Wednesday, 23 November 2016

Macro and Credit - Critical threshold

"If you wish to be a success in the world, promise everything, deliver nothing." - Napoleon Bonaparte
Watching with interest the violent rotations in fund flows with Emerging Markets debt funds recording a $6.64 (-1.9) billions of outflows last week, the largest ever in terms of $AUM thanks to "Mack the Knife" (King Dollar + positive real US interest rates) while financial-sector funds experienced as well some monster flows to the tune of $7.2 billions, in effect validating somewhat our "macro reverse osmosis" discussed again in our previous conversation, we reminded ourselves for this week's chosen title as an analogy the definition of "critical threshold". Critical threshold is a notion derived from the percolation theory, which by the way ties up nicely when it comes to fluid movements and osmosis and refers to a threshold, that summons up to a critical mass. Under the threshold the phenomenon tends to abort, but, above the threshold, it tends to grow exponentially hence the risk for osmosis and flows to become at some point excessive, which would mean deflation bust and defaults for some. In cases the phenomenon is not sudden and take times to operate (such as a gradual surge in the US dollar) we would have used a critical phase or phase transition as a title for this week's musing but not this time around given the violence of the moves we have seen as of late.

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

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

  • Macro and Credit -  Is reverse osmosis finally playing out?
While last we week we reacquainted ourselves with our reverse osmosis macro theory relating to the acceleration of flows out of Emerging Markets, the latest raft of data relating to flows of funds clearly points out to a buildup in "Osmotic pressure" and a risk to break through the "critical threshold" and a significant "margin call" on the huge US dollar shortage that has been building up. On our twitter feed in fact we recently joked that the Fed was not behind the curve, but, that the curve was behind the Fed (watch the flattening...). The acceleration in the rise in US yields and in particular real yields have accelerated as of late, putting additional pressure on gold, Emerging Markets alike. If indeed the dollar rally continues to run unabated then, in continuation to our previous conversation, there is no doubt in our mind that trouble will be the outcome for the leveraged "macro tourists" carry players in the Emerging Market space. When it comes to trends, we do follow funds flows as indication of rising instability. To that effect, we read with interest Deutsche Bank's Weekly Fund Flows note from the 21st of November 2016 entitled "The great unwind?":
"Expectations of a looser US fiscal policy added fuel to the reflationary fire, triggering a bond sell-off across regions and classes on the one hand while also arranging for a strong return of equity inflows on the other hand. investors moved away from bonds at the highest weekly pace since the taper tantrum in 2013, as rising inflation expectations prompted outflows in both credit and sovereign bond fund categories, with US mandates bearing the brunt. In tune with the market, last week’s post-election flow data also saw a renewed appetite for DM equities as the reception of Trump's plans on tax cuts and infrastructure spending resulted in the highest weekly inflows for US equity funds since Dec’14 (see chart below).

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

EM equity fund redemptions also climbed to a one-year high. We remain particularly worried about intensifying EM capital flight on the back of a stronger dollar, and think EM redemptions are likely to continue." - source Deutsche Bank
If indeed when it comes to "credit" we look at the "credit impulse", in order to gauge the strength of economic growth, when it comes to flows and financial markets we like to look at Deutsche Bank's liquidity pulse, being the standard deviation from the mean of the relative between the current flow (4-week average as % of NAV) and the average size of flows in the last 13 weeks to get a better idea of the "critical threshold". Below are a couple of charts relating to equities and pointing towards a rotation from EM to DM with US equity funds talking the bulk of the flows:
- source Deutsche Bank

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

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

If indeed the pressure from "Mack the Knife" continues to build up, then obviously "de-risking" will be de rigueur, which should lead to additional significant outflows. So all in all not only we should be seeing additional capital outflows from EM under pressure but, in the financial sphere, if the trend is indeed your friend, there is further pain ahead in this "Great rotation" currently playing out. Furthermore, while there has been some additional pressure in the High Yield space seeing $3.8 billion of outflows, marking a third straight week of leakage for the asset class. A continuation of both a flattening of the yield curve and a surge in the US dollar will eventually start hurting credit and spreads could start widening at some point. As pointed out from a recent BIS paper entitled "The dollar, bank leverage and the deviation from covered interest parity" (H/T fellow blogger Nattering Naybob) we quoted recently on our tweeter feed:
"The highly significant coefficient on the US dollar index is -0.49, which implies that a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending. The estimated coefficient for lending to banks is even larger in absolute value (-0.61), implying that the decline is even stronger for interbank lending." - source BIS
In their long report the BIS indicated that a strengthening of US dollar has adverse impacts on bank balance sheets, which, in turn, reduces banks’ risk bearing capacity. An appreciation of the dollar entails a widening of the cross-currency basis and a contraction of bank lending in dollars. So all in all, our "exuberant" equities friend should be wary of outflows, the surge of "Mack the Knife" and a flattening of the yield curve, because in our book, once you've passed the critical threshold, there is more pain ahead with contraction of credit and consumption, if our murderous friend continues its rampage. If you forgot what a global credit crunch looks like, then you should be concerned by the devastation that can bring in very short order a US dollar shortage. 

When it comes to the aforementioned "risk bearing capacity for banks" think about rising hedging costs because as per the below chart from a Nomura note from the 17th of November entitled "Japanese investors' foreign bond buying (Oct 2016)", since late October, USD/JPY basis has been widening again. So, dear investors you can not only expect rising hedging costs going forward but a higher cost of capital, which entails credit spreads widening at some point:
"USD basis costs fell after the adoption of new MMF regulations in the US, but …
We attribute the rise in USD basis costs until early October to new MMF regulations, which were implemented on 14 October. The valuation method for prime MMFs (primarily investing in commercial paper issued by corporates) held by institutional investors was revised in such a way that these instruments could incur losses.
This likely prompted a shift from prime MMFs to government MMFs (which invest more than 99.5% of their funds in cash, government bonds, and government bond repos). This made Japanese banks USD funding via commercial paper more difficult. USD Libor also rose on expectations that USD funding would become tighter for Japanese banks, which led to a widening of USD/JPY basis.
Once the new regulations were implemented, the tightening of USD funding materialized, and USD/JPY basis began to narrow. Since late October, however, USD/JPY basis has been widening again. Moreover, USD Libor may rise if a Fed rate hike at the December FOMC meeting becomes more likely, which could translate into higher currency-hedging costs, in our view." - source Nomura
USD libor, dear friends, will rise if the Fed hikes in December FOMC meeting (100% certainty according to market pundits). This will accentuate even more currency-hedging costs. So what could be the consequences given Japanese Lifers and their investment friends have been large buyers in 2016 of foreign bonds, this could lead Japanese investors to look back into domestic issues or switch some of their appetite towards cheaper alternatives such as Euro denominated bonds longer than 10 years.

As a reminder from our July 2016 conversation "Eternal Sunshine of the Spotless Mind", Bondzilla the NIRP monster has been more and more "made in Japan":
"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"." - source Macronomics, July 2016
Unfortunately for the "macro tourists" out there, playing the leveraged carry trade, if there is something that carry players hate most is bond volatility! It is therefore difficult for us to envisage some stability in the Emerging Markets space until US interest rates stabilize. We have yet to see some sort of stabilization.

Also, we believe that the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line for stretched EM dollar denominated leveraged players. Right now, when it comes to the US, the latest Senior Loan Officer Opinion Surveys (SLOOs) point to some easing as of late as indicated by Bank of America Merrill Lynch in their HY Wire note of the 21st of November entitled "Don't be a hero":
"We use three main criteria to forecast HY default rates: the Senior Loan Officer Opinion Survey (SLOOS), credit migration rates, and real rates in the economy. When combined, these three inputs have an 85% correlation over the next 12 month trailing default rate at any given point in time. This makes sense because looser lending conditions, a higher proportion of upgrades, and lower real rates all make it easier for an issuer to secure funding and hence maintain balance sheet liquidity. For Loans we use a two factor model - rates don’t have a meaningful impact on the asset class, especially since they are floating in nature.

"Our HY model is most sensitive to the lending standards as reported by senior loan officers on a quarterly basis- a measure that has declined from a relative high of 11.6% in April of this year to 1.5% today (Chart 18). The survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. Another way to assess issuer access to funding is by tracking the proportion of risky companies that have been able to tap the HY capital markets on a trailing 12-month basis. While this too has a high predictive power of defaults (Chart 17), it doesn’t add enough incremental explanatory power to justify adding an additional variable. Further, the lead time of the risky issuance model is less consistent than the lending survey. Hence we choose to rely on SLOOS for the purpose of our model. Just like for bonds, SLOOS is a good indicator of the level of default rates for loans a year later. However, in the case of loans, the default rates are more sensitive to the asset class’s migration rates than the lending survey, quite the opposite of bonds.
Another interesting point to note about the SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. On the other hand, it undershoots when defaults are driven by idiosyncratic events in individual sectors such as what we witnessed in the 2015 commodity bust. Our forecasted default rate for 2015 thus happened to be lower than the realized headline default rate but higher than the ex-commodity rate" - source Bank of America Merrill Lynch
The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years has ended.

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

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

  • Final chart - The dollar is their currency but our problem for 2017
The continuation of a surging US dollar and a flattening of the US yield curve could represent a significant headwind for 2017. This is as well indicated in the final chart we selected from Bank of America Merrill Lynch HY Wire note of the 21st of November entitled "Don't be a hero" displaying the USD appreciation versus YoY EBITDA growth (ex-Energy):
"Given the strengthening dollar, a fall in earnings growth and a pickup in treasury yields, we’re concerned that unless sales growth accelerates meaningfully in 2017, ex-Commodity fundamentals may disappoint relative to 2016. And although we were becoming emboldened by what appeared to be stronger revenue growth in Q3, as more companies report we are finding that unfortunately our optimism may have been misplaced; sales growth for Q3 now stands at just 3.7% whereas 11 days ago it was 8%." - source Bank of America Merrill Lynch
If optimism is somewhat misplaced, it could well be that our eternal equities optimists friends could be somewhat getting ahead of themselves in their "reflation" wishes. But that's another story as for now it's rally time in the equity world and we don't want to be the party spoilers for now.

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

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