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 !

Macro and Credit - Mercantilism

"What generates war is the economic philosophy of nationalism: embargoes, trade and foreign exchange controls, monetary devaluation, etc. The philosophy of protectionism is a philosophy of war." - Ludwig von Mises

Looking at the strong yet short bounce in equities following market jitters on Italian wobbles (while enjoying some much needed R&R hence our lack of recent posting), indicative of our "white noise" previous analogy, given the acceleration in the trade war rhetoric in the G7, soon to be G6 by the look of it, when it came to selecting our title analogy we decided to go for the simple one of "Mercantilism". "Mercantilism" is a national economic policy designed to maximize the trade of a nation and, historically, to maximize the accumulation of gold and silver (as well as crops). Mercantilism was dominant in modernized parts of Europe from the 16th to the 18th centuries before falling into decline, although we would argue that it is still practiced in the economies of industrializing countries in the form of individual rights. High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Even if mercantilism and protectionism are applied through the same economic measures, they have opposite aims. Mercantilism is an offensive policy aimed at accumulating the largest trade surplus (China, Germany). Conversely, protectionism is a defensive policy aimed at reducing the trade deficit and restoring a trade balance in equilibrium to protect the economy (United States). Mercantilism is the economic version of warfare using economics as a tool for warfare by other means backed up by the state apparatus, that simple. In our previous conversation we reminded ourselves our thought from October 2016, namely that we were drifting towards the inevitable longer-term violent social wake-up calls: populist parties access to power, rise of protectionism, the 30’s model. Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:

"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..." - source Macronomics, January 2018

Hence our "Mercantilism" analogy or basically the reality is that we are fast moving from a cooperative world to a non-cooperative world à la 1930s. It isn't only tensions rising between China and the United States, or United States with Europe, there is as well growing tensions between European country and internal tensions rising even in Germany putting Merkel's feeble coalition at risk thanks to political tensions surrounding immigration issues. We would like to repeat what we we wrote in June 2012 in our conversation "Eastern Promises":

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."  

Remember, it is still a game of survival of the fittest after all:

Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.

Also in June 2012, in our conversation "The Unbearable Lightness of Credit" we argued the following:

"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries".

This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.

The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.

"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia

"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 

Could Europe allow for the adoption of the "Sinatra Doctrine"? We wonder, but nonetheless, before we enter into the nitty gritty of our long overdue new conversation, we thought it would be interesting to remind ourselves of the above given our take for Europe from our November conversation "Chekhov's gun" is still as follows:

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…)." - source Macronomics, November 2014

In this week's conversation, we would like to look at the continuous adverse effects of moving from QE to QT, and the impact is having on Emerging Markets with rising tensions as well on the trade war front. 

Synopsis:

• Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
• Final charts - Capital Flows? This time it's really different.

• Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...

While the short-vol pigs house of straw was the first casualty to go in the change in the sea of liquidity provided by our "Generous Gamblers" aka our dear central bankers, Emerging Markets have been of course next in the line in the change of the narrative with the return of  "Mack the Knife" aka rising US dollar and positive US real rates. We wrote in our last missive that investors were moving back into assessing the "return of capital" rather than the "return on capital". This is creating rising dispersion thanks to investors being more "issuer credit profile" sensitive with the return as well of US cash in the allocation tool box. The rise in dispersion should continue to make active management benefit from this trend after years of being in the shadow of passive management and consequent fund inflows into ETFs.

With the receding tide of cheap liquidity, there is no doubt an intensification in the competition for capital. When it comes to credit, we have recommended to start moving up the quality spectrum and tone down the high beta game, basically meaning being more defensive that is as the game is changing.

Sure some pundits when it comes to Emerging Markets would like to point out to "fundamentals". Yes they do indeed matter particularly when looking at current accounts, but in the end, if there is spillover and contagion from the "usual suspects" with Argentina, Turkey and now Brazil, then what will matter much more is "liquidity". Right now liquidity is being drained by central banks, this will ensure financial conditions tighten. As many have pointed out, including ourselves, the Fed will hike until something breaks, and in the end, what drives the credit cycle is simply the Fed. On the matter of liquidity, which we think is paramount, we read with interest Morgan Stanley's take from their FX Pulse note from the 14th of June entitled "Liquidity Breaks Correlation":

 "Global liquidity… 

The pool of global liquidity appears to be starting to shrink. Several factors are at play here. First, the Fed's balance sheet reduction is increasing pace while the ECB and BoJ are reducing their asset purchases (Exhibit 8).

On net, global central bank liquidity is likely to turn negative over time when compared to GDP growth. Second, the global economic expansion suggests that capital will increasingly be allocated to 'real' economic uses as opposed to financial assets. A closed output gap suggests rising capital demand as spare capacity is eroded, and investment into new capacity requires financing.

Third, the flattening of the US yield curve has reduced the incentive of local financial institutions to transform short-term liabilities into long-term assets (maturity transformation). If banks are less willing to generate liquidity through the maturity transformation process, another buyer will have to step in to make up for the shortfall. Japanese banks liquidating their FX-denominated assets is evidence that demand for US assets is falling outside the US as well, meaning tighter liquidity conditions as demand for financial assets declines (Exhibit 9).

...volatility... 

Tighter liquidity conditions suggest higher volatility as the risk-absorbing capacity of markets declines. When liquidity is ample, all boats tend to get lifted. The reverse effect may be more selective, though. EM volatility has risen sharply, but DM volatility, with the exception of some credit markets, has been relatively muted (Exhibit 10).

Indeed, US equity markets are trading near historical highs, while the 10-year Treasury yield fell back from the recent 3.12% cycle high. It seems the liquidity pool is both shrinking and becoming more concentrated, too. One explanation for the differential in volatility is that we have simply seen a rotation – out of EM and into DM – which explains why DM volatility has been relatively muted compared to EM. This too suggests that a positive outlook for US shares may no longer imply that EM assets will perform well too if they increasingly attract funds at EM assets' expense.

The feedback loop: It is likely that recent market thinking and positioning have been, at least in part, impacted by RBI Governor Patel's recent op-ed where he suggested that the Fed's balance sheet reduction, coupled with rising US public deficits and private debt levels, is leading to an absorption of offshore USD liquidity. Many EM economies experienced recessions following the US taper tantrum in 2013, which in turn resulted in balance sheet consolidation and reduced foreign funding needs. Still, EM countries require capital inflows to keep the economic expansions in place, particularly in the current environment of closed output gaps where spare capacity is increasingly scarce.

Indeed, 2017 saw record inflows into EMs, but this has turned into outflows, tightening local financial conditions and thus their economic outlooks. If not addressed, this issue could create bearish economic feedback loops where liquidity outflows worsen the growth outlook, resulting in more outflows, and leading to even more weakness.

Thus, it may be argued that the US fiscal expansion, implemented at a time when the US output gap was closed and global funding costs were at the lows (and are now rising), may actually reduce the length of the global economic cycle, sowing the seeds for financial asset volatility and investors increasingly seeking safety. Our bearish risk outlook projected for 2H18 has gained traction, we think.

The FX message: Currencies not requiring capital imports and running net foreign asset positions should perform best in this scenario, explaining our bullish JPY call. EUR and Nordic currencies offer value too in this regard. As long as markets only de-correlate but do not fall collectively, CHF should weaken, though. As noted above, the relatively low risk of its asset position suggests that it is not much exposed to waning risk sentiment; otherwise, its income balance would be far higher. Thus, CHF may benefit less than the other surplus currencies should risk sell off. CHFJPY shorts may begin to look attractive again." - source Morgan Stanley

While we got out of EM equities back in January this year following impressive performance in 2017, we continue to believe that US equities will fare much better relative to EM in 2018, contrary to what played out in 2017. Fund flows related wise, in similar to US High Yield, where there is a large contingent of retail punters, Emerging Markets are starting orderly retreat from the asset class at a rapid pace. This is confirmed by Bank of America Merrill Lynch GEMs Flow Talk note from the 14th of June entitled "EXD & LDM outflows continue… 8th straight week down; big blow for EXD":

"EPFR fund flows down: EM debt 8th consec week down

• EXD, LDM and EM Equity were all down, while blended funds were slightly up.
• 8 negative weeks in a row for overall EM debt, outpacing the large negative trend recorded at the end of 2016 (six consecutive weeks down) but still not as bad as the one registered since Oct 15 – Feb 16 (18 consecutive weeks down).

• EPFR aggregate EM debt flows were down -0.3% total.

-0.1% for Local Debt (LDM), -0.5% for External Debt (EXD),
+0.1% blended funds and -0.1% EM equity.

• ETF flows were down in LDM but positive in EXD (-0.2% and +0.2%).

EXD outflows are from retail and mild vs 2013

EXD funds now have a small negative total YTD outflow after this week. They are still quite small compared to the large wave of outflows in 2013, at a time when retail investors were a larger part of the EM market (Chart 1).

We do not think they returned.
The outflows reported by EPFR have been almost entirely from small retail accounts who are less than 5% of the EXD market ($66bn AUM of the $2.4tn EXD outstanding). The remaining funds monitored by EPFR are another 5% of the EXD mutual funds in the US, SICAVs in Europe and ETFs. (Table 5).

The rest, who do not report weekly, include mainly large privately managed accounts, pension funds, sovereign wealth funds, insurance companies and banks and who are the mainstay of the EM buyer base. Our institutional managers do not report these sorts of institutional outflows at this time, and we believe there are still EM mandates expected." - source Bank of America Merrill Lynch

In a competitive system for capital allocation, with the receding QE tide thanks to QT, we are much more concerned about the "corporate sector" due to dollar funding and leverage in some instances. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure so watch what oil prices do going forward, not only what the US dollar does. It is not a surprise to see LATAM High Yield down 3.8% YTD compared to Asia High Yield only down 3.3% YTD. Overall in both EM and DM, credit has suffered more than equities when US High Yield has been much more stable relative to EM as well.

One might ask itself that if indeed the short-vol yield pigs house was made of straw, then maybe the EM yield pigs house is made up of wood and the next step could be a full blown EM crisis on our hands. Bank of America Merrill Lynch made some interesting points in their Credit Market Strategist note from the 8th of June entitled "When the tides goes out":

"EM crisis?

Other markets benefiting from QE include EM. With a rising dollar the greatest rollover risk is now for countries that have relied on external dollar denominated financing and are running deficits. Hence, this year’s worst performing countries in terms of currency depreciation and sovereign CDS include Venezuela, Argentina, Turkey and Brazil (Figure 1).

In terms of spillover risk to US credit, we would de-emphasize the EM story and focus on Italy and the European sovereign situation, which has much more cross-exposures to the US and systemic risk to the global financial system. Of course, the Italian story is also partially an outcome of QE that allowed cheap deficit financing, and made worse with the coincident timing of ECBs coming final taper (Figure 2).

Another important contributing factor has been a fixed exchange rate (euro member), which used to be how EM countries got into trouble via large current account deficits." - source Bank of America Merrill Lynch

Sure fundamentals matter, but given the receding tide in liquidity thanks to central banks turning slowly turning off the tap, more and more liquidity will matter. There is as well the L word for leverage and on that point we are worried about US corporate leverage which has been creeping up in recent years on the back of a buyback binge. To illustrate this we would point out towards another point made in Bank of America Merrill Lynch note about the state of credit fundamentals:

"Final update on 1Q credit fundamentals

Based on almost final data for 1Q (covering 97% of companies), gross leverage for US public non-financial high grade issuers increased to 3.04x in 1Q from 2.98x in 4Q, while net leverage rose to 2.67x from 2.54x. Both gross and net leverage are now the highest on record (Figure 36).

For our “core” issuers excluding Energy, Metals and Utilities gross leverage was 2.39x, up from 2.34x in 4Q but below 2.40x in 3Q-17. Net leverage increased to 1.79x from 1.59 in 4Q (Figure 37).

The coverage ratio fell to 8.23 in 1Q from 8.44 in 4Q for the full universe of issuers (Figure 38), and was a bit lower at 10.79 in 1Q compared to 10.91in 4Q for the core set of issuers (Figure 39).

- source Bank of America Merrill Lynch

It's not only the leverage which is higher in US Investment Grade credit, quality as well has been worsening in a market where secondary trading is much weaker than before thanks to low inventories on US banks balance sheet and less appetite in providing "risk" in a context where "passive" management through ETFs has exploded in terms of inflows. It isn't a good recipe for when things will start heating up, but, we are not there yet in this credit cycle. Dispersion is rising still between issuers as the competition to attract capital is ratcheting up thanks to central banks turning the liquidity spigot gradually until it hurts.

If L is for "Leverage" when looking at US credit, L is as well the word for "Liquidity". Liquidity, as many veterans from the Great Financial Crisis (GFC) know is a coward. For EM it is already the case as pointed out in another note from Bank of America Merrill Lynch, in their Emerging Markets Weekly from the 14th of June entitled "It is the "L" word...Liquidity":

"It is the "L" word...Liquidity

• Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
• EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high.

Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons. First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether. Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions. Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.

It is a tale of two markets ‒ before and after April 16 Before April 16, EM debt was a different market, outperforming every other debt asset class, with continued EM inflows (2%) while there were outflows from US (-4%) and non-US HY (-7%). Unlike 2013, EM inflows persisted, even during the first 75bp of the US rate rise from Sept 2017 to April 16, 2018. Since then institutional flows are somewhat offsetting the small retail outflows and EXD ETF inflows have been fairly stable. EM issuance was up 8% through April 16, while that for US IG and HY was lower by 7% and 25%, respectively (EM supply? Relax. It is not as bad as you fear). 

2017 to early 2018 large growth

EM economies are still booming and new markets have opened with new demand. First, GCC sovereign issuance and frontier markets have grown rapidly, offering investment opportunities for high credit quality crossover buyers, as well as higher yielding and promising credit stories offering diversification. In addition, China has become more than one-third of EM corporate issuance and as much as 90% of that is placed in Asia, much in China itself. Fundamentally, most of those markets have not changed in the last 2 months." - source Bank of America Merrill Lynch

Yes, in illiquid markets, size matters. No matter what some sell-side pundits would like to spin, liquidity trumps fundamentals. It is your ability to trade that matters.

Having learned quite a few things from reading over the years the research from the wise Charles Gave of Gavekal research for whom we have great respect, at this juncture from QE to QT we think we needed to reminded ourselves his wise words:

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

Last year rush for Argentina 100 year bond was indeed a case of more money than fools for EM. As the tide slowly recedes and we turn from QE to QT, we will over the course of the next quarters gradually discover who has been swimming naked, given capital will flow more discerningly we think. QE was a period where money thanks to NIRP and ZIRP was chasing anything with a yield without distinction. Now with rising dispersion, there will be truly more "credit analysis" done at the issuer level. Times are changing as pointed out by Bank of America Merrill Lynch in their Credit Market Strategist note from the 15th of June entitled "On the road from QE to QT, redux":

"On the road from QE to QT, redux

We have used this title before (see: Credit Market Strategist: On the road from QE to QT 29 March 2018) and this week’s central bank meetings - Fed, ECB and BOJ - motivate us to recycle it. Quantitative easing (QE) was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed. There is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).

However, we are currently in this intermediate phase - i.e. on the road from QE to QT - where things remain orderly although technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).

Hence, we have seen higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4).

Domestic QT+ foreign QE/NIRP=OK

The reason we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5).

Thus, if US yields rose too much due to QT and rate hikes there would be large foreign inflows. Hence, US yields would not increase too much and fixed income volatility remains moderate. While this week the ECB announced the end to QE, they came out dovish by promising continued negative interest rates (NIRP) for a long period of time (Figure 6).

NIRP in the Eurozone works much like QE, as explained below, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.

How does the ECB influence the back end of the curve? It is very simple: with negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9).

That asserts bull flattening pressure on both rates and quality curves.

We have not seen this movie before

While QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years.

However, while we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020. This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate." - source Bank of America Merrill Lynch.

The escape route is somewhat less tricky for the Fed than for the ECB. It remains to be seen if Mario Draghi will rock the boat before the end of his term in 2019. We do not think he will. The Bank of Japan remains so far committed to QE, so there is still some time on the gradual tightening spigot we think.

Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities market are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out. On the subject of disruption from trade wars, we read with interest Barclays take from their Thinking Macro note from the 1st of June entitled "Trade war in perspective":

"US trade protectionism: Where do we stand?

This year, the US has implemented a number of protectionist trade actions. In March, President Trump announced a 25% tariff on steel (10% on aluminium) imports. The US Trade Representative (USTR) then proposed a 25% intellectual property (IP) related tariff on 1,333 Chinese goods. President Trump then asked the USTR if it was possible to impose tariffs on a further $100bn of Chinese goods. Import tariffs in the automotive sector are also being considered. Some progress has been made in trade negotiations with China (see China: Tariffs on hold, long negotiations continue, 12 May 2018). But escalation risks remain, since the steel tariff exemption will expire on 1 June and the White House said it will impose a $50bn IP tariff on Chinese products, with the list published by 15 June 2018.

We use a VAR model to quantify the potential impact of US tariffs on global growth and CPI inflation. The first year estimates are subject to high model and parameter uncertainty. We thus use second year estimates. These show that a 1% unilateral rise in US tariffs as share of US imports may reduce global growth by 0.3pp and increase inflation by 0.4pp. That said, the impact of the steel tariff, even without exemptions, would only lead to a 0.1pp decline in global growth and a rise of 0.1pp in CPI inflation, as steel is only 0.33% of US imports.

Large economic effects larger require big tariffs. If the proposed 25% tariff of $100bn of Chinese goods is added to the steel tariff, together with tit-for-tat retaliation, our model shows that such a scenario would raise CPI inflation by 1.1pp and cut growth by 0.9pp.
Our model suggests that the adverse effects of US trade tariffs on emerging markets are likely to be much larger and more persistent. This is intuitive, as these economies have been the largest beneficiaries of the most recent globalisation wave. According to our model, a 1% rise in US tariffs leads to a 1.1pp reduction in EM growth in the first year, versus 0.5pp for DM. For CPI inflation, the numbers are +1.1pp for EM versus +0.2pp for DM.

However, there are a number of mitigating factors. In the first age of globalisation, US tariff policy was very active, but large retaliations were rare. Similarly, their 70% success rate incentivises the US and EU to keep the WTO for resolving trade disputes. In addition, President Trump’s drive for deregulation, by removing entry barriers, could encourage more services trade, which may mitigate the negative effect of higher tariffs on goods. That said, any rise in services trade flows is unlikely to fully offset the impact of higher tariffs on EM countries, given the size and persistence of the effects estimated in this paper.

The impact is larger for emerging, than developed, markets

Emerging markets have likely benefitted the most from the trade hyper-globalisation of the 1990s. The abundant and competitively priced labour supply in these countries, together with free trade, led to large FDI inflows, allowing these countries to export their way up the development ladder. Intuitively, this suggests that these countries should also be more vulnerable to a rise in protectionism. In this section, we split our global real GDP growth and inflation variables into corresponding variables for emerging and developed markets, to econometrically examine if EM economies react differently to DM economies.

Figure 8 and Figure 9 shows the results for EM and DM economies, respectively. This breakdown produces several interesting results. First, EM GDP growth is likely to shrink by roughly twice as much as DM. Second, the DM GDP effect is short-lived and not statistically significant after one year, but is much more persistent in EM. Finally, the impact on EM CPI inflation is approximately five times as large as in DM. This could be due to higher USD denomination of financing flows and trade transactions, as well as different monetary policy reactions to external shocks in EM than DM.

Not surprisingly, the effect of the current US steel tariffs is much larger for EM economies (Figure 10.) than DM economies (Figure 11).

We compare first year estimates, because of a lack of statistical significance for the DM GDP response after the first year. With the steel tariff alone, our model suggests that EM (DM) GDP growth could fall by 0.3pp (0.1pp) and inflation rise by 0.3pp (0.1pp). With steel tariff retaliation, EM growth could fall by -0.7pp, with inflation rising by 0.7pp, which are sizable effects. If the US unilaterally implements IP-related tariffs on $50bn of goods from China, then EM (DM) growth could fall by 0.9pp (0.4pp) and inflation rise by 0.8pp (0.15pp). In the case of tit-for-tat retaliation, EM (DM) real GDP growth falls by 1.7pp (0.7pp) and inflation rises by 1.7pp (0.3pp). Overall, DM would only really feel any effects from tariffs in this very last scenario, while the impact for EMs is already sizable if the current steel tariffs are retaliated against.

The return of US protectionism can be disruptive

In this section, we review the main lessons from our econometric exploration of US tariffs. Modelling the impact of US tariffs on short-term global growth and inflation is challenging. Academic work has focused on the long-term effect, and uncertainty about the impact in the first year after the tariff announcement is large. Our estimates are based on a gradual tariff reduction, while the current situation is a rapid tariff rise. The estimates presented in this paper should therefore be interpreted accordingly. However, they nevertheless provide a first econometric view on how President Trump’s tariffs might affect the world economy.

Our results suggest that US tariffs act like a negative supply shock to the world economy, lowering global growth and raising inflation. However, only large tariffs produce large effects: the current US Steel tariff is only 0.33% of US imports and would reduce global growth only by 0.1pp, while raising global inflation by 0.1pp. It is only when $50bn of IP-tariffs are added and retaliated tit-for-tat that growth falls 0.6pp, while inflation rises 0.7pp.

The impact on emerging markets is much greater than on developed markets. The EM GDP growth impact is twice as large as on DM and significantly more persistent. The EM CPI inflation response is approximately five times as large as in DM. While there are a number of mitigating factors that are not accounted for, the analysis suggests that EM economies will be affected to a much greater extent than developed markets.

Overall, US protectionism could be disruptive, especially if tariffs are large and are retaliated. Emerging markets will likely be more affected than developed markets." - source Barclays

So there you go, if you think EM woes are overdone because of "fundamentals" then again you would be wrong if trade war escalates this could lead to a stagflationary outcome. Then of course, there is as well the trajectory of the US dollar and oil prices to factor in. From a liquidity perspective, we think the second part of the year will be challenging as the central banks turn off the liquidity spigot. You should continue to be overweight DM over EM on a relative basis overall. Then again, there are as well different stories and different issuer profiles. In a rising dispersion credit world, you need to go back to "credit analysis" and this is why active management should be favored right now over passive management. It is time to become more "discerning".

For our final charts, given the increasing competitive nature of capital allocation when liquidity is being withdrawn, we would like to highlight how this cycle is unique.

• Final charts - Capital Flows? This time it's really different.

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015 and in 2018) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

Capital flows react to real interest rates dynamic. Following years of financial repression in this cycle, the reaction and velocity of the moves we are seeing are therefore much larger from a standard deviation point of view. Our final charts come from Wells Fargo Economics Group note from the 13th of June entitled "Capital Flows Part III: This Time Is Different" and highlights the unique nature of the current economic cycle which ultimately affects capital flows as per our reverse osmosis theory stated above:

"The relationship between interest rate expectations and exchange rates has become harder to quantify, largely due to the unique nature of the current economic cycle. This changing dynamic ultimately affects capital flows.

What About Expectations?

As we have discussed in two previous reports,* capital flows respond to relative interest rate and exchange rate dynamics across borders. We now turn to the effect of expectations on our three variables. Expectations have played an increasingly important role in market participants’ reactions to global events. For example, recent Italian political developments led the euro to decline against the dollar, while Italian bond yields rose more than 100 bps (below chart).

While it is too soon to determine any effect these political tensions could have on capital flows, it is clear that expectations play a role in short-term exchange rate and interest rate dynamics. In the long run, these dynamics affect capital flows.

Expectations of central bank actions have also caused unpredictable swings in foreign exchange rates and interest rates. As previously discussed, our currency strategy team has found additional rate hikes from the Fed to be less supportive of the dollar, while at this stage, tightening on the part of foreign central banks has been more supportive of foreign currencies. Throughout much of 2017, short-term rate expectations moved in favor of the U.S. dollar, but the dollar declined (below chart).

This is likely due in part to the FOMC being further along its tightening path relative to other major central banks, and market participants having already priced in future rate hikes to a large extent. Market-implied probabilities of a rate hike are nearly 100 percent for today’s FOMC decision. Market participants likely see the FOMC as only having so many rate hikes left before reaching its terminal rate, and this means the potential for rate hike “surprises” is much lower.

In turn, the effect of interest rate expectations on exchange rates has been harder to quantify. As the Fed began to tighten policy in 2015-2016, one could theoretically identify a more direct relationship between the probability of a Fed rate hike and its effect on the dollar. However, as global central banks have engaged in unconventional monetary policy measures, the focus has turned toward perceived policy stances through actions such as quantitative easing, rather than a pure reaction to actual rate hikes.

Reviewing Past Cycles: All Else Is Not Equal for Capital Flows

The evolving relationship between interest rate expectations and exchange rates confirms why this cycle is unique. We have found that country-specific characteristics lead to volatility in capital flows, and similarly influence expectations. In the U.S. for example, prior cycles may have had a rising rate environment, but lacked a fiscal stimulus. This difference is compounded by unconventional global monetary policy and a deteriorating fiscal outlook during one of the longest economic expansions in recent history (below chart).

These differences influence investors’ relative allocation of capital, and decision makers would do well to pay attention to the unique outcomes that stem from differing market expectations."  -source Wells Fargo

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike as discussed in our "Mack the Knife" July 2015 musing to repeat ourselves. Why did past Mercantilism failed and will fail again? Just read again Adam Smith's 1776 "The Wealth of Nations" in 1776. In his book Adam Smith's argued that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He showed that trade can be mutually beneficial, an argument also made later by David Ricardo. In January 2017 in our conversation "The Ultimatum game" we argued:

"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 

Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits but we ramble again...

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country." - Adam Smith

Stay tuned !