Monday 12 June 2017

Macro and Credit - Potemkin village

"Now I believe I can hear the philosophers protesting that it can only be misery to live in folly, illusion, deception and ignorance, but it isn't -it's human." - Desiderius Erasmus

Looking at the CoCo Bond slaughter surrounding the €1 takeover of ailing Spanish banking giant Banco Popular by another giant Santander, while thinking about the much vaunted narrative surrounding a Spanish "recovery", we reminded for our title analogy of Potemkin village. While markets are still racing ahead, on renewed optimism and reduced wall of worries, with credit still in tightening mode, thanks to significant fund inflows, we are already seeing some cracks in the narrative, particular in consumer credit in the US decelerating, which we think warrant close monitoring. On the subject of our title analogy, a Potemkin village is any construction (literal or figurative) built solely to deceive others into thinking that a situation is better than reality (Spain and other subjects come to mind). The term comes from stories of a fake portable village built to impress Empress Catherine II during her journey to Crimea in 1787. In similar fashion the story surrounding the appeal of AT1 bonds aka CoCo bonds and the recovery of some part of the European banking sector is akin to a Potemkin village, with a narrative solely built to deceive others into thinking that the situation is better than reality. On numerous occasions we have voiced our distaste for European banks equities. In this on-going "Japanification" process, we would rather continue to play the credit part, but, we continue to have a profound aversion for CoCo bonds, being short gamma that is and its poor risk/reward "beta" proposal.

In this week's conversation, we would like to look what we think of the second part of 2017 and why we are switching, probably early to "defense" and asking ourselves how long before the cycle turns.

  • Macro and Credit - Credit cycle turning, dude are we there yet?
  • Final chart - US Consumer Credit taking a break.

  • Macro and Credit - Credit cycle turning, dude are we there yet?
While we have been wise in early 2017 to fade the US long dollar crowd while remaining short term Keynesian and bullish equities and all things credit in the first part of the year, supported by strong fund flows thanks to NIRP still plaguing a significant part of the Fixed Income world, the deflation of the "Trumpflation" narrative could indeed put a spanner into the most recent performances of the various beta trades, one being High Yield. For the much vaunted "reflation" trade to continue to play out we think, you would need higher inflation expectations and higher and steeper yield curve. In both last two instances, no matter how the Potemkin narrative is playing out for some pundits, appearences, unfortunately can be deceptive, particularly when you cannot hide a flattening yield curve. 

With European High Yield yielding a paltry 2.59%, we can always go tighter à la 2007, but, credit wise, the risk-reward appears to us less and less appealing with US 10 year Treasuries yielding 2.21%. The Iboxx HY Corporates cash index dropped to just 2.89%, setting a new record low in the process, which is of course supported by the hunt for yield and significant inflows. While it doesn't mean you need to rush for the bunker and don a kevlar helmet as of yet, it does seems to us that there are already cracks showing up in the narrative such as weakening loan demand and decelerating consumer credit that already warrant close monitoring in this long extended credit cycle.

What appears to us fairly clearly is that, as the Trumpflation narrative is fading, so is the beta narrative. The outperformance in beta at least in credit has been very significant in the first half of 2017 and as well during the second part of 2016. Yet as we posited above, it looks to us increasingly that the second part of 2017 could become more complicated for a continuation in all things beta and we would rather reach for quality at this stage in credit. On the subject of beta in credit, we read with interest Bank of America Merrill Lynch's take on the subject in their Credit Strategy note from the 9th of June entitled "Beta losing its shine":
"Beta is losing its shine
A year ago ECB bought its first corporate bond, as part of the CSPP program. Lots have changed since then. ECB now holds more than €90bn of corporate bonds; an eighth of the eligible bonds universe. The beta trade has been in vogue since.
There is a clear correlation between macro and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins). So for the beta trade to continue outperforming we need higher inflation expectations and higher and steeper rates. With inflation expectations lowering in the past months we see risks that the beta trade has less favourable risk-reward profile. The dovish ECB yesterday further supports our view that in relative terms beta will underperform from here.
A key factor that has supported the relative outperformance of high beta over low beta pockets of the market was the rates cycle. Higher inflation expectations and higher and steeper rates were pivotal to see the beta trade performing. With inflation expectations lowering in the past months we see increasing risks that the beta trade has less favourable risk-reward profile. To be clear, we are not saying that high beta parts of the market will stop tightening, just that their relative outperformance will significantly reduce.
We think that the beta trade is linked to the growth outlook and inflation expectations. The stronger the economic data and the subsequent improvement in inflation expectations, the stronger the outperformance of high-spread / high-beta assets vs low-spread/ low-beta ones. As the chart above shows, there is a clear correlation between macroeconomic metrics (5y5y inflation swaps for instance) and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins) on a spread ratio basis. 
Till this backdrop improves again, we will favour reducing risk on corporate hybrids, high-yield bonds and senior financials CDS (vs senior bonds, high-grade credit and iTraxx Main, respectively), beta pockets that have performed significantly in the past months." - source Bank of America Merrill Lynch
We do agree with the above and in fact our tool DecisionScreen is telling us the same when it comes to its signal switching to slightly negative for US High Yield:
The current signal is at -0.25. The aggregated rule is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The trading rule statistics from 1986-09-03 to 2017-06-07 delivered a Sharpe Ratio of 2.13 with an annual volatility of 2.40%.

From a low volatility perspective, should we see in coming weeks a renewed bout of volatility, given the strong inflows in fund flows in conjunctions of the return of Bondzilla the NIRP monster made in Japan returning to play with Japanese Lifers and their friends deploying their cash, as pointed out in Bank of America Merrill Lynch, credit outperformed stocks in Europe last month and could continue to prove more resilient in case of some weaknesses in the equities space:
"The beta trade is also a function of investors’ perception about the pace of QE. As credit investors were expecting the ECB to start tapering purchases across the sovereign and the credit program proportionally (more in our Credit Investor Survey from April), they looked to add more beta, riding the reach for yield trade. However, credit investors realised, over the past month, that the ECB is more than happy to up the CSPP program when supply comes and thus provide stronger support for “eligible” assets. Additionally “eligible” assets look cheap vs “non-eligible” assets and thus we think that there is room for a catch up trade, as the ECB is on full-on mode buying “eligible” credit instruments.
We will be looking for two signals for us to become more constructive on beta-assets: (i) a pick-up on inflation expectations and (ii) a slower pace of the CSPP. Till then we expect the relative pace of tightening of high beta pockets like corporate hybrids, high yield bonds and senior financials CDS (vs seniors, high-grade and iTraxx Main, respectively) to slowdown." - source Bank of America Merrill Lynch
Whereas we remain more defensive on High Yield at the moment, tactically speaking, Investment Grade in both Europe and the US should be more resilient in the case of renewed pressure on equities and high beta credit, hence our appetite to reach for quality rather than yield currently. Wednesday will set up the tone for both inflation expectations and the Fed's hiking path as we will get the most recent reading on Core CPI in the US. Yet the deceleration in credit growth seen as of late is a cause for concern and it will be interesting to see the Fed's take on the subject. With the recent weakness seen in US breakevens pointing towards a deflation in the "Trumpflation" narrative, we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 9th of June entitled "Deflation and rate hike":
"Deflation and rate hike
Since 1957 there have been 722 overlapping two-month periods. As core CPI prices almost always go up (Figure 1), in only six of these, or less than 1%, have we seen core CPI deflation – but that includes the most recent March-April period this year (Figure 2).

On Wednesday we get the most recent (May) reading on core CPI as well as the Fed’s rate decision. With the Fed widely expected to hike, and normally not inclined to surprise investors, a rate hike is the baseline. But the inflation data has to be concerning, especially as long term inflation expectations have now completely retraced their post-election increase (Figure 3).

Moreover, as we have consistently pointed out this year, other data is week and suggest everybody is in wait-and-see-mode, including C&I and consumer lending data (see: Situation Room: In wait and see mode 07 February 2017). So the Fed has to be very careful in crafting the statement message and press conference. While the biggest near term risk for spreads remains a correction in equities we remain bullish on HG credit spreads." -source Bank of America Merrill Lynch
As well, if indeed there is a return of the "Japanification" narrative and a continuation in soft data, not only it makes sense to reach for Investment Grade credit but it makes also sense to go for MDGA (Make Duration Great Again). As we stated flow wise, Investment Grade is not losing steam as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 9th of June entitled "Buy what they (ECB) buy":
"Highest inflow into IG in 44 weeks
Tapering? What tapering? CSPP buying numbers have been moving higher in the past month, while PSPP absorbed most of the tapering pressure. IG credit emerges as the winner, as investors are piling on the same ECB trade that worked when CSPP was announced. The “buy what they buy” is hence making the IG market highly resilient. Another reason why inflows have been strong lately, especially for the mid- and long term funds, has been the slowdown and reversal of the trend seen in the previous months of higher and steeper yield curves. As our analysis has shown, the level and trajectory in the rates market is a very strong predictor of flows in credit market.
Over the past week…
High grade funds recorded another week of inflows; the 20th in a row. The latest inflow has been the highest in 44 weeks and the second-highest since EPFR data started. High yield fund flows remained in positive territory for a seventh week. Inflows to European-domiciled HY funds were coming from European and global-focused funds, while US-focused funds recorded outflows. Government bond fund flows were marginally positive last week, recording the first inflow in five weeks. Money market funds recorded their second consecutive weekly inflow. Overall, Fixed Income funds recorded their 12th consecutive weekly inflow and the highest in 45 weeks, thanks to a strong credit inflow.
European equity fund flows were positive for the 11th week in a row. The asset class has seen a positive trend despite the volatility in the size of inflows." - source Bank of America Merrill Lynch
The latest dovish comments from the ECB's supremo Mario Draghi is providing additional support for the fun uphill, the bond market that is. The carry trade in Europe is still the trade du jour thanks to the central bank and its purchases. But, behind the deceitful narrative, we remain very wary of oil prices and its deflationary weigh on "inflation expectations" and the potential for additional sell-off they could trigger in financial assets thanks to some Sovereign funds and oil producing countries under pressure from continuing lower oil receipts. 

Behind the Potemkin village of higher equity prices and tighter credits lies the on-going fight to the death between OPEC countries in general and Saudi Arabia in particular with US shale producers. The strategy of trying to drive US shale producers towards bankruptcy has spectacularly backfired thanks to innovation in 2016. On this subject Bank of America Merrill Lynch again highlighted in their 2016 Breakeven Analysis published on the 9th of June in their report entitled "The Incredible Shrinking US Breakevens" the relentless fall in breakeven prices which spell bad news in the light of recent OPEC cuts trying to offset the stiff competition. 
"2016 Breakeven Prices declined 9%…1-yr B.E. & $43/boe
In 2016, North American investment grade oil & natural gas producers continued to sharply reduce their cost structures with the mean aggregate breakeven (B.E.) price declining 9% to $54.22 per equivalent barrel of oil (/boe). However, when we adjust our methodology to look at B.E.s using reserve replacement costs (RRC) from just 2016, we find that B.E.s are much lower than that with a mean cost of $42.64 per boe with 11 of 17 companies having B.E. cost structures under $50/boe.

In short, this clearly explains why with oil prices trading around $46 per barrel WTI, the U.S. rig count continues to rise. Companies are making attractive (in some cases VERY attractive) returns in the current price environment. With capital still relatively cheap, our analysis suggests that crude prices would need to decline back to $40/bbl to change this behavior.
2016 Breakeven Prices declined 9% over 2015
Operating costs decline but lower realizations offset some of the benefit After the sharp 16% decline in the industry breakeven price among North American investment grade (IG) issuers in 2015, the aggregate breakeven price for the industry declined to $54.22 per barrel of equivalent production, down another 9% from 2015. Total costs for the seventeen companies in our annual breakeven report declined by 11% in 2016, relatively lower than the 15% reduction in unit costs we have calculated last year. Producers continued to cut costs in the first half of the last year and consequently cut production as commodity prices softened. While these cost savings are significant, we believe that it will be difficult to continue to cut costs beyond a point. Added to that, average price realizations relative to the West Texas Intermediate and Henry Hub averages for the year modestly declined to 57% from 58% in the previous year.
As commodity prices declined further, producers adopted different strategies to optimize costs like rationalizing production expense, reducing employee counts, recontracting service terms, asset sales, etc. Our annual review of unit costs and resulting breakeven calculation showed this declining trend clearly with 14 of the 17 companies achieving breakeven cost reductions.

The decrease in revenue due to lower realizations and production cuts more than offset declining costs and as a result, average margins per boe fell 10% y-o-y to a loss of $6.25/boe. In particular, the gassy names saw margins erode or if they did rise, the improvement was at a much slower pace than oil producers." - source Bank of America Merrill Lynch
On a side note, the velocity in the surge of 5 year forward breakeven inflation is what killed Gold post the US elections. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations matters. Both gold and TIPS function as a hedge against unexpected inflation. But returning to the relationship between commodities and rising real rates we also agree with Bank of America Merrill Lynch's take from their Global Liquid Markets note from the 12th of June entitled "Oil is the Fed's canary":
"Commodities perform poorly on rising real rates...
Yet our rates strategists argue that opposite seems to be happening. For starters, as a number of Trump administration initiatives such as tax and health care have stalled, economic growth expectations have fallen. Also, gasoline prices are already down year on year as OPEC production cuts have failed to remove the oil inventory overhang, acting as a drag on inflation (Chart 5).

Moreover, a fast and furious recovery in US shale oil production YTD suggests we are witnessing yet another technology-induced deflationary episode. With expectations already stretched, a less accommodative Fed that accidentally creates a higher real rate environment could further exacerbate the recent drop in commodity prices. We have previously found that rising real rates are associated with negative commodity beta returns, and falling real rates are associated with positive commodity returns (Chart 6).

Moreover, changes in commodity prices can mechanically cause big swings in realized inflation, but can also drive expected inflation near term, exacerbating the Fed's problem. another sell-off may signal a policy mistake
Real rates have a causal impact on commodity prices due to a variety of transmission channels (Chart 7).

Demand for consumed commodities like oil and base metals tends to fall when real rates rise all else equal, as it makes consumption of energy intensive goods harder to finance. Higher real rates also tend to be associated with a stronger USD, which can hurt consumption of energy intensive goods in EM countries. True, periods of high nominal yields have been associated with higher commodity returns during the past 20 years, as economic expansions tend to be characterized by both strong commodity demand and high nominal interest rates. However, periods of ultralow nominal interest rates have been linked to very poor commodity performance since the Global Recession (Chart 8), as commodities need healthy global nominal GDP growth to move higher.

So far, the commodity markets have assumed oil prices are lower because of a supply glut. However, if the Fed hike next week triggers another leg down in commodity prices, the focus may turn on demand conditions. Should the Fed be sleepwalking into a policy mistake next week, commodities may provide some warning signs." - source Bank of America Merrill Lynch
And that's the main issue with the Potemkin village of the GDP recovery story being sold out by many pundits, namely that in reality Global nominal GDP growth is not healthy, yet the Fed is continuing in its hiking path and tells us it is data dependent. 

So to answer the question relating to the credit cycle turning, yes it is slowly but surely turning but, we are not there yet. A burst in inflation and a significant rise in inflation would force the hand of the central banks, and this we think could be the real catalyst for a nasty bear market in various asset classes as discussed recently. We are also data dependent and watching very closely the trend in consumer credit as per our final chart.

  • Final chart - US Consumer Credit taking a break.
Back in our conversation "Orchidelirium" at the end of last month we asked ourselves if the US consumer was "maxed out".  We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. This is a significant indicator to monitor in the coming months we think and our final chart comes from Wells Fargo Economics Group note from the 7th of June and shows that consumer credit was below expectations in April and shows that year-over-year percent change in consumer credit needs to be monitored closely: 
"Consumer Credit Growth Decelerates
  • Consumer credit rose by just $8.2 billion in April, the slowest pace since mid-2011. Both nonrevolving and revolving credit growth were soft in the month.
  • Revolving and nonrevolving credit growth have continued to move in lockstep on a year-ago basis. This convergence makes sense as student and auto lending cool, while revolving credit plays catch up after an unusually slow recovery." - source Wells Fargo
While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general.

"Everything's fine today, that is our illusion." - Voltaire
Stay tuned!

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