Macro and Credit - The Swiss Wall

"When things are steep, remember to stay level-headed." - Horace

Looking at the consequences of a finally Dovish Fed leading to a significant rise in gold and gold miners, with a continuation of the rally in risky assets, given we have been vacationing in the French Alps, it reminded us, this time around for our title analogy about a steep and difficult piste in the Portes du Soleil ski area, on the border between France and Switzerland called Le Pas de Chavanette, also called the Swiss Wall. 

This particular slope is classified in the Swiss/French difficulty rating as orange, which means that it is rated as too difficult to fit in the standard classification of green (very easy), blue (easy), red (intermediate) and black (difficult). It has a length of 1 kilometre and a vertical drop of 331 metres, starting at 2,151 metres above sea level. In similar fashion, if indeed the Atlanta Fed's Q1 US GDP estimate is estimated at 0.9% and the Fed continues with its "normalization" process, while there are some early signs of credit slowing, then in similar fashion to those who have experienced skiing on the much dreaded Swiss Wall (like ourselves) will know that this particular "slope" or normalization process, can quickly become hazardous, to say the least. The scary Swiss Wall starts in a narrow pass on the mountain top with an inclination of 40 degrees. The initial 50 metres have to be skied or boarded by everyone taking Le Pas de Chavanette. Especially without fresh snow, the slope gets icy quickly, turning the area between moguls into ice sheets. Not making a turn in these situations means that you miss the next mogul, and pick up too much speed to make the next one after that, starting off a tumble that ends a couple of hundred metres down the slope, while hitting a few dozen icy bumps in the course. By having kept interest rates, too low for too long, and given the Fed's propensity of being often behind the curve (or the slope), means, when it comes to our chosen analogy that markets could potentially tumble, hence the defensive outflows seen as of late from High Yield where the punters (or skiers) are aware of the difficulties that lie ahead of them. In similar fashion, on the Swiss Wall, after the initial very steep stretch, the choice can be made, up until the rocky passage in the direct path, to escape to the less steep left hand side of the slope, where a stumble is less dangerous. The direct path down Le Pas de Chavanette, to the right hand side and down the rocky passage, should only be taken by very experienced skiers and riders who know how to handle moguls, as it is effectively a continuation of the first 50 metres. As the slope eases out, it is easier to negotiate the moguls and make a single run down to the end, although the inclination and bumps still call for significant dexterity and physical strength. It remains to be seen, which path the Fed will decided to take and how experienced skiers they are when it comes to take the very slippery slope of the interest rate normalization process. In similar fashion to skiers venturing on the Swiss Wall, wearing protective gear like a helmet and a back protector is highly recommended. Same things goes in these "inflated" markets we think.

In this week's conversation we would like to look at how global financial risks can be driving spreads, in conjunction with near term political risks.

Synopsis:

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
• Final chart - USD likely to weaken given current position in historical tightening cycle

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous

While there has been a continuation in the performance of risky assets and in particular equities on the back of the Fed's rate hike and a somewhat more dovish tone, in terms of outflows, there has been a continuation of a defensive stance building up in credit, leading to a rotation from High Yield towards Investment Grade. We do remain short term "Keynesian" when it comes to credit and in particular Investment Grade, yet we are cautious on a longer time frame due to the leverage accumulated thanks to cheap credit which funded buybacks on a grand scale, weakening in the process corporates' balance sheets. In similar fashion to skiers on the Swiss Wall, as of late investors have chosen to take the less steep left hand side of the slope, where a stumble is less dangerous. This can be seen in fund flows as reported by Bank of America Merrill Lynch from their Follow the Flow note from the 17th of March 2017 entitled "Quality yield inflows as political risks near":

"Cautious flows 

Heading to the Dutch elections, investors preferred to look for quality yield. Inflows into high grade bonds strengthened considerably, while outflows hit HY funds particularly hard. Equity funds suffered light outflows, as equity investors wanted to be light heading to the Dutch elections. However, we feel that post the strong risk-on moves yesterday, part of these flows should reverse back to high yield and equity portfolios. 

Over the past week… 

High grade funds continued on the same positive trend of late for the eighth week in a row; and recorded an inflow as strong as the one a week ago. Monthly data reveal that February flows were the strongest in 6 months. High yield funds flow dipped into negative territory; making last week’s outflow the largest in 32 weeks. Looking into the domicile breakdown, among the European HY domiciled funds the ones that focus on US and European HY were the ones that recorded the vast majority of the outflows, while outflows from globally-focused funds were marginal. HY monthly flows remained positive for a third month in a row. 

Government bond funds flows remained on negative territory for another week, recording a sizable outflow, the largest in 12 weeks. Money market funds weekly flows remained positive for a second week. Overall, fixed income funds flows flipped back to negative after 11 weeks of inflows. However February data reveal that FI funds recorded the strongest inflow in six months. European equity funds flows flipped back to negative territory, recording relatively mild weekly outflows. Monthly flows remained relatively muted in February for a third month in a row for the asset class.

Global EM debt fund flows continued on a positive trend for a 7th week. The asset class has seen ~$14bn of inflows YTD. Commodities funds flows flipped back to positive. On the duration front, strong inflows continued in short-term IG funds for the 13th week in a row. Mid-term funds posted a small outflow, while flows in long-term funds flipped to a marginal positive figure after three weeks of notable outflows. " - source Bank of America Merrill Lynch

There has been definitely a scare in The Swiss Wall of investing when it comes to High Yield as reported by Bank of America Merrill Lynch in their High Yield Flow Report entitled "The outflows continue":

"Largest outflows from HY since Ukraine; 3rd largest ever 

US HY recorded a $4.06bn (-1.7%) net outflow last week, the largest since August 2014 and 3rd largest of all time. This brought the YTD total back into negative territory at - $3.3bn (-0.9%) through Wednesday. Whereas last week’s $2.8bn in redemptions were driven mostly by HY ETFs, open-ended funds bore the brunt of this session’s outflows with a $3.1bn (-1.6%) net loss. Similar to the aggregate high yield figure, this was the largest outflow from open-ended funds since the Ukrainian plane crash in the summer of 2014.

Although there has not been one cataclysmic event to cause the recent burst of outflows, they have likely been driven by a combination of higher rates, renewed fears over another dip in oil prices, and a fatigued rally that pointed towards a reluctance to continue investing in high yield. These withdrawals have pulled down returns in March, which currently stand at -1.4% through the 15th. Non-US HY also recorded a sizeable outflow totaling -$1.64bn (-0.6%) last week, their first period of net redemptions since November." - source Bank of America Merrill Lynch

If indeed investors (or skiers) have been on the cautious side prior to the FOMC rate hike decision, hence their rotation towards a more defensive position, we are awaiting to see if the Japanese investors crowd such as the gigantic GPIF and Lifers will come back to play with their foreign bonds allocations as they should be enticed by higher yielding US investment grade once more. What we also find of interest relating to our analogy is that investors and skiers alike, given the Fed's dovish tone, are encouraged by some sell-side pundits to take the right hand side and down the rocky passage of the Swiss Wall of investing namely in "equities". So far this year as indicated by Bank of America Merrill Lynch in their Fixed Income Weekly Strategy note from the 17th of March, this strategy has been vindicated:

 - source Bank of America Merill Lynch

Yet, from a valuation perspective and given current US valuation levels reached, from a skiing perspective and thanks to the Fed's dovish tone as of late, we would therefore rather go for EM equities if we had to make this choice down the slope of the Swiss Wall of investing. The bullish "skiing" stance down the Swiss Wall of investing is as well put forward by Bank of America Merrill Lynch in their Relative Value Strategist note from the 13th of March entitled "In the realm of diminishing returns":

"Don’t be a hero 

Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights. And after the strong jobs report, we think the near-term path of spreads is likely to lead them further towards these lows, post-FOMC and the March CDX roll. That said, in our view credit as an asset class is now past its prime; at these valuations, we believe we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. In our view, if there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, it is now. 

Great or not, the rotation is here 

If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit. In particular, we like being long S&P 500 vs. short in a HY cash index product (hedged for rates). Over the last 7y, in excess return terms, corporate bonds have failed to consistently generate returns that would overcome the losses during bad times. The upside vs. downside payoff looks far better in equities and CDX than in corporate bonds. Going forward, if the economy remains on this trajectory, the equity market is likely to continue outperforming credit. The prospect of higher rates is more favourable to equities, while in HY, negative convexity will likely cap any significant capital appreciation here on. On the downside, certain tax policy proposals which aren’t being priced in, namely borderadjustment tax and the elimination of interest-rate deductibility, are likely to have a significant negative impact on both equities and credit if implemented. Within credit, we think high yield companies are more susceptible than HG names and a short in HY cash is likely to provide a good offset to a SPX long from a policy risk perspective. 

Upside, downside, and in between 

For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either. For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads. Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

We do agree with Bank of America Merrill Lynch, that, for bolder skiers, going for the synthetic option for playing High Yield makes sense first because of the liquidity factor provided by the index, second because of the lower duration factor compared to cash.

Of course, like any difficult slope, it can always get trickier on the ever changing Swiss Wall of investing. The rally can continue thanks to a dovish tone from the Fed which would be supportive of EM asset classes and put pressure on the crowded long US dollar positions. When it comes to credit, we do agree with Bank of America Merrill Lynch's take, that we are getting closer to the lower bounds of credit spread, even with the technical support of lower supply in the primary markets:

"In the realm of diminishing returns 

Credit spreads, unlike stock prices, have a lower bound (notwithstanding the recent spurt of negative spread bonds in Europe). We’re aware that we trot this statement out every now and then, as credit benchmarks approach previous tights, but it is a point worth bearing- the payoff in credit becomes more asymmetrical at tighter spread levels. Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights, reached in June of 2014. And after the strong jobs report for February, the near-term path of spreads is likely to lead them further towards these lows. Over the coming weeks, we think there is potential for spread compression, post-FOMC and also into the March CDX roll. 

In last week’s HY Wire, we noted the similarities between now and the first half of 2014. Of course, back then geopolitics and oil prices poured cold water on the rally by the third quarter and that set the stage for high volatility and poor returns for the next two years. For this year too we think the second half has the potential to turn sour as disappointment with legislative progress in Congress starts weighing on the market. As we wrote last month, it seems as if all the good has already been priced in, with little to account for the bad. That said, it is difficult to pinpoint what will eventually make the market turn and more importantly, when. There’s also the possibility, that the underlying strength in the economy and confidence keeps risk assets buoyed for much longer. 

In our view what is perhaps more certain, is that credit is now past its prime; at these valuations, we think we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. This is well reflected in our HY returns forecast for the year – around 6% - and even better in our year ahead title – ‘Don’t be a hero’. If there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, we think it is now. 

• If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit – consider long S&P 500 vs. short in HY cash.
• For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either.
• For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads.
• Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

In our Swiss Wall of investing, when there is plenty of snow, the path downhill is easier on both side of the slope. But, as conditions changes and when the snow melts away at the end of the season, leading to some icy parts forming, not only it gets trickier even for the experienced skier like ourselves, but you need to chose your path more wisely according to the weather conditions. At this stage of the credit cycle, it becomes easier we think to stumble, no matter how experienced you think you are. What we have learned from both our investing experience and skiing the Swiss Wall is the need to stay humble and avoid being overconfident. From one day to the next, the Swiss Wall is never the same slope, this is why it makes it very challenging at this stage of the credit cycle. Even if Emerging Markets (EM) looks currently more enticing from an allocation perspective compared to Developed Markets (DM), as put forward by Bank of America Merrill Lynch in their EM Corporate Weekly note from the 14th of March 2017 entitled "Beware of fat tails", "Global financial risk" is the most important short term driver of spreads (icy patches):

"Global financial risk most important ST driver of spreads 

Ahead of the upcoming risk events (FOMC, Dutch & French Elections), we analyze past short-term drivers of EM credit spreads. Using a simple econometric model, we find that changes in UST yields, commodity prices, and global financial stress are able to explain more than half of the variation in credit spreads. Changes in BofAML’s Global Financial Stress Index (GFSI) are the most important driver (a one standard deviation increase in the GFSI is associated with +6 bps wider EMCB OAS). The second most important factor is changes in UST yields, followed by commodities. Our analysis also finds that these three factors can only explain 84 bps of spread tightening for our EMCB index since July 1st, compared to an actual tightening of 111 bps. This residual can likely be explained by technical factors which we do not explicitly include in our model. 

In Focus: quantifying the drivers behind spreads 

EM corporates are facing two different currents: on the one hand, technicals remain strong and credit fundamentals are improving on the back of higher commodities and GDP growth. On the other hand, valuations look expensive and a rise in external risks could lead to a re-pricing of credit spreads. In an attempt to quantify the historical impact of external factors on spreads, we run a simple multivariate linear regression model. We gathered weekly data from Jan 2012-Mar 2017 for our EM corporate indices as well as several external factors. Our baseline specification is the following:

Where UST5Y is the weekly bp change in 5Y UST yields, Commodities is the weekly percentage change in the S&P GSCI index, and GFSI is the weekly unit change in BofAML’s Global Financial Stress Index which is a measure of global cross-asset risk. 

Global financial risk biggest driver of spreads 

Results from our model suggest that BofAML’s GFSI index has the biggest impact on spreads: a three standard deviation weekly increase in the GFSI index is associated with spreads widening by 18 bps. EM HY is more correlated with changes in the GFSI than EM IG: a 3SD increase is associated with +36 bps of widening for EM HY vs. +12 bps for EM IG. LatAm is more correlated with the GFSI than other regions (Chart 3) with an est. spread widening of 25 bps given a 3SD move compared to +11 bps for Asia.

By sector Basic Materials and Real Estate are most correlated with the GFSI while Capital Goods are the least (Chart 4).

The last time the GFSI index rose by 3SD was February 12th 2016 (China and commodity selloff). Note that the GFSI has a correlation of 0.67 with the VIX. The latter did not show as much explanatory power in our regressions, which is why we prefer the GFSI. It is also a broader measure of risk appetite. 

Higher commodities associated with tighter spreads 

As expected, a 10% (4 SD) increase in commodity prices is associated with spreads tightening by 10 bps, holding other factors constant. EM HY is more sensitive to changes in commodities than EM IG, while LatAm is more sensitive than other regions given the larger share of commodity issuers (47%). On a sector basis, Energy, Basic Materials, and Transportation are most negatively correlated with commodity prices. 

EM HY has most negative correlation with UST yields 

In contrast to the positive correlation between the GFSI and spreads, changes in UST yields are negatively correlated with changes in spreads. A 50 bps (4.7 SD) weekly increase in 5Y UST yields is associated with OAS spreads tightening by 16 bps (beta of - 0.33), holding other factors constant (Chart 3). This implies that average yields would rise by 34 bps if 5Y UST yields rise by 50 bps. We also tested to see whether is a difference in the estimated beta depending on whether UST yields are rising or falling, but didn’t find any statistical significance. EM HY has a more negative beta than EM IG (-0.6 vs. -0.3) while Asia has the least negative beta across the regions (-0.2 vs. -0.4 for LatAm and EEMEA). On a sector basis, energy and consumer goods have the most negative beta, meaning spreads stand to tighten the most in a rising UST environment. 

Spreads have tightened more than predicted since July 

This regression also allows us to check whether the 111 bps tightening in EMCB spreads since July 1st 2016 is justified based on the actual changes in UST yields, commodity prices, and global financial stress. We find that the 103 bps increase in UST yields can explain 30 bps of the tightening in spreads, the 5% rise in commodities can explain 8 bps of tighter spreads, and lower financial stress can explain 46 bps of spread tightening. In total, our model calculates that EM spreads should have tightened by 84 bps since July 1st, implying that spreads overshot by 27 bps. However, the three variables in our model explain only 53% of the total variation in spreads, so it is possible that other factors which we don’t account for, such as technical factors or EM specific news account for the remaining spread tightening. High frequency data on technical factors are difficult to come across but we will explore this topic in future research." - source Bank of America Merrill Lynch

Now, if you remember our February 2016 conversation "The disappearance of MS München", we quoted Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis, when it comes to assessing warning signals that could weight on spreads:

"Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis - Macronomics, February 2016

In world where positive correlations have been rising as discussed in last year's conversation and where global economies are much more intertwined, we have noticed in recent years much larger standard deviation moves, which have had significant large impacts on a very short period of time in various asset classes. In fact what is of interest from the quoted EM report from Bank of America Merrill Lynch comes from the volatility of spreads and kurtosis:

- source Bank of America Merrill Lynch

In similar fashion to the Swiss Wall of investing, as we move towards the end of the credit cycle, kurtosis is showing up, meaning that bursts of volatility can be faster and shorter in terms of time frame as we saw in the first part of last year with the Energy sector and spreads blowing out initially, and outperforming in the second part of the year. We continue to be very wary of the second part of 2017 which could play out as the reverse of 2016, namely we could move from "good performance" to "bad performance". The rally so far this year for many asset classes has been significant.

One thing appears clear to us is that the dovish tone of the Fed might indeed be linked to the recent weakness we mentioned last week in Commercial & Industrial (C&I) lending:

"Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth)." - source Macronomics, March 2017 

This "dovish" respite most likely explains the rebound in the Euro versus the crowded long US dollar and is providing an additional boost for EM asset classes in the process. Yet, we think the trend in C&I lending is worth following very closely. This is as well highlighted by Bank of America Merrill Lynch Credit Market Strategist note from the 17th of March entitled "HG sector outlook: long beta, leverage and inflows":

"Soft data is hard, hard data soft 

The Fed’s patience makes sense as hard economic data outside the labor market has been relatively soft. As we have highlighted (see: Situation Room: In wait and see mode 07 February 2017), loan demand has been soft recently – C&I lending for example has been flat since October while consumer loans on bank balance sheets have risen just 4% (Figure 36, Figure 37).

Clearly everybody is in wait and see mode pending details of actual fiscal policy expansion from the new administration – including especially tax reform. Until they deliver – and that is not a small task – it would be counterintuitive to see a marked hawkish shift at the Fed. In the meantime we remain bullish on high grade credit spreads." - source Bank of America Merrill Lynch.

We agree with the above, namely that before taking the more difficult path of the the Swiss Wall of investing with its normalization process, the Fed is clearly awaiting for more clarity from the new US administration. On a side note, we were quite surprised by the strong rally in gold/gold miners following the FOMC as we were expecting a more hawkish tone from the Fed on the back of ADP/NFP data releases.

From our continued contrarian position and Swiss Wall of investing perspective, we believe that the US dollar is likely to weaken further, contrary to the herd mentality, which has been taking a different path on this slope and a significant long position on the "greenback" as per our final chart below.

• Final chart - USD likely to weaken given current position in historical tightening cycle

While the trade war rethoric seems to be still in play following the most recent G20 meeting, we still believe as per our early 2017 conversations that the path on the Swiss Wall of investing is lower, not higher in the current environment. This is as well highlighted in our final chart from Barclays note Thoughts for the Week Ahead entitled "The Fed says carry on":

"We expect further near-term USD weakness, concentrated primarily against high-yielding currencies. History suggests that this point in the Fed’s tightening cycle is typically followed by further near-term USD weakness, stable equity prices and lower 10y UST yields (Figure 1). 

Although low-yielding G10 and EM currencies will likely struggle to materially strengthen further against the USD, the drop in cross-asset volatility (Figure 2) will likely support high yielders, particularly the ones with positive idiosyncratic stories (RUB, INR, IDR and BRL), in our view.

Additional USD consolidation is also likely, amid still elevated long USD and short UST positioning, according to CFTC data (Figure 3). 

- source Barclays

One could argue that, if everyone is thinking the same, no one is really thinking, because, if indeed the Fed's recent caution on the Swill Wall of investing appears to be warranted in the light of the recent Atlanta Fed 1st quarter GDP projection and slowing credit growth, there is indeed a possibility for our "bold skiers" to "tumble" if one takes into account their current stretched positioning but, we ramble again...

"Tis one thing to be tempted, another thing to fall." - William Shakespeare

Stay tuned!