Macro and Credit - From Dysphoria to Euphoria and back

"Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart." - Alan Greenspan

Looking at the very strong rally experienced so far this year in the high beta space nearly erasing the pain inflicted in the final quarter in 2018, when it came to selecting our title analogy, we reminded ourselves about "Dysphoria" being a profound state of unease or dissatisfaction. In a psychiatric context, dysphoria may accompany depression, anxiety, or agitation, whereas the opposite state of mind is known as "Euphoria". As well, this post is a continuation of our November 2016 conversation "From Utopia to Dystopia and back", given the continuing reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally which we think will materialize even more in the upcoming European elections next month. But, from our much appreciated behavioral psychologist approach to macro and credit perspectives, we reminded ourselves the wise words of our friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":

"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013

Returns are related to starting valuations and are more volatile during transitional states  regimes, this is a very important point for credit investors we think going forward: 

"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.

As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013

Also, "dysphoric and euphoric" moves in markets are regular features we think in late cycles:

"Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle). " - Paul Buigues, 2013

Another great illustration of this manic-depressive behaviour from credit investors was the very significant rally in high beta credit during the second part of 2016 and in particular in the CCC bucket in US High Yield thanks to its exposure to the energy sector and to the rebound seen in oil prices at the time.

In this week's conversation, we would like to look at the start of the deleveraging in US corporate credit and what it entails, a subject we already approached in January 2019 in our conversation "The Zeigarnik effect" as well as in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets".

Synopsis:

• Macro and Credit - Under reconstruction
• Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets

• Macro and Credit - Under reconstruction

Given "Deleveraging" is generally bad for equities, but good for credit assets, one might wonder if indeed credit might in the near term start outperforming equities with CFOs become more defensive of their balance sheet. This would of course lead to less support to some US equities with reduced buybacks and even dividend cuts in some instances. Obviously buybacks have been highly supportive of the ongoing rally seen in US equities over the years thanks to multiple expansion. When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out, that simple.

An illustration of the above was pointed out by Lisa Abramowicz from Bloomberg on the 24th of April relating to AT&T:

"What's good for AT&T's bond investors is bad for its stock holders. The company is losing subscribers as it cuts debt, leading to a stock slump. Its bonds, however, are soaring." - source Bloomberg

This is exactly the risks we highlighted back in January 2019 in our conversation "The Zeigarnik effect"

"If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think." - source Macronomics, January 2019

While the rally in high betas have been very significant so far this year with even the CCC bucket for US High Yield delivering around 8.8% return YTD, flows points towards "quality" (Investment Grade) over "quantity" (US High Yield) it seems as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 26th of April entitled "Reaching for quality yield":

"IG funds flows continue uninterrupted

Another week of the same it seems. Fixed income investors continue reaching for “quality yield” via high-grade paper, while reducing risk in the government bond market. With government bond yields still close to the lows, it comes as no surprise to us that investors are looking to source non-negative yielding instruments. At the same time the lack of clarity on global growth is deterring investors from adding risk in equities.

Over the past week…

High grade funds saw an inflow for an eighth week in a row, extending the longest streak of inflows since 2017. We note that the slower pace w-o-w could be attributed to the short week due to the Easter holidays. Should we adjust this week’s inflow (for only three business days) it is almost at the same level as the inflow seen a week ago.

High yield funds recorded an inflow last week, the third in a row. Looking into the domicile breakdown, European-focused funds recorded the bulk of the inflow followed by Globally-focused funds. US-focused funds saw an outflow.

Government bond funds registered an outflow for the second week in a row. We note that the pace (despite the short week) has more than doubled w-o-w. Money Market funds recorded a sizable outflow last week, the second largest ever recorded. All in all, Fixed Income funds enjoyed their sixteenth consecutive week of inflows.

European equity funds continued to record outflows; the eleventh in a row. Note that over the past 59 weeks the asset class has recorded only two weeks of inflows.

Global EM debt funds recorded a small outflow, only the second this year, reflecting the appreciation of the USD over the past couple of weeks. Commodity funds saw an outflow last week, the third in 2019.

On the duration front, even though there were inflows across the curve, mid-term IG funds saw the bulk of the inflow." - source Bank of America Merrill Lynch

Back in early April in our conversation "Easy Come, Easy Go", we pointed out to the return of "Bondzilla" the NIRP monster and the returning appetite from Japan's Government Pension Investment Fund GPIF and their friends Lifers, shedding hedging and adding more credit risk in their allocation process. Therefore it is not a surprise to us to see an increase in allocation to Investment Grade credit in terms of fund flows.

The appetite for foreign bonds for Japanese Lifers is indicated by Nomura in their Matsuzawa Morning Report from the 23rd of April entitled "Pension funds continue to build portfolios premised on an economic downturn":

"Lifers continued to buy super-long JGBs at relatively high levels in March. Buying generally tends to increase in January-March, but the fact that they are continuing to buy even as yields drop significantly, suggests that their shift to other assets such as foreign bonds is not sufficient. Four of the nine major lifers had released their FY19 investment plans as of yesterday. They are divided on Japanese bond investments, with two lifers intending to increase and two planning to reduce Japanese bonds. Compared with last year, they are not in favor of hedged foreign bonds (particularly USTs). They mention shifting instead to unhedged foreign bonds and, even among foreign assets, moving out of government bonds to credit and alternative investments, but it is not clear how far these can go as substitutions. Most of the lifers forecast USD/JPY rates around 108-110 at end-FY19, with all expecting rates to be about the same as at present or JPY somewhat stronger. The lifers predict 10yr UST yields in a 2.30-2.70% range, anticipating neither a rate hike nor a rate cut. Given these projections for the overseas environment, we believe lifers are unlikely to reduce the amounts left idle in Japan for lack of other options compared with FY18, but they could increase these amounts." - source Nomura

To repeat ourselves, 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.

Also something to take note is that as dispersion is rising (which is a late credit cycle feature) some investors are playing it more "defensive" hence the reach for "quality". As well as pointed out by another Nomura Matsuzawa Morning Report from the 25th of April entitled "Flows return from EMs to US", it is worth noting what is happening in Emerging Markets credit wise:

"Overseas markets were risk-off overall on Wednesday. While flows were concentrated in the US, it looked to us like money was being pulled out of EMs. In the FX market, DXY increased significantly for a second day and USD/JPY reached the 112 range. At the same time, JPY was strong across the board in cross pairs, indicating that the market’s risk sentiment is weak—emblematic of unfavorable USD strength. EM currencies were also weak. Germany’s IFO came in below forecast, forcing investors to unwind their trades made hastily on the premise of Europe’s economic recovery. This makes sense to us, but we do find it interesting that Australia’s weak CPI not only triggered an AUD sell-off, but devolved into a risk-off flow that spilled over into EM and Japanese markets as well. It seems to us that market sentiment on EMs and resource-rich countries is beginning to deteriorate, so that even a small factor causes a major response in the market.

The CDS spread in EMs widened relatively significantly and reached the highest level since 3 January (Figure 2).

However, spreads on other instruments that act like canaries in a coal mine for the credit market, such as US high-yield bonds and European financial institutions’ subordinated bonds, are relatively stable, which leads us to surmise that these wide spreads can be attributed to an issue specific to EMs (supply/demand? fundamentals?) rather than to a risk-off flow in the entire credit market. In terms of supply/demand, we believe hedge funds locked in profits during the EM rally in January- March and are timing their return to the US to coincide with US companies’ strong earnings results. We see few factors that would prolong and deepen this flow, unlike the flows returning to the US due to the intensification of the US-China trade dispute last year. In terms of fundamentals, Chinese policymakers’ moves toward a more neutral policy stance could be having an impact. Yesterday, the People’s Bank of China (PBoC) injected liquidity via a targeted medium-term lending facility (see the 24 April edition of Asia Insights). This is seen as an alternative to lowering the reserve requirement ratio, and after this supply was announced, additional easing expectations declined, causing short-term rates (SHIBOR) to rise and Chinese equities to fall. If the PBoC were to rush into a more hawkish stance at this point, we believe risk-off flows in EMs would intensify. In any case, during Japan’s 10-day holiday to mark the imperial succession, we expect EMs to be the focus. In addition to Japan’s holiday, China will have its May Day holiday on 1-3 May, and this could restrain the market’s movements. In addition, the release of China’s manufacturing PMI on 30 April could change economic sentiment.

Ironically, the concentration of flows in the US as economic conditions there improve has pushed down US bond yields as well, and the market reflects higher Fed rate cut expectations. In fact, Japanese investors seem to be playing a role in this, and the International Transactions in Securities released this morning show that they were major net buyers of foreign bonds for a second straight week in the most recent week for which data is available (week of 15 April; Figure 1).

Expectations for a Fed rate cut by end-2019 rose to 63% (56% on the previous day). Given that US economic sentiment has improved since April, it seems strange to us that a rate cut in 2019 should be part of the market’s main scenario, but as noted above, this can also be seen as a sign that investors are preparing for a credit event stemming from EMs during Japan and China’s national holidays. However, in this case, US bond yields would have room for a reactionary rollback once this period has passed without event." - source Nomura 

The overseas support from Japanese investors to US credit markets should not be underestimated. They provide significant support to US credit markets hence the importance of tracking their investment and flows from a credit and macro perspective. as per the chart below from Nomura FX Insights report from the 24th of April entitled "Lifers still look for foreign assets":

- source Nomura

This is chart we think is very important we think from an allocation perspective as explained by Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":

"Party like it’s 2016

During the years 2015-2017 foreigners and bond funds/ETFs bought all net supply of US corporate bonds (Figure 1), creating excess demand and driving spreads much tighter starting in February 2016.

Then in 2018 the Fed engineered a disorderly rate hiking cycle and a yield shock, as they were the only major central bank hiking and at the same engaged in QT. As a result, the corporate bond market lost the foreign buyer and inflows to bond funds/ETFs plummeted – hence the big 112bps increase in corporate yields during 2018 was necessary in order to attract other buyers, specifically pension funds (the majority of which state and local).

Given the Fed’s capitulation on monetary policy tightening this year we think 2019 will look much like 2016 as far as corporate bond demand goes, with foreigners and bond funds/ETFs once again buying all net supply. While the outlook for demand this year thus is similar to 2016, we expect ~$250bn less net supply ($100bn less gross supply, $150bn more maturities). Hence, we are unable to escape thinking that demand-supply technicals will remain positive and supportive for spreads for a while. Just like in 2016, although spreads this time are tighter so the rally cannot continue as long (Figure 2).

2019 vs. 2016

Foreign buying – as reflected in negative net-dealer-to-affiliate volumes – has been running very strong this year at a pace matching what we saw in 2016 YtD (Figure 3).

Given that peak weakness in 2016 was on February 11, i.e. later in the year than the January 3rd wides this time, not surprisingly inflows to IG bond funds and ETFs are running well ahead of 2016’s pace YtD (Figure 4).

However, on adjusting for the difference in timing within each year clearly inflows this year following the wides is ramping up much faster that we saw following peak spreads in 2016. Finally gross new issuance is running at the exact same pace this year YtD as in 2016 (Figure 5).

For 2016 we originally forecast about $1.2tr of supply and ended up getting almost $100bn more ($1.289bn). For 2019 we are also forecasting about $1.2tr, and with the decline in yields and wide open markets, clearly the risk this year is again to the upside relative to our forecast first published in a very different environment in 4Q18. Should we again get about $100bn up upside, keep in mind that net supply will still be down $150bn this year due to more maturities." - source Bank of America Merrill Lynch

Indeed, we could see a continuation of the "melt-up" at least in credit markets thanks to the strong technical support in conjunction with overseas interest from the likes of Japanese investors.

But, returning to our main story of "Deleveraging" by CFOs, this we think could provide even more support to credit markets and translate into more "sucker punches" à la AT&T as illustrated earlier in our conversation. This would favor even more credit investors over equities investors we think. So, yes we are "bullish" credit. On that very subject of "Deleveraging by CFOs, we read with great interest Bank of America Merrill Lynch's take in their Credit/Equity Strategy note from the 22nd of April entitled "The Age of Balance Sheet Repair":

"A formula for growth in a low-growth environment

Low growth, low interest rates and low equity valuations in recent years have pushed US corporations to search for new drivers of financial performance. Many of them gravitated to a formula of tapping their balance sheet capacity to issue cheap debt and fund M&A and share buybacks. In only the last five years, companies repurchased $2.7trln of shares, paid $3.3trln in dividends, all while increasing their debt by $2.5trln. For some perspective, their combined capex budgets stood at $9.6trln during this time.

About 30% of EPS growth driven by gross buybacks

Buybacks have been seen as the savior of a lackluster profits cycle: US stocks (proxied by the Russell 3000 ex-Financials/Utilities/Real Estate) have seen EPS growth of 45% over the last five years, but gross share buybacks contributed 12ppt, ~30% of that growth (with the net buyback impact about half of that, or 6ppt). Over the same period, net debt doubled. An elevated equity risk premium and a low cost of debt encouraged debt-funded buybacks, and a scarcity of real revenue growth made this more compelling.

The age of balance sheet repair is here

Late 2018 was the turning point in this cycle of expanding debt balance sheets, buying growth and rewarding shareholders, in our opinion. Interest rates have risen and the market dislocation in Q4 played the role of a wake-up call to the largest bond issuers. This message was particularly loud and clear as it related to BBB issuers, many of whom saw their spreads north of 200bps, levels normally reserved for HY bonds. Given their sizes – many in excess of $20bn in bonds, higher than any existing HY issuer – the message was also critical: delever, or else expect material risk premiums if downgraded to HY. We include screens for largest BBB issuers, those with greater ability to delever and those with greater degree of dependence on capital markets.

Reset your expectations lower from here

Today, the game has changed. Three times as many investors want companies to pay down debt than to buyback stocks, and the cost of equity capital reflects this: the relative multiple of levered companies vs. cash-rich companies is now at a 7% discount to history. We expect a return to normalcy: recall that buyback-driven EPS growth was largely a post-crisis phenomenon, and pre- 2009, companies were mostly net issuers. Based on these and other considerations, our S&P 500 EPS forecast for 2020 of $180 (7% growth) incorporates no net buyback effect, and we see downside risk to per share growth going forward from dilution, not net share count reduction. Sectors where buyback activity is most likely to continue (Fins and Tech, where leverage is still historically low) may be unduly rewarded as the buyback theme grows scarce.

Strong balance sheets are good for all investors

The key takeaway here is that times are changing. After years of transferring value from bondholders to shareholders companies may now be forced to instead defend their balance sheets at the expense of shareholders. Our findings suggest that initial negative reaction in share prices is often short-lived, and eventually equities benefit from stronger balance sheets too." - source Bank of America Merrill Lynch

You have been warned, the fourth quarter was a wake-up call for many US CFOs and given the euphoria we have seen as of late in high beta, we would rather side with the "cowards" aka credit markets over "equities" in the second half of this year, particularly given Investment Grade is as well a far less volatile proposal.

The leverage "situation" is described in more details in Bank of America Merrill Lynch's note:

"Low growth, low interest rates, low equity valuations

In the years that passed since the Global Financial Crisis (GFC), many historical norms that were established over previous decades came into question. Economic growth has slowed with the trailing-10yr real US GDP growth bottoming out at 1.5% annualized in 2011-2018, a post-great depression low. This growth pattern also compares to 3.6% 10yr trailing average in the 2003-2006 cycle, and 4.2% in the mid-1990s. Inflation has also dropped to 60-year lows, as measured by core PCE. The Fed responded to this predicament by keeping real interest rates at negative levels for several years in a row.

For US corporations, this backdrop implied two new factors: their earnings were unusually difficult to grow organically, and their debt was unusually cheap (Figure 1).

Their managements have responded to this macro backdrop in a predictable way, by borrowing cheap debt and using its proceeds to buy back shares, thus improving EPS, and funding M&A (Figure 2).

Fast forward to today, and we are looking at corporate balance sheets that are carrying cyclically high levels of debt leverage, a development that usually happens after credit cycle turns and EBITDAs drop.

The large credit expansion over the last decade was supported by both strong demand and ample supply of corporate bonds. On the demand side investors were forced to reach for yield in US credit as a function of inability to achieve their income targets in other fixed income markets. On the supply side companies were put their balance sheets to use by borrowing at the historically low interest rates, while also satisfying the growing demand for their bonds.

While borrowing to enhance shareholder returns and acquire new businesses is not a new phenomenon, it has reached new highs over the past decade (Figure 2). Looking more broadly at US nonfinancial corporate business, corporate bond borrowing covered 58% of net spending on buying equities. This includes both share buybacks and M&A activity (Figure 3).

Reaching the limits of releveraging

The demand and supply dynamics are now turning less favorable to releveraging. On the demand side Fed’s hiking cycle in 2018 made it more difficult for foreign investors to buy US corporate bonds due to higher FX hedging costs. At the same time higher interest rates and the corresponding bond price declines weakened inflows to high  grade bond funds and ETFs. The result was a notable decline in demand for corporate bonds in 2018, although it has improved this year. In terms of supply, higher corporate bond yields mean borrowing costs have increased for US companies.

On top of that after years of cheap credit a number of issuers have reached their balance sheet limits. For US non-financial issuers leverage is currently around cyclical highs (Figure 4).

Based on BofA Merrill Lynch Global Fund Manager Survey, equity investors are now more focused on balance sheet repair that at any other point in this credit cycle (Figure 5).

Investors have grown disenchanted with buyback driven per share growth and are more interested in balance sheet improvement. Almost half (43%) of investors want excess cash used to improve balance sheets, a post-crisis high, compared to just 33% desiring increased capex and a paltry 16% desiring cash return to shareholders. The chart also shows strong cyclicality and previously has reached this level of credit-related concerns only in 2008 and 2002.

A preference for clean balance sheets is evident in valuations, where we find that levered companies within the S&P 500 have de-rated to trade a historical discount to cash-rich peers (Figure 6).

- source Bank of America Merrill Lynch.

If indeed equity investors are getting "Dysphoria" being a profound state of unease or dissatisfaction, and want companies to improve their balance sheets, then indeed it should lead to more "Euphoria" from credit investors we think.

Strong technicals on the back of overseas demand and a 2016 issuance level situation does indeed make us bullish for now on credit markets and in particular for US Investment Grade thanks to a dovish Fed as per our final chart below

• Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets

While a strong source of demand for US credit markets comes no doubt from "overseas" in general and Japan in particular, the dovish tilt from the Fed on the back of strong technicals such as issuance make it very supportive for credit markets for now as per our below chart displaying the fall in interest rate risk coming from Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":

"Crucial ingredient for the rally: Re-pricing the FedWe want to end by discussing the key sources of demand driving the present environment of strong technicals in IG – bond funds and ETFs and foreigners. The key development for both is this major shift in monetary policy expectations. The below chart shows that the Fed funds futures market went from pricing in three rate hikes over the coming twelve months to now pricing in about one ease (Figure 11). 

There are two key consequences of this: 1) dramatic decline in interest rates and 2) a much more benign outlook for dollar hedging costs for foreign investors." - source Bank of America Merrill Lynch

So if indeed we have seen a lot of "Euphoria" in the rally so far seen this year particularly in the high beta space  with the start to year for the S&P since 1987 (+17%) , with Oil up 35%, Small Caps by 19% and High Yield up by 9% (HYG) and Investment Grade (LQD) up a cool 7%, given the current "Dysphoria" feeling about the level of leverage for US corporate balance sheet, rest assured that they are more potential for additional AT&T sucker punches being delivered. One would be wise to trade accordingly and rotate towards the credit part of any US issuer at risk but we ramble again...

"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher

Stay tuned!

Macro and Credit - Lethe

"Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." - Mark Twain

Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named "Lethe". The river of "Lethe" was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness. 

In similar fashion, every investors drinking again from the "river of liquidity" provided by central banks including the large infusion from China's PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means "oblivion", "forgetfulness", or "concealment". It is related to the Greek word for "truth", aletheia (ἀλήθεια), which through the privative alpha literally means "un-forgetfulness" or "un-concealment". While the privative "alpha" might means "un-forgetfulness", the on-going rally is purely of one of "high beta" given the return of the "carry" trade thanks to low rate volatility and global central banking dovishness. 

In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again...

In this week's conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.

Synopsis:

• Macro and Credit - The road to oblivion?
• Final chart - It's not only central banks, buybacks got your back...

• Macro and Credit - The road to oblivion?

Given the definition of "oblivion" is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of "goldilocks" will last following the baby bear market we saw during the fourth quarter of 2018. 

Sure it’s  a great start  in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good "proxy" for global trade, has seen recently unemployment surging to 4.4%.

No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups  reported this week.

No surprise the "D" for "Deflation" trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the "Lethe" river flowing again.

If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed's latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.

While investors took another bath into the central banking river of "Lethe", when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all "recessions" are "deflationary" in nature, and most central banks have been powerless in anchoring solidly inflation expectations. 

When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled "The Hidden Costs of Risky Auto Loans to Consumers and Our Communities":

"The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.

• Auto lending rebounded from the Great Recession in part because of low interest rates (fueled by the Federal Reserve Board’s policy of quantitative easing) and a perception by lenders that auto loans had held up better than mortgages during the financial crisis. As one hedge fund manager noted in a 2017 interview with The Financial Times, during the recession, “consumers tended to default on their house first, credit card second and car third.”
• A 2014 report by the Federal Reserve found that a consumer’s perception of interest rate trends had as strong an effect on the decision of when to buy a car as more expected factors like unemployment and income.
• Low-income borrowers are particularly sensitive to changes in loan maturity according to a 2007 study, suggesting that the longer loan terms of recent years may have been an important spur for the rapid rise in auto loans to low-income households.
• A 2018 study by researchers at the University of California, Los Angeles, tied the fall in transit ridership in Southern California to increased vehicle availability, possibly supported by cheap auto financing.

The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.

• Americans are carrying car loans for longer periods of time. Of all auto loans issued in the first two quarters of 2017, 42 percent carried a term of six years or longer, compared to just 26 percent in 2009. Longer repayment terms increase the total cost of buying an automobile and extend the amount of time consumers spend “underwater” — owing more on their vehicles than they are worth.
• Many car buyers “roll over” the unpaid portion of a car loan into a loan on a new vehicle, increasing their financial vulnerability in the event of job loss or other crisis of household finances. At the end of 2017, almost a third of all traded-in vehicles carried negative equity, with these vehicles being underwater by an average of $5,100.
• The increase in higher-cost “subprime” loans has extended auto ownership to many households with low credit scores but has also left many of them deeply vulnerable to high interest rates and predatory practices. In 2016, lending to borrowers with subprime and deep subprime credit scores made up as much as 26 percent of all auto loans originated.
• Auto lenders — and especially subprime lenders — have engaged in a variety of predatory, abusive and discriminatory practices that enhance consumers’ vulnerability, including:

• Providing incomplete or confusing information about the terms of the loan, including interest rates.

• Making loans to people without the ability to repay.

• Discriminatory markups of loans that result in African-American and Hispanic borrowers paying more for auto loans.

• Pushing expensive “add-ons” such as insurance products, extended warranties and overpriced vehicle options, the cost of which is added to a consumer’s loan.

• Engaging in abusive collection and repossession tactics once a consumer’s loan has become past due.

- source US PIRG, February 2019

In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less "senior" when it comes the recovery value potential. 

As we pointed out in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?", credit cycles die because too much debt has been raised:

"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion." - Macronomics, October 2017 

This is why on this very blog we follow very closely financial conditions and the Fed's quarterly SLOOs as well a fund flows. 

Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:

• "7% of auto loans are 3+ months delinquent . Auto loan delinquencies climbed to $9 billion in 2018. 
• Transportation is the second-leading expenditure for American households, behind only housing. Approximately one hour of the average American’s working day is spent earning the money needed to pay for the transportation that enables them to get to work in the first place.
• Americans owed $1.26 trillion on auto loans in the third quarter of 2018, an increase of 75 percent since the end of 2009.
• The amount of auto loans outstanding is equivalent to 5.5 percent of GDP — a higher level than at any time in history other than the period between the 2001 and 2007 recessions." - source US PIRG, February 2019

Given that the auto industry is notoriously cyclical,  and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.

On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo's Economics Group Weekly Economic and Financial Commentary from the 22nd of February:

"Canary in the Camry?

Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?

Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute." - source Wells Fargo

Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven't seen in the last 25 years? We wonder.

If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled "Spreads stall heading into SFIG":

"Consumer Portfolio Services, Inc (CPSS or CPS) - sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn

Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.

The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.

The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.

The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction." - source Bank of America Merrill Lynch

To repeat ourselves, credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly "S&P500 dependent", the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the "Lethe" liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the "illiquid stuff" such as the now "famous infamous" leveraged loans regardless of their recent "strong" performance.

For now, investors have dipped again into "Lethe" hence the return of the "goldilocks" narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure "goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:

"The Trouble with ‘Goldilocks’The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.

We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities." - source Morgan Stanley.

A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.

Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their "The Inquirer" note from the 18th of February entitled "Is Global Monetary Reflation here?":

"In the last week, it seems like global central banks have started a possible process of monetary easing, in line with our views (The Inquirer: Planet Earth to Policymakers: Please Reflate 31 December 2018). If so, this would be very positive for Asia/EM stocks.
In the US, Fed governor Lael Brainard raised the possibility of ending balance sheet contraction by year-end 2019, ahead of schedule; in Europe, the possibility of a TLTRO came from Commissioner Benoit Coeure, and China printed a massive January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018, above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn. Global monetary reflation is possibly on the way. As of now, we remain bullish. We expect the world's central banks to reflate monetary policy, a view we have held since late last year.
Paraphrasing Mike Tyson, everyone's got an investment strategy, until they get punched in the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity analysis (different from "fund flows") was popular in financial markets three decades ago. We remember having a standalone research product in the mid-1990s called "Liquidity Analysis" replete with central bank balance sheets, commercial bank entrails, and the net supply and demand for equity. These days, eyes glaze over when we bring up base money growth, money multipliers, and monetary velocity. However, as the last decade has taught us, we should pay attention to this stuff. Our global strategist, Michael Hartnett, has maintained a consistent focus on liquidity and central bank balance sheets
as part of his toolkit.
1) We think the biggest risk to equities in Asia and EMs is the potential mismanagement and premature contraction of central bank balance sheets. Conversely, it is also the most lucrative opportunity. The correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years. World equities have a similar correlation of 0.94 since 2009. Central bank balance sheets are the most important driver of stock prices, in our view, by lowering risk premia, and cutting off deflation risk. The rest is detail, in our view.

2) We think the Fed is the most flexible in course correcting - they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.

3) However, we worry that in Europe, Japan, and most importantly, China - a total of USD40tn in GDP, or half the world's total - a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.

The world monetary base is shrinking, only the sixth time since 1980 - each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession.

Why should this time be different? The US Fed's projected balance sheet contraction of about USD40bn a month will likely reduce the US monetary base 13.8% this year (after contracting 10.7% last year), and the global real monetary base by 1.6%. After spending seven years telling us that the Fed B/S expansion was equivalent to rate cuts, we are now told that the opposite - B/S contraction is like "watching paint dry". Ostensibly, this comes from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years. The Lael Brainard "end-QT earlier" is helpfully walking back some of this prior aggressive QT fervor. And that’s a good thing -that’s the main impetus to growth in old, indebted and unequal societies.
4) Apart from China, which has control over its money multiplier through the high reserve requirement ratio, most large economies have seen falling money multipliers for the last two decades. Stopping QE - or slowing the QE-induced growth of the monetary base - will likely lead to a sharp drop in M2 growth (M2 is simply the monetary base multiplied by the money multiplier). Couple that with the secular drop in monetary velocity from the declining incremental productivity of debt, and slower nominal global GDP (and EPS) growth is highly likely. Rising indebtedness globally, demands a stronger money supply growth rate to maintain a desired level of economic (and earnings
growth). This is an identity, not a theory. This is increasingly true for China, with its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to impose more severe costs on growth there. The world's central bankers seemed oblivious to this until last week, and even now it is not clear where they stand. Welcome back to the secular stagnation debate. And the potential threat of a "too tight policy mistake".

Chair Ben Bernanke during his testimony about the Federal Reserve Board’s semiannual report on monetary policy said that he equated $150-200 billion of QE as being equivalent to a 25bps reduction in short term rates. So 600billion in QE2 was equivalent to a 75bps reduction.
https://www.c-span.org/video/?298238-1/monetary-policy-report (at 32 minute)

Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)" - source Bank of America Merrill Lynch

It seems to us that Jerome Powell has finally done the math hence the "u-turn" as seen in the increasing use of "patience" in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the "Lethe" river thanks to the rescue of central banks.

Another strong support as well to the "high beta" rally narrative and "risk-on" environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political "left" side.

• Final chart - It's not only central banks, buybacks got your back...

Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled "Buybacks on pace for another record year" and shows that in similar fashion to 2018, the return of buybacks on top of the central banking "Lethe" river provides additional support to the "oblivious" crowd of investors jumping with both feet on the high-beta wagon:

"Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1).

The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels." - source Bank of America Merrill Lynch

If "R" is for Recession and "L" is for Leveraged then "G" is for Gold. With the recent return of the river of unmindfulness, no wonder, the strong "bull" market has been "reincarnated" and the zombie companies can continue to "live" another day but we are ranting again...

"To err is human; to forgive, divine." - Alexander Pope, English poet

Stay tuned !

Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!