Macro and Credit - Iconic Memory

"There are things known and there are things unknown, and in between are the doors of perception." - Aldous Huxley

Looking at the significant acceleration in the melt-up in the equities space in early 2018 on the back of decent macro data and earnings, with credit spreads going towards the 11 level on the credit amplifier in true Spinal Tap fashion, when it comes to selecting our first title analogy for the new year we decided to go for "Iconic memory". The development of iconic memory begins at birth and continues as development of the primary and secondary visual system occurs.  A small decrease in visual persistence occurs with age. Iconic memory is the visual sensory memory (SM) register pertaining to the visual domain and a fast-decaying store of visual information. It is a component of visual memory and is described as a very brief:

1. The duration of visible persistence is inversely related to stimulus duration. This means that the longer the physical stimulus is presented for, (QE 1, 2 and 3) the faster the visual image decays in memory.
2. The duration of visible persistence is inversely related to stimulus luminance. When the luminance, or brightness of a stimulus is increased, the duration of visible persistence decreases. Due to the involvement of the neural system, visible persistence is highly dependent on the physiology of the photoreceptors and activation of different cell types in the visual cortex. This visible representation is subject to masking effects whereby the presentation of interfering stimulus during, or immediately after stimulus offset interferes with one's ability to remember the stimulus

Information persistence represents the information about a stimulus that persists after its physical offset (Tapering). It is visual in nature, but not visible. The brief representation in iconic memory is thought to play a key role in the ability to detect change in a visual scene such as the continuation of the Fed's reduction of its balance sheet and its impact which has yet to be fully assimilated by many investors due to their "Iconic memory" we think. In similar fashion the "Iconic memory" of the Great Financial Crisis (GFC) has led many retail investors including the US middle-class to continue to be scared out of the stock market and leading the top 10% of American households to now own 84% of all stocks. 

In this week's conversation, we would like to look at what allocations could benefit 2018 in the on-going "goldilocks" environment thanks to a very muted volatility overall but, the most important question, we think will be once again the direction of the US dollar. In terms of "allocation" we gave a small Christmas present in our last musing on the 17th of December when we hinted that we liked gold miners again because they had "cheapened" a lot. We continue to like the sector for 2018. 

Synopsis:

• Macro and Credit - The US Dollar New Year's hangover
• Final charts - Credit Conditions in early 2018? Take it "easy"

• Macro and Credit - The US Dollar New Year's hangover

While in early January last year we indicated our contrarian view to the long USD investing crowd and we also indicated that in the context of a weaker US Dollar one should rather be overweight Emerging Markets (EM) equities versus US equities. The US dollar index fell by around 10% in 2017 which does indeed validates our early contrarian stance of 2017 as per our conversation "The Woozle effect":

"It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier." - source Macronomics, January 2017

And as indicated from the table below from the blog "The Capitalist Spectator", playing the outlier namely being overweight EM versus Equities has rewarded the "contrarian crowd" handsomely in 2017:

- source The Capitalist Spectator

Could 2018 play out differently than 2017 when it comes to the US Dollar? We do not think so, yet no doubt we could see in the early stage of 2018 a technical bounce of the US dollar. But, for us, from our "Iconic memory" perspective, we still see a weakening of the US dollar from a medium term perspective. On that note we agree with Barclays take from their note from their Thought for the Week Ahead note from the 7th of January entitled "The perils of following the consensus":

"USD: Holiday hangover

The USD has lost ground versus practically all major G10 and EM currencies (except for the JPY and MXN) since mid-December. Price action suggests that FX markets had largely anticipated the announced tax bill. Our economists have taken a closer look at the final details and recently updated their forecasts (see US Economics Research: 2018-19 US Outlook: Tax cut-induced bounce in activity, 4 January 2018). The tax plan is likely to boost near-term growth prospects by about 0.5pp and push out any slowing in the economy into 2019. Above-trend growth and a tightening labor market imply an increase in inflation toward the Fed’s target, and we now look for four Fed hikes in 2018 and three in 2019, taking the target fed funds rate to 3.00-3.25%.

That said, we do not see a lasting effect of the tax plan in pushing potential growth and, hence, long-term rates higher. The expected temporary boost to growth would be driven, largely, by a one-time improvement in disposable income. With many of the changes to personal taxation expected to be phased out of the bill, we do not expect it to have a permanent effect. In addition, it is likely to have heterogeneous effects for consumers based on household situations and the type of income earned. On the investment side, business spending has tended to have low elasticity with respect to changes in the required rate of return on capital, and as such, we are skeptical that it can deliver a substantial increase, particularly given the maturity of the business cycle. Finally, the discussion of restrictive immigration and trade policies that are also on the administration’s agenda may work against delivering lasting productivity improvements.

We remain USD bears over the medium term on account of an overvalued exchange rate (13% versus BEER), compression in risk premium in the US as symbolized by a bear-flattening yield curve, and a global backdrop that remains positive both in terms of cyclical prospects (the US cycle looking more mature) and from a valuation perspective. We believe the market’s focus will shift from tax policy to other policy priorities in Washington. These include approving the budget, immigration (DACA, the border wall, etc.), healthcare (renewal of CHIP, paying for Obamacare subsidies, etc.), and trade policy (NAFTA, alongside Korea and China). The 19 January government shutdown deadline and the seventh round of NAFTA negotiations on 23-28 January should be on investors’ radar." - source Barclays

As per our final conversation for 2017, either you think we are in a bull flattening case or in a bear flattening case:

"In a Bear Flattener case thanks to the Fed's Rician fading, it is still TINA playing out for the Japanese investor crowd" - source Macronomics December 2017.

We argued in our previous conversation that Japanese investors (and global credit and overall allocation wise these guys matter a lot) tends to be dip buyers ensuring in effect a bear flattening of the US yield curve. In 2018 we will watch again very closely what "Bondzilla" the NIRP monster "Made in Japan" will do in terms of "allocation". It is a major support to US credit markets as well. We think monitoring what the Bank of Japan (BOJ) does in 2018 will be paramount. On that note we agree with Deutsche Bank's take from their Japan Fixed Income Weekly note from the 5th of January entitled "BOJ normalization could pose a tail risk to domestic and overseas rates":

"Global investors focusing on the BOJ?

We expect the BOJ to be a major focus of attention among global investors in 2018. We say this because any change in the BOJ's monetary policy stance could have significant ramifications for how Japanese investors approach foreign bonds.

For example, the January 2016 launch of BOJ NIRP and September 2016 institution of YCC each had an important impact on international bond investment flows. Japanese banks were net sellers of foreign bonds to the tune of around JPY1 trillion and life insurers were big net buyers (+JPY4.8 trillion) over the 34- month period between the April 2013 launch of QQE and the January 2016 launch of NIRP, but the subsequent eight-month period up until the September 2016 launch of YCC saw net purchases of JPY5.2 trillion by banks and JPY9.3 trillion by lifers. The obvious conclusion is that the introduction of BOJ NIRP played a major role in the decline in the 10y UST yield from above 1.9% to below 1.4% that was observed between January and July 2016.

Conversely, the eight-month period following the launch of BOJ YCC (October 2016~) saw banks sell off foreign bonds to the tune of JPY9 trillion while lifers cut back their net purchases to just JPY1.3 trillion. We attribute this to bear-steepening of the JGB curve under YCC leaving domestic players with less of  an incentive to invest in foreign bonds, with life insurers in particular probably becoming more willing to wait for overseas interest rates to move higher once they perceived that the risk of the JGB curve bull-flattening had diminished.

Banks began FY2017 by selling off foreign bonds to the tune of JPY5.6 trillion in April (the biggest monthly selloff on record), rebuilt their holdings somewhat through July, and then shifted back into selling mode, meaning that they have now sold more than they have bought since April 2013. Lifers have also remained slow to add to their positions. We attribute this to a flattening of the UST curve —with the 10y yield having ranged between 2.00% and 2.60% even as the Fed has proceeded with multiple rate hikes—reducing the relative appeal of USTs. The flipside is that we see ample potential for Japanese investors to shift into dip-buying mode in the event of overseas yield curves starting to face bear-steepening pressure.

The key question among overseas investors is whether BOJ easing will continue to serve as an anchor for global interest rates. Under the current easing framework, demand from yield-starved Japanese investors should help to prevent overseas long-term interest rates from rising more than modestly. Conversely, if domestic long-term interest rates rise as a consequence of the BOJ commencing "normalization" efforts, then overseas interest rates could rise sharply due to Japanese players seeing less of an incentive to invest abroad. The trajectory of overseas interest rates in 2018 and beyond could therefore depend in significant part on what the BOJ decides and does.

It would not be at all surprising for short- to medium-term JGB yields to move significantly higher if BOJ normalization starts to be seen as a realistic possibility given that (1) foreigners have been by far the most active traders in negative yield short- to medium-term JGBs and (2) BOJ normalization is liable to reduce the FX "hedge premium" available to foreigners (and hence the attractiveness of short- to medium-term JGBs) by causing (negative) USD/JPY basis swap spreads to tighten.

Foreigners' cumulative net purchases have totaled JPY23 trillion for Japanese long-term debt securities and JPY14 trillion for short-term debt securities since the April 2013 launch of QQE, with medium-term JGBs likely to have accounted for much of the former if purchases were indeed funded mostly via the basis swap  market. Up until 2016 net purchases tended to increase when basis swap spreads widened, with this positive correlation reflecting the ability of foreign investors to earn positive spreads over USD LIBOR. However, we would expect foreigners to start reducing their Japanese bond holdings if and when the BOJ commences normalization, in which case short- to medium-term JGB yields might face some quite strong upward pressure until the YCC framework (which will presumably remain in place at least initially) begins to exert its influence once again.

Much will ultimately depend on inflation, but we are wary of bear-steepening risk under the YCC framework

Our US economics team expects US inflation to quicken in 2018, supporting a total of four further Fed rate hikes and a rise in the 10y UST yield to around 3%. The JGB yield curve is liable to face at least some bear-steepening pressure under such a scenario. However, we do not expect Japanese inflation to establish a firm foothold at or above +1% and thus see little prospect of the BOJ actually commencing normalization this year. As such, we will be looking for Japanese investors to step up their purchases of foreign bonds if interest rates move higher, thereby acting as a counterbalance. Irrespective of how many times the Fed hikes, upside for JPY rates is likely to be limited so long as Japanese inflation remains sluggish, leaving foreign bonds as the best means of generating carry. We expect the JGB curve to face a certain amount of bear-steepening pressure in 1H 2018 if overseas interest rates do indeed rise, but bull-flattening pressure may then start to dominate if the Japanese economy loses momentum, domestic CPI inflation peaks out, and the BOJ persists with its YCC framework.

The most obvious risk scenario is that of the BOJ shifting into normalization mode, in which case interest rates could rise quite sharply both at home and abroad. Attention in the first quarter of 2018 is thus likely to be focusing largely on (1) whether domestic and overseas inflation accelerates and (2) whether the Fed hikes once again in March." - source Deutsche Bank

As we pointed out it is still TINA (There Is No Alternative) for the Japanese investing crowd therefore we believe the bear-flattening of the US yield curve will continue its "Iconic memory" movement in 2018.

But moving back to the US dollar and the New Year's hangover, we read with interest Nomura's take in their FX Insights note from the 4th of January entitled "Two factors hurting the dollar":

"As is often the case, markets move when it is least convenient. The dollar has tumbled since mid-December until now – a period when investors were more likely to be embroiled in family dramas and over-eating than to be trading FX markets. Dollar weakness has come despite the passing of US tax cuts, an associated upgrade to US growth expectations and a hawkish Fed. There are many medium-term factors that we think are weighing on the dollar, but in terms of short-term factors, two stand out:

1. The dollar typically falls after a hike. Markets are all about expectations and it was likely the expectation of the December Fed hike that was helping the dollar. The actual hike, then, would naturally reset those expectations and would lead to a “buy the rumour, sell the fact” dynamic in the dollar. Indeed, the dollar has followed a pattern of trading relatively well into Fed hikes, but selling off after (Figure 1).

This time appears to be no different.

2. Rising US inflation expectations could be hurting the dollar. Wednesday’s ISM report showed the prices paid component bouncing back from an earlier dip. Oil prices are marching higher. Importantly, US inflation expectations as priced by US rates markets have consistently risen since early December. The 10yr breakeven from the TIPS market breached 2% in recent days – the first time since early 2017, and the 5y5y inflation swap inflation breakeven has gone above 2.35%. The dollar does not always move with inflation expectations (notably during the” Trumpflation” phase), but typically it does (Figure 2).

Some of this co-movement could be the dollar influencing inflation expectations, but some could be inflation affecting the dollar (through PPP, real yields or “credibility”). Either way, inflation could be returning as a market factor.

Of course, the start of the year is a period when market liquidity is poor. Therefore, we need to be cautious in extrapolating too much from price action, but these two factors do warrant some attention." - source Nomura

It isn't a surprised to see inflation returning as a market factor. A surge in inflation expectations would indeed mark a return of volatility and would be negative for bond yields. If inflation expectations are rising, then again it would continue to be headwind we think on the US dollar. Morgan Stanley in an interesting FX Pulse note from the 4th of January 2018 entitled "New USD Lows in Store" make as well the case for a lower US dollar:

"The case for USD weakness. The USD has come back under selling pressure and the DXY is set to break its early September low. This renewed weakness has occurred despite continued positive US economic surprises (Exhibit 2).

However, we note that the strength of US performance should be taken in the context of the global economy. Global synchronized growth, which should eat into global capacity reserves, will in turn clear the way for a pick-up in investment. Investment requires funding, which augurs poorly for funding currencies.

USD is the world's dominant reserve and funding currency. In order for a currency to be considered a funding currency, it should meet two important criteria: expected funding costs should stay below anticipated returns on investment; and the availability of capital must be ample.

In other words, there needs to be a substantial supply of the currency to be lent out and institutions or individuals willing to lend it. By definition, a dominant reserve currency meets this criterion.

As the world's primary reserve currency, then, it is no surprise that the USD makes up the majority of cross-border foreign-currency lending (Exhibit 5).

Other currencies may temporarily fall into the funding currency category, such as JPY, EUR, and CHF, which have seen periods of significant outflows.

Funding qualifications. The use of QE by global central banks has altered the funding environment, with central banks absorbing outstanding sovereign bonds in exchange for base money. In the case of QE programs from the ECB and Riksbank, EUR- and SEK denominated sovereign bonds held by foreigners declined as a proportion of total bonds outstanding (Exhibit 6).

In comparison, the proportion of foreign holdings of US Treasuries held relatively stable despite the Fed conducting its QE operations.

However, the relative stability of foreign Treasury holdings masks an important underlying shift. While foreign private accounts reduced their Treasury holdings, the ownership by foreign central banks increased. Two factors explain this. First, the Fed's QE operations took place in a period when global currency reserves were rising (2009- 2013), so demand for Treasuries from reserve managers rose in tandem. Second, debt issuance by the US government during this period also increased, so as demand for Treasuries grew with the Fed entering the market, supply also expanded simultaneously.

US assets for sale. Importantly, US agency debt and higher-yielding corporate bonds did experience a significant uptick in foreign holdings. Unlike in Europe and Japan, where private fixed income assets are in relatively limited supply, the US bond market offers a high yielding alternative to sovereigns. This in part explains the increase in the US' net foreign liability position (Exhibit 7).

Private foreign investors selling their Treasury holdings to the Fed reinvested those funds into higher-yielding USD-denominated bonds.

Our key point here is that foreign holdings of USD-denominated debt have increased, while foreign holdings of European debt instruments have declined. A similar dynamic has taken place for equities, where foreign ownership of US equities has more than doubled, which contrasts with trends in the foreign ownership of European equities. An important implication is that, should US assets lose their relative attractiveness (e.g., widening credit spreads, declining equities), then there could be a substantial amount of foreign-held USD-denominated assets for sale. In comparison, the relatively smaller share of foreign-owned assets in Europe renders it more immune to a pullback in foreign sentiment. This is why an environment of rising global bond yields may see the USD lose further ground.

The increase in the US's net foreign liability position comes at a time of relative stability in the US current account, with the deficit fluctuating around 2.5% of GDP since 2009 (Exhibit 8).

However, inward US net foreign direct investment (as provided by the World Bank) has turned negative for the first time since 2006. The composition of US inflows has become narrower, which renders the USD more vulnerable to selling once US equity and credit markets turn lower.

The case for JPY strength. One could argue that foreign ownership within the JGB market has increased, too. The BoJ's QE operations resulted in a significant absorption of JGBs held by the Japanese banking system, which reached the lowest level since 2007 and is now lower than that held by foreign investors (Exhibit 9). 

Importantly, many of these foreign JGBs have been currency hedged - with the FX hedge offering additional income, as opposed to a cost. Indeed, with the widening of the USDJPY basis, the returns offered for asset swaps into Japanese fixed income have increased. These foreign purchases have helped keep JGB yields low, particularly as the majority of the currency-hedged return comes not from the yield on the JGB itself, but from the currency hedge, which renders these foreign investors fairly price-insensitive.
The cross-currency basis represents the cost difference between domestic and offshore FX. A wider basis, all else equal, suggests tight offshore liquidity conditions, while a narrower basis indicates that offshore liquidity is relatively more ample. At this point, the 1 year USDJPY cross-currency basis is trading at its tightest since the summer of 2017, reducing the relative attractiveness of foreign accounts holding FX-hedged JGB exposures (Exhibit 10).

The reduction in this exposure may have no initial FX impact given the FX-hedged nature of the investments. The second order effects, though, are important, as reduced exposures could lead to a potential steepening of the JGB curve. A steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities. For more detail on our JPY framework and why we no longer view the JPY as a funding currency, see: JPY: Impact of Bank Lending.

The neutral rate matters. Despite the Fed hiking rates 5 times since 2015, the USD will remain the globe's best funding currency. Buoyant financial conditions suggest that the Fed's gradual pace of rate hikes has not yet overtaken the market's perceived neutral rate of interest. The continued easing of financial conditions and the strong growth environment, it can be argued, suggest that the Fed may be behind the curve. Moreover, with soon-to-be Chair Powell taking the reins of the Fed in February, President Dudley planning to retire in mid-2018, and the three vacancies on the Board, markets may begin to question whether the FOMC's reaction function is set to change.

Forget the textbook. Textbook analysis would suggest that the estimated $1.5 trillion deficit expansion as part of the recently-passed tax reform bill, coupled with the limited degree of economic slack, should lead to higher US rates and a stronger USD. However, real yields remain at low levels by historical standards.

One way to explain this dynamic is that markets believe that there has been a structural shift in the mix between growth and inflation. However, another explanation could be a perceived shift in the Fed's reaction function, justifying real yields staying low.

Accommodative Fedspeak. FOMC participants have generally eschewed aggressive policy tightening, remaining instead in favor of a gradual normalization which keeps financial conditions from tightening prematurely. Indeed, despite the 5 rate hikes so far this cycle, financial conditions are at their loosest level since 2014 (Exhibit 13).

The most recent FOMC minutes support this thesis. However, some have also supported a looser regulation approach, most notably soon-to-be Chair Powell, whose comments during his testimony suggested an openness to regulatory reform.

Combining easy monetary policy with financial deregulation suggests that the velocity of money is poised to rise, which bodes well for USD liquidity conditions remaining ample. Other major central banks such as the ECB and the BoJ are also likely to gradually normalize their policy stances. This speaks in favor of the EUR and JPY against the USD as these areas remain investment destinations.

Explaining real yields. What drives real yields? Traditional academic research has suggested that factors such as demand deficiency, demography and aging societies, inequality, and poor total factor productivity are important, and these may explain the current low real yield environment within the DM world.

A recent BIS study has enriched this debate by claiming that the above factors may explain the evolution of DM real yields over the past 30 years, but they fail to explain real yield behaviors in eras preceding the 1980s. Instead, they argue, changes in central bank regimes may have had a bigger impact on the broader evolution of real yields. The current low real yield environment began in the early 1980s when DM central banks began adopting inflation-targeting regimes.

The effects of inflation targeting. Inflation targeting has been successful by maintaining price stability and providing stable funding conditions in the DM and EM alike, which has been an important foundation for EMs to develop income and wealth. Another implication, though, may have been an increase in liquidity preference (increased demand for cash and cash-like instruments) within DM economies which may also explain demand deficiency and, implicity, weak DM investment. This is because low and stable inflation reduces the costs of saving - compared to higher and less stable inflation, which may incentivize consumers to invest in other financial assets or consume.

Creating higher inflation expectations may reduce this liquidity preference, pushing these funds into circulation within the economy. The combination of Fed policy accommodation and financial deregulation may be sufficient to do so. A weaker USD in the FX market would be the side effect.

Bringing China into the equation. Prices tend to fall when supply exceeds demand. DM investment-to-GDP ratios have come down within the post-Lehman environment. However, what investors often miss is that the global investment-to-GDP ratio has been rising since the early 1990s, driven in large part by China (which currently has a 40% investment-to-GDP ratio). Exhibit 17 shows the relationship between the US 10-year yield with the global investment-to-GDP ratio. Yields declined as investment rose relative to GDP.

The fact that much of the investment took place in China, which has closed and regulated capital and financial accounts, may have helped global bond yields to stay low via two key channels. First, China's investment boom had largely been funded by local savings, meaning that little foreign capital was needed (which would have drawn capital away from DM bond markets). High household savings and an accommodative PBoC provided the sufficient liquidity. Second, the emphasis on investment provided a source of latent deflationary pressure, pushing inflation risk premia lower. This, in turn, bolstered the demand for liquidity, as inflation risks were low and stable, and in turn supported subsequent demand weakness.

In general, it is fairly unusual within a historical context to see a domestic investment boom without foreign funding contributing to it. Typically, investment booms and current account deficits (where investment exceeds domestic savings) should go hand in hand. When this is not the case, then funding costs tend to decline. Another example has been Japan's investment boom in the 1980s, which turned Japan into a country of low inflation even before the 1990s and beyond.

The concentration of investment in China, where local liquidity was sufficient to finance it, meant that global demand for capital did not rise, which allowed yields to stay low. Should China's investment boom be replaced by investment in other jurisdictions with open capital accounts, prices may still face disinflationary headwinds, but funding pressures would rise. The Fed, then, has an incentive to counter these disinflationary headwinds by keeping policy accommodative.

Still bullish on EM: The bearish USD story has been seen across the emerging market spectrum too. As risk appetite remains strong, investors will likely focus on vol-adjusted carry again to capture excess return. As seen in Exhibit 18, most of the high-yielding EMFX offers such value and we are bullish on most of these currencies.

We believe that rising global growth momentum, improving EM fundamentals and reasonable valuation in EMFX will prompt new inflows into EM in 2018." - source Morgan Stanley

Whereas Morgan Stanley believes a steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities, we do not think Japanese investors have much alternative at the moment so the TINA trade will still make them buyers of the dip as mentioned above in our conversation. While we do expect some short term pull-back and US dollar strength in the near term, we do think that from our Iconic memory perspective more weakness lies ahead for the US dollar and given the positive macro momentum, equities wise, we would continue chasing EM over US equities from an allocation perspective. When it comes to credit, it is still "carry on" as we move again towards that famous 11 on the credit amplifier in true Spinal Tap fashion, basically more of the same, though as we pointed out we expect debt-fueled M&A to be a big theme in 2018 which will no doubt deliver some "sucker punches" along the way to the Investment Grade investing crowd, so, as we repeated in various conversations, dust up your LBO screener in 2018.

Yes 2018 has started with a bang with relentless tightening and equities indices racing even higher, the goldilocks environment is still alive and kicking, even if there are some genuine geopolitical concerns on the background. It is still pretty much "carry on". In our final chart below, for those still rooting for US High Yield, financial conditions in early 2018 still remain plentiful. Apart from a surge in inflation expectations that would warrant a faster tightening by the Fed in 2018, we do not see at the moment the catalyst for a sell-off unless of course our Iconic memory is playing with our thought process but we ramble again...

• Final charts - Credit Conditions in early 2018? Take it "easy"

As we pointed out, the goldilocks environment continues to be supportive thanks to low volatility in various asset classes. Credit conditions remain a key support for sensitive credit such as US High Yield, yet we do think after the significant rally of low beta in 2017 including the CCC bucket, one should start switching from quantity (yield) towards quality (up the rating spectrum). After all the US yield curve continues to bear flatten thanks as well to its Japanese support. Our final charts come from CITI Monday Morning Musings from the 5th of January entitled "Five Charts to Start 2018" and display comforting credit conditions:

"Comforting Credit Conditions

Commercial & Industrial (C&I) lending standards are the key reasons for being comfortable with the upcoming trend in business activity. Figure 9, which is key, illustrates the long-term relationship between the two and Figure 10 provides additional underlying detail. Essentially, easy money lowers the cost of capital and allows corporations to fund hiring plans, capex and working capital needs with C&I credit conditions providing a nine-month lead getting us well into 4Q18. As we have shown in the past, industrial production is very closely correlated with changes in net income.

- source CITI

While the US dollar has started 2018 with a hangover, we do expect a short term rebound in the near future though we remain bearish in the medium term. Meanwhile, no doubt to us, the central banking narrative is changing and it isn't only the Fed which has been retreating from QE, the ECB and even the BOJ are paring as well. Though your Iconic memory might be still playing tricks, you have been warned, the level of the strike on the central banking put is fading we think.

"There is no truth. There is only perception." -  Gustave Flaubert

Stay tuned !

Macro and Credit - Rician fading

"The very concept of objective truth is fading out of the world. Lies will pass into history." -  George Orwell

Watching at the dizzying levels reached by the BitCoin (BTC) mania in true "Orchidelirium" fashion in conjunction with the latest FOMC decision being the final for Janet Yellen with disappointing wage growth on the background still confounding the Phillips curve cult members, when it came to picking up our post title analogy for our final long post of the year we reminded ourselves of "Rician fading" given the weakening central banking support narrative. Rician fading or Ricean fading is a stochastic model for radio propagation anomaly in case you asked and is caused by partial cancellation of a radio signal by itself (Fed's support to financial markets) - the signal arrives at the receiver by several different paths (hence exhibiting multipath interference: ZIRP, QE, NIRP and more), and at least one of the paths is changing (lengthening or shortening). Rician fading occurs when one of the paths, typically a line of sight signal, is much stronger than the others (Fed's tapering then balance sheet reduction). In Rician fading, the amplitude gain is characterized by a Rician distribution. In wireless communications, fading is variation or the attenuation of a signal with various variables. In similar fashion, with forward guidance being the preferred tool of the Fed, the strike level of the put provided by the Fed in recent years is now falling hence our fading analogy with the attenuation of the signal coming from the Fed's balance sheet reduction. 

In this week's conversation, we would like to look at what it entails to navigate in a much "flatter" world courtesy of the Fed, and if indeed yield curves predict recessions in advanced economies or whether it's the "wealth effect".

Synopsis:

• Macro and Credit - Navigating in a flat world
• Final charts -  Just "bid'em up".

• Macro and Credit - Navigating in a flat world

Flat yield curves are most of the time associated with a maturing business cycle, making many investors wondering whether a recession is "imminent" or not. Whereas we pointed out in many of our recent musings that credit would hit the level 11 on the credit amplifier in true spinal tap fashion, many as of late have been pointing out towards the recent dislocations in cross currency basis and the risk of heightened dollar funding crisis and a looming liquidity scarcity. 

For some pundits, higher funding costs would make dollar fixed income assets less palatable for the foreign investing crowd. We pointed out in the past that a large support from US credit markets was "Made in Japan" in our 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. " - source Macronomics, July 2017

As we pointed out as well recently in our conversation "Stress concentration", when it comes to US Investment Grade and the appetite from foreign investors, it has been a TINA trade (There Is No Alternative):

"As long as the volatility in rates remains subdued, it is still "goldilocks" for credit markets and the fun continues to run "uphill", to the bond market that is. For now our central bankers have managed to tame volatility, and not only in rates." - source Macronomics, November 2017

As we indicated in this conversation also is that the low volatility regime has not only been a VIX or a MOVE index story. It has also been the case in various asset classes. When it comes to credit, everyone is still dancing and playing the "carry trade". Though with the Fed's "Rician fading", some are wondering with growing US funding pressure if indeed some "carry tourists" might decide whether or not to stick around with TINA or simply head home, which would surely no doubt lead to some "repricing" and credit spreads widening. On that matter we read with interest HSBC's take from their "Dollar Drought" note from the 8th of December entitled "Looming liquidity scarcity" in which they argue that dollar fixed income allocations could be impacted on a currency hedged basis for foreign investors:

"Cross border fixed income flows

Assuming our views of heightened dollar borrowing costs were to materialise in the next few quarters, we explore in the following section what would be the medium-term investment implications for global investors. To do this, we look at cross-border FX and duration-hedged dollar assets versus the local equivalent. We find that in most cases, the dollar funding costs are beginning to eat away at the spread pickup that non-US investors have enjoyed while buying dollar-denominated securities. In some cases, a pickup still exists such as USD IG credit FX hedged to JPY while in other scenarios EUR long-end core bonds look be more attractive for US based investors.

Eurozone investors

Using FX hedges alone, USD IG credit still has a small pickup versus EUR IG (figure 9).

However, the pickup is much smaller now than in 2014-15 when euro fixed income outflows were at their largest. In the rates space, the simultaneous flattening and steepening of the long-end of the US and euro-area government bond curves, respectively, means that long-dated euro core bonds provide better currency hedged yields for US investors than local USD government securities. With 6mo Eurodollar deposit rates at 1.65% and 6mo EUR Interbank rates at -0.32%, eurobased real money investors with USD assets are already paying 197bp on their currency hedge (selling USD forward at 1.65% and buying EUR forward at -0.32% to make 197bp). This assumes no basis swap cost. Add that in (3mo basis swaps are currently -43bp) and hedging costs are 240bp. With USD IG13 yielding just 3.20%, there is only 0.80% of yield left.

On an FX and duration-hedged basis, there is not much in it: USD IG spreads trade on top of EUR IG (figure 10), as they have now for a couple of years.

For institutional investors that need to hedge FX – insurers for example, given the regulatory cap – then flows into USD assets should diminish, particularly as Fed rate hikes progress.

Japanese investors

For JPY-based investors, USD IG continues to offer a modest pickup versus EUR when FX hedged back into yen (figure 11).

However, the scale of pickup is smaller than back in 2014-2015, given the four Fed hikes since December 2015. Similarly for JPY-based investors, there is very little pickup when duration is also hedged out (figure 12).

Japanese life insurers had been less active in the UST market this year, despite the relatively tight level of cross-currency basis swap spreads versus previous years. But given that the long end of the UST curve has flattened meaningfully, there is not much spread left for Japanese investors in the US market. On the contrary, JGB ASW buying remains a key theme for the medium term

UK investors

For GBP investors, the USD IG market has become much more expensive to hedge (it costs around 90bp), making USD credit FX hedged back to GBP unattractive versus 2016 levels. GBP IG was helped by investors returning home from USD credit in 2017. We could see more of the same in 2018.

Foreign ownership of US credit 

Overall, we know that foreign ownership of US credit has reached record levels. In the short run, this has generated positive momentum in USD IG credit amid the global search for yield (figure 13).

However, over the longer term, it leaves a large investor overhang, with USD2.5trn in USD credit from US issuers owned by foreigners. Once Yankees are included (using BIS data), foreign holdings (excluding ABS) rise to USD5.7trn (figure 14), out of the estimated USD13.2trn of USD-denominated corporate bonds.

We know from events such as LTCM in 1998 that capital flows back home can accelerate when volatility rises. In the low volatility regime in 2017, this has not been a problem. However, should volatility rise, cross-border flows may move from the Jekyll of positive momentum, to the Hyde of capital flight.

Looking beyond fixed income markets, we note the US net international investment position (NIIP) has reached unprecedented levels of -USD8.3tn, compared with just -USD4.0tn before the financial crisis (figure 15). 

On the one hand, it is fine for the world’s largest reserve currency to attract foreign inflows from multiple investor types (foreign exchange reserve investors are natural buyers of US Treasuries; multinational pension funds are natural buyers of equity and debt capital market issuers; etc). But what has occurred this cycle in particular has been a flight of fixed income capital from central bank-repressed markets, particularly in JPY, EUR, and CHF, to high-yielding DM markets such as USD fixed income. Given this, movements in front end US rates and cross-currency basis swaps will be closely watched in 2018.

The issuer perspective

For issuers, US corporate supply in front end EUR (reverse Yankees – US names issuing in euros) swapped back to USD remains attractive, in our view. At the longer end, however, the maths no longer work. (What is attractive for US investors is unattractive for US issuers.) This suggests we may see more industrial and auto reverse Yankee issuance rather than utility and telco, given different natural funding maturities.

The funding gap between EUR and USD, from a US issuer’s perspective, is also not as large now as it was in H1 2015 when reverse Yankee issuance was at its peak. Indeed, reverse Yankee new issues as a percentage of all EUR IG issuance ticked down from 25% to 23% between 2015 and 2017" - Source HSBC

While there might be very little pickup when duration is also hedged for Japanese investors during the 2004-2006 Fed rate hiking cycle, Japanese investors reduced their hedging and went for more credit risks. Will it be different this time around? With so much negative yielding bonds around, we find it is difficult  already to turn negative on US credit in true TINA fashion. The question you need to ask yourself when it comes to how 2018 will present itself from a foreign allocation perspective towards US fixed income and in particular for Mrs Watanabe (Mr Watanabe being too busy with BitCoin, but we ramble again...), the GPIF (Government Pension Investment Fund) and their Japanese Lifers friend is whether we are in a bull flattening case or in a bear flattening case: 

• In a Bull Flattener case, the shape of the yield curve flattens as a result of long term interest rates falling faster than short term interest rates.  This can happen when there is a flight to safety trade and/or a lowering of inflation expectations.  It is called a bull flattener because this change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market.
• In a Bear Flattener case short term interest rates are rising faster than long term interest rates.  It is called a bear flattener because this change in the yield curve often precedes the Fed raising short term interest rates, which is  generally seen as bearish for both the economy and the stock market.

But before we look at the predictive recessionary abilities of the yield curve, we would like to look at how our Japanese friends could react to flattening in 2018, given as we pointed out in many conversations, what these guys do matter for flows in financial markets and it matters a lot!

On that subject we read with interest Nomura's Rates note from the 14th of December entitled "How will Lifers address flattening in 2018":

"Lifers’ sensitivity to yield levels: Foreign assets

Even if we narrow the focus to foreign assets, we find a clear preference among lifers for investments offering higher yields. In FY10-FY11 and FY14-FY16, lifers favoured hedged USTs (Figure 7) as they had the highest yields (Figure 6).

In FY12-FY13, OAT yields adjusted to levels comparable with UST yields, and lifers responded by increasing EUR-denominated assets at a similar pace to USD denominated assets. They also increased their EUR-denominated assets in H1 2017.

Lifers’ sensitivity to yield levels: Bear flattening/bull flattening

The flattening in the UST market has received much attention, but the implications differ depending on whether the curve bear flattens or bull flattens (link). In the case of bear flattening, lifers tend to gravitate towards foreign bond investment, but bull flattening encourages lifers to move away from foreign bonds and they are left with no choice but to park their money in yen bonds.

Lifers accelerated their investment in JGBs rather than USTs (Figure 7) in late 2011 to 2012 (a period marked by the European debt crisis and a fight in the US government over raising the debt ceiling; Figure 8), when the UST curve bull flattened.

Japanese investors showed a growing preference for foreign assets from 2010, but they ramped up their JGB investment at one point. We attribute this to the fading appeal of USTs as their yields fell.

At the same time, the trend shifted from bear steepening to bear flattening in 2013-14 (as the taper tantrum subsided), but at the same time lifers accelerated their UST investment. We attribute this to the growing appeal of USTs as their yields rose. Lifers played a part in the flattening trend, in our view. Subsequently, bear flattening turned into bull flattening in 2015, but during this period lifers slowed their UST investment.

- source Nomura

Nomura indicates in their note on the possibility of Lifers showing an increasing preference for domestic and credit instruments. In a Bear Flattener case thanks to the Fed's Rician fading, it is still TINA playing out for the Japanese investor crowd while Mr Watanabe is busy punting BTC. They also made the following point: 

"Lifers tend to reduce their currency-hedge ratio when JPY weakens more than they had expected. In view of this, we would expect lifers to lower their currency hedge ratio and continue investing in USTs if JPY weakens. The median of lifers’ forecast range in their H2 FY17 plans is JPY112 (average for the nine lifers). If JPY strengthens more than this, some lifers could invest in foreign bonds without currency hedges on the assumption that JPY will weaken again, but overall we would expect lifers to show a greater preference for currency hedges."  - source Nomura

Higher yielding bonds for "Bondzilla" the Japanese NIRP monster continue to be the trade du jour. Japanese investors as posited by Nomura tends to be dip buyers ensuring in effect a bear flattening of the US yield curve, that simple.

Moving on to the subject of the predictability recessionary abilities of the US yield curve, we read with interest CITI's Global Economics View note from the 12th of December entitled "Do Yield Curves Predict Recessions in Advanced Economies":

"Why would the yield curve help to predict recessions?

The slope of the yield curve reflects a number of factors, including expected future interest rates and a number of premia related to inflation risks, interest rate risks as well as supply/demand dynamics. Other things equal, higher future growth and higher inflation should imply higher future nominal interest rates. Usually, higher rates/growth/inflation are also associated, other things equal, with higher term premia. We would therefore expect that low growth would be associated with a shallow slope of the yield curve. Low (growth) expectations can also be self-reinforcing. And indeed, in the US, the 10y-3m spread tends to lead GDP growth by about 1-2 years (Figure 1).

An inverted yield curve could also cause lower growth, as it makes bank lending (and other maturity transformation) less profitable, which could reduce banks’ willingness to lend.

However, the slope of the yield curve is affected by a range of factors which are likely to vary over time. (Growth, rate or inflation) expectations may at times also be unduly low (i.e. wrong). In addition, there is no specific reason to expect an inverted yield curve to be equally informative over time. For example, the level of the yield curve is likely to be relevant. Lower trend growth, lower average inflation and lower neutral rates should be expected to lead to a lower average term premium, which could be unrelated to recession risks over time. Additionally, the yield curve reflects much more information than is captured by the value of the 10y- 3m or 10y-2y spread.

Technical factors and policy can also play a role. For instance, when interest rates were deemed to be at an effective lower bound, and even more so when central banks buy long-duration assets, the slope of the yield curve was ‘artificially’ flattened. Large-scale asset purchases by central banks often were deliberately intended to bring down long-term interest rates, in the case of the BoJ’s yield target explicitly. In addition, higher term spreads can often hinder growth (they do of course imply higher borrowing costs). One would therefore perhaps expect the yield curve to be more useful for ‘safe assets.’

Yield Curve and Recessions: Evidence in the US

Several studies suggest that the yield curve is a relatively reliable predictor of (US) recessions. The slope of the Treasury yield curve between the 3-month or 2- year maturity and the 10-year yield turned negative ahead of each of the last seven US recessions since 1970, and flattened substantially ahead of the 1960 recession (Figure 2).

The average lead between the time the 3m-10y curve inverted and the onset of a recession was 12 months (15 for the 2y-10y spread), with the minimum lead at 6 months and the maximum at 17 months (10 and 23 months for the 10y-2y, respectively, Figure 5).

However, the current slope of the yield curve does not suggest that a recession is imminent. First, according to simple models, the current slope of the US yield curve only suggest a ~10% probability of a recession in 12 months (Figure 4).

However, it is worth noting that a 20% probability threshold – which would imply a 48bp spread in the 3m-10yr and a 15bp spread in the 2y-10y – would capture all US post-war recessions with a reasonable lead, with only two false  signals of recession since the 1960s (see Figure 5).1 Since 1960, the average lead from the time the probability crossed the 20% threshold was 14 months for the 10y- 3m spread and 16 months for the 10y-2y spread (Figure 5). From current levels, it would require slightly more than 50bp of further flattening in the 3m-10y to reach this threshold. Even a flat yield curve (i.e. zero spread) would point at only a 31% probability of a recession in 12 months and estimates based on the 10y-2y spread instead give a similar picture.

Second, much of the recent flattening seems to reflect a reduction in the slope of the term premium. According to the NY Fed’s ACM model, term premia account for 47bp of the 77bp flattening in the 10y-2y spread since the start of the year, with changes in expected interest rates explaining the rest. Meanwhile, rate expectations were historically the main driver of flattening and inversions ahead of US recessions (Figure 6), even though it was less clear for the last two recessions (Figure 7).

Evidence outside of the US

The flattening of the yield curve in the US has been much more extensive than in other AEs this year, where 10y-3m slopes have usually flattened by only 10- 20bp (e.g. in Canada, France, Australia, UK) or in fact slightly steepened (Germany, Italy, Japan, Sweden, Figure 8). Compared to the historical average (since 1997), the yield curve is currently only flatter in the US, Japan, Canada and France, and steeper in the remaining countries. The US stands out alongside Japan in how flat the yield curve is relative to its historical value, and in Japan the BoJ actively manages the 10-year JGB yield. However, it is also worth noting that the average long-term level of the slope of the yield curve also varies quite widely among AEs, from 35bp in New Zealand to 188bp in Italy.

Moreover, the slope of the yield curve is not a reliable and useful predictor for recessions in other AEs. For instance, using an inverted yield curve (10y-3m spread) as the criterion to predict recessions would have yielded 5 false positives in Canada since 1960 (against two in the US), 11 in Australia (since 1969), 7 in Japan (since 1966), and 4 in Italy (since 1973). In addition, the yield curve did not invert ahead of recessions in Sweden (1970, 1975 and 1980), Italy (2007 and 2011) and France (2002, 2008 and 2011), and the Eurozone (2011).

Germany appears to be the only other AE where the yield curve inverted with some regularity ahead of recessions, similar to the US (and also with two false positives). Also, in line with the US, the 10y-2y term spread in Germany leads 10y- 3m spread in predicting recessions. In Germany, the current yield spread (133bp for the 10y-3m and 106bp for the 10y-2y) suggests a 10-15% probability of a recession over the next 12 months, but is likely significantly distorted by the ECB’s asset purchase programme (APP).

One reason why yield curves are less informative in other AEs relative to the US could well be that those yield curves are influenced by US asset prices (and relatively more so than their economies are influenced by the US economy) and therefore are more noisy indicators for recessions." - source CITI

With the Fed's Rician narrative, we also tend to agree with CITI that US asset prices do influence other yield curves. But, the distortion from the strong radio propagation anomaly powered by the central banks and in particular the Fed has rendered the Bear Flattening unavoidable. 

The current high level of consumer confidence and recent positive spins coming from US macro data is masking the fact that US consumers are resorting to releveraging with the help of consumer credit. US wages  have finally lead one sell-side pundit such as Bank of America Merrill Lynch to throw in the towel in their Situation Room note from the 13th of December simply entitled "The Phillips curve is dead". Take that Norwegian Blue Parrot! For us, the US consumer is showing growing signs of strain in a US economy plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents). 

It appears to us that the Rician fading is finally showing us that 2018, (and we think the second part ) could clearly be the start in the change of narrative and marking the last inning of a very long cycle, leading us to believe that one should become more and more defensive and active when it comes to 2018. (We like Gold Miners at the moment, they have cheapened a lot). 

In relation to our favorite Norwegian Blue Parrot and the bear flattening narrative, we read with interest Bank of America Merrill Lynch Securitization Weekly Overview note from the 15th of December entitled "The wheel is turning - cycle talk":

"As 2017 winds down, we turn philosophical and consider the role of cycles in our lives, starting with the fixed length physical cycle of a year, defined by the earth’s rotation around the sun, and extending that to related fixed length economic and political cycles such as a tax or fiscal year and political terms (for example, 4-year presidential terms). Currently, for example, 2017 is drawing to a close and Republicans have a sense of urgency to complete a tax deal: the calendar year is interacting with the political cycle to encourage political progress.

We consider how these fixed length economic and political cycles interact to form variable length economic and market cycles and where we might be in the current cycle. At a minimum, we think that success on tax reform means the chances the up wave in the current economic/market cycle extends out to 2020 improve. This bodes well for securitized products, for as we noted in our Year Ahead Outlook, while tax reform is sold as a GDP/income boost story, the big gains will come in wealth, particularly for those long risky assets, including securitized products.

Translating this into economic numbers, unemployment is probably all that really matters when it comes to thinking about economic and market cycles, including the current one. Chart 1 shows the headline unemployment rate back to 1965.

The wave-like cyclical pattern is evident, even if the length and the minimum and maximum of each cycle are variable. Importantly, with the unemployment rate currently at 4.1%, it is at the third lowest cyclical level of the past 50 years; prior cycle lows came in 1968 (3.2%) and 2000 (3.8%). Surely, given this, we must be nearing a bottom, and the economic – and market – cycle is coming to an end.

As a reminder, this bottoming and economic/market cycle process usually happens because the Fed thinks low unemployment will create inflation and raises rates, bringing an end to the cycle (Chart 2, Fed Funds v unemployment rate).

With another rate hike from the Fed this week, it appears as if that’s how things are playing out once again; eventually, the hikes will matter and unemployment will move up in response to rate hikes. But, as some of our colleagues have suggested (see “The search for missing inflation” and “The Philips curve is dead”), this time is a little different: problematic inflation has failed to surface in spite of the collapse in the unemployment rate over the past 8 years. Is inflation the looming problem the Fed’s actions seem to imply? If it’s  not, perhaps unemployment still has more downside than Chart 1 suggests. Perhaps the Fed will change its tune.

An alternative view on unemployment, and the economic cycle: the profound impact of income inequality

Our primary theory for why inflation is missing and the Philips curve is dead is the rise in income inequality (Chart 3) over the past 50 years.

Wage pressures at the low end of the income spectrum just aren’t there, due to globalization, demographics, union weakness, technology displacement, etc. It appears as if wage growth at the high end of the income spectrum can only do so much (not a lot) to drive overall inflation. We also think the drop in labor force participation (Chart 4) is a contributing factor, with so many leaving the labor force for various reasons since 2000: hopelessness, drug addiction, retirement, disability, etc.

The unemployment rate is understated by virtue of many dropping out of the labor force; as a result, we may well not at an inflationary-inducing level of unemployment. The cyclical view of Chart 1 may not be as scary relative to inflation as it may look; as a result, unemployment may actually have room to move quite a bit lower.

To account for these factors, we compute an alternative measure of unemployment, U’, as follows (U is the headline inflation rate):

U’ = U * exp(income inequality)^2 / labor participation rate

We normalize the income inequality and labor force participation data to the low in unemployment in 1968. Chart 5 shows the history of this alternative measure, along with the standard unemployment rate. The cyclical nature of the data is preserved, but it provides a somewhat different picture of the minima and maxima.

Specifically, it shows a very different picture on the all-time peak level of unemployment. The massive spike in unemployment associated with the Great Financial Crisis looks far worse than the comparable level of unemployment that was observed in the early 1980s, and more accurately captures the unemployment zeitgeists of the respective periods. In this framework, 2008-2009 shows as the catastrophe that it was.

Similarly, the current level of unemployment does not appear to be as low as the nominal expression of 4.1% unemployment, which says that times right now are about as good as they have ever been over the past 50 years. We think it’s fair to say that many do not feel that way. The alternative measure we compute has the adjusted unemployment rate at 5.6%. In this view, there has been significant progress made on employment over the past eight years, but the inequality and participation adjusted unemployment rate is still fairly elevated by historical standards and is well above the prior cycle lows of 2000 (4.8%) and 1968 (3.2%). This data seems to jive with zeitgeist a little more than the headline number, in our view.

When we do a Philips curve view of unemployment and inflation (Chart 6, PCE core inflation v 1/U’), we see that the current level of adjusted unemployment has not done much to trigger higher inflation.

Perhaps it’s missing inflation, or perhaps unemployment has just not dropped enough to trigger inflation. We’ll let readers decide. We believe that, eventually, declining unemployment will trigger inflation and that, eventually, it will be appropriate for the Fed to hike aggressively; we’re just not there yet. According to this measure, though, we need significantly lower unemployment to get us there.

Consider some math to assess how much lower. Assuming there won’t be much change in inequality or labor participation in the next few years, this means most of the decline will have to be driven by declining headline unemployment. Using the above formula, to get us back to the 2000 level of 4.8% adjusted unemployment rate, the headline unemployment number needs to drop to 3.45%. To get us back to the 1968 level of 3.2% adjusted unemployment (note that BofAML economist Ethan Harris thinks the  current inflation cycle may be similar to the late 1960s, so that may be the more relevant data point), this cycle would need to see the headline unemployment rate hit 2.35%. Obviously, these are extraordinarily low numbers and it would take a while to get there, but we think they may be useful in thinking about how long the current cycle might last.

Low unemployment and wealth

In our Year Ahead Outlook, we noted that the true goal of tax reform is wealth accumulation. Reform is sold as a GDP/income boost story, but the big gains will come in wealth, particularly for those long risky assets, including securitized products. With that in mind, we republish the chart showing household net worth as a % of disposable income per capita versus the inverse of the headline unemployment rate (Chart 7, quarterly data).

We also recreate that chart using the adjusted unemployment rate (Chart 8, annual data); Chart 8 suggests significant additional upside is possible, as the unemployment gauge is not particularly stretched.

Our view is that this measure of household wealth will not peak until about the time the unemployment rate hits the cycle low and turns higher; perhaps it will lead by a quarter or two, but it will be roughly coincidental. In other words, the length of the up wave in cyclical wealth accumulation that began in 2009, around the time unemployment peaked, will ultimately be determined by how low unemployment can go and how long it will take to get there." - source Bank of America Merrill Lynch

It reminds us about the Laffer Curve which used to mean the following: "Too Much Tax Kills the Tax". With the upcoming Tax deals mostly benefiting the 1%, we would opine that "Too Much Wealth Effects Kills the Wealth" but we would digress...

For our final chart below and point for the year, we indicated in our recent musings that once the tax deal is a done deal, US corporates with more clarity ahead could resume/start some M&A typical in the late stage of the credit cycle game in the first part of 2018.

• Final charts -  Just "bid'em up".

As a tongue in cheek reference to the mighty Bruce Wasserstein aka "Bid 'Em Up Bruce", the M&A legend, our final charts comes from Wells Fargo from their Credit Spotlight note from the 27th of November entitled "Potential for M&A Boom in 2018", and displays US corporates $2 trillion "dry powder" as well as the S&P 500 P/E and deal premium and implied accretive cash deal multiples. If you think some valuations are getting "silly", we think it is about to get "sillier":

Large-cap Non-Financial U.S. companies have $2 trillion of cash, much of which may be freed up for use of M&A in 2018. With the expected certainty of tax policy, combined with the potential of this cash being freed up, next year M&A may rise to a new high. Not only would this allow for M&A to return to a more normalized level given the level of equity prices, but we could see some make-up for the lack of M&A this year. With bond yields remaining low, companies can afford to pay high multiples and still have the acquisition be accretive to earnings. The gap between what the average company would cost to buy compared to what the average IG company can afford to pay and have the deal be accretive to earnings if financed with 100% debt remains quite wide. This gulf has been a hallmark of this cycle and is contributing to the desire for IG companies to engage in debt-financed M&A, despite elevated company valuations. Currently, a company making a fully debt-financed acquisition and funding at the average of the IG market can pay up to 47x earnings for a company and still have the deal be accretive to earnings, even without accounting for synergies. This compares to only 20x for much of the 1990s, which is below where the average company was trading." - source Wells Fargo

If "Rician fading" is a stochastic model for a radio propagation anomaly, then again $2 trillion in cash in conjunction with the U.S. corporate tax rate being cut to 21 percent and cut taxes for wealthy Americans should enable more "wealth effect" with an acceleration of debt-financed M&A à la 2007. Make sure you have your LBO screener at hand in 2018. Just a friendly "credit" advice.

Before we return in 2018 we wish you dear readers a Merry Christmas and a Happy New Year to all your family and friends. 

Don't hesitate to interact more with us either via comments, through twitter, LinkedIn, or on our facebook page in 2018. As a reminder you can as well subscribe to our musings by registering for e-mail delivery via the blog.

"Old soldiers never die; they just fade away." -  Douglas MacArthur

Stay tuned !