Macro and Credit - Dyslipidemia

"You can stroke people with words." -  F. Scott Fitzgerald

While learning that Global debt had reached a record $237 trillion in 2017 which is more than 327% of global GDP and that since 2007 global debt has increased by $68 trillion, when it came to selecting our title analogy for this week's musing, we reminded ourselves of the medical term "Dyslipidemia". "Dyslipidemia" is an abnormal amount of lipids (e.g. triglycerides, cholesterol and/or fat phospholipids) in the blood (such as global debt). In developed countries, most dyslipidemias are hyperlipidemias; that is, an elevation of lipids in the blood such as debt levels in comparison to many Emerging Market countries. This "abnormality" level is often due to diet and lifestyle. "Dyslipidemia" can lead to cardiovascular disease, which can be symptomatic but we ramble again...

In this week's conversation, we would like to look at cracks showing up in the "growth" narrative put forward by many pundits. 

Synopsis:

• Macro and Credit - Mirror Mirror...is global growth beautiful?
• Final charts -  Confidence can turn on a dime

• Macro and Credit - Mirror Mirror...is global growth beautiful?

As we concluded our previous conversation about some stretched positioning such as long oil, short US Treasury Notes, to name a few, the recent weakness in macro data seems to point somewhat to a different story painted by the rosy tainted narrative of strong global growth which has been prevailing in recent months. As we also pointed out in our last musing, on top of weakening macro data, fund outflows have been increasing, particularly from credit funds. We also argued that the "goldilocks" narrative which had prevailed in credit markets in general and Investment Grade in particular has been changing since the beginning of the year. This is particularly due to the "technical bid" from central banks which has been prevailing for so long, on top of significant issuance levels. Yet, it seems to us that with the central banking put slowly but surely fading, rising dispersion as pointed out as well in numerous conversations is a sign of the lateness in the credit cycle given investors are becoming much more discerning at the issuer level. This also why we advised for a reduction in beta exposure as well as the need to raise cash levels, moving towards a more defensive position. 

When it comes to global data and our "Mirror Mirror", they have started to turn negative. On this subject we read with interest Bank of America Merrill Lynch's take from their Global Liquid Markets Weekly note from the 9th of April entitled "Synchronized cracks":

"Global data surprises turn negative

Synchronized global growth was the buzzword of 2017 and generally expected to continue into 2018. However, global data surprises have turned negative for the first time since mid-2017, potentially due to forecasts being optimistic in the first place. While trade tensions have been widely cited as the reason for the drop in global equities, the realized weakness in global data may be a more straightforward explanation. Chart 1 depicts the stable relationship between MSCI World returns and global data surprises over the past five years.

Markets are assuming Euro zone data deterioration will be transitory

The immediate focus in terms of weaker data is the Euro zone, where data surprises are now the most negative since the peripheral crisis. There are two unknowns here – how much of this weakness is related to weather disruptions and how much reflects a convergence of soft survey data with the reality of weaker hard data. However, this also means the typical rationale for mean reversion in data surprises (economists revising projections) is unlikely to apply here if the weakness is being attributed to temporary factors. Upcoming data, particularly the April PMIs, will be crucial and the fact that EUR has been resilient to the data deterioration suggests the pain trade for markets will be if the weakness persists.

While seasonal distortions mean China slowdown is a blind spot

The relative blind spot in our view is China. With investors mostly looking past the distortions of the Jan-Feb Chinese data, the March numbers should help provide more clarity. Our economists expect a broad deterioration in the official numbers that begin releasing this week (China Economic Watch: Preview of March and 1Q macro data: Softer activity growth momentum 05 April 2018), while some of the higher frequency indicators warrant caution as well.

• Shipments of iron ore to China’s key ports has been weakening in both annual and sequential terms (Chart 3).

The latest March data show the biggest YoY decline since 2015 in both value and volumes. This may partly reflect the very high level of inventories at Chinese ports but at least partly symptomatic of a weaker demand trend.

• Steel production data, particularly for key factories, is less sensitive to inventory swings and supply adjustments, therefore providing some indication of the state of domestic investment, particularly property and infrastructure. Data including the first 20 days of March shows production is still positive YoY but rolling over recently (Chart 4).

• Chinese asset prices are reflecting a growing sense of unease, with a simultaneous drop in commodity prices, domestic rates and equities in recent months (China – sensing the unease 21 March 2018). While this may partly reflect risk premium associated with US-China trade tensions, the fact that even non-tradeable sectors such as real estate have been hit point to domestic demand concerns as well.

Market implications

If Euro zone and China growth moderate, the assumption of synchronized global growth could be challenged. While US Treasuries are becoming desensitized to equity swings (see Rates section), economic data still matter and would temper the upside for US rates. The US dollar would benefit against high-beta commodity and EM FX, but also against the EUR where the divergence with data is extreme. Finally, we are bearish thermal coal relative to forwards (see Commodities section)." - source Bank of America Merrill Lynch

As we have hinted on many occasions, when everyone is thinking the same (in terms of the consensus positioning being very stretched), one might indeed wonder if everyone is thinking. As the central banking "technical bid" is fading, fundamentals matter more than ever. Given rising geopolitical tensions in conjunction with the trade war rhetoric seen lately, one might wonder whether this is sufficient enough to put a further dent into confidence, which has shown in the past its capacity to turn on a dime. For us the short positioning on the 10 year part of the US curve appears to us stretched. Sure the trade war narrative doesn't seem to provide some support to increase the duration exposure, though we think possible further deterioration of fundamentals could eventually cost the bond bears crowd. 

On the subject of the rates story we read with interest Bank of America Merrill Lynch "Rates" segment of their "Synchronized cracks" note:

"• Levered funds' record short positioning remains, and still a risk for bond bears.
• Unlike 2017, asset managers did most of the buying in the rally; unlike 2015-16, USTs pale vs. cash in a risk-off.
• Looking ahead, economic data hold the key for the direction of rates more than equity markets.

This time is different

In our view, the impact of trade tensions ultimately translates into higher rates. As we detail here, the market is only reacting to the growth impact of tariffs but not the inflation impact with both real rates and breakevens lower since February.
In terms of flows, the two biggest differences in this rally compared to recent history are: 1) most of the UST buying came from asset managers, not short covering from levered funds; 2) the rise of cash as a Treasury alternative in risk-off moves. The former suggests economic data hold the key for the direction of rates, more so than risk-off flows; the latter is a confirmation of our view that cash as the new ‘safe haven’ asset threatens the stock/bond correlation.

Levered funds positioning risk remains

Despite the 10% equity market correction and the 20bp rally in 10y rate from February highs, levered funds community stood firm with their net short positions in the futures market. According to CFTC data, the week following the March FOMC meeting did see some profit taking, especially in the 2-year contract. However, overall positioning among levered funds barely budged from the record shorts reached a few weeks ago (Chart 5).

While we have seen evidence of UST short positioning unwind among European investors, the risk of a rally led by positioning unwind remains.

Asset managers did most of the buying since Feb, unlike 2017

Compared to a year ago, this time is different. Much of the buying over the last two months came from asset managers – Treasury futures market saw about $70bn (in 10y equivalent terms) increase in net long positions from this community, whereas levered funds saw $13bn increase in net shorts over the same period. A year ago, the month after March 2017 FOMC meeting saw over 40bp rally in 10y Treasuries and levered funds bought the most, with almost $40bn reduction in net shorts (Chart 6).

The asset manager demand recently was likely propelled by the volatility in risk assets, whereas the levered funds buying in 2017 was driven by a slowdown in tax reform progress and disappointing economic data after Q1.

Cash is now a competing asset

The other interesting development in this risk-off move was the rise of cash as an asset class, threatening rate/equity correlation. Unlike what we were used to seeing, government bond fund inflows in recent weeks were almost negligible compared to historical episodes, especially funds investing in medium and long maturity securities (Chart 7).

At the same time, evidence from money market fund flows reflects greater interest in cash. Seasonally, Q1 tended to see outflows from these funds largely due to anticipation of tax-related withdrawals. However, February and March saw almost $30bn inflows, compared to the average of $40bn outflows from 2012 to 2017 (Chart 8).

Holding cash in the MMF now seems to be a much better alternative for many investors than holding Treasuries with much bigger duration risk.

Watch what the data say, not just what the stocks do

The fact that levered funds are willing to shrug off the risk-off moves in the equity market and trade discussions suggest to us that the driver behind the market volatility is more important than the volatility itself. While we have seen sporadic weaker economic data prints in the US from the consumer side, it’s not enough to convince investors the growth momentum has run its course. The risk-off move could certainly put pressure for rates to move higher, the ultimate test though comes down to the data." - source Bank of America Merrill Lynch

Mirror, Mirror...indeed, watch the data more and more, because it matters. We do agree with Bank of America Merrill Lynch that it is becoming more important than volatility itself. Sure, investors are not convinced yet the growth momentum has run its course, but, as per confidence, the stretched positioning seen on the long end of the US yield curve has the potential to change rapidly should the growth narrative appears to what it seems to us, namely, slowing. No offense to the bond bears out there but even in this much vaunted global synchronized recovery narrative, yield can and will move lower as shown in the below chart from Bank of America Merrill Lynch The Flow Show note from the 12th of April entitled "Gold-ishocks":

"Buried Treasuries: record pace of YTD US Treasury inflows ($18.6 YTD, $3.4 this week); global synchronized recovery, record profits, low unemployment, massive fiscal stimulus, Fed selling, $70 oil…yet 10-year USTs still unable to break >3% and equities (homebuilders down, utilities up – Chart 3) confirm yields can move lower.

- source Bank of America Merrill Lynch

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

As a reminder:

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

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

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

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

If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do. While we have seen some flows return to High Bonds according to Bank of America Merrill Lynch to the tune of $0.4 billion which has been the first inflow for the last 13 weeks and with some rebound as well in Investment Grade with $3.8 billion inflows (66 fund inflows of past 68 weeks), the narrative we think is slowly changing for "goldilocks" in the credit space. This is probably tied up to lower volatility in interest rate volatility and it remain to be seen if the important Japanese investing crowd will return in the coming weeks to US credit markets shores. So yes we could see short term some sort of "relief rally" but we don't expect this to last medium term.

As we pointed out earlier on in our conversation, the central banking technical bid is fading and fundamentals are starting to matter more again. On that note we read with interest Société Générale's note from the 11th of April entitled "The Sword of Damocles - 2Q18 Outlook - Why spreads should widen and how to protect your portfolio":

1. The real worry is whether growth will slow in 2019, and defaults rise in 2020.
2. We see a return to late 2015 levels on this fear.
3. Avoid high beta credits and cyclicals. Be defensive.

1. The market is expensive
2. And valuations are the mother of returns
3. Asset allocators may switch credit for cash and equities (though it is slow to do)

The worst combination would be higher inflation and weaker growth. Yet it is not impossible.

Conclusion on technicals:

1. Supply has been low but should accelerate.
2. ECB demand will decline (as we all know).
3. Which means Europe will follow the US, and it is too expensive." - source Socété Générale

In our credit book as well, increase dispersion, should eventually drive spreads wider particularly in the light of our recent comments surrounding the rise in leverage and the fall in credit quality overall. For the moment, dispersion are coming from single names rather than sectors such as we have seen in the past with the energy sector credit woes in 2016 and recent credit woes in the retail sector. We expect dispersion to rise and impact more sectors going forward. Of course the usual suspects in the US are where the "leverage" is namely tech and healthcare but, that's not a secret. 

If inflation is indeed accelerating and growth is slowing, then again, the dreaded "stagflation" word comes to mind as we posited also in past musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation. Sure the explosion of the pigs' short-vol house of straw was triggered by sudden fear of rising wage inflation, but, we continue to believe that a sudden burst of inflation, would no doubt take down their "credit" houses of straw and twigs:

"If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about" - Macronomics

We pointed out as well in this prior conversation that credit cycles die because too much debt has been raised in the final point of this long conversation. Yet another veiled reference to "Dyslipidemia" one could point out. 

 Some might point out, it could be too early to see the fear of trade wars sapping "confidence" in the growth outlook, but we do think as per our last point, that when it comes to "growth" and "stability" in complex structures such as financial markets, confidence matters.

• Final charts -  Confidence can turn on a dime

While geopolitical tensions are quite palpable, the increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated. We believe that for a continuation of the global growth narrative to prevail, confidence matters and matters a lot. We continue to see cracks in the macro narrative on both the hard side as well as a weaker tone now in soft data such as consumer confidence. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 13th of April entitled "Fear factor" and display the reaction of various equity markets since the announcement of steel and aluminum tariffs as well as the Global PMI Manufacturing New Export Orders and Volume of world merchandise trade:

"Fear factor

One of the striking developments in the last two years is how investors, consumers and business leaders have learned to shrug off confidence shocks. The result is not only a steady pick-up in confidence indicators, but a pick-up in growth as well. In recent weeks, however, the markets seem to have found something they can’t dismiss: the prospect of trade wars. Here we argue that the way this “war” is developing, the US is the most exposed, followed by China and then relatively open economies around the world. This is because the US is looking to change its relationship with all of its major trading partners, with a particular focus on China. In other words, while most countries are “fighting” on only one front, the US is fighting on many fronts.

Let’s take a look at signs of confidence effects thus far, and what to watch if the “war” escalates.

First responder: global equity markets

It is much too early for fears of trade wars to impact hard data. In the meantime, equity markets are the best canary in this coal mine. Chart 1 shows the change in equity prices since the day before the steel and aluminum tariffs were announced for the US and the countries the Trump Administration is targeting.

Not surprisingly, the US (S&P 500) and China (Shanghai Composite Index) markets have dropped the most over this period.

Thus far the equity market seems to be pricing in a high probability of a benign outcome, with small drops in response to major threats and then rebounds on more assuring comments. The market response to the US-Korea trade deal is also telling. Korea made concessions on autos, steel and currency manipulation, but there was virtually no response for stock prices of the impacted companies. For example, Korea agreed to raise its quota on US car imports from 25,000 to 50,000. However, the “big three” US companies only shipped 19,911 cars to Korea last year. Not surprising the stock price of US and Korean car companies shrugged off the news.

Second responder: confidence surveys

A similar story applies for confidence indicators. As Michelle Meyer and team show, there are early hints that trade war fears are impacting confidence indicators in the US, particularly for manufacturing firms. Canadians are also growing concerned. The latest Business Outlook Survey from the Bank of Canada found that “while firms’ expectations for US economic growth have strengthened further, some cited rising protectionism and reduced competitiveness as factors limiting the impact on their sales.” The survey also shows a shift toward negative views of US policy overall. Asked how US policies had impacted “your business”: a year ago 11% said favorably and 10% unfavorably while in the latest survey 8.8% said favorably and 20.1% unfavorably. Confidence in Mexico dipped sharply in response to the initial threats to NAFTA, but has rebounded recently on hopes of minor changes to the treaty.

Outside of the NAFTA region, only Germany seems worried. Here are some representative thoughts from our regional economists:

• Germany: According to the latest IFO survey, “the threat of protectionism is dampening the mood in the German economy.”
• UK: The local press has generally reported this as something that is happening elsewhere rather than to the UK.
• Japan: Our equity analysts say firms don’t seem overly concerned about trade wars.
• Australia: At this stage, the press has focused on the opportunities these frictions presents for Australian exporters, particularly in agriculture. Perhaps the most important hint of global risk comes from Purchasing Managers reports. The global index of manufacturing export orders dipped in February and March (Chart 2). 

Two months does not make a trend, and the level of the index is still healthy, but this bears watching.

The biggest loser(s)

It is not surprising that even a small probability of an outright trade war is resonating in the markets. After all, the main battle involves the two most important economies in the world. It also comes at a time when stronger trade is underpinning global growth. The World Trade Organization reports that the growth in global merchandise trade volumes accelerated from 1.8% in 2016 to 4.7% last year. Hence, after a period of weakness, trade is again significantly outgrowing GDP. Looking ahead, they expect 4.4% growth this year, but also present a downside scenario in which trade volumes drop (Chart 3).

- source Bank of America Merrill Lynch

For us, stretched positioning in conjunction with geopolitical risks are major looming threats. That simple. This could lead to a "hot summer" indeed. Sell in May and go away? As say the old adage, in the current case of "Dyslipidemia", high cholesterol and high blood pressure do not mix well, in similar fashion, high debt level (leverage) and volatility do not either...

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

Stay tuned !

Macro and Credit - Fandango

"When you combine ignorance and leverage, you get some pretty interesting results." - Warren Buffett

While enjoying some much needed R&R (Rest & Recuperation) basking under the sun far away (hence our lack of posting recently), we still managed to look at market gyrations with the continuation of outflows from US High Yield as well as weaknesses in Investment Grade Credit. When it came to selecting our title analogy for this first 2nd Quarter musing, we reminded ourselves, of "Fandango" being a lively couples dance from Spain usually in triple meter, traditionally accompanied by guitars, castanets or hand-clapping which can be sung and danced. The "fandangos grandes" (big fandangos) are normally danced by couples, which start out slowly with gradually increasing tempo. Many varieties are derived from this one. As a result of the extravagant features of the dance, the word "Fandango" is used as a synonym for "a quarrel," "a big fuss," or "a brilliant exploit". Given the return of heightened volatility in 2018, following years of "financial repression" from our central bankers/planners, we thought our analogy would be appropriate given the earliest "Fandango" melody dates from 1705, and was probably the first "dance battle" and it also appeared also in the third-act finale of Mozart's opera Le nozze di Figaro (1786). As we reiterated in our early March conversation "Intermezzo" CITI's Chuck Prince had a nice dancing analogy in July 2007:

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing" - Chuck Prince

We also added at the time:

"To some extent, early market jitters such as the ones caused by the explosion of the pig's "short-vol" house of straw amounted to an "intermezzo" we think. A larger musical work is at play and it is the evolution of the credit cycle. It is slowly and gradually turning, with macro hard data erring on the soft side recently (US durable goods orders falling 3.7% in Jan, vs 2.0% drop expected) while consumer confidence, being soft data, printing on the strong side. When it comes to liquidity, it is being withdrawn by the Fed through its "Quantitative Tightening" (QT)." - source Macronomics, March 2018

Although Spanish in origin, "Fandango" is one of the main folk dances in Portugal. The choreography is quite simple: on its more frequent setting two male dancers face each other, dancing and tap-dancing one at each time, showing which one has the most lightness and repertoire of feet changes in the tap-dancing.  While one of the dancers dances, the other just "goes along". Afterwards, they "both drag their feet for a while" until the other one takes his turn. They stay there, disputing, seeing which one of them makes the feet transitions more eye-catching. Obviously current "market transitions" are becoming more and more "eye-catching" with the relative surge of volatility noticed in 2018, particularly with weakening "soft data" such as consumer confidence hence our "musical" analogy title.

In this week's conversation, we would like to look again at US corporate fund flows as well as US corporate leverage in conjunction with the rising trade war rhetoric which, as we indicated in various previous conversations is "bullish" for gold. 

Synopsis:

• Macro and Credit - Fandango and leverage don't mix very well
• Final chart -  US labor market still impaired by low productivity growth

• Macro and Credit - Fandango and leverage don't mix very well

While the short-vol pigs house of straw was the first casualty in the "capital structure" thanks to the change of the "volatility" narrative, it seems to us more and more that we are witnessing as well the gradual end of the "goldilocks" environment which has prevailed for so long in somewhat "bulletproof" credit markets. All in all, it appears that the three bears namely inflation expectations, rising volatility and trade protectionism are coming after "Goldilocks". The second quarter is therefore starting on a much more tactical note which according to us needs some rethinking surrounding "asset allocation". If indeed "Fandango" means a clear return of volatility in 2018, then it makes sense overall to reduce your beta exposure across equities and credit and raising some cash levels in the process. Sure some pundits would like to point out the solid macro backdrop thanks to strong growth expectations as we move into "earnings" season, but, given the rising tensions surrounding the "trade war" narrative, it represents serious headwinds should things escalate quickly between China and the United States.

There is no doubt in our mind that the credit cycle is slowly turning, while many pundits are focusing their attention towards the "technical" spike in the Libor-OIS spread, we would rather focus our attention on flows and fund outflows. We have to confide that we are part of the crowd that believes QT could prove to be inflationary as we indicated back in February 2018. On the subject of QE evolving towards QT, we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 29th of March entitled "On the road from QE to QT":

"While QE was wonderful and led to favorable technicals in the form of too much money chasing too few bonds, QT (quantitative tightening) is the opposite - i.e. leads to unfavorable technicals and periods of too many bonds chasing too few investors. While QE suppressed volatility and led to a buy-the-dip mentality, QT is the opposite - i.e. higher volatility and sell-the-dip. While under QE fundamental erosion did not matter and strategists were king, under QT companies better not disappoint and analysts are king. Our outlook piece described 2018 as a year where the technical deteriorate, although due to plentiful foreign QE market conditions remain relatively orderly - despite US QT - even though volatility increases (see: 2018 US High Grade Outlook: Long analysts, short strategists 21 November 2017).

Such view is clearly playing out as at times - such as in March - this year’s decline in supply is insufficient to mitigate the decline in demand and spreads move wider. Next month (April) we are due to swing in the other direction with partial retracement of recent weakness, as supply declines – not just corporate bonds but more broadly and globally - while demand is supported more by the start to Japan’s new fiscal year (though smaller than in previous years due to the high cost of dollar hedging). But keep in mind that this year technicals are impaired on a more permanent basis and rebounding supply in May - and more weakness in the front end of the curve as the corporate investor outlines plans for reducing cash positions - should lead to renewed spread widening pressures.

The trillion dollar challenge

Figure 1 and Figure 2 below show our updated view of US fixed Income technicals in 2018 – refer to Figures 7 and 8 in our outlook piece. For full details of this analysis please see our above referenced 2018 outlook piece. Assuming 25% less foreign buying in 2018 compared with 2017 (down 50% for corporate bonds based on YTD net dealer to affiliate volumes and flat for Treasuries based on our rates strategists’ view), 51% lower inflows to bond funds and ETFs (implied by our model for HG bond fund/ETF flows, see: Credit Market Strategist: Inflows to taper 26 January 2018) given how the year began), the Fed’s balance sheet reduction and our forecasted fixed income net supply we see a relatively balanced market in 2017 where other investors only had to net buy about $181bn. However 2018 looks far less balanced with a need to attract roughly $973bn of additional money throughout the year, but especially in 2H. Our view remains that this requires meaningfully higher yields – obviously we have that already and expect further increases on the road to 3.25% on the 10-year by year-end. Add the coming pension rotation and chances are we will see limited further yield pressures.

Less is more

As expected supply volumes accelerated to $124bn in March from $98bn priced in February. That puts supply in March of this year 5% below $131bn issued in March of 2017. However, unlike in 2017 supply is weighing much more on spreads this year. The ICE BofAML high grade index is 15bps wider month-to-date, compared to 1bp of spread widening over the same period last year. The difference is that this year the seasonal acceleration in supply coincided with much weaker demand. The two biggest sources of demand for high grade corporate bonds – foreign investors and bond funds and ETFs – declined by close to a half compared to 2017. First, dealer selling to affiliates, which is a proxy for foreign demand, was down 47% in March of this year compared to 2017 (Figure 3).

Similarly, inflows to mutual funds and ETFs (based on daily reports that account for about 50% of the total AUM) are down 66% so far in March relative to the same period last year (Figure 4).

Hence the current period is similar to the spring and summer of 2015, when supply volumes accelerated in an environment of slowing mutual fund and ETF inflows, leading to wider spreads (Figure 5).

Just as in 2015 secondary market spreads of high grade issuers announcing new issue bond deals underperformed significantly. Weaker secondary spreads for issuers coming to the primary market highlight the role of supply in driving the general market spread wider (Figure 6).

- source Bank of America Merrill Lynch

What matters to us, when it comes to our concerns relative to further credit spread widening obviously is the weaker tone in fund flows as reported as well in the latest Bank of America Merrill Lynch Follow the Flow note from the 3rd of April:

 "Outflows from IG, HY and equities

European IG, HY and equity funds have recorded outflows last week, during a broader risk off trend. The trend was worsened with outflows from equities tripling w-o-w, while outflows from IG have more than doubled. Within credit in particular, wider spreads amid an influx of new deals over the past weeks has not been supportive for high grade fund flows.

Over the past week…

High grade fund flows remained on negative territory for a second week in a row. However we think that the flow trend has worsened more than what the underlying trends in rate vol and spreads would entail. We think that flows should improve going forwards into a quieter April-May period. 

High yield funds continued to record outflows (20th consecutive week). Looking into the domicile breakdown, outflows have been recorded across the board last week, with the majority of it coming out of US and Globally-focused funds.

Government bond funds recorded their 11th consecutive week of inflows as investors have been reaching for “safety”, amid Trade Wars and falling risk assets. All in all,

Fixed Income funds flows remained on negative territory for a second week in a row. European equity funds continued to record outflows for a third consecutive week; with outflows tripling over the past week. Last week’s outflow was the largest since July 2016." - source Bank of America Merrill Lynch

What matters for more stability in US Investment Grade Credit could indeed be a reprieve in bond volatility but there is as well we think something that needs close monitoring which is, the importance of foreign flows and in particular Japanese flows. This a point we approached in various conversations. US credit benefits from a very important support from the Japanese investing crowd as per our July 2017 conversation "The Butterfly effect":

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.

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:

"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS 

Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk." - source Macronomics, July 2017

While we disagreed at the time, thinking it was too early when it comes to the advantage of FX-Hedged US IG credit given that in the Fed rate hiking cycle Japanese investors sacrificed currency risk for credit risk. It is worth noting that since the beginning of the year, Japanese flows have been waning and this is a cause for concern when it comes to the stability of Investment Grade flows and credit spreads we think. This is highlighted in the below chart from Nomura from their FX Insights note from the 26th of March entitled "Who will be left behind?":

- source Nomura

This might be due to the end of the Japanese fiscal year and might be a temporary weakness but, we think going forward, this will be very important to track when it comes to assessing the strength of the US Investment Grade credit market.

As pointed out by our friend Edward J Casey in his latest March Credit Observations on Linkedin, it is important to track the Credit ETF Arrhythmia:

"The waves of an EKG quickly allow your doctor to see how well your heart is functioning. Credit spreads perform a similar function, allowing us to see signs of market stress or strain. After recovering from February's volatility spike, credit is closing wider for the quarter. Spreads remain well within healthy trading ranges, but the ETF arrhythmia is worth closely monitoring. Year to date LQD, HYG & JNK have experienced over $12 billion of outflows, shrinking assets by -18%" - source Edward J Casey, March Credit Observations

We could not agree more, in this accelerating Fandango. Flows and outflows matter more and more as many are dancing closer and closer towards the exit it seems in this gradually tightening environment thanks to the Fed's hiking path. In a late business cycle, with the Fed in a normalization process in conjunction with rising volatility, this could lead to a carry trade unwind, making it less likely carry return will turn positive and this could provide additional headwind for US credit we think. While Libor-OIS has been the recent focus for many pundits, watching cross-currency basis matters, particularly USD/JPY for US credit support.

The consequences from ZIRP to NIRP in both Europe and Japan has provided a strong critical support to US credit in recent years as indicated by Deutsche Bank's note by Torsten Slok entitled "Risks to US credit from April entitled "Risks to US credit from higher inflation, more Treasury supply, ECB exit, and higher hedging costs for foreigners":

"A lot of money moving from Europe into US fixed income

US investors have no appetite for foreign bonds

Foreigners hunting yield in the US after interest rates turned negative in Europe and Japan

Foreigners are now the biggest holders of IG, HY, and loans

ECB exit and higher US Treasury yields leading to less demand from abroad for US IG

Since QE started credit quality has deteriorated

- source Deutsche Bank

As we pointed out in our bullet point "Fandango" (rapid outflows) and leverage generally do not mix very well together particularly when liquidity on banks balance sheet has been dwindling in recent years, making the exit door even more tinier that what it used to be even during the Great Financial Crisis (GFC).

The question therefore one needs to ask in the face of rising aversion for US Investment Grade is where do we stand in terms of "leverage"? On that particular point we read with interest UBS's take from their Global Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?":

"Is US corporate leverage higher than reported?The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?

Where are corporate credit market excesses?

We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).

And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).

By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.

More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum – i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through  '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).

How concerning are leverage levels, and are earnings add-backs hiding risks

US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).

While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme – primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).

To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals – public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).

Across the capital  structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 – one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).

But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans – but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.

We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.

Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to  be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA – suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 – 21%).

Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 – 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).

For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).

What early warning signals are you monitoring and what is the prognosis?

At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).

Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).

Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.

Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).

And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall.

Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS

For UBS it appears that "Goldilocks" have not run its course, yet one thing for certain as we posited in In November in both our conversations "Stress concentration" and "The Roots of Coincidence" where we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018. The trend in dispersion we discussed as well in our previous conversation is indicative that investors have become much more discerning at the issuer level, this is a sign that the narrative in credit markets is slowly but surely changing as the rhythm in the "Fandango" increases we think.

With the upcoming release of the US nonfarm payroll numbers, as per our final chart we think that the US labor market is still being impaired by low productivity and hysterisis.

• Final chart -  US labor market still impaired by low productivity growth

Hysteresis in unemployment can generally be observed when businesses switch to automation during a market downturn. Workers without the skills required to operate this machinery or newly installed technology will find themselves unemployable when the economy starts recovering. In effect, loss of job skills cause a movement of workers from a cyclical unemployment stage to a structural unemployment group. Our final chart comes from Bank of America Merrill Lynch Liquid Insight note from the 30th of March entitled "US labor market still looks polarized" and displays the US labor market polarization with the US adding more jobs for high and low skilled occupations relative to middle-skilled ones:

Continued polarization

“Polarization” in the job market–where high-skilled and low-skilled work has grown, but middle-skilled and middle-class employment has stagnated–may be a crucial feature in explaining why historically low unemployment has failed to generate substantial wage growth so far. This adds to the long list of factors explaining the disconnect between the low unemployment rate and slow wage growth. As we have argued in past research, we think slow wage growth reflects, in part, the low productivity environment, compositional shifts in the labor force and a change in the structure of compensation packages. The persistence of polarization in the job market throughout this recovery is another reason for the only slow growth in overall wages. It is also another reason the FOMC will likely keep the hiking cycle gradual, keeping a lid on the USD.

The key feature in jobs today is the type of “tasks” done in them

As we wrote in our previous note, the distinguishing characteristics of a job in the current labor market is not simply the skill level required for it or the industrial sector it is in, but rather, the sort of tasks it requires. In particular, tasks that have a repetitive, “routine” quality are now the most vulnerable to automation and the march of technology, robotics and artificial intelligence." - source Bank of America Merrill Lynch

Obviously the consequences of such "hysterisis" and "polarization" are that they are clearly  contributors to tame aggregate wage pressures despite the low unemployment level reached. Higher-paying jobs might be continuing to grow but what is indeed lacking and which is worrying is the hollowing out of the American Middle-class. The stagnant wages of middle and lower skilled workers have had political consequences and were no doubt one of the driving forces behind the election of president Donald Trump. This is an issue we discussed in January 2017 in our conversation "The Ultimatum game":

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

For now the rhythm in the "Fandango" dance is increasing while some positioning appears to us stretched (US Treasury Notes short base, very long Oil speculative positioning, short US dollar to name a few) making some "convex" trades from a "contrarian" perspective somewhat enticing but, we ramble again...

"Never give a sword to a man who can't dance." -  Confucius

Stay tuned!