Macro and Credit - The Korsakoff syndrome

"A nation that forgets its past can function no better than an individual with amnesia." -  David McCullough, American historian

Watching with interest the continuation of "Mack the Knife" (King Dollar + positive real US interest rates) Emerging Markets bloody rampage with Gold continuing to suffer thanks to Gibson Paradox (negative correlation between gold prices and real interest rates), and also reminding ourselves it has been ten years since the onset of the Great Financial Crisis (GFC), when it came to selecting our title analogy, we decided to go for the Korsakoff syndrome. The "Alcoholic" Korsakoff syndrome is an amenestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). This neurologic disorder is caused by lack of thiamine in the brain and is as well exacerbated by the neurotoxic effects of alcohol (or QE...).  The syndrome and psychosis are named after Sergei Korsakoff, a Russian neuropsychiatrist who discovered the syndrome during the late 19th century. There are seven major symptoms of alcoholic Korsakoff syndrome (amnestic-confabulatory syndrome): 

1. anterograde amnesia, memory loss for events after the onset of the syndrome
2. retrograde amnesia, memory loss extends back for some time before the onset of the syndrome
3. amnesia of fixation, also known as fixation amnesia (loss of immediate memory, a person being unable to remember events of the past few minutes)
4. confabulation, that is, invented memories which are then taken by the patient as true due to gaps in memory, with such gaps sometimes associated with blackouts
5. minimal content in conversation
6. lack of insight
7. apathy – the patients lose interest in things quickly, and generally appear indifferent to change.

Back in 2011, in our conversation "Anterograde and Retrograde Amnesia", we commented on the dollar liquidity crisis which was brewing at the time and severely impacted EM as well as the European banking sector as whole which was saved by the ECB's LTROs late that year. The difference of course this time around is thanks to the ECB support, European financials credit spreads have not exploded à la 2011. Yet, with the Fed busy withdrawing liquidity thanks to QT in conjunction with a rising US dollar, as a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

We touched on the various form crisis could take in our long February 2016 conversation "The disappearance of MS München". While we won't go again about the various forms a crisis can take, from a currency crisis to a credit crisis, everyone not suffering from the Korsakoff syndrome is rightly asking when this already long cycle will end and what to look for.

In this week's conversation, we would like to look at the potential signs marking the end of the cycle.

Synopsis:

• Macro and Credit - What to look for the Boom moving to Bust?
• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

• Macro and Credit - What to look for the Boom moving to Bust?

There is no doubt that liquidity issues always lead to financial crisis. This was the case in 2011 and the ECB prevented the meltdown in the European banking system with its LTROs which was followed by Swap agreements with the Fed. The normalization process followed by the Fed in conjunction with its QT is of course validating our much vaunted global macro reverse osmosis theory discussed on numerous occasions on this very blog hence the continues pressure applied on Emerging Markets thanks to the surge in the US dollar, providing a strong headwind on gold for the time being. 

Given the 10 year anniversary of the GFC, many pundits are questioning how long until the music stops given the flattening of the yield curve as a sign we are reaching the end of the credit cycle. Timing is of course everything, eventually perma bears will be right but the question is when. On this subject we read with interest CITI's latest Global Multi-Asset View entitled "For Whom the Clock Ticks: How Long Till End-Cycle" published on the 4th of September:

"Even a broken clock...

“A man with a watch knows what time it is. A man with two watches isn’t so sure.”
- Segal’s law

Probably the most common question any strategist gets asked is where we are in the investment cycle. Even those who don’t like our debt-equity clock seem to have a triangle or a wave or some equivalent alternative: the notion of the economic cycle, and how markets respond to it, is simply the foundation of how most people think about investing.

But recent months have revealed a problem – even for strategists purportedly using the same framework. While Rob and the equity strategists would put the hands on the clock earlier in “Phase 3” – say 7 o’clock (Figure 1) – Matt and the credit strategists argue markets are closer to Phase 4, or 9 o’clock (Figure 2) – if indeed they recommend using the clock these days at all.

Our debate mirrors parallel discussions on the shape of the US yield curve. Many economists are dismissive of its current flatness, arguing that it has been distorted by QE, and that rising inflation should soon lead to higher yields and steeper curves. But others, including the San Francisco Fed, our rates strategists and our credit strategists, argue that its steady flattening poses a genuine and immediate problem for risk assets.

Settling these questions is of critical importance. This is especially true for equity investors, who face the dangerous challenge of riding a late-cycle bull market but avoiding the end-cycle carnage when it breaks. Credit investors lose out in both stages, but somehow they seem resigned to that.

While we always receive a steady stream of such questions, recent weeks have seen the trickle turn into a torrent – perhaps fuelled both by the yield curve and this year’s fading returns in most assets outside the S&P. These enquiries are coming not only from traditional asset managers but also from corporates, private equity,  infrastructure and other “alternatives” investors – counterparties whom we do not speak to regularly, and who may well change their positions only once or twice a cycle.

This note is designed at least to air our differences, if not necessarily to resolve them. First, we lay out how the cycle has worked traditionally, and explain why markets seem to follow a global cycle even in the face of regional and sectoral differences in growth and in earnings. Second, we examine the many ways in which this cycle has bucked the traditional pattern. Finally, we look for guidance in history as to what really triggers the transition to Phase 4, and hence what happens next. Unfortunately it is hard to provide definitive answers: we argue that much depends on whether you think the cycle is driven by fundamentals or by market movements, and on whether this cycle’s distortions have merely slowed down the clock’s alarm function, or broken it entirely.

How the cycle works

Our thoughts on how the cycle is supposed to work haven’t really changed over the decades. Companies go through regular phases of leveraging and deleveraging, and you can normally tell where you are in the cycle both from what they’re doing with their balance sheets and from the response in credit and equity markets. Here’s how we put it back in 2005:

Starting at 12 o’clock, in the depths of recessions companies go through intense periods of restructuring in order to reduce their debt burdens. Assets are spun off, dividends skipped and equity raised in order to generate cash and reduce the risk of bankruptcy by paying down debt. Once this activity gets underway, credit spreads rally sharply — the risk of default is perceived to be past its peak — even though equity markets remain in the doldrums because issuance is dilutive and earnings continue to fall.

Eventually, cost cutting and aggressive restructuring, accompanied by economic recovery, yields a rebound in profits (after 3 o’clock). In this next phase, both earnings growth and debt/EBITDA are improving, causing credit and equity to rally together. However, as the cycle matures, this progressively gives way to a period of lower quality earnings growth, in which share gains are often achieved at the expense of corporate leverage, for example through acquisitions or share buybacks (after 6 o’clock). This keeps equities rallying, but deteriorating balance sheets start to drive credit spreads higher.

Finally, the resultant balance sheet deterioration comes to a head, creating a crisis in which profits cannot be sustained, and both equities and credit sell off (after 9 o’clock). It’s time to take all risk trades off. This is usually associated with a recession which induces the retrenchment which eventually allows the cycle to start all over again.

By and large, we think this framework has held up pretty well, and it is not too difficult to discern its workings in the US over multiple decades. Equities and credit are sometimes positively correlated (Phase 2 and 4) but they can also be negatively correlated (Phase 1 and 3). This is visible in terms of the alternation between credit and equity market returns (Figure 3), and in terms of the cyclical leveraging and deleveraging of nonfinancial corporates’ balance sheets (Figure 4).

To be sure, not every cycle is driven by corporates, and the credit and equity market movements are not quite as regular as, well, clockwork. In the 1970s, movements in oil prices were larger drivers of the economy than corporate leverage per se, and emerging from the 1982-3 recession in particular, we cannot see a “Phase 1” in which credit rallied before equities.

But even when recessions were not actually caused by the non-financial corporate sector – as in 2008 – the broad patterns have still seemed to hold. The recession was preceded by a long period of leveraging up, in corporates as well as in households, and credit market returns turned south months (if not years) before equity market returns did. Understanding the workings of the cycle is a useful way to think about how you should invest.

Time waits for no man (but seemingly for a few corporates)

Note that we have never claimed that it has to be the same “time” for different regions, or even for different sectors. Indeed, while similar principles hold at the individual company level, with credit and equity prices responding to changes in  balance sheets, different companies can employ very different strategies. For example, while US-based Apple is reducing its cash pile with the primary intention of rewarding shareholders, China’s Anbang – after a previous spree of debt-fuelled acquisitions – is now making bond-friendly disposals and trying to shore up its balance sheet.

Aggregating leverage statistics across companies and sectors is as much an art as a science; we often joke that you can demonstrate that aggregate leverage is doing almost anything if only you try hard enough. To what extent when calculating net debt/EBITDA should the tech sector cash pile be allowed to offset the debt burdens shouldered elsewhere? Should you calculate median (net debt/EBITDA), median (net debt)/median(EBITDA), or use means? How as an investor in public equities should you treat the hundreds of billions in debt from private-equity-owned names?

Nevertheless, even given substantial variation at the company and sector level, it is possible to calculate overall averages (Figure 5).

It is almost remarkable how similar are the patterns those averages follow across regions and different data sources (Figure 6).

From the noise of individual companies’ balance sheet decisions, there emerges a global cycle.

We can see different levels of global correlation when we look at other important variables. While GDP growth is imperfectly correlated, with the US generally considered to be ahead of other countries, EPS growth by region is more closely related, especially recently. And, despite being more volatile, actual stock price returns (Figure 9) or credit spread changes (Figure 10) are all but indistinguishable across regions. Markets are highly correlated, even if fundamentals aren’t.

Beyond this, it seems to us that there is a strong element of reflexivity to the process. Company balance sheet decisions, and investor calls on what to buy and sell in credit and equities, are not taken in a vacuum: they influence one another. When Vodafone bought Mannesmann in 1999 in what was then the largest ever M&A deal, its stock continued to rally. This increased the likelihood that AOL would end up buying Time Warner. When Enron filed for bankruptcy in 2001, the environment of increased investor nervousness added to the risk that WorldCom would subsequently do so in 2002. Market movements – and investors’ and corporates’ responses to them – are themselves significant drivers of the cycle.

But how have markets been moving this time round, and what does that tell us about the all-important transition to Phase 4?

Who stopped the clock?

In fundamental terms, this cycle things seem to have proceeded pretty much as usual. A period in which profits were growing faster than debt, from 2009 to 2012, has been followed by one in which debt has been growing faster than profits. As a result, overall corporate leverage has risen well beyond that reached in 2008, to the highest level ever recorded outside of an actual recession (Figure 4, Figure 5, Figure 6). Presumably one reason this has been possible is that record-low levels of interest rates have made interest payments look manageable, even with record-high levels of debt (Figure 11).

When broken down by sector, the pattern is more varied, but probably no more so than normal.

The sectors seemingly most intent on leveraging up are those which it might be reasonably argued ought to be most able to bear it: Utilities, Healthcare, Consumer Staples and Telecoms. That said, in many cases they are now running with substantially more leverage than ever previously (Figure 12).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13).

Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6).

Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13). Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6). Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

Putting these numbers together, Matt thinks aggregate leverage is higher than might be expected outside of a recession, and hence more reminiscent of late Phase 3 than early Phase 3. But low interest rates and the predominance of increased leverage amongst the more defensive sectors help explain why this has not yet been seen as a problem for markets as a whole. Moreover, there are even signs that aggregate leverage is beginning to decline given recent strong profit growth and helpful US tax cuts.

But Rob’s primary reason for thinking this is Phase 3 is not based on fundamentals but more on market movements – in particular, the current outperformance of equities relative to credit is classic Phase 3. Other Phase 3 characteristics, such as narrowing market leadership, are also evident (Global Equity Quarterly: Narrowing Bull Market)." - source CITI

The reason the credit clock has been much slower than usual is of course due to the Korsakoff syndrome, namely that central banks intervention have been very supportive of credit spreads in many instances, providing as well some support to many "zombie" companies which should have been eliminated but managed to survive thanks to the low interest rates environment. Record low levels of interest rates have made interest payments manageable even with higher leverage creeping up thanks to the distortion created by our central banking deities.

While EM have been on the receiving end of the latest summer heat thanks to the strong dollar, the S&P 500 and US stocks have been racing ahead while the rest of the world has been languishing. Credit wise both US High Yield and US Investment Grade have had a less torrid time than EM High Yield or EM equities. Indicators of aggressive issuance such as the percentage of the CCC credit bucket accessing the primary market has remained fairly stable still and revenues even for US High Yield remain overall solid as per the below Bank of America Merrill Lynch chart:

- source Bank of America Merrill Lynch

The most recent quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points that financial conditions still remain favorable. Overall credit remains fairly stable for now at least in the US as pointed out by CITI's comprehensive report:

"A central banker in the works

Most importantly, the steady leveraging-up by companies since 2012 has simply not been accompanied by spread widening on anything like the same scale as in previous cycles. Indeed, even with non-financial corporate leverage higher than the levels seen in 2008 and (on some universes) 2001-2, credit spreads are not far off traditional cyclical tights, especially in US HY (Figure 15).

The pattern in € HY and $ and € investment-grade is similar, if slightly less extreme. Even long-term charts – over which period it becomes difficult to difficult to obtain consistent universes for both spreads and leverage – suggest that something is awry (Figure 16).

If it were just credit spreads which were behaving in this fashion, the signal could perhaps be ignored, or dismissed as an excessive focus on headline debt levels rather than interest coverage and debt sustainability. Indeed, the rating agencies invoke just such an argument when asked why such high debt levels have not led to an increase in downgrades.

But the same time period – since 2012 – which has seen leverage rising and spreads tightening also reflects a breakdown in other market relationships. Equity volatility traditionally correlates with metrics designed to capture policy uncertainty (the number of references to uncertainty in the news, for example). But since 2012 uncertainty has been high, and yet volatility across markets has been setting new record lows (Figure 17). 

Changes in consensus earnings expectations used to correlate with equity market moves in every region, yet since 2012 that relationship has broken down too, even if it is now beginning to re-establish itself (Figure 18, Figure 19).

Matt has argued loudly for several years that all these breakdowns are due to QE, and “too much money chasing too few assets”. He thinks that as central banks pull back, both credit and equities are vulnerable, and cites in his support continuing strong correlations between global central bank purchases and market movements. As was visible in February this year, the central banks have effectively “broken” the normal clock functioning, and credit can no longer be relied upon to lead equities in the way it has done historically.

Rob sees it slightly differently. QE intentionally decoupled credit spreads (kept falling) from corporate leverage (kept rising). Even as balance sheets moved through 6 o’clock, so central bankers kept risk asset pricing back at 5 o’clock. The reason that equity volatility fell is that it is highly correlated to credit spreads (Figure 20), and QE kept spreads falling.

But now that has changed. As central banks step back, so the credit and equity markets will catch up with fundamentals. This year’s rise in spreads and volatility finally marks the move into Phase 3 that, without QE, would have started in 2012. Rob thinks that QE has held the clock back, not broken it." - source CITI

One could indeed agree somewhat with Rob from CITI that, indeed the Korsakoff syndrome associated with prolonged ingestion of QE has clearly distorted the "credit clock" and slow down the normal aging process thanks to financial repression and low interest rates. Now with QT in full swing, the tide is slowly but surely turning, with the over-leveraged players being the first one taken to the cleaners such as the house of straw of short-vol yield pigs and now the house of sticks of macro EM tourists carry pigs.

What about record high corporate margins? Surely trade war and surging PPI will eventually put a dent in corporate margins one might argue as corporations pass on price increases onto their customers. CITI discusses as well this issue in their note:

"Time is an illusion. Lunchtime doubly so.

Unfortunately a closer examination of both market and fundamental data in this cycle does relatively little to shed light on this debate, or at a minimum can be construed as arguing in both directions.

One potential end-cycle sign is compression of corporate margins, at least as proxied by companies’ unit labour costs (usually the major driver of their cost base) relative to output prices (tracked by the broad GDP deflator). In the US in 1979, 1989,1999 and 2007, labour costs rose more rapidly than output prices as the cycle matured, labour gained in pricing power and corporate profit margins were  squeezed (Figure 21).

Something similar happened for the Euro area in 1999, 2007- 8 and in 2012 (Figure 22).

Each time, this was a useful warning that companies were resorting to leverage in order to support earnings growth, and of the consequent vulnerability of the equity market.

Rob agrees that you may get a rolling over in “per unit” margins in the macro data, even as overall profit margins of listed corporates keep rising. But a combination of strong volumes and high margins are enough to keep profits rising and the bull market rattling along (Figure 23).

Overall profit margins don’t collapse until the recession begins, volumes fall and companies are left with excess fixed cost bases. As such profit margins are a coincident indicator with the stock market, which is why Matt doesn’t like them. They don’t give any prior warning; they always look great right up to the last minute.

The trouble is, this time round, while there is some evidence of margin compression in the Euro area, US unit labour costs have been oscillating without any clear trend. However you look at it, the sort of earnings growth and especially revenue growth we have seen in 2017-18 simply defies traditional models for what is “supposed” to happen at this stage of the cycle." - source CITI

There is indeed a "Dissymmetry of lift" between the US and Europe, leading to the current growth differential outcome with Europe slowing at the moment while the US showing signs of expansion with the latest ISM. Some would argue it could be a peaking sign in this credit cycle. Also as we have argued various times, a sudden acceleration and surge in oil prices would obviously ignite more inflationary expectations (or scare) and lead to a more hawkish Fed. This would of course be much more negative for asset prices overall and lead to the famous bust after the boom.

Another interesting discussion within CITI's note has been around mutual fund flows. Those who read us on a regular basis know that we look at mutual fund flows as an indicator of investors mood and confidence. This we think is quite interesting:

Yet another potentially useful late-cycle indicator is mutual fund flows. You might reasonably have expected Phase 3 to be associated with strong flows into equities. A strong rotation from bonds into equities is very visible in 1997-2000, and is notable by its absence this time round, perhaps suggesting Phase 3 has much further to run (Figure 24).

But both 1985-87 and 2005-2007 were associated with exuberance in fund flows in general – an exuberance which now seems to be running out of steam. Another way to think of fund flows is in terms of total inflows to all risky assets (bonds, equities and hybrid funds combined) relative to inflows to money market funds and deposits. This seems to follow a regular cycle with respect to deposit rates (Figure 25).

In Phases 1 & 2, emerging from recession, when deposit rates are low, and valuations are cheap, investors do most of their saving in risk assets. As the cycle matures and as deposit rates rise, they steadily move some of their savings in deposits. Eventually in Phase 4, they sell all risk assets, prices fall, deposit rates are cut and the, eventually, the cycle starts again. This year’s tremors in markets may be a sign that just such a phase is being reached already.

Yet here too, the signals are ambiguous. Fund flows both influence market returns and are influenced by them (Figure 26).

While we find it quite easy to imagine a scenario in which fund outflows drive markets lower and trigger a growth slowdown, it is by no means a foregone conclusion. We seemed to be embarking on just such a negative path in February 2016, but then an unusual (from the perspective of these charts) rally in markets – admittedly following more central bank intervention – halted the outflows and triggered two years of further inflows. While central bank easing now feels much less likely, positive market returns in equities, driven by earnings growth and share buybacks, may well suffice to spark inflows of their own
accord.

If Matt is right, further central bank withdrawal should mean the inflows fizzle out and turn to outflows, conclusively creating a bear market not just for credit but also for equities. If Rob is right, central bank withdrawal and renewed corporate releveraging should cause credit spreads to widen, but equities may yet have further to rally. They become the only game in town. But equally, it would not be that surprising – especially given the example of the Energy and Materials sectors, and the broad-based deleveraging thanks to earnings growth – for us to skip Phases 4 and 1 entirely, and go straight back to the “organic” deleveraging associated with Phase 2, in which both credit and equities rally. This is, in effect, what markets did during 2017. But was that fundamentals, or the effect of extraordinary central bank policies? Once again, this cycle defies easy categorization." - source CITI

We think, when it comes to Matt King's argument about inflows fizzling out and turning to outflows, creating a bear market is an interesting proposal. In our final chart below we would like to provide additional support to Matt King's view

• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

To add more ammunition to this hypothesis we would like to point out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. Could that be finally a reliable "Boom to Bust" indicator?

"Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand–based narrative of credit cycles and can be useful for policymakers.

A large body of literature in macroeconomics and finance studies the link between credit markets and macroeconomic cycles. A pattern that emerges from the data is that credit booms precede downturns in macroeconomic activity. This pattern attracts considerable attention from academics and policymakers: if credit markets are at the root of macroeconomic fluctuations, then it is important to better understand what drives credit cycles and identify leading indicators to try and design policies that will moderate them.

In this paper we show that investor portfolio choice toward high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms. An increase in our measure in year t predicts credit booms marked by the other indicators in the literature in years t+1 and t+2. These other indicators include the proportion of low-quality bond issuers (Greenwood and Hanson, 2013; López-Salido, Stein, and Zakrajšek, 2017), the degree of reaching for yield in the bond market (Becker and Ivashina, 2015), balance sheet growth in financial intermediaries (Schularick and Taylor, 2012; Krishnamurthy and Muir, 2015), and various measures of credit spreads (Gertler and Lown, 1999), in particular the excess bond premium (EBP) recently proposed by Gilchrist and Zakrajšek (2012).

In addition, our measure, as a leading indicator of credit booms, positively predicts GDP growth and negatively predicts unemployment rates in years t+1 and t+2 (before they turn in the reverse direction in year t+3)."  - source Wharton paper, by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein 

Prolonged ingestion of QE surely is a way leading to many credit investors getting the Korsakoff syndrome such as the Macro EM tourists that piled into the 100 years bond issued by Argentina, causing them memory loss of their fiduciary duty but we ramble again...

"We live in a world where amnesia is the most wished-for state. When did history become a bad word?" - John Guare, American playwright.

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 !