Macro and Credit - Anatomy of Criticism

"Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things." - Winston Churchill

Watching with keen interest, the continuation of the beta rally in both equities and credit, while looking at the weakening of the US duration trade on renewed discussions on tax reforms in the US as well as most recent macro data, when it came to electing this week's title analogy, given the growing change of narrative coming from our central bankers, we reminded ourselves of Canadian literary critic Northrop Frye's work entitled "Anatomy of Critiscim" from 1957. In Frye's Anatomy of Criticism, he deals extensively with what he calls myths of Spring, Summer, Fall, and Winter:

• Spring myths are comedies, that is, stories that lead from bad situations to happy endings. Shakespeare's Twelfth Night is such a story and QE 1 as well in addition to the suspension of mark to market accounting rules. and other supports provided by our "Generous gamblers" aka our central bankers.
• Summer myths are similarly utopian fantasies such as Dante's Paradiso or Universal Basic Income, or incredible valuation levels for Aramco's upcoming IPO.
• Fall myths are tragedies that lead from ideal situations to disaster. Compare Hamlet, Othello, and King Lear and the movie Legends of the Fall, or the referendum in Catalonia, or the ongoing face-off with North Korea.
• Winter myths are dystopias; for example, George Orwell's 1984, Aldous Huxley's Brave New World, and Ayn Rand's novella Anthem and the rise of the robots, including the spying of individuals through social networks and other means.

In similar fashion, all human narratives have certain universal, deep structural elements in common. Same things goes with credit and business cycle, no exception there. Our credit criticism in various musings have illustrated a rising unhealthy state of things to paraphrase Churchill. As we pointed out as well more recently, the beta rally is still going strong towards 11 that is, in true Spinal Tap fashion. After all records have to be broken on the way up as well as on the way down. But, contrary to the perma-bear crowd, we still think this rally has some more steam to go, given current financial loose conditions we are seeing, hence the outperformance of the beta play such as the CCC High Yield credit bucket this year. Of course there is always the exogenous risk factors at play, which could indeed spark some repricing in the on-going rally. We had the BREXIT, the Trump rally and now we have the on-going political tussle in Spain which we have decided to coin "FRACASTONIA" but we ramble again...Anyway, from a financial markets point of view in the coming weeks is the rising change of narrative from central bankers. Like in Disney's movie Fantasia, it's looks to us that our sorcerer's apprentice is starting to think it's liquidity injection via his magic broom is getting a little bit out of control, and for this little guy, financial stability matters, and matters a lot.

Dear readers, we would like to apologize for the lack of posting recently, but we have been travelling hence our difficulties in putting our thoughts down in our usual weekly fashion. In this week's conversation, we would like to look at if in credit, carry is still the trade du jour, or put it simply, is it still "beta max". Also from a macro perspective, we will look again at inflation from an autocorrelation problem perspective.

Synopsis:

• Macro - Inflation has an autocorrelation problem.
• Credit - Beta max? Don't get "carried" away.
• Final chart - A structural weakness in the labor market

• Macro - Inflation has an autocorrelation problem.

While we recently took many potshots at the Phillips Curve "cult members" and discussed also the change in markets fundamentals such as globalization and demographics which have to some extent weighted on the efficiency of the Fed's model, we would like to look at additional reasons why the Fed continues to deviate from its 2% inflation mandate and what it entails. On that subject we read with interest Wells Fargo's take from their note from the 3rd of October entitled "Is There an “Invisible Hand” Behind the 2 Percent Inflation Target Rate?":

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” - Mark Twain

Executive Summary 

The Federal Open Market Committee’s (FOMC) 2 percent inflation goal is often targeted by adjusting the FOMC’s monetary policy stance. The implicit assumption (or the invisible hand) behind the 2 percent inflation target is that the inflation rate is mean-reverting at the 2 percent rate. However, this assumption requires further inspection and raises questions regarding the possibility that the inflation rate would deviate from the target rate. Moreover, what is the behavior of above-/below-target inflation? Are these deviations temporary or permanent in nature? 

An inflation target plays a critical role in the FOMC’s monetary policy decision making process. Therefore, testing, instead of assuming, to determine if the PCE inflation rate is mean-reverting is crucial for decision-makers.

Our statistical analysis suggests that the PCE inflation rate may be mean-reverting, although the evidence is tenuous. So, can we assume inflation is mean-reverting, and what level of confidence do we have? A mean-reverting series, by definition, can fluctuate from its mean but eventually returns to some average value. The next challenge is to estimate the pace of adjustment. That is, how long does it take the inflation rate to return to the target rate after deviating from it? And does the PCE inflation series have a persistence/autocorrelation problem? 

Why is persistence/autocorrelation of the inflation rate a concern for decision-makers? Inflation persistence has crucial policy implications as a consistently below-/above-target inflation rate would suggest an accommodative/restrictive monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of monetary policy normalization would be a possible result if below-target inflation persists for an extended period of time. 

To Anticipate the Results 

Our analysis indicates that inflation has an autocorrelation problem. Put differently, when the inflation rate deviates from the target rate, inflation takes a long period to get back to the 2 percent target rate. One major reason is that the current inflation rates are highly correlated with the past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate than if autocorrelation were not present. For example, during the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months. 

Furthermore, persistently low inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the Phillips curve suggests an inverse relationship between the unemployment rate and inflation. The recent debate about the Phillips curve status is reflective of the characteristic that the original Phillips curve does not allow for an autocorrelation problem. Persistently low inflation may also explain part of the slower wage growth in recent years. Low inflation rates may reduce business production and their ability to raise prices, and, thereby, may affect profit margins in a low-productivity economy. The wage-price spiral may have lost its speed as well.

Source: U.S. Department of Labor and Wells Fargo Securities 

The 2 Percent Inflation Target Rate: Is Inflation Mean-Reverting? 

Statistically, if a series is mean-reverting then that series will move around its mean (the FOMC is assuming the 2 percent is the mean) and deviations from the mean (higher/lower inflation periods) are temporary in nature. As a policy model, the FOMC’s 2 percent target assumes, implicitly, the inflation rate is mean reverting. 

We live in a constantly changing world and need to test, instead of assume, that the PCE inflation rate is mean-reverting. We apply a unit root test (ADF test) to find out if the inflation rate is mean-reverting.1 The PCE deflator (year-over-year percent change) is the preferred inflation measure of the FOMC, and, thereby, we utilize that series in our analysis, Figure 1.

For the 1984-2017 period, we find the inflation rate is mean-reverting and the mean is 2.3 percent. In the next step, we apply the state space approach to test the possibility of a structural break in the inflation rate series. If we find a structural break in the inflation rate and the break coefficient is positive (negative), then that indicates the inflation rate has shifted upward (downward) since the break date. We found two breaks—one positive and the other negative. Both breaks represent the price swings during of the 2008-2009 financial crisis. Therefore, the inflation path temporarily shifted and then returned to the long run average—a typical behavior of a mean reverting series.

Autocorrelation: When Slow and Steady May Not Be Enough to Win the Race 

If a series is mean-reverting, the fluctuations from the mean are temporary—but fluctuations still exist. Thus, while inflation rates may deviate from the mean, it is crucial to find out the pace of adjustment. How long does it take inflation to get back to the mean? PCE inflation persistently above or below the 2 percent target rate is not ideal for the FOMC. Both of these scenarios would ask for an extended period of a particular monetary policy stance. One way to test if the inflation rate series has a persistence problem is to test for an autocorrelation. The inflation data having an autocorrelation problem would indicate that the farther the inflation rate deviates from the target rate, the longer the inflation rate would take to return to the 2 percent target rate.

We estimate autocorrelation functions (ACFs), and the estimated correlation coefficients are nonzero, statistically, for first 12 lagging months, Figure 2. Furthermore, if the estimated coefficients are non-zero then that indicates the underlying series has the autocorrelation problem. We found that the PCE inflation series is autocorrelated, which indicates current inflation rates are highly correlated with its past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate. During the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months.
This gives reason for the market’s expectation that the pace of monetary policy adjustment would be gradual as well. 

Why is the persistence/autocorrelation of the inflation rate noteworthy for monetary policy decision-makers? Inflation persistently below the target would indicate an accommodative monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of the monetary policy normalization is a possible result of persistently lower inflation. 

Final Thoughts: The Invisible-hand may need a Boost 

The mean-reverting along with lack of autocorrelation/persistence assumptions may be the ‘invisible hand’ behind the 2 percent target rate. However, our findings of autocorrelation suggest the invisible hand may need a boost. Moreover, the autocorrelation/persistence problem has broader implications for decision makers, as persistently lower inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the original Phillips curve does not anticipate an autocorrelation problem, Figure 3.

A persistently low inflation rate may also explain part of the slower wage growth in recent years. The persistently low inflation rate may reduce business production and their ability to raise prices and thereby may affect profit margins in a low-productivity era. The wage-price spiral may have lost its speed as well. Therefore, the invisible hand behind the inflation rate may need a boost." - source Wells Fargo

So on top of structural headwinds mentioned while criticizing the Phillips Curve model aka the Norwegian Blue parrot, inflation does suffer from an autocorrelation problem as well it seems. Furthermore, there has been rising discussions surrounding a potential return of inflation in recent weeks, not only on the blogosphere, but, as well from the sell-side. Concerns of the tightness in certain labor markets in Developed Markets (DM), make some sell-side pundits wonder if inflation could not make an unexpected return. Despite the low inflation conundrum discussed in various musings of ours, we do think that the change of the narrative from our central bankers is more a case of loose financial conditions than anything else. Regardless of the undershoot of the Fed's inflation mandate, we do think that Financial Stability matters more, when it comes to their rising discomfort with valuation levels reached in many asset classes. This is an important point put forward by Bank of America Merrill Lynch in their Liquid Insight notes from the 6th of October entitled "Jobs and FX":

"When central banks ignore low inflation 

Since the latest USD rally started in mid-August, the only currencies that have done even better than the USD are GBP and CAD. In all three cases, the respective central banks surprised markets with a hawkish turn, either hiking, as in the case of the BoC, or effectively announcing that a hike was on the way, as in the case of the Fed and the BoE. In all three cases, the real reason was not inflation concerns: UK inflation is above the BoE’s target, but mostly because of the sharp GBP drop since the Brexit referendum. Concerns that the labor market was getting too tight was the main reason, in our view, possibly leading to inflation pressure in the future. 

This suggests to us that many G10 central banks may either believe inflation is temporarily low, or that available inflation measures are missing something important. In Don’t fight the central banks when they want to do the right thing we argued that the Fed and most likely other central banks are also concerned about asset price bubbles and that they would take advantage of the “good times” to normalize policies, despite low inflation. It may not be their job to call a bubble, but it would also be irresponsible to allow bubbles to form. Leaning against the wind may be a good compliment to macro prudential measures, which have proved to have a mixed record anyway. 

Inflation could still surprise to the upside. The Phillips curve has lost its appeal, but the gap between labor markets and inflation is the widest it has been in recent decades (Chart 1). 

Some indicators suggest US inflation is not that low, with an index including a larger basket of goods suggesting US inflation is high and rising (Chart 2). 

Global monetary policies remain very loose in any case. A simple Taylor rule suggests that global monetary policies have never been looser than today in recent decades, with all G10 central banks having loose policies (Chart 3 and Chart 4).

Monetary policies have a long way to tighten before they become tight.

At the same time, while in recent years G10 central banks were involved in a form of a currency war, this has changed more recently. We believe Fed tightening—hikes and unwinding of its balance sheet—creates more room for other central banks to adjust their policies to a stance more consistent with their domestic conditions, without being concerned that their currencies may overshoot. 

Labor markets and FX valuations 

We are trying to assess possible inflation pressures by looking at the extent to which G10 labor markets are tight. Even if the Phillips curve is flat, or at least more flat than it used to be, recent central bank focus on labor market constraints suggests to us that the answer on which central banks are likely to move next may be in the labor market.
To do so, we do not have to know the natural rate of unemployment, which is difficult to estimate in practice. Instead, we look at the difference between the latest unemployment rate from the lowest level since 1980. It is reasonable to assume the smaller this gap, the tighter the labor market, and the more likely the central bank may want to tighten policies.
We then compare labor market tightness with valuation of G10 currencies. We also take a simple approach in FX valuation, by considering the z-scores of real effective exchange rates from their 20-year averages. Currencies that deviate the most from their historical average are likely to be the most misaligned. The results could provide insights on which G10 FX crosses could perform well in the medium term because of central bank policies, keeping everything else constant.

The Chart of the Day shows the results from this analysis, as follows:

• GBP/CHF has the most upside potential. The UK labor market is the tightest in G10, with the unemployment rate at an all-time low. At the same time, GBP is the most undervalued G10 currency. On the other hand, unemployment remains historically high in Switzerland, while the CHF is overvalued. Of course, Brexit uncertainty is what is keeping GBP weak. Still, our results suggest GBP/CHF has the most potential to appreciate in G10 if the BoE starts a hiking cycle, or if the UK and the EU agree on a Brexit transition. EUR/GBP will also weaken in this case, as the Eurozone has the highest unemployment rate compared with its own history.
• CHF/JPY could weaken. The cross is overvalued, while the labor market in Japan is tighter than in Switzerland. This is consistent with our bearish CHF outlook.
• The Scandies could do well against the Antipodeans. SEK and NOK are historically cheaper and with tighter labor markets than AUD and NZD. Our results also support buying CAD against AUD and NZD.
• The outlook for EUR/USD is mixed based on this analysis. Although the Eurozone has much higher unemployment than the US, EUR/USD is somewhat undervalued. This is consistent with our projections, expecting EUR/USD to weaken slightly more, to 1.15, by end-2017, but appreciate back to 1.19 in 2018.
• Similarly, our analysis suggests balanced risks for USD/JPY, with the US labor market tighter than in Japan, but USD/JPY overvalued.
• EUR/JPY on the other hand could weaken, as Japan’s labor market is tighter than in the Eurozone, while EUR/JPY is historically strong. However, this analysis does not take into account the ECB constraints, which are likely to force early QE tapering next year. If the BoJ remains committed to its loose monetary policies, EUR/JPY could even appreciate more—for these reasons, long EUR/JPY was one of our high conviction year-ahead trades for 2017. 

Bottom FX line 

Our analysis suggests possible surprises from central banks in G10 as they focus more on labor market conditions, despite low inflation, could support GBP against CHF and EUR, with the caveat of downside risks from Brexit negotiations. They could also support the Scandies, CAD and JPY against the Antipodeans, and could also be bearish for CHF/JPY. 

Although our results are mixed for the USD, as the US labor market is tight but the USD is not historically weak, we would argue the Fed will continue leading the normalization process, which should keep the USD supported. In any case, the USD is not far from its historical average, suggesting it could appreciate more in the short term. We expect Fed tightening to create more room for other central banks to follow, without being concerned that their currencies could overshoot. This suggests to us that the trigger to position for monetary policy divergence in G10 FX could be provided by the December Fed hike, particularly if markets move closer to the Fed’s dot plot for next year. Progress in US tax reform could have a similar impact, although with a much stronger USD
appreciation, in our view. " - source Bank of America Merrill Lynch

While we agree with Bank of America Merrill Lynch's view that the Fed and other central banks are also concerned about asset price bubbles, when it comes to USD strength, we have already seen a significant rally in a short period of time. A cause for concern we think, from an "Anatomy of Criticism" perspective lies in the growing trade war rhetoric between several countries. This would not be supportive of the USD dollar, on the contrary. While everyone is focusing on the US tax reform, we do think that it will be essential to monitor possible growing tensions in global trade in the months ahead.

When it comes to asset price bubbles, we also think that we continue to be on a trajectory of going to 11 that is, in true Spinal Tap fashion when it comes to valuation levels. We might have been overly defensive credit wise when it comes to the performance of the beta space and in particular the CCC High Yield bucket. It remains to be seen how long this game is going to continue. In the meantime flows remain supportive and the change in the narrative from our central bankers is yet to be perceived  as a meaningful threat by the investors crowd.

• Credit - Beta max? Don't get "carried" away.

Whereas we continue to witness a significant mountain of negative yielding assets globally, the credit mouse trap has been set by our central bankers. For investors starved of safe yield, anecdotally we even have seen Investment Grade investors with no choice but to reach out for more duration and more credit risk. No wonder they have gone for higher quality high yield, causing the BBs rating bucket to return a very decent 6.8% YTD. At the same time, low volatility and minimal credit losses, have led CCCs  credit canary to reward handsomely credit investors with a YTD of 9.8% according to Bank of America Merrill Lynch. The current low interest rates volatility is providing a "goldilocks" environment for credit. Unless there are some meaningful exogenous factors that come into play, it seems to many that the game of "carry" appears to be "bulletproof". 

As we pointed out in recent musings, no doubt to us that we will go to 11, valuation wise in true Spinal Tap fashion. On the subject of valuation for credit we read with interest Deutsche Bank's Credit Strategy note from the 20th of September entitled "Is Carry Still King?":

"Valuations even more stretchedThe performance seen through the summer has only served to make credit appear to be even more expensive as we head towards Q4. Figure 2 (left) updates our often used analysis highlighting where current spreads rank relative to their own histories for a broad selection of credit indices. As we stand all but two of the analysed indices are at a spread level tighter than the median. For EUR HY, spreads are at levels where they have been tighter less than about 15% of the time through history. It is not quite so extreme for IG but non-financial BBBs across all currencies are around the cusp of the tightest quartile. Looking at the right hand chart, which is focused on the rank history for EUR non-financials, we can see that we reached even tighter spreads in early August. 

In Figure 3 we look at EUR IG and HY non-financial spread histories to get a sense of where current spreads sit relative to levels going all the way back before the financial crisis. As can be seen, the current HY/IG spread ratio is near a record low and we continue to see HY valuations as stretched at an absolute level as well as relative to IG. Nevertheless, we are also cognizant of the fact that at the current stage of the economic cycle stretched valuations can persist for a while. Overall, we think HY would be more vulnerable in a sell-off following its recent outperformance.

Spreads supported by positive economic momentum 

In general, there's no doubting that across the credit spectrum valuations appear expensive. However continued performance has been supported by the solid macro backdrop. In particular European macro data have generally been strong in recent weeks/months. In Figure 4 we show our economists' SIREN monitors looking at indices summarising both economic growth momentum and macro surprises.

(For more information on these monitors, please see the relevant section in DB Focus Europe, available at goo.gl/8P8tJw.) The SIREN Momentum index has been in a new, higher range in the last six months, consistent with close to 2.5% annualised GDP growth. At the same time the SIREN Surprise index has also improved since the middle of the year, edging back into positive territory.

In addition to the supportive macro data we have also continued to operate against a backdrop of low volatility which tends to keep spreads tight. Measures of market volatility remain at the lower end of ranges and as such we couldn't entirely rule out some further spread compression. Updating our simple spread model looking at where implied equity, rates and FX volatility suggest that while HY spreads are broadly in line with the volatility-implied levels, for IG an argument can be made that spreads could get even tighter. But at the very least the charts suggest that if we don't see a meaningful move higher in volatility then spreads are likely to remain close to the current relatively tight levels. 

Will technicals provide some headwinds? 

Obviously, central banks remain a key driver of asset prices and in EUR credit, the ECB CSPP remains a powerful force keeping spreads in check. While we do expect the ECB to announce a further trimming of the overall QE programme on 26 October, we expect them to err on the side of caution given the absence of inflationary pressures. The ECB's exit from the bond market is likely to take place over an extended period of time even if the economy evolves according to their forecasts. While we do expect the negative technicals of a QE taper to lead to moderate widening of spreads, as long as economic fundamentals continue to be strong we would not expect a meaningful sell-off in credit." - source Deutsche Bank

Indeed, central banks remain the key driver of asset prices, hence the importance to track the change in their narrative. Both the Fed and the ECB will probably reduce the alcohol content of the credit punch bowl at a very slow pace.

While we advise for caution, the continuation of the rally in all things beta seems to be pointing towards the development of a state of euphoria. As long as the narrative of our generous gamblers doesn't meaningfully change or some exogenous factors comes into play (Catalonia aka "Fracastonia", North Korea and more...) it seems we are surely going to move towards the 11 level. After all records are meant to be broken. In this high stake poker games, it seems the margin for error is smaller by the day, we would rather tone down the enthusiasm and continue building some defenses. One could opine that given the on-going goldilocks period for credit thanks to low interest rates volatility, one should continue to play the "beta max" game as posited by Société Générale in their Credit Strategy Weekly note from the 29th of September entitled "Only a shock can shake credit":

"Only a shock can shake credit 

Into the last stretch of what has been another good year: The last quarter of the year is upon us, and so far the performance has been fairly healthy across the various credit asset classes. After surpassing all major political tests, there remains one hurdle in the form of the ECB meeting in late October. The risk is that the central bank announces a rapid withdrawal of QE support that disrupts the markets. Even a slow withdrawal is likely to be enough to push sovereign risks higher and put pressure on credit spreads, even if we believe that CSPP will be the last programme to be altered. At best, the ECB will simply announce an extension, and in that case it’s plain sailing until the end of the year. But a tapering announcement is not improbable, and in that sense we prefer to reduce duration, as we expect the credit curves to steepen. 

High beta sectors remain the place to be: Tapering or no tapering announcement, the higher beta sectors (AT1 CoCos, sub insurance, Tier 2 bonds and corporate hybrids) remain the better investment alternatives on both sides of the Atlantic, in our view. If there is no tapering, the high beta sectors, names and bonds will outperform given the higher carry and tightening potential. But if tapering does come and we see yields on a rising trend, then these sectors are likely to be the more volatile, but the higher breakevens will provide a better cushion and ultimately a better performance than low beta, low yielding, high rated and long maturity bonds." - source Société Générale

Whereas macro data continues to be supportive, from an "Anatomy of Criticism" perspective, only a change in the narrative from our "Generous Gamblers" constitute the largest threat to the investors crowd. The herd mentality continues to be strong in playing the beta game. When it comes to US Investment Grade Credit as shown by Bank of America Merril Lynch in their Situation Room report from the 11th of October entitled "New post-crisis tights" we are going to 11 in a Spinal Tap fashion:

"On Tuesday our benchmark US high grade index reached the tightest level at 103bps since the financial crisis. This follows the previous spread market peak over three years ago, when spreads bottomed out at 106bps on June 24, 2014 (Figure 1).

Here we update our analysis on where spreads stand currently relative the prior market peak in 2014 (see Vs. post-crisis tights). One factor contributing to tighter spreads currently are the large downgrades to high yield in 2015, mostly among EM credits. With many wider issuers out of the high grade index, EM spreads are now 40bps tighter than in June 2014, while DM issuer spreads are actually 3pbs wider." - source Bank of America Merrill Lynch

Thanks to low rate volatility, the carry game enables all sort of beta plays. Unfortunately, it is getting late in the game and central bankers have started to lower the volume in the credit binge party. You have been warned.

Whereas the latest job report was a miss, for our final chart, there is more to the low inflation story and its coming in the US from structural issues preventing an acceleration in wages increases and it has to do with the labor market.

• Final chart - A structural weakness in the labor market

We won't go through again all the arguments we have put forward for the Fed's broken Phillips Curve model, hopefully we have put that Norwegian Blue parrot to rest, no offense to the cult members out there. What is we think more interesting from a US macro perspective is that there is a structural weakness in the US labor market which, as pointed out by Wells Fargo in their report from the 6th of October entitled "Taking the Long View Over the Short Run Dip". The Beveridge curve shows that the mean duration of unemployment remains stubbornly high:

"Structural Problems Persist: Drag on GrowthFor any given unemployment rate (labor supply), the vacancy rate (job openings) remains wider than in the previous expansion (bottom graph), however the slack is gradually tightening. 

This Beveridge Curve signals a structural weakness in the labor market which is confirmed by several labor market survey indicators. Compared to a year ago, the unemployment rate for those without a high school education and with a high school diploma remains higher than the unemployment rate for those with some college. The mean duration of unemployment rate remains at 24.4 weeks which is higher than any level since 1982. Finally, the prime age labor force participation rate has risen over the last year but remains far below the level of participation since 1990." - source Wells Fargo

If inflation remains low, is also due to the fact that the prime age labor force participation rate hasn't been repaired and is still pretty much impaired. Fed minutes show concern that low inflation is not transitory. Whereas the Fed finds it mysterious that inflation is still so low, we don't. Maybe the Fed should start their own "Anatomy of Criticism" after all, but we ramble again...

"The true mystery of the world is the visible, not the invisible." -  Oscar Wilde

Stay tuned!

Macro and Credit - Experiments in the Revival of Organisms

"Life is obstinate and clings closest where it is most hated." -  Mary Shelley

Looking at the latest gyrations in risky markets including credit markets following our timely musing relating to "Gullibility", while thinking of our next post title we found it amusing the numerous attempts by various financial pundits in "reviving" the Phillips curve which we have been so critical of in recent conversations. For our title analogy we decided to steer towards the creepy given our title analogy refers to a 1940 Soviet motion picture which document Soviet research into the resuscitation of clinically dead organisms. It is available from the Prelinger Archives and is in the public domain. The creepy operations depicted are credited to Doctor Sergei Brukhonenko and Boris Levinskovsky who were demonstrating a special heart-lung apparatus called the autojektor (or autojector), also referred to as the heart-lung machine, to the Second Congress of Russian Pathologists in Moscow. Their modern "Frankenstein" experiments (involving decapitations) were related to the heart-lung machine. It was designed and constructed by Brukhonenko, whose work in the video is said to have led to the first operations on heart valves. The autojektor device demonstrated in the film is similar to modern ECMO machines, as well as the systems commonly used for renal dialysis in modern nephrology. The film depicts and discusses a series of medical experiments. It begins with British scientist J. B. S. Haldane appearing and discussing how he has personally seen the procedures carried out in the film and have saved lives during the war. The experiments start with a heart of canine, which is shown being isolated from a body; four tubes connected are then connected to the organ. 

You are probably asking yourselves already where we going with this creepy analogy of ours (after all being outright "scary" drives traffic for some blog pundits...), but in these Frankenstein markets to say the least, we found it amusing the attempts by so many including the PhDs are the Fed to cling on outdated models that were fit to purpose in their own time but not anymore. As pointed out by our friend Ilya Kislitskiy (@sayfuji on Twitter), resurrection is a complicated business, same thing goes with "Experiments in the Revival of Organisms":

"What can cause global anxiety? Maybe the fact that Phillips curve somewhere is "complicated" and "partially resurrecting" elsewhere? I definitely feel uncomfortable." - Ilya Kislitskiy (@sayfuji on Twitter)

Rest assured we do too, when it comes with macro old-school Phillips-curve-fans. Life is indeed obstinate, to paraphrase Mary Shelley, the author of Frankenstein. This is particularly the case with the Fed and the financial community when it comes to clinging to outdated models. It doesn't necessarily mean that these pundits' Phillips curve "autojektor device" will not eventually lead to a better model. In our book, for the time being, experiments in the revival of macroeconomic models such as the Phillips curve, defeat the purpose but we ramble again...

Also, when it comes to our analogy, Frankenstein markets comes to mind given Bondzilla, the NIRP monster has indeed become insatiable for anything with a yield. In similar fashion to Dr Frankenstein, our generous gamblers aka central bankers have become increasingly nervous with the "creatures" (or bubbles) they have spawned with their various resuscitation experiments and this is even without the exogenous geopolitical turmoil as of late. In recent years they have been doing various experiments in the revival of organisms, some European banks come to mind when we think about "zombies" in homage to recently departed horror film maverick director George A Romero. 

In this week's conversation, we would like to look at the need to continue building up your defenses in the credit space, meaning further rotation into higher quality in this overextended beta game given the accumulation of late cycle signs we are seeing.

Synopsis:

• Macro and Credit - Frankenstein markets thanks to our Modern Prometheus
• Final charts - Fun in Funds

• Macro and Credit - Frankenstein markets thanks to our Modern Prometheus

When one looks at a 70% rise in the VIX index over just three days, a 2% drop in global equities in conjunction with widening credit spreads including of course High Yield and the beta crowd, a young investor would have caught fright. But, in retrospect, this was merely a blip given our Dr Frankensteins are still busy with their central banking experiments. Obviously the big question is surrounding Bondzilla the NIRP monster, given the massive creature has been in growing in size since the start of our central bankers various iterations.

What is already starting to show credit weakness, we think is indeed coming initially from US Commercial Real Estate (CRE). Of course as we pointed out in our most recent conversation, consumer credit is another piece of the credit puzzle we watch carefully as this credit cycle unfolds and is indicative of the lateness of it.  Back in February in our conversation "Pareidolia" we pointed out the following:

"At this stage of the cycle, there is a tendency for excesses (real estate prices, subprime auto loans, etc.) to build up meaningfully. For instance, we have been monitoring the weakening demand for credit but in particular Commercial Real Estate given the latest Federal Reserve Senior Loan Officer Survey has shown that financial conditions have already started to tighten meaningfully in that space" - source Macronomics, February 2017

CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. By tracking the quarterly Senior Loan Officers Surveys (SLOOs) published by the Fed you can have a good view into credit conditions. Credit conditions for CRE have already started to tighten since a couple of quarters and from a valuation point of view, it does feel that we are close in many instances to "peak valuation". From a valuation perspective we read with interest Wells Fargo's note from the 14th of August entitled "CRE Deal Volume Shows Late-cycle behavior Q2 Chartbook" particularly the part linked to the Hotel segment of CRE:

• "Still reflecting the previous headwind of weak corporate profits and a stronger dollar, the seasonally adjusted real revenue per available room (RevPAR), which is the product of occupancy and the real average daily rate (ADR), fell to just 0.2 percent in Q2, year-over-year. That said, corporate profits were up more than 3 percent in Q1, and the dollar is softer suggesting there are some upside risks.

• Real RevPAR for higher-end hotels (luxury, upper upscale and upscale) posted its fifth straight year-over-year negative reading in six quarters in Q2, while the pace for lower-end hotels (mid- and economy-scale), has slowed significantly from its cycle peak of 8.0 percent in late-2014 to just 0.8 percent.

- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

Are we at "Peak Occupancy" in this rate cycles? It certainly looks this way to us. Also the negative trend in Real RevPAR growth is yet another sign that the credit cycle is slowly but surely turning we think.

It is fairly clear to us that when it comes to credit availability and lending, the CRE space indicates things are indeed slowing as per Wells Fargo's remarks from their report:

• "Senior loan officers reported that CRE lending standards tightened across the three categories while demand cooled during Q2. A net share of around 17 percent of banks, which is classified as “moderate,” reported tightening standards for construction and land development loans and multifamily.

• According to the Mortgage Bankers Association (MBA), total commercial/multifamily debt outstanding broke the $3 trillion mark in Q1. At 41 percent, commercial banks and thrifts still comprise the largest share of debt outstanding.
• Consistent with lending standards, loan growth in multifamily and construction and land development has slowed from its cycle high. Growth in income properties is also moderating.

- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

There are more signs from the CRE market alone that the credit cycle is slowly but surely turning and it is of course showing up in this market first.

When it comes to "Experiments in the Revival of Organisms", clearly the CRE market has reached record valuation levels as pointed out by Wells Fargo. Our Dr Frankensteins at the Fed should clearly be nervous about these lofty valuations levels we think:

"Elevated pricing (Figure 2) has also been a concern for investors, and we suspect the disconnect in pricing and transaction volume is also due to still-elevated levels of cross-border transactions.

Indeed, the low global rate environment and reach for yield, and in some cases, safe-haven plays made U.S. CRE a preferred asset class in many markets by foreign investors. With global economic conditions stabilizing, the risk of global deflation less of a concern, and hence, some major central banks expected to begin tightening monetary policy next year; investors are bracing for higher cap rates in the U.S. and abroad, and in turn, lower valuations. That said, the short and long-end of the curve are largely driven by different determinants. Moreover, cap rates don’t necessarily move in lock-step with the 10-year U.S. Treasury yield. On a global scale, the average cap rate in the U.S. in Q2 was the highest among the 11 countries tracked by RCA (e.g. France, Australia, etc.), with the risk premium still favorable at more than 400 basis points.

- Source: FDIC, Mortgage Bankers Association and Wells Fargo Securities

Sure valuation wise, as we pointed out in our most recent conversation "The Barnum effect", in these Frankenstein markets thanks to the modern Prometheus, already expensive asset classes such as European High Yield can become even more expensive thanks to central banking "Barnum effect". No doubt their Marshall amplifier can reach "11", as in the famous movie Spinal Tap. After all, as long as the Dr Frankensteins are in the game, you got to keep dancing right?

You are probably asking when the tide will be turning when it comes to the "Macro and Credit" picture. On this very subject we read with interest Barclays note from the 11th of August entitled "Macro Credit Framework: Let's be reasonable" where they update their framework for credit returns:

"With credit valuations near post-recession tights, we believe this is a good time to update our macroeconomic framework for credit returns. The core of our framework is that:

• For the purposes of forecasting credit performance, we can reduce the business cycle into two regimes: a steady state in which the economy is growing consistently and a transitional state that includes recessions plus de 12 months before and after. Macroeconomic indicators can signal which state the economy is in.
• Spreads evolve differently in the transitional state than in the steady state.
• Valuations are the key driver of returns for both steady and transitional states, but the distributions shape of those returns varies across regimes. 

- In the steady state, returns are more normal for a given valuation, and treating returns as normal should be adequate for rough estimates of returns and loss probabilities.

- Transitional state distributions are more skewed, making the distribution of expected returns rely more heavily on starting valuations.

Applying the framework to the current environment suggests a 70% chance of positive excess returns for BBB credits, with an expected return near carry (Figure 1 ). 

The macro framework suggests that we should expect 60-70bp of Six-Month Excess Returns for Corporate BBBs

Defining Business Cycle Regimes

For the purposes of making return forecasts, we believe that only two regimes really matter:

• Steady state is the default, covering periods of consistently positive economic growth that are the “expansion phase” of traditional business cycles. These phases have periods of both slower and faster growth, but without the sustained deterioration that marks a recession.
• Transitional states have been less frequent (especially in the past 30 years) and consist of recessions plus the 12 months preceding and following them.

There are number of reasons to condense the macro environment to only two regimes:

• There are clear differences in how credit returns behave in the two regimes with credit more likely to widen, and more likely to linger at wider spreads during transitional states (Figure 2).
  
  But further subdivision do not seem to add much information - for example, for a given valuation, there is not much difference in returns from "early" in a recession to "late" - so it is sensible to use fewer states.

• It makes it easier to define the conditions of being in each state, which makes it more likely that we will make the correct call. In general, we think it is relatively straightforward to understand when we are in a recession or its aftermath that means the only difficult call is whether we have moved from a steady to a transitional state.

Economic Indicators - Clue for Transitional Periods

The most challenging part of our framework is determining whether we have entered the transitional state, but we think there are useful indicators for when that happens. There are a number of layers to the process. First, the preconditions need to be in place. Then the timely indicators give us information about whether we are within the 12 months of a recession. Finally, a qualitative evaluation informs us whether our preferred signals are likely to have their usual reliability.

Preconditions for a Recession

Fed hiking cycles and tighter bank lending standards have historically been preconditions for recessions. The past six recessions have been preceded by Fed hiking cycles and leading up to the past two recessions, bank lending standards have tightened (Figures 3 and 4).

Intuitively, this makes sense - the economic benefits of looser Fed policy and accelerating lending conditions lean against the possibility of a recession.

While these indicators are necessary for a recession, they do not by themselves signal that a recession is imminent - both can be in place for multiple years before a recession begins. While these preconditions are currently being met, we must look at more timely measures that signal the economy is entering a transitional state.

Near-Term Indicators 

Jobless Claims

We believe that jobless claims are one of the best indicators of a regime shift, because they generally start to rise about a year before the economy enters a recession. This makes them particularly well timed for the move to a transitional state. Their usefulness as an indicator for credit is supported by the tendency of rising jobless claims to predict negative future returns for credit (Figure 5), consistent with our analysis that spreads generally widen from tights during the transitional state.

The decline in jobless claims has been impressive since 2009, and the measure is at all-time lows after adjusting for total jobs in the economy. With less slack in the series, the decline in claims has lost momentum, suggesting that further improvements could be limited (Figure 6).

However, claims have remained low or flat for multiple years in the past, so flattening alone is not sufficient to indicate a rise in claims. Consequently, we do not believe that jobless claims are currently signaling that we are entering a transitional period (although that assessment could change quickly).

Output Gap

The second timely indicator that we use for our macro credit framework is the output gap - a measure that Barclays Economics uses as a framework for the US business cycle (Figure 7).

The output gap uses a multivariable approach - with inputs such as working hours, output, employment, unemployment, and the labor force - to measure the actual output of the US economy versus the potential output.

We find that the output gap tends to follow the business cycle closely. The indicator typically peaks about three quarters prior to a recession, on average, and starts to roll over during the transitional state (Figure 8).

Coincidentally, spreads also tend to widen when the output gap is declining (Figure 9).

Currently, the output gap has closed and is near the 2005-2006 peak, meaning that the current business cycle is mature. However, the indicator does not seem to be rolling over and is not indicating that we are entering a transitional state yet.

Qualitative factors

In relation to position within the business cycle and whether the economy is entering a transitional period, it also makes sense to monitor qualitative factors that could pose risks to the current steady state of the economy.

Consumer Credit

Trends in consumer credit have become a cause for concern. Consumer debt outstanding has risen for credit cards, auto loans, and student loans, giving consumers less room to use debt to support spending. Delinquency rates have also begun to rise in all three cohorts (Figure 10), with the auto loan sector particularly worrisome.

Along with the significant growth in auto credits outstanding, auto loan quality has worsened, and auto sales have lost momentum. While these trends are somewhat troublesome, the size of the auto loan market pales in comparison with the mortgage market, a major issue in the last recession. And despite some deterioration in the quality of the ABS market, losses so far have been modest. Therefore, we do not believe that concerns in the auto sector will push the economy into a transitional state at the moment, but any further development should be closely monitored.

Retail sector

Weakness in retail has been a theme in 2017, with the sector facing revenue losses to e-commerce competitors and lower returns on assets because of overcapacity. Because the retail sector is such a large employer - up to 10% of American workers are in the sector in some capacity - there is a reasonable question about whether a sector restructuring could spill into the broader economy. We examined this question in greater depth in US Economics and Credit Strategy: Technology-based change leaves retail looking overextended, and our conclusion is that so far jobs are not being lost at a fast enough pace to create exogenous recession risk. For example, the number of retail workers affected by bankruptcies has increased quickly, rising above 200k over the past 18 months (Figure 11), but given that the US sees about 250k new jobless filings a week (a record low), that is not yet enough to cause broader problems.

Returns are more volatile during transitional states 

The next component of our framework is to understand what the most reasonable distribution of returns is likely to be within each state. The first thing we observe is that returns are related to starting valuations in both regimes (Figure 12).

We also note that for a given valuation, they are more volatile, and more likely to be negative, in the transitional state.

We base this analysis on Moody's data on spreads for industrial BBB long bonds. The series starts in 1919, which allows us to calibrate spread performance around 17 recessions. This is a significant advantage over using the Bloomberg Barclays Indices, which cover only three recession cycles. The disadvantage is that the Moody's data do not provide carefully structured return calculations, so we need to estimate returns using carry, spread changes (assuming the same duration as the BBB long index), and historical default rates to account for losses.

Digging a little deeper into the steady state, both returns and volatility rise consistently with starting spreads, in a very orderly relationship (Figure 14).

We also note that they look fairly normally distributed, although with some extra downside tail risk (Figure 15).

By contrast, in the transitional state, returns are less clearly related to valuation (Figure 16).

This seems to be related to more pronounced skew during these periods. But the degree and direction of skew also appear to be a function of valuation.

• When spreads have been in middle third (between 215 and 285bp), they have widened on average, but usually not enough to offset all returns from carry. As a result, the average estimated six-month return has been about 90bp. At the same time, the occurrences of large gains have been balanced fairly even against the number of large losses.
• When spreads have been the widest third (widest than 285bp), they have usually tightened, generating an average estimated six-month return of more than 200bp. They have also had higher-than-normal probabilities of large gains or tightening events." - source Barclays.

This analysis in our opinion is very interesting from a Macro and Credit perspective, as posited by our Friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":

"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013

Returns are related to starting valuations in both regimes, this is a very important point for credit investors we think. Also, according to Barclays, in the transitional state, returns are less clearly related to valuation. As concluded as well in this previous 2013 by our friend Paul:

"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.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013

Do not focus solely on the current low default rates when assessing forward credit risk. Trying to estimate realistic future default rates matter particularly when there are more and more signs showing that the cycle is slowly but surely turning in both CRE and consumer credit. Peak jobless claims and peak hotel occupancy might after all show us that we are indeed moving towards a transitional state in these Frankenstein markets. One thing for certain, the energy sector credit woes in 2016 and outperformance in the second part of 2016 was a sign that returns can be clearly related to valuation or when credit spreads reached do not make economic sense that is when average high-yield spreads above 1000bp can be irrational.

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity. 

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

 We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed in past conversations to explain violent rotations in flows from Emerging Markets. 

As we have seen on numerous occasions, and as we have remarked in our conversation  "Critical threshold", higher yields can lead to material fund outflows. As a reminder, more liquidity = greater economic instability once QE ends. As we move towards the transitional state described by Barclays in their note, one way of "mitigating" dwindling policy support would be to "embrace" a barbell strategy. 

For our final chart, no doubt to us than in these Frankenstein markets and experiments in the revival of organisms, it has been a "Goldilocks environment" for US credit.

• Final charts - Fun in Funds

Bondzilla the NIRP monster has been created by our Dr Frankensteins in various central banks. Clearly the instigation of NIRP has put the demand for US credit from foreign investors into overdrive and it has been as we pointed out recently "Made in Japan". Our final charts come from Wells Fargo Credit Connections report entitled "Correction mode" from the 11th of August and displays fund flows relative to net share buyback:  

"Follow the Money

"Nearly $1.2 trillion of new money has flowed into U.S. Taxable Fixed Income mutual funds and ETFs since 2009. Much of that money came from Money Markets as central banks slashed cash rates and investors rotated from cash to bonds to enhance their yield. International investors jumped on the bandwagon in 2014 following the Fed’s taper tantrum, and accelerated their buying last year after European and Asian central banks cut cash rates to negative. Throughout the entire period, the lion’s share of money poured into U.S. IG credit funds. An upsurge in demand for corporate bonds allowed corporations to ramp up gross bond issuance to record levels of nearly $1.5 trillion per annum over the past six years. Much of that bond issuance was used to fund share buybacks, which helped buoy stock prices. All of this is shown in the charts above and below.

So, the $1.2 trillion question is, when does this virtuous cycle end? The short answer is, not yet as the world remains awash in excess savings and global central banks continue to pump about $200 billion of new cash into the system each month via their existing QE programs. But, we suspect the slow march back towards cash has begun. In the U.S., the Fed has raised the Fed Funds rate by 100 bps over the past 20 months to 1.25% (upper bound) and remains in tightening mode. The Wells Fargo Securities’ economists expect another hike this year, and three more next year. However, cash rates in Europe, Switzerland and Japan remain deeply negative. Until these rates are greater than zero, global excess cash will likely continue to hunt for yield enhanced investment opportunities around the world, a portion of which should flow into U.S. credit and serve as a backstop against spikes in volatility." - source Wells Fargo

As long as our Dr Frankensteins keep pumping into the system and NIRP stays firmly into play, there is no reason why asset prices cannot go even further towards the 11th mark on the Marshall amplifier of our central banks. The only creepy and scary thing with experiments in the revival of organisms is when our mad scientists will lose control of their Bondzilla, but we guess that's a story for another day while we keep monitoring the credit impulse globally and weakening signs from the US.

"Invention, it must be humbly admitted, does not consist in creating out of void, but out of chaos. " - Mary Shelley

Stay tuned !