLcBGAs/s320/BAML%2B-%2BEuro%2Barea%2BPMIs%2Bfollow%2Bglobal%2BPMIs%2Bwith%2Ba%2Blag.jpg" width="320" /></a></div>
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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).</blockquote>
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<a href="https://1.bp.blogspot.com/-jtlhH1u2-Ts/XDoT2x6W2QI/AAAAAAAAVPU/WmXVnOiCoBIhT1S9YQsm2qF4lO6l0Zj-ACLcBGAs/s1600/BAML%2B-%2BPMI%2B-%2BImplied%2Bmargins.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="293" data-original-width="376" height="249" src="https://1.bp.blogspot.com/-jtlhH1u2-Ts/XDoT2x6W2QI/AAAAAAAAVPU/WmXVnOiCoBIhT1S9YQsm2qF4lO6l0Zj-ACLcBGAs/s320/BAML%2B-%2BPMI%2B-%2BImplied%2Bmargins.jpg" width="320" /></a></div>
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- source Bank of America Merrill Lynch</div>
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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.</div>
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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. </div>
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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:</div>
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"<b>Intensity of risk rally reaches historical records</b></blockquote>
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An incredibly strong rally in credit has taken HY spreads down to 450bps from 540bps levels reached in early January. <span style="color: red;">HYG has rallied 5.4% from its low prints around Christmas, the strongest such 10-day rally since Oct 2011</span> (post-US downgrade rebound) and March 2009 (post-GFC recovery). <span style="color: red;">CCCs have outperformed BBs by 230bps in this move, and Energy was the strongest sector contributor</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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. <span style="color: red;">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</span>.</blockquote>
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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.</blockquote>
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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.</blockquote>
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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. <span style="color: red;">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</span>.</blockquote>
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<span style="color: red;">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.</span> 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. <span style="color: red;">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</span>. 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</blockquote>
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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. </div>
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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?":</div>
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"<b>Some signs of relief</b></blockquote>
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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.</blockquote>
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<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>High grade</b> 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. <b>High yield </b>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.</blockquote>
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<b>Government bond</b> funds recorded a large inflow this week, the largest in 27 weeks and the 5th over the past 6 weeks. Meanwhile, <b>Money Market</b> funds recorded another sizable inflow. All in all, Fixed Income funds recorded an inflow, putting an end to 18 consecutive weeks of outflows.</blockquote>
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<b>European equity</b> 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</blockquote>
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<a href="https://4.bp.blogspot.com/-9HH58N6l7r8/XDoiL34PWaI/AAAAAAAAVPg/2Azd1Lde7FULpPMmYdDQEvt0hyVBIkZKQCLcBGAs/s1600/BAML%2B-%2BRisk%2Bassets%2Bfund%2Bflows%2Bmanaged%2Bto%2Brecord%2Ba%2Brebound%2Bin%2Bthe%2Bfirst%2Bweek%2Bof%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="288" data-original-width="512" height="180" src="https://4.bp.blogspot.com/-9HH58N6l7r8/XDoiL34PWaI/AAAAAAAAVPg/2Azd1Lde7FULpPMmYdDQEvt0hyVBIkZKQCLcBGAs/s320/BAML%2B-%2BRisk%2Bassets%2Bfund%2Bflows%2Bmanaged%2Bto%2Brecord%2Ba%2Brebound%2Bin%2Bthe%2Bfirst%2Bweek%2Bof%2B2019.jpg" width="320" /></a></div>
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<b>Global EM debt</b> 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. <b>Commodity </b>funds recorded another inflow, the 5th in a row.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
On the <b>duration </b>front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while <b>long-term</b> funds experienced a decent inflow." - source Bank of America Merrill Lynch.</blockquote>
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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.</div>
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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:</div>
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<a href="https://3.bp.blogspot.com/-yaOqPcZvtgo/XDonS6uh3FI/AAAAAAAAVPs/zYVmcu_MmjYNXUTQeWBaJRBDVwnttfkZQCLcBGAs/s1600/BBG%2B-%2BGrim%2Breaper%2Bon%2Bprofit%2Bcuts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="478" data-original-width="866" height="176" src="https://3.bp.blogspot.com/-yaOqPcZvtgo/XDonS6uh3FI/AAAAAAAAVPs/zYVmcu_MmjYNXUTQeWBaJRBDVwnttfkZQCLcBGAs/s320/BBG%2B-%2BGrim%2Breaper%2Bon%2Bprofit%2Bcuts.jpg" width="320" /></a></div>
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- graph source Bloomberg</div>
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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 "<a href="http://www.atimes.com/article/how-widespread-is-creeping-deflation-in-the-us-stock-market/">How widespread is creeping deflation in the US stock market?</a>":</div>
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"<b>Companies with challenged business models account for nearly two-thirds of the S&P 500's top 50 earners</b></blockquote>
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"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.</blockquote>
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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.</blockquote>
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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%).</blockquote>
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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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
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<a href="https://2.bp.blogspot.com/-ygTpCCZfB44/XDorwq3m4BI/AAAAAAAAVP4/6f_gowiDYcsh4fKBjNWedwdIeP3Ct99wgCLcBGAs/s1600/ATIMES%2B-%2BD%2BGoldman%2B-%2B50%2BTop%2BEarners%2Bin%2BSPX.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="879" data-original-width="1239" height="227" src="https://2.bp.blogspot.com/-ygTpCCZfB44/XDorwq3m4BI/AAAAAAAAVP4/6f_gowiDYcsh4fKBjNWedwdIeP3Ct99wgCLcBGAs/s320/ATIMES%2B-%2BD%2BGoldman%2B-%2B50%2BTop%2BEarners%2Bin%2BSPX.jpg" width="320" /></a></div>
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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.</blockquote>
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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.</blockquote>
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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.</blockquote>
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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.</blockquote>
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Taken together, companies with challenged business models generate nearly two-thirds of the earnings among the top 50 members of the S&P 500.</blockquote>
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- source Asia Times - David P. Goldman</div>
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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 "<a href="https://macronomy.blogspot.com/2018/10/macro-and-credit-armstrong-limit.html">The Armstrong limit</a>", we quoted as well another article from David P. Goldman and discussed the "profit illusion". </div>
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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:</div>
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"<b>Earnings downgrades = GDP downgrades</b></blockquote>
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<ul>
<li>Earnings estimates continue to be slashed, which suggest that further downward revisions to GDP growth are forthcoming.</li>
<li>While the direction of revisions is relevant, be careful relating actual earnings growth to economic performance.</li>
<li>After controlling for oil prices and the services share of the economy, economic and earnings growth become much less correlated.</li>
</ul>
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<b>Resetting expectations</b></blockquote>
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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</blockquote>
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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. </blockquote>
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<a href="https://4.bp.blogspot.com/-tnzyqNpxK_0/XDouqYlqTRI/AAAAAAAAVQM/pE6lClUG3IMTcW2urLU4SZGB48MctLLNwCLcBGAs/s1600/BAML%2B-%2BPositive%2Bcorrelation%2Bbetween%2BEPS%2Band%2Bnominal%2BGDP%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="309" data-original-width="371" height="266" src="https://4.bp.blogspot.com/-tnzyqNpxK_0/XDouqYlqTRI/AAAAAAAAVQM/pE6lClUG3IMTcW2urLU4SZGB48MctLLNwCLcBGAs/s320/BAML%2B-%2BPositive%2Bcorrelation%2Bbetween%2BEPS%2Band%2Bnominal%2BGDP%2Bgrowth.jpg" width="320" /></a></div>
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This means there is more to the story. We see three reasons that earnings will differ from US economic growth:</blockquote>
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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.<br />
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.<br />
3. The S&P 500 has a greater concentration of manufacturing</blockquote>
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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.</blockquote>
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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). </blockquote>
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<a href="https://1.bp.blogspot.com/-MXd3RHLhMMk/XDovmJHeHvI/AAAAAAAAVQY/LJDMCD6wNccN-imNuFNZOdNJ8Ui0mzykACLcBGAs/s1600/BAML%2B-%2BEPS%2Bgrowth%2Bis%2Bmuch%2Bmore%2Bvolatile%2Bthan%2BNominal%2BGDP%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="312" data-original-width="391" height="255" src="https://1.bp.blogspot.com/-MXd3RHLhMMk/XDovmJHeHvI/AAAAAAAAVQY/LJDMCD6wNccN-imNuFNZOdNJ8Ui0mzykACLcBGAs/s320/BAML%2B-%2BEPS%2Bgrowth%2Bis%2Bmuch%2Bmore%2Bvolatile%2Bthan%2BNominal%2BGDP%2Bgrowth.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>We revise together</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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, <span style="color: red;">the consensus forecast for earnings and GDP growth tend to be revised in tandem</span>. </blockquote>
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<a href="https://3.bp.blogspot.com/-XgGC3uznHQU/XDowEGr3auI/AAAAAAAAVQg/QRUs-HGjlMcklXHUX6JsrLYGyDvj8dwLQCLcBGAs/s1600/BAML%2B-%2BHistorical%2Brevisions%2Bto%2Bconsensus%2BEPS%2Band%2BGDP%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="266" data-original-width="526" height="161" src="https://3.bp.blogspot.com/-XgGC3uznHQU/XDowEGr3auI/AAAAAAAAVQg/QRUs-HGjlMcklXHUX6JsrLYGyDvj8dwLQCLcBGAs/s320/BAML%2B-%2BHistorical%2Brevisions%2Bto%2Bconsensus%2BEPS%2Band%2BGDP%2Bgrowth.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Collecting all data</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
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</blockquote>
<div style="text-align: justify;">
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.<br />
<br />
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - Macro matters again...</span></li>
</ul>
</div>
<div style="text-align: justify;">
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":<br />
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<a href="https://1.bp.blogspot.com/-6GPAE_5wcVI/XDs9inihPCI/AAAAAAAAVQs/KgT41SJKOsEINxXdlvaL8bIx2SPZPglbwCLcBGAs/s1600/BAML%2B-%2BTop%2B10%2Bfactors%2Bwith%2Bhighest%2Bexplanatory%2Bpower%2B-%2Bmacro%2Bfactors.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="368" data-original-width="387" height="303" src="https://1.bp.blogspot.com/-6GPAE_5wcVI/XDs9inihPCI/AAAAAAAAVQs/KgT41SJKOsEINxXdlvaL8bIx2SPZPglbwCLcBGAs/s320/BAML%2B-%2BTop%2B10%2Bfactors%2Bwith%2Bhighest%2Bexplanatory%2Bpower%2B-%2Bmacro%2Bfactors.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
<b>Macro mattered more than fundamentals in 2018</b></blockquote>
<blockquote class="tr_bq">
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).</blockquote>
<blockquote class="tr_bq">
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.<br />As for fundamental factors, one of the most explanatory factors on returns in both 2018 and 4Q was Beta.</blockquote>
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<div style="text-align: justify;">
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<a href="https://3.bp.blogspot.com/-aSrsrvCbY0E/XDs95_EK8jI/AAAAAAAAVQ0/57ESpx9-1UUhM238aojI7usp37tny_BQgCLcBGAs/s1600/BAML%2B-%2BMacro%2Bhas%2Bincreasingly%2Bmattered.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="431" data-original-width="835" height="165" src="https://3.bp.blogspot.com/-aSrsrvCbY0E/XDs95_EK8jI/AAAAAAAAVQ0/57ESpx9-1UUhM238aojI7usp37tny_BQgCLcBGAs/s320/BAML%2B-%2BMacro%2Bhas%2Bincreasingly%2Bmattered.jpg" width="320" /></a></div>
<br /></div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<b>Stocks less sensitive to macro (idiosyncratic stocks) have outperformed</b></blockquote>
</div>
<div style="text-align: justify;">
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-dEHw0s932DU/XDs_cf_er2I/AAAAAAAAVRA/a9su_BXaWFM_lT1PK79QJKsFupY25EpCACLcBGAs/s1600/BAML%2B-%2BIdiosyncratic%2Bstocks%2Boutperformed%2Bsystematic%2Bstocks%2Bduring%2Bthe%2Bfinancial%2Bcrisis%2Band%2Bover%2Bthe%2Blast%2Bfour%2Byears.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="383" data-original-width="391" height="313" src="https://1.bp.blogspot.com/-dEHw0s932DU/XDs_cf_er2I/AAAAAAAAVRA/a9su_BXaWFM_lT1PK79QJKsFupY25EpCACLcBGAs/s320/BAML%2B-%2BIdiosyncratic%2Bstocks%2Boutperformed%2Bsystematic%2Bstocks%2Bduring%2Bthe%2Bfinancial%2Bcrisis%2Band%2Bover%2Bthe%2Blast%2Bfour%2Byears.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
• 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.</blockquote>
<blockquote class="tr_bq">
• 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.</blockquote>
<blockquote class="tr_bq">
• 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.</blockquote>
</div>
<blockquote class="tr_bq" style="text-align: justify;">
<br />
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<a href="https://3.bp.blogspot.com/-T4om0dntpyA/XDtAc_rMAaI/AAAAAAAAVRM/Hc8xY9_V5WsBWwjYz8VpABsaCYplGafsQCLcBGAs/s1600/BAML%2B-%2BUncertainty%2Bover%2Btrade%2Bdrove%2Bmultiple%2Bcompression.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="415" data-original-width="386" height="320" src="https://3.bp.blogspot.com/-T4om0dntpyA/XDtAc_rMAaI/AAAAAAAAVRM/Hc8xY9_V5WsBWwjYz8VpABsaCYplGafsQCLcBGAs/s320/BAML%2B-%2BUncertainty%2Bover%2Btrade%2Bdrove%2Bmultiple%2Bcompression.jpg" width="297" /></a></div>
</blockquote>
<div style="text-align: center;">
- source Bank of America Merrill Lynch</div>
<br />
<div style="text-align: justify;">
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.</div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
"The only safe ship in a storm is leadership." - Faye Wattleton, sociologist</blockquote>
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Stay tuned ! </div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-60546431152211718882019-01-05T22:51:00.002+00:002019-01-08T12:44:11.265+00:00Macro and Credit - The Clemency of Titus<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Clemency is the noblest trait which can reveal a true monarch to the world." - Pierre Corneille</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Watching with interest France getting a onetime exemption for its swelling budget deficit for 2019 with France now expecting a budget deficit of 3.2% of GDP (it will be higher rest assured...), whereas Italy in recent days has offered to target a budget deficit of 2%, when it came to selecting our title analogy for our first post for 2019, we decided to go for a musical one, Mozart's 1791 opera entitled "The Clemency of Titus". </span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">In 1791, the last year of his life, Mozart was already well advanced in writing Die Zauberflöte by July when he was asked to compose an opera seria. The commission came from the impresario Domenico Guardasoni, who lived in Prague and who had been charged by the Estates of Bohemia with providing a new work to celebrate the coronation of Leopold II, Holy Roman Emperor, as King of Bohemia. The coronation had been planned by the Estates in order to ratify a political agreement between Leopold and the nobility of Bohemia (it had rescinded efforts of Leopold's brother Joseph II to initiate a program to free the serfs of Bohemia and increase the tax burden of aristocratic landholders). Leopold desired to pacify the Bohemian nobility in order to forestall revolt and strengthen his empire in the face of political challenges engendered by the French Revolution. No opera of Mozart was more clearly pressed into the service of a political agenda than "La clemenza di Tito" (The Clemency of Titus), in this case to promote the reactionary political and social policies of an aristocratic elite. No evidence exists to evaluate Mozart's attitude toward this, or even whether he was aware of the internal political conflicts raging in the kingdom of Bohemia in 1791. </span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">In similar fashion, we think that the European Commission's one off "clemency" in relation to France's budget deficit trajectory comes from a desire to "pacify" and "forestall" revolt and maintain the European "empire" in the face of upcoming European elections and political challenges. These challenges have been increasing at a rapid pace in 2018 with the rise of their nemesis aka "populism" but, we ramble again...</span><br />
<span style="font-family: inherit;"><br /></span>
<br />
<div style="background-color: white;">
<span style="font-family: inherit;">In this first post of the year, we would like to look at the continuation of "risk-off" and what it entails. We have been pretty clear about the need to reduce your high beta exposure credit wise in the light of additional weakness in oil prices affecting dearly the US High Yield CCC bucket. Also, we did advise you to raise your cash levels to start playing defense and we were lucky enough to spot the peak in US equities in our first October conversation "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-armstrong-limit.html">The Armstrong limit</a>". The rest, as we say, is history...But, as 2019 is already showing, volatility is very strong. </span><br />
<span style="font-family: inherit;"><br /></span></div>
<div style="background-color: white; text-align: left;">
<div style="line-height: 20.8px; text-align: justify;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - Looking for "safe havens"</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final chart - <span style="color: #333333;"> Confidence has taken a knock</span></span></b></i></li>
</ul>
</div>
</div>
<span style="font-family: inherit;"><br /></span>
<br />
<ul style="line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - Looking for "safe havens"</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: #333333;">As we pointed out in our November conversation "<a href="http://macronomy.blogspot.com/2018/11/macro-and-credit-zollverein.html">Zollverein</a>", </span><span style="background-color: white;">when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". </span><span style="text-align: left;"><span style="color: #333333;">The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index managed to lose 2.54% over the month of December, still managing to post a positive return of 0.44% whereas US High Yield was down 2.26% for the year, close to US Investment Grade losses at 2.25%. Flow wise, </span></span><span style="text-align: left;"><span style="color: #333333;">U.S. High Yield funds ended up a bloody 2018 with a $3.94 billion withdrawal for the week ending on December 26. The full-year outflow amounts to a cool $35.3 billion, according to Lipper weekly reporters.</span></span></span></div>
<div style="text-align: justify;">
<span style="text-align: left;"><span style="color: #333333; font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="background-color: white;">Back in September in our conversation "</span><a href="https://macronomy.blogspot.com/2018/09/macro-and-credit-korsakoff-syndrome.html" style="background-color: white;">The Korsakoff syndrome</a><span style="background-color: white;">", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "</span><a href="https://t.co/vDIt4c36b7" style="background-color: white;">Mutual Fund Flows and Fluctuations in Credit and Business Cycles</a><span style="background-color: white;">" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).</span><br style="background-color: white; color: #333333;" /><br style="background-color: white; color: #333333;" /><span style="color: black;"><a href="http://knowledge.wharton.upenn.edu/article/why-junk-bond-funds-can-be-an-early-economic-indicator/" style="background-color: white;">This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle</a><span style="background-color: white;">. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.</span></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white; color: #333333;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;">Why do we look at fund flows? There is as well another reason to our focus.</span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="background-color: white;">We like to look at fund flows from a total return perspective. This is a subject we also discussed in our January 2018 conversation</span><span style="background-color: white;"> "</span><a href="https://macronomy.blogspot.com/2018/01/macro-and-credit-lindemann-criterion.html" style="background-color: white;">The Lindemann criterion</a><span style="background-color: white;">":</span></span><br />
<blockquote class="tr_bq" style="background-color: white; line-height: 1.3em; margin: 1em 20px;">
<span style="font-family: inherit;">"<b>Fund flows have a tendency to </b><b>follow total returns</b></span></blockquote>
<blockquote class="tr_bq" style="background-color: white; line-height: 1.3em; margin: 1em 20px;">
<span style="font-family: inherit;"><span style="color: #333333;">Fund flows have a tendency to follow total returns, both on the way up and on the way down.</span><span style="color: #333333;"> </span><span style="color: red;">When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash</span><span style="color: #333333;">. </span><span style="color: #333333;">As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018</span></span></blockquote>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Of course, retail investors, being more feebler when it comes to their holding, no wonder they have been recently fleeing leveraged loans ETFs given the "liquidity" focus and attention it has been given by many pundits including former central bankers. As indicated by <a href="http://www.leveragedloan.com/us-leveraged-loan-funds-see-another-record-withdrawal/">LeveragedLoan.com</a> on the 1st of January, outflows in leveraged loans have been significant in recent weeks:</span></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-_y-cNyMUk0o/XC4ndOUVUeI/AAAAAAAAVLs/tZkSXi7J_mIUzByIOZWDUrAehdjmAXMbwCLcBGAs/s1600/Leveraged%2BLoan%2B-%2B.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="474" data-original-width="713" height="212" src="https://4.bp.blogspot.com/-_y-cNyMUk0o/XC4ndOUVUeI/AAAAAAAAVLs/tZkSXi7J_mIUzByIOZWDUrAehdjmAXMbwCLcBGAs/s320/Leveraged%2BLoan%2B-%2B.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
U.S loan funds saw yet another record outflow during the week ended Dec. 26, as retail investors withdrew $3.53 billion, according to Lipper weekly reporters.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
That’s the sixth straight substantial outflow, totaling a massive $13.5 billion, punctuating a staggering turnaround for the asset class. Before that withdrawal streak, U.S. loan funds and ETFs had seen some $10.3 billion of net inflows. For 2018, then, the final figure will be a net outflow of $3.1 billion, according to Lipper.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The most recent activity brings the four-week trailing average to a $2.6 billion outflow.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Loan funds accounted for $2.9 billion of this week’s outflow, while ETFs accounted for a $626 million outflow. The change due to market value was negative $746 million.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
With the withdrawal, loan fund assets have dropped to $90.7 billion, including $9.8 billion from ETFs, says Lipper. — Tim Cross" - source LeveragedLoans.com</blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">When the trend is not your friend...The pressure on funds has been relentless and outflows significant in various asset classes as indicated by Bank of America Merrill Lynch in there Follow The Flow report from the 28th of December entitled "</span><span style="text-align: left;">The worst year since the ’08 crisis":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"</span><b>Closing the worst year since ’08</b><span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Only a few days to go before the end of the year, and 2018 will be remembered as the worst year since 2008. Outflows dominated this year across high-yield, high-grade, equities and EM debt funds. The lack of yield across European fixed income assets and the lack of catalysts to reverse the outflows we have seen this year are painting a dim picture for 2019. With macro indicators continuing to point to more downside, we expect further widening in credit land. <span style="color: red;">We also expect further beta underperformance</span> amid challenging liquidity backdrop and rising idiosyncratic risks as the ECB QE is now over.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Over the past week…</b><span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<div style="text-align: justify;">
<b>High grade</b> funds suffered another outflow, making this one the 20th week of outflows over the past 21 weeks. <b>High yield</b> funds recorded another outflow, the 13th in a row. Looking into the domicile breakdown, US-focused funds led the outflow trend, while Euro and Global-focused funds were slightly less impacted.<span style="text-align: left;"> </span></div>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<div style="text-align: justify;">
<b style="font-weight: bold;">Government bond</b> funds recorded an inflow this week, the fourth in a row. Meanwhile<b>,</b></div>
<div style="text-align: justify;">
<b>Money Market</b> funds recorded another large outflow.<span style="text-align: left;"> </span></div>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<div style="text-align: justify;">
All in all, <b>Fixed Income</b> funds recorded another outflow, bringing this year’s outflow to</div>
<div style="text-align: justify;">
$102bn, a negative record for the asset class.<span style="text-align: left;"> </span></div>
</blockquote>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-OPVeW7Y4daU/XC4xLByWp-I/AAAAAAAAVL4/zx-zoy03EzA0IrwCQ74dwHcoNvdJkrJwQCLcBGAs/s1600/BAML%2B-%2Bfund%2Boutflows%2Bin%2BFixed%2BIncome.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="586" data-original-width="1058" height="177" src="https://4.bp.blogspot.com/-OPVeW7Y4daU/XC4xLByWp-I/AAAAAAAAVL4/zx-zoy03EzA0IrwCQ74dwHcoNvdJkrJwQCLcBGAs/s320/BAML%2B-%2Bfund%2Boutflows%2Bin%2BFixed%2BIncome.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<div style="text-align: justify;">
<b>European equity</b> funds also continued to record outflows, making this week the 16th</div>
<div style="text-align: justify;">
consecutive week of outflows. During the past 42 weeks, European equity funds</div>
<div style="text-align: justify;">
experienced 41 weeks of outflows.</div>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Global EM debt</b> recorded another large outflow this week, the 12th in a row.<br />
<b>Commodity</b> funds recorded another inflow.<span style="text-align: left;"> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
On the duration front, <b>short-term</b> and <b>mid-term</b> IG funds led the negative trend by far, while the <b>long-end</b> of the curve recorded another small inflow." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">We agree with Bank of America Merrill Lynch, cracks in credit markets have been significant and unless there is some stabilization, there will be additional pain inflicted to the high beta crowd hence the need to reach for quality.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">As well throughout 2018, we mentioned rising dispersion in credit markets with investors becoming more discerning when it comes to selecting issuer profiles. We also touched on the increasing trend in large standard deviation moves in various asset classes typical in the late stage of an extended credit cycle which has been plagued by years of repressed volatility thanks to central banks meddling.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">For instance, the latest Japanese yen's flash crash/rally highlighted how Mrs Watanabe aka Japanese retail investors, through Uridashi funds are still heavily invested in carry trades for extra yield such as the Turkish Lira, though in recent years they have drastically increased their allocation to the US dollar it seems as indicated by Bloomberg on the 3rd of January in their articled entitled "<a href="https://www.bloomberg.com/news/articles/2019-01-02/yen-surge-algos-set-off-flash-crash-moves-in-currency-market">Flash-Crash’ Moves Hit Currency Markets</a>":</span><br />
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<a href="https://1.bp.blogspot.com/-JSuJbxjkgCU/XC93VSDmYuI/AAAAAAAAVME/emxo2EG_D1sR2mxyMWJHM8Emhd8z26gMQCLcBGAs/s1600/BBG%2B-%2BDollar%2Byen%2BAsian%2BTrading%2BThursday.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="261" data-original-width="465" height="179" src="https://1.bp.blogspot.com/-JSuJbxjkgCU/XC93VSDmYuI/AAAAAAAAVME/emxo2EG_D1sR2mxyMWJHM8Emhd8z26gMQCLcBGAs/s320/BBG%2B-%2BDollar%2Byen%2BAsian%2BTrading%2BThursday.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"With Japan on a four-day holiday this week, traders said they struggled to handle a flood of sell orders with pricing erratic. Once the yen strengthened past 105.50 against the dollar, others were forced to cover their short yen positions, said traders who asked not to be identified as they aren’t permitted to speak publicly.</blockquote>
<blockquote class="tr_bq">
“It looks more like a liquidity event with the move happening in the gap between the New York handover to Asia,” said Damien Loh, chief investment officer of hedge fund Ensemble Capital Pte., in Singapore. “It was exacerbated by a Japan holiday and retail stops getting filled on the way down especially in yen crosses.”</blockquote>
<blockquote class="tr_bq">
As a result, the yen surged against every currency tracked by Bloomberg, and was up 1 percent against the dollar at 107.78 by 9:30 a.m. in London.</blockquote>
<blockquote class="tr_bq">
The haven asset has strengthened against all its major counterparts over the past 12 months as concerns over global economic growth mounted and stocks tumbled. It rose 2.7 percent against the dollar last year, the only G-10 currency to gain versus the greenback." - source Bloomberg</blockquote>
Given the intensity of the selling in December, with credit spread widening and gold surging as well in conjunction with the Japanese yen, no wonder investors are trigger happy when it comes to seeking refuge from the indiscriminate selling we have seen over the last quarter and in particular during the last month of the year.<br />
<br />
The search for safe havens is well described also in Bloomberg's article from the 3rd of January entitled "<a href="https://www.bloomberg.com/news/articles/2019-01-03/havens-are-back-baby-yen-gold-and-bonds-rediscover-their-mojo">In This Mess of a Market, Safe Havens Are Making a Comeback</a>":<br />
<span style="font-family: inherit;"></span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"</span>The remarkable thing about recent yen performance may not be its almost 4 percent surge against the dollar on Thursday, but the fact the currency just clocked its best month in about two years.</blockquote>
<blockquote class="tr_bq">
That exact statistic also applies to gold, which in December notched the largest jump since January 2017. Both assets have continued to climb this year. Meanwhile, bonds of G-7 governments had their best December in a decade, according to a Bank of America Merrill Lynch index.</blockquote>
<blockquote class="tr_bq">
Put simply, traditional havens are back.</blockquote>
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<a href="https://4.bp.blogspot.com/-YkN14T4zv_0/XC94-CC5U3I/AAAAAAAAVMQ/fIao61pTvFchuYnJ-zrx9OYQ6c5LgMD0gCLcBGAs/s1600/BBG%2B-%2BRelentless%2Byen.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="675" data-original-width="1200" height="180" src="https://4.bp.blogspot.com/-YkN14T4zv_0/XC94-CC5U3I/AAAAAAAAVMQ/fIao61pTvFchuYnJ-zrx9OYQ6c5LgMD0gCLcBGAs/s320/BBG%2B-%2BRelentless%2Byen.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
The same myriad of drivers bedeviling equity investors in 2019 is also sending them to safety. While the trade war is showing up in real-world data, it’s cropping up in company earnings too, as evidenced by Apple Inc.’s guidance cut on Wednesday. At the same time, Federal Reserve tightening is sapping liquidity and in the process reigniting volatility in markets. Idiosyncratic risks from the likes of Brexit and Italy’s budget squabble with the European Union are merely compounding the risk-off mood -- and adding fuel to the haven trade." - source Bloomberg</blockquote>
With earnings disappointment leading to more large standard deviations move in equities as indicated by Apple but by also Delta Airlines, with no real clear resolution as of yet in the trade war narrative between China and the United States, 2019 has started with even more volatility to say the least.<br />
<br />
No wonder as indicated by Bloomberg's article above that the shiny little metal aka "gold" has been seen as well as a "safe haven" in times of acute turmoil:<br />
<blockquote class="tr_bq">
"<b>Going for Gold</b></blockquote>
<blockquote class="tr_bq">
Sentiment toward gold also brightened in mid-October, when money managers abandoned their record net-short position against the metal as the outlook for the dollar deteriorated.</blockquote>
<blockquote class="tr_bq">
Since then, investors have piled into exchange-traded funds backed by bullion, which have amassed 126 tons of metal worth $5.2 billion in 60 sessions -- the biggest increase over a comparable period in more than 18 months.</blockquote>
<blockquote class="tr_bq">
A paring of expectations for rate hikes has also contributed to demand, as gold typically falls during periods of monetary tightening because it’s a non-interest bearing asset.</blockquote>
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<a href="https://1.bp.blogspot.com/-BQjk00wdWJ0/XC9_A6FOFUI/AAAAAAAAVMc/rWYymE6pKUYR1-soXlteBvC3g2BgHwvygCLcBGAs/s1600/BBG%2B-%2BSentiment%2Bshift%2B-%2BGold%2BETFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="675" data-original-width="1200" height="180" src="https://1.bp.blogspot.com/-BQjk00wdWJ0/XC9_A6FOFUI/AAAAAAAAVMc/rWYymE6pKUYR1-soXlteBvC3g2BgHwvygCLcBGAs/s320/BBG%2B-%2BSentiment%2Bshift%2B-%2BGold%2BETFs.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
“Gold is bid due to multiple headwinds” for the world economy, said Ole Hansen, the head of commodity strategy at Saxo Bank A/S by email. “Stocks, the dollar and bond yields are all down while the risk of further U.S. rate hikes has almost been removed.” - source Bloomberg</blockquote>
This is as all to do with investors looking at the flattening of the yield curve, weaker macro data and deceleration in global trade in conjunction with weaker earnings than expected and trying to figure out if the Fed will show some "Clemency" in similar fashion as Titus did in Mozart's opera.<br />
<br />
<div>
<span style="text-align: left;">We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "</span><a href="http://macronomy.blogspot.com/2014/01/credit-departed.html" style="text-align: left;">The Departed</a><span style="text-align: left;">", it has been working again nicely in December:</span></div>
<div>
<blockquote class="tr_bq">
<i>"<b>If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both.</b> <b><span style="color: red;">Buy put-call parity</span></b>,<b> if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up.</b>"</i></blockquote>
</div>
Of course given the uncertainty surrounding the number of hikes and additional tightening from the Fed with the acute weakness in US equities, no wonder some pundits have been resorting to this "put-call parity" strategy.<br />
<br />
Obviously, the sudden rise in US wages to 3.2% YoY in December, the fastest pace since April 2009 and with Nonfarm payrolls coming at 312K versus 177K expected, with a more dovish Fed on the wire as we type this very post, it seems that Fed chairman Jerome Powell has been listening to Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the <a href="https://www.wsj.com/articles/quantitative-tightening-not-now-11544991760">Wall Street Journal</a>, hence the strong rebound seen in equities markets today. Not only have we seen the return of a Fed put, hence our "clemency" title analogy, but China has well has come to the rescue of decelerating growth with its cut of the required reserve ratio by 1% to release cash into the economy and support rapidly stalling growth. The RRR for banks will drop by 0.5% on January 15 and a further 0.5% on January 25, the PBOC said. Here comes the central banking "cavalry".<br />
<br />
For credit markets, at least on the US side damages have already been done as seen in large outflows seen in recent weeks. What would clearly stabilize the situation we think, at least for US High Yield, would be a bounce in oil prices which would probably lessen the velocity in credit spread widening particularly in the high beta space of the CCCs bucket highly exposed to the energy sector.<br />
<br />
Can the Fed restore "goldilocks"? A not too hot and not too cold economy? We wonder again, how much damage has been inflicted to US earnings due to the long lasting trade war narrative. Was the Apple large standard deviation move a wake-up call for the Fed?<br />
<br />
One thing for sure is that the Huawei fight with the US administration is not about trade war, but mostly about "tech" war (and 5G). On that subject, we recently used the following chart in relation to the quantity of jobs created versus the quality as per the data from the BLS, this doesn't comprise the latest data release:<br />
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<a href="https://3.bp.blogspot.com/-IExxXDQ5PRE/XC-gtzJcuWI/AAAAAAAAVMo/sl1zblu1MbMc4zZ8DvlpesCp5nU03YJ6ACLcBGAs/s1600/BLS%2B-%2BNovember%2B2018%2Bdata%2Bon%2Bemployment%2Bpopulation%2Bratio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="552" data-original-width="861" height="205" src="https://3.bp.blogspot.com/-IExxXDQ5PRE/XC-gtzJcuWI/AAAAAAAAVMo/sl1zblu1MbMc4zZ8DvlpesCp5nU03YJ6ACLcBGAs/s320/BLS%2B-%2BNovember%2B2018%2Bdata%2Bon%2Bemployment%2Bpopulation%2Bratio.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source BLS - Macronomics</div>
<br />
<br />
<div>
<span style="font-family: inherit;">Back in January 2017 in our conversation "<a href="http://macronomy.blogspot.com/2017/01/macro-and-credit-ultimatum-game.html">The Ultimatum game</a>" we argued:</span></div>
<div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 </span></blockquote>
</div>
<div>
<span style="font-family: inherit;">Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits. T</span>he lackluster most recent Purchasing Managers Index showed a fall in the reading from new orders in the US from 61 to 51, and China as well has been decelerating with its export orders falling below the 47 mark. This clearly shows that there is no clear winner from a trade war. </div>
<div>
<br /></div>
<div>
Sure talks are about to start again between China and the United States but at this stage, as we stated above, it is all about damage assessment on earnings. </div>
<br />
Given the Fed has been on a hiking path in conjunction with its QT, as we stated in our conversation "<a href="https://macronomy.blogspot.com/2018/10/macro-and-credit-ballyhoo.html">Ballyhoo</a>" in October 2018, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions, a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions. On the subject of financial conditions we read with interest Nomura Special Report from the 28th of December entitled "Financial conditions turned restrictive for growth":<br />
<blockquote class="tr_bq">
"<b>Key Developments</b></blockquote>
<blockquote class="tr_bq">
<ul>
<li>Our revised US financial conditions index (FCI) suggests financial conditions are now restrictive for growth (Figure 1).</li>
</ul>
</blockquote>
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<a href="https://3.bp.blogspot.com/-ymDLII3S6jI/XC-qx0lkFgI/AAAAAAAAVM0/rQdxMri3BG03Wskei8SbDJRmWXwyMuknQCLcBGAs/s1600/Nomura%2B-%2BUS%2BFinancial%2Bconditions%2Bindex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="359" data-original-width="552" height="208" src="https://3.bp.blogspot.com/-ymDLII3S6jI/XC-qx0lkFgI/AAAAAAAAVM0/rQdxMri3BG03Wskei8SbDJRmWXwyMuknQCLcBGAs/s320/Nomura%2B-%2BUS%2BFinancial%2Bconditions%2Bindex.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
<blockquote class="tr_bq">
<ul>
<li> Since the end of September our FCI has declined almost a full percentage point – from +0.7% to roughly -0.3% currently. The units of our FCI are the contribution of financial factors to growth over the next six months (see Refreshing US Financial Conditions Index for a complete explanation).</li>
</ul>
</blockquote>
</blockquote>
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<a href="https://2.bp.blogspot.com/-9aX5_bEyOjk/XC-rbsuUW2I/AAAAAAAAVM8/BBy-tcn43PEMnm343Mb9W1DC8N96oYwbwCLcBGAs/s1600/Nomura%2B-%2BUS%2BFinancial%2Bconditions%2Bindex%2B2012-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="322" data-original-width="558" height="184" src="https://2.bp.blogspot.com/-9aX5_bEyOjk/XC-rbsuUW2I/AAAAAAAAVM8/BBy-tcn43PEMnm343Mb9W1DC8N96oYwbwCLcBGAs/s320/Nomura%2B-%2BUS%2BFinancial%2Bconditions%2Bindex%2B2012-2018.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
<ul>
<li>After heightened volatility in October and November, US equity markets sold off sharply in December. So far this month the S&P 500 index is down 10.8% (through 27-Dec). Implied equity volatility remains high. The VIX index jumped sharply in December and remains elevated.</li>
<li>Corporate spreads have widened notably since end-September. Investment grade options-adjusted spreads are now roughly at their long-term median, but they remain well below levels reached in late 2015 and early 2016.</li>
<li>Business surveys suggest that credit is only modestly harder to get, at least for smaller businesses.</li>
<li>The recent tightening of financial conditions is notable, in both equity and credit markets, and will probably affect how the FOMC sees the risks around its forecast.</li>
<li>Potential external risks, such as Brexit, US-China trade negotiations and US fiscal policy debates in Congress, raise economic uncertainty and have a potential to tighten financial conditions further.</li>
<li><span style="color: red;">At the margin, the recent tightening of financial conditions reduces the probability that FOMC will raise short-term interest rates again soon</span>." - graph source Nomura.</li>
</ul>
</blockquote>
This explains probably the "reflexivity" issue seen in the markets given the flattening of the yield curve with weaker macro data and decelerating global growth which created anxiety relating to the double impact of both rate hikes and QT on financial conditions.<br />
<br />
As pointed out by Andreas Steno Larsen from Nordea on his twitter feed there is a direct relationship between US Financial Conditions and ISM Manufacturing PMI:<br />
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<a href="https://4.bp.blogspot.com/-JPuP_RHfw60/XDC--KOD-KI/AAAAAAAAVNQ/SsAAXKgU3J89EAae9BanWNlDo2FBsm-GACLcBGAs/s1600/Nordea%2B-%2BISM%2Band%2BFinancial%2Bconditions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="448" data-original-width="710" height="201" src="https://4.bp.blogspot.com/-JPuP_RHfw60/XDC--KOD-KI/AAAAAAAAVNQ/SsAAXKgU3J89EAae9BanWNlDo2FBsm-GACLcBGAs/s320/Nordea%2B-%2BISM%2Band%2BFinancial%2Bconditions.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"We have been pretty explicit recently that ISM would drop FAST! ISM dropped from 59.3 to 54.1 in Dec.<br />
Unfortunately more of the same is in store over the coming 3-4 months. Below 50 readings could be on the cards." - source Nordea, twitter</blockquote>
<div>
Obviously the recent dovish tone taken by Fed chairman Jerome Powell seems to have had the desired effect of tampering the velocity in the tightening. </div>
<div>
<br /></div>
<div>
As pointed by Bloomberg in their article from the 3rd of January entitled "<a href="https://www.bloomberg.com/news/articles/2019-01-03/powell-pledged-allegiance-to-data-and-some-of-it-looks-grim?srnd=premium">Jerome Powell Pledged Allegiance to Data and Some of It Looks Grim</a>", the Fed is clearly in damage assessment mode when it comes to the data, regardless of the strong Nonfarm payroll print:</div>
<blockquote class="tr_bq">
"<b>Factory Pain</b>If there’s one place where the data are souring decisively, it’s manufacturing. The Institute for Supply Management’s factory index dropped by the most since 2008 last month and touched a two-year low. While the ISM gauge remains in expansionary territory at 54.1, just 11 of 18 industries reported growth in December. That’s the fewest in two years.</blockquote>
<blockquote class="tr_bq">
Production problems are far-reaching. JPMorgan Chase &Co. and IHS Markit’s global manufacturing index fell in December to the lowest level since September 2016 as measures of orders and hiring weakened, data showed this week.</blockquote>
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<a href="https://1.bp.blogspot.com/-4ePSHaDi6EU/XDDA61ibeVI/AAAAAAAAVNc/9Q4N8CEKEdgsrV188tkO3MJ1V9Rp-dd-wCLcBGAs/s1600/BBG%2B-%2BAll%2Bfive%2Bregional%2BFed%2Bfactory%2Bgauges%2Bweakened%2Bin%2BDecember.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="675" data-original-width="1200" height="180" src="https://1.bp.blogspot.com/-4ePSHaDi6EU/XDDA61ibeVI/AAAAAAAAVNc/9Q4N8CEKEdgsrV188tkO3MJ1V9Rp-dd-wCLcBGAs/s320/BBG%2B-%2BAll%2Bfive%2Bregional%2BFed%2Bfactory%2Bgauges%2Bweakened%2Bin%2BDecember.jpg" width="320" /></a></div>
<div>
<br /></div>
<div>
<blockquote class="tr_bq">
Trade uncertainty and concerns about global growth seem to be an important factor in the recent U.S. weakness: tariff worries have surfaced repeatedly in Fed surveys. Apple Inc. cut its revenue outlook this week for the first time in nearly two decades thanks to weaker demand in China.</blockquote>
<blockquote class="tr_bq">
<b>Housing Wobbles</b> </blockquote>
<blockquote class="tr_bq">
Fed officials watch the housing market because it’s an interest-rate sensitive sector, and it’s been showing signs of cooling for months. That hasn’t abated since the Fed last met: the pending home sales index dropped 0.7 percent on a monthly basis in November, compared to an analyst expectation for a 1 percent gain. Home prices are still rising, but the latest S&P CoreLogic Case-Shiller index showed that gains continue to moderate.</blockquote>
</div>
<blockquote class="tr_bq">
<b>Market Souring</b></blockquote>
<blockquote class="tr_bq">
While it’s not a real-economy measure, the Fed closely watches market volatility because it can feed through to consumer and business sentiment and the real economy. Stocks saw the worst December rout since the Great Depression and a few near-term Treasury security yields have crept above their longer-term counterparts since Powell’s December press conference, a sign that investors were pessimistic about the outlook for growth.</blockquote>
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<a href="https://3.bp.blogspot.com/-rGe4lP-5qTk/XDDBbdJTVsI/AAAAAAAAVNk/NqDQX3bHifM2Xxv7HcB2Vk_IN4S4ESGeACLcBGAs/s1600/BBG%2B-%2BWorried%2Bmarkets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="675" data-original-width="1200" height="180" src="https://3.bp.blogspot.com/-rGe4lP-5qTk/XDDBbdJTVsI/AAAAAAAAVNk/NqDQX3bHifM2Xxv7HcB2Vk_IN4S4ESGeACLcBGAs/s320/BBG%2B-%2BWorried%2Bmarkets.jpg" width="320" /></a></div>
<div>
<blockquote class="tr_bq">
That’s enough to make Powell’s colleague in Texas, Dallas Fed President Robert Kaplan, argue for putting rate increases on hold for the first couple of quarters of 2019.</blockquote>
<blockquote class="tr_bq">
“This is a very critical time. We need to be very vigilant. We need to be on our toes. And I think patience is a critical tool we should be using during this period. We can get this right,’’ Kaplan told Bloomberg Television in an interview on Thursday." - source Bloomberg</blockquote>
</div>
<div>
The big question is, will this be enough to initiate a strong rebound in equities and a rally in all things "high beta" such as leveraged loans? </div>
<br />
When it comes to leveraged loans, as pointed out by Lisa Abramowicz from Bloomberg on her twitter feed, there has been already some "short covering" happening:<br />
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<a href="https://4.bp.blogspot.com/-GrQImVDC3YE/XDC-JeJ88LI/AAAAAAAAVNI/e5RllfCVSyotrD4CUW2P1W6KJnfY3tL0wCLcBGAs/s1600/BBG%2B-%2BBKLN%2Bbounce%2B-%2BLisa%2BAbramowicz.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="515" data-original-width="1105" height="149" src="https://4.bp.blogspot.com/-GrQImVDC3YE/XDC-JeJ88LI/AAAAAAAAVNI/e5RllfCVSyotrD4CUW2P1W6KJnfY3tL0wCLcBGAs/s320/BBG%2B-%2BBKLN%2Bbounce%2B-%2BLisa%2BAbramowicz.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"BKLN, the biggest leveraged-loan ETF, is posting its best one-day rally in its eight-year history. Loans are suddenly benefiting from both a more positive outlook on the U.S. economy paired with benchmark rates that are rising again." - source Lisa Abramowicz - Bloomberg - twitter</blockquote>
Again what could cause a sustained rally? Clearly the "Clemency" of both the Fed and the PBOC can trigger some significant "short covering" also a positive agreement between the United States and China would alleviate some concerns, yet when it comes to the forward EPS optimism we criticized back in 2018 as not being warranted, it is all about how much "reflexivity" has been triggered and how much "confidence" has been shattered by the recent violent gyrations in various asset classes we think.<br />
<br />
"The Clemency of Titus" aka Fed Chairman Jerome Powell is linked to the transmission mechanism between FOMC policy and the real economy. On this very subject we read with interest Wells Fargo's take from their note from the 3rd of January entitled "Time to Press Pause? Financial Conditions & the FOMC":<br />
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Financial Conditions Have Tightened</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Financial markets deteriorated sharply at the end of 2018. The S&P 500 fell more than 10% in the fourth quarter, while the yield on the 10-year Treasury security slid about 30 bps as investors flocked to safer assets. Given the forward-looking nature of markets, the tumult raised concerns about growth in the new year and was even seen as a reason the FOMC might hold off on its widely telegraphed rate hike in December. Chairman Powell stated numerous times in his post-meeting press conference that the Committee was not looking solely at financial markets, but broad financial conditions. So how have financial conditions—not just markets—evolved recently, and what does it mean for economic growth and the future path of FOMC policy?</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
For a wide-ranging view of financial conditions, we turn to the Chicago Fed’s National Financial Conditions Index (NFCI). The index includes 105 variables, capturing leverage, risk and credit conditions. Since the index is constructed to average zero over time (with a standard deviation of one), negative readings indicate historically loose financial conditions, while positive readings indicate historically tight conditions. Therefore, higher values of the index are indicative of tighter financial conditions.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The NFCI rose 14 bps over the fourth quarter of 2018 (Figure 1). </blockquote>
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<a href="https://2.bp.blogspot.com/-rp2TYc-o1Go/XDDtoPuqwcI/AAAAAAAAVNw/aQOGiEbYk-QX4rVWkrle6gtAFgN1ut7LQCLcBGAs/s1600/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="278" data-original-width="331" height="268" src="https://2.bp.blogspot.com/-rp2TYc-o1Go/XDDtoPuqwcI/AAAAAAAAVNw/aQOGiEbYk-QX4rVWkrle6gtAFgN1ut7LQCLcBGAs/s320/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex.jpg" width="320" /></a></div>
- Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities<br />
<blockquote class="tr_bq" style="text-align: justify;">
The move was the largest quarterly increase since the start of 2016—a point at which the FOMC hit pause on rate hikes. Specifically, risk-related measures, like the VIX index and TED spread, have risen over the past few months. At the same time, indications of leverage, like weakening corporate debt issuance, have pointed to more restrictive financial conditions (Figure 2). </blockquote>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-_T-7bTT88cM/XDDuES23zmI/AAAAAAAAVN4/oRojmt4SS3kJheRNp7mcIPsOLQMX-vaXwCLcBGAs/s1600/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex%2BSubindexes.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="276" data-original-width="331" height="266" src="https://1.bp.blogspot.com/-_T-7bTT88cM/XDDuES23zmI/AAAAAAAAVN4/oRojmt4SS3kJheRNp7mcIPsOLQMX-vaXwCLcBGAs/s320/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex%2BSubindexes.jpg" width="320" /></a></div>
<br />
- Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities<br />
<blockquote class="tr_bq" style="text-align: justify;">
Credit conditions, which reflect the willingness to borrow and lend at prevailing prices, have been little changed. But the overall NFCI generally remains at a low level, indicating that general financial conditions are not overly restrictive at present.</blockquote>
</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<b>Financial Conditions: The Transmission Channel between FOMC </b><b>Policy and the Real Economy</b></blockquote>
<blockquote class="tr_bq">
Financial conditions per se are not an objective for the FOMC, but they are taken into account due to their indirect effects on the Fed’s two policy goals: “price stability” and “maximum employment.” The committee’s aim in tightening policy is to prevent the economy from overheating to the point that it risks significantly overshooting its inflation target, which it defines as PCE inflation of 2%. However, the FOMC’s primary policy tools, the fed funds rate and the balance sheet, have little direct effect on the Fed’s two policy objectives.</blockquote>
<blockquote class="tr_bq">
Instead, the FOMC’s tools affect the economy by influencing other interest rates and risk taking. In that way, financial conditions capture the transmission of FOMC policy to the real economy. Businesses and households will modify investment and saving plans depending on the relative ease or tightness of financial conditions. Tighter conditions, reflecting the availability and cost of credit, may reduce the ability and/or willingness to take on debt, which, all else equal, could weigh on growth in investment and consumption and thereby on the overall rate of real GDP growth. In contrast, easier conditions could stoke up growth in consumption and investment.</blockquote>
</div>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Behind the Starting Line after Three Years of FOMC Tightening</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Given that financial conditions are influenced by FOMC policy, it is not unexpected to see broader financial conditions tighten as the Fed normalizes policy. In other words, tighter financial conditions are an anticipated byproduct of FOMC rate hikes. But monetary policy decisions and broad financial conditions do not always move in tandem. Despite the FOMC raising its target range for the fed funds rate 225 bps since late 2015, financial conditions as measured by the NFCI have eased on net over the period (Figure 3). </blockquote>
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<a href="https://1.bp.blogspot.com/-1L7JGOr-Tsg/XDDu6ZP0xxI/AAAAAAAAVOE/qxYs1OBQjpsB9daNFTXtu-nqHAjfAlM9wCLcBGAs/s1600/WF%2B-%2BNet%2BChange%2Bin%2BNFCI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="265" data-original-width="325" height="260" src="https://1.bp.blogspot.com/-1L7JGOr-Tsg/XDDu6ZP0xxI/AAAAAAAAVOE/qxYs1OBQjpsB9daNFTXtu-nqHAjfAlM9wCLcBGAs/s320/WF%2B-%2BNet%2BChange%2Bin%2BNFCI.jpg" width="320" /></a></div>
- Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities<br />
<blockquote class="tr_bq" style="text-align: justify;">
The easing has primarily come in terms of credit, with, for example, corporate bond spreads narrower and bank lending standards looser. The overall easing in financial conditions since late 2015 stands in contrast to the previous two tightening cycles in which the FOMC raised rates by the same amount. As noted previously, general financial conditions do not appear to be overly restrictive at present.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
With financial conditions still easy relative to when the Fed first began to normalize policy, does that mean there is more tightening in store? In each of the previous six rate-hiking cycles, the FOMC did not stop until financial conditions had tightened on net (Figure 4). </blockquote>
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<a href="https://3.bp.blogspot.com/-S-AG-T8-U7U/XDDvO7vj5xI/AAAAAAAAVOM/RZ9mR2XDR5UuJtYR4V9mrJMSzatyENc-wCLcBGAs/s1600/WF%2B-%2BNet%2BChange%2Bin%2BNFCI%2B2.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="267" data-original-width="320" src="https://3.bp.blogspot.com/-S-AG-T8-U7U/XDDvO7vj5xI/AAAAAAAAVOM/RZ9mR2XDR5UuJtYR4V9mrJMSzatyENc-wCLcBGAs/s1600/WF%2B-%2BNet%2BChange%2Bin%2BNFCI%2B2.jpg" /></a></div>
- Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities<br />
<blockquote class="tr_bq" style="text-align: justify;">
This historical record suggests that the FOMC may very well have a few more rate hikes to go in this cycle, at least at first glance.</blockquote>
<blockquote class="tr_bq">
<div style="text-align: justify;">
<b>Does the FOMC Need to See Financial Conditions Tighten Further?</b></div>
</blockquote>
<blockquote class="tr_bq">
<div style="text-align: justify;">
The traditional NFCI does not take into account underlying economic conditions. All else equal, it makes sense for investors to take on more risk, for households to take on more debt and for lenders to ease standards in an improving economic environment. As a result, financial conditions and economic conditions are often closely correlated. Therefore, it is not unusual to see financial conditions ease, at least for a time being, at the same time the FOMC is raising rates—both are responding to a stronger economy.</div>
</blockquote>
<blockquote class="tr_bq">
<div style="text-align: justify;">
To isolate financial conditions only, the Chicago Fed also calculates an Adjusted National Financial Conditions Index (ANFCI). The ANFCI controls for the macroeconomic environment, and thus it is more telling in regard to how underlying financial conditions have evolved. By this measure, financial conditions have tightened more in recent months than implied by the NFCI alone (Figure 5). </div>
</blockquote>
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<a href="https://4.bp.blogspot.com/-YxKceOCY-po/XDDwREu3QrI/AAAAAAAAVOY/o9vqbNZSH_M7ySS9xUshk6iywqH11noFQCLcBGAs/s1600/WF%2B-%2BFinancial%2BConditions%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="264" data-original-width="315" src="https://4.bp.blogspot.com/-YxKceOCY-po/XDDwREu3QrI/AAAAAAAAVOY/o9vqbNZSH_M7ySS9xUshk6iywqH11noFQCLcBGAs/s1600/WF%2B-%2BFinancial%2BConditions%2BIndex.jpg" /></a></div>
- Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities<br />
<blockquote class="tr_bq">
<div style="text-align: justify;">
Specifically, the ANFCI has increased about 20 bps since late September, which is about twice as much as the increase in the NCFI. Although the ANFCI remains low in a historic context, the rise in the index implies that financial conditions are a bit tighter in total than when the Fed first began raising rates in late 2015 (Figure 6).</div>
</blockquote>
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<a href="https://1.bp.blogspot.com/-cX9ptyuavWI/XDDwniNY7UI/AAAAAAAAVOg/RzWYML62-D4C5_MPQVLdZElmjwm5CZ7gwCLcBGAs/s1600/WF%2B-%2BNet%2Bchange%2Bin%2Badjusted%2BNFCI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="266" data-original-width="313" src="https://1.bp.blogspot.com/-cX9ptyuavWI/XDDwniNY7UI/AAAAAAAAVOg/RzWYML62-D4C5_MPQVLdZElmjwm5CZ7gwCLcBGAs/s1600/WF%2B-%2BNet%2Bchange%2Bin%2Badjusted%2BNFCI.jpg" /></a></div>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;"> - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities</span><br />
<blockquote class="tr_bq" style="text-align: justify;">
The degree to which financial conditions have tightened over a rate-hike cycle helps quantify how far—or short—the FOMC has come. Yet there is no set amount by which financial conditions need to tighten, or a threshold to cross, before the FOMC stops raising rates. If the economy is showing few signs of overheating, looser financial conditions relative to the start of a tightening cycle are not necessarily a problem. The same can be said for an economy where growth is slowing back toward its longer-run trend, as is the case today.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
How financial conditions impact the stability of the overall financial system may, however, be of concern. If a prolonged period of loose financial conditions stokes instability via greater risk taking, more leverage and questionable credit, then those factors may affect policymaking. That said, the primary means of addressing financial instability are likely to be targeted regulatory (macro-prudential) policies by the Federal Reserve and other federal banking agencies rather than the blunter tool of changes in interest rates by the FOMC. At present, the Fed generally does not seem to be unduly concerned with financial stability. The Federal Reserve Board’s inaugural Financial Stability Report released in November found that while valuations are elevated, private sector credit risks are moderate and leverage and funding risks are low.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Moreover, the cumulative amount of tightening in financial conditions may not be as much of an issue as the speed. Over the past month, the financial conditions indices rose faster than at any time since the start of 2016 (Figure 7). </blockquote>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-I7xINTXQxsI/XDDxPGsXvNI/AAAAAAAAVOs/o6A5i09AOpYpNQIug2rgCAveB4FYwSz2wCLcBGAs/s1600/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex%2B4%2Bweek%2Bchange.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="266" data-original-width="370" height="230" src="https://4.bp.blogspot.com/-I7xINTXQxsI/XDDxPGsXvNI/AAAAAAAAVOs/o6A5i09AOpYpNQIug2rgCAveB4FYwSz2wCLcBGAs/s320/WF%2B-%2BNational%2BFinancial%2BConditions%2BIndex%2B4%2Bweek%2Bchange.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
Given that it takes time for financial conditions to effect the real economy, the FOMC could perceivably hold off on subsequent rate hikes in the near term as it waits to see how financial conditions have affected growth prospects.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Conclusion: The FOMC Might Revisit the Pause Button</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: red;">The last time financial conditions tightened as sharply as this past December was at the start of 2016. Back then, the FOMC had just raised the fed funds target rate for the first time since the crisis</span>. However, signs of slower growth in China caused volatility in financial markets to spike and overall financial conditions tightened. Following its initial rate hike in December 2015, the FOMC subsequently remained on hold until December 2016.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Our most recent forecast, which was compiled in early December, looks for two 25 bps rate hikes in 2019, first in March and again in September. But we readily acknowledge that the risks are skewed to a longer pause in the first half of the year than we thought just a month ago. Overall financial conditions do not appear to be overly restrictive at present, but they clearly have tightened in recent weeks. Consequently, the FOMC may decide that a period of wait-and-see is again appropriate, especially with the fed funds target rate already close to many committee members’ estimates of “neutral” and with inflation showing few signs of significantly exceeding the Fed’s target of 2%. We will be watching incoming data and making changes to our Fed call, as appropriate." - source Wells Fargo</blockquote>
<div style="text-align: justify;">
Sure "Titus" might have shown some "late" clemency and maybe just re-initiated the infamous/famous "put" given the recent rout in various asset classes, but it remain to be seen if it too late to re-ignite the "animal spirits" and trigger a sustained rally given that a lot of damages have already been inflicted on the back as well of more surprises to be seen on more "earnings surprises à la Apple or Delta Airlines. We continue to advocate playing defense and use the rally to reduce your beta exposure in search of quality. It doesn't matter how long the Fed's clemency is going to last, we think we are clearly in the final innings of this extended credit cycle and you probably should focus more your attention on capital preservation than capital appreciation. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
If indeed the Fed is data dependent (or more likely S&P dependent...), then obviously, the "Clemency of Titus" is somewhat warranted as per our final chart below showing that for global CFOs, they have been less optimistic thanks to trade war fatigue obviously. </div>
<br />
<span style="font-family: inherit;"></span><br />
<ul style="line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Confidence has taken a knock</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">If success is a mind game, so is confidence and in the case of CFOs as per our final chart from Bank of America Merrill Lynch's The Inquirer note from the 31st of December entitled "Planet Earth to Policymakers - Please Reflate", then there is more downside to come when it comes to Global PMIs:</span></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-57JUJZA7Kqs/XDExM-xt4-I/AAAAAAAAVO4/GZqyE_yrO3c5pJDeEzlRVk4ThX917VjcgCLcBGAs/s1600/BAML%2B-%2BGlobal%2BCFO%2Bconfidence.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="283" data-original-width="529" height="171" src="https://4.bp.blogspot.com/-57JUJZA7Kqs/XDExM-xt4-I/AAAAAAAAVO4/GZqyE_yrO3c5pJDeEzlRVk4ThX917VjcgCLcBGAs/s320/BAML%2B-%2BGlobal%2BCFO%2Bconfidence.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<b>The view of asset markets and global CFOs is in sync – global growth is now in a broad, deep and persistent slowdown.</b> The IMF, however, sees global real GDP growth going from 3.73% in 2018 to 3.65% in 2019, a second decimal slowdown. Policymakers are in the same stable boat, which is vulnerable to capsizing. The breadth of OECD leading indicators, which was near historical highs at the start of the year, has weakened considerably. In October 2018, only 10% of countries saw YoY rises in the OECD leading indicator vs. 71% in January 2018. In January 2018, 46 of 47 global equity markets were above their 200-day moving averages, now only 7 of 47 are. The world monetary base is contracting 0.5% YoY, and likely to shrink 4.6% by December 2019, unprecedented in 37 years.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>The bottom line:</b> Financial markets and CFOs think the world economy is in real trouble. Policymakers are oblivious to this scenario. One of them is going to be wrong. Past history suggests, the policymakers. The science experiment of Quantitative Tightening might be halted, the Chinese credit impulse is still in free-fall and might need to be revived a lot more dramatically, and global fiscal easing could be a lot more muscular. Those are 2019’s likely surprises. If this happens, Asia and EM equities could be in for massive gains. Stay tuned." - source Bank of America Merrill Lynch</blockquote>
Could the central bank cavalry come to the rescue of global equities? Or is too little too late? We wonder....<br />
<br />
<blockquote class="tr_bq" style="text-align: justify;">
"If there is something to pardon in everything, there is also something to condemn." - Friedrich Nietzsche</blockquote>
<span style="font-family: inherit;">Stay tuned! </span></div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-33078731142722590912018-12-21T17:00:00.001+00:002018-12-24T16:29:00.626+00:00Macro and Credit - Fuel dumping<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." - Arnold H. Glasow, American author</blockquote>
<div style="text-align: justify;">
Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("<a href="https://macronomy.blogspot.com/2018/08/macro-and-credit-dissymmetry-of-lift.html">Dissymmetry of lift</a>" in August 2018, "<a href="https://macronomy.blogspot.com/2013/04/credit-coffin-corner.html">The Coffin corner</a>" in April 2013, the other being "<a href="https://macronomy.blogspot.com/2014/05/credit-vortex-ring.html">The Vortex Ring</a>" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the <a href="https://www.wsj.com/articles/quantitative-tightening-not-now-11544991760">Wall Street Journal</a> yet it seems that as we pointed out in our October conversation "<a href="https://macronomy.blogspot.com/2018/10/macro-and-credit-explosive-cyclogenesis.html">Explosive cyclogenesis</a>":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. <span style="color: red;">We think that the Fed's put strike price is much lower than many thinks</span>.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".</span> "- Macronomics, October 2018</blockquote>
<div style="text-align: justify;">
<span style="text-align: left;">The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".</span></div>
<div style="text-align: justify;">
<span style="text-align: left;"><br /></span></div>
<div style="text-align: justify;">
In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...<br />
<br /></div>
<div>
<div style="background-color: white; line-height: 20.8px; text-align: justify;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - 2019: "Mean" mean reversion?</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final charts - What the Fed see and what they don't... </b></i></span></li>
</ul>
</div>
<div style="text-align: justify;">
<span style="text-align: left;"><br /></span></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - 2019: "Mean" mean reversion?</li>
</ul>
<div style="text-align: justify;">
In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.<br />
<br />
In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":<br />
<blockquote class="tr_bq">
"<b>More outflows and no more CSPP</b></blockquote>
<blockquote class="tr_bq">
Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.</blockquote>
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<a href="https://2.bp.blogspot.com/-__8x4yf0Jws/XBzPORb6QnI/AAAAAAAAVJA/Dp_5McaPVeAz1bbp2Lu37l9drW8-Ns3NwCLcBGAs/s1600/BAML%2B-%2BCSPP%2Bparty%2Bis%2Bover.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="284" data-original-width="511" height="177" src="https://2.bp.blogspot.com/-__8x4yf0Jws/XBzPORb6QnI/AAAAAAAAVJA/Dp_5McaPVeAz1bbp2Lu37l9drW8-Ns3NwCLcBGAs/s320/BAML%2B-%2BCSPP%2Bparty%2Bis%2Bover.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq">
High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. <b>High yield</b> funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.</blockquote>
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<br />
<blockquote class="tr_bq">
<b>Government bond</b> funds recorded an inflow this week, the 2nd in a row. Meanwhile, <b>Money Market</b> funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.</blockquote>
<blockquote class="tr_bq">
<b>European equity funds</b> recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.</blockquote>
<blockquote class="tr_bq">
<b>Global EM debt</b> recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.</blockquote>
<blockquote class="tr_bq">
On the <b>duration </b>front, <b>mid-term</b> IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch</blockquote>
When the trend in outflows is not your friend...</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As per our November conversation "<a href="https://macronomy.blogspot.com/2018/11/macro-and-credit-zollverein.html">Zollverein</a>", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per <a href="http://www.leveragedloan.com/leveraged-loan-funds-log-record-2-53b-outflow/">LeveragedLoan.com</a> outflows have been significant and accelerating in the asset class:<br />
<blockquote class="tr_bq">
"<b>Leveraged loan funds log record $2.53B outflow</b></blockquote>
<blockquote class="tr_bq">
U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.</blockquote>
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<a href="https://2.bp.blogspot.com/-SaH3u-HXYis/XBzoSKd0n5I/AAAAAAAAVJU/0_SQH4a4vbsFkHa5APIZx0g14bbqphhUACLcBGAs/s1600/LeveragedLoans%2B-%2Boutflows%2B20-12-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="480" data-original-width="711" height="215" src="https://2.bp.blogspot.com/-SaH3u-HXYis/XBzoSKd0n5I/AAAAAAAAVJU/0_SQH4a4vbsFkHa5APIZx0g14bbqphhUACLcBGAs/s320/LeveragedLoans%2B-%2Boutflows%2B20-12-2018.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
<span style="color: red;">This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.</span></blockquote>
<blockquote class="tr_bq">
<span style="color: red;">Mutual funds were the catalyst in the latest period</span> as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.</blockquote>
<blockquote class="tr_bq">
Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.</blockquote>
<blockquote class="tr_bq">
The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com</blockquote>
</div>
<div style="text-align: justify;">
If this isn't "fuel dumping" then we wonder what it is:<br />
<blockquote class="tr_bq">
"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg </blockquote>
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<a href="https://1.bp.blogspot.com/-xccxupg-Hhs/XBzqPoPBa8I/AAAAAAAAVJg/tRfXaYSTvOkIx823pLzrjQS24glf1h4jwCLcBGAs/s1600/BBG%2B-%2BLev%2BLoans%2B20-12-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="929" data-original-width="1600" height="185" src="https://1.bp.blogspot.com/-xccxupg-Hhs/XBzqPoPBa8I/AAAAAAAAVJg/tRfXaYSTvOkIx823pLzrjQS24glf1h4jwCLcBGAs/s320/BBG%2B-%2BLev%2BLoans%2B20-12-2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Bloomberg</div>
<br />
It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".<br />
<br />
For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "<a href="https://macronomy.blogspot.com/2018/11/macro-and-credit-zollverein.html">Zollverein</a>":<br />
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<a href="https://4.bp.blogspot.com/-nC9MQUmUZeM/XBz4Q9xY86I/AAAAAAAAVJs/mn-_NEzM5GMxKLGEpA1BQQrhkmSdVjUUgCLcBGAs/s1600/BAML%2B-%2BLoan%2Bprices%2Bhave%2Bbeen%2Bin%2Bfree-fall.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="296" data-original-width="522" height="181" src="https://4.bp.blogspot.com/-nC9MQUmUZeM/XBz4Q9xY86I/AAAAAAAAVJs/mn-_NEzM5GMxKLGEpA1BQQrhkmSdVjUUgCLcBGAs/s320/BAML%2B-%2BLoan%2Bprices%2Bhave%2Bbeen%2Bin%2Bfree-fall.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch</blockquote>
Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:<br />
<blockquote class="tr_bq">
"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."</blockquote>
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<br /></div>
<div style="text-align: center;">
- source Bloomberg - Lisa Abramowicz - twitter</div>
<br />
Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.<br />
<br />
But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":<br />
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Executive Summary</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth<br />
<b></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Stress Appears in the Leveraged Loan Market</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1). </blockquote>
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<a href="https://3.bp.blogspot.com/-LWEinxdEg0U/XBz9xTa9BkI/AAAAAAAAVKE/wN3nC3eNis4jbZekq5y323VSYLP6GAaBwCLcBGAs/s1600/WF%2B-%2BLeveraged%2BLoans%2Boutstanding.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="278" data-original-width="329" height="270" src="https://3.bp.blogspot.com/-LWEinxdEg0U/XBz9xTa9BkI/AAAAAAAAVKE/wN3nC3eNis4jbZekq5y323VSYLP6GAaBwCLcBGAs/s320/WF%2B-%2BLeveraged%2BLoans%2Boutstanding.jpg" width="320" /></a></div>
<div style="text-align: center;">
Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities</div>
<blockquote class="tr_bq" style="text-align: justify;">
Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).</blockquote>
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<a href="https://1.bp.blogspot.com/-khnxNW_q4Iw/XBz-BTbU2fI/AAAAAAAAVKM/5LP1WKso4iwq_k-MIX-_MpgwhrYo-YRywCLcBGAs/s1600/WF%2B-%2BLeveraged%2BLoan%2BPrice%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="327" height="270" src="https://1.bp.blogspot.com/-khnxNW_q4Iw/XBz-BTbU2fI/AAAAAAAAVKM/5LP1WKso4iwq_k-MIX-_MpgwhrYo-YRywCLcBGAs/s320/WF%2B-%2BLeveraged%2BLoan%2BPrice%2BIndex.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
<span style="text-align: center;">Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities</span> </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.</blockquote>
<blockquote class="tr_bq">
Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?</blockquote>
<blockquote class="tr_bq">
<b>Does the Leveraged Loan Market Have Broader Macro Implications?</b></blockquote>
<blockquote class="tr_bq">
When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?</blockquote>
<blockquote class="tr_bq">
Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans. </blockquote>
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<a href="https://4.bp.blogspot.com/-Zp7Ki1ZZqk4/XBz_PTFs5PI/AAAAAAAAVKY/VX1yKCuh48UzDjCoLGvzSCZ8ZpnU9ghbACLcBGAs/s1600/WF%2B-%2BC%2Band%2BI%2Bloans%2Bvs%2BLeveraged%2BLoans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="276" data-original-width="333" height="265" src="https://4.bp.blogspot.com/-Zp7Ki1ZZqk4/XBz_PTFs5PI/AAAAAAAAVKY/VX1yKCuh48UzDjCoLGvzSCZ8ZpnU9ghbACLcBGAs/s320/WF%2B-%2BC%2Band%2BI%2Bloans%2Bvs%2BLeveraged%2BLoans.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
<span style="text-align: center;">Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities</span></blockquote>
<blockquote class="tr_bq">
The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. </blockquote>
<blockquote class="tr_bq">
Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001. </blockquote>
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<blockquote class="tr_bq">
<span style="text-align: center;">Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities</span></blockquote>
<blockquote class="tr_bq">
More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.</blockquote>
<blockquote class="tr_bq">
<span style="color: red;">C&I lending accounts for less than 20% of total bank credit</span>. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well. </blockquote>
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<a href="https://2.bp.blogspot.com/-a4i0yiaIDUg/XBz_t8XxtKI/AAAAAAAAVKk/2kpE9p7kETAwZUSewkBxFGjowj-6fPEPgCEwYBhgL/s1600/WF%2B-%2BBank%2BCredit%2Bvs%2BLeveraged%2BLoans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="277" data-original-width="339" height="261" src="https://2.bp.blogspot.com/-a4i0yiaIDUg/XBz_t8XxtKI/AAAAAAAAVKk/2kpE9p7kETAwZUSewkBxFGjowj-6fPEPgCEwYBhgL/s320/WF%2B-%2BBank%2BCredit%2Bvs%2BLeveraged%2BLoans.jpg" width="320" /></a></div>
<div style="text-align: center;">
Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities</div>
<blockquote class="tr_bq">
Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.</blockquote>
<blockquote class="tr_bq">
In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, <span style="color: red;">the overall financial health of the non-financial corporate sector has deteriorated over the past few years</span>. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.</blockquote>
<blockquote class="tr_bq">
Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. <span style="color: red;">If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth</span>." - source Wells Fargo</blockquote>
After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.<br />
<br />
Yet, when it comes to C&I loans, change in the last three months have been significant we think:<br />
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<a href="https://2.bp.blogspot.com/-eEXJz-4M6iw/XB0J4WiUlII/AAAAAAAAVKs/z5YP-Koa_mg5eoPpLWCbxUH60aaittIwQCLcBGAs/s1600/BAML%2B-%2BC%2Band%2BI%2Bloans%2BDecember%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="387" data-original-width="598" height="207" src="https://2.bp.blogspot.com/-eEXJz-4M6iw/XB0J4WiUlII/AAAAAAAAVKs/z5YP-Koa_mg5eoPpLWCbxUH60aaittIwQCLcBGAs/s320/BAML%2B-%2BC%2Band%2BI%2Bloans%2BDecember%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Bank of America Merrill Lynch</div>
<br />
As we mused in our conversation "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-ballyhoo.html">Ballyhoo</a>" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".<br />
<br />
This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":<br />
<blockquote class="tr_bq">
"<b>Getting ahead of the shocks</b></blockquote>
<blockquote class="tr_bq">
One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”</blockquote>
<blockquote class="tr_bq">
To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2). </blockquote>
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<blockquote class="tr_bq">
The shocks are run individually through FRB/US and sustained through the simulation period. </blockquote>
<blockquote class="tr_bq">
The results of the stylized exercise are presented in Table 1. There are several points worth noting:</blockquote>
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<blockquote class="tr_bq">
<ul>
<li>Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.</li>
<li>The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.</li>
<li>Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2</li>
<li>The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.</li>
</ul>
</blockquote>
<blockquote class="tr_bq">
What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch</blockquote>
While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "<a href="https://macronomy.blogspot.com/2018/10/macro-and-credit-armstrong-limit.html">The Amstrong limit</a>" was probably lucky:<br />
<blockquote class="tr_bq">
"<span style="font-family: inherit;">Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.</span></blockquote>
We wondered at the time if we had reached the "boiling point". In retrospect we did.<br />
<br />
The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "<a href="https://macronomy.blogspot.com/2013/02/credit-bold-banking.html">Bold Banking</a>" we used another aeronautics reference:<br />
<blockquote class="tr_bq">
"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of <a href="https://www.youtube.com/watch?v=ReSm7r45_ds">the demise of "Czar 52" on the 24th of June 1994</a> which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".</blockquote>
<blockquote class="tr_bq">
So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?</blockquote>
<blockquote class="tr_bq">
A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not French president Hollande in that instance but we digress...).</blockquote>
<blockquote class="tr_bq">
When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013</blockquote>
For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.<br />
<br />
<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - What the Fed see and what they don't... </span></li>
</ul>
With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":<br />
<blockquote class="tr_bq">
"<b>Caught Between A Rate Hike and A Hard Place</b></blockquote>
<blockquote class="tr_bq">
Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.</blockquote>
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<blockquote class="tr_bq">
The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.</blockquote>
<blockquote class="tr_bq">
Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.</blockquote>
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<blockquote class="tr_bq">
The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.</blockquote>
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<blockquote class="tr_bq">
The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo</blockquote>
It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...<br />
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We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.<br />
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<div style="text-align: left;">
as the old pilot saying goes:</div>
<i>"There are old pilots and there are bold pilots; there are no old, bold pilots!" </i></blockquote>
Stay tuned !</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-55453335108515712842018-12-13T22:54:00.000+00:002018-12-13T22:54:04.698+00:00Macro and Credit - Mithridatism<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus</blockquote>
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<div style="text-align: justify;">
Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. </div>
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The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. </div>
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<br /></div>
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For example, the Australian <a href="https://www.nationalgeographic.co.uk/animals/2018/07/koalas-eat-toxic-leaves-survive-now-scientists-know-how">Koalas</a>' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:</div>
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<a href="https://4.bp.blogspot.com/-8utxMdl_UGQ/XBE6W5ANcvI/AAAAAAAAVG8/-qe8dmGODw0zkjVoQBtzS3Oymp4tx4LZwCLcBGAs/s1600/Cameron%2BKusher%2B-%2BAustralian%2Bhousing%2Bfeeling%2Bthe%2Bheat.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="647" data-original-width="1157" height="178" src="https://4.bp.blogspot.com/-8utxMdl_UGQ/XBE6W5ANcvI/AAAAAAAAVG8/-qe8dmGODw0zkjVoQBtzS3Oymp4tx4LZwCLcBGAs/s320/Cameron%2BKusher%2B-%2BAustralian%2Bhousing%2Bfeeling%2Bthe%2Bheat.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed </blockquote>
<div style="text-align: justify;">
While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend <a href="https://www.linkedin.com/in/carl-hodson-thomas-3499141a/">Carl Hodson-Thomas</a> Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.<br />
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<div>
<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.</span></span></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
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<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - 2019: When the central banks are no longer your "friends"...</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final chart - Did the Fed already break something?</b></i></span></li>
</ul>
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<br /></div>
<div style="text-align: justify;">
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - 2019: When the central banks are no longer your "friends"...</li>
</ul>
<div>
As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:</div>
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<a href="https://3.bp.blogspot.com/-UTPqz5dv-no/XBKKWf-wSMI/AAAAAAAAVHI/7Z7tKur4wJkhJ3DYzbZRbIE0zu7bV2zcQCLcBGAs/s1600/BBG%2B-%2BHY%2Bvs%2BEM%2Bcredit%2Bselloff%2B%2B-%2BLisa%2BAbramowicz.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="617" data-original-width="1030" height="191" src="https://3.bp.blogspot.com/-UTPqz5dv-no/XBKKWf-wSMI/AAAAAAAAVHI/7Z7tKur4wJkhJ3DYzbZRbIE0zu7bV2zcQCLcBGAs/s320/BBG%2B-%2BHY%2Bvs%2BEM%2Bcredit%2Bselloff%2B%2B-%2BLisa%2BAbramowicz.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter</blockquote>
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<div style="text-align: justify;">
Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "<a href="https://www.wsj.com/articles/investors-bet-10-billion-against-popular-bond-etfs-11544533200?mod=searchresults&page=1&pos=1">Investors Bet $10 Billion Against Popular Bond ETFs</a>":<br />
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<blockquote class="tr_bq">
"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.<br /><br />The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .</blockquote>
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<a href="https://3.bp.blogspot.com/-spiUkrnWPaY/XBKO0LFt7eI/AAAAAAAAVHU/2bqcIY_IuLY5-h0MXoffcBdOhyG9b4XpQCEwYBhgL/s1600/WSJ%2B-%2Bshorting%2BETFs%2Bin%2Bcredit%2Bland.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="447" data-original-width="551" height="259" src="https://3.bp.blogspot.com/-spiUkrnWPaY/XBKO0LFt7eI/AAAAAAAAVHU/2bqcIY_IuLY5-h0MXoffcBdOhyG9b4XpQCEwYBhgL/s320/WSJ%2B-%2Bshorting%2BETFs%2Bin%2Bcredit%2Bland.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
<br />Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ</blockquote>
Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence. The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "<a href="http://macronomy.blogspot.com/2018/11/macro-and-credit-zollverein.html">Zollverein</a>" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.<br />
<br />
Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):<br />
<blockquote class="tr_bq">
<div style="text-align: justify;">
"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.</div>
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<div style="text-align: justify;">
Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said." </div>
</blockquote>
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<a href="https://3.bp.blogspot.com/-ceseDEno5Go/XBKTsPFjYvI/AAAAAAAAVHg/y4eTUyCcg3QeJlzXMk59CyrjraCJEsCtgCLcBGAs/s1600/FT%2B-%2BCLO%2Bspread%2Bwidening.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="381" data-original-width="554" height="220" src="https://3.bp.blogspot.com/-ceseDEno5Go/XBKTsPFjYvI/AAAAAAAAVHg/y4eTUyCcg3QeJlzXMk59CyrjraCJEsCtgCLcBGAs/s320/FT%2B-%2BCLO%2Bspread%2Bwidening.jpg" width="320" /></a></div>
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- source Financial Times</div>
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There is more pain to follow we think in 2019. As we pointed out in our November conversation "<a href="http://macronomy.blogspot.com/2018/11/macro-and-credit-zollverein.html">Zollverein</a>", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:</blockquote>
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<a href="https://4.bp.blogspot.com/-0i1xIw__ixo/XBKZnm2CaQI/AAAAAAAAVHs/Og7A3NRe-UobJ19NY2JQyVTJsHY2p7BYwCLcBGAs/s1600/BBG%2B%2B-%2BPKD%2B7.5%2B2020%2Bbonds%2B%2B-%2BLisa%2BAbramowicz.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="519" data-original-width="1200" height="138" src="https://4.bp.blogspot.com/-0i1xIw__ixo/XBKZnm2CaQI/AAAAAAAAVHs/Og7A3NRe-UobJ19NY2JQyVTJsHY2p7BYwCLcBGAs/s320/BBG%2B%2B-%2BPKD%2B7.5%2B2020%2Bbonds%2B%2B-%2BLisa%2BAbramowicz.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Bloomberg - Lisa Abramowicz - twitter</div>
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The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.<br />
<br />
In their <a href="https://www.datagrapple.com/Blog/Show/12201/are-there-more-to-follow.html">most recent blog post on the 12th of December</a>, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:<br />
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<a href="https://2.bp.blogspot.com/-wr8WcbJtxQo/XBKbSoi2-qI/AAAAAAAAVH4/OTrGc_3PWfon0VUGywC12s5GlKsFDNyiACLcBGAs/s1600/DataGrapple%2B-%2BUS%2BHY%2BEnergy%2BPKD.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="427" data-original-width="721" height="189" src="https://2.bp.blogspot.com/-wr8WcbJtxQo/XBKbSoi2-qI/AAAAAAAAVH4/OTrGc_3PWfon0VUGywC12s5GlKsFDNyiACLcBGAs/s320/DataGrapple%2B-%2BUS%2BHY%2BEnergy%2BPKD.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple</blockquote>
In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.<br />
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The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:<br />
<blockquote class="tr_bq">
"<b>Outflows have now erased the QE flow</b></blockquote>
<blockquote class="tr_bq">
Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE. </blockquote>
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<a href="https://2.bp.blogspot.com/-LO0YVo37urI/XBKePEbR8LI/AAAAAAAAVIE/ZzUFqOvGm6Mcop0-2jgJxmK6nXo57yHQQCLcBGAs/s1600/BAML%2B-%2BBack%2Bto%2Bpre-QE%2Blevels.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="300" data-original-width="524" height="183" src="https://2.bp.blogspot.com/-LO0YVo37urI/XBKePEbR8LI/AAAAAAAAVIE/ZzUFqOvGm6Mcop0-2jgJxmK6nXo57yHQQCLcBGAs/s320/BAML%2B-%2BBack%2Bto%2Bpre-QE%2Blevels.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.</blockquote>
<blockquote class="tr_bq">
<b>Over the past week…</b></blockquote>
<blockquote class="tr_bq">
<br /><b>High grade</b> funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. <b>High yield</b> funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. </blockquote>
<blockquote class="tr_bq">
<b>Government bond</b> funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, <b>Money Market</b> funds suffered again a large outflow, though half the size of last week’s.</blockquote>
<blockquote class="tr_bq">
<b>European equity funds</b> continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.</blockquote>
<blockquote class="tr_bq">
<b>Global EM debt</b> recorded a large outflow this week, the 9th in a row, in sharp contrast<br />with the improving trend we saw during the past 7 weeks. Commodity funds recorded a<br />marginal outflow.<br />On the <b>duration </b>front, we saw outflows across the entire curve, though mid-term IG<br />funds led the trend by far." - source Bank of America Merrill Lynch</blockquote>
So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.<br />
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When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:<br />
<blockquote class="tr_bq">
"<b>The Toxic Brew that threatens near term…</b></blockquote>
<blockquote class="tr_bq">
Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019. </blockquote>
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<a href="https://1.bp.blogspot.com/-pj-UeD4H_Zk/XBKmbHSzCwI/AAAAAAAAVIQ/UqHblfQt-V0JdljYF4SBdcxu5vbymN0sgCLcBGAs/s1600/BAML%2B-%2BReal%2BGlobal%2BMonetary%2Bbase%2Bshrinking.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="309" data-original-width="841" height="117" src="https://1.bp.blogspot.com/-pj-UeD4H_Zk/XBKmbHSzCwI/AAAAAAAAVIQ/UqHblfQt-V0JdljYF4SBdcxu5vbymN0sgCLcBGAs/s320/BAML%2B-%2BReal%2BGlobal%2BMonetary%2Bbase%2Bshrinking.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years. </blockquote>
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<a href="https://1.bp.blogspot.com/-7QoD_ZIQVbs/XBKmz-VRduI/AAAAAAAAVIY/2d3UAaLLS9QvrCZd3WKaZMkKVp15eNNTQCLcBGAs/s1600/BAML%2B-%2BNet%2Bproportion%2Bof%2BOECD%2Bcomposite%2Bleading%2Bindicators%2Bwith%2Bpositive%2B12months%2Bchange.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="285" data-original-width="823" height="110" src="https://1.bp.blogspot.com/-7QoD_ZIQVbs/XBKmz-VRduI/AAAAAAAAVIY/2d3UAaLLS9QvrCZd3WKaZMkKVp15eNNTQCLcBGAs/s320/BAML%2B-%2BNet%2Bproportion%2Bof%2BOECD%2Bcomposite%2Bleading%2Bindicators%2Bwith%2Bpositive%2B12months%2Bchange.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001. </blockquote>
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<a href="https://3.bp.blogspot.com/-BP-EHid4JGc/XBKnGTR8InI/AAAAAAAAVIg/m4Gs8flpnyI80AgOhfuUEkYtS9Tja-mTwCLcBGAs/s1600/BAML%2B-%2Bglobal%2Bequity%2Bmarkets%2Babove%2Btheir%2B200%2Bday%2Bmoving%2Baverages.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="301" data-original-width="819" height="117" src="https://3.bp.blogspot.com/-BP-EHid4JGc/XBKnGTR8InI/AAAAAAAAVIg/m4Gs8flpnyI80AgOhfuUEkYtS9Tja-mTwCLcBGAs/s320/BAML%2B-%2Bglobal%2Bequity%2Bmarkets%2Babove%2Btheir%2B200%2Bday%2Bmoving%2Baverages.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch</blockquote>
So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.<br />
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<br />
While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.<br />
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<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Did the Fed already break something?</span></li>
</ul>
Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:<br />
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<a href="https://4.bp.blogspot.com/-dSWN45h2gtU/XBLd-IHxOhI/AAAAAAAAVIw/WF-5QTuLycsW5WF0oqZ1ibokrCEHy3tvQCLcBGAs/s1600/BAML%2B-%2BThe%2BFed%2Btightening%2Bin%2Bthis%2Bcycle%2Bis%2B5.2%2Bpct.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="312" data-original-width="558" height="178" src="https://4.bp.blogspot.com/-dSWN45h2gtU/XBLd-IHxOhI/AAAAAAAAVIw/WF-5QTuLycsW5WF0oqZ1ibokrCEHy3tvQCLcBGAs/s320/BAML%2B-%2BThe%2BFed%2Btightening%2Bin%2Bthis%2Bcycle%2Bis%2B5.2%2Bpct.jpg" width="320" /></a></div>
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- source Bank of America Merrill Lynch</div>
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Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...<br />
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<blockquote class="tr_bq">
"The true alchemists do not change lead into gold; they change the world into words."- William H. Gass</blockquote>
Stay tuned !</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-52728980847766533602018-12-06T15:57:00.001+00:002018-12-08T13:09:12.327+00:00Macro and Credit - The Sorites paradox<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"Even the largest avalanche is triggered by small things." - Vernor Vinge, American writer</blockquote>
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Looking at the pre-revolutionary mindset of my home country France, with Paris under siege as we warned about in our conversation "<a href="http://macronomy.blogspot.com/2018/11/macro-and-credit-last-of-romans.html">Last of the Romans</a>" in mid-November, in conjunction with the very fast fading rally seen on the back of the United States and China trade war truce, when it came to selecting our title analogy given liquidity is continuing to be withdrawn by the Fed's QT, though as of late it seems they blinked, with softer global macro data including US housing, we decided to go for "The Sorites paradox". The "Sorites paradox", sometimes called the paradox of heap is a paradox that arises from vague predicates. A typical formulation involves a heap of sand, from which grains are individually removed. Under the assumption that removing a single grain does not turn a heap into a non-heap, the paradox is to consider what happens when the process is repeated enough times: is a single remaining grain still a heap? If not, when did it change from a heap to a non-heap? A common first response to the paradox is to call any set of grains that has more than a certain number of grains in it a heap. If one were to set the "fixed boundary" at, say, 10,000 grains then one would claim that for fewer than 10,000, it is not a heap; for 10,000 or more, then it is a heap. A second response attempts to find a fixed boundary that reflects common usage of a term. So the question is when is a bubble a bubble? When will QT turn the bubble into not a bubble? We wonder. Is hysteresis being the dependence of the state of a system on its history the answer? Equivalent amounts of sand may be called heaps or not based on how they got there. If a large heap (indisputably described as a heap) is slowly diminished, it preserves its "heap status" to a point, even as the actual amount of sand is reduced to a smaller number of grains. For example, suppose 500 grains is a pile and 1,000 grains is a heap. There will be an overlap for these states. So if one is reducing it from a heap to a pile, it is a heap going down until, say, 750. At that point one would stop calling it a heap and start calling it a pile. But if one replaces one grain, it would not instantly turn back into a heap. When going up it would remain a pile until, say, 900 grains. The numbers picked are arbitrary; the point is, that the same amount can be either a heap or a pile depending on what it was before the change. Also, one can establish the meaning of the word "heap" by appealing to consensus. The consensus approach typically claims that a collection of grains is as much a "heap" (or bubble) as the proportion of people in a group who believe it to be so. In other words, the probability that any collection is considered a heap is the expected value of the distribution of the group's views aka a "<a href="https://en.wikipedia.org/wiki/Quasitransitive_relation">Quasitransitive relation</a>", but we digress.</div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at why it is increasingly important to play much more defensively as we move towards what could be a jittery 2019.</span></span></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
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<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - Don't be the last one left to pick up the "credit" tab...</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final chart - Liquidity and credit spreads go hand in hand</b></i></span></li>
</ul>
</div>
<br />
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - Don't be the last one left to pick up the "credit" tab...</li>
</ul>
Looking at yesterday drop of 3.10% of the Dow Jones as we pointed out in our last conversation, it wasn't really that surprising given the weakening decelerating tone in global growth in general and cyclicals such as Autos and Housing in particular:<br />
<blockquote class="tr_bq">
"Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end." - source Macronomics, November 2018</blockquote>
As well we pointed last week that if you wanted to go "short" credit, then US leveraged loans were definitely something to look at as pointed out by Lisa Abramowicz on a Twitter feed:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"Prices on leveraged loans have dropped to the lowest since 2016 even though their benchmark rate Libor has quickly risen, meaning this debt should pay out higher interest rates. This throws into question the concept of floating-rate debt as a hedge against rising rates.</blockquote>
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<a href="https://1.bp.blogspot.com/-H0BbLAnWRqI/XAfyntaL8cI/AAAAAAAAVEE/HiSF_cBV1_Al-EP--s43kXsjHlN3gxP7QCLcBGAs/s1600/BBG%2BLev%2BLoans%2B-%2B05-12-2018%2B-%2BLisa%2BAbramowicz.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="763" data-original-width="1239" height="197" src="https://1.bp.blogspot.com/-H0BbLAnWRqI/XAfyntaL8cI/AAAAAAAAVEE/HiSF_cBV1_Al-EP--s43kXsjHlN3gxP7QCLcBGAs/s320/BBG%2BLev%2BLoans%2B-%2B05-12-2018%2B-%2BLisa%2BAbramowicz.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
On one hand, loan investors get more income from their holdings as rates rise. On the other, the market seems to perceive the corporate borrowers as less creditworthy as their cost of financing rises. So if loan investors want to sell their holdings, they'll get a lower price." - graph source Bloomberg - Lisa Abramowicz - Twitter feed.</blockquote>
Indeed, liquidity is as always a "coward" and the longer you stay at the "credit" bar, the likelier you are to be shocked by "price discovery" when the credit markets will in earnest turn "South" and you will end up picking an expensive bar tab hence our call for reducing your illiquid high beta exposure.<br />
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<div style="text-align: justify;">
While leverage loans are an evident target pointed out by so many investor pundits, regulators and central bankers in these days and ages, other interesting instruments such as AT1s aka called Contingent Convertibles (CoCos) as well as Corporate Hybrid bonds fit the bill when it comes to being potentially "illiquid" and harmful. Sure it's fun on the way up, pretending to generate "alpha" for your clients by playing the "beta" pure carry game, but, when the party has been extended as it has been in credit land, then again, not starting to be a little bit more "cautious" is a good recipe for asking for trouble and finding it eventually through "price discovery".</div>
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<br /></div>
<div style="text-align: justify;">
On the subject of "illiquidity" and credit we read with interest JP Morgan's Portfolio Insights note relating to the evolution of market structure. Their paper is entitled "Managing illiquidity risk across public and private markets":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"In theory, investors are compensated for this through the higher returns available in private assets over the full life cycle of the private investment. In other words, to harvest the illiquidity risk premium in private markets, investors need to be able to stay the course, weathering any variation in the cash flow profile over the full cycle. This means that cash calls would need to be funded from elsewhere in the portfolio.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The ability to accept this type of risk ranges widely across investor types. Those that may be subject to redemptions or fund withdrawals (e.g., mutual fund managers) are less able to bear uncompensated illiquidity risk than those with a long- term pool of capital to deploy (e.g., sovereign wealth investors). Further, during times of market crisis, when investors are already seeking to cut exposure to public markets, threats to liquidity are generally correlated and can compound to become a serious issue for investors. Investors could face liquidity demands arising from redemptions and a prudent desire to hold higher portfolio cash buffers. At the same time, on the private asset side there may be cash calls to finance, calls that are best covered from public assets — and thus, avoiding uncompensated illiquidity traps in public markets becomes a priority. To fully assess the illiquidity risk in a portfolio, all of these factors need to be considered holistically.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Taking high yield (HY) bonds as an example of a potentially illiquid public asset with both market and illiquidity risk, we can ask whether, over a defined time horizon, the probability of being forced to crystallize a loss under adverse liquidity conditions is appropriately compensated (see Addendum, “Modeling the cost of high yield trading under illiquid conditions”). Early in the economic cycle, when credit spreads are wide, the illiquidity premium in an asset such as high yield credit may well offer an additional return compared with a replicating stock-bond portfolio. However, as the cycle matures and credit spreads tighten, there will come a tipping point — some breakeven level of spread — where the return in credit is not sufficient to offset the probability-weighted risk of a loss over a defined time horizon. Effectively, the illiquidity risk has at that point become uncompensated and investors may be better served expressing their desired level of market risk via a replicating stock-bond portfolio.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The scale of the potential illiquidity during times of market stress is demonstrated in Exhibit 8, again using HY credit as an example. The illiquid credit asset will suffer from wider bid-ask spreads and much reduced transaction volumes; large transactions can take considerable time to execute in markets where prices are dropping sequentially over multiple trading sessions.</blockquote>
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<a href="https://4.bp.blogspot.com/-Usj-G7vxe5g/XAf5uVjAxbI/AAAAAAAAVEQ/AUHsCnGtwVkNxoqrYbokoCrJCAUGWa_9gCLcBGAs/s1600/JPM%2B-%2BPrice%2Bimpact%2Band%2Bdays%2Bto%2Btransact%2Bin%2BUS%2BHY%2Bstressed%2Bmarkets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="397" data-original-width="831" height="152" src="https://4.bp.blogspot.com/-Usj-G7vxe5g/XAf5uVjAxbI/AAAAAAAAVEQ/AUHsCnGtwVkNxoqrYbokoCrJCAUGWa_9gCLcBGAs/s320/JPM%2B-%2BPrice%2Bimpact%2Band%2Bdays%2Bto%2Btransact%2Bin%2BUS%2BHY%2Bstressed%2Bmarkets.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Turning to private market assets, as investors have increasingly added private assets to portfolios there is commensurately more focus on the risk that they could be forced to liquidate private investments at an inopportune time to meet an additional capital call. Alternately, redemptions and other portfolio-level cash requirements may force them to exit private investments at an undesirable point. Since such events tend to occur during adverse conditions in public markets and the economy at large, the most relevant question is how bad things might really get." - source JP Morgan</blockquote>
Exactly, large positions can take a long time to unwind, particularly when dealer inventories are nowhere near to the level they had prior to the Great Financial Crisis (GFC).<br />
<br />
Also as another illustration of what it would take to liquidate a sizable position of $1 billion in US High Yield in the case of a recession and where credit spreads should be to reflect that "illiquidity" premia would be significantly wider as pointed out in JP Morgan's note:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"For an investor that may need to liquidate $1 billion of high yield and anticipates any crisis to be average in its severity, credit spreads above around 270bps compensate for illiquidity risk. But if the investor’s subjective view of the probability of recession over the next year were to increase to 33%, then the breakeven credit spread required to compensate fully for illiquidity risk would jump to 320bps and as high as 398bps in a worst-case drawdown scenario. As portfolio size increases — and the potential illiquid asset trade size grows — the ex-ante breakeven spread required to compensate for illiquidity risk increases. Crucially, there is no economy of scale for illiquidity risks and, indeed, there are very apparent diseconomies of scale." - source JP Morgan</blockquote>
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Given the significant rise in corporate credit issuance in recent years, one could conclude that current credit spreads do not reflect this "illiquidity" premium.</div>
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<div style="text-align: justify;">
But, given that the Fed seems to have recently "blinked" recently following a more dovish tone at the Economics Club of NY by Jerome Powell, one could indeed think that there is still value for "credit" pickers even in US High Yield. We have long argued that as dispersion is rising in this late cycle environment, proven credit specialists in the issuer selection process would outperform the passive investment crowd. </div>
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<br /></div>
<div style="text-align: justify;">
This effectively could dampen slightly the widening moves seen recently. On this subject we read Wells Fargo's take from their Credit Connections note from the 30th of November entitled "Honey B's":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"Credit markets continue to groan under the pressure of policy uncertainty (both monetary and fiscal), trade wars, a recent upsurge of idiosyncratic events and heavy bond supply. That said, secondary market credit spreads appear to be stabilizing after Fed Chairman Jay Powell struck a more dovish tone at his recent presentation to the Economic Club of NY. The shift was subtle and nuanced, but enough to convince markets that the Fed may slow the pace of policy tightening in the coming months. With credit spreads at year-to-date and multi-year wides, we recommend that investors start to set up for 2019 with select longs in credits poised to deleverage next year and beyond. Triple-B and double-B credits look particularly attractive to us in this environment. </blockquote>
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<a href="https://2.bp.blogspot.com/-7txN55Cc_ls/XAgAWX5OV7I/AAAAAAAAVEc/CCZ9TpSwZOYH6Xz1KTg-I8k7VNZHCrr1ACLcBGAs/s1600/WF%2B-%2BCorporate%2Bbonds%2Bspreads%2Bat%2Bwides.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="292" data-original-width="422" height="221" src="https://2.bp.blogspot.com/-7txN55Cc_ls/XAgAWX5OV7I/AAAAAAAAVEc/CCZ9TpSwZOYH6Xz1KTg-I8k7VNZHCrr1ACLcBGAs/s320/WF%2B-%2BCorporate%2Bbonds%2Bspreads%2Bat%2Bwides.jpg" width="320" /></a></div>
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<a href="https://3.bp.blogspot.com/-Fi-1sq1Zpwk/XAgAZ2qiSnI/AAAAAAAAVEg/NParSmnz5tkZCFf-AuG7Nl3_gfiyb0cZwCLcBGAs/s1600/WF%2B-%2BDecompression%2BBBB%2Bvs%2BBBs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="298" data-original-width="425" height="224" src="https://3.bp.blogspot.com/-Fi-1sq1Zpwk/XAgAZ2qiSnI/AAAAAAAAVEg/NParSmnz5tkZCFf-AuG7Nl3_gfiyb0cZwCLcBGAs/s320/WF%2B-%2BDecompression%2BBBB%2Bvs%2BBBs.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
The build-up of debt, increased borrowing costs and tighter monetary policy suggests that a growing number of companies will need to focus on deleveraging and balance sheet repair next year to preserve credit ratings and ensure ongoing access to capital markets. While this might not be great news for the economy it should certainly help the overall credit worthiness of the corporate sector and allow credit spreads to compress (somewhat) after a year of sustained widening. Conversely, those companies that cannot or will not address balance sheet issues will find a much less forgiving investor base and considerably higher borrowing costs. In this environment credit selection is paramount.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Funding Pressures</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
When considering which companies have the greatest urgency to deleverage it is helpful to look at the distribution of debt maturities. The term structure of maturities is a simple analysis to look at when companies are faced with refinancing pressures. At a high level, the amount of refinancing risk faced by IG companies is considerably greater than the risk faced by HY companies over the next three years. As the charts below show, about $2.2 trillion of investment grade debt is scheduled to mature 2019-2021. </blockquote>
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<a href="https://1.bp.blogspot.com/-vU11GQSbv2M/XAgA09r9zdI/AAAAAAAAVEs/E6lBDfr1QuI9Q_TjTXQ-cgnpWClqQSK-wCLcBGAs/s1600/WF%2B-Refi%2Brisk%2BIG.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="292" data-original-width="418" height="223" src="https://1.bp.blogspot.com/-vU11GQSbv2M/XAgA09r9zdI/AAAAAAAAVEs/E6lBDfr1QuI9Q_TjTXQ-cgnpWClqQSK-wCLcBGAs/s320/WF%2B-Refi%2Brisk%2BIG.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
This represents about 30% of all outstanding IG debt, with roughly 53% owed by non-financial companies and 47% owed by banks, insurers, financial companies and REITs. Maturities steadily climb over the next three years and peak in 2021 with about $800 billion of debt scheduled to mature. This stands in sharp contrast to HY. Over the same period, about $250 billion of HY debt scheduled to mature represents about 15% of all outstanding HY debt. In fact, next year HY maturities total just $40 billion. </blockquote>
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<a href="https://2.bp.blogspot.com/-_RqRMitGjW4/XAgBUnjch7I/AAAAAAAAVE4/AMRJTHnZVEIB6pCUOd5p8w9fvMxshkbKACLcBGAs/s1600/WF%2B-%2BRefi%2Brisk%2BHY.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="299" data-original-width="422" height="226" src="https://2.bp.blogspot.com/-_RqRMitGjW4/XAgBUnjch7I/AAAAAAAAVE4/AMRJTHnZVEIB6pCUOd5p8w9fvMxshkbKACLcBGAs/s320/WF%2B-%2BRefi%2Brisk%2BHY.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
Considering HY companies have issued about $175 billion of debt this year, refinancing pressures look particularly light next year. As a result, in the aggregate, HY companies look better positioned than IG companies to deal with tighter monetary conditions and higher interest rates over the next few years." - source Wells Fargo</blockquote>
<div style="text-align: justify;">
Though, as pointed out by Morgan Stanley in our recent conversation, the effect of widening credit spreads on the unemployment rate is significant and positive:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal." - source Morgan Stanley</blockquote>
<div style="text-align: justify;">
The most important chart going forward? Jobless Claims vs. Job Cut Announcements (trend forming?):</div>
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<a href="https://1.bp.blogspot.com/-dH3cfzvOZ5M/XAgIh5bA49I/AAAAAAAAVFE/rseqykveMIU1mPWd_6eitPqwkmHujIGUACLcBGAs/s1600/BBG%2B-%2BJobless%2Bclaims%2Bvs%2Bjob%2Bcuts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="354" data-original-width="658" height="172" src="https://1.bp.blogspot.com/-dH3cfzvOZ5M/XAgIh5bA49I/AAAAAAAAVFE/rseqykveMIU1mPWd_6eitPqwkmHujIGUACLcBGAs/s320/BBG%2B-%2BJobless%2Bclaims%2Bvs%2Bjob%2Bcuts.jpg" width="320" /></a></div>
<div style="text-align: center;">
- Graph source Bloomberg</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Leading indicators of initial unemployment claims rose again last week to 234K (and 220K consensus) from 224K with 4 week average up to 223 K from 219K. (up from 211K average in Q3. Take notice of this! </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So from a "Sorites paradox" perspective, if wider spreads impact unemployment going forward due to balance sheet deleveraging, earnings and profitability matter as well when it comes to predicting a surge in defaults rates as highlighted by our friend <a href="https://www.linkedin.com/in/edwardjcasey/">Edward J Casey</a> in his November credit commentary:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Probability of nonfinancial corporates is a key driver of the default rates</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<br />
Nonfinancial profits gained $66.2 billion in the third quarter. The annual pace of gains increased to +8.2% from -8.3% two years ago.</blockquote>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-vaicrT8hZx8/XAgKnVbNXaI/AAAAAAAAVFQ/v6pxN8izbWM-fBVZeCbirT4W2IvcJ1y6wCLcBGAs/s1600/Ed%2BCasey%2B-%2BNon%2Bfin%2Bprofit%2Bvs%2Bdefaults.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="224" data-original-width="464" height="154" src="https://1.bp.blogspot.com/-vaicrT8hZx8/XAgKnVbNXaI/AAAAAAAAVFQ/v6pxN8izbWM-fBVZeCbirT4W2IvcJ1y6wCLcBGAs/s320/Ed%2BCasey%2B-%2BNon%2Bfin%2Bprofit%2Bvs%2Bdefaults.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
The US default rate declined to 3.2% in October and is expected to improve to 2% in next year.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Since the recession corporate profits have grown +8.6% annualized, well ahead of GDP of +2.3%.</blockquote>
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<a href="https://2.bp.blogspot.com/-bPSWm5sCxzg/XAgLxCSfF3I/AAAAAAAAVFc/Ry-z41iRek4QWb2SvNsim34CubEtUKVNwCLcBGAs/s1600/Ed%2BCasey%2B-%2BGDP%2Bvs%2BCorporate%2Bdebt%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="242" data-original-width="468" height="165" src="https://2.bp.blogspot.com/-bPSWm5sCxzg/XAgLxCSfF3I/AAAAAAAAVFc/Ry-z41iRek4QWb2SvNsim34CubEtUKVNwCLcBGAs/s320/Ed%2BCasey%2B-%2BGDP%2Bvs%2BCorporate%2Bdebt%2Bgrowth.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<b>One driver behind profit growth has been the massive expansion in corporate debt which has grown by +4.3%, nearly twice the pace of real GDP.</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Cumulatively nonfinancial profits gained +115% compared to GDP of +23% and corporate debt of +46%." - source <a href="https://www.linkedin.com/in/edwardjcasey/">Edward J Casey</a></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In our "credit" heap of sand, grains are individually removed thanks to the Fed's QT, the one question that remains is which grain will trigger the avalanche?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So if illiquidity is not "priced" correctly in credit and valuations are considered "lofty" from a consensus approach perspective, then again one may rightly ask when will it break? As pointed out by <a href="https://www.linkedin.com/in/edwardjcasey/">Edward J Casey</a>, it is all depending on corporate profits rolling over, watching earnings in 2019 will be paramount:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Equity valuations continue to outpace corporate profits.</b> The ratio of profits to equity market cap declined to 7.7%</blockquote>
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<a href="https://4.bp.blogspot.com/-yzTWiL3WHNs/XAgP5qZdDAI/AAAAAAAAVFo/TFZP9p6bQs0DHRcUVzbGqcfuDJLqwFV8wCLcBGAs/s1600/Ed%2BCasey%2B-%2BCorp%2Bprofits%2Band%2BWilshire%2Bindex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="230" data-original-width="464" height="158" src="https://4.bp.blogspot.com/-yzTWiL3WHNs/XAgP5qZdDAI/AAAAAAAAVFo/TFZP9p6bQs0DHRcUVzbGqcfuDJLqwFV8wCLcBGAs/s320/Ed%2BCasey%2B-%2BCorp%2Bprofits%2Band%2BWilshire%2Bindex.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<b>With credit yield headed higher, corporate profits will be facing a headwind of higher net interest expenses.</b></blockquote>
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<a href="https://3.bp.blogspot.com/-21ngIDlDnm0/XAgP_pZQrNI/AAAAAAAAVFs/Z-TQRv0oe5AcXwh7KYqhslzRIQn2WtU-gCLcBGAs/s1600/Ed%2BCasey%2B-%2BNonfin%2BCorp%2Bprofits%2B%2B-%2BCost%2Bof%2BDebt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="230" data-original-width="464" height="158" src="https://3.bp.blogspot.com/-21ngIDlDnm0/XAgP_pZQrNI/AAAAAAAAVFs/Z-TQRv0oe5AcXwh7KYqhslzRIQn2WtU-gCLcBGAs/s320/Ed%2BCasey%2B-%2BNonfin%2BCorp%2Bprofits%2B%2B-%2BCost%2Bof%2BDebt.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
On prior occasions spikes in the cost of debt have been coincident with annual gains in corporate profits rolling over" - source <a href="https://www.linkedin.com/in/edwardjcasey/">Edward J Casey</a></blockquote>
<div style="text-align: justify;">
If wages growth continues to accelerate in conjunction with earnings coming under pressure, then equities valuations in 2019, could be "repriced" much lower, just saying.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And when it comes to earnings we are closely watching the space. We read with interest Bank of America Merrill Lynch's Revision Ratios report from the 30th of November entitled "More cutting, less raising":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Earnings Revision Ratio</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>US joins the rest of the world in negative revisions</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
In November, the 3-month earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest decline since April and the lowest level in nearly two years. A ratio of below 1 means more cuts than raises to earnings estimates, and this is the first time in over a year-and-a-half that analysts have taken down estimates. The US has caught up with the rest of the world with more cuts than raises. Trends have decelerated since early 2018 following tax reform as we expected, but the ratio now sits just a hair above its long-term average. We use the 3m ERR as one of five inputs in our market outlook: an above-average ratio has generally preceded strong near-term returns, whereas a ratio below average has signaled more muted near-term returns (Chart 2).</blockquote>
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<a href="https://1.bp.blogspot.com/-fWVsKZ6ss2s/XAhEww_CAlI/AAAAAAAAVGA/Cpeo5ANNojgw7d8EWxTwLoB5ZKIsF6P-gCLcBGAs/s1600/BAML%2B-%2BERR%2Bvs%2Bannualized%2Bforward%2B2%2Bmonth%2Breturns.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="224" data-original-width="233" src="https://1.bp.blogspot.com/-fWVsKZ6ss2s/XAhEww_CAlI/AAAAAAAAVGA/Cpeo5ANNojgw7d8EWxTwLoB5ZKIsF6P-gCLcBGAs/s1600/BAML%2B-%2BERR%2Bvs%2Bannualized%2Bforward%2B2%2Bmonth%2Breturns.jpg" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li> In November, the three-month (3m) earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest monthly decline since April and the lowest level in nearly two years.</li>
</ul>
</blockquote>
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<a href="https://1.bp.blogspot.com/-mdrdeFVIvgs/XAhK9O_IZmI/AAAAAAAAVGY/blMhuuJHNWY6lqFFLcuzsF7chL73Q5W3QCLcBGAs/s1600/BAML%2BSPX%2B3%2Bmonths%2BEarnings%2BEstimates%2BRevision%2BRatio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="304" data-original-width="396" height="245" src="https://1.bp.blogspot.com/-mdrdeFVIvgs/XAhK9O_IZmI/AAAAAAAAVGY/blMhuuJHNWY6lqFFLcuzsF7chL73Q5W3QCLcBGAs/s320/BAML%2BSPX%2B3%2Bmonths%2BEarnings%2BEstimates%2BRevision%2BRatio.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>With the ratio now below 1.0, this suggests more cuts than raises to earnings estimates for the first time in over a year-and-a-half.</li>
<li>The ERR sits just slightly above its long-term average of 0.87.</li>
<li>The more volatile one-month (1m) ERR similarly fell to a two-year low of 0.73 from 0.77.</li>
<li>The ratio is below 1.0, suggesting more cuts than raises to earnings estimates for the second consecutive month.</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>In November, all sectors (except Staples) saw their 3m ERR moderate (Chart 1). Energy, Real Estate, and Technology saw the biggest deterioration.</li>
</ul>
</blockquote>
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<a href="https://2.bp.blogspot.com/-g40f_CgS1CA/XAhKOOeULSI/AAAAAAAAVGQ/n5hhpIIHBT43a3_d9zAPgXKavM-OkyhWwCLcBGAs/s1600/BAML%2B-%2BChange%2Bin%2B3m%2Bearnings%2Brevision%2Bratio%2Bby%2Bsector.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="224" data-original-width="233" src="https://2.bp.blogspot.com/-g40f_CgS1CA/XAhKOOeULSI/AAAAAAAAVGQ/n5hhpIIHBT43a3_d9zAPgXKavM-OkyhWwCLcBGAs/s1600/BAML%2B-%2BChange%2Bin%2B3m%2Bearnings%2Brevision%2Bratio%2Bby%2Bsector.jpg" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Most sectors are now seeing more cuts than raises to earnings estimates amid widespread deterioration in revision trends. Energy, Utilities, and Tech are seeing slightly more positive than negative revisions to earnings estimates.</li>
<li>Utilities is the only sector with an above-average ERR, while the ratio is in line with the historical average for Financials, Health Care, Industrials, and Technology.</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li> Similarly, throughout November, most sectors except Utilities and Technology saw more negative than positive revisions to estimates.</li>
</ul>
</blockquote>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://4.bp.blogspot.com/-dXCW_ddTKeM/XAhLV70P65I/AAAAAAAAVGg/iK1sNNKgRuk12IidSQwXpnc-Vbl2c3eJACLcBGAs/s1600/BAML%2B-%2BSPX%2Bone%2Bmonth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="312" data-original-width="398" height="250" src="https://4.bp.blogspot.com/-dXCW_ddTKeM/XAhLV70P65I/AAAAAAAAVGg/iK1sNNKgRuk12IidSQwXpnc-Vbl2c3eJACLcBGAs/s320/BAML%2B-%2BSPX%2Bone%2Bmonth.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<ul>
<li>Energy, Materials, and Comm Svcs had the weakest one month revision trends.-" source Bank of America Merrill Lynch</li>
</ul>
</blockquote>
<br />
On top of the deteriorating picture for "earnings", in their report Bank of America Merrill Lynch also added the following in their report:<br />
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Bad breadth in credit? Distress ratio ticks up</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
We watch revision ratios closely because “breadth” measures can sometimes be early indications of broader issues within markets. Our High Yield team’s distress ratio – the percentage of US high yield bonds with an option-adjusted spread above 1000bp – has similarly proven to be a good leading indicator of defaults. This ratio has recently worsened, and now sits at a 10-month high." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
Because we do not like this picture we think from a "Sorites paradox" perspective you should continue to reduce your high beta exposure and rotate from growth to consumer staples equities wise, also reduce your financials subordinated pocket (until and if a new LTRO is announced by ECB), and continue to raise cash levels and park it in the US front-end of the curve. We think as well that recent moves in the long end of the US yield curve looks enticing, we are looking at the 30 year bucket and long dated zero coupons given that the "deflationista" camp seems to make a comeback with global growth clearly decelerating.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As we pointed out earlier in our conversation, QT is indeed reducing the size of the credit heap (bubble). Trade accordingly as per ouf final chart below.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Liquidity and credit spreads go hand in hand</span></li>
</ul>
</div>
<div style="text-align: justify;">
The tone in credit spreads has had a weaker tone in recent weeks on the back of significant outflows from mutual funds as the Fed has been continuing to withdraw liquidity in the system with QT. Our final chart comes from CITI European Portfolio Strategist note from the 22nd of November entitled "Post QE World - Bear Market, Bull Market or Kangaroo Market" and displays the relationship between central banks liquidity and Investment Grade credit spreads:</div>
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<a href="https://4.bp.blogspot.com/-h7m1scY3COs/XAlEwKPslbI/AAAAAAAAVGw/lNtNi1Tzzckp1RhPZisVV3OUd8vBewW3wCLcBGAs/s1600/CITI%2B-%2BCentral%2BBanks%2BSecurities%2BPurchases%2Bvs%2BIG%2Bspread%2Bchange.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="307" data-original-width="374" height="262" src="https://4.bp.blogspot.com/-h7m1scY3COs/XAlEwKPslbI/AAAAAAAAVGw/lNtNi1Tzzckp1RhPZisVV3OUd8vBewW3wCLcBGAs/s320/CITI%2B-%2BCentral%2BBanks%2BSecurities%2BPurchases%2Bvs%2BIG%2Bspread%2Bchange.jpg" width="320" /></a></div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<b>Liquidity and financial markets have been tied closely together</b></blockquote>
<blockquote class="tr_bq">
Citi credit strategists have shown a powerful relationship between net central bank purchases and moves in credit spreads and equity markets. By extension, reducing/reversing QE should drive credit spreads sharply higher and equity prices sharply lower. From our (equity) side, we argue that it depends very much on the nominal growth backdrop and the pace of tightening. Progressive tightening and an extending economic cycle are still likely to see credit spreads widen, but also are likely to support an extending profit cycle. Historically, there is a phase in markets where credit spreads widen but equity markets make fresh highs driven by rising EPS. This remains our base case, but we acknowledge the end cycle debate." - source CITI</blockquote>
Sure it was a fun and exciting long credit party but from our perspective and in respects to the "The Sorites paradox" and the risk of an avalanche, we would rather start in earnest to play "defense" given 2019 might prove to be even more problematic for risky asset prices than 2018. Just saying... </div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
"The one certainly for anyone in the path of an avalanche is this: standing still is not an option." - Norman Davies, British historian</blockquote>
<br />
Stay tuned !</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-36050226676433663912018-11-28T21:08:00.002+00:002018-11-28T21:08:41.547+00:00Macro and Credit - Zollverein<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"An empire founded by war has to maintain itself by war." - Montesquieu</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the evolution of the Brexit negotiations in conjunction with the tone down stance between Italy and the European Commission surrounding the budget, while waiting for the next G20 and potential US and China ease in trade war tensions, when it came to selecting our title analogy, we reminded ourselves of the Zollverein, or German Customs Union. The Zollverein was a coalition of German states formed to managed tariffs and economic policies within their territories, organized under the Zollverein treaties in 1833 and formally starting on the first of January 1834. The foundation of the Zollverein was the first instance in history in which independent states had consummated a full economic union without the simultaneous creation of a political federation or union. The original customs union was not ended in 1866 with outbreak of the Austro-Prussian War, but a substantial reorganization emerged in 1867. The new Zollverein was stronger, in that no individual state had a veto. The Zollverein set the groundwork for the unification of Germany under Prussian guidance. After the defeat in 1918, the German Empire was replaced by the Weimar Republic and Luxembourg left the Zollverein. The rest, as we usually say, is history...</span></div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at what the latest widening in credit spreads mean in terms of outlook for 2019.</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - So, you want to short credit?</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><i><b>Final charts - C</b></i><b><i>hange is in the air for global asset markets</i></b></span></li>
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<li style="line-height: 20.8px; text-align: justify;"><b><span style="font-family: inherit;">Macro and Credit - So, you want to short credit?</span></b></li>
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<span style="font-family: inherit;">While we touched in our previous conversation on the widening of credit spreads in general and the impact of falling oil prices on high beta US High Yield CCCs in particular, there has been a lot of chatter recently around the lofty valuations in leveraged loans in conjunction with the fall in prices of the asset class.</span></div>
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<span style="font-family: inherit;">Sure no doubt US High Yield CCCs is in the line of fire when it comes to its exposure to the Energy sector:</span></div>
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<a href="https://1.bp.blogspot.com/-7SVNtqcDCFg/W_62SD1sJ-I/AAAAAAAAU_0/zja98RroC2UPFc2GqHRSUUqVZKwTa1iHACLcBGAs/s1600/BAML%2B-%2BUS%2BHY%2B%2BCCC%2Bexposure%2Bto%2BEnergy%2Bsector.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="415" data-original-width="738" height="179" src="https://1.bp.blogspot.com/-7SVNtqcDCFg/W_62SD1sJ-I/AAAAAAAAU_0/zja98RroC2UPFc2GqHRSUUqVZKwTa1iHACLcBGAs/s320/BAML%2B-%2BUS%2BHY%2B%2BCCC%2Bexposure%2Bto%2BEnergy%2Bsector.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit;">Oil prices and US High Yield are highly connected (15%). CCC bucket is feeling the pain right now with 20.1% of exposure to the Energy sector:</span></div>
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<a href="https://4.bp.blogspot.com/-SbXUBg3hwAk/W_62e2LA32I/AAAAAAAAU_4/G53SGlOnNuYGDXbJLUxD0h8bAnDAgSJLgCLcBGAs/s1600/BBG%2B-%2BCCC%2Bbonds%2Blose%2Btop%2BUS%2Bcredit%2Bspot.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="314" data-original-width="600" height="167" src="https://4.bp.blogspot.com/-SbXUBg3hwAk/W_62e2LA32I/AAAAAAAAU_4/G53SGlOnNuYGDXbJLUxD0h8bAnDAgSJLgCLcBGAs/s320/BBG%2B-%2BCCC%2Bbonds%2Blose%2Btop%2BUS%2Bcredit%2Bspot.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Bloomberg</span></div>
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<span style="font-family: inherit;">For sure US High Yield being "high beta" no wonder they raced ahead of the pack when it was a good time to be long Oil. Given the recent unwind of the speculative long positioning in oil and clear deterioration in the global growth narrative, no wonder credit in general and high beta in particular is starting to feel the heat and there is more "heat" to come as per the below chart from Factset displaying the S&P 500 Energy Forward 12-months EPS vs Price of oil for the last 20 years:</span></div>
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<a href="https://1.bp.blogspot.com/-HFAUy_7JHeM/W_7HSsiGAGI/AAAAAAAAVBk/ZNepjtrcMwkQEEIm6b2dArXxlqrF2JJ2wCLcBGAs/s1600/Factset%2B-%2BSPX%2B500%2BEnergy%2BForward%2B12%2Bmonth%2BEPS%2Bvs%2BOil%2Bprices%2B20%2Byear.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="391" data-original-width="684" height="182" src="https://1.bp.blogspot.com/-HFAUy_7JHeM/W_7HSsiGAGI/AAAAAAAAVBk/ZNepjtrcMwkQEEIm6b2dArXxlqrF2JJ2wCLcBGAs/s320/Factset%2B-%2BSPX%2B500%2BEnergy%2BForward%2B12%2Bmonth%2BEPS%2Bvs%2BOil%2Bprices%2B20%2Byear.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Factset</span></div>
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<span style="font-family: inherit;">As well, we argued in the past that<a href="http://macronomy.blogspot.com/2012/05/growth-divergence-between-us-and-europe.html"> the growth divergence between US and Europe were due a difference in credit conditions</a>. </span></div>
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<span style="font-family: inherit;">The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will show it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg from our November 2013 conversation "<a href="https://macronomy.blogspot.com/2013/11/credit-in-doldrums.html">In the doldrums</a>":</span></div>
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<a href="https://3.bp.blogspot.com/-940JOo_WODI/W_65osa9skI/AAAAAAAAVAM/6ZQ3-3mnTQwuCUJf9AfddiPvmtjgF6cuACLcBGAs/s1600/BBG%2B2013%2Bchart%2BPMI%2Band%2BCredit.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="286" data-original-width="400" height="228" src="https://3.bp.blogspot.com/-940JOo_WODI/W_65osa9skI/AAAAAAAAVAM/6ZQ3-3mnTQwuCUJf9AfddiPvmtjgF6cuACLcBGAs/s320/BBG%2B2013%2Bchart%2BPMI%2Band%2BCredit.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Bloomberg</span></div>
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<span style="font-family: inherit;">There is a clear relationship we think between credit and macro from our perspective. Today the picture is more contrasted. </span></div>
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<span style="font-family: inherit;">While previously the data for Europe's aggregate PMI was more easily available, the below charts points to a faster deterioration in global growth in Europe (red line), while in the US given the credit cycle is more "advanced", Leveraged Loan prices have started in the US to fall faster than in Europe (blue line):</span></div>
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<a href="https://4.bp.blogspot.com/-pHnYIvWL0EI/W_65c8Mfp3I/AAAAAAAAVAI/TEsOHIwudVAHD3xpMRCB4XOj-0_GTjhCQCLcBGAs/s1600/BBG%2B-%2B2013%2Bchart%2Bcredit%2Band%2Bmacro.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="486" data-original-width="1357" height="114" src="https://4.bp.blogspot.com/-pHnYIvWL0EI/W_65c8Mfp3I/AAAAAAAAVAI/TEsOHIwudVAHD3xpMRCB4XOj-0_GTjhCQCLcBGAs/s320/BBG%2B-%2B2013%2Bchart%2Bcredit%2Band%2Bmacro.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Bloomberg</span></div>
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<span style="font-family: inherit;">Many financial pundits and central bankers are clearly worried, for good reason about the froth in the Leveraged Loan markets as we are seeing not only prices falling rapidly, but the growth of the sector has been significant as per the below chart from LCD, an offering of S&P Global Market Intelligence displaying the rapid growth in US Loan Funds Assets Under Management:</span></div>
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<a href="https://2.bp.blogspot.com/-7XUQ_xqxjOY/W_67TjLFELI/AAAAAAAAVAc/BUjNEXxmP2U5EiYLcl5Op1Hfn9A2tEoXQCLcBGAs/s1600/LCD%2B-%2BUS%2BLoans%2BFunds%2B-%2BAUM.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="465" data-original-width="720" height="206" src="https://2.bp.blogspot.com/-7XUQ_xqxjOY/W_67TjLFELI/AAAAAAAAVAc/BUjNEXxmP2U5EiYLcl5Op1Hfn9A2tEoXQCLcBGAs/s320/LCD%2B-%2BUS%2BLoans%2BFunds%2B-%2BAUM.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source LCD, an offering of S&P Global Market Intelligence </span></div>
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<span style="font-family: inherit;">As we pointed out again in our last conversation, our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". As pointed out by the website "<a href="http://leveragedloan.com/">LeveragedLoan.com</a>", outflows in both leveraged loans and high yield are starting to "bite":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Investors Withdraw $2.2B from US High Yield Bond Funds, ETFs</b></span></blockquote>
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<span style="font-family: inherit;">U.S. high-yield funds reported an outflow of $2.19 billion for the week ended Nov. 21, according to weekly reporters to Lipper only. This result reverses positive readings in the prior two weeks, and brings the year-to-date total outflow to roughly $26.5 billion.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-E72qVHAhDWM/W_6-5Q5FYnI/AAAAAAAAVAo/ERF1Cg7IPfcKLFjVbaT6BrfpBJukTSDdACLcBGAs/s1600/Lipper%2B-%2BHY%2Bfund%2Bflows.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="414" data-original-width="616" height="215" src="https://1.bp.blogspot.com/-E72qVHAhDWM/W_6-5Q5FYnI/AAAAAAAAVAo/ERF1Cg7IPfcKLFjVbaT6BrfpBJukTSDdACLcBGAs/s320/Lipper%2B-%2BHY%2Bfund%2Bflows.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">The year-to-date total exit continues to mark an unprecedented outflow from high-yield funds, outpacing last year’s total outflow of roughly $14.9 billion, which stands as the largest exit on an annual basis to date.</span></blockquote>
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<span style="font-family: inherit;">Mutual funds led the way, posting their largest outflow since February at $1.51 billion. ETFs saw another $682.4 million pulled by investors during the observation period. The four-week trailing average narrowed marginally to negative $427 million, from negative $470 million in the prior week.</span></blockquote>
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<span style="font-family: inherit;">The change due to market conditions was a decrease of $1.49 billion, according to Lipper. Total assets at the end of the observation period were roughly $193.4 billion. ETFs account for roughly 22% of the total, at $41.8 billion. — Jon Hemingway</span></blockquote>
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<b><span style="font-family: inherit;">US Leveraged Loan Funds See Hefty $1.7B Cash Outflow</span></b></blockquote>
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<span style="font-family: inherit;">U.S. loan funds reported an outflow of $1.74 billion for the week ended Nov. 21, according to Lipper weekly reporters only. This is the second major outflow of the past four weeks, and just the eighth negative reading of 2018.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-YVqRHHLLShk/W_6_E-2MSPI/AAAAAAAAVAs/U0TbNAwpo0ETGLcU39FEIzX5FrXzWxRmACLcBGAs/s1600/Lipper%2B-%2BLoan%2Bfund%2Bflows.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="473" data-original-width="706" height="214" src="https://3.bp.blogspot.com/-YVqRHHLLShk/W_6_E-2MSPI/AAAAAAAAVAs/U0TbNAwpo0ETGLcU39FEIzX5FrXzWxRmACLcBGAs/s320/Lipper%2B-%2BLoan%2Bfund%2Bflows.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">Last week’s outflow was the heaviest since the week ended Dec. 16, 2015 ($2.04 billion) and comes just three weeks after a $1.51 billion exodus over the last week of October (this excludes a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 8, which came as the result of a reclassification at a single institutional investor).</span></blockquote>
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<span style="font-family: inherit;">With that, the four-week trailing average slumps to $767.8 million, its lowest level in nearly three years.</span></blockquote>
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<span style="font-family: inherit;">As with the other recent outflow, mutual funds led the way with $1.07 billion pulled out, while the total for ETFs was roughly $673 million. For ETFs that is the largest exit on record behind the $551.5 million loss for the week ended Oct. 31. Of note, ETF flows were positive in the weeks between, whereas mutual fund flows were negative for the fourth consecutive week.</span></blockquote>
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<span style="font-family: inherit;">While last week’s outflow puts a dent in the year-to-date total inflow, it remains a substantial $8.6 billion.</span></blockquote>
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<span style="font-family: inherit;">The change due to market conditions last week was a decrease of $774.3 million, the steepest decline since Dec. 16, 2015. Total assets were roughly $105.5 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $12.1 billion. — Jon Hemingway - source LeveragedLoan.com</span></blockquote>
<span style="font-family: inherit;">The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost returned –0.52% in the month to date and 3.46% in the YTD. Sure some pundits would like to point out that contrary to the dismal performance of credit in 2018, in similar fashion to 2008 as indicated by Driehaus on their Twitter feed:</span><br />
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<a href="https://1.bp.blogspot.com/-jplI0lNlz-o/W_6_60i1ZtI/AAAAAAAAVA8/lP9bVJ4WcO4wCBP5h3u5CyDG_NUePkoRwCLcBGAs/s1600/BBG%2B-%2BDriehaus%2B-%2BYRD%2Breturn%2Bnegztive%2Bon%2Beach%2Bof%2Bthe%2Bmain%2BUS%2Bcredit%2Bindexes%2B-%2B1st%2Btime%2Bsince%2B2008.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="264" data-original-width="643" height="131" src="https://1.bp.blogspot.com/-jplI0lNlz-o/W_6_60i1ZtI/AAAAAAAAVA8/lP9bVJ4WcO4wCBP5h3u5CyDG_NUePkoRwCLcBGAs/s320/BBG%2B-%2BDriehaus%2B-%2BYRD%2Breturn%2Bnegztive%2Bon%2Beach%2Bof%2Bthe%2Bmain%2BUS%2Bcredit%2Bindexes%2B-%2B1st%2Btime%2Bsince%2B2008.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">"YTD return is negative on each of the main US credit indexes (High Yield, Investment Grade and Aggregate). 1st time since 2008 that returns for all 3 indexes are negative through mid-November. Lately, I find myself saying “first time since 2008” a lot more frequently" - graph source Bloomberg - Driehaus - Twitter feed.</span></blockquote>
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<span style="font-family: inherit;">Sure, the S&P/LSTA U.S. Leveraged Loan 100 Index is roughly around +3.5% YTD, so still overall unscathed some would argue. Also in 2008, the index was down by a cool -28%, for perspective but we do think that if you want to go "short" credit, then indeed Leveraged Loans are a "prime" candidate" as pointed out by Peter Tchir in a July 2018 tweet:</span></div>
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<span style="font-family: inherit;">"Many forget LCDX traded worse than HYCDX during 2008 due to positioning and then loans were more clearly senior." - source Peter Tchir, Twitter</span></blockquote>
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<span style="font-family: inherit;">Given the considerable size in Cov-Lite Loans in this credit cycle, then indeed, if the credit markets start unravelling, Leveraged Loans are clearly in the front line:</span></div>
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<a href="https://2.bp.blogspot.com/-h8-1Fc3aCdI/W_7Gn--N_0I/AAAAAAAAVBc/XB5gaPxewXMU1_vVhADlsdL9YvevZLnwwCLcBGAs/s1600/BAML%2BCov%2BLite%2Bissuance%2BNov%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="354" data-original-width="457" height="247" src="https://2.bp.blogspot.com/-h8-1Fc3aCdI/W_7Gn--N_0I/AAAAAAAAVBc/XB5gaPxewXMU1_vVhADlsdL9YvevZLnwwCLcBGAs/s320/BAML%2BCov%2BLite%2Bissuance%2BNov%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit;">Of course Leveraged Loans, are starting to follow the painful path of other segments of the credit markets already in conjunction with global growth decelerating:</span></div>
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<a href="https://4.bp.blogspot.com/-JPqBNeRxspg/W_7EL6mBi2I/AAAAAAAAVBI/g8Y0WBtapfAtYUQbtVS-87IKR6QoVIKTwCLcBGAs/s1600/SRLN%2B-%2BAdam%2BButler%2B-%2BSenior%2BLeveraged%2Bloans%2B-%2B23-11-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="396" data-original-width="900" height="140" src="https://4.bp.blogspot.com/-JPqBNeRxspg/W_7EL6mBi2I/AAAAAAAAVBI/g8Y0WBtapfAtYUQbtVS-87IKR6QoVIKTwCLcBGAs/s320/SRLN%2B-%2BAdam%2BButler%2B-%2BSenior%2BLeveraged%2Bloans%2B-%2B23-11-2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">"Those of you glued to action in US equities to guide investment positions may want to devote some attention to this chart of returns to senior leveraged loans (SRLN) in excess of T-bills. Likely to be an epicenter of action in the next crisis, and currently breaking trend." <span style="text-align: center;">- source Adam Butler - Twitter feed</span></span></blockquote>
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<span style="font-family: inherit;">Clearly if indeed credit markets start "breaking bad" in 2019, then for those of you not having the necessary ISDA to short the synthetic LCDX index could use ETFs to express their "short" view on Leveraged Loans as indicated by IHS Markit by Sam Pierson on the 26th of November in his article "<a href="https://ihsmarkit.com/research-analysis/etf-lending-continues-to-thrive.html">ETF lending continues to thrive</a>":</span></div>
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<span style="font-family: inherit;">"Not all ETFs can be created out of borrowed securities, in particular those with exposure to illiquid asset classes. One such example is the Invesco Senior Loan ETF, BKLN, which consists of a basket of leveraged loans. The fund has seen increased demand from short sellers in Q4, with over $800m in current loan balances. Only a small handful of the underlying loans have any availability in securities lending, so borrowing shares from long holders of the ETF is essentially the only means of sourcing the borrow. Lenders have attempted to pass through increased rates, though the increased fees in late October and early November saw an immediate response of returned shares, driving fees lower. Once the borrow fee declined the balances picked up and fees have started to move up again. It's worth noting that BKLN has a 67bps expense ratio, which means that if short sellers can borrow for less than that rate there is an arbitrage assuming no movement in the underlying asset class. Additionally, the YTD increase in OBFR means that short selling any easy-to-borrow asset will result in a positive rebate to cash proceeds."</span></blockquote>
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<a href="https://2.bp.blogspot.com/-jkg0UGxNi5s/W_7EkRkQpuI/AAAAAAAAVBQ/jhV4lVdWtNsZwZZT4r--jPdpj7mVEsMrwCLcBGAs/s1600/Invesco%2BSenior%2BLoan%2BETF%2Bequity%2Bshort%2Bdemand%2Band%2Bshare%2Bprices%2B-%2BSam%2BPierson.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="458" data-original-width="650" height="225" src="https://2.bp.blogspot.com/-jkg0UGxNi5s/W_7EkRkQpuI/AAAAAAAAVBQ/jhV4lVdWtNsZwZZT4r--jPdpj7mVEsMrwCLcBGAs/s320/Invesco%2BSenior%2BLoan%2BETF%2Bequity%2Bshort%2Bdemand%2Band%2Bshare%2Bprices%2B-%2BSam%2BPierson.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">The $BKLN ETF is a popular way to hedge/short the asset class, in part owing the 67bps expense ratio (short sellers benefit from higher expense ratio, all else equal), though increased borrow costs over the last week may, again, dampen demand." - source Sam Pierson, Twitter feed.</span></blockquote>
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<span style="font-family: inherit;">As we have argued in our recent November conversation "<a href="https://macronomy.blogspot.com/2018/11/macro-and-credit-stalemate.html">Stalemate</a>", Housing markets turn slowly then suddenly, same thing goes with Leveraged Loans as pointed out by Peter Tchir. </span></div>
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<span style="font-family: inherit;"><br /></span></div>
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<span style="font-family: inherit;">The question that everyone is asking when it comes to credit markets as we move towards 2019 and the sell-side is sending out their outlooks is asking ourselves if we will be entering indeed a "bear" market in credit. On this subject we read with interest Morgan Stanley's synopsis and note from their 2019 Outlook for North America published on the 25th of November and entitled "The Bear Has Begun":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>We believe the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>A more challenging macro backdrop:</b> In 2018, weakening flows and tighter liquidity conditions served as the key headwinds in credit, but as an important offset, the US economy remained solid. In 2019, we think it gets tougher on both fronts – monetary policy will likely near restrictive territory for the first time this cycle, while the tailwind from a booming economy fades as growth decelerates and earnings growth potentially slows to a standstill. As that happens, late cycle risks may morph into end-of-cycle fears, continuing to break the weak links along the way, especially the more levered parts of corporate credit markets.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Late cycle and beyond: </b>A turn in the credit cycle is not a specific point in time, but instead occurs in stages, over multiple years, beginning when growth is strong. With credit flows turning, financial conditions tightening, and idiosyncratic risks rising, <b><span style="color: red;">we think that process has already started, slowly for now</span></b>. And remember, the vulnerabilities in a cycle are always ignored on the way up. As this process continues to unfold and credit conditions tighten, the bull market excesses - this time centered around non-financial corporate balance sheets - should become increasingly clear.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>A few silver linings:</b> While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising fairly quickly, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. Additionally, while spreads are nowhere near where they will likely peak when the cycle fully turns, after the recent sell-off, valuations are not as extreme in places. Both of these factors help at the margin. That said, <span style="color: red;"><b>we very much stick to our bigger picture view that the credit bear market is under way, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality</b></span>.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>2019 forecasts: </b>In our base case we forecast a -0.8% IG excess return, a 0.5% HY total return and a 1.3% loan total return. We expect $1.24tr, $183bn, and $436bn in IG, USD HY, and institutional loan gross issuance, respectively. Lastly, we project a 2.9% HY default rate.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Recommended positioning:</b> In IG we prefer As over BBBs, Fins over non-Fins, the front-end of the curve, low $- priced bonds, US over European banks, and European over US BBBs. In HY and loans we remain up-in-quality, and prefer short-duration HY bonds. We have a modest preference for loans over HY, but think that view may change later in the year. In derivatives we prefer long CDX risk to cash, owning long-dated vol, positioning for decompression, and buying BBB CDS protection vs index." - source Morgan Stanley</span></blockquote>
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<span style="font-family: inherit;">As we pointed out in our previous note, credit mutual flows matter and it's probably matters as well for the Fed as well given the most recent dovish rhetoric coming from its chairman Jerome Powell. The latest price action in both the US dollar and Emerging Market equities is giving some much needed respite to the Macro tourists, which have been on the receiving end of the Fed's QT and hiking policy. </span></div>
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<span style="font-family: inherit;"><br /></span></div>
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<span style="font-family: inherit;">Weakening flows clearly have been a trend this year in credit markets as indicated by Morgan Stanley in their long interesting outlook note:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Restrictive Fed Policy and Decelerating Growth – a Tougher Combination</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Tightening liquidity conditions should remain a headwind in 2019, at least initially, as the Fed pushes rates near restrictive territory, while continuing to shrink its balance sheet at the maximum rate, for now. Taking a step back, for most of 2018, we argued that a tightening in Fed policy, especially in the current cycle, was a material headwind for credit. In a nutshell, central bank stimulus was massive in this cycle, and highly supportive of credit. We thought the process in reverse, at the least, would weaken the flows into credit markets, driving higher volatility, with less of a “liquidity buffer” to cushion the shocks. In our view, these headwinds have materialized, just slowly and in stages. As we show in Exhibit 2 and Exhibit 3, flows into credit markets did weaken in 2018 across multiple sources.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-QrjyzFkxqvw/W_7mOscVjuI/AAAAAAAAVBw/39T_iB8olDsP4PyyTmXlSugmHNlnadMlACLcBGAs/s1600/MS%2B-%2BMuch%2Bweaker%2Bmutual%2Bfund%2Bflows%2Bin%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="261" data-original-width="395" height="211" src="https://4.bp.blogspot.com/-QrjyzFkxqvw/W_7mOscVjuI/AAAAAAAAVBw/39T_iB8olDsP4PyyTmXlSugmHNlnadMlACLcBGAs/s320/MS%2B-%2BMuch%2Bweaker%2Bmutual%2Bfund%2Bflows%2Bin%2B2018.jpg" width="320" /></span></a></div>
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<a href="https://1.bp.blogspot.com/-GUFtO9gNezw/W_7mfbVafQI/AAAAAAAAVB4/DLRZciiDoecgVZT19KpopoMsiDsCnjTqwCLcBGAs/s1600/MS%2B-%2BForeign%2Bdemand%2Bslowed%2Bnotably%2Bas%2Bwell.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="251" data-original-width="380" height="211" src="https://1.bp.blogspot.com/-GUFtO9gNezw/W_7mfbVafQI/AAAAAAAAVB4/DLRZciiDoecgVZT19KpopoMsiDsCnjTqwCLcBGAs/s320/MS%2B-%2BForeign%2Bdemand%2Bslowed%2Bnotably%2Bas%2Bwell.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Weakening flows clearly hit global credit markets this past year, one-by-one.</b> For example, Exhibit 4 shows the spread widening in 2018 in US IG, in EM credit, in European credit, and most recently in US high yield, with financial conditions tightening in the process.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-9D_j9sT0WZ8/W_7nGRk_MtI/AAAAAAAAVCE/NcReHIeHENAKAdfKz_Nl1pS4m8gE9_JOwCLcBGAs/s1600/MS%2B-%2BTighter%2Bliquidity%2Bconditions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="279" data-original-width="402" height="222" src="https://2.bp.blogspot.com/-9D_j9sT0WZ8/W_7nGRk_MtI/AAAAAAAAVCE/NcReHIeHENAKAdfKz_Nl1pS4m8gE9_JOwCLcBGAs/s320/MS%2B-%2BTighter%2Bliquidity%2Bconditions.jpg" width="320" /></span></a></div>
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<a href="https://1.bp.blogspot.com/-BUo_ACqQW4Q/W_7m3WHHWMI/AAAAAAAAVCA/fEw8_MJ_eRUKPzr9FEa4IUnKIhpWl1PngCLcBGAs/s1600/MS%2B-%2BAfter%2Ba%2Bbrief%2Bperiod%2Bof%2Bcalm%2Bin%2B3Q%252C%2Bfinancial%2Bconditions%2Bcontinued%2Bto%2Btighten.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="273" data-original-width="394" height="221" src="https://1.bp.blogspot.com/-BUo_ACqQW4Q/W_7m3WHHWMI/AAAAAAAAVCA/fEw8_MJ_eRUKPzr9FEa4IUnKIhpWl1PngCLcBGAs/s320/MS%2B-%2BAfter%2Ba%2Bbrief%2Bperiod%2Bof%2Bcalm%2Bin%2B3Q%252C%2Bfinancial%2Bconditions%2Bcontinued%2Bto%2Btighten.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>As we have frequently argued, fundamental issues are easier to hide when liquidity is </b><b>flooding into markets, and it is not anymore.</b> As liquidity conditions get squeezed, it is natural for dispersion in performance across asset classes, regions, sectors, and single names to pick up, with the weak links breaking first. US high yield was more resilient for most of the year than other markets, in part due to very low supply, and in part given its close ties to the strength in the US economy. But even HY, the "resilient" credit market, has only managed a roughly flat total return YTD, despite very strong earnings growth, a solid US economy, and supply down ~30%, which we think speaks to the importance of this tightening in liquidity conditions.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Looking to 2019 – two points are key to remember:</b> 1) The liquidity withdrawal is going to accelerate, at first, and 2) unlike in 2018, it will happen as growth is decelerating. We think this will create an even more challenging backdrop, with the outperformance of higher beta credit fading as a result. On the first theme, as we alluded to above, our economists expect two more rate hikes in 2019 (after one more hike in December 2018).</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">We can debate where monetary policy sits in relation to neutral, but in our view, the flattening in the Treasury curve this past year, the tightening in financial conditions, as well as some of the weakness in key interest rate-sensitive parts of the economy, such as housing and autos, tells us that monetary policy is already pretty close to ‘tight.’ And remember, this tightening will not be just a US phenomenon going forward, as we see it. The ECB will be done buying bonds next year and hike in 4Q19, and the BoJ and BoE will hike in 2Q19, with the BoJ likely to reduce JGB purchase amounts as well, according to our economists.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-hbFFi9Q3pnc/W_7oxZRQX6I/AAAAAAAAVCU/-79T__GfNdgPSp7Sz8DlT4XafVMag7YXQCLcBGAs/s1600/MS%2B-%2BMonetary%2Bpolicy%2Bmay%2Bbecome%2Brestrictive%2Bin%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="283" data-original-width="395" height="229" src="https://3.bp.blogspot.com/-hbFFi9Q3pnc/W_7oxZRQX6I/AAAAAAAAVCU/-79T__GfNdgPSp7Sz8DlT4XafVMag7YXQCLcBGAs/s320/MS%2B-%2BMonetary%2Bpolicy%2Bmay%2Bbecome%2Brestrictive%2Bin%2B2019.jpg" width="320" /></span></a></div>
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<a href="https://2.bp.blogspot.com/-Zkl9nECAgDE/W_7o18HosOI/AAAAAAAAVCY/zVtiSjQKTPcfHQzT3sgUNr-SI259JzY2QCLcBGAs/s1600/MS%2B-%2Band%2BG3%2Bcentral%2Bbank%2Bbalance%2Bsheets%2Bmay%2Bbe%2Bshrinking%2Bat%2Bthe%2Bsame%2Btime.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="270" data-original-width="397" height="217" src="https://2.bp.blogspot.com/-Zkl9nECAgDE/W_7o18HosOI/AAAAAAAAVCY/zVtiSjQKTPcfHQzT3sgUNr-SI259JzY2QCLcBGAs/s320/MS%2B-%2Band%2BG3%2Bcentral%2Bbank%2Bbalance%2Bsheets%2Bmay%2Bbe%2Bshrinking%2Bat%2Bthe%2Bsame%2Btime.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>But remember, throughout 2018, investors could consistently fall back on the idea that the US economy was booming with extremely strong earnings growth.</b> Hence, it was easier to write off the multitude of macro headwinds (i.e, tighter Fed policy, tariffs, China/EM weakness, Italian politics, etc…) as “noise.” Going forward, these dynamics are changing. <b><span style="color: red;">We expect US growth to decelerate notably, from 3.1% in 2018 to 1.7% in 2019, (with GDP growth of just 1.0% in 3Q19) as fiscal stimulus starts to fade, the interest rate-sensitive parts of the economy (i.e., autos/housing) continue to soften</span></b>, financial conditions tighten, and tariffs weigh on business investment. </span></blockquote>
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<a href="https://1.bp.blogspot.com/-hu7UtmNoE60/W_7qUvP9gHI/AAAAAAAAVCo/TlzG64Jb1-AGCL7naULk47pjUKceSrF8QCLcBGAs/s1600/MS%2B-%2BUS%2Bgrowth%2Bto%2Bslow%2Bnotably%2Bin%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="217" data-original-width="397" height="174" src="https://1.bp.blogspot.com/-hu7UtmNoE60/W_7qUvP9gHI/AAAAAAAAVCo/TlzG64Jb1-AGCL7naULk47pjUKceSrF8QCLcBGAs/s320/MS%2B-%2BUS%2Bgrowth%2Bto%2Bslow%2Bnotably%2Bin%2B2019.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">As we show in Exhibit 9, the global economy has already slowed, with the US bucking the trend so far, thanks in part to atypical late-cycle fiscal stimulus, but we think the US will converge to the downside as 2019 progresses.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-lWSd7nkxDss/W_7qW5j1eYI/AAAAAAAAVCs/wW1tVvijJBsJlz5Mfh8vL3sexmaIrOdbQCLcBGAs/s1600/MS%2B-%2BUS%2Bconverging%2Bdownward%2Bto%2Bthe%2Brest%2Bof%2Bthe%2Bglobe.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="255" data-original-width="397" height="205" src="https://3.bp.blogspot.com/-lWSd7nkxDss/W_7qW5j1eYI/AAAAAAAAVCs/wW1tVvijJBsJlz5Mfh8vL3sexmaIrOdbQCLcBGAs/s320/MS%2B-%2BUS%2Bconverging%2Bdownward%2Bto%2Bthe%2Brest%2Bof%2Bthe%2Bglobe.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b>Even more importantly, our equity strategists expect a material slowdown in earnings growth, with the likelihood of an outright earnings recession for a quarter or two in 2019 reasonably high</b>. In their view, comps get very challenging next year, and margins will compress, with slower top-line growth and costs rising in many places, despite consensus expectations for margin expansion. We think markets are finally waking up to these earnings/growth risks with this recent sell-off.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-75PebZvaffE/W_7q_EWr-oI/AAAAAAAAVC4/Dqv3-4qIwaEb8XwbNBO7LWe0x8aK5BkYACLcBGAs/s1600/MS%2B-%2Bslowdown%2Bin%2Bearnings%2Bgrowth%2Bin%2B2019.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="266" data-original-width="401" height="212" src="https://4.bp.blogspot.com/-75PebZvaffE/W_7q_EWr-oI/AAAAAAAAVC4/Dqv3-4qIwaEb8XwbNBO7LWe0x8aK5BkYACLcBGAs/s320/MS%2B-%2Bslowdown%2Bin%2Bearnings%2Bgrowth%2Bin%2B2019.jpg" width="320" /></span></a></div>
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<a href="https://1.bp.blogspot.com/-5gjalPfNXc0/W_7rCYsXpXI/AAAAAAAAVC8/-th8sd_YZpYwyxamvbkaO0r_pbQPwcyfQCLcBGAs/s1600/MS%2B-%2BMargins%2Bsqueezed.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="269" data-original-width="386" height="223" src="https://1.bp.blogspot.com/-5gjalPfNXc0/W_7rCYsXpXI/AAAAAAAAVC8/-th8sd_YZpYwyxamvbkaO0r_pbQPwcyfQCLcBGAs/s320/MS%2B-%2BMargins%2Bsqueezed.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;"><b>Yes, 1.7% GDP growth is still manageable, and far from recessionary levels</b>. In fact, one could make the case that this level of growth is ideal for credit – not too hot, not too cold. While we don’t disagree at a high level, we think details matter. In our view, slower growth in the middle of a cycle, which drives very accommodative central bank policy, is ideal. A slowdown in growth near the end of a cycle as a result of a restrictive Fed is not, and we think runs the risk that investors start to price in a higher likelihood that the cycle is coming to an end.</span></blockquote>
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<blockquote class="tr_bq">
<span style="font-family: inherit;"><b>With growth slowing, and financial conditions tightening, will the Fed stop hiking? For now, we think the Fed "put" is fairly deep out of the money</b>. Unlike at past points in this cycle, the Fed’s hands are more tied, with growth well above trend, unemployment at ~40 year lows, and core PCE now at 2%. That said, our economists expect the Fed to pause its rate hike cycle in 3Q19 and to end balance sheet normalization in Sep-19. For a short period of time, these dynamics could certainly boost sentiment. Longer term, we are not sure that they would be so bullish for markets. If the Fed stops hiking because they are at their perceived neutral rate and they believe inflation trends are benign, that may be positive. But if they stop hiking because the economy is weakening, that may be quite negative. In fact as we show in Exhibit 12, the biggest bouts of spread widening in a cycle, especially in HY, happen from the point when the Fed stops hiking, until deep into the rate cutting cycle, as that is when growth is rolling over.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-7rVlcLKUFDg/W_72ljCKEnI/AAAAAAAAVDM/eqLCao2d604Jmu-u7ewVLonPQ5DwJWDOwCLcBGAs/s1600/MS%2B-%2BMarket%2Bperform%2Bworst%2Bafter%2Bthe%2BFed%2Bstops%2Bhiking.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="270" data-original-width="406" height="212" src="https://3.bp.blogspot.com/-7rVlcLKUFDg/W_72ljCKEnI/AAAAAAAAVDM/eqLCao2d604Jmu-u7ewVLonPQ5DwJWDOwCLcBGAs/s320/MS%2B-%2BMarket%2Bperform%2Bworst%2Bafter%2Bthe%2BFed%2Bstops%2Bhiking.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;">Regardless of exactly when the Fed pauses, in this cycle, buying when growth is booming has not worked well (Exhibit 13), and we think this time will be no different as the macro backdrop reverts back down to, or even below, trend.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-1n-cwRoa3ZE/W_72rRlLSyI/AAAAAAAAVDQ/lCwG6W-B7QI_Ys1-lNSZMWTqpxD5kxbsgCLcBGAs/s1600/MS%2B-%2BISM%2Bvs%2BHY%2BSpreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="269" data-original-width="396" height="217" src="https://1.bp.blogspot.com/-1n-cwRoa3ZE/W_72rRlLSyI/AAAAAAAAVDQ/lCwG6W-B7QI_Ys1-lNSZMWTqpxD5kxbsgCLcBGAs/s320/MS%2B-%2BISM%2Bvs%2BHY%2BSpreads.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"><b>Adding everything up, we think macro challenges will grow in 2019</b>. Monetary policy will continue tightening, with global central banks committed to removing stimulus, for now. All while the environment of very strong US growth and very robust earnings growth will fade. We think that backdrop will become even tougher for credit, especially some of 2018’s outperformers like US HY and loans, and continue to expose the fundamental challenges in the asset class built up over nearly a decade-long bull market." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end. Clearly the narrative has been changing and as we stated in our previous conversation:</span><br />
<blockquote class="tr_bq">
<span style="background-color: white;"><span style="font-family: inherit;">"When the Credit facts change, I change my Credit mind. What do you do, Sir ..." - source Macronomics</span></span></blockquote>
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<div style="text-align: justify;">
<span style="font-family: inherit;">Our final chart below indicates that change is in the air for global asset markets and that 2019 could prove to be even trickier than 2018 as the credit cycle continues to gradually turn.</span></div>
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<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;"><b>Final charts - C</b><b>hange is in the air for global asset markets</b></span></li>
</ul>
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<div style="text-align: justify;">
<span style="font-family: inherit;">The latest "dovish" take from Fed Jerome Powell's speech is clearly enticing to trigger some short term rally , we do think that 2019 will eventually be even more challenging as global growth is decelerating. Our final charts come from Bank of America Merrill Lynch from their Commodity Strategies 2019 outlook from the 18th of November and show that there is a trend for higher interest rates and volatility ahead of us:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Equity markets are sowing winds of change</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">While higher real interest rates have been a clear headwind to gold, the rise in the global risk free rate also seems to push up equity market volatility. Our equity derivatives team has been warning about this trend of higher interest rates and higher volatility for some time (Chart 134). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-y5JTDn2_6KA/W_7903Qya8I/AAAAAAAAVDg/eydW03lrDUw92zi1wOGGuG1fzb6X9I6fACLcBGAs/s1600/BAML%2B-%2Bequity%2Bderivatives%2Bteam%2Bvol%2Band%2Brates.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="303" data-original-width="393" height="246" src="https://3.bp.blogspot.com/-y5JTDn2_6KA/W_7903Qya8I/AAAAAAAAVDg/eydW03lrDUw92zi1wOGGuG1fzb6X9I6fACLcBGAs/s320/BAML%2B-%2Bequity%2Bderivatives%2Bteam%2Bvol%2Band%2Brates.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">True, global equity markets have been a tale of two cities this year, with US equity markets rising and the rest of the world lagging (Chart 135). But the pickup in volatility suggests that change is in the air for global asset markets</span></blockquote>
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<a href="https://4.bp.blogspot.com/-gWOVo6egsxs/W_7-D3KB9GI/AAAAAAAAVDk/jMBl874vrA8Vqn6x_DCFKpA3IO53WGwKACLcBGAs/s1600/BAML%2B-%2Bglobal%2Bequity%2Bmarkets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="313" data-original-width="386" height="259" src="https://4.bp.blogspot.com/-gWOVo6egsxs/W_7-D3KB9GI/AAAAAAAAVDk/jMBl874vrA8Vqn6x_DCFKpA3IO53WGwKACLcBGAs/s320/BAML%2B-%2Bglobal%2Bequity%2Bmarkets.jpg" width="320" /></span></a></div>
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<b><span style="font-family: inherit;">A rising VIX will eventually force the Fed to slow...</span></b></blockquote>
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<span style="font-family: inherit;">It is easy to forget that the S&P500 total return index posted a Sharpe ratio of 3.0 last year, but it is running just on 0.5 this year. Of course, the large pick up in equity market volatility (VIX) is hurting risk-adjusted equity market returns (Chart 136). </span></blockquote>
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<a href="https://2.bp.blogspot.com/-BbMQ7sO9CBo/W_7-caP4BMI/AAAAAAAAVDw/NLGil8xtFusBwxqgGYLgAJiiRWmreGhngCLcBGAs/s1600/BAML%2B-%2Blarge%2Bpick%2Bup%2Bin%2Bequity%2Bmarket%2Bvol.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="313" data-original-width="389" height="257" src="https://2.bp.blogspot.com/-BbMQ7sO9CBo/W_7-caP4BMI/AAAAAAAAVDw/NLGil8xtFusBwxqgGYLgAJiiRWmreGhngCLcBGAs/s320/BAML%2B-%2Blarge%2Bpick%2Bup%2Bin%2Bequity%2Bmarket%2Bvol.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">But also equity markets have struggled to break higher this year on a number of factors. The most important issue for gold here, however, is that a further drop in equity market values could eventually encourage the Fed to slow down its monetary tightening path (Exhibit 6). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-l6g8-YnqJ9E/W_7-qm5JMWI/AAAAAAAAVD0/OJtPJ1AlfREP-tdwKr5-MBmInSIloka4gCLcBGAs/s1600/BAML%2B-%2Ba%2Bfurther%2Bdrop.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="389" height="250" src="https://3.bp.blogspot.com/-l6g8-YnqJ9E/W_7-qm5JMWI/AAAAAAAAVD0/OJtPJ1AlfREP-tdwKr5-MBmInSIloka4gCLcBGAs/s320/BAML%2B-%2Ba%2Bfurther%2Bdrop.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">So higher equity vol will likely lend support to the yellow metal going forward." - source Bank of America Merrill Lynch</span></blockquote>
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<span style="font-family: inherit;">When it comes to our Zollverein analogy, while Italy continues to be a concern, we believe that France should clearly be on everyone's radar as the situation is deteriorating in conjunction with its public finances. It remains to be seen if 2019 will see the New Zollverein aka the European Union coming under pressure as it did in 1919, leading in Germany to the introduction of the Weimar Republic but, we ramble again...</span></div>
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<span style="font-family: inherit;">"Look back over the past, with its changing empires that rose and fell, and you can foresee the future, too." - Marcus Aurelius</span></blockquote>
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<span style="font-family: inherit;">Stay tuned ! </span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-86357937324947748862018-11-16T15:31:00.001+00:002018-11-25T17:39:47.981+00:00Macro and Credit - Last of the Romans<div dir="ltr" style="text-align: left;" trbidi="on">
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"Bad money drives out good" - Gresham’s Law</blockquote>
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Looking at the massive capitulation and fall of oil prices, feeling somewhat liquidation from a wounded player in the market, as well as looking at the escalation in the war of words between the Trump administration and Europe, not paying enough their "fair" share for "defense", when it came to selecting our title analogy, we reminded ourselves the term "Last of the Romans". The term "Last of the Romans" (Ultimus Romanorum) has historically been used to describe an individual or individuals thought to embody the values of Ancient Roman civilization - values which, by implication, became extinct on his or their death. In the United States, "Last of the Romans" was used on numerous occasions during the early 19th century as an epithet for the political leaders and statesmen who participated in the American Revolution by signing the United States Declaration of Independence, taking part in the American Revolutionary War, or established the United States Constitution. Looking at the trajectory of the United States, with its swelling budget deficit and rapidly growing interest payments share of the budget and political polarization, when it comes to the fall of an Empire, the fall of the Roman Empire comes to mind. We read with great interest Ben Hunt's latest missive on Linkedin entitled "<a href="https://www.linkedin.com/pulse/foundation-empire-ben-hunt/">Foudation and Empire</a>":</div>
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"The other way to be richer than your economy grows is to take wealth from the rest of the world. The other way is to turn alliance into empire. And then suck it dry. Or as we'd say in bloodless economic-speak, "extract rents".</blockquote>
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The Athenians did it. The Romans did it. The British did it. And history remembers each of these imperial nations rather fondly. They were the Foundations of their day, at least as the victors write the history books.</blockquote>
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I submit to you that the "economic nationalist" trade policies of Trump and Lighthizer and Navarro and Bannon and the rest of that crew understand this other way. I submit to you that <span style="color: red;">when Trump expresses excitement over collecting some billions of dollars in Chinese tariffs, he genuinely believes that he is adding to the "wealth" of the United States. I submit to you that when Trump demands that Europe pay more for defense, his goal is to turn NATO into a profit center</span>. I submit to you that applying a simple mercantilist lens explains 99% of our foreign policy towards Korea, Saudi Arabia, Iran and Russia.</blockquote>
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Does this sort of rent-seeking empire-sucking foreign policy "work"? Sure, particularly if you run it like a mob protection racket. Cough, cough. I mean, of course it ultimately ends in tears and constant warfare, but hey, we've got an election to win. What's a little inertia, despotism and maldistribution among friends? " - source Ben Hunt <a href="https://www.linkedin.com/pulse/foundation-empire-ben-hunt/">on Linkedin.com</a></blockquote>
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Of course as the saying goes, any resemblance to actual persons, living or dead, or actual events is purely coincidental. To make yet another parallel between Ben's must read paper and the Fall of the Roman Empire, we read with interest Cato Institute note entitled "<a href="https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/1994/11/cj14n2-7.pdf">How excessive government killed ancient Rome</a>":</div>
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"At first, the government could raise additional revenue from the sale of state property. Later, more unscrupulous emperors like Domitian (81—96 AD.) would use trumped-up charges to confiscate the assets of the wealthy. They would also invent excuses to demand tribute from the provinces and the wealthy. Such tribute, called the aurum corinarium, was nominally voluntary and paid in gold to commemorate special occasions, such as the accession of a new emperor or a great military victory. Caracalla (198—217 AD.) often reported such dubious “victories” as a way of raising revenue. Rostovtzeff (1957: 417) calls these levies “pure robbery.”" - source Cato Institute.</blockquote>
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While obviously the United States comes to mind when it comes to the recent spat with Europe relating to "defense" cost and extracting "rent" from their "allies", also in relation to excessive taxation and wealth confiscation, taxation levels in France have become so rapacious that the French government is facing public discontent which will come in full display on the 17th of November. Again, watch this space, because whereas everyone is focusing on the on-going Mexican standoff between Italy and the European Commission in relation to the Italian budget, we think that France's trajectory is worth monitoring: public spending represents 56.4 % of GDP whereas the average in other countries in the European Union amounts to 47 %. We live in interesting times. Just saying...</div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at what the latest fall in oil prices entails in conjunction with the rise of the US dollar, as well as the growing stress in credit and the deceleration in global growth.</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
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<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - </b></i><b><i>When the Credit facts change, I change my Credit mind. What do you do, Sir ...</i></b></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final charts - US Investment Grade credit, retail is finally dragging their feet...</b></i></li>
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<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - When the Credit facts change, I change my Credit mind. What do you do, Sir ...</li>
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In our previous conversation, following the US midterm elections we were wondering whether we would see a period of "Goldigridlock" namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. Obviously, the markets have seen more jitters in recent days and oil prices, as expected in our previous musing has started to put some pressure on the high beta CCC bracket in US High Yield. As we indicated in our previous conversation, in our book credit leads equity and we are closely watching credit drifting wider.<br />
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We have not been the only one watching credit drifting wider, following rising dispersion in recent months. We read recently with interest Morgan Stanley's US Economics note entitled "Cracks in Credit":<br />
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"<b>Widening credit spreads are in focus as a recent development with potential implications for financial conditions and the economic outlook.</b> Recent moves in credit have not had a material impact on our economic outlook to date, but the risk bears watching as a sustained tightening in corporate credit conditions can create strong headwinds for economic activity.</blockquote>
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<a href="https://2.bp.blogspot.com/-Dr_3UYvc6g4/W-2255hmAXI/AAAAAAAAU8k/LeTgK7Eq6zMu7xSNYIYTEZ-X9123OxTMACLcBGAs/s1600/MS%2B-%2BUS%2BCorporate%2BBBB%2B-%2B10%2Byear%2BTreasury%2BSpread.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="288" data-original-width="368" height="250" src="https://2.bp.blogspot.com/-Dr_3UYvc6g4/W-2255hmAXI/AAAAAAAAU8k/LeTgK7Eq6zMu7xSNYIYTEZ-X9123OxTMACLcBGAs/s320/MS%2B-%2BUS%2BCorporate%2BBBB%2B-%2B10%2Byear%2BTreasury%2BSpread.jpg" width="320" /></a></div>
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<b>Policymakers at the Fed are paying close attention as well.</b> In a recent speech, Governor Brainard judged the easy state of corporate credit conditions and narrow credit spreads as upside risk factors with respect to the economic outlook that "could push the short-run neutral [fed funds] rate above its longer-run value." But Governor Brainard was more cautious on the medium term implications, noting that "financial vulnerabilities are building" and pointed to particularly notable risks in the corporate sector, "where low spreads and loosening credit terms are mirrored by rising indebtedness among corporations that could be vulnerable to downgrades in the event of unexpected adverse developments." We interpret this to mean that policymakers believe that easy corporate credit conditions are supportive for activity today, but the unwind could generate even larger downside risks over the medium-term.</blockquote>
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This perspective reminds us of a 2014 speech from former Fed Governor Jeremy Stein, where he warned about the risks from compressed risk and term premia resulting from the Fed's quantitative easing and forward guidance policies, and with particular focus on the economic impacts of the inevitable reversal in those risk spreads—“there is a cost associated with pushing risk premiums too low, because doing so increases the likelihood that they may revert back in a way that hinders the Federal Reserve's ability to achieve its mandated objectives.” Stein noted a "striking asymmetry" in the impact of corporate credit spreads—<b>widening spreads were more informative and more negative for the future economic outlook, but narrowing spreads had virtually "no discernible effect at all on economic activity</b>."</blockquote>
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Motivated by Stein's observations, below we show a summary perspective on how credit spreads impact GDP growth and the labor market. <b>The asymmetry of the simple relationships shown here is stark. A widening in corporate credit spreads is associated with more material and significant deterioration in GDP growth two quarters ahead </b>(Exhibit 2), while the relationship between narrowing corporate credit spreads and two quarter ahead GDP growth is flat and insignificant (Exhibit 3).</blockquote>
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<a href="https://1.bp.blogspot.com/-E3LwYDMu8uM/W-25FFLEyVI/AAAAAAAAU8w/DsLQy75FzK0-KiOTj-CiBFubOsuHCDnVgCLcBGAs/s1600/MS%2B-%2BWidening%2Bcredit%2Bspreads%2Bweigh%2Bon%2Beconomic%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="298" data-original-width="375" height="254" src="https://1.bp.blogspot.com/-E3LwYDMu8uM/W-25FFLEyVI/AAAAAAAAU8w/DsLQy75FzK0-KiOTj-CiBFubOsuHCDnVgCLcBGAs/s320/MS%2B-%2BWidening%2Bcredit%2Bspreads%2Bweigh%2Bon%2Beconomic%2Bgrowth.jpg" width="320" /></a></div>
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<a href="https://3.bp.blogspot.com/-fQAnJ23mzZs/W-25Waf7afI/AAAAAAAAU84/eErM6wiKwdgFOt-vfbxQeIeJsBgVmzklACLcBGAs/s1600/MS%2B-%2BBut%2Bnarrowing%2BCredit%2BSpreads%2BHave%2BLittle%2BDiscernible%2BEffect.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="300" data-original-width="384" height="250" src="https://3.bp.blogspot.com/-fQAnJ23mzZs/W-25Waf7afI/AAAAAAAAU84/eErM6wiKwdgFOt-vfbxQeIeJsBgVmzklACLcBGAs/s320/MS%2B-%2BBut%2Bnarrowing%2BCredit%2BSpreads%2BHave%2BLittle%2BDiscernible%2BEffect.jpg" width="320" /></a></div>
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A simple regression here finds that every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with 0.3pp lower GDP growth after two quarters, all else equal. For the same narrowing in credit spreads, the effect on GDP growth is roughly zero.</blockquote>
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<b>The same relationship is true for labor market activity. The effect of widening credit spreads on the unemployment rate is significant and positive</b> (Exhibit 4). </blockquote>
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<a href="https://4.bp.blogspot.com/-7FHM8lzugSo/W-25ss0mGsI/AAAAAAAAU9A/OWeBes0CoDYZM-B4VtaHJqsvg_ctxg12ACLcBGAs/s1600/MS%2B-%2BWidening%2BCredit%2BSpreads%2BLead%2Bto%2BWeaker%2BLabor%2BMarket%2BConditions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="310" data-original-width="379" height="261" src="https://4.bp.blogspot.com/-7FHM8lzugSo/W-25ss0mGsI/AAAAAAAAU9A/OWeBes0CoDYZM-B4VtaHJqsvg_ctxg12ACLcBGAs/s320/MS%2B-%2BWidening%2BCredit%2BSpreads%2BLead%2Bto%2BWeaker%2BLabor%2BMarket%2BConditions.jpg" width="320" /></a></div>
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A simple regression here finds that every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal. For the same narrowing in credit spreads, the effect on the unemployment rate is roughly zero (Exhibit 5).</blockquote>
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<a href="https://1.bp.blogspot.com/-cTvchxNFgxw/W-2591yLu7I/AAAAAAAAU9M/wZf_yVLlQKspZMpwTpZwkSxdCJR-gz7VwCLcBGAs/s1600/MS%2B-%2BBut%2Bnarrowing%2Bspreads%2Bdo%2Blittle%2Bto%2Bstimulate%2Blabor%2Bmarket%2Bactivity.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="309" data-original-width="378" height="261" src="https://1.bp.blogspot.com/-cTvchxNFgxw/W-2591yLu7I/AAAAAAAAU9M/wZf_yVLlQKspZMpwTpZwkSxdCJR-gz7VwCLcBGAs/s320/MS%2B-%2BBut%2Bnarrowing%2Bspreads%2Bdo%2Blittle%2Bto%2Bstimulate%2Blabor%2Bmarket%2Bactivity.jpg" width="320" /></a></div>
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Of course we recognize that the magnitude of these simple estimates may be larger than if we incorporated these scenarios into a larger-scale dynamic macro model, so the emphasis of the analysis above is to show the asymmetric impacts on economic activity from corporate credit developments. This effect is consistent in other models as well, for example in our payrolls model where the corporate credit spread predicts employment when it widens, and the variable "turns on" in downturns, but has no impact in expansions.</blockquote>
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Looking at credit in a broader financial conditions perspective, <b>our modeling finds that a 100bp sustained widening in BBB credit spreads over four quarters would be the equivalent of a 62bp increase in the fed funds rate</b>. We will be watching how credit markets evolve over the coming weeks and months to see how sustained recent moves are, and how spreads evolve in conjunction with broad financial conditions. As of the September FOMC, policymakers saw financial conditions as an upside risk to the outlook, and so the recent tightening may simply reduce that upside risk in their view. Further tightening in financial conditions may be warranted before these developments have material implications for Fed policymakers." - source Morgan Stanley</blockquote>
In similar fashion we will be closely watching how credit markets evolve in the coming weeks, given that as the GE story has been widely commented, we are seeing increasing rising dispersion leading to some credit spreads blowing out in spectacular fashion in some instances. This we think, is typical of a late credit cycle. We have reached a stage where credit picking skill matters. We also think that cash levels need to be raised and that the front end of the US yield curve offers again some protection in a more volatile environment.<br />
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As we indicated in our previous conversation we are watching oil prices and credit:<br />
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<span style="font-family: inherit;">"Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket." - source Macronomics, November 2018</span></blockquote>
Of course we have seen this move before back in 2015 when oil prices came crashing down. DataGrapple on their blog on the 14th of November entitled "Déjà Vu":<br />
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<a href="https://4.bp.blogspot.com/-UOIpwmO_QYY/W-3d40IH7pI/AAAAAAAAU9Y/QxW4Zuu49hMC89mAJN7hI89g0OHKJTLnwCLcBGAs/s1600/DataGrapple%2B-%2BEurope%2BIG%2B14-11-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="368" data-original-width="618" height="190" src="https://4.bp.blogspot.com/-UOIpwmO_QYY/W-3d40IH7pI/AAAAAAAAU9Y/QxW4Zuu49hMC89mAJN7hI89g0OHKJTLnwCLcBGAs/s320/DataGrapple%2B-%2BEurope%2BIG%2B14-11-2018.jpg" width="320" /></a></div>
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"It is not 2015 all over again, when oil went from $100 per barrel to $42, but the roughly 25% fall in oil price from $86 per barrel to $67 since the beginning of October has eventually caught credit investors’ attention. Worries over rising oil production around the world and weakening demand from developing countries has just driven a 12-day uninterrupted fall which just ended today. Stockpiles are building, and producers are struggling to agree on production cuts. According to experts, supply will likely outstrip demand by early next year due to a potential cooling of the global economy and slower growth in China, which is in the middle of a trade war with the United States. <span style="color: red;">On both sides of the Atlantic, the risk premia of oil companies have been remarked wider. The weakest American credits like Weatherford International or Transocean Inc have been impacted the most (+ 700bps at 2,457bps and +127bps at 535bps respectively over the last week), but even European names which are traditionally much more stable have seen their credit risk re-assessed</span>. During the past week, Repsol is 19bps wider at 80bps, BP is 17bps wider at 62bps, while Equinor ASA and Total are 11bps wider at 35bps and 39bps respectively." - source DataGrapple</blockquote>
As economic growth decelerates as seen in Germany, Japan and Italy, China and other places, of course the fall in oil prices is biting again credit markets. This is not really surprising.<br />
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Given the pain inflicted to credit markets in particular and equities market in general falling the fall in oil prices in a recent past with a low point touched in March 2016, many pundits seems to be concerned by the recent crash in oil prices and the spillover effect it could have again. On that subject we read with interest Bank of America Merrill Lynch Situation Room note from the 14th of November entitled "Still Stormy":<br />
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"Today, not surprisingly, we received a number of questions on whether we are concerned about the recent rapid decline in oil prices. We are not (yet). As far as the high grade Energy sector is concerned, we went through a major stress-test four years ago when oil prices last plunged. That forced companies to deleverage, be conservative about capex and work to aggressively lower break-even oil prices (See: Annual Breakeven Analysis: Breakevens fall for the fifth straight year and make $45 the new $50 30 April 2018, Figure 1). </blockquote>
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<a href="https://2.bp.blogspot.com/-TvTMe4iFf-E/W-3pxuHfYmI/AAAAAAAAU98/ui219b7fL04TGji4o8YlmImGX9rEOImYQCLcBGAs/s1600/BAML%2B-%2BOil%2BPrices%2Bvs%2BHG%2BOil%2Band%2BGas%2Bsector%2Bbreak-even%2Bcosts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="363" data-original-width="516" height="225" src="https://2.bp.blogspot.com/-TvTMe4iFf-E/W-3pxuHfYmI/AAAAAAAAU98/ui219b7fL04TGji4o8YlmImGX9rEOImYQCLcBGAs/s320/BAML%2B-%2BOil%2BPrices%2Bvs%2BHG%2BOil%2Band%2BGas%2Bsector%2Bbreak-even%2Bcosts.jpg" width="320" /></a></div>
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While in 2014 break-even oil prices (WTI) were $70.81/bbl they have by now nearly halved to $38.30/bbl. That leaves plenty of cushion for most companies right now – unlike in 2014.</blockquote>
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This is a general point we have been making, by the way, that the credit quality of high grade companies is the best it has been in decades, as companies and industries have been tested and forced to improve. For example, during the commodities downturn that started four years ago, as discussed above, but also the financial crisis and Dodd-Frank greatly improved the credit quality of banks and before that the early 2000s fraud cases led to Sarbanes-Oxley. This is one key reason that in the next downturn the rate of downgrades to high yield is likely to be the lowest ever.</blockquote>
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The other aspect of declining oil prices relevant to investors is what they signal about demand – and OPEC mentioned this. Same thing for this week’s concerns about iPhone sales. <span style="color: red;">There is plenty of foreign economic weakness even though the US economy is strong</span>. The antidote to these concerns is hard data on the US economy starting with Retail Sales and producer surveys tomorrow. The idiosyncratic stories GE, PCG and BATSLN are – well idiosyncratic. For the various macro stories such as Brexit, trade war, etc. there appears to be marginal improvement. High grade supply volumes should be on the heavy side during the remaining eight days this month where the market is open (and potentially into the first week of December). From what we are hearing this includes deals coming earlier than what we expected – such as Takeda, of which it appears the USD part will be much smaller than we thought." - source Bank of America Merrill Lynch</blockquote>
Sure, for Bank of America Merrill Lynch, the US economy is "plain sailing" yet, we do not adhere to their optimism. We pointed out concerns relating to US housing in our October conversation "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-ballyhoo.html">Ballyhoo</a>". Falling US savings rate, in conjunction with housing affordability issues on top of increasing usage of credit cards from the US consumers to maintain their level of consumption with rising PPI and surging healthcare costs for Baby Boomers, do not paint such a "rosy" picture in our book. Maybe we have been used to being too "cynical" from our "credit" perspective or simply put, maybe we are part of the Last of the Romans. There is no doubt in our mind that we are coming closer to the end of an extended credit cycle thanks to cheap credit and multiples expansion with massive buybacks.<br />
<br />
The continuation of the rise in US interest rates is a well creating higher dispersion and more repricing of risk given the surge in "real rates" (a headwind for gold prices in true Gibson Paradox fashion one might opine). We made the following comment on the 10th of November on another platform the following:<br />
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<a href="https://3.bp.blogspot.com/-9GjRndsZ2qs/W-3fcZQ7III/AAAAAAAAU9k/b7HoBLqU-zEOhcMnv4xnOc5NWqsE5cXJACLcBGAs/s1600/Macrobond%2B-%2BReal%2Brates%2B10th%2Bof%2BNovember.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="355" data-original-width="806" height="140" src="https://3.bp.blogspot.com/-9GjRndsZ2qs/W-3fcZQ7III/AAAAAAAAU9k/b7HoBLqU-zEOhcMnv4xnOc5NWqsE5cXJACLcBGAs/s320/Macrobond%2B-%2BReal%2Brates%2B10th%2Bof%2BNovember.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
"Life of PI: Real rates spiked to 3.14% in late October 2008. Currently real rates have touched 1.15%. Could 2% real rates be the new pain threshold to watch for?</blockquote>
<blockquote class="tr_bq">
With real rates rising on the back of the Fed’s rate-hiking stance, no wonder we pointed out recently the divergence between gold prices ($1,208.6) and US 5 year TIPS. With the surge of the US dollar in conjunction with the rise in real rates, this marks the return of the “Gibson paradox”:</blockquote>
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<a href="https://2.bp.blogspot.com/-6gc-BEyiepc/W-3hZR51LLI/AAAAAAAAU9w/YTQlLnbOQmYmS8yapxeNfZh0XmV8YCo6gCLcBGAs/s1600/Macrobond%2B-%2BGibson%2BParadox%2B10-11-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="355" data-original-width="806" height="140" src="https://2.bp.blogspot.com/-6gc-BEyiepc/W-3hZR51LLI/AAAAAAAAU9w/YTQlLnbOQmYmS8yapxeNfZh0XmV8YCo6gCLcBGAs/s320/Macrobond%2B-%2BGibson%2BParadox%2B10-11-2018.jpg" width="320" /></a></div>
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<span style="text-align: justify;">- source Macrobond - Macronomics</span></div>
<br />
Of course it might be seen as too early for the gold prices to shine again in the light of the Fed's continued hiking path, but at some point deflationary forces could reassert themselves and both gold prices and the long end of the US yield curve could benefit (yet for the latter it is hard to be enthusiastic given the aggravation of the US budget deficit).<br />
<br />
At least there is some solace coming for the bond bulls, given that oil prices falling means that inflation is clearly moving from being a tailwind during most of the course of 2018 to a headwind for the remainder of 2018.<br />
<br />
Also, more and more pundits are pointing towards the rising risk in corporate credit, in terms of valuations, liquidity and other metrics. It is a subject we have tackled on many occasions on this very blog. The latest ruction on GE is indicative of rising dispersion, not the start yet of the turn of the credit cycle for the worse. On that point we read with interest Bank of America Merrill Lynch's take from their Situation Room note from the 13th of November entitled "Perfect storm for credit":<br />
<blockquote class="tr_bq">
"Today’s most important developments included at least the following five: 1) Monday was a bond market holiday so today fixed income investors had to catch up to yesterday’s 2% decline in equities. 2) Yesterday’s sell-off included the reaction to more negative headlines over the weekend for GE and GS. 3) We know foreign economic activity is relatively weak and investors are seeing a number of potential signs of weak demand including possibly disappointing iPhone sales and plunging oil prices (including - 7.83% today). 4) Significant new issuance volumes are looming this week and through the end of the month. 5) Meaningful decline in interest rates. That proved a perfect storm for credit and recipe for wider spreads.</blockquote>
<blockquote class="tr_bq">
Over the past month, as GE was gradually downgraded to BBB1, its outstanding bonds have now repriced not only to BBB levels, but to BB-rated levels in HY (Figure 1). </blockquote>
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<a href="https://2.bp.blogspot.com/-TcbDCeWuQzY/W-6vuPNCdzI/AAAAAAAAU-I/lX8bbXAA-NEJVvK3Koieqbq-n3kK1PM_gCLcBGAs/s1600/BAML%2B-%2BGE%2Bhas%2Brepriced%2Bto%2BHY%2Blevels.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="382" data-original-width="516" height="236" src="https://2.bp.blogspot.com/-TcbDCeWuQzY/W-6vuPNCdzI/AAAAAAAAU-I/lX8bbXAA-NEJVvK3Koieqbq-n3kK1PM_gCLcBGAs/s320/BAML%2B-%2BGE%2Bhas%2Brepriced%2Bto%2BHY%2Blevels.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
At the turn of the month, when the company’s index ratings are reduced to BBB1 GE will become the 6th largest BBB rated issuer with just shy of $50bn of outstanding index eligible debt (Figure 2). That represents 0.8% of the IG market, 1.5% of BBBs and 3.9% of HY. When General Motors and Ford were downgraded to HY in 2005 they measured 6.5% and 6.3% of the HY market, respectively. Our view is that GE is small enough, and the story sufficiently idiosyncratic, to leave other large BBB capital structures relatively little affected as this story plays out." - source Bank of America Merrill Lynch</blockquote>
Obviously, this has all to do with "repricing". The rise in dispersion is increasing as real rates are moving up, meaning that investors are becoming acutely more discerning to issuer profiles and trajectory. It's not only a case for credit markets, it is as well the story so far in equities with the rotation from growth stocks to value stocks and also the significant headwinds and underperformance in cyclicals in autos and housing stocks with global trade and global growth cooling down as of late. At this stage of the cycle, active stock/credit picking skills are becoming essential. Gone are the days when everything was moving up in synch as the Fed gradually tightens up the liquidity spigot through its QT policy. In that context, we continue to believe that active management should be in a better position to come back into favor. Though, for many Hedge Fund managers, the month of October has not been validating this trend so far.<br />
<br />
When it comes to financial conditions, as we discussed recently and above, when the velocity in declining asset prices is important, this "reflexivity" feature can add up to the tightening. In terms of credit cycle and forward default rates, we look on a quarterly basis at the Fed's Senior Loan Officer Opinion Survey (SLOOs). This is what Bank of America Merrill Lynch had to say in relation to the latest survey in their Situation Room note from the 13th of November entitled "Perfect storm for credit":<br />
<blockquote class="tr_bq">
"<b>Competing harder for less business</b></blockquote>
<blockquote class="tr_bq">
<br />
The Fed’s fresh October senior loan officer survey released today showed weaker demand across the board for C&I, CRE, residential mortgage, auto and credit card loans. The survey cited increases in customers’ internally generated funds, reduced customer investment in plant or equipment, and customers’ borrowing having shifted to other lenders as important reasons for weaker C&I loan demand. In terms of lending standards, banks reported easing standards for C&I, mortgage, and credit card loans, while tightening standards for CRE and auto loans.</blockquote>
<blockquote class="tr_bq">
In addition, the October survey added special questions on the effect of the slope of the Treasury yield curve on lending policies. Banks responded that the change in the slope of the yield curve year-to-date “had not affected lending standards or price terms across the major loan categories.” However, “when asked their potential response to a prolonged hypothetical moderate inversion of the yield curve over the next year, banks responded that they would tighten standards or price terms across every major loan category if the yield curve were to invert, a scenario that they interpreted as a signal of a deterioration in economic conditions, likely being followed by a deterioration in the quality of their existing loan portfolio. In addition, major shares of banks reported lending would become less profitable and their bank’s risk tolerance would decrease in this scenario.”</blockquote>
<blockquote class="tr_bq">
<b>C&I and CRE loans</b></blockquote>
<blockquote class="tr_bq">
In the latest October survey a net 15.9% and 3.1% of banks reported easing lending standards over the previous three months for loans to large/medium C&I firms and small C&I firms, respectively, compared to 15.9% and 7.6% in the prior July survey. For CRE loans the net share reporting tightening standards increased again to 3.9% in October from 1.9% in July. Please note that the CRE value reported here is the average for the three separate questions on loans for construction and land development, loans secured by nonfarm nonresidential structures, and loans secured by multifamily residential structures (Figure 17).</blockquote>
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<a href="https://1.bp.blogspot.com/-VmOSMLqN5fI/W-7GYaXxwsI/AAAAAAAAU-U/LaEUvryWU5Uikg7SfwazcDkl59JoyJKEgCLcBGAs/s1600/BAML%2B-%2BLending%2Bstandards%2Band%2BC%2526I%2Bloans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="288" data-original-width="384" height="240" src="https://1.bp.blogspot.com/-VmOSMLqN5fI/W-7GYaXxwsI/AAAAAAAAU-U/LaEUvryWU5Uikg7SfwazcDkl59JoyJKEgCLcBGAs/s320/BAML%2B-%2BLending%2Bstandards%2Band%2BC%2526I%2Bloans.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
C&I loan demand weakened according to a net 14.5% of banks for large/medium firms and 10.8% for small firms, respectively, compared to a net 2.9% and 9.1% reporting stronger demand in July. For CRE loans the net share reporting weaker demand also increased to 10.9% in October from 7.2% in July (Figure 18).</blockquote>
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<a href="https://4.bp.blogspot.com/-DUyLYrq9ud4/W-7Gm52dKII/AAAAAAAAU-Y/TNKFZFXimhA4dHqoBLfA9adiOBYjFRznQCLcBGAs/s1600/BAML%2B-%2BLoan%2Bdemand%2B%2B-%2BC%2526I%2Bloans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="296" data-original-width="378" height="250" src="https://4.bp.blogspot.com/-DUyLYrq9ud4/W-7Gm52dKII/AAAAAAAAU-Y/TNKFZFXimhA4dHqoBLfA9adiOBYjFRznQCLcBGAs/s320/BAML%2B-%2BLoan%2Bdemand%2B%2B-%2BC%2526I%2Bloans.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
<b>Mortgages</b></blockquote>
<blockquote class="tr_bq">
Banks continued to ease lending standards for residential mortgage loans. A net 11.3% and 10.0% of banks reported loosening lending standards for GSE-Eligible and QMJumbo mortgages, respectively, compared to a net 15.3% and 4.8% in July, respectively (Figure 19). </blockquote>
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<a href="https://4.bp.blogspot.com/-q14cX01TJ44/W-7HOwn-VFI/AAAAAAAAU-k/ug4bucVv_Nc-u9Hpmm8lfl42tW3Zs0ZWwCLcBGAs/s1600/BAML%2B-%2BLending%2Bstandards%2B-%2Bresidential%2Bmortgages.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="294" data-original-width="375" height="250" src="https://4.bp.blogspot.com/-q14cX01TJ44/W-7HOwn-VFI/AAAAAAAAU-k/ug4bucVv_Nc-u9Hpmm8lfl42tW3Zs0ZWwCLcBGAs/s320/BAML%2B-%2BLending%2Bstandards%2B-%2Bresidential%2Bmortgages.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
Meanwhile, the net share reporting weaker demand for GSE-Eligible and QM-Jumbo mortgages jumped to 21.3% and 15.0% in October, respectively, from a net 5.1% and 6.6% in July (Figure 20).</blockquote>
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<a href="https://3.bp.blogspot.com/-Y67shrUjQLQ/W-7HvEaOzUI/AAAAAAAAU-s/GlJR1lTZmVEUZhU_hIjjseaO3ar8q5JZgCLcBGAs/s1600/BAML%2B-%2BLoan%2Bdemand%2B-%2Bresidential%2Bmortages.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="300" data-original-width="384" height="250" src="https://3.bp.blogspot.com/-Y67shrUjQLQ/W-7HvEaOzUI/AAAAAAAAU-s/GlJR1lTZmVEUZhU_hIjjseaO3ar8q5JZgCLcBGAs/s320/BAML%2B-%2BLoan%2Bdemand%2B-%2Bresidential%2Bmortages.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
<b>Consumer loans</b></blockquote>
<blockquote class="tr_bq">
A net 2.2% of banks tightened lending standards for auto loans and a net 3.6% of banks loosened lending standards for credit card loans according to the fresh October survey. This is a reversal from a net 12.0% of banks loosening lending standards for auto loans and a net 3.5% of banks tightening lending standards for credit card loans in the prior (July) survey (Figure 21). </blockquote>
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<a href="https://1.bp.blogspot.com/-TowixmN1tlc/W-7IMcGJPOI/AAAAAAAAU-8/1rYZsZq7uBkYFSeL5ceQIehverQZ-e0IgCEwYBhgL/s1600/bAML%2B-%2BLending%2Bstandards%2B-%2Bconsumer%2Bloans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="294" data-original-width="379" height="248" src="https://1.bp.blogspot.com/-TowixmN1tlc/W-7IMcGJPOI/AAAAAAAAU-8/1rYZsZq7uBkYFSeL5ceQIehverQZ-e0IgCEwYBhgL/s320/bAML%2B-%2BLending%2Bstandards%2B-%2Bconsumer%2Bloans.jpg" width="320" /></a></div>
<br />
<blockquote class="tr_bq">
At the same time a net 1.8% and 4.3% of banks reported weaker demand for auto and credit card loans, compared to a net 3.5% of banks reporting stronger demand for auto loans and a net 2.1% of banks reporting weaker demand for credit card loans in July, respectively (Figure 22).</blockquote>
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<a href="https://4.bp.blogspot.com/-MX6sbcUD4To/W-7Itd4aqTI/AAAAAAAAU_A/MobSMk9HSsM7vjZt_rBQYamfvcmBOvxRgCLcBGAs/s1600/BAML%2B-%2BLoan%2Bdemand%2B-%2Bconsumer%2Bloans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="291" data-original-width="388" height="240" src="https://4.bp.blogspot.com/-MX6sbcUD4To/W-7Itd4aqTI/AAAAAAAAU_A/MobSMk9HSsM7vjZt_rBQYamfvcmBOvxRgCLcBGAs/s320/BAML%2B-%2BLoan%2Bdemand%2B-%2Bconsumer%2Bloans.jpg" width="320" /></a></div>
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<div style="text-align: center;">
- source Bank of America Merrill Lynch.</div>
<br />
Yes, financial conditions remain very "accommodative" and it is probably the reason why the Fed will continue on its hiking path. We continue to think that investors' expectations of the Fed's number of hikes in 2019 are "undershooting".<br />
<br />
Our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". Our final charts below look at additional headwinds building up for US credit fund flows.<br />
<br />
<b><br /></b>
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<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><b>Final charts - US Investment Grade credit, retail is finally dragging their feet...</b></li>
</ul>
When it comes to "monitoring" the evolution of the credit cycle in general and credit markets in particular, we like to look at fund flows. This is a subject we discussed in our January 2018 conversation "<a href="https://macronomy.blogspot.com/2018/01/macro-and-credit-lindemann-criterion.html">The Lindemann criterion</a>":<br />
<blockquote class="tr_bq">
"<b style="background-color: white; font-family: inherit;">Fund flows have a tendency to </b><b style="background-color: white; font-family: inherit;">follow total returns</b></blockquote>
<blockquote class="tr_bq">
Fund flows have a tendency to follow total returns, both on the way up and on the way down. When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash. As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018</blockquote>
More recently in September in our conversation "<a href="https://macronomy.blogspot.com/2018/09/macro-and-credit-korsakoff-syndrome.html">The Korsakoff syndrome</a>", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "<a href="https://t.co/vDIt4c36b7">Mutual Fund Flows and Fluctuations in Credit and Business Cycles</a>" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).<br />
<br />
<a href="http://knowledge.wharton.upenn.edu/article/why-junk-bond-funds-can-be-an-early-economic-indicator/">This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle</a>. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Our final charts come from CITI US High Grade Focus note from the 14th of November entitled "Hot topics in IG credit" and shows that inflows are vanishing, particularly from the retail side in US Investment Grade Credit and also that foreign demand is not as strong as it used to be:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>Retail has become a net drag on IG credit…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Mutual funds and ETFs that invest in IG bonds beyond 3 years to maturity are seeing inflows vanish…</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
– Between 2015 and 2017, mutual funds focused on the IG asset class absorbed slightly more than their share of net issuance of three-year and longer IG paper, providing a solid foundation for credit spreads during periods of turbulence. Fund inflows into all IG categories excluding funds with a short-maturity focus grew at an annual rate of 10%-15% of fund assets at a time when the market for IG corporate bonds with greater than 3 years to maturity grew between 7%-9%. As the (3yr) IG market growth rate has slowed to 3%, fund inflows are turning south. On a 3m annualized basis, the mutual fund and ETF community is seeing outflows at an annualized rate of roughly 5%. (Figure 1). </blockquote>
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<a href="https://4.bp.blogspot.com/-0KF3VzgHuCQ/W-7Uz5EKIaI/AAAAAAAAU_M/_zvxbP1e5Fsqe4M6uxk8SOW9arvrbqlXgCLcBGAs/s1600/CITI%2B-%2BFund%2Bflows%2Bas%2Ba%2Bpercent%2Bof%2Bassets%252C%2BIG%2Bfunds%2Band%2BETFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="261" data-original-width="351" height="237" src="https://4.bp.blogspot.com/-0KF3VzgHuCQ/W-7Uz5EKIaI/AAAAAAAAU_M/_zvxbP1e5Fsqe4M6uxk8SOW9arvrbqlXgCLcBGAs/s320/CITI%2B-%2BFund%2Bflows%2Bas%2Ba%2Bpercent%2Bof%2Bassets%252C%2BIG%2Bfunds%2Band%2BETFs.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
We prefer to exclude developments in short duration IG funds because their lower rate sensitivity; indeed, short-duration funds continue to receive healthy inflows with 1-4 year duration single-A IG yields at 3.51%. That's only 55 bps lower than the yield of single-A 4-9 year duration bonds. The post-crisis average yield difference is 133 bps.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b> … as Treasury yields weigh</b> on investor sentiment </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
– We contrast the rate of inflows into US IG mutual funds focused on maturities greater than three years against the year-over-year change in 10-year Treasury yields in Figure 2. </blockquote>
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<a href="https://2.bp.blogspot.com/-7uh-vJyLllc/W-7VIbnDUyI/AAAAAAAAU_U/P90nqV9KcjEXpctSQyiTBDU6AxJTIuO2ACLcBGAs/s1600/CITI%2B-%2BUS%2BIG%2BLong-Duration%2BFlow.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="261" data-original-width="357" height="233" src="https://2.bp.blogspot.com/-7uh-vJyLllc/W-7VIbnDUyI/AAAAAAAAU_U/P90nqV9KcjEXpctSQyiTBDU6AxJTIuO2ACLcBGAs/s320/CITI%2B-%2BUS%2BIG%2BLong-Duration%2BFlow.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
The momentum in yields provides a strong signal about changes the direction of fund flows, perhaps because households base expectations for rate changes on current trends. In the 2013 "Taper Tantrum" year-over-year changes in Treasury yields moved from -150 to +100 as fund inflows dropped from +20% to -10%. On a 3m basis, outflows maxed out at an annualized rate of 25%. Citi's 10Y rate view of 2.85% portends a slight positive for the fund outlook. Retail outflows become a greater concern if the IG market returns to a 5-10% market growth rate.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>…while the international demand picture is growing more complex</b></blockquote>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<b>To start on a bright spot, Taiwanese investors are pumping cash into US IG through local ETFs…</b></blockquote>
<blockquote class="tr_bq">
– Taiwanese financial institutions have introduced locally listed foreign bond ETFs at a rate of one new ETF per two weeks in 2018, and the pace has increased to one per week since the beginning of August. (Figure 1). </blockquote>
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<a href="https://2.bp.blogspot.com/-fCg909-rmNk/W-7YpiWdKQI/AAAAAAAAU_g/xNMEaPOCP8ET8QDJAjtw6ZAkpPR3jk4GACLcBGAs/s1600/CITI%2B-%2Binflows%2Binto%2BTaiwanese%2Blisted%2BETFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="265" data-original-width="356" height="238" src="https://2.bp.blogspot.com/-fCg909-rmNk/W-7YpiWdKQI/AAAAAAAAU_g/xNMEaPOCP8ET8QDJAjtw6ZAkpPR3jk4GACLcBGAs/s320/CITI%2B-%2Binflows%2Binto%2BTaiwanese%2Blisted%2BETFs.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
In the past two months alone, these ETFs have seen inflows of $2.8 billion, of which $1 billion was directed toward DM IG paper. The fastest-growing ETFs focus on tech, bank, telecom, BBB and 4.5% coupon or higher paper; all are focused on bonds with at least 15 years to maturity. Taiwan lifers are awaiting a rule change expected to provide new avenues around a 45% cap on foreign corporate bonds (e.g. underwriting more USD-denominated policies). Until then, buying ETFs (and classifying them as local equities) could provide an alternative means to gain access to long-duration, higher-yielding paper. Demand from ETFs is more dispersed than traditional Taiwan flows, which may eliminate some technical pressure on the 10s30s curves of particular issuers and securities.</blockquote>
<blockquote class="tr_bq">
<b> … although the broader picture for currency-hedged foreign inflows into US IG corporate bonds is somewhat bleak</b> </blockquote>
<blockquote class="tr_bq">
– The trailing 12m rate of purchases remained steady at $82bn, the slowest pace since early 2013. And the forward indications of foreign demand for US corporate bonds are mixed at best, and will almost certainly be levered to investors' willingness to take open (unhedged) positions in US-dollars. </blockquote>
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<a href="https://3.bp.blogspot.com/-Dv8zfdzZTpk/W-7ZDNPQGSI/AAAAAAAAU_o/uQOMjzZNQ-ctIRNhw9YAdzip3NJ3AlyNgCLcBGAs/s1600/CITI%2B-%2BMonthly%2Brate%2Bof%2Bforeign%2Binflows%2Binto%2BUS%2BIG%2Bcorporate%2Bbonds.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="265" data-original-width="356" height="238" src="https://3.bp.blogspot.com/-Dv8zfdzZTpk/W-7ZDNPQGSI/AAAAAAAAU_o/uQOMjzZNQ-ctIRNhw9YAdzip3NJ3AlyNgCLcBGAs/s320/CITI%2B-%2BMonthly%2Brate%2Bof%2Bforeign%2Binflows%2Binto%2BUS%2BIG%2Bcorporate%2Bbonds.jpg" width="320" /></a></div>
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<blockquote class="tr_bq">
At some stage, global investors may be freed from the knotty challenge of balancing foreign credit risk with foreign currency risk, should global yields continue to rise, opening up domestic alternatives. (See: North America Multi-Asset Focus – Foreign Flows in US Fixed Income). Buying USD without costly FX hedges is an alternative but less likely with DXY at 18 month highs." - source CITI</blockquote>
So while everyone and their dog are focusing on what is happening in equities with the "great rotation" from growth to value and the "repricing" it entails, us, being part of the "Last of the Romans" when it comes to assessing "credit risks", we'd rather focus on what is happening in credit flows.<br />
<blockquote class="tr_bq">
"I think the history of the world suggests if one studies the Romans, and one studies the early Greeks, and one studies the history of the world, they all eventually falter if they don't come back to the basic aspect of integrity and honor and feelings of love one for another." - Jon Huntsman, Sr.</blockquote>
Stay tuned ! </div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-10228865385513433362018-11-08T17:01:00.000+00:002018-11-08T17:01:07.041+00:00Macro and Credit - Stalemate<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"In life, as in chess, forethought wins." - Charles Buxton, English public servant</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the outcome of the US midterm elections in conjunction with a divided congress leading somewhat to a gridlock, as well as the tentative rebound in Emerging Market equities, when it came to selecting our title analogy, we decided to go again for a chess analogy on this very post (see previous chess analogies: "<a href="https://macronomy.blogspot.com/2015/03/credit-zugzwang.html">Zugzwang</a>", <span style="text-align: left;">"</span><a href="http://macronomy.blogspot.com/2012/07/credit-europe-game-of-century.html" style="text-align: left;">The Game of The Century</a><span style="text-align: left;">")</span>. "Stalemate" is a situation in the game of chess where a player whose turn it is to move is not in check but has no legal move. The rules of chess provide that when stalemate occurs, the game ends as a draw. During the endgame, stalemate is a resource that can enable the player with the inferior position to draw the game rather than lose. In more complex positions, stalemate is much rarer, usually taking the form of a swindle, a ruse by which a player in a losing position tricks his opponent, and thereby achieves a win or draw instead of the expected loss. A swindle in chess only succeeds if the superior side is inattentive. Stalemate is also a common theme in endgame studies and other chess problems. The outcome of the US midterm elections gridlock could create short term what we would call "Goldigridlock", namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. In conjunction with the return of buybacks following the blackout period of earnings, then, this obviously could be bullish equities wise we think, with high beta pulling ahead until the end of the year. For credit, we are not too sure, given a fall in oil prices with definitely put pressure on the high beta CCC bracket of US High Yield and its well documented exposure to the energy sector but, we ramble again...</span></div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at what the US midterm election stalemate entails of asset prices in general following a very much "red October".</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - Goldigridlock for asset prices? </span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final charts - The invisible hand is fading...</span></b></i></li>
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<b><i><span style="font-family: inherit;"><br /></span></i></b></div>
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<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - Goldigridlock for asset prices? </span></b></i></li>
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<span style="font-family: inherit;">The month of October was clearly a bloodbath for many asset classes and diversification didn't offer protection. While the velocity in real rates as we pointed out in our previous conversation forced a serious repricing of the Fed "put" at a much lower strike, the fact that it was a blackout period thanks to earnings reporting season and lack of buybacks, being another strong pillar in US equities rally seen in recent years was enough to wreak havoc on global markets on the back of weaker US equities. Looking at the below performance chart from Bank of America Merrill Lynch for the month of October can clearly see that, indeed, “misery loves company”:</span></div>
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<a href="https://1.bp.blogspot.com/-CZ6XXr_tiHY/W-LRtZpGJjI/AAAAAAAAU6E/M4pytbVM9oQjoKYP_8ES48UhWrSD0vSFACLcBGAs/s1600/BAML%2B-%2BPerformance%2Bof%2Basset%2Bclasses%2B-%2BRed%2BOctober.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="353" data-original-width="473" height="238" src="https://1.bp.blogspot.com/-CZ6XXr_tiHY/W-LRtZpGJjI/AAAAAAAAU6E/M4pytbVM9oQjoKYP_8ES48UhWrSD0vSFACLcBGAs/s320/BAML%2B-%2BPerformance%2Bof%2Basset%2Bclasses%2B-%2BRed%2BOctober.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit;">As we pointed out in our final chart in our mid-October conversation "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-under-volcano.html">Under the Volcano</a>", 2018 has marked the return of large standard deviations move, typical of late cycle behavior in conjunction with rising dispersion. </span></div>
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<span style="font-family: inherit;">What we also find interesting (H/T Driehaus on Twitter) is that 89% of asset classes tracked by Deutsche Bank have a negative total return YTD in USD terms. This is the highest percentage on record since 1901. Last year just 1% finished without negative total return:</span></div>
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<a href="https://2.bp.blogspot.com/-hWGP1zfBP78/W-LS4ZxOoJI/AAAAAAAAU6Q/M4euFBfsCn0kKfksLF7fm4JP3ZRMo5N8ACLcBGAs/s1600/DB%2B-%2BPercentage%2Bof%2BAssets%2Bwith%2Ba%2Bnegative%2Btotal%2Breturn.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="292" data-original-width="859" height="108" src="https://2.bp.blogspot.com/-hWGP1zfBP78/W-LS4ZxOoJI/AAAAAAAAU6Q/M4euFBfsCn0kKfksLF7fm4JP3ZRMo5N8ACLcBGAs/s320/DB%2B-%2BPercentage%2Bof%2BAssets%2Bwith%2Ba%2Bnegative%2Btotal%2Breturn.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- source Deutsche Bank - Driehaus Twitter feed</span></div>
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<span style="font-family: inherit;">2018 is indeed a year where volatility and large standard deviations move have staged a comeback as the US Federal Reserve is trying to exit the stage with its Quantitative Tightening policy (QT) and its continuing hiking process. US Employment and wage growth likely to trigger another hike in December from the Fed. That’s a given. Total nonfarm payroll employment increased by 250,000 in October vs. 190,000 expected. Over the year, average hourly earnings have increased by 83 cents, or 3.1 %. Fed will remain hawkish.</span></div>
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<span style="font-family: inherit;">With the "Stalemate" with the latest US midterm elections, what are the implications for asset prices, one might rightly ask?</span></div>
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<span style="font-family: inherit;">First thing we would like to look at given the recent bounce from Emerging Market equities with Brazil leading ahead the bounce thanks to the hope brought by the presidential elections is the trajectory for the US dollar and what it means for "high beta". On that subject we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of November entitled "Midterm outcome":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>FX: a split Congress is bearish USD, but downside could prove limited</b></span></blockquote>
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<span style="font-family: inherit;">As we have argued, tonight’s split Congress outcome should result in dollar weakening. We think this could continue for a while yet as the first order effects of US growth deceleration and increasingly-limited monetary policy support cause a reevaluation of long USD exposure. Ultimately, second order effects could limit USD downside; however, we think that markets are likely to focus on first order effects for now.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Initially, <span style="color: red;">we expect a weaker USD predicated on a further softening in US growth leading to reduced monetary policy support. US growth deceleration from the 2Q high water mark should continue as intense political gridlock precludes new stimulus measures, putting the prospect of a Fed move beyond neutral in doubt for now absent convincing evidence of inflationary pressure.</span> Indeed, our US economics team is forecasting a gradual US growth deceleration toward 2% (around potential) by the end of next year, alongside a largely-benign inflation profile. While a Fed move beyond neutral was never in the market (the Fed is still priced to end the cycle at around the long-term median dot of 3%), a move above neutral looks increasingly less likely given the new information set. Thus, interest rate support for USD looks asymmetrically skewed to the downside, and the market’s expectation for Fed hikes next year (currently about +50bp) is at risk of compression, in our view. Positioning is net long USD – particularly in the riskier parts of the FX spectrum (Exhibit 1). </span></blockquote>
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<a href="https://2.bp.blogspot.com/-uuSxg37nHOE/W-MEBXNCl7I/AAAAAAAAU6g/XScC8_YnVl4mcRAqIKRINX1J33X3Nj9WwCEwYBhgL/s1600/BAML%2B-%2BUSD%2Bmarket%2Bposition.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="210" data-original-width="529" height="127" src="https://2.bp.blogspot.com/-uuSxg37nHOE/W-MEBXNCl7I/AAAAAAAAU6g/XScC8_YnVl4mcRAqIKRINX1J33X3Nj9WwCEwYBhgL/s320/BAML%2B-%2BUSD%2Bmarket%2Bposition.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Diminished rationale for USD longs and a potential relief rally in markets post-midterm resolution suggests liquidation flow driving USD lower. Finally, we would expect modestly higher USD risk premium – reflecting a state of political acrimony in DC – to provide an additional headwind to the dollar. That said, because the Senate has remained Republican-controlled, we do not expect a material spike higher in USD risk premium arising from the expectation that House leadership could successfully remove the President through impeachment.</span></blockquote>
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<span style="font-family: inherit;">Looking beyond the initial reaction, however, we think that potential second round effects could serve to limit USD downside. Successful resolution of the present state of global trade policy uncertainty has become more challenging, particularly if President Trump’s negotiating position has been weakened as we suspect may well be the case. To be sure, the evolution of global trade policy uncertainty is critical to the global economic cycle. Reduced prospects for a speedy end to this uncertainty, and indeed increased risks of further deterioration, add to downside global growth risk in our view. Although hardly a recession story, US deceleration represents a potential negative impulse to the already-sagging global economy. <span style="color: red;">An increase in risk aversion as markets anticipate a global downturn could thus broadly support the dollar</span>. Finally, on a brighter note, compromise on US economic stimulus later next year is possible due to potentially overlapping interests. Democrats seem to be advocating an increase in infrastructure spending, and the President may well seek to prime the economy in advance of his 2020 reelection bid. If ultimately successful, this should support USD as it could lead to a renewed bout of US cyclical and monetary policy divergence.</span></blockquote>
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<span style="font-family: inherit;"><blockquote class="tr_bq">
<b>Historical parallels suggest gridlock is not always so benign</b></blockquote>
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The consensus among investors is that a gridlock is a benign outcome for markets. We think this may be overly optimistic. In our view, the most relevant historical precedent for the next half year may be the months following the mid-term elections of 2010 that resulted in the same configuration in Washington as the latest elections (with the President’s party controlling the Senate but the other party controlling the House). In 2011, the Republicans, upon regaining control of the House, used the debt ceiling as a lever to demand budget reduction by the Obama administration. <span style="color: red;">The brinksmanship that </span><span style="color: red;">ensued raised concerns in the market of a possible default by the US government which led to a sharp sell-off in risky assets as well as a major rally in rates (10y Trsy yields falling from 3.7% in March 2011 to 1.8% by September). The USD came under considerable selling pressure during the same period as foreign investors avoided US </span><span style="color: red;">assets (EUR/USD rose from 1.30 in January to 1.48 by July that year)</span>. The market turmoil around the US debt ceiling crisis probably exacerbated the Eurozone sovereign crisis that occurred later that year (which saw the euro surrendering all of its earlier gains).</blockquote>
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<span style="font-family: inherit;"><blockquote class="tr_bq">
With the House Democrats having stated their intention to open new investigations against President Trump and with the 2020 presidential election campaign kicking off very soon, we see greater chances of brinksmanship than cooperation. History suggests that brinksmanship could mean lower rates and lower USD." - source Bank of America Merrill Lynch</blockquote>
With growing downside risk for growth with a notable deceleration in Europe and in global trade, there is indeed potential scope for the US yield curve to start flattening again. A conjunction of a flatter yield curve would be positive for the long end of the US yield curve and a falling US dollar would enable Emerging Market equities to continue to rally in the near term we think.<br />
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Second point, the recent fall in oil prices is as well putting some pressure on US breakevens as of late, meaning that for now a scary inflation spike has been avoided but, nonetheless, healthcare inflation, namely acyclical inflation is something to monitor closely as indicated by Bank of America Merrill Lynch in their US Economic Viewpoint note from the 5th of November entitled "Inflation in pictures":<br />
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"<b>No scary inflation monsters</b></blockquote>
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<ul>
<li>Procyclical inflation has moved sideways over the past year, despite the unemployment rate improving by half a percent to 3.7%. The muted inflation response highlights the flattening in the Phillips curve.</li>
<li>In No fear of an inflation curveball, we evaluated whether there was a kink in the Phillips curve at full employment. We find some, but not strong evidence, and therefore believe a strong cyclically-driven breakout in inflation is unlikely.</li>
<li>While procyclical inflation has been flat, acyclical inflation has picked up, healthcare in particular. We expect healthcare inflation to continue to accelerate, driven by hospital services.</li>
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<a href="https://3.bp.blogspot.com/-C6Vjkteatp0/W-MkWL44_mI/AAAAAAAAU6o/M-sAqkGswNMeyQvKgQJ9oopVWkdR_aLLQCLcBGAs/s1600/BAML%2B-%2BProcyclical%2Bvs%2Bacyclical%2Binflation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="286" data-original-width="385" src="https://3.bp.blogspot.com/-C6Vjkteatp0/W-MkWL44_mI/AAAAAAAAU6o/M-sAqkGswNMeyQvKgQJ9oopVWkdR_aLLQCLcBGAs/s1600/BAML%2B-%2BProcyclical%2Bvs%2Bacyclical%2Binflation.jpg" /></span></a></div>
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<a href="https://1.bp.blogspot.com/-C6Vjkteatp0/W-MkWL44_mI/AAAAAAAAU6o/A0zqYzj4um8SZPV4FaPzdOOiKl0_9q5vwCEwYBhgL/s1600/BAML%2B-%2BProcyclical%2Bvs%2Bacyclical%2Binflation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="286" data-original-width="385" height="237" src="https://1.bp.blogspot.com/-C6Vjkteatp0/W-MkWL44_mI/AAAAAAAAU6o/A0zqYzj4um8SZPV4FaPzdOOiKl0_9q5vwCEwYBhgL/s320/BAML%2B-%2BProcyclical%2Bvs%2Bacyclical%2Binflation.jpg" width="320" /></span></a></div>
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<ul><span style="font-family: inherit;">
<li>In No inflation monsters under the bed, we looked at the disaggregated PCE components and found that there was an increasing share of PCE that has moved into a “low inflation” (0-2%) bucket, and a dwindling share in the “high inflation” (5-10% bucket).</li>
<li>This shift in inflation dispersion is illustrative of a structural move lower in inflation. A lower trend decreases the probability of an inflation breakout.</li>
<li>Digging into the components, we found that healthcare services accounts for much of the shift. As healthcare inflation picks up going forward, we may see some reversal of the shift, albeit into the more moderate 2-5% inflation range.</li>
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<a href="https://4.bp.blogspot.com/-i4MUuR-4uhk/W-Mk4lo6VBI/AAAAAAAAU6w/Ybs8NBr3HRIBgiaKYcvp4s5BL6rPnmiigCLcBGAs/s1600/BAML%2B-%2BDecline%2Bin%2Bthe%2Bshare%2Bof%2BPCE%2Bcategories%2Bwith%2Bhigh%2Binflation%2Band%2Ban%2Bincrease%2Bin%2Blow%2Binflation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="326" data-original-width="385" height="270" src="https://4.bp.blogspot.com/-i4MUuR-4uhk/W-Mk4lo6VBI/AAAAAAAAU6w/Ybs8NBr3HRIBgiaKYcvp4s5BL6rPnmiigCLcBGAs/s320/BAML%2B-%2BDecline%2Bin%2Bthe%2Bshare%2Bof%2BPCE%2Bcategories%2Bwith%2Bhigh%2Binflation%2Band%2Ban%2Bincrease%2Bin%2Blow%2Binflation.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">Another reason to expect only a gradual pickup in inflation is because of inflation expectations, which have drifted lower over the cycle and serve as an anchoring point.</span></li>
<li><span style="font-family: inherit;">In particular, University of Michigan 5-10yr inflation expectations have descended to a trend of 2.5%. The central tendency has also consolidated closer to the median, mostly from the 75th percentile. This indicates a greater decline in those expecting high inflation.</span></li>
<li><span style="font-family: inherit;">Given core inflation is likely to run above target by next year, inflation expectations could improve, presenting upside to the outlook. But even with some improvement in expectations, inflation upside would likely remain contained." - source Bank of America Merrill Lynch</span></li>
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<span style="font-family: inherit;">In our recent conversation we hinted that housing was in earnest starting to turn "South" in the US and that housing affordability was becoming a headwind on top of US consumers using their savings and increasing their use of the credit card to maintain their consumption level. Both auto and housing, which are very cyclical in nature are clearly showing the late stage of the credit cycle in our book. </span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">One segment where spending rises with age is healthcare (out-of-pocket and government). Healthcare will account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further:</span><br />
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<a href="https://1.bp.blogspot.com/-Va_WeBLaaXA/W-MrUQA9rhI/AAAAAAAAU68/lCgoPvrezjky6Z4ACs2npoZbtGQq0InBQCLcBGAs/s1600/Macrobond%2B-%2BUS%2BCPI%2Bcomponents.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="163" data-original-width="385" height="135" src="https://1.bp.blogspot.com/-Va_WeBLaaXA/W-MrUQA9rhI/AAAAAAAAU68/lCgoPvrezjky6Z4ACs2npoZbtGQq0InBQCLcBGAs/s320/Macrobond%2B-%2BUS%2BCPI%2Bcomponents.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond</span></div>
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<span style="font-family: inherit;">Sure falling oil prices bring some relief to the US consumers but rising healthcare costs as well as housing costs will not be sufficient to offset the risk of "stagflation". We could see lower growth ahead and even looming recession risk.</span><br />
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<span style="font-family: inherit;">As we pointed out in our recent conversation "<a href="https://macronomy.blogspot.com/2018/10/macro-and-credit-ballyhoo.html">Ballyhoo</a>", <span lang="EN-US" style="color: red; line-height: 115%;">Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street</span><span lang="EN-US" style="line-height: 115%;">. </span>If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:</span><br />
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<a href="https://4.bp.blogspot.com/-ez9-uMEk2x4/W-Qy8hfEEDI/AAAAAAAAU7U/eHYXVXi5D0oVy6GfybX6_RiF9-Gnm79cACLcBGAs/s1600/Macrobond%2B-%2BUS%2BMichigan%2B-%2BHousing%2B-%2BBuying%2Band%2BSelling.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://4.bp.blogspot.com/-ez9-uMEk2x4/W-Qy8hfEEDI/AAAAAAAAU7U/eHYXVXi5D0oVy6GfybX6_RiF9-Gnm79cACLcBGAs/s320/Macrobond%2B-%2BUS%2BMichigan%2B-%2BHousing%2B-%2BBuying%2Band%2BSelling.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond</span></div>
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;">Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder.</span></span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">As pointed out by Lisa Abramowicz on her Twitter feed, you need going forward to monitor closely in the months ahead the rise in inventory of new unsold homes:</span><br />
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<a href="https://1.bp.blogspot.com/-tRm28FN5QSk/W-Qx4qi33JI/AAAAAAAAU7I/hVsTgzu-uEs_BhbgwmvcSJrCo5qYwhyugCLcBGAs/s1600/SoberLook%2B-%2BThe%2BDaily%2BShot%2B-%2BInventory%2Bof%2Bnew%2Bunsold%2Bhomes%2Breached%2B7%2Bmonths.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="422" data-original-width="548" height="246" src="https://1.bp.blogspot.com/-tRm28FN5QSk/W-Qx4qi33JI/AAAAAAAAU7I/hVsTgzu-uEs_BhbgwmvcSJrCo5qYwhyugCLcBGAs/s320/SoberLook%2B-%2BThe%2BDaily%2BShot%2B-%2BInventory%2Bof%2Bnew%2Bunsold%2Bhomes%2Breached%2B7%2Bmonths.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;">"The inventory of new unsold homes in the U.S. has reached the highest level since 2011, as measured in months of supply. https://blogs.wsj.com/dailyshot/2018/11/07/the-daily-shot-the-inventory-of-unsold" - source Lisa Abramowicz, Twitter</span></blockquote>
<span style="font-family: inherit;">In a response to Lisa's Tweet, M&G Bond Vigilantes made the following important point on Twitter:</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"If you saw the Lisa Abramowicz tweet about inventory of new unsold homes reaching 7 months, you should worry. Historically that level is consistent with GDP growth of zero. This chart is from our 2007 blog."</span></blockquote>
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<a href="https://3.bp.blogspot.com/-HXKy5qll7L8/W-Q1CQvQzzI/AAAAAAAAU7g/YG-v2Bt_IM4grLtR0SMmkd2oo8ojFwHogCLcBGAs/s1600/M%2526G%2Bbond%2Bvigilantes%2B-%2Bhousing%2Binventory%2Bleads%2BGDP%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="540" data-original-width="720" height="240" src="https://3.bp.blogspot.com/-HXKy5qll7L8/W-Q1CQvQzzI/AAAAAAAAU7g/YG-v2Bt_IM4grLtR0SMmkd2oo8ojFwHogCLcBGAs/s320/M%2526G%2Bbond%2Bvigilantes%2B-%2Bhousing%2Binventory%2Bleads%2BGDP%2Bgrowth.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source M&G Bond Vigilantes - Twitter</span></div>
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<b><i><span style="font-family: inherit;"><br /></span></i></b></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Housing has always been a leading indicator in the United States when it comes to forecasting GDP growth.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">To illustrate further the rift between Main Street's much more sanguine view of housing than Wall Street we would like to point towards Wells Fargo's take on the weakness in home sales from their Economics Group note from the 7th of November entitled "Home Sales Remain Soft":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>The Softening For-Sale Market Has Been Good for Apartment Owners</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: red;">The magnitude and speed at which home sales have weakened is surprising, following just a three-quarter of a percentage point rise in mortgage rates.</span> We suspect the problem is a lack of affordable product in the markets where potential home buyers would like to live. This helps explain why sales turned down well ahead of this fall’s rise in mortgage rates. The lack of inventory in desirable markets is a function of how highly concentrated economic growth has been in this cycle. Two industries, technology and energy, have accounted for a disproportionate share of job growth. While job gains have broadened more recently, a larger proportion of the high-paying, creative industry jobs are being added in submarkets closer to the central business district. By contrast, job growth in suburban markets has been slower to recover and wage gains have lagged for many occupations that are at greater risk of automation and outsourcing.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The rapid growth in higher value-added positions closer in to many major cities has fueled a housing crunch that has sent home values and rents soaring in many rapidly growing markets. The lack of developable lots closer in to the city has fueled growth of in-fill developments and teardowns, which have often removed more affordable homes from the market. The resulting battles over gentrification have also led to some political blowback, which has stymied development in some areas. Growth is also creeping back out toward the suburbs, particularly those that are developing their own urban cores. What has largely been missing, however, has been the push to develop exurban areas, where land has historically been less expensive. Such development has remained elusive, as higher development costs have largely offset any savings in raw land costs.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The same trends impacting home sales are evident in the rental market. Demand remains strong for amenity-rich apartments located near the city center or in the metro area’s second or third largest employment centers. Demand for apartments further out in the suburbs has taken longer to recover but has been doing better more recently, reflecting stronger job growth and an acceleration in wage gains. The suburbs have generally seen less development, so the improvement in demand has pulled vacancy rates lower and pushed rents higher. New suburban development remains elusive, however, and most new projects continue to cluster around pricier submarkets closer to the central business district.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-vTNoWOJeUy0/W-RQ4VSWFfI/AAAAAAAAU7w/1-EuIn5OTrEzN9HgKq7hNMRPUNz5-oZRgCLcBGAs/s1600/WF%2B-%2BApartment%2Bsupply%2Band%2Bdemand.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="279" data-original-width="335" height="266" src="https://4.bp.blogspot.com/-vTNoWOJeUy0/W-RQ4VSWFfI/AAAAAAAAU7w/1-EuIn5OTrEzN9HgKq7hNMRPUNz5-oZRgCLcBGAs/s320/WF%2B-%2BApartment%2Bsupply%2Band%2Bdemand.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">We have further reduced our forecasts for home sales and new home construction following the recent string of weaker housing reports and downward revisions to previous data. We still see new home sales increasing over the forecast period but now look for just 5.6% growth in 2019 and 5.3% growth in 2020. </span></blockquote>
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<a href="https://3.bp.blogspot.com/-sdSodHWMRQ0/W-RQwFkchZI/AAAAAAAAU7s/RODJs8KWuJoNX35LEVGq5n7ry8U0ppH2wCLcBGAs/s1600/WF%2B-%2BHousing%2BStarts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="279" data-original-width="337" height="264" src="https://3.bp.blogspot.com/-sdSodHWMRQ0/W-RQwFkchZI/AAAAAAAAU7s/RODJs8KWuJoNX35LEVGq5n7ry8U0ppH2wCLcBGAs/s320/WF%2B-%2BHousing%2BStarts.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Much of that increase will come from more affordable homes in the South and West, which will restrain new home price appreciation. With little inventory, new home construction will continue to gradually edge higher. Apartment development is now expected to remain stronger for a little longer. There are a great deal of projects in the pipeline and a large number of proposed projects that have not yet moved forward. Demand for well located projects should remain strong, but vacancy rates will likely rise as job growth moderates in 2019 and 2020." - source Wells Fargo</span></blockquote>
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<span style="font-family: inherit;">We do not share the optimism above relating to new home construction due to affordability issues coming from rising mortgage rates due to the Fed continuing its hiking path, their views being supported by the most recent employment report. Housing affordability has become a headwind, no wonder in some parts of the US prices are starting to cool down as indicated by Bloomberg on the 30th of October in their article entitled "<span style="text-align: left;"><a href="https://www.bloomberg.com/news/articles/2018-10-30/homes-slipping-beyond-grasp-of-buyers-across-u-s-as-rates-rise">Mortgage Rates Are Pushing U.S. Homes Out of Reach</a>":</span></span></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"While U.S. home prices have gained almost 60 percent since March 31, 2012, according to the S&P Corelogic Case-Shiller 20-City Composite Index, household income is up a little less than 30 percent in the same period, Bureau of Economic Analysis data shows. The average rate for a 30-year fixed mortgage rose from about 3.85 percent at the start of 2018 to about 4.74 percent now, Bankrate.com reports. Next year, it’s expected to rise further.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-cnQUyqilzM4/W-RUMrxtDZI/AAAAAAAAU8A/o3C8U8763Po2Phg6PLHN_7OqlEqarg-mACLcBGAs/s1600/Bloomberg%2B%2B-%2BAffordability%2Bgap.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="675" data-original-width="1200" height="180" src="https://3.bp.blogspot.com/-cnQUyqilzM4/W-RUMrxtDZI/AAAAAAAAU8A/o3C8U8763Po2Phg6PLHN_7OqlEqarg-mACLcBGAs/s320/Bloomberg%2B%2B-%2BAffordability%2Bgap.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">A buyer with a $2,500 monthly housing budget has lost almost $30,000 in purchasing power this year, according to Redfin Inc., a national brokerage.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In Orange County, California, more than 30 percent of homes for sale in the metro area would become unaffordable to buyers with a $3,500 monthly budget, Redfin estimates. In San Jose, that number would be almost 40 percent." - source Bloomberg</span></blockquote>
<span style="text-align: justify;"><span style="font-family: inherit;">Housing markets turn slowly then suddenly...Just a thought.</span></span><br />
<span style="text-align: justify;"><span style="font-family: inherit;"><br /></span></span>
<div style="text-align: justify;">
<span style="font-family: inherit;">While the US elections stalemate and the return of buybacks should be supportive, US markets for many years have been levitating and defying gravitation provided by the central bank support. This support has been obviously fading during the course of 2018 with QT as per our final charts below.</span></div>
<span style="text-align: justify;"><span style="font-family: inherit;"><br /></span></span>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - The invisible hand is fading...</span></li>
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<span style="font-family: inherit;">If October has been murderous for various asset classes thanks to the conjunction of several factors such as the velocity in the rise of real rates, blackout period leading to smaller buybacks, escalating tensions in the trade war narrative between the United States and China as well as Italian worries, our final charts from Bank of America Merrill Lynch coming from their European Credit Strategist note entitled "The hunt for red October" from the 2nd of November clearly shows that the "invisible hand" coming from the central bank is fading:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>The end of the “invisible hand”…</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Last month wasn’t unique, though. We think it reflects a bigger picture theme…namely that assets are now struggling to produce meaningfully positive returns in an era of less central bank liquidity. The “invisible hand” that once propped-up market prices is now significantly smaller.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Chart 1 shows that there are precious few assets that remain above water this year. In fixed-income land, US leveraged loans have produced total returns of around 4%. </span></blockquote>
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<a href="https://4.bp.blogspot.com/-Wau4VnZfKOw/W-RojllE-yI/AAAAAAAAU8Q/tSLZ06Sh9qQa9qvwB7gubwdE-M-aj7ZFgCLcBGAs/s1600/BAML%2B-%2BThe%2Bfew%2Bwinners%2Band%2Bthe%2Bmany%2Blosers%2Bin%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="344" data-original-width="383" height="287" src="https://4.bp.blogspot.com/-Wau4VnZfKOw/W-RojllE-yI/AAAAAAAAU8Q/tSLZ06Sh9qQa9qvwB7gubwdE-M-aj7ZFgCLcBGAs/s320/BAML%2B-%2BThe%2Bfew%2Bwinners%2Band%2Bthe%2Bmany%2Blosers%2Bin%2B2018.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In Europe, many government debt markets – with the exception of Italy – are up for the year, albeit only by a modicum. But note that the biggest loser of all during the QE era, namely cash, has turned into one of the best performing assets of 2018 (1.5% total returns).</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">…the start of abnormal markets?</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">This spectrum of returns, however, is also far from normal. Chart 2 shows the historical percentage of assets with positive vs. negative returns on a yearly basis (our sample contains over 300 equity, fixed-income, commodity and FX indices). </span></blockquote>
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<a href="https://4.bp.blogspot.com/-xSPctg7LBgw/W-Rofvp7tlI/AAAAAAAAU8M/6cu3Yptn_wgCZtfLKdnwt62uDSlwXYs6gCLcBGAs/s1600/BAML%2B-%2BOnly%2B23%2Bpct%2Bof%2Bassets%2Bhave%2Bpositive%2Btotal%2Breturns%2Bin%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="344" data-original-width="382" height="288" src="https://4.bp.blogspot.com/-xSPctg7LBgw/W-Rofvp7tlI/AAAAAAAAU8M/6cu3Yptn_wgCZtfLKdnwt62uDSlwXYs6gCLcBGAs/s320/BAML%2B-%2BOnly%2B23%2Bpct%2Bof%2Bassets%2Bhave%2Bpositive%2Btotal%2Breturns%2Bin%2B2018.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">This year, we find that only 23% of assets have produced positive total returns. As can be seen, historically this is a very low number. In fact, such a number is usually only observed in periods of financial crises (2008), debt crises (2011), or just plain old recessions. And yet despite the shocks and bumps lately, the global economy is still humming along fairly nicely in 2018.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In our view, after such a big drawdown last month, markets are likely prepped for a rebound in November. Yet, we caution that bounces in risk sentiment could still be shallow ones. After all, with so many assets trending lower this year, long-only investors are finding that there are much fewer ways to help them diversify and protect their portfolios." - source Bank of America Merrill Lynch</span></blockquote>
<span style="font-family: inherit;"><span style="text-align: justify;"></span></span><br />
<div style="text-align: justify;">
<span style="font-family: inherit;">One could argue that, no matter what "stalemate" we have reached in the United States midterm elections, the "fall" in the fall is surely indicative that at some point winter is coming. Could housing woes be seen as leaves already falling? We wonder...</span></div>
<span style="text-align: justify;"><span style="font-family: inherit;"><br /></span></span>
<blockquote class="tr_bq" style="text-align: justify;">
<div style="text-align: left;">
<span style="font-family: inherit;">“How did you go bankrupt?" </span></div>
<span style="font-family: inherit;"><div style="text-align: left;">
<span style="font-family: inherit;">Two ways. Gradually, then suddenly.” - Ernest Hemingway, The Sun Also Rises</span></div>
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<span style="font-family: inherit;">Stay tuned!</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-41203922750742099152018-10-31T14:26:00.000+00:002018-10-31T14:26:01.006+00:00Macro and Credit - Explosive cyclogenesis<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Invincibility lies in the defence; the possibility of victory in the attack." - Sun Tzu</span></blockquote>
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<div style="text-align: justify;">
<span style="font-family: inherit;">Looking at the bloodbath occurring in various sectors of the US equity markets during the scary month of October historically for financial markets such as the Black Monday of October 16th 1987, when it came to selecting this week title analogy, we decided to go towards a meteorological analogy, namely "Explosive cyclogenesis". "Explosive cyclogenesis" is also referred as a weather bomb. The change in pressure needed to classify something as explosive cyclogenesis is latitude dependent. For example, at 60° latitude, explosive cyclogenesis occurs if the central pressure decreases by 24 mbar (hPa) or more in 24 hours. Given the velocity in which US "real rates accelerated upwards at the beginning of the month in conjunction with the surge of the balance sheet reduction of the US Fed to $50 billion per month. The Fed’s QE Unwind Reaches $285 Billion From the 6th of September through the 3rd of October, the Fed’s holdings of Treasury Securities fell by $19 billion to $2,294 billion, the lowest since March 5, 2014. Given an explosive cyclogenesis occurs if the central pressure decreases rapidly, in similar fashion, the acceleration in the Fed's reduction of its balance sheet triggered the "weather bomb" on financial markets. </span></div>
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<div style="text-align: justify;">
<span style="font-family: inherit;">Many pundits have been reminding themselves of Black Monday given it occurred during the month of October as well. Many have forgotten the Great Storm of 1987 which was a violent extratropical cyclone that occurred on the night of 15-16th of October. That day's weather reports failed to indicate a storm of such severity, an earlier, correct forecast having been negated by later projections. On the Sunday before the storm struck, the farmers' forecast had predicted bad weather on the following Thursday or Friday, 15–16 October. By midweek, however, guidance from weather prediction models was somewhat equivocal. Instead of stormy weather over a considerable part of the UK, the models suggested that severe weather would reach no farther north than the English Channel and coastal parts of southern England. At 2235 UTC, winds of Force 10 were forecast. By midnight, the depression was over the western English Channel, and its central pressure was 953 mb. At 0140 on 16 October, warnings of Force 11 were issued. The depression now moved rapidly north-east, filling a little as it did, reaching the Humber Estuary at about 0530 UTC, by which time its central pressure was 959 mb. Dramatic increases in temperature were associated with the passage of the storm's warm front. During the evening of 15 October, radio and TV forecasts mentioned strong winds, but indicated that heavy rain would be the main feature, rather than wind. By the time most people went to bed, exceptionally strong winds had not been mentioned in national radio and TV weather broadcasts. The storm cost the insurance industry GBP 2 billion, making it the second most expensive UK weather event on record to insurers after the Burns' Day Storm of 1990. </span></div>
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<span style="font-family: inherit;">Following the storm few dealers made it to their desks and stock market trading was suspended twice and the market closed early at 12.30pm. <span style="color: red;">The disruption meant the City was unable to respond to the late dealings at the beginning of the Wall Street fall-out on Friday 16 October, when the Dow Jones Industrial Average recorded its biggest-ever one-day slide at the time, a fall of 108.36</span>. City traders and investors spent the weekend, 17–18 October, repairing damaged gardens in between trying to guess market reaction and assessing the damage. The 19th of October, Black Monday, was memorable as being the first business day of the London markets after the Great Storm. The trigger for the "weather bomb" in early October which led to a 10% mini-crash was a warning by Fed chairman Jay Powell that the Fed planned to push interest above the "neutral rate" to prevent overheating. So, central pressure fell rapidly, real rates shoot up and the rest is as we say history but, we ramble again.</span></div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at the buildup in recession signs we are seeing adding to the "reflexivity" in the tightening of financial conditions. Are the "weather" forecasts of no recession in sight justified? We wonder.</span></span></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
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<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - "Reflexivity" and Recessions</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final charts - Where is the "credit" weather bomb?</span></b></i></li>
</ul>
</div>
<span style="font-family: inherit;"><br /></span>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - "Reflexivity" and Recessions</span></li>
</ul>
<span style="font-family: inherit;"><br /></span>
<div style="text-align: justify;">
<span style="font-family: inherit;">As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks. As pointed out on Twitter by Tiho Brkan displaying a chart from JP Morgan , almost all asset classes have negative YTD returns (first time in 40 years).:</span></div>
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<a href="https://2.bp.blogspot.com/-2mtcBPBN9F0/W9iNX1bKTmI/AAAAAAAAU4M/6SnQGp2OIuol-uYFZXt-64ECEDLkPnHQgCLcBGAs/s1600/JPM%2B-%2Bmost%2Basset%2Bclasses%2Bnegative%2Bin%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="772" data-original-width="960" height="257" src="https://2.bp.blogspot.com/-2mtcBPBN9F0/W9iNX1bKTmI/AAAAAAAAU4M/6SnQGp2OIuol-uYFZXt-64ECEDLkPnHQgCLcBGAs/s320/JPM%2B-%2Bmost%2Basset%2Bclasses%2Bnegative%2Bin%2B2018.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- graph source JP Morgan, H/T Tiho Brkan</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<div>
<span style="font-family: inherit;">The rise in “real rates” triggered repricing of forward EPS, and forced investors to mark a lower strike to the Fed “put”. Real rates grew at the same pace as 12 months Forward EPS until the “repricing”:</span></div>
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<a href="https://2.bp.blogspot.com/-e1BHT3nT75Q/W9hlxeb0MLI/AAAAAAAAU28/MK9ROJ_V5_sn5r7aKnQcAE0HqQOJTSzVwCLcBGAs/s1600/Macrobond%2B-%2B10%2Byear%2Breal%2Brates%2Band%2BFWD%2BEPS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="893" height="141" src="https://2.bp.blogspot.com/-e1BHT3nT75Q/W9hlxeb0MLI/AAAAAAAAU28/MK9ROJ_V5_sn5r7aKnQcAE0HqQOJTSzVwCLcBGAs/s320/Macrobond%2B-%2B10%2Byear%2Breal%2Brates%2Band%2BFWD%2BEPS.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- graph source Macrobond</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Given financial markets should act for many investorss as a "<a href="https://www.investopedia.com/terms/d/discounting-mechanism.asp">discounting mechanism</a>", no wonder, with liquidity being removed thanks to QT, markets have had to "reprice" forward EPS accordingly in such a short period of time. The US markets have been defying gravity way too long and their outperformance versus the rest of the world has been significant in 2018.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<div>
<span style="font-family: inherit;">When it comes to "buying the dip", Merryn Somerset Webb in the Financial Times makes some interesting comments:</span></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"October shouldn’t be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors perhaps) this is nasty. For the rest of us it is good news, twice over.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40 per cent of S&P 500 companies have reported in this earnings season and some 80 per cent of them have managed to produce a positive surprise. Digitalisation may well be about to transform productivity in developed economies. And there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Second, stock markets outside the US really are not that expensive anymore and pockets of them are beginning to look like they offer some value. That should please long-term investors.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for." - source Financial Times - Merryn Somerset Webb </span></blockquote>
<div>
<span style="font-family: inherit;">In terms of "cheap" market outside the US, and as pointed out in her article as well, apart from the United States, Russia regardless of US sanctions, was left pretty much unscathed relative to other Emerging Markets. Russia, equity market should be priced for a continued rebound. Forget the sanctions, rising oil prices could be very supportive and with a PE of around 5.2, you have very limited downside. The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors; given the extreme volatility of American politics (and thus sanctions). Comparing Eurobond yields with Russian equity yields for the same risks will show you more "arbitrage" opportunities so we suggest you do your homework on this...</span></div>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">But, for sure, with rising dispersion, active management as pointed out by Merryn Somerset Webb should come back into play, given the growing rotation between value and growth:</span></div>
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<a href="https://4.bp.blogspot.com/-5zfmU-LnEZw/W9htblARkqI/AAAAAAAAU3I/nmTFMOQJmXgX5Y7YWO-fURvxaVcalhA3gCLcBGAs/s1600/Reuters%2BThomson%2BReuters%2BDatastream%2B-%2Bspread%2Bbetween%2BRussell%2Band%2BValue.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="440" data-original-width="585" height="240" src="https://4.bp.blogspot.com/-5zfmU-LnEZw/W9htblARkqI/AAAAAAAAU3I/nmTFMOQJmXgX5Y7YWO-fURvxaVcalhA3gCLcBGAs/s320/Reuters%2BThomson%2BReuters%2BDatastream%2B-%2Bspread%2Bbetween%2BRussell%2Band%2BValue.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- source Thomson Reuters Datastream - H/T Holger Zschaeptiz on Twitter.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<div>
<span style="font-family: inherit;">The growth trade over value trade is over. That’s your "great rotation" from "growth" to value" in one chart…</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">Moving back to the "main course" namely "Reflexivity" and Recession, we do believe that we have passed "peak" consumer confidence in the US. For instance the University of Michigan’s consumer sentiment index fell from 100.1 in September to 98.6 in October. This we think was “peak” consumer confidence with cyclicals such as Housing and Autos becoming a headwind for the US consumer.</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<div>
<span style="font-family: inherit;">Sure US Q3 GDP came at an annualized 3.5% but, it is because Americans save less to sustain spending as income gains cool. Americans saved 6.2% of their disposable income matching the lowest level since 2013:</span></div>
</div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-XT602iqp2vI/W9h-8vQH29I/AAAAAAAAU3U/q-jx8gPHx4MafblLVsuXrr1MVFzKCF7AgCLcBGAs/s1600/Bloomberg%2B-%2BDipping%2Binto%2Bwallets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="437" data-original-width="776" height="180" src="https://1.bp.blogspot.com/-XT602iqp2vI/W9h-8vQH29I/AAAAAAAAU3U/q-jx8gPHx4MafblLVsuXrr1MVFzKCF7AgCLcBGAs/s320/Bloomberg%2B-%2BDipping%2Binto%2Bwallets.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- graph source Bloomberg</span></div>
<div>
<u><span style="font-family: inherit;"><br /></span></u></div>
<div>
<u><span style="font-family: inherit;">On top of that we can list the following "headwinds":</span></u></div>
<div>
<div>
<ul>
<li><span style="font-family: inherit;">Investors are selling the shares that hit quarterly earnings expectations at the highest rate since 2011. Good times are behind us…</span></li>
<li><span style="font-family: inherit;">Early indicators show that economic conditions continue to weaken in China</span></li>
<li><span style="font-family: inherit;">Residential investment fell 4% marking the third straight quarterly decline. That hasn’t happened since late 2008 and early 2009.</span></li>
<li><span style="font-family: inherit;">Breaking bad? Even equity-long short hedge funds could see their worst month since the Great Financial Crisis (GFC). August 2011 level reached so far.</span></li>
<li><span style="font-family: inherit;">U.S. investment-grade bond funds reported $1.6 billion in outflows in the past week, the fourth consecutive withdrawal for total redemptions of $7.2 billion; HY funds reported $2.1 billion of outflows according to Wells Fargo Securities.</span></li>
</ul>
</div>
</div>
<div>
<span style="font-family: inherit;">We could also add David P Goldman's recent comments in Asia Times that <a href="http://www.atimes.com/article/us-consumer-discretionary-stocks-propped-up-by-credit-card-binge/">US consumer discretionary stocks have been propped up by credit card binge</a>:</span></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"Consumer discretionary stocks have outperformed the S&P 500 by about 10% during the past year. That may be about to change.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-jjKGz264FWM/W9iCDcOgbYI/AAAAAAAAU3g/8MdaOhTzq9cSwxjoA5FJcRSuXwyltFJGgCLcBGAs/s1600/David%2BGoldman%2BAtimes%2B-%2BConsumer%2BDiscretionary%2Bvs%2BSPX.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="408" data-original-width="623" height="209" src="https://3.bp.blogspot.com/-jjKGz264FWM/W9iCDcOgbYI/AAAAAAAAU3g/8MdaOhTzq9cSwxjoA5FJcRSuXwyltFJGgCLcBGAs/s320/David%2BGoldman%2BAtimes%2B-%2BConsumer%2BDiscretionary%2Bvs%2BSPX.jpg" width="320" /></span></a></div>
<div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Consumer spending remains robust in the United States according to this morning’s US data release. Personal spending was up 0.4% in September, or a 5% annual rate. The problem is that personal income rose only 0.2%, or a 2.4% annual rate.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Consumers are spending more than they earn. The past year’s pop in consumer spending depended on credit cards. That’s not a sustainable situation.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">The chart below shows three-month changes in US retail sales vs. three-month changes in credit card debt outstanding. During the past year, the two lines look nearly identical.</span></blockquote>
</div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://1.bp.blogspot.com/-IGFZmrBproo/W9iCXZlBt8I/AAAAAAAAU3o/QunLG7wA9eMs3FGp8CJoXgWbosbTJWiogCLcBGAs/s1600/David%2BP%2BGoldman%2BAtimes%2B-%2BChange%2Bin%2Bcredit%2Bcard%2Bdebt%2Bvs%2Bchange%2Bin%2Bretail%2Bsales.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="661" data-original-width="911" height="232" src="https://1.bp.blogspot.com/-IGFZmrBproo/W9iCXZlBt8I/AAAAAAAAU3o/QunLG7wA9eMs3FGp8CJoXgWbosbTJWiogCLcBGAs/s320/David%2BP%2BGoldman%2BAtimes%2B-%2BChange%2Bin%2Bcredit%2Bcard%2Bdebt%2Bvs%2Bchange%2Bin%2Bretail%2Bsales.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Here’s another way to measure the dependence of retail sales on credit cards: The six-month rolling correlation between monthly changes in retail sales and monthly changes in credit card balances outstanding has risen to about 70%.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-B-xkXSA1r1s/W9iC-jno81I/AAAAAAAAU30/TlwwoJDSuZ83n6JMfPl48HCpv2esHt1zACLcBGAs/s1600/David%2BP%2BGoldman%2BAtimes%2B-%2BRetail%2Bsales%2Bvs%2BRevolving%2Bcredit%2B-%2B6%2Bmonth%2Bcorrelation%2Bof%2Bmonthly%2Bchange.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="661" data-original-width="911" height="232" src="https://3.bp.blogspot.com/-B-xkXSA1r1s/W9iC-jno81I/AAAAAAAAU30/TlwwoJDSuZ83n6JMfPl48HCpv2esHt1zACLcBGAs/s320/David%2BP%2BGoldman%2BAtimes%2B-%2BRetail%2Bsales%2Bvs%2BRevolving%2Bcredit%2B-%2B6%2Bmonth%2Bcorrelation%2Bof%2Bmonthly%2Bchange.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: center;">
<span style="font-family: inherit;">- source David P Goldman - Asia Times</span></blockquote>
<div>
<div>
<span style="font-family: inherit;">US consumers might not be “buying the dip” but, are dipping into their savings to “sustain” their consumption and that's something to worry about. We haven't even much growth deceleration in Europe at this stage. We recently mused around shipping indicative of a slowdown in global trade in our latest conversation "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-ballyhoo.html">Ballyhoo</a>" and the Harpex index as an indicator.</span></div>
</div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">Apart from the clear underperformance of the exported oriented German Dax Index or the Korean Index, Anastasios Avgeriou, Chief Equity Strategist at BCA Research pointed out on <a href="https://www.linkedin.com/feed/update/urn:li:activity:6462779980223963136/">Linkedin today</a> a very interesting chart:</span></div>
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<a href="https://4.bp.blogspot.com/-toAxEfNkkVM/W9iEbZU_NVI/AAAAAAAAU4A/O8hKXQmviWsUXFBbR44-Qki-BucDPlYwgCLcBGAs/s1600/StockCharts%2B-%2BDax%2Band%2BChip%2Bstocks%2Bsensitive%2Bto%2Bglobal%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="507" data-original-width="770" height="210" src="https://4.bp.blogspot.com/-toAxEfNkkVM/W9iEbZU_NVI/AAAAAAAAU4A/O8hKXQmviWsUXFBbR44-Qki-BucDPlYwgCLcBGAs/s320/StockCharts%2B-%2BDax%2Band%2BChip%2Bstocks%2Bsensitive%2Bto%2Bglobal%2Bgrowth.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"Who would have thought that the DAX and chip stocks are more or less the same trade... Both are very sensitive to global growth and thus interest rates. In other words, rising interest rates hurts them, and vice versa..." - source Anastasios Avgeriou, Chief Equity Strategist at BCA Research </span></blockquote>
<div>
<span style="font-family: inherit;">Misery do loves company one would argue. Cyclicals such as housing, autos and even chips have been impacted by the deceleration in global trade hence the latest weakness seen in Europe from slower GDP growth. </span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">As well there are some other signs pointing towards trouble at a later stage, which will follow the "relief" rally we are seeing. </span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">For instance, as pointed by the IIF, despite stronger earnings growth this year, many US companies struggle with debt service:</span></div>
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<a href="https://4.bp.blogspot.com/-_qjq237lCSI/W9mexmbcyxI/AAAAAAAAU4Y/QH_xUaoxcXUDAPTA1V24XXuqN-SF39puACLcBGAs/s1600/IIF%2B-%2BUS%2Bcompanies%2Bstuggling%2Bwith%2Bdebt%2Bservices.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="314" data-original-width="481" height="208" src="https://4.bp.blogspot.com/-_qjq237lCSI/W9mexmbcyxI/AAAAAAAAU4Y/QH_xUaoxcXUDAPTA1V24XXuqN-SF39puACLcBGAs/s320/IIF%2B-%2BUS%2Bcompanies%2Bstuggling%2Bwith%2Bdebt%2Bservices.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq">
<span style="font-family: inherit;">"Many companies are not generating enough earnings to cover interest expenses - despite still strong earnings growth. With growth expected to slow in 2019 and rates still rising, the problem could get worse" - source IIF</span></blockquote>
<span style="font-family: inherit;">In our book credit leads equity and we are closely watching credit drifting wider thanks to the Fed tightening slowly but surely the credit noose as can be seen in the below Bloomberg chart posted by Lisa Abramowicz on her Twitter feed:</span><br />
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<a href="https://3.bp.blogspot.com/-7ano9IDhTUg/W9mmHOrBi1I/AAAAAAAAU48/nG7UjyeAfqYTxQRK7vd81fh5GzUM73XrgCLcBGAs/s1600/Bloomberg%2B-%2BCCC%2Bindex%2B-%2BLisa%2BAbramowicz.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="668" data-original-width="1554" height="137" src="https://3.bp.blogspot.com/-7ano9IDhTUg/W9mmHOrBi1I/AAAAAAAAU48/nG7UjyeAfqYTxQRK7vd81fh5GzUM73XrgCLcBGAs/s320/Bloomberg%2B-%2BCCC%2Bindex%2B-%2BLisa%2BAbramowicz.jpg" width="320" /></span></a></div>
<span style="font-family: inherit;">"Yields on US High Yield bonds with CCC ratings just climbed above 10%, the highest level since the end of 2016" - source Bloomberg - Lisa Abramowicz on Twitter</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket.</span><br />
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And of course the problem is getting worse given rates have been rising in-line with improving growth estimates as per the below chart from Bank of America Merrill Lynch:</span></div>
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<a href="https://4.bp.blogspot.com/-2p3khriXqt4/W9mjV04VPNI/AAAAAAAAU4k/UOEXu4u1TtA3_Cq14IKRP5-HNUCp1y-mACLcBGAs/s1600/BAML%2B-%2BRates%2Brising%2Bin-line%2Bwith%2Bimproving%2Bgrowth%2Bestimates.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="670" data-original-width="1415" height="151" src="https://4.bp.blogspot.com/-2p3khriXqt4/W9mjV04VPNI/AAAAAAAAU4k/UOEXu4u1TtA3_Cq14IKRP5-HNUCp1y-mACLcBGAs/s320/BAML%2B-%2BRates%2Brising%2Bin-line%2Bwith%2Bimproving%2Bgrowth%2Bestimates.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">If indeed growth is slowing, then again the US Treasury Notes yield should be falling as well. It is difficult to play it at the moment given the rise in issuance by the US Treasury.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">When it comes to "Smart Money" some have already been heading towards the exit as pointed out by Eric Pomboy on Twitter with the below Bloomberg chart:</span></div>
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<a href="https://4.bp.blogspot.com/-xZR-L11LdKw/W9mkZwqThKI/AAAAAAAAU4w/gUXHvqs40Zo70NiWTsaX2wRNW7dXkrX-ACLcBGAs/s1600/Bloomberg%2B-%2BSmart%2BIndex%2Bas%2Bof%2B29-10-2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="709" data-original-width="1326" height="171" src="https://4.bp.blogspot.com/-xZR-L11LdKw/W9mkZwqThKI/AAAAAAAAU4w/gUXHvqs40Zo70NiWTsaX2wRNW7dXkrX-ACLcBGAs/s320/Bloomberg%2B-%2BSmart%2BIndex%2Bas%2Bof%2B29-10-2018.jpg" width="320" /></span></a></div>
<div style="text-align: center;">
<span style="font-family: inherit;">- graph source Bloomberg - Eric Pomboy on Twitter</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Someone is clearly not waiting for the explosion of the "weather bomb" it seems...</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">One thing for sure, the October "Explosive cyclogenesis" aka weather bomb was another warning shot by the Fed but it seems no one was really listening. This effectively means that the Fed’s strike price for US stocks is much lower as it has removed the reference to monetary policy being accommodative. This is pointed out by Morgan Stanley in their Global Interest Rate Strategist note from the 26th of October entitled "The Financial Conditions Jackpot":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"FOMC participants have been clear that the outlook for the hiking cycle is unlikely to shift simply because of equity market volatility. This sort of guidance led to interest rate vol lagging the sharp rise in equity vol. We think this is justified by fundamentals and do not yet recommend buying shorter expiry interest rate options outright. Only when the narrative of FOMC participants starts to shift will we consider paying theta. And when that occurs, we expect short-tail vol to outperform long-tail vol.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">A long way to neutral?</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Exhibit 47 illustrates how 1m10y vol has been lagging the spike in the VIX. </span></blockquote>
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<a href="https://4.bp.blogspot.com/-IDxDMFX79h4/W9mpn_fHnRI/AAAAAAAAU5I/wfxNJz3U84k1FK-1KXj5h78-Gja4JgvZACLcBGAs/s1600/MS%2B-%2BInflation%2Blevered%2Bstock%2Bbasket%2Bvs%2B10%2Byear%2Bbreakeven%2Bover%2Bthe%2Blast%2B5%2Byears.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="268" data-original-width="530" height="161" src="https://4.bp.blogspot.com/-IDxDMFX79h4/W9mpn_fHnRI/AAAAAAAAU5I/wfxNJz3U84k1FK-1KXj5h78-Gja4JgvZACLcBGAs/s320/MS%2B-%2BInflation%2Blevered%2Bstock%2Bbasket%2Bvs%2B10%2Byear%2Bbreakeven%2Bover%2Bthe%2Blast%2B5%2Byears.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">This is true of rates vol in general, which has underperformed equity vol in both realized and implied terms. We believe the main driver of this dissociation has been the general dismissal by most FOMC participants of the volatility seen in the stock market. This is an excerpt from the Q&A that followed the September FOMC press conference (our emphasis):</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i><span style="font-family: inherit;">CHAIRMAN POWELL. So I don’t comment on the appropriateness of the level of stock prices. I can say that by some valuation measures, they’re in the upper range of their historical value ranges. But, you know, I wouldn’t want to—I wouldn’t want to speculate about what the consequences of a market correction should be. You know, we would—we would look very carefully at the nature of it, and I mean, it—really— really what hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that’s a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that’s a really bad situation. <b>A simple drop in equity prices is— all by itself, doesn’t really have those features</b>. It could certainly feature—it could certainly affect consumption and have a negative effect on the economy, though.</span></i></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">More recent comments from FOMC participants echoed that sentiment, despite the S&P 500 index being 10% off the highs. In effect, this implied that the Fed is not close to stepping in to support the stock market by altering the path for monetary policy. In other words, the so-called "Fed Put" is still out of the money. This is likely to maintain some certainty in the rates market as to the path for rates in the near term as the Fed seems set to at least reach its estimate of neutral.</span></blockquote>
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<a href="https://2.bp.blogspot.com/-SzhkIxTMmds/W9msVbTnXuI/AAAAAAAAU5U/G-6wJ9Z4tNcUTNLQRO57w3iQItKrv6sPgCLcBGAs/s1600/MS%2B-%2BRegression%2Bof%2B1m10y%2Bimplied%2Bvol%2Bon%2Bthe%2BVIX%2Bsince%2B2010.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="321" data-original-width="310" height="320" src="https://2.bp.blogspot.com/-SzhkIxTMmds/W9msVbTnXuI/AAAAAAAAU5U/G-6wJ9Z4tNcUTNLQRO57w3iQItKrv6sPgCLcBGAs/s320/MS%2B-%2BRegression%2Bof%2B1m10y%2Bimplied%2Bvol%2Bon%2Bthe%2BVIX%2Bsince%2B2010.jpg" width="309" /></span></a></div>
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<a href="https://2.bp.blogspot.com/-MRnWUwvDzsY/W9msYT43tII/AAAAAAAAU5Y/mSlpptC0cM47fXs6lGiMIlg1apga6Si1QCLcBGAs/s1600/MS%2B-%2BA%2Blook%2Bat%2BFinancial%2BConditions%2BIndices.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="309" data-original-width="320" src="https://2.bp.blogspot.com/-MRnWUwvDzsY/W9msYT43tII/AAAAAAAAU5Y/mSlpptC0cM47fXs6lGiMIlg1apga6Si1QCLcBGAs/s1600/MS%2B-%2BA%2Blook%2Bat%2BFinancial%2BConditions%2BIndices.jpg" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Less uncertainty about rates begets lower vol. Of course, rates are still going to see higher vol in a risk-off move as a result of investment flows as well as shifting probabilities surrounding the outlook for the Fed. But our view is that this volatility will not be both sustainable and notable until the Fed Put is in the money." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">Until the Fed Put is in the money, that is until the weather bomb has been digested by the market in similar fashion to the rapid storm experienced back in October 1987.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">While many pundits are still reeling from the "bloody" October, and many are asking themselves where trouble is brewing, we do believe that some parts of US credit markets do contain some potential "weather" bombs as per our final charts below</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;"><br /></span>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - Where is the "credit" weather bomb?</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">Credit always leads equities in our book when eventually we will have a definitive turn of the credit cycle. For storm chasers out there, we believe that some parts of US Credit Markets are showing signs of fragility, and it's not only the fall in quality of Investment Grade Credit. Our final charts comes from Wells Fargo Economics Group note from the 29th of October entitled "Which Sectors Have Driven Business Sector Debt Growth" and shows that the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Business Sector Debt Is Up By Nearly $5 Trillion</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In a recent report, we noted that the financial health of the U.S. non-financial corporate (NFC) sector has deteriorated, at least at the margin, in recent quarters. For example, the debt-to-GDP ratio of the NFC sector has trended up to its highest level in decades (below chart). </span></blockquote>
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<a href="https://4.bp.blogspot.com/-nhN0V2R9-gg/W9m073JcqxI/AAAAAAAAU5o/K5RcPh-t9uccKV4_p5U14JiEyjs8u9c6ACLcBGAs/s1600/WF%2B-%2BNonfinancial%2BCorporate%2BDebt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="256" data-original-width="339" height="241" src="https://4.bp.blogspot.com/-nhN0V2R9-gg/W9m073JcqxI/AAAAAAAAU5o/K5RcPh-t9uccKV4_p5U14JiEyjs8u9c6ACLcBGAs/s320/WF%2B-%2BNonfinancial%2BCorporate%2BDebt.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Not only do non-financial corporations borrow from financial institutions such as banks, but they also issue bonds in the corporate debt market. In that regard, the market value of investment grade (IG) corporate bonds has shot up from less than $2 trillion during the depths of the financial crisis to more than $5 trillion today. The value of high yield (HY) corporate bonds has mushroomed from about $400 billion in late 2008 to nearly $1.3 trillion today.<br />The value of corporate bonds outstanding—IG and HY—has plateaued in recent months. But, lending by commercial banks to the NFC sector continues to trend higher. Indeed, the amount of leveraged loans outstanding has grown to almost $1.1 trillion at present from about $800 in early 2016 (below chart). </span></blockquote>
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<a href="https://2.bp.blogspot.com/-GZMYoah2LKc/W9m1PGDAubI/AAAAAAAAU5w/6D9HV6vsw8UKDGnwQOaS7NTX8z_WeHABwCLcBGAs/s1600/WF%2B-%2BLeveraged%2BLoans.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="257" data-original-width="339" height="242" src="https://2.bp.blogspot.com/-GZMYoah2LKc/W9m1PGDAubI/AAAAAAAAU5w/6D9HV6vsw8UKDGnwQOaS7NTX8z_WeHABwCLcBGAs/s320/WF%2B-%2BLeveraged%2BLoans.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In total, the value of corporate bonds (IG and HY) and leveraged loans outstanding has risen by nearly $5 trillion, which is an increase of roughly 180%, since late 2008. Is this growth in corporate debt a widespread phenomenon or does it reflect higher debt loads in just a few sectors?<br />We disaggregated the business sector into 11 broad subsectors, and we find that debt has increased in each of these subsectors over the past 10 years (bottom chart). So the increase in business sector debt has been generally widespread. But, not every subsector has had the same experience in terms of debt growth. The financial sector leads the pack with an absolute increase in debt outstanding in excess of $1 trillion over the past ten years (horizontal axis in bottom chart). </span></blockquote>
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<a href="https://3.bp.blogspot.com/-rP2fqKytkgg/W9m1dj3X6nI/AAAAAAAAU50/M8W5uPacetYEiY5TzpK-clZK8qQp8xdJQCLcBGAs/s1600/WF%2B-%2BDebt%2Bby%2Bsector.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="256" data-original-width="339" height="241" src="https://3.bp.blogspot.com/-rP2fqKytkgg/W9m1dj3X6nI/AAAAAAAAU50/M8W5uPacetYEiY5TzpK-clZK8qQp8xdJQCLcBGAs/s320/WF%2B-%2BDebt%2Bby%2Bsector.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Although the financial sector is the largest sector in terms of total debt outstanding ($1.8 trillion in Q3-2018, which is denoted by the size of the bubble), its 132% rise in outstanding debt places it below the average in terms of debt growth over the past 10 years (vertical axis). Other subsectors with slower-than-average debt growth since Q4-2008 include utilities, transportation, basic industries, consumer cyclicals and communications.<br /><span style="color: red;">There are three subsectors that stand out in terms of debt growth over the past 10 years. The debt in the non-cyclical consumer goods industry, which includes food & beverage, healthcare and pharmaceuticals, has experienced a 275% increase in debt outstanding to $1.2 trillion at present. Energy (400% increase to nearly $700 billion) and technology (almost 600% to roughly $650 billion) are also notable for the debt growth they have experienced.</span> In sum, most business sectors have experienced rising levels of debt over the past 10 years, but the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector." - source Wells Fargo</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">So there you have it, given Tech is under pressure, the energy sector is depending on the trajectory of oil prices to stay afloat (see our above point relating to interest expenses coverage) and consumer goods are depending on a more and more fragile US consumer, you can probably think that there is indeed an Explosive cyclogenesis in the making...Happy Halloween!</span></div>
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<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore." - Vincent Van Gogh</span></blockquote>
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<span style="font-family: inherit;">Stay tuned !</span></div>
</div>
Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-40111313896889017162018-10-24T15:12:00.004+01:002018-10-24T15:12:44.770+01:00Macro and Credit - Ballyhoo<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
"Chaos is inherent in all compounded things. Strive on with diligence." - Buddha</blockquote>
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<div style="text-align: justify;">
Watching with interest recent market gyrations, with the intervention of China in the mix to calm down the turmoil in its equities market, when it came to selecting this week's title analogy, we decided to go for the word "Ballyhoo":</div>
<div style="text-align: justify;">
</div>
<ol>
<li>: a noisy attention-getting demonstration or talk</li>
<li>: flamboyant, exaggerated, or sensational promotion or publicity</li>
<li>: excited commotion</li>
</ol>
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<div style="text-align: justify;">
A "Ballyhoo" is as well a "publicity, hype" from circus slang, "a short sample of a sideshow" used to lure customers (1901), which is of unknown origin. The word seems to have been in use in various colloquial senses in the 1890s. In nautical lingo, ballahou or ballahoo (1867, perhaps 1836) was a sailor's contemptuous word for any vessel they disliked. There is as well a 2009 book entitled "Heroes and Ballyhoo" by Michael K. Bohn about sports stars during the period 1919-30s an "era of wonderful nonsense", when sport-crazed public demanded spectacles instead of just matches. Given this golden crazy age lasted 12 years long and many pundits are indicating that a recession in the United States could happen in the next two years, we are indeed wondering when this period of "irrational exuberance" to paraphrase former Fed supremo Alan Greenspan will end. On a side note, for sports fanatics out there, baseball legend Babe Ruth personified the Golden Age of the roaring "Ballyhoo" twenties, a close second was the boxer Jack Dempsey. </div>
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<div>
<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at housing as yet another sign that we think we have reached "peak" US economic activity.</span></span></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
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<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b>Macro and Credit - The real state of Real Estate in the US and the consequences</b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b>Final chart - Beware of the velocity in tightening conditions</b></i></li>
</ul>
</div>
<br />
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Macro and Credit - The real state of Real Estate in the US and consequences</li>
</ul>
<div style="text-align: justify;">
<div>
Back in April 2012 we indicated the following relationship with the housing bubble: </div>
<blockquote class="tr_bq">
"The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fueling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012" - source Macronomics, April 2012</blockquote>
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<a href="https://3.bp.blogspot.com/-acUDTS8UjcY/W8-OaLGOArI/AAAAAAAAUzg/VFPn39m_unwcyR0mddYvgC1R7iXKvdWPACLcBGAs/s1600/Macrobond%2BBaltic%2BDry%2Bindex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="301" data-original-width="802" height="120" src="https://3.bp.blogspot.com/-acUDTS8UjcY/W8-OaLGOArI/AAAAAAAAUzg/VFPn39m_unwcyR0mddYvgC1R7iXKvdWPACLcBGAs/s320/Macrobond%2BBaltic%2BDry%2Bindex.jpg" width="320" /></a></div>
<div>
<blockquote class="tr_bq" style="text-align: center;">
- source Macrobond</blockquote>
<div>
The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea. Dry bulk cargo represents the largest part of the $380 billion shipping industry. Container shipping traffic is driven by consumer spending as it is dominated by consumer products. <span style="color: red;">Container volumes to the United States are dependent on the housing market</span>. Furniture and appliances are some of the top freight categories imported in both the United States but, in Europe as well from Asia. </div>
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<div style="text-align: justify;">
Any changes in consumer spending trends are depending on the health of the housing market:</div>
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<a href="https://2.bp.blogspot.com/-SAzHQUMnIac/W8-PWpZpNBI/AAAAAAAAUzs/tC3N9CllWc0Urjmg5xXxnlo5t5e-xR19QCLcBGAs/s1600/Macrobond%2B-%2BHousing%2BStarts%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="811" height="155" src="https://2.bp.blogspot.com/-SAzHQUMnIac/W8-PWpZpNBI/AAAAAAAAUzs/tC3N9CllWc0Urjmg5xXxnlo5t5e-xR19QCLcBGAs/s320/Macrobond%2B-%2BHousing%2BStarts%2BOctober%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Macrobond</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
With the Fed on its hiking mission, house affordability is being impacted through rising mortgage rates. Housing is getting more expensive in conjunction with labor shortages and rising costs linked to some extent to tariffs such as those on imported steel.</div>
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<div style="text-align: justify;">
Basically it seems that the housing market in the United States seems to be stalling as affordability is becoming an issue:</div>
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<a href="https://4.bp.blogspot.com/-hcvE1CoJpcU/W8-PyWEGFKI/AAAAAAAAUz0/ZZTNvAaf29UqGCZ-Cy7ZtPlmP9o2OJjdgCLcBGAs/s1600/Macrobond%2B-%2BUS%2BHousing%2BAffordability%2B-%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://4.bp.blogspot.com/-hcvE1CoJpcU/W8-PyWEGFKI/AAAAAAAAUz0/ZZTNvAaf29UqGCZ-Cy7ZtPlmP9o2OJjdgCLcBGAs/s320/Macrobond%2B-%2BUS%2BHousing%2BAffordability%2B-%2BOctober%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Macrobond</div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
Making a quick detour to shipping, there are as well signs that global trade is indeed cooling off. </div>
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<br /></div>
<div style="text-align: justify;">
Another indicator other than the BDY is the Harpex Shipping Index. It is considered a good indicator of global economic fleet shipping activity since it tracks changes in freight rates for container ships over broad categories. It is slightly different than the BDY. Harpex weights average daily charter rates across eight size classes of vessels to formulate its index. A vessel containing dry bulk generally transports a single load type. Containers ship, by comparison, usually transport a wider variety of finished goods, which makers therefore <span style="color: red;">the Harpex Shipping index a more accurate indicator for measuring global trade</span>:</div>
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<a href="https://2.bp.blogspot.com/-ChUI94QdV4U/W8-QvjftKxI/AAAAAAAAU0A/2qqH2YHsiEMiiHQvEvlDy50D_g-WXJicQCLcBGAs/s1600/Macrobond%2B-%2BHarper%2BPetersen%2BHarpex%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="811" height="155" src="https://2.bp.blogspot.com/-ChUI94QdV4U/W8-QvjftKxI/AAAAAAAAU0A/2qqH2YHsiEMiiHQvEvlDy50D_g-WXJicQCLcBGAs/s320/Macrobond%2B-%2BHarper%2BPetersen%2BHarpex%2BOctober%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Macrobond</div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
We can clearly see a deceleration in global trade happening at the moment thanks to this index.</div>
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<br /></div>
<div style="text-align: justify;">
But, let's return to US Housing. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The housing market has clearly been the weak spot in the “strong economy” narrative. The Fed’s hiking path is leading to rising 30 year fixed mortgage rate towards 4.90%, the highest level touched since April 2011:</div>
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<a href="https://1.bp.blogspot.com/-pV0ft5dHhoE/W8-TJfVwwSI/AAAAAAAAU0M/RON6o-eg_Lky7DNN6qdNzVJkvWgD-_xXwCLcBGAs/s1600/Macrobond%2B-%2B30%2Byrs%2BMortgage%2BLending%2BRate.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="811" height="155" src="https://1.bp.blogspot.com/-pV0ft5dHhoE/W8-TJfVwwSI/AAAAAAAAU0M/RON6o-eg_Lky7DNN6qdNzVJkvWgD-_xXwCLcBGAs/s320/Macrobond%2B-%2B30%2Byrs%2BMortgage%2BLending%2BRate.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Macrobond</div>
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<div style="text-align: justify;">
Single-family homebuilding is the largest share of the US housing market and fell by 0.9%. Housing affordability is becoming a challenge. </div>
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At the same time, US housing prices are now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012:</div>
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<a href="https://4.bp.blogspot.com/-rO8BtvRjLOo/W8-UmFX9ToI/AAAAAAAAU0Y/6wrp1T7rMsYCb7PBNPzvjcdD3jAlFBhIgCLcBGAs/s1600/Macrobond%2B-%2BResidential%2BReal%2BEstate%2BPrices.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://4.bp.blogspot.com/-rO8BtvRjLOo/W8-UmFX9ToI/AAAAAAAAU0Y/6wrp1T7rMsYCb7PBNPzvjcdD3jAlFBhIgCLcBGAs/s320/Macrobond%2B-%2BResidential%2BReal%2BEstate%2BPrices.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Macrobond</div>
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<div style="text-align: justify;">
On the subject of housing being a cause for concern, we read with interest Bank of America Merrill Lynch's US Economic Weekly note from the 19th of October entitled "Will housing hurt?":</div>
<blockquote class="tr_bq" style="text-align: justify;">
"Will housing hurt?<br />
<ul>
<li>We have made a number of changes to our housing forecasts to reveal a weaker trajectory of sales, starts and home prices amid rising rates.</li>
<li>We think home price appreciation is set to slow but not fall negative absent a recession in the overall economy.</li>
<li>Housing is no longer a tailwind for the economy, but the headwinds are blowing very gently.</li>
</ul>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Home prices: from boom to bust</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Home prices nationally, as measured by the S&P CoreLogic Case-Shiller index are running at 6.0% yoy as of the latest data in July. Assuming some modest slowing into the end of the year, we believe we are on track for home prices to end up 5.0% this year, as measured by 4Q/4Q change. As we look ahead into next year, we expect the slowing in home prices to persist, leaving home price appreciation (HPA) of 3% at the end of 2019 (Chart 1). </blockquote>
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<a href="https://4.bp.blogspot.com/-A2wkD1J72Vw/W8-efSnmDcI/AAAAAAAAU0k/qYrjr4KLb-8joHMLMdHdQHLQpeJ3OwUHwCLcBGAs/s1600/BAML%2B-%2BHome%2Bprice%2Bappreciation%2Bto%2Bslow.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="301" data-original-width="378" height="254" src="https://4.bp.blogspot.com/-A2wkD1J72Vw/W8-efSnmDcI/AAAAAAAAU0k/qYrjr4KLb-8joHMLMdHdQHLQpeJ3OwUHwCLcBGAs/s320/BAML%2B-%2BHome%2Bprice%2Bappreciation%2Bto%2Bslow.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Thereafter we expect home price appreciation to hold at that 3.0% pace in 2020.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Back to econ 101, home prices should be a function of housing supply and demand. As we argued in Home sales: the peak has been reached, we think existing home sales peaked at the very end of last year and have since been moving sideways in a choppy fashion. <span style="color: red;">This is a function of affordability which has been challenged from rising mortgage rates and elevated home prices</span>. Inventory levels have remained extremely low, but since we look for some continued growth in single family housing starts but little change in home sales, we could start to see the supply of homes increase. The modest shift in the demand curve and out of the supply curve naturally implies slower home price appreciation. As Chart 2 shows home price appreciation typically peaks along with the peak in home sales.</blockquote>
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<a href="https://2.bp.blogspot.com/-92UpYHskDWw/W8-e05hVO7I/AAAAAAAAU0s/D-ItLPCyoXYqigJP9c-TbWMCjRbHkalwQCLcBGAs/s1600/BAML%2B-%2BThe%2Bpeak%2Bin%2Bsales%2Bcorresponds%2Bto%2Bthe%2Bpeak%2Bin%2Bhome%2Bprices.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="301" data-original-width="386" height="249" src="https://2.bp.blogspot.com/-92UpYHskDWw/W8-e05hVO7I/AAAAAAAAU0s/D-ItLPCyoXYqigJP9c-TbWMCjRbHkalwQCLcBGAs/s320/BAML%2B-%2BThe%2Bpeak%2Bin%2Bsales%2Bcorresponds%2Bto%2Bthe%2Bpeak%2Bin%2Bhome%2Bprices.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
With mortgage rates heading higher, the challenges with affordability will continue. As a simple rule of thumb based on the NAR’s affordability index, we find that a 50bp increase in mortgage rates would need about a 5.5% offsetting drop in home prices in order to keep affordability unchanged. Of course, this does not account for the rise in income which provides an additional modest offset. Plugging in forecasts for mortgage rates based on our rates strategy call for the 10 year to end this year at 3.25% and 3Q 2019 at 3.35% – which implies close to 5.15% and 5.25%, respectively, for the 30-year fixed-rate mortgage – we would see affordability continue to slip lower (Chart 3). </blockquote>
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<a href="https://2.bp.blogspot.com/-aY-T25lTcIY/W8-fIvuACjI/AAAAAAAAU00/F0XKshNH85w2FzuD5z4JZ_Gc4JRiOk2ogCLcBGAs/s1600/BAML%2B-%2BRates%2Bwill%2Bcontinue%2Bto%2Bdepress%2Bhousing%2Baffordability.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="313" data-original-width="391" height="256" src="https://2.bp.blogspot.com/-aY-T25lTcIY/W8-fIvuACjI/AAAAAAAAU00/F0XKshNH85w2FzuD5z4JZ_Gc4JRiOk2ogCLcBGAs/s320/BAML%2B-%2BRates%2Bwill%2Bcontinue%2Bto%2Bdepress%2Bhousing%2Baffordability.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
While affordability would still be above the historical average, it would still be more challenging than the past several years.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Another important aspect when thinking about the trajectory of home prices is an idea called “mean reversion”. Home prices are ultimately anchored to a fair value which is a function of income growth. Based on the OECD’s methodology, we compare nominal Case-Shiller home prices with disposable income per capita, indexed to 100 in 1Q 2000 (Chart 4) which shows the overvaluation during the housing bubble given the irrational exuberance in the market and easy credit conditions. </blockquote>
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<a href="https://4.bp.blogspot.com/-C-PHzD75Jeo/W8-hbSXTecI/AAAAAAAAU1Q/6oqOQvCT9ik-aq9brfumgoBGxwHrswIVgCLcBGAs/s1600/BAML%2B-%2BHome%2Bprice%2Bare%2Bovervalued.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="301" data-original-width="382" height="252" src="https://4.bp.blogspot.com/-C-PHzD75Jeo/W8-hbSXTecI/AAAAAAAAU1Q/6oqOQvCT9ik-aq9brfumgoBGxwHrswIVgCLcBGAs/s320/BAML%2B-%2BHome%2Bprice%2Bare%2Bovervalued.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
The housing bust left prices to tumble back below fair value. <span style="color: red;">Based on our calculation, prices are once again overvalued on a national level, albeit not nearly as much as during the bubble period</span>. Over time the overvaluation can be solved in two ways: 1) home prices grow at a rate below income for a period of time to close the gap; 2) home prices decline to correct the valuation difference. The pull to fair value can be quite strong.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Regional realities</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
We have been discussing the national outlook for the housing market but the dynamics will vary on a regional basis. Focusing on the top 20 metropolitan statistical areas (MSAs), we find that all 20 are still witnessing positive YOY home price appreciation, ranging from a low of 2.8% in Washington DC to a high of 13.7% in Las Vegas.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Generally speaking the West Coast has seen stronger home price appreciation relative to other regions. This reflects the fact that the West has enjoyed robust economic growth, supported by the thriving tech sector, which has led to greater income and wealth creation. This subsequently feeds into housing demand and a bid on prices (Chart 5). </blockquote>
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<a href="https://4.bp.blogspot.com/-jkEGBjXOdJM/W8-f6Rsc9yI/AAAAAAAAU08/XKOxMIF-yY8wuUj6davRVRq-b0DpllMbQCLcBGAs/s1600/BAML%2B-%2BStronger%2Bper%2Bcapita%2Bincome%2Bgrowth%2Bleads%2Bto%2Bfaster%2BHPA.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="306" data-original-width="382" height="256" src="https://4.bp.blogspot.com/-jkEGBjXOdJM/W8-f6Rsc9yI/AAAAAAAAU08/XKOxMIF-yY8wuUj6davRVRq-b0DpllMbQCLcBGAs/s320/BAML%2B-%2BStronger%2Bper%2Bcapita%2Bincome%2Bgrowth%2Bleads%2Bto%2Bfaster%2BHPA.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
At the same time, the West has also suffered from greater building constraints and a more severe housing shortage, owing to restrictive land-use regulations and zoning laws. This has contributed to home prices well outpacing income growth. Unsurprisingly, a regional analysis of price/income ratios finds the greatest levels of overvaluation in Western MSAs (Chart 6). </blockquote>
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<a href="https://4.bp.blogspot.com/-tI5O5gi5HSc/W8-gjzSs_-I/AAAAAAAAU1E/_xjaMOJzFTIiDDOkOh4wJCyF8fKMbDfaQCLcBGAs/s1600/BAML%2B-%2BPrice%2Bto%2Bper%2Bcapita%2Bincome%2Bby%2BMSA-region.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="337" data-original-width="387" height="278" src="https://4.bp.blogspot.com/-tI5O5gi5HSc/W8-gjzSs_-I/AAAAAAAAU1E/_xjaMOJzFTIiDDOkOh4wJCyF8fKMbDfaQCLcBGAs/s320/BAML%2B-%2BPrice%2Bto%2Bper%2Bcapita%2Bincome%2Bby%2BMSA-region.jpg" width="320" /></a></div>
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<blockquote class="tr_bq" style="text-align: justify;">
Conversely, the Midwest cities were generally undervalued.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The higher prices rise in overvalued regions, the harder they may fall. So outright price declines could be seen as demand pulls back, though as discussed earlier we think this is less likely for aggregate national prices. Meanwhile, more affordable areas should continue to see price gains assuming healthy regional economic growth.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Sales and starts are a bit weaker</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
While existing home sales have peaked and will continue to hold around 5.5 million through next year, we see further upside for new home sales, albeit only modest. We forecast new home sales to edge up to 665K next year from our forecast of 640K this year, which is up from 612K last year. Why would new home sales increase while existing home sales move sideways? The recovery in new home sales was much slower since builders were hesitant to add supply to a challenged market, particularly in the early stages of the recovery.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
We have revised down our forecast for starts this year and next. We expect 1.260 million starts this year and 1.30 million next year. The gain will be entirely in single family construction as multifamily has little upside. </blockquote>
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<a href="https://1.bp.blogspot.com/-_SIlZFvuvAw/W9BLIOjCokI/AAAAAAAAU1w/rsikUrOuIwM2n90OPwMVBfLn9K3f8a8TgCLcBGAs/s1600/BAML%2B-%2BSummary%2Bof%2Bhousing%2Bforecasts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="161" data-original-width="529" height="97" src="https://1.bp.blogspot.com/-_SIlZFvuvAw/W9BLIOjCokI/AAAAAAAAU1w/rsikUrOuIwM2n90OPwMVBfLn9K3f8a8TgCLcBGAs/s320/BAML%2B-%2BSummary%2Bof%2Bhousing%2Bforecasts.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Bank of America Merrill Lynch </div>
<blockquote class="tr_bq" style="text-align: justify;">
While we expect single family starts to edge higher – consistent with continued elevated levels of NAHB homebuilder sentiment and low levels of inventory – we think builders will be cautious in the face of rising mortgage rates." - source Bank of America Merrill Lynch</blockquote>
<div style="text-align: justify;">
Unfortunately we do not share Bank of America Merrill Lynch's optimistic view. That would not make us "perma-bears" but we do not fall easily prey to "Ballyhoo" games namely sensational promotion.</div>
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<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="color: red; line-height: 115%;">No offense to Bank of America Merrill Lynch but, Main Street has had a much better
record when it comes to calling a housing market top in the US than Wall Street</span><span lang="EN-US" style="line-height: 115%;">. </span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;"><br /></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;">If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:</span></div>
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<a href="https://1.bp.blogspot.com/-HaDCKRWrMec/W8-j7GncdyI/AAAAAAAAU1c/0BApbi7D52QZj_CyzgMqjaXA1QadgRfCQCLcBGAs/s1600/Macrobond%2B-%2BUS%2BMichigan%2B-%2BHousing%2B-%2BBuying%2Band%2BSelling.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://1.bp.blogspot.com/-HaDCKRWrMec/W8-j7GncdyI/AAAAAAAAU1c/0BApbi7D52QZj_CyzgMqjaXA1QadgRfCQCLcBGAs/s320/Macrobond%2B-%2BUS%2BMichigan%2B-%2BHousing%2B-%2BBuying%2Band%2BSelling.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: center;">
<span lang="EN-US" style="line-height: 115%;">- graph source Macrobond</span></blockquote>
<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;"><br /></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">Maybe after all, they are spot on
and now is a good time to sell houses in the US? Just a thought. Main Street
was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. </span><a href="https://www.bloomberg.com/news/articles/2018-10-18/u-s-recession-chances-in-next-two-years-top-60-jpmorgan-says"><span lang="EN-US" style="line-height: 115%;">Many pundits are predicting a recession in the US economy
in the next two years</span></a></span><span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;">.</span><span style="font-family: "times new roman" , serif; font-size: 13.5pt;"><o:p></o:p></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;"><br /></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;">As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up and when during the summer the house of sticks of the macro tourist carry pigs blew up (Turkey, Argentina, etc.). We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount to track going forward as the credit noose tightens.</span></div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;"><br /></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;"></span></span></div>
<div class="MsoNormal" style="text-align: justify;">
Furthermore, it’s isn’t only residential housing which is a concern, in recent years Commercial Real Estate prices have gone through the proverbial “roof”:</div>
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<a href="https://4.bp.blogspot.com/-OKNkVIHBIeE/W8-kx-hPNUI/AAAAAAAAU1k/WBjQ2u9hqdc9TEWM1-DgwYrmPosHb33HgCLcBGAs/s1600/MAcrobond%2B-%2BCRE%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="386" data-original-width="778" height="158" src="https://4.bp.blogspot.com/-OKNkVIHBIeE/W8-kx-hPNUI/AAAAAAAAU1k/WBjQ2u9hqdc9TEWM1-DgwYrmPosHb33HgCLcBGAs/s320/MAcrobond%2B-%2BCRE%2BOctober%2B2018.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: center;">
- graph source Macrobond </blockquote>
<div>
We think that "housing is no longer a tailwind for the economy" and that "headwinds are blowing very gently" is in this case a "Ballyhoo".<br />
<br />
If one looks at US Homebuilders index versus the S&P500 that cyclicals matter when it comes to assessing the rising probabilities of a US recession:<br />
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<a href="https://2.bp.blogspot.com/-LrVj6fjPlHs/W9BPRCsh7eI/AAAAAAAAU18/UIL8GIlWxK8omQcTbCrHmo150bxhy1HaQCLcBGAs/s1600/Macrobond%2B%2B-%2BSPX%2Band%2BHomebuilders%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="386" data-original-width="793" height="155" src="https://2.bp.blogspot.com/-LrVj6fjPlHs/W9BPRCsh7eI/AAAAAAAAU18/UIL8GIlWxK8omQcTbCrHmo150bxhy1HaQCLcBGAs/s320/Macrobond%2B%2B-%2BSPX%2Band%2BHomebuilders%2BOctober%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Macrobond</div>
<br />
<div style="text-align: justify;">
This is telling you that housing activity is leading overall economic activity, housing being a sensitive cyclical sector. We have reached "peak" everything when it comes to US economic activity. It might be very well all downhill from there. We are already seeing signs in Europe with the latest PMIs of global trade deceleration, and not only from shipping mentioned above.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Also, if one looks at the S&P500 versus US Regional banks, one could conclude that "misery loves company":</div>
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<a href="https://3.bp.blogspot.com/-YJ9L9JDtNio/W9BQEPyAULI/AAAAAAAAU2E/liHitFlmVfMjiOig1IxljxOyUjOeujNXgCLcBGAs/s1600/Macrobond%2B%2B-%2BSPX%2Bvs%2BRegional%2BBanks%2B-%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="386" data-original-width="793" height="155" src="https://3.bp.blogspot.com/-YJ9L9JDtNio/W9BQEPyAULI/AAAAAAAAU2E/liHitFlmVfMjiOig1IxljxOyUjOeujNXgCLcBGAs/s320/Macrobond%2B%2B-%2BSPX%2Bvs%2BRegional%2BBanks%2B-%2BOctober%2B2018.jpg" width="320" /></a></div>
<div style="text-align: center;">
- graph source Macrobond</div>
<div>
<br /></div>
<div style="text-align: justify;">
The Regional Banks index has fallen 16.58% from its high back in early June and has fallen 7.05% since the start of October. Bank OZK’s stock dropped nearly 24% on the 19th of October after Commercial Real Estate (CRE) write-offs. The Arkansas-based bank is one of the largest condo construction lenders in Miami, NYC and LA. You would be wise thinking about selling your condo in Miami according to Main Street's predictive history.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As indicated by Bank of America Merrill Lynch in their weekly Securitized Products Strategy weekly note from the 22nd of October, bank stocks and MBS basis have a strong relationship since 2015:</div>
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<a href="https://2.bp.blogspot.com/-CQyaMdSMv_I/W9BcTv7kRSI/AAAAAAAAU2Q/lWoubYOqV5s3Akyjzx74FY_NhnUNQ0mFACLcBGAs/s1600/BAML%2B-%2BBank%2Bstocks%2Band%2BMBS%2Brelationship.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="297" data-original-width="533" height="178" src="https://2.bp.blogspot.com/-CQyaMdSMv_I/W9BcTv7kRSI/AAAAAAAAU2Q/lWoubYOqV5s3Akyjzx74FY_NhnUNQ0mFACLcBGAs/s320/BAML%2B-%2BBank%2Bstocks%2Band%2BMBS%2Brelationship.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>How Q3 bank earnings inform us</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Domestic bank demand is key to agency MBS valuations; one simple relationship we have ascribed to is the strong relationship between bank equity valuations and the current coupon mortgage basis. Even recently, lower bank stock valuations have coincided with the basis widening. The underlying logic tying these two together is the outlook for bank balance sheets, reflected in stock prices, suggesting a technical backdrop for bank demand for agency MBS.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
Many individual moving parts, however, come into play on the various pieces of bank balance sheets. For example, theory suggests deposits are impacted by the Fed’s balance sheet runoff. Appetite for securities relies on tolerance for capital volatility related to AOCI (all other comprehensive income), which changes with rate views and duration appetite. Finally, loans funded vary based on credit risk appetite and industry competitiveness, such as non-bank participation and accessibility to the high grade, high yield markets. These moving parts change, dampening or expanding bank demand for securities. We leverage the 3Q18 earnings call transcripts of the largest banks to extract takeaways on driving factors influencing these trends.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Lower tolerance for incurring AOCI risks</b> – Tax reform, lower tax rates specifically, has reduced bank tolerance for incurring AOCI risks. AOCI losses have led to a larger tax deductible historically than what the current lower tax regime offers. The outlook for higher rates this year, and the potential for even higher rates ahead, has dampened enthusiasm for banks to take duration risk.</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Cash is king, a compelling alternative, only getting better</b>– Cash yielding 2+% compared to a post-crisis era of offering nothing raises the bar for investing in securities and taking on duration risk. Projecting returns on cash, along the forward path, only further stands to enhance the appeal of this strategy. Indeed, this is how the Fed’s tightening of policy works its way through banking channels, essentially raising the risk-free rate!</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b>Yes, higher base case NIMs, but a few IF’s echoed</b> – The selloff in rates highlights better NIM opportunities presented today, as deposit rates undershoot model forecasts. However, it is far from being just this simple. Convexity concerns and volatility ahead pose risks, along various forward paths. The outlook for loan growth, hinging on whether the economy keeps expanding, dictates securities demand, be it for HQLA/LCR reasons or for NIM/earnings.</blockquote>
<div style="text-align: justify;">
The big question is can the US economy continue to expand as such a pace when housing is already struggling and even if FICO scores get lowered to facilitate credit card use by a pressurized US consumer?</div>
<br />
There are indeed some implications down the line as highlighted by Bryce Coward from Knowledge Leaders Capital in his blog post from the 19th of October entitled "<a href="https://blog.knowledgeleaderscapital.com/?p=15818">More evidence of a slowing housing market, and its implications</a>":<br />
<blockquote class="tr_bq" style="text-align: justify;">
"The slowdown housing activity leads overall economic activity by eighteen months. Housing, being one the most cyclically sensitive sectors of the economy, often feels the impact of higher rates well before other areas. This alone implies a peaking of economic activity right about now, leading to persistently slower growth rates through Q1 2020. </blockquote>
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<a href="https://3.bp.blogspot.com/-U_7hxo-Jbv8/W9BvA6-3gxI/AAAAAAAAU2c/4xADCtt7wTwl5zLMZ5pq3xN4odYUOY1VgCLcBGAs/s1600/Knowledge%2BLeaders%2BCapital%2B-%2BExisting%2Bhome%2Bsales%2Bcompared%2Bto%2Bnominal%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="788" data-original-width="1089" height="231" src="https://3.bp.blogspot.com/-U_7hxo-Jbv8/W9BvA6-3gxI/AAAAAAAAU2c/4xADCtt7wTwl5zLMZ5pq3xN4odYUOY1VgCLcBGAs/s320/Knowledge%2BLeaders%2BCapital%2B-%2BExisting%2Bhome%2Bsales%2Bcompared%2Bto%2Bnominal%2BGDP.jpg" width="320" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<br />Not coincidentally, a peaking of economic activity about now is also consistent with the 1.2% fiscal stimulus boost we’re getting in 2018. Incremental stimulus for 2019 drops to .4%, with the potential of that entire stimulus being negated by dead weight losses from tariffs, but that is a topic for another day." - source Knowledge Leaders Capital</blockquote>
<div style="text-align: justify;">
This ties up nicely we think with Main Street sanguine view of the housing market, namely that it's less and less the time to buy a house and more and more the case of selling a house as per the previous credit cycle call Main Street made. The credit cycle is no doubt turning regardless of the "Ballyhoo" put forward by some pundits.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Sure overall, the latest quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points towards gradual tightening of financial conditions overall, yet the recent move based on the sensitivities of major market variables points towards an accelerating trend as per our final chart.</div>
<br />
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;">Final chart - Beware of the velocity in tightening conditions</li>
</ul>
<div style="text-align: justify;">
Our final chart comes from Morgan Stanley US Economics note from the 11th of October and indicates how using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"<b>An updated view on financial conditions indices shows a mixed picture, with the<br />Chicago Fed’s FCI actually easing further in the week ending October 5, while other alternative financial conditions metrics show a more considerable tightening in recent days.</b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
The Chicago Fed updated its weekly FCI this morning. The latest update covers through last Friday, October 5, so it’s quite lagged. Somewhat surprisingly, the index eased 0.026 points – the largest one-week easing since the week ending August 10 and the 13th consecutive week of easing for the index. </blockquote>
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The index now stands at a level of -0.76, a low since July 2015, driven by lower readings on the risk, credit, and leverage subcomponents. 49 underlying indicators tightened in the last week and 56 loosened – some of the biggest contributions to easier conditions were the Markit IG 5-yr senior CDS index, HY 5-year senior CDS index, and the 3-month TED spread.</blockquote>
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An alternative metric that we look at for a more real-time look at financial conditions has shown a greater tightening in financial conditions so far this week. This metric tracks financial conditions based on the sensitivities of major market variables in the Fed’s FRB/US macro model, and we express it in a fed funds rate equivalent. </blockquote>
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By this approach, financial conditions have tightened about 10bp from last Friday and about 50bp from the end of September. That compares with the experience from early February this year when financial conditions tightened about 80bp over a two week period." - source Morgan Stanley</blockquote>
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Is this velocity seen in greater tightening of financial conditions a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions, or is it simply a case of "Ballyhoo" at play? We wonder...<br />
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"Civilization begins with order, grows with liberty and dies with chaos." - Will Durant, American historian</blockquote>
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Stay tuned!</div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-39730116911312502732018-10-14T22:15:00.003+01:002018-10-18T12:55:05.947+01:00Macro and Credit - Under the Volcano<div dir="ltr" style="text-align: left;" trbidi="on">
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<span style="font-family: inherit;">"A democracy is a volcano which conceals the fiery materials of its own destruction. These will produce an eruption and carry desolation in their way." - Fisher Ames, American statesman</span></blockquote>
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<span style="font-family: inherit;">Looking at the large wobbles experienced in financial markets this week, leaving many pundits wondering if we had attained "<a href="http://macronomy.blogspot.com/2018/10/macro-and-credit-armstrong-limit.html">The Amstrong limit</a>" and trying to figure out if it was the start of something much larger at play, when it came to selecting this week's title analogy, we decided to steer back towards literature this time around. "Under the Volcano" is a famous1947 novel by English writer Malcom Lowry. The novel tells the story of Geoffrey Firmin, an alcoholic British consul in the small Mexican town of Quauhnahuac, on the Day of the Dead, 2 November 1938. When it comes to QE and alcoholism, we reminded ourselves our September conversation "<a href="http://macronomy.blogspot.com/2018/09/macro-and-credit-korsakoff-syndrome.html">The Korsakoff syndrome</a>" being an amnestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). But what is of interest to us in our chosen analogy, is that this great novel of the 20th century has 12 chapters and the following 11 chapters beside the first introductory chapter happen in a single day. In similar fashion one could posit that the credit clock has 12 hours. In his novel Lowry alludes to Goethe's Faust as well as references to Charles Baudelaire's les Fleurs du Mal. We also used similar reference to Baudelaire's Les Fleurs du Mal back in December 2011 in our conversation "<a href="http://macronomy.blogspot.com/2011/12/markets-update-credit-generous-gambler.html">The Generous Gambler</a>" and in 2014 in our conversation "<a href="https://macronomy.blogspot.com/2014/09/credit-sympathy-for-devil.html">Sympathy for the Devil</a>":</span></div>
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<span style="font-family: inherit;">"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.</span></blockquote>
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<span style="font-family: inherit;">Throughout Malcom Lowry's novel the number 7 appears, in similar fashion, we are seeing many signs reminiscent in the current credit cycle of the year 2007 or even with 1987 (the DJIA topped in '87 at 2700) given today we have both dividends and buybacks paid out in excess of operating cash flow. Both are being funded with debt accumulation exactly as it was the case in the year 2007. Also, one may argue that somewhat, European bond investors made a "Faustian bargain" with Mario Draghi aka our "generous gambler" but we ramble again. </span></div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at once again where we stand in the credit cycle and ask ourselves how long until we see it definitely running.</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
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<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - What's under the "credit" volcano?</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"</span></b></i></li>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - What's under the "credit" volcano?</span></li>
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<span style="font-family: inherit;">As we pointed out in our most recent conversation, the latest quarterly Fed Senior Loan Officers Opinion Survey (SLOOs) continues to indicate overall support for credit markets yet the market feels more and more complacent à la 2007 we think:</span></div>
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<a href="https://4.bp.blogspot.com/-xUdfRUryDJc/W8DP7mple8I/AAAAAAAAUxE/KT708hoqgvgBXy_SI7LanrPeo1z-6SKHwCLcBGAs/s1600/Macrobond%2B-%2Blending%2Bstandards.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="326" data-original-width="605" height="172" src="https://4.bp.blogspot.com/-xUdfRUryDJc/W8DP7mple8I/AAAAAAAAUxE/KT708hoqgvgBXy_SI7LanrPeo1z-6SKHwCLcBGAs/s320/Macrobond%2B-%2Blending%2Bstandards.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond</span></div>
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<span style="font-family: inherit;">The most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line. The Fed quarterly SLOO survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. The SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Credit always leads equities in our book.</span></div>
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<span style="font-family: inherit;">Credit investors look at the CDS roll. The most recent roll into the new contracts was in September, the new “on-the-run” benchmark series. The current steepness of CDS curves is a headwind for anyone “bearish” on credit and wanting to express it through CDS products. Too costly right now:</span></div>
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<a href="https://1.bp.blogspot.com/-JCCTlXk5kZ4/W8Db-Dg-8wI/AAAAAAAAUxc/RaFxa-XaOxM2SPTseSooo105IkMzDeUYACLcBGAs/s1600/Ed%2BCasey%2B-%2BBloomberg%2B-%2BPositive%2Bsloping%2BCDS%2BCredit%2BCurves.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="304" data-original-width="688" height="141" src="https://1.bp.blogspot.com/-JCCTlXk5kZ4/W8Db-Dg-8wI/AAAAAAAAUxc/RaFxa-XaOxM2SPTseSooo105IkMzDeUYACLcBGAs/s320/Ed%2BCasey%2B-%2BBloomberg%2B-%2BPositive%2Bsloping%2BCDS%2BCredit%2BCurves.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- <span style="text-align: left;">Graph source Edward Casey - Bloomberg</span></span></div>
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<span style="font-family: inherit;">Yet, there is no doubt rising “dispersion” which in effect means that credit investors are becoming more discerning when it comes to their selection process of various issuers’ profile. This we think is another sign of a late credit cycle.</span></div>
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<span style="font-family: inherit;"><span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">To illustrate further the deterioration in the credit cycle overall picture, one could look at European High Yield and in particular Consumers and
Cyclicals as shown in the below chart by </span><a href="https://www.datagrapple.com/Blog/Show/12166/roaring-wider.html"><span lang="EN-US" style="line-height: 115%;">DataGrapple on the 9<sup>th</sup> of October</span></a></span><span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;">:</span><span style="font-size: 13.5pt;"><o:p></o:p></span></span></span></div>
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<a href="https://3.bp.blogspot.com/-k__B3lIh86s/W8Dcgzr-rJI/AAAAAAAAUxk/sfLeM_Co_t0AcXOp1z6cUZVbCDTgXas2wCLcBGAs/s1600/DataGrapple%2B-%2BEurope%2BHY%2BConsumer%2Bcyclical.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="330" data-original-width="619" height="170" src="https://3.bp.blogspot.com/-k__B3lIh86s/W8Dcgzr-rJI/AAAAAAAAUxk/sfLeM_Co_t0AcXOp1z6cUZVbCDTgXas2wCLcBGAs/s320/DataGrapple%2B-%2BEurope%2BHY%2BConsumer%2Bcyclical.jpg" width="320" /></span></a></div>
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<span lang="EN-US" style="font-family: inherit; line-height: 115%;">“It was a mixed session with BTPs, stocks and rates sending contradicting signals throughout the day. In credit, there was a constant theme though, as investors sold risk on higher beta auto and autopart related names. The sector has been heavy for a couple of days, a phenomenon that was pinned down to the upcoming EU environment ministers meeting to discuss emission caps, which is widely expected to result in a push for a more ambitious set of rules. It culminated this morning in a proper battering of TTMTIN (Jaguar Land Rover Automotive Plc) which saw its 5-year risk premium marked 45bps wider at the open. This aggressive move followed the September sales numbers reported by the company. The year-on-year decline amounts to 12.3%, as strong sales for new models were offset by weakness in China where demand dropped 46.2% on the back of import duty changes and continued trade tensions. This came exactly a month after Ralf Speth, the CEO, warned that a hard Brexit would cost the company £1.2Bln a year and would wipe out its profits. The company also confirmed the two-week temporary closure of its Solihull factory, which employs almost a quarter of the group’s workforce in the UK. Some profit taking on short risk positions eventually emerged at the end of the session and limited the widening of TTMTN’s 5-year risk premium to 28bps at 485bps, but the negative trend of the past nine months which is obvious on the above grapple shows no sign of abating and is in fact gathering momentum since the roll.” – source DataGrapple</span></blockquote>
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<span style="font-family: inherit;">With rising dispersion, and global trade deceleration and the effects of the trade war narrative, we are already seeing cyclicals underperforming. </span><br />
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In similar fashion to 2007, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage or CLOs with lack of covenants such as Cov-lite loans as per the below chart from Bank of America Merrill Lynch, indicative of aggressive issuance:</div>
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<a href="https://1.bp.blogspot.com/-7a60dIZbHa4/W8JZ0RqFzMI/AAAAAAAAUxw/zCcUq3J4rrc5xMAsvj0_Kz-zzMcfiwRaQCLcBGAs/s1600/BAML%2B-%2BCov%2BLite%2Bissuance%2Bas%2Bpercentage%2Bof%2Bmarket%2Bsize%2B-%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="358" data-original-width="445" height="257" src="https://1.bp.blogspot.com/-7a60dIZbHa4/W8JZ0RqFzMI/AAAAAAAAUxw/zCcUq3J4rrc5xMAsvj0_Kz-zzMcfiwRaQCLcBGAs/s320/BAML%2B-%2BCov%2BLite%2Bissuance%2Bas%2Bpercentage%2Bof%2Bmarket%2Bsize%2B-%2BOctober%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit;">What is of interest to us, regardless of the "liquidity" issues many pundits have been talking to about in relation to mutual funds and the strong growth in passive management through ETFs in recent years has been the rapid growth of the private debt market in this very long credit cycle.</span><br />
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<span style="font-family: inherit;">On this subject we read with interest Bank of America Merrill Lynch High Yield Strategy note from the 12th of October entitled "The Next Credit Cycle - Scenarios for HY, Loans, and Private Debt":</span><br />
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<span style="font-family: inherit;">"<b>Private debt, the fastest growing segment in US credit</b></span></blockquote>
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<span style="font-family: inherit;">By its very nature, the private debt market is more difficult to analyze as most deals never get included in any widely followed indexes or make it into otherwise publicly reported portfolios. Even estimating the size of this market is a challenge, and we had to go about it backwards, by starting with known overall corporate debt stack and removing otherwise known and attributable pieces. We think, the market is somewhere between $400-$700bn in size, and it was the fastest growing segment of US credit, including bonds, bank and non-bank loans, over the past five years.</span></blockquote>
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<span style="font-family: inherit;">This report outline our understanding of structure, major investor types, growth, sector composition, leverage and covenant trends, key risks and mitigating factors of the private debt space. We find this asset to feature many hallmarks of a classic new hot market, which often results in unsustainable growth trajectories leading to eventual corrections, required to stabilize the market at longer-term sustainable levels. This report is also part of our broader take on US lending landscape that we published in collaboration with our banks and asset managers equity research and economics teams.</span></blockquote>
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<b><span style="font-family: inherit;">Loan covenants are the defining feature of this cycle</span></b></blockquote>
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<span style="font-family: inherit;">The syndicated leveraged loans continued to attract investor interest since the GFC, as their investment thesis (significant yield pickup coupled with no interest-rate sensitivity) remains appealing to many. As a result, <span style="color: red;">the leveraged loan market has grown by 19% in the last two years, 44% in the last five, and doubled in the last ten</span>. Strong demand forces asset managers have to compete for new deal allocations on both pricing and structures. Coupons are getting squeezed, leverage pushed up, and covenants dropped. And while tight pricing and elevated leverage are expected side-effects at this stage of the cycle, the degree of covenant deterioration has reached new levels in recent years, well beyond the outdated “cov-lite” label.</span></blockquote>
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<b><span style="font-family: inherit;">The next credit cycle: modeling potential credit losses</span></b></blockquote>
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<span style="font-family: inherit;">We bring all our knowledge of the three segments of leveraged finance – HY, loans, and private debt – in one place by running side-by-side credit loss models for three distinct scenarios: consensus middle-of-the-road, mild recession and a full-scale recession. Our interest primarily focuses on the last one as it helps us better understand the downside scenario and help us make more informed risk management decisions.</span></blockquote>
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<b><span style="font-family: inherit;">Key takeaways</span></b></blockquote>
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<span style="font-family: inherit;"><span style="color: red;">We estimate the next credit cycle, when it happens, could bring credit losses to the extent of 2x of expected annual yield income in high yield and leveraged loans, and 1.3x in private debt. Investors could also experience temporary mark-to-market losses of up to 5x of their annual income.</span> To put this downside risk into perspective, it would take a 325bps increase in yield to wipe out 2 years of yield income in HY, given the 4yr duration of this asset class. In other words, a 150bps increase in Treasury yields coupled with a 150bps widening in spreads is less damaging than a cyclical turn. While we do not believe the next credit cycle turn is imminent, this evidence improves our confidence in the existing positioning recommendation to begin underweighting lowest quality segments of the market in favor of higher quality segments." - source Bank of America Merrill Lynch</span></blockquote>
<span style="font-family: inherit;">As per the above executive summary from their very interesting report, we do agree that the next credit cycle downturn is not imminent, yet we see rising M&A activity and rising dispersion as additional indicators of how late the credit cycle is. The summer drift for Emerging Markets has created some additional dispersion this time between EM High Yield and US High Yield as per the below chart from Bank of America Merrill Lynch:</span><br />
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<a href="https://3.bp.blogspot.com/-OXq2e5kvQPM/W8N90yInVfI/AAAAAAAAUx8/7Xxdn87Qnt02xcPNpEQZBCSqlzZuxhfNACLcBGAs/s1600/BAML%2B-%2BUS%2BHY%2Bvs%2BEM%2BHY%2B-%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="289" data-original-width="465" height="198" src="https://3.bp.blogspot.com/-OXq2e5kvQPM/W8N90yInVfI/AAAAAAAAUx8/7Xxdn87Qnt02xcPNpEQZBCSqlzZuxhfNACLcBGAs/s320/BAML%2B-%2BUS%2BHY%2Bvs%2BEM%2BHY%2B-%2BOctober%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit;">Both rising oil prices and strong earnings have been very supportive of US High Yield so far.</span><br />
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<span style="font-family: inherit;">But, returning to the subject of loose covenants aka Cov-lite loans we read with interest Bank of America Merrill Lynch's take:</span><br />
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<span style="font-family: inherit;">"<b>Loan covenants are an epitome of this cycle</b></span></blockquote>
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<span style="font-family: inherit;">The syndicated leveraged loans continued to attract investor interest in the last few years, as their investment thesis (significant yield pickup coupled with no interest-rate sensitivity) remains appealing to many. As a result, the leveraged loan market has grown by 19% in the last two years, 44% in the last five, and doubled in the last ten. Both syndicated loan and CLO issuance is hitting new records (Figure 8).</span></blockquote>
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<a href="https://1.bp.blogspot.com/-NZaAbpTxMN4/W8N-yzK6XjI/AAAAAAAAUyI/8b_XgMEb3oMNR3DYIxPyvuFcBLUXPl1mgCLcBGAs/s1600/BAML%2B-%2BSyndicated%2Bloans%2Bas%2Ba%2Bpct%2Bof%2Bleveraged%2Bfinance%2Bdebt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="292" data-original-width="379" height="246" src="https://1.bp.blogspot.com/-NZaAbpTxMN4/W8N-yzK6XjI/AAAAAAAAUyI/8b_XgMEb3oMNR3DYIxPyvuFcBLUXPl1mgCLcBGAs/s320/BAML%2B-%2BSyndicated%2Bloans%2Bas%2Ba%2Bpct%2Bof%2Bleveraged%2Bfinance%2Bdebt.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">With strong demand for loans in recent years, asset managers have to compete for new deal allocations primarily on two scales: pricing and structures. Coupons are getting squeezed, leverage pushed up, and covenants dropped.</span></blockquote>
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<span style="font-family: inherit;">CLOs are in a particularly sensitive spot, where their ability to compete on pricing and leverage is limited as they have to make math work over the cost of funding and adhere to minimum rating constraints. As a result, some managers could be more inclined to compete by accepting looser investor protections for the same price and leverage.</span></blockquote>
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<span style="font-family: inherit;">A typical CLO ramp-up period includes a warehousing stage that could last for about six months. During this stage, new loans are being acquired as a collateral for the future CLO deal, and an equity investor in a warehouse facility carries the risk of market conditions moving against them during this ramp-up period. Therefore, equity investors are incentivized to close the ramp-up period as soon as possible.</span></blockquote>
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<span style="font-family: inherit;">This pressure is counterbalanced by established time windows on CLO warehousing facilities, which arguably allow managers some flexibility to bypass on deals they view as particularly unattractive. The choice of a CLO manager could depend on how quickly such manager is expected to complete this stage. There is a premium associated with well-established managers. In some cases, CLO manager and equity investor are the same entity.</span></blockquote>
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<span style="font-family: inherit;">Pressure to ramp up a portfolio for future CLO at the time of record CLO issuance volumes puts some managers in a position where they are forced to compete on the strength of investor protections for a given level of credit risk/coupon.</span></blockquote>
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<span style="font-family: inherit;">Retail funds also contribute to excess demand for loan product as they continue to see inflows. YTD 2018, loan funds are seeing a 10% inflow, compared to a 9% outflow from HY funds. Loan funds have higher tolerance towards lower quality (B2/B3) paper compared to CLOs.</span></blockquote>
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<span style="font-family: inherit;">While there are some natural limits on how aggressive they can be on pricing (via pricing floor on their liabilities), there are no immediate consequences to accepting looser covenants. <span style="color: red;">During the period when default rates are low (like today), the impact from looser covenants through lower loan recoveries is negligible. This would likely change, once default rate increase in the next credit cycle</span>.</span></blockquote>
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<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Key risks in continued deterioration of investor protections</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Strong competition in the new CLO/loan asset management space in the last few years led to deterioration in key investor protections, such as restricted payments, asset sales, EBITDA add-backs, and incremental debt capacity.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">These covenants are critically important to recovery in case of default, as they are capable of directly affecting the pool of assets available to creditors in bankruptcy, and the extent of creditors’ ability to establish claim over it vs. unsecured and equity investors.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Loan recoveries, defined as post-default trading prices, averaged a relatively high 65% since 2007 as a function a large proportion of loans recover near-par in restructuring. Tight covenant packages helped them achieve stronger controls over asset pools in bankruptcy or other distressed resolution.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">This may change in the next cycle as key covenants have been eroded in recent years. Assuming the proportion of near-par recoveries is cut in half, average first lien loan recovery rate could drop to low-50s%. For example, on a $1.1tn loan market size with 15% peak default rate and 15% undershoot in recovery (50% vs 65% historical) this is an equivalent of $25bn of capital being permanently wiped out purely as a function of poor covenants. The next credit cycle is likely to bring some very poor recovery prints in certain most aggressive capital structures. We discuss various scenarios for defaults/recoveries later in this report.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Covenants are particularly weak in the broadly syndicated loan market, where the competition for new deal allocations is high. The private/direct lending space has also seen some deterioration in investor protections, but to a lesser extent than what we have seen in the syndicated transactions.</span></blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Key mitigating factors</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Not all loans lacking covenants carry the same risk of low recovery. <span style="color: red;">“Cov-lite” is not a new term, as it was coined at the end of last credit cycle, in 2006-2007, when a growing number of new loans were coming in without a maintenance covenant. In such cases, issuers were not required to adhere to leverage tests once the loan was issued</span>. We have long found this particular covenant mundane, as the experience of multiple breached maintenance covenants has demonstrated that lenders generally reserved their right to declare technical default, and instead chose to provide waivers for a fee.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Post-Global Financial Crisis, the number of such “cov-lites” has grown to the vast majority of new leveraged loans by around 2013, so again, not a new development. In a sense, the “cov-lite” misnomer is an unfortunate label that muddies the waters of a real problem for the next credit cycle, which is epitomized by the new structures lacking other key covenants.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;"><i><span style="font-size: x-small;">(Definitions of certain key covenants: Structural subordination: Protection against lien dilution or structural subordination for existing lenders. Restricted payments: Protection against cash leakage and value transfers that depletes value of associated collateral. Debt Incurrence: Protection against issuers leveraging up or paying other debt holders at the detriment of existing lenders. Investments: Protection against issuer taking on risky investments through carve-outs and builder baskets. Asset sales: Protection for lenders to enable them to benefit from asset sale proceeds and excess cash flows.)</span></i> - Source Bank of America Merrill Lynch</span></blockquote>
<span style="font-family: inherit;">As far as aggressive indicators are concerned we have yet to see an equivalent surge into LBOs we did in the previous credit cycle as a percentage of market size as per the below chart from Bank of America Merrill Lynch:</span><br />
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<span style="font-family: inherit;">- source Bank of America Merrill Lynch</span></div>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">Given the deterioration in credit quality overall, as we have stated in numerous of our previous conversations <span style="color: red;">we expect lower recovery values during the next downturn</span>.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">On the subject of what is "Under the Volcano" credit wise and what could possibly happen in terms of credit losses during the next downturn, in their report Bank of America Merrill Lynch does an interesting analysis:</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"<b>The next credit cycle: sensitivity analysis</b></span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">In this section, we take three major asset classes under our coverage: HY, syndicated loans and private debt, describe their current pricing in fundamentals, and run three scenarios for the future (Figure 10).</span></blockquote>
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<br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">The first scenario is base-case, consensus, middle of the road: the current economic trajectory persists, the Fed delivers on its dot plot estimates, and credit losses stay relatively modest, even for the floating rate instruments.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">The second scenario, is the stressed case, which resembles a full scale recessionary environment, with earnings dropping 30% and the Fed being forced to cut rates back to zero. This is a scenario we pay most attention to in an attempt to properly manage a risk budget in coming years. The third scenario (shown in greyed-out columns next to stressed, is designed to represent a modest recession with better outcomes. Think of an energy experience in 2014-2015, perhaps a touch heavier or lasting a few months longer.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Note that while we show HY and syndicated loan spaces in two separate columns, the reality of the situation is that these spaces are not mutually exclusive as some issuers are present in both markets. With this limitation in mind, we think of this attribution as being defined by issuers that are predominantly HY or predominantly loans. We believe that such representation, while imperfect, allows us to more properly model the capital structure behavior of these otherwise distinct asset classes.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;"> <b>Scenario #1: +100bp move in LIBOR, “average” loss rates</b>This section is the base-case for the next couple of years, implies the macro environment remains broadly supportive and the Fed achieves its longer-term dot plot forecast. We note the following dynamics in our analysis:</span></blockquote>
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">The impact on issuer fundamentals here is visible in changing coupons to the extent they are floating, and interest coverage ratios (ICRs) change in response to coupons.</span></li>
<li><span style="font-family: inherit;">ICRs get somewhat problematic in syndicated loans and private debt space, but they remain generally manageable and comfortably above 2x.</span></li>
<li><span style="font-family: inherit;">Leverage here is assumed to be unchanged, even though one could reasonably expect both earnings and debt to grow, somewhat out of sync with each other, over the next few years in a scenario where the Fed is able to deliver four more rate hikes. We did not aim to make this exercise about our judgment on those two imperfectly synchronized growth rates, and decided to leave leverage assumption unchanged in pursuit of simplicity and clarity of more consequential arguments that follow.</span></li>
<li><span style="font-family: inherit;">We think some moderate credit losses could come out of this scenario, but unlikely to mark a turn in credit cycle more broadly. Such incremental moderate credit losses are more likely to surface in the syndicated loan and private debt spaces, where capital structures are predominantly floating rate.</span></li>
<li><span style="font-family: inherit;">Importantly, we do not view this scenario as being directly linked to the next substantial pickup in credit losses. This is not how the cycle ends.</span></li>
</ul>
</blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Scenario #2: a full-scale recession</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">The key component of our sensitivity analysis is designed to define a full-scale recessionary experience.</span></blockquote>
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">We assume earnings decline 30% (normal recessionary range 30-40%), Fed cuts rate down to zero and Libor bottoms out at 0.50%, leverage/ICR ratios respond accordingly as functions of unchanged debt levels, lower earnings and somewhat lower interest expenses, to the extent of their floating nature.</span></li>
<li><span style="font-family: inherit;">Given these changes in issuer fundamentals, leverage would be likely to increase to 6.7xin HY, 8.6x in syndicated loans, and 7.5x in private debt.</span></li>
</ul>
</blockquote>
<span style="font-family: inherit;"><br /></span>
<br />
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">Under these prevailing leverage conditions, we argue the default rates could hit 10% in HY (normal recessionary range 8-12%), meaningfully higher level of 14% in loans, and 12% in private debt.</span></li>
</ul>
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">The HY bond market has an established track record of peak default rates over three independent credit cycles, with a normal recessionary peak level of 8-12%. We thus argue for a middle-of-the-road type of default experience here in the next credit cycle.</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Such track record is materially less reliable in syndicated loans, where the 2001-2002 cycle arrived when the asset class was in its infancy, and the 2008-2009 was arguably softened by the extraordinary policy response aimed specifically at banks and structured finance products, although not directly CLOs.</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Our argument for a 14% default rate rests on our understanding of substantial growth rates that were witnessed here in recent years, coupled with the higher leverage measures relative to other related asset classes. Leverage in the syndicate loan market could hit 8.6x under a moderate assumption of a 30% drop in EBITDAs.</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">Private debt space has no meaningful track record in previous credit cycles as the asset class has grown to its present size only in the past few years, although its early origins are traceable to the previous decade. We thus rely our 12% default rate assumption here primarily on its leverage measures, which are assumed to be (but not always directly observable) around 5x-5.5x, in between HY and syndicated loans.</span></li>
</ul>
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<br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">• We also assume recovery rates of 35% in HY, 60% in loans and private debt. Recovery rates here are defined as trading prices shortly after the event of default. This measure differs from ultimate recovery, which is the payout on the other side of a restructuring process.</span><br />
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;"><span style="color: red;">Syndicate loan recoveries are penalized as a function of three factors: poor investor protections/covenants and poor tangible asset coverage in sectors most exposed to syndicated loans (technology, services, and retail)</span>. We do give the loan market a benefit for the fact that its structure is now materially less exposed to mark-to-market instruments, thus limiting the extent of fire sales that took place in 2008-2009.</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;"><span style="color: red;">A 60% recovery assumption in private debt, is a very rough estimate, given absence of verifiable historical track records and extremely low liquidity</span>. Paradoxically, the latter could be viewed as a benefit, as absence of any practical ability to trade out of a position could arguably prevent many private loans from ever being “marked-to-market” in a restructuring process. We aim to approach this question more holistically however, essentially making an argument that if an independent expert were to make a bona-fide assessment of such loan’s true market value in a distressed situation, he/she must have applied an additional discount for illiquidity.</span></li>
</ul>
<ul>
<li><span style="font-family: inherit;">While we heard a wide range of opinions on this particular aspect of our scenario analysis from various experts in this subject matter we felt that at the end of the day, inability to trade cannot be reasonably argued to increase intrinsic value, even if it does make its determination less transparent.</span></li>
</ul>
</blockquote>
</blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">• Permanent credit losses are defined as the peak default rate times expected duration of the cycle (we assume 2 years) times (1 minus recovery rate).</span><br />
<ul>
<li><span style="font-family: inherit;">We also calculate temporary mark-to-market losses based on assumed low print in secondary market prices of 65c in HY, 70c loans, and 60c in private debt. Naturally the confidence in these assumptions must be taken in consideration with expected depth of liquidity.</span></li>
<li><span style="font-family: inherit;">We separate between permanent and temporary loss here in an effort to highlight the fact that the latter is not crystalized unless an investor sells at that low print, although everyone is taken for a ride to that level. The permanent loss is unavoidable if a portfolio is exposed to an instrument in question.</span></li>
<li><span style="font-family: inherit;">We estimate permanent losses to be roughly 2x the current annual income generated in HY and syndicated loans and 1.3x in private debt. Temporary losses are estimated at 4-5x the annual income level.</span></li>
<li><span style="font-family: inherit;">To put it another way, investors stand to wipe out 4-5 years of their income if a recessionary scenario described above were to materialize in this exact form, although a material portion of that is likely to be recaptured in a subsequent upswing. <span style="color: red;">They are also likely to never recover 2 years of their current income, assuming a passive benchmark exposure to HY/loans and 1.3 years to private debt</span>.</span></li>
</ul>
</blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;"> Scenarios #3: a mild/short recession</span></b></blockquote>
<blockquote class="tr_bq">
<ul>
<li><span style="font-family: inherit;">Highlighted in grey next to each scenario, we are also showing less stressed scenarios, to give readers a better sense of the range of likely outcomes. We think of these more- and less-stressed scenarios as equally likely to materialize over the next few years, dependent on currently unknown circumstances of the next downturn.</span></li>
<li><span style="font-family: inherit;">We also give the private debt a greater benefit of the doubt that recoveries there could be materially better in such less stressed scenario, function of lower leverage and better covenant protections in that space.</span></li>
<li><span style="font-family: inherit;"><span style="color: red;">The key takeaway here is that temporary losses could be limited to 3 years of income in HY/loans and 2 years in private debt. Permanent losses could claim 1.5yrs, 1yrs, and 0.6x yrs respectively</span>.</span></li>
<li><span style="font-family: inherit;">In a more optimistic scenario, we assume somewhat lower credit losses in loans and private debt. Default rates are assumed at 10% in this less stressed scenario, while recoveries are at 70% in syndicated loans and 75% in private debt (credit given for patient institutional capital, and better structured deals vs syndicated loans)." - source Bank of America Merrill Lynch</span></li>
</ul>
</blockquote>
<span style="font-family: inherit;">We do expect on our side, to repeat ourselves, lower recoveries into the next downturn given "Under the Volcano", there is we think the "liquidity illusion" which is an important factor to take into account in such a scenario analysis and exercise. Anyone who has been through the credit market turmoil of 2007/2008 will tell you that liquidity is a coward and often "bids" are "by appointment only" in such instances.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">This is of course a concern which is as well highlighted in Bank of America Merrill Lynch's long interesting report:</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"<b>Constrained liquidity as a factor in our analysis</b></span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Liquidity has generally been a constraining factor throughout the history of leveraged finance markets. HY bond and leveraged loans have rarely provided investors with particularly deep secondary trading markets – at least, if one’s point of reference is determined by experienced in large cap equities, higher-quality bonds, FX, or commodities.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">In the past, there were episodes when lev fin liquidity was relatively good, as was the case in 2006-2007. Additionally, throughout history, there were selected large capital structures that often had deep two-sided markets. Rarely do experienced leveraged finance investors expect deep liquidity to last over considerable time or encompass a considerable number of issuers in this market.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">The topic of liquidity in the leveraged finance space has emerged as an issue of particular concern to credit investors, particularly after the Global Financial Crisis. After all, dealers curtailed their market-making activities as a result of both new regulations (capital requirements and the Volcker Rule, the latter which we detail later this section), as well as changes to dealer risk appetite and policies. The days of multi-billion dollar inventories of HY bonds on bank balance sheets came to an end shortly after 2008.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">In recent years, aggregate dealer inventories in HY rarely exceed $5bn. This $5bn stand against a $1.3tn market by size and against $6-8bn of average trading volume it generates in a given day.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">These facts lead to concerns that while the liquidity situation appears sustainable in times of inflows into the asset class, it may be easily disrupted in times of market stress and significant investor withdrawals. Additionally, if liquidity can be described as limited in HY bonds, and perhaps even more constrained in broadly syndicated loans, it is may be nonexistent in smaller middle-market and private debt spaces, where the whole tranches are often held in only a handful of accounts.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">We generally share these concerns and agree with the argument that the next credit cycle will present an important test to the stability of leveraged finance market’s trading infrastructure. The key point here is to remember that while the AUM (assets under management) in funds promising investors daily liquidity gas grown by hundreds of billions of dollars in recent years, the dealer balance sheets went the other way and compressed to a significant extent. With all these reservations in mind, <span style="color: red;">we do not count ourselves among doomsayers that predict a severe dislocation in corporate credit as a result of liquidity constraints</span>.</span></blockquote>
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<a href="https://4.bp.blogspot.com/-oCmifIOqbAs/W8ObAZHuFsI/AAAAAAAAUy8/-g7pDnXgBMEDKU1McqoGjPU_ez8mwigswCLcBGAs/s1600/BAML%2B-%2BAggregate%2Bdealer%2Binventories%2Bin%2BUS%2BHY.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="271" data-original-width="384" height="225" src="https://4.bp.blogspot.com/-oCmifIOqbAs/W8ObAZHuFsI/AAAAAAAAUy8/-g7pDnXgBMEDKU1McqoGjPU_ez8mwigswCLcBGAs/s320/BAML%2B-%2BAggregate%2Bdealer%2Binventories%2Bin%2BUS%2BHY.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">As we introduced this topic above, we started with a description of the secondary market that has been perennially illiquid with exceptions due to unusually lax risk management episodes or unusually well traded cap structures. Seasoned investors who have participated in this market over several credit cycles understand its liquidity constrains on the DNA level.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">The fact that dealers have stepped back has been balanced with the fact of new trading venues, counterparties, and instruments emerging to fill the void. </span></blockquote>
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<a href="https://1.bp.blogspot.com/-411bJm6Lqmc/W8Oa6e5oIaI/AAAAAAAAUy4/SyACpjs64Fs6eIPJPuXZSWM8_auiMDadgCLcBGAs/s1600/BAML%2B-%2BHY%2Btrading%2Bvolumes%2Bin%2BUS%2Bmillions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="272" data-original-width="387" height="224" src="https://1.bp.blogspot.com/-411bJm6Lqmc/W8Oa6e5oIaI/AAAAAAAAUy4/SyACpjs64Fs6eIPJPuXZSWM8_auiMDadgCLcBGAs/s320/BAML%2B-%2BHY%2Btrading%2Bvolumes%2Bin%2BUS%2Bmillions.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">There are several competing electronic trading platforms in credit space today that did not exist prior to the financial crisis. Hedge funds and other opportunistic investor types are counting themselves among active market makers and they have stepped in during the recent episodes of market volatility with firm bids. Portfolio instruments such as ETFs, total return swaps, and options now complement CDX (credit default swap) indexes in allowing investors to transfer risk more efficiently.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Will the bid-ask spreads widen meaningfully in the next stress episode? Of course they will. Will the market necessarily malfunction in that scenario? Not necessarily. Recent deep stress volatility events such as Dec 2015 (a small distressed fund failing), Jun 2016 (Brexit), Nov 2016 (Trump election), and Jan 2017 (VIX fund failures) have proven that the leveraged finance markets continued to operate. In fact one could argue that all these episodes rewarded those who had the discipline, the risk budget, and the market sense to step in and take advantage of those temporary dislocations. We count ourselves among those who believe in this argument." - source Bank of America Merrill Lynch</span></blockquote>
<span style="font-family: inherit;">We are no perma bears or doomsayers per se but, for us, liquidity in credit markets is a concern, particularly given record issuance levels in recent years also in private credit markets. The GAM fund meltdown during the summer is illustrative of our concerns. </span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">Growth in issuance is a problem also highlighted by Morgan Stanley in their Corporate Credit Research note from the 5th of October entitled "The Nature of the BBBeast":</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"BBB IG debt outstanding has grown significantly in this cycle, a story most IG credit investors know quite well. For example, at ~$2.5 trillion outstanding, BBB par has increased 227% since the beginning of 2009. </span></blockquote>
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<a href="https://2.bp.blogspot.com/-TgjAiEw16EI/W8Oi-j9Of5I/AAAAAAAAUzI/mxHLW2GqH9Q1IAXYQngAQnDgtMLGJzqRACLcBGAs/s1600/MS%2B-%2BIG%2BBBBs%2Bnow%2Btotal%2B%25242.5%2Btrillion%252C%2B50pct%2Bof%2BIG%2Bindex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="299" data-original-width="490" height="195" src="https://2.bp.blogspot.com/-TgjAiEw16EI/W8Oi-j9Of5I/AAAAAAAAUzI/mxHLW2GqH9Q1IAXYQngAQnDgtMLGJzqRACLcBGAs/s320/MS%2B-%2BIG%2BBBBs%2Bnow%2Btotal%2B%25242.5%2Btrillion%252C%2B50pct%2Bof%2BIG%2Bindex.jpg" width="320" /></span></a></div>
<br />
<blockquote class="tr_bq">
<span style="font-family: inherit;"><span style="color: red;">The majority of the increase in BBB debt stems from net issuance ($1.2 trillion), followed by downgraded debt ($745 billion).</span> Notably, the growth in BBB debt outstanding is not being skewed by a single sector or a small part of the market. Yes, large issuers have grown significantly. For example, the top 25 non-financial BBB names have a total of $685 billion in index debt (up from $257 billion in 1Q09). But the number of BBB issuers has also increased by 60% since 2009, while all sectors have increased BBB debt, large and small companies alike. In other words, the increase has been broad-based across the market.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">So what does this mean big picture? <span style="color: red;">Credit cycles are always different from one to the next. But a consistent rule of thumb over time that we live by when looking for problems down the line: Follow the debt growth</span>. Very simply, applying to the current cycle, we think BBBs will be one (of a few) stress points when the cycle does turn. Downgrade activity will likely be meaningful. And when thinking about other markets that could feel the effect, remember the BBB part of the IG index is now ~2.5x as large as the entire HY index.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;"><span style="color: red;">The good news is that this is not a story for today</span>, in that ratings downgrades tend to lag the market. In other words, the big wave of downgrades will likely not come until credit spreads are much wider than they are right now, which will take time to play out. But more importantly, valuations are pricing in very few fundamental risks, in our view, with the BBB/A spread basis still near cycle tights. Hence we remain up-in-quality." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">As central banks are pulling back, “macro” driven markets are no doubt making a return and credit indices such as Itraxx Main Europe and CDX IG and High Yield in the US are useful tool to hedge rising “liquidity” risk coming from credit markets when next downturn will show up.</span><br />
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<span style="font-family: inherit;">Finally, for our final chart, as we pointed out during in previous conversations, 2018 displayed larger and larger standard deviations move, typical as well of late cycle behavior in conjunction with rising dispersion. </span><br />
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"</span></li>
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<span style="font-family: inherit;">The latest bout of volatility wasn't that much of a surprise, it was a conjunction of several factors such as fast rising real rates, a more aggressive tone from the Fed in general and Powell in particular. Whereas the February event was the equivalent for the house of straw of the short-vol pigs of the eruption of Mount Vesuvius in 79 AD, vaporizing in an instant large players of the short-volatility complex, the latest event was mostly a tremor, geopolitical risks aside. We do not yet see credit spreads turning decisively, nonetheless the deteriorating trend for cyclicals in conjunction with trade deceleration outside the United States warrants close attention we think. Our final chart comes from Morgan Stanley's Cross-Asset Dispatches note from the 11th of October entitled " FAQ After a Large Decline":</span><br />
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<span style="font-family: inherit;">"<b>Large moves are still happening more often: </b></span></blockquote>
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<span style="font-family: inherit;">This remains true; 2018 is still on pace for some of the highest frequency of 3-sigma moves post-crisis. Liquidity remains poor.</span></blockquote>
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<a href="https://3.bp.blogspot.com/-Vj73URgXZ9A/W8OrpkamlpI/AAAAAAAAUzU/hycXV05yXjgn3VoPAcq2dXcsLMvA31d5wCLcBGAs/s1600/MS%2B-%2Brun-rate%2Blarge%2Bmoves%2Bin%2Bstock%2Bindices.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="274" data-original-width="474" height="184" src="https://3.bp.blogspot.com/-Vj73URgXZ9A/W8OrpkamlpI/AAAAAAAAUzU/hycXV05yXjgn3VoPAcq2dXcsLMvA31d5wCLcBGAs/s320/MS%2B-%2Brun-rate%2Blarge%2Bmoves%2Bin%2Bstock%2Bindices.jpg" width="320" /></span></a></div>
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<b><span style="font-family: inherit;">What happened?</span></b></blockquote>
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<span style="font-family: inherit;">We think that recent moves are about several factors colliding around the 3.20% level for 10-year Treasuries, rather than a simple case of 'higher rates are bad for risk'. Those factors? A break of a 5-year+ real yield range, compression of the US equity ERP above 3.25% and very stretched performance of value versus growth (see Cross-Asset Dispatches: Are Rising Rates a Problem? October 7, 2018).</span></blockquote>
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<b><span style="font-family: inherit;">How unusual was this move?</span></b></blockquote>
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<span style="font-family: inherit;">The overall move for S&P 500 wasn't that extreme versus what we saw over the last several years but yesterday was the worst day for the NASDAQ in almost seven years. More broadly, this was also one of the worst days for growth globally. The value outperformance was even more pronounced outside the US as European value posted the best one-day performance versus growth post-crisis.</span></blockquote>
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<span style="font-family: inherit;"><b>Positioning – it is light, but in pain:</b> </span></blockquote>
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<span style="font-family: inherit;">2018 has been a hard year (see Easier Financial Conditions, Still a Tough Year, September 23, 2018). The last five days have only confirmed this, bringing losses to one of the last bastions of strong performance and concentrated positioning – growth/tech. Investors have been hit hard by recent price action, which makes us less optimistic than we'd otherwise be about overall positioning indicators looking quite light.</span></blockquote>
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<span style="font-family: inherit;">2018, unfortunately, seems to be a year where every asset class has a turn in the barrel.</span></blockquote>
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<b><span style="font-family: inherit;">The Fed 'put' remains out-of-the-money: </span></b></blockquote>
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<span style="font-family: inherit;">We also do not expect much help for policymakers, at least not yet. US inflation and unemployment remain in a very different place than under Chairs Yellen and Bernanke. As of late September, the Chicago Fed's Adjusted Financial Conditions Index was still easier year on year (in a tightening cycle, we think that the Fed would want this tightening). And we think that the Federal Reserve strongly values its independence; comments by the administration are unlikely to have an impact." - source Morgan Stanley</span></blockquote>
<span style="font-family: inherit;">Sure, things are brewing "under the volcano à la 2007", one might opine, and of course geopolitical events continues to be known unknowns, yet the US still appear for the time being as much stronger magnet for global capital than Europe for instances as per the significant amount of outflows seen in recent weeks. It is again a case of "<a href="https://macronomy.blogspot.com/2018/08/macro-and-credit-dissymmetry-of-lift.html">Dissymmetry of lift</a>" we think, yet, the latest signs of global liquidity withdrawal are showing again dispersion such as rotation from growth to value, and investors turning more defensive in some instances given we are entering the latest innings of this long credit cycle but, we are repeating ourselves again...</span><br />
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<blockquote class="tr_bq">
<span style="font-family: inherit;">"Hope of ill gain is the beginning of loss." - Democritus</span></blockquote>
<span style="font-family: inherit;">Stay tuned !</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-65216302890791794702018-10-01T19:10:00.002+01:002018-10-01T22:21:43.746+01:00Macro and Credit - The Armstrong limit<div dir="ltr" style="text-align: left;" trbidi="on">
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<span style="font-family: inherit;">"Men go abroad to wonder at the heights of mountains, at the huge waves of the sea, at the long courses of the rivers, at the vast compass of the ocean, at the circular motions of the stars, and they pass by themselves without wondering." - Saint Augustine</span></blockquote>
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<span style="font-family: inherit;">Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment. Above earth, this begins at 18-19 km (59,000-62,000 feet) above sea level. The term is named after United States Air Force General Harry George Armstrong who was the first to recognize this phenomenon. Commercial jetliners are required to maintain cabin pressurization at a cabin altitude of not greater than 2400 m (8,000 feet). The Armstrong limit describes the altitude associated with an objective, precisely defined natural phenomenon: the vapor pressure of body-temperature water. Back in August in our conversation the "<a href="https://macronomy.blogspot.com/2018/08/macro-and-credit-dissymmetry-of-lift.html">Dissymmetry of lift</a>", we discussed our Quantitative Tightening (QT) amounted to reducing global liquidity and tightening global financial conditions overall as well as less airflow to maintain growth (we are already seeing signs in Europe). When it comes to airflow and liquidity relating to equity indices we touched in this subject in two previous conversations: <span style="text-align: left;">"</span><a href="https://macronomy.blogspot.com/2013/04/credit-coffin-corner.html" style="text-align: left;">The Coffin corner</a><span style="text-align: left;">" in April 2013, the other being "</span><a href="https://macronomy.blogspot.com/2014/05/credit-vortex-ring.html" style="text-align: left;">The Vortex Ring</a><span style="text-align: left;">" in May 2014. When it comes to our analogy and our reference to the</span><span style="text-align: left;"> Nikkei and US equity indices we remember clearly that the Nikkei hit its all-time high on 29 December 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44, before closing at 38,915.87, having grown six fold during the decade. Sure the S&P 500 has grown six fold during the decade since the collapse of Lehman Brothers but it's within 1% of its all time high. One question investors are starting to ask themselves is what is the "Armstrong limit" for US equities? Bank of America Merrill Lynch in their recent The Flow Show note from the 27th of September entitled "Jay stalking" have two very interesting charts when it comes to equity allocation from Global Wealth and Investment Management (GWIM) into equities and cash allocation levels:</span></span></div>
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<a href="https://4.bp.blogspot.com/-vgEM2R8MpKY/W7ILyCNZD-I/AAAAAAAAUuo/xuSYwlak_6Mq0VfbdVsA_WQHndP3ntpzwCLcBGAs/s1600/BAML%2B-%2BGWIM%2Bequity%2Ballocation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="297" data-original-width="398" height="238" src="https://4.bp.blogspot.com/-vgEM2R8MpKY/W7ILyCNZD-I/AAAAAAAAUuo/xuSYwlak_6Mq0VfbdVsA_WQHndP3ntpzwCLcBGAs/s320/BAML%2B-%2BGWIM%2Bequity%2Ballocation.jpg" width="320" /></span></a></div>
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<a href="https://3.bp.blogspot.com/-bLuHs-ptu2U/W7IL0qp3WnI/AAAAAAAAUus/cYF3xq0etF8dnRRmWTr8RwkuIbgrvaImQCLcBGAs/s1600/BAML%2B-%2BGWIM%2Bcash%2Ballocation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="305" data-original-width="399" height="244" src="https://3.bp.blogspot.com/-bLuHs-ptu2U/W7IL0qp3WnI/AAAAAAAAUus/cYF3xq0etF8dnRRmWTr8RwkuIbgrvaImQCLcBGAs/s320/BAML%2B-%2BGWIM%2Bcash%2Ballocation.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit; text-align: left;">- source Bank of America Merrill Lynch</span></div>
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<span style="font-family: inherit; text-align: left;">One might indeed wonder what level is the "Armstrong limit" before boiling point we think...</span></div>
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<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at once again at the US consumer which seems to be increasingly relying on his credit card as well as other signs that warrants monitoring at this stage in the cycle.</span></span></div>
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<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - What's the Armstrong limit for the US consumer's confidence?</span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final charts - The "profit" illusion</span></b></i></li>
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<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Macro and Credit - What's the Armstrong limit for the US consumer's confidence?</span></li>
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<span style="font-family: inherit;">In continuation to our last conversation, we think it is essential for the US growth outlook and forward earnings to continue to focus on the state of the US consumer. After all, the first on the line in any case of trade war escalation is the US consumer who gets the price increase passed onto by corporations facing a surge in costs. With the US consumer confidence index climbing to 138.4 in September from 134.7 in August, the highest since September 2000 we are wondering if it is the absolute Armstrong limit.</span><br />
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<span style="font-family: inherit;">On this question we read with interest Wells Fargo's take from their US Consumer Confidence note from the 25th of September:</span><br />
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<span style="font-family: inherit;">"<b>In the past 51 years, only 11 times has confidence been higher than it is today. Said differently, roughly 98% of the time confidence is lower than it is now. That’s good news for the consumer, but for how long?</b></span></blockquote>
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<b><span style="font-family: inherit;">Remember the Sock Puppet Commercials?</span></b></blockquote>
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<span style="font-family: inherit;">The last time consumer confidence was as high as it is today was in the year 2000. A number of financial and economic indicators from that era are similar to where they are today. The stock market was soaring to all-time record highs, the unemployment rate was below 4% and the economy was in its 10th year of uninterrupted expansion. Then, as now, there were few people seeing an end in sight.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-Or5TLtJRIfY/W7IpQ6bN9EI/AAAAAAAAUu8/qcYHEwd77XI1PeZOZNzhS3U3VKXvm7LMgCLcBGAs/s1600/WF%2B-%2BConfidence%2Bvs%2BUnemployment.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="272" data-original-width="355" height="245" src="https://1.bp.blogspot.com/-Or5TLtJRIfY/W7IpQ6bN9EI/AAAAAAAAUu8/qcYHEwd77XI1PeZOZNzhS3U3VKXvm7LMgCLcBGAs/s320/WF%2B-%2BConfidence%2Bvs%2BUnemployment.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">While we still think the current expansion has room to run, we would be remiss not to make note of just how rare a thing it is to see confidence at these lofty levels. Only in 11 individual months since 1967 have we seen confidence higher than it is today. Nine of those months were in the year 2000. The other two were in 1999. This is the thin air of the high peaks.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-6-CSYPHRnk0/W7IpiPQXZvI/AAAAAAAAUvE/BDeTrd5cuhYpnYgkuVqjiub1GYDru_RlwCLcBGAs/s1600/WF%2B-%2BConference%2BBoard%2BConsumer%2BConfidence%2BSep%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="272" data-original-width="355" height="245" src="https://1.bp.blogspot.com/-6-CSYPHRnk0/W7IpiPQXZvI/AAAAAAAAUvE/BDeTrd5cuhYpnYgkuVqjiub1GYDru_RlwCLcBGAs/s320/WF%2B-%2BConference%2BBoard%2BConsumer%2BConfidence%2BSep%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"><b><span style="color: red;">The euphoria is not limited to the consumer sector. The ISM manufacturing index is at its highest level since 2004 and the NFIB Small Business Optimism Index, an indicator of small business confidence, is at its highest level on records that date back to 1974.</span></b> The fact that these measures are at record highs does not preclude them from going higher, but one characteristic that they all share is a tendency to peak before a slowdown.</span></blockquote>
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<b><span style="font-family: inherit;">No Time Like the Present</span></b></blockquote>
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<span style="font-family: inherit;">There is an interesting dynamic going on between consumers’ assessment of the present situation, compared to expectations for the future. As seen in the middle chart, the present situation measure is running well ahead; in the prior cycle there was a similar divergence late in the cycle.</span></blockquote>
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<b><span style="font-family: inherit;">Some Things That Are Different From 2000</span></b></blockquote>
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<span style="font-family: inherit;">The below chart plots consumer confidence alongside both retail sales (ex-autos) and real income growth on a per-capita basis. Here we see something that Fed policymakers have been wringing their hands over throughout this cycle, which is: if the labor market is so hot, how come income growth is so tepid? </span></blockquote>
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<a href="https://4.bp.blogspot.com/--AttMn-Py6A/W7Ip3ryX4XI/AAAAAAAAUvM/MD_CQ5MAWlAVOAKVn8LLyozM1BA2DEGygCLcBGAs/s1600/WF%2B-%2BConfidence%2Bvs%2BRetail%2BSales%2Band%2BIncome.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><span style="font-family: inherit;"><img border="0" data-original-height="272" data-original-width="355" height="245" src="https://4.bp.blogspot.com/--AttMn-Py6A/W7Ip3ryX4XI/AAAAAAAAUvM/MD_CQ5MAWlAVOAKVn8LLyozM1BA2DEGygCLcBGAs/s320/WF%2B-%2BConfidence%2Bvs%2BRetail%2BSales%2Band%2BIncome.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;"><b><span style="color: red;">That slower income growth tempers our enthusiasm for the ability of consumer spending to sustain growth indefinitely.</span></b> We will get the latest read on this when the personal income and spending numbers hit the wire on Friday of this week.</span></blockquote>
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<b><span style="font-family: inherit;">I Don’t Know Why I Go to Extremes</span></b></blockquote>
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<span style="font-family: inherit;">For now, the surge in retail sales cannot be denied and we would be foolish to bet against the consumer with such a solid backdrop for consumer confidence. The official write-up that accompanied the release stated that “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy.” We would not disagree, but what takes the shine off the apple for us is that extremes, by definition, imply “reaching a high, or the highest degree.” If this is the extreme, there is nowhere to go but down." - source Wells Fargo</span></blockquote>
<span style="font-family: inherit;">With US Personal Income rising 0.3% in August, slightly less than expected (0.4%) last Friday, then indeed slower income growth should indeed temper slightly your enthusiasm we think.</span><br />
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<span style="font-family: inherit;">As a reminder from last week's conversation, and as per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return. It is worth remembering this from an Armstrong limit perspective:</span><br />
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<a href="https://1.bp.blogspot.com/-A_WdlyUutfg/W7Iuf6UHDRI/AAAAAAAAUvY/3_TNMXM3TOQ29a7fT9EGmqcnJsA1BQWcgCLcBGAs/s1600/Macrobond%2B-%2BUMICH%2Band%2Bstock%2Bmarket%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://1.bp.blogspot.com/-A_WdlyUutfg/W7Iuf6UHDRI/AAAAAAAAUvY/3_TNMXM3TOQ29a7fT9EGmqcnJsA1BQWcgCLcBGAs/s320/Macrobond%2B-%2BUMICH%2Band%2Bstock%2Bmarket%2BOctober%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond (click to enlarge)</span></div>
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<span style="font-family: inherit;">Also, keep that in mind when looking at the significant rise of the S&P 500, because we think that we are in the melt-up "euphoria" phase and have yet to touch the "Armstrong limit":</span><br />
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<a href="https://2.bp.blogspot.com/-EBEyNwwa4Ko/W7Iv0Am3HYI/AAAAAAAAUvk/0qcIVLtrPdc_Iz3KtkYQQPmfXqeU6ptdwCLcBGAs/s1600/Macrobond%2B-%2BSPX%2Band%2Bthe%2BBusiness%2Bcycle.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://2.bp.blogspot.com/-EBEyNwwa4Ko/W7Iv0Am3HYI/AAAAAAAAUvk/0qcIVLtrPdc_Iz3KtkYQQPmfXqeU6ptdwCLcBGAs/s320/Macrobond%2B-%2BSPX%2Band%2Bthe%2BBusiness%2Bcycle.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond (click to enlarge)</span></div>
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<span style="font-family: inherit;">Or you could also ask yourself as well what is the "Armstrong limit" when it comes to the S&P 500 Profit Margins in this long in the tooth credit cycle:</span></div>
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<a href="https://2.bp.blogspot.com/-6oWQO3yfDDk/W7I0eqx8s2I/AAAAAAAAUvw/8BO12YAmZRonTwvCmQK3l3Z_Q_ZtJOCFgCLcBGAs/s1600/Macrobond%2B-%2BSPX%2B500%2BProfit%2BMargins%2BOct%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://2.bp.blogspot.com/-6oWQO3yfDDk/W7I0eqx8s2I/AAAAAAAAUvw/8BO12YAmZRonTwvCmQK3l3Z_Q_ZtJOCFgCLcBGAs/s320/Macrobond%2B-%2BSPX%2B500%2BProfit%2BMargins%2BOct%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond (click to enlarge)</span></div>
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<span style="font-family: inherit;">You could as well ask yourselves when will we reach "peak" M&A, which is also a sign you generally see in late credit cycles:</span></div>
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<a href="https://3.bp.blogspot.com/-MRJmD3RFnS0/W7I1pL0yYLI/AAAAAAAAUv8/VxqicWRVU5gBTTh8-l5LWlkkQM5zAr5ewCLcBGAs/s1600/Macrobond%2B-%2BUS%2BM%2Band%2BA.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://3.bp.blogspot.com/-MRJmD3RFnS0/W7I1pL0yYLI/AAAAAAAAUv8/VxqicWRVU5gBTTh8-l5LWlkkQM5zAr5ewCLcBGAs/s320/Macrobond%2B-%2BUS%2BM%2Band%2BA.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond (click to enlarge)</span></div>
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<span style="font-family: inherit;">In last week's conversation, "<a href="http://macronomy.blogspot.com/2018/09/macro-and-credit-white-tiger.html">White Tiger</a>" we indicated that although everyone is focusing on the flattening of the yield curve, from an inflationary expectations perspective we worry a lot for asset prices about a spike in oil prices if we do get geopolitical flares up in November between the United States and Iran:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<span style="font-family: inherit;">The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles." - source Macronomics, September 2018</span></span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">So for us, from an Armstrong limit perspective, we are closely watching the evolution of oil prices:</span><br />
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<a href="https://1.bp.blogspot.com/-KVlHdA6qtIc/W7I7-1nkyII/AAAAAAAAUwI/K93_7c3EB3AKvnZT9G0vwdcMrB_YP2LUQCLcBGAs/s1600/Macrobond%2B-%2BBrent%2BCrude%2BPrices%252C%2BUSD%2Bper%2Bbarrel%2B-%2B1st%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="394" data-original-width="844" height="149" src="https://1.bp.blogspot.com/-KVlHdA6qtIc/W7I7-1nkyII/AAAAAAAAUwI/K93_7c3EB3AKvnZT9G0vwdcMrB_YP2LUQCLcBGAs/s320/Macrobond%2B-%2BBrent%2BCrude%2BPrices%252C%2BUSD%2Bper%2Bbarrel%2B-%2B1st%2BOctober%2B2018.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- graph source Macrobond</span></div>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">An inflation spike is very much on our radar. Oil has extended its gains after the longest quarterly rally in a decade thanks to a slowdown in American drilling as well as supply concerns. The U.S. and Saudi Arabia have discussed market stability yet it seems there are some questions relating to spare capacity with traders highlighting a potential surge towards $100 a barrel at some point. </span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;">From an Armstrong limit perspective relating to the state of the US consumer, oil prices matter because not only retail has been sustained by the rise in credit card use but housing is seeing headwinds already thanks to rising mortgage rates. The issue at hand is the size of energy costs for the US consumer relative to his consumer spending. On that subject we read with interest Wells Fargo's take from their note from the 28th of September entitled "What Good is a Bigger Paycheck if it All Goes to Gas Money?":</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"<b>Wages and salaries posted the largest monthly increase since January, but increasingly higher gas prices and other energy costs are commanding a larger share of consumer spending.</b></span></blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Income Gets Boost from Wages</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Personal income increased 0.3% in August, which was a bit shy of the 0.4% that had been expected by the consensus. </span></blockquote>
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<a href="https://3.bp.blogspot.com/-J0-fi9guMzU/W7JFc4F_OUI/AAAAAAAAUwc/n1FiMAKl-Jkr1UkbwGwY_AUT4pJQe9NCwCLcBGAs/s1600/WF%2B-%2BPersonal%2Bincome.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="263" data-original-width="355" height="237" src="https://3.bp.blogspot.com/-J0-fi9guMzU/W7JFc4F_OUI/AAAAAAAAUwc/n1FiMAKl-Jkr1UkbwGwY_AUT4pJQe9NCwCLcBGAs/s320/WF%2B-%2BPersonal%2Bincome.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;">More than two thirds of the increase was due to the fact wages and salaries notched a solid 0.5% gain. That was the best monthly increase since January and the latest indication that the hot job market is at last translating into meaningful improvement in wages.</span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Personal interest income, which comprises less than a tenth of overall income, was down for the second straight month and was in fact the only category of personal income that declined during the period.</span></blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Energy Costs Taking up Larger Share of Consumer Spending</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">Despite the slightly softer print on the income side, spending did not disappoint with the 0.3% pick-up in outlays, matching the consensus expectation. The fact that wages and salaries drove much of the increase explains why the saving rate was able to remain unchanged at 6.6%.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-L1ESGj_ldV8/W7JFZAiMgLI/AAAAAAAAUwY/PZdo9orkvp8hy1MOTg8DmZLyW8MmlM0-ACLcBGAs/s1600/WF%2B-%2BWage%2Band%2BSalaries.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="265" data-original-width="355" height="238" src="https://1.bp.blogspot.com/-L1ESGj_ldV8/W7JFZAiMgLI/AAAAAAAAUwY/PZdo9orkvp8hy1MOTg8DmZLyW8MmlM0-ACLcBGAs/s320/WF%2B-%2BWage%2Band%2BSalaries.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;">Consumer durable goods outlays slipped 0.1%, but every other major category of spending was either flat or positive to varying degrees. Echoing one of the themes from the August retail sales report in which gas stations reported faster sales than other types of stores, the biggest category gainer in terms of price was energy goods and services, up 1.9% on the month. This category includes spending on gasoline but also includes energy goods delivered to the home through utilities like electricity and natural gas. The takeaway is that higher energy prices in August might have been holding back spending in other categories. Excluding food and energy, spending was flat in August.</span></blockquote>
<blockquote class="tr_bq">
<b><span style="font-family: inherit;">Inflation Dynamics</span></b></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">People are not suddenly buying a lot more gasoline. Prices, of course, are largely to blame. <b><span style="color: red;">The energy prices category within the price indices has seen double-digit percentage gains in each of the past four months. Mercifully for consumers, prices for durable goods have also been lower in each of those past four months, ameliorating the impact of higher energy prices</span></b>. The headline measure for the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, slowed slightly to 2.2% from 2.3% on a year-over-year basis in July.</span></blockquote>
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<a href="https://1.bp.blogspot.com/-70ddIp9CcWo/W7JFT5_KNnI/AAAAAAAAUwU/RaAfi9lyseALSrKy1QLBlbSJJRqsBIfWQCLcBGAs/s1600/WF%2B-%2BPCE%2BDeflator%2Bvs%2BCore%2BPCE%2BDeflator%2BOctober%2B2018.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="278" data-original-width="355" height="250" src="https://1.bp.blogspot.com/-70ddIp9CcWo/W7JFT5_KNnI/AAAAAAAAUwU/RaAfi9lyseALSrKy1QLBlbSJJRqsBIfWQCLcBGAs/s320/WF%2B-%2BPCE%2BDeflator%2Bvs%2BCore%2BPCE%2BDeflator%2BOctober%2B2018.jpg" width="320" /></span></a></div>
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<blockquote class="tr_bq">
<span style="font-family: inherit;">Existing tariffs on a variety of imports totaled roughly $100 billion in August; with this week’s additional tariffs on $200 billion going into effect, the price effects for consumers might become more tangible. <b><span style="color: red;">The nation’s largest retailer this week warned that it might be forced to charge higher prices</span></b>.<br />In its statement earlier this week, the Federal Reserve noted that “inflation on a 12-month basis is expected to move up in coming months” before eventually stabilizing near the Fed’s 2% target rate." - source Wells Fargo</span></blockquote>
<span style="font-family: inherit;">Tariffs and rising gas prices do not bode well for the euphoric US consumer we think in the near future. Sure US equities, consumer confidence and even US High Yield have had a very good run in 2018 (CCCs have outperformed higher quality by a wide margin: +5.6% of excess returns) in comparison to the rest of the world, so it's highly likely that the "risk-on" euphoric mood will continue given financial conditions are still fairly accommodative (as per the most recent Fed SLOOs), but we think that 2019 could start becoming much more challenging as QT accelerates and depending on the Fed's hiking path as we are officially out of negative real rates for now.</span><br />
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">In continuation to our “macro”
long conversation “</span><span style="line-height: 115%;"><a href="http://macronomy.blogspot.com/2018/09/macro-and-credit-money-illusion.html"><span lang="EN-US" style="line-height: 115%;">The Money illusion</span></a></span><span lang="EN-US" style="line-height: 115%;">”, where we concluded that liquidity
is a coward and where </span><span lang="EN-US" style="line-height: 115%;">we repeated what we indicated back in June 2015 from our conversation
"</span><span style="line-height: 115%;"><a href="http://macronomy.blogspot.com/2015/06/credit-third-punic-war.html"><span lang="EN-US" style="line-height: 115%;">The Third Punic War</span></a></span><span lang="EN-US" style="line-height: 115%;">", <b>bear
markets for US equities generally coincide with a significant tick up in core
inflation, </b>given the amount of buybacks since with the issuance of debt in many instances in our final charts below, we are wondering if there could be as well a "profit illusion" when it comes to the US markets.</span></span><br />
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;"><br /></span></span>
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;"><br /></span></span></div>
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<ul style="background-color: white; line-height: 20.8px; text-align: left;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final charts - The "profit" illusion</span></li>
</ul>
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<div style="text-align: justify;">
<span style="font-family: inherit;">Sure, liquidity is a coward and as many have pointed out, with dwindling inventories on banks balance sheet and the very significant rise in corporate debt issuance in credit markets, one can indeed ask if "liquidity" is an illusion. On the question of the "profit illusion" our final charts come from our esteemed former colleague David P. Goldman who now writes in Asia Times and ask if buybacks are creating the illusion of profit in his article from the 28th of September entitled "<a href="http://www.atimes.com/article/something-strange-is-happening-with-us-corporate-profits/">Something strange is happening with US corporate profits</a>":</span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;">"<b>Are companies creating the illusion of higher profits through stock buybacks? </b></span></blockquote>
<blockquote class="tr_bq">
<span style="font-family: inherit;">It was reported earlier this week that S&P 500 companies bought back a record US$189 billion of their own shares in the first quarter of this year. The buybacks make results look better than they really are, <a href="https://www.wsj.com/articles/companies-buy-earnings-gains-by-buying-back-stock-1537711201">as The Wall Street Journal reported</a>.</span></blockquote>
<blockquote class="tr_bq">
The charts below show that raw, unadjusted US corporate profits actually FELL year on year, and corporates are creating the illusion of higher profits by buying back shares.</blockquote>
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<a href="https://4.bp.blogspot.com/-9wr_DAnXWNM/W7JW_-lGqqI/AAAAAAAAUws/x5Gtm7tQXlMcENTgDDzGGyqumUYVjDElwCLcBGAs/s1600/Asia%2BTimes%2BDG%2B-%2Bnonfin%2Bcorp%2Bprofits.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="661" data-original-width="909" height="232" src="https://4.bp.blogspot.com/-9wr_DAnXWNM/W7JW_-lGqqI/AAAAAAAAUws/x5Gtm7tQXlMcENTgDDzGGyqumUYVjDElwCLcBGAs/s320/Asia%2BTimes%2BDG%2B-%2Bnonfin%2Bcorp%2Bprofits.jpg" width="320" /></a></div>
<blockquote class="tr_bq">
This is the rawest, simplest measure of profits, before tax and inventory/capital consumption adjustments, which are model driven. This is basically what corporations report on their income tax, and it doesn’t look terribly strong.</blockquote>
<blockquote class="tr_bq">
Are profits rising or falling? </blockquote>
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<a href="https://1.bp.blogspot.com/-vgOaIkAmZ94/W7JXnQhm3II/AAAAAAAAUw0/97amiiBfHug1NcndnOjLWK9D4wKrTpC3gCLcBGAs/s1600/Asia%2BTimes%2B-%2BDG%2B-%2BPretax%2BUS%2Bcorp%2Bprofits%2Bwith%2Band%2Bwithout%2Badjustments.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="661" data-original-width="909" height="232" src="https://1.bp.blogspot.com/-vgOaIkAmZ94/W7JXnQhm3II/AAAAAAAAUw0/97amiiBfHug1NcndnOjLWK9D4wKrTpC3gCLcBGAs/s320/Asia%2BTimes%2B-%2BDG%2B-%2BPretax%2BUS%2Bcorp%2Bprofits%2Bwith%2Band%2Bwithout%2Badjustments.jpg" width="320" /></a></div>
<div style="text-align: center;">
- source Asia Times - David P. Goldman</div>
<br />
One could contend that the boiling frog which is a fable describing a frog being slowly boiled alive, could be related to the Armstrong Limit looking at the altitude reached by equities and some valuation metrics. As a reminder, the premise of the fable is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for our inability or unwillingness to react to or be aware of sinister threats that arise gradually rather than suddenly such as the markets we are seeing one could argue. Though some would add that "thermoregulation" by changing location is a fundamentally necessary survival strategy for frogs and other ectotherms, rendering the legend a "myth". From an Armstrong Limit perspective, we certainly hope that some investors have their "<a href="https://en.wikipedia.org/wiki/G-suit">g-suits</a>" on given the lofty levels reached in some instances. Also we do not know yet what is the Fed's own "Armstrong limit" in their current hiking path but we ramble again...<br />
<span style="font-family: inherit;"><br /></span>
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<blockquote class="tr_bq">
"There can be no rise in the value of labour without a fall of profits." - David Ricardo</blockquote>
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<span style="font-family: inherit;">Stay tuned !</span></div>
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Anonymousnoreply@blogger.com0tag:blogger.com,1999:blog-8554347448299984407.post-89979351565496588542018-09-24T22:17:00.000+01:002018-10-01T16:21:06.101+01:00Macro and Credit - White Tiger<div dir="ltr" style="text-align: left;" trbidi="on">
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets." - Stanley Druckenmiller</span></blockquote>
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<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">Watching with interest the trade war between the United States and China ratcheting up with Beijing cancelling its plans to send two delegations to Washington, given the season of fall is upon us, when it came to selecting our title analogy, we decided to go for "White Tiger". The White Tiger is one of the four symbols of the Chines constellations. It is sometimes called the White Tiger of the West and represents the West in terms of direction as well as the autumn season. It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, or if there was peace throughout the world. Obviously for those who remember our June conversation "<a href="https://macronomy.blogspot.com/2018/06/macro-and-credit-prometheus-unbound.html">Prometheus Unbound</a>", we argued the following:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by <a href="https://www.theatlantic.com/international/archive/2015/09/united-states-china-war-thucydides-trap/406756/">Graham Allison</a> former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:<br />- source Macronomics June 2016 </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War" -</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">In similar fashion, more recently maverick hedge fund manager Ray Dalio came to a similar prognosis in his recent musing entitled "<a href="https://www.linkedin.com/pulse/path-war-ray-dalio/">A Path to War</a>" on the 19th of September:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b><span style="color: red;">The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history</span></b>. It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do. In either case, it is well-recognized as classic by historians. The following sentence describes it as I see it in a nutshell:</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful. In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects. What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric. At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them. That continues until the cycle begins again (because of a rival power emerging).</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Appreciating this big economic/geopolitical cycle that drives the ascendancies and declines of empires and their reserve currencies requires taking a much longer (250-year) time frame, which I will touch on briefly here and in more detail in a future report.<br />Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur. However, that is not always the case. History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists. The two types of relationships are:</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want. In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in. In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path. Both sides will inevitably follow the same approach.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In the back of the minds of all parties, regardless of which path they choose, should be their relative powers. In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it. When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way. On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive. That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again." - source Ray Dalio</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Because the color white of the Wu Xing theory also represents the west, the white tiger became a mythological guardian of the West on the mythological compass. The White Tiger is as well considered in China as the ruler of the Autumn and the governor of the metallic elementals (hint for you gold bugs out there...) but we ramble again. Will the age of reason disappear with the White Tiger? We wonder.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="background-color: white;"><span style="font-family: inherit;">In this week's conversation, we would like to look at the gradual path towards recession in the US and how does the credit cycle will end.</span></span></div>
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<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
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<div style="background-color: white; line-height: 20.8px;">
<b><u><span style="font-family: inherit;">Synopsis:</span></u></b></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Macro and Credit - Credit cycles die of "old age". </span></b></i></li>
<li style="line-height: 20.8px; text-align: justify;"><i><b><span style="font-family: inherit;">Final chart - Hey Fed, NAIRU this!</span></b></i></li>
</ul>
</div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><b><span style="font-family: inherit;">Macro and Credit - Credit cycles die of "old age". </span></b></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">While many pundits have been focusing on the continuation of the flattening of the yield curve, as we pointed out in our most recent conversation again, credit cycles die because too much debt has been raised. What the most recent Fed quarterly survey Senior Loan Officers Opinion Survey (SLOOs) tells us is that financial conditions remain very benign still. Yet, no one can ignore the hiking path followed by the Fed and that already some part of the economy such as housing are already feeling the heat and the gradual tightening noose of financial conditions. </span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">From a "White Tiger" perspective, a full-blown trade war between China and the United States would push US companies to pass on prices increases onto the US consumer. Any acceleration in inflation would lead to the Fed to be more aggressive with its hiking stance. The rhetoric of Fed members in recent week has become decisively more “hawkish”.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">First question we are asking ourselves is when does the US consumer gets "maxed out"? We are already seeing credit card usage surging as well as the return of housing equity extraction thanks to the return of HELOC. On this subject we read with interest Wells Fargo Economics Group note from the 18th of September entitled "Consumer outlook in a rising rate environment":</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>Executive Summary</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span style="color: red;">Conventional wisdom has it that rising interest rates are bad for consumer spending because swelling financing costs put a squeeze on a household’s capacity for other outlays</span>. What if conventional wisdom is wrong? Our analysis finds that a rising interest rate environment does not immediately snuff out consumer spending growth.</span></blockquote>
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<span style="font-family: inherit;">As the current expansion stretches further into its tenth year, the economy is on track to eclipse the expansion of the 1990s as the longest on record. In this report we consider the outlook for consumer spending against this backdrop of a record-setting expansion and consider how long the good times will last. Our base-case scenario, spelled out in this special report, anticipates a modest pick-up in consumer spending, at least in the near term. <b><span style="color: red;">Eventually, like all good things, the longest economic expansion on record will come to an end and consumer spending will come back down with it</span></b>. That will likely occur alongside financial conditions that warrant rate cuts by the Fed. <span style="color: red;">The precise timing of these events is tough to get right, but by signaling this drop-off in activity in late 2020</span>, we are essentially saying that while the end of the party is not imminent, no cycle lasts forever.</span></blockquote>
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<span style="font-family: inherit;">- Source Bloomberg LP, The Conference Board, University of Michigan and Wells Fargo Securities</span></div>
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<span style="font-family: inherit;">As per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return:</span></div>
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<a href="https://3.bp.blogspot.com/-6Ok4IfmQaQ0/W6kY3DkE1zI/AAAAAAAAUro/BwFe0kxk-k0QMQnO2Cr7BEJYwedBR5O-wCLcBGAs/s1600/Macrobond%2B-%2BUMICH%2BConsumer%2BConfidence%2Band%2Bthe%2BStock%2BMarkets%2B.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="301" data-original-width="859" height="112" src="https://3.bp.blogspot.com/-6Ok4IfmQaQ0/W6kY3DkE1zI/AAAAAAAAUro/BwFe0kxk-k0QMQnO2Cr7BEJYwedBR5O-wCLcBGAs/s320/Macrobond%2B-%2BUMICH%2BConsumer%2BConfidence%2Band%2Bthe%2BStock%2BMarkets%2B.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">- source Macrobond (click to enlarge).</span></div>
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<span style="font-family: inherit;">Before we go into more details of Wells Fargo's note, there are a couple of points we would like to make. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77%. Also back in March in our long conversation "<a href="https://macronomy.blogspot.com/2018/03/macro-and-credit-intermezzo.html">Intermezzo</a>", when it comes to consumer credit, as pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see. We pointed out the following from Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon":</span></div>
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<span style="font-family: inherit;">"<b>Items to watch</b></span></blockquote>
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<span style="font-family: inherit;"><b>Lower income consumers are more levered than they appear:</b> The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). <b><span style="color: red;">Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%</span></b>. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.</span></blockquote>
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<span style="font-family: inherit;"><b>The subprime/low income consumer is stretched: </b>Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt. </span></blockquote>
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<a href="https://4.bp.blogspot.com/-dQErcwstolo/W6kavrrAahI/AAAAAAAAUsA/MkwXhtaHVs0GYc2YLn8jJxVALeCfoNTNACLcBGAs/s1600/DB%2B-%2BNearly%2B18pct%2Bof%2Bconsumer%2Bspending%2Bis%2Bgoing%2Bto%2Bhealthcare%2Bcosts%2Ban%2BATH.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="425" data-original-width="584" height="232" src="https://4.bp.blogspot.com/-dQErcwstolo/W6kavrrAahI/AAAAAAAAUsA/MkwXhtaHVs0GYc2YLn8jJxVALeCfoNTNACLcBGAs/s320/DB%2B-%2BNearly%2B18pct%2Bof%2Bconsumer%2Bspending%2Bis%2Bgoing%2Bto%2Bhealthcare%2Bcosts%2Ban%2BATH.jpg" width="320" /></span></a></div>
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<span style="font-family: inherit;">Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).</span></blockquote>
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<span style="font-family: inherit;"><b>Socio-economic divide driving credit cycle: </b>While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, <b><span style="color: red;">a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge</span></b>." - source Deutsche Bank</span></blockquote>
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<span style="font-family: inherit;">The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles.</span></div>
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<span style="font-family: inherit;">But let's return to Wells Fargo's take:</span></div>
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<span style="font-family: inherit;">"<b>A Consumer Spending Framework in the Context of Rates</b></span></blockquote>
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<span style="font-family: inherit;">As we would at any time in the business cycle, we consider the macro drivers of consumer behavior. Consumer sentiment and confidence, by about any measure, are at or near high levels last seen around 2001; which, not coincidentally, was in the late stages of that prior long-lasting expansion (Figures 1 & 2). We also look at the purchasing power in consumers’ wallets, be it in the form of personal income, which is at last picking up (albeit in only a modest way) or in access to capital through borrowing, where measures of revolving consumer credit growth indicate a levelling off more recently. Finally, we tally the actual spending numbers reflected in the personal income and spending report and the monthly retail sales numbers, both of which have been on a roll in recent months.</span></blockquote>
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<span style="font-family: inherit;">In an effort to better inform a consumer outlook, it is essential to have a framework for thinking about these fundamentals and how households will manage finances at this late stage of the cycle. The trouble with considering this period in the context of what has happened in prior cycles is that for a long stretch in the current cycle, from December 2008 until December 2015, the Federal Reserve maintained a near zero interest rate policy (ZIRP), and at various points during those years was engaged in a broad expansion of the balance sheet through quantitative easing (QE), (Figures 3 & 4). </span></blockquote>
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<span style="font-family: inherit;">- source Federal Reserve System and Wells Fargo Securities</span></div>
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<span style="font-family: inherit;">The Fed has historically purchased Treasury securities to expand the monetary base, although the monetary policy “medicine” applied during that era, including the purchases of mortgage-backed securities and other assets, had not been tried before, at least not in the United States.</span></blockquote>
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<span style="font-family: inherit;">Central bank actions, no doubt, are a factor in the remarkable duration of the current cycle, and on that basis any informed outlook for consumer spending ought to not only consider these macro drivers (like confidence, access to capital and willingness to spend) but to consider them in the context of Fed policy.</span></blockquote>
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<span style="font-family: inherit;">To that end, we went back to just before the 1990s expansion began in 1989 and divided the years since into four broad categories based on what the Federal Reserve was doing with monetary policy at the time: (1) lowering the fed funds rate, (2) a “stable” rate environment, (3) raising the fed funds rate and (4) ZIRP with QE.</span></blockquote>
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<span style="font-family: inherit;">The date ranges for each of these periods is spelled out in Table 1 below. </span></blockquote>
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<span style="font-family: inherit;">Most of the time periods are straightforward, although the one period that might invite critique is that we have characterized the time period from March of 1995 through January 2001 as “stable” (revisit Figure 3).</span></blockquote>
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<span style="font-family: inherit;">One could reasonably observe that the fed funds rate actually moved up and down during that nearly six-year stretch. Our argument for calling it “stable” is that this period was essentially from the “mid-cycle” slowdown until the end of that expansion. Admittedly, there were adjustments up and down throughout the period, but from the start of the period to the end, the funds rate finished just 50 basis points higher. Reasonable minds could disagree, but in our view, the idea of thinking of that period as four unique rate cycles would unnecessarily complicate our analysis.</span></blockquote>
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<span style="font-family: inherit;">With our various Fed cycle dates established, we looked at our macro drivers for consumer spending through the lens of the Fed policy that was in place at the time. For each interest rate backdrop, we calculated the average levels for various measures of <b>consumer confidence</b>, the average annualized growth rate of <b>personal income</b>, the average net monthly expansion in <b>consumer credit</b> and finally the average annual growth rates of both <b>real personal consumption expenditures</b> and of <b>nominal retail sales</b>.</span></blockquote>
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<span style="font-family: inherit;">A key takeaway from our exercise, depicted in Table 2 below, is that measures of consumer fundamentals tend to do best in periods of stable interest rates. Interestingly though, a rising rate environment is almost as good for these same consumer fundamentals. </span></blockquote>
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<span style="font-family: inherit;">Perhaps that is not altogether surprising, considering that the Fed is apt to raise rates when the economy is at full employment and inflation is heating up beyond the Fed’s comfort zone. Those factors tend to exist when the economy is doing particularly well or even overheating.</span></blockquote>
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<span style="font-family: inherit;">The inverse of that dynamic may explain why the worst rate theme for consumer spending is during periods when the Fed is lowering rates. Personal income and spending as well as nominal retail sales all performed worst during periods when the Fed was cutting rates. Interestingly, the lowering of interest rates does not compel consumers to increase their appetite for credit, at least not immediately. The average net monthly increase in consumer credit came in a distant last during periods when the Fed was actively lowering rates.</span></blockquote>
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<b><span style="font-family: inherit;">2020 Vision</span></b></blockquote>
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<span style="font-family: inherit;">So what sort of Fed policy theme should we consider looking forward? To judge from the Fed’s dot plot, a visual rendering of policymakers’ own forecasts for the fed funds rate, the FOMC is closing in on its neutral rate for fed funds. With most dots clustered around 3.00 to 3.25% and the current fed funds rate at 2.00%, there are only four or five quarter-point rate hikes left to go in the current cycle, barring some change in forward guidance from the Fed (Figure 5). </span></blockquote>
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<span style="font-family: inherit;">Our forecast anticipates two more hikes this year and another three next year. After that it stands to reason we would be in a stable rate environment slightly above the neutral rate until the Fed’s understanding of r* changes (favoring another hike) or until conditions warrant a cut. In a separate special report1, we explained our use of an analytical framework we recently developed to inform our view of Fed policy going forward and why we look for the FOMC to raise rates another 125 bps before it cuts rates at the end of 2020.</span></blockquote>
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<span style="font-family: inherit;">In forming our outlook for the consumer, we take the findings of our rate-environment study and overlay them with our expectations for Fed policy over the next couple of years. If things play out the way we anticipate, monetary policy is entering an era of transition unlike anything the economy has seen in more than a decade. For a number of factors including the longevity of the cycle, growing fiscal budget imbalances and a potential fallout from the global economy, we indicated in our initial 2020 forecast that by the end of our forecast horizon the Fed would likely begin cutting the fed funds rate.2 A rate-tightening environment is expected to prevail at least through the first part of 2019, which will be followed by a stable rate for another year or so before the Fed begins to signal eventual rate cuts.</span></blockquote>
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<span style="font-family: inherit;">For the consumer, this Fed forecast implies a pick-up in the pace of consumer spending in the near term before an eventual slowing the further out we go in the forecast period. Full year PCE growth was 2.5% in 2017. By the time we close the books on the current year, we expect the comparable number for 2018 to pick up to 2.6%, prior to quickening to 2.7% in 2019 and slowing to just 2.2% in 2020 (Figure 6).</span></blockquote>
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<span style="font-family: inherit;">- Source: Bloomberg LP, Federal Reserve Board, U.S. Department of Commerce and Wells Fargo Securities</span></blockquote>
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<b><span style="font-family: inherit;">Outlook</span></b></blockquote>
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<span style="font-family: inherit;">Consumers may be better prepared to endure a slowdown than in the past. The saving rate, currently at 6.7%, is rather elevated given the late stage of expansion, while real median household income surpassed its pre-recession peak in 2017. With the unemployment rate currently matching low levels last seen in the late 1960s, there remains little slack in the economy. The labor market is expected to grow increasingly tight, with the unemployment rate trending to as low as 3.3% by 2020. Similarly, inflationary pressures that continue to gradually build over our forecast horizon will put downward pressure on real income gains.</span></blockquote>
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<span style="font-family: inherit;">The length of the current expansion is expected to surpass that of the 1990s, taking the title as the longest expansion on record. <b><span style="color: red;">While monetary policy changes act as signals to markets about the health of the economy and/or concerns about inflation expectations, we must be sensitive to policy movements and their implication for consumer spending</span></b>. Our initial 2020 forecast expects the Fed to surpass its neutral rate, prior to beginning to cut policy by the end of 2020. <b><span style="color: red;">With this signal of a slowdown in activity, we are essentially saying that this expansion will eventually draw to a close</span></b>. The rate cutting environment will act as a last call announcement – and for the consumer sector it serves as a valuable indication for longevity of this expansion." - source Wells Fargo</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Whereas we agree with the timing, we disagree with the perceived health of the US consumer, as per the above points illustrated in a previous Deutsche Bank research note. There is more leverage than what can be seen, not only when it comes to the US consumer but as well when it comes to the distorted balance sheets of many US corporates after years of a buy-back binge and a fall in the quality of the overall rating for the Investment Grade category much closer to "junk" than in the previous cycle.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div class="MsoNormal" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">Overall the timing for the end of the credit cycle could indeed be in the region of 2020. This is as well Ray Dalio's most recent view and also Christopher R. Cole, CFA
from Artemis Capital Management as per his July
2018 letter entitled “</span><a href="https://static1.squarespace.com/static/5581f17ee4b01f59c2b1513a/t/5ba146f40ebbe8c212e8b7c7/1537296120640/Artemis+Letter+to+Investors_What+is+Water_July2018_2.pdf"><span lang="EN-US" style="line-height: 115%;">What is water?</span></a><span lang="EN-US" style="line-height: 115%;">”:<o:p></o:p></span></span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">“When you are a fish swimming
in a pond with less and less water, you had best pay attention to the currents.
The last decade we’ve seen central banks supply liquidity, providing an
artificial bid underneath markets. Now water is being drained from the pond as
the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest
rates.</span><span lang="EN-US" style="line-height: 115%;">Despite this trend, U.S.
equities will very likely escape 2018 without a crisis or volatility regime
shift because of the one-time wave of corporate liquidity unleashed by tax
reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by
dust storms of debt refinancing, quantitative tightening, and poor demographics
causes liquidity to evaporate.”</span><span lang="EN-US" style="line-height: 115%;"> – Source Christopher R. Cole, CFA from Artemis Capital Management<o:p></o:p></span></span></blockquote>
<div style="text-align: justify;">
</div>
<div class="MsoNormal" style="text-align: justify;">
<span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;">The whole note written by Christopher R. Cole is worth
a read particularly on the subject of passive management and liquidity. His quote
from above resonates as well with our opening quote from maverick investor
Stanley Druckenmiller.<o:p></o:p></span></span></div>
<span style="font-family: inherit;"><br /></span>
<span style="font-family: inherit;"> As well in his note, Christopher R. Cole indicates when he thinks we will most likely have another crisis on our hands:</span><br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">“When does this all end? If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<b><span lang="EN-US" style="line-height: 115%;"><span style="font-family: inherit;">A crisis-level drought in liquidity is coming between
2019 to 2022 marked by a perfect dust storm of unprecedented debt supply,
quantitative tightening, and demographic outflows.</span></span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><span lang="EN-US" style="line-height: 115%;">Quantitative easing has caused
the natural relationship between corporate debt expansion and default rates to
break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and
high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d).
This is not sustainable. <b><span style="color: red;">Years of cheap money has led scores of investors to
buy debt at levels that do not reflect credit risk</span></b>. The poster child is the
2017 issuance of 100-year Argentina bonds (USD denominated) that were
oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where
Argentina has not defaulted, much less a century. That medium of bond market
demand has already begun to show signs of cracking.”</span><span lang="EN-US" style="line-height: 115%;"> – Source Christopher R. Cole, CFA from Artemis Capital
Management<o:p></o:p></span></span></blockquote>
<span style="font-family: inherit;">Fiduciary duty anyone? Credit cycles tend to die of old age and too much debt. We have entered the season of the White Tiger we think. Only a few innings left. </span><br />
<span style="font-family: inherit;"><br /></span>
<br />
<div style="text-align: justify;">
<span style="font-family: inherit;">On the current evolution of the credit cycle we read with interest Bank of America Merrill Lynch's take in their High Yield Strategy note from the 21st of September entitled "The Evolution of the Credit Cycle:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"<b>The Evolution of the Credit Cycle</b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">As we continue to study the state of the current credit cycle, the accumulated evidence sides with the argument that it has more room to develop, as long as few more years. Previous cycles have lasted anywhere between 6-8 years, on average, and this observation would make it an unusual development to see the current cycle extend for much longer. However, we also note that more broadly, this economic cycle has been an unusual one in many respects, including how long it took the US GDP to return to trend growth rates, the unemployment to decline, and the inflation to recover. And if those major macroeconomic variables took an unusually long time to return to normal levels, then why should we expect the credit cycle to be an average one?</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Away from this argument, we also continue to believe that the commodity episode in 2015-2016 represented a partial cycle in and of itself. Among the most conclusive pieces of evidence in support of this view, we present the charts in Figure 3 for debt growth and Figure 4 for capex. </span></blockquote>
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<a href="https://4.bp.blogspot.com/-i3RrBWY_ebw/W6lFhi9wI3I/AAAAAAAAUtE/Tmoon78pjPwSRRxkJNjDrS342eB0P07PQCLcBGAs/s1600/BAML%2B-%2BUS%2Bnon%2Bfinancial%2Bcorp%2Bdebt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="308" data-original-width="406" height="242" src="https://4.bp.blogspot.com/-i3RrBWY_ebw/W6lFhi9wI3I/AAAAAAAAUtE/Tmoon78pjPwSRRxkJNjDrS342eB0P07PQCLcBGAs/s320/BAML%2B-%2BUS%2Bnon%2Bfinancial%2Bcorp%2Bdebt.jpg" width="320" /></span></a></div>
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<a href="https://3.bp.blogspot.com/-wUYoKIskXSw/W6lGcS0-24I/AAAAAAAAUtQ/J1D_0mOWIN0LiHEG_vkY99yIIsivhJW5wCLcBGAs/s1600/BAML%2B-%2BUS%2Bnon-financial%2Bcorporate%2Bcapex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="325" data-original-width="406" height="256" src="https://3.bp.blogspot.com/-wUYoKIskXSw/W6lGcS0-24I/AAAAAAAAUtQ/J1D_0mOWIN0LiHEG_vkY99yIIsivhJW5wCLcBGAs/s320/BAML%2B-%2BUS%2Bnon-financial%2Bcorporate%2Bcapex.jpg" width="320" /></span></a></div>
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<a href="https://2.bp.blogspot.com/-5hXzEDU3bxo/W6lG1bdboDI/AAAAAAAAUtY/Vwbfx4gXY-Yugm58UJmeByEQwbqDuj6FACLcBGAs/s1600/BAML%2B-%2BUS%2Bnon-financial%2Bcorporate%2Bcapex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="325" data-original-width="406" height="256" src="https://2.bp.blogspot.com/-5hXzEDU3bxo/W6lG1bdboDI/AAAAAAAAUtY/Vwbfx4gXY-Yugm58UJmeByEQwbqDuj6FACLcBGAs/s320/BAML%2B-%2BUS%2Bnon-financial%2Bcorporate%2Bcapex.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In both cases, we highlight cyclical turns, as defined by catalyst events as the starting points and subsequent observed peaks in trailing 12mo HY issuer default rates as ending points.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Both graphs suggest that previous cyclical turns have occurred at similar points on each respective line, had similar impact on each measure, and had left them at similar levels after defaults receded. Both graphs also suggest that a cyclical turn at current levels and given their recent trends would be inconsistent with historical experiences going into previous default cycles.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">And yet, inconsistent does not imply impossible, particularly in light of trade tariffs that are being threatened and imposed by the Trump Administration. It remains our view that at the end, these policies are unlikely to survive the test of time, however it is difficult to say how much time it would take to prove them wrong and how much damage they could do in the meantime.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">The exact timing of cyclical turns is an inherently uncertain exercise and we do not claim to possess superior skills to do so. Instead, our approach relies on using all available data and analytical tools to help us make a judgment on a relatively short next-12mo time horizon, and continue doing so as time progresses and new data becomes available. As such, we made a call that this cycle was unlikely to turn at this point last year. With all the evidence we accumulated since then, we believe this view still holds today.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Our default model continues to suggest low likelihood of a meaningful spike in defaults over the next year, based on its latest inputs. It currently projects a 3.25% issuer weighted rate during this time period, marginally lower than the actual realized 3.41% rate as calculated by Moody’s (Figure 5). A 3.25% issuer default rate would be consistent with 2.0% par-weighted rate. </span></blockquote>
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<a href="https://2.bp.blogspot.com/-qJqDk0hZsXw/W6lHmhN4HJI/AAAAAAAAUtk/yJwaIAPOE3oZJk0rEqsjNNy8iv3NQ1zkwCLcBGAs/s1600/BAML%2B-%2BActual%2Bvs%2Bestimated%2B12mo%2BHY%2Bissuer%2Bdefault%2Brates.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="315" data-original-width="401" height="251" src="https://2.bp.blogspot.com/-qJqDk0hZsXw/W6lHmhN4HJI/AAAAAAAAUtk/yJwaIAPOE3oZJk0rEqsjNNy8iv3NQ1zkwCLcBGAs/s320/BAML%2B-%2BActual%2Bvs%2Bestimated%2B12mo%2BHY%2Bissuer%2Bdefault%2Brates.jpg" width="320" /></span></a></div>
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<a href="https://2.bp.blogspot.com/-X4wPq-fPoTo/W6lH1n7XiLI/AAAAAAAAUto/3ha2TbaH6VI7YoYrYOLstHnWFHFzhiIpwCLcBGAs/s1600/BAML%2B-%2BEstimated%2Bdefault%2Brates%2Bby%2Btime%2Bhorizon.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="313" data-original-width="400" height="250" src="https://2.bp.blogspot.com/-X4wPq-fPoTo/W6lH1n7XiLI/AAAAAAAAUto/3ha2TbaH6VI7YoYrYOLstHnWFHFzhiIpwCLcBGAs/s320/BAML%2B-%2BEstimated%2Bdefault%2Brates%2Bby%2Btime%2Bhorizon.jpg" width="320" /></span></a></div>
<span style="font-family: inherit;"><br /></span>
<br />
<blockquote class="tr_bq" style="text-align: justify;">
<b><span style="font-family: inherit;">How it ends?</span></b></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">In our last year’s outlook on the prospects of this credit cycle, we listed<b><span style="color: red;"> three key risks to its longevity: (1) inflation spike; (2) trade contraction; and (3) sector distress</span></b>. We think all three remain valid and potent sources of known risks going forward as well. In our judgment, the spike in inflation remains a lower probability risk, followed by trade contraction, somewhat higher on our scale of likely developments, and still inside of a tail risk zone.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">A contraction in one of the key industry sectors is a higher probability outcome, in our opinion, albeit not an imminent one. Previously, we published our thoughts on capital allocation trends across various sectors, and identified healthcare as the most overextended sector in terms of the amount of capital raised in recent years.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">A higher capital formation could lead to higher capex, higher production capacity, higher supply, lower prices, and an eventual need to remove excess capacity. The latter stage often goes hand in hand with a need to eliminate excess debt that was used to finance excess capex.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;"><b><span style="color: red;">Other sectors that we found to be overextended on this scale include autos, utilities, and food producers, although these three are relatively small compared to healthcare.</span></b></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">And at the end of this conversation on risks, we think it is also important to remind ourselves that previous cycles have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. We do not see any particular reasons as to why the next one would break out of this mold." - source Bank of America Merrill Lynch</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">From our "White Tiger" perspective, an inflation spike is something very much on our radar, hence our close attention to market gyrations in oil prices and geopolitical risk, the famous known unknowns which have been building up recently in world which has decisively moved from cooperation to noncooperation.</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">As we have stated above, many pundits are focusing on the flattening of the yield curve, from an employment and non-accelerating inflation rate of unemployment (NAIRU), Monetary policy conducted typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure, we think the Fed will once again be behind the curve as per our final chart.</span></div>
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<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<ul style="background-color: white; line-height: 20.8px;">
<li style="line-height: 20.8px; text-align: justify;"><span style="font-family: inherit;">Final chart - Hey Fed, NAIRU this!</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">In our previous conversation we discussed the great work of American economist Irving Fisher, in relation to NAIRU, the concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus, the famous dual mandate of the Fed. We won't go into more details about our fondness of the Phillips curve, it's a subject we have discussed on this very blog on many occasions. Our final chart comes from Deutsche Bank's US Economic Perspectives note from the 20th of September entitled "How the Powell Fed can make history" and shows that the Fed has never succeeded in returning unemployment to NAIRU from below without a recession ensuing:</span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"With unemployment now noticeably below standard measures of its natural level of full employment and likely to tighten further and with wage and price inflation returning to desired levels and likely to continue upward, the Fed has a delicate task on its hands. It needs to begin to close the gap between growth of aggregate demand and aggregate supply in the economy — in other words, to slow and eventually reverse the tightening of the labor market before it risks pushing up inflation and inflation expectations excessively. The question is whether it can do so without pushing the economy into recession and causing unemployment to surge upward, overshooting its natural rate.</span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">Many in the market already see the storm clouds of recession gathering in the distance, a narrative that has found an ally in the flattening yield curve. Talk of a downturn by 2020 is increasingly in vogue and for good reason: a soft landing in unemployment from below NAIRU has never been achieved before. In the modern history of US national economic statistics since the late 1940s, every time the unemployment rate has overshot to the downside, policy firming by the Fed has helped drive the economy into recession (Figure 1).</span></blockquote>
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<a href="https://3.bp.blogspot.com/-PJUMskOD7fk/W6lPixLtXKI/AAAAAAAAUt4/0B0GvM44zDcu_QL4NV6t7VxTM7SFg_ecQCLcBGAs/s1600/DB%2B-%2BThe%2BFed%2Bfailure%2Bwith%2BNAIRU.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: inherit;"><img border="0" data-original-height="398" data-original-width="583" height="218" src="https://3.bp.blogspot.com/-PJUMskOD7fk/W6lPixLtXKI/AAAAAAAAUt4/0B0GvM44zDcu_QL4NV6t7VxTM7SFg_ecQCLcBGAs/s320/DB%2B-%2BThe%2BFed%2Bfailure%2Bwith%2BNAIRU.jpg" width="320" /></span></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">We think the Powell Fed can make history by achieving the unprecedented outcome of a soft landing from below sans recession." - source Deutsche Bank</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Contrary to the elements put forward in this very interesting note, we think that once again this time isn't different. On a final note we thought we had run out of arguments against the cult of the Philipps curve as per our conversation "<a href="https://macronomy.blogspot.com/2017/08/macro-and-credit-dead-parrot-sketch.html">The Dead Parrot Sketch</a>" back in August 2017, we did read additional arguments against the Phillips curve cult in Saad Filali's take on Seeking Alpha in his article "<a href="https://seekingalpha.com/article/4207592-inflation-much-supply-enough-unions">There Is No Inflation: Too Much Supply, Not Enough Unions</a>", which we found of great interest. It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, it could be said that the white tiger only appeared when the BIS ruled with absolute virtue as per <a href="https://www.bis.org/publ/qtrpdf/r_qt1809.pdf">their very interesting most recent quarterly survey</a>, but we digress...</span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: inherit;">"Liquidity is oxygen for a financial system." - Ruth Porat</span></blockquote>
<div style="text-align: justify;">
<span style="font-family: inherit;">Stay tuned!</span></div>
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