Macro and Credit - Easy Come, Easy Go

"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

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...

In this week's conversation, we would like to look at the return of Bondzilla the NIRP monster made in Japan given Japan's Government Pension Investment Fund GPIF is likely to come back strongly to the Fixed Income party.

Synopsis:

• Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.
• Final charts - The deflation play is back in town

• Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.

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.

"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:

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" 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.

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.

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. " - source Macronomics, March 2019

"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":

"Annual plan for new FY unveiled

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.

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.

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.

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).

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.

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).

In contrast, the share of foreign bonds increased to 17.4%, closer to the upper range of the current allowable range (19%). The fund has recently been purchasing foreign bonds aggressively, as it likely judges negative-yielding domestic bonds as unattractive (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.

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%).

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. 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, there is room for the fund to further shift from domestic bonds into foreign bonds.

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.

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.
In comparison with 2014, market interest in the GPIF portfolio change seems much lower (Figure 4).

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).

- source Nomura

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.

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":

"Dovish central banks revive the bond market

As global central banks continue on their dovish path, more money is flowing into credit and fixed income funds more broadly.

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.

Over the past week…

High grade funds recorded an inflow for the fourth week in a row, albeit at a slower pace than last week. 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.

High yield 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.

Government bond funds saw inflows for a second straight week, while the pace has been ticking up over the past couple of weeks. Money Market 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.

European equity funds continued to record outflows; the seventh in a row. Note that the pace of outflows shows no sign of slowing down.

Global EM debt funds recorded their fifth consecutive week of inflows. Note that last weekly inflow was the largest in seven weeks. Commodity funds saw another inflow last week, the fourteenth over the past sixteen weeks.

On the duration front, short-term IG funds underperformed whilst mid and long-term IG funds recorded strong inflows amid a broader reach for yield trend." - source Bank of America Merrill Lynch

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.

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 "Improving the Cycle Indicator – Countdown to Downturn":

"Cycle inflection argues for more cautious portfolio tilt – pare back exposure in US stocks and HY, add allocation to US duration, RoW stocks

But just because a shift in our cycle indicator is imminent, it doesn't mean that broad asset rotation needs to occur now:

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. 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.

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:

• 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.
• 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.
• Tilt towards long-duration in late-cycle, add cash: UST and cash combined have the largest allocation in downturn.

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.

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.

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. 

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:

"New cycle indicator, still same old cycle (for now)

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.

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.

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, 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, driven by many key macro indicators being above-trend ( Exhibit 23 ).

…but a market cycle peak is imminent

We don't think that this expansion can be sustained for long:

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.

What this chart suggests is that, 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%, up from ~60% from end-2017 when we last checked up on the cycle.

What's been behind this prediction? The strong unbroken run of improving data over the last year has been the main 'culprit':

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 ).

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. At any rate, our market cycle indicator and the probability gauge are very clear – an inflection from expansion to downturn is on the horizon." - source Morgan Stanley

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.

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:

• Germany : 44.1 vs 47.6-Feb
• France : 49.7 vs 51.5-Feb
• Italy : 47.4 vs 47.7-Feb
• Eurozone : 47.5 vs 49.3-Feb 

This is a reflection of world trade growth further slowing as highlighted by DHL's Global Trade Barometer from March 2019:

"Key findings:

• 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.
• Prospects weakening for most surveyed countries – but remain above neutral 50, still indicating positive growth, apart from South Korea
• 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.

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).

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.

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.

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

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. 

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.

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.

We have been asked recently by one of our readers on  the rise in interest rate volatility seen recently through the MOVE gauge index responding by posting its biggest two-day gain since 2016. 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":

Rates Moves Dictating Credit Moves

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.

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.

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. This seems to support our short-term view that BBBs should outperform their beta.

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

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.

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.

• Final charts - The deflation play is back in town

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":

"Positioning into Q2: 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).

Weekly flows: $8.6bn into bonds, $0.4bn into gold, $12.5bn out of equities.

Credit inflows: $5.2bn into IG, $2.2bn into EM debt, $0.9bn into HY.

Max deflation: record redemptions from TIPs ($1.3bn).

Equity outflows: $7.7bn out of US, $4.8bn out of EU, $2.0bn out of EM.

Cyclical outflows: $1.5bn out of financials, $0.4bn out of consumer, $0.2bn out of
tech.

Q2 catalyst: 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).

Q2 scenarios: evolution of BofAML global EPS model forecasts will determine whether Stagnation, Recession, Recovery the dominant Q2 outcome.

Stagnation: 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.

Recession: 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.

Recovery: 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.

Next up: 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

"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. 

"There is no gambling like politics."- Benjamin Disraeli, British statesman

Stay tuned ! 

Macro and Credit - Respite

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

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

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

Synopsis:

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

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

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

- Graph source Bloomberg

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

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

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

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

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

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

- source Bank of America Merrill Lynch

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

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

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

"Intensity of risk rally reaches historical records

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

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

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

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

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

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

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

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

"Some signs of relief

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

Over the past week…

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

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

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

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

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

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

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

- graph source Bloomberg

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

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

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

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

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

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

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

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

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

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

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

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

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

(click to enlarge)

- source Asia Times - David P. Goldman

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

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

"Earnings downgrades = GDP downgrades

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

Resetting expectations

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

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

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

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

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

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

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

We revise together

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

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

Collecting all data

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

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

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

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

• Final charts -  Macro matters again...

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

Macro mattered more than fundamentals in 2018

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

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

Stocks less sensitive to macro (idiosyncratic stocks) have outperformed

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

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

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

- source Bank of America Merrill Lynch

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

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

Stay tuned ! 

Macro and Credit - Under the Volcano

"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

Looking at the large wobbles experienced in financial markets this week, leaving many pundits wondering if we had attained "The Amstrong limit" 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 "The Korsakoff syndrome" 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 "The Generous Gambler" and in 2014 in our conversation "Sympathy for the Devil":

"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

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. 

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.

Synopsis:

• Macro and Credit -  What's under the "credit" volcano?
• Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"

• Macro and Credit -  What's under the "credit" volcano?

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:

- graph source Macrobond

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.

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:

- Graph source Edward Casey - Bloomberg

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.

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 DataGrapple on the 9^th of October:

“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

With rising dispersion, and global trade deceleration and the effects of the trade war narrative, we are already seeing cyclicals underperforming. 

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:

- graph source Bank of America Merrill Lynch

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.

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":

"Private debt, the fastest growing segment in US credit

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.

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.

Loan covenants are the defining feature of this cycle

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, the leveraged loan market has grown by 19% in the last two years, 44% in the last five, and doubled in the last ten. 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.

The next credit cycle: modeling potential credit losses

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.

Key takeaways

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. 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

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:

- source Bank of America Merrill Lynch

Both rising oil prices and strong earnings have been very supportive of US High Yield so far.

But, returning to the subject of loose covenants aka Cov-lite loans we read with interest Bank of America Merrill Lynch's take:

"Loan covenants are an epitome of this cycle

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).

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.

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.

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.

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.

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.

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.

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. 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.

Key risks in continued deterioration of investor protections

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.

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.

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.

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.

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.

Key mitigating factors

Not all loans lacking covenants carry the same risk of low recovery. “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. 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.

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.

(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.) - Source Bank of America Merrill Lynch

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:

- source Bank of America Merrill Lynch

Given the deterioration in credit quality overall, as we have stated in numerous of our previous conversations we expect lower recovery values during the next downturn.

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:

"The next credit cycle: sensitivity analysis

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).

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.

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.

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.

 Scenario #1: +100bp move in LIBOR, “average” loss ratesThis 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:

• 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.
• ICRs get somewhat problematic in syndicated loans and private debt space, but they remain generally manageable and comfortably above 2x.
• 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.
• 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.
• 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.

Scenario #2: a full-scale recession

The key component of our sensitivity analysis is designed to define a full-scale recessionary experience.

• 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.
• 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.

• 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.

• 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.

• 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.

• 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.

• 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.

• 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.

• 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). 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.

• A 60% recovery assumption in private debt, is a very rough estimate, given absence of verifiable historical track records and extremely low liquidity. 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.

• 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.

• 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).

• 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.
• 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.
• 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.
• 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. 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.

 Scenarios #3: a mild/short recession

• 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.
• 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.
• 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.
• 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

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.

This is of course a concern which is as well highlighted in Bank of America Merrill Lynch's long interesting report:

"Constrained liquidity as a factor in our analysis

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.

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.

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.

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.

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.

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, we do not count ourselves among doomsayers that predict a severe dislocation in corporate credit as a result of liquidity constraints.

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.

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.

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.

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

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. 

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":

"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.

The majority of the increase in BBB debt stems from net issuance ($1.2 trillion), followed by downgraded debt ($745 billion). 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.

So what does this mean big picture? 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. 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.

The good news is that this is not a story for today, 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

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.

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. 

• Final chart - Large standard deviation moves, the "market" volcano is becoming more "active"

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":

"Large moves are still happening more often: 

This remains true; 2018 is still on pace for some of the highest frequency of 3-sigma moves post-crisis. Liquidity remains poor.

What happened?

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).

How unusual was this move?

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.

Positioning – it is light, but in pain: 

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.

2018, unfortunately, seems to be a year where every asset class has a turn in the barrel.

The Fed 'put' remains out-of-the-money: 

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

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 "Dissymmetry of lift" 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...

"Hope of ill gain is the beginning of loss." - Democritus

Stay tuned !