Macro and Credit - Easy Come, Easy Go

"There are many harsh lessons to be learned from the gambling experience, but the harshest one of all is the difference between having Fun and being Smart." - Hunter S. Thompson

Looking at the return of the "D" trade, "D" for "Deflation" that is with the return of the strong "bid" for bonds, marking the return of the duration trade on the back of "goldilocks" for "Investment Grade" which we foresaw, pushing more inflows into fixed income relative to equities, when it came to selecting our title analogy, we decided to go for a cinematic analogy "Easy Come, Easy Go". It is a 1947 movie directed by John Farrow, who won the Academy Award for Best Writing/Best Screenplay for Around the World in Eighty Days and in 1942, and was nominated as Best Director for Wake Island. "Easy Come, Easy Go" is the story about Martin Donovan, a compulsive gambler. His gambling habits leave him constantly broke and under arrest from a gambling-house raid. He places bets as well for the tenants of his boardinghouse, who lose their money and ability to pay the rent. Martin, came upon a sunken treasure but his philosophy is "easy come, easy go," promptly squanders all the loot. Looking at the various iterations of QE and the return to more dovishness from central bankers around the world, which lead no doubt to rise of so called "populism" with the asset owners having a field day, particularly the renters through the bond markets, over "Main Street", it is clear to us that the "treasured" support provided by central bankers to politicians has been all but "squandered". For example, French politicians have done meaningless structural reforms leading to unsustainable taxation creating the rise of the "yellow jackets" movement hence our pre-revolutionary stance. As we say in France, c'est la vie.  As in the move, with Martin's daughter Connie not knowing what else to do, she tries to solve her dad's debts by taking bets on a horse race. In similar fashion, central bankers have decided to add more dovishness on more debt, resulting in even more debt being created. Caveat creditor but we ramble again...

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

Synopsis:

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

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

In our most recent conversation we pointed out again that we advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. To repeat ourselves, we continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength. You have to become much more selective we think in the issuer profile selection process.

"Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan" as we pointed out again in our most recent conversation. We also indicated as well:

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective.

Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk. " - source Macronomics, March 2019

"Bondzilla" the NIRP monster should not be underestimated in our macro allocation book. On this particular point we read with interest Nomura's FX Insights note from the 29th of March entitled "GPIF: sustained aggressive foreign buying more likely":

"Annual plan for new FY unveiled

The Government Pension Investment Fund’s (GPIF) annual plan for the new fiscal year suggests the fund can manage its portfolio more flexibly. This should allow the fund to continue purchasing foreign bonds aggressively, while reducing exposure to negative yielding domestic bonds. This shift is also likely to lead a higher share of foreign bonds in the updated target portfolio, which will be announced by end-March 2020. Given the significant size of the GPIF’s AUM, this flexible stance will be crucial for Japan’s financial market and yen-crosses. We expect pension funds’ foreign bond purchases to support yen-crosses during the new fiscal year.

The GPIF announced its annual plan for the new fiscal year. In the annual plan, the GPIF noted that it will manage its portfolio according to the basic portfolio, as usual. However, the GPIF added two important points for its portfolio strategy in the new fiscal year, in relation to the allowable range of the target portfolio.

First, the GPIF repeated that automatically reinvesting redemptions from exposure to domestic bonds may not be appropriate in the current market environment. Thus, for now, the fund will manage its domestic bond portfolio more flexibly in relation to the allowable range. The fund will maintain the total amount of domestic bonds and cash within the allowable range of domestic bonds (25-45%). The GPIF has already announced the temporary deviation in domestic bond exposures from the allowable range last September and thus, this point is not entirely new (see “Equity flows supporting yen-crosses”, 26 September 2018). However, flexibility has now been extended into the new fiscal year that commences next week, and the fund can continue to reduce exposure to domestic bonds for a longer amount of time.

Second, the GPIF added a new sentence, stating: “the fund will examine the application of allowable range for asset classes as necessary, as the fund is formulating its new target portfolio (Figure 1).

In April 2014, the GPIF stated that it would flexibly manage its portfolio in relation to the allowance rage, as it started reviewing its target portfolio for the next medium-term plan (see “GPIF: Time for whale-watching”, 4 December 2018). Owing to the increased flexibility, the fund could begin investing in equities and foreign bonds before it announced the new target portfolio in October 2014. Although the communique this year differs from five years ago, this additional comment could provide the fund with more opportunity to manage the portfolio more flexibly in the new fiscal year.

We think these statements are significant for Japan’s financial market and yen-crosses this year. As of end-December, the share of domestic bonds had declined to 28.2%, closer to the lower bound of the current allowable range (25%, Figure 2).

In contrast, the share of foreign bonds increased to 17.4%, closer to the upper range of the current allowable range (19%). The fund has recently been purchasing foreign bonds aggressively, as it likely judges negative-yielding domestic bonds as unattractive (Figure 3). Historically, the pace of foreign bond purchases in Q4 last year was at the highest pace (see “Three important JPY flow stories”, 1 March 2019). Without the two additional points above, the GPIF would need to start liquidating foreign bonds, while accumulating exposures to domestic bonds again.

However, as the fund can manage its portfolio more flexibly in the new fiscal year, it should be able to continue purchasing foreign bonds, even if the share exceeds the upper limit (19%).

As the BOJ’s negative rate policy will be extended further, in our view, we think it would be reasonable for the GPIF to continue reducing the fund’s exposure to domestic bonds, while shifting into foreign bonds. At the moment, both domestic and foreign equity shares central of the GPIF’s target portfolio are at 25%, but the central target for foreign bonds is just 15%. Thus, there is room for the fund to further shift from domestic bonds into foreign bonds.

The GPIF will release its new basic portfolio by end-March 2020, while the announcement could take place by end-2019. We see a strong probability that the GPIF would raise the share of foreign bonds then, and its flow could lead to JPY selling.

As of end-December, total AUM managed by the GPIF was at JPY151.4trn (USD1.4trn), and 5% portfolio shift into foreign bonds could generate JPY7.6trn (USD65-70bn) of JPY selling.
In comparison with 2014, market interest in the GPIF portfolio change seems much lower (Figure 4).

Nonetheless, we believe the annual plan released today shows the fund’s investment in foreign bonds will remain significant this year, and the diversification should support cross-yens well (Figure 5).

- source Nomura

So, from an allocation perspective, you probably want to "front run" the GPIF and its lifers friend, given they play "Easy come, Easy Go" particularly well in adding US dollar credit exposure we think.

When it comes to flows, and all the "fun" going into the bond market, it is already happening as per Bank of America Merrill Lynch's note from the 29th of March entitled "Bonds over stocks":

"Dovish central banks revive the bond market

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

It feels that this trend is here to stay amid low inflation and lack of growth in Europe, and continued political headwinds (Brexit, trade wars). As macroeconomic data trends are bottoming out and central banks continue to remain dovish, we think that credit gap wider risks are limited.

Over the past week…

High grade funds recorded an inflow for the fourth week in a row, albeit at a slower pace than last week. However we note that one fund suffered an outflow of almost $1bn. Should we adjust for that the inflow would have been more than $2.7bn.

High yield funds enjoyed their fifth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the inflows, with the other half favouring US-focused funds more than European-focused funds.

Government bond funds saw inflows for a second straight week, while the pace has been ticking up over the past couple of weeks. Money Market funds recorded an outflow last week, the strongest over the last five weeks. All in all, Fixed Income funds enjoyed another week of strong inflows.

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

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

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

Follow the flow as they say, but follow Japan when it comes to credit markets exposure, given that they are no small players when it comes to global allocation.

So should you play "defense" allocation wise or continue to go "all in"? On that very subject we read with interest Morgan Stanley's Cross Asset Dispatches note from the 31st of March entitled "Improving the Cycle Indicator – Countdown to Downturn":

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

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

Looking at the optimal allocation for the ACWI/USD Agg porfolio, we find that weighting between global equities and bonds doesn't really change materially until a downturn starts. However, rotation within asset classes occurs throughout expansion and into the cycle turn – for example, US equities see weighting fall throughout expansion in favour of RoW stocks, and fixed income portfolios rotate towards long-duration away from intermediate maturities over the same time. In other words, downturn may trigger the broad cross asset allocation, but investors should still look to tilt more defensive within asset classes throughout expansion.

What would this defensive tilt look like? Examining the optimal allocations for: i) USD Agg/ACWI; ii) Multi-asset; and iii) USD Agg portfolios through various cycles over the past 30 years, using realised next one-year returns, these shifts need to occur for a more defensive positioning:

• Pare back equity risk, especially US versus RoW: Optimal weight to stocks tends to fall from expansion to downturn as stocks go from seeing a boost in returns to a drag.
• Reduce US HY to max underweight: Allocation to lower-quality (BBB and HY) corporates typically collapses in expansion, given the unattractive returns profile; downturn only sees performance deteriorate further, taking HY (and BBB) to its lowest weighting in the cycle.
• Tilt towards long-duration in late-cycle, add cash: UST and cash combined have the largest allocation in downturn.

These are largely in line with our current recommendations, based on our cross-asset allocation framework of which the cycle indicator forms one of the three pillars, along with long-run fair value models and short-run expectations from our strategy colleagues.

With long-run capital market assumptions which are below average for most assets, unenthusiastic 12-month forecasts from our strategists and a cycle model that's about to turn, we reiterate our stance to be EW in stocks, with a preference for ex-US equities, EW in bonds, with a tilt towards USTs, and UW in credit, in particular low-quality corporates. For investors looking for late-cycle hedges, we also recommend vol trades like buying credit puts, USDJPY puts and long Eurostoxx calls versus S&P calls to take advantage of dislocations in the vol space." - source Morgan Stanley.

Of course everyone is looking at the inverted US yield curve as a good predictor of a downturn to show up and markets are already pricing rates cut from the Fed. From a lower volatility positioning, it makes sense to be overweight US Investment Grade and adding duration and somewhat reduce exposure to US High Yield. In Europe, when it comes to financials, credit continues to benefit from the ECB support, financial equities, not so much, regardless of the price to book narrative put forward by many sell-side pundits. We continue to dislike financials equities and rather play exposure through credit markets, even high beta offers better value. 

But what about the cycle? Is it already turning in the US given the inversion of the US yield curve? On that specific point Morgan Stanley in their note pointed out the following:

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

Our revamped US cycle indicator suggests that the market is still in expansion. But our model also says there's a high chance (~70%) of a shift to downturn within the next 12 months.

Our market cycle indicators are a central part of our cross-asset framework, launched with our initiation of coverage nearly five years ago. While prior builds have served us well over this time, generally pointing to continued cycle expansion amid bouts of volatility, we have looked to continually improve these indicators. This is the latest iteration.

The main changes to the methodology revolve around index composition, weighting system and the way we systematically categorise cycle phases, relying on breadth of change across metrics instead of moving averages. The result is, in our view, an improved cycle indicator which can better flag turns in real time, with greater confidence and less lag. Currently, the revised US cycle indicator ('v2019') ( Exhibit 22 ) points to continued expansion, driven by many key macro indicators being above-trend ( Exhibit 23 ).

…but a market cycle peak is imminent

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

Exhibit 26 shows our real-time downturn probability gauge, which estimates the chance of our cycle model inflecting to downturn from expansion within the next 12 months, based on historical experience.

What this chart suggests is that, given the level of the cycle indicator, the chance of a shift to downturn over the next 12 months is elevated at close to 70%, up from ~60% from end-2017 when we last checked up on the cycle.

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

Since April 2010, we've not had a six-month period where a majority of the components of the cycle indicator were not improving; it is, to our knowledge, the longest streak in history ( Exhibit 27 ).

Historically, such an environment of data improvement breadth and depth (with the likes of unemployment rate and consumer confidence hitting extreme levels in recent months) has meant a high probability of cycle deterioration in the next 12 months – after all, what goes up must come down. Indeed, the latest disappointing consumer confidence data pushes the number of cycle indicator components deteriorating over the last six months to seven now – enough to be considered 'critical mass'. If such deterioration persists, our rules-based approach to identifying cycle phases could very well call a switch from expansion to downturn as early as next month. At any rate, our market cycle indicator and the probability gauge are very clear – an inflection from expansion to downturn is on the horizon." - source Morgan Stanley

As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured.

It doesn't mean equities cannot rally further, there is still the on-going US-China trade spat yet to be resolved. Right now Macro continues to deteriorate, particularly in the Eurozone with its Manufacturing PMI falling to 47.5 (49.3 - Feb). Germany and Italy were notable contributors to the stronger decline:

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

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

"Key findings:

• Overall GTB index for global trade falls by -4 points to 56 compared to December, signaling only a slight growth and coming ever closer to stagnation.
• Prospects weakening for most surveyed countries – but remain above neutral 50, still indicating positive growth, apart from South Korea
• Outlook for global air trade is sluggish, dropping by -3 to 55 points. Growth of global ocean trade is also slowing down, reflected in an index value of 56, a decrease by -5.

According to the latest three-months forecast by the DHL Global Trade Barometer (GTB) global trade is foreseen to grow only slowly. The overall growth index decreased by -4 points compared to the last update in December, scoring 56 points in March. The slowdown is especially attributed to the significant decelerating growth prospects of India (-18) and South Korea (-12).

Also in the US, trade growth is expected to lose momentum (-5 points), whereas the GTB forecasts for China (-1), Germany (+2), Japan (-2) and the UK (+2) are largely in-line with the previous update.

The outlook for global air trade is sluggish, dropping -3 to 55 points. All surveyed countries are forecasted to slowdown in air trade except for Germany (+9). The largest declines are expected for South Korea (-14), India (-13) as well as Japan (-5). China and US dropping moderately with -3 and -2 points. Moreover, the index for South Korea and UK air trade drops below 50 points, suggesting a contraction of air trade growth.

Global ocean trade outlook is also modest, seeing decelerated growth (-5 points to 56). The largest downturns are found in India (-20), South Korea (-10) and US (-7). German ocean trade further weakened, as the country’s index falls slightly by -2 to 46 points. China (-1 point) is forecasted to decelerate slightly. Meanwhile, ocean trade in the UK (+4 points) and Japan (+2 points) is picking up some steam." - source DHL - Global Trade Barometer, March 2019

With China’s Caixin March manufacturing PMI beating expectations at 50.8 from 49.9 last month (50.0 expected), optimism that China can once again provide the heavy lifting for global growth has been renewed, hence the latest positive tone from financial markets. 

Could it be that we will see weaker growth for longer? In that case bonds could continue to perform in that environment where bad news is good news again thanks to the renewed "Easy Come, Easy Go" stance from central banks.

We can therefore expect US Treasury Notes 10 year yield to fall further in that context. It seems that bond bears were a little bit too hasty in 2018 in the demise of the long duration trade.

We have been asked recently by one of our readers on  the rise in interest rate volatility seen recently through the MOVE gauge index responding by posting its biggest two-day gain since 2016. We replied that it didn't change our recommendation of playing "quality", Investment Grade that is, over "quantity", US High Yield. On that specific point we read with interest Barclays US Credit Alpha note from the 29th of March entitled "Rates Moves Dictates Credit Moves":

Rates Moves Dictating Credit Moves

Interest rate volatility remains high, with consequences for the credit market, as spreads have widened modestly. In addition to the decline in yields, the 3m10y Treasury spread has inverted, and the market is implying a rate cut by the Fed for the first time since the beginning of 2013. The last time 3m10y was inverted and the market implied a significant rate cut was in late 2006, as the prior economic cycle reached maturity. As Figure 2 shows, equities rallied at that point, and credit spreads held in despite concerns about a weaker economy.

An obvious question is whether the current inversion signals the end of the cycle, since, in the past, recessions have occurred on average four quarters after the 3m10y inverts. However, the 2y10y curve has typically already been inverted, which is not the case today. We believe more caution is warranted based on recent curve moves, consistent with our forecast for wider spreads at year-end.

Digging deeper into the relationships of credit markets around the 3m10y inversions in 2000 and 2006, we notice significant differences compared with this year. In both instances, high yield was outperforming investment grade and the BBB/A spread ratio was flat or lower. This seems to support our short-term view that BBBs should outperform their beta.

We had also been advocating owning BBBs versus BBs recently, and the gap between those spreads has moved almost 20bp higher from the recent lows. While a sizable move, it still does not make BBs look particularly cheap. However, we think that differences in trading conventions for the high yield and investment grade markets are behind a lot of the BB underperformance and expect some bounce-back for BBs in spread terms as soon as rates stabilize. Traders are quoting BB prices broadly flat over the past week, as rates rallied and spreads moved 20bp wider. In contrast, BBB bonds are quoted more or less unchanged on spread, but their prices jumped more than a point. Underscoring the technical nature of the move, we note that even within capital structures that have both BBB and BB rated bonds, such as Charter Communications, the basis spiked. As a result, we believe there could be some near-term tactical spread outperformance for BBs." -source Barclays

We could see a continuation in the high beta rally yet it doesn't seem to us vindicated by recent flows, so we would rather stick with our defensive call for the time being.

Given all of the above, we are more inclined towards credit markets and "coupon clipping" and playing it safe through Fixed Income and credit markets as warranted by current fund flows we are seeing and Japanese support coming from overseas. As well our final chart displays the defensive positioning as we enter the second quarter.

• Final charts - The deflation play is back in town

Looking at the dismal macro data which has tilted central banks towards a much more dovish stance, the positioning and fund inflows for the second quarter appear to be more geared towards "deflation assets". Our final chart comes from Bank of America Merrill Lynch The Flow Show note from the 28th of March entitled "Pavlov's Dog Bites Fed" and shows "Deflation vs Inflation flows":

"Positioning into Q2: consensus starts Q2 long “secular stagnation” & “deflation”; YTD $87bn inflows into “deflation assets” e.g. corp & EM bonds & REITs, and $42bn redemptions from “inflation assets”, e.g. EAFE equities & resources (Chart 4); investors are discounting neither recession (they love corporate bonds) not recovery (they don’t like cyclical equities).

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

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

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

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

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

Q2 catalyst: Positioning & Policy were positive catalysts in Q1; Profits will be the catalyst in Q2; we say consensus global EPS numbers remain too high (BofAML Global EPS model forecasts -9% EPS growth in the next 12 months vs. analyst consensus 0% - Chart 5).

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

Stagnation: global EPS forecast stagnates @ -5-10% as US growth dips below 2%, global PMIs vacillate around 50, US rates fall toward anchored/negative Japanese & Eurozone rates, secular “Japanification” trade of past 10 years hardens; the big tell...credit bid, volatility offered; the big trades...long 30-year UST, biotech, short resources, volatility.

Recession: global EPS forecast drops to -15% as surge in US unemployment claims indicates US consumer joining manufacturing recession in China, Japan & Eurozone where PMIs drop to 45; the big tells...oil <$50/b, JNK <$33, INJCJC4 >300k; the big trades...short tech & corporate bonds, long T-bills, US dollar & VIX.

Recovery: global EPS forecast turns positive as “green shoots” in Asian exports (Chart 1) & Chinese growth blossom, while lower US rates boost US housing data; credit spreads prove once again they are better lead indicator for risk assets than government bond yields (Chart 6); the tells...SOX >1450, XHB >$42, KOSPI >2350, yield curve steepens; the trades...long global banks, short bunds & US dollar.

Next up: big 5 datapoints in coming week to set course for Q2 (see table 1); tactically we are in Q2 “Recovery” camp; H2 we expect big top in markets before debt deflation/policy impotence leads risk assets lower."  - source Bank of America Merrill Lynch

"Easy Come, Easy Go", we believe that US equities face headwinds coming from a more defensive stance from CFOs ready to defend their balance sheet and start reducing buybacks, CAPEX and even dividends in some instances. This would be more beneficial in that context to credit investors. Earnings are already facing EPS "headwinds". The continuation of the rise in oil prices though is still supportive for US High Yield. Yet, given the "high beta" nature of High Yield, we would prefer to play it safe rather than going all in à la Martin Donovan. 

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

Stay tuned ! 

Macro and Credit - The Sorites paradox

"Even the largest avalanche is triggered by small things." - Vernor Vinge, American writer

Looking at the pre-revolutionary mindset of my home country France, with Paris under siege as we warned about in our conversation "Last of the Romans" in mid-November, in conjunction with the very fast fading rally seen on the back of the United States and China trade war truce, when it came to selecting our title analogy given liquidity is continuing to be withdrawn by the Fed's QT, though as of late it seems they blinked, with softer global macro data including US housing, we decided to go for "The Sorites paradox". The "Sorites paradox", sometimes called the paradox of heap is a paradox that arises from vague predicates. A typical formulation involves a heap of sand, from which grains are individually removed. Under the assumption that removing a single grain does not turn a heap into a non-heap, the paradox is to consider what happens when the process is repeated enough times: is a single remaining grain still a heap? If not, when did it change from a heap to a non-heap? A common first response to the paradox is to call any set of grains that has more than a certain number of grains in it a heap. If one were to set the "fixed boundary" at, say, 10,000 grains then one would claim that for fewer than 10,000, it is not a heap; for 10,000 or more, then it is a heap. A second response attempts to find a fixed boundary that reflects common usage of a term. So the question is when is a bubble a bubble? When will QT turn the bubble into not a bubble? We wonder. Is hysteresis being the dependence of the state of a system on its history the answer? Equivalent amounts of sand may be called heaps or not based on how they got there. If a large heap (indisputably described as a heap) is slowly diminished, it preserves its "heap status" to a point, even as the actual amount of sand is reduced to a smaller number of grains. For example, suppose 500 grains is a pile and 1,000 grains is a heap. There will be an overlap for these states. So if one is reducing it from a heap to a pile, it is a heap going down until, say, 750. At that point one would stop calling it a heap and start calling it a pile. But if one replaces one grain, it would not instantly turn back into a heap. When going up it would remain a pile until, say, 900 grains. The numbers picked are arbitrary; the point is, that the same amount can be either a heap or a pile depending on what it was before the change. Also, one can establish the meaning of the word "heap" by appealing to consensus. The consensus approach typically claims that a collection of grains is as much a "heap" (or bubble) as the proportion of people in a group who believe it to be so. In other words, the probability that any collection is considered a heap is the expected value of the distribution of the group's views aka a "Quasitransitive relation", but we digress.

In this week's conversation, we would like to look at why it is increasingly important to play much more defensively as we move towards what could be a jittery 2019.

Synopsis:

• Macro and Credit - Don't be the last one left to pick up the "credit" tab...
• Final chart -  Liquidity and credit spreads go hand in hand

• Macro and Credit - Don't be the last one left to pick up the "credit" tab...

Looking at yesterday drop of 3.10% of the Dow Jones as we pointed out in our last conversation, it wasn't really that surprising given the weakening decelerating tone in global growth in general and cyclicals such as Autos and Housing in particular:

"Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end." - source Macronomics, November 2018

As well we pointed last week that if you wanted to go "short" credit, then US leveraged loans were definitely something to look at as pointed out by Lisa Abramowicz on a Twitter feed:

"Prices on leveraged loans have dropped to the lowest since 2016 even though their benchmark rate Libor has quickly risen, meaning this debt should pay out higher interest rates. This throws into question the concept of floating-rate debt as a hedge against rising rates.

 On one hand, loan investors get more income from their holdings as rates rise. On the other, the market seems to perceive the corporate borrowers as less creditworthy as their cost of financing rises. So if loan investors want to sell their holdings, they'll get a lower price." - graph source Bloomberg - Lisa Abramowicz - Twitter feed.

Indeed, liquidity is as always a "coward" and the longer you stay at the "credit" bar, the likelier you are to be shocked by "price discovery" when the credit markets will in earnest turn "South" and you will end up picking an expensive bar tab hence our call for reducing your illiquid high beta exposure.

While leverage loans are an evident target pointed out by so many investor pundits, regulators and central bankers in these days and ages, other interesting instruments such as AT1s aka called Contingent Convertibles (CoCos) as well as Corporate Hybrid bonds fit the bill when it comes to being potentially "illiquid" and harmful. Sure it's fun on the way up, pretending to generate "alpha" for your clients by playing the "beta" pure carry game, but, when the party has been extended as it has been in credit land, then again, not starting to be a little bit more "cautious" is a good recipe for asking for trouble and finding it eventually through "price discovery".

On the subject of "illiquidity" and credit we read with interest JP Morgan's Portfolio Insights note relating to the evolution of market structure. Their paper is entitled "Managing illiquidity risk across public and private markets":

"In theory, investors are compensated for this through the higher returns available in private assets over the full life cycle of the private investment. In other words, to harvest the illiquidity risk premium in private markets, investors need to be able to stay the course, weathering any variation in the cash flow profile over the full cycle. This means that cash calls would need to be funded from elsewhere in the portfolio.

The ability to accept this type of risk ranges widely across investor types. Those that may be subject to redemptions or fund withdrawals (e.g., mutual fund managers) are less able to bear uncompensated illiquidity risk than those with a long- term pool of capital to deploy (e.g., sovereign wealth investors). Further, during times of market crisis, when investors are already seeking to cut exposure to public markets, threats to liquidity are generally correlated and can compound to become a serious issue for investors. Investors could face liquidity demands arising from redemptions and a prudent desire to hold higher portfolio cash buffers. At the same time, on the private asset side there may be cash calls to finance, calls that are best covered from public assets — and thus, avoiding uncompensated illiquidity traps in public markets becomes a priority. To fully assess the illiquidity risk in a portfolio, all of these factors need to be considered holistically.

Taking high yield (HY) bonds as an example of a potentially illiquid public asset with both market and illiquidity risk, we can ask whether, over a defined time horizon, the probability of being forced to crystallize a loss under adverse liquidity conditions is appropriately compensated (see Addendum, “Modeling the cost of high yield trading under illiquid conditions”). Early in the economic cycle, when credit spreads are wide, the illiquidity premium in an asset such as high yield  credit may well offer an additional return compared with a replicating stock-bond portfolio. However, as the cycle matures and credit spreads tighten, there will come a tipping point — some breakeven level of spread — where the return in credit is not sufficient to offset the probability-weighted risk of a loss over a defined time horizon. Effectively, the illiquidity risk has at that point become uncompensated and investors may be better served expressing their desired level of market risk via a replicating stock-bond portfolio.

The scale of the potential illiquidity during times of market stress is demonstrated in Exhibit 8, again using HY credit as an example. The illiquid credit asset will suffer from wider bid-ask spreads and much reduced transaction volumes; large transactions can take considerable time to execute in markets where prices are dropping sequentially over multiple trading sessions.

Turning to private market assets, as investors have increasingly added private assets to portfolios there is commensurately more focus on the risk that they could be forced to liquidate private investments at an inopportune time to meet an additional capital call. Alternately, redemptions and other portfolio-level cash requirements may force them to exit private investments at an undesirable point. Since such events tend to occur during adverse conditions in public markets and the economy at large, the most relevant question is how bad things might really get." - source JP Morgan

Exactly, large positions can take a long time to unwind, particularly when dealer inventories are nowhere near to the level they had prior to the Great Financial Crisis (GFC).

Also as another illustration of what it would take to liquidate a sizable position of $1 billion in US High Yield in the case of a recession and where credit spreads should be to reflect that "illiquidity" premia would be significantly wider as pointed out in JP Morgan's note:

"For an investor that may need to liquidate $1 billion of high yield and anticipates any crisis to be average in its severity, credit spreads above around 270bps compensate for illiquidity risk. But if the investor’s subjective view of the probability of recession over the next year were to increase to 33%, then the breakeven credit spread required to compensate fully for illiquidity risk would jump to 320bps and as high as 398bps in a worst-case drawdown scenario. As portfolio size increases — and the potential illiquid asset trade size grows — the ex-ante breakeven spread required to compensate for illiquidity risk increases. Crucially, there is no economy of scale for illiquidity risks and, indeed, there are very apparent diseconomies of scale." - source JP Morgan

Given the significant rise in corporate credit issuance in recent years, one could conclude that current credit spreads do not reflect this "illiquidity" premium.

But, given that the Fed seems to have recently "blinked" recently following a more dovish tone at the Economics Club of NY by Jerome Powell, one could indeed think that there is still value for "credit" pickers even in US High Yield. We have long argued that as dispersion is rising in this late cycle environment, proven credit specialists in the issuer selection process would outperform the passive investment crowd. 

This effectively could dampen slightly the widening moves seen recently. On this subject we read Wells Fargo's take from their Credit Connections note from the 30th of November entitled "Honey B's":

"Credit markets continue to groan under the pressure of policy uncertainty (both monetary and fiscal), trade wars, a recent upsurge of idiosyncratic events and heavy bond supply. That said, secondary market credit spreads appear to be stabilizing after Fed Chairman Jay Powell struck a more dovish tone at his recent presentation to the Economic Club of NY. The shift was subtle and nuanced, but enough to convince markets that the Fed may slow the pace of policy tightening in the coming months. With credit spreads at year-to-date and multi-year wides, we recommend that investors start to set up for 2019 with select longs in credits poised to deleverage next year and beyond. Triple-B and double-B credits look particularly attractive to us in this environment.

The build-up of debt, increased borrowing costs and tighter monetary policy suggests that a growing number of companies will need to focus on deleveraging and balance sheet repair next year to preserve credit ratings and ensure ongoing access to capital markets. While this might not be great news for the economy it should certainly help the overall credit worthiness of the corporate sector and allow credit spreads to compress (somewhat) after a year of sustained widening. Conversely, those companies that cannot or will not address balance sheet issues will find a much less forgiving investor base and considerably higher borrowing costs. In this environment credit selection is paramount.

Funding Pressures

When considering which companies have the greatest urgency to deleverage it is helpful to look at the distribution of debt maturities. The term structure of maturities is a simple analysis to look at when companies are faced with refinancing pressures. At a high level, the amount of refinancing risk faced by IG companies is considerably greater than the risk faced by HY companies over the next three years. As the charts below show, about $2.2 trillion of investment grade debt is scheduled to mature 2019-2021.

This represents about 30% of all outstanding IG debt, with roughly 53% owed by non-financial companies and 47% owed by banks, insurers, financial companies and REITs. Maturities steadily climb over the next three years and peak in 2021 with about $800 billion of debt scheduled to mature. This stands in sharp contrast to HY. Over the same period, about $250 billion of HY debt scheduled to mature represents about 15% of all outstanding HY debt. In fact, next year HY maturities total just $40 billion.

Considering HY companies have issued about $175 billion of debt this year, refinancing pressures look particularly light next year. As a result, in the aggregate, HY companies look better positioned than IG companies to deal with tighter monetary conditions and higher interest rates over the next few years." - source Wells Fargo

Though, as pointed out by Morgan Stanley in our recent conversation, the effect of widening credit spreads on the unemployment rate is significant and positive:

"every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal." - source Morgan Stanley

The most important chart going forward? Jobless Claims vs. Job Cut Announcements (trend forming?):

- Graph source Bloomberg

Leading indicators of initial unemployment claims rose again last week to 234K (and 220K consensus) from 224K with 4 week average up to 223 K from 219K. (up from 211K average in Q3. Take notice of this! 

So from a "Sorites paradox" perspective, if wider spreads impact unemployment going forward due to balance sheet deleveraging, earnings and profitability matter as well when it comes to predicting a surge in defaults rates as highlighted by our friend Edward J Casey in his November credit commentary:

"Probability of nonfinancial corporates is a key driver of the default rates

Nonfinancial profits gained $66.2 billion in the third quarter. The annual pace of gains increased to +8.2% from -8.3% two years ago.

The US default rate declined to 3.2% in October and is expected to improve to 2% in next year.

Since the recession corporate profits have grown +8.6% annualized, well ahead of GDP of +2.3%.

One driver behind profit growth has been the massive expansion in corporate debt which has grown by +4.3%, nearly twice the pace of real GDP.

Cumulatively nonfinancial profits gained +115% compared to GDP of +23% and corporate debt of +46%." - source Edward J Casey

In our "credit" heap of sand, grains are individually removed thanks to the Fed's QT, the one question that remains is which grain will trigger the avalanche?

So if illiquidity is not "priced" correctly in credit and valuations are considered "lofty" from a consensus approach perspective, then again one may rightly ask when will it break? As pointed out by Edward J Casey, it is all depending on corporate profits rolling over, watching earnings in 2019 will be paramount:

"Equity valuations continue to outpace corporate profits. The ratio of profits to equity market cap declined to 7.7%

With credit yield headed higher, corporate profits will be facing a headwind of higher net interest expenses.

On prior occasions spikes in the cost of debt have been coincident with annual gains in corporate profits rolling over" - source Edward J Casey

If wages growth continues to accelerate in conjunction with earnings coming under pressure, then equities valuations in 2019, could be "repriced" much lower, just saying.

And when it comes to earnings we are closely watching the space. We read with interest Bank of America Merrill Lynch's Revision Ratios report from the 30th of November entitled "More cutting, less raising":

"Earnings Revision Ratio

US joins the rest of the world in negative revisions

In November, the 3-month earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest decline since April and the lowest level in nearly two years. A ratio of below 1 means more cuts than raises to earnings estimates, and this is the first time in over a year-and-a-half that analysts have taken down estimates. The US has caught up with the rest of the world with more cuts than raises. Trends have decelerated since early 2018 following tax reform as we expected, but the ratio now sits just a hair above its long-term average. We use the 3m ERR as one of five inputs in our market outlook: an above-average ratio has generally preceded strong near-term returns, whereas a ratio below average has signaled more muted near-term returns (Chart 2).

•  In November, the three-month (3m) earnings estimate revision ratio (ERR) fell to 0.87 from 1.11 — the biggest monthly decline since April and the lowest level in nearly two years.

• With the ratio now below 1.0, this suggests more cuts than raises to earnings estimates for the first time in over a year-and-a-half.
• The ERR sits just slightly above its long-term average of 0.87.
• The more volatile one-month (1m) ERR similarly fell to a two-year low of 0.73 from 0.77.
• The ratio is below 1.0, suggesting more cuts than raises to earnings estimates for the second consecutive month.

• In November, all sectors (except Staples) saw their 3m ERR moderate (Chart 1). Energy, Real Estate, and Technology saw the biggest deterioration.

• Most sectors are now seeing more cuts than raises to earnings estimates amid widespread deterioration in revision trends. Energy, Utilities, and Tech are seeing slightly more positive than negative revisions to earnings estimates.
• Utilities is the only sector with an above-average ERR, while the ratio is in line with the historical average for Financials, Health Care, Industrials, and Technology.

•  Similarly, throughout November, most sectors except Utilities and Technology saw more negative than positive revisions to estimates.

• Energy, Materials, and Comm Svcs had the weakest one month revision trends.-" source Bank of America Merrill Lynch

On top of the deteriorating picture for "earnings", in their report Bank of America Merrill Lynch also added the following in their report:

"Bad breadth in credit? Distress ratio ticks up

We watch revision ratios closely because “breadth” measures can sometimes be early indications of broader issues within markets. Our High Yield team’s distress ratio – the percentage of US high yield bonds with an option-adjusted spread above 1000bp – has similarly proven to be a good leading indicator of defaults. This ratio has recently worsened, and now sits at a 10-month high." - source Bank of America Merrill Lynch

Because we do not like this picture we think from a "Sorites paradox" perspective you should continue to reduce your high beta exposure and rotate from growth to consumer staples equities wise, also reduce your financials subordinated pocket (until and if a new LTRO is announced by ECB), and continue to raise cash levels and park it in the US front-end of the curve. We think as well that recent moves in the long end of the US yield curve looks enticing, we are looking at the 30 year bucket and long dated zero coupons given that the "deflationista" camp seems to make a comeback with global growth clearly decelerating.

As we pointed out earlier in our conversation, QT is indeed reducing the size of the credit heap (bubble). Trade accordingly as per ouf final chart below.

• Final chart -  Liquidity and credit spreads go hand in hand

The tone in credit spreads has had a weaker tone in recent weeks on the back of significant outflows from mutual funds as the Fed has been continuing to withdraw liquidity in the system with QT. Our final chart comes from CITI European Portfolio Strategist note from the 22nd of November entitled "Post QE World - Bear Market, Bull Market or Kangaroo Market" and displays the relationship between central banks liquidity and Investment Grade credit spreads:

Liquidity and financial markets have been tied closely together

Citi credit strategists have shown a powerful relationship between net central bank purchases and moves in credit spreads and equity markets. By extension, reducing/reversing QE should drive credit spreads sharply higher and equity prices sharply lower. From our (equity) side, we argue that it depends very much on the nominal growth backdrop and the pace of tightening. Progressive tightening and an extending economic cycle are still likely to see credit spreads widen, but also are likely to support an extending profit cycle. Historically, there is a phase in markets where credit spreads widen but equity markets make fresh highs driven by rising EPS. This remains our base case, but we acknowledge the end cycle debate." - source CITI

Sure it was a fun and exciting long credit party but from our perspective and in respects to the "The Sorites paradox" and the risk of an avalanche, we would rather start in earnest to play "defense" given 2019 might prove to be even more problematic for risky asset prices than 2018. Just saying... 

"The one certainly for anyone in the path of an avalanche is this: standing still is not an option." - Norman Davies, British historian

Stay tuned !

Macro and Credit - Explosive cyclogenesis

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

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

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

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

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

Synopsis:

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

• Macro and Credit -  "Reflexivity" and Recessions

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

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

- graph source JP Morgan, H/T Tiho Brkan

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

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

- graph source Macrobond

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

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

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

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

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

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

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

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

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

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

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

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

- graph source Bloomberg

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

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

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

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

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

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

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

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

- source David P Goldman - Asia Times

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

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

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

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

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

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

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

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

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

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

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

- source Bank of America Merrill Lynch

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

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

- graph source Bloomberg - Eric Pomboy on Twitter

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

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

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

A long way to neutral?

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

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

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

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

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

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

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

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

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

"Business Sector Debt Is Up By Nearly $5 Trillion

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

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

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

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

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

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

Stay tuned !