Monday, 18 September 2017

Macro and Credit - The Two Who Stole The Moon

"Three things cannot be long hidden: the sun, the moon, and the truth." - Buddha

Watching with interest the continuation of the beta trade in conjunction with new record highs in US equities, we listened with great interest to the interview on Bloomberg of the always wise real Gandalf of central banking namely William White from the OECD. In this must see interview, the former great wizard of the BIS goes through the "end game" and the current state of affairs. Given recent discussions in the central banking world of helicopter money and also the growing discussions about universal basic income, while thinking about our title analogy, we reminded ourselves of the 1962 Polish children's film based on  Kornel Makuszyński's 1928 story "The Two Who Stole the Moon". The film stars the Kaczyński twins, two of the country's future political leaders of Poland incidentally. Despite having been known to Polish children for many generations, the film gained renewed fame in the 2000s because it starred two of the country's future leaders: Lech Kaczyński, who served as President of Poland from 2005 until his death in a 2010 plane crash, and his identical twin brother Jarosław Kaczyński, the Prime Minister of Poland from 2006 to 2007, Chief of Office of the President of Poland from 1990 to 1991, and current chairman of the Law and Justice party. The twins were thirteen at the time. The story of the film we are using as a title analogy is about two twins, Jacek and Placek who are two cruel, greedy and lazy boys whose main interest is eating, eating anything, including chalk and a sponge in school. One day they have the idea of stealing the moon; because, after all, it is made of gold:
"If we steal the moon, we would not have to work""But we do not work now, either...""But then we would not have to work at all".
After a few small adventures, they really manage to steal the moon. Immediately a gang of robbers notices the little thieves and captures them. The two regain their freedom, and one of the twins devises a plan to enter the "City of Gold". The plan works, but when the robbers try to collect the gold, they turn into gold themselves. The twins escape and then run home and promise to help their parents with their work as farmers. In similar fashion, our central bankers have been stealing the "printing press" and the idea of "helicopter money" or universal basic income is doom to fail given as posited by Adam Smith:
"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
No matter how our central bankers or bitcoin followers would like to play it, even after "stealing the moon", as the Polish children story goes, the twins ended up having to work with their parents as farmers, labour being the first price, the original purchase, but we ramble again...

In this week's conversation, we would like to look at the financial conditions versus the upcoming update of the Fed's dot plot.

  • Macro - Losing the dot plot
  • Credit - US Investment Grade - putting the brakes on leverage
  • Final chart - The only easy day was yesterday

  • Macro - Losing the dot plot
In our previous conversation "Aleatoricism", we discussed how immune the US yield curve has been to the Fed's "Jedi tricks" given the on-going flattening stance and the recession predictability of an inversion of the US yield curve. A very important point mentioned we think was that with a December hike, the threshold for a 69.2 percent chance of a recession during the next 17 months (average lead time) according to the study we quoted and made by Wells Fargo would be reached. Their framework has predicted all recessions since 1955 with an average lead time of 17 months, therefore one wants to be extra careful in 2018 for any signs of slowdown/recession. What is of interest and in continuation to our last conversation relating to the Fed's dot plot with the upcoming update is that the Taylor rule has fallen about 20 bp since the June update. Financials conditions matter particularly when looking at the Taylor rules used by the Fed. On this subject we read with interest Deutsche Bank's Fed Notes from the 13th of September entitled "Can loose financial conditions save the Fed's dots?":
"With an announcement to begin tapering balance sheet reinvestment viewed as nearly a done deal at next week’s FOMC meeting, focus will be on any signs of a shift in the Fed’s views about the expected policy rate path as represented by the “dots.” While the recent string of soft inflation prints argues for some downgrade to the dots, one key question is how much, if at all, loose financial conditions can counterbalance disappointing inflation and support the Fed’s rate hike expectations.
Taylor rules and financial conditions
Financial conditions have eased considerably in recent months. After bouncing around near zero just prior to the US election – a level indicating that financial conditions were broadly neutral for growth – our high-frequency financial conditions index (FCI) rose to its highest (i.e., most growth-supportive) level in several years in August (Figure 1).

Our FCI has declined slightly over the past month but continues to indicate that financial conditions are loose, signaling solid growth in the coming quarters.
As our FCI has risen, traditional Taylor rules, which do not account directly for financial conditions, have fallen sharply. In recent years, the predicted fed funds rate from a Taylor rule espoused by Chair Yellen in a March 2015 speech has implied a fed funds rate above the Fed’s actual policy rate. However, the recent decline in measures of the neutral fed funds rate, or r-star, and recent soft inflation, have led to a collapse in the prescribed fed funds rate towards the actual policy rate. Indeed, after peaking near 2% at end-2016, the fed funds rate implied by Yellen’s preferred rule has fallen to near 1.2%, just above the current effective fed funds rate (Figure 2).

And the predicted fed funds rate from this Taylor rule has fallen about 20bp since the Fed last updated their dots in June.
Does the easing in financial conditions alter this story? In previous work, we constructed an FCI-augmented policy rule to quantify how movements in financial conditions would affect fed funds rate prescriptions from traditional Taylor rules. In that work, we converted the level of our FCI into a fed funds rate equivalent at each point in time, and then incorporated this value into the Taylor rule that
Yellen mentioned.
According to this FCI-augmented Taylor rule, loose financial conditions in recent months have consistently added between 30 and 50bp to the typical Taylor rule prescriptions (Figure 3).

Nevertheless, the FCI-augmented Taylor rule has also fallen considerably. After peaking at around 2.25% in February 2017, with core PCE inflation near 1.9% and the Laubach-William’s measure of r-star around +0.1%, the FCI-augmented Taylor rule has fallen nearly 60bp to 1.69%. It has also fallen by about 5bp since the Fed last updated their rate expectations at the June FOMC meeting. In other words, loose financial conditions are only able to partially offset the decline in the fed funds rate predicted by traditional Taylor rules.
Do Fed officials care about financial conditions?
There is correctly some skepticism about how important financial conditions are for the Fed outlook. Some officials, such as NY Fed President Dudley, clearly put meaningful weight on financial conditions. But financial conditions are less of a focus for other Fed officials, and in fact, the traditional Fed view has been that financial conditions and financial stability considerations are typically better dealt with via supervision and regulation tools, not monetary policy.
In this context, it is important that the FCI-augmented rule can also be interpreted as capturing a forward-looking element to monetary policy expectations. Financial conditions provide an important signal about economic growth in the upcoming quarters (Figure 4).

In turn, FCIs provide information about future developments in the Fed’s dual mandate – full employment and 2% inflation. Fed officials that are less inclined to place significant weight on financial conditions may therefore still want to consider the impact of financial conditions on growth, the labor market, and inflation when setting their expectations for rate increases in the coming quarters. That is, current loose financial conditions can provide some support for a view that growth will remain solid, the labor market will continue to tighten, and inflation should rise from current low levels.
Financial conditions alone unlikely to save the dots
Recent soft inflation prints have been a critical driver of the decline in Taylor rule predictions for the fed funds rate. As such, a rebound in the inflation  trend in upcoming months would produce a meaningful increase in rule-based prescriptions. This Thursday’s US CPI print could also be critical for the September dots. A stronger print that is in line with our expectations and consensus, could give the Fed some confidence in their central narrative that inflation should rebound and return towards the Fed’s 2% objective after recent weakness.
We will detail our expectations for the dots more precisely in a September FOMC preview note later this week. But while loose financial conditions are likely to help keep rate hike expectations stable for some key Fed officials, like Dudley, the conclusion from our analysis here is that financial conditions alone are unlikely to be enough to save at least some Fed dots from falling." - source Deutsche Bank
US CPI came out at 0.4% month-on-month and 1.9% year-on-year, which was above expectations of 1.80%. It's too early to expect a rebound inflation towards the Fed's 2% target we think. On that point we disagree with Deutsche Bank. Deutsche Bank in their Japan Economics Weekly note from the 25th of August entitled "The decline in labor share touched a very important point relative to our Norwegian Blue parrot aka the Phillips Curve when it comes to wages and productivity relative to the end of an economic expansion:
"Financial markets think that a strong economy tightens the labor market, driving wages up, but people who are hired closer to the end of an economic expansion phase have lower productivity and are hence paid lower wages. Thus, the preconception that the rise in per-capita wages accelerates in an economic expansion is doubtful." - source Deutsche Bank
This is exactly what we have been saying when discussing recently the Phillips curve, the deflationary bias of capitalism and the Experience Curve. As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations.

Also, when it comes to including Financial Conditions in the Taylor rules, this is a subject we discussed in our conversation "An Extraordinary Dislocation" given we would prefer the Fed used a Wicksellian Differential:
"Before we start our usual Macro and Credit musing we would like as a reminder to discuss Wicksell Differential and the credit cycle (linked to the leverage cycle). Wicksell argued in his 1898 book Interest and Prices that the equilibrium of a credit economy could be ascertained by comparing the money rate of interest to the natural rate of interest.  This simply equates to comparing the cost of capital with the return on capital. In economies where the natural rate is higher than the money rate, credit growth will drive a positive disequilibrium in an economy. When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers. At the Bank for International Settlements since 1987, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
So when we hear Janet Yellen at the Fed saying the following:
  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
We reminded ourselves that Wicksell used just the housing sector to illustrate his theory. Excess lending dear Mrs Yellen, always lead to "overinvestment". Just because the Taylor Rule used by the Fed doesn't include asset prices, it doesn't mean in our book that asset values are not out of line of historical norms
Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge)." - source Macronomics, October 2016
Of course the Wicksellian Differential is an ex-post measure, so, it isn't that helpful for investors as a predictor (or the Fed but still better than a crude Taylor rule).

The leverage ratio and the rate of profit or changes in general price level or output per worker are much better factors to take into account for designing a predictive tool. We also pointed out in our previous conversation the importance of the Fed's quarterly Senior Loan Officer Opinion Surveys (SLOOs) in terms of credit impulse and credit availability guides for the US credit markets. As we pointed out last week, we do monitor as well the shape of the High Yield credit curve through its proxy the CDX High Yield CDS index. We also look at the ability of the CCC rated US High Yield segment's ability in tapping the credit markets as a sign of tightening financial conditions:

- source Bank of America Merrill Lynch

Overall the market is pretty much open still for the CCC rating bucket (the Energy sector and Healthcare being the most prominent sectors in the US), yet for the last 12 months, the trend of the market has been somewhat a tad tighter as per the above graph.

What is of interest to us is the importance of comparing the cost of capital with the return on capital from a Wicksellian Differential perspective hence the importance of tracking the evolution of the cost of capital as pointed out by Wells Fargo in their Interest Rate Weekly note from the 13th of September entitled "Evolution of the Cost of Capital Over the Business Cycle":
"Equity capital is one factor in financing economic growth and yet the cost of equity capital varies over the business cycle.
Top Line Growth: The Reward for Capital Investment
Nominal GDP growth provides a starting point to judge the top-line growth opportunities for business and thereby a measure of incentives to balance against the cost of capital.
As illustrated in the below graph, nominal GDP growth provides evidence of a linear downward trend over time.

This downward trend in growth signals that nominal GDP growth is not a mean-reverting series. This observation stands against the claim that somehow nominal growth and capital returns will come back to some average value over time.
The Price-Earnings Ratio: Another Non Mean Reverting Series
Commentators frequently argue that equity price-earnings ratios are either above or below some average value and that this difference indicates the equity market is under or overvalued. However, as illustrated by the below graph, an average value can be calculated for any time series, but that does not indicate that the behavior of that series will return to some average value. Mean-reverting behavior for a series cannot simply be assumed. 

In fact, the P/E ratio is not mean reverting. There have been significant shifts in the series in October 1987 (downward) and in October 1991 (upward) and then down again in July 2002. In fact, the P/E ratio is dependent on the behavior of several economic fundamentals such as expected nominal growth and interest rate polices as well as regulatory changes and exogenous shocks that alter the risk/reward calculus. The P/E ratio is not independent of the economic cycle and, instead, a product of the many forces of the economic cycle.
CAPE Ratio: Another Product of Economic Fundamentals
Cyclically adjusted price/earnings (CAPE) is another measure to judge the pattern of equity finance costs relative to a recent past (bottom graph). This series, as well as the P/E ratio itself, is subject to many exogenous forces that result in a pattern of behavior that reflects the influence of economic, political and regulatory forces.
The CAPE ratio is not mean-reverting, thus there is no single number that is the standard of value. Second, the CAPE ratio is subject to several shocks that shift the behavior of the series (Sep. 2001, Oct. 2008, Nov. 1998) such that the ability to judge the cost of equity finance relative to the recent past will have to adjust to the many structural shifts in the CAPE series.

Since the 1970s, the CAPE ratio does evidence peaks prior to a recession but the series also provides evidence of declines such that the CAPE ratio does not appear to provide a reliable leading indicator. Instead, the CAPE ratio itself is an endogenous part of the economic cycle and is a function of ongoing changes in economic activity as the business cycle matures." - source Wells Fargo
Of course there have been so many articles relating to lofty valuations in many various asset classes from the usual perma-bear crowd, which will be right in the end. But, what matters we think, is the potential change in the central banking narrative. For us, as we pointed out in various musings, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. This would create the necessary conditions for a change in the direction of markets. In our recent musings, we pointed out that in the on-going credit "Goldilocks" scenario, already expensive asset classes would become even more expensive, going to 11 that is, in true Spinal Tap fashion.

On another note, whereas the first part of the year saw a significant rally in Emerging Markets equities thanks to  US dollar woes and our correct January call, we are wondering if indeed the US dollar is not due for a bounce, should some tax reforms be passed by the US administration.

When it comes to credit and the lowering of quality we have witnessed in US Investment Grade, leverage in recent years has been going up thanks to buybacks and M&A. As of late there seems to be a pause at this stage, which is "credit friendly".

  • Credit - US Investment Grade - putting the brakes on leverage

The latest rafts of earnings report, in conjunction with the SLOOs we mention, have shown us that Financial Conditions are still loose. Richer equity valuations have somewhat dampened the appetite of CFOs in pursuing buybacks as well as M&A for the time being. When it comes to the current stability of credit spreads, this is a welcome respite given leverage is higher in the US than in Europe as indicated by Société Générale in their Market Wrap-up note from the 29th of August entitled "Where US leverage is rising the most":
"US balance-sheet leverage has risen
Chart 1 shows the change in US debt/equity. The weighted average is shown in blue; the median is shown in brown. Both have risen since around 2013, and while the weighted average is not quite back to 2002/3 levels, the median is within a whisker of these points.
How did we get here? Chart 2 shows the breakdown of the median leverage numbers by industry. Two sectors – Real Estate and Utilities – have seen only modest increases. Other sectors have risen more sharply, and the biggest rise has been in Mining & Energy, still the sector with the lowest overall leverage.

US income-sheet leverage has also risen 
Chart 3 shows the weighted average of US net debt/EBITDA;

Chart 4 shows the median level. Of the two, Chart 4 is more worrying.

The weighted average level of income-sheet leverage is nowhere near the 2001 peak (let alone the late-2008 peak) and has been declining since early 2016. The median figure keeps climbing and is now close to the 2002 peak.
Looking at net debt/EBITDA by sector confirms the concerns with the median figures. Chart 5 shows that leverage has dropped slightly in the Mining & Energy sector but continues to rise in the Consumer and Industrials sectors, while Telco leverage has been flat.

The Consumer and Industrial sectors are among the most cyclical in the index, so if the economy turns down and EBITDA starts to decline, we should expect these leverage ratios to jump much more sharply.
Income-statement leverage has also been rising in the Real Estate and Utilities sectors, which we show separately in Chart 6 to make both charts more legible. 
US cash-flow leverage is up as well
Finally, we turn to interest coverage, our cash-flow leverage indicator. Charts 6 and 7 show the weighted average and median levels of the indicator across the IG and HY universes.

Net interest coverage, which we plot in reverse to make these charts comparable to the preceding ones, has been falling, but this fall has stabilised on an average basis and is declining in median terms. This is comforting, but remember that interest coverage is probably going to be the last leverage indicator to flash warning signs.
It’s worth noting moreover that the worsening in interest cover since 2010 has largely been limited to two sectors – Mining and Real Estate. In addition, real estate interest coverage remains high in absolute terms:
Conclusion: reasons to worry about the cyclicals 
What should we conclude from these numbers? Balance-sheet leverage and income-sheet leverage are both near the top of their historical ranges, so both are giving warning signals. A drop in EBITDA and net income would lead to historical highs both in income and cash leverage. This, combined with relatively tight spreads, should make investors more defensive on the US credit market.
The sectors where we are most wary are first Mining & Energy and second the Consumer and Industrial sectors. The problems of the Mining & Energy sector are well known; by contrast the cyclical Consumer and Industrial sectors are probably more vulnerable than investors realise. Telecoms are also showing higher leverage and could be challenged if interest rates rise and refinancing conditions become more difficult. The most defensive sector is certainly Utilities, with Real Estate fairly defensive too in comparison to historical leverage levels." - source Société Générale
As we are slowly but surely moving towards the end of this long credit cycle, we do agree that it is time to start building up defenses and move up the quality ladder, yet there is no denying that we are currently seeing some respite not only through better SLOOs but also with CFOs tempering their appetite for increasing leverage in the US as indicated by Bank of America Merrill Lynch Situation Room note from the 13th of September entitled "Spending less on stocks":
"Spending less on stocks
With even the late reporters 2Q results in by now, data from US non-financial high grade issuer cash flow statements shows that companies have again reduced spending on both share buybacks and acquisitions during the quarter (Figure 1, Figure 2).

This spending has been trending down as a share of free cash flow as well (Figure 3).

The decline is notable because buying your own or other company equity is typically the biggest drivers of leverage for the high grade market (Figure 4).

The reason for the decline is likely a combination of richer equity valuations as well as better growth globally that allows companies to deliver EPS growth without resorting to financial engineering. Finally, robust supply volumes in the first half despite decelerating cash needs supports our view that issuance was front-loaded this year.
Aggregate data for our universe of high grade issuers shows expenditure on net share buybacks declining from $84bn in 4Q-16 to $73bn in 1Q and $64bn in 2Q. Similarly spending on acquisitions fell from $99bn in 4Q-16 to $72bn in 1Q and $62bn in 2Q." - source Bank of America Merrill Lynch.
Although this is a welcome respite, US Investment Grade spreads benefit from a bigger interest rate buffer than European Investment Grade spreads, so if and when the ECB decides to taper its purchases the impact will be different. But, given the cyclical exposure to US Investment Grade, slower growth would probably have a more meaningful impact in the US thanks to the leverage difference. We might not be heading for the bunker yet and don a kevlar helmet, but, we are keeping a close eye on 2018 for potential signs of exhaustion in the credit and business cycle.

  • Final chart - The only easy day was yesterday
Whereas Financial Conditions matter for Taylor rules as per our macro bullet point, it remains to be seen how accommodative the Fed is going to be at its next FOMC meeting, whether it will keep a somewhat dovish stance or adopt a more hawkish tone, relative to its worries about Financial Stability, meaning they would start indicating they are about to drain some alcohol out of the credit punch bowl they have been serving for so many years. After all, in our book the Fed is the "credit cycle". Our final chart comes from Bank of America Merrill Lynch and displays the National Financial Conditions Index from the Chicago Fed, as goes the saying, the only easy day was yesterday, for tomorrow, we are not too sure:
"The best high level metric that reflects these benign conditions is the Chicago Fed’s National Financial Conditions Index seen in Chart 3. It’s tightened ever-so-modestly in the past month, going from -0.88 to -0.85. But the long term perspective shows that we are still in record territory as far as easy financial conditions. A slightly lower level of - 0.898 was observed in June 2014, but we have to go all the way back to August 1993 to the all-time low of -1.0 – not very far from where we are today; it was six months later, in early 1994, that a dramatic and disruptive hiking cycle began, but those were different times. Financial conditions don’t really get much easier than they are today.
With that in mind, the question is whether the Fed is ready to shift the framework at next week’s meeting, and deliver a more hawkish message than markets expect. As one gauge of the market’s dovish view of the Fed, there is currently a 53% probability assigned to a December rate hike (up from about 20% a week ago, but still well below 100%), and there is still about a 75 bp spread between what the market thinks for YE 2018 versus the Fed’s last dot plot. As we noted last week, this disconnect seems to represent a source of near-term risk for securitized products spreads; it’s the #1 reason we think spreads are more likely to widen than tighten in September-October. With financial conditions as easy as they are, and with a 10yr breakeven inflation expectation of 1.85% (in other words, pretty close to 2.0%), the Fed seems to have a great opportunity to deliver a hawkish message. Obviously, though, hawkish has not really been the MO for the Yellen Fed, so it seems reasonable to assume a “balanced” outcome is most likely.
If the Fed is dovish next week, securitized products spreads will probably tighten, but modestly. If the Fed confirms the market view, and December hike probability is still at about 50% a week from now, spreads will likely remain range-bound. If the Fed is hawkish, and hike probabilities increase materially, we expect spread widening. We think there is some asymmetry around spread widening potential relative to tightening potential, so we retain our defensive posture for September-October. If it’s a dovish Fed next week, we’ll give up on the defensive posture. If it’s hawkish, and spreads begin to widen, we will eventually look to add on spread weakness. Longer term, for fundamental and technical reasons, we remain constructive on securitized products." - source Bank of America Merrill Lynch
The major big question we have these days is relative to the direction of the dollar. Will it continue to "break bad" or are we due for some important rebound which would have implications for the rally seen so far this year in Emerging Markets equities? We wonder but, we are not lazy enough to go and steal the moon just yet...

"Don't tell me the moon is shining; show me the glint of light on broken glass." -  Anton Chekhov

Stay tuned ! 

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