Monday, 10 April 2017

Macro and Credit - Drums Along the Mohawk

"The most persistent sound which reverberates through man's history is the beating of war drums." - Arthur Koestler, Hungarian novelist

Looking at the brief return of "exogenous" factors thanks to the escalations in Syria, leading to some interesting market gyrations in conjunction with a weaker Nonfarm payrolls number with, no surprise an Atlanta Fed revised GDPNow report for US 1st quarter GDP to a miserable 0.6%, made us remember for our title analogy of John Ford's 1939 historical technicolor film called Drums Along the Mohawk. The film was John Ford's first color feature movie and was a box office success. It tells the story of settlers on the New York frontier during the American Revolution suffering British, Tory and Indian attacks on their farm before the Revolution ends and peace is restored. The time of the story is July, 1776, and the spirit of revolution is in the air. The valley's settlers have formed a local militia in anticipation of an imminent war. The latest change in the rhetoric when it comes to the events in Syria, could no doubt spur some renewed volatility in the markets in conjunction with the upcoming French elections. It seems to us that along the Markets' Mohawk Valley, drums are indeed resonating and the eerily calm volatility akin to the one seen in the last months of 2006, as per our previous week's musing could face a significant regime change in the upcoming weeks, should "exogenous" factors return to the forefront. 

In these days and age of delusions and populism, beating the war drums have always been a short cut for politicians to garner support in very short order. Couples of examples come to our mind:
-The crumbling military government of Argentina with their Falklands adventure
-The response from Prime Minister Thatcher against Argentina's incursion solidifying her political base and garnering very large support.
-The second war in Chechnya which boosted the popularity of Russian president Putin
-The invasion of Iraq in 2003 by the Bush administration
-The Libya operation for French president Sarkozy
-The Mali operation for French president Hollande

 To name a few...

In this week's conversation we would like to look at Financial markets gyrations during "exogenous" factors such as "conflicts" and what Q2 entails in terms of potential surge in volatility. 

  • Macro and Credit - Delusions and gyrations
  • Final chart - Fiscal stimulus, if you give it, earnings will come...

  • Macro and Credit - Delusions and gyrations
In somewhat a similar replay to Q1 2016, we expect US GDP for 1st quarter to disappoint. The recent weakness in the latest Nonfarm payroll report and our recent call to extend duration exposure has made us dip back slightly into long US treasuries. When it comes to our gold mining exposure, we are quite satisfied by the year to date performance overall and we will continue to add opportunistically. As our readers know by now, we didn't embrace the herd mentality spirit of the long US dollar crowd and so far the performance for the first quarter has validated our stance. We continue to prefer in terms of positioning other markets than the US when it comes to equities. 

As we await for the return of the Japanese investment crowd in US credit thanks to an improving cross-currency basis, it seems European domiciled accounts have been front running as of late the Japanese crowd which is now entering their new fiscal year as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 7th of April entitled "Blame it on the Basis":
"More into risk assets
Last week we recorded inflows across a broad range of risk assets. Inflows have been recorded across equities, EM debt, commodities and HY funds. Inflows into high grade bonds have also strengthened. This was mainly driven by inflows into dollar IG bond funds that over the past two weeks have accounted for almost half of the total flows into this space. This move into USD credit from European-domiciled accounts was probably motivated by the recent tightening in the EUR–USD cross-currency basis.
Over the past week…
High grade funds flows remain strongly on the positive side for the eleventh week in a row. Last week’s inflow was also the largest since August ‘16. The inflows came equally from USD and EUR focused funds to the tune of $1.3bn.

High yield fund flows switched to positive after three weeks of outflows. Looking into the domicile breakdown, as charts 13 & 14 show, the largest part of the inflow came mainly from Europe-focused funds, followed by US-focused HY funds.
Government bond funds flows remained positive for the second week but inflows were marginal. Money market funds weekly flows turned strongly positive after a brief week of outflows. Overall, fixed income funds recorded their third consecutive inflow, and the highest in 36 weeks, supported by strong credit inflows. 
European equity funds flows remained on positive territory for a second week.
Global EM debt fund flows continued on a positive trend for the tenth week in a row and the third consecutive one over the $2bn mark. Commodities funds saw their fourth week of inflows; nonetheless we note the recent weakening in the magnitude of the inflow.
On the duration front, inflows continued in short-term IG funds for the 16th week in a row. Mid-term funds posted another strong inflow and the highest in nine weeks. Flows in long-term funds were lower than the previous week but remained positive for the fourth week in a row." - source Bank of America Merrill Lynch
When it comes to the Japanese investment crowd and their appetite for foreign bonds, one clear picture worth mentioning has been their recent distaste for French government bonds which they have been shunning in anticipation of the French elections. On that specific point we read with interest Bank of America Merrill Lynch's take on Japan selling pressure on French debt from their Japan Rates and FX Watch note from the 10th of April entitled "Japan BoP: New fiscal year, new flow:
"Trump shock done for now; France and seasonality the themes in April
After a painful three consecutive months of sales in foreign bonds after Trump’s victory, Japanese investors finally stopped selling with a small net purchase of ¥39.0bn in March. The continued bleeding from banks is likely over with only small net sales of ¥367.8bn compared to the previous three months with monthly net-sales over ¥1tn. If US treasuries continue to trade in a range with no further progress in Washington, we would not expect another month of selling as a result of the impact caused by Trump’s victory. On the other hand, the French election will continue to one of the key determinants of Japan’s bond flow into April and may cause another round of de-leveraging with much depending on the evolution of the polls.
- source Bank of America Merrill Lynch

The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table above. Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation.

Whereas fund flows continue to be supportive for now, another factor to take into account other than "exogenous" factors such as geopolitical events has been the weakening in hard data as of late. As we mentioned in numerous previous conversations, we believe the credit cycle is ending slowly but surely ending. On this specific subject we mentioned we have been monitoring closely the trend in C&I Loans as they are more reflective of what is happening in the real economy. Given financial conditions have been both tightening for Commercial Real Estate (CRE) and for C&I Loans, it remains to be seen if we are going through a soft patch à la Q1 2016, or if there is indeed more to it with some recent rise in delinquencies in both mortgages and auto loans. The below chart from Bank of America Merrill Lynch displays US C&I Loans versus EU Corp Loans since 1985:
- source Bank of America Merrill Lynch

Last three months changes for C&I loans have been negative with January ending at -0.1%, February at -0.4% and March at -0.7%, clearly indicative of a deteriorating trend. The big question obviously is if this continued trend will prevent the Fed from hiking in June with odds currently above 60%. The latest patch of soft data does indeed make us wonder whether there is more clarity awaited in regards to US fiscal stimulus and reforms, or if there is more to it. On that subject we read with interest Bank of America Merrill Lynch analysis from their Credit Market Strategist note from the 7th of April entitled "Is soft the new hard data?":
"Is soft the new hard data?
This week saw some softness in hard data as auto sales and jobs growth declined sharply. While two observations do not make a trend, this occurrence nevertheless is noteworthy as on the one hand very positive sentiment indicators suggest activity should pick up (Figure 1), while on the other hand loan data suggests everybody is in wait-and-see mode pending details of fiscal stimulus (=tax reform) - which highlights the risk of softer hard economic data.

For example, weekly bank asset data shows that C&I lending has not increased since September 7 last year (Figure 2), the first period of no growth for at least six months since the 2008-2011 aftermath of the financial crisis, and prior to that after the early 2000s recession (Figure 3).

At the same time, consumer loan growth has slowed substantially - up just 1.4% since the US elections compared with 3.1% the same period the prior year (Figure 4). 

As tax reform by House Speaker Ryan's own account is not going to happen anytime soon, and likely will be watered down as the Border Adjustment Tax (BAT) is replaced by a Value Added Tax (VAT) and the elimination of net interest deductibility for corporations, the biggest near term risk to our bullish outlook for credit spreads we maintain is a correction in equities - most likely prompted by weak hard data." - source Bank of America Merrill Lynch
Is there something more ominous at play or are we going through a soft patch like in Q1 2016? We believe it will be essential to track the evolution of consumer credit in the coming weeks from a credit perspective. There is as well a possibility that the "Trumpflation" trade is continuing to fade and that investors were somewhat delusional in their expectations. For the continuation of the rally in equities, earnings will be key and so will be the guidance provided apart from "exogenous" factors that could trigger renewed bouts of volatility.

Moving back to the subject of "exogenous" factors and their impact on financial markets gyrations we read with interest Nomura's take on the subject from their Japan Compass note number 433 from the 8th of April entitled Financial market movements during US wars":
"Flows tend to be risk-on at outbreak; rates market and USD movements depend on Fed policy
Markets have become risk-off and bond yields have fallen in response to the US launching air strikes against Syria.
However, we do not recommend investors buy bonds aggressively; at least until the Fed suggests that it will address this new geopolitical risk by weakening its hawkish stance.
In the past, the outbreak of a war by the US has led to risk-on flows (i.e., reflecting the US’s military dominance). However, as Russia supports President Bashar al-Assad of Syria, we believe the US is unlikely to start a war and overthrow the president, as in past conflicts, but will likely seek another resolution (or the conflict would simply fade without escalating further). In these circumstances, we believe the equity market will remain under pressure for some time, until uncertainties are cleared.
We also note that the Trump administration’s move toward reorganizing the National Security Council in such a way as to weaken its pro-Russia, far-right proclivities. If this leads to a higher support rating for the Trump administration, markets may react with risk-on flows, in our view.
In previous cases of US wars (e.g., Gulf War, Iraq War), markets tended to: 1) become risk-off as the event that triggered a war occurred; and 2) become risk-on as the US or multi-national force took military action. However, these tendencies clearly took place only in equity markets, and the rates and currency (USD) markets tended to move more in line with central bank policies.
The previous two US wars occurred during the Fed’s easing cycles (i.e., when economic conditions were poor, which may have made encouraged the US government to seek military options).
The US’s military action against Syria was unexpected, and the context and pretexts are not as clear as in the Gulf War and Iraq War (Iraq’s invasion of Kuwait, 9-11 terrorist attacks and Iraq’s possession of WMD). Unless the conflict is resolved in one way or another, the equity market would likely remain under pressure. A resolution may not materialize as a full-scale war. Before the Iraq War, e.g., Iraq accepted UN nuclear weapons inspections.
In contrast with the Gulf War and Iraq War, the Fed is in its hiking cycle now, with macroeconomic conditions improving in the US. Considering the rates and currency markets moved more in line with Fed policy during these two wars, and were not affected much by investor concerns over military risks, we believe these market movements will depend on the resilience of the economy in view of the geopolitical risks.
When Iraq invaded Kuwait, the Fed was apparently more wary of a macroeconomic slowdown caused by higher crude oil prices than a rise in inflation expectations (the US economy actually entered a recession and the Fed began cutting rates)." - source Nomura
Obviously the asset class most susceptible to large variation thanks to "exogenous" factors linked to geopolitical tensions remain oil in the current situation. As highlighted by the Euchre on his twitter feed, Kuwait's invasion by Saddam Hussein in the early 90s was a good illustration of exogenous factors impacting significantly oil prices:

- source The Euchre - Twitter feed

And, as far as we are concerned when it comes to Drums Along the Mohawk, where oil goes, so does High Yield CCC as per our short term graph below displaying the correlation between both asset classes:
- source

This is not a surprise given the large weight in the CCC sector of the Energy sector, which has been issuing in drove in recent years.

While everyone, in many instances have been sounding the alarm, when it comes to valuations and in particular US High Yield, oil prices remain a key support for High Yield as indicated by the weak performance experienced in the first half of last month as highlighted by Bank of America Merrill Lynch in their High Yield Strategy note from the 4th of April entitled "1st half pain, 2nd half gains":
"Strong back half of March not enough to offset weak start
Driven by a combination of lower oil prices and uncertainty surrounding Healthcare and tax reform, the first half of March proved to be the worst two-week performance for high yield since the election slump that occurred last November. Not surprisingly given the reasons behind the pullback, the two worst performing sectors through March 14th were Health Care (-2.32%) and Energy (-2.97%). However, a mid-month 25bp hike from the Fed and respite from oil weakness provided markets with sufficient confidence around the growth and inflation trajectory that performance was able to turn around in the 2nd half of the month. Although high yield was unable to recoup the 180bps in losses accumulated during the first two weeks, a +0.7% return from the 14th to the 31st helped limit losses on the month to just -0.21%. This brought the YTD total return down slightly, though the figure remains at a respectable +2.7% (+11.4% annualized). With the first quarter of 2017 in the books, we take a moment to reassess the strategic outlook for high yield during the remaining 9 months of the year." - source Bank of America Merrill Lynch
Of course recent fund flows in conjunction with rising oil prices have validated once again a strong appetite for High Yield in recent weeks, hence the second half of March rally in the asset class. Does that mean we remain defensive? Once again we would like to re-iterate our short-term Keynesian somewhat "bullish" stance, yet we remain medium term Austrian from a credit cycle perspective and we will watch very carefully the evolution of credit conditions as well as oil prices. We continue to believe we are starting to notice some early signs in the deterioration of the credit cycle. As we posited recently, 2017 could indeed play the reverse of 2016, namely that the second part of the year could see a weaker tone in and upset this on-going "risk-on". 

  • Final chart - Fiscal stimulus, if you give it, earnings will come...
While Drums are beating Along the Mohawk, and given recent weakness with hard data becoming soft, the "Trumpflation" trade which has been running since the elections on renewed hope for Fiscal stimulus, makes us wonder if earnings as we enter earnings season will materialize on top of markets pundits hoping for a delivery. Our final chart comes from Nomura's Rates Weekly note from the 7th of April entitled "Risk markets, what's left in the easing tank" and displays the S&P 500 profitability metrics, showing clearly that easy money rather and multiple expansion rather than earnings have been in the driving seat of the rally since 2012:

"We think Figure 2 is self-explanatory from the standpoint that easy money drove asset valuations to lofty levels. However, just like Greenspan’s comments in the late 1990s, markets can remain irrational for longer too. Current stock market dynamics, relative to profitability metrics (and by extension P/Es) look eerily like the 1999-2001 experience.
Back then, the view was that earnings would eventually come as “the internet” would revolutionize the world; it did, but it took years to do so from an efficiency standpoint and profits never materialized for many because they seized to exist post the crash. Stimulus (and prospects of a new fiscal policy) has clearly driven markets, so wouldn’t the reverse be true if the economy does not accelerate and/or we do not get the full US fiscal plans?" - source Nomura
Markets since the US elections have no doubt been trading on hope some fiscal stimulus would materialize with the new US administration. Yet recent softening in hard data and disappointing earnings could potentially have an impact, not only Drums Along the Mohawk...If the US administration does give it, will earnings return? We wonder...

"Nothing is more sad than the death of an illusion." -  Arthur Koestler, Hungarian novelist

Stay tuned!

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