Macro and Credit - The Roots of Coincidence

"Coincidence is God's way of remaining anonymous." -  Albert Einstein

Watching the unabated inflows into Investment Grade funds, the 44th in a row, with pundits reaching for quality yield other quantity (High Yield), hence our "Great Rotation" narrative, when it came to selecting our title analogy we reminded ourselves of the 1972 book "The Roots of Coincidence" by Arthur Koestler. In his introductory book to parapsychology, including extrasensory and psychokinesis, Koestler postulates links between modern physics and their interaction with time and paranormal phenomena. His book was influenced by the work of Carl Jung and the concept of "synchronicity" which on a side note gave the title of the fifth and final studio album of English rock band the Police, the band's most successful release (the album Ghost in the Machine was also inspired by another Koestler's book). In his book, Koestler claims that paranormal events could be explained by theoretical physics. According to him, distinct types of coincidence are linked to serendipity aka "luck". You might be wondering already where we are going with this but we find it rather surreal to read the following essay by the New York Fed entitled "The Low Volatility Puzzle: Are Investors Complacent?" on the 13th of November in which the authors discuss the low volatility conundrum without a single time indicating the reason number one of the low volatility regime, namely their main employer and their buddies in other central banks being the main culprits in price manipulation on a grand scale. Overall this is akin to a circular reference pushed towards paroxysm we think, only for them to come to the conclusion in their paper that maybe central banks are responsible, maybe they are not hence our "Roots of Coincidence reference. No offense to the authors of the above Fed of New-York article but the low volatility regime is not a "paranormal phenomena" and the "Roots of Coincidence" has been the action of the central banks acting in "synchronicity". Whenever you have the S&P falling by 1% it seems you immediately get a Fed board member reassuring investors about the "free put" offered to them. The situation is similar in Europe and even worse in Japan where the Bank of Japan (BOJ) has become shareholder "numero uno" of many Japanese large caps via their ETFs guzzling. Maybe we are indeed not that intelligent and we don't really "get it", but when we read articles such as these, we are starting to question ourselves about the sanity of our central planners but we ramble again...

In this week's conversation, we would like to look at "roots of coincidence" in the ongoing "Goldilocks" given observable market conundrums that makes this current low volatility regime "paranormal" and therefore unsustainable.

Synopsis:

• Macro and Credit - The incidence of  central banks' "coincidences"
• Final chart -  Cracks in the credit narrative - are we there yet?

• Macro and Credit - The incidence of  central banks' "coincidences"

Last week we rebuked the "Minsky" moment in the High Yield market but, we did indicate we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. Yet the "roots of coincidence" have solely been based on central banks intervention in "price manipulation" leading to acute financial volatility repression and severe distortions. There is not a single day when there isn't the usual "permabear" pointing out to the severity of the distortion as we wait for that famous "Minsky" moment. To repeat ourselves, in our book, the match that will light the bear market narrative will simply be a significant rise in inflation expectations. We are not there yet. We don't pretend to have extrasensory  powers but we do believe that 2018 could mark the end of Goldilocks and lead to a significant rise in volatility, and we are particularly cautious for the second part of 2018, at least that's what our credit antennas are telling us but we digress. We have continuously been beating the credit drums about switching from quantity (High Yield) towards quality (Investment Grade). We continue to believe that when it comes to credit risk premia when it comes to European High Yield, we think that now there are more risks than rewards (Altice and their SFR woes being a case for caution), particularly when one looks at the flattening of the US Yield curve. Duration wise we'd rather own 5 year US Treasury Notes than an equivalent 5 year European High Yield fund or ETF. Sure, some pundits would probably like to point us towards convexity risk in Investment Grade, at least in the US you have somewhat more of an interest rate buffer than Europe (Veolia latest three year issue at negative yield anyone?). Also we started the year being US Dollar bears, and our contrarian stance has been validated so far regardless of the recent dead cat bounce. We continue to see headwinds for the US dollar even with tax cuts kicking in. This means that we would rather favor EM equities still over US equities in 2018. 

To add more fuel to the "roots of coincidence" relating to the overall complacency in volatility we read with interest Société Générale's take from the Multi Asset Portfolio note from the 28th of November entitled "Be ready for the end of Goldilocks":

"Low volatility and liquidity withdrawal are key concerns

In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the “positive” Trump, investors continue to push asset prices, volatility and leverage to historical extremes. Yet, a low volatility carry environment with rather extreme positioning is a dangerous combination, which we recently likened to dancing on the rim of a volcano. 

Volatility remains low across asset classes, on the verge of further monetary policy normalisation

It is true that volatility is relatively expensive for some asset classes, as realised volatility is now lower than implied volatility. But overall, we still observe low volatility across asset classes. With asset prices reaching record high levels, and pushing volatility down, we as investors run the risk of reliving the parable of the boiling frog: the gradual heating is so comfortable that the frog does not perceive the danger and ends up cooked. It seems that markets for now are unwilling or unable to perceive the gathering threats.

We don’t believe that it is sustainable. Additional rate hikes from the Fed over the next two years in order to reach the 2.8% neutral rate should start putting pressure on the VIX, as has been the case historically, with contagion effects across asset classes.

Liquidity withdrawal will be the main story next year – switch from equities to bonds

Growth in both developed and emerging markets will continue to creep gradually higher, with the US setting the tempo but likely reaching a peak sometime during the course of next year. In this context, we expect the main central banks to further reduce the size of their balance sheets. A direct consequence will be liquidity withdrawal from the financial system, which will put upward pressure on sovereign bonds yields, especially at the back end of the curve through some normalisation of abnormally low term premium. We prefer sovereign bonds to equity, especially in the US.

Indeed, the last 50 years have been characterised by the secular downward trend in developed markets sovereign bond yields, exacerbated by the post-crisis waves of QE. The equity space benefited significantly from the lower interest rate environment, which pushed index prices up, and from the add-on from dividends in a recovering economy while investors searched for yield. Low bond yields pushed investors into riskier asset classes to enhance returns.

Going forward, as UST yields normalise, especially at the back end of the curve (we see 10y USTs reaching 2.80% by 3Q18), the competitive advantage of US equities will start to fade.

Positioning is stretched

Another sign of complacency can be found in positioning. Having a closer look at hedge funds’ net positioning across 24 assets, we try to understand throughout the years – in January of each year – the percentage of assets with extreme positioning. We define extreme positioning as a net position level higher or lower than one standard deviation away from the historical average.

The chart on the following page shows that in January 2017, 54% of hedge funds’ net positioning on the pool of assets under review can be considered extreme (currently at 54.2%). The main culprits are: VIX, as being short VIX future volatility has delivered tremendous return since 2016; US 5y, reflecting the anticipation of further Fed hikes and improved fundamentals; crude oil; and copper. The last time positioning was stretched on such a similar share of the assets under review happened to be in January 2007, or a few months before the global financial crisis.

Low correlation within assets can exacerbate a sell off

The low level of correlation within assets is also worrying in our view. For now, as mentioned previously, the goldilocks environment – lukewarm growth and contained inflation expectations – favours the expression of idiosyncratic risks or fundamentals versus big macro drivers. The average cross asset correlation has been on a downward trend, while the average equity correlation is reaching 20%, near its lows.

The low correlation is good as of now, as it brings some diversification benefit within a multi-asset portfolio – for example, the decorrelation between EM and global equity markets observed last quarter persists and partly justifies our 7% allocation within the multi-asset portfolio, alongside the supportive growth, yield and US dollar outlooks. However, it also gives a false sense of security, as the correlation regime can quickly reverse in case of risk-off events in the markets and exacerbate a market sell-off." - source Société Générale

When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward. 

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game. The "Roots of Coincidence" thanks to our central bankers has led to some markets conundrums as highlighted by Deutsche Bank in their Global Financial Strategy note from the 28th of November entitled "Markets upsets: Rationally explaining five conundrums":

"Five market conundrums

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)

90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.

Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model (see our 7 November Global Financial Strategy, “Rates declining after Lower House election; share prices remain high”). Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3).

At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again (see our 16 November report, “Back to normal? Japanese equities return to model after volatility shock”). Recently volatility decreased, and stocks have begun to diverge upward from our model again.

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)

Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.

Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.

Question 3: Ongoing yield-curve flattening

Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11).

Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.

Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13).

If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.

Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.

Question 4: Ongoing decline in interest-rate and stock-price volatility

As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding.

In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.

In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17).

There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.

Question 5: Ongoing tightening in credit spreads

Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.

The default rate (Figure 30) clearly shows that the corporate credit cycle reversed.

The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end."  -source Deutsche Bank

While financial conditions remain loose as indicated by Deutsche Bank, the hiking path of the Fed is the "Roots of Coincidence" in the start of some tightening of some lending standards. The question in relation to the change of the narrative is how long until the Fed breaks something? We wonder. Also, there is a heightened probability that the Fed finds itself once more behind the curve should renewed inflationary expectations materialize in 2018. It's not only the Fed which is in a bind of its own, the ECB should be worried from the heat coming from Germany and it's not only in real estate...

Credit wise for 2018 low spreads means potential negative excess returns in 2018 at least for European High Yield, making it particularly vulnerable to exogenous factors of the geopolitical type. There is no "Roots of Coincidence" once you reach the lower bound in credit spreads in the "beta" game, yet rising dispersion means better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversation, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. This is also indicated by Société Générale in their Credit Strategy Outlook for 2018 published on the 28th of November and entitled "The sword of Damocles unsheathed":

"Markets follow a predictable pattern in the relationship between dispersion (alpha risk) and direction (beta risk) as summed up Table 8 below.

We see dispersion rising in 1H 2018. At the beginning, this dispersion is not likely to drive spreads wider as a whole, but soon the market will go from phase 2 to Phase 3, with higher dispersion pulling spreads as a whole wider too." - source Société Générale.

There is no "Roots of Coincidence" there, dispersion as we posited last week is indicative of credit cracks in the narrative.

For our final chart, one might wonder what would be a better leading indicator to rising problems in credit markets.

• Final chart -  Cracks in the credit narrative - are we there yet?

So you have tightening credit standards for some segments of US consumer credit, while overall financial conditions remain loose, yet rising dispersion in conjunction with negative basis are a sign that some cracks are starting to show up in the credit narrative making many investor pundits wondering what would be a useful indicator for spotting additional problems coming up. Our final chart is from Société Générale Market Wrap-up note from the 27th of November entitled "The one leverage ratio that tells you when spreads will widen" and displays balance sheet leverage figures as an indicator of rising problems in credit markets:

"While focusing on EBITDA is useful, there is a better leading indicator for problems in credit markets – balance sheet leverage figures such as debt/equity or debt/assets. Chart 5 shows the non-financial debt/assets ratio in the US relative to spreads: the average ratio weighted by the market cap of the debt is shown in blue, the median ratio is shown in brown, and US corporate spreads using the Moody’s series are shown in grey.

"The high levels of leverage in 1999 on a weighted average basis preceded the spread widening in 2001-2002. The rise in leverage from 2005-2007 was a warning ahead of the credit sell-off of 2008. Since 2013, balance sheet leverage has been widening and has continued to rise despite the 2015 spread widening (which has now been fully reversed). Credit investors should focus on this leverage ratio when considering how markets will perform in 2018." - source Société Générale

There you go, no offense to the musings of the New-York Fed and their paranormal questioning relative to the low volatility regime issue, the credit mouse trap has been set by our central planners and they are indeed at the "Roots" of the everything has a low volatility "coincidence". We don't need extrasensory and psychokinesis powers to determine the main culprit we think but we are rambling and ranting again it seems...

"The worst possible turn can not be programmed. It is caused by coincidence." -  Friedrich Durrenmatt

Stay tuned !