Macro and Credit - Tantalizing takeoffs

"When everything seems to be going against you, remember that the airplane takes off against the wind, not with it." -  Henry Ford

Watching at the dizzying summits reached by US stock market indices with the Dow flirting with 20,000 on the back of the Trump rally, as we move towards the final days of 2016, with a continuation of US Treasuries getting pummeled, when it comes to selecting our title analogy, we decided to go for a vintage flying analogy this time around, "Tantalizing takeoffs" being the nickname for the 50th Beechcraft AT-11 Kansan AT-11 built in 1941 and being currently the oldest flying. The AT-11 was setup as a smaller version of the B-17 Flying Fortress or B-24 Liberator. This provided a simulated training environment similar to the full sized bombers. While in the past we have used as well a reference to aircrafts, particularly in our long 2013 post "The Coffin Corner", which is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013.

On a side note the latest decisions from the ECB amounts to us as clear confirmation of that indeed Mario Draghi is clearly affected by "the spun-glass theory of the mind" given that he stated that “uncertainty prevails everywhere,”

The current melt-up dynamics reminds us what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices." 

Are we entering the final melt-up for asset prices, or is really the much vaunted "reflationary story" playing out in earnest? Or is it simply a case of "Information cascades playing out again as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...)? We wonder.

In this week's conversation we would like to look again at some Emerging Markets vulnerabilities given the recent hike by the FED and the continued pressure stemming from "Mack the Knife" aka King Dollar + positive real US interest rates. 

Synopsis:

• Macro and Credit -  Emerging Markets, from convexity to concavity?
• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

• Macro and Credit -  Emerging Markets, from convexity to concavity?

Back in 2013 we expressed our concern regarding the impact a dollar squeeze of epic proportion would have on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
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?
It is a possibility we fathom." - Macronomics - June 2013

Also back in December last year we indicated a macro convex trade to think about for 2016 relating to a potential devaluation of the HKD which won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016. We made our call for a break in the HKD currency peg as per our September conversation and made additional points made last year in our conversation "Cinderella's golden carriage". In February in our conversation "The disappearance of MS München", we also looked out the Yuan hedge fund attack through the lenses of the Nash Equilibrium Concept :

"When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making." - source Macronomics, February 2016

While obviously our prediction was too outrageous for 2016, we do think that the HKD peg will once again come under pressure in 2017. On that very subject we read with interest Bank of America Merrill Lynch Asia FI and FX Strategy Viewpoint note from the 15th of December entitled "HKD to be challenged in 2017":

"HKD under pressure again

The HKD is under depreciation pressure again. We believe investors’ recent positions were based more on speculative than on fundamental reasons. These positions may be supported by the increase in the US Federal Reserve’s rate hike expectations for 2017. There is a risk of a pullback in USD/HKD forward points and HKD rates if RMB depreciation expectations stabilise over the coming weeks and investors take profit.

Brace the outflows

We believe 2017 will be a year of outflows from Hong Kong. The current account surplus is expected to decrease while capital outflows accelerate. That would cause Hong Kong to draw down its foreign exchange reserves.

Weaker FX, higher rates

Outflows, a slowdown of CNH-HKD conversion, and a declining aggregate balance will shape the HKD market next year. We forecast USD/HKD to rise to 7.80 and 3M HIBOR to rise to 1.50% by end-2017. We are biased to pay USD/HKD forward points and biased to pay front-end HKD rates." - source Bank of America Merrill Lynch

As we pointed out back in November in our conversation "When Prophecy Fails", when it comes to currency attacks it is more about the resolve of the speculators than the fundamentals:

"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." - source Macronomics, November 2016

As pointed out by Bank of America Merrill Lynch in their note, we are seeing a repeat of last year brief attack on the HKD:

"The HKD is under depreciation pressure again. Investors have recently long USD, short HKD forward outright, which has pushed up USD/HKD forward points to its highest level since early 2016. HKD rates have consequently increased and the 3M Hong Kong Interbank Offered Rate (HIBOR) fixing jumped over 10bps (Chart 1).

Both speculative and fundamental reasons related to Mainland China supported the recent market movement (Exhibit 1):

Speculative

The correlation between the HKD and CNH broke down in 3Q: while the RMB continued to depreciate, the HKD was stable (Chart 2). 

But the strong economic links and the growing impact of China on Hong Kong’s interest rates suggest insufficient risk premium was priced into the HKD. So even if Hong Kong’s currency board is credible, which is our base case not least because it has withstood multiple tests in the past, interest in the market to hedge against tail risks persists.

The HKD is also sometimes used as a proxy for the CNH. Proxies for the CNH are attractive when the associated carry costs on shorting the CNH are high (Chart 3).

But provided Hong Kong’s currency board does not change, we believe the potential gains from shorting the HKD as a proxy for the CNH are ultimately limited. In our view, trades based on this rationale are vulnerable to being unwound in the short term.

Fundamental

Hong Kong has started to experience outflows so far this year: in 1H 2016, Hong Kong recorded outflows equivalent to -0.9% of GDP. As such, there are already signs that the HKD will be under fundamental depreciation pressure. We believe the outflow theme in Hong Kong will be much more pronounced in 2017 than in 2016, especially since the US Federal Reserve raised its policy rate for the second time after the global financial crisis in December.

We believe recent positions were based more on speculative than on fundamental reasons, based on the timing of the move.

Speculative depreciation pressure on the HKD picked up after concerns over the RMB increased due to:

• China’s low FX reserve numbers in November
• Reports of curbs on capital outflows from China
• Growing uncertainty over the US-China trade relationship

These speculative pressures may persist in the near-term after the US Federal Reserve raised its Federal Funds rate projections from two hikes to three hikes in 2017. A broad USD rally could raise concerns over capital outflows from China and, ultimately, raise RMB depreciation expectations: we showed that broad USD strength and an increase in policy uncertainty raise capital outflows from China by Chinese investors.

But we also point out that Hong Kong’s 2Q balance of payments (BoP) data have been available since September 2016 and so we think the outflow theme was not the main driver behind the recent move.

As such, there is a risk of long USD, short HKD forward outright positions based on speculative reasons being unwound if the RMB depreciation expectations stabilise over the coming weeks and investors take profit." - source Bank of America Merrill Lynch

While clearly the current pressure on the HKD is based on rising speculations, obviously, the amount of currency reserves is a crucial parameter. The accumulation of reserves by the Hong Kong Monetary Authority (HKMA), make the current speculative move difficult to sustain.

One thing for certain, when it comes to Hong Kong and its vulnerability with their currency board matching the path of the Fed with rate hikes is clearly its real estate market. On that matter we read with interest Deutsche Bank's Hong Kong Property note from the 16th of December entitled "Risk of falling off the edge":

"Every 25bps rate hike would push up mortgage payments by about 2.4%

By looking at the sensitivity of residential affordability in Hong Kong to mortgage rate hikes, every 25bps increase in mortgage rates would translate into an approximate 2.4% increase in monthly mortgage payments or to push down residential affordability (i.e. increasing the debt-servicing ratio) by about two percentage points. Conversely, residential property prices would need to fall by about 2.4% in order to maintain the debt-servicing ratio at the current 68%. By assuming Hong Kong will follow the 75bps rate hike expectation in the US in 2017, residential prices would need to fall by 7.2%. Alongside our expectation of a 3% decline in median household income, we anticipate an 11% decline in Hong Kong residential prices in 2017. If mortgage rates are to normalize to the level of 2005/06 at about 5.75%, residential prices would need to fall by 28% from current levels.

Liquidity conditions look ample for now, although downside risks are rising

Liquidity conditions remain ample in Hong Kong so far, with a stable monetary base, currency lying in strong side convertibility and composite interest rates remaining low. However, the recent surge in interbank rates in HK has led to some concerns about the need to lift the Prime rate in HK. We believe that the near-term spike in interbank rates could be a reflection of expectations of higher rates, potential liquidity outflow and HIBOR finally catching up with USD LIBOR.

Although the large banks have signaled that the Prime rate will remain unchanged, we believe there is a risk that HK banks may need to move the Prime lending rate upward if: 1) HIBOR continues the upward shift that led to increasing the proportion of mortgage loans moving to capped rate Prime loans, 2) a strong liquidity outflow leads to higher deposit funding costs for large banks, and 3) there is much weaker/reversal of system deposit growth, with more signs of a tightening of loan-to-deposit ratios.

- source Deutsche Bank

So overall while our outrageous predictions seems difficult to materialize, the pressure on HKMA to intervene again in 2017 will rise again and if indeed there is vulnerability somewhere, then it might be smarter to "short" some Hong Kong real estate players rather than betting for now the demise of the currency peg.

When it comes to Asia and vulnerabilities, clearly China comes to mind particularly given its rapid credit expansion and the potential for a trade war to flare up with the new US administration. In relation to China being concerning, we read with interest Deutsche Bank take in their Asia Local Markets Weekly note from the 16th of December entitled "Jamais vu":

"Fed & AsiaFor all of the Draghi like nuances, Yellen (& the Fed) sounded and acted hawkish this week. And for once, it looks like the market has no choice but to chase the dots, which are moving away (and up).

For Asia, that should mean,

• Policy divergence will get more acutely in focus in 2017. The market is pricing in slightly over 60bp of tightening by the Fed next year - and still below the dots - but at best one rate hike anywhere in Asia. Indeed, DB Economics, and most of consensus forecasts, do not think even this modest amount of tightening will be realized. FX is then the natural outlet for this divergence in policy outlooks. And like we have been arguing, not just in the high yielders which run the risk of capital reversal - or more likely, no fresh inflows - but also in the low yielders, and ones which also map to the trade/geopolitical policy narrative of the incoming US administration (think Korea, think Taiwan)
• China in particular has some tough policy choices to make here. The Fed tailwind to the dollar will only make these choices harder for the Chinese. Either allow a significant re-pricing of the RMB complex (and take the risk of an unstable cobweb pattern), or burn down reserves (and take the 'credit' hit on the sovereign), or shut the capital gates down even tighter. Likely that they will opt for a mix of the lot. Importantly, though, none of these options look supportive of the liquidity or rates complex - offshore and (increasingly) onshore. Overnight CNH rates are trading at 12%; trading in key bond futures has been halted for the first time; and local press (Caixin) is reporting of big banks suspending lending to non-financial institutions. The move up in inflation only makes the rates re-set story in China that much more compelling to own.
• The local stories will likely define the axis of differentiation in 2017. The dollar move will probably take most of the Asia currency and rates complex with it, to begin with. But the local stories will likely define where on the dollar smile each market ends up next year - be it the policy choices the central banks make (rates, FX, regulatory), or the headwind from political noise (Korea, Malaysia, India)." - source Deutsche Bank

Obviously until "Mack the Knife" aka King Dollar + positive real US interest rates ongoing rampage stops, there is more pain to come for some Emerging Markets players in 2017. Yet, we think that the movement has been too rapid on both the US dollar and interest rates and have yet to be meaningfully confirmed by US fundamentals. While the EM fund flows hemorrhage has stabilized, at least for equities, it remains to be seen how long the resiliency will remain with a continuation of rising yields and we agree with Deutsche Bank's comments from their note:

"US equity bullishness has likely helped arrest outflows from Asia

The buoyancy in US equities – despite the large repricing in US yields – and the softness in vol indicators like VIX has helped contribute to a general resilience in risk. After close to $10bn of outflows from Asian equities in November, the outflows have stopped, although money has not really returned. Again we remain skeptical on the durability of this calm. The correlation of Asian equities to US stocks has been falling since the election and indeed with the US less likely to share the spoils of growth with the world, a decorrelation in returns should widen. Moreover, January has been seasonally weak for US equities for the last three years, which suggests a correction could lie ahead. Chinese equities have also been under strain given the rates market developments, with Asia straddling the divergence.

The market has not been as focused on the potential negative Trump dynamics for Asia from trade, geopolitics, and widening policy divergence 

The market has primarily focused in this first-round on the fiscal implications of a Trump administration, and the re-pricing of growth and inflation expectations. The other side of the coin – of potential protectionist and geopolitical disruption – has been harder to price given large outstanding uncertainties about Trump’s approach off the campaign trail. Once Trump actually assumes office in January, this uncertainty should fade, with a need to take a formal stance on issues like labeling China a currency manipulator, imposition of tariffs and the bargaining chips in play from the One China Policy to North Korea. There has also been outsized focus on the divergence theme between US versus Europe and Japan, but this is equally pertinent for Asia where markets have been in a multi-year easing mindset driven by disinflation, poorer demographics, sensitive credit cycles, and little external lift. If, as DB Economics believes, there is little appetite and ability in Asia to follow the Fed, rate differentials are going to impose pressure on Asian FX. On the other hand, if markets begin to price rate hikes, then unwind of duration stories and debt outflows from the region could be equally painful.

The market has been fighting the “major” battles

With dramatic moves in major G10 currency pairs like USD/JPY, EUR/USD, and in US rates, it is quite likely that macro positioning has been concentrated on trading these bigger themes and breaks. Indeed, even as JPY shorts were being added last week (on the IMM), investors were believed to be squaring back on KRW shorts. However as price action in the majors gets more stretched, the market should begin to look for catch-up trades and mis-pricings elsewhere.

End of year and idiosyncratic effects may have helped slowed moves

While market illiquidity into year-end could have exaggerated negative price action, there are other yearend forces which could have helped. There has been little fresh supply of debt in local markets which should have helped with bond technicals. Similarly, on the debt side, major asset allocation decisions are likely to be taken only in the New Year. Issuance calendars will start up afresh in January, when demand-supply mismatches would be more acutely felt. Central banks  may have also been more active in supplying dollars to manage FX weakness, given greater sensitivity to year-end closing levels. In individual markets like  Indonesia, inflows related to tax amnesty repatriation are likely helping contain the moves. In Malaysia, the wind down of the NDF market, and the immediate provision of greater exporter supply may have helped, but we estimate that significant hedges from real money, equity, and banks could be transitioning onshore in the coming months as offshore hedges roll off. Current account surpluses in much of North Asia are seasonally stronger around year-end, but dip significantly in Q1, with Chinese New Year inactivity, and with holiday export orders behind them

In sum, we are unconvinced that regional FX resilience can last, and would be positioning for a catch-up move higher in USD/Asia into the New Year. We continue to concentrate our USD longs against North Asian pairs that would be most exposed to any worsening in Chinese stress, fallout from a US equity market correction, a negative shift in the regional trade/geopolitical order, and where currencies have relatively poorer seasonality at the start of the year." - source Deutsche Bank

As we posited in our recent musing, the biggest "known unknown" remains the political stance of the US administration relating to trade with China. From our perspective, 2017, will continue, as per 2016 to offer renewed volatility on the back of political uncertainties given the new year will have plenty of political events, ensuring therefore an increase in volatility and large standard deviation moves like we have been used so far this year. Overall "Mack the Knife" will continue to weight on global financial conditions, particularly in EM where there has been a significant amount of US dollar denominated debt issued in recent years. As pointed out as well by Deutsche Bank, the pressure of the US dollar and rising rates will put further pressure on Chinese financial conditions:

"Risk of further capital measures remains high.

In response to the ongoing RMB weakness, driven in part by the divergence in US-China monetary policy, China has again introduced a series of capital measures particularly on RMB cross-border flows (see Trying Times for RMB, 7 December 2016). However, with outflows not abating and as RMB depreciation pressure continues to build, the risk of more such controls remains high, which are likely to drive further tightening in offshore RMB liquidity.

Reversal of RMB internationalisation should tighten

RMB liquidity further. The latest regulations introduced are likely to have accelerated the decline in RMB deposits in the offshore market again, shrinking the overall RMB liquidity pool in the offshore market.

Possible maturing of USD/CNH forwards. 

China earlier this year accumulated a large chuck of short USD forward positions, which are likely to mature in the coming months. If a part of these are allowed to mature, like in August/September, it could well be sufficient to create CNH tightness." - source Deutsche Bank

Whereas for now, convexity rules, be aware that concavity could once again come back to the forefront in early 2017 with markets at the moment continuing the probe again the willingness of the HKMA to defend the peg with additional weakness coming from the RMB and a potential slowing growth outlook for China.

If indeed there is a potential in 2017 for an early "risk-reversal" à la 2016, then again, it looks to us that, from a contrarian perspective the level reach by long US treasuries is starting to become enticing.

• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

Whereas gold and gold miners in conjunction with bonds have been on the receiving end of "tantalizing takeoffs" for equities on the back of the US election, our final chart comes from Bank of America Merrill Lynch Securitized Products Strategy Weekly report from the 16th of December shows that in recent years, rising yields have been followed by declining breakevens, which have been therefore followed by declining real rates:

• The 60 basis point rise in the breakeven rate since late June 2016 is the largest rise of the past 4 years. The unusually large move would seem to have some room to give back some of the recent gains.
• The past month’s rise in the real rate is the second largest of the past 4 years. Over the 4-year period, sharply rising real rates have been followed by declines in the breakeven rate, which in turn have been followed by declines in the real rate.

"Given the persistence of the patterns in recent years, we think that over the next 4-8 weeks, the odds favor a decline first in the breakeven rate and then in the real rate. Overall, nominal yields are therefore likely to move lower. Given that the nominal rate has risen by 80 basis points over the past month, we would not be surprised to see a 50% retracement over the next 4-8 weeks, which would bring the 10yr yield back to the 2.20% area. Time will tell." - source Bank of America Merrill Lynch

If indeed, this scenario plays out, then we could see some reversal of Gibson's paradox given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. End of the day the most important factor for gold prices is real interest rates. One thing for sure 2017 will have sufficient political events to offer yet again plenty of risk-reversal opportunities rest assured.

"The political graveyards are full of people who don't respond."- John Glenn, Astronaut

Stay tuned!

Macro and Credit - The spun-glass theory of the mind

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill

Looking at the results stemming from the Italian referendum in conjunction with the continued gyrations in financial markets on the back of rising FX volatility thanks to "Mack the Knife" aka King Dollar + positive real US interest rates, when it came to selecting our title analogy for this week's musing, we reminded ourselves of "The spun-glass theory of the mind" which is the belief that the human organism is so fragile that minor negative events, such as criticism, rejection, or failure, are bound to cause major trauma to the system (think Brexit, Trump's election). "The spun-glass theory of the mind" is essentially not giving humans, and sometimes patients, enough credit for their resilience and ability to recover, like central banks have been doing, dealing with economic woes with their "overmedication" programs (ZIRP, QE, NIRP, etc). In 1973, the brilliant University of Minnesota clinical psychologist Paul Meehl poked fun at what he called the “spun glass theory” of the mind which is the false notion that most of us are delicate, fragile, and easily damaged creatures that need to be handled with kid gloves. Since then, many researchers have shown that most people are surprisingly resilient even in the face of extreme trauma. Economies are similar, such as the United Kingdom which showed it was more than tremendously resilient while many pundits were predicting "trauma" and disaster should Brexit happens. In similar fashion, Nassim Nicholas Taleb in his book "Antifragile" showed that there's an entire class of other things that do not simply resist stress but actually grow, strengthen, or otherwise gain from unforeseen and otherwise unwelcome stimuli (Iceland). The main underlying concepts of both "The spun-glass theory of the mind" and "Antifragile" is that the majority of causal relationships are nonlinear and so are market movements (hence the relative ineffectiveness of VaR models - Value At Risk we discussed in February in our conversation "The disappearance of MS München"). Typically both have a convex section where the curve rises exponentially upward and is associated with a positive effect (antifragile) and a concave section that declines exponentially downward and has a negative effect (fragile). Think of the dose of a prescription drug. At first, as central banks increase the dose, the health benefits improve (convexity) for financial assets. But, beyond a certain dose side effects and toxicity cause harm (concavity), such as Debt-fueled economies given debt has no flexibility. Therefore highly leveraged economies cannot stand even a slowdown without risking implosion like our current situation, but we ramble again. 

How do you "hedge" in such a nonlinear world? The way to do it, we think, is to use a barbell strategy that positively captures the optionality of the variable (being long in the convex area and short in the concave area).  If indeed, we live in a nonlinear world and given correlations are less and less static and change more and more frequently, leading to larger and larger standard deviation moves such as typically going way up during downturns, it therefore eliminates Markowitz portfolio theory of diversification benefit. Just when you think your diversification will render your portfolio "antifragile" it brings instability and "fragility" to it. A barbell strategy should render your portfolio more "antifragile". Why is so? Markowitz portfolio theory causes investors to "over allocate" to risky asset classes such as "High Yield" and/or Emerging Markets and play the same crowded "beta" game. In similar fashion, "The spun-glass theory of the mind" cause central bankers to "overmedicate". One could conclude that "Overmedication" leads to "Over allocation". 

In this week's conversation we would like to look again at the importance of flows versus stocks from a macro and credit perspective, taking into account "overmedication" and "over allocation".

Synopsis:

• Macro and Credit -  It's a question of flows versus stocks
• Final chart - Could Japanese equities be antifragile in 2017?

• Macro and Credit -  It's a question of flows versus stocks

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

Before we delve more into the nitty-gritty, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy at least in Europe has been in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE in Europe is not sufficient enough on its own to offset the lack of Aggregate Demand (AD) we think.

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed again recently relating to violent rotations in flows. 

From that perspective, we read with interest Citi Research note from November entitled "How does active fund management survive in 2017?" where as well they tackle the very important point of stock versus flows:

"Is it the stock or the flow of QE that matters?

Essentially, central banks tend to think in "stock" terms

 “Reduce the quantity available to investors & prices will lift permanently”

 To us, QE flows seem very important empirically

Reduce the QE flow by just ~1/3 & markets are quite likely to fall

That makes an asset not priced to fundamentals but to policy …

… prone to non-linear reactions when perceptions of policy change" - source CITI

As we have seen in recent weeks, and as we have remarked in our conversation  "Critical threshold", higher yields leads to material fund outflows in the short-term as indicated by Bank of America Merrill Lynch Follow the Flow note from the 2nd of December entitled "Where's the money going?":

"High grade funds had their fourth week of outflows, and the third that exceeds the $1bn mark. High yield funds recorded their fifth week of outflows in a row; so far this year they have lost more than $10bn. As chart 13 below shows, the outflows this time came mainly from European and global funds, where on the other hand US high yield funds recorded an inflow.

Government bond funds had yet another outflow, the eighth in a row, reflecting rising QE-tapering risks. Money market weekly fund flows were relatively subdued recording a negative flow. Overall, fixed income funds flows remain largely negative, and over the past four weeks almost $20bn has flown out of European domiciled funds.

European equity funds flows switched aggressively to the negative side again, post a short stint of inflows. Last week the asset class had its biggest outflow in eleven weeks. Outflows so far this year are just shy of $100bn.

Global EM debt fund flows remained negative for the fourth week in a row; nonetheless we note a significant improvement in the trend, with the latest outflow being significantly smaller than that of the previous two weeks. Commodities funds also were in negative territory for a third week, as higher inflation expectations support reflation trades.
On the duration front, short-term IG funds flows remained negative for a second week. Mid-term funds had their fourth outflow in a row but riding an improving trend; while long-term funds recorded a marginal inflow." source Bank of America Merrill Lynch

Whereas central banks tend to focus their attention on "stocks", we'd rather focus ours on "flows", from a macro perspective as well as from a fund perspective. Evidently the consequences of "Mack the Knife" aka King Dollar + positive real US interest rates can also be seen in the "Great Rotation" from Europe and Emerging Markets towards the US hence validating our "macro osmosis process":

"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.

As a reminder, more liquidity = greater economic instability once QE ends for Emerging Markets. Now if indeed "flows" matter, we took a keen interest in reading the impact  "Mack the Knife" has had on Emerging Markets as indicated by Bank of America Merrill Lynch in their GEMs Flow Talk note from the 1st of December 2016 entitled "Reported foreign holdings of local debt dropped 6% in November so far":

"EPFR weekly fund flows
• EPFR measures mutual funds and ETFs (AUM about $225bn)
• This week’s outflows were less than last week which was less than the prior week.
• EPFR outflows in the 3 weeks since the election were:
-4.0% for EXD
-3.7% for LDM
• Part of that is ETFs, whose outflows since the election as a % of ETF AUM were:
-8.1% for EXD
-7.3% for LDM

2013 lessons were learned well, take fast action
• Outflows have been faster than in 2013 (Chart 1)

• Largest 3 week outflow in 2013 was only -4.2% for all currency funds.

Foreign holdings of local debt sharp drop – $40bn implied
• We track $640bn of foreign holdings of local debt
• We observed 6.2% outflows for the month of November in 4 countries (India,
Indonesia, Hungary and Turkey) with foreign holdings of $107bn.
• If all countries had the same average outflow of 6.2%, then applied to the $640bn
of foreign holdings, this implies we could have had a $40bn total outflow in Nov.
Since the election – $35bn potential outflow
• We observed 5.5% outflow since the election.
• If we apply this rate to the $640bn foreign holdings, it implies a $35bn total
outflow in the few weeks since the election." - source Bank of America Merrill Lynch

We recently pointed out that "macro tourists" and levered carry players alike did play the second half of 2016 more aggressively hence the extension of their credit risk and duration risk leading to faster deleveraging and consequently outflows and pain inflicted. Obviously we guess that your next question is going to be how much more additional outflows could be expected particularly from the impact of a rising US dollar is having on Asia for example given capital outflows matter and matter a lot, so does a US dollar shortage as well although Stanley Fischer from the Fed thinks as of late there is no liquidity issue. Regarding this matter we read yet another Bank of America Merrill Lynch note from their Connecting Asia series entitled "Flow and flight":

"We examine two of the most pressing issues facing Asia investors in the Post-Trump election victory world.
The first, is how much capital reversal and outflow in Asia is yet to run amid USD strength, rising yield differential with the US and CNY depreciation. Thus far, some USD24bn in foreign bond and equity portfolio flows are being unwound and compares with the maximum drawdown of USD55bn during the GFC – see front page chart.

The countries that we find are at the sharp end of this outflow are Korea, India, Indonesia and Malaysia.
The second is how investors should evaluate Asia FX and rates vulnerability to the tail risk of rising trade protectionism and confrontation. The brief answer to this is that China, Korea, Taiwan and Thailand appear most vulnerable, while Indonesia and India may be the least.
Ultimately, the combination of capital outflows and rising trade protectionism discussed in this report, suggests that FX risk premiums and volatility for CNY and KRW will rise. From an FX hedging strategy perspective, we continue to recommend low delta 6M USD call, CNH puts such as our year-ahead top trade recommendation for USD/CNH 7.60 strikes.

Portfolio drawdowns – how much more to go?We highlight the maximum drawdown Asian markets have previously seen in terms of outflows. This gives us a sense of the worst case scenario as far as outflows are concerned relative to FX reserves. The bottom line is:
• The largest outflow Asia saw on a cumulative basis was ~USD 55bn during 2008. In comparison to this, Asia has seen about USD 24bn of outflows since October 2016 (see Chart 1 for cumulative outflows during other risk off periods).
• Equity outflows so far have been around 9.9bn USD since October 2016, led by. India, Taiwan and Thailand. When compared to historical drawdowns, the larger equity markets of Korea, Taiwan and India stand to lose the most, although only in Korea’s case does the worst case scenario account for a substantial portion of FX reserves (19%, see Table 1).

• Bond outflows, so far have been about 14bn USD since October 2016, with most seeing outflows of at least 2bn USD. When compared to historical drawdowns, Malaysia stands to lose the most, with the worst case scenario representing about 6.3% of current FX reserves (see Table 2).

- source Bank of America Merrill Lynch

While obviously the biggest "known unknown" lies in the foreign trade policies which will be adopted by the new US administration. As we pointed out in our last musing, measures that would restrict global trade would no doubt be bullish for gold in that particular case. For now, in relation to gold we still remain neutral.

But moving back to credit and nonlinearity, one way of "mitigating" dwindling policy support given recent talks from the ECB in tapering its stance would be to "embrace" a barbell strategy as pointed out by Citi Research note from November entitled "How does active fund management survive in 2017?":

"Barbell when repression is at risk of being wound down

Belly of the credit curve holds disproportionate amount of unpaid β" - source CITI

What would be an interesting barbell credit wise in our opinion? We would favor US credit markets obviously from a flow and currency perspective. We would go long US investment grade credit than European investment grade and even selectively long European non-financial High Yield issuers due to lower leverage than their US peers. But should you want to play the beta game from a "barbell" perspective, then again US High Yield via its derivatives US CDX High Yield, given that it is less sensitive to convexity and interest rate risks and less exposed to CCCs (10% versus 16% weight in cash index), should the risk-on environment persist on the back of favorable macro data. 

From an allocation perspective, we are already seeing once again decoupling between US credit and Europe, because, as we stated on many occasions, the Fed tackled earlier one "stocks" issues on banks balance sheet, which in effect, enabled a stronger credit income and better economic growth relative to Europe, whereas the ECB has in no way alleviated the burden of "stocks" plaguing peripheral banks in the form of nonperforming loans, therefore in no way repairing the broken credit mechanism that stills explain the on-going "japanification" process and much weaker growth prospects. To that effect, if indeed the US reflation story is playing out, then again it makes sense to "over allocate" to US credit as once again decoupling could be on the menu between both regions. This is clearly illustrated by Bank of America Merrill Lynch in their European Credit Strategist note from the 2nd of December entitled "The Italian job":

"The last month has presented something rather rare: a truly decoupled global credit market. For instance, US high-grade spreads went 2bp tighter in November, while Euro high-grade spreads went 16bp wider. And the phenomenon seeped into high-yield credit too: US spreads tightened by 24bp in November, while European spreads widened by 47bp. After the moves of the last month, headline IG spreads in Europe are now wider than US high-grade spreads out to almost 10yrs in maturity.

“Politics” has been the undoing of European credit lately. Italy heads to the polls on Sunday amid a climate of rising global populism. And ECB tapering noises have driven a pattern of rising rates and wider spreads in Europe over the last month (note, though, BofAML base case is for an €80bn QE extension until Sep-17).
Yet, even with all the political hiccups that Europe has encountered over the last 5yrs, genuine decoupling of credit markets has not been common. Chart 2 shows that there have only been 3 periods over the last 10yrs when European and US credit spreads went in different directions.

Decoupling – the new norm for ‘17

We think decoupling between US and European credit will be a lot more common in 2017 though. In fact, our US credit strategy colleagues forecast US high-grade spreads to tighten by 20bp next year. In Europe, we expect high-grade spreads to widen by 20bp.

Much of the divergence in views is simply down to technicals – which shouldn’t come as a surprise given how technicals have been the be-all and end-all of credit markets for the last few years. In the US, we expect Republican tax proposals to lead to a big drop in US high-grade net supply next year. But in Europe, we expect shareholder-friendly activity (M&A, in particular) to broaden out in 2017, and contribute to a further jump in supply. This should leave the Euro market with too many bonds and not enough buyers.

Get in quick…

In fact, lingering QE tapering noises may just coax European companies to speed up their spending and issuance plans, for fear of missing the (low-yield) boat. This means the risk of supply being front-loaded in the first half of next year, leading to some heavy indigestion for the Euro credit market.
Recall that this is not too dissimilar to what US companies did in 2014 as the Fed drew closer to their first interest rate hike. As chart 3 shows, US M&A volumes were brisk in the middle of 2014. Then, as better US data pushed yields higher, issuers moved quickly to fund the M&A backlog, leading to some big months of US high-grade supply in September and November 2014.
This also caused a big decoupling in credit markets: US high-grade spreads widened by almost 40bp in the second half of 2014, while European high-grade spreads went slightly tighter. We fear the same bad technicals could be at work in Europe next year if companies rush to issue ahead of any potential QE tapering." - Bank of America Merrill Lynch

If indeed we get this "reflationary" case playing out, then again we might have a situation where US credit continues to outperform European credit in 2017.

Going forward, when it comes to following a potential deterioration in US High Yield we encourage you to keep an eye on a possible flattening of the CDX HY curve, being the derivatives proxy for the US High Yield market. As per Credit Market Analysis (CMA) latest chart, it is worth following the trend to see if indeed the CDX HY series 27 will be getting flatter as we move towards 2017. We noticed that one year protection has started to move upwards albeit very slowly, while it is yet a meaningful move for the moment contrary to what we had back in November last year where 1 year was only 50 bps apart from 3 year, you should keep an eye on the shape of the curve:

- source Credit Market Analysis

Right now, it is hard to be as sanguine as we were in November regarding US High Yield given at the time of the fast flattening movement we were seeing at the end of 2015. We continue to see a risk-on environment for the time being, although as we pointed out last week when discussing credit conditions in the US for Commercial Real Estate, it does appears to us that some segments including our CCC credit canary are already experiencing tightening financial conditions. The most important indicator to track, risk wise is "Mack the Knife" aka King Dollar + positive real US interest rates. 

Finally for our final chart and if the "spun-glass theory of the mind" is correct, then indeed we think if the US dollar continues to shine, then it makes sense to "over allocate" to Japan given earnings are higher there.

• Final chart - Could Japanese equities be antifragile in 2017?

While the risk-on mode is still prevailing thanks to the strong beliefs in the reflation story playing out, from an equity perspective, corporate earnings and payouts remain the principal drivers of equity returns. To that extent, our final chart comes from Barclays Global equity and cross-asset strategy note from the 28th of November entitled "Reassessing the rotations" and displays earnings in Japan relative to the US and Europe:

- source Barclays

While it remains to be seen how long the "reflationary story" continues to play out, for now it is indeed "risk-on", but no doubt there are many political events lining up in 2017 that could put a spanner in the works. One thing is clear to us though, is that when it comes to markets commentators and some members of the sell-side, 2016 has proven with both Brexit and the US election that the spun-glass theory of the mind is alive and well...

"Success breeds complacency. Complacency breeds failure. Only the paranoid survive." -  Andy Grove, former CEO of Intel.

Stay tuned!

Macro and Credit - From Utopia to Dystopia and back

"For other nations, utopia is a blessed past never to be recovered; for Americans it is just beyond the horizon." - Henry A. Kissinger

Hearing about the passing of Cuban leader and revolutionary Fidel Castro also an accessory ambassador to the Rolex brand, and given the continuous rise in government bonds yields, while thinking about what should be our title analogy, we thought about the current situation. Our current situation entails we think a reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally. Also, it seems as of late that there has been somewhat since the Trump election an opposite movement in the financial sphere from financial dystopia aka financial repression from our central bankers towards utopia aka a surge in inflation expectations leading to large rotations from bonds to equities and rising "real yields". Also, another reason from our chosen title is the recent UK bill requiring internet firms to store web histories for every Briton's online activity. The most famous examples of "Dystopian societies" have appeared in two very famous books such as 1984 by George Orwell and of course Brave New World by Aldous Huxley. Dystopias are often portrayed by dehumanization, totalitarian governments, environmental disasters or other characteristics associated with cataclysmic declines in societies. Dystopia is an antonym for Utopia after all, used by John Stuart Mill in one of his parliamentary speeches in 1868. Dystopias are often filled with pessimistic views of the ruling class or a government which has been brutal or uncaring. It often leads to the population seeking to enact change within their society, hence the rise in what is called by many "populism". What is important we think, from our title's perspective is that financial repression goes hand in hand with dystopia given that the economic structures of dystopian societies oppose centrally planned economy and state capitalism versus a free market economy. One could infer that central banks' meddling with interest rates with ZIRP, NIRP and other tools is akin to a dystopian approach also called financial repression. Right now we think that on the political side, clearly, the pessimistic views of the ruling class has led to upsetting the outcomes of various elections this year such as Brexit and the US election thanks to "optimism bias" from the ruling class. So all in all, Utopia has led to political Dystopias, creating we think inflationary expectations for now and therefore leading to euphoria in equities or what former Fed supremo Alan Greenspan would call "irrational exuberance" when effectively, it is entirely rational given market pundits expect less "financial repression" to materialize in the near future but we ramble again...

In this week's conversation we would like to look at what to expect in 2017 from an allocation perspective, while since our last conversation there has been some sort of stabilization in the rise of "Mack the Knife" aka King Dollar + positive real US interest rates, it appears to us that the first part of 2017 could get complicated.

Synopsis:

• Macro and Credit -  Erring on the wider side
• Final chart - Gold could shine again after the Fed

• Macro and Credit -  Erring on the wider side

As we have pointed out in recent musings, credit investors since the sell-off in early 2016 did not only extend their credit exposure but, also their duration exposure, which as of late has been a punishing proposal thanks to convexity particularly for the low coupon / long duration investment grade crowd. While total returns have still been surprisingly strong in the second part of 2016, particularly in High Yield in both Europe and the US, the "beta" players should be more cautious going forward. 

We think that the goldilocks period for credit supported by a low rate volatility regime has definitely turned and slowly but surely the cost of capital is rising. 

For instance, in the US while the latest Senior Loan Officer Opinion Surveys (SLOOs) has pointed to an overall easing picture as of late as per our previous conversation, in the US, Commercial Real Estate is already pointing towards tightening financial conditions as indicated by Morgan Stanley in their CRE Tracker note from the 18th of November:

"CRE Lending Standards Tighten For the Fifth Straight Quarter in 3Q16

•The Federal Reserve’s Senior Loan Officer Opinion Survey showed CRE lending standards continued to tighten in 3Q16, marking the fifth straight quarter of net tightening.

•Overall, standards tightened at a stable pace, with 29.5% reporting net tightening compared to 31.3% in 2Q16. Large banks have been tightening more than other banks, but the 3Q16 release shows that large banks’ tightening pace has slightly slowed.

•Tightening has been most pronounced in multifamily loans, and in 3Q16 other banks upped their tightening pace in this category.

•Loan demand continues to strengthen but has decelerated quarter-over-quarter: only 5.8% reported a net increase in demand compared to 12.0% in 2Q16. Demand is stronger for construction loans relative to the other two types.

•Our studies have shown that tightening lending standards and/or decreasing loan demand tend to lead to declining CRE property prices.

- source Morgan Stanley

While we have tracked our US CCC credit canary issuance levels as an indication that the credit cycle was slowly but surely turning, the above indications from the US CRE markets is clearly showing that the Fed is about to hike in a weakening environment, should they decide to fulfill market expectations in December. Obviously while the market is clearly anticipating their move and has already started a significant rotation from bonds towards equities, the move from Dystopia to Utopia and Euphoria will have clear implications for credit spreads in 2017, and should obviously push them wider we think. 

This thematic is clearly as well the scenario being put forward by most of the sell-side crowd when it comes to their 2017 outlook for credit. For instance we read with interest Morgan Stanley's take on the macro backdrop for credit for the US entitled "From Cubs to Bears":

"We are cautious on US credit for 2017: Across the spectrum, credit markets will likely finish 2016 with the best returns in many years – certainly better than we anticipated. If we had to boil the rally from February-October down into two factors, we think the recovery in oil/energy explains the first half, and the massive global reach for yield driven by low rates and easy central bank liquidity explains the second. In our view, fundamental risks are still very elevated, and while sentiment has become bullish around the impact of a Trump presidency, any way we look at it, credit is moving out of the 'sweet spot'. Specifically, the days of ultra-low rates, ultra-low volatility, and ultra-easy Fed policy are in the rear-view mirror. All while valuations are considerably richer than this time last year – not a great setup for 2017.
More specifically, our cautious call on US credit is based on three key points, which we expand on in the first section below:

1. A less benign environment: We would not underestimate the impact central banks have had on markets. Now, eight years into a cycle, we expect inflation to rise, the Fed to hike quicker, and the dollar to break out. Fiscal stimulus helps growth, but there are clear offsets, like tighter financial conditions. This is a backdrop where mistakes are more likely and costly.
2. Fundamentals are weak, late-cycle risks have risen, and the Fed could push us to the edge quicker: Markets anticipate defaults one year in advance. Lower defaults in 2017 are in the price. Rising defaults in 2018 are not.
3. Credit is priced for a benign environment as far as the eye can see: IG spreads adjusted for leverage and HY default-adjusted spreads have rarely been tighter. In addition, higher Treasury yields make the 'reach for yield' argument for US credit much less compelling.

Adding everything up, we do not think this is the point in the cycle to reach for yield, and most of our recommendations are up-in-quality as a result. And we note that better growth does not always equal better returns. In the second half of cycles, negative excess return years come more frequently than you might expect, and we expect to see one in 2017.

Moving Out of the Macro 'Sweet Spot'

The US economic environment is becoming less supportive of credit markets. Our economists forecast US GDP to grow at 1.9% in 2017, 0.3pp higher than the baseline, given our expectations around fiscal stimulus. Why not a bigger number? First, it is important to remember that the underlying headwinds to growth that have driven a subpar expansion for eight years have not gone away just because Trump was elected. Second, our economists assume that a material tightening in financial conditions offsets some of the benefits of fiscal stimulus. For example, we now expect the Fed to hike twice in 2017 and three times in 2018, the dollar to rally by 6%, and 10Y Treasury yields
to hit 2.75% in 3Q, (2.50% at year-end), very different from our prior forecasts of low rates and ultra-accommodative Fed policy. These risks may rise further later in 2017, if markets begin to worry that Yellen will be replaced with a much more hawkish Fed chair. Third, right now investors seem to be focused on all the benefits from stimulus, but downplaying the risks to Trump's policies that were so concerning in the run-up to the election. It doesn't take much for sentiment to swing back in the other direction or for current lofty expectations around fiscal stimulus to disappoint.

Either way, there is much greater potential variability around our forecasts, given all of the unknowns. For example, in our bear case where we assume Trump takes a hard line on trade, GDP growth is hit by 0.6pp, even assuming material tax cuts and infrastructure spending.

~2% growth by itself is manageable, but unlike earlier in this cycle, the Fed is not adding stimulus, but instead withdrawing liquidity. And remember, even with fiscal stimulus, the Fed is still tightening into a much more anemic growth environment than inpast rate hike cycles (Exhibit 3), significantly later in the cycle, and with profits growing considerably slower.

Due to this subpar recovery, markets have become very dependent on central banks, and when the liquidity spigot turns off, credit has consistently had problems. In fact, over the past two years, the Fed has struggled to get in even one hike a year. We would not dismiss the impact on markets if the Fed has to step on the brakes more quickly, given how much central bank policy may be supporting valuations, given the starting point on growth, and with the US economy much later in a cycle than when the Fed has begun hiking in the past.

In addition, less easy liquidity could become a global theme next year. Our economists expect the ECB to announce tapering at its June meeting, and a shift in the BOJ's 10Y yield target in 4Q17 – very different from the risk-supportive environment from central banks immediately post Brexit.

Lastly, even with this rate rise, the market is still only pricing in ~1.5 hikes in 2017 – thus risks are asymmetric. If growth disappoints, the Fed has little ability to release a verbal dose of monetary stimulus like this past year, when rate hike expectations quickly dropped from 3 to almost 0. Alternatively, if this is the year where inflation starts rising, there is plenty of room for rate hike expectations to rise. In addition, with IG and HY spreads 37bp and 204bp tighter vs. when the Fed hiked last December, credit markets also do not have the same shock absorber as last year." - source Morgan Stanley

The last point is particularly true given that the second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle. 

There is no doubt in our mind that we are moving towards the last inning of the credit cycle and there has been various signs of exhaustion as of late such as our CCC credit canary issuance indicator or as above tighter lending conditions for CRE which is trading at elevated valuation levels, but on these many points we agree with Morgan Stanley's take that fundamentals are clearly showing signs of deterioration in the credit cycle that warrants caution we think:

"Elevated Fundamental Risks Late in the Cycle

Markets are very late cycle, according to our indicators, and even compared to this time last year, fundamentals are weak. To provide a few examples on the first point: The Fed is expected to continue hiking, and looking at the shadow fed funds rate, has already tightened policy by a similar amount as in past cycles. Lending conditions have tightened (measured by the % of banks tightening C&I, CRE, auto, and now consumer loans), and leverage is very high. Margins, M&A, and auto sales look like they have possibly peaked. In addition, leading economic indicators have rolled over, employment has slowed from the peak in early 2015, and productivity has declined. Along similar lines, looking at our cross-asset team’s indicator, the US may have entered the 'Downturn' phase of the cycle earlier this year.

The deterioration in corporate balance sheet quality also indicates elevated cycle risks.
For example, as we show below, leverage is at or near record levels across credit markets. In addition, the leverage increase has been broad-based (outside of financials), and the ‘tail’ in the market has grown substantially. For example, the highly leveraged tail has doubled since 2011 in high yield (two-thirds of this tail is ex-commodities) and 30% of the IG market is levered over 4x today, compared to only 11% in 2010.

This deterioration in credit quality should not come as a surprise – low rates and ultra-easy liquidity for eight years have had negative side effects. What should be concerning is that, historically, the sharpest rise in leverage tends to occur in recessions when earnings collapse. Hence, the fact that leverage is this high in a growing economy means that it will likely peak at a much higher level than in the past when a downturn finally hits. We would also note that leverage is not the only area of concern, with interest coverage and cash/debt also trending lower in most markets.

In an environment of higher rates and better growth, as markets are seemingly anticipating, could leverage come down? We think it is possible, but unlikely. First, better growth should, if anything, encourage more aggressive corporate behavior, which is why historically, the biggest declines in leverage come after a credit cycle. Second, we would not dismiss the underlying headwinds to a big pickup in earnings at this stage in the expansion, especially if the dollar rallies 6% as we expect. Yes, corporate tax cuts could help, although even there we need to wait for the details – if tax cuts are paid for in part by getting rid of tax preferences and there is a tighter noose around what is considered domestic income, the aggregate benefit may be lower. But bigger picture, weak productivity and rising wages are a few of the many headwinds to profitability that probably aren't going away. Lastly, even if leverage does drop modestly, higher rates are an offset when thinking about future defaults. Ultimately, we think the damage has been done looking at fundamentals, and better growth, higher rates, as well as faster rate hikes if anything, push us to the cycle edge more quickly. We note that the later years in an equity bull market when growth is strong are often not bullish for credit. For example, in 2000, HY excess returns were down 16.3%. 

Assessing credit quality in aggregate, we think the fuel for a default/downgrade cycle is clearly present. And with banks tightening lending standards now across C&I loans (albeit only modestly per the latest survey), CRE, and autos, and no longer easing for consumer lending, this credit cycle is actually playing out as one would expect in a long, slow default wave. Yes, the defaults so far have been predominantly commodity focused, but in our view, it is normal for the problem sector to drive the stress early on.

The key question of course is one of timing – when do default/downgrade risks start to spread beyond commodities in a bigger way? In our view: Sooner than most think. We discuss our default and downgrade expectations in more detail in the forecasts section below. But in short, default rates will likely drop in 2017, which we think is in the price, with the HY energy sector 955bp tighter since the wides in February.

However, according to our numbers, defaults will start rising again in 2018, likely peaking in 2019. Without going into the details, we base our assumptions on the lag between when the indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today.

If our estimates are correct, this default wave will last ~4.5 years in total (having begun in 2016), similar to the 1999-2003 cycle. And we think there are logical reasons to assume a prolonged cycle. For example, the prevalence of cov-lite loans and somewhat elevated interest coverage will not make overall default volumes lower, in our view, but could mean defaults take longer to materialize. In addition, if a recession occurs while rates are still generally low, the tailwind of falling yields will not be there this time around, which could slow the bounce off the bottom.

Last and most importantly, if defaults start rising again in 2018, the market should price that in next year. As we show below, years when defaults rise more than 2%, spreads tend to widen by 283bp on average the year prior, as the market prices in those risks. Or said another way, the fact that defaults will drop in 2017 should have little bearing on spreads in 2017.

As a result, the only way to rationalize today’s valuations is to assume a benign default environment for several years, which we believe is a low probability. Looking back in time, we only have one good example of when defaults rose temporarily due to one sector and then subsequently dropped without a near-term recession. That took place in 1986, yet even then, defaults only fell for two years, and subsequently rose into the 1990 recession. Also we would note the Fed was not hiking at the time, but instead cut rates by ~200bp in 1986 to cushion the blow – very different from today." - source Morgan Stanley

Furthermore, a continuation in the rise of "Mack the Knife" aka the US Dollar and real rates, then again US earnings could come under pressure and financial conditions will no doubt get tighter and hedging costs for foreign investors pricier, which could somewhat dampen foreign appetite from the like of the Japanese investor crowd and Lifers in particular, leaving in essence very little room for error when it comes to credit allocation towards the US, hence we would favor quality (Investment Grade) and low duration exposure until the dust settle, meaning some sort of stabilization in current yields gyrations from a US allocation perspective.

Obviously for Europe, in terms of credit, the story is slightly different given the on-going support from the ECB but clearly the risk lies more into a rise in political "Dystopia" rather than financial "Utopia" given the on-going deleveraging process of the European banking sector. To that effect, whereas there has been a very significant rally in the European banking sector when it comes to equities as of late in conjunction with the US sector thanks to less "Dystopia" and rising yields, we still favor high quality European financials credit in the current environment. Even European High Yield is more enticing thanks to lower leverage than the US. To illustrate the "japanification" process in Europe and the reduced "credit impulse" largely due to peripheral banks being capital impaired thanks to bloated balance sheets due to nonperforming loans (NPLs), we would like to point out once more to the difference in terms of deleveraging between Europe, the US and Japan when it comes to their respective banking sector as highlighted as well by Morgan Stanley in their European Credit Outlook note from the 28th of November entitled "As Good As It Gets":

"In our base case, we expect bank credit to outperform non-financials because valuations are less distorted, technicals remain supportive, fundamentals at the system level continue to improve (albeit at a slower pace) and regulatory pressures on the sector are easing. The earnings squeeze on account of negative rates and flat curves is also likely to ease, at least in some parts of the system, on account of recent moves in bond yields. Moreover, the possibility of ECB purchases (while lower now) is still an important source of optionality.

Banking on favourable technical and valuations: 

Delving into some of the factors listed above, we note that the positive, but subdued, lending impulse has been a favourable set-up for bank credit. It has helped to ease concerns of financial conditions and at the same time has kept the supply technical supportive. As shown in Exhibit 28, net issuance
of senior unsecured paper and covered bonds from European banks are barely positive. The need for funding is modest and the avenues are many, with the ECB still an attractive alternative to bond markets. Against this backdrop, we expect senior bank supply to remain muted in 2017. Another important factor that informs our view is regulations. As our bank analysts have been highlighting for some time now (see The Potential for MREL, September 23, 2016), MREL is likely to be supportive for bank debt. They believe that non-preferred senior/'Tier 3' will be the MREL of choice for most banks, increasing structural protection for opco seniors and far lower needs to issue senior debt." - source Morgan Stanley

We hate being "party spoilers" for our equities friend and their "optimism bias" but, in the current deleveraging and "japanification" process, we'd rather go for financials credit wise thanks to the technical support and lower volatility of the asset class compared to equities. No matter how strong the rally has been as of late in equities, for credit there is a caveat, you need to pick your issuer wisely in Europe. Europe is still a story of subdued credit growth given that the liquidity provided by the backstop of the ECB has not meaningfully translated into credit growth for the likes of Portugal and Italy and in no way resolved the Damocles sword hanging over the Italian banking sector and their outsized NPLs issue.

Overall as "Dystopia" is fading, marking a return of bond volatility, we would be surprised to see a continuation of the strong rally seen in the second part of 2016 for credit markets in 2017. Whereas we have not seen signs of clear stabilization for "Mack the Knife" aka King Dollar + positive real US interest rates, hence our neutral stance for the time being on gold, in our last chart, we would like to point out that gold could shine again following the Fed in December.

• Final chart - Gold could shine again after the Fed

Whereas Gibson's paradox, thanks to  "Mack the Knife" has reversed meaningfully during the month of November, we could have a surprise rally after the Fed's decision in December according to our final chart from Deutsche Bank's "Mining Chart of the Week" note from the 25th of November:

"After five of the last eight US interest rate hikes, gold has rallied

The gold price has declined 7% so far in the month to reach a nine-month low on expectations of a US rate hike in December and improved sentiment that recessionary risks are fading with hopes of a Trump-led fiscal stimulus. The precious metal now looks less shiny; but what’s next? History teaches us that gold can rally after the Fed has hiked. As we show on this week’s chart, since 1976, in five instances out of eight, gold rallied with rising Fed rates.

Reading through the Chart

We find it interesting that even in an environment of flat/rising US GDP growth and rising interest rates, gold can rally – this happened in 1977-78, 1993-95, and 2004-06." - source Deutsche Bank

Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again. As a bonus chart we would like to point out Bank of America Merrill Lynch's chart highlighting the relationship between gold and global trade from their Metals Strategist note from the 21st of November:

"Trade is an unknown
Trade, the other cornerstone in US President-elect Trump’s plan, has been discussed contentiously. In our view, measures that would restrict global trade would do a lot of damage to economic activity. Against this backdrop, we note that trade has been subdued anyway, and this may not change imminently given developments including a shift in economic activity from DM to EM has run its course for now. Of course, this raises uncertainty over the strength of global growth, which is supportive of gold (Chart 67).

Having said that, we believe a wholesale crackdown on US and global trade cannot be in the interest of the US president elect and we are cautiously optimistic that outright trade wars may not be the core agenda for 2017, so we track developments in this area mostly as a bullish unknown for gold." - source Bank of America Merrill Lynch

Whereas the markets and US voters have so far embraced the utopian idea that the new US Administration could make America great again, it remains to be seen if this state of euphoria is warranted.

"The euphoria around economic booms often obscures the possibility for a bust, which explains why leaders typically miss the warning signs." -  Andrew Ross Sorkin

Stay tuned !