Macro and Credit - Critical threshold

"If you wish to be a success in the world, promise everything, deliver nothing." - Napoleon Bonaparte

Watching with interest the violent rotations in fund flows with Emerging Markets debt funds recording a $6.64 (-1.9) billions of outflows last week, the largest ever in terms of $AUM thanks to "Mack the Knife" (King Dollar + positive real US interest rates) while financial-sector funds experienced as well some monster flows to the tune of $7.2 billions, in effect validating somewhat our "macro reverse osmosis" discussed again in our previous conversation, we reminded ourselves for this week's chosen title as an analogy the definition of "critical threshold". Critical threshold is a notion derived from the percolation theory, which by the way ties up nicely when it comes to fluid movements and osmosis and refers to a threshold, that summons up to a critical mass. Under the threshold the phenomenon tends to abort, but, above the threshold, it tends to grow exponentially hence the risk for osmosis and flows to become at some point excessive, which would mean deflation bust and defaults for some. In cases the phenomenon is not sudden and take times to operate (such as a gradual surge in the US dollar) we would have used a critical phase or phase transition as a title for this week's musing but not this time around given the violence of the moves we have seen as of late.

In this week's conversation we would like to look at the violent flows rotations and what it entails in terms of critical threshold and risks as we move towards 2017 given the on-going killing spree of "Mack the Knife" on gold and US Treasuries and EM as well.

Synopsis:

• Macro and Credit -  Is reverse osmosis finally playing out?
• Final chart - The dollar is their currency but our problem for 2017

• Macro and Credit -  Is reverse osmosis finally playing out?

While last we week we reacquainted ourselves with our reverse osmosis macro theory relating to the acceleration of flows out of Emerging Markets, the latest raft of data relating to flows of funds clearly points out to a buildup in "Osmotic pressure" and a risk to break through the "critical threshold" and a significant "margin call" on the huge US dollar shortage that has been building up. On our twitter feed in fact we recently joked that the Fed was not behind the curve, but, that the curve was behind the Fed (watch the flattening...). The acceleration in the rise in US yields and in particular real yields have accelerated as of late, putting additional pressure on gold, Emerging Markets alike. If indeed the dollar rally continues to run unabated then, in continuation to our previous conversation, there is no doubt in our mind that trouble will be the outcome for the leveraged "macro tourists" carry players in the Emerging Market space. When it comes to trends, we do follow funds flows as indication of rising instability. To that effect, we read with interest Deutsche Bank's Weekly Fund Flows note from the 21st of November 2016 entitled "The great unwind?":

"Expectations of a looser US fiscal policy added fuel to the reflationary fire, triggering a bond sell-off across regions and classes on the one hand while also arranging for a strong return of equity inflows on the other hand. investors moved away from bonds at the highest weekly pace since the taper tantrum in 2013, as rising inflation expectations prompted outflows in both credit and sovereign bond fund categories, with US mandates bearing the brunt. In tune with the market, last week’s post-election flow data also saw a renewed appetite for DM equities as the reception of Trump's plans on tax cuts and infrastructure spending resulted in the highest weekly inflows for US equity funds since Dec’14 (see chart below).

If such stimulus in combination with reduced business regulation were to lead US GDP growth higher (as our US economists expect), we could finally see a normalisation of flows whereby money rotates out of over-allocated bond funds ($1tn of inflows since 2009) and into DM equities ($400bn of inflows since 2009). Last week’s bond-to-equity pull was strong in the US, and if rates continue rising this should go on.
Meanwhile another rotation seems to be in the making, as a rising dollar accompanied by fears of trade renegotiation spelled panic over emerging market fund flows. The run for EM bonds, which already looked increasingly  tired the past two weeks, took a big hit with highest redemptions since Jul’13 (see chart below) and the highest outflows in dollar terms since 2004.

EM equity fund redemptions also climbed to a one-year high. We remain particularly worried about intensifying EM capital flight on the back of a stronger dollar, and think EM redemptions are likely to continue." - source Deutsche Bank

If indeed when it comes to "credit" we look at the "credit impulse", in order to gauge the strength of economic growth, when it comes to flows and financial markets we like to look at Deutsche Bank's liquidity pulse, being the standard deviation from the mean of the relative between the current flow (4-week average as % of NAV) and the average size of flows in the last 13 weeks to get a better idea of the "critical threshold". Below are a couple of charts relating to equities and pointing towards a rotation from EM to DM with US equity funds talking the bulk of the flows:

- source Deutsche Bank

Whereas so far US equity funds have been receiving most of the inflows whereas EM has been on the receiving end of the "reverse osmosis" theory, given the surge in "Mack the Knife", it looks to us that once again a weakening Japanese yen against the dollar should go hand in hand with a surge of the Nikkei index, currency hedged. particularly in the light of the liquidity pulse which has yet to surge meaningfully.

When it comes to bonds and flows it is a different story as the velocity in the surge of US yields has translated into outflows from bonds funds and particularly EM funds towards equities for the time being:

- source Deutsche Bank

If indeed the pressure from "Mack the Knife" continues to build up, then obviously "de-risking" will be de rigueur, which should lead to additional significant outflows. So all in all not only we should be seeing additional capital outflows from EM under pressure but, in the financial sphere, if the trend is indeed your friend, there is further pain ahead in this "Great rotation" currently playing out. Furthermore, while there has been some additional pressure in the High Yield space seeing $3.8 billion of outflows, marking a third straight week of leakage for the asset class. A continuation of both a flattening of the yield curve and a surge in the US dollar will eventually start hurting credit and spreads could start widening at some point. As pointed out from a recent BIS paper entitled "The dollar, bank leverage and the deviation from covered interest parity" (H/T fellow blogger Nattering Naybob) we quoted recently on our tweeter feed:

"The highly significant coefficient on the US dollar index is -0.49, which implies that a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending. The estimated coefficient for lending to banks is even larger in absolute value (-0.61), implying that the decline is even stronger for interbank lending." - source BIS

In their long report the BIS indicated that a strengthening of US dollar has adverse impacts on bank balance sheets, which, in turn, reduces banks’ risk bearing capacity. An appreciation of the dollar entails a widening of the cross-currency basis and a contraction of bank lending in dollars. So all in all, our "exuberant" equities friend should be wary of outflows, the surge of "Mack the Knife" and a flattening of the yield curve, because in our book, once you've passed the critical threshold, there is more pain ahead with contraction of credit and consumption, if our murderous friend continues its rampage. If you forgot what a global credit crunch looks like, then you should be concerned by the devastation that can bring in very short order a US dollar shortage. 

When it comes to the aforementioned "risk bearing capacity for banks" think about rising hedging costs because as per the below chart from a Nomura note from the 17th of November entitled "Japanese investors' foreign bond buying (Oct 2016)", since late October, USD/JPY basis has been widening again. So, dear investors you can not only expect rising hedging costs going forward but a higher cost of capital, which entails credit spreads widening at some point:

"USD basis costs fell after the adoption of new MMF regulations in the US, but …
We attribute the rise in USD basis costs until early October to new MMF regulations, which were implemented on 14 October. The valuation method for prime MMFs (primarily investing in commercial paper issued by corporates) held by institutional investors was revised in such a way that these instruments could incur losses.
This likely prompted a shift from prime MMFs to government MMFs (which invest more than 99.5% of their funds in cash, government bonds, and government bond repos). This made Japanese banks USD funding via commercial paper more difficult. USD Libor also rose on expectations that USD funding would become tighter for Japanese banks, which led to a widening of USD/JPY basis.
Once the new regulations were implemented, the tightening of USD funding materialized, and USD/JPY basis began to narrow. Since late October, however, USD/JPY basis has been widening again. Moreover, USD Libor may rise if a Fed rate hike at the December FOMC meeting becomes more likely, which could translate into higher currency-hedging costs, in our view." - source Nomura

USD libor, dear friends, will rise if the Fed hikes in December FOMC meeting (100% certainty according to market pundits). This will accentuate even more currency-hedging costs. So what could be the consequences given Japanese Lifers and their investment friends have been large buyers in 2016 of foreign bonds, this could lead Japanese investors to look back into domestic issues or switch some of their appetite towards cheaper alternatives such as Euro denominated bonds longer than 10 years.

As a reminder from our July 2016 conversation "Eternal Sunshine of the Spotless Mind", Bondzilla the NIRP monster has been more and more "made in Japan":

"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"." - source Macronomics, July 2016

Unfortunately for the "macro tourists" out there, playing the leveraged carry trade, if there is something that carry players hate most is bond volatility! It is therefore difficult for us to envisage some stability in the Emerging Markets space until US interest rates stabilize. We have yet to see some sort of stabilization.

Also, we believe that the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line for stretched EM dollar denominated leveraged players. Right now, when it comes to the US, the latest Senior Loan Officer Opinion Surveys (SLOOs) point to some easing as of late as indicated by Bank of America Merrill Lynch in their HY Wire note of the 21st of November entitled "Don't be a hero":

"We use three main criteria to forecast HY default rates: the Senior Loan Officer Opinion Survey (SLOOS), credit migration rates, and real rates in the economy. When combined, these three inputs have an 85% correlation over the next 12 month trailing default rate at any given point in time. This makes sense because looser lending conditions, a higher proportion of upgrades, and lower real rates all make it easier for an issuer to secure funding and hence maintain balance sheet liquidity. For Loans we use a two factor model - rates don’t have a meaningful impact on the asset class, especially since they are floating in nature.

"Our HY model is most sensitive to the lending standards as reported by senior loan officers on a quarterly basis- a measure that has declined from a relative high of 11.6% in April of this year to 1.5% today (Chart 18). The survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. Another way to assess issuer access to funding is by tracking the proportion of risky companies that have been able to tap the HY capital markets on a trailing 12-month basis. While this too has a high predictive power of defaults (Chart 17), it doesn’t add enough incremental explanatory power to justify adding an additional variable. Further, the lead time of the risky issuance model is less consistent than the lending survey. Hence we choose to rely on SLOOS for the purpose of our model. Just like for bonds, SLOOS is a good indicator of the level of default rates for loans a year later. However, in the case of loans, the default rates are more sensitive to the asset class’s migration rates than the lending survey, quite the opposite of bonds.

Another interesting point to note about the SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. On the other hand, it undershoots when defaults are driven by idiosyncratic events in individual sectors such as what we witnessed in the 2015 commodity bust. Our forecasted default rate for 2015 thus happened to be lower than the realized headline default rate but higher than the ex-commodity rate" - source Bank of America Merrill Lynch

The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years has ended.

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, one would expect leveraged players, carry traders and tourists alike to start feeling nervous for 2017.

Also, rising rates can easily curtail the US consumer which would ultimately disappoint earnings growth and sales as the ability to use cheap funding wane with rising interest rates, meaning less potentially less buybacks regardless of the US repatriation factor vaunted by some pundits. This leads us to our final chart as in the end, for us Europeans, the US dollar might be their currency but our collective problem in 2017 we think.

• Final chart - The dollar is their currency but our problem for 2017

The continuation of a surging US dollar and a flattening of the US yield curve could represent a significant headwind for 2017. This is as well indicated in the final chart we selected from Bank of America Merrill Lynch HY Wire note of the 21st of November entitled "Don't be a hero" displaying the USD appreciation versus YoY EBITDA growth (ex-Energy):

"Given the strengthening dollar, a fall in earnings growth and a pickup in treasury yields, we’re concerned that unless sales growth accelerates meaningfully in 2017, ex-Commodity fundamentals may disappoint relative to 2016. And although we were becoming emboldened by what appeared to be stronger revenue growth in Q3, as more companies report we are finding that unfortunately our optimism may have been misplaced; sales growth for Q3 now stands at just 3.7% whereas 11 days ago it was 8%." - source Bank of America Merrill Lynch

If optimism is somewhat misplaced, it could well be that our eternal equities optimists friends could be somewhat getting ahead of themselves in their "reflation" wishes. But that's another story as for now it's rally time in the equity world and we don't want to be the party spoilers for now.

"In politics stupidity is not a handicap." - Napoleon Bonaparte

Stay tuned!

Macro and Credit - When Prophecy Fails

"Experience is the only prophecy of wise men. Alphonse de Lamartine," - French poet

Looking at the dislocation and violent bond market gyrations that followed our second "prescient" call (following our correct Brexit call) on Trump being elected in the US as indicated in our conversation "Empire Days" which by the way earned us two nice bottle of wines thanks to our friends being plagued by "Optimism bias", we decided to steer towards "behavioral psychology" for our chosen title analogy this time around by referencing the classic 1964 book of social psychologists Leon Festinger, Henry Riecken and Stanley Schachter where they deal with the psychological consequences of disconfirmed expectations. While we have already used "Cognitive dissonance" as a previous title, this book was very importance in the sense that it published the first cases of dissonance. The chief reason for us selecting the above title reside in the fact that not only did the US election was a case of disconfirmed expectations and of course "Optimism bias" but, the resulting wakening of "Bondzilla" the NIRP monster led to the reversing of Gibson paradox given the sudden rise in real yields that lead to not only a bloodbath in the bond space but also a vicious sell-off in both gold and gold miners, with silver not spared either. As a reminder about Gibson paradox from previous conversations: When real interest rates are below 2%, then you get bull market in gold, the reverse also works. There has never been an episode in history when Gibson's paradox failed to operate. Real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates and the aforementioned "sucker punch" delivered in a very short order. So while many noses have been bloodied in recent days following Trump's victory, our contrarian and behavioral posture tells us we think the market might be trading way ahead of itself given the uncertainties relating to what the policies which will be implemented by the new US administration. When it comes to disconfirmed expectations and its inflationary bias as of late, we are still awaiting to see additional pressures coming from wages before we embrace the recovery mantra. Nonetheless we have been gradually de-risking our early 2016 barbell position significantly (long US long bonds / long gold miners) in favor of cash in US dollar terms waiting for the time being for the dust to settle and the fury to abate before dipping back our toes.

In this week's conversation we would like to revisit our July 2015 theme of "Mack the Knife", also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation. Of course what is happening in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:

"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 

Wave number 1 - Financial crisis 

Wave number 2 - Sovereign crisis 

Wave number 3 - Currency crisis

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

Real interest rate and US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

Synopsis:

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
• Final chart - People are trading on hope: Higher growth or higher inflation?

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife

For us, Mack the Knife = King Dollar + positive real US interest rates. 

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

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

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2016 after the US elections in very short order) started once again the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

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

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits and displayed in the below chart from Bank of America Merrill Lynch from their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go":

"Asia: It’s complicated

We expect weaker Asian currencies vs USD. In addition to the higher US rates channel, Asia is very exposed to US trade protectionism and will rely on rate cuts, weaker currencies and domestic fiscal policies to offset those risks. We like short KRW and SGD vs USD, and we remain short CNH against a narrow CFET basket as outflows are expected to continue (Chart 2). A complicating feature will be the greater scrutiny on USDCNH and whether President elect Trump will come true on his election threat to charge 45% punitive tariffs on Chinese exports to the US." -source Bank of America Merrill Lynch

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). So, all in all, the likely Fed hike in December in conjunction with USD strength will once again result in additional capital outflows which are leading not surprisingly to textbook bigger CNY depreciation from China.

When CNY / USD depreciation expectations continue to rise or USD strengthens, you can expect once again more pressure on capital outflows if other macro factors remain relatively stable. Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield (ETF JNK and outflows) and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates) hence our propensity in this kind of situation to raise significantly cash levels in US dollar terms.

Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. On the subject of monitoring for the purpose of the exercise, we read with interest Nomura's latest Capital Flow Monitor from the 14th of November entitled "EM Pressure Index Update":

• EM central banks (excluding China and the OPEC countries) continued to buy reserves in foreign currencies to the tune of $37.7bn in October vs. $12.0bn the prior month, led primarily by strong purchases from Hong Kong (around $25.3bn). This is the eighth consecutive month of net buying by these EM central banks. Of these 20 EM central banks, two sold reserves, nine bought, and nine did not intervene.

• After adjusting for FX valuation and coupon payment effects, we estimate that China sold FX to the tune of $11.2bn in October, after having sold around $29.8bn in September.

• EMFX pressure rose moderately: Our Global EM FX Pressure Index (excluding China and the OPEC countries) continues to deteriorate. The main contributors to the pick-up in pressure are the South Korea, Indonesia, Israel and Russia, in that order of significance. This was partly offset by lower FX pressure in the Philippines, Mexico (MXN appreciated significantly in October), and Brazil.

Global EM FX Pressure Index

The Global EM FX Pressure Index combines information on EM central bank reserve dynamics and EM FX price action.
EM FX price action is measured by the monthly percentage change in EM currencies against the USD. Reserve dynamics are measured by EM central bank intervention (in USDbn) scaled by the money base. EM central bank intervention is estimated to be based on changes in the level of FX reserves, adjusted for valuation effects. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
The methodology above is developed by the IMF

• EMFI pressure rose in October: Our Global EM Fixed Income Pressure Index, which combines information on cross-border flows into EM local bonds and price action, indicates a significant increase in pressure. The absolute pressure level was high in October relative to history.

Global EM Fixed Income Pressure Index

The Global EM Fixed Income Pressure Index follows a similar methodology and combines information on cross-border flows into EM local currency bonds and EM local currency bond price action.
EM local currency bond price action is measured by the change in bond prices, computed based on the monthly change in 10yr sovereign yields and a 7yr duration assumption. Cross-border flows are acquired from various local sources; most of them are estimated based on changes in foreign holdings of local currency bonds. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
Estimates for the current month are made based on flow data from Mexico, India, Indonesia, Hungary, South Africa, and Turkey. A revision will be made (in the following month) once data from Colombia, Brazil, Malaysia, Korea, Russia, Poland, Israel, Thailand, and the Czech Republic are released.

Pressure on EM bonds rose in October

• EMFI pressure rose: The index fell to -1.2% (a significant rise in pressure). As indicated in Figure 2, this level of pressure is low compared to historically.
• Bond flow: EM local bond markets saw an estimated outflow of $4.3bn, compared with an inflow of $9.1bn of inflows in September and $2.0bn of inflows in August (based on a consistent sample of six countries that have reported for May: Mexico, India, Indonesia, Hungary, South Africa, and Turkey).
• Price action: Of the 19 EM countries we track, two countries saw their sovereign yields fall, while 17 rose (Figure 9). Russia (+54bp) and Turkey (+33bp) saw their sovereign yields rise the most, while Brazil (-19bp) and India (-2bp) saw their yields fall the most. Yields in the advanced economies rose, with US 10yr yields up around 23bp, Japanese only up 4bp, and eurozone up an average of 35bp, led by Italian bonds.

- source Nomura

From our monitoring perspective and our interest in dwindling currency pegs with Egypt being the latest one to throw in the towel, given that we won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September 2015 conversation and with the additional points made in our conversation "Cinderella's golden carriage", we might have had once again our timing wrong in 2016 as far as the HKD is concerned. But, when it comes to dwindling currency pegs and with our own prophecy failing so far to materialize in 2016 we would like to remind you the trend for currency pegs so far. When it comes to our 2016 "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop if Mack the Knife continues his run unabated:

-source Société Générale

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been". We also note from Nomura's research piece that when it comes to intervention by country and capital flows, once again Hong Kong Monetary Authority (HKMA) had to step in significantly in October:

- source Nomura

What has been happening of course for Emerging Markets and yield hunters alike is that central bank's meddling with interest rates (ZIRP, QE, NIRP) drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, leveraged loans and emerging market debt to satisfy their yield appetite. The problem, however, is some of these "macro tourists" underappreciating exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle will eventually turn in earnest (not yet the case according to the latest US Senior Loan Officer Survey showing some easing as of late) annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range as we have seen earlier on in 2016 for the energy sector. Yet, it seems given the significant returns delivered in the second part of the year to the High Yield sector, that some of these "macro dimwits" have not learned their lesson, given that not only they have increased their credit exposure, but, they have also extended their duration exposure at the same time! Hence the on-going bloodbath. As a reminder, in the current low yield environment, both duration and convexity are higher; therefore price movements lower for bonds are larger.

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":

"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realizing the dangers of using too much "overmedication" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space and Emerging Markets bond funds alike. Even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in bond funds given that the Fed's role is supposedly one of "financial stability". We will not delve again into our views relating to positive correlations and large standard deviation moves as we have already tackled the subject in February in our conversation "The disappearance of MS München" conversation. We commented at the time that the fate of the attack of the Yuan and in effect the attack of the HKD peg could be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think.

When it comes to the much feared Mack the Knife and Asia, Bank of America Merrill Lynch in their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go" looks further into the dominating risk from a rising US dollar:

"Does dollar strength dominate everything?

The sharp reversal higher in risk assets following the Republican clean sweep has raised the question of whether reflation optimism (driven by the end of gridlock and expectations of US fiscal stimulus) could support Asia FX over the coming months. We are skeptical, at least vs the USD. As we have argued, the biggest implication of a Republican clean sweep is a stronger USD and higher US rates– this should lead to higher USD/Asia, even if trade-weighted FX performance remains more sensitive to risk.

US tax cuts – this time is different for Asia

Historically, large US tax cuts have been followed by a widening of the US current account deficit driven by higher imports (Chart 9).

This supported Asia export growth and exchange rates, especially during the Bush tax cuts of 2004 (Chart 10).

However, this time could be different, partly because the US household spending has been shifting towards non-tradable services. More importantly though, Trump’s policy platform itself is geared towards reducing dependence upon foreign goods and services.

Trade policy risks

While the prospect of draconian trade restrictions is still uncertain under a Trump Presidency, some risk premium is likely to be factored into Asia FX. There will be particular focus on the trade policy stance towards China. China is currently far from meeting the existing US Treasury criteria for currency manipulation, primarily because it has not engaged in RMB weakening intervention. It will be important to watch if the US Treasury amends these criteria under the new Administration. Another issue would be China’s expectations to be granted market economy status on 11 December 2016, fifteen years after its WTO accession, and the negotiations around this. A key risk is if China chooses to weaken its currency more quickly ahead of these events and the new Administration taking office." - source Bank of America Merrill Lynch

In the current context, from an allocation perspective, we are neutral on gold and silver until we see more stabilization in the move in real rates. While many have been jumping on the "equity" bandwagon, if indeed there is further weakening of the yen relative to the USD then again, the Japanese Nikkei should benefit so what is not to like in going long Nikkei hedged in either USD or Euro? Also, the strengthening of the HKD, should benefit Chinese shoppers and Japan from a "retail" perspective. This is already a subject we discussed in our conversation"Cinderella's golden carriage" in December 2015 as  tourists amounts to more than 12% of  Hong-Kong to GDP:

"So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again." -source Macronomics, December 2015

As we stated before, if Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think. While our "prophecy" failed in 2016, if the trend continues, who knows how long Hong Kong can hold the line.

When it comes to failing prophecies and high expectations, particularly of the inflationary type and the market trading ahead of itself our final chart below is highlighting once again the gap between equity investors (the eternal optimists) and fixed income investors (the eternal pessimists). 

• Final chart - People are trading on hope: Higher growth or higher inflation?

While the Fixed Income crowd continues to be trounced by rising real rates and surging inflation expectations we do believe that the market is trading way ahead of itself and speculating already on what the new Trump administration will be able to deliver. The significant rise in interest rate volatility in conjunction with real rates means that not only fixed income in general and emerging markets in particular are getting slammed, but, it means once more that Gibson's paradox is at play at the moment hence our neutral stance for the time being and cautiousness. Our final chart from Deutsche Bank's Torsten Slok Chief International Economist and illustrates the different trajectories of volatility between rates markets and equities:

"Fixed income markets and equity markets are following completely different narratives after the election. Rates markets are focusing on higher inflation and what it means for rates across the curve, including the risk of the Fed falling behind the curve. Equity markets, on the other hand, are focusing on higher GDP growth, and equity markets don’t seem to worry about the risks of an overshoot of inflation and the Fed falling behind the curve. These different ways of looking at the election outcome have opened up a huge gap between rates volatility and equity volatility." - source Deutsche Bank

Indeed, mind the gap, because if volatility continues to surge in rates markets, we have a hard time believing it will not eventually spill-over to equities. We shall see if the inflationary prophecy materializes itself in the coming months. For the time being, like any good behavioral therapist, we'd rather focus on the process of a rising US dollar rather than on the prophetic content of the policies which will be followed by the new US administration.

"In the computer field, the moment of truth is a running program; all else is prophecy." -  Herbert Simon, American scientist

Stay tuned!

Macro and Credit - Pregabalin

"Optimism is the opium of the people." - Milan Kundera

Watching with interest the largest outflow ever in US High Yield ($3.9bn last week) in conjunction with the unprecedented 9 days of weakness in US equities and the concomitant rise in the VIX index, given the indecisive outcome for the US elections thanks partly to the FBI's recent change of heart, when it came to selecting this week's title analogy, we decided to steer towards a pharmaceutical one. Pregabalin is a medication used to treat epilepsy but more commonly to treat generalized anxiety disorders. Given markets predicaments and violent gyrations, one might wonder if indeed one should take some pregabalin to ease these rising anxieties. While we have been musings around a pre-revolutionary mindset setting in on the global stage, no doubt to us that the rise in flare-ups in Hong-Kong, Florence in Italy, Greece and palpable rising tensions in France as a few examples, make us believe that the US elections anguishes are not the beginning of the end but more likely akin to the end of the beginning to paraphrase Winston Churchill. Although investors have received some respite as of late with the FBI changing again its tune, we do believe that no matter how some pundits would like to spin it, the lateness in the credit cycle appears to be as evident as the recent record numbers in M&A transactions typical of a late credit cycle rally.

In this week's conversation rather than focusing on the US elections outcome, we would like to look at the situation in Europe when it comes to disintermediation and deleveraging for the European banking system as well as shipping still being a deflationary indicator.

Synopsis:

• Macro and Credit - Disintermediation accelerating in Europe
• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping
• Final chart: Asia will become the largest driving force in world trade in the coming decades

• Macro and Credit - Disintermediation accelerating in Europe

While we have in many musings discussed the "japanification" process linked to the significant deleveraging process needed in the European banking system versus the US, we were reminded by KPMG as per Bloomberg's article on the 30th of October that European bank were still sitting on €1.2 trillion of nonperforming loans on their balance sheets:

"Eight years after Lehman Brothers’ collapse sparked the financial crisis, Europe’s banks still have 1.2 trillion euros ($1.3 trillion) of non-performing loans and will probably be stuck with them for decades to come, according to KPMG LLP.
Anemic economic growth across the region is making it harder for lenders to off-load toxic assets, hurting profitability while banks also come under pressure from tougher capital rules and fines for misconduct, London-based KPMG said in a report published Monday. Firms could take “decades rather than years” to reduce their exposures, hampering profitability.
European lenders are battling to cut soured loans as they face evaporating income from lending amid negative interest rates from the European Central Bank. Net interest margins, the difference between income from lending versus cost of funding, average about 1.2 percent in the region compared with about 3 percent in the U.S., according to KPMG.
“Reversing the profitability of European banks is not a lost cause but it will certainly be a lot of hard work,” Marcus Evans, a partner at KPMG’s ECB office, said in a statement. “It’s clear that across Europe banks are still grappling with the new world of low, or negative, interest rates and mounting capital and regulatory costs.”
The total value of toxic loans in Europe has surged since 2008 from about 1.5 percent of lending to more than 5 percent since 2013, according to the report. This has a negative impact on profitability from unpaid interest, raising provisions against impaired assets and realizing losses when disposing bad debts, according to KPMG." - source Bloomberg

When it comes to dealing with this burden, we have been pretty vocal in the past of what needed to be done back in July when we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":

"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

We also re-iterated our call on ailing Southern European banks back in August in our conversation "The Law of the Maximum":

"Either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started...." - source Macronomics, August 2016

What is of course of interest when it comes to deleveraging, disintermediation and "japanification" is that corporate bond funding in Europe has been on the rise thanks to record issuance levels in the bond market. The financial repression from the ECB in conjunction with its latest corporate bonds asset purchases has moved hand in hand with the primary market for bonds. On the subject of disintermediation, we read with interest Société Générale quarterly note entitled "In the mood for loans" published on the 7th of November:

- source Société Générale

Whereas the above picture shows the overall picture, it is far more interesting to look at it on country to country basis given the significant differences between core countries and peripheral countries, where the impact of nonperforming loans has not been trivial when it comes to providing new loans regardless of the compression in interest rates for new loans as put forward as a success by the ECB:

- source Société Générale

What we find most interesting from Société Générale's report from a "credit impulse" perspective is the situation in Europe compared to the US, which we pointed out in the past has led to different growth outcome in recent years:

- source Société Générale

Obviously the pressure NIRP is putting on Europeans Banks Net Interest Margins (NIM) is accelerating the disintermediation process while in no way leading to some massive improvement for peripheral countries in credit impulse leading to better growth prospects, Italy being a good example of the failings of the ECB, not to mention the unresolved large pending issues of growing nonperforming loans which has yet to be addressed meaningfully. The impact of the European Banking Association core tier one capital rule which lead to a credit crunch in Southern Europe as some banks decided to drastically reduce their loan book to attain the core tier one ratio threshold can be seen in the below chart from Société Générale's extensive loan report:

"YTD figures show a big contrast between the two corporate lending markets. Bonds are obviously more resilient then loan funding, which could fall more than 30% short compared to 2015.
Part of this shift is attributable to the strong impact of the ECB’s CSPP buying programme. The impact of this programme (between €8-9bn of purchases per month) has strongly narrowed bond spreads and has very likely diverted supply towards bonds." - source Société Générale

As we pointed out in numerous conversations is that, liquidity doesn't resolve solvency but, more importantly, the longer time you take to deal with nonperforming loans, the weaker the credit impulse and your economic recovery and ultimately economic growth. But for now, the ECB and disintermediation, in similar fashion to what happened in Japan in the past, makes investment grade credit still an appealing proposal, particularly in the US thanks to the continuous appetite from the Japanese crowd in general and lifers in particular as pointed out by Nomura in their FX Insights note from the 28th of October entitled "JPY: Lifers still prefer foreign bonds":

"Japanese lifers’ investment plans show strong demand for foreign bonds, even after the introduction of yield curve control by the BOJ. Slight steepening in the JGB yield curve since early July is viewed as not enough for them to consider aggressive JGB investment. Their views on hedging suggest unhedged foreign bond investment is likely when JPY appreciates. The current USD/JPY spot is already slightly higher than their end-March forecast, but dip-buying demand from lifers is likely, especially if US political uncertainty disappears." - source Nomura

So while US High Yield as of late have seen significant outflows particularly in the feeble retail ETF space, we continue to favor quality (Investment Grade) over quantity (low rated US High Yield such as CCCs). Though some expect the convexity game to bite with additional rate hikes from the Fed starting in December which could impact dearly the long dated / low coupon investment grade crowd. At least for now, in terms of flows, the Japanese investor crowd still has your back.

Moving on to the never ending argument between inflation or deflation, while we chose the middle grown in our previous conversation discussing "biflation" over "stagflation", we continue to assess the deflationary forces at play thanks to the shipping industry as per our next bullet point.

• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping

As we pointed out in the past, when it comes to deflationary pressures, disintermediation and "japanification" process, we have long been looking at shipping loans as a good indication of deterioration in global trade and credit. We have regularly pointed out German banking woes when it comes to their outsized exposure to the sector which has been impacted in recent years by slumping freight rates illustrative of weaker global trade. This has been leaving shipping companies struggling to pay their creditors which meant that some German banks decided that they would even themselves run some ships to avoid recognizing their losses. For instance, back in 2013, German Commerzbank given their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses.

What some pundits fail to grasp when assessing world trade is that containerized traffic is dominated by the shipment of consumer products hence our stance regarding the weak recovery we are seeing. Any change in consumer spending trends depends on a more pronounced housing market revival and will directly impact container traffic. Weaker demand means weaker traffic, that simple.

When it comes to German banks exposure, there is much more deleveraging to come in relation to their shipping loan portfolios and woes as per Société Générale's report:

"Already evidenced in the 3Q15 data, German, Greek and UK banks shrunk their balance sheets in the sector in 2015 by -20% to -34%.
On the other hand, French, Benelux and Scandinavian banks all increased their balance sheets by 8% to 9%, while NL banks did so by+22%."

• "Within the container segment, mid-sized panamax vessels are being particularly hit by the situation. The Hanjin bankruptcy has been exacerbated by the re-opening of the widened Panama Canal, which means the Panama vessels are now undersized and outdated.
• In the offshore business, drilling business remains very weak. Many drilling rigs and jackups are struggling to find profitable redeployment at the end of existing contracts, and the idle fleet is therefore increasing, which will put pressure on cash flow in due course.
• New financing activity is low, and there has been a flight to quality among lenders, who are increasingly selective on new business while they closely manage existing portfolios. Liquidity remains strong for the top credits, and funding can be very aggressive despite the weak underlying markets. This is particularly true in Asia, where local banks (Malaysian, Taiwanese, Indian, etc) can price very aggressively to support their local clients, while Chinese lessors are being aggressive on a global scale to build market share.
• In addition to this difficult environment, the uncertainties regarding the Basel IV regulatory capital study are further constraining banks’ appetite for new lending. The new framework, as initially drafted, is based on more standardisation and higher capital requirements for shipping lending activities, the result of which would potentially further reduce bank liquidity for this business as well as increase the cost of borrowing for shipping clients. This might in time narrow the pricing gap between traditional bank lending and alternative sources of funding in the capital markets, particularly non investment grade. Banks will need to be more agile in managing portfolios, and without anticipating the final implementation of the Basel IV rules, banks will have to be more innovative in their distribution, extending their OTD model.
• During the summer, the industry acknowledged the bankruptcy filing of South Korea’s third largest shipping company, Hanjin Shipping. This is by far the largest bankruptcy in the sector and will have important consequences. The two other large Korean shipping companies, STX and HMM, have also been through significant restructuring in the past. HMM has announced that it is among a list of five potential bidders for some Hanjin ships.
• A number of significant strategic operations took place this year and could bring some discipline to the container sector in the future. Examples are Marseilles-based CGM-CGA’s acquisition of Singapore’s NOL; Hamburg-based Hapag-Lloyd’s merger with Qatar/Saudi Arabian-backed UASC; and, hot off the press, the likely merger of the container operations of the three largest Japanese shipping companies – NYK, MOL and K-Line.
• Overall, the outlook remains challenging, which is no doubt a source of stress to ship-owners and banks alike. This will require more innovation as banks evolve towards Basel IV, possibly accelerating their OTD business models to manage capital more smartly. Investor appetite for IG shipping debt is proven, with the likes of pension funds active in this market.
• The difficulty will stand with non-IG lending (i.e. the majority of the shipping sector) where alternative investors such as hedge funds and infrastructure funds have very different approaches to pricing. Whereas banks value the underlying collateral over which they have security and this currently drives the advantageous capital treatment and lower margin, typically hedge funds don’t value this component and price on an unsecured high yield basis." - source Société Générale

On top of the weakness in global trades, which has been plaguing the shipping industry and their banking creditors, the only solace they have seen as of late has been coming from weaker bunker fuel prices. As a reminder bunker fuel constitutes the bulk of voyage expenses for shipping companies. Higher bunker fuel prices would adversely affect already ailing earnings for the industry as a whole. Bunker fuel prices, the largest cost of running a ship, correlate with crude oil prices.  For the week ended October 28, 2016, the average bunker fuel price was $321–$325 per ton. Bunker fuel prices are 13% higher than they were in the same period in 2015, when they were $321–$324 per ton. A continuation in the rise of bunker fuel would of course put additional strain on already difficult earnings for the industry as a whole. On top of that new types of bunker fuel need to be developed to meet demand for low sulfur marine fuel following the decision of the International Maritime Organization to impose a global 0.5% sulfur cap on marine fuel in 2020, according to bunker industry organization IBIA. This will as well put additional pressure on the cost structure for existing shipping companies, meaning more pain to come thanks to increase regulation and more provisions to make for the likes of Commerzbank. This means probably more "pregabalin" intake for shipping companies and creditors alike we think but we ramble again...

When it comes to deflationary forces at play in global trade, we do not see a reversal in sight for the current weakening trend we have seen in recent years. This is as well clearly put forward by Deutsche Bank in their Logistics note from the 8th of November entitled "Weak environment - no trend reversal in sight":

"Over the next three to five years, global trade is likely to grow only at or around the same pace as global GDP.

This structurally weaker momentum should be reflected in slow growth in the global and regional flow of goods, as has already been the case in recent years. In its role as an open, export-oriented economy, Germany – and the German logistics sector in particular – should continue to feel the sting of this development. At a nominal average of 2% a year, turnover growth in the sector is likely to be below the long-term average in the years ahead.

Global openness – the share of trade in global GDP – increased from just over 10% in the mid-1990s to more than 30% in 2008.

In the wake of the 2008/09 global recession, global trade suffered a setback. Openness fell to around 27% in 2009. Due to the lingering weakness in global trade since 2012, global openness has yet to return to above 29% in 2015. We expect global trade to remain anemic in the years to come.

Low global trade growth goes hand in hand with weak momentum in the global flow of transportation.

The growth rate in international seaborne trade fell each year between 2012 and 2015. Growth came in at just 2% in 2015 – its slowest pace since 2009, a year plagued by recession. The situation is similar in global airfreight, where transport volume grew by an average of just 1.5% a year between 2010 and 2015. Between 1993 and 2010, airfreight transport volume expanded by more than 5% a year.

The slow expansion of trade in recent years is ultimately also reflected in domestic freight transport.

In 2015, the total volume of goods transported in Germany was only around 3% higher than it was in 2011, corresponding to an average annual growth rate of 0.7%. Between 1995 and 2011, transport volume increased by an average of 2.6% a year. The total volume of goods transported in Germany looks likely to grow by only slightly over 1% a year between 2017 and 2019.

In this climate, it is not surprising that the German logistics sector has also been mired in less than stellar growth for years now.

Nominal turnover in the sector increased by only slightly over 1% a year between 2012 and 2015. As a result, average growth was significantly lower than it was between 2003 and 2008 (4.6% a year). From 2016 to 2020, turnover growth in the German logistics sector will probably come in at just over 2% a year on average. Some segments, such as contract logistics and the provision of value-added services, fundamentally offer opportunities for higher growth." - source Deutsche Bank

So if you think that the rise of populism and discontent à la 30s is potentially coming back, then indeed, global trade could be further threatened down the line by additional pressure on "Global Openness as described above by Deutsche Bank. If global trade does remain anemic in the years to come, then indeed the deflationary floor we mentioned embedded in US TIPS we talked about recently as a low correlated asset allocation tool is still of good value we think.

If politicians start in earnest dealing with "globalization" thanks to rising discontent triggered by a rise in inequality, then again the inflationary burst we have seen will not lead we think to "stagflation" but no doubt to the "biflation" scenario we mentioned in our last conversation:

"What we are seeing we think is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand." - source Macronomics, 30th of October

The weaker trend in global trend has been running on since 2012 as illustrated by Deutsche Bank in their note:

"The lingering weakness in global trade since 2012 caused global openness to fall to 29% in 2015. Our analyses to date suggest that global trade is likely to continue posting anemic development in the years ahead, as the elasticity of international trade with regard to global GDP growth has probably decreased, partially due to structural factors. As a result, the link between cyclical and structural factors continues to exist.

In particular, the following aspects point to continued weak global trade going forward: slower economic growth in China and the realignment of the Chinese economy towards more domestic consumption, the probable plateau in the development of global value chains, the faltering status of multilateral trade liberalisation and the increase in the number of additional trade restrictions since 2008. Furthermore, there are no unique events on the horizon with the potential to boost trade globally or, at the very least, regionally. In the previous decade, such events included China’s admission to the WTO in late 2001 and the EU’s eastward expansion in 2004. This less positive outlook for global trade also means muted prospects for globally active logistics companies." - source Deutsche Bank

But, if you believe like ourselves in very long term trends, then indeed what we are seeing is the rebalancing towards Asia as mentioned by Angus Maddison in his outstanding book "Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History". The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This is where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:

• Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
• Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
• In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.

Before you reach for your pregabalin, we encourage you to read the stunning work of Angus Maddison given our final chart.

• Final chart: Asia will become the largest driving force in world trade in the coming decades

Asia will become the largest driving force in world trade in the coming decades and this is clearly illustrated as well in Deutsche Bank's note by our final chart taken from their note:

"Significant shift in the flow of trade away from Europe and towards AsiaBehind the aggregated global flow of trade lies a significant shift in the importance of regional trade within a continent or between continents. At 27%, the trade in goods within Europe continues to account for the lion’s share of global trade. But, from the early 1990s to today (2010-2015 average), it has grown slower than global trade overall, bringing Europe’s share down by five percentage points. Asia, by contrast, has grown significantly in importance. The share accounted for by trade within Asia increased by eight percentage points to 23% over the same period (chart 7).

China’s breathtaking rise to becoming the world’s largest trading power (WTO admission in 2001) was the main driving force behind Asia’s growing importance. China is a partner in each of the five largest bilateral trade relationships that have seen the strongest growth in their share of global trade since the early 1990s. Bilateral trade between China and the US has seen the strongest growth in importance and now places fourth with a share of almost 3% of global trade. In relative terms, trade between the US and Japan and between the US and Canada has lost the most significance. However, bilateral trade between the US and Canada remains in first place.
This shift towards Asia is likely to continue on account of the significantly higher growth rates in Asia than in Europe and progress on trade agreements, such as the Trans-Pacific Partnership (TPP), the Regional Comprehensive Economic Partnership (RCEP) and the Free Trade Area of the Asia-Pacific (FTAAP). Although the Transatlantic Trade and Investment Partnership (TTIP) negotiations between the US and Europe are still under way, critical voices have recently been gaining strength among the public and policymakers. Should the trend that has been around since the early 2000s continue, trade within Asia could outstrip trade within Europe by 2019.
A look at the flow of trade between the continents also illustrates Asia’s growing importance. The share of global trade accounted for by the flow of goods between Asia and Europe has grown by more than one percentage point since the early 1990s, reaching 13% in 2015. Although the significance of trade between America and Asia started to decline in the early 1990s, it has again risen to 12% since the mid-2000s. The importance of trade between America and Europe has fallen by almost three percentage points to 7%." - source Deutsche Bank

Sometimes the long term trend is indeed your friend...While the credit clock might be slowing thanks to central banks meddling, deflationary forces while temporarily at bay might come back thanks to the risk of renewed populism, rising discontent over inequalities and a return of protectionism, but that's another story. For the time being all eyes are on the US elections.

"Under the pressure of the cares and sorrows of our mortal condition, men have at all times, and in all countries, called in some physical aid to their moral consolations - wine, beer, opium, brandy, or tobacco.' - Edmund Burke

Stay tuned !