Macro and Credit - Inflationism

"For the merchant, even honesty is a financial speculation." - Charles Baudelaire

Watching with interest the Fed's additional dovishness with the continuation in the rally in high beta and in particular credit, marking the return of "goldilocks at least for this asset class, when it came to selecting our title analogy, given the potential stagflationary outcome thanks to the Fed being S&P500 dependent, we decided to go for "Inflationism". "Inflationism" is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy. The contemporary Post-Keynesian monetary economic school of Neo-Chartalism, advocates government deficit spending to yield full employment, is attacked as inflationist, with critics arguing that such deficit spending inevitably leads to hyperinflation. Neo-Chartalists reject this charge, such as in the title of the Neo-Chartalist organization the Center for Full Employment and Price Stability. Also, a related argument is by Chartalists, who argue that nations who issue debt denominated in their own fiat currency need never default, because they can print money to pay off the debt similar to what we are hearing these days from the MMT supporters. Chartalists note, however, that printing money without matching it with taxation (to recover money and prevent the money supply from growing) can result in inflation if pursued beyond the point of full employment, and Chartalists generally do not argue for inflation. It also worth noting that Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]
"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." 

Keynes explicitly pointed out the relationship between governments printing money and inflation:

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." 

The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In  that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "Fearing slower growth, Fed says no rate hikes this year":

"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.

This is a market that rewards cowardice – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times

This is clearly a market favoring "coupon clipping" we think but we ramble again.

In this week's conversation, we would like to look at the growing "stagflation" risks, which have been on this very blog a scenario we highlighted could happen.

Synopsis:

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig
• Final charts - Oh my God they killed Macro volatility again!

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig

In our previous conversation we highlighted the fact that "Deleveraging" and Deflation were good for credit markets. As expected, the additional dovish tone from the Fed is leading towards a reach for yield across credit. We also indicated that as long as interest rates volatility was remaining muted, it would be hard to be negative on credit markets. Given last Tuesday, Merrill Lynch's Move index, which tracks implied volatility on one-month Treasury bill options fell to a reading of 43.68, the lowest since the index’s inception in 1988, no surprise to see a continuation of the rally in high beta credit.

Rentiers seek and prefer deflation and fixed income investors continue to benefit from central bankers accommodative stance in that context. This definitely doesn't put us into the perma bear camp but more into the "realistic" camp we think hence our "japanification" stance.

Looking at the latest data coming out of Europe in general and Germany in particular, with Eurozone Manufacturing PMI coming at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10 year German bund is going again negative. As well, France Services PMI fell to 48.7 from 50.2 and expectations of 50.6 and Manufacturing PMI declined to 49.8 from 51.5 clearly pointing towards recession for the Eurozone.

Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":

"Dovish central banks and uncertainty favour quality

The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.
As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.

Over the past week…

High grade funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.
Government bond funds saw inflows following two weeks of outflows.
Money Market funds recorded an outflow last week, reversing a two-week streak of inflows.
All in all, Fixed Income enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.
European equity funds continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.
Global EM debt funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.
On the duration front, long-term IG funds were the laggards as short- and mid-term IG funds recorded inflows." - source Bank of America Merrill Lynch

Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:

"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:

"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016

This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.

If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.

This is what we suggested in our previous conversation:

"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019

Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.

We have also recently advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. We continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength.

On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":

"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1).

As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.

Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.

Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement. To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).

About one-third of all CCCs continue to trade at distressed levels, whereas for most of last year that proportion stood at 20% or below. This outcome suggest that investors remain cautious in reaching for credit risk among the names that otherwise would have the highest upside from here if a low-default scenario were to play out in coming months.
Note that reopening in the CCC new issue market has done little so far to alleviate concerns surrounding these two real-time indicators (dispersion and distress). Perhaps, the newly minted CCCs are yet again viewed as carrying relatively stronger credit profiles compared to the rest of that space, although any comps here are particularly challenging given the highly idiosyncratic nature of this segment. In addition, the B3/below segment in leveraged loans also experienced a sharp slowdown around yearend and has only recovered modestly since then. The latest-3mo pace of activity here is running at less than one-fifth of its peak levels reached in the middle of last year.
Lastly, Moody’s has reported 17 global HY defaults in the first two months of 2019, of which 12 were among US issuers. These counts are the highest over the past year and compare to an average of 2.7 default events per month in the second half of 2018." - source Bank of America Merrill Lynch

Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.

When it comes to the support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan".

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. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":

"Japan 101

It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view.

Going forward, we can expect Japanese selling in a narrow window around fiscal year-end (March 31), where they tend to repatriate money (Figure 2).

It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.

EUR bonds and JGBs for life

Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.

Who let the doves out?

However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed. Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.

While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged.

Instead, the main driver is the Fed’s dovish capitulation. The most common dollar hedging strategy for foreign investors involves a maturity mismatch with the underlying assets, as they roll short term – such as 3-month – forward fx rates. The cost of such strategy is driven by the difference between short term interbank rates, which in turn is driven mainly to relative monetary policy rates.
In early 4Q18 the Fed was the only major central bank hiking rates (3x priced in in 12months), as the BOJ and ECB were on hold. Foreign investors buying US corporate bonds rationally expected to be rolling into prohibitively expensive dollar hedges in 2019, leaving expected future yields after hedging costs on par with 90bps for 30-year JGBs (Figure 4).

Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.

Here to stay

We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch

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.

This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":

"Lifers opt for credit rather than anticipating weak JPY

In an interview with Bloomberg last week, a major life insurer stated that it was offsetting the impact of currency hedging costs by selling FX call options (partly giving up the advantages of weak JPY), and by taking credit risk, generating returns of about 1% even after fully hedging. This former approach resembles that taken by two other major lifers interviewed recently (see page 7 of the 5 March Navigator), but this lifer seems to be more concerned about the minimal room JPY has to weaken than worried about the risk of stronger JPY. Regarding the latter, credit spreads are not only wider overall in the US than in Japan, but the yield curve is steepening (Figure 5), and as a result, lengthening  maturities have a greater effect in improving yields.

For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again." - source Nomura

In relation to our "gold" outlook, while we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices.  Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.

Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen 17 Weeks of outflows totaling $21.8 billion. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":

"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.

Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.

First, speaking to the growth (or lack thereof) in HY par outstanding since 2016, and what that may imply, we think some often forget that this has been a very long ten-year cycle. The HY market, in fact, has grown substantially (+112% since the end of 2008, based on the index we track), just all that growth took place in the first six years.

Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.

Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal.

As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.

Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.

Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).

Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002).

Some still argue while that may be true, 2016 in particular, was unique due to the collapse in oil prices, which is a much lower risk in the future. In our view, any hope that HY would be more resilient in the next growth scare (or outright recession) should have been thrown out the window after witnessing the price action in 4Q18. After all, once the weakness in 2018 became about growth/earnings growth rolling over, the resilience of HY ended. At that point, spreads widened by almost 250bp, and HY underperformed the leveraged loan market, despite seemingly weaker fundamental metrics in the latter.

We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.

Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley

Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.

With a return of ultra dovishness from our generous gamblers aka our dear central bankers, given the new record low in rates volatility as per the Move Index cited earlier on in our long conversation, as per our final charts below it seems to us that macro volatility has been somewhat "killed" again...

• Final charts - Oh my God they killed Macro volatility again!

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:

"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.

"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse

Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018).

Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.

The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.

This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.

The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.

But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle).

However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).

Better stay nimble…" - source HSBC

 So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...

"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." -  Henry Ford

Stay tuned !

Macro and Credit - Stalemate

"In life, as in chess, forethought wins." - Charles Buxton, English public servant

Watching with interest the outcome of the US midterm elections in conjunction with a divided congress leading somewhat to a gridlock, as well as the tentative rebound in Emerging Market equities, when it came to selecting our title analogy, we decided to go again for a chess analogy on this very post (see previous chess analogies: "Zugzwang", "The Game of The Century"). "Stalemate" is a situation in the game of chess where a player whose turn it is to move is not in check but has no legal move. The rules of chess provide that when stalemate occurs, the game ends as a draw. During the endgame, stalemate is a resource that can enable the player with the inferior position to draw the game rather than lose. In more complex positions, stalemate is much rarer, usually taking the form of a swindle, a ruse by which a player in a losing position tricks his opponent, and thereby achieves a win or draw instead of the expected loss. A swindle in chess only succeeds if the superior side is inattentive. Stalemate is also a common theme in endgame studies and other chess problems. The outcome of the US midterm elections gridlock could create short term what we would call "Goldigridlock", namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. In conjunction with the return of buybacks following the blackout period of earnings, then, this obviously could be bullish equities wise we think, with high beta pulling ahead until the end of the year. For credit, we are not too sure, given a fall in oil prices with definitely put pressure on the high beta CCC bracket of US High Yield and its well documented exposure to the energy sector but, we ramble again...

In this week's conversation, we would like to look at what the US midterm election stalemate entails of asset prices in general following a very much "red October".

Synopsis:

• Macro and Credit - Goldigridlock for asset prices? 
• Final charts -  The invisible hand is fading...

• Macro and Credit - Goldigridlock for asset prices? 

The month of October was clearly a bloodbath for many asset classes and diversification didn't offer protection. While the velocity in real rates as we pointed out in our previous conversation forced a serious repricing of the Fed "put" at a much lower strike, the fact that it was a blackout period thanks to earnings reporting season and lack of buybacks, being another strong pillar in US equities rally seen in recent years was enough to wreak havoc on global markets on the back of weaker US equities. Looking at the below performance chart from Bank of America Merrill Lynch for the month of October can clearly see that, indeed, “misery loves company”:

- source Bank of America Merrill Lynch

As we pointed out in our final chart in our mid-October conversation "Under the Volcano", 2018 has marked the return of large standard deviations move, typical of late cycle behavior in conjunction with rising dispersion. 

What we also find interesting (H/T Driehaus on Twitter) is that 89% of asset classes tracked by Deutsche Bank have a negative total return YTD in USD terms. This is the highest percentage on record since 1901. Last year just 1% finished without negative total return:

- source Deutsche Bank - Driehaus Twitter feed

2018 is indeed a year where volatility and large standard deviations move have staged a comeback as the US Federal Reserve is trying to exit the stage with its Quantitative Tightening policy (QT) and its continuing hiking process. US Employment and wage growth likely to trigger another hike in December from the Fed. That’s a given. Total nonfarm payroll employment increased by 250,000 in October vs. 190,000 expected. Over the year, average hourly earnings have increased by 83 cents, or 3.1 %. Fed will remain hawkish.

With the "Stalemate" with the latest US midterm elections, what are the implications for asset prices, one might rightly ask?

First thing we would like to look at given the recent bounce from Emerging Market equities with Brazil leading ahead the bounce thanks to the hope brought by the presidential elections is the trajectory for the US dollar and what it means for "high beta". On that subject we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of November entitled "Midterm outcome":

"FX: a split Congress is bearish USD, but downside could prove limited

As we have argued, tonight’s split Congress outcome should result in dollar weakening. We think this could continue for a while yet as the first order effects of US growth deceleration and increasingly-limited monetary policy support cause a reevaluation of long USD exposure. Ultimately, second order effects could limit USD downside; however, we think that markets are likely to focus on first order effects for now.

Initially, we expect a weaker USD predicated on a further softening in US growth leading to reduced monetary policy support. US growth deceleration from the 2Q high water mark should continue as intense political gridlock precludes new stimulus measures, putting the prospect of a Fed move beyond neutral in doubt for now absent convincing evidence of inflationary pressure. Indeed, our US economics team is forecasting a gradual US growth deceleration toward 2% (around potential) by the end of next year, alongside a largely-benign inflation profile. While a Fed move beyond neutral was never in the market (the Fed is still priced to end the cycle at around the long-term median dot of 3%), a move above neutral looks increasingly less likely given the new information set. Thus, interest rate support for USD looks asymmetrically skewed to the downside, and the market’s expectation for Fed hikes next year (currently about +50bp) is at risk of compression, in our view. Positioning is net long USD – particularly in the riskier parts of the FX spectrum (Exhibit 1).

Diminished rationale for USD longs and a potential relief rally in markets post-midterm resolution suggests liquidation flow driving USD lower. Finally, we would expect modestly higher USD risk premium – reflecting a state of political acrimony in DC – to provide an additional headwind to the dollar. That said, because the Senate has remained Republican-controlled, we do not expect a material spike higher in USD risk premium arising from the expectation that House leadership could successfully remove the President through impeachment.

Looking beyond the initial reaction, however, we think that potential second round effects could serve to limit USD downside. Successful resolution of the present state of global trade policy uncertainty has become more challenging, particularly if President Trump’s negotiating position has been weakened as we suspect may well be the case. To be sure, the evolution of global trade policy uncertainty is critical to the global economic cycle. Reduced prospects for a speedy end to this uncertainty, and indeed increased risks of further deterioration, add to downside global growth risk in our view. Although hardly a recession story, US deceleration represents a potential negative impulse to the already-sagging global economy. An increase in risk aversion as markets anticipate a global downturn could thus broadly support the dollar. Finally, on a brighter note, compromise on US economic stimulus later next year is possible due to potentially overlapping interests. Democrats seem to be advocating an increase in infrastructure spending, and the President may well seek to prime the economy in advance of his 2020 reelection bid. If ultimately successful, this should support USD as it could lead to a renewed bout of US cyclical and monetary policy divergence.

Historical parallels suggest gridlock is not always so benign

The consensus among investors is that a gridlock is a benign outcome for markets. We think this may be overly optimistic. In our view, the most relevant historical precedent for the next half year may be the months following the mid-term elections of 2010 that resulted in the same configuration in Washington as the latest elections (with the President’s party controlling the Senate but the other party controlling the House). In 2011, the Republicans, upon regaining control of the House, used the debt ceiling as a lever to demand budget reduction by the Obama administration. The brinksmanship that ensued raised concerns in the market of a possible default by the US government which led to a sharp sell-off in risky assets as well as a major rally in rates (10y Trsy yields falling from 3.7% in March 2011 to 1.8% by September). The USD came under considerable selling pressure during the same period as foreign investors avoided US assets (EUR/USD rose from 1.30 in January to 1.48 by July that year). The market turmoil around the US debt ceiling crisis probably exacerbated the Eurozone sovereign crisis that occurred later that year (which saw the euro surrendering all of its earlier gains).

With the House Democrats having stated their intention to open new investigations against President Trump and with the 2020 presidential election campaign kicking off very soon, we see greater chances of brinksmanship than cooperation. History suggests that brinksmanship could mean lower rates and lower USD." - source Bank of America Merrill Lynch

With growing downside risk for growth with a notable deceleration in Europe and in global trade, there is indeed potential scope for the US yield curve to start flattening again. A conjunction of a flatter yield curve would be positive for the long end of the US yield curve and a falling US dollar would enable Emerging Market equities to continue to rally in the near term we think.

Second point, the recent fall in oil prices is as well putting some pressure on US breakevens as of late, meaning that for now a scary inflation spike has been avoided but, nonetheless, healthcare inflation, namely acyclical inflation is something to monitor closely as indicated by Bank of America Merrill Lynch in their US Economic Viewpoint note from the 5th of November entitled "Inflation in pictures":

"No scary inflation monsters

• Procyclical inflation has moved sideways over the past year, despite the unemployment rate improving by half a percent to 3.7%. The muted inflation response highlights the flattening in the Phillips curve.
• In No fear of an inflation curveball, we evaluated whether there was a kink in the Phillips curve at full employment. We find some, but not strong evidence, and therefore believe a strong cyclically-driven breakout in inflation is unlikely.
• While procyclical inflation has been flat, acyclical inflation has picked up, healthcare in particular. We expect healthcare inflation to continue to accelerate, driven by hospital services.

• In No inflation monsters under the bed, we looked at the disaggregated PCE components and found that there was an increasing share of PCE that has moved into a “low inflation” (0-2%) bucket, and a dwindling share in the “high inflation” (5-10% bucket).
• This shift in inflation dispersion is illustrative of a structural move lower in inflation. A lower trend decreases the probability of an inflation breakout.
• Digging into the components, we found that healthcare services accounts for much of the shift. As healthcare inflation picks up going forward, we may see some reversal of the shift, albeit into the more moderate 2-5% inflation range.

• Another reason to expect only a gradual pickup in inflation is because of inflation expectations, which have drifted lower over the cycle and serve as an anchoring point.
• In particular, University of Michigan 5-10yr inflation expectations have descended to a trend of 2.5%. The central tendency has also consolidated closer to the median, mostly from the 75th percentile. This indicates a greater decline in those expecting high inflation.
• Given core inflation is likely to run above target by next year, inflation expectations could improve, presenting upside to the outlook. But even with some improvement in expectations, inflation upside would likely remain contained." - source Bank of America Merrill Lynch

In our recent conversation we hinted that housing was in earnest starting to turn "South" in the US and that housing affordability was becoming a headwind on top of US consumers using their savings and increasing their use of the credit card to maintain their consumption level. Both auto and housing, which are very cyclical in nature are clearly showing the late stage of the credit cycle in our book.  

One segment where spending rises with age is healthcare (out-of-pocket and government). Healthcare will account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases.  This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further:

- graph source Macrobond

Sure falling oil prices bring some relief to the US consumers but rising healthcare costs as well as housing costs will not be sufficient to offset the risk of "stagflation". We could see lower growth ahead and even looming recession risk.

As we pointed out in our recent conversation "Ballyhoo", Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:

- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder.

As pointed out by Lisa Abramowicz on her Twitter feed, you need going forward to monitor closely in the months ahead the rise in inventory of new unsold homes:

"The inventory of new unsold homes in the U.S. has reached the highest level since 2011, as measured in months of supply. https://blogs.wsj.com/dailyshot/2018/11/07/the-daily-shot-the-inventory-of-unsold" - source Lisa Abramowicz, Twitter

In a response to Lisa's Tweet, M&G Bond Vigilantes made the following important point on Twitter:

"If you saw the Lisa Abramowicz tweet about inventory of new unsold homes reaching 7 months, you should worry. Historically that level is consistent with GDP growth of zero. This chart is from our 2007 blog."

- graph source M&G Bond Vigilantes - Twitter

Housing has always been a leading indicator in the United States when it comes to forecasting GDP growth.

To illustrate further the rift between Main Street's much more sanguine view of housing than Wall Street we would like to point towards Wells Fargo's take on the weakness in home sales from their Economics Group note from the 7th of November entitled "Home Sales Remain Soft":

"The Softening For-Sale Market Has Been Good for Apartment Owners

The magnitude and speed at which home sales have weakened is surprising, following just a three-quarter of a percentage point rise in mortgage rates. We suspect the problem is a lack of affordable product in the markets where potential home buyers would like to live. This helps explain why sales turned down well ahead of this fall’s rise in mortgage rates. The lack of inventory in desirable markets is a function of how highly concentrated economic growth has been in this cycle. Two industries, technology and energy, have accounted for a disproportionate share of job growth. While job gains have broadened more recently, a larger proportion of the high-paying, creative industry jobs are being added in submarkets closer to the central business district. By contrast, job growth in suburban markets has been slower to recover and wage gains have lagged for many occupations that are at greater risk of automation and outsourcing.

The rapid growth in higher value-added positions closer in to many major cities has fueled a housing crunch that has sent home values and rents soaring in many rapidly growing markets. The lack of developable lots closer in to the city has fueled growth of in-fill developments and teardowns, which have often removed more affordable homes from the market. The resulting battles over gentrification have also led to some political blowback, which has stymied development in some areas. Growth is also creeping back out toward the suburbs, particularly those that are developing their own urban cores. What has largely been missing, however, has been the push to develop exurban areas, where land has historically been less expensive. Such development has remained elusive, as higher development costs have largely offset any savings in raw land costs.

The same trends impacting home sales are evident in the rental market. Demand remains strong for amenity-rich apartments located near the city center or in the metro area’s second or third largest employment centers. Demand for apartments further out in the suburbs has taken longer to recover but has been doing better more recently, reflecting stronger job growth and an acceleration in wage gains. The suburbs have generally seen less development, so the improvement in demand has pulled vacancy rates lower and pushed rents higher. New suburban development remains elusive, however, and most new projects continue to cluster around pricier submarkets closer to the central business district.

We have further reduced our forecasts for home sales and new home construction following the recent string of weaker housing reports and downward revisions to previous data. We still see new home sales increasing over the forecast period but now look for just 5.6% growth in 2019 and 5.3% growth in 2020.

Much of that increase will come from more affordable homes in the South and West, which will restrain new home price appreciation. With little inventory, new home construction will continue to gradually edge higher. Apartment development is now expected to remain stronger for a little longer. There are a great deal of projects in the pipeline and a large number of proposed projects that have not yet moved forward. Demand for well located projects should remain strong, but vacancy rates will likely rise as job growth moderates in 2019 and 2020."  - source Wells Fargo

We do not share the optimism above relating to new home construction due to affordability issues coming from rising mortgage rates due to the Fed continuing its hiking path, their views being supported by the most recent employment report. Housing affordability has become a headwind, no wonder in some parts of the US prices are starting to cool down as indicated by Bloomberg on the 30th of October in their article entitled "Mortgage Rates Are Pushing U.S. Homes Out of Reach":

"While U.S. home prices have gained almost 60 percent since March 31, 2012, according to the S&P Corelogic Case-Shiller 20-City Composite Index, household income is up a little less than 30 percent in the same period, Bureau of Economic Analysis data shows. The average rate for a 30-year fixed mortgage rose from about 3.85 percent at the start of 2018 to about 4.74 percent now, Bankrate.com reports. Next year, it’s expected to rise further.

A buyer with a $2,500 monthly housing budget has lost almost $30,000 in purchasing power this year, according to Redfin Inc., a national brokerage.

In Orange County, California, more than 30 percent of homes for sale in the metro area would become unaffordable to buyers with a $3,500 monthly budget, Redfin estimates. In San Jose, that number would be almost 40 percent." - source Bloomberg

Housing markets turn slowly then suddenly...Just a thought.

While the US elections stalemate and the return of buybacks should be supportive, US markets for many years have been levitating and defying gravitation provided by the central bank support. This support has been obviously fading during the course of 2018 with QT as per our final charts below.

• Final charts -  The invisible hand is fading...

If October has been murderous for various asset classes thanks to the conjunction of several factors such as the velocity in the rise of real rates, blackout period leading to smaller buybacks, escalating tensions in the trade war narrative between the United States and China as well as Italian worries, our final charts from Bank of America Merrill Lynch coming from their European Credit Strategist note entitled "The hunt for red October" from the 2nd of November clearly shows that the "invisible hand" coming from the central bank is fading:

"The end of the “invisible hand”…

Last month wasn’t unique, though. We think it reflects a bigger picture theme…namely that assets are now struggling to produce meaningfully positive returns in an era of less central bank liquidity. The “invisible hand” that once propped-up market prices is now significantly smaller.

Chart 1 shows that there are precious few assets that remain above water this year. In fixed-income land, US leveraged loans have produced total returns of around 4%.

In Europe, many government debt markets – with the exception of Italy – are up for the year, albeit only by a modicum. But note that the biggest loser of all during the QE era, namely cash, has turned into one of the best performing assets of 2018 (1.5% total returns).

…the start of abnormal markets?

This spectrum of returns, however, is also far from normal. Chart 2 shows the historical percentage of assets with positive vs. negative returns on a yearly basis (our sample contains over 300 equity, fixed-income, commodity and FX indices). 

This year, we find that only 23% of assets have produced positive total returns. As can be seen, historically this is a very low number. In fact, such a number is usually only observed in periods of financial crises (2008), debt crises (2011), or just plain old recessions. And yet despite the shocks and bumps lately, the global economy is still humming along fairly nicely in 2018.

In our view, after such a big drawdown last month, markets are likely prepped for a rebound in November. Yet, we caution that bounces in risk sentiment could still be shallow ones. After all, with so many assets trending lower this year, long-only investors are finding that there are much fewer ways to help them diversify and protect their portfolios." - source Bank of America Merrill Lynch

One could argue that, no matter what "stalemate" we have reached in the United States midterm elections, the "fall" in the fall is surely indicative that at some point winter is coming. Could housing woes be seen as leaves already falling? We wonder...

“How did you go bankrupt?" 

Two ways. Gradually, then suddenly.” - Ernest Hemingway, The Sun Also Rises

Stay tuned!

Macro and Credit - Explosive cyclogenesis

"Invincibility lies in the defence; the possibility of victory in the attack." - Sun Tzu

Looking at the bloodbath occurring in various sectors of the US equity markets during the scary month of October historically for financial markets such as the Black Monday of October 16th 1987, when it came to selecting this week title analogy, we decided to go towards a meteorological analogy, namely "Explosive cyclogenesis".  "Explosive cyclogenesis" is also referred as a weather bomb. The change in pressure needed to classify something as explosive cyclogenesis is latitude dependent. For example, at 60° latitude, explosive cyclogenesis occurs if the central pressure decreases by 24 mbar (hPa) or more in 24 hours. Given the velocity in which US "real rates accelerated upwards at the beginning of the month in conjunction with the surge of the balance sheet reduction of the US Fed to $50 billion per month. The Fed’s QE Unwind Reaches $285 Billion From the 6th of September through the 3rd of October, the Fed’s holdings of Treasury Securities fell by $19 billion to $2,294 billion, the lowest since March 5, 2014. Given an explosive cyclogenesis occurs if the central pressure decreases rapidly, in similar fashion, the acceleration in the Fed's reduction of its balance sheet triggered the "weather bomb" on financial markets. 

Many pundits have been reminding themselves of Black Monday given it occurred during the month of October as well. Many have forgotten the Great Storm of 1987 which was a violent extratropical cyclone that occurred on the night of 15-16th of October. That day's weather reports failed to indicate a storm of such severity, an earlier, correct forecast having been negated by later projections. On the Sunday before the storm struck, the farmers' forecast had predicted bad weather on the following Thursday or Friday, 15–16 October. By midweek, however, guidance from weather prediction models was somewhat equivocal. Instead of stormy weather over a considerable part of the UK, the models suggested that severe weather would reach no farther north than the English Channel and coastal parts of southern England. At 2235 UTC, winds of Force 10 were forecast. By midnight, the depression was over the western English Channel, and its central pressure was 953 mb. At 0140 on 16 October, warnings of Force 11 were issued. The depression now moved rapidly north-east, filling a little as it did, reaching the Humber Estuary at about 0530 UTC, by which time its central pressure was 959 mb. Dramatic increases in temperature were associated with the passage of the storm's warm front. During the evening of 15 October, radio and TV forecasts mentioned strong winds, but indicated that heavy rain would be the main feature, rather than wind. By the time most people went to bed, exceptionally strong winds had not been mentioned in national radio and TV weather broadcasts. The storm cost the insurance industry GBP 2 billion, making it the second most expensive UK weather event on record to insurers after the Burns' Day Storm of 1990. 

Following the storm few dealers made it to their desks and stock market trading was suspended twice and the market closed early at 12.30pm. The disruption meant the City was unable to respond to the late dealings at the beginning of the Wall Street fall-out on Friday 16 October, when the Dow Jones Industrial Average recorded its biggest-ever one-day slide at the time, a fall of 108.36. City traders and investors spent the weekend, 17–18 October, repairing damaged gardens in between trying to guess market reaction and assessing the damage. The 19th of October, Black Monday, was memorable as being the first business day of the London markets after the Great Storm. The trigger for the "weather bomb" in early October which led to a 10% mini-crash was a warning by Fed chairman Jay Powell that the Fed planned to push interest above the "neutral rate" to prevent overheating. So, central pressure fell rapidly, real rates shoot up and the rest is as we say history but, we ramble again.

In this week's conversation, we would like to look at the buildup in recession signs we are seeing adding to the "reflexivity" in the tightening of financial conditions. Are the "weather" forecasts of no recession in sight justified? We wonder.

Synopsis:

• Macro and Credit -  "Reflexivity" and Recessions
• Final charts -  Where is the "credit" weather bomb?

• Macro and Credit -  "Reflexivity" and Recessions

As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks. As pointed out on Twitter by Tiho Brkan displaying a chart from JP Morgan , almost all asset classes have negative YTD returns (first time in 40 years).:

- graph source JP Morgan, H/T Tiho Brkan

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".

The rise in “real rates” triggered repricing of forward EPS, and forced investors to mark a lower strike to the Fed “put”.  Real rates grew at the same pace as 12 months Forward EPS until the “repricing”:

- graph source Macrobond

Given financial markets should act for many investorss as a "discounting mechanism", no wonder, with liquidity being removed thanks to QT, markets have had to "reprice" forward EPS accordingly in such a short period of time. The US markets have been defying gravity way too long and their outperformance versus the rest of the world has been significant in 2018.

When it comes to "buying the dip", Merryn Somerset Webb in the Financial Times makes some interesting comments:

"October shouldn’t be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors perhaps) this is nasty. For the rest of us it is good news, twice over.

First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40 per cent of S&P 500 companies have reported in this earnings season and some 80 per cent of them have managed to produce a positive surprise. Digitalisation may well be about to transform productivity in developed economies. And there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)

Second, stock markets outside the US really are not that expensive anymore and pockets of them are beginning to look like they offer some value. That should please long-term investors.

It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for." - source Financial Times - Merryn Somerset Webb 

In terms of "cheap" market outside the US, and as pointed out in her article as well, apart from the United States, Russia regardless of US sanctions, was left pretty much unscathed relative to other Emerging Markets. Russia, equity market should be priced for a continued rebound. Forget the sanctions, rising oil prices could be very supportive and with a PE of around 5.2, you have very limited downside. The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors; given the extreme volatility of American politics (and thus sanctions). Comparing Eurobond yields with Russian equity yields for the same risks will show you more "arbitrage" opportunities so we suggest you do your homework on this...

But, for sure, with rising dispersion, active management as pointed out by Merryn Somerset Webb  should come back into play, given the growing rotation between value and growth:

- source Thomson Reuters Datastream - H/T Holger Zschaeptiz on Twitter.

The growth trade over value trade is over. That’s your "great rotation" from "growth" to value" in one chart…

Moving back to the "main course" namely "Reflexivity" and Recession, we do believe that we have passed "peak" consumer confidence in the US. For instance the University of Michigan’s consumer sentiment index fell from 100.1 in September to 98.6 in October. This we think was “peak” consumer confidence with cyclicals such as Housing and Autos becoming a headwind for the US consumer.

Sure US Q3 GDP came at an annualized 3.5% but, it is because Americans save less to sustain spending as income gains cool. Americans saved 6.2% of their disposable income matching the lowest level since 2013:

- graph source Bloomberg

On top of that we can list the following "headwinds":

• Investors are selling the shares that hit quarterly earnings expectations at the highest rate since 2011. Good times are behind us…
• Early indicators show that economic conditions continue to weaken in China
• Residential investment fell 4% marking the third straight quarterly decline. That hasn’t happened since late 2008 and early 2009.
• Breaking bad? Even equity-long short hedge funds could see their worst month since the Great Financial Crisis (GFC). August 2011 level reached so far.
• U.S. investment-grade bond funds reported $1.6 billion in outflows in the past week, the fourth consecutive withdrawal for total redemptions of $7.2 billion; HY funds reported $2.1 billion of outflows according to Wells Fargo Securities.

We could also add David P Goldman's recent comments in Asia Times that US consumer discretionary stocks have been propped up by credit card binge:

"Consumer discretionary stocks have outperformed the S&P 500 by about 10% during the past year. That may be about to change.

Consumer spending remains robust in the United States according to this morning’s US data release. Personal spending was up 0.4% in September, or a 5% annual rate. The problem is that personal income rose only 0.2%, or a 2.4% annual rate.

Consumers are spending more than they earn. The past year’s pop in consumer spending depended on credit cards. That’s not a sustainable situation.

The chart below shows three-month changes in US retail sales vs. three-month changes in credit card debt outstanding. During the past year, the two lines look nearly identical.

Here’s another way to measure the dependence of retail sales on credit cards: The six-month rolling correlation between monthly changes in retail sales and monthly changes in credit card balances outstanding has risen to about 70%.

- source David P Goldman - Asia Times

US consumers might not be “buying the dip” but, are dipping into their savings to “sustain” their consumption and that's something to worry about. We haven't even much growth deceleration in Europe at this stage. We recently mused around shipping indicative of a slowdown in global trade in our latest conversation "Ballyhoo" and the Harpex index as an indicator.

Apart from the clear underperformance of the exported oriented German Dax Index or the Korean Index, Anastasios Avgeriou, Chief Equity Strategist at BCA Research pointed out on Linkedin today a very interesting chart:

"Who would have thought that the DAX and chip stocks are more or less the same trade... Both are very sensitive to global growth and thus interest rates. In other words, rising interest rates hurts them, and vice versa..." - source Anastasios Avgeriou, Chief Equity Strategist at BCA Research 

Misery do loves company one would argue. Cyclicals such as housing, autos and even chips have been impacted by the deceleration in global trade hence the latest weakness seen in Europe from slower GDP growth. 

As well there are some other signs pointing towards trouble at a later stage, which will follow the "relief" rally we are seeing. 

For instance, as pointed by the IIF, despite stronger earnings growth this year, many US companies struggle with debt service:

"Many companies are not generating enough earnings to cover interest expenses - despite still strong earnings growth. With growth expected to slow in 2019 and rates still rising, the problem could get worse" - source IIF

In our book credit leads equity and we are closely watching credit drifting wider thanks to the Fed tightening slowly but surely the credit noose as can be seen in the below Bloomberg chart posted by Lisa Abramowicz on her Twitter feed:

"Yields on US High Yield bonds with CCC ratings just climbed above 10%, the highest level since the end of 2016" - source Bloomberg - Lisa Abramowicz on Twitter

Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket.

And of course the problem is getting worse given rates have been rising in-line with improving growth estimates as per the below chart from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

If indeed growth is slowing, then again the US Treasury Notes yield should be falling as well. It is difficult to play it at the moment given the rise in issuance by the US Treasury.

When it comes to "Smart Money" some have already been heading towards the exit as pointed out by Eric Pomboy on Twitter with the below Bloomberg chart:

- graph source Bloomberg - Eric Pomboy on Twitter

Someone is clearly not waiting for the explosion of the "weather bomb" it seems...

One thing for sure, the October "Explosive cyclogenesis" aka weather bomb was another warning shot by the Fed but it seems no one was really listening. This effectively means that the Fed’s strike price for US stocks is much lower as it has removed the reference to monetary policy being accommodative. This is pointed out by Morgan Stanley in their Global Interest Rate Strategist note from the 26th of October entitled "The Financial Conditions Jackpot":

"FOMC participants have been clear that the outlook for the hiking cycle is unlikely to shift simply because of equity market volatility. This sort of guidance led to interest rate vol lagging the sharp rise in equity vol. We think this is justified by fundamentals and do not yet recommend buying shorter expiry interest rate options outright. Only when the narrative of FOMC participants starts to shift will we consider paying theta. And when that occurs, we expect short-tail vol to outperform long-tail vol.

A long way to neutral?

Exhibit 47 illustrates how 1m10y vol has been lagging the spike in the VIX.

This is true of rates vol in general, which has underperformed equity vol in both realized and implied terms. We believe the main driver of this dissociation has been the general dismissal by most FOMC participants of the volatility seen in the stock market. This is an excerpt from the Q&A that followed the September FOMC press conference (our emphasis):

CHAIRMAN POWELL. So I don’t comment on the appropriateness of the level of stock prices. I can say that by some valuation measures, they’re in the upper range of their historical value ranges. But, you know, I wouldn’t want to—I wouldn’t want to speculate about what the consequences of a market correction should be. You know, we would—we would look very carefully at the nature of it, and I mean, it—really— really what hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that’s a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that’s a really bad situation. A simple drop in equity prices is— all by itself, doesn’t really have those features. It could certainly feature—it could certainly affect consumption and have a negative effect on the economy, though.

More recent comments from FOMC participants echoed that sentiment, despite the S&P 500 index being 10% off the highs. In effect, this implied that the Fed is not close to stepping in to support the stock market by altering the path for monetary policy. In other words, the so-called "Fed Put" is still out of the money. This is likely to maintain some certainty in the rates market as to the path for rates in the near term as the Fed seems set to at least reach its estimate of neutral.

Less uncertainty about rates begets lower vol. Of course, rates are still going to see higher vol in a risk-off move as a result of investment flows as well as shifting probabilities surrounding the outlook for the Fed. But our view is that this volatility will not be both sustainable and notable until the Fed Put is in the money." - source Morgan Stanley

Until the Fed Put is in the money, that is until the weather bomb has been digested by the market in similar fashion to the rapid storm experienced back in October 1987.

While many pundits are still reeling from the "bloody" October, and many are asking themselves where trouble is brewing, we do believe that some parts of US credit markets do contain some potential "weather" bombs as per our final charts below

• Final charts -  Where is the "credit" weather bomb?

Credit always leads equities in our book when eventually we will have a definitive turn of the credit cycle. For storm chasers out there, we believe that some parts of US Credit Markets are showing signs of fragility, and it's not only the fall in quality of Investment Grade Credit. Our final charts comes from Wells Fargo Economics Group note from the 29th of October entitled "Which Sectors Have Driven Business Sector Debt Growth" and shows that the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector:

"Business Sector Debt Is Up By Nearly $5 Trillion

In a recent report, we noted that the financial health of the U.S. non-financial corporate (NFC) sector has deteriorated, at least at the margin, in recent quarters. For example, the debt-to-GDP ratio of the NFC sector has trended up to its highest level in decades (below chart).

Not only do non-financial corporations borrow from financial institutions such as banks, but they also issue bonds in the corporate debt market. In that regard, the market value of investment grade (IG) corporate bonds has shot up from less than $2 trillion during the depths of the financial crisis to more than $5 trillion today. The value of high yield (HY) corporate bonds has mushroomed from about $400 billion in late 2008 to nearly $1.3 trillion today.
The value of corporate bonds outstanding—IG and HY—has plateaued in recent months. But, lending by commercial banks to the NFC sector continues to trend higher. Indeed, the amount of leveraged loans outstanding has grown to almost $1.1 trillion at present from about $800 in early 2016 (below chart).

In total, the value of corporate bonds (IG and HY) and leveraged loans outstanding has risen by nearly $5 trillion, which is an increase of roughly 180%, since late 2008. Is this growth in corporate debt a widespread phenomenon or does it reflect higher debt loads in just a few sectors?
We disaggregated the business sector into 11 broad subsectors, and we find that debt has increased in each of these subsectors over the past 10 years (bottom chart). So the increase in business sector debt has been generally widespread. But, not every subsector has had the same experience in terms of debt growth. The financial sector leads the pack with an absolute increase in debt outstanding in excess of $1 trillion over the past ten years (horizontal axis in bottom chart).

Although the financial sector is the largest sector in terms of total debt outstanding ($1.8 trillion in Q3-2018, which is denoted by the size of the bubble), its 132% rise in outstanding debt places it below the average in terms of debt growth over the past 10 years (vertical axis). Other subsectors with slower-than-average debt growth since Q4-2008 include utilities, transportation, basic industries, consumer cyclicals and communications.
There are three subsectors that stand out in terms of debt growth over the past 10 years. The debt in the non-cyclical consumer goods industry, which includes food & beverage, healthcare and pharmaceuticals, has experienced a 275% increase in debt outstanding to $1.2 trillion at present. Energy (400% increase to nearly $700 billion) and technology (almost 600% to roughly $650 billion) are also notable for the debt growth they have experienced. In sum, most business sectors have experienced rising levels of debt over the past 10 years, but the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector." - source Wells Fargo

So there you have it, given Tech is under pressure, the energy sector is depending on the trajectory of oil prices to stay afloat (see our above point relating to interest expenses coverage) and consumer goods are depending on a more and more fragile US consumer, you can probably think that there is indeed an Explosive cyclogenesis in the making...Happy Halloween!

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore." - Vincent Van Gogh

Stay tuned !