Thursday, 24 August 2017

Macro and Credit - The Dead Parrot sketch

"Fake is as old as the Eden tree." - Orson Welles

We read with interest the latest minutes from the FOMC and in continuation with our previous themes of revivals of defunct model, obviously once again their "beloved" Phillips curve model came to the forefront of their discussions, not only at the Fed but at the ECB as well. Therefore, when it came to selecting this week's title analogy, we could not resist but use a reference to Monty Python's flying Circus Dead Parrot Sketch which first aired on the 7th of December 1969. The sketch portrays a conflict between disgruntled customer Mr Praline (played by Cleese) and a shopkeeper (Michael Palin), who argues whether or not a "Norwegian Blue" parrot is dead. It pokes fun at the many euphemisms for death used in British culture. Obviously, one could be disgruntled at our central bankers and the lack of inflation within their inflation mandate. In the meantime some sell-side pundits and most recently central bankers have continued to discuss if the Phillips curve is "dead" or simply "resting" like a "Norwegian Blue" parrot. We rest our case. We find it amusing that a joke dated c. CE 400, recently translated from Greek, shows similarities to the Parrot sketch. It was written by Hierocles and Philagrius and was included in a compilation of 265 jokes titled Philogelos: The Laugh Addict. Probably yet another case of "barbaric relic" given the affection for gold from our central bankers but we ramble again...

In this week's conversation, we would like to look at the ongoing 2007 party like in credit that keeps going while there is indeed the need to be more discerning (beta wise that is) we think at this stage but first we will take another potshot at the Phillips curve cult members.

  • Macro - The Norwegian Blue parrot really DID exist but not anymore...
  • Credit - Smarten your beta
  • Final chart - Credit Mad Men

  • Macro and Credit - The Norwegian Blue parrot really DID exist but not anymore...
The latest FOMC notes from the July minutes do indicate how puzzled our central bankers have become on the validity and efficiency of their Phillips curve framework. Back in May this year in our conversation "Wirth's law" we discussed the wage conundrum in the US, pointing out that real wage growth had so far eluded the Bank of Japan and are still eluding the United States, hence the dismal prospects for inflation expectations given high qualification jobs in many instances have been replaced by low qualification jobs (yes training matters...). Also, 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.

Following our recent musings our friend Kevin Muir, the author of the excellent and very entertaining blog the Macro Tourist reached out and asked several questions relating to the Norwegian Blue parrot aka the Phillips curve:
"Hey Martin.  I just your latest two pieces.  I really enjoyed them.  
What is your belief about the Phillips curve?   Is it dead?  Shifted down?  
I know you discussed your views about the mismatch in skills, but the curve does indeed seem to be obsolete.
I know to some extent it doesn't matter what we think- the Fed's reaction function is what matters.  But I am curious about your personal thoughts.  
I am beginning to think that Yellen's training as a labour economist is making her more hawkish than she should be.  As you point out, they think inflation is coming.  So they are tightening.  
I realize you are probably more bearish on the economy than me, so it is easier to say the Phillips curve is not kicking in, and the economy is rolling over, so the point is moot.
But if we get a global economic upswing that drags the US along, will we see real wage growth?  
Thanks, Kev." - source Kevin Muir, author of the Macro Tourist
Of course real wages are that's the most important point for inflation expectations, real wage growth matters and matters a lot. We pointed out a few things to Kevin such as the fact that a business owner is always a "deflationista", in the sense that he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. No offense to our central planners of the world but true capitalism is inherently "deflationist" when it comes to prices. For the simplicity of our reasoning, we are not taking into account oligopolies, cartels and other shenanigans being played these days in many instances (ZIRP, NIRP, etc.). Real prices always fall and inflation is simply organized theft which is willingly pursued and supported by our central bankers, at 2% or even 4% (should they decide to try and fail in tweaking their sacrosanct target).

As well, we pointed out to Kevin the excellent work of (unfortunately little known to so many) French economist Jean Fourastié relating to real wages, real prices and productivity. One particular book comes to mind "Pourquoi les prix baissent - Why prices fall". published in 1984. We do not know if this book is available in English, but, in our humble opinion it is a must read book and should be on the required reading list of any serious central banker or aspiring economist.

For Fourastié, real prices could only be observed by dividing the prices of any product by hourly wages (link in French). The inverse of real prices calculation measures purchasing power parity. What is the most important economic fact in the last 300 years? Most probably the fall in "real" prices for wheat prices with hourly wages on the Y axis:
- source Jean Fourastié

Also in our previous conversation from September 2012 "Pareto Efficiency" we indicated the following when it comes to "wheat prices" and "revolutions":
"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.
  Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.
When it comes to volatility in wheat prices and the ultimate effect of manipulating prices or when "real" prices become "fake" prices or "manipulated" prices, we reminded ourselves with our May 2016 conversation "When Doves Cry" and the fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation":
At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:
"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 
The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets.
To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:
  -source Macronomics, May 2016 

Hence the importance of using observable "real prices" and the impact monetary inflation can have on hourly wages and purchasing power when you want to assess the levels of inflation (Venezuela comes to mind...). We also reminded ourselves of Adam Smith's quote in relation to real "price" formation:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith

But moving back on the subject of the Norwegian Blue parrot, we read with interest Barclays Global Economics note from the 18th of August entitled "Questioning the reliability of the Phillips curve:
"Inflation discussion dominates July minutes
  • The FOMC deliberated at length the risks to the inflation outlook, including the effectiveness of its current Philips curve framework in forecasting inflation.
  • Although the minutes reveal increased concern about the inflation outlook, we did not sense that the committee is ready to pause rate hikes at this point.
  • The committee sounded confident about labor market progress, but financial stability and further easing in financial conditions were a concern.
Three broad themes that stood out from the July FOMC minutes, in our view, are the increased concern among committee members about the inflation outlook; strong consensus that labor market progress has been significant; and worries about financial stability, given easy financial conditions despite monetary policy tightening. Even if the committee may have wanted to strike a balanced tone between its concerns about inflation (which would argue for a more cautious tightening path) and those about financial stability (which would argue for continuing on its path), markets seemed to read the minutes as dovish and lowered the probability of a December hike significantly, from 44% to 36%.
Also notable in these minutes was the change in tone with regards to federal government policy. Earlier in the year, committee members viewed fiscal policy as a potential upside risk to the growth and inflation outlook, but in the July minutes, those expectations were toned down or reversed. A few in the committee pointed out that “the likelihood of near-term enactment of a fiscal stimulus program had declined further or that the fiscal stimulus likely would be smaller than they previously expected,” while several others commented that policy uncertainty (including fiscal policy, trade, and health care) “was tending to weigh down firms’ spending and hiring plans.” This downgrade on the policy front was balanced to some extent by an upgrade of the external sector, as a brighter international economic outlook was seen as boosting prospects for US exports.
We maintain our call for a December hike, but see recent inflation data and the discussion in the FOMC minutes as having lowered the likelihood of its happening. In our view, continued misses on the inflation front would not make it tenable for the FOMC to hike in December. Further disappointment in this front could pause the path for the federal funds rates until the FOMC feels confident that its price stability mandate is within reach.
Some in the FOMC question the validity of its current inflation framework
The committee recognised continued misses on its inflation forecast and suggested that it would likely remain low over the second half of the year. But it also continued to assign much of the recent decline to idiosyncratic factors. While the discussion about the near-term outlook seemed broadly unanimous, there was more disagreement about the medium run. “Many” participants saw risks that inflation would remain below 2% for longer than they currently expected, and “several” saw risks to inflation as tilted to the downside. Similarly, while the committee agreed on the importance of long-term inflation expectations, not all agreed that they remained stable, and “a few argued that continuing low inflation expectations may have been a factor putting downward pressure on inflation”.
But perhaps a bigger surprise came when a number of participants challenged the way in which the Fed analyzes and forecasts inflation. They argued that “much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as […] employment of resources increased above long-run sustainable levels” – basically, a description of a Phillips Curve (PC) type of framework. A few participants argued that it was not particularly useful in forecasting inflation, while most said it remained valid despite its recent flatness. While we would agree with the latter group, we find the very opening of this discussion as evidence that concerns about the persistent misses on the inflation mandate are starting to weigh on the committee. While many have criticised the PC before, no clear candidate has emerged as a way to analyze inflation in a monetary policy setting, a fact that will, in our view, limit how far this discussion can go within the committee.
Instead, a common theme among policymakers in recent years has been to find exceptions that could have led to a temporary and transitory flattening in the PC. These minutes were no exception, as they listed a number of reasons for the coexistence of low inflation and low unemployment, including less responsiveness of prices to resource pressures (stickier prices), a lower natural rate of unemployment, more slack in the labor markets that may not be captured by the unemployment rate, nominal wage growth and inflation reacting with a lag to labor market tightening, and a loss of firm pricing power from global developments and from technology.

While we do not think the Fed reached the conclusion that its inflation framework was invalidated by the recent softness in inflation, having this discussion at all raises the risk of a shift in the reaction function away from a focus on resource utilization and the PC. But it could also drive the FOMC to look for areas where it may have mis-measured the amount of spare capacity in the economy, for instance in the recent increase in the labor force participation rate of prime age women (see Rising participation among prime age workers, August 11, 2017). As discussed in Wage growth is not as weak as it seems, August 4, 2017, we share the committee’s view that the rate of increase in nominal wages is not low in relation to the rate of productivity growth and the modest rate of inflation. Overall, this shift in emphasis could likely imply fewer rate increases over the forecast horizon, given the weakness in incoming inflation data since earlier this year. We continue to expect an announcement on balance sheet normalization at the September meeting and a third rate increase this year in December, but we have reduced our subjective probability about a rate increase later this year to about 50% (down from 60% previously)." - source Barclays
To be fair to the Phillips curve cult members and also to Monty Python, the Norwegian Blue parrot did really exist as pointed out by a Daily Mail article in may 2008:
"Adding to the absurdity was the fact that parrots - being tropical birds - don't come from Scandinavia.
Or do they? For now, in a development putting the sketch in a completely different light, it turns out that the Norwegian Blue did exist.
Dr David Waterhouse, a fossil expert and Python fan, has found that parrots not only lived in Scandinavia 55million years ago, but probably evolved there before spreading into the southern hemisphere.
His discovery was based on a preserved wing bone of a previously unknown species, given the scientific name Mopsitta Tanta - and now nicknamed the Norwegian Blue.
The dead parrot script, voted Britain's favourite alternative comedy sketch by Radio Times readers in 2004, was written by Cleese and Graham Chapman and first broadcast in 1969.
As he returns the ex-parrot to Palin's pet shop, Cleese is assured it is just resting or stunned, being "tired following a prolonged squawk" and "pining for the fjords".
Cleese bangs it on the counter, trying to wake it up, screaming: "Hello, Mister Polly Parrot! I've got a lovely fresh cuttlefish for you!" But it is definitely expired.
Dr Waterhouse, 29, said of Mopsitta Tanta: "Obviously, we were dealing with a bird that is bereft of life, but the tricky bit was establishing it was a parrot."
He was studying for a PhD at the University of Dublin in 2005 when he visited a museum in Jutland and spotted a fossilised 2in-long humerus - appropriately enough, the funny bone - among bird remains which had been found near an open-cast mine.
Research has now confirmed the bone was part of an upper wing from a bird in the parrot family. Although the mine was in Denmark, the birds would also have lived in what is now Norway."
[ ...]

"However, the Pythons were wrong about one thing...the Blue could hardly have pined for the fjords.
"This parrot shuffled off its mortal coil around 55million years ago, but the fjords in Norway were formed during the last Ice Age and are less than a million years old," said Dr Waterhouse." - source Daily Mail
So dear Kevin, to answer your question we think that the Phillips curve, in similar fashion to the Norwegian Blue parrot did exist but is now simply "resting" in a Monty Python way. Same goes for the ECB's view on the Phillips curve as per Barclays recent note:
"The ECB’s accounts focused on a flat Phillips Curve and financial stability
The ECB’s accounts of the August meeting explored the Phillips Curve relationship in detail. Given the latest data, the accounts “acknowledged the strengthening of the economic expansion and confirmed that the risks to the growth outlook were broadly balanced”. At the same time, the accounts contain a very detailed discussion of the flattening Phillips Curve relationship, including due to labour market reform, hysteresis effects from prolonged high unemployment, the backward looking nature of wages, as well as the deleveraging process in the euro area. Nevertheless, the GC argued that the Phillips Curve relationship likely remained intact, but that “patience, persistence and prudence” were needed as this process would likely take time and be contingent on “very substantial degree of monetary accommodation”. While the statement explicitly mentions firm survey evidence of emerging labour shortages, a decomposition of the euro area wide European Commission survey (Figure 1) suggests that this is mainly driven by Germany (Figure 2), where, despite a 3.8% unemployment rate, wage pressures remain to be seen. Overall, the discussion is in line with underlying inflation on a moderate recovery trend and is unlikely to accelerate in the near term (Euro area inflation: Core improves but doesn't shift gear, 31 July 2017)."
All in all, with "patience, persistence and prudence" like the shopkeeper in Monty Python's sketch, we might see the Phillips Curve come back to life, but for the moment it is pretty much as the Norwegian Blue parrots, they really DID exist - but now they are all 'stiff, bereft of life and ex-parrots'.

This ends our numerous potshots we have taken in 2017 relative to the Dead Parrot aka the Phillips curve. In our credit point below, we have in recent months suggesting rotation towards higher quality credit and also recommended playing more defensively at this stage of the credit cycle while we continue monitoring the trend in credit conditions in particular consumer credit.

  • Macro and Credit - Smarten your beta
Back in June in our conversation "Potemkin village", we posited that as the Trumpflation narrative was fading, so was the beta narrative. In fact our tool DecisionScreen told us the same at the time when it came to its signal switching to slightly negative for US High Yield. The aggregated rule we use 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 beta trade is also a function of investors’ perception about the pace of QE. Our central planners might be using a dead parrot for guidance, but, anyone is trying to guess the change of the rhetoric, should the doves finally become hawks in the near term given financial stability matters and matters a lot for this crowd. We continue to remain slightly negative on US High Yield and we monitor closely the shape of the CDX High Yield curve, particularly the front-end, to see whether the curve is starting to flatten or not.

On the subject of smartening your beta we read with interest Barclays US High Yield note from the 18th of August entitled "Choose your Beta Wisely":
"Some of the fear that gripped risk markets due to geopolitical events just a week ago looks to have subsided. But the pick-up in volatility during that episode, has many investors more closely considering the tie between credit and equity markets. On the surface, there appears to be a dislocation between SPX and high yield valuations, but we expect the relationship to revert to its historical beta once the earnings-related volatility subsides.
US HY Still Looks Dislocated Versus S&P 500; Less So Versus Russell 2000
To start in Figures 1 and 2, we simply plot US HY Index spreads versus the S&P 500 ("S&P") and Russell 2000 ("RTY").

While not perfect comparisons, we believe asset allocators and specialists alike often look to the two broader indices to help formulate a first cut opinion on cross-asset performance and relative value. In terms of a short-term signal worth further dissection, we find that US HY spreads look modestly dislocated (wide) relative to its relationship with the S&P since the beginning of 2016. The relationship looks more in line when comparing US HY to the RTY. These findings are consistent with the broader narrative of small-cap equities and other higher-beta risk assets underperforming in August.
What could further explain the divide? Constituents differences and relative sector weightings provide a clue. Among the set of issuers in the High Yield Index, 62 are also in the S&P and 224 are also in RTY, with each group accounting for roughly 18% of par outstanding in the High Yield Index. Not surprisingly, the quality breakdown shown in Figure 3 suggests that the S&P cohort is higher in quality relative to the RTY constituents.

While neither cohort is exactly comparable to the High Yield Index, the quality weights of the High Yield Index align slightly better with the RTY than the S&P, which may help to explain the dislocation seen in Figure 1. That said, higher-quality credits have actually underperformed on a beta-adjusted basis recently, as noted in this week's Tuesday credit call. As a result, we find the magnitude of high yield's underperformance with respect to the S&P somewhat surprising considering that high yield is underweight higher quality.
Figure 4 shows the differences in sector exposures relative to the High Yield Index for both equity index's matched cohorts.

With the exception of energy, the S&P cohort is actually more closely aligned with respect to index weights than the RTY cohort. That said, the S&P's relative underweight with respect to energy has been a key driver of its outperformance relative to both the RTY and US HY in 2Q17, when E&P companies were faced with a litany of issues. However, adjusting for the differences in sector exposures using the weightings of the S&P cohort, we find that the High Yield Index would still have widened by the same 31bp in the aftermath of the recent sell-off despite its outsized energy exposure.
Quantifying How Sensitive Credit Returns Are To Equity Returns Now
While optically, high yield may appear modestly disconnected with respect to the S&P 500, it's worth noting that this relationship is somewhat fickle. In Figure 5, we track the trailing 6-month betas of daily total returns of the US High Yield Index versus the S&P and RTY.

As shown, both have gyrated significantly over time, suggesting that there is not a single best fit to explain the relative performance of credit and equities beyond short periods of time. At the moment, the betas are all generally towards the lower end of their two-year range, though slightly higher for the S&P than the RTY. This likely reflects the relatively more benign macro and volatility backdrop that has persisted for most of the last 12 months now that many of the stresses around weak commodity prices in 2015 and 2016 have become better understood and digested.
While it is true that the credit/equity relationship has been far from stable, it is interesting to note that the High Yield Index has consistently displayed higher sensitivity with respect to the S&P than the RTY. In other words, in order to design a "true" delta neutral portfolio, one would theoretically have to short more units of the S&P than the RTY against a long High Yield Index exposure. Of course, determining the "correct" market neutral hedge ratio is complicated by the changing face of the equity/credit relationship. Nonetheless, using the rolling 1-year historical total return beta to equities as the hedge ratio, we find that the return of the hedged portfolio is closer to zero using the SPX (Figure 6). 
A simple regression of weekly returns of the SPX and RTY against HY returns over the past five years would suggest that high yield displays a marginally better fit with respect to the S&P (R-squared of 36%) than the RTY (33%). Over the past month, however, high yield performance has more or less tracked its beta to the RTY month-to-date total returns through Wednesday's close (0.16x) has been closer to its historical beta to RTY (0.21x). Meanwhile, the ratio of high yield to SPX returns (-6x) suggests that its relationship to SPX (characterized by a total return beta of 0.32x to S&P) has recently broken down. For the reasons stated above, this divergence has less to do with its outsized commodity exposure, and has more to do with idiosyncratic stories and earnings-related volatility. But looking forward, we believe that high yield will perform more in line with its historical beta to the SPX once these concerns subside" - Barclays
Of course it should perform in line with its historical beta to the SPX. It remains to be seen how long US High Yield and the S&P 500 maintain their "elevated" valuation level. This of course, partially depending on the trajectory that will be taken by oil prices in the second part of the year.

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from we also used in the past (data up to the end of July):
Correlation 0.966, R2 0.933, 139 months in sample - source

In case you are asking, it shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits.

When it comes to credit, defaults and leverage matters but pointing out the "low default rate" in Europe or elsewhere like some pundits do, it is we think "oversimplistic". Leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash we think should you want to play the "hedging" beta game. Just a thought. When it comes to the maddening crowd our final chart displays WPP cds prices move following their profit warning and the warning it delivered for both credit and equity players.

  • Final chart - Credit Mad Men
 Our final chart comes from DataGrapple's latest blog entry entitled "Do as I say, not as I do" and displays WPP CDS 5 year price evolution. The comments they made are very interesting from the point of view of credit investors but as well in the light of  WPP's "forward guidance" and the very challenging situation for retail. One might wonder if the situation will be contained...
"WPP blames “Uncertainty and short-termism reducing investment in favor of buybacks/dividends, although market levels lowering attraction” as a reason for the lack of dynamism of the advertising market. Companies are cutting costs to keep dividends & buy-backs very close to 100% of operating profits. At the same time WPP intends “Use of our substantial cash flow to enhance EPS through acquisitions, share buy-backs and debt reduction”. This was not enough to avoid the 10% drop in WPP’s share price today. WPP credit default swap did not react as much. The CDS is only 3 bps wider at 63 bps. Looking at the attached grapple, we see that the credit market is much more cautious on WPP for some time. The CDS is 40% wider than its lows mid-June. The company intends to use cheap debt to increase its net debt to twice its EBIDTA. The uncertainty of WPP’s EBITDA is a new challenge for credit investors. However, today was more an equity story with an interesting analyst presentation with a lot of data. WPP confirmed for instance the stress on the retail sector which is cutting on ads, -3% yoy.
Meanwhile, the credit index market was quiet. The credit index index option market was busier with some investors looking at options rather than outright hedges for the months to come." - source DataGrapple
As we pointed out recently, credit options are still a cheaper way in hedging your credit bets than going outright long the CDS index from a negative carry perspective. Volatility might indeed return in September thanks to additional US political uncertainties and other exogenous factors. It remains to be seen if contrary to the Phillips curve, volatility is not a dead Norwegian Blue parrot after all, we don't think it is but we ramble again...

"What the eyes see and the ears hear, the mind believes." - Harry Houdini

Stay tuned!

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