Saturday 27 May 2017

Macro and Credit - Orchidelirium

"What, if as said, man is a bubble." -  Marcus Terentius Varro, Roman author
Looking at the recent parabolic surge in Bitcoin (BTC), for us it first resonated with the Dutch Tulip Bulb Bubble of 1637 given the existence of 840 different crypto currencies for a total market capitalization of 85 billion USD. Yet, after our initial thoughts, we reminded ourselves for our chosen title analogy of the Orchidelirium Victorian era flower madness when collecting and discovering orchids reached extraordinarily high. Orchidelirium was seen as similar to Dutch tulip mania. What we find amusing when it comes to Bitcoin is that in November 2013 Nout Wellink, former president of the Dutch Central Bank, described Bitcoin as "worse than the tulip mania," adding, "At least then you got a tulip, now you get nothing". No offense to Nout Wellink but at least when you bought European High Yield in the past you used to get some yield, now you get nothing but at least, in case of default, there is some form of recovery given that what make most of the value are the expectations of the reimbursement of the principal. More recently, Dutch politicians have offered to ECB supremo Mario Draghi a solar-powered plastic tulip in reminder of bubble concern as reported by Bloomberg on the 10th of May in their article entitled "Draghi stays calm on stimulus as Dutch warn of risks with tulip". The latest parabolic surge in Bitcoin and other crypto currencies, while not powered by solar power but mostly by computer power and speculative endeavors, we find the analogy with Orchidelirium of particular interest given today there still exists some levels of orchid madness, that has sometimes resulted in theft of exceptional orchids among collectors such as the Ghost Orchid. Indeed we live in interesting times and no doubt some level of orchid madness can be felt but we ramble again.

In this week's conversation, we would like to look at potential cracks in the credit cycle such as slowing loan demand in particular in consumer credit in the US and other late credit cycle indicators such as the ebullient art markets and classic cars.

  • Macro and Credit - Is the US consumer "maxed out"?
  • Final charts - Modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn

  • Macro and Credit - Is the US consumer "maxed out"?
Back in March 2017 in our conversation "The Endless Summer" we concluded our long conversation asking ourselves if the US consumer was somewhat "maxed out". We indicated as well that this on-going "Endless Summer" had created a significant windfall for the holders of financial asset. While in recent conversation we have argued that we remained short-term "Keynesian" given the large inflows pouring into various asset classes, while longer term we do remain "Austrian". We are still very cautious for the second part of 2017. 

The "wealth effect" has globally lifted all boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. From our credit perspective, it appears to us that "cracks" in credit in the US are beginning to show up, particularly in the form of slowing loan demand. While we are not yet sounding the alarm bell, we think in the coming months it is going to be paramount to monitor credit demand and in particular consumer credit. 

You already know the story relating to Commercial Real Estate (CRE) and Commercial & Industrial Loans (C&I) from our recent musings. Despite the "Orchidelirium" over consumer confidence numbers post the US election, C&I growth is trending down (since the beginning of the year) and they are more reflective of what is happening in the real economy. As we indicated recently, weak loan demand tends to be associated with higher volatility yet markets are displaying very high complacency and seem to be oblivious to this recent negative trend, making this continuing rally, one of the most hated bull market in recent history.

From our credit and macro perspective, we live in a credit world hence the importance of tracking loan demand. The latest Fed Senior Loan Officer and Opinion Survey (SLOOS) showed that all is not well in the world of credit as per Wells Fargo note from the 17th of May entitled "Fed Survey Points to Slowing Loan Demand":
"The Fed’s Senior Loan Officer and Opinion Survey showed cooling loan demand for businesses and consumers in Q1. Citing uncertainty and lower risk tolerance, banks continued to tighten standards for CRE loans.
Business Loan Demand Tails Off
The Federal Reserve’s April 2017 Senior Loan Officer Opinion Survey (SLOOS), which roughly corresponds to Q1 2017, points to a general slowdown in loan demand for businesses and consumers. Reports of tightening lending standards varied across loan categories, however.
As shown in the below chart, large and small businesses demand for loans has been moderating since the start of 2016. Domestic and foreign banks reported weaker loan demand on net over the first quarter.

Notably, the slowdown in commercial & industrial (C&I) loan growth does not appear to be due to stricter lending standards, as banks reported no significant net tightening. The survey showed a modest net easing for C&I loans by domestic banks, but a slight tightening by foreign banks.
The SLOOS C&I lending data are contrary to the details within the GDP release. While the survey data point to a slowdown in business loan demand in Q1, the GDP report indicated a strong pickup in business fixed investment with outlays rising at a solid 9.4 percent annualized rate. The strength in business investment may reflect firms’ use of other sources of funding, such as bond issuance and stronger profits.
Consumer Loan Demand Cools
The Fed survey also showed a cooling in consumer loan demand, a finding consistent with the weaker pace of consumer spending in Q1. Lenders reported reduced demand for most consumer loan categories over the quarter, with particular softness in demand for credit card and auto loans (below chart).

A moderate share of banks reportedly tightened auto loan standards in Q1, marking the fourth consecutive quarter of net tightening. Banks stated widening spreads of loan rates over their cost of funds and raised the minimum credit score threshold over the quarter. For credit card loans, a modest share of banks reported easing lending standards, while terms on other consumer loans remained unchanged on balance. We do not take the softer consumer lending report as the start of a new trend and look for consumption to re-emerge in Q2.
CRE Lending: Continued Tightening
The April SLOOS showed that lenders are continuing to monitor pockets of risk in the commercial real estate (CRE) sector, as a significant net share of banks reported further tightening in most CRE loan policies (below chart).

In fact, a major share of banks cited a more uncertain outlook for CRE property prices, vacancy rates and other fundamentals, and reduced risk tolerance as reasons for tightening credit standards. In a recent speech, Boston Fed President Eric Rosengren noted that while a handful of favorable factors have helped support CRE valuations, “positive trends can sometimes evolve into prices that increase more than fundamentals justify.” Banks’ continued tightening of CRE credit should help ease financial regulators concerns of elevated pricing." - source Wells Fargo
While the slowdown in consumer lending is yet to show a similar trend seen recently in other segment such as CRE and C&I, it will remain essential to monitor the situation in the coming months. From our point of view, while equities market are still racing ahead and credit spreads tightening with a clear outperformance of high beta in that respect, it remains to be seen how long fundamentals will be deteriorating and if Q2 will see some sort of reversal. So far, credit weaknesses are simply being ignored by the Orchidelirium crowd. 

In similar fashion, we read with interest Bank of America Merrill Lynch Global Economic Weekly note from the 26th of May entitled "When is "intervention" "manipulation"?" asking themselves about the weakness in consumer credit:
"Are there cracks in consumer credit?
  • Consumer credit creation has slowed, adding to concerns that consumer demand has weakened.
  • We see several factors at play—some benign—which help explain the slowdown, prompting us to fade some of the weakness.
  • We remain positive on the consumer outlook as fundamentals are solid but think it is wise to keep an eye on these indicators.
Credit slowdownThere are signs that consumer credit creation may be slowing. According to the New York Fed’s Quarterly Report on Household Debt and Credit, new mortgage originations dropped to $491bn in 1Q from $617bn in 4Q. Also it showed that the growth in the number of open credit card accounts decelerated in 1Q 2017, implying that demand for revolving credit may be slowing. In fact, respondents from the Senior Loan Officer Opinion Survey reported that demand for credit cards on net has slowed despite looser credit standards (Chart 2).

In this piece, we take a look at the potential causes of the slowdown in credit creation, specifically revolving credit, and what it means for consumer demand in the near term
Assessing the potential causes
A few potential reasons—some benign and some not so benign—appear to be at play for the slowdown.
1. Involuntary account closures:
The latest New York Fed’s Survey of Consumer Expectations (SCE) Credit Access report for February showed an uptick in involuntary account closures. Five percent of respondents reported that at least one credit account was closed by the respondents’ lender, up from 3.8% in the prior survey in October 2016 and the highest recorded since the survey began in late 2013. Breakdown by respondents’ credit score shows a notable pickup in account closures for less credit worthy consumers as 14.8% of respondents with credit scores at or below 680 reported an account closure, up from 9.6% in the prior survey (Chart 3).

This could be a potential sign that household finances may be stretched as households are beginning to have a more difficult time remaining current on their debt payments. Indeed, the New York Fed’s Report on Household Debt and Credit showed notable growth in seriously delinquent balances for credit cards and auto loans in the last two quarters (Chart 4).

We have already started to see pace of auto sales begin to moderate which we think could be a potential source of weakness for the economy. Further deterioration of the household balance sheet could slow consumer demand.
2. Perception vs Reality:
As mentioned above lenders are reporting looser standards. However, better consumer demand failed to follow. According to the NY Fed’s SCE Credit Access survey, close to 30% of respondents reported that they think they would be rejected for a credit card today, near comparable levels seen last year (Chart 5).

Additionally the same report noted that the application rate for credit cards fell to 25.3% from a high of 30.6% in June 2016, further corroborating the lack of increase in demand. What’s interesting is that application rates are down across the credit score spectrum suggesting it may be broad-based perception that credit is hard to obtain at the moment. Given that lenders remain constructive on lending standards, the slowdown may prove to be transitory.
3. The influence of Millennials:
In the wake of the Great Recession, Congress passed the CARD Act of 2009, a comprehensive credit card reform legislation to protect consumers. Under the bill, lenders cannot issue credit cards to a consumer under the age of 21 unless they prove they have independent income or obtain a cosigner. Given more restrictions to obtaining credit, many millennials are less “credit mature” in their 20s compared to the previous generations. Therefore, as millennials come of prime working age, many are having a tough time obtaining credit cards as lenders are unwilling to extend credit to individuals that have a short or no credit history, hampering credit creation. Moreover, due to the experience of the Great Recession millennials may be less inclined to buy using credit or are “convenience users” who pay off their entire credit card balance every month, limiting the need for multiple credit cards.

Implication for the economy
It’s unclear whether the slowdown in the growth of revolving credit is just a temporary soft patch or a more nefarious sign of a downturn in the economy. On one hand, we are starting to see some cracks in consumer demand. Even accounting for residual seasonality and warmer weather conditions dampening heating demand, personal consumption expenditures slowed notably to start the year. Also, the lackluster April retail sales report and a step back in auto sales since March does not inspire confidence that we will see a quick rebound. In this environment, a slowdown in credit creation stands out. On the other hand, we’ve had situations in the past where credit demand had receded during expansions only to reverse. Also, as previously mentioned, some of the potential factors at play for the pullback in credit demand could be more about changing demographics and tastes rather than a signal of weakness.
At this point, we are inclined to mostly fade the weak signals. The consumer backdrop is largely supportive. Job growth remains robust and given the low level of the unemployment, wage growth should head higher, albeit slowly. Also, aggregate household leverage has returned to healthy levels and the saving rate remains elevated (Chart 6).

This suggests that there may be another gear for consumption if households deemed it worthwhile to spend or it can be used as a buffer to stabilize against any potential negative shock that may hit the economy.
Bottom line
The jury is still out on credit conditions for the consumer. Credit demand seems to have slowed but lending standards remain favorable. On the other hand, we are starting to see pockets of stress on the household balance sheet that could spark weakness in the overall economy but so far it seems contained. We will be closely monitoring credit conditions for early warning signs of a slowdown in the economy. It squarely remains a risk to our outlook." - source Bank of America Merrill Lynch
Whereas it is too early to envisage some clear headwinds for the US economy thanks to weaker loan demand, it is clear to us that, in this late credit cycle, it remains very important to track SLOOs going forward. While default rates remain subdued in comparison to 2016, tightening in credit standards in conjunction with rate hikes will eventually weight on High Yield but for now, inflows remain strong and in particular in Investment Grade as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 26th of May entitled "Inflows into high grade continues":
"The convexity trade
Buy what they buy or buy convexity. IG funds continued to see strong inflows, as the ECB has been buying a larger volume of corporate bonds over the past couple of weeks. Additionally, flows into equity funds have improved over the past couple of months, on the back of a supportive earnings story in Europe. On the flip side, flows into high yield have slowed significantly, as the market now offers the lowest yield on record.
Over the past week…
High grade funds recorded another strong weekly inflow, the 18th in a row. High yield fund flows also remained in positive territory for a fifth week, but last week’s inflow was marginal. Looking into the domicile breakdown, as Chart 13 shows, inflows to European-domiciled HY funds with a European-focus were also marginal, while the inflows from global-focused funds were offset by outflows from US-focused funds.
Government bond fund flows last week were negative for a third week. So far this year, the asset class has suffered losses in 14 out of 21 weeks. Money market funds suffered a sizable outflow last week, the second in a row and the largest in 60 weeks. Overall, Fixed Income funds recorded their 10th consecutive weekly inflow, but this one was the smallest in five weeks.
European equity funds continued to see inflows for a ninth consecutive week. However, the pace has slowed down w-o-w. So far this year, the asset class has seen more than $15bn of inflows.
Global EM debt funds continued to see inflows, for a 17th consecutive week. The asset class has so far this year enjoyed stellar inflows of over $33bn. Commodities funds had their 11th week of inflows, predominately driven by inflows into gold funds.
On the duration front, positive flow numbers were recorded in mid-term and short-term IG funds, for the ninth and 23rd week in a row, respectively. However, flows into long-term funds were negative for a second week." - source Bank of America Merrill Lynch
With such a strong tide in credit funds and particularly High Grade, it is hard to see how the Orchidelirium can cease for the time being. Many portfolio managers we know are getting bored by the day by this one way market, with new highs daily, record low volatility, tighter credit spreads and steady inflows. Apart from an exogenous factor such as a geopolitical event, it's hard to think about what could be a catalyst for a reversal in this Orchidelirium.

Some would point out to the record levels touched by household debt surpassing 2008 peak as indicated in Wells Fargo's Interest Weekly note from the 24th of May:
"Household debt rose 1.2 percent in Q1 to $12.73 trillion, surpassing the $12.68 trillion mark set in Q3-2008. After accounting for population growth and inflation, however, households are not nearly as levered as 2008.

Aggregate Household Debt Returns to 2008 Levels
Household debt rose by $149 billion in Q1-2017, bringing the aggregate level of debt to an all-time high (top chart). Although the return to this level of debt has grabbed headlines, there are a few important considerations when comparing household borrowing today relative to a decade ago.
First, the composition of debt has changed significantly. There has been a shift away from mortgage lending and towards autos and education-related debt. As a share of total debt, student loans have more than doubled from a 4.8 percent share in Q3-2008 to a 10.6 percent share today. Auto lending has seen a similar, albeit more moderate, trend. Mortgage debt, however, remains $670 billion below its 2008 peak.

Second, although household debt has surpassed its previous peak, this ignores a series of other factors, such as population growth, inflation and growth in real output. As illustrated by the dark line in the middle chart, nominal debt per capita still remains short of its 2008 level. After adjusting for inflation, blue line, it is even clearer that the average household’s debt portfolio is smaller relative to a decade ago. When viewed through this lens, the recent growth in household debt looks much more modest.

Loan Quality Fairly Stable on Trend
In terms of loan quality, household debt delinquencies remained roughly flat in Q1, although there were some differences between categories of loans. Auto loan delinquencies ticked modestly higher and have risen very gradually over the past few quarters (bottom chart). Credit standards on autos have tightened from already relatively constricted levels; the median credit score for a newly originated auto loan was 706 in Q1, a 6 point increase from Q4 and well above the 686 reading in Q3-2007 on the eve of the Great Recession. Mortgage debt drove most of the growth in Q1. As we have highlighted in other reports, a mild winter weather likely pulled forward some housing activity that would typically take place in the spring. This in turn helped spur a strong first quarter for the housing market, with real residential construction expenditures rising at a 13.7 percent annualized rate. Auto loans and student loans grew $10 billion and $34 billion, respectively, while credit card balances declined by $15 billion.

On balance, the recent growth in household debt is a broad sign of strength rather than consumer weakness. Student loans remain a long-term secular challenge, and other areas, such as autos, warrant close monitoring as new data become available. That said, household leverage remains lower than it was in the 2000s credit bubble while the personal saving rate is higher. Despite the Q1 weakness, we expect real consumer spending to rebound in Q2 amid an ever-tightening labor market and healthy consumer confidence." - source Wells Fargo.
Yet, the latest batch in soft macro data such as retail sales and New Home Sales falling by 11.4% the most since 2015, it remains to be seen if indeed as in Q1 2016, that the soft patch we had in Q1 2017 with the now revised 1st Quarter GDP at 1.2% will be offset going forward by better macro data in Q2 2017. With US durable goods orders falling by 0.7% in April for the first time in 5 months we are wondering if the trend in softer macro is going to continue while confidence is very strong in another rate hike by the Fed in June. 

  • Final charts - Modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn
Back in July 2016, in our conversation "Who's Afraid of the Noise of Art?" we quoted one of the recurrent themes of our friends at Gavekal research, namely that it has “never been so expensive to be rich” particularly if you want to snap up a classic Ferrari it seems. Kudos to our central bankers and their obsession with the "wealth effect":
"As most of our readers will know, modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn of the economic cycle. And interestingly, over the past couple of months, these assets have really been shooting up, breaking several records on the way" - source Gavekal, July 20th 2006.
History does indeed rhyme and we must confide that at this stage of the "credit cycle", we are afraid of the Noise of Art given back in 2006 our Gavekal friends indicated the following:
 "Usually, the last thing to go up in prices are rare automobiles" - source Gavekal Five corners, July 20th 2006.
This time it's different? We don't think so. Our final chart comes from Knight Frank's most recent wealth report and displays the stellar performance of classic cars in recent years:
"The Drive to Quality
For classic cars, “2016 was the year of the slowdown,” says HAGI’s Dietrich Hatlapa. For anybody not familiar with the market, that looks like a slightly downbeat claim as annual growth was still a very respectable 9%. But set against total growth of 151% over the past five years, it is clear that the market has dropped down a few gears. “Those who were in it just for the money have moved on,” says Mr Hatlapa. “The market is now more in the hands of the collectors and specialists, which I think is good news for the real enthusiast.”
According to data from the Kidston 500, another market-tracking index, of the cars put up for sale at the top international auctions during 2016, 78% sold by number – down from 84% in 2015 – while the proportion of cars selling for below their low estimate rose by 20%.
The pattern is the same in the US, says Brian Rabold, Vice President of Valuation Services at specialist insurer Hagerty. The firm’s Blue Chip index, which tracks the value of 25 of the European, US and Japanese cars most prized by US collectors, fell by 1% last year. “Over the past year or so we’ve seen a shift from a sellers’ to a buyers’ market,” he says. “People are becoming more selective. Last year there were 26% fewer auction sales of cars over US$1m in North America.” He also notes a shift in interest towards new models like the Porsche 911R. “Our top 1,000 clients are buying cars from the 2000s like never before.”
But despite the slowdown, the rarest cars in the right condition with the most desirable provenance will continue to set world records, says Mr Hatlapa.
Simon Kidston, who set up the Kidston 500, agrees: “Yes, the pace of deal making is noticeably slower, and the headline figures don’t convey that the underlying mood is much more reflective and uncertain amongst buyers and sellers. But until there are better, more mobile and tax efficient havens for cash, the market is likely to remain active and capable of reaching new peaks when fresh discoveries emerge from hiding.”
As if to prove the point made by Mr Hatlapa and Mr Kidston, a Ferrari 1957 335 Sport became the most expensive car to go under the hammer ever, in euro terms at least, when it was sold by Artcurial in Paris for €32m.
In the US, the annual Monterey sales also delivered new benchmarks. An historic 1962 Shelby Cobra went for over US$13m with RM Sotheby’s, making it the most expensive American car to sell at auction. A 1955 Jaguar D-type grabbed the record for the priciest British car to go under the hammer when it fetched almost US$22m. And, dispelling the myth that nobody is interested in older cars any more, Alfa Romeo joined the party with a 1939 8C Lungo Spider making just under US$20m – a new record for a pre-war vehicle.
However, the most expensive car sold last year was handled privately by Mr Kidston. The exact price achieved for the 1962 Ferrari 250 GTO has not been revealed, but it exceeded the highest sum ever paid at auction (US$38m for another 250 GTO sold by Bonhams) for a classic car and was possibly the biggest deal ever struck." - source Knight Frank - The Wealth Report 2017
However, there is more under the hood that meets the eye. As we indicated back in our July 2016 conversation, we have kept a close eye during the last couple of months on our interesting, yet entertaining exercise of building up a "virtual garage" made up of "classic cars" of interest and monitored on an ongoing basis their valuation by using the website "". What we have continued to notice since we added a few cars in our "virtual garage" is some interesting price revisions taking place. For instance a Ferrari Dino 246 GTS was parked in February 2017 at the price of €449,000 and now is offered at €397,000. Another Ferrari Dino 246 GT was parked as well in February for a price tag of €375,000, now it is offered at €315,000. A Ferrari 250 GTE was parked in May 2016 for €475,000 and is now offered for €395,000. Rarities such as some 1955 Mercedes-Benz 300 SL Coupé Gullwing are still commanding an impressive 1,600,000 EUR price tag and are yet to show any price revisions at the moment. 

What we find of great interest is the "Cantillon effect" and the significant rise in price appreciation for classic cars can be directly link we think to our central bankers generosity and their "dear wealth" effect and some form as well of Orchidelirium. Yet, the classic car market continues to face some headwinds as per the latest read from the Hagerty Market Index which is an inflation adjusted open ended index (similar to the DJIA or NASDAQ Composite) based on change in dollars and volume of the market:
- source Hagerty

Furthermore in a period of Orchidelirium and in similar fashion to 2006 we are not surprised to see records being broken in art auctions as per last week in New York as reported by ArtNet:
"A staggering $1.6 billion worth of art changed hands during New York’s auction gigaweek last week. The three houses stuffed 11 sales of Impressionist, Modern, postwar and contemporary art into just five days. The combined total is up $400 million from the equivalent sales in May 2016, which made $1.2 billion. What should market-watchers take away from the onslaught? Here are our parting observations:
Biggest Trend: Big-Ticket Lots
Top-heaviness seems to increasingly define the evening sales. Both Christie’s and Sotheby’s were deeply reliant on a few top items. Consider Sotheby’s postwar and contemporary sale, where the record Basquiat, which sold for $110.5 million, represented a third of the evening’s $319.2 million total. Throw in the second-priciest lot of the night, a Roy Lichtenstein that fetched $24 million, and the two items account for about 42 percent of the sale.
Biggest Winner: Christie’s
All told, Christie’s made $833.9 million from its four sales last week, besting rival Sotheby’s by nearly $200 million. The publicly-traded auction house made a combined $635 million from its five sales. Meanwhile, Phillips, which did not hold Impressionist and Modern auctions, made $128.9 million last week.
Biggest Loser: The Owner of This Wade Guyton
It’s easy to focus on record prices and dizzying numbers, but don’t forget: Not everyone who puts an artwork up for auction makes money. To wit: One unlucky collector bought Wade Guyton’s Untitled (2005) at Christie’s New York in March 2014 for $1 million. It sold at Phillips last week for $670,000—a $330,000 loss. Ouch.
Most Likely to Make Auctioneers Nervous: Big-Ticket Withdrawals
Each house withdrew a major lot at the last minute last week—an indication of just how skittish consignors can get in the absence of guarantees. At Phillips’ contemporary art evening sale, the consignor of the second-highest estimated work, Gerhard Richter‘s Abstraktes Bild (1994) (est. $15–20 million), got cold feet. (“It is the consignor’s decision to take the painting out of the sale and we have to respect that,” Phillips’ chairman Cheyenne Westphal said after the auction.) The evening before, Christie’s withdrew Willem de Kooning‘s Untitled II (1977), which had a hefty estimate of $25–35 million. But perhaps the biggest disappointment was Tuesday’s last-minute withdrawal of Egon Schiele‘s painting Danaë (1909) (est. $30–40 million) from Sotheby’s Impressionist and Modern art sale. Not only was it the priciest lot of the evening, it was also the cover lot of the catalogue. The painting’s $30 million low estimate had represented some 20 percent of the low estimate of the sale overall.
And…the Best-Selling Artist of the Week: Jean-Michel Basquiat
Not only is the American artist responsible for the most expensive single work of art sold last week—the $110.5-million canvas Untitled (1982)—he also cleaned up at all three auction houses. All told, the 27 Basquiat works on offer in both the day and evening sales sold for a total of just over $200 million. Here’s the breakdown.
Christie’s: $57,863,500
Sotheby’s: $130,905,004
Phillips: $12,976,000
Total: $201,744,504" - source ArtNet
Absence of guarantees are indicative of tightening financial conditions as well in the art market. If you read again our July 2016 you well learn that auction guarantees have proliferated since the financial crisis. Irrevocable bids were part of financial machinations that distort the art market. When highly valued works with prearranged bids come up for auction, in many cases there is no genuine bidding and they were bought by the guarantors. In the past, so-called irrevocable bidders were compensated with a part of the auction house’s sales commission only if another buyer purchased the artwork that they had backed. Now, by opting for a fixed fee, they are guaranteed a payout and can get the artwork effectively at discount. Auction houses have resorted in the past to "vendor financing" but as well as paying some buyers to bid on its artwork. If potential buyers are not even agreeing on fixed fee to make at least a minimum bid as per Sotheby's 2016 incentive, then we are not surprised there were big-ticket withdrawals. Yet another indication of deterioration in the "credit" cycle coming this time around from the art market.

So not only there is a risk for yet another soft patch in Q2 and other macro releases and additional pressure from loan demand and consumer credit, but we think you should also keep a close eye on what is happening in the art market also at risk of facing a "soft patch". While "classic cars" have enjoyed "stellar returns" for the savvy and wealthy investors, they continue to show sign of slow down and price revisions.

"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Arthur Fisher

Stay tuned!

Thursday 18 May 2017

Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author
Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
  • Final chart - Trumpflated

  • Macro and Credit - Attempts in exploiting the Phillips curve have failed
Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas
We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:
"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:
"Wage wars
The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.
There is the theory
The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.
The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.
And then the data
We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.
We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch
Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:
"In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017
Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:
"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).
- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":
"Current state of Japan’s labour market
Japan’s labour market is at its tightest level since the early 1990s 
Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."
- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016
We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:
"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages
The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.
Progress until now and further progress on labour reforms should help Japan’s economic recovery continue
The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.
 Back in our January conversation "The Ultimatum game", we indicated the following:
"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.
The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

  • Final chart - Trumpflated
For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:
"The deflating of the reflation trade
As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.
US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse
As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley
Stay tuned!

Thursday 11 May 2017

Macro and Credit - Another Brick in the Wall

"Success is having to worry about every damn thing in the world, except money." -  Johnny Cash
Looking with interest at the elections of new French president maverick Macron, in effect putting another brick in the wall of worry, hence our title analogy, we reminded ourselves of Pink Floyd's 1979 rock opera with "Another Brick in the Wall being the title of three songs set to the variations of the same basic theme:  subtitled Part 1 (working title "Reminiscing"), Part 2 (working title "Education"), and Part 3 (working title "Drugs"). Part 2 was in fact a protest song which somewhat resonates clearly with the rise of populism in general leading to Brexit and Trump's election, whereas the results so far in 2017, seems to be the reverse of what has been playing out in Financial markets in 2016 where we had a dismal first part of the year and political surprises in the second part of 2016 in conjunction with a very significant rally in all things beta in the second part of 2016. 2017 so far has seen significant records being broken for equities indices, tighter credit spreads, and record low vix, which many pundits punting towards "complacency". In our previous conversations, we have indicated that while we did remain short-term "Keynesian" when it comes to our "risk-on" feeling, hence our reduction in both our gold miners exposure and duration exposure, we believe that the second part of 2017 could play as a reverse of the second part of 2016.

In this week's conversation we would like to look at a trade which has been put forward by many pundits including Jeffrey Gundlach of DoubleLine Capital, which is the case for EM equities versus the S&P 500 from an allocation and macro point of view.

  • Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
  • Final chart - Weak loan demand tends to be associated with high volatility

  • Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
While many pundits have been mesmerizing at the record low level touched recently by the "fear index" VIX, we reminded ourselves a previous conversation from 2013 entitled "Long dated volatilities: a regime change". As we posited back in 2013, it seems we are clearly back in the low regime of 2004-2007, and credit spreads as of late are also a reminder of the tightness in credit we experienced firsthand in our banking days at the time. Back in our old conversation we made some interesting comments relating to Emerging Markets and volatility which, we think, from a macro perspective are still extremely valid:
"Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum - Tokyo Presentation - August 2007).

Regime switches also lead to potentially large consequences for investors' optimal portfolio choice hence the importance of the subject." - source Macronomics, January 2013.
We also mentioned at the time that different regimes corresponds to period of high and low volatility, and long and bull market periods in conjunction with the credit cycle. At the time of our previous post we also indicated that the importance of regime change was paramount to asset allocation given:
"The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other.
  • For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks. 
  • On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
  • In a bear regime the share allocated to stocks increases with the investor’s horizon." 
- source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.
Also we mentioned at the time that retail investors had been net sellers of stocks since 2007. Yet, in recent years, it seems many have returned using ETFs as an investment vehicle of choice, shunning active management to passive management in the process.

Returning to the very subject of our conversation, there is indeed a case being made which so far year-to-date has been validated performance wise to go long EM equities versus the S&P 500. As a reminder, since the inception of the MSCI EM index back in 1988, the MSCI EM / S&P 500 ratio has experienced two significant boom/bust cycles:

Arguably there has been a significant growing gap between both indices since 2014, while the S&P 500 has been no doubt racing ahead:
- source

With the benefit of hindsight, we can summarize those two cycles in the following way:

Cycle 1 (1988-1999)
  • Boom phase (EM outperforming between 1988 and 1996): With the disappearance of the Eastern Bloc, Second and Third World countries were bound to join the First World, and mankind would reach Fukuyama’s “End of history” (1992). Trade barriers fell, stable governments became the norm, and EMs became an investible asset class. The first EM boom culminated with the 1997 Asian crisis.
  • Bust phase (S&P outperforming between 1996 and 1999): As EMs were still suffering from the aftermath of the crisis, US equities were led by the first tech bubble.

Cycle 2 (1999-Now)
  • Boom phase (EM outperforming between 1999 and 2011): Following the tech crash 2000, investors turned away from the new economy. The term itself became used derisively, as the tangible economy came back with a vengeance, introducing new investment themes: the commodities super cycle, stagflation, the Hubbert peak, etc.
  • Bust phase (S&P outperforming since 2011): In the early 2010s, the new economy finally started to become a reality, capitalizing on the huge infrastructure investments that were made during the first tech bubble. At the same time, new technologies (fracking, clean tech, electric cars…) made the developed world less dependent on energy and raw materials.

To sum up, EMs vs. S&P is not a merely a bet on global growth but put it simply a sectorial bet:
  • MSCI EMs returns are dominated by old economy industries, commodity- and more generally stuff-producing companies. EM equities are a bet on scarcity and inflation.
  • S&P 500 returns are dominated by the new economy: tech, platform companies, business services etc. The S&P is a bet on innovation, deflation and creative destruction.
One might argue that EMs are not pure old economy with the significant weight of Samsung and Tencent for example. But, one might also opine that Korea and Taiwan are not really truly Emerging Markets anymore. Though our simplified interpretation doesn't match the truly "old economy", you get our point when it comes to the sectorial bias.

After its nearly 60% correction since its 2011 heights, there are currently several factors at play indicating that we could be at the beginning of a third cycle in the MSCI EM / S&P ratio.

The CRB Industrial Metals Equity Index (CRBIX Index) has had a significant rally since January 2016:

Following the same trend until recently, there were some indications that there was somewhat a revival in the Chinese materials sector:
- source
(Correlation 0.909, R2 = 0.826, 228 months in sample).

But given our premises that EM being a sectorial bet, still dominated by old economy industries, commodity and more generally stuff-producing companies, EM does indeed appear to be a bet on scarcity and inflation. With Chinese PPI slowing down, one might rightly ask, what's the overall picture if we take into account Chinese Iron Ore spot prices?
- source
(Correlation 0.907, R2 = 0.823, 72 months in sample).

Clearly Iron Ore spot prices are very volatile particularly given the recent clamp down on the famous Wealth Management Products (WMP) by the Chinese government but also reflects a tightening in Chinese financial conditions as well.

After all, weaker commodity prices was reflected in the latest data out of China given the  producer price index (PPI) slowed more than expected in April, falling to a year-on-year pace of 6.4% from 7.6% in March.

Regarding commodities themselves, Dr. Copper, (the PhD in economics) is something we would like to look at to get some cues on this sectorial premise of ours:
- source
(Correlation 0.896, R2 = 0.802, 228 months in sample).

Australia’s terms of trade is also an interesting indicator of MSCI EM/ S&P ratio, due to Australia’s heavy reliance on commodities:
- source
(Correlation 0.932, R2 = 0.869, 228 months in sample).

After all, we are seeing tighter liquidity from China in its moves to rein in leverage which could potentially weigh on economic growth as it is attempting a "controlled demolition" of the shadow banking bubble which was let loose.

Regarding inflation, the recent increase in inflation expectations hasn’t yet been factored in by the MSCI EM vs. S&P ratio:
- source
(Correlation 0.859, R2 = 0.737, 132 months in sample).

Additionally, Chinese devaluation fears, which roiled world markets during the summer of 2015, have substantially receded since the beginning of the year:
- source
(Correlation -0.869, R2 = 0.741, 36 months in sample).

Yet the pullback in TIPS inflation "breakeven" rates with US 5 year breakeven rates trending lower have shown that the "Trumpflation" trade has been cooling as of late. Though the recent weakness in precious metals with silver getting spanked daily can be attributed to a gradual rise in real rates we think, another manifestation of Gibson's paradox as a reminder:
"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 a 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 getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - source Macronomics
On a side note, there has never been an episode in history when Gibson's paradox failed to operate. The real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude our side note, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates. This is clearly illustrated in the below chart from Deutsche Bank European Equity Outlook note from the 11th of May:
- source Deutsche Bank

So far in 2017, the outperformance continues to play out in favor of EM as per the chart below displaying the S&P 500 performance relative to iShares MSCI EM:

- source Bloomberg

Flow wise commodities funds according to the latest Follow the Flow note from Bank of America Merrill Lynch have seen their eighth week of inflows, however showing signs of slowing down with gold and oil prices moving lower recently. We think most of the ongoing correction in the commodity complex is tied up to the "controlled demolition" of WMP led by China. Emerging market equities have historical strong correlation to commodities, yet, investors have continued pushing emerging market equites higher.

Given the pressure on Chinese A shares, should you want to play this trade via ETFs we would agree with Bloomberg's take from the video embedded in their article  "Gundlach Says Short the S&P 500 and Buy Emerging Market ETF" from the 9th of May, that you would be better off using IEMG ETF (South Korea and no China A shares) rather than EEM ETF given the ongoing tightening pressure in China. Yet, with KOSPI rallying as well 13.6% and breaking through the 2300 at an all-time high, the rally has been significant but mostly led by Samsung. We continue to believe that overall markets are trading on expectations of structural reforms in many instances (US, France, South Korea, etc.).

In relation to Emerging Markets, if in Macro, demography is destiny, we continue to like the asset class given as shown in the recent Bloomberg graph workforces are still expanding in India, Southeast Asia, Vietnam as well has a very young population and Southeast Asia overall is offering very compelling growth prospects:

- source Bloomberg (H/T Tiho Brkan

On top of that, China's Silk Road initiative with their willingness in expanding towards the West is clearly going to spur in its surroundings economic growth and renewed demand for commodities while China is transitioning its internal imbalances towards consumption rather than domestic fixed asset investments. The long term macroeconomic impact of such endeavor should not be underestimated.

While we still believe in some continuation of "risk-on", yet we could potentially get a pullback, we are closely watching oil, being at the moment the major brick within our wall of worry when it comes to potential credit spreads widening and spillover. We continue to follow closely the credit cycle and the global credit impulse which has shown recently by China and as well from the latest US Fed Senior Loan Officer survey, continues to point towards a slowdown thanks to weaker demand as per our final chart below.

  • Final chart - Weak loan demand tends to be associated with high volatility
While markets have successfully climbed the wall of worry with the French elections angst, we continue to track the slowly but surely eroding credit cycle and credit impulse. The significant performance of risky asset classes and beta in particular since the second part of 2016 in the on-going low volatility regime thanks to central banks meddling, makes us feel a tad more nervous about the continuation of the rally in the second part of the year while we are acutely aware as we wrote recently that the final inning in a credit cycle always is often associated with a final large melt-up.

When it comes to the volatility quandary, we read with interest DataGrapple's take on the subject from their blog post from the 9th of May entitled "Is volatility a thing of the past?":
"Most of the political risk is behind us in Europe. Unless his party shows very poorly during the general election next month, Mr Macron should be in a position to at least form a coalition with the center right. In the UK, there seems to be little doubt that the Conservative will secure a strong majority in Parliament in a few weeks. In Germany, whoever comes on top in the September ballot will be a member of the current ruling coalition. So the main source of uncertainty is Italy where the 5-star movement and its anti-euro stance is leading the poll, but elections should not be held this year. We know that they will take place before May 2018, but their exact date has not been set. With talks around the restructuring of the Greek debt apparently making progress, the euro area should enjoy a period respite. That is the message sent to the market by investors who are selling options, betting on a very low realized volatility up to the September expiry. The implied volatility of options with a strike 10% out of the money are trading sub 40% on all indices for the next 5 expiries." - source DataGrapple.
Have reached peaked complacency? One might wonder. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 8th of May and displays C&I Loan demand versus the VIX index which clearly shows that often weak credit demand tends to be associated with high volatility which shouldn't be that surprising given we live in a credit based world:
"Senior loan officers vs. VIX
One of the key stories we have been tracking for most of the year is the lack of loan demand in the US across the board. That was apparent in the February Senior Loan Officer Survey as well as subsequently weekly bank asset data from the Fed. Hence not surprisingly today's fresh Sr. Loan Officer Survey showed continued very negative
growth in consumer loan demand as well as deterioration into negative territory for C&I lending. It thus appears that the key post-election story continues - i.e. while optimism is high everybody is in wait-and-see mode pending details on tax reform from the new administration. The longer this lasts the greater the risk of more weakness in hard data. It appears a great contradiction to these circumstances that the VIX closed today at 9.77 - the lowest since December 1993. Weak loan demand tends to be associated with high volatility, not low (Figure 1)."
- source Bank of America Merrill Lynch

If credit conditions are tightening in both China and the US, and we continue to see a weaker tone in the commodities space, it is hard not to start worrying about weaker aggregate demand overall and not only in oil prices. Yet another brick to keep an eye on in your personal wall of worry we think but we ramble again...

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman.

Stay tuned!
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