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 - Dissymmetry of lift

"Risk is trying to control something you are powerless over." -  Eric Clapton

Watching with interest the latest US GDP rising at an annual rate of 4.1 percent in the second quarter of 2018 while seeing Europe decelerating, with France kissing goodbye to its 2% annual growth target, when it came to selecting our title analogy we decided to go back to using our much liked  aeronautics/aerodynamics themes given it had been a while we didn't on that blog (our previous favorite one was "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014). The "Dissymmetry of lift is used in rotorcraft and refers to an uneven amount of lift on opposite sides of the rotor disc. It is a phenomenon that affects single-rotor helicopters and autogyros in forward flight. Balancing lift across the rotor disc is important to a helicopter's stability (or economic growth). The amount of lift generated by an airfoil is proportional to the square of its airspeed. In a zero airspeed hover the rotor blades, regardless of their position in rotation, have equal airspeeds and therefore equal lift. In forward flight the advancing blade has a higher airspeed than the retreating blade, creating unequal lift across the rotor disc. When dissymmetry causes the retreating blade to experience less airflow than required to maintain lift, a condition called retreating blade stall can occur. This causes the helicopter to roll to the retreating side and pitch up (due to gyroscopic precession). This situation, when not immediately recognized can cause a severe loss of aircraft controllability. You are probably asking yourselves already where we going with this but QT, in our book amounts to less airflow required to maintain growth in Emerging Markets and Europe. Dollar liquidity is being reduced, hence the risk for a stagflationary outcome, in essence stalling growth can and will occur.  To reduce dissymmetry of lift, modern helicopter rotor blades are mounted in such a manner that the angle of attack varies with the position in the rotor cycle. However, there exists a limit to the degree by which "Dissymmetry of lift" can be diminished by this means, and therefore, since the forward speed "v" is important in the phenomenon (like "v" for velocity), this imposes an upper speed limit upon the helicopter or for our central bankers of this world and their "helicopter money".

In this week's conversation, we would like to look at the rise in stagflationary risk, particularly in Europe with signs as well of a global slowdown.

Synopsis:

• Macro and Credit - Is a stagflationary outcome looming?
• Final chart - Coming soon - bids by appointment only...

• Macro and Credit - Is a stagflationary outcome looming?

The latest growth data coming from Europe and with the continuation of some Emerging Markets woes for the usual suspects such as Turkey many pundits have been pointing out towards a stagflationary outcome. The increasing pressure coming from the trade war narrative which has been prevailing has so far been translating in an increase in PPIs, which could put some pressure on already elevated corporate earnings, no matter how good some recent earnings have been except of course for some darlings of the Tech sector namely the FANG group including our much used Twitter which have been on the receiving end of some nasty price action recently (Facebook was after all a 4 sigma event).

As we indicated in various conversations of ours, in our book, positive correlations always led to larger and larger standard deviations move. 2018 is no exception on the contrary and indicates brewing instability thanks to growing concerns over liquidity. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis and given central banks are somewhat trying to extract themselves from the price meddling/setting game, this mark a return at the forefront of "global macro" we think. Rising dispersion and the return of volatility makes active management "fun" again. For instance according to Nomura and as pointed out by Zero Hedge: 

"The collective three-day move in U.S. “Value / Growth” has been the largest since October 2008 - a 4.3 standard deviation event relative to the returns of the past 10 year period." - source Nomura/Zero Hedge

As we pointed out in the past, as per above link, large moves are more frequent in 2018. On this subject we read with interest Morgan Stanley's take in their Cross-Asset Dispatches note from the 22nd of July entitled "Yes, Large Moves Are Happening More Often":

"It's not your imagination. Surprises (large moves relative to expectations) are becoming more common across asset classes.

Defining a 'large move': Large moves matter to the extent that they surprise expectations. We define a 'large move' as a 3-sigma one-day move in price relative to what was implied by options markets at the time across global equities, rates, FX and commodities.

Large moves are becoming more common: 2017 was remarkable. Despite low levels of volatility that made the bar for a large move relatively low, few occurred. 2018 is very different, with more large price swings versus market expectations than any post-crisis year.

A sign that liquidity can be fleeting, even as markets climb: Tightening monetary policy and geopolitical risks may explain part of this uptick. But we think that it is also suggestive of constrained market liquidity, with growing markets supported by the same (limited) dealer balance sheet. This isn't the problem of a single asset class. It's everywhere.

Investment implications: Options markets should at least price in a steeper skew across asset classes and especially so in a less liquid asset class like credit. On a broader note, investors should be cautious about using the low realised volatility environment of 2017 as a parallel for the year ahead." - source Morgan Stanley.

In conjunction to late cycle M&A rising activity, these large standard deviations move are also typical of being in a late cycle we think.

This as well indicated into more details by Morgan Stanley in their interesting note:

"Large moves are becoming more common

2018 has seen a meaningful uptick in large moves relative to option-implied expectations across most asset classes. The contrast with previous years is most pronounced in global equities, which are on pace to see the highest number of such moves since 2008.

However, when aggregated across asset classes, the trend is clear. 'Large moves' are becoming more common in 2018, and are running at the highest rate since 2008.

This result holds at different thresholds. Below, we show the same combined chart over time, but counting the instance of 2 standard deviation moves. It shows a similar recent uptick.

Many explanations, but liquidity looms large

There are many ways to explain the recent uptick in these large moves, especially in hindsight – tightening policy, extreme sentiment towards equities and USD to start the year, trade tension and geopolitical risks. The fact is that volatility has remained generally low in 2018, lowering the hurdle for a large move.

All are likely at work. But the explanation we find most worth discussing is liquidity (or, more accurately, the lack thereof). The fact that constrained liquidity is present across major markets mirrors the broad-based uptick we've seen in outsized moves.

Markets have grown. Dealer capacity has not

It may not feel like it, but financial markets are significantly larger than they were a

decade ago. Consider the following, comparing July 2008 and today:

• S&P 500 market cap: US$11.5 trillion in July 2008. US$24.8 trillion today.
• EUR sovereign bond market: €4.6 trillion in July 2008. €7.5 trillion today.
• USD aggregate bond market: US$10.7 trillion in July 2008. US$20.1 trillion today.
• EM sovereign bond market (this includes EMBI-eligible sovereigns and quasi-sovereigns and excludes private corporates and non-EMBI sovereigns): US$288 billion in July 2008. US$894 billion today.

Yet while markets have grown steadily over the last decade, the means to trade them have not. The last 10 years have seen a historic deleveraging of bank balance sheets globally, a response to the clearly overextended state of balance sheets prior to the crisis.

Credit markets provide one of the most directly measurable, and stark, examples of this. On the left-hand axis of Exhibit 10, we plot the total size of US credit markets, as proxied by the combined size of the Bloomberg Barclays IG and high yield indices. On  the right axis, we plot total dealer holdings of US corporate bonds – a significantly larger market with a lot less inventory on the shelves.

Dealer holdings of corporate bonds have shrunk from 3% of the market to just 0.3% today. While this means that dealers themselves have less to liquidate, their capacity to move risk to a new buyer may be limited and require larger repricing of the asset class in times of stress.

Central bank dominance

As traditional banks pulled back, central banks became significant market players, accumulating quantities of assets over the last 10 years. Central banks hold 28% of the Agency MBS market (the Fed), 22% of the European sovereign market (the ECB), ~10% of the European IG credit market (the ECB again) and ~42% of the JGB market (the BoJ).

As central banks built these positions, liquidity in the affected assets was excellent. It's hard to imagine anything better for liquidity than the presence of a steady, deep, well telegraphed bid. But these forces are now swinging in the other direction. The Fed's purchases have already begun to reverse, the ECB's are likely to over the next six months, and with close to half of its bond market already owned by the BoJ, it will eventually face a constraint." - source Morgan Stanley

On top of that we are seeing weaknesses in global PMIs in conjunction with trade war escalation risk between China and the US. As discussed in our long June conversation aptly called "Mercantilism", liquidity, is indeed a coward. Also, in April this year in our conversation "Dyslipidemia", we pointed out that "credit markets" is one very large area where liquidity has been falling as pointed out as well above by Morgan Stanley's note:

"If you want to play the "bond bears" at some point down the credit cycle road then obviously, you should look at credit markets. As we posited in our previous musing, given the size of the ETF complex in that space and dwindling inventories since the Great Financial Complex, you don't need to be a genius to figure out, that the ETF Fixed Income complex dwarfs the "exit" door.

As a reminder:

This is what we wrote in our November 2017 conversation "The Roots of Coincidence":

If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do" - source Macronomics, April 2018

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

This is what we wrote in our November 2017 conversation "The Roots of Coincidence": 

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward.

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game" - source Macronomics, November 2017

Sure, performance wise, credit has regained some allure during the month of July with both high beta credit and even CCC high yield and also US Investment Grade and fund outflows for High Grade funds have stabilized. Yet this rebound happens when fundamentals relating to growth on the macro side have been deteriorating. With the U.S. planning to propose a 25% tariff on $200 billion in Chinese imports, in the latest rumors, this could no doubt lead to "Dissymmetry of lift", with a stagflationary outcome, with the US currently pulling ahead but with Europe and the rest of the world facing headwinds.

Markets are less liquid in that context and more fragile than most are anticipating we think. On that subject we read with interest Bank of America Merrill Lynch's take in their European Credit Strategist note from the 25th of July entitled "The economics of fragility":

"Summer carry” often proves to be a misnomer. Over the last few years there has invariably been something that has gone awry between July and August. This year though, so far so good for market calm. Note that US rates vol (MOVE index) and European equity vol (V2X index) are hovering near their start-of-year levels, despite the plethora of macro shocks that 2018 has already witnessed. And there remains plenty on the event risk front that could still emerge given heightened geopolitical tensions, commodity weakness, attacks on central bank independence and a China slowdown.

Trade wars and the unravelling of synchronised growth

Out of all the current macro risks, though, the one that we believe will be the most market moving is trade. As we argued in our last Strategist, an intensification of US-EU trade tensions could drive fears of “Quantitative Failure”. After all, the Eurozone is a large, open, economy and the ECB has – for political reasons – recently announced the end of QE. But conversely, any hint of a simmering in tensions will likely be taken well by investors, in our view. As the chart on the front page shows, uncertainty over global trade policy has now risen to levels last seen in late 1994, which was around the time of NAFTA’s inception. Therefore, much concern regarding trade is already in markets.

For us, the outlook for global trade is supremely important, and the current trade skirmish should not be seen as just another “fly in the ointment” for markets. Trade tensions put at risk one of the big secular themes of the last few years – namely that of global synchronised growth.

Chart 2 shows the distribution of annual GDP changes across OECD countries since 2004. Note that last year was the first time since 2006 that all OECD countries posted positive economic growth rates. The consequence of this was that market volatility fell to unprecedented levels. Economic certainty effectively bred market certainty.

Although global growth is likely to be strong this year – at just under 4% – signs are emerging that the recovery has become less synchronised, a concern echoed by the IMF over the weekend at the G20 Finance Ministers meeting. As a consequence, markets have become more fragile in 2018.

The signs

What are the signs of less synchronised growth? Chart 3, for instance, shows the extent to which US equities have decoupled from EM equities since May this year.

Trade tensions have depressed global growth proxies, such as Emerging Markets. Yet, the US economy continues to be buoyed by Trump’s significant fiscal stimulus (and note the near record EPS surprise stats from the current US earnings season).

In Europe, after the impressive 0.7% quarterly GDP print at the end of last year, growth slipped to 0.4% in the first quarter of 2018. Emerging Market weakness – in particular China – likely explains some of the loss of Europe’s economic momentum lately, especially given Germany’s export focus.

Chart 4 shows the extent to which financial conditions in China have tightened. Looking at Total Social Financing as a percentage of China M2, one can see that the measure has fallen to a record low.

Moreover, with the US powering ahead economically vis-à-vis the rest of the world, and trade tensions rising, the broader EM complex has suffered. Chart 5 shows the performance of a number of EM currencies versus the US Dollar. We compare two periods: the 2013 Taper Tantrum and this year’s trade spat. 

As can be seen, it’s not just those counties with obvious current account imbalances (Turkey, for instance) that have seen worse currency performance this year compared to the Taper Tantrum. Plenty of EM currencies have depreciated more vs. the USD in 2018 than in 2013." - source Bank of America Merrill Lynch

 As we pointed out in our most recent conversations, EM are more exposed to a trade war escalation which would be detrimental to growth. Europe as well has significant exposure to EM through the European banking system. Therefore "Dissymmetry of lift" or to put it another way, a stagflationary outcome is a strong possibility. Sure some pundits would like us to distinguish between cyclical inflation from an inflationary trend. From our perspective, as we have repeated so many times, for a true bear market to materialize you need inflation as the trigger match, regardless if it is cyclical or not. This would lead to additional "repricing" in asset classes.

On the risk for a stagflationary outcome to play out, we took note of Nomura's take in their Economic Perspectives paper from the 27th of July entitled "Bicycles, bumps and brakes":

"Or why stagflation risks are rising

A well-functioning world economy is like a bicycle moving rapidly along a path. The rider represents central banks and governments making adjustments, left and right and via the brakes, to keep the bicycle on a steady path. However, an even greater force keeping the bike upright is the torque created by the spinning wheels, which is analogous to the private sector’s inclination to borrow and spend. As long as the bicycle (i.e., the economy) moves at a sufficient pace – but not too quickly – only small (policy) adjustments are needed to keep it moving steadily forward. Mostly, however, it is the torque (i.e., the private sector) that keeps the bike upright and moving. Problems arise though if the bicycle starts moving downhill too rapidly and, particularly, if bumps then start to appear on the road. If the rider does not know whether there are bumps on the road – and more importantly – whether more of them lie ahead, there is a greater likelihood that the bike will come to a stop, either because the brakes are deliberately applied by the rider or – upon hitting one of these bumps – because it has veered out of control and crashed.

In our view, several bumps have appeared in recent months that are either already destabilising the world economy or, at the very least, threaten to do so in the coming months. That list – perhaps obviously – includes heightened protectionism and the growing threat of a global trade war. However, it also includes a supply-driven rise in oil prices, an unexpected reboot of populist politics in a number of developed and developing economies, growing financial strains from deleveraging pressures in China and a stronger US dollar. In the meantime, our bike (i.e., the world economy) has been heading downhill more quickly, as late-cycle pressures have gathered pace and are now triggering tighter monetary policies from a number of central banks. In short it is time to turn more cautious on the global macro outlook and expect greater volatility. - source Nomura

We like their analogy because it ties up nicely to "v" we mentioned above when it comes to avoiding stalling when encountering "Dissymmetry of lift". With their analogy Nomura is adopting a much more cautious tone going forward:

"It is with that analogy in mind that we are now holding a more cautious view toward the global economic outlook. As we wrote in Darker Clouds, we believe the annual pace of global GDP growth has now peaked (Figure 2) and that a deceleration phase now lies ahead.

The risks to consensus forecasts for global growth moreover are, in our view, now tilted to the downside. Absent major financial imbalances and other overheating pressures, we still think that a recessionary phase for the world economy can be avoided, but a sub-trend growth phase is now much more probable as we head through the next year.

Why is that bicycle analogy of so much relevance to this? With reference to our schematic in Figure 1, it is because several bumps have appeared in recent months that either are already destabilising the world economy or, at the very least, threatening to do so in coming months.

That list – perhaps obviously – includes heightened protectionism and the growing threat of a global trade war. But it also includes a supply-driven rise in oil prices, an unexpected reboot of populist politics in a number of developed and developing economies and growing financial strains from deleveraging pressures in China. In the meantime, our bike (i.e., the world economy) has been heading downhill as late-cycle pressures have gathered pace triggering tighter (or less restrictive) monetary policies from a number of central banks. A stronger US dollar has been one manifestation of these pressures insofar as US Fed tightening has been much more intense relative to the rest of the world. However, a stronger dollar has equally helped apply a brake on other emerging economies that have high USD-denominated debt levels and, by the same token, generated some hard-to-spot bumps in the road ahead.

The protectionist threat

We look at some of these factors in more detail, starting with arguably the most important: protectionism. We think this is important for a number of reasons. Firstly, it appears to already be having some impact on global economic activity. In Figures 5 and 6 below, we look at the recent deceleration of the leading indicators of global growth (manufacturing PMIs) in a number of major economies relative to their respective exposure to global protectionism (proxied by their current account position) in Figure 5 and to their exposure to oil (proxied by oil trade) in Figure 6. The correlation in Figure 5 is admittedly far from perfect but nevertheless suggests that those economies which have relatively high trade surpluses (e.g., Germany and the broader Eurozone) have been hit harder in recent months than those that have trade deficits (e.g., the US).

In other words, greater trade protectionism seems to be exerting some impact on relative growth patterns. This contrasts with high oil prices which, as Figure 6 suggests, do not yet seem to triggering the same (relative) response.

Digging into the details of more recent flash manufacturing PMI surveys (from Markit) leads us to a second reason why greater protectionism is important, namely the supply response and the (relative) inflation impact, which we believe are underappreciated. The details of the latest US manufacturing PMI, for example, revealed that trade frictions have become a major cause of concern, with July showing the steepest rise in prices charged for goods and services yet recorded as firms passed costs – frequently linked to tariffs – onto customers (Figure 7).

The same survey revealed that supply chain delays reached a record high amid rising shortages of key inputs. To put more simply, the US economy seems to have been on the receiving end of a negative supply shock.

Simulations on the Oxford Economics model from a full-blown trade-war scenario between the US and China – shown and described in Figure 9 below – suggest significant damage to the world economy.

Depressed confidence in the US and tighter financial conditions add to supply-side “stagflation” effects already described above and which could – according to the model – lower GDP growth by 0.7 percentage points below baseline in 2019 and by a cumulative 1% by 2020. The hit to China would be even more significant, given its greater dependence on exports with GDP growth some 0.8 percentage points lower than baseline in 2019 and 1.3% by 2020. Since this simulation mostly concerns trade channels between the US and China, the simulated response in Europe is a little weaker, but global supply chain damage and tightening global financial conditions would still lower GDP in the Eurozone by 0.4% points in 2019 and by a cumulative 0.5% points in 2020.

The dollar, China and late cycle US pressures are additional bumps in the road

Aside from greater protectionism – and as discussed above – there are several additional bumps in the road at present that make steering our bicycle (i.e., the world economy) somewhat hazardous. The charts in Figures 10 to 16 below home in specifically on the US dollar, on China and on monetary and fiscal policy issues:

– Firstly on the dollar, we note that its appreciation in recent weeks has triggered a marked tightening in global financial conditions (Figure 10).

This tightening moreover has moved well beyond what would have been implied by the unwinding of quantitative easing policies by the world’s central banks. And insofar as that unwind implies a further tightening of financial market conditions in coming months this suggests more downside for the world economy than those central banks may have imagined based on domestic (cost of capital) considerations alone. As an aside, we note that a stronger US dollar may trigger more downside to global USD-denominated nominal GDP growth – and thus for the revenue streams of multinational companies – in the period ahead as well (Figure 11). A stronger US dollar is also unlikely to help de-escalate trade tensions.

– On China – and related to those issues concerning the US dollar – we note the growing funding strains for companies that have issued offshore USD-denominated debt and the trend toward rising defaults in the corporate sector in recent months (Figures 12 and 13).

As our China economist notes (see The State Council initiates fiscal stimulus), while there has been a greater willingness to pursue more activist fiscal policies and/or allow the RMB to depreciate to mitigate the impact from these pressures, we think that markets are likely to increasingly focus on the sustainability of this policy action and the deleveraging pressures that still lie ahead.
– On monetary policy, we note the late-cycle pressures that are likely to leave some central banks – and the US Fed in particular – with limited, if any, recourse to loosen monetary policy for the time being and with a line of least resistance that points to more restrictive policies (Figure 14).

The complicating factor here – from a global perspective – is the likely waning of fiscal impulses as we head into next year in the Eurozone, UK and many emerging economies (excluding China) relative to the US, where the fiscal impulse will remain relatively strong (Figure 15).

That obviously could continue to pressure US inflation higher compared with elsewhere, not least if we add into the equation aforementioned issues concerning protectionism, oil prices and late-cycle wage pressures. Even in the face of a negative supply shock, with pro-cyclical US fiscal policy a counter-cyclical monetary policy stance would not be unreasonable.

What’s the bottom line?

Our conclusions from this discussion and analysis are as follows:
– Global growth will slow from its current above trend-rate toward a below-trend rate over the next 12- 15 months and probably disappoint consensus forecasts. By definition, the volatility of growth will rise as well from current historically low levels. It would be highly unusual for asset price volatility to remain as low as has been in this environment (Figure 3).
– The US economy will continue to perform relatively well as global growth cools compared with other major economies. That is by virtue of its relatively low exposure to global trade and to higher oil prices as well as a still-solid contribution from fiscal policy. This will leave Fed tightening in vogue (relative to elsewhere) not least when we add in inflation dynamics and the US economy’s cyclical position.
– On that inflation issue, we think the incoming (global) data are more likely to surprise on the upside than the downside in the immediate months ahead. That is a function of several factors, including a delayed response to the world economy’s cyclical upswing in recent quarters alongside the cost pressures that concern higher tariffs and higher oil prices. Ordinarily those cost pressures might be contained for a while if typical late-cycle pressures from firmer capital investment activity and stronger productivity growth came on stream. Given all the bumps on the road that are now triggering angst about the global growth outlook, we question whether this activity will now be strong enough to meaningfully quell those cost pressures.
– A stagflation scenario – the combination of negative growth surprises and positive inflation surprises – would not be constructive for risk assets. That’s particularly if policymakers – in the face of a trade-off between low growth and high inflation – opt to combat rising inflation. In light of positive output gaps, rising core inflation and pro-cyclical US fiscal policy, this might not be unreasonable. This could invoke a tighter policy response, hampering longer-term growth expectations and speed up curve inversion. Natural hedges in this environment include long US inflation break-evens.
– Finally, the metric that perhaps obviously bears watching most closely in the coming weeks is the US dollar. That holds the key, in our view, for how growth, inflation and monetary policy will evolve in the period ahead and by extension for how risk assets will evolve as well." - source Nomura

Now you probably understand better why our "Dissymmetry of lift" analogy is akin to a stagflationary outcome ("v" for "velocity, not speed in our economic case). Sure we are watching as well what the US dollar will be doing in the coming months like anyone else but trade war escalation and rising oil prices would not do a favor in the usually volatile quarter ahead we think. Liquidity is fading thanks to QT with the US pulling ahead for now from the rest of the world.

Overall liquidity is receding and growth apart from the US (for now) is slowing, in conjunction with heightened trade war risks looming. It is therefore not a surprise to see many pundits like ourselves putting forward the risk for a stagflationary outcome. Liquidity for credit markets is a concern, particularly with swelling passive strategies in the ETF complex in recent years when dealers have been retrenching. Our final chart below is illustrative of the risk in credit markets from a "liquidity" perspective.

• Final chart - Coming soon - bids by appointment only...

As per Lowenstein above, liquidity is always backward-looking yardstick. If anything, it’s an indicator of potential risk, it always is. Our final chart is coming from Bank of America Merrill Lynch Situation Room note from the 30th of July entitled "The chicken, not the egg" and shows that Investment Grade dealer inventories appears to be now negative:

"The chicken, not the egg

With the return of excess demand conditions for corporate bonds, we estimate that IG dealer inventories (superior to 1-year) are now negative (about -$240mn) for the first time ever. The only negative inventory number on record in the Fed’s data is for the week ended October 28, 2015, which was most likely an error due to well-known difficulties tracking long maturity bonds (Figure 1).

This is bullish for credit spreads as dealer inventories tend to be leading indicators for prices. While here it is easy to become entangled in a chicken vs. egg discussion, as one could argue that that the causation runs in reverse with low dealer inventories the result of strong markets – and thus tighter spreads – we find strong statistical evidence that inventories lead spreads historically, not the other way around. Low inventories thus add to the bullish case for IG corporate spreads" - source Bank of America Merrill Lynch

It might be the case that indeed as we pointed out in our last conversation that equities might be too high relative to credit. When it comes to global growth and the US versus the rest of the world, we think it is a case of "Dissymmetry of lift" but we ramble again...

"The investor of today does not profit from yesterday's growth." -  Warren Buffett

Stay tuned !